Argentina - Economic recovery and growth

-F 5 Economnic Recovery and Growth Vr  pad U L/&+ A WORLD BANK COUNTRY STUDY Akrg-%enti'na Economic Recovery and Growth The World Bank Washington, D.C., U.S.A.  Copyright (C 1987 The World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of Arnerica First printing December 1987 World Bank Country Studies are reports originally prepared for intermal use as part of the continuing analysis by the Bank of the economic and related conditions of its developing member countries and of its dialogues with the governnents. Some of the reports are published informally with the least possible delay for the use of governnents and the academic, business and financial, and development conmnunities. Thus, the typescript has not been prepared in accordance with the procedures appropriate to formal printed texts, and the World Bank accepts no responsibility for errors. Any maps that accompany the text have been prepared solely for the convenience of readers. The designations and presentation of material in them do not imply the expression of any opinion whatsoever on the part of the World Bank, its affiliates, or its Board or member countries concerning the legal status of any country, territory, city, or area or of the authorities thereof or concerning the delimitation of its boujndaries or its national affiliation. The most recent World Bank publications are described in the catalog New Publications, a new edition of which is issued in the spring and fall of each year. The complete backlist of publications is shown in the annual Index of Publications, which contains an alphabetical title list and indexes of subjects, authors, and countries and regions; it is cf value principally to libraries and institutional purchasers. The latest edition of each of these is available free of charge from the Publications Sales Unit, Department F, The World Bank, 1818 H Street, N.W, Washington, D.C. 20433, U.S.A., or from Publications, The World Bank, 66 avenue d'Iena, 75116 Paris, France. Library of Congress Cataloging-in-Publication Data Argentina : economic recovery and growth. (A World Bank country study) 1. Argentina--Economic policy. 2. Monetary policy-- Argentina. 3. Fiscal policy--Argentina. 4. Argentina --Economic conditions--1983- . I. World Bank. II. Series. HC175.A849 1988 338.982 87-34069 ISBN 0-8213-0999-4  PREFACE This report is based on the findings of a World Bank mission that visited Argentina in April 1986. The mission comprised the following members: F. Desmond McCarthy (Mission Chief) Constantino Lluch (Labor/Employment) Claudio Frischtak (Industry) William Tyler (Trade) Alberto Verme (Consultant - Private Investment) Thomas Boyatt (Consultant - Export Marketing) Javier Gonzalez-Fraga (Consultant - Monetary) Maria Claudia Franco (Research Assistant) Harutaka Hamaguchi (Young Professional) This document provides a brief overview of the mission's findings. The main focus of the mission was on the macro environment, and so did not deal with many important sectors such as agriculture, mining, and construction. Since the mission's visit, the Government has carried out a number of significant policy reforms, especially in trade policy and the public sector. These reforms are in line with some of the report's recommendations, and in such instances this report should be viewed as supportive of Government initiatives. - iii -  CURRENCY EQUIVALENTS Currency Unit - Austral (A) Exchange Rate Effective March 30, 1987 US$1.00 1.541 Austral 1.00 Austral - US$0.649 A 1,000,000 - US$649,000 - iv -  Table of Contents Page No. GLOSSARY OF ACRONYMS COUNTRY DATA EXECUTIVE SUMMARY . . * . . * * * . * . * . . * .* * . . . * * xi PART I. BACKGROUND . o 4 a . . . . . . e . . . e . . . * I1 CHAPTER 1. INTRODUCTION . . T . . . . . . . e N . a . e e . 1 CHAPTER 2. THE AUSTRAL PLAN . . . . . . . . . . . . . . ., 2 - Initial Results of the Plan . .. ...... 2 - Results of the Plan To Date e e e . o* . 3 PART 11. POLICIES FOR GROWTH D...*. . .4,..., 5 CHAPTER 3. INSTITUTIONAL REFORM . * . . .. . . . e. . . 5 Uncertainty/Rules of the Game c * O 0 * e 5 - Financial Sector Reform . e 0 e 6 - Procedures and Bureaucracy * . * e * * * e 7 - Brazil-Argentina Trade Pact , a . , * a o . a 8 CHAPTER 4e MACROECONOMIC POLICY . . . . . . . * . * * * e 8 - Resource Availability . . . . . . . . . . . . 8 - Fiscal Balance . .............. e * e 10 - Relative Price of Tradables 0 * e , * * 12 - Prices and Wages. * * * * * * e * * e Q * * 12 - Interest Rates 0 . . * e * * e * * a * . . 14 - Investment e a s e e 0 * e e * e * e e 16 - Public Investment .e...,. . , . 17 - Private Investment* . . * * . e * * * o 18 - Industral Sector e . . 20 - Barriers to Growtthh. a a C S 21 CHAPTER 5. EXTERNAL BALANCE . .. o . .. . . . . . . . . . 22 - External Debt .* *. . 0 @ **a e 0 0 t e e 0 e 22 - Trade 0 * . e 0 0 e s0 o * * * 0 * a a * * a 23 v  - vi CHAPTER 6. MEDIUM-TERM POLICIES AND PROSPECTS . . . . . . . 27 - Base-Case Scenario ..a.,. a a *O e 0 * * 27 - High-Case Scenario . . . * e a..... 29 - Risks e e X 6 @ e e e e e a e a a e a a 9 * 31 TABLES 1 Summary of Key Macroeconomic Aggregates, 1978-86 2. Indicators of Incentives and External Trade, 1978-86 3. Recent Indicators, 1985-87 4. Structure of the Financial System's Assets and Liabilities 5. Taxation for Corporations: Example of Fiscal Complexity 6. Balance of Savings, Investments, and Interest Payments, 1972-86 7. Nonfinancial Public Sector Finances, 1983-86 8. Financing the Public Sector Deficit 9. Real Effective Exchange Rates, 1970-86 10. Product Concentration Ratios, Selected Years 11. Balance of Payments, 1983-86 12, Key Assumptions Used in Base-Case Projections, 1983-92 13. Projections of Key Variables: Base-Case Scenario, 1985-95 14. Actual and Projected External Requirements and Financing: Base-Case Scenario, 1981-94 15, Projections of Key Variables: High-Case Scenario, 1985-95 16. Nonfinancial Public Sector Accounts: Comparison of the Base- and High-Case Scenarios MAP (IBRD 12432R2)  GLOSSARY OF ACRONYM4S AACRE Asociacion Argentina de Con- Argentine Association of sorcios Nacionales de Expe- Regional Experimental Con- rimentacion Agricola sortia ADMIIRA Asociacion Metalurgica Argentina Argentine Metallurgy Association ANA Administracion Nacional de National Customs Administra- Aduanas tion BANADE Banco Nacional de Desarrollo National Development Bank BCRA Banco Central de la Republica Central Bank of Argentina Arge-ntina BONAVI Bonos Nacionales de Intereses variable interest rate bonds Variables BONEX Bonos Externos foreign bonds (US dollar- denominated Government bonds) CEM Country Economic Memorandum CEN Corporacion de Empresas Corporation of National Nacionales Enterprises CEPAL Comision Economica para Economic Commission for LatinoamLerica Latin America (ECLA) CD Certificado de Deposito certificate of deposit CGIAR/CGR Consultative Group on inter- national Agricultural Research CGT Confederacion General de Trabajo General Confederation of Workers CKD completely knocked down CONADE Consejo Nacional de National Development Desarrollo Council CPI consumer price index CRM Cuenta de Regulacion Monetaria Monetary Regulation Account (Interest Equalization Fund) DGI Direccion General Impositiva General Tax Directorate DIF Deposit Insurance Fund DJAT Declaracion Jurada de temporary admission import Admision Temporaria request DJNI Declaracion Jurada de import permit Necesidades de Importacion DNPC DirecciorL Nacional de National Directorate of Promocion Comercial Commercial Promotion FIEL Fundacion de Investigaciones Latin American Foundation Economicas Latinoamericanas for Economic Research FUNDECO Fundacion Economica Economic Foundation GATT General Agreement on Tariffs and Trade GDP gross domestic product GDFI gross domestic fixed investment - vii  - viii - IBRD International Bank for Reconstruction and Development IDB Inter-American Development Bank IFS International Financial Statistics IICA Instituto Interamericano de Inter-American Institute for Cooperacion Agricola Agricultural Cooperation IMF International Monetary Fund INDEC Instituto Nacional de National Institute for Stat- Estadistica y Censo istics and Census INPE Institute Nacional de National Economic Planning Planeamiento Economico Institute INTA Instituto Nacional de National Institute for Agri- Tecnologia Agropecuaria cultural Technology JNC Junta Nacional de Carnes National Meat Board JNG Junta Nacional de Granos National Grain Board LIBOR London Interbank Offer Rate M&LT medium and long term NADE Nomenclatura Arancelaria de Customs Classification for Exportacion Exports NFS nonfactor services PRESEX Programas Especiales de Special Export Program (PEX) Exportacion RER real exchange rate REER real effective exchange rate SIC Standard Industrial Classification SIGEP Sindicatura General de General Comptroller of Empresas Publicas Public Enterprises SITC Standard Industrial Trade Classification SKD semi-knocked down SMI small and medium-size irndustry SNESR Servicio Nacional de Economia National Rural Economic y Sociologia Rural and Sociological Service VA value added VAT value-added tax VNA Valores Nacionales Ajustables indexed national bonds WPI wholesale price index YPF Yacimientos Petroliferos state oil company Fiscales  COUNTRY DATA - ARGENTINA AREA POPULATION 8/ DENSITY 1/ - -- - ----- --- -- 2766.9 thous. sq km. 3.I million (1986) 10.7 per sq. km. Rate of Growth: 1.6 16.9 per sq. km. of arable land POPULATION CHARACTERISTICS I/ HEALTH 2/ Urude Birth Rate (per 1000) 23.6 Population per physician (thous.) 0.5 Crude Death Rate (per 1000) 8.9 Population per hospilal bed (thous.) 0.2 Infant Mortality tper 1000 live births! 34.4 INCOME DISTRIBUTION 2/ DISTRIBUTION OF LAND OWNERSHIP -- - - - - - - - --- --- -- -- -- -- -- -- -- - - - o of national income, highest quintile 50.3 7 owned by top 1OZ of owners o0iwest quiXtile 4.4 X owned by smallest 1Oa of onners ACCESS TO SAFE WATER 11980) ACCESS TO ELECTRICITY (1980) 5 of population - urban b5.0 X of population - total 87.0 rural 17.0 NUTRITION I/ EDUCATION - - -- -- - - - -- -- -- -- -- Calorie intake as '% of requirements 119.2 Adult literacy rate % 93.0 31 Per capita protein intake (grams per day) 99.7 Primary school enrollment 2 107.0 1/ GNP PER CAPITA IN 1986: US $ 2153 41 GROSS NATIONAL PRODUCT IN 1986 8/ ANNUAL GROWTH RATES (X, const. prices) ,0- ---- - - - -- - - - -- -- - - - - - - - US $ "In. % of SNP 1970-75 1975-80 198O-85 1986 8/ - - - - - -- - - - -- - - -- - - -- - - -- -- GNP at market prices L 6061.1 100.0 1.8 -3.4 7.1 Gross Dcmestic Investment 8257.6 12.5 1.9 4.4 -16.2 18.5 Gross National Savings 7487.9 11.3 0.5 2.0 -13.8 -7.0 Current Account Balance -2645.0 -4.0 Exports of goods & NFS 8797.0 13.3 -4.7 14.1 5.2 -8.6 Imports of Goods & NFS 7025.0 10.6 0.6 13.3 -13.0 16.9 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1986 89 Value Added Labor Force 5/ V.A. Per Worker US $ Mln. Thous. US $ Agriculture 1063I.P 15.2 1334 12.0 7970.9 Industry 25192.8 36.0 3488 31.4 7222.5 Se6-l1cr E 534150.2 48.8 6277 5b.6 5440.7 Tota!/Average 69980.0 100.0 11099 100.0 6304.9 GOVERNMENT FINANCE Consolidated Public Sector Central Government Au$ MIA. " n;f GDP Au$t ln. a of GDP 195 1985 1983-85 1985 1985 1983-85 ---- --- --- ---- ---- ---- -----,-- Current Receipts 10 7 2 7.7. 24.5E; 6666.5 16.8 16,1 Current Fxpenditures 10077 25.4 25.8 4146.6 10.5 10.6 Current Balance 635 1.6 -1.3 2519.9 6.4 5.5 Capital Expenditures 2420 6.1 6.7 645.3 1.6 1.6 Surplus or Deficit -1746 -4.4 -7.9 21. 5.5 4.5 External Financing (net) 436 1.1 1.4 489 1.2 1.0 - ix -  CDUNTRY DATA - ARGENTINA MONEY, CREDIT AND PRICES 1980 t981 1982 1983 1984 i'Y85 1986 -- - - - - --- --- --- --- -- - - - (Millions of Au$ outstanding end of period) Money and Quasi Money 8.6 16.0 38.3 193.6 1195.3 7337.9 Bank Credit to Public Sector 2.8 10.8 34.8 212.3 994.9 1i640.1 Bank Credit to Private Sector 8.3 22.2 68.9 290.8 18222.4 9398.3 Money and Quasi Money as Z of GDP 30.4 .3 29.4 h 28.4 22.6 18.5 Wholesale Price Index (1981=i00i 47.9 100.0O 357.3 1646.8 11093.0 8482P.7 138982.2 Annual percentage changes in: General Price Index 75.4 109.0 257.3 360.9 573.6 664.6 63.9 Bank Credit to Public Sector 0.3 385.2 322.2 610.1 468.6 164.9 sank Credit to Private SActor 0.2 266.0 310.4 422.1 626 7 5i5.7 BALANCE OF PAYMENTS 1975 1980 1986 8/ MERCHANDISE EXPORTS (AVERAGE 1984-19,86) -- - --- -- - - ---- ---- --- --- - - - - - -- - - - - ----------- - (Millio'ns of U0S$1 US $ lmn. '7 Exports of Goods. NFS 3704 10765 8797 Imaports of Goods' NFS 4518 14024 7025 ricultural goods 3462.7 44.2 Resource gap (deficit - -814 -3259 1772 Manuf. goods of a ric. orig 2545.7 32.5 Manuf. ot industrial origin 1821.3 2r3. 3 Interest Payments [net) -4v.60 -947 -3939 Other Factor Pavments (net) -15 -584 -484 Total 7R IQ iTh Net Current Transfers r 23 5 Balance on Current Account -1284 -4767 -2645 EXTERNAL DEBT, DEC. 31, 1986 LS $ Min. Direct Investment .. 788 574 ---------------------------- --------- Public M&LT Loans (net) -12 3400 762: Public Debt 40-1496 Disbursements 1018 5809 3134 Private Deht 8578 Amortization 1030 2409 2372 Total Outstanding & Disbursed 49074 Subtotal -12 3400 762 IBRD 896 Other Capitali (net) 189 -2217 487 IDE 1368 IPF 232 6 Changes in Reserves - incr 1107 2796 822 Bilaterals 3140 Bonds 335A Connmercial Banks 37990 gross Peserves (end year) 618 728 3927 Net reserves (end year) -20 6641 9998 DEBT SERVICE RATIO FOR 1986 6/ 7r5 RATE OF EXCHANGE 7! -- interest service ratio 48.8 U $1.00 = Au $ 0..0001 8 TBRO/IT LENItiDIG,g3 O'EEi ER31 ,t, 1986 (Min. US $1 Au.e$ 1.00 = US $ 5555.6 ----------- i IBRD ITDA 1986S 8/ - --atstanuirn & Disbursewd c% - US $ 1.00 = Au $ l. 94303 un-li bursed 96 - Au $ 1.00 = US 1.06-041 0 t s t--di .i mrci i Eb Pir sd 183 ------------~---------------------------------- -------------- ------ -----------------------.-------------------------------- 1! Between 1982 and 1985. !Beieen 1917, 0 and 197q6. 3/ 1978. 4/ EcSotiiate. Bank Atlas methodolo. 7f Calculated by applying 198u ratios ot sectoral categories to total pPu1-ztlin t5o 1986 5timl-tsd popul2tion. 6/ Excludes arrears and 3aortization of short-term det; includes recheduling of debt. 7/ Year average. 8/ Preliminary. -x -  xi EXECUTIVE SUMMARY i. In recent decades, Argentina has failed to realize its economic potential. Its ranking, among countries in terms of GDP per capita has fallen steadily from among the most developed to close to the median. Economic policy has changed erratically as the country was buffetted by conflicting demands in a pluralistic society. The democratic government of President Alfonsin, which came to power in late 1983, was faced by an economy in disarray, a large external debt, and a number of political difficulties. ii. Following the failure of some attempts to stabilize the economy through orthodox (primarily demand management) policy measures, the Austral Plan was introduced in June 1985. The Plan combined some heterodox measures such as wage and price controls with more traditional measures such as reduction of the public sector deficit and establishment of a more favorable exchange rate to improve external and domestic balances. iii. The measures taken included tighter monetary and fiscal controls, real interest rates to encourage savings and stem capital flight, and, later, the introduction of a crawling peg regime to ensure a more competitive exchange rate* Steps were taken to improve the management of public enterprises by appointing technocrats as managers and strengthening Governmen.c regulatory agencies and their oversight responsibilities. iv. By the first quarter of 1986, relative success on the inflation front and initial attempts to improve export performance and redef1irf the role of the public sector were tempered by a poor medium-term outlook for economic growth. The outlook was poor because many reforms remained to be undertaken, while tangible gains from policies directed toward improving export prospects and stimulating private sector activity were slow in coming. The reforms undertaken were largely supply-side in'itiatives, and even with these changes it takes time to alter deep-rooted ways of thinkinig and doing business. Progress was further hindered by adverse changes in the terms of trade. ve In March 1986, the Government decided to relax the price freeze and move to a system of administered prices. This move was followed in April by the introduction or a series of mini-devaluations of the austral. Prices began to rise again in mid-year, reaching a monthly rate of 8.8%. At the same time, increased credit availability facilitated a strong recovery of the real economy so that in the third quarter of 1986 real output was up 118% over the corresponding quarter of 1985. The increase in the industry and manufacturing sector was 26,5%. In late August, the authorities moved to a restrictive monetary policy, higher public sector prices, and a reversal of some of the relaxation of price controls, This had the desired effect on inflation, with the consumer price index (CPI) falling to 4,7% and wholesale price index (WPI) to 3% for December 1986. However, real interest rates were driven up, creating problems for industry.  - xii vi. In November/December 1986 monetary policy became more accommodating, and in January 1987 the CPI reached 7.6%. Accordingly, in Februiary 1987, the Government introduced another package with the aim of stemming the resurgence of high inflation and reactivating the economy. The package included a devaluation of the austral by 6.6% and a wage/price freeze. The latter was presented as a temporary measure to help stabilize the economy and allow time for the structural reforms, especially in trade, finance, and the public sector. The wage freeze was set until June 1987, while the price freeze was open-ended to preclude speculative behavior. vii. As policies of structural adjustment to support medium-term growth are extended and strengthened, it is expected that the economy will revive. This revival is expected to result from a number of factors, including structural reforms in trade, the financial sector, and the public sector and some form of "social contract" to ensure an acceptable labor policy. The needed changes would be facilitated by efficiency gains, an area in which Argentina has substantial room for improvement. There would be a steady but realistic increase in investment. Historically, much of the private sector investment in Argentina has tended to either follow or accompany that of the public sector. Current high interest rates are also a strong deterrent to private investment. On the export side, the industrial sector will need time to reorient itself towards exports after 20 to 30 years of accommodation to a highly protected domestic market, interrupted briefly by ill-conceived import liberalization in the late 1970s. At the same time the agricultural sector, which is quite efficient, finds itself stymied by closed markets, unfavorable prices, and restrictions on international competition. viii6 There are three central recommendations to complement the broad thrust of structural reform: (a) a moderate increase in investment, with noninflationary financing; (b) a resource mobilization strategy; and (c) reforms to improve the business environment. It is expected that the private sector will be a primary beneficiary of structural reform, ix. Until the business climate has improved, the report recommends a carefully targeted and moderate increase in investment. This increase would raise consolidated public investment as a share of GDP from 6.1% (1985) to 6v6% (1987) but would still be substantially below levels of the last decade. This recommendation is in line with the Argentine program supported by an International Monetary Fund (IMF) agreement, although slightly larger (a 1% increase over the 1986 level vs. a 0.7% increase in the IMF program). The investment increase would be financed primarily by an increase in net external capital inflows, an increase in the yield of some taxes, such as tie value-added tax (VAT), and a reduction in costs in state enterprises, The increased net capital flows should initially be directed at carefully chosen public sector investments to begin modernization of the country's physical and social infrastructure while alleviating critical bottlenecks to recovery and growth. Investment should be directed to areas which could quickly achieve cost recovery and which generally command a broad political consensusi such as telecommunications/ postal system, ports, and selected social sectors.  - xiii - x. The report also identifies several possibilities for increasing resource mobilization and improving the business environment. Suggestions include introduction of a country equity fund and an export financing facility, rationalization of the role of the public sector, and schemes to modify the debt burden, suclh as debt equity and lease-back arrangements for new investments. These measures would be complemented by initiatives to stimulate incustrial development and exports and to rationalize labor markets. The net effect of these measures is expected to be stronger private sector participation in the economy. xi. The focus of the report is on policy reform, with the central issue being resumptioa. of growth without the release of inflationary prer3sures. The Government will need to be prepared to handle expeditiously any incipient inflation. Responses may include the need to invoke wage/ price controls until the changes in macroeconomic policy take hold, These will depend on the timely introduction of structural reforms, especially in the areas of trade, finance, and public sector rationalization, Efforts directed toward achieving a social pact should be pursued so that the Government can remove itself from wage-income policy deliberations. Timely implementation of structural reforms should facilitate the process. A number of policy reform recommendations are summarized in the action matrix on the next page. These include, on the institutional side, greater cooperation between the public and private sectors through clarification of rules of the game, financial sector reform, streamlining of procedures, privatization, and public sector reorganization. On the economic side, recommendations include a moderately tight fiscal policy, with a reduction of the deficit from its 1985 level of 4.2% of GDP. This reduction should be effected primarily through reductions of transfers to public enterprises and increases in revenue (improved tax administration combined with a modest increase in receipts from the value-added tax). Monetar policy would allow for a slightly positive interest rate for depositors while controlling the money supply and coordinating fiscal policy to help reduce inflation. The real effective exchange rate would be allowed to improve gradually through continued mini-devaluations and trade reform. The basic recommendation is the support of present macro policies, with continued reliance on fiscal and monetary policies. This program should be supported in the short-term by increased public sector investment in key areas such as telecommunications and ports. In the medium term the private sector would assume an increasingly major role, but in the short term an increased role is warranted for public sector investment initiatives, Even in the transitional period, the proposed investment initiatives are expected to contribute to a revival of private investment, Industrial incentives should be streamlined to reduce some of the obstac'es to increased competition that exist in the current system. Overlying all is the need to clarify and adhere steadily to the rules of the game to reinforce the gains of the Austral Plan.  - xiv - PRINCIPAL SPHERES OF ACTION SUBJECT ACTION DISCUSSED IN REPORT (PAGE NO.) Macro - Fiscal Policy Reinforce stability; aim for a steady 10 reduction of the deficit and quasi-deficit of the public sector over the next two- to three-year period. Expenditures: reduce net transfers ta public enterprises to zero, with net return on equity to the Government for some enterprises. Revenues: strengthen tax reform; increase yield from value-added tax; review all public expenditures/ revenues to improve efficiency and the use of economic criteria for investment planning. - Inflation Continue policy of not printing money to 11 finance public sector deficit; use external borrowing; aim for an annual rate in 1987 lower than the 80% increase of 1986 and a steady improvement thereafter. - Interest Rates -Seek to achieve real rates that are 14, 16 moderately positive for deposits, and as financial reform takes hold aim for average annual real lending rates of about 5-10%. X Relative Prices Ensure a competitive exchange rate and tilt 11 of Tradables to tradables gradually by reducing anti- export bias and continuing mini- devaluations. Institutions Reduce uncertainty through closer public/ 5 private cooperation and clarification of rules of the game; streamline procedures! Growth bureaucracy. - Short-Term Increase public sector investment in 5, 16 carefully chosen areas such as telecommunications/postal system, ports. To minimize any inflationary impact, finance this boost by increasing external net flows, tightening tax administration, cutting costs in state enterprises, and reducing public expenditure. - General Reduce uncertainty by clarifying role of 18 Increase in Government; create a private investment Private fund; form a privatization unit; facilitate Investment innovative financing in such areas as output sharing and lease-back project arrangements; and develop improved instruments to increase domestic resource mobilization, such as housing fund.  -xv- Debt Devise a financing plan matched to a 22 medium-term growth pattern; evaluate debt/equity swaps and secondary market opportunities. Sector Policies/ Structural Reforms - Financial Strengthen supervision; increase 6 efficiency; reduce spreads; and rationalize rediscount operations of the Central Bank, This requires studies of both bank and nonbank institutions and the capital market, - Labor Move away from wage controls; 13 rationalize public employment in central government, provinices, and public enterprises. - Industry Improve efficiency and competitiveness; 20 reduce time horizon for incentives to four and six years; reinforce present efforts by DGI to reduce abuses of incentives. - Trade Improve export incentive system by elim- 23 inating the antiexport bias through reform of the temporary admission system; and elimination of indirect tax burden on exports; provide export financing facility at competitive international market rates; devise marketing strategy; reform import system by replacing nontariff barriers with import tariffs, coupled with assistance to firms adversely affected to help them adjust.  PART I. BACKGROUND CHAPTER 1. INTRODUCTION 1. Argentina has a rich endowment of human and capital resources. But, its development in recent decades has been rife with volatile political, social, and economic change. There has boen a failure to achieve any net growth in GDP since 1978. Key macroeconomic aggregates are given in Table 1. Even the high export growth rates in some years were due to special conditions, such as recovery of cereal and vegetable oil exports in 1985 from highly depressed levels and the purchase by the Soviet Union in 1981 of US$3.5 billion of grain following the U.S. embargo. The result has been a general erosion of Argentina's economic standing vis-a-vis other countries. This decline is coupled with a widespread feeling in Argentina of disillusionment with the country's economy and within Government's ability to play a constructive role. 2. President Alfonsin assumed the presidency in December 1983. ,Following the excesses of the military regime, the country was essentially bankrupt, with an external debt of almost US$45 billion--equivalent to 70% of GDP. After initial attempts at stabilizing the economy failed, a new economic team introduced the Austral Plan in June 1985. The plan was greeted with widespread popular support. It was perceived to be pulling the economy back from the brink of hyperinflation, and the country experienced generally raised expectations for a restoration of economic growth. 3. After a few months of relative success on the inflation fronts it gradually became clearer that revitalizing the sluggish economy would bi more difficult than expected. Indeed the success with inflation madd nioft evident the many deep-rooted problems that had been festering for the pa6t 20 or 30 years. While the agricultural sector was quite competitive, much of the industrial sector had become accustomed to operating in a small .fid heavily protected market. The instability of the real exchange rate had been a contributing factor to the variability of exports. Selected indicators of incentives and external trade are given in Table 2. Iore recently, shifts in terms of trade exerted a further negative influence on exports. The large swings in real wages and interest rates were indicative of the unstable economic policy climate, Similarly, the public sector had not emphasized efficiency during more affluent times and had absorbed many inefficient enterprises. Since society had adjusted to this way of doing business, there were many sociopolitical groups that viewed major changes as a threat to their interests, This was particularly the case in labor markets, which were dominated by highly politicized unions, and among various entrepreneurs who enjoyed the rents from their oligopolistic position. Following the introduction of the Austral Plan, the inflationary smokescreen dissipated, and such demands became much more difficult to accommodate. This change in perspective required that some net gains be made available for distribution (a positive sum game), which in turn meant that the economy should be moved without too much delay onto a positive growth track.  -2- 4e Argentina has made many attempts at stabilization, and a number of these plans contained elements similar to those of the Austral Plan. In 1957/58, a one-year wage freeze resulted in fiscal surplus and low inflation rates but failed to produce an increase in real investment. In the early 1960s, low real wages and attractive terms to foreigners produced a surge in investment, but a poor harvest and high beef prices led to an erosion of confidence in the economy. The mid-1960s saw the other side of the policymaking pendulum, with expansionary monetary, fiscal, and wage policies. Those policies led to a wage-price spiral, higher public deficits, and again a loss of confidence. Following a military takeover, the new economic policy included price and income controls and an exchange rate devaluation of 25%. While inflation was reduced to 10% and fiscal accounts improved, a fall in grain prices triggered another beef cycle and soon led to the collapse of the program. Following the turbulence of the early 1970s, there was again a period of high wages, accompanied by an inward-looking policy package, controls on foreign investment, and nationalization of bank deposits. Initially GDP and consumption increased, but by 1975 high inflation, increasing fiscal deficits, price distortions, and supply shortages were aggravated by a European ban oni Argentine meat imports and higher oil import costs. This situation undermined the economic policy, leading to chaos and eventually to a military takeover. The incoming regime in 1976 moved back to an outward-oriented strategy. The fiscal deficit was initially reduced as a result of higher real receipts as inflation rates dropped and some temporary tax increases were introduced. When inflation resumed in 1979, a new course was adopted. The peso was devalued vis-a-vis the US dollar but at a rate lower than the inflation rate. The overvaluation of the peso led to a surge in imports, deindustrialization, financial insolvency for many enterprises, and deterioration in the net external position and fiscal accounts, and the program was abandoned in March 1981. The large debt that was accumulated in the period continues to be a major problem for policymakers. When President Alfonsin assumed office in late 1983 following the South Atlantic War of the previous year, the economy was faced by increasing inflation, deterioration in the balance of payments, and an industrial recession. In late 1984, the Government entered a 15-month standby agreement with the IMF and in 1985 rescheduled its external debt with commercial and official creditors, covering its obligations to the end of 1985. In the first half of 1985, economic conditions worsened. The Government was unable to adhere to the program, and the standby agreement was suspended. The stage was set for the Austral Plan. CHAPTER 2. THE AUSTRAL PLAN Initial Results of the Plan 5. The Austral Plan combined heterodox measures and traditional measures. In order to turn around inflationary expectations the Government moved from gradualism to shock treatment.l/ The key elements of the plan were a wage-price freeze, tight fiscal and monetary policy, and monetary reform. A new currency, the austral, was introduced with the exchange rate 1/ Similar plans have also been introduced in Brazil and Israel. A comparison of the initial impact is given in P.T. Knight, F.D. McCarthy, S. van Wijnbergen, Finance and Development, December 1986.  -3- f ixed to the US dollar. Nonindexed contracts were converted into the new currency according to scales designed to eliminate the capital gains and losses due to the drop in inflation. The indicators presented in Table 3 shows some of the efrects of the plan. The immediate results were a fall in inflation from near hyperinflation levels to about 2% per month for the second half of 1985; an increase in money demand, with M1/GDP, growing from less than 4% to over 8%; and a trade surplus for 1985 of US$4.6 billion. The economy began to grow more rapidly in the last quarter of 1985 and the first quarter of 1986. Union groups began to press for wage increases, while others expressed skepticism about the ability of the Government to contain the deficit. Consequently, a second set of measures were introduced in April 1986. These measures included a move to a crawling peg, some increases in public sector prices, and increases in wages and pensions to help correct their erosion in real terms. The Government also announced its intention to move from the price freeze to a system of administered prices. Results of the Plan To Date 6. Although there are many reasons for the numerous failed attempts ,at stabilization in Argentina, the main reason has been unsustainable pressures on resources from competing groups. The present Government seems to ';da7v. adopted a pragmatic approach and demonstrated a more flexible attitude without sacrificing the fundamental objectives of the reform. The initial conditions prevailing when this plan was initiated differed Lrom those of previous plans largely because of the massive external debt burden, which stood at US$46.9 billion as of the end of 1984. The transfer needed to service this debt imposes severe restrictions on policy options, particularly those affecting investment. The possibilities for financing investment over the medium term may be analyzed by considering three aggregate accounts: private, public, and external. As the reform of the public sector takes hold, it is expected that expenditures on that account will be compressed. In the short term, however, only limited additional resources can be anticipated from that source. The external account is in surplus to service the debt, so net transfers on that account are of the order of US$2 billion per year out of the country. This in turn means that the burden of financing investment falls on the private sector. The private sector in turn casts an anxious eye on the Government's ability to meet its obligations without raising taxes or pressuring the private sector to absorb domestic debt. The private sector suggests that expenditures be reduced by more prudent management and perhaps some privatization and they argue that this would reduce financing needs, lower interest rates, and then stimuJlate investment. 7a The annualized inflation rate (CPt) fell from over 1000% in the first half of 1985 to about 40% for the second half. The change in the wholesale price index was even lower. In July 1986 inflation rates began to increase again as private sector wages increased in response to Government relaxation of wage and price controls. In August the increase in the CPI peaked at 8.8%. The authorities constrained monetary growth and strengthened wage and price controls again, so that the October increase in the CPI was down to 6.1%. 8. Real wage behavior varied greatly by sector. The main losers were those in central Government, where real wages fell by 18% over the  -4- first 9 months because of continuing erosion by low but positive inflation rates. Real wage losses in the private sector were largely offset by informal payments. 9. Under the tight monetary policy, real interest rates were initially about 3-4% per month. While the demand for real balances alidost doubled as inflation fell the monetary authorities sought to limit monetary growth. There are those who argue that restrictive monetary policies may have been unwise, but given the recent experience of near hyperinflation it was perhaps correct to err on the restrictive side. In early 1986, as inflation increased and nominal interest rates were regulated, real interest rat-es dropped close to zero and were even negative for a while, prompting some disquiet over the possible resumption of capital flight. 10 The Government sought restraint in fiscal policy by pledging to finance the public deficit by external borrowing other than by issuing money. The substantial improvement in the fiscal accounts was achieved almost completely on the revenue side. Revenue increased by the equivalent of 6% of GDP between the first and second half of 1985 as a result of higher real receipts as inflation fell and of improved tax administration. There was some slippage on the expenditure side because of losses by the Central Bank on its rediscounts and higher-than-expected expenditures by provincial governments. These slippages were partially offset by lower transfers to public enterprises. 11. The real exchange rate depreciated as inflation resumed, though at a much lower rate. The nominal exchange rate was pegged to the US dollar and benefited from the depreciation of the dollar by about 40% vis-a-vis the currencies of other industrialized countries during the first eight months of the program. This meant that the real exchange rate for the austral varied little until the second quarter of 1986. A stronig trade surplus of US$4.6 billion in 1985 resulted largely from a severe curtailing of imports, but owinig to interest payments of almost US$5 billion, the current account deficit was about US$1 billion. 12. After nearly two years the verdict on the plan is perhaps one of qualified success. Increases in inflation of the size experienced in August 1986 and again in January 1987 emphasize the need to expedite the structural reforms. Strong measures have been taken to improve tax administration and to reform public enterprises by improving management. Following a sluggish first half in 1986, real growth picked up strongly, for a yearly increase in GDP of 5.5%e Investment was up 11.9%, including a turnaround in private investment. Performance on inflation and the deficit has been commendable. In July/August 1986 inflation again increased, and the administration initially responded (August 1986) by curbing money growth and strengthening price controls. At the same time banks were given the authority to carry out transactions previously handled only in the black market. This constituted a de facto lowering of reserve requirements and was a step toward making banks more competitive. Alarms were triggered when the CPI for January 1987 reached 7.6%. A new set of measures was introduced in February 1987 to curb inflation and reactivate the economy. These measures included a 6.6% devaluation of the austral, followed by further devaluations of 2% in May and June; an increase in the miniimum wage of 13% together with an inflation adjustment for the first quarter, followed by a freeze until June; a price freeze (for an  -5- unspecified period to avoid speculative behavior); increases of 2% for public utility charges, 15% for petrol, and 15% for cigarettes 15%, and a move to cut regulated interest rates to 3% (deposits) and 4% (lending). Proposed measures include a monthly budget for rediscounts and the introduction of a futures market in public bonds. The wage/price measures should be considered as temporary, to allow time for the structural reforms, especially in trade, finance, and the public sector, to take effect. There is also the possibility that major parties may take the opportunity to move toward a social pact and institutional reforms which will permit the Government to withdraw from wage-income bargaining. PART II. POLICIES FOR GROWTH 13. The Argentine Government perceives the main objective of economic policy to be sustainable, steady growth to help consolidate democracy. In the Argentine context as in most others, various facets of adjustment such as financial and public sector reform can best be implemented during a period of strong economic growth. To achieve this requires a consistent set of monetary, fiscal, and pricing policies and concomitant changes in behavior and institutional reforms. Although these areas are interconnected, for purposes of exposition the report focuses on three broad areas: institutional reform (Chapter 3), macroeconomic policy (Chapter 4), and external balance (Chapter 5). Many of the measures have already been set in motion and, if the underlying policy reform agenda is carried through, can be expected to lead to a buoyant outcome in the medium-term. The short-term or transition phase, however, poses special problems because political expediency may require more dramatic measures. This issue is discussed in Chapter 6, along with medium-term policies and prospects. CHAPTER 3. INSTITUTIOIAL REFORM 14. If the economy is to move forward and realize its potential, price policy must become more flexible, the Government less bureaucratic, and the economy more open in terms of outward orientation and receptivity to change. Institutional reform is needed to facilitate this transition. Four aspects of reform are noted: uncertainty/rules of the game, financial sector reform, procedures and bureaucracy, and the Brazil-Argentina Trade Pact. Uncertainty/Rules of the Game 15. In recent years, Argentina's erratic economic performance has introduced a strong element of uncertainty. Before the introducion of the Austral Plan, the macroeconomic policy environment was quite unstable. But in spite of the relatively stable environment since then, entrepreneurs still tend to be risk-adverse, particularly in their investment decisions. This is a serious and profound problem, requiring a strong commitment by major groups in public and private sectors to reach a viable consensus on their respective roles. This process could be facilitated by the formation of informal groups, with broad-based participation, that would discuss such issues as industrial strategy, export promotion, and regional development and work toward a clear articulation of the rules of the game. Although complaints about the absence of such rules may be a rationalization for  -6- continued rent-seeking behavior, there is a legitimate need for clarification. It must be noted, however, that a number of issues need political resolution. Recommendation. Although the public is informed of short-term policy measures, insufficient information is provided on medium-term goals. There is a need for a statement at the highest level of Government that explains the policy framework for both the short and medium terms and the type of economic structure that can be expected, ideally over the next 5 to 10 years but at least for the term of the present administration. It is essential that the statement be credible. Its credibility could be enhanced by involving key groups in the development of the official position on such issues as the following: broad fiscal objectives, financial sector policy; exchange rate regime, trade policy, privatization, and the roles of the central government, provincial government, and public enterprises. The Government should indicate whether it intends to tilt gradually toward the tradables sector, which industries can expect to face stiffer competition and when, which sectors can expect to benefit from incentives, what its priorities are for its public investment program, when improvements in social services can be expected, and when provincial government rediscount facilities will be phased out. Financial Sector Reform 16. The financial system affects virtually every area of ecoIiomic activity. The system in Argentina is fragile, inefficient, very high cost, fragmented, and in large measure does not fulfill its role as financial intermediary because it has discretionary control of only about 28% of its assets. A detailed analysis of the system is needed. Recommendation. There is a need for financial sector reform to address three major areas: fragility/confidence, inefficiency, and management (in particular, of rediscounts). (a) Fragility/confidence 17. There are serious problems with some banks; much of their assets are immobile and their portfolios are of questionable quality at best. More active supervision by the Central Bank is needed, particularly for loan classification, on-site inspection, and improved public disclosure of financial information on individual banks. Such supervision would facilitate a smooth tranbition to a more secure systern. The Central Bank must also have adequate legal authority to eliminate any undesirable practices. The public confidence in the banking system could be improved by an insurance scheme for both public and private banks. (b) Inefficiency 18. During the period of high inflation before the Austral Plan, real balance shrank and the velocity of money increased (in May 1985 the monthly velocity was about 2.0) as people moved out of pesos and sought refuge in a plethora of financial instruments. To accommodate these needs, the number of banks, branches, and bank employees increased dramatically. As inflation fell, the demand for these services subsided, and banks now find it increasingly difficult to meet their operating costs. The spread (above average cost of funds) needed for operating costs (net of commission) is  7- presently estimated at 1.64% per month or 23% per year. Spreads to provide the Argeiitine economy with competitive financial services should be in the range of the 5-10% (real rates) per year typical of other countries such as Korea. A comprehensive bank reform package will be needed to provide help to facilitate mergers, reduce staffing, and reorganize the liquidation procedures of banks. (c) Rediscounts 19. Over 60% of the credit to the private sector is channeled through a complex system of rediscounts. These rediscounts are financed by substantial reserve requirements (see Table 4) and then channeled through the Central Bank to a variety of i-ntermediaries and end-users. Virtually every rediscoBnt is a special case, with its own set of terms and a potential for abuse. While some rediscounts serve a useful function that might not be satisfied by normal market channels, there are a number of serious problems. (a) Because of losses incurred by the Central Bank, there is a fiscal cost known as the quasi-fiscal deficit, (b) The system leads to a b'ghly fragmented market. (c) Because of the reserve and forced savings requirements, the banking sector has no discretion over 72% of total deposits. 20. Over time many of the problems could be largely eliminated by an orderly contraction and reduction of these rediscountsb This would require a much improved management information system. The required reserve levels could be reduced to about 20% of deposits. This reduction could be achieved through an orderly transition to preclude any disecuilibria in the positions of financial intermediaries and to satisfy the legal requirements of contractual arrangements. At the same time the reform package would provide a safety net to f acilitate the changes that would result as provincial governments no longer had ready access to this source of fina'icing. Procedures and Bureaucracy 21. As a result of the complex plethora of public instituItions that have sprung up in Argentina, issues of access to government funds or import permits and exemptions from various taxes are major considerations (and time consumers) for many entrepreneurs. In many aspects of public administration, inefficiencies abound. Taken one at a time, similar examples can be found in most other countries. However, in few countries as advanced as Argentina is there such an agglomeration. Table 5 presents a typical example of just one aspect of the complex fiscal system. Equivalent tax revenue could be generated with a rationalized system. But each inefficiercy is likely to be associated with some form of rent-seeking activity, and in a stagnant economy the recipiernts of these rents are unwilling to give them up very easily. If the country does succeed in moving to a higher growth level, improvements in efficiency might be easier to achieve, 22, As the economy seeks to become more open, these inefficiencies will severely hamper its competitiveness.  - 8 - Recommendation. (a) For all procedures and bureaucracies that directly affect the external sector, an independent authority should be appointed to propose an alternative procedure that is comparable to best practice in the more efficient economies with which Argentina competes. (b) On the domestic side, an independent authority is needed to mobilize public opinion to identify abuses, as was done with some success and with only minimal bureaucracy to reinforce the price freeze during the early days of the Austral Plan. Brazil-Argentina Trade Pact 23. On July 29, 1986, a set of 12 protocols was agreed on by the Presidents of Argentina and Brazil as a basis for a future common market for Latin America. The protocols focus primarily on capital goods, for which it is anticipated that all tariff and nontariff barriers to bilateral trade between Argentina and Brazil will be eliminated. The implications of this bilateral trade agreement need to be analyzed carefully. One expected immediate result was that Argentine wheat exports would benefit. The producer price for wheat in Brazil is over US$240 per ton while Argentina exports at about US$75 per ton. The capital goods sector in Brazil now has a delivery time of 12 months for orders due to the booming economy and financing is not available for foreign suppliers. This should give an immediate opportunity to Argentine producers. While there are obvious trade opportunities generated by the pact, perhaps even more important would be the implied erosion of isolationist thinking. Politically, support has been virtually unanimous. The extension of the temporary admission scheme for imports (early 1987) to include all Brazilian imports to be used as inputs for export goods offers the possibility for reducing domestic costs in industries such as food processing. The accords are expected to result in an increase in exports of capital goods from US$50 million to US$100 million in 1987, and mosu recent estimates are for annual wheat exports of 1.5 million tons. Prospective large market opportunities in a neighboring country are attractive, especially when world market prospects seem difficult over the medium term. CHAPTER 4. MACROECONOMIC POLICY 24. The main concern of economic policy is to consolidate stability while moving to sustainable growth. This requires a careful balancing of an acceptable fiscal deficit and adequate resources for investment so that financing needs will not jeopardize stabilization. Resource Availability 25. Some indication of the magnitude of resource flows is given in Table 6. For selected years, the savings-investment balance is estimated for the private, public, and external sectors. The role of the debt is highlighted by including interest payments. Major shifts in the balance occurred from the early and mid-70s to recent years. During the early years, low external debt interest payments of about 1% of GDP allowed external sector savings (trade balance) to remain at low levels. During these years, investment was in the 22-24% of GDP range, with the public sector accounting for about one-third of investment. The financing pattern  -9 was typically that of near-balance or even surplus in the public sector current account (excluding interest payments) so that it could make a positive contribution to aggregate savings; the private sector financed the rest. 26. In 1980 and 1981 large current accournt deficits (see Table 1) made the achievement of external equilibrium increasingly elusive. The authorities sought to finance investment by increased external borrowing, but at the same time savings were channeled abroad. The external transfer needed to service the debt reached 7% of GDP. The private sector, facing the prospect of widespread bankruptcies, was unable to meet the external obligations, so the public sector stepped in to assume much of the debt. While this provided some respite for the private sector, the impact on public sector finances was disastrous. Much of the adjustment by both public and private sectors was borne by investment, Thus public sector fixed investment (national accounts definition) as a share of GDP fell steadily to an all-time low of 3.8% in 1985 while the total gross figure fell to 10.6%. Average per capita income fell in these last years, but there was an even steeper decline in the savings rate, especially the private savings rate which dropped to 14.3% of GDP in 1985 from previous levels close to 20% of GDP. It seems that some reduction in savings effort by the private sector was associated with the Government assumption of much of the private sector debt in 1983/84. Where can increased resources come from? There are three complementary lines for dealing with the problem: (a) increasing public sector savings; (b) reducing the trade surplus by increasing imports, with corresponding external capital inflows; and (c) increasing private sector savings. 27. The first line would require either public sector revenue increases or expenditure reductions. A thorough public expenditure review would be desirable. This review would emphasize improved efficiency of expenditure and greater reliance on the use of economic criteria in formulating investment policy. On the revenue side, current initiatives on tax reform and the tightening of tax administration have already produced substantial gains, but further increases (above 27-28% of GDP) are likely to prove more difficult. On the expenditure side, a number of initiatives in public enterprises can be expected to yield results over the medium term. Active implementation of rediscount reform should be a high priority. The remaining major item, capital expenditures, has already been cut perhaps too much. While improvement may be expected over the medium term, it seems unlikely that the public sector deficit of about 4% in 1986 can be reduced by much more than 1% per year. Continued pressure is needed to ensure steady progress. The deficit of the nonfinancial public sector ot 2% of GDP for 1986 showed an improvement of 6% of GDP over the corresponding period in 1984. 28. The second option is to some extent outside the immediate direct control of Argentine policymakers but will be conditioned by foreign perceptions of the country and its economic policy and by progress in negotiations on its external debt. These factors in turn will determine  - 10 - what additional net capital flows may be forthcoming and under what terms. Recently Congress approved legislation that includes an amnesty or "blanqueo fligh t" which is expected to lead to some repatriation of capital. But, any significant reversal of capital flight seems to be contingent on a stable economic regime with adequate profit opportunities. 29. The third option is conditioned by Argentine perceptions of their economic regime. To date private investment has not returned to the levels of the 1970s. The reasons offered for this reluctance to invest are lack of clarity in the rules of the game (discussed in para. 15) and the belief that the Government has not yet come to grips with the "hard" structural issues. The private sector would like to see the fiscal deficit reduced even further and a diminished role for the public sector, especially in the productive sector. The worldwide decline in oil prices and comparably dim prospects for wheat and beef also discourage private investment. For the present, the private sector remains on the sidelines. Sustained private sector response requires a steady increase in confidence in economic policy and the availability of adequate financing at reasonable terms. Some specific measures to address this are given later in this section. In particular, domestic resource mobilization could be increased through a well-designed housing finance program. One such program, the UPAC system, has proven quite successful in Colombia. 30. From a resource perspective, it is essential that the private sector make a stronger contribution, increasing its present savings level of under 10% of GDP to its more trad.itional savings levels of 19-20% of GDP. It seems unlikely that this will occur in the next year or so; however, it is necessary to analyze the factors that are retarding savings and to introduce appropriate vehicles to improve the situation. Thus in the short term, it is necessary to rely to a greater degree on the second option, increased imports financed by additional net external flows. We now move to consider the budget implications. Fiscal Balance 31. Public sector finances are summarized in Table 7. (These are discussed further in Chapter 6). On the expenditure side, wages and salaries constitute about 9% of GDP. It is unlikely that this can be cut much further for the central Government. Transfer payments also constitute about 9-10% of GDP. Net transfers to public enterprises should be reduced to zero from their 1985 level of 1.79% of GDP, and at least some enterprises should make a positive contribution to public finance. Because of restructuring costs, it is unrealistic to expect this to be comple tely achleved in less than two to three years. The large subsidies to enterprises such as Argentine Railways are hard to trim in absolute terms, while pension payments will increase with population growth (Argentina has a high dependency ratio of close to 2:1). As a share of GDP, however, these can be reduced in a more buoyant economy. The interest payments (while only including national and provincial governments) will be determined largely by international interest rates on the external side; domestic real rates should not be allowed to become negative. The ques-ion then is, what is the nature of the trade-off between the deficit (and its financing) and inflation?  32. Analysis shows that there is a strong relation between the budget deficit and inflation. If the deficit could be reduced to zero, there is general agreement that this would have a highly favorable impact on inflation, inflationary expectations, and overall confidence in the policy regime. The problem is how to do this and over what time frame. The noninterest public sector deficit together with interest obligations on domestic and foreign debt can be financed by a combination of four methods: increases in foreign debt, increases in domestic debt, seignorage gain, and the inflation tax. Increases in foreign debt are subject to agreement with foreign lenders, while domestic debt cannot prudently be increased much above its present level of about 25% of GDP. Seignorage gain comes from an increased growth rate for a given level of monetization of the economy. The remaining "source" of financing is the inflation tax. The amount of this tax is determined by the interaction of two effects: higher inflation tends to increase the tax while reducing the monetary base. Thus there is no single answer to what each source of financing should contribute to financing various deficit levels. A range of possible consistent choices for two deficit levels (3.6% and 2% of GDP) are presented in Table 8.2/ In this table the role of domestic debt is essentially neutral. This means that new domestic debt can be issued to cover the cost of existing debt. But if there were any significant increase in domestic debt above present levels, this would exert further inflationary pressure. Other combinations can be developed as needed for alternate choices, but the key feature is that for a given availability of net external flows the level of the deficit is determined by the equilibrating inflation level. 33. Restrictive fiscal policy could also seek to accelerate the deficit. In principle, this could include temporary consumption taxes, higner income taxes, and some infra-marginal capital taxes. This package would lead to reduced consumption but higher investment levels, which is very unlikely to be politically acceptable. A different approach, the high-case scenario, is discussed in Chapter 6. This is close to the second scenario in Table 8 (II). It aims to reduce inflation to zero and leads to a reduction in real debt in the medium term.3/ Essential to this scenario is that additional external resources be made available in the short term to finance higher growth through well-targeted investment expenditures. Through real economic growth, the deficit is reduced because some expenditure items (transfer arLd interest payments) do not expand as rapidly as a share of GDP. This also requires some new revenue measures (higher VAT receipts) to be phased in gradually. Recommendation. The Governmnent should improve efficiency of all public expenditures so that the fP-al deficit is steadily reduced over the medium term. Specific measures could be identified through an early, comprehensive review of all public expenditures and revenues. In the short-term, additional external financing or improved domestic resource mobilization should be used to increase well-targeted invest.ment expenditures. This point is expanded in Chapter 6. 2/ The deficit for 1986 was 3.6% of GDP. 3/ Inflation in 1986 was 80% (CPI).  - 12 - Relative Price of Tradables 34. During recent years the exchange rate policy has been quite erratic. The real effective exchange rate since 1970 (see Table 9) shows substantial variations in the quarterly index. There are a number of technical problems in constructing such an index when there are large intra-period variations and substantial changes in financial/commercial spreads. There is also the issue of choosing the appropriate base year. In the late 1960s to early 1970s, most analysts would agree that the rate was at a "reasonable" level as Argentina enjoyed strong trade surpluses. Similarly, there is consensus that it became grossly overvalued during the Martinez de Hoz stabilization period. This was followed by the contractionary policy and the modest rise of the real exchange rate following the introduction of the Austral Plan. The pegging to the US dollar turned out to have been a fortunate move, as the real exchange rate vis-a-vis its aggregate trading partners showed little deterioration for most of the first eight or nine months of the plan. It could not have been maintained, however, without a continuing fall in the US dollar. 35. In April 1986 the Government adopted a policy of mini- devaluations to achieve a competitive exchange rate. Since then, there have been a number of mini-devaluations. The parallel market premium provides a useful barometer of economic confidence and of whether the official exchange rate is getting out of line. Because Argentina has a relatively open capital market, this indicator can be quite volatile. Measures to reduce this volatility such as the recently (February 1987) proposed futures market in Government bonds are desirable, In view of present adverse movements in terms of trade, it is important that the real exchange rate not be allowed to deteriorate further. (The issue is discussed further in Chapter 5 in the context of external equilibrium.) Prices and Wages 36. The income policy is one of the key features of the Austral Plan. Under the Plan, the price freeze of June 1985 was modified to a more relaxed price control (administered) system in April 1986, but price controls were again strengthened on August 29, 1986, following a resurgence of inflation in July/August of that year. These volatile inflationary episodes highlight the need to seek a more market-oriented system as soon as feasible. Prices in Argentina may be loosely classified into three categories: public services, mark-up pricing, and market pricing. For most public services, prices should seek to recover costs; relatively comnpetitive sectors have the discipline of market pricing. The biggest problem seems to arise in industrial sectors in which producers enjoy some degree of monopoly or oligopoly power in a protected market, (These sectors are identified more clearly later in this section in the discussion of industrial sector issues.) When faced by strong union demands, these producers have acceded and simply passed on the costs to consumers. Although this led to sharp fluctuations in nominal wages, the trend in the average real wage has been, close to zero over the last two decades. For all practical purposes, there has been no growth in the average earnings of wage earners in Argentina since 1950. Economic growth has resulted in extra employment and, perhaps, real increases in the incomes of the self-employed (about 30% of total employment in 1980). Some degree of  - 13 - import liberalization can help to restrain inappropriate price increases. A major problem is the absence (on average) of any significant productivity gains over the last few decades. Because of the absence of such gains, distribution conflicts tend to be heightened. While a "workable" wage policy or social pact is urgently needed, a positive sum game would allow such a pact to work. A relatively closed economy and the absence of a stable economic environment have resulted in a bias toward financial transactions and an indifferent record on productivity. A detailed study of industry should be able to identify actions needed to increase productivity since Argentina's record in this respect ranks poorly by international standards. 37. Despite the crucial importance of wages, it is difficult to obtain agreement on an appropriate index of the real wage. The National Institute for Statistics and Census (INDEC) series shown in Table 3 indicates a steady erosion of the real wage (official blue collar) under the Austral Plan up to February 1986, as nominal wages were held fixed and inflation continued at about 2% per month. But this index may not be a comprehensive measure of the complete wage situation. The Government's nominal wages per hour for each category (grade) were held in check up to early 1986, at which time they had lost close to 20% in real terms. But an examination of total Government wage payments per employee in the fiscal accounts shows a far less precipitous drop. This is accounted for by two phenomena: an increase in overtime payments and grade creep. In the private sector there is some evidence of various side payments such as low- interest loans. Many of these informal payments are now being regularized. The result has been that the adjusted real wage in the private sector has not fallen and may have risen in some subsectorst The main losers on the wage side appear to have been government workers and those on nensions. The problems for policy posed by each of the three categories of public employment are very different. Almost a million people are employed in Administracion Nacional and public enterprises, distributed among 250 agencies and with about 150 alescalafonesil (payroll systems). In Adm'inistracion Nacional, the reduction in real salaries has caused a shift in employment toward secondary earners (females and youth), to the detriment of a civil service career. Public enterprises continue to be a large fiscal burden, so the reduction in employment in the last 10 years has probably not been enough for efficient operation. The expansion of employment in local government is, very likely, the outcome of political pressure and the ability of provincial governments to finance their operations through provincial banks, Unification of "escalafones" and for creation of a civil service, further economy of operation in public enterprises, and control of employment in local government are important policy objectives. 38. Following the initial setbacks of the tripartite conference between Government, private sector, and unions to reach a social contract, wage policy again became the responsibility of the Government. In a mixed economy such as Argentina's, this is obviously an undesirable situation, The Government should move away from wage-price controls as soon as is expedient, but without reverting to wage indexation, which tends to accelerate inflation and introduce downward rigidity in average real wages. A social pact could help t>e Government set the stage for its own withdrawalS, so that over time wage-income issues would be discussed between  - 14 - representatives of workers and management. The removal of price controls will vary by subsector. For competitive subsectors, price controls can be removed in harmony with trade reform. For subsectors that need to adjust to external competition, prices can be negotiated as part of a broader package (including trade liberalization, pricing of inputs by parastatals, and restructuring programs). For some subsectors, the danger of domestic producers exerting oligopolistic control rieeds continued attention. Interest Rates 39. When the economy went from near-hyperinflation levels in May/June 1985 to the relatively low monthly level of approximately 2% in the months soon after the introduction of the Austral Plan (see Table 3), the real interest rate increased, (Selected interest rates are given in Table 2.) This phenomenon has been observed during stabilization in similar high- inflation situations, such as the German experience of the 1920s. One explanation for this effect on real interest rates is that demand for real balances (money deflated by the price index) is a fuinction of nominal interest rate. During high inflation, nominal interest is also high. The introduction of stabilization means that the real money stock remains more or less constant initially. This, in turn, means that the nominal interest rate, to equilibrate the system, needs to fall little if any. Accordingly, under the new, much-reduced inflation levels the real interest rate rises sharply. Ideally this real interest rate should be reduced as quickly as feasible. This, however, requires a judicious adjustment of the rate of monetary expansion to changes in velocity and the inflation level. During the year after the introduction of the Austral Plan, demand for real balances more than doubled from pre-Plan levels. Government policy has concentrated on short-term fine-tuning. At the beginning of the month, M44/ is adjusted to try to maintain liquidity on an even keel by seeking to avoid major erratic fluctuations in market interest rates. This is difficult to achieve because excess money supply can trigger a resurgernce of inflation while undue tightness c'rives real interest rates up too high. Experience suggests the best course is to keep a tight rein on the money supply immediately after stabilization and then, as confidence is restored and velocity falls, to increase the supply prudently. This would result ideally in a dynamic adjustment path that would lead in the first stage toward a convergence of inflation, interest, and exchange rate changes. This essentially seems consistent with the policy followed by the Argentine monetary authorities, as indicated in Graph 1. 40. In the second stage, it is important for the level of inflation to move closer to zero. This has proven more difficult to achieve. Consequently, the interest rates are higher than might be desirable for investors in fixed assets. This poses a dilemma for policymakers. If interest rates are allowed to become negative in real terms, as seemed imminent in May 1986, there is the threat that holders of financial assets may place them abroad. In Argentina this is always a consideration; 4/ Mi = Currency + demand deposits M2 = MI + regulated time and savings deposits M3 = M2 + free deposits M4 1 M3 + indexed deposits  15 - Grph 1 KEY ECONOMIC INDICATORS (% MONTHLY EFFECTIVE RATE) Int I t Ion - fegulated Lending Rato 4 2 Devaluation Unregulated Lending Rats 4 40 44 L T37g 44 36 36 32 i32 29 20 24 24 28 20 12 TM12 4 4 ilQl. Rpr May Jun Jul Rug Sp Oct Noy Doc Zan Feb Mar Fp : Source: G.F. Macroeconomia.  - 16 - capital flight during the previous regime is estimated at more than US$30 billion.5/ 41. Perhaps the most significant factor in pushing up interest rates is the Government's own financing needs. If financial sector reform proceeds along the lines indicated, this should help to reduce interest rates over time. In the meantime, it seems appropriate to keep a floor of zero or a moderately positive real interest rate for depositors because lower rates would encourage capital flight. The upper limit should also be contained to avoid higher rates that push up costs for investors. Tllere is evidence that high real interest rates do not stimulate overall savings but encourage a shift from real investment toward financial assets. Thus, over time the aim should be to achieve aereQ annual real lending rates of about 5-10%. Investment 42. Resumption of growth requires a significant increase in investment from the present depressed level of 11.9% of GDP (1986) to a rate closer to the traditional level of about 22% of GDP (see table below). A Dennison-style accounting suggests that a steady-state growth rate of 4% could be achieved with this level of capital accumulation. Estimated factor contributions to annual growth rate of GDP, are 0.7% for labor and 1.8% for capital, for the medium term. This would require a contribution of close to 1.5% for technical change/productivity. On the basis of comparative country studies and economically more stable years in Argentina, this seems reasonable. In the mixed economy that has evolved in Argentina, public and private investment have been closely related so that in most sectors private initiatives have followed or accompanied those of the public sector.6/ While restoration of the private sector contribution to resource mobiTization is central to medium-term growth, in the short-term the public sector will still be obliged to play a major role. Deficit constraints pose a difficult problem, as financing needs and the inflation trade-off need careful consideration. PUBLIC AND PRIVATE INVESTMENT /a AS A PERCENTAGE OF GDP 1970 1977 1982 1983 1984 1985 1986 est. Public 8.5 11.1 6.7 6.4 3.9 3.8 4.5 Private /b 13.7 13.2 9.9 7.8 8.5 6.8 7.4 Total 22.2 24.3 16.6 14.2 12.4 10.6 11.9 /a Central Bank (national account) definition. 7b Including inventory. 5/ See World Financial Markets, Morgan Guaranty, March 1986, for a review. 6/ An econometric analysis gave a correlation coefficient of 0.64.  - 17 - Public Investment 43, A recent World Bank review of the public investment program7/ analyzed in detail the following sectors: energy, transport, industry, and urban infrastructure. In many instances public investment is urgently needed, but only for energy and transport is there a coordinated plan. In deciding on public investment expenditures, planners should emphasize projects that: (a) contribute to the medium-term productive capacity and infrastructure of the nation (that is, investments should not include poorly conceived make-work projects); (b) have a favorable impact in the short term on supply responses by alleviating major bottlenecks; (c) have an accept,-ble impact on public finance and ideally, generate a positive cash flow promptly; (d) fall within clearly defined, appropriate spheres of activity for Government; and (e) include, wherever possible, a specific complementary role for Llie private sector, 44. Although it might seem that there are few investments which dould fulfill all these criteria the following suggestions--which are not listed in order of relative importance--are worthy of consideration: (a) Telecommunications and Postal System. The poor condition of these services is a major constraint on the efficiency of business operations. A dependable telephone/postal system i