Document o f The World Bank FOROFFICIAL USEONLY ReportNo. 43473-TR INTERNATIONAL BANK FORRECONSTRUCTIONAND DEVELOPMENT PROGRAMDOCUMENT FORA PROPOSED SECOND PROGRAMMATIC PUBLIC SECTOR DEVELOPMENTPOLICY LOAN (PPDPL 2) INTHE AMOUNT OF EUR255.4 MILLION (US$400MILLION EQUIVALENT) TO THE REPUBLICOF TURKEY May 17,2008 Poverty Reductionand Economic Management Unit Turkey Country Unit Europe and Central Asia Region This document has a restricteddistributionand may be used by recipients only inthe performance o ftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization. TURKEY GOVERNMENTFISCALYEAR - January 1-December 31 CURRENCYEQUIVALENTS (Exchange Rate Effectiveas of May 13, 2008) Currency Unit New Turkish Lira (YTL) US$1.00 1.2570 YTL YTL 1-00 0.80 US$ Weights andMeasures Metric System ABBREVIATION AND ACRONYMS CEM ICountryEconomicMemorandum CEPEJ IEuropeanCommission for the Efficiency of Justice FOR OFFICIAL USE ONLY Vice President: Shigeo Katsu Country Director: Ulrich Zachau Sector Director: Luca Barbone Sector Manager: Bernard G.Funck Task Team Leader: Zafer Mustafaoglu This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not be otherwise disclosed without World Bank authorization. THEREPUBLIC TURKEY OF SECONDPROGRAMMATICPUBLIC SECTORDEVELOPMENT POLICY LOAN (PPDPL 2) TABLEOFCONTENTS I INTRODUCTION . ........................................................................................................................................ 1 I1. COUNTRY CONTEXT ............................................................................................................................... 2 OVERVIEW........................................................................................................................................................... 2 RECENT ECONOMICDEVELOPMENTS INTURKEY ................................................................................................ 4 MACROECONOMIC OUTLOOK AND DEBT SUSTAINABILITY .................................................................................. 7 111 THE GOVERNMENT'S PROGRAM . ....................................................................................................... 9 I V. BANK SUPPORT TO THE GOVERNMENT'S STRATEGY .............................................................. 10 LINK TO CPS..................................................................................................................................................... 10 COLLABORATION WITH THE IMFAND OTHER DONORS ..................................................................................... 12 RELATIONSHIPTO OTHER BANK OPERATIONS ................................................................................................... 12 LESSONS LEARNED ............................................................................................................................................ 13 ANALYTICALUNDERP~INGS ........................................................................................................................... 14 V . THE PROPOSEDPPDPL2 ...................................................................................................................... 14 RATIONALE FOR WORLD BANKSUPPORT OF THE PPDPL PROGRAM ................................................................. 14 PROGRAMMATIC FRAMEWORK AND OPERATION DESCRIPTION ......................................................................... 18 POLICY AREAS SUPPORTED BY THE LOAN ......................................................................................................... 19 COMPONENT I:SUSTAINING ANENABLINGMACROECONOMIC FRAMEWORK ................................................... 19 COMPONENT 11: SOCIAL SECURITY AND SOCIAL ASSISTANCE REFORM ............................................................. 20 COMPONENT 111: PUBLIC FINANCIAL AND EXPENDITURE MANAGEMENT REFORM ........................................... 30 COMPONENTIV: PUBLIC ADMINISTRATION ANDGOVERNANCE ........................................................ 38 FUTUREPROGRAMAND POSSIBLEPPDPL 3 ..................................................................................................... REFORM 45 PROGRAM GOALSAND EXPECTED OUTCOMES .................................................................................................. 47 V I . OPERATION IMPLEMENTATION ...................................................................................................... -50 POVERTY AND SOCIAL IMPACTS ........................................................................................................................ 50 IMPLEMENTATION. MONITORING EVALUATION AND .......................................................................................... 52 FIDUCIARY ASPECTS .......................................................................................................................................... 53 DISBURSEMENT AND AUDITING ......................................................................................................................... 55 ENVIRONMENTAL ASPECTS ............................................................................................................................... 56 RISKSAND~SKMITIGATION............................................................................................................................. 57 ANNEXES ANNEX I:LETTER OF DEVELOPMENT POLICY ANNEX 11: PROGRAM MATRIX FOR THE PROPOSEDPROGRAMMATIC PUBLIC SECTOR DEVELOPMENT POLICY LOAN (PPDPL) SERIES ANNEX 111: THE WORLD BANK-IMF RELATIONS ANNEX IV: TURKEY AT A GLANCE ANNEX V: SELECTEDPOLICY ACTIONS FROM THE GOVERNMENT'S NINTHDEVELOPMENT PLANINPPDPL2 RELATEDAREAS ANNEX VI: SUMMARY NOTE ON THE LATEST GDP REVISION ANNEX VII: PENSIONREFORMS INTURKEY ANNEX VIII: POVERTY AND DISTRIBUTIONAL IMPACTSOF PPDPLREFORMS ANNEX IX: DECENTRALIZATIONAND FISCAL RISKS: INTERNATIONALEXPERIENCE The ProposedLoanwas preparedby an IBRDteam consistingof Zafer Mustafaoglu(ECSPE) as team leader; Mediha Agar (ECSPE); HannahKoilpillai (LOAFC); James Anderson (ECSPE); SedaAroymak (ECSPS); Dilek Barlas (LEGEC); Pinar Baydar (ECCU6); David S. Bernstein (ECSPE); Jeanine Braithwaite(HDNSP); RaifCan (ECSHD); Sarbani Chakraborty (ECSHD); RodrigoChaves (ECSPE); Banu Demir (ECSPE); William R. Dillinger (ECSPE); Jesko S. Hentschel(ECSHD); John Innes(ECSHD); Zeynep Lalik (ECSPS); SeemaManghee (ECSSD); Kamer Karakurum Ozdemir (ECSPE); Anita M. Schwarz (ECSHD);Mark Roland Thomas (ECSPE); SanjayN.Vani (ECSPS); Aristomene Varoudakis (ECSPE). Peer Reviewers: CristianC. Baeza(LCSHH), DanaWeist (PRMED) and James Parks (LCSPR) LOAN AND PROGRAM SUMMARY REPUBLIC OF TURKEY SECOND PROGRAMMATIC PUBLIC SECTOR DEVELOPMENT POLICY LOAN (PPDPL 2) Borrower Republic o f Turkey Implementing Undersecretariat o f Treasury Agency Amount Euro 255.4 million (US$400 million equivalent) Terms The term for the Euro denominated commitment-linked flexible loan with a fixed spread to Turkey for the proposed Euro 255.4 million PPDPL 2 i s 22.5 years, including a 12.5 year grace period and level repayment o f principal. Tranching Single tranche to be disbursedon effectiveness. Description The PPDPL series supports a sustained medium-term process of legal, institutional, and structural development that promotes growth, improves public governance and service delivery and strengthens social conditions by (a) maintaining an enabling macroeconomic framework; (b) reforming the country's social protection system, (c) continuing the ongoing process o f upgrading financial controls and public expenditure management, and (d) improving the administration and governance o f the public sector. The government's program supported by the Loan contains actions, milestones, and expected results in each of the above four broad areas o f public policy. This reform program supports a substantial portion o f the authorities' strategy to improve public service delivery and public institutions. Accordingly, PPDPL 2 (Euro 255.4 million) i s designed around four program areas and contains prior actions and triggers supporting actions critical to achieving program objectives. The authorities and the Bank have agreed to follow PPDPL 2 with a third operation (PPDPL 3) as the achievement o f the program objectives depends critically on consistent implementation and further deepening o f structural reforms supported under the PPDPL series. The first component of PPDPL 2 supports the macroeconomic framework that has underpinned Turkey's recovery and strong growthafter the 2001 crisis, with an aim to ensure sustainability of growth and mitigate risks arising from a complex and dynamic external environment. The second component focuses on improving the quality o f fiscal adjustment as well as social protection through parametric pension 1 reform, implementation o f administrative reforms intended to strengthen administrative capacity, and supporting efficiency- increasing and cost-saving measures in the health system in order to contain pressures inhealth expenditures. The third component supports sustained implementation of the Public Financial Management and Control (PFMC) Law that has underpinned the outstanding improvements in the pub1,ic expenditure management system in Turkey. The areas supported focus on establishing strategy development units in all government institutions, introducing accrual basis accounting for the government, and improving the link between policy objectives, resources allocationprocess and the public investment. The fourth component supports improvements in the administration and governance o f the public sector through actions intended to reduce regional disparities, improve quality o f public delivery at local level, and improve the justice system. The areas supported focus on increasing the efficiency and the quality o f judicial services, including increasing resources available to the judiciary, institutional and structural changes (such as the establishment o f Regional Courts o f Appeal) and modernization o f thejudiciary through upgrading of infrastructure and automation. Benefits The potential benefits are substantial. An enabling macroeconomic framework will continue to be an important underlyingdriver for the sustained growth experienced by Turkey since 2002. Improving the legal and institutional dimensions o f public expenditure management (PEM) will enable prioritization and efficient use o f public resources and will contribute to creating fiscal space for growth promoting expenditures such as in education and infrastructure. Implementation o f the PEM reforms will increase transparency and accountability in the public sector as well as comparability o f the fiscal aggregates at international level. Ultimately it i s expected to help improve the credit ratings o f Turkey's foreign-currency denominated debt and reduce the risk premia on domestic debt, which would reduce the cost o f debt servicing. The reformed social protection system is expected to provide insurance against old age, poverty, illhealth, and more effective and better targeted social assistance to the poor, while ensuringthe financial viability o f better access to these services. The reforms will lead to fiscally sustainable and equitable system. .. 11 Better focused regional development efforts and more effective provision o f public services at the local level will contribute to increase income levels inthe lagging regions, improving quality o f local service delivery and facilitating more effective utilization o f pre-accession funds from the European Union (EU). Improvements in the justice system and anti-cormption efforts are expected to reduce obstacles to economic and social development. An effective and efficient judicial system is important to the provision o f public services. In addition, justice sector reforms help to safeguard citizens' rights and implementthe EU legislation that i s essential in the EUaccession process. Improving the quality o f judicial services i s also an important factor in enhancing the investmentclimate inTurkev. Risks The Turkish economy faces non-negligible risks. On the external front, the current account deficit (CAD) continues to be a source o f concern - although it i s estimated to have narrowed slightly to 5.7 percent of gross domestic product (GDP) in2007 from 6.1 percent in2006. Other risk factors include changes in investor sentiment in financial markets and their effect on public debt sustainability, spillovers from global liquidity tightening, or fallout from US sub- prime mortgage market distress. These factors would affect Turkey's economic situation because o f the public debt which has a relatively short maturity and i s relatively sensitive to exchange and interest rate movements. Nevertheless, it has decreased substantially as a share o f GDP since 2001 and i s expected to continue to decrease under a baseline projection. The episodes o f turmoil in international financial markets during May-June 2006 and February 2007 and their impact on domestic markets both showed that Turkey i s still vulnerable to sudden changes in investors' sentiment, and that Turkey's resilience to shocks has substantially increased. The Turkish economy has broadly weathered well the most recent volatility in international markets since August 2007 untiltoday. Following a successful constitutional challenge to an earlier draft o f the Social Security and UHI(UHI) Law in 2006, there i s a non- negligible risk that the recently approved revised law will be challenged before the Constitutional court again. The government has moved to make the new law consistent with the Constitution but some risk o f an adverse ruling remains. The proposedprogram leaves time for constitutional review and finalization o f the ... 111 necessary secondary legislation. Implementation o f the law would be monitored under a subsequent PPDPL 3. Additionally, the reform program contains actions, such as implementation o f the administrative reform o f the social security system, which raise considerable challenges during the transition to a new system. Containment o f health expenditures i s also a sensitive issue, as there i s often a fine line between providing health services to society and to the poor in particular, and containing unnecessary spendingor reducing inefficiencies inspending. The possibility of phasing out in2008 o fthe program supported by the International Monetary Fund (IMF), and of a slower EU accession process, if realized, could weaken anchors o f policy reform that untilnow helpedunderpineconomic policies. Finally, a recent case filed with the Constitutional Court calling for the dissolution of the ruling party Justice and Development Party (AKP) could create risks for reform implementations. PO88837 iv PROGRAMDOCUMENT FORA PROPOSEDSECONDPROGRAMMATICPUBLICSECTOR DEVELOPMENT POLICY LOAN(PPDPL 2) TO THE REPUBLIC OFTURKEY I. INTRODUCTION 1. The Turkish government embarked on an extensive structural reform program as a response to the 2001 severe economic crisis and inorder to break away from the instabilities and inefficiencies o f the past decade. The weak public governance, inadequate public expenditure management and weak public institutions created an environment for populist policies and growing macro-fiscal imbalances. Increasingfragilities inthe macroeconomic structure owing to the fiscal and monetary policies implemented during the 1990s moved the Turkish economy away from the stable growth path. Inappropriate policies implemented in social security, State Owned Economic Enterprises (SEE), and agricultural support resultedin serious deterioration in public finances. The increasing debt stock and the resultant high real interest rate environment caused inflation to become chronic on the one hand, and domestic savings to be directed towards financing public deficits rather than funding productive investments, on the other hand. The Turkish government responded to the 2001 crisis with a well-designed economic program of tight monetary, fiscal, and incomes policies and wide ranging structural reforms in order to address the challenges raised by the severe economic crisis. 2. With the determined implementation o f the reform program, the Turkish economy has gone through significant structural changes initiated to restore macroeconomic stability permanently and make the economy more efficient, flexible and productive A strong fiscal adjustment with a large public sector primary surplus target has been at the center o f the economic program implemented since then. The fiscal adjustment has been accompanied by ongoing implementation o f a comprehensive long-term government program to modernize the institutions and procedures o f public sector management. The process o f EU accession that was launched on October 3, 2005 has also become a driving force for the continuation and deepening o f these reforms. Consistent with these needs, the authorities have adopted a program o f sustained medium-term legal, institutional, and structural developments aimed at promoting growth, improving public service delivery, strengthening public governance and judicial system and reforming social security system. 3. To support the authorities in key fronts o f this agenda, the Bank's Board approved the Public Sector Development Policy Loan, designed to support policy actions within the overall government program inkey areas. The first PPDPL (Euro 403 million) in support o f this program was approved in June, 2006. This document presents the second operation inthis series (PPDPL 2). Similar to the first operation, PPDPL 2 supports policy actions in four areas, to (a) maintain an enabling macroeconomic framework; (b) reform the country's social protection system, (c) upgrade public financial controls and expenditure management systems, and (d) improve the administration and governance o f the public sector. 11. COUNTRY CONTEXT OVERVIE w 4. Turkey has been experiencing strong growth since 2002 - driven in part by the government's commitment to sound economic policies and a benign international economic environment. Annual growth averaged 6.8 percent in the period 2002-2007. Output increased more than a third in this period - the strongest growth performance among Organization for Economic Cooperation and Development (OECD) members. The implementation o f tight fiscal and monetary policies has contributed to a considerable reduction in inflation and improvement inpublic debt sustainability. Considerable progress has also been achieved in restructuring the financial sector, improving the business environment, and reforming the public sector. 5. Good policies and credible external anchors have been critical for Turkey's economic success since the 2001 crisis. Turkey's impressive economic performance is due first and foremost to credible and sustained stabilization, with strong fiscal discipline at its core, combined with an ongoing structural reform agenda. IMF and WBG support o f the reform programs and the beginning of the EU accession negotiations in 2005, constituted the external anchors of the successful program. 6. The authorities have implemented major reforms over the past six years. Substantial progress has been achieved in reducing inflation and real interest rates, improving public finances, restructuring the financial sector, improving the business environment, and reforming the public sector. Key markets have beenliberalized and regulatory capacity inthe economy has been strengthened-including banking supervision. Strong fiscal and monetary policies helped improve debt sustainability as well as lower inflation and inflationary expectations. Stability, predictability, and market confidence have improved. Convergence with EU levels o f income per capita i s on-going which-if maintained-would represent a significant break from past short- lived economic booms followed by downturns. 7. Fiscal performance has been strong since 2002, notwithstanding a loosening earlier in 2007. The primary surplus for the public sector averaged 4.5 percent o f GDP inthe period 2002- 07. The size o f the fiscal adjustment i s unprecedented and its effects on the economy have been very positive, Nonetheless, the quality o f fiscal adjustment could be improved as the primary surpluses were obtained mostly by increasing taxes and reducing the expenditures o f State Owned Enterprises (SOEs). Expenditurerationalization inthe rest o f the general government has been limited. The large majority o f public expenditures remain inflexible, including the public sector wage bill, transfers to cover the social security deficit, and servicing o f public debt. This means the state has limitedability to invest ingrowth enhancing areas. 8. The Central Bank of the Republic of Turkey (CBRT) used short-term interest rates as the main instrumentto influence inflation expectations together with targets for monetary aggregates. After reaching the historically low level of 7.7 percent inflation at the end of 2005, explicit inflation targeting was adopted in January 2006. However, inflation has remained above the official targets since then. 2 Table 1: Key EconomicIndicators Proj. 2/ 2001 2002 2003 2004 2005 2006 2007 2008 MAIN MACRO INDICATORS GDP Growth -5.7 6.2 5.3 9.4 8.4 6.9 4.5 4.0 CPI Inflation(Dec-Dec) 68.5 29.7 18.4 9.3 7.7 9.7 8.4 9.3 Nominal Interest Rate 99.1 63.5 44.1 24.9 16.2 18.0 18.3 15.4 Real ex-ante Interest Rate 3/ 35.5 30.3 30.2 15.4 6.0 8.5 10.8 UnemploymentRate 8.4 10.3 10.5 10.3 10.3 9.9 9.9 Unit Wage Index (1997=100) 71.1 72.9 85.8 96.1 108.3 107.5 113.7 PUBLIC SECTOR Primary Balance(%GDP) 3.8 3.3 4.9 5.5 5.1 4.6 3.5 3.5 Net Public Debt (%GDP) I/ 66.4 61.5 55.2 49.1 41.7 34.2 29.1 26.2 EXTERNAL BALANCE Current account balance(% GDP) 1 9 -0 3 -2.5 -3.7 -4.6 -6.I -5.7 -6.5 Exports(fob, $ bn) 4/ 34.4 40.1 51.2 67.0 76.8 91.O 114.3 I39 7 Tourism ($ bn) 8.1 8.5 13.2 15.9 18.2 16.9 18.5 19.6 ExternalDebt (%GDP) 57.7 56.3 47.3 41.2 35.0 39.0 37.5 39.5 CBT Reserves($ bn) 5/ 19.8 28.1 35.2 37.6 52.4 60.7 74.0 86.4 - Memo GDP (YTL billion) 240.2 350.5 454.8 559.0 648.9 758.4 856.4 978.1 I/IncludesthegovernmentsecuritiesissuedtorecapitalizetheSDIFandstatebanks. 2/ WB and IMF projections 3IAverage ofmonthly nominal interest ratedivided by 12-monthaheadinflation 4/Includes shuttle trade 51 Includesgold reserves Source: Governmen6 IMF and WB estimates. 9. Inparliamentary elections inJuly 2007, Turkey's governing party (AKP) won an absolute majority in Parliament and a renewed mandate to form a single party government. The new Government i s committed to pursuing an ambitious program o f economic and institutional reforms. 10. Despite the good economic performance o f the past years, macroeconomic vulnerabilities remain. So far Turkey has weathered the recent uncertainties and the ongoing market volatility originating from US sub-primemortgage losses, demonstrating much improved resilience o f the economy. Nevertheless, the Turkish economy still faces significant risks arising from: (i)its large CAD, at 5.7 percent o f GDP at end-2007; (ii)its public debt - which has a relatively short maturity and i s relatively sensitive to exchange and interest rate movements; (iii)the moderating fiscal policy stance inthe wake o f weakening global conditions; and, (iv) the slowing disinflation process. Highreturnson Turkishassets have brought large international flows to the country and the resultant increase in exposure of foreign investors in Turkish assets has made the economy more vulnerable to changes in global risk appetite. The possible materialization o f these risks hinges on international as well as domestic events. 11. The prospect o f Turkey's EU accession remains a key anchor o f political and economic reforms. The EU accession negotiations were formally launched in October 2005. The EU accession negotiations provide impetus for deepening and broadening the reforms required for Turkey's convergence to the EU average income per capita. Notwithstanding temporary setbacks, the EU harmonization agenda and accession process are expected to continue in the years ahead. Indeed, the Government has prepared a six-year program o f economic, social, and institutional harmonization with the EUAcquis Communitaire. Inits Action Plan, dated October 8, 2007, the Government reiterated its commitment to implement EU-related reforms, 3 highlighting their importance for Turkey's own development. Negotiations on one chapter, science and research, were opened and provisionally closed in June 2006. As of March 2008, negotiations on five out o f 35 chapters of the EUAcquis Communitaire were open. RECENTECONOMICDEVELOPMENTS IN TURKEY 12. Turkish Statistical Institute (TURKSTAT) released the long-awaited revision to GDP data on March 8, 2008. The mainreasonfor this revision was to reflect structural changes in the economy since 1987 in national accounts statistics. Another reason was to harmonize Turkey's GDP estimates with the European System of Accounts (ESA) 95. TURKSTAT plans to complete full alignment with the ESA 95 by 2011. The recent revision updates the base year to 1998 from 1987, and includes both changes in methodology and coverage'. With this revision, historical GDP series - both in real and nominal terms - have changed significantly. For instance, Turkey's 2006 GDP has beenrevisedup by 31.6 percent innominal terms. 13. Based on the revised figures, annual GDP growth averaged 6.8 percent in the period 2002-2007 on the back of robust private consumption and investment demand (Table 2). In 2007, the Turkish economy grew at a healthy pace - albeit slower than in previous years, in part driven by imports outpacing exports and deceleration of domestic demand, reflecting lagged impact of the monetary policy tightening that followed the volatility of May-June 2006. GDP reached US$658.8 billion, and GDP per capita reachedUS$9,333 in2007. Real GDP growth i s expectedto remainmodest at around 4 percent in2008. Table 2: Growth Decomposition(Contributionto GDP Growth, Percent) 2001 2002 2003 2004 2005 2006 2007 Private Consumption Exp. -4.5 3.2 6.8 7.7 5.6 3.3 3.2 GovernmentConsumption Exp. -0.1 0.7 -0.3 0.6 0.3 0.8 0.3 Public Sector FixedInvestment -1.0 0.3 -0.6 -0.2 0.7 0.1 0.2 Private Sector FixedInvestment -5.5 2.0 3.1 5.6 3.1 3.1 0.6 Change in Stocks -1.1 2.1 -0.4 -1.9 0.1 -0.1 1.7 Exports of Goods& Services 0.8 1.6 1.6 2.7 1.9 1.6 1.6 Importsof Goods & Services 5.7 -3.8 -4.9 -5.1 -3.3 -1.9 -3.1 GDP Growth -5.7 6.2 5.3 9.4 8.4 6.9 4.5 Source: TURKSTAT, and Staffcalculations 14. Turkey's large CAD remains as a source of concern. Together with the strong recovery in the economy, the deficit began widening in 2003. It continued deteriorating due to rising oil prices and the growing trade imbalance fueled large capital inflows. A strong recovery of private investment and the buoyancy of domestic demand also contributed to a growing deficit. After reaching a record high of 6.1 percent of GDP in 2006, the CAD-to-GDP ratio narrowed slightly to 5.7 percent in 2007 - in part as a consequence of a slowdown of domestic demand and moderate recovery in tourism revenues (Figure 1). Nevertheless, the CAD i s expected to widen to around 6.5 percent of GDP in2008 on the back of increasing energy and commodity prices. ' Please seeAnnex VI for a detailed discussion. 4 15. Despite the widening inthe CAD, the quality of its financing has improved considerably. Short-term inflows accounted for only 6 percent of total net inflows in 2007, compared to 55 percent in 2004. Non-debt creating flows covered more than 50 percent of the CAD in2007. In particular, net Foreign Direct Investment (FDI) flows amounted Figure 1: Total and Non-oil CAD ( percent of GDP) to US$ 9 billion (1.9 percent of GDP) in 2005, and reached a historical high of US$ 19.8 billion in 2007 (3 percent of GDP). Net FDI flows are projected to remain robust in 2008 at about 1.7 percent of GDP. Nonetheless, the share of debt-creating inflows i s still considerable. 16. Large exposure of foreign investors in Turkish assets has 0 Non-oil CAD 0 CAD made the economy more vulnerable Source. CBRT, TURKSTAT, Staff calculations to changes in global risk appetite. Foreign ownership of Turkish treasury bonds and stocks totaled US$76 billion, and accountedfor about 30 percent of the bond market, and 71 percent of the equity market as of March2008 (Figure 2). 17. Fiscal performance has beenstrong since 2002, notwithstanding a loosening in2007. The public sector primary surplus averaged 4.5 percent of GDP in the period 2002-07. The fiscal performance was relatively weak in 2007-partly driven by expenditure overruns inthe first half of the year. In addition, lower than expected tax revenues also contributed to the underperformance as economic activity slowed down in 2007. The Figure 2: Foreign Holdings of Equities and Government Bonds entire public sector generated a primary surplus of 3.5 percent of GDP in 2007. The central government budget performed relatively well inthe first quarter of 2008. When calculated using the IMF definition, the primary surplus of the central government budget 2003 2004 2005 2006 2007 2008-Mar amounted to YTL 8.3 billion (US$ EE7TotalSecunties heldby foreigners 7.5 billion), reflecting more than 30 - Sharem bonds market -Share percent increase compared to the u1equity market same period of 2007. The Source: CBRT, Central RegistryAgency, Staffcalculations government targeted a 4 percent of GDP primary public sector surplus for 2008 during the preparation of the 2008 budget. Nevertheless, the authorities reducedthe primary surplus target to 3.5 percent of GDP during the seventh and final review of the IMF Stand-By Arrangement (SBA), inpart because of anticipated higher transfers to local administrations, expected implementation of the labor market reform, and higher plannedinfrastructure investment. 5 18. Inflation started to pick up in 2006 increasing to 9.7 percent-significantly higher than the official target of 5 percent. In2007, Consumer Price Index (CPI) inflation lost momentum - albeit not enough to meet the annual target, as it declined to 8.4 percent. The CBRT has announced its commitment to bring inflation down to 4 percent in the period 2008-2010. Nevertheless, the annual CPI inflation was on an upward path in the first four months of 2008, mainly driven by increases in food and - Figure 3: Target Path and ActualiExpected Inflation in energy prices. The annual CPI inflation is 2008 expected to remain above the official target of 4 percent in2008 (see Figure 3). ....................... 19. The ongoing global volatility, .........f..........'-. originated from US sub-prime mortgage losses, has affected all emerging markets including Turkey. The Istanbul Stock 2.0 ........................................ X . Exchange (HE) index has dropped by 20 0.0 percent between July 2007 and April 2008, and the yield on the YTL denominated benchmark bond has increasedfrom 17.5 to -Actual/Expected + Targeted path 18.8 percent despite a monetary easing of "i. +2 band x -2 band 225 basis points in the same period. iource: TURKSTAT, CBRT Turkish treasury bonds by a total of US$ 7.4 billion between August 2007 and February 2008 - reflecting reducedrisk appetite for Turkishassets. A recent court case calling for the dissolution of the governing party AKP has also beenperceived negatively by investors. 20. In addition, a comparatively high level of external debt makes Turkey Figure 4: Gross External Debt-to-GDP Ratio vulnerable to significant depreciation of the I m "V currency. The external debt to GDP ratio 50 fell from 56 percent in2002 to 37.5 percent 40 in 2007 (Figure 4). It is projected to 30 increase in the near term, albeit at a 88 20 decelerating pace, reflecting mainly an 10 0 expected widening in the CAD in 2008. 2002 2003 2004 2005 2006 2007 2008 Corporate sector external borrowing is expected to be the main driver of the Private External Debt W Public External Debt projected increase in external debt ratio, as L it has beeninrecent years. 21. Although the risks are non-negligible, there have been considerable improvements in Turkey's key vulnerability indicators over the last six years - namely: (a) the cost of borrowing has declined; (b) the annual inflation rate has declined sharply; (c) the composition and maturity of public debt have improved; (d) debt management practices have strengthened; and (e) the public debt-to-GDP ratios have declinednoticeably. 22. Turkey's substantial foreign exchange reserves and flexible exchange rate regime mitigate risks associated with capital reversals. Foreign exchange (FX) reserves of the CBRT increased from US$19.8 billion in 2001 to US$74 billion in 2007. Reserves represented 55 6 percent of gross external financing requirements in 2006 and more than covered Turkey's short- term external debt in the first half of 2007. Turkey's flexible exchange rate regime has helped cushion outflows during periods of volatility. 23. Relationship with the IMF: The IMF approved a three-year Special Drawing Rights (SDR) 6.7 billion (US$ 10.8 billion) SBA to support Turkey's economic and financial program in May 2005. The program envisioned low single digit inflation and 10 percentage point reduction in the government's net debt to GDP ratio. On May 9, 2008, the IMF Board approved the completion of the seventh and final review of the SBA and the disbursementof the remaining SDR 2.25 billion (US$3-65 billion). Consequently, the three-year SBA has been successfully completed. MACROECONOMIC ANDDEBTSUSTAINABILITY' OUTLOOK 24. Over the medium term, it is expected that Turkey should sustain growth rates of around 5 percent, as envisaged by the government and the IMF. Conditions are in place for Turkey to sustain such growth rates. The strong growth in private investment expenditure in the period 2004-2007 - despite a slowdown in 2007, and the robust industrial production growth starting from the last quarter of 2005 are indicative of the improved prospects for sustained growth and employment generation. Although the recently emerging difficulties in the electricity sector due to growing demand and underinvestment in the sector are likely to pose risks for future growth, the Government i s taking a number of measures to address the potential supply-demand imbalance and to ensure an adequate and reliable supply of electricity, as well as efficiency inits consumption. The Bank will provide support to the Government's strategy through its electricity sector Development Policy Loan (DPL) which is plannedfor the second half of 2008. 25. The medium-term projection of economic growth averaging 5 percent annually during 2008-2013 i s underpinned by: (a) strong external anchors, supporting enhanced confidence inthe policy framework; (b) improved macroeconomic stability, which would stimulate private investment and consumption demand; (c) stronger export performance, which would permit faster import and output growth; and (d) strong external inflows, includingFDI. 26. After a slight improvement in 2007, the CAD-to-GDP ratio is projected to widen to around 6.4 percent of GDP in 2008 - in part due to an expected increase in commodity and oil prices. Turkey needs to generate enough medium and long term capital inflows to meet its large levels of external financing requirements, while keeping short-term debt inflows at prudent levels. Net FDI flows reached US$ 19.8 billion in 2007 and is projected to remain strong at about US$ 12.5 billion per year on average over 2008-2012-a major contribution to the country's mediumterm external financing requirements. 27. Public debt sustainability. The net public debt to GDP ratio fell from a high of 66.5 percent in 2001 to 29.1 percent in 2007. The net debt ratio i s projected to fall further in 2008- 2012. Realization of this outcome depends on sustained growth, continued fiscal discipline as represented by primary surpluses of around 3 percent of GDP, stable exchange rates and a favorable external environment. However, public debt stock is still sensitive to interest and exchange rate movements as a considerableportion of the central government's domestic debt is * Theprojectionspresented in this section are made by the World Bank. 7 infloating rate notes (50 percent as of end-2007) and a substantial share of total debt stock is in FX andFX-linkedinstruments(32 percent as of end-2007). 28. Public debt sustainability hinges on continued fiscal discipline. Sensitivity analyses of public debt dynamics demonstrate the importance of commitment to sound economic policies. Under an extreme scenario, characterizedby fiscal loosening, rising interest rates, and a growth slowdown in 2008-2009, the net public debt ratio would jump to about 39 percent by 2009, declining only slightly thereafter. 29. However, stochastic simulations assign low probabilities-less than 2.5 Figure 5: Net Public Debt to GDP Ratio under Baselineand percent-to extreme scenarios. Alternative Scenarios Stochastic simulations produce 45.0 , confidence intervals for the public debt 40 0 35 0 ratios corresponding to varying degrees 30 0 25 0 of uncertainty for four key 20 0 macroeconomic variables: (a) domestic I 5 0 I O 0 interest rates, (b) the growth rate, (c) the 5 0 exchange rate, and (d) the foreign 0 0 2008 2009 2010 201I 2012 interest rate. Assuming a gradually declining fiscal surplus in the period 2008-2012, there is a 97.5 percent Source: Sfaflprojecfions probability that the net public debt-to- GDP ratio will remain between 12 and 26 percent (Figure 6). There is a 75 Figure6: Net PublicDebt to GDP Ratio (percent) percent probability that this ratio will 1 remain within 16-20percent. 35i I 30 30. The potential direct impact of a 25 setback in the envisaged social security 20 15 reform on the net public debt ratio would be zero in the short-term; the impact would still be negligible in the medium-term as the cumulative fiscal savings from the reform are estimated to be limited to 0.9 percentage points of GDP in the period 2009-2014. Source: Stafforoiections Nevertheless, the successful implementation of the reform could positively impact Turkey's public debt sustainability in the medium-term through an improvement in the country's credit ratings, which would be reflected in a lower risk premium on the interest paid on public debt. Over the long term, on the other hand, a setback in the reform would have a negative impact on the public debt ratio as the cumulative fiscal gains from the reform are estimated at 7.7 percentage points o f GDP in 2009-2025-increasing the net public debt-to-GDP ratio to 20 percent by 2025 compared to 12 percent in the reform scenario. In the longer-term, the impact would be even larger as the cumulative fiscal savings from the reform are estimated to be around 200 percentagepoints of GDP in2009-2075. 8 111. THE GOVERNMENT'S PROGRAM 31. Turkey's economic policy framework and reform program are described in a number of separate but consistent documents. Turkey's medium-termeconomic policy and reform program i s articulated in the Ninth Development Plan (2007-2013)' which was published in the Official Gazette on July 1, 2006. The government follows implementation of the development plans through its annual programs and the 2008 Annual Program was publishedin October 2007. The priorities of the current administration were spelled out in the 60th Government Program presentedto Parliament on August 31,2007 and inthe Action Plan of the government published on January 10, 2008. Turkey also produces annual EU Pre-Accession Economic Programs that detail short and medium term policy actions and structural reform priorities related to EU accession. The 2007 Pre-AccessionProgram, which covers the 2008-2010 period, was submitted to the EU Commission in December 2007. Moreover, Turkey has moved to medium term budgeting since 2006, and the third medium term fiscal plan covering the period of 2008-2010 was issued in the Official Gazette dated July 3, 2007. These policy documents are consistent among themselves. 32. Key long-term development goals include transforming the country's economic and social structure in order to become an influential regional economic power, raising the quality of and access to health and education services, improving income distribution, strengthening scientific and technological capacity, enhancing effectiveness in infrastructure services and protecting the environment. The vision i s that of a modern and secular participatory democracy, fully integrated in the European community, playing a critical role in its region, with an export- oriented, technology-intensive productive structure. Turkey sees the EU accession process as an important opportunity for harmonization with international norms and standards. 33. Inthis context, the NinthDevelopment Planvision is "a Turkey which grows instability, shares her income more equitably, i s competitive at a global scale, transforms into an information society and has completed the stage of legal harmonization for EUmembership". 34. Inorder to achieve this vision, the NinthDevelopment Plan comprisesfive "development axes" or strategic areas of action, namely: (a) Increasing Competitiveness, (b) Increasing Employment, (c) Strengthening Human Development and Social Solidarity, (d) Ensuring Regional Development and (e) Increasing Quality and Efficiency inPublic Services. 35. The new vision and the related development axes heavily coincide with the development agenda supportedunder the new Country Partnership Strategy (CPS). The CPS i s shaped directly by Turkey's NinthDevelopment Plan and by the Government's Program andaims at contributing to three main development pillars: (i) improved competitiveness and employment, (ii) equitable human and social development, and (iii) efficient provisionof high-quality public services. 36. The proposed PPDPL 2 is strongly aligned with the new strategic objectives of the government; supporting selectively key elements of the Government's Development Plan (see Annex V). Strengthening Human Development and Social Solidarity, Ensuring Regional Development and Increasing Quality and Efjciency in Public Services are the three development axes supported by PPDPL 2. The program supported by PPDPL 2 i s a subset of the actions included ineach of these three development axes. 9 37. For instance, the Strengthening Human Development and Social Solidarity axis includes actions aimed at (a) improving the effectiveness of the health system, (b) improving income distribution, social inclusion and fight against poverty, (c) increasing effectiveness of the social security system. The Ensuring Regional Development axis includes actions aimed at (a) making regional development policy effective at the central level, (b) ensuring development based on local dynamics, and (c) increasing institutional capacity at local level. The Increasing Quality and Effectiveness in Public Services axis includes actions aimed at (a) improvingjustice system, (b) increasingpolicy making and implementationcapacity, and (c) developing humanresources in the public sector. Annex V presents more details about the Ninth Development Plan. The 2008 Annual Program o f the government includes specific actions in each of these areas with a view to achievingthe objectivesenvisionedinthe NinthDevelopmentPlan. 38. These program areas were chosen in view of their importance, the quality of the economic and sector work on the subjects conductedjointly by government and the Bank, their strong relationship to the CPS objectives, and the close relationship and complementarities amongthemselves which allows combiningthese elements into a coherent package of reforms. IV. BANKSUPPORTTO THE GOVERNMENT'S STRATEGY LINKTO CPS 39. A new CPS was endorsedby the Bank's Executive Directors on February28, 2008. The goal of the new CPS for FY08-11i s for the Bank Group to be a partner with Turkey inrealizing her development vision-to achieve fast and sustained growth with equity-through full integration into the Government's formulated development strategy. Accordingly, the CPS is shaped directly by Turkey's Ninth Development Plan and by the Government's Program and aims at contributing to three main development pillars: (i)improved competitiveness and employment, (ii)equitable human and social development, and (iii) efficient provision of high- quality public services. 40. The authorities expressed strong interest in DPLs to accompany and support Turkey's ongoingreform agenda, primarily because of the Bank's comparative advantageinpolicy advice and support linked to flexible budget financing. Under the new CPS, public sector reforms will be supported through the PPDPL series, while a proposed series of Competitiveness and Employment Development Policy Loan (CEDPL) would support the investment climate, the financial sector, the labor market, innovation and technology. Similarly, the proposedDPLs in the area ofenergy will support energy supply security. 41. The new CPS envisages that the phasing of Bank financing and the mix of DPLs and investment financing will be flexible. Thus, Bank financing may be front-loaded, back-loaded, or evenly phased, and the share of DPLs may exceed or fall short o f the expected fifty percent average in any one year and over the 4-year CPS period-depending on the economic circumstances in Turkey and the substantive content and pace of implementationof the Turkish authorities' economic reform and investment programs. Recognizing the importance of continuity and predictability, the Bank will nonetheless aim, working with the authorities, to manage Bank financing ina way consistentwith a broadlyevendistribution of newcommitments over the CPS period. The two mainreasons for flexibility inthe instrument mix and phasing of 10 Bank financing, reflecting the Turkish authorities' preference, are the intrinsic and persistent uncertainties and volatility in global financial markets and the rapid evolution o f the Turkish economy. Such flexibility in instrumentchoice i s also consistent with the implementation o f the Bank Group's M I C Strateg~.~ 42. The scale of available Bank financing and its phasing over the CPS period will be determined by the Bank's review and approval o f each new loan commitment. The Bank's review will focus on the maintenance o f sound macroeconomic management, financial sector stability, and progress in the three CPS development areas, namely (a) improved competitiveness and employment opportunities, (b) equitable human and social development, and (c) the efficient provision o f highquality public services. 43. Specifically, the Bank will assess Turkey's macroeconomic management and financial sector stability and performance inthe three CPS development areas by considering public policy action triggering progress inthe following six reform areas: 0 Continued good macroeconomicpolicies,through the implementation o f a satisfactory macroeconomic framework broadly in line with the scenario presented in the CPS document. 0 Continued good financial sector policies, designedto enhance financial sector stability through improved efficiency o f the financial sector, including public sector banks. 0 Improved investment climate and reduced informality through measures such as the enactment o f the new commercial code, further simplificatiodreform of the income tax system, and development o f a strategy for combating informality. 0 Improved functioning of the labor market including through the enactment of legislation aimed at increasing labor market flexibility and participation, especially for women and youth, reducing non-wage labor costs, and increasing the protection for workers relative to protection o fjobs. 0 Implementation of sustainable and more equitable social security through measures such as the enactment and initial implementation o f a revised Social Security and UHI Law that addresses the Constitutional Court decision while maintaining the twin objectives o f long-term fiscal sustainability and equitability o f the social security system, continuation o f targeted benefits to poor families, and adoption o f a new social assistance law. 0 Improved effectiveness of public expenditures, through measures such as the enactment o f appropriate state aid legislation in conformity with EU directives, budget implementation consistent with the medium-term framework, continued implementation o f the PFMC Law and the adoption o f a new law on the Turkish Court o f Accounts (TCA). Strengtheningthe World Bank's engagement with IBRD partner countries(DC2006-0014), September 7,2006 and Strengtheningthe World Bank's engagementwith IBRD partner Countries(DC2007-0022), October 9,2007 11 COLLABORATION WITH THE IMFAND OTHER DONORS 44. The IMF and World Bank teams have collaborated closely in Turkey, and standard working arrangements broadly follow the guidelines for enhanced Bank-Fund collaboration. This has includedparticipation o f Bank staff inmeetingswith government o fthe Fund's program review missions, and IMF staff invited to key Bank review meetings and meetings with government. The IMF has taken the lead inmacroeconomic stabilization and the World Bank in social and structural areas, with close collaboration in structural areas that have a particular impact on macroeconomic stability. 45. Inthe areas o fthe government's program supported by PPDPL, collaborationbetweenthe Bank and the IMF has focused on strengtheningPEM system while maintaining fiscal discipline. The IMF has taken the lead in the short-term measures needed for the fiscal adjustment such as incomes policy, urgent revenue and expenditure measures, and budget monitoring and reporting. The Bank has taken the lead in assisting government on the medium-term PEM strategy, rationalization o f the Public Investment Program (PIP), public procurement reform, accounting reform, and public liability management. Public employment policy, medium-termtax strategy, anti-corruption strategy and civil service reform are further areas o f Bank involvement. 46. The ongoing EU accession process has generated increased demand for the Bank's services in Turkey. Incollaboration with the European Commission (EC) the Bank completed in March 2006 the first o f a series o f Country Economic Memorandum (CEM) focused on EU accession and a second CEM was completed inApril 2008. The program i s fully consistent with and supportive o f the Lisbon Agenda which envisions to make the EU one o f the most competitive and productive regions o f the world. 47. The Bank has coordinated closely with the EU its advice on public procurement and follow up technical assistance to the Public Procurement Agency (PPA). The social security reforms supported under the PPDPL series are in conformity with the European Social Model, and will help Turkey both stay on track interms o f Copenhagen criteria but also move forward in terms o f meeting the Lisbon agenda. The establishment o f Development Agencies (DAs), supported under the PPDPL 2, will help establish the institutional infrastructure requiredfor the use o f EU's structural funds. 48. The Bank's assistance on public debt management issues has been oriented towards EU practices and the Maastricht criteria. The Bank is coordinating its dialogue on financial management issues with the EU, and the law on PFMC i s consistent with EU standards on internal controls. The EU has provided support for additional institution-building initiatives under the public sector reform program, including support for peer review and twinning arrangements for the TCA and support for the Ministry o f Finance (MOF). RELATIONSHIP OTHER BANKOPERATIONS TO 49. Turkey's public sector reform program since 2000 has included PEM reform, tax policy and administration reform, public liability management and governance reform. Lendingsupport was through the Economic Reform Loan (ERL) (2000) and the three PFPSALs PFPSAL I(July - 2001), PFPSAL I1(April 2002) and PFPSAL I11(June 2004 and June 2006). PPDPL series have beenthe next programmatic series supporting reforms inTurkey's public sector as a continuation o f the public sector reform agenda envisaged under the PFPSAL program. The first PPDPL was deliveredin June 2006. Financial sector reform components o f the PFPSAL program have been integrated into the CEDPL series o f which the first one was deliveredinJune 2007. 50. The PPDPL series have strong linkages with a number o f other Bank-financed investment projects. The Health Transition Project (HTP) approved inJune 2004 supports a comprehensive health sector reform program that will improve the cost-effectiveness o f the health care system so that the introduction o f UHIcan become fiscally sustainable. Likewise, the Privatization Social Support Project (PSSP) series (PSSP and PSSP 11) i s providing the necessary social support to ensure the continued highly successful privatizationprogram. LESSONSLEARNED 5 1. The World Bank made its first loan to Turkey in 1954, shortly after the country became a member. The Bank has been active in virtually all sectors and has conducted a great amount of analytical and advisory services. Consequently, numerous lessons have been learned in this relationship and the most relevant from the perspective o f this Loan are summarized in the Country Assistance Evaluation (CAE) for the period July 1, 1993 to June 30, 2004. The Bank's 2005 Review o f World Bank Conditionality constitutes another source o f lessons learned relevant to DPLs to Turkey. 52. Lessons learned have been reflected in the design o f the PPDPL program as follows. First, in Turkey the Bank benefits from bundling its analytical work and policy dialogue with lending to achieve effectiveness. The 1993-2004 CAE found that little formal economic and sector analysis was carried out up to the late 1990s but that thereafter economic and sector analysis has become a larger part o f the Bank's program which has increased program effectiveness materially. The PPDPL program has been designed on the basis o f a substantial amount o f analytical work. 53. Turkey is able to borrow from financial markets at low spreads and maturities, sometimes, longer than those offered by the Bank. In addition, Turkey has access to funding from a variety o f other development partners, which in some cases are able to lend at lower financial and compliance costs than the Bank. Thus, the Bank's ability to effectively engage with the government on program design depends largely on the quality o f its analytical work and policy dialogue capability-key elements in supporting program ownership. In this regard, the CAE also found that the policy dialogue has been more effective with the increased management focus on Turkey that resultedfrom greater decentralization o f Bank decision-making to Ankara and the increased role o f the Country Office in program monitoring and implementation. The PPDPL program i s being managed from the Country Office with input from staff based in headquarters, as required. 54. The 2005 Review o f World Bank Conditionality indicates that disbursement conditions should be few and focused on actions critical for achieving the results sought under a program. The Bank's policy loans to Turkey have seen a dramatic decrease in the number o f conditions. For example, the second tranche o f the ERL was disbursed in 2004-four years after Board approval. One reason for this long delay i s that this loan had about 40 disbursement conditions. Since the approval o f the ERL, policy loans have been increasingly focused on critical actions. PPDPL 2 has only eight prior actions. 13 55. Country ownership is fundamental for the program supported by this Loan as evidenced by the political difficulty entailed by some of the elements in the envisagedprogram of reforms. This recognition calls for flexibility and for collaboration with key domestic reform leaders in developing the analytical underpinning of the reform for their use in their own policy dialogue with national constituencies. ANALYTICALUNDERPINNINGS 56. The World Bank has provided considerable analytical support to Turkey's public sector reform program through four CEMs (2000,2003,2006, 2008), Country Procurement Assessment Report (2001), Country Financial Accountability Assessment (CFAA, 2001) and Public Expenditure and Institutional Review (PEIR, 2001) and Municipal Sector Review (2004) and Public Expenditure Review (PER, 2006). The Bank has been providing technical assistance in developing the government's technical capacity to run pension reform option simulations for several years. In addition, a report on costing UHI was provided in 2004. A Joint Poverty Assessment Report was completed inAugust 2005. A labor market study was finalized in April 2006 and a new Programmatic CEM Series has been launched, of which the first CEM was concluded in February 2006 and the second one in April 2008. A PER was concluded in December2006. V. THE PROPOSEDPPDPL 2 RATIONALE FOR WORLD BANKSUPPORT OF THE PPDPLPROGRAM 57. World Bank support to the implementation of the program with this Loan i s justified because (a) the program supports a substantial amount of good public policies-which are expected to contribute to improving social outcomes, modernizing public expenditure management systems, strengthening public governance andjustice system, ensuring provision of high quality public services and reducing regional disparities- and because (b) the authorities have strong ownership of the program as evidenced by the fact that they implemented successfully all the prior actions-some of whichwere highly challenging. 58. The Government's program puts great emphasis on improving the efficiency and quality of public services. Improving the quality and management of public expenditures, strengthening public sector governance, improving judicial services, putting into practice the e-government, reducing regional disparities, improving local delivery of public services are among the key priorities. 59. Continuing improvements in the composition and quality of public spending will greatly help Turkey meet its development challenges and foster sustained growth. Fiscal consolidation so far has relied heavily on revenues. Future efforts on the expenditure side will be important to increasethe sustainability of fiscal adjustment and helpsupport economic growth inparticular by containing current expenditures so that sufficient fiscal room i s left for financing productive public investments. Moreover, a strong public sector primary surplus will needto be maintained inorder to acceleratethe reduction ofpublic debt inproportion to GDP and forestall pressures on the external current account. To this end, reducing state aid and implementing the social security reform will be important. 14 60. Increased fiscal space could be sought possibly by reducing spending in functional areas where it appears to be oversized in international comparison and by implementing reforms that improve efficiency and help contain costs in areas where expenditure pressures are being felt- such as health care and pensions. Horizontal reforms, focused on the careful formulation o f the investment program, would also help contain pressures on investment spending across functional areas. The Government recognizes the importance o f ensuring appropriate allocations for operation and maintenance (O&M) of public capital as accelerated decay o f capital goods may unduly burdenthe investmentprogram inthe future. A framework conducive to a greater role o f the private sector in the financing, development and operation of infrastructure should be created-requiring a predictable policy and regulatory environment, together with careful design o f Government commitments to private operators to minimize the risk o f contingent liabilities. 61. Addressing the unfinished agenda in Public Financial Management (PFM) reform represents a major challenge. Far-reaching PFM reforms have improved budget coverage, formulation, execution, accounting, auditing, and procurement, providing a new legal framework for modern public expenditure management and accountability. The main challenge ahead i s the implementation o f the reform agenda throughout the entire general government. The key areas that require further attention are: (i)enabling a fully functioning internal audit structure; (ii) enactment o f the TCA legislation, and (iii)improving the financial management and control structure o f the remaining Extra Budgetary Funds (EBF) and revolving funds. Effective leadership and coordination among agencies would be required for the effective implementation o f the overall P F Mreform agenda. 62. Despite the recent improvements, public sector governance remains a key priority for Turkey inthe mediumterm. The NinthDevelopment Plan o f the Government for the 2007-2013 period identified "increasing quality and effectiveness o f public services" as one o f the 5 development axes. Priorities under this axes include among others restructuring o f the public administration, human resources management andjudicial reform. The public sector governance and judicial reform agendas are o f crucial importance for a strong investment climate conducive to growth and job creation, and thus for meeting Turkey's long-term development challenges. Turkey would also benefit from a strong public administration that is more apt to implementthe EUAcquis Communitaire. Similarly the justice sector will play a critical role in adapting to EU requirements and standards. Improving public sector governance encompasses a broad agenda, underpinning many o f the short-term and medium-term priorities in the Accession Partnership with Turkey adopted by the EU Council in January 2006.4 Some key challenges, for example, include (a) promoting judicial reform-to ensure consistent interpretation o f legal provisions and strengthenthe efficiency of procedures; and (b) ensuring effective, transparent, and participatory local administration-a key for improving the quality o f public services; for effective implementation o f regional development policies and rural development and the absorption o f EUpre-accession funds. 63. Addressing regional differences is also part o f the Government's medium-term agenda. Income disparity both across regions and provinces inTurkey i s considerable. Inorder to support 2006/35/EC: Council Decision o f 23 January 2006 on the principles, priorities and conditions contained in the Accession Partnershipwith Turkey. httD://euroua.eu,int/smartapi/cgi/sga doc?smartaui!celexaui!urod!CELEXnumdoc&lg=en&numdoc=32006D0035& model=nuichett 15 regional development and facilitate the use o f EU funds for this purpose, the Government has begun to set up DAs. These would play a planning and coordination role, supporting implementation o f regional plans and programs. As o f March 2008, only two DAs have been established in regions o f Izmir and Adand Mersin but the government is planning to establish DAs in all 26 Nomenclature of Territorial Units for Statistics (NUTS) 2 regions. Other remaining challenges include: (i)designing and implementing a national strategy for regional development, (ii) managing the EU funds for regional development, and (iii) building capacity at the DAs. 64. Advancing decentralization will have a major impact on the efficiency and quality o f public services at the local level. Local administrations account for only about 10 percent o f government expenditures. The Government has embarked on a gradual process of decentralization. The authorities are aware o f the importance o f successful decentralization, o f improvements in the technical capacity o f local administrations and in local accountability, and o f the matching o f expenditure responsibilities and revenues. The targeting o f transfers to local administrations i s also a key issue, given the wide disparities in tax bases among the local administrations. 65. On the basis o f the analysis summarized above, the Loan has been designed to support policy interventions in key areas with the aim o f contributing to improving the country's social protection system, upgrading financial controls and public expenditure management systems, and improving the administration and governance o f the public sector. 66. There i s clear evidence that the authorities are committed to the reform program supported by the proposed Loan as evidenced by (a) the existence o f a well-designed medium term government program encompassing all these important reform areas (Section 111and Annex V) and by (b) the substantial progress achieved in outcomes. Therefore, the PPDPL 2 supports the implementation of a credible program o f structural reforms with full government ownership, a program that builds on Turkey's successful returnto economic stability and rapid GDP growth. 16 P e m c 2C m C l zE...- InE P a c .fiz .-ue g .- k L .-C0m c, .Y CII W Ba.. m .-R 8 I k .I x PROGRAMMATICFRAMEWORKOPERATION DESCRIPTION AND 67. The PPDPL series is intended to support the government's medium-term program of legal, institutional, and structural policy actions aimed at consolidating fiscal adjustment and modernizing the institutions and procedures o f public sector management and service delivery. The government has adopted a well defined medium term program that will be implemented flexibly in order to react to unpredictable events as they unfold-includingy for instance, the process o f EU-accession negotiations, political cycles, and global events. 68. The EU accession process has become a driving force for Turkey's reform efforts over the recent years. It has provided an anchor for the continuation and deepening of reforms, thus fostering Turkey's growth potential and accelerating convergence to EU living standards. The NinthDevelopment Plan of the government was prepared with the vision of, among others, full harmonization with the EU's institutional and legal framework for member countries. The Government has prepared a six-year program o f economic, social, and institutional harmonization with the EU Acquis Communitaire. The proposed PPDPL 2 i s aligned with the new strategic objectives o f the government, supporting selectively key elements o f the Government's Development Plan (see Annex V) and the process o f EUaccession. 69. Bank support under the PPDPL program will follow a programmatic approach. This approach provides flexibility for program implementation which allows adaptation in timing and sequencing to the ongoing dynamic process o f EU accession negotiations. Priorities within the overall public sector reform program may change as EUnegotiations advance. 70. The operations under the PPDPL series support actions in four components, namely: (a) maintaining the currently enabling macroeconomic framework; (b) reforming the country's social protection system; (c) continuing the on-going process o f upgrading the financial controls and expenditure management o f public resources; and (d) improving the administration and governance of the public sector. 71. The first PPDPL has already supported a number o f reforms to tackle this agenda. Accordingly, the PPDPL 2 supports important second stage critical implementationachievements since the first operation infour connected subjects within the government's program. All actions and milestones supported by PPDPL 2 are included in Turkey's broader economic policy and reform program (Section I11 and Annex V). PPDPL 2 was predicated on the enactment o f the amended Social Security and UHI Law on May 8, 2008. The followings are the core policy actions supported by the Loan. All o f them have beensuccessfully met. 0 Implementation of the Law reforming the administrative dimensions of social security by unifying the existing three social security schemes (Law No. 5502) is on track. In particular, satisfactory implementationof an agreed action plan resulted in (a) consolidated electronic records of the previous social security institutions and use of integrated identity number system, (b) personnelpolicies for the new SSI and a core cadre of staff; (c) established financial management and claims adjustment systems, (d) uniquepositivedrug lists for all participantsin the new SSI. 0 An expenditure tracking system for pharmaceuticals has been established and is operational. 18 0 All secondary legislation required for the PFMC has been published and has becomeeffective. 0 Strategy development units responsible for strategic planning, budgeting, accounting and internal control functions have become operational in all general governmentinstitutions. 0 2006 financial statements of central government institutions and local administrationshave been prepared on an accrualbasis. a A law for the establishment of Regional Courts of Appeal has been enacted and made effective,in order to ease the backlogof cases within the Court of Appeals. a On-line connections among courts have been established through satisfactory implementationof the NationalJudicialNetworkProject(UYAP). 0 At least two DAs have been established and are operational. 72. Inaddition to the above core policy actions, the authorities have completed a substantial number o f other important policy actions and milestones in the implementation o f the broader reform program supported by PPDPL 2-as presented in the program matrix in Annex 11. Progress o f this magnitude bodes well for continued future implementation o f a comprehensive mediumterm public sector reform program. 73. What follows i s a brief description o f the structural constrains that the actions implementedunderthe program seek to ameliorate or remove. POLICYAREASSUPPORTEDBY THE LOAN COMPONENT SUSTAINING ANENABLINGMACROECONOMIC I: FRAMEWORK 74. Over the last few years, Turkey has been among the fastest growing economies in the world. Inflation has fallen to single digits for the first time inthree decades, and macroeconomic vulnerabilities have been significantly reduced. Elements in this performance include a tight fiscal policy, a flexible exchange rate, and reforms in the public and financial sectors. On the other hand, large exposure of foreigners in Turkish assets, substantial external financing needs, comparatively short maturity o f the public debt, highgross external debt stock, and highroll-over rates imply some vulnerability to exogenous shocks. 75. The challenge for the authorities is to minimize the impact that the realization o f these risks would have on growth, employment, and poverty-among other key variables. Therefore, the government and the Bank have agreed that maintaining a satisfactory macroeconomic framework should be a condition for disbursingthe PPDPL 2. 76. Inassessingwhether the macroeconomic framework is satisfactory, Bank staff have used projections o f Turkey's medium-term macroeconomic outlook to assess the sustainability o f its fiscal program, balance o f payments, and associated debt dynamics. These projections have been made using a macroeconomic consistency model which focuses on (a) fiscal and debt sustainability risks, (b) balance of payment vulnerabilities, (c) monetary and exchange rate risks, and (d) financial sector risks. 77. Bank staff has also taken into considerationthe views of the IMF and regards the status o f the IMF stand-by program-in place since May 2005-as an additional element to conclude that 19 Turkey's macroeconomic situation is adequate and that government policies are likely to be sustainable over the mediumterm COMPONENT 11: SOCIAL SECURITY AND SOCIAL ASSISTANCE REFORM 78. Turkey had a fragmented social protection system in the past as three separate social security institutions provided services to workers, civil servants and self employed. Registration with one of the three institution determined eligibility for pensions, health insurance, and unemployment insurance. This fragmented structure with incompatible databases had facilitated noncompliance which negatively affected the system's revenue as large numbers o f employers and workers neither paid their pension contributions nor their health insurance premiums. 79. In order to create an effective and modern social protection system, the Turkish government has embarked on a comprehensive and challenging social security reform consisting o f four main pillars since 2004. The first pillar aims at establishing a unique pension regime, which involves long and short term insurance programs except health insurance. The second pillar supports the establishment o f a UHI to finance a fair, preventive, treatment-oriented and high quality health service for the whole population. The third pillar involves the unification of the currently diversified social assistance and services. The fourth pillar aims at integrating the three separate social security institutions under a single administration so as to provide social protection services ina facilitating and accessible as well as effective manner to the citizens. 80. The Bank has been providing support to the government efforts in reforming Turkey's social protection system through its PPDPL program. The first PPDPL supported the unification o f the three fragmented social security institutions under a single administration and introduction o f a parametric pension reform together with UHI. Although the law reforming the pension parameters and creating legislative base for UHIwas partly canceled by the Constitutional Court in December 2006 (mostly for articles related to civil servants), the government has shown its commitment to the broader social protection reform agenda in Turkey and moved forward with implementation o f the administrative restructuring and certain parts o f UHI reform. The government also amended the Social Security and UHILaw inorder to address the Constitutional Court ruling through enactment o f the Law No. 5754 on May 8, 2008. Full implementation o f the law is scheduled for October 2008 in order to allow time for the issuance o f secondary regulation required for the implementation. This Loan (PPDPL 2) acknowledges the progress achieved since the first operation in areas where there was no legal challenge and the government has made a substantial advancement. Administrative Dimensions of the Social Security System 81. One o f the key goals o f the social protection reforms inTurkey was to tackle the previous fragmentation o f the social security system. Apart from inherent and historic parametric imbalances in the pension system (low retirement age and generous benefit calculations), the fragmentation o f the system itself had posed significant structural problems: different pension parameters (accrual rate, retirement age, valorization, indexation etc) existed in the previously three existing institutions (Social Security Institution for Workers in the Old System (SSK), Social Security Institution for Civil Servants in the Old System (Emekli Sandigi) and Social Security Institution for Self-Employed and Farmers inthe Old System (Bag-Kur)), compromising horizontal equity. Incompatible databases meant that transfers of social security records o f the 20 insuredwere significantly hampered ifnot impossible. Further, the fragmentation o f the system itself was responsible for low collection rates, limited access to pension benefits, as well as - especially for health insurance coverage - discretionary granting o f services to formally not eligible beneficiaries. 82. Unifyingsocial security regimesby mergingthe previously existing institutions hadto go hand in hand with a wide-reaching and complicated administrative reform. In many respects, such administrative reforms are the necessary condition for the effective implementation o f the parametric pension reforms as well as the implementation o f the introduction of the UHIreform. The agenda o f such administrative reform was significant and included inter alia, establishment o f legal basis for the merging o f the previously existing three social security institutions; integration o f staff working for the previously existing social security institutions. Creation o f a unified database for the pension system, integrating the previously non- compatible technology platforms into a new system. Such integration was to start with the conversion to new citizen identification numbers of all individual records of active contributors, passive members (beneficiaries) but then also all records of past contributors that had an interrupted contribution record, eliminating double entries and counting; establishment o f a unified database for the UHI, including the merging o f the beneficiary (and dependent) databases and then establishing a financial management and claims adjustment system that would be capable o f linking provider claims for the actual provision o f services for beneficiaries to the insurance record o f beneficiaries inthe UHI; 0 ultimately, the establishment o f a single pension fund (integrating collection o f pension contributions, health premiums and pension payments) as well as the establishment o f a UHI Fund (managing other financial flows in the health sector, including premiums paid by the budget on behalf o f the poor and health expenditures o f civil servants). 83. The first PPDPL supported the law reforming the administrative dimension o f social security by unifying previously existed three social security institutions (Law No. 5502 dated May 2006). Given the tremendous challenge o f mergingthe three institutions so as to create an effective modern single institution, the authorities and the Bank have agreed that the implementation o f the above law would be supported under the second operation with a clear action plan among other things. 84. Despite the difficulties created by the cancellation of some parts o f parametric pension and UHIreform by the Constitutional Court in December 2006, the government did press ahead, and made major advance, regarding important parts o f the administrative reform agenda. First, effective January 1, 2007, the previously existing three social security institutions were replaced by the Turkish Social Security Institution (SSI) as had been established by Law No. 5502 from May 16'h, 2006. 21 85. Second, significant progress has been achieved in effective personnel integration: around 10,300 staff, representing about 40 percent o f total staff o f the previously existing institutions has already been fully integrated into SSI, the large majority at the provincial level. Additionally, a unified staff policy i s beingapplied uniformly to all current staff o f SSI. 86. Third, advances toward the establishment of a unified database have also been remarkable. For example, the former SSK pension insurance institution for workers transferred 30 million individual records to SSI and o f these, 14.5 million have been reclassified with a unique T.R. identification number, including all new and active members. All citizen identification numbers o f current beneficiaries (retirees) are similarly complete. The remaining 15.5 million records from SSK needto be examined one-by-one given that these are either not in electronic environment or not active. 87. Finally, major progress i s witnessed also through today's functioning o f the medical messenger (MEDULA) system which links the Social Security Institute's information system to health providers and effectively collects data on health service utilization o f insuredbeneficiaries and provides for electronic payments to the providers. System development was started in the last quarter o f 2005 and the system now provides for (i)service provider as well as beneficiary identification and verification; (ii)transfer, prescription and investigation request notification; (iii)payment processing; and (iv) invoicing. Today, MEDULA is fully operational, having linked 2882 public and certified private hospitals. Medical examinations, tests, and treatments are recorded on an individual basis in all contracted private health institutions, university and public hospitals. 88. The current operation (PPDPL 2) supports the significant advance made on the administrative reform agenda as outlined above. Specifically, Government implemented an agreed action plan on administrative reform in a satisfactory way which included (i)making significant progress towards consolidating electronic records o f the previous social security institutions as witnessed by the above-mentioned updating and conversion o f 14.5 million pension fund records o f SSK; (ii) established personnel policies as well as core cadre o f staff o f the new SSI; (iii)fully established the financial management and claims adjustment system (MEDULA); and(iv) harmonized a unique positive druglist for all participants inthe new SSI. ParametricPension Reform 89. The amended pension reform as enacted on May 8, 2008 is projected to result in substantial fiscal savings in the long run, and to help move the Turkish pension system toward international parameters, as shown in Figure 7. The elements o f the reform are detailed in Table 3. The key parameters are discussed below. 90. The retirement age in Turkey will reach current international norms of 65 for both men and women under the amended Law. However, the Law provides for a slow transition to the new retirement ages, with the retirement age o f 65 not being fully reached until 2070. Nevertheless, moving to age 65 even inthe future i s a major improvement over the current final retirement ages o f 60 for menand 58 for women. 91. The minor increase in contribution period is not a significant factor assuming no change in behavioral assumptions. The rising retirement age will automatically lead to increased 22 contribution periods, making this minimum period a non-issue unless workers choose to contribute only the minimumyears requiredfor a pension and evade pension contribution inprior years. The projections presented assume no change in workers' behaviors with respect to contribution. 92. The benefit accrual rate which has beentraditionally high inTurkey is now beingreduced closer to international fiscally sustainable norms which are close to 1.5 percent o f benefit per year of contribution. The accrual rates for civil servants are being reduced from 3 percent per year to 2 percent per year for new entrants and for private sector workers from approximately 2.75 percent to 2 percent per year for new entrants. While the new accrual rates remain somewhat above the international standards, taken together with the valorization parameters for past earnings, discussed below, the overall benefit ratio comes closer to international norms. 93. The averaging period for wages usedinpension calculation is being gradually introduced to lifetime career average wages for farmers and civil servants, which i s in line with international best practice. The averaging period for private sector employees and the self-employed was already beingincreased to lifetime average. 94. The revaluation o f past earnings (valorization), which had been set at growth o f nominal GDP for private sector employees and the self-employed, has now beenreduced to inflation plus 30 percent o f real GDP growth. As nominal GDP growth outpaced wage growth by considerable margins, valorization was very high in the past by international standards and contributed substantially to the growing deficit in the social security system. The new, lower revaluation parameter together with the benefit accrual rate brings the overall benefit ratio closer to the international standards. The new revaluation parameter will also apply to farmers whose pensions were previously based on weighted average o f premium steps, and to new civil servants' salary. The original version o f Law No. 55 10 had linkedrevaluation o f past pensions to 50 percent o f average wage growth and 50 percent o f inflation, but had been struck down by the Constitutional Court on the grounds that a reliable wage series did not exist in Turkey and that some part o f GDP growth should be included in the revaluation. The provisions in Law No. 5754 seek to accommodate the Constitutional Court's concern inthis regard. 95. The indexation of pensions post-retirement is also moving from being linked to growth in civil servant wages to growth in the price index for new civil servants and farmers. Previously, private sector workers and the self-employed were already indexed by law to inflation so this does not represent a change for them. Table 3: Pension Parameters Before and After the Law Before La Law No. 5510 as Original Law Private Bag-Kur Self- Bag-Kur Civil Servants Amended by Law No. 5510 Sector Employed Farmers No. 5754 Employees Retirement Gradualtransition Gradual Gradual Gradual Gradual Gradual Age from 38 and 43 for transition from transition from transition from transition from transition from female and male, 38 and 43 for 38 and 43 for 38 and 43 for 38 and 43 for 38 and 43 for respectivelyto 58 female and male, female and female and female and female and and 60 for female respectively to male, male, male, male, and male, for those 58 and 60 for respectivelyto respectively to respectively to respectivelyto beginning work female and male, 58 and 60 for 58 and 60 for 58 and 60 for 58 and 60 for after 1999,and for those female and female and female and female and 23 Table 3: Pension Parameters Before and After the Law Before La No. 5510 Law No. 5510 as Original Law Private Bag-Kur Self- Bag-Kur Civil Servants Amended by Law No.5510 Sector Employed Faimers No. 5754 Employees transition to 65 for beginning work male, for those male, for those male, for those male, for those both men and after 1999, and beginning beginning work beginning work beginning women for those transition to 65 work after after 1999 after 1999 work after beginning work in for both men 1999 1999 2009 and who and women for complete their those beginning minimum work in 2007 contribution period after 2048 Contribution Gradual increase Gradual increase Gradual 25 years of 25 years of 25 years of Period from 14 years to from 14 years to increase from contribution; contribution; contribution 19.4 years for 19.4 years for 14 years to partial pension partial pension for men; 20 those beginning those beginning 19.4 years for available for available for years for work after 1999 work after 1999 those shorter shorter women; and further and further beginning duration duration increase to 20 increase to 25 work after years for those years for those 1999; partial beginning work beginning work pension after April 30, in 2007 as available for 2008 as private private sector shorter sector employees; employees; duration partial pension partial pension available for available for shorter duration shorter duration Benefit 2% per year of 2.5% per year of 3.5% for first 3.5% for first 70% for 25 75% for 25 Accrual Rate contribution for all contribution I O years; 2% 10 years; 2% years, reduced years, reduced except existing until 2015 and for next 15 for next 15 by 1YOper year by 1% per year civil servants, 2% thereafter years, and years, and for shorter for shorter private sector 1.5% 1.5% thereafter duration before duration employees and self thereafter 1999; 3.5% for employed, who first 10 years, will receive 3% per 2% for next 15 year for their first years, and 1.5% I O years and 2% thereafter per year subsequently Averaging Gradually moving Gradually Gradually Gradually Gradually Last salary Period for to lifetime earnings movingto movingto movingto moving to Wages Used for all except lifetime earnings lifetime lifetime lifetime in Pension current civil earnings earnings earnings Calculation servants Revaluation 100% inflation 50% inflation 100% nominal 100% nominal 100% wage 100% wage o f past plus 30% of real plus 50% GDP growth GDP growth growth of civil growth of civil earnings GDP growth for all average nominal servants servants except current civil wage growth servants Indexation of 100% inflation for 100% inflation 100% inflation 100% inflation 100% inflation 100%wage pensions, all except current growth of civil post- civil servants servants retirement Minimum 35% o f minimum No minimum Determinedby Determined by Determinedby Determined Pension wage, raised to pension Council of Council of Council of by Council of 40% if pensioner Ministers Ministers Ministers Ministers has dependent spouse or child 24 Table 3: Pension Parameters Before and After the Law Law No.5510 as Original Law Private Bag-Kur Self- Bag-Kur Civil Servants Amended by Law No.5510 Sector Employed Farmers No. 5754 Employees Contribution 20% for pensions 20% for 20% for 20% for 20% for 36% for Rate except for civil pensions pensions pensions pensions pensions and servants retiree health Minimum Minimum wage - Minimum wage Minimum Step 1 on an Step 1 on an Contribution all those earning wage income table income table Base below minimum wage are not mandatorily insured 96. The Constitutional Court also objected to the treatment of civil servants in the original version of Law No. 5510. The amended Law No. 5510 seeks to address these concerns by grandfathering the current civil servants and applying the unifiedprovisions only to new entrants to civil service. Table 4: Decline in Implicit PensionDebt due to Reform (percent of GDP in PresentValue Terms) ~~ ~~~ ~~ ~~ ~ ~ ~ 2009 2025 2050 2075 percent of GDP Reform for private sector only 19 35 65 66 Reform for private sector and self employed 27 49 86 89 Reform for all groups 30 56 106 111 Memo Items: Implicit pension deficit under NO reform case (% of GDP) 197 191 205 203 Implicit pension deficit under reform case (% of GDP) 167 135 99 92 Pensioners and contributers under each group as a % ofthe total -Private sector workers 53 54 56 58 -Self employed 27 28 30 30 -Civil Servants 20 18 14 12 97. Fiscal savings from the new social security and UHI law as amended by Law No. 5754, compared with the status quo, will be large if the law is implementedin full over the long run- and even the fiscal savings from the reform of the system for the private sector and self- employed alone will be large. Figure 7 shows the substantial cost savings. The savings are primarily attributable to the change in revaluation of past earnings in the short run and to the increased retirement age and unified parameters for civil servants in the long run. Accordingly, the reform generates increasingly higher fiscal savings relative to GDP, from an initial 0.2 percent of GDP culminating to 6.3 percent of GDP in the long run. These large fiscal savings reduce the implicit pension deficit by more than half in the long term, compared with the status The implicit pension debt is the sum of the present value of all expected future benefit payments to current pensioners plus the sum of the prorated present value of expected future benefit payments to current contributors, 25 Figure 7: Turkey's PensionDeficit Before and After Reform 0.0% -1.O% & -2.0% c3 n -3.0% rcl *0 8u -4.0% -6.0% Year -Base II Reformfor private sector only -+-Reform for private sector and self-employed~ ~ ~ l - ~ ~ * ~ ~ ' ~ ' ' * Reformfor all Universal Health Insurance 98. The UHI reform being implemented in Turkey is a fundamental structural reform, matched in importance and size by few other countries in the world. Traditionally, and in line with the structure of the social security system, health insurance coverage in Turkey was linked to formal sector workers (and their dependents) being members of separate insurance funds, leaving both a fragmented and inefficient system as well as significant under-coverage of the population not linked to the formal labor market. Separately, the Ministry of Health (MOH) provided services, mainly to the uncovered population through its own network of public providers. The introduction of the "Green Card" system in 1992 -with an aim to providing access to a basic health insurance for the poor until Turkey implementedUHI - helped close the coverage gap substantially but not completely. The health services delivery system was also fragmented with purchasers such as SSK managing their own hospitals, MOH managing their prorated for the percentage of their lifetime contributionsthey have already made. In simple terms, if the pension system were to stop today, the implicit pension debt is what the government owes all participants, contributorsand beneficiaries. The implicit pension debt does not include future contributions as revenue because in a pension system each future contributioncarries a new future liability. 26 own hospitals and primary care clinics complemented by University hospitals and private providers. 99. The public policy objectives behindthe introduction o f UHIinclude improving access to quality health services by the poor, improving the efficiency and quality o f the health system and putting on a normal footing the somewhat chaotic access to health insurance where large numbers o f ineligible (non-contributing) individuals obtain services -regardless of their income levels. The key elements o f UHI include: (a) mandatory participation with contributions based on level o f income; (b) coverage o f poor citizens by the government through premiumpayments on behalf of the poor; (c) cost-effective management o f the system based on improved risk pooling, an enhanced benefits package and the introduction o f strengthened provider payment systems that reward providers for efficiency and quality. 100. The UHI reform integrates the entire health financing system (the separate social insurances and the Green Card system) into one universal insurance scheme under the SSI. With this integration, SSI becomes the single purchaser inthe system responsible for negotiating and signing contracts with public and private providers to deliver a pre-defined, harmonized health care package for all citizens. 101. The government has identifieda number o f key policy measures requiredfor an effective and efficient UHI.These include: Facilitation o f access to healthcare services, with primary health providing the foundation o f the health care system and compliance with the referral chain; 0 Competitive procurement o f services and goods from public or private sector, 0 Establishment o f fast and effective functioning o f a reimbursement mechanism with the helpo fan electronic provisioning system. 0 Provision o f quality, fast, clean, and appropriate healthcare services, which improves quality o f health and lives o f individuals 102. For the aforementioned measures to be achieved, the Government's Health Transformation Program (HTP) must be successfully implemented. Key reforms under HTP include: (i), as the planner and the auditor, (ii) MOH widespread, easily accessible and patient friendly health services, which includes strengtheningprimary health care, family medicine and establishing an efficient referral system, (iii)availability o f motivated health personnel with adequate information and skills, (vi) enhanced quality o f care in health facilities, (vii) institutional restructuring to support rational management o f pharmaceuticals and medical devices. 103. The objective o f the UHIreform that the proposed loan supports is the implementation of an effective and fiscally sustainable UHI system. Specifically, the program supported by the proposed loan includes: (i) creation o f an enabling legal environment for UHI, (ii)capacity the building measures that will assist SSI to carry out health financing functions (resource mobilization, risk pooling and purchasing), (iii)policy measures aimed at effective implementation o f UHI (MOH restructuring, establishment o f appropriate pharmaceutical and medical devices regulation, regulationo f private provision). 27 104. The first PPDPL (2006) supported the creation o fthe legal basis for introducing a fiscally sustainable UHI. Although, the Constitutional Court did not object to introduction o f UHI, the cancellation of the articles related to civil servants by the Court led to a postponement o f the implementation o f the whole legislation. Nonetheless, the govement's health reform program continued. Health insurance coverage under the formal health insurance system (now integrated under the SSI) has steadily risen from 35.5 million in 2004 to 44.5 million in 2007. Similarly, the Green Card system - providing health insurance access to the poor - has expanded from 7 million to 9.3 million over the same time frame. Taking into account that about 7 million civil servants and their dependents are currently covered, the actual coverage gap in Turkey today i s estimated to be around 10 million individuals. Under UHI, this group would be formally enrolled. Health benefits across the different (formal) health insurance schemes are largely synchronized (2007 health budget law or the Health ImplementationRegulation (SUT)), and UHI implementation will merely expand this benefitspackage to the remaining citizens who join UHI. 105. Nonetheless, health expenditures have continued to rise rapidly over the past years. Consolidated real health expenditures increased by 18.7 percent between 2004 and 2007. The increase in health expenditures i s essentially explained by: (i)expanded access to outpatient health services in the absence o f a strengthened primary health care system, which means most primary care visits occur in a hospital setting (ii)absence o f a referral system, (iii)lack o f demand side controls that would constraint consumers, (iv) a fee for service payment system for inpatient and outpatient services without any constraints on volume. 106. An actuarial analysis of UHI indicates the following:6 (i) health expenditures as a total percentage o f GDP will increase from the current level o f 5.7 percent (baseline before implementation o f UHI) to 6 percent by 2010. This increase reflects coverage expansion under UHIas well as expansion of the SSI benefits package (latest changes under SUT in July 2007 which allows SSI insurees access to University and private hospitals without a referral) to those currently under Green Card as well as new enrollees, (ii)by 2033, without cost management reforms, total health expenditures as a percent o f GDP would increase to 9 percent o f which 7 percent would be public, (iii)under the cost management scenario, total health expenditures would still grow but more moderately (6.7 percent o f GDP) (See Figure 8 for implications for public expenditures). 107. This analysis emphasizes the importance of implementing cost management measures geared to effectively control the growth in health expenditures on both public and private providers' side, This will involve strengthening the strategic purchasing function of SSI and effectively implementingthe price setting and regulation instruments. Also, on the revenue side, improved collection will contribute to fiscal sustainability. Important steps have already been taken in this direction through the initial implementation o f a fixed price system for outpatient procedures-though this has recently beensuspended by the Council of State rulingwhich is yet to be finalized-, capitation-based payment system for family doctors, global budget with M O H and now university hospitals (as stated in the Social Security and UHI Law), and the implementation o f Diagnostic Related Group (DRG) (bundledpricing for acute inpatient services World Bank: UHIactuarialanalysis: Projectinghealth expenditure growth under UHI:Cost pressure and cost managementscenarios. This analysis assumes that high case scenario of 7.2 million of the Turkish populationthat will be brought under UHI. 28 based on diagnosis). Full scale implementation o f these payment reforms i s critical for effective cost management inthe Turkish health sector. 108. The program supported by the proposed loan builds and expands on the policy actions that had been supported under the first operation, as the government has continued to move swiftly on the implementation and preparation o f the UHIreform. These actions can be grouped infollowing areas, all supported byPPDPL 2. 109. StructuralMeasures. This loan supports three structural measures that Government has implemented: first, the creation o f a unique positive drug list defining Figure 8: Projected Growth in Public Expenditures on Health as a percent of GDP eligible and cost effective pharmaceuticals that are covered 8.0 l------ for reimbursement under the UHI. Second, the Government has established and implemented a fixed price for some groups o f outpatients and inpatients services i ............. for public, university and private & hospitals. However, this has recently been suspended by the Council o f State ruling which i s yet to be finalized. The 0.0 Government has also implemented 2008 2010 2033 tight global budget caps for state 1 Cost pressure Cost management1 hospitals on a quarterly basis. The -C recently amended Social Security Source: Staff projections and UHILaw also includes key cost management measures: (i) will be allowed to implement SSI a co-payment system for outpatient services, (ii) negotiate an annual global budget with M O H and university hospitals, thereby effectively capping expenditures for these two groups o f hospitals, and (iii)implement a ceiling on prices charged by private hospitals where the difference betweenthe price charged and the amount paid by SSI i s paid by the patient. Under the current implementation, there is no such ceiling. 110. System Integration and Development. System integration has advanced significantly. First, and as pointed out above, MEDULA system now links the Social Security Institute's information system to health providers and effectively collects data on health service utilization o f insured beneficiaries and provides for electronic payments to the providers. As o f September 2007, all providers with a contract with SSI are required to submit claims using this system. Second, the administration has established an expenditure tracking system for pharmaceuticals. This system, a sine qua non for the effective management of expenditures for pharmaceuticals. 111. These two system developmentshave critical importance for the implementation o f UHI and have effectively established a fast and efficiently functioning reimbursement mechanism based on contemporary control systems so as to prevent abuse o f national resources. Considering the fact that the increase inhealth expendituresover the past years is almost entirely explained by the increase inthe quantity o f numbero fmedical services and number o fprescriptions for drugs, PPDPL 2 recognizes the importance of establishing an effective reimbursement and control 29 mechanism. In this regard, PPDPL 2 supports the establishment o f MEDULA and the expenditure tracking system for pharmaceuticals as core disbursement actions. Moreover, a system such as MEDULA is critical for the future implementation by SSI o f sophisticated hospital and outpatient provider payment mechanisms including pay-for-performance schemes that can ensure that providers are meetingSSI stipulated goals o f patient access and quality. 112. The MEDULA and the expenditure tracking system for pharmaceuticals also gather a large number o f statistical data -paving the road for developing an efficient management support system which will be essential when the UHI is fully introduced. In this context, one important next step will be to establish the link betweenthe pharmaceutical tracking system and the MEDULA system so as to match the information on beneficiary, provider, diagnosis and pharmaceutical use all over Turkey. 113. Preparation for full implementation of the UHI and PPDPL 2. Several PPDPL 2 actions support the full implementation o f the UHI System. First, with the passage o f the Social Security and UHI Law, SSI now has the legal mandate to develop the testing mechanism to determine the poor population whose premium payments will be covered by Treasury. SSI has two years to develop and implement a new targeting methodology. This will include recertifying current GreenCard holders. As fiscal analysis shows, the planned expansion o f UHIto the entire population will lead to additional significant costs o f coverage for SSI as Treasury premium payments will fall significantly short o f additional expected health expenditures. This re- emphasizes the importance o f containing future rapid increases in health expenditures as mentioned above. Further, cut-off income levels currently established inthe Law will need to be carefully reviewed regarding their impact on horizontal equity as well on the labor market (that the levels set for exemptions do not provide incentives for informal employment). 114. Inconclusion, the current operation (PPDPL 2) supports the significant progress made on the UHI reform agenda as outlined above. Specifically, the government (a) established an expenditure tracking system for pharmaceuticals and (b) adopted tight global budget caps for state hospitals on a quarterly basis. COMPONENT111: PUBLICFINANCIALAND EXPENDITURE MANAGEMENT REFORM Public ExpenditureManagement 115. In the 1 9 9 0 ~leading up to the 2001 crisis, a fragmented budget and ineffective fiscal ~ accountability mechanisms in Turkey's public sector contributed to large fiscal imbalances. Fiscal policy was not within the control o f policy makers since a fragmented budget made both maintenance o f fiscal discipline and management o f fiscal risks difficult. Multiple layers of inspections and internal controls were ineffective but provided incentives for agencies to establish off-budget flows to evade controls, further fragmenting the budget. Extensive off- budget activities made it difficult to estimate, and therefore manage, the full extent o f government finance and e~penditure.~ Underlying public sector structural and management issues were analyzed in the 2000 and 2003 CEMs and the 2001 PEIR. 30 116. Past pre-crisis periods (1994, 1999 and 2001) were characterized by large public sector borrowing requirements, due to sharp increase in public wages, widening o f social security deficits and transfer expenditures, including transfers to state banks.' 117. State banks kept accumulating so-called `duty losses' incurred as they were directed to fund government programs and to provide subsidized lendingto certain borrowers. With limited public information about the extent o f these duty losses, and the widespread perception that they constituted a contingent government liability, the sustainability o f public debt came into question. Large off-budget expenditures o f so-called EBF added to these concerns about the sustainability o f public debt. 118. Moreover, until 2001 PFM in Turkey was dominated by an outdated legal framework (Public Accounting Law dated 1927). A multitudeo f extra-budgetary funds and revolving funds seriously jeopardized budget discipline, a plethora o f control and inspection agencies, focused on compliance rather than ensuring the effectiveness o f management and control systems. The supreme audit institution (TCA) was limited by its restricted mandate. General government institutions lacked uniform accounting and reporting standards and a chart o f accounts that could be readily consolidated. Accounting was cash-based, PFM systems were not able to capture expenditurearrears nor government assets and liabilities, including contingent liabilities. 119. The 2001 crisis provided the impetus for policy-makers to address economic, social and structural issues -including PFM- ina comprehensive manner. Inresponse to the 2001 crisis, Turkey adopted a newmedium-termmacro-economic program and launched a renewedstructural reform program inDecember 2001.9 The renewed program incorporateda three-pronged strategy to achieve macroeconomic stability supported by improved social cohesion: (a) macroeconomic policies to restore fiscal stability and growth, and aggressively support disinflation process; (b) structural policies and institutional reforms to address financial sector and weaknesses in the P F M system; and (c) enhanced social dialogue with increased emphasis on protecting the most vulnerable groups. Accordingly, public sector reform since 2001 has focused on achieving the significant fiscal adjustment required to underpin macroeconomic stabilization, while simultaneously addressing underlying structural/institutional weaknesses. There has been significant progresson both fronts. 120. Fiscal adjustment in Turkey had two initial objectives. The first was to generate sufficient primary surplus to support a credible macroeconomic framework that would improve financial market confidence, facilitate debt reduction, and reduce inflation and interest rates. The second was to undertake structural/institutional reforms needed to address the underlying weaknesses in PFM that have contributed to the boom-bust cycles that have been a persistent feature o f the Turkish economy for some years. 121. The enactment of the PFMC Law in 2003 has provided a new legal framework for modern public expenditure management and accountability. The underlying objectives o f the new PFMC Law are to improve the quality of the public service delivery, enhance the functioning o f the government and increase accountability and transparency in the public sector. The Law has introduced strategic management concept through (i)linking plans and policies 'Transfer to state bankswas either in the form of capital injection or inthe form of duty losses. 9 Supportedby an IMF Stand-byArrangement (SBA) and the Bank's ProgrammaticFinancialand Public Sector Adjustment Loans (PFPSALs) 31 with the budgets; (ii)initiating institutional strategic plans and performance budgets; and (iii) introducing medium term fiscal framework in the budgeting process. Moreover, the Law strengthens the link between responsibilities o f the officials and politicians and their accountability to the public. It also improves the public expenditure and financial management processes in line with international practices. In order to support these new management concepts, a number of systemic reforms have been implemented simultaneously, including a Government Financial Statistics (GFS) compliant budget classification, an online budget management information system, an online networked accounting system for the central government, and a tax management system. 122. PFM and accountability reform program o f the Government has been one o f the policy areas supported by the Bank since 2001 first with the PFPSAL and then PPDPL series." Reforms inthis area aimed at both achieving a sustainable fiscal adjustment as well as tackling the lack of budgetary transparency which was as an ultimate source o f the crisis. The reform program, a expanded the coverage ofthe budgetto the entire central government institutions, and adopted international standards-IMF's GFS classification- o f budget classification that enabled economic, functional, and institutional breakdown for the entire general government; 3 abolishedallbudgetary funds,withtheexceptionoftheSupport PriceStabilizationFund (DFIF), and all but five EBF (Le., the Social Solidarity Fund, the Defense Fund, the Promotion Fund, Savings Deposit Insurance Fund(SDIF) and the Privatization Fund) that ledto improved fiscal discipline; 3 increased credibility of the budget formulation through introduction of medium term program and fiscal plan; 3 enhancedtransparencybydisclosinginformationondetailedfiscalbalancesofEBF,local administrations, social security institutions, and revolving funds as an attachment of the budget submittedto the Parliament; a eliminated the ex-ante control function of the MOF and TCA, and transferred this authority to the line agencies; a developed automated Online Public Accounting System (Say2000i) to be usedfor the entire central government; and 3 movedgraduallyfromthecashbasedaccountingtoaccrualbasedaccounting. 123. Continued progress in the quality o f public sector management depends on effective implementationo f the PFMC Law. The 2006 PER highlighteda number o f remaining issues and challenges for completing the P F Mreforms: 0 Expanding accrual accounting and reporting to the entire general government, 0 Full implementationo fthe PFMC Law by loThe details of the PFM reformand its outcomes supportedunder the PFPSALseries are presentedin the PFPSAL 3 ICR. 32 o establishing strategy development units (responsible for budgeting, internal control and financial services), o establishing internal audit units, and o completingthe secondary legislation. Preparation of a policy matrix defining priorities and accompanied by a set o f measures with associated costs and implementation timetables to guide the line agencies in preparing their annual budgets, harmonizing the Medium Term Program's (MTP) sectoral classification with the budget functional classification. Enactment o f a new TCA Legislation to strengthenthe financial audit function. 0 Bringing the remaining EBF and more than 1,000 revolving funds inside the budget and subjecting them to internal control and audit regime definedinthe PFMC Law. Eliminating overlap between inspection boards in line ministries and internal audit units. 124. The Bank has been providing support to the public expenditure reform agenda of the Government. The PPDPL program supports selected key policy actions within the government program with an aim to contributing to the attainment o f the following outcomes by the Government: 0 Improved fiscal discipline, better prioritization o f expenditures through strategic allocation of public resources, increased linkage between policy-planning and budgetingwith a mediumterm approach. 0 Strengthened Public Financial Control and Audit functions, more transparent and betterperforming government sector: o GFS consistent budget classification, accrual-based financial statements for the whole o f government in accordance with internationally acceptable financial reporting standards, o Better implementationand monitoring of budget execution o Reduced off-budget activities o Disclosure and reportingo ftax expenditures, 125. PPDPL 2 recognizes the achievements accomplished by the authorities in implementing the PFM reforms since the first operation. Accordingly, the policy matrix for the loan includes three core disbursement actions and several milestones related to implementation o f the PFM reforms. All the milestones and core disbursement actions have been met. In this context, the following achievements indicate the progress made in public expenditure and financial management reforms since the approval o f the first PPDPL. 126. Implementation of the PFMC Law and secondary legislation. After the enactment o f PFMC Law, completion o f the secondary legislation was one o f the main requirements for the full implementation of the Law. The government has issued all the requiredsecondary legislation for the implementation o fthe PFMC Law. Inthis regard, total o f 47 secondary legislations inthe form o f regulation and communique have been issued and become effective. Among these 33 secondary legislations, the critical ones are: (i) and procedures of strategic planning in the rules public administrations, (ii) andprocedures of internal control and ex-ante financial controls, rules (iii)publicsectorinternalcontrol standards, (iv) financial servicesexpertsregulation, (v) rules and working principles of the strategy development units (vi) rules and working principles of internal auditors, (vii) internal audit strategy paper. 127. The third medium-term fiscal plan covering 2008-2010, prepared by the government in June 2007 based on the macro policies, targets and sectoral policies and priorities laid out inthe mediumterm macro plan. After preparation and implementation of the 2007 budget, all general government institutions have prepared their 2008 budget according to the GFS budget classification. This common budget classification sets the ground for consolidating general government revenues and expendituresdata which was missing inthe Turkish system inthe past. 128. Since 2006, while submitting central government budget draft to the Parliament, the Government included aggregate revenue and expenditure projections on the revolving funds, extra-budgetary funds, social security institutions, and local administration to inform the Parliament about the entire general government sector including off-budget activities. The General Directorate of Public Accounts (GDPA) has begun collecting monthly financial statistics inrespect of revolvingfunds. Quarterly statistics is postedMOF websiteregularly. 129. Administrative restructuringunder the PFMC Law. As the mainresponsible agency for the implementation of the PFMC Law, the MOF carried out an internal administrative restructuring in order to manage and monitor implementation. MOF has completed its restructuring in line with the new roles introduced by the PFMC Law. Four new departments have been established to serve as central harmonization unit, namely the Financial Management, Internal Control, Internal Audit, and Training and Quality Departments. A total of 27 personnel have beenappointed inthese departments. 130. Strategy development units have been established and fully operational in all general government institutions.These units are essential for the successful implementation of the PFMC Law since they are responsible for the financial management and control functions. More specifically, these units cover strategic planning, performance based budget preparation and its execution, internal control, and accounting and reporting. Strategy development units have been newly created at the central government institutions, while existing structures have beenassignedthe role for strategy development units at the local administrations level. 131. The appointment o f around 600 financial services experts was completed to the strategy development units out of 1,200 positions for the central government. After the completion of orientation training, the MOF is planning to provide two weeks training during the period of June-September2008, 132. Internal Audit Capacity.As the head of administrations take more responsibility in line with the increase in their flexibilities, establishing a well functioning internal audit structure becomes crucial. Internal audit units which reports directly to the head of the administration are critical for the system to provide assurance on the internal control systems and realization of managerial responsibility principle. Developing internal audit capacity i s still an ongoing process. As of January 2008, 677 internal auditors have been appointed in the general government institutions. The training for 374 internal auditors for 90 days has been completed and they have been certified. The second group training was initiated in January 2008 and i s 34 expected to be finalized by end May 2008. With the completion of this training, total number o f 661 internal auditors will be certified. 133. Strategic Planning in Public Institutions. In line with the strategic management concept of the PFMC Law, institutional strategic planning has been initiated in the public administrations to allocate the pubic resources according to government policy priorities. The Government completed the strategic planning piloting in the eight institutions, and carried out a strategic management survey covering 95 public administrations to evaluate institutional and technical capacity of the administrations for undertaking strategic planning. Based on the outcomes of these studies, the Government decided to go ahead with a phased out approach in expanding the strategic planning in the central government administration. The time frame for this expansion has beendetermined as end-2006- beginning of 2009. As o f February 2008, total of 108 central government institutions prepared their strategic plans in line with the announced timetable. For the local administrations, as determined by the Municipality Law, 149 local administrations out of 269 with more than 50,000 populations prepared their strategic plans. Although, SOEs are not covered under the PFMC Law, the Government issued a Council o f Ministers' decision that introduced strategic planning for the SOEs also. According to this regulation, the SOEs are requiredto complete their strategic plans which cover 2009-2013 period byJuly 2008. 134. Performance based budgeting is moving ahead in line with the strategic planning time table for the central government institutions. So far 26 central government institutions prepared performance based budgets, out o f 44 requiredto do so according to the announced timetable. 135. Accrual Basis Financial Statements. The importance o f accrual accounting for macroeconomic policy arises from the fact that it measures assets and liabilities that are relevant to the overall stance o f fiscal policy and fiscal sustainability, but which are not measured by cash accounting. Analyzing the fill cost o f the public service provision i s important when considering alternative service delivery options including outsourcing. Additionally, accrual accounting allows a fill assessment of the government's financial position by showing all resources and obligations. 136. Accrual accounting started for the central government institutions - general budget, special budget and regulatory and supervisory agencies in 2006. After the issuance o f detailed accounting plans for local administrations which are consistent with the general government accounting regulation, M O F started collecting the local administrations financial data on an accrual basis consistent with the rest o f the General Government. Although the local administrations are not part o f the say2000i accounting system, the M O F incorporated electronically quarterly trial balance o f the local administration into the say 2000i accounting system. Through this development, the consolidated local administrations balance sheet was generated by the M O F on an accrual basis for 2006. 137. Once the social security institutions data are collected in the same format, the MOF will be able to generate consolidated general government financial statements on an accrual basis. Because o f the institutional restructuringo f the SSI - merger o f the three institutions under one umbrella-the social security institutions were not able to produce their accrual based financial statements. 35 138. Tax expenditures. Tax expenditures which are in the form of revenue forgone and do not appear explicitly as spending, can play important role in implementing government policy priorities. Lack of scrutiny or ability to monitor tax expenditures makes it difficult to evaluate the cost, efficiency and equity impact of these expenditures. The MOF included a list of tax expenditures and the related estimate amounts arising from the income tax, corporate tax, value added tax, special consumption tax, and other laws for the 2008-2010 period as an attachment to the budget. The total tax expenditure for 2008 was estimated as YTL 12.4 billion. Moreover, a more detailed study on tax expenditures completing the list has beenpublished on the web page of MOF. This report defines 87 articles or sub-articles as tax expenditures and provides an estimate tax expenditures amount of YTL 11.9 billion for 2007. 139. Other public expenditure and financial management reforms. The government is committed to key public expenditure and financial management reforms, which are also part of the EU accession negotiations. Such reforms include, for instance, passage of a satisfactory Turkish Courts of Accounts (TCA) Law and State Aid Law. The EU Commission has now taken center stage in these reforms. Although the EU accession negotiations have created a powerful external anchor for the reforms, it, at the same time, made the modality and timing of these legislations subject to the government's own policy reform schedule and status of negotiations with the EU. For instance, given that the enactment of the draft TCA Law has beenmade by the EU Commission a closing benchmark for the Financial Control Chapter under the EU accession negotiations, it is highly likely that a satisfactory law will be enacted. However, its timing is uncertain. Similarly, a new draft law on state aid has been submitted to the Prime Minister's office but timing of the parliamentary approval is yet to be determined. Nonetheless, the government expressed its interest in enacting the draft state aid law to comply with the EU Acquis Communitaire and asked for Bank support under the PPDPL program. 140. Recognizing the importance of flexibility in program design, and the implications of the dynamic process of EU accession negotiations for public sector reform, PPDPL 3 i s designed to support a broadened measure to advance public expenditure and financial management reforms through one or more actions such as adoption of a satisfactory TCA Law or a satisfactory state aid law consistent with the Government's program for EUharmonization. 141. Public Investment:Despite significant success inrationalization of the PIP in the recent years, ensuring sufficient resources for high quality public investment projects remains a key challenge. While existing infrastructure needs are sizeable, expenditure pressures in investment will only rise further as alignment with the EU accelerates. The Government has recognized repeatedly the expected expenditure pressure on the PIP in its Annual Programs. The 2008 program reiterates two major problems in the PIP; first, the lack of adequate resource allocation to current investment needs, and second inefficiencies inusing these allocations. 142. Going forward, it i s important to increase the stock of public capital with a strategic view. However, it is also important to secure appropriate allocations for O&M of the existing capital stock. This is an important requirement not only for improving the quality of services, but also for restricting the cost of the projects. The main issues related with O&M expenditures in Turkey canbe cited as follows: 0 Lack of a common framework for definitions and methodology. 36 Insufficient allocations for O&M needs- accelerating the decay of capital goods and unduly burdeningthe investment program inthe future. 143. In its investment program guidelines for 2008-2010, the State Planning Organization (SPO) envisages (a) prioritization of infrastructure investments that would contribute to meeting social needs and promoting productive activities and (b) enhancing the effectiveness, productivity and timeliness of public investments through continued rationalization efforts. The 2008 investment program i s consistent with the framework provided by the NinthDevelopment Plan and the priorities expressed in four of the development axes (excluding employment) are reflected inthe public investment allocations and related regulations. 144. The authorities have increased emphasis on public asset management as evidenced by the prioritization of O&M expenditures in the 2008 Annual Program. In June 2007, the Bank and SPO organized a joint workshop on public operations and maintenance expenditures. The workshop facilitated extensive discussions by the participants from key public institutions on issues regarding the current state of the operations and maintenance expenditures, actual needs, problems and solution proposals. In advance of the workshop, SPO requested from all public institutions for the first time the stock of public capital and current and planned operations and maintenance spending. This information as well as other data and information produced by public institutions for the preparations for the workshop serves as a sound starting point for the future work on operations and maintenance. Inaddition, a report was preparedby SPO with the proceedings of the presentations delivered at the workshop and key issues that were identified as well as suggested next steps. Furthermore, five pilot agencies for establishing an O&M framework have been identified by SPO. These agencies are Electricity Generation Company (EUAS), General Directorate of Highways (KGM), General Directorate of Hydraulic Works (DSI), Ministry ofEducationand MOH. The numberofpilot agenciescould be expanded. 145. There is also increased flexibility granted to the line agencies in reducing the approval requirements by SPO, such as in (i) making changes in the subcomponents of projects and (ii) reallocation of funds within the agencies' investment budget. This i s establishedby the Council of Ministersdecree on the "Implementation, coordination and monitoring of the 2008 Program". 146. This loan (PPDPL 2) recognizes the government's strong efforts to improve the link between the resource allocation process and actual investment needs through, among other actions, 0 initiation of a study on assessment of the actual needs for maintenance expenditure; 0 identification of at least five pilot public institutions for establishing an O&M framework with an aim to unify the definitions and classification of expenditures, improve needs assessment and monitoring and evaluation (M&E) of O&M expenditures. This would pave the way for issuing public asset maintenance guidelines for all public institutions which will be supported under the follow up operation PPDPL 3. 147. Inconclusion, the PPDPL 2 includes three core actions underthis component-requiring satisfactory implementation of the PFM reforms in key areas. The summary presented above indicates that there has been sufficient substantial progress in implementing key aspects of the reform by, for instance: (a) requiring that a medium term strategy be the framework for 37 determining fiscal aggregates and linking sector budgets to policy priorities; (b) issuing all the required secondary legislation essential for the implementation of the PFMC Law; (c) establishing strategy development units in all general government institutions; (d) preparing financial statements on accrual basis for the central government and local administrations; (e) improving fiscal transparencythrough publishing a full list of tax expenditures; and, (0initiation of a study on assessment of the actual needs for O&M expenditures and identification of at least five public institutions. COMPONENT IV: PUBLICADMINISTRATIONANDGOVERNANCEREFORM Improvingthe Justice System 148. While actions in this area were only a tangential part of the original PPDPL program, deeper dialogue with authorities on recent reforms, objective evidence about their success and opportunities to promote further judicial reforms through the PPDPL series support the importance of making this an area o f support under PPDPL 2. Legal and judicial reform has become a significant topic since Turkey's official application for EUmembershipin 1999. Since that time, the country has embarked on legal reform efforts focused on constitutional and legal changes intended to strengthen democracy, the rule of law and the protection of human rights. As a result of these efforts, Turkey now performs very well in comparison with EU and EU accession members along various dimensions measured by surveys such as the 2005 Business Environment and EnterprisePerformance Survey (BEEPS) jointly conducted by the World Bank and the European Bank of Reconstruction and Development (EBRD) and 2006 Doing Business (WB/IFC). The performance of Turkish courts has improved significantly along most dimensions of performance since 2002, according to BEEPS data, both in absolute terms and in relation to the new EU members, including in areas such as independence, honesty, speed and ability to enforce decisions. These improvements provide a foundation for enhancing judicial service delivery, improving the business environment, and strengthening implementation of EU legislation, which will be key criteria inassessing Turkey's readinessfor membership. 149. Despite the gains, these performance improvements have been from a low 2002 base and most firms still do not find Turkey's courts to be affordable, quick, impartial or consistent in implementing laws. Turkish courts continue to face problems with backlogs and delays and concerns about the quality ofjudicial process. Infact, only approximately 40 percent of all firms felt that Turkish courts were fast. While institutional changes have been adopted through legislation, thejudiciary i s still perceived to be insufficiently independent from the executive. 150. Since 2004, major reform efforts have been undertaken in the Turkish judicial system. Substantial revisions have been made to main laws governing the system, namely the Criminal Code, Criminal Procedural Code, Civil Code, Law on the Establishment of the Regional Courts of Appeal, and the Law on the Establishment of Justice Academy. These legislative changes have introduced new policies in the judicial system and strengthened the institutional structure. In addition, drafts of the Commercial Code, Code of Obligations, Civil Procedural Code and Administrative Procedure Code have beenprepared. 151. Introduction of Alternative Disputes Resolution (ADR) is being considered in order to reduce pressure on the courts. The preparation of a draft law on mediation i s on-going, and the current draft of the Civil Procedure Code is expected to unify the rules governing international and domestic arbitration. It is important for Turkey to develop a legal basis for mediation similar 38 to other EU countries. In parallel to the drafting o f the mediation law, the steps needed to establish its institutional base need to be considered. One proposal originating from the commission preparing the draft law on mediation would be to establish mediation centers that oversee the training and certification of mediators and disseminate information on new mediation processes to the public. 152. The Ministry o f Justice has initiated a program for consolidating the courts through the closing o f small remote courthouses and the design o f new, larger courthouses across the country that consolidates judicial functions under one roof. The ministry has closed 137 small court houses around the country that do not have sufficient workload. According to Ministry o f Justice, as of December 2007, 66 courthouses have been constructed, 26 courthouses are under construction, and 53 courthouses are in the planning or design phases. The budgetary allocation for the judiciary has doubled from 2005 to 2007 (in Euro terms) allowing for significant increases in the salaries o f judges. However, as a percentage o f GDP, the judicial budget has increased only from 0.1 percent to 0.13 percent. Most EU countries, by comparison, spend between0.2 to 0.4 percent o ftheir GDP on thejudiciary (based on EuropeanCommission for the Efficiency of Justice (CEPEJ) data for 2004). 153. Going forward, sustained efforts at implementing institutional changes are necessary to fwrther improve the efficiency and effectiveness o f the system. First,judicial reforms should aim to identify and develop sufficiently qualified and trained human resources and expand the physical infrastructure available to the court system. Second, judicial reforms should promote efficient and accountable management o f these resources and the increasing level o f financial resources dedicated to the judicial system. Finally, judicial reforms should identify bottlenecks and structural issues in the system and try to address them through legal and regulatory changes, procedural reforms and institutional strengthening. On this basis, implementation o f new electronic networks and automated processes will help develop and monitor reform outcome indicators; such as lower case backlog, shorter duration o f cases, improved access to justice, and betterpopular assessment o fjudicial quality. 154. A thorough implementation of the reforms discussed above would contribute to the government's objectives of (i)better management o f resources and their allocation, (ii) increased efficiency o f the judicial process, (iii) improvedjudicial services, and (iv) reduction o f backlogs of cases. 155. The Bank and the authorities have agreed that the Bank would provide support to the judicial reforms under its PPDPL program with an aim to continue supporting Turkey's strides in improving the justice system. The PPDPL 2 includes the following prior actions: (i)law for the a establishment o f Regional Courts o f Appeal has been enacted and made effective, in order to ease the backlog o f cases within the Court o f Appeals; (ii) connections among courts have online beenestablished through satisfactorily implementation o f the National Judicial Network Project (UYAP), (iii)training programs for judges and prosecutors through the National Justice Academy have been expanded. The Justice Academy has assumed all the mandatory pre-service training for candidate judges and prosecutors. The delivery o f the in-service training programs has improved and optional foreign language courses are being offered. 156. The establishment o f the Regional Courts of Appeals is an important step aimed at easing the case load o f the Courts o f Appeals as well as allowing the Supreme Court to reduce its 39 caseload and play a guiding role for the judicial system. The law enabling establishment of regional appeals courts was enacted in October 2004 (Law No: 5235 published in Official Gazette on October 7, 2004) and became effective as of June 1, 2005. However, the MOJ does not expect the courts to be operational until late 2009 or early 2010. This delay is due to the need to identify and appoint judges and staff. The new courts cannot be fully operational without appropriate staffing ofjudges, prosecutors and auxiliary personnel and without in-depth training for this staff. Three regional courts of appeals located in Ankara, Erzurum and Diyarbakir are being constructed with the support of EU funds and are expected to be completed by early summer 2008. Additional regional appeal courthouses are expected to be completed in 2010 according to the MOJ. Notwithstanding EU-supported training assistance for judges, prosecutors and court staff who could work in the regional appeals courts, identifying, appointing and training judges and court staff i s the critical bottleneck slowing the operation of the regional appeals courts. 157. An advanced National Judicial Network Project (UYAP) became operational during 2007. UYAP has been designed in order to improve the functioning of the judiciary and its connection to all other governmental institutions. Judges and prosecutors have been provided with personal computers, and a web site has beenconstructed that provides free access tojudicial personnel and contains the case law of the higher courts. More than 90 percent of courthouses are connectedto the system. UYAP provides judges and others with: (i) database of legislative a changes; (ii)higher court and European Court of Justice decisions; (iii)a case distribution system; (iv) electronic evidence with e-signatures; and (v) e-filing and electronic tracking of cases by lawyers. UYAP requires additional resources in order to produce the judicial statistics necessary for the government to monitor case flow and backlogs; provide specific data on types of cases and their processing times and evaluate the progress on implementing judicial reforms. UYAP also requires an integrated resource management system in order to achieve its primary goal and the integration of an automatedcase management system. While an EUproject on case management likely will provide the latter assistance, additional resources and efforts are needed to bring the UYAP system to a satisfactory level of operation. 158. The independenceof the Justice Academy needs to be further strengthened (two out of seven Board members are from MOJ and 12 out of 29 members of the general assembly overseeing the Academy are either MOJ directors or closely associated with the MOJ). Progress has beenmade since the establishment of the NationalJustice Academy in2002 inproviding pre- service and in-service training to judges, prosecutors and court personnel. The Justice Academy has assumed all the mandatory pre-service training for candidate judges and prosecutors. The delivery o f the in-service training programs has significantly improved, and optional foreign language courses are now being offered by the Justice Academy. A total of 1306prosecutors and judges have received pre-service training in 2007 and a total of 2666 judges and prosecutors received in-service training from the Justice Academy during 2004-2007. However, the Academy lacks sufficient institutional and human resources capacity and does not have the authority to hire permanent trainers. Also, the institution has not yet developed a comprehensive training strategy and curricula to respondto the most up-to-date needs ofjudges and prosecutors, particularly in areas of commercial law. Inaddition, the role of the MOJ's Training Department should be clarified inorder to avoid overlaps with the activities of the Academy inthe area of in- service training. 40 159. Inconclusion, the PPDPL 2 includes two core actions for improving the justice system. The summary presented above indicates that there has been sufficient substantial progress in implementing key aspects o f the reform (a) enactment o f the law for the establishment of Regional Courts o f Appeals; and (b) establishment o f online connections among courts through satisfactorily implementation o fthe National Judicial Network Project (UYAP). Decentralization 160. The Turkish public sector is highly centralized. Local administrations account for only about 10 percent o f general government expenditures. The government has embarked on a gradual process o f decentralization. 161. The Government is aware that successful decentralization will require improvements in the technical capacity o f local administrations and improvements inlocal accountability and that any decentralization o f expenditure responsibilities must be matched by a corresponding adjustment in revenues. The targeting o f intergovernmental transfers i s another key issue, given the wide disparities in tax bases among Turkey's 3,225 municipalities and 81 provinces. Inan attempt to tackle the growing stock o f municipal arrears, the Government has completed a restructuring program in2007. It i s critical to design and implementnecessary measures to avoid buildingup ofnew arrears. 162. The Government's overall objective i s to position local administrations to deliver the public services for which they are responsible in an efficient and responsive manner. The Government's program includes: a revision o f the legislative framework o f all three categories o f local administrations", consolidating small local administrations into viable units, improving local accountability mechanisms, and improving controls over staffing levels and recruitment; training programs for mayors and local administrators to ensure effective implementationof the new laws 0 changes in the level and targeting o f intergovernmental transfers and the assignment o f local taxes and fees; and 0 steps to reduce the existing stock o f municipal arrears and avoid new arrears; 163. The first PPDPL supported: (1) the enactment of legislation, governing municipalities, metropolitan municipalities, and Special Provincial Administrations (SPAs); (2) the restructuring o f municipal arrears; and (3) the preparation o f a satisfactory draft law on provincial and municipal revenues. 164. The Municipalities Law enacted in July 2005 required the consolidation of small municipal governments into administratively viable units (with a minimumpopulation o f 2,000). As a result, 863 municipalities have beenredefinedas villages and are under the jurisdiction o f I1Turkey's national territory is divided into 81 provinces, each headed by a centrally appointed governor. Urban areas within provinces are organized as municipalities (of which there are 3,225). Rural areas are under the direct control of the provincial governments and are administered by Special Provincial Administrations (SPAs). The 16 officially-designatedmetropolitanareas have a two tier structure, in which individual municipalities are subordinate to a metropolitanmunicipality. 41 SPAs. It improved accountability by requiring councils to meet on a monthly basis and permitting local stakeholder participation in special commission o f municipal councils. The new Law on SPAs, similarly, improves accountability by permitting elected provincial assemblies to appoint their own chief executive officers. Analogous changes were made in the Metropolitan Municipalities Law, enacted inJuly 2004. 165. With respect to arrears, restructuringagreements have beenreached with three-quarters o f the municipalities (covering an estimated 70 percent o f the stock) and are now under implementation. Six water and sewerage institutions o f the metropolitan municipalities have also reached agreement on their arrear restructuring. Safeguards have been put in place to ensure against a repetition. The Government i s now authorized to withhold up to 20 percent o f the monthly revenues of municipalities to recover arrears on current account and an additional 20 percent to recover debt service due on the restructured debt. 166. Since the approval o f the first PPDPL, the Government has taken several significant steps in furtherance of its decentralization agenda. The secondary legislation required for the implementation o f the Metropolitan Municipalities Law, the SPAs Law and the Municipalities Law has been completed. In 2007, 5 implementingcirculars have beenissued including (i) norm cadre principles and standards for municipalities, municipal enterprises, local administration service unions and SPAs, (ii)procurement o f rural services, and (iii) recruitment procedures for local administrations staff. 167. Inaccordance with the Government's program, a satisfactory draft SPA and Municipality Revenue Law had been prepared prior to the approval o f the first PPDPL, and this law was submitted to Parliament on September 26, 2006. Since that time, the legislation has been extensively debated. A moderately revised version o f the legislation i s now under consideration. The current version would make two major changes in the existing structure o f local administrations' revenues. First, it would increase the overall volume o f central government transfers by expanding the definition o f central government taxes subject to sharing. If fully implementedin2009, the total volume o f revenue sharing would increase by about 26 percent or 0.5 percent o f GDP. Second, it would change the distribution o f revenue sharing among categories o f local administrations and would introduce two new criteria into the distribution o f these shares. These would include indicators o f poverty (such as a provincial development index) and a performance index. 168. The Government is aware that the proposed increase intransfers will impose a net cost on the central government budget unless it is accompanied by a corresponding decentralization o f expenditure responsibilities. Some efforts at functional decentralization have already been undertaken. The Government has abolished the Rural Services General Directorate and transferred its responsibilities and staff to the SPAs (although the Government continues to pay their salaries on an interim basis.) The Government is now considering a transfer of certain functions in fields of social services, culture, tourism, youth and sports. In its 2008 annual program, the Government declared that the legislation that establishes all central government institutions will be reviewed. This will be based on a functional review by the SPO and i s intendedto the clarify roles and responsibilities o f each tier o f government. 169. The Government is also taking measures to rein in other fiscal risks o f decentralization. (See Annex IX). The Municipalities Law limits the total stock o f municipal debt to 100 percent 42 of current revenues (150 percent inthe case o f metropolitan municipalities) and requires Ministry of Interior approval for any borrowing that would increase the debt-revenue ratio above ten percent. The Law No. 6183 on Public Receivables and the Law No. 4749 on Public Finance and Debt Management permit the Government to deduct debt service owed by local administrations to the Treasury and other public entities from intergovernmental transfers. The proposed new municipal revenues law would facilitate that process by permitting the Government (via Iller Bank) to deduct up to 40 percent o f local administration transfers for this purpose at the discretion of the Minister responsible for the Treasury. Law No. 4749 and its implementing regulation as well as annual Budget Laws set limits for municipal external borrowing under Treasury guarantees. 170. In addition, the PFMC Law requires local administrations to submit periodic financial reports to the Government, enabling the Government to better monitor their financial condition. In2006, MOF started gathering quarterly local administrations financial data on an accrual basis. In 2007, the General Directorate o f Local Administrations within the Ministry of Interior published the general activity report for local administrations. Based on the quarterly data, the report makes available consolidated expenditures o f local administrations both by economic and functional classification. The report provides information on a wide range o f activities o f the local administrations. The report aims to shed light on budget outcomes and levels o f indebtedness, human resources, physical capital and investments o f SPAS, municipalities and local administration unions. 171. These achievements are reflected in the policy matrix for PPDPL 2. As shown in Annex 11, these call specifically for the implementation o f the new legislative framework for local administrations, the completion o f the secondary legislation required for its implementation, and the submissiono fa satisfactory law on SPA and municipality revenuesto Parliament. Regional Development 172. Regional economic disparities in Turkey are considerably wider than in EU countries and have persisted over time". This concerns the Government, in part because these disparities are reflected inrelatively low levels o f household income and social conditions incertain parts of the country. Economic disparities may also reflect a failure to exploit economic development opportunities inpoorer regions. 173. The Government has made regional development a priority. It i s one o f five development axes in Turkey's Ninth Development Plan. The Government's 2008 Annual Program provides the policy framework for four components under the regional development axis; namely: (i) increasing the effectiveness o f regional development policies at the central level; (ii) achieving development based on local dynamics; (iii)improving institutional capacity at the local level and (iv) promoting rural development. 174. The Government's immediate objectives include: (i)designing and implementing a national strategy for regional development, aligning investment programs and priorities with regional needs, (ii) building capacity inDAs and ensuring that they function effectively and inan accountable manner, and (iii)effectively managing the EU funds for regional development. "UsingthemeasureofTheilindexfor 2001, regionaldiscrepancyinTurkeyishigherthansomeofthe newEU members like Poland, Hungaryand Czech Republic as well as the EU 15 countries like Spain, Portugal and Ireland. 43 Interest in regional development has also been strengthened by the EU accession process. Regional development is one of the five components of the EU's Instrument for Pre-Accession Assistance (IPA), which provides the financial framework for EU funds for the period 2007- 2013. 175. The PPDPL program supports the Government's efforts to: strengthenthe framework for the coordination of regional policies at the national level and for regional development strategies of each region through the preparation of a national level regional development strategy, complete the legal and operational framework for the establishment and functioning of DAs and improve their capacity to planand execute regional plans at the regional level, and make effective use of EUIPA funds. 176. Preparation o f a national level regional development strategy is already underway. Once completed, the national level strategy will establish a framework for the coordination of regional policies at the national level and for the preparation of regional development strategies in the regions. In February 2008, SPO hosted a workshop on the initial findings of the World Development Report (WDR) 2009 on spatial disparities and a discussion of the subject by participants from other key public institutions, private sector and academia. The event took place as part of the continuous dialogue with the authorities on regional development policies and has aimed to contribute to the ongoing preparation of the national level strategy. In addition, the Government has identified fifteen "growth p01es"'~ which would be the focus of regional development efforts. 177. Substantial progress has also been made on the establishment of DAs. In 2006, the government announced its intention to create DAs in the each of the country's 26 NUTS-2 regions. These would operate largely in a planning and coordination role, supporting the implementation of regional plans and programs and coordinating activities of sectoral ministries and local units of government. Inthis context, the first PPDPL called for the enactment of a law authorizing the establishment of DAs. The Law No. 5449 was ratified and came into force in February 2006. The law outlines the duties, powers and organizational structure of the agencies and requires the establishment of DAs inthe 26 NUTS-2 regions. It assigns DAs several sources of revenues, including fixed shares of central and local administration revenues, along with access to EU funds and contributions from local chambers of industry and commerce. The State Planning Organization (SPO) is designated as the national level coordination body for the agencies. Each agency is to be establishedthrough a Council of Ministers Decree. 178. Two DAs have now been established under a Council of Ministers Decree dated July 2006. One i s TR62 (Adana and Mersin provinces) and the other TR31 (Izmir). In both DAs, Administrative Boards (decision making bodies) and Development Councils (advisory bodies) have become operational and have initiated work on identifying their short term "pre- development strategies", while the General Secretaries of the agencies have been appointed. 13The fifteen provinces identified as growth poles are: Diyarbakir, Elazig, Erzurum, Gaziantep, Kayseri, Malatya, Samsun, Sivas, Sanliurfa, Trabzon, Van, Batman, Kastamonu, Kars and Kahramanmaras. 44 Secondly, regulations on (i)personnel policy and management, (ii)working principles o f the DAs and (iii) and accountingprincipleswere issuedinJuly and September 2006. Finally, budget at the end of 2006, personnel examinations have been completed for both DAs. Twenty-seven new staff has been recruited for Adana/Mersin DA and twenty-six have been recruited for the Izmir DA. The process o f establishing DAs was temporarily halted in 2007, due to a challenge to their constitutionality. While the Constitutional Court's decision, rendered in November 2007, annulled certain provisions affecting the appointment o f staff and tax exemptions, it left the remainder o f the DA law intact enabling the Government to establish new DAs and permitting the existing agencies to fully operate. The Government also plans to establish investment support offices ineach province ineach o f the regions. 179. It is expected that about five new DAs will be established until the end o f 2008. Furthermore, the secondary legislationwill be completed in2008 and all new agencies thereafter. The drafts o f five new regulations are under preparation on the establishment o f investment promotion offices, audit o f the agencies, project support, performance measurement and inter- DA collaboration. 180. The Government has also taken steps to ensure the effective absorption o f EU funds. In 2006, the Prime Ministry issued a circular setting out the framework for monitoring three EU- supported regional development programs. The M&E activities o f the four regional development programs which are being implemented in 9 NUTS 2 regions have been performed by the personnel o f project implementation and coordination units in the regions, and by Governor's staff inprovinces. In2007, the Government prepared a "Strategic Coherence Framework" which provides a general framework for the operational programs under the regional development and human resources development components o f IPA. The 2007-2009 Indicative Financial Framework envisages Euro 524 million envelope will be used for regional development in Turkey, under three operational programs; regional competitiveness, environment and transportation. 181. Reflecting these achievements, the PPDPL 2 supports in particular the satisfactory implementation o f the DA law, as evidenced by (1) the issuance o f regulations on the role o f DAs, use o f funds, personnel policy and management, budgetary and accounting standards, performance measurement criteria and audit requirement for all DAs, (2) satisfactory progress on the establishment and operationalization o f at least two DAs and (3) the establishment of the legal basis for allocating budgetary resources to at least one pilot growth pole. The Government has satisfiedthese conditions. FUTURE PROGRAMAND POSSIBLE PPDPL3 182. The government is committed to continue implementingthe reforms with a well-specified medium-term program. Inthis context, the authorities have requested the Bank to follow PPDPL 2 with a third operation (PPDPL 3) as the achievement o f the program objectives depends critically on consistent implementation and further deepening o f structural reforms supported under the PPDPL series. The new CPS for 2008-2001 1 envisages the third operation inFY09 but the authorities and Bank staff will consider when to present to the Board of Executive Directors PPDPL 3 for approval dependingthe actual progress inkey reform areas. 183. PPDPL 3 i s expected to support the implementation o f the government's medium-term program o f legal, institutional, and structural policy actions to consolidate fiscal adjustment and 45 modernize the institutions and procedures of public sector management and service delivery. Accordingly, PPDPL 3 will also support actions infour components, namely: (a) maintaining the currently enabling macroeconomic framework; (b) reforming substantially the country's social security and social assistance system; (c) continuing the on-going process of upgrading the financial controls and expenditure management of public resource; and (d) improving the administration and governanceof the public sector. 184. More specifically, Table 5 presents a list of policy actions, milestones that are in the government program and which could be supported under PPDPL 3. The table also presents (in bold) the indicative triggers agreed by the government as key program indicators to justify moving to PPDPL 3. 185. Implementation of the social security reform will be a priority for the government's program planned to be supported by PPDPL 3. In 2006, Parliament passed a landmark reform, including parametric changes in the pension system and the introduction of UHI. In December 2006, the Constitutional Court canceled articles related to civil servants-effectively blocking the implementation of the law. The Government has amended the Law No. 5510 to address Constitutional Court ruling by the Law No. 5754 enacted on May 8, 2008. Full implementation ofthe law will be supportedunder the third operation. 186. The authorities and the Bank staff have identified five key policy actions as indicative triggers for proceeding with the planned PPDPL 3. The selection of these key actions recognizes the fact that the government has adopted a medium term program that is anchored to the EU accessionprocess, but with flexibility inthe timing and sequencing of reforms. Priorities within the overall public sector reform program may change as EUnegotiations advance and so may the preferences regarding the specific subjects of Bank support within the wider government program. Table 5: Board Conditions, Milestones,and Indicative Triggers to be Supported by the Planned PPDPL 3 * (Indicative Triggers are in Bold) Component I.Sustaining MacroeconomicStability The governmenthas maintaineda satisfactory macroeconomic framework. Component 11. Social Security and Social AssistanceReform Short term fiscal sustainability o f the social security system is maintained as evidenced by a combined deficit not exceeding3 percentof new-GDP. The Social Security and UHI Law has been implemented as enacted in June 2006 and as amended in May 2008 in order to ensure longterm fiscal sustainabilityand equity in the social security systems. Continued satisfactory implementation of the action plan resulted in (a) creation of a combined data warehouse, (b) establishment of financial management and decision support systems, (c) unified work processes, (d) completed personnelassignments, (e) establishment of a system for the coordinated monitoring o f patient visits to hospitalsand the use o f pharmaceuticals. Roadmapfor introducingproxy-meanstesting for non-contributorshas been issued. SSI has undertakenan actuarial analysis for the appropriate premium rates for the targeted poor. A satisfactory social assistance reform law aimed at increasing the effectiveness and targeting of the social assistance system through coordinationof social assistance policies has been enacted. UHIactuarial baselineestimates includingSUT has been completed in order to assess the fiscal impact ofthe benefitpackage. Secondary legislation for the implementation of Article 73 of Law No. 5510 as amended by Law No. 5754 has been adopted to put in place cost management mechanismsfor the health sector. DRG pilot implementation has been expanded to 10 percent of university hospitals and 5 percent of private 46 hospitals in order to manageexpenditures at hospital level. MOH restructuringlaw has been enacted in order to complete separationo f provisionand regulatoryhnctions o f MOH. A Law on the Establishmentofthe National Pharmaceuticaland MedicalDevicesAgency has been enacted. The Public HospitalUnionsPilot ImplementationLaw has been enacted. Component 111. Budget and Public Financial Management Reform Continued satisfactory implementation ofthe PFMC Law. Guidelines for performance based budgeting have been revised and at least 50 institutions have prepared their performance budget. In line with the time table announced in 2006, all central government institutions and municipalities and SPASwith a population of more than 50,000 completed their first strategic plans. Five public sector accounting standards in conformity with InternationalPublic Sector Accounting Standards Board(IPSAS) have been issued. Financialstatements of consolidatedgeneralgovernmenthave beenprepared on an accrual basis for 2007. The budgetary annex on tax expenditures has been expanded to include refined list and cost estimate of tax expenditures in 2009 budget proposal. Public expenditure and financial management reforms have been advanced through one or more measures such as adoption of satisfactory TCA law or satisfactory state aid law consistent with the government's program for EU harmonization. Pilot implementation for the selected agencies for establishing an O&M framework has started and guidelines for asset maintenancefor all public institutionshave been finalized by SPO. The government has put in place a program of capacity enhancement for selectedthree pilot public institutions to improve project cycle management and particularlypreparation of sound feasibility studies for investment uroiects. Component IV. Public Administration and Governance Reform Ministry of Justice has developed an implementation plan for the funding, housing and staffing of the Regional Courts of Appeal includingan implementationtimetable. A law establishing a Judicial Information Technology (IT) Agency has been enacted in order to integrate, operate, manage and maintainthe UYAP network. The governmenthas published a strategy for judicial reforms. A Law on Mediation for civil disputes has been enacted. A new Civil Procedural Code has been enacted in order to reducebacklogs in courts. A satisfactory law on SPA and Municipality Revenues has been enacted and is being implemented through secondary legislation. At least five more DAs have been establishedand are operational, includingin the less developed regions. A nationallevelregionaldevelopment planhas been prepared. Regional level investment support offices have been establishedin at least two DAs. *Detailedanalysis of the economic policy relevanceof policy actionsto be supported under PPDPL 3 is presented in Annex I1and summarized inthe following section on the expected outcomesof the program PROGRAM GOALS AND EXPECTED OUTCOMES 187. The goals of the program are summarized in the first column of Table 6, the expected program outcomes in the immediate years after PPDPL 3 are identified in the second column, and the contribution o f the program to CPS objectives (outcomes the WBG expects to influence duringthe CPS period) are presentedinthe third column. 188. It should be noted, however, that the program's key outcomes will take time to be realized -in the case of parametric pension reform the outcome o f fiscal sustainability will take a number of generations to be obtained. In other cases, there will be significant lags betweenthe realization of outcomes and the ability to monitor them -such i s likely to be the case o f having well functioning DAs and the ability to measure substantial development at the regional level. 47 Therefore, an effort has beenmade infinding short-term outcomesthat couldbe measured during programimplementationand which would be proxies for the longer-termoutcomessought by the programand which, for its very nature, couldbe achievedquickly. 189. The key long term public policy outcomes will be ultimately realized well beyond the time frame of the program. Continuedprogress towards meetingthe ultimate long term goals of the programwill be monitoredover time. 190. The program is expected to make a significant contribution to the objectives set in the CPS of (a) making the economy more resilient to crises that disproportionately affect the most vulnerable; (b) contributing to sustainable economic growth that i s critical to pull many of the poor out of poverty; (c) promoting human development; (d) improving efficiency and effectiveness in public services; (e) strengthening the public service governance and judicial services; and (f) reducing regional differences by improving the delivery of and access to services, and creatingjobs indisadvantagedareas. Program Areas and Goals Expected Program Outcomes Contribution of Program Upon Completion Sustaining Macroeconomic Stability Long-termmacroeconomic stability. The targets of the macroeconomic Supports Turkey's macroeconomic program have been met, including policies to help reduce economic (a) single digit inflation rates, (b) vulnerability. economic growth of at least 5 percent, (c) declining real interest rates. sot 11 Security and Social Assistance Re, rm Unify the fragmented three different There is one single administrative Contributes to efficient service administrative structures for structure for all pensioners delivery and spending in social workers, civil servants and self- protection. employed and improve efficiency in service delivery and spending. At a minimum to arrest the deficits The social security deficit as a Contributes to making the economy of the social security institutions in percentage o f GDP has (a) ceased to more resilient to crises that the immediate term and to reduce grow and (b) the actuarial projected disproportionately affect the most them over the long term to bring deficit has fallen by approximately vulnerable and creating fiscal space about the sustainability of fiscal 0.4 percentage point relative to the for growth enhancingexpenditures. balances necessary for macro base case in 2016 and decreased to stability and to create the fiscal below 2 percentof GDP by 2050. space for implementing Turkey's development agenda. To improve the fiscal sustainability Equity of pension system improves: Contributesto makingsocial security o f the social security system but, pension parameters are unified for more equitable and extending health equally important, improve its equity workers, self-employed and new insurance coverageto 100 percent o f and efficiency. civil servants. the population in a fiscally sustainable manner. Increase health coverage of the UHIhas been introduced in a fiscally society and improvethe provision of sustainable manner and covers all 48 health services population. Improve social assistance for the Effective financial protection o f the Contributes to more efficient poor. poor in health: a new targeting resource utilization and efficiency in system (such as proxy means testing) the delivery of health services. is introduced for non-contributory Systemic changes inthe health sector health insurance, is implemented, target improvements in management and reaches at least 50 percent of the and organization of health services. vulnerable populationin 2011. Budg! and Public Financial Management 1 !form Improve public expenditure Effective implementation of PFMC Contributes to rationalizingTurkey's management in all General Law maintained. public expenditure management Government institutions. system and improvingits structure. Strategy development units have Contributes to improving spending been established in all general efficiency and the link between government institutions and are policy objectives and actual operational. spending. Financial controls and internal and Contributes to improving policy external audit structures improved. formation, cost accounting and implementation capacities of Improve the government's ability to The GFS budget classification institutionsand organizations. estimate and manage public finances covers the entire general lack of which contributed to past government. Contributes to making the economy crises. more resilient to crises that Financial statements for the central disproportionately affect the most government and local vulnerable. Improve transparency and administrations have been prepared accountabilityin public spending. on an accrual basis. Contributes to reshaping the role of the state in the economy, improving There is a complete list of tax public sector management, and expenditures and an accurate securing public debt sustainability. estimate o f their costs with a proper functional classification. Improve the link between policy Efficiency and economic life of objectives, available resources and existing public capital stock public investment spending increased. includingefficient use o fthe existing public capital stock. Fast, fair and reliable operation of Improvements in the quality o f Contributes to an effective provision thejudicial system judging process and legal and ofjudicial services. institutionalstructures. Legal disputes resolved in a fast, Alternative dispute resolution Contributes to strengthening public simple and effective manner with methods have been established in the sector governance. low costs and reduced workload of legalsystem. judicial authorities Increased efficiency in judicial Implementation of the National I I 49 services and accelerated judicial Judicial Network Project (UYAP) process through transfer of services establishes online connections o f 95 into the electronic environment and percent or more of courts by end sharing information among judicial 2011 institutions and other public organizations Promote regional development to Contributes to reducing regional reduce regional income disparities Satisfactory progress towards differences by improving the through redefining the establishmentof DAs. delivery of and access to services - responsibilitiesand strengthening the in disadvantaged areas - with a view financial position of local to ultimately improving job administrations as well as creating opportunities. institutions charged with developing specific regions. Redefine the responsibilities and Contributes to improving local strengthen the financial position of A new legislative framework has service delivery. local administrations been put in place for local administrations and is being implemented. VI. OPERATION IMPLEMENTATION POVERTY AND SOCIAL IMPACTS 191. The actions and reforms supported under this PPDPL 2 program are expected to have, overall, positive distributional and poverty impacts in Turkey. Ina broader context, the program aims to contribute to macroeconomic stability by maintaining an enabling macroeconomic environment and by improving fiscal sustainability of the social security system-ultimately creating fiscal space for growth enhancing expenditures. The recent past provides evidence o f how effective a sustained high growth could be in reducing poverty as about 7 million people were pulled out o f poverty since 2003. In a more specific context, several o f the actions supported under the program are expected to have direct positive impacts, most importantly the implementation o f the UHI. Several others, including the pension reform under the revised Social Security and UHI Law, are expected to have more indirect, albeit important, positive impacts (See Annex VIII). 192. Poverty. The PPDPL program is expected to contribute to a long-term positive impact on poverty in Turkey, as it i s designed to increase the sustainability, effectiveness and coverage o f the social security system and social safety-net. Turkey has made considerable progress in reducing poverty: between 2002 and 2006, Turkey's boom led to a significant reduction in the share o f the population living inpoverty - albeit at a somewhat slower pace than could have been hoped for, According to official statistics, overall poverty declined from 27 percent to around 18 percent between 2002 and 2006. Rural poverty rates decreased little, however, increasing the stark differences betweenurban and rural living standards. 193. The low rate of extreme poverty is reflective both o f Turkey's per capita income level as well as o f the importance of existing formal and informal social safety-nets. The informal safety 50 net, where neighbors and extended family members provide help in times of dire straits, is an important feature o f Turkey's society. However, with migration, reduced family sizes (reflective o f the significant reduction in fertility rates in Turkey) urbanization and modernization, this traditional informal social safety-net has started to change as has been demonstrated from the results o f qualitative poverty analysis undertaken inthe context o f the preparation o f the PPDPL. Thus over time, the institutional social safety-net - most importantly access to free health insurance, a conditional cash transfer program reaching 2.6 million children, as well as direct and in-kind support through local solidarity foundations - has become more important to help families and individuals in social risk management and the prevention o f poverty. Important coverage gaps remain, though. Access to the formal social security networks has remained low; however, as job creation has taken place in the informal sector, due to the high costs o f compliance with formal social security requirements inthe formal sector. Around 50 percent o f the working population is not covered under the social security system, a proportion which is bigger among the lower age cohorts. The reforms under the PPDPL series aim to address these issues by strengthening the social security system, ensuring its long-term fiscal sustainability, reducing the costs o f compliance, extending coverage and ensuring that social assistance receives adequate financing and i s targeted more effectively. 194. UHI component of revised Social Security and UHI Law is expected to have direct positive distributional and poverty impacts if coverage expansion and exemptions are realized as planned. Government plans to extend free formal health insurance coverage to all those falling below a specific level o f per capita income. The Law also introduces several partial premium subsidies for today's uncovered population that does not qualify for free coverage but will be protected from full premium payments. The realization o f such potential positive impacts will depend on a number o f factors, however, including design and implementation of premium contribution exemption policy, effective delivery o f a package o f health services and maintaining the fiscal sustainability o f the health system as the health costs have risen fast inthe recent past. Pension component o f revised Social Security and UHILaw i s expected to have indirect positive distributional and poverty impacts as the reform i s geared to make the system fiscally sustainable as well as to improve horizontal equity. The use o f such fiscal space will depend on economic and social considerations in the fkture but it would allow for additional expenditures which are potentially more progressive than the current tax financing o f the deficit that does not benefit the poor. The parametric reforms would also strengthen the expected benefits from formalization from the workers' perspective by increasing the likelihood o f pension payments inthe future and would contribute to formalization inthe economy. 195, Apart from the above direct (UHI) and more indirect (pension parametric reform) poverty and distributional impacts, several other PPDPL 2 supported reforms and actions also have the potential o f benefiting the poor (See Annex VIII) but, at this stage, the materialization o f such benefits are somewhat more removed from those pertaining to the policy actions mentioned above. Given the high degree o f dependence o f the more vulnerable population on public services (infrastructure, household basic services, and social services), improvements o f public service deliver and strategic planning are of particular importance for the poorer parts o f society. Better judicial services have potential to benefit population at large by improving access to justice services, including the more vulnerable and contributing to improving the business environment and confidence in the economy eventually leading to better labor market outcomes. 5 1 Better focused regional development efforts and more effective provision of public services at the local levelwill assist inincreasingincome levels inthe lagging regions andthe poor. 196. Gender. The reforms supported by the PPDPL program are likely to have a positive impact on women. Women will benefit disproportionately from the introduction of UHI, where those currently uncovered (estimated at between 6 and 22 percent of the population) will be provided with full basic health coverage for the first time. Currently those without formal coverage, and many of those with Green Card coverage, receive rudimentary or even no basic health care, although critical health conditions are invariably treated by hospitals even when the patient has no coverage. This results in many simple health problems escalating to more acute conditions. Although there is little evidence of the uninsuredbeing refusedcare, there are clearly increases in female morbidity and a general lack of efficiency resulting from this very imperfect system. Extending improved quality ante-natal and other health care services to all women through UHI will result in a major welfare gain and help Turkey to meet its Millennium Development Goals on infant and maternal mortality. 197. Inthe case ofpension reform, the issues are more nuancedandcomplex. Currently, as in many countries, women working in the formal sector effectively gain a higher rate of return on their pension contributions due to a lower retirement age and greater longevity. However, relatively few women are currently contributing (or beneficiaries) of the pension system and the fiscal sustainability - and with it the likelihood of the pension system actually rewarding those that have contributed during the working life - is low. While the pension reform supported by the PPDPL series equalizes the pro-female difference in the current system, it will raise the likelihood of receiving pension payments significantly. It is also expected, and Government is making significant efforts through other reforms, to increase the effective protection of the work force by encouraging formal and more flexible employment, which should especially impact on the share ofthe female work force coveredby the pension regime inthe future. IMPLEMENTATION, MONITORING EVALUATION AND 198. The Undersecretariat of the Treasury will be responsible for coordinating actions among other concerned ministries and agencies. A number of other agencies are involved in the implementation of the public sector reform program being supported by the PPDPL program including the Prime Ministry, SPO, MOF, Ministry of Justice, MOH, Ministry of Labor and Social Security (MOLSS), Ministryof Interior, TCA and SSI. 199. As part of the PPDPL preparation process, the Bank has discussed with both the MOLSS and the SSI the development of an ongoing M&Eprocess of the social security reforms to ensure adequate feedback from beneficiaries to policy-makers. This qualitative feedback mechanism will complement the ongoing quantitative poverty monitoring which is undertaken annually (and continuously) since 2002 by the TURKSTAT, supportedby the SRMP loan and which would be supported also by the HTP. M&E i s traditionally a weak area within the Turkish social sector ministries, but there is a strong understanding of the need to strengthen such mechanisms. The Bank has worked to strengthen both quantitative and qualitative monitoring mechanisms in the Directorate General of Social Assistance and Solidarity (SYDGM), MOH, Social Services & Child Protection Organization (SHCEK) and the Ministryof National Education. The system for the MOLSS and SSI are supportedunderthe HTP. 52 200. Bank staff will focus on the impact outcomes o f the program and the adjustments that need to be made to the operation as it evolves, to take into account the latest country developments, stakeholder support, and feasible options for realizing the intended development goals. The review will be largely based on the monitoring indicators (benchmarks) and the goals of the program. At the same time, the overall status o f the government's program will be monitored to determine whether country conditions and the specific conditions o f the proposed operation have beenmet. FIDUCIARY ASPECTS 201. Modernization o f Turkey's system o f public financial accountability in line with international standards was an urgent PEM priority. Enactment o f the PFMC Law in 2003 marked a defining moment for the PFM. The PFMC Law defines the new principals, rules and structures for the Turkish PFM systems including budget formulation and execution, financial and internal control systems, and internal and external audit structures. The budgets and indicative proposals for the following two years are prepared according to the functional, economic and institutional classifications defined under the PFMC Law. The Government Finance Statistics (GFS) analytical budget classification and the accrual based accounting systems have been expanded to all general government institutions, including local administrations. The MOF is able to consolidate the budget realization for all general government institutions. Periodic financial statements are prepared regularly and on time. GDPA prepares aggregated financial reports for the central government, which are publishedas a monthly bulletin. The PFMC Law has transferred the authority to incur expenditures and provide other approvals for expenditures above predetermined thresholds (internal control over budget expenditures) to the Strategy Development Units established within each public administration. The most important positive feature o f the PFMC Law is that it combines duties and responsibilities in a single spending authority who incurs expenditures and i s kept accountable. The PFMC Law has also introduced a modern internal audit framework. With devolution o f authority and responsibility to spending agencies, the need has increased for a modern internal audit organization that can assure the head o f the spending agency on the soundness o f the internal control system. The PFMC Law requires each public administration to establish an internal audit unit withinits administration. 202. Accounting. An automated online accounting system has beenimplemented. The MOF developed in-house an automated online accounting system, Say2OOOi system has been up and running since 2002. The system networks and captures receipts and payments from more than 1,500 sites o f the MOF's GDPA across Turkey as they are made. The system can produce periodic financial statements and covers all general budgetary institutions except the Office o f the President and accounting office for the State Debt within the Treasury. The initiative to introduce modified accrual accounting incompliance with GFS requirements i s making progress. Turkey has consciously switched from cash-based to an accrual basis o f accounting. A uniform chart o f accounts that i s harmonized with budget classification has been implemented. The GDPA has issued a new framework for the accrual-based chart o f accounts. It i s harmonized with the economic classification o f the newly adopted GFS budget classification system. The new chart o f accounts enabled the GDPA to compile financial statements consistent with the 2001-GFS budget classification. Article 49 o f the PFMC Law mandates that accounting be harmonized with the international standards, and standards be issued by a Government 53 Accounting Standards Board (GASB), which was established as the general government's sole standard-setting authority, and has been operating since June 2006. The GASB i s under the MOF, comprised o f representatives from the TCA, State Planning Organization (SPO), MOF, Treasury, and other agencies. 203. Procurement. Turkey has moved decisively to upgrade its public procurement legislation and practices in line with international standards. The current Public Procurement Law was enacted in2002. The Law is based on the UnitedNations Commission on International Standards (UNCITRAL) Model and moves Turkey in the direction o f compliance with EU standards. The independent PPA established by law to oversee public procurement and ensure enforcement o f the new procurement standards is fully operational. The Government i s working on new procurement legislation for SOEs in the public utilities sectors consistent with the relevant EU directive in order to improve operational efficiency o f the SOEs. Benchmarking o f Turkey's public procurement system against an internationally recognized baseline o f best practice in procurement was carried out jointly by the World Bank and the Turkish PPA in February 2006 and updated in October 2007. The benchmarking included analysis of four main pillars: legislative and regulatory framework (Pillar I);institutional framework and institutional capacity (Pillar 11); procurement operations and market practices (Pillar 111); and the integrity o f procurement systems (Pillar IV). It showed that the country achieved its greatest progress and most impressive results in the area o f legislative and regulatory framework (Pillar I), and in improving integrity o f the national public procurement system (Pillar IV). Further improvements in the public procurement are nevertheless critical for efficient functioning o f the system. The important areas requiring attention are: (a) lowering o f the threshold for publication o f contract award decisions; (b) eliminating restrictions in the form o f thresholds for participation by international bidders; and (c) simplifying dispute resolution system. Finally, selection o f consulting services procedures would benefit from use o f quality-and-cost based selection system, particularly for the assignments that require high competence and relevant experience. Turkey is one ofthe countries where the Bank had consultations for the use o f country systems in procurement inNovember 2007, and the Bank received an official request from the Government to participate as one o f the pilot countries in January 2008. The Government proposed two phased approach, whereby the first phase would address country level procurement assessment, policy analysis and capacity development and the second phase to pilot the use with a sector or a project to be selected by the Government. Subject to the Bank Board approval o f the pilot plan, next steps will follow. 204. Auditing. Effective financial accountability requires extensive modernization of Turkey's public audit system. The objectives are twofold: (a) clarify institutional responsibilities, promote improvements in audit quality in line with international standards and support the shift from ex-ante controls to ex-post monitoring in harmony with the efforts to improve operational performance; and (b) expand the scope o f TCA audits to cover the entire general government including local administrations, autonomous agencies, social security institutions, remaining extra-budgetary funds and revolving funds, with the overall objective of transforming the TCA into an effective state audit institution. These objectives have been facilitated by enactment of the PFMC Law and will further be completed through enactment o f the new TCA law. The PFMC Law established a framework for decentralizing internal audit to the line agencies inline with EUrequirements. It discontinuedthe TCA's involvement inbudget 54 execution and focused on ex-post audits, including performance audits. The TCA i s committed to undertake internal reforms to align its institutional structure with international standards for state audit institutions, to upgrade its audit capabilities, and to reach consensus with the other government audit bodies on implementation o f the reform. A draft action plan for the TCA's internal reform has been prepared and will be improved, including through a peer review by auditors from other European state audit institutions. The action plan i s expected to be adopted by the Government and TCA after the enactment o fthe TCA Law. DISBURSEMENT AUDITING AND 205. Disbursementand ImplementationArrangements. The proposed loan will follow the Bank's disbursement procedures for DPLs. The untied balance o f payments support will be disbursed against satisfactory implementation o f the program and not tied to any specific purchases and no procurement requirements will be needed. Upon approval o f the loan and notification by the Bank o f Loan effectiveness, the Government will submit a withdrawal application. The IBRD will deposit the proceeds o f the loan with the CBRT, which will form part o f the official FX reserves at the request o f the Undersecretariat o f Treasury. The government will utilize the proceeds o f the loan in foreign currency for either foreign debt servicing or for crediting the local currency equivalent into the treasury single account for financing budgeted expenses. Prior to that, the borrower will pay a front-end fee amounting to 0.25 percent o f the loan amount from its own resources. If, after deposit in this CBRT account, the proceeds of the loan are usedfor ineligible purposes (for example, to finance items imported from nonmember countries or goods or services on the IBRD standard negative list), the IBRD will require the borrower to either: (a) return that amount to the account for use for eligible purposes; or (b) refund the amount directly to the IBRD, in which case the IBRD will cancel an equivalent undisbursedamount o f the loan. 206. Accounts, Auditing and Closing Date. The administration o f this loan will be the responsibility o f the Undersecretariat o f Treasury. The government will maintain accounts and records, or ensure that such items are maintained, showing that loan disbursements were in accordance with provision o f the Loan Agreement. Such accounts and records will be maintained ina form acceptable to the Bank. The IMF had conducted a safeguards assessment o f the CBRT inApril 2002 and determinedthat, while number of measures was taken to strengthen the CBRT, such as the conduct of a quality external audit and the preparation of financial statements according to International Financial Reporting Standards (IFRS), there remained a number of vulnerabilities that needed to be addressed. The assessment recommended reorganization o f the internal audit function, expansion o f the role o f the audit committee, publication o f IFRS financial statements, and reconciliation o f program monetary data with the audited financial statements, includingan audit o f the treasury component. Since then CBRT has taken a number measures including reconciliation o f monetary data with audited financial statements and its audit by the independent auditor, publication o f annual audited financial statements and the independent auditors report, reorganization o f internal audit function, including the adoption o f a new charter and the appointment o f the head o f the internal audit department. The audit reports by independent auditors on the financial statements o f the CBRT for the year 2005, 2004 and 2003 provided a clean audit opinion. Past audits and generally positive assessment by the IMF indicate that there are no strong reasons for asking additional 55 safeguards such as audit of deposit account. As a result o f the above, no audit will be necessary underthis loan. The closing date of the loanwill be June 30, 2009. ENVIRONMENTAL ASPECTS 207. Because of the nature of the policy actions supported under the program and the substantial long-term positive impact on poverty which is envisaged as a result of PPDPL series, this operation in unlikely to have any significant negative effects on the environment. Having said this, it is useful to characterize some of the potential environmental risks associated with expected policy reforms. 208. Public sector reform programs of the type supported by PPDPL 2 embrace expenditure frameworks, budget transparency, accountability, better financial management, and improved service delivery. The overall emphasis on improving governance and quality of spending and enhancing the transparency with which resources are allocated should improve environmental spending along with other forms. Thus, in principle, these reforms will be positive for environmental institutions, unless fiscal contraction falls disproportionately on such institutions, which is not envisagedunder PPDPL 2. 209. Improved coverage of the pension and health insurance systems i s expected to have a greater impact on the urban formal wage sector, perhaps increasing the incentive for rural workers to seek formal urban wage employment, increasing the burden on urban services, and contributing to urban environmental problems. Conversely, there could be reduced environmental degradationinrural areas because of rural-to-urban migration. 210. Turkey's environmental priorities are outlined invarious strategy documents focused on several areas including Turkey's National Report on Sustainable Development (2002) prepared for the Johannesburg Summit, the environmental chapter of Turkey's National Program for the Adoption of the Acquis (2001), and the National Environmental Action Plan (1998). A number of sectoral strategies complement these national reports, such as the Nutrient Reduction Action Plan (2002) which focuses on efforts to reduce agricultural waste runoff to the Black Sea; the National Forest Program (2004), which considers the scope for improving forest management; and the National Strategy and Plan of Action on Biodiversity (2001) which outlines Turkey's commitments as a signatory to the Convention on Biodiversity. Protected Area Management Plans have been prepared in a participatory manner at the four sites (Sultansazligi, Igneada, Camili and Koprulu Kanyon) with strong local consultation on land use and zoning of the protected areas. Unfortunately to date only one management plan (Sultan Sazligi) has been approved after modification to present it as the Long-term Development Plan required under current legislation. 211. Inurban areas, Turkey's environmental challenges are primarily associated with air and noise pollution, industrial waste management, waste water management, sanitation, and access to clean water, complicated by the burden of providing urban housing and services to accommodate the growing number of rural-to-urban migrants. In rural areas, environmental degradation is most profoundly felt amongst upland communities where soil loss and deforestation have reducedthe agricultural sector's productive capacity. 212. The EU is providing assistance to the government to build capacity for environmental management, regulation, enforcement and monitoring, as well as for developing revised legal 56 instruments for nature conservation. In addition, it i s providing support for the establishment of the Regional Environment Center, with the objective of providingtraining and capacity building of civil society groups. Turkey-EU Environment Screening process has been completed and report finalized on June 22,2007. RISKSAND RISKMITIGATION 213. Vulnerability to financial crises. While risks remain, there has been significant improvement inmany vulnerability indicators since the 2001crisis includingfor example that (a) the cost of borrowing has been declining, (b) the annual inflation rate has declined sharply; (c) the composition and maturity of public debt have improved; (d) debt managementpracticeshave strengthened; (e) the public debt-to-GDP ratios have declined remarkably; and (f) the official reserves of the CBRT rose substantially from around US$ 19 billion in 2001 to US$74 billion in 2007. Nevertheless, the large CAD, substantial external financing needs, a comparatively high debt stock and relatively short maturities imply that the economy remains vulnerable to a "sudden stop" infinancing. 214. There have been a number of instances where changes in global risk appetite led to volatility in Turkish markets over the last two years. Turkish markets recovered relatively quickly from volatility in financial markets inMay-June 2006, February 2007, and April 2007 - demonstrating economy's improved resilience to such shocks. Nevertheless, these events also highlighted Turkey's continuing vulnerability to external and internal shocks as it was among the hardest hit countries. Turkish markets have recently been affected by declining global risk appetite due to developments originated in the US sub-prime mortgage market. The ISE index has dropped by 20 percent between July 2007 and April 2008, and the yield on the YTL denominated benchmark bond has increased from 17.5 to 18.8 despite a monetary easening of 225 basis points inthe same period. A change in global liquidity conditions and risk appetite for emerging markets remains an important external risk factor. Under these circumstances, the strength of economic fundamentals may play a key role in investment decisions of foreign investors. 215. Mitigating these risks requires maintaining the confidence of domestic and foreign financial market participants. The EU accession process and the IMF-supported program have acted as "twin anchors" for Turkey's economic policy. The possibility of a phasing out of the IMF SBA in 2008, and of a slower EU accessionprocess, if realized, could weaken the anchors of policy reform that untilnow helpedunderpineconomic policies. 216. Turkey's substantial FX reserves and flexible exchange rate regime mitigate risks associated with capital reversals. FX reserves of the CBRT increased from US$ 19 billion in 2001 to US$ 74 billion in 2007. Reserves represented 55 percent of gross external financing requirements in 2006 and more than covered Turkey's short-term external debt as of September, 2007. Turkey's flexible exchange rate regime has helped cushion outflows during periods of volatility. Systemic risks in the banking sector have been addressed, the state banks have been re-capitalized, and the open FX position of the banking sector has moved close to balance. CBRT independence and the regulatory bodies for banking, energy, telecommunications and public procurement are increasing the effectiveness of economic management in line with international and EUnorms. Fiscal adjustment has shifted the primary fiscal balance from deficit to surplus and the legal framework for better fiscal management i s being gradually put inplace. 57 217. Maintaining satisfactory macroeconomic performance and continuation o f structural reforms will be the key to mitigating external financing risks. They will signal to market participants that Turkish fundamentals are sound and thus mitigate the risks associated with large external financing needs. Inits Action Plan dated January 10, 2008, the government reiterated its firm commitment to maintaining strong fiscal discipline, inflation targeting, flexible exchange rates, and overall macroeconomic stability, while deepening structural reforms, including implementationo f the Social Security Reform. 218. External factors. Although the resilience o f the economy has greatly improved, a key challenge for Turkey will be coping with potentially volatile capital flows. Turkey remains vulnerable to a sudden reversal in capital flows since, compared to other emerging economies, it has a high total external debt. The mitigating factor for both EU accession risks and global financing risk will be for the authorities to move forcefully on their program o f structural reforms so as to convince markets that Turkish fundamentals are sound. Geo-political events in the neighboring region may affect Turkey negatively through increased risk aversion by market participants (Le., higher spreads) and oil prices - as the country i s a net energy importer and the price o f energy affects the current account negatively. 219. Banking Sector. The Turkish banking sector's exposure to foreign capital outflows is mitigated by the fact that capital inflows in contrast to many other countries in the region have not come through the banking system, but rather through the government securities market, investmentsat the ISE, and more recently directly to the corporate sector inTurkey. The effects on the banking sector would thus mostly be second order as liquidity in the money market and government securities market would dry up if capital were to leave Turkey on a large scale. Since 2002, there has beena major shift in banking assets from government securities to private sector credits. The source o f bank profits has shifted from trading and treasury revenue to profits from net interest revenue in the loan and deposit business. The tighter fiscal policy, as well as confidence in the ongoing reform process, has made the speculative trading business less attractive inboth currency and interest rate positioning. 220. The shift toward domestic credit would seem to have two positive benefits. The banking system has become less susceptible to market risks that accompany international debt crises- mainly rapidly rising real interest rates and falling exchange rates-and financial deepening improves the prospect for development. However, the change in bank portfolios has increased the relative importance o f credit risk. The expansion o f the credit portfolio leaves the banking system potentially vulnerable to a substantial increase in domestic interest rates because borrowers may be unable to meet interest and principal payments at substantially higher rates. Banks may also become vulnerable to the impact o f troubles in financial markets outside the banking system duringdebt crises. 221. Banks are using currency swaps to hedge any currency mismatch on their balance sheets -which means better management o f the associated risks. At the same time, these hedges allow banks to create fixed interest rate local currency liabilities and thereby better manage the interest rate risk from the growing mortgages in local currency. Non-Performing Loans (NPL) have declined and loan provisions have grown leaving banks with very small net NPL ratios. This at a time when the loan portfolio grew rapidly from US$38 billion in May 2003 to US$ 249 billion inJanuary 2008. 58 222. The regulatory and supervisory framework has been strengthened-although some weaknesses remain. The entry of foreign banks into the Turkish banking sector over the past few years has contributed importantly to a more stable sector. Most private banks in Turkey have gotten a foreign partner or have been acquired by foreign banks since the beginning of 2005. Foreign owned banks are more likely to sustain access to international capital markets, and the bigger international banks are more likely to be able to support the Turkish subsidiaries in cases of distress. 223. Despite increased resilience, the banking sector remains exposed to a reversal of capital flows. Nonetheless, several factors mitigate the probability of a crisis. Turkey has experienced the failure of a large bank without experiencing a systemic run. The inter-bank market i s very small implying individual bank problems are unlikely to be transmitted to the system as a whole. The Turkish financial system performed well under stress because, among other things, the policies instituted by the CBRT since the 2001 crisis and thoughtful management of debt maturity structure by the Treasury have provided financial market participants with the incentives to makeprudent decisionsand given them the tools to execute these decisions. 224. Political, legal and implementationrisks. Two major political risks are (1) increased political uncertainty arising from the recent case filed with the Constitutional Court calling for the dissolution of the rulingparty AKP; and (2) addressingborder tensions with Iraq. These risks are very substantial, though not overwhelming. The recent lawsuit by the Turkey's Chief Prosecutor with the Constitutional Court requesting the dissolution of the ruling party AKP and other developments in the internal politics are likely to create non-negligible risks for reform implementations. Turkey's consistent international outlook and continued orientation toward EU accession, notwithstanding the ups and downs, have been and are expected to remain a major unifying force behindpolitical and economic reforms. 225. Public sector reform program faces legal, political and implementation risks that can underminethe achievement of the goals of the program without necessarilytriggering a financial crisis. Following a successful constitutional challenge to an earlier version of the Social Security and UHILaw in 2006, there is a non-negligible risk that the recently approved revised law will be challenged before the Constitutional Court again. The government has moved to make the new law consistent with the Constitution but some risk of adverse ruling remains. Nonetheless, the government has shown firm commitment to social security reform by amending the Law in order to address the Court decision and by implementing the other dimensions o f the reform such as unifying the previously existed three separate administrations for workers, civil servants and self employed. The proposed program leaves time for constitutional review and finalization of the necessary secondary legislation. Implementation of the law would be monitored under a subsequent PPDPL 3. 226. Implementation of major public reforms needs strong coordination and monitoring. Public sector reforms, by the nature of the issues they address, tend to be cross-cutting and take time to implement. A mitigating factor for the coordination risk is the increased reliance on EU technical assistance. For example, the MOF has started to receive technical assistance from the Netherlands MOF to assist with "secondary legislation regarding the budgetary process (according to the Maastricht Criteria), the strengthening of the institutional framework for an improved budget process and more efficient budget policy." 59 227. Social consensus on the reform program and sufficient institutional capacity are needed for the implementation o f the reform program. The complexity and social impact o f many elements o f the reform program, for example, the reform o f the social security system, governance, and decentralization o f service delivery, requireconsensus building among the social partners that takes time and inevitably results incompromises. 228. The social security reform requires both strong institutions and close collaboration amongst them for the reforms to be successful. Moreover, the introduction o f UHIalone without the concurrent complementary reforms in strengthening the health referral system, rationalizing pharmaceuticals procurement and providing more autonomy to hospitals to increase their efficiency, could lead to the un-affordability o f UHIfrom a fiscal point o f view. Fortunately, the government i s well aware o f these risks and i s from the beginning giving as much attention to institutional issues as to the policy design itself. However, the experience o f increased health expendituresin2005 and 2006 demonstrates the fiscal risks inherent inthe health system and the need for the government to be both vigilant in monitoring such expenditures and in introducing tougher administrative measures to control pharmaceutical expenditures. 60 Table 7: Risk Assessment Template for Lending Operations Risk Factors Description Mitigation measures Rating a Ratinga prior to of mitigation residual risks Country and sector factors Macroeconomic policy Comparatively high debt Strong fiscal adjustment underpins framework levels and large CADS macroeconomic program. EU create financingrisk. accession process continues to anchor reform process and economic program. A public sector primary budget surplus of 3.5 percent o f GDP-new series has been targeted for 2008. The quality of the CAD financing has improved as evidenced by increasing share of non-debt creating capital inflows. Flexible exchange rate could mitigate a sharp exchange rate correction. CBRT policy independence guaranteed by law. Sector policies and Reform fatigue as the Exceptionally strong mandate for the 3 2 institutions government enters into its government supports reform second term. environment. Continued EU negotiations. IF1 including WB and its new CPS. Political stability and Single party has created Government has been careful to 3 3 governance most stable government in manage the political tensions and years. Nonetheless, the avoid confrontation. recent lawsuit by the State Prosecutor requesting the dissolution of the governing party AKP could increase risks for political stability. Further more, political tensions could also appear around Constitutional reform and other internal politics. Borrower and other official Government is keen to All prior actions have already been 2 2 ownership retain ownership of reforms. taken. Institutional capacity (project The merger o f the three Government has created a core team 3 2 agency and country) social security institutions is that is managing the process o f challenging. PEM reforms integration. Bank support through a now needto be extended to component of a companion health 61 local administration level. project. EU support is available for Implementation o f the the PEM reforms. Government is decentralization reform actively engaged in institutional could be challenging. capacity building in collaboration with the EU and other donors. External factors Economic (market) Developments in US The authorities remain committed to 4 3 developments subprime mortgage market macroeconomic stability and high and possible fallout for primary surpluses to reduce Turkey. Change in risk outstanding debt and to achieving appetite for emerging permanent disinflation. The banking markets. Geopolitical system has been strengthened and is tension in the region could less exposed to insolvency risk as a be very disruptive, including result o f large exchange and interest increased risk aversion and rate changes. Flexible exchange rate substantially higher energy could mitigate a sharp exchange rate prices. correction. Social and environmental factors Compliance with Bank safeguard policies where applicable Country social/environmental No particular risks identified 2 2 protectionsystems beyond the general social/environmental risks. Fiduciary factors Compliance with Bank Despite significant progress Strong Bank involvement in 2 2 fiduciary guidelines and in the overall framework, procurement and financial Country public financial general risks remain. management, together with accountabilitysystems harmonizationwith EU. Internal and otherfactors Staff skills (includingstability A large cross sectoral team Active efforts to ensure a strong 2 2 in assignment) has been working with team. Government for two years. Supervision resources One tranche operation. The country program is sufficiently 1 1 funded and subsequent operations are includedin the CPS. Other factors Overall risk The program supports risky Government has strong ownership, 3 2 second generationreforms. EU accession process provides strong external anchor. aRatingon four-point scale according to probabilityo foccurrenceand magnitude of adverse impact where 4 representshigh risk while 1 representslow risk. 62 Annex I Page 1 of 8 ANNEXI:LETTER DEVELOPMENT OF POLICY REPUBLIC OF TURKEY PRIME MINISTRY The Undersecretariatof Treasury Ref: B.02.1.HZN.0.08.01.05-182.03(232) Ankara, May 16,2008 16.05.08* 2 2 3 4 8 Mr.RobertB.Zoellick President The World Bank Washington DC 20433 U.S.A. Dear Mr.Zoellick, 1. Our Government's commitment to sound economic policies and structural reforms has resulted in a spectacular recovery after the 2001 crisis and people's lives have improved significantly. Annual growth averaged 6.8 percent in the period 2002-2007. The outlook for debt sustainability has improved, and inflation has seen an impressive decline through fiscal discipline and tight monetary policy. Substantial progress has also been achieved in improving public finances, reforming the public sector, restructuring the financial sector, and improving the business environment. Key markets have been liberalized and regulatory capacity in the economy has been strengthened -including banking supervision. Our future reform priorities are contained in three key documents, namely the Ninth Development Plan (2007-2013), the Government Action Plan, and the Program for Harmonizationwith EUacquis. 2. This impressive economic performance is due first and foremost to credibleand sustained stabilization, with strong fiscal discipline at its core, combined with an ongoing structural reform agenda. IMF and the World Bank Group support as well as EU accessionnegotiations have also contributed to successful implementation of the reform program. 3. Turkey's key long-term development goals include strengthening human development and social solidarity, ensuring regional development and increasing quality and efficiency in public services. Inthis context, our aim is to sustain high growth and to further strengthen the public sector by (a) maintaining an enabling macroeconomic framework, (b) reforming the country's social protection system, (c) continuing the ongoing process of upgrading public expenditure management and financial controls, and (d) improving the administration and governance of the public sector. 4. Our Government has implemented a number of key actions and i s ready to move ahead with the rest of the Public Sector Reform Program. On this basis, we request World Bank support for our Program by approving a SecondProgrammatic Public Sector Development Policy Annex I Page 2 of 8 Loan (PPDPL 2) and the disbursement of the EUR 255,400,000 (USD 400,000,000 equivalent). We firmly believe that the reforms detailed inthis letter merit full support from the World Bank and the international community. I. SustaininganEnablingMacroeconomicFramework 5. Over the last six years, Turkey has been experiencing strong growth. Inflationhas fallen considerably, public debt sustainability has improved, and macroeconomic vulnerabilities have significantly been reduced. Key elements contributing to this performance include a tight fiscal and monetary policy, a flexible exchange rate, and structural reforms in the public and financial sectors. 6. The economy grew by 4.5 percent in 2007, down from an average of 7.2 percent in the period of 2002-2006, due to deceleration of domestic demand, reflecting inpart elevated interest rates and a weakening of net exports on the expenditure side; and drought-related shortfall of agricultural production on the supply side. In2008, we expect growth to remain strong at about 4.5 percent. The disinflation process has slowed down inthe recent years due to commodity and food price shocks. In 2008, we expect inflation to remain above the target as a consequence of surging energy and food prices, and the recent depreciation of the YTL. However, we remain committed to bringing inflation down to 4 percent inthe medium-termto lay the foundations for sustained and high growth. The CAD-to-GDP ratio narrowed slightly to 5.7 percent in 2007 from 6.1 percent in2006. We expect the deficit to widen reaching around to 6.5 percent of GDP in 2008 on the back of increasing energy and commodity prices. The quality of external financing has improved as the non-debt creating flows covered more than 50 percent of the CAD in2007. Foreign direct investment is expectedto remainrobust in2008. 7. Tight fiscal policy has been the cornerstone of our program, facilitating disinflation, reducing real interest rates and leading to declining debt ratios. We are committed to cautious fiscal stance in the period ahead. In 2007, a combination of higher than planned spending and weaker than expected revenue caused by slowdown of economic activity has resultedin a lower than targeted primary surplus. At this juncture, we view that a primary surplus of 5 percent is no longer required for public debt sustainability as the net public debt-to-GDP ratio fell to 29.1 percent of GDP in 2007 from 66.5 percent in 2001. Hence, we expect public sector primary surplus at 3.5 percent of GDP in2008. 11. Social Security and Social Assistance Reform 8. Our Government fully recognizes the importance of an effective and modern social protection system. To this end, we have embarked on a comprehensive and challenging social security reform consisting of four main pillars since 2004. The first pillar aims at establishing a unique pension regime, which involves long and short term insurance programs except health insurance. The second pillar supports the establishment of a universal healthinsurance to finance a fair, preventive, treatment-oriented and high quality health service to the whole population. The Annex I Page 3 of 8 third pillar involves the unification o fthe currently diversified social assistance and services. The fourth pillar aims at integrating the three separate social security institutions under a single administration so as to provide social protection services in a facilitating and accessible as well as effective manner to our citizens. 9. In order to address the issue of sustainability of the pension system, we have prepared a set o f legislations to overhaul the social security system and bring the system to balance in the long term. There are two key pieces in the social security and universal health insurance reform package, namely Social Security Institutional Law No. 5502 enacted on May 20, 2006 and Social Security and Universal Health Insurance Law No. 5510 enacted on June 16, 2006. The Law No. 5510 reforming the pension parameters and creating legislative base for universal health insurance was partly canceled by the Constitutional Court in December 2006 -mostly for articles regulating civil servant pensions. Nevertheless, our Government has remained committed to the social protection reform agenda and moved forward with the implementation o f the administrative restructuring and certain parts o f universal health insurance reform. At the same time, we have amended the Law No. 5510 by Law No. 5754 enacted on May 8,2008 in order to address the Constitutional Court ruling. With a view to accommodate the Constitutional Court's concerns, we have grandfathered existing civil servants but the new civil servants who would enter into the system after the effectiveness o f the Law are included within the scope o f the reform. We kept the essence o f the reform intact by bringingthe key pension parameters closer to international norms -though with a long transition period in the case o f retirement ages- and by substantially improving the long term fiscal sustainability o fthe pension system.We have also ensured uniformity and equity inthe system by unifyingthe pensionparameters for all groups. 10. We will start full implementation o f the amended Law No. 5510 as o f October 2008 in order to allow time for the issuance o f secondary legislation requiredfor the implementation. We are fully committed to the implementation o f the Law and we intendto address any challenges to the Law or its implementation as they arise, withinthe spirit o fthe reform that we have embarked on. Parametric Pension Reform 11. Our objectives under the parametric pension reform are to achieve fiscal sustainability, uniformity and equity in the system. The parametric pension reform will result in substantial fiscal savings inthe long run and will help move the Turkishpension system toward international parameters. Within the context of this reform (i)retirement ages in Turkey are increased to current international norms o f 65 for both men and women, albeit with a long transition period, (ii) benefitaccrualrateisreducedclosertofiscallysustainableinternationalnorms, (iii)the the revaluation of past earnings which had been set at growth o f nominal GDP for private sector employees and the self-employed i s reduced to inflation plus 30 percent o f real GDP growth, and (iv) the indexation of pensions post-retirement is linkedto inflation except for civil servants who had already beeninthe system. Annex I Page 4 of 8 Administrative Dimensions of the Social Security System 12. One o f the key goals o f our reform program was to tackle the previous fragmentation o f the social security system. Our Government has made significant progress in the administrative reform agenda. Implementation o f the Law No. 5502 reforming the administrative dimensions o f social security by unifying then existing three social security schemes i s on track. Particularly, our policy actions include (a) consolidating electronic records o f the previous social security institutions and using an integrated identity number system, (b) establishing personnel policies for the new social security institution and a core cadre o f staff, (c) establishing the financial management and claims adjustment systems, and (d) harmonizing a unique positive drug list for all participants in the new Social Security Institution. Inaddition, legislative changes have been enacted that give the Social Security Institution the authority to develop and apply advance screening such as proxy-means testing, in identifying the poorest for eligibility to non- contributory health insurance. UniversalHealth Insurance 13. The Universal Health Insurance reform being implemented in Turkey today is a fundamental structural reform, matched in importance and size by few other countries in the world. Traditionally, health insurance system in Turkey was fragmented and inefficient with a significant share o f population being uncovered, as coverage was linked to formal sector workers. The Ministry o f Health provided services, mainly to the uncovered population through the Green Card system. However, due to lack o f an integrated system, large numbersof formally non-eligible individuals were able to obtain services. Overall health costs o f the system were rising, attributable to expanded access to outpatient health services in the absence o f a strengthened primary health care system, absence o f a referral system, and lack o f demand side controls. With the introduction o f Universal Health Insurance, we aimed at, among other things, improving access to quality health services by the poor, improving efficiency o f the health system, and effectively regulating access to health insurance. 14. In this context, our Government has taken the following policy actions for a successful implementation o f Universal Health Insurance; (a) establishment o f an expenditure tracking system for pharmaceuticals, and (b) adoption o f tight global budget caps for state hospitals' 2008 budgetson a quarterly basis. 111. PublicFinancialand ExpenditureManagementReform 15. The enactment of the Public Financial Management and Control (PFMC) Law No. 5018 in 2003 has provided a new legal framework for modern public expenditure management and accountability. Our Government i s committed to satisfactory implementation o f this landmark PFMC Law. The underlying objectives o f the PFMC Law are to improve the quality o f the public service delivery, enhance the functioning o f the government, and increase accountability and transparency inthe public sector. With this Law ,we have introduced strategic management Annex I Page 5 of 8 concept through linking plans and policies with the budgets, initiating institutional strategic plans and performance budgets, and introducing medium term fiscal framework in the budgeting process. 16. Our Government has issued all required secondary legislations for the implementation of the PFMC Law. Inthis regard, a total of 47 secondary legislations inthe form of regulationand communiqu6 have been issued and become effective. Among these secondary legislations, the critical ones are; (a) rules and procedures o f strategic planning in the public administrations, (b) rules and procedures of internal control, (c) public sector internal control standards, (d) financial services experts regulation, (e) rules and working principles o f the strategy developmentunits, (f) rules and working principles o f internal auditors, and (g) internal audit strategy paper. 17. Establishing a well functioning internal audit structure i s crucial for the successful implementation o f the PFMC Law. Developing internal audit capacity i s still an ongoing process. So far, more than 374 appointed internal auditors in the general government have been trained on internal auditing standards and implementations under the new PFMC system, and have beencertified. 18. Inline with the strategic management concept, we have established strategy development units -which are essential for the successful implementation o f the PFMC Law- and these units are fully operational inall general government institutions. Strategy development units are responsible for strategic planning, budgeting, accounting and internal control functions. 19. Our Government also recognizes the need for aligning budgetary process with international practices. In this context, using accrual accounting in fiscal accounts i s o f critical importance particularly for macroeconomic policy. Its importance arises from the fact that it measures assets and liabilities that are relevant to the overall stance o f fiscal policy and fiscal sustainability, but which are not measured by cash accounting. After initiating the accrual accounting inthe central government in 2006, the Ministry of Finance started collecting the local administrations' financial data on an accrual basis consistent with the rest o f the general government. The Ministry o f Finance incorporated electronically quarterly trial balance o f all local administrations into the Say2000i accounting system. Through this development, the consolidated local administrations balance sheet was generated by the Ministry o f Finance on an accrual basis for 2006. As a result, 2006 financial statements o f central government institutions and local administrations have beenprepared on an accrual basis. 20. As part o f our efforts to enhance fiscal transparency and accountability, our Government published a complete list o f tax expenditures, which defines 87 articles or sub-articles as tax expenditures and provides an estimate o ftax expenditures for 2007. 21. Our Government i s aware that ensuring sufficient resources for high quality public investmentprojects remains a key challenge inTurkey, despite some success inrationalization o f the Public Investment Program (PIP) in the recent years. In our Annual Programs, we have recognizedthe expected expenditure pressure on the PIP o f an acceleration o f the alignment with the EU. Our 2008 Program reiterates two major problems in the PIP; first, lack o f adequate resource allocation to current investment needs, and second inefficiencies in using these allocations. In order to improve the link between the resource allocation process and actual investment needs (particularly new investment needs that may arise due to the EU alignment process), we have (a) initiated a study on assessment of the actual needs for maintenance Annex I Page 6 of 8 expenditure, and (b) identified five pilot public institutions for establishing an Operations and Maintenance Framework. IV. Public Administrationand GovernanceReform Improving the Justice System 22. Legal and judicial reform has become a significant topic since Turkey's official application for EU membership in 1999. Since that time, we have embarked on legal reform efforts focused on constitutional and legal changes intendedto strengthendemocracy, the rule o f law and the protection o f human rights. As a result o f these efforts, Turkey now performs very well in comparison with EU and EU accession members along various dimensions measured by surveys such as the 2005 Business Environment and Enterprise Performance Survey (BEEPS) and 2006 Doing Business. 23. Despite the gains, Turkish courts continue to face backlogs and delays. In order to improve the justice system and ease the backlog o f cases, we have enacted a law for the establishment o f Regional Courts o f Appeals, which i s now effective. The establishment o f the Regional Courts o f Appeals i s an important step aimed at easing the case load o f the Courts o f Appeals as well as allowing the Supreme Court to reduce its caseload and play a guiding role for thejudicial system. We expect the courts to be operational inlate 2009 or early 2010 as Ministry o f Justice needs to identify and appoint judges and staff to these courts. We have also established online connections among courts through satisfactory implementation o f the National Judicial Network Project (UYAP). More than 90 percent o f courthouses are connected to the system. Our government has also expanded training programs for judges and prosecutors through the National Justice Academy which has assumed all the mandatory pre-service training for candidate judges and prosecutors. Inaddition, we have improved the delivery o f the in-service training programs. Decentralization 24. We are aware that the Turkish public sector i s highly centralized with central government accounting for about 90 percent o f general government expenditures. Therefore, we have embarked on a gradual process o f decentralization. At the same time, we are also aware that successful decentralization will require improvements in the technical capacity o f local administrations and improvements in local accountability and that any decentralization o f expenditure responsibilities must be matched by a corresponding adjustment inrevenues. In this context, we are committed to satisfactory implementation o f the Metropolitan Municipalities Law, the Special Provincial Administrations Law and the Municipalities Law. So far, we have completed the secondary legislation required for the implementation o f these laws. In 2007, we issued 5 implementing circulars including (a) norm cadre principles and standards for municipalities, municipal enterprises, local administration service unions and special provincial Annex I Page7 of 8 administrations, (b) procurement o f rural services, and (c) recruitment procedures for local administrations staff. 25. Our Government also prepared and submitted to the Parliament a draft law on Special Provincial Administration and Municipality Revenues on September 26, 2006. The current version would make two major changes in the existing structure of local administrations' revenues. First, it would increase the overall volume o f central government transfers by expanding the definition o f central government taxes subject to sharing. Second, it would change the distribution o f revenue sharing among categories of local administrations and would introduce two new criteria into the distribution o f these shares. These would include indicators o f poverty (such as a provincial development index) and a performance index. 26. We are also taking measures to reinin fiscal risks o f decentralization. The Municipalities Law limits the total stock o f municipal debt. The Law No. 6183 on Public Receivables and the Law No. 4749 on Public Finance and Debt Management permit the Government to deduct debt service owed by local administrations to the Treasury and other public entities from intergovernmental transfers. The draft Special Provincial Administration and Municipality Revenues Law would facilitate that process by permitting the Government (via Iller Bank) to deduct up to 40% o f local administration transfers for this purpose. Law No. 4749 and its secondary legislation as well as annual Budget Laws set limits for municipal external borrowing under Treasury guarantees. In addition, the PFMC Law requires local administrations to submit periodic financial reports to the government, enabling the government to better monitor their financial condition. The General Directorate of Local Administrations within the Ministry o f Interior has published for the first time in 2007 the general activity report for local administrations, in accordance with the PFMC Law. The report aims to shed light on budget outcomes and levels o f indebtedness, human resources, physical capital and investments o f special provincial administrations, municipalities and local administration unions. Regional Development 27. Regional development i s one o f our key policy challenges, especially in light o f our objectives to achieve more equitable economic development and to reduce income disparities across regions, with the ultimate aim o f convergence with the EU average income. Indeed, regional development i s one o f the five development axes identified in Turkey's Ninth Development Plan. Our 2008 Annual Program provides the policy framework for four components under the regional development axis, namely (a) increasing the effectiveness of regional development policies at the central level, (b) achieving development based on local dynamics, (c) improving institutional capacity at the local level, and (d) promoting rural development. 28. In 2006, we announced our intention to create Development Agencies (DAs) in the country's 26 NUTS-2regions. These would operate largely in a planning and coordination role, supporting implementationo f regional plans and programs and coordinating activities of sectoral ministries and local units of government. In this context, we enacted a law authorizing the establishment o f DAs, which became effective in February 2006. The law outlines the duties, Annex I Page 8 of 8 powers and organizational structure of the agencies and requires the establishment of DAs inthe 26 NUTS-2 regions. We have made substantial progress on this ground and established DAs in two NUTS-2 regions by the Council of Ministers Decree dated July 2006, one of which i s for Adana and Mersin provinces and the other for Izmir province. Both DAs have become operational and have initiated work on identifyingtheir short term "pre-development strategies". InJuly and September 2006, we issuedregulations on (a) personnelpolicy and management, (b) working principles of the DAs, and (c) budget and accounting principles. Finally, at the end of 2006, we completed examinations for recruitment of personnelfor bothDAs. 29. The process of establishing DAs was temporarily halted in 2007 due to a challenge to their constitutionality. While the Constitutional Court's decision, rendered in November 2007, annulled certain provisions affecting the appointment of staff and tax exemptions, it left the remainder of the D A Law intact, enabling the government to establish new DAs and permitting the existing agencies to fully operate. Currently, the law on the establishment of DAs is being implementedsatisfactorily. 30. Inaddition to progress inestablishing the DAs structure to promote institutional capacity at the regional level, we identified, based on both qualitative and quantitative indicators, fifteen "growth poles" in regions where both intra and interregional convergence need i s higher. We have created the legal base for budgetary allocation for at least one pilot implementation of the growth poles program in order to promote institutional capacity building and human resources. Our government has also taken steps to ensure the effective absorption of EU funds. In2006, the Prime Ministry issued a circular setting out the framework for monitoring three EU-supported regional development programs. In 2007, the Government prepared a "Strategic Coherence Framework" which provides a general framework for the operational programmes under the regional development and human resources development components of IPA. 31. We are committed to maintaining the macroeconomic stability and fiscal discipline. We believe that the policies and actions describedinthis letter are adequate to achieve the objectives of the public sector reform program. We have taken all the agreed actions under PPDPL 2. We also stand ready to take additional measures, if necessary, to ensure the continuation and success of the reform program supportedby the PPDPL program. Yours sincerely, Mehmet $IM&K Minister of State B = n Y L s0 0 .Ie -c .I LQ) 2 u,0 B n 5aa 2 v, a a0 Y*h .-P2ma 0 C .I 0 .I*um u u s L .I I a" 0 ai M 0 > V 43 Y P B -d 8 w 2 I -2, I- 2 0 u, U 'e8E 8 3 0 Q4 0 0 ;=o 0 . ; C Q E R b $ F e R cC E c L !! e E U 4 fi .2 C E cC 5 1 2L a, z ' E 0 P 0 C Y 0 .I a, Annex 111 Page 1 of 4 ANNEX111:THEWORLDBANK-IMFRELATIONS 1. The World Bank and IMF teams have worked in close collaboration in Turkey, and standard working arrangements broadly follow the guidelines for enhanced Bank-Fund collaboration. The IMF has taken the lead in macroeconomic stabilization and the World Bank in social and structural areas, with close collaboration in structural areas that have a particular impact on macroeconomic stability. Background 2. After the collapse of the 2000 exchange rate-based disinflation program and the floating o f lira in February 2001, the banking system experienced heavy losses, inflation soared and the economy contracted by nearly 10 percent. Public debt climbed to over 90 percent o f GNP (old series) in 2001, partly owing to the costs o f bank restructuring. After the crisis, the Turkish government introduced a three-year economic program backed by a SBA with the IMF and series o f programmatic loans from the Bank and since then, strong fiscal consolidation and disinflation efforts have laidthe basis for a rapid and powerful recovery. 3. Turkey concluded the last Fund-supported program covering the period o f 2005-2008 successfully. The reforms have delivered a decisive break with Turkey's history of high and variable inflation, and low and volatile growth. 4. Leaving the favorable developments aside, the Turkish economy faces a number o f risks as well. The strong economic recovery, the appreciation o f YTL and rising oil prices have also led to widening CAD which continue to remain a source o f concern. The high size o f the government debt, its short maturity, and its currency composition i s also a major source of vulnerability. For the mediumterm, the authorities' main challenge i s to implement policies that achieve the goals o f sustained growth and low inflation. With the start o f the EU accession negotiations, the alignment with the EU Acquis Communitaire and rapid income convergence to the EUaverages now constitute further challenges. The SBA for Turkey (2005-2008) 5. The Executive Board o f the IMF approved a three-year, SDR 6.66 billion (approximately US$ 10.8 billion) SBA inMay 2005 to support Turkey'seconomic and financial program through May 2008. 6. The overriding goals of the program were to create conditions for sustained growth that will raise living standards and reduce unemployment; facilitate convergence towards the EU economies; and bring about an orderly exit from Fund support. To achieve this, the program aimed to: 0 Deal effectively with short-term macroeconomic challenges and, inparticular, reduce the CAD to more sustainable levels. 0 Secure permanently lower inflation, by retaining the floating exchange rate, preserving CBRT independence under formal inflation targeting. Annex I11 Page 2 of 4 0 Further improve the government debt position through continued sizable primary surpluses, shifting towards longer debt maturities, and underpinning the fiscal adjustment with structural fiscal reforms. 0 Improve Turkey's net FX reserve position and strengthen its resilience to unexpected external developments. 0 Maintain financial sector stability by further improving the supervisory and regulatory framework, accelerating asset recovery and privatization o f state banks. 0 Implement a structural reform agenda that enhances Turkey's growth prospects, lowers unemployment, and improves the investmentclimate. 7. The program's macroeconomic framework was centered on achieving high and sustained growth o f around 5 percent each year. Inflation was targeted at single digits for 2006, declining to the low single digits by the end o f the program. 8. Growth has moderated in line with program assumptions, inflation i s in single digits, and the public debt burden is being reduced steadily. The authorities' adherence to prudent macroeconomic policies has played a key role in supporting these developments. The main challenge to the economic outlook i s the large CAD, which has beendriven by increasing energy and commodity prices and strengthening of YTL. The authorities' response to the current account developments-strong budgets, tight monetary policy with explicit inflation targeting, and accelerated reserve accumulation-has beenappropriate. The CBRT's cautious approach to interest rate cuts i s appropriate given still challenging inflation outlook in2008. Areas inwhich the World Bank leads 9. The Bank has taken the lead instructural areas where both institutions have conditionality including bankruptcy reform, corporate sector restructuring, social security reform, regulatory and market reforms in telecommunications and energy, agriculture reform, and privatization. The Bank i s also in the lead in areas such as health, education, infrastructure, governance and environmental management. Areas in which the Fund leads 10. The Fund takes the lead in macroeconomic stabilization including macro-fiscal policy, monetary policy, exchange rate policy and financial stability and risk management. Areas of shared responsibility 11. The work on public sector management and governance has focused on strengthening PEM system while maintaining fiscal discipline. The Fund has taken the lead in the short-term measures needed for the fiscal adjustment such as incomes policy, urgent revenue and expenditure measures, and budget monitoring and reporting. The Bank has taken the lead in assisting government on the medium-term P E M strategy, rationalization o f the PIP, public procurement reform, accounting reform, and public liability management. Public employment Annex I11 Page 3 of 4 policy, medium-term tax strategy, anti-conuption strategy and civil service reform are further areas o f Bank involvement. 12. The challenge facing Turkey inthe financial sector has been to address the banking crisis and putting inplace an appropriate legal and regulatory framework that would minimize the risk o f future crises. The Bank has taken the lead in reform o f the legal framework and regulations for bank supervision, the institutional development o f the Banking Regulation and Supervision Agency (BRSA) and SDIF, and the structural reforms required to guide the restructuring and improve the governance o f the state banks, as well as work on Non-Bank Financial Institutions (NBFI). The Fund has taken the lead in assessing the soundness of the banking system and where there was an immediate fiscal impact such as the re-capitalization o f the state banks, the closing o f insolvent banks, and the private bank recapitalization scheme. On the state banks agenda and resolution o f private banks the Fund and Bank have worked closely as a team. The Bank intends to continue its support for financial sector reform in Turkey including the development o f the NBFIfor which a major study has recently beenconcluded. Current Status of the IMF SBA 13. As o f May 9, 2008, the IMF Board approved the completion of the seventh and final review o f the SBA and the disbursement o f the remaining SDR 2.25 billion (approximately US$ 3.6 billion) thus, the full amount envisaged under the SBA (SDR 6.66 billion) was disbursed. Consequently, the three- year SBA has been successfully completed. The following i s the press release by the IMF on the completion o f the seventhand final review discussionsof the SBA. IMFExecutiveBoardCompletes Seventh and FinalReviewUnderthe Stand-By Arrangementfor Turkey and Approves USS3.65 BillionDisbursement Press Release No. 08/106, May 9,2008 The Executive Board o f the International Monetary Fund(IMF) today completed the seventhand final review under the three-year SDR 6.66 billion (about US$10.8 billion) Stand-By Arrangement for Turkey, which was approved on May 11, 2005 (see Press Release No. 051104). The completion o f this review enables Turkey to draw immediately the remainingbalance under the arrangement, equivalent to SDR 2.25 billion (about US$3.65 billion). The Board also approved Turkey's request for waivers of non-observance of the end-December 2007 quantitative performance criteria in the fiscal area (primary balances o f the consolidated government sector including and excluding state economic enterprises, overall balance o f the social security institutions, and consolidated primary spending o f the central government and social security institutions). At the conclusion of the Executive Board's discussion on Turkey, Mr.Dominique Strauss-Kahn, Managing Director andChairman, stated: "The Turkish economy has continued to perform reasonably well despite a challenging external environment, with economic activity showing resilience and FDI inflows remaining buoyant. Annex 111 Page 4 of 4 However, supply shocks have raised inflation, and turbulence in global credit markets has heightenedTurkey's external financing risks. Recent domestic political developments have also weighed on investor sentiment. In response to these external and domestic developments, Turkishfinancial markets recently unwound some of last year's large gains. "The authorities have responded to these challenges by taking important steps to bring their economic program back on track. Adoption o f the social security reform i s a major achievement that will contribute to the long-run sustainability o f public finances. Recent actions to strengthen tax administration, reform the energy sector, and enhance bank prudential requirements are also welcome. "Short-run macroeconomic policies will need to balance carefully the desire to support growth with the needto contain inflation and the CAD. From this perspective, it will be essential that the authorities adhere closely to their updated plans for this year to target an unchanged primary surplus relative to 2007 of at least 3% percent of GDP. This revised target creates room to decompress infrastructure spending and bring forward a worthy but costly cut in labor taxes. New initiatives that further erode the structural fiscal position should be resisted to preserve the downward path o f public debt and avoid further unwarranted pressure on monetary policy to stem inflationary pressures. From this perspective, it is important to make the envisaged reform o f subnational governments' finances fiscally neutral. "The central bank has revisedupwards its inflation forecasts in response to a series o f shocks to food and energy prices as well as a weakening in the lira, while reaffirming its medium-term target o f 4 percent. It has also appropriately adopted a tighteningbias. Entrenching the credibility o f the inflation targeting regime requires that the central bank respond promptly to broadening price pressures by tightening monetary policy and avoid lifting prematurely its tightening bias once inflation i s back on a declining path. "To anchor fiscal policy expectations, the authorities have announced a new medium-term fiscal framework that aims to cut gross public debt by some 10 percentage points o f GDP within five years. This objective i s underpinned by a policy commitment on the primary surplus, which i s targeted to decline from 3 percent o f GDP in 2009 to 2% percent o f GDP in 2012. Achieving these targets will require continued efforts to enhance revenue collection and significant discipline in restraining current spending. The authorities are encouraged to formalize their medium-termfiscal framework by adopting an explicit fiscal rule. "Turkey has achieved considerable success by adhering to the Fund-supported program that is now drawing to a close. Looking ahead, Turkey's challenge will be to press forward on the reform path to further entrench macroeconomic stability and decisively lift potential growth to facilitate convergence toward EU income levels," Mr.Strauss-Kahn said. Annex IV ANNEXIv:TURKEY A GLANCE Page 1 of 3 AT Turkey at a glance 3/19/08 Europe 8 upper Key Development Indicators Central middle Turkey Asia income Age distribution, 2006 (2006) Male Female Population,mid-year (millions) 70.6 460 810 70-74 Surface area (thousandsq. km) 784 24,114 41,460 Populationgrowth (%) ... 80-84 0.0 0.7 Urbanpopulation(% of total population) 71 64 75 50-54 40-44 GNI (Atlas method, US$ billions) 511.3 2,206 4,790 30-34 GNI per capita (Atlas method, US$) 7,240 4,796 5,913 20-24 GNi per capita (PPP, international$) 12,334 9,662 10,817 1C-14 D4 GDP growth (96) 6.9 6.8 5.6 15 10 5 0 5 10 (5 GDP per capita growth (X) 6.8 4.9 percent (most recent estimate, 200&2006) Povertyheadcountratio at $1 a day (PPP, %) 3 1 Povertyheadcountratio at $2 a day (PPP, %) 19 10 IUnder-5allty rate (per 1,000) Lifeexpectancyat birth (years) 71 69 70 Infantmortality(per 1,000live births) 26 28 26 I Child malnutrition(% of childrenunder 5) 4 5 1 Adult literacy,male (% of ages 15 and older) 95 99 94 Adult literacy,female (% of ages 15 and older) 80 96 92 Gross primaryenrollment,male (% of age group) 98 103 106 Grossprimary enrollment,female (% of age group) 91 100 104 Access to an improvedwater source (% of population) 96 92 93 Access to improved sanitationfacilities (% of population) 88 85 81 1990 1995 2000 2005 OTurkey UEurope a Centra Asia Net Aid Flows 1980 1990 2000 2006' (US$ miluons) Net ODA and official aid 953 1,202 327 464 Growth of GDP and GDP per capita (Oh) Top 3 donon (in 2005): France 33 65 8 115 Austria 27 8 11 22 l5 T Spain 0 4 12 Aid (% of GNI) 1.3 0.8 0.2 0.1 Aid per capita (US$) 21 21 5 7 Long-Term Economic Trends 90 85 00 Consumerprices (annual Oh change) 60.3 54.9 9.8 GDP implicit deflator (annual96 change) 88.1 58.3 49.2 9.3 &GDP - GDP per capita Exchangerate (annual average,local per US$) 73.8 2,608.9 623,700 1,431,110 Terms of trade index (2000= 100) 63 93 100 92 198040 1990-2000 2000-06 (average annualgrowth %) Population,mid-year (millions) 44.5 56.2 67.4 70.6 2.3 1.6 1.3 GDP (US$ millions) 70,903 150,661 265,384 526,429' 5.3 3.8 5.1 (% of GDP) Agriculture 26.5 18.1 10.8 9.4 1.2 1.5 1.8 Industry 19.6 26.4 30.0 28.2 7.2 4.4 5.7 Manufacturing 17.3 22.7 21.4 19.5 7.3 4.5 5.4 Services 53.9 55.5 59.2 62.4 5.8 4.5 5.6 Householdfinal consumptionexpenditure 77.0 68.7 70.5 70.5 3.4 5.3 Generalgov't final consumptionexpenditure 11.6 11.0 11.7 12.3 4.9 3.2 Grosscapital formation 18.2 24.5 20.8 22.1 5.0 9.1 Exportsof goods and services 5.2 13.4 20.1 22.7 11.6 7.2 Importsof goods and services 11.9 17.6 23.1 27.6 11.0 9.9 Grosssavings 16.1 24.3 17.8 17.1 Note:Figures in italics are for years other than those specified. 2006 data are preliminary...indicatesdataare not available. 3/19/08 a. Aid data are for 2005. b. Revised GDP series for 1998onwards. DevelopmentEconomics, Development Data Group (DECDG). Annex 1V Page 2 of 3 Turkey Balance of Payments and Trade 2000 2006 Governance indicators, 2000 and 2006 (US$ millions) Total merchandiseexports (fob) 30,721 91,937 Total merchandiseimports (uf) 54,398 138,973 Voice and accountability Nettrade in goods and services -10,585 -27,877 Politicalstability Workers' remittancesand compensationof employees (receipts) 4,560 1,111 Regulatory quality Currentaccountbalance -9,823 -32,192 Ruleof law as a % of GDP -3.7 -6.1 Controlof corruption Reserves,includinggold 26,106 60,705 0 25 50 75 100 Central Government Finance 32006 Countrys percentilerank (C-100) 02000 higher YDIUBI belle, rahngs mply (% of GDP) Currentrevenue(includinggrants) 20.4 21 2 Source Kaufmann-Kraay-Mastruzzi World Bank Tax revenue 18.2 18.5 Currentexpenditure 31.9 28 7 Technology and Infrastructure 2000 2005 Overallsurplus/deflcil -8.7 0.0 Paved roads (% of total) 35.3 Highestmarginaltax rate (%) Fixed line and mobilephone Individual 35 subscribers(per 1,000people) 512 868 Corporate 30 20 Hightechnologyexports (% of manufacturedexports) 4.8 1.5 External Debt and Resource Flows Environment (US$ millions) Total debt outstandingand disbursed 117,108 207,735 Agriculturalland (% of land area) 53 54 Total debt service 21,937 47,407 Forest area (% of landarea) 13.1 13.2 Debt relief (HIPC,MDRI) - - Nationallyprotectedareas (% of land area) 2.6 Total debt (% of GDP) 44.1 39.5 Freshwaterresourcesper capita (w.meters) 3,150 Total debt service (% of exports) 41.4 32.0 Freshwaterwithdrawal(% of internal resources) 16.5 Foreigndirect investment (net inflows) 982 21,864 CO2 emissions per capita (mt) 3.3 3.1 Portfolioequity (net inflows) 489 5,138 GDP per unit of energy use (2000 PPP $ per kg of oil equivalent) 5.7 6.1 :omposition of total external debt, 2005 IDA 71 196 Energyuse per capita (kg of oil equivalent) 1,142 1,151 IBRD 5829 467 IMF '4646 Other multi 38218 ---*- '--4 105732 375 Prwate. Private Sector Development 2000 2006 Time requiredto start a business (days) 6 Cost to start a business (% of GNI per capita) 26.5 Time requiredto register property(days) --- 6 Rankedas a majorconstraint to business (%of managerssurveyedwho agreed) Tax rates 37.6 Economicand regulatorypolicy uncertainty 31.1 Stock market capitalization(% of GDP) 34.9 40.3 Bank capitalto asset ratio (%) 6.1 13.5 Note: Figuresin italics are for years other than those specified. 2006 data are preliminary ..indicatesdata 3/19/08 are not available - indicatesobservationis not applicable. DevelopmentEconomics, DevelopmentData Group (DECDG) Annex IV Page 3 of 3 MiIlennium Development Goals Turkey With selected targets to achieve between 1990and 2015 (estimate closestto dateshown, +/- 2 yearsj Goal 1:halve the rates for $1a day-poverty and malnutrition Poverty headcount ratioat $1 a day (PPP,% of population) Povertyheadcount ratio at nationalpoverty line ( O hof population) Share of income or consumption to the poorest qunitile( O h ) Prevalenceof malnutrition(Ohof children under 5) .~~~._.____..____-_______~I___..__.__ Goal 2: ensure that children are able to complete primary schooling ___ Primaryschool enrollment (net,O h ) Primarycompletion rate (% of relevant age group) Secondary schoolenrollment (gross, Oh) Youth literacyrate (% of people ages 15-24) Goal 3: eliminate gender disparity in education and empower women Ratio of girls to boys in primary and secondary education ( O h ) Women employed in the nonagricultural sector (% of nonagriculturalemployment) Proportionof seats held by women in national parliament (Oh) Goal 4: reduce under5 mortalityLy two-thirds ____I__ Under-5 mortality rate (per 1,000) Infant mortality rate (per 1,000 live births) Measles immunization(proportion of one-year olds immunized, %) Goal 5: reduce niaternal mortality by three-fourths Maternalmortality ratio (modeled estimate, per 100,000live births) Birthsattended by skilled health staff (% of total) _Goal _ _ _ _ _ ~ _ ~ _ 6:halt and begin to reversethe spread of HlVlAlDS and other mdor diseases Prevalence of HiV (Ohof population ages 15-49) Contraceptive prevalence(% of women ages 15-49) Incidenceof tuberculosis(per 100,000people) Tuberculosiscases detected under DOTS ( O h ) Goal 7: halve t-oportion of people without sustainable accessLo basic needs __ Access to an improvedwater source ( O hof population) Access to improvedsanitation facilities (YOof population) Forestarea ("A of totallandarea) Nationallyprotectedareas (% of total landarea) CO2 emissions(metrictons per capita) GDP per unit of energy use (constant 2000 PPP $ per kg of oil equivalent) Goal 8: develop a global partnershiefor development Fixedline and mobilephone subscribers (per 1,000 people) Internet users (per 1,000people) Personalcomputers(per 1,000people) Youth unemployment ( O hof total labor force ages 15-24) Fducatlon indicators (%) Measles immunization (% of I-year olds) ICT indicators (per 1,000 people) '"1 ::Ii a-c-w ' 1 Oo0 , 75 , , , , , , , 0 2000 2002 2005 1990 1995 2000 2005 2000 2002 2005 --O-Primary net enrollment ratio 43- Ratioofgirlsto boysinprimary& OFixed + mobile subscribers [>Turkey secondary education [.>Europea CentralAsia C3 Internetusers Note: Figuresin italicsare for years other than those specified ,indicatesdata are not available 3/19/08 Development Economics,Development Data Group (DECDG). Annex V Page 1 of 6 ANNEXv:SELECTED POLICY ACTIONSFROMTHE GOVERNMENT'S NINTHDEVELOPMENT PLANIN PPDPL2 RELATED AREAS Strengthening Human Development and Social Solidarity 1. The main purpose o f the policies inthe area o f human development and social solidarity will be to raise the quality of life and welfare of the society by ensuring that all segments of the population benefit sufficiently from the basic public services as well as a multi-dimensional social protection network. While the main policies o f priority are education and health for the provision o f basic public services; as for the development o f social protection network, they will be setting up policies for an inclusive and sustainable health and social security system, increasing efficiency o f social services, improving income distribution, social inclusion and fighting poverty, protecting and strengtheningculture, and developing social dialogue Improving Health Services The UHIsystem will be implementedto facilitate accessto health services. The family medicine service model will be spread to all provinces by the endof 2008 Inorder to make the operation ofhospitals more efficient and improve the quality oftheir services, hospitals will be gradually made autonomous in financial and administrative terms. With the aim o f increasing service quality, national standards concerning service provision and personnel will be determinedand the system for the accreditation o f health institutions will be established. The planning, regulatory and supervisory role o fthe M O H will be strengthened. With the efficient operation o f the referral system and widespread use o f information systems, provision o f services at hospitals will be facilitated and monitoring o f health expenditureswill be ensured. Mechanisms will be established to control the quality and use o f pharmaceuticals and medical devices as well as the effectiveness o f these expenditures. Increasing Effectiveness of the Social Security System The social security system will be provided with a structure, which will cover the entire population, can meet the changing needs o f the society, have financial sustainability, and provide good quality services. The social insurance system will be extended in a way to cover the entire working population and informal employment will be prevented. Financial sustainability o f the social security system will be achieved considering the actuarial balances. A structure, which will prevent loss o f rights and repeated benefits and provide effective, accessible and sustainable services, will be established through transition to full automation in the information processing infrastructure o f the social security system. Annex V Page 2 of 6 The principles of equality, social justice, efficiency and effectiveness will be the basis o f the social services and assistance system. A common database will be set up in order to determine the individuals that will benefit from the system, and an objectively operating detection mechanism will be established. The shortage of qualified personnel in the area o f social services and assistance will be eliminated and the qualifications o f the existingpersonnel will be improved. Ensuring Regional Development 2. Regional development policies will contribute to national development, competitiveness and employment by increasing productivity o f regions on the one hand, and they will serve the basic objective o f reducing regional and rural-urban disparities on the other hand. 3. In this context; emphasis will be placed on activities towards increasing the consistency and effectiveness of policies at the central level, creating a development environment based on local dynamics and internal potential, increasing institutional capacity at the local level and accelerating rural development. Making Regional Development Policy Effective at the Central Level The planning tools and standards at the national, regional and local levels o f planning hierarchy will be identified and the consistency of plans will be ensured. An integrated system for the management and supervision o f plans, including the physical plans, taking the management onthe spot principle as the basis will be formed. 0 A regional development strategy at national level will be prepared to provide coordination in regional development and to constitute a general framework for sublevel plans and strategies to be prepared. 0 The coordination and collaboration among central agencies in the resource allocation in conformity with created policies and implementation stages will be strengthened, and the programming, project preparation, implementation, M&E capacities o f institutions and agencies will be increased. 0 Regional development plans will be prepared to determine strategies and priorities towards triggering local dynamics and internal potentials and they will be flexible, dynamic, participatory and feasible. Development strategies and plans o f all regions will be completed in collaboration with DAs and they will be provided with sufficient financing. 0 Spatial prioritizing and focusing will be ensured in public investment and service provision in order to increase job opportunities and quality o f life in the regions and to increase both inter-regional and intra-regional interactions through improving accessibility. 0 Attraction centers with a highpotential to grow and provide services to surrounding areas will be determined, particularly in less developed regions and firstly the accessibility of these centers will be improved and their physical and social infrastructure will be strengthened. Ensuring Development Based on Local Dynamics and InternalPotential Annex V Page 3 of 6 Particularly in underdeveloped regions, human resources and social capital will be developed in such a way as to support specialization at the local scale, and labor force training programs considering regional potentials and labor market characteristics will be implemented. Special training programs to develop entrepreneurship will be supported with the collaboration o f public institutions and organizations, the private sector, universities and NGOs within the approach o f development based on local dynamics and internal potential. IncreasingInstitutionalCapacity at the Local Level Cooperation and partnerships among public institutions and organizations, private sector and the NGOs will be supported and information exchange will be encouraged by setting up cooperation networks. Support will be given for having a sufficient number o f qualified technical personnel and equipment in local organizations, primarily in local administrations. Project preparation, implementation, M&E capacities o f institutions and agents having a role in the development process will be increased. Efficiency inresource utilization will be ensured. On the spot principle will be taken as the basis in regional and local development practices. Participation will be increased and increasing the synergy, support and awareness towards implementation will be ensured through the creation o f a partnership culture among the key stakeholders o f development. Starting with underdeveloped regions, contribution of non-governmental organizations to local and regional development efforts will be encouraged. IncreasingQuality and Effectivenessin Public Services 4. With the aim o f increasing quality and effectiveness in public services; duties, powers and functions o f public institutions and organizations will be revised and conflicts in this area will be eliminated, policy formation, cost accounting and implementation capacities of institutions and organizations will be increased, human resources will be improved, information and communication technologies will be efficiently utilized in the provision o f public services to citizens and effective provision o fjustice and security systems will be ensured. IncreasingPolicyMaking and Implementation Capacity 0 Transition to strategic management in public institutions and organizations will be completed with the transformation management approach duringthe Plan period. With the aim o f strengthening harmonization among the reforms towards increasing policy formation and implementation capacity in public administration, a common sense and vision will be developed with regard to the implementation of the reform and the transition period will be planned. Functionality o f higher policy texts will be increased as the basic reference framework duringpolicy formation and implementation as requiredby the plan hierarchy. Harmonization and relationship between development plans, and national, regional and sectoral plans, programs and strategies will be strengthened and interaction and connection will be ensured between the strategic plans of public administrations and higher policy texts. Annex V Page 4 of 6 All public administrations will prepare and implement their strategic plans during the Plan period in order to ensure that management decisions are formed with a medium to long-term perspective for the improvement o f management quality in public administrations; a result oriented management understanding and budgeting based on purposes and objectives i s developed; sensitivity towards the demands o f the beneficiaries i s increased in supplying public services; and participation and accountability i s established. This process will be scheduled for each institution. In order to rationalize the policy formation process and to ensure that the policies are based on data and information, a qualitative and quantitative data management system will be developed. Numerical, fictional and analytical methods will be utilized in both policy formation and costing processes. The structure o f the budget will be transformed to display the costs o f the policies to be implemented and the performance of public administrations, by considering the cost of the policies to be implemented by public administrations, the groups affected by these policies and their opportunity costs. Public resources will be allocated according to performance programs. In the framework o f creating a performance culture in public administrations, measuring, M&Eprocesses will be improved. 0 The existing administrative and human capacity in public administrations will be developed in terms o f both quality and quantity, in line with the strategic management approach, and programs targeting the harmonization o f the management culture with the new structure will be organized. Improving the Justice System Efforts towards increasing the quality o f judging process and main components o f this process will be continued; legal and institutional regulations, which will ensure the fast, fair, reliable and proper operation o f the judging process, inthe framework o f the rule of law and state o f law requirements, will be realized. 0 With the aim o f accelerating economic, social, and cultural development, the appropriate legal environment will be provided. 0 With the aim o f resolving disputes in a fast, simple and effective manner with low costs and reducing the workload o f judicial authorities as a result, it will be ensured that alternative dispute resolution methods are put in place in Turkish legal system in an effective manner. 0 Legal regulations regarding the professional ethics rules, with which the judicial system personnel should comply, will be made. 0 Law on education and training will be restructured to provide the students with methodological and analytical thinking skills. 0 Arrangements that will protect the rights o f those unjustly treated in the framework o f contemporary criteria will be put in place and judicial assistance services will be increased to a sufficient level. Annex V Page 5 of 6 The system o f execution of sentences and its institutions will be brought up to international standards. 0 The rules in administrativejudging procedures will be ensured to be in conformity with the operationofthe administrativejudicial system. With the aim o f accelerating the judging process, the number o f judges and assistant judicial personnel will be increased. 0 Efficient use o f judicial services will be ensured by accelerating the judicial process achieved through the transfer of services into the electronic environment and sharing information amongjudicial institutions and other public organizations. 0 Activities to establish new specialized courts, where required, will be carried out. Annex VI Page 1 of 2 ANNEXVI: SUMMARYNOTEONTHELATESTGDPREVISION 1. On March 8, 2008, TURKSTAT introduced a fourth revision to Turkey's GDP series and updated the base year to 1998 from 1987. TURKSTAT has been compiling national accounts data since 1929. GDP usingthe production and expenditure approaches has beenestimated both innominal and realterms based onthe concepts ofthe 1968 System ofNational Accounts (SNA) since 1972. The data have been published at a quarterly frequency since 1987. The national income accounts data from 1923 onwards were revisedbased on data in 1948, 1968 and 1987. 2. The main reason for the latest revision was to reflect structural changes in the economy since 1987 in national accounts statistics. Another reason was to harmonize Turkey's GDP estimates with the ESA 95. This work was initiated in 2004 and completed in March, 2008. TURKSTAT plans to complete full alignment with the ESA 95 by 2011. 3. With this revision, the authorities aimed at (a) improving the measurement of Turkey's economic activities; (b) enhancing international comparability o f Turkey's statistics; and (c) meetingdata requirementsof international institutions. 4. The new series embody improvements in both methodology - such as introduction o f the benchmarking system, changes in the measurement o f financial intermediation services, introduction o f chain index method - and coverage - such as inclusion o f some additional sectors: leasing, factoring, private pension funds and non-profit financial intermediation, to name a few. The historical revision i s also due to improvements in data sources and statistical techniques. This revision has brought significant changes to GDP series both inreal and nominal terms for the last nine years, as well as for the first three quarters o f 2007 (Table Al). The revised series maintain the trend o f real GDP growth but adjust nominal GDP levels upwards by about 32 percent on average. Table Al: Revised GDP Statistics (current (current (constant rate of prices, prices, prices, real million million thousand GDP ( m 2001 178,412 147,285 109,885 2002 277,574 182,564 118,612 2003 359,763 241,302 125,485 2004 430,511 300,578 136,693 2005 487,202 361,470 146,781 481,497 90,500 2006 576,322 400,046 155,732 526,429 96,738 Note Comparison for the whole year o f 2007 is not possible since the old series are not available beyond 2007Q3 5. The recent revision to national income data has resulted in significant changes in Turkey's key macroeconomic indicators - although their trends have remained broadly unchanged (Table A2). For instance, the revised GDP data also show that the CAD-to-GDP ratio Annex VI Page 2 of 2 increasedsubstantially,while the public debt-to-GDPratiowas on a sharplydecliningpathinthe period 2002-2006. Nevertheless, with the revision, shares of expenditure components in GDP have changed considerably. To illustrate, the revised data show an increase in the domestic savings-to-GDPratio in 2006 - comparedto a 1.5 percentagepoint of GDP decline implied by the old series. A similar differencecan also be observedinthe gross investment-to-GDPratio in 2006. Table A2: Key Economic Indicators of Turkey Before the GDP revision After the GDP revision Indicators 2001 2002 2003 2004 2005 2006 2001 2002 2003 2004 2005 2006 Real Sector (Percent) Real GDP growth rate -7.5 7.9 5.8 8.9 7.4 6.1 -5.7 6.2 5.3 9.4 8.4 6.9 Privateconsumption growth rate -9.2 2.1 6.6 10.1 8.8 5.2 -6.6 4.7 10.2 11.0 7.9 4.6 PrivateGFCF growth rate -34.9 -5.3 20.3 45.5 23.6 17.4 -32.9 16.9 23.7 36.1 16.2 15.0 Gross investment(%GDP) 15.9 21.3 22.8 25.9 25.1 24.9 15.1 17.6 17.6 19.4 20.0 22.1 Gross domestic savings (%GDP) 18.2 19.8 19.5 20.1 18.4 16.9 19.2 19.2 16.6 16.8 16.5 17.1 (Percentof GDP) 'ublic Sector Primary balance 5.1 4.2 6.3 7.1 6.8 6.6 3.8 3.3 5.0 5.4 5.1 5.0 Gross debt stock 106.1 92.5 82.5 77.1 71.6 63.3 78.8 73.3 65.3 59.4 53.8 48.1 Domestic 70.3 55.8 56.0 54.3 52.9 46.4 52.2 44.2 44.3 41.8 39.7 35.2 External 35.8 36.8 26.6 22.8 18.8 16.9 26.6 29.1 21.0 17.5 14.1 12.9 Net debt stock 89.4 77.7 69.7 63.8 55.4 45.0 66.4 61.5 55.2 49.1 41.6 34.2 Domestic 52.3 45.9 48.0 46.4 46.7 39.7 38.9 36.3 37.9 35.7 35.1 30.2 External 37.1 31.8 21.8 17.4 8.6 5.3 27.6 25.2 17.2 13.4 6.5 4.0 External Sector Current account balance 2.3 -0.8 -3.3 -5.2 -6.3 -8.0 1.7 -0.7 -2.6 -4.0 -4.7 -6.1 Trade balance -2.5 -4.0 -5.8 -7.9 -9.3 -10.3 -1.9 -3.2 -4.6 -6.1 -7.0 -7.8 Exports of goods and non-factor services 33.6 29.6 28.6 29.9 28.6 29.1 25.2 23.5 22.7 23.0 21.5 22.1 Imports of goods and non-factorservices 29.3 28.6 29.0 32.5 32.5 35.1 21.9 22.6 23.0 25.0 24.4 26.6 Grossexternal debt 77.1 71.0 59.8 53.5 46.8 51.9 57.7 56.3 47.3 41.2 35.1 39.5 of which private 28.6 23.6 20.3 21.2 23.0 30.1 21.4 18.7 16.1 16.3 17.3 22.9 Short-termexternal debt 11.1 9.0 9.5 10.6 10.3 10.6 8.3 7.1 7.5 8.2 7.7 8.0 Foreign direct investment 2.3 0.6 0.7 1.0 2.8 5.0 1.7 0.5 0.6 0.7 2.1 3.8 Source: TURKSTAT, Turkish Treasury, CBRT, Staffcalculations. Vote: Comparison for 2007 is not possiblesince the old series are not available beyond200743. Annex VI1 Page 1 of 4 ANNEXVII: PENSIONREFORMSTURKEY IN 1. Pension reform in Turkey has been a long process, beginning from a removal of the minimum retirement age in 1991, which resulted in the most generous eligibility conditions in the world. The movement back toward internationally acceptedparametershas required multiple steps as would be expected for a politically difficult reform where the parameters were greatly out of line with international best practice. 2. The 1999 reform introduced a minimumretirementage for workers, but beginning at the very young ages of 38 for women and 43 for men, culminating in a retirement age of 58 for women and 60 for men applicable to those joining the social security system for the first time after the reform was legislated. O f the four schemes targeted at different types of workers, the benefit determination for two of them, private sector employees and the self-employed, were harmonized, while the benefits provided to the other two groups, civil servants and farmers remained unreformed. The key parameters in the harmonized schemes including a relatively high 35 percent benefit provided for the first 10 years of contributions, followed by a lower annual accrual rate of 2 percent per year for the next 15 years and 1.5 percent per year subsequently. The incentives in such a system clearly encourage shorter contribution histories in that the first years of contributions generate proportionally higher pensions than additional years. Furthermore, while the salary base on which the pension is based was to be gradually increased to lifetime average salary from the previous 3 or 5 year average, the previous salaries were revalued using the growth rate of nominal GDP. The revaluation parameter, which typically is linked to the growth of average nominal wage, was chosen in the absence of a well accepted wage series in Turkey, but resulted in a generous revaluation, ranging from 33 percent to 70 percent higher than international best practice would suggest. Indexation post-retirement was also linked exclusively to inflation although after the first two years, the Government typically provided higher pension increases than inflation and best practice would suggest. Finally, the number of contributing days was gradually raised from 5000 to 7000, or from 14 years to 20 years, for a full pensionwith reducedpensions available for those with as few as 10years. 3. In the initial years of the 1999 reform, the fiscal balance of the pension funds markedly improved, but beganto deteriorate again in2002, with the largest growth inexpenditures coming from the relatively unreformed civil servant system. The Government in response drafted new legislation, the original Law No. 5510, which was passed by Parliament inMay 2006. This Law unified the benefit structure for all workers inTurkey and raisedretirement ages for new entrants gradually to 65 for both men and women. The pension would be calculated as 2.5 percent of salary for each year of contribution until 2015 and 2 percent per year thereafter, of the average salary, gradually phasing from the existing averaging period to lifetime average. Previous salaries were to be revalued by 50 percent of inflation and 50 percent of nominal wage growth, and pensions would be indexed by inflation only after retirement. The contribution period would gradually increase to 9000 days from the previous 7,000 days. But all contributions paidprior to the reform would be credited using the pre-reform benefit formula, and only the post-reform contributions would be calculated using the new formulas. 4. This Law was initially vetoed by the President, resubmitted to Parliament, and then approved by the President, who turned it over to the Constitutional Court for a ruling. The Constitutional Court declared key parts of the Law unconstitutional. After elections, the Annex VI1 Page 2 of 4 Government chose to amend the Law to address the issues raised by the ConstitutionalCourt. Specifically, the Court raised the issue of the lack of a reliable wage series in Turkey and the wish to see economic growth included in the revaluation parameter. The Government has responded by changing the revaluationparameter to 100 percent of inflation and 30 percent of real GDP growth. The Court also raised the issue of maintaining a separate system for civil servants and indexing civil servant pensions to salary growth of current civil servants, but tempered this ruling by also suggesting that the system would need to be fiscally sustainable. The Government has chosen to grandfather the existing civil servants under their separate system, but to changethe parametersapplyingto new civil servantsto bringthem inline with the pensionparametersappliedto all other workers inTurkey. All of the parametersof the new and old lawsare showninTable A3. 5. In response to severe strikes by labor unions in March 2008, the Government also has allowedexistingprivate sector workers to earn an accrual rate of 3 percentfor their first 10years, and all private sector workers, new and existing, to retire at full pension with only 20 years of contributions. 6. The Government added a coupleof additionalmeasures. One establisheda minimumold age pensionof 35 percent of minimum wage for pensionerswithout dependents, and 40 percent of minimum wage for pensionerswith dependents. The other exemptedall workers earning less than the legal minimum wage from paying contributions. This latter measure may have been recognitionthat collecting contributions at minimum wage from workers who contribute at less than half minimum wage would have been difficult, even not impossible. Nevertheless, these workers who previouslycontributedfor healthbenefitswill receive at least a partialsubsidy from Government for healthinsurance and will no longer receiveanything, but the means-testedsocial pensioninold age. 7. The fiscal implicationsof the new Law relativeto the current system are shown inFigure A1 under the assumptionthat no behavioral changes take place. Clearly, there are major fiscal improvementsboth inthe medium and longterm from undertakingthese reforms. There is still some risk that the constitutional court will not accept the unified parameters for new civil servants in addition to their concerns over existing civil servants. But even in this case, the reformsare a substantial improvementover the current systemalthoughthe longterm deficit will remaintoo highto be permanentlysustainableinthis case. 8. However, it should be noted that the parameters chosen might entice some workers and employers to respond by reducing their contribution period and reducing it to the minimum required years prior to retirement. The particular problematic parameters are the level of the minimumpensionand the revaluationof past wages. The minimumpensionis set at 35 percent of minimum wage for all pensioners,whether basedon partialwork history or full work history. For minimum wage workers with the minimum contributionperiod of 15 years, the benefit rate would only be 30 percent of minimum wage if the past wages had been revalued in line with average wage growth. Since they are revalued only approximately with 40 percent of average wage growth, there will be a substantial subsidy to these workers from the minimum pension. Shouldworkers respondto this incentive, the revenuesshown inFigure A1 will be lower as will expenditures inthe longerrun. Annex VI1 Page 3 of 4 FigureAl: Turkey's PensionDeficit Before and After Reform 0.0% -1.O% p, -2.0% n il 3 -3.0% & L -5.0% -6.0% Year -Bas e I.. IReform for private sector only -+-Reform for private sector and self-employed =~~*~~'*~=i~~** Reform for all Table A3: Pension ParametersBefore and After the Law Before L a No. 5510 Law No. 5510 as Original Law Private Bag-Kur Self- Bag-Kur Civil Servants Amended by Law No. 5510 Sector Employed Farmers No. 5754 Employees ~~ Retirement Gradual transition Gradual Gradual Gradual Gradual Gradual from 38 and 43 for transition from transition from transition from transition from transition from female and male, 38 and 43 for 38 and 43 for 38 and 43 for 38 and 43 for 38 and 43 for respectivelyto 58 female and male, female and female and female and female and and 60 for female respectivelyto male, male, male, male, and male, for those 58 and 60 for respectively to respectivelyto respectivelyto respectively to beginning work female and male, 58 and 60 for 58 and 60 for 58 and 60 for 58 and 60 for after 1999, and for those female and female and female and female and transition to 65 for beginning work male, for those male, for those male, for those male, for those both men and after 1999,and beginning beginning work beginning work beginning women for those transition to 65 work after after 1999 after 1999 work after beginning work in for both men 1999 1999 2009 and who and women for complete their those beginning minimum work in 2007 contribution period after 2048 Contribution Gradual increase Gradual increase Gradual 25 years o f 25 years of 25 years of Period from 14 years to from 14 years to increase from contribution; contribution; contribution Annex VI1 Page 4 of 4 Table A3: Pension Parameters Before and After the Law Before Lr No. 5510 Law No. 5510 as Original Law Private Bag-Kur Self- Bag-Kur Civil Servants Amended by Law No.5510 Sector Employed Farmers No.5754 Employees 19.4 years for 19.4 years for 14 years to partial pension partial pension for men; 20 those beginning those beginning 19.4years for available for available for years for work after 1999 work after 1999 those shorter shorter women; and further and further beginning duration duration increaseto 20 increase to 25 work after years for those years for those 1999; partial beginning work beginning work pension after April 30, in 2007 as available for 2008 as private private sector shorter sector employees; employees; duration partial pension partial pension available for available for shorter duration shorter duration Benefit 2% per year of 2.5% per year of 3.5% for first 3.5% for first 70% for 25 75% for 25 Accrual Rate contribution for all contribution 10years; 2% 10 years; 2% years, reduced years, reduced except existing until 2015 and for next 15 for next 15 by 1% per year by 1% per year civil servants, 2% thereafter years, and years, and for shorter for shorter private sector 1.5% I.5% thereafter duration before duration employees and self thereafter 1999; 3.5% for employed, who first 10 years, will receive 3% per 2% for next 15 year for their first years, and 1.5% I O years and 2% thereafter per year subsequently Averaging Gradually moving Gradually Gradually Gradually Gradually Last salary Period for to lifetime earnings moving to moving to moving to moving to Wages Used for all except lifetime earnings lifetime lifetime lifetime in Pension current civil earnings earnings tarnings Calculation servants Revaluation 100% inflation 50% inflation 100% nominal 100% nominal 100% wage 100% wage of past plus 30% of real plus 50% GDP growth GDP growth growth of civil growth of civil earnings GDP growth for all average nominal servants servants except current civil wage growth servants Indexation of 100% inflation for 100%inflation 100% inflation 100%inflation 100% inflation 100%wage pensions, all except current growth of civil post- civil servants servants retirement Minimum 35% of minimum No minimum Determined by Determinedby Determinedby Determined Pension wage, raised to pension Council of Council of Council of by Council of 40% ifpensioner Ministers Ministers Ministers Ministers has dependent spouse or child Contribution 20% for pensions 20% for 20% for 20% for 20% for 36% for Rate except for civil pensions pensions pensions pensions pensions and servants retiree health Minimum Minimum wage - Minimum wage Minimum Step 1 on an Step 1on an Contribution all those earning wage income table income table Base below minimum wage are not mandatoriIy insured Annex VI11 Page 1 of 4 ANNEXVIIk POVERTY AND DISTRIBUTIONAL IMPACTS OF PPDPLREFORMS 1. The actions and reforms supported under this PPDPL 2 program are expected to have, overall, positive distributional and poverty impacts in Turkey. Ina broader context, the program aims to contribute to macroeconomic stability by maintaining an enabling macroeconomic environment and by improving fiscal sustainability o f the social security system-ultimately creating fiscal space for growth enhancing expenditures. The recent past provides evidence o f how effective a sustained high growth could be in reducing poverty as about 7 million people were pulled out of poverty since 2003. In a more specific context, several o f the actions supported under the program are expected to have direct positive impacts, most importantly the implementation of the UHI. Several others, including the pension reform under the revised Social Security and UHI Law, are expected to have more indirect, albeit important, positive impacts. 2. UHI component of revised Social Security and UHI Law No. 5510: expected direct positive distributional and poverty impacts if coverage expansion and exemptions are realized as planned. First, Government plans to extend free formal health insurance coverage (with premiums paid for by Treasury) to all those falling below a specific level of per capita income (1/3 o f per capita gross minimumwage which is relatively close, albeit slightly above, the current per capita poverty line for an average family). Today's effective free health insurance coverage through the Green Card system reaches about 9 million households but undercoverage o f the poorest two deciles remains important - the estimated effective coverage rate o f the poorest decile i s 54 percent, o f the second poorest decile 34 percent. The actions supported through PPDPL 2 include authorizing SSI to develop and apply advance screening methods to reach these beneficiaries and extend the effective coverage o f the poor. Second, the Law also introduces several partial premium subsidies for today's uncovered population that do not qualify for free coverage but are unable to pay full premiumpayments. 3. The realization o f such potential positive impacts will depend on a number of factors, however. First, the design and implementationo f the exemption policy during the next two years will be core to extending effective financial protection to all the poor. Direct means testing (income or consumption assessment) i s not being used in Turkey today given the large share o f the working population in the informal sector (around half) as well as existing local administrative capacities. But Turkey does have positive experiences with the application o f proxy means testing under the conditional cash transfer program which reaches 2.6 million beneficiaries. The extension (and implementation at the local level) for such testing to an additional 10 million people (or roughly 2.5 million households) which are, according to the administrative data, not covered today, will require a substantial administrative effort and capacity building - only than will the exemption policy reach the poor effectively. Second, complementary to the reach o f the poor and vulnerable i s an effective delivery o f a package o f health services covered by the insurance. Given that private service providers will be able to charge co-payments (with the specific level to be determinedby the Council o f Ministers), most o f the poorer population will continue to seek care through public providers. The setting of incentives through relative provider prices as well as the human resources policy in the public sector will be key to ensuring continued good quality public provider care. Third, the success o f the implementation of the UHI itself - and thereby its ability to provide effective financial protection for the poor - will also depend on an overall containment o f health costs which have Annex VI11 Page 2 of 4 risen fast in the past years. An unsustainable increase o f overall health expenditures could both underminethe implementation of the reform itself as well as the effective implementation o f the exemption policy. 4. Pension component o f revised Social Security and UHI Law; potential indirect positive distributional and poverty impacts. The pension reforms o f the revised Social Security and UHI Law are geared to make the system fiscally sustainable as well as to improve horizontal equity. Few o ftoday's poor are contributing to the formal pension system so the benefitsfrom increasing the likelihood o f pensionpayments inthe future (given that the system becomes sustainable) are relatively small. However, potential indirect positive impacts could be realized. First, over the medium-run, the parametric reforms are going to create fiscal space (by reducing the pension deficit-which i s predicted to increase in the long term up to 7 percent o f old-GDP unless reformed-from today's 4 percent o f old-GDP to about 2 percent by 2035 and below 0.5 percent in the longer term) and albeit the use of such fiscal space will depend on economic and social considerations in the future, it would allow for additional expenditures (or a reduced overall borrowing requirement o f Government) which are potentially more progressive than the current tax financing o f the deficit that does not benefit the poor. Second, the parametric reforms would strengthenthe expected benefits from formalization from the workers' perspective by increasing the likelihood o f pension payments in the future - and while demand from formal private enterprises appears to play a very important role in determining the choice o f formal/informal work contracts today, such increased expected benefits could have an important positive impact on formal employment in the future. More workers could then benefit from access to income- maintenance instruments for their old-age. 5. Other actions and reforms supported by PPDPL 2: dependent on further actions/reforms to materialize positive distributional and poverty reduction potential. Apart from the above direct (UHI) and more indirect (pension parametric reform) poverty and distributional impacts, several other PPDPL 2 supported reforms and actions also have the potential o f benefiting the poor - but, at this stage, the materialization o f such benefits are somewhat more removed from those pertaining to the policy actions mentioned above. They are summarized in Table A 4 below. 6. The reforms supported by the PPDPL program are also likely to have a positive impact on gender equality. Women will benefit disproportionately from the introduction o f UHI, where those currently uncovered (estimated at between 6 and 22 percent o f the population) will be provided with full basic health coverage. Currently those without formal coverage, and many of those with Green Card coverage, receive rudimentary or even no basic health care, although critical health conditions are invariably treated by hospitals even when the patient has no coverage. This results in many simple health problems escalating to more acute conditions. Although there i s little evidence o f the uninsuredbeingrefused care, there are clearly increases in female morbidity and a general lack o f efficiency resulting from this very imperfect system. Extending improved quality ante-natal and other health care services to all women through UHI will result in a major welfare gain and help Turkey to meet its MillenniumDevelopment Goals on infant and maternal mortality. Annex VI11 Page 3 of 4 Table A4: Potenti 1 Poverty and Distributional Benefits f Other PPDPL 2 Actions Action/Reform Content Potential Poverty/Distribution Link Budget and PFM Reform Number of actionsheforms aimedto Giventhe high degree of improvepublic service delivery dependence of the more vulnerable through, inter alia, improving populationon public services strategic planning, linking policiesto (infrastructure, householdbasic budget allocations, introducing services, and social services), performancebudgeting, introduction improvements of strategic planning of operations & maintenance o f particular importance for the framework. poorer parts of society. Continuationof actiordreforms necessary so that benefits can materialize. Public service quality needs to be monitoredcontinuously. ImprovingJudicial System Supportedactions/reforms aimed to Potentialto benefitpopulationat ease backlogo f cases injudicial large by improvingaccess to justice system, improvedjudicial services, services, includingthe more more effectiveresourcethrough vulnerable and contributingto establishment of regionalcourt of improvingthe businessenvironment appeals, online connectionbetween and confidence in the economy courts, trainingprograms forjudges. eventually leadingto better labor market outcomes. Actions are necessary first steps which future pro-poorjustice reform can build on (taking into accountthe specific bottlenecksfor most vulnerable). Decentralizationand PPDPL program supports regional Improvingregionalcapacity and Regional Development development and loweringof local administrative capabilitiesin regionaldisparities through support the poorer areas o fthe country (East for establishment of DAs, capacity and South-East)will be necessary building at the local level, and for effectiveand better local public launching of growthpole program. service delivery (either individual services for householdsor area services in infrastructure). Improving capacities, planning capabilitiesand empowering local communities is medium- to long-run processand will dependon the distributionof local support functions beweenregions itself (as today's better-offregionsmight be able to benefitmore from central support inthe short-run). 7. Inthe case of pension reform, the issues are more nuancedand complex. Currently, as in many countries, women working in the formal sector effectively gain a higher rate of return on their pension contributions due to a lower retirement age and greater longevity. However, relatively few women are currently contributing (or beneficiaries) of the pension system and the fiscal sustainability - and with it the likelihood of the pension system actually rewarding those that have contributed during the working life - i s low. While the pension reform supported by the PPDPL series equalizes the pro-female difference in the current system, it will raise the Annex VI11 Page 4 of 4 likelihood o f receiving pension payments significantly. It i s also expected, and Government i s making significant efforts through other reforms, to increase the effective protection o f the work force by encouraging formal and more flexible employment, which should especially impact on the share o fthe female work force covered bythe pensionregime inthe future. 8. Complementarity o f PPDPL Program to Other Reforms: The reforms inthe PPDPL series are complementary to reforms supported through other Bank lending instruments, most importantly regarding labor market reform. Most importantly among these i s the labor market reform which i s supported through the CEDPL (P074181). The social security reform and the envisaged improvements in fiscal balances are expected to lay the ground for labor market reforms. With employment generation as well as advance on the job ladder beingthe most direct possibility for poorer families to improve their well-being, labor market actions and reforms that contribute to job creation and better risk protection o f workers are core to any anti-poverty strategy. The Bank has undertaken a significant amount o f analytical work on labor markets in Turkey over the past years, including a Labor Market Study (2006) and a report on youth employment as well as the labor market impact of a reduction in social security taxation. These form the analytical basis for the Bank's support inthis area. Annex IX Page 1 of3 ANNEXIx:DECENTRALIZATION FISCAL AND RISKS:INTERNATIONALEXPERIENCE 1. Over the last twenty years, over two thirds o f the world's nations (excluding microstates) have embarked upon some form of decentralization which can take several forms. Perhaps the most important -even the sine qua non- aspect o f decentralization i s political: the transformation o f former administrative units o f central government into separate political entities, with leadership chosen through local elections rather than by central appointment. Decentralization can also take the form o f explicit transfers o f functional responsibilities to local administrations. It may involve an increase in local resources, either through an expansion o f local taxing powers or an increase in intergovernmental transfers. Decentralization can also take the more subtle form of deregulation, such as the removal of the central government's authority to approve local budgets or control the number or salary levels o f local staff, 2. Inprinciple, decentralization can increase the efficiency and responsiveness of the public sector. Devolving resource allocation decisions to locally elected leaders can improve the match between the mix of services produced by the public sector and the preferences o f the local population. (Oates 1972). This is, inpart, because local officials are better acquainted with local conditions and priorities than their counterparts at the central level. In addition, they are more accessible to their constituents and can be held accountable for local results through local elections. (Ostrom, Schroeder, and Wynne 1993). Decentralization can also increase the variety o f services provided in different jurisdictions, allowing citizens to "vote with their feet'' and locate themselves injurisdictions that match their particular preferences. (Tiebout 1956; Inman and Rubenfeld 1997). 3. There are downside risks to decentralization. First, o f course, is the risk that locally elected officials may be no more responsive to their constituents than their centrally-appointed predecessors. Local democracy i s a fallible instrument. Local governments are as susceptible to capture by special interests as officeholders at higher levels o f government. Decentralization also carries other, more inherent, risks. Local governments are likely to take a parochial view o f the public interest. In making spending decisions, they can be expected to take only the interests o f their constituents into account. This may be a virtue when the issue is the frequency of garbage collection, but not when it involves services, such as sewage treatment, that affect other jurisdictions. Functional decentralization may run aground on the limited technical capacities o f local government. Local governments-particularly small ones-often have difficulty attracting and retaining qualified staff. It may also widen disparities in the quality o f services offered by different jurisdiction. In the absence o f central financial support, decentralizing primary education can result inwider variations inper student spendingthan might be desirable. 4. Decentralization may also pose macroeconomic risks.These can take several forms: Structural deficits 5. Long term structural deficits can arise when governments increase the resources o f local governments without transferring a corresponding level of expenditure responsibilities. Brazil's 1988 Constitution, for example, required the federal government to transfer nearly half the proceeds of its two principal taxes to local administrations, but made no provision for a corresponding transfer o f expenditures. To reduce its resulting deficit, the Government was Annex I X Page 2 of 3 forced to increase its reliance on revenue sources not subject to sharing-principally social security contributions-and make drastic cuts incapital spending. 6. Such deficits are not an inherent part o f decentralization. Governments can, and do, transfer expenditure responsibilities along with revenues. (In fact, governments in Eastern Europe and Africa have been more inclined to offload functional responsibilities without revenues than the other way around.) In the short term, one approach i s to limit the amount o f increases in local revenues to the amount the government was spending on the function in question inthe year before it was decentralized. This ensures budget neutrality. It i s not however, a long term solution, as it locks in an arbitrary level and geographical distribution o f spending. Government can provide a more flexible and better targeted method o f allocation by incorporating the increased level o f funding into an existing revenue sharing formula or by distributing funds on an earmarked basis according to a formula specifically devised for the function in question. The recent EU accession countries, for example, distribute general revenue sharing on a mixed origidpopulation basis but distribute funding for teachers salaries on the basis o f enrollment. Note that in all such cases, governments need to adopt a transitional arrangement to avoid sudden cuts in the revenues o f individual jurisdictions. This can be accomplished through the use o f buffers (Le., a limit on the percentage change in transfers from one year to the next) or, if affordable, through hold-harmless provisions that ensure that no jurisdiction will suffer a loss intransfer revenues, at least innominal terms. Loss of control overfiscal policy 7. Decentralization can also hamper a government's ability to exercise fiscal policy, by ceding control over major tax instrumentsto local administrations or by permanently obligating central governments to share a fixed proportion o f their revenues with local units. Under these circumstances, central governments may find themselves unable to generate sufficient revenue for the national government. Again, this i s not an inherent drawback. Governments in Eastern Europe, for example, fix the level o f transfers on an annual basis, taking into account both local and macro-economic interests. Local borrowing 8. But it is not only structural imbalances betweenrevenuesand expenditures or the loss o f control over fiscal policy that constitute the fiscal risks o f decentralization. There i s also the risk that newly empowered local governments may borrow excessively and then force central governments to come to their relief. 9. Subnational governments borrow in a variety o f ways. They run up salary arrears to their employees. They run up arrears to contractors, suppliers, and public utilities. They fail to pay their employees' social security or income tax obligations to the central authorities. They also undertake more explicit forms o f debt. They borrow from private domestic and foreign banks. They borrow from IFIs, with or without government guarantees. Some float bonds. 10. Some such forms o f borrowing would appear to be self-limiting. Suppliers are unlikelyto continue to extend credit if they go unpaid. Unpaid public employees may go on strike. Private banks, with their own capital at risk, would appear to have a strong incentive to lend prudently. But evidence suggests otherwise. Recent history is littered with cases o f sub-national governments that have run up unsustainable levels o f debt and have appealed, successfully, to Annex IX Page 3 of 3 central governments for debt relief. This creates a clear moral hazard. It encourages sub-national governments to over-borrow and creditors to over-lend, secure inthe knowledge that the national government will come to their mutualrelief. 11. One solution to this problem i s regulation. Many countries in Latin America and Eastern Europe, for example, impose ceilings on local government borrowing. These typically take the form of maximum debt service-to-revenue ratios or debt stock-to-revenue ratios. Some permit central governments to withhold debt service from intergovernmental transfers. Some also regulate the supply of credit, imposing high reserve requirements on banks for loans to local government. A few have introduced bankruptcy procedures, which, in extremis, turn local financial decision-making power over to a court- or government-appointed receiver, until such time as the local government is able to meet its obligations. 12. Regulation is only as effective as the political willingness to enforce it. Inthe absence of consistent and comprehensive enforcement, it is sometimes necessaryfor a central government to demonstrate the consequences of irresponsible borrowing by standing aside while a local government defaults. Once private lenders are persuaded that lending to sub-national governments carries real risks, they may be more likely to confine their loans to local governments that are likely to repay. Map section TURKEY PROVINCE CAPITALS* NATIONAL CAPITAL RIVERS TURKEY MAIN ROADS RAILROADS PROVINCE BOUNDARIES* This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other information INTERNATIONAL BOUNDARIES shown on this map do not imply, on the part of The World Bank Group, any judgment on the legal status of any territory, or any endorsement or acceptance of such boundaries. *Province names are the same as their capitals. 26°E 28°E 30°E 32°E 34°E 36°E 38°E RUSSIAN FEDERATION RUSSIAN FEDERATION BULGARIA BULGARIA Black Sea 0 50 100 150 200 Kilometers To To To To 42°N Burgas Burgas Kurdzhali Kurdzhali 0 50 100 150 Miles GEORGIAGEORGIA 42°N Edirne Edirne Sinop Kirklareli Kirklareli To To Bartin GREECKomatiniDardanelles E Bosporus BatumiBatumi Zonguldak Tekirdag kirdag Istanbul Istanbul KastamonouKastamonou Kuzey Samsun Artvin Artvin Kura To To To KarabükKarabük Ardahan Ardahan Sea of KocaeliKocaeli Trabzon KirovakanKirovakan AZER-AZER- (Izmit) (Izmit) DüzceDüzce Anadolu Ordu Marmara Devrez Rize Rize Yalova lova BAIJAN BAIJAN SakaryaSakarya Daglari GiresunGiresun BoluBolu Kars Kars (Adapazari)(Adapazari) ÇankiriÇankiri Kizil Amasya Amasya Çorum Çorum Çoruh ARMENIAARMENIA 40°N Kelkit ¸ Çanakkale Çanakkale GümüshaneGümüshane 40°N Bursa Bursa Bilecik Bilecik Tokat To Baybur Bayburt Agri Dagi Sakarya Aras (5166 m) Balikesir Balikesir Eskisehir Eskisehir ANKARAANKARA Cekerek Igdir Igdir Erzurum Erzurum AgriAgri Kirikkale Kirikkale ErzincanErzincan Yozgat zgat Sivas Sivas Kütahya Kütahya Firat To To AZER.AZER. Maku Maku Kizil Kirsehir Kirsehir Tunceli nceli Afyon Afyon BingölBingöl Manisa Manisa Izmir Izmir Lake ISLAMIC Usak Usak Tu Tuz To To GölüGölü ElazigElazig Murat MusMus Van VanVa AksehirAksehir NevsehirNevsehir Salmas Salmas KayseriKayseri REP. OF 38°N GölüGölü BitlisBitlis AksarayAksaray Aydin Ay MalatyaMalatya HoyranHoyran IRAN Gölü Gölü DiyarbakirDiyarbakir Siirt Siir Denizli Denizli NigdeNigde Batman Batman To To BaysehirBaysehir AdiyamanAdiyaman Burdur Burdur Oroumieh Oroumieh IspartaIspartaGölüGölü KonyaKonya Kahraman Kahraman Tigris HakkariHakkari MuglaMugla Seyhan Ceyhan Maras Maras SirnakSirnak GREECE Euphrates MardinMardin To To Osmaniye Osmaniye Gaziantep Gaziantep Dahuk Dahuk Sanliurfa Sanliurfa To Damir Damir Antalya Antalya Göksu KaramanKaraman Kabu Kabu Adana Adana To To Al Hasakah Al Hasakah IBRD Gulf of Icel Kilis Kilis Antalya IRAQ IRAQ 36°N To To JUNE Toros Daglari (Mersin) Hatay (Antakya) Aleppo Aleppo 33501R1 SYRIAN ARAB SYRIAN ARAB 2007 Mediterranean Sea 28°E 30°E 32°E 34°E REPUBLIC REPUBLIC To Ladhiqiyah 42°E 44°E