A WORLD BANK COUNTRY STUDY 8777 Public Disclosure Authorized FILECOPY Turkey A Strategy for Managing Debt, Borrowings, and Transfers under Macroeconomic Adjustment Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized

A WORLD BANK COUNTRY STUDY

Turkey A Strategy for Managing Debt, Borrowings, and Transfers under Macroeconomic Adjustment

The World Bank Washington, D.C. Copyright © 1990 The International Bank for Reconstruction and Development/THE WORLD BANK 1818 H Street, N.W. Washington, D.C. 20433,U.S.A.

All rights reserved Manufactured in the United States of America First printing June 1990

World Bank Country Studies are among the many reports originally prepared for internal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governments. Some of the reports are published in this series with the least possible delay for the use of governments and the academic, business and financial, and development communities. The typescript of this paper therefore has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use. Any maps that accompany the text have been prepared solely for the convenience of readers; the designations and presentation of material in them do not imply the expression of any opinion whatsoever on the part of the World Bank, its affiliates, or its Board or member countries concerning the legal status of any country, territory, city, or area or of the authorities thereof or concerning the delimitation of its boundaries or its national affiliation. The material in this publication is copyrighted. Requests for permrissionto reproduce portions of it should be sent to Director, Publications Department, at the address shown in the copyright notice above. The World Bank encourages dissemination of its work and will normally give permission promptly and, when the reproduction is for noncommercial purposes, without asking a fee. Permission to photocopy portions for classroom use is not required, though notification of such use having been made will be appreciated. The complete backlist of publications from the World Bank is shown in the annual Index of Publications,which contains an alphabetical title list (with full ordering information) and indexes of subjects, authors, and countries and regions. The latest edition is available free of charge from the Publications Sales Unit, Department F, The World Bank, 1818H Street, N.W., Washington, D.C. 20433,U.S.A., or from Publications, The World Bank, 66, avenue d'Iena, 75116Paris, France.

ISSN: 0253-2123

Library of Congress Cataloging-in-PublicationData Turkey: a strategy for managing debt, borrowings, and transfers under macroeconomic adjustment. p. cm. -- (The World Bank country study) ISBN 0-8213-1594-3 1. Debt relief--Turkey. 2. Debts, External--Turkey. 3. Debts, Public--Turkey. 4. Fiscal policy--Turkey. I. International Bank for Reconstruction and Development. II. Series. HJ8770.7.T87 1990 336.3'4'09561--dc2O 90-38838 CIP ABSTRACT

Developing countries facing a debt burden have had to cope with issues of both external and internal adjustment. This study on Turkey examines both external and domestic debt aspects in the context of a macroeconomic adjustment effort that started nearly ten years ago. The study analyzes how Turkey, after undergoing a major rescheduling in 1978-82, has been able to re-establish market access and to obtain significant amounts of voluntary new money from international commercial sources, a feat which few developing countries outside of Asia have achieved. It is a task that other countries will face over the coming years. How Turkey was able to sequence this and to penetrate various markets is a subject of broad interest. The study also analyzes institutional questions and issues of liability management, again topics germane to other countries.

Overall, the study analyzes the transfer Problem in Turkey -- the external transfer that needs to be made to foreign creditors and the necessary "internal transfer" from the private to the public sector. The internal transfer problem arises because most of the external debt is held in the public sector, which therefore needs to service the debt. In order to do so, the public sector has been resorting to domestic finance, which in turn complicates the task of domestic adjustment, specifically the level of real interest rates, inflationary finance, and savings and investment levels. In order to sustain the external transfer, the public sector will increasingly be called on to generate additional resources to reduce the burden on the private sector.

ACKNOWLEDGEMENTS

This report is based on the findings of two Bank missions that visited Turkey in December 1988 and September 1989. The report was discussed with the Government of Turkey during the latter visit. The missions consisted of Messrs. Jeffrey Balkind (EMlCO, mission leader), Gunnar Eskeland (CECPE), Alfredo Thorne (EMTTF), Stijn Claessens, Ishac Diwan (IECDI), and Dennis Flannery (CFSFA). Ms. Barbara Mondestin (EMlCO) assisted in preparation of the report. Ms. Aysel Basci (IECDI) assisted in the external debt strategy module and scenarios.

The authors of the report are Jeffrey Balkind, Stijn Claessens, Ishac Diwan, Gunnar Eskeland and Alfredo Thorne.

Messrs. Parvez Hasan (Chief Economist, EMENA) and William McCleary (Lead Economist, EMI) participated in the report discussions in Ankara in September 1989.

The mission wishes to thank the authorities in the Undersecretariat of Treasury and Foreign Trade, the State Planning Organization, and the Central Bank of Turkey for their detailed collaboration in this study, as well as the staff of the World Bank Resident Mission in Ankara for their valuable support.

The efforts of all those who participated in this study are deeply appreciated. The report was edited by Bruce Ross-Larson and Robin Gaster.

- iii - CURRENCY EOUIVALENT (Period Averages)

Turkish Lira per US$1.00

1980 76.04 1981 111.22 1982 162.55 1983 225.46 1984 366.68 1985 521.98 1986 647.51 1987 857.20 1988 1,421.00 1989 (December) 2,350.00

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS

CB - Central Bank of Turkey EBC - External Borrowings Committee EBF - Extrabudgetary Fund EER - Effective Exchange Rate ELF - Exchangeable Loan Facility FMS - Foreign Military Sales JLTPR - Japanese Long-Term Prime Rate LIBOR - London Interbank Offer Rate MIMCs - Moderately Indebted Middle-Income Countries NICA - Non-Interest Current Account NPR - Nominal Protection Rate PPF - Public Participation Fund PSBR - Public Sector Borrowing Requirement REPO - Repurchase Agreement SEE - State Economic Enterprise SIMCs - Severely Indebted Middle-Income Countries SIS - State Institute of Statistics SPO - State Planning Organization VAT - Value Added Tax

- iv - Table of Contents

Page No.

INTRODUCTION xi

EXECUTIVE SUMMARY (xv - xxviii)

PART I: THE EXTERNALTRANSFER

Chapter I: The Need for an Increased External Transfer ... 1....

A. Introduction: The External Transfer Problem ...... 1 B. Current Account Developments ...... 3 C. Sustaining Growth in Transfer Capacity: Private and Public Investment ...... 11 D. Current Account Scenarios ...... 15

ChaRter II: Structure and Growth of External Debt ...... 24

A. Background ...... 24 B. External Debt Structure in 1988 ...... 24 C. Creditworthiness and Debt Ratios Analysis ...... 31 D. Future Outlook ...... 34 E. Conclusions ...... 37

Chapter III: Financing Plan and External Borrowing: A View of the Future ...... 38

A. Background ...... 38 B. Financing Plan ...... 38 C. New External Borrowings: Sources, Terms and Costs .... 44 D. Diversification of Sources and Instruments ...... 52 E. Syndicated Bank Lending versus Bond Issues ...... 53 F. Conclusions ...... 58

Chanter IV: Managing External Risks ...... 59

A. Currency Composition ...... 59 A.I. Analysis ...... 59 A.2. Conclusions ...... 66 B. Interest Exposure of External Liabilities ...... 67 B.1. Analysis ...... 67 B.2. Conclusions ...... 69 C. Recommendations for Implementing External Liabilities Management ...... 70

PART II: THE INTERNAL TRANSFER

Chapter V: Public Debt and Fiscal Deficits ...... 76

A. Background ...... 76 B. Structure of Domestic Debt ...... 76 C. Public Sector Deficits and Financing ...... 81 D. Conclusions ...... 90

- v - - vi -

Chapter VI: The Internal Transfer Problem ...... 91

A. Background ...... 91 B. Resource Transfer Between the Public and Private Sectors ...... 91 C. Implications for the Financial Sector ...... 96 D. Conclusions ...... 110

PART III: THE ROAD AHEAD

ChaRter VII: Institutional Setup for Managing Debt and Borrowings 112

A. Overall Structure ...... 112 B. The Management of Borrowings and Control of Debt ...... 112 C. Status of Data-Debt Management ...... 114 D. Coordination and Overall Management of the Process ...... 116 E. Recommendations on External Debt Management ...... 118 F. Institutional Aspects of Domestic Debt Management: An Agenda for Further Analysis ...... 120

Chapter VIII: Strategic Considerations and Suggestions ...... 122

A. Turkey's Macroeconomic Program and Realism of its Debt Strategy ...... 122 B. Vulnerability to External Shocks ...... 125 C. Effectiveness of Debt Management ...... 127 D. Domestic Debt ...... 128 E. Access to Various Markets ...... 128 F. Additional Measures ...... 130

LIST OF ANNEXES

Annex 1 Current Account Scenarios 132 Attachment I Debt Strategy Module 135 Annex 2.1 Turkey: Selected External Debt Indicators and 1980-88 142 Annex 2.2 High Case Financing Requirements, 1987-93 143 Annex 2.3 Mid-Case Financing Requirements, 1987-93 144 Annex 2.4 Low-Case Financing Requirements, 1987-93 145 Annex 3.1 External Financing Requirements, 1984-89 147 Annex 3.2 Public Sector External Borrowings in 1988 148 Annex 3.3 OECD Commitments to Turkey, 1979-88, By Country 151 Annex 4 An Illustration of the Cost of Swaps 152 Annex 5 A Technical Note on the Estimation of Public Sector Deficits 153 Annex 6 Demand for Assets in Turkey 173 Annex 7 Organizational Structure of the Undersecretariat of Treasury 181 and Foreign Trade

Map: - vii -

LIST OF TEXT TABLES AND FIGURES

Table/Figure No. Page No.

Chapter I: The Need for an Increased External Transfer 1......

Table 1.1 Current Account - Summary Presentations, 1983-1988 .. 3 1.2 Sectoral GDP Growth, 1983-1988 ...... 5 1.3 Sectoral GDP Deflators, 1983-1988 ...... 6 1.4 Commodity Composition of Exports, 1987-1988 ...... 7 1.5 Consumer Prices Indices, 1983-1988 ...... 8 1.6 Commodity Composition of Imports, 1987-1988 ...... 9 1.7 Gross Fixed Investment ...... 13 1.8 Current Account Scenario, 1989-1993 - High Case ..... 22 1.9 Current Account Scenario, 1989-1993 - Mid Case ...... 22 1.10 Current Account Scenario, 1989-1993 - Low Case ...... 23 1.11 Current Account Scenario, 1989-1993 - Plan Case ..... 23

Figure 1.1 Current Account and Transfer Abroad ...... 2 1.2 Fixed Investments - Public and Private as Shares of GNP 12

Chapter II: Structure and Growth of External Debt ...... 24

Table 2.1 External Debt Outstanding by Creditor Type ...... 25 2.2 Net Flows by Creditor Type ...... 26 2.3 Shares of Total Credit and Terms on New Loans by Credit Type ...... 27 2.4 Shares of Public/Private Sector External Debt ...... 29 2.5 Dresdner Accounts ...... 30 2.6 Debt Ratios ...... 32 2.7 International Comparison ...... 33 2.8 Simulation 1: High Case Scenario ...... 36 2.9 Simulation 2: Low Case Scenario ...... 37

Chapter III: Financing Plan and New Borrowings ...... 38

Table 3.1 External Financing Requirements and Sources ...... 42 3.2 Turkey Public Sector External Borrowings in 1989 .... 45 3.3 Turkey's 1988 and 1989 Borrowings by Currency Distribution 50 3.4 Turkish Bonds Issued in West Germany ...... 54 3.5 Turkey's Eurodollar Borrowings ...... 56

Figure 3.1 Financing Decision Tree ...... 39

Chapter IV: Managing External Risks ...... 59

Table 4.1 Currency Composition of Short-, Medium- and Long-Term External Debt as of August 1988 ...... 60 4.1a Contracted Medium- and Long-Term Borrowings During 1987-1988 ...... 60 4.2 Net Trade Plus Other Goods and Services, Excluding Interest Payments ...... 64 4.3 Currency Composition of Net Income and Expenditure of the Central Bank and Commercial Banks ...... 65 4.4 Correlations of Exports, Imports, Non-Interest Current Account and Current Account with USDollars--LIBOR .. 69 - viii -

Chapter V: Public Debt and Fiscal Deficits ...... 76

Table 5.1 Domestic Public Debt Outstanding as Reported by Treasury 77 5.2 Structure of Public Sector Debt ...... 79 5.3 Below-the-Line Consolidated PSBR Estimates ...... 82 5.4 Above-the-Line Consolidated PSBR Estimates ...... 83 5.5 Real Consolidated Public-Sector Deficit ...... 86 5.6 Breakdown of Adjusted Money Finance ...... 88

Figure 5.1 Composition of Stock of External Debt ...... 80

Figure 5.2 Share of Foreign and Domestic Finance ...... 87

Chapter VI: The Internal Transfer Problem ...... 91

Table 6.1 Real Net Savings ...... 92 6.2 Pressure of Consolidated Public Sector Deficit on the Domestic Financial Market ...... 97 6.3 Consolidated Banking Sector Balance Sheet, 1983-1988 100 6.4 Alternative Short-Term Investment Opportunities for Large Depositors ...... 110

Fiju e 6.1 Net Real Savings Composition ...... 93 6.2 Ratio of Principal and Interest to New Borrowings ..... 99 6.3 6M Deposit, and Bill Rates in TL and US ...... 102 6.4 Lending Interest Rates in TL and US ...... 102 6.5 Interbank Foreign Exchange Rates ...... 105 6.6 Overnight Nominal Interest Rates ...... 105 6.7 Deposits, Bonds and Bill Rates in TL ...... 106 6.8 Lending and Deposit Rates in TL ...... 106 6.9 Bank's Average Real Spread (No Non-Performing Loans) 107 6.10 Proportion of Banks Gross Spread Taxed (zero non-performing assets) ...... 107 6.11 Proportion of Banks Gross Spread Taxed (different non-performing assets) ...... 108

Chapter VII: Institutional Setup for Managing Debt and Borrowings . 112

Firure 7.1 Turkey External Debt Management and Borrowings System . 119

Chapter VIII: Strategic Considerations and Suggestions ...... 122

Table 8.1 Impact of Alternative Oil Prices on the Current Account 126 - ix -

LIST OF BOXES

1.1 Management of Uncertaintities and Financing of the Current Account ...... 15

2.1 Where Does Turkey Stand on the Debt Front? ...... 34

3.1 Where Do Borrowings Come From and Where Do They Go? ...... 40

3.2 Turkish Bonds Issued in West Germany ...... 55

3.3 Eurodollar Borrowings Since December 1988 ...... 56

4.1 Criteria for Active Currency Composition Management ...... 61

4.2 Criteria for Interest Rate Management ...... 67

7.1 Organizing the Management of Debt ...... 113

8.1 Turkey's Strategy ...... 122

8.2 Relevance to Debt Reduction ...... 124

INTRODUCTION

1. This report is the third in a series that have tackled the central question facing Turkey's economy: how to overcome a high debt burden, while at the same time pursuing programs of stabilization, adjustment and growth. Few countries have been able to balance these daunting (and at times competing) goals. After eight years of an economic reform program that has been largely successful, although some major problems persist, such as inflation, Turkey is on the way to overcoming its debt burden. The External Debt, Fiscal Policy and Sustainable

Growth Report, (hereinafter referred to as the "Fiscal Policy Report") t/ (No. 7162-TU) dated September 9, 1988, analyzed how output growth can be maintained while exercising prudent creditworthiness criteria. The report demonstrated how fiscal policy can play an important role in reconciling external economic targets with internal balances. Of importance to the current exercise, the Fiscal Policy Report argued against applying excessive external restraint (i.e. against aiming at too sharp a reduction of the growth rate and against too rapid a lowering of the current account deficit). Rather, it stressed the need for substantial fiscal adjustment, in order to reduce inflation and to achieve a consistent macroeconomic framework over the medium term.

2 2. The Country Economic Memorandum (Report No. 7378-TU)t/ dated October 12, 1988 analyzed economic developments of 1987-88 within a medium term economic framework that envisaged sustainable growth, fiscal improvements, and inflation reduction. That report, too, stressed the need for the Government to reduce the fiscal deficit and to consolidate its successful performance on the external sector. Both reports were discussed with the authorities, who agreed with the Bank's concerns and analyses. Throughout this period, the Government and the Bank increased their dialogue on both short-run and medium- term issues, as Turkey strived to reinforce the stabilization program.

3. Debt problems cannot be viewed only from an external or internal angle. Thus, the current report looks at Turkey's total debt -- external and domestic public debt -- in order to develop the linkages between the two and to obtain a closer reading of the likelihood that Turkey will work its way out of these combined problems. While the report is organized into three parts -- external transfer, internal transfer and future outlook -- the issues are part and parcel of the broader issue of the viability and sustainability of current economic policies in Turkey. The structure of the report is depicted in the following diagram:

I These two reports are internal, unpublished documents of the World Bank.

- xi - KEYTHEME: THE TRANSFERPROBLEM AS THEMEANS TO WORKINGONE'S WAY OUTOF DEBT

A. EXTERNALTRANSFER B. INTERNALTRANSFER

Chapter 1: MacroDimensions ' Chapter5: PublicDebt and (Currentand CapitalAccounts FiscalDeficits Analysis;Investment in Tradeables)

Chapter2: ExternalDebt Structure ChapterSector6: Implications(Net Private for theand FinancialNet and ComparativeAnalysis PublicSavings Analysis)

Chapter3: ExternalBorrowings :

Chapter4: ManagingExtemal Risks. (Currency,Interest Exposure and Trade Flows)

I C. THE ROADAHEAD 4

Chapter7: InstitutionalAspects

Chapter8: Turkey'sProspects for OvercomingIts High Debt

ksr/w44776a - xiii -

4. As shown in the diagram, Chapter 1 of the report examines the key macro aspects that will determine the extent of Turkey's borrowings and debt service in the future. Specifically, this involves analysing the external transfer through the current account and examining the relationship to the capital account. An important element in the foreign transfer picture is the degree to which Turkey will be able to continue its export drive, which in turn depends on investment and output in the tradeable, as distinct from the non- tradeable sector. Essentially, the chapter is examining the first of the "two gaps" often discussed in the economic literature -- the trade gap (Part II of the report covers the second gap).

5. Chapter 2 analyzes the structure of Turkey's external debt, using the key ratios for past and projected debt, and it compares these to the ratios of several other countries. The dynamics of the debt hump is examined and several important conclusions are drawn.

6. Chapter 3 analyzes how Turkey sets its financing plan and borrowing targets, and how it accesses external markets to achieve the planned borrowings (and specifically which borrowings), as well as the supply constraints of various financing instruments in foreign capital markets.

7. Chapter 4 examines questions concerning the optimal mix of currencies in Turkey's external debt stock (assessing these against indicators such as the distribution of Turkey's trade). The chapter also analyzes the appropriate mix of interest rate exposure (floating rate debt versus fixed rate debt) for Turkey. The chapter draws some important conclusions regarding how Turkey can better protect itself from both currency swings and interest rate movements. Finally, the chapter sets out some criteria by which Turkey could manage its liabilities more actively in future and the prerequisites to achieve this.

8. Part II of the report examines internal transfer issues, by looking at net savings (investment minus savings gap), which is the mirror image of the trade gap analyzed in the first part of the report. Chapter 5 looks at fiscal deficits and their financing, while Chapter 6 assesses the impact on the domestic financial sector by looking at the structure of domestic public debt and the financing pressures implied by the fiscal imbalances. The chapters use the methodology of the real fiscal deficit, and looks at what is sometimes referred to as the third gap -- the fiscal gap -- in order to assess economic sustainability in the medium term.

9. Part III of the report looks at the overall system and process for debt management (Chapter 7), that exists within the Government agencies and makes some suggestions for change in order to tighten up the control process and to achieve greater efficiencies between debt management, borrowings orchestration and assets/liabilities control. The policy role of the External Borrowings Committee is considered and several suggestions are made for intensification of its functions. Aspects of domestic debt management are also discussed briefly.

10. The final chapter takes stock of where Turkey stands today in regard to both foreign and domestic debt questions, as well as in relation to its economic adjustment program. A number of strategic questions are posed and - xiv - various suggestionsare made for the Government'sconsideration. The purpose is not to provide a blueprint -- indeed in a rapidly evolving world with many interdependenciesbetween domestic and foreign markets and between economic and financial issues, it is more important to develop flexible criteria by which the Government can continue to refine its own strategy. It is essential that any strategy be sufficientlyrobust to enable Turkey to weather both good and difficult times, so that a consistentmedium term course can be maintained. EXECUTIVE SUMMARY

Background

1. Whether a country, once having been confrontedby a major debt crisis, can effectively work itself out of the consequencesof such a situation is a matter that remains largely unproven. Turkey is one of a half dozen countries, at most, that are on the path to achieving this, but the journey is far from complete. The next two years will be crucial for Turkey, during which it will be facing an unprecedented amount of debt amortization, largely to the OECD countries, while at the same time it will continue to address its domestic economic problems -- particularly the fiscal deficit and inflation.

2. The extent of a country'sability to work its way out of a debt problem is essentially a macroeconomicquestion. Financing techniques,comprehensive and sound borrowing programs, and risk-hedgingmeasures can all help, but are secondary to the question of whether a country has the appropriate macro framework in place to produce the external transfer needed. Thus, this report assessesTurkey's macro framework,concentrating on those aspects germaneto debt questions. The report provides detailed analysison external and domestic debt (in relation to fiscal policy) and extends the work contained in two other Bank reports on Turkey. '/

3. When Turkey experienceddebt service difficultiesin 1978-1982and had to negotiate rescheduling,it was clear that it would face periods of negative net foreign transfers (i.e., having to transfer resources abroad), in contrast to the past period of receiving positive transfers from abroad. It was also clear that Turkey would require some time to work its way out of its macro problems and overcome its debt burden. Turkey's effort to sustain an adjustment program over eight years is well known -- economic growth has been high (an average of over 5 percent per annum during 1983-88),investment and savingshave both risen significantlyas shares of GNP (to around 25 percent) and the current account deficit has fallen by nearly eight percentage points of GNP (from a deficit of 6 percent in 1980 to a surplus of 2 percent of GNP in 1988).

Macro Setting

4. Beginning in mid-1988, a sharp downturn in economic activity dampened Turkey'spreviously overheated economy. The GNP grew by only 3.4 percent in 1988 and is expected to grow by only 1.8 percent in 1989. This compares to growth of 7.4 percent in 1987 and 8.1 percent the year before. Some fiscal improvement was achieved in 1988 -- official estimatesshow that the public sector borrowing requirement(PSBR) declined to 6.4 percent of GNP in 1988, down from 7.8 percent of GNP in 1987 (excludingnet lending). Other measures of fiscal performance also show similar improvement(para. 32). Public investment fell by 3 percent as a result of broad cutbacks in public expenditures. Imports stagnated (1 percent growth)with the sharpestfall observed in the last quarter. However,

1/ External Debt. Fiscal Policy and SustainableGrowth Report (September1988) and Turkey Country Economic Memorandum (CEM), October 1988.

- xv - - xvi - due to booming tourism revenues, terms of trade improvement, and moderate export growth, the current account swung from a deficit of 1.4 percent of GNP in 1987 to a surplus of about 2 percent of GNP in 1988 ($1.5 billion surplus). This outcome took some pressure off the borrowing program, and it allowed the Central Bank to build up reserves and to retire short-term debt. Aided by favorable exchange rate movements between the US dollar and the other currencies prominent in Turkey's external debt stock, Turkey's total debt fell for the first time in many years -- from $40.9 billion in 1987 to $39.1 billion in 1988. Foreign investment more than tripled to $350 million 1988. These factors combined to reduce the external debt to GNP and external debt to export ratios (to 55 percent and 200 percent respectively, compared to 60 percent and nearly 250 percent in 1987).

5. Inflation, as measured by the December-over-December change in the Wholesale Price Index (WPI), rose from 49 percent at the end of 1987 to 70 percent at the end of 1988. This was the first year during the 1980's that a movement in the PSBR was not accompanied by the same directional movement in inflation. Given the leads and lags related to both fiscal and monetary aggregates, a significant drop in inflation has yet to occur. The sharp fall in the economy's growth rate has exerted some downward pressure on inflationary expectations, but not enough to bring about a meaningful decline in such expectations. Inflation currently remains around 70 percent and with signs of economic growth picking up again, the prospects for inflation abatement in the short-term are uncertain.

6. The Government's program for 1989 called for economic growth of 5.0 percent, reduction of inflation to 50 percent by December 1989 (with a GDP deflator of 58 percent), and a PSBR/GNP ratio of 5 percent. The surplus in the current account was expected to decline to $820 million and the external debt stock to remain at around $40 billion. On the fiscal side, the Government program envisaged continued improvement in the fiscal balances of the central government, State Economic Enterprises (SEEs) and extra-budgetary funds (EBFs), recognizing that in 1988 the EBFs, and to a lesser extent the local governments, did not fully achieve their planned improvements. In April 1989 the economic growth estimate for 1989 was lowered (to 3.7 percent) and the PSBR target was lowered to 4.6 percent of GNP. Latest estimates for 1989 indicate economic growth of 1.8 percent, inflation of 70 percent, a PSBR of 5.6 percent and a current account surplus of around $700 million (0.8 percent of GNP) for the year as a whole.

7. The Sixth Five Year Plan (1990-94) contains several important targets that bear upon debt aspects. The Plan envisages an average economic growth of 7 percent per annum, starting with 5.7 percent in 1990 and rising steadily thereafter. Inflation is expected to fall to 13.5 percent by 1994. The current account is expected to be in surplus in all years. The debt to GNP ratio is expected to decline to 25 percent by 1994 and the debt service ratio to improve to 21 percent. Three debt management objectives in the Plan are to increase the share of medium and long-term debt in total debt, to reduce the share of short term debt, and to increase the share of the private sector in foreign financing. - xvii -

PART I: Working One's Way out of Debt -- The External Transfer

8. After emerging from a serious external debt crisis requiring a major rescheduling, Turkey implemented a comprehensive economic reform program, which aimed at reorienting the economy towards market forces and providing an increased role for the private sector. The program emphasized, inter alia, growth in exports and in GNP as means to deal with increasing debt service requirements. Future debt service requirements were on a increasing trend, and adjustment to a reduced trade deficit was required: capital inflow could no longer play the dominant role in supply of foreign exchange. Thus, Turkey faced a classical transfer problem: domestic production would have to increase relative to domestic demand, if a greater surplus of real resources was to be transferred abroad.

9. Turkey's export growth in the past is indeed impressive, averaging 15 percent per annum in the period 1983-1988 in current dollar terms. The corresponding import growth has been 6 percentage points lower, but since the starting point was a substantial trade deficit ($3 billion), these disparate growth rates did not bring down the trade deficit until 1988. Industrial exports provided almost 100 percent of the increased exports during this period. The strong growth of exports in the early 1980s and lately the equally strong growth of tourism have provided the necessary cushion of foreign exchange to service the external debt. Workers' remittances from abroad have generally remained strong as well.

10. A review of the export figures underlines the key role performed by the industrial sector, which grew by more than two percentage points faster than the GNP during 1983-1987. Disaggregated price indices show that a stimulus to increased manufacturing production can indeed be seen in increasing relative prices of manufactured goods. Such an increase in the relative prices of tradeable goods is expected in a country increasing its transfer abroad, since it induces consumers to shift to non-tradeables and producers to shift to tradeables, both of the groups contributing to a larger exportable surplus. The process of changing relative prices has been driven by two mechanisms. The prices of tradeable goods were increased directly, through aggressive real exchange rate depreciations (averaging 5 percent per annum during 1983-1988), and the prices of non-tradeable goods have been compressed through a downward pressure on real wages. In October 1988 the real effective exchange rate began to appreciate as a result of Central Bank intervention and this trend continued in 1989, driven mainly by market forces.

11. Gross fixed investment was significantly stepped up during the 1980's. Yet, contrary to what would be expected under a scenario of rising external transfer needs, investment has increasingly been undertaken in non-tradeable sectors. Private investment in housing has been increasing rapidly, and the public sector has reduced its investments in manufacturing, increasing those in infrastructure. The manufacturing industry inherited excess capacity from the late 1970's, and growth in production and exports was therefore possible through increased capacity utilization. However, due to high inflation and high real lending rates, investment in the manufacturing sector has generally been low compared to the sector's role in the economy. This is a worrying feature since a sustained external transfer will demand significant increases in investments in the tradeable sectors. - xviii -

12. Four scenarios for the current account of the balance of payments were formulated (illustrative the Government's Plan Case plus a High, Mid and Low case), in order to explore how the gaps in the current account and the capital account can be closed. It should be emphasized that these are illustrative scenarios and are not formal projections of the Turkish economy in the medium- term. Turkey is fairly well balanced in its trade, both across subsectors and with respect to trade partners, thus not as vulnerable to terms of trade shocks as less diversified economies. The three scenarios are, however, quite different, illustrating the difficulty in interpretation of the large, unexpected surplus on the current account in 1988. If the events in 1988 are seen as structural shifts (e.g., the continued strong growth in tourism) Turkey is likely to run surpluses or small deficits in the future, and debt ratios would decline. If, on the other hand, a combination of adverse external shocks and weak domestic policies occur, a future with strained finance is possible. A situation of running either large current account surpluses or large deficits would both be "costly" to Turkey. In the former case Turkey would resemble a capital-exporting country, and would have to rely more on domestic financing of its development program. In the latter case, Turkey would be borrowing too much from abroad. Thus, a balanced current account seems to be the appropriate goal to be strived for.

13. The scenarios produce a need for gross disbursements in 1989 of $4.2 billion in the High-Case, $5.4 billion in the Mid-Case and $5.9 billion in the Low-Case. The differences in the required gross capital inflows increase over the years, even though only a moderate negative terms of trade shock is assumed. In the High- and Mid-Cases external borrowing needs are assumed to be covered increasingly by financial markets, because of the declining net flows from official creditors. In the Low-Case, obtaining the necessary external financing looms as a problem and the contributions of financial markets in particular show a fall-off. Simulations of future flows, based on the World Bank's data base of external debt stock, provide valuable insights into the importance of managing the current account closely and of matching borrowing needs to debt service obligations. It shows that Turkey faces a challenge of accessing a broader private market for its debt, even for scenarios with only slightly increasing external debt. On the current account and gross disbursements side, 1989 is turning out to fall between the Mid- and High-Cases mentioned above. However to achieve consistency with targets over the medium term, a full economic program for 1990 and beyond needs to be assessed. (Elaboration of such a program, however, is beyond the scope of this report).

External Debt Structure

14. In most respects, Turkey's external debt ratios improved in 1988 over 1987. Debt to GNP, debt to exports, and total debt declined as mentioned above. Short-term debt fell from 21.8 percent of total debt in 1987 to 20.5 percent of total debt in 1988. This was the first time in many years that a decline in total debt occurred, and was a result of appreciation of the dollar, as well as Turkey repaying more short-term debt than had been anticipated, due to its improved foreign exchange reserve position. Since the debt to GNP and debt to export ratios are typically used as measures of creditworthiness, the improvements in both are significant for Turkey. While the latter is important in measuring the amount of resources that can be used for debt service in the short run, the former is more of a long-term measure of indebtedness. - xix -

15. Turkey's debt service ratio remained at around 38 percent in 1988, due to large-scale amortization of principal and high interest costs. The improved reserve position, however, allowed Turkey to repay over $1 billion of short-term debt. Interest payments to exports fell from 15.9 percent in 1987 to 14.2 percent in 1988.

16. A cross-country composition comparison shows that Turkey -- as one of the Moderately Indebted Middle-Income Countries (MIMCs) -- has a debt burden similar to that of Indonesia and heavier than that of Tunisia, Korea, Portugal, and Hungary. Turkey's burden is heavier than Tunisia's or Korea's reflecting the smaller proportion of concessional funds that Turkey receives (compared to Tunisia) and the early stage of Turkey's export drive (compared to Korea). Korea has also managed to lower the cost of its international finance through off-shore Asian borrowings. On the other hand, Turkey's debt burden is not as onerous as the Severely Indebted Middle-Income Countries (SIMCs).

17. Nevertheless, Turkey's debt ratios point to difficulty in the road ahead. The current debt servicing burden is comparable between Turkey and the other indebted middle income countries. Some of the SIMCs have regularly rescheduled their debt since 1982, thus securing some short-terim relief and lower debt service ratios. The SIMCs improved profile (those that have secured improvement) may have been achieved at the cost of a heavier future debt service, in addition to short-term costs connected with being cut off from the international voluntary loan market and having to incur more expensive trade finance. In contrast, Turkey's active financing in international markets has been accompanied (and is partly driven) by increased trade -- both export and import finance arising from strong economic growth prior to 1989 -- and by a desire to preserve access to international commercial markets.

18. It is important to understand the dynamics of the "debt hump" (the hump in debt service is more relevant than a hump in debt stock). When Turkey emerged from its reschedulings in 1981, its future debt service was projected to be small until 1986, but to jump in 1986, as grace periods expired. However, it was also expected that debt service would then decline slowly as the principal was repaid. This gave rise to the notion that "the hump" in debt service would start to get smaller. In reality, as the debt service was partially financed by new borrowings, this logic turned out to be incorrect. Instead of decreasing, debt service increased in 1987 and 1988, and is expected to continue to rise in the medium term, with the rate of growth dependent on the size of the current account deficits, as well as the terms of new borrowings. Since Turkey has been repaying low cost debt carrying longer maturities, and financing this through higher cost, debt carrying shorter maturities, the hump in debt service has tended to become a "moving hump." However, Turkey had few options, as concessional lending dried up and Turkey itself rejected any thought of requesting additional reschedulings or seeking debt relief -- a stance which deserves the international community's wholehearted support.

19. Whether Turkey will experience a decline in its external debt service hump in the foreseeable future rests on at least four factors: (i) the performance of the current account; (ii) the terms at which Turkey borrows its new money; and (iii) the extent to which Turkey can gain some efficiencies or savings through more active liability management; and (iv) the exogenous effects of movements in world interest rates and cross-currency exchange rates. To - xx -

obtain a decline in debt service in nominal terms, Turkey would have to run sizeable current account surpluses for several years in a row, in order to build up foreign exchange reserves and retire its debt faster than is now anticipated. This may happen, but it is not a necessary condition for maintaining credit- worthiness. The key aspect is for the debt service ratios (debt service to exports, interest to exports, interest to GNP) to decline over the medium term. The projections do show such an improvement occurring in the ratios, beginning in 1991.

Financing Plan and New Borrowings

20. When the Government formulated its financing requirements for 1989-91, it estimated that it would need to borrow from abroad about $5.0 billion annually gross (in project credits plus non-project credits) or $15 billion over the period stated. The Government based its borrowings plan on several factors, including the external transfer outlook, the outlook for the current account deficit) and the implied net transfer of private savings to the public sector.

21. A sources and uses projection of financing needs in 1989 shows that the Government will need to obtain about $3.8 billion this year (compared to $4.8 billion last year). The decline is made possible by the improved current account picture and reserve increases. Medium- and long-term borrowings of $2.0 billion are required, of which over $1 billion would be in balance-of-payments financing. The latter is required to help to meet debt service requirements of $7 billion in 1989. For Turkey to have had sufficient funds in place to meet this external debt servicing, the authorities have had to pay attention to: (i) the ability of the economy to maintain strong export growth and continued buoyancy in tourism revenues, which has provided the basic foreign exchange resources needed to service the debt; (ii) the ability to lower the real fiscal deficit and to reduce inflation (continuing process), so that other financing pressures are reduced; and (iii) the receptivity of the foreign markets to Turkish paper and loan requests.

22. An examination of Turkey's borrowings in both 1988 and 1989 shows that the programs were extremely large (about 80 loans per year), diverse, and well balanced. The currency composition at 1988 borrowings matched the existing stock of debt, the sequencing was even (unlike in previous years) and project financing declined as a proportion of total borrowings, due to the cutbacks in investment expenditure implemented in the course of the year. Borrowings from financial markets increased. A scrutiny of the terms obtained shows that the weighted average interest rate on all borrowings was 7.9 percent. This looks low, but is explained by the fact that two-thirds of the borrowings were in currencies which carry low interest rates as a tradeoff for the expectation that those currencies would appreciate over the term of the loan. The weighted average maturity that Turkey incurred was 7.5 years, shorter than that needed if Turkey is going to reduce its debt hump. All efforts should be devoted to trying to obtain longer maturities, be these on syndicated bank loans or on bond issues. In 1989 Turkey resorted increasingly to Euro-dollar borrowings.

23. In early 1988, acting entirely on its own initiative, Turkey resorted to international bond financing through the offering of Deutsche-mark bonds in the West German capital markets (without any formal link-up with the West German governmental agencies, unlike the case of the Mexico-US Treasury offering in - xxi -

1988). The seven German bonds have raised substantial amounts (over DM 2 billion) at spreads which narrowed considerably over time. These operations confirmed the view that one of the most important determinants of costs is the degree of "presence" in the market. Increased presence helps to lower the spread and fees charged over the base rate, possibly more than any other factor.

24. The criteria that determine success in the syndications market are not necessarily the same as those for the bond market. The crucial role of accurate estimation in pricing and the discrete outcomes (either success or failure of a given offering) make bond financing a specialized activity. This form of financing represents an area of growing potential for Turkey, and the authorities might look broader to the Zurich, Luxembourg, and Tokyo bond markets as potential sources of the future.

Managing External Risks

25. Even if Turkey arranged the most cost-effective borrowings possible, it can be argued that significant potential exists for reducing risk and realizing savings or avoiding unanticipated costs through risk-hedging measures. Main areas of risk involve currency and interest rate movements.

Currency Composition

26. Over the period 1982-88, about $9 billion of the increase in Turkey's external debt can be attributed to changes in cross-currency exchange rates. The large proportion (68 percent) of non-US dollar currencies in Turkey's portfolio of liabilities has resulted in these large movements in the dollar measured debt stock and debt service. Such swings are likely to continue in the future, (although possibly by less than in the 1984-87 period), given the volatility of exchange rate changes and given the currency composition of Turkey's external debt stock and of its new borrowings contracted in 1987-88 -- which were (heavily) skewed toward non-US dollar currencies. To evaluate whether these large swings imply significant risks regarding Turkey's real debt service burden, it is necessary to evaluate whether Turkey's ability to generate foreign exchange moves in line with cross-currency exchange rate changes. Several criteria are important:

(i) the status of net liabilities (external liabilities minus external assets, such as foreign exchange reserves) needs to be managed;

(ii) the country's overall financial and economic exposures, rather than only the Government's (public) indebtedness;

(iii) the tradeoffs between the expected effective costs/benefits of particular financial instruments; and

(iv) Turkey's ability to generate foreign exchange -- which in turn breaks down into policies regarding currency baskets, trade patterns, currency composition of non-interest current account flows, and the terms of trade in relation to cross-currency exchange rates. - xxii -

27. Analyzing Turkey's assets and liabilities using the above criteria, it appears that its external debt is reasonably balanced in terms of currency composition and this picture has improved in 1989 with increased dollar borrowings. There are, however, some imbalances with respect to the Japanese yen and the Swiss franc and lesser so to the US dollar. It would be advisable to limit, and possibly reduce, the share of Japanese yen liabilities and to continue to increase the share of US dollar liabilities in Turkey's external debt. The imbalance with respect to the Swiss franc is less serious, as the large amount of trade with West Germany and the large share of DM-denominated flows will tend to compensate for the Swiss franc exposure, as the Swiss franc and the DM are highly correlated. In the short term, the US dollar share of medium- and long-term debt service remains relatively high (40 percent) compared to the US dollar share in the medium- and long-term debt stock (26 percent), as US dollar debt service payments will be coming due earlier. This implies that the currency mismatch is somewhat reduced in the short term. Beyond 1990, the mismatch increases as yen and other non-US dollar debt service payments come due. It thus becomes more important either to achieve a more diversified trading pattern and currency composition of non-interest current account flows -- that is, more net trade with Japan and a higher amount of net yen inflows -- or to limit, and possibly reduce, the amount of Japanese yen borrowings, or both.

Interest Exposure

28. At the end of 1988, floating rate debt constituted approximately 48 percent of total external debt, up 11 percentage points from 1984. Since small movements in the level of international interest rates can result in large swings in Turkey's debt service, Turkey faces a relatively large nominal exposure to interest rate changes. It is, therefore, advisable that Turkey significantly reduce the amount of floating rate debt, including short-term debt. An additional argument for taking on fixed rate debt is that the growth in Turkey's floating rate debt has occurred mainly in the last three years when commercial borrowing expanded and when interest rates were relatively low. Conversely, interest rates are now rising and might continue to rise over the medium term. A prudent target would be to have a maximum of 40 percent of total debt at floating rates (including short-term debt). It should be feasible to achieve this target over the near term through new borrowings and (limited) interest swaps. In implementing tighter external liabilities management and reducing short- and long-term currency mismatches, the Government should:

(i) hedge Turkey's foreign currency liabilities, short-term as well as long-term, using its reserves. This would imply an increase in yen-denominated reserves held by the Central Bank in its investment portfolio, in order to match the growing yen-denominated debt service payments;

(ii) consider increasing the share of US dollar-denominated short-term borrowings; currently 52 percent of short-term borrowings are in dollars, which is not sufficient to correct the overall imbalance; and

(iii) consider futures, forward arrangements, and options -- these transactions can be used as short-term instruments to hedge or - xxiii -

limit exposures. The Central Bank has already used foreign exchange options for this purpose.

29. Regarding new borrowings, the strategy should be to continue to adjust the existing stock of debt towards a more optimal diversification. This implies an expansion and broadening of the markets and investors' bases for Turkey's bond issues, syndications, and placements. In addition, it may be possible to (marginally) change the currency composition of funds received from the growing Japanese market away from yen-denominated toward US dollar-denominated funds or funds denominated in other currencies. The possibility of obtaining non-yen funds in Japanese markets exists; the World Bank, for instance, has raised substantial amounts of dollar funds in the Japanese market, while some countries such as Indonesia have been able to tap the Japanese (official and/or guaranteed private) markets in non-yen currencies successfully.

30. So far as existing liabilities are concerned, currency swaps -- such as transforming yen-denominated liabilities into US dollar-denominated liabilities -- could be an appropriate strategy for Turkey, provided that a number of key conditions are satisfied. These include having the right institutional set-up that would allow for a careful evaluation of debt structure and exposures; extensive technical and market experience; sufficient market access; flexibility of instruments; and an evaluation of credit constraints. Furthermore, swaps have an element of rigidity; the borrower may lock itself into a currency (or interest structure) which, ex-post, may turn out to be disadvantageous. Nevertheless, swaps can be unrolled, basically by putting a reverse-swap on top of the existing swap, but indirect costs will increase commensurately. Since swaps are (partially) counted by banks against their exposure limits, they could over time limit Turkey's ability to secure additional new borrowings. The increased capital use could result in higher spreads charged on Turkey's other loans, which would have to be compared with the savings potential of swaps. Despite these concerns, swaps remain an important new technique which the authorities should seriously consider in the future.

31. Finally, swapping existing floating interest liabilities into more fixed interest rate liabilities would be an appropriate strategy for Turkey, given the high proportion of liabilities subject to interest rate fluctuations and the relatively limited use of hedging instruments. The short-run cash flow implications -- higher costs in the short-term -- are likely to be justified, given the reduction uncertainty of that would result over the longer term. - xxiv -

PART II: Public Debt. Fiscal Deficits and the Necessary Internal Transfer

32. On a year-to-year basis, the "real" public sector deficit has not displayed the same picture as the PSBR (as is to be expected due to the adjustments made on the inflation component of interest when estimating the real deficit). The PSBR fell from 10 percent of GNP in 1980 to 4.5 percent in 1986, it rose to 7.8 percent in 1987 and is estimated to have declined to about 6.4 percent of GNP in 1988. The "real" public sector deficit rose from 1.7 percent of GNP (on average) during 1980-83 to 9.6 percent in 1984, declined to 6.5 percent of GNP in 1987, and declined again in 1988 to 4.1 percent of GNP. Thus, the below-the-line measure of the Consolidated PSBR matches the trend and direction in the Governments above-the-line measure of the PSBR in 1987 and 1988 -- they both deteriorated in 1987 and both improved in 1988 (by 2.0 - 2.5 percent of GNP). Differences in the two estimates are accounted for by the quasi-fiscal deficits of the Central Bank. Nevertheless, Turkey needs to continue striving for a sustained improvement in the public sector deficit.

33. For many years Turkey has had a small level of domestic public debt. Since 1979, domestic public debt has fluctuated between 3 percent and 8 percent of GNP. However, when Turkey started to auction Treasury bills in 1985, the level of such debt began to grow and currently stands at about 8 percent of GNP (which is still low compared to many other countries). The lack of a decline in the real fiscal deficit, combined with the decrease in foreign financing (due to the falling current account deficit) has resulted in an increased reliance on domestic debt. This has important implications, because it shows that the public sector has not been able to start making an external transfer. Moreover, the rise in domestic public debt has also increased fiscal deficits, as the interest cost of this debt is nearly as high as that of external debt, due to high nominal interest rates.

34. Successful production of a positive net transfer will depend mainly on the capacity of the public sector to raise resources. Yet, the increasing importance of private savings as a source of finance since 1985 and the declining importance of foreign savings is clearly seen. In fact, since 1988 real net foreign savings turned negative, indicating that real net private savings, in addition to providing resources to finance the deficit, have also provided resources to sustain a real transfer abroad. Thus, a continued reduction in the fiscal deficit is required in order to ease the burden on the private sector.

35. A large portion of the real net private savings transfer to the public sector has occurred through the inflation tax. Since this tax can be considered as forced savings, it can also be seen as an indication of the private sector's general reluctance to finance the deficit. Other means of transferring resources to the public sector have necessitated high real interest rates (on lending) and a reduction in the proportion of credit channelled to the private sector.

36. An indicator of the pressure of the consolidated public deficit on the domestic financial market was constructed. It shows that the pressure was at its peak in 1988 -- the claims of the fiscal sector amounted to 33 percent of nominal private savings in 1988, up from 18 percent in 1986. The ratio of the stock of net domestic public debt to M2X (M2 plus foreign exchange deposits) likewise increased from 14 percent in 1986 to 30 percent in 1988. Both of these indicators show that there is an increased stress being placed on the domestic - xxv - financial sector. Given the fiscal pressures and the growth of domestic public debt, the authorities should undertake the institutional reforms that will permit the domestic market to absorb the public debt. However, the more fundamental need is to reduce the fiscal deficit (including quasi-fiscal activities of the Central Bank) in order to reduce the pressures on the domestic market and to slow the growth of such debt. In the absence of such broad fiscal improvement, Turkey could find itself with a domestic debt burden that would add to its existing foreign debt burden, giving it a total debt problem that could be very difficult to manage.

37. The analysis of the first two parts of the report show that unless a sustained and more extensive fiscal adjustment is effected, Turkey will not be able to generate the internal resources in the public sector in order to meet its external transfer obligations. The dimensions of this two-sided challenge are not always seen together; yet they cannot be separated. Domestic adjustment should be seen as the counterpart to the external debt solution. Moreover, the fact that Turkey has recently achieved a stronger position on the external sector should not lead to any relaxation of the domestic stance. On the contrary, the implications of a current account surplus (or a much reduced deficit) are that Turkey will more than ever need to draw resources out of domestic fiscal adjustment and in particular out of the financial sector, which in turn needs to have efficient markets and systems to meet this challenge. The room for maneuver on both the external debt/borrowings and the domestic debt side is not large and economic policy implementation needs to take this into account at all times.

Institutional Set-Up

38. Turning to the institutional system in Government to handle debt management and to formulate a borrowings strategy, the structure needs to be flexible enough to adjust to rapidly evolving situations in financial markets. But it also needs to have sufficient controls in place. Economic liberalization should not be confused with the relaxation of controls on the growth of foreign debt and borrowings, either for loans that are taken on directly by the Government or those that are guaranteed by the state. These are functions that cannot, and should not, be liberalized.

39. The creation of the External Borrowings Committee (EBC) in January 1988 has helped the Government to plan and control the borrowing and expenditure programs. The balancing of macro and sectoral priorities and their financing is a difficult process that requires review at a high level, as well as the detailed and integrated work of officials of the Treasury, SPO and the Central Bank. The work of the EBC needs to become visible, more intensive, and more carefully sequenced around the priority policy issues facing Turkey's borrowings program. For example, with world interest rates rising, should Turkey consider trying to swap some of its floating rate debt into fixed rate notes? Should certain loans be swapped into other currencies? How much project financing versus balance of payments financing should Turkey engage in the coming years? These are some of the strategic questions that need to be resolved. While the economic management system in Turkey does have a sound structure and apparatus for tackling economic policy questions, more thought should be given to pursuing such strategic debt/borrowing questions facing Turkey. - xxvi -

40. To handle these questions, analytical capacity needs to be expanded at two levels: (i) at the EBC level, which needs to continue to receive regular advice from the established agencies (Treasury, Central Bank) on strategic choices facing Turkey with regard to debt and borrowings; and (ii) on liability management at the agency level. New activities in such matters as swaps (if desirable) and on other financing activities could be considered. The commercial borrowings teams in both the Treasury and Central Bank (for reserve management) could be expanded. In June 1989 the Treasury created a new department within the External Relations Directorate to handle commercial borrowings, separate from the Project Financing Department.

41. In addition to handling external debt, the Public Finance Directorate of the Treasury handles domestic public debt. Turkey's auction system for Treasury bills/bonds has made substantial progress since its launching in 1985. However, the growth of the primary market is restricted by the lack of institutions and instruments that would allow greater access of firms and individuals. Thus, the market is dominated by the large commercial banks who hold Treasury bills as part of their liquidity requirements to the Central Bank. Large non-bank dealers or brokers who are registered with the Capital Markets Board also bid on the Treasury bills/bonds.

42. The World Bank's Financial Sector Adjustment Loan (FSAL II) is assisting the Government in improving the primary market and in developing the secondary markets. Objectives include the introduction of greater transparency in the bid process and broadening of the participants to include mutual funds and firms/individuals. Greater flexibility in the instruments to allow smaller units of bills/bonds is being considered, as well as the introduction of variable rate bonds on longer maturities. Both the Treasury and the Central Bank exercise key roles in the development of these markets and instruments. Although, much has been achieved in the past four years, there is still a great deal to be done to obtain a smooth harmonization of financial sector goals with monetary and fiscal policy goals.

The Road Ahead

43. Turkey remains vulnerable to various external shocks that could impact upon its debt strategy. The three most important shocks involve: (i) world oil prices; (ii) world interest rates; and (iii) world trade. Various scenarios show that these shocks can be handled. However, if they occur at the same time, and if this happens alongside a low-case in the current account (slow exports, low workers remittances), Turkey could be sufficiently hard-hit that debt servicing problems could arise. In order to provide the economy with resilience to meet these potential shocks, it is essential therefore that appropriate macro policies regarding stabilization and adjustment be pursued.

44. Turkey has pursued a full menu of borrowings, which is likely to grow even more diverse in the future. Which markets to approach and in which sequence, remains a matter for the authorities to decide. Turkey should continue to benefit from the different attitudes that exist in commercial markets, some of whom are more interested in certain financial instruments than in others. The diversification of various instruments and sources will remain as important to Turkey in the future, as it was in 1988. Thus, Turkey needs to develop a - xxvi i -

robust borrowings strategy that can be adjusted to meet changing trends in the coming few years.

45. The extensive borrowings that Turkey has arranged from commercial markets attests to the validity of the original Baker Plan idea (that is, if a country pursues a sustained economic reform program, it should be able to eventually access voluntary commercial borrowings). Turkey was not on the list of the Baker Plan countries, nor is it mentioned as a candidate for special measures under the Brady Plan since it is able to access commercial markets voluntarily. Nevertheless, Turkey will need to persevere with its economic reforms so that it does not have to resort to special global initiatives which, however important they may be, carry considerable uncertainty at the individual country level. Turkey's approach of accessing diverse markets, while pursuing a program of comprehensive economic reforms, offers it the best chance of achieving a full "debt-workout". To do this, the policymakers will need to maintain the confidence of the international markets that Turkey's macro-economy remains creditworthy.

46. In terms of policy:

(i) The authorities need to attach the highest priority to achieving a sustained reduction in inflation, which can only be achieved through a steady reduction in the public sector deficit. The public sector borrowing requirements need to continue to decline, building on the 1988 performance;

(ii) Greater harmony needs to be obtained among the various goals of current account balance, fiscal improvement, external debt reduction and inflation reduction. It is difficult to achieve progress on all fronts at all times. Thus, the authorities need to have a close sense of what the "markets are saying". The strengthening of the current account in 1988-89 greatly helped the external borrowings picture - - both because fewer borrowings were needed and because markets took the current account developments as an important indicator of the realism of debt service obligations.

(iii) Considering the growing proportion of domestic public debt and the pressures placed on the domestic financial sector from Treasury borrowings, it is important that domestic public debt not be seen as the main financing vehicle in the future. This implies that a balanced current account, rather than a surplus, should be aimed at (since with current account surpluses, net borrowings inevitably will have to come more from the domestic economy than from external sources). To achieve a balanced current account, there needs to be a return to steady, non- inflationary economic growth. To achieve this, continued fiscal restraint and a tight monetary program will need to be maintained consistently;

(iv) The Government's strategy to limit net new external borrowings is sound and is to be commended. This is all the more reason that the borrowings program needs to be executed smoothly and - xxviii -

with reasonable precision so that the required funds are obtained in good time. This is not an easy task, with increased scarcity of resources available for lending to developing countries. Turkey will need to continue to set its record apart from that of other indebted countries, so that it can preserve market access. Turkey should continue to try secure the longest maturities possible and rely less on short-term debt instruments;

(v) Even if new external borrowings are obtained to the full amount and in the timely manner needed, there remains an important area of financial planning that remains to be done, pertaining to the management of existing liabilities. While decisions on past loans are a matter of history, the implications need not be considered to be entrenched. Namely, currency composition can be altered through swaps and pre-payments. The future range of decisions should include the potential to achieve increased liquidity and possibly some savings through a closer alignment of Turkey's pattern of debt stock composition (by currency) with its trade patterns. Also, greater balancing of floating rate debt and fixed rate debt (implying a neutral position regarding future interest rate movements) should be strived for;

(vi) Turkey's institutional set-up for managing its debt needs to be fully coordinated and to be sufficiently strong in both analytic capacity and system coverage to handle the many challenges facing it. Turkey's debt management experience of the last five years augers well for the future, but this should not preclude making further changes that can further improve capacity; and

(vii) Finally, in planning the economic program and the financing requirements, the policymakers should give great weight to the internal transfer challenge of the public sector and to the related pressures on the domestic financial system. To meet the external transfer associated with a continued high level of debt service, Turkey needs to achieve progress on both fronts -- external and internal transfer. The first round of adjustment has been achieved -- improvement in external balances -- and now the second and more difficult round of adjustment, involving a sustained fiscal deficit reduction, will need to be carried through. Turkey's record of the past nine years gives reasonable confidence that this can be achieved, but it will require cohesive economic management and hopefully it will be accompanied by fewer economic shocks than occurred in the 1970's when Turkey's debt problem came to the forefront. PART 1:

THE EXTERNAL TRANSFER

CHAPTER I: THE NEED FOR AN INCREASED EXTE7RNALTRANSFER

A. Introduction: The External Transfer Problem

1.01 After a period of receiving net transfers from abroad, Turkey faced a balance of payments crisis, and had to reschedule external debt between 1978 and 1982. Thus, after being unable to finance the requirements of the current account without renegotiation of terms, Turkey was extended further credits (largely through prolonged maturities), thereby creating breathing space for adjustment. However, rising future debt service obligations called for increasing transfers, higher gross capital inflow, or both.'/ For capital inflow to materialize, lenders (or investors) generally want to see future debt service obligations not to exceed the capacity to service debt,,2/ Therefore, a strategy to increase the transfer capacity usually is a prerequisite for, and complementary to, a strategy to increase capital inflow. Lenders had demonstrated their cautiousness through the rescheduling, and the country had to adjust to transfer more resources abroad. This process of adjustment, called the transfer problem in the literature, consists of increasing the non-interest current account surplus (NICAS), defined as follows;

1/ A country's transfer abroad is its non-interest current account surplus (NICAS = - NICAD). An increased external transfer is reflected in an improved trade balance, and generally requires a reallocation of resources from tradeable to non-tradeable production. The capital inflow is positive when new borrowing plus net foreign investment (and other non-debt capital account inflows) exceeds repayment (including net investment flows).

2/ Generally, capital inflow can be unconstrained, borrower-constrained, or lender-constrained. Creditworthiness analysis assumes that cautious lenders restrict lending when there is a risk of default. Often, a ratio of external debt to resources, for instance income (D/Y), is seen as an indicator of creditworthiness. Then, the transfer abroad consistent with non-deteriorating creditworthiness is given by:

(1) NICAS > D(t-l)*(i-n) where D(t-l) is the debt stock of the previous. year, i is the real interest rate, and n is real income growth. Condition (i) states that the ratio of debt to GNP can be held constant with a non-interest current account deficit if the growth rate exceeds the real interest rate, and that this allowable deficit (or necessary surplus) is greater the greater the absolute difference between n and i. However, a country can be increasing its transfer voluntarily, or because it is forced to by its lenders, irrespective of whether the NICAS satisfies condition (i) or not. The approach taken here is that a rescheduling in itself is a statement by lenders that they are unwilling, individually and voluntarily, to extend the credits needed to meet debt service requirements for a given current account. Then, the country has no alternative,but to increase its transfer. -2-

(i) NICA -X - M + A where for simplicity net receipts from invisibles (such as freight income and tourism) and net non-interest factor receipts are included in the trade balance (X-M), X is exports and M is imports, and A is the value of unrequited transfers, such as workers' remittances.

1.02 Turkey has experienced faster growth of exports than of imports (also for net receipts of invisibles) during the 1980's, but because the process started with the trade balance in deficit, the transfer abroad did not really increase from the level that it reached in 1982 until 1987 (Figure 1.1). In the meantime, interest payments were rising, so the current account deficit was not reduced significantly from its 1982 level before 1988, when Turkey realized a current account surplus for the first time since 1973.

Figure 1.1: Current Account and Transfer Abroad

Current Account and Transfer Abroad

5

4

3-

2-i

-4

1975 1976 1977 1979 1979 1990 1991 1992 1993 1994 1905 1996 19 39g

3 NICA + Curr.Acct. -3-

1.03 As can be seen from equation (i) the solution to the external transfer problem requires that exports grow faster than imports. Production thus has to grow faster than domestic demand, so that a larger exportable surplus emerges. In general, this also requires a shift of resources from production of non-tradeable to tradeable output, in order for the surplus capacity either to replace imports or to produce additional exports. If driven by market forces, such a shift will occur if the prices of non-tradeable goods relative to those of tradeable goods decline. Such a change in relative prices can be stimulated directly through the exchange rate, and will also come about as a result of a reduction of domestic demand. In this chapter, trade developments are seen in the light of disaggregated GDP figures and relative prices, in order to see to what extent and how an increased transfer was made possible. In section C, the sustainability of external transfers in the magnitude of the one made in 1987 or larger is viewed in the light of investments during the later years.

B. Current Account Developments

1.04 Turkey's export performance in the aftermath of the reschedulings ending in 1982 is indeed impressive (Table 1.1). Earnings from merchandise exports have grown by 15 percent annually on average over a six-year period measured in current dollars, exceeding the growth rate of import expenditures by 6 percentage points. The developments with respect to receipts and payments from other goods, services, and income is even more striking: receipts increased by 24 percent annually, exceeding the growth rate of payments by 12 percentage points. The trade deficit -- as well as the deficit on goods, services, and income -- remained fairly unchanged until 1988, at around $3 billion. These deficits were unchanged despite disparate growth rates of income and expenditure items.

Table 1.1: Current Account: Summary Presentation ($millions)

Percent Av.ann. growth 1983 1984 1985 1986 1987 1988 83-88

CURRENT ACCOUNT MERCHANDISE EXPORTS FOB 5905 7389 8255 7583 10322 11846 14.9 MERCHANDISE IMPORTS FOB -8895 -10331 -11230 -10664 -13551 -13646 8.9

TRADE BALANCE -2990 -2942 -2975 -3081 -3229 -1800

OTHER GOODS,SERVICES, AND INCOME: CREDIT 2041 2366 3148 3250 4111 5945 23.8 TRAVEL 420 548 1094 950 1476 2355 41.2

OTHER GOODS,SERVICES, AND INCOME: DEBIT -2734 -2945 -3184 -3646 -4282 -4812 11.9 INTEREST -1511 -1586 -1753 -2134 -2507 -2799 12.9

TOTAL: GOODS, SERVICES, AND INCOME -3683 -3521 -3011 -3477 -3400 -667

TOTAL UNREQUITED TRANSFERS 1785 1901 1782 1949 2418 2170 4.0 WORXERS' REMITTANCES 1513 1807 1714 1634 2021 1755 3.0

CURRENT ACCOUNT BALANCE -1898 -1407 -1013 -1528 -982 1503 NON-INTEREST CURRENT ACCOUNT BALANCE -387 179 740 606 1525 4302

Source: Central Bank of Turkey. -4-

That points to a fourth striking observation; interest payments have been increasingat 13 percent annually on average, due to capital inflows as well as exchange rate and interest rate movements. The size of trade and resource balance deficits also point to Turkey's stable flow of remittancesfrom workers abroad. This flow has allowedTurkey to run trade deficitswhich would otherwise have been possible only with a much more rapid growth of external debt.3/

1.05 The reform programs in Turkey during the 1980's, supportedby eight years of structural adjustment lending from the World Bank as well as standby Arrangementsfrom the IMF (para. 3.12), favored trade liberalization. Quotas and quantitativerestrictions have been replacedby instrumentsusing the price mechanism, such as tariffs, levies, taxes, and subsidies. These changes have brought a greater openness and flexibilityto the economy, as well as gains in efficiencyand fiscal revenue. Further,real exchangerate depreciationsas well as more targeted export incentives have boosted competitiveness,and brought approximatealignment between official and equilibrium exchange rates.4/ The 1980'sbrought a shift from the traditionalpolicy of import-substitutiontoward export-orientedgrowth. The bias againstexports has progressivelybeen removed, with the aim that the import-competingsectors should not receive tariff protection compared to the exporting sectors.5/

1.06 One would expect an increased external transfer to be driven by decliningrelative prices in non-tradeablesectors, forcing productive resources to shift into production of tradeables. Such a process could be initiated neutrally by a general suppression of demand, or directly by stimulating tradeableproduction through the trade regime. In Turkey, fiscal and monetary policies have not been contractive,leaving a greater role for incomes policy and demand switching policies. Reduced demand has resulted from real wage erosion (and thereby redistributionof income to individualspresumably with a lower consumptionpropensity) as well as throughhigh interest rates. Relative prices have also been addresseddirectly, through incentives,tariffs, and the exchange rate regime. 1.07 Disaggregatedgrowth data (Table 1.2) partly confirm the shift in production that we would expect to see from such a process. Services predominantlynon-tradeables, and constitutingabout 50 percent of official GNP figures in Turkey) have grown less than the overall growth rate (annual average growth of 5.4 percent). Agriculturaloutput growth,however, has been even lower (3.6 percent).

3/ In defining the ratio of debt service to export earnings, workers' remittancesare usually included in the export earnings, to reflect their role in financing imports and debt service.

4/ After a real exchange rate depreciationof 30% in 1980, the real exchange rate has depreciatedon average 4 percent annually through 1987.

5/ In August 1989 the trade regime was further liberalizedfollowing on the extensive liberalizationimplemented in 1985-86. The August 1989 measures involved removal of some quantitativerestrictions and reduction of selected import taxes. -5-

Table 1.2: Sectoral GDP Growth (factor cost at 1968 Prices) over 1980

Annual ------Index Value------Average Change Sector 1983 1984 1985 1986 1987 1988 1981-88 (percent) Agriculture 6.3 10.0 12.9 21.7 24.2 32.8 3.6 Industry 21.5 34.0 42.3 54.8 69.4 76.0 7.3 Mining (6.4) 2.5 13.6 7.0 10.9 20.6 2.4 Manufacturing 25.3 38.1 45.8 59.9 75.5 80.1 7.6 Energy 21.8 35.3 46.1 67.8 86.7 106.8 9.5

Services 11.6 17.5 22.0 30.1 38.9 44.3 4.7 Construction 1.7 3.2 6.3 15.6 23.4 25.9 2.9 Trade 20.0 29.5 35.6 48.6 63.1 68.8 6.8 Transport & Communication 6.4 14.5 19.9 25.3 33.5 37.1 4.0 Public Services 14.5 17.3 21.2 25.6 31.4 39.9 4.3 Other Services 9.5 14.4 18.1 25.1 31.6 36.9 4.0

CDP at Market Prices 13.6 20.1 26.3 36.8 46.9 52.2 5.4

Source: SIS, SPO and World Bank Data.

1.08 Disaggregateprice data indicatehow relative prices have played a role in shifting the weights between sectors. Government policy, such as to encouragehousing construction,has also influencedsectoral activity. As shown in Table 1.3, the relative prices of manufactured goods and energy have increased, thus stimulatingproduction as well as depressing domestic demand. Manufacturedgoods predominantlyare directly tradeable,while energy production plays a role both in import substitution and indirectly as input in the production of tradeables. However, some of the non-tradeablesectors, such as transport and communicationand general services, also experienceda favorable shift in relativeprices. Agriculturedoes not show such a relativeprice shift. In fact, after public services, this sector shows the lowest relative price increases. This may reflect that other governmentpolicies have interferedwith the objective to shift resources to tradeablesectors, preventing agricultural prices from rising. -6-

Table 1.3: Sectoral GDP Deflators Relative to Overall GDP Deflator (1978-79=100)

Sector 1981 1982 1983 1984 1985 1986 1987 1988

Agriculture 92.8 86.2 84.5 87.7 83.7 81.1 83.2 77.1 Industry 116.5 120.9 122.8 123.1 127.0 124.9 122.5 125.6 Mining 175.7 184.4 198.3 185.8 195.1 183.1 179.1 171.5 Manufacturing 110.9 113.8 115.7 114.4 114.7 111.6 111.2 114.9 Energy 125.0 141.9 134.9 161.3 201.5 212.9 189.6 189.2

Services 97.9 99.5 98.7 99.1 95.0 94.5 96.1 96.2 Construction 91.3 88.8 85.6 88.0 81.0 83.9 86.8 84.7 Trade 114.8 116.1 117.3 119.8 111.3 107.0 108.0 108.2

Transport & Communication 112.7 116.3 117.9 115.3 116.2 114.1 112.6 115.1

Public Services 64.6 68.3 63.6 51.0 46.7 49.3 52.9 49.5

Other Services 102.1 101.7 100.5 111.4 110.0 110.6 111.6 115.0

GDP at Market Prices 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Source: SIS, SPO and World Bank Data.

1.09 As can be seen in Table 1.4, agricultural exports have been at a standstill from 1983 (with the exception of 1988), while manufacturing exports have tripled. In light of the declining relative prices of agricultural products, it is not surprising that the agricultural sector has played a small role in the export drive. The prices of agricultural products are held below world market prices through different intervention mechanisms, in order for the population and the industry to receive affordable supplies.6 / At the beginning of the eighties, the sector had an export share of the same magnitude as that of the manufacturing sector. Considering that the agricultural sector still employs more than 50 percent of the civilian labor force, while it accounts for only 20 percent of GNP, it seems likely that a demand stimulus via reduced effective taxation of the sector would release an unutilized export potential in this sector.

6/ World Bank, Review of Agricultural Pricing and Trade Policies, Report No. 7764-TU (June 1989). Table 1.4: Commodity Composition of Exports (millions of US$)

Percent Annual Percent Growth Growth 1987 L988 1983-87 1987-88

Agriculture and livestock 1,852.5 2,341.4 -0.4 26.4 Industrial crops 430.9 546.8 -5.1 26.8 Other Agriculture 1,421.6 1,794.6 1.3 26.2

Mining and quarry products 272.3 377.2 9.6 1.3

Industrial products 8,065.2 8,943.5 21.9 10.8 Agriculture-based processed products 953.9 884.7 9.2 -7.3 Textiles 2,707.1 3,201.4 20.1 18.3 Hides and leather products 721.9 514.1 39.2 -28.7 Chemicals 526.5 734.3 27.8 39.5 Iron and steel 851.8 1,457.5 20.3 71.1 Metal Products and machinery 787.5 384.5 59.1 -51.2 Others 1516.5 1,767.0 18.5 16.5 Total Exports 10,190.0 11,662.1 15.5 14.4

Source: State Planning Organization.

1.10 At a more disaggregated level, there is a marked decline in the export revenues from industrial crops, but a healthy growth of 7 percent annually in the earnings from agriculture-based industrial exports provides some explanation for this. However, imports of industrial crops have also grown substantially, now approaching the same magnitude as those of exports in the same category. This could be one of the less apparent cost of the bias against agriculture in the domestic price regime, indicating that even the support function of agriculture may be hurt through these policies.7 /

1.11 Further disaggregation of disparate price developments is possible at the level of consumer prices. In Table 1.5, three subaggregates are associated with non-tradeable output: housing, transportation, and health and personal care. The relative prices for transportation and housing have, as expected, declined, whereas the price increases for health and personal care have been above average. The pattern expected with respect to a solution to the external transfer problem (that relative prices of non-tradeable goods decline) is probably in this case disturbed by the needs represented by the internal transfer problem. In areas where the public sector is producing without

7/ Industrial exports based on agricultural products may be held down by the low prices of agricultural products, if the supply of inputs is suppressed by the low prices. - 8 -

competition,prices may be raised in order to improvepublic finances. The same process has probably affected energy prices (Table 1.3), an area in which the public sector is dominant. Price increasesby state economic enterpriseshave been frequent during the adjustmentperiod of the eighties, mostly for fiscal reasons.

Table 1.5: DisazarezateConsumer Price Indices.Annual Change

Relative price in Average 1988 as perc.of rel. Year 1983 1984 1985 1986 1987 1988 Ann.Change price in 1983

Foodstuffs 47.9 38.2 57 42.3 39.8 71.1 49.0 114.4 Housing 33.9 39.8 58.3 32.5 24.1 58.7 40.6 81.0 Clothing 37.5 39.9 43.8 45.3 45.8 87.8 49.1 115.3 Health, care 47.9 38.2 57 42.3 48.7 82.6 52.1 129.9 Transport 33.9 39.8 58.3 32.5 24.8 80.2 43.8 92.5

General 35.4 48.4 44.9 34.6 38.9 75.4 45.7 100.0

Source: SIS

1.12 Table 1.4 furthershows that industrialexport growthhas been broad- based. Export of textiles accounted for 27.4 percent of revenues from merchandiseexports in 1988, when the revenues reachednearly twelve times those of 1977. This subsector alone contributesmore export earnings than those of tourism, as well as those of total agricultural exports. At the level of consumer prices, the stimulus to increased resource input in this sector is indicated: the annual price increases for clothing have been 3.5 percentage points above the general inflation (Table 1.5) inducing consumers as well as producers to increase the exportable surplus. Other sectors giving a contribution to export earnings above $500 million are: hides and leather products (see footnote 8), chemicals, iron and steel, metal products and machinery. These dominant subsectors together have increased export earnings by 20 percent annually,since 1983. The broad range of growth across subsectors, and thereby the diversification,is demonstratedby the fact that the remaining industrialsubsectors have increasedby 19 percentannually over the same period. These accounted for 19.8 percent of industrialexport earnings in 1988.

1.13 An important contribution to the increase in foreign exchange earnings after 1984 has come from the booming tourism (Table 1.1). Turkey was probably well positioned,when significantcurrency depreciationsimproved its competitivenessin the beginning of the eighties and when the industry also increased its sophistication. The revenues from tourism increased from $200 million in 1975 to $500 million in 1984, thereafterrising by nearly $500 million annually to reach $2.4 billion in 1988.

1.14 Combinedforces resultingfrom the internaland the external transfer needs have contributedto the competitivenessof Turkish exporters reflected in these figures. As a result of a decline in real wages, the wage bill of most firms has declined,compared to interestexpenses and other inputs. While public sector wages have declined more in real terms than have private sector wages, a real wage decline of 8 percent I/ in the private sector has of course shifted the marginal costs of Turkish producers downward, thereby increasing their competitiveness.9/ A process of increasing competitivenessthrough erosion of real wages tends to meet resistance after a while, either through political pressure and social tension or through increasingeffective indexation. Since the costs to the economy of incentives and further real exchange rate depreciationsat present appear to be high (see Chapter 5), these instruments are also likely to contribute less stimulus in the years to come. These reflections indicate that gains in competitivenesswill have to be based to a greater extent on productivityincreases in the future.

Table 1.6: Commodity Compositionof Imports (millionsof US$)

Annual Growth 1987 1988 1983-1987

Agricultureand livestock 782.3 499.3 54.3 Industrialcrops 364.4 N.A. 58.7

Mining and quarry products 3,034.1 2,861.3 (3.1) Fuels 2,711.1 2,686.0 (4.4)

Industrialproducts 10,346.6 10,979.1 16.3 Agriculture-basedprocessed products 719.5 738.4 37.1 Chemicals,Rubber and Plastic 2,425.3 2,509.5 14.7 Iron and steel 1,536.9 1,655.3 22.8 Metal Products and machinery 2,510.4 2,462.1 14.5 Electrical appliances 940.0 1,075.2 17.5 Motor vehicles 549.9 690.1 3.0 Others 1,664.6 1,848.5 15.6

Total 14,163.0 14,339.7 11.3

Source: State Planning Organization.

1.15 The commodity composition of imports (Table 1.6) reveals that Turkey's trade pattern is quite well balanced,and thus to some extent provides a natural hedge against terms-of-tradeshocks. Industrialproducts have a 73 percent share of imports, while 77 percent of exports. Among the seven

8/ World Bank, CEM, op.cit.

9/ Wages do not of course give the full picture of earnings. Special programs, such as the Mass Housing Fund, have provided substantialincome (capital asset support) and may have helped to boost domestic savings. As shown in Chapter 5, the internal transfer of private savings to the public sector becomes crucial when public net savings are negative. - 10 -

categories accounting for more than $500 million of exports (Table 1.4), five also exceed this threshold for imports (Table 1.6). The most apparent imbalance appears with respect to Turkey's oil imports ($2.7 billion in 1988); a 20 percent change in oil prices affects the trade balance by $0.5 billion.'°/ However, the oil-exporting countries in the Middle East are important markets for Turkey's exporters, and the higher import bill associated with higher oil prices thus tend to coincide with higher export revenues."/

1.16 Breaking down Turkey's exports and imports by trade partners, OECD countries purchase 63 percent of exports, and supply 64 percent of imports (1987), while the respective shares for EC countries are 48 and 40 percent, for Middle Eastern countries 27 percent and 19 percent. The impact of flows from tourism and workers remittances means that exposure towards the purchasing power of EC countries is less balanced than the trade balance would suggest, but Turkey's current account is generally well diversified with respect to trade 2 partners as well as product range .1 /

1.17 A breakdown of imports into investment goods, raw materials, and consumption goods indicates a close link between imports and the growth of GNP and exports. In 1988, 28 percent of imports were investment goods, 57 percent were raw materials, and only 15 percent were consumer goods. In light of the ongoing adjustment, this of course points at prudent resource allocation, but it also indicates a vulnerability demanding careful current account management; balance of payment difficulties and restraint on imports will damage growth of production and exports immediately.

Recent developments

1.18 In 1988, the current account produced a surplus of $1.5 billion, amounting to 2.1 percent of GNP. This was $2.4 billion above the target for the year, and $2.5 billion up from the deficit in 1987 of $1 billion."3 / On an aggregate level, favorable markets are reflected in export prices 3.4 percent higher than in 1987, while import prices were 1.1 percent lower than the previous year (oil prices 18 percent lower, other prices 3.7 percent higher). Trade developments are quite different from the current account pattern through the 1980's: export growth in 1988 was strong in agriculture (26%) while lower (10.9%) for industrial products, it was stagnant to OECD, stronger to Islamic countries (partly due to generous export financing from the Central Bank), and booming to others. Revenues from tourism are reported to have increased by 60%. The most significant contribution to an improving trade balance came from the imports bill, estimated to have grown at a modest 1.3%, only partly explained

10/ No demand response is assumed.

11/ In the four years 1984 through 1987, there were major oil price changes in 1986 and in 1987. In these two years, changes in export revenues from the Middle East compensated for about 50% of the price shock.

12/ As it is shown in Chapter 4, the stock of debt is also quite well diversified, and matches the needs of the current account with respect to currency composition.

13/ The large swing in the current account was unanticipated at the beginning of 1988. - 11 - by a significant slowdown in domestic demand during the year. Low domestic demand, a good agricultural harvest (and world market prices), lower oil prices (saving $500 million) as well as booming tourism thus are the main identified driving forces behind the improvement.

1.19 The gradual reduction of export incentives through 1988 undoubtedly represents a challenge to the exporting sectors. In the second half of 1988, when fiscal policy was contractive, incentives were reduced, and domestic demand definitely slowed down, both imports and exports decelerated. Generally, one would expect a slowdown in domestic demand to create an incentive to export particularly now that capacity utilizations are generally lower, creating incentives for firms to seek new markets. In the second half of 1988, however, the slowdown in domestic demand was not offset by any increased production and sales of export goods, due to a combination of less receptive export markets and reduced fiscal incentives. Hence, in assessing the developments on the external side, there were indications of a slow-down in exports to the OECD, although the rapidly changing events in Eastern Europe will likely create new opportunities for Turkish export products. As shown in Part II, the costs to the economy of the fiscal deficit are very high, so the actions to reduce the use of incentives and exchange rate depreciations are understandable. Turkey still needs to balance the needs for fiscal improvement against short-term trade balance improvements, however, and can therefore not commit itself not to resort to export stimulating instruments. In Chapter 5, we will see how a contraction of fiscal policies in general will support improvement in the current account improvement, and thereby reduce the need for market-distorting export stimuli.

1.20 Some of the factors leading to the current account surpluses in 1988 and in 1989 need further analysis. In particular, detailed analysis is needed of exports (disaggregated by commodity and by destination) and of tourism revenues (visitor origins and location preferences), to assess potential constraints to further rapid growth both at the demand and the supply side. For the purpose of making projections, there is some uncertainty with respect to the role of structural shifts, specifically regarding whether 1988 can be repeated in the coming years, as we will discuss later.

C. Sustaining Growth in Transfer Capacity: Private and Public Investment

1.21 In the previous section, we saw how an impressive growth in the exports of industrial products occurred through the 1980's, while a significant increase in the external transfer did not materialize before 1988 because the trade balance was initially in a large deficit, and imports also grew strongly. In this section, the extent to which the investment program is supportive of the external transfer is analyzed. Causes seen to influence investment, such as fiscal policies, inflation, real interest rates, incentives and the allocation of credits are only briefly commented on. The claim on savings made by the fiscal deficit, which is seen as the major cause of the unsatisfactory investments in tradeable sectors, is discussed in Part II of this report.

1.22 In order to produce an increased external transfer, resources must be made available within tradeable sectors. In the short run, the limited substitutability of existing productive resources must be utilized, while in the longer run investments can change the capital stock so that the capacities in tradeable sectors increase. Turkey has chosen a growth-oriented strategy, in which investments are to be protected through the adjustment process. This has short term costs in terms of consumption: since the current account deficit - 12 - equals the differencebetween investmentand savings, the strategy implies that consumptionmust carry the burden.

1.23 From 1983 to 1988, total fixed investmenthas increasedmarkedly, from 18.9 percent to 23.9 percent of GNP. For 1988, fixed investment was targeted at 24.8 percent of GNP, but public investmentwas cut during the year in an effort to adjust public expenditureswhen the revenues fell short of target. As can be seen from Figure 1.2, investment in Turkey traditionallyhas been fairly equally shared by the private and the public sector,with the public role declining, in accordance with government policy. Both sectors have increased their investments since 1983, the main steps taken in 1985 through 1987.

Figure 1.2:

Fixed Investments A SWres of GNP '44

43-

12-

11-Pub[IIc

Sectoral Brekivatd

4

3- 2-

0

1983 1984 1905 1988 1987 1988

Sectoral Breakdown

1.24 The bulk of private sector investment (Table 1.7) in 1987 were in housing, manufacturingand transportation(in order of magnitude), followed by agriculture, tourism and mining. Transportation and agriculture have been steadily declining, while housing and tourism have been increasing sharply (tourism from a very low base). Investment in manufacturinghas been constant at about a third of private sector investment until 1987, when it dropped sharply. Counting agriculture,mining, manufacturing,tourism and energy as tradeablesectors, private investmentin 1988 was less oriented toward tradeable sectors than it was in 1983; the share in tradeable sectors has been steadily declining from 49.9 percent to 36.5Z. - 13 -

Table 1.7: Gross Fixed Investment (shares in percent)

Private Sector Public Sector

1983 1985 1987 1988 1983 1985 1987 1988

Tradeable Sectors 49.9 46.6 38.7 36.5 63.3 54.6 46.3 47.0 Agriculture 12.2 8.9 6.9 5.6 8.3 5.8 8.9 9.4 Mining 1.3 1.4 1.5 1.4 9.6 10.1 3.7 3.8 Manufacturing 35.0 33.5 25.6 23.8 18.6 14.1 6.5 6.1 Tourism 0.7 2.2 3.8 4.8 0.6 1.1 2.4 2.0 Energy 0.7 0.6 0.9 0.9 26.2 23.5 24.8 25.7

Non-tradeable Sectors 50.0 53.5 61.2 63.5 36.7 45.4 53.8 53.0 Transportation 16.9 17.9 12.4 10.9 22.5 28.5 32.6 29.6 Housing 28.4 30.3 43.9 48.3 1.5 2.4 1.5 1.9 Other 4.7 5.3 4.9 4.3 12.7 14.5 19.7 21.5

Source: State Planning Organization.

1.25 In the public sector (Table 1.7), energy and transportation together account for more than half of all fixed investment. The share in transportation has increased significantly from 22.5 percent in 1983 to 32.6 percent in 1987, while share in energy has been stable or slightly declining. The role of the public sector in agriculture in 1987 was about the same as that of the private sector, but had been held fairly constant in the recent five years, as opposed to the private sector's decline. Public sector investment in manufacturing and mining has been sharply reduced, consistent with a policy of increasing the role of the private sector in these fields, while prioritizing public responsibility for infrastructure. Using the same definitions of tradeable sectors, the 63.3 percent of public investment that was made in tradeable sectors in 1983 had fallen to 47 percent in 1987.

1.26 Investment in manufacturing in 1987 equalled 3.7 percent of GNP, or only 15.4 percent of total investments. This contrasts with the sector's share of 23.9 percent of GNP, and its dominant role in the successful growth of GNP and exports during the last five years. The sector's output has consistently grown at a higher rate than that of other sectors, and has also provided almost 100 percent of the crucial additional export earnings since 1983. The sector's exceptional growth performance despite low investments is partly explained by the general climate -- a decline in real wages, real exchange rate depreciations and explicit export incentives -- but would have been impossible without excess capacity inherited from the investment boom in the late 1970's. Private capacity utilization in manufacturing peaked at 77.5 percent in the first quarter of 1988, and further growth within the sector must be expected to demand a significant increase in investments. While the public sector's withdrawal from manufacturing industry is largely consistent with its strategy of increasing the role of the private sector, the response to the explicit and implicit incentive structure is even more crucial. The sector can grow at exceptionally low ICORs when idle - 14 -

capacity can be activated, but these ICORs will be seen to be increasing when capacity expansion is needed to a greater extent.

1.27 The composition of investments during 1983 - 1988, alongside rapid GNP and export growth, thus raises some concerns. The public sector's shift from tradeable to non-tradeable sectors makes sense only if the private sector steps in and makes significant investments in tradeable goods. This has not been the case during most of the 1986-89 period due to rising inflation. With the exception of the (relatively small) private investments in the tourism sector, only housing investments have increased significantly, while investment in manufacturing has been constant or declining.

1.28 In conclusion, the composition of the investment program does not sufficiently support the increased external transfer needed. Some modifying aspects should be mentioned, however: To the extent that infrastructure investment stimulate private sector investments in tradeable sectors, the increasing weight given to infrastructure could be seen as consistent with a shift of resources to tradeable sectors. The effect on the transfer capacity of the economy is indirect, however, and impact -- as well as the lag -- depend on the specific investments made, as well as other determinants of the investment climate.

1.29 As the public sector withdraws from the sectors generating export earnings, it will have to ensure the growth in these sectors through the general incentive structure. The general macroeconomic demand management, ensuring that domestic absorption is low enough to facilitate a transfer, must be accompanied by a sectoral breakdown, whereby capacity is found in due time within exportables and importables. The low levels of investment in tradeable sectors must be seen in the light of a weak and pressed financial system (see Part II). The resulting inflation and high real and nominal interest rates are detrimental to most unsubsidized long-term productive investments.

1.30 An important aspect of a debt service strategy is the extent to which capital inflow finances investments over and above those made possible with domestic savings. The fact that Turkey stepped up the level of investments through the 1980's obviously reduces the immediate impact of curbed consumption on the transfer produced. The composition of the investment program as well as exogenous market developments determines to what extent the investments result in a greater future transfer capacity. The capacity of the economy will be determined not only by the diversification of the real asset portfolio, but also by the amount (and form) of finance obtained from abroad. Turkey has found itself with an increasing debt-burden after 1982, and has adjusted consumption while increasing investments under continuous capital inflows. Terms of trade effects have been moderate (except for the oil price shocks of the 1970's) and since 1980 the country has undertaken wide-ranging economic reforms and maintained prompt debt service. In the next section, aspects of risk and liquidity are discussed in relation to short term current account management. In the short run as well as in the long run, such close current account management is needed in order to balance external and internal goals (as is further analyzed in Part II). The costs of such management, as well as the amount of domestic savings made available, is a part of the savings-investment problem. - 15 -

D. Current Account Scenarios

Box 1.1: Management of Uncertainties and Financing of the Current Account

1.31. Uncertainty affects both capital account and current account items in a (direct) positively correlated manner. Negative terms of trade shocks, associated with a higher current account deficit and thereby with a need for higher capital inflows, are likely to coincide with a more reluctant lending stance by Turkey's creditors."4 / The difference in the current account and the capital account (including net borrowings) are financed by a change in net reserves, but the way in which an unfavorable current account is financed may be associated with great present and future costs. This fact underlines the need for active current account management (through which the authorities influence the trade balance via domestic demand, trade regime, etc.), even though not all variables influencing the current account can be controlled. Empirical studies, showing that the demand for exports and imports is quite elastic, indicate that demand switching and domestic demand manage- ment can indeed affect the proceeds from the trade balance.15 /

1.32. If external funding is found in a way which does not provide implicit or explicit hedges against external shocks (this is the typical pattern, although Turkey has managed quite well within the limited scope of substantially changing currency composition in the short term, see Chapter 4), more debt will imply greater vulnerability. The reason is that the external debt requires an outflow of foreign currency that can not be manipulated through current account management.1 6 / As far as possible, uncertainty can be met by obtaining longer maturities on liabilities, and striving for a liquid, flexible assets portfolio.

1.33 In 1988, Turkey suddenly saw itself with more abundant foreign exchange, and used it to reduce short term debt and build up reserves, rather than to reduce medium and long term borrowing. This choice is consistent with a policy to increase liquidity when the circumstances allow for it. Instruments available to manage the current account (incentives, levies, lira-intervention) also represent "liquidity" to the extent that they are not fully utilized; if the external environment turns adverse they can be put further into effect, creating breathing space when the supply of loans or demand for exports is below

14/ Under reasonable assumptions about the effect of negative terms of trade shocks, foreign direct investment is likely to be affected negatively, just as voluntary lending.

15/ See for instance the Fiscal Policy Report, op.cit, and World Bank, PPR Working Paper 122, (Faini, Pritchett, Clavijo) 1989. Demand for exports is often shown to be price elastic, thus sensitive to incentives and the real exchange rate, while imports to a greater extent are responsive to domestic demand.

16/ The large interest bill in Turkey limits the flexibility with which one can manage current accounts. - 16 -

7 expectations .1 / Conversely, when the current and capital accounts, together, are not strained (as was the case in 1988), current account stimulation can be relaxed, saving costs as well as increasing future maneuverability.

The Necessary Domestic Policy Framework

1.34 In order to explore how the current account and the capital account can be matched, key parameters of the domestic economy need to be considered. The historical background is one of remarkable growth in exports and GNP, supported by a continuous capital inflow. However, as it is shown earlier in this chapter, investments in tradeable sectors have declined, and a further increase in capacity utilization in the manufacturing industries is unrealistic. Thus, if additional capacity is not established in tradeable sectors, growth in domestic demand will force imports to increase and exports to stagnate or decline. A future with supply constrained production in tradeable sectors would jeopardize the current account development necessary to make creditors comfortable with further gross inflows. Moreover, if the tradeable sectors are working at capacity, current account management through incentives and exchange rate depreciations can become ineffective. Then, the only instrument at hand in short run current account management is contractive fiscal policies and attempts to reduce the domestic growth rate.

1.35 As shown in the Fiscal Policy Report, an environment of high taxation of financial intermediation, high and variable inflation, and high real interest rates on lending affects private investment negatively. The provision of sector-targeted credits and subsidies are believed to have compensated partly for the negative effect of high real interest rates on investment, but this has not prevented the investments from taking place increasingly in non-tradeable sectors. As implied by the analysis in Part II, the public sector borrowing requirement exercises a major role in determining the level of private investments. For a given level of foreign finance, the public sector borrowing requirement can be financed only through monetization or domestic borrowing. The first of these sources will be associated with the rate of price inflation, while the latter will come about either through a higher real interest rate or through rationing bank credit, prioritizing the public sector. The broader set of fiscal policies, including the public investment program, tax and incentive structure, regulatory framework for the SEEs, trade regime, etc. has an even greater role in determining investment. Regarding the composition of investments, the public sector has shifted a significant amount of own resources into non-tradeable sectors. Private investment in housing, supported by the Mass Housing Fund, has picked up at the cost of manufacturing investment.

1.36 Hence, unless additional capacity within the tradeable sectors be put in place, any positive domestic growth rate will imply a growth in domestic

17/ If an instrument is provided at increasing marginal costs, there will be limits for its use defined by costs in terms of other objectives. This is the case for cash incentives to the extent that the costs of a greater fiscal expenditure become unbearable. The limit can also be given directly in terms of the effect on the current account; if the net revenues from imports and exports (the trade balance) approaches a price elasticity of one, exchange rate depreciations will not "work". The latter problem is likely when exports are import-intensive, when demand for Turkish tradeables is price-insensitive, and when the economy is fully indexed (hedged). - 17 - demand and a rapidly deteriorating trade balance. Such an increase in investments is unlikely, unless the pressure for resources from the fiscal deficit is reduced significantly. A fiscal contraction is likely to imply a slowdown of growth in the short term, implying that the policy shift will lower imports and thereforeaffect the foreign trade balance positively in the short term. Indeed, this has happened since mid-1988.

Current Account Scenarios

1.37 Four scenarios for the current account -- a High, Mid, and Low- Case plus the Government'sSixth Five Year Plan Case -- are presentedto explore the links between the current and capital accounts and the implications for future financing and debt service. (Attachment I of Annex I explains the underlying assumptionsand methodology of the module used in the projections.) It should be stressed that our illustrativescenarios are not formal economic projectionsof the Turkish economy in the medium-term. They are scenariosused to illustrate a particular point. The High Case Scenario and the Low Case Scenario,which are both deemed quite likely, illustratea "low" and a "high" external financing need, respectively. The High Case is similar to the Plan Case. A scenario between these two -- the Mid-Case -- illustrates that even quite optimistic assumptions imply considerablefinancing needs, and may call for a reduced domestic growth rate. As a background, illustrativeeconomic scenariosconcerning domestic and foreign demand,which drive the trade balance, are laid out. It is assumedthat productionof tradeableswill be supply-driven, and consequently that investments in tradeable sectors are increased. Any failure of investment in tradeable sectors to pick up will eventually prevent foreign demand from supporting export growth, thus increasingthe likelihoodof a financing need as indicatedby the Low Case Scenario, including the need for a slowdown of domestic growth.

1.38 Foreign and domestic demand drive the current account in these scenarios, thus assuming that capacity investments in tradeable sectors are restored, so that exports and imports are partly supply-driven. Much of the differencebetween the high exports and the low exports scenarios is explained by different interpretationsthat can be made regardingthe 1988 current account results. Certainly, reading the 1988 trade and resource balance as new information about a stable equilibrium for the prices and income levels prevailing through 1988, Turkey will be in a comfortable foreign exchange position in the next few years. Unless Turkey experiencesnegative terms of shocks, the countrywill be repaying debt (net) or borrowing only small amounts, and debt ratios will be improving. This prospect is explored in the High Case Scenario,which yields a currentaccount surplusof $995 million for 1989, almost identical to the Government's target. On the other hand, if one reads the elements of 1988 partly as structural shifts and partly as transitory shifts (e.g. the sharp fall in imports or the non-lastingeffects of regulatorychanges affecting exports), the basis for future current account projections will be shifted significantlydown towards the path of the 1987 deficit.'&/By exposing this basis to moderate terms of trade shocks (half a standarddeviation of export

18/ Developmentswhich contributedto the current account surplus in 1988 were: a good harvest, favorableworld market prices for agriculturalgoods, low oil prices, credits and other incentives to exporters. In 1988 tourism was strong after being depressedby events such as Chernobyland terrorism in 1986 and 87. Tourism is expected to continue the strong performanceof 1988. - 18 -

prices, two years in a row), Turkey's borrowing needs in the near future will be considerable, although some corrective action is assumed undertaken by the authorities, in order to reduce the domestic growth rate. Such a prospect is explored in the Low Case Scenario. The Medium Case Scenario is arrived at by adjusting the 1988 base less than in the Low Case, so that the current account is in balance in 1989, and not assuming any terms of trade shocks in the future.

1.39 Simulation of the financing of the various scenarios by different creditors and terms is based on the analysis of debt stock and recent borrowing in Chapter 2. It is assumed that world market interest rates stay at end-1988 levels, and that future exchange rate changes satisfy interest rate parity under this assumption. Thus, when balance of payments is reported in current dollars, debt in all currencies command the same interest costs when including exchange rate changes (but the loans of course differ with respect to spread, concessionality, etc.). This is a more relevant assumption than fixed exchange rates, since low-interest currencies tend to appreciate over time.

Assumptions Common to the Scenarios

1.40 Export growth is linked to the real growth rate of Turkey's trade partners with an elasticity of 1.2.19/ These economies are assumed to be growing at 2.2 to 3 percent annually (Table 1.8), which is consistent with World Bank planning assumptions. This yields growth rates in real terms of 2.6 to 3.6 percent. In nominal terms, with a dollar inflation rate of 4 percent, export earnings will grow by 6.6 percent to 7.6 percent annually. This is well within the supply capacity of the economy. Import growth is linked to domestic income growth with an elasticity of 1.4. This is in the range of formerly applied planning assumptions, and reflects the expected effect of a slowdown of trade liberalization, as well as a recent past of a broad-based growth in manufacturing output.'/ The parameter is also plausible in the light of recent cross-country empirical studies.2 1 / With the domestic growth rates of the Government's program, 4 percent in 1989 and 5 percent thereafter, the implied import bill in current dollars grows at 9.6 percent in 1989, 11 percent per annum later. These disparate growth rates of foreign and domestic economies imply a "pull" towards increasing trade deficits. Imports will be growing faster than exports, unless these forces are countered by effective current account management, which we have chosen to model in the form of a reduced domestic growth rate (demand switching would be less effective at high capacity utilization ratios). As will be seen in the Low Case Scenario, these assumptions can lead to a current account scenario which would be very difficult to finance. In that scenario, even after a necessary lowering of the domestic growth rate to 3.5 percent per annum, the financing need is seen as very high. Invisibles: Tourism earnings are assumed to grow at 15 percent annually in current dollar terms, down from 40 percent on average the last 5 years. Interest payments are calculated through the capital account simulations (Chapter 2). Other invisibles (credit and debit) are assumed to grow by the same rates as exports and imports, respectively. Transfers are assumed constant at their 1988 level. The predominant component is workers' remittances, which have been quite stable since 1980.

19/ The Fiscal Policy Report, op.cit.

20/ CEM, op.cit.

21/ Faini, Pritchett, Clavijo, op.cit. - 19 -

A. The High Case Scenario

1.41 As mentioned, for 1989, this scenario is almost identical to the Government's Plan Case except that, in the outer years, the High Case shows smaller current account surpluses than does the Plan Case. The base for the projections for 1989 and beyond are the 1988 figures. The growth rates still pose a pull towards increasing trade deficits, however, and the current account surplus is declining by nearly $0.5 billion annually, reaching a deficit of $473 million in 1993. In the recent past, export growth has been higher, and the difference between export growth and import growth has been positive. The High Case scenario envisages lower export growth rates because no real exchange rate depreciation is built into the projections (as opposed to an average depreciation of 6 percent annually between 1982 and 1988). Further, no terms of trade shocks are assumed in this scenario, reflecting the view that today's relative prices convey information about future relative prices (Turkey's terms of trade have on average improved by 5.7% annually over the last 5 years). In the past, oil price changes have been the dominant source of terms of trade shocks (and will probably be so in the future), but a major change in oil prices is not assumed. As it is argued earlier in this chapter, Turkey is partly hedged from the impact of oil price changes through compensating changes in export revenues from the Middle East. Table 1.8 shows the High Case Scenario.

B. The Mid-Case Scenario

1.42 In 1988, Turkey has an exceptionally good agricultural year, whereas 1989 started with a severe drought. This and other factors are reflected when the Mid Case scenario starts from a lower base in its 1989 projection. Thus, imports are higher and exports lower than in the High Case scenario. To meet the same domestic demand, Turkey's imports will increase by about $500 million and exports will drop by about $400 million. In this scenario the nominal export growth will be about 3.9 percent in 1989. With these assumptions, the 1989 trade deficit will be about $1 billion higher than that of the High Case and the current account balance is expected to be in slight deficit (Table 1.9).

C. The Low Case Scenario

1.43 The uncertainty with respect to the interpretation of the 1988 figures is here explicitly addressed (Table 1.10). Some of the identified factors underlying the current account improvement in 1988 are in this scenario not expected to continue and some adjustments are therefore made to the growth rates. The adjustments do not change the effect of a $1.5 billion surplus in 1988 (higher reserves, lower short term debt), but they ensure that the trends are only partly shifted by the 1988 events. In 1988, export prices increased by 3.5 percent and import prices decreased by 1 percent, on average.'/ These new prices are seen as shifts, and thus used as basis for the projections. On the other hand, future volumes build on trends that are not shifted by the 1988 events. The volumes above trend experienced in 1988 are therefore seen as a once-off gains, while the prices achieved are seen as "permanent changes".

1.44 These underlying assumptions were then exposed to two moderate consecutive, negative terms of trade shocks. Export prices fall by 1.5 percent each of the years 1990 and 1991, which equals half a standard deviation of export

22/ State Planning Organization. - 20 - prices each time. A supply response from exporters of the same magnitude is assumed, so that growth in export revenues will be 3 percentage points below trend these two years. A policy adjustment is assumed in order to modify the negative effects of the developments observed through this scenario. The authorities are assumed to succeed with policies to reduce domestic demand growth, resulting that GNP growth falls to 3.5 percent annually. The combined effect is that export earnings increase by 5 percent annually on average between 1989 and 1993, while the import bill increases by 11 percent on average. For invisibles, the same corrections are made, but no terms of trade shocks are applied.

D. The Government Five-Year Plan Scenario

1.45 The Government's Sixth Five Year Plan (1990-94) targets for the balance of payments are shown in Table 1.11. The plan case shows a higher current account surplus than the High Case scenario, especially over time, since it assumes higher export growth rates (13.2% annually) and higher GNP growth rates (7 percent on average per annum versus our 5 percent). Whereas the High Case assumes that the trade balance deficits rise substantially (more than doubling), the Plan projects the trade balance deficit to rise more gradually (25 percent increase over the period). Since the Plan also assumes higher domestic growth rates than the High Case scenario, the pressure from domestic absorption will be high. The projection thus implies a shift to a lower import elasticity as well as a more competitive export industry. If realized, the Plan Targets will allow for a faster net repayment of debt than the High Case. The absolute value of the debt stock will therefore drop rapidly, and ratios of debt to exports or debt to GNP, even more so. Indeed, with the envisaged successful development of exports, the country could afford to import more, thus allowing for investments or consumption.

1.46 Results: As mentioned, the results are summarized in Tables 1.8- 1.11. The non-interest current account surplus is unchanged at $4.3 billion from 1988 to 1989 in the High Case ($4.1 billion in the Plan Case), but falls to $2.6 billion in the Low Case. In the Mid- and Low-cases, the trade and resource balances are deteriorating, but faster in the Low Case. In the High and Plan Cases the trade balance does not deteriorate as much because of higher exports. There is a large difference between the High/Plan Case Scenarios and the Low Case scenario. The uncertainty is largely due to whether the 1988 outcome remains sustainable. The difference also comes from the negative terms of trade shocks applied in the Low Case, even when these are countered by a lower domestic demand growth. The implications for capital inflow are explored in Chapter 2. The ability to attract the necessary capital inflow, as well as the perceived costs of future debt service, will determine whether a "low case", if it materializes, can be financed, or if it should be met by a more drastic current account management, such as curbing domestic growth and aggressively depreciating the exchange rate. - 21 -

1.47 To run either large deficits or large surpluses on the current accountwould both be costly for Turkey in terms of scarce imports and forsaken growth. Likewise, a large capital inflow (as in the Low Case), can be either impossible to finance or unattractive,because of the involved costs. Thus, policies chosen by the authoritiesare likely to steer the ultimate consequences of any shocks towards moderate non-interest current account surpluses in the medium term. The need for tight current account management from the point of view of financeabilitymust be seen in the light of the discussion in Chapter Two. -22-

Table 1.8: Current Account Scenario, 1989-1993 - High Case

High Case, Results: History: ScanarioProjections: EffectiveGrouth rates: (xt/xt-1)-1

yg7-qu 1969 1990 1991 1992 1993 88 89 90 91 92 93 Trade Balance -3229 -1800 -2238 -3039 -3834 -4752 -5809 MerchandiseExports 10322 11846 12718 13562 14593 15702 16896 14.8 7.4 6.6 7.6 7.6 7.6 MerchandiseImports -13551-13646 -14956-16601 -18427 -20454 -22704 0.7 9.6 11.0 11.0 11.0 11.0 Other Goods Serv.Inc.cr 4111 5945 6562 7225 8004 8878 9857 TraveL 1476 2355 2708 3114 3582 4119 4737 59.6 15.0 15.0 15.0 15.0 15.0 Other 2635 3590 3854 4110 4423 4759 5120 36.2 7.4 6.6 7.6 7.6 7.6

Other Goods Serv.lnc.deb -4282 -4812 -5482 -5661 -5918 -6241 -6667 Interest -2507 -2799 -3276 -3212 -3200 -3224 -3318 11.6 17.0 -2.0 -0.4 0.8 2.9 Other -1775 -2013 -2206 -2449 -2718 -3017 -3349 13.4 9.6 11.0 11.0 11.0 11.0 Total Goods Serv. Income -3400 -667 -1158 -1475 -1748 -2116 -2619 Private Unreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 Workers Remittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0 Private Unreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 Official Unreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0 Non-int.Curr.Acct.Surplus 1525 4302 4286 3905 3620 3276 2867 Curr.Acct.Balance -982 1503 1010 693 420 52 -451

Source: World Bank Calculations.

Table 1.9: CurrentAccount Scenario, 1989-1993 - mid Case

Mid-Case,Results: History: ScenarioProjections: EffectiveGrowth rates: (xt/xt-1)-1

171988 1989 1990 1991 1992 1993 88 89 90 91 92 93 Trade Balance -3229 -1800 -3199 -4087 -4983 -6011 -7188 MerchandiseExports 10322 11846 12303 13120 14117 15190 16345 14.8 3.9 6.6 7.6 7.6 7.6 Merchandise Imports -13551 -13645 -15502 -17207 -19100 -21201 -23533 0.7 13.6 11.0 11.0 11.0 11.0 Other Goods Serv.lnc.cr 4111 5945 6562 7225 8004 8878 9857 Travel 1476 2355 2708 3114 3582 4119 4737 59.6 15.0 15.0 15.0 15.0 15.0 other 2635 3590 3854 4110 4423 4759 5120 36.2 7.4 6.6 7.6 7.6 7.6 Other Goods Serv.Inc.deb-4282 -4812 -5689 -6104 -6518 -7052 -7749 Interest -2507 -2799 -3483 -3655 -3800 -4035 -4400 11.6 24.4 4.9 4.0 6.2 9.0 Other -1775 -2013 -2206 -2449 -2718 -3017 -3349 13.4 9.6 11.0 11.0 11.0 11.0 Total Goods Serv. Income -3400 -667 -2325 -2966 -3497 -4185 -5080 Private Unreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 WorkersRemittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0 Private Unreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 Official Unreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0 Non-int.Curr.Acct.SurpIus 1525 4302 3326 2857 2471 2018 1488 Curr.Acct.BaLance -982 1503 -157 -798 -1329 -2017 -2912 Source: World Bank Calculations - 23 -

TabLe 1.10: Current Account Scenario, 1989-1993- Low Case

Low Case, RcauLts: ActuaL: Scenario Projections: EffectiveGrowth Rates: (xt/xt-1)-1

1987 1988 1989 1990 1991 1992 1993 88 89 90 91 92 93

Trade BaLance -3229 -1800 -3422 -4501 -5572 -6375 -7278 MerchandiseExports 10322 11846 12443 12950 13624 14741 15949 14.8 5.0 4.1 5.2 8.2 8.2 MerchandiseImports -13551 -13646 -15864 -17451 -19196 -21116 -23227 0.7 16.3 10.0 10.0 10.0 10.0

Other Goods Serv.Inc.cr 4111 5945 6244 6882 7640 8489 9441 TraveL 1476 2355 2474 2845 3271 3762 4326 59.6 5.0 15.0 15.0 15.0 15.0 Other 2635 3590 3771 4038 4369 4727 5115 36.2 5.0 7.1 8.2 8.2 8.2

Other Goods Serv.Inc.deb -4282 -4812 -5703 -6061 -6515 -7077 -7776 Interest -2507 -2799 -3363 -3487 -3683 -3962 -4350 11.6 20.2 3.7 5.6 7.6 9.8 Other -1775 -2013 -2340 -2574 -2832 -3115 -3426 13.4 16.3 10.0 10.0 10.0 10.0

TotaL Goods Serv. Income -3400 -667 -2881 -3680 -4447 -4963 -5613

Private Unreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 Workers Remittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0

Private Unreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 OfficialUnreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0

Non-int.Curr.Acct.Surplus 1525 4302 2650 1975 1404 1167 905 Curr.Acct.BaLance -982 1503 -713 -1512 -2279 -2795 -3445

Source: World Bank Calculations.

Table 1.11: The Current Account in the Plan Case

1989 19I9 1991 1992 1293 1994

Trade Balance -2,578 -3,065 -3,182 -3,239 -3,387 -3,823

MerchandiseExports (FOB) 12,281 13,444 1,5272 17,527 20,039 22,832

MerchandiseImports 14,859 16,509 18,454 20,765 23,426 26,655

Current Account Balance 820 947 1,450 1,919 2,272 2,172 (Other items not shown) - 24 -

CHAPTER II: STRUCTURE AND GROWTH OF EXTERNAL DEBT

A. Background

2.01 After a period of financial disorder at the end of the 1970's, a major goal of Turkey's economic policies in the 1980's has been to improve its balance of payments performance and to regain international creditworthiness. This effort was supported by successive IMF stand-by agreements, an OECD special action support program, and the restructuring of Turkey's international debt. This effort has been quite successful, as Turkey was able to produce significant non-interest current account surpluses mainly by promoting exports using real exchange rate depreciation as well as specific export subsidies.

2.02 The challenge in the coming years will be to sustain that trend in order to accommodate a continuing shift in Turkey's sources of funding from official sources to market borrowings. In this process, the authorities will be helped by Turkey's generally favorable image in the international capital markets due to the general improvement of economic performance and the prompt servicing of its foreign debt. However, the difficulties ahead should not be underestimated; on the one hand, the heavy debt burden associated with a large external debt and with the withdrawal of the official lenders requires increased resources. But on the other, foreign financing is becoming more expensive, shorter term, more volatile, and the cost of export promotion has become an important contribution to the fiscal imbalances. These problems should encourage further prudence in the choice of fresh borrowing and domestic resource mobilization, and more attention to liability management.

B. External Debt Structure in 1988

2.03 The stock of outstanding debt declined from $40.9 billion in 1987 to $39.1 billion at the end of 1988 (see Table 1 below and Annex 2 for details). This is the first time in the 1980's that the level of indebtedness has declined when expressed in US dollar terms. The decline is explained by two factors: (i) first, total net inflows (total new borrowings minus amortization payments) were small in 1988 at about $0.2 billion, as compared to $3.4 billion and $3.1 billion in 1986 and 1987 respectively (Table 2.2). The exceptional performance of the balance of payments in 1988 which registered a surplus of over $1.5 billion, allowed the authorities to retire over $1 billion of short term debt, reversing the trend of the last four years, when short term debt increased rapidly by over $1 billion annually (Table 2.2); (ii) second, the currency valuation effect due to the dollar appreciation at the beginning of 1988 reduced the dollar value of the outstanding debt by about $2.3 billion. This compares with an aggregated valuation effect that increased the stock of debt by about $11 billion between 1985 and 1987, when the dollar depreciated considerably (Table 2.2). These figures have been estimated on the basis of year-end stocks and net flow figures. Discrepancies can arise to the extent that (i) the stock data has not been corrected adequately for exchange rate changes; (ii) flow data are not measured accurately in the balance of payments; and (iii) Turkish residents have accumulated unrecorded foreign assets. - 25 -

Table 2.1: External Debt Outstanding by Creditor Type (1984-1988) (millions of US dollars)

1984 1985 1986 1987 1988

Total External Debt 1/ 21,563 25,976 32,783 40,932 39,057 Of which: Official Long Term 1/ 10,246 12,388 15,040 18,292 17,508 Private long term 5,389 5,645 7,268 9,532 9,714 Short Term Debt 2/ 2,728 3,939 5,603 6,726 5,640 Dresdner Accounts i/ 1,774 2,677 3,787 5,612 5,897 IMF 1,426 1,326 1,085 770 299

Memorandum items Short term /Total debt (%) 4/ 24.7 23.8 22.8 21.8 20.5 Variable rate/Total debt (%) l2/ 42.3 42.1 43.7 44.2 44.5

Notes: 1/ Includes adjustment for valuation changes in IBRD loans arising from the World Bank's currency pool system. The cumulative adjustment on IBRD loans was $1,363 million as of December 31, 1988. This explains the difference between the Government's official figures of $37,694 million total debt at end-1988. V Total short term debt from private and public sources plus foreign exchange deposits; excludes Dresdner accounts. 3/ All maturities. 4/ Includes the short term portion of Dresdner accounts as short term debt; hence, the proportion is lower than is shown in Annex 2. 5/ Includes all short term debt including all Dresdner accounts as variable rate debt.

Sources: Treasury, IBRD, Central Bank of Turkey.

2.04 Despite the slowdown of net borrowing in 1988, gross borrowing stood at a near record $5.9 billion. In effect, while Turkey has been running non-interest current account surpluses since 1984, the overall current account has been in deficit (until 1988) due to the large interest payments on externaL debt. Thus, part of the interest bill and the whole amortization bill had been financed by new borrowings. Until 1984, the debt burden was relatively low, the result of the grace periods arising from the 1980-82 rescheduling. But total debt service (including short-term debt repayments) rose steeply after 1984, reaching $8.5 billion in 1988, more than twice its size in 1984. This heavy burden represented about 38 percent of exports (of goods and services plus transfers) and nearly 10 percent of GNP in 1988 (see Tables 2.6 and 2.7 later). - 26 -

Table 2.2: Net Flows by Creditor Tvpe 1984-1988 (millions of US dollars)

1984 1985 1986 1987 1988

Total Debt service 3,106 4,527 4,501 6,080 8,486 of which: Amortization 1,381 2,614 2,369 3,465 5,719 Interest 1,725 1,913 2,132 2,615 2,767

Gross disbursements 4,393 4,344 5,749 6,590 5,896 Net Flow 3,012 1,729 3,380 3,124 177 Valuation change 1/ -397 2,684 3,427 4,906 -2,631

Net Flows by creditor type Official Long Term 1,066 558 644 410 199 Private long term 280 -133 1,096 1,187 569 Short Term Debt 2/ 940 1,211 1,664 1,123 -1,086 Dresdner Accounts 769 344 352 850 926 IMF -43 -251 - 376 -445 -431

Notes: 1/ Calculated as the difference between the change in stocks and new net flows. 2/ Excludes Dresdner accounts.

Sources: Treasury, Central Bank of Turkey, IBRD estimates.

2.05 Besides the termination of the grace periods and the heavy net borrowings between 1985 and 1987, the increase in the debt service is also the result of a dramatic shift in Turkey's sources of credit. Since 1984, the bilateral creditors who financed a large part of the 1980-82 rescheduling have been reducing their lending, and Turkey has financed a growing share of its borrowing from more expensive commercial loans that carry shorter maturities and grace periods. The changing profile of Turkey's lenders is evident in Table 2.3: between 1984 and 1988, the share of gross lending by multilateral and bilateral sources was reduced from 48% to 26% while the share of financial markets increased from 33% to 61%.

2.06 Net lending is a useful concept, as it measures new lending netted of amortization payments. Thus, a positive net flow measures the increase in the debt stock that is not due to valuation changes, but rather to net lending. A negative net flows from a particular creditor group indicates that the group is reducing its absolute exposure to Turkey. With the exception of the IBRD and the Dresdner accounts -- which maintained a relatively stable share of total net flows -- the shares of all the other creditor groups show a very pronounced - 27 - shift.'/ This is depicted in Table 2.3, which shows that:between 1983 and 1987, non-IBRD official sources (multilateral and bilateral) reduced their relative exposure to Turkey, while the share of commercial sources in total net flows has increased by more than two-folds. In addition to reduced gross borrowing from official sources, increasingly larger debt service obligations to those sources came due in the recent years, leading to a turnaround in their share of total net lending. Already in 1984, the official non-IBRD lenders contributed only 10% of total net flows; but by 1987, they reduced their exposure by an amount equal to 15% of total net flows. The withdrawal of this group required large net financing from other sources and in particular, from the financial markets whose share of net flows rose from 34% to 74%. The very rapid build-up of the net exposure to Turkey of commercial sources is partly due to the relatively low proportion of debt owed to them prior to 1984.

Table 2.3: Shares of Total Credit and Terms on New Loans by Creditor Type

Share of total Share of total Terms of new com- disbursements net flows -mittments, 1988 ------1/- 1983 1987 1983 1987 Int. Mat. Grace

IBRD 16 12 22 15 7.8 16.6 4.6 Other multilateral 2/ 18 4 18 -8 5.4 11.4 7.5 Official bilateral 14 10 -8 -7 5.2 18.3 5.3 Financial markets 3/ 33 61 34 74 7.8 7.0 3.0 Dresdner accounts i/ 19 13 34 27 10.6 1.0 0.0

Total 100 100 Total 100 100 Av. 7.3 7.5 4.9

Notes: _/ These are simple weighted averages of new commitments. 1 Includes IMF. ./ Includes increase in short term debt, net suppliers credit and private non-guaranteed debt; excludes the Foreign Military Sales (FMS). i/ Terms are weighted averages of the three maturities available.

Sources: IBRD

t/ The Dresdner Scheme is a special arrangement between Dresdner Bank in the Federal Republic of Germany and the Central Bank of Turkey, to attract deposits of Turkish workers residing in Germany. The Central Bank of Turkey sets the interest rates offered under the scheme, with the Dresdner Bank acting as an agent to facilitate remittances back to Turkey. These funds are in addition to the figures for workers' remittances that appear in the balance of payments. See paras. 2.13-2.15 for more discussion. - 28 -

2.07 As a result of this dramatic shift in the source of external credits and because debt contracted from financial markets tends to have a shorter maturity than the official debt, the maturity profile of Turkey's outstanding external debt has been reduced from 16.5 years in 1980 to 11.2 years in 1988. The types of financing now used typically carry higher interest rates and shorter maturities than the outstanding debt (see Table 2.3). Excluding the recent FMS issues (see Chapter 3), the average maturity of new loans was only 7.5 years in 1988.

2.08 There are signs however that this trend can be gradually reversed. Turkey has lately been able to borrow more from capital markets at gradually better terms: in particular,between 1987 and October 1989 the Government of Turkey and the Central Bank borrowed about $1.2 billion equivalent from the Frankfurt bond market in seven bond offerings that raised as much funds as the syndicated bank loans (see Chapter 3). After the first of the seven offerings, the maturities of the remaining issues have been extended (from five to seven years), while the spread decreased (from 200 to less than 100 points over the German Bund rate). This is a significant achievement for a country once confronted with debt problems requiring reschedulings in 1978-82, to be able to borrow so extensively in the West German capital markets five years later. Also, as shown in Chapter 3, Turkey has been able to borrow effectively in the Japanese markets. In the future, both Yen and Eurodollar issues continue to appear promising sources of capital to Turkey.

Short Term Debt

2.09 After an extremely rapid rise in 1985 and in 1986 (of 44% and 42% respectively), the rate of growth of short term debt (excluding the Dresdner accounts) subsided to less than 20% in 1988. The current account surplus of $1.5 billion in 1988 allowed the authorities to reduce short term debt by about 10%. However, the share of short term debt in total debt outstanding remains high, at about 16% if we exclude the short-term Dresdner accounts, and at 30% when they are included. Since trade finance is estimated to consume only about $3 billion, the difference (about $2.6 billion) may reflect the difficulty in securing sufficient amounts of long-term loans. (Tables 2.1 and 2.2).

2.10 While the recent stabilization of the share of short-term debt in total debt is a welcome achievement, it will be important in the medium term to continue reducing the stock of short term debt, as was done in 1988. That would not only reduce the gross borrowing needs over the short term, it would also reduce the cost of foreign debt, in terms of both the financial costs and the risk of instability. In this respect, a review of the Dresdner scheme should be envisioned, given the extremely costly nature of this form of finance (see below for a more detailed analysis). Moreover, the authorities should be concerned about the stability of the foreign exchange currency accounts in Turkish banks. While the system currently seems very liquid, safeguards must be created to ensure stability in the event of balance of payment difficulties, however unlikely that may be. - 29 -

Variable Rate Debt

2.11 Debt subject to interest rate changes (including short-term debt) has been increasing as a share of total debt, and now represents about half of Turkey's total debt, thus considerably increasing the exposure of the domestic economy to interest rate risk. Given the increased volatility of world interest rates, one important task of liability management must be to contain such risks, both by attempting to continue reducing short term debt, by borrowing more at fixed rates (and here, the new access to bond financing will help), and by possibly swapping some of the medium-term outstanding floating rate debt into fixed interest rates debt (see chapter 4).

Public/Private Debt

2.12 Three-quarters of Turkey's external debt is held by the public sector, but the private sector share has been growing since 1982. The latter share increased sharply in the period 1982-86, but seems to have stabilized around 25% in 1988. While the increase was mostly due to additions in medium and long term debt, the high level of private borrowings is mostly due to the large share of private debt in total short term debt. Table 2.4 below shows the shares of private debt and public debt.

Table 2.4: Private Sector Share in Three Categories of Debt (percent)

1982 1983 1984 1985 1986 1987 1988 Private Share of:

MLT Debt 6.0 7.7 9.5 11.4 12.5 14.9 15.0 Short Term Debt 60.0 57.1 57.9 60.1 57.7 52.2 55.0 Total Debt 11.4 13.9 16.7 20.6 22.5 23.4 25.0 Memo Item: Public Sector Share 88.6 86.1 83.3 79.4 77.5 76.6 75.0 of Total Debt

Source: Undersecretariat of Treasury, IBRD estimates.

The Dresdner Scheme

2.13 The amounts outstanding under the Dresdner scheme increased slightly when measured in US dollars from $5.6 billion in 1987 to $5.9 billion in 1988 (see table 2.5). Measured at fixed exchange rates, the Dresdner total account increased by $926 million. This increase was offset by a large negative valuation change of $641 million due to the depreciation of the DM against the US dollar in the first three quarters of 1988 (about 90% of the outstanding deposits are denominated in DM). The net inflow in 1988 was therefore slightly larger than in 1987 ($850 million), but, due to the contraction of Turkey's total net borrowing from other sources, the contribution of the Dresdner scheme to - 30 -

total net borrowing was substantial, at over five time total net flows (details in Annex 2).

Table 2.5: Dresdner Accounts (millions of US dollars equivalent)

1982 1983 1984 1985 1986 1987 1988

Debt Outstanding 818 1,249 1,774 2,677 3,787 5,612 5,897 Net Flows 802 573 769 344 352 850 926 Valuation change 16 -102 -244 559 758 975 -641 Dresdner/Total Net Flows .75 .34 .26 .20 .10 .27 5.2

Source: Central Bank of Turkey and IBRD estimates.

2.14 Given the heavy reliance of the capital account on this form of finance, concerns about both the stability and the cost of the Dresdner funds become extremely important. Accordingly, effective May 15, 1989 the Central Bank reduced the interest rates offered under the scheme by about 3-4 percentage points and introduced other reforms. Dresdner accounts are now be restricted to the following five currencies: US$, DM, Dutch Florin, French and Swiss Franc. Dresdner Bank accepts only one and two-year deposits and sight deposits are no longer offered. The latter is a major improvement towards greater stability. In the case of withdrawals before maturity, depositors will receive only 2 percent interest. Interest rates under the scheme are:

DM DF FF SWF US$ (in percent)

1-year deposits 6 6 6 4 10 2-year deposits 9 9 9 6 12

The new rates are significantly lower than the previous rates, for instance 6 percent, versus 10 percent for one-year DM deposits.

2.15 In the future, the authorities should continue to look for additional ways to lower the costs of the Dresdner Scheme, including the administrative costs, and further reforms of the Dresdner scheme will need to be carefully sequenced, given the importance of this source of funding in terms of net flows. Policy changes should balance capital account inflow considerations with concerns about the net cost of funds. This can involve the establishment of minimum balances, a renegotiation of the reserve policy and the timing of the banking transactions with Dresdner Bank, and possibly, changes to the tax liability on accounts that in effect remain with the banking system until the depositor returns to Turkey. Besides the Dresdner Scheme, the Central Bank manages, as part of its balance of payments operations, the short-term debt stock. In this sense it performs a vital function in liability mangement. - 31 -

C. Creditworthiness and Debt Ratio Analysis

Market perceptions

2.16 In the course of this study, contacts were made with numerous international commercial bankers and investment bankers in Turkey and in New York, London, Frankfurt and Tokyo. The purpose of these discussions has been to develop an understanding of market views with regard to Turkey's likely access to external financing during the next few years. The market appreciates that Turkey has now emerged from a long and difficult post- rescheduling period and that the Government has performed remarkably well vis-a-vis the debt service commitments that it undertook at the beginning of that period and are will to provide Turkey with commercial finance (new money). However, banks and investors alike continue to hold a cautious attitude partly because of global developments on the debt front and partly because of remaining economic imbalances in Turkey, such as inflation. This is probably because inflation is taken as a signal of unsustainable demand for credit. Successful efforts by the Government to further improve its economic balances are likely to be met by considerable support frDm the financial community.

2.17 The price of Turkey's external debt in quoted secondary market transactions in New York has remained more or less constant at 98-99 cents on the dollar during the last few years. However, this quoted price does not seem to be a good reflection of the actual price at which transactions are carried out. The reason why the quoted price is so high is partly due to the fact that there is very little supply of Turkish paper in the secondary markets. Market information indicates the existence of occasional larger discounts in interbank trading, of around 3% to 5%, depending on the spread and maturity of the Turkish paper in question, but there is little such secondary trading taking place.

2.18 The Government's stance to curb public investment and hence excessive borrowing (see Chapter 7) was viewed favorably by the financial community, even though it created uncertainty as to what would be the status of individual project proposals and borrowing offers. This process is taking on clearer shape, as Turkey rationalizes its public spending program, and it may explain why 1989 turned out again to be a year in which the authorities were able to obtain the necessary loan funds as and when needed.

2.19 The large volume of short term borrowing in 1L987 and in the beginning of 1988-- both by the private and public sectors -- worried the banks. They were especially concerned by the fact that certain public sector borrowers were taking on short-term credits on terms that were considerably more costly than the longer-term borrowings of the Central Government. Tlhis reduced the market's appetite for Government paper and exercised upward pressure on the terms at which the Government itself can borrow. This situation too has eased as the public sector agencies engaged in less borrowings from mid-1988 onwards (see Chapter 7).

2.20 As analyzed in detail in Chapter 3, Turkey has developed a range of diversified borrowings sources and instruments in the European, New York and Tokyo capital markets. The floatation in December 1989 of the Turkish Investment Fund (TIF) on the New Stock Exchange, which was partly underwritten by the - 32 -

International Finance Corporation (IFC), adds another important dimension to Turkey's access to world capital markets. All of these various initiatives constitute elements of a borrowings and financing strategy based on market solutions.

Creditworthiness and Debt Ratio Analysis

2.21 Debt ratios are helpful for ascertaining creditworthiness in the medium term, and for measuring the burden of foreign debt service. They are also helpful in drawing international comparisons, an exercise that gives clues about the reactions of the international financial community to a given economic situation in debtor countries. The main ratios are summarized below and the details are shown in Annex 2.

Table 2.6: Debt Ratios (in percent)

1984 1985 1986 1987 1988

Total debt/GNP 1/ 44.7 50.5 58.0 60.6 55.6 Total debt/Exports 2/ 186 198 263 249 200 Interest/GNP 1/3/ 3.6 3.7 3.8 3.7 3.9 Interest/Exports 2/3/ 14.9 14.6 17.1 15.2 14.2 Debt service/Exports Z/4/ 26.9 34.6 36.1 36.3 37.9

Notes: 1/ GNP evaluated at year average exchange rate 2/ Exports of goods and services plus workers remittances 3/ Total interest including interest on short term debt 4/ Total debt service including interest on short term debt

Sources: Treasury, Central Bank of Turkey, IBRD estimates.

2.22 The debt to GNP and debt to export ratios are typically used as measures of credit-worthiness. While the latter is important for measuring the amount of resources that can be used for debt service in the short run, the former is a longer term measure. It is also important to recognize that in the short run, an increase in the debt to GNP ratio is not necessarily adverse, since this measure is affected by real devaluations, which are designed to increase exports and thus to reduce the debt to export ratio. In 1988, both ratios improved after a large deterioration in 1986 and they now stand at 56% and 200% respectively. The improvements were supported by a large currency valuation effect and a modest net inflow. A continuation of this trend is likely to markedly improve the market perceptions of Turkey's credit-worthiness, especially as the international market is now awaiting a confirmation of a long-term improvement in the external account.

2.23 An international comparison reveals that stabilization of these ratios will indeed place Turkey in a situation comparable to those of Portugal and Hungary. Moreover, Turkey -- a member of the Moderately Indebted Middle-Income - 33 -

Countries (MIMC) Group of countries -- is clearly in a much better position than the Severely Indebted Middle-Income Countries (SIMCs), principally due to its export drive, which has resulted in a debt to export ratio that is now about 30% lower than the comparable ratio of the SIMCs. Table 2.7 shows this comparison.

Table 2.7: International Comparison (1988)

Turkey Tunisia Korea Portugal Hungary Indonesia SIMCG MIMCS

Total debt ($bil) 39 7 37 17 18 52 518 205 Total debt/GNP 56 70 22 42 65 69 54 54 Interest/GNP 4 4 2 3 5 5 4 3.5 Total debt/exports 200 138 52 95 140 247 317 207 Debt service/exports 38 23 13 29 27 44 41 35

' SIMC:Severely Indebted Middle-Income Countries Include: Argentina, Bolivia, Brazil,Chile, Congo P.R., Costa Rica, Cote d'Ivoire, Ecuador, Honduras, Hungary, Mexico, Morocco, Nicaragua, Peru, Philippines, Poland, Senegal, Uruguay, Venezuela.

f MIMC:Algeria, Cameroon, Cape Verde, Colombia, Dominican Republic, Egypt, Gabon, Greece, Guatemala, Israel, Jamaica, Paraguay, Syrian Arab Repub:Lic, Turkey, Yugoslavia, Zimbabwe.

Source: World Debt Tables 1988; World Bank; Washington D.C.

Debt Burden

2.24 The debt service and interest ratios remained high due to the heavy debt burden in 1988. The total debt service to exports ratio (including workcers remittances) remained around 37 percent. However, the interest to exports ratio declined slightly (from 15.2 percent in 1987 to 14.2 percent in 1988) due to a small rise in interest expense and continued export growth. The goal of new borrowings and liability management should be to stabilize or lower these ratios, principally by reducing the exposure to interest rate and cross currency risk and attempting to shift to cheaper sources of finance. Moreover, a furt:her diversification of financing sources and in particular of the Eurobond market will help to reduce Turkey's reliance on expensive sources of finance such as the Dresdner accounts, and might allow enough breathing space to refinance the most expensive short term debt. * 34 -

Box 2.1: Where Does Turkey Stand on the External Debt Front?

2.25 An international comparison reveals that the debt burden in Turkey is lower to that of Indonesia and heavier than that of Tunisia, Korea, Portugal and Hungary. Turkey's burden is heavier than Tunisia's because a smaller portion of foreign debt is concessional in Turkey. The burden is heavier than Korea's because a larger proportion of GNP is exported in Korea, and because Korea has managed to lower the cost of its international finance through access to off-shore Asian sources of finance.

2.26 The various debt burden ratios point to the challenges in the road ahead. The burden of external debt appears higher in Turkey than in the average MIMC. It is only slightly lower than for the average SIMC group because the latter have more recently rescheduled their debts (thus securing some short-term relief), while Turkey is in the midst of servicing its projected peak in debt obligations arising from a much earlier rescheduling. The SIMC's profile may have been achieved at the cost of a heavier future burden (as happened with Turkey if one compares the 1979 vs. the 1989 profiles), in addition to short-term costs connected with difficulties in attracting voluntary lending and adequate trade finance. On the other hand, Turkey has actively sought commercial funds, despite a significant debt burden, because it believes continued market access to be fundamental to its workout prospects (Chapters 3 and 8 discuss this in more detail). This strategy is not necessarily suitable for SIMCs, but is of great interest to the MIMCs.

D. Future Outlook

2.27 When Turkey emerged from its reschedulings in 1981, its future debt service was projected to be small until 1986, given the grace period on the repayment of rescheduled debt that averaged 5 years. The debt service was thus supposed to jump around 1986 as large amortization payments come due, and to slowly decline thereafter as the principal was repaid. This gave rise to the notion that once the 1986 "hump" in debt service was passed, debt obligations would get smaller. In reality, as the debt service payments were partially financed by new borrowings, this logic turned out to be incorrect, and debt service increased substantially both in 1987 and in 1988. Moreover, it quite likely that debt service will keep increasing in the future, with the rate of growth dependent on the size of the current account deficits, and as important, on the terms and especially the maturity structure of new borrowings.

2.28 In order to project the likely growth of debt service, we have used the two most illustrative scenarios for the current account described in Chapter 1, namely the High and Low Cases. Both scenarios use the government target GNP growth rate of 4% in 1989 and our estimate of 5 percent thereafter. The first scenario essentially assumes that the trend observed in the last two years in - 35 - the current account will continue in the future. This gives rise to a scenario in which the non-interest current account starts ct a surplus of over $4 billion in 1989, declining to a surplus of $2.8 billion n 1993. The second scenariLo is more pessimistic as it assume a negative terms cf trade shock of 1.5% in 1989 and again in 1990. This movement represents about half the standard deviation of the terms of trade and can thus be expected to occur with a reasonable probability. Moreover, the low scenario allows for a policy response to diffuse the effect of the terms of trade shock on the current account (the export elasticity is increased after the shocks while the import elasticity is reduced). As a result, the overall current account is assumed to be at a deficit of around $700 million in 1989 (rather than the high case surplus of just under $1 billion), increasing over time to a deficit of $3.5 billion in 1993. However, the non-interest current account would remain in surplus, throughout, declining to only $0.9 billion in 1993. In both scenarios, we take into account the changing composition of Turkey's lenders and the implied shortening of maturities.

2.29 The results of the simulations appear in Tables 2.8 and 2.9. In spite of the small difference in the assumptions underlying the two scenarios, the results of the simulations are quite different. In the high case, Turkey debt ratios improve markedly while in the low case, they remain essentially constant, with a moving debt service hump.

2.30 In the high case scenario, gross borrowing initially falls to about $4 billion in 1991 due to the current account surpluses. But over time, the current account surplus decreases in order to accommodate GNP growth, and foreign borrowings picks up again. Borrowings from private borrowers decline most, since it is assumed that this source is treated as a residual source. As a result, commercial disbursements of about $2 billion, rising to $3 billion by 1993, are sufficient to fill the financing gap.

2.31 All the debt ratios decline over time in this high case scenario. The debt to exports ratio reaches a level of 150 and the debt to GNP ratio falls to 38 percent in 1993. These ratios would place Turkey in a situation comparable to those of Portugal and Korea today. As debt is effectively repaid over time, the debt burden ratios also decline, with the debt service to exports ratio falling to 29 percent in 1993. Again, this would make Turkey's situation in 1993 similar to that of Korea and Portugal today.

2.32 In the low case scenario however, Turkey's borrowing needs remain around $6 billion or more annually. As a result, the debt service burden builds up, partly because of a necessary reliance on larger amounts of expensive and shorter term commercial debt. In this scenario, commercial borrowings of $3.5 billion are needed in 1989, rising to $6.6 billion in 1993. The debt service obligation rises to $9 billion in 1993. These amounts again indicate the difficulty of the low case scenario, particularly when we compare the detailed borrowings of 1988, which while large, never reached these magnitudes (see Chapter 3).

2.33 Nevertheless, the debt ratios remain stable in the low case scenario. This suggests that with a reasonable probability, the descending part of the "hump" in debt service has not yet been reached. In reality, the debt service ratios will not decline unless: (i) Turkey runs current account surpluses that - 36 - are large enough to allow for a net reduction in the stock of debt; or (ii) Turkey manages to refinance its existing debt with new borrowings that have longer maturities and grace periods than the existing debt stock. Given the shift from official to market finance, the latter is unlikely unless Turkey reschedules its external debt. Thus, without a rescheduling,larger current account surplusesas assumed in the high case scenariowill be required in order to reduce the need for large gross borrowings in the future.

2.34 The financingneeds from commercial sources are thus likely to oscillate between $2.5 billion and $4 billion in the next two years with the exact requirementdependent on the performanceof the current account, as well as on the maturities and grace periods of the new loans. This should be compared with the record borrowing of about $2.5 billion from these sources in 1988 and a slightly lower level thus far in 1989. As a consequence,and if past trends are not reversed, there might well be in the future a heavy need for commercial borrowings in times of current account weakness. Given that commercial supply tends to dry up in such times, our simulationanalysis impliesthat Turkey might face external financing difficultiesin the future,with an associatedneed for either further increases in short-term debt or import restrictions. If such a situation were to arise, the existence of large amounts of short-term currency deposits could lead to financial instability,in the absence of international support. This suggests the need for an increasedexport effort. As important, the requiredswitch to more volatilemarket borrowingsdemands a sustainedeffort to reduce risk: at this juncture, Turkey cannot afford an open position in relation to either interest rate risk or exchange rate risk.

Table 2.8: Simulation 1: High Case Scenario (1987-1993) (billionsof US dollars)

1987 1988 1989 1990 1991 1992 1993

Non Interest Current Account 1.5 4.3 4.3 3.9 3.6 3.3 2.8 Debt Service 6.1 8.5 8.2 8.6 7.4 7.8 7.9 Gross Disbursements 6.6 5.9 4.2 4.8 3.9 4.6 5.1 of which: Private Creditors 1/ 4.8 3.9 1.8 2.8 2.0 2.6 3.1

Total debt/Exports 248 200 193 180 169 160 152 Total debt/GNP 60 54 50 46 43 40 38 Debt service/Exports 37 38 41 40 31 30 29 Interest/Exports 16 14 16 15 14 13 12

1/ includes short term debt and Dresdner accounts.

Source: IBRD estimates. - 37 -

Table 2.9 Simulation 2: Low Case Scenario (1987-1993) (billions of US dollars)

1987 1988 1989 1990 1991 1992 1993

Non Interest Current Account 1.5 4.3 2.6 1.9 1.4 1.1 0.9 Debt Service 6.1 8.5 8.3 7.8 8.2 8.8 9.4 Gross Disbursements 6.6 5.9 5.9 5.8 6.9 7.7 8.6 of which: Private Creditors 1/ 4.8 3.9 3.5 3.9 5.0 5.7 6.6

Total debt/Exports 248 200 207 207 209 208 209 Total debt/GNP 60 54 55 56 57 57 57 Debt service/Exports 37 38 42 37 37 36 36 Interest/Exports 16 14 17 17 17 16 17

Note: Mid-Case Scenario not shown here as it is not as illustrative as the above two scenarios from the financing perspective.

1/ includes short term debt and Dresdner accounts.

Projections using RXD System Strategy Module,IBRD.

E. Conclusions

2.35 The exceptional improvement of the current account in 1988 has allowed Turkey to improve its external liability position. Total debt has declined when measured in dollar terms, and the past trend of a rising short-term debt wEas reversed. While the prospects for the future look reasonably good, it will be important to develop new debt management techniques to reduce the exposure to interest rate and exchange rate risk, so as to reduce the risks of slippages. Given the need to shift to market sources for new external borrowings, any such slippages can become quite costly, since the additional debt service burden will most likely need to be financed with shorter term and more expensive credits than the outstanding debt. -38-

Chapter III: FINANCINGPLAN AND EXTERNAL BORROWING

A. Background

3.01 This chapterreviews Turkey's financingplan for the medium term and the relatedborrowings program. First, the aggregateexternal financingtargets for 1989 are discussedby sources and uses, along with capital inflows/outflows, comparingthese to the 1988 actuals. Second,the (itemized)borrowings programs executed in 1988 and in 1989 (upto October) are analyzed in detail, in order to provide an indication of the feasibilityof the financing plan presented, and also to provide insightsinto Turkey'sstrategic choices in the future (discussed in Chapter 8). Throughout,the focus is on sovereignrisk borrowings -- those that the Goverrmientborrows itself or guarantees: borrowingsby the Treasury, Central Bank, and State Economic Enterprisesare included, but non-guaranteed borrowings by the private sector are excluded. Finally, the chapter concludes with some recommendationson Turkey's market choices.

3.02 The pressure to arrange external borrowings stems from the need to finance a given current account deficit in a given year, and the need to have financingin place to meet amortizationpayments on externaldebt. With the rise in amortization requirements starting in 1986 (arising from the 1978-82 reschedulings),Turkey has had to ensure that at various times in the year (usuallyaround July and November,December and January) it has sufficientfunds in place to meet its debt service obligationsin a timely manner. Increasingly, Turkey has resorted to borrowing from internationalcommercial sources to fill the financinggap.

3.03 One factor mitigating this problem has been the declining current account deficit, which dropped from 6 percent of GNP in 1980 to less than zero at present. The pattern has been one of steady improvement;in only in a few years (such as in 1986) did the current account deficit rise, causing the Governmentto meet the gap in that year through increasedshort-term borrowings. Had it not been for the performanceof the current account, Turkey would have had a substantiallyhigher debt profile today.

B. Financing Plan

3.04 The Governmentbases its borrowings plan on several considerations: (i) the external transfer outlook; (ii) the outlook for the current account; (iii) the implied transfer of net private savings to the public sector; and (iv) the strategy (adoptedin 1989) that the Treasury'snew externalborrowings would be limited to the amount of principal repaymentsfalling due in the given year. This means that the public sector external debt stock is in essence being rolled over. When the Government formulatedits financingrequirements for 1989-91 as part of the document entitled Turkey: Economic Developments Policies and Prospects,dated March 1988 (which was distributedto numerous commercialbanks in London, New York, Frankfurt, and Tokyo), the Government estimated that it would need to borrow from abroad about $5.0 billion annually (in project credits plus non-projectcredits), or about $15 billion over 1988-91. As a comparison, Turkey borrowed $6.8 billion in 1987 and $5.8 billion in 1988. In 1989 Turkey's -39- external borrowings declined to $4.96 billion in accordance with the strategy to limit borrowings to the amount of principal falling due. This reduced need for arranging external borrowings is an important new development for Turkey, because it not only gives the policy makers more time to arrange the most suitableborrowings from any market,but it also allows the flexibilityto choose which market to enter. Since this process is so important to the theme of this study, we will now examine the borrowings in detail.

Figure3.1 FINANCINGDECISION TREE*

-SPO-TresrySPO_ -__ _ _ _ Treasury - Treasr1Deids l ~~~~~~~~~Financethe Estimatedio to BudgetDeficit Givesthe Macro Givesthe Financing l Balancesfor theYear Needsfor theYear

Gross \ Is it Obtained?- Extera Borowings

Gross Is it Obtained? - DomesticBorwng __ _ _ Issuingof Government Bondsand Treasury Bills

Central (Up to 15% of BankAdvances BudgetaryAppropriations)

Additional Borrowings Sought

Additional Additional Foreign Domestic Borrowings Borrowings

'Processes depictedfor various actions throughout the year. ksrdw44776b -40-

Box 3.1: Where Do Borrowings Come from and Where Do They Go?

3.05 When a country borrows for "balance of payments purposes," it does so ostensibly to obtain foreign exchange resources to meet a variety of needs such as financing imports, building reserves, meeting debt service payments, etc. But because of the fungibility of money, some of the foreign funds indirectly help to finance general budget expenditures. Moreover, for a country like Turkey that has access to voluntary commercial borrowings, and is active in borrowing from both foreign and domestic market sources, one can view its borrowing choices as a "decision tree" depicting the sequenced steps shown in Figure 3.1.

3.06 At any given time in a year, a Government can try to borrow X amount of funds (in various foreign currencies) or it can to try borrow X-D1 funds, where Dl represents that portion of domestic borrowings which in effect substitute for foreign funds. Given Turkey's reasonably open foreign exchange system involving numerous types of movements of funds between commercial banks and the Central Bank (related to reserve requirements on foreign exchange deposits and surrender requirements on export firms), when the Government sells Treasury bills to local banks some of the proceeds ultimately end up with the Central Bank as a result of interbank market transactions and open market transactions of the Central Bank. Government funding of its own operations involves a complex set of inter- relationships, but it clearly has two main sources of borrowings -- foreign and domestic. Thus, at a given time the Government can try either to increase the amount of foreign borrowings sought, or of domestic borrowings. This fungibility between foreign and domestic borrowings -- which has not been fully analyzed in the economic/financial literature -- is even more pronounced in Turkey than in most developing countries because of several factors: (i) under increased capital account liberalization, domestic currency can be easily converted into foreign currency in Turkey (which puts pressure on the exchange rate); (ii) Turkey has been pursuing (and needs to pursue) a large amount of balance of payments financing in order to provide the foreign exchange needed, among other purposes, to service the external debt; and (iii) a portion of domestic public debt also plays an indirect role in helping to meet external debt service payments, although the precise links are difficult to establish (see Chapter 5). -41-

3.07 In the borrowing process depicted above, when the Turkish Government: sets its external borrowings target (at, for example, the $5 billion of foreign borrowings raised in 1989), and then proceeds to "go to market" to obtain these borrowings, it needs to monitor whether it meets its borrowing target in any given month. If a shortfall develops -- because of cross-currency exchange rate movements or a lack of willingness on the part of financial institutions/ investors to increase their exposure to Turkey - - the Government might find thal it needs to increase domestic borrowings as an alternative, or it might perhaps; suggest that private external borrowings be raised which, if swapped with the Central Bank, can make up the difference.

3.08 In formulating its financing plan for a given year, the Governmenl: draws upon its official macroeconomic targets as reflected in the Annual Program. The Government's 1989 borrowing targets and the actuals (for 1988 and 1989) are shown in Table 3.1 below, on a sources and uses basis. The details and the comparative figures for 1984-88 are shown in Annex 3.1. -42-

Table 3.1: External Financing Reguirements and Sources (in US$ millions)

1988 1989 1989 Actual Target Revised estimate

A. Outflows 5,266 4,270 4,300

Repayments 3,927 3,800 4,050 IMF Repurchases 467 235 250 Credits Extended 607 0 0 Portfolio 4 0 0 Current Account Deficit -- 235 -- Net Errors & Omissions -- 0 -- Counterpart Items 261 0 0

B. Inflows 3,179 1,425 1,904

Current Account Surplus 1,503 -- 711 Direct Investment 352 300 450 Credits Extended -- 300 200 Dresdner 549 575 250 Short Term Deposits 428 250 150 Net Errors & Omissions 347 0 143 Counterpart Items -- 0 0

C. Financing Reguirements 2,087 2,845 2,396

D. Financing 2,087 2,845 2,396

Project Credits 1,141 850 1,262 Medium & Long Term Credits 3,167 2,220 2,808 Short Term Credits (979) 375 (904) DMBS Reserves (821) (250) 80 CB Reserves (421) (350) (850)

Source: Central Bank, Foreign Exchange Department, Balance of Payments Div. -43-

3.09 Looking at the sources (inflows) side, the current account surplus declined in 1989, while amortizationof foreigndebt (outflowsor uses side) rose from $3.9 billion in 1988 to $4.1 billion in 1989. Interest (which is included in the current account) amounted to $3.1 billion compared to $2.8 billion in 1988. Thus, total debt service in 1989 is estimatedat $7.2 billion, about the same level as in 1988. Central Bank reserves are estimated to have increased by nearly $430 million in 1989. IMF repurchasesdeclined from $467 million 1988 to $250 million in 1989. Looking at the financing side, project credits rose in 1989, while other medium and long-termcredits (e.g. balance of payment loans) declined compared to 1988. To obtain its financing, Turkey continued to seek syndicatedbank loans, bonds, and other forms of financialmarket borrowings. Short-term credit declined in accordance with the Government's strategy of retiring short-termdebt in favor of obtainingMLT loans. In fact, the Treasury issued instructionsto Turkish entities to slow the increaseof short-termdebt, while the Central Bank itself retired $200 million of European commercialpaper in favor of an Exchange Loan Facility (ELF) from the First Bank of Chicago. Direct foreign investment increasedby $100 million to $450 million in 1989.

3.10 In order for Turkey to arrange sufficient funds to meet external debt: service of more than $7 billion in 1989, the authoritieshad to pay attention to the followingkey factors:

(i) the economy's ability to maintain strong export growth and continuedbuoyancy in tourismrevenues, which has provided the basic foreignexchange resources needed to servicethe externa:l debt;

(ii) the degree to which confidence was being restored in the ability of the Government to lower the fiscal deficit and to reduce inflation on a sustained basis (this is a continuing process); and

(iii) the receptivityof the various foreignmarkets to Turkishpaper in general, and to arranging specific syndicated bank loans and bond issues, as and when required.

3.11 Given that the needs for Balance of Payments financingare decliningin Turkey, the authoritieshave been able to obtain the funds they needed without much difficulty. However, if the low case scenario described in Chapter 1 materializes,Turkey could again experience financing difficulties. This is particularlyso, given the uncertaintiesthat exist both domesticallyand abroad (see Chapter 8). The next section analyzes Turkey's past borrowings and their terms, as well as assesses which instrumentsand sourceshave been the dominant forms of financing,as a guide to the future on the funding side. -44-

C. New External Borrowings: Sources. Terms and Costs

3.12 Background. In the early 1980's, the IMF and the World Bank were the main providers of capital to Turkey. Turkey utilized from the IMF SDR 1.8 billion in various stand-by arrangements stretching from 1978-85. The World Bank provided $1.6 billion through five structural adjustment loans during 1980-85. Besides these two sources, very little new MLT money came into Turkey for program (non-project) loans. After 1984, project lending picked up strongly for the energy, industry, agriculture, and transportation sectors. In fact, as a result of depressed world market conditions for machinery and equipment, the Government found itself facing numerous offers from competing syndicates to float particular deals. Financing was easily raised for various investments such as the motorways program, for which Turkey borrowed about $2.2 billion during 1985-88. Most of this came in the form of commercial loans and suppliers' credits, often covered by export credit agencies.

3.13 As shown in Chapter II (Table 2.3), financial markets in fact accounted for 61 percent of total disbursements and 74 percent of total net flows to Turkey in 1987, compared to 33 percent and 34 percent respectively in 1983. This scale of voluntary borrowings was a very dramatic change, and it confirmed the impression that in the case of Turkey the Baker Plan was already at work (see Chapter 8, Box 8.2). This outcome is all the more impressive when one considers that it occurred in the absence of any attempts at "concerted lending".

3.14 The full list of Turkey's public and publicly guaranteed borrowings, covering loans from multilateral, official, other bilateral, and commercial sources obtained between January 1 and December 31, 1988 is shown in Annex 3.2, whereas the list of such loans obtained between January 1, 1989 and December 31, 1989 is shown below in Table 3.2: Table 3.2

TURKEY: PUBLIC SECTOR EXTERNAL BORROWINGS IN 1989 (1.1.1989-31.12.1989)

Maturity/ USS Millions Creditor or Credit Limit Grace Period Interest Rate Value as of Name of Credit Sector Guar. Debtor Lead Bank Currency (millions) (years) (percent) December 1989

1. Government to Government Credit Communications -- RT Gov't.-Belgium BF 200.0 30/10 2 5.7 2. Selcuk University (SU) Other -- SU Dental Seimens DM 0.9 5/0 Noncash Credit 0.5 3. Turkish Soil Office-Crop Purchase Other RT TMO CCC USD 4.3 3/1 LIB+3/16 4.3 4. General Purpose Borrowing BOP -- RT ERF YEN (bn) 12.5 10/5 5.20 86.9 5. Selcuk University Other -- US Nisho lwai YEN (bn) 236.0 5/0 Noncash Credit 1.6 January Total 99.0

6. General Purpose Borrowing SOP -- RT ERF SFR 30.0 10/4 5.25 19.4 7. PTT-86 Pieces Broadcasting Equipment Comnunications RT PTT C. Bankverein AS 45.7 7/1.5 7.1(X20)-6.35(X80) 3.8 8. Steel & Iron Company Manufacturing TCZB TDCI Bankers Trust USD 25.0 1.25/1 LIBOR-1 25.0 February Total 48.2

9. Istanbul Tuzia-Leather Ind. Construction Manufacturing -- RT Cred.Com.France FF 36.6 10/2 PIBOR+1.25 6.3 10. Istanbul Tuzta-Leather Ind. Construction Manufacturing RT Gov't.-France FF 24.4 30/10 2.25 4.2 11. Turkish Development Bank Manufacturing RT TKB FMO HFL 19.0 14.5/5 8.25 9.9 12. PTT-Sattelite Communications RT PTT Com.Sat.Systems USD 16.9 5/3 6 16.9 13. General Purpose Borrowing BOP -- RT ERF YEN (bn) 5.0 10/5 5.3 34.8 14. Turkish Electricity Authority Energy RT TEK KFW DM 5.7 8/1 7.58 3.3 15. Fast Railway Transportation Project Transport RT Ml Svenska Hand. SFR 48.0 5/0.5 SFR LIBOR+0.5 31.1 March Total 106.5

16. Financing 85% of Cow Import Other -- RT D.G. Bank DM 3.7 8/1 6.75 2.1 17. Min. of Interior, Walky-Talky Purchase Other -- RT Midt. Bank Aval USD 6.0 5/1 LIBOR+1 6.0 18. Financing 15% of Cow Import Other -- RT D.G. Bank Lux. DM 0.6 6/1 LIBOR+1.25 0.4 19. Eurodollar Bond Issue by Treasury BOP -- RT JP Morgan USD 200.0 10/10 11.5 200.0 20. Steel & Iron Co. Financing Coal Import Manufacturing RT TDCI Bankers Trust USD 50.0 1/0 IBOR+0.05 50.0 21. Cukobirlik Other -- RT CCC USD 5.0 3/1 LIBOR+0.25 5.0 22. Central Bank of Turkey, BOP SOP -- Cs Mitsui Bank USD 200.0 7/6.5 LIBOR+1.25 200.0 April Total 463.5

23. Purchase of Agro Machine Agricul. -- RT Landesbank AS 7.9 7/1 6.75 0.7 24. Natural Gas DistributionSystem, EGO Adm. Infrastructure -- RT BanrqueIndosuez FF 5.3 10.5/0.5 PIBOR+1.125 0.9 25. General Purpose Borrowing BOP -- RT ERF YEN (bn) 5.0 10/10 5.50 34.7 26. Natural Gas Distribution System, EGO Ackn. Infrastructure RT EGO Bankers Trust USD 5.5 3/2 LIBOR+1 5.5 27. Eregli, Steel & Iron Co. Manufacturing RT ERDEMIR Saloppekiheim & Cie DM 6.5 10/2.5 6.75 3.8 28. State Ports, Air Adm.Excavator Purchase Transport -- RT Central Weschel USD 5.0 5/2 LIBOR+1.25 5.0 29. EregLi, Steel & Iron Co. Manufacturing RT ERDEMIR Int.Bank Fur Aus. AS 104.5 10/3 5.5 8.8 30. General Purpose Borrowing BOP -- RT ERF DM 40.0 10/10 6.875 23.6 31. Divrigi-Isk. Railways System Transport -- RT Gov't.-France DM 36.0 20/7.5 3.10 21.3 32. Marmara University-TV Education Project Communications -- UM For a Company YEN (bn) 92.9 3/0 JLTPR 0.6 33. State Ports, Air Adm.Excavator Purchase Transport -- RT Ganz Danu USD 8.2 10/2 7.25 8.2 34. Natural Gas Distribution System, EGO Adm. Infrastructure -- RT Govt.-France FF 6.3 30/10 2.25 1.1 May ToraL 114.2 Table 3.2

TURKEY: PUBLIC SECTOR EXTERNAL BORROWINGS IN 1989 (1.1.1989-31.12.1989)

Naturity/ US$ Millions Creditor or Credit Limit Grace Period Interest Rate Value as of Name of Credit Sector Guar. Debtor Lead Bank Currency (milLions) (years) (percent) December 1989

35. Agro Industry Projects Other -- RT IORD USD 150.0 17/5 IBRD PR 150.0 36. T.Dev. Bank, Bond Issue Manufacturing RT KIT-TKB Daiwa Sec. YEN (bn) 10.0 10/10 6.1 69.5 37. Small- & Medium-Scale Ind. Projects Manufacturing -- RT IBRD USD 204.5 17/5 IBRD PR 204.5 38. Bond Issue by Treasury BOP -- RT Nomura Int. USD 280.0 10/0 5-1/2% 280.0 39. III Agricultural Credit Other -. RT IBRD USD 250.0 17/5 IBRD PR 250.0 40. Central Bank of Turkey, BOP BOP -- Cs Sumitomo Bank USD 200.0 10/3 LIBOR+1 200.0

June Total 1,154.0

41. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 16.8 3/1 LIBOR+0.0625 16.7 42. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 8.5 3/1 LIBOR+0.0625 8.5 43. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 8.1 3/1 LIBOR+0.0625 8.1 44. Eregli, Steel & Iron Co. Manufacturing RT ERDEMIR Int.Bank Fur Ausen AS 102.9 10/3 5.5 8.7 45. Eregli, Steel & Iron Co. Manufacturing RT ERDEMIR ABD Exim USD 10.8 10/2 9.65 10.8 46. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 0.7 3/1 LIBOR+0.0625 0.7 47. Bond Issue BOP -- RT CommerzBank DM 400.0 7/0 7.75 236.1 48. Financial Aid by Germany Manufacturing -- RT Govt.-KFW(Ind.Fund) DM 150.0 30/10.5 2 88.6 49. Eregli, Steel & Iron Co. Manufacturing RT ERDEMIR Saloppekiheim& Cie DM 12.4 10/2.5 AKA 7.3 50. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 8.4 3/1 LIBOR+0.0625 8.4 51. Financial Aid By Germany BOP -- RT Govt.-KFW(Ind.Fund) DM 25.0 30/10.5 2 14.8 52. Bord Issue by T. Agricultural Bank BOP -- TCZB Bankers Trust USD 140.0 12/3.PUT LIBOR+1.25 140.0 53. Turkish Soil Office-WheatPurchase Agricul. RT TMO CCC USD 1.7 3/1 LIBOR+0.0625 1.7 54. Eregli, Steel & Iron Co. Manufacturing RT ERDEMIR Banq. Nat. de Paris YEN (bn) 745.7 7/3 LIBOR+1 5.1 55. Turkish Soil Office-Wheat Purchase Agricul. -- TMO CCC USD 8.1 3/1 LIBOR+0.0625 8.1 4Ž 56. Turkish Soil Office-Wheat Purchase Agricul. RT TMO ABD USD 5.5 3/1 LIBOR+0.0625 5.5 a' 57. Turkish Soil Office-Wheat Purchase Agricul. RT TMO ABD USD 2.6 3/1 LIBOR+0.0625 2.6 58. Turkish Soil Office-Wheat Purchase Agricul. RT TMO ARD USD 2.5 3/1 LIBOR+0.0625 2.5 59. Turkish Soil Office-Wheat Purchase Agricul. RT TMO ABD USD 2.5 3/1 LIBOR+0.0625 2.5 60. Turkish Soil Office-Wheat Purchase Agricul. RT TMO ABD USD 17.0 3/1 LIBOR+0.0625 17.0

July Total 593.7

61. Trakya University Other RT UT SIAS DM 0.4 1/ -- 0.2 62. DIDA-CombatArmed Vehicle ManufacturingProj. Other RT DIDA AMRO Bank HFL 125.8 12/2 LIBOR+0.615 65.5 63. T. Agriculture Ind. Manufacturing -- RT IDB USD 15.0 2.5/1.5 8.5 15.0 64. Turkish Soil Office-Wheat Purchase Agricul. RT TMO CCC USD 4.2 3/1 LIBOR+0.0625 4.2 65. DIDA-CombatArmed Vehicle ManufacturingProj. Other RT DIDA Barclays Bank DM 26.9 13/3 OECD CONSENSUS 15.9 66. DIDA-CombatArmed Vehicle ManufacturingProj. Other RT DIDA Chase Investment USD 30.0 7/3 LIBOR+1.125 30.0 67. DIDA-CombatArmed Vehicle ManufacturingProj. Other RT DIDA Generale Bank BF 4.1 12/2 OECD CONSENSUS 114.7 68. DIDA-CombatArmed Vehicle ManufacturingProj. Other RT DIDA Barclays Bank DM 21.6 13/3 OECD CONSENSUS 12.7 69. Eregli - Steel Iron Co. Manufacturing RT EDC Int.Bank Fur. Auss AS 78.1 12/3.5 5.5 6.6 70. Turkish Soil Office-Imp. of Corn Agricul. RT TMO ABD USD 5.5 3/1 LIBOR+0.0625 5.5 71. Turkish Soil Office-Imp. of Corn Agricul. RT TMO ABD USD 2.7 3/1 LIBOR+0.0625 2.7 72. Turkish Soil Office-Imp. of Corn Agricul. RT TMO ABO USD 4.1 3/1 LIBOR+0.0625 4.1 73. Turkish Soil Office-Imp. of Corn Agricul. RT TMO ABO USD 2.7 3/1 LIBOR40.0625 2.7

AUGUST TOTAL 279.8 Table 3.2

TURKEY: PUBLIC SECTOR EXTERNAL BORROWINGS IN 1989 (1.1.1989-31.12.1989)

Maturity/ USS Millions Creditor or Credit Limit Grace Period Interest Rate Value as of Name of Credit Sector Guar. Debtor Lead Bank Currency (millions) (years) (percent) December 1989

74. BOTAS-Liq. Natural Gas Station Project Energy RT BOTAS BFCE-BNP-CONS. FF 564.0 13/3.5 PIBOR+1 (**) 97.4 75. Bond Issue by Treasury BOP -- RT JP Morgan USD 200.0 10/5 (*) 10.25 200.0 76. Kinali-Sakarya Motorway Supplementary Fin. Transport -- RT Bank of Tokyo YEN (bn) 6.0 8.5/4 JLTPR+1.375 41.7 77. BOTAS-Liq. Natural Gas Station Project Energy -- RT Gov't. - France FF 400.0 25/10 3 69.0 78. 11. FMS Refinancing Other -- RT Lazard Freres USD 403.4 24/0.5 8.8154 403.4 79. Municipalities Union, Technical Advisory Infrastructure RT Municip. Concord Comm. Coop. USD 1.9 5/0.5 LIBOR+1 1.9 80. Turkish Soil Off.-Imp. of Rice Agricul. RT TMO ABD USD 4.3 3/1 LIBOR+0.0625 4.3 81. Turkish Coal Company Energy -- TTK MachinoExport USD 1.0 5.5/1.5 6.5 1.0

SEPTEMBER TOTAL 818.7

82. Bingol-Mus Rural Development Project Other -- RT IFAD SDR 15.5 18/3.5 8 20.4 83. Credit Syndication for Treasury BOP -- RT Mitsui-Fuji USD 200.0 5/3 LIB+1(3) LIB+1 1/8 200.0 84. Turkish Soil Off.-Wheat Purchase Agricul. RT TMO ABD USD 10.7 3/1 LIBOR+0.0625 10.7 85. TEK-Ataturk-Elb.-Ank.Elec. Con. Energy RT TEK Commerzbank DM 30.0 6/5/2.5 IBOR+1.25 17.7 86. Eregli Iron & Steel Company Manufacturer RT Erdemir KFW DM 8.3 10/2.5 OECD Con. 4.9

OCTOBER TOTAL 253.7

87. 20 Pieces Drilling Machine Infrastructure -- RT Mitsui Bank USD 6.4 5 / 9.15 6.4 88. 20 Pieces Drilling Machine Infrastructure -- RT Mitsui Bank USD 1.1 7 /2 LIBOR+1.125 1.1 89. Bond Issue BOP -- RT Sumitoma USD 250.0 6 /6 9.75 250.0 1 90. Post-Telephone-Telegraph Communications RT PTT Japon Nec YEN 310.1 6 /2 JLTPR-0.2 2.1 4- 91. TEK-Ataturk-Elb.-Ank.Elec. Con. Energy RT TEK KFW DM 30.5 6.5/2.5 LIBOR+1.25 18.0 4 92. TEK-Ataturk-Elb.-Ank.Elec. Con. Energy RT TEK KFW(Gov. to Gov.L.) DM 90.5 30/10 2 53.4 93. TEK-Ataturk-Elb.-Ank.Elec. Con. Energy RT TEK KFW DM 53.0 12/2.5 Germany Mark.Int.R 31.3 94. EGE Univ. Purchase of Tools Communications -- Univ. EGE Ohmeda USD 0.1 1.1/0.5 -- 0.1 95. EGE Univ. Purchase of Tools Communications -- Univ. EGE Nissho lwai YEN 37.5 1.1/0.5 -- 0.3

NOVEMBER TOTAL 362.7

96. Ataturk Dam-Hydro-Et.Power Plant Energy -- RT Union B. of Switz SFR 6.2 12/2 3 YR+1 7/8 4.0 97. T. Vakiflar Bank Energy -- Vakiflar B.Privatbanken DM 110.0 2 / LIBOR+0.0625 64.9 98. DB-Deniz Nakliyat-ShipConst. Transport -- Denizcilik Den Norske Crdbank USD 29.0 12/4 LIBOR+1 29.0 99. DB-Deniz Nakliyat-ShipConst. Transport -- Denizcilik Den Norske Crdbank USD 29.0 12/4 LIBOR+1 29.0 100. Ataturk Dam-Hydro-Et. Power Plant Energy -- RT KFW DM 24.1 12/2 Fins.Mal.+1.25 14.2 101. Global Loan BOP -- RT ERF SFR 70.7 10/5 6.5 45.8 102. Concessional Loan BOP -- RT ERF SFR 4.4 10/5 1 2.8 103. Bond Issue BOP -- RT Daiwa Sec. USD 100.0 6 /6 9.75 100.0 104. 111. AgriculturalProjects Agricul. -- RT OECF YEN 35.2 25/7 OECF 2.9 244.7 105. Syndication BOP -- RT Bank of Tokyo YEN 20.0 7 /3 JLTPR+1.25 139.0

DECEMBER TOTAL 673.4

TOTAL 4,967.7 (*) = Bullet (**) = Interest is PIBOR+1% during the grace period and 9.65% (fixed) during repayment period.

SOURCE: Treasury -48-

Scale of Borrowings

3.15 Turkey contracted 88 loans in 1988 and 103 loans in 1989. In 1988 a total of $5.8 billion was obtained, which was in accordance with the borrowing plans set at the beginning of the year. As itemized above, in 1989 a total of $4.96 billion was borrowed. The breadth and diversity of Turkey's borrowings is striking.'/ About 60 percent of all borrowings (including bond issues) were for balance of payments and debt service purposes. The low proportion of projects reflects the cutbacks in the Government's investment program, a trend which continued in 1989. Another striking feature is that the currency composition of new borrowings in 1988 (excluding the Foreign Military Sales Refinancing)2 / matched almost exactly the currency composition of Turkey's debt as of January 1988 (see also para 4.02). For any country to carry out a borrowing program of 80 loans in a year (an average of seven loans per month) amounting to over $5 billion is no small feat. This is particularly so considering that the majority of the loans were from commercial markets. This large and complex program required that policy-makers make numerous judgments and decisions about the reasonableness of interest rates and fees charged by lenders, as well as about the currency composition of loans.3 / In several cases, the Treasury acted as the guarantor, the actual borrower being the development banks (TSKB, 4/ TKB), and state economic enterprises (such as Sumerbank; the Soil Products Office (TMO); Turkish Maritime Bank; and THY (airline) shown in lines l/ The fact that Turkey had a current account surplus of $1.5 billion in 1988 compared to an original target of a deficit of $880 million might have been expected to result in a need for less foreign borrowings. However, the surplus was not anticipated. Also, in order to help build-up foreign exchange reserves (which have risen to three months of imports, double the level of most previous years) and to provide a cushion for the rise in amortization payments, the Government felt it necessary to carry out its 1988 borrowing program more or less as planned.

2/ In 1988 the US Government offered several countries (Israel, Indonesia, Portugal and Turkey) the opportunity to refinance their Foreign Military Sales (purchases) from the US. The US Government backed 90% of the FMS Refinancing and Turkey collateralized the remaining 10%. The total FMS Refinancing in Turkey's case was $1.5 billion, of which $941 million was a zero coupon bond issue (item 73 of Table 3.2). Due to its size, the FMS deal, which was concluded in December 1988, distorts the overall picture. Consequently, in most cases end of November comparisons are drawn instead, unless otherwise stated.

3/ Such judgments about market conditions and the appropriate spreads to pay are open to much "second-guessing." Given this, it is to the credit of the decision-makers that so large a borrowing program was carried out on time without much hesitation.

4/ Other Turkish borrowers such as the Industrial Development Bank of Turkey (TSKB) and the Development Bank of Turkey (TKB) have also borrowed from the Japanese markets. -49-

68 and 76 of the table), and some of the extra budgetary funds such as the Public Participation Fund (PPF) for the motorways program. The data also show that the Central Bank plays a role in many of the loans. 5/ The level of the 1988 borrowings ($5.8 billion) was higher than that of 1987, on account of the FMS Refinancing. In both 1989 and 1990 the level of borrowings is projected to be around $4.5 billion.

Sequencing

3.16 The sequencing of the borrowings shows a fairly steady pattern of around $200-400 million per month of funds borrowed, except in December 1988 when the FMS Refinancing distorted the pattern because of its large amount. In June 1989 there was a large bulge in borrowings ($1.2 billion) because of the semi-annual concentration of debt service payments due. Similarly, in May and June 1988 borrowings were in excess of $500 million in each month, in anticipation of the mid-year bulge in debt service payments. In late 1988 there was a slowing down of borrowings because of the favorable swing in the current account. It is important to stress that since the tables only show actual loans concluded, they do not give a full picture of Turkey's market demand, which at times has even been higher. This situation arises when several simultaneous and competing approaches are made to arrange financing for a given project, knowing that only one financing package may be given the go-ahead--for example, as with the consortia bidding on the three Build-Operate and Transfer (BOT) Thermal Power projects (para. 7.16).

Currency Composition

3.17 Excluding the FMS Refinancing, dollar denominated borrowings constituted about one-third and non-dollar borrowings about two-thirds of total 1988 borrowings (Table 3.3 below). However, in 1989 in order to achieve a better balance, dollar borrowings were sought, accounting for nearly two-thirds of new borrowings (by amount). The proportion of Yen borrowings declined between these two years, as did the Deutsche mark denominated borrowings. Interestingly, the tables do show that in some instances the Government did exercise choices related to currency selection. For example, Japanese yen funds were borrowed from the European Resettlement Fund (line 6 of Annex 3.2), rather than in ECU-denominated or DM-denominated funds. During the course of 1989 several detailed sessions were held by the Treasury on currency composition questions, including detailed discussions with the World Bank on the changes to the IBRD currency pool.

5/ The Central Bank (Merkez Bankasi or TCMB) is the designated borrower's agent, meaning that the Central Bank acts as the correspondent bank for receipt of funds and repayments, just as many of the IBRD disbursements and repayments go through the Federal Reserve Bank of New York before being transmitted to/from the IBRD via international commercial banks. -50-

Table 3.3: Turkey's 1988 and 1989 Borrowings by Currency Distribution (in US$ Millions)

1988 Borrowings s 1989 Borrowings Currency Amount % Amount % US$ 1,744 38.2 3,144 63.3 Yen (billion) 915 20.0 661 13.3 DM 1,087 23.9 635 12.8 SwFr 258 5.7 103 2.1 French Franc 312 6.8 179 3.6 Belgian Franc 16 0.2 120 2.4 Pound Sterling 137 3.0 - - Dutch Florin 49 1.1 75.5 1.5 Austr. Shill. 5 0.1 28.5 0.6 Others 35 1.0 20.4 0.4 Total 4,560 100.0 4,967 100.0

Memo Item:IBRD 616

Avg. Terms: 1988 Borrowings

Avg. Maturity: 12.6 years (with FMS) 7.5 years (without FMS)

Avg. Interest: 7.9 percent (with FMS) 5.6 percent (without FMS)

Avg. Grace: 4.9 years (with FMS) 2.2 years (without FMS)

a/ Excludes the refinancing of the Foreign Military Sales (FMS).

Source: World Bank calculations.

Interest Rates and Maturities

3.18 The interest rate paid on commercial loans is expressed in terms of a spread or margin over basic reference rates, such as the London Interbank Rate (LIBOR) or the US Treasury Bill rate. Short-term loans usually carry lower spreads but carry uncertainties about the cost of renewal; for example, the Central Bank's $300 million borrowing from the European Commercial Paper (ECP) market in August 1988 (item 53 of Annex 3.2), which was at 50 basis points above the commercial paper index, was retired in favor of longer-term sources.6 / Table 3.2 shows that in many instances Turkey has been borrowing at LIBOR plus 75,

6/ On longer term loans, a spread of 50 basis points (an interest rate of 7.25 percent when LIBOR is 7.75 percent) is considered to be a low spread for most LDC borrowers to pay, although countries in East Asia (Korea, Malaysia and Thailand) are able to arrange borrowings at these and even lower spreads. -51-

LIBOR plus 100, and at times LIBOR plus 150 basis points.7/ On certain capital market instruments (the German bonds and the fixed rate dollar bond, discussed in paras. 3.17 and 3.26) the spreads have been in excess of 200 basis points. Also, the spreads do not include special fees and other charges of banks, which can raise the "effective interest rate" paid even higher. Depending on whether a loan is on a fixed rate or on a floating rate basis, the margin again will vary, although not by much. In the case of the syndications launched under the B-loan for the Second Financial Sector Adjustment Loan (lines 59a and 59b, of Table 3.2), the spreads were 100 and 110 points over the Japanese long term prime rate (JLTPR) for the floating and fixed rate components respectively. The $150 million fixed rate Eurodollar bond, which Bankers Trust arranged in December 1988 (item 80 of Table 3.2) was priced at 11 1/4 percent, or 216 basis points above the US Treasury bond rate at that time. The fact that this was Turkey's first dollar borrowing (from financial markets) since February 1988 partly explains the high spread paid (see market presence argument in para. 3.28).

3.19 Table 3.3 also shows calculations of the weighted average interest rates paid on loans contracted in 1988, which was 7.9 percent (weighted average, including the FMS). Without the FMS, which being a dollar operation pushes the average interest rate up, the weighted average interest rate on all loans was 5.6 percent, reflecting lower rates on yen funds and official loans from European agencies, particularly the European Resettlement Fund. However, with regard to Deutsche mark and yen loans, there already has been, and there might arise in the future a significant exchange rate cost which might offset, or perhaps exceed the benefits derived from lower interest rates. The average maturity was 7.5 years (without FMS), which is less than Turkey needs to lower its debt hump. With the FMS, the average maturity was 12.6 years, but given the special one- time nature of the FMS operation, that calculation is not meaningful.

Size of Loans and Market Access

3.20 In 1988 loans ranged in size from $1.5 billion for the FMS Refinancing, $400 million for the FSAL II A-loan from IBRD, $318 million for the FSAL II B-loan from a syndicate of Japanese financial institutions (with IBRD participation), and down to loans of $5 million or less for small projects. Similar patterns are seen in the 1989 borrowings. Most loans fall in the $5 million to $50 million range. It is not evident that large loans command a lower interest rate, although the full picture (including other fees which the table does not show) would probably reveal the more usual pattern of economies of scale -- that small loans have higher transactions costs on average than large loans, and are therefore comparatively more expensive to arrange. Nor does there seem to be a pattern of large loans carrying higher than average interest rates (for reasons of risk, for example). However, there is a clear pattern of repeat loans paying lower spreads over time.

7/ In some of the loans, the interest rate is quoted on the Paris Interbank rate (PIBOR) and in the case of yen borrowings from the Japanese market (as distinct from yen borrowings from the ERF for example), the interest quoted is usually the margin over the Japanese long-term prime rate (JLTPR). -52-

D. Diversification of Sources and Instruments

3.21 With regard to sources, Turkey's borrowings strategy is aimed at diversification. Its source of funds consists of several key features, in order of priority for obtaining funds:

(i) Relying on multilateral lenders such as the World Bank and the European Resettlement Fund for a large share of lending. Within this group, World Bank lending has been the dominant element;

(ii) Seeking official bilateral loans from Government agencies (for example, a line of credit from the West German Government), or lines of credit from development banks such as Kredit Anstalt of Germany (KFW). The distribution by donor country is shown over the period 1979-82 in Annex 3.3. The declining share of aid overall is clearly shown, as well as the increasing role of Japan as a source of official finance;

(iii) Obtaining credits from export credit agencies, such as HERMES (Germany), COFACE (France), US EXIMBANK, Japan EXIM, and SACCE (Italy). Annex 3.3 also shows the growing role of export credits;

(iv) Borrowing from financial markets using syndicated bank loans, bond issues, and Euro-commercial paper issues, as market conditions and information permit; and

(v) Refinancing certain loans, if the opportunity arises (e.g. the FMS Refinancing).

3.22 Drawing on the balance of payments projections contained in Chapter 1 and the debt profile discussed in Chapter 2, Turkey's borrowings patterns fall into three distinct phases:

(i) in the first period (1981-85), the roles of the IBRD, IMF, and OECD official lenders were paramount in providing Turkey with the funds necessary to meet a moderately high level of debt service, while the current account deficits were in the 6 percent to 2 percent of GNP range;

(ii) in the second period (1986-90), debt service requirements have increased (and are continuing to rise). The expiration of the grace periods under the OECD reschedulings coincided with current account deficits in 1986-87, and external borrowings showed a steep rise, particularly from export credit agencies and financial markets; and

(iii) starting in 1991, the picture eases as Turkey's debt-service ratio decreases even though the absolute level of debt and of debt service may not show any decline.

Looking at the sources of borrowings and considering that Turkey is still in the period of high debt service costs, the country will need to organize and sequence -53-

its approaches to various markets carefully, in order to obtain the necessary funds as and when required.

3.23 Care will also have to be taken regarding the balance to be sought between different instruments. Turkey essentially has five sources of quick- disbursing funds for Balance of Payments Financing, all of which it has tapped in the past years: and no doubt will try to do so in the coming years, as follows: (i) the World Bank; (ii) bilateral support on adjustment loans (e.g. from Japan); (iii) syndications; (iv) bonds; and (v) Euro-commercial paper. Turkey also has several sources for Proiect Financing -- bilateral (government to government) concessional loans, export credit agencies, the World Bank, suppliers credits, and commercial markets. Since the latter sources are well known, they will not be discussed further in this chapter, although some strategic comments are made in Chapter 8. However, there are significant differences between syndicated loans and bonds, and it is useful to analyze these two forms of finance in more depth.

E. Syndicated Bank Lending Versus Bond Issues

(1) Syndicated Bank Loans

3.24 Turkey has been active in the syndicated bank loan market since 1984 when confidence was restored in the Government's ability to adjust its economy successfully. However, the Government's ability to raise syndicated funds did not weaken in 1986-87, even though economic performance faltered. One reason was that most of the syndications were for project financing and seldom for balance of payments financing, except when they were linked with IBRD A-loans, and it may be that the catalytic support of the World Bank did make the difference. Various forms of syndications were utilized -- single lead banks, multiple lead banks, investment banks, and commercial banks all working together. More often than not, the borrowings were denominated in US dollars or in one of the major European currencies. However, starting in 1985, Turkey began actively approaching the Japanese market, in conjunction with World Bank B-loans for the First Financial Sector Adjustment Loan (FY86) and the Energy Sector Adjustment Loan (FY87). The Second Financial Sector Adjustment Loan (FY88) continued this trend. All of these operations involved syndicates of more than a dozen Japanese commercial banks and life insurance institutions, who were supportive of Turkey's requests for balance-of-payments financing.

3.25 Aside from the Kayraktepe Power Project (FY86) and the FSAL I B-loan, there have not been any Eurodollar syndications in conjunction with World Bank B-loans, because the Eurodollar market -- to the extent that it could provide money to Turkey -- was mainly interested in providing project finance and was reserving its position for participation in such large potential projects as the BOT energy projects. Thus, Turkey continued to look towards Japan for its balance of payments financing and to European markets for the more traditional project financing. This stratification appeared to suit the lenders' interests, as well as Turkey's interests in diversifying its sources of funding. -54-

(2) Bond Markets - The German Capital Markets

3.26 Beginning in 1987 and in 1988 there was a shift in strategy. Turkey found a number of financing opportunities in Europe through the German bond market. Also, in December 1988 Turkey entered the Eurodollar market for the first time in several years, with a Bankers Trust Eurobond of $150 million (item 80 in Annex 3.2). Since bond issues are likely to represent a growing form of finance for Turkey in the future, it is worth discussing these operations in some detail, which are listed in Table 3.4 below.

Table 3.4: Turkish Bonds Issued in West Germany

Amount Term Spread Issuer Lead Bank Date (DM (Years Over Yield Million) -Months) Bund X Rate (Points)

Central Bank of Turkey Commerzbank Feb. 87 125 2-6 210 7.09 Central Bank of Turkey Commerzbank Sep. 87 200 3-1 160 7.48 Eximbank of Turkey Dresdnerbank Jan. 88 200 4-5 122 7.67 Central Bank of Turkey Commerzbank Mar. 88 300 5-8 112 7.57 Republic of Turkey Commerzbank Apr. 88 500 5-8 92 7.46 Republic of Turkey Dresdner Bank Oct. 88 300 6-2 92 7.66 Republic of Turkey Commerzbank Jul. 89 400 6-11 n.a. 7.90 Total 2,025 a/ German bond prices are compared with the rates offered for German federal bonds (the Bund Rate) of the same maturity for public utilities, usually the post office or railway authorities. For tax reasons, the price quoted does not represent the actual interest that the bonds would actually yield. A withholding tax on the interest earned on foreign bonds floated in the German capital markets was introduced in late 1988. The second to last column indicates how the margin between Turkish and domestic German bonds narrowed from the time of the first issue. The rates are quoted in basis points (one hundredths of a percent) over the Bund Rate.

Source: Middle East Economic Digest; Treasury data; and IBRD data. -55-

Box 3.2: Turkey's Bonds Issued in West Germany

3.27 Very few developing countries have been able to float their bonds abroad. However, since early 1987, Turkey has issued seven bonds in the West German capital markets without any assistance needed from the authorities in Bonn; which is a remarkable achievement. The seven bond issues are shown in Table 3.4:

3.28 The first two bond issues were floated by the Central Bank of Turkey and the issues were managed by Commerzbank. The amounts raised were modest (DM 325 million) while the spread paid over the bund rate was high (160-210 basis points). The spread has declined with the subsequent five issues from 122 basis points to 90 basis points over the bund rate. The amounts that were raised through each issue rose to DM 300 million - DM 500 million. The yields have ranged between 7.09% at the outset to 7.90% in the last offering reflecting movements in interest rates in West Germany's capital markets.

3.29 The seven German bond issues have raised a total of DM 2,025 million (or over $1.0 billion) since February 1987 and have played a crucial role in helping Turkey to meet its debt service obligations during that period. Moreover, the bonds have generated funds that were not readily available in the European syndicated loan markets, given the latter's preoccupation with certain major projects. Moreover, it is important to note that the decline in Turkey's spread appears to result mainly from the German capital market's increased familiarity with "Turkish risk" despite the deterioration that occurred in Turkey's domestic economic indicators (e.g. inflation). In fact, scrutinizing the interest rates, spreads, and maturities that were paid by Turkey in 1988, and comparing these to the margins paid in 1987, one sees that the financial terms were influenced very little by changes in Turkey's economic performance over the last two years. If anything, market terms improved slightly -- the spread declined and the maturity of the bonds lengthened. This result is counter-intuitive. What the market seems to be saying is that the rise in Turkey's inflation from 50 percent to 75 percent (as happened between December 1987 and mid-1989) was less significant (worrisome) than was the improved image arising from the strengthened current account -- from the point of view of accessing international markets. However, this can only be a short-term sentiment and it is unlikely that the market will continue to ignore domestic economic imbalances. This important point is appreciated by the authorities. -56-

Box 3.3: Eurodollar Borrowings

3.30 Since late 1988 Turkey has increasingly turned to the Eurodollar market. For several years Turkey had refrained from taking on dollar borrowings from commercial sources, except in the case of specific projects. Partly this was because of high US interest rates and partly it was becasuse of the lack of interest from US banks for non-project lending. Table 3.5 shows the increasing proportion of Euro-dollar borrowings contracted by Turkey.

Table 3.5: Euro-Dollar Borrowings Since December 1988

Lead Loan Amount Borrower Bank Type ($m) Maturity Terms

Government of Turkey Bankers Bond 150.00 10 years 11.125% (December 1988) Trust

Central Bank of Turkey Sumitomo Term Loan 200.0 10 years LIBOR + 1% (June 1989) Bank 3 years (1-3 years) grace LIBOR + 11/8 (put (4-5) option) LIBOR + 11/4

Government of Turkey Mitsui, Term Loan 200.0 5 years LIBOR + 1% (October 1989) Fuji 3 years (1-3) Bank grace LIBOR + 11/8 (4-5)

Government of Turkey J.P. Bond 200.0 10 years 11-1/2% (April 1989) Morgan (Public (put 125 basis straight) option) points

Government of Turkey J.P. Bond 200.0 10 years 10-1/4% (September 1989) Morgan (Public (put 120 basis straight) option) points

Government of Turkey Nomura Discount 280.0 10 years 5-1/2% (June 1989) Securities Note (put 120 basis (Private) option) points

Government of Turkey Sumitoma Bond 250.0 6 years 9 3/4% (Public 120 basis straight) points

Source: World Bank and Treasury Data. -57-

3.31 As shown in Table 3.5, Turkey took on a Eurodollar Bond amounting to $150 million in December 1988, sold by Bankers Trust through secondary outlets. The next two loans in the table were regular syndications arranged by a Japanese bank in the Euromarket. Turkey's decision to focus on the Eurodollar market reflected its desire to balance more evenly the currency compostion of its debt stock, and to take advantage of an easing of interest rates in the US capital markets at the time. This can be seen in the above table whereby the two J.P. Morgan-led bonds raised $200 million each with the first one carrying coupon rate of l/2percent and the second more than a full percentage point lower at 101/4 percent. The spreads paid on these Eurodollar borrowings were around 125 basis points and have been declining over time. The maturities show some lengthening (to ten years) but since the bonds carry a put option exercisable after five years, it makes it difficult to know in advance what the effective maturity will turn out to be. Nevertheless, such bond offerings with put options are of growing interest to both lender and borrower, because of the flexibility given to the former (the puts are at the lender's discretion), whereas for the borrower it allows a deal to go through which otherwise might not be possible under uncertain market conditions.

3.32 In order to understand the decision process of investors as it relates to Turkey's situation, one needs to translate broad market conditions into individual investor considerations. Three factors at least seem to be important:

(i) Overall country limits -- financial institutions might be unable or unwilling to increase their exposure in a given case, because they have reached their own internal limits of lending to that country; and

(ii) certain banks or official export credit agencies may feel that they have reached their individual limits because they have used up their "committed funds". In some cases they may have extended loans for projects, some of which may not move ahead (e.g. the motorways discussed in para. 7.14). Banks look at total loans committed, including the block of undisbursed funds, which in effect are tying up the prospects of other loans; and

(iii) Bond ratings, as mentioned in para 3.34, such ratings are currently being sought.

3.33 Once bond rates are set, the financing process is an "all-or-nothing" attempt, 8/ whereas syndications can have various intermediate results (as regards size and terms). Further, if such bonds are taken up by a broad range

8/ In April 1988 a bond issue by the Greek Electricity Authority was not taken up in the Frankfurt market, the same week that the Turkish Treasury bond of DM 500 million sold quickly. The Greek note was offering a coupon rate of 6.50 percent versus 6.75 percent on the Turkish note and 6.0 percent for new German bonds at the time. The foreign bonds are subject to a withholding tax (see Table 3.4). -58-

of financial institutions 9/ and individuals, and if Turkey prices the bonds "right," the Government/lead bank should be able to sell the bonds in the modest amounts that have been requested. If Turkey offers, for instance, a coupon rate of about 90 basis points above that offered by the German Government on its bonds, and the market perceives this as sufficient spread to compensate for higher Turkish risk (versus German risk which arguably is close to zero to bond holders), then the Turkish paper will be "competitive." But what are the effective limits to the aggregate amounts that can be raised through foreign bond issues? The answer to this question is not obvious and needs to be tested through various offerings. In contrast, syndicated bank loans do not involve this uncertainty, since their effective limits can be more quickly and reliably tested through direct "soundings" to the banks concerned.

F. Conclusions

3.34 As analyzed above, bonds involve rather different considerations than syndicated bank loans. The authorities are well-advised to go after both forms of finance, as well as to pursue other sources, such as the European commercial paper market. However, the Government needs to sequence all of these market approaches carefully, since an uncoordinated program tends to send out the wrong signals. Given the success of the German bond issues, Turkey should consider replicating these instruments in other markets. Potential continues to exist in the Frankfurt market for both bonds and syndicated loans; in the London market for syndicated funds and European commercial paper; in the Tokyo market for syndicated loans and bonds; and possibly in the Zurich and Luxembourg markets. It is difficult to draw any conclusions about the New York bond market regarding Turkish paper, since the FMS Refinancing deal was a special operation, backed by the US Government agencies. Standard & Poor's is in the process of preparing a credit rating on Turkey, which should improve Turkey's ability to "float paper" in New York or other markets. Wherever Turkey floats its paper, it should consider trying to lengthen the maturities obtained, particularly in the Frankfurt market where the Turkish bond is more familiar and a maturity of in excess of seven years should be possible. The key strategic points are to preserve flexibility and access to various markets and to consider various alternatives and trade-offs before committing the Government to excessive funding from any one source. The next chapter analyzes Turkey's exposure to risks and recommends means of reducing such risks.

9/ Although we do not have data on the distribution of the bond holdings, our discussions with the lead banks (see Table 3.4) indicated that the bond market for Turkish paper does not have great depth and there is no secondary market trading in the issues. In fact, most of the bonds are held by the underwriting banks in their own portfolios. -59-

Chapter IV: MANAGING EXTERNAL RISKS

A. Currency Composition

1. Analysis

4.01 Between half and two-thirds of the increase in Turkey's external debt since 1985 (measured in dollars) can be explained by the depreciation of the US dollar vis-a-vis other major currencies, as a large part of Turkey's external debt has been denominated in non-US dollar currencies. In 1982-1985, cross-currency exchange rate changes led to a reduction in the growth of external debt as the dollar appreciated vis-a-vis other major currencies. Overall, $9 billion of the increase in Turkey's external debt during 1982-1988 can be attributed to the changes in cross-currency exchange rates.'/ Part of these valuation changes could have been anticipated, as currencies with low, nominal interest rates are more likely to appreciate to offset the interest differential. By comparison, the currency adjustment on the external debt of all developing countries reporting to the World Bank was a cumulative $68.40 billion over 1981-1987, or approximately 8 percent of the debt stock of about $900 billion at the end of 1987. The currency adjustment effect in 1987 was approximately $69.9 billion, or 9 percent of the debt stock at end-1986, indicating that net currency adjustments between 1981 and 1986 were more or less zero. However, the aggregate for all developing countries masks great differences between individual countries, and Turkey's experience with cross-currency exchange rate changes is not atypical. For instance, it has been estimated that Indonesia's external debt repayments were 35 percent higher in 1987 than this would have been if cross-currency exchange rates had remained at their 1]981 levels.2 / Table 1 provides the currency composition and level of Turkey's external debt as of end- December 1988 and the currency composition of external borrowings contracted respectively in 1987 and 1988.

1/ This calculation is made by comparing annual net flows with differences in year-to-year dollar measured stock values. The 1988 CEM calculates the currency year-to-year adjustment using the currency compositions at the beginning of the year and the changes in the cross-currency exchange rates over the year. Differences between the two methods can be due, as the 1988 CEM notes, to: a) unrecorded foreign asset accumulation; b) underestimated current account deficits and capital account flows; and c) measurement problems. The 1989 OECD Consortium report on Turkey estimates with a cumulative $3 billion exchange rate adjustment for 1982-1988.

2/ Furthermore, Indonesia's debt service to exports ratio increased from 8.2 % in 1981 to 27.8% in 1987. If exchange rates and commodity prices (primarily oil) had remained at their 1981 levels, then Indonesia's debt service to exports ratio would have been only 14.8%, implying that more than 65% of the increase in the debt service ratio can be explained by cross-currency exchange rate changes and commodity price movements alone. -60-

TABLE 4.1: CURRENCY COMPOSITION OF SHORT-. MEDIUM-TERM AND TOTAL EXTERNAL DEBT AS OF END-DECEMBER 1988 a)

USS DM YEN SwFr HFL STR FF Other

Short 52.3% 38.4% - 2.1% - 0.7% 1.7% 4.8% Medium 25.7% 32.6% 19.8% 9.1% 1.3% 1.0% 2.0% 8.6% Total 31.1% 33.8% 15.8% 7.7% 1.0% 0.9% 1.9% 7.8%

a) Corrected for World Bank Currency Pool. As the World Bank Currency Pool consists in large part of non-US dollar currencies (approximately 85 percent was non-dollars currencies at the end of June 1988), the correction for the World Bank Currency Pool can be quite large. If we had assumed that the World Bank Currency Pool was completely dollar denominated, the currency composition of total debt stock would have been: US$41.7 percent, DM 31.7 percent, Yen, 11.5 percent, SwF 5.3 percent, HFL 0 percent, STR 0.9 percent, FF 1.9 percent, and Other percent.

CONTRACTED MEDIUM- AND LONG-TERM BORROWINGS DURING 1987 AND 1988 (in million) a)

Total US DM YEN SwFr HFL STR FF Other

01-12 1987 $3,583 million 27% 24% 22% 8% 2% 4% 10% 3% 01-12 1988 $4,560 million 38% 24% 20% 6% 1% 3% 7% 1%

a) Corrected for World Bank Currency Pool. 1988 numbers do not include the FMS refinancing.

Source: Central Bank of Turkey

4.02 As the table shows, the currency composition of funds borrowed during 1987 and 1988 approximately matches the currency distribution of the existing debt stock between US dollars (27-38 percent) and non-dollars (73-62 percent). This is an impressive achievement, to the extent that the currency composition of the debt stock is desirable on risk diversification and minimization grounds. By comparison, the currency composition of all developing countries' external -61-

debt at the end of 1987 was: 50 percent US dollar, 9 percent DM, 14 percent yen, 2 percent STR, 4 percent FF and 21 percent other.3/

Problems in the Existing Currency Composition

4.03 The large proportion of non-US dollar currencies in Turkey's portfolio of liabilities has resulted in large movements in the dollar measured debt service over 1980-1988, and in the dollar measured external debt stock. These large positive and negative swings are therefore likely to continue given the volatility of exchange rate changes and given the currency composition of Turkey's existing external debt stock and new borrowings. However, an evaluation of the real risks/costs of these large swings implies an evaluation of whether Turkey's ability to generate foreign exchange moves commensurate with cross-currency exchange rate changes. Several criteria have been proposed in the past to deal with the question of optimal currency composition, which the chapter discusses below.

Box 4.1: Criteria for Active Currency Composition Management

4.04 First of all, it is important to emphasize that a country should manage its external liabilities and assets in an integrated fashion, as what really needs to be managed are its net liabilities, i.e. , external liabilities minus external assets such as foreign exchange reserves. Second, we must distinguish between a situation in which the Government manages its sovereign external liabilities in relation to its own economic and financial exposures, and one in which it aims to manage them in relation to the country's overall economic and financial exposures. Depending on whether firms and individuals have access to financial instruments to hedge external risks, the two approaches can lead to different outcomes.

4.05 In general, decisions regarding the management of external liabilities (and external assets, e.g., foreign exchange reserves) have to be determined by a tradeoff between the expected effective costs/benefits of particular financial instruments and the uncertainty of those costs/benefits in relation to the behavior of other external variables, such as exports and foreign prices. In the case of currency composition decisions, the effective nominal costs of liabilities denominated in different currencies, after adjusting for exchange rate changes, can be expected to be equal to each other, as movements in cross-currency exchange rates can be expected to compensate for nominal interest

3/ At 1982 exchange rates the dollar share would have been 56% at the end of 1987, indicating the effect of cross-currency movements on relative shares. See the December 1988 issue of Quarterly Review of Financial Flows to Developing Countries. (World Bank), for some further information on the effect of currency movements on aggregate debt stocks and debt service. -62-

Box 4.1: Criteria for Active Currency Composition Management (continued) rate differentials.4 / Hence, the basic rule for choosing currencies should not be nominal cost minimization but (real) risk minimization, to be achieved through matching the effective currency composition of Turkey's ability to generate foreign exchange with the currency composition of Turkey's external liabilities. In essence, there is no point in pursuing arbitrage gains through playing off nominal interest rates and currency movement risks.

4.06 In this section, we assume that, given the relative restrictive access of Turkey's private sector to foreign funds and foreign financial hedging instruments, the Government intends to manage its external liabilities with respect to the country's overall exposures and thus the non-interest current deficit.5 / The currency composition of Turkey's capacity to generate foreign exchange will, inter alia, be related to the following four factors: the composition of the currency basket with respect to which the Government manages the domestic currency; the country's external trading pattern, exports, and imports, as well as the pattern of other goods and services flows (including workers' remittances but excluding interest payments); the currency composition of the country's non-interest current account flows; and the relation between the country's term of trade movements and cross-currency exchange rates changes .6/

4/ Abstracting from transaction costs, a perfect arbitrage can be made between borrowings in alternative currencies using the forward exchange (or currency swap) markets. This arbitrage implies covered interest parity: the forward (or swap) rate represents the interest differential between the alternative currencies and the after forward (or swap) costs of borrowings in alternative currencies will be equalized. To the extent that the forward exchange rate represents the equilibrium forecast of the expected future. spot rate, the effective costs of borrowings in different currencies can be expected to be equal and uncovered interest parity will hold. Ex-ante deviations from uncovered interest parity can be due to factors such as risk premiums and to some extent these deviations can therefore be anticipated. However, ex-post deviations from uncovered interest parity can not be anticipated and active currency management should therefore be employed to reduce risk through proper diversification.

5/ The relative restrictive access of Turkey's private sector to foreign capital markets is supported by the fact that reported Private Non-Guaranteed Debt accounted for only 3% of Turkey's total external debt at the end of 1988. Source: World Bank

6/ For more detail on the principles underlying optimal currency composition see Kroner and Claessens, "Improving the Currency Composition of External Liabilities: Applications in Indonesia and Turkey", PPR Working Paper, no. 150, the World Bank, 1989. -63-

4.07 Currency Basket: Turkey's currency is managed with respect to the US dollar and the DM using approximate weights of 65 percent and 35 percent respectively. In general, the best rule for determining those weights should be based on the general balance-of-payments situation, the real exchange rate targets, and resulting tradeoffs related to the prices of exports, the costs of imports, the country's trading pattern, the markets in which the country sells and buys it goods and services, and its relative competitiveness in these markets and other factors. Hence, if the weights in the currency basket used in Turkey's exchange rate management are determined optimally in light of these tradeoffs, then the weights in the currency basket represent the optimal currency weights for the stock of external debt as well. If indeed the currency basket weights are currently optimal, then Turkey's debt composition should roughly be 65 percent dollar and 35 percent DM. Taking into account the high correlation among most European currencies (with perhaps the pound sterling as an exception) the external debt portfolio seems reasonably balanced with respect to the European currencies (roughly 50 percent) compared to the European weight in the basket (35 percent). The major imbalances in Turkey's current portfolio composition would, under these assumptions, be too few US dollars and too many Japanese yen, with growth in the latter increasing significantly in the last two years. The dollar's weight in the basket is 65 percent while its weight in the debt portfolio is 31 percent. The Turkish lira is not managed with respect to the Japanese yen, thus the Japanese share in Turkey's external debt (16 percent) could represent an imbalance.

4.08 Trade Pattern: Turkey's net trade, including workers' remittances, is largely with the EC (of which net trade with and remittances from West Germany represent the lion's share) and the Middle East, a region whose economies are predominantly based on the US dollar (see Table 2). If indeed, as this rule implicitly assumes, the appreciation of an export market currency implies increased export earnings from that country in terms of value (and potentially, increased export volumes to that country, as relative prices decline), while the opposite holds for imports, then the pattern of net external flows can provide a guide for the composition of external debt, as that pattern provides an indication of the sensitivity of a country's ability to generate foreign exchange in response to currency movements.7/ For Turkey, some imbalances do seem to exist between net trade and other flows and the currency composition with respect to the US dollar, the Japanese yen, and the Swiss franc. The balance of Turkey's trade and other goods and services flows (including workers remittances) with the EC (as a whole) and Germany individually is in surplus, while the balance with Japan and the United States is in deficit. On the other hand, the shares of US dollar and Japanese yen in the external debt stock are relatively large. It seems, therefore, solely on the basis of this criterion, that a reduction in the share of both Japanese yen and the US dollar is advisable.

7/ As interest as well as principal repayments expose Turkey to exchange rate risks, it is important to study the non-interest current account patterns and flows and not only the current account patterns and flows. See the World Development Report (1985) for some more references on this rule. -64-

TABLE 4.2: NET TRADE PLUS OTHER GOODS AND SERVICES. EXCLUDING INTEREST PAYMENTS (millions of US dollars)

USA WGerm Jap Switz 0th. EEC MEast 0th Total

1986 -628 1390 -585 -123 889 406 -1416 -67 1987 -652 2163 -704 -9 1571 8 -1816 561 1988 -759 3188 -345 -79 2854 594 -1293 4160 a) Including workers' remittances, which are assumed to be predominantly from West Germany, and assuming that net other goods and services flows are predominantly from other countries in the EC. Tourist revenues are assumed to be 30% from W. Germany and 70% from other EC countries.

Source: SPO

4.09 Currency Composition of Net Flows: The currency composition of the net non-interest current account flows (see Table 4.3) is heavily skewed toward the US dollar with the DM representing the second largest share. Evidently a large part of Turkey's trade, even though conducted with trading partners with non-US dollar home currencies, is invoiced in US dollars. This confirms a world-wide pattern: approximately 55 percent of world exports are denominated in US dollars, 14.5 percent in DMs, 7.5 percent in Sterling, 6 percent in French Francs and the remainder 17 percent in other currencies.8 / From this point of view, there appear to be some imbalances in Turkey's external debt composition. Turkey's net currency receipts are largely in US dollars, approximately 58 percent for the first eight months of 1988, and DMs, approximately 43 percent, while Japanese yen net currency receipts are negative, approximately -7 percent, as imports are that much larger than exports to Japan. At the same time, the share of US dollar liabilities in Turkey's total external debt is only 31 percent while the share of Japanese yen liabilities is positive and relatively large, 16 percent, having increased from 11 percent in 1986. The net flows portion would therefore indicate that Turkey should have more dollars in its external debt portfolio and fewer Japanese Yen.

8/ Data as reported by S.A.B. Pagee, "The Choice of Invoicing Currencies in Merchandise Trade", National Institute Economic Review, 1981. See further Magee, Stephen and Ramesh Rao, "Vehicle and Nonvehicle Currencies in International Trade", American Economic Review, Proceedings, Vol. 70, no. 2, pp. 368-373, May 1980. -65-

TABLE 4.3: CURRENCY COMPOSITION OF NET INCOME AND EXPENDITURES OF THE CENTRAL BANK AND COMMERCIALBANKS

US $ DM YEN SwFr HFL STR FF 0th Sum

1986 161% 18% -35% -20% 4% -22% 3% -9% 100% 1987 71% 54% -14% -9% 6% -8% 4% -3% 100% 1988 58% 43% -7% 0% 3% -. 2% 4% -. 8% 100%

Sources: Central Bank and World Bank Staff estimates.

4.10 Relationship between Terms of Trade and Exchange Rates: It is important to note that the invoice currency does not necessarily have to represent the "pricing" currency. It is likely, for example, that exporters to Turkey determine their export prices not only on the basis of their domestic currency costs but also on the circumstances in the world market for a particular export good, after which they then translate these factors into a third invoice currency, such as the dollar. For example, German exporters will be influenced in setting their prices not only by their own cost structure but also by the behavior of Japanese, U.S., and other competitors, each of which may calculate the dollar invoice price of their goods by multiplying the domestic currency price with the dollar/yen and other exchange rates. Similar effects will exist for Turkish exporters. On the demand side, consumers in different countries will similarly determine their demand for a particular good based on the domestic currency price of the particular good and other substitutes. As a result, multiple exchange rate changes will influence the pricing and resulting quantities traded of a particular good, and the price could be independent of the value and denomination of the invoicing currency. The structure of the market (competitive, oligopolistic, monopolistic), and thus demand and supply elasticities will determine the effects of exchange rate changes on price and quantity changes. Turkey's economic exposure to a particular currency change will therefore not necessarily be the accounting exposure or the nominal quantity invoiced or traded, but could be more complex. For example, a Turkish exporter to the United States will likely be influenced by the Turkish lira/dollar, as -66-

well as the DM/dollarand the yen/dollarexchange rates.9/ Final judgment on the economicexposure, as opposed to accountingor nominal exposure,will therefore very much depend on empirical facts. For instance, one can look at the relationshipbetween terms of trade and exchange rate changes. The terms of trade represent some measure of the purchasing power of exports, and hence, indicatesome real costs of servicingdebt denominatedin different currencies. The (empirical)relationship between Turkey's terms of trade, an index of the purchasing power of Turkey's foreign exchange, and foreign currency movements indicatesa relativelyhigh correlationbetween the monthly changes in the terms of trade with movements in the US dollar and European currencies and a lower correlationwith the movements in the Japanese yen. Turkey could, perhaps, best diversify to reduce the impact of terms of trade shocks by borrowing a large share of US dollarsand Europeancurrency liabilitiesand diversifingits foreign assets (e.g.,foreign exchange reserves)more toward the Japanese yen. However, this empriricalfinding should be used and interpretedwith some caution, as the relationshipbetween Turkey's terms of trade and exchange rates is not very stable, which might imply that the optimal portfolio composition cannot be calculatedwith sufficientaccuracy.

2. Conclusions

4.11 Using the above criteria, it appears that Turkey's external debt is reasonablybalanced in terms of currency composition. There are, however, some imbalanceswith respect to the US dollar, the Japanese yen, and the Swiss franc. It would be advisable, on the basis of the above analysis, to limit or reduce the share of Japanese yen liabilitiesin Turkey's external debt and increasethe share of US dollar liabilitiesas was undertakenduring 1989. The imbalancewith respect to the Swiss franc is less serious, as the large amount of trade with Germany and the large share of DM-denominatedflows will tend to compensatefor the Swiss franc exposure,as the Swiss franc and the DM are highly correlated. In the short term, the US dollar share of medium- and long-term debt service remains relatively high (40 percent) compared with the US dollar share in the medium- and long-termdebt stock (26 percent)as US dollar debt servicepayments will be coming due relativelyearlier than non-dollarpayments. This impliesthat the currency mismatch is somewhat lower in the short than in the long term.

9/ An even more illustrativeexample of the difference between nominal and real exposurewould be a producer in the USA which neither imports nor exports any raw materials or goods. Even though nominally not exposed, i.e., neither its currency nor its trading pattern nor the currency compositionof its flows (all dollar) indicate any form of exposure, the firm can be heavily exposed to, let's say, the (real) DM/dollar rate as its West German competitors becomes more or less competitiveand subsequentlythe firm's cashflows can be affected. A good example is oil. Oil is quoted in dollars, but its price increasedwhen the dollar fell, thus being more stable when measured in other non-dollar currencies. One could argue that the oil price is likely to influence the Japanese and Turkey's economy similarly (through imports) and that therefore the Japanese Yen has some indirect hedging potential for Turkey's economy. -67-

Beyond 1990, the currency mismatch in debt service increases as yen and other non-US dollar debt service payments will be coming due. It thus becomes important either to achieve a better diversified trading pattern and currency compositionof non-interestcurrent account flows in the medium to long term-- i.e., more net trade with Japan and a higher share of net yen inflows--orto limit, and possibly reduce, the share of Japanese yen in medium- to long-term borrowings,or both.10/

B. Interest Exposure of External Liabilities

1. Analysis

4.12 As noted in the Chapter 2, a large and increasing part of Turkey's total external debt is of a floating interest rate character (variablerate debt or short term debt that is rolled over). At the end of 1988, floating rate debt or debt that is subject to resettlement of interest rate, constituted approximately48.8 percent of total external debt, up 11 percentage points from 1984. In light of the historic volatility of internationalinterest rates (the standard deviation of the US dollar LIBOR interest rates over the period 1980-1988was 3.38 percent and the average LIBOR interestwas 10.74 percent) and as small movements in the level of internationalinterest rates can result in large swings in Turkey's debt service (see simulationsin the Annexes), Turkey faces a relatively large nominal exposure to interest rate changes. The simulationsin the Annexes actually imply that a one percentagepoint change in interestrates leads to a change of approximately$150 million in Turkey's annual debt service in the early 1990's. Interest rate risks thus represents a substantialexposure for Turkey.

Box 4.2: Criteria for Interest Rate Management

4.13 Much has been written on the adverse effects of high nominal and real interest rates in the late 1970's and early 1980's on the debt servicingburden of developing countries. However, little analysis has been devoted to the question what, ex-ante, the most preferred interest rate structurewould be for a country, and what the "optimal"division of floatingversus fixed rates would have been ex-ante. In other words, it has not been resolved whether the accumulationof a high percentage of floating interestrate debt by many Highly IndebtedCountries (HICs) in the late 1970's early 1980's was necessarilyex-ante

10/ When interest parity holds perfectly, borrowing low nominal interest currencies can provide cash flow managing benefits as low nominal rate currency borrowings have a longer duration than high nominal interest rate currencies. To the extent that a borrower has (or expects to have) a cashflow constraint,this can be a factor to take into account. -68-

Box 4.2: Criteria for InterestRate Maniagement(continued) a bad strategy."/ In corporatefinance much attentionhas been devoted to the matter of interestrate structuresand yield curves. Even thoughnot completely conclusive,this literaturehas indicatedthat borrowingon a floatinginterest rate basis, or borrowing short term and rolling over, is on average less expensivethan borrowinglong term on a fixed interestrate basis, calculating both costs over an equal lendinghorizon (i.e.,comparing borrowing on a floating rate basis, or rollingover short-termdebt to lendingon a fixed rate basis for an equallylong maturity).12/ The yield curve evidentlyincorporates a premium for longer maturityborrowings which reflectsnot only the market expectations of future short-term interest rates, but also a risk and liquiditypremium. However,it has not clearlybeen establishedwhether the lower expectedcost of variable interestrate debt is sufficientto compensatefor the risks involved for the borrower in rolling over short-termdebt or borrowing on a floating interest basis.13/ The empirical literaturehas shown that borrowings on a floatingrate basis often does not yield substantialex-ante nominal or real cost savings compared to borrowing on a fixed rate basis relative to the risks involved. Naturally, this depends on which way interestrates move and over what period.

4.14 For a country, the exposure with respect to the interest cost of floatingrate, short-termdebt has to be measuredwith respect to the behavior and variabilityof foreign exchange with which it services the debt. If, for example,increases in US dollarLIBOR rates are associatedwith increasedexports from Turkey,then Turkey'sexposure to interestrates would be substantiallyless than that indicatedby nominalquantities alone, such as the amount of variable interestrate debt. In that case, Turkeywould have a naturaloffsetting factor against interestrate shocks as foreignexchange earnings would tend to move in line with interestrates. In order to check whether any positive or negative relationshipexists betweenthe level of, and changesin, internationalinterest rates and indicatorsof (the costs of) foreignexchange availability, such like exports, imports, non-interestcurrent account flows, and the regular current accountbalance, a correlationanalysis was performed. The resultsare reported in Table 4.4.14/

11/ Even though, as most observerswould agree, much of the problems of the HICs in the early eighties can be attributedto the large portion of floating interestrate debt and rising interestrates, the fall in interestrates in the later part of the eightieshas not contributedsignificantly to an alleviation of their debt burdens. So even this period does not shed any clear light on the issue of optimal interest structure.

12/ Puttingborrowing on a floatingbasis and rollingover short-termborrowing on the same footing, assumes of course that the short-termfunds will remain available.

13/ See for instanceSummers, 1989.

14/ This approach should be viewed as only an indicativemeasure of interest exposure;if for instanceno adjustmentis made for changes in relativeprices affecting trade, external flow figures have to be balanced against the opportunitycosts of servicingexternal liabilities, e.g. the costs of imports. -69-

TABLE 4.4: CORRELATIONS OF EXPORTS. IMPORTS. NON-INTEREST CURRENT ACCOUNT AND CURRENT ACCOUNT WITH US DOLLAR--LIBOR. PERCENTAGE LEVELS (Prob) CHANGES (Prob)

EXPORTS -.45 (.0001) .053 (.5632) IMPORTS -.33 (.0002) -.081 (.3794) Non-Interest Cur. Acc. 0.11 (.4844) -. 074 (.6335)

Current Account 0.161 (.2908) .050 (.7462)

a) Monthly data. Period 1978-1988 for exports and imports and 1985-1988 for others. Probabilities of rejecting R2sO in parenthesis.

Sources: IFS, IMF

4.15 From Table 4.4 it is clear that the relationships between the level and changes in interest rates and Turkey's non-interest current account and regular current account are very weak and insignificant. The only significant relationships seem to be between the level of exports and imports and the level of international interest rates: these correlation coefficients are significantly negative. The correlation coefficients of the period-to-period changes of these same variables with period-to-period changes in US LIBOR are insignificantly different from zero. The negative correlations of exports with interest rates is especially worrisome as it suggests that movements in interest rates are not only not offset by movements in export values but are even aggravated by perverse movements. This relationship would imply that Turkey does not have a natural hedge against interest rates movements.15/

2. Conclusions

4.16 It appears that Turkey is exposed to movements in interest rates, given the high percentage of floating rate debt and the absence of a natural hedge. Hence, the analysis and other reasons mentioned in Chapter 2 indicate that Turkey

15/ The period over which these correlations were estimated may have led to some bias: over 1978-1988 international interest rates fell while Turkey's exports, for other reasons which are likely unrelated to movements in international interest rates, expanded dramatically. To the extent that one believes that this period was exceptional, the results may consequently be biased. Over longer time periods the relationship between international interest rates and measures of exports from developing countries to industrial countries has been slightly negative, but barely significant. A more complete analysis could involve a multiple regression in which other variables influencing Turkey's balance of payments situation enter (e.g. economic activity in OECD countries). -70-

needs to reduce the amount of floating rate debt, including short-term debt. An additional argument for taking on fixed rate debt is that the growth in Turkey's floating rate debt has mainly occurred in the last three years though expansion of commercial borrowing, when interest rates were relatively low.16/ A prudent target would be to have less than 40 percent of total external debt in floating rate debt (including short-term debt). It should be feasible to achieve this target over the near term through new (fixed rate) borrowings and (limited) interest swaps. Turkey is already moving in this direction.

C. Recommendations for Implementing External Liabilities Management17 /

4.17 The above analysis has important implications for the Government, which should address the following topics with respect to its external asset and liability management: the policy framework; technical training; hedging of short-term foreign exchange risks; new borrowings; and swap transactions. 18/

4.18 Policy Framework: Institutional and policy guidelines are required to define the broader objectives of external assets and liabilities management and the type of tools authorized. The framework will have to call for a proper evaluation of Turkey's exposure to currency changes and Turkey's external debt

16/ To the extent that one believes that international interest rates on average will rise over the medium term rather than fall and to the extent that this is not reflected in the yield curve, the large portion of variable rate debt could present an increased debt service burden as well as increased risk for Turkey. Increasing further the share of fixed interest rate debt would be further advisable under such a scenario. Currently the yield curve is relatively flat. Further information about the variability of real and nominal interest rates in different currencies could influence the fixed versus variable rate decision in a particular funding currency.

17/ For further references on and description of external liability management we refer to publications such as The Roundtable Conference on Trends in International Capital Markets: Implications for Developing Countries, organized by the World Bank and Queen Elizabeth House, held at Oxford University, February 20-26, 1988, which had a special session devoted to Asset and Liability Management Techniques. The Commonwealth Secretariat, the IMF, and other institutions also publish regularly on new developments and new techniques of developing country financing. The 1988-1989 edition of the World Bank Debt Tables had a "box" devoted to risk hedging and risk transformation

18/ Sovereign liability management has become an increasingly important part of overall external borrowing strategy for many developing countries. Treasuries in the Asia/Pacific region have been furthering their liability management through the continuing prepayment of expensive yen debt, further maximizing of swaps and by streamlining their debt offices. Countries like Thailand and India have been actively involved in interest and -- to a lesser extent -- currency swaps, marrying their asset and liability management, and venturing into new capital markets, mostly away from yen denominated liabilities. -71-

structure, along the lines indicated in this report, and will require extensive analytical work. The framework and guidelines should consist of four components: 1) the institutional setup, as discussed in Chapter 6; 2) the longer-term strategic considerations and relevant tradeoffs and the resulting broader parameters; 3) the short-term operational objectives and parameters; and 4) the execution of the borrowings and other external liability policies. The longer-term strategic policy framework should be developed along the lines indicated above and should result in broad medium- to long-term borrowing targets in terms of currency composition, interest structure, maturity, the investor base, etc. A rolling five-year target with annual revisions could represent such a plan. The short-term framework should, in accordance with the longer-term plan, involve a more detailed annual borrowing plan, taking into account expectations regarding debt service payments, pipeline disbursements, trade and other flows, market sentiments, market opportunities, export and import trends, etc. The short-term operational guidelines should be broad enough to allow managers to capture attractive market opportunities in the execution stage, while ensuring at the same time overall control and the creation of proper records. Annual borrowing targets, including one for currency composition and targets vis-a-vis the split between fixed and floating rates, would be indicated at the outset, so that the managers can have some discretion for market developments, without having to justify every decision along the way. Agreement on these broad principles is fundamental to achieving sufficient clarity in objectives, while retaining reasonable delegation of responsibilities (see Chapter 7).19/

4.19 Technical training: Lead time will be required to familiarize operational staff with new external liability and hedging instruments, set in place computer support, etc. It is therefore important to further develop the technical capacity of staff early on. The World Bank has provided support to other developing countries by placing people for temporary assignments in commercial banks, and has held seminars in Washington on asset management for central bankers. It could provide further support to Turkey.

4.20 Short-term foreign exchange risks: Given that the short-term currency mismatch is still considerable, even though less than the long-term currency mismatch, the Government should consider a number of strategies to correct this, as follows:

a) Use of reserves: reserve management objectives should include hedging Turkey's foreign currency liabilities, short-term as well as long-term. This would imply an increase in yen-denominated reserves held by the Central Bank in its investment portfolio in

19/ The annual program should build on work already under way in the Treasury. -72-

order to match the growingyen-denominated debt servicepayments.2/

b) Short-term borrowings: to improve the currency composition of external liabilities,Turkey should continueto try to increasethe share of US dollar-denominatedshort-term borrowings; currently, 58 percent of short-termborrowings are in dollars, which is not sufficient to correct the overall imbalance.

c) Futures,forward arrangements, and options: these transactionscan be used as a short-terminstrument to hedge or limit exposures.The Central Bank has already used FX-options for this purpose.2 1/ Additional experience and a proper institutionalframework should allow greater use of these instrumentsin risk hedging (see also Chapter 6). The objectiveshould be to match short-termcash flows better, and to reduce the risks on open positions,while ensuring the liquidity,security, availability, and profitabilityobjectives of reserve management.

4.21 New borrowings: Over the medium to long term, the proper strategy is to continue to adjust the existing stock of debt through new borrowings toward a wider diversification in terms of investor bases, floating versus fixed interestrate, currency compostion,and maturity,balancing the diversification objectiveagainst the benefits of a larger presence in individualmarkets (e.g. lower spreads as a result of increased familiarity on the part of Turkey's lenders). This implies a continuationof the expansion and diversificationof the markets and investor bases for Turkey's bond issues, syndications, and placements,and could as reflectedin, for example,in the further expansioninto the US dollar fixed interest rate bonds market. Longer maturities secure funds for a longer period and reduce thus Turkey's vulnerabilityto access to foreign finance. In addition, it may be possible to (marginally)change the currency compositionof funds from the Japanese market -- likely an important source of funds -- away from yen-denominated toward US dollars and other currency denominated funds. The possibility of obtaining non-yen funds in Japanese markets exists; the World Bank for instance has raised substantial amounts of dollar funds in the Japanese market, while Indonesiawhich successfullytapped

20/ This could possibly also imply some change in the distribution of the currency compositionof reserves in other currencies, such as between DR, the Swiss franc, and US dollars. However, since the mission does not have data on foreign exchange reserves distribution(by currency) we are not in a position to make any specific recommendations.

21/ Multicurrency options, giving the country the option to draw down funds denominatedin a stipulatedcurrency of its choice or switch over the amount of loan from one currency to another, have been successfully used by India, Malaysia, and Thailand, among others. The multiple option facility is a particular flexible form which can include a number of options, including short-termsecurities as well as loans, to be used at the borrower's discretion. Taiwan has used such a facility recently to raise domestic currency finance. -73-

the (officialand/or guaranteed)market in non-yen currencies in the Japanese market. It might be possible for the lenders (such as Japan's Eximbank) to transformthe currency denominationof its yen loans through currency swaps into the borrower's preferred currency (e.g. dollars), before disbursements(or as part of the loan contract).a/

4.22 Another possibility for transforming currency risks may be redenominationoptions. Indonesiawas for instance able to secure a Euro-yen revolvingcredit and term loan (Y 40 bn) from six Japanese commercialbanks in November 1988, which could, at Indonesia's own discretion,be drawn down and repaid in Japaness yen or in US dollars. In exchange for the option to withdraw funds in dollars or yen, Indonesia paid a slightly higher spread over LIBOR. Recently, Indonesia also obtained a total of around $550 million from Japan's Eximbank,of which $200 million will be provided in US dollars and the remainder in Japanese yen. This was the first time that the Eximbank has agreed to lend in currenciesother than yen. In a similar vein, Tunisia was recently able to raise US funds from commercial sources with an option to convert these funds into French francs at a later date. The Turkish authorities should consider trying to obtain similar arrangementsfrom the Japanese and other lenders if warranted. As a result, Turkey would not be have to be charged a credit risk premium twice, as would be the case if existing funds were swappedwith a third party or if other featureswere added later.

4.23 Currency swaps: Swapping existing external liabilities, largely transformingyen-denominated liabilities into US dollar-denominatedliabilities, could be an appropriate strategy for Turkey provided that a number of key conditions are satisfied. These include: the right institutionalsetup which allows for a careful evaluation of debt structure and exposures; extensive technical and market experience;sufficient market access; flexibility;and an evaluation of credit constraints. Swaps do have an element of rigidity: the borrower may lock itself into a currency (or interest structure)which, ex-post, may turn out to be very disadvantageous. Even though swaps can be unrolled, basicallyby puttting a reverse-swapon top of the existing swap, indirectcosts (legal, expenses, and credit premium) will increase commensurately. Swaps are (partially)counted by banks against their exposure limits, and in general they

22/ In 1986 46% of all new issue in Japanese Yen were directly swapped into other currencies. -74-

use up capital.2 3 / Swaps could thus over time limit Turkey's ability to secure additional new borrowings as regulations require capital to be side aside, and as swaps will also reflect generally Turkey's capital use and credit profile through a premium (spread). Nor are swaps easy to evaluate financially, requiring credit evaluation of counter parties and their potential to undertake swaps depends on timely actions to take advantage of market opportunities. They certainly require sophisticated institutional set-up.24/ Annex 4.1 provides examples of the costs of swap transactions from Yen to US dollars.

4.24 Swaps have been used by countries such as China, India, Malaysia, and Thailand. From contacts with foreign banks in Turkey and banks in Europe, and from information from the Government of Turkey, it appears that at the moment Turkey has reasonable access to the currency swap market and could execute, if it so desired and if it paid the appropriate transaction price, a reasonable annual swap program. It is advised that Turkey develop the expertise for currency swaps with the objective of reducing the currency mismatch of existing liabilities over time. The World Bank might be able, if necessary, to provide technical expertise and training opportunities for professionals, as it has for a number of developed and developing countries.

4.25 Interest rate swaps: Swapping existing floating interest liabilities into fixed interest rate liabilities would be an appropriate strategy for Turkey given the high percentage of floating rate liabilities and the shortage of

23/ The new capital adequacy guidelines adopted by the G-10 governments (BIS Capital Adequacy Guidelines) stipulate that swaps represent an exposure in the amount equivalent to a certain fraction of the face amount of the swap, for which an allocation of capital is necessary. The guidelines suggest that the exposure in a currency swap would be calculated as the sum of the total replacement costs of the swap, for which the swap would be marked to market, and an amount for potential future credit exposure calculated on the basis of total notional principal amount. The latter part would be calculated on the basis of suggested conversion factors which would be applied to the notional principal value of the swap and would be (provisional and subject to national authorities discretion) 1% for currency swaps with a maturity of less than one year and 5.0% for swaps with a maturity of more than one year. The required ratio of required bank capital to the calculated exposure measure would be 8%. Standard claims on OECD central governments and central banks receive a zero risk weighting according to the BIS guidelines.

24/ Currency swaps (as well as interest swaps) can at times also be used to reduce the cost of borrowing as they can allow for spread compression by taking advantage of differences in credit ratings of two parties in different financial markets. The World Bank, which pioneered this form of arbitrage, has at times been able to raise funds through currency swaps at significant savings compared to raising similar funds though direct borrowings. The technique has been particularly useful to the Bank when a given market had been saturated for direct borrowings because some ceilings were reached, but through swaps was still available as a funding source. -75-

offsetting factors. The short-run cashflow implications in the form of higher interest rates in an upward sloping yield curve environment are likely to be justified given the large reduction in the uncertainty of future debt service payments. Prerequisites similar to those for currency swaps will have to be satisfied, however.2 5 / In addition to interest rate swaps, interest caps, combined with floors, can be used to mitigate interest rate risks. Interest caps can limit the effective interest rate over the life of the loan (or in particular periods) (by setting a ceiling on the interest payments), while floors put a lower limit on the interest rate.

4.26 Commodity bonds and other instruments: There are several kinds of commodity bonds which, essentially, provide a hedge against future commodity price fluctuations. They are designed so that when commodity prices rise the associated debt service also rises, and vice-versa, thus providing an ideal hedge for a developing country which is heavily dependent on commodity exports. / Even though Turkey has a much more diversified exports base than most primary commodity exporters, an external borrowing instrument in which debt service would be linked to some index of export activity (e.g., a measure of OECD activity) could also represent a very good hedging instrument as debt service on the instrument and Turkey's exports will then likely move together. Non-recourse financing (stand-alone finance), as currently already in use, could in effect also present a natural hedging instrument against external shocks through its more variable payment obligation. Other forms of more "indexed" or variable payments instruments, some of which would more likely be issued by Turkey's private sector, could include forms of convertible bonds, quasi-equity, and equity -- portfolio as well as direct. Those instruments also represent advantages from an external liability management point of view. They can lead to risk sharing with developed capital markets, require a form of managerial involvement by the provider of the finance which can lead to significant additional advantages, and in general could provide the right micro-level incentives for project selection and project management. The establishment of a Turkey Equity Portfolio Fund (under consideration) could also offer significant advantages for Turkey's external liability management as it could offer a way to diversify some domestic risk and could have a favorable impact on the domestic financial markets, in particular the corporate equity and bond markets.

25/ The BIS guidelines stipulate that the exposure inherent in interest rate swaps is calculated as the sum of the total replacement value and the potential future exposure. The latter is calculated as a fraction of the notional principal amount and would be nil for contracts under 1 year and 0.5% for contracts of one year and over. Interest swaps will require in general a lower credit spread than currency swaps, which primarily reflects the lower volatility of interest rates compared to exchange rates.

26/ Brazilian companies and the Mexican government are considering commodity price indexed bonds (gold and oil, respectively) as part of their debt restructurings.

PART I:

THE INTERNALTRANSFER -76-

PART TTi THE INTERNAL TRANSFER

CHAPTER V: PUBLIC DEBT AND FISCAL DEFICITS

A. BACKGROUND

5.01 Part I of this report focused on external debt strategy. From this discussion it became apparent that Turkey had regained its creditworthiness in the international markets by pursuing an economic reform program which led to a reduction of the ratios of total foreign debt to exports, total service of foreign debt to exports, and foreign debt to GNP. This was achieved by a rapid increase in exports and high GNP growth.1 Yet, Turkey could not reduce the total stock of foreign debt, largely because of substantial exchange rate losses incurred; in fact, the foreign debt stock increased. However, since 1988 the authorities have moved to confront the other aspect of the debt problem: how to produce a net positive transfer abroad. In brief, this implies that authorities need to free domestic resources, convert them into foreign currency, and transfer them abroad. This is the so-called transfer problem. 5.02 Successful production of such a transfer will depend chiefly on the capacity of the public sector to raise these resources (to the extent that most of the foreign debt is public). This chapter opens the discussion of the internal transfer by examining public sector readiness to meet the transfer problem. We thus discuss the structure of public debt, the size of fiscal deficits, and their source of finance. This discussion will be continued in the following chapter, where we analyse the implications of the size of the deficit and its financing on the domestic financial sector. 5.03 This chapter is organized as follows. In section B tne structure of domestic debt is analyzed, and stock of domestic debt estimated. Section C discusses the size of the public sector deficit and its sources of finance. Annex 5.1 explains formally some of the definitions, methodology and sources of data used in the calculation of the estimates used in the discussion in the text. B. STRUCTURE OF DOMESTIC DEBT

5.04 The structure of total public debt and the relation between domestic and foreign public debt can be observed via the trend in net (i.e., liabilities less assets) domestic public and foreign debt. Structure of the Net Domestic Public Debt 5.05 The first step is to determine the actual stock of net domestic public debt. Table 5.1 shows the Treasury's estimates of its domestic public debt; two observations are worth noting. First, the table is not a comprehensive measure of consolidated public sector debt, since it does not include a portion of the Treasury's stock of debt which is held by the Central Bank, and a portion of the debt of the SEEs, EBFs, and the amount of net debt of the Central Government that is outstanding with the domestic financial sector. Nor does it include public sector assets. Seconl, Treasury classifies the item 'consolidation' as

1/ See: The Fiscal Policy Report, September, 1988, for a detailed discussion of the strategy. - 77 -

domestic debt which in reality is part of foreign debt. About 90% of this item is made up by loans granted to the Treasury by the Central Bank financed with Central Bank foreign liabilities,and exchange rate losses accumulatedon these liabilities.By Central Bank law, the exchange rate losses of Central Bank's foreign liabilitiesare a claim on the Treasury;yet, the Treasury has not always paid them to the CentralBank. Moreover,the CentralBank has not charged interest on this debt.However, consolidations of public sectordebt (whichmost governments do and which Turkey also does, recognizing that this process is difficult due to data constraints)have been attemptedand thereforevarious items cancel each other out in the process of measuring domestic public debt.

TABLE 5.1 DOMESTIC PUBLIC DEBT OUTSTANDINGAS REPORTED BY TREASURY (as % of GNP)(1) 1980-83 1984 1985 1986 1987 1988 Average

NET DEBT STOCK 16.1 21.1 21.3 23.4 23.1 21.1 (at end-period) Bonds 2.4 2.4 3.2 3.4 3.2 3.8 Bills 1.0 1.3 1.5 1.8 2.6 2.0 Consolidation 9.7 14.9 14.2 15.9 15.4 13.6 Central Bank Adv. 3.1 2.4 2.4 2.3 1.9 1.6 SOURCE: Treasury (1) Since stocks are measured at end-of-yearprices while GNP is measured at mid-year prices, nominal stocks of debt were converted to mid-year 1980 real prices before computing its ratio to real GNP at 1980 prices. For this reason these ratios might differ from the official ones. See Annex 5 for the estima- tion method.

5.06 Table 5.2 reports the estimates of the stock of net domestic public debt corrected for these two aspects,2 along with two estimatesof the stock of net foreignpublic debt are also reported.Three key observationsemerge: First, the net domestic public debt (7.6% of GNP in 1988) is small relative to the net foreign public debt both including capital losses (47% of GNP in 1988) and excludingthe capital losses/gains(28% of GNP in 1988). However, since 1984 net domestic debt has tended to increase.Yet, before analyzing the effects of this size of domestic debt in the economy (Chapter6) it is necessary to compare the increase in the stock of net domestic public debt with the supply of domestic funds (i.e., the flows of private savings and the stock of net domestic public debt with the stock of financial wealth, such as M2X). Furthermore,there are high costs to this debt in both nominal and real terms. For instance, in 1986 the nominal interest expense of the net domestic public debt was 2.7% of GNP, while that of the net foreign public debt was 3.5% of GNP; in real terms these

2/ These estimates were obtained using the same methodology as in The Fiscal Policy Report. - 78 -

ratios were 1.4% and 1.8% respectively,3 despite the fact that the size of net domestic public debt stock was less than one quarter that of the net foreign public debt stock (includingcapital losses). 5.07 Second, the most importantsource of domestic public finance has been Central Bank -- monetary -- finance followed by bonds and bills. Bank credit fluctuated considerablyand increased sharply only in 1988, chiefly due to the relianceof SEEs on this source. Notably, monetaryfinance has been consistently importantwhile bonds and bills, as a source of finance for the public sector, have become increasinglyimportant over time. 5.08 Third, the most importantborrowers of funds were the Central Bank, the Central Government and the SEEs. However, this statementneeds to be qualified because it excludes transferswithin the public sector; data availabilitydoes not permit the necessary corrections. For example, a large proportion of the monetary component of the Central Bank's financewas transferredto the Central Governmentas Central Bank advances,while similar transactionsoccurred between the CentralGovernment and the SEEs. Also, as will be discussedlater, the Central Bank has to be financethe servicingof the Treasury'sforeign debt on the Central Bank balance-sheet (for example, by expanding the money supply to purchase the foreign exchange resources). That servicing usually includes payment of the exchange rate losses accumulatedon this foreign debt (i.e., the consolidation item in Table 5.1), which, by Central Bank's Charter, are a Treasury liability, yet is rarely repaid by the Treasury. 5.09 Finally, another very importantfeature of Turkey's debt structure to be seen in Table 5.2 is the large size of the net stock of foreign public debt, includingthe capitallosses relative to the stock of foreignpublic debt excluding them capital losses (rows IIa and II in Table 5.2). Although capital losses (see "Memo" item in Table 5.2) are not resourcesborrowed, they are a liabilitywhich will have to be serviced.In general, the greaterthe stock of net foreignpublic debt that includes the capital losses, the greaterwould have to be the transfer of resourcesabroad, and thus the greater the pressureof the foreigndebt service on domestic resources. Although the extent of this pressure will depend on the extent to which the country has access to more foreign resources, this indicator also has a domesticdimension: it representsfuture claim on the country'swealth, a claim which needs to be paid -- and generated -- in foreign currency.

3/ See: The Fiscal Policy Report, Table 3.16. 1986 is the only year for which there is an estimate of total interest expenses on net domestic public debt (i.e., including SEEs). - 79 -

TABLE 5.2 STRUCTURE OF PUBLIC SECTOR DEBT (as % of GNP)(1) 1980-83 1984 1985 1986 1987 1988 Average I. TOTAL DOMESTIC DEBT PLUS 9.98 10.81 12.06 11.35 12.07 13.53 CENTRAL BANK FINANCE(2) (A + B) A. DOMESTIC DEBT 4.85 2.60 4.42 4.26 6.38 7.55 (=1+2+3=4+5+6) SOURCES: 1. Bonds and Bills 3.33 3.78 4.65 5.19 5.81 5.80 2. Net Bank Credit 2.84 0.50 1.07 1.41 1.95 2.33 3. EBFs -1.32 -1.68 -1.30 -2.34 -1.38 -0.58 BORROWERS: 4. Central Government 2.63 2.97 4.23 4.18 5.45 5.57 5. SEEs 3.54 1.32 1.48 2.43 2.31 2.55 6. EBFs -1.32 -1.68 -1.30 -2.34 -1.38 -0.58 B. CENTRAL BANK 5.13 8.21 7.63 7.09 5.69 5.98 FINANCE(2) II.TOTAL NET FOREIGN DEBT 19.67 23.56 24.51 26.91 27.46 27.71 (Excl. K losses/gains)(3) IIa.TOTAL NET FOREIGN DEBT 24.06 33.32 36.55 45.67 46.40 46.76 (Incl. K losses/gains) MEMO: ACCUMLATED FOREIGN 4.39 9.76 12.04 18.76 18.94 19.05 EXCHANGE LOSSES(4) (IIa-II) SOURCES: Central Bank, Quarterly Bulletin; and Treasury. See Annex 5 for fur- ther discussion on the derivation of these estimates. (1) Since stocks are measured at end-of-year prices while GNP is measured at mid-year prices, nominal stocks of both domestic and foreign debt were con- verted to mid-year 1980 real prices before computing its ratio to real GNP at 1980 prices. (2) This is the finance appropiated through monetary expansion adjusted for the subsidized credit extended to the private sector, i.e., rediscounts. (3) This estimate excludes the capital loses (gains) caused by a real effective devaluation (appreciation) in the domestic currency and by changes in international exchange rates. For the estimates for the period 1980-86 the actual currency composition of the foreign debt was used and, for the remaining period the currency composition of end-1986 was used. (4) These are the foreign exchange losses accumulated as a result of fluctuations of international and domestic exchange rates. - 80 -

FIGURE 5.1 COMPOSITION OF STOCK OF EXT DEBT As % of Stock in TI ISO - 140 130 120 110 100 90 80 70 60 -

40- 30 - 20 -

10

-10 -20 - -30- -40

-50 - , I I _ l l l l I 1979 1980 1981 1982 1983 1984 198S 1986 1987 1988

C R Stock + Inter Ps o RDevTI

5.10 The actual size of the total stock of foreign public debt including capital losses (row IIa in Table 5.2) can be decomposed into three factors: the stock of foreign public net debt excluding capital losses which is the debt actually contracted; the effect of changes in changes in international exchange rates and in currency composition of the stock of debt and the effect of changes in the real effective domestic exchange rate, i.e., Turkish Lira to the U.S. dollar. The net sum of the last two effects made up the valuation effect or capital losses. In Figure 5.1 the foreign debt (expressed as percentage of the total debt including capital losses) have been decomposed into these three effects; this figure, therefore, enables us to appreciate the factors that had had a major importance in the growth of the foreign debt. For instance, for the period 1979 to 1984 this figure indicates that the public foreign net debt increased, chiefly, as a result of the real effective devaluation of the T1;4

4/ A real effective devaluation/appreciation of the Tl to the U.S. dollar can be defined as a real devaluation/appreciation of the T1 relative to the basket of currencies with which Turkey trades. A closer observation to the real effective exchange rate index (RER) -- see Figure A.5.1 in Annex 5.1 -- would suggest that most of the real devaluation took place between 1980 and 1986, and after that period the RER index shows an appreciation. - 81 -

and the change in international exchange rates and in currency composition of the debt -- less dollar-denominated -- had the favorable effect of reducing its current value. From 1984 to 1987 the total foreign debt increased as result of the fluctuation in international currencies (depreciation of the U.S. dollar relative to the other international currencies) and in currency-composition, i.e., a reduction in dollar-denominated debt. Figure 5.1 is also clear in showing that the capital losses generated between 1984 and 1988 as a result of the depreciation of the dollar relative to the rest of international currencies is comparable to the capital gains generated between 1980 and 1984 as a result of the appreciation of the dollar.5 In fact, this figure suggests that most of the capital losses recorded in 1988 are the result of a real effective devaluation of the Tl. C. PUBLIC SECTOR DEFICITS AND FINANCING 5.11 This section is devoted to analyzing the sources of financing of the public sector deficit. For this purpose the concept of below-the-line fiscal deficit or fiscal deficit estimated through changes in net public sector lia- bilities is introduced. These estimates will then be used in the following chapter to analyse the impact of the fiscal deficit on the domestic financial sector. First, the below-the-line nominal fiscal deficit is reported. Second, after introducing the concept of real public deficit (the nominal deficit corrected for inflation), we discuss the sources of finance. The Below-the-Line Public Sector Deficits 5.12 An alternative method of estimating the nominal Public Sector deficit is by estimating it through changes in public sector net nominal liabilities (liabilities less assets). This is the so-called below-the-line method. Table 5.36 reports these estimates for the period 1984-88. To arrive at the consolidated PSBR we have made two adjustments to the below-the-line non-financial PSBR. First, we have added the so-called "quasi-fiscal" deficit, since in the case of Turkey the Central Bank is involved in activities that in most other countries would correspond with public sector activity (e.g., rediscount lines). Second, as defined in the IMF's definition of the PSBR, we have included the net lending to the private sector, which is defined as the loans granted to the private sector.7 These calculations (Non-Financial PSBR and Central Bank's Quasifiscal), in line with Government's methodology, exclude the valuation effects (actual and/or accrued) arising from capital losses on the net foreign public sector liabilities. These "capital losses" originate from the fluctuations in the real exchange rate of the Tl and international currencies. Currency fluctuations only

5/ See also The Fiscal Policy Report for further elaboration on this point. 6/ All estimates in this table were calculated in nominal terms. See Annex 5 for a discussion of the methodology. 7/ There is a problem with the estimate of net lending in Table 5.3 and in Table 5.4 which in the future can be corrected; it includes all rediscounts granted by the Central Banks to the private sector. A more accurate measure should include only those rediscounts arising from the quasi-fiscal activities, that is, it should exclude the rediscounts granted by the Central Bank to banks to meet short-term liquidity needs. However, to the extent that net lending is added to both the Governement's and the Bank's estimates to obtain the respective PSBR estimates, our conclusions would not be affected. - 82 -

affect the deficit estimate in Table 5.3 (and the Government's, see Table 5.4) to the extent that it affects the Tl equivalent of interest payments on the net foreign public debt. However, as we will see in the following section, when the foreign debt is amortized, as has been happening in Turkey since the early 1980s, the realized portion of these capital losses should be considered as part of the financeable deficit, namely the PSBR. However, due to lack of sufficient data, we have not calculated the realized capital losses.

TABLE 5.3 BELOW-THE-LINE CONSOLIDATED PSBR ESTIMATES (As percentage of GNP) 1984 1985 1986 1987 1988

TOTAL BELOW-THE-LINE CONSOLI- 10.6 9.4 8.9 11.2 8.7 DATED PSBR (=1+2+3)(1,2) 1 Below-the-Line Non- 2.7 5.0 6.2 7.6 5.8 Financial PSBR (2,3) 2 Below-the-Line Central 9.9 3.5 1.6 2.0 2.1 Bank's Quasi-fiscal Deficit(2,4) 3 Total Net Lending(5) -2.0 0.9 1.1 1.6 0.8 Source: See Annex 5.1.

(1) PSBR was estimated as suggested in the IMF's methodology, by adding the nominal deficit plus net lending to the private sector. (2) These estimates exclude the capital losses (gains) caused by a real effective devaluation (appreciation) in the domestic currency and by changes in international exchange rates. For the estimates for the period 1980-86 the actual currency composition of the foreign debt was used, and, for the remaining period, the currency composition of end-1986 was used. (3) This is the non-financial nominal public sector PSBR estimated through changes in nominal liabilities of the consolidated public sector. See Annex 5.1 for the methodology used in arriving at these estimates. (4) This is a below-the-line deficit estimated using the Central Bank's balance sheet. See Table A.5.8 and Annex 5.1 for more discussion. (5) This is defined as the sum of MHF's loans to the private sector plus Central Bank's rediscounts granted to the private sector. For the period 1983-84, it was assumed that MHF's loans to the private sector were zero.

5.13 A similar set of estimates but calculated using the above-the-line method are reported in Table 5.4. In this case also the total above-the-line PSBR is defined as the sum of the officially calculated non-financial PSBR, plus the above-the-line Central Bank quasifiscal deficit -- estimated using Central Bank's Profit and Loss statements -- and plus the same net lending used in Table 5.3. - 83 -

TABLE 5.4 ABOVE-THE-LINE CONSOLIDATED PSBR ESTIMATES (As percentage of GNP) 1984 1985 1986 1987 1988

TOTAL ABOVE-THE-LINE CONSOLI- 5.5 6.7 6.4 10.0 7.2 DATED PSBR (=1+2+3)(1) 1 Official Non-Financial 6.5 4.6 4.7 7.8 6.4 Above-the-Line PSBR (2) 2 Above-the-Line Central 0.9 1.1 0.8 0.6 0.0 Bank's Quasifiscal Defi- cit(3) 3 Total Net Lending(4) -2.0 0.9 1.1 1.6 0.8

Source: See Annex 5.1. (1) PSBR was estimated as suggested in the IMF's methodology, by adding the nominal deficit plus net lending to the private sector. (2) Is the government estimate of the PSBR and excludes the quasi-fiscal deficit of the Central Bank. (3) This is a cash-flow deficit estimated using the Central Bank's Profit and Loss statements, i.e., it is an above-the-line estimate. See Table A.5.4 for a detailed breakdown in Annex 5.1 for the methodology. (4) This is defined as the sum of MHF's loans to the private sector plus Central Bank's rediscounts granted to the private sector. For the period 1983-84, it was assumed that MHF's loans to the private sector were zero.

5.14 Although in theory both methods for estimating the nominal PSBR (i.e., below- and above-the-line) should yield similar estimates, this is not completely apparent from Tables 5.3 and 5.4. This is in spite of the fact that we had applied a compatible methodology in estimating both the below- and the above-the-line PSBR estimates. The differences are partly explained by data consistency problems, and partly as a consequence of the different treatment of capital losses in the Central Bank's profit and loss and balance-sheet accounts. 5.15 Two aspects are worth underlining from Tables 5.3 and 5.4. First, except for 1984, both methods yield very close estimates for the non-financial PSBR. In 1984 there was a large consolidation of public sector debt. The differences, as explained before and more formally in Annex 5.1, have to do with the different treatment of the foreign exchange capital losses in the Central Bank's profit and loss account and in the balance sheet. Second, taking 1985 as the benchmark, both consolidated PSBRs estimates show a very a similar trend. The nominal PSBR increases up to 1987 and falls in 1988, this is in spite of the fact that the inflation level increased sharply between 1987 and 1988. Thus, both the above- and below-the-line estimates show an improvement in fiscal improvement in 1988 of about 2.0-2.5 percentage points of GNP.8

8/The above-the-line estimates though show a greater improvement than the below-the-line. - 84 -

The Public Sector Real Deficits and their Sources of Finance 5.16 During inflationary periods, as explained before, nominal deficits can become an unreliable indicator for assessing public sector performance. In general, a country experiencing high inflation and with a large public debt stock, as was the case of Turkey in the mid and late 1980s, will experience an increase in its nominal public deficit regardless of whether expenditures were reduced or revenues increased. That is because nominal interest rates usually adjust fully for inflation, thus increasing the size of the nominal deficit. Moreover, as we will see in the following chapter, savings estimates not corrected for inflation over-estimate private sector savings. It is therefore convenient to undertake the analysis of public sector performance, and that of savings in the following chapter, using estimates corrected for inflation. As defined in Annex 5.1, real public deficits are the sum of the so-called primary deficit (total revenues less non-interest expenditures) plus the real interest expense on net public debt, i.e., net domestic public debt and net foreign public debt. 5.17 The estimate of the real deficit calculated through changes in the real consolidated public sector's net liabilities and its sources of finance are reported in Table 5.5.9 The real deficit is a useful measure of effective fiscal performance, i.e., fiscal performance corrected for inflation. It indicates the size of the resources claims of the public sector on other sectors' real resources (i.e., private and foreign), and how these resources were transferred to the public sector. Table 5.5 suggests that after the fiscal contraction in 1986, real deficits increased in 1987 and then decline in 1988. Real deficits as in the official nominal PSBR shows a strong expansion in 1987, but the 1988 contraction is less sizeable -- but nonetheless sizeable -- to that shown in the officially nominal PSBR. Table 5.5 is clear in indicating that this was the result of the government's policy of reducing its reliance on foreign finance. 5.18 Table 5.5 also reports the foreign exchange capital losses incurred every year. As discussed earlier, these are incurred as a result of fluctuations in the international currencies in which Turkey's foreign debt is denominated and as a result of real devaluations in domestic currency. Table 5.5 indicates that Turkey incurred substantial capital losses up to 1987 and, in the period 1987-88 these were very small.'0 Although, all of these capital losses are not an immediate claim and, thus excluded from the definition of public sector deficit in Table 5.5, they are a future claim. In practice, however, the realized capital losses -- the proportion of the capital losses paid when the foreign debt is

9/For this calculation, we have treated inflation-tax as a financing item, as we implicitely assume that the inflation rate is determined, "ceteris paribus", by the proportion of the deficit financed by money creation. In other words, it is through the inflation mechanism that resources are transferred from the private to the public sector. To treat the inflation-tax as a tax revenue item, as it is sometimes found in the literature (i.e., an above-the-line item), would imply assuming that the inflation rate is not affected by the proportion of the deficit financed with monetary creation, i.e., that is given ex-ante. 10/See Chapter IV for a discussion of currency composition. - 85 -

serviced -- should be included in the definition of the deficit,"1 but it was not possible to make this estimate with the data available. It is important, however, to underline that capital losses become a realized claim when the foreign debt comes due, which in the case of Turkey, is occurring all the time (see Chapter 2). To this extent, the estimate of the real deficit in Table 5.5 is underestimated; this is particularly the case of 1987 and 1988 when Turkey made significant payments on her foreign debt. 5.19 A close observation of the sources of finance indicates that since 1984, with the exception of 1986, a large proportion of the real deficit had been financed with domestic resources. This can be more clearly appreciated in Figure 5.2, where the share of domestic and foreign financing in relation to the total deficit has been plotted. Figure 5.2 shows that since 1986, domestic finance as a share of the total real deficit has increased sharply while the share of foreign finance has fallen.

"/The Government, for instance, in its estimate of the PSBR only considers the capital losses in the interest component, i.e., the interest expense is estimated as the product of the interest times the stock evaluated at current exchange rates. - 86 -

TABLE: 5.5 REAL CONSOLIDATED PUBLIC SECTOR DEFICIT (As percentage of GNP)(1) 1980-83 1984 1985 1986 1987 1988 Average

TOTAL REAL PS DEFICIT 1.68 9.69 6.41 5.39 6.52 4.13 (Excl. K losses on For. Debt)

A.ADJUSTED MONEY FINAN- 1.70 5.74 2.57 1.74 1.82 3.40 CE(2)

1. Inflation Tax 1.84 2.56 2.80 1.92 2.75 3.23 2. Seignorage -0.15 3.18 -0.23 -0.18 -0.93 0.17 B.NET DOMESTIC DEBT -1.42 -0.22 1.92 0.06 2.39 1.03 FINANCE

3. Bonds and Bills -0.07 0.94 1.03 0.77 0.95 -0.13 4. Net Bank Credit -0.83 -1.32 0.58 0.40 0.63 0.33 5. EBFs -0.52 0.16 0.31 -1.10 0.81 0.83 C.NET FOREIGN DEBT 1.41 4.17 1.93 3.58 2.31 -0.30 FINANCE (Excl. K losses of For. Debt)(3)

D.NET FOREIGN DEBT 4.97 6.06 4.61 10.88 3.71 -0.56 FINANCE (Incl. K losses of For. Debt) MEMO: FOREIGN EXCHANGE 3.56 1.89 2.68 7.30 1.40 -0.26 LOSSES (D-C)(5)

SOURCE: Central Bank, Quarterly Bulletin; and Treasury. See Annex 5 for fur- ther discussion on the derivation of these estimates. (1) Since stocks are measured at end-of-year prices while GNP is measured at mid-year prices, nominal stocks of both domestic and foreign debt were con- verted to mid-year 1980 real prices before computing its ratio to real GNP at 1980 prices. (2) This is the portion of money finance which is used to finance the deficit, i.e., after deducting the portion returned to the private sector (see Table 5.5 for a breakdown). (3) This estimate excludes the capital losses (gains) caused by a real effective devaluation (appreciation) in the domestic currency and by changes in international exchange rates. For the estimates for the period 1980-86 the actual currency composition of the foreign debt was used, and, for the remaining period, the currency composition of end-1986 was used. (5) These are the capital losses (gains) incurred each year as a result of fluctuations in international exchange rates and of real devaluation of the domestic exchange rate. A negative sign indicates a gain. - 87 -

FIGURE 5.2 SIHARE OF FOREIGN AND DOMESTIC FINANCE (As percentage of Total Real Deficit) 130- 120 - 110

90 80

70-

60- so u 40 C. 30-

20-

I0 a~~~~~~~~~~~~~Yer 0- -10 3

-20-

1981 1982 1983 1984 1985 1986 1987 1988

Years 0 Foreign + Domestic

5.20 The most important sources of domestic finance are money finance and net bank credit. Bonds and bills were an important source of finance during the period 1985-87. In 1988, however, their use declined sharply. This relative decline will be discussed in Chapter 6. It was, however, a direct consequence of the Treasury's decision to cap real interest rates by restricting the volume of public debt instruments sold. It is important, however, to underline the different nature of net domestic credit (i.e., the sum of bank credit, bonds and bills and EBFs finance) and money finance. While availability of net domestic credit is market determined, depending on the willingness of bankers to lend to the public sector and on the availability of private sector financial assets, money finance is, to a certain extent, enforced: the private sector is forced to transfer resources to the public sector. These resources are extracted through money finance which is the sum of seignorage (the increased real demand for base money as the economy grows) and the inflation tax (the revenue obtained from non-interest bearing asset holders during inflationary periods). The inflation tax, in particular, is an instrument used to force the private sector to transfer savings to the public sector. And, as shown in Table 5.5 (row 1), the inflation tax has been an important source of financing of the real public sector deficit: it has contributed, on average, 2% of GNP. - 88 -

5.21 Table 5.6, which provides a breakdown of the sources of adjusted money finance (i.e., the portion of money finance used to finance the real fiscal deficit) suggests that the two main sources were an increase in banks' reserves and an increase in currency in circulation. There was also a one-time gain obtained when rediscounts to the private sector were reduced in 1984. This explains the sharp increase in money finance in that year. 5.22 On average, banks' reserves were a very important source of finance during the period 1980-85 and in 1988. However, these events are explained by two different reasons. On average, the increase in reserve finance during the period 1980-85 was explained by an increase in Ti denominated deposits (in fact, the reserve requirement ratio on sight and time deposits was reduced from 35% in December 1982 to 19% in December 1985), in 1988 the increase in reserve finance was explained by a sharp increase in the reserve requirement ratio on sight and time deposits from 10% in August 1987 to 25% for sight deposits and 14% for time deposits in October 1988.12 However, since deposits denominated in Ti (and more precisely M2) had been falling since 1986, the increase in reserve finance in 1988 was a once-and-for-all effect. In the future, if deposits remain constant, an increase in reserve requirement would require an increase in the reserve requirement ratio, i.e., an increased tax on banks.

TABLE: 5.6 BREAKDOWN OF ADJUSTED MONEY FINANCE (As percentage of GNP) 1980-83 1984 1985 1986 1987 1988 Average

ADJUSTED MONEY FINANCE 1.70 5.74 2.57 1.74 1.82 3.40 (1+2+3+4)(1)

1. Currency 1.33 1.02 0.99 1.03 1.47 1.15 2. Reserves 2.16 2.57 1.93 0.94 1.03 2.82 3. Rediscounts -1.64 1.99 -0.26 -0.43 -0.79 0.70 4. Other -0.15 0.16 -0.09 0.20 0.11 0.13 SOURCE: Central Bank, Quarterly Bulletin; and Treasury. (1) This is the portion of the money finance which is used to finance the public deficit, i.e., after deducting the portion returned to the private sector through rediscounts.

12 /In May 12, 1989 reserve requirement on banks deposits were, once again, changed; and these changes were made effective April 14. Reserve requirements on sight deposits were changed from 25% to 20%, on 3-month deposits from 14 to 20% and for deposits up-to-l-year from 14 to 10%. Also, the Central Bank introduce deposits with maturities varying from 2 to 5 years with variable interest rates and impose reserve requirements which fluctuate between 8% and 2%. Taking into account the quasi-money composition, it is very likely that the ratio of reserve requirements to quasi-money would increase, thus increasing public finance from this source and the taxation on banks. - 89 -

5.23 The amount of finance provided by increased currency was, on average, between 1% and 1.5% of GNP. And, although, for 1988 Table 5.6 shows a drop to 1.1% of GNP from 1.5% of GNP in 1987, thus suggesting a more restrictive monetary policy, this was not the case for the first three quarters of 1988. Up to the third quarter, as shown in Table A.5.6, money finance was greater than 1.6% of GNP. In general, the greater the reliance on this source, the greater the inflation pressures. Further, since inflation discourages individuals' demand for currency, it also introduces inflationary pressures by reducing the demand for currency relative to its supply.13 In Turkey, as we conclude in Annex 6.1, demand for currency is very sensitive to inflation level. This implies that stabilizing the portion of the deficit financed with respect to currency issued may involve a higher inflation. This relationship is illustrated by the inflation-tax figure in Annex 6.1. 5.24 Before moving on, it is important to enquire into the fiscal implications of a net positive public sector transfer abroad.14 The fact that only in 1988 the public sector showed a net public sector transfer abroad (i.e., the net foreign public finance excluding capital losses was still positive, see row C in Table 5.5)15 should not inhibit us from drawing the full implications of a public sector net transfer abroad. This would be a counterfactual exercise. The data shows (see Table 5.5 and Figure 5.2) a sharp fall in dependence on foreign financing both as percentage of GNP and as a share of the total real fiscal deficit. 5.25 It is useful to look at the implications of a net positive public sector transfer abroad (i.e., a reduction in net foreign public debt excluding capital losses) through the use of the public sector debt-dynamics identity shown as equation (5.1),16

(5.1)(5.) b*=- d +(r- g)b + (r*- g)b* -m -6b, where 6, 6* and m are the ratios of the partial derivatives of net domestic public debt, net foreign public debt and adjusted stock of money base to GNP, b, b* and d are the ratios to GNP of net domestic public debt, net foreign public debt and primary deficit denominated in Tl, g is the rate of growth of the economy and r and r* are the real interest rates on net domestic public debt and net foreign public debt.

13/To reduce the currency supply, the authorities relied on banks reserves (i.e., required reserves and liquid reserves), thus benefiting from both sources of money finance: currency and banks' reserves. 14/The surplus on the current account, which measures the total net positive transfer abroad, can be broken into the portions corresponding to the public and private sectors. 15/The surplus in the current account suggests that it was the private sector that had a net transfer abroad and not the public sector, 16/This identity is derived from the real fiscal deficit equation in Annex 5.1. See also Stanley Fischer, 'The Economics of the Government Budget Constraint'. Lecture delivered at the Central Bank of Pakistan. March 1989. - 90 -

5.26 This identity asserts that for the ratio of net foreign debt to GNP to fall, the sum of the increase in net domestic debt and in the increase in the adjusted money base needs to be greater than the primary deficit, assuming that average real interest rates on net domestic public debt and on net foreign public debt are equal to the rate of growth of the economy. However, if these average real interest rates are greater than the rate of growth of the economy, as seems to be the case in Turkey, then the sum of the increase in real net domestic public debt and the increase in adjusted money base will need to be financed. 5.27 Although, on average, the average real interest rates on net domestic public debt and net foreign public debt are higher than the growth rate, one might think that in 1988 the average real interest rate on net domestic public debt was smaller than the rate of growth. The reason for this was that it was artificially held down. The public sector reduced its cost of domestic debt by forcing the private sector to hold low-yielding debt instruments, such as base money in inflationary periods, and by capping the rate on bonds and bills in 1988. For instance, the real weighted interest rate of bonds and bills declined from 15% in 1986 and 7% in 1987 to -3% in 1988. However, since the real effective interest rate paid can be artificially held down only in the short term, it is more appropriate to measure it at opportunity cost (the market rate), which was unambiguously greater than the growth rate (see discussion and evidence in Chapter 6). 5.28 Equation (5.1) thus underlines Turkey's future fiscal dilemma in trying to make a net positive public sector transfer abroad: either it reduces its primary deficit and the difference between the average real interest rates and the rate of growth of the economy; or it must increase its net domestic debt and the adjusted money base. Obviously, the latter alternative would be more prob- lematic, for as we will argue in the following chapter, the large public sector deficit is already showing signs of stress in the domestic financial sector.

D. CONCLUSIONS

5.29 Our conclusion is that, although Turkey has reduced the size of the fiscal deficit in 1988, the decline in foreign financing since 1986 has resulted in increased reliance on domestic debt, which illustrates the difficulties that the public sector is facing in making an external transfer. Moreover, increases in the domestic debt of the public sector have also increased public deficits, as the cost of this debt is very high. Also, excessive reliance on the domestic financial sector and on the instruments used to channel resources from the private to the public sectors -- in particular the greater reliance on money finance -- has contributed to the high inflation and the high real interest rates. 5.30 The public sector need to make an external transfer would demand a greater reduction of its primary deficit (i.e., its non-interest current account) while at the same time attempting to reduce inflation and the high real interest rates through a comprehensive economic program. Moreover, reform of the current public debt auction system is also required (see Chapter 7) -- to make it more transparent and competitive -- and to rely less on money finance and more on efficient domestic debt financing. Such policies would help to ease the external transfer difficulties. - 91 -

CHAPTER VI: THE TNTERNAL TRANSFER PROBLEM

A. RACKGRQUND 6.01 As discussed in earlier parts of this report, Turkey faces the challenge of producing a net positive transfer abroad. Its success will depend chiefly on the public sector's capacity to raise these resources (as most of the foreign debt is public) but also on the capacity of the financial system to mobilize them, by encouraging private sector savings in public debt instruments. This chapter, by discussing the implications of public financial policy for the domestic financial sector, will attempt to assess the ability of the public and private domestic financial sectors to meet the transfer challenge. 6.02 This chapter is organized as follows. Section B looks at the resource transfer in a savings and investment framework (i.e., how much of the net real private savings needs to be transferred to the public sector to finance its deficit). Section C looks at the implications of the public sector's increased reliance on the domestic financial sector for the mobilization of domestic resources, taking into account the undeveloped and fragile nature of this market. Annex 6.1 offers some preliminary estimates for a demand for assets model and the interest and income elasticity of substitutions are reported. Also, using these results, the inflation-tax schedule on currency holdings is reported. B. RESOURCE TRANSFER BETWEEN THE PUBLIC AND PRIVATE SECTORS 6.03 This section discusses first the real (inflation-corrected) resource transfer between sectors, and second the mechanism by which these resources were transferred. For this purpose we use the savings-investment framework that links the financial requirements of the real fiscal deficits with the supply of resources from the foreign and private sectors. This framework indicates the size of the transfer of resources needed for a given public sector deficit, and the sectors which finance it.

The Transfer of Real Resources 6.04 From the real net savings accounting identity the real budget deficit (minus the net real public savings) is equal to the sum of real private and foreign net savings. This can be written as equation (6.1),

(6.1) Real Budget Deficit

-- RNS a-RNS'+ RNSf,

where RNS denotes real net savings (i.e., savings less investment) and superscripts pu, p and f stand for public, private, and foreign sectors.

6.05 Table 6.1 reports on real net savings estimates by sector and composition; and in Figure 6.1 the real net savings of the public, private and foreign sectors are plotted together. Real net savings estimates are different from those reported by official accounts, as they have been corrected for inflation. The real deficit is as defined in the previous section (see Table 5.4), real foreign savings is - 92 -

the deficiton the currentaccount less the foreigninflation component of nominal interest expenses on the net foreign debt,1 and real net private savings are a residual -- as in the national accounts.

TABLE: 6.1 REAL NET SAVINGS(1) (As percentageof GNP) 1980-83 1984 1985 1986 1987 1988 Average

Total Net Savings: 0.0 0.0 0.0 0.0 0.0 0.0 (=A+B+C) A. Foreign Sector 1.9 2.0 1.4 3.3 0.7 -3.0 B. Public Sector(2) -1.7 -9.7 -6.4 -5.4 -6.5 -4.1 Gross Savings 10.0 0.0 5.0 8.2 6.8 6.2 Investment 11.7 9.7 11.4 13.6 13.3 10.3 C. Private Sector -0.2 7.7 5.1 2.1 5.9 7.2 Gross Savings 8.9 17.3 14.5 13.1 17.9 20.5 Market Determined(3) 7.1 14.7 11.7 11.2 15.1 17.2 Inflation tax (4) 1.8 2.6 2.8 1.9 2.7 3.2 Investment 9.1 9.6 9.4 11.0 12.0 13.3 SOURCE: SPO, National Accounts and Tables 5.5 and 6.2. (1) Figures in this table are different from official data because of the two correctionsmade. First, net and gross savings figures have been adjusted for inflation.This correction affects the official foreign savings (net and gross) as it excludes the inflationcomponent on interest expenses of the foreign debt; and the public and private savings (net and gross), as it also deducts the the inflationcomponent on the interest expenses of the domestic debt. Second, public sector savings (net and gross) have been adjusted to include the so-called quasi-fiscaldeficit of the Central Bank. Investment figures are the official ones. (2) This is the same as the total real deficit in Table 5.5. (3) These are defined as the differencebetween gross savings and inflation tax or forced savings. (4) This is the adjusted inflation tax (same as row A in Table 5.5), i.e., after deducting the portion of the gross inflationtax which in effect remains with the private sector.

6.06 The interpretationof these estimates is also different from that of the official net nominal savings estimates.Real net savings estimates in Table 6.1 indicatesthe proportionof real net private savingsand real foreignsavings (i.e., real income from abroad) claimed by the public sector to finance its real fiscal deficit. The reason for undertakingthis exercise in real terms is that (as we said) nominal net savings over-estimatethe net private sector's savings

I/ We used net foreign public debt as a proxy for total net foreign debt. The inflationcomponent of nominal interest expenses on the net foreign public debt is the product of the foreign inflationconfronted by Turkey (i.e., that of her main trade partners and thus incorporatesdevaluations/appreciations of Turkey's main trade partners' currencies) and the previous period stock of net foreign public debt denominatedin Tl. - 93 -

during inflationary periods. In particular, these estimates assume that indi- viduals consider as income all of the inflationary component of interest payments, which are really compensation for the depreciation of their financial assets during inflationary periods.

6.07 The increasing importance of real private savings as a source of finance since 1985 and therefore, the declining importance of foreign savings since the same year is apparent in Table 6.1. In fact, since 1988 real net foreign savings show a negative sign, indicating that real net private savings in addition to providing resources to finance the public deficit, have also provided resources to sustain a net real transfer abroad (i.e., a private sector net transfer). Both observations underline the links between the strategy to encourage a total net positive transfer abroad (sum of public and private transfers) and the domestic financial markets. In particular, for a given real fiscal deficit, a net positive transfer abroad (a surplus in the current account) has to be financed by increasing private savings. Obviously, a reduction in the real fiscal deficit will ease the burden on the private sector. FIGURE 6.1

NET REAL SAVINGS COMPOSITION (as percentage of GNP)

7 6

4- 3 2

0-

-2 -3 > -4

-6 -7 -8 -9

- 10 -- ______1980 1981 1982 1983 1984 1985 1986 1987 1988

Years 0 Net public + Net private O Net foreign - 94 -

6.08 Two other aspects emerge from Table 6.1. First, this Table suggests that a large portion of the real net private savings transfer to the public sector occurred through the inflation tax. For example, in the period 1985-88 (when the inflation tax was rising), on average, 40% of the real net savings transferred from the private to the public sector were accounted for by the inflation tax. Although this might indicate the public sector's preference for low-cost funds, to the extent that the real interest rate on bank credit and bonds and bills increased (see Section C) and that the inflation tax can be considered as forced savings, it can also be seen as an indication of the private sector's reluctance to finance the deficit. In other words, had the public sector decided not to use the money finance, the public deficit would have had to be cut or would have had to bear the higher cost of domestic finance.

6.09 Second, in comparing the foreign savings in Table 6.1 and the increase in foreign public debt in Table 5.5 (row C), it is possible to observe years, such as in 1985, 1987 and 1988, when the increase in net foreign public debt was greater than the foreign savings (i.e., increase in total debt). This suggests that the private sector was making a net positive transfer abroad while the public sector was benefiting from a net negative real transfer (i.e., the net foreign public debt was increasing). Mechanism used to Transfer the Resources 6.10 The mechanism whereby the market determined net savings (excluding the inflation tax) transfer was achieved has important implications for the current strategy of reducing the foreign savings, cutting the public sector deficit, and increasing private sector investment. This is the link between high fiscal deficits and high private net savings. 6.11 As discussed at length in a previous report,2 a large portion of the resources transferred from the private to the public sector occurred through high real interest rates and through a reduction in the proportion of credit allocated to the private sector.3 Both had the effect of generating the net private savings necessary to finance the public sector deficit, while at the same time reducing the deficit in the current account of the balance of payments (which is the same as a reduction in foreign savings). This explains how high public sector deficits were consistent with low foreign savings. 6.12 However, the regression results on the savings and investment functions reported in that report4 also suggested that most of the increase in net savings would have come from a reduction in private investment, rather than from an increase in private savings. How then can this reduction in private investment be reconciled with the observed high export growth and moderate increase in private investment? (Private investment increased from 9.9% of GNP in 1980 to

2/ See, The Fiscal Policy Report, September, 1988.

3/ In the report it is argued that the share of credit to the private sector increased, thus counterbalancing the negative effect of the interest rates. However, as will be shown in the following section, a detailed analysis of the consolidated balance sheet of the banking system indicates that the share of credit to the private sector experienced a small reduction. See also Tables 5.4 and 6.1.

4/ See The Fiscal Policy Report, September 1988. 95 -

13.3% of GNP in 1988.) This implies that the effects of high real interest rate and the declining share of private credit on private investment and savings were not the only mechanisms by which a high public deficit was made consistent with low foreign savings. In fact, to counterbalance these negative effects on private investment, Turkey relied on a complex system of subsidies to the private sector that sustained the growth of exports and of private investment.5 These subsidies aimed at increasing the profitability of these export industries and of a subset of investors (the priority sectors) by reducing the cost of capital through subsidizing the interest rate or by making credit more available. 6.13 However, at the same time, and as a result, the public sector's deficit was increasing. To encourage or force savers to hold public debt, the public sector had to resort to both non-market and market mechanisms. The most notable non-market mechanism has been the inflation tax or forced savings in low-yielding savings instruments; and the most important market mechanism has been the tax exempt interest income on Treasury bonds and bills.6 6.14 Up to now this seems to have been a very important ingredient of the overall strategy followed by Turkey, with very successful results. In terms of the net savings balances in Figure 6.1 and Table 6.1, this strategy has reduced the public sector's present and future revenues and penalized marginal investors or exporters, those who were not eligible for these subsidies. The public sector reduces its present revenues through the granting of subsidies to exporters and investors; and it reduces its future revenues by exempting bond holders of tax on interest income. The penalization occurs because those investors and exporters who were not favored have to pay the market cost, which is higher than it would be had the public sector not provided these subsidies. Moreover, newcomers receive no benefits because most benefits are granted as a rebate on a tax liability. Both of these groups, the excluded and the newcomers, have to pay for the cost of this strategy. 6.15 However, this strategy of subsidizing exports and investment is running into difficulties for two main reasons: (i) because of the size of the deficit (more discussion will follow in Section C) and the adverse effect it causes, notably crowding-out of private sector investment which outweighs the benefits from the subsidy scheme; and (ii) because if the public sector continues to grant subsidies through the exemption of taxes, thus reducing its future revenue, it will also be increasing its future deficit. This can be avoided if the new income generated by exporters or investors outweighs the loss in revenue from tax exemptions. However, the higher these tax exemptions and the longer they are maintained, the less likely that will be. 6.16 Sharply cutting the deficit by discouraging private sector exports and investment (through a cut in the subsidies) can produce a sharp fall in export and total growth. This can mean loss of international creditworthiness if Turkey experiences a dramatic increase in its ratios of total foreign debt to exports

5/ There are also other important subsidies such as those granted on mortgage loans aimed at reducing the cost of housing for low income earners. 6/ It is not clear, though, how a tax imposition on interest income from bonds and bills would affect the demand for these instruments. It might happen -- as happened before -- that the market determined interest rate will increase, thus leaving the after-tax rate of return unchanged. - 96 -

and of total foreign debt to GNP. This difficulty calls for a strategy aimed at cutting the fiscal deficit while at the same time making private investmentand exports grow -- keeping the ratios of the stock of foreign debt to GNP and to exports constant.The only way to move to a lower deficit and higher growth seems to be by increasingprivate savings faster than the increase in investment,and by phasing out the subsidies in a carefullypredetermined sequence. Failure to do this could result in a recessionor an increasein the currentaccount deficit, both of which would place great strains on the economy -- particularly when Turkey still faces a debt problem. C. IMPLICATIONSFOR THE DOMESTIC FINANCIALSECTOR 6.17 The public sector's reliance on the domestic financial system has had importanteffects on the functioningof the domestic financial market. First, the pressure of the domestic public debt on the supply of financial savings is analyzed; second, we discuss the effect of reliance on the domestic financial sector and of high nominal deficits on the real interest rates; and third, the effect on banks' behavior and profitabilityis discussed. Pressure of Public Sector Deficits on the Domestic FinancialMarket 6.18 There are two complementaryways of looking at the problem of fiscal pressureon the domesticfinancial market. First, one could constructan indicator for the pressure that public sector deficits exert on the domestic financial system; and second, one could look at the share of domestic credit allocated to the public sector.Table 6.2 reports on an estimate for the first indicator,and Table 6.3 reports on the consolidatedbanking sector balance sheet. 6.19 The indicatorfor the pressure exerted by the public sector deficit on the domestic financial sector is not the real deficit, because the government usually needs to raise money to refinance the payment of the nominal interest payments and not just to make real interest payments.7 What is needed is a cash-flowestimate of the fiscal deficits:the amount of nominal resourcesthat the public sector needs to raise from the domestic financialsystem, for a given supplyof foreignresources, in order to meet its paymentscommitments. Obviously, if foreign resources increase, the pressure on the domestic financial sector diminishes;but if the public sector needs to transfer resources abroad (i.e., negative foreign financing),the pressure on the domestic financialsector will increase. 6.20 As definedmore formallyin Annex 5.1, the pressureof the fiscal deficit on the domestic financialsector can be defined as the sum of mor,eyfinance and net nominal domesticpublic finance, i.e., includes the increase in the real net domestic financeplus the inflationcomponent. Table 6.2 reports these estimates. To the extent that the indicatorof fiscal pressureon domesticfinancial markets

7/ In addition, it is also possible to suggest that individualscannot always anticipate with errorless precision the inflation component of the nominal interest rate payments received on their financial assets (e.g., public sector liabilities),thus to a certain degree, they suffer from money illusion. See, for discussion: V. Tanzi; M. I. Blejer and M. 0. Teijeiro. "The Effects of Inflationon the Measurementof Fiscal Deficits", in Blejer, M. and Ke-Young Chu (Eds.). Measurement of Fiscal Impact: MethodologicalIssues. Washington D.C.: IMF, June 1988. - 97 -

TABLE 6.2 PRESSURE OF THE CONSOLIDATED PUBLIC SECTOR DEFICIT ON THE DOMESTIC FINANCIAL MARKET (As percentage of GNP)(1) 1980-83 1984 1985 1986 1987 1988 Average

TOTAL PRESSURE (A+B) (2) 2.42 6.59 5.73 2.94 6.69 8.56

A. MONEY FINANCE (from 1.70 5.74 2.57 1.74 1.82 3.40 Table 5.6) B. NET NOMINAL DOMESTIC 0.72 0.85 3.16 1.20 4.87 4.88 DEBT FINANCE(3) (1+2+3) 1. Bonds and Bills 1.10 2.23 2.52 2.06 3.42 3.08 2. Net Bank Credit 0.43 -0.84 0.86 0.73 1.41 1.52 3. EBFs -0.81 -0.53 -0.22 -1.60 0.04 0.28 MEMO ITEMS: (in percentage) Ratio of Pressure of Fis- 23.25 33.97 35.80 18.16 35.18 33.43 cal Deficits to Nominal Private Savings Ratio of Pressure of Fis- 15.83 68.29 53.78 28.91 65.46 86.42 cal Deficits to CBs Pri- vate Financial Savings Ratio of Stock of Net 23.27 10.36 16.23 14.40 23.29 29.73 Domestic Public Debt to M2X

SOURCE: Central Bank, Quarterly Bulletin; and Treasury. (1) Since stocks are measured at end-of-year prices while GNP is measured at mid-year prices, nominal stocks of both domestic and foreign debt were con- verted to mid-year 1980 real prices before computing its ratio to real GNP at 1980 prices. (2) Is an estimate of the pressure on the domestic financial market of the public sector deficits (see discussion in the text).

uses the concept of net nominal domestic finance, it is closer to the definition of the nominal deficit; yet, since it excludes foreign finance, it is smaller than the nominal deficit. The indicator for fiscal pressure on domestic financial markets measures QnlX the pressure exerted in the domestic financial market. 6.21 This pressure was greatest in 1984-85 and 1987-88, and generaly increased after 1986, from 2.9% of GNP in 1986 to 6.7% and 8.6% of GNP in 1987 and 1988. 1988 is the year of maximum pressure. These increases are a clear evidence of the reduction of net foreign finance; as net foreign finance started to decline and deficits remained unchanged, reliance on the domestic financial sector - 98 -

increased. In terms of sources, the greatest pressure was exerted by money financing and by the net nominal domestic finance. The sharp increase in 1987 and 1988 was explained by both components money finance and nominal net domestic finance. The former increased from close to 1.7% of GNP in 1986 to 3.4% in 1988; the latter from 1.2% of GNP in 1986 to 4.9% of GNP in 1988.

6.22 In the last three rows of Table 6.2, the indicator of the fiscal pressure on the domestic financial market is compared with nominal private savings and the Central Bank's definition of private financial savings,8 and the stock of net domestic public debt (row A in Table 5.2) is compared with private financial assets in the banking sector (M2X). These ratios measure the claim of public sector resources relative to their supply; one measures in terms of flows and the other of stocks. The first ratio of pressure on the financial markets to nominal private savings indicates that this pressure was close to its peak in 1988 -- near its level of 1984. In 1988, claims of the fiscal sector amounted to 33% of nominal private savings. The ratio of pressure on the financial markets to private financial savings (i.e., the supply of financial resources in this market), indicates that in 1988 it reached its peak point -- more than 80% of the private financial savings were allocated to finance the PS deficit.9 The ratio of the stock of net domestic debt to M2X reached its peak in 1988. The demand for private financial savings has increased very fast; while in 1984 the ratio of net domestic public debt to M2X was 10%, in 1988 this increased to 30%. As we will see later, this increasing pressure is already generating signs of stress in the domestic financial sector, as is indicated by the high real interest rates and increasing inflation rates.

6.23 Another way to illustrate the pressure that the fiscal deficit exerts on the domestic financial system is to look at the cash-flow of the public sector debt; that is, the ratio of new debt issued to the payment of principal and interest. The higher the ratio, the greater the cost to the public sector and the greater the pressure on domestic financial resources. In Figure 6.2, this ratio and its interest and principal components for bonds and bills are plotted together.l1 Once again, the evidence confirms the high cost of the debt in cash-flow terms and the heavy pressure on the domestic financial market; on average, for every one Tl issued of bonds and bills only 0.2 Tl goes to finance the primary deficit (i.e., Dt in Annex 5.1).

8/This flow of private financial savings was obtained from Table 6 pp 11 of Sak, Guven and Sevtap Sungu "Reflections on Securitization in the Context of Turkey". Paper presented to the CMB/OECD Conference on Current Issues in Turkish Capital Markets. Ankara: Central Bank, September, 1989. A problem with this definition of private financial savings, however, is that it excludes currency. 9/This ratio of pressure of the pressure of the fiscal deficits on to private financial savings overestimates the true pressure on the financial market as it excludes currency holdings and as shown in Table 6.2 the public sector in 1988 financed a significant proportion of its deficit with money finance. The trend -- as suggested by the other two ratios -- is more likely to be correct. IO/The formulas for variables in Figure 6.2 are: P/NI, (P+I)/NI and I/NI respectively; where, NI is new issue of bonds and bills, P is repayment of principal and I is nominal interest repaid. Although it would have been desirable to make this calculation for the total domestic debt, the available data was insufficient. - 99 -

FIGURE 6.2 Ratio of Prin and Int to New Borrowings For Bonds and Bills

0.9

0.8

0.7 -

0.6

0

0.4

0.3 -

0.2-

0.1

0 - l l l l l 1984 1985 1986 1987.1 1987.2 1987.3 1987.4 1988.1 1988.2 1988.3 1988.4 Years/Quarters C Principal + Prin + Int 0 Interest

6.24 A summary of the consolidated banking sector balance sheet is reported in Table 6.3. By accounting identity, the sum of the net foreign assets (foreign assets less foreign liabilities) and domestic liabilities of the banking system (sum of rows A and D in Table 6.3) is equal to the sum of domestic credit (sum of rows B and C in Table 6.3). For example, a decrease in the net foreign assets (i.e., an increase in foreign liabilities greater than the increase in foreign assets) of the banking system -- such as an increase in the Central Bank's foreign debt -- has to be matched by an increase in domestic credit (sum of rows B and C) or a decrease in M2 (row D). However, Table 6.3 also indicates that a strategy aimed at making a net positive transfer abroad, that is, an increase in net foreign assets, would require a decrease in domestic credit or an increase in M2. This table thus enables us to see more clearly the effects of public sector reliance on the domestic supply of financial resources. 6.25 Overall, this table suggests that for the period 1983-86, the expansion in domestic credit (chiefly, the increase in net credit to the public sector) and in the item "other items " (row C) was chiefly financed by a decrease in net foreign assets -- chiefly, an inflow of foreign liabilities to the Central Bank -- and by an increase in M2. The table shows that the faster increase was - 100 -

TABLE 6.3 CONSOLIDATED BANKING SECTOR BALANCE SHEET (As % of GNP) 1983 1984 1985 1986 1987 1988

A. Net Foreign Assets -3.36 -6.85 -10.88 -15.11 -18.93 -14.80 (A=D-B-C) B. Domestic Credit 22.46 25.95 27.47 31.86 29.85 N.A. 1. Public Sector Net 5.20 11.60 11.69 12.09 11.21 N.A. Public Sector,gross 16.93 23.06 25.80 29.17 29.40 27.34 Bonds(Pub. Adm.) 1.54 3.13 4.47 5.08 5.46 5.47 Other(Credits) 15.39 19.92 21.33 24.09 23.94 21.87 2. Private Sector, 17.27 14.35 15.77 19.77 18.64 15.67 gross

C. Other Items, net 5.15 4.70 8.29 9.15 11.19 N.A. Gross(unclassified) 9.00 7.76 9.42 11.24 16.67 15.67 D. Broad Money (M2) 24.25 23.80 24.88 25.91 22.11 19.56 1. Narrow Money (Ml) 14.31 10.35 9.80 11.16 11.08 8.28 2. Quasi-Money 9.94 13.45 15.08 14.75 11.03 11.28 MEMO ITEMS: Broad Money (M2X)(1) 24.42 25.09 27.23 29.58 27.39 25.36 FEX(2) 0.17 1.29 2.34 3.68 5.28 5.80 SOURCE: For the period 1983-87, Central Bank worksheets; and for 1988, Central Bank, Quarterly Bulletin. (1) This is row D (M2) plus FEX. (2) These are the residents Foreign exchange deposits. experienced in net domestic credit to the public sector from 5.2% of GNP in 1983 to 12% in 1986 and in "other items"11 from 5.2% of GNP in 1983 to 9% in 1986. A close inspection of "other items" suggests that 90% of it is accounted for by the exchange rate losses on foreign liabilities, which are, according to the Central Bank's Charter, a Treasury liability. During the period 1983-86, the sum of net credit to the public sector and in "other items" increased by about 11% of GNP. This was financed by a decrease in net foreign assets on the order of 12% of GNP, and by an increase of more than 1% of GNP in M2; domestic credit to the private sector (row 2) showed a very moderate increase during the same period.

ll/It is important to note that bank credit to the public sector in Table 6.3 also includes banks' holdings of bonds and bills. Also, official deposits must be collateralized 65 percent by Treasury securities. Banks in Turkey are the most important holders; individuals' holdings have been negligible and are limited to those trading in the REPO market. - 101 -

6.26 The period 1987-88 suggests a different conclusion. The increase in net foreign assets and the fall in M2 in 1988 relative to 1987 was chiefly financed by a fall in net domestic credit to the private sector. The sum of credit to the public sector and the item "other items" as suggested by the gross figures, showed no significant change. 6.27 The observations from Table 6.3 for the periods 1983-86 and 1987-88 is consistent with earlier observations that while the availability of foreign sources of finance had led to an expansion of the public sector, once these started to dry up, private sector credit began to fall, yet the domestic credit to the public sector showed a slight fall.

6.28 Using evidence discussed in Chapter 5, two mechanisms were most used by the authorities to encourage the private sector to finance the increase in net foreign assets.

6.29 First, there was monetary expansion (monetary financing) and its resulting inflation. In general, when the Central Bank expands the monetary base by generating more inflation, it encourages the private sector to increase its nominal money holdings, and therefore, to increase private sector holdings of nominal net assets. These resources could then be used to pay for the foreign liabilities by purchasing foreign exchange in the domestic market, and also by increasing the net domestic credit to the public sector, if the Treasury's foreign liabilities were the ones that were reduced.

6.30 Second, there was an increase in real interest rates. Real lending interest rates remained high until the end of 1987 and after a short-term decline in early-1988, they peaked up again by mid-1988 (see Figure 6.4). In general, an increase in real interest rates encourages private sector asset holders to hold more financial assets (i.e., M2) and borrowers to demand less credit, thereby releasing financial resources to finance the increase in the net foreign financial assets or the net credit of the public sector. The exchange rate works in a similar way: expectation of a real devaluation encourages the private sector to increase its holdings of foreign-denominated assets and discourages new borrowing in foreign currencies.12 However, when there is a large proportion of foreign liabilities, as in Turkey, the necessary resource transfer generated by a real devaluation needs to be much larger. The private sector needs to accumulate sufficient net assets to outweigh the increase in the domestic currency value of the foreign liabilities (i.e., to compensate for the exchange rate losses). In Turkey, to the extent that the private sector does not increase its asset holaing in the same proportion (i.e., M2) by which Central Bank's foreign liabilities increase, real devaluations need to be compLemented with an increase in real interest rates or by monetary financing.1 3

'2/The only situation under which total net assets of the private sector will not increase is if the real interest rate on loans does not fully compensate for the real devaluations. 131For a similar argument see: OED, The Overview of Structural Adjustment Loans I-V. Washington D.C.: The World Bank, April 1988. - 102 -

6.31 The upshot in Turkey, which appears very clear from Table 6.3, was that despite the rapid increase in real lending rates since 1984 (fluctuating between 10% and 40%), credit to the private sector decreased only in 1987 and 1988. This could, of course, reflect the importance of subsidized credit, but perhaps more important, it might also reflect the high proportion of non-performing loans'4 and thus of distress borrowing in the financial system, and the fact that nominal interest expenses are tax-deductible. However, this presents a serious problem for a strategy aimed at increasing net foreign assets by reducing domestic credit. The demand for credit does not seem very sensitive to changes in the real interest rate.

The Effect of Public Sector Deficits on the Real Interest Rates 6.32 In Turkey, real interest rates are affected by both the increasing public sector reliance on the domestic financial sector and by the decreasing foreign savings. The high level of the real interest rate is a widespread concern in Turkey. And interest rates are also affected by the policy of subsidizing exports and investments, which had caused the segmentation of the financial market.

6.33 Turkey has, since the early 1980's, pursued an exchange rate policy consistent with a reduction in the current account deficit. One instrument used to achieve this was by trying to devalue its real exchange rate with Turkey's main trade partners. Moreover, in general, the lower the current account deficit desired (i.e., the lower the borrowing from abroad), the higher the real exchange rate needed. To further encourage the increase in exports, Turkey also used an export subsidy scheme.

FIGURE 6.3 FIGURE 6.4

6 M Deposit, and Bills Rates in TI & US Lending Interest Rates in TL and US

60- 30-

20- 40- I40 -30

o- 20- lo

-10 10

-30 -20,

1984 1985 1986 1987 i988 19S9 1984 1985 1986 1987 1988 1989 84...88/7... k4,,0/0,... O LIBOR i. US TSillin. TI 6 DepInti 0 L..dTL I L.d US

14/Although it is difficult to provide supportive evidence on the importance of non-performing loans as these are classified as performing loans in Turkish banks' balance-sheets, this is widely accepted among bankers and authorities. - 103 -

6.34 This policy has had an effect on the domestic market via the effect of the exchange rate devaluation on the real interest rate.15 It not only encouraged currency substitution, from Tl-denominated assets into foreign currencies (see Annex 6.1 for an estimation of the elasticity of substitution),1 6 but, to the extent that the domestic interest rate is market determined, domestic real interest rates adjusted for the expected real devaluation. This not only meant that real domestic interest rates became high (see Figure 6.4), but also that they were subject to a high variance as a consequence of the instability in the financial market, as asset holders do not know ex-ante the future levels of real domestic interest rates and of the real exchange rate. 6.35 The real effective foreign and domestic deposit and lending interest rates are compared in Figures 6.3 and 6.4.17 The two most noticeable aspects of these figures are: the high level of both foreign and domestic interest rates, the higher level of the domestic real lending interest rate relative to the international real lending interest rate and their high variance.18 Starting in 1984, real interest rates, on average, varied between -20% and above 60% (see Figure 6.4). But perhaps more important, the banks' and individuals' management of their portfolios became unstable. Although speculation is necessary for arbitrage, one cannot disregard its adverse effects in terms of both banks' primary objective of lending to increase production capacity, and of the authorities' monetary management -- by encouraging currency substitution (see Annex 6.1 for more discussion).19 Both of these are now typical features of Turkey's financial markets. 6.36 The October 1988 run on the Tl is an example both of banks' difficulties in placing their funds with low-risk clients, and of the monetary authorities' inability to conduct a stable monetary policy (c.f., the rapid increase in the dollar real deposit and lending rates). The increase in foreign exchange deposits (although restricted) and in banks' foreign exchange assets and liabilities are examples of the banks' difficulties in finding low-risk borrowers. For example, total foreign liabilities of deposit money banks increased from 10% of M2X in

15/In equilibrium and with full capital mobility, the real interest rate in the domestic market should be equal to the international real interest rate plus the real devaluation plus a risk premium. 16/In recent years, currency substitution has been further encouraged by making the cost for banks' of reserve requirements on FEX lower than those deposits denominated in Tl. See below. 17 /Foreign rates were converted into real Tl rates by applying the formula: r = (((l+i*)/(l+p*))(l+e)-l)100, where r is the international real interest rate expressed in Tl, i* is the nominal interest rate in the international market, p* is the international price index measured as a weighted average of Turkey's main trade partners and e is the effective real rate of exchange with Turkey's main trade partners. Notice that since (l+p*) is in both the denominator and the numerator (used to calculate the real exchange rate) it cancels out. For the calculation of all real interest rates, the last quarter annualized inflation rate was used. 18/The high level of the real deposit and lending rates of the US market is explained chiefly, by the strong real devaluation of the Tl undertaken by Turkey. See formula in note 17. '9/A high domestic inflation also encourages currency substitution and, thus contributes to the loss of control by the authorities of the monetary management. - 104 -

1983 to 53% at the end of 1987; and foreign exchange deposits increased from being 6% of deposit money banks' foreign liabilities in 1983 to 51% in 1987.20 This does not imply that the authorities should abandon their real devaluation policy which has been crucial in reducing their current account deficit, but rather that this policy needs to be consistent with the pressure that the financial sector can absorb without causing uneasiness in the financial market. This point becomes more relevant when it is realized that many banks are carrying a sizeable proportion of non-performing assets, and are thus vulnerable to speculation. 6.37 The October 1988 crisis is a good illustration of the effects of a speculative surge on banks' stability. In Figures 6.5 and 6.6, the interbank nominal exchange rate (TL/US$) and the interbank overnight annual nominal interest rates are plotted. The crisis started when banks and foreign exchange traders in general, anticipated a nominal devaluation and started to speculate against the Turkish lira by buying foreign currency. The banks' behavior could be explained by the acceleration of inflation and by the fact that in the past the Central Bank always tried not to let nominal devaluation lag too much behind inflation. However, the banks forced the nominal devaluation much faster than the Central Bank would have wanted in this instance. 6.38 Moreover, banks, on average, favoured time deposits denominated in foreign currencies by offering nominal interest rates above those offered in the international markets such as the LIBOR interest rates. For instance, in 1988 the bank offering the highest interest on foreign deposits was paying 10.9% on dollar-denominated deposits and 8.1% on DM denominated deposits, while the LIBOR interest rates on both currencies for similar maturity deposits were 8.2% and 4.2% (see Annex, Table A.6.1). Banks offering the lower interest rates were offering 7.8% and 4.8% respectively, lower than the international average for dollar-denominated deposits and higher for deposits in DM. A similar conclusion could be drawn from 1986-87 figures. In general, in countries that are subject to foreign exchange controls -- eventhough these are faily relaxed in Turkey -- commercial banks do not need to offer interest rates on foreign deposits above international levels, as they are subject to little competition from abroad. Furthermore, the attractiveness of these deposits, as discussed in Annex 6.1, arises from the devaluation and from inflation. This evidence then underlines Turkish banks' eagerness to capture these type of deposits and to increase their overall volume of deposits. In fact, these deposits grew very fast in the recent past. 6.39 Figure 6.5 shows the rapid nominal devaluation of the Tl in the interbank foreign exchange market as banks started to speculate against it. The nominal exchange rate went from close to 1700 Tl/US$ in early September to close to 2000 in early October. Figure 6.5 also shows the sharp fall in the interbank exchange rate over a very short period (three days) as a result of Central Bank intervention. The Central Bank intervened in the market first by increasing the overnight nominal interest rate from 40% annualised nominal interest rate on October 12 to 329% by October 14, to close a source of speculative funds. Second, the Central Bank started selling in the foreign exchange market at a lower price, and in less than three days the interbank nominal exchange rate fell from close to 2000 T1/US$ to close to 1600 Tl/US$. This discussion thus underlines the risk involved

20/Data obtained from: OECD, Op. Cit., Paris: OECD, 1988. Table 16, page 40. - 105 -

in foreign exchange trading, and its effects on the domestic financial system. It also illustrates the authorities' difficulties in conducting a stable monetary policy. FIGURE 6.5 FIGURE 6.6

INTERBANK FOREIGNEXCHANGE RATES OVERNIGHTNOMINAL INTERESTRATES MINIUUU AND MAXIMUM UINIMUU AND UAAXILUUU I.96 340 I .94 320 1.9.z 300 189 20 1.88 260 06 F 240 1.84 ~~~~~~~~~~~~~~~~~~~~220 1.82 200 1,0 ~~~~~~~~~~~~~~~~~~~~~~~~160- 61.70 Ds 1a0 1.76- 20 1.74 100- 1.72 00 1.7 6,0 1.60 40 1.66 2 0

SEPT OC , ( SEPT OCT IV NO.V

0 Minmu. 4. M--,u 0 Minimum M_...um

6.40 Domestic real interest rates are also influenced by the proportion of the deficit financed with domestic resources and the instruments used. As discussed earlier, the deficit is financed using two main instruments. First, by raising finance through the market mechanism, i.e., auctioning of bonds and bills, and borrowing from banks at the market interest rate; and second, by resorting to non-market instruments such as money finance or the imposition of reserve requirements and liquidity ratios. Both produce a similar effect: financial crowding out. Yet, one operates through a general increase in the interest rate, while the other works by quantity rationing, and in the end, also affects the real interest rates. The more money finance is used the higher and more uncertain the inflation rate. This greater uncertainty associated with inflation (as shown in Annex 6.1) discourages demand for financial assets, thus affecting the real interest rate. The greater the reserve requirements on banks, the lower the supply of loanable resources, which increases the real lending interest rate; to the extent that this becomes a tax on the financial institutions, it also increases the spread between lending and deposit rates. 6.41 The most relevant domestic interest rates are plotted in Figures 6.7 and 6.8. The two different pressures on domestic real interest rates are clear from these figures. First there is the close relation between the real deposit and the real Treasury bill interest rates (in Figure 6.7), which suggests that deposit rates also incorporate the pressure that the deficit exerts on the financial market. In other words, there is a close substitution between both savings instruments. Moreover, this close relation is also warranted from the functioning of the REPO market (see below for more discussion), which, to a large extent is a sub-market which enables banks to increase yields to their preferred customers and to give banks more flexibility in their allocation of resources. The point is that the higher the portion of the deficit financed domestically, the higher will be the level of the Treasury bill rate, and this will be transmitted to the deposit rates. - 106 -

FIGURE 6.7 FIGURE 6.8

Deposit, Bonds and Bills Rates in TI Lending and Deposit Rates in TI (R..l m; ...... t.,) (ReO.lrAt., 3r ht .... t) 0~~~~~~~~~~~~~~~~~~~~~~~8

70 -

60-

20- 00

40- I0 30

6 0 VI 20

I 0~~~~~~~~~~~~~~~~~~~~~~~~~3

-20 - -10

-20 -30 - ~~~~~ ~~~~~~~~~~~~~~~~-301v~

190 190 I900000 1987 909 00 19085 196 1987 1900 1909 M -Ch/Y- MOnTIhY-e O I Y. o-d t 6MO TOill O 6 MO D,poil L.ndig R.t. I Y0. DPO.j 6 M. PO-it

6.42 The sharp fall in the real interest rates of Treasury bills' in 1988 (see Figure 6.7) was the consequence of the Treasury's decision to lower these interest rates by changing the mechanics of the auctioning. The auctioning changed from a system where the pre-anounced volume determined the interest rate, to one in which the interest level determined the volume -- allowing a cap on interest rates. As a result, the volume of real bonds and bills issued showed almost no increase in 1988 (see Table 5.4), yet to compensate for the lack of finance, the public sector had to increase its use of Bank credit. In the end, to the extent that the pressure of the fiscal deficit was not reduced, it still fed into the real interest rate and the capping of the interest rates on bonds and bills could only be seen as a temporary measure.

The Effects of Public Sector Deficits on Banks' Behavior 6.43 The use of reserve requirements affects both interest rates and also banks' behavior. Figure 6.8 shows these other implications, indicating both the high real interest rates, and also the wide spread between lending and borrowing rates. On average, Turkish banks' need a high spread to finance the imposition of reserve requirements and of other taxes, and to compensate them for the income not received on their non-performing assets. Moreover, as will be shown, the fact that a significant share of assets are non-performing makes banks more sensitive to reserve requirements and other taxes. 6.44 Two different indicators for the spread between lending and deposit real interest rates are plotted together in Figure 6.9. The first (the effective) indicator measures the effective spread for the banks once the cost of reserve requirements and other taxes had been taken into account; and the second (the gross) indicator measures only the difference between the weighted average interest received on loans and that paid on deposits, i.e., it excludes the cost for banks of reserve requirements and of other taxes. Hence, the difference between these two measures is an estimate of the share of the banks' gross spread (or gross profitability) transferred to the public sector through the imposition of reserve requirements or other taxes. Both spreads are measured in real terms - 107 -

and exclude operational costs, which are above 4% in Turkey,2 1 and banks' spread on foreign exchange trading. The ratio of the spread taxed to the total gross spread in plotted in Figure 6.9 and, suggests that between 1986 and 1988, more than half of the spread was transferred to the public sector, and also that in 1988 this proportion was reduced and banks' profitability increased. This change coincided with the period when the Treasury was pushing interest rates down. Yet this reversal did not last for long, and in October 1988, when banks' reserve requirements were increased and deposit interest rates were liberalized,22 the proportion of the gross spread taxed increase from around 20% to above 70% (see Figure 6.10) and, as a result, banks profitability fell sharply.

FIGURE 6.9 FIGURE 6.10

Bank's Average Real Spread Proportion of Bks Gross TI Spread Taxed (No 8,n-p. 1.rming L..ns( *ssumi,.g Zn. Non-PL..At-ing Asset. 70 110

60 - I 0 90-

40 -~~~~~~~~~~~~~~~~~~~~~~0 40 ~~~~~~~~~~~~~~~~~~~~~~~~70

* 30- 40

20 -s 40- 10

8 320

-(0 ~~~~~~~~~~~~~~~~~~~~~~~~~0

1986 1987 8808 1989 1986 1987 1988 1989

"oll'lr"eAl WOHrHWYEAR D Ett.,tl.. t Cl0o..

6.45 However, Figures 6.9 and 6.10 do not take into account the fact that banks are not receiving all the interest due on their loans, as they hold non-performing loans. In Figure 6.11 the same two estimates for the proportion of gross spread taxed are plotted but it is now assumed three different hypothesis in relation to the average proportion of non-performing assets in the banking system (0%, 10% and 25%). The conclusion, although subject to further analysis, is very clear: if banks do have on average between 10% and 25% of non-performing assets, then the public sector would be taxing almost &1 of the available profitability of banks. Moreover, Figure 6.11 also shows the dramatic increase in the cost of reserve requirements in October 1988. Assuming banks do carry a proportion of non-performing loans, it is possible to suggest that, on average, and before accounting for operational costs, banks in Turkey are unprofitable in their Tl operations after payments for the cost of reserve requirements and other taxes. Therefore, the conclusion reached after taking into account that banks hold a proportion of non-performing loans is very different to that reached assuming that they do not have non-performing loans.

21/See Op. Cit. OECD, pp. 69, Table 27. 22/Banks' profitability also fell in October 1988 as a consequence of the lib- eralization of domestic deposit interest rates and the fact that some banks set their domestic deposit interest rates very high (see Figure 6.7). - 108 -

FIGURE 6.11 Proportion of Bks Gross T1 Spread Taxed Assuming Different Non-Per/Per Assets Soo -

450 -

400

350

ov 300

u 250 -

C 200 -

150 j

100

50* / *a| F1*1

1986 1987 1988 1989 MONTH/YEAR 0 0% + 10% o 25%

6.46 Moreover, as is well known, when banks become unprofitable in cash terms because of their non-performing assets -- that is, if balance-sheets do not record these assets as non-performing __23 banks will search for activities that will yield them a quick and substantial return. However, in doing so they will overexpose themselves. Examples of this behavior is the size of banks' unregulated off-balance sheet activities relative to total assets, which, on average are around 40% of total assets.24 In Turkey banks have been resorting to unregulated off-balance sheet activities such as the REPO and foreign exchange markets as a means to increase their profits in a very short time. Although banks trading in the REPO and foreign exchange market do not necessarily increase their risk exposure (as happens in many other countries), the fact that Turkish banks hold a high proportion of non-performing assets -- thus reducing their cash-flow -- makes them more prone to take more risk, as they need the high profits. Problems arise because of the banks' inability to match inflows with outflows. Moreover,

23/When non-performing loans are classified as performing, profits recorded in their financial statements will not be adjusted for the fact that the accrued income on these loans was not received. 24/The ratio of off-balance sheet activities for the consolidated banking sector balance sheet increased from 34% in December 1988 to 40% in August 1988. - 109 -

the risk assumed in these operations is not fully reflected inbanks balance-sheets. Banks will therefore, become vulnerable to unexpected short-term shocks, such as an unexpected increase in interest rates or devaluation. 6.47 Figures 6.5 and 6.6 illustrate very clearly the risk of trading in the foreign exchange market. These swift changes in the exchange rate suggest that banks can, in a few days, lose a very large amount of money. 6.48 The so-called Repurchasement Agreement (REPO) market is another source of instability for banks . In brief, this market consists of a sub-market for deposits and loans where banks offer the instruments to their preferred or wholesale customers. When banks want to increase the interest paid on the short-term deposits (of less than a month) they do so by selling Treasury bills to their preferred customers, for a period of less than the maturity (which is three months or more). The Treasury bills, however, very rarely change hands, remaining in bank security boxes, and thus banks use these several times. Banks also offer the opposite service to customers who have invested in Treasury bills and want to borrow against them. Table 6.4 shows estimates for the real interest rates on REPOs, Treasury bills, and sight deposits: REPO deposits' real interest rates are greater than those on sight deposits; and Treasury bills' interest rates are greater than those on REPO deposits. This then suggests that both banks and depositors benefit from the REPO market; the banks profit from the difference between the Treasury bills and the REPO real deposit interest rates, and the depositors profit from the difference between the sight deposit real interest rates (which is the opportunity cost) and the REPO deposit interest rate. Similarly, on the loan side, borrowers benefit by not having to sell their Treasury bills to get the cash needed, and banks increase their yield on the loan (the interest charged on the loan plus the yield received on the Treasury bill during the period of the loan). Moreover, and very important, REPO deposits are not subject to reserve requirements, thus enabling banks to increase the amount of resources lent. 6.49 The risk for banks arises, as in the foreign exchange market, from a maturity mis-match (i.e., exposure). The operation of the REPO market makes it difficult for banks to guarantee a perfect match, especially in an environment, characterised by swift movements in interest rates and expectations. The October crisis made it apparent that these shocks do happen. Moreover, the fact that Central Bank does not control this market, and that the banks do not report on their volume of activity, make the REPO market a source for banks to increase their profitability, but also for increasing banks exposure. - 110 -

TABLE: 6.4 ALTERNATIVE SHORT-TERM INVESTMENT OPPORTUNITIES FOR LARGE DEPOS- ITORS Repurchasement Agreements Real Interest Real Interest (REPO)(1) Rates Rates Average Average on 3 Months on Sight Deposits Real Interest Maturity Treasury (less than 1 Rates(2) (No of Days) Bills(2) month)(3) (%) (%)

1988 Jan -41.0 17.5 -35.9 -49.1 Feb -39.5 21.5 -31.5 -42.8 Mar -24.6 18.8 -17.0 -34.7 Apr -21.4 16.2 -13.3 -31.9 May -11.7 22.2 0.4 -23.5 Jun 9.5 15.0 22.8 -6.0 Jul 14.0 13.8 28.5 2.0 Ago 6.9 13.0 7.3 -10.0 Sep -9.8 23.0 -3.5 -28.6 Oct -7.7 21.5 -12.3 -26.7 Nov -24.0 19.3 -18.8 N.A. SOURCE: Central Bank and Treasury (1) These are the interest rates and average maturities on the REPO made between the Central Bank and the Banks. (2) These are the interest rates on the last transaction of the month. Real rates were obtained by using the last quarter inflation rate. i.e., backward rate. (3) This is the weighted average of the interest rate offered by deposit money banks on sight deposits.

D. CONCLUSIONS 6.50 The conclusion here is that by financing its deficits with instruments such as reserve requirements the public sector is forcing banks to over-stretch themselves, chiefly because by taxing a large portion of their cash-flow profits (i.e. , after excluding the income not received on non-performing loans), the government's policy is encouraging banks to overexpose themselves. In the end, the use of high reserve requirements could prove self-defeating, because a major bank failure will have consequences both on the fiscal deficit and on monetary policy, thus affecting overall macroeconomic policy. 6.51 Our overall conclusion is that Turkey's financial sector is showing signs of being overstretched. This is partly due to its undeveloped nature, particularly the low supply of financial savings, and partly to the increased demand for domestic resources to cover public sector deficits; fiscal deficits have not declined since 1986, and dependence on domestic resources to finance them has increased. The latter process is producing adverse effects, such as high inflation and high real interest rates. - ill -

6.52 In consequencewe recommendthat the authoritiesfocus on reducing the budget deficit and on undertakinginstitutional reforms of the financialmarket which will permit this market to absorb the increase in domestic public debt needed to produce a transfer of resources abroad. Both reforms will take time and demand careful planning and sequencing.These reforms will determine the pace at which resources can be transferredabroad.

PART III:

THE ROAD AHEAD - 112 -

Chapter VII: INSTITUTIONAL SET-UP FOR MANAGING DEBT AND BORROWINGS

7.01 For a country grappling with debt problems, and also pursuing adjustment, the need for economic liberalization should not be confused with the relaxation of controls over foreign borrowings. Such controls cannot, and should not, be liberalized either for loans taken on directly or those guaranteed by the state. While firms -- public or private -- need to take responsibility for their own borrowing decisions, it is critical that the central authorities have a full picture of the borrowings contracted at any time and of the implications for the country's debt service obligations. In most countries, the planning and control of public borrowings involves functions by treasuries, finance ministries, central banks, and state planning agencies. This chapter assesses Turkey's debt management system and makes some recommendations for its strengthening.

A. Overall Structure

7.02 In Turkey the control of debt and the management of borrowings (these should not be seen as identical functions) are principally centered in the Undersecretariat of the Treasury and Foreign Trade, the agency reporting to the Prime Ministry charged with the responsibility of arranging and negotiating all foreign public sector borrowings (and/or guaranteeing such borrowings), as well as numerous other functions on economic policy. The Treasury exercises a key role in formulation of the Budget and the Annual Economic Programs, working closely with the State Planning Organization (SPO), the Central Bank (CB) and the Ministry of Finance and Customs (MOF). The Treasury is also the key agency managing the Government's program domestic borrowings, principally through auctions of Treasury bills and bonds.

7.03 The orchestration and negotiation of foreign borrowings shows the Treasury's work with the foreign financial community most clearly. In many other economic areas, the Treasury works closely with the SPO, CB, and MOF. But in decisions about the level and composition of borrowings, about the sources of such borrowings, and their appropriate sequencing, the Treasury exercises the key role -- supplemented by the Central Bank and, to a lesser degree, the SP0. Since this process is not always clearly understood, either in Turkey or in many other countries, it is useful to analyze how it works and where improvements can be made.

B. The Management of Borrowings and the Control of Debt

7.04 The Treasury, in collaboration with the SPO, decides on the total foreign borrowing requirements of the public sector for the year, based on the Annual Macro Program and the targets in the Balance of Payments and Budget. The level of domestic borrowing is set, based on assumptions about the financing gap, interest rates, inflation, and other parameters. Borrowing for the state in its name, the Treasury has responsibility for the preparation, signature, -113- payment, repayment, and registrationof all types of external borrowings. It negotiates most public loans and is responsible for disbursing and servicing state debt, includingpublicly guaranteedexternal debt. In addition,it assists the State Economic Enterprises (SEEs) in loan negotiations and provides Government guarantees of such loans. All direct borrowing by public entities are subject to the approval of the Treasury. All private sector borrowings exceedingone year maturity are also subject to the Treasury's approval,and all borrowers are obliged to register the new loan agreementswith the Treasury's External Debt Department and to report all payments and disbursements made monthly. Borrowings of less than one year do not require prior approval, but need to be reported to the Treasury.

Box 7.1: Organizing the Management of Debt

7.05 A key question for any country is how it should organize its debt management functions and how effectivelyis this carrried out? In Turkey, Treasury and Central Bank play key roles. Responsibilityfor managing the external debt lies with the Treasury'sDirectorate of Public Finance (also called the Directorateof State Debt and SEEs) and particularlythe External Debt Follow-up Department,which was establishedin 1984. (See Annex 7.1.) The Director-Generaland his staff exercise key roles in the control of external and domestic debt by providing senior officials in the Treasury with a view of debt stocks and flows and, if necessary, macro balance developments. The compila- tion of external debt statistics is the responsibilityof the External Debt Follow-up Departmentwithin this Directorate.The Department tracks all disbursements,as well as debt servicing, and updates the debt data informationsystem. Another department in this General Directorateis responsiblefor domestic borrowings (Treasurybills and bonds). Functions include planning the level of such borrowings, as well as managing the flotationprocess and servicing the bonds (remittingcoupon payments). The two Directorates-- Public Finance and External Economic Relations -- work closely together, and the interactionwith the Central Bank is being strengthened(see below).

7.06 The management of debt data is handled by a different General Directorate from that of external borrowings (see Annex 7.1). The Directorateof External Economic Relations is the department responsible for formulatingthe external borrowing program, followingdevelopments in the internationalcapital markets, proposing specific borrowings initiatives,undertaking analysis of the terms and conditions of agreements,negotiating the various loans, and ratifying loan agreements. The Directoratenegotiates all non-project loans and assists, where required, in loan negotiationson projects involvingcentral and municipal entities, as well as those for the SEEs. In June 1989 the Treasury created a new department for InternationalCapital Markets, which is responsible for arranging all commercialborrowings of the Treasury. -114-

Box 7.1: Organizing the Management of Debt (continued)

7.07 The Central Bank of Turkey (CB) also exercises important functions in debt management. It services the foreign debt in practice, in the sense of handling the transactions. It also carries out specialized functions in asset (reserves) and liability management. The Central Bank has been a direct borrower in international markets, usually borrowing funds to boost reserves whenever necessary (this need has become less pressing in the last year due to the favorable current account position). The Central Bank is also responsible for managing the country's foreign exchange and for managing the short-term debt. It also handles key schemes, such as the Dresdner Scheme, and sets policy on liquidity and reserve requirements in accordance with the overall monetary program. In addition, the CB handles certain special activities that affect debt, such as the export credit arrangements to Iraq. The Research Department of the CB carries out studies, some of which relate to external debt aspects. The International Department consists of two divisions:

(i) the Balance of Payments (BOP) Division, which handles short- term debt and determination of the financing gap; and

(ii) the International Organizations Division which plans the borrowings and arranges certain credit lines to close the financing gap.

Within the Central Bank these two divisions are in charge of debt management. The BOP Division is also responsible for preparing pro- jections on the current account, capital account and financing require- ments, and for knowing the details of the flows of foreign exchange deposits (non-resident portion), workers' remittances and Dresdner Scheme funds. Certain data on disbursements and Revolving Fund payments and repayments are also maintained by the CB, since it handles these funds. The Balance of Payments projections are particularly crucial to the formulation of the annual economic program and the longer-term view of the economy. Considering all of these functions, the Central Bank is obviously an important part of Turkey's debt management system.

C. Status of Debt-Data Management

7.08 Turkey was one of the first developing countries to put in place a sophisticated debt data system. In 1983-84 the Treasury, with technical assistance provided by the IMF and the World Bank, installed a computerized data base for medium- and long-term loans. The system, which is managed by the External Debt Department of the Public Finance Directorate, records all borrowings exceeding one year maturity. This allows the Treasury to manage its - 115 - outstanding debt obligations and to undertake the necessary analysis. The data base is now regularly updated, and the quality and coverage of data are good. The system can calculate the dollar equivalent (or any numeraire) value of the stock of outstanding debt at any given time and it contains details on debt service, full itemization of loans and information on maturities, etc. Despite this progress, there remains a need to clarify the division of tasks between the Treasury and Central Bank for recording certain disbursements and repayments. Both agencies have certain responsibilities to enter data and check data. The Treasury handles all medium and long-term debt as well as some short-term debt. The Central Bank handles some short-term debt (for reserves) and special schemes like the Dresdner Scheme (see Chapter 2). To broaden general understanding of key topics (e.g., exchange rate volatility) developments need to be reviewed at the department level, instructions issued to staff, and information copies/summaries sent to other concerned departments. For example, the impact of the changes in hard currency rates, particularly vis-A-vis the US dollar and Japanese yen in recent years has had a significant impact on Turkey's debt stock (the debt stock grew in 1986-87 and in 1988 the stock declined). The implications of these developments need to be more broadly analyzed and understood, which would enable better planning over the medium-term horizon.

7.09 It is well known that timely disbursement data are difficult to collect, but it is necessary to develop a system that can track this information more closely. Sources for cross-checks include the customs data system (maintained by the Ministry of Finance), in addition to reports of borrower and creditor transactions maintained by the Central Bank and commercial banks. The Directorate General of Public Finance has taken a number of initiatives in the past year for making the system more up-to-date and complete in coverage, such as bringing disbursement/repayment data up-to-date on various loans and reconciling economic flow data that stem from the current account of the Balance of Payments with debt stock data (changes in debt stocks) that pertain to the Capital Account. Regarding the IBRD Currency pool valuation changes, the Public Finance Directorate has revised its system to enable it to more quickly reflect the monthly fluctuations. Recently, the Government has requested technical assistance from the World Bank to enable the authorities to reflect the currency pool (on IBRD debt stock) more accurately.

7.10 The next phase envisioned for the debt-data management system is to enter in the data base the information related to short-term debt. This is an important task, as short-term debt now represents a significant part of Turkey's debt (about 16 percent of total debt). Furthermore, short-term debt. is an important element in the liability management process. Since short-term debt characteristics are likely to change over time more rapidly than medium- and long-term debt, it is important to centralize this task at the Central Bank where the information is more readily available. This will require a clearer sharing of tasks between the respective debt data divisions at the Treasury and the Central Bank, and a transfer of some computer files on short-term debt.

7.11 To implement modern liability management techniques to lower the costs and risks involved with foreign debt, it will be important to develop in both the Treasury and the Central Bank units a set of standard tables and aggregation programs. These should include precise projections and scenario -116-

programs that provide answers to the "what if" questions, related to movements in internationalinterest rates and cross-currencyexchange rates. The External Debt Follow-up Division has recently upgraded its capacity,but still needs to recruit a Computer Programming Specialist to carry out fully its tasks. The Central Bank, by contrast,has enough capacity to take on enlarged tasks at this time.

D. Coordinationand Overall Management of the Process

7.12 The foregoingdelineation of functionsappeared to work satisfactorily until 1987 when the proliferationof certain public sector projects threatened to undermine the coherence of Turkey's debt and borrowings system. The Governmentneeded to take a view on the merits, and priorities,for example, the various highway loans, and on how these should fit togetherin the overallpublic investmentprogram. An equallyimportant problem related to the decentralization program launched in 1985, whereby municipalitiesand local governmentsembarked on numerous infrastructureprojects which in some cases have involved foreign loans (usually suppliers credits). In several instances the sponsors had not obtained the approval of the Treasury to obtain foreign borrowings. Again, decentralizationshould not imply the freedom to take on foreign borrowings without the scrutiny or approval from the Central Government authorities. By December 1987 the Government realized that the process had gone too far, and a substantialtightening was necessary.

7.13 In January 1988, a ministerial-levelCommittee on External Borrowings (EBC) was created to strengthen the Government'scapacity to plan and control its external borrowings program. The Committee is chairedby the same Minister of State to whom the Treasury reports. The Committee includes the Minister of Financeand Customs, the Undersecretaryof Treasury,the Governor of the Central Bank, the Undersecretaryof SPO, and other key officials. The objectivesof the Committeewere spelled out in Article 16 of the Council of Ministers Decree of February 16, 1988. The Decree stipulated that projects financed by foreign loans needed to have been included in the annual program, and it was the State Planning Organization'sfunction to confirm whether this was the case. The Treasury was to be provided with enough informationabout the local, foreign, and total financingrequirements of the project as well as the intended sources of financing (both domesticand foreign). Without prior consentof the Treasury, foreign financing could no longer be obtained for the local costs of project expenditures.

7.14 The provisions in the February 1988 Decree show how a high-level Committee can strengthen the powers of regular agencies (SPO and the Treasury in this case). The extensive borrowings contracted for the motorways program during 1985-87 indicatedthat tightercontrols were needed generally,especially over the tendency to increase foreign loans to include the domestic portion (civil works and local equipment) of expenditures. Total external borrowings in 1985-87 for the motorways program amounted to about $2.2 billion, pushed up by a large civil works component, which could have been financed by local sources. However, the funds were obtained through suppliers credits and commercial credit (syndicatedbank loans). Now that the above decree has been issued, and consideringthat investmentexpenditures have been and will continue -117- to be cut back, it remains to be seen what the fate of these foreign loans will be. Will they be prepaid, will they be refinanced,or will they remain as is, and what will be the attitude of the lenders?'/ These questions are now being examined at both the macro and sectoral levels as part of a possible Highway Sector Investment Loan from the World Bank. Such reassessmentcould be an importantpart of rationalizingthese foreigndebt obligations,considering that there is a large gap between committedand undisbursedfunds.

7.15 The balancing of macro and sectoral priorities as they relate to external borrowingsis a difficultprocess that requires review at a high level, such as by the Committee referred to above. It also requires the detailed and integratedwork of Treasury,SPO, and CentralBank officials. Thus, the creation of the External BorrowingsCommittee (EBC) was a significantstep forward. But what else should the Committeecover, and what additionalresources does it need?

7.16 One of the EBC's objectives is to formulate a debt strategy and to elaborateon the principles governingforeign borrowing. Thus, it cannot delve into the approval of every public sector project. Nor should it, as this function is best carried out by the mandated entities (principallyTreasury and SPO). But the criteria for determiningwhat issues the Committee should, or should not, cover in carrying out its objectives--andwhat major projects it should review in ratifying the debt arrangementsof a given venture -- needs to be thought out. It is importantfor the Committee to exercise tighter controls, and demonstrateto internationalmarkets that a coherent debt management system is indeed in place. An illustrationof the EBC's role was the decision to refinance the Foreign Military Sales, includingwhat should be the size of the refinancings. Other large projects or financingpackages will come up, and the EBC will need to consider these fully. A case in point is the Build-Operate- and-Transfer(BOT) projects,which the EBC might have discussed already.2/ The BOT projects are large ($1 billion or more) and involve implicit (or even explicit)Government guarantees. This aspecthas been controversialand explains part of the delay in launching the scheme. The more the Committee can demonstrateregarding its impact, the greaterwill be the foreign confidence in Turkey's debt management system.

7.17 Another important issue is the relationshipof external borrowing to domestic borrowing. The fungibilityof these two forms of debt is a key area

1/ The Governmenthas retained the servicesof an internationalconsulting firm to conduct an audit of the motorway program.

2/ The BOT scheme involves constructionand operation of a project (in energy generation,transportation or other kinds of infrastructure)by a consortiumof foreign firms who would provide the equipment, raw materials, and technical know-how to run the project for 15 years or longer (including in perpetuity). This scheme has been adopted by several countries including Pakistan, Turkey and Indonesia. In the Turkey version, there would be a transfer of the project to the Government at the end of the period at a pre-agreed formula and price. Investmentfunds are supposed to come entirely from abroad and thus there should be no drain on the Government investmentbudget. -118-

of concern for policymakers. How much should Turkey try to obtain from abroad, and how much should it try to obtain from the domestic markets? The question is of growing concern given the rising share of interest expense in the Consolidated Budget and the crowding out of private investment. It is also difficult to disentangle this question from the different purposes and uses of the two forms of borrowings. As mentioned in Chapters 3 and 5, both foreign and domestic borrowings grew in 1987-88. Where extra financing was needed, the Government resorted to the domestic market. There is a view in Government that borrowing from the domestic market is cheaper for the Government than borrowing abroad (since inflation erodes the value of domestic debt). Considering, however, the large proportion of interest costs in the budget and the high nominal interest rates in Turkey, it has also been argued that external sources are cheaper. The reason is that the repayment of a growing stock of Treasury bonds at current interest rates is straining the budget, which in turn reduces the ability of the authorities to achieve fiscal balance. Thus, as recommended in Chapter 6, domestic bond borrowings should not be relied upon continuously. The debt borrowing analysts in the Treasury need to carry out frequent analyses to see whether external or domestic borrowing is cheaper, and what the appropriate balance is between them. These are key issues for the policymakers (Treasury, CB, SPO and the EBC) to decide upon, based on sound analyses from the staff.

E. Recommendations on External Debt Management

7.18 The existing debt management system in Turkey works reasonably well. However, in order to consider various choices and tradeoffs affecting the country's debt, the Government needs to develop more analytical capabilities in those areas crucial to debt management, such as new borrowing techniques and instruments to manage existing liabilities more closely. As shown in the following diagram, the existing linkages between the key agencies on debt questions -- Treasury, SPO and Central Bank -- are clear. Although the system is now well-established, there remain areas for improvement in capacity and in strategy formulation. The capacity aspect involves mainly the question of how to engage in more active liability management to balance the portfolio of credit lines -- by currency composition -- and to hedge (to the extent that this is possible) against sharp swings in interest rates. As analyzed in Chapter 4, there are potentially important aspects in this area that can be studied on a continuing basis and, if feasible, actions could be implemented.

7.19 The External Borrowings Committee could be a natural starting place for strategy work, but like any committee that operates in a non-frequent manner, it is difficult to obtain consistent and systematic advice from this source. Thus, the Treasury and Central Bank will principally have to handle these matters. In order to formulate a strategy regarding what is the ideal currency composition and what is the ideal mix (for Turkey) of fixed versus floating rate debt stock, various analyses will have to be undertaken. Once the norms are established, then managers and staff will need to carry out trades (debt swap decisions) that will enable the norms to be met on a routine basis throughout the year. No one individual is meant to have the burden of acting unilaterally, but rather that person should have well established norms to point to which can Figure 7.1 TURKEY EXTERNAL DEBT MANAGEMENT AND BORROWING STRATEGY SYSTEM

External Borrowings ~~~ ~Committee (EBC) Provides macro balances Provides special papers and data Provides special services to papers and data the EBC services to the EBC

r 14 ,,~~~resuyandl | SPO Forig1Tra e Central Bank

Annual International Programs Public Finance External Economic Department Programs General Relations General Division Directorate Directorate Balance ot International Payments Organizations * Records Data Division Division * Prepares annual borrowingZs * Analyzes debt trends program * Makes cross currency * Prepares BOP * Plans borrowings adjustments * Identifies and secures specific projections borrowings from official and Prepares debt service commercial sources * Estimates Financing * Arranges credit lines projections Gap *Analyzes liability * Analyzes liability management potential * Handles Short term management potential debt data

This figure depicts certain processes of the three key agencies regarding debt aspects and is not an organization chart. sube/w44898 -120- justify his decision to select a particular currency or interest rate and maturity combination.3 /

7.20 In order to handle such active liability management, an expansion of capacity and, possibly, some reorientation of existing functions is needed both within the Central Bank and the Treasury. Our Figure 7.1 is only a notional idea. It is up to the Government to organize how best it wishes to tackle these topics, which are likely to grow more important in future, as Turkey continues to work its way through its debt situation relying primarily on market solutions. For these new activities to work well, Treasury and Central Bank staff will need to continue and intensify their contacts with foreign financial markets, both through enhanced computer link-ups and through personal contacts with key financial institutions.

F. Institutional Aspects of Domestic Debt Management: An Agenda for Further Analysis

7.21 This chapter has concentrated on the institutional mechanism to handle external debt management. Domestic debt management involves some of the same units of the Treasury, particularly the General Directorate of Public Finance (see Annex 7.1). Within this Directorate there are two departments, one for external debt and one for Treasury operations/domestic debt. Also, the Treasury's General Directorate for Banking plays an important role given that the buyers of the Treasury bills/bonds are the major commercial banks.

7.22 In 1985 the Treasury moved to an auction system for selling its securities. The major bidders in the bill auctions are banks and non-bank dealers/brokers registered with the Capital Market Board. Since the banks can meet part of their liquidity requirements to the Central Bank by holding Treasury securities, the banks have naturally become the major holders of such instruments. Also, official deposits can be collateralized by holding Treasury securities.

7.23 The growth of the primary market has been restricted by the lack of institutions and instruments that would allow greater access of firms and individuals. Repurchase Agreements (REPO's) are illegal except those between the Central Bank and its authorized dealers. Nevertheless, there is a large informal market for REPO transactions between commercial banks and their large clients. The existing mutual funds which increasingly offer an alternative to the REPO's, are dominated by banks. Also, non-competitive bids from the public are not allowed. The market for Government securities remains fragmented and underdeveloped. Clearly, the primary market auctions can be improved through a more consistent application of the "rules of the game," i.e., the authorities should guarantee transparency in the auctions. At times, the authorities have

3/ The World Bank's Finance Complex is organized along these lines, with a Risk Management and Financial Policy Department (FRS) that plans and sets norms and a Financial Operations Department (FOD) that goes out and achieves a borrowing mix to meet these norms. -121- allowed "overriders"(allowing bids that were in excess of the amounts being offered at the beginningof the week). Also, the authoritiesplaced caps on the Treasurybills sold in the secondhalf of 1988 which, while lowering the Treasury bill rate, introduced more uncertainty into the market because basic elements of the bid process were not being consistentlyfollowed.

7.24 To encouragethe growth of primary and secondarymarkets for Government securities,the authoritiesshould study whether:

- the entry of indegendentmutual funds into the Treasurybill market can be facilitated;

- "Non-competitivebids" (NCB's) can be allowed to facilitate individual investor participation;

- repurchase agreements can be legalized subject to strict supervision;

- more transparencyin the bid process can be obtained; and

- a more dynamic secondarymarket can be developed.

7.25 On many of these questions, the Treasury, working in close collaborationwith the Central Bank and the Capital Markets Board, is able to analyze the constraints and develop solutions that will provide greater order and depth to the market. Some of this analysis is underway in the context of the World Bank's Second Financial Sector Adjustment Loan and related working papers. The deepening and refinement of the primary market and developmentof the secondary markets are important financial sector goals which need to be harmonized with the macro goals/prioritiesof fiscal and monetary policy. This can only be done through a close, combinedeffort of the Treasury,Central Bank, and SPO (in its role of setting the annual program financing targets). The Central Bank's roles in organizingan interbankmarket and in conducting open- market transactions(as an instrumentof monetary policy) are essential to the regularizationof the domestic public debt market. It is also important that the ability of the private sector to issue corporatebonds be developed, for which the role of mutual funds is essential. These are some of the items that the Government needs to study regardingpublic domestic debt. - 122 -

Chapter VIII: STRATEGIC CONSIDERATIONSAND SUGGESTIONS

8.01 Having discussedTurkey's macro framework,its debt structure, and its borrowingsprogram in some depth, and having taken an integratedview of external and domestic debt aspects, several questionsarise. These fall into three broad areas: (a) the consistency of Turkey's macroeconomicprogram and the realism of its debt strategy; (b) the vulnerability of the Turkish economy to world shocks; and (c) the effectiveness of its debt management. Some of these questionshave come from financialinstitutions with whom the Bank is in regular contact through its global debt work, while others have come from commercial markets in Ankara and Istanbul. It is important to set out some of these strategic questions and issues, and to assess their relevance to Turkey's situation and outlook.

A. Turkey's MacroeconomicProgram and the Realism of its Debt Strategy

8.02 The Government'smacroeconomic program has been assessed in various Bank reports, as well as in Chapters 1 and 5 of this report. Here, it suffices to add that although there are many inter-relationshipsthat must be assessed when evaluating the adequacy of a macro framework or program, Turkey's fiscal imbalances have been identified as the major structural issue facing policy- makers. If the path of fiscal deficitreduction through appropriateexpenditure restraint and revenue generationis strengthenedon a sustainedbasis, then the outlook for the Turkish economy is favorable.

Box 8.1: Turkey's Strategy

8.03 Turkey's debt workout strategy is best characterizedas resting on the belief that it is fundamentalto establish a name as a reliable creditor who honors financial obligations,through a determined appli- cation of credible adjustment and export growth policies. While this may appear elementary,it is worth stressing,because no other aspect of Turkey's approach has impressedfinancial markets more than the fact that after a severe economic crisis, Turkey has now gone through eight years of uninterrupteddebt service, while tackling a combinationof stabilization,adjustment, and debt-workoutproblems, however difficult it has been. It is by its uninterrupteddebt service that Turkey has set its record apart from those of most other heavily indebted countries. While the economic program is far from complete -- particularlywith regard to inflation -- Turkey has had remarkable success in export growth, and it has reoriented its economy toward a market driven system. These three aspects are the main reasons why Turkey enjoys a reasonably positive rating in credit markets. Moreover, the markets welcome Turkey's rejection of any thoughts of requesting additional resche- dulings (this stance is widely known). If sound and consistent economic policies are applied, Turkey has reasonableprospects that it will move into the 1990's with an improved macroeconomicframework and a lower relative debt burden. - 123 -

8.04 Nevertheless, it is important to clarify one misconception held in the credit markets, which concerns the "debt hump." Our analysis shows that the hump in debt service is a moving hump, contrary to general belief. Thus, it is not obvious if and when a decline in the debt service will begin. The fact that Turkey has been taking on higher cost debt at shorter marturities than that represented by the debt stock which it is retiring is unfortunate, but inevitable. As part of the OECD rescheduling package, Turkey has been repaying lower cost debt obligations carrying longer maturities at a time when there is little concessional money available.'/ Consequently, it has had to use commercial funds, which generally carry shorter maturities and higher costs. Even then, Turkey can only obtain such funds on a supply-constrained basis. Turkey has tried to lengthen the maturities of the new loans, but this has not been an easy process, and on average, 7-8 year money is replacing 10-15 year money. The World Bank's Cofinancing Program has helped to strengthen Turkey's possibility of obtaining funds in excess of ten years in both the European and Japanese markets, but such programs cannot be expected to fill the entire gap.2/ Thus, Turkey has resorted to innovative financing instruments of its own, involving mainly the bond issues in the West German capital markets. The Dresdner Scheme has been a costly form of finance, and while there have been important recent changes (para. 2.13), further modifications which could reduce the effective costs, as well as the reliance on the Scheme, should be examined by the authorities.

8.05 Whether Turkey will see a decline in its external debt-service hump in the foreseeable future rests on four factors: (i) the performance of the current account; (ii) the terms at which Turkey borrows its new money; and (iii) the extent to which the country can gain some efficiencies or savings through more active liability management; and (iv) the exogenous effects of movements in world interest rates and cross-currency exchange rates. It is important to clarify that when we talk of "the debt hump," this describes absolute amounts and as well as the behavior of certain ratios. However, we should emphasize the distinction between a hum- in debt stock, and a hump in debt service (the latter is the more relevant consideration). It is quite conceivable that Turkey's debt stock will decline in nominal dollar equivalent terms (as it did in 1988), as well as in terms of ratios (such as debt to GNP), but it is also likely that, at the same time, debt service will continue to rise. To obtain a decline in debt service in nominal terms, Turkey will have to run sizeable current account surpluses for several years in a row, in order to build up foreign exchange reserves and retire its debt faster than is now anticipated. This may happen, but it is not a necessary condition for maintaining creditworthiness. The key aspect is for the debt service ratios (debt service to exports, interest to exports, interest to GNP) to decline over the medium term. The key factors that will determine the

1/ In comparison, Indonesia (a country with a similar debt profile to Turkey) receives a larger share of concessional aid through the IGGI Consortium, mainly on account of its lower per capita income.

2/ During 1985-88 there were five B-loan operations for Turkey, in which the Bank took participations of 10-20 percent. These loans helped to raise substantial amounts of syndicated bank loans for Turkey (about $1 billion in total) at reasonable rates and terms (twelve year maturities in most cases). - 124 - dynamics of the debt-servicehump will be the size of Turkey's futureborrowings, the average terms at which it can borrow, compared to the terms of the stock of debt that it will be repaying,and the behavior of cross-currencyexchange rates. Over the first two factors,Turkey has some control. Over the third it has none, except to try to diverisfy risk. Factoring all this into account, the Bank's projectionsdo show such an improvementin the key ratios, beginning in 1991.

8.06 One must ask why at times concerns remain among Turkey's various creditors. The reasons are difficultto disentangle,but are clearly influenced by the generally poor experience of most other countries confrontinghigh debt problems, as well as by the deterioration in Turkey's domestic economic indicators, particularly inflation since late 1987. On the other hand, the strong current account performance in 1988 has led to an increase in market confidence. Developments in Eastern Europe could lead to higher demand for Turkish products whereas markets in the Middle East are likely to remain depressed. Unless a steady growth of exports to is achieved, the pillar that has enabled Turkey to overcome its debt burden so far -- the strong growth of manufacturedexports -- could falter. The more Turkish exporterspenetrate the European markets, the firmer will be the country'sprospects.

Box 8.2: Relevance to Debt Reduction

8.07 Turkey was not one of the countries included on the list of Baker Plan countries,although as depicted in Chapter 2, it had debt indicators that were similar to some of the more heavily indebted countries (HIC's). The type of economic reforms, the high output growth, and the extensive commercial funds obtained by Turkey attest to the Baker idea having already been at work in Turkey's case. Again, under the Brady Plan list, Turkey is not considered to be in need of debt reductionmeasures, on account of its more favorable outlook generally. Also, its external debt is not traded at much of a discount. Debt reduction schemes make little sense in this case. Turkey should not want its debt to trade at a discount, as this affects market confidence,and therefore the ability to raise voluntary borrowings.

8.08 The authoritiesare mindful of the situationof the severely indebted countries, which has prevented them from being able to access voluntary commercial borrowings. The central element of any economic reform plan is for the country to bring its macro balances into line, particularlythe fiscal imbalances. The Turkish authoritieshave attached highest priority to this task, so that their approach of working one's way out of debt through self-orchestratedmarket borrowings,without any concerted lending arrangements,will remain the preferred, and realistic, strategy. - 125 -

Box 8.2: Relevance to Debt Reduction (continued)

8.09 A related question is the whole area of debt-equity conversions. Turkey has not engaged in any debt-equity conversion schemes since 1982 when it began to wind down its Non-Guaranteed Trade Arrears (NGTA) Scheme, which involved a debt-equity feature. It is unclear whether debt-equity swaps on a broad scale would help a country like Turkey. Rather, it should concentrate on attracting foreign investment directly through maintaining a sound macro frame- work. Moreover, on a practical level, the absence of a discount on Turkey's external debt renders debt-equity swaps difficult. However, certain debt-equity swaps could be linked to specific privatization plans where a potential "equity purchaser" is already a creditor of that state economic enterprise, and the external debt is exchanged at (or close to) face value.

B. Vulnerability to External Shocks

8.10 Turkey remains vulnerable to various economic shocks, which can impact on its debt strategy. The three most important shocks involve: (i) world oil prices; (ii) world interest rates; and (iii) world trade.

1. World Oil Prices

8.11 A significant rise in oil prices (greater than 10 percent in 1990) would have a significant effect on Turkey's balance of payments, since Turkey's oil imports still constitute about 25-30 percent of its total imports. A rise of say US$2 (ten percent increase) in the price of a barrel of oil is estimated to cause a deterioration in Turkey's balance of payments of nearly $350 million, calculated as follows:

(i) Turkey's current account surpluses of $1.5 billion and $700 million respectively in 1988 and 1989 occurred partly because of a decline in the volume of oil imports, as a result of lower economic growth. This situation contrasts with the large volume increases in 1986-87 when economic growth was around 7-8 percent and domestic oil prices were falling in real terms;

(ii) Assuming that there is no other reason for a change in the volume of Turkey's oil imports in 1990, the following table shows the impact of different assumptions about oil prices on Turkey's oil imports: - 126 -

Table 8.1: Impact of AlternativeOil Prices

Current Account Impact

(a) Change in World Oil Price 10% 20% 30%

(b) Increase in the value of oil imports relative to current forecast ($ millions) 350 500 750

8.12 However, line (b) above is likely to overstate the resulting current account deteriorationbecause: (i) prices for the bulk of Turkey's oil imports are negotiated on a bilateral basis for fixed periods, such as 6 months or 1 year. Thus, developmentsin the world market tend to affect Turkey with a lag; (ii) the bilateral negotiationsoften involvebarter arrangements. Therefore, if oil prices rise, Turkish exports to the Middle East might also rise, diminishingthe negative impact on the current account; and (iii) import volume could fall as prices rise, meaning that the assumption of no change in volume is not realisticdue to the price elasticityeffect. Net imports in dollar terms might therefore not rise as much as shown. Incorporatingthese factors, the current account deteriorationresulting from higher oil prices may be in the range of half to two-thirds of the figures on line (b). For example, if oil prices continue to rise (say by 20% in 1990) the current accountmay deteriorate by about $500 million. Changes of that order should not present any major difficultiesfor the Turkish economy. However, if oil prices were to rise by say US$10 per barrel in 1990 and in subsequent years, there would be a substantial adverse effect on the current account, requiring additional borrowings to fill the gap, which would place more strains on the debt-service burden.

2. World Interest Rates

8.13 As stated in para. 4.12 about 45 percent of Turkey's debt (including short-term debt) is estimated to be subject to variable interest rates. Since almost 90 percent of Turkey's foreignexchange reserves are held in variable rate instruments,interest variable net debt amounts to about $15 billion. Thus, for every 1 percentage point rise in world interest rates, the Turkish current account would deteriorateby about $150 million. If LIBOR rates were to rise by 3 percentage points in 1990 (which exceeds most forecasts),the net effect on Turkey'scurrent account would be a US$450 million deterioration,which, while not insignificant,would be manageable.

3. World Trade

8.14 As already stated, exports lie at the center of Turkey's debt strategy. Current projectionsshow a growth in world trade of about 5 percent in 1989. More pertinent here are the trade prospects for Turkey's markets and its products, and the outlook for the trade policy regime. In para. 8.07 several factorswere cited regardingthe uncertaintysurrounding Turkey's export markets. However, similar uncertaintieshave existed in previous years, yet Turkey's export record in most years (except for 1983 and 1986) has been impressive. Moreover,Turkish industry is in a much strongerposition now than it was in the - 127 - early 1980's. The textiles and leather industries are producing superior products today, and other sectors such as light engineering and electrical appliances ("white goods," refrigerators, etc.) are making large strides. The authorities have been consistent in their belief that the most important factor underlying Turkey's debt workout strategy is the role of exports. Thus, the Government has preferred to support exports through a mix of exchange rate policy, export tax rebates, and preferential credit, to offset the impact of high lending rates. However, the latter schemes have involved substantial explicit or implicit subsidies, and if the fiscal deficit concerns remain paramount, Turkey may have to reduce incentives even further.

8.15 Given that the current account is in much stronger shape today than had been anticipated just one year ago and given that there is still need for substantial fiscal consolidation, the Government should reconsider whether it needs to maintain elaborate fiscal incentive schemes. Large export firms and trading entities enjoy a generous array of incentives,3 / and some efficiencies could be obtained by rationalizing the schemes. On the other hand, private manufacturers have alleged that the loss of benefits from the previous export tax rebates (which have recently been phased out) have not been balanced by the extension of preferential credit from the Turkish EXIMBANK.

C. Effectiveness of Debt Management

8.16 In order to develop market confidence it is essential for policymakers to function with both strategic vision and attention to the many details that make up a comprehensive financing plan and borrowings program. Considering that the Government has placed such high priority on overcoming Turkey's debt burden, and that Turkey is one of only a half dozen countries which, after being confronted by a major debt crisis, appear to be working their way out of the crisis, the Government can claim credit for its success in this area. However, markets do perceive some confusion regarding project financing, as several large projects have come to the financial markets, have been financed (or offers have been assembled, as in the Thermal Power BOT projects), after which there has been no progress in implementation. If these standstills are a result of rethinking the economic viability or even of the need for making a particular investment at all (such as the reordering of priorities in the energy sector away from generation to distribution investments, given excess supply at present), then this is understandable. But if the factors causing delay are due to prolonged conflict within the Government regarding certain planned investments (such as some of the motorways), then naturally the markets will tend to get anxious. This is particularly true for syndicated bank loans, but less so for general purpose bonds, since the latter are not project-linked.

8.17 The work of the External Borrowings Committee (EBC) needs to become visible, more intensive, and more carefully sequenced around the priority policy issues facing Turkey's borrowings program. For example, with world interest rates rising, should Turkey consider trying to swap some of its floating rate debt into fixed rate notes? Should certain loans be swapped into other

3/ See the Private Manufacturing Study (Report No. 6684-TU) dated June 1987, as updated by staff working papers. - 128 -

currencies? What would be the impact on Turkey's ability to generatenew funds, if commercial bank commitments were used to make swaps? How much project financingversus balance of payments financingshould Turkey seek in 1989? These are some of the strategicquestions that need to be resolved. While the economic managementsystem in Turkey does have a sound structureand apparatusto consider such questions, it is not clear that in 1988 there was a consistent line of action followed by the EBC. Over the coming months, the role of the EBC needs to be clarified.

D. Internal Transfer and Domestic Debt

8.18 The analysis of Part II of the report has bought out the internal transfer problem which needs to be dealt with through a lowering of the fiscal deficit. Moreover, there is a large and growingpressure on the financialsector emanating from the domestic debt stock, which is growing at a rate in excess of the economy's growth rate. Hence, the public sector deficit, which drives the borrowing program, needs to be curtailed further. As a target, it would seem that the Government should aim at a domestic borrowings program which provides growth of only around 4-5 percent per annum in net terms (after paying off maturing bonds and bills). Currently, Turkey's stock of domestic public debt (net of consolidation)amounts to about 8 percent of GNP. Thus, the total public debt burden (externalplus domestic public debt) is around 63 percent of GNP, which is below the level of most heavily indebted countriesand even below that of Italy. However, concern arises not from the level but the growth of such debt, consideringthat Turkey had a very small stock of domestic public debt in 1984. Fiscal policy should aim at reducing such public indebtednessover the medium term.

8.19 Treasury bill rates have fluctuated between 45 and 65 percent in the first half of 1989, with some variable rates introducedsince the fourth quarter of 1988. Given the crowding-outpressures, domestic public borrowings should be slowed down, which can only occur if the fiscal deficit is sharply reduced. The authorities need to look at more comprehensivemeasures of fiscal health, such as indicated in Part II of this report. The analytical capacity to undercake real fiscal deficit analyses should be expanded in SPO, Treasury and the Central Bank. Finally, economic policy should ensure that the necessary fiscal improvementsare indeed made through close review of the attainment of key economic targets.

E. Access to Various Markets

8.20 Turkey has several strategicoptions to choose from in deciding which instrumentsto pursue and which markets to approach. Commercialfinance divides into two broad groups:

(i) Syndications.underwriting facilities and contingent "take-out" arrangements which can consist of such instruments as an - 129 -

ExchangeableLoan Facility.4/ All of these types of financing instrumentsare arrangedby lead banks with groups of other banks participating,if they wish. Turkey has arranged several general purpose syndicatedloans as well as project loans (see below); and

(ii) Capital Market Offerings such as the six bond issues in West Germany.

8.21 Aside from general purpose commercial finance, Turkey can approach export credit agencies (ECAs) for financingregarding specificprojects, and if the ECAs are interested they might agree to provide funds out of their own resources, as well as "cover" up to certain amounts of the commercial finance to be arranged for the project. The commercial financing component of the project will usually also be obtained as a result of a syndication.

8.22 Turkey faces a key question of determining how much export credit financing and commercial financing it should try to obtain, the appropriate b..lance between these two sources, and the appropriate balance between concessionalfunds (e.g. those from the European ResettlementFund) and harder funds, recognizingthat the availabilityof concessionalfunds is limited.

8.23 One side-effect of Turkey's increased sophistication in tapping commercialmarkets is that there is a tendencyto bypass approachingthe official bilateral and export credit sourcesbecause funds can quickly be arranged, and because the instrumentsare considerednew and interesting. This has not been true in every case, and certain ECAs are be seen as major players in Turkey's overall financing -- EXIMBANK (Japan), Hermes (West Germany), ECGD (United Kingdom) and COFACE (France). Recently, the Canadian Export Credit Agency (and commercialbanks) agreed to provide financingfor the Ankara Metro. In the case of the BOT Thermal Power Project both US EXIMBANK and Japan EXIMBANK might provide financing, each for the respective suppliers/contractors(Bechtel/ Chiyodda-Ku/Westinghouse).Official bilateral aid is the missing element in this process compared to the early 1980s (Governmentto Government, through the respective aid agencies). As noted in Chapter 2, this has been a dwindling source of finance for Turkey, which largely explains why its overall cost of borrowings has been rising, pushing the debt hump further out.

8.24 The markets that Turkey should approach,and in which sequence,remains a matter that the authoritiesknow how best to decide. However, it is useful to note that the markets for syndicated bank loans appear quite segmented -- the Japanese banks have been most responsive to Turkey while recently some US banks have also been active in arranging broad-based funds, as discussed in

4/ On March 8, 1989 the financialpress reported that the First National Bank of Chicago had arranged for the Central Bank of Turkey an Exchangeable loan Facility (ELF) of $200 million,which has flexibilityto be drawn down and repaid in different currencies and at various terms. The spread ranged from 50-120 basis points over LIBOR, dependingon the currency chosen and the length of time each bank was to stay in the loan. Essentially,the banks are providing short- term money which can be convertedlater into longermaturities for an incremental fee. - 130 -

Chapter 3. The European banks have exercised a more traditional role of arranging direct (single bank) loans, as well as syndicated loans for specific Turkish projects. As indicated in Chapter 3, Turkey should broaden its European base, as well as the Japanese market, if currency risk can be better diversified.

F. Additional Measures

8.25 As indicated in Chapter 4, Turkey can take steps improve its insulation against currency and interest rate movements. The amount of savings that it might generate out of swapping existing liabilities will depend on future currency movements, and on the actions that Turkey takes to lower the non-dollar portion of its debt stock.5 / At a minimum, Turkey should try to arrange a mix of currencies even when it is borrowing from Japanese sources (from syndications or from Japan EXIMBANK). The Government should consider how it might set up capacity to handle active liability management, integrating its expertise in reserve management (the Central Bank's function) with diversification of new borrowings (mainly the Treasury's function).

5/ Given that the Bank in May 1989 introduced several changes to its currency pool, borrowers have more certainty as to the currency distribution of their disbursements from IBRD. - 131 -

LIST OF ANNEXES AND CHARTS

Page No. Annex I

Table 1: High Case Current Account: Assumptionsand Projections ... 132

Table 2: Mid Case Current Account: Assumptionsand Projections .... 133

Table 3: Low Case Current Account: Assumptionsand Projections .... 134

Attachment 1: Debt Strategy Module: Methodology ...... 135

Figure 1.1 Assumptions...... 141

Annex II

Annex 2.1 External Debt Indicators and Ratios, 1980-88 ...... 142

Annex 2.2 High Case FinancialRequirements, 1989-93 ...... 143

Annex 2.3 Mid Case Financial Requirements,1989-93 ...... 144

Annex 2.4 Low Case Financial Requirements,1989-93 ...... 145

Figure 2.1 Turkey Disbursements,Amortization, Net Flows, Net Transfers 146

Annex III

Table 3.1: External FinancingRequirements - 1989 ...... 147

Table 3.2: Public Sector External Borrowings in 1988 ...... 148

Table 3.3: Financial Flows to Turkey - Bilateral ...... 151

Annex IV

An Illustrationof the Cost of Swaps ...... 152

Annex V

A Technical Note on the Estimation of Public Sector Deficits ...... 153

Annex VI

Demand for Assets in Turkey...... 173

Annex VII

OrganizationStructure of the Treasury ...... 181 132 - - 132 - ~~~~~~~TableANNEX1 I

HIGH CASE CURRENTACCOUNT: ASSUMPTIONSAND PROJECTIONS HighCase CurrentAccount Assumptions: 1989 1990 1991 1992 1993 USS inflation 4.0% 4.0% 4.0X 4.0% 4.0% Turk realGNP 4.0% 5.0% 5.0% 5.0% 5.0% lWorLdreaLGNP 2.8% 2.2% 3.0% 3.0% 3.0% TLira realpr 0.0% 0.0% 0.0% 0.0% 0.0O For.Inc.elast.ofimp.: 1.2 M.exp 7.4% 6.6% 7.6% 7.6X 7.6% Travel Credit 15.0% 15.0% 15.0% 15.0% 15.0% Domn.Inc.elast.ofimp 1.4 M.inp 9.6% 11.0% 11.0% 11.0% 11.0% Other, credit 7.4% 6.6% 7.6% 7.6% 7.6% Other,debit 9.6% 11.0% 11.0% 11.0% 11.0%

HighCase, ResuLts: History: ScenarioProjections: EffectiveGrowth rates: (xt/xt-1)-1

1987 1988 1989 1990 1991 1992 1993 88 89 90 91 92 93

TradeBaLance -3229 -1800 -2238 -3039 -3834 -4752 -5809 Merchandise Exports 10322 11846 12718 13562 14593 15702 16896 14.8 7.4 6.6 7.6 7.6 7.6 MerchandiseImports -13551 -13646 -14956 -16601 -18427 -20454 -22704 0.7 9.6 11.0 11.0 11.0 11.0

OtherGoods Serv.lnc.cr 4111 5945 6562 7225 8004 8878 9857 Travel 1476 2355 2708 3114 3582 4119 4737 59.6 15.0 15.0 15.0 15.0 15.0 Other 2635 3590 3854 4110 4423 4759 5120 36.2 7.4 6.6 7.6 7.6 7.6

Other GoodsServ.Inc.deb -4282 -4812 -5482 -5661 -5918 -6241 -6667 Interest -2507 -2799 -3276 -3212 -3200 -3224 -3318 11.6 17.0 -2.0 -0.4 0.8 2.9 Other -1775 -2013 -2206 -2449 -2718 -3017 -3349 13.4 9.6 11.0 11.0 11.0 11.0

Total Goods Serv. Income -3400 -667 -1158 -1475 -1748 -2116 -2619

Private Unreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 Workers Remittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0

Private Unreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 Official Unreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0

Non-int.Curr.Acct.Surplus 1525 4302 4286 3905 3620 3276 2867 Curr.Acct.BaLance -982 1503 1010 693 420 52 -451 - 133 ANE- MID-CASE CURRENTACCOUNT ANNEX 1 ASSUMPTIONSAND PROJECTIONS a Mid-Case Current Account Assumptions:a/ 1989 1990 1991 1992 1993 USS inflation 4.0% 4.0% 4.0% 4.0% 4.0% Turk realGNP 4.0% 5.0% 5.0% 5.0% 5.0% World realGNP 2.8% 2.2% 3.0% 3.0% 3.0% TLira realdpr 0.0% 0.0% 0.0% 0.0% 0.0% For.Inc.eLast.ofimp.: 1.2 M.exp 7.4% 6.6% 7.6% 7.6% 7.6% TravelCredit 15.0% 15.0% 15.0% 15.0% 15.0% Dom.Inc.elast.ofinp 1.4 M.imp 9.6% 11.0% 11.0% 11.0% 11.0% Other,credit 7.4% 6.6% 7.6% 7.6% 7.6% Other,debit 9.6% 11.0% 11.0% 11.0X 11.0%

Mid-Case,Results: History: ScenarioProjections: EffectiveGrowth rates:(xt/xt-1)-1

1987 1988 1989 1990 1991 1992 1993 88 89 90 91 92 93

Trade Balance -3229 -1800 -3199 -4087 -4983 -6011 -7188 MerchandiseExports 10322 11846 12303 13120 14117 15190 16345 14.8 3.9 6.6 7.6 7.6 7.6 MerchandiseImports -13551 -13646 -15502 -17207 -19100 -21201 -23533 0.7 13.6 11.0 11.0 11.0 11.0

Other Goods Serv.Inc.cr 4111 5945 6562 7225 8004 8878 9857 Travel 1476 2355 2708 3114 3582 4119 4737 59.6 15.0 15.0 15.0 15.0 15.0 Other 2635 3590 3854 4110 4423 4759 5120 36.2 7.4 6.6 7.6 7.6 7.6

Other Goods Serv.Inc.deb-4282 -4812 -5689 -6104 -6518 -7052 -7749 Interest -2507 -2799 -3483 -3655 -3800 -4035 -4400 11.6 24.4 4.9 4.0 6.2 9.0 Other -1775 -2013 -2206 -2449 -2718 -3017 -3349 13.4 9.6 11.0 11.0 11.0 11.0

Total Goods Serv. Income -3400 -667 -2325 -2966 -3497 -4185 -5080

PrivateUnreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 WorkersRemittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0

PrivateUnreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 OfficiatUnreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0

Non-int.Curr.Acct.Surplus1525 4302 3326 2857 2471 2018 1488 Curr.Acct.Balance -982 1503 -157 -798 -1329 -2017 -2912

a/ In 1989, the nominalexport and importgrowth rates are estimatedat 3.8 percent and 13.6 percent,respectiveLy. - 134 - ANNEX 1 LOW CASE CURRENT ACCOUNT: Table 3 LowCase Current Account ASSUMPTIONSAND PROJECTIONS Assumptions: 1989 1990 1991 1992 1993 USS inflation 4.0% 4.0% 4.0% 4.0% 4.0% Turk reatGNP 4.0% 5.0% 5.0% 5.0% 5.0% World realGNP 2.8% 2.2% 3.0% 3.0% 3.0% TLira reatdpr 0.0% 0.0% 0.0% 0.0% 0.0% Underlying growth rates: For.inc.elast.of imp.: 1.4 M.exp 7.9% 7.1% 8.2% 8.2X 8.2% travcr 15.0% 15.0% 15.0% 15.0% 15.0% Dom.inc.elast.of imp 1.2 M.imp 8.8% 10.0% 10.0% 10.0% 10.0% othothc 7.9% 7.1% 8.2% 8.2% 8.2% othothd 8.8% 10.0% 10.0% 10.0% 10.0%

ExogenousExp.price increase -1.5% -1.5% QuantityResponse -1.5% -1.5% ExogenousImp.price increase QuantityResponse

Low Case, Results: Actual: ScenarioProjections: EffectiveGrowth Rates: (xt/xt-1)-1

1987 1988 1989 1990 1991 1992 1993 88 89 90 91 92 93

TradeBaLance -3229 -1800 -3422 -4501 -5572 -6375 -7278 MerchandiseExports 10322 11846 12443 12950 13624 14741 15949 14.8 5.0 4.1 5.2 8.2 8.2 MerchandiseImports -13551 -13646-15864 -17451 -19196 -21116 -23227 0.7 16.3 10.0 10.0 10.0 10.0 other GoodsServ.Inc.cr 4111 5945 6244 6882 7640 8489 9441 Travel 1476 2355 2474 2845 3271 3762 4326 59.6 5.0 15.0 15.0 15.0 15.0 Other 2635 3590 3771 4038 4369 4727 5115 36.2 5.0 7.1 8.2 8.2 8.2 other GoodsServ.lnc.deb -4282 -4812 -5703 -6061 -6515 -7077 -7776 Interest -2507 -2799 -3363 -3487 -3683 -3962 -4350 11.6 20.2 3.7 5.6 7.6 9.8 Other -1775 -2013 -2340 -2574 -2832 -3115 -3426 13.4 16.3 10.0 10.0 10.0 10.0

TotalGoods Serv. Income -3400 -667 -2881 -3680 -4447 -4963 -5613

PrivateUnreq.transf.cr. 2088 1825 1824 1824 1824 1824 1824 -12.6 -0.1 0.0 0.0 0.0 0.0 WorkersRemittances 2021 1755 1755 1755 1755 1755 1755 -13.2 0.0 0.0 0.0 0.0 0.0 Other 67 70 69 69 69 69 69 4.5 -1.4 0.0 0.0 0.0 0.0

PrivateUnreq.transf.deb. -22 -19 -19 -19 -19 -19 -19 -13.6 0.0 0.0 0.0 0.0 0.0 officialUnreq.transf.cr. 352 364 363 363 363 363 363 3.4 -0.3 0.0 0.0 0.0 0.0

Non-int.Curr.Acct.SurpLus 1525 4302 2650 1975 1404 1167 905 Curr.Acct.Balance -982 1503 -713 -1512 -2279 -2795 -3445 - 135 - Annex I Attachment

WORLD BANK RXD DEBT STRATEGY MODULE

w~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~------...... __g

DEBT AND INTERNATIONAL FINANCE DIVISION INTERNATIONAL ECONOMICS DEPARTMENT

April 1989 - 136 - Annex 1 Attachment THE IECDI DEBT STRATEGY MODULE

RATIONALE

Providing sound advice on debt management is increasinglyimportant to the Bank's mission. To provide this advice, economists must be able to model and quantify the consequencesof certain "what if" scenarios on the overall debt burden of a given borrower country. In simple cases these scenarios may show the effect on one borrower's debt and debt service requirementsof assumptions on the world economic outlook, such as future fluctuations of interest and exchange rates. More sophisticated scenarios include debt reorganization possibilities, such as reschedulings, write-offs, debt conversions, debt buybacks, or debt-equity swaps. The Debt Strategy Module (DSM) is a new tool developed by the InternationalFinance and Debt Division (IECDI) to assist Bank staff in performing these types of analyses.

The DSM is an extension of the RXD system, which manages the Bank's Debt Database. This module allows an analyst to combine loan-level detail on existing debt stock with the analyst's own assumptions about trends in the borrower's macroeconomic indicators, world interest rates, currency exchange rates, new borrowing, and debt reorganization. A completed strategy provides an overview of the Borrower's financial future under the assumptions contained in the strategy's input components. Because the analyst can alter these assumptions easily, alternatives can be quickly assembled and examined.

The projection "engine" at the heart of the RXD system generates the consequences of the strategy inputs using detailed information in the borrower's file. The results are aggregated and relevant debt-related parameters, such as debt service ratios, are projected. The projection period for a strategy can range from the short term (one to three years beyond the last historical data in the database) to the long term (20-plus years). This flexibility can make DSM a valuable tool in many areas of Bank work, including:

IECDI Work

o Short-term projections to expedite production of SAVEM tables

o Long-term, detailed projections for individual countries

o Short-term, country-specific projections for input to the Capital Flow Model, which in turn generates long-term projections for the world.

Work in the fterations Complex

o Support for Economicand SectorWork (ESW) and preparationof Country Economic Memoranda - 137 - Annex I Attachment o Issue-specific,rapid-response analyses by the Country Department economists, as part of the Bank's on-going advisory relation with borrowers,

o Sensitivity of debt management plans to changes in interest rates, exchange rates, and the borrower's economy.

Work in the Finance Complex

o Portfolio assessment (percentageof IBRD lending in projected total lending)

In short, DSM gives the department and others in the Bank a way to make greater use of the data accumulated in the Debt Database. It gives access to IECDI's wealth of data on current debt, plus a framework for testing the effects of various alternative assumptions on the future debt and debt service burden of a particular borrower.

RELATION TO RMSM

The question arises: when should the DSM be used instead of RMSM (Revised Minimum Standard Model)? RMSM has the advantage of linking debt variables to balance-of-paymentsand domestic production data. The advantage of DSM is that debt-relatedvariables can be examined in detail, and forecastscan be made with more precision. For example, complexassumptions regarding interest and exchange rate movements can be incorporatedinto the DSM with ease, but in RMSM only with great difficulty. Also, DSM results can be imported into RMSM or other models.

Therefore, the answer hinges on how much detail the analyst needs to present regarding the balance of payments. If the balance of payments segment can be reduced to 7 variables, the DSM can be used. However, if the key interest in the projection exercise is the overall performance of the economy, and if considerabledetail is required on the balance of payments, then working directlv in RMSMwill be advantageous.

DSM INPUTS AND OUTPUTS

Figure 1 diagrams the major input components that define a strategy and the results obtained when the strategy is run.

O The Debt Stoc comprises the existing loans to the Borrower from all non-domestic sources, as recorded in the Debt Database. Future disbursementand payment streams from the Borrower's debt stock are projected for each year in the strategy period.

o The CountrX Scenario is a set of gross economic indicatorsfor the Borrower. It includeshistorical data for past years, retrievedfrom the reference files of the database, plus future-year estimates by the analyst. The indicators required for the fullest use of DSM's capability are GDP, exports and imports of GNFS, reserve stocks,and the non-interest current account balance. (The current account - 138 - Annex 1 Attachment balance net of interest payments must be used, since DSM projects interest payments as a result of the model.)

Debt Stocke (from Debt Databasc)e

Standard Countryon Scenao Reports STRATEGY Logic \_ ASSUM inONS \ F New BofEowings Debt Reorganization ni c t s sumrie in4t TItSATEGY ourPrIT t\ 2 ~~~~~FILEI SCENARIOFILES ~

Country Scenario /Optional / /File / co ScenarioceAmWorld a Interest Rates

Pigure 1. Input and Output Components of a Strategy o World financial conditions are summarized in the World Scenario component. A World Scenario comprises an Interest Rate Scenario and an Exchange Rate Scenario. Each scenario begins with one year of historical data from the database's reference files and continues forward through the projected years of the strategy. The analyst can use Planning Assumption Committee (PAC) estimates, available within RXD, for key interest rates and exchange rates. The analyst can also manually enter his or her own estimates. DSM provides built-in functions to project estimates for rates not supplied by PAC. In addition, an interest rate parity function for projecting exchange rates is available. o Currently, DSM supports strategy-specific assumptions about prospective new lending (New Borrowings),debt reorganization,or both at once. A debt reorganization may take the form of a rescheduling,refinancing, deferral, annulment, or some combination of these more specializedactions. o The analyst can fine-tunea strategyby adding SelectionLogic. This componentallows the analyst to select and reclassifyloans from the - 139 - Annex 1 Attachment debt stock and to set up useful classificationsfor new borrowings or the results of debt reorganization.

Once all the input components of a strategy have been defined, the model's results are computed by running the strategy. Each strategy run produces a Financial Reauirements Table and an output file.

O Samples of the Financial Requirements Table are included in the attached Exhibits. The Base Case table shows a country'sprojected debt situation with conventional rescheduling and sufficient new borrowings to balance the annual finance gap. Each additionalcase shows the effect of a specific combination of debt reduction and debt reorganizationactions. These can be compared with each other as well as with the Base Case.

o The output file contains the results of the strategy and can be used to produce a variety of standard reportsin addition to the Financial RequirementsReport. It can also be used to produce data interchange files for use in other computer-basedpackages.

Additional Table Outputs

Using the output file, the analyst can request standard tables from the system. Each table shows an important aspect of the strategy in a labeled, presentation-readyformat. In addition to the FinancialRequirements Table, the user specifies parameters in one table set-up panel to produce any of the following tables:

o The Debt Strategy Detail Table gives details of standard debt characteristics for groups of existing loans or new borrowings, disaggregated into categories of interest to the user.

O The Creditor Profile provides a summary of the terms and currency mix offered by major groups of creditors to the Borrower over an eight-year period. Using one date field in the set-up panel, the analyst determinesthe startingyear for the table. Thus, a Creditor Profile can be run for the eight years preceding the strategyperiod, to see the borrower's recent credit history. Or the analyst can run the table for the strategy period, to summarize the prospective creditors and terms envisioned in the completed strategy.

O The New LendingAssumptions table shows gross disbursementsover the strategy period split between the debt stock (from the database)and the new borrowings added by the strategy. The percentage of new borrowings in each currency is also shown.

o World Scenario Tables are produced from the correspondingScenario files. The analystcan produce a rate table from any of the Interest Rate or Exchange Rate Scenarios. - 140 - Annex 1 Attachment Data Interchange Files as Strategv Output

The DSM gives the analyst options to produce, from the initial strategy output, data transfer-files in different formats. The formats are designed to allow direct import into analytical packages used by Bank economistsand other analysts. Currently, the DSM supports translationsfor import to LOTUS 1-2-3 and to RMSM.

SPECIAL FEATURES

The DSM panel sequenceshave been designed for use by a wide user community with no previous experiencewith RXD. There are additionalfeatures that lighten the user's input burden or automate routine computations.

o Access to PAC estimates. DSM has system-maintainedbase scenarios, consisting of the PAC estimates for future interest rates and currency exchange rates. Any DSM user can use these scenarios directly as strategy inputs or can copy them as a starting point for tailored scenarios.

o ProjectionFunctions. Developingmultiple-year scenarios for a dozen or more interest rates or currency exchange rates usually involves estimating one or more key rates, then calculating proportional changes in the others. Through extensiveconsultation with IEC staff and Country economists, projection functions have been built into DSM to perform frequently-usedcomputations at the user's request.

Exchange rates for an unestimated currency can be projected as a weighted average of currencies for which estimates are given. The analyst controls the choice of base currenciesand their relative weights.

- Exchange rates can also be projected under the assumptionof interest rate parity across currencies, using the relations among interest rates in one historical period.

o IBRD exchange rate. The World Scenario tables include an IBRD exchange rate, which DSM automaticallycomputes as a currency mix. The computationalgorithm allows for transitionsfrom a current IBRD currency mix to a target mix in the future. - 141 - Annex 1: Figure 1

World Scenario 1: Assumptions

Exchange Rates Interest Rates 9 (USlICurrency Rate 10 (Percent)

9 / 10 (Percent ; ~~~~~~~~~~~~~~~8

6 35 Lstg Eua 4

3

-1 2 88 89 90 91 92 93 94 95 88 89 90 91 92 93 94 95

World Scenario 2: Alternative Exchange Rates (USS/Currency Rate )

9

7

5

3

1 5wf . . DM- FF 88 89 90 91 92 93 94 95 - 142 - ANNEX 2.1 SELRCTEDDBBI INDICATORSAND DEBB RAlTOS - TURKEY (in Million of US)

1 13#1 1#1 136 1364 I#S 1i6 1#67 19U

DektSteels (fD ) 19,U8 19,131 19,67S 26,287 2s15 25,76 32,733 40,932 39,067 Long-Tern (DOD) 15,496 15,665 16,068 15,683 15,635 18,034 22,308 27,824 27,221 Official Creditors 9,523 10,019 10,510 10,327 10,246 12,388 15,040 18,292 17,508 IBRD 1,158 1,546 1,962 2,336 2,358 3,432 4,662 6,290 6,130 Private Creditors 5,974 5,646 5,548 5,355 5,389 5,645 7,268 9,532 9,714 Use of IMF Credit 1,054 1,322 1,455 1,567 1,426 1,326 1,085 770 299 Short-Term 2,490 2,194 1,347 1,788 2,728 3,939 5,603 6,726 5,640 Dresdner 0 0 818 1,249 1,774 2,677 3,787 5,612 5,897 Grow DisIurmmetm 3,6" 2,438 3,227 3,012 4,363 4,244 6,749 *,590 5,8S6 Long-Term 2,436 1,969 2,094 1,628 2,511 2,788 3,733 4,616 4,969 Official Creditors 1,543 1,503 1,426 1,075 1,746 1,547 1,545 1,734 2,029 IBRD 313 454 500 486 628 636 6S6 787 832 Private Creditors 893 455 668 553 765 1,241 2,188 2,883 2,940 IMF Purdch 640 472 331 370 173 0 0 0 0 Short-Term 490 0 0 441 940 1,211 1,664 1,123 0 Dresdner 0 0 802 573 769 344 352 850 926 AuwtlUiem 747 1,211 2,161 1,3 1,2' 2,614 2,3" S,44 5,719 Long-Term 592 797 1,185 1,159 1,165 2,363 1,993 3,020 4,202 Officil Creditors 372 323 663 727 680 989 901 1,324 1,830 IBRD 45 63 84 112 126 155 235 316 472 Private Creditors 219 474 522 432 485 1,374 1,092 1,696 2,372 IMF Repurchases 155 107 129 180 216 251 376 445 431 Short-Term 0 296 847 0 0 0 0 0 1,086 Dresdner 0 0 0 0 0 0 0 0 0 latweet Pay6ems 324 1,462 1,56 158 1,725 1,013 2,132 2,607 2,719 Long-Term (INT) 501 980 1,117 1,158 1,119 1,240 1,323 1,521 1,728 Official Creditors 207 S49 474 618 597 700 819 908 1,071 IBRD 88 101 126 162 199 245 354 460 535 Private Creditors 294 631 64S 540 522 540 504 613 657 IMF Charges 51 96 149 153 179 161 123 82 9 Short-Term 272 416 257 161 258 289 342 423 473 Dresdner 0 0 42 111 169 223 344 482 589 Det Sue. 1,571 2,662 3,72 2,922 l,1i 4,527 4,601 6,972 8,518 Long-Term(TDS) 1,093 1,777 2,302 2,317 2,284 3,603 3,316 4,541 5,930 Official Creditors 579 672 1,138 1,345 1,277 1,689 1,721 2,232 2,901 Private Creditors 514 1,106 1,165 972 1,007 1,913 1,596 2,309 3,029 IMF Credit 206 203 277 333 396 412 499 527 440 Short-Term 272 712 1,104 161 258 289 342 423 1,559 Dresdner 0 0 42 111 169 223 344 482 589 Not Fbw 2,819 1,2 1,6 1,673 3,612 1,729 3388 3,124 177 Long-Term 1,844 1,162 908 469 1,346 426 1,740 1,596 767 Official Creditors 1,170 1,180 762 348 1,066 58 644 410 199 Private Creditor 674 -18 146 121 280 -133 1,096 1,187 569 IMF Credit 485 364 203 190 -43 -251 -376 445 -431 Short-Term 490 -296 -847 441 940 1,211 1,664 1,123 -1,086 Dresdner 0 0 802 573 769 344 352 850 926 Net T des 1,$6 -261 -410 1,28 -18 1,248 617 -2,623 Long-Tenn 1,343 182 -209 -688 227 -814 417 75 -961 Official Creditors 964 832 288 -269 469 -142 -176 -498 -871 Private Creditors 380 450 -497 -419 -242 -672 593 574 -90 IMF Credit 433 269 54 37 -222 -412 -499 -527 -440 Short-Term 218 -712 -1,104 280 682 922 1,322 700 -1,559 Dresdner 0 0 760 462 599 121 8 369 338 Mareesmsi e1ai_atrs GroasNational Product (GNP) 55,801 56,240 51,543 49,683 48,228 51,445 56,503 67,496 70,263 Growth (%) -18.4 0.8 -8.4 -4.6 -2.9 6.7 9.8 19.5 6.7 Exports Including Workers Rem. (XGFS) 5,742 8,509 10,068 9,459 11,562 13,101 12,467 16,454 19,542 Growth (%) 23.2 48.2 18.3 -6.0 22.2 13.3 -4.8 32.0 18.8 Importsof Goods and Services(MGS) 9,251 10,510 11,157 11,629 13,276 14,415 14,310 13,551 13,646 Growth (%) 49.4 13.6 6.2 4.2 14.2 8.6 -0.7 -5.3 0.7 Reserve Stocks (RES) 3,298 2,426 2,802 2,728 2,442 2,318 2,966 3,254 3,672 MGS (%) 36.7 23.1 25.1 23.5 18.4 16.1 20.7 24.0 26.9 Cunrent Account Balance 4,409 -1,916 -985 -1,898 -1,487 -1,030 -1,528 -982 1,503 Toeal 1xtm Deb RatSi EDT / XGFS (%) S31.6 225.4 196.5 214.5 186.5 198.3 263.0 248.7 199.9 EIYDTGNP(%) 34.1 34.1 38.2 40.8 44.7 50.5 58.0 60.6 55.6 Debt Service/XGFS(96) 27.4 28.2 28.6 30.9 26.9 34.6 36.1 36.3 3S.0 RESI EDT() 17.3 12.6 14.2 13.4 11.3 8.9 9.0 8.0 9.4 RES / MGS (months) 4.3 2.8 3.0 2.8 2.2 1.9 2.5 2.9 3.2 INT/XGFS(%) 14.4 17.5 15.5 16.7 14.9 14.6 17.1 15.2 14.2 INT/GNP(%) 1.5 2.7 3.0 3.2 3.6 3.7 3.8 3.7 3.9 Short-TermDebt (X) 13.1 11.4 11.0 15.0 20.9 25.5 28.6 30.1 29.5 Variable Rate Debt (%) 40.2 39.2 35.8 37.7 42.S 42.1 43.7 44.2 44.5 - 143 - ANNEX 2.2 FINANCIALRBQUUUMENIS TABLL - TUURKY 0H4 C- Int Putty SMezi - Ia MYIll. &1US)

1167 1S8 11 111 S"I lse 19

De Steebs (EI 40,9 39,067 39,177 39,278 39,689 46,U6 41,973 Long-Term (DOD) 27,824 27,221 27,868 29,094 29,277 29,885 31,076 Offidal Creditors 18,292 17,506 18,549 18,661 18,930 19,275 19,828 Private Creditors 9,532 9,713 9,320 10,433 10,347 10,610 11,249 Use of IMF Credit 770 299 0 0 0 0 0 Short-Term 6,726 5,640 5,199 3,852 3,852 3,852 3,852 Dresdner 5,612 5,897 6,110 6,332 6,560 6,799 7,044 Gram DIsAaus 8,591 65,S 4,9 4,774 3,878 4,69 6,134 Long-Term 4,616 4,969 4,209 4,774 3,878 4,589 5,134 Official Creditors 1,734 2,030 2,401 1,942 1,900 1,959 1,997 Private Creditors 2,883 2,939 1,807 2,832 1,978 2,630 3,136 Short-Term 1,123 0 0 0 0 0 0 Dresdner 850 926 0 0 0 0 0 A-etimt_is 3,486 5,719 4,#0 5,409 4,214 4,544 4,54 Long-Term 3,020 4,202 4,269 4,013 4,214 4,534 4,546 Official Creditors 1,324 1,830 1,906 2,119 1,930 1,941 1,794 Private Creditors 1,696 2,372 2,362 1,894 2,284 2,592 2,751 IMF Repurchases 445 431 250 49 0 0 0 Short-Term 0 1,086 441 1,347 0 0 0 Istaot Payne,"a 207 2,719 3,276 3212 3,200 3,224 3,311 Long-Term (INT) 1,521 1,728 2,113 2,126 2,154 2,152 2,220 Official Creditors 908 1,071 1,233 1,238 1,218 1,2S4 1,267 Private Creditors 613 657 881 887 935 918 953 IMF Charges 82 9 23 4 0 0 0 Short-Term 423 473 489 408 348 348 348 Dresdner 482 589 651 674 699 724 750 De-btS.. 6,972 8,618 8C 8,62 7,414 7,767 7,864 Long-Term(TDS) 4,541 5,930 6,382 6,139 6,368 6,686 6,766 Ofricial Creditor 2,232 2,901 3,139 3,358 3,148 3,175 3,062 Private Creditors 2,309 3,029 3,243 2,781 3,220 3,510 3,704 IMF Credit 527 440 273 53 0 0 0 Short-Term 423 1,559 930 1,755 348 348 348 Dresdner 482 589 651 674 699 724 750 Not Nw. 3,124 177 -761 43 437 56 88 Long-Term 1,596 767 -60 761 -337 56 588 Official Creditors 410 200 495 -178 -30 18 203 Private Creditors 1,187 568 -555 939 -306 38 385 IMF Credit -445 -a3 -250 -49 0 0 0 Short-Term 1,123 -1,086 -441 -1,347 0 0 0 D"sdner 850 926 0 0 0 0 0 Not Tr1adws 617 -2,63 -4,27 4,847 4,537 4,168 -2,730 Long-Term 75 -961 -2,173 -1,366 -2,490 -2,096 -1,632 Official Creditors -498 -871 -738 -1,416 -1,249 -1,216 -1,064 Private Creditors 574 -90 -1,436 51 -1,242 -881 -568 IMFCredit -527 -440 -273 -U 0 0 0 Short-Term 700 -1,559 -930 -1,755 -348 -348 -348 Dresdner 369 338 451 -674 -699 -724 -750 M _aaomieladeteu Real GNP Growth (%) 4.0 5.0 5.0 5.0 5.0 Gross National Product (GNP, Current US$) 67,496 70,263 77,788 84,788 92,418 100,735 109,801 Export Eamings Incidg Workers Rem. (XGS) 16,454 19,542 21,031 22,537 24,347 26,330 28,502 Growth (%) 32.0 18.8 7.6 7.2 8.0 8.1 8.2 Imports of Goods and Services(MGS) 13,551 13,646 14,958 16,604 18,430 20,457 22,708 Growth (%) -5.3 0.7 96 11.0 11.0 11.0 11.0 Reserve Stocs (RES) 3,254 3,672 4,285 4,713 5,185 5,703 6,274 MGS (%) 24.0 26.9 28.6 28.4 28.1 27.9 27.6 Current Account Balance -982 1,503 995 676 401 32 -473 TOWalEteml Det Ratbe EDT / XGS t%) 248.7 199.9 186.3 174.3 163.0 154.0 147.3 EDT I GNP (%) 60.6 55.6 50.4 46.3 42.9 40.2 38.2 Debt Service l XGSt%) 36.3 38.0 37.1 32.3 30.5 29.5 27.6 RES / EDT (%) 8.0 9.4 10.9 12.0 13.1 14.1 14.9 RES I MGS (months) 2.9 3.2 3.4 3.4 3.4 3.3 3.3 INT/XGS(%) 15.2 14.2 15.6 14.3 13.1 12.2 11.6 INT/GNP(%) 3.7 3.9 4.2 3.8 3.5 3.2 3.0 Short-Term Debt (%) 30.1 29.5 28.9 25.9 26.2 26.3 26.0 Variable Rat Debt (%) 4.2 44.5 43.3 43.4 4.6 44.9 45.6

1. Items To Finance (a+b+c+d) -4,768 -4,292 -4,209 -4,775 -3,879 4,592 -5,142 a Non-Intrest Cur Acc Bal (NICAB) 1,525 4,302 4,271 3,888 3,601 3,256 2,845 b Changesin Resrves -289 -418 -613 -428 -472 -518 -571 c Other Non-Debt Capital Account 81 326 369 387 406 427 448 d Debt ServiceDue 4,080 -8,518 -8,236 -,622 -7,414 -7,757 -7,864 2. Inflows From Disbursements 6,590 5,896 4,209 4,774 3,878 4,589 5,134 3. Net Non-Int. Finance Gap (a+b+c) 1,313 4,194 4,027 3,847 3,55 3,165 2,722 4. RemainingFinance Gap(I+2) 1,822 1,603 0 0 0 0 0 - 144 - ANNEX 2.3

FINANCIAL REQUJUEMINlI TABLE - TURKEY (Md C - It~ Pe S_ylia - a Mili OsUSB i167 1NS Iet 1919 l5 am DeS SJeeks(BDI') 40,1W2 8657 40,2S7 41,W 44,690 47,143 61,2 Long-Term(DOD) 27,824 27,221 28,962 30,363 32,335 35,145 38,986 Official Creditors 18,292 17,506 18,496 18,611 18,883 19,232 19,788 Private Creditors 9,532 9,713 10,467 11,752 13,452 15,913 19,196 Use of IMF Credit 770 299 0 0 0 0 0 Short-Term 6,726 5,640 5,199 C,l99 5,199 5,199 5,199 Dresdner 5,612 5,897 6,110 6,332 6,560 6,799 7,044 Gns Disbsaalt 6,5AN SAN ,873 S,1M A,lW S,7I 7,824 Long-Term 4,616 4,969 5,373 5,162 5,908 6,796 7,824 Official Creditors 1,734 2,030 2,400 1,941 1,899 1,959 1,997 Private Creditors 2,885 2,989 2,974 3,221 4,009 4,837 5,826 Short-Term 1,123 0 0 0 0 0 0 Dresdner 850 926 0 0 0 0 0 A sawds 8445 5719 4957 4,87 4,480 4,674 4,777 Long-Term 3,020 4,202 4,266 4,258 4,499 4,674 4,777 Official Creditors 1,324 1,830 1,906 2,118 1,929 1,940 1,793 Private Creditors 1,696 2,372 2,361 2,140 2,571 2,735 2,984 IMF Repurdia 445 431 250 49 0 0 0 Short-Term 0 1,006 441 0 0 0 0 Itemb Paymmi 3?7 2,7M 8,488 8,461 3IM 4,6 4,401 Long-Term(INT) 1,521 1,728 2,263 2,421 2,546 2,755 3,096 Offrcial Creditors 906 1,071 1,257 1,288 1,274 1,301 1,346 Private Creditors 613 657 1,006 1,133 1,272 1,454 1,749 IMF Charges 82 9 23 4 0 0 0 Short-Term 423 473 654 556 56 56 556 Dresdner 482 589 661 674 699 724 750 DeL seie 5,72 8,5618 8,440 7,62 SM SIM,7 9,17 Long-Term(TDS) 4,541 5,9S0 6,529 6,680 7,046 7,430 7,873 Official Creditors 2,232 2,901 3,162 3,406 3,203 3,241 3,139 Private Creditors 2,309 3,029 3,367 3,274 3,843 4,188 4,734 IMF Credit 527 440 273 53 0 0 0 Short-Term 423 1,559 987 556 556 556 556 Dreadner 482 589 651 674 699 724 750 Not Fbw 3S,124 177 417 864 1,480 2,122 3,544 Long-Term 1,596 767 1,108 903 1,409 2,122 3,046 Official Creditors 410 200 495 -177 -29 20 204 Private Creditors 1,187 568 612 1,080 1,438 2,102 2,842 IMF Credit 445 -41 -250 -49 0 0 0 Short-Term 1,123 -1,066 -441 0 0 0 0 Dresdner 850 926 0 6 0 0 0 NotTTrande 617 -2,62 4,11" -2,1 -2,m -1,91S -1,265 Long-Term 75 -961 -1,156 -1,518 -1,137 -653 -49 Official Creditors -498 -871 -762 -1,465 -1,304 -1,282 -1,142 Private Creditors 574 -90 -394 -53 166 648 1,093 IMF Credit 427 40 -273 -53 0 0 0 Short-Term 700 -1,559 -987 -554 -556 -556 -556 Dresdner 369 338 -51 -674 -699 -724 -750 _aaoe.crl _lndiea Real GNP Growth (%) 4.0 5.0 5.0 5.0 5.0 Gross National Product (GNP, Current USS) 67,496 70,263 73,776 77,464 81,338 88,658 96,637 Export Earninp Incldg Workers RenL (XGS) 16,454 19,542 20,616 22,096 23,871 25,817 27,961 Growth (X) 32.0 18.8 6.5 7.2 8.0 8.2 8.3 Imports of Goods and Services(MGS) 13,551 13,644 15,504 17,210 19,103 21,204 23,536 Growth (%) -5.3 0.7 13.6 11.0 11.0 11.0 11.0 Reserve Stocks (RES) 3,264 3,672 4,285 4,713 5,185 5,703 6,274 MGS (%) 24.0 26.9 27.6 27.4 27.1 26.9 26.7 Current Account Balance -982 1,503 -173 -815 -1,347 -2,038 -2,935 Toel EtIral Det Rail EDT I XGS (%) 248.7 199.9 195.3 189.6 184.7 182.6 183.3 EDTIGNP(%) 60.6 55.6 54.6 54.1 54.2 53.2 53S0 Debt Servict I XGS (%) 36.3 38.0 38.8 36.0 34.8 33.7 32.8 RES/EDT (X) 7.8 9.4 10.6 11.3 11.8 12.1 12.2 RES / MGS ('nonths) 2.9 S.2 3.3 3.3 3.3 3.2 3.2 INT I XGS (%) 15.2 14.2 16.9 16.5 15.9 15.6 15.7 INT/GNP (%) 3.7 3.9 4.7 4.7 4.7 4.6 4.6 Short-TermDebt (%) 30.1 29.5 28.1 27.5 26.7 25.4 23.9 Variable Rate I) (%;) 44.2 44.5 45.0 46.4 47.3 49.0 50.8 Fi_1da Rsqdmas 1. Items To Finanve (a+b+c+d) -4,768 -4,292 -4,374 -5,163 -5,913 4,803 -7,837 a Non-Interest Cur Acc Bal (NICAB) 1,520 4,286 3,310 2,840 2,453 1,997 1,465 b Changes in Renrves -289 -418 -613 -428 -472 -518 -571 c Other Non-Debt Capital Account 81 326 369 387 406 427 448 d Debt Service Du. 4,080 -8,518 -4,440 -7,962 -8,300 -8,709 -9,179 2. Inflows From Distzrsementa 6,590 5,896 5,373 5,162 5,908 6,796 7,824 S. Net Non-mt. Fnanme Gap(a+b+c) 1,31S 4,194 3,066 2,799 2,387 1,906 1,S42 4.RemainingFinanceGap(1+2) 1,822 1,603 0 0 0 0 0 - 14 5 - ANNEX 2.4 FNANCIAL RPQUIRLMBN1S TABI - TURKY (Lw Casm- NoUye To of TreI Shoi - b bosoPaty S.e...i - le MsIm d US$)

i167 less " 194r 1"s,11u in Do llt eeks(EDI) 40,91 36,067 46,965 4,4 46,311111 524 SO9N Long-Term(DOD) 27,824 27,221 29,596 31,711 34,38 38,256 42,662 Official Creditors 18K292 17,546 1,549 18,661 18,950 19,275 19,828 Private Creditors 9,532 9,713 11,047 13,060 15,70S 18,981 22,834 UseofIMF Credit 770 299 0 0 0 0 0 Short-Term 6,726 5,640 5,199 5,199 ,199 5,199 5,199 Dresdner 5,612 5,897 6,110 6,332 6,560 6,799 7,044 GrossDishuesumIs ,5 5IM 5,93 5,8 6,57, 7,8 S ,626 Long-Term 4,616 4,969 S,936 5,883 6,870 7,698 8,626 Official Creditors 1,734 2,030 2,401 1,942 1,900 1,959 1,997 Private Creditors 2,883 2,9S9 3,S3 3,941 4,970 6,738 6,628 Short-Term 1,123 0 0 0 0 0 0 Dredrner 850 926 0 0 0 0 O AusUrnli 3,466 5,719 4,9411 431O 4,61 4,786 56,8 Long-Term 3,020 4,202 4,269 4,261 4,502 4,789 5,036 Offical Creditors 1,324 1,830 1,906 2,119 1,960 1,941 1,794 Private Creditors 1,696 2,372 2,362 2,142 2,572 2U848 3,242 IMF Reprduah 4465 431 260 49 0 0 0 Short-Term 0 1,086 441 0 0 0 0 1trs Paymss 2,57 2,798 "3 3,487 3,68 3,6 4,311 Long-Term (INT) 1,521 1,728 2,200 2,339 2,515 2,769 3,131 Offical Creditors 908 1,071 1,233 1,238 1,218 1,234 1,267 Private Creditors 613 667 967 1,101 1,297 1,534 1,863 ItF Charge 82 9 23 4 0 0 0 Short-Term 423 473 489 469 469 469 469 Dreldner 482 S89 651 674 699 724 750 Dot SerSe 5,172 86511 8"2 7,767 8,185 1,761 ,384 Long-Term (TDS) 4,641 5,950 6,469 6,601 7,018 7,558 8,167 Officlk Creditors 2,232 2,901 3,139 3,358 3,148 3,175 3,062 Private Creditors 2,309 3,029 3,329 3,243 3,869 4,383 5,105 IMF Credit 527 440 273 53 0 0 0 Short-Term 423 1,559 930 469 469 469 469 Dreedner 482 S89 661 674 699 724 750 Not Pima 3,114 177 977 1,573 2,368 2,989 3,690 Long-Term 1,596 767 1,668 1,622 2,368 2,909 3,590 Official Creditors 410 2G0 495 -178 -30 18 203 Private Creditors 1,187 568 1,173 1,800 2,398 2,890 3,386 IMF Credit 445 -41 -260 -49 0 0 0 Short-Term 1,123 -1,066 -441 0 0 0 0 Dreedner 850 926 0 0 0 0 0 Not TraNsur 617 -2,33 -2,8 -1,914 -1,316 -1,116 -760 Long-Term 76 -961 -633 -717 -147 140 459 Official Creditors -498 -871 -738 -1,416 -1,249 -1,216 -1,064 Private Creditors 574 -90 206 699 1,101 1,366 1,523 IMF Credit -527 -440 -273 -53 0 0 0 Short-Term 700 -1,569 -930 -469 -469 -469 -469 Dreedner 369 358 -651 -674 -69 -724 -750 Ma=WeseIdC..eRtAinl Real GNP Growth t%) 4.0 5.0 5.0 6.0 5.0 Gross National Product (GNP, Current US$) 67,496 70,263 73,776 77,464 81,338 88,668 96,637 Export Eaming Incldg Workers Rem. (XGS) 16,454 19,542 20,966 22,476 24,292 24,980 27,140 Growth (%) 32.0 18. 7.3 7.2 8.1 2.8 8.6 Imporb of Goods and Services(MGS) 13,561 13,646 16,870 17,457 19,203 21,123 23,236 Growth (%) -5.3 0.7 16.3 10.0 10.0 10.0 10.0 ReserveStocks (RES) 3,254 3,672 4,285 4,713 5,185 5,703 6,274 MGS (%) 24.0 26.9 27.0 27.0 27.0 27.0 27.0 Currant Account Balance -982 1,506 -733 -1,533 -2,308 -2,821 -3,474 Toal Bxtr Dokt Rad EDT I XGS (%) 248.7 199.9 195.1 192.4 191.0 201.2 202.3 EDT / GNP (%) 60.6 55.6 56.4 55.8 57.0 56.7 56.8 Debt Service/ XGS (9) 36.3 38.0 37.6 34.7 33.7 35.0 34.6 RES I EDT (%) 8.0 9.4 10.5 10.9 11.2 11.3 11.4 RES I MGS (months) 2.9 3.2 3.2 3.2 3.2 3.2 3.2 INTJXGS(%) 15.2 14.2 16.0 15.5 15.2 15.9 16.0 INT I GNP (%) 3.7 3.9 4.6 4.5 Ls 4.5 4.5 Short-TermDebt (%) 30.1 29.5 27.6 26.7 25.3 23.9 22.3 Variable Rate Debt (%) 44.2 44.5 46.7 47.9 48.3 50.7 52.6

1. Items To Finance (a+ b+ c+d) 4,768 -4,292 -5,937 -5,884 4,871 -7,701 -8,633 a Non-Ineret Cur Acc Bal (NICAB) 1,520 4,286 2,630 1,954 1,380 1,141 876 b Changes in Resves -289 -418 -613 -428 -472 -518 -571 c Other Non-Debt Capital Account 81 326 369 387 406 427 448 d Debt Service Dtw -6,080 4,518 -8,323 -7,797 -8,185 -8,751 -9,386 2. Inflows From Disabursmente 6,590 6,896 5,936 5,883 6,870 7,698 8,626 3. Net Non-lnt. Finnce Gap(a+b+c) 1,313 4,194 2,S86 1,913 1,314 1,050 753 4.RemainingFinanceGap(1+2) 1,822 1,603 0 0 0 0 0 - 146

Annex 2: Figure 1

Turkey

Disbursements Amortization (US$ Billions) (USS Billions)

4 4

3 3

2 2

1 1

0 0 88 89 90 91 92 93 94 95 88 89 90 91 92 93 94 95

Net Flows Net Transfers (USS Billions) 0 (USS Billions)

~~~~~~~~~~-22

-3 -3

-4 -4

-5 -5 88 89 90 91 92 93 94 95 88 89 90 91 92 93 94 95

Official Bilateral IBRD Other Multilateral Financial Markets Suppliers Private Nonguaranteed TURKEY: External Financing Requirements, 1984-89 (in millions of $)

1989 1989 1984 1985 1986 1987 1988 Target Revised Estimate

A. OUTFLOWS 3393 4083 4232 5313 5266 4270 4300 Repayments 1104 1858 2145 2657 3927 3800 4050 IMF Repurchases 138 103 241 344 467 235 250 Credits Extended 573 296 253 842 607 0 0 Portfolio 0 0 0 29 4 0 0 Current Account Deficit 1407 1013 1528 982 - 235 - Net Errors & Omissions - 813 65 459 - 0 - Counterpart Items 171 - - - 261 0 0

B. INFLOWS 1030 858 1344 1711 3179 1425 1904 Current Account Surplus - - - - 1503 - 711 Direct Investment 113 99 125 110 352 300 450 Credit Extended - - - - - 300 200 Dresdner 343 260 385 568 549 575 250 Short Term Deposits 104 276 583 609 428 250 150 Net Errors & Omissions 470 - - - 347 0 143 Counterpart Items - 223 251 424 - 0 0

C. FINANCING REQUIREMENTS 2363 3225 2888 3602 2087 2845 2396

D. FINANCING 2363 3225 2888 3602 2087 2845 2396 Project Credits 733 923 1296 1101 1141 850 1262 Medium & Long Term Credits 1417 912 1374 2561 3167 2220 2808 Short Term Credits 1061 987 823 692 (979) 375 (904) DMBS Reserves (1,052) 423 (60) (103) (821) (250) 80 CB Reserves 204 (20) (545) (649) (421) (350) (850)

SOURCES: Central Bank, Foreign Exchange Dept., Balance of Payments Div. - 148 - Annex 3.2

table 3.2: TIJU,KY- Public Sector External Borrovinas in 1988

C' dit Nam of Credit Sector Guarantor DObtor Creditor or Currency Limit Maturity/ Interest US$"Uillions LeadBank (oi3lIond GracePeriod Rate ValueCs of billioni t,aursl (nrcant) December198U

1. TPO, Csral Ilvrts Agricultiw rCZt rto ccc (US Credit Corporation US0 6. a 25/1 L18 6.8 2. Tm, Cornv[Mortt Agriculture TCZB TM ccC USO 2.luM 3/1 LI8 2.3 3. MassHousing Fund tousir. Ic sElF Jap. Leasing fIt 5,8bn 7 JLTPRtl.l 43.4 4. Ismir Highwa? transport - TC ErringTrust US0 350 35.0

5. General Loan 80t - Treasury (European Re- tettlent Fund) DP l0OOun 10/5 6 s5.0 6. General Loan A _ rTreasury (EuropeanRe- settlement Fund) YEN 3.Obn tOS 5.2S 22.6 7. Turkish SugarFactories. Supplies Credit Manufacturing TC Sugar fac. SIESESAG 0" 5 90n T/0.5 7.00 3.2 8. IDport of Generators 9. Developmentof Manu- f*cturing Etports fanufacturing TC tSltB IttRO uso 100l 17/4 I6AO.0. 100.0 10. TOO,Corn Import Agriculture - TID CCC 11. Japaneso Line for import of Japan*se quip. soP - reasury JapanEIPrIS YEt 10.OOb S V1Srs*SS Variable 75.3 12. Turk. Exiwbank4ondIsse MOP TC TO Dreosder ank Om 200.0. a/5.5 6.75 L09J Total for January 455'8

13. General Loan tOP - Treasury (European Resettle- mnt Fund) SFR 100.0. 10/S 4.875 66.4 14. TCOWIskenderun Divrigi Railway Transport rc TC0O Islamic Dvelop- _nt Sank USO 'tI- 10130entha 8.0 18.1 15. Digital Project Counication TC P7T Goneralo9 (french) BEF 626.0. 6 25 16.4 16. PTt Electronical ToleoponaTransport TC PTI ISKPACOtBERCE (YugO5l&vi5J 350 la.go I LIDa.I(nofoes) 10.0 17. Secondgond Itsuo Iourlsa - tourism S. Nikko Sec. iEt 100.0 Tfn 6.4 r5.3 1B. Trlegcsunication Project Comnication - PIT DEC(Canada) USo 25.0. 10/3n18.0.75 25.0 19. tIzir Highway Trantsort - IC Irv. Trust Cons. USo 97.0 13.5/3S5 .18#5/t8 97J8 Total for February 309.9

20. ResrveoManagement 9OP - TCB BanbkerTrust US0 100.0. 3/3 UVLET 100.0 21. Construction for tourise Tourisi - Tourism AMU Sank 0. 3.0s S/3 Lr.1 .25 1.6 22. Third Bond Issueby the Central Bank ooP TC JCIS CO _ERZBANK DM 300.0. 7 BULLET6.3/4 164.8 23. Purchasingof oquipmnt by ths Eximbenk Manufacturing - - F 4.40 5R0.5 KFW 2.4 24. Purchasing of 4 lieliceptae eofense IC SAGI Ih8O05UE2 Ff 50.0 5/2 L1R50 .25 13.0

2Z. Import Financing Credit Line - Troosury 1i(lTMMt JP3 1.8b S/05 JLPTR*1.0 13.3 26. Purchasingof Modulators by tho Eximbank Maufacturirg - KEW onOPW 1.50 5/0_5 Total for Pbruh 296.0

27.Second End. Training Proj. Edcation - Treasury 18R0 USD 115,.0 1715 18RD.O.5 15.& Zs. Import Fioancing-TCDD Line of Crod. TC 31N03SU3 FF 175.0. 5/1 LISORl .25 28 5 29. IpoFrt Financing-TCSO Transport - TC INOOSZ FF 200J.0 5/1 E.F.O. 32.5 30. 1KB-Lin4 of Leasing Leaving of . Sk I3 e4uipment - TKIS Islamic D0 Ban ISO lO S 31. Kinali-Sakarya 23 motorway-Socsnd Transport TC Treatury Sank of ToQwo JPy 2.00k 3.S/4 JLPTAI1.375 32. Bosphorus Bridge

33. PT? Co_nication TC PTT Hoog-llong Bank USD 4.40 6/1 L10SRO11/4 4 4

34. Ifoort of Cos for grooding Agriculturo - Tr*asury D.6. Sank 0 17.10 T fAi0.5 1 fi . 4 Total for April. tamir i . s o Annex 3.?

trd15 t Np of Credit Sector r,asetor Ib4tr tredit r ' Currency Liset Cssererac814st $Sliillins s Load Bems tSiiliOnIs Gr"e Per fed m&t. VOISOas Of -illius iwersl r Iarant) b(c r '08 csX 35. ODlAS.Natural Gas pipeline Isergy tC loCTAs CCtWC PP fl. 2.5/. 8 .7 12.6 36. BoadIssue sop - Tr"eavry C- lBUS 0.l 500.1 7 e.5 274.7 37. Producties of Triple Phsphte - - Treasury Spnsh Gav, UN 4.w 2U7 (cmncesston&,) 2.3 38. fertiliser Sun 39* Produetion Of Phopate Fortilisar IS_mews) - IC TUCSAS S.A. EtSPL o 4.0. 7 6.4 (0tt- 2.5 consortiumrate) 398. Production Of Phosphate Fbrtilier (Saoun) - 1dB UBSAS 0B.A. t SFA 0on 6.7. 5 L. aR1.25 3,7 40. Natural Gas Distribution-AMkar Energy IC tCo 0w US0 73.0 7/3.8 LIOR.l 1/4 73.0 41.. Natural Gas Distribstion-Anker [ner"Y IC IGO 2 CS UKpodcs 68.O. 20 yers 1.75 fixd 116.9 4*b. Natural Gas Oistribution-Ankar Energy tC ttO SC4S UKpounds 12.0. 7 LIODRfl 1/ 20.6 42. Gnral La - T EEuropen tesettluset fun Ssr 65.0. 10 4.S 43.2 43. TUPIAS Enrgy - - ALBAAKA US0 2.0. 1.3 9.45 fetal for PAy 874.6 asm 44. Foreign Trade Credit Ceneral tC lurkish [Xi" "Itsubighl Bnk jPY 10.0b OULLIT 6.3 75.3 45 cT IrYnvestments Cosrsication IC PT CCF US0 14.2 10/2 S.7i 14.2 46. General Loan DO - IC EuropeanuBoettle- _ent F9s JPV 10.0l, 28/20 5.625 76.3 47.. ASICI-Vter Supply Infrastructure - IC Germ _. 0an 36.0 30/10 2 20.9 47b. ASICI-ater Supply Infrastructure - IC £FV am 32.3 12/3. KlPW 17.7 48. SAL 11 w - IC iNC USO 4000.0 17.6 18110.0. 4QG Total for June 84035

1/8 at OKI 4.7 49 PowerStatrohn he tnmigy PoworStation *tC TE Credit BankVorein AustrSlhil)lng 59.S 6.522 Em~~~~~~~~~~~~~~~~~~~~~~~~(portCredit 4/5 at 6.26

498. TEK,Cayirhas' Thermal Cdt"Wri ut.Siln . ./ utin. FPoerStation Energy IC TEt Credit Bakereis Austr Shi111ng 0.6 4.8/9 Austrin .8 intortst+1

, Balanceof PaD)nts - ers Trutt lSO O Lil51Q Total for July 166 6

Sl. BIlckse Univorsity - Juespenes Firm SPY 144.9 1.0

52. Isttanbul1Natural Gas -I ws G o 0sttributatn Pro), tson. sw S COFACE) Fr 1.4e 1/3. Pn t0.1.25 225.2 Impayment Principal :8.75

53. ICI (GP) _ TCB Stu_erican Bent USC 60.0 80 bests points ever COIndes lotal for Avust $526.2

54. Jap ERsICofi&ssni2g r1n` ial - Iresury Jaa E. US collar 400 17/5.5 5.3 400.0 of FsALtt Sctor 55. kallway Electrification Iransport Trea"sur TtCOO t US cells 14W0 173.9 56. 6amenralLee' MP rasr urewoa Be.. Fund Ws& Franct 20.0. 7/1 S.0 1734.

67 Agriculture Credit Agriculture Treasury TCZB Dr Benk am 1S.7. 7.8 ve'table 8.Bs 58 Agrscuiture Credit Areulture Ireacry ?CZ8 20 Dark OK 2.80 6.6S1.1.25 1. 6 be. FAL. It B-loan Fisntl- treasury svivdscleftt (B1Anks JIN- 2~ ft leave. c boanS YEN 27.7. 12t1 JLlP.T 222c

3261s o.2 - 150 - Annex 3.2

TABLE 3.2: TURKEY - Public Sector External Borrowings in 1988

Credi t Nam of Credit Sector Guarantor Debtor Creditor or Currency Limit Maturity/ Interest USSMiillions Lead Bank (millions/ Grace Period Rate Vadle as of bill1 i ons)I ( wearOI aDercent) Decemb" r1988

59b. FSAL 11 B-loan Financial _ Treasury Syndication YEN 13.3bn 12/5 Variable 106.6 60. Mobile Telephone System Telecom Treasury PTT Finnish Export Credit Agency 32.9. 7 LIBOR+1O '08.6 Total for September $784.87 October

61. TKSFinancing Industry Treasury TK8 KFW DM 6.0 KFWFixed 3.4 62. tK8 Financing Industry Treasury TKB KFW Om 57.0 EuroPean Floating+0.5 28.8 63. Central Electronic Systm Telecom Treasury PTT Siemsfis 01 37.31R European Floating Rate 21.1 TKK US Dollars 40.4. LIBOR+0.75 43.4 Total for October $96.6 Noveber

64. BondIssue 8OP _ Treasury OresdnerBank Om 300.0 7 92 basis pts. 400.0 over Sund rate 65. Akdeniz University Education Treasury (at 6 Yon) - 4 o-er us/d*rss 3a3 Nissko Ira (Japan) 66. Purchaseof 6 helicopters Oefense - Treasury Sikorsky US 0 40.5 7/1 LI80R+1 a.5 67~ Cr dit Financo Chemicals - TUGSAS IKS US 0 15.0 10 7.0 15 68. Credit Finance Textiles - SumerbankIKd US 0 10.0 10 7.0 10 69. TelecomEquip. Telecom Treasury PTT Mitsui Bank 7 1 6/3 LltOR+1.25 7.7 70. Export Credit Export - - Yar,ichi YEN lObn 8/5 6.3 80.2 Securities 71. Radar Equipment Aviation Mhdid Credit Om 31.5 15/5 1.75 17 8 Center Total for November $343.6m Oetbl

_72. Triple Phosphate Chemicals TUGSAS - Arab Sanking Corp. ON 6.7 7/2 LIB0R+1.25 3.8

73. FMS Refinancing Defence - Treasury BankerTrust US 0 941.0 27/15 9.8 941 .0 74. FMS Rofinancing OQfence - Treasury BankorTrust US 0 300.0 7/1f5 9.4 300.0 75. FMS Refinancing Defence - Treasury BankerTrust US D 262.1 14/7 9.6 262.1 76. THY-Airbus Aviation Treasury THiY C. Itgsh & Co. US0 620.0 15/3 LIBOR+0.875 60.0 77. THY-Airbus Aviation Treasury THY C. Itgoh & Co. US 0 60.0 15/3 LIB0R+0.875 60.0 78. Turkish Maritime Bank Shipping - PMaritime Shipping BankAKA Om 8.64 5/60 6.25 4.9 Bank 79. GermanGovernment Foreign Aid - Treasury GermanHukumet Om 10.0 30/10 2.0 5.6

80. Eurobond bOP - Treasury Bankers Trust US 0 150.0 10/10 11.125 150 0 rotal for December $1 787m Total for 1988 ISS735b

32011 pg.23

Source: Treasury Data. wiaacial flows to Turtey 1979-119

£4e4ioa- and buq-term

mmIllion

OECD, Special has. 66 _ IS 1919-62 1Is) 1964 19S 1966 Al4 Exnpot Aid cavort A4 aspert Aid Expert aid a pr*t AId mPeort i4d taport credit cgodit credit cr.dit credit credit credit 461 LI 41it)) 41) (i)t1

0 ctcis 1biateje I * 4 -- 6.1 -- . -- Jlatria .0 4.401 7 63.2 34.2 6.1 154.9 -- 69. 31.9 92.0 5.9 1.3 4.3 9.S 4.2 1.6 .019i53 -- -- 6.1S *0.I -- 6.0 9.2 - tL0.0 -- 149.5 Canada 26.1 ------Dusark 13.3 -- 2.1 -- 1.0 ij1 ------2.S riIlamd 2.0 -- -- - 266.3 1 26.3 -- £6.5 75.1 17).1 97.0 366.7 0.1 fraucc 99'. 199.6 -- -- - S.65 265.4 60.0 116.S 7312 683.3 159.S 451.1 ftemamy 75.9 4_1.0 311.4 S.6 217.5 297.0 20.0 166.2 40.0 7S.1 6.1 25.S 145.S Italy 131.0 300.0 -- - - 279.1 162.0 211.4 634.0(21 *53.9 5113.42) 324.9 200.0 1.05 -- 9.0 64.6 125.1 101.6 Japa ______t0 -- -- _ _ _- __ umeboucs 1.6 12.6 - 2.0 ------61 - 61.1 -- 11.0 metb.elgad 605. 0.e -- 16.S -- 09. 61.0 ------O.S 0.6 -- -- Uer"t *0.3 0.6 *.S------4.9 -- 16 1.S -- owed" 16.S 10.6 -- -- 9.S - 16.6 0.9 -- 267.1 -- S5.1 -- 69.0 -- SwltserLS0d 6710 - -- L60 __ LO S.& 1.1 I.# 104.0 - 17.2 -- 3. |-- United Kingdom 129.9 -_ 257.9 299.3 1M00 95.6 119.6 33.5 - 604. 12.0 SAt.d States 9 83.1 146.2 1. 1£51.7 17S.0 *63.1 1 310.1 464.) 1 301.9 620.0 2 407.6 69e0. I eoo 2 totel bIlateral 2 695.7 1 019.4 199.4 476.1 292.7 1 225.0

1. Ofticial ex"°t credits *ad *aport credit guaraetees- 2. Includial lecg-terg crdilts by the gate Usk of Jepam. Seurc,t crediters respowtLag.

z - 152 -

ANNEX 4.1

An Illustration of the Cost of Swaps

As an illustration of the usage of swaps, we consider a swap from an existing, fixed interest rate liability in Japanese Yen with a maturity of 5 years to both a floating and a fixed interest rate obligation in US dollars. The table provides some indicative figures for this type of swap based on May 5th 1989 market conditions for a borrower with AAA credit standing and for different levels of the interest rate incurred on the existing Yen liability. The spreads in the table are quoted in basis points and the levels of 6 month US LIBOR and 5 year US Treasury were respectively 10 1/16 percent and 8.95 percent.

Floating Interest: Fixed Interest: Fixed Interest: YEN Spread over LIBOR Spread over US Treasury Rate: Level

5% -28 +48 9.43% 6% +84 +160 10.55% 7% +196 +272 11.67%

For a Japanese Yen, fixed interest rate liability with a 10 year maturity the figures would be as follows (10 year US Treasury was 9.00%):

Floating Interest: Fixed Interest: Fixed Rate: YEN Spread over LIBOR Spread over US Treasury Level

5% -38 +47 9.47% 6% +74 +159 10.59% 7% +186 +271 11.71%

These numbers do not include any indirect and direct costs that would be charged by the financial intermediary in connection with the swap. In particular, the figures do not include any credit spread that may be charged by the intermediary and/or any indirect costs involved in putting up collateral as assurance against the credit risks involved.

After accounting for all costs involved, the all-in costs spread over US LIBOR rates and the all-in cost spread over US Treasury can be compared to the all-in costs of a direct funding operation in floating and fixed US dollar of the same maturity. - 133 -

ANNEX 5 A TECHNICAL NOTE ON THE ESTIMATION OF PUBLIC SECTOR DEFICITS'

5.01 In this annex the definitions, methodology and data sources used in estimating the nominal and real fiscal deficits and the pressure of the fiscal deficits on the domestic financial market are discussed. Also, it incorporates the so-called quasi-fiscal deficit of the Central Bank into the discussion of the fiscal deficits. The algebraic definitions of the fiscal deficits are discussed in the first section; and the methodology and sources of information used in estimating the real and nominal fiscal deficits through changes in net public sector liabilities are explained in the second section.

A. THE ALGEBRA OF FISCAL DEFICTTS 5.02 In this section the algebraic definition of the real and nominal deficits, the pressure of the deficits on the financial sector and of the quasi-fiscal deficits are derived and discussed. Equations will be defined using the continous time approach, thus enabling the reader a clearer understanding of the underling concepts. However, calculations in Chapter 5 were made using the discrete time approach due to data limitations.2

Nominal Fiscal Deficits 5.03 The nominal deficit including foreign exchange losses is defined as in equation (A.5.1),

(A.5-1) D+i-B+(i*+F)-B*-E=IH+B+B*-E+B*-E, where, D is the primary deficit, B and B* are the stocks of nominal net domestic and net foreign public debt denominated in Tl and in dollars respectively, i is the weighted average nominal average interest rates on net domestic debt denominated in Tl, i* is the weighted average international nominal interest rate denominated in dollars, H is the stock of money used to finance the public sector, E is the nominal exchange rate of Tl/US $, a dot above the variable denotes the partial derivative with respect to time (i.e., dx/dt), a hat denotes the rate of change (i.e., (dx/dt)*(l/x)) and t is a time index. Stocks, as is common, are evaluated at end-of-year prices.

'/This methodology is the same as developed by EMTTF for the purpose of The Fiscal Policy Report, September, 1988. 2/The difference between the continous and discrete time approaches is that in the discrete time approach the time period is specifically shown, this though makes this approach cumbersome. The continous time approach has the advantage of being more faithful to the data-generating process (i.e., how data is generated in real life). However, available information enabled us only to use the discrete time approach for our calculations. - 154 -

5.04 By decomposing A into (E)/(E) in the left hand side of equation (A.5.1) and cancelling similar terms in the left and right hand side of the equation, it is possible to arrive to the definition of the nominal deficit excluding capital losses expressed as equation (A.5.2),

(A.5.2) D+iB+i*B*-E=fH+B+B*.E, where variables are as defined before.

5.5 The left hand side of equation (A.5.2) is the definition of the fiscal deficit from above-the-line and the right hand side is the definition from below-the-line or, through changes in net liabilities of the public sector. As it is apparent from this equation, errors in applying the correct exchange rate in either side of the equation will yield errors in the estimation. Real Fiscal Deficits 5.06 The real fiscal deficit including capital losses can be derived in a similar way as we derived the nominal fiscal deficit excluding capital losses. Let the real deficit including foreign exchange losses be defined as in equation (A.5.3),

(A.5. 3) D+ b+(r*+e)-b* e=H+b+6*-e+b* e, where a lower case variable indicates the variable in real terms (i.e., xt = Xt/Pt, where Pt is the end-of-period price index) r is the real weighted average interest rates on net domestic public debt denominated in Tl, r* is the real weighted international interest rate, e is the real effective exchange rate and the rest of variables are as before.

5.07 By rearranging and cancelling similar terms at the left and right hand side of the equation, it is possible to arrive at the definition of real fiscal deficits excluding capital losses expressed as equation (A.5.4),

(A.5.4) D+r-b+r*-b*-e=H+b+b*-e, where variables are as defined above. As before, the left hand side of equation (A.5.4) is the-above-the-line definition of real fiscal deficit and the right hand side is the below-the-line definition. Quasi-Fiscal Deficit 5.08 A useful extension of the definition of consolidated fiscal deficits is the definition of quasi-fiscal deficit of the Central Bank. As is well known, the Central Bank in Turkey performs certain activities that would have corresponded to the fiscal sector; the quasi-fiscal deficit definition is an attempt at measuring the net position of the Central Bank resulting from these activities. The quasi-fiscal deficit, therefore, should be interpreted as a transfer from the public to the private sector. Later on, in Section B, we will describe the methodology and discuss an estimate for the quasi-fiscal deficit based on the Profit and Loss Account of the Central Bank. - 155 -

Table A.5.1: BALANCE SHEET AND PROFIT AND LOSS ACCOUNT OF A CENTRAL BANK BALANCE SHEET

Assets Liabilities

Foreign Assets (FA x E) Foreign Liabilities (FLx E) Credit to the Government(C9) Domestic Liabilities (DL) Capital Losses on Credit to the Gov- Unadjusted Base Money (HT ) ernment (Ce') Net Worth (NW) Credit to the Banks (Cb) Credit to the Private Sector(CP)

PROFIT AND LOSS ACCOUNT Debit Credit

Interest Paid on Foreign Liabili- Interest Received on Foreign Assets ties((i*+E)xExFL) ((i*+ P)xExFA) Interest on Domestic Liabilities (ixDL) Interest Received on Credit to the Government (ixCg) Net Income (N W) Interest Received on Credits to Banks (iX Cb) Interest Received on Credits to the Private Sector (ixCp)

5.09 An example -- suited for Turkey -- of Balance Sheet and Profit and Loss Account of a Central Bank is reported in Table A.5.1. Making net foreign liabilities as NFL=FL-FA and adjusted money base as H = HT-CP, the increase in net worth in period t (i.e., NW) is defined from the balance sheet as expressed by equation (A.5.5) and from the Profit and Loss Account as expressed by equation (A.5.6),

(A.5.5) 9 (A5-)Nw=C +(Cg'+iCb-NPL-E-NFL-P-]H-LL,

(A.5.6) iCb+ (A--6)NW= i-C +-bi- Cp-(i*+E) -NFL -E- i -DL,

where variables are as defined before. 5.10 Using equations (A.5.5) and (A.5.6), let us define the quasi-fiscal deficit including foreign and domestic exchange rate losses as expressed by equation (A.5.7),

(A-5 Q7)QFD =(i*+P)-NFL-E+i-DL-i-Cg-i_C b-iCp

= NFL -E +NFL -P + IH+ L- C9g-- C9'- Cb - 156 -

where QFD denotes quasi-fiscal deficit and the rest of variables are as defined before. The first line of this equation defines the QFD from the income side, i.e., above-the-line, and the second line defines it from the liability side, i.e., from below-the-line. As before, after cancelling similar terms at both sides of equation (A.5.7), let define the QFD free from international and domestic currency fluctuations (QFDf) as in equation (A.5.8),

(A.5-8) QFD' =i*NFL-E+iDL-i Cg-i-Cb'-iCP

= NFL -E+ H +D'L- C9-_C9gl_Cb, and let us define the real quasi-fiscal deficit free from international and domestic currency fluctuations (qfdf) as in equation (A.5.9),

(A-5-9) qfdf =r*-n,fl-e+r-dJl-r-c'-rC b _r _Cp

= n f I *e + H -+-d'I - c69- c 9t - Cb, where a lower case variable indicates the variable in real terms (i.e., xt Xt/Pt, where Pt is the end-of-period price index). 5.11 In all three equations (A.5.7, A.5.8 and A.5.9), the first line defines the quasi-fiscal deficit from the income side, i.e., above-the-line, and the second line from the liability side i.e., below-the-line. These definitions assume that Central Bank's operation costs are zero and that all income/expen- ditures in the Profit and Loss Account generates cash-flow. A more refined definition would have excluded from the above definitions those activities typical of a Central Bank, such as the credit to banks (Cb)3 and the issue of own liabilities for open market operations (DL) purpose. However, in the case of Turkey, - - as shown the Central Bank's Balance Sheet -- none of them are important. Moreover, open market operations are performed with government securities making it difficult to distinguish an open market operation from credit to the government.

5.12 A characteristic of the Turkish Central Bank -- depicted in our defi- nitions of QFD -- is the inclusion of the item "Cgl", which is defined as the capital losses on Central Bank's net foreign liabilities resulting from fluctuations in exchange rates. By Central Bank law, the exchange rate losses of Central Bank's foreign liabilities are a claim on the Treasury; yet the Treasury has not always paid them to the Central Bank. For instance, in the 1987 Balance Sheet this item represent more than 40% of the total Central Bank's assets. The Central Bank, by including the C&l on the asset side, understates the true size of the quasi-fiscal deficit. Moreover, for this reason and because the item C8I exceeds the total capital losses from cross and domestic currencies

3/This is the case, for instance, with the very short-term line of credits that central banks open for commercial banks, and banks use them only for very short-term liquidity needs. However, when this credit turns into more long-term loans because of some banks' solvency problems, then it is possible to argue that these loans should be included in the definition of quasi-fiscal deficit. The central bank is in effect making a transfer to the private sector. - 157 -

fluctuations -- calculated as the difference between the CBs NFL at current international and domestic exchange rates and the total CBs NFL at fix 1980 international and domestic exchange rates -- the above-the-line QFD is larger than the below-the line one. As we argued in Chapter 5 and in Section B in this Annex, it is this inconsistency between the Balance Sheet and the Profit and Loss Account of the Central Bank which results in the discrepancy found when the consolidated fiscal deficit from above-the-line and below-the-line. Pressure of the Fiscal Deficit on the Domestic Financial Market

5.13 Using the definition for nominal fiscal deficit in equation (A.5.2), it is possible to define fiscal deficits' pressure on domestic financial markets as in equation (A.5.10):

(A.5 lO)PFM = Di.B+±{i*.B*.E-AB*.E}

where PFM is the indicator for pressure on the domestic financial market of the public deficit and the rest of variables are as defined before. 5.14 The term in brackets ( in equation (A.5.10) is equal to the non-interest current account of the public sector with opposite sign, or the net inflow of foreign finance for the public sector with opposite sign; the more negative this term is relative to the total fiscal deficit -- i.e., the greater the inflow of public foreign finance -- the lower the pressure of the deficit on the domestic financial market. This term will become positive when the country is performing a transfer abroad, i.e. , when the country is re-paying her foreign debt and, thus, resulting in a greater pressure on the financial market than that exerted by the fiscal deficit. B. METHODOLOGY AND SOURCES OF DATA 5.15 This section focuses on the methodology and sources of data used to estimate the deficit through changes in net liabilities of the public sector. In what follows, the discussion of the methodology for calculating foreign debt finance, domestic debt finance, money finance and quasi-fiscal deficits is undertaken. Foreign Debt Finance 5.16 Table A.5.2 reports in the first column the main items of the net foreign liabilities of the public sector (foreign assets and liabilities of the Central Bank and foreign liabilities of the government and SEE's), in the second and third columns the data for 1987 and 1988 for this same breakdown; and in the fourth column the sources from where the data were obtained. 5.17 First, the nominal net foreign liabilities free from domestic and international currency fluctuations was estimated. For this purpose the non-dollar portion of the foreign public sector net foreign liabilities was converted to 1980 exchange rates by using the 1980 non-dollar to dollar exchange rates. - 158 -

TABLE A.5.2: FOREIGN EXCHANGE LIABILITIESOF THE PUBLIC SECTOR (in millions of US Dollars)

1987.IV J 1988.IV j DATA SOURCES(*) I ------1I. FOREIGN EXCHANGEASSETS OF THE I I I Central Bank's CENTRAL BANK I I I QuarterlyBulletin

11.1 RESERVES | 1,765.60 | 2,330.42 | CB8 1a.4 11.2 GOLD 1,627.03 I 1,424.93 I CBB la.1+2 11.3 INCONVERTIBLES I 156.36 I 153.81 I CBB 1a.5 1I.4 OTHER FX ASSETS I 1,947.36 I 2,306.69 I CBS 1a.39 11.5 TOTAL ASSETS OF THE CENTRAL BANK j 5,496.35 6,215.85 I

III. FOREIGN EXCHANGE LIABILITIESOF THE CENTRAL BANK

111.1 OVERDRAFTS I 289.78 I 169.30 I CBB lp.2 111.2 INCONVERTIBLES I 386.53 I 361.22 I CBB 1p.32 111.3 DRESDNER I 5,913.00 6,208.00 f CB - Worksheets II-4 DIRECT BORROWINGSAND CTLDs | 4,179.07 | 2,876.09 I CBB 2p.27 jII.5 LETTERS OF CREDIT 106.23 106.46 CBB 1p.30 111.6 BANK DEPOSITS AND OTHER 4,995.20 I 5,457.20 j CBB 2p.2 5-(II.l+1I.2 +11.3) I 111.7 TOTAL FOREIGN LIABILITIESOF THE 115,869.81 115,178.27 1 CBB 2p.28 I CENTRAL BANK

III. FOREIGN EXCHANGE LIABILITIESOF j I I Central Bank's OF GOVERNMENT AND SEEs I | outstandingExternal i| I| Debt worksheets I 1111.1 MEDIUM-LONGTERM 116,974.00 117,727.00 I I 1111.2 IMF I 770.0C 299.00 1111.3 SHORT-TERM I 491.00 242.00 | IIII.4IBRD I 6,289.50 6,129.70 |III.5 TOTAL FOREIGN LIABILITIES 124,524.50124,397.70 I I 1 OF GOVERNMENT AND SEEs

IIV. NET FOREIGN EXCHANGE LIABILITIES OF THE PUBLIC SECTOR 134,897.96 133,360.12 I = I + III - I

V. PRICES AND EXCHANGE RATES I I |StatePlanning organization,| I I Main Economic Indicators IV.1 EXCHANGERATE TL/USS I 991.18 I 1,795.04 I I |V.2 EXT. CURR. PRICE INDEX(**) I 1.17 I 1.14 I I IV.3 EXT. ADJ. PRICE INDEX(**) I 1.27 I 1.29 IV.4 DOMESTICPRICES I 11.35 I 19.89 IV.5 RER INDEX I 1.32 I 1.34 I I V.6 DOMESTIC AVERAGE PRICE INDEX(**) I 8.89 I 15.60 I V.7 AVERAGEEXC RATE TL/US$ I 855.68 I 1,416.49 I - I-- I-- I

(*) For instance,CBB la.5, indicatesCentral Bank's QuarterlyBulletin, Table la, row 5.

(**) Base 1980=1 - 159 -

5.18 The ratio of nominal net foreign finance (i.e., the increase in net nominalforeign liabilitiesof the public sector)free from currencyfluctuations to GNP was calculated:(i) by estimatingthe increase in net foreign liabilities of the public sector free from currenciesfluctuations denominated in dollar (i.e.,by calculatingB*,= B*,- B*, l); (ii) by multiplyingit by the currentannual average Tl/US $ exchange rate; and (iii) by dividing it by the nominal GNP. 5.19 Second,the ratio of the real net foreign finance free from currencies fluctuationsto real GNP was estimated:(i) by estimatingthe stock of net foreign liabilities at 1980 dollar prices by using an internationalweighted average price index. This price index was estimated using a geometric average formula as expressedby equation (A.5.11),

(A.5.11) i-n (P* /P* 0 where:P* 7 (P*L/E80$) after taking natural logs at both sides of the equation this can be written as:

(A.5.11a) i- aiLn(*' l$) P *t = el where: a' is a weight that takes the value of the proportion of total foreign trade performedwith currencyi, P is the end-yearConsumer Price Index of country with currency i, E'1$is the end-year exchange rate of currency i with respect to the US dollar in 1980, Ln is the natural log, FT denotes a product and L denotes a sum. 5.20 It is important to notice from this methodology that both the stock of net foreign liabilitiesand the internationalweighted average price index used (i.e., numerator and denominator) exclude fluctuations in the international exchange rates. 5.21 (ii) By calculatingthe stock of net foreign debt of the public sector at mid-1980 Tl prices (i.e., in real Tl terms).This was done by multiplyingthe stock of foreign liabilitiesfree from currenciesfluctuations by the end-1980 exchange rate of Tl to US $ and by dividing this product by an end-of-period domestic price index with base 100 in mid-1980. And (iii), the ratio of the annual change in stock of real net foreign liabilites free from currency fluc- tuations at mid-1980 T1 prices to current GNP at 1980 prices was estimated. The use of this ad-hoc domestic price index assuresus that both the numerator (the change in stock in real net foreignliabilities) and the denominator(the current GNP in real terms) were evaluated at the same prices: mid-1980. As it is well known, when this correctionis not performedin inflationaryeconomies this price effect can introduceimportant distortions in the final result.This price effect results from the fact that the numeratoris evaluatedat end-of-yearprices (the case of stocks in real terms) while the denominator is evaluated at mid-year prices (the case of flows in real terms). - 160 -

5.22 The estimate of net foreign finance including international and domestic currencies fluctuations as a percentage of GNP in Table 5.4 was estimated (i), by estimating the Tl stock of net foreign liabilities including currency fluc- tuations at mid-1980 prices. This was estimated by multiplying the dollar- denominated stock of net foreign liabilities without correction for currency fluctuations by the current end-1980 Ti/US $ exchange rate and dividing it by the ad-hoc end-of-period domestic price index with base at mid-1980. And (ii), by calculating the annual change in the mid-1980 stock of net foreign liabilites and dividing it by the current GNP at 1980 prices. Capital losses were obtained as the difference between the estimates which include capital losses and those which exclude them.

5.23 The two international price indexes -- including (Int Cur PS) and excluding (Int Adj PS) international currencies fluctuations -- and the real effective exchange rate index (RER) are plotted in Figure A.5.1. As in the IMF methodology, in this figure an appreciation in the RER is shown as an increase in the price index and a devaluation as a decrease. The difference between the international price index which includes the fluctuation of international cur- rencies and that which excludes them, is the effect of fluctuation in international currencies; and the difference between RER and the international price index which includes the fluctuation in the international currencies is the effect of the real effective devaluation (appreciation) of the Turkish Lira against the basket of international currencies. Both the two international price indexes and the RER have the same weights for international currencies and correspond to Turkey's share of the total trade performed with each currency. By comparing Figure A.5.1 with Figure 5.1 one can see the effect that changes in international prices, international currencies fluctuation and of real effective devaluation (appreciation) of the Tl have had on the stock of net external public sector debt. - 161 -

FIGURE A.5.1 RER AND INTERNATIONAL PS INDEXES INCL AND EXCL CURRENCIES FLUCTUATIONS 1 .4

1.3

1.2

1.1

0.9

0.8

0.7

0.6- 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988

o INT ADJ PS + INT CUR PS o RER INDEX

Domestic Debt Finance 5.24 Table A.5.3 reports in the first column the decomposition of the domestic debt, in the next two columns the estimates for 1987 and 1988 in nominal terms and in the last column the sources where the data was obtained. 5.25 First, the ratio of nominal net domestic debt finance to GNP was calculated: (i) by estimating the annual increase in net domestic debt at current prices; and (ii), by dividing it by GNP at current prices. 5.26 Second, the real net domestic debt finance to real current GNP was calculated (i) by calculating the stock of net domestic debt at 1980 prices by dividing the stock of nominal net domestic debt by the ad-hoc end-of-year domestic price index with base in mid-1980; (ii), by calculating the annual differences in the stock of net domestic debt at 1980 prices; and (iii) by dividing the change in the stock of net domestic debt at 1980 prices by the current GNP at 1980 prices. - 162

TABLE A.5.3: NOMINAL NET DOMESTIC DEBT OF THE PUBLIC SECTOR AND ADJUSTED BASE HONEY (in milLion of current Tl)

1987.IV 1988.IV I DATA SOURCES(*) ------II. NOMINAL NET DOMESTIC PUBLIC SECTOR DEBT I 4,757,356.20 I 9,655,380.00 I

1. CENTRAL GOVERNMENT 4,064,835.20 I 7,134,000.00 A. BONDS AND BILLS I 4,330,564.20 7,421,000.00 I Treasury's I 1.1. Bonds I 2,407,250.50 I 4,880,000.00 j worksheets I 1.2. Bills I 1,923,313.70 I 2,541,000.00 B. MET CREDITS 1 (265,729.00)1 (287,000.00)1 1.3. Bank Credits 1 1,118,959.00 1,795,400.00 I a. Deposit Money Banks 1 1,094,543.00 I 1,748,800.00 I CBB 3a.10+3a.12 I b. Development Banks 24,416.00 46,600.00 CBB 5a.7 1.4. Bank Deposits 1,384,688.00 2,082,400.00 I a. Deposit Money Banks 1,172,696.00 1,777,000.00 I CBB 3p.31 b. DeveLopment Banks 211,992.00 j 305,400.00 CBB 5p.29

2. SEEs j 1,721,730.00 3,265,500.00 A. NET CREDITS 2.3. Bank Credits I 2,862,058.00 j 4,630,100.00 I I a. Deposit Money Banks I 2,248,900.00 j 3,425,100.00 I CBB 3a.18 I b. Development Banks 613,158.00 1,205,000.00 | CBB 5a.13 2.4. Bank Deposits 1,140,328.00 I 1,364,600.00 a. Deposit Money Banks 1,138,293.00 J 1,355,200.00 I COB 3p.36 I b. Development Banks I 2,035.00 I 9,400.00 CBB 5p.30 I

3. EBFs 1(1,029,209.00)1 (744,120.00)1 EBF's I 3.1. R.S.Certificates 766,480.00 721,480.00 1 Information I | 3.2. EBFs Deposits j 1,795,689.00 1,465,600.00 1

III. NOMINAL NON-ADJUSTED AND ADJUSTED BASE MONEYI I I I I I 1. NON-ADJUSTED BASE MONEY I 5,080,532.00 9,060,300.00 I a. Currency in Circulation 2,274,737.00 3,425,600.00 I CBB 4ap.23 I b. Vault Cash I 769,368.00 j 1,092,800.00 I CBS 3a.1 c. Free Reserves I 438,491.00 I 794,000.00 CBB 8mk.12 I I d. Required Reserves 1,597,936.00 3,747,900.00 I CBB lp.13

I 2. ADJUSTED BASE MONEY I 4,247,311.00 j 7,657,100.00 I A. REDISCOUNTS I 1,036,379.00 1,736,100.00 a. Deposit Money Banks I 893,119.00 I 1,289,300.00 1 CBB 2a.17-2p.38 b. Other Fin. Inst. I 143,260.00 I 446,800.00 I CBB 5p.28-5a.4+3a.4 B. IMPORT DEPOSITS I 203,158.00 I 332,900.00 I CBS lp.31 I I I . I III. PRICES AND OUTPUT (1980 = Base) I I|State Planning Organization III Main Economic Indicators I DOMESTIC PRICES(ENO) I 11.35 I 19.89 DOMESTIC PRICES(AVE) I 8.89 I 15.60 I I NOMINAL GNP I 58,387.20 I 100,386.00 I I REAL GNP(CPI) I 6,567.74 I 6,436.61 I INFLATIONCEND) I 55.05 75.21 ------

(*) For instance, CBS 4ap.23, indicates Central Bank's Quarterly Bulletin, Table 4ap, column 23. - 163 -

Money Finance 5.27 Table A.5.3 also reports the money finance estimates. As before, the first column shows the breakdown, the next two columns the estimates for 1987 and 1988 at current prices and the last column the sourceswhere the information was obtained.The adjusted money base estimate,which is defined as the portion of base money used to finance the public sector,was obtainedby adding currency in circulationplus total banks' reserves (vault cash, required and free banks' reserves) plus import deposits less rediscountsgranted to the private sector. 5.28 The ratio of money finance to GNP was estimated first, by calculating the annual change in the adjusted money stock at current prices; and second,by dividing it by GNP at current prices. More formally this can be written as:

NP, where H is the stock of adjusted money stock at currentprices and GNP is the GNP at current prices. 5.29 It is common to find in the literaturedifferent methods and definitions for money finance, seignorage and inflation tax; it is therefore helpful to discuss the definitionsand methods used in our analysis and their relation to others.While the most accurate definitionwould have been to use continousform equation (i.e., an integral), the data available only rendered it possible to use a discrete form equation (i.e., changes in end-year stocks). 5.30 The inflation tax and seignorage estimates reported in Table 5.4 are definedas the portion of seignorageand inflationtax used to finance the public sector deficit. The difference between the total money finance (i.e., that estimated from the non-adjustedmoney stock) and the portion of money finance used to finance the public sector deficit (i.e., the adjusted money finance), are the resourcesreturned to the private sector, e.g., through rediscounts. 5.31 Formally, the true seignorage and inflation tax can be defined as equations (A.5.12) and (A.5.13),4

(A.5.12) (ht- ht-1)

gnpt and

(A.5.13) ITt = tn -l

H CGNP where: St is the seignorage, ITt is the inflation tax, h,=-F,gnp,= - (i.e., lower case variables denote the variable in real terms),Ht is the adjustedmoney stock, PT1 is the average domestic consumer price index with base 1980, P, is the end-of-perioddomestic price index with base mid-1980, P, is the inflation rate and GNPt is the GNP at current prices.

4/A more precise estimate would had been obtained using integrals. - 164 -

5.32 Seignorageas expressedby equation (A.5.12)is defined in the same way as we defined the real net foreign and real net domestic finance. A problem of estimatingseignorage and inflationtax as expressedby equations (A.5.12) and (A.5.13),is that they do not add to the adjusted money finance. And, because we wanted a definitionof seignorageand of inflation tax that would add up to the adjusted money finance, we decided to define seignorageas equation A.5.12 and inflationtax as the differencebetween money financeand seignorage.Formally, the definitionof inflationtax used can be written as equation (A.5.14),

(A.5.14)lT Ht- Ht-l ht- htI T' GNPt gn pe by expanding and rearrangingequation (A.5.14),it is possible to arrive to an expressionthat relatesour definitionof inflationtax (IT')to the true inflation tax (IT) as definedby equation (A.5.13).This is expressedas equation (A.5.15),

(A.5.15)IT (H-H 1 )P- IT lTt +(Ht-Ht-1) Pt-Pt t (1 + Pt) GNPt Pt where variables are defined as before. 5.33 Differencesbetween IT and IT' are very small (less than 0.5% of GNP), except for 1981 when the rate of inflationincreased sharply. As it is apparent from equation(A.5.15), these differencesdepend on the rate of inflationmeasured by the end-of-perioddomestic prices index, on the differencebetween the average and end-of-perioddomestic price indexes and on the size of the nominal money finance (second term in equation A.5.15). In general, during periods of high inflationIT' underestimatesIT and during periods of decelarationof inflation IT' overestimatesIT. Examples of the latter are 1982 and 1984. 5.34 A less troublesomemethod to decomposethe adjustedmoney finance term between seignorage and inflation tax -- which was used in The Fiscal Policy Report -- would have been by using equation (A.5.16),

(A.5.16) Ht- Ht-l H- ( l + t)X H t-l Ptx Ht-l GNPt GNPt GNP,

this equationcan also be expressedin termsof the true seignorageand inflation tax as defined by equations (A.5.12and A.5.13), (A.5.16a) Ht- Ht-I Pt Pt-, =S t: +ITt*- GNPt Pt Pt where variables are as defined before. - 165 -

5.35 From equation (A.5.16a) it is apparent that seignorage and inflation tax as definedby equation (A.5.16) is slightlydifferent from the true seignorage and inflation tax (S and IT). In general, if inflation is increasing then the estimatedseignorage and inflationtax using equation (A.5.16)will underestimate the true seignorage (S) and overestimatethe true inflation tax (IT). However, as mentioned before, differencesare small and will only become worrisomewhen the inflationrate experienceslarge fluctuations.At the end, the decision of how to define seignorageand inflationtax will depend on the particular interest of the author and on the purpose of the study. Quasi-FiscalDeficit 5.36 The quasi-fiscaldeficit, was estimatedboth from the Profit and Loss Account and from the Balance Sheets of the Central Bank. The above-the-line quasi-fiscaldeficit estimate which, added to the government PSBR estimate -- alsoestimated through above the line -- will yield the above-the-lineconsolidated fiscal deficit estimate.Both estimatesof the consolidatedfiscal deficit from below-the-lineand above-the-lineare reported in Tables 5.3 and 5.4 and its detail is reported in Tables A.5.4, A.5.7 and A.5.8. 5.37 The above-the-linequasi-fiscal estimates are reported in Table A.5.4. In this table the Profit and Loss Account of the Central Bank is reported; the items which generate more cash-flowhave been put at the top of the table and those which generate less cash-floware at the bottom of the table.At the extreme bottom of this table the Net Profits as reported in the Profit and Loss Account of the Central Bank and an estimate for the cash-flow Net Profits (i.e., the cash-flow quasi-fiscaldeficit) are reported. This latter estimate intends to correct for those revenues/expenditureswhich, although recorded in the Profit and Loss Account, are not effectivelyreceived. An example is the revaluation of gold. A cash-flowNet Profit or Loss indicatesthe true net profitseffectively received or, if it is a loss, the demand for additional liabilitiesto finance it. In the case of a Central Bank this is particularlyimportant because it has the advantageof being able to issue reservemoney as its liability:the Central Bank finances its losses by forcing the private sector to increase its nominal money holdings through the creation of a higher level of inflation. 5.38 The cash-flowestimate of net profits of the CentralBank was calculated by deductingfrom the reported "Net Profits" those items which we believe do not generate a cash-flow net income. As mentioned before, this is the case of the revaluationfrom gold, but also of other items such as the interest on Public Sector (Treasury and SEE's) assets. Although this method for estimating the cash-flowNet Profits can be debatable and, thereforeneeds further refinement as more data becomesavailable, the fact that for the period 1983-88this estimate is very close to "Net InterestReceived" suggests that it is a relativelyeffective estimateof the cash-flowgenerated. Most of the surplusrecorded in the reported "Net Profits" is explainedby the net income accrued but not received, such as the revaluationof gold. 5.39 However, as mentioned in Chapter 5, this estimate of cash-flow Net Profits is under-estimatedrelatively to the below-the-linequasi-fiscal deficit - 166 -

Table A.5.4 PROFIT AND LOSS ACCOUNT OF THE CENTRAL BANK OF THE REPUBLIC OF TURKEY (As percentage of GNP) l-- …- 1983 1984 1985 1986 1987 1988 l…--- …-…-…-…-…-…-…------l II. NET INTEREST RECEIVED (=A-B) I -0.11 -0.88 -1.08 -0.48 0.07 0.07

A. INTEREST RECEIVED (1) 1.17 0.70 0.62 0.92 1.45 1.94

1. Interest received on various advances I 1.06 0.59 0.37 0.39 0.66 a.- Advances against treasury guaranteed biLls j 0.08 0.02 0.06 0.08 0.18 b.- Advances commercial bills 0.68 0.30 0.07 0.07 0.09 l c.- Advances mediumn-termcredits 0.21 0.19 0.19 0.18 0.20 d.- Advances agricuttural biLls I 0.04 0.04 0.02 0.03 0.10 I e.- Others 0.05 0.03 0.03 0.03 0.09 l

2. Interest received from foreign correspondants 0.09 0.10 0.17 0.38 0.30 a.- Current and time deposits accounts | 0.09 0.10 0.17 0.22 0.13 l I b.- Portfolio accounts 0.00 0.00 0.00 0.17 0.18

I 3. Other Interest 0.02 0.01 0.07 0.14 0.13 I a.- Interest charged on due debts 0.00 0.00 0.05 0.13 0.11 of Public Sector Institutions 0.00 0.00 0.00 0.00 0.00 I b.- Penalty Interest on Reserve Requirements | 0.01 0.00 0.00 0.00 0.00 c.- Others 1 0.01 0.01 0.02 0.01 0.02

| B. INTEREST PAID (1) I 1.28 1.58 1.70 1.40 1.38 1.87 |

I 1. Interest paid to foreign correspondants I 0.27 0.33 0.46 0.53 0.39

2. Others I 1.01 1.25 1.24 0.88 0.96 a.- Interest paid on foreign exchange accounts 0.22 0.14 0.25 0.72 0.77 i.e., on Dresdner Bank scheme. l I b.- Interest paid on foreign exchange deposit accountsl 0.00 0.01 0.12 0.12 0.11 I i.e., on voluntary foreign exchange deposits. I c.- Interest paid on reserve requirements i 0.79 1.10 0.87 0.03 0.06 I I (including Tt reserve requirements up to 1985) d.- Others j 0.00 0.00 0.00 0.00 0.02 I

III. NET COMMISSIONS RECEIVED I -0.02 0.00 -0.02 0.00 0.02 0.06

I A. COMMISSIONS RECEIVED j 0.05 0.04 0.03 0.03 0.04 0.15 I B. COMMISSIONS PAID 0.07 0.04 0.05 0.03 0.03 0.08

lII!.NET PROFITSFROM GOLD AND FOREIGNEXCHANGE OPERATIONS 0.24 0.99 1.18 0.58 0.05 0.07

A. PROFITS FROM GOLD AND FOREIGN EXCHANGE OPERATIONS j 0.24 0.99 1.18 0.58 0.06 0.10 a.- Gold trading profits and evaluation difference 0.00 0.84 0.97 0.39 b.- Foreign exchange trading profits I 0.23 0.11 0.10 0.11 c.- Interest earned on swaps 0.00 0.00 0.00 0.07 I d.- Arbitrage profits I 0.01 0.01 0.01 0.01 e.- Earnings on portfolio accounts held with 0.00 0.00 0.10 0.00 foreign correspondants f.- Others I 0.00 0.03 0.00 0.00 0.00 0.00

| B. LOSSES FROM GOLD AND FOREIGN EXCHANGE OPERATIONS 0.00 0.00 0.00 0.00 0.02 0.03 l-.…- .------167 -

Table A.5.4 (continued) PROFIT AND LOSS ACCOUNT OF THE CENTRAL BANK OF THE REPUBLICOF TURKEY (As percentageof GNP) ------I I 1983 1984 1985 1986 1987 1988

…l…- l…. JIV. OTHER NET RECEIPTS I 0.00 -0.02 -0.01 0.01 -0.01 -0.05 I

A. PROFITS FROM SECURITIES I 0.00 0.00 0.00 0.00 0.00 0.00 X B. OTHER PROFITS 0.04 0.02 0.02 0.04 0.03 0.00 | C. OTHER EXPENDITURESAND LOSSES j 0.04 0.04 0.03 0.04 0.05 0.05

IV. PROVISIONSAND DEPRECIATIONSALLOWANCES I 0.01 0.02 0.02 0.03 0.02 0.03 I

IVI. PERSONNELEXPENDITURES I 0.05 0.05 0.05 0.05 0.06 0.06 |

|VII NET PROFITS 0.05 0.03 0.01 0.03 0.04 0.06 I I I i IMEMO: CASH-FLOWNET PROFITS C= QUASI-FISCALSURPLUS) (2) | -0.08 -0.86 -1.10 -0.82 -0.56 0.02 1(=VII-(I.A.1.a+I.A.1.e+I.A.2.b+I.A.3.a+lll.A.a+llI.A.c+Ill.AI I I l …l… l ……- I

SOURCE: CENTRAL BANKS OF THE REPUBLIC OF TURKEY, ANNUAL REPORT (Variousyears); and CENTRAL BANK worksheets.

(1) For 1987 the breakdownof items "InterestPaid" and "InterestReceived" do not match with the total because the breakdownused was a provisionalestimate, while the total was a definitiveestimated reported in Central Bank's Annual Report. (2) For 1987 estimated the reported breakdown for "Interest Received" and "Interest Paid" was used and since the breakdownfor item "Net Profits from Gold and Foreign ExchangeOperations" was unavailable,aLL of III was deducted;and for 1988, when a similar breakdownwas unavailable,"Cash-Flow Net Profits"was defined as "Net Profits" Less (111+IVa-V). - 168 -

because the expenditureson CentralBank's net foreign liabilitiesin the Profit and Loss Account are not fully captured.A way to illustrate this is by using our below-the-linequasi-fiscal definition, expressed as equation (A.5.17),

(A.5.17) QFD bl= H + NFL - E + DL- C! , by defining equation (A.5.5) (which is the below-the-linenet worth identity) in terms of H, expressed as equation (A.5.5a),

(A.5.5a)H~ = Cg +iCg' + C- NF7L .E- NFL .4 N t. a, _ D,L, and substituting equation (A.5.5a) into equation (A.5.17).After cancelling-out and re-arrangingsimilar terms our below-the-linecan be defined as equation (A.5.17a),

(A.5.17a) bl = -) + b- NUlc , where variables are as defined in Section A and the superscripts al and bl denote above- and below-the-line respectively. 5.40 Equation (A.5.17a) defines our below-the-lineQFD as the difference between the so-called"devaluation account" and the estimatedcapital losses due to fluctuationsin domestic and internationalexchange rates -- the term in parenthesis-- , the loans granted to private banks -- which we assumed to be are negligible -- and the QFD estimated from the Profit and Loss Account -- i.e., QFDa,--NW"'. It is apparent from our earlier discussion and from the above- the-line estimatesreported in Table A.5.7 that the largest item accounting for the differencebetween the below-and above-the-lineQFD is the term in parenthesis in equation (A.5.17a).However, a definitive conclusion would require more informationon what is contained in the item CG& and on the Profit and Loss Account. tlBLI1.5.5 STRUCTURIO PUBLIC SICTO7 DIBT (aBI of GNP)(1)

------1979 1980 1981 1962 1983 1984 1985 1986 1987.1 1987.111987.111 1987.1V 1988.1 1988.111988.111 1988 1I

1. TOTALDOIESTIC D1OT PLUS 15.58 11.58 9.12 10.80 8.41 10.81 12.06 11.35 10.50 10.63 12.71 12.07 11.13 13.08 14.51 13.53 CENTRILBANK FININCI (2) (A.!) A.DOEISTIC DIBt 9.21 7.49 4.54 4.36 3.02 2.60 4.42 4.26 4.47 4.31 6.79 6.38 6.41 7.49 8.06 7.55 (:1+2+3:4+5+6) INSTRUEINTS: 1. Bondsand Bills 3.70 3.65 3.29 3.32 3.05 3.78 4.65 5.19 5.30 5.28 6.56 5.81 5.43 5.71 5.89 5.80 2. NetBank Credit 5.51 3.98 2.18 3.26 1.95 0.50 1.07 1.41 1.03 0.81 1.91 1.95 1.78 2.52 2.85 2.33

3. IBIs 13) 0.00 -0.14 -0.93 -2.22 -1.98-1.68 -1.30 -2.34 -1.86 -1.78 -1.68 -1.38 -0.80 -0.74 -0.68 -0.58 BOROVIPRS 3. CentralGovernment 2.97 2.78 2.07 3.45 2.22 2.97 4.23 4.18 4.90 4.44 6.15 5.45 5.16 6.31 5.17 5.57

4. SEEs 6.23 4.84 3.40 3.13 2.78 1.32 1.48 2.43 1.42 1.65 2.31 2.31 2.05 1.92 3.56 2.55:

6. EIEs(3) 0,00 -0.14 -0.93 -2.22 -1.98 -1.68 -1.30 -2.34 -1.86 -1.78 -1.68 -1.38 -0.80 -0.74 -0.68 -0.58

B. CEITRtLBill FINANCI(2) 6.38 4.10 4.59 6.44 5.39 8.21 7.63 7.09 6.03 6.32 5.92 5.69 5.32 5.59 6.45 5.98 11l.TOTAL NET FOR9IGN DEBT (4) :17.43 20.53 18.55 18.81 20.7823.56 24.51 26.91 NA. N.A. N.1. 27.46 R.I. 27.18 27.53 27.71 (Ixcl. I losses/gains)

:Ila.TOTAL NIT FOREIGN DEBT :12.13 20.53 21.86 24.61 29.22 33.32 36.55 45.67 NA.. R.I. N.A. 46.40 N.A. 45.12 47.26 46.76 (Incl. K losses/gains)

:blRO:ACCUMULATED FOREIGN RICH LOSSIS (5) -5.30 0.00 3.31 5.80 8.44 9.76 12.04 18.76 N.A. NA.. N.A. 18.94 N.A. 17.94 19.73 19.05 (lla-ll)

,~~~~~~~~~~~~ I SOURCIS:Central Bank, Quarterly Bulletin; andTreasury

(1)Since stocks are measuredat end-of-yearprices ahile GNPis seasuredat mid-yearprices, stocksof both domesticand foreign debt wereconverted to 1980mid-year prices beforecomputing its ratio to real GNPat 1980prices. (2) Thinis the financeappropiated through monetary expansion adjusted for the subsidizecredit extendedto theprivate sector, i.e., rediscounts, (3) Forthe first three quarters of 1987and 1988,it wasassused the net debt of end-19B7and end-1988 respectively. (4)This estimate for thestock of foreign debtexcludes the capital losses (gains) causedby a real devaluationof (appreciattion)in thedomestic currency and by cbanges in internationalexchange rates. forthe estimatesfor the period 1980-86the actual currencycomposition of the foreign debtwas used and, for theremaining period the currencycomposition of end-1986vas used. T)these are the foreign exchangelosses accumulatedas a result of fluctuationsof internationaland domestic exchange rates. TaBLI:I.5.C RlALCONSOLIDATID PUBLICSECTOI DEFICIT (IBperCentage of G1?) 1)

, . . - ,~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ 1980 1981 1982 1983 1984 1985 11881987.1 1987.111987.111 1987.11 1988.1 1988.11 1988.1111988.17

TOTALREaL PS DIFICIT 0.83 -1.06 5.32 1.65 9.69 6.41 5.39 N.A. N.a. B.A. 6.52 N.A. 2.76 4.43 4.13 (liel.I losses of for. Debt) :A. ADJUSTEDNONITE lINAIC(2) 0.67 1.79 3.47 0.85 5.74 2.57 1.74 0.26 0.80 0.75 1.82 0.73 1.34 2.78 3.40

1. Inflation Tax 3.25 0.99 1.27 1.86 2.56 2.80 1.92 0.54 0.95 1.35 2.75 0.86 1.35 2.04 3.23: 2. Seignorage -2.58 0.79 2.21 -1.00 3.18 -0.23 -0.18 -0.28 -0.14 -0.60 -0.93 -0.13 -0.01 0.74 0.17

1B.NIT DOMESTIC DIRTINAN1CI -2.15 -2.39 0.17 -1.30 -0.22 1.92 0.06 0.67 0.42 2.86 2.39 -0.49 1.21 1.65 1.03

3. Bondsand Bills -0.22 -0.09 0.29 -0.25 0.94 1.03 0.71 0.67 0.54 1.18 0.95 -0.12 0.00 0.06 -0.13

4. let BankCredit -1.78 -1.50 1.24 -1.28 -1.32 0.58 0.40 -0.23 -0.48 0.61 0.63 -0.90 0.60 0.89 0.33

5. IEFs(3) -0.14 -0.80 -1.36 0.23 0.16 0.31 -1.10 0.23 0.36 0.47 0.81 0.53 0.61 0.70 0.83

C. NET1O0EIGN DIBT FINANCI(4)M 2.30 -0.46 1.68 2.10 4.17 1.93 3.58 N.a. N.A. N.A. 2.31 N.A. 0.21 0.00 -0.30 0 (cicl. I losses of For. Debtl

D. 11TFOREIGN DIBT FINANCI 7.84 2.85 4.42 4.77 6.06 4.61 10.88 N.A. I.A. N.A. 3.71 N.A. -0.46 0.75 -0.56 (lnel. I losses of for. Debt)

llil0: FOREIGNEXCHANGE LOSSIS(5) 5.54 3.31 2.74 2.67 1.89 2.68 7.30 N.A. N.a. l.A. 1.40 N.A. -0.67 0.75 -0.26 (D-C)

SOUiCI:Central Bank, Quarterly Bulletin; andtreasury.

(1)Stocks were converted to average1980 prices beforecalculating its ratio to GiP. (2)This is theportion of soneyfinance which Is used to financethe deficit, i.e.,after deductinlthe portion returnedto the private sector (see Table5. for a breakdown). (3) forthe first three quarters of 1987and 1988it wasassused that thechange in net debtwas equal to that of end-1987and of end-1988respectively. (4)This estisate excludesthe capital loses (gains) causedby a real effective devaluation(apreciation) in the domestic currency and by changes In international exchangerates. Forthe estimates for theperiod 1980-86 the actual currencycomposition of theforeign debt wasused and, for theremaining period the currency compositionof end-of-1986was used. (5) Theseare thelosses incurredeach year due to fluctuationsin internationalexchange rates and to real devaluationsin the domesticexchange rate - 171 -

TABLE: A.5.7: BREAKDOWNOF NOMINALFISCAL DEFICIT ABOVE-THE-LINEGOVERNMENT'S ESTIMATES (1) (As percentage of GNP) l…l 1984 1985 1986 1987 1988 I l…- -… l …- IPSBR (= A+B) 5.4 6.6 6.6 10.1 6.8 I

IA.NET LENDING(1) I -2.0 0.9 1.1 1.6 0.8 I lB.TOTAL NOMINALDEFICIT (=I+II+III+IV+V) j 7.4 5.7 5.5 8.5 6.0 I

II. CENTRALBANK (2) j 0.9 1.1 0.8 0.6 0.0 I

|II. CENTRALAND LOCALGOVERNMENT (3) I 4.8 2.3 3.6 4.4 4.2 2.1 FOREIGNFINANCE I 1.8 -0.8 0.3 -0.3 0.6 I 2.2 CENTRALBANK NET ADVANCES j 1.0 1.0 0.7 0.6 0.7 2.3 DOMESTICFINANCE 22.0 2.1 2.6 4.1 2.9 I 2.3.1 BONDSAND BILLS (4) I 2.5 2.6 2.2 3.4 3.1 I 2.3.2 NET BANK'S CREDIT (5) I -0.5 -0.5 0.4 0.7 -0.2 I

1111. NON-FINANCIALSEEs I 2.7 3.1 3.4 4.4 2.5 3.1 FOREIGNFINANCE I 1.6 1.5 2.2 2.2 1.1 3.2 CENTRALBANK NET ADVANCES l -0.3 0.3 0.0 1.0 0.1 I 3.3 DOMESTICFINANCE (5) j 1.4 1.3 1.3 1.2 1.4 |

IIV. FINANCIAL SEE's -0.4 0.0 -0.1 -0.2 0.0 I

IV. EBFs -0.6 -0.8 -2.2 -0.7 -0.7 | I 4.1 FOREIGNFINANCE I 0.0 0.0 0.0 1.1 0.1 I 4.2 DOMESTICFINANCE (5) -0.6 -0.8 -2.2 -1.8 -0.8 l ……--… . … … ……- SOURCE:Central Bank, QuarterLy BuLletin; and Treasury.

(1) These estimates were caLcuLated by the Government froml revenues and expenditures.

(2) This is defined as the sun of MHF's Loans to the private sector pLus CentraL Bank's rediscounts granted to the private sector. For 1984, it was assumed that MHF's Loans to the private sector were zero. This definition is different to that used by the IMF.

(3) This is the above-the-Line quasi-fiscal deficit estimated in Table A.5.4.

(4) In addition to the Central and Local Governments, it also incLudes the Local Administration, Revolving Funds and SociaL Security Institutions.

(5) This is an estimate of net new issues of Treasury bills and bonds (i.e., bills and bonds sales less repayment of principal), using the Treasury data.

(6) It aLso incLudes changes in the cash balance position.

(7) IMF's definition excludes this item, as it is intended to be a non-financial PSBR estimate. - 172 -

TABLE A.5.8 BREAKDOUNOF NOMINAL FISCAL DEFICIT ESTI1MATEDTHROUGH CHANGESIN NET TOTAL PUBLIC SECTORLIABILITIES (As percentage of GNP)

…------1984 1985 1986 1987 1988 I ------.------IPSBR (- A+B) 10.6 9.4 8.9 11.2 8.8 I

IA. NET LENDING (1) I -2.0 0.9 1.1 1.6 0.8 I

IB. TOTAL NOMINAL DEFICIT (=I+II+III+IV) | 12.6 8.5 7.8 9.6 7.9 (Exci K losses) I FOREIGN FINANCE (2) | 6.1 2.7 4.9 2.9 -0.4 | DOMESTICFINANCE 0.9 3.2 1.2 4.9 4.9 | BONDSAND BILLS j 2.2 2.5 2.1 3.4 3.1 NET BANKS CREDIT I -0.8 0.9 0.7 1.4 1.5 EBF's I -0.5 -0.2 -1.6 0.0 0.3 MONEYFINANCE I 5.7 2.6 1.7 1.8 3.4

II. CENTRALBANK (3) I 9.9 3.5 1.6 2.0 2.1 I I 1.1 FOREIGNFINANCE (2) I 4.6 2.0 0.8 1.7 -0.6 1.2 MONEY FINANCE I 5.7 2.6 1.7 1.8 3.4 1.3 NET ADVANCESTO PUBLIC SECTOR -0.4 -1.0 -0.9 *1.5 -0.8 | 1.3.1 TO CENTRALGOVERNMENT I -1.9 -0.7 -0.7 -0.6 -0.4 I | 1.3.2 TO PUBLIC ENTERPRISES | 1.5 -0.4 -0.2 -1.0 -0.3 l~~~~~~~~ I |11. CENTRALAND LOCAL GOVERNMENT I 5.1 3.9 4.7 5.2 3.6 2.1 FOREIGN FINANCE (2),(4) I 1.4 0.6 2.8 0.9 0.1 2.2 CENTRALBANK NET ADVANCES 1.9 0.7 0.7 0.6 0.4 2.3 DOMESTICFINANCE | 1.9 2.7 1.2 3.7 3.1 | I 2.3.1 BONDSAND BILLS I 2.2 2.5 2.1 3.4 3.1 J 2.3.2 NET BANK'S CREDIT I -0.4 0.1 -0.8 0.3 0.0 I I 1111. SEEs I -1.9 1.3 2.9 2.1 1.9 3.1 FOREIGN FINANCE (2),(4) I 0.1 0.2 1.2 0.1 0.1 I I 3.2 CENTRALBANK NET ADVANCES -1.5 0.4 0.2 1.0 0.3 1 3.3 DOMESTIC FINANCE | -0.5 0.7 1.5 1.1 1.5 | 3.3.1 NET BANK'S CREDIT I -0.5 0.7 1.5 1.1 1.5 I

IIV. EBFs -0.5 -0.2 -1.4 0.2 0.3 I 4.1 FOREIGN FINANCE (2),(4) | 0.0 0.0 0.2 0.2 0.1 | | 4.2 DOMESTIC FINANCE -0.5 -0.2 -1.6 0.0 0.3 | l. ,. . . .-- . .- l SOURCE: Central Bank, Quarterly Bulletin; and Treasury.

(1) This is defined as the sum of MNF's loans to the private sector plus Central Bank's rediscounts granted to the private sector. For 1984, it was assuned that MNHF'sloans to the private sector were zero. (2) This estimate excludes the capital losses (gains) caused by a real effective devaluation (appreciation) in the domestic currency and by changes in international exchange rates. (3) This is a below-the-line estimate for the Central Bank's quasi-fiscal deficit. See Annex 5.1 for its definition and further discussion. (4) To estimate the foreign finance breakdown between General Government, SEES and EBFs we have apptied the share of the increase in foreign finance without correction for capital losses for each of these sectors, i.e., we have assumed the the currency conposition of the General Government's, SEE's and EBF's is the sae as that of the rest of the public sector i.e., total public sector's foreign debt Less that of the Central Bank. - 173 -

ANNEX 6 1 Demand for Assets in Turkey: A Preliminary Work

6.01 The purpose of this annex is to define a simple framework to estimate the real interest elasticity of substitution of the demand for assets. In this sense, it should be regarded as an extension of the estimates done in a previous report.1 This annex will enable us: (i) to measure the sensitivity of real interest rates to public sector's financial policy; and (ii) to estimate the inflation rate at which the inflation-tax revenue is maximised. First, the model is described; and second, the results are reported and discussed. Available data on assets and interest rates permitted us only to estimate a partial model, yet results on this exercise are useful. Further refinement of the model will be helpful to understand how exogeneous shocks (e.g., changes in monetary policy) are transmitted through the financial system and into private sector's savings and investment decisions.

lhe Model 6.02 In short, this model asserts that the desired demand for each asset relative to total wealth is a function of the vector of real rates of return and total wealth.2 This is equation (A.6.1).

(A.6-1) A * W = ci Z(_ I)bijRj+ diW,

where A,* is the desired holding of asset i, W is total wealth, Ri is the real rate of return of the asset j and ci, bij, and di are coefficients. Since

by definition T'-jw -=l, then the constraints Z?1bj=O, Z, 1di, and c=c, l must hold in the stationary state.

6.03 There are two problems with this model. First, as stressed by Brainard and Tobin(1968) this is only valid for the stationary state; in real life savers do not always hold their desired portfolio, they take some time to adjust to the different variables that determine their demand for assets and it will be more reasonable to think that in the short run they are in disequilibrium. This calls for dynamic modelling. This problem is very important, for many empirical studies for developed and developing countries have used a model that assumes that investors are always in their long-run

'I See volume II of: The Fiscal Policy Report, September, 1988. 2/ See Brainard and Tobin(1968), and although they use income instead of wealth, we decided to specify it with wealth as a proxy for permanent income. Furthermore, empirical results favour the use of the latter. - 174 -

equilibrium,which is certainly not true.3 Furthermore, dynamic modelling implies that investorswill not only respond to current and lagged values of the interestvariables, but also to the extent that they are in disequilibrium in their desired portfolio. That is, demand for asset i at period t will be a function of the past values of their holdings of asset i; of their holdings of other assets; of the real rates of return on asset i (i.e., own real interest rate) and of the real rate of return of other asset holdings (i.e., cross real interest rates). Moreover, since adjustment to desired holdings is not immediate,current and laggedvalues of all variablesshould be included. More formally,this can be expressedas equation (A.6.2). This is a simultaneous stock adjustment system.

(A.6.2) A A 1 l=~ L 1 ZIk(Ak - Akt

where Ai and Ak are as before and Zik are the coefficientsof adjustment in relation to past holdings of the same and other assets, i.e. own and cross. If ksi, as in a non-simultaneousmodel then O

3/ For developingcountries studies and a survey of them see, e.g. Gupta(1984). The only study that to our knowledgeattempts a similarapproach for a developing country is that made by Ortmeyer(1985)for Korea. For a more detail discussion of the model and probable shortcomingssee Brainard and Tobin(1968) and Fried- man(1977).For an example of an empiricalstudy using equation (A.6. 1) see Taylor and Clements(1983). 4/ See Thorne (1986), Chapter 4 for a more detail discussion of this model. - 175 -

that real interest rates can be negative - and they were - they cannot be expressed in logs. In the stationary state (i.e., when g=O) the solution of the dynamic model will be given by equation (A.6.3)below.

(A.6.3) (Ct+Z? b.+

- = K,where:K= e( where the variables are defined as above and lower case variables denotes the log of the variable. In the stationary state the ratio of asset i to total wealth is a constant and this will be given by the level of real interest rates and wealth. By definition ',- 1,. This seems to be a more adequate way to estimate the Brainard-Tobinmodel for a developing country, for it explicitly asserts that investorsare in disequilibriumin the short-run and that only in the long-run do they achieve their desired portfolio. It makes use of both short and long-run informationcontained in time-seriesdata. Empirical Results 6.07 Turkish data on assets, interest rates and wealth is scarce. For this reasonswe decided to estimate the model only for two assets,using three real interest rates and using current income rather than permanent income. Further studies will be needed to refine these results. The assets used were currency holdings (i.e., non-interestbearing assets) and Turkish lira (T1) denominatedinterest bearing assets.The latter was defined to include demand and time deposits (i.e., M2 less currency holdings). The interest rates used were: the annual rate of inflationwith a negative sign as the real rate of return on non-interest bearing Tl assets; a weighted average interest rate on Tl denominated interestbearing assets (weightsvary according to private sector holdings of each asset);and a weightedaverage interestrate on foreign currency denominated assets (weights vary according to foreign currency composition of residential portion of foreign exchange deposits). It would had been desireable to include the rest of assets that comprise total private sector's wealth, which would had enable us to close the general equilibrium model, but data was not available.In particular,it would have been important to include the demand for bonds and bills and the interest rate on this debt instruments, as this would have enable us to measure more accurately the effect of the deficit in the private sector's demand for assets. Future extensions of the model can yield very useful results. 6.08 Equations (A.6.4) and (A.6.5) report the best regression results using OLS (ordinaryleast squares) for the equations of demand for currency and of interest bearing assets in Tl. The data used was quartely for the period 1981.3 to 1988.2. 6.09 The long run or stationary-statecoefficients are reported in Table A.6.1. The most importantobservations from the long-runcoefficients results are the following. First, the strongesteffects on the demand for assets are the effects of the own real rate of interest and of current income. In the case of the demand for currency, for instance, a decrease in the inflation rate by 10 percentage points will increase the ratio of currency to GNP by - 176 -

Equation (A.6.4) Equation (A.6.5) Dependent Variable: LN(C/GNP) Dependent Variable: LN(FA/GNP) Constant -1.37 LFAGP, 0.40 (-2.78) LN(FA/GNP) 1 4 (9.01) 0.22 (-j53 0.80 (1.46) (5.48)

-0.11 (-P,-I) -0.57 (0.78) (-3.59) Rfx -0.33 RIO 0.24 (-5.16) (2.10)

Ln(RGNP,) 1.31 RIX1 0.025 (2.68) t (0.35)

Ln(RGNP,-I) -1.76 Ln(RGNP,) -0.24 (-3.57) (-9.36)

k2 0.80 T2 0.79 DW 1.82 DW 1.47 SSR 0.084 SSR 0.047 where C is currency holdings in TL, FA is interest bearing assets denominated in Ti, GNP and RGNP are nominal and real GNP, R is the real annual interest rate using the last quarter annualized infaltion rate, p is the annual inflation rate, superscripts fa and fx denote real interest of interest bearing assets in Tl and in foreign exchange respectively, LN is the natural log, R2 iS the statistic for goodness of fit for the equation adjusted for degrees of freedom, DW is the Durbin Watson statistic and SSR is the sum of squared residual.

2%. Similarly, an increase by 10 percentage points in the real interest rate on these assets will increase the ratio of interest bearing assets to GNP in 4%. 6.10 Second, the closer substitute to hold currency are foreign exchange deposits (FEX). The coefficient of the real interest rate of this alternative asset is even higher than that of the negative of the rate of inflation. This suggests that a real devaluation of the Tl will encourage asset holders to switch to FEX even if the inflation rate do not increase. An increase in inflation will further reinforce this switch. To the extent that both effects have been in operation in Turkey in the last two years, they explain the fast decline of currency holdings and the rapid increase in FEX's. Notice also that neither the coefficient of the real interest rate on interest bearing assets in TI in the demand for currency holding's equation nor the coefficient of the real interest rate on FEX in the demand for interest bearing assets equation is not statistically significant different from cero. This reinforces the above conclusion that in Turkey FEX are a close substitute for currency. (It still remains to be seen the regression results for the other demand for - 177 -

Table A.6.1 Long-run Coefficientsof Regression Results

Variable -p RIa Rfx Income Elas- ticity

GNP 0.219 0.0 -0.33 -0.45 GPA

CNP 0.38 0.41 0.0 -0.4 where variables are as before. The income elasticity is computed relatively to the dependentvariable (i.e., C and CFA). The income elasticitywith respect to C and FA can be calculated as 0.55 and 0.6 respectively. assets held by the private sector.) The implication of this (which needs further analysis)is that strong real devaluationscoupled with an increasing rate of inflationwill make authoritieslose control of monetary management (e.g., policies aimed at curbing inflationusing monetary policy). Moreover, this also means that the base of the inflation-taxwill shrink very fast, thus authorities to collect the same inflation tax will need to produce a higher inflation rate to compensate for the decline in currency holdings. This higher inflationrate, however, will further discourageprivate sector's holdings of currency. 6.11 Third, income elasticity of demand for currency and of interest bearing assets in Tl is small. This is even if the income elasticity is computed on C and FA -- 0.55 and 0.6 respectively-- and not on their ratios to GNP. However, the interpretationof these coefficientsis not clear because they were estimatedusing current income and not permanent income or wealth. It might well be the case that the relatively low coefficientsare simply indicatingthe high variance of current income relativelyto permanentincome. In any case the coefficients indicate that asset holders have a relatively low propensity to increase their financialassets holdings as their current income increases.The difference is allocated to the increase of other asset holdings (assets from outside the organised financial market and/or assets not modelled) and/or to the increase in consumption. 6.12 The interpretationof a positive effect of the negative of the rate of inflation is somewhat striking as one would have expected a negative coefficient:the lower the inflationthe greater the demand for cash-balances and, thus, the lower the demand for interest bearing assets. The fact that this coefficient is showing a positive effect might be indicating that at higher inflationrates the greateris the risk of holding long maturity assets. The reason for this is that asset holders are uncertainabout what the realized inflation rate would be; and although past expereince provide a way to form expectationsabout its future level, it is always inaccurateand asset holders' losses can be large. - 178 -

Inflation Tax 6.13 These results can be used to estimate what would be the maximum inflation tax for the given demand function for currency. To estimate the total inflation tax one would need to add the inflation tax collected on the other non-remunerated deposits at the Central Bank such as banks' reserve requirements. Moreover, to see the full implications of an increasing inflation rate (i.e., a decrease in the real rate of return on currency holdings) one would need of the other demand for assets functions (not modelled) to work out how the new equilibrium is attained once an exogeneous shock such as an increase in the inflation rate is experienced. In general, for a given wealth, a sudden increase in the inflation rate by encouraging asset holders to reduce their currency holdings will exert the strongest downward pressure on the real interest rates of assets with which currency holding is a closer substitute. The strength will depend on the elasticity of substitution of currency holdings relative to inflation and the volume of resources freed. 6.14 In Figure A.6.1 the inflation tax on currency holdings and the demand for currency holdings are plotted together. In this simulation it was assumed that only the inflation rate varies and that the other variables remain constant. While this is a simplifying assumption, it is clear that this is -not a realistic assumption as real interest rates do vary with inflation -- i.e., the higher the inflation rate the greater asset holders uncertainty about future inflation rate levels - - and similarly with current and permanent income: production and investment is also affected by future uncertainty about relative prices. Furthermore, the currency demand function can also experience a structural shift, and this needs to be further analysed. The curve in Figure A.6.1 is useful only as an illustration of what would be the curve if the assumptions hold. 6.15 This Figure shows that the inflation tax on currency holdings increases up to a maximum which is reached at an annual inflation rate of around 100-140 percent. Thereafter the inflation tax declines steadily. This same figure also shows the steady decline in the demand for currency as inflation rises. - 179 -

FIGURE A. 6.1 LAFFER CURVE OF INFLATION TAX On Currency Holdings

2.6

2.4 -

2.2 -

2-

1.8 - z 1.6- o 1.4-

1.2- IN -

0.8-

0.6-

0.4

Annual Inflation Rates in % El Inf Tax + Dem for Curr - 180 -

TABLE: A.6.2 INTEREST RATES OFFERED BY BANKS ON 1 YEAR FOREIGN EXCHANGE TIME DEPOSITS (FEX)(1) (In percentage) Name of Share in Share of Bank Overall FEXs in Total Liabi- lities 1986 1987 1988 Total FEX(2) of each Bank US $ DM US $ DM US $ DM (%) (%)

Ziraat Bankasi 20.3 22 7.8 4.8 7.8 4.8 7.8 4.8 Akbank 10.1 24 7.8 4.8 7.8 4.8 7.8 4.8 Garanti Bankasi 4.5 32 8.8 5.2 8.8 5.8 9.0 6.3 Disbank 0.9 33 9.8 6.8 8.5 6.0 8.5 5.5 Sumerbank 1.1 22 11.0 9.0 9.0 7.0 8.0 7.0 Imar Bankasi 2.4 95 12.5 9.1 12.0 9.1 10.9 8.1 Memo: LIBOR(3) 7.0 4.6 7.6 4.2 8.2 4.2 SOURCES: Central Bank; IMF, International Financial Statisitics and Banks Association of Turkey.

(1) These are the annual average interest rates, except for 1988 which is the average of the last 10 months. (2) Is the share of each bank FEX relatively to the total of the financial system. (3) US dollar deposits are annual average interest rates on 1 year maturity deposits and DM deposits are annual average on 6 month maturity deposits. Unrdersecretarial of Treasut

Undersecrelary

Depuly Under secrelary

GeneralDirecor Gtdnral d)irector Geiteral Director rt of Forraitsn ol Banking ol n}z. t conomtic Ftedlolons Exchange .Public Finance r_ tn 1a wr: 0) l~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~a. O,

Direcor I Drec or Dere"or r, n tst General |General General n1 o pz s: {_ | , | r *~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~rrltI OI _ w . _ w . ~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~t'.pi Deputy Director Deputy Direclor Deputy Director Deputy Director Dep ty Drcior Deuy Dlecj cq t- Gienerd Genrwdl Geneal, Gnetal Geerl enrl t 0 ri rt.0 rt WoWr;Bank MeAlilaiaeral | |Foreign Cufrrncy| Capilal Anntual l l T| r Pfosecds Futuanctnga& Operallons |M Xarkeets | Programs g Trasury mi Depanment f undjs Department Depa!)1silmentl | Departmenl Departmenl | D pdrtmo-n §

IMF ;tHDT tBi1dtteal Cdpotal Banking Service | |External Detabs| 1 813.61rilce t1nancing i | Moveenions I In Seclor Volk)w up I ol l'ayrnertls Dlepaltlnrien I Depanmnlon D eparnmenl I | I)parnmenl Dlepamirlent Wpariniet. I I I- -* enea | Geernlal |enerl |eneral |Eernat GeoiernExchage |n I Mulilldul I CBaal Markels |Poiges Currec Sapial|lDAnbis DOrganilent | u Depa rtment Dpanmenl F Dparlment D a Deparnmenlt

IEnetgy Metal & IManutdcluringI Sector t Depanmen) aD

l,z r*46 14/ 1 Distributors of World Bank Publications

ARGETINA FINLAND MALAYSIA Forsucrt morim Calo Hirsh SRL Akuteroni Ktjakauppa UntveritydMalaya Coopative Internatioral SubsraiptionService Gleria Gumes P.O Box128 Bodah, Limeid P.Q Box41095 Florida165.4th Floor-Ok 453/465 SF4100 PO. Bo 1127,lJahnPotaliBam Craighall 1333Bueno Airs Heolinsi 10 Kwalalnpur Jothanenbueg 2D24

AUSTRALIA, PAPUA NEW GUINEA. FRANCE MEXICO SPAIN FIPpSOLOMONISLANDS, Wrdd SankPublications INFOrEC Mundi-Prs Lbror SA. VANUATU,AND WESTERNSAMOA 66, avenue d'Ira ApartadoPoal l22-860 Castdlol37 DA. Soks &Jnu 75116Pas 140l6DOTatpan,MedoDF. 27OO1Madrid 648SWidts,rseRoad Miltdsh 3132 GERMANY,FEDERAL REPUBLIC OF MOROCCO Litbrae InterndcionalAEDt30 Vitoia UNO-Vanig Socielte tuda Marketing Marci.n CondU deCent, 391 Poppeladrefe,Allee 5 12 rue Mat, Bd. d'Asf e 09019Barltona AUSTRIA D-530 BSn I Caablana Ger,ld nd Co. SRI LANKAAND THE MALDIVES Grabs 31 GREECE NETHERLANDS Lake Hore Bookhop A-lll Wian KEME InOr-Pubtikira b. PO.Box 244 24, Ippodn Sireet P Plstirs P.O. Box14 1I1, SirChittlanpa1a A. Grdiner BAHRAIN Atlheu-11635 7240RALades Ma-tha B.hrain Researnd Coarudtancy Cotombo2 AssdociteLUd. GUATEMALA NEWZEALAND P. Bom221n Ubren Piextr Santo Hil' library nd Ishnrmton Service SWEDEN Manama,Town 317 CetroiCulhzn Piedra Santa PrivateSag Fsi7sagk tBhe 11 call. 6-50zoa I NMeMark FritrFackbakaforetagt BANGLADESH Gu tea bCity Audr.ad Kopergagata 1ZBo16356 B2, Mic,o Indurist Devdopment S-10327 Seodehalo AsoistanceSociety (MIDAS) HONG KONG, MACAO NIGERIA Horse S, Road 16 Aia 2 Ltd. Univerity PFe Iinited Fors dipiodre Dhinmondi R/Area Mrgkk Post Office ThreeCrownsBWitdingJeicho Wenneerr-WlinsAB Diska 1209 Bub.SoetoMN.37 Privte MailBag 5095 Bon 304 Mogktok Kbwloon tbadm S-10425 Stockhodt BrDIC8rq H.ag Ksng 156 Nw Ahmed Sak NORWAY SWITZERLAND Chitiagong401 HUNGARY N ne C-nr.marionCemter Fcr-islk Wime Kllhr- Bertrand NMar v-i 2 Librie Payt 76, KDA Avenue P.O BoX139 P. O BX 6125Etier dta 6,rue G-eeus Kulr 1389 Budapest62 NMW020 o6 Campost 381 CH 1211G-rer 11 BELGIUM INDIA OMAN PublicaisnideMNsxioUnis Allied Publishr Private Lid. MEMRBhdnoai-onS S-ces Porrcrn: Av. du RS 202 751 Mant Rod PDO.Bo 1613,5eeb Aiport Libririe Payt 1060 eusds Madras-600032 Mut Ser de Abonnemebt Caseposal 3312 BRAZIL Branchqk PAKIaSTAN CH 1002 Lausanne PublEcarcsTe-ricas Innnat iiiai 1SJN. Heredi Marg Mitn BorkAgency Ltd.. Ballard Erbat 65,Stahrah-Quaid-Azanm TANZANIA Rus PeixotoGornide,2D9 Bombyy- 400038 PO. BoxNo. 729 rfdUniversityPreso 0t409SSoPruno,SP Lahoel3 P.O SOn529 13/14AsaAll R-d arlea Salbm CANADA New Delhi-110 032 PERU La Die Editrial Dan 1riollSA THAILAND CF. 55,150BrueAipere 17 ChittananpnAvenue Aptds 3824 Certral Deptartent Stre Bich-ville Quebec Calcutt-700072 liars 3D6Sts Road 34BSE6 Bangkok JayedevaHostd Building PHILIPINES CHINA SthMin Road Gndhinagsr National StB ore TRINIDADI&TOBAGO, ANTIGUA Chins Financial& EonaicPublihing Bangalre-56019 701 Rizn Avenue BARBUDA,BARBADOS, Hour PO. BoX1934 DOMIN;CA, GRENADA,GUYANA, 4SD. FoSi D-nglie 3-5-1129Kaguda Cr Road MetesManila JAMAICA,MONTSERRAT, ST. IBtjing Hyderabad-500027 KITTS & NEVS, ST. LUCIA. POLAND ST. VINCENT& GRENADINES COLOMBIA PearthanaFlats, 2nd Floor ORPAN Sy-tecaioStudies Unit EnlaceLtds. NearThkceB Navsngpu-s Pat IKdulry i Naul #9 Wait Street Apastbdo Aeo 34270 Ahmedabad-3801009 0m-901Warsoawa Cur-pe BogotaDE. Trinidad,Want Indie PatialaHorse PORTUGAL COSTA RICA 16-AAahokMarg Livtcia Portugal TURKEY ubrer,aTrejux Lucnow-226001 RsDoCarmo7074 Haet Kitapevt AS. CaUe11-13 1201 Libn l1kblCddiNM. 469 Av. FerndezGdll INDONESIA Beyoghu San 3 Pn Idir Limited SAUDIARABIA, QATAR Istanbul JL SarmRatulani 37 JaBir Sooktore COTED'IVOIRE P.OSBX 191 P.O BSX3196 UGANDA Centre dEditro et de Diffuto, JakartaPusat Riyadl 11471 Uganda Bookahop Afric-ns(CEDA) P.O.Box 7145 04 B.P.541 IRELAND MEMRBInormtion Servic K-palI Abidjan04 Plateau TDC Paibiieh Bench of/i= 12 North FrederickSreet Al Al. Stret UNITEDARAB EMIRATES CYPRUS Dublin I Al Dahs Center MEMR8Gurl Ca. MEMRBIfomtion Servi Fust Floor P.O. Box6097 Pfl BoX2098 ITALY P.O. Box7188 St%ijh NictGiD LU Coonmiriornta- Saoi SPA Riyadh Via Beirdetto Fortini, 120/10 UNITEDKINGDOM DENMARK Casels PoWl. 552 Haj,AbduIah Alicxa Building MiaroinfoLtd. SamfundoLitterahr 53125Florence King Kraled Street P.O. BSx3 Rosnoern- Alld 11 PD. BSx3969 Altto, Hamphiro GU342PG DK-1970FredeimksbergC JAPAN Daurtan Eygland u Easter Brok S-ei DOMINICANREPUBUC 37-3,Hoogs 34-C , Sunkyc-ki113 33,Mrituunmed Ha Awd Street URUGUAY EditorsTaDer,C pocA. Tokyo P.O. BSan9978 itotohMacNrldondd UbIr Reurac one IsabelaCatdiCca 309 Jddab SnJoe 1116 Apatado Porta 2190 KENYA M-tenvid SantoDomingo AfricaBcok Seioe (EIA.)Ltd. SINGAPORE,TAIWAN, MYANMAR, P. OB- 45245 BRUNEI VENEZUELA ELSALVADOR Nirobt I Mtion Publcati Libera dd Ste Fusadan Privae Ltd. Aptdo. 60337 AvenidaManm Eniqu-Arauj 3530 KOREA,REPUBUC OF 02-061stFl, Pei-PuIndustrial Cars- 1060-A EdiSionSISA, leer P Pan Kon Bori Clprrhirorn Bldg SmSalvador P.O.Bx 101,Kwmgwhsinun 24INewIndustrialRoad YUGOSLAVIA Seout Singore 1953 lugoslsetes Ktojigs EGYPT,ARAB REPUBLIC OF YU-1100 BRelgradrTg Reprbbke Al Ahram KUWAIT SOUTH AFRICA,BOTSWANA Al GCl Street MEAERBInfr-tiss Service FPoraig tiale Cairo P.O.BD 5465 OkfordUniveeity Peris S-uther- Africa ThrMiddleEastOb erver P.O.Box 1141 S ChmvarbiSeet CapyTen somM Cairo 7>

-E o - C~~~o .1~~~~~~~~~~.a

0~~~~~~~~~~~~~~~~~~~~~,

The World Bank Headquarters European Office Tokyo Office 1818 H Street, N.W. 66, avenue d'Iena Kokusai Building Washington, D.C.20433, U.S.A. 75116Paris, France 1-1 Marunouchi 3-chome Chiyoda-ku, Tokyo 100,Japan Telephone: (202)477-1234 Telephone: (1) 40.69.30.00 Facsimile:(202) 477-6391 Facsimile:(1) 47.20.19.66 Telephone: (3)214-5001 Telex: wui 64145WORLDBANK Telex:842-620628 Facsimile:(3) 214-3657 RCA248423 WORLDBK Telex:781 -26838 Cable Address: INTBAFRAD WASHINGCTONDC

ISBN0Q213-1594-3