Ankara, June 26, 2001

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

Dear Mr. Köhler:

1.   We have continued to make good progress in implementing the ambitious agenda spelled out in the Memorandum on Economic Policies (MEP) attached to our letter dated May 3, 2001. In that letter, we presented our strategy for overcoming the recent crises and putting Turkey on a path to sustainable growth. This strategy relies on strong structural reforms, prudent fiscal and monetary policies under a floating exchange rate regime, and an enhanced social dialogue. Following the completion of the sixth and seventh reviews on May 15, we have maintained a good record in implementing our program. The quantitative performance criteria for end-May were observed with large margins, and we have taken further steps in banking and other structural areas (Annexes A and B). Indeed, since May 3 parliament has continued to work with extreme speed. It has approved all the laws and legal amendments foreseen in the program, providing an impressive record of structural reform. On this basis, we request completion of the eighth review under the stand-by arrangement. We also request modification of the ceilings for the performance criterion on the cumulative primary expenditure of the central government for the remainder of 2001, in line with the supplementary budget adopted by parliament on June 14 (Annex C).

2.   We have been encouraged by the initial results of our program. The benchmark treasury bill rate fell by over 50 percentage points between mid-April and mid-June. After the sharp increases in the price level in March and April following the large depreciation, the more modest price increases in May indicate that CPI inflation remains on a path broadly consistent with our initial inflation estimates. While we have not yet moved to formal inflation targeting, which we intend to implement as soon as feasible, we are projecting CPI inflation at 18 percent in the second half of the year, and we aim at bringing inflation down to about 2 percent per month (on a seasonally adjusted basis) in the final quarter. Indicators of economic activity confirm a recession in the early part of the year, but we expect the restoration of confidence, strong export growth and expenditure switching, and record-high tourism activity to help initiate a recovery in the second half of the year, limiting the decline in GNP to the projected 3 percent in 2001. The developments on the external current account in the first quarter of the year are in line with the projected broad balance for the full year.

3.   We remain firmly committed to the unfaltering implementation of the program, with the help of strong international financing support and an open communications policy. The May 3 letter remains the main document describing our policies for 2001–02, and is updated in the present letter in a number of areas. To fulfill the program's financing needs, we have secured substantial official and private financing. The recent augmentation of IMF support under the stand-by arrangement and the forthcoming support from the World Bank under the Programmatic Financial and Public Sector Adjustment Loan are the key elements of the official financing package. As for private sector involvement, we recently held meetings with foreign banks in Frankfurt and New York, and have received commitments from these banks to maintain their current exposure to Turkish banks and to seek to rebuild their interbank and trade credit lines as the program is implemented. On our communication policy, we are taking a number of initiatives to better explain the economic program to the investor community and the public at large. We have published the May 3 letter and the MEP and, for the first time, agreed to the publication of the IMF staff report. The Treasury has hired new external communication staff, enhanced the contents and frequency of press releases, and is preparing fact sheets on aspects of the program on its website. The Central Bank of Turkey (CBT) and the Bank Regulation and Supervision Agency (BRSA) have both held meetings with the media and the banking community to explain the program, and have posted information about the program on their respective websites.

Incomes policy

4.   Incomes policy will continue to play an important role in the program. Wage negotiations for public sector workers were concluded in late May. We estimate that the two-year agreement will lower the ratio of average net salaries of public sector workers and civil servants from 2.6 in 2000 to 2.2 in the first contract year before raising it to 2.3 in the second contract year. While the agreement therefore results in a significant realignment of the relative wage of public sector workers in 2001, the outcome was not fully in line with our objectives. Nevertheless, the unions agreed to postpone payment of the wage increase slated for the first six months of the contract to early 2002, and the agreement involves a substantial decline in real wages in 2001. To offset the additional cost to the public sector of about 0.4 percent of GNP in 2001, we have taken a number of measures to achieve the targeted increase in the public sector primary surplus (see paragraph 7 below). Moreover, we will strengthen the dialogue with social partners to encourage moderate wage and price increases in the private sector. To this end, the Economic and Social Council will meet at least once a quarter and will become more central to the dialogue now that its legal status has been strengthened. In these meetings, the achievements and objectives of the program will be highlighted, and we will encourage forward-looking price- and wage-setting behavior anchored to the program's targets, including through wage and price guidelines for the private sector consistent with the inflation objective. In addition, the Minister of State for Economic Affairs will continue to make a determined outreach effort to labor unions, industrialists, employers, and bankers.

Fiscal policy

5.   Our fiscal efforts in 2001 have been strong. In the consolidated central government, the primary surplus (excluding privatization proceeds, transfers of profits from the CBT, interest receipts, and the cost of state banks' recapitalization) through April at 1.8 percent of annual GNP was somewhat above our projections, owing to the strong performance of the withholding tax on interest income in April, and preliminary data for May suggest an even larger, and more broad-based, overperformance. Regarding policy efforts, in May we raised VAT rates as planned, and increased the minimum contribution base relevant for social security payments by 40 percent, while increasing the contribution ceiling from four to five times the minimum contribution. We also raised petroleum consumption taxes by over 20 percent in May and by 16 percent in June, more than originally planned. In the state enterprise sector, we have made substantial progress in implementing the comprehensive set of measures specified in paragraph 32 of the May 3 MEP. With the exception of the public sector wage agreement and the grain support price decision (see next paragraph), all these measures have been implemented as planned.

6.   Nevertheless, there have been some deviations from original plans. The public sector wage agreement will add TL 250 trillion to the central government wage bill and TL 410 trillion to the wage bill of state enterprises this year. We will also need TL 80 trillion more than originally budgeted to cover the additional civil service wage bill arising from slightly higher-than-projected CPI increases earlier this year. Moreover, the increase in the wheat support price by a weighted average of 63.4 percent exceeded targeted inflation, resulting in an additional cost to the public sector of TL 200 trillion. Finally, in line with World Bank advice, we have increased direct income support to farmers by TL 100 trillion compared with the May program. All in all, these deviations add some TL 1 quadrillion (0.6 percent of GNP) to public expenditure this year.

7.   We have taken offsetting measures to remain on track to meet our public sector primary surplus target of 5.5 percent of GNP in 2001. Achieving this target is a key part of our strategy to ensure a sustainable debt position. The additional measures we have already put in place are as follows. First, as mentioned above, we raised petroleum consumption taxes in May and June more than originally planned, and in the remainder of the year will increase them monthly at least by WPI inflation. Second, in the state enterprise sector, we have decided to increase electricity and gas prices more than originally planned. Specifically, the average price of electricity sold by TEAS (the electricity generation company) will rise gradually to US$5.1 cents/kwh by the end of the year, so as to achieve an average of US$4.5 cents over the year, the tariffs of TEDAS (the electricity distribution company) will increase accordingly, and the average sale price of BOTAS (the natural gas company) will reflect input costs strictly. Third, on June 11 TEKEL (the tobacco and alcohol company) increased cigarette and alcohol prices by 16-22 percent. Fourth, to increase the activity of private traders in the grain market and to allow TMO (the soil products office) to regulate the market with minimum cost, the government has issued a decree setting the margin between the purchase and sale prices at 18-26 percent, compared with 12-20 percent last year. In total, the above-mentioned measures are estimated to yield 0.3 percent of GNP in the remainder of the year. We believe that these measures, together with the stronger-than-expected revenue performance in April and May (with a full-year effect of 0.3 percent of GNP), will fully compensate for the remaining additional fiscal cost of the deviations mentioned in the previous paragraph.

8.   On June 14, parliament approved a supplementary budget for 2001 consistent with the program objectives, meeting a condition for the completion of the eighth review. This budget targets the consolidated central government primary surplus at 5.2 percent of GNP (excluding privatization proceeds, transfers from the CBT, interest receipts, and the cost of state banks' recapitalization) and incorporates the impact of all the revenue and expenditure measures described in detail in paragraphs 30-31 of the MEP attached to our letter of May 3. While the supplementary budget provides only an overall envelope for expenditure, we will protect the real value of spending on health, education, and social areas. To ensure that the primary surplus target is reached, the Ministry of Finance stands ready, if necessary, to issue directives to reduce discretionary noninterest expenditure relative to budget allocations during the year.

9.   Supporting measures are being introduced to reduce government borrowing costs and facilitate the placement of government debt. The Treasury's domestic borrowing program for June is based on the strong primary budget position and the use of external resources, allowing for a sharp reduction in the domestic debt rollover ratio to 47 percent for this month. Strong fiscal policy and the use of additional external assistance are expected to keep the Treasury's domestic borrowing need well below redemptions during the second half of 2001. To reduce this need further and lengthen the maturity on domestic debt, the government has undertaken a voluntary debt swap, prepared with the help of advisors from two international investment banks. The auction held on June 15 was successful, resulting in an exchange of some US$8 billion of short-maturity Turkish lira government paper for a mix of longer-dated Turkish lira and foreign exchange indexed government paper. Other steps to improve debt management are also being taken. A committee of public and private sector representatives will announce in July its proposals to institute a strengthened primary dealer system by end-August. The legal framework for debt management will be provided by a new Law on Public Finance and Debt Management. Preparations are on track for the draft Law to be submitted to parliament by end-June.

Monetary and exchange rate policy

10.   In its pursuit of price stability in the transition toward direct inflation targeting, the CBT will continue to focus on the control of monetary aggregates under the floating exchange rate regime. Developments through May—base money below (but close to) the program's indicative ceiling, and inflation and growth broadly on the projected path—indicate that there is no need to revise the monetary parameters in the program at this point.¹ Hence, the CBT will aim to keep base money closely in line with the indicative ceilings specified in Annex E of the May 3 MEP. This base money path—designed to be consistent with our inflation and growth projections—will continue to be the key nominal anchor for the program. The CBT stands ready to raise money market rates even if base money is close to its target, should other inflation indicators suggest that the disinflation process is in jeopardy. Regarding NDA, as indicated in the May 3 MEP, the ceilings specified in the program allow for the bulk of the external financing to be used to reduce the government's borrowing needs, thereby facilitating a decline in interest rates and contributing to the sustainability of the government's debt position. To keep NDA within the targeted path, the CBT will adjust money market interest rates as needed. To offset the expansion of NDA resulting from the use of external financing, the floors on Net International Reserves (NIR) have been set to allow the CBT to mop up this additional liquidity through the sale of foreign exchange. Starting in July, the CBT will announce to the markets the timing and amounts of its auctions to sell foreign exchange tied to the external resources being lent to the government to alleviate its borrowing requirement. These sales of foreign exchange will coincide as much as possible with any creation of domestic liquidity generated by the use of those resources by the government in financing its domestic operations. Any other intervention in the foreign exchange market will be strictly limited to the smoothing of short-term fluctuations, and will be effected primarily through auctions. In this regard, the CBT will also refrain from lending or borrowing foreign exchange in the interbank market.

11.   The CBT is making progress in the preparatory work to move to a direct inflation targeting framework as soon as feasible. It is enhancing its information base, including through improving its structural and short-term models and preparing new surveys of financial markets' expectations about inflation and other macroeconomic indicators, which will start by September 2001. During the preparatory phase, the CBT will continue to discuss inflation targeting with officials from countries that are implementing such a monetary policy framework, and will seek further technical assistance as needed. The CBT is improving its communication strategy also in this area, to clarify both how monetary policy is being conducted in the transition to inflation targeting, and how it will be carried out once the transition is complete.

Structural policies

Banking

12.   We will make every effort to keep banking reform on track:

• The strengthening of state banks is progressing well. The three state banks with negative net worth (Ziraat, Halk, and Emlak) have been recapitalized to the regulatory levels. The overnight position of these banks (and the banks owned by the Savings Deposit Insurance Fund, SDIF) was eliminated by mid-June, and the stock of repurchase agreements of state and SDIF banks with the CBT was brought to below TL 7 quadrillion by end-May (both are conditions for completing the eighth review). A law (see below) has been approved by parliament to facilitate the closing of Emlak (that is, the revocation of its license) and the transfer of all its liabilities and some of its financial assets to Ziraat and Halk (another condition for completing the eighth review). Moreover, a reporting system has been put in place to monitor profits/losses, liquidity, and interest rate margins in the state banks. The reports generated by this system indicate that Ziraat and Halk now have positive margins and that deposit withdrawals have so far been limited. Independent outside auditors have also been appointed for each bank. Finally, a law has been passed by parliament to allow the implementation of several key measures in reforming state banks. The law includes provisions to (i) facilitate the closure of Emlak, (ii) promote the operational restructuring of state banks, and (iii) remove the government's power to impose duty losses in the future.

• Substantial progress has been made in the resolution of SDIF banks. The SDIF banks have been recapitalized to cover their negative net worth. We are in the process of finalizing the sale process of three banks: Demirbank, Bank Ekspres, and Sümerbank (the first transition bank). The closure of Ulusal has now been completed, with its assets and liabilities having been transferred to Sümerbank for resolution. The process of selling Iktisat will commence once the Sworn Bank Auditors finalize their evaluation of the bank's financial position. On June 15, the BRSA issued a decision to merge three of the remaining four SDIF banks (Etibank, Interbank, and Esbank) into a second transition bank (under Etibank), while the fourth one (Türk Ticaret) would be closed down. Merging these banks into a transition bank or placing them into liquidation is a condition for completing the eighth review.

• The capital bases of private banks are being strengthened. The BRSA has assessed the financial condition of all 27 private domestic deposit-taking banks, and commitment letters will be signed with all the banks identified as financially weak or undercapitalized (a condition for completing the eighth review). In these letters, the managements of individual banks will be required to commit themselves to take action, by specific dates, to strengthen the financial condition of their banks and to ensure appropriate capitalization levels. Initial steps in recapitalizing these banks will be taken immediately, and some capital will already be raised before end-June 2001, followed by additional capital augmentation steps from then until the end of year, by which date all banks are expected to be in full compliance with all prudential regulations. BRSA will promptly impose sanctions prescribed in the Banking Law on any bank that does not fully comply with the commitment letter. These sanctions range from the replacement of managers and board members in less severe cases to full intervention in the case of more serious violations. Assessment of compliance with the commitment letters will be a focus area in the subsequent program reviews.

• In May, the CBT put in place an enhanced monitoring system to provide weekly data on interest rates offered by individual banks. Combined with daily bank-by-bank data on interbank transactions, these data provide early warning of liquidity pressures and facilitate early intervention of problem banks.

• Legislative amendments and the newly-appointed professional BRSA Board will help reinforce the implementation of banking reforms. The amendments to the Banking Law enacted on May 28 have provided (i) immunity for BRSA staff from prosecution for actions taken while performing their duties; (ii) tax deductibility for specific loan loss provisions; (iii) that a regulation on connected lending in line with EU regulations will be issued by June 28, 2001 (a structural benchmark); and (iv) additional powers to the SDIF's Collection Department (COD) in carrying out loan recoveries. Moreover, we are in the process of fully staffing the COD, and preparing operational guidelines for loan recovery. In addition, we will transfer all the nonperforming loans of Sümerbank above TL 75 billion (some 1,200 loan files) to the COD by end-July. Finally, a law to eliminate the remaining tax hurdles for mergers, including in the financial sector, has been approved by parliament.

Enhancing the role of the private sector in the economy

13.   Privatization, including preparations for divestiture of large state-owned assets, is moving apace. We expect that a new professional board and management team of Türk Telekom will be put in place shortly, meeting a condition for completing the eighth review. The immediate priority of the new Telekom Board will be to adopt a plan for corporatization. The Privatization Administration is working on a privatization plan for Türk Telekom in accordance with the new Law, which the Ministry of Transport will present to the Council of Ministers as soon as the plan is finalized. While the timing of sale of individual enterprises will depend on market conditions (which in turn are linked to our progress in implementing the economic program and restoring financial stability), the Privatization Agency is moving ahead with the preparation for privatization of assets in its portfolio. Specifically, advisors have been engaged for the further sale of state participations in TUPRAS (the oil refinery) and POAS (petrol stations), and we expect that the public offering of both companies could be carried out in the fourth quarter of this year. Now that domestic air fares have been liberalized, the public offering for Turkish Airlines is also foreseen for the fourth quarter. Following the adoption of the Sugar Law in April and the new Tobacco Law in June (the latter is a condition for completing the eighth review), we will move ahead with the privatization of the sugar and tobacco factories in the context of our agricultural reform program supported by the World Bank. In the steel sector, a major operational restructuring involving the reduction of the workforce is underway, in preparation for the eventual privatization of ERDEMIR through a merger with ISDEMIR. Following a review of obstacles for the sale of state-owned land, legal amendments to facilitate these sales will be submitted to parliament by the summer recess. All in all, we believe that the targeted US$1 billion in privatization proceeds in the remainder of this year is well within reach.

14.   We are also making progress in improving the business climate. The law to implement the constitutional amendment on international arbitration was approved by parliament on June 21, meeting a structural benchmark. A study on administrative barriers to investment by the World Bank's Foreign Investment Advisory Service is expected to be completed in late June. In view of the need to incorporate the views of all relevant agencies, the conference to discuss the conclusions of this study can only be held in early September, and will be followed by the presentation of an action plan to the Council of Ministers shortly thereafter.

Transparency

15.   The work toward improving the transparency and efficiency of public management is moving ahead. In particular, we have adopted a tax regulation in June that extends the use of tax identification numbers (TINs) in the financial sector starting in September 2001, meeting a condition for completing the eighth review. The tax administration will make full use of the information provided by the TINs to broaden the tax base and improve compliance. We also remain committed to improving fiscal accounting and reporting. In May, the Treasury and IMF staff organized a two-day seminar on budget classification and accounting, and held technical discussions on how to move toward accrual accounting. Since then, we have started publishing in the monthly reports of the Treasury a "lending minus repayments" item to monitor the payments by Treasury of called guarantees and the amounts repaid. A new budget classification in line with international standards has been completed, and will be implemented in six pilot budget agencies for the 2002 budget. The law providing for the closure of the remaining 15 budgetary funds (except DFIF) and two extrabudgetary funds was approved by parliament on June 19, meeting an end-June structural benchmark.

16.   We are also moving ahead with a three-pronged plan to improve governance in the public sector and promote effective government. First, a Public Expenditure and Institutional Review (PEIR) was completed with a series of intra-governmental workshops in Ankara in May, with the support of the World Bank. An international conference will be held in November to disseminate and discuss the findings of the PEIR study. Second, an international conference on Promoting Good Governance and Anti-Corruption in Turkey will be held in early September, also with the support of the World Bank, to diagnose the problem, develop actions, and mobilize political support. Third, to strengthen the code of conduct of government officials, a law to streamline the prosecution of public officials has been forwarded to parliament.

17.   Following up on the fiscal transparency report completed last year, we are requesting the preparation of the data module of the IMF's Reports on Observance of Standards and Codes (ROSC). Last summer's ROSC module on fiscal transparency was well received. We believe that the data module will provide a useful assessment of our economic data and dissemination practices, further adding credibility and transparency to our economic data and policies. We expect an IMF team to visit Ankara in October to work with us on this report.

Very truly yours,