Argentina - Strategies toward industrial and export development

Report No. 534Nlb-AR' Auntina: Strated. - Ind,s5tria1 and Export DXx i ioprent Septptvi)mer 30, 1985 Latin Amnerica and Caribbean Regional Office FOR OFFICIAL USE ONLY ", 15 .-~~~~~~~~~ ! 19m5 8 " ,~~~1 , i Document of the World Bank This document has a restricted distribution and may be used,hy recipients orily in the performance of their official duties. Its corntents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit = Argentine Peso ($a) until June 16, 1985. On June 17, 1985, as part of a currency reform, the currency unit was changed to "Austral" which was converted as of that date as the equivalent of 800 Argentine Pesos. Official Exchange Rates: Average in May 1985: US$1 = 525 Argentine Pesos June 14, 1985: US$1 = 725 Argentine Pesos From June 17, 1985: US$1 = 0.800 Australes LIST OF ABBREVIATIONS ADEBA Asociacion de Bancos Argentinos (Association of Argentine Banks) BANAPE Banco Nacional de Desarrollo (National Development Bank) BCRA Banco Central de la Republica Argentina (Central Bank of Argentina) BONEX Bonos Externos (Foreign Bonds - Government bonds denominated in US dollars and bearing international interest rates) CACE Consejo Asesor de Comercio Exterior CEPAL Comision Economica para America Latina (Economic Commission for Latin America - ECLA) CONICET Consejo Nacional de Investigaciones Cientificas y Tecnologicas (National Council for Scientific and Technological Research) CRM Cuenta de Regulacion Mlonetaria (Monetary Regulation Account) DAT Pireccion General de Asesoramiento Tecnico (Directorate of Technical Assistance, Province of Santa Fe) DFI Direct Foreign Investment DJNI Declaracion Jurada de Necesidades de Importaciones (Legal declaration required for import permits) ENTEL Empresa Nacional de Telecommunicaciones (State Telephone Company) FIEL Fundacion de Investigaciones Economicas Latinoamericanas (Latin American Foundation for Economic Research) GDP Gross Domestic Product INDEC Instituto Nacional de Estadistica y Censo (National Institute For Statistics and Census) INTI Instituto Nacional de Tecnologia Industrial (National Institute for Industrial Technology) ITD Industrial Technology Pevelopment QRs Quantitative Restrictions R&D Research and Development SIGEP Sindicatura General de Empresas Publicas (General Comptroller of ,I'blic Enterprises) SOMISA State Steel Company SMI Small and Medium Scale Industry -Anexo I", (Lists of tariff positions formally established as "prohibited Anexo II", items", "imports subject to prior consultation", and Anexo III *"restricted for reasons of public health/hazards", respectively, under the imrport control decree Decree 4070/84) -Secretaria de Industria" means Secretariat of Industry "Secretaria de Comercio Exterior- means Secretariat of External Trade  FOR OMCIAL USW ONLY This report is based on an industrial, trade and financial sector mission which visited Argentina during May 20-June 19, 1985. The mission was composed of: Krishna Challa (Mission Chief) Fernando Montes (Financial Economist) Marko Voljc (Operations Officer/Economist) Peter Wogart (Industrial Economist) Claudio Frischtak (Industrial Economist) Anil Kapur (Industrial Restructuring Specialist) Darius Mans (Economist/Industrial Technology Specialist) Alejandro Schwedhelm (Industrial Specialist) Manuel Nunez (Investment Officer, IFC) Rudolf Homes (Consultant-Financial Economist). Messrs. Arturo Meyer and Jose Delfino (Consultants) assisted the mission in the field. A draft version of the report was discussed with the Government by Messrs. Challa and Sokol during a visit to Argentina from September 12 to 18, 1985. Tis docmenlt has a restictd ditibuton nd may be used by ecpiets o* in the pew.une of ther oficidal due Its utctntsma not oterwi be disosed whout Wwrd Bank autorizaon  ARGENTINA STRATEGIES TOWARD INDUSTRIAL AND EXPORT DEVELOPMENT TABLE OF CONTENTS Page No. PREFACE AND ACKNOWLEDGEMENTS .. .............. .... .. vii OVERVIEW AND HIGHLIGHTS ........................................ ix I. MACRO-ECONOMIC SETTING AND STRUCTURE OF THE INDUSTRIAL AND EXPORT SECTORSoo.o.. ......v.* ...................... 1 A. Macro-Economic Background......... ......... .........0.... 1 B. Recent Macro-Financial Developments...,......,,,,...... 3 Overviewo.&..ee..e........................................ 3 Deficits and Inflation....................... ..........,, 3 Interest Rates and Financial Subsidies .................... 5 Financial Disintermediation and Demonetization............ 7 Effect on External Accounts and Exchange Rates ............ 7 Impact on Corporate Finances ................0............ 7 C. Structure and Evolution of Argentine Industry.............. 8 D. Structure and Evolution of Argentine Exports................ 10 E. Financial Condition of Industrial Firms...................... 11 II. OVERALL SECTOR STRATEGY AND POLICY ORIENTATION ........ o......o. 15 A. Overall Sector Strategy.. ..... .0.0... ...... ...0......... 15 B. Measures to Alleviate Policy Uncertainties and Skepticism... 16 C. Coordination of Policies ar] Implementing Actions among Government Agencies ........ .. ... **00.. .0.0**..............0&0* 17 D. Exchange Rate Policy......o..................o............. 18 E. External Trade Policies and Regime .......................... 19 F. Investment Policies............00........ ...... 26 G. Policies Toward Direct Foreign Investment .................e.. 27 III. EXPORT PROMOTION POLICIES, MECHANISMS AND POTENTIAL ....... ...... 29 A. Overview ... .oo.o........o........................... .o....... o...... 29 B. Export Promotion Policies, Incentives And Programs ......... 29 (a) Temporary Admission System .............................. 30 (b) Tax Reimbursement Scheme..............o....... o..... .. 30 (c) Export Financing and Guarantee Programs ........... ..... 31 (d) Participation of Indirect Exporters.................... 32 (e) Administrative Procedures.............................., 32 (f) Special Programs for Exporters.o........................ 33 (g) Non-Financial Services for Exporters.. .............o .... 34 (h) Information System on Foreign Trade and Export Markers. 35 (i) Inter-Institutional Coordination .......... ......... ... 36 (j) Export Promotion and Investment Incentives .........00.... 37 (k) Subsector Studies ..............000.00 .............. 37 C. Prospects And Potential For Industrial Exports.......o....... 38  - ii - Page No. IV. MEASURES TOWARD LONGER TE-M EFFICIENCY AND COMPETITIVENESS..... 43 Introduction ................................... 43 A. Strengthening the Financial System and Financial Services To the Productive Sector ................................... .. . 43 Structure and Evolution of the Financial System .............. 43 Institutional Structure ................................... 43 Concentration ................................ 45 Inter-Company Credit and Dollarization..................... 47 Impact cf Financial Disintermediatien and Overdimensioning... 47 Quality of Bank Portfolios ............................................ 51 Agenda for Financial System Reforms .......................... 52 Interest Rate Policies....................... ............ . 52 Institutional Reforms in the Financial Intermediation System .................................... 53 Approach to Regulation and Longer Term Development of the Financial System .................................... 54 Strengthening of Bank Supervision.......................... 55 Transparency of Information...... .... .... 56 Institutional Mechanisms to Assist in Financial B. Restructuring and Privatization Of Public Sector Enterprises ..................................................... 58 Restructuring/Rationalization of Parastatal Industrial Enterprises ................................................... 58 Privatization of Public Sector Enterprises... .............. 59 Conceptual Framework ..................................... 59 The Institutional Framework .............. ................ 61 C. Technology Development Policies and Institutions ............. 62 Institutional Support ........................................ 63 Reorientation of Technology Institutes ...................o 64 Technical/Vocational Training Facilities................. 64 Technology Policies. ................. 65 Tax Incentives ........................................... 65 Technology Imports Policy............ ................... . 65 Financing of Technology Development/Adaptation............... 66 Prospects ......................................................... 67 D. Development of Small and Medium Scale Industry ............... 67 Background ................................................... 67 Contrasting SMI Experience in Argentina and Other Countries.. 68 Agenda for SMI Action .............*.e . .... 69  - iii - Page No. V. AGENDA FOR PRIORITY ACTION .................. ............. 71 Programs Supporting Trade Policy Reforms and Export Development. 71 Financial Sector Reform...................... ........ . 71 Programs to Support Restructuring of Selected Parastatal Tndustries, Individual Enterprises and/or Subsectors ............ 72 Broader Privatization Programses o.,eo...eeeooee............................. 72 SMI eeomn ................. 72 Tnv,estment Financing ......e....ee.....e.........e...e..e.... 72 Technology Development. ................................... 73 Overall Priorities and Bank Support............................. 73 LIST OF ANNEXES ANNEX I Evolution of Monetary and Financial Sector Indicators... 75 C-1 CBA Open Market Operations, i985eee..9&........... 78 C-2 Bank Loans in Real Terms (1981-100)............... 78 T-1 Creation and Distribution of Monetary Resources - Consolidated Financial Sytt e m 79 T-2 Central Bank (CBRA) - Determinants and Absorption of the Monetary Base.... 80 ANNEX II Import and Export Regime and Procedures................. 81 Trade Protection System...... ......................... 81 Import Regime: General Imports (Decreto 4070/84)..... 81 Imports Under the Temporary Admission Regimeime..... 84 Import Policy and Administration............. e..... 86 Export Procedures..................................... 87 A-1 Steps for Importaticn............................. 90 A-2 Rationale for Administrative Interventions in z K 5 0 0 r t s ~~~~~~~~~~91 ANNEX III Some Characteristics of Selected Major Industrial Metalworking Suusectors............... 00 00..... 93 Pulp and Paper Subsector ......... 94 Footwear Subsectorb.......... O...* .... ... 0000.00.000* 95 Petrochemical Subsector ..............Q................ 96 Plastics Subsector.ooseeeoooessseoe* 97 Steel Subsctoe....o r. 98 Class Subsector ........... . . ........ 99 Electronics Subsectorbs.e....t or..........e. . .** 100 ANNEX IV Public Sector Enterprises in Argentinae...... 103 A. Introduction....9*... 103 B. Financial Performance........e....e..e. ......e.. 104 C. The Parastatal Industrial Enterprises............... 105 D. Past and Ongoing Privatization Programs in Argentina 106 T-1 Principal Legal Regimes Governing State E n t e r p r i s e s ~~~~~~~~109 T-2 Number of State and Provincial Enterprises by Formation of Local Framemwoe-.........0-0.6006 110  - iv - Page No. T-3 Jurisdiction of State and Provincial Enterprises by illr ............................. 1 T-4 Bahia Blanca Petrochemical Complex................ 112 T-5 Classification of Public Enterprises by Sector and by Legal Framework ........ 113 T-6 Classification of Public Enterprises by Industrial Subsector ......................................... 114 T-7 Current Status of Privatization Program......00636 115 C-1 Financial Performance of Public Enterprises ....... 116 C-2 Public Enterprise Financial Performance Vs. Public Deficit .................................... 117 C-3 Financial Performance of Public Enterprises.....6. 118 ANNEX V Structure and Evolution of Industry T-1 Manufacturing Industry - Value Added by Subsector (Millions of 1970 Pesos).......................... 121 T-2 Manufacturing Industry - Value Added by Subsector (In Percentages) .................................. 122 T-3 Industrial Production....... ...... e........... 123 T-4 Worker-Hours Worked .......................... ..... 124 T-5 Productivity Indicator............................ 125 T-6 Gross Domestic Fixed Investment ................... 126 ANNEX VI Structure and Evolution of Exports T-1 Manufacturing Industry - Exports by Subsector (Millions of 1970 US$)............................ 127 T-2 Manufacturing Industry - Exports by Subsector (Millions of Current US$) ................................. 128 T-3 Manufacturing Industry - Exports by Subsector (In Percentages) .................................. 129 T-4 Argentine Exports by Destination........ ......... 130 ANNEX VII Banking System Indicators T-1 Structure of the Banking System ............ee. 131 T-2 Indicators of Portfolio Quality in the Financial System ........... . .............. .................... 132 T-3 Commercial Banks - System......................... 133 T-4 Commercial Banks and Savings Banks - Consolidated Accounts ................................................ 134 T-5 Commercial Banks - National Public ................ 135 T-6 Commercial Banks - National Private ............... 136 T-7 Commercial Banks - Foreign (Branches and Subsidiaries) ................................... 137 ANNEX VIII Financial Indicators of Industrial Firms T-1 Profitability of Argentine Industrial Firms ....... 139 T-2 Profitability of Argentine Industrial Firms by Manufacturing Subsector-....o..... . . 140 T-3 Rates of Failure of Manufacturing Firms and Enployment Reduction ..........* e.g........g.. 141  -v - Page No. ANNEX IX Characteristics of Small and Medium Scale Industry T-1 Development of Small and Medium Size Industry in Argentina...................................... 143 T-2 Changes in Output and Capacity Utilization of SMIs 144 T-3 Major Subeectors with Important SMI Activities 1 980 ................................................. 145 T-4 Degree of Concentration and Changes in Output Employment and Productivity, 1970-1982 (in %) ..... 146 T-5 International Comparison of SMI-Participation in Industrial Employment.. ......................... 147 ANNEX X Structure of Import Tariffse............................ 149 ANNEX XI Foreign Direct Investment T-1 Regulations Governing Foreign Direct Investment... 151 T-2 Share of Foreign-owned Companies in Industrial Production........................................ 154 T-3 Share of Foreign Companies in Industrial Production.................e....o..e........... 155 T-4 Foreign Investments Approved per Yearn*.......... 156 ANNEX XII BCRA'S Export Financing Programs T-1 Conditions for BCRA's Pre-export Financing Scheme ................ 157 T-2 Conditions for BCRA's Post-Shipment Financing T-3 ECRA's Export Financing Schezne................... 159 -'-3 BCRA's Export Financing Scheme ........... 161  Ike I S
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4 1 11) Iz Li  - vii - 1. This report presents the findings of a World Bank industry, trade and financial sector mission which visited Argentina during May/June 1985. The mission had detailed discussions with relevant Government officials, representatives of private and public sector industrial firms, and financial institutions and research institutes about current performance and future needs and options in the sectors studied. 2. The report uses as a point of departure previous work done in connection with the latest World Bank Country Economic Memorandum for Argentina, based on an economic mission which qisited Argentina during June/July 1983. Parallel work on agriculture sector policies and prospects (currently in process as part of the preparation of a proposed Bank sector loan) is also relevant, especially with regard to the relative priorities of industry and agriculture. 3. A special effort has been made to focus on current issues and strategic options/decisions in the industrial, export and financial sectors. This "operational" orientation means that the report spends relatively little time on historical analysis and issues on which a consensus appears to exist (e.g., exchange rate policy), and devotes greater attention and depth of analysis to unresolved issues now facing the Government. Also, mission judgements aad qualitative analysis played a role equal to that of quantitative analysis in arriving at many of our recommendations. Finally, a relatively detailed analysis of the current status of the Argentine financial sector and the major issues facing it is included, since the responsiveness of the financial system to the productive sectors is a key ingredient in the success of a new industrialization and export development strategy. This approach has been adopted in order to make the report directly useful to the Government in considering the options on development strategies and programs, and to provide useful background to the multilateral, commercial and other institutions involved in development assistance programs in Argentina. 4. The mission wishes to convey its deep appreciation for the coopera- tion and support which it received from the various Government agencies, including the Economic Policy Wing of the Ministerio de Economia, Secretaria de Comercio Exterior, Secretaria de Industria, Secretaria de Hacienda, Secretaria de Planificacion, Ministerio de Relaciones Exteriores y Culto, Ministerio de Defensa, Banco Central de la Republica Argentina, Banco Nacional de Desarrollo, Secretaria de Ciencia y Tecnologia, Consejo Nacional de Investigaciones Cientificas y Tecnologicas, Instituto Nacional de Tecnologia Industrial, the Comision Nacional de Privatizacion and Sindicatura General de Empresas Publ' as. The mission also received a considerable amount of help from several public and private research institutions, parti- cularly CEPAL, FIEL and Fundacion Mediterranea, private and public sector industry representatives and chambers of industry, export and import chambers and trading companies, private commercial banks and Asociacion de cancos Argentinos (ADEBA), to all of whom we wish to express our most sincere thanks. Excellent logistics and office support provided by the Ministerio de Economia, BCRA, BANADE and local office of the United Nations Development Program is also gratefully acknowledged.  I - N- ,V  - ix - OVERVIEW AND HIEGLIGHTS 1. By mid-1985, the Argentine economy was in a critical state. Faced with severe imbalances in the domestic and external sectors and a situation dangerously close to hyperinflation, the Government put in place in June a comprehensive adjustment program for sharply reducing the public sector deficit and inflation. The program involves an immediate and substantial increase of fiscal revenues, large reductions in public expenditures, a temporary freeze on all prices in the economy, and a currency reform designed to neutralize past inflationary expectations. The program's targets are ambitious: to bring down in the very near term the annual inflation rate from over 1000 percent to near zero; to reduce the public sector deficit from an estimated 12.5 percent of GDP in the first half of 1985 to 2.5 percent in the second half; and to substantially increase foreign exchange earnings (or savings) and reverse capital outflows so as to achieve a manageable balance of payments. This shock treatment was considered essential by the Government and the public if uncontrollable hyperinflation was to be avoided. A permanent reversal of inflationary expectations will require continued strict control over the overall fiscal deficit. This will in turn require increased efforts to contain and reduce public expenditure, and to raise real prices and tariffs in public enterprises. At the same time, the economy has to resume real growth and expand exports at a faster pace. Preliminary indications point to rising public co:ifidence in both the ability of the Government to undertake decisive action and the future prospects of the economy. 2. This report is cautiously optimistic. While the adjustment program should help to establish a more stable and balanced monetary, financial and fiscal environment and to correct past imbalances, the immediate prospects are for a significant further contraction. Industrial capacity utilization rates, as well as the levels of output, investment and employment, are likely to fall below their current low levels before growth can be expected. The unusually severe current industrial recession may deepen to a point where irreparable structural damage is inflicted on large segments of Argentine industry, particularly those with higher value-added and skill intensity. Anxieties about a deepened recession, the financial fragility of many firms, and potentially heavy structural damage to industry formed the background to the mission's examination of available options for short- and medium-term industrial and export strategies. A key objective was to examine policies and instruments that would help arrest the economic downturn, initiate a process of industrial recovery, and stimulate improvements in industrial efficiency and competitiveness. The new framework of policies and instruments should also lay the basis for longer term structural change in the industrial sector in favor of areas which more fully reflect Argentina's comparative advantages in technology and skill-intensive activities. 3. A major conclusion of the report i; that, at present, a vigorous export drive is the main available option for the resumption of industrial growth, concurrent with the expansion of employment and investment, and with- out a simultaneous acceleration of inflation. Thus it is of the utmost importance that the Government provide appropriate price signals, institu- tional support, and a positive policy environment for the industrial sector to embark on an export drive. An effective short- and medium-term industrial  - x - strategy should have at its core a program of export promotion and development. In particular, conditions should be created under which industrial firms would embark on an aggressive and sustainable export drive with production specifically oriented toward exports, rather than treating exports as a residual activity to fill slack in demand in the domestic markets. 4. The key element of an export promotion and industrial development strategy should be a set of trade, exchange rate and investment policies which are stable, predictable and adequately designed. However, past distortions, the inability of market mechanisms to fully correct them,and public skepticism suggest that price it,centives derived from adequate trade, exchange rate and investment policies alone may be insufficient to expand exports in the near term, or to make them a major factor in economic recovery. The erratic nature of prior policies has discouraged exporters and produced widespread skepticism about the opportunities offered by inter- national markets and the ability of Argentine exporters to profit from them. It will be essential to overcome such skepticism if firms are to invest the substantial resources needed for a vigorous export drive. This may require an initial "push" in the direction of export development, involving measures specifically designed to stimulate industrial exports. 5. Additional measures are needed to stimulate and sustain industrial efficiency and competitiveness, induce required longer term structural changes, and maximize the contribution of industry to economic growth. They include: improvements in the efficiency of public sector enterprises through restructuring and/or privatization; stimulation of technology development to facilitate modernization and greater specialization in Argentine industry; modernization and growth of small and medium industries; and actions to streagthen and restore the effectiveness of the financial system and to facilitate restructuring of economically viable private sector enterprises which may have suffered financial erosion during the imbalance of recent years. Specific action programs in each of these areas should form part of the medium term industrial strategy. The report includes proposals for the relevant policy reforms, administrative improvements and institutional strengthening. 6. The strategy outlined above would be consistent with the stated intentions of the Government as reflected in its "Guidelines (Lineamientos) of an Economic Growth Strategy 1985-89." The detailed elements of an industrial and export development strategy in many of the areas identified above have yet to be defined, however. This report suggests specific measures that could help to fill this gap in each of the key areas identified. It will also be necessary to improve coordination among the principal government agencies responsible for setting or implementing industrial policies/strategies; in the past deficiencies in this regard have led to a dispersion of efforts and inefficient utilization of scarce human and institutional resources. 7. The report concludes that a well articulated export development strategy should form part of the overall framework of macro-policies for economic recovery. Combined with other complementary measures to facilitate a gradual adjustment of the industrial sector to the euerging structural needs of the economy (e.g., assistance in restructuring of parastatal  - xi - industries and private sector firms facing financial problems, incentives for technology development) this approach would provide a suitable environment within which recent unfavorable trends in industrial exports, efficiency and growth, could be reversed. In the mission's judgement, Argentina has substantia'l potential for increasing its export earnings relatively soon, provided that the macro-economic stabilization efforts meet with at least moderate success and that appropriate policy, institutional and other initiatives are put in place in a consistent and timely manner. Specifically, the Government should expand its efforts to promote exports of goods in which Argentina enjoys a natural competitive advantage, including agricultural and other natural-resource-based products; special emphasis should be placed on the more skill-intensive and higher value-added products, whose current very low rate of capacity utilization and export-output ratios should allow them to respond rapidly to appropriate export stimuli. Expanded exports should also facilitate the resumption of industrial investment, modernization and growth in the medium term; and promote increased employment opportunities and improvements in labor skills/ technology levels 8. The report is organized as follows. Section I gives a brief over- view of the macro-economic setting, the evolution and main characteristics of the industrial and export sectors in Argentina, and the impact of recent macro-financial events. The rest of the report discusses specific issues and recommendations related to industrial, trade and financial sector strategies that would be appropriate under the Government's economic program. Section II reviews available options and makes specific recommendations with regard to overall industrial and foreign trade sector strategies and the associated broad policy/incentives framework (e.g., exchange rate policies, trade policies, investment incentives). Section III is devoted to elaboration of a detailed set of recommendations on policies and action programs for export development; it also assesses the potential for expanding industrial exports. Section IV deals with other measures for fostering sustainable longer term industrial growth, efficiency and competitiveness, including necessary reforms in the financial sector. 9. Section V provides a synthesis of the main recommendations in the form of an agenda for priority Government action in the industrial, financial and export sectors, and discusses possible World Bank support in these areas.  I. I&CROECONONIC SETTINC AND TE INDUSTRIAL ANID MEPORT SECORS A. Macroeconomic Background 1/ 1.01 Argentina is a country rich in human capital and natural resources which was counted among the "developed countries" in the early decades of the twentieth century. However, the 1930s Depression severely curtailed exports of the traditional agricultural products which had been the foundation of Argentina's rapid devc'opment. The ensuing economic crisis triggered a reformulation of the country's development strategy, which, for the next four decades, became, in varying degrees, inward-looking and protectionist. This strategy succeeded in promoting rapid industrialization, but, as easy import- substitution possibilities were exhausted, balance of payments crises increased in frequency, and economic growth became more erratic. Increased public sector spending placed growing pressure on fiscal stability, while price, credit and interest rate controls inhibited saving and investment and distorted the allocation of resources. 1.02 A marked reversal of direction was undertaken in 1976, beginning with an austere stabilization program accompanied by a relaxation of price, marketing, and financial controls, major devaluations of the peso, sharp reductions in the fiscal deficit, and improved export incentives. The initial results of the program were encouraging with respect to exports and foreign exchange reserves growth and a reduction in unemployment. However, progress toward reducing inflation was not as rapid as expected, leading to further major changes in macro-economic policy. Adjustments of the exchange rate, which had outpaced domestic inflation during the 1976-78 period, were instead now being set according to pre-announced schedules ("tablitas") at rates below the prevailing rate of inflation, as a device to reduce inflationary expectations. A five-year schedule of import tariff reduction was also introduced to encourage greater import competition. The opening of the economy to outside competition was intended to force a restructuring, particularly of the industrial sector, along the lines of Argentina's comparative cost advantages in world trade. Remaining controls on credit, interest rates and foreign exchange transactions were also largely abolished. 1.03 As these measures began to take hold, however, the fiscal situation was beginning to deteriorate again in the face of growing expenditures, particularly for debt service, defense, and domestic security, as well as increases in public sector wages. The growing deficit fed the very infla- tionary pressures which the exchange rate and tariff policies were intended to reduce. The consequent real appreciation of the peso reached nearly 40Z by the end of 1980 relative to 1977. This appreciation, combined with falling import barriers and stagnating international prices, put Argentine tradeable goods producers, both exporters and import-competing industries, at a serious competitive disadvantage. Imports increased rapidly, and the growth of exports declined. 1/ Paragraphs 1.01 to 1.06 are based on the summary of the latest Bank economic Memorandum on Argentina (Gray Cover Report No. 4979-AR of June 1984).  - 2 - 1.04 A rapid inflow of external capital, encouraged by high domestic interest rates and the low rate of nominal devaluation, served temporarily to finance the large public sector deficit and augment the nation's inter- national reserves. External indebtedness more than doubled between cnd-1978 and end-1980, much of the increment contracted at short term. Growing expectations of a major devaluation dramatically reversed these flows by the second half of 1980, and reserves declined precipitously through the first quarter of 1981. Real GDP growth fell from 7% in 1979 to 0.7% in 1980 and 6% in 1981. Unemployment rose and inflation again accelerated. The indus- trial sector faced a rising tide of bankruptcies, and the solvency of the financial system was placed increasingly in doubt. 1.05 The worsening economic situation and the inauguration of a new Government led to the abandonment of the exchange rate policj and suspension of the import liberalization program in March 1981. The next year and a half was marked by a rapid succession of governments, extreme economic uncer- tainty, and a deteriorating international environment, highlighted by the conflict in the South Atlantic and the cessation of voluntary foreign comercial bank lending. 1.06 GDP declined an additional 5% in 1982, and the public sector deficit exceeded 15% of GDP. By the end of 1982, Argentina's external debt amounted to rearly US$ 44 billion, more than a third of it, including arrears, falling due within one year. Little of the de'bt accumulation appears to have financed productive new investment; indeed, much of it seems either to have financed military purchases or replaced fleeing Argentine capital. Debt service due in 1983 (even excluding the repayment of short-term debt) exceeded export earnings, reflecting the impact of large borrowings during the late 1970s and the early 1980s, which has been the major cause of current account deficits in recent years. The economy recovered somewhat beginning in 1983, with GDP growing by 3% in that year and by 2% in 1984. Inflationary pressures, however, increased, fueled by continued high public sector deficits, which increased to about 16Z of GDP in 1983 before moderating somewhat in 1984 to about 12% of GDP as an austerity program was launched. 1.07 In mid-1985, recognizing the urgent need to break inflationary expectations and prevent an uncontrollable process of hyperinflation, the Government abandoned the gradualist approach to adjustment in favor of a shock" treatment. Accordingly, it announced a strong stabilization and adjustment program in June 1985. As part of the program, it committed itself to not using new emission to finance the public sector deficit, which it promised to bring down to 2.5% of GDP by the end of 1985, established a new currency, the 'austral", and introduced a temporary freeze on wages and prices. In addition, it proposed a tax reform to the Congress and initiated steps toward strengthening tax administration to reduce evasion and delinquency. Prior to the announceme_c of the new policy package, the Government also put into effect a step-devaluation of the currency, increased petroleum prices and transport and power tariffs, froze employment in the public sector, and began reorganizing major state enterprises to reduce costs and improve operating efficiency. Consistent with the program, the Government revised and agreed on tighter targets under its stand-by agreement with the International Monetary Fund. The early results of the new stabilization program are promising. The monthly inflation rate as measured by the Consumer Price Index fell from about 30% during June, to about 6% in July, 32 in August and an estimated 2X in September.  - 3- B. Recent Macro-financial developments Overview 1.08 The large imbalances which have afflicted the Argeratine economy over the past several years, including a steep and unsustainable growth of f