Argentina - Second Industrial Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY . Report No. 3538a-AR STAFF APPRAISAL REPORT ARGENTINA SECOND INDUSTRIAL CREDIT PROJECT November 5, 1981 Projects Department Latin America and the Caribbean Regional Office 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 December 31, 1975 US$1 = $a 65 $al = US$.0154 December 31, 1976 US$1 = $a 277 $al = US$.0036 December 31, 1977 US$1 = $a 599 $al = US$.0017 December 31, 1978 US$1 = $a 1,007 $al = US$.0010 December 31, 1979 US$1 = $a 1,622 $al = US$.0006 December 31, 1980 US$1 = $a 2,000 $al = US$.0005 June 30, 1981 US$1 = $a 4,963 $al = US$.00020 (Financial Rate) 1/ June 30, 1981 US$1 = $a 7,565 $al = US$.00013 (Ex/Import Rate) 1/ LIST OF ABBREVIATIONS BANADE - Banco Nacional de Desarrollo (National Development Bank). BCRA - Banco Central de la Republica Argentina (Central Bank). FIEL - Fundacion de Investigaciones Economicas Latinoamericanas (Latin American Economic Research Foundation). GDP - Gross Domestic Product. INTI - Instituto Nacional de Tecnologia Industrial (National Institute of Industrial Technology). WPI - Wholesale Price Index. 1/ On June 21, 1981 the Argentine authorities created a dual exchange system with a freely fluctuating rate for financial transactions and a fixed rate to be adjusted monthly for exports and imports.  FOR OFFICIAL USE ONLY ARGENTINA: SECOND INDUSTRIAL CREDIT PROJECT - BANCO NACIONAL DE DESARROLLO STAFF APPRAISAL REPORT TABLE OF CONTENTS Page No. I. THE SECTORS *...................................... 1 A. The Industrial Sector ..... ....................... 1 Introduction ....... ...................... 1 The Structure of Industry ................ 2 Manufactured Exports and Imports ............. 3 Industrial Employment . .................... . 4 Industrial Policy .................... 5 The 1976-80 Program and Its Impact on the Industrial Sector ................. . 6 The New Government Program .. .................... 7 Prospects and Project Implications .............. 8 B. The Financial Sector ............................. 9 The Financial System . . ................... . 9 - The Previous System ..... .................... . 9 - The New System ............................... 10 Monetary Policy ...... ........................... 12 - Interest Rates ...... ......................... 12 - Bank Portfolio Status ........................ 13 - Resource Mobilization and Industrial Financing ....... ........................... 13 C. The Mining Sector ................................ 14 Background ...................................... 14 Supply-Demand for Mineral Products ............. . 15 Government Policy and Legislation ........ ... . 15 Mining Projects ....... .......................... 16 This report was prepared by Messrs. Robert Kanchuger, Claudio Joseph, Peter Wogart, Jose Lopez-Lopez, Jorge Barrientos, Arnaldo Leon, and Andres Liebenthal, following a field appraisal in February/March 1981. This document has a restricted distribution and may be used by recipients only in the performance of their offlcial dutie Its contents may not otherwise be disclosed without World Bank authorization.  - ii - Table of Contents (Continued) Page No. II. THE BANCO NACIONAL DE DESARROLLO (BANADE) .... .......... 17 A. The Institution ................ .. ............... 17 Background ..................................... 17 Board of Directors, Organization and Staff 17 Appraisal, Supervision and Procurement. 19 Manpower Development ..........................19 Management Control and Information . . . 20 B. Operations ...................................... 21 General . . 21 Operations by Departments ...................... 23 - Investment and Development Credit Department 23 - External Finance Department . . 24 - Mining Department .................... . 24 - Ordinary Credit Department . . 25 Financial Policies *.,....................... 25 Lending Terms ....... ...... 25 Financial Position and Results. 26 - General ...... ......... 26 - Revenues, Costs and Profitability . .28 - Portfolio Quality and Reserves ..... . 29 - Source of Funds and Needs .............. 30 Cofinancing .... .......... 33 External Auditing Arrangements . .33 III. THE PROJECT ............... 34 A. The First Industrial Credit Project ........ 34 B. Project Objectives and Design .34 - The Industrial Energy Conservation Component 35 - The Provincial Banks ........................ 36 - Technical Assistance ........................... 37 C. The Proposed Loan ..................................37 General Description .37 Subloan Terms ............. 38 Approval Limits . . .38 Retroactive Financing .............................., 39 Procurement and Disbursemen . . .39 Project Benefits and Risks . . .. . . 39  - iii- Table of Contents (Continued) Page No. IV. AGREEMENTS REACHED AND RECOMMENDATIONS .................... 40 A. Agreements Reached....... 40 B. Recommendations ................. 42 TABLES 1.1 Nominal and Real Interest Rates. 1.2 Sources of Investment Financing. 1.3 Base Metals - Consumption and Local Supply. 2.1 Loans Outstanding in BANADE Portfolio at Year End. 2.2 BANADE's Peso Lending Classified by Purpose. 2.3 BANADE Peso Loans Received by Enterprises Located in Different Areas of the Country. 2.4 Loans Committed by Investment and Development Credit Department. 2.5 BANADE Interest Rates (Peso Loans) 2.6 Growth of Assets and Equity Compared to Inflation Rate. 2.7 BANADE's Portfolio Analysis of Arrears Over Ten Days. 2.8 Arrears Position Over Ten Days by Sector. 2.9 Projected Assets, Loan Portfolio and Equity. 2.10 BANADE's Estimated Foreign Currency Loan Commitments. LIST OF ANNEXES Annex 1 - Supplementary Tables - The Sectors T-l Growth of GDP and lndustrial Output 1971-80. T-2 Structure of the Argentine Manufacturing Sector. T-3 Commodity Exports, 1976-1979. T-4 Output per Worker in Manufacturing, 1973-1980. T-5 Real Effective Exchange Rates for Major Imports and Exports, 1969-1980. Annex 1 - Attachments - The Sectors Attachment 1 Mining Promotion Law.  - iv - Table of Contents (Continued) Annex 2 - Supplementary Tables - The Banco Nacional de Desarrollo (BANADE) T-1 Banking System Deposits. T-2 Banking System Loans. T-3 BANADE Loans Granted in Pesos by Industrial Group. 1977-1979 T-4 Loans and Guarantees Classified by Purpose. 1977-1979 T-5 Past and Projected Balance Sheets of BANADE (pesos). 1975-1985 T-6 Past and Projected Balance Sheets of BANADE (dollars). 1975-1985 T-7 Past and Projected Income Statements of BANADE (pesos). 1976-1985 T-8 Past and Projected Income Statements of BANADE (dollars). 1976-1985 T-9 Past and Projected Source aLnd Application of Funds Statements of BANADE (pesos). 1976-1985 T-10 Past and Projected Source and Application of Funds Statements of BANADE (dollars). 1976-1985 T-l1 Breakdown of BANADE's Arrears Position by Main Categories. T-12 BANADE's Arrears Position by Location. T-13 BANADE External Lines of Credit, January 31, 1981. Annex 2 - Attachments - The Banco Nacional de Desarrollo (BANADE) Attachment I BANADE's Board of Directors. Attachment 2 BANADE's Organization Chart. Annex 3 - Attachments - The Project Attachment 1 Industrial Energy Conservation. Attachment 2 The Instituto Nacional de Tecnologia Industrial (INTI). Annex 4 - Disbursement Schedule. Annex 5 - Documents in Project File. MAP  I. THE SECTORS A. The Industrial Sector Introduction 1.0 Argentina was one ot the first Latin American countries to develop a sizeable industrial sector. The growth of industry was fostered by a growing domestic demand and by natural protection resulting from its distant location from major world centers of industrial production. By the turn of the century, industry's share ot GDP was about 15%, and about 20% of the nation's labor force was employed in a large number of relatively small plants mostly involved in the primary processing of agricultural products such as wool, beef, hides and leather, dairy products, vegetable oils and extracts; wood pulp, paper printing and publishing; and non-metallic minerals and construction materials. During the first half of the twentieth century, the industrial sector went through periods of rapid growth during the depressior of the 1930's and during World Wars I and II, largely because of the need to substitute for imported goods that were no longer available. The textile industry increased its share of the domestic market from less than 30% in the 1920s to 50% in the 1940s. Even more rapid was the shift to domestic rubber production, which had provided less than 101' ot total consumption before 1930 but was able to furnish nearly 90% by the end of the decade. During World War II, Argentina's industrial sector further increased its overall share of the domestic market (to about 85%), as basic industries were established to produce metals, machinery and appliances, and the first public investment in industry was made in the strategic steel industry. 1.02 In the early post-war period, the industrial sector continued fu grow quite rapidly with the introduction of modern technology and knowhow, achieved largely through substantial foreign investment, which increased from US$15 million in 1954 to over US$100 million by 1961, increasing the foreign share of industrial investment from 3% to nearly 10%. Protection from competing imports was granted almost indiscriminately, and favored traditional industries such as processed foods, textiles and other consumer goods, as well as the establishment and rapid expansion of new durable goods industries, especially automobiles, metal products and petro-chemicals. The government took an active role in stimulating the growth of industry through the use ot a combination ot toreign exchange and import controls, high tariffs and special tax incentives, and by establishing public sector enterprises in basic industries such as steel and petro-chemicals. At the same time, the government pursued policies which encouraged high wage settlements, which resulted in rapidly increasing labor costs. Under these conditions there was little incentive for industrialists to establish efficient, cost-effective plants, and many enterprises suffered from low capacity utilization, high operating costs and low productivity. In addition, recurring high inflation discouraged real competition among firms and did not provide an incentive for increasing efficiency or reducing costs. 1.03 From the mid-1950's to the late-1970's, fluctuations in industrial output and investment were more significant in Argentina than in the other major industrial nations in Latin America. The growth of the sector was either zero or negative during 6 of 25 years in the period 1955-79, reflecting foreign exchange shortages and numerous government price stabilizacion efforts to cut back demand. Nevertheless, average growth rates both for industry and  -2- GDP, were about the same in Argentina and its neighbors. The major reason for the continuing growth of Argentine industry was the initial dynamism of newly established industries such as petro-chemicals, mechanical engineering and transport equipment, which more than doubled their output between 1950-75, and increased their share of total manufactured output from 16% to 34% during the same period. Anniual growth in manufactured value added, which had averaged 4.1% in the 1950's, rose to 5.6% in the 1960's and accelerated to 7.2% between 1970-74, before i.t fell by -0.1% during 1975-79. As a consequence, the share of manufacturing in total value added rose from 25% in 1950 to 29% in 1970 but has since been reduced to the 26% level (see Annex 1, Table 1). The Structure of Industry 1.04 Manufacturing represents the principal sector in the generation of gross domestic product. In many respects, Argentina's industrial structure is similar to that of industrialized countries. It is highly diversified with a substantial proportion (exceeding 60%) originating outside the traditional consumer-goods industries and involving the production of relatively sophisticated capital goods, intermediates and durable goods. Nevertheless, the high price structure of many manufactured products, especially among the more "dynamic" industries, suggests that industrial output is overvalued (i.e. at international price levels the value of indus- trial output relative to other sectors of the economy is less than the relative value stated in domestic prices). 1.05 While there has been substantial restructuring with the various subsectors of the manufacturing sector during the 1976-80 period, the data for the major subsectors indicate a continuation of the earlier trend away from the traditional industries. Compared to 1970, food beverages, tobacco, textiles and clothing lost over 5 percentage points of their contribution to manufacturing value added, while the metal mechanical, vehicle and machinery sectors gained over 4.5 percentage points (See Annex 1, Table 2). 1.06 The most recent industrial census in Argentina was carried out in 1974. It indicated that over one-half of the industrial firms registered in Argentina are located in the city or surrounding province of Buenos Aires. Tw-o other provinces, Santa Fe and Cordoba, also are important industrial centers, and together account for an additional one-fourth of registered firms. Firms in the province and city of Buenos Aires area tend to be larger than those in the rest of the country, and consequently, almost three-fourths oF the nation's industrial workers are employed in those areas. The pattern of distribution is as follows: Province No. of Firms % of Total No. of Workers % Total Buenos Aires 50,144 38 710,600 47 Buenos Aires (city) 26,448 20 370,300 25 Santa Fe 16,053 12 144,500 10 Cordoba 14,210 10 113,700 7 Other 26,847 20 170,100 l' TOTAL 133,702 100 1,509,200 100  - 3 Manufactured Exports and Imports 1.07 Since high-cost import substitutes, sold almost exclusively to domestic customers, continued to require large amounts of imported inputs, both industrialists and policy-makers realized by the early 1960's that high and stable growth rates could not be achieved without engaging in a program of export diversification. In 1962, several fiscal measures, such as 'drawbacks"t and rebates on taxes as well as special lines of credit at subsidized rates of interest, wqere introduced. Because of an erratic exchange rate policy, however, these measures had little effect on industrial exports during the early years of the export diversification drive. Significant strides were made only in the late 1960's when the authorities simplified the exchange rate system, extended the "drawbacks", instituted a tax refund incentive of 10% of the value of exports and negotiated new preference agreements with the LAFTA partners. These measures were further bolstered by increased export credit facilities by the Central Bank and by establishment of an export insurance scheme. 1.08 Argentina has traditionally been an exporter of processed agricul- tural goods, such as meat and dairy products, vegetable oils and extracts, wood and, more recently, sugar and soybeans. It is only in the last 15 years that manufactured exports have become important. The rapid expansion of the "dynamic" industries is reflected in the changing export shares experienced by the various subsectors, with machinery and vehicles accounting for nearly 40% of total manufactured exports by 1976, metal products industries increasing their share to 13%, and the share of traditional industries falling from 50% to 25%. Argentina used its more advanced technical knowledge in entering into preference agreements within the region to sell goods to other Latin American countries; about one-half of manufactured exports went to other LAFTA countries. 1.09 Real export growth was fairly rapid, averaging 18.6% per year between 1966-70, and 21.6% between 1970-74, and about 15% on average, there- after. Since the mid-1960's industrial exports have made an increasing con- tribution to the growth of total exports. In 1965, industrial exports amounted to 25% of total exports but by the mid-1970s their share had risen to almost one-half; although agro-based manufactures are the main component of this trade, the share of the non-agro based manufactures has also risen. Manu- factured exports reached a high of US$1.6 billion in 1978 but declined subsequently as a result of the significant real appreciation of the exchange rate. Consequently, after manufacturing's share of total exports advanced from 8% in 1966 to 26% in 1978, it declined to 20% by 1980. 1/ Declines in exports were significant in automobiles and in such traditional and rela- tively labor intensive activities as textile and leather products. This shortfall was partially offset by substantial increases in the foreign sales of resource-based products such as petroleum derivatives and metals, par- ticularly aluminum, iron and steel (see Annex 1, Table 3). I/ Since industrial exports represent only about 10% of industrial output but about 50% of total exports, a relatively minor shift in terms of output can have a major impact on the composition of exports.  - 4 - 1.10 Industrial imports doubled between 1970-75, increased only margin- ally between 1976-78, but grew by 73% in 1979 and 55% in 1980. The import! GDP ratio rose from 8% to 10% in :L979, and in 1980 to 12%. Increasing i'mport competition for industry is indicated by the expanding share of imports in total supply of manufactured products; by 1979-80, there was a substantial. degree of openness in the capital goods sector, a relatively large and still expa-nding share of imports in the intermediate goods industries, and a small but rapidly increasing import penetration in the consumer goods sector. Industrial Employment 1.11 The manufacturing sector has offered limited new opportunities for employment during the last thirty years. This has been due primarily to the fact that: (i) new industries and technologies introduced were relativel,y capital intensive; (ii) successive governments artificially reduced the relative cost of capital by subsidizing interest rates and overvaluing the foreign exchange rate for capital goods; and (iii) labor legislation with its inflexible rules and substantial fringe benefits discouraged labor intensive production. l112 Total employment in the manufacturing sector, which had reached 1.4 million in 19509 expanded by about 1% p.a. on average between 1950 and 1970. In spite of its rapid growth in output, the share of employment generated by the "dynamic" industries has remained constant since the late 1950's (at 38% of total manufacturing employment). Manufacturing employment as a percentage of total employment actually declined from 28% in 1950 to 25% in 1970. It was only in the early 1970s that labor absorption by industry began to grow, (averaging about 3% p.a. between 1970-75), but this increase was almost entirely the result of a rapid expansion of output and employment by state-owned enterprises. During the 1976-80 period overall unemployment in Argentina was the lowest ever recordeid, largely caused by large labor transfers between the manufacturing and service sectors. It is estimated that employment in manufacturing fell by about 20% between 1975 and 1980, and that by the end of the latter year, employment in manufacturing was only 20% of total employ- ment. The reduction in employment was particularly sharp for the intermediate and capital goods industries, which decreased their work forces by nearly 30% in the last five years. While tax legislation, introduced in October 1980, has lowered labor costs by reducing the social security contributions of industrial enterprises by 20%, the effect on employment has yet to be realized. 1.13 This development combined wiith the investments in new machinery and equipment made by those sectors led to substantial productivity increases in the 1977-80 period, particularly in capital goods industries. Output per worker in 1979/80 was on average 30% above the 1975/76 level, and output per working hour realized a 20% gain (see Annex 1,, Table 4).  -5- Industrial Policy 1.14 In the past, Argentine foreign trade and investment policies have paid inadequate attention to considerations of economic efficiency and long- run balance of payments equilibrium. They have focused on growth and diversi- fication through an import substitution strategy utilizing multiple exchange rates, import tariffs and restrictions, as well as numerous fiscal and credit incentives for investment in less developed regions. While the general pattern of trade policies is readily described and summarized, the actual effects of these policies on industrial development are difficult to measure. Output, employment, exports and imports and other variables have been subject to a great number of other policy measures, some of which had very little economic rationale. Due to the structural disequilibrium between a low-cost export oriented agricultural sector and a high-cost domestically oriented industrial sector, several Argentine governments opted for multiple exchange rate systems; these were characterized by fixed nom-iral exchange rates which were adjusted sporadically by substantial jumps, combined with import tariffs and surcharges to limit imports and varying sets of fiscal and monetary incentives to stimulate non-traditional exports. 1.15 Protective tariffs have existed since 1875, but it was only during the Depression that they were raised to significant levels. This system became more prohibitive in World War II and in the early postwar period with the introduction of prior import deposits and bilateral trading agreements. Throughout the postwar period Argentina continued the policy of high protec- tionism. Although nominal tariffs were among the major tools of import protectior. during the early 1960s, exchange surcharges ranging from zero to 235% were the most important means for protecting industry. Low or zero surcharges were levied on such important inputs as iron ore, rubber, newsprint, fertilizer, coal and petroleum products. On the other hand, consumer goods, automobiles and luxury goods were charged with rates of over 200%. Due to the overvaluation of the basic import rate this structure of surcharges increased the "effective" protection for many consumer goods even more. In addition, special protection was granted to such industries as steel and textiles through the introduction of "official" prices, on which duties were based. 1.16 It was not until 1967 that a general tariff reform attempted to rationalize the whole protection system according to the extent of import competition, degree of fabrication, and economic end-use. By reducing the extremely high tariffs for certain products, the average legal tariff level was reduced from 119% to 62%; at the same time, the peso was devalued by 42%. Since tariffs continued to be set higher for consumer than for industrial inputs or investment goods, "effective" rates were one-and-a-half to two times above the nominal rates, reflecting the fact that imported inputs of raw materials and intermediate inputs were either freed from import duties or were taxed at low rates. The tariff reform of 1967 was reversed, by increasingly restrictive foreign trade policies in subsequent years. Tariff rates for most durable consumer goods and those capital goods produced in the country were set at levels of over 100% in the early 1970s. In addition, the authorities designed an increasing number of import controls and import finance restric- tions. During the balance of payments crisis in 1974, imports of 600 items,  - 6 - mostly consumer goods, were prohibited; another 1,200 items were added to the prohtbited list in 1975. Importers were furthermore required to deposit a sum equal to 40% of the C.I.F. value at the Central Bank; these prior deposits were raised to 100% at the beginning of 1975. Tle 1976-80 Program and its Impact onz the Industrial Sector 1.17 In 1976 a new Government came into power, with a basic aim of achieving a more stable growth and increased productivity through: (i) stabil- izing prices through control of public expenditures and wages; and (ii) liberalizing trade to enable Argentine industry to become more competitive internationally. Steps were taken to unify the exchange rate, and imports of most items covered by the 1972 and 1975 prohibited lists were freed in July 1976. In November 1976, tariff rates for 4,000 of 7,600 positions in the tariff schedule were reduced by an average of 25%. In order to lower effective protection more rapidly, the authorities concentrated on cutting import tariffs on final products. 1.18 Interest rates were freed, and quantitative restrictions on imparts and advance import deposits were abandoned in 1977. To recover quickly from several years of price control, a large number of manufacturers raised their prices more often and at higher rates than was justified by cost consideration.s. Consequently, the Government initiated a number of discussions with individual industry groups and used reductions in import tariffs as a tool to enforce relative price stability. Import tariffs for manufactured goods were brought down from an average of 94%, in 1976 to 53% in late 1977. 1.19 When industrial prices continued to increase at about 150% per year in 1978, the government adopted a strategy designed to more radically open up the economy to foreign competition by combining tariff reductions together with a preannounced exchange rate policy of stepped reductions utilizing decreasing rates of devaluation. Preannounced limits on rates charged by public utilities, wages, and net domestic credit, were introduced to low-er inflationary expectations and to restrain Argentine businesses from increasing prices. Import tariffs on industrial products were further curtailed in 1978 to an average of about 30%. 1/ 1.20 Prior to 1976, the swings of Argentine economic policy went between favoring urban-industrial-import substitution activities and rural-agricultural- export activities. In 1979/80 this was changed. Both import substitutes and exports suffered from the low peso/dollar exchange rate. Meat packers and textile factories alike were squeezed. The main criteria separatirig the favored from the unfavored were: (a) a firm's capital structure; and (b) the distinc- tion between traded and non-traded goods. Industrial firms that had high debt-equity ratios were hurt, while more conservative firms with either a lower debt or a larger part of their debt in, foreign currencies were less affected. Producers of goods that were exporting or that were subject to 1/ Nevertheless, effective protection still averaged close to 70% in early 1980, after all non-tariff import fees as well as freight and insurance charges were included.  import competition suffered, while producers of services and of nontrade- able goods prospered. Some firms were affected indirectly. Suppliers of synthetic textile firms did not suffer from direct import competition, but their market weakened because of import competition in textiles. Paper produjcers and glass bottle makers supplying packaging material to domestic food processors suffered as food products exports fell and imports rose. Diesel engine manufacturing was cut to one-fourth of capacity, because the demand for domestic tractors and earth-moving equipment fell precipi- tiously. 1.21 The hardest hit were firms with high peso indebtedness and rapidly decreasing import protection coverage. The archetype was the fruit canning industry, which formerly had exported a significant part of sales, but then became subject to import competition. It is an inherently seasonal industry, accustomed to financing high seasonal working capital requirements including high cost tin cans. because half of all tin plate used must be purchased at high prices from SOMISA, the state-owned steel plant. Major companies in this industry ceased operating in 1980. Other hard-hit activities included electronics (competition from the Far East), but not color TV which enjoyed "infant" industry protection; meat packing and fishing (high input prices, relatively low international prices); some textiles (competition from Brazil, the Far East and elsewhere); paper products, and some chemicals (a reflection of their customers' problems); tractors and earth-moving equipment (import competition plus weak investment demand from the agricultural sector); and associated engine and tire manufacturers. The New Government Program 1.22 When on March 29, 1981, a new government assumed office in the face of a deteriorating balance of payments situation, it opted for a devaluation of the peso by 30%. In order to diminish the inflationary impact of the devaluation: (a) export taxes for traditional agricultural products were raised to 12%; (b) export reimbursements for regional products were lowered by three percentage points; and (c) export reimbursements for manufactured products were limited to a maximum of 25%. 1.23 On the import side, all external tariffs of 55% and over were reduced by 12 percentage points. The maximum tariff for all commodities over 43% and less than 55% were cut to 43%. A Governmental Commission of representatives of the Ministries of the Economy and Finance, Industry and Mining, Agriculture, Trade, and Public Services is to evaluate the current import tariff and export reimbursement system and make suggestions for possible change in late 1981. 1.24 Although the maxi-devaluation was accompanied by a modest attempt to confiscate windfall profits in exporting activities, the basic policy principles of the current authorities have been very much the same as the 1976-80 guidelines. The new Minister of Economy made it clear that the government was determined to: (i) maintain the program of opening up the economy; (ii) unify external tariffs and export reimbursements; and (iii) minimize negative effective protection in the productive sectors.  - 8- 1.25 Uncertainty prevailed until mid 1981, characterized by a continuous outflow of foreign exchange; industrialists pressured for increased protection and/or more devaluation. In June a second and third devaluation of 30% each was undertaken, giving to the manufacturing sector a real exchange rate which was over 257% above the one which they experienced in 1977, at a time when the sector realized rapid advances in output and exports. Prospts and Project Implications L126 The new economic team, which took office at the end of March, has to resolve a number of problems simultaneously. It will have to walk the tight- rope between stimulation of production on the one hand and stabilization on the other. After the recent devaluations inflation accelerated again, although economic activities were depressed. Resolution of the inflationary problem will involve important decisions, bearing directly on the welfare of the industrial sector. Currently, the authorities are engaged in a renewed attempt to control public sector outlays and with it decrease spending on non- tradeable goods and services. On the other hand, there seems increasing need of industry specific policies. While the new President's promise to stimulate the productive sector, has not yet been translated into specific fiscal and monetary incentives beyond the peso devaluations, which reduced competition for imports and increased the profitability of exports, the financial restructuring of a large number of enterprises is to proceed with help of the public sector through substantial rediscounts from the Central Bank. 1.27 Significant structu-ral changes have occurred in the last few years; yet it is too early to detect a clear pattern of industrial development which is broadly in line with Argentina's comparative advantages. At first sight, it would seem that the change from the traditional to the more modern and capital intensive subsectors has continued, but a series of interviews conducted by the Bank with over 50 inclustrial firms (both large and small) shows that relative gains which certain subsectors made in one year were cancelled out later. The degree of uneven protection in 1979/80, together with the real appreciation of the peso, had an important bearing on indus- trial production of major subsectors, the capital goods sector being probably the most prominent example. The 1980 tax changes and the more recent exchange rate increases have, however, significantly improved the productive sector's situation in general and the incentive system of the manufacturing sector in particular. If the policy objective of lower and more even protection is implemented, it is likely that the emerging industrial structure will become more efficient, but also more capital intensive. 1.28 While the economic policies of the previous government to restructure the industrial sector became increasingly severe and were encountering mounting difficulties, they held the promise of increasing industrial produc- tivity through greater specialization and consolidation and improving resource allocation. The concepts of more effectively controlling production costs, operating efficiently and meeting the challenge of external competition had  - 9 - become part of industrial thinking. To what extent the current authorities will be able to continue the opening-up process without incurring major disruptions and distortions in the industrial sector will depend crucially on their ability to improve rapidly public finances and control inflation. The Government has indicated its intention to the Bank to promote increased industrial efficiency and exports and to liberalize foreign trade, using policy instruments which will take into consideration trade policies of Argentina's major trading partners. A comprehensive industrial sector profile study will be undertaken by the Ministry of Industry in 1981/1982 and will include an analysis of effective protection of Argentine industries, which will help to set guidelines for future action with regard to industrial sector policies. Satisfactory terms of reference for the effective protection study and the assignment of qualified personnel for carrying out the study will be a condition of loan effectiveness. The government has agreed to discuss with the Bank the study on effective protection, and its future course of action with regard to industrial sector policies. The specific study on effective protection will be carried out not later than June 30, 1982. B. The Financial Sector The Financial System 1.29 The financial system in Argentina consists of the Central Bank (BCRA), four national banks (Banco de la Nacion, Banco Nacional de Desarrollo, Banco Nacional Hipotecario, and Caja de Ahorro y Seguro), 31 provincial and municipal banks, 177 private commercial banks, 230 finance companies and 28 mortgage banks. The total number of financial institutions declined from over 700 entities in the mid-1970s to 470 entities in 1980. As a consequence of the 1977 legislation favoring the establishment of all purpose commercial banks, the number of commercial banks nearly doubled while the number of finance companies have more than halved. The process of consolidation and restructuring of the banking system can be expected to continue until the present period of economic adjustment is completed. 1.30 The previous system. From September 1973 until May 1977 a system of nationalized deposits was in effect in Argentina for the second time in the post-war period. In the centralized system deposits were accepted on the account of the Central Bank which paid interest while financial entities received a commission fee for their intermediary role. Banks were res- ponsible for credit and investment management under Central Bank established limits, conditions and guarantees of bank portfolios. Levels and direction of credit were determined through rediscount policy, which attempted to be selective in two aspects: (a) channeling credit volume to particular financial intermediaries according to criteria unrelated to the volume of deposits received by those same financial intermediaries; and (b) channeling credit to particular economic activities and particular geographic regions. The official justification for this system was to allow tight monetary control by the Central Bank and to obtain the best distribution of available credit according to the requirements of the economy.  -- 10 - 1.31 While possibly attractive in theory, the application of the system had negative effects. Credit redistribution among financial entities affected their profitabilities differently and reduced competition. In order to affect the desired redistribution of credit, interest rates were differentiated according to sector, region and time of the year. Conceptual and practical difficulties of defining criteria for credit assignment, and the impossibility of controlling the marginal use of resources, prevented the system from attaining its goals, resulting in an inefficient assignment of resources. 1.32 Ihe process of accelerating inflation that started in 1974, jointly with a fixed interest rate policy pursued during the period, resulted in negative real interest rates for most financial assets and led to changes in the system of centralized deposits. A subsystem in the form of an acceptance market developed. The system of term deposits, even though operating formalliY within the centralized system, started to work de facto in a decentralized way, with banks allowed to issue credit automatically in relation to the amount of deposits that they had captured. l/ The system resulting from these changes was a hybrid, composed on one side by a centralized subsystem for which a 100% reserve requirement was in effect and on the other by a sub- system with a zero percent reserve requirement. Since the subsystem with no reserve requirements expanded rapidly., the actual average reserve requirement for the system as a whole tended to decline over time. in late 1974, the Central Bank progressively lost control over the system and hence the money supply. The financing of the public sector deficit and the level of redis- counts increased at the same time as the money multiplier increased with the effective decline in the reserve requirement. Thus, both the behavior of the monetary base and of the multiplier led to an explosive increase in the money supply. 1.33 The new system. The economic program announced on April 2, 1976, included a profound reform in the financial system among its goals. This reform reintroduced the full intermediation role of the banking system, provided the financial system with a legal and regulatory framework that has led to increasing degrees of competitiveness and efficiency, and set solvency and responsibility requirements on financial institutions in accordance with the nature of their respective activities. One of the first measures taken by the new economic authorities in pursuit of those goals was to convert the previous centralized deposit system to a new system! where monetary control was achieved through the application of a minimum reserve requirement and through open market operations. The new system started to operate on June 1, 1977. It reserves monetary intermediation to commercial banks, the only entities allowed to accept current deposits, and allows complete freedom of interest rates; it establishes competition as the means to obtain an efficient finan- cial system, and thus places minimal regulation on entry into the market; and it establishes a guarantee system for deposits in national currencv in all financial entities. 1/ For a while this last system was subject to interest rate regulations, but starting in June 1975, banks were permitted to freely set interest rates on loans and deposits.  - 11 - 1.34 The impact of the reform has been substantial. The deregulation of interest rates has resulted in positive real rates and, thus, for the first time in decades Argentine savers have beern able to protect their savings against inflation in the domestic financial markets. The increase in savings channeled through the banking system has progressively raised the monetization of the Argentine economy. The ratio between monetary assets (M3) of the private sector to GDP has climbed from 8% in 1976 to 18% at the end of 1978, 21% at the end of 1979, and 30% in 1980. The increased monetization has allowed a two-fold increase in real terms in the volume of credit available through the financial system. At the same time, a shift in the composition of that credit has occurred. In 1976, total credit to the private and public sectors accounted for 64% and 36% respectively; as of December 1980, credit to the public sector accounted for 23% of total credit, thus raising the private sector share to 77%. 1.35 Even thcugh the financial reform has been successful in promoting savings, increasing monetization of the Argentine economy, and expanding private sector credit, the Argentine banking system encountered growing prob- lems in 1980/81 as a result of the weakened financial position of the indus- trial sector and the lack of experience of the monetary authorities. The main issues relating to the Argentine banking system and its operations have been: (a) the short-term and unstable nature of its deposits and the associated difficulties of extending the maturities of the loans; (b) the volatility and relatively high levels of domestic interest rates; and (c) the weak portfolios of many private domestic banks leading to numerous failures and increased participation of foreign and public sector banks. 1.36 In order to improve the financial structure of firms in the indus- trial sector, the authorities plan to introduce a policy of Central Bank rediscounts in late 1981, which commercial banks will be able to use for long-term lending. Financial institutions can borrow up to the equivalent of 12% of their deposits from the Central Bank and use these funds for four year loans with a grace period on principle of two years and interest payments to be made by the end of each year. The rediscount rate is determined by a bidding process, with the minimum rate set by the daily interest rate of depositors in the Argentine banking system. Eighty five percent of the loans have to go to the primary sectors and manufacturing in order to restructure the debt of enterprises in those branches. Borrowers may not receive more than 30% of their total outstanding debt. 1.37 The strengthening of the financial system is to be achieved by in- creased capitalization of banks, enforcement of inflation accounting to prevent financial intermediaries from distributing illusory profits, and increased financing for the mergers and acquisitions among national financial institutions. In addition, financial incentives will be offered to broaden the demand for stocks on the domestic capital market.  - 12 - Monetary Policy 1.38 Monetary and credit policies from 1976 to 1980 have been an integral part of the economic stabilization and reconstruction program, aiming At remonetizing the economy and at improving resource allocation thro-ugh the reformation and liberalization of money and capital markets. Since the fiscal deficit had become the major source of monetary expansion in 1975 and early 1976, the thrust of the stabilization program was on control- ling public expenditures, raising tax collection and covering the remaining deficit through non-inflationary financing. For the monetary authorities it meani reducing deficit financing by the printing press and attracting private finds for Treasury obligations. Until late 1978, several attempts were made to control money supply and with it total credit. With the adoption of the prefixed exchange rate policy within the monetary approach to the balance of payments in early 1979, mobility of external capital became a keystone of economic policy, leaving the monetary authorities only with the control over net domestic credit. 1.39 Interest rates. The most recurrent complaint of the industrial business coAmunity during the last four years in Argentina refers to the high levels of interest rates. Many firms have experienced difficulties because of high fJlancial costs, which in some cases rose to over 20% of total revenue. However, a look at the development of interest rates indicates that after the initial surge in 1977 and early 1978, real interest rates were well below 10% for over 18 months. It was only during the second semester of 1980 and the first quarter of 1981 that interest rates increased rapidly in real terms, this time as a consequence of strong expectations of a large devaluation. Table 1.1: NOMINAL AND REAL INTEREST RATES (Annual Averages) Nominal Rates Real Rates Weighted Domestic Foreign Domestic Foreign Average 1977 196.6 133.6 20.0 -5.3 11.7 1978 195.4 89.9 21.4 -22.0 7.1 1979 144.8 86.8 6.9 -18.4 1.4 1980 104.9 42.8 29.9 - 9.5 16.9 SOURCEe Mission estimates.  - 13 - 1.40 With total freedom of capital movements, the Argentine financial system became rapidly integrated into the world financial system. Foreign funds have been playing a major role in providing financing for Argentine firms and in establishing upper limits to interest rates. Internal interest rates are determined largely by international interest levels plus expected peso devaluation. Until early 1980, expectations were increasingly contained, but after the banking crisis in March and April expectations of a substantial peso devaluation ran high. The change from the original adjustment schedule to a 1% per month (October-December 1980) and later 2% per month devaluation (January-March 1981) and finally the 10% devaluation in February 1981, forced domestic interest rates even higher without attracting new external capital. The new authorities devalued the peso by 30%, when they came to power in April 1981. That measure, however, was insufficient to stabilize expectations and consequently the government introduced a two tier exchange rate system in June 1981, after devaluing the Argentine peso by a further 60%. The export/ import exchange rate was fixed at a$4,963 per US$1 ard has been adjusted upwards according to the difference of international and domestic inflation. The free exchange rate for financial transaction started out at a$7,565 per US$1, in- creased slightly in July but has since then stabilized. 1.41 Bank portfolio status. The portfolios of most Argentine banks contain significant amounts of bad debt. A 1980 Central Bank survey of the portfolio structure of 200 banks set the figure at 40% but that included all loans which were in arrears by 10 days or more, an unusually conservative definition of "bad" debt. The relative inexperience of Argentinian bankers in risk assessment and the existence until recently of a guarantee system for bank portfolios have been major causes of portfolio weakness. Two generations of Argentine bankers have grown accustomed to risk-free banking activity. With the establishment of a free banking system, many Argentine bankers have failed to recognize the new risk component or have lacked risk assessment expertise. Furthermore, the difficulties in risk evaluation have been compounded by the unstable economic environment. The short-term impact of the tariff reform and exchange rate changes made projections of the future based on past experience of particular sectors and firms difficult. 1.42 Another dilemma was presented by the 100% guarantee system for bank deposits. That guarantee system was introduced to give domestic banks a better chance to compete with foreign and official banks. The system, however, allowed banks to grow by competing for deposits with above-market deposit rates. Those banks then accepted above-average risks. While guaran- tees were lowered in late 1979, many Argentine banks and financieras are still offering high interest rates and accepting high risk loans and thereby leaving open the possibility of future bank failures. 1.43 Resource mobilization and industrial financing. Total gross private investment, which had grown by almost 86% in real terms during the period from 1967 to 1975, fell back to the 1973/74 level during the 1977/80 period (Table 1.2). The decline in investment in the 1977/80 period can be attributed to three principal factors: (a) declining demand for goods experienced by some subsectors as a result of the opening of the economy and the restructuring of the industrial sector; (b) higher financing costs; and (c) uncertainty about future economic developments.  - 14 - 1.44 Private investment financing needs in Argentina have traditionally relied heavily on depreciation and retained earnings. The difficulties expe- rienced by some industries in the 1977/80 period reduced the availability of financing from these sources. The mix of loan financing changed in this period as domestic interest rates soared and external capital became available at lower rates. The percentage of foreign loan financing as a share of private investment almost tripled from 1975/76 to 1977/80, while the percen- tage of domestic loan financing declined by about a third. The amount of new equity investment including direct foreign investment, although not large in absolute terms, took a large percentage jump from 1% to 2.7% of total financing in the period 1975/76 to 1977/80. Table 1.2: SOURCES OF ILNVESTMENT FINAiCING Private investment and its financing 1967/69 1970/72 1973/74 1975/76 1977/80 Gross Private Investment 10.15 13.06 13.20 18.89 12063 (in 1970 bill $a) Financing (in % of Gross Private Investment) l. Depreciation and retained earnings 75.1 66.0 66.2 55.5 60.0 2. Equity capital 6.0 4.1 13 1.1 2.7 Foreign 5.3 3.0 0.9 0.8 2.1 Domestic 0.7 0.8 0.4 0.3 0.6 3. Debt 18.9 29.9 32.5 43.4 37.4 Domestic 18.2 19.9 34.l 29.1 24.8 Foreign 0.7 10.0 -1.6 4.3 12.6 SOURCE: IBRD, "Argentine Special Report: Private Sector Impact of 1976-80 Program." C. The Mining Sector Background 1.45 Although Argentina shares some of the favorable geological features of its neighbor Andean countries, the mining sector makes a far smaller contribution to its economy than it does in those countries. Since 1960 the sector's participation in GDP has been between 1.5-1.7%, equivalent to about US$350 to US$400 million per year (1978 prices). Most of this con- tribution comes from the mining of non-mnetallic minerals including construc- tion materials and cement. Mining of the base metals such as copper, lead, and zinc, has been restricted to a relatively limited number of small opera- tions. The only exception has been "Minera Aguilar," which is controlled by a U.S. company and operates a 2,200 tons per day mine and concentrator in the  - 15 - Andes producing zinc, lead, and silver concentrates. The government that came to power in 1976 committed itself to increasing the importance of the mining sector in the Argentine economy by promoting private sector exploration and development. Supply-Demand for Mineral Products 1.46 To understand better the mining sector in Argentina it is necessary to differentiate three subsectors: (a) mining of base metals, (b) mining of iron ore, and (c) mining of non-metallics. As shown in Table 1.3, Argentina's relatively small requirements for base metals, with the exception of copper, tin, nickel, and other minor metals, is practically covered by domestic supply. Imports in 1978 amounted to US$56 million for copper, US$10 million for tin, and US$5 million for nickel. Table 1.3: BASE METALS--CONSUMPTION AND LOCAL SUPPLY l1 Consumption Domestic Supply Metric Tons Metric Tons Lead 31,000 31,000 Zinc 32,000 37,000 Copper 30,000 2,000 Tin 1,200 600 Nickel 800 - Tungsten 70 70 l/ Domestic supply includes only Argentine mine production, it does not include metals imported as such or contained in concentrates. 1.47 The mining of iron ore is practically restricted to one operation, Hierro de la Patagonia, with a total production of about 200,000 tons per year of ores containing 44% iron. Steel consumption in the country is estimated to be about three million tons per year, with total imports of iron ores, steel, and related products amounting to some US$274 million in 1978. The industry of non-metallics, including construction materials (crushed stone, ballast, gypsum, lime, clay, etc.) and cement is well developed in the country and it appears that the local supply is adequate. Nevertheless, imports of salt, sulphur, stones, ceramics and other non-metallic products amounted to some US$40 million in 1978. Government Policy and Legislation 1.48 Although the government that came to power in 1976 stated from its inception its intention to promote the development of Argentina's mining sector, it has been only recently that two key decree-laws have been issued to  -- 16 - is erfect The MIning Promotion Law (Regimen de Promocion Minera), (Ley No. 22095 of October 1979) is intended to promote the development of mining activities, including research, exploration, development, and exploitation of m:ness-. .-prodlucts and its beneficiation, smelting and refining, through duty exerarstions and tax incentives for investments in these activities (Annex 1, Attac:hment ). In addition, the mining code was amended (Ley No. 22259 of Ju1;7 I.9A,C' tn bring it up to date with new technological developments and, by add1ng two new chapters, to outline a legal framework for developing large sca:le. min_n_ through concession contracts for exploration and exploitation. These contracts are to be let by the government under International competi- tisiea `dding and are intended to attract foreign investors. 1.eif Tihe 14ining Promotion Law also regulates the operation of the Mining Devel opment Funid, which was created in 1974 to provide financial assistance for exploration and mining feasibility studies to medium and small scale inling projects. This fund is basically financed through a duty on imports of mineraf pAroducts and semi-processed metals and special contributions by the Ministry of Finarnce. Terms and conditions for the loans are specific for each project. However, should the results of a mining exploration project be neg at Ire the fund ca;: waive the repayment of up to 80% of the amounts loaned. The Funad ts handled directly by the Secretariat of Mining, through its tech- nical r a-ld oarn administrationr is carried out by BANADE, I 5f-' T',,,e nexct most likely major mLining Project in Argentina is the devel- opment o-. El Pachon porphyry copper deposit. Drilling has revealed approxi- mately S'CO million tons of mineralization averaging 0.67% copper and 0.016% molybdenut-i.Z A -feasibility study was prepared in 1978, but no further deci- sLons ha>7a been made on development. St. Joe Minerals has been unsuccessful In attractlng partners for the project. Other possible major future projects are YarIlsa nNegro, BaJo de la Al imbrera, and Nevados de Famatina. The Farallon Negro deposIts have known reserves of gold, silver, manganese, togeLher -wLth some copper. Bajo de la Alumbrera is a porphyry copper deposit with estimated reser-ves of 430 rillion tons of ore averaging 0.85% copper with manor -old. values. Nevados de Famatina has molybdenum and copper potential. The development of the projects mentiolned above, will require very large !investments9 some exceeding US$1 billion. Investments of this size will no douit require external capital financing. There are several small projects F-or deelopment and expansions in the small scale base mining sector where about 20 to 30 small/medium eniterprises are involved. The financial require- ments 'or these projects can be adequately covered by local financing institu- tions, among which BANADE plays the most important role.  - 17 - II. THE BANCO NACIONAL DE DESARROLLO (BANADE) A. The Institution Background 2.01 BANADE was created as an autonomous government-owned development bank in December 1970, out of the reorganized Banco Industrial, which in turn, had been established in 1944 to provide term financing for industry. By early 1976, however, lending at highly negative real interest rates during a period of very high inflation had almost completely eroded BANADE's equity base, and its operations had come to a virtual standstill. Prior to 1976, BANADE's low interest loans frequently became a channel for subsidies to industry and in particular to deficit-ridden state enterprises. Recognizing the importance of the institution as virtually the only domestic source of term financing for industry, the new more open market oriented government that came to power in 1976 recapitalized BANADE, brought in an experienced board of directors and adopted a new Charter. 1/ The new Charter was promulgated by Law No. 21629, dated August 26, 1977. The Charter set the principal objective of BANADE to be the support of industrial and mining development, particularly in the private sector. In doing so, it gave priority to long- and medium-term financing needs, using its own resources and those it obtains in domestic and foreign capital markets. The Charter provides safeguards for the maintenance of BANADE's operational autonomy, sound evaluation standards and financial viability. BANADE's Statement of Objectives and Policies, adopted in 1977, provides support and detail for these objectives. 1/ Since 1976, BANADE's management has sought to concentrate its financial assistance on sound private sector industrial and mining development projects and to apply lending, interest rate and indexation policies designed to conserve its capital base. 2.02 In addition to its primary development banking objectives, BANADE also provides commercial banking facilities and currently ranks third in Argentina among financial institutions in total deposits, having about 4% of the total in the banking system (Annex 2, Table 1). The Banco de la Nacion and the Banco de la Provincia de Buenos Aires rank first and second in deposits. BANADE ranks fourth in the country in loans outstanding, behind the aforementioned banks and the Banco Hipotecario Nacional, with about 3% of the total (Annex 2, Table 2). BANADE has an important role providing working capital loans to industry and is active in promoting and supporting foreign trade. Board of Directors, Organization and Staff 2.03 BANADE's Board of Directors consists of a President, Vice-President and ten directors, all appointed by the government for terms of four years. The members of the Board have had varied industrial, administrative and managerial experience (Annex 2, Attachment 1). The Board appoints BANADE's 1/ BANADE's Charter and Statement of Policy and Objectives appear in Annex I and II of the Staff Appraisal Report for the First Industrial Credit Project, Report No. 1521b-AR, May 25, 1977.  - 18 - General Manager, the Assistant General Managers and Department heads. It is responsible for establishing strategy and policy within the framework of BANADE's charter and approving operations. BANADE's Board Chairman and President is Dr. Celestino Carbajal, who was appointed to his position earlier this year, after extensive experience in industry, government and finance. 2.04 BANADE is administered by its General Manager and six Assistant General Managers, who receive support services from five departments that report to the General Manager (see Organization Chart, Annex 2, Attachment 2). The General Manager, Dr. Hector Ghirlanda, a career BANADE employee, with 2 7 years experience in the organization was appointed to his position in 1978 . BANADE has 33 branch offices throughout the country. About one third of BANADE's 3,600 employees are assigned to branch offices. The level of lending authority delegated to branch offices is related to branch office size and varies from $a490 million to $a980 million. In the head office, the General Manager has been delegated maximum lending authority of up to $a2.4 billion. Loans above these amounts must be approved by the Board of Directors. 2.05 Lending operations in BANADE's head office are conducted through four departments headed by Assistant General Managers. These Departments are Investment and Development Credit, Mining, Ordinary Credit and External Finance. The Departments are headed by persons with extensive experience and are staffed with knowledgeable and skilled personnel. Many of BANADE's technical personnel have second jobs; a practice that has been common for many years in the Argentine civil service. Undoubtedly, this affects staff productivity, but the system works and is accepted by BANADE's management. The phenomenon arose partly because of low public sector salaries. The macro-economic pressures to reduce public sector expenditures by holding down public sector salaries, however, are such that it would not be useful to press for basic changes in compensation levels at this time. There are also atti- tudinal adjustments toward public sector employment that would have to be addressed in a broader context than this project, if the issue of dual employ- ment is to be successfully resolved. The BANADE management is concerned about dual employment problem and some of the measures to be considered in the manpower development program (paras. 2.09 and 2.10) should help address the problem. 2.06 In addition to the Departments concerned with lending, the Bank has taken an interest in the activities of the Economics Department, because of the support it can provide to lending operations in assessing priorities and making sound economic judgements. Since 1977 the Economics Department has produced 8 to 10 market studies annually of various industrial subsectors. The quality of these studies has improved significantly in the last two years. The studies have been a useful tool for BANADE's project promotion and analysis. The Department has also begun to supply to BANADE's lending departments information on major economic indicators and industrial produc- tion, investment and export plans. Several special studies are planned, including one analyzing industry's sources and uses of medium and long term capital. The department will also be responsible for engaging a consultant to carry out the qeffective protection study which is discussed in parae. 1.28  - 19 - Appraisal, Supervision and Procurement 2.07 Project appraisal is conducted by teams of financial analysts, engineers, accountants and economists. The engineering specialists--other than mining and oil and gas specialists--are located in the Technical Services Division of the Investment and Development Credit Department. Those projects that have been reviewed by the Bank have met satisfactory professional standards. Management has been agressive in promoting courses in project analysis which have been taught by BANADE personnel and outside consultants. The Technical Services Division has published manuals and guidelines on project preparation and evaluation which have assisted BANADE staff and clients. As a result of the influence of the First Industrial Credit Project, financial and economic rate of return analysis has become accepted as a valuable tool within BANADE. BANADE agreed with the Bank under this project that economic rates of return would be calculated on new or expansion projects receiving subloans cver US$500,000. Economic rates of return on re-equipment or modernization projects --which are defined to be projects which will not increase production more than 30%--are only calculated for subloans over US$2 million. Financial rates of return are calculated for new and expansion projects that receive subloans of over US$100,000. Financial rates of return are also calculated on re-equipment or modernization projects that receive subloans over US$500,000. BANADE has agreed to continue to use the same standards for rate of return analysis for the proposed loan. BANADE has agreed to calculate economic rates of return on projects of any size where there has been a significant increase in the effective protection of the goods to be produced by the project, unless the Bank otherwise agrees. BANADE has instituted procedures for supervising loan implementation. Procurement and shipping documents are checked and visits made to project sites to verify project progress. BANADE requires three quotations for the purchase of goods and services, unless the borrower demonstrates that the obtaining of such quotations is not feasible. BANADE maintains a comparative list of prices of goods and services it normally finances and checks the reasonableness of proposed procurement prices against that list. For procurements of $500,000 or more under the project, BANADE has agreed to require sub-borrowers to identify sources of supply on an international basis, as well as to solicit sufficient price quotations so as to assure efficient procurement. 2.08 Although BANADE's procedures for supervising physical progress on projects has been satisfactory, it has not been as diligent in evaluating the developmental impact of completed projects. BANADE has agreed to improve this aspect of supervision and to provide supervision reports to the Bank on a regular basis. Manpower Development 2.09 BANADE has maintained its manpower at about the same level for the past five years. Except in rare circumstance, hiring has been restricted to new professionals in junior level positions and clerical staff. The number of BANADE's staff does not seem to be excessive in view of the limited use of data processing facilities in BANADE's operations. A large amount of BANADE's paper work still must be hand processed. Although BANADE has a large core of experienced professionals, many of them do not work full time and maintain  - 20 - outside jobs (para. 2.05). Management's tolerance of second jobs, employment security and a relatively attractive package of fringe benefits have limited employment turnover. BANADE has, however, experienced difficulty in retain- ing its brightest and most dynamic technical people. 20lG Recently, due to the economic slowdown and consequent limited employ- ment opportunities, BANADE has been able to hold some of the experienced and highly qualified employees, who in more normal times might have left for more Lucrative private sector opportunities. Although BANADE is currently able to keep Lts existing staff and to attract young qualified professionals, it seems to have difficulty in attracting mid-career professionals necessary for certain technically specialized areas (e.g. data processing, geology, and mining engineering). This is in part due to the excessively inward looking policy adopted by BANADE's personnel management, that any kind of professional can be created from within the organization. This policy has reduced the level of professionalism in technically specialized areas, including the personnel management area itself. It has also aggravated the distorted age distribution of BANADE's staff, which consists of a large number of older professionals and young trainees, with an insufficient number of mid-career professionals. Recognizing these problems, BANADE's management has agreed to prepare a comprehensive manpower development plan by June 30, 1982 and to carry- out the plan according to a timetable satisfactory to the Bank. The Dian would include systems and programs for personnel evaluation, promotion, incentives, training, hiring and recruitment, as well as a program for the preparation of managerial personnel to assume positions of increased resoonsibility. nana ement Control and Information 2.11 BANADE's management is aware that significant improvement can be made in BANADE's management information system which would permit more effi- cient programming of operations, financial planning, allocation of resources and monitoring of operations. Voluminous but uncoordinated financial data is rnormally provided to BANADE's management, but it does not contain suffi- cient a-nalysis and is also not presented in a way which would facilitate managerial decisions. BANADE's management considers that a key role could be played by computerized data processing in improving this situation and in reducing the amount of time spent by professional and technical personnel on routine and frustrating tasks for which they are overqualified. BANADE's data processing center is currently installing additional new equipment necessary to enlarge and improve its system. The equipment should be fully operational by late 1981 and will provide BANADE satisfactory processing capability. 2.12 The Central Bank of Argentina's (BCRA) new accounting procedures and auditing requirements 1/ have increased the urgency and importance of review- ing existing data processing applications. BANADE's management intends to hire additional experienced data processing analysts to improve its capability 1/ BCRA regulations require that BANADE have its 1981 annual financial statements certified by external auditors. Beginning in 1982 the regulations require a quarterly audit report in addition to an annual report.  - 21 - of expanding into new programming applications which would meet BCRA require- ments and other needs. New applications to be considered are: (i) a system to monitor foreign currency operations (e.g. maturities position and repayment schedule of loans, portfolio analysis of foreign currency loans and analysis of loans in arrears and reschedulings); (ii) analysis of arrears and resched- ulings of local peso-denominated loans; (iii) general information of branch offices and the consolidation of such information with head office activities; and (iv) personnel administration. BANADE has agreed to a timetable for the carrying out of a plan of action for the design and installation of management control and information systems. B. Operations General 2.13 BANADE has experienced a rapid increase in its lending operations over the last five years (Table 2.1). In dollar equivalent terms, the total portfolio of loans grew 728%, so that at the end of 1980, loans outstanding were the equivalent of US$3.6 billion. About 33% of the loan portfolio contained loans denominated in foreign currency, while the remaining 67% contained loans denominated in Argerntine pesos. BANADE's foreign currency denominated loan portfolio has increased more rapidly than its peso denominated portfolio, growing from US$84 million at the end of 1976 to US$1.2 billion at the end of 1980. The rapid growth of the foreign currency portion of the portfolio reflects the success that Argentina and BANADE have had in attracting foreign lines of credit in recent years. BANADE's foreign currency loans may be used by BANADE's clients to finance both foreign and local costs, unless the foreign credit line to BANADE contains specific restrictions on its use. BANADE's normal policy is to pass the foreign exchange risk on to its borrowers, so that foreign credits are onlent in the currency in which BANADE is obliged to repay. Table 2.1: LOANS OUTSTANDING IN BANADE'S PORTFOLIO AT YEAR END Foreign Currency Loans 1/ Local Currency Loans 1/ Total Loans $a US$ $a US$ $a US$ Year billion million billion million billion million 1976 23 84 96 348 119 429 1977 68 113 314 523 381 637 1978 418 415 974 967 1,392 1,382 1979 1,098 677 2,578 1,589 3,676 2,267 1980 2,337 1,168 4,799 2,400 7,136 3,568 1/ BANADE's automated information and data retrieval system is programmed to provide loan profile information on peso loans. Data for foreign currency loans is manually retrieved and therefore frequently more difficult to obtain. The information presented in this report reflects this situation. SOURCE: BANADE  - 22 - 2.14 Although BANADE lends to many industrial and mining subsectors, its lending in the last several years has given emphasis to the chemical industry (see Annex 2, Table 3). Peso loans to this industry accounted for about 21% and 36% of loans in 1978 and 1979 respectively. This in large part reflects the recent rapid development of the petrochemical industry in the Bahia Blanca area utilizing indigenous natural gas and petroleum resources. Mining loans have represented close to 10% of BANADE's total commitments in these two years and the balance has been committed to a broad range of other industrial subsectors. BANADE's loans are principally made to finance fixed investments. (See Annex 2, Table 4 on Loans and Guarantees Classified by Purpose.) Fixed investment peso loans have accounted for over 70% of the local currency loans made annually in every year but one since 1977, while working capital financing has represented less than 20% of such loans in all but one year. The following is a summary analysis of this relationship: Table 2.2: PERCENT OF BANADE'S PESO LENDING CLASSIFIED BY PURPOSE Year Fixed Investment Working Capital Other Total 1977 73.2 14.7 12.1 i0O.0 1978 70.0 19.9 10.1 100.0 1979 62.5 36.3 1.2 1oo.0 1980 81.9 15.1 3.0 100.0 (through 11/30) SOURCE: BANADE 2.15 Although BANADE makes short--term and commercial bank type loans, it is basically a long term lender. It classifies its loans as short-term (up to three years), medium term (between three and five years) and long-term (over five years). Over 80% of BANADE's outstanding local currency loans were for terms of more than three years as of November 30, 1980. About 42% of the loans were for terms of three to five years; 40% for terms of more than five years; and 18% for less than three years. 2.16 BANADE's effective delegation of lending authority, has permitted its branch offices to play an active role in committing loan resources. The branch offices have been responsible for committing since 1977 between 20% and 40% annually of BANADE's peso loans. In the last three years for which data have been collected the Federal Capital and the Greater Buenos Aires area have received less than 20% of loans granted by BANADE. Excluding this area and the province of Buenos Aires, the rest of the country received between 40% and 60% of BANADE's peso loans in the three year period. This distribution of lending is presented in the following summary table:  - 23 - Table 2.3: PERCENTAGE OF PESO LOANS RECEIVED BY ENTERPRISES LOCATED IN DIFFERENT AREAS OF THE COUNTRY 1977 1978 1979 Federal Capital and Greater Buenos Aires Area 13.2 18.8 18.1 Province of Buenos Aires (Excluding Greater Buenos Aires Area) 26.1 30.6 42.1 Rest of Country 60.7 50.6 39.2 SOURCE: BANADE Operations by Department 2.17 BANADE's lending operations are principally carried out by the tour departments,--Investment and Development Credit, External Finance, Mining and Ordinary Credit. Bank loan funds in the first project have been channelled through the first three departments. The departments act with considerable autonomy and BANADE's operations can best be understood by a brief review of each of them. 2.18 Investment and Development Credit Department. The Investment and Development Credit Department makes medium- and long-term development loans to industry. The projects may be new or expansion of existing facilities. It is the largest of the lending departments with 247 employees. More than half of the employees are in Technical Services, which provides engineering, financial, economic and other technical support services required for credit application evaluation to the Investment and Development Credit Department, as well as to BANADE's other departments and branch offices. The department committed about 45% of the Bank funds available for onlending under the first project. Its lending over the last three years has been as follows: Table 2.4: LOANS COMMITTED BY INVESTMENT AND DEVELOPMENT CREDIT DEPARTMENT Year No. of Loans (US$ million) 1978 233 470.6 1979 328 541.0 1980 100 467.1 SOURCE: BANADE  - 24 - 2.19 The decrease in lending activity in 1980 is attributable to lower investment in expansion projects, particularly by those industries exposed to increased competition from imports. The reduction in the volume of lending in 1980 was 7ess marked than the drop in the number of projects, due to the financing of several very large capital intensive projects in the petrochemical and oaper industries. Lending in these two sectors accounted for an average of over 60% of the Department's peso lending over the last two years. 2.20 Lending by the department has been medium- and long-term, with most loans fall ing into the five to ten year range. The economic rate of returni of the projects for which the return was calculated fell into the 20% to 40% range, while the financial rate of return was in the 15% to 30% range. 2.21 External Finance Department. The External Finance Department was established in 1978 and has been financing imported equipment to modernize Argentine industry with lines of credit from abroad. About 53% of the funds available for onlending under the Bank's First Industrial Credit Loan to BANADE were utilized by this Department. The Department which has 145 staff members also has the responsibility for financing exports and mobilizing exter-nal capital. 2.22 Between 1978 and 1980, the Department extended 209 credits, total- ling US$180.8 million. The number of loan operations began with an initial 17 in 1978, increased to 91 in 1979 and 101 in 1980. During this period World Bank ftunds accounted for 18.6% of the total value of the loans made by the Department, but represented almost three quarters of the loans made. The World Bank resources during this period were used to finance smaller equipment purchases and in general smaller borrowers. The average subloan size in this period was about US$215,000. Loans for equipment are for shorter terms than those financed by the Investment and Development Credit Department, with 80% of the loans being for five years or less, and none of the loans having a term of more than 10 years. 2.23 Mining Department. The Mining Department is responsible for medium- and long-term lending for mining and oil and gas exploration and development. The department has recently expanded from two to three divisions in connection with the Bank's Oil and Gas Credit Project. The new division is responsible for carrying out the Bank financed Oil and Gas Project and has seven employees. The other two divisions employ about eighty persons. The Mining Development Division provides technical support services to and promotes new projects in the mining industry through its eight mining promotion offices. It receives assistance from a West German Government technical assistance team. The Credit Division evaluates loan applications and supervises the mining loan portfolio. The department has used about 5% of the funds available for onlend- ing iander the Bank's First Industrial Credit Project. 2.24 Government interest in promoting mining development has stimulated additional lending in the mining sector. Peso loans committed in 1979 in- creased 185% in dollar equivalent terms from 1978 to 1979. The rising trend continued into 1980, with lending for the first nine months of the year almost equalling lending for 1979. Foreign currency loans were only US$2.0 million and US$2.5 million in 1978 and 1979. Foreign currency loans increased significantly--to US$63 million--in 1980. The sharp increase was due to lendinag for oil and gas exploration, which represented 72% of foreign currency lending in 1980.  - 25 - 2.25 Ordinary Credit Department. The Ordinary Credit Department has three divisions with 167 employees. The Department has an Ordinary Credit division which extends working capital and other short-term credits to in- dustry. A Small Industries Division provides working capital credits to small industry and provides longer term financing for new and expansion projects of less than US$2 million, provided those projects do not have direct import financing requirements. If they do, the projects are referred to the Invest- ment and Development Credit Department if related to new and expansion projects, or to the External Finance Department for re-equipment and modern- ization projects. The Litigation and Payment Arrears division is responsible for following up on late payments for the Department and the other lending offices of BANADE. Financial Policies 2.26 BANADE's Policy Statement sets forth financial limitations on its operations which are adequate to protect the institution from unreasonable financial risks. These policies cover concentration of risk assets, equity investments, liquidity and liability management, financial ratios, and management of special funds. 2.27 In its medium- and long-term lending, BANADE may finance up to 80% of total project cost but not more than 150% of the borrower's unimpaired capital and reserves. Short-term loans to a single borrower may not exceed 30% of the borrower's capital and reserves and the total of this amount plus short-term guarantees may not exceed 50% of medium- and long-term loans granted by BANADE. All guarantees, short- and long-term, issued by BANADE in favor of a single borrower may not exceed 150% of the borrower's total funded indebtedness. Furthermore, the total exposure of BANADE in loans and guaran- tees with a single borrower may not exceed 200% of the borrower's capital and reserves nor 30% of BANADE's capital and reserves. Finally, the borrower's total debt-to-equity ratio may not exceed 3:1. 2.28 BANADE may participate in new equity issues of private industrial and mining enterprises up to 10% of the private firm's total subscribed capital. Aggregate equity investments may not exceed 20% of BANADE's capital and reserves, and, furthermore, the holding period of equity investments is limited by the Charter of Incorporation to three years after listing on a stock exchange. Lending Terms 2.29 Foreign currency loans are repayable by BANADE's sub-borrowers in the currency in which BANADE borrows and carry an interest rate that includes a fixed margin above BANADE's borrowing costs. Peso loans are subject to indexation and have rates of interest that vary depending on the location and type of the projects. The lowest rates of interest apply to industrial projects located in frontier areas and mining exploration projects. All peso loans, with the exception of short-term working capital loans provide for indexation based on interest rates paid on term deposits; short-term working capital loans charge a high fixed rate of interest. (A discussion of the indices BANADE has used and their effectiveness in preventing erosion of BANADE's capital is contained in paras. 2.36 - 2.38.).  - 26 - 2.30 The objective of loans for industries in frontier areas is to promote regional development and decentralizaiton. The period of amortization of these loans is up to 12 years including two years of grace and they bear an interest rate of 2% per annum plus indexation. Mining exploration projects use funds administered by BANADE for the Mining Exploration Fund of the Mining Secretariat. These loans are set at varying terms (para. 1.49). 2.31 BANADE's interest rates for new projects qualifying under the Industrial Promotion Law are 5% and 7% plus indexation for expansion projects and equipment financing. The foregoing loans are made on terms of up to 12 years, including 2 years of grace. Permanent working capital credits bearing interest rates between 9% and 13.5% per annum plus indexation are provided to industries for up to 12 years (including 2 years grace) for credits to expand production and also to restructure debts. Seasonal working capital loans of less than a one year term are available at a fixed rate of 9.8% per month. 2.32 The First Industrial Credit Project provided that the loan be relent in dollars at 11%, with the cross currency risk born by the government. The subloan interest rate on these loans was raised to 12% in November 1980. The subloan interest rate for this project is described in paras. 3.11 and 3.12. Table 2.5: BANADE INTEREST RATES (Peso Loans) Type of Loan Indexed Interest Rates Terms 1. Frontier Areas Yes 2% annual 12 years, including two years of grace. 2. Industrial Yes 5-7% annual 12 years, including two Promotion Law years of grace. 3. Permanent Working Yes 9-13.5% annual 12 years, including two Capital years of grace. 4. Seasonal Working No 9.8% monthly Up to one year Capital Financial Position and Results 2.33 General. During 1976 BANADE was recapitalized by the Government through an infusion of new capital and a capitalization of liabilities amount- ing to an equivalent of US$208 million. 1/ This action reduced the debt/equity 1/ Annex 2, Tables 5 to 10 contain BANADE's past and projected balance sheets and income and source and application of funds statements.  - 27 - ratio from 36.6:1 at year end 1975 to 1.6:1 at year end 1976. BANADE's Policy Statement issued in 1977 provided that the recapitalized institution's total debt would be limited to ten times its capital and reserves. The debt/equity ratio limitation is reasonable, given BANADE's role as a mixed commercial and development bank. 2.34 As of year-end 1980, BANADE's debt/equity ratio was 5.5:1, which, although much higher than the 2.6:1 ratio at year-end 1979, still allows for considerable additional leverage. 1/ The debt/equity ratio rose due to continued growth in liabilities (both locally mobilized time and demand deposits and foreign borrowings) and some equity erosion in real terms. Total assets reached $a9,068 billion at year-end 1980 (about US$4.6 billion equivalent), a 29% p.a. increase in real terms (using the WPI, wholesale price index, as deflator) over the year-end 1979 level. The growth of assets, loan portfolio and equity compared with the inflation rate are shown below: Table 2.6: GROWTH OF ASSETS AND EQUITY COMiPARED TO INFLATION RATE (in $a billion) 76/80 1976 1977 1978 1979 1980 Increase Total Loan Portfolio 119.4 381.4 1,391.6 3,676.4 7,135.9 60x Total Assets 216.5 622.3 1,900.8 4,464.4 9,068.3 42x Equity 83.8 211.0 517.2 1,166.2 1,398.3 17x Inflation Rate (WPI) - 147.2 143.3 128.7 57,7 22x 2.35 As shown above, from 1976 to 1980, total assets (which are almost all financial) increased 42 fold, the loan portfolio 60 fold from a smaller base, and equity about 17 fold. The wholesale price index increased about 22 fold over the same period. Thus, while assets, including the loan port- folio, increased substantially in real terms, the equity base of BANADE declined by about 30% in real terms over the same period. Although not satisfactory, this result is still a distinct improvement over the results in 1975 prior to the Bank's involvement with BANADE, when equity declined to only about US$7.0 million equivalent after years of lending at highly negative interest rates in real terms. 2.36 BANADE's improved ability to protect itself against domestic infla- tion and preserve its equity base has been due to several factors. BANADE's foreign currency loans are not affected by domestic inflation and have grown to represent about a third of BANADE's portfolio at year end 1980. The source 1/ BANADE's foreign borrowings include government guarantied loans for state enterprises in 1980 which carry little or no risk to BANADE. Were borrowings for state enterprises not included in BANADE's financial statements, the debt/equity ratio for 1980 would be reduced.  - 28 - of these funds are from BANADE's foreign borrowings. The funds are then relent to BANADE's clients and are repayable in the currency in which BANADE is obligated tc repay its loan. The medium and long term peso denominated loans have since 1976 been subject to indexing while short term loans have carried nominal rates of interest exceeding the inflation rate. BANADE's policy has been to retain earnings--including that portion attributed to indexation. Thus, were the index on peso-denominated loans and the nominal interest rate on short term loans adequate, BANADE should have been able to protect its equity base, provided portfolio losses could be contained. To the extent that there has been an erosion of BANADE's capital, it has principally been due to two factors. The first is that some of the older medium and longer term loans in the portfolio did not have any provision for indexation. Except for high interest short-term loans, non-indexed loans no lornger represent a significant percentage of BANADE's portfolio. The second is that the indexing mechanism, as explained in the following paragraph, has not always been adequate. Management has been aware of the problem and has made adjustments to help ensure maintenance of equity value in real terms in the future. 2.37 Revenues, costs and profitability. BANADE aow charges a floating interest rate on its term loans in pesos which is based on the Central Bank- computed weighted average of interest rates paid on term deposits (tasa testigo). BANADE used to charge peso interest rates in term loans linked to the wholesale price index (WPI), which proved satisfactory at a time when most peso lending Twas made using Central Bank and equity funds. However, with the growth of time and demand deposits, which now fund some 30% of assets (up from 8% in 1977), BANADE became exposed to substantial risks arising from divergence between the deposit rates and relending rates. This eventually caused a negative spread leading to the erosion of BANADE's equity in real terms mentioned above. Since May 1980, all new term loans in pesos have interest rates based on the tasa testigo. In March 1981, interest rates on all out- standing term peso loans were converted from a WPI base to a tasa testigo base invoking a clause incorporated into loan agreements allowing BANADE to change the index for peso interest rates. 2.38 BANADE maintained a steady growth in its net earnings in the period 1976 to 1979. Return on total assets averaged between 11% and 15% during that period. The situation changed sharply in 1980, when return on total assets dropped to 2% and net income decreased to $a 181.7 billion (US$90.8 million). The relatively poor 1980 performance was attributable to the negative spread on some of BANADE's peso lending caused by the use of the WPI in setting inter- est rates on BANADE's peso loans. Poor earnings in the first quarter of 1981, prior to the adoptioin of the tasa testigo, will cause some further erosion of BANADE's equity base and an increase in the debt/equity ratio to 7:1. A strong recovery is projected for 1982 as a result of using the tasa testigo interest rate on all outstanding peso term loans in 1982. BANADE's 1982 return on equity after taxes will rise to 56% after being at 13% and 37% in 1980 and 1981, respectively. i/ Beyond 1982, BANADE's income continues to increase, but at a diminishing rate as deposit growth and net external 1/ Based on the inflation assumptions explained in Annex 2, T-5.  - 29 - borrowing slow. Should inflation exceed BANADE's expectations, projections for income growth and real return on equity should remain substantially intact, since about one third of BANADE's loans are foreign exchange deno- minated and BANADE's peso loans are satisfactorily indexed. However, in order to help protect BANADE further against possible erosion of capital as a result of exchange losses, inflation and business failures, the government has agreed to require BANADE to take such measures as may be necessary to maintain BANADE's equity in real terms. 2.39 BANADE's administrative expenses have been kept between 2.0% to 2.4% of average total assets over the last five years. The administrative expense level seems moderate given the large number of small loans made by BANADE, its branch system and the still large number of certain categories of staff relative to volume of operations. The ratio of administrative to total assets should decline over the next several years as BANADE's efficiency further im- proves due to programs for manpower development (para. 2.09) and improvements in management control and information systems (para. 2.11). 2.40 Portfolio quality and reserves. In spite of the problems affecting Argentina's economy, the quality of BANADE's loan portfolio has remained satisfactory due to its: (a) conservative approach to lending (e.g., sizeable collaterals and/or guarantees and BANADE's ratio analysis test); (b) good appraisal capability; and (c) proportionally large lending to industrial subsectors that have been less seriously affected by competition from imports (e.g. petrochemi-cals, cement and construction industry). 2.41 The Board of BANADE reviews the status of past due loans monthly, in order to ensure that proper reserves are set aside for loan losses. As of December 31, 1980, BANADE's reported total arrears of principal and interest over 10 days amounted to $a308.2 billion (US$154.1 million equivalent), re- presenting 6.4% of BANADE's total outstanding portfolio (Annex 2, Tables 11 and 12). Arrears over three months, totalled $a183.1 billion (US$91.6 mil- lion equivalent), or 4.0% of the total portfolio. Peso-denominated and foreign currency loans in arrears over three months represented 0.2% (US$2.65 million equivalent) and 3.7% (US$88.9 million equivalent) of BANADE's total outstanding portfolio for year-end 1980, respectively. Peso denominated loans totalling about $a5.9 billion (US$3.0 million equivalent) were rolled-over and rescheduled in 1980. Almost twice the value of foreign currency credits (about US$6.1 million equivalent) were renegotiated during the same year. Table 2.7: BANADE's PORTFOLIO ANALYSIS OF ARREARS OVER 10 DAYS (percentage of outstanding portfolio) Peso-Denom. Foreign Currency Consolidated Dates Loans Loans Portfolio December 31, 1978 3.5 4.6 4.0 December 31, 1979 3.6 4.4 4.0 April 30, 1980 3.8 4.5 4.1 July 31, 1980 4.9 5.1 5.0 September 30, 1980 6.1 4.3 5.2 December 31, 1980 9.4 4.2 6.4  - 30 - 2.42 Loss provisions as a percentage of total portfolio have increased from 7.2% (December 31, 1979) to 10.2% (December 31, 1980). Provisions for bad debts by BAiNADE appear adequately to cover possible losses in its loan portfolio. BANADE's term loans are secured by pledges on assets, mortgages and other tangible guarantees. Most of the short-term working capital credits representing about 13% of BANADE's portfolio are unsecured. 2.43 As of December 31, 1980, 1,807 firms were in arrears. Most of the arrears were concentrated in three industrial sectors representing 71% of the firms and about 75% of total money value in arrears. Table 2.8: ARREARS POSITION OVER 10 DAYS BY SECTOR Sectors Percent of Firms Percent of in Arrears Arrears Wood and Paper Products 28.5 13.5 Electrical Equipment 25.0 21.5 Food and Beverages 17.5 40.0 Subtotal 71.0 75.0 Others 29.0 25.0 Total 100.0 100.0 2.44 The mission reviewed about 10% in amount (9.2% in number of firms) of BANADE's portfolio in arrears and found that high financial costs and a sluggish demand are the main reasons for loans in arrears and reschedulings. Industries experiencing reduced demand are those which must compete with low priced imports. Those industries that still have high effective protection have experienced little difficulty in servicing debt. 2.45 Source of funds and needs. At year-end 1980, about 40% of BANADE's liabilities were accounted for by time and demand deposits, another 41% by foreign currency obligations and the remaining amount accounted for by mis- cellaneous obligations. BANADE's sources of funds have gone through a sig- nificant change since 1975. Prior to 1975 local currency funds were obtained by rediscounting loans at the Central Bank, and by borrowing from ofLicial sources. Beginning in 1976, BANADE was authorized to accept deposits and this has become the major source for peso resources. BANADE's extensive system of branches has facilitated raising short-term funds in the domestic market to meet its resource needs. Foreign currency borrowings were also at minimal levels in 1976 as a result of Argentina's relatively poor international credit standing. As confidence in Argentina's economic management grew in inter- national money markets, BANADE was able to tap foreign financing sources. Foreign currency obligations have grown 10 fold in the 1976-1980 period, from US$157.2 million in 1976, to US$1,574.2 million in 1980.  - 31 - 2.46 BANADE's time and demand deposits have increased rapidly over the 1976-1980 period partly due to its strong efforts, but also due to uncertain condition in the financial sector which led to deposit shifts from private to m.ore secure public banks. BANADE's time and demand deposits are expected to remain practically constant in real terms during the 1981-1985 period. However, foreign currency obligations are expected to grow a significant 31% in 1981 largely as a result of borrowing for several state-owned enterprises, with BANADE acting as financial agent. BANADE's foreign currency loan obliga- tions are expected to 4increase at a more modest nominal growth rate (in US dollars) of 15% per year through 1985. Assuming a 10% dollar inflation rate, real growth in foreign currency obligations will be about 5% per year. BANADE's equity resources are also projected to grow a modest 4.8% per year in the 1981-1985 period, taking into account some initial deterioration in 1981, prior to the adoption of the cost of funds index for local currency lending (para. 2.37). Although real resource growth will be slow in the forecast period, it is antic4pated that there will be structural shifts in lending. Over the past few years, BANADE, as a secure state owned financial interme- diary with a large share of deposits, found it necessary to provide a larger share of working capital credit to industry than it might otherwise have done. With expected improvements in the financial system BANADE will then be able to give more emphasis to medium and long term lending. BANADE's projected assets, loan portfolio and equity are shown below in 1980 pesos. Table 2.9: PROJECTED ASSETS, LOAN PORTFOLIO AND EQUITY ($a billion in 1980 prices) 1980 1981 1982 1983 1984 1985 Total Assets 9,068 10,192 10,758 11,043 11,230 11,347 Loan Portfolio 7,136 8,696 9,231 9,541 9,800 9,991 Total Equitv 1,398 1,281 1,470 1,550 1,630 1,769 2.47 BANADE has been reasonably successful in obtaining certain types of foreign financing since 1976. The financing it has obtained has fallen into two categories: (a) export financing from official banks, which is frequently long-term and low interest rate in nature, but with restricted sources of procurement; and (b) medium term and short-term commercial bank financing, with interest rates set at fixed amounts above the floating London Inter-Bank rate. As of January 31, 1981, foreign commercial and official bank lines of credit amounting to US$632.7 million were outstanding, of which US$451.6 million remained to be utilized (Annex 2, Table 13). BANADE is active in negotiating foreign lines of credit and recently completed negotia- tions for a US$250 million from a group led by Citicorp for the benefit of several state enterprises. (BANADE loans to these arid other state enterprises are guaranteed by the government and carry no risk of loss by BANADE.) BANADE has several other major credits under negotiation and anticipates cofinancing about US$200 million of commercial bank loans with the proposed Second Industrial Credit loan.  - 32 - 2.48 Bank funds represent about 11% of BANADE's estimated foreign cuirrency commitments during the loan commitment period (through year-end 1983). The following table describes BANADE's estimated foreign currency commitment requirements through 1985 and the source of these fuids. Table 2.10: BANADE'S ESTIMATED FOREIGN CURRENCY LOAN COKMITHENTS EXCLUDING OIL AND GAS, AND PUBLIC SECTOR NEEDS 1981 1982 1983 1984 1985 Source of Funds IBRD Loan 1463-AR 16 - - - IBRD Proposed 2nd Industrial Credit 15 39 45 - Sub-Total 31 39 45 - - Other External Sources 199 251 305 450 550 TOTAIL 230 290 350 450 550 Commitment of Funds a/ Fixed Assets 133 174 227 315 412 Working Capital b/ 97 116 123 135 138 TOTAL 230 290 350 450 550 a/ Includes Bank funds to be channelled by the provincial banks. b/ Includes Financial Consolidation. 2.49 It is likely that up to 40% of the Bank loan funds available to BANADE would be used to continue to finance equipment replacement (see para. 3.02 for a description of project components). Another 40-45% of loan funds would likely be used to finance new and expansion projects. The major demand for such financing is currently from the cement and petrochemical industries. There are also several projects in the pipeline that are receiving incentives under the government's regional development program. At appraisal the pipeline for new and expansion projects for which applications or serious inquiries had been received was US$290 million. The pipeline of applications for mining projects was US$54 million at appraisal. It is estimated that about 5-10% of loan funds would be used to finance projects in the mining sector. The remain- ing 10% of loan funds would be used to finance projects for industrial energy conservation. 2.50 It is estimated that total foreign currency loan commitment demands on BANADE--including new applications not yet in the pipeline--would amount to US$700 million through the loan commitment period. Bank funds will, tnerefore, have to be used with other external funds to meet the financing need of projects now in BANADE's pipeline and that are likely to enter the pipeline during the loan commitment period.  - 33 - Cofinancing 2.51 BANADE has asked that the Bank enter into a cofinancing agreement of up to twice the size of the Bank loan. BANADE anticipates that the association with the Bank will allow it to obtain better terms from private foreign banks than it might otherwise be able to negotiate. A US$100 million Eurodollar loan was obtained from a syndicated group of foreign banks under a cofinancing agreement concluded in connection with the first project at a time when Argentina was beginning to reestablish its standing in international credit markets. As in the first project, a new cofinancing arrangement would include a cross-default clause, agreement to exchange relevant information and provi- sion to channel service payments through the Bank. It is expected that the maturity of a private foreign loan obtained through cofinancing will be about eight years. In order to facilitate the mixing of the shorter term private funds and Bank funds and to assist BANADE in matching the amortization of subloans to the amortization of its external borrowings as closely as possible, the Bank agreed to permit BANADE to adjust toward the later maturities the amortization of subloans from Bank funds. Such action would permit a more even subloan repayment schedule and a less onerous debt service burden on subborrowers during the early years of a project. External Auditing Arrangements 2.52 Until early this year Argentine law required that BANADE's accounts be audited by the Central Bank (BCRA). The first project provided that the audit of BCRA be submitted to the Bank within four months of the end of BANADE's fiscal year. BANADE's accounts were last audited by BCRA for its fiscal year ending December 31, 1978. The 1980 banking crisis placed compet- ing demands on BCRA staff and BCRA has been unable to assign personnel to audit BANADE's accounts. BCRA issued a decree in February 1981 requiring that all banks, including BANADE, be audited by private external auditors for the year ending December 31, 1981. BANADE is now in the process of selecting a private auditing firm to undertake the 1981 audit. In view of the difficulties for external auditors to verify control systems in effect in prior years, BANADE proposed and the Bank agreed to an interim arrangement with its Sindico 1/ to hire qualified auditors to perform the audit of BANADE's 1980 accounts following Bank guidelines. This audit certifies financial statements for 1980 and uses comparative figures for 1979. For the year 1981 and subsequent years BANADE has agreed to annual audits of its accounts by external auditors satisfactory to the Bank and the submission of the audit to the Bank within six months of the end of BANADE's fiscal year. 1/ The Sindico is the government's appointed representative who is responsible for supervising BANADE's compliance with its Charter and with applicable laws, decrees and regulations.  - 34 - III. THE PROJECT A. The First Industrial Credit Project 3.01 The First Industrial Credit Project provided US$100 million in a loan to BANADE to assist in financing the foreign exchange costs of fixed assets for investment subprojects in the industrial sector and technical assistance for BANADE. The project was approved by the Executive Directors in June 1977 and became effective in November of the same year. The US$99.75 million of loan funds available for onlending for investment subprojects was completely committed by BANADE in May 1981. The remaining funds for technical assistance should be completely committed in the near future. About 53% of the funds available for onlending have been used to finance the replacement and modernization of equipment, principally by smaller and medium size enter- prises. The remainder of onlending was to finance new and expansion projects of larger enterprises (45%) and mining enterprises (2%). Although the first project was initially slow in getting started, commitments began to accelerate after BANADE and its clients became more familiar with Bank procedures and requirements. It is anticipated that the loan should be fully disbursed by mid-1982, only six months beyond the date anticipated in the Staff Appraisal Report. B. Project Objectives and Design 3.02 The principal objective of the proposed second project is to support the Government's goal of making the industrial and mining sectors more efficient. It would do so by continuing to help BANADE finance the type of subprojects that have been financed under the first loan, including modernization and replacement of equipment as well as new and expanded pro- duction by industrial and mining firms. In addition, new features would be introduced focussing on several more narrowly defined development objectives within the Government's overall program. Major emphasis would be given to a program for industrial energy conservation (see Annex 3, Attachment I). Development credits would also be channeled through provincial banks to help stimulate regional development and mobilize the provincial bank resources for industrial development. The project would include technical assistance to help BANADE in its institutional development and INTI in undertaking its responsibilities in developing an industrial energy conservation program. To assist in financing the project, complementary external medium term funds from private financial institutions would be raised by BANADE through cofinancing arrangements.  - 35 - 3.03 In order to help assure that the project continues to support the goals of developing a more efficient industrial sector in Argentina two sets of actions have been agreed to with BANADE and the government. The first allows the Bank to require economic rate of return analyses for subprojects of any size, whenever there have been changes by the government which would significantly increase effective protection of the goods to be produced by a proposed subproject (para. 2.07). The second will cause the government to complete a study on effective protection of Argentine industries. The results of that study and the actions proposed to be taken on its conclusions will be discussed by the Argentine authorities with the Bank (para. 1.28). The Industrial Energy Conservation Component 3.04 The industrial energy conservation program supported by the project will involve a strengthening and extension of the capabilities of BANADE and the National Institute for Industrial Technology (INTI). (Annex 3, Attachment 2 contains a description of INTI). BANADE will establish a line of credit for conservation investments, i.e., investments whose purpose it will be to reduce production costs through a more efficient use of energy, including but not limited to retrofit equipment. The Bank loan will allocate US$10 million to this program. Although it is possible that demand for these funds could reach as much as US$40 million during the loan commitment period, a more conservative allocation is justified in view of delays that could be encountered in initiating a new program. This credit line will be coordinated by a senior loan officer in BANADE who will combine resources made available by the Bank with BANADE's domestic credit lines to provide a financing package for the investments. For this purpose BANADE will perform the credit appraisal based on its standard procedures and will rely on INTI for the technical appraisal. The terms of the relationship between BANADE and INTI will be established in an agreement between the two institutions. The signing of this agreement will be a condi- tion of disbursement for the energy conservation component of the project. 3.05 The agreement between INTI and BANADE will provide that INTI will promote energy conservation, perform energy audits and perform technical appraisals of conservation investments. The audited firms would then be referred to BANADE where they would apply for financing using the special credit line. The agreement will permit technical appraisals to be performed by third parties, such as private consultants or the firms themselves. The agreement will provide that BANADE pay INTI a fee for the performance of the appraisal. 3.06 INTI's participation in the conservation program will have four principal components: (i) an energy advisory service that will perform energy audits for all subsectors of industry and perform the technical appraisal of loan applications under BANADE's conservation credit line; (ii) a trining program to prepare energy auditors and company energy managers; (iii) a promo- tion campaign for energy conservation; and (iv) laboratory services as neces- sary to support the program. INTI's service would be mainly directed at medium and small industry and would, within three years, be able to perform  - 36 - about 200 energy audits per year. This program will complentent the planned energy conservation study under the Bank's Refirnery Conversion Project (Loan 2032-AR) which includes a number of audits of major plants. The program will provide a subsidized service to a clientele that is not expected to turn to private conservation consultants because of their perceived high cost. The subsidized energy audits are necessary to promote energy conservation and accelerate the transition of the industrial sector toward greater energy efficiency. The subsidy would be paid out the national budget In the same way that INTI covers its research activities. The government has agreed to have INTI carry out the program. The Provincial Banks 3.07 The provincial banks are those owned or controlled by the provincial governments in Argentina. There are currently 26 such banks in the country. These banks have about 20% of the deposits in the banking system and account for about 19% of total bank loans. They were formed initially to fill banking needs in the provinces which were not being met by private commercial and foreign banks. They have growrL in importance since the first provincial bank--the Banco de la Provincia de Buenos Aires--was established in 1822. Each of the provinces now has a bank and they provide a wide range of commer- cial banking services, as well as lending for agricultural development and provincial infrastructure. Except for a relatively small effort begun by the Banco de la Provincia de Buenos Aires in 1978, little has been done by the provincial banks to provide term credit for private sector industrial development. The provincial banks have extensive field office networks in the provinces that they serve, which allows them to reach communities that BANADE, with its more restricted field office establishment is unable to reach. The provincial banks represent a largely untapped resource for channeling credits to the industrial sector. 3.08 The provincial banks included in the project would promote the credit line and would provide project preparation assistance to potential subborrowers. They would assume the credit risk for loans and would provide complementary funds where necessary. BANADE would do the appraisal of sub- projects for the provincial banks and charge a fee for this service. The provincial banks would have the following obligations and duties: (i) assure that BANADE's loan policies and regulations are observed; (ii) give their approval in principle to subloans before they are submitted to BANADE for appraisal; (iii) supervise the use of funds by the subborrower; (iv) issue periodic reports on the progress of subprojects; (v) maintain records of sub- loans; and (vi) comply with reasonable requests for information from BANADE. 3.09 BANADE has agreed that provincial banks participating in this program would sign subloan agreements which would reflect their and BANADE's responsibilities. The signing of such subloan agreements satisfactory to the Bank would be a condition of disbursement for onlending those loan funds allocated to provincial banks.  - 37 - Technical Assistance 3.10 The technical assistance part of the project will consist of: (a) The study of the Argentine incentive system discussed in paragraph 1.28. (b) Institutional support for the energy conservation program discussed in paragraphs 3.04 to 3.06. (c) BANADE's manpower development plan and program discussed in paragraph 2.10. (d) The design and installation of the management control and information systems for BANADE discussed in paragraph 2.12. Loan resources will be used for financing technical assistance costs for all of the above items, except the energy conservation program and the effective protection study of the Argentine industries which will be financed with the Government's own resources. Project items will include studies, consultant services, training and computer software programs. C. The Proposed Loan General Description 3.11 The proposed loan of US$100 million would finance the foreign exchange component of projects in the industrial sector and technical assist- ance to BANADE and INTI. The loan would be made to BANADE with the guarantee of the Government of Argentina at the current bank interest rate of 11.6% p.a. and the standard commitment fee on the undisbursed balance (3/4% p.a.). Loan categories and onlending arrangements will be as follows: Amount US$ million A. BANADE loans to subborrowers and to provincial banks (i.e., for onlending) for industrial and mining subprojects. 89.5 B. Industrial energy conservation subprojects. 10.0 C. Technical assistance and training. 0.5 Total 100.0 million  - 38 - 3412 Bank funds for subprojects would finance the cost of imported equipment and the foreign exchange component of locally manufactured equipment. BANADE will relenid the proceeds of the proposed Bank loan either in the same basket of currencies as the Bank loan with a spread of at least 2.5% to cover administrative costs, or in dollars with a spread of at least 5% to cover administrative costs and the cross currency risk. If BANADE chooses to onlend in the same basket cf currencies as the Bank loan it will first have to furni sh the Banlk satisfactory repayment procedure for its subloans. The proposed loan is expected to be committed by March 319 1984. and disbursed by March 313 1986. Following standard DFC practice, the amortizatiorn of the credit portion of the loan would conform to the aggregate of the amortizattian schedules of individual subloans, subject to a maximum term of f ifteen years. The technical assistance component of the loan would have a termt of 15 years, with a three year grace period and a fixed amortization schedule. Subloan Terms 3.13 Subloans from BANADE and the provincial banks would be for up to fifteen years including a reasonable grace period not to exceed three years. BANADE may adjust principal payments on Bank subloans for subberrow7ers using funds from both the Bank loan and other external financing in order that th1v aggregate principal payments by the subborrower may be approximately equaL, Unless the Bank otherwise agrees, Bank loan funds for any one subproiece wzould be limited to US$7 million if there were no other external financing includad in the subproject. Bank loan funds for a subproject could exceed US$7 rn on and be as much as US$12 million, provided that Bank loan funds over US$7 million would be matched by an equal or greater amount of external financing. It is anticipated that this arrangement would encourage additional cofinancing. As indicated in the preceding paragraph, subloans may be reloaned in the disbursed basket of currencies, or in dollars. The interest and fee schedule of provincial bank subborrowers would be no less than that established for BANADE subborrowers. The provincial banks' repayment obligation would either be in dollars or the disbursed basket of currencies, depending on the repay- ment obligation of subborrowers. Interest payable by the provincial banks to BANADE on such loans will have a spread of at least 2.5% to cover BANADL'S bearing of the cross currency risk on dollar denominated subloans. The spread to cover BANADE's administrative costs would be negotiated by BANADE wti provincial banks on a case by case basis. Approval Limits 3.14 The requirements for the calculation of financial and economic rates of return analysis for BANADE subprojects are described in para. 2.07. The same requirements will apply to provincial bank subborrowers. The free limit for subloans would be set at US$2.5 million, except that: (i) BANIADE il submit for the Bank's approval, the first two energy conservation subprojects and the first two subprojects from any provincial bank; (ii) where there has been a substantial change in effective protection since loan signing