Argentina - Second Trade Policy Loan Project

Documnt of The World Bank FOR OMCIL USE ONLY se~~~~~~~A - 2'1Z_ Rqot No. 1 -4858-AR REPORT AND RECOMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPNENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND TRADE POLICY LOAN IN AN AMOUNT EQUIVALENT TO US$300.0 MILLION TO THE REPUBLIC OF ARGENTINA October 3, 1988 Country Department IV Latin America and the Caribbean Regional Office This document hbs a resticted dsbuion an may be used by recpnts only a tbe perfomuance of dedr offiial duties. Its contents may not otherwise be dbelosed without World Bak authoization.  Currency Unit - Austral (A) On September 22, 1988, the controlled exchange rate ("commercial Tate") was US$1 = A 12.00; the free market exchange rate ("financial rate") stood at US$1 - A 14.33. GOVERNMENT OF ARGENTINA FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ARGEX - Argentina Exports BCRA - Central Bank of Argentina DJNI - Sworn Declaration of import Need GATT - General Agreement on Tariffs and Trade GDP - Gross Domestic Product IMF - International Monetary Fund NADE - Nomenclature of Export Duties and Taxes NADI - Nomenclature of Import Duties and Taxes ORP - Official Import Reference Price QR - Quantitative Import Restriction REER - Real Effective Exchange Rate SICE - Secretariat of Industry and Foreign Trade TAR - Temporary Admission Regine TPL - Trade Policy and Export Diversification Loan TPL II - Second Trade Policy Loan  - i - lOR OFFICIAL USE ONLY ARGENTINA SECOND TRADE POLICY LOAN Table of Contents Page No. LOAN AND PROJECT SUMM ARY. ..... ............... .. . .ii. PART I. TIM ECONOMY ....................... ........... ........... 1 A. Structural Problems and Re:ent Developments ............. 1 - Backggrou nd ............ ........... ..... 1 - Stabilization Efforts from 1984 to 1987 .............. 4 - The October 1987 Program and Developments in 1988 .... 6 B. The Government's New Program: Plan Primavera ............ 7 - Stabilization Efforts ....... . .. 7 - Nonfinancial Public Sectot. . a - The Quasi-fiscal Deficit. .. .. . ... . ..... 10 - The Balance of Payments and External Finance ... 11 - The Monetary Program ... 13 - Performance to Date ............................... . . 14 C. Progress on Structural Problems and Plans for Further Reform.s.......... 15 - Public Finance..................................... 15 - Financial System . . . 17 D. Medium Term Prospects and External Financing ............ 18 - Current Account ......... . ..8.......................... i - Savings and Investments .... . . 19 - External Finance .... ....... .. 20 E. Macroeconomic Monitoring ..... ........ 20 P. Risks to the Macroeconomic Program . .... 22 PART II. TRADE POLICY IN ARGENTINA.t ........ 23 - Background ....... 23 - The Import Regime in 1987 ............................ 24 - The Export Regime in 1987 ............................ 26 - Export Response to the TPL Supported Trade Reform .... 27 - Domestic Industrial Incentives ....................... 28 PART III. THE TRADE AND INDUSTRY REFORM PROGRAM IN 1988189 ... 29 A. Program Scope and Loan Objectives . . 29 B. The Action Program ..................................... 30 - Removal of Non-tariff Import Barriers and their Substitutes ........................................ 31 - Reduction and Rationalization of Tariff Protection... 31 - Limitation of Safeguards, Anti-dumping and Anti-subsidy to the Short-term ..... ............... 31 - Deregulation of Exports ....... ...................... 32 - Tightening of the Industrial Promotion Regime ........ 33 C. Related Policy Reforms . . 34 D. Macroeconomic and Social Impact . . 35 - Exchange Rate and Balance of Payments ................ 35 - Fiscal Implications ................... 36 - Social Impact ..36 This docunent has a retriced distbution and may be used by rcipients only in t e perfo%awe | of their official duties. Its contents may not otherwise be disclosed without World Ba k authc 4zaton.|  - ii - Table of Contents (cont) PART IV. FEATURES OF THE PROP(SED LOAN ......................... . ... . 37 A. Loan History ................................................ 37 B. Loan Amount, Borrower and Implementing Agency ........... 38 C. Letter of Development Policy and Letter of Sector Policy .................................................. 38 D. Tranche Release, Disbursement, Procurement and Audit ................................................... 38 E. Monitoring and Reporting ................. ............... 39 P. Benefits and Risks .......... ..... ...... .......... 39 PART V. BANK GROUP OPERATIONS ................ ..... ... 41 PART VI. COLLABORATION WITH THE IMP ... ........... .......... . 43 PART VII. RECOMMENDATION. . . ........ 43 TEXT TABLES 1. Summary of Public Sector Deficit. ........ ................ .... 9 2. Balance of Paymentsa y m es......... . .... 12 FIGURES 1.1 Real Exchange Rate ........ .... 3 1.2 Interest Payments, Trade Balance and Current Account . . 3 1.3 Real Wages . .............. ........................................ 3 1.4 Investment and Savings ............ ...... 3 1.5 Monthly Inflation ......* .............. 3 1.6 Public Savings Before and After Interest Payments . . 3 ANNES Annex I: Economic Indicators 1. Argentina - Key Macroeconomic Indicators 2. Argentina - Balance of Payments, 1980-1985 3. Argentina - Balance of Payments, External Capital and Debt 4. Argentina - Non-financial Public Sector Deficit, 1987-1989 5. Argentina - Quasi-fiscal Surplus in Real Terms, 1988-1989 6. Argentina - Factors of Monetary Expansion Annex II: Status of Bank Group Operations Annex IIIs Supplementary Loan Data Sheet Annex IV: Government's Development Policy Letter Annex V: Government's Sector Policy Letter Annex VI: Policy Reform Matrix Annex VIIs Technical Assistance Component Annex VIII: Trade Statistics 1. Argentina - Structure of Import Protection for the Manufacturing Sector 2. Argentina - Real Effective Exchange Rate, 1987-1989 3. Argentina - Realized Trade Taxes and Subsidies and Anti-Export Biases by Product Category (January-August 1987) 4. Argentina - Exports by Commodity Groups, 1970-1987 5. Argentina - Imports by Commodity Groups, 1970-1987 6. Argentina - International Prices, Trade Volume Indices and Terms of Trade, 1970-1987 MAP: IBRD 20450  - fixi - ARGENTINA SECOND TRADE POLICY LOAN Loan and Program Summary Borrrower: Argentine Republic. Amount: US$300 million equivalent. Termss 15 years. including 5 years of grace, at the standard variable interest rate. Loan and Program Description: The proposed Second Trade Policy Loan (TPL II) would be the second operation to support the Government's program for integrating Argentina into the world economy. The first phase of this program was supported by a Bank Trade Policy and Export Diversification Loan (TPL). It brought free-trade status to Argentine exporters and removed a substantial number of quantitative import restrictions (QRs). The response of non- traditional industrial exports has been very encouraging. The proposed TPL II would support the implementation of the second phase, in which the Government would address the hard core of import protection, deregulate exports and tighten an industrial investment incentive system that tends to undercut the opening of the economy. Inter alia, the proposed loan would support the Government's efforts to raise the exposure of domestic industrial production to import competition without QRs from 63? to 85? while reducing the average level of tariffs from 43Z to 302 and the maximum tariff rate from 115? to 50Z. Benefits and Risks: The program supported by the proposed TPL II would free industrial trade from regulatory constraints and would reduce the burden and the dispersion of trade taxation so as to allow the industrial sector to compete efficiently in the world market. Over the medium-term, the program can be expected to: (i) raise industrial exports and reduce the dependence on volatile commodity export earnings; (ii) increase industrial labor demand; and (iii) raise the productivity of investment. The success of the reform program hinges on the Government's credibility to sustain the supporting macroeconomic framework. A policy reversal might be unavoidable should the private sector conclude that the reforms would be short-lived and would, therefore, fail to respond. It is, thus,  - Iv - necessary to: (i) relax the constraints on the exchange rate by consistently implementing the recent macroeconomic policy initiatives, especially the deficit reduction measures; and (ii) address the initial adverse trade balance effects through a credible combination of exchange rate adjustment and external financing. The risk is reduced by: (i) the Government's commitment to maintain a competitive exchange rate; (ii) the implementation of proposed policy measures to reduce the combined fiscal deficit from 4.6S of GDP in the current fiscal year to 2.42 in the next fiscal year based on a the macroeconomic program stated in the Government's Letter of Development Policy; and (iii) the Government's reduced reliance on new issues of domestic debt instruments and the related easing of crowding out pressure. Furthermore, the Government has begun discussions with its external creditors and intendsi to have a complete external financing plan for 1988 and 1989 in place by the end of this year. Estimated Disbursements: The loan would be disbursed in two tranches. The first tranche of US$150 million would be available for disbursement upon fulfillment of conditions of effectiveness. which includes a reduction of the production coverage of QRs from 371 to 18X and of the average production weighted tariff rate from 431 to 301. The second tranche of US$147.65 million would be released upon: (i) progress in the macroeconomic program, satisfactory to the Bank; and (ii) the fulfillment of specified conditions, including the reduction of the QR production coverage to 15?, the removal of industrial export licenses and an action plan, satisfactory to the Bank, for the administrative control of the industrial investment incentive regime. Disbursements of US$2.35 million for consultant's services, training and equipment purchases would be completed by June 1990. Schedule of Disbursements: Amount in US$ Millions Bank FY 1989 1990 Annual 300.00 - First and Second Tranche 297.65 Consultant's Services and Equipment 2.35 - Cumulative 300.00 300.00 Appraisal Report: This is a combined President's and Staff Appraisal Report.  INTERNATIONAL BMAK FOR RECONSTRUCTION AND DBEVELOPMENT REPORT AND '^VCOOE3NDATION O THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SECOND TRADE POLICY LOAN TO THE ARGENTINS REPUBLIC 1. I submit the following report and recommendation on a proposed loan to the Republic of Argentina for the equivalent of US$300 m4.llion, in support of the Government's program of trade policy reform. The loan would be repaid over 15 years, including 5 years of grace, at the standard variable interest rate. 2. The Executive Directors have received a Country Economic Memorandum entitled "Argentina% Economic Recovery and Growth' (6467-AR), dated May 19, 1987. Part I of the present report is based on the findings of macroeconomic missions that visited Argentina in May, August and September 1988, respectively. PART I. THE ECONONY A. Structural Problems and Recent Developments Backtround 3. Argentina has suffered chronic macroeconomic instability and slow growth since the 1940s. Heavy dependence on agricultural exports whose world market prices are highly volatile has made macroeconomic management inherently difficult. Fiscal and monetary policies, however, have ttnded to compound the volatility and have often destabilized the economy even when the external environment was favorable. Instability has discouraged domestic saving and capital formation, and this in turn has led to slow growth. 4. Trade and iadustrial policses over the last half-century have also contributed to instability and slow browth. The import-substitution industrialization drive begun in the 1930s evolved over the years into autarkic policies that walled out ccmpetition from imports and discouraged exports. Through much of the post-war period, average effective protection levels exceeded 60 percent with wide nominal tariff dispersion. In addition, import prohibitions, quantitative restrictions, and opaque subsidies to industry (such as the "buy-Argentina" policy of the public sector) further insulated the sector from international competition. This accentuated instability and slowed industrial growth because the economy remained dependent on volatile commodity exports while industrial productivity grew slowly in the absence of external competition. 5. Beginning in the late 1940s, the Government expanded the state's direct role in the economy. The Government became a net borrower of funds to finance capital formation and subsidies for favored activities through direct transfers, tax exemptions, and hidden transfers through the financial system. Initially, until the mid-1950s, much of the additional  Government expenditures could be financed from a gradual reduction of external reserves and surpluses of the country's social security system, but soon thereafter large and chronic fiscal deficits became a dominant feature of the Argentine economy. In the mid-1970s and then again in the early 1980s deficits exceeded 10 percent of GDP. State-led growth could only be sustained through foreign borrowing and domestic money creation. 6. In the early 1980s, rising world oil prices, slower OECD growth, surging real international interest rates, and declining commodity prices combined with inappropriate domestic policies to plunge Argentina int.o deep recession. The Government used the exchange rate to lower inflation expectations between 1978 and 1981, and this led to heavy borrowing from foreign sources; when confidence in the exchange rate policy waned, capital flows reversed, eventually precipitating a crisis. From 1980 through 1982, while the public sector contracted US$12.8 billion in new loans, short-term capital outflows and international reserve losses amounted to US$21.7 billion. The abrupt cessation of voluntary commercial bank lending in 1982 and the resulting uncertainties required strong and immediate adjustment measures, but the South Atlantic conflict dominated the Government's concerns, and precluded adjustment policies during 1982 and 1983. 7. When the present Government assumed power in December 1983, it inherited a deeply indebted and severely distorted economy. The external debt was US$45.1 billion, about 70 percent of GDP. The public sector either owed or had assumed most of the external debt. As the borrowed funds had been invested poorly and had financed substantial capital flight. the external public liabilities had no corresponding domestic assets, and so their servicing would require enormous transfers from the private sector in coming years. Public sector finances were out of control in the wake of the costly South Atlantic war, inflation was running at 20 percent a month, and investment was contracting. Per capita GDP was 20 percent lower than it had been in 1980, unemployment was rising, and the struggle over income shares intensified as real income shrank, unleashing waves of strikes and wage-price increases. 8. tie sevfre structural problems of the economy were evident in the deterioration of savings and investment balances. At end-1983, gross investment had fallen to less than 60 percent of the 1978-80 level (Figure 1), and national savings had declined to less than half 1978-80 levels during the same period. Inflation drove savings out of the country, strangled financial markets, and increased the risk of investments in projects of longer gestation. The increasingly heavy weight of external debt reversed the traditional pattern of resource flows as the country became a sustained net exporter of capital after 1981. 9. In this context, the highest priority of economic policy was restoring macroeconomic stability in order to control inflstion. Without such stability, limited external and domestic savings would not find their way into investment and could not expect to produce sustained growth. This effort in turn hinged upon the success of the Government in reducing its fiscal deficit since reducing the public draft on national savings was the only practical way of reducing upward pressure on domestic interest rates  - 3 - Figure 1 #~~~~~~~~~~~~~~~A w .a nt . T d 3.0 2.5llil .10.0 '~~~~~~~~~~~~~~~~~~~~IV LEdl Is i Mis 96 ISM I" L" m m IM L"is 9U 155 US Wet.:~ ~ ~ ~ ~ ~ ~~~aO. Zstwe.* *lH S ctoir, ItSti UCtWU la~ ~ ~ ~~laum 100 15 10 2.3~~~~~~~~~~~1 Sig I~~~~~~~~~~~~~~~~~ 15 ~~~~~~~~~~~~~~~~~3.0 LQ9 m Lqo qn i Lqp~!9w set go I=1904Igo sm.5 NIote, l4ufias,*ii Public sector. national accounts basis  and avoiding inflationary money creation. Government revenues had to accommodate new expenditures for foreign interest payments in excess of 4 percent of GDP. The struggle to stabilize the economy therefore became central to economic policy over the next four years. Stabilization Efforts from 1984 to 1987 10. The present Government came into office committed to restoring real wages and growth. It first attempted an incomes poliey to quell inflation and distribute adjustment costs more equitably. Selected prices (public sector goods and services, private sector goods subject to price controls, foreign exchange adjustments, and regulated interest rates) were pegged to the anticipated inflation rate, and to decreed real wage increases. However, as the fiscal deficit was not under control, this policy mix stimulated aggregate demand making the external accounts even more unsustainable. The economy grew by 2.6 percent in 1984. The fiscal deficit, although lower than in 1983, was nevertheless over 12 percent of GDP and continued to drive the inflation rate, which averaged 18 percent monthly for a year, the highest in this decade. Already low external commodity prices fell another 10 percent and, having achieved neither stabilization nor economic growth, the Government was forced to shift policy. 11. A new progrsm, begun in October 1984 under a 15-month stand-by arrangement with the IMF, included adjustment of public prices, devaluation, and tight credit policy as well as some relaxation in price controls. These actions probably staved off hyperinflation--monthly inflation rates fell from around 30 percent to 18 percent by the end of 1984--and improved the external accounts slightly. But policy loosened in the first quarter of 1985, and public sector price adjustment and devalaation slipped behind the inflation rate. Moreover, wage increases were decreed in January and March to compensate for higher-than-expected inflation. 12. With the economy stagnating and consumer prices rising at an annual rate exceeding 1,000 percent, the Government announced a more comprehensive initiative in mid-June 1985, the Plan Austral. The program's objective was to break the 'inertial' pressures arising from the effects of irflation expectations on contracts and on asset demands. The measures iD .uded a wage-price freeze, a tightened fiscal and monetary policy, and a fixed exchange rate following a steep devaluation. A new currency, the austral, was introduced. 13. Partly because the fall in inflation expectations increased the willingness to hold money and partly because of the monetary restriction, real interest rates turned sharply positive. Real GDP contracted 4.4 percent in 1985, but a rebound in consumption and investment in the fourth quarter of 1985 led to a strong recovery the following year. Investment rose in real terms in 1986 after five years of contraction, and real GDP rose 5.4 percent. Monthly inflation fell from about 30 percent to about 2 percent over the second half of 1985. The economy achieved some remonetization: the M1IGDP ratio rose from 4 to 8 percent. The fiscal  - 5 - deficit fell by half to about 6 percent of GDP, partly because real revenues rose through the Tansi effect and partly because of higher real public enterprise prices. The trade surplus reached US$4.6 billion on account of improved agricultural production and prices, as well as lower imports resulting from the stabilization program. The new program enabled Argentina to reschedule its external debt with commercial and official creditors in August 1985. 14. The renewed growth, however, generated new pressures on prices and external accounts, and exposed fundamental weaknesses in the Plan Austral. First, the fiscal program failed to eradicate the public sector's imbalances, and once this became evident, inflationary expectations revived. Even if only a part of the fiscal adjustment was politically feasible prior to the program, the Government could have taken advantage of the program's popularity to carry out a major tax reform. Second, the program was superimposed on a closed economy, so the competitive pressure of international prices did not effectively discipline real increases of product prices forcing over reliance on wage price agreements. The domestic consensus between business and labor remained too weak to forestall significant real wage and pension increases in late 1985 and early 1986, contributing to a resurgence of inflation expectations. Without a large stock of international reserves and a credible fiscal program, 'unfreezing the economy reignited inflationary expectations. Finally, the deterioration in the terms of trade further undermined the program's fiscal and income effects. 15. Thus, by the end of the first quarter of 1986, higher aggregate demand and reemerging fiscal control problems contributed to renewed resurgent inflation. The Government decided nevertheless to end the price freeze in April 1986, devaluing 4 percent at the same time and announcing that henceforth it would set exchange rates and public sector prices in accordance with the inflation rate. These measures, combined with higher- than-anticipated wage adjustments, generated further inflationary pressure. Renewed GDP growth and increased foreign exchange availability increased Import demand more than 20 percent with respect to the compressed 1985 level. Merchandise exports declined 17 percent because of a deterioration in world grain and oilseed prices, even though industrial exports, which had grown 20 percent in 1985, maintained their new high level because of the attractive exchange rate. Therefore, despite lower world interest rates, the current account deficit rose from US$953 million (1.5 percent of GDP) to US$2,859 million (3.8 percent of GDP). Once again, the Government had no option but to impose restrictive monetary policies early in the third quarter of 1986, and real growth slowed in the fourth quarter. 16. The slowdown continued into 1987, but inflation did not abate. Falling world grain prices and reduced export tax rates reduced public sector revenues. Further, the spending of several provincial governments and municipalities and certain public enterprises, far exceeded their budgets and more than consumed the central administration's surplus. In addition, the central bank's *quasi-fiscal* activity became a means of channelling housing and other subsidies to favored sectors.  - 6 - The October 198? ProRram and DeveloDments in 1988 17. Tne deteriorating fiscal and quasi-fiscal deficit during 1987 left a legacy of worsening disequilibrium in financial markets. This resulted in the eventual increase in inflation in 1988. The demands of the public sector on national savings were sharply increased, as the combined deficit mounted to a high level of 9.4 percent of GDP.11 18. In October 1987, just after the Congressional and provincial elections, the Government announced a new emergency effort to control inflation. This included new fiscal measures and a price freeze. To cope with the fiscal situation, Congress in January 1988 passed the October package of measures, including taxes on bank checks and a forced savings program; it raised the tax on savings and time deposits 2 percentage points, and increased the tax on the transfer of public sector bonds by 0.75 percentage points. Public sector prices were increased to higher real levels than at the end of 1987. However, by the end of June, it was clear that revenues continued to fall because of the effects of inflation on lagged tax collections, the tax exemptions eroding the VAT and other taxes and apparent evasion; the initial 1988 targets would not be achieved. 19. The pace of inflation accelerated progressively in the first semester. After a first quarter of near single digit inflation, prices rose about 20 percent per month in May and June and accelerated to over 25 percent in July. This reflected, among other factors, removal of price controls in the first quarter of .-38, higher public enterprise prices, aad recovery of agricultural prices. In April 1988, the Governmeut reduced the price control coverage to 25 percent of the consumer price index, and in May reduced it to 12 percent. Also, the new socizl security tax had an effect on prices. 20. The inflation resurgence quickly led to an erosion in public confidence. The demand for money fell precipitously and the willingness of the public to hold public liabilities put further pressure on monetary policy. The seve~t y of the new inflation episode compelled the Government to act. 1/ The "combined deficit" of the public sector refers in this report to the deficit of the consolidated nonfinancial public sector, excluding the provinces, measured on a cash basis plus the operational deficit of the Central Bank associated with fiscal expenditures, the so-called quasi-fiscal deficit (discussed below). Provincial governments are excluded from the computation of total borrowing requirements because the provinces are not required to report their budgets on a cash basis.  7- B. The Government's New Program: Plan Primavera 21. On August 3, 1988, the Government annotunced a new policy package, since labelled the *Plan Primavera". Following the initial announcement, the Government invited the Bank to undertake an assessment of the plan, and to discuss how the plan could be better linked to structural reforms already under discussion between the Bank and Argentina. Accordingly, a mission (including both macroeconomic and sectoral specialists) visited Argentina in August to assess the internal consistency, feasibility and sustainability of the policy package, while at the same time negotiating the present loan, and the revised conditions of effectiveness of the Banking Sector Loan. This mission helped the government articulate an overall agenda of structural reforms oriented to fiscal adjustment, improved efficiency, and restoration of growth, and the parameters of a stabilization program. A follow-up mission reviewed the Government's initial fiscal and monetary programs for 1989, and made suggestions for further significant changes. The outcome of these discussions was the Letter of Development Policy, signed by the Government on September 22, and thereafter made public as a declaration of its policy intentions. 22. The recent discussions represent an evolution, and intensification of the dialogue on adjustment issues between the Bank and Argentina that has taken place over the last two years. As detailed further in Part V of this report, this dialogue has encompassed policy-based loans in major sectors, technical assistance lending, and economic and sector work. By the same token, it is anticipated that the Bank will support the overill program of structural adjustment through a number of further interventions, including further operations in the financial sector, in the public enterprises, and in industrial restructuring. Stabilization Effort,% 23. The stabilization components of the plan are predicated on the analysis that the recent high rates of inflation are attributable both to inertial components and to the excessive demand for domestic credit on the part of the public sector in the presence of unusually narrow domestic financial markets. The August measures, therefore, included a voluntary price freeze to reduce the inertial component, but also placed emphasis on strong reductions in the demands of the public sector on domestic savings and credit from the Central Bank. 24. Prices were anchored in several ways. The policy is built upon an agreement with industrial groups to hold price increases to no more than 3.5 percent in September and to zero in October. Also, the Government has announced that public enterprise prices, after an increase of 30 percent prior to the beginning of the program, would be kept unchanged until end- September; a 4 percent increase is envisaged for the month of October. The Central Bank devalued the official rate of the austral by 11.4 percent at the start of the program, and froze the rate through September 30; a further devaluation of 3 percent has been announced for October. Wages of the Central Administration were also frozen. 25. The Government's fiscal objective is to constrain the combined deficit to the level of external savings reasonably mobilized by the Government plus a small margin for reasonable expectations on  - 8 - remonetization of the economy. The government has placed all imports except oil as well as about half of industrial exports in the free exchange market; this is an effective exchange rate tax that will further reduce the deficit of the combined public sector. The Government has committed itself to prevent the differential between the official and free exchange rates from going beyond 25 percent, and to unify exchange markets gradually starting April 1, 1989. In the meantime, by buying foreign exchange from exporters surrendered at the official rate, the Government will realize an exchange rate gain when it sells this exchange to importers at the free market rate. This gain is expected to yield about 0.5 percent of GDP on an annual basis in both 1988 and 1989. 26. The 1989 budget, presented to Congress on September 29 and before the start of the fiscal year for the first time in a decade, forms the basis for the new macroeconomic program. This budget, together with supplemental measures presented below, would result in a substantial improvement in the combined deficit from 4.6 percent of GDP in 1988 to 2.4 percent of GDP in 1989 (Table 1). This result would imply a reduction of over two-thirds when compared to the extremely high 1987 level (9.4 percent). 27. Following discussions with the Bank, the authorities are committed to important supplemental spending cuts and revenue increases beyond those shown in the budget program for 1989. These inciudes (i) a reduction of expenditures of more than US$500 million; (ii) the reinstating of the VAT rate to 18 percent (or equivalent measures) by January 1, 1989; (iii) a reform of the VAT and of excise taxes with the dual objective of increasing revenue and decreasing the distortions resulting from the industrial promotion scheme, anticipated to be in place by mid-year; (iv) a short-term program to increase substantially the ability of the Federal Tax Office (DGI) to collect taxes. The Bank expects to work closely with the Government in its tax reform and tax administration program. 28. As now formulated, the program will require recourse to domestic financing for approximately 1 percent of GDP. This assumption, which underscores the need for a firm monetary policy in the months ahead, can be compatible with the desired rate of inflation reduction if the demand for austral-denominated assets increases during 1989. This increase appears plausible, as lower inflation and inflationary expectations can be expected. Key to the program's success are elements in each of its main components--nonfinancial public sector performance, the quasi-fiscal deficit, external finance, and the monetary program. Ronfinancial Public Sector 29. Primarily because of falling revenues, the performance of the nonfinancial public sector in 1988 is expected to improve only modestly over the unsatisfactory performance of 1987. The deficit of the non- financial public sector is projected to fall from 4.7 to 4.3 percent of GDP. Even though total expenditures fell in 1988 relative to 1987 (from 24.2 to 22.7 percent of GDP), revenues also have continued to fall (from 20.1 percent of GDP in 1987 to 18.7 percent in 1988) (Table 1).  Table 1: SUMMARY OF PUBWIC SECTOR DEFICITS (percent of GDP) -------------------------------------------------------- 1987 1988 1989 -------------------------------------------------------- Nonfinancial Public Sector Public Sector Savings -1.4 -1.6 1.4 Current Revenues 19.5 17.8 20.1 Current Expenditures 20.4 19.2 19.8 Public Enterprises Savings -0.5 -0.3 1.1 Capital Revenues a/ 0.5 0.9 1.1 Capital Expenditures 3.8 3.5 3.5 Borrowing Requirement 4.7 4.3 1.0 Central Bank Domestic operating result bI -3.8 0.3 -0.2 External result -0.9 -0.6 -1.2 Quasifiscal Deficit 4.7 0.3 1.4 Combined Public Sector Deficit 9.4 4.6 2.4 a/ Includes forced savings scheme bI Includes 45 percent provisions on loans to, and income, from BHN as well as gains from the exchange rate tax estimated to be 0.52 in 1988 and 0.62 in 1989.  - 10 - 30. The fall in revenue collection is one of the most worrisome features of the economic performance. The acceleration of inflation in both years can explain part of the decrease in revenues with respect to GDP, but more fundamental causes also appear at work. Tax collection has long been hampered by low voluntary compliance. Also, the industrial promotion scheme has eroded the base of the VAT, income and capital taxes. On the other hand, the public enterprise performance in 1988 has shown signe of improvement. 31. The 1989 budget, and the supplementary measures (para. 26) envisage a reduction of the non-financial public sector borrowing requirements to about 1 percent of GDP on a cash basis. This ambitious target appears viable because of changes in the budgetary process and exceptional revenue and expenditure measures that have been initiated by the government. The most important budgetary development is the adoption of the principle of independence of the central administration budget from those of the main past sources of deficit creation: the public enterprises, the provincial governments, and the social security system. This means that there is a *natural tendency of the public sector accounts to produce a relatively low deficit, by historic standards, if inflation were to be reduced to manageable levels. This, together with the new social security taxes whose effect would be felt fully in 1988, permitted authorities to project initially--prior to the supplemental measures- -reductions of the 1989 non-financial public sector deficit to about 2.2 percent of GDP down from 4.3 percent in 1987. 32. This initial apassivea outcome of the budgetary exercise, however, would not have been consistent with the objective of decreasing the reliance on domestic sources of credit. The modifications to the program, therefore, include additional measures (para. 26) to increase revenues and decrease expenditures of the central administration and of public enterprises. These are expected to contribute a further reduction of 1.2 percent of GDP. The revenue measures would provide about 0.6 percent of GDP and the expenditure reductions would provide a like amount. These will enable the nonfinancial public sector deficit to be reduced to one percent of GDP. The Quasi-fiscal Deficit 33. The operational quasi-fiscal deficit of the Central Bank is comprised of a foreign and a domestic component. The external component comprises the interest payments on the foreign debt less interest earned on the Central Bank's foreign exchange assets. Domestic fiscal expenditures effected through the Central Bank were the major source of the expansion of the public sector's demand for credit in 1987, particularly credit for housing and industrial finance through the public banks whose portfolio recovery has been egregiously low. As noted already, the Central Bank has long been used as a vehicle for granting distortionary subsidies to selected interest groups while circumventing the budget process. The Government made considerable progress in 1988 in checking these expenditures and making them transparent by informing Congress of the  - 11 - rediscount budget for 1988. As a consequence of this and other factors,2/ the quasi-fiscal deficit is expected to shrink in 1988 to 0.3 percent of GDP from 4.7 percent in 1987. 34. The Government intends to restrain Central Bank quasi-fiscal expenditures in 1989, an objective supported by the Banking Sector Loan. Under the program supported by the loan, the discretionary sources of quasi-fiscal expenditures will be under control. Under this program, the domestic component of the quasi-fiscal deficit will be virtually zero (a slight worsening relative to 1988 because inflation is assumed to be more uniform in 1989). However, a considerable worsening will be registered on the external component of the deficit because of the increase in external interest payments of the Central Bank. Consequently, the quasi-fiscal deficit for 1989 is expected to reach 1.4 percent of GDP, contributing substantially--unless offset elsewhere--to the demand for domestic credit of the overall public sector (Table 1). The Balance of Payments and External Finance 35. The Government's balance of payments projections are for a current account deficit of about US$2.3 billion in 1988 and about US$2.6 billion in 1989 (Table 2). Exports, boosted by recent increases in prices, are expected to reach US$10.2 billion in 1989, while imports are expected to rise to US$6.4 billion because of the projected economic recovery in 1989 and some increase in imports associated with trade liberalization. The notable improvement in the trade balance, rising from US$3.1 billion in 1988 to US$3.8 billion in 1989, is more than offset by the substantial rise in foreign interest rates, which push interest payments up by US$1.1 billion. The projected current account deficit therefore is US$300 million greater in 1989 than in 1988. Both years, however, are substantially improved relative to 1987, when terms of trade losses and flooding cut heavily into agricultural exports. 36. The evolution of the capital account depends heavily upon the success of ongoing discussions between the Government and its external creditors. The Government has begun discussions with the IMF and the commercial banks and expects to mobilize a conventional package in due course; it also expects to request a Paris Club meeting as the latest agreement only covers obligations due through June 30, 1988. 37. The composition of capital inflows sharply changes in favor of the private sector over the three year period 1987-89. This is because several short-term obligations of the Government and the Central Bank (including bonds, short-term credit lines and the like) are coming due in 1989 and cannot be fully rolled over; and at the same time, the private sector has experienced some success, especially through foreign direct investment aad debt conversion in garnering more foreign resources. As a consequence, 2/ Among the latter is the effect of the sudden deceleration in inflation, which results in high real interest rates on Central bank rediscounts, as there is a two-month adjustment lag in the setting of nominal interest rates on Central Bank domestic interest-bearing liabilities.  - 12 - Table 2: BALANCE OF PAYMENTS -----------------------------------------------------------------__----- 1987 1988 1989 ---------------------------------------------------------,---------__--- Exports (goods) 6359 8855 10200 Imports (goods) -5800 -5800 -6400 Trade Balance 5!9 3055 3800 Net Non-Factor Services -348 -248 -227 Financial Services -4485 -5089 -6154 Of which: Interest -4145 -4655 -5750 Current Account Surplus -4282 -2283 -2581 Capital Account Surplus 1426 2454 2659 Direct Foreign Investment -19 996 886 Multilateral Sources 733 364 850 IBRD 700 329 617 IDB 33 35 233 Bonds and Debt Conversion -195 -380 -377 Of which: Debt Conversion 0 -306 -388 Other Capital -337 -1076 100 Commercial Banks 1244 Additional Financing 2550 1200 Net Reserve Change (--increase) 2856 -171 -78 Of which: IMF 614 255 258 Memo: Funds Available to Public Sector as a share of GDP (2) 4.2 2.3 1.4 Source:----------------------Central----------------------Bank-------__- Source: Central Bank  - 13 - foreign finance to the public sector will be about 1.4 percent of GDP, about one-third of its level in 1987. While this shift is generally a welcome development, it has the adverse consequence of forcing greater adjustment on the public sector if the Government wishes to minimize its borrowing from domestic financial markets. The Monetary Program 38. The projected recourse to domestic financing of the overall public sector deficit for approximately one percent of GDP in 1989 will rely in part on use of credit whose counterpart results in money creation. For the program to succeed, the increase in money supply must be compatible with the additional demand that the public will require. A further constraint on monetary policy is also posed by the declared exchange rate policy, that is expected to maintain a maximum differential between the official and the free exchange rates not exceeding 25 percent, thus posing a limit to domestic interest rates. The monetary program for 1989 (Annex Table 6) is consistent with these dual requirements of the Plan Primavera. 39. The sharp increase in the rate of inflation In 1988 precipitated a further demonetization of the economy during the first eight months of the year. Real Ml and M2 dropped to the lowest levels on record, as a percentage of GDP. This reflected an attempt to limit capital losses on Ml (which bears no interest), and generally negative real interest rates on M2 and other financial aggregates, reflecting to a certain extent the unanticipated recent inflationary surge. 40. Growth of money supply, on the other hand, was strong, the direct or indirect consequence of the public sector deficit. As the operational surplus of the government was insufficient to pay for the interest on the external debt and arrears were building up, the contribution of the external transactions of the private sector led to important increases in money creation. And while the central bank has not been directly extending credit to finance the central government's deficit since the start of the Plan Austral in 1985, other avenues are open to increase money supply as a result of operations with other entities of the public sector. Thus, during 1988, a large amount of expiring government bonds could not be rolled over voluntarily at reasonable interest rates, resulting in the decision to monetize these obligations. Credit to the social security system was increased, and another source of money creation came from the quasi-fiscal deficit. 41. The Central Bank can and did act to reduce the potential increase in money supply by increasing forced investments and by issuing short-term bonds to mop up liquidity. While this succeeded in reducing disequilibrium in the money markets, the interest cost of conducting sterilization operations is very high, and leads to further increases in the quasi-fiscal deficit in the very short term. Thus, a necessary condition for the restoration of orderly growth of monetary aggregates is a fundamental reduction of the forces that lead to es ante expansion of the money base, chiefly the public sector deficit. The measures envisaged in the Plan Primavera are the basis for the 1989 monetary programs they foresee a sharp decline in the public-sector-related sources of monetary creation; together with the increase in the demand for M1 and M2 that can reasonably be  - 14 - expected as a result of a sustained lowering of inflation, they are consistent with the restoration of orderly monetary growth conditions, and with a decrease in the need of the monetary authorities to issue short-term bonds. 42. Monetary management will nonetheless need to be strong, as many uncertainties surround the outlook for the year. The foreign sector is expected to continue to provide a strong source of money creation, as the foreign exchange surplus of the private sectors is increased by the improved trade performance. The resumption of cxternal interest payments on the part of the central government will, however, act as a partial absorption factor. The restrictions on rediscounts, supported by the Banking Sector Loan, will virtually eliminate that source of money creation. Central Bank action might, however, be needed if it experienced new difficulties in rolling over the outstanding government debt stock, and, more fundamentally, if inflationary developments were to lead to a lower-than-expected growth of money demand. Performance to Date 43. The Plan Primavera is now in its third month. The plan has registered a moderate success in reducing inflation and restoring a measure of confidence in financial markets. The combined (wholesale and consumer) inflation rate in August reached about 30 percent; this was the result of sharp increases of wholesale list prices3/ just before the enactment of the plan and the 30 percent increase in public enterprise prices. The Government's successive agreements with industrialists to hold down prices in September and October have contributed to a substantial slowdown in wholesale prices; progress as measured by the Consumer Price Index was less encouraging in part because beef prices continued to rise. On the whole, the combined price index may rise by about eight percent in September. 44. Wage settlements have been broadly consistent with the desired reduction of inflation, although with diverging performances among sectors. Wages in the public administration (except for military wages) and in the public enterprises were kept at the targeted inflation rates in August/September, and no increases were foreseen for October. In other industrial sectors wage settlements have been higher, although the Ocushion* built into the wholesale prices as a result of the early-August hikes has probably left sufficient room for profitability for the enterprises concerned. 3/ The wholesale price index in Argentina is recorded on the basis of list, rather than actual prices. This fact is in part responsible for the wide discrepancies experienced between the behavior of the CPI and that of the WPI. These discrepancies have been particularly marked during 1988.  - 15 - 45. The strict monetary policy conducted in August and September, together vith the anticipated declines in inflation, led to expectations of high real interest rates, and helped spur a strong capital inflow that contributed to the build-up of reserves of the Central Bank. The announcement that the official exchange rate would be pegged at AS12 per US dollar for a period of two months, and that the free exchange rate would not be allowed to go beyond a 25 percent limit, made investment in austral-denominated assets yielding between 9-12 percent per month extremely attractive. This policy has helped minimize imported inflation. C. Progress on Structural Problems and Plans for Further Reforms 46. The short-term macroeconomic program is complemented by a foundation of continuing structural reforms affectings (i) public finance, (ii) the financial system, and (iii) external trade. The pressure of the external debt crisis, persisting short-term macroeconomic problems, and strong political opposition has at times dealt setbacks to the reform process, but the direction of change has been consistent. In the first two of these areas important policy actions the Government has taken since assuming office are summarized, followed by the measures the Government has indicated it plans to take over the remaining year of its term. The third area is the subject of this loan. Public Finance 47. The new constitutional Government assumed office without an effective taxation system and, perhaps more important, without a budget process. The budget process had not operated for years: private groups were accustomed to negotiating 'bilaterally' with the Government or specific agencies. Since the process had no mechanism for reconciling competing claims on public resources, it had an inherent bias toward deficit spending. Moreover, the military regime had embarked on several costly low-return investment projects, symbolized by the nuclear power program, which now can only be postponed or stopped at a high cost. There was also a continued erosion of the base of direct and indirect taxes as a result of the widening of the scope of the industrial promotion law. 48. Perhaps the most important structural change is the adoption of the principle of separation of the accounts of the central administration from those of the institutional sectors traditiona;ly responsible for deficit spending -- the provinces, the public enterprises, and the social security system. For the first time, both the 1988 and 1989 budget are built around clearly defined ceilings for these entities; this means no transfers beyond the agreed revenue sharing for the provinces, transfers amounting only to the payment of external interest payments for the public  - 16 - enterprises, and no transfers for the social security system. This policy, rigorously pursued4/ during this year, is expected directly to reduce the demands on the central administration, and, through greater budget responsibility, to increase the level of efficiency in the provision of public services. 49. The Government has reorganized the public enterprise sector's policymaking and regulatory framework. Policymaking was transferred to the appropriate ministries, and budgetary control was transferred to a specially created holding company, the Board of Public Enterprises (Directorio de Empresas Publicas--DEP). In addition to approving annual budgets, DEP now monitors all public enterprise income and expenditures on a bimonthly basis ard reviews monthly reports on contracted debt. The Government enacted a 'demonopolizationg decree in November 1987, which opened some areas formerly reserved for the state to private investors and competitors. Finally, the Government intends to continue deregulation in telecommunications, petroleum, gas, steel, and railroads; to continue privatization efforts with planned sales of Aerolineas Argentinas, ENTEL and ELMA; and to revise procurement practices to reduce the implicit abuy- Argentina' subsidies. 50. In its relations with provincial governments, the Government took a major step forward to improving the accountability and transparency of the provincial governments' finances in January 1988 by passing a new coparticipation law establishing specific ceilings for access to federal financing. Previously the provincial governments could rely on the federal government for revenues, and, failing that, on borrowing from provincial banks who could secure funding from the Central Bank via overdrafts and rediscounts. The new law specifies a fixed division between national and provincial revenues, increasing the share of revenues for provincial disposition from 48 to 57 percent of coparticipated taxes. Any provincial expenditures in excess of these revenues must be financed with provincial taxes. Ending provincial bank overdrafts has also reinforced this fiscal discipline. 51. The deficits of the social security funds have widened over the last two decades. The number of eligible pensioners has increased relative to the workforce as the population structure has aged. Also, legislation enacted in the :9709 extended coverage to workers previously not included. In order to address these problems, new taxes are expected to restore its financial balance of the system through 1989 and beyond. 4/ For example, the provinces are prevented from seeking additional funding through the use of rediscounts with the Central Bank, a traditional source of quasi-fiscal deficits. The policy has been enforced through the shutting down of three provincial banks in late 1987 and early 1988, when they exceeded their overdraft limits with the Central Bank.  - 17 - S2. Finally, other important recent developments affect revenues of the public sector. First, the Congress in September passed the unified industrial promotion law (discussed in Part II). Over time this will serve to stem the fiscal drain of lost tax revenues due to industrial incentives; the new law will also help improve resource allocation. In addition, as noted the Government (with the assistance of the Bank) is embarking on major efforts in tax administration and indirect tax reform to improve the efficiency, yield, and equity of the tax system. Financial system * 53. Unstable macroeconomic policies and performance have badly damaged the country's financial system over the past two decades, culminating in the mid-1982 collapse. The policy approach varied from a regime of strong * regulation (1973-75), to extreme interest rate liberalization and credit allocation with loose supervision and easy entry (1977-82), and then back to financial repression and reliance on the Central Bank for credit--partly in response to the 1982 collapse, as well as to the Government's growing fiscal needs. The present Gove.nment has sought gradually to move to a more market-oriented system. Reflecting the continued macroeconomic instability, the financial system is still plagued with high real interest rates, large spreads, shallowness and segmentation. Moreover, several public financial institutions, including most prominently the Mortgage Bank (BHN), the National Development Bank (BARADE), and many provincial banks, have eroded their capital base and thus become excessively dependent on the central bank for credit. Several require substantial restructuring. 54. The financial system contributes to the public sector's chronic deficits by channelling disguised fiscal expenditures through the credit system. In the past, the provinces' deficits have been partially covered by loans from provincial banks; these in turn have financed themselves through overdrafts and rediscounts from the central bank. Subsidies for housing mortgages have partially taken the form of inadequate loan recovery through BEN, whose operating deficits were covered by Central Bank rediscounts. Similarly, subsidies to the industrial development bank, BANADE, have been financed through rediscounts. Being unwilling to pay the high real interest rates demanded by the financial markets for public sector borrowing, the Government has relied heavily on high reserve requirements and forced investments. In October 1987 authorities committed themselves to reduce reserve requirements for additional deposits as part of a liberalization program (including the end to administered interest rates) that would relieve credit allocation distortions. However, the Government was forced to raise marginal reserve requirements from three to 25 percent (by increasing them from three percent to eight percent and instituting an additional compulsory deposit of 17 percent based on the average of deposits in the prior two months) in the first half of 1988 to curtail liquidity growth and to prevent a sharp rise in interest rates in the course of funding the fiscal deficit. 55. The Government has taken various measures to strengthen the financial system since 1986. These includet ti) liberalization of interest rates (1987); (ii) stringent regulations on loan portfolio classification, provisions for loan losses, and interest accruals on doubtful loans (1987-88); (iii) deposit insurance for all small deposits (1987);  - 18 - (iv) improvement in regulation and supervision of banks, including their portfolio, capital structure, and transparency to the public; (v) liquidation of several insolvent financial intermediaries--most importantly, sale of the largest private bank, the Banco de Italia, and several branches of publicly owned banks (1984-87). 56. Since most of these measu:es were taken within the last 18 months in a context of instability, they have not yet made a substantial impact on the sector's main problems. The Government, however, has indicated that it will continue efforts to reform the financial system by taking the following measurest (i) presenting to Congress a draft law to reform the central bank charter to Increase its autonomy and to limit its power to finance the public sector; (ii) strengthening prudential regulations (loan portfolio classification and loan-loss provision) and the supervisory role of the central bank; (iii) creation of an entity independent of the central bank to administer liquidation of assets formerly held by bankrupt institutions and now in receiverships (iv) reorganization of the major public sector banks (e.g., BANADE and provincial banks) through recapitalization, restructuring and progressive elimination of central bank finance; (v) reform of the BHN through progressive elimination of central bank finance and augmenting its nonretail (second tier) operations; this would include improving cost recovery and provision of a new capital structure with possible contributions from international organizations and private pension funds. As long as the overall macroeconomic situation improves, the Government's efforts to carry out further financial system reforms would remove significant structural impediments to growth. D. Medium-term ProsDects and External Financing 57. If the Government's adjustment and stabilization program succeeds and efforts at structural reforms persist, they will contribute to unleashing the long-dormant productive potential of this resource-rich country. After relatively slow growth in 1988 (1.5 percent), output could expand at rates in excess of 3.5 percent for the 1989-95 period. This assumes policy consistency and continuity, adequate external finance and stability in international agricultural prices and interest rates. Current Account 58. Tbe recent drought in the United States is expected to boost 1988 agricultural exports to levels considerably above 1987. Prices rose in the last half of June by 20-40 percent. Soybean exports are now expected to rise more than 50 percent in value, while wheat export receipts are projected to increase by 40 percent. Manufactured exports are also expected to grow substantially on account of the favorable export incentives and producers' response to divert sales away from depressed domestic markets. Over the medium term, exports, stimulated by reforms of the trade regime and the competitive exchange rate prevailing since 1986, would play a leading role in economic growth, expanding by about eight percent annually for the period 1988-95. Nontraditional exports would be  - 19 - the driving force as they benefit most from the trade reforms supported by the Trade Policy and Export Diversification Loan and by the proposed Second Trade Policy Loan, particularly from the introduction of an efficient and fully automatic temporary admission regime, the reimbursement of individual taxes and the removal of most export licenses and export taxes. However, there is also some room for the growth of agricultural exports beyond the growth of consumption in industrialized countries as Argentina's loss of market shares in the recent past has mainly been due to supply factors. 59. Imports, on the other hand, after expanding by about six percent in 1989 in response to the trade reform and import demand accompanying new growth in the economy, would grow annually by about six percent for the period. This pattern reflects a growing openness of the economy to import competition, manifest in a modestly rising ratio of imports to GDP. This increase is of course also influenced by the outlook for external finance. 60. This trade performance, together with a LIBOR rate of nine percent, would produce some improvement in the current account balance over the coming years, albeit slow. Over the next five years, the current account deficit would decline to under US$1.9 billion as improvements in the trale balance would be partially offset by interest payments on increased indebtedness. Nonetheless, because the economy is growing at a reasonable and sustainable rate, the ratio of the current account deficit to GDP is projected to fall from about 3.2 percent to under 1.8 percent by 1993. Saving and Investment 61. To realize growth rates of 3.5 percent or more in 1989-95, both private and public savings would have to increase from their present rates of under 11 percent to over 16 percent in 1993. Increased domestic savings rates are necessary to finance continued high levels of external interest payments and increased domestic investment in productive activities. This implies that reforms in the financial system have to be consolidated so as to permit financial markets to mobilize and mediate savings efficiently, that inflation must continue to decelerate and stabilize at a new low level to make saving attractive, and that domestic income must grow to provide a basis from which to generate savings. The public sector necessarily plays a leading role in mobilizing new savings, for without concerted efforts, it cannot fund its investment program and pay its debt obligations except through relying on the inflation tax and/or inflationary domestic borrowing. 62. Higher domestic savings rates, together with foreign savings, could provide the impetus for much needed new investment--investment which is a sine qua non for expanded export potential. In the projection, investment is seen to grow from about 13 percent of GDP in 1988 to approach 18 percent at the end of the period. Much of this would go to replace badly deteriorated capital stock. Such improvements in both saving and investment depend critically upon private sector confidence in the macro and sectoral policy framework and the stability of these policies over time. Exchange rates, trade and financial market policies are among the most important in this regard.  - 20 - External Finance 63. One of the most problematic aspects of the medium-term outlook is the availability of foreign finance. Even with improved trade performance, projections indicate that amounts required from external creditors will be substantial if the country expects both to grow and to service its external debt over the next five years. The Government is discussing with the IMF a new Standby Arrangement that would run through 1989. For 1988-89, the Government will be requesting new money from the commercial banks equal to roughly half of interest due. Serious discussions with the commercial banks started in early October and it is the Government's expectation that a new financing plan for 1988/89 will be in place by the end of this year. 64. Putting together an external financing program is essential, and without an active Bank role such a program may not materialize. The economic situation in Argentina is at an important turning point and timely international support is warranted. Extended delay in agreeing on an external financing program might jeopardize the success of the program and risk bringing about an outcome unfavorable to all creditors. 65. The Bank is providing leadership with the clear expectation that the Government of Argentina will fulfill its commitment, as stated in the Letter of Development Policy, to reach an expeditious agreevdnt with external creditors, particularly the IMF, before the end of the year. As noted below, satisfactory progress on putting in place an external financing program will be an important criterion against which to assess macroeconomic performance. 66. Over the medium-term, the projections suggest that even with official net disbursements averaging US$700 million over the 1990.92 period, the country would need roughly US81.5-2.0 billion annually in additional financing. E. Macroeconomic Monitoring 67. The Bank will undertake another macroeconomic assessment in early 1989. This would provide the basis for the release of the second tranche of the Trade Policy Loan (US$150 million) and the first tranche of tne amended Banking Sector Loan (US$200 million). The Bank would undertake a further macroeconomic assessment in July 1989, which would provide the macroeconomic basis for the second tranche of the proposed BSL (US$200 million). Both missions would consider progress on three aspects of the program: external finance, policy actions, and economic performance. 68. In addition to actions under the specific loans, the Government's program includes several actions to improve the macroeconomic framework. The most important actions are as follows:  - 21 - -- Measures to achieve a nonfinancial public sector cash deficit of 1 percent of GDP, including both revenue-enhancing measures and expenditure cuts. By December 31, 1988, the Government will submit legislation to Congress to reform the value-added and sales taxes so as to Lcrease revenues by 1.2 percent of GDP and reduce allocative distortions with the intent of implementing the proposed reform before mid-year 1989; and restoration of the VAT to 18 percent (or equivalent tax) before January 1, 1989. Specific improvements in tax administration will also be undertaken. The Bank is working closely with the Government on iosues of tax policy, and improvements in tax administration. -- Limits on quasi-fiscal expenditures of the Central Bank, including most importantly the rediscount budget, so as to achieve a total deficit of no larger than 1.4 percent of GDP in 1989; as agreed under the Banking Sector Loan, this means that new rediscounts granted (other than to the BHN) will be less than total recoveries (amortization and interest) of previously agreed rediscounts as well as specific ceilings on BHN rediscounts conforming to financing commitments as of January 1988; also, reserve requirements are not to be raised above their August 15, 1988 level while compulsory investments from the commercial banks are not to be increased. -- Execution of the fiscal and monetary programs described above. Monetary aggregates would be consistent with the projected increase in money demand, and with the Government's announced exchange rate policy, continue to maintain a competitive exchange rate. -- Public utility rates will be adjusted so as to be consistent with the fiscal targets for 1988 and 1989. -- Transfers to provinces, public enterprises and social security are not to exceed those contained in the program. -- Progress on restructuring BHN, BANADE, Ferrocarriles Argentinos, and improvement in public procurement according to agreed action plans. 69. Economic Performance. In addition to these key policy areas, the Bank will also closely watch the overall evolution of the economy over the coming months. This entails an evaluation of the evolution of key prices (e.g., the real exchange rate, wages, interest rates) as well as economic performance (e.g. inflation, output, and balance of payments). The Government has agreed that it will take appropriate adjustment measures in consultation with the Bank if adverse developments occur. For example, higher than anticipated inflation rates for the last quarter of 1988 would require an immediate policy response since the monetary and fiscal programs for 1989 are predicated upon a relatively moderate single digit monthly inflation rate through the remainder of 1988.  - 22 - F. Risks to the Macroeconomic Prosram 70. The Bank's country support strategy contains three types of risks that the program may fail; that the needed external financing will not be available; and that implementation will only be partial. 71. Risks to the Program. The success of the program in the next few months is subject to several risks. Real tariffs of public enterprises have been eroded more than was originally intended because inflation in September (and possibly October) will be higher than projected. Failure to regain originally planned levels by the end of the year would jeopardize the revenue and savings objectives for 1988 and 1989. Moreover, if attempts to regain lost ground are delayed, the necessary corrections might reignite inflationary expectations and trigger a price spiral. Similarly, loss of confidence could also materialize if the real exchange rate were allowed to appreciate significantly, as might happen if the official exchange rate were used as an anti-inflationary tool and if inflation were to turn out higher than expected. Capital inflows that have helped remonetize the economy could just as quickly reverse with a waning in private confidence. Conscientious macroeconomic management, vigorous implementation and careful monitoring could attenuate these risks. 72. External Financing. Mobilizing adequate external finance for 1988189 in the current situation for Argentina will be difficult. With the Bank's program firmly in place, it is important that the Government work assiduously to bring other external creditors into the general framework. The Bank will use its best offices to bring about a satisfactory outcome. 73. Risks to Implementation. It is alecs possible that the Government may not be able to follow through with -he program; if adjustments are needed, it may not be able to make the required adjustments. This is an important risk in an election year. A related risk is that the new Government which is expected to assume office in December 1989 may have a quite different diagnosis of current problems and reverse the course of some or all of the reforms. 74. These risks are mitigated by the fact that political commitment to this program has been given by the President of the Republic. Also relevant is the considerable public awareness in Argentina and consensus of the gravity of the fiscal situation, the need to control inflation, and the Importance of international linkages to the growth of the domestic economy. Moreover, opposition parties have an interest in inheriting a functioning Government and a growing economy to manage. This may find expression in the political campaign, and in any event will of necessity be thrust upon any incoming administration, regardless of political persuasion.  - 23 - PART It. TRADE POLICY IN ARGENTINA Background 75. Industrial import substitution in Argentina started as a response to the interruption of trade flows during the Great Depression and the Second World War. After 1945, however, successive Governments continued to pursue the substitution strategy through import protection and export controls and, since the early 19509, also through investment incentives. The twin policies of insulation from the world market and of state-led investment, while reducing the share of imports in GDP from .4 in the late 1920s to .1 from the late 19509 onwards, failed to promote satisfactory rates of economic growth. Real GDP per capita increased at an average rate of only 1.3Z between 1935139 and 1980184 while growing 3.42 in neighboring Brazil and 2.6? and 3.22 in Australia and in Canada, respectively, two countries that resemble Argentina's factor and resource endowment as well as her pre-1940 per capita income. Prior to the debt crisis, Argentina's investment efforts as well as educational coverage compared favorably with those of industrial market economies. Her relative decline, therefore, reflects an inefficient use of human and physical resources. The inefficiency can be associated with the protracted reliance on trade interventions and government guidance of domestic industrial activity which, inter alia, tended to prevent investors from responding through export diversification to the secular decline in the commodity terms of trade; render impossible the realization of scale economies through specialization; and stifle the competitive forces which underlie the process of innovation. 76. The Liberalization Attempt of 1976-81. The economic policy authorities progressively dismantled the protective barriers between 1976 and 1981. However, switching development strategies has turned out to be precarious and beset with pitfalls. One lesson from the second half of the 1976-81 liberalization phase indicates that the exchange rate must remain competitive. Between 1979 and 1981, the attempt to eradicate inflation through preannounced exchange rate changes resulted in a 1002 real exchange rate appreciation. The resulting damage to industrial capacity--a 25 percent loss of value added which has not been recovered since--was blamed on trade liberalization as much as on the exchange rate policy, leading to a complete reversal of both. The Peso was massively devalued in 1981. The free trade phase came to an end with foreign exchange rationing in 1982. The democratically elected Government, in December 1983, replaced foreign exchange ratio with quantitative import restrictions (QRs) that came to cover more than 70 percent of domestic manufacturing production. A second lesson of the liberalization phase warns that reformers take heed of interactions between foreign trade policy and domestic industrial policy. When the average tariff rate was lowered from 98Z in 1976 to 22? in 1981, the largely oligopolistic producers of intermediate goods were successful in obtaining both investment incentives and special non-tariff import protection from the industrial promotion regime. Rather than adjusting their price strategies to import competition, they managed to reinforce their positions and extend market control vertically and horizontally. 77. A new initiative to integrate the industrial sector into the international division of labor began in 1987. The new program was flanked by a competitive real exchange rate, and it was graduated. In the first  - 24 - phase, which was supported through a Bank Trade Policy and Export Diversification Loan (TPL), the Government focussed on creating free trade status for Argentine exporters, but it also removed a substantial number of QRs. A thorough reform of the import regime was planned for the second phase, to be followed by the deregulation of domestic industrial policies. 78. The trade regime at the end of 1987 is shaped bys (i) the tariff reform of the 1976-81 period; (ii) the introduction of QRs in 1983; and (iii) the implementation of the TPL supported reforms in 1987. In the following description of the import regime and the export regime in 1987, the TPL supported changes are highlighted. The description, however, encompasses all components of trade policy so as to lay the ground for the analysis of the measures of the second phase of trade reform which would be supported through the proposed TPL II. For each component of trade policy, the sequence of actions through the first and second phase of reform is depicted in the Policy Reform Matrix (Annex IV). The Import Regime in 1987 79. Under national law, trade policy is one of the few areas of Argentine economic policy-making in which the executive branch has discretionary authority. The Government, therefore, tends to use trade policy instruments also for non-trade objectives. This is reflected in a structure of (i) base tariffs and quantitative import restrictions designed to serve trade policy objectives; and (ii) a variety of import surcharges and exemptions and of export taxes and export license requirements intended to guide investments, raise revenues and support price policies. Under international law, trade policy is bound by the country's status as a GATT member and by the signing of the Tokyo Round agreements on technical barriers to trade, customs valuation and import licensing procedures. Argentina did not enter into the agreements on government procurement, subsidies and countervailing duties, and on antidumping procedures. 80. Import Tariffs. The basic tariff structure without surcharges and exemptions is characterized by: (i) a 01-38Z tariff band for import positions that cover more than 951 of domestic production; (ii) average tariff rates of 221 (unweighted) and 28Z (production weighted); (iii) a structure of effective tariff protection that is skewed in favor of textiles and of basic intermediates (paper, iron and steel, non-ferrous metals, chemical substances); and (iv) a marked distinction between low tariffs on non-competing imports and high tariffs on imports that compete with domestic production. An across-the-board import surcharge of 15 percentage points was imposed under the Plan Austral and has resulted in a 15X-53Z tariff band for 95 of domestic production and a production weighted average tariff rate of 43S. Tariff rates of up to 1151 are applied to automobiles, motor vehicle bodies and tractors. In addition, temporary tariff surcharges as well as tariff exemptions are applied under the industrial promotion regime. The domestic producers of certain electronic goods, in addition to a basic tariff protection of 531, have since 1986 enjoyed a surcharge of 40 percentage points which is scheduled to be reduced to 30 percentage points in 1988, to 15 percentage points in 1989 and to zero in 1990. The import of capital goods that do not compete against domestically produced substitutes, on the other hand, is exempted from import duties in all cases in which the investment is benefitting from the industrial promotion regime (Decree 515).  - 25 - 81. Quantitative Import Restrictions. The Argentine import nomenclature NADI (Nomenclatura Aranceleria y Derechos de Importacion), recognizes 11,726 positions of which 11,219 describe industrial goods. QRs are generated 'trough lists of NADI positions that are subject tot (i) prohibitions for health and public safety reasons (covering mainly pharmaceuticals); (ii) the import control of the General Directorate of Military Industries (iron and steel); or (iii) a process of 'prior consultation' with domestic producer associations about the need for imports. In January 1987 the three lists among them protected 62.3Z of domestic manufacturing production. During 1987 the Government substantially reduced the production coverage of the prior consultation list as part of the reform program supported by TPL. Particularly important were the October 1987 removals of QRs on processed food, paper * and cardboards, and on synthetic fibers. By December 1987 the proportion of total production covered by the 5,021 NADI positions still on one of the QR lists had come down to 36.8?, although the TPL Loan Agreement had only requested a reduction to 52.3?. The Government abstained from imposing any temporary tariff surcharges to which it would have been entitled under the Loan Agreement. 82. Import Licensing. The removal of tariff positions from a QR list amounts to a full liberalization only when the importation of goods is subsequently automatic. In Argentina, a document called Sworn Declaration of the Need to Import (Declaracion Jurada de Necesidad de Importacion - DJNI) is required for all goods. By end-1987 the issuance of this license amounted to a mere formality for 85 percent of tariff positions which were not on a QR list. The commercial bank with whom an importer arranges the foreign exchange also issued without delay the DJNI and only afterwards informed the Secretariat of Industry and Foreign Trade (SICE) for statistical purposes--a process which can be considered to be fully automatic. For imports under the remaining 15 percent of tariff positions. however, the importer had to file an application directly with SICE. The Secretariat normally granted approval after about three working days, but could reject or postpone the application in cases in which it suspected foreign export subsidization or dumping or in cases of sudden import floods. In these cases, the removal from a QR list implied only that domestic producers' associations were no longer involved in the import authorization process. 83. Antidumping, Antisubsidy, and Safeguard Measures. The Argentine Customs Law ('Codigo Aduanero') recognizes the instruments of antidumping duties, antisubsidy (countervailing) duties and safeguard measures and describes procedures for dealing with applications by interested parties. The antidumping and antisubsidy procedures are not consistent with the respective Tokyo Round Agreements as they replace the investigation of injury to domestic producers with the provision that injury has to be assumed once the import price falls at least 15 percent below the average local supply price. However, the administrative machinery for handling applications for antidumping and countervailing duties as well as safeguard measures has not been developed in Argentina. Domestic producers of competing goods hardly missed the mechanism in times of a pervasive QR protection which they could influence through the 'prior consultation' process. Following the substantial reduction in the production coverage of QRs in 1987, the Government has used discretion in the approval of import  - 26 - licenses to deflect demands for an effective antidumping and antisubsidy mechanism. 84. Official Reference Prices and Specific Tariffs. Until end-1987, the customs valuation of all imports was based on the concept of a anormal user price*. For goods with a production coverage of nearly 62 the normal user price was established through an official price (precio oficial) which was fixed in US dollars. For all other goods the Customs Administration applied the complex valuation method of a so-called Customs Cooperation Council which in effect amounted to variable reference prices. The instrument of specific tariffs, though recognized in the Customs Law, was not applied as it had been made redundant by the Customs valuation practice. The Government signed the Customs Valuation Code of the Tokyo Round and the Argentine Congress passed a law to modify the Codigo Aduanero accordingly. Upon signing the Code, however, the Government explicitly reserved the right to use specific tariffs after introducing valuation according to the invoice, i.e. it held on to an equivalent protection instrument. By end-1987 the Customs Valuation Code was not yet applied. The EuPort Regime in 1987 85. Temporary Admission Regime (TAR). In early 1987 Argentina's regime of admitting duty-free imports for export produces was highly restrictive, excluding both capital goods and intermediates unless their domestic supply price exceeded 302 or more of the C.I.F. import price. Even for non-competing imports the system was not automatic but required a case-by-case review by SICE. The 1987 reforms under the TPL supported program established a comprehensive temporary admission regime with two administratively distinct components. The standard TAR applies to intermediates only, whereas the so-called ARGEX (Argentina Exports) allows for the duty-free import of capital goods on the basis of a multiannual export contract. Imports under the TAR are handled in the same way as other imports, except that they are exempt from duties. TAR imports are fully automatic only under NADI positions which have been taken off the QR lists and for which SICE's discretion over the issuance of the import licence has been removed. (See para. 47,. The additions to the standard TAR in the second half of 1987 covered the hard core of chemical, paper and textile intermediates, which had long been defended by local interest groups. The 1987 import figures already show a remarkable response: imports under the standard TAR have risen 1382 over 1986 (6.7? of imports in 1987 compared to 3.4? in 1986). The participation in the ARGEX has so far been minimal because the industrial promotion regime offers easier conditions for the duty-free import of capital goods. 86. Export Controls. The export of nearly all primary commodities, as well as of manufactured goods with a production coverage of 31?, requires the prior authorization from one of a number of public agencies. Under the program supported by TPL, the Government reduced the number of agencies involved from 30 to 7, and established a joint one-stop-window process in Buenos Aires for all agencies but the agency for grains. The process reduced the cost of obtaining an export license but could not remove the discouraging effect of a license requirement. Not all export controls, however, reflect an anti-export bias. Sanitary and quality controls, for example, support Argentina's continued access to export markets, while  - 27 - other controls are required by international agreements which, inter alia, impose voluntary export constraints. Argentine law, furthermore, restricts the exportation of a number of defense and environment-related goods. Most controls, though, establish an inefficient priority for domestic supplies over export supplies which prevents Argentine products from penetrating export markets. The controls serve, in effect, as complementary instruments for domestic price policies. 87. Export Taxes. The Argentine Government has traditionally depended heavily on revenues from export taxes on primary commodities. Under the program supported by the Agricultural Sector Loan, agricultural export tax rates have been limited to at most 702 of their Hay 1985 level resulting in an average maximum tax rate of about 121. The average realized export tax rate for primary commodities was 8.51 during the first eight months of 1987. For manufacturing exports the realized rate stood at 3.6Z during the same period. Export taxes were particularly high on products of leather, linen and cork as well as on cosmetics and chemical elements. During 1987 export taxes were removed for nearly 800 positions of the manufacturing part of the export nomenclature. Yet about 950 positions with a domestic production coverage of 152 remained subject to export taxation at the end of the year. 88. Indirect Tax Reimbursement and Subsidies for Exports. A general scheme for indirect tax reimbursement for non-traditional exports was introduced in 1987. The Bank supported the scheme under TPL, and the Government agreed to phase out the previous special export program (PEEX), under which firms could qualify for direct subsidies on incremental exports. The average realized rate of tax reimbursement (including direct subsidies) varied markedly between export goods. During the first eight months of 1987, the rate stood at .72 for primary products, .41 for processed food, 1.6? for leather goods and 10.4? for the rest of the manufacturing exports. Net of export taxes, the rate stood at -7.82 for primary products, -3.92 for processed food, -8.0? for leather goods and 8.8? for industrial (as distinct from agro-based) manufactures. 89. Export Financing. Commercial banks offer export credits at competitive rates (LIBOR plus a spread of about 21). The Central Bank maintains rediscount facilities for pre-shipment and for post-shipment export financing for a list of industrial goods that covers about 60? of domestic manufacturing production. The credits are denominated in Australes and indexed to the U.S. dollar. They were provided at subsidized annual interest rates of 12 and 4? for, respectively, pre-shipment and post-shipment before being raised to 4.5X and 6.5?, respectively, in June 1988 and equalized at 8? in August 1988. Since 1981 rediscount uses under these facilities have varied between 272 and 392 of industrial exports reflecting changes in monetary policy. Export Response to the TPL Supported Trade Reform 90. Argentine exporters have been, until recently, remarkably unresponsive to changes in the real exchange rate as well as to changes in production capacity, domestic demand, real wages and costs of imports. Since exporting requires a more than short-term commitment, domestic producers evidently chose not to react to changes in conditions which they  - 28 - perceived as temporary. However, the Government's continuous policy of maintaining a competitive exchange rate for trade transactions since 1985, and of introducing the free-trade status for exporters in 1987, is finally producing results. The early indicator of increased TAR imports is confirmed by recent quarterly figures of current dollar exports of industrial manufactures. In the last quarter of 1987 and the first two quarters of 1988 these exports surpassed those of the corresponding periods of the previous years by more than 50Z. The figures indicate that exporters are beginning to respond to the signals of the open trade regime. Domestic Industrial Incentives 91. Domestic industrial policy in Argentina is subject to fairly detailed legislation. The core of the incentive regime is formulated in the industrial promotion law 21.608, which codifies two sets of incentives, one related to imports (tariff exemptions for imported intermediates and capital goods and temporary tariff surcharges on competing imports), the other to fiscal incentives (exempzions or deferments of the valued added tas, the profits tax, the tax on net worth, and the stamp tax). The incentives are provided for selected projects and, once the investment phase has been completed, for between 10 and 15 years of production of the promoted plant. The core promotion law is supplemented by a set of laws and executive decrees which regulate the distribution of incentives across provinces and sectors. The Secretariat of Industry and Foreign Trade (SICE) applies the promotion schemes for the so-called special sectors and for 18 provinces. Four provinces and the Territory of Tierra del Fuego are subject to special industrial promotion laws which entitle the respective Provincial and Territorial Governments to grant exemptions from federal taxes and tariffs. 92. The industrial promotion regime is costly both in terms of fiscal revenues foregone and of economic distortions created. Not counting the tax evasion inspired by the regime, the fiscal cost can be estimated at 3.52 of GDP. The economic distortions are particularly evident in the massive relocation of plants between provinces in response to an excessive variation in the effective subsidy per unit of value added between 272 in the Province of Buenos Aires and 1002 in Tierra del Fuego, as well as in the spread of low value added, assembly-type operations in the provinces that are subject to special promotion laws which allow for value added tax exemptions for the suppliers of promoted firms. 93. The fiscal and the economic costs of the promotion regime tend to constrain trade reform actionss (i) The foregone revenues are a prominent source of the structural public sector deficit. The deficit, in turn, creates a constant pressure for trade taxation, while its inflationary impact invites expectations that the exchange rate might be used as a stabilization instrument, thereby causing insecurity with regard to the real exchange rate which tends to inhibit investments into export-orieited activities. (ii) The excessive variance of incentives between regions prompts firms to use their funds for defensive investments in the specially promoted provinces rather than for attempts to capture the opportunities created by the opening of the economy. (iii) The lack of transparency in the allocation of tax benefits and the insufficient administrative control over the compliance of promoted firms with their obligations invite strategic market behavior. Incumbent firms, instead of taking their lead  - 29 - from the relative price changes brought about by the trade reform, are tempted to rely on their preferred access to the authorities in charge of industrial promotion and to use the incentives to extend their control over the domestic market. 94. The Government has worked with the Argentine Congress on a new unified industrial promotion lav that would address the above issues for new project approvals. The acquired rights under the old regime, however, which can last up to 15 years, would not be affected. The Congress passed the new law on September 27, 1988. The Government expects the law to be promulgated through executive regulatory decrees in the second half of 1989. The existing promotion regime, however, can be tightened through a number of administrative beasures, and this would relax the constraints on trade reform policy. The Government is undertaking such measures, to be described shortly, as part of its trade reform program for 1988/89. PART III. THE TRADE REORK PROGRAM IN 1988189 A. Proaran Scope and Loan Obiectives 95. ScoPe. The proposed TPL II operation takes account of the lessons from previous liberalization attempts (see para. 42) by supporting a trade reform program thats (i) includes administrative measures to tighten the existing Industrial promotion regime; and (ii) is flanked by a program of fiscal and monetary policy measures which would remove the basis for expectations that, time after time, trade taxes would be used to compensate for shortfalls in fiscal revenues and the exchange rate would be used for the purpose of stabilization, thus randomly affecting the competitive edge of domestic producers. 96. Through the actions under the 1988/89 trade reform program, the Government currently is implementing the second phase of its plan to integrate the Argentine industrial sector into the international division of labor, which constitutes a core element of its medium-term strategy to start a self-sustained process of catching up with the proc-t*4iity level of countries with a comparable factor endowment. The TPL-supported actions during the first phase brought free-trade status for exporters, particularly through an effective TAR and a system of indirect tax reimbursements, and removed a substantial number of QRs. The program for the second phase, while completing the reform of the export regime and improving the control over domestic industrial activities, focuses on the exposure of Argentine industry to import competition. The detailed targets and measures of the program are described Jn the Government's Sector Policy Letter (Annex V) and are outlined and assessed in the following sections. In addition, they are depicted in the Policy Reform Matrix (Annex VI). 97. The Government's fiscal and monetary program as outlined in the Development Policy Letter (Annex IV) and evaluated in Part I of this Report would provide an acceptable framework for the proposed Second Trade Policy Loan and for the Banking Sector Loan. Progress in its implementation would be central to the Bank's evaluation of the macroeconomic policy stance upon which the effectiveness of the Banking Sector Loan as well as the second tranche release of TPL II, are predicated. For the tranche releases of TPL II, furthermore, the macroeconomic policy stance would have to be  - 30 - consistent with the targets of trade policy reform, which would include a competitive exchange rate for Argentine exporters. 98. Objectives. The proposed loan would support a set of sector- specific reforms to achieve the following objectives: (i) the removal of non-tariff barriers to imports; (ii) the reduction and rationalization of tariff protection; (iii) the limitation of safeguard measures and anti-dumping and anti- subsidy duties to the very short-term; (iv) the deregulation of industrial exports; and (v) the tightening of the existing industrial promotion regime. The indicators against which the achievement of these objectives is to be measured are described in the following paragraphs along with the detailed measures and their proposed timing. A summary in the form of a policy reform matrix is provided in Annex VI. The matrix allows for an overview of the sequence of measures for each of the objectives in both the TPL and the TPL II supported programs. B. The Action Proaram Removal of Non-tariff Imvort Barriers and their Substitutes 99. Quantitative Import Restrictions. During 1987 the Government reduced the production coverage of QRs from 62.31 to 36.86, which is about 15.5? percentage points lower than had been targeted under the first Trade Policy Loan. In the Development Policy Letter to TPL the Government had indicated that it would gradually reduce the production coverage of QRs to an end-target of 20? by 1990. Meanwhile, the Government has accelerated the QR removal program. In early 1988, the Government abolished the control of the General Directorate of Military Industries over iron and steel imports and it removed tractors and agricultural machinery from the list of prior consultation with domestic producer associations. The two measures reduced the production coverage of QRs to 30.2?. On September 21, 1988, the production coverage of QRs has been further reduced to 18.0?. Prior to second tranche release, which is expected for early 1989, the coverage would decline to 15.0Z. 100. Import Licensing. All imports under the about 11,000 NADI positions without QRs will be fully automatic by second tranche release. The import license will be issued without delay by the comercial banks which will only afterwards inform the Secretariat of Industry and Foreign Trade (SICE) for statistical purposes, i.e. SICE will no longer have discretion over imports. Prior to loan effectiveness, this process of fully automatic approval will be extended from currently 5,804 NADI positions to 7,800 positions.  - 31 - 101. Official Reference Prices and Specific Tariffs. Since January 1, 1988, the Argentine Customs Administration follows the Customs Valuation Code of the Tokyo Round, i.e. all ad valorem duties are calculated on the basis of the invoice. Upon signing the Code, Argentina reserved the right to apply specific tariffs (in US dollars), thereby holding on to an equivalent protection instrument. The true reform content of removing reference prices, therefore, can only be evaluated in combination with the incidence of specific tariffs. As part of the TPL I1 supported program, the Government has agreed to limit specific tariffs to NADI positions with a total production coverage not exceeding 7 percent. This compares to the previous situation in which all goods were either valued at fixed *official prices" or through a nontransparent procedure for determining 'normal user prices". Reduction and Rationalization of Tariff Protection 102. Tariff Level. The production weighted average of legal tariff rates currently stands at 432. The Government will reduce this average to 302 prior to loan effectiveness. 103. Rationalization. Once non-tariff barriers are dismantled, differences in the tariff levels become important sources of allocative distortions. The Government, therefore, will rationalize the tariff system simultaneously with the removal of non-tariff barriers. The rationalization program has the following components: (i) Tariff land. The tariff rates for NADI positions with a total production coverage of 951 are currently situated in a 0-53Z band. Prior to effectiveness, the Government will narrow the tariff band to 0-402 and apply it to NADI positions with a total production coverage of at least 97Z. (ii) Maxi=um Tariff late. Prior to loan effectiveness the Government will reduce the maximum tariff rate from 1151 to 50. (iii) Temporary Tariff SurcharEes. The Government will not apply specific temporary tariff surcharges other than those existing for computer equipment, which will be phased out according to a schedule which ends in September 1990. Limitation of Safetuards. ntidumPing and Antisubsidy to the Short-Term 104. The demand of domestic producers for protection against sudden import floods, as well as against alleged dumping and foreign subsidization of exports to Argentina, can be expected to increase sharply following the removal of both QRs and SICE's discretion over the issuance of import licenses. The welfare argument in favor of such measures rests on the temporary nature of the external disturbance--the producer costs of coping with the disruption may swamp the consumer benefits that arise from temporarily lower prices. The experience with safeguard, antidumping and antisubsidy measures, however, shows that they tend to be perpetuated, thus preventing the effi-ient adjustment of domestic producers to what has  - 32 - turned out to be a shift in world market conditions. The Government, therefore, has agreed to a time limit. After lasting for an accumulated six months within a period of two years, any safeguard, antidumping or antisubsidy measure is no longer considered temporary. Any such measure would then either be discontinued or accomodated within the 152 ;.:oduction coverage limit for QRs and the 302 limit on the production weighted average tariff rate, i.e. it would replace the protection of other goods. Deregulation of Extorts 105. Temporary Adm.1.9sion Regime. The two TARs for, respectively, interme-diate and capital goods will be affected by both the trade reform and the macroeconomic programs (i) The removal of QRs and of SICE's discretion over the issuance of import licenses also brings full automaticity for the TAR imports of all goods that are not covered by the NADI positions on the remaining QR lists. (ii) The removal of tariff exemptions for capital goods imports under a special decree within the industrial promotion regime encourages the use of the TAR for capital goods. (iii) The Government's decision to move all imports (including TAR imports) to the free market exchange rate and industrial exports to either the official rate (agro-based manufactures) or to the average of the free market and the official rate (industrial manufactures) has temporarily weakened the free-trade status of Argentine exporters. The macroeconomic program stated in the Letter of Development Policy, however, is expected to create the conditions under which the Government can accelerate the transfer of all exports to the free market exchange rate which it has announced for 1989. In addition, the Government has recently introduced the Domestic Letter of Credit and has extended the TAR for intermediate goods to indirect exporters. 106. Export Controls. Prior to second tranche release, the Government will remove all industrial export controls that establish a priority for domestic supplies over export supplies. The remaining export license requirements or prohibitions will be those that are either explicitly required by a law of the Argentine Congress or by an international agreement or that serve to maintain sanitary and quality standards of Argentine exports or to protect endangered species of the Argentine natural habitat. These controls are acceptable as: (i) Argentine law refers to defense related goods only, the flow of which is restricted on non-economic grounds; (ii) the international agreements relate to voluntary export constraints and to the multilateral fiber agreement, the adherence to which constitutes the best course of action for the exporting country once the agreement has been imposed; and (iii) the maintenance of sanitary and quality standards tends to improve the access to export markets over the medium term. 107. Export Taxation. In August 1988 the Government removed the export taxes for 360 positions of ths export nomenclature (NADE). The production coverage of taxes on industrial exports thereby came down from 15.1? to 12.2?. Prior to second tranche release, the Government will reduce the production coverage further to 7.5Z.  - 33 - Tlptentng of the Industrial Promotion Regime 108. During 1987 and 1988, the Government took steps to tighten the application of the general industrial promotion law 21.608 which includes the special sector schemes as well as the industrial promotion schemes for 18 provinces (excluding Tierra del Fuego and four provinces with a special legal status). Through SICE as the authority of application, the Government: (i) reduced by half the tax incentives for the production phase of promoted projects by lowering the rate of tax exemption and the promotion period; and (ii) increased the transparency of project selection by making a new set of criteria public. To counter the anti-export bias, which results from the tendency to defensive investments in highly promoted provinces, SICE explicitly included the export potential of a project in the list of selection criteria. In August 1988, furthermore, the Government abolished Decree 515 under which SICE had liberally extended import tariff exemptions for capital goods to promoted firms. The removal of Decree 515 has not only a beneficial revenue effect, but it also reduces economic distortions by ending the discretionary power of SICE over this instrument and by reducing the dispersion of effective protection. Due to the above measures, which are supported through the proposed loan, the fiscal costs of the SICE controlled part of the industrial promotion regime are substantially reduced. Since, furthermore, indexed tax liabilities are coming due for payment, revenues foregone in the SICE controlled part of the industrial promotion regime are estimated to fall from about .82 of GDP in 1987 to .3S in 1988 and to zero in 1989-93. 109. With regard to the special provincial schemes, the Government has removed benefits that were not explicitly required by the law, namely: (i) the value added tax exemption for inputs purchased by the suppliers of promoted firms; (ii) the indirect tax reimbursement for 'exports from the Argentine mainland to the island of Tierra del Fuego; and (iii) t'Le special reimbursements of up to 40? of the production value for deliveries of promoted firms in the southern provinces (Patagonia) to Tierra del Fuego. The fiscal savings are estimated at .3 percent of GDP. However, new project approvals under the special provincial regimes as well as the lagged revenue effect of previous approvals are estimated to over- compensate these savings leading to a .2t of GDP increase in the fiscal cost of the special provincial promotion regimes in 1988. The Government can bring about a lasting decline in the aggregate costs of the industrial promotion regime only on the basis of the unified industrial promotion law which was passed by the Argentine Congress on September 27, 1988. Once this law ha -en promulgated through executive regulatory decrees, the right of Provincial Governments to grant exemptions from federal or coparticipated taxes will be eliminated. The fiscal savings, however, will only materialize over the medium-term as the law will not curb the rights which firms acquired under the old regime. In 1989-90, the law can only prevent further cost increases. 110. As part of the TPL IZ supported program, the Government will implement a plan of action that serves the dual purpose of: (i) further containing the development of costs under the existing promotion regime by reducing the reputed massive tax evasion; and (ii) building the institutional apparatus for an efficient application of a unified industrial promotion regime as soon as the new law Is promulgated. Within the program the Government will, prior to second tranche release:  - 34 - ti) conduct, through the Tax Revenue Service (DOI), an audit of 400 firms that claim tax benefits under the industrial promotion regime, to check the compliance of these firms with the obligations (regarding fixed capital investment, output and employment) they entered when accepting the benefits; (ii) establish a joint information system for SICE, DGI and the Secretariat of Finance on all promoted projects and on the promoted as well as unpromoted activities of all firms claiming benefits under the industrial promotion regime; (iii) build, within SICE, the institutional capacity for effectively fulfilling the audit functions ascribed to it both by the existing promotion law and, extended to all provinces, by the new unified law as currently before Congress; (iv) make public, through a decree or resolution, the criteria for the audit of promoted firms and for decision making on the cancellation of benefits resulting from such audits; and (v) prepare a plan of action, satisfactory to the Bank, for the cancellation of benefits to firms that have been found in violation of their commitments. These actions are expected to reduce the fiscal costs of the promotion regimes further by about .2Z and .42 of GDP in 1989 and 1990, respectively. 111. Technical Assistance. A Technical Assistance Component (TAC) has been designed to strengthen the Government's control of the industrial promotion regime. Tne Government would: (i) hire external auditors which would support the tax inspectors of DGI in the task of auditing 400 firms; (ii) employ consultants for the design and implementation of a joint information system on all promoted projects and firms, including the design of an adequate computer configuration; (iii) employ consultants for the training of the additional staff of SICE's supervision unit; and (iv) purchase computing equipment for the joint information system and for SICE's supervision unit. Details of the TAC are provided in Annex VII. C. Related PolicZ Reforms 112. Price Policy. Periods of sLrong and weak controls of wages and prices have alternated in Argentina since 1955, reflecting efforts to both contain inflation and maintain the real income of organized labor and special interest groups. Price and wage controls are linked to trade policies. Import protection allows domestic producers to acquire some degree of monopoly power which facilitates mark-up pricing. The domestic producer has few incentives to resist wage demands, or to respond with productivity enhancing adjustments, when protection allows him to pass cost increases on to consumers. The Government is then tempted to control both prices and wages. Having in effect assumed responsibility for income distribution, it becomes exposed to the pressures from organized labor and specific interest groups, and may try to pass the burden to unprotected groups through a combination of price and export controls. With the removal of quantitative restrictions on imports and exports, therefore, the Government dismantles one important barrier to entry that sustains mark-up pricing, and it obviates the rationale for price and wage controls in the sectors that are opened to trade. 113. Under the Plan Austral, the Government used temporary price controls as a heterodox stabilization instrument, intended to break inflationary expectations while orthodox monetary and fiscal policies were to sustain stability. The controls have been unsuccessful as witnessed by  - 35 - intermittent periods of price freezing and defreezing. Since the price freeze of October 1987 deregulation has been progressing quickly. By May 1988, price controls were applied to goods that accounted for only 12.5t of the consumer price index. The Government announced at that time that all controls, except for pharmaceuticals, would be eliminated within the year 1988. In addition, following the enactment of a new labor law in January 1988, the Government moved out of wage negotiations in the private sector. Under the Plan Primavera, the Government has abstained from reinstating price and wage controls, but haa relied on voluntary agreements with the Union Industrial and the Camara de Comercio that their members would neither increase listed prices nor accede to wage demands that are inconsistent with inflation targets. The Government has not strictly ruled out the possibility of price controls should the voluntary agreements fail. However, the Government has backed up its inflation policy by accelerating the removal of QRs and the reduction of tariffs. Since September 21, 1988, only 18? of domestic manufacturing production are protccted through QRs. The tariff reform has been announced for October 21, 1988. Following previous experiences with the practice of price controls, the authorities can be expected to abstain from setting prices which would inhibit imports. 114. Public Procurement. The implementation in practice of the Compre Argentina' law has come to restrict both import competition and domestic competition. The provision obliging the public sector to 'buy national' at 'reasonable prices' is in practice used to keep out competing imports through prior consultation with producer associations. Moreover, the bidding and evaluation procedures are not sufficiently transparent to ensure that the most competitive domestic bidder will be awarded the contract. The system stimulates market sharing agreements and price rigging, and it has deteriorated into another source of the public sector's fiscal problem. In July 1988, the Government changed the regulations of the *Compre Argentina' law with the result of increasing the competition for incumbent domestic suppliers to the public sector by stiffening conditions under which local suppliers can object to public sector imports, and by providing better access for new domestic spppliers through a transparent bidding process. The measure is partk of the comprehensive public enterprise reform undertaken by the Government. A Bank Public Enterprise Reform Loan is in preparation that would support policy changes which would further enhance both import competition and domestic competition for public purchases. D. Macroeconomic and Social ImPact Exchante Rate and Balance of Paiments 115. Import protection creates an overvaluation of the long-term real exchange rate and, through this mechanism, an anti-export bias. Other taings being equal, it can be estimated that the lowering of import protection brought about by the 1988189 trade reform program depreciates the long-term real exchange rate by 4Z. Since the export supply response lags behind the increase of import demattd, however, this depreciation would not forestall a transitory deterioration of the trade balance which can be estimated at US$300-350 million. The relative modest estimate of the trade balance effect reflects the fact that the exchange rate adjustments since 1985 have already eroded the significance of QRs as a protective device.  - 36 - The transitory trade balance effect would have to be met bys (i) a cut in domestic absorption; (ii) external financing; (iii) reserve financing; (iv) an additional exchange rate depreciation; or (v) a combination of these measures. 116. In the context of the Plan Primavera, imports were moved from the official to the free market exchange rate resulting in a strong initial depreciation of the real effective exchange rate for imports that overcompensated for the appreciation in July which was due to the accelerated inflation. It is expected that this depreciation will not be fully eroded by domestic inflation oaer the coming months. (See Table 2 of Annex VIII.) The Plan Primavera insofar appears to be consistent with the trade reform program. By continuing to transact exports at the official rate (except for 50? of the receipts from industrial manufactures exports that can be exchanged at the free market rate), however, the Government has imposed an implicit export tax. If permanent, such an export tax would tend either to deteriorate the trade balance or lead to a further depreciation of the real exchange rate. However, the Government has committed itself publicly to transfer all export transactions to the free market rate before the end of 1989, and to start the process in April 1989. The gradual unification of exchange rates for trade transactions is reflected in the fiscal program for 1989. Fiscal Implications 117. The fiscal savings generated by the tightening of the industrial promotion regime have been estimated at .8S and 1.02 of GDP in 1989 and 1990 respectively. The increasing import volume due to the trade reform program can be estimated to yield additional tariff revenues of about .15Z of GDP in 1989. In the following years, a industrial exports respond to the reduced anti-export bias of the trade regime, the import volume can be expected to grow more vigorously allowing for additional tariff revenues of more than .5Z of GDP. Despite the reduction of the production weighted average tariff rate by 13 percentage points, the realized tariff rate is expected to fall by only 3 percentage points as tariff exemptions are removed and the import weighted is reduced less than the production weighted average tariff rate. This would reduce tariff revenues by about .25? of GDP. The whole program, including the tightening of the promotion regime, would then yield additional revenues reaching 1.252 of GDP in 1990. Social Impact 118. The Government's program for trade reform is reversing the traditional policy of insulating the industrial sector from the world market, and it initiates a move out of the pervasive regime of state-led investment. Protracted reliance on these policies has caused Argentina's real per capita income to decline relative to all but a few countries in the world and, over the last decade, also in absolute terms. The decline has fallen disproportionately on families that rely on labor income, social security transfers and the availability and quality of public services. Trade protection has come to favor capital-intensive industries over labor- and skill-intensive industries, thus reducing labor demand. The regimes for industrial promotion have greatly strengthened the capital-intensity bias and have, in addition, induced a process of disintegration through  - 37 - which the share of both labor and capital in the value of production declined. The policy of industrial promotion, in particular, has contributed to a crisis of public finance which, in turn, has caused an erosion of real social security transfers and a deterioration in the public provision of social services such as health and education. The determined execution of the proposed reform program will be the most important contribution the Government can make to improve the well-being of the working poor, the pensioners and those that depend on the public provision of social services. 119. Real costs of adjustment, however, are unavoidable for the workers of those firms that will prove unable to survive in an environment of increased competition and reduced government support. Their smooth transfer to expanding firms or new firms cannot be assured as displaced workers will have to compete on the labor market with the unemployed and the underemployed. Aggregate labor demand can only be expected to rise after the structural reforms have succeeded to lead the economy to a higher growth path. 120. The democratically elected Government introduced, as one of its first measures, a food supplement program and a drug assistance fund for the benefit of about 1.4 million needy families. Both have turned out to be low-cost and efficient anti-poverty instruments which may also be used to support the families of displaced workers. In addition, the efficiency of the public supply of health, housing and education services could be improved. A recent Bank Country Study ('Argentinas Social Sectors in Crisis", June 1988) found that better targeting as well as cost recovery from those who can afford to pay would go a long way in expanding the provision of these services to those in need. The Bank is assisting the Government to address the issues through the Technical Assistance Loan for Social Sectors Management. PART rv. FEATURES OF THE PROPOSED LOAN A. Loan History 121. The proposed loan builds on the Trade Policy and Export Diversification Loan (TPL) which was approved in May 1987. TPL supported the first phase of the Government's trade policy reform program with a strong focus on improving export competitiveness. The second phase initially was envisaged to consist of a gradual elimination of non-tariff barriers over a three-year period. The momentum created by the successful implementation of the first phase, however, encouraged the Government to accelerate the reform program. The Government and the Bank entered into an intensive dialog on the reform of the industrial policy framework that covered the regulatory framework and the incentive regimes for both foreign trade and domestic industrial activity. This is reflected in the structure of the Second Trade Policy Loan which focuses on import liberalization but has, in addition, strong components for the support of a further deregulation of the export regime and for the tightening of the industrial promotion regime. The TPL was appraised in April/May 1988. Negotiations were held in Buenos Aires in August 1988. The Argentine delegation was led by Mr. Ramon da Bouza, General Director, Ministry of Economy. Supplementary loan data are provided in Annex III.  - 38 - B. Loan Amount, Borrower and Implementing Agency 122. A loan of US$300 million is proposed in support of the significant advance the Government has been making in the reform of the trade regime. The loan would be quick disbursing except for the technical assistance component of US$2.35 million. The borrower would be the Republic of Argentina; the implementing agency would be the Ministry of Economy. C. Letter of Development Policy and Letter of Sector Policy 123. The basis for the loan is provided by a Letter of Development Policy (Annex IV) and by a Letter of Sector Policy (Annex V) in which the Government declares its commitment to adopt and implement the reforms described above. The Letter of Development Policy states the Government's macroeconomic and medium-term adjustment program, whereas the Letter of Sector Policy details the objectives and measures in the area of trade and industrial promotion. D. Tranche Release, Disbursement. Procurement and Audit 124. The quick-disbursing component of the proposed loan would essentially be disbursed in two tranches. The first tranche of US$150 million would be available upon loan effectiveness. The conditions of effectiveness call for, inter alia, a consistent macroeconomic policy framework; the reduction of the production coverage of QRs from 36.8Z to 18.0?; and the reduction of the production weighted average tariff rate from 43? to 302. (See Annex III.) 125. The release of the second tranche is projected to take place about early 1989 after loan effectiveness following an exchange of views with the Government. The release would be contingent upon, inter alia, a consistent macroeconomic policy framework and progress in the macroeconomic program stated in the Letter of Development Policy, satisfactory to the Bank; the reduction of the production coverage of QRs to 15.0X; the reduction of the production coverage of export taxes to 7.5?; the removal of most industrial export licenses; the audit of about 400 firms benefitting from the industrial promotion regime; and an action plan, satisfactory to the Bank, for dealing with firms that are found to be in violation with their commitments under the industrial promotion regime. (See Annex III.) 126. The loan (excluding the technical assistance component) would be applied to 100? of the c.i.f. costs of eligible imports. Eligible imports would be all goods except those normally excluded under Bank policy-based lending, such as alcohol, tobacco, and armaments, goods financed by other Bank loans or from other official multilateral and bilateral sources. Retroactive financing up to 20? of the loan amount from July 1, 1988, would be permitted. The remainder of the loan (US$2.35 million) would be disbursed against expenditures under the technical assistance component for consultants' services and the purchase of equipment. (See Annex VII.) Disbursement of this latter part of the loan would be independent of tranche releases but would be completed before June 30, 1989. 127. Both private and public sector imports would be eligible for financing. Contracts estimated to cost US$5 million or more each, will be  - 39 - procured through international competitive bidding. Contracts under US$5 million each would be awarded on the basis of the normal procurement practices of the purchaser. Goods in the context of the Technical Assistance component which are estimated to cost US$250,000 or more each will be procured through international competitive bidding, whereas goods costing less than the equivalent of US$250,000 may be procured on the basis of local competitive bidding in accordance with procedures satisfactory to the Bank. Prior review would be carried out by the Bank in all cases of international competitive bidding as well as in the first case of local competitive bidding in the context of the Technical Assistance component. Consultants to be financed with the proceeds of the loan will be employed in accordance with the principles and procedures set forth in the 'Guidelines for the Use of Consultants by World Bank Borrowers and by the World Bank as Executing Agency" published by the Bank in August 1981. All disbursements would be made against a statement of expenditures to be submitted by the Central Bank (IBCRA). Also, BCRA is expected to undertake the screening process to ascertain that the above conditions have been met and to request disbursement of the loan on the basis of documented import payments from the coamercial banks. 128. BCRA will be responsible for maintaining separate accounts to record and monitor loan disbursements and repayments. All records and accounts related to expenditures financed under the proposed loan, including those for statement of expenditures, would be audited each year in accordance with sound auditing principles by independent auditors acceptable to the Bank. Bank staff would periodically review the accounts. S. Monitoring and Reporting 129. The proposed loan would require monitoring of both the macroeconomic program described in the Letter of Development Policy and the implementation of the specific trade reform actions described in part III of this report. The Bank will monitor the macroeconomic program and the trade reform program through regular supervision and exchange of views with the Government. Since supervision of the macroeconomic program would also be required for the Banking Sector Loan, the Bank would coordinate the monitoring activity for the two loans. Prior to second tranche release of TPL II, which is expected for March 1989, the Government will prepare a detailed report covering all specific actions under the trade reform program. This report will provide input for a mid-term review which, jointly with an update of the January 1989 review of the macroeconomic program, would form the basis for the release of the second tranche of the loan. The Government and the Bank have agreed on the production weights for tariff positions which are required for calculating the production coverages and the production weighted tariff average. F. Benefits and Risks 130. Benefits. Opening the economy, modernizing the state and deregulating markets are the interdependent elements of the Government's strategy. Though success is not assured, it can be said safely that there is no alternative strategy that could achieve both economic stability and sustained growth, thus ending the pattern of wild fluctuations around a declining trend of relative income. The trade reform program, which would  - 40 - be supported by the proposed loan, is central to the strategy as it unshackles the industrial sector from internal and external constraints and from distorting incentives to allow it to compete efficiently in the world market. The program would generate further benefits: (i) industrial export supply is expected to respond strongly to the further reduction of the anti-export bias of the trade regime and the industrial promotion regime, and this would reduce the economy's dependence on highly volatile world commodity markets; (iii) industrial labor demand can be expected to grow over the medium-term as the strong capital intensity bias of import substitution is redressed and as export activities increasingly reflect the comparative advantages of the country in more labor- and skill-intensive operations; (iii) the productivity of investment will increase as the industrial sector responds to foreign competition and as technology- intensive imports become freely available. 131. Risks. The success of the reform program hinges upon the Government's perceived credibility to sustain the policy changes. Should the private sector conclude that the reforms will be short-lived, speculative imports, a faltering export supply response and intensified efforts at tax evasion through provincial regimes might force the Government to abandon the program. Private sector confidence could be jeopardized by (i) an appreciating real exchange rate for trade transactions; (ii) an unsustainable macroeconomic policy situation, particularly with regard to the public sector deficit; (iii) a perceived inability to mobilize external financing; (iv) political risks in the context of upcoming elections as the Government might be tempted, when dislocations in import competing sectors become more severe, to yield to the pressure of management and labor in affected industries to reverse the import liberalization or use industrial promotion for rescue operations; and (v) adverse external developments. There are, however, significant elements in the Government's program and the design of Bank assistance which reduce these risks. 132. The Government's most important asset is that it has been able to build credibility in the area of trade policy. Since 1985, the Government has maintained a competitive exchange rate for trade transactions. The Government has, furthermore, implemented the 1987 program ahead of schedule, and it has, in the case of the steel industry, visibly demonstrated its skill in dealing with powerful special interests. The Government's credibility would, furthermore, be greatly enhanced through the proposed TPL II and the Banking Sector Loan as well as the fiscal reform program that is complementary to the two loans, and would be strengthened by a Technical Assistance Loan for Tax Reform that is currently under preparation. These loans would demonstrate to the private sector that the Government has a sound program of policy reforms which address the core issues of Argentina's structural problem. 133. The domestic risks, furthermore, are reduced by: (i) the Government's commitment to move all exports to the free market exchange rate, starting the process in April 1989 and completing it before the end of 1989; (ii) the Government's increasing determination and demonstrated actions to reduce the combined public sector deficit; and (iii) the general acceptance, by all political parties, that the strategy of import substitution has run its course.  - 41 - 134. The external risk would consist of a new downturn of commodity prices, an international interest rate hike and increased protectionism in industrial export markets. Current expectations, however, are for strong grains and soybean prices and, at a later stage, beef prices because of the ser'ous drought in the USA. These increases are projected to compensate two thirds of the increase of US$1.1 billion in interest payments expected for 1989 that is due mainly to increased interest rates on foreign debt. The risk of protectionist measures against increasing industrial exports from Argentina is real. Argentina's GATT membership, the application of the customs valuation code aadd the replacement of export subsidies under PEEX by a GATT consistent indirect tax reimbursement scheme, however, have enhanced the Government's position for addressing possible protectionist moves. PART V - BRNK GROUP OPERATIONS 135. To date, the Bank has made 38 loans to Argentina, totaling US$4,030.2 million (net of cancellations), $1,427.8 million of which is undisbursed. The volume and composition of Bank lending have gone through wide swings due to periodic macroeconomic and sectoral difficulties. Bank lending since 1985 has amounted to an aggregate of $2,344.0 million and has focused upon the development of the hydrocarbon and power sectors; support of structural and sectoral reforms in trade, banking and agriculture; assistance in improving public sector and social sector management; support of port development and municipal development; and the provision of lines of credit for agriculture and small-scale industry. The implementation of Bank-assisted projects has suffered from cumbersome bureaucratic procedures, curbs on public investment stemming from fiscal austerity, and the private sector's reluctance to invest in an uncertain economic environment. In response to these constraints, the Government upgraded its surveillance of implementing agencies and restructured several projects to improve their execution. The Bank has also instituted procedures for monitoring monthly disbursements and for periodic project implementation reviews with the Government. As a result, disbursements under Bank loans trinled in FY87 as compared to FY86, when they stood at $150.9 million, and increased to $874.9 million in FY88, i.e. by 73 percent as compared to FY87. 136. IFC has made investments in 22 companies in Argentina, totaling USS 582.9 million, of which US$ 133.6 million is undisbursed. Promotional efforts are geared to export or import substitution-oriented projects, with emphasis on oil, petrochemicals a-id related sectors, and agroindustry. IFC will also continue to seek investments in projects in which its presence would facilitate the formation of joint ventures with foreign participation and act as a catalyst to attract higher levels of commercial financing. 137. Over the past two years, the Government and the Bank have been working together very closely on a broad range of economic and sectoral issues. In March 1987, the Government and the Bank agreed on a "Business Plan0 which outlined the objectives and strategies of sectoral reforms combined with an action program, and identified possibilities for a companion program of Bank assistance. This set the agenda for sectoral reform, which has been adhered to by the Government, has continued to guide  - 42 - the Government's reform activities, and has led to several Bank supported sectoral reforms. The Letter of Development Policy circulated by the Government on September 22. 1988 confirms and reinforces this agenda of structural reforms. Significant progress has already been achieved in rationalizing the export regime, which the Bank has supported through the Agricultural Sector loan and the first Trade Policy loan, as well as the Second Agricultural Credit loan. In parallel, the Government has initiated a reform of the banking sector, which is a pre-requisite for the success of Government efforts to modernize the real sectors of the economy,and which has also been supported by a Bank loan. An important complementary step to the reform of the trade regime in rationalizing industrial regulation has been taken with the congressional approval last month of the industrial promotion law. Reform of the public sector is an essential element in modernizing the economy. This has begun with the analytical and institution-building work undertaken under the Technical Assistance loan for Public Sector Management (TAPSM). The recently approved Technical Assistance loan for Social Sectors Management will help to prepare and initiate the carrying out of reforms in the social sectors. Rationalizing the finances of provincial and municipal governments is also an important objective, which has been supported by the recently approved Municipal Development loan. It will help to strengthen the financial management of provinces and municipalLties, and focuses on the municipalities' capacity to plan, finance, and fxecute cost-effective investment programs and to recover their costs. she Bank conducted economic missions to discuss the adjustment policy fraitework and environment in March and August 1988. The objective was to provide analysis for the Government to take into account in preparing its 1988-89 macroeconomic program. These missions also provided the basis for the Bank's view of the macroeconomy. While the Government-Bank policy dialogue is intense, reform takes time, and the Bank will continue to work with the Government in implementing these adjustments. 1S8. The Bank's assistance strategy for Argentina aims at supporting the country's key macroeconomic and sectoral reform programs, including fiscal reform. It includes both economic and sector work and lending operations in support of Argentina's development objectives and of its medium-term economic recovery and structural reform program. The Bank is planning to continue lending to Argentina at about the $1 billion per year level, predicated upon the continued implementation of the structural reform program outlined in Part I above. To this end, the Bank is programming economic and sector work with a strong operational orientation. Sector work will concentrate on financial, agricultural, industrial, regional decentralization, provincial finances, and environmental issues. In support of our work program, the Bank will continue to promote the use of UNDP funds, and will continue to seek cofinancing opportunities, and further cooperation with the IDB as well as with Japan, Italy, and Spain, in particular, is expected. 139. The Bank's lending efforts would be directed at addressing the key reform programs in Argentina. (a) Trade Liberalization and Export Diversification: The proposed Second Trade Policy loan would build on the substantial achievements of the first, and should enable the Government to establish a competitive framework for the industrial sector. (b) Financial System Reform: Implementation of the Banking Sector loan, for which an amendment is proposed to the Board, will help to continue the efforts  _ 43 - already undertaken by the Government in this area, and should be followed by further banking sector loans aimed at helping to restructure some of the major public banking institutions. In addition, the Bank will study specific financial problems of the provinces, in the expectation that this would lead to a loan in support of provincial structural changes and investments. (c) Public Sector Rationalization: The Bank is supporting Government plans to rationalize the public sector through support for policy changes, restructuring of certain public enterprises and the provision of technical assistance, which should lead in the near future to a Public Enterprise Restructuring loan, to a social sector investment project, as well as to sector loans in health and education. The proposed Housing Sector loan is directed at rationalizing the Government's role in housing construction, better targeting subsidies to the needy, and reducing inefficiencies in construction operations, and further municipal development loans are expected. Finally, the Bank will assist the Government in a major effort to improve the efficiency, yield and equity of the nation's tax system through a technical assistance loan which is expected to be presented for Board consideration in FY89. (d) Industrial Development: Industrial modernization and restructuring projects are in preparation, which should enable Argentina's industry to take a competitive position in world markets. (e) Energy Development: Work on a new generation of sector loans in power and hydrocarbons has begun, with the proposed Electric Power Sector loan, which should be followed by further energy sector loans. The program also envisages support for infrastructure development through investments in areas such as transport and water supply. PART VI. COLLABORATION VITH THE DMF 140. The Bank will continue the collaboration that it has followed with the IMF in the previous stages of this project. There have been detailed discussions with Fund staff on Argentina's trade policy performance in the context of the TPL and on the proposed loan. The Bank will also pay special attention to the findings and position of the IMF when reviewing macroeconomic performance for loan effectiveness and second tranche release. PART VIr. RECOMMENDATION 141. I am satisfied that the proposed loan wruld comply with the Articles of Agreement of the Bank and recommend that the Executive Directors approve the proposed loan. Attachments October 3, 1988 Barber Conable Washington, D.C. President  - 44 - neou Table 1: AMOETiD - KEY eCOIC ICDICATOrs Papuletion: S196l9 iON (MP Poe CP ito 268t Actuet Projected 1965. 19 1967 1908 199 1990 1991 1902 199S trowth ibteo (percent). GOP -4.4 5 4 1.6 1.S 3.2 3.7 3.7 3.6 S.t Otf -4.8 8.1 2.3 1.6 2.9 3 8 4.0 3.9 4.1 @f per cepIts -4.7 7.0 0.4 -0.3 1.1 2.9 2.1 2.1 2.2 Private C _n tinh per ep7te -8.S 7.1 1.6 -2.5 -1.0 1.5 0.8 1.2 1.3 bt0t Indimctor. a/ ifS OLT (M illion WA5t) 46019 52866 s207e 57206 57622 59555 61s6 62911 636 IW Credit Outatenol;na (Milliion USI) 2180 27i0 3946 4201 4459 4459 4459 4459 4459 Total OW 1t. incl. tlF (M llion US1) 50199 s55e0 S6022 61407 62261 64014 46111 61370 S6JS2 OII lLT/Emporte as (1) 468.8 606.? 621.3 520.2 459.7 466.4 437.9 410.0 362.0 Om0 LT/Current MP (1) 74.3 79.7 78.7 79.2 74.5 71.2 6t8.3 64.7 61.0 Debt ervice (Hi II ton US.) 9444 5397 5926 66m0 6157 6429 7SO 7875 9210 Debt see-.co/Curront CDP (O) I,.6 6.1 8.6 9.2 7.9 7.7 6.3 6.1 68 Dbt servico/E ports 05 (t) 92.2 61.9 70.7 60.7 46.9 80.3 53.8 51.3 55I1 tntero,t tfLt (HilIion USt) b/ 480t 3862 4148 4742 5450 5214 5680 6114 6498 t nterst oIST/Espoete as (t) b/ 46.9 42.6 48.2 41.9 42.4 39.9 39.2 36,9 36.6 tt.rtet HLY/Current (VP (U) b/ 7.4 s.e 6.0 6.6 7.0 6.2 6.3 6.3 6.2 National Account fit of Constant CDP: Investment 10.5 11.8 13 1 12.5 14.4 14.9 16.0 16.6 17 6 iastic Savings 17 14.6 13.6 16.3 16.9 16.9 20.3 23.4 22 4 Ntionel Sevings @1 9.2 9.0 8.3 10.7 12.7 13.3 14.7 15.7 16.6 Public Investent 5.2 4.9 4.6 4.8 4 S 4.5 5.3 S.5 5.5 Pubic National Savings d/ 2.1 0.7 -2.2 -1.1 0.4 2.0 2.4 2.6 3.0 Private Investment s.3 6.9 6.3 7.7 9.9 10.4 10.7 11.3 12 1 Private Natonal Sa.lnga 7.0 8.3 10.S I1.8 12.3 1t.3 12.3 13.1 13.8 Puble)lPrl.oto lnvneteent 0.96 0.71 0.6S 0.62 0.45 0.40, 0.49 0.49 0.45 Exteroal trde Indicatetr (percent): Grain osporte rest growth rnte 19.4 -30.3 -31.1 25.0 7.7 2.5 2.5 2.S 2.5 iEprt ONFS reel growth roote 12.5 -10.0 -13.3 14.4 7.3 6.0 5.9 4.9 4 9 berte of OS/Cur,ent CDP 15.6 13.1 12.2 15.2 16.2 15.3 15.6 15.8 I6.0 lepOrt 0F reel growth th ret. -14.4 21.1 4.5 -9.0 5.7 6.1 7.0 6.6 6.7 Importe of 095/Curront UOP 9.1 10.8 U.9 t1.3 11.6 11.3 11 4 It.4 1t.4 Current Account (NI II Ion UN5t) -953 -2656 -4266 -2284 -2561 -2394 -2224 -2116 -1864 Current Account/Current ODP -1.5 -4 3 -6 2 -3.2 -3.3 -2.9 -2.5 -2.2 -I 8 Interest Coverage Ratio 64.8 36.3 5.0 59.2 62.1 61.4 6s.3 67 5 70.8 Torus of Trade Inde. (1960 - 100) 94.7 89.9 90 7 96.7 99.5 94.5 97.4 100.3 t03.4 Source: LA4C a/ Nadiuo and Ltng Term Dbt and relevant ratioe inelude preumed lon. t inancing gape. b/ Date on tfLT interost payent from thlo Central 8enI of Argentin. It includs IF i;nterest. c/ tieludo current trensfo,. 4/ National account basis. 04-Oct-se  - 45 - PAnua Table 2: MWVQk - ALAMCE OF P*IS04 Actual Projacted 195 1986 1987 1tw0 1989 190 1991 1992 t1s3 Eaort of aod ed #WS 10495 9075 am 1107 1250 18074 14405 1568 17109 rc"die (P.0.0) 8890 65 6sse 0s8s 10202 1021? 11299 1257S 13654 No" fctor services 1640 1es 2026 2142 2877 2552 2776 2sss 8172 Impors ot Goods and WFS 11448 11935 12878 139 1541s 18 629 17016 18973 NaecFliandl (P.0.8) 8614 4724 5m 50 0400 So8t 7572 an02 90oo Wm Fe.or S i ice. 2077 24W8 2374 280 260S 2600 20e4 2783 268 Roarca Blance 4851 1550 208 2907 573 8323 31822 42S9 4742 N4a Factor loco" -5304 -4416 -44e6 400 4154 -5717 -0040 -6377 -0606 Facter Receipts 253 857 210 810 271 804 827 854 881 Fect.r Payeantt -5807 -4773 -4704 -5400 -6425 -6021 -63sr -6781 -0987 OCT Int r"t) 4806 8862 4140 4742 s450 5214 S650 6114 6498 t Curraet Tronf era 0 2 -4 -1 0 0 0 0 0 Cu.rnt Accout Balance -58 -2856s -4206 -2204 -2591 -29 -2224 -2118 -1864 W tees Feral8. Investmnt 919 574 -19 9e6 886 900 972 1050 1134 Not iLT WaON* 27 5768 2872 84S9 1514 1744 1552 13f0 730 Nat Short tor, CgI tat i-234 -4186 -701 -12i -304 3S0 350 SW 350 Otier Cap itol 1500 145 1523 -514 441 -350 -850 -350 -350 COvng in Raep . C- * increse-) -1071 so8 1111 -352 44 -250 -300 -ao0 0 at% Credit ft. lif 1007 145 014 255 258 0 0 0 0 Stores of current (VP (percent) Rourcc blanc. 6.7 2.3 0.8 3. 4.6 4.0 4.2 4.4 45 iLT Irter t Pry_ante 7.4 5.9 6.0 6.6 7.0 6.2 0.3 6.3 6 2 Currcnt Acrount Blasc. -1.S -4.3 -0.2 -3.2 -8.3 -2.9 -2.5 -2.2 -1 8 Toat ttLT CaltAl Inflo 4.8 8.7 3.4 4.8 2.0 2.1 1.7 1.4 0.7 Nat Credit from 1W 1.0 0.2 0.9 0.4 0.8 0.0 0.0 0.0 0.0 Foreign lxien Reearves are" Reg. I... acid (UN Si l i;on) 4749 4185 3075 3427 3883 3633 3a3 4233 4233 bElianga Rates, Australee poe UN (period av*reg) 0.60 0.94 2 10 Auatralee ar SDR (Dacester) */ 0.08 1.54 5.30 Reel tffect;.. lxchange Rate (1980 * 100 56.10 51.40 54.00 Sourco: LAiCO a/ FiPtr for 1988 as of July 190. 04-Octt-  - 46 - Amse Table 8t ARtEtl - 8UUANE Of PAlWUS. RX1L CAIITAL. NO ----------------------------------.--.-----------------_- Actos Projected *9S iU SW ? lo Igo Iwo 1X 199 1iw3 -- _ -- - - -. - - -- - -- . _ -- - - -. . -- - - - - - - _.__---_.___-----------------._________.___-_._____________________-_______________ wANIC OF PAW4TS Mst exoerts of foode and WS -953 -9660 -4278 -2i .-21 f -29 -m2-22t1 -s18S4 Exsorts of GOods end tES 10495 9075 6 1180 1280 18074 14405 15698 17109 Itort4 of Goods nsd WS 11448 11985 12878 15590 1i481 184 1629 17616 16673 Hot Foct.s Iows -5304 -"16 -4486 -409 -6184 577 -504ti -6377 60 Not Tl ofers 0 2 -a -1 a a 0 0 0 Current Account Otisoce -95t -2g88 -4626 -9296 -2591 -2894 -2224 -2118 -1864 Direct Foreign Investment */ 919 574 -19 9#6 6 9gm 972 to0o 1134 Net ItT (Loon*) 2766 576s 2372 an 815 205 -340 -231 -4e3 Other Cspit l -385 -4042 1731 -1402 820 -850 -350 -350 -350 Change IV Reser1s (- Incrc e) -1671 863 tlil -382 44 -250 -300 -300 0 D1S ISOUS94SQETs 0t -el-- --nt- 0 0 0 0 0 0 0 0 0 Gross d6bursseents of ItT tonse 75f4 74J 4317 4411 31d7 4333 8006 t4o0 sos. Pbl, snd Pub. OGussted 7706 7844 5212 6017 8974 4061 4857 4258 3942 wItilatiterel 470 870 1000 702 10 1? 1240 1257 lSG of* I" 144 406 N5 85 *15 674 924 902 737 el Istarot 510 1236 054 514 460 soo 800 500 S00 Prt,. Ousorttsd sod Unidentifi d 6St4 5s29 2863 4265 147 1539 1692 1599 1578 Private f4an-GOwwwwooAd 0 0 0 0 0 0 o0 0 TTAL ILT OCIUIIR1 VtW b/ Public sod Publicly ouaranteed 6070 6a77 11360 19318 1to 310 sis 16651 18114 18747 itbiletrsl 622 92 1619 1949 26S 8282 3909 4583 486o */s low 622 ?) 1s619 1949 2566 3232 3909 4131 4660 e/, 1OA 0 Q 0 0 0 0 0 0 0 ilst.er.l 4626 6536 8141 e4ts 877e 90m8 932 9081 Om86 Pe;i. OGus. snd Un;dontof; d St496 41243 42675 44342 45197 4714e 49417 s12 8S952 Pr;lon. -Owursntesd 0 0 0 0 0 0 0 0 0 TOTAL SHORT-TE1 OM6 -2384 -4186 -70t -1295 -304 350 80 350 3SO OEM SMVICE Total Public ftd P;iv,te tLT 80199 S560 s8o22 61407 622l 64014 e5611 4t370 S6352 tst Ssrvics Pysots -9910 -5965 -6091 -6011 -tost -6856 -7931 4102 -9637 el/o Interest 4006 3882 4146 4742 8480 3214 5sSO 6114 6496 Debt Service so S of Esworet of 0AS 92.2 61.9 70.7 60.7 48.9 80.8 83.3 S1.j 55 1 Total Short Tor Debt Setvice Psy_snts -2710 -4995 -701 -1465 -604 180 180 130 ISO Short Torm Psynota * X of Efprt, of OM -26.5 -52.7 -8.4 -13.S -4.8 1.2 1.1 1.0 0.9 A-#. lot. Rat. on Loons (5) 9.0 6.6 7.2 8.5 9.0 9.0 9.0 9.0 9.0 eAt6 GROW EXPOSRE (5) I DOD/loal 000 1.2 1.7 2.9 3.2 4.1 5.0 5.9 6.7 7.1 ISR Disb./Totwl Oros D;sb. 1.9 S.S I.4 7.7 16.6 14.9 13.4 18.6 11.1 ISS Debt Ser.ice/Total Debt Service 1.2 3.4 S.1 5.8 6.3 7.2 7.S 6.2 e.; IDA OD/Totel OtO 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Source? LA4CO a/ Includes 4dt conoversion b/ Do" ot ioludd IW. 04-Oct-66  47 - ANNEX I Table 4 Table 4. N4INA IAL P SECMM EFICT (tmclilnq provincial puen ts) (cash bi 1997 ! 1988 1919 !Y.aral ! I II 111 IV Years)! I it 'il IV VW !Y 1! ! llpercent of Gap) CURMET ACCOSt ! Currant lennues 19.5 17.7 17.2 17.7 18.7 ! 17.9 ! 19.5 20.5 20.8 16.4 ! 19.5 Tax Rveu ! 17.4 ! 11.2 15.7 14.2 17.2 ! 16.3 ! 18.0 19.0 19.3 17.2 ! 18.0 Rem-tea Revenoue ! 1.9! 1.5 1.5 1.5 1.1! 1.5 ! 1.5 1.5 1.5 1.4 1.5! Cutrrent Eapeniture ! 20.4 1 19.5 18.1 18.0 20.7 ! 19.2 ! 18.6 20.4 20.5 21.! 20.0 ! Persmol ! 3.5 ! 3.0 3.5 3.4 4.1 ! 3.4 ! 3.8 4.0 3.7 4.0 ! 3.8 ! goods and Services 1.4 ! 1.4 1.2 1.2 1.2! 1.3! 0.9 1.1 1.3 1.4 ! 1.2 ! lnternt on Debt ! 2.3 ! 3.1 2.8 1.5 2.5 ! 2.5 ! 1.7 2.9 2.1 3.5 ! 2.S ! hdtic ! 0.4 ! 1.1 0.6 0.2 0.5 0.4! 0.5 0.5 0.7 0.8 ! 0.4 ! Freile 2.0 ! 2.0 2.2 1.2 2.0 1 1.9 ! 1.2 2.4 1.4 2.7 ! 1.9 ! Current I Capital transfers ! 12.8 ' 11.7 10.9 11.4 12.5 ! 11.6 ! 11.9 12.3 13.2 12.4 ! 12.2 ! Other Curret Ezpeaditures ! -0.3 ! 1.1 1.2 -0.5 0.3 ! 0.5 ! 0.3 0.2 0.3 0.3 ! 0.3 ! Public Enterprims Savinp ! -0.5 ! -0.9 -1.0 0.8 0.1 ! -0.3 ! 0.4 0.4 1.4 0.2 ! 0.7 ! Public Sector Savings ! -1.4 ! -2.9 -2.4 0.5 -1.9 ! -1.4 1.5 0.3 1.7 -2.8 ! 0.2 ! CAPITAL ACCOUNT ! Capital Rvnues and ah. o!. ! 0.5 ! 0.3 2.0 0.7 0.3 0.9 0.2 1.4 1.4 1.4 ! 1.1 ! ! ! Capital Expediturn (gross) ! 3.9 3.9 3.1 3.4 3.7 ! 3.5 ! 3.3 3.5 3.7 3.7 ! 3.5 PU8IC SECT ! a a a a a 11NINB REOUIREIITS ! 4.7 6.4 3.4 2.1 5.2 ! 4.3 ' 1.4 1.9 0.4 5.1 ! 2.2 Neso: Priary surplus ! -0.9 ! -2.0 1.3 0.2 -0.9 -0.4 ! 1.2 2.1 2.5 -0.5 ! 1.3 TOTAL FIIUlCIN a I a a a a -----! ! ~~~~~~~~~~~~~~~~~~~~~~~! !a a. Net Use of Credit ! 3.4 ! 6.9 0.2 4.0 4.7 ! 4.0 ! 1.5 2.4 1.9 3.5 ! 2.3 ! Dsstic ! 0.4 2.3 0.4 0.9 0.2! 1.0 ! 0.4 0.4 0.6 0.7! 0. ! Foreig ! 3.2! 4.4 -0.3 3.2 4.5! 3.0 ! 1.1 2.1 1.3 2.9! 1.0 ! ! ! a ! ! b. let Us of Advacp ! 0.0 ! 0.0 0.0 -0.1 -0.1 -0.1 ! 0.0 0.0 0.0 0.0 ! 0.0 c. Chane in stenl arrars! 1.0 ! 0.7 3.1 -0.4 -0.5 ! 0.7 ! 0.1 0.3 0.0 -0.3 ! 0.0 d. Ikt change in oth. liabil.! 0.2 ! -1.2 0.1 -1.4 1.1 ! -0.3 ! 0.0 -1.0 -1.4 1.9 ! -0.1 Sourcet: Ninistry of Ecnmy. a/ Cerrected for intra-annual inflation  - 48 - ANNEX I Table 5 Table 5. QUASI-FISCAL SURWLUS IN REAL TER1, 1908-1989 tpercent of GOP) 1988 199 II all Bill DIV Year GI oil g111 DIVt Yer Doaestic coonent -3.22 -0.52 3.20 3.57 0.73 -0.05 0.31 0.16 -0.37 0,01 Nosinal resalt -1.42 2.08 4.93 2.61 2.04 -0.01 0.59 0.81 0.74 0.54 eIto: Exchange rate ta 0.00 0.00 0.29 1.81 0.52 1.16 0.80 0.56 0.02 O.2 Monetary correction 1.79 2.b1 2.03 0.85 1.82 -1.19 1.08 -1.21 -1.12 -1.15 External coeponent -0.95 -0.24 -0.98 -0.29 -0.61 -1.10 -0.93 -1.37 -1.44 -1.22 Quasi-fiscal sxpl{ts bi -4.16 -0.76 2.22 3.26 0.12 -1.15 -0.61 -1.21 -1.91 -1.21 Loss provisions cl -0.07 0.03 1.01 0.88 0.46 0.40 0.19 0.17 0.16 0.23 Adjusted quasi-fiscal -4.09 -0.79 1.21 2.40 -0.34 -1.54 -0.80 -1.38 -1.97 -1.43 Rein: or 90962 146225 260376 305470 802933 347901 407J63 476513 557035 1789012 a/ Adjusted for intra-annual inflation bJ IMF definition ci 45 percent provisions on loans to and incoe fro* MN  - 49 ANNEX I Table 6 Tabl) 6. FACTUS OF NO NTARY EIPANSIOK funthbly avragss, pWrcenta intrease) Ue U9 0111 OIV 8u ! 01 0113 0111 10V Year8 ! Eapansion of Honey ase Supply 2.39 12.66 23.51 -0.19 10.27 ! t.22 1.01 3.7 9.30 ! 7.80 ! Ceta Govt. -.0 -09 -17 -0 -0 ! ! !32 86 632 -.9 -04 ! Chanp in cet Foreign Assets o 0.17 11.79 14.62 -3.03 1 6.0 4.589 1.61 -0.29 6.18 3.57 due to operations withs : Prieate ctoNr 2.01 14.92 17.47 0.25 ! 9.62 ! 10.18 11.31 8.29 10.53 8.84 Public ente pris s -1.53 -2.38 -3.64 -3.19 ! -6.91 ! -2.90 -3.11 -3.31 -3.48 ! -5.60 Central SYit. y 0. -0.93 -1.36 0.00 ! -0.8t -3.26 -9.61 -6.32 -1.99 ! -10.48 Other -0.37 -0.79 1.01 -0.10 ! 0.0 ! -0.140 0.10 0.16 0.19 ! 0.04 Chan in credit to Public Sector t7. 11.32 15.59 4.06 ! 11.4 2 1.52 3.61 3.25 4.73 ! 3.94 ! cRedit to Nto-finanil P.S. 1.83 2.99 9.90 1.51 ! 5.24 ! -1.28 0.22 0.21 1.33 0.37 -nttibation of expiring bonds 2.67 2.19 7.06 0.36 ! 4.05 0.00 0.00 0.00 0.00 0.00 ocial Security 0.12 0.60 1.06 1.15 ! 1.53! -1.28 0.22 0.21 1.33 ! 0.37 Other 0.51 0.23 0.26 0.00 ! 0.30 ! 0.00 0.00 0.00 0.00 ! 0.004 asi-fiscl defit 5.4 9.29 7.14 2.53 6.80 3.46 3.b6 3.16 3.59 ! 3.93 Paysents ot interest 3.7 8.32 6.90 2.55 6.00 ! 2.80 3.39 3.50 3.45 5! Rediscounts 1.74 0.97 0.35 -0.02 ! 0.80 0 .66 0.28 0.12 0.19 ! 0.36! c, a apt etral bank operations -.68 -5.89 -7.05 -0.49 -8.56 ! 1.52 2.87 0.97 2.26 ! 1.04 Opec-eaket operations -2.91 -1.99 -0.62 -1.85 ! -3.42 !-2.65 -0.62 -0.90 -4.43 -3.44! Other ai -5.77 -3.91 -6.43 1.36 !-5.14 4.17 3.48 1.77 6.69 ! 4.49! Bas eoneyi9fl 5.18 5.11 5.02 4.19 ! ! 4.41 4.62 4.41 4.93 !a hl/BDP 4.36 3.95 3.37 3.22 ! ! 3.31 3.54 3.50 3.65 ! a Source: Dance Central de la Republica, Nonetary Progras *1 Includes other ftorts of sonetary expansin or contraction.  _ 50 _ ANNEX II ST&'rUS OF BANK GROUP OPERATIONS Pae I of A. STATEMENT OF BANK LOANS AND IDA CREDITS (AS of -March 31, 1988) ARGENTIMA Amount less Loan No. Year Borrower Purpose Cancellations Undisbursed (125$- million) Fully disbursed loans (18) 901.6 1521 1978 Argentina Grain Storage 87.0 22.5 1761 1979 Argentina Yacyreta Power 210.0 1.0 2031 1981 Banco Nactonal Oil and Gas 87.6 34.7 de Desarrollo Credit 2032 1981 Yaciolentos Refinery 200.0 3.0 Petroliferos Conversion Fiscales 2063 1981 Banco Nacional Industrial 100.0 31.7 de Desarrollo Credit It 2296 198 Argentina Highway 100.0 22.6 2592 1985 Yacisientos Gas Utilization 180.0 165.2 Petroliferas and Technical fiscaler Assistance 2032-1 1986 Yaciaelntos Refinery 116.0 8.8 Petroliferos Conversion Fiscales 2641 1986 Argentina Water Supply 60.0 59.5 2675 1986 Argentina Agricultural 350.0 172.8 Sector Loan 2712 1986 Argentina Public Sector Mgt. 18.5 13.6 2751 1986 Argpntina Power 14.0 14.0 Engineering 2793 /a 1987 Argentina Small and Medium 125.0 125.0 Scale Industry Credit 2805 /a 1987 Argentlna Port 50.0 i0.0 2815 1987 Argentina Trade Policy 500.0 *.0 2854 lb 1987 Serviclos Power 276.0 276.0 Ulectricos Distribution Gras B.A. 2920 lb 1988 Argentina fuwicipal Dev, 120.0 12'0X3 2923 )fi 1968 Argentina Banking Sector 400.0 400.0 TOTAL 3,895.7 of which has been repaid 713.9 3,181.8 Amount Sold 12.8 Of which has been repaid 12.8 Total now held by Bank 3,169.0 Total undisbursed 1,524.4 /a Not yet effective. ?- Not yet signed. 5/05/88  - 51 - ANNEX II Page 2 of 2 B. STATEMENT OF IFC INVESTMENTS (As of March 31, 1988) ARGENTINA Amount in US$m. Year Oblisor Type of Business Total Equity Loans 1960 Acindar Industria Arg.S.A.* Steel Products 3.7 - 3.7 1960 Papelera Rio Parana, S.A.* Pulp and Paper 3.0 - 3.0 1961 Fadess S.A.* Automotive 1.5 - 1.5 1962 Pasa* 3.0 - 3.0 1965/72 Celulosa Argentina, S.A. Pulp and Paper 12.5 - 12.5 1969/75 Dalmine Siderca, S.A.* Steel Products 17.0 - 17.0 1969 Editorial Codex, S.A.* Printing 7.0 2.0 5.0 1971/73 Calera Avellaneda, S.A* Cement 5.5 - 5.5 1977184 Alpargatas S.A.I.C. Textiles & Fibers 30.4 2.0 28.4 1977 Soyex S.A. Soybean Processing 25.0 - 25.0 1978 Massuh, S.A. Pulp and Paper 29.9 2.4 27.5 19781 Juan Minetti, S.A. Cement 103.0 - 103.0 1978/79 Ipako-Industrias Chemicals and 20.3 2.0 18.3 82187 Petroquimicas Arg. Petrochemicals 1979/83 Alpesca S.A. Fisheries 6.8 1.6 5.2 84 1984/86 Petroquimica Cuyo S.A.I.C. Petrochemicals 46.6 4.0 42.6 1986 Inversiones Industriales Capital Market 1.3 1.3 - S.A. and Roberts S.A. - 1986 Atanor S.A.M. Chemicals 8.0 1.0 7.0 1986 Banco Roberts S.A. Capital Market 10.0 - 10.0 Hidra Oil Chemicals and 80.0 - 80.0 1987 Garovaglio/Zorraquin Food & Food Proc. 13.0 - 13.0 1987 Terminal 6 Port, Storage 5.5 - 5.5 1988 Bunge y Born Food & Food Proc. 40.0 - 40.0 1988 Arcor Food & Food Proc. 12.0 - 12.0 1988 BRLP Dev. Finance 30.0 - 30.0 1988 Astra Chemicals 12.4 - 12.4 1988 Chirete Chemicals 5.2 5.2 - 1988 Bridas Chemicals 20.6 - 20.6 1988 Banco General de Negocios Finance 10.0 - 10.0 Total Gross Comuitments 563.2 21.5 541.7 Less Cancellations, Terminations Repayments and Sales 225.5 2.0 223.5 Total Commitments Now Held by IFC 337.7 19.5 318.2 Total Undisbursed (IFC only) 164.2 8.8 155.4  - 52 - ANNEX III Page 1 of 3 ARGENTINA SECOND TRADE POLICY LOAN Supplementary Loan Data Sheet Section Is Timetable of Key Events (a) Time taken by the country to prepare the loan: 7 months (b) Appraisal Mission: April/May 1988 (c) Completion of Negotiations: August 1988 (d) Planned date of effectiveness: November 1988 Section IIs Special Bank Implementation Actions None Section III: Special Conditions (a) The following are the additional conditions of loan effectiveness referred to in para. 124: i) the Government's macroeconomic policy framework including its fiscal, monetary and exchange rate policies, is consistent with the objectives of the Program set forth in the Goverment's Letter of Development Policy (Annes IV) and the Letter of Sector Policy (Annex V); (ii) the production coverage of QRs has been reduced from the level of 36.82 existing on December 31, 1987 to 18.02 or less; (iii) the number of tariff positions (NADI positions) describing goods for which the importation process is fully automatic, i.e. not subject to any Government discretion, has been raised from 5,804 existing on December 31, 1987 to 7,800 or more; (iv) the production weighted average of tariff rates has been reduced from 43Z existing on December 31, 1987 to 302 or less; (v) the tariff band has been reduced from 0-532 for tariff positions with an aggregate production coverage of 952 existing on December 31, 1987 to 0-402 for tariff positions with an aggregate production coverage of not less than 972; (vi) the maximum tariff rate has been reduced from 1152 existing on December 31, 1987 to 502 or less; (vii) the production coverage of specific tariffs has been maintained at less than 72;  - 53 - ANNEX III Page 2 of 3 (viii) no specific tariff surcharges are applied other than the temporary surcharges for certain electronic goods which continue to be phased out according to the schedule set forth in NINEC Resolution No. 418186 (ending September 30, 1990); (ix) any countervailing duties, anti-dumping duties or safeguard measures that may have been applied for more than an accumulated six months within two years have conformed to the requirements of paragraphs a (ii) and a (iv) of this section; and (x) the implementation of DGI's program for the auditing of beneficiaries under the industrial promotion regime has made progress, satisfactory to the Bank. (b) The release of the second tranche of the loan would be contingent upon the Bank having been satisfied, after an exchange of views with the Government, with the progress achieved in carrying out the program, and the Bank having been furnished with evidence satisfactory to it that: (i) the Government has made progress, satisfactory to the Bank, in the implementation of the macroeconomic program set forth in the Letter of Development Policy (Annex IV); (ii) the Government has continuously implemented the ioan effectiveness conditions set forth in paragraphs a (i) and a (iv-ix) of this section; (iii) the production coverage of QRs has been reduced to 15.O or less; (iv) the importation process for goods not subject to QRs is fully automatic; (v) the production coverage of industrial export taxes has been reduced from 15.12 on December 31, 1987 to 7.52 or less; (vi) all export controls (prohibitions or license requirements) for industrial goods have been abolished other than those established in: (a) a law of the Argentine Congress; (ii) an international agreement; or (iii) a resolution exclusively for the maintenance of reasonable health and product quality standards or for the protection of the environment; (vii) the Tax Revenue Service (DGI) has made progress satisfactory to the Bank in its program for the auditing of beneficiaries under the industrial promotion regime including the completion of 400 audits; and (viii) the Secretariat of Industry and Foreign Trade (SICE) hass (i) strengthened its capacity for supervising the existing industrial promotion regime as well as the regime envisaged by  - 54 - ANNEX III Page 3 of 3 the unified industrial promotion law currently before Congress in a manner satisfactory to the Bank; (iii) issued regulations establishing the criteria for the cancellation of benefits under the industrial promotion system; and (iii) prepared a plan of action, satisfactory to the Bank, for dealing with the results of the audits conducted by DGI, including the cancellation of benefits for firms in violation of their commitments under the industrial promotion regime.  - 55 - ~~~~AM= IV Page 1 of 8 LETTER OF DEVELOPMENT POLICY Buenos Aires September 22, 1988 Mr. Barber B. Conable President The World Bank Washington, D.C., 20433 Dear Mr. Conable: 1. In early August, the Argentine Government announced an economic program designed to reduce inflation and thereby stimulate growth. Embracing both stabilization objectives and medium-term goals, the program is intended to curb inflation as well as to help reverse the secular deterioration in saving and investment that has occurred during the 19808. Even though investment rates have improved in the last two years, the economy still has not been able to recover from the debt crisis and macroeconomic instability of the early 1980s. The substantial reversal in flows of net external resources after 1982 has implied a difficult and prolonged adjustment that must lead to a process of sustained economic growth. 2. The Government's short-term measures constitute a strong program of action that can lead the country away from endemic inflation and towards a more promising future. The short-term fiscal objective is to limit the public sector's financing needs as much as possible to amounts that can be borrowed from abroad, so that total financing is consistent with the monetary policy designed for stabilization. In order to place the economy on this development path, short-term measures are being complemented by structural reforms. In this respect, the Government is implementing an extensive reform program that leads to the integration of the Argentine economy with the rest of the world, the modernization of the State and to a general deregulation of markets. With these objectives, the Government is moving in the direction of eliminating quantitative restrictions to imports, reforming the industrial promotion incentives and reforming the * financial markets to improve the efficiency of private sector activity. Finally, we are comnitted to improving the efficiency of the public sector's own operations, particularly in public enterprises. Both the short-term actions and the structural reforms constitute necessary elements to secure sustained growth and macroeconomic stability of the Argentine economy. Macroeconomic Goals 3. Early experience with the measures announced in August is encouraging. We expect that the rate of inflation will decrease substantially in coming months. We believe, however, that sustained progress toward our goals of permanently reduced inflation, reduced real interest rates, improved efficiency and increased investment will require additional measures as outlined here.  M= IV - 56 - Page 2 of 8 4. Achieving our near-term fiscal objective implies that the ccnsolidate public sector deficit including the Central Bank's quasi-fiscal deficit will have to be reduced from 4.6 percent of GDP in 1988 to a maximum of 2.4 percent in 1989. Fiscal moderation is essential to attain our goals of a unified, market determined exchange rates by the end of 1989. 5. Reducing the combined public sector deficit on a cash basis to 2.4 percent of GDP will require a substantial adjustment in the nonfinancial public sector because the quasi-fiscal deficit is determined largely by movements in external and internal interest rates, and is therefore basically outside the direct reach of policy instruments. As external interest rates have risen during 1988 and the Central Bank will absorb the new external debt of the public sector in 1988-89, the quasi- fiscal deficit will increase from 0.3 percent of GDP to 1.4 percent of GDP. This means that the non-financial public sector deficit will have to shrink by more than 3 percentage points of GDP--from 4.3 percent to 1 percent--to reach the objective of 2.4 percent of GDP. 6. To accomplish this goal, the Government intends to improve tax administration and collection as well as introduce a new tax reform aimed at broadening the tax base and improving its horizontal and vertical equity. This additional fiscal effort will yield gross additional public sector revenues equivalent to about 1.5 percent of GDP in 1989, of which, about 0.6 percent would be available to the Treasury after revenue sharing with the pruvinces. An additional 0.6 percent of GDP deficit reduction will be achieved through specific expenditure cuts, equivalent to about US$500 million, by national administration and public enterprises. These measures will reduce pressure on domestic financial markets and thus contribute to a reduction in real interest rates which in turn will reduce the quasi-fiscal deficit of the Central Bank. 7. The combined overall public sector deficit of 2.4 percent of GDP for 1989 is expected to be financed by the proceeds of public sector external borrowing equivalent to 1.4 percent of GDP. Given the expected remonetization of the economy in 1989, the projected level of domestic financing (not exceeding 1 percent of GDP) is consistent with the Government's near-term stabilization target of monthly inflation of less than 5 percent. It is also consistent with the objective of avoiding any further crowding out of the private sector. Nonetheless, prudent conduct of monetary policy is of fundamental importance for the success of the plan. 8. Its spite of relatively favorable agricultural export prices and vigorous growth of both traditional and industrial exports expected to amount US$10. billion in 1989, we project a modest increase in Argentina's current account deficit from US$2.4 billion in 1988 to US$2.6 billion in 1989. Substantial improvements in the country's trade balance of US$750 million in 1989--a 27 percent increase over 1988--are more than offset by increases of US$1 billion in interest payments mainly due to increased interest rates on foreign debt. 9. The Government has begun discussions with its external creditors and intends to have a complete external financing plan for 1988 and 1989 in place by the end of this year.  - 57- AM IV Page 3 of 8 Public Sector Reform 10. Disequilibria in public finances have been a continuing feature of recent Argentine history. In 1975, the deficit reached 15.5 percent of GDP and remained between 10 and 15 percent for much of the remainder of the decade. Foreign borrowing, especially after 1979, financed most of these deficits. The 1982 crisis triggered an interruption in credit flows and caused a significant deterioration of public finance: sharp real devaluations and high international interest rates increased the domestic resources required to meet external interest payments. In 1983, just before the present Government took office, the fiscal deficit was the highest registered in the last 30 years, 16.1 percent of GDP. 11. The Government has been addressing the fiscal problem through across-the-board expenditure restraint, attempts to improve management of the public sector and concerted efforts in the four areas affecting the deficitt central government, relations with the provinces, public enterprises, and social security. The Government began tax reform efforts in 1985 and an additional package was passed in January 1988. Expenditure measures have affected public sector wages and public investment. To reduce the deficit of the public enterprises measures have been taken towards increasing tariffs, expenditure control, demonopolization and deregulation of selected public enterprise activities, together with the start of a program of privatization of public sector enterprises. The Government will not make funds available to the provinces beyond these fore&een in the co-participation law, nor with the Central Bank finance the provinces through extension of rediscounts to provincial banks. Transfer to public enterprises will be confined to the funds already earmarked for them. Simailrly, the Social Security System will have no recourse to general Treasury revenues. Federal Government 12. In order to facilitate an early agreement on priorities, the Government will submit the 1989 budget to Congress before December 31, 1988. 13. The Government regards restoration of its revenue base as one of the most urgent tasks it faces. Action will be taken both to reduce evasion and improve collection under the existing structure, to reduce leakage under the industrial promotion system and to broaden the tax base, while reducing distortions implicit in the present tax system and in the current system of industrial incentives. To these ends the Government Will: - Immediately move to strengthen the tax administration and audit capabilities of the DGI. - Develop by Deceziber 31, 1988, a medium-term plan of action for the further development of the DGI. - Request Congressional approval of legislation which increases penalties for tax evasion and which facilitates legal prosecution of tax evaders.  - 58 - AMMX IV Page 4 of 8 - Improve the auditing capabilities of both the DGI and the Secretariat of Industry to determine abuses under the existing industrial promotion system so that appropriate penalties can be imposed. - Request passage of the Industrial Promotion Lam currently before Congress. 14. These administrative and legislative measures will be accompanied by the development of proposals for tax reform to take effect next year, in part to replace revenue lost with exchange rate unification. The Government will begin immediately the study of a project of tax reform with the objective of increasing total revenues and enhancing the efficiency of tax system. The project will define ways to increase the tax base. Particular attention will be devoted to a reform of the VAT and excise tax system. The project will be completed by the end of 1988, and will be the basis for legislation to be submitted to Congress by that date. Implementation of the reform will be sought starting July 1, 1989. The design of the tax reform as well as ways of improving tax administration will be elaborated by the Government in consultation with organizations representing the private sector. Public Enterprises 15. The objectives of the Government's program continue to be increasing the quality of services supplied through public enterprises, while securing access to private resources to increase investment and contributing to the reduction of the overall fiscal deficit. To achieve these objectives, the National Government has reorganized the regulatory framework and decision-making structure of the public enterprises sector to clarify the financial relations of the sector to the National Government. Sectoral policies have been placed under the responsibility of the Ministry of Public Works (MOSP), and budgetary and financial control of the enterprises managed by the MOSP has been assumed by a holding agency of public enterprises, the Public Enterprises Board (DEP). 16. Increased accountability of public enterprises requires that they operate in an predictable environment with respect to their tariff levels. This is particularly important if the principles referred to above restricting their access to Treasury finance are to become well- established. Accordingly, at the end of the current policy on public utility rates and fuel prices, the Government will undertake adjustments to maintain prices in real terms. The goal would be to prevent an erosion in the real revenues of public utilities. We consider that in the electric power sector there is a need to improve working margins of federally owned utilities. It is also our intention to adjust relative prices of gas and diesel (gas-oil) to encourage utilization of the former. 17. We shall maintain our efforts to improve the financial planning and management of public enterprises by the following means: - The DEP will require all enterprises within its charge to develop budgets and performance targets for 1989. The approved budgets and plans will be published by December 31, 1988.  - 59 - ANNU ITV Page 5 of 8 -- The DEP will continue its efforts to standardize accounting and information systems among enterprises, as well as improving long-term planning of investments and finances in a consistent fashion. 18. In order to improve operating efficiency and reduce working capital needs of public enterprises, the Government will direct immediate attention to procurement and inventory control practices. To this end, the Government, through the Ministry of Public Works, will develop by December 31, 1988, for enterprises reporting to it, guidelines to increase the competitiveness and transparency of the enterprise procurement process, guidelines in purchase programming and inventory control, and methods for monitoring compliance by public enterprises with the guidelines. These measures will be complemented by continuing reforms of the 'Compre Nacional" policies that apply to public sector procurement, with a view to reducing cost and increasing the efficiency and competitiveness of the public enterprises and their suppliers. 19. The Government will give urgent attention to the restructuring of Perrocarriles Argentinos and the development of an action plan to divide the current operation into specific lines of business (freight, inter-city passenger and suburban passenger). In addition, to ensure that oil exploration activities are protected from continuing fiscal pressure and are consistent with the Government's general policy of encouraging private sector participation, the Executive will sign the Petroplan Decree so that the program can start before the end of the year. Financial Sector Policies 20. The financial public sector in Argentina has traditionally been characterized by the strong participation of the Central Bank in financial intermediation; substantial recourse to the banking system as a source of involuntary public sector deficit financing; and the existence of serious inefficiencies in the operation of certain national and provincial public banks. 21. Central Bank participation in financial intermediation has taken place both through overregulation of the sector and a substantial volume of Central Bank lending through rediscounts. To finance rediscounts and the deficit of the nonfinancial public sector, the Central Bank has imposed heavy reserve requirements and other forced investments on the financial system's deposits. 'When reserve requirements and forced investments have not been enough, the monetary base has been expanded. Moreover, losses on the lending operations of several public banks--most prominently the National Mortgage Bank (BHN), the National Development Bank (BANADE) and certain provincial banks--have eroded their financing base and these banks have therefore become excessively dependent on Central Bank credit. 22. In recent years these problems have resulted in large Central Bank losses (the quasi-fiscal deficit referred to earlier), adversely affecting interest rates and inflation. Financial intermediaries, in turn, have substantially reduced credit to the private sector and become inefficient. They have to charge large spreads to cover high operating costs and losses associated with reserve requirements and forced investments.  A60 AN IY - 60 - Page 6 of P 23. Particularly in the last two years, the Government has taken numerous measures to rationalize the financial public sector and to strengthen the financial system. These reforms include: ti) a restrictive policy on new Central Bank rediscounts (excluding rediscounts to BHN, the net cash flow of Central Bank rediscounts has been negative during January- August 1988); (ii) stre'.jlined rediscount portfolio administration, including greater transparency (the 1988 rediscount budget has been sent to Congress together with the fiscal budget); (iii) a reduction in subsidies associated with Central Bank rediscounts; (iv) liberalization of interest rates; (v) improvement in regulations and supervision of financial institutions; (vi) deposit insurance for all small-sized deposits; (vii) liquidation of several insolvent intermediaries as well as privatization of other whose administration had been taken over by the Central Bank; and (viii) strong sanctions against overdrafts of the public banks. 24. The Government intends to continue its efforts by taking the following measures: - Continuing the rationalization of Central Bank rediscounts, including improved accounting, transparency, and a negative cash flow; - Gradually reducing reserve requirements and forced investments to facilitate access by the private sector to financial resources; - Establishing a deposit insurance agency for the rehabilitation or liquidation of ailing financial intermediaries; - Continuing to improve supervision and transparency in the financial system as well as firmly enforcing prudential regulations (particularly on provOsions for potential loan losses); - Restructuring major public banks--especially BHN and BANADE--to transform these institutions into self-sustaining financial intermediaries (discontinuing reliance on Central Bank rediscounts and gradually reducing existing indebtedness with the Central Bank). The Central Bank will continue to restrict rediscounts to BUN only to finance BHN's lending commitments outstanding as of January 1988; a vigorous collection policy- -including automatic foreclosure of loans in arrears--will be an important source of funds for BHN. Trade Policy 25. Export expansion, efficient import substitution, increased international competitiveness, and overall investment growth in the productive sectors are key elements of the medium-term strategy. The country's poor export performance in the past, while partly caused by external conditions, has reflected a domestic economic policy environment not conducive to export activity. This environment in the past included  - 61 - ANEX IV Page 7 of 8 overvalued and unstable exchange rates, heavy protection for domestic market production and sales, export taxes and other impediments to exports. Recently these policies have begun to change. Since 1985, the Government has pursued a policy to stimulate exports, principally through a high and stable exchange rate policy. 26. During 1987, the Governments (i) transformed the temporary admission regime for imported inputs for exports, extending it to almost all intermediate goods and making it automatic; (ii) removed export taxes for about 800 positions of the export nomenclature; (iii) introduced a general GAST--compatible scheme for indirect tax reimbursement for exports; (iv) improved credit risk assessment in export financing; (v) reduced the production coverage of quantitative import restrictions from 62 to 37 percent of manufacturing production; and (vi) undertook a program to simplify export and import procedures. 27. Since the beginning of 1988, the Government has taken other important steps: (i) transferred authority over iron and steel imports from the General Directorate of Military Industries to the Secretariat of Industry and Foreign Trade, which subsequently removed all quantitative import restrictions on iron and steel, thereby reducing the production coverage of quantitative restrictions to 32 percent); (ii) reduced the production coverage further to 30 percent by removing the import restrictions on agricultural machinery and tractors; (iii) removed all reference prices in line with the application of the special temporary admissions regime to indirect exporters after first introducing a Domestic Letter of Credit; and (v) reduced import tariffs on iron and steel, pe&ujgiuiicals, agro-chemicals, pulp and some paper products. 28. The Government recently has taken measures tot (i) reduce the production coverage for quantitative import restrictions to less tha. 18 percent of manufacturing output and to make importation of all other goods fully automatic; (ii) remove export taxes for about 400 posititns of the export nomenclature; and (iii) remove tariff exemptions outside the temporary admissions regime. Sy October 21, 1988, the Government intends to reduce the average tariff rate to 30 percent (on a production-weighted basis) and the maximum tariff rate to 40 percent, thereby also reducing tariff dispersion. In addition, by April 30, 1989, the Government intends tot (i) start the process of transferring all export transactions to the free market exchange rate; (ii) reduce the production coverage of quantitative import restrictions further to 15 percent; (iii) remove a substantial number of export taxes; and (iv) remove export licenses that are neither required by law or international agreement, or not justified on grounds of health, quality control, or environmental protection. 29. Other new measures will include: -- simplification and liberalization of export procedures, specially those affecting small- and medium-size firms; and -- development and implementation of a comprehensive international marketing strategy and improvement in the quality of government services for exporters, specially for small- and medium-size enterprises.  - 62 - Page a of 8 Industrial Policy 30. The objective of the Government's industrial policy is to promote an internationally competitive industrial sector capable of realizing its full export potential. Efficient and competitive industry will increase Argentina's global market share and improve the population's standards of living. Achieving this goal requires that trade reform be complemented with a reform in industrial investment incentives to increase investment productivity., Implementation of macroeconomic and financial reforms is also necessary to mobilize financial resources to undertake the investment. 31. The present provincial and sectoral investment regime entail a large fiscal cost--nearly 3.5 percent of GDP--and do not encourage the most efficient investment. In 1988, the Government sent to Congress a law that would unify the industrial promotion system by abolishing the special provincial and sector regimes. 32. As noted earlier, the Government will request a rapid passage of the above legislation through the Senate and undertake the related measures noted above to reduce the fiscal cost and tax abuses associated with the present incentive regime. Cop.clusion 33. I believe you will agree this is an important agenda of measures. The Government fully intends to pursue these measures vigorously. However, our success depends on financial support from your organization. Two sectoral loans--the Banking Sector Loan and the Trade Policy Loan--have already been negotiated. In addition, several other investment loans are under preparation. I trust that thim program and its implementation constitute an adequate basis for the materialization of these loans. Sincerely, Juan Sourrouille Minister of Economy  - 63 - ANNX V Page 1 of 5 ARGENTINA SECOND TRADE POLICY LOAN LETTER OF SECTOR POLICY Mr. Barber Conable President International Bank for Reconstruction and Development Washington, D.C. Dear Mr. Conables 1. Argentina is rapidly approaching a crucial turning point. If the country can accelerate its efforts to reform the state and integrate the economy with the world as well as put in place a program of external finAnce, it will be able to surmount the obstacles that might impede sustained growth in the years ahead. The Government has formulated a strong program of action that could lead the country away from the path of endemic inflation and toward a more promising future. The program's ultimate success will rest not only on the conviction of the current administration, but also on the determination of all Argentines to persevere with the reform program. However, success also depends on the decisiveness of Argentina's financial partners to work with the Government in implementing this program to rekindle investment and growth. 2. Trade reform and industrial deregulation are at the core of the Government's action program. In 1987, the Government has implemented a strong trade reform program, supported by the World Bank through a Trade Policy and Export Diversification Loan, which focussed on the introduction of free-trade status for Argentine exporters, but also reduced substantially the production coverage of quantitatire import restrictions. The Government has, in 1988, vigorously continued the trade reform on the import side, and plans to complete the reform by early 1989. Closely coordinated with the trade reform, the Government has also worked with the Argentine Congress on a drastic overhaul of the domestic framework for the regulation and promotion of industry. In this context, the Government wishes to request a World Bank loan in support of the trade policy program and of complementing administrative actions on industrial promotion.  - 64 - ANNEX V Page 2 of 5 Change of the Policy Model 3. Inward-looking economic policies begun in the 19308, the unintended outcome of the world depression and trade contraction, and were deliberately strengthened in the 1940s, providing a legacy of high cost industries. Over 50 years of industrialization oriented towards the domestic market, supported by subsidies and high protection, has left the country with serious problems of efficiency and competitiveness in the industrial sector. In the 19809, macroeconomic instability and the unavailability of long term investment financing has further inhibited the capacity of the industrial sectors to become efficient and competitive. 4. Export expansion, efficient import substitution, increased inter- national competitiveness, and overall investment growth in the productive sectors are key elements in the medium-term strategy. The country's poor export performance in the 1980s, while partly due to external reasons, has reflected a domestic economic policy environment not conducive to export activity. This environment has in the past included overvalued and un- stable exchange rates, heavy protection for domestic market production and sales, export taxes and other impediments to exports. Only recently have these policies begun to change. 5. At the end of 1984, the Government defined a program of economic integration into the world economy as a key part of its medium-term strategy. This approach was designed as part of the overall, in-depth reform of the structures and behavior of the economy. The Government recognized that with changes in the incentive framework industrial investment could be made much more efficient, and Argentina's world market share could increase substantially. 'While the program of opening the economy up assigns an important role to agricultural production and the utilization of energy resources, a central reliance is placed on industry, which needs to be modernized. Industrial exports enable the economy to better withstand the vagaries of conmmodity prices. With a larger share of exports coming from industry, the country would be better positioned to control its domestic macroeconomy. Trade Policy Performance Until 1987 6. An important effect of the Plan Austral on trade and industry has been the progressive real depreciation of the exchange rate for trade transactions. Fiscal necessities of the 1985 stabilization plan, however, prompted the Government to impose a tariff surcharge of 15 percentage points. The combined effect of real depreciation and tariff increase has been that a number of the quantitative import restrictions, particularly for intermediate goods, have become non-binding. 7. The Government started to reform trade policy in 1986, and has since intensified its efforts. The measures in 1987 were supported by a Trade Policy and Export Diversification Loan from the World Bank. During  - 65 - ANNEX V Page 3 of 5 1987, the Government: (i) transformed the temporary admission regime for exports, extending it to almost all intermediates and capital goods and making it automatic; (ii) removed export taxes for about 800 positions of the export nomenclature; (iii) introduced a general GATT-compatible scheme for indirect tax reimbursement for exports; (iv) improved credit risk assessment in export financing; (v) reduced the production coverage of quantitative import restrictions from 62.3 percent to 36.8 percent of manufacturing production; and (vi) undertook a program to simplify export and import procedures. 8. The first indicator for a success of these reforms was a raise of imports under the temporary admission regime for intermediates by more than 120S in 1987 over 1986. The most recent export figures for the fourth quarter of 1987 and the first quarter of 1988 show an increase of about 50? over first two-quarters of 1987 for the export of industrial manufactures. The Government's perseverance in bringing about a competitive exchange rate despite a difficult macroeconomic situation, and of moving rapidly in 1987 to establish free market status for exporters appears to produce results. Recent Trade Policy Actions 9. The Government has taken other important steps. It: (i) transferred the authority over iron and steel from the General Directorate of Military Industries to the Secretariat of Industry and Foreign Trade, which subsequently removed all quantitative import restrictions on iron and steel, thereby increasing the production coverage of fully automatic imports by 5.3 percentage points; (ii) removed all reference prices in line with the application of the GATT customs valuation code; (iii) extended the standard and the special temporary admissions regime to indirect exporters after first introducing a Domestic Letter of Credit; (iv) reduced import tariffs on iron and steel, petrochemicals, agro-chemicals, pulp and some paper products; and (v) removed quantitative restrictions on agricultural machinery and tractors, reducing the production coverage of QRs to 30.22. 10. Currently, the Government is preparing the following actions: (i) replacing the tariff exemptions for imported capital goods granted to firms that benefit from industrial promotion by a general flat tariff rate of 52 for all importers; (ii) removing export taxes for a substantial number of agricultural and industrial goods; and (iii) announcing publicly a trade reform program concentrating on the removal of QRs and the reduction of the maximum and the average tariff rate. Continuing Trade Policy Actions 11. The Government intends to complete the trade reform by early 1989. Until October 31, 1988 or before, the Government will: -- reduce the production coverage for quantitative import restrictions (QRs) to 18X;  - 66 - ANNEX V Page 4 of 5 -- reduce the maximum tariff rate to 402 and the average production weighted rate to no more than 302; - maintain the production coverage of ad valorem tariffs at no less than 93Z; __ not apply specific tariff surcharges other than the temporary surcharges for certain electronic goods that will expire progressively until September 1990; and __ remove all industrial export interventions other than those explicitly required in an Argentine law or in an international agreement or necessary for the maintenance of health and quality standards. Until March 31, 1989, the Government will, furthermore: -- reduce the production coverage of QRs to 15.0; -- reduce the production coverage of industrial exports taxes to 7.5?; and -- bind safeguard measures as well as countervailing duties and anti-dumping duties to the limits on the production coverages of QRs and ad valorem tariffs and on the average tariff rate. Complementing Domestic Industrial Policy Actions 12. The Government recognizes that the effectiveness of its trade policy reform is seriously impaired by: (i) provisions in the various industrial promotion laws that are responsible for high fiscal costs, misallocation of labor and capital, and the replacement of export oriented investments by defensive investments in internal markets designed to capture special tax advantages; and (ii) a lack of administrative control over the system that compounds the fiscal costs and economic distortions and facilitates substantial tax evasion. 13. A thorough reform of the industrial promotion system requires a new unified industrial promotion law as well as changes in the structure of taxation. The Government has worked with the Argentine Congress on a law that would unify the industrial promotion system by abolishing the special provincial and sector regimes. It would further replace specific tax and tariff exemptions by tax credits that can be charged against various tax liabilities, thus avoiding serious allocative distortions. In addition, the Government has taken the following administrative measures: (i) the application of a more transparent and rigorous project ranking methodology to applicants for benefits, thereby increasing investment efficiency and reducing in half the authorized fiscal benefits; (ii) improvement in the  - 67 - ANNEX V Page 5 of 5 effectiveness of the tax oollection associated with the deferment scheme through the introduction of a system of real warranties (Resolution 2794187); (iii) reduction of fiscal cost and closing of tax loopholes through the elimination of the freely transferable tax credits on sales of the suppliers to promoted firms with exemptions on the value-added tax on purchases (Decree 575188); (iv) eliminating the indirect tax reimbursement for suppliers from the mainland to the island of Tierra del Fuego. 14. The fiscal costs and the economic distortions of the existing industrial promotion system can only be contained through improved administrative control. In this context, the Tax Revenue Service is currently investigating all promoted firms and is preparing reports to the national and the provincial authorities of application. The Government will, until March 31, 1989s (i) accelerate the program of investigations conducted by the Tax Revenue Service; (ii) strengthen the auditing functions of SICE which is the Authority of Application for the special sector regimes and for all but five provinces; (ill) make public a transparent set of auditing criteria; and (iv) submit a plan of action to deal with all cases of irregularity detected by the Tax Revenue Service.  hI -.-P---- iI il '?Il'ijj{ ..~~~~~~~~~1 ..... _ iliii'