Argentina - Industrial sector study

Report No. 6990-AR Argentina Industrial Sector Study April 11, 1988 Industrial Deve!opment Division Industry and Energy Department FOR OFFICIAL USE ONLY Document of the World Bank 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 EQUIV/ALENT ACRONYMS CFI Consejo Federal de Inversion CKD Completcly Knocked Down DNFH Direccion General de Fabricacion Militares ERP Effective Rates of Protection GIP Gross Industrial Product GDP Gross Domestic Product INDEC Instituto Nacional de Estadisticas y Censor iSIC International Standard Industry Classification IVA Impuesto de Valor Agregado (Value-Added Tax) REER Real Effective Exchange Rate SICE Secretaria de Industria y Comercio Extcrior  FOR OMCIAL USE ONLY ARGENTINA: INDUSTRIAL SECTOR STUDY TABLE OF CONTENTS Page No. SUMMARY AND CONCLUSION................................***.* * ... i - xi CHAPTER I* THE TRADE REGIME AND THE SHAPING OF THE ARGENTINE INDUSTRIAL SECTOR: 1970-1987 ...................... 1 I. Introduction ...eo................. ,....o.oo.o 1 II. The Trade Policy Regime ...................... 5 A. The Liberalization of the Trade Regime: 1976-81 oo............. *... ..............-0 6 B. The Structure of Protection in 1987 ...oo.. 12 III. Conclusions .................................. 18 CHAPTER II* IMPORT SUBSTITUTION AND INDUSTRIAL PROMOTION IN ARGENTINA I* Introduction ................................. 21 II. The System of Industrial Incentives: Evolution, Current Framework and Fiscal Cost . 21 III. Economic Impact of the Investment Incentives . 27 A. Allocative Impact of the Incentive Regime.. 27 B. Investment Incentives and Industrial Concentration ............................. 36 C. Investment Incentives, Intersectoral Mobility and Firm Conduct ................. 41 IV. Conclusions o..0*0*0.............. ..0...*.. 45 This report was written by Claudio Frischtwk (team leader, IENIN), Jean-Michel Doublet (IENIN), Barbara Mierau (LA3TF) and Marilou Uy (LA2TF), following a mission in April/May 1987. Information was drawn from the reports of the following consultants: Daniel Azpiazu (Investment Incen- tives); Javier Cardozo (Footwear); Graciela Gutman and Fernando Porta (Dairy Products); Edgardo Lifachitz and Bernardo Kosakoff (Intereensal Comparisons of Industrial Structure); Edgardo Lifchitz (Price Linkages Coefficients); Hugo Nochteff (Consumer Electronics); and Enrique Scala (Metal Mechanics). The MICOM unit of the IENIN division provided word processing services and Valerie Chisholm secretarial assistance. Thi document has a restricted distribution and may be used by recipients only in the tserformance of their official duties. Its contents may not otherwise be disclosed witho'it World Dank sutho$.i*tjon.  TABLE OF CONTENTS (Cont.) Page No. CHAPTER III THE IMPACT OF THE POLICY REGIME ON COMPETITION AND INDUSTRIAL PERFORMANCE: EMPIRICAL EVIDENCE *....... 47 I. Introductfon ....eeooeoe*e*oe..e00000000000 47 II. A Discussion of Selected Structural Characteristics 00 .......................... 47 A. Overall Levels of Concentration .......... * 48 B. International Comparisons ................ 48 C. Concentration Dynamics ................... 51 III. An Assessment of Competition ................. 54 A. Determinants of Competition .............. 54 B. Domestic Competition ..................... 55 C. Barriers to Import Competition and Export Rivalry ...... ..................... 60 D. Assessment of Competition ................ 62 IV. Impact of the Policy Regime on Industrial Performance o.................................. 65 A. Industrial Growth and Structural Change .. 65 B. The Policy Regime and Economic Efficiency. 67 C. International Competitiveness and Export Performance ....................... 71 V. Conclusions 75 CHAPTER IV. AN APPROACH TO POLICY REFORMoo.o. .................. 77 Io Introductiono.......... 0.00o0o................ 77 II. The Direction, Scope and Coordination of Industrial Policy Reform ..................... 78 III. A Unified Strategy of Reform of the Trade Regime and the System of Price Controls ...... 80 A. Trade Reform ....o.ooo*4,o*#*#$ooo*o**o 80 B. Phasing out the System of Price Controls . 81 C. Coordinating and Phasing Price Decontol and Trade Liberalization ................. 82 IV. Reform of the Investment Incentive Regime ...., 85 A. Bias Toward Capital Intensity ............ 85 B. Bias Toward Low Value-Added Activities 000 86 C. Sectoral Biases *o.........o..o....o*oooo 87 D. Bias Toward Provincial Concentration of Incentives o#oooooooooooo*oo****ooo*ooo 87 E. Excessive Fiscal Costs ................... 87 F. Investment Incentives as an Element of Competition Policy o..oo.o.o..o..ooo... 88 G. Legal and Administrative Complexity o.oo 90 V. Concluding Remarks **0oe0000oo *oooo* 90 Bibliography ........... o***o*o**ooooo 93  TABLE OF CONTENTS (Cont.) TABLES Table 1.1 Selected Manufacturing Indicators Table 1.2 Nominal and Effective Rates of Protection, 1969 Table 1.3 Comparison of Price Differentials aad Tariff Levels (1976-77) Table 1.4 Nominal and Effective Rates of Protection 1976 and 1977 Table 1.5 Nominal Rates of Protection in the Argentine Manufacturing Sector, 1987 Table 1.6 Nominal Tariff Rates, Mean and Standard Deviation of Tariff by Country Table 1.7 Quantitative Restrictions in the Argentine Manufacturing Sector Table 2.1 Argentina - Nature of Sectoral Incentives Table 2.2 Argentina - Nature of Regional Investment Incentives 1987 Table 2.3 Fiscal Costs of Investment Incentives Table 2.4 Argentina - Effective Subsidy from Industrial Incentives Table 2.5 Argentina - Effective Subsidy and Cost Advantage of the Investment Incentive System Table 2.6 Effective Rates of Protection (ERPs) in Consumer Electronics (Color TV) 1983-86 Table 2.7 Argentina: Distribution of all Employment and Investment of Promoted Projects, 1974-1987 Table 2.8 Ranking of Sectors by Total Promoted Investment Relative to Value-Added in Sector, Current US$000 Table 2.9 Distribution of Promoted Investment Across Broad Industrial Categories, 1974 to 3/1987 Table 2.10 Share in Value Added of New and Indigenous Industries in La Rioja, 1973 and 1984 Table 2.11 Argentina - Provincial Distribution of Promoted Investments anc Gross Domestic Product Table 2.12 Promoted Projects, Employment and Investment 1974-March 1987, by Degree of Concentration Table 2.13 Argentina - Structural and Behavioral Characteristics of Major Projects with Investment Incentives Table 2.14 Distribution of the Top 50 Promoted Projects 1974-87 by Ownership Table 2.15 Changes in the Structure of the Textile Industry, 1973 and 1984 (% of Production Value) Table 2.16 Argentina: Linkages in Capital and Production Structure: The Case of Petroquimica de Bahia Blanca, 1985 Table 3.1 Industrial Concentration in Argentina Table 3.2 Comparison of Four-Firm Concentration Ratios in Industry Table 3.3 Distribution of Industries by Four-Firm Concentration Ratio Table 3.4 Indicators of Concentration for Manufacturing Industry, 1973-84 Table 3.5 Distribution of Concentration Levels Table 3.6 Average Differences in Concentration Indices by Sector, 1973-84 Table 3.7 Size and Output Distribution of Firms in Manufpcturing Industry  TABLE OF CONTENTS (Cont.) TABLES Table 3.8 Ease of Entry by Type of Goods Table 3.9 Distribution of Sectors in the Economy by Degree of Domestic Competition Table 3.10 Main Intermediate Goods Subsectors with Low Domestic Competition Table 3.11 Main Capital Goods Subsectors with Low Degree of Competition- Table 3.12 Domestic Competition by Blocks Table 3.13 Distribution of Tradeable Goods Subsectors in the Economy by Degree of Import Competitiveness Table 3.14 Export Performance and Rivalry (1984) Table 3.15 Distribution of Seetors in the Economy by Degree of Global Competition Table 3.16 Argentina: Share of Manufacturing Value-Added in GDP Table 3.17 Indicators of Performance for Some Skill-Intensive High Value-Added Subsectors Table 3.18 Estimates of Costs Incurred Due to Scale Diseconomies (To Firms Surveyed; in X of Actual Costs) Table 3.19 Relative Changes in Factor Productivity for Subsectors with a Low Degree of Competition, 1973-84 Table 3.20 Comparisons of the Price of Aluminum, 1986/87 Table 3.21 Comparisons of Prices of Intermediate Goods, Argentina and 3rasil, 1987 Table 3.22 Leading Export Manufacturing Subsectors Table 3.23 Export Shares, 1966-83 Regional Exports as a Percentage of World Exports Table 4.1 Argentina: Price and Import Liberalization Matrix Table 4.2 Argentina: Promotion Levels and Extent of Competition FIGURES Figure 1.1 (a) Real Effective Exchange 'ate Index (b) Monthly Inflation Rates (c) Real Wage Index (d) Real Regulated Lending Rates Figure 1.2 (a) Imports of Intermediate Products (b) Imports of Consumer Goods (c) Imports of Machinery and Equipment Figure 1.3 Manufacturing Value Added, 1970-85 Figure 1.4 Manufacturing Employment, 1970-85 Figure 2.1 Argentina: Cement Production and Installed Capacity, 1970-85 Figure 3.l Trends in Manufacturing Value-Added by Type of Goods Figure 3.2 Trends in TFP and Labor Productivity, 1970-85  TABLE OF CONTENTS (Cont.) APPENDIX TABLES Table Ti Argentina: Major Recipients of Promoted Investments (1974-87) Table T2 Argentina: Evolution of Industrial Concentration of Industries that Received the Major Share of Promoted Investments Between 1974 and 1987 (March) Table T3 Argentina: Characteristics of the Top 50 Projects by Type of Good (1974-87 March) Table T4 Distribution of the Top 50 Promoted Projects Between 1974 and 1987 by Type of Ownership Table T5 Comparison of Scales of Production, Argentina and U.S. in Motal Mechanical Industries Table T6 Optimal and Actual Scales According to Firms Surveyed in Various Sectors Table T7 Price Comparisons (Ex-Factory, 1983) Table T8 Comparison of Industry Average Ex-Factory Prices Between Argentina, Brazil and tbe U.S., 1983 APPENDIX PIGURE Figure F1 Distribution of Gross Industrial Product by Size of Firms, 1984 (a) Wood Industry (b) Food Manufacturing (c) Chemical Industry (d) Textiles (e) Paper Industry (f) Manufacturing Industry (g) Mechanical Industry (h) Other Industries (i) Metal Industry (j) Non-Ferrous Metal Industry AN A2 Methodology for Estimation of the Effective Subsidy A3. Methodology, Data Sources and Results I. Definition of the Indicators Used II. Assessment of Domestic Competition III. Assessment of Import Competition IV. Assessment of Export Rivalry V. Assessment of Global Competition VI. Price Linkage Coefficients VII. A Note on the Linkage Between the Herfindahl Index and Industry Price Cost Margins  TABLE OF CONTENTS (Cont.) ANNEX TABLES Table A3.1 Differences in Technical and Economic Concentration, 1973-84 Table A3.2 Matrix of Correlation Coefficients Table A3.3 Assessment of Domestic Competition in Argentine Manufacturing Industry, 1986-87 Table A3.4 Assessment of Import Competition Table A3.5 Assessment of Import Competition in Argentine Manufacturing Industry Table A3.6 Export Performance and Rivalry, 1985 Table A3.7 Assessment of Global Competltion in Argentine Manufacturing Industry 1986/87  ARGENTINA: INDUSTRIAL SECTOR STUDY SUMMARY AND CONCLUSION i. This report examines Argentina's trade and industrial policy regime and its impact on industrial structure, competition and perfor- mance. It suggests that, since the mid-1970s, a combination of macropolicy shocks and highly distortiouary trade and industr.al policies have led to a decline in industrial performance and international competitiveness. In contrast with most middle-income developing countries, average manufactur- Lig growth was already low in the 1966-73 period (4.4% p.a.), and turned negative (-1.6% p.a.' in 1973-83. Over the 1966-83 period, manufacturing exports grew by just 1.5%, with Argentina's share in world manufacturing exports falling from 0.8% to 0.4%. The Policy Regime and Industrial Si:agnation ie. The erosion of Argentina's relative position is rooted in the perverse synergy of two factors. First, severe macroeconomic instability and the repeated policy shocks generated excessively risk-averse and anti-competitive economic conduct. Second, high trade barriers and generous, long-lasting investment incentives to domestic firms, gradually deterred competition and mobility, reinforcing established producers In mture and declining subsectors. iIi. Frequent policy changes have caused substantial fluctuations in prices and rendered the economic environment very unstable. Partly as a result, Argentine industrialists have become unusually risk-averse in their investment decisions. Produ ers, 'acing increased variance in prices, pro- fits and institutional arrang.eaentsi, have diversified away from the real or perceived higher risk of directly productive activities. Also, in an attempt to insulate themselves against market shocks, firms have consolidated their positions and in:reased their market power by vertical and horizontal integration. iv. The serious difficulties in firms' planning and decision-making combined with unattractive rates of risk-adjusted profitability, contri- buted to the decline in the rate of investment, which fell from 21.22 to 11.3% of GDP between 1970 and 1985; private investment fell from 13.1% to 7.5Z. At current rates, gross fixed domestic investment barely covers depreciation of capital assets. v. The adverse impact of an unstable macropolicy environment on the level of investment and the pattern of resource allocation has been further magnified by two key features of the policy frame toward industry: the trade regime and the system of investment incentives.  - ii - vi, Trade barriers decreased Import compatition for most established activities; many sectore have had infinlte protection for extended periods. New areas of production, on the other hand, have faced negative protection. The infant industry argument was turned upside down: relief from import competition was provided for the more mature and declining sub- sectors, while new or innovative activities were penalized. High profits from domestic operations enabled firms to operate in isolation from Inter- national markets, shielding them from export rivalry. Even during reces- sions, small production scales and costly inputs deterred exports. Argentine producers became as a result insulated from the exacting cost, quality and performance requirements of export markets. vii. Non-tariff barriers constitute the core of the country's present system of import restrictions. The prevailing non-tariff barriers do not take the form of outright quantitative restrictions. Rather, they consist of a system of complex and cumbersome licensing procedures. This system is characterized by a lack of transparency, leaves plenty of room for dis- cretionary actions, distorts resource allocation, and encourages collusive behavior among producers. viii. The most heavily protected sectors are food products and tex- tiles, where 60% and 49% of total production is completely sheltered with imports prohibited through both the restrictive list and systematic rejec- tions under the prior consultation regime. In addition, products included in certain sectoral promotion programs (such as petrochemicals and steel) have benefitted from heavy protection during project start-up and beyond. ix. Nominal tariff protection in Argentina is, on the other hand, relatively moderate: ad valorem duties range from 0% to 48%, with a small number of items subject to higher duties reaching 87%. The mean unweighted tariff for manufacturing industry is 31.9%, with a standard deviation of 10.1%, roughly comparable to that for the economy as a whole. A substan- tial dichotomy exists, however, between tariffs levied on goods not locally produced vs. goods which are produced domestically. Protection Is, thus, particularly strong for traditional sectors such as textiles and apparel, while tariffs are below average in electric machinery and scientific equipment. x. A system of investment incentives, comprising tax and other exemptions, has been the other major barrier to competition and structural change. Through the incentive system, established firms obtained unit cost advantages which have helped them consolidate their market position. Entrants, competing for scarce fiscal resources, were at a disadvantage relative to well-informed incumbents that had already demonstrated the ability to fulfill domestic demand requirements. The system's bias in favor of capital-intensive techniques and low value-added activities, in which Argentina has no obvious comparative advantage, and its emphasis on mature and declining subsectors, deterred investment in new industrial segments, slowing down positive industrial restructuring.  - iii - xi. Simulation results show that the investment incentive subsidy per unit of value added rises with capital intensity. For a share of value- added in production of 48% (1984 national average), the subsidy per unit of value-added increasas from 39% to 82% as capital intensity (the share of capital income to value-added) rises from 10% to 85%. The incentive system has also favored low value-added activities, with subsidies often exceeding generated value added. The subsidy per unit of value-added increases from 63% to 75% as value-added share of the production value falle from 75% to 48% (using for share of capital earnings in value added, the 1984 itndustry average of 73%). At a 15% value-added level, incentives would account for nearly 1.5 times the value added. xii. Fiscal incentives have enabled firms to lower costs by 13% to 41%. They have heavily favored process industries, particularly of inter- mediate goods. Since 1974 over 50% of projects and 81.5% of promoted investment amounts were in intermediate products. Capital goods, consumer durables and consumer non-durables have accounted for a minor part of promoted investment, respectively 2.2%, 2.3% and 13.9%. Finally, about 80% of promoted investments benefitted large dominant firms. Thus, nearly all the realized promoted investments in cement, paper paste, fertilizer, plastics and resins, and pulp wood, were undertaken by one of the top eight firms in the industry. xiii. The basic proposition of this report is that industrial stagna- tion in Argentina cannot be understood without reference to these biases. While succeeding in promoting rapid industrialization in the post-war period, these policies came to imply higher levels of protection and promotion to process (particularly intermediates) and assembly industries, while penalizing design and fabrication activities. xiv. In addition, these policies, instead of promoting new activities, have come to protect those sectors characterized by large sunk costs, outdated processes and receding markets. They strengthened the market position of leading incumbents in mature and declining industries, to the detriment of entrants in areas of emerging comparative advantage. Ulti- mately, they slowed down the flow of resources to new activities, by insulating domestic producers from the forces of competition and structural change. An Approach to Policy Reform Xv. The damage done to the industrial sector by the policy regime cannot be reversed in the very short term. Producers will take time to readapt their expectations concerning the economic and policy environment in Argentina and to change their conduct. Nonetheless, it is reasonable to expect that with a more stable macroeconomic environment, and a less biased and protective policy regime, Argentine producers will respond by expanding _nvestment and directing resources toward more productive activities.  - iv - xvi. The Constitutional Government has already taken a number of important steps to provide greater macroeconomic stability, a more open and transparent trade regime, and a less distorted incentive structure. To some degree, however, the limited nature of many of these steps has con- strained the response of industrial firms. It is now essential to move decisively with a trade and industrial strategy aiming at a more competi- tive economic environment, and a progressive integration of Argentine industry into the reglonal economy and world markets. , accelerate firms' supply response the Government may also want to support entry of new entre- preneurs and development of industrial technology through limited and targeted (at the "point of distortion") functional intervention. Thus, certain gaps in financial markets, for example, might call for the provi- sion of seed and innovation finance (through risk-sharing arrangements such as conditional loans and other quasi-equity instruments). xvii. The Scope of Policy Reform. Changes need to be introduced in the way the Government regulates and promotes industrial activities and how it manages international trade. The technical, allocative and managerial inefficiencies resulting from policy-determined barriers to competition and growth need to be dealt with first, by lowering these barriers, stimulating export rivalry and introducing a greater measure of import competition; and second, by supporting entrants and innovators in areas of actual or emerg- ing comparative advantage. xviii. To create a competitive, growth-inducing environment, it is essential that the Government change not only its policies, but also its practices in a number of areas. It is of particular importance that entrants be able to threaten and penetrate stable markets dominated by few large firms, including public sector enterprises, which currently are shielded from competition by existing regulations. Although this report focuses on the trade regime and the system of investment incentives, the scope for policy reform is considerably larger. Regulatory controls on entry, such as those found in the sectoral programs, for example, should be abolished; such controls are anti-competitive devices that protect and transfer rents to incumbents. xix. The public sector procurement system is another area that needs to be part of a comprehensive package of policy reform. First, the bidding and evaluation procedures are not sufficiently clear and transparent to ensure that the most competitive bidder will be awarded the contract. Col:.usion, agreements on market sharing, price rigging and other non- competitive strategies are stimulated by the system. Most firms regard profitability on public contracts as superior to what prevails in the domestic market. The second aspect stems from the fact that, since the early 1960s, excessive preference has been given to national suppliers (even in case of monopolies), providing an additional shield from external competition. There is, in sum, considerable scope for the Government to move forcefully with an entry-inducing, pro-competitive, policy in procurement.  -v - xx. Coordination of policy reform. To ease the transition and mini- mize the possibility of creating new distortions, changes in industrial policies need to be coordinated with adjustments in the trade regime. Rapid import liberalization in an environment where producers are con- strained by regulatory barriers to entry and growth, including price controls, would limit economic gains and could result in costs that ulti- mately might lead to a reversal in trade reform. For import competition to be a progressive instrument of industrial development, domestic producers have to be free to allocate resources and price output in response to market signals, to provide an equal basis for competition with imports. xxi. On the other hand, if prices are freed from controls in a market where entry and expansion are precluded or hindered by regulatory fiat, or competing imports are blocked through binding trade barriers, the exercise of market power by incumbents could lead to the gouging of consumers. Producers would not face the threat of actual or potential competition; they could extract from buyers the rents generated by protection. xxii. As part of a coordinated strategy of industrial and treale reform, the lowering of trade and regulatory barriers to competition should be timed to be implemented pari-passu with the decontrol of industrial prices. The process of reform presumes that rents will be competed away progressively by lowering policy-induced barriers to competition and reduc- Ing, or eliminating, a substantial part of investment incentives. At the same time, freedom of pricing in a more competitive environment will ensure that producers are rewarded by the market for their efforts in engaging efficiently and innovatively in the business of production. xxiii. Finally, trade and industrial policy reform can play an important role in the management of inflation. An effective anti-inflationary strat- egy would require, inter alia, minimizing the scope for intermediate goods subsectors (which are often characterized by increasing returns and monopolistic organization) to amplify price increases. xxiv. When scale economies are large relative to the domestic market, the predominance of "natural" monopolies or oligopolies is economically justified, and technical efficiency losses from their break-up may not be offset by the gains from having more actors in the market. In these circumstances, trade competition becomes the only feasible means to drive producers to efficient price-output combinations (short of regulatory controls). xxv. Thus, in an environment characterized by limited domestic com- petition and high natural entry barriers, the ability to decontrol prices without rekindling inflation is predicated an increasing the extent of import competition. The process of import liberalization tends, however, to have only a gradual impact on the competitive behavior of domestic producers. There are informational lags (buyers' knowledge of the expanded set of opportunities is initially limited) and, more important, market frictions, that preclude imports from Immediately driving domestic prices to border levels. New importers are often unable to establish, at least in  - vi - the short term, effective distribution channels, provide technical assist- ance, etc. Commonly, dominant producers become dominant importers. This has been observed in Argentina and other countries in the initial phases of trade liberalization. To the extent that these lags and frictions are significant, price liberalization in the least eompetitive sectors could be complemented by transitional controls to ensure that domestic prices do not exceed the cif price of competing imports. xxvi. In conclusion, for the Government to carry out a process of policy reform which stimulates competition and growth while preserving price stability, it would need to move on a number of fronts simulta- neously, providing a greater extent of trade competition, reforming the system of price controls, changing the system of investment incentives and lowering or eliminating regulatory barriers to mobility. A. Trade Reform xxvii. Two critical dimensions of competition are associated with a trade regime reform: import competition and export rivalry. Both need to be stimulated In Argentina. Reform of the Import regime is needed both to inject discipline in markets dominated by few firms, and to promote intra- industry specialization. Through pre-announced changes in the trade regime, domestic and border prices should be brought into line progres- sively, with border prices guiding domestic producers to a more efficient allocation of resources. xxviii. Recently, the Argentine Government has initiated a number of reforms designed to stimulate exports and to gradually reduce the restric- tiveness of the current import regime. The Government has announced its intention to eliminate the prior consultation list by early 1988, transfer- ring all products from this list to the "automatic" category. xxix. Trade policy reform should now focus on phasing out the remaining quantitative restrictions by (i) implementing the present Government pro- posals of eliminating the prior consultation list, (ii) ending non-tariff restrictions established by sectoral programs, and (iii) further simplify- ing import documentation requirements. This process should be supported by a stable exchange rate policy which would effectively channel resources toward the production of exportables and efficient import-competing activi- ties. The transition period could be facilitated by temporary tariff surcharges with a clearly defined time schedule of short duration, a course that the Government is presently considering. xxx. The Government should also strive to reduce and eventually elimi- nate the widespread use of tariff exemptions and special tariff sur- charges. They tend to undermine the validity of the tariff system, while reducing its transparency, introducing discretionary elements and increas- ing the dispersion of effective protection. The tariff system should, instead, be made to fully bear the weight of protection.  - vii - B. Phasing out the System of Price Controls xxxi. For competitive subsectors, full price decontrol should be introduced immediately. In uncompetitive markets, progressive removal of barriers to mobility and competition, including substaxatial reduction in trade barriers, should accompany the decontrol of industrial prices. The transition period to a decontrolled system should be short (not more, say, than six months to a year). xxxii. For those subsectors in which price decontrol will be gradual and coordinated with an increase in import competition and a lowering of barriers to mobility, prices should be fixed at import price levels. This should be regarded as a transitional policy, until import competition becomes fully binding and regulatory barriers to entry are phased out. Prices should be liberalized completely, except in the few cases of non- contestable monopolies producing non-tradeable goods and services. C. Coordinating Price Decontrol and Trade Liberalization xxxii. A staggered removal of price controls and a progressive reduction of the extent of protection is recommended. Were there neither transaction costs nor institutional constraints, a once-and-for-all removal of distor- tionary policies would be preferred. However, with significant sunk costs, considerable friction in factor mobility, and imperfectly competitive markets, a more gradual approach may be indicated. A strategy of gradu- ated, yet decisive elimination of barriers to competition may also help baild support and thus achieve sustainable progress of reforms. xxxiv. In the absence of knowledge about effective rates of protection, one cannot argue for a specific sequence in the process of import liberali- zation. Nonetheless, it ie particularly important to subject the least competitive industries to ti6e discipline brought about by import competi- tio.i. Among the least competitive industries, intermediate goods (charac- terized by very high price linkages) have the largest economic impact. Liberalizing imports (and tightening investment incentives) of these indus- tries would erode the rents being transferrod to them, while providing economy-wide benefits in the form of lower prices. xxxv. A number of countries that have been able to sustain reforms in the trade regime have initiated them with intermediate goods, primarily because this first stage of liberalization raised the effective rates of protection of users, which had often been negative, and promoted a large interest group backing reform. However, if this process raises already high levels of effective protection among some final users, steps must be taken to simultaneously lower nominal protection to those producers. An initial focus on intermediates would also generate support because they tend to have the highest price linkages to the rest of the economy. As such, they become a critical link in the mechanism which propagates inflationary pressures. Import competition would help severe this link.  - viil - xxxvi. Price decontrol should be pursued simultaneously, immediately introduced in competitive industries. Price liberalization for subsectors should move in tandem with lowered restrictions on firm mobility, and binding import competition, measured by the degree of import penetration and by the domestic/border price differentials. D. Reform of the Investment Incentive Regime xxxvii. The investment incentive system has generated a heavy fiscal burden: its estimated fiscal cost (in terms of revenue foregone) in 1986 was 1.9% of GDP or 53% of the public sector deficit. The investment incentive regime has also been very costly in economic terms, by favoring activities characterized by high capital intensity and low value added. The system also seems to promote industries with high concentration and helped foster oligopolistic practices among leading incumbents. In terms of the regional allocation of incentives, the system has favored a few select Provinces. While achieving only limited regional deconcentration of industrial activities, it has resulted in very large economic efficiency losses. xxxvIii. Currently the Government is attempting to rationalize investment incentives. It should aim at reducing the amount of fiscal incentives and the period of their application, making them available to all industries in all Provinces. The project selection criteria should be improved, with an emphasis on export-oriented investments. The bias against entrants and higher value-added or more labor-intensive activities should be elimi- nated. A new investment incentive Law, under discussion in Congress, could constitute a major step in helping modernize Argentina's industry if based on these considerations. (1) Bias Toward High Capital Intensity xxxix. The bias toward capital-intensive activities would be partially offset (a) by substantially reducing the length of time (from 15 to say 5 years) during which investors may avail of tax deferments and profit tax exemptions; (b) by subjecting tax deferments to interest payments; and (c) by removing the value added tax exemptions from purchases. xl. SICE's new procedures in ranking projects have already reduced this bias, since the fiscal costs per employment generated (the variable used to rank projects) tend to be higher for more capital-intensive activities, giving them the lowest priority. Since changing this ranking criteria, labor intensive activities have moved up the scale relative to capital-intensive goods. xli. Further reduction of tax deferments to investors and of exemp- tions from taxable profits would make the system more neutral. Tax defer- meLts, for instance, should be payable within not more than five years; they should be fully and immediately reimbursed if projects are not carried out within 2-3 years of approval. Exemptions from taxable profits should be more limited, and be given for at most five years.  - lx - xlii. Reducing the tariff exemptions from imported capital equipment and from all imported inputs would also lessen the incentives toward capi- tal use. It Is recommended that tariff exemptions from Imported capital equipment be granted only once and at the initial stage of the project, and that firms in Tierra del Fuego be exempt only from tariffs on capital equipment Imports, and not on inputs. (2) Bias Toward Low Value-added Activities xliii. Reducing the time horizon of value-added tax exemptions would partially offset the bias favoring low value-added activities. To elimi- nate it, value-added tax exemptions should be phased out altogether. Since many promoted firms already avail of these incentives, to merely eliminate them would signify that such firms would have an unfair advantage over entrants. Incumbents, therefore, should also be denied access to this tax incentive. This is possibly the only way to effectively deal with the very substantial economic and fiscal distortions arising out of value-added tax exemptions (and deferrals), while preserving horizontal interflrm equity (by not penalizing entrants and discouraging their investment). Since eliminating these exemptions to incumbents may be difficult, a program of phased reductions in incentives may have t- be considered. (3) Sectoral Biases xliv. The same set of intermediate goods which have been most favored in the past--petrochemicals and chemicals, ferrous metals, and cellulose-- remain under special sectoral incentives. Since these industries take extensive advantage of provincial incentives, the set of procedures devel- oped by SICE, by reducing the importance of these industries in the alloca- tion of provincial incentives will, in part, reduce this bias. xlv. Phasing out the sectoral programs is essential. These indus- tries, especially the heavy intermediates, have been receiving substantial benefits for the past two decades. Since many are declining, the Govern- ment may want to consider interim measures to facilitate adjustment to new technological and demand conditions, rather than merely continuing to stimulate growth. Sectoral incentives should be replaced by horizontal policies promoting entry of new entrepreneurs (through the provision of seed finance, technical assistance and training), and modernization and technology development of industry. Promotion should be moderate, well- focused and time-bound. (4) Bias Toward Provincial Concentration of Incentives xlvi. Investment incentives are especially generous to a selected set of Provinces with special programs and to the National Territory of Tierra del Fuego. Firms responded accordingly by relocating their plants to these areas. Provinces with lower per capita incomes had no access to similar promotional instruments. It is quite critical to avoid undue concentration of incentives among few Provinces and Tierra del Fuego. To carry out the  - x - objective of economic deconcentration more effectively, the Goverrment should eliminate the special programs for Catamarca, San Luis, San Juan, La Riojs and Tierra del Fuego and replace it with a program of strengthening provincial infrastructure which would address distortions of past policies in this respect. (5) Excessive Fiscal Costs xlvii. The incentives of the Industrial Promotion Law need to be down- sized significantly, in order to make the associated fiscal costs compati- ble with the requirements of fiscal balance in public sector accounts and to lower the economic efficiency losses associated with regional disloca- tion of industrial activities. When, in 1983, authority was shifted to the Provinces, the number of promoted projects rose five times and the fiscal cost of the system doubled. Moreover, there is no evidence that the promoted relocations enhanced commensurably industrial productivity. xlviii. An improved Industrial Promotion Law could require substituting present tax exemptions, notably the value-added tax, by a system of tax credits. Generally, and within a declining ceiling of fiscal incentives, industrial promotion should be accessible to industries in all Provinces, preferably under equal conditions, on the basis of realistic evaluations of tax revenues foregone. Therefore, maximum amounts would have to be set not only for individual Provinces but also individual investment activities. (6) Investment Incentives As An Element of Competition Policy xlix. One of the paramount goals in revising the system of investment incentives is to encourage competition and to reduce the transfer of rents to selected industries. The proposed reforms in both sectoral and provin- cial programs would reduce the bias of the system in favor of subsectors which are the largest recipients of incentives and also the most uncompeti- tive. The presumption is that the profits normally absorbed by these sub- sectors are quite sufficient to finance their investment needs. 1. SICE's new ranking procedure already lessens the bias toward highly concentrated subsectors by de-emphasizing heavy process activities. Many of the features of the evaluation methodology being developed at SICE could serve as useful starting points for developing provincial criteria for project approval. Making the system of screening automatic and more transparent, and removing extensive consultations ("consulta previa") between major producers and Government officials, would also lessen the selection bias toward leading incumbents. By phasing out sectoral programs and removing their entry-restrictive provisions, reforms would also address the pro-incumbent bias of the system. Government permits for steel and cellulose production are still required, and so are plant scale require- ments for petrochemicals, etc. Entry is also deterred by the cost advan- tage to incumbents benefitting from fiscal incentives for extended periods, which should be accordingly reduced quite drastically.  - xi - (7) Legal and Administrative Complexity 11. The current system maintain several laws and decrees, each one outlin'ng different provisions for each sectoral program. With the autoAomy granted to promoted provinces, each province has also set up its own regulations and criteria. It is suggested, therefore, that the Laws be integrated and simplified (possibly within the scope of a single Law), whereas the criteria for screening should also be made transparent and consistent with overall industrial policy objectives. lit. In a truly automatic regime, both stages of the screening process should be changed or the consultation stage eliminated and the remaining one refined. If both stages are retained, the first-stage criteria should be made consistent with the overall objective of relating the proposed Investments benefits with their fiscal costs. The current changes in the criteria for ranking projects as developed by SICE are a significant step in the right direction; they could be improved further by giving more emphasis to the export content of the product. (D-254q)  CHAPTER I THE TRADE REGIME AND THE SHAPING OF THE ARGENTINE INDUSTRIAL SECTOR 1970-1987 I. Introduction 1.01 This study examines Argentina's industrial policy regime and its impact on the performance of the manufacturing sector. Since the mid-1960s growth of manufacturing value-added has slowed significantly (Table 1.1). In contrast with most other middle-income developing countries, average manufacturing growth was negative (-1.6% p.a.) in the 1973-8^ period. In addition, both the share of manufactured exports in manufactured output (8.6% in 1983) and its rate of growth (1.5% in the period 1966-83) have been extremely low. Table 1.1: SELECTED MANUFACTURING INDICAIORS Growth of Manufacturing Share of Growth Rate of GDP Value Added Manufacturing Manufacturing Per Capita Exports in GHD Exports 1984 1966-73 1973-83 1966-83 1983 a/ 1966-83 (US$) () (X) (%) (2) (%) Argentina 2,230 4.4 -1.6 0.8 V.S 1.5 Brazil 1,720 8.6 3.4 4.8 11.9 8.8 Chile 1,700 2.0 -1.6 -0.4 33.7 7.2 Colombia 1,390 7.8 2.1 4.5 15.5 5.4 Japan 10,630 13.4 5.9 11.0 16.2 11.9 Rorela 2,110 21.9 11.8 18.7 36.9 2.3.4 Mexico 2,040 9.8 4.4 6.4 9.7 6.3 Tirkey 1,160 9.5 4.4 8.0 11.1 10.6 Q GMO - Gross mmnufacturing output. Source: IENIN data base. 1.02 The erosion of Argentina's position relative to other middle- income countries over the last 20 years is rooted in a perverse synergy of two factors. First, severe macroeconomic instability and repeated policy shocks generated excessively risk-averse and anti-competitive economic conduct. Second, high trade barriers and generous, long-lasting investment incentives to domestic firms, gradually deterred competition and mobility, reinforcing established producers in mature and declining subsectors.  - 2 - 1.03 Frequent policy changes have caused substantial fluctuations in mwst prices and rendered the economic environment very unstable. Particu- larly since the 1960s, policy-makers have been groping for a means of reconciling macroeconomic stability with a resource-intensive process of import substitution and a multiplicity of conflicting societal demands. Domestically, Governments have attempted, generally unsuccessfully, to raise resources through a combination of taxation and borrowing without resorting to an inflation tax. External balance has been equally hard to achieve, in view of the economy's inability to expand exports to finance the needs of an import-intensive industrialization process. 1.04 The extent of price instability can be observed in Figure 1.1 (a-d). The real effective exchange rate (REER), for example, first rose (appreciating the peso), in the early 19709, to 70X above its 1970 level (a level generally regarded as fairly close to an equilibrium exchange rate), and subsequently fell 50X below this base line. An attempt to use the REER as an anti-inflationary instrument in the late 1970s led again to a 40X appreciation with respect to the 1970 level. Other key prices, such as interest rates and real wages, show a similar history of sharp oscillations. 1.05 Partly as a reflection of these fluctuations, Argentine indus- trialists have become unusually risk-averse in their investment decisions. Producers, facing increased variance in prices, profits and institutional arrangements, have diversified away from the zeal or perceived higher risk of directly productive activities. Also, in an attempt to insulate themselves against market shocks, firms have consolidated their positions and increased their market power by vertical and horizontal integration. 1.06 The serious difficulties in firms' planning and decision-making combined with unattractive or negative rates of risk-adjusted profita- bility, contributed to the decline in the rate of investment, which fell from 21.21 to 11.31 of GDP between 1970 and 1985; private investment fell from 13.1% to 7.51. At current rates, gross fixed domestic investment barely covers depreciation of capital assets. 1.07 The adverse impact of the macropolicy environment on the level of investment and the pattern of resource allocation has been magnified by two key features of the policy frame toward industry: the trade regime and the system of investment incentives. Industrial stagnation in Argentina cannot be understood without reference to their biases or dual nature. While succeeding in promoting rapid industrialization in the post-war period, these policies have come to favor: established incumbents over potential entrants, once subsectors were consolidated; certain assembly and process activities (particularly of intermediate goods), to the detriment of more skill-intensive and higher value-added production; and mature and declining industries against innovative and high-growth sectors.  (A) REAL EFFECTIVE FIGURE 1.1 (8) L nuTION RATES Is "o - |970 1*7* t t, s