Argentina - First and Second Trade Policy and Export Diversification Loan Projects

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 12747 PROGRAM COMPLETION REPORT ARGENTINA TRADE POLICY AND EXPORT DIVERSIFICATION LOAN AND SECOND TRADE POLICY LOAN (LOANS 2815-AR AND 2996-AR) FEBRUARY 9, 1994 Country Operations Division Country Department IV Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the perfornance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ABBREVIATIONS AND ACRONYMS ASL - Agricultural Sector Loan BANADE - Industrial Development Bank BHN - National Housing Bank BSL - Banking Sector Loan CET - Common External Tariff CPS - Combined Public Sector IFI - International Financial Institutions ISI - Import Substitution Industrialization LAIA - Latin American Integration Association LDP - Letter of Development Policy OED - Operations Evaluation Department PCR - Program Completion Report QR - Quantitative Import Restriction SICE - Secretariat of Industry and Foreign Trade TA - Technical Assistance TAR - Temporary Admission Regime TFP - Total Factor Productivity TPL 1 - Trade Policy and Export Diversification Loan TPL 2 - Second Trade Policy Loan FSCAL YEAR January 1 - December 31  FOR OFFICLIL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Dir.otor-CGnerai Operation. Evaluation February 9, 1994 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Program Conpletion Report on Argentina - 7rade Policy and Export Diversification Loan and Second Trade Policy Loan aLoans 2815-AR and 2996-AR) Attached is the Program Completion Report on Argentina - Trade Policy and Export Diversification Loan and Second Trade Policy Loan (Loans 2815-AR and 2996-AR) prepared by the Latin America and the Caribbean Regional Office. The Government did not comment on Parts I and m of the PCR and did not prepare Part II. The PCR provides a good and informative account of the role of these two loans in recent developments in Argentina. The loans, approved in 1987 and 1988 respectively, were the cornerstone of the Bank's assistance strategy at that time in support of a gradual opening of Argentina's trade account. However, until the inauguration of a new Government in July 1989, borrower ownership of more comprehensive structural change waxed and waned. Thus, the absence of serious fiscal reforms during 1987 caused the Government's program to collapse and hence the first loan must be rated as unsatisfactory. The second loan may be seen differently. Shortly after first tranche release in November 1988 the absence of genuine domestic support for fiscal reform resurfaced and the macroeconomy deteriorated into hyperinflation: the Bank suspended disbursements. The severity of the ensuing crisis was such, however, that old interest groups lost all credibility. By mid-1990 significant reforms had been enacted by the new Government, including fiscal reform and renewed trade liberalization, and the Bank released the second tranche of the second loan. Throughout the crisis, the Bank maintained its policy dialogue and was then ready with follow-up adjustment operations. On this basis, the achievements of the second loan must be seen as satisfactory. Subsequent reforms and economic growth have been impressive, and the overall program can now be judged sustainable. Because the two loans helped lay the seeds for Argentina's reform program, they made a modest contribution to the institutional development impact of the Bank's assistance. The key elements of Argentina's current economic program are currency convertibility and improvement in the fiscal fundamentals. Inflation has been drastically reduced, and capital inflows have fueled a strong recovery. Real exchange rate appreciation, however, has motivated the Government to increase import protection for selected products. The ultimate benefits of the program will depend on the Government's ability to maintain macroeconomic stability and achieve sustained growth. The two operations will be audited by OED as a cluster audit of Bank adjustment lending to Argentina at that time, including an aborted Banking Sector Loan. The focus is expected to be on longer-term issues, especially the sustainability of the capital flows, competitiveness and related policies to promote investment and exports, and on the social impact of the adjustment process. Attachment ( This document has a resticted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disdosed without World Bank authorization.  I  FOR OFFICIAL USE ONLY PROGRAM COMPLETION REPORT ARGENTINA TRADE POLICY AND EXPORT DIVERSIFICATION LOAN AND SECOND TRADE POLICY LOAN (LOANS 2815-AR and 2996-AR) TABLE OF CONTENTS PREFACE ........................................................ i EVALUATION SUMMARY .......................................... iii PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE .... .......... 1 I. PROGRAM IDENTITY ......... ............................... 1 II. OVERVEW .............................................. 1 A. Background ............................................ 1 B. Trade Reform 1986-92 ..................................... 4 C. Bank Assistance ......................................... 6 Im. TPL I............................. 7 A. Strategy .............................................. 7 B. Loan Design . .......................................... 8 C. Implementation .......................................... 8 IV. TPL 2 ........................ .......................... 10 A. Plan Primavera .......................................... 10 B. Trade Strategy and Loan Design ............................... 11 C. Implementation by Alfonsin Administration ........................ 12 D. Implementation by Menem Administration ......................... 13 V. IMPACT OF TRADE REFORM .................................. 15 VI. LESSONS FROM THE ARGENTINE TRADE REFORM EXPERIENCE ... ..... 17 VII. THE WORLD BANK'S PERFORMANCE ........................... 19 VII. OPERAfONAL ISSUES ...................................... 20 A. Program Relations with Government ............................. 20 B. World Bank-IMP Relations .................................. 21 C. Loan Disbursement Performance ............................... 21 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.  TABLE OF CONTENTS (cont'd.) ANNEXES: I: Compliance with Loan Conditions: Ln. 2815-AR ......................... 23 II: Compliance with Loan Conditions: Ln. 2996-AR ......................... 25 III: Policy Statement of Economic Adjustment: Ln. 2815-AR .................... 27 IV: Policy Matrix: Ln. 2815-AR ...................................... 36 V: Letter of Development Policy: Ln. 2996-AR ............................ 41 VI: Letter of Sector Policy: Ln. 2996-AR ................................ 49 VII: Policy Matrix: Ln. 2996-AR ...................................... 54 PART II: PROGRAM REVIEW FROM THE BORROWER'S PERSPECTIVE ... ..... 56 PART IIJ: BASIC DATA ............................................ 57 A. TRADE POLICY AND EXPORT DIVERSIFICATION LOAN LOAN 2815-AR ............................................ 57 B. SECOND TRADE POLICY LOAN LOAN 2996-AR ............................................ 58  PROGRAM COMPLETION REPORT ARGENTINA TRADE POLICY AND EXPORT DIVERSIFICATION LOAN AND SECOND TRADE POLICY LOAN (LOANS 2815-AR and 2996-AR) PREFACE This is the joint Program Completion Report (PCR) for the two trade policy loans to Argentina, respectively, the Trade Policy and Export Diversification Loan (TPL 1) in the amount of US$500.0 million equivalent and the Second Trade Policy Loan (TPL 2) in the amount of US$300.0 million equivalent. The TPL 1 (Loan 2815-AR) was approved on May 19, 1987; all but US$4.03 million was disbursed and the last disbursement made in December 1987. The TPL 2 (Loan 2996-AR) was approved on October 27, 1988; it was fully disbursed and the last disbursement made in September 1990. Both loans closed on December 31, 1990 - respectively 30 months and 13 months behind schedule. The two loans supported the gradual opening of Argentina's trade account between 1986 and 1990. The loans were also the centerpieces of Bank assistance for the reactivation program of 1986/87 and the stabilization program of 1988 which preceded the 1989-90 hyperinflation and recession. This PCR therefore evaluates the Bank's involvement in both the trade and the macroeconomic policies of 1986-90. Due to the unusual scope, Part I exceeds space limitations. The PCR was prepared by the Country Operations Division of Country Department IV of the Latin America and the Caribbean Regional Office (Preface, Evaluation Summary, Parts I and o). On April 29, 1993, the Bank sent the Borrower Parts I and Im with the request to prepare Part n1 by June 11, 1993, but no reply was received. Preparation of this PCR was started during the final supervision mission for TPL 2 in July 1990, but was repeatedly interrupted by urgent other assignments of the task manager. The PCR is based on loan-related documents - the two Reports of the President; Loan Agreements; supervision reports; correspondence between the Bank and the Borrower; and internal Bank memoranda - and on economic reports and internal memoranda relating to the economic programs between 1986 and 1992.   i-I- PROGRAM COMEPLETION REPORT ARGENTINA TRADE POLICY AND EXPORT DIVERSEFICATION LOAN AND SECOND TRADE POLICY LOAN (LOANS 2815-AR and 2996-AR) EVALUATION SUMMARY Objectives I1. 'Me purpose of the two loans was to help the Government open the economy to trade. The loans were also central to the Banlc's aim of helping the Government design and implement a credible economic strategy. 2. The trade reform objectves were: (i) support for stabilization policies through price and wage discipline in an enlarged tradables sector; (ii) a more efficient trade balance adjustment to shifts in the external position; (iii) an upward sbift in total factor productivity (TFP) due to increased allocative efficiency, reduced rent-seekzing, lower managerial inefficiency, and realization of scale economies; (iv) hligher TFP growth connected with export expansion, wider input availability, and competitive pressure; and (v) increased investment as firms seek to improve productivity, pursue export opportunities, and ,respond to reduced uncertainty about policies. 3. The objectives of supporting economic strategy underwent changes in the period covered by the two loans. In 1986/87, the Banlc participated in a concerted effort of the international financial institutions (lFIs) and bilateral donors to provide fiscal and balance of payments support for a reform- based economic reactivation. With insufficient fiscal adjustment, the reactivation strategy proved unsustainable. In the second semester of 1988, the Banlc supported a heterodox stabilization program, te so-called Plan Primavera. The Bank: considered this program as the Government's last chance to avert the economic and social costs of hyperinflation, including a possible military coup; the Bank: was also concerned about pressures to default on preferred debt. The objective of preventing hyperinflation was not attained. However, Bank support achieved the other objectives: helping Argentin master the crisis with its democratic institutions strengthened, launching a comprehensive program of structural reforms, and avoiding default on preferred debt. At the time of the second tranche release of the TPL 2 in August 1990, the objective of Banlc assistance was to help the authorities irnplement the economic program which the Banlc had helped to design. Loan Design and Impleinentation 4. TPL 1. In 1986/87, the Goverrnment relied on heterodox policies to hold monthly inflation below 5 percent. De-emphasizing the need for up-front fiscal reform, the Government pursued a reactivation strategy based on public investmnent, financial deregulation to improve private investment financing, and export expansion; economic growth was expected to restore public finances over the medium-term. 'Me strategy received support through a Standby Agreement with the IMF. 5. Policies toward export expansion included: subsidization of non-traditional exports; removal of commodity export taxes; and introduction of "free trade status" for industrial exporters. The latter included the elimination of license requirements and taxes on industrial exports, improved reimbursement of indirect domestic taxes, expansion and automatization of the Temporary Admission Regime (TAR), and removal of quantitative import restrictions (QRs) primarily on inputs used in export production. A  - iv - gradual import liberalization would begin once reactivation had restored full employment. The TPL I was designed to support the introduction of free trade status for industrial exporters through a quick- disbursing component (US$496 million equivalent) conditioned on the above measures. A TA component (USS4 million equivalent) would finance studies underpinning the import liberalization phase, consultant services to improve economic reform management, and equipment purchases for the Customs Administration. Macroeconomic conditionality for the TPL 1 included satisfactory 1987 performance and 1988 plans with respect to fiscal, public investment, real exchange rate, and external financing objectives. 6. The Government implemented most export liberalization measures ahead of Board approval in May 1987; and readily met the other sector policy conditions as scheduled. The macroeconomic program, however, faltered as the Government engaged in unprecedented spending increases ahead of the September 1987 Congressional elections, which brought the country to the brink of hyperinflation. A new heterodox stabilization program was launched in October; it included tax reforms subject to Congressional approval. In this context, the Government also revised its trade reform strategy: terminating export subsidy programs and adopting a program for the elimination of all QRs until year's end, beginning with QRs having a production coverage of 10 percent. The Bank released the second tranche of the TPL 1 in December 1987, after the IMF had extended support by declaring Argentina eligible for drawing from the Standby agreement. 7. TPL 2. In the first semester of 1988, the Bank and the Government engaged in an intensive dialogue on the design of a program for comprehensive public sector reforms aimed at restoring the fiscal fundamentals. The economic situation, however, deteriorated rapidly after Congress had refused to approve the fiscal measures announced in October. The IMF declined consideration of another waiver, and relations with the Government subsequently broke down. Argentina stopped interest payments to commercial banks and the Government came under political pressure to default on preferred debt. Austerity measures provoked a string of general strikes and - in April - a coup attempt. By July, a complete loss of economic control was imminent. The President appealed to domestic interest groups to support a new stabilization program - the Plan Primavera; and requested multilateral and bilateral support for the external financing on which the Plan depended. 8. The Bank decided to provide support without being joined by the Fund. Bank staff helped the authorities give greater coherence to the Plan Primavera, and secured agreement on monitorable macroeconomic targets. A key element of the Plan was a dual exchange rate system - to be phased out after April 1989 - which was equivalent to an export tax collected through the Central Bank. While the Plan Primavera thus implied a temporary reversal of reform on the export side, it also was accompanied by significant import liberalization; inter alia: a major tariff reform; further reductions in the production coverage of QRs; and achievement of full automaticity of import financing in two steps. The Government also suspended the national industrial promotion regime, and took first measures toward assuming administrative control of the tax exemptions granted under various provincial industrial promotion regimes. 9. The TPL 2 was designed to support the import liberalization and the attainment of macroeconomic objectives. The Government met all effectiveness conditions allowing for disbursement of the first tranche in November 1988. The macroeconomic program, however, unravelled in early 1989 and the Bank suspended further disbursement in March. A complete loss of confidence rendered the authorities unable to prevent the economy from sliding into hyperinflation; monthly inflation peaked at 203 percent in July 1989. Trade reform was partially reversed in this period, including introduction of an explicit export tax covering 100 percent of all exports and prior approval of advance import declarations as a condition for import financing. 10. President Menem assumed office in the midst of hyperinflation in July 1989. The new authorities recognized the priority for sustainable fiscal adjustment, which could only be brought about by divesting  - v - the state from all non-core functions, eliminating subsidies, restoring the tax base, and rebuilding the tax administration. Progress in these reforms has since produced a gradual but steady improvement in the fiscal fundamentals. The new Government quickly reinstated full automaticity of import financing. It also began a gradual process of removing the remaining QRs and reducing import tariffs which by July 1990 exceeded TPL 2 second tranche release conditionality. The authorities also took measures to curb provincial industrial promotion that went beyond TPL 2 conditionality. For fiscal reasons, however, the Government phased out export taxes only according to an extended schedule. The Bank released the second tranche - granting a waiver of the export tax condition - in August 1990, after analysis of the effect of all trade reform measures on the anti-export bias of the trade regime had shown that import liberalization measures more than compensated for the export tax. The IMF had signified its endorsement of the macroeconomic program by reactivating its Standby Agreement. Results 11. The gradual trade liberalization of 1986-90 was followed by more drastic liberalization measures in 1991; this included the almost complete elimination of export taxes and QRs, and the removal of pernicious administrative barriers which had previously not been attempted. As a result, Argentina has since 1986 moved from one of the most closed and intransparent trade regimes to one of the more open and transparent. One indicator is the reduction of the anti-export bias from about 65 percent in 1986 to about 15 percent in 1992. Equally important, this was achieved by a liberalization of both exports and imports, not by offsetting import protection with industrial export promotion. 12. Trade liberalization shares objectives with other reform policies aimed at adjustment and market- based development including reforms of the tax structure, removal of subsidies, privatization, and deregulation. Since all of these have been implemented in Argentina in the last 2-3 years, it would not be possible to quantify the contribution of trade liberalization. However, the impact of the reform is visible in the expansion and increased diversification of trade, which is instrumental for the attainment of the wider objectives described above. Between 1986 and 1992 the volume of merchandise trade increased 126 percent compared to a 12 percent increase in real output; over the last two years, the share of consumer goods in total merchandise import rose from only 6 percent to 26 percent. Findings 13. Lessons. The Argentine experience suggests the following lessons: * the success of stabilization efforts depends on fiscal reforms being initiated at the beginning of a program; while heterodox policies can help bringing stabilization effects forward, they will be short-lived without progress in fiscal reforms; * provided a credible stabilization program is in place, trade reform need not wait for its completion; instead, trade liberalization should be part of the program from the beginning, both to increase price and wage discipline and to generate a more efficient framework for restoring a viable external position; * a trade reform stands little chance of being sustained if other state-led development policies remain in place; * quantitative restrictions on both exports and imports should be rapidly dismantled at the start of the reform; reforms of the tax structure and tax administration may be required before export taxes and import tariffs can be eliminated or brought down to a sustainable level; and  - vi - * a de facto, if not legally open capital account leaves the authorities without room for accommodating a trade reform with an up-front nominal devaluation; since the equilibrium real exchange rate can change for reasons unrelated to trade reform, it may be better to focus on deregulation to increase the flexibility of domestic prices and wages. 14. Sustainability. Argentina's gradual trade reform suffered a temporary reversal in 1989, but was resumed later in that year. It appears doubtful that a more aggressive liberalization in 1986/87 would have prevented the reversal. Instead, the necessary political support for a complete opening developed only after the 1989 collapse had made it plain that the country had no alternative. The change in public perception and the inclusion of trade reform in a comprehensive program of public sector reforms after 1989 are the main factors that have made the opening sustainable. 15. Bank Performance. The weak points in the Bank's performance concern the assistance for a flawed economic program and trade reform strategy in 1986/87. These reflect reliance on the Fund's assessment and insufficient prior economic and sector work. The Bank's support for the Plan Primavera created controversy, but needs to be evaluated in light of the Bank's wider objectives at the time. After a flawed start, the Bank's performance in assisting the authorities in the design and implementation of a comprehensive reform program including trade liberalization has been outstanding.  PROGRAM COMPLETION REPORT ARGENTINA TRADE POLICY AND EXPORT DIVERSIFICATION LOAN AND SECOND TRADE POLICY LOAN (LOANS 2815-AR and 2996-AR) PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE I. PROGRAM IDENTITY 1. Program Names: Trade Policy and Export Diversification Loan (TPL 1) Second Trade Policy Loan (TPL 2) Loan Numbers and Amounts: Loan 2815-AR (US$500 million) Loan 2996-AR (US$300 million) RVP Unit: Latin America and Caribbean Country: Argentina Sector: Trade HI. OVERVIEW 2. Argentina went through a period of turmoil in 1988-90 - marked by hyperinflation, recession, and repeated coup attempts. The country mastered the crisis with its democratic institutions strengthened; and in the past two years long-term trends of economic decline and high inflation have been reversed. Bank assistance played an important role in helping the Government design and implement structural reforms which turned the inward-oriented and state-led Argentine economy into a more open, market- based system. The two trade loans which are the subject of this PCR supported policy reforms, both in the run-up and during the crisis. A. Background 3. In the 1930s Argentina used import substitution industrialization (ISI) policies - subsidies and import restrictions - to cope with the loss of agricultural export markets resulting from the protectionist response of industrial countries to the Great Depression. At the end of the Second World War, ISI policies were intensified (i.a., through export restrictions) and complemented with state-led development policies including establishment of a large public enterprise sector and regulation of virtually all markets. While creating a large and diversified industrial sector, the policies depressed productivity growth causing Argentina to fall behind countries with a similar initial level of development and resource endowment, such as Canada and Australia. 4. Tax exemptions, public enterprise losses and use of the public administration as employer of last resort began to seriously erode public finances in the early 1970s, pushing annual inflation into the triple- digits. Civil unrest and accelerating inflation prepared the ground for a military take-over in April 1976. The new authorities implemented a trade reform, but engaged in an internally inconsistent experiment combining exchange rate-based disinflation with massive, mostly externally financed public spending. The disinflation program was abandoned in early 1980 and the trade reform reversed; but public spending continued to expand without commensurate revenue increases in the run-up to the 1982 war in the South  -2 - Atlantic. To avoid an industrial and financial crisis, the authorities also assumed most of the external debt the private sector had contracted. When external funding was cut off, the authorities relied on Central Bank financing of a deficit which was greatly enlarged by external interest obligations. The private sector, in an effort to escape the inflation tax, gradually withdrew from the financial system and reduced its real holdings of currency. Demonetization and a de facto very open capital account rendered the macroeconomy increasingly vulnerable to domestic and external shocks. Savings and investment rates fell as Argentines increasingly saved and invested abroad. 5. In December 1983, the democratically elected President Alfonsin took office from a military government discredited by human rights abuses, military defeat, and economic mismanagement. Restoring democratic institutions and the rule of the law was the President's highest priority. The first economic team made an incoherent attempt at generating a wage-led recovery. An orthodox stabilization program -- supported by an IMF Standby agreement - followed in mid-1984, but was not fully implemented. Inflation accelerated in the first semester of 1985, reaching 30 percent per month by June. A new economic team led by Minister Sourroullle then launched a heterodox stabilization program, the Plan Austral. In addition to sharp austerity measures and revenue enhancements including a 10 percent import tariff surcharge, the Plan emphasized measures to break inflation inertia: a fixed exchange rate, a currency reform and broad-based income policies. Initially successful in reducing inflation to about 2 percent per month and triggering a strong recovery, confidence in the Plan began to erode when the authorities - meeting political resistance - gave up on promised fiscal reforms. 6. Monthly inflation increased to 4-5 percent in the second quarter of 1986, when price and wage controls were relaxed, the currency devalued, and the exchange rate put on a crawling peg. The authorities then adopted a program for economic reactivation, which emphasized public investment, financial deregulation and trade reform; but also included the implementation of national and provincial industrial promotion schemes established by the previous military government. Economic growth was expected to restore public finances over the medium-term. However, the program failed to generate confidence, and the Government was repeatedly forced to return to price controls and ad hoc austerity measures. Unpredictable inflation became the main impediment to the recovery of private savings and investment. When the Government finally turned to fiscal reforms as part of a new heterodox stabilization effort -- the Plan Primavera - in August 1988, it could no longer muster the necessary political support. In the second quarter of 1989, a complete loss of confidence resulted in massive flight out of domestic assets, pushing the economy into hyperinflation. This left the President little choice but to hand over office ahead of time to his newly elected successor - President Menem - in July 1989. 7. The crisis proved cathartic. Although hyperinflation returned in end-1989 and early 1990, comprehensive structural reforms aimed at restoring macroeconomic stability and stimulating growth were gradually put in place. These reforms included a more efficient tax structure, modernizing the tax administration, ending industrial subsidies, opening public procurement to foreign competition, downsizing the public administration, and privatizing public enterprises; in addition to deregulating markets and completing the trade reform. Progressively, reforms improved the fiscal fundamentals and brought in place the framework for an open, market-based economy with the state's role focussed on core public functions. In March/April 1991 the Convertibility Plan - a policy framework characterized by full currency convertibility at a legally fixed exchange rate and zero Central Bank financing - was introduced. The Plan successfully brought forward the improvement in confidence. Monthly inflation fell to 1-1.5 percent and interest rates declined sharply, inspiring a sustained strong recovery. The recovery has been characterized by trade liberalization, deregulation and a continuing improvement in the fiscal fundamentals. However the balance of payments continues to depend on massive and potentially volatile capital inflows.  -3- Figure 1: Argentina - Economic Indicators 1980-92 GDP Growth Rate and Resource Balance Investment and Savings a/ , ~~~~2 5 T 10 - - - N*aeenad e e e e e e e e e . -Savings eb eb o eb o eF e eb 0 eb e o el l O . . . .,.. -10 5 ;. GOP GmO-A Bno (%G fe e Ine GOP) a/ % of GOP Real Exchange Rate a/ Monthly Inflation Rate a* 2SO- ~~~~~~~~~~99 .- July 00: 205% 200 ~~~~~~~~~~~~~~79 1,50 59 50 1~~~~~~~~~~~~~~~9 100 ~~~~~~~~~~~~~~39 so ~~~~~~~~~~~~~~~19 I O C-1