Argentina - Trade Policy and Export Diversification Loan Project

Documet Of The World Bank FOR OFFICIAL USE ONLY 2)d,t/ _)c;/S . Report No. P-4483-AR REPORT AND RECOMMENDATION OF THE PRE:IDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN IN AIT AMOUNT EQUIVALENT TO US$500.0 MILLIO" TO THE ARGENTINE. REPURLIC FOR A TRADE POLICY AND EXPORT DIVERSIFICATIQ.-LO.AN May 19, 1987 This document has a restricted distribution and may be used by recipients only in the performance or their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1 M Austral 0.80 (June 14, 1985 to April 8, 1986) US$1 = Austral 1.255 (December 31, 1986) US$1 - Austral 1.541 (March 30, 1987) WEIGHTS AND MEASURES 1 hectare (ha) = 10,000 m2 = 2.47 acres 1 kilogram (kg) = 2.2 pounds 1 metric ton (m ton) = 1,000 kg GLOSSARY OF ABBREVIATIONS ARGEX - Argentine Exports BCRA - Central Bank of Argentina BONEX - Government-Issued Dollar Denominated Bonds IMF - International Monetary Fund DJAT - Temporary Admission Regime Import Request DJNI - Import Request SICE - Secretariat of Industry and Foreign Trade TAR - Temporary Admission Regtime REPUBLIC OF ARGENTINA FISCAL YEAR January 1 - December 31  FOR OMCIAL USE ONLY ARGENTINA TRADE POLICY AND EXPORT DIVER3IFICATION LOAN Loan and Project Summary Borrower: Argentine Republic. Amount: US$500 million equivalent. Terms: 15 years, including 3 years of grace, at the standard variable interest rate. Project Description: The proposed loan would support the first phase of the Government's trade policy reform program. The objective of the program is to support the Government's adoption of an outward-looking strategy focused on improving export competitiveness and increasing the efficiency of Argentine industry. This would redress the strong anti-export bias in the present system of tariff and non-tariff protection. It would also be linked to the maintenance of an adequate exchange rate. ln conjunction with the Loan, the Government would: (a) expand the temporary admission regime and introduce automaticity and uniformity in its operation, moving towards "free trade" status for exporters; (b) simplify the whole system of approvals and controls of trade administration; (c) eliminate the remaining export taxes on manufactures and reimburse indirect taxes on exports; (d) rationalize the protection system through the gradual reduction of non-tariff barriers to trade, including the transfer in 1987 of a block of 700 tariff positions from the prior consultation list to the automatic list; and (e) formulate an Action Program of trade reform for the second phase of the trade policy reform program consistent with the gradual elimination of most import non-tariff restrictions over a three-year period and rationalization of the import tariff structure (described in the Government's Policy Statement on Economic Adjustment--Annex V). The program would produce an improvement in growth, efficiency and export capacity. Project Risks: The risks of the trade policy reform program relate to the possibilities of setbacks in macroeconomic policy that would interfere with a gradual and sustainable opening up of the economy: strong domestic opposition because of difficulties in adjusting to the new incentives, the possible lack of an adequate private 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.  - ii - investment response to the export incentives, further strains on the banking sector, and adverse developments in the world economic environment which could lessen the political scope to import liberalization. These risks are mitigated by the Government's strong commitment to stabilize the economy and tn proceed with a broad program of structural reforms which include besides trade policy adjustment, a banking sector reform, rationalizing the public sector and increasing the role of the private sector in the economy. These risks are also expected to be reduced by the Government's recent successes in negotiating a multiyear rescheduling and new monies with the commercial banks and a new standby program with the IMF, and by the progress in trade policy reforms achieved already, particularly in eliminating export taxes, moving towards "free trade" status for exporters and opening up the economy. Estimated Disbursements: The first tranche of US$248 million would be available upon loan effectiveness, to be disbursed by reimbursing 100Z of foreign exchange payments for imported inputs for exports and for imports in the automatic list which do not require prior import requests, and 100Z of the costs of complementary computer and telex equipment and weight scales and consultants' services required to strengthen the Borrower's capability to carry out the Program amounting to US$4 million. Disbursements for this latter purpose would not be subject to the proposed tranching of the loan. The second tranche of US$248 million would be released provided the review of the macroeconomic program and of trade policies in December 1987 demonstrates satisfactory implementation of the agreed program. k2!sal Report: This is a combined President's and Staff Appraisal Report. Map: IBRD No. 12432R2.  INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT REPORT AND RECOHMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED LOAN TO THE ARGENTINE REPUBLIC FOR A TRADE POLICY AND EXPORT DIVERSIFICATION LOAN 1. I submit the following report and recommendation on a proposed loan to the Republic of Argentina for the equivalent of US$500.0 million in suppcrt of a Trade Policy and Export Diversification Loan. The loan would have a term of 15 years, including three years of grace, at the Bank's standard variable interest rate. PART I - THE ECONOMY 2. The Executive Directors have received a report entitled "Argentina: Strategies toward Industrial and Export Development" (5841b-AR), dated September 30, 1985. A Public Sector Investment Review (6354-AR) report dated November 17, 1986 has also been distributed to the Executive Directors. The present report reflects the major findings of the latter report and of subsequent updating missions. Country data sheets are presented in Annex I. A new Country Economic Memorandum is under preparation. Background 3. Argentina has rich natural resources, a highly literate popula- tion, an export-oriented agricultural sector and a diversified industrial sector. The economic performance of the country has suffered, however, from policy instability, economic distortions, and weak public sector management capabilities. Industrial production is largely domestic market oriented, and available resources are not utilized efficiently. Until recently, the country also suffered chree-digit inflation. A. Economic Developments of the Last Decade 4. Over the last decade, abrupt shifts in economic policies weakened Argentina's productive capacity and exacerbated structural imbalances. Changes in policies produced large and rapid fluctuations in real GDP, inflation, the real exchange rate, the external trade balance, real interest rates and wages. 5. High and rising inflation, physical and technological deterioration of the country's productive capacity, major dislocations in industrial production and huge external debt service requirements resulted in general economic stagnation, such that the real 1985 per capita GDP was  -2- 1 1X lower than its 1970 level. Heavy borrowing in the late 1970s multiplied the country's external debt as a share of GDP sevenfold (from 10% to 68%). Today, interest payments on the external debt absorb nearly half of gross domestic savings, compared to less than 5% in the early 1970s. 6. The productive sectorsp particularly manufacturing, are beset by major structural and financial problems. More than 40% of capacity in the construction industry, artificially inflated during the brief construction boom of the late 1970s, is now idle. Most manufacturing firms lack sufficient working capital. Financial intermediation is costly and inefficient, interest rates are high both in nominal and real terms, and oversized banking institutions are suffering severe difficulties. B. Recent Economic Developments 7. A democratically elected Government took office at the end of 1983, facing spiralling inflation and growing balance of payments difficulties. Also, the after-effects of the industrial recession were threatening the solvency of the financial system. 8. Toward the end of 1984, the Government entered into a 15-month standby agreement with the IMF and rescheduled in 1985 its external debt wich commercial and official creditors covering its obligations up to 1985. The Government moved to comply with the conditions under the standby agreement despite a deepening recession. However, during the first quarter of 1985, the Government's adherence to the program became weak, leading to a suspension of the standby agreement. 9. During the second quarter of 1985, economic conditions worsened significantly. The economy faced spiralling inflation while the recession intensified. The Government then decided to abandon gradualism in favor of "shock treatment" and set about preparing the country for a major change in economic policy necessary to break inflationary expectations. In June 1985, it devalued the peso by 18% to improve relative prices and introduced a number of fiscal measures with the purpose of drastically reducing the overall public sector cash deficit. It increased prices of petroleum and gas products and public tariffs; introduced a temporary 10% import surcharge and a 9 percentage point increase in the export tax to reduce che fiscal deficit; and cut expenditures in the 1985 budget by 12%. It also announced a freeze on wages and prices. 10. These measures, which supported completion of the first review of the standby agreement with the IMF, comprised the following elements: (a) a drastic cut in the total public sector deficit (including Central Bank operating losses) from 12.5% of GDP in the first half of 1985 to 2.5% on average in the second half, with the deficit to be financed by external borrowing, thus eliminating domestic credit expansion to the public sector. Further expenditure cuts were to follow the ones undertaken, and lower inflation was to reduce the negative effects on tax receipts arising from collection lags and also allow for lower nominal interest rates, thus reducing interest service payments; (b) a reduction in the balance of payments' current account deficit from 3.5% of GDP in 1984 to 2.4% in 1985; and (c) a monetary reform that included the introduction of a new currency unit pegged to the US dollar and a system for de-indexing peso-denominated contracts.  - 3 - 11. The Government made substantial progress in stabilizing the economy during 1985. The annualized inflation rate fell from about 1,200% in the first half of 1985 to 40% in che second half, as measured by the consumer price index. The consolidated public sector cash deficit was reduced from 12Z of GDP during the first semester of the year to 4% of GDP in the second semester. The deficit in the current account of the balanee of payments was reduced to about US$1.0 billion (1.5% of GDP) from about US$2.4 billion in 1984 (3.5% of GDP). As a result, the reserve position of the Central Bank improved ana gross international reserves increased to an equivalent of five months of imports. The cost of adjustment fell upon domestic interest rates which remained very high in real terms, ranging between 5-8% per month, on GDP which fell by about 4.4% in real terms in 1985, and on income levels, with real salaries falling substantially. Real GDP per capita dropped by 6.8%. 12. In March 1986, the Government began to phase out the wage and price freeze and replaced it by a system of administered prices. In April, it introduced crawling peg type adjustments in the exchange rate system and in public tariffs, and adopted a program to step up tax collection. The final tranche of the standby agreement was disbursed in June 1986 following the Government's presentation to the Fund of a letter setting out its proposed economic policy objectives for the second half of the year. The Government also received the final scheduled disbursements of new money under the agreement with the commercial banks. 3. Prices began to rise again in mid-1986, reaching a monthly rate of 8.8% in August. Inflationary pressures were rekindled by excessive growth of Che money supply, the phasing out of the wage/price freeze, and a sharp rise in the price of meat which weighs heavily in the consumer price index. In response to these developments, the Government changed its stabilizaticn strategy. It adopted a more restrictive monetary policy. The Government also reaffirmed its adherence co a tight fiscal policy and reintroduced price controls, adjusting prices in line with a targeted decline in the rate of inflation to 3% per month by year end, but kept a flexible price system in competitive sectors. These measures were combined with selective liberalization of imports. As a result of the new measures, the monthly rate of increase in the consumer price index began to slow down and fell to 4.7% in the month of December. The overall public sector cash deficit was maintained at a manageable level, estimated at about 3.9% of GDP for 1986, as a result of improved revenue collections and expenditure controls. 14. During 1986, the economy rebounded strongly from the sharp decline in real output in 1985. Both investment and consumption expenditures expanded in 1986. Although the tight monetary policy introduced during the last quarter of 1986 dampened the upturn in economic activity, real GDP is estimated to have risen by about 5.5% for the year, fueled by a very strong recovery in the industrial sector. Real GDP per capita is estimated to have increased by 3.9%. The upsurge in economic activity, together with simplified trade procedures, produced an estimated 24% rise in the value of merchandise imports. The value of merchandise exports, on the other hand, which was severely restrained by a deterioration in world grain prices, has been estimated to have fallen by 17%. As a consequence, the deficit in the current account of the balance of payments increased to about US62.6 billion (3.8% of GDP), compared to US$1 billion (1.5% of GDP) a year earlier.  -4- C. The Government's 1987 Stabilization Program 15. The Government has announced the targets and instruments of its new 15-month economic program in a standby agreement with the IMP. According to this agreement, the Government aims to: (a) reduce inflation to about 40% by the end of 1987 vis-a-vis about 80% in 1986; (b) reduce the current account deficit of the balance of payments to US$2.2 billion in 1987 (3X of GDP) from US$2.6 billion in 1986 (3.8% of GDP); and (c) achieve a 4% real growth of the economy in 1987. The increased price stability to be brought about by the program is to lead to a decline in real interest rates and a recovery of private investment and growth, provided that the external financing required by the program from commercial banks (US$2.15 billion) and multilateral and bilateral sources, including the funds necessary to pay the payment arrears accumulated during 1986, is forthcoming. The program is designed to achieve its objectives through: (a) a further reduction in the public sector deficit (from 3.9% of GDP in 1986 to 2.5% on average in 1987); (b) a stricter monetary policy with moderately positive lending rates; and (c) structural reforms in trade, finance and public enterprise management as incentives to the private sector. The efforts to improve the efficiency of the productive and financial sectors and of the public administration will be supported by a relaxation of price controls. 16. In January and February of 1987, inflationary pressures rekindled with consumer prices rising to about 7% per month. Towards the end of February, the Government therefore introduced a new package of economic measures which included a wage and price freeze until the end of June 1987, increased taxes and public sector prices, and also depreciated the Austral by 7%. Indications are that the rate of inflation will decline significantly in April; the Government expects annualized monthly inflation rate to reach, and remain at, the target levels of its program. The Government also is pursuing negotiations with the labor unions and the private sector to forge a social pact that would make these parties rather than the Government responsible for compliance with agreed wage and price guidelines. D. Growth and Balance of Payments Prospects 17. Improving Argentina's growth prospects for the rest of the decade will require, in addition to the successful implementation of the adjustment program during 1987, the multiyear rescheduling of the country's external debt by its creditors, continued lending from multilateral, bilateral and commercial sources (between 2-3% of GDP in an annual basis) and a substantial expansion in exports through the rest of the decade. The 1;87 current account deficit of the balance of payments has been projected to be financed by "fresh" money provided by the commercial banks, disbursements from the IMF standby, increas'ng disbursements of existing and projected loans from multilateral and bilateral sources, and direct foreign investment. Based upon the timely adoption by the Government of mediumrterm growth policies, real GDP is projected to grow on average at about 3.8% per year during 1987-90. This will depend upon expanding industrial exports and increasing agricultural exportable production. It will also depend upon renewed private sector investment activities and the availability of increased external financing over the next years. This projected growth will also depend upon improvements in budget control and execution and upon increasing the operating efficiency of public  enterprises Important for maintaining the competitiveness of industry. Under these assumptions, the current account deficit would decline from 1987 on, as a result of increasing revenues from industrial and agricultural exports. E. Debt Service and Creditworthiness 18. At the end of 1985, the total public sector external debt of Argentina was US$38.7 billion. From US$8.4 billion at the end of 1978, it had grown more than fourfold. The structure of the debt also changed radically during the 1978-1983 period. At the end of 1978, debt to commercial banks constituted 381 of the total, but this ratio rose to 60Z by the end of 1980 and to 871 by the end of 1984. By 1979, total debt service requirements had already surpassed net exports, and, since 1982, the trade surplus, although large, has not been sufficient to pay the accrued interest. Thus, when the South Atlantic crisis disrupted ncrmal rollovers and lending in 1982, Argentina began accuaulating principal and incerest arrears. The Government provided exchange rate guarantees for the rescheduled private external debt and eventually assumed a large part of the private sector's external obligations. Total external debt, including arrears and private sector obligations, reached US$48.3 billion by the end of 1985 and is estimated to have reached US$49.1 billion by the end of 1986. 19. A sustained effort by the Government to implement domestic policy reforms, including a reduction in the degree of trade protection and measures to stimulate competition and structural change in industry, combined with externd.1 support from financial sources, should enhance Argentina's export potential. This should improve prospects for reducing its debt-to-exports ratio from a level of almost 5 in 1985 to slightly over 3 by the mid-1990s, its external debt servicing ratio (excluding short-term) from about 79% in 1985 and an estimated 76% in 1986 to about 62% in 1990, its external interest service ratio from about 50% in 1985 to an estimated 49% in 1986 and about 39Z in 1990, and its total debt as a percentage of GDP from about 75% in 1985 and an estimated 70% in 1986 to about 58% in 1990. These projections assume that Argentina's external debt to the commercial banks and bilaterals will be rescheduled through 1990. Provided that the arrears are eliminated according to the current program, the large debt amortization payments due in 1987-90 are restructured with a modest increase in the commercial banks' exposure, both in nominal (about 12Z) and in real terms (about 31), and the Government's macroeconomic program is maintained on track during 1987-89, Argentina should be able to meet the servicing requirements of its external debt during 1987-1990, including new borrowing. At the end of 1985, the Bank's share of Argentina's total debt outstanding and disbursed was 1.3%, and its share of external debt service payme2ts was 1.0%; both shares are projected to reach 6.1% and 5.0% by 1990, respectively. 20. The gross financing needs of the Government's economic program (under the standby with the Fund) for 1987 are estimated at about US$9,600 million, including elimination of external payment arrears (US$480 million) and replenishment of reserves (US$830 million). The Government expects to cover the bulk of these needs (50%) through agreements with creditor banks (rescheduling of US$4,100 million maturities due in 1937) and the Paris Club (medium- and long-term debt service payments of US$640 million due in 1986-87). To cover the remaining gap, the Government has reached agreement with the Steering Committee of its creditor banks on a new money facility  money facllity of US$1,950 million (US$1,330 million net lf payment of arrears and repayments to other creditors is taken into account) from thecommercial banks, US$760 million from the multilaterals, US$1,380 million from the Fund and US$1,250 million from the bilaterals including US$150 million of untied financing from EXIM Japan. The Government is also counting on US$125 million of direct (non-debt creating) foreign investment. 21. The commercial bank's exposu-.e in Argentina is expected to increase by US$4.5 billion and the World Bank's by US$2.5 billion during 1986-90. One consequence of these increases is that the Bank's average share of net disbursements during this period would amount to 37.8% compared to 62.8% for the commercial banks. This signifies a large increase for the Bank in relative terms vis-a-vis the commercial banks because past Bank lending has been at very low levels while the commercial banks had been rapidly increasing their exposure. Consequently, any increase in Bank lending now cannot but result in a significant increase in its exposure as compared to that of the commercial banks, although in absolute terms it would represent a modest 6.1% of total debt in 1990. PART II - THE GOVERNMENT'S MEDIUM-TERM STRUCTURAL REFORM PROGRAM A. Medium-Term Framework for Structural Reform 22. Argentina's development performance over the medium-term will depend heavily upon the, continued success of the present stabilization policies and the implementation of structural reforms. Restoring domestic and overseas confidence in economic management and renewing private sector investment will require reinforcing stability in the policy regime and in price movements, expanding exports and maintaining economic growth. The 1987 policies represent a critical phase of the medium-term program, in which stability would be achieved, permitting continuation of economic growth as the country is reoriented towards a more open and competitive economy. 23. The Government has completed, in close consultatior. with the Bank, a framework paper that sets forth the strategic underpinning of the Government 's economic policies and outlines the otjectives and content of Ongoing structural reforms. The Government has submitted the paper to the international financial community. The paper stresses the need for structural change in the public sector and a reduction of its role in the economy, according a primary function to private investment. The paper repeatedly stresses the intention of the Government to open the Argentine economy to international markets and to deregulate the external and internal sectors and to liberalize external capital flows. In the area of banking, the paper refers to incentives for promoting mergers and acquisitions, strengthening the Central Bank's supervisory capabilities and functions, deregulating financial markets and reducing minimum reserve requirements and rediscounts. 24. In line with the Government's program of structural reform, the Bandz's projections for 1987-90 (Table 1) indicate that Argentina has the potential to triple the economic growth rate it achieved during the previous decade. The projected economic growth depends on the speed of  -7- a.ble 1: ARBENTINA - KEY NRCROECONWONIC INDICATORS, 1983-1991 ctual Prelim. Projected 1993 1394 1995 1996 1987 1989 1989 I90 l9 91 SOP groxth rate 3.3 2.5 -4.4 5.5 4.0 3.7 3.9 3.8 3.8 6DY growth rate 2.6 3.4 -4.8 3.9 3.6 4.1 4.0 4.0 3.7 BDY/capita growth rat. 1.0 1.7 -6.3 2.3 1.9 2.5 2.4 2.4 2.1 Consuaptionicapita growth rate 1.6 4.3 -6.4 7.3 0.6 1.3 1.2 1.3 1.5 Debt Service 1/ 2/ 13303 9898 8139 6674 6374 5744 6924 7956 1499 Debt Service/XGS IX) 133.7 96.1 77.6 75I9 64.1 52.6 59.5 62.3 62.1 Debt Service/JOP (U ) 20.5 14.5 12.6 9.5 8.5 7.0 7.9 9.1 9.1 Gross Investaent/6D1P () 3/ 17.0 14.7 12.9 12.8 13.5 14.2 15.0 15.8 16.5 Dross Domestic Savings/ffP IX) 3/ 21.5 19.7 19.7 15.5 16.5 17.5 19.4 19.3 19.7 National SavingsdG6P (1) 31 13.2 11.0 11.3 9.6 11.0 12.4 13.5 14.3 15.1 Marginal National Savings Rate -0.49 -0.79 0.04 -0.21 0.45 0.51 0.41 0.37 0.36 Public lnvesteentiGDP (2) It 7.3 6.1 5.6 6.3 6.5 6.6 6.8 7.0 7.2 Public Savinqsi6DP 1I -5.2 -2.2 1.6 2.3 3.0 3.9 4.3 4.8 5.2 Private InvesteentIfiP (X) It/ 4 9.7 9.6 7.2 6.5 7.0 7.6 9.2 9.8 9.3 Private Savings/SDP hI 26.0 21.9 18.1 13.2 13.5 13.6 14.1 14.5 14.5 Public Investment/private anvestuent 5f 0.8 0.7 0.8 1.0 0.9 0.9 0.8 0.3 0.0 Sovernment Revenues/SDP II 23.6 22.9 27.0 25.4 26.5 26.4 26.5 26.6 26.7 fiovernment Expenditures/EMP 1/ 34.7 31.2 31.4 29?.4 29.0 289. 2098 28.9 28.7 Deficit (-I or Surplus (+)I6DP 11 -11.1 -9.3 -4.4 -4.0 -2.5 -2.4 -2.3 -2.2 -2.0 Exports Growth Rate 3/ 11.5 0.2 5.9 -9.4 12.3 3.6 4.8 3.5 3.5 Exports/GDP 1X) 3/ 14.7 14.3 15.9 13.6 14.7 14.7 14.9 14.8 14.8 Imports Growth Rate 3/ -2.4 2.4 -11.7 11.6 6.9 5.3 6.0 4.6 5.6 Imports/SDP (1) 3/ 10.2 10.1 9.4 9.9 10.2 10.3 10.6 10.6 10.9 Current Account Balance II -2461 -2392 -953 -2645 -2227 -1752 -1625 -1646 -1635 Current kcount Balance/SDP (X) 11 -3.8 -3.5 -1.5 -3.8 -3.0 -2.1 -1.8 -1.7 -1.6 I/ At current US dollars. 2/ Excluding short term principal repayments. 3/ At constant prices. 4/ Includes changes in stocks. 5/ hinistry of Economy definitions are used here. Notes: Debt includes public and publicly guatanteed, IF, private non-guranteed and short term debt. Exports and imports include gowds and non-factor services.  structural reform and level of external financing. Taking Into account the heavy burden Df external debt service on domestic savings, the fall in per capita income and consumption levels over the last decade, and constraints on external financing, the projections are essentially based on gains in economic efficiency, through comprehensive structural reforms, rather than increases in investment. 25. Specifically, the projections ahow the following scenario for 1987-1990: GDP would grow 3.8% p.-. which would allow an increase inL per capita consumption of 1.2% p.a. By 1990, per capita GNP would reach US$2,235 or 91% of the 1974 level. Domestic savings of about 18% of GDP, compared to about 12X of GDP in 1983-86, would provide the bulk of fixed investment, which would increase to about 15% of GDP during 1987-90 from about 13% in 1983-1986. The projections for 1987-90 indicate that external lnterest payments would absorb 6% of GDP, thus creating a need for external savings equivalent to 2.7% of GDP. Exports would grow 5% p.a. in volume terms. Even with a projected faster growth of imports of 5.6% p.s.-- however from a smaller base than exports--the deficit in the current account of the balance of payments would improve from 3.8% of GDP in 1986 ta 1.8% in 1990. 26. The projected export performance would lower significantly Argentina's debt service ratios. The overall debt service ratio has been projected to decline from 76% in 1986 to 62% in 1990. The major improvements would become clearly apparent during 1991-95, when around 75% of interest payments could be met by the surp'lus in the resource balance. B. Structural Reforms Already Undertaken 27. The Government has complemented its stabilization program with the Initiation of broad-based structural reforms in the areas outlined in the above-mentioned paper, for which the Government has a well-articulated schedule of implementation. Fiscal reforms include increases in excise and income taxes and lower export taxes. Tax collection improved through the elimination of bank and stock exchange secrecy and stock holdings were made nominative. These measures were complemented, inter alia, by an overhaul of the system of inflation adjustments for tax purposes, the introduction of a presumptive tax for small taxpayers, improvements in tax administration, changes in the value-added tax and increases in public sector tariffs. With respect to trade reform, the Government has introduced an automatic duty-free temporary admission regime with broad coverage that includes indirect exporters. It has improved the effective exchange rate for exporters through reimbursement of indirect taxes and elimination of taxes on manufactured and agro-based products. Import and export procedures have been simplified to take less time and reduce paperwork. Bankers' acceptances have been reintroduced. The information system for exporters has been strengthened. Imports for capital goods not produced in the country, or which are produced in Argentina but cannot be delivered on a timely basis, have been freed. The Government has also freed bilateral trade with Brazil on a large number of capital goods (over 300 products) and has also allowed the automatic duty-free import of all inputs for exports from Brazil. 28. The Government has taken the first steps towards financial sector refo-m. It has initiated a gradual deregulation of financial markets.  -9- Reserve requirements on unregulated deposits have been eliminated, the commercial banks' ability to accept free deposits has been increased by about 40%, the limits on lending rates for loans Einanced through free deposits have been eliminated, and the Central Bank is being reorganized. BONEX-backed (dollar-denomlnated government bonds) inter-company transactions intermediated by banks h-sve been legalized. The Government has also successfully introduced new medium-term bonds as a first step to develop a longer-term capital market. With respect to public sector management, the Government has announced a major reform program designed to improve the efficiency of the state enterprises in the telecommunications, transportation and energy sectors, combined with plans for the privatization of industrial and other productive parastatals. The former encompasses efforts to reduce public sector employment in the national administration, to improve public sector management, and to create a holding company to accelerate restructuring of parastatals. The largest public enterprise, YPF (state oil company), is to be reorganized. The Government has divested itself of two industrial enterprises and has called for bids for purchase of Austral Airlines (which serves domestic routes and has a 501 market share). It has indicated its intention to privatize its shares in the commercially-oriented enterprises under the Defense Ministry beginning with the petrochemical companies. It intends to proceed with the privatization of those companies in which it holds a minority position and has presented to Congress a draft law that would allow it to privatize the companies in which it has majority holdings. Finally, with respect to private sector incentives, the Government has indicated its intention to eliminatz restrictions on capital transfers, encouraged private ports development, opened 90% of the prospective acreage under YPF's jurisdiction to private sector exploration and improved contract terms for the private sector in petroleum exploration and production, and agreed on a framework to settle a foreign investment dispute regarding ownership and operation of the Center-West gas pipeline. C. Structural Reforms Proposed 29. Beyond the above actions, the medium-term macroeconomic policy package included in the Government's medium-term framework paper concerns: (a) incomes policy; Cb) trade policy; (c) financial system; and (d) public sector rationalization. Incomes Policy 30. The crucial issue for the Government is, once the current price freeze is lifted, how to phase out the system of administered prices or of wage and price controls so as to permit a realignment of relative prices without jeopardizing the control of inflation and the upward trend in economic activity. The Government intends to continue its system of administered prices for those activities which do not face international competition. It has indicated its intention to set subsector-specific ranges for wage and price increases in 1987; actual salary Increases are to be determined through collective bargaining. Prices in competitive subsectors are to be liberalized (to date part of the petrochemicals and wine and liquor industries), while prices in subsectors that need to adjust to international competition over the next few years will be negotiated with representatives of those subsectors as part of a broader incentive package to prepare them for a gradual opening up of the economy.  - 10 - Longer-term adjustment programs would be formulated, agreed, and timephased for subsectors with severe structural problems (such as steel and paper products). In some subsectors (petrochemicals), the Government wants the private sector to self-police wage and price developments while holding out the threat of accelerated import liberalization. The Government believes that a gradual phase-out of wage and price controls is consistent with the need to enhance the general perception of stabillty in Argentina (where indexation practices are deeply rooted), and that it would permit selective, gradual changes in relative prices; a different approach may not be credible and would jeopardize the desired return of unregulated collective bargaining. Trade Policy 31. Following the June 1985 devaluation, the country's exchange rate was pegged to the U.S. dollar. This policy continued until April 1986 in the face of higher domestic than international inflation. Argentine exports, however, remained competitive for some months (on the basis of a trade-weighted basket of currencies) because of the devaluation of the U.S. dollar vis-a-vis the currencies of industrialized countries. In the second quarter of 1986, the fixed exchange rate policy was abandoned and replaced by an active crawling peg devaluation with respect to the U.S. dollar. So far, the Government has been able to maintain the real exchange rate, measured by changes in consumer prices, at about the level of the June 1985 real exchange rate based on a basket of currencies. This however, does not take into account the elimination of export taxes on manufacturing and agroindustrial products, the reduction of export taxes on agricultural products and hydrocarbons and the reimbursement of import duties on inputs and reimbursement of indirect taxes on exports which have served to offset the Austral appreciation for exports. With these changes, the real exchange rate has improved over the mid-1985 levels. The Government plans to maintain the June 1985 exchange rate in real terms in 1987 and review its adequacy on the basis of changing economic conditions and evidence of export performance, without rekindling inflationary pressures. 32. The current export incentive system utilizes three major instruments for export promotion: (a) import duty exemptions to eligible exporters; (b) indirect tax rebates; and (c) credit at low but positive rates of interest. The current system has many weaknesses which affect its efficiency (para. 36) which the proposed loan addresses. Moreover, the Government intends to undertake a program to improve the operations of the export financing system and other export promotion activities, streamline Central Bank policies and procedures governing export financing and release of foreign exchange, and implement measures to improve credit availability to exporters. 33. The rapid fall in reserves during 1980-82 led the Government co put in place quantitative restrictions on imports. The Government intends to undertake a phased elimination of import restrictions, beginning with automatic duty-free access to iaputs required for exports (paras. 56-57). In this context, recourse to tariff protection will be increased temporar:ly, as most tariff positions are moved from the prior consultation list to the automatic import list as part of a broader import liberalization (para. 59) and then reduced gradually over a three-year period (para. 59). The current tariff structure is characterized by moderate rates and a not very substantial degree of dispersion.  - 11 - Financial System 34. Central to the Government strategy is the restructuring of capital markets for which a financial sector reform has been initiated. The lack of a long-term capital market is a major factor constraining investment financing for the private sector. Financing costs will have to be lowered for producers to undertake the investments needed for increasing Argentina's competitiveness. The Government's objective is to reduce prohibitive operating costs of the banking system, gradually phase out distortions and directed credit, eliminate Central Bank subsidies, enhance competition among private and public banks, strengthen the liquidity position of the banking system and simplify the implementatlon of monetary policies. For this purpose, the Government intends to: Ca) set up effective internal audit and control procedures; (b) centralize rediscount management; (c) strengthen its intervention capabilities; (d) redesign tha deposit guarantee system; (e) reduce reserve requirements and rediscounts; (f) deregulate lending and deposit markets; (g) narrow the differential rate between the regulated and unregulated segments; and (h) restructure private and public banks. Public Sector Rationalization 35. The Government has given high priority to curtailing the public sector deficit to reduce inflationary pressures and crowding out of the private sector. It proposes to reduce public sector participation in the economy, increase the efficiency of parastatal enterprises and enhance their self financing ability. At the same time it needs to upgrade productive support and social infrastructure for the needs of a growing and more diversified economy, and to price public sector products and services according to their economic cost. For this purpose the Government proposes to introduce economic criteria and sector policies in a coherent multiyear public investment planning and budgeting process; expand public investment to strengthen key productive support infrastructure, review priorities in investments, initiate public sector administrative reforms to expedite decision-making processes and reduce staff, prepare training programs to upgrade technical qualifications of civil servants, continue rationalizing expenditures and strengthening tax administration, sell or liquidate non-strategic public enterprises, introduce modern management and corporate structures and practices in strategic parastatal enterprises, manage them by objectives and control of results; give parastatals more operational autonomy through multiyear performance and budget plans - "plans by contract" on the French model (contracts-plan), increase cost-effective provision of social services, and enhance the planning, budgeting and financing capability of the Provinces. PART III - THE EXTERNAL SECTOR A. Background 36. Structure and Evolution of Exports. Traditionally, the major part of Argentina's exports has consisted of resource-based products. Nonetheless, manufacturing industry has demonstrated, during periods of adequate macroeconomic and trade policies, a competitive advantage based on the availability of a large pool of skilled manpower. Between 1970 and 1974, manufactured exports exhibited remarkable growth, evenly distributed between resource-based and skill-intensive subsectors. By 1974,  - 12 - skill-intensive products comprised 34% of Argentine exports. After 1974, manufactured exports continued to grow in real terms, albeit at a considerably slower pace until the erratic exchange rate policies and the trade reform of the late 1970s severely crippled many export-oriented activities. At the beginning of che 1980s, the composition of exports underwent a major transformation, with metal products, machinery and equipment falling to half of their value in real terms, and resource-based products taking up the slack. By 1984, skill-intensive products amounted to only 10% of manufactured exports. In 1985, however, agro-based exports and primary exports declined and industrial exports rose by almost half in real terms. Metal-based products and machinery accounted for two-fifths of the increase in manufacturing exports. The total value of commodity exports in 1986 is estimated to have declined to US$7.0 billion, which is lower than the 1980 nominal value. A major factor in the stagnation of export revenues has been the steady decline of world commodity prices, particularly for grains; floods and heavy rains also contributed to this outcome in 1986. On the other hand, the growth of industrial exports has continued to be stymied by timid export promotion policies, the excessively protective trade regime, and the continuing anti-export bias of the incentive framework. 37. Past Trade Policy Reforms. During 1979-81, the Government, while trying to control rising inflation, eliminated quantitative restrictions on imports and introduced progressive tariff reductions p2,l passu with a substantial appreciation of the domestic currency. These measures were combined with the introduction of a fully automatic temporary admission regime which was improperly used by many non-exporters. As a consequence, the country was swamped by imports. The inconsistency between the trade reform scheme and che exchange rate policy led co a reduction in manufactured exports that aggravated the consequences of opening up the economy to foreign competition. The real value of manufactured exports which had peaked before the introduction of the reforms still has not regained its previous level. Moreover, the physical volume of industrial output fell by an accumulated 25% over the period of the liberalization attempt. Sector employment dropped even more. The damage produced by these policies went beyond the sharp reductions in output and employment that--under different circumstances--might have been transitory. Certain industries were dismantled and some of the highly skilled labor force emigrated. The country's industrial capacity received a severe blow, while the economy's expected export reorientation failed to materialize. As a consequence, the manufacturing sector's current export capacity is probably lower than it was before the 1979-81 reforms. It is noteworthy that, as a reaction to this episode, the country adopted a more protectionist trade regime than before. 38. Permanence of Policy Reform. Despite the country's damaging legacy of past attempts, the Government intends to pursue an export-oriented development strategy and to move gradually toward trade liberalization. It considers that vigorous export expansion is the main non-inflationary approach that will enable the country Co resume sustainable economic growth. The introduction of a new round of trade policy reforms cannot afford co repeat the previous mistakes, leading to further traumatic output losses, particularly since the Government is making a deliberate effort to regain private sector confidence in order to  - 13 - induce a sustained recovery in Investment. The private sector is also determined to avoid a repetition of the 1979-81 experience. At the same time, the labor unions are likely to become significantly more belligerent if still further reductions in real wages and industrial employment take place. Since past attempts to change trade policy have led to contrary results and have lessened the country's development potential, it is of utmost importance that the reforms supoorted by the proposed loan have a lasting effect. A more rapid import liberalization program would create opposition (and damage) that would derail the reforms. A gradual approach, under which industrial firms would first benefit and br strengthened through improvements in export incentives, to be followed by wider import competition, stands a better chance of success as the country becomes outward-looking and shifts its strategy to diversify exports. The recommended policy and procedural changes, through the revival of the industrial sector, should develop a powerful interest group which can be expected to continue private sector support for these reforms. B. Constraints to Performance 39. Five sets of issues in the trade regime explain the decline in manufacturing and agroindustrial exports and overall performance and provide the basis for medium-term adjustments. First, the temporary admission regime has been deficient and its value as an export promotion instrument has been quite limited. Second, Argentina has been traditionally protectionist. Prohibitively bigh tariff walls, quantitative restrictions, and outright import prohibitions have been the policy tools used by most past governments. Of these, quantitative rescrictions currently remain as a constraint to performance. Third, the complexity of import and export procedures has been an important factor deterring export performance. Fourth, export taxes have become a disincentive to exports. Finally, export subsidies create distortions which affect resource allocation. Temporary Ad-mission Regime 40. Argentina's temporary admission regime (TAR) has been highly restrictive since it has only covered imports that cannot be supplied domestically or where the price of domestic supplies exceeds roughly by 3U% or more the c.i.f. price of the imported good. Thus, a strong protectionist element has existed in the temporary admission system, neutralizing a good portion of its intended exporc promotion value. The procedure has required a case-by-case review of the DJAT (Declaracion Jurada de Admision Temporaria-a TAR import request) applications, causing considerable delays. The applications are reviewed by a government committee which publicizes and reviews the complaints of affected domestic producers. Protectionist considerations often prevail; standards for admission or rejection are not explicit. In practice, DJAT applications have been strongly contested by some producers who try to force exporters to use domestically produced inputs. The legal regulations governing the temporary admission regime explicitly prohibited, until very recently, the transfer of goods imported temporarily. Some exporters have circumvented this prohibition by importing via the TAR and passing on the inputs to a supplier, who works in a made to order system; Customs has considered this illegal. In addition, a TAR could be used only by a producer who at the time of importing inputs can demonstrate a firm export order or, a steady,  - 14 - predictable flow of exports. New and occasional exporters were penalized. Moreover, until very recently, Argentine customs laws did not permit the temporary admission of capital goods unless these were to be re-exported. Re-export of capital goods embodied in goods produced and exported has also not been allowed. The Import Regime 41. Argentina does not have formal import prohibitions, except for those related to defense, health, environmental, and other non-economic considerations which add up to 827 tariff positions (covering about 3.6% of the value of production--see Annex VII) out of a total of 11,490. However, the trade regime does include tariff and non-tariff barriers. Since tariffs are moderate, non-tariff barriers and administrative procedures play a major role in restricting imports. Although a large part of non-tariff barriers do not take the form of quantitative restrictions, they distort resource allocation and export incentives, while tariffs are wore transparent, put a "ceiling" on nominal protection and are otherwise superior. 42. All imports require presentation and government approval of a permit (Declaracion Jurada de Necesidades de Importacion--DJNI). For about 7,147 tariff positions (62% of the total) which accounted for about 48.5% of manufacturing production in 1985, issuing the DJNI requires four cumbersome steps in two different organizations: (a) the application is received at the Secretariat of Industry and Foreign Trade (SICE), where (b) the data are entered into a computer data base; (c) the data are processed in a computer located in the Ministry of Social Welfare; and (d) the DJNI is returned to SICE for consideration of approval and delivery to the importer. The remaining 3,516 tariff positions (equivalent to about 48% of the value of production)--covering mostly imports competitive with local production-are subject to more discretionary authorizations that result in further protection from imports. For most of these, the import permit applications are referred to the producers' associations, which assess whether there is local production available to satisfy the needs of the potential importer. For about 1,333 tariff positions with partial protection, corresponding to abouit 22% of the value of production, imports enter the country after the issuance of import permits. For the remaining positions in the previous consultation list, 2,183 positions, (equivalent to about 26% of the value of production) the import restrictions are fully binding as a result of the intervention of the producers' associations and thus imports are effectively prohibited. As a rule, the producers' associations approve the issuance of import permits only if domestic production is not available with little or no regard for price competitiveness. Although SICE formally decides whether or not to authorize imports, it seldom overrules the producers associations' recommendations. In some cases, this cumbersome system of prior approval may take up to six months. 43. Openness of the Trade Regime. Argentina's trade regime is moderately open to international competitiTn when measured by tariff positions included in the automatic DJNI list, based on their equivalent value of industrial production (Annex VII). Goods corresponding to tariff positions equivalent to almost half of the value of industrial production can now be imported without any prior documentation (para. 59). In the  - 15 - context of the trade reform program, the Bank and the Government analyzed nominal rates of protection of all tariff positions on the basis of a three-digit disaggregation of the value of industrial production and of tariff positions as of 1985 (Annex VII). The highest degree of nominal protection is found in processed food production, paper products, textiles, furniture and wood products, chemicals, and leather and leather products (Annex VII, page 2). Although Argentina is quite competitive in food production, its packaging industry operates at very high costs and the GovernmenC maintains a very high level of non-tariff protection. The textile, paper, and chemical products industries are characterized by high operating and financial costs, obsolete equipment and in some cases large outstanding debts. The other heavily protected industrial activities face strong competition from neighboring countries. The Government has changed Its approach to industrial protection. It recently granted temporary five-year tariff protection up to 100% of the c.i.f. value of imports for new production activities In the informatics sector. Tariff protection Is to be decreased gradually from the initially agreed level to 50% over the five-year period. Nevertheless, informatics products and inputs can be imported without non-tariff restrictions. 44. Import Tariff Levels and Structure. Tariff protection is moderate (Annex VII) because the ad valorem rates currently applicable are still those set at the time of the 1979 reforms, except for temporary tariff protection for some tariff positions (electronics) granted in 1986 with a 1002 tariff rate. Tariff rates range from 0 to 38Z, although a small number of items accounting for about 1% of imports pay higher duties. In mid-1985, these rates were augmented by ten percentage points by a surtax imposed as part of the Austral Plan. Data for 1985 shows that 34% of Argentina's imports entered the country duty-free; another 31% of imports paid duty at a rate of 10% or lower; 12% of imports paid between 10% and 20X; and the remainder paid higher rates (Including 14.4% of imports which paid 38% or higher). Overall, the ratio between tax collections and imports for 1985 indicates that the average realized tariff rate is 21% (including the surcharge). In addition to the basic tariff duty, the surcharge, and the value-added tax the importers must also pay the following: (a) a statistical fee of 3% on the c.i.f. value of imports; (b) a 12% tax on freight charges for the Merchant Marine Fund; and (c) a tax of 0.5% on the c.i.f. value of imports for the Export Promotion Fund. Import and Export Procedures 45. Automatic DJNIs. In the past, the issuance of automatic DJNIs was used as a non-tariff restriction to limit Imports when there was both insufficient availability of foreign exchange and domestic production was threatened by competitive imports. In 1986, DJNTs represented less of a bottleneck than before since their procedures were significantly simplified. For importers in good standing, Customs has now established a simplified import procedure to clear goods from Customs within 48 hours after their arrival. Except for the identification of the goods prior to their nationalization, all of Customs' -e3rifications are made after the goods enter the country, Any error or inconsistencies in the documentation causes the importer to pay stiff penalties and they risk being denied the possibility of continuing to utilize the simplified import procedure.  - 16 - 46. Prior Authorization of Expcrt Shipments. The large number of public agencies involved in issuing prior authorizations of export shipments deters export activity. It causes delays and introduces uncertainty about shipment dates, thus increasing costs for the private sector. After consultation with the Bank, the Government at the end of 1985 consolidated all the prior authorizations required for export shipments into a single procedure managed by Customs. A presidential decree instructed the 30 public agencies involved to appoint officials to work in a special area provided by Customs (the "ventanilla unicaT--one stop administrative window), where exporters would apply for prior authorizationi. The Government has established that for any public agency that does not send its representatives, Customs is to consider their prior authorization as granted. The exporters are satisfied with the way the new system operates. However, it only functions in Buenos Aires and other Customs offices in the country which have adequate telex communications with Buenos Aires, which excludes 23 of the total 49 Customs offices. Export Taxes 47. Export taxes have traditionally been levied for generating revenues, largely concentrated on agricultural products. Most export taxes on manufactured commodities were eliminated in August 1986 as part of the program under the proposed loan. Export taxes on petrochemicals were reduced to 10X of their f.o.b. value from 30-70%. A program for reducing export taxes on agricultural commodities has been agreed with the Bank in the context of the Agriculture Sector Loan (Loan 2675-AR); the Government has reduced export taxes in line with the second-tranche conditions of the loan, although all conditions of second-tranche release (i.e. the introduction of the land tax) have not yet been satisfied. The Export Financing Scheme 48. The export financing scheme has been operating since the mid 1960s as a rediscounting facility in the Central Bank of Argentina (BCRA). It is characterized by inadequate controls, lack of automaticity, and generally benefits only well established large exporters, excluding first-time exporcers, small producers and indirect exporters. Financing is obtained on the basis of individual export orders and letters of credit and BCRA does not accept annual export plans as a basis for establishing credit lines, except in a very few special cases on the basis of long-term export agreements. Traditionally, the availability of these funds has been governed more by monetary regulations and controls than by the need to finance non-traditional export growth. The amount of exporr financing as a proportion of export value has therefore been characterized by sharp fluctuations (in 1983, for instance, preshipment financing covered 21% of non-traditional exports, compared with 34% in 1984; post-shipment financing accounted for 28% uf all non-traditional exports in 1982, compared with 18X in 1984). More recent information indicates that the amount of credit financing outstanding is about US$325 million compared to more than double this amount during 1984. BCRA's export financing scheme has provided below market, although positive, interest rates: 1% p.a. for preshipment financing to Argentina's exporters for Australes indexed to the US dollar loans and LIBOR when financed from deposits in foreign currency. For preshipment financing, the minimum period granted is 150 days. However, if the export is not completed in this period, an extension of 60 days is  - 17 - granted at 10% interest p.a. Also if no export is made, the loan is converted to Australes and the borrower is charged 1.5 times the BCRA rediscount rate. The issue of interest rate distortions would be addressed by a proposed Export PromotLon Project. 49. The Special Export Program (PEEX). In the absence of adequate export promotion instruments and concerned about the downward trend in exports, in early 1986 the Government introduced the PEEX to allow duty-free imports of inputs for domestic production and for exports. These benefits are avallable if the domestic producer commits himself to incremental exports over the life of the contract. Exporters are also entitled to subsidies of up to 15% on the incremental value of their exports. The subsidy would be granted after the exporter responds to the Government's invitatlon to join the PEEX in a given year ("llamado") and the Government approves the exporters' proposals. A recent analysis of Argentina's export promotion regime shows that a considerable amount of transfers and subsidies have been provided to the export sector, mostly through export financing during the past several years. The subsidies under the PEEX were introduced as a transitory, notional indirect tax reimbursement pending the introduction of a well designed indirect tax reimbursement scheme (a new system has been recently put in place--pars. 58). About US$50 million has been included in the 1987 budget to pay for subsidies granted in 1986. The bulk of these subsidies will only reach a very few large exporters (some 30-40 out of several thousand firms), many of them multinationals and parastatals. Moreover, many of these firms export products for which demand has been stagnant. Their exports have generally had slower growth rates than those of other Argentine exporters who have received fewer or no incentives. PART IV - THE PROPOSED OPERATION A. Loa History 50. In the area of trade policy reform and export diversification, the Bank has pursued two objectives: reform of the trade regime (through the proposed loan), and support of key institutions in the export subsector (through a proposed Export Promotion Project). A Bank Industrial Sector Mission which visited Argentina in May/June 1985 reco-mended strategies for industrial and export development (Report No. 5841B-AR). These activities are being pursued under the Public Sector Management Techaical Assistance Project (Loan No. P-4320-AR) which includes an industry and trade component, and are analyzed in the FY87 country economic report. 51. The proposed loan grew out of discussions with the Government beginning in February 1986 on the policy measures required to promote export-oriented growth, to correct the continuing balance of payments deficits, and to make the economy more competitive. The operation has been processed concurrently with the Government's formulation and implementation of a medium-term program of adjustment. The loan was appraised in November 1986. Technical discussions were held in Washington during February 23-28, 1987. The Argentine delegation was led by Mr. Ramon da Bouza, National Director of External Finance, Ministry of Economy. Negotiations were held in Washington during April 2-3, 1987. The Argentine delegation was led by Nr. Alfredo Garcia, External Finance Department, Ministry of Economy. Supplemeatary loan data are provided in Annex III.  - 18 - B. Relationship Between the Proposed Operation and Policy Reforms 52. The objective of the trade reform program is to support the Government's adoption of an outward-oriented growth strategy focused on improving export competitiveness and gradually increasing the efficiency of Argentine industry. This should reduce the negative protection to exports while reducing the high positive procection of sales in the domestic market. In the interim, the resource pull--which is exerted by relative rather than absolute protection rates--will continue co be strongly inward, albeit declining. The trade reform program would also be linked to the maintenance of an adequate exchange rate. In conjunction with the Loan, the Government would: (a) expand the temporary admission regime and introduce automaticity and uniformity in its operation, moving towards "free trade scatus" for exporters; (b) simplify the approvals and controls of trade administration; (c) eliminate the remaining exporc taxes on manufactures and reimburse indirect taxes on exports; (d) rationalize the protection system through the gradual reduction of non-tariff barriers to trade, including the elimination of prior documentation requirements for abouc 7,847 tariff positions (equivalent to 58.5Z of the value of industrial production); and (e) formulate an Action Program for the second phase of the trade policy reform program. The program would also include a pilot export promotion component. The component would focus on preshipment financing to be provided to exporters to cover their import requirements for exports and would be operaced as a special fund of the Central Bank with commercial banks acting as intermediaries. For this purpose, an account would be created in the Central Bank for bilateral parallel financing p2rticipacion in the component. The proposed loan would assist the Government in the short term by supporting an increase in imports necessary for the growth and export orientation of the economy and at the same time improve the country's capacity co service its debt. The proposed loan would be the first of two proposed policy-based loans to support successive phases of trade reform. The first phase would focus on measures needed to strengthen exporc competitiveness and expand exports rapidly while initiating a gradual process of import liberalization. The main thrust of this phase is to strengthen export promotion through an adequate operation of the two TAR systems, initiate a process of removal of quantitative import restrictions (QRs) over a three-year period and eliminate trade controls. The second phase would focus on a continued, and comprehensive, reform of the system of protection which would include che gradual elimination of restrictions on most tariff positions and the rationalization of the import tariff structure. C. The Trade Policy Reform Program 53. The program of trade policy reform supported by the loan is presented in the Government Policy Statement on Economic Adjustment (Annex V). The measures subsumed by this program and the schedule for their implementation are summarized in Annex IV. 54. Macroeconomic Policy Framework. The Government is complementing its stabilization efforts with structural reforms designed to lay the basis for medium-term growth. The gradualistic approach of the Government with respect to trade policy reforms will require maintaining a viable and  - 19 - stable economic policy environment based on concinued improvements in monetary, fiscal, exchange rate, external accounts, and rationalization of public investments. A strong export orientation would be consistent with its pro-export thrust. An outward-looking development strategy must be installed as a permanent feacure avoiding past abrupt policy swings. The Bank shares the Gcve:nment's position that Argentina's economic development strategy has to boe toward outward-oriented growth and that a viable macroeconomic policy framework is essential to achieve the objectives of the loan. The proposed loan provides therefore, that, for loan effectiveness and second-tranche release, the Bank shall be satisfied that the macroeconomic policy framework is consistent with the Government's trade liberalization objectives (paras. 73-74). 55. Competitive Exchange Rate. The Government has accelerated the monthly rate of crawl slightly above the differential between domestic and international inflation. At the end of February 1987 the Government depreciated the Austral further by 7%. The Government has announced that it will depreciate the Austral by 2% per month during May and June while the temporary wage and price freeze, introduced co bring down inflation, remains in effect. The Government has also introduced an export insurance mechanism to protect exporters from exchange losses. The Government would demonstrate to the Bank, before the release of the second tranche, the degree of competitiveness of the real exchange race based on adequate export performance (para. 79). 56. The Export Incentive Package. The major incentive reforms adopted under the loan with the objective of promocing uniformicy of access to export incentives are: (a) introduction of a special TAR system, Argentina Exports (ARGEX), which includes automacic, duty-free access to all imported inputs required in the production of exports encompassing all tariff positions and including capital goods, on the basis of a multiannual export contract; (b) expansion of the standard TAR system to 6,600 automatic duty-free tariff positions pertaining to inputs required in the production of exports. Capital goods will remain outside the coverage of the standard TAR. The extension of the TAR would cover those tariff positions which are used as inputs for exports. It would not cover all tariff positions currently in the automatic list of final goods. The difference in coverage in the latter list is made up of capital and consumer goods which have relatively high tariff protection. The exporter, however, would have access to all tariff positions if he were to enter into a multiannual export contract through the ARGEX. Both TAR systems include autonatic access to foreign exchange, for transfers to indirect exporters of goods imported under the TAR, and for occasional exporters to replenish inventories duty-free. The Government introduced both TAR systems to ensure that all of the exporters needs would be addressed. The Government would, before second-tranche release, review the adequacy of both systems over time co ensure the automatic import of inpucs for exporEs. After being in operation for a sufficiently long period, the Government would be able to assess their merits with a view to establish a single system. The expecced effect of these reforms is an increase in imports and then a subsequent expansion of exports since exporters will be able co utilize inputs at international prices. 57. Operational Reforms. Following discussions with the Bank regarding the proposed loan, SICE and Customs procedures for exporters have  - 20 - already been streamlined and simplified through: (a) drastic reduction in processing time for DJAT applications; (b) doubling of the time span for complying with the original export commitment; (c) application of more uniform procedures to collect fees from DJAT applicants; and (d) drastic shortening of the DJAT application forms. As a condition of second-tranche release, the Government would demonstrate to the Bank the adequacy of operation of the two TAR systems to ensure the automatic import of inputs. 58. The Removal of Export Distortions and Restrictions. As part of the program under the loan, the Government has already: (a) eliminated most export taxes on manufactured commodities; (b) reduced export taxes on petrochemicals to 10% of their f.o.b. value; and (c) introduced an effective mechanism to reimburse indirect taxes on exports. (The exporter can be reimbursed totally or partially for indirect taxes paid. Reimbursement of 10%, 12.5%, and 15% of the f.o.b. value of exports for specified export products is allowed. Reimbursement in excess of 15Z of the f.o.b. value of exports requires an analysis of the indirect taxes paid by the respective good). The profitability of exports is estimated to have improved by about 5% on average as a result of the elimination of export taxes and by an additional 10% on average on account of the reimbursement of indirect taxes. The Minister of Economy's Statement on Economic Policy indicates that the Government will not provide further subsidies (para. 49). For firms which currently have an export contract, the subaidy element would need to be eliminated when the contract expires. Agreement on terms of reference for a study on interest rates applicable to the borrower's export credit programs would be a condition of effectiveness of this loan and the Government would exchange views with the Bank subsequently on the study's conclusions and recommpndations. In the area of export restrictions, as noted in para. 46, the Government consolidated all the prior authorizations required by export shipments for the one-stop administrative window procedure. The window now operates with representatives of only six agencies (Meat Board, Under-Secretariat of Fisheries, Military Industries, Defense Ministry, Aluminum Agency, Army Horses Department and Race Horses Association). Export shipments which are not related to these six agencies do not require prior authorization from Customs. Twenty-five institutions previously participating in the procedure have de facto been eliminated. For the latter agencies, Customs has agreed to supply them with statistical information after the export shipments have been made. Customs is currently finalizing arrangements to expand telegraph lines to connect all of its offices by telex. The Government would commit itself, before second-tranche release, to extend the telecommunications system to all 49 Customs of f ices and to present to Congress, if necessary, legislation which would formally exclude those agencies which are de facto no longer participants in such approval process. 59. Phasing Out Import Restrictions. In December 1985, the Government transferred most tariff positions from the prohibited list to the prior consultations list. In January 1986, all prior documentation requirements were eliminated for 7,147 import tariff positions (corresponding to 62% of total tariff positions) equivalent to 48.5% of the value of industrial production. The importer can now arrange external  - 21 - financing with the commercial banks and imporc withouc any intervention from SICE. The rules for applying QRs have been tightened significantly in favor of the importer through new procedures which: (a) reduce total consultation tine to 15 days from up co six months previously; (b) require approval of import requests after 5 days (wichin the 15 day limit) if no opinion is issued by the pertinent producers' association; (c) if the association gives an opinion, SICE only has an additional 10 days to resolve the issue; (d) put the onus of supporting evidence on the associations; and (e) specify that once an import request has been approved, a precedent is established that will rule out any further producer association intervention for that tariff position. The Government has committed itself not to change the new pzocedures for moving tariff positions out of the prior consultation list without Bank agreement or fail to enforce such procedures. The Government has also committed itself, in the Minister's Policy Statement, to transfer most of the remaining import tariff positions in the prior consultation list to the automaCic list over a three-year period. These commitments also include: (a) before second-tranche release, the elimination of prior documentation for an additional 700 tariff positions (bringing the fully automatic total to 7,847 tariff positions) equivalent to at least 10% of the value of industrial production (the total equivalent value of production of fully automatic tariff positions would then rise to 58.5%); and (b) to increase by the end of the chree year period the number of tariff positions on the automatic list to about 80% of the value of industrial production. In parallel, the Government would also move the above-mentioned 700 tariff posicions to the the automatic list in the standard TAR, so as to give a clear signal of its import liberalization goals. The Government would also undertake the following studies: (a) effeccive protection; and (b) timing, actions and effects of the removal of QRs, including the rationalization of the temporary tariff protection. The recommendations of these studies would be implemenced in che proposed follow-up loan. 60. Reduction of Import Controls, and Import Tariff Levels and Structure. Customs has initiated a program to simplify import procedures which has already sharply reduced the tine importers require to withdraw their goods. The program is being extended to simplify import procedures furcher, to increase revenue collection, to provide reliable import data, and to detect over-invoicing. SICE has simplified the paperwork required for imports and exports, disaggregated tariff positions to provide flexibility in moving them to the automatic list, and decided on pending cases of tariff adjustments. The Government has committed itself to grant a maximum transitory tariff protection of up to 100% for tariff positions moved out of QRs. However, at least 85% of the tariff positions eligible for initial tariff protection would receive no more than 70% tariff protection. Transitory tariff protection would be phased out over a three-year period to a tariff band with a 40% maximum and a 10% minimum, the schedule for which would be agreed before second-tranche release. The Government would also maintain some range of flexibility with respect to the maximum tariff band since it has difficulties in assessing the protection required. Thus, for a reduced number of tariff positions (no more than 25% of tariff positions which are given transicory protection), the Government would introduce a temporary surcharge of up to 20% of the c.i.f. value of imports ac the end of the three-year period. These are considered suitable as a means of phasing out the elimination of QRs. The  - 22 - Government would also undertake a study which would focus on introducing competition in government procurement. The recommendations of the study would be implemented in the proposed follow-up loan. 61. The Trade Policy Reform Program - An Assessment. The policy adjustments needed to sustain medium-term growth Include trade policy and a number of other reforms. These have been outlined in the Government's Medium-Term Framework Paper. As noted below, crucial trade policy reforms will create opportunities for growth and employment based on Argentina's international comparative advantage. In the absence of such opportunities, it will be difficult or impossible to phase out most quantitative import restrictions or to implement many other necessary reforms. Moreover, the gradual reduction of trade policy distortions will exert pressures for change in the whole structure of domestic production costs and output prices, and will thus serve to identify other needed structural adjustments and to guide policy reforms accordingly, as the economy moves towards international competitiveness and relative prices. If trade reform is to be successful and lasting, it must be accompanied by other reforms (paras. 30, 32, 33, and 34) to make the most of the new opportunities that will emerge in a more open economy. The reforms supported by this loan are intended to strengthen export promotion incentives and to initiate the process of import liberalization, but without creating serious dislocations in the economy that might thwart Government efforts to make Argentine industry more competitive. Sased on the results of implementing the first phase of the program, a proposed follow-up loan would support the second phase of policy reform, focusing on completion of the process of opening up the economy, by eliminating quantitative restrictions and also by introducing competition in government procurement, and by rationalizing the structure of import tariffs. D. Expected Effects of the Policy Reform Program 62. The Government's medium-term adjustment program and the more specific reforms envisaged under the trade policy reform program are expected to have the following results. 63. Growth and Employment Effects. The projected increase in exports and the expansion of capacity utilization and output of tradable goods would be a critical factor in raising the rate of economic growth. in addition, the expansion of output is likely to create new job opportunities. 64. Reorientation Towards Tradables and Balance of Payments Effects. The combined impact of the substantial appreciation of the real exchange rate and the liberal import regime of the 1979-81 period contributed to a 25% accumulated loss in the volume of industrial production, a fall of almost 30% in sector employment, and the outright destruction of many industries; capacity utilization in manufacturing dropped to 60% by the third quarter of 1980 from the 70-75% range before 1979. In the capital goods subsector, the drop was even more dramatic. By the second quarter of 1981, capacity utilization levels had dropped to 48Z. The continuing devaluation of the real exchange rate (because of the crawling peg) and the improvements in the profitability of exports envisaged under the TARs will go a long way toward reviving capacity utilization and redirecting real resources to the tradable goods sectors,  - 23 - particularly manufacturing and agroindustry. The projected outcome would be an increase in the growth rate of the industrial sector to about 5.6% per yriar on average in 1987-89, compared toL the 3.3% annual average decrrase during 1981-85. 65. The strengthening of export incentives is estimated to raise the profitability of exports of goods by 10-15%, improving the relative profitability of exports vis-a-vis import substitution, and therefore promoting the outward orientation of the economy. While the share of exports as a proportion of GDP is projected to rise only gradually, the composition of exports would change significantly, with an expansion of manufacturing exports offsetting the effect of falling prices for Argentina's agricultural exports. Imports, particularly of capital goods and intermediate inputs required for exports, will also need to grow sharply in 1987, but strong export performance is expected to compensate these additional imports. As a consequence, the resource balance is expected to improve in 1988. Exchange rate policy is also expected to produce, inter alia, an expansion in earnings from tourism and transport services as Argentina becomes a wore attractive country for tourists. As a result, the deficit in the current account of the balance of payments as a percentage of GDP is projected to decrease from 3.8% in 1986 to about 3% in 1987, about 2.61 in 1988 and 1.8% in 1990. 66. The projected decline in the current account deficit, to a significant extent the result of the economy's new outward-looking orientation and the implementation of structural reforms, implies that the growth of debt outstanding and disbursed, and of external debt service obligations is likely to decelerate over the medium term. Together with the expansionary effects of exchange rate policy and of the incentive package for exports, this also implies that Argentina's creditworthiness indicators will improve significantly by the mid-1990s. E. Social Impact of Trade Policy Reforms 67. Social development, income distribution and employment have been adversely affect d by the abrupt shifts in economic policy over the last decade. Social conditions worsened significantly as a consequence of the 1979-81 import liberalization and of the