Argentina - Public Sector Reform Loan

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 14781 IMPLEMENTATION COMPLETION REPORT ARGENTINA PUBLIC SECTOR REFORM LOAN (LOAN 3394-AR) JUNE 29, 1995 Country Operations Division Country Department I Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization. CURRENCY EQUIVALENTS Currency Unit: Argentinean Peso Exchange Rate 1 US Dollar = 1 Peso (Since April 1, 1991, the exchange rate has been pegged to the US Dollar by law.) GOVERNMENT OF ARGENTINA FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ANA National Customs Administration, Administraci6n Nacional de Aduanas BANADE National Development Bank, Banco Nacional de Desarrollo BHN National Housing Bank, Banco Hipotecario Nacional BICE Investment and Trade Bank, Banco de Inversi6n y Comercio Exterior BONEX External Treasury Bonds, Bonos Externos del Tesoro CECRA Executive Committee to Control the Administrative Reform, Comit6 Ejecutivo para Controlar la Reforma Administrativa CGN National Accounting Office, Contadurfa General de la Naci6n CIF Cost insurance and freight DGI General Tax Board, Direcci6n General de Impositiva FSAL Financial Sector Adjustment Loan GOA Government of Argentina IDB Inter-American Development Bank IMF International Monetary Fund PB Participating Banks PE Public Enterprise PERAL Public Enterprise Reform Adjustment Loan PSRL Public Sector Reform Loan PSRTAL Public Sector Reform Technical Assistance Loan SIGENAC Executive Controller of the Nation, Sindicatura General de la Naci6n SIGEP General Auditing Office of Public Enterprises, Sindicatura General de Empresas P6blicas TAL Technical Assistance Loan TCN National Court of Accounts, Tribunal de Cuentas de la Naci6n VAT Value-Added Tax FOR OFFICIAL USE ONLY TABLE OF CONTENTS PREFACE .......................................i EVALUATION SUMMARY ............................ ii PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE ............................. 1 A. PROJECT IDENTITY........................... 1 B.BACKGROUND .............................1 C. LOAN OBJECTIVES .......................... 2 The Government's Strategy .................... 2 The Bank's Strategy ......................... 2 D. LOAN DESIGN ............................. 3 Revenue Mobjilization ........................ 3 Expenditure Reduction and Rationalization ............ 4 Central Bank Reorganization ................... 5 Coordination With Other Bank Operations ........... 6 E. REVENUE MOBILIZATION COMPONENT ........... 7 Implementation.............................7 The Bank's Role in Revenue Mobilization ........... 8 Results of Improved Revenue Mobilization ........... 9 F. EXPENDITURE REDUCTION AND RATIONALIZATION COMPONENT ............................9 Implementation . ........................... 9 The Bank's Role in the Expenditure Reduction Component of the Loan ................. 10 Results of Improved Expenditure Reduction and Rationalization . ...................... 10 G. CENTRAL BANK REORGANIZATION COMPONENT ... 11 H. MACROECONOMIC FRAMEWORK COMPONENT ..... .11 I. INSTITUTION BUILDING ...................... 12 Tax Administration ........................ 12 Customs Administration ..................... 12 Federal Administration ...................... 12 Central Bank Reorganization . ................ ..13 J. SUSTAINABILITY ........................... 13 K. LESSONS LEARNED ........................ 14 L. BANK PERFORMANCE ....................... 16 M. BORROWER PERFORMANCE .................. 16 N. COORDINATION WITH THE IMF AND THE IDB ...... .17 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 wihout World Bank authorization. PART II: PROGRAM REVIEW FROM THE BORROWER'S PERSPECTIVE ............................. 24 PART III: STATISTICAL INFORMATION .................. 25 Table 1: SUMMARY OF ASSESSMENTS .............. 25 Table 2: RELATED BANK LOANS/CREDITS ........... 26 Table 3: PROJECT TIMETABLE..................... 27 Table 4: PROJECT FINANCING ................... 27 Table 5: BANK RESOURCES: STAFF WEEKS ........... .27 Table 6: BANK RESOURCES: MISSIONS .............. 28 ANNEX Table A: Key Macroeconomic Indicators ............... 29 Table B1-B3: NATIONAL ADMINISTRATION REFORM .... 30 Table C: FISCAL COST OF INDUSTRIAL PROMOTION .... 31 STATUS OF SECOND TRANCHE RELEASE CONDITIONS . . 32 -'- ARGENTINA IMPLEMENTATION COMPLETION REPORT PUBLIC SECTOR REFORM LOAN (PSRL, LOAN 3394-AR) PREFACE This is the Implementation Completion Report (ICR) for the Public Sector Reform Loan (PSRL) No. 3394, to the Argentine Republic, in the amount of US$325 million. The loan, intended as a quick- disbursing adjustment operation, is repayable in 17 years, including 5 years of grace, at the standard variable rate. The PSRL was approved on July 30, 1991 and closed on December 31, 1993. It was fully disbursed in two tranches of US$162.5 million each, released on September 23, 1991 and March 9, 1993. The Inter-American Development Bank (IDB) co-financed the PSRL with its first-ever adjustment loan to Argentina. The PSRL was accompanied by a US$23 million Public Sector Reform Technical Assistance Loan (PSRTAL, Loan No. 3362) which was co-financed by a 150.0 million yen grant from the Ministry of Finance of Japan. This ICR was prepared by the Country Operations Division of Country Department I of the Latin America & the Caribbean Regional Office (Preface, Evaluation Summary, Parts I and III). The ICR was based, inter alia, on the Initiating Memorandum, the Report and Recommendation of the President, the Loan Agreement, Mission Reports, correspondence between the Borrower and the Bank, and internal Bank memoranda.  -ll- ARGENTINA IMPLEMENTATION COMPLETION REPORT PUBLIC SECTOR REFORM LOAN (LOAN 3394-AR) EVALUATION SUMMARY Project Objectives The US$325 million PSRL Loan to the Government of Argentina, approved on July 30, 1991 was designed as an integral component of an effort to stabilize the Argentine economy and eliminate Argentina's persistent structural deficit through targeting key public sector reforms. The PSRL provided support in the Government's efforts to: (i) increase revenues through reorganization of the Tax and Customs Administrations and reduction of industrial promotion and tax exemptions; (ii) decrease and rationalize expenditures through streamlining the Federal Administration, improving systems of budgeting and accounting, and decreasing earmarked funds; and (iii) reorganize the Central Bank so as to make it an independent institution able to focus upon its core function as monetary authority. The Bank's role was to offer the technical assistance and financing necessary to permit the Government to achieve its objectives for the balance of payments without recourse to inflationary domestic credit creation. The resources from the PSRL permitted the Government to replace domestic borrowing (on onerous terms) with foreign loans. It used the counterpart from .he loans to pay indemnization of workers as part of its administrative reform. The PSRL was complemented by the ongoing Public Sector Reform Technical Assistance Loan (PSRTAL for US$23 million), which provided financing for goods and services to facilitate meeting PSRL conditionality and is currently helping to institutionalize the resulting reforms. Similarly, the Tax Administration Loan (Ln. No. 3015, US$6.5 million) financed improvements in tax administration which allowed the GOA to meet targets established by PSRL. The overall strategy for eliminating the persistent fiscal deficit was also supported by the Public Enterprise Reform Adjustment Loan (PERAL, Loan No. 3291 for US$300 million), which focussed on reorganization and privatization of public enterprises, and its accompanying Public Enterprise Reform Executive Loan (PEREL, Loan No. 3292 for US$23 million), which helped finance the cost of consultants for restructuring the PE framework and the telecommunications and railway organizations. Implementation The PSRL was disbursed against import receipts according to prevailing guidelines in two tranches of US$162.5 million each. The first tranche was available for disbursement at the time of loan effectiveness. The second tranche was available for release when 14 specific conditions were met. All but one of the 14 specific second tranche loan conditions--including the politically and technically difficult measures of the passage of the Federal Administration Reform, Financial Management and Control Law and the Central Bank Charter--were met by February 1993; the second tranche was released on March 9, 1993. The loan was also conditioned upon evidence of progress on the macroeconomic program, and indeed, macroeconomic indicators were strong, exceeding projections in -111- many critical areas. The unsatisfied condition pertained to the enactment and implementation of a Public Procurement Law which would abrogate existing Compre Argentino (Buy Argentine) laws, which provided procurement subsidies to preferred domestic producers supplying public enterprises. The condition was waived in view of progress already made, and because privatization had reduced the urgency of an explicit repeal of this legislation. As of June 1995, the law remains in Congress, and there is no expected date for its passage. In addition, in the latter half of 1993, contrary to the spirit of the loan's effort to reduce industrial promotion costs, there was a slight resurgence of industrial promotion, and a partial exemption of the VAT for producers in Tierra del Fuego was extended to the year 2003. Finally, measures announced in March 1995 to tighten the fiscal accounts could reverse, at least temporarily, efforts to reduce wage compression in the public sector. Despite these shortcomings, the vast majority of the loan conditions were met, including the critical enactments of the Federal Administrative Reform and the Financial Administration and Performance Control Law. The PSRL was successful in supporting reforms pursued under the Convertibility Plan to eliminate the fiscal deficits that generated hyper-inflation and to launch economic recovery. Under the Plan Monthly inflation fell from 24.9 percent in 1990 to an annual average rate of 4.2 percent by 1994; the fiscal accounts improved from a deficit of 2.5 percent of GDP in 1990 to a surplus of 1.8 percent in 1993; and annual economic growth during 1990-93 was in the 6-9 percent range. However, while macroeconomic aggregates for 1994 remained positive, with growth of 7.1 percent and inflation of less than 4 percent, fiscal performance began to falter during the second semester. Significant efforts were required during the last quarter to achieve a surplus of 0.7 percent of GDP. Economic performance is now projected for 1995-96 to be substantially below that of the previous four-year average of 7.7 percent, due to the spillover effects of the Mexican financial crisis. Summary of Findings The successes of the Loan can be attributed to a variety of factors. First, Argentina was engulfed in macroeconomic crisis and willing to undergo a major structural reform in order to decrease its massive deficit. Second, given Argentina's balance of payments needs, co-financing from the Inter- American Development Bank significantly of the Loan in ensuring that conditionality was met. Third, the Loan benefitted from the intellectual capital, experience, ongoing dialogue and personal relationships developed during the course of previous projects and economic work. Without the Bank, the Argentine Government undoubtedly would have undergone a public sector reform, however, it is doubtful it would have been as comprehensive or structural as it was. Loan conditionality that required the passage of laws by the legislature was critical for ensuring the sustainability of reforms. This, however, required substantial preparation work in formulating the proposed laws and reviewing changes during legislative deliberations, and the ability of the executive to push the laws through Congress. Such a strategy entailed considerable risk, witness the failure to pass the legislation to abolish the Compre Argentino Laws. While the loan was largely successful, owing to a variety of factors, future operations might be cautioned against using this approach. The ongoing regional crisis represents the first significant challenge to the sustainability of the program, which remains particularly sensitive to foreign capital flows. For its part, to date the Government has reacted swiftly to the crisis to further strengthen the fiscal accounts and the banking system. While the duration of the regional crisis and the sustainability of the program are still uncertain, the policy and institutional improvements fostered by the PSRL have served the Government well in meeting this challenge. -1- ARGENTINA PUBLIC SECTOR REFORM LOAN (LOAN 3394-AR) IMPLEMENTATION COMPLETION REPORT PART I: PROGRAM REVIEW FROM THE BANK'S PERSPECTIVE A. PROJECT IDENTITY Project Name: Public Sector Reform Loan Loan Number: 3394-AR RVP Unit: Latin American and the Caribbean Region Country: Argentina Type of Loan: Support for public sector reform B. BACKGROUND 1. During a half century of slow economic growth, Argentina gradually fell from the ranks of the world's most prosperous nations. This decline can be traced mainly to increased reliance since the 1940s on state-led growth and its associated chronic public sector deficits and endemic inflation. Economic policy was commonly used to propagate rules and transfers favoring successive groups with access to power--unionized labor, privileged industrialists, housing contractors and selected middle class home buyers, some provincial governments and the military. Public expenditures surpassed 50 percent of GDP, and high levels of external protection compounded the misallocation of resources. 2. The abrupt end of voluntary foreign commercial credit in the early 1980s and the sudden rise in real international interest rates--coupled with the 1982 South Atlantic War which provoked a financial collapse that forced the Government to assume responsibility for all foreign debt and placed additional pressure on public finances--led the Treasury to resort increasingly to money creation. To avoid the inflation tax, the private sector withdrew its resources for the financial system and reduced its real currency holdings. By the mid-1980s, the country entered its longest period of stagnation this century. Savings and investment rates fell as Argentines saved and invested abroad. Labor productivity fell, poverty worsened, and unpredictable inflation became the main impediment to recovery of private savings and investment. By the late 1980s, subsidies through the budget, tax exemptions, agricultural regulations, public enterprises, and central bank rediscounts were roughly 8 percent of GDP, average tariffs exceeded 40 percent, and quantitative restrictions protected 60 percent of domestic production. 3. Upon taking office in July 1989, the Menem Administration recognized that without macroeconomic stability, the economic slide could not be reversed. Its November 1989 stabilization program, supported by the IMF, relied on a fixed exchange rate and stressed fiscal performance and structural reforms more than the Plan Austral (1985) and Plan Primavera (1988) programs initiated by Alfonsin, Menem's presidential predecessor. Despite successes in passing legislation to sell PEs, suspend most subsidies, limit Central Bank credit to the public sector and expand the VAT tax base, these measures failed to earn the confidence of financial markets, and the primary surplus remained -2- insufficient to transfer resources to the Central Bank to cover its large nominal interest bill on domestic debt and its external debt service. Meanwhile, high interest rates required to support the fixed exchange rate drove up the Central Bank's interest bill thus creating an unsustainable cycle: the Central Bank created money to pay its own interest bill and then borrowed back the australes to sterilize the endogenous monetary expansion. The program finally exploded in early December 1989 when markets moved against the austral and interest rates skyrocketed. 4. On December 15, 1989, a new economic team floated the exchange rate and removed nearly all remaining price controls. Amid inflation fears and rumors of dollarization, the exchange rate depreciated sharply as demand for austral-denominated assets plummeted further. Over the New Year's weekend, to forestall imminent hyperinflation, the authorities converted virtually all domestic commercial bank time deposits, worth about US$3.5 billion, and most of the Central Bank and Treasury's outstanding debt that the deposits financed, into 10-year dollar-denominated External Bonds (BONEX). While this penalized savers, the measure halved the potential liquid stock of financial assets, stopped incipient hyperinflation, and eliminated the Central Bank's destabilizing quasi-fiscal deficit by eliminating its short-term debt and its interest burden. However, the Government failed to complement these measures with fiscal adjustments that would have reduced the public sector demand for credit, and it failed to prohibit Central Bank money creation. In early February 1990, unexpected price adjustments for public enterprises and persistent rumors of dollarization triggered renewed fears of high inflation. In February 1990, the ensuing collapse in money demand from its already low level spun the economy into hyperinflation, and it was in this environment that preparation for the PSRL began. 5. In early 1990, the Argentine Government was prepared to undergo a massive deficit-reducing reform, and it was willing to accept the political consequences of such a reform; however, it lacked a coherent strategy for achieving this reform. The Bank, for its part, aided by substantive knowledge from previous work done on Argentina's tax administration, public finance, financial sector and trade laws, had a clear vision of reforms that the Argentines needed to undergo in order to reduce their public sector deficit. This situation provided for a synergistic reform effort. The program was aided further by the fact that the GOA trusted the Bank's advice, based upon Argentina's previous experience with the Bank during the Plan Primavera episode, when the Bank remained supportive despite the ultimate short-term failure of the Plan. In order to effect permanent improvements, the Bank sought concrete reforms that most likely would have been avoided in the Bank's absence. Specifically, these were reforms in tax administration, personnel administration, financial management, industrial promotion and the Central Bank Charter. It was believed that only an all-encompassing strategy, inherently high yield and high risk, could be effective in executing a massive public sector reform. C. LOAN OBJECTIVES The Government's Strategy 6. The Bank encouraged the Government to switch strategies from incentive reforms (trade liberalization and financial deregulation) to public sector reforms focused on sustainable fiscal improvement and an efficient retrenchment of the state on core public functions. Structural changes, including reorganizing and downsizing the Federal government, privatizing PEs, improving management in the provinces and reforming the social security system, were intended to replace temporary measures such as emergency taxes and wage and investment compression. The second phase of the structural reform program focused on a major administrative reform (which included decentralizing secondary education and other public services to the provinces), expenditure controls, improvements in tax policy -3- to make it more efficient and effective, reductions in the costs of industrial promotion (by deferring payments or canceling contracts for industrial promotion), and efforts to reorganize the Central Bank and make it an independent monetary authority. The Bank's Strategy 7. The Bank's medium-term objective was to improve public finances--a strategy supported by the Bank's PERAL, PEREL, Tax TAL and PSRTAL as well as PSRL-- to help eliminate the persistent structural deficit causing economic instability, slow growth and increased poverty over the last decade. Endemic deficits originated with an erosion of revenue capacity and an inability to contain expenditures. The Bank's strategy called for rationalizing public expenditures and improving the revenue base while focusing the Government's activities on protecting the poor during adjustment and making much-needed infrastructure investment. To this end, the Bank engaged in its investment loans in water supply and the social services (and more recently, capital markets development), thus helping lay the basis for a private sector-led investment recovery. D. LOAN DESIGN 8. The PSRL targeted several areas for increasing public revenues, decreasing expenditures and improving the functions of the Central Bank. It was decided that the loan could only be presented to the Board on the strength of extensive pre-Board actions as described below, which required numerous Bank missions during the post-appraisal and negotiation phase. Hence, there was no effectiveness conditionality but that for second tranche release was substantial. Revenue Mobilization 9. Pre-Board Actions for Tax Structure Reform. In February 1990, the Government implemented a major tax reform that improved efficiency and increased potential revenues. The VAT covered all goods at a 13 percent uniform rate, income taxes on corporations were lowered from 33 to 20 percent (with a minimum payment of 1 percent of assets), and individual income taxes were simplified to 5 brackets between 10-30 percent (with a withholding tax for wage earners). These taxes replaced capital gains and personal net wealth taxes. Second, a subsequent reform package in February included a ten day time limit on VAT and income tax payments and an indexing system under which taxes due would be adjusted on a daily basis for estimated current inflation. Third, a new law in early 1990 levied stringent penalties on tax evaders. Fourth, the Government extended the VAT to services and increased its rate to 15.6 percent in November 1990 while maintaining the VAT without adding new exemptions. Last, the February 1991 package raised the asset tax from 1 to 2 percent, widened the income tax base by suspending loss-carry forwards, raised the VAT to 16 percent, raised the gas tax to 33 percent, increased the bank check tax from 0.4 to 1.2 percent, pegged energy prices to international prices, and raised PE tariffs, which had been temporarily frozen since September 1990. 10. Pre-Board Actions for Inproving Tax Administration. By July 1991, real revenue and efficiency gains were to be found in rebuilding the severely eroded tax administration. To this end, the Government was able to build upon past Bank efforts through the 1988-89 Technical Assistance for Tax Reform Loan (3015-AR). By the Board Date, the Government had begun making the General Tax Office (DGI) more effective through: (1) increasing site inspections, (2) incorporating 200,000 VAT tax payers to the tax rolls, and (3) implementing a computerized audit and control system for the largest -4- 1,000 taxpayers. In addition, the Government had initiated reforming customs administration by drafting the revision of customs norms and designing a new organizational structure. 11. Pre-Board Actions for Reducing Tax Exemptions and Industrial Promotion. The Government began restructuring its industrial promotion obligations with the July 1989 Emergency Law which deferred 50 percent of industrial promotion payments for one year in exchange for bonds to be paid two years later. In consultation with the Bank, the Subsecretary of Public Revenues canceled benefits for 43 firms, and Decrees 435 of March 1990 and 612 of April 1990 transferred authority for industrial promotion from provincial administrations and Tierra del Fuego to the Subsecretary of Public Revenues, under the Ministry of Economy. In addition, the Government replaced provisions which allowed beneficiaries to deduct their full costs rather than value added from taxes. Early in the loan program, the Bank was concerned that the Government was reluctant to adopt an aggressive policy to reduce tax expenditures if the audit process produced the desired reductions (less than US$600 million in 1991 and US$200 million in later years). In November 1990, it initiated a mandatory census for all promotion schemes other than Tierra del Fuego on penalty of benefit cancellation. One-quarter of beneficiaries did not respond, and their cases were processed. The self-monitored tax deduction system was dissolved, replaced by a full audit for compliance with original contracts. Those passing the audit received nontransferable fiscal bonds applicable against taxes in the year of tax obligation. This allowed the Government to end evasion and know the fiscal costs of the subsides. Those failing to meet the promises of their original contracts received a bond, sharply reduced in value in proportion to the noncompliance; they were also audited for back taxes. 12. To reduce the substantial fiscal cost of exemptions granted to producers in Tierra del Fuego, the Government reduced specific duties on the electronics industry from 100 percent ad valorem to 50 percent in 1990, and then in March 1991 converted these to ad valorem rates of 22 percent. These measures induced many closings. Nonetheless, the policy provided for transition period by exempting domestic producers from the internal tax on electronics products until February 1992, at which time all protection for the industry in Tierra del Fuego was to be eliminated. 13. Second Tranche Release Conditions For second tranche release, the Government was required to: (1) maintain the VAT covering goods and services without granting new exemptions beyond those already in force as of December 1, 1990; (2) progress on the DGI reform evidenced by: (i) increasing the number of tax audits performed in the preceding 12-month period to at least 115 percent of audits performed during fiscal 1990, (ii) increasing the aggregate value of the tax assessment made during the preceding 12-month period to at least 120 percent of that made in fiscal 1990, (iii) increasing the aggregate value of additional tax collection resulting from tax inspections assessments to at least 85 percent of the total value of such assessments in the preceding 12 month period, and (v) establishing a tax roll system to cover all taxpayers both at the national and regional levels; and (3) implement a computerized control system for at least 25 percent of import tax receipts. 14. The Government was required to reduce the fiscal costs of industrial promotion schemes to less than 30 percent of projected costs without reform for 1994 by: (i) initiating the legal process for 800 firms whose benefits had been suspended, (ii) completing the DGI's review of 2,500 industrial projects receiving incentives during 1991-92, (iii) laying the legal foundation for the bond exchange (a nontradable tax credit against future tax obligations), and (iv) including actual amounts of contracted expenditures in the 1994 budget as line items in order to lend transparency to the tax expenditures. Because industrial promotion for Tierra del Fuego was particularly costly, the Bank insisted that the Government move to eliminate any programs promoting industrial activities on the Island. -5- Expenditure Reduction and Rationalization 15. Pre-Board Actions for Reducing Federal Employment and Improving Workers' Incentives. In 1991, wages accounted for 70 percent of all federal expenditures remaining after interest and transfer payments. Despite the unpopularity of downsizing in a time of high unemployment, under the March 1990 Emergency Decree 435, the Government: (i) froze all vacancies and promotions, (ii) reduced the number of federal Secretariats and Subsecretariats from 153 to 60, (iii) eliminated overtime, (iv) required early retirement for those within two years of normal retirement, (v) enforced bans against double employment and (vi) sharply reduced the operations of the BHN and the BANADE. 16. In early September 1990, with the Bank's assistance, the Government prepared the Administrative Reform Program designed to restructure and downsize the entire Federal Government. Decree 1757 established a commission to oversee the reform, reduced the cost of indemnization to displaced workers, and created the possibility of revising federal employment statutes to eliminate permanent tenure benefits. The Program, establishing a legal basis for reform, was codified in Decree 2476 of November 1990. Not including reductions in secondary teachers, the Government intended to maintain a ceiling on federal employment of no more than 480,000 workers. The federal downsizing was coupled with an effort to increase efficiency by attracting highly skilled managers and workers by improved incentives. In March 1990, the Government increased the salary compression ratio from 2:1 to 17.5:1. Decree 1727 of August 1990 allowed the Government to reopen labor agreements to change permanent tenure rights or "stability privileges" of federal employees that for years had prevented managers from replacing unproductive or even corrupt employees. The Government also issued measures to enforce bans on double employment. 17. Pre-Board Actions to Reform Budgeting and Accounting. At the time of loan preparation, the Government had already begun its effort to improve budgetary control by merging the auditing agency of the public enterprises (SIGEP) with the Ministry of Economy. Still, the Government lacked a comprehensive system which coordinated budgeting, accounting, debt management and the Treasury. With the Bank's assistance, the Government set specific goals: (i) establish accounting norms, (ii) increase internal and external auditing, (iii) distinguish between accounting, internal registration/control and external control, (iv) withdraw judicial responsibilities for the prosecution of public fraud cases from the TCN (National Court of Accounts), (v) account for important expenditures (e.g., PEs) in the budgetary process, (vi) program the budget and conduct a regular review of public expenditures, (vii) maintain ex-post performance control and control of budget execution, (viii) submit timely budgets, (ix) promote public investment in budget planning, (x) tailor modern information systems to support financial management, and (xi) curb earmarked funds and industrial promotion schemes. Prior to preparation for the loan, the Government had already limited transfers to the provinces with the aid of the co-participation law implemented in January 1988 and limited transfers to PEs. These budgetary commitments complemented reforms already underway supported by the PERAL. In 1990, a task force was named to review the 1991 progress, a committee was designated to control expenditures for 1990-91, and the President issued a decree that placed all revenues under provisionary control of the Treasury, adjusted projections of budget needs for inflation, and reviewed expenditures that accounted for the Administrative Reform Program and the new public sector policies. 18. Second Tranche Conditions. Second tranche loan conditions called for achievement of federal employment reduction targets as outlined in the Government's Administrative Reform Program as well as an increase in the salary compression ratio, a program for senior executives, a computerized salary payments system and the establishment of legal grounds for the new compensation and payment system. The second tranche release conditions also called for budget and accounting reforms: passage and -6- implementation of the new Law of Financial Management and Performance Control, implementation of a new Public Procurement Law covering procurement of goods and services and management of public assets, preparation and submission of the 1992 budget to Congress before November 1991 (based upon a complete programmatic review and new budgeting system), progress made in the elimination of at least 25 Earmarked Funds, and resistance from making transfers to the Argentine provinces and public enterprises during 1991 in excess of amounts authorized under the 1991 Budget Law bill. Central Bank Reorganization 19. Pre-Board Actions in the Central Bank Reform. The 1989 Economic Emergency Law set a clear goal for the Central Bank; it was to be an independent entity whose principal objective was sustaining the value of the nation's currency. But the Central Bank lacked the asset basis to control monetary policy. It was encumbered by its antiquated organization and was incapable of carrying out its bank supervision and rediscounting duties. The first step toward recapitalizing the Central Bank was the conversion of the Central Bank's domestic short-term interest-bearing obligations into ten-year BONEX in late 1989. The 1991 Convertibility Law, which pegged the exchange rate to the US dollar, paved the way for reform that would enable the Central Bank to focus on its function as a monetary authority. The Central Bank Charter, compiled with Bank assistance, would define Central Bank functions and reorganize its internal structure. Since early 1991, the Central Bank has published financial statements that reveal its balance sheet; since April 1991 it has published its reserve position weekly to provide the public with information to monitor implementation of the Convertibility Law. 20. Second Tranche Conditions. The conditions for second tranche release included: (i) reorganization of the Superintendency; (ii) elimination of the system of commercial bank advances to the social security system, which counted as bank reserves and complicated monetary control and made it difficult to know the current monetary base; (iii) removal of trade financing functions from the Central Bank; and (iv) a new draft charter. Coordination With Other Bank Operations 21. The Public Sector Reform Technical Assistance Loan The PSRL's accompanying Public Sector Reform Technical Assistance Loan (PSRTAL for $23 million) is currently halfway through its scheduled implementation. As part of the customs administration component of the program, the development of the computerized MARIA project for customs declarations along with a primary communications network between ports and the Customs Headquarters are nearly completed; simplification of the new Custom Code, establishment of related norms, and development of four administrative systems are expected to be completed in six months. In addition, the customs component has undertaken infrastructural improvements such as the installation of a chemical analysis laboratory, and a training program has trained 200 people in the Customs School. As a result of these efforts, collections have increased since 1991 from $100 million per month to $250 million and irregularities in valuation of merchandise have decreased from 50% in 1992 to 18% in 1993 while the dispatch of imports and exports has been reduced by 30%. Through automation, discretionality in Customs operations has been greatly reduced long with a 15 % reduction in the number of intervening agents. Support for Administrative Reform and Modernization of the Central Government through modernization of the National Public Administration has thus far resulted in savings of $63 million for the Government from reducing physical space by 220,000 square feet, a 25 percent reduction in APN staff since April 1990, and a reduction in average processing time by 50 percent. Meanwhile, deregulation activities resulted in an estimated aggregate fiscal net gain to the state of $322.4 million in 1993. As part of its financial -7- management and control component, technical support provided for the development and implementation of new methods and procedures with related manuals and policy guidelines to be applied in: budget preparation and execution, cash and debt management, accounting, and internal and external control; the development and implementation of an integrated financial system; and a training program for public officials of the key financial offices. Finally, as part of the loan's components to reorganize the Central Bank and the Superintendency of Financial Entities, a computerization and communications strategy has been designed, and implementation of the system and its two applications: accounting and current accounts; and the training of technical personnel and end users, was undertaken in 1994. 22. Other linchpins of the Bank's support of public sector reforms in Argentina support reforms in public enterprises and the provinces. The PERAL and its accompanying executive loan, the PEREL, supported the major structural changes in the public enterprise sectors, including divestitures, enterprise rationalization, and new pricing regimes. The level and pace of privatization exceeded targets. The subsequent PERAL II Loan (FY93 for US$300 million), targeted to privatize defense-related industries, was also largely implemented in a timely manner. The Provincial Development Loan provided technical assistance and resources to finance provincial public investments in proportion to the success of individual provinces at increasing their own savings and balancing their budgets. The recent Provincial Reform Loan (FY95 for US$300 million) would support the Federal Government's effort to promote the reform of provincial finances by promoting sustainable policies and the improved allocation of public resources in the provinces. Taken together, these reforms support ambitious structural changes in the organization and financing of the Argentine public sector. E. REVENUE MOBELIZATION COMPONENT Implementation 23. All conditions within the revenue mobilization component of the loan were initially met. In the later half of 1993, however, there was a partial resurgence of quasi-industrial promotion. 24. Expansion of the VAT and Changes in Tax Policy. Tax Revenues The Government gradually expanded the tax base and shifted (As % of GDP] from reliance on inefficient to efficient taxes. The Government did modify the VAT excluding from the VAT financial services, credit cards payments, services financed . . by pension funds, and boats and airplane repairs. But the VAT base was also broadened to cover insurance operations with Decree No. 171/92 and financial activities and transports were incorporated in the VAT base with Decree I go 1 91 1 92 93 1 94 1 No. 879/92. In accordance with international procedures, ini Taxes MTax HaNdles SocialSecuity Decree No. 294/92 allows the VAT reimbursement to foreign tourists. 25. Improving Tax Administration. The PSRL played a vital role in accelerating tax administration reform by supporting the inspection program, reconstruction of tax rolls, auditing reform, and tax enforcement initiated under the Tax Administration Loan. 26. Reform of Customs Administration. Customs replicated the DGI's Large Taxpayers system. By October 1992, it covered nearly 40 percent of National Customs Administration (ANA) collections. -8- Beginning December 1, 1992, the Government required the uniform customs declaration (manifestos) at its main port of entry (Ezeiza Airport) using an adaptation of the French customs computer system (MARIA). Ezeiza Airport represented 25 percent of imports by value. The program was implemented in July 1993, and completion of other sites were scheduled for June 1994. 27. Reduction of Tax Exemptions and Industrial Promotion. The Government canceled all existing contracts not yet activated and canceled rights to renew existing contracts. It planned to audit all firms for tax payments due during the 50 percent suspension of the promotion laws in 1989-90, when evasion was especially high. In November 1992, the Government enacted Decree 2054, establishing the legal basis to issue nontransferable tax credits to beneficiaries that could be applied against future tax litigation. By February 1993, the Government had assigned all tax benefits. Before firms could use benefits, however, the DGI reviewed past tax payments and adjudicated firms that elected to undergo closer scrutiny through an appeal. During this process, firms could not claim benefits. Firms choosing to maintain the system were subject to immediate DGI inspection to assess their compliance with all laws and decrees since July 1989 with respect to industrial promotion benefits. 28. By June 1992, Decree 888/92 was to end preferential subsidies to exports from Tierra del Fuego, hence, the Non iai Pbi ecor Baac remaining benefit was exemption from the VAT. Decree 1999 (enacted October 29, 1992) was to phase out over 4 years the VAT exemption for electronics producers. Tariff protection for the industry fell from 35 to 20 percent, reducing the effective fiscal subsidy; the statistical tax for all imports (which serves as a minimum tariff) was raised from .. 3 to 10 percent. In the latter half of 1993, a partial 1231123423"12341234123412241234 resurgence of industrial promotion was observed though in a different form than before. Tax rebates were granted to -NFPS Balance -Op. Prrmry Suiplus ---ieresI specific sectors and non-tariff barriers have been gradually introduced on specific goods such as textiles and shoes. The Government has claimed that these constitute transitory measures. The other apparent reversal is the Government's policy toward Tierra del Fuego producers. The recent adhesion of Tierra del Fuego to the Pacto Fiscal will revert this measure since, contrary to second tranche release conditions pertaining to this issue, the firms located in Tierra del Fuego will be required to pay only 25 percent of the VAT until 2003. The Bank's Role 29. The Bank played a catalytic role by coordinating the efforts of a disorganized economic team and by helping the Argentines to focus on specific objectives. The success of the program was bolstered by the Loan's accompanying PSRTAL, and the fact that the PSRL was able to build upon foundations of tax administration reform set by the Bank's Tax Administration TAL. The Bank's loan schedule and conditions for release of the second tranche further served as a monitoring agent. The combined effect of the time constraint and the Bank's assistance provided for the rapid implementation of tax reforms, particularly in customs, that might not have occurred otherwise. The Bank's stand on tax exemptions and industrial promotion, from the beginning, was that continued loan preparation was contingent upon the Government's continued efforts to permanently reduce tax expenditures supporting the Industrial Promotion Regime. The Government faced a great deal of political pressure to maintain or increase levels of industrial promotion, and at the time, the Government remained firm in maintaining and eventually decreasing industrial promotion. Despite recent signs of slight resurgence of industrial promotion, the gains that have been made would not have been met without support from the loan and -9- pressure from the Bank. In particular, when the reform was delayed because of logistical problems concerning the bond exchange, the Bank helped the Government to circumvent these obstacles. Results of Improved Revenue Mobilization 30. Tax and Customs Reform. Between 1989 and late 1992, tax revenues on a cash basis doubled; the share from efficient taxes (that gave incentives to investment and savings) grew from 50 to less than 5 percent. Between 1990 and 1992, the number of VAT taxpayers increased from 700,000 to 1.6 million, collection of VAT payments doubled as a share of GDP, and although average tariff coverage and quantitative restrictions were falling, the program to improve the ANA resulted in a threefold increase in collections of import taxes as a share of GDP. The Public Finance Review (February 1993) concluded that improved effort at tax collection and expanding the tax base, after controlling for changes in tax rates, tax policy, and decreased inflation and improved economic performance, were responsible for more than 60 percent of the increased revenue performance. 31. Industrial Promotion. The Government projected that cuts in industrial promotion expenditures alone would produce fiscal savings of as much as US$2.4 billion in 1993, while subsidies to promote the Tierra del Fuego regime would fall from 1990 levels of US$350 million to less than US$50 million in 1995. In light of the greater goal of reducing federal expenditures and market distortions, the recent 15 percent subsidy on capital goods and the retreat from Tierra del Fuego reforms threatens to counteract gains made from successful reforms such as the industrial production reform. While the Bank regards this and other quasi-subsidies to the paper and other industries as permissible transitory measures, the Bank believes that sound industrial policy requires their eventual elimination. F. EXPENDITURE REDUCTION AND RATIONALIZATION COMPONENT Implementation 32. All but one condition within the expenditures component of the loan were met. 33. Reform of the Federal Administration. The Government's Administrative Reform Program (October 1990) resulted in a major reorganization of the Federal Government including streamlining the federal administration, maintaining and attracting high calibre workers, and reallocating resources in order to increase efficiency. 34. Improving the Budget and Accounting Processes. The Government reduced spending jurisdictions more than 50 percent between 1990 and 1992 as part of the administrative reform; in 1991 and 1992, the Central Government maintained the budgeted limits on transfers to PEs and provinces; it decreased the number of earmarked accounts from 152 in 1989 to 59 in 1992, and 44 in 1993; and in 1991, for the first time in nearly a half century, the National Administration budget for the following year was submitted on time. For 1993, the Executive again presented a proposed budget to Congress on schedule, and it was approved before the start of 1993. The Government enacted a Public Financial Administration Law in September 1992 that revamps national fiscal accounting, improves budgeting and control systems and establishes modern auditing systems for public expenditures. 35. In 1991, the Government, with Bank assistance, began preparation of a ground-breaking Law of Financial Management and Performance Control. The Minister of Economy's influence was critical to its passage on September 30, 1992 and its implementation a month later. The Law provided for -10- internal control functions to support management through monitoring and audits, while the external control function essentially focussed on ex-post performance control based on the information produced by the internal control structure. 36. In 1992, the Government prepared a draft Public Procurement Law, intended to make public purchasing more competitive and more transparent. It would eliminate procurement subsidies to preferred domestic producers such as those supported by the Buy-Argentina (Compre Nacional Law, estimated as high as 1 percent of GDP annually. In early 1993, there was discussion with the Bank's Legal Department as to whether the loan condition had been met. At the time, the Bank was working with the Government to fine-tune the draft law, and a Presidential decree (2284/91) had suspended all Buy-Argentina Laws. The Bank's Legal Department asserted that conditionality required that the Procurement Law contain an explicit derogation of Compre Argentino Laws. After consultation with Bank specialists, the Government agreed to a number of provisions that would make the bidding process more competitive, including clarifying the bidding procedures and introducing "single envelope" procedures based on pre-qualification for international contracting. In January 1993, the public procurement condition was waived when the Government had submitted the Law to Congress but passage was expected to take several months. As of June 1995, the Law remains with the House of Representatives and there is no expected date for its passage. The Bank's Role in the Component 37. It is doubtful that, in the absence of the Bank's support, the administrative program would have been implemented as smoothly as it was and the reform would have been as comprehensive as it was, including improvements in the incentives systems as well as general downsizing. The ambitious loan conditions laid out by the Bank to provide budget and accounting processes provided a checklist of actions necessary for establishing permanent improvements. The Bank placed particular emphasis on the importance of the Financial Management and Control Law. For the first time in Argentine history, a law would establish a comprehensive definition of the public sector, define financial responsibilities and set up a modern control and auditing framework. The Law replaced the past system of opaque, discretionary, and often ad hoc Treasury (or Central Bank) expenditures with a system of transparent, congressionally mandated expenditures subject to the normal audit processes. Although the Bank applied steady pressure on the Government to enact its Public Procurement Law, it has not been passed into Law. The higher-than-expected rate of privatization and the suspension of Buy-Argentina Laws have diminished the condition's urgency, and the Government has been successful at achieving its broader goal of improving expenditure rationalization without yet complying with this loan condition. Results of Improved Expenditure Reduction and Rationalization 38. Reduction of the Federal Administration By early 1993, the Federal Government shrank from 617,000 in 1990 to 284,000 as a consequence of the reform program. The number of on-budget positions (excluding teachers) were reduced by one-third, three quarters of which was due to direct retrenchment. In 1991-92, the Government paid about US$312 million in severance claims associated with these reductions, hence, the program generated only modest immediate fiscal savings. But the program could eventually produce annual savings as high as US$1 billion. The program would require on average a six-month period of income maintenance at 75 percent of salary, followed by a limited number of severance payments averaging about US$3,000. The total cost of the indemnization program is estimated to be US$300-425 million. -11- 39. Despite the achievements of the program, there are several related issues that should be addressed. First, the Aministration reform greatly improved efficiency in the Ministry of Economy but was less successful in the other areas such as the Ministries of Health and Education. Second, the task of reducing provincial and municipal employment--not part of the PSRL--remains to be addressed. 40. Reform of the Budgetary Process. If the enhanced 200 expenditure controls resulting from the new Law of Financial Management and Performance Control reduce non-interest 1nn 19 no 9 9 n2 1993 1n9 expenditures by 3 percent, as projected, they would provide US$450 million in savings. Combined transfers to the provinces and to PEs were A$9,055 less than budgeted amounts. Earmarked funds fell from 151 in 1990 to 44 in 1994, representing expenditures of US$419 million, less than 3 percent of the budget. G. CENTRAL BANK REORGANIZATION COMPONENT 41. Implementation, the Bank's Role, and Results. The Government met all conditions within the Central Bank component of the loan. The Bank encouraged the Government to draft a new Central Bank Charter, reorganize the Superintendency, eliminate commercial bank advances to the social security system and remove trade financing functions from the Central Bank. Central Bank employment declined 30 percent from end-1990 to September 1992. The Central Bank Reform played a principal role in reducing and stabilizing prices. The average monthly CPI inflation fell from 24.9 percent in 1990 to zero inflation in February 1994 and an annual inflation rate of 3.9.2 by end-1994. H. MACROECONOMIC FRAMEWORK COMPONENT Nonfinancial Public Sector 42. Argentina's macroeconomic recovery during 1990-94 Primry Balance was very successful, particularly in light of Argentina's (in % of GOP] hyperinflation in early 1990 and renewed inflation and 10 exchange rate devaluation in 1991. Economic expansion Interest increased real GDP by a average of 7.7 percent per year; P investment rates increased; and international reserves more Balance than tripled since the beginning of the program and now back virtually the entire money base. The macroeconomic program exceeded loan targets in many areas, including 4 Overall Surplus public sector revenues, capital expenditures (due to f accelerated privatization), and public sector balance. Current 2 expenditures, at 15.6 percent of GDP, were marginallyPrimar higher than the projected 14.6 percent because automatic 0 U Ai transfers to the provinces were counted as national expenditures. Actual annual real GDP growth rates of 8.9, 8.7, 6.0, and 7.1 percent in 1991, 1992, 1993 and 1994 respectively, far exceeded Board conservative projections of - 2, 2.5, 2.8, and 2.8 percent. -12- 43. The Bank's Poverty Assessment Study indicates that Argentina's urban poverty declined dramatically between 1990 and 1993 with economic growth and price stability. In 1989, almost half of the population of Metropolitan Buenos Aires reported receiving incomes below the poverty line, whereas by May 1993 the poverty rate had dropped to 17.6 percent. However, given the strong relationship between unemployment and poverty, Argentina's urban unemployment rate is worrisome-- since 1992 the unemployment rate has increased continuously, reaching 12 percent in late 1994, despite the high rate of economic growth during this period. Thus, sustaining these improvements in the rate of poverty, as well as enhancing the distribution of income, will require consolidating the macroeconomic reforms and extending them to increase the flexibility of labor markets, as well as increasing the effectiveness of social service expenditures. I. INSTITUTION BUILDING 44. The PSRL called for substantial institutional building. Tax and Customs Administrations Reforms improved the agencies' abilities to monitor, collect and audit taxpayers. Streamlining and restructuring the Federal Government decreased onerous personnel expenditures and enabled the Government to maintain and attract quality employees. And the reorganization of the Central Bank was vital to the long-term stability of the macroeconomic program. Tax Administration 45. In compliance with second tranche release conditions of the PSRL, the DGI established a control system for the largest taxpayers that came on stream in February 1991 (it covered 66 percent of tax collections by end-1992) and rebuilt tax rolls through more than 450,000 site inspections in 1990-92. The universal tax roll was developed, and in 1993, the tax authorities gained the capability in the computer system to undertake audits, checks and monitoring on the entire taxpayer base, which was estimated to reach 2.8 million by year-end 1993. The number of VAT taxpayers increased from 700,000 in 1990 to 1.6 million in 1992. The DGI increased its audits 179 percent in relation to 1990, and another 80 percent relative to 1991 in the first 8 months of 1992. Although the aggregate value of assessments in 1991 after DGI audits was lower than 1990, this was because virtually all large assessments were transferred to the judiciary for prosecution under the new penal code, and therefore are not registered as assessments. The substantial increase in the "voluntary payment" category of tax receipts indicates that tax assessments were in fact increasing in value. Also, the number of businesses closed by the DGI for VAT violations rose from 750 in 1990 to 8,200 in 1991, and was estimated to have reached 18,000 in 1992. Customs Administration 46. The Bank stressed the importance of customs administration reforms that would include norms, procedures, and personnel policy in order to rationalize the internal organization. The Bank helped the Government tailor the DGI's Large Tax Payers system for the main operational centers of ANA, and helped adapt and implement the French customs computer system at the main port of entry. Federal Administration 47. The Government's Federal Administration Reform Program, drafted with Bank assistance, anticipated net retrenchments of 110,000 plus transfers of non-teaching personnel of 11,000 to the provinces, for a total reduction of about 121,000. The program decentralized secondary education to -13- the provinces in the course of 1991-92, reducing federal employment by 54,000 positions, financed through improved revenues from the shift in the tax base toward greater co-participated revenues. By the second tranche release, federal employment had been cut by more than 103,000 positions in 1991- 92, a net reduction of 15 percent since 1990; in addition, 284,000 teachers and health workers had been transferred to the provincial governments. Rather than simply lay off workers, this effort was based on a ministerial reorganization that focused on federal activities related to core objectives. 48. The Administrative Reform also called for efforts to increase work incentives and improve management. The Government increased the compression ratio from about 2:1 in March 1990 to 17.5:1 in the new pay scale (with Decree 2712/91). Decree 2129/91 established a senior executive service program for qualified technical and management staff with three monthly salary levels. By February 1993, over 170 (out of 300) senior executive positions had been filled through the competitive review process. However, it should be noted that among the fiscal measures recently taken in response to the effects of the Mexican financial crisis, was a highly visible move to cut the salaries of higher level government officials. While this has been billed as a temporary, emergency measure, it represents at least a momentary reversal of efforts under the loan to reduce wage compression in the public sector. Central Bank Reorganization 49. The reform program required by the PSRL aimed to: (i) reorganize the Superintendency, a first step toward enhancing its powers and separating it from the Central Bank; (ii) eliminate the system of commercial bank advances to the social security system, which counted as bank reserves as this system complicated monetary control making it difficult for the authorities even to know the current monetary base; (iii) remove the trade financing functions from the Central Bank; and (iv) produce a new draft charter. On September 23, 1992, the Government passed the New Charter. Complementing the Law of Convertibility, it removed non-core activities from Central Bank duties enabling it to focus on its function as a monetary authority. The new Bank Charter eliminated the Central Bank's role as liquidator of failed financial institutions and elevated the status of the Superintendency of Bank, requiring confirmation by the Senate. The period of visit of financial firms declined from an average 24-36 months to 12-15 months reflecting progress in the approving of bank supervision in the Superintendency. Bank liquidations reduced staff by 27 percent; and the total number of Central Bank staff declined 30 percent from end-1992 to September 1992. J. SUSTAINABILITY 50. The legislative changes and institutional strengthening achieved by the Loan augers well for the sustainability of the reforms. After four successful years, the Government's convertibility program is still on track. The key factor has been growth in private sector confidence brought about by a series of structural reforms and establishment of a low and permanent ceiling on the Government's payments to commercial creditors. The main risks to the program are associated with disruptions in capital inflows; failure to improve competitiveness through productivity growth; and unforeseen political developments threatening fiscal equilibrium. Strongly rising international interest rates could reverse capital inflows inducing a sharp economic contraction with adverse consequences for the financial system and public finances. Over the medium-term, meeting growth expectations crucially depends on strong export growth. In the context of the legally fixed exchange rate, this requires competitiveness to be restored through productivity growth above rates achieved by international competitors. The authorities would otherwise come under pressure to devalue the exchange rate, which would carry its own inflation risk, in the context of a highly dollarized -14- economy. A weakening of fiscal discipline for political reasons constitutes another risk, in the context of a very open capital account. In such an event, international reserves and therefore the monetary base could decline sharply, which would severely test the convertibility program. However, memories of hyperinflation make it unlikely that the electorate will endorse in the near future populist policies that would undermine the hard-won gains in fiscal discipline. 51. However, while macroeconomic aggregates for 1994 remained positive, with growth of 6 percent and inflation of less than 4 percent, fiscal performance began to falter during the second semester due to lower than expected revenues and increased expenditures. The social security accounts, in particular, deteriorated with the transition costs of introducing the new optional private pension system, a reduction in employer's wage taxes, and the absorption by the Federal Government of three financially-ailing provincial pension systems. Moreover, in late 1994, the regional loss of confidence, provoked by the crisis in Mexico, also represents a crucial test for the sustainability of the reforms promoted by the Loan. Indeed, the budgetary control systems implemented by the program have allowed the Government to react swiftly to the need to tighten fiscally and the overall balance was in equilibrium for 1994, and another round of fiscal measures was announced in early March 1995 to help restore investor confidence. K. LESSONS LEARNED 52. The PSRL's overall success at completing complex public sector reforms are owing to several major factors. First, Argentina was engulfed in macroeconomic crisis and willing to undergo a major structural reform in order to decrease its massive deficit. Second, before the official start of loan preparation, a sound foundation of information had been gleaned through ESW and related public sector loans. The Bank's past experiences with Argentina during the Financial Sector discussions in November 1989, the research for the Reforms for Price Stability and Growth (September 1989) Report No. 7994 and for the Public Finance Review: From Insolvency to Growth Report No. 10827 (February 1993), the Plan Primavera Reforms as well as work on the Public Sector Technical Assistance Loan No. 2712 (1988) and the Technical Assistance for Tax Reform Loan No. 3015 (1989) established the foundation for work on the Public Sector Reform Loan. The 1988 Public Sector Technical Assistance Loan and Tax TAL, as well as the 1988-1989 Plan Primavera provided opportunities for Bank members to not only build on information gathered through these works, but also build upon relationships with Argentine officials that arose through these interactions. Third, the Government trusted the Bank to act in the Country's interests. This trust was borne of the Bank's demonstrated past commitment to Argentina, particularly during the Plan Primavera experience from August 1988 to February 1989, during which the Bank remained supportive of the Argentine Government while other lenders retracted. The combined effect of these factors produced a synergistic reform effort. The Government realized that its past efforts provided only temporary relief from economic instability, and it was willing to take the political risks that accompany profound structural changes. While the Government's economic team was new and discombobulated, and it lacked the organization, strategy and finances to undertake such a reform, the Bank had a clear and concrete vision of what steps needed to be taken to effect real change. Without the Bank, the Argentine Government undoubtedly would have undergone a public sector reform, however, it is doubtful it would have been as comprehensive or structural as it was. 53. Initiation. The Public Sector Reform Loan was initiated by the Argentine Government. The Government's past experiences with the Bank, particularly through the Plan Primavera (1988-89) and the Financial Sector Discussions in November 1989 convinced the Argentines that the Bank was -15- committed. Conclusion: It stands to reason that the reform effort would be more cooperative when the Borrower trusts the commitment, capabilities and motives of the Bank from the start of the project. 54. Loan Conditionality. In light of the fact that second tranche release conditions were rigorous, supporting major structural reforms, the loan was remarkably successful. Conditionality included the implementation of four laws, one of which was the single unmet condition. Furthermore, the recent resurgence of industrial promotion is consistent with the Government's initial resistance to the Bank's insistence in eliminating industrial promotion. Conclusion: These shortcomings suggest that compliance is more difficult when it entails legislative passage and/or politically unpopular actions. To avoid high levels of non-compliance, the Bank would be prudent to engage in loan discussions with administrations that have explicitly expressed a desire to undergo important reforms, regardless of the political risks involved. The Bank's other option, to exclude these conditions from loan agreements might be acceptable if these conditions could be met during negotiations before the loan signing. 55. Previous ESW. Previous research and sector work played a significant role in laying the groundwork for the PSRL. The loan process was facilitated by economic analysis undertaken for the Country Economic Memorandum tax policy study, Tax Policy for Stabilization and Economic Recovery- Argentina Report No. 8067 (November 1989) and work on the public finance and the Reforms for Price Stability and Growth- Argentina Report No. 7994 (July 1989) as well as discussions on the financial sector reform (October-November 1989). In constructing the loan objectives, its designers were able to take advantage of gains made by past Bank Loans (such as the Public Sector Technical Assistance Loan, No. 2712 and the Tax Administration Loan, No. 3015 of 1988-89). Conclusion: The merits of research and sectoral work should be evaluated on an individual basis. In the case of the PSRL, previous work and research provided a great deal of important information and the basis for policy dialogues. 56. Implementation. Smooth implementation of these rather complex loan conditions to a great degree can be attributed to ongoing dialogue, advance preparation and the competency of individual actors. The Bank immediately responded and helped the Government to identify alternate modes of effectively meeting goals set by the Loan Agreement. For example, when the Government was having difficulty implementing its bond exchange program for industrial promotion beneficiaries, the Bank helped the Government formulate an alternative program which entailed immediate DGI audits for beneficiaries rejecting the exchange program. The Loan was fortunate in that inflation remained manageable despite ongoing inflationary fears. Failure of the Government to repeal explicitly Compre Argentino Laws by passing a Public Procurement Law is the one condition that was not met fully. At the time that a waiver was requested, the Government was making solid progress on the draft legislation and it appeared to be a matter of time before a completely satisfactory law were passed. Despite this disappointment, the higher-than-anticipated pace of privatization and the fact that the Compre Argentino Laws were suspended have diminished the relevance of Procurement Law. Conclusion: Again, the value of experience and preparation cannot be understated. Experience on the part of the Bank enabled the Bank to help the Borrower use creative means to meet loan conditions. The loan process was also buoyed by strong actors, such as the Minister of Economy, who almost singlehandedly pushed the Financial Law and Budget Control Law through Congress. While the Bank had hoped for a Public Procurement Law which included repeal of Compre Argentino legislation, it is doubtful that the net results of delaying release of the second tranche would have improved the overall impact of the reform program. In fact, in retrospect, the waiver was a prudent decision. Hypothetically, the PSRL may have benefitted from heavier and earlier pressure on the loan conditions entailing legislative passage and implementation (such as the Procurement Law condition), yet some delays, such as the delay in the bond exchange for industrial promotion beneficiaries, would not have been detected early on. Other -16- Bank loan operations may benefit from this lesson and may apply early pressure for the progress of loan conditions that require approval from political bodies outside of the executive. However, the Bank also should be cautioned to have reasonable expectations in what it can accomplish legislatively. 57. Post-Closing Follow-Up. The Division continues to keep an eye on developments related to the Public Sector Reform Loan. The Bank is paying close attention to new quasi-industrial promotion (in the form of subsidies to capital goods), and part of the Provincial Adjustment Loan is intended to address a need for downsizing within provincial governments, similar to the Federal Administrative Reform Program. In particular, follow-up on the civil service reform and improvements in the payments system would have enhanced this program. Conclusion: It may be advisable to provide follow-up evaluations of continued progress for reform programs, for the short time frame of the program means that evaluations are based upon short-term compliance with loan conditions rather than the long-term objectives they are intended to achieve. L. BANK PERFORMANCE 58. The Bank provided finances, technical assistance and a framework for the Government undergo a largely successful public sector reform that encompassed vast areas of reform in federal revenues, federal expenditures and Central Bank issues. Some risks linger, however, such as the non-passage of the Public Procurement Law, the recent emergence of new quasi-industrial promotion policies and the reneging of Tierra del Fuego industrial promotion reduction decrees, developments that have emerged despite the fact that the Bank stressed the crucial aspect of industrial promotion reduction as a component of the loan. The loan's successes greatly outnumber its shortcomings. Through ongoing dialogue between Argentine officials and the Bank, the PSRL was devised, implemented and disbursed smoothly. The Bank's short lag time in responding to questions from the Argentine Government kept the project going when it came upon obstacles. The Bank provided technical assistance for the Tax Reform Program through the PSRTAL and met with government officials during numerous missions to ensure that the program was moving according to schedule. The Bank was able to take considerable advantage of past ESW, the 1988-89 Tax TAL, and past discussions and relationships with Argentine officials. The Bank firmly stressed the importance of certain conditions, for example, the Federal Administration Reform, the Tax Reform, the Industrial Promotion Bond Exchange and the Financial Management and Performance Control Law. Although the Argentine Government had undertaken public sector reform before the introduction of the PSRL, it is unlikely that it would have pursued a reform of such magnitude without the Bank's support. M. BORROWER PERFORMANCE 59. The Government complied initially with all but one of the fourteen specific second tranche conditions for the PSRL. This condition, the passage of the Public Procurement Law, currently remains in Congress. The Government was also initially slow to respond to the Bank's industrial promotion conditions and has since retracted its Tierra del Fuego decrees and have introduced new policies in other areas that constitute quasi-industrial promotion. The Government's successes, and there are many, are owing to a variety of factors. In some cases, it was the influence of key Argentines that provided the necessary support for passage of legislation, the Financial Management and Performance Control Law, for example. The Government did a remarkable job of prevailing with an exhaustive reform program, particularly the Federal Administrative Reform and the Industrial Promotion Reform, during times when it was politically unpopular to do so. -17- N. COORDINATION WITH THE IMF AND THE IDB 61. The Bank has worked closely with the IMF in the design and supervision of adjustment operations, in formulating country strategy and in ESW using common data and ensuring consistent conditionality. The IMF prepared a new stand-by arrangement in July 1991-92 with the Government, the results of which were incorporated into the Bank's targets for short-term macroeconomic monitoring. IMF and Bank staff consult continually about specific policies; the IMF adopted the Bank's recommendations on administrative reform, tax and customs administration, income tax, industrial promotion, and Central Bank issues in their own discussions with the borrower. Since 1989, the Bank and the IMF have several parallel missions, and Bank staff have also participated in Fund missions. 62. The IDB co-financed the PSRL with its first adjustment operation in Argentina and one of the first for that institution ever. Its representatives have participated in all Bank missions, and IDB staff have signed joint aide memoirs for these missions. In addition, the IDB provided resources for consultants and other aspects of loan preparation. Given the magnitude of Argentina's balance of payments needs, co-financing by the IDB significantly increased the leverage of the Loan in ensuring that conditions were met. 9 -19- ANNEX page 1 of 5 STATUS OF SECOND TRANCHE RELEASE LOAN COVENANTS Revenue Mobilization 1. Value Added Tax Maintain VAT, covering both goods and services, with no exemptions other than those existing as of December 1, 1990. Complied. Although the Borrower did modify the VAT with Decrees No. 501/91 and 1669/91 and Law 24073/92 (adopted March 1991, August 1991 and April 1992 respectively), thereby excluding from the VAT base financial services and payments with credit cards, and exempting minor activities such as services financed by pension funds and boats and airplane repairs. At the same time, however, the VAT was broadened to include insurance operations with Decree No. 171/92 in January 1992, and in June 1992, financial activities and transports were incorporated in the VAT base with Decree No. 879/92. In accordance with international procedures, Decree No. 294/92 allows the VAT reimbursement to foreign tourists. 2. Tax Administration Make satisfactory progress in tax administration reform as evidenced by: (i) increasing the number of tax audits performed in the preceding 12- month period to at least 115 percent of the number of audits carried out during fiscal year 1990; (ii) increase the aggregate value of the tax assessment made during the preceding twelve-month period to at least 120 percent of the total value of such assessment made during fiscal year 1990; (iii) increase the aggregate value of additional tax collection resulting from tax inspections assessments to at least 85 percent of the total value of such assessments in the immediately preceding twelve- month period; and (iv) establish a tax roll system for purposes of controlling all tax payers at both the national and regional levels. Complied. 3. Customs Administration Make satisfactory progress in implementing the Customs Reform Program as evidenced by the installation of an automated customs tariff and collection control system covering about 25 percent of import tariff revenues. Complied. The MARIA program was fully implemented at Ezeiza Airport in 1993, and other sites were scheduled according to the following calendar: Aeroparque in Buenos Aires, November 1993; Buenos Aires Port, January 1994; Campana, Rosario, Paso de los Libres, April 1994; Cordoba and Mendoza, May 1994; Bahia Blanca, Puerto Madryn, Rio Grande, June 1994. 4. Industrial Promotion Take satisfactory measures to limit the fiscal costs of the Industrial Promotion Regime as evidenced by: (i) replacing previously granted tax exemptions with tax bonds applicable against tax liabilities; (ii) suspending benefits for firms declared ineligible after the audit process as set out in the Control Program for Industrial Promotion; and (iii) completing requisite decrees and -20- ANNEX page 2 of 5 resolutions to establish the administrative and legal basis for control of audited firms. Complied. Decree 2054, issued November 1992, supplemented with three ministerial resolutions, accomplished the following: (i) enacted the bond substitution across the board for qualifying firms; (ii) established legally the forfeiture penalties for firms falling short of their original contractual commitment; (iii) established an annual tax credit as the vehicle for compensation; (iv) established uniform rules for the application of promotion benefits to suppliers of promoted firms (the IVA compra regime) for purposes of the compensation, and rules for payment of past benefits during the emergency suspension; (v) circumscribed benefits for firms that had not yet activated their projects; (vi) provided for voluntarily resigning from the system while preserving the DGI's right to inspect for future tax fraud; and (vii) any firm choosing to maintain the present system would be subject to immediate DGI inspection to assess whether it had complied with all laws and decrees since July 1989 with respect to industrial promotion. 5. Take satisfactory measures to eliminate tariff and tax incentives and other subsidies promoting industrial activities in the territory of the province of Tierra del Fuego. Not in compliance. The Government did initially comply with this condition. At the time of second tranche release, the Government had issued decree 888/92 which would have ended preferential subsidies to exports from the island, and Decree 1999 would have phased out the VAT exemption over four years. Since then, however, this exemption has been extended until the year 2003. 6. Not enact or otherwise put into effect or grant new tax exemptions, reductions or incentives similar to, or included among those provided under the Industrial Promotion Regime, as of December 31, 1990. Not in compliance. The Government did initially comply with this condition. Until the second half of 1993, the Government complied with this condition; the industrial promotion law (Law 23614) was suspended until September 1993, and no new industrial promotion had been granted since the beginning of the program. Forms of quasi- industrial promotion other than those explicitly reduced through this loan, have since emerged. The overall gains from industrial promotion reductions of this loan, however, greatly outweigh these recent developments. Expenditure Reduction and Rationalization 7. Administrative Reform Achieve satisfactory progress in implementing staff reductions included in the Administrative Reform Program. Primarily, this called for total gross lay-offs of 121,000. Complied. -21- ANNEX page 3 of 5 8. Improve the incentives system by: (i) increasing the salary compression ratio of the national administration to at least 10:1; (ii) establishing the program for senior executives described in the Administrative Reform Plan; (iii) establishing a mechanism to control salary payments through computerized issue of checks (or other auditable, noncash form of payment) for the National Administration, permitting timely information and auditable accounts on a monthly basis for the Subsecretary of Finance; and (iv) establishing new rules and the legal basis for a new compensation and payment system. Complied. 9. Expenditure Control Put into effect the new Financial Management and Performance Control Law, excluding the enactment or issuance of all necessary regulations. Specifically, the new law: (i) assigns full internal accounting responsibilities to the National Accounting Office in the Treasury (CGN), including the implementation of the new financial and accounting information systems, accounting norms and the preparation of the national financial accounts; (ii) creates a system for internal control of the Executive Branch by transforming the existing SIGEP into Executive Controller of the Nation (SIGENAC) reporting directly to the President, and establishing a network of internal auditing units reporting to the heads of the various government entities and operating on the basis of auditing norms defined by SIGENAC and under its supervision; and (iii) restructures the TCN into the new agency for external control, the General Auditing Office of the Nation (GAO) reporting to Congress. Complied. The Law was passed by Congress on September 30, 1992. 10. Put into effect a law regulating the procurement of goods and services and the management of public assets, including the enactment or issuance of all necessary regulations. Not in compliance. At the time of second tranche release, the Government had agreed to: (i) clarify the bidding procedures; (ii) include pre-qualification procedures; (iii) clarify sole-source contracting procedures; (iv) revamp the proposed "private initiatives" contracting procedure" (v) introduce "single envelope" procedures based on pre- qualification for international contracting; (vi) introduce consideration of price in hiring consultants; and (vi) establish procedures consistent with international regulations for projects with financing from international organizations. A Law of Public Procurement was submitted to Congress in January 1993, where it remains. There is no expected date for its passage. 11. Submit a Budget Law bill for 1992 to Congress on time. Complied. The Executive Power has also submitted proposed budgets on time for 1993 and 1994. -22- ANNEX page 4 of 5 12. Eliminate at least 25 Earmarked Funds, comprising at least 22 percent of the total Earmarked Fund's resources. Complied. 13. Not make transfers to the Borrower's provinces or public enterprises in excess of amounts authorized under the Borrower's 1991 Budget Law bill submitted to Congress on February 12, 1991. Complied. Central Bank 14. Achieve satisfactory progress in the implementation of the Central Bank reorganization activities including: (i) the enactment of the New Central Bank Charter; (ii) the implementation of the reforms to the Central Bank's Superintendency of Banks and Financial Institutions; and (iii) the elimination of the Central Bank's role as liquidator of financial institutions together with reductions of the staff and other administrative support previously assigned to the carrying out of such functions. The new Central Bank Charter was to accomplish the following: (i) provide Central Bank directors sufficient independence to manage the institution with the objectives of preserving the value of the currency; (ii) restrict the Central Bank from financing public sector open market purchases of government securities with specified legal limits; (iii) remove functions from the Central Bank not directly related to its fundamental function of currency stability, including removal of the trade credit and bank liquidation functions from the present Central Bank; (iv) restrict Central Bank credit to commercial banks to emergency liquidity rediscounts associated with its lender of last resort functions; (v) prohibit the Central Bank from issuing interest-bearing liabilities; and (vi) strengthen the Superintendency of Financial Entities. In addition, the Central Bank removed functions ancillary to their functions by transferring legal authority on failed institutions to the courts for their resolution. Complied. The New Central Bank Charter was passed by the Congress on September 23, 1992, and was made effective on October 30, 1992. The final version, reflecting Bank input, included: (i) the establishment of the Central Bank's independence; (ii) the elevation in status of the Superintendency within the Central Bank with the requirement that he or she be a member of the board, and as such, be confirmed by the Senate; (iii) proscription of direct lending to the Treasury; (iv) proscription of the issuance of interest- bearing liabilities; (v) limits on the use of rediscounts to emergency situations consistent with "lender of last resort" functions; and (vi) removal of non-core function responsibilities such as trade financing, liquidation of banks and on-lending of publicly guaranteed credit. In addition, the number of staff associated with the liquidation of closed banks declined from 309 to 223 between December 31, 1990 and September 1992. While the staff associated with bank liquidation activities declined about 27 percent, the total number of employees in the Central Bank declined 30 percent from December 31, 1990 to September 1992. -23- ANNEX page 5 of 5 Macroeconomic Framework 15. Maintain a macroeconomic policy framework consistent with the objectives of the PSRL program. Complied. -24- PART II PROGRAM REVIEW FROM THE BORROWER'S PERSPECTIVE (Not received from the Borrower.) - 25 - ARGENTINA PUBLIC SECTOR REFORM LOAN (LOAN 3394-AR) IMPLEMENTATION COMPLETION REPORT PART II: STATISTICAL INFORMATION Table 1: Summary of Assessments A. Achievement of Objectives Substantial Partial Negligible Not applicable Macro policies X Sector policies X Financial objectives X Institutional development X Physical objectives X Poverty reduction X Gender issues X Other social objectives X Environmental objectives X Public sector management X Private sector development X B. Project sustainability Likely Unlikely Uncertain x C. Bank performance Highly satisfactory Satisfactory Deficient Identification X Preparation assistance X Appraisal X Supervision X D. Borrower performance Highly satisfactory Satisfactory Deficient Preparation X Implementation X Covenant compliance X Operation E. Assessment outcome Highly Highly satisfactory Satisfactory nsatisfactor unsatisfactory x - 26 - Table 2: Related Bank Loans/Credits Loan/credit title Purpose Approval Yr. Status Preceding operations 1. Municipal Development Loan Assist provincial/municipal govts. 1988 Disbursing (L-2920-AR) through improvements in financial mechanisms for municipal investments. 2. Tax Administration (TAL 1) Strengthen the DGI structural reform 1989 Disbursed (L-3015-AR) program through TA in computarization tax inspection, training, and control. 3. Provincial Development Provide financial support and incentives 1991 Disbursing (L-3280-AR) for provinces to undertake their own adjustment programs, consistent with national program, through physical investments. 4. Public Enterprise Reform Part of Bank program to support GOA's 1991 Disbursed Adjustment Loan (PERAL) objectives of stabilizing the economy and (L-3291-AR) resuming growth. Loan aims to support efforts to privatize PEs in several sectors and to assist in mgmt. improvements in other sectors. 5. Public Enterprise Reform Same as above, plus finance costs of 1991 Disbursing Execution (PEREL) service and equipment contemplated (L-3292-AR) under the accompanying PERAL and extend activities to additional sectors. Following operations 1. 2nd Public Enterprise Reform Part of Bank program to reduce public 1993 Disbursed (PERAL II) (L-3556-AR) sector participation in the productive sector. Loan aims to privatze defense- related firms, convert defense activities to civilian use and promote competition. 2. Financial Sector Adjustment Part of a Bank program to reduce the 1993 Disbursed (L-3558-AR) role of the state in the financial sector, strengthen the banking sector and its supervisory framework and provide resources for Argentina's debt and debt service reduction arrangements. - 27 - Table 3: Project Timetable Date actuall Steps in project cycle Date planned latest estimate Identification 02/20/90 Appraisal 06/00/90 11/07/90 Negotiations 01/00/91 05/02/91 Board presentation 03/00/91 07/30/91 Signing 08/13/91 Effectiveness 03/00/91 09/23/91 Second tranche release 03/00/92 03/09/93 Project completion Loan closing 12/31/94 Table 4: Project Financing (US$} Source Planned Revised Final IBRD 300.0 325.0 325.0 IDB 300.0 300.0 300.0 Total 625.0 Table 5: Bank Resources: Staff Inputs (Manweeks) Stage of Project cycle FY90 FY91 FY92 FY93 Total Preparation 67.5 32.7 100.2 Appraisal 0 69.6 0 0 69.6 Negotiations 0 34.6 12.6 0 47.2 Supervision 0 0 27.7 15.9 43.6 Sub-total 67.5 136.9 40.3 15.9 260.6 - 28 - Table 6: Bank Resources: Missions Stage of Month/ Number of Days in Specialized staff Project cycle Year Persons field skills represented Through appraisal Identification 02/00/90 5 44 b,c,e,f,i. PSRTAL Coordination 04/00/90 6 63 a,d,i. Pre-appraisal mission I 06/00/90 7 79 a,d,e,f,h. Pre-appraisal mission II 09/00/90 5 45 a.d.e.f.h.i. Pre-appraisal mission III 10/00/90 2 14 1,g. Appraisal through Board approval Appraisal mission I 11/00/90 9 117 a,d,f,g,h. Appraisal mission II 12/00/90 2 18 d Post-appraisal mission I 01/00/91 2 20 a Post-appraisal misison II 02/00/91 4 24 a,k. Post-appraisal mission Ill 04/00/91 1 3 a Board approval through effectiveness Supervision mission I 09/00/91 1 2 e Supervision mission II 10/00/91 1 5 f Supervision mission III 11/00/91 3 56 i,g,h. Supervision mission IV 01/00/92 2 17 f Supervision mission V 02/00/92 4 56 a,d,e,h. Supervision misison VI 03/00/92 3 27 a,d,h. Supervision mission VII 07/00/92 1 12 f Supervision mission VIII 10/00/92 7 63 a,d,e,f,g,h,j. Procurement mission I 01/00/93 1 6 a Audit mission 04/00/93 1 16 i Specializations: a. Task Manager b. Public Bank Expert c. Education Expert d. Economist on the Central Bank e. Industrial Economist f. Financial Analyst g. Public Expenditures Specialist h. Tax Policy Specialist i. Financial Sector Expert j. National Accounts Specialist 29 Table Al: Key Macroeconomic Indicators (in percent unless otherwise specified) 1990 1991 1992 1993 1994 1991 1992 1993 1994 (actual) (as projected in Presidents Report) at (actual figures) Annual Real Growth Rates GDP constant market price 0.1 2.0 2.5 2.8 2.3 8.9 8.7 6.0 7.1 Private Consumption per capita -7.5 3.0 -1.6 0.0 0.6 10.3 9.5 2.9 4.3 National Accounts (% of current GDP) c Total lnvestment 8.9 11.9 13.5 14.3 14.8 14.6 16.7 13.4 20.0 Private 5.9 8.2 9.7 10.1 10.3 12.4 14.3 16.0 17.7 Public 3.0 3.7 3.3 4.2 4.5 2.2 1.9 2.4 2.3 National Savings 10.5 9.9 11.6 12.3 13.1 13.2 13.0 15.5 16.4 Private 12.1 8.5 9.3 9.0 8.9 13.3 11.8 13.5 15.4 Public -1.6 1.4 2.3 3.3 4.2 -0.1 1.2 2.0 1.0 Foreign Savings -1.6 2.0 1.9 2.0 1.7 1.4 3.7 2.9 3.6 ICOR (lagged) -8.3 4.5 4.8 4.8 5.2 1.6 1.9 3.3 3.0 Public Sector Total Current Revenues d/ 9.7 15.5 15.4 15.2 15.9 11.5 12.5 12.3 12.9 Total Current Expenditures eJ 11.9 15.7 15.1 14.6 14.7 12.5 12.4 12.1 11.3 PE Non-interest Savings 0.9 1.1 1.2 1.5 1.6 0.2 0.2 0.3 0.0 Public Savings -1.5 1.0 1.6 2.2 2.3 -0.7 0.7 1.5 0.5 Capital Expenditures 1.4 2.6 2.6 2.7 3.0 1.0 0.3 1.0 1.0 Nonfinancial Public Sector Balance -2.5 -0.8 -0.1 -0.2 0.1 -0.7 0.7 1.5 -0.2 Quasi-Fiscal Surplus 0.0 0.1 0.1 0.1 0.1 0.0 -0.1 0.1 0.1 OverallBalance Financed by: -2.4 -0.6 0.0 -0.1 0.1 -0.7 0.6 1.6 0.0 External Borrowing (net) -2.0 0.1 0.7 0.3 0.7 1.4 -0.4 1.7 0.3 Net Domestic Financing 4.3 0.6 -0.8 -0.7 -0.9 -2.0 -0.1 -0.1 -0.2 Balance or Payments Expots GNFS (real growth rare) 21.8 -15.3 3.4 4.6 4.7 -0.5 -1.1 7.2 12.1 Exports of GNFS/Current GDP 10.5 7.6 7.6 7.3 8.0 7.3 6.6 6.3 6.3 Imports GNFS (real growth rate) -2.6 23.3 5.6 6.0 5.3 66.3 53.4 11.2 19.1 Imports GNFS/Curmnt GDP 5.0 5.6 6.0 5.8 6.0 6.2 8.2 8.2 9.2 Resource BalanceiCurrent GDP 0.05 2.0 1.9 2.0 2.0 0.02 -0.02 -0.01 -0.02 Current Account Balance/Current GDP 0.01 -1.4 -1.3 -1.3 -1.1 -0.01 -0.04 -2.90 -3.60 Current Account Balance (million USS) 1331 -2535 -2373 -2475 -2272 -2768 -8361 8456 8557 Debt Indicators Total DOD (million USS) 59413 60339 61608 63896 65750 69830 37304 37945 97077 Total DOD/Current GDP) 0.42 0.42 0.49 0.51 0.50 0.37 0.38 0.34 0.35 Debt Service Total/Current GDP 3.3 7.0 6.6 6.4 6.7 5.9 3.5 3.0 3.3 Interest Total(million USS) 5757 5241 4913 5228 5127 4955 4173 3634 4874 Interest Total/Current GDP 0.04 0.04 0.04 0.04 0.04 0.03 0.02 0.01 0.02 Prices, Exchange Rates and Interest Rates Domestic Inflation Index (annual) 2023.0 79.0 40.0 25.0 20.0 141.0 15.3 7.5 3.9 Real Exchange Rate Index (1987=100) 99.5 72.0 75.1 79.2 79.2 61.8 53.2 48.9 49.3 LBOR 8.9 7.7 7.5 7.8 7.4 7.3 3.9 3.4 4.9 Monetary Survey - Expansion to Money (million Pesos) International Reserves 13423 6391 3986 4123 7526 9093 12495 17222 17929 Domestic Credit 20529 55463 60387 54283 74445 50710 51197 63068 73671 Private Sector 6567 34520 67519 63736 105222 24235 27547 42617 53220 Public Sector 13962 20943 -7131 -14452 -30783 26425 23650 20451 20451 Quasi-money 2693 53690 52103 48220 67530 5023 9047 12797 14342 MI 2701 17397 17368 16073 22510 7929 11692 16632 19567 GDP (million USS) 141400 124900 124900 124100 132500 139700 22800 255300 279500 a / Projections in Presidents Report were based on old national accounts data; these have been converted to new national accounts system. b / Estimate. c / Projected national accounts figures and actual 1991 figures based on old national accounts data, hence, actual 1991-1994 figures are relatively high, except the foreign savings figures, which are relatively low. They are not directly comparable to actual 1991-94 figures. d / Includes net operational surplus of Public Enterprises. c / Transfer of quasifiscal expenditures to the Treasury in 1990; includes PE interest payments. - 30 - 'Ible BI-B3: National Administration Reform Program Apnil 199 1993 Reductions Budget Total Lay-ofTs at Transters Total National Administration b/ 671479 284215 387264 103469 c/ 233795 Administrative Reform Program 341021 227677 113344 90913 22431 National Administration (Budgeted) 268246 184667 83579 61148 22431 Central Administration 123646 61276 62370 39939 22431 Decentralized Agenc3s 144600 123391 21209 21209 Othe National Administration (off Budget) 72775 43010 29765 29765 Other Programs 330458 56538 273920 12556 261364 Legislature 12405 12405 0 ... ... Judiciary 14053 17476 -3423 -3423 ... Nation Accounts Court 1000 1021 -21 -21 ... Teachers 303000 25636 277364 16000 261364 Memo: Amed Forces (A.F.) and Conscripts d/ 131297 112594 18703 18703 National Administration and Armed Forces 802776 396809 405967 122172 c/ 283795 Gross lay-offs (exc. Lax agencies. Police and A. F.) 121600 al Reducuons n positions via lay-otfs. early retrcrment and attrition. b/ Does not a%clude University Teachers, estimated to be around 95,000. c/ Total net lay-ofs. Discounting increases in the main tax collection agencies (13,300) and police (4,800). total gross lay-offs reach 121,600. d/ Net of civilian personnel in Ministry of Defense, included in National Administration budget (above). Includes conscripts, which were reduced from 29,000 in 1990 to 12,000 in 1992, a reduction of 17,000. el Gross total lay-ofTs of 121.600 (footnote c) in the National Administration plus military reductions, are 140,300. Apri 1990 1993 Reduction Budget Total Administrative Reform Program 341021 227677 113344 Budget National Administration 268246 184667 83579 Central Administration 123646 61276 62370 Decentralized Agencies 144600 123391 21209 OfI-Budget National Administration 72775 43010 29765 Central Administration 0 0 0 Decentralized Agencies 72775 43010 29765 at National Administration covered in Decree 2476/90 and in 'Hacia un Estada Moderno* repot - 31 - Apri 1993 Reducuon 1990 Budgct National Adminisuaion 268246 184667 83579 Centl Adminisaton 123646 61276 62370 Ministry of Economy and Public Works 11115 6973 4137 MiUistry of Foreign Affairs 3082 1611 1471 Ministry of Health 44360 12022 32338 Ministry of Labo and Social Security 2374 2149 725 Ministry of Defense 41293 27020 14278 Ministry of Interior 1167 1173 -6 Ministry of Culture and Education 14157 4120 10037 Ministry of Justice 1751 1765 -14 Presidency 3342 4438 -1096 Decentralized Agencies 144600 123391 21209 a/ 1993 Budget definition. because of changes in administrative structure selected agencie have been grouped diflerenity from previous layouts in order to make data comparable. h/ Does not include Teachers and Military. - 32 - Table C: Fiscal Cost of Industrial Promotion: Estimated Fiscal Cost and Savings of Reform Progrz (Million of USS of June 1990) 1990 1991 1992 1993 1994 1995 Tax Expenditures Before Reforms (Projected) a/ 3012 3269 3491 3945 3675 3719 Industrial Promotion 2661 28338 3085 3521 3232 3256 Existing Projects b/ 2451 2468 2455 2681 2182 1996 Law 23614 (Projected) c/ 210 420 630 840 1050 1260 Tierm del Fuego dt 351 381 406 422 443 463 Savings from Policy Reforms 528 822 828 2382 2256 2335 Industrial Promotion 518 760 630 2118 1929 1910 Suspension of Promotion for New Projects e/ 210 420 630 840 1050 1260 50% Benefit and IVA Compras Suspension f/ g/ h/ 308 340 0 0 0 -172 Penalties for Non-Compliance with Emergency Law il 0 0 0 353 0 0 Reduction in Benefits - Decree 2054 j/ 0 0 0 925 879 822 Tierra del Fuego k/ 1/ 10 62 198 264 327 425 Fiscal Cost After Reforms 2484 2447 2663 1563 1419 1384 Industrial Promotion 2143 2128 2455 1403 1303 1346 Tierra del Fuego 341 319 208 160 116 38 a I Includes SICE and Four Provinces programs. Based on February 1993 information. b / Equal to "Costa Fiscal Utilizado." c / Includes USS210 million per year of new projects. as provided in law 23614 of September 1989, but not yet in force. d / Production and import levels are assumed to increase at a 4.5% rate after 1992. e / Savings from suspension of Law 23614 (footnote b). f / Suspension of 50 % of benefits by the Emergency Law. Only 20 % of the tax obligation is estimated to have been paid. g / It is assumed that only 50 % of the IVA compras was acutally collected during 1990 and 1991. In 1992, a judicial decision suspended the collection of IVA compras. h / The refund of the IVA compras paid during April 1990 to December 1991 starts in 1995. i / It is assumed that during 1990 and 1991, onlvu 20 percent of the tax liability from the 1989 Emergency Law was actually paid. This amount was announced to be paid in 1993, as a consequence of audits. including a penalty of 100%, as provided by law. The refund of the original payment, as provided by Law, will also come in 1993. j / This measures the fiscal savings from the bond substitution process started in December 1992 (decree 2054). k / Includes suspension of reimbursements to the continent (June 1990). I / Includes 1991-92 fiscal savings from reduction in the domesuc sales tax (impuestos internos); also includes 1993-95 savings from decree 1998/92 (November 1992), assuming a yearly percent fall of 8% in production and import levels after 1992. DOCUMENT OF THE INTER-AMERICAN DEVELOPMENT BANK NOT FOR PUBUC USE PROGRAM COMPLETION REPORT ARGENTINA PUBLIC SECTOR ADJUSTMENT PROGRAM (LOAN No. 633/OC-AR) F r 1995 Rev M-ch 9, 1995  PREFACE This is the Program Completion Report (PCR) for Argentina's Public Sector Adjustment Program (PSAP), which was supported by a fast disbursing operation in the amount of US$ 325 million (Loan No.633/OC-AR). The loan was approved on September 25, 1991 and was fully disbursed by March 1993. This report was prepared by specialists of the Finance and Basic Infrastructure Division 3. Preparation of the report began on December 1, 1994. The report is based on the loan documents, supervision reports, correspondence with the borrower and internal memoranda. s ABBREVIATIONS ANA National Customs Administration BCRA Central Bank of the Republic of Argentina CPI Consumer Price Index ENTEL National Telecommunications Enterprise EFF Extended Fund Facility IDB Inter-American Development Bank IFI Intermediary financial institution IMF International Monetary Fund IRR Internal rate of return INDER National Reinsurance Institute PSAP Public Sector Adjustment Program QR Quantitative restriction SIGENAC Executive Comptroller's Office YFP Federal Petroleum Enterprise VAT Value-added tax WB World Bank t - ii - INDEX I. EVALUATION SUMMARY . . 1 A. INTRODUCTION . . . 1 B. OBJECTIVES AND DESCRIPTION OF THE PROGRAM. ......... . . . . 2 C. COMPLIANCE WITH POLICY CONDITIONALITY....... . . . . . . -... 3 D. PROGRAM RESULTS. ........ . . . . . . . . . . . . . . . . . 3 E. MAIN LESSONS. ......... . . . . . . . . . . . . . . . . . . 3 (a) Design.................. ...... . . . 3 (b) Execution and Monitoring. . ............ . . . 4 (c) Disbursement Procedures........ ...... . . . . . 4 (d) Sustainability. ......... . . . . . . . . . . . . . . 4 (e) Bank and Borrower Performances . . ............. . . . 5 F. MAIN RECOMMENDATIONS FOR FUTURE OPERATIONS. ......... . . . 5 II. ANALYSIS OF THE OPERATION . . . . . . . .............. 5 A. BACKGROUND . . . . . . . . . . . . . . .............. 5 B. OBJECTIVES AND DESCRIPTION OF THE LOAN .............. . C. COMPLIANCE WITH POLICY CONDITIONALITY . ..............9 D. PROGRAM RESULTS . . . ....................... 9 (a) Macroeconomic Performance . . . . ..............9 (b) Fiscal Performance . . . . . . . .............. 10 (c) Public Procurement Law . . . . . .............. 13 (d) Central Bank Reorganization............... . . . . 5.13 E. MAIN LESSONS FROM THE PROGRAM................. . . . . 5.14 (a) Design......................................... .. . .. . 14 (b) Execution and Monitoring............... . . . . 9.14 (c) Disbursement Procedures;................ . . . . 9.14 (d) Program Risks . . ............. .... . . . . . 15 (e) Sustainability . .......... ....... . . . . . 15 (f) Bank and Borrower Performances....i.o. . . . . . . . . . 15 F. MAIN RECONENDATION FOR FUTURE OPERATIONS . . . . . . . . . . . . . 16 III. BASIC PROGRAM INFORMATION . . . . . . . . . . . . . . . . . . . . . 16 A. BASIC DATA. .P.....d.. . . . . . . . . . . . . . . . . . . . 16 B. (DB FINANCING .. . . . . . . . ... . . . . . . . . . . . . . . . . 16 C. FINANCING. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 ANNEXES Annex A Report on Second Tranche Release - 111 - PROJECT KEY DATA Borrower: Republic of Argentina Executing agency: Ministry of Economy Amount and purpose:. Import financing US$321.75 million Inspection and supervision US$ 3.25 million Total US$325.00 million Sources: Ordinary Capital US$325.0 million Terms and conditions: Amortization 20 years Grace period 5 years Interest rate variable Commitment fee 0.75 % Inspection and supervision 1% Disbursement period: Original 2 years Actual 1 year and 5 months after effectiveness PROJECT COMPLETION REPORT ARGENTINA PUBLIC SECTOR ADJUSTMENT PROGRAM ( LOAN No. 633/OC-AR ) I. EVALUATION SUMMARY A. INTRODUCTION 1.1 Argentina followed inward-oriented substitution policies since the 1930s that led to the development of a protected, non-competitive manufacturing sector, which grew with the shortages of consumer goods that prevailed during the Second World War and the immediate postwar period. The Government also expanded into the productive and service sectors as well as into the financial sector in the areas of development and mortgage banking. Since the 1950s, Argentina's economy experienced erratic and low real growth, high inflation, declining investment/GDP ratios, and capital flight. The situation began to worsen in the mid-1970s as balance of payments and fiscal deficits further clouded the economic situation and their financing led to heavy borrowings from abroad. 1.2 Anti-inflationary policies followed during 1979-81 used the exchange rate as an anchor under a pre-announced devaluation schedule (tablita). Significant private capital inflows attracted by short-term financial benefits financed mostly consumer goods imports, tourism expenditures, and outflows of funds (e.g. real estate investments in Uruguay). The increased trade deficit and the rising debt service payments deteriorated the current account balance of payments. Private enterprises were adversely affected by high real interest rates and high debt/capital ratios and experienced severe difficulties, which also impacted on the financial sector. The fiscal deficit worsened as revenues declined with the economic slowdown. The overvaluation of the currency could no longer be sustained in early 1981. 1.3 The abandonment of the tablita in March 1981 led to a financial collapse of the private sector. As a result, the government had to honor the "exchange guarantees" it had issued to private debtors and, thus, became responsible for nearly all private external debt. Subsequently, international interest rates shot up to very high levels and foreign financing sources began to dry out with the retrenchment of international commercial banks from Latin-America on account of the South Atlantic conflict and, particularly, the 1982 debt crisis, which was triggered by the Mexican moratorium on the external debt. As a result, Argentina's external debt multiplied while its sources of financing were limited to multilateral lending. Commercial debt rescheduling and limited amounts of new money became a necessity. 1.4 Rather than making an effective fiscal adjustment to pay for its debt service obligations, the government resorted to money creation and used 2 foreign exchange restrictions anc/or broad quantitative restrictions on imports to mobilize resources for this purpose. The private sector gradually withdrew its resources from the financial system to avoid the inflation tax. Meanwhile, several stabilization programs failed and inflation kept recurring with renewed strength until it reached 200 percent in July 1989. 1.5 The crisis provided the momentum for an early transfer of power to the newly elected President, whose administration launched programs of stabilization and structural reform with mixed results in 1989 and 1990. Advances in privatization of public enterprises and administrative reforms were not accompanied by a stable fiscal equilibrium or success in the control of inflation. Hyperinflation resurfaced in December 1989 and, after some decline, inflation climbed again at end-1990. In early 1991, a major stabilization program began. The program comprised revenue and expenditure measures to eliminate the fiscal deficit. The turning point was an April 1991 convertibility law establishing a par fixed exchange rate peso/dollar, which so far has been maintained albeit with some corrective measures as export competitiveness weakened. The aim of the measures is to reduce domestic costs, including labor and social security costs, through structural adjustments on the supply side to restore the economy's competitiveness. 1.6 The Government aimed at balancing the public sector accounts, reversing the demonetization of the peso economy, and normalizing relations with external bank creditors.The fiscal and quasi-fiscal deficits so far had been virtually eliminated, partly with the proceeds of the privatization of public enterprises and debt-equity conversions. The monetization of the economy was enhanced by the introduction of bimonetarism,. the strengthening of the peso free convertibility with a reportedly 100 percent dollar backing of the monetary base, freeing financial intermediaries to provide credit in pesos or dollars, guaranteeing dollar deposit withdrawals in the same currency, and deregulating the stock exchange. With respect to the external debt, the Government moved to renegotiate the debt with commercial bank creditors under the Brady plan, which supported major debt and debt service reductions with a strong linkage to economic reforms. B. OBJECTIVES AND DESCRIPTION OF THE PROGRAM 1.7 The Bank loan supported the Public Sector Adjustment Program (PSAP) in a cofinancing operation with the WB. The main objective of the PSAP was to remove the sources of the- public sector deficit. Towards this end, the PSAP concentrated in three areas: increasing fiscal revenues; rationalizing public expenditures; and restructuring the central bank (BCRA) and reducing its role in deficit financing. 1.8 The revenue component aimed at increasing collections and reducing evasion. It included: expanding the value-added tax base; removing up to 80% of manufacturing subsidies; and, more importantly, strengthening the tax administration through better and expanded auditing of declarations, more complete taxpayers rosters, greater efficiency, computerization of 3 internal and custom taxes, and administiative restructuring of tax offices. 1.9 The expenditure component aimed at lowering expenditures by reducing the federal bureaucracy by over 120,000 and the federal payroll by 25 percent, by strengthening budgetary management and by expenditure controls. In addition, the program supported the creation of a special executive service of about 1,500 people to alleviate, on a selective basis, the flattening of the wage scale of the federal administration; this was envisaged as a step in creating a high level civil service well- remunerated to run the country's bureaucracy. 1.10 The BCRA restructuring component aimed at restoring its role as the monetary authority and avoid a repetition of past practices when BCRA was an important source of financing for all government levels. The loan required: a new charter, a drastic reduction in credit to the non- financial public sector, staff reductions and the termination of the financial support to commerce and to the liquidation of banks. C. COMPLIANCE WITH POLICY CONDITIONALITY 1.11 The Bank loan was approved on September 25, 1991 and had been disbursed by March 26, 1993. Second tranche disbursements were delayed because the supporting import documentation was not provided in a timely manner. D. PROGRAM RESULTS 1.12 The program was successful in reducing macroeconomic instability originating in the fiscal accounts. The revenue component based mostly on administrative improvements of the tax administration and the expanded VAT tax base increased Central Government revenues over 4 percentage points of GDP during 1990-93. The expenditure management and control component, however, did not contribute much to deficit reduction as total expenditures of the Central Government increased about 2 percentage points of GDP during 1990-93. The BCRA component resulted in a significant improvement of the financial sector's supervision, a new BCRA charter, the restructuring of the BCRA, and limitations on credit to the non-financial public sector. However, recent events (reappearance of the fiscal deficit, unsustainable rising current account balance of payments deficits, Mexican peso difficulties) raise questions about the medium-term sustainability of the program (see main body of the report). E. MAIN LESSONS (a) Desizn 1.13 The main design lesson from the PSAP is the confirmation that the conditionality should concentrate on a few, key important areas rather than dispersed over many components and sub-components. This was the positive experience of the PSAP, which had few components. The dispersion of the conditionality over many areas is a recipe for incomplete or sub- 4 standard performance in one or more sub-components, wich, in an overall balance, has to be accepted as some level of compliance. 1.14 The PSAP demonstrates also the importance of the overall macro context or policy framework in which the program is being implemented. Argentina was involved in a broadly based overall program of structural reforms of which the PSAP was a part. All reform programs were consistent and had full government support. In particular, the PSAP, by strengthening public finances, was a fundamental element of the quest for price stability, which was the core of the government policy. (b) Execution and Monitorin 1.15 The PSAP provides a lesson about the importance of the government and other public sector bodies being fully committed to the program as a condition of success. In this case, the government had a strong commitment and pushed forward the agreed measures. With respect to monitoring, this is facilitated by a well-focused and concentrated program, which was the case of the PSAP. (c) Disbursement Procedures 1.16 The PSAP developed difficulties for the provision of the necessary support documentation for second tranche release. The support of the WB permitted to circumvent this obstacle but this approach should not be satisfactory for dealing with the problem. The lesson extracted from the PSAP experience is that procedures for tranche disbursement should be clarified at the negotiation stage to avoid misunderstandings. (d) Sustainability 1.17 The risk of unforeseen developments derailing progress obtained under the PSAP is still present. Macroeconomic performance is crucial to the sustainability of the results of the PSAP. This concerns maintaining the exchange rate regime, restoring export competitiveness, generating genuine savings and foreign exchange earnings to service the public sector debt and cover current account balance of payments developments. Up to now the Government has been able to stay the course. However, the program still confronts potential risks arising of: the fallout from the Mexican peso crisis on capital markets, higher international interest rates, failure of productivity increases to exceed those of trading partners and thus failure to boost competitiveness for strong export growth, and pressures for a devaluation leading to higher inflation rates. 1.18 A program dealing with the public sector deficit, which basically achieves results through revenue increases and much less through expenditure reductions, is bound to develop difficulties if the economy encounters major problems affecting adversely growth and tax revenues. Some indications of fiscal disequilibrium already surfaced in 1994 and could widen in 1995. It is too early to assess the magnitude of the impact. 5 (e) Bank and Borrower Performances 1.19 Bank performance was adequate in the framework agreed at the time for cofinancing WB operations. 1.20 Borrower performance was satisfactory in complying with Bank conditions, with the exception of the enactment of the Public Procurement Law. However, the. documentation required for second tranche release was not provided as required, forcing the Bank to rely on WB information. F. MAIN RECOMMENDATIONS FOR FUTURE OPERATIONS 1.21 An adjustment program should concentrate on a few, important areas to ensure meaningful reform results. In this connection, the diagnosis of the problem and the identified solutions should be very accurate. II. ANALYSIS OF THE OPERATION A. BACKGROUND 2.1 Argentina embarked on import-substitution policies since the 1930s Great Depression. These policies led to the development of a protected, non- competitive manufacturing sector, which grew with the shortages of consumer goods that prevailed during the Second World War and the immediate postwar period. A parallel development was a significant expansion of the Government into productive and service sectors, such as petroleum, coal, steel, electricity, telecommunications, railways and airlines, and into the financial sector with development and mortgage banks. Since the 1950's, Argentina's economy experienced significant difficulties characterized by erratic and low real growth, high inflation, declining investment/GDP ratios, and capital flight. 2.2 Anti-inflationary policies followed during 1979-81 used the exchange rate as an anchor under a pre-announced devaluation schedule (tablita), which lagged behind the inflation rate; they exacerbated the economic deterioration. Significant private capital inflows attracted by short-term financial benefits financed mostly consumer goods imports, tourism expenditures, and outflows of funds (e.g. real estate investments in Uruguay) and did not add significantly to the production and exporting capacity. The increased trade deficit and the rising debt service payments deteriorated the current account balance of payments. The fiscal deficit worsened as revenues declined with the economic slowdown. The overvaluation of the currency could no longer be sustained in early 1981. 2.3 The costs of the experiment were. significant. First, an increasingly overvalued peso led to an import boom and significant deficits in the current account balance of payments while lack of expenditure discipline and real revenue declines sharply increased the fiscal deficit. Larger fiscal and balance of payments deficits were financed with substantial foreign borrowings when international interest rates were highly positive in real terms. These borrowings were used to finance fiscal deficits, 6 losses of public enterprises and provincial governments, industrial promotion schemes favoring privileged industrialists, housing contractors and selected middle class home buyers, military expenditures and, in addition, foreign exchange gaps to sustain the pre-announced devaluation schedule. Second, the financial structure of private enterprises became very weak. Private enterprises were adversely affected by high real interest rates and high debt/capital ratios and experienced severe difficulties, which also impacted on the financial sector and on public finances. Third, the public debt stock escalated further when private debtors experienced difficulties with their external debt obligations and the Government had to honor its exchange guarantee commitments and become responsible for almost all private external debts. As a result, the public external debt service increased very significantly in 1982. At the same time, the armed conflict with Great Britain and, particularly, the Mexican debt moratorium led to a retrenchment of foreign commercial banks from lending in Latin-America. 2.4 With the retrenchments of foreign lenders from the region in 1982, servicing the external debt became a serious problem. Argentina's access to external financing was limited to multilateral lending. Resorting to involuntary debt rescheduling of debts with foreign commercial banks with the commitment of some new money became a necessary arrangement. The debt- servicing problem was further compounded by the well-known transfer problem, i.e, the generation of income and foreign exchange earnings by producers/exporters and the transfer mechanism for appropriating these resources by the Government for payment to the creditor banks. Military and civilian governments avoided the problem and resorted to foreign exchange restrictions, quantitative import restrictions and money creation instead of generating genuine fiscal resources. Stabilization programs failed and inflation rekindled after each failure. A severe crisis developed when inflation reached 200 percent in July 1989. 2.5 The crisis facilitated an earlier transfer of power to the newly elected President, who took office with a strong mandate to stop the chaotic economic situation and carry out programs of stabilization and structural reform. The government launched a privatization program of public enterprises in 1990, which covered the airline, telecommunications company, railways, oil and gas companies, power and water companies, steel, armament factories, etc. with the proceeds of these sales providing resources for a temporary improvement of public finances. However, the initial stabilization efforts were not successful; hyperinflation levels were recorded in December 1989 and, after some decline, inflation began to accelerate again in late 1990 and early 1991. 2.6 A new program began reversing the trend in April 1991. It aimed at reducing inflation, changing the structure of production, balancing the public sector accounts by increasing tax revenues and controlling expenditures, continuing the privatization of public enterprises, reversing the demonetization of the peso economy, and restructuring the central bank (BCRA). The turning point was the April 1991 Convertibility Law establishing a par fixed exchange rate peso/dollar, with free convertibility, and a reportedly 100 percent dollar backing of the 7 monetary base. This led to the dollarization of deposits and credits of financial intermediaries, and the guarantee of dollar-deposit withdrawals in the same currency. The peso/dollar exchange rate so far has been maintained albeit with some temporary corrective measures, such rebates to improve export competitiveness, or pressures from the investment climate in the region, particularly the devaluation of the Mexican peso and its aftermath on financial markets. 2.7 To stimulate private activities, trade liberalization efforts continued. The maximum import tariff rate was reduced to 20 percent; quantitative import restrictions were removed, except for cars; export taxes were eliminated and indirect taxes reimbursed to exporters; and the anti- dumping mechanism was revamped to comply with the GATT Code. In parallel, restrictions on professional, transport and port services were ended to reduce businesses costs. Labor legislation was approved aiming at improving collective bargaining and providing more flexibility. 2.8 On the strength of the reform program, the Government negotiated in 1992 with creditor commercial banks, under the Brady plan, a debt and debt service reduction program. The DDSR Agreement restructured about US$21 billion of external debts with commercial banks and normalized the situation of about US$8 billion of past due interest. The Agreement provided a partial discount and a lower fixed interest rate in exchange for normalizing the repayments and continuing the implementation of significant policy reforms and structural adjustments. The agreement improved Argentina's creditworthiness and ability to attract foreign financing. 2.9 The above-noted developments shaped the growth performance of the economy. The real GDP's growth rate fluctuated during the 1980's, dropped 6 percent in 1989 and showed no growth in 1990. Savings and investment rates in Argentina dropped as funds increasingly moved abroad. However, under the 1991 stabilization and reform program, the economy recovered. During 1990-93, GDP grew over 7 percent a year and exports of goods increased 2 percent a year. Nevertheless, productive investment was insufficient to restore competitiveness. The current account balance of payments deteriorated abruptly from a surplus of US$4.6 billion in 1990 to a deficit of US$11.6 billion in 1994, reflecting the increasingly uncompetitive trade position and the reduction of protection. Imports expanded from US$3.7 billion in 1990 to US$15.5 billion in 1993 and rose again by 40 percent in the first semester of 1994 compared to the same period in 1993. 2.10 Projections for 1995 indicate the need for continuous private capital inflows and the essential importance of boosting export performance. Given developments in the Mexican capital market, the inflows of foreign private capital is not ensured; thus, the balance of payments financing would most likely be a function of desired savings and investment levels in the private sector. I 1 World Bank, Provincial Reform Loan, President Report No. P-6414-AR. 8 B. OBJECTIVES AND DESCRIPTION O THE LOAN 2.11 The Bank loan provided US$325 million in support of the PSAP to help cover some of the costs of the adjustment. This was a cofinancing operation with the World Bank (WB), which provided also US$325 million in support of the adjustment program. 2.12 The principal government objective in undertaking the PSAP was to take corrective action to remove the sources of the public sector deficit. To accomplish this, the PSAP covered the following areas: (1) increasing fiscal revenues; (ii) rationalizing public expenditures; and (iii) reforming the Central Bank (BCRA) and, in particular. reducing its deficit financing of the government. 2.13 On the revenue side, the program included important steps to increase government revenues, as follows: (I) expanding the value-added tax base to cover services and the vetoing by the Executive of any new exemption to this tax; (ii) eliminating up to 80 percent of the subsidies granted to manufacturing; (iii) strengthening the tax-administration through better audit systems to cover the 30,000 largest taxpayers in 1991 and all taxpayers in 1992; (iv) cross-checking of taxpayers declarations for social security payments and tax collections; (v) stimulating greater efficiency of tax collectors with a revenue-sharing system; (vi) improving the follow up and collection of taxes owed as a result of audits; and (vii) revamping of the General Tax Directorate (DGI), with particular reference to revisions of administrative regulations and budgetary procedures, and the introduction of new procedwres for hiring personnel and purchases by DC1. In addition, drastic actions were taken against firms which were not in compliance with VAT procedures; about 200 firms were closed down in the initial steps of the program. The program also supported a new computerized system for the control of import classification to reduce errors and corruption. 2.14 On the expenditure side, the program consisted of: (I) reducing the federal bureaucracy by 120,000 no later than May 1, 1992, with particular emphasis on the elimination of whole government functions and entities rather than on piecemeal reductions; (11) diminishing by 25 percent payroll expenditures; (iii) improving salary scales for about 1,500 executives as a step in creating a high-level executive service to correct the flattening of the federal wage pyramid; (iv) a termination package for fired employees, which consisted of payments for six months at 75 percent of the original vage plus a lump-sum payment plus maintenance of social benefits for one year; and (v) strengthening budgetary programming of and controls over expenditures, including drafting legislation on financial management and controls. 2.15 With respect to the BCRA, the program aimed at restructuring the Superintendency of Banks; a new charter for the BCRA; a substantial reduction of credit to the non-financial public sector as a result of the progress in sttengthening public finances; termination of BCRA's. financial support to commerce and to the liquidation of bank., which conveyed a parallel staff reduction under conditions similar to those granted to government employees. 9 C. COMPLIANCE WITH POLICY CONDITIONALITY 2.16 The loan was approved by the Board on September 25, 1991 and was fully disbursed by March 1993. After loan signing on November 15, 1991, first tranche disbursements took place on December 13, 1991 and second tranche disbursements in March 1993 after loan conditions had been met. Second tranche disbursement of the cofinanced WB loan had taken place a month earlier in February 1993. D. PROGRAM RESULTS (a) Macroeconomic Performance 2.17 The main program objective of reducing the chronic macroeconomic instability was achieved. In general, the macroeconomic performance was consistent with the program objectives. The government economic program lowered inflation substantially by establishing a fixed peso/dollar exchange rate and full convertibility while achieving a fiscal balance. With price stability, the economy recovered its growth path; GDP grew an average 7.9 percent a year during 1990-93. However, unemployment reached levels exceeding 10 percent, which are significantly above traditional country levels, and the trade account deficit of the balance of payments widened to about US$5.0 billion in 1994 from US$3.7 billion in 1993, as imports were fueled by domestic demand and the peso appreciation. Capital inflows financed the larger current account deficit. Table 1 MACROECONOMIC INDICATORS (billion dollars or %) ITEM 1990 1991 1992 1993 19941 GDP 69 181 727 255 280 Exports (FOB) 12 12 12 13 15 Imports (FOB 4 8 14 15 20 Trade Balance 9 4 -1 -2 -5 Gross Domestic Investment/GDP (%) 14 14 17 18 20 National Savings/GDP (%) 18 15 14 16 16 Foreign Savings/GDP (%) -4 -1 2 2 4 Current Account B.O.P. 5 -1 -6 -8 -11 Net Foreign Assets (Monetary Survey) 4 6 3 8 52 Reserves (Monetary Survey) 4 9 11 15 152 Federal Deficit (-), cash basis (% of GDP) -3 -1 1 1 0 1 Preliminary. 2 July 1994. Sources: IFS and WB, PR-6414-AR, and Secretaria de Programaci6n Econ6mica, Informe Econ6mico, 1994. 10 2.18 Sustainability of the program in the medium-term depends on corrective actions. The government medium-term strategy is: (i) with respect to export competitiveness, to reduce domestic production costs, particularly through lowering equivalent-dollar wages and eliminating the employer's payroll contribution to social security below those of Argentina's trading partners; and (ii) with respect to balance of payments imbalances, to increase national savings to compensate for the recent instability in capital markets, which might not provide the private capital inflows needed to finance the current account balance of payments deficit. In this connection, legislation was approved to ease collective bargaining and provide more flexibility to the labor market, and to reform the social security system into a capitalization program and eliminate the employer's contribution. New legislation on these two matters is now under discussion in Congress. Despite the increase in private savings, external private capital inflows will still be needed to ensure a smooth transition to a sustainable balance of payments. (b) Fiscal Performance 2.19 Fiscal performance was satisfactory from 1990 to 1993 as the current and overall deficits of the Central Government became small surpluses. Tax administration was successful in reducing tax evasion and pushed collections to record levels. Central Government revenues increased from about 12 percent in 1990 to over 16 percent in 1993. The expenditure reduction in the Central Government, however, was less successful as current expenditures increased from 14 percent of GDP in 1990 to 17 percent in 1993, increase which was not fully compensated by a slight drop of capital expenditures. Total expenditures increased from 15.6 percent of GDP in 1990 to 18.1 percent in 1993. 2.20 In 1994, there was some deterioration of the fiscal accounts resulting on under performance in compliance with some of the IMF's targets. Afterwards, with the Pension Reform Law 2041, which became effective on July 1, 1994, payroll revenues on manufacturing activities were transferred to new pension arrangements and the employer contribution eliminated, while the government retained the liabilities of the old pension system. As a result, the government has been experiencing monthly fiscal deficits in the second half of 1994, which have continued into 1995. Reductions of employer's payroll contributions, for commerce and services scheduled for January 1, 1995 were postponed until the fiscal situation improves. The pension reform effect, combined with the increase in interest payments from higher international interest rates on part of the external' debt (past-due interest bcoris), is likely to increase the public sector deficit over that of 1994. Early estimates are for a government deficit of US$2 billion. 2.21 The fiscal and quasi-fiscal deficits were virtually eliminated through: (i) increases of the value-added tax rate from 13 percent to 18 percent with very limited exemptionsi; the value-added tax (VAT) collections expanded from 2.3 percent of GDP in 1990 to 6.2 percent in 1994; (ii) a large revenue impact of rebuilding the tax rolls and improving the tax 1 Raised to 21% in March 1995. 11 administration to combat tax evasion; (iii) lower manufacturing subsidies; (iv) stronger expenditure controls, redimensioning of the public administration; (v) lower transfers to the provinces and public enterprises; (vi) the proceeds of the privatization of public enterprises; and (vii) the reduction of interest payments associated with the renegotiation of the external debt. The primary surplus of the public sector reached 2.1 percent of GDP in 1992 and 2.7 percent in 1993 before declining to 1.1 percent in 1994. 2.22 On the revenue side, the government made serious efforts to raise revenues through VAT rate increases and improvements in the general tax administration (DGI), which had a substantial impact on increasing Central Government revenues, as nsted in paragraphs 2.19 and 2.21. The administrative improvements :arried out were: (i) the number of audits increased significantly and the collection target of over 85% of the additional tax liabilities determined by these audits was accomplished; (ii) a universal roster of taxpayers was established and the coverage of the roster of large taxpayers was expanded from 60,000 in 1992 to 250,000 in 1994; (iii) the value of tax assessments increased although it did not lead to higher global assessments over those of 1990, as required by the conditionality, because most important valuations were sent to the courts for disposition in compliance with the new penal code; and (iv) revenues from the "voluntary" tax payments category doubled as a ratio to GDP between 1990 and 1992. 2.23 In addition, the program to improve customs administration was successful in raising import tariffs revenues, which tripled from 1990 to 1992. The basic tools were: the adoption of the French customs computerized system (MARIA), the simplification of procedures and norms, and the adoption of the General Tax Directorate (DGI) system for controlling large taxpayers. 2.24 With respect to industrial promotion exemptions, the program led to a significant overhaul of the system. The tax administration examined 2,500 industrial establishments benefitting from these exemptions and the government promulgated Decree No. 2054 and three ministerial resolutions, which established the legal and administrative set up for the control of the audited firms. The Decree required that all firms remaining under the old system would be subject to an audit to ascertain its co:apliance with all laws and decrees enacted since 1989. Decree No. 2054 also established: (i) new rules replacing tax exemptions with non-negotiable tax certificates, which could be used to pay tax liabilities; (.i) termination of benefits for firms not in compliance with their initial commitments; (iii) limitations of benefits for beneficiary firms which had not begun operations; and (iv) new uniform rules for the application of the VAT regime norming sales of suppliers to firms benefitting from the industrial promotion scheme. 2.25 The elimination of the fiscal and other incentives to manufacturing activities in the province of Tierra del Fuego also achieved .satisfactory results. The domestic tax on sales of electronic equipment was repelled in november 1991; export subsidies were terminated by Decree 888/92; the VAT exemption for manufacturers of electronic equipment was expected to be 12 gradual,y eliminated in four years by Decree 1999/92 but has been partially retained until the year 2013, as noted below; and import tariff protection was reduced from 35% to 20%. However, the special preferential treatment of Tierra del Fuego was only partially eliminated. In 1993, a partial exemption of the value-added tax (7 percent instead of 18 percent) was retained until the year 2003 and, under MERCOSUR's external tariff arrangements, the province was permitted this prerogative until the year 2013; inputs also are imported duty free. 2.26 The government, at disbursement of the second and final tranche of the loan, had complied with a closely related condition requiring that no new tax exemptions or other benefits would be provided after December 1990 under the Industrial Promotion Regime or other existing legislation. Later on, however, special exchange rate arrangements have been established for some manufacturing activities adversely affected by the Convertibility Law regime, such as car exports. 2.27 On expenditure reduction, the government complied satisfactorily with the conditionality. However, total public expenditures remained at about the same level. Declines in infrastructure expenditures, debt service, and miscellaneous other expenditures were compensated mostly by increases in social security expenditures, which went up from 5.86 percent of GDP in 1991 to 8.84 percent in 1994. 2.28 With respect to staff reductions, about 120,000 jobs were eliminated at the Federal level, of which 22,000 were transferred to the provinces, about 19,000 were laid-off in the armed forces, and 20,000 retired. This was partly compensated with the reported increases in revenue-collection personnel and police,. which totalled 13,300 and 4,800, respectively. During 1991-92, the cost of the reduction in force was about US$312 million. Public enterprises employment declined from 347,000 in 1989 to 37,000 in 1994 as a result of the privatization program. Overall, it is estimated a reduction in force of about 300,000 jobs in the public sector. 2.29 The Law on Financial Management and Performance Control was approved on September 30, 1992 and the corresponding regulations were issued. The law established: (i) an integrated public financial management system, including comprehensive budgeting and accounting for the federal public sector; (ii) an effective system of internal controls for the Executive branch, coordinated by the executive comptroller's office, which reports directly to the President of Argentina; and (iii) reestablished a National General Auditing Office, which reports to Congress. 2.30 Other conditions on expenditure accounting control that the government complied with were: (i) the annual budgets submitted to Congress to be based on a new programming system; (ii) the elimination of earmarked funds, which dropped from 151 in 1990 to 59 in 1992, with a parallel reduction in expenditures of 23%, which was close to the agreed percentage reduction; further action in 1993 reduced the number of funds to 44, which represented about 3% of the budget and are no longer a source of subsidies to the private sector; (iii) transfers to the Provinces were lowered 13 significantly bel.w 1991 budget authorization while transfers to public enterprises were only slightly lover. 2.31 At the same time that the government took steps to reduce expenditures, it established a senior executives service and widened the pay ratio between top executives and other staff positions. Decree No. 2712/91 established a new pay scale for civil service. (c) Public Procurement Law 2.32 At second tranche disbursement, the Board's tranche release document noted that the government had not fully met its commitment to enact and put into effect the Public Procurement Law. A draft law had been prepared clarifying and revamping bidding, pre-qualification, price, and contracting procedures, and particularly those procedures dealing with projects financed by multilateral banks and other international organizations. The law had been submitted to Congress in January 1993 but has not been approved. However, a Presidential decree advanced most of the expected changes by postponing preferences for domestic firms and issuing administrative instructions to purchasing agencies. The privatization of state enterprises also contributed to a positive result on this score as these entities did most of the procurement of goods in the public sector. (d) Central Bank Reorganization 2.33 The monetary authority of the Central Bank of the Republic of Argentina (BCRA) was reestablished with several actions. Short-term, high interest deposits were converted to long-term dollar bonds (BONEX) at LIBO-based rates in January 1990, thus ending the destabilizing practice of BCRA of covering its losses with short-term debt. This was followed by the approval of the Convertibility Law in April 1991, which fixed the exchange rate at one peso per one US$, de-indexed contracts, permitted dollar transactions, and required a 100 percent dollar backing of the monetary base; and by the passage of a new BCRA Charter in September 1992 to reestablish an independent monetary authority. The dollarization of deposits and credits of financial intermediaries, the dollar guarantee of deposit withdrawals in the same currency, and the deregulation of the stock exchange strengthened the monetization of the economy. 2.34 The reorganization of the BCRA was carried out in step with the agreed changes. The new BCRA charter prohibited the bank from issuing bonds, lending to financial intermediaries (except for short-term liquidity needs), paying interest on deposits, and financing the government by more than 10 percent a year. It also required the reform of the Superintendency of Banks and the transfer of the activities connected with the liquidation of banks from BCRA to the courts. BCRA retained the liquidation of assets of failed banks. As a result of the restructuring the total number of employees of BCRA dropped 30 percent from 1990 to 1992; the staff associated with the liquidation of failed banks also declined about 27 percent. 14 2.35 The regulatory framework of the banking system experienced a significant improvement. Apart from eliminating restrictions, the new norms represent a significant step to strengthen the solvency of the banking system with the introduction of Basle-type norms on the risk classification of assets and minimum capital requirement at 8 percent of said assets. The new criteria for portfolio classification was expected to be in place by December 1994 and the provisioning needed to be provided by July 1995. Argentina's banking system is overdimensioned for the existing business and thus tends to charge higher fees and interest rates to cover expenditures. The full impact of the Basle-type rules on asset classification and provisioning to cover minimum solvency requirements is likely to lead to a rationalization of the banking system. Already some banks have failed and others are experiencing liquidity difficulties, which may worsen if the portfolios are not of good quality. E. MAIN LESSONS FROM THE PROGRAM (a) Desizn 2.36 The main lesson from this program concerns the importance of keeping the conditionality centered on a few important areas to ensure the overall success of the adjustment operation. The PSAP experience clearly supports this approach. It shows positive results on a well-defined, concentrated conditionality. Complex conditionality could be tackled more successfully under several operations. 2.37 A second design lesson relates to the consistency with the overall policy program being carried out by the government. The PSAP's design was consistent with the overall adjustment policy followed by the government, which covered many areas under several adjustment programs. In particular, it should be mentioned the close connection between price stability and sound fiscal accounts and a properly functioning central bank and banking system. (b) Execution and Monitoring 2.38 The commitment of the national authorities to the implementation of the program is essential for positive implementation results. This was the case with Argentina's PSAP with the strong commitment of the Ministry in charge of economic policy, who also had the firm support of the President. 2.39 With respect to monitoring, the importance of a clear, identifiable level of advance in measuring progress should be stressed. It helps substantially to keep down monitoring activities but also helps ensure more substantial compliance. (c) Disbursement Procedures 2.40 The second traniche disbursement was the subject of some misunderstanding. A disbursement request was made by the government without the appropriate documentation supporting the fulfillment of the conditionality. The documentation was put together with help from the WB staff that prepared 15 the tranche release for that institut.on. The disbursement was further delayed for the need to wait, in cofinancings with the WB, for the WB's Board decision approving the disbursement with a waiver on the condition requiring the enactment of the Public Procurement Law. In this connection, it should be noted that the collaboration WB-BID was satisfactory. (d) Program Risks 2.41 The Bank documentation anticipated the potential risk of rising unemployment linked to the reduction in force in the public sector. The PSAP impact on unemployment has been magnified by the economic consequences of overall deflationary economic policies with unemployment reaching about 13 percent of the labor force. However, there was no negative feedback to stop the program. 2.42 The identified risk in the loan proposal of a condition not been fulfilled materialized in the case of the Procurement Law as noted above. (e) Sustainability 2.43 The main risk noted in the loan proposal was that of unforeseen developments derailing or reducing the effectiveness of the overall program despite a committed government. The economic conduction has been instrumental in carrying forward the program. Nevertheless, despite this commitment, there are potential developments ahead, which may raise major hurdles in the near future, e.g. pressures on public finances. If this risk materializes, there is a lesson to be drawn: public sector financial adjustments are closely interrelated with the short and medium term performance of the economy and, unless there is vigorous economic recovery and growth, fiscal performance could deteriorate as revenues falter. 2.44 Furthermore, private savings increase should be a clear goal of the overall reform program to ensure the sustainability of the macro reform program. In this context, the lesson is that domestic measures should be put in place to help avoid an import stampede caused by trade liberalization and an overvalued currency. These measures might include transitory selective consumption taxes, limits on consumer credit, etc. to ease the transition and create the conditions for lasting reforms and avoid booms and busts, which would be blame on the reforms.. (f) Bank and Borrower Performances 2.45 Bank performance was adequate in view of the existing constraints at that time, which required the Bank to cofinance adjustment operations developed by the WB. 2.46 Borrower performance was satisfactory in complying with almost all the loan conditions in a timely manner. The only major exception was the Public Procurement Law. The documentation required to meet disbursement conditions, however, was not timely provided for second tranche disbursement as noted above. 16 F. MAIN RECOM(ENDATION FOR FUTURE OPERATIONS 2.47 This operation provides a good example to be followed: an adjustment program concentrated in a few, important areas with a good diagnosis and where important results are feasible. The operation provides a clear case to contrast against other programs with a much broader, all-inclusive coverage but with potential non-compliance in several areas. III. BASIC PROGRAM INFORMATION Country: Argentina Loan number: 633/OC-AR Name of the operation: Public Sector Adjustment Program Borrower: Republic of Argentina Executing agency: Ministry of Economy Modality: Fast-disbursing A. BASIC DATA Orizinal Program Committee (SLP): 08/10/90 Program Committee (SLS): 05/08/91 Loan Committee: 08/01/91 Negotiations: 08/12/91 Board approval date: 09/25/91 Loan contract signing: 11/15/91 First tranche disbursement: 12/13/91 Second tranche disbursement: 03/26/93 B. IDB FINANCING (million US$) Total IDB amount disbursed 325 Total Program 650 IDB percent of total 50 % C. FINANCING (million US$) 1. Total 650 IDB loan (Ordinary Capital) 325 WB loan 325 2. Disbursement Schedule ma H& First tranche 162.5 162.5 Second tranche 162.5 162.5 3. Loan Disbursement Disbursed 325.0 Canceled none 4. Disbursement Dates Expected Actual First tranche 12/15/91 Second tranche 12/31/93 03/26/93 at the latest 5. Terms Grace period 5 years Amortization 20 years First amortization 11/15/96    LMI MA N Repcrt No 1478 1 Type: ICR