Argentina - Second Industrial Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY i Report No. P-3146-AR REPORT AND RECOIMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE DESARROLLO WITH THE GUARANTEE OF THE ARGENTINE REPUBLIC FOR A SECOND INDUSTRIAL CREDIT PROJECT November 10, 1981 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS June 30, 1981 Currency Unit = Argentine Peso ($a) US$1 $a 4,963 (financial rate) US$1 million = $a 4,963 million $a 1 million = US$ 200 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS BANADE - Banco Nacional de Desarrollo (National Development Bank) INTI - Instituto Nacional de Tecnologia Industrial (National Institute of Industrial Technology) FISCAL YEAR January 1 to December 31  FOR OFFICIAL USE ONLY ARGENTINA SECOND INDUSTRIAL CREDIT PROJECT Loan and Project Summary Borrower: Banco Nacional de Desarrollo (BANADE). Guarantor: The Argentine Republic. Amount: US$100.0 million equivalent. Terms: 15 years, including 3 years of grace, at 11.6% per annum. The amortization schedule will conform to the aggregate of the following two amortization schedules: (a) for the US$99.5 million for industrial subprojects, the aggregate amortization schedule of the subloans fixed at the time when funds have been fully committed; and (b) for the US$0.5 million for technical assistance, standard Bank amortization schedule. Relending Terms: Subloans by BANADE to subborrowers (excluding provincial banks) will have maturities of up to 15 years and up to 3 years of grace with Bank loan interest rate plus a minimum of 5% per annum for dollar-denominated subloans and a minimum of 2.5% per annum for subloans in pooled currencies. Subsidiary loans by BANADE to provincial banks will bear an interest rate no lower than that of the Bank loan plus a minimum of 2.5% for dollar- denominated subloans. Provincial banks will onlend at an interest rate at least equal to that charged BANADE's subborrowers. Project Description: The project will assist BANADE to finance modernization and replacement of equipment, as well as new and expanded production by industrial and mining firms. A special feature of this loan will be the establishment of a line of credit for an industrial energy conservation program. Development credits under this project will also be channelled through the provincial banks to help stimulate regional development and mobilize the provincial bank resources for industrial development. Technical assis- tance will be provided to help BANADE's institutional development and the National Institute of Industrial Technology's development of an industrial energy con- servation program. The project's major risks are (i) changes in exchange rate and interest rate policies that would make the line of credit unattractive and (ii) a return to protectionist policies that would stifle the process towards increased industrial efficiency. | This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  - i~i - Bank FY 82 83 84 85 Estimated Disbursements: Annual 15 20 25 40 Cumulative 15 35 60 100 Appraisal Report: Report No. 3538-AR  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE IBRD TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO BANCO NACIONAL DE DESARROLLO WITH THE GUARANTEE OF THE ARGENTINE REPUBLIC FOR A SECOND INDUSTRIAL CREDIT PROJECT 1. I submit the following report and recommendation on a proposed loan to Banco Nacional de Desarrollo (BANADE) with the guarantee of Argentine Republic for the equivalent of US$100 million to help finance a Second Industrial Credit Project. The loan would have a term of 15 years, including 3 years of grace, with interest at 11.6% per annum. The amortization schedule will conform to the aggregate of the following two amortization schedules: (a) for the US$99.5 million for financing industrial subprojects, the aggregate amortization schedule of the subloans fixed at the time when funds have been fully committed; and (b) for the US$0.5 million for technical assistance, standard Bank amortization schedule. PART I - THE ECONOMY 1/ Introduction 2. The most recent Economic Memorandum (No. 2988-AR) was distributed to the Executive Directors in August 1980. An economic mission visited Argentina in November 1980; its findings have been incorporated in this report. Country data sheets are attached as Annex I. A special report on the impact of the Government's stabilization and reform policies on the private sector will be distributed in the near future. Background 3. Argentina is a semi-industrialized country with a per capita income in 1979 of US$2,280, a sizeable middle class and a relatively even distribution of income. Postwar GDP growth has averaged 3.5% in an economy which has been subject to strong cyclical fluctuations. Sharp swings from expansionary fiscal, monetary and wage policies to restrictive stabilization programs have occurred five times since 1950. During the early 1970s, when Argentina's external situation was favorable, the Government pursued an ambitious public investment program. Large increases in public expenditures, nominal wages and credit resulted in strong growth of domestic output, while maintenance of fixed exchange rates led to rapidly increasing imports. In mid-1974, poor weather, falling world grain prices, and an EEC ban on beef imports halted export growth. Deterioration of the foreign sector coincided with an intensi- fication of domestic social and political conflict. Acceleration of the wage-price spiral propelled inflation to over 300% in 1975 and an annual rate of about 800% in early 1976. A rapidly increasing foreign debt and a drastic fall in foreign exchange reserves threatened a serious foreign exchange crisis. 1/ This section is virtually the same as that in the President's Report for the Oil and Gas Credit Project (P-3092-AR) dated June 17, 1981, except paragraphs 15-22 which were updated to take into account recent developments.  - 2- Stabilization Efforts 1976-1978 4. The administration, which took office in March 1976, had, as its initial objectives, strengthening the balance of payments, restructuring the external debt and preventing hyper-inflation. The balance of payments improved as soon as export taxes were reduced and capital flows were freed. Monetary and fiscal policies, supported by wage controls, succeeded in bringing down the rate of inflation from 780% during the year ending in April 1976 to 150% a year later. No further progress was made, however, in reducing infla- tion during the remainder of 1977 and 1978. At the same time output fluctuated greatly. After recovering rapidly from the 1975-1976 recession, growth came to a halt in late 1977 when credit restrictions and record high interest rates resulted in a drop in investment. 5. External sector policies introduced in 1976 immediately produced favorable export results while imports were held down by two recessions. As a consequence, the resource balances registered surpluses of US$1.9 billion and US$2.8 billion in 1977 and 1978 respectively. Current account surpluses were accompanied by large capital inflows. At the beginning, the public sector was the primary borrower, but starting in 1977 high domestic interest rates induced the private sector to borrow abroad on an increasing scale. Although the authorities introduced some controls in 1978, long-term capital continued to flow into Argentina, and by the end of that year gross foreign exchange reserves stood at US$5.8 billion, equivalent to 14 months of imports. Net reserves amounted to US$5.0 billion. This reserve growth permitted a new approach to inflation control in the framework of an open economy. The 1979/1980 Program 6. In late December 1978 the Government announced a stabilization program with predetermined schedules for adjustment of (i) exchange rates, (ii) prices of fuels and public sector services, (iii) wages, and (iv) the monetary base of internal origin, combined with a five-year import tariff reduction schedule and the formal reopening of the capital market to inter- national transactions. Most of the adjustments were to follow a declining trend, designed to dampen inflationary expectations and to limit price increases of domestic producers. Foreign competition was to reduce the rate of price increases of domestic tradeable goods to the level determined by: (a) the rate of price increases abroad, and (b) the rate of depreciation of the peso. It was recognized, however, that possible tariff redundancy and lags in the adjustment of imports would delay this l"convergence" of domestic and foreign inflation rates. 7. Shortly after the announcement of the 1979-84 tariff liberalization schedule, the Government started a supplementary program of temporary tariff reductions for goods whose domestic price increases substantially exceeded increases in international prices and the rate of devaluation. In addition, tariffs for all capital goods were eliminated temporarily in order to facil- itate the re-equipment and modernization of Argentine industry.  - 3 - 8. One notable feature of the stabilization strategy was the secondary role of monetary policy. The pre-fixing of the peso/dollar rate, along with the elimination of capital controls, allowed the monetary authorities to influence only the monetary resources originating from domestic sources. By setting quarterly targets for this variable, the monetary authorities wanted to limit internal public sector borrowing and ensure an adequate supply of credit to borrowers who had no access to foreign credit sources. Fiscal policy was also viewed to be of secondary importance insofar as short-term stabilization objectives are concerned. To mitigate inflationary expectations, however, and to reach the long-run goal of decreased state intervention, the authorities were able to decrease the central government's deficit from 2.1% of GDP in 1978 to 1.5% in 1979. The overall public sector deficit was reduced significantly from its 1978 level of 5.0% of GDP to 3.5% in 1979. Results of the Program 9. Most of the policies outlined above were implemented during the course of 1979. The key variable, the exchange rate, was moved according to plan, the tariff reform was applied, public sector prices and tariffs were adjusted as envisaged, and monetary resources of internal origin expanded only slightly more than projected. However, total money supply expanded rapidly, because the elimination of capital controls and the maintenance of the schedule for exchange rate devaluation, despite high internal inflation, led to heavy capital inflows amounting to over US$1.5 billion in the first nine months. With a tight labor market prevailing throughout 1979, nominal wages increased more rapidly than scheduled. The Government eliminated the legal limitations on wage increases in September. 10. After some adjustment lag, during which the peso appreciated sig- nificantly in real terms, inflation substantially decelerated. The general wholesale price index, which rose at an average rate of 8.3% per month from January to August 1979, increased by an average of only 3.5% per month from September 1979 to December 1980, the lowest monthly rates since early 1974. The deceleration in inflation led to some real depreciation of the exchange rate, higher real wages and positive real interest rates during the last three months of 1979. Initially, domestic price increases were dampened by decreasing prices of primary products, but the industrial sector's exposure to international competition became the primary factor in late 1979 and 1980. As expected, the branches most exposed to foreign competition were those which showed price deceleration most clearly. 11. In accordance with the preannounced schedule, the peso was devalued by 2.8% in January 1980, with a 0.2% decrease in the rate of adjustment in each of the following months, amounting to 25% for the whole year. Effects of the past appreciation of the peso in real terms and tariff reductions led to a continuous deceleration in inflation as reflected in the wholesale price index. With prices of traded goods decelerating, it was expected that internal market adjustments would result in a slowing down of prices of non-tradeables as well. However, this did not happen; domestic terms of trade deteriorated for traded goods, in general, and export products in particular.  - 4 - 12. The Government's policies had a major impact on the private sector. In order to survive, firms had to adopt measures that in the longer term would augur well for increased growth and productivity. In the short term, however, many firms have faced a severe profit squeeze and cash-flow problem. The traditional agricultural sector in the Pampas appears to have responded to the general decline in producer prices positively by intensifying production with emphasis on cereal crops and oilseed cultivation; as a consequence yields and exports have increased. Producers outside the Pampa (fruits, wool and cotton), however, found it more difficult to compete. In industry, success or failure at the enterprise level has been importantly influenced by the previous degree of protection and the quality of financial management. Firms cut costs by providing fewer products, and many sold subsidiaries to generate badly needed cash for improving new machinery and equipment to modernize production. Some firms were unable to cut costs in line with decreasing revenues, however, because of escalating financial costs and rising real wages despite a substan- tial decline of employment in the sector. 13. During the second semester of 1980 several new measures were adopted, the most important of which affected incentives for imports and exports. In addition to an acceleration of the rate of devaluation, a change in the tax structure lowered payroll taxes and increased the rate of the value added tax. Industrial firms are now reimbursed the additional value added taxes when exporting, whereas before they did not receive reimbursement for labor taxes. That tax change was equivalent to a de facto devaluation for exports equivalent to between 5 and 15%, depending on the relative labor costs of each enterprise. As regards industrial imports, the substitution of domestic payroll taxes by value added taxes, which are paid by importers as well as by domestic producers, amounted to a devaluation equivalent to the increase in the value added tax. 14. Nonetheless, with imports booming and exports slowing down, the current account surpluses of 1976-78 turned into a deficit of about US$4.7 billion by 1980. Growing expectations that the peso would be devalued, and uncertainties attached to the imminent change of Government, triggered heavy capital outflows. A 10% devaluation in early February 1981 was insufficient to calm foreign exchange markets. Capital outflows accelerated, and annualized rates of interest for short-term peso borrowing reached 56.4% in real terms during the first quarter of 1981. Recent Measures of the New Administration 15. The conditions facing the Argentine economy when the new Government took office on April 1, 1981, were extremely difficult. The 10% devaluation had failed to stem the expectations for further devaluations. Very high real interest rates had led to some private business moratoria and closing- downs. The external debt of the country had reached more than US$30 billion - half of it to be repaid in 1981. Besides, external conditions facing the country were not bright: world recession was expected to go deeper, inter- national prices of main exportable grains were falling and the beef cycle was in its downward phase. The new Government's economic program is aiming at reducing the balance of payments deficit and easing the financial problems of the debt-ridden private sector, without radically shifting from the longer-term economic liberalization program. Three policy "packages" have been introduced since April 1981.  16. The first "package", introduced on April 2, devalued the Argentine peso by 30% and set the monthly rate of future devaluations at 4%. To dampen the inflationary effect of the devaluation and to reduce the windfall gains accruing to exporters, transitional export taxes (12% ad valorem) were intro- duced on agricultural exports, and export reimbursements for manufactured products were limited to a maximum of 25%. The Argentine Government also declared its continued commitment to the long-term program of trade liberal- ization and included in the package the elimination of a number of special export incentives and the lowering of import tariff ceiling to 43% - the latter being in accordance with the 1979-84 tariff liberalization schedule. Following the devaluation, the reserve position of the Central Bank improved and the rates of interest - which had peaked during the predevaluation rush on dollars - began to decline. 17. In its second "package", introduced on April 24, the Government instituted a scheme for refinancing the debts of agricultural and industrial firms which had been squeezed between the rising cost of loans and the competi- tion by imports. Cautious not to expand the monetary base unduly, the new credit injection, to be accomplished through Central Bank rediscount operations, was set at the equivalent of US$4 billion and offered in three installments. At the same time, commercial banks reserve requirements were raised from 12 to 14%. While the scheme reduced the probability of massive defaults, it fell short of consolidating the precarious financial situation of the industrial sector at large because of the relatively small size of the total credit made available (private sector debt was approaching US$30 billion) and the delays involved in the loan allocation procedure. Also, continuing speculation against the peso renewed upward pressures on short-term interest rates. 18. The third "package", introduced on May 8, consisted of measures to limit the public sector deficit, which was running considerably above the level projected for the first quarter of 1981. Among the measures were a review of the investment program to reduce outlays, the offer of public companies for sale to the private sector and a 5 percentage point increase in import tariffs to increase fiscal revenues. Wages and other current expendi- ture adjustments of the public sector were lagged behind inflation, which accelerated to an average of 13% per month during the second quarter, compared to a 4.2% monthly average during the first quarter. 19. Pressure on the peso intensified, leading to another devaluation and to the creation of a separate floating rate for "financial transactions" in June. Efforts to restore public confidence in economic management were comple- mented by the announcement (August 20) of the Government's short- and medium- term objectives and related measures. Included were an expansion of the industrial refinancing operation announced in the second "package" and meas- ures to strengthen taxation and curtail public sector spending. These measures helped to stabilize the capital markets. The refinancing program was expanded to ease the cash flow broblems of industrial firms. Together with the mainte- nance of a realistic exchange rate, this should permit the renewed expansion of industrial output and exports. The Government's program is attempting to reduce inflationary pressures without returning to the inefficient protective measures and subsidies of the past. Crucial to this undertaking will be the Government's success in reducing the public sector deficit, through selective  -6- review and curtailment of the investment program and the introduction of strict controls over current expenditure, as well as strengthening of tax collection and continued adjustments in public sector tariffs and prices. Medium- and Long-Term Development Prospects 20. During 1981 and 1982, business failures of weak or overexpanded firms and unemployment are likely to increase. Availability of long-term credit for reequipment and modernization will be a crucial requirement for supporting the restructuring of industry. Since the private sector is also expected to take on a number of tasks previously undertaken by the public sector, considerable flexibility and efficiency will be required of the Argentine financial system. While agricultural production decreased in 1980 because of unfavorable weather conditions, growth in agricultural output has been strong in 1981 and should continue on the expansion path started in the early 1970's. The trade surplus this year is expected to be over US$4 billion. Agricultural investments and exports should rise given the improved incentives and credit conditions and favorable prices of Argentine products in interna- tional markets. For 1982 and 1983, Argentina aims to achieve trade surpluses of US$3.0 and US$2.5 billion respectively. 21. The current account balance turned negative in 1979, and, despite projected trade surpluses, is likely to remain in deficit for a few years. Substantial capital flows from world markets, bilateral arrangements, export credits, and direct private sources are necessary to maintain investment levels. Official multilateral sources may play an important role by providing financial support combined with technical and organizational assistance and by stimulating capital flows from other sources. Argentina's medium- and long- term external public debt amounted to US$9.1 billion at the end of 1980 and private external debt, US$4.4 billion. The external debt service ratio was 26% in 1979, and is estimated to have been 30% in 1980. Since the Central Bank earned interest on its large foreign exchange reserves, the total net debt service ratio was reduced to about 24% in 1980. The Bank's share of the external public debt was 5% and its share in debt service was 3%. On balance,these shares are not expected to increase significantly in the next five years. 22. It is too soon to quantify the effects of the present measures. The ongoing liberalization process has enhanced the competitiveness of the economy. Argentina has rich natural and human resources, and is self- sufficient in energy. For these reasons and assuming prudent economic policies, Argentina remains creditworthy for long-term borrowing. PART II - BANK GROUP OPERATIONS IN ARGENTINA Bank Operations 23. After a hiatus of five years, lending to Argentina was resumed in September 1976. Total lending to date, net of cancellations, amounts to US$1,606.7 million. To assist Argentina through the initial stabilization effort following the crisis in 1976, Bank lending has focused on major infra- structure projects and the provision of credit and training to productive sectors.  - 7 - A grain storage project was designed to enable Argentina to export agricultural products in a more orderly manner; an industrial credit project helped support moderni-zation and expansion of export oriented industries, and the projects for power, highways and railways provided part of the infrastructure necessary to facilitate agricultural and industrial expansion. Recently, the Bank began lend- ing to Argentina's hydrocarbon sector through a series of loans. The oil and gas engineering loan was the first step in helping Argentina improve its knowledge of hydrocarbon reserves through expanded audits of reserves and seismic surveys; the coal exploration loan will improve the basis for a rational exploitation of Argentina's coal resources. The oil and gas credit loan will promote private sector participation in the exploration and development of the hydrocarbon sector; and the refinery conversion loan will improve the product mix of Argentina's refined petroleum products to meet local demand. 24. Disbursements of Bank loans have been slower than expected. Per- sistent high rates of inflation, the need for fiscal austerity and inertia of the private sector did not provide a conducive environment for progress of Bank financed projects. During the last twelve months, however, the pace of disbursements has picked up considerably. Annex II contains a summary statement of Bank loans and notes on the execution of ongoing projects. 25. Future projects would support Government efforts to modernize the economy through: (i) upgrading public sector enterprises and rationalizing sector policies; (ii) restructuring the industrial sector to increase *efficiency and improve export performance; and (iii) helping the Government in its efforts to transfer responsibilities to provincial authorities and promote private sector participation. Within the framework for proposed assistance, the oil and gas sector offers ample possibilities for continued Bank participation. Argentina's sizeable hydropower potential, shared with riparian neighbors, represents another attractive field for Bank assistance. In the transport sector, the Bank is helping with the preparation of a highway sector project and plans to continue supporting other modes of transport. 26. To help modernize the industrial sector, the Government has reduced import duties to encourage adoption of measures to increase local efficiency. Under the proposed loan the Bank would assist the Government in strengthening financial and human resources for industrial development. In addition, the present administration has taken long strides toward opening up areas for private sector or joint ventures which traditionally have been the exclusive domain of the public sector. New mining legislation has cleared the way for the development of Argentina's substantial mineral reserves by the private sector. Possible Bank participation could help rationalize sector policies, attract foreign investors and promote domestic private sector participation. 27. The Government has embarked on a major revision of the revenue sharing system and the distribution of Government responsibilities/expenditures to reduce bureaucracy, synchronize the supply of services more closely with demand and provide services more effectively at lower cost. In support of these policies, a proposed project in the water supply and sewerage sector would help develop provincial institutions, consolidate sector finances and effectively expand service coverage. Bank participation in pollution control, regional water development and flood control are additional possibilities that are under study.  -8- IFC Operations 28. As of September 30, 1981, IFC had made 14 loans to borrowers in Argentina totalling US$174.4 million and two equity investments of US$2.5 million, of which US$101.5 million have been repaid, cancelled or sold. A summary of IFC's investments, is shown in Annex II. PART III - THE INDUSTRIAL, FINANCIAL AND MINING SECTORS The Industrial Sector 29. Argentina was one of the first Latin American countries to develop a sizeable industrial sector. The growth of industry was fostered by an expanding domestic market and by natural protection resulting from its distant location from major world centers of industrial production. By the turn of the century, industry's share of GDP was already about 15%, and about 20% of the nation's labor force was employed in a large number of relatively small plants. From this base, industrial growth surged ahead during World War I, the depression of the 1930's and again during World War II, propelled each time by the substitution of locally manufactured goods for imported products. After World War II, the Government promoted the industrial sector through a combination of foreign exchange and import controls, high tariffs and special tax incentives. Annual growth in manufacturing value added, which had averaged 4.1% in the 1950's, rose to 5.6% in the 1960's and accelerated to 7.2% between 1970-74, before it fell to -0.1% in 1975-79. These average industrial growth rates, however, conceal wide fluctuations in the annual rates of expansion which were experienced because of foreign exchange shortages and intermittent Government price stabilization efforts. The share of manufacturing in total value added rose from 25% in 1950 to 29% in 1970 but has fallen again to 25%. The decline in industrial output growth and its share in total GDP in the second half of the 70's resulted partly from the stabilization and structural adjustment measures introduced by the new Government in 1976. 30. In the fifteen years following World War II, the Government's indus- trialization policy focused on an import substitution strategy utilizing multiple exchange rates, import tariffs and restrictions, as well as numerous fiscal and credit incentives for investments in less developed regions. These measures encouraged a shift from the traditional industries to the modern subsectors, mainly chemicals, rubber, metals, machinery and equipment. In spite of a fairly rapid growth rate and continuous diversification, the manufacturing sector was confronted with the following problems: (i) a substantial degree of instability with rapid swings from strong expansion to sharp contraction; (ii) a high-cost structure as reflected in relatively high prices and underutilization of capital; (iii) heavy import dependence espe- cially of the dynamic branches of the industrial sector; and (iv) a low labor absorption rate. The low efficiency levels in various industrial subsectors stemmed principally from the high and uneven protection of import- substitution industries, lack of control and inefficient management in many state enterprises supplying basic inputs to industry, and mismanagement of public finances, which frequently deprived the private sector of necessary funds.  - 9 - 31. Industrial Exports. Because of the industrial sector's heavy dependence on intermediate goods imports, the sector growth became sensitive to shortages of foreign exchange. Policymakers realized that higher and more stable growth rates could only be achieved through export diversification. In an effort to stimulate exports, the Government introduced several fiscal and monetary incentives in 1962 but these measures had little influence in the first years because of erratic exchange rate policies. Significant strides were made only in the late 1960's when these incentives were supplemented by global reimbursements of income taxes, an export insurance scheme and more realistic exchange rate adjustments. With these efforts, Argentina's role as an exporter of processed agricultural goods was extended to machinery, vehicles and metal products. These products accounted for over half of total Argentine exports by 1976. Manufacturing's share of total exports advanced from 8% in 1966 to 26% in 1978 but declined to 20% in 1980, resulting partly from the appreciation of the real exchange rate and the structural adjustment taking place in the overall economy. Export declines were significant in automobiles and in such traditional and relatively labor intensive activities as textile and leather products. This shortfall was partially offset by increases in the foreign sales of resource-based products such as petroleum derivatives and metals, particularly aluminum, iron and steel. 32. Industrial Employment. The manufacturing sector has offered limited new opportunities for employment during the last thirty years because: (i) new industries and technologies introduced were relatively capital intensive; (ii) successive governments artificially reduced the relative cost of capital by subsidizing interest rates and overvaluing the foreign exchange rate for capital goods; and (iii) labor legislation with its inflexible rules and substantial fringe benefits discouraged labor intensive production. Total employment in the manufacturing sector expanded on the average by only about 1% per year between 1950 and 1970. Manufacturing employment as a percentage of total employment actually declined from 28% in 1950 to 25% in 1970. It was only in the early 1970s that labor absorption by industry began to grow significantly (averaging about 3% p.a. between 1970-75), and this increase was almost entirely the result of a rapid expansion of output and employment by state-owned enterprises. During the 1976-80 period, employment declined sharply in the manufacturing sector, leading to increasing self- employment in the service sector. It is estimated that employment in manu- facturing fell by about 20% between 1975 and 1980, and that by the end of the latter year, employment in manufacturing was only 20% of total employment. 33. The 1976-80 Industrialization Program. As discussed in Part I of this report, the Government which assumed power in 1976 aimed to achieve more stable growth and increased productivity through price stabilization and trade liberalization. Steps were taken to unify the exchange rate, and imports of most items covered by the 1972 and 1975 prohibited lists were freed in July 1976. In November 1976, tariff rates for 4,000 of 7,600 positions in the tariff schedule were reduced by an average of 25%. Interest rates were allowed to rise to positive real levels and quantitative restrictions on imports and advance import deposits were abandoned in 1977. By the end of 1977, import tariffs for manufactured goods were brought down from an average of 94% to 53%.  - 10 - 34. The Government adopted in 1979 a more radical strategy designed to open up the economy to foreign competition by combining tariff reductions together with a preannounced exchange rate policy utilizing decreasing rates of devaluation. Preannounced limits on rates charged by public utilities, wages, and net domestic credit, were introduced to lower inflationary expecta- tions and to restrain Argentine businesses from increasing prices. Import tariffs on industrial products were further curtailed to an average of about 30%, although effective protection still averaged close to about 70% in early 1980 after all non-tariff import fees as well as freight and insurance charges were included. The opening up of the economy is suggested by the rise of the import/GDP ratio from 7% in the early 1970's to 8% in 1977/78, 10% in 1979 and 12.3% in 1980. Increasing import competition for industry is indicated by the expanding share of imports in the total supply of manufactured products. Government liberalization policies have resulted in the expansion of import shares in the intermediate and capital goods industries, and a rapidly increas- ing import penetration in the consumer goods sector. The overall import-output ratio in industry rose from less than 12% in 1971 to close to 24% in 1979. 35. The impact of the above developments on manufacturing firms varied widely. Producers of export goods or those subject to import competition suffered while producers of services, nontradable goods and tradable goods still enjoying significant degrees of protection posted continuous profit- ability. External competition forced a number of firms to specialize in high quality products and to integrate vertically. Many producers of capital goods either closed down or shifted production to supply large Government projects and the still highly protected automobile industry. Many firms cut production drastically, maintained their most important skilled workers, but operated at a loss, eating into their equity and the assets of their creditors. Despite these short-term difficulties arising from the restructuring process, it is expected that consolidation of smaller firms and specialization on production in which Argentina has greater comparative advantage will result in a more efficient and productive industrial structure. The concepts of more effectively controlling production costs, operating efficiently, and meeting the challenge of external competition have begun to play a more important part in the industrial thinking in Argentina. 36. The Government's New Program. The recent measures of the Government, which assumed office in April 1981, and the possible implications of these measures were discussed in Part I of this report. From all indications, the basic policy principles are similar to the 1976-80 guidelines, and will be continued. In addition to export measures, the Government has reduced by 12 percentage points all external tariffs of 55% and over. A commission composed of representatives of the Ministries of the Economy and Finance, Industry and Mining, Agriculture, Trade and Public Services has been formed to evaluate the current import tariff and export reimbursement system and make suggestions for possible changes. 37. The Government will have to walk a tightrope between stimulation of production on the one hand and stabilization on the other. After the recent devaluations inflation is accelerating again and will continue to do so unless renewed stabilization efforts are undertaken. Resolution of the inflation problem will bear directly on the welfare of the industrial sector. Industrial firms have been helped temporarily by the peso devaluation but the financial restructuring of a large number of enterprises may have to proceed with the help of the public sector.  - 11 - 38. The Government has submitted to the Bank a statement affirming its efforts to promote increased industrial efficiency and exports and to liberalize foreign trade. To this end, the Government will undertake a comprehensive industrial sector profile study which will include an analysis of effective protection of Argentine industries. The specific study on effective protection will be carried out not later than June 30, 1982. The submission to the Bank of satisfactory terms of reference and assignment of qualified personnel to undertake the study on effective protection is a condition of loan effective- ness (Section 6.01 of the Loan Agreement). The Government will furnish the Bank the results of the effective protection study and exchange views with the Bank on its future course of action with regard to industrial sector policies (Section 3.04 of the Guarantee Agreement). The Financial Sector 39. Argentina's relatively well developed financial system consists of the Central Bank, four national banks viz., Banco de la Nacion (BN), Banco Nacional de Desarrollo (BANADE), Banco Nacional Hipotecario (BNH), and Caja de Ahorro y Seguro (CAS), 31 provincial and municipal banks, 177 commercial banks, 230 finance companies and 28 mortgage banks. The total number of financial institutions declined from over 700 entities in the mid-1970's to 470 entities in 1980. As a consequence of the 1977 legislation favoring the establishment of all purpose commercial banks, the number of commercial banks nearly doubled while the number of financial companies has been reduced by 50%. 40. From September 1973 until May 1977 a system of nationalized deposits was in effect in Argentina. In this centralized system deposits were accepted for the account of the Central Bank, which paid interest, while financial entities received a commission fee for their intermediary role. Banks were responsible for credit and investment management, while the Central Bank established limits, conditions and guarantees on bank portfolios. Accelerated inflation that started in 1974, jointly with the interest rate policy pursued during the period, resulted in negative real interest rates for most financial assets and led to changes in the system of centralized deposits. The system of term deposits, even though operating formally within the centralized system, started to work in a decentralized way, since banks were allowed automatically to issue credit in relation to the amount of their deposits. The system resulting from these changes was a hybrid, composed, on the one side, by a centralized system for which a 100% reserve requirement was in effect and, on the other, by a sub-system with a zero percent reserve require- ment. Since the sub-system with no reserve requirements was the one that experienced the fastest growth, the actual average reserve requirements for the system tended to decline overtime. As a consequence, the Central Bank lost progressively its ability to manage the money supply. 41. The 1976 economic program reintroduced the full intermediation role of commercial banks and provided the financial system with a legal and regulatory framework that led to increased competition and efficiency. Under the new system monetary control was achieved through the application of minimum reserve requirements and open market operations. Monetary inter- mediation was reserved to commercial banks, the only entities allowed to accept current deposits. Interest rates were completely freed and deposits in national currency in all financial institutions were insured through a  - 12 - nationwide guarantee system. The deregulation of interest rates has resulted in positive real interest rates and, thus, Argentine savers have been able to protect their savings against inflation in the domestic financial market. The increase in savings has progressively raised the monetization of the Argentine economy, with the ratio between monetary assets of the private sector to GDP climbing from 8% in 1976 to 30% in mid 1980. In turn, the volume of credit available through the financial system has doubled in real terms. At the same time a shift in the composition of the credit has occurred; the private sector now accounts for 77% of total credit compared to 69% in 1976. 42. Since 1979/80, however, the Argentine banking system has increasingly faced liquidity problems. Many private domestic banks have weak portfolios because of the weakened financial position of the industrial sector. The existence of a 100% guarantee system for bank deposits encouraged commercial banks to attract deposits with high interest rate and then lend the funds to risky borrowers. When interest rates were raised in 1977/78, industrial firms were able to absorb higher financial costs by passing them on as higher prices. Since 1979 however, increased import competition has put a ceiling on prices of firms selling traded goods resulting in increased occurrence of loan defaults. At the same time, the volatility of prices and interest rates for loans made it difficult for the banking system to extend loans beyond the thirty-day maturity. As a consequence, firms have been financing their long- term capital investments with short-term funds at very high real interest rates of the past two years, thus, affecting virtually their entire debt structure. 43. In order to improve the financial structure of firms in the primary and secondary sectors, the authorities introduced a policy of Central Bank rediscounts in April 1981, which commercial banks will be able to use for long-term lending. Under this policy, financial institutions can use a part of their deposits for four-year loans with a grace period of two years and interest payments to be made by the end of each year. While the introduction of this policy offered an important step towards the alleviation of the immediate financial problems of many firms, it has lagged in the face of the conflicting desire to limit monetary expansion. As a consequence, the term credit needs of industry will not be fully met by the financial system. Meanwhile, although foreign loan financing as a share of gross private invest- ment has nearly tripled from 1975/76 to 1977/78, access to foreign borrowing is restricted to larger firms. The proposed loan to BANADE would thus fill an important gap in the financing of medium and small firms in the Argentine industrial sector. The Mining Sector 44. Although Argentina shares some of the favorable geological features of its neighbor Andean-countries the mining sector makes a far smaller contribu- tion to its economy than it does in those countries. Since 1960 the sector's participation in GDP has been between 1.5%-1.7%. Most of these contributions come from the mining of non-metallic minerals. Mining of base metals such as copper, lead and zinc has been restricted to a relatively limited number of small operations. The only exception has been the U.S. controlled company "Minera Aguilar" which operates a 2,200 tons per day mine and concentrator producing zinc, lead and silver concentrates. The Government has committed itself to increase the importance of the mining sector by promoting private sector exploration and development.  - 13 - 45. Recently, two key decree-laws have been issued to promote the development of Argentina's mining sector. The mining code was amended to outline a legal framework for developing large-scale mining through concession contracts for exploration and exploitation. The new Mining Promotion Law is intended to promote the development of mining activities through duty exemp- tions and tax incentives for investments in this field. The Law also regulates the operation of the Mining Development Fund which provides financial assis- tance for exploration and mining feasibility studies to medium and small-scale mining projects. 46. The size of some of the mining projects currently under preparation in Argentina will require very large investments, some exceeding US$1 billion requiring external capital financing. There are, however, several small projects for development and expansion in the small-scale base mining sector where about 20 to 30 small/medium enterprises are involved. The financial requirements for these projects can be adequately covered by local financing institutions among which BANADE plays the most important role. The First Industrial Credit Project 47. The First Industrial Credit Project provided US$100 million to BANADE to assist in financing the foreign exchange costs of fixed assets for investment subprojects in the industrial sector and technical assistance for BANADE. The project became effective in November 1977. The US$99.75 million of loan funds available for onlending for investment subprojects was committed by BANADE in May 1981. The remaining funds for technical assistance should be completely committed in the near future. About 53% of the funds have been used to replace and modernize equipment of small and medium size enterprises. The remainder has been used to finance new and expansion projects of larger enterprises (45%) and mining enterprises (2%). Subloans were lent in dollars at 11% interest rate, initially, and at 12% beginning November 1980 with the Government bearing the cross-currency risk. It is anticipated that the loan will be fully disbursed by mid-1982. 48. The first project's principal goals have been achieved in the following ways: (i) term credit was provided for efficient industrial devel- opment; (ii) other external financing was stimulated; cofinancing of US$100 million was secured from a group of banks led by Lloyd's and Bank-assisted subprojects have also received funds from external sources; (iii) BANADE's institutional capacity to appraise projects has been enhanced, in part in response to the Bank criteria used for evaluating project feasibility. PART IV - THE PROJECT Background 49. The Government of Argentina and BANADE have requested a Bank loan to help finance a Second Industrial Credit Project. A project preparation mission visited Argentina in November 1980 and the project was appraised in February/March 1981. Negotiations were held in Washington in August/September  - 14 - 1981. The delegation of the Government of Argentina was headed by Mr. Guillermo Blanco, Director of Economic Policy, Ministry of Economy; BANADE's delegation was headed by Dr. Luis Mey, Director, BANADE. A report entitled "Staff Appraisal Report - Argentina - Second Industrial Credit Project" (No. 3538-AR) is being distributed separately. Special conditions of the loan are provided in Annex III. 50. The principal objective of the project is to support the government's goal of making the industrial sector more efficient. Along the lines of the first Industrial Credit Project, it will continue to assist the modernization and expansion of industry by providing fixed interest term credits to finance the foreign exchange component of subprojects. It will also finance subprojects in the mining sector and will introduce a credit line for industrial energy conservation. Part of the loan will be channelled through provincial banks to help stimulate regional development and mobilize provincial bank resources for industrial development. The project will include technical assistance to help BANADE in its institutional development. Also, the project provides for the Government to undertake an industrial sector review (para. 38) and for the Instituto Nacional de Tecnologia Industrial, using its own resources, to develop an industrial energy conservation program. To assist in financing this project, complementary external medium-term funds from private financial institutions would be raised by BANADE through co-financing arrangements (para. 71). 51. The loan of US$100 million will be made to BANADE with the guarantee of the Government of Argentina. The specific loan categories will be as follows: Amount US$ million (i) BANADE loans to subborrowers and to provincial banks (i.e., for onlending) for industrial, and mining subprojects 89.5 (ii) BANADE loans for industrial energy conservation subprojects 10.0 (iii) Technical assistance and training 0.5 BANADE will relend either directly to the sub-borrowers or through the pro- vincial banks for mining and industrial subprojects, specifically for re- equipment or modernization (i.e., those subprojects that will not increase production more than 30%), as well as new production and expansion. The loan proceeds will finance the cost of imported equipment and the foreign exchange component of locally manufactured equipment. A specific loan amount of US$10 million is allocated to the energy conservation program to emphasize the program's need for special promotion and institutional development efforts. However, this allocation is indicative; a transfer could be made to the other loan components if the projected demand for the energy conservation loan is not realized as expected. Conversely, if the demand turns out to be higher than projected, a transfer could be made from the other loan categories to finance energy conservation subprojects.  - 15 - 52. The loan includes technical assistance for: (i) design and implementation of BANADE's Manpower Development Plan and Program; and (ii) design and installation of BANADE's Management Control and Information Systems. Loan proceeds will be used to finance consultant services, training and computer software programs. 53. The loan is expected to be committed by March 1, 1984 and disbursed by March 31, 1985. The amortization of the credit portion of the loan will conform to the aggregate of the amortization schedules of individual sub- loans, subject to a maximum term of 15 years. The technical assistance component of the loan will have a term of 15 years, with a 3-year grace period and a fixed amortization schedule. The Borrower 54. BANADE is the successor institution to the Banco Industrial, which was founded in 1944 to provide term financing for industry. It was created as an autonomous Government-owned bank in 1970. Its operations virtually came to a standstill by 1976, principally as a result of lending at highly negative real interest rates during a period of high inflation. It was recapitalized and reorganized under a new Charter and Board of Directors in 1976. BANADE's new management sought to concentrate its financial assistance on private sector lending and to apply lending interest rate and indexation policies designed to conserve BANADE's capital base. In addition to its primary devel- opment banking objectives, BANADE also accepts deposits and provides commercial banking services. It ranks third in Argentina among all banks in deposits and fourth in loans outstanding. It has an important role in providing working capital loans to industry and in foreign trade financing. 55. Organization and Management. BANADE's Board of Directors consists of a president, vice president and ten directors, all appointed by the Govern- ment for terms of four years. The Board appoints BANADE's General Manager, Assistant General Managers and Department heads. The Board is also responsible for establishing strategy and policy within the framework of BANADE's charter and approving operations. BANADE has its headquarters office in Buenos Aires and 33 branch offices throughout the country. About one-third of its 3,600 employees are assigned to branch offices. 56. BANADE's lending operations are conducted through four departments, viz., Development Credit, Mining, Ordinary Credit and External Finance. These departments which are headed by assistant general managers are staffed with skilled personnel and project analysis is conducted by teams of financial analysts, engineers, accountants and economists. Many of BANADE's technical personnel have second jobs; a practice that has been common for many years in the Argentine civil service. Undoubtedly, dual employment adversely affects productivity. BANADE is concerned about the problem and will address it in the context of a manpower development program. Assurances were obtained that BANADE's management will prepare a comprehensive Manpower Development Plan by June 30, 1982 and will carry out the plan according to a timetable satisfactory to the Bank (Section 3.07 of the Loan Agreement). The Plan will include systems and programs for personnel evaluation, promotion, incentives, training, hiring and recruitment, as well as a program for the preparation of managerial personnel to assume positions of increased responsibility. The Bank and BANADE also discussed and agreed on a Management Control and Information  - 16 - System which seeks to improve BANADE's programming and monitoring of opera- tions, financial planning and allocation of resources. The new system contem- plates increased and better use of data processing equipment. BANADE agreed to carry out the the Management Control and Information System according to an action plan satisfactory to the Bank. The Bank and BANADE will review the progress on the action plan not later than June 30, 1982 and every six months thereafter, until the completion of such action plan (Section 3.08 of the Loan Agrement). 57. Operations. BANADE's outstanding loans at year end 1980 were the equivalent of US$3.6 billion, having grown over 700% in the last five years. About one-third of BANADE's outstanding loans are denominated in foreign currency and the balance in local currency. BANADE's loans are principally made to finance fixed investment. Fixed investment peso loans have accounted for over 70% of the local currency loans made annually in every year but one since 1977. Although BANADE makes short term and commercial bank type loans, it is basically a long-term lender. About 80% of its outstanding loans on November 30, 1980 were for more than three years. The branch offices have been active in committing loans and have been responsible for committing annually since 1977 between 20% and 40% of BANADE's peso lending. Although all industrial subsectors have benefitted from BANADE lending, emphasis has been given in recent years to lending to the petrochemical industry. 58. Lending Terms. Foreign currency loans are repayable by BANADE's subborrowers in the currency in which BANADE borrows and carry an interest rate that includes a fixed margin above BANADE's borrowing costs. The principal of peso loans, other than short-term working capital loans, are indexed based on the Central Bank's computed weighted average of interest rates paid on term deposits (tasa testigo). The mark-ups above the tasa testigo vary between 2-13.5% depending on the type of project and its location. The lowest interest rates apply to industrial projects located in frontier areas and mining exploration projects. The amortization period of loans for industries in frontier areas is up to 12 years including 2 years of grace, bearing an interest rate of 2% per annum plus indexation. The interest rates for new projects qualifying under the Industrial Promotion Law are 5% and 7% plus indexation for expansion projects and equipment financing. These loans are made on terms of up to 12 years, including 2 years of grace. Fixed working capital credits bearing interest rates between 9% and 13.5% per annum plus indexation are provided to industries for up to 12 years, including 2 years of grace for production expansion and debt restructuring. 59. Financial Position and Results. BANADE's Policy Statement limits its debt to ten times its capital and reserves. At year end 1980 the debt equity/ratio was 5.5:1, which although much higher than the 2.6:1 ratio at year-end 1979, still allows for considerable additional leverage. The ratio rose due to continued growth in liabilities and some equity erosion in real terms. Since 1976 BANADE has had a substantial growth, with its loan port- folio having increased sixty fold, total assets forty-two fold and equity seventeen fold, during a period when there was a twenty-two fold increase in the wholesale price index. 60. BANADE maintained a steady growth in its net earnings in the period 1976 to 1979. Return on total assets averaged between 11% and 15% during that period. The situation changed sharply in 1980, when return on total assets dropped to 2%. The relatively poor 1980 performance was attributable to the  - 17 - negative spread in BANADE's peso lending. BANADE indexed its loans to the wholesale price index at a time when the rate of increase in wholesale prices lagged behind the interest rate BANADE had to offer to maintain deposits. Since early 1981, however, all new term loans in pesos have interest rates based on the tasa testigo and rates on all outstanding term peso loans were converted from the wholesale price index base to the tasa testigo base. As a result, BANADE's earnings in the latter part of 1981 should recover and earnings for 1982 should show a strong gain over 1980. Assurances were obtained that the Government will undertake to require BANADE to take all such measures as may be necessary to maintain BANADE's equity in real terms (.Section 3.02 of the Guarantee Agreement). 61. Portfolio Quality and Reserves. In spite of the problems affecting Argentina's economy, the quality of BANADE's portfolio has remained satisfac- tory because of its: (a) conservative approach to lending; (b) good appraisal capability; and (c) proportionally large lending to sectors that have not been seriously affected by competition from imports. Arrears over three months represent 4% of the portfolio and the provision for bad debt is an adequate 10.2% of the portfolio. 62. External Auditing Arrangements. Until early this year Argentine law required that BANADE's accounts be audited by the Central Bank. The first Bank-financed credit project provided that the audit be submitted to the Bank within four months of the end of BANADE's fiscal year. BANADE's accounts were last audited by the Central Bank for its fiscal year ending December 31, 1978. The 1980 banking crisis placed competing demands on the Central Bank's staff, resulting in a decree in February 1981 requiring that all banks, including BANADE, be audited by external auditors for the year ending December 31, 1981. In view of the difficulties for external auditors to verify control systems in effect in prior years, BANADE proposed and the Bank agreed to an interim arrangement for the Sindico 1/ to hire qualified auditors to perform the audit of BANADE's 1980 accounts following Bank guidelines. The Bank has received the audit and it is considered satisfactory. For the year 1981 and subsequent years, BANADE's accounts will be audited by independent auditors satisfactory to the Bank and the results of such audits will be submitted to the Bank within six months of the end of BANADE's fiscal year (Section 4.02 of the Loan Agreement). Project Implementation 63. A review of BANADE's financing needs indicates that there is likely to be a demand for foreign currency commitments of about US$870 million through the loan commitment period (year end 1983). The estimate of demand takes into account pending loan applications and serious inquiries received by BANADE. As Bank funds would represent only about 11% of BANADE's estimated foreign exchange requirements during the loan commitment period, Bank funds would have to be supplemented by other external funds (para. 71). 1/ Sindico is the Government's appointed representative for supervising BANADE's compliance with its Charter and other applicable laws, decrees and regulations.  - 18 - 64. The Energy Conservation Component. A Bank review of the conserva- tion potential for industry concluded that industry's energy use efficiency could be increased by approximately 15% through introducing a number of "good housekeeping" practices and, in some cases, retrofitting with specifically designed equipment. The eventual reduction in industrial energy costs implied by those energy savings is estimated to be US$216 million/year. It was further estimated that 36% of this conservation potential can be achieved by 1985 if an effective industrial energy conservation program is started in 1981. Such a program would require a promotional campaign, training workshops and approximately 500-600 energy audits to be performed over the 1981-85 period. The estimated investment in equipment for retrofitting is about US$100 million. 65. The conservation program supported by this project will involve strengthening and extending the capabilities of BANADE and the Instituto Nacional de Tecnologia Industrial (INTI), a government organization that furnishes technical support to industry. BANADE will establish a line of credit for conservation investments, i.e., investments which will reduce production costs through a more efficient use of energy. The Bank loan will allocate US$10 million to this program. Although it is possible that demand for these funds could reach as much as US$40 million during the loan commitment period, a conservative approach is justified in view of delays that could be encountered in initiating a new program. BANADE will perform the credit appraisal based on its standard procedures and .:.ll rely on INTi for the technical appraisal. Technical appraisals can be performed by third parties, such as private consultants or the firms themselves, subject to INTI's review. The terms of the relationship between BANADE and INTI will be established in an agreement between the two institutions (Section 3.06 of the Loan Agreement). The signing of this agreement is a condition of loan disbursement for the energy conservation component of the project (Section 2.02(d) of the Loan Agreement). 66. INTI's participation in the conservation program will have four principal components: (i) an energy advisory service that will perform energy audits for all subsectors of industry and perform the technical appraisal of loan applications under BANADE's conservation credit line; (ii) a training program to prepare energy auditors and company energy managers; (iii) a promotion campaign for energy conservation; and (iv) laboratory services as necessary to support the program. INTI's services will be mainly directed at medium and small industry and within three years INTI should be able to perform about 200 energy audits per year. This program will complement the planned energy conservation study under the Bank's Refinery Conversion Project (Loan 2032-AR) which includes a number of audits of major plants. 67. The Provincial Banks. The provincial banks are those owned or controlled by the provincial governments in Argentina. There are currently 26 such banks in the country and they have about 20% of the deposits in the banking system. The provincial banks have extensive field office networks in the provinces that they serve, which allows them to reach communities that BANADE with its more restricted field office establishment is unable to reach. The provincial banks represent a largely untapped resource for channeling credits to the industrial sector.  - 19 - 68. The provincial banks included in the project will promote the credit line and will provide project preparation assistance to potential subborrowers. They will assume the credit risk for loans and will provide complementary funds where necessary. BANADE will do the appraisal of sub- projects for the provincial banks and charge a fee for this service. The provincial banks will have the following obligations: (i) assure that BANADE's loan policies and regulations are observed; (ii) give their approval in prin- ciple to subloans before they are submitted to BANADE for appraisal; (iii) supervise the use of funds by the subborrower; (iv) issue periodic reports on the progress of subprojects; (v) maintain records of subloans; and (vi) comply with reasonable requests for information from BANADE. This delineation of responsibilities will be spelled out in subsidiary loan contracts that would be entered into by BANADE and the provincial banks on terms and conditions satisfactory to the Bank (Section 3.04 of the Loan Agreement). The signing of these agreements will be a condition of disbursement of loan proceeds for onlending to the provincial banks (Section 2.02(d) of the Loan Agreement). 69. Subloan Terms and Conditions. Subloans from BANADE and the provin- cial banks will have maturities of up to 15 years including a reasonable grace period not to exceed 3 years. Unless the Bank otherwise agrees, Bank loan funds for any one subproject will be limited to US$7 million if there were no other external financing included in the subproject. Bank loan funds for a subproject can exceed US$7 million and be as much as US$12 million, provided that Bank loan funds over US$7 million will be matched by an equal or greater amount of foreign financing (Section 2.02(a) of the Loan Agreement). It is anticipated that this arrangement will encourage additional cofinancing. Subloans will be reloaned in either pooled currencies or in dollars, and will carry an interest rate equal to the Bank rate, plus a spread of 2.5% for BANADE's administrative costs, a commitment fee on the undisbursed balance, and at least 2.5% to cover cross-currency risk in the case of dollar subloans. Thus, dollar subloans will carry an interest rate equal to the Bank rate plus a total spread of at least 5%. The interest and fee schedule of provincial bank subborrowers will be no less than that established for BANADE's subborrowers (Schedule 3 of the Loan Agreement). 70. When submitting subprojects, BANADE will advise the Bank of any Government measures that have significantly increased the effective protection of the product to be produced. The free limit for subloans will be US$2.5 million, except (i) that BANADE will submit for the Bank's approval, the first two energy conservation subprojects and the first two subprojects from each provincial bank and (ii) where there has been a substantial increase in effec- tive protection since loan signing for the product of a subproject for which financing is being sought, the free limit will be reduced to US$500,000 (Section 2.02(c) of the Loan Agreement). New or expansion subprojects will have economic rates of return calculated for subloans over US$500,000 and financial rates of return for subloans over US$100,000. Re-equipment or modernization subprojects will have economic rates of return calculated for subloans over US$2 million and financial rates of return for subloans over US$500,000. In addition, BANADE will calculate economic rates of return on subprojects irrespective of size where there has been a significant increase in the effective protection of goods to be produced by the subprojects (Section 3.05 of the Loan Agreement).  20 - Cofinancing 71. BANADE expects to enter into cofinancing agreements of about US$200 million with private foreign banks. The agreements will include a cross- default clause, agreement to exchange relevant information and provision to channel service payments through the Bank. The maturity of the private foreign loans are expected to be about eight years. In order to facilitate the mixing of the shorter term private funds and to assist BANADE in matching the amortization of subloans to the amortizations of its external borrowings as closely as possible, the Bank agreed to permit BANADE to adjust toward the later maturities the amortization of subloans from Bank funds (Section 2.08(b) of the Loan Agreement). Such action will permit a more even subloan repayment schedule and a less onerous debt service burden on subborrowers during the early years of a subproject. Retroactive Financing 72. Retroactive financing of up to US$5 million will be available to finance expenditures under subloans of not more than US$500,000 after the date of approval of the Loan by the Bank's Executive Directors (Section 2.02(d) of the Loan Agreement). Procurement and Disbursement 73. As a standard procedure, BANADE requires that its borrowers receive three quotations in purchasing goods financed by its loans, unless it is demonstrated that the obtaining of such quotations is not feasible. A further administrative check is made by BANADE on the reasonableness of prices, even after quotations are received. For this project, BANADE gave the assurance that for procurement of goods and civil works in contracts of US$500,000 or more, private firms will be asked to identify principal local and foreign sources of supply and will solicit price quotations from a reason- able number of them (Section 3.03 of the Loan Agreement). BANADE will provide potential sub-borrowers a model subloan agreement specifying the procurement procedures which the sub-borrowers should follow. Disbursement of funds for subprojects will be on the following basis: (a) 100% of foreign expenditures for direct imports; (b) 60% of total expenditures of foreign equipment purchased off the shelf; (c) 45% of total expenditures for locally produced goods for energy conservation sub-projects; and (d) 30% of total expenditures for locally produced equipment. The percentages above represent estimated average foreign exchange costs. Under the technical assistance component, the Bank would disburse: (i) 75% of the cost of consultancy services and computer software; and (ii) 100% of training expenditures abroad (Section 2.02(a) of the Loan Agreement). Project Benefits and Risks 74. The proposed project supports the Government's objective of making the industrial sector in Argentina more efficient. It would do so by financing the foreign exchange costs of credits for the purchase of equipment to modernize industry, to expand and create new production, to assist the mining industry and to aid industry in conserving energy. The loan will be expected to stimulate cofinancing of US$200 million; loan funds will be used with shorter term and higher interest commercial credits to finance the subprojects.  - 21 - 75. The loan would be of particular assistance to industries which find the purchase of new equipment essential to maintaining their competitive position. The project will provide important institutional assistance to INTI to establish an industrial energy conservation program. The energy audit surveys will be the basis of obtaining credits from BANADE to finance energy saving capital invest- ments. Such investments will not only make Argentine industry more efficient, but will have positive effects on the balance of payments. Important institu- tional assistance will also be provided to BANADE in improving its management control and information systems and developing its human resources. The loan would bring the resources of provincial banks to bear in making development credits available to industries that might not otherwise be reached by BANADE. It is anticipated that the project will generate 1,500 new jobs. This figure is relatively low because the equipment financing and energy conservation components of the project will not generate net new employment and the new production and expansion projects will be designed to be labor efficient to make their products more competitive. 76. The project's major risks are (a) changes in exchange rate and interest rate policies that would make the line of credit unattractive and (b) a return to protectionist policies that would stifle progress towards increased industrial efficiency. However, the Government has provided a statement to the Bank affirm- ing its efforts to support the development of efficient industry in Argentina. The Government will also undertake a comprehensive industrial sector profile study, including an analysis of effective protection, which will help define the areas of comparative advantage and assist in setting guidelines for further tariff reform. The Government will discuss with the Bank the results of the effective protection study and future course of action with regard to industrial sector policies (Section 3.04 of the Guarantee Agreement). Recent economic events also indicate increasing financial constraints on the part of private investors and the possibility of a slowdown in economic growth which may result in lower demand for subloans under this project. It is estimated, however, that there is a substantial number of projects in the pipeline that will generate demand up to year-end 1983. This loan is estimated to be about 11% of BANADE's expected foreign currency loan commitments during the loan commit- ment period. Other risks in the project are that the new programs in indus- trial energy conservation and provincial banks might run into start-up problems. These are normal risks for new programs and are acceptable. PART V - LEGAL INSTRUMENTS AND AUTHORITY 77. The draft Guarantee Agreement between The Argentine Republic and the Bank, the draft Loan Agreement between the Bank and Banco Nacional de Desarrollo (BANADE) and the Report of the Committee provided for in Article III, Section 4(iii) of the Articles of Agreements are being distributed to the Executive Directors separately. 78. Special conditions of the proposed loan are listed in Section III of Annex III.  - 22 - 79. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank. PART VI - RECOMMENDATION 80. I recommend that the Executive Directors approve the proposed loan. A. W. Clausen President Attachment November 10. 1981 Washington, D.C.  - 23 - ANNEX I Page 1 of 5 ARGENTINA - bOCIAL INDICATORS DATA SHEET ARGENTINA REPERENCE GROUPS (WEIGHTED AVE7GES LAND AREA (THOUSAND SQ. KM.) - MOST RECENT ESTIMATE - TOTAL 2766.9 MOST RECENT MIDDLE INCOME MIDDLE INCOME AGRICULTURAL 1785.0 1960 /b 1970 lb ESTIMATE lb LATIN AMERICA & CARIBBEAN EUROPE GNP PER CAPITA (US$) 640.0 1120.0 2230.0 1616.2 2609.1 ENERGY CONSUMPTION PER CAPITA (KILOGRAMS OF COAL EQUIVALENT) 1109.7 1684.3 2038.3 1324.1 2368.4 POPULATION AND VITAL STATISTICS POPULATION, MID-YEAR (THOUSANDS) 20611.0 23748.0 27313.0 URRAN POPULATION (PERCENT OF TOTAL) 73.6 78.4 82.0 64.2 53.2 POPULATION PROJECTIONS POPULATION IN YEAR 2000 (MILLIONS) 34.3 STATIONARY POPULATION (MILLIONS) 42.0 YEAR STATIONARY POPULATION IS REACHED 2075 POPULATION DENSITY PER SQ. KM. 7.4 8.6 9.9 34.3 80.6 PER SQ. KM. AGRICULTURAL LAND 12.0 13.0 15.1 94.5 133.9 POPULATION AGE STRUCTURE (PERCENT) 0-14 YES. 30.8 29.1 28.2 40.7 30.1 15-64 YRS. 63.7 63.7 63.4 55.3 61.5 65 YRS. AND ABOVE 5.5 7.2 8.4 4.0 8.3 POPULATION GROWTH RATE (PERCENT) TOTAL 1.