REPUBLIC OF TURKEY
PRIME MINISTRY
THE UNDERSECRETARIAT OF TREASURY

Ankara, July 31, 2001

 

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C., 20431
U.S.A.

Dear Mr. Köhler:

1. We have continued to implement forcefully our ambitious economic reform program. The applicable quantitative performance criteria for end-May and end-June were observed, and we have taken further important steps in banking and other structural areas (Annexes A and B). On this basis, we request completion of the ninth review under the stand-by arrangement. We also request modification of the ceilings for the performance criterion on the cumulative primary expenditure of the central government for the remainder of 2001, consistent with our revised annual inflation projections. Moreover, we request modifying the indicative ceilings on base money, and thereby the performance criteria on the net domestic assets of the Central Bank of Turkey, for the remainder of the year in line with our updated macroeconomic framework. All other performance criteria and indicative targets remain unchanged.


2. After a difficult first half, the economy is beginning to show a positive response to the strengthened program. GNP fell in the first quarter of 2001 by 4.2 percent year on year, and is expected to have fallen further in the second quarter. Moreover, the persistence of very high real interest rates and the contraction of domestic demand are burdening bank and corporate balance sheets and putting pressure on the enterprise sector, especially on the small and medium enterprises that account for the bulk of employment. On the other hand, signs of an incipient recovery are emerging: capacity utilization edged up by more than three percentage points from April to June, and the central bank’s business surveys show increased confidence among respondents, partly because of surging exports and a boom in tourism. Moreover, the inflationary impact of the large February depreciation seems to have largely played itself out, and the inflation slowdown, which began in May, continued in June with 3 percent CPI inflation during the month. Finally, the slowdown and the depreciation of the Turkish lira have led to a marked turnaround in the external current account.


3. Looking ahead, we believe that further progress under the program, together with continued international financial support, will rebuild confidence, help lower interest rates, and facilitate the economic recovery. The May 3 letter, updated by the letter of June 26, remains the main document describing our policies for 2001–02, and is further updated in this letter in several areas. The major financial support from the IMF (some US$19 billion committed for 1999–2002) and the World Bank (US$6.2 billion committed for 2001–03) provides assurances of adequate official financing. Regarding private sector involvement, following the June 12–13 meetings with foreign commercial banks, we have sent letters to the participants, seeking their commitment to maintain their exposures to Turkey at mid-June levels, with a view to restoring December 11, 2000 exposures as the program is implemented. We have already received responses, and are following up with foreign banks that have had difficulties in maintaining their exposure. We believe that the policies and measures described in this letter are adequate to achieve the objectives of the program, but we stand ready to take additional measures if necessary to keep the program on track, consulting regularly with the Fund.

Communications policy

4. We are making strong efforts to explain our economic strategy and achievements under the program. In recent months, we have already taken a number of steps, including outreach efforts by the State Minister for Economic Affairs and other senior officials in Turkey, meetings with international investors abroad, the issuance of statements and the publication on official websites of material explaining the program, and the revamping of the Treasury’s media relations unit to facilitate a more pro-active approach to explaining economic policies and developments under the program. We have also continued to publish the letters of intent, and agreed to the publication of the IMF staff reports. In the period ahead, we will hold regular domestic press conferences; seek to better explain economic policies; and hold additional road shows in major international financial centers and Turkey. Moreover, building on our already active contacts with international investors, we are exploring the scope for setting up a more formal investor council, as has been done in other major emerging markets countries. Such a council would help to further improve investor sentiment, reduce the volatility in capital flows, and strengthen our ability to monitor shifts in market perceptions.

Macroeconomic framework

5. We have revised our macroeconomic projections for 2001 in light of recent data. While the fall in output in the first quarter was somewhat greater than forecast, leading indicators of activity and export developments suggest an output recovery starting in the third quarter. Taking into account the decline in activity that has taken place so far, we now project a fall in real GNP for 2001 as a whole of 5½ percent, compared with the original program projection of a decline of 3 percent. Although the increase in inflation in the second quarter resulting from the initial depreciation of the lira was slightly above original projections, the recent decline in inflation indicates that our target of 2 percent monthly inflation by end-2001 is within reach. For the whole year, we now expect CPI inflation (December over December) to be 58 percent, compared with the originally projected 52.5 percent. For the next twelve months (June over June) we expect CPI inflation to fall to the 30–35 percent range. The external current account balance is expected to show a US$5 billion (3 percent of GNP) surplus for the year (compared with the originally projected broad balance), given continued strong tourism performance, the rebound in exports (especially in the automobile sector), and the fall in imports.

Fiscal policy and debt management

6. Fiscal policy has remained on track. Through end-May, the primary surplus of the consolidated government sector reached 3.4 percent of annual GNP, comfortably exceeding the program target by 1.7 percent of GNP. This was underpinned by overperformance of income taxes (especially the withholding tax on interest); delays in investment by extrabudgetary funds; and lower-than-projected expenditures in state enterprises, especially in the agricultural area. For the consolidated central government budget, we kept primary expenditures within the end-May ceiling, and for end-June, our cumulative primary balance remains above program projections by 0.2 percent of GNP. On the policy side, we expect the revenue impact of the recent overruling of the proposed VAT rate increase on telephones to be offset by departure levies for residents, and a fee on savings deposits.


7. We remain on track to meet our primary surplus target of 5.5 percent of GNP in 2001, as revenue overperformance is expected to continue and as state enterprise finances are better than expected. We expect higher inflation to more than offset the impact of lower growth on revenues, leading to an additional 0.2 percent of GNP in revenue during the second half of the year. Combined with the overperformance already realized during the first half (0.2 percent of GNP), and higher-than-expected rate increases realized at Türk Telekom in June (yielding 0.1 percent of GNP for the year), this provides room to offset the weakening in real public expenditures implied by the revision to the macro economic framework. In any case, should deviations emerge later in the year, we would reduce discretionary noninterest expenditures, and take revenue measures as needed to ensure attainment of the primary surplus target.


8. The  increases in primary expenditures consistent with the new macroeconomic framework and the primary surplus target are intended either to maintain the original path for real public spending or to alleviate the impact of the crisis on the most affected. Some 0.4 percent of GNP of the increase will be reflected in the consolidated central government budget, and is due to inflation indexation of pension payments and civil servants’ salaries and additional transfers to social security institutions to help them maintain health expenditures constant in real terms. The revised performance criteria on the ceilings on the primary expenditure of the consolidated central government reflecting this increase are shown in Annex C. While the more depreciated exchange rate could raise our utility and agricultural subsidy costs (which are defined in U.S. dollars), we expect to be able to contain the possible additional costs within the budget appropriations. Spending will also increase in the broader public sector by 0.1 percent of GNP, accommodating outlays financed by an expected World Bank loan to support the Social Risk Mitigation Project. This loan is aimed at increasing education, health, and other social spending on the poorest members of society. This reflects our continued emphasis on supporting and strengthening the social safety net, given recent economic difficulties. For all other spending items, we will adhere to existing budget ceilings.


9. We are taking further steps to strengthen the overall fiscal position and to improve overall budgetary management. We are preparing the 2002 fiscal strategy with a view to further increasing the public sector’s primary surplus to 6.5 percent of GNP. This will require tight expenditure restraint, and in our budget call we have asked agencies to limit their spending requests to a level consistent with no real increase. We expect to finalize the central government budget proposal in October. While spending will be restrained next fiscal year, we hope to see an increase in the efficiency of spending through the implementation of a new public procurement law. We expect to submit this law to parliament by October 15, 2001 (a structural benchmark), after consulting with the World Bank and EU. To further support our budgetary restraint and our cash planning, we will begin regularly monitoring expenditure commitments. Until our new computerized accounting system is operational (at the end of 2001), and extended to include reporting of commitments, we will use quarterly surveys as monitoring devices, beginning at the end of the third quarter of 2001. To minimize the burden of taxation necessitated by our expenditure plans, we will also seek to broaden the tax base. In this context, last year we received technical assistance from the IMF on tax policy and administration. We are now working jointly with the World Bank to adopt a medium-term strategy for improving the tax system in Turkey by end-2001. Finally, we continue to make progress on the extension of tax identification numbers to financial transactions, expected to commence on September 1, and we will intensify our efforts at collecting arrears by setting strict performance standards for tax offices.


10. We are taking a number of steps to reduce the government’s borrowing needs and costs so as to ensure the orderly rollover of government debt:

  • The government will maintain a strong primary budget position. Together with the use of external resources, this will keep the Treasury’s domestic borrowing need well below redemptions during the remainder of 2001.
  • On July 26, we announced a package of measures to further reduce the rollover risk. To encourage a move toward longer maturities for bank liabilities, we will differentiate withholding tax rates on deposits, applying lower rates for longer maturity deposits and higher rates for shorter maturities with the intention of keeping this measure broadly revenue neutral. To encourage more direct holdings of treasury bills by households, we  propose to raise the income tax exemption for buyers of government paper from the equivalent of TL 4.9 billion to TL 50 billion until end-2002 (when a broader reform of the system is planned). To reduce the cost of banking sector intermediation the CBT will begin paying interest on Turkish lira required reserves. Finally, to remove barriers to import financing, we will lower the tax on foreign import credits from 6 to 3 percent. These measures will not have a significant fiscal impact. Should deviations emerge, we will take additional measures to achieve our fiscal targets.
  • In addition, Treasury’s gross borrowing from private banks will be reduced substantially through the participation of state banks and the CBT in the rollover of Treasury obligations. Nearly one third of the scheduled redemptions in the coming months are owed to state banks and the CBT. As anticipated in the original program, the liquidity provided through these redemptions should correspondingly increase demand for Treasury paper, either directly through the participation of state banks in Treasury’s rollover, or indirectly to the extent that redemptions financed a move of depositors toward private banks. Following the recapitalization in May, the financial position of state banks has been strengthened considerably, and the rate at which deposits have moved to other banks has not been as rapid as anticipated. As such, these institutions are expected to have the capacity to participate directly in the debt rollover for some time. To this end, the portion of Treasury’s redemptions that is not needed to cover state banks’ liquidity needs will be redeemed in the form of new Treasury paper bearing market interest rates and quarterly coupons. This measure will ensure that state banks’ balance sheets remain strong, while these banks are being prepared for sale in line with our original strategy, and in the meantime should reduce rollover risk by ensuring the borrowing from private banks remains below their redemptions. Should the state banks face unexpected liquidity needs because of deposit withdrawals, such liquidity will be provided promptly by the Treasury. Also, in line with our original strategy to reduce balance sheets of intervened banks, the Treasury will continue to service all obligations to SDIF banks in cash.
  • The new Law on Public Finance and Debt Management has been presented to Parliament (meeting a structural benchmark under the program), and will provide the necessary legal framework for strengthened debt management. We expect that the new framework will be in place by end-November 2001.
  • With the recent passage of legislation to establish private pension and insurance funds, we expect nonbank institutions to increase their participation in Treasury bill auctions over time.

11. Confidence that Turkey’s public debt burden is sustainable is a critical element of the program’s success. Taking into account the more conservative assumptions on growth and inflation in 2001, Turkey’s debt burden remains sustainable even if ex-ante interest rates were to remain close to the high averages of the past decade. To achieve sustained rapid growth—a basic objective of our program—a significant decline in real interest rates is required. In this regard, we believe that continued progress in implementing the program will further strengthen market sentiment and facilitate the convergence of interest rates and other macroeconomic variables to program objectives.

Monetary and exchange rate policy

12. We are moving ahead swiftly with our plans to introduce inflation targeting. To this end, the CBT has made considerable progress in strengthening its information base and accelerating its modeling and research efforts. Monetary policy decisions are already being increasingly guided by the inflation outlook. Since under this monetary framework communication with the public and markets will be important, we will also accelerate our efforts to establish mechanisms, including regular issuance of inflation reports, to ensure transparency and the effectiveness of monetary policy. The next inflation report will be issued by early October. In view of the expected improvements in the fiscal situation, the rapid progress on banking reforms, and the completion of the pass-through from the initial depreciation to prices, we intend to formally make an inflation target the nominal anchor of monetary policy beginning in the last quarter in 2001. At that time, we will announce an inflation target for 2002, supported by an indicative quarterly inflation path. In the meantime, the CBT will regularly assess the inflation developments and outlook and, based on this assessment, will adjust interest rates consistent with the disinflation objective. As the program is implemented and inflation continues to decline, we expect short-term interest rates to be on a declining trend, although the CBT stands ready to raise rates as needed to support a continued fall in inflation.

13. During the transition to inflation targeting, base money will remain the nominal anchor for the disinflation effort. In line with the updated macroeconomic framework, and more closely reflecting the seasonal behavior of currency demand, we have prepared revised targets for the monetary base (Annex D). To help achieve the base money target, the CBT will sell foreign exchange (see next paragraph) and adjust money market rates as needed.


14. Discretionary foreign exchange intervention will be limited to smoothing operations. Consistent with the program strategy, the CBT will continue to conduct two types of foreign exchange operations. First, the CBT will sell foreign exchange in the market to offset the impact on domestic liquidity of  the use of external borrowing for the budget for domestic payments. To this end, the CBT will place all such external support in a special account. The portion of these funds which is used for domestic payments will be sold in pre-announced auctions. Second, the CBT may also intervene from time to time to smooth temporary exchange rate fluctuations. However, to avoid taking bets against the market, such intervention will be infrequent and in both directions, consistent with the floating exchange rate regime.

Banking sector reforms

15. We have continued to make rapid progress on banking sector reform. Commitment letters with plans to raise banks’ capital to adequate levels by end-2001 have been signed with private banks identified as financially weak. Five banks that were unable to commit to credible recapitalization plans were intervened on July 10. Three of the four SDIF banks (Etibank, Interbank, and Esbank) for which no interest had been shown by potential investors were merged into a second transition bank (under Etibank) on July 2. Moreover, Bank Ekspres has been sold to a local group, and an international bank (HSBC) won the bid to further negotiate the sales and purchase agreement of Demirbank until September 20. Negotiations on the sale of Sümerbank are still ongoing. If no agreement can be reached about the sale, liquidation procedures will be initiated before end-September. We revoked the license of Emlak bank on July 9, and its banking assets and liabilities have been transferred to Ziraat, which has been adequately capitalized to absorb those assets. A monitoring system has been introduced to monitor profits/losses, liquidity, and interest rate margins of the state banks. The independent audit of the state banks has been completed, and outside advisors have been appointed to guide the operational restructuring of state banks. An omnibus law to facilitate the restructuring of the state banks as well as mergers of banks and their subsidiaries has also been passed.

16. Several further steps are being taken to strengthen the financial position of private banks:

  • For the financially weak banks that have committed to capital strengthening plans, we have established a framework to monitor closely banks’ compliance with the agreed plans. The BRSA will promptly impose the sanctions prescribed in the Banking Law on any bank that does not fully comply with the plan.
  • We will continue to monitor the financial condition of private banks, and our strategy will remain to require banks identified as financially weak to agree with the BRSA on capital strengthening plans. Whenever such plans cannot be agreed, the banks in question will be resolved promptly, by the time of the following program review.
  • A strengthened regulatory framework will help reinforce the implementation of banking reforms. In this context, an amended regulation on connected lending has been issued.

17. We remain committed to resolving the banks taken over by the SDIF by end-2001, and will in the meantime continue the operational restructuring of these banks:

  • We will continue to ensure that the deposit rates of the SDIF banks are in line with those of private banks, and that the SDIF banks adhere to the minimum maturity guidelines while remaining liquid.
  • We will finalize resolution strategies for the five newly intervened banks (Kent, EGS, Bayindir, Taris, and Site) as soon as the Sworn Bank Auditors have completed their assessments (this is expected by end-September).
  • We have finalized a strategy to resolve Türk Ticaret through voluntary liquidation, once the legal process has been completed. We expect the resolution process to be initiated within two months.
  • The sales process for Iktisat Bank will begin once the Sworn Bank Auditors have completed their financial evaluation. Iktisat and Etibank (the second transition bank) will be put into voluntary liquidation by end-2001 if they cannot be sold before then.
  • The SDIF’s Collection Department (COD) will soon become fully operational. To date, 74 employees have been hired, and the staff will be increased to around 100 by end-2001. New operational guidelines for loan recovery have been approved by the BRSA Board, and will be submitted to the Prime Ministry by end-July, to be issued in the Official Gazette. The bulk of nonperforming loans above TL 75 billion from Sümerbank, Bank Ekspres, and Türk Ticaret have been transferred to the COD. The files from Etibank, Interbank, Esbank, Demirbank and Iktisat will be transferred to the COD by end-September 2001.

18. The work to prepare the state banks for privatization is moving ahead:

  • Progress has been made with the operational restructuring (branch and staff consolidation) of Ziraat and Halk. Criteria for branch closures and reductions in employees are being worked out, with rationalization to be completed over the next 18 months.
  • Following the transfer of Emlak’s assets and liabilities to Ziraat on July 9, a shareholders’ meeting will be held on August 17 to appoint a liquidator. Furthermore, while all of Emlak’s branches initially were transferred to Ziraat, we are currently in the process of identifying branches that will be transferred to Halk by end-August 2001.
  • The process of privatizing Vakif will resume as soon as market conditions permit. Following passage of the law facilitating more flexible sale methods, the implementing decree has been opened for signature by cabinet ministers.

19. We will ensure that our strategy strengthens and consolidates viable banks. To this end, we have established basic principles for the resolution of the SDIF and undercapitalized private banks: (i) any bank to be sold or merged must be properly recapitalized upfront; (ii) the new owner must fully comply with the required “fit and proper” criteria; (iii) the new owner must also be able to provide a convincing business plan to ensure the bank’s future profitability; and (iv) the recapitalized bank must be viable/profitable and be in compliance upfront with all prudential regulations. We will ensure that these principles are properly adhered to for all future bank sales or resolutions involving the BRSA or SDIF.

20. We will ensure that the BRSA has the legal right and financial resources to maintain and recruit qualified staff, with employment conditions in line with the institutions under its supervision. We realize that the soundness of the banking system to a large extent depends on the way in which the BRSA carries out its responsibilities, which in turn depends on the quality of its staff. Similarly, to maximize its loan recoveries and to minimize the cost imposed on taxpayers, the Collection Department within the SDIF will have the financial resources to recruit experienced private sector banking experts.

Privatization, business climate, and governance

21. The preparations for divestiture of large state-owned assets are advancing as planned. While market conditions will continue to guide the timing of asset sales, we are pushing ahead with the necessary preparations:

  • The Privatization Administration (PA) is in the process of completing the draft offers for TUPRAS (oil refinery) and POAS (petrol distribution), and the public offerings are slated for the fourth quarter of 2001 as planned.
  • The government will resubmit the Tobacco Law that parliament approved in June as soon as parliament reconvenes. The concerns expressed on managing the transition period are being addressed through various projects supported by the World Bank. The PA will prepare privatization plans for TEKEL (tobacco and alcohol monopoly) and SEKER (sugar company), consistent with the commitments under the World Bank Economic Reform Loan, by end-2001.
  • We will immediately start preparations for the privatization of electricity generation and distribution assets for which there are no pending contracts for Transfer of Operating Rights. For those assets for which such contracts are pending, we will conclude or otherwise resolve the pending contracts before end-October 2001 (the new deadline in the amended Electricity Markets Law), and then move ahead with the privatization of the remaining assets as envisaged in our May 3 Memorandum on Economic Policies. We are receiving assistance from the World Bank in the implementation of the new Electricity Markets Law.
  • We are working with the Ministry of Energy to prepare for the transfer of gas companies from BOTAS to the PA’s portfolio.
  • Petkim (petrochemicals company) and Turkish Airlines are undergoing operational restructuring (in the former case through plant closures, in the latter through sales of aircraft and staff layoffs) to improve their financial position in preparation for privatization. Also, we are preparing for the privatization of ERDEMIR (steel company) through a merger with ISDEMIR
  • Several steps will be taken toward the privatization of Türk Telekom: the company will contract advisors by end-October 2001 (a structural benchmark) to develop a corporatization plan acceptable to the World Bank by end-2001, which will streamline the operations of the company in preparation for its privatization; the Tender Committee for the privatization of Türk Telekom will be appointed shortly, and the PA will start the preparation of the privatization plan, which is expected to be completed by end-2001 (a structural benchmark). We are exploring the possibility of IFC assistance in the form of a pre-privatization investment.
  • Two laws that will regulate the sale of government-owned land have recently been enacted. These laws provide the basis for incentives to facilitate land sales, such as payment in installments, exemption from taxes and fees on sale transactions, and exemption from property tax. To implement the land sales, a coordination committee has been set up under the chairmanship of the Ministry of Finance with the participation of the Land Registry Office, the Ministry of Tourism, and other interested institutions.  Moreover, the circulars and directives defining the details of land sales, including assessment procedures, have been adopted.

In sum, we remain confident that the expected proceeds from privatization of US$1 billion for the remainder of 2001 will be received as envisaged under the program.

22. We are also implementing planned steps to improve the business climate. The study on administrative barriers to investment by the World Bank (FIAS) was completed in June as envisaged. The executive summary of the report has been circulated to the relevant agencies for comments in preparation for a September workshop. An action plan will be presented to the Council of Ministers by end-September 2001.

23. We are also implementing our strategy to improve governance in the public sector:

  • In early July, we held a World Bank-supported workshop on ways to fight corruption. Based on these findings, a working group is now preparing an action plan, in advance of the anti-corruption conference scheduled for September. The Prime Minister has sent a circular to all government agencies relating to the initiative to strengthen transparency, requesting recommendations and setting up special committees to tackle this issue; this is expected to help involve the agencies more directly in this effort.
  • On government expenditure management, the Public Expenditure and Institutional Review (prepared in collaboration with the World Bank) has been finalized, and the strategy for improvements in expenditure management is now being implemented. As first steps, a High Planning Council resolution on the rationalization of public sector investments has been adopted, and line agencies have been instructed through the 2002 budget call to prepare their budgets in line with the macroeconomic targets. As part of the implementation of this strategy, we are now preparing a conference on expenditure management scheduled for November 2001.

24. We are taking steps to alleviate the impact of the temporary contraction of activity on viable private sector companies. We are channeling some of the long-term credits secured from the European Investment Bank and other sources to the small and medium enterprise sector. We are also protecting the funding of the Turkish Eximbank within the limits of our fiscal constraints.

Social dialogue and incomes policy

25. Our economic program respects the need for social consensus and social dialogue. To that end, we expect that the first meeting of the Economic and Social Council since its legal status was established will be held in August 2001. Moreover, to guide wage and price expectations, we have raised the minimum wage by 19.8 percent from July, consistent with projected inflation for the remainder of the year.

26. Finally, we are carrying out a number of enhanced social policies with the support of the World Bank. These include: (i) strengthened monitoring of the social impact of the crisis; (ii) preparations for the introduction of the unemployment insurance scheme from the middle of next year; (iii) strengthening the social safety net for the most vulnerable groups, especially children; (iv) providing cash benefits and re-insertion programs for workers displaced as a result of privatization; (v) protecting public expenditure on health, education and social protection at levels above the average of the last three years (as a share of GNP); and (vi) introducing direct income support to farmers during the remainder of 2001.


Very truly yours,
 

Kemal DERVÝÞ
Minister of State for Economic Affairs

Süreyya SERDENGEÇTÝ
Governor of the Central Bank of Turkey

 

Annexes
A. Quantitative Performance and Indicative Targets
B. Structural Policy Conditionality, 2001
C. Performance Criteria on the Cumulative Primary Expenditure of the Central Government
D. Performance Criteria on the Net Domestic Assets of the Central Bank of Turkey