Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 5357-TU

STAFF APPRAISAL REPORT

TLTRKEY

PULP AND PAPER REHABILITATION PROJECT

April 5, 1985

Industry Department

This document bas a restricted distribution and mav be used by recipients only in the performance of'their official duties. Its contents mav not otherw-ise be disclosed w-ithout World Bank authorization.

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CUHRRENCY EQUIVALENTS (as of April 1984)

US$1.00 = Turkish Lira (TL) 325TL 1.00 = US$0.00308

FISCAL YEAR

January 1 - December 31

WEIGHTS AND MEASURES

I ton (t) = 1,000 kilsograms = 2,205 pounds1 meter (m) = 1.094 yards = 39.4 inches1 kilometer (km) = 1,000 neters = 0.'21 miles1 cubic meter (m3 ) = 35.3 cubic feet1 bone dry unit (BDU) = 2,400 bone dry pounds of wood chips1 hectare (ha) = 2.47 acres

Volume of wood expressed as m3 refers to solid wood volumeunder lbark

ABBREVIATIONS

DYB - Devlet Yatirim Bankasi (State Investment Bank)FAO - Food and Agriculture Organization of the United NationsGOT - Government of Turkey0GM - Orman Genel Mudurlugu (General Directorate of Forestry)SEE - State Economic EnterpriseSEKA - Turkiye Seluloz ve Kagit Fabrikalari General Mudurlugu

(SEE for Pulp and Paper)SFO - State Planning OrganizationTA - Technical AssistanceTSKB - Turkiye Sinai Kalkinma Bankasi (Industrial Development

Bank of Turkey)

FOR OFFICAL USE ONLYTURE

APPRAISAL OF THE PULP AND PAPER REHABILITATION PROJECT

TABLE OF CONTENTS

Page No.

I. INTRODUCTION .*.*....... ............... *...........1........

II. THE TURKISH PULP AND PAPER INDUSTRY ........................ 2

A. Economic Background ....... ................. 2B. The SEE System ... **................... 2C. Performance of the Industry ... *.......*..*.......... ... 3D. Historical Development ... .......................... .....** 4E. Structure of the Industry ............................... 4F. Fibrous Raw Material Resources ........................ 5

1. Total Fiber Consumption ......... .... . ..... .. .......... 52. Wood ...................... ........... ............ 53. Waste Paper ....... 74. Straw/Reed *......................................... 7

G. Government Policies in the Subsector .................... 8H. Privatization ........................................... 10I. Bank Role in the Subsector *............................ 11

III. THE COMPANY ....................................... 12

A. Background and Organization .................. ........... 12B. Management Information System .................. V ....... 14C. Production Performance ......... ............ ....... 14D. Reforms of Personnel Policy ............. .. ...... 15E. SEKA's Historical Financial Performance ................. 16F. Financial Restructuring ............................... 17G. SEKA's Prices and Pricing Policy ........................ 19

IV. THE MARKET ........ *.....e.... .. & ........................... 22

A. Background ..................................... o......... 22B. Projected Demand/Supply for Paper and Paperboard ........ 25

1. Aggregate Demand and Supply ..... ..................... 252. Newsprint ..... ,2763. Paperboard ........................................... 274. Pulp ................................ 29

C. Prices .......... .... *...* ....................... ... 301. General Market Influences ... *..*a .................... 302. Newsprint ................................................ 303. Paperboard ........ ............ . ........... .... . 324. Pulp ..................................... *.................. 32

Vo THE PROJECT ........ ................ ....... 32

A. Project Scope and Technology ............................ 32B. Project Description ................... ............... 34

1. Aksu Mill ........................................ O*............ 342. Dalaman Mill ..................................................... 34

This report was prepared by Messrs. R. Chalk, Y. Cookes, and K. Zamani ofthe Industry Department.

IThis document has a restriced distributon and may be used by recipients only in the performance oftheir official duties. Its contents way not otherwise be disdosed without World Bank authorization. |

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TABLE OF CONTENTS (Continued) Page No.

3. Afyon Hill **********s*a******........... ......... 354. Spare Parts .......................................... 355. Energy Conservation ...... ............................ 356. Technical Assistance Program .... ..................... 35

C. Wood Supply .... ......................................... 37

D. Environmental Impact .................................... 37E. Project Implementation Arrangements ............. ........ 38

VI. CAPITAL COSTS, FINANCING PLAN, PROCUREMENT AND DISBURSEME1IT 40

A. Capital Cost Estimate ... go .........-..... 40B. Financing Plan .......... ..... 41C. Channelling of the Proposed Loan .... .................... 42D. Procurement and Disbursement ............................ 42

VII. FINANCIAL. ANALYSIS .................... ........... .... 44

A. Basis of Projections .................................... 44

B. Sales Volume and Revenues with the Project .............. 45C. Production Costs . ..................................... 45

D. Financial Projections ....... .......................... 46

E. Financial Rate of Return and Sensitivity Analysis ....... 47F. Financial Covenants ..... ......... Os ............ 48G. Auditing and Reporting Requirements ..................... 48

VIII. ECONOMIC ANALYSIS AND RISKS ........... .................... 49

A. Introduction ...... ...................................... 49

B. Adjusted Costs and Benefits for Economic Analysis ....... 49C. Economic Rate of Return ................................. 49

D. Net Foreign Exchange Savings ................... 51E. Other Benefits ... .......... 8 .... 52F. Risks ................................... 52

IX. AGREEMENTS ................. ................................ 53

ANNEXES

2-1 Technical Assistance to the Go,ernment: Terms of Reference for Pulpand Paper Industry Study

3-1 SEKA - Historical Level of Employment3-2 SEKA - Historical Financial Performance, 1977-833-3 SEKA - Consolidated Projected Income Without the Project and Without

Restructuring3-4 SEKA - Cash Flow Projection Without the Project and Without

Restructuring3-5 SEKA - Consolidated Projected Balance Sheets Without the Project and

Without Restructuring3-6 SEKA - Comparison of List Price with Import Parity Price between July

1982 and January 1984 for Selected Grades/Comparison of List Pricewith Average Manufacturing Cost for Selected Grades in mid-1983

3-7 SEKA - Consolidated Projected Income Without the Project (with PriceIncreases and Restructuring)

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ANNEXES (cont.)

3-8 SEKA - Cash Flow Projections Without the Project (with PriceIncreases and Restructuring)

3-9 SEKA - Consolidated Projected Balance Sheets Without the Project(with Price Increases and Restructuring)

4-1 Historical Paper and Paperboard Consumption in Turkey4-2 Newsprint Prices for United Kingdom and India4-3 Comparison of 1983 CIF and Domestic Prices for Dalaman Mill Grades4-4 Bleached Short Fiber Pulp Price in Major European Importing Countries

5-1 Terms of Reference for Technical Assistance Program to SEKA

6-1 Capital Cost Estimate6-2 Projected Disbursement Schedule of the Proposed Bank Loan

7-1 Assumptions Used in Financial Analysis7-2 SEKA - Total Projected Production Volumes with and without Project7-3 SEKA's List Prices (April 1984)7-4 SEKA - Projected Production Costs with the Project for 19937-5 SEKA - Projected Production Costs without the Project for 19937-6 SEKA - Consolidated Projected Income with the Project (with Price

Increases and Restructuring)7-7 SEKA - Cash Flow Projections with the Project (with Price Increases

and Restructuring)7-8 SEKA - Consolidated Projected Balance Sheets with the Project (with

Price Increases and Restructuring)7-9 Cost and Benefit Streams for Aksu Mill Project Component7-10 Cost and Benefit Streams for Dalaman Mill Project Component7-11 Cost and Benefit Streams for Afyon Mill Project Component7-12 Cost and Benefit Streams for All Mill Project Components

8-1 Assumptions Used in Economic Analysis8-2 Economic Cost and Benefit Streams for Aksu Mill Project8-3 Economic Cost and Benefit Streams for Dalaman Mill Project8-4 Economic Cost and Benefit Streams for Afyon Mill Project8-5 Economic Cost and Benefit Streams for All Mill Project Components

MAP

IBRD - 18435 Turkey

DOCUMENTS AVAILABLE IN THE PROJECT FILE

Reference Title

1. Rehabilitation Project Feasibility Study for SEKA(6 volumes), April 22, 1983, prepared by Rust International

2. Software Study, Prepared by SEKA, (2 volumes) April 11, 19833. SEKA's Consolidated Balance Sheets for 1982 and 19834. Domestic Resource Cost (DRC) calculations

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TURKEY

PULP AND PAPER REHABILITATION PROJECT

Loan and Project Summary

Borrower: Government of Turkey

Beneficiary: SEKA, the State Economic Enterprise for Pulp and Paper,and the Government of Turkey

A.ount: US$55.1 million equivalent

Terms: Currently applicable variable Bank rate for a term of 17years including 4 years of grace.

ProjectDescription: The project would be the first phase of a continuing

restructuring and rehabilitation program for Turkey'spulp and paper industry. Technical assistance (TA) wouldbe provided to the Government and to SEKA, and physicalrehabilitation would be undertaken in several of SEKA'sexisting plants. The TA to the Government would providea comprehensive review of the pulp and paper subsectorincluding ar. in-depth study of the potential forselective privatization of SEKA facilities. The TA toSEKA would involve a wide-ranging program of managementand operational improvement, including study of the woodsupply, and help to develop a medium-term strategy forSEKA. Physical rehabilitation in three of SEKA's millswould provide for increased production, improved quality,and cost reduction. Critical spare parts would bepurchased, and energy-saving improvJements made in all ofSEKA's mills.

Benefitsand Risks: The TA to Government is expected to have a significant

impact on policies related to the pulp and papersubsector and its future development, including importantsteps toward the privatization of SEKA. The TA to SEKAwill provide substantial improvement in the managementand operation of SEKA with resulting improvement inprofitability. The physical rehabilitation will providesignificant economic and financial benefits withrelatively small capital investment. The economic andbefore-tax financial rates of return for the project as awhole are 41% and 34%, respectively. There are nosignificant risks associated with the physicalrehabilitation components of the pro,4ct. In the case ofTA to SEKA, there is a risk that recommended improvementsin management and operating procedures might be perceivedas threats by certain levels of SEKA's staff and lesd tolack of cooperation and reduction of expected benefits.To avoid this risk and to maximize the benefits, SEA' s

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own management and staff will play an active role indiagnosis of problems, and the planning andimplementation of the program. A second risk is thatprices would be lower and input costs higher thanprojected. Effective implementation of SEKA's pricingpolicy, which allows a wide latitude and freedom tomaintain market-oriented prices, plus the arrangementsfor wood supply, should minimize these risks.

Local Foreign Total- (US$ million) -

Estimated Cost: Plant Costs 17.8 30.6 48.4TA to SEKA 1.0 2.0 3.0Base Cost Estimate 18.8 32.6 51.4

Physical Contingencies 2.6 4.6 7.2Price Escalation 6.6 11.3 17.9Refinancing PPF - 0.6 0.6Working Capital 3.4 1.5 4.9Interest During Construction 0.2 4.2 4.4TA to Government 0.1 0.3 0.4

Total Financing Required 31.7 55.1 86.8

Local Foreign Total-- .(US$ million) --

Financing Plan: IBRD Loan - 55.1 55.1Government - Equity 31.6 - 31.6

- Contribution for Study 0.1 - 0.1

Total 31.7 55.1 86.8

Bank FY 1986 1987 1988 1989 1990EstimatedDisbursements: Annual 2.2 24.7 21.3 6.4 0.5

Cumulative 2.2 26.9 48.2 54.6 55.1

Economic Rateof Return: 41%.

TURE

PULP AND PAPER REHABILITATION PROJECT

I. INTRODUCTION

1.01 The Government of the Republic of Turkey (GOT) has requested aBank loan of US$55.1 million equivalent to finance the foreign exchangecosts of a project to begin the restructuring and rehabilitation of itspulp and paper industry.

1.02 The project would be undertaken by Turkiye Seluloz ve KagitFabrikalari Genel Mudurlugu (SEKA), the State Economic Enterprise (SEE),which owns and operates eight pulp and paper mills currently producing some70% of the country's pulp and paper requirements (Map IBRD No. 18435). Theproposed Bank loan would be made to the Government who would on-lendUS$54.8 million equivalent to SEKA to cover about 63% of the total amount(US$86.8 million equivalent) required to finance the Droject and 100% ofthe foreign exchange requirements. The Government would utilizeUS$0.3 million for Technical Assistance.

1.03 The project would be the first step towards restructuring andrehabilitation of Turkey's pulp and paper industry. A significantcomponent of the project would be Technical Assistance (TA) to theGovernment and to SEKA. The TA program to the Government would include acomprehensive study of the pulp and paper subsector to develop subsectorobjectives and strategies, including an appropriate structure for thesubsector, forest management and wood supply, and an in-depth review of thepossibilities for privatization of SERA, including assisting SEKA and theGovernment to identify suitable arrangements that could interest localprivate sector and/or international pulp and paper companies to invest inSEKA's operations. The TA to SEKA would involve a program of operationaland maintenance training, study and recommendations for improvement ofenvironmental protection, improvements to organization, manpower,financial/accounting and management information systems. Rehabilitationwork would be carried out in three of SEKA's mills which would benefit fromincreased production and improved product quality. In addition, theproject would provide funds for the import of critical spare parts and forthe implementation of certain energy-savifng improvements in all SEKA mills.

1.04 The project evolved from several government policies:(i) concentrating industrial invesLMent in the rehabilitation of existingindustrial capacity rather than building new plants; (ii) improving theefficiency of SEEs; and (iii) selective privatization of SEEs. The projectwas identified by the Industrial Projects Identification Mission to Turkeyin July 1980, and was prepared by the US consulting firm Rust Overseasincorporated (RUST) who were hired by SEKA using an advance from the Bank'sProject Preparation Facility. The project was appraised in October 1983,and M4ay 1984, by Messrs. Chalk, Crookes, and Zamani, of the IndustryDepartment.

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II. THE TURKISH PULP AND PAPER INDUSTRY

A. Economic Background

2.01 The Turkish economy, having grown at 6% annually between 1967 and1978 has undergone a marked transformation over the last decade, with theshare of industry in GDP rising to 23% in 1978 and to about 32% atpresent. The economic progress was, however, punctuated by severe balanceof payments crises in 1970 and 1977, mainly because of the country'soveremphasis on import substitution and inability to develop a strongexport base, coupled with heavy debt service on foreign borrowings. Theeconomic crisis in 1977 was a particularly serious one, following whichreal GDP increased by only 2.8% in 1978, and decreased by 0.9% in 1979, andby 0.7% in 1980. Real GDP, after falling for two consecutive years,expanded by 4.1% and 4.6% in 1981 and 1982, respectively. In 1983, GDPgrowth slowed to about 3.2% due in large part to the effect of adverseweather conditions on agricultural production. Industrial value addedincreased by an estimated 6.6%.

2.02 Turkey's development strategy prior to 1980 had given highpriority to industrialization based mainly on import substitution and thedevelopment of the regions outside the major urban centers. The Governmenthas generally been involved in basic industries where private capital hashesitated to enter because of long gestation periods, heavy capitalrequirements or high risks. Consequently the public sector and the SEEshave played an important role in industrialization. The presentGovernment's program for restructuring the economy seeks to replace anindustrialization strategy based on import substitution with one by anoutward orientation and with more involvement of the private sector.Measures designed to stabilize the economy include, among others, arealistic and flexible exchange rate, control of inflation, deregulation ofinterest rates to encourage private savings, and rationalization of publicinvestments.

B. The SEE System

2.03 The SEEs in Turkey were established 50 years ago. The SEEscurrently account for about 32% of total fixed investment, and about 11% ofnon-agricultural employment. In industry, SEEs have a virtual monopoly inpetroleum refining and basic metals, and have a large share in steel,fertilizers, pulp and paper, cement, coal, sugar, machinery and chemicals.Supervision of SEE operations was the general responsibility of the relatedMinistry and the specific responsibility of the High Control Board, anauditing organization which reported directly to Parliament. TheGovernment provided the SEEs with the credit and capital needed to sustainoperations and to make new investments, within the framework of theFive-Year Plan and the Annual Programs. The majority of the problemsafflicting the SEEs have arisen from the fact that while the enterpriseshave formally been organized as economic entities with the objectives ofefficiency, productivity and profitability, they have in the past been

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subject to constant intervention by the Government in pursuit of differentand often conflicting objectives. The causes of poor performance haveincluded price controls, lack of autonomy, low operational efficiency,frequent changes of management, inadequate salaries for managerial andtechnical staff, internal organizational problems, and a confusion betweeneconomic, social and political goals.

2.04 Reform of the SEEs has been a major goal of the Government'sstructural adjustment program. The SEE reform Law 2929 of October 1983,and a later Decree of June 1984 (Decree 233 which is due to become lawshortly)1 / signal the importance the Government attaches to bringing aboutgreater efficiency in SEE performance through decentralization ofresponsibility, greater management autonomy, and competition. SEE reformhas also been supported by the Bank through its structural adjustment loansas well as through ceveral ongoing Bank-assisted projects which includecomponents that address specific organizational restructuring andmanagement improvement issues. In the short run, there is considerablescope for strengthening the management and improving the operationalefficiency of SEEs. The Government considers the time opportune,therefore, to shift from a broad approach of SEE reform to a moredifferentiated one concentrating on individual enterprises. The proposedproject builds on this objective and focusses on SEKA, whose poor financialperformance has placed substantial burdens on the budget. The projectwould assist the Government to explore ways to privatize SEKA and wouldaddress a number of serious problems in SEKA including weak organizationand management as well as inefficient operating and maintenance practices.In addition, the project would focus on physical rehabilitation of existingmills rather than on investment in new facilities. This is consistent withthe country's policy of limiting public sector investment in manufacturingto permit concentration of public investment on high priorityinfrastructure projects. Nevertheless, some manufacturing investment torehabilitate existing productive facilities still has priority to enablethe SEEs involved to earn reasonable returns on past investments.

C. Performance of the Industry

2.05 In 1983, the private and public sectors of the pulp and paperindustry, with output valued at approximately TL 80,000 million, accountedfor around 2.5% of industrial output, and its 16,000 workers accounted forabout 2% of total industrial employment. The industry has made significantprogress since 1970, attaining close to full domestic self-sufficiency inthe production of paper and paperboard. In 1970, domestic production ofpaper and paperboard accounted for only 56% of consumption of paperproducts. In contrast, by 1983, domestic production of 568,000 tonsaccounted for more than 90X of consumption. Newsprint and sack kraft have

1/ As an indicator of the importance the Government attaches to SEEimprovements, the new Decree 233 places most of the manufacturingSEEs, including SEKA, under the Office of the Prime Ministry ratherthan the Ministry of Industry and Trade. A State Minister is directlyresponsible for the SEEs.

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been imported in varying quantities over the past few years, but suchimports will be substantially reduced as production in recentlycommissioned mills increases (Chapter IV). In other grades in whichdomestic self sufficiency has been attained, e.g. hygienic papers and somecoated boards, there has recently been some measure of success inexporting, amounting to about 5% of total domestic production of thesegrades.

D. Historical Development

2.06 Turkev's first paper mill was established by the SEE, Sumerbank,at Izmit in 1934. Responsibility for this plant together with all publicsector participation in the pulp and paper industry was transferred to theseparately constituted SEE, SEKA, in 1955. This original mill underwent aseries of expansions and production rose from an initial 9,000 tons in 1934to more than 130,000 tons by 1970. Turkey, however, remained a substantialand growing importer of paper products, in particular, newsprint. Toaddress this problem, the Government undertook a series of ambitiousintegrated pulp and paper mill investments starting In the early 1970s.Also, private investors were actively expanding existing operations andbuilding new mills. These investments, together with substantial tariffprotection, rapid industrial growth, urbanization, and increasing literacy,provided the framework within which domestic paper production grew from151,000 tons in 1970 to 568,000 tons in 1983.

E. Structure of the Industry

2.07 The pulp and paper industry has evolved over the last 25 yearsinto two distinct sectors, public and private, with characteristicdifferences in grade mix, raw material requirements, and the degree ofvertical integratUon. Production trends in the two sectors are illustratedin the following table.

Turkey - Total Paper and Paperboard Production('000 tpy)

SEKA Private Sector Total

1940 10 101950 18 181960 56 3 597970 1?4 18 1521975 308 64 3721978 304 123 4271979 301 '142 f431980, 3.n 154 4551981 366 131 4971982 398 138 5361983 393 175 563

Sources: SE-KA, TSKB.

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2.08 The private pulp and paper sector is based primarily on wastepaper, straw, and some imported pulp, and mainly produces hygienic Paper,wrapping paper, and paperboard. The private sector made significantadvances in the 1970s, and now accounts for about one third of thecountry's production. There are 36 mills in the private sector. Ingeneral, these private mills are quite small with an average capacity ofabout 5,000 tpy, but five are of moderate size, 20,000 tpy or larger. Onthe other hand, SEKA's mills have an average installed capacity of about90,000 tpy which, overall, are of a size comparable to mills inindustrialized countries.

2.09 SEKA currently has eight pulp/paper mills in operation whichaccount for some two thirds of the country's total output of paper andpaperboard. SEKA will continue to dominate the industry in the mediumterm, particularly in the production of chemical and mechanical pulps from*vood and the conversion of these pulps to paper in integrated mills.SEKA's production is based primarily on the extensive natural coniferousforests of the Black Sea, Marmara, Aegean, and Mediterranean Regionsalthough some straw, reed and hemp are also used, as well as imported pulp.

F. Fibrous Raw Material Resoutrces

1. Total Fiber Consumption

2.10 Wcod is SEKE's most important fibrous raw material, supportingabout 80% of SEKA's pulp production. In the private sector, waste paper isthe predominant fiber soerce. Ogerall, in 1983, production of paper fromthe various raw raaterials was approximately as follows: wood 53%, wastepaper 28%, straw and reeds 10X, and imported pulp 9%7. Cor.sumption offibrous raw materials for the past four years is summarized in thefollowing tab'e.

Turkey - Fibrous Raw Material Use

SEKA Private Sector1930 1981 1982 1983 1980 19fil 1982 1983

Wtood ( 'r0 m3 ) 90)5 1,193 1,230 1A043Straw/Reed ('00'?, ton, 36 60 25 34 29 36 36 65Waste Paper ( '0)0 ton) 29 46 43 44 130 1i7 133 148Imported Pulp ('000 ton) 17 ?5 40 2' ?2 20 26 28

Sources: SEKA7 TSKP .

_. 'Wood

2.11 Turkey has extensive natural fcrests iir the mour.tainous areas ofthe Black Sea, Marmara, Aegean and Mediterranean regions, which are thelargest forest tesources in the Middle East. Virtually all of .heceuntry's forest resources are vested in .he state. Approximately20 million ha -.re classifi.ed as forested area aid over the past 5 years

total production of roundwood has averaged 7.5 million m3/yr or about0.4 m3 fha. By comparison, wood production in Scandinavia is more than1.5 m3 /ha. The lower utilization figure for Turkey reflects a moreconservative forest management policy providing for lower annual allowablecut, less developed forest infrastructure, and less extensive wood-usingindustries. Notwithstanding these factors, the current attainable economicoutput is estimated by the Ministry of Agriculture and Forestry at12 million m3 /yr and a level of up to 16 million m3/yr is consideredfeasible with expansion of the forest road network.

2.12 The paper industry's wood purchases over a recent 4-year periodhave varied from 1.0 million m3 /yr to 1.5 million m3/yr and, as the tablebelow indicates, have comprised between 12% and 21Z of industrial roundwoodproduction.

Turkev - Production and Utilization of Roundwood('000 mi/yr)

1978 1979 1980 1981

Pulpwood 987 1,032 653 692Sawlogs/Veneer Logs 5,660 4,820 4,847 5,165Pitprops 663 558 533 702Small Industrial Roundwood, etc. 796 545 654 787

Total Industrial Roundwood 8,106 6,955 6,687 7,346

Paper Industry Purchases 984 1,467 1,206 963% of Industrial Roundwood 12.1 21.1 18.0 13.1

Sources: FAO, SEKA.

2.13 SEKA's current and prospective maximum annual pulp productioncapacity requires some 2.3 million m3/yr of wood, or only about 20% of thecurrently attainable industrial wood production. The availability of logsfor SEKA is reasonably secure, particularly as SEEs are given priority.However, delays sometimes occur due to the production and storage systemwhere logs may be stored for long periods in forest depots. SEKA isresponsible for log transport from the forest depot to its mills, anddelays in finalizing trucking contracts can cause further delays in wooddelivery. However, in the past year SEKA has had considerable success inimproving the delivery and other arrangements for wood supply at one mill,and expects to extend these arrangements to other mills (para 5.14). Underthe Bank-financed Mlorthern Forestry Project (Loan 1585-TU), industrialroundwood production in 1984 was limited to some 53% of the appraisalestimate due to problems of regenerating cut-over forests and encroachmentand illegal fellings by forest villagers. These difficulties are to bestudied in depth by the mid-term project review initiated in March 1985.Moreover, these issues will be addressed on a national scale under the TAcomponent of the proposed project (para 5.11).

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2.14 Wood Prices. The price of sawlogs to SEKA is based on theaverage actual open market auction price for the previous six months.Pulpwood price on the other hand is negotiated annually by SEKA and theGeneral Directorate of Forests to cover the cost of replacing wood that isconsumed by the industry, plus the cost of managing and protecting suchforests and an appropriate return on the invested forestry capital. Theprice currently paid by SEKA is substantially in line with internationalprices. Provision is made in the TA component of the project (para 5.11)to review the whole process of setting wood prices.

2.15 Privatization of Forest Management. In view of the Government'sprivatization policy and successful examples around the world of privateforest industries managing their own wood resources (Canada, Sweden, USA,Chile, Swaziland, etc.) the possibility of doing this in Turkey will bereviewed under the project (para 5.11). In other countries, harvestinglicenses or other forms of concessions have been granted to integratedforest industries companies so that they can manage their own wood supplyin accordance with sound forest management and silvicultural practices.The company benefits by having direct control over the harvesting anddelivery of its main raw material, while the Government benefits becauseprivate industry becomes more encouraged to invest in forest industry andthe cost of forest management passes to the entity concerned. Governmentretains all its power to assure that the resource is managed efficiently ona sustained yield basis.

3. Waste Paper

2.16 Waste paper usage constitutes about 30% of Turkish paper andpaperboard consumption and about 28% of the subsector's fibrous rawmaterial supply. The usage of waste paper is low in relation to its use inEurope where it accounts for about 40Z of paper products consumption. Theavailability of this material depends on the collection system, and this israther poorly organized. However, in recent years a company has beenformed which deals specifically in the collection and sale of waste paper,and, furthermore, the association of Turkish pulp and paper manufacturershas since formed an industry working group to study ways of improving thecollection system even further.

4. Straw/Reed

2.17 These materials are used by SEKA to produce short-fiber bleachedchemical pulp which basically substitutes for imported hardwood pulp.Although the physical properties of this raw material result in a pulpslightly inferior to imported hardwood, the quality is fully acceptable forthe limited number of grades of paper in which it is used. SEKA and theprivate sector also use straw to produce a relatively high yieldchemi-mechanical pulp which is used for corrugating medium and other typesof lower-quality boards. An estimated 10-15 million tons of straw isgenerated in Turkish agriculture each year. This material is mostly usedin animal husbandry. The requirements for pulping, about 100,000 tons peryear, represent less than 1% of the amount generated. Although the

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abundance of straw makes it a relatively cheap material to purchase, thecosts of c-llection, baling, and transportation are significant, and reducethe comparative cost advantage over wood to only about 30%: typically inSEKA's mills fibrous raw material cost to produce I ton of bleached pulpwill be about USS100 when using straw compared with US$150 for wood. Reedsare used only in the Afyon pulpmill (para 5.07). SEKA has contracts withlocal peop'le who manually harvest reeds from a nearbv lake and deliver themto the mill at a fixed price. As is the case for straw, the high cost ofcollecting and delivering reeds reduces the comparative advantage over woodsuch that fiber cost per ton of pulp is only 25% lower than when pulpingwood.

C. Government Policies in the Subsector

2.18 The expansion of the pulp and paper industry during the !960s and1970s was inspired principally by the desire to attain domesti-cself-sufficiency in paper produlcts in line with the dominant theme inTurkish industrial policy of import-substitution in that period. The stateplayed a major role in this process.

2.19 The Government had to finance all the large-sca'le integratedwood-pulp and paper mills because of the capital intensive, long gestationnature of the projects and the private sector did not have the requiredfinancial resources. M,oreover, these investments -were concentrated in thepaper grades that were of key importance to the state's policy in promotingeducation and industry, namely, newsprint, printing/writing paper and sackkraft. As domestic output of these grades started to expand, the pursuitof these objectives was reinforced with formal price controls onprinting/writir-g paper and newsprint. In addition, within the framework ofthe policy of self-sufficiency, the expansion of output in these gradesprov-ded a domestic source of waste paper, a key raw material for theprivate sector.

2.20 Furthermore, in the 1970s, the Government provided a highlyprotective cariff structure within which domestic output could expand. Thehigh nomii.ai tariff was also reinforc-ed by restrictions on imports under aforeign exchange allocation system. However, over the past few years, SEKAwas under political pressure to limit price increases and prices did notkeep pace witth domestic inflation. By the end of 1983, SEKA's averagesales price was about 20% below the comparable import parity price. TheGoverrnment has recently adopted new industrial and trade policies, thethrust of which is to open up the Turkish economy to more competition fromabroad, through import liberalization measures and lower tariffs and importduties. Under the new policies, since the beginning of 1984, controls overimportation of paper and paper products have been relaxed and nominaltariff rates have been significantly reduced, i.e., for newsprtnz from 23%to '5;O for printing and writing paper trom 60% to 25%, for kraft sack andwrapping paper from 50% to 3O% However, the Government has recently

levied a temporary surcharge 2/ to soften the impact of tradeliberalization and the reduction in tariffs on the existing mills and tosafeguard the industry from dumping practices. Further progress inrationalization of the tariff structure and other trade policies are beingmonitored under the Fifth Structural Adjustment Loan (2441-TU).

2.21 Since 1980, the Government has focused on strengthening theSEEs, and has undertaken several measures to make their economicenvironment more competitive (para 2.04). As a result, SEKA has benefitedfrom greater managerial autonomy with continuity of senior management andstability of policies. Since the passage of the SEE Reform Law in October1983, the Government has encouraged SEKA to excercise its freedom to setits own prices in the light of market conditions (para 3.19). Since early1984, the Government also has focused on SEKA's (and other SEEs') capitalstructure and significant outstanding debts of SEKA have been consolidatedand converted to equity (para 3.16). Moreover, the Government intends tostrengthen management and operational efficiency of SEKA through arehabilitation program, and explore opportunities for privatization ofSEKA. Even though the Bank, through its previous lending in thesub-sector, has acquirea considerable knowledge of the pulp and paperindustry in Turkey, as part of the proposed project the Government willundertake a comprehensive sector study, under which it will: review theproblems and prospects of the pulp and paper industry; develop subsectorobjectives and develop targets for the next decade; formulate industrystrategies which would be most effective in achieving the objectives; andestablish a pulp and paper industry development program, includinginvestment plan, necessary policy reform, and other appropriateadjustments. The study will also include identifying pulp and paperrehabilitation projects in the private sector and an in-depth review of thepossibilities for privatization of SEKA including suitable packaging thatcould interest local private sector firms and/or international pulp andpaper companies to participate in privatization of SEICA. The draft Termsof Reference for the proposed study, which have been discussed and agreedupon with the Treasury and State Planning Organization (SPO), are includedas Annex 2-1. SPO, on behalf of the Government, will undertake the study,assisted by consultants, and with the support of Turkiye Sinai KalkinmaBankasi (TSKB) and SEKA. During negotiations, agreement was reached withthe Government that the study will be completed by September 30, 1986, andbe made available to the Bank for review and comment.

2/ The amounts vary by grade of paper and are stated in US$ but payablein TL. The amounts are, per ton: newsprint $70, printing and writing$125, kraft paper $25, coated board $100. According to SEKA, Swedishexport prices for certain grades of kraft paper, newsprint, andprinting papers are 5-15% lower on average than if these products werepurchased locally in Sweden. Swedish newsprint can be landed inIstanbul at $340/ton cif. A similar situation exists with Romanianpaper imports.

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H. Privatization

2.22 The Government's objective is to improve the efficiency ofmanufacturing SEEs to develop their competitive position domestically andinternationally. Privatization is considered a useful mechanism toaccelerate the process. At this stage the Government is consideringvarious privatization alternatives including divestiture, sale of shares tothe public, leasing, management contracts, etc. However, the Governmenthas no preconceived ideas regarding privatization of specific sectors andbelieves that all related aspects should be studied before a definitestrategy is adopted. In the case of SEKA specifically, the Government viewis that SEKA must first be put on a sound footing, both financially andoperationally, so that it may attract sufficient interest from the privatesector and also provide to t'e Government an appropriate and reasonablevalue for its assets. In preparation for this, the Government has agreedwith the Bank to include in the project a TA program which would, in part,examine appropriate industry structure and privatization possibilities.This approach is prudent. It is also pertinent to point out that previousGovernment policies have enabled private sector participation in somesections of the pulp and paper industry and in fact about one third of thecountry's production of paper and paperboard currently comes from privatesector enterprises. There are, however, a number of factors which havediscouraged private sector investments in large integrated mills such asare owned and operated by SEKA. These are: (a) high capital investmentand long implementation period; (b) main raw material (wood) is uadergovernment control; and (c) a major portion of the output is sold to alimited number of powerful buyers -- in the case of newsprint, newspaperpublishers and in the case of kraft paper, cement companies and sackmanufacturers -- and prices have been kept too low in the past to realize asatisfactory return on investment.

2.23 In spite of these and other difficulties, there are certaincomponents of SEKA which may be suitable for spinning off, as a short-termfirst step towards full privatization of SEKA, including the followingunits: (a) Akdeniz sawmill; (b) Balikesir sawmill; (c) Akdeniz Tug andBarge facilities; and (d) Bolu fiberboard plant. The above units areconsidered as suitable possibilities because capital costs are relativelylow (US$5-15 million), there is good potential for profit, and although inmost cases the units are integrated with SEKA mills they can still beoperated as independent units. As a first step, and following up on theBank's suggestion during appraisal of the project, SEKA has decided thattheir Bolu fiberboard plant is a suitable candidate for immediateprivatization, and has already made such a recommendation to the HighEconomic Council. The Government has confirmed that a few individual casessuch as this should be pursued even before the strategic studies arecompleted. During negotiations, agreement was reached with SEKA that theywould consult with the Bank prior to divesting any of their major assets ifsuch action would significantly affect their financial position.

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2.24 In the longer term, larger scale privatization possibilities,short of complete sale of SEKA, might logically be concentrated on certainproduct lines which could be attractive to private investors, both foreignand local. Specifically, newsprint and bleach kraft pulp operations andtheir expansions could be considered. Newsprint requires coniferous wood(e.g. pine), and in contrast to other countries in the Middle East, Turkeyis well endowed with this resource. Also it has a relatively good positionwith regard to electric power supply in those regions where EFKA's millsare located. Furthermore, projection of Turkey's domestic demand fornewsprint (para 4.07) indicates that construction of a third newsprint millshould start in about 1987. A new private or joint ventL.re company mightbe formed to take over SEKA's two existing newsprint operations (Aksu andBalikesir) and build the third mill. Such a proposal might be attractiveto a foreign newsprint producer as a means of gaining access to Turkey'slarge domestic market and other Middle East markets. Bleached kraft pulpproduction by local private sector paper producers could be achievedthrough sale of SEKA's Afyon pulp mill. This mill produces short fiberpulp, partly to replace imports, from wheat straw and reeds, which areobtained from farmers and local villagers. Thus the major impediment ofgovernment control of the main raw material, wood (para 2.22), would not bea factor. Also, SEKA's long proposed Karadeniz project to produce longfiber bleach kraft pulp makes technical and commercial sense and lacks onlya guaranteed wood supply and financing. A private group operating Afyonmight logically expand their interest to the Karadeniz project which wouldhave an assured domestic market and would provide a controlled source ofhigh-quality long fiber pulp for their non-integrated paper mills.

I. Bank Role in the Subsector

2.25 Bank participation in the subsector began in 1974 with a loan tothe Government of US$40 million for the Antalya Forest Utilization Project(Loan 957-TU), of which US$35.5 million was onlent to SEKA for the Akdenizintegrated pulp and paper and sawmills and the remaining US$4.5 million wasfor modernization of forestry operations. There were delays in theimplementation of the Akdeniz component, primarily due to initial changesin the site location. The mill was commissioned in late 1983 and is nowexceeding the production rates estimated at the time of appraisal. TheBank also provided a loan of US$70 million to SEKA for the BalikesirNewsprint Project (Loan 1258-TU) which was signed in 1976. The objectiveof the loan was to finance construction of a newsprint paper and sawmill,as well as pollution abatement facilities. Implementation was delayed onaccount of a shortage of materials and domestic financing during a periodof general economic crisis in Turkey. The facilities were commissioned in1981. After initial technical difficulties, production performance iscurrently at 80% of design capacity, which is close to appraisa'lestimates. The experience gained from these projects has been taken intoaccount in the design of the proposed project, which provides for acomprehensive technical assistance program aimed at strengthening SEKA'smanagement structure and improving operation and maintenance procedures.The Bank also made a US$86 million loan for the Northern Forestry Project(Loan 1585-TU) signed in 1978 and currently under implementation. The

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project has sought to improve the Government's forest management planningand operations as well as to increase industrial roundwood production.Industrial roundvood production is below project estimates due todifficulties experienced in regenerating cut-over forest areas andadherence to outdated and conservative forest management practices.Nonetheless, efforts are continuing on introducing more modern forestrypractices.

2.26 In addition to these direct loans, about US$7 million in proceedsfrom the DYB I and DYB II Projects (Loans 1024-TU and 1379-TU) wereutilized to finance partially investments designed to balance productionfacilities at the Dalaman and Caycuma mill. The Project Completion Reportof February 10, 1984 for DYB I (Loan 1024-TU) and the Bank report entitled,Sector Operations Revilew: The Industries and DFCs Program in Turkey(No. 3077-TU), dated July 18, 1980 concluded that a major lesson learnedfrom the Bank's experience with DYB is that improvements in SEE performancecan be better achieved through direct loans and industrial sector policydialogue. Both of these recommendations have been taken into account indesigning the proposed project.

2.27 Through TSKB, the Bank is also indirectly involved (Loan 2093-TU)in the expansion of the private sector with Kartonsan, a company whichproduces coated board and is currently increasing its production to85,000 tpy. IFC has been actively involved in the private sector andcurrently holds equity in Viking Pulp and Paper Company, one of the largerprivate sector mills producing about 12,000 tpy of wrapping paper.

III. THE COMPANY

A. Background and Organization

3.01 SEKA was established in 1955 as the SEE in charge of publicsector operations in the pulp and paper sector. Until the 1960s, Izmit wasthe only SEKA plant. However, since then, SEKA has gone through a majorexpansion program involving the construction of seven mills. Each of thesemills is a separate legal entity, incorporated as a company under Turkishlaws. However, autonomy is limited to general and routine operationalmatters, and in practice they operate as divisions of SEKA. SEKA'sauthorized capital, fully Government owned, as of the end of 1983 wasTL 70,000 million. SEKA has about 11,000 employees in headquarters andoperating mills.

3.02 Since April 1983, as a part of the SEE reorganization andreforms, an additional company, Bolu fiberboard plant, has been added toSEKA's operation, bringing the total number of companies under SEKA tonine. SEKA's total installed annual capacity as of the end of 1983 amountsto over 500,000 tons of pulp, paper and paperboard, 275,000 m3 of sawnwood,and 6 million m2 of fiberboard and laminated board.

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3.03 As per the new SEE decree (para 2.04), SEKA's Board of Directorsis now composed of six members, a chairman, who is also General Director,and five directors. Two of the directors are drawn from the AssistantGeneral Directors of the Enterprise. All board members are appointed bythe Government for three-year terms. The Board of Directors concentrateson policy issues, leaving executive powers to the General Director. TheGeneral Director is assisted by a Technical Assistant General Director, andan Administrative Assistant General Director.

3.04 At the mill level, the organizational structure is similar tothat of SEKA's headquarters, but overall mill management autonomy islimited and confined to undertaking instructions from headquarters. Eachmill has a management committee consisting cf a chairman and four members.The duty of the management committee is to reach and implement decisionsregarding the management of the mill in accordance with predeterminedoperating targets, plans and budgets.

3.05 The management committee members are nominated from among thehigher level mill managers. The chairman of the management committee isthe Mill Manager, who is aided by two assistants, one in charge oftechnical matters and the other in charge of administration. Both aremembers of the management committee. The Technical Assistant Mill Manageris responsible for day-to-day manufacturing, including quality control andproduction record keeping. The Administration Assistant Mill Manager isresponsible for accounting, personnel functions, security, welfare andsales.

3.06 the lack of continuity and motivation of management have beenmajor problems confronting SEKA. Historically, most senior managementappointments have been politically motivated, subjecting the day-to-dayoperations of the enterprise to a political process which in turn hasprodlced several undesirable results, including lack of continuity inpolicies and practices, insecurity for professional staff, low morale, andinappropriate investment decisions. As in all SEEs, low salary structurehas been a major deterrent for attracting and holding competent mangers.In recent years, the situation in SEKA has improved. Since 1982, theenterprise has benefitted by the appointment of a General Director who is aprofessional manager with an engineering background and more than 25 yearsof experience in industrial management and administration. Since hisappointment he has launched at least two major developments in SEKA.First, he has given more autonomy to mill managers and made them moreaccountable for operational performance. Second, he has created a"Department of Management and Methods", headed by a professional recruitedfrom outside SEKA. This department has already initiated a Job EvaluationProgram in the Izmit mill, with the objective of linking salaries toperformance. The program will be extended to all SEKA mills in duecourse. While SEKA has enjoyed for the past three years continuity ofmanagement, relative freedom from political interference, and more autonomyfor mill mangers who are therefore better motivated, the major issue of lowpay and other benefits for management and professional staff remainsoutstanding, and can only be addressed in the context of reform of theoverall SEE system, which is currently under way.

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B. Management Information System

3.07 SEKA's present management information system, similar to that ofother SEEs in Turkey is designed for general purpose requirements andwithout due consideration for the special features and characteristics ofthe industry it serves. The system does not provide an adequate basis forplanning and control and requires major review and upgrading. SEKA'sreporting requirements from its mills is extensive and involves substantialclerical work and bookkeeping often with delays. Under the present system,headquarters is kept informed daily on such items as production figures andcash position. There are weekly, monthly, quarterly and annual reports.SEKA in turn consolidates these reports and submits them to theGovernment. However, at SEKA's headquarters, data collected are ofteninsufficiently focused on relevant aspects and data are not processedadequately, partly because it is overly voluminous. Upgrading of themanagement information system and computerization of the system is includedin SEKA's rehabilitation program.

C. Production Performance

3.08 SEKA's production during 1977-83 for paper and paperboard foreach mill is given below:

Turkey - SEKA - Paper and Paperboard Production (1977-83) a/(v000 tons)

Designcapacity 1977 1978 1979 1980 1981 1982 1983

Izmit 150c/ 126 124 126 128 128 132 118Caycuma 75 65 58 49 43 57 57 56Aksu 82 71 56 61 63 63 61 60Dalaman 75c/ 77 66 65 67 75 81 79Afyon 50b/ - - - 7 9 19 20

Balikesir 100 - - - - 42 67 80

Total 482b/ 339 304 301 301 365 398 393

a! Not including Akdeniz, which began production in 1984, and Kastamonu,which will start commercial production in 1985.

b/ Afyon was commissioned in 1980 and produces only pulp which iscurrently transferred only to SEKA mills. To avoid double counting,its output is not included in total figure.

c/ Capacity of Izmit and Dalaman may be considerably higher depending ongrade mix.

Source: SEKA.

With a few exceptions, SEKA's capacity utilization is low in comparisonwith similar mills in North America and Scandinavia where utilization of atleast 90% is normal. In the past year SEKA, including the Afyon mill,

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averaged only about 75Z. The production of Izmit has been relativelystable with minor fluctuations between 118,000 to 13X,000 tons per year.The production at Caycuma has fluctuated significantly, between a peak of65,000 tons in 1977 (87% of the design capacity), to a low of 43,000 tonsin 1980 (57% of the design capacity). The low production level in 1979 and1980 was mainly the result of general material shortages during thoseyears, and poor maintenance practices and frequent unscheduled downtime.Another major factor affecting Caycuma's operations is the significantimbalance between the pulp mill and the paper mill. The principalbottleneck is the chemical recovery boiler which can only support45,000 tons of pulp production per year. Actual production is maintainedat a higher level by purchasing additional pulping chemicals and wastingthe spent chemicals, an expensive and environmentally harmful practice.Production at Aksu has been low, averaging only 75% of design capacity overthe past five years, and fluctuating between a high of 71,000 tons (87% ofthe design capacity), in 1977, to a low of 56,000 tons (68% of the designcapacity) in 1978. This has been mainly due to poor maintenance practicesexacerbated by shortages of spare parts, power interruptions, and frequentunscheduled downtime. For example during 1981, the Aksu plant experienced188 incidents of power disturbances, which caused over 5,000 tons of lostpaper production. Since this time, the Turkish Electric Authority has madesignificant improvements to the system and power interruptions are nolonger considered a serious problem. Production at Dalaman has beenrelatively stable, with capacity utilization close to 100%. The Dalamanmill is well maintained and well managed. Afyon performance has been poorsince its commissioning in 1980, although the production level has improvedsomewhat in 1983, and actual production for the year was 20,000 tons ofpulp, about 40% of its rated capacity. The low capacity utilization atAfyon has been in the past mainly due to technical problems in the milldesign. Balikesir was commissioned in 1981 and production build-up hasbeen satisfactory and is expected to reach design level before 1986.

D. Reforms of Personnel Policy

3.09 Overstaffing has been a major problem confronting SEKA'smanagement. In line with the SEE policy reform, since 1980, SEKA has takenspecific measures to address the issue of the overstaffing. These measureswere: freezing the number and structure of job positions for existingoperations at the level of November 1980; canceling 50% of job positionsbecoming vacant through resignation, retirement or death; and allocatingpriority to staffing new mills with existing manpower. As a result, during1980-83 some 1,382 positions representing 10% of total job positions inSEKA were eliminated, of which 913 positions were related to Izmit, 158 toAfyon, 110 to Caycuma, 94 to Aksu, 67 to Dalaman and 40 positions wererelated to SEKA Headquarters. During the same period, some 197 additionalhirings took place to cover the needs of the Balikesir mill which wascoming to full production. The net impact of these measures which amountsto 36% higher productivity for SEKA's employees is shown in Annex 3-1 andis summarized in the following table:

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Turkey - SEKA - Labor Productivity Between 1980-83

1980 1981 1982 1983

Production of Paper & Paperboard ('000 tons) 301 365 398 393Number of Employees a/ 11,300 11,082 11,068 10,952Productivity (tons of paper & paperboard/employee) b/ 26.6 32.9 35.9 35.9

a/ Excluding employees in the mills under construction.bI Comparisons with other countries may be misleading owing to the wide

range of mill sizes and product mix. However, in the major pulp andpaper producing countries, labor productivity of companies which, likeSEKA, have a broad mix of pulp and paper grades, ranges typically from50 to 100 tpy/employee.

E. SEKA's Historical Financial Performance

3.10 The historical financial performance for 1977-83 is presented inAnnex 3-2 and summarized in the following table:

Turkey - SEKA - Summary of Historical Financial Performance for 1977-83(Million TL)

1977 1978 1979 1980 1981 1982 1983Income StatementNet Sales 4,281 6,785 10,956 22,821 33,307 46,918 60,802Gross Profit 293 1,339 425 4,170 2,593 2,586 2,429Financial Charges 468 544 908 1,450 3,136 6,811 6,991Profit Before Tax (463) 602 (1,504) (324) (2,313) (8,457) (14,673)

Balance SheetCurrent Assets 3,456 4,531 9,496 14,720 20,304 25,918 31,810CurrentLiabilities 4,299 5,791 12,526 16,395 28,996 40,631 55,112I.ong-Term Debt 6,163 9,318 13,881 21,690 27,453 32,175 39,767Equity 101 843 2,788 12,031 14,353 16,541 44,190a/

Key Financial RatiosGross Profit/NetSales (%) 6.8 19.7 3.9 18.2 7.8 5.5 4.0

Gross Profit/Costof Goods Sold (x) 7.3 24.6 4.0 22.3 8.4 5.8 4.2Current Ratio 0.80 0.78 0.76 0.90 0.70 0.64 0.58Long-TermDebt:Equity 98:2 92:8 83:17 64:36 66:34 66:34 47:53a/

a/ In May 1984 the Government revalued SEKA's assets by TL 28,409 millionretroactive to 1983. Without this revaluation, the debt:equity ratiowould be 72:28.

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3.11 The deteriorating financial situation of SEKA over the period1977-83 can clearly be seen from the above figures. Although total salesrevenue has increased consistently over this period both as a consequenceof increasing production volumes and prices, costs have been increasing ata more rapid rate, resulting in gross profit margin (net sales minus costof goods sold) which has been erratic between 1977-1980, and graduallydeclining in 1981-83. For the period as a whole, gross profit margin as apercentage of sales averaged about 10X. However, for 1982 and 1983, itaveraged about 5%. The poor gross profit margin record is largely theconsequence of the slow and partial adjustment of product prices toincreasing input and conversion costs (paras 3.17 to 3.18), as well as lowcapacity utilization and low operating efficiency.

3.12 SEKA had accumulated losses of about TL 30,515 million by the endof 1983, largely as a result of price restraints, high financial charges(representing 48% of the total loss in 1983) and other expenses such asdepreciation. The long-term debt to equity ratio improved from 98:2 in1977 to 47:53 in 1983 largely as a result of the injection of additionalequity for the establishment of new mills and the revaluation of assets tothe extent of TL 28,409 million in 1983. The current ratio stayedconsistently below one over the period 1977-83 in spite of relativelyextensive restructuring and funding of liabilities undertaken by theGovernment over the years. In summary, SEKA's financial position at theend of 1983 was weak and unless effective measures were taken to result inadequate profits and satisfactory financial ratios, the situation wouldhave deteriorated further.

F. Financial Restructuring

3.13 Without major restructuring, the decline of SEKA would continueat an accelerating rate as current liabilities increase to cover theoperating deficit. Financial projections have been prepared on this basis(Annexes 3-3 through 3-5), and are summarized in the following table:

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Turkey - SEKA - Financial Projections without FinancialRestructuring and Without Price Increases al

(US$ million at current prices)

1984 1985 1986 1987 1988

Net Sales Revenue 302 350 392 431 470

Operating Profit (14) 0 8 14 18Interest 29 30 31 31 30Other Expenses (net) 4 5 5 5 6Net Income (pre-tax) (47) (35) (28) (22) (18)

Cash From Operations Before Debt-Service 15 28 36 41 45New Equity _ _ _ _ _Short-Term Borrowing 35 25 18 10 5Net Change in Working Capital 12 7 7 7 7Total Debt Service 46 45 46 45 44Net Cash Flow (8) 1 1 (1) (1)

Gross Profit on Net Revenue (%) (0-4) 3.7 5.7 6.9 7.5Gross Profit on Cost of Goods Sold (Z) (0.4) 3.9 6.1 7.4 8.1Debt Service Coverage Ratio 0.4 0.6 0.8 0.9 1.0Current Ratio 0.5 0.5 0.5 0.5 0.5Long-Term Debt:Equity 99:1 - - - -

a/ Numbers may not add due to rounding.

3.14 These projections indicate that without financial restructuring,short-term borrowings over the next five years of about US$100 millionequivalent would be required to cover projected cash deficits, even thoughthe production from the new mills (Balikesir, Akdeniz and Kastamonu) wouldbe increasing. Under these circumstances, debt-service coverage and thecurrent ratio would be inadequate, and the equity base would be eroded tozero. Even with price increases (para 3.19), without major financialrestructuring, SEKA's financial position would remain unacceptable (e.g.current ratio below 1.0).

3.15 In early 1983 the Government realized that largely due to pastcontrols on pricing, SEKA was in a serious financial situation, andrecognized that unless some major financial restructuring was undertaken,SEKA's financial situation would quickly deteriorate, and SEKA's operationscould come to a stop. As a result, and as part of an overallrehabilitation program for SEKA to make the Enterprise more competitiveboth domestically and internationally, the Government had drawn up afinancial assistance plan involving a subscription to aboutTL 12,000 million of SEKA's new equity through various measures of cashinjection and capitalization of outstanding treasury short term debts in1983, and capitalization of some additional TL 835 million of long termdebt in 1984, along with provisions for revaluation of assets. In October1983, the Bank's appraisal mission discussed the scope and impact of these

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measures with the Government and estimated that SEKA needed aboutUS$100 million equivalent additional financial restructuring over and abovethat already provided to restore an adequate level of liquidity. TheGovernment at that time acknowledged the need for additional restructuringbut no decision was made.

3.16 The present Government also recognized the gravity of SEKA'sfinancial situation and the need for additional financial restructuring,and included SEKA in its plan for the restructuring of selected SEEs.Under this plan, initiated in January 1984, as a decree law, certain debtsof selected SEEs to each other, to the Treasury and to the Central Bank areto be consolidated and taken over by the Central Bank. This plan affectedsignificant portions of SEKA's debts, and some TL 39,195 million of SEKA'sdebt in different categories was consolidated to a single liability andconverted to equity capital (or equivalent) from the Central Bank inSEKA.31

G. SEKA's Prices and Pricing Policy

3.17 After 1980, Government control of SEE's selling prices wasdiscontinued except for certain basic necessities, which in SEKA's caseincludes newsprint. Theoretically, SEKA has been free to set prices forall other paper products. However, in spite of its semi-autonomy insetting prices, SEKA has not had a well-defined pricing policy. SEKA'sstated practice has been that prices be set to recover manufacturing costsplus a margin of about 2-10%, depending on the product, with dueconsideration of CIF prices. Although stated by SEKA, this general rule,in the past has not been applied consistently, as shown in Annex 3-6.

3.18 One of the serious difficulties with SEKA's price setting in thepast has been that increases have often been implemented with too large atime lag and been insufficient to keep up with domestic inflation. Toillustrate, the recent price trends for three of SEKA' s main grades aretabulated below.

31 The conversion amounts to about US$121 million of new equity byreducing debts to trade creditors (US$28.8 million), treasury(US$54.7 million), central bank (US$37.0 million), and othershort-term creditors (US$0.4 million).

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Turkey - SEKA - Percentage Real Price Change for Selected Paper Grades

List Price inCurrent Terms (TL/ton) Real Price Change (Z)

Printing Wholesale Printing& News- Price a/ & News-

Writing print Sack Index Writing print Sack

July 1982 165,000 107,000 110,000 171.5 - - -

July 1983 214,000 119,400 127,000 215.7 3.1 (11.2) (8.2)Jan. 1984 235,400 131,300 139,700 265.0 (10.5) (10.5) (10.5)

a/ Source: International Financial Statistics, IMF.

The table shows that, in spite of significant price increases In cur-rentterms, for all three grades, there has been a steady decline of prices inreal terms for rnewsprint and sack paper of 11.2% and 8.2Z, respectively,between July 1982 and July 1983, and of 10.5% for all grades between July1983 and January 1984. Considering that the selected grades make up about70% of SEKA's total output in 1983, the financial impact of the decline inreal prices is severe. Also, as illustrated in Annex 3-6 for the selectedgrades, a decline in equivalent current prices in US dollar terms, as aresult of the declining value of the Turkish lira, has occurred during aperLod when international paper prices, in current terms, have held steadyor Lacreased.

3.19 Clearly, SEKA's pricing policy has been a major issue affectingboth its short- and long-term viability. In early 1984, the Governmentreaffirmed its policy to allow SEKA to set its own prices freely for allthe grades according to market conditions. The Government policy towardsSEEs is stated in Decree Law 233 (June 1984). However, in the Decree Law,there is provision for Government intervention in price setting. In suchsituations, the Decree Law stipulates that if the administered prices arebelow cost, then the loss as well as unrealized profit will be compensatedthrough budgetary transfer, and the amount of unrealized profit will be setby computing a 10% profit on the cost of goods sold. It is this Decree Lawthat sets the broad outline of SEKA's new pricing policy. As a result, inthe first four months of 1984, SEKA has increased its prices by more than40% across the board in two steps - 10% in January 1984 and 30% in April1984. While new prices are well above those of December 1983, on averagethey are substantially equal to import parity prices, but well below thelanded cost after addition of applicable duty and levies. Recently, asprotection against dumping, the Government has levied a new tax on variousimports in the form of a lump sum amount per ton, stated in dollars butpayable in local currenc_ (para 2.20). In case of paper and paperboardthese amounts per ton are: newsprint US$70, sackpaper US$25, and printingand writing US$125. The following table illustrates this comparison:

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Turkey - Current Price Comparison for Selected Grades in May 1984

CIF &CIF & Duty &

SEKA List Price CIF b/ Duty LevyItem TL/ton $/ton a/ $/ton $Iton $/ton

Printing & Writing 306,000 900 860 1,075 1,200Newsprint 167,500 493 490 564 634Sack Kraft 182,000 535 600 780 805

a/ Exchange rate TL 340 = $1.00.b/ Based on current estimates of Western European spot prices.

3.20 During negotiations SEKA's pricing policy was thoroughlydiscussed and the following policies were enunciated by SEKA: (i) SEKA'sprices are set in accordance with the provisions of Decree No. 233 of June1984; and (ii) it is SERA's objective to produce efficiently, so as to bein a position to set prices at levels which do not depend on protectionmeasures and are not increased unduly to cover high costs caused byinefficient operations. It was agreed that the Bank and SEKA shall fromtime to time, at the request of either party, exchange views with regard tooperational and pricing policies and measures to be taken for theirimplementation. These arrangements provide a satisfactory basis forguiding SEKA's pricing strategy.

3.21 The measures regarding financial restructuring and priceincreases stated above have the effect of stabilizing the present financialsituation, and providing some assurance that future levels of profitabilitywill be satisfactory. Financial projections prepared on this basis(without the proposed rehabilitation project) are contained in Annexes 3-7through 3-9 and summarized in the following table:

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Turkey - SEKA - Financial Projections with Financial Restructuringand Price Increases a/

(US$ million at current prices)

1984 1985 1986 1987 1988

Net Sales Revenue 312 372 417 459 500

Operating Profit (4) 22 33 41 48Interest 19 16 14 13 11Other Expenses (net) 4 5 5 5 6Net Income (pre-tax) (28) (2) 14 23 31

Cash From Operations Before Debt-Service 24 50 57 63 67New Equity 121 - - - -

Short-Term Borrowing 17 - - - -

Net Change in Working Capital 12 7 7 7 7Total Debt Service 156 31 30 27 25Net Cash Flow (6) 12 21 29 36

Gross Profit on Net Revenue (Z) 2.7 9.5 11.4 12.5 13.0Gross Profit on Cost of Goods Sold 2.7 10.5 12.8 14.2 15.0Debt Service Coverage Ratio - 1.6 1.9 2.3 2.7Current Ratio 1.4 1.6 2.0 2.5 3.1Long-Term Debt:Equity 33:67 30:70 26:74 22:78 18:82

a/ Includes price increases in effect up to April 1984. Numbers may notadd due to rounding.

3.22 While there remains a need for modest short-term borrowing in1984, no further borrowing is required, and from 1985, debt-servicecoverage and current ratios would exceed 1.5. Thus, SEKA would be in areasonable financial position and able to undertake the proposedrehabilitation project.

IV. THE MARKET

A.. Background

4.01 Turkish paper and paperboard production, imports, exports andapparent consumption over the period 1970 to 1983 are as follows:

CUHRRENCY EQUIVALENTS (as of April 1984)

US$1.00 = Turkish Lira (TL) 325TL 1.00 = US$0.00308

FISCAL YEAR

January 1 - December 31

WEIGHTS AND MEASURES

I ton (t) = 1,000 kilsograms = 2,205 pounds1 meter (m) = 1.094 yards = 39.4 inches1 kilometer (km) = 1,000 neters = 0.'21 miles1 cubic meter (m3 ) = 35.3 cubic feet1 bone dry unit (BDU) = 2,400 bone dry pounds of wood chips1 hectare (ha) = 2.47 acres

Volume of wood expressed as m3 refers to solid wood volumeunder lbark

ABBREVIATIONS

DYB - Devlet Yatirim Bankasi (State Investment Bank)FAO - Food and Agriculture Organization of the United NationsGOT - Government of Turkey0GM - Orman Genel Mudurlugu (General Directorate of Forestry)SEE - State Economic EnterpriseSEKA - Turkiye Seluloz ve Kagit Fabrikalari General Mudurlugu

(SEE for Pulp and Paper)SFO - State Planning OrganizationTA - Technical AssistanceTSKB - Turkiye Sinai Kalkinma Bankasi (Industrial Development

Bank of Turkey)