1. This statement provides an update on economic and policy developments since the staff report (EBS/02/109, 6/20/02) was issued. The new information does not change the thrust of the staff appraisal, but underscores two of its key messages: (i) vulnerabilities remain, calling for an unwavering commitment to the program; and (ii) for the authorities’ efforts to be fully successful, lessening market concerns about domestic political uncertainty will be critical.

2. Latest indicators continue to suggest that the macroeconomic objectives for 2002 remain within reach. Both exports and imports showed strong performance in April (seasonally adjusted monthly increases of 15 and 24 percent, respectively), confirming a pick-up in activity. Capacity utilization remained unchanged in May on a seasonally adjusted basis, but was up by 5 percentage points from a year earlier. The CBT’s most recent survey shows a slight increase in the mean inflation expectation for the end of the year to 35.6 percent, still close to the 35 percent end-year target.

3. Market indicators have, however, weakened further over the past week. The impact of favorable news—including completion of the prior actions and the announcement of the Board date—has been more than offset by continued political uncertainty, market concerns about the implications of the bank audit results, and contagion from weak global markets and Brazil. Since June 19, the interest rate on the benchmark bond has risen 5 percentage points to 75 percent, the Turkish lira has depreciated by 2 ½ percent against the U.S. dollar, stock prices have fallen by 4 percent, and the spread on Turkish Eurobonds has widened by another 100 basis points. On June 26, Standard and Poor’s lowered the outlook to stable from positive on its B– sovereign rating for Turkey.

4. The authorities have followed up on the private bank audit and recapitalization exercise. As noted in Box 4 in the staff report, the targeted assessments (based on two audits) showed the level of nonperforming loans (NPLs) in 26 privately owned banks to be 16 percent of total loans at end-2001, compared with the earlier reported 5 percent. The NPL estimate has now been updated to reflect two developments. First, the intervened Pamuk bank has been excluded, leaving 25 banks to be covered. Second, given uncertainties about the financial condition of the common shareholder in Pamuk and Yapi Kredi, the BRSA decided that out of prudential caution Yapi Kredi needed to classify all its connected loans as doubtful and make provisions (net of collateral) equal to 50 percent of the outstanding amount of connected loans. These two changes raised the NPL ratio for private banks to 25 percent. Even with the increased provisioning requirements, Yapi Kredi’s capital adequacy ratio is 10.2 percent.

5. Further progress has been made in meeting structural conditionality in banking. On June 22, the BRSA issued a revised regulation on the new accounting standards to ensure that banks’ end-2002 balance sheets comply with IAS, meeting an end-June structural performance criterion. Considerable progress has also been made toward meeting the end-June structural performance criterion on reducing the number of state bank branches by 800. With 80 branches closed between April 4, 2001 (when the restructuring of state banks started) and end-2001 and 679 more closed through June 25 this year, the authorities will, however, likely miss the performance criterion by a small margin. The staff will follow up on branch closures in the context of the third program review.

6. End-June monetary targets are likely to be met. By all indications, the performance criterion on net international reserves and the indicative target on net domestic assets will be observed with considerable margins. The authorities report, however, that the performance criterion on base money is likely to be met by only a small margin, since currency demand has been higher than anticipated, both because of stronger than usual seasonal factors (in agriculture and tourism) and the effects of the intervention in Pamuk bank. The staff will monitor developments and seek continued compliance with the monetary targets in the context of the third review.

7. The authorities have also taken measures to keep fiscal policy on track. Between late May and June 26, the authorities raised sugar prices by 4 percent, natural gas prices by 8 percent, and prices for alcohol, tobacco, tea, and pulp and paper by 10-15 percent. The staff estimates that these measures have a direct impact of about ½ percent on the CPI, and that they close about one third of the full-year fiscal gap of ½ percent of GNP. Increases in telecommunication charges, which would close the bulk of the remaining gap, are expected shortly. Further increases in alcohol, tobacco, and sugar prices are scheduled for September.

8. The staff supports the authorities’ request to waive the applicability of the end-May performance criterion on the cumulative primary balance of the consolidated government sector. The relevant full information is not yet available. However, as discussed in paragraph 2 of the staff report, preliminary data strongly suggest that the performance criterion was met.