Argentina - 1983 economic memorandum

Report No. 4513-AR ILE Co Argentina C 1983 Economic Memorandum May 23, 1983 Latin America and the Caribbean Regional Office FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Peso ($a) Exchange Rate Effective = May 6, 1983 US$1.00 = 76,500 $a 1,000 = US$0.013 $a 1,000,000 = US$13.07  FOR OFFICIAL USE ONLY PREFACE Since early 1981, the Argentine economy has been beset by growing political uncertainty, marked by several changes of government and a brief but costly war. The Government which took office in mid-1982 has been trying to heal the wounds of the economy, to improve Argentina's international standing, and to achieve the transition of power to a civilian regime by the end of 1983. The main text of this report analyzes the developments in the economy up to the end of the first quarter of 1982. A postcript deals with the problems and policies of the period between the outbreak of the South Atlantic crisis and the end of the first quarter of 1983. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   TABLE OF CONTENTS Page No. SUMMARY ............. .................................. i-vi I. MACRO-ECONOMIC DEVELOPMENTS ........................... I Background .......... .................................. 1 The 1981 Recession and the Policies for Recovery ...... 3 Stabilization Efforts during First Quarter 1982 ....... 5 Summary of the 1979-1981 Experience .... ............... 8 II. PUBLIC SECTOR FINANCES ................................ 10 Size of the Public Sector ............................. 10 Tax Revenue ........................................... 11 Public Pricing Policy ................................. 14 Public Expenditure .................................... 14 1982 Budget ........................................... 20 Efforts to Reduce the Size of the Public Sector ....... 21 Summary of Fiscal Performance ......................... 22 III. INDUSTRIAL SECTOR OVER THE 1976-81 PERIOD .23 Liberalization Efforts and Their Impact on Industry 23 Productivity, Profits and Investment .24 Finances of the Industrial Sector .29 The Impact of the Deterioration of the Industrial Sector on the Banking System .34 The Impact of the 1979-81 Program on Industrial Structure 36 IV. CONCLUSIONS ........................................... 37 POSTSCRIPT ...... .........................e 40 The South Atlantic Crisis ............................. 40 The Aftermath of the Crisis ............................ 40 Financial Reform ...................................... 41 The Stabilization Program ............................. 42 Exchange Rate Policy .................................. 42 Fiscal Policy ......... ................................ 42 Monetary Policy ........ ............................... 43 Performance .......... ................................. 43 External Debt Rescheduling ............................ 46 Prospects for Economic Recovery ..... .................. 49 Medium-Term Prospects ................................. 51 This report is based on the findings of a mission that visited Argentina in October-November 1981. The mission consisted of Messrs. Fred D. Levy (mission chief), Kutlay Ebiri (country economist), Roberto Zagha (country economist) and Ms. Consuelo Cruz (statistical assistant). Mr. Ebiri visited Argentina in April 1983 to prepare the updating postscript.  TABLE OF CONTENTS (Continued) APPENDICES I. The Structure of the Public Sector and Public Revenue II. A Note on Self-Employed Sector Tables in the Text and Appendices Page No. Table 1 External Debt Registered with the Central Bank, 1978-1981 ........................................ 3 Table 2 Treasury Operations, First Quarter 1982 .... ....... 6 Table 3 Changes in Effective Exchange Rates for Exports, January 1982. 7 Table 4 Balance of Payments, 1981 and 1982 First Quarter 7 Table 5 ]'ublic Sector Operations in Terms of GDP, 1971-1981 11 Table 6 Tax Elasticities, 1971-1980 .12 Table 7 Structure of the Treasury Tax Revenue, 1979-1981 13 Table 8 Total Tax Revenue, 1980-1981 .13 Table 9 Adjustments in Relative Public Tariffs, 1981 14 Table 10 Structure of Public Expenditure, 1976-1980 ......... 15 Table 11 Treasury Expenditures, 1980-1981 ..... .............. 16 Table 12 Public Savings and Saving/Investment Ratios, 1971-1981 .18 Table 13 Public Sector Deficit and its Composition, 1971-1.981 19 Table 14 Selected Indicators of Manufacturing Industry, 19i80 26 Table 15 Profits and the Averiage Rate of Return in the Industrial Sector, 1975-1981 .28 Table 16 Investment in the Industrial Sector, 1975-1981 30 Table 17 Financial Resources Channelled to the Industrial Sector, 1975-1980 .31 Table 18 Debt/Equity Ratios in the Industrial Sector, 1976-1981 ......................................... 33 Table 19 Rates of Return on Equity in the Official Banking System, 1978-1979 .................... 34 Table 20 Zero Profit Lending Rates and Zero Profit Spreads, 1977-1981 ........................................ 35 Table 21 Liabilities of "Bankrupt" Enterprises, 1975-1981 ... 36 Table 22 Post-War Growth in the Argentine Economy, 1946-1980 38 Table P.1 Trade Account, 1983/I . .............................. 44 Table P.2 External Debt Registered at the Central Bank ....... 47 Table P.3 Original and Proposed Schedules of the Registered External Debt ............ I . 47 Table P.4 Growth in 1982 .............. ......................... 49 Appendix II Industrial Employment, 1973-1981 ...... .............. II.1  Page 1 of 2 COUNTRY DATA - ARGENTINA AREA POPULATION DENSITY Total: 2,781,142 km2 1/ 28.6 Million (mid-1982) 10.3 persons per km2 Agricultural: 1,913,070 km2 1/ Rate of Growth: 1.6 (from 1970 - 1980) 2.6 persons per km2 (rural population/ agricultural land) POPULATION CHARACTERISTICS (1975 - 1980) HEALTH Crude Birth Rate (per 1,000) 21.4 Population per physician (1975) 527 Crude Death Rate (per 1,000) 8.9 Population per hospital bed (1970) 175 Infant Mortality (per 1,000 live births) 3.2 INCOME DISTRIBUrION (1976-1979) % of domestic income, highest quintile 50.3 lowest quintile 4.4 ACCESS TO PIPED WATER (1976 - 1979) ACCESS TO ELECTRICITY (1970) E of population - urban 76 % of dwellings 76 - rural 26 NUTRITION (1977) EDUCATION Calorie intake as % of requirements 124 Adult literacy rate % (1970) 93.0 Per capita daily protein intake 108 Primary school enrollment %(1977) 110.0 2/ GNP PER CAPITA IN 1982 : US$2,359 GROSS DOMESTIC PRODUCT IN 1982 ANNUAL RATE OF GROWTH (%, constant prices) US$ Mln. % 1970-75 1975-80 1979-81 GDP at Market Prices 72.2 100.0 3.8 1.9 -3.5 Gross Domestic Investment 12.4 17.2 2.0 6.3 -6.1 Gross National Saving 7.7 10.7 -0.4 3.0 -16.0 Current Account Balance -2.4 -3.3 Exports of Goods, NFS 9.1 12.6 4.8 11.2 -2.2 Imports of Goods, NFS 6.8 9.4 2.1 12.4 1.3 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1982 Value Added at Factor Prices Labor Force V. A. Per Worker US$ Bln. Z Thousands % US$ % Agriculture 8.8 14.0 1,450 13.1 6,069 107 Industry 22.5 35.7 3,099 28.0 7,260 128 Services 31.6 50.3 6,520 58.9 4,847 85 Total/Average 62.9 100.0 11,069 100.0 5,683 100 GOVERNMENT FINANCE 2/ Consolidated Public Sector Central Covernment ($a bln.) % of GDP ($a bln.) % of GDP 1981 1981 1979-81 1981 1981 1979-81 Current Revenue 188,303 34.5 35.1 87,503 16.0 16.5 Current Expenditure 174,941 32.0 30.5 82,243 15.0 14.8 Current Surplus 13,362 2.4 4.6 5,260 1.0 1.7 Capital Expenditure 53,552 9.8 9.6 14,728 2.7 2.7 External Assistance (net) 3,641 0.7 1.1 1/ Continental area. 2/ At 1982 exchange rate and prices.  Page 2 of 2 COUNTRY DATA - ARGENTIXA MONEY, CREDIT AND PRICES 1978 1979 1980 1981 1982 1/ (Million $a outstanding end period) Money and Quasi Money 16,632 48,749 91,208 188,058 312,620 Credit to Public Sector 2/ 1,578 4,552 15,929 98,339 171,942 Credit to Private Sector 2/ 15,297 47,252 111,914 318,511 526,224 Money and Quasi Money as % of GDP 32 35 32 34 Wholesale Price Index (1970-100) 478 1,192 2,091 4,382 15,610 Annual percentage changes in: Wholesale Price Index 146 149 75 110 256 Bank Credit to Public Sector 126 188 250 517 75 Bank Credit to Private Sector 181 209 137 185 65 BALANCE OF PAYMENTS MERCHANDISE EXPORTS (AVERAGE 1978-80) 1975 1979 1980 1981 (Millions us$) Exports of Goods and NFS 3,704 9,601 10,763 11,563 Cereal 1,099 15.0 Imports of Goods and NFS -4,518 -9,253 -13,980 -12,542 Oilseeds 638 3.0 Resource Balance -814 348 -3 17 -979 Beef and products 947 13.0 Industrial exports 1,695 22.5 Interest Payment (net) -460 -493 -956 -2,964 All other commodities 3,034 40.5 Total 7,413 100.0 Net Transfers 15 -427 30 -23 Balance on Current Account -1,284 -537 -4,689 -4,702 EXTERNAL DEBT, DECEMBER 31, 1981 Direct Foreign Investment - 265 739 927 U5$ Bin. Net MLT Borrowing -12 2,812 3,697 8,623 Disbursements (1,018) (3,795) (5,189) (11,997) Ptublic Debt 10,506 Amortization (-1,030) (-983) (-1,492) (-3,344) Non-Guaranteed Private Debt 12,166 Other Capital Transactions 189 1,902 -2.,484 -8,685 Total Outstanding & Disbursed 22,672 Change in Reserves 1,107 -4,442 2,737 3,807 DEBT SERVICE RATIO for 1981 % Public Debt 3 Non-Guaranteed Private De'bt 15 Total Outstanding and Disbursed 18 IBRD/IDA LENDING, (Decembe]r 31, 1981; Million US$): Outstanding & Disbursed 477.4 Undisbursed 889.0 Outstanding incl. Undisbursed 1,366.4 I/ Except for price movements, estimates for October by IMP. 2/ Consolidated financial system credit, includes official assets in foreign exchange, does not incluide "unclassified" assets.  SUMMARY Macroeconomic Policies and Performance March 1976-March 1981 i. March 1976 marked the latest of a series of economic and political crises which had characterized the past several decades of Argentine history. With inflation approaching 400%, international reserves exhausted, and GDP declining, a military regime assumed control. The new administration acted quickly inter alia to reduce the public sector deficit, free prices and interest rates, and correct the exchange rate. In response, exports expanded rapidly, domestic savings rose, international reserves recovered, and inflation was reduced to just below 150% in 1977 and 1978, but then stabilized at that level. ii. At the end of 1978, a new set of policies was introduced with the intention of accelerating the progress against inflation, while, at the same time, achieving a longer-term restructuring of the economy more in accordance with the country's comparative advantages in international trade. The primary tools adopted for accomplishing both objectives were the gradual reduction of import barriers, via a five-year schedule of customs duty reductions, and the announcement several months in advance of exchange rate adjustments considerably below the current rate of infla- tion. In this way, the price-setting freedom of domestic producers would be increasingly constrained by competition from imports. iii. This new approach did achieve, in the last quarter of 1979, a significant further reduction in the rate of inflation. GDP also rose 7% in 1979, the highest rate in a decade. Crucial to the strategy's sustained success, however, would be the consistency of other policies in restraining aggregate demand, and a positive response in the productive sectors in making the investments and efficiency improvements necessary both to meet the growing foreign competition in the domestic market and to enter export markets. Productive investment was expected to be facilitated by the financial sector reforms and removal of impediments to foreign capital flows begun in 1976. iv. Substantial cuts in public sector expenditures and improved revenue performance had succeeded in reducing the public sector deficit from 16% of GDP in 1975 to 4% of GDP in 1977. Although revenues continued to rise relative to GDP after 1977, expenditures, too, began to accelerate, and the deficit remained constant at 4% of GDP through 1980. (Argentine accounting practice, during a time of high inflation, treats part of interest charges on the public debt "below the line," as amortization of principal; if considered above the line, the calculated deficit would be increased by about 3% of GDP.) Monetary expansion also remained rapid, fueled in part by heavy capital inflows in 1978 and 1979. v. The policy of lagging exchange rate adjustments behind the rate of inflation continued through 1980, even though monthly price increases continued at, or slightly above, the new plateau established in the last quarter of 1979. Altogether the peso appreciated some 45% in real terms from the end of 1977 to the end of 1980, resulting in a substantial shift in the relative domestic prices of traded and non-traded goods and, coupled with legal wage adjustments, a sharp increase in unit labor costs expressed in US dollars.  - ii - vi. Consequently, instead of promoting a smooth transfer of resources from uncompetitive, import-substituting sectors to sectors of potential export, tradeable goods industries generally found their competitiveness in both domestic and foreign markets reduced. The result was a 107% jump in imports (at constant dollars) froni 1978 to 1980, which, alongside a 13% drop in exports and rising interest payments on the external debt, turned a US$1.8 billion current account surplus into a $4.7 billion deficit, the latter equivalent to about 8% of GDP. vii. Public confidence in the Government's economic policies was further weakened during 1980 by growing signs of recession in the indus- trial sector and by the failure early in the year of several f:Lnancial institutions. Expectations of a large peso devaluation increased, despite Government assurances to the contrary, and capital flight appeared and intensified over the course of the year. Heavy public sector foreign borrowing was undertaken toward the end of the year and held 1980 reserve losses to US$2.7 billion. The drain on reserves continued through the first quarter of 1981, during which another US$3 billion was lost. Expec- tations of a major devaluation were heightened by a now increasing public sector deficit, falling industrial output, an ineffective 10% devaluation declared in February, and the imminent change of government scheduled for April. viii. By the end of 1980, the external debt exceeded US$27 billion, more than double its level of two years earlier. Its structure had also changed radically. The level of private foreign debt had tripled over the period, with $5.1 billion of the $8.6 billion increment having less than a one-year maturity. The short-term borrowing of the public sector had also risen sharply, particularly in 1980, so that by year-end 38% of the total debt outstanding had been contracted at short term. The Argentine Economy in 1981-1982 ix. In April 1981, with recession deepening, the balance of payments deteriorating rapidly on both current and capital accounts, and amid grow- ing fears of large-scale bankruptcies in the industrial and financial sectors, the Government of General Viola abandoned the exchange rate policy in effect since 1978 and placed the tariff reduction program in suspension. After successive 23% devaluations in April and early June failed to stabilize the foreign exchange market and to stop the loss of reserves, the Government acted to split the market in late June.. A crawling "commercial" exchange rate, administered by the Central Bank, was applied to merchandise trade, while a floating "financial" rate was intended to absorb and stabilize speculative expectations and thereby encourage a reduction of domestic interest rates. x. A number of measures were taken over the year in an effort to alleviate the financial difficulties of the industrial and banking sectors and to lay the basis for economic riecovery. These included a tax moratorium, programs for refinancing private enterprise debts, additional export incentives, and exchange rate insurance for newly acquired or refinanced external debt. These efforts failed to restore public confidence, however, in part because of open policy disagreements within  - iii - the Government itself and consequent delays in making announced programs effective. Major policy decisions important to private sector expecta- tions, e.g. the future of the tariff reduction program, were left up in the air. xi. Amid the continuing uncertainty, GDP declined 6% in 1981, the industrial production index falling 16% to below the level reached in 1970. Fixed investment declined 15% in real terms. Inflation, propelled in part by the massive devaluations, once again rose to three-digit levels, totaling 180% for the year (December-December). xii. As the malaise deepened, the Government was replaced in December 1981. The new administration of General Galtieri acted quickly to reunify the exchange market and float the peso. Public wages and tariffs were frozen and export subsidies reduced. An intensified effort was announced to divest public enterprises and drastically reduce the public sector deficit (to 2% of GDP). Top priority was given to reducing inflation and stabilizing the exchange market. Only then, it was reasoned, would interest rates decline, permitting the recovery of economic activity. xiii. Significant progress was made during the first quarter of 1982 to reduce inflation and the government deficit and to calm the exchange markets. Interest rates remained high, however, as financing of the public sector deficit shifted from the external to the domestic capital market, and GDP in the first quarter was 6% below that of a year earlier. A rise in exports, particularly of agricultural products, and falling imports contributed to an improvement of the balance of payments. These trends were halted by the outbreak of hostilities in the South Atlantic and the sacrifice of economic objectives to the war effort. Once peace was restored, Argentina would again have to cope with the problems of its external accounts, inflation and recession, and priority attention would again have to be given to management of the public sector deficit and the precarious financial situations of the industrial and commercial sectors. Public Sector Finances xiv. It has been a major proclaimed policy of all the governments since 1976 to reduce the size and scope of the federal public sector, with the objectives of relieving the inflationary pressures which emanated from chronic public deficits, increasing the role of the market in resource allocation, and decentralizing governmental functions to the provinces. Efforts in this regard are reflected in the 10% reduction in the number of central government employees, the 27% reduction of public enterprise work forces, and the 13% increase in provincial government employment which occurred between 1976 and 1981. (Provincial government, as used here, includes the Municipality of Buenos Aires.) Notwithstanding these efforts and the substantial reduction of state market interventions, the direct economic activity of the public sector continued to account for a large fraction of GDP.  - iv - xv. From 1975 to 1980, pub]Lic sector expenditures were equivalent to a roughly constant 40% of GDP, while total public sector revenues were increased from 24% to 36% of GDP. As a consequence, the deficit was reduced from 15% of GDP in 1975 to 4% in the years 1977-1980. However, it rose to almost 7% in 1981, as total public revenue fell faster than both expenditures and GDP. xvi. Although relying heavily on indirect taxes, tax revenues grew significantly faster than GDP from 1976 to 1980, as new property taxes were introduced, inflation accounting was applied to corporate balance sheets, growing imports more than offset the reduction of customs duty rates, and tax administration generally was improved. OnI the other hand, public enterprise tariff rates lagged badly behind inflation from 1978 to 1980, income tax liabilities were postponed in 1981, deepening recession eroded the tax base, and the finances of the social security system deteriorated sharply. xvii. Public sector expenditures remained high throughout the period despite the stated intention to reduce them. After falling significantly in 1976 and 1977, total real wages and salaries paid to public employees rose steadily until 1981, when they were cut. Defense and security expen- ditures rose significantly, their reported share increasing from 15% to 23% of the total central government expenditures. Rapidly mounting interest charges on the public debt also made reduction of the federal deficit increasingly difficult, as did the need for transfers to cover the deficits of the provinces and the social security system. xviii. Among the revenue measures introduced in early 1982 were increases in the value-added tax, de-indexing of the income tax exemption level, the introduction of a 10% tax on nonsubsidized exports, and an upward adjustment of public enterprise tariffs. The Government also declared a public sector wage freeze, reduced export subsidies, and cut public investments. The objective was to reduce the deficit to 2% of GDP. These efforts, however, were overtaken by the war. xix. The successive administrations in 1981 and 1982 gave considerable attention to the objective of transferring public enterprises to the private sector. Late in 1981, a presidential commission was established to prepare a list of companies for privatization. Conflicting views within the Government, however, coupled with the financial difficulties of both the public enterprises and their potential private buyers, prevented much progress from being made. The questions of the proper size and role of the public sector, as well as the efficiency and financial viability of major public enterprises will remain high on the agenda for Argentine policy- makers in the postwar period. Industry and Finance xx. The restructuring of the! industrial sector after several decades of high protection from foreign competition was a major objective of the trade and exchange rate policies instituted in 1978. The financial system had already been substantially liberalized in ]977 -- including the freeing of interest rates and foreign capital movements -- in order to mobilize  - v - both domestic and external savings and channel them to the most productive sectors. The appreciating real exchange rate and lowering of tariff and non-tariff barriers to trade, coupled with the increased availability of financing at international interest rates, would induce potentially competitive domestic industries to modernize while inefficient operations would be retired from the market. xxi. A number of factors, however, many of them interrelated, impeded the expected investment and modernization. As noted above, the appre- ciating real exchange rate distorted relative prices to the detriment of both import-competing and potential export industries, and the impact on the country's trade balance raised increasing doubts about the sustainabil- ity of the exchange rate policy and increasing pressures to reverse the trade liberalization. Adding to the uncertainties facing an industrialist were large and rapid fluctuations in relative product and input prices, including interest rates. Interest rates were highly sensitive to exchange rate expectations and were, in any event, substantially higher than the controlled rates of the past, exacerbating the cash flow problems of firms, many of whose sales were declining as a result of import competition and the general recession. Moreover, many firms still had the high debt-equity ratios motivated by the negative real interest rates of the past. Conflicting government policy statements and long delays in the implemen- tation of announced programs contributed to the uncertain environment in 1981. xxii. Significant adjustments, although not always constructive, did occur in the industrial sector over this period. At the aggregate level, employment in manufacturing declined 24% from 1975 through 1980, while output per manhour rose an average 24%. (Because of the real appreciation of the peso, however, unit labor costs, expressed in US dollars, rose 127%.) Of 23 industrial subsectors, nine (including electrical machinery, textiles, clothing, shoe manufacturing, wood products and construction materials) contracted by 10% or or more during 1975-80, while six (includ- ing basic metals, furniture, rubber and petroleum products) increased output 10% or more. In general, non-tradeable goods fared better than industry as a whole, as the share of imports in the supply of industrial products rose from 10% to 25%. Overall investment levels in private industry are estimated to have covered little more than depreciation over the entire period, having risen sharply in 1976 and 1977 but falling steadily thereafter. xxiii. In spite of the elimination of foreign capital controls, the Argentine financial market remained highly segmented with both banks and final borrowers having differential access to foreign sources of funds. At the same time, 100% deposit guarantees permitted a number of local banks to attract depositors while specializing in high-risk borrowers. Subsequent bankruptcies caused a brief financial panic in early 1980 and set off a first ominous wave of capital flight. Private sector debt grew rapidly, much of it representing distress borrowing, as firms faced falling sales and rising interest charges.  - vi - xxiv. Declining profits in th,e industrial sector brought a rapidly growing volume of bankruptcies and formal agreements with creditors after 1978, with serious implications for the banking system. By late 1981, an estimated 17% of the system's asset portfolio was suffering liquidity problems, and 8% of total exposure was listed as uncollectable. Two offi- cial refinancing schemes introduced during 1981 proved largely ineffective, and the long delay and official hesitation with which the second of these was finally instituted served to heighten the general uncertainty and malaise. xxv. By the end of 1981, pressures were strong to reverse the trade liberalization policy, already in de facto suspension pending a new indus- trial policy statement scheduled for completion in early 1982. It was clear that the restructuring objectives set forth in 1978 were being, at best, imperfectly achieved and were, in any case, superseded by the severe recession and financial crisis now besetting a large proportion of the industrial sector. As with other aspects of economic policy, this debate, too, was temporarily put aside at the onset of the South Atlantic war. xxvi. Despite the evident failure of the policies adopted in 1978, the structural adjustment objectives that motivated them remain valid. The distortion of incentives and macroeconomic crisis that ensued were not inherent to liberalization but rather to the fundamental contradictions among the specific policy measures adopted to achieve it. Instead of opening greater world market opportunities to Argentine enterprises and stimulating investments in modernization and expansion, the industrial sector's competitiveness both at home and abroad was reduced, and investment was made both highly risky and expensive. xxvii. A policy of aiming more gradual -- but more comprehensive -- liberalization via tariff rationalization and a realistic exchange rate policy, with greater concern for dlebt management and control cif the public sector deficit could have offered better incentives to the long-run changes being sought and thus stood a betiter chance of being sustained. The present policy outlook in Argentina is uncertain, but one can probably anticipate a period of some suspension of liberalization as a new basis for stable expectations is sought.  I. MACRO-ECONOMIC DEVELOPMENTS Background 1. Argentina enjoys the benefits of being a resource-rich country (including human capital as well as natural resources) and having a large traditional export sector which, in the post World War II period, paid for the inefficiencies of a costly growth strategy. This strategy included heavy protection of domestic industry and a high level of direct public sector participation in industry, trade and finance. Production technology and the scale of industrial operations were affected by distortions in relative factor prices, and the inefficiencies of public enterprises were covered by fiscal transfers. 2. The inward-looking strategy collapsed in 1975 in the wake of a public sector deficit equal to 16% of GDP, an inflation rate shooting up from 20% to 192%, a sharp deterioration of the current account of the balance of payments and a decline in international reserves to only one-month's worth of imports. The economic crisis was coupled with widespread political violence and led in 1976 to a military takeover of the government. The new Government, presided by General Videla, adopted a series of measures to stabilize the economy and to regain the confidence of international capital markets. The new policies first tackled inflation and balance-of payments problems, but aimed also at paving the way for an economic system which would allocate and utilize its resources more efficiently in the medium-term. Multiple exchange rates were abolished, and a unified and flexible exchange rate policy was adopted; price controls, together with collective wage bargaining, were abolished. The finances of the public sector, where current expenditures alone exceeded current revenue by 28% in 1975, were to be improved through changes in the tax laws and a reduction in the number of public employees. In 1977, interest rate ceilings were eliminated, and the capital market was allowed to operate freely. 3. The stabilization measures were largely successful: between 1975 and 1978, exports increased by more than 80%, foreign reserves rose to 17 months of imports, the public sector deficit was reduced to 4% of GDP, and the gross domestic savings rate increased from 19% to 25% of GDP. However, despite the initial success in bringing down the rate of inflation from 499% (1976) to 146% (1978), the progress against inflation slowed down, leading the Government to take further action. In an effort to stabilize expecta- tions and to begin to open the economy to foreign competition, it decided, in December 1978, to preannounce (8 months in advance) devaluation schedules and public sector prices and to reduce customs duties according to a five-year schedule. 4. The schedules of preannounced nominal exchange rates, the so-called "tablita," and public enterprise tariffs called for steadily decreasing rates of adjustment in order first to dampen inflationary expectations. If inflationary expectations lagged, however, then the real exchange rate would appreciate, and the fall in the relative price of imported goods would increase the degree of foreign competition.  - 2 - 5. Ten months after the schedules were instituted, the inflation rate decreased considerably: from a monthly 8.7% in the first quarter to 2.3% in the last quarter of 1979 (see Appendix Table 6.3). The economy also recov- ered from the recession of 1978, with the highest growth rate achieved in the 1970's. Monthly exchange rate adjustments lagged considerably behind differ- ential inflation, however, and the peso appreciated 24% in real terms between December 1978 and December 1979. Thanks to rising international commodity prices and a bumper wheat harvest, the negative effects of appreciation on exports were offset, and merchandise exports increased 22% (inI current dol- lars). Imports, on the other hand, were affected strongly by both the reduc- tions in tariffs -and the increasingly overvalued peso, rising 43% in real terms. Factor payments abroad and the non-factor services deficit doubled, as a result of a sharp increase in external tourism and direct investment income. The deterioration of both merchandise trade and services balances resulted in a current account deficit. Foreign exchange reserves, which had been climbing since 1977 in response to high domestic interest rates, reached a peak (equal to 18 months of imports) in 1979. Foreign capital con- tinued to pour in, but mainly at short-term maturities. 6. The growth spurt of 1979 was short-lived. Exchange rate adjust- ments continued to lag behind differential inflation, hurting export sectors and import-competing industries alike. The level of economic activity drop- ped in the first half of 1980, as the problems of agriculture and livestock were accentuated by droughts and falling international prices, and industry found itself in an increasingly difficult situation under the pressure of rising financial costs and cheaper imports. Real lending rates rose above 25%, and the peso appreciation reached 41% by the end of 1980. The peso was nominally devalued only 50% between December 1978 and December 1980, while the domestic wholesale price and cost-of-living indexes increased 3.6 and 4.5 times, respectively. 7. The decline in GDP growth from 7.1% iin 1979 to 0.7% in 1980 reflec- ted absolute contraction in both nanufacturing industry and agricultural pro- duction. The positive overall growth was centered in the banking and con- struction sectors. Despite success in reducing inflation, public confidence progressively weakened over the course of the year in the wake of the failure of several large financial institutions, deepening recession, the perceived bogging down of efforts to reduce the public sector deficit, high interest rates, and the steady real appreciation of the peso. 8. In spite of a moderate rise in exports in current doLlars, the cur- rent account deficit reached US$4.7 billion in 1980, reflecting a substantial (51%) rise in imports. Foreign exchange reserves by year-end had declined 28% to US$6.9 billion from an all-time high of US$9.7 billion at the end of 1979. With the forthcoming change of government heightening expectations of a correction of the exchange rate, capital outflow during the f-irst quarter of 1981 reached dramatic proportions. In February, prior to the change of government, a 10% devaluation was enacted in an effort to halt the outflow, but it served only to quicken the pace and led the authorities to resort to emergency borrowing to cover the loss in reserves. Nevertheless, losses during the first quarter amounted to US$3.0 billion, or 40% of the reserves held at the end of 1980.  - 3 - 9. The total external debt registered with the Central Bank stood at US$27.2 billion at the end of 1980 (see Table 1), more than double its level at the end of 1978. 1/ Its structure had also changed radically. Outstanding private sector external debt (including some publicly guaranteed debt) more than tripled over the period, with US$5.1 billion of the $8.6 billion increment having maturities of less than one year. Short-term borrowings of the public sector also increased sharply, so that US$10.3 billion, or 38 percent of total debt outstanding, had been contracted at short term. Table 1: EXTERNAL DEBT REGISTERED WITH THE CENTRAL BANK, 1978-1981 (Millions of US Dollars) 12/31/1978 12/31/1979 12/31/1980 4/30/1981 Total External Debt 12,496 19,034 27,162 30,538 A. Public Sector 8,357 9,960 14,459 17,159 Medium- and Long Term 6,747 8,265 10,284 11,510 Short Term 1,610 1,695 4,175 5,649 B. Private Sector 4,139 9,074 12,703 13,379 Medium- and Long Term 3,102 5,438 6,593 7,434 Short Term 1,037 3,636 6,110 5,945 /1 /1 As of April 1981, private short-term debt may be overstated. The Central Bank believes that a large proportion of private debt was prepaid in anticipation of peso devaluation. SOURCE: Central Bank The 1981 Recession and the Policies for Recovery 10. In response to the growing balance-of-payments crisis, the new Government, presided by General Viola, devalued the peso by 23% on April 2, 1981. Following the devaluation, reserves recorded gains in April of some US$1.2 million. However, when the monthly inflation rate tripled, the rush to the dollar was renewed, and interest rates soared. A refinancing scheme to help industry with its liquidity problems may instead have helped to finance the renewed capital outflow. Continued reserve losses led to another 23% devaluation on June 2, but this devaluation, too, failed to restore confidence and stop the capital outflow, and the Government acted to split 1/ Official data show a net additional debt of US$3.4 billion by the end of April 1981, contracted largely by the public sector. This may have been offset, however, by an unregistered reduction of outstanding short-term debt of the private sector (see the note to Table 1).  - 4 - the foreign exchange market on June 22. 2/ The Government also reaffirmed the commitment to trade liberalization, and top-bracket import duties were reduced by up to 12 percentage points. At the same time, however, the five-year tariff reduction schedule was suspended pending a review of trade and industrial objectives. 11. The devaluations in 1981 were accompanied by temporary tax measures intended to absorb the windfall gains accruing to exporters and to compensate partially for the rise in the peso value of imported goods. Also, to offset the effects of devaluations on firms with external debts and to encourage capital inflow through the elimination of exchange risk, a devaluation compensation scheme anid an exchange rate guarantee system were introduced for firms either restructuring existing debts or contracting new medium- or long-term loans. 12. The Government wanted to hold the "financial" rate within narrow limits (with a view to having the two rates converge in the near future), and the Central Bank occasionally intervened, through Banco de la Nacion, to stabilize the free exchange market. Such efforts, however, proved to have a counterproductive impact on expectations, which were also affected by the delay of rains in the Pampa and of industrial recovery, together with rumors of new exchange market regulations and declining confidence in the Government. In spite of a last el-fort to introduce a forward exchange market to be managed by the Central Bank, pressure continued, and the financial peso lost a further 28% of its value in the fourth quarter. At the end of 1981, the nominal exchange rate stood 80% below its 1980 year-end value. 13. During 1981, GDP fell 6%, with manufacturing output contracting 16%. Unemployment doubled to an official rate of 6%, and inflation soared again to 110%. The problems facedL by manufactu-ring, the largest productive sector, were echoed by the construction, trade, transport and banking 2/ Under the new system, imports' and exports of goods were transacted at a "commercial" rate fixed by the Central Bank, while all other trans- actions, including payments of insurance and freight on merchandise trade, as well as other factcr and non-factor services, were conducted at a freely floating "financial" rate. Further, exporters of "promoted products", which provided around 30% of total export revenue, were able to exchange 10% of export proceeds at the financial rate. A mandatory delay of 180 days on the official remittance of import bills (f.o.b. value) also increased the effective exchange rate for merchandise imports. To eliminate the resultant exchange risk, importers frequently covered their exchange needs in the financial market.  - 5 - sectors, all of which contracted. The financial sector faced increasing difficulties, as many of its industrial borrowers became insolvent. Two debt relief schemes, introduced in April and November, fell short of their targets (see paras 58-61), and the financial strain on producers was aggravated by the steady fall in demand. Agriculture, thanks to both good weather and correction of the exchange rate, recorded a 3.7% growth in 1981, although its output was still below the 1979 level and only slightly above that of 1974. Yields in major export crops, corn and sorghum,rose almost 50%, although the wheat yield remained low. 14. After rising to 23% of GDP in 1980, fixed investment fell to 21% of GDP (a 15% fall in real terms) in 1981. Nevertheless, considered against the rates of GDP growth of the last two years, 0.7% and minus 6%, respectively, gross fixed investment was surprisingly high . Expectations of large-scale devaluations apparently contributed to more capital goods being imported (in current dollars) in 1981 than in 1980, much of the import occurring in the first quarter, when the level of economic activity had already started to decline. Stabilization Efforts during First Quarter 1982 15. As the situation continued to deteriorate, a new Government, headed by President Galtieri, took office in late December 1981. Among its immediate measures were: (i) the reunification of the foreign exchange market and the floating of the peso, resulting in an implicit devaluation of 32%; (ii) the revitalization of efforts to reduce the size of the public sector through the privatization of state enterprises; and (iii) the freezing of wages and public tariffs and reduction of export subsidies, together with other measures to reduce public expenditures and increase tax revenue. The freeze on public tariffs was introduced, in spite of its negative effects on public revenue, in order to induce greater efficiency in public enterprises and to reduce cost-push pressures and inflationary expectations. 16. The Government believed that as the inflation started to slow down in response to the reduction of the public deficit, inflationary expectations would be revised downward, leading to a significant fall in interest rates. The resultant decline in financial unit costs would allow firms to restructure their debts and extricate themselves from the financial "straitjacket". Households, moreover, would direct more of their funds to consumption, stepping up the demand for domestic products and bringing about the recovery of investment. 17. During the first quarter of 1982, the Treasury deficit, which was given the central role in the program, was reduced 38% below its 1981 level in real terms (see Table 2). The reduction reflected, in large part, the freeze on public wages, the deindexation of the tax-exempt portion of income, and a rise in the rate of the VAT. Treasury revenue held close to its 1981 level, in real terms, despite the sharp fall of GDP. The Government's borrowing from the Central Bank was also significantly reduced, the burden shifting to the internal financial market.  -6- Table 2: TREASURY OPERATIONS, FIRST QUARTER 1982 (Billion pesos and percentages) First Quarter Real Change 1982 Over First Quarter 1981 (percent) Total Revenue 12,379 --3.1 Total Expenditure 18,513 -18.2 Deficit 6,134 -37.7 Financing: Central Bank 3,751 -36.6 Internal Credit (net) 4,623 /1 External Credit (net) -2,240 71 /1 Involves changes from positive to negative (negative to positive). SOURCE: Ministry of Economy 18. As a consequence of the efforts to reduce the deficit, the rate of inflation (as measured by the wholesale price index) declined rapidly: after a surge to 14% in response to the reunification of the foreign exchange markets, the monthly inflation rate fell to 5.5% in February and 4.5% in March. The fall in the rate of interest was slow, however, reflecting the shift of public sector financing from the Central Bank to the internal capital market and also, perhaps, uncertainty regarding the Government's ability to resist rising pressures for an expansionary policy. The thirty-day bank lending rate, which was 8.5% during the last quarter of 1981, remained almost stable at that level during January and February and fell only slightly (to 8.1%) in March. 19. Following the reunification and floating of the peso, relative stability was restored to the foreign exchange market. The freed exchange rate, together with prepayment facilities and export subsidies of up to 10%, helped to stimulate a substantial increase of industrial exports during the first two months of 1982. The reunLification substantially raised the effective exchange rate for exporters, in spite of the reduction of subsidies (see Table 3). Given the depressed state of domestic demand, reduced pressure on wages (as a result of increased unemployment and the public wage freeze), and the near-zero opportunity cost of capital (average capacity utilization in industry was 55% in the second half of 1981), industry increased its efforts to gain entry to world markets. Leading the trend were metal and paper products and textiles. The real increase in total exports (including the traditional items) was 9% during the first quarter compared to the same period in 1981.  - 7 - Table 3: CHANGES IN EFFECTIVE EXCHANGE RATES FOR EXPORTS (Based on pre-float rates) 1. 20% or less Machinery, transport equipment, tools, leather products. 2. Between 21% and 25% Chemicals, shoes, steel tubes, sugar, raw wool, cereals and oilseeds, raw meat. 3. Between 26% and 30% Hides and skins, meat products, food products, cotton yarn, rubber, paper, coal, aluminum. 4. 43% Fuels: diesel and gasoline. SOURCE: Fundacion de Investigaciones para el Desarrollo (FIDE). 20. With both exports and imports responding to the recession and the more favorable exchange rate, the trade account turned positive in the first quarter of 1982 (see Table 4). Reserves recorded gains early in the year, but the trend changed in March, as a result, once again, of diminishing confidence in the sustainability of economic policy. As reserve losses in March reached US$266 million (60% of the gains in the first two months), the exchange rate depreciated a further 13%. Table 4: BALANCE OF PAYMENTS, 1981 AND 1982 (FIRST QUARTER) (Million US dollars) 1981 (I) 1982 (I) Current Balance -1,849 -74 Merchandise Trade (net) -913 690 Exports 1,878 2,140 Imports -2,791 -1,450 Services -932 -767 (Interest) (-637) (-720) Unilateral Transfers -4 3 Capital Account -1,136 242 Change in Reserves -2,985 168 SOURCE: Central Bank  - 8 - 21. The external debt profile improved during the first three months of 1982, as the private sector was able to reduce its short-term obligations by US$166 million, while its medium- and long-term debt increased US$265 million. The public sector debt profile also improved, with a reduction of US$254 million in short-term and a US$261 million increase in medium- and long-term debt, fulfilling also the objective of keeping public external debt constant in rca.l terms. 22. GDP during the first quarter of 1982 was 5.9% below that of the first quarter 1981. The sectors affected most were construction (-15.1%), industry (-13.2%), and banking (-12.9%). Among industrial sub-sectors, wood products and furniture contracted almost 40%, and machinery and equipment 28%. Apart from agriculture, which recorded positive growth (7.4%), the only industry that held its own during t:he recession seems to have been basic metals, for which 1982 first quarter production was almost equal to that of the 1980 first quarter. Investment: was 27% below that of a year earlier and equivalent to less than 2/3 of the 1980 level. The reduction in construction activity reflects a sharp fall in both private (-21%) and public (-8%) investment. The drastic fall in the demand for capital equipment (42% vis-a-vis 1981 and 51% vis-a-vis 1980) is reflected in the contraction of both imports and domestic capital goods output. Summary of the 1979-1981 Experience 23. At the end of 1978, the Government of Argentina introduced a set of policies intended to achieve both short-run price stabilization and a longer-term restructuring of the economy along more efficient lines consistent with the country?s comparative advantages in international trade. The primary tools utilized for accomplishing both objectives were the gradual reduction of import barriers and the pre-announcement of exchange rate adjustments considerably below the current rate of inflation. Crucial to the approach's success was, first of all, the consistency of other policies in restraining aggregate demand; and secondly, a positive response from the productive sectors in making the efficiency improvements necessary to meet the growing foreign competition in the domestic market and to exploit the opportunities opened to export. Productive investment was to be facilitated by the financial sector reforms and removal of impediments to foreign capital flows begun in 1976. 24. Although success in reducing inflation was becoming evident: by late 1979, the policy approach ultimately failed. In early 1981, with recession deepening, the balance of payments deteriorating rapidly on both current and capital accounts, and growing fears of wholesale bankruptcies in the industrial and f'inancial sectors, the exchange rate policy was a,bandoned, and the tariff reduction program was at least temporarily suspended. and its future placed in doubt. Among the factors contributing to this failure was the inability of the authorities, after some initial success, to reduce the public sector deficit and constrain the growth of aggregate demand. The result, in the context of the Government's exchange rate policy, was a sharp  - 9 - real appreciation of the peso, stimulating the rapid growth of imports and discouraging exports. Consequently, instead of promoting a smooth shift of resources from uncompetitive import-substituting sectors to sectors of potential export, tradeable goods industries found market opportunities on both sides reduced, while domestic input costs continued to rise. As expectations of a peso devaluation increased, despite Government assurances to the contrary, and public confidence, in general, declined, capital flight appeared and intensified, and real interest rates rose, further squeezing private enterprise finances and exacerbating the economic contraction. 25. Efforts through 1981 to restore public confidence and lay the basis for economic recovery and the resumption of trade liberalization were not successful. Many factors, economic and political, were responsible for the malaise. Among the major factors were the continued inability to reduce the public sector deficit and the precarious financial situations of the industrial and banking sectors. These aspects of Argentina's continuing economic difficulties are examined in greater detail in the following two chapters.  - 10 - II. PUBLIC SECTOR FINANCES Size of the Public Sector 26. The objectives of each successive government since 1976 have included the reduction of the size and scope of public activity, with a view to diminishing the inflationary impact of large public deficits and to raising the geaeral level of efficiency. However, in spite of the signifi- cant steps taken to reduce state market interventions (such as the removal of price and interest rate controls and the abolition of quantitative trade restrictions), direct public activity continued on a large scale. In fact, notwithstanding the attempts to cut down the number of public employees and to divest public enterprises, the relative importance of the public sector increased, as private industry contracted. 27. During the period 1976-1981, public expenditures averaged the equivalent of 39.6% of GDP, 3/ excluding payments of interest treated in the public sector accounts as amortization (i.e. inflation correction of public debt), which, in their turn, accounted on average for an additional 3% of GDP. On the other hand, in spite of the efforts to increase tax revenue, the policy of reducing real public tariff levels, as well as economic instabil- ity, caused overall public revenue to lag significantly behind public expen- diture. Thus, the total public revenue averaged, during 1976-1981, the equivalent of 34% of GDP. This represented, nevertheless, a considerable increase over the revenue performance of the early 1970's, when the ratio was around 26%. The public sector's share in fixed investment increased from the 1971-75 average of 26% to an average 44% during 1976-80. 28. An overall 7% reduction in public employment (including official banks but excluding the municipalities other than that of Buenos Aires) was achieved between 1976 and 1981, largely through attrition. The enterprises, in particular, shed 27% of their work force over the period. The number of central government employees was reduced by 10%,, while provincial govern- ments, and especially the Municipality of Buenos Aires, actually increased personnel by 13%, reflecting, to some extent, the decentralization of health and education services. 3/ The numerator of this ratio reflects consolidated public sector expendi- ture (including intrasectoral sales, but excluding intrasectoral finan- cial transfers) as recorded in the public sector accounts, while the denominator is the GDP as shown in the national accounts. The implied share of the public sector in the national accounts is overstated because of the double-counting of intrasectoral movements of goods and services.  - 11 - Table 5: PUBLIC SECTOR OPERATIONS, 1971-1981 1/ (Percent of GDP) Financing Total Total Net External Net Internal Revenue Expenditures 2/ Balance Credit Credit 1971 28.3 32.8 -4.5 1.2 3.3 1972 26.4 31.9 -5.5 1.1 4.5 1973 27.1 34.6 -7.5 0.1 7.4 1974 30.7 38.7 -7.9 0.9 7.1 1975 23.8 39.0 -15.2 0.1 15.1 1976 28.0 39.1 -11.1 1.1 10.0 1977 33.0 37.0 -4.0 1.3 2.8 1978 37.3 41.2 -3.8 1.4 2.4 1979 35.1 38.3 -4.0 1.4 2.6 1980 36.2 40.2 -4.0 1.7 2.3 1981 35.2 41.8 -6.6 4.6 1.9 1/ Includes general government and public enterprises. _/ "Interest as amortization" is not included. SOURCE: Central Bank and Ministry of Economy Tax Revenue 4/ 29. Total tax revenue increased significantly after 1976, reflecting improvements in the tax system. New property taxes enlarged the tax base substantially, and mandatory inflationary accounting in corporate balance sheets also contributed to the increase in income tax revenue. Following the elimination of quantitative restrictions on imports and the more than doubling of the dollar value of imports, import taxes also increased signifi- cantly, notwithstanding the reductions in tariffs. Tax administration in general was helped also by the indexation of late payments which eliminated the implicit subsidy to delinquent taxpayers. 30. In spite of the above-mentioned improvements, which increased the overall buoyancy of the tax system (see Table 6), the tax structure continued to reflect the traditional pattern, which relied heavily on indirect taxes (4/5 of Treasury tax revenue). Also, within this category, foreign trade - 4/ See Appendix I for a description of the structure of public sector revenues.  - 12 - mainly import - taxes continued to play a major role, reflecting difficulties of administering the value-added tax. _/ Table 6: TAX BUOYANCIES, 1971-1980 1971/75 1976/80 With respect to the (DP: Total Tax Revenue .77 1.44 Treasury Tax Revenue .49 1.15 Income Taxes .24 1.27 Property Taxes .05 1.81 Production & Consumption Taxes .58 1.58 (incl. VAT) Import Taxes .49 2.05 Export Taxes .92 -5.91 With respect to imports: Import Taxes .59 1.78 SOURCE: Appendix Table 5.4 31. Tax revenue in 1981 increased by 4.6%, in real terms despite the recession (see Table 8), reflecting the tax changes of 1980. The announce- ment of a tax moratorium in June 1981 (becoming effective in October) caused a substantial fall in tax revenue, but collections in the last quarter more than offset the earlier fall. The loss of revenue caused by a reduction in employers' contributions to social security (see Appendix T) was to be partly compensated by the parallel rise in the rate, and extension of the base, of the value-added tax. However, both because output dipped more than employment in 1981, and because administration of the VAT has proved to be difficult, net revenues remained below expected levels, leading to a deterioration in the social security system's finances. Fuel tax revenue also increased, reflecting both the effeclt of real devaluations on fuel prices and the rise in the proportion of transfers from the StaLte Petroleum Company (YPF) to the Treasury. 5/ The Tax Office (DGI) estimates that evasion of the value-added and sales taxes is as high as 50% of the taxes collected. The DGI classifies taxpayers into six groups according to the magnitudes of their fiscal obligations. The top group consists of some 22,000 enterprises, which contribute 50% of total VAT and sales tax revenue. Their performance is monitored continuously, and therefore evasion in this group is not widespread. The bulk of the tax revenue losses is thus the result of the actions of the other five groups.  - 13 - Table 7. STRUCTURE OF TREASURY TAX REVENUES, 1979-1981 (percent) 1979 1980 1981 Tax Revenue 100.0 100.0 100.0 1. Income Tax 11.0 12.6 14.3 2. Capital Taxes 6.7 6.5 7.0 3. Production & Consumption Taxes 60.3 60.3 81.0 a) VAT and Sales Taxes 31.1 34.3 41.7 b) Excise Taxes 13.6 13.4 14.9 c) Stamp Duty 6.6 6.8 5.4 d) Fuel Taxes 1/ 4.0 3.8 18.9 e) Others 6.9 1.9 0.1 4. Foreign Trade 22.0 26.2 31.2 a) Import Tax 19.0 23.4 24.5 b) Export Tax 0.6 0.5 3.4 c) Foreign Exchange Transactions 2.3 2.4 3.2 5, Tax Amnesty -- 0.0 0.0 6. Social Security Tax Compensation 2/ -- -5.6 -33.4 1/ Appropriations by the Treasury only. 2/ Transfers to social security system from the Treasury to compensate for the revenue losses caused by the change in the social security tax. SOURCE: Appendix Table 5.4 Table 8: TOTAL TAX REVENUE, 1980-81 (Billions of 1980 pesos and percentage change) 1980 1981 Change TOTAL TAX REVENUE 61,512 64,355 4.6 SHARED TAXES ("Coparticipados") 58,286 62,452 7.1 Income Taxes 8,626 8,657 0.4 Property Taxes 4,504 4,237 -5.9 Value Added Tax 23,328 25,764 10.4 Excise Taxes 9,192 9,172 -0.2 Others 1/ 2,136 922 -56.8 Fuel Tax Transfers 2/ 7,306 10,875 48.9 Others 3,195 2,825 -11.6 NON-SHARED TAXES 2,867 1,885 -34.2 OTHER TAXES 358 18 -95.0 1/ Including social security tax. 2/ Reflects the change in the Treasury appropriation rate. SOURCE: Fundacion de Investigaciones para el Desarrollo (FIDE)  - 14 - Public Pricing Policy 32. Public pricing policy went through four different phases between 1976 and early 1982. During 1976 and 1977, the real levels of public tariffs were increased. From the beginning of 1978, in an attempt to dampen the rate of inflation, tariffs were adjusted at a slower rate than inflation. In the face of larger subsidies required by public enterprises, the Government reversed the policy again in mid-1979 (see Appendix Table 5.10). During this third period, which lasted until the end of 1981, the policy was to keep real tariff levels constant. In the early months of the Viola Government (from April to July 1981), however, major devaluation-induced increases in the inflation ratie were not reflected in public tariffs (especially the price of electricity) until later in the year (see Table 9). By December 1981, average real tariffs had regained their December 1980 levels and reached 86.2% of the 1978 average. In January 1982, nominal tariffs were frozen, and the public pricing policy was put under review. Table 9: ADJUSTMENTS IN REAL PUBLIC TARIFFS 1/, 1981 (1960 = 100) General Level Fuel Energy Transport January 122.2 120.1 100.5 111.4 February 122.4 121.2 100.4 110.3 March 122.9 122.4 101.2 109.9 April 117.5 114.0 95.4 109.1 May 113.7 110.5 92.1 95.7 June 107.9 107.2 87.1 95.7 July 106.4 104.7 85.3 98.6 August 109.8 108.4 89.5 101.1 September 117.0 119.5 92.0 106.9 October 124.1 126.4 95.5 108.4 November 125.0 127.9 95.2 110.3 December 121.6 125.1 93.2 104.9 1/ Relative to domestic non-agriculture wholesale prices. SOURCE: Appendix Table 5.10-B Public Expenditures 33. Public sector expenditures in Argentina accounted for more than 40% of GDP during 1980 and 1981. Between two-thirds and three-fourths of the total was directed to current expenditures, which included wages, secondary inputs and interest payments on the public debt (see Table 10). The latter, under Argentine accounting, is composed of two parts: the first is "pure" interest, net of inflationary adjustment, while the second is "interest as amortization", i.e. that part of interest needed to compensate the loss in the value of capital due to inflation. (This latter portion is not included in the above-line expenditures by the Argentine fiscal accounts.) 'Interest as amortization" has remained constant at around 3% of GDP in recent years.  - 15 - 34. In spite of reductions in the number of public employees, the share of wages in overall public expenditure, after falling significantly in 1976 and 1977, steadily increased until the beginning of 1981. During 1981, however, average real wages in the public sector fell 14%, and, combined with further reductions in the number of public employees, the share of wages in overall public expenditure declined. Table 10: THE STRUCTURE OF PUBLIC EXPENDITURE, 1976-1980 (Percent) 1976 1977 1978 1979 1980 1981 TOTAL EXPENDITURE 100.0 100.0 100.0 100.0 100.0 100.0 Wages and Salaries 28.9 25.9 28.7 31.2 34.6 30.7 Goods & Services 21.4 19.0 19.6 19.2 18.5 19.2 Gross Fixed Investment 28.7 32.2 29.3 26.0 23.8 21.9 Other Expenditures 21.0 22.9 22.4 23.6 23.1 28.2 (including indexed interest payments) SOURCE: Appendix Tables 5.6, 5.8 and 5.9 35. During the post-1976 period, the pattern of social and administra- tive expenditures of the central government underwent substantial change (see Appendix Table 5.7). Known defense and security expenditures rose from an average of 15% to 23% of the total; education and culture, and social welfare increased their shares (from 7% to 10% and from 10% to 17%, respectively), while the funds allocated to health and general administration were reduced in relation to the total. The composition of overall 'economic' expenditures did not change appreciably, and reflected the pattern of fixed capital investments, of which 60%-75% went to energy and transport (see Appendix Table 5.12). 6/ 36. Despite the repeatedly declared intention to reduce the federal deficit, total Treasury expenditure in 1981 was 15% more than in 1980 in real terms. Seventy-two percent of this increase was attributable to increased transfers to the provincial governments, and 7% to the rise in the central government's own investment expenditures. During 1981, transfers to state enterprises were limited to 78% of their 1980 magnitude by the rationaliza- tion of public tariff policy (see Appendix Table 5.5). Including "interest as amortization" and excluding transfers, the central administration accounts illustrate the limitations on efforts to reduce expenditures (see Table 11). Central government wages were reduced in real terms, but fixed capital expen- ditures increased, as did interest payments, whose share rose from 24% to 34% 6/ Argentine public accounting lists a part of defense expenditures under "investment". Over the period 1978-80 defense "investments" were equal to 25% of total defense expenditures.  - 16 - of total treasury expenditures, reflecting the increasing indebtedness of the government as well as the rise in external debt service caused by the devaluation and increased interest rates. Table 11: TREASIJRY EXPENDITURES, 1980-1981 1/ (Billions of 1980 pesos 2/ and percent) 1980 1981 Absolute Share Absolute Share (1) (2) (3) (4) TOTAL 17,458 (100.0) 21,023 (100.0) Wages & salaries 9,182 (52.6) 8,438 (40.1) Goods & services 2,401 (13.8) 2,641 (12.6) Interest on debt 62 (0.4) 197 (0.9) Interest as 4,140 (23.7) 7,044 (33.5) amortization Fixed capital 1,621 (9.3) 2,303 (11.0) investment Financial investment 52 (0.3) 399 (1.9) /1 Excludes transfers to other agencies; includes interest as amortization. /2 Deflated by the general wholesale price index. SOURCE: Table 5.5 and the Ministry of Economy. 37. In spite of improvement in the self-financing ratios of provincial government investments since 1977, their burden on the Treasury increased in 1980, resulting in the need for larger emergency transfers also in 1981. Some provinces which produce a higher proportion of tradeable goods were hit as early as 1978. Later, as exporting became less profitable, the financial profile of agricultural producers in general deteriorated. Further, weather conditions, as well as lower investment, contributed to the drop in yields of all major crops (except sugar cane, tobacco, and linseed) in 1980. The province worst hit was Chaco: more than half of Chaco's income comes from cotton, whose production had been falling since 1977/78, and dropped by almost half in the 1980/81 harvest. The increasing indebtedness and falling deposits of Chaco farmers paralyzed the provincial bank and led in March 1981 to intervention by the Central Bank, which provided two rediscounts amounting to 1,250 billion pesos. 38. During 1981, transfers t:o the official banks in the provinces took two forms. The first consisted of eight-year (two-year grace) loans from the Banco de la Nacion or National Savings and Loan Association to provincial governments for the capitalization of the banks. These loans carried the official average interest rate. I'he provinces which were helped most by this program were Chaco, Cordoba, Santa Fe, Tucuman and Mendoza. In  - 17 - addition, there were two Central Bank rediscount schemes, which provided funds especially to banks in Chaco, Mendoza, Santa Fe, Corrientes and Cordoba. 39. Reflecting a substantial improvement in revenue performance, the overall public sector saving/investment ratio jumped sharply in 1977, but then declined steadily through 1981 (see Table 12). Public investments started in earlier years without solid financing increased the resources required in 1981 and coming years (both because of the funds needed to complete the investments and the servicing required for indexed loans). Indeed, of the total transfers of the Treasury, the share going to finance the investments of other public authorities rose from 25% to 41% between 1980 and 1981 (see Appendix Table 5.5). 40. Savings ratios of the state enterprises deteriorated during 1979, when tariffs were lagged behind inflation, recovering slightly in 1980. Not being able to reduce their investments, the enterprises borrowed heavily. Their indebtedness in local currency increased 2.8 times in real terms. Compared to a 1.8 times increase in private sector local indebtedness, this rapid expansion reflected in part the relatively less significant use of foreign resources by the state enterprises. Discouraged to borrow from abroad, their external indebtedness rose only 36% in real dollar terms during the same two-year period, even though the cost of external credit was only 60% that of internal credit. 41. The direct impact of the multiple devaluations of 1981 on the cost of public investment was equal to about 9% of the investment budget. 7/ The indirect effects of devaluation on public expenditure in general -- through the prices of domestic goods and services, including indexed interest payments on public debt -- were much greater. Revenue effects of the devaluations remained limited because of the sharp fall in imports. 42. Another element that raised the level of public expenditure in 1981 was the emergency borrowing. From the fourth quarter cf 1980 onwards, private capital outflow drained reserves, and the Treasury and state enterprises were led to borrow to compensate the losses, altering the debt profile of the public sector significantly and raising the overall levels of interest and spread. On top of the service on short- and medium-term public debt, both of which more than doubled between 1978 and 1980, this emergency borrowing put an additional burden on the 1981 budget. The deterioration of the profile of the public debt was striking: the proportion of short-term debt in the total debt of the Treasury increased from 25% to 38% between December 31, 1980 and April 30, 1981 (see also para 8 and Table 1). 7/ The 1978-80 average of the ratio of machinery and equipment to total investment was 31%; the average import component of machinery and equipment was 34%. The imported inflation rates were 75% and 158% in 1980 and 1981, respectively.  Table 12: PUBLIC SAVINGS AND SAVING/INVESTMENT RATIOS, 1971-1981 (Percent)