Argentina - Public Sector Reform Loan (PSRL) Project

Dooumax of The World Baik FMomcULuMoMN Rutt N.i.P-5492-AR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PUBLIC SECTOR REFORM LOAN (PSRL) IN AN AMOUNT EQUIVALENT TO US$325 MILLION TO THE ARGENTINE REPUBLIC JULY 5, 1991 This document has a restricted disbon and my be used by recipiens only ir the pefrmance of bir offiil dties its conte_ may not odtrise be disbosed witout Wor Su* auhodiation.  Cuzreuov Uhit - Austral 1A8) The austral was fixed at A$10,000 - US$1.00 as of April 1, 1991. FiJsual Y January 1 - December 31 Princioal Abbreviations and Acronyms Used BANADE Banco Nacional de Desarrollo National Development Bank BCRA Banco Central de la Rop6blica Central Bank of Argentina Argentina BHN Banco Hipotecario Nacional National Housing Bank BONEX Bonos Externos External Bonds CECRA Comit6 Ejecutivo para Controlar Executive Committee to Control la Reforma Administrativa the Administrative Reform CGN Contaduria General de la Naci6n National Accounting Office DGI Direccion General Impositiva General Tax Office ENTel Empresa Nacional de National Telephone Telecomunicaciones Company' PA Perrocarriles Argentinos Argentine Railways GAO Contraloria General de la Naci6n General Auditing office of Nation PERAL Pr6stamo de Ajuste para la Public Enterprise Reform Reforma de las Empresas PGblicas Adjustment Loan PERIL Pr6stamo de Ejecuci6n para la Public Enterprise Reform Reforma de las Empresas PGblicas Execution Loan PSRTAL Pr6stamo de Asistencia T6cnica Public Sector Reform Technical para la Reforma del Sector P6blico Assistance Loan SIGENAC Sindicatura General de la Naci6n Executive Controller of the Nation SIGEP Sindicatura General de General Auditing Office of Empresas P8blicas Public Enterprises TCN Tribunal de Cuentas de la Naci6n National Court of Accounts VAT Impuesto Sobre E1 Valor Agregado Value Added Tax yPp Yacimientos Petroliferos Fiscales State Petroleum Company  FOa oFnciAL US ONLY Maine of Cotents PaoeRo Loan and Program Summary . . . .. . . . . . . . . . . . . . . . . . . i-i. I. THE L. . . . . . . . . . . . . . . . . . . . . . . . . . . . A. Dackground . . . . . . . . . . . . . . . . . . . . . . . . . . B. Stabilization Program of the Menem Goverment . . . . . . . 2 The July 1989 Stabilization Attempt . . . . . . . . . . . . 2 The 1990 Program . . . . . . . . . . . . . . . . . 3 1991-92 Program and l 8tandby . .. . . . . . . . . . .. 6 C. Macroeconomic Outlook . .. . . . . . . . . . . . . . . .. 7 D. External Debt Management ... . . * ........... 8 II. MAIN PU,LIC SECTOR ISMUES . . . . . . . . . . . . . . . . . . . . 9 A. Main Problems . . . . . . . . . . . . . . . . . . . . . . . . 9 Revenues .............. . . . . . . . . . .. 10 Expenditures . . . . . . . . . . . . . . . . . . . . . . . 11 FinancingW . . . .... ....... ................... ............. 13 B. Recent Public Sector Reforms Outside the Federal Government . 14 Public Enterprises .......* 14 Provincial Finances . .. ..... .. . . . . . . . . ... 1s Financial System . . . . . . . . . . . . . . . . . . . 15 Trade Regime . . * . . . . . . . . . * . * . . . . . 16 1II. THE PUBLIC SECTORfREFORNM PROGRA ........ .... . 17 A. Revenuess More Efficient Mobilisation . . . . . . . . . . . . 17 Tax Policy and Administration .............. 17 Closing Loopholes through Industrial Promotion . . . . . . 18 B. Expenditure Reductions: Focusing on Core Functions . . . . . 20 Administrative Reform. 999999999999999999 20 Budget Process . . . . . . . . . . . . . . * * * . . . 22 C. Financings Reforming the Central Bank . . . .... . 25 I. PRPSED LM .. ... .. .. . . ... ....... 26 A. objectives and 8cope of the Loan .... ........ 26 B. Rationale for the Loan . ................. . 26 C. Loan Conditions * . . . . . . . . . . . . . . . .... . . . . 27 D. Macroeconomic Framework . . . . . . . . . . . . . .. 29 This report was based upon an appraisal mission that took place November 7-24, 1990 and a Post-Appraisal Mission (January 31 - February 8, 1991) The core team of the missions consisted of Richard Newfarmer (Task Xanager), Paul Beckerman (Central Bank), Roberto Manrique (Research Assistance), Antonio Martin del Campo (Expenditures), and Jaime Vaisquez-Caro (Revenues). Supervising managers: Suman K. Bery (Division Chief) and Pieter Bottelier (Department Director). Peer reviewers: Miguel Kiguel (CRC1G) and Barbara Nunberg (CECPS) This document has a restricted distribution and may be used by trcipients only in the performnance of their official duties. Its contents may not otherwise be disclosed without World Bank authoriza -"  ZagaLiQ. B. Cooperation with other Financial Institutions . . . . . . . . 29 International Monetary Sund . . . . . . . . * . 0 * * . . . 29 Snttr-Amrcoan Developmnt Bank . . . . .. . . . . . . . 30 P. Program lmplementation . . . . . . . . . . . . . . . . .*. . 30 Dibursement and Prourment . . . . . . . . . . . . . . . 30 Accouanting nd Auditing . . . . . . . .. . . . . . . . 31 0. Impact, Benefits and Risks . . . . . . . . . . . . . . . . . 31 social Impact . . . . . . . . . . . ... . . 31 Benefits ., . . . . . . . . . . . . .............. 32 Risk ......................................... 33 V. COUNTRY-1SSISThNCE = A= AND !MS . . . . . . . . . . . 34 A. Previouus Bank xprene ....... .................... . 34 B. Bank Strategy . . . . . . . . . . . . . . . * * *35 C. Private Investment and ISC Lending Program . . . . . . . . . 35 VI. RiCOMNENDATIO . . . . . . . . . . . . . . . . . . . 36 ANNEX Is Letter of Development Policy ANNRX II: Key Macroeconomic Indicators ANNEX III: Selected Statistical Tables ANNEX IV: Policy Matrix ANNEX Vs Statement of Bank Loans ANEoX VIS Statement o IFC Investments ANNEX VIIs Administrative and Civil Service Reform Program  PULI BRCO REO lOA EP5R Loan *d -PoMasaM Bumat Aoggwars 3 Argentine Republic Amounts US$325 million eqpivalent Colinagina: US$300 million equivalent by the IDB Tormos Repayable in 17 years, including 5 years of grace, at the standard variable rate. QbieJtive. s The objective of this program is to reduce the chronic macroeconomic instability that has slowed economic growth, utifled the private sector, impeded job creation, and worsened absolute poverty during the last decade. The propoued Public Sector Reform Loan (PSEL) will reduce the public sector deficit and therefore the need for inflation financing. This loan, part of a broader Bank program to help restructure and reduce the size of Argentina's public sector, will support fundamental reforms of the Federal Government and Nonetary Authority. Specifically, the loan would support major changes ins (i) revenue mobilization, (ii) expenditure rational- ization and (iii) the Central Bank and its relation to the Treasury. Bonefita and Risks* In the absence of public sector reform and permanent deficit reduction, there is virtually no hope that private investment could recover or that income levels of the poor could rise; the probability of renewed hyperinflation would be substantially higher, with its enormously high human costs-- sudden rises in unemployment associated with the severe recession accompanying a breakdown in the payments and prlce system. The reforms supported in this program will help reduce the structural deficit of the public sector by approximately 1.5-3.2 percent of CDP on an annualized basis in 1991-93 and substantially more in future years. Since the reforms necessarily involve a reduction in public employment, a special transition program has been designed for displaced workers. Bank financial assistance will allow the Government to implement its macroeconomic program at noninflationary levels of reserve accumulation and domestic credit creations Bank technical assistance will increase the probability that the Government will be able to implement a reform of this magnitude.  - ii - The main risks are that macroeconomic instability might undermine the political strength of the Government to implement reforms, entrenched political opposition might delay or dilute reforms, and the lack of adequate staffing in senior positions within the Government might undermine implmen- tation. The Government's demonstrated willingness to work closely with the IMP in its stabilization program, and its commitment to continuing public sector reform--amply supported by the public at large--mitigate these risks. The Bank and the IDS have financed technical teams to help strengthen public sector management; also, the Argentine private sector, as an independent initiative, has formed a privat- foundation to support the administrative reform with training and management advice. satimated Diabureementt The loan would be disbursed against import receipts according to prevailing guidelines in two tranches of US$162.5 million each. The first tranche would be available for disbursement at the time of loan effectiveness. The second tranche would support specific actions in the reform program. A US$23 mil- lion Public Sector Reform Technical Assistance Loan (PSRTAL) was approved by the Board on June 25, 1991, and will accompany the proposed loan to finance information systems for customs, civil service and budget administration, and the Central Bank. Retroati Financines Because of the many measures taken before Board presentation, US$65 million, or 20 percent of the total loan amount, would be made available for retroactive financing of expenditures incurred after January 1, 1991. Schedule of Disburements :8S millo Bnk FY Em Ym Annual 162.5 162.5 Cumulative 162.5 325.0 Rate of Returns Not applicable. &apraLsal Reports Not applicable.  JPRORT ANDM 3 mN IOI OF mg PRWSIDN or T IWJrNAATIOIIL MmN "a1 RUncONSTRcwOn mm EVLPU T N NiNUVEp Ring= 03H A P IN A amO EQuI TO U5S325 MILLIO TO _3 AB_x_ _-3s M U4z= 1. *I submit the following report and recomendation on a proposed loan to the Argentine Republic for the equivalent of US$325 million to support a program of public sector reform. The loan would have a term of 17 years, including 5 years of grace, at the Bank's standard variable interest rate. The Inter-American Development Bank (IDB) would cofinance the operation with a US$300 million loan. The Public Sector Reform Loan (PSRL) would be accompanied by a Public Sector Reform Technical Assistance Loan (PSRTAL) for the equivalent of US$23 million to finance the installation of control systems in the budget office, custom and Central Bankg that loan was processed in parallel with the PSRL, and was approved by the Board on June 25, 1991. m. SC 2. During the first decades of the 20th century, Argentina enjoyed a standard of living on a par with Southern Europ. The primary engine of Argentine growth was a large agricultural export sector. The Great Depression triggered a reformulation of the country's policy framework, which progressively stressed protection for domestic industry, transfers of resources from agriculture to the urban Lndustrial and service sectors, and wage poliey and lncome distribution. The public sector became increaLngly involved in resource allocation. While the strategy was initially successful, by the mid-19SOs terms of trade turned agaLast agrieulture, easy domestic import-substitution possibllities became exhausted, and balance of payments crises increased in frequncy; economic growth became more variable. At the same time, increased government spendLng and an expanded role of the public sector led to burgeoning public deficLits. The Government financed a high portion of these defLcits through the domestic financlal system, which together wlth rigld prlce, credit, and interest rate controls, repressed and distorted its development. The foundations for sustained economic growth gradually eroded. 3. The state-led model began to exhaust ltself in the mid-1970s, and the long-run growth path of the economy turned sharply downward. Argentina, the most affluent LatLn American country in 1962, fell to fourth place by 1989. National income per capita is about 26 percent lower today than in 1974. Investment, tradLtionally 20-23 percent of CDP, began a sustalned fall to an 11-13 percent level In the late 1980s. Prlvate investment has recovered to only 50-60 percent of those earlier levels. The lnvestment rates of the economy are now so low that they may not permit adequate replacement of depreciating capital stock.  - 2 - 4. The savings performance of the economy also reflects serious structural problems. National savings rates have fallen from about 20 percent of GDP in the early 1970a to under 10 percent. Public savings fell steadily from 1970 to 1975, and then again from 1977 to 1982, with only a partial recovery thereafter. Public savings before interest 2ayments had, by 1987, recovered virtually to the same level as those of 1970-72, about 5 percent of GDP, but these were still too low to cover the full interest bill of the Government this underscores both the difficulty imposed upon Argentina's public sector because of the heavy weight of its external debt as well as its lack of sustained progress in mobilizing resources efficiently and controlling expenditures. Private sector savings have failed to recover, and are now little more than half their early 1970w levels. Sconomic conditions have led Argentines to save vast amounts abroad; aside from understating private savings in national accounts, these resources abroad are unavailable for job- creating investment in Argentina. 5. The abrupt end to easy foreign commercial credit in the early 1980s and sudden rise in real international interest rates forced a reversal in external transfers, and diverted domestic savings into foreign interest payments; this required that the public sector extract more resources from the private sector to make these payments. These internal transfer requirements only exacerbated the existing structural deficit that plagued the economy in the 1970e and during the first part of the 1980s. As foreign finance dried up, an ever greater share of the combined public sector borrowing requirement was financed through the domestic financial system and eventually money creation. To avoid the resulting inflation tax, the private sector gradually withdrew its resources from the financial system and reduced its holdings of currency; this, together with the effects of inflation on real revenue collection, made the macroeconomy progressively more usnetable and weakened the instruments of monetary policy. Inflation, high and uA1predictable, became the main impediment to the recovery of private savings ard investment. During the 1980w alone, the price level increased by a factor of 3.36 million, and the decade ended with two episodes of hyperinflation in 1989. S. Stabilisation Proarars of tMe MOMas government The July 1989 Stabilizatio *nttsmDt 6. Upon taking office in July 1989, the Menem administration reanqnized that without macroeconomic stability the long economic slide could not be reversed. It announced a program relying on the nominal anchor of a fixed exchange rate. The stabilization program, supported by the W4 beginning in November 1989, gave more weight to fiscal performance and to structural reforms than the earlier stabilization attempts of tho Alfonsln years, the Plan Austral (1985) and the Elan Primavera (1988). The new Government was able to pass legislation authorizing the sale of public enterprise assets, the suspension of most subsidies, and limitations on Central Bank credit to the public sector. Later, it eucceeded in passing a major tax reform which widened the base of the value added tax (VAT), first to nearly all goods and then to services. Nonetheless, the near-term effects of  - 3 - those measures were lnsufficient to earn the confidence of wary financial mrkets that had experienced soveral failed programs and just sufferod a major hyperinflatton. Even though the nonfinancial public sector accounts improved *teadily through the fourth quarter of 1989, the primary surplus was insufficient to transfer resources to the Central Bank to cover its laqge nominal interest bill on domestic debt, much less its external debt service. Eventually, the high interest rates required to support the fixed exchange rate drove up the interest bill of the Central Bank; this created an unsustainable financial cycle in which the Central Bank had to create money to pay its own interest bill and then had to borrow back the australes to sterilize the endogenous monetary expansion. A markets moved against the austral in early December and interest rates skyrocketed, the program fLnally exploded. 7. On December 15, 1989 a new economic team floated the exchangi rate and removed nearly all remaining prie, controls. The exchange rate depreciated sharply as demand for austral-denominated assets plummeted further in response to fears of inflation and rumors of dollarization. Over the New Year weekend, to forestall imminent hyperinflation, the authorities announced the forced conversion of virtually all domestic commercial bank time deposlts, worth about US$3.5 billion, and the bulk of the Central Bank and Treasury's outstanding debt that the deposits financed, into 10-year dollar-denominated External Bonds (BONEX). Whlle this ponalized savers, the measure directly halved the potential liquid stock of financial assets and stopped the incipient hyperinflation. Moreover, it eliminated the destabilizing quasi- fiscal deficit of the Central Bank by eliminating the Central Bank's short-term debt and its interest burden. S. However, the Goverrment falled to complement these measures with fiscal adjustments that would have reduced the public sector demand for credit; the Central Bank also allowed monetary creation. At the beginning of February 1990, unexpected price adjustments for public enterprises and persistent rumors of dollarization triggered renewed fears of high inflation. The ensuing collapse in money demand from its already low level immediately spun the economy into hyperinflation in February. MMe 1990 Prooras 9. In early March 1990, the authorities responded with a new program predicated upon structural and emergency fiscal initiatives (Decree 435). lts main structural elements were an announced reduction in public sector employment through early retirement, elimination of overtime, and a sharp retrenchment in the operations of the National Housing Dank (BUN) and the National Development Bank (BANADE). Other expenditure and revenue measures included a 60-day suspension of payments due on public sector contracts and an extension of the partial suspension of the regional industrial subsidy program. The Central Bank was specifically prohibited from providing direct or indirect financing of any kind to the public sector, including the public enterprises. The IMF Board approved a resumption of the stand-by program on May 25, 1990. The program sought to increase public sector primary surplus to 4.2 percent of GDP in 1990.  - 4 - 10. Decree 435, coupled with tlghtened monetary policy throughout February, rapldly improved pubilc confidence. High dometic lnterest rates, together with the expectation of exchange rate stablifty, implied high returns in dollar terms. Capltal flowed in to rebuild flnancial balances and the austral began to revalue ln splte of Central Bank purchases of foreign exchange. Monthly inflation rates fell from 70-80 percent in December-March to a 10-15 percent range in aprll-September, and then to 4-6 percent in the fourth quarter. 11. The flical accounts improved substantially ln the second quarter of 1990. Performance in the second half of 1990 sllpped, however, because wages and pensions, at historically low lwvels in the second quarter, wore raised; public utility pricse ln real terms were allowed to fall slightly; and progress on revenue improvements was slow because of the recession and continued weakness in tax adminsltration. social security pensiovn payments, although well below the legal obligations of the Government, were also raised. To improve the fiscal balance, the Government undertook ome fiscal measures in the fourth quarter--price increases in the public enterprises, the extension of the VAT to services, and an increase in the VAT to 15.6 pereent- but these were insufficient to offset December fiscal performance. Neanwhile, monetary performance weakened. Provinclal banks, which had borrowed excessively from interfirm markets in the second and thlrd quarters to repay past rediecounts to the Central Bank, but were unable to service these credits in the fourth quarter as interest rates rose and deposits fell; the Central Bank had no choice but to prov4de new liquidity rediscounts, and this had a direct effect on money creation. In the final days of December, amidst news of the weakening fourth quarter performance, policy disputes within the economic team, and press reports of corruption, the exchange rate suddenly devalued. The rate moved from A5S,S00 in late December to A$9,000-A$10,O00 in mid-January, and inflation, having slowed to 2.3 percent monthly in December, jumped up to 8.9 percent in January and 32.5 percent in February 1991. 12. Although the 1990 program unravelled at the end of the year, the economy did not spin into hyperinflation as it had done the year before--in large measure bscause of greater fiscal effort and accelerating progress on structural reforms. The Government achieved a primary surplus of 2.2 percent of GDP on a cash basis in 1990--an improvement of more than 3 percentage points of GDP compared to the 1987-89 average (Figure 1). In addition, progress on the structural elements of the program provided some confidence to markets. The Government sold assets or concessions in telecommunications, roads, airlines, hydrocarbon deposlts, and railways; the asset sales and concessions produced about US$600 million in cash for the Government, and reduced its external commercial debt by over US$7 billion. The Government also extended the VAT to virtually all goods and services, reduced special transfers to the provinces and public enterprises, deregulated the hydrocarbon sector at year-end, and announced decrees to reduce the sLze and scope of the federal government (see below). In trade, it reduced the maxlmum tariff to 24 percent (save for some specific duties), reduced the coverage of quotas, and virtually eliminated the advance notice system for imports. In the financial sector, it closed the retail activitLes of the Housing and Development Banks. Reforms in 1990 thus paved the way for further reforms in 1991.  FIGR 1 NOWNiAMCIAL PUDIC SECTOR DEFICIT OF COMIWNIED PUBLIC SECTOR P_o _t of G_OP_ Pmat of GOP 10 _ S. Owu2 *tflolt S P/ - r. Su . 4p|us 0 -1 0 -2 Pri B, 1987 1968 1989 1090 1981 Pros. -s~~~- 1987 1989 1990 1991 a/ Proo. a - anc / C atmi Bak Sa Let aueatart of Mt and progwm aw I7IS/1-4) r pto*oftd LEVEL OF EXTERNAL PROTECTION REVENUE FROM ASSET SALES AND PRIVTLWTIONS Pwe nt US SLLION Q"ntitatlvU Ratrtloew a/ 0- 600 AMerg TsArffs bI 40- s 1.0 1087 1988 1980 1990 1981 1988 198 1990 1991sft at Pr.dotIo gammf bi Webwd by d.mmtleo oeootte Latt .eata of 1*1 to 0etaleted  - 6- 1991-92 Propaa W.