Argentina - Second Agricultural Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY d-A/ 2 Z'? 70 - Report No. 7261-AR STAFF APPRAISAL REPORT ARGENTINA AGRICULTURAL CREDIT PROJECT II May 17, 1986 Agricultural Operations Division IV Latin America and the C riboean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY UNIT - AUSTRAL (A) As of September 25, 1987: USS1.00 - A 2.60 A 1.00 - US$0.38 On OC.toier 14, 1987 a two-tier excharnge rate system announced: Commercial fixed rate (official): US$1.00 - A 3.50 A 1.00 - US$0.29 ?c*e market rate (December 1, 1987): US$1.00 - A 4.19 A 1.00 - USS0.24 FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES The metric system has been used throughout the report. ABBREVIATIONS BANADE National. Bank of Development (Banco Nacional de Desarrollo) BNA Bank of the Argentine Nation (Banco de la Nacion Argentina) GOA Government of Argentina IDD Inter-American Development Bank IICA Inter-American Institute of Cooperation for Agriculture (Instituto Interamericano de Cooperacion oara la Agricultura) INTA National Institute of Agricultural Technology (Instituto Nacional de Tecnoloaia Agropecuaria) JNC National Heat Board (Junta Nacional de.Carnes) JNG National Grain Board (Junta Nacional de Granos) PPF Project Preparation lacility PRONAGRO National Program for Agriculture (Proarama Nacional Agrolecuario) SAGyP Secretariat of Agriculture. Livestock and Fisheries (Secretaria de Acricultura. Ganaderia v Pesca) SGEP Public Enterprise Auditor (Sindicatura General de Emoresas Publicas) SOE Statement of Expenditure  FOR OMCLAL USE ONLY ARGENTINA AGRICULTURAL CREDIT PROJECT II Table of Contents .Page No. 1. LOAN AND PROJECT SUMMARY ......... ............... 1 1I. TMc AGRICULTURAL SECTOR. 3 Agriculture in the Economy. 3 Principal Non-Financial Institutions in the Sector . . 4 The Banking Sector. 5 Agricultural Credit. 6 Bank of the Argentine Nation (BNA). 6 IBRD's Experience in Lending for Agriculture ... ......... 7 III. THE PROJE - ....... 8 Origin and Rationale for Bank Involvement ... .... 8 Project Objectives and Description ....... 9 Project Implementation ....... 9 Lending Terms and Conditions ....... 10 Project Costs and Financing ....... 11 Procurement ....... 12 Disbursements ....... 12 Accounting and Audits ....... :3 Reporting ....... 13 Financial Analysis of Investment Models .. ..... 14 Project Risks ....... 14 Environmental Impact ....... 15 IV. SUMMARY OF AGREEMENTS REACHED AND RECOMMENDATION ....... 15 ANNEXES 1. Bank of the Argentine Nation ....... 17 2a. Credit Regulations ....... 35 2b. Selection Criteria for Financial Intermediaries ....... 47 2c. Participation Agreement ....... 51 3a. Monitoring and Evaluation Component Costs ... .... 58 3b. Consultant Draft Terms of Reference ....................... 59 4. Flow of Funds ............................................. 61 5. Structure of Interest Rates ............................... 62 6. Estimated Schedule of Disbursements ....................... 63 7. Key Indicators and Reporting Requirements ................. 64 8. Illustrative Investment Plans ............................. 66 9. Selected Documents and Data Available in Project File .... 77 Map: IBRD 20837 This report is based on the findings of an appraisal mission that visited Argentina from November 9 to 27, 1987. This mission was comprised of Messrs. W. Nickel (Mission Leader), M. Wilson,.J. Parker, A. Guzman, and M. Hagerstrom (Consultant). The mission was jointly conducted with IDB whose special team included Messrs. J. Fernandez (Mission Leader), A. Vives, and F. Gonzaga. This document has a restricted distribution and may be used by recipients only in the performance of their oMcial duties. Its contents may not otherwise be disclosed without World Bank authorization.  ARGENTINA AGRICULTURAL CREDIT PROJECT II I. Loan and Project Summary Borrowers Bank of the Argentine Nation (BNA). Beneficiaries: Sectoral Sub-Borrowers. Amount: US$106.5 million equivalent. Terms: Fifteen years, including five years of grace, at the standard variable interest rate. On-lendin2 Terms: The Borrower would make available loan funds to participating financial intermediaries in US dollar- denominated australes and would charge a spread to cover the cross-currency exchange risk on IDB and IBRD loans. BNA, in a second-tier capacity, would rediscount 82Z of all subloans approved by first-tier banks (to be financed equally by IBRD and IDB). Sub-borrowers would contribute at least 15Z of investment cost financing. Interest rates to sub-borrowers would be variable and positive in real terms. Principal would be adjusted by agreed indices to maintain value. Subloan-specific terms and conditions, consistent with agreed credit regulations, would be negotiated between participating financial intermediaries and their clients. The Government would cover any deficiency in cross-currency risk provisions during amortization of the IBRD and IDB loans. Project Obiectives: The project would increase agricultural growth through modernization of farm machinery, livestock development, and adoption of cost-effective, efficient technology consistent with growth, diversification, and soil conservation. It would also foster increased participation and efficiency in agricultural lending through the apex operation proposed. Project DescriDtion: The project would include: (a) a general line of credit to finance investments and complementary working capital for such items as modern machinery, livestock development, land improvements, orchard planting, land development, storage, and packing facilities; and (b) monitoring and evaluation of project impact.  -2- Project Benefits: Principal project benefits would include (a) increased cost effectiveness and efficiency in production fron, machinery modernization and technological changes; (b) greater product diversification; (c) higher efficiency in product handling and storage; axid (d) so,il conservation. These would result in higner incomes and export earnings. Institution-building would take place through apex lending and through involvement of private and provincial banks in agricultural investment financing. Project Risks: (a) Uncertain credit demand, complicated by high cost of non-subsidized credit and difficult macroeconomic climate. This risk is mitigated by more stable world prices, reduced export taxes, the urgent need to replace worn-out farm machinery, very limited alternative investment credit, and the flexible credit terms of this project linking adjustment of principal to products of sub-borrowers. Illustrative investment models indicate credit would be financially attractive. Demand surveys supTpirt the proposed project size; and (b) possible periodic liquidity shortages within participating banks, mitigated by newly reduced reserve requirements. Estimated Costs: Local a/ Foreign Total -US$ Million --------- A. Investment Credit 283.20 70.80 354.0 B. Monitoring and Evaluation 0.75 0.75 1.5 Total 283.95 71.55 355.5 a/ Net of taxes and duties. Financing Plan: (US$ million) IBRD 106.5 IDB 105.0 Participating Financial Intermediaries 45.0 Sub-borrowers 99.0 Total 375 Estimated Disbursements: IBRD FY: 1989 1990 1991 1992 1993 1994 1995 1996 ------------------------ USS Million ---------------------- Annuala/ 16.5 15.4 19.3 20.2 16.8 10.9 5.6 1.8 Cumulative 16.5 31.9 51.2 71.4 88.2 99.1 104.0 106.5 a/ Includes initial deposit in Special Account of US$10.5 million equivalent. Economic Rate of Return: Not Applicable Map: IBRD 20837  -3- II. THE AGRICULTURAL SECTOR Agriculture in the Economy 2.1 The agricultural sector generates about 702 of Argentina's foreign exchange earnings, 16? of GDP, and 17? of employment. The country's diverse agroclimatic base permits production of a wide range of agricultural commodities that enables self-sufficiency in most foodstuffs as well as raw materials for the nation's agroindustries. The country has a variety of climatic conditions ranging from subtropical to cold, but lies mainly in the temperate zone. Cereals and oilseeds represent principal crop activities, accounting for about 902 of cropped area. Beef, the dominant livestock activity, has declined in recent years due to normal production cycles, loss of export markets, and diminished competitiveness with double-cropped wheat and soybeans. In the recent past, the sector has pedformed better than the general economy and in fact has acted as a brake to a general decline. While overall GDP fell by an annual average of 2.12 over the 1980-85 period, agriculture increased by an average of 2.3Z. Crop output fell in 1986; farmers compensated to bolster cash flows to some degree by continuing ;attle herd liquidation. While 1987 was another year of low output, better weather and stronger prices (para. 2.3) appeared to have had a favorable impact on spring planted area (October-December) of selected crops, in particular, soybeans. 2.2 Constraints to Growth. Despite some technological advances, a well-developed input distribution system, and a highly competitive environment for agricultural product marketing, the sector has been performing well below potential. Because of general economic uncertainties, low incentives, low world prices, and frequently high positive real interest rates, farmers have generally used minimal fertilizer and other chemicals, and also because of scarcity of investment capital have not replaced and modernized their farm machinery pool. In 1987 the average age of tza:tors in use was almost 18 years, with per unit area coverage greater than would be expected for a country with Argentina's level of agricultural development. Accordingly, farmers traditionally have opted for low-risk, low-input technologies that have led to foregone productivity and depletion of soils. In addition, recent declines in world prices and loss of markets for Argentina's principul exports--grains and beef--have revealed a serious vulnerability and a need to diversify production and exports where possible while boosting efficiencies in farming systems where cereal-oilseed rotations are to be maintained. Agricultural Policy. Government (GOA) has given priority to stimulating agricultural production and exports as an important element to economic recovery. To counter deterioration in farmgate prices, GOA has reduced export taxes even faster than agreed under the Bank-financed Agricultural Sector Loan (paras. 2.18-2.19). For the 1986-87 crop season export taxes were reduced to a weighted average of 52X of May 1985 levels, compared with 70? required for Sector Loan second tranche release. Further reductions, virtually to zero, were announced in July 1987. It has also adopted a medium-term agricultural development program (PRONAGRO) to establish sectoral priorities and strategy. PRONAGRO defines the following secLoral objectives: (a) increase production of cereals and oilseeds; (b)  expand agricultural exports; (c) develop regional economies; (d) generate employment; and (e) encourage natural resource conservation. It proposes distinct, complementary strategies in the Pampa and non-Pampa areas (Map No. 20837) bolstered by selective nationwide initiatives. 'in the Pampa, the area of most intensive and productive agriculture. PRONAGRO also proposes concentration on cereal and oilseed developmert through technological improvements and agroindustrial development to capture more value-added in exports, increased investment in grain storage, and expansion of the cultivated Lrea. The latter activities would be associated with some shift of livestock production to less productive, non- Pampa areas with concomitant upgrading of livestock technology. In the non-Pampa zone, PRONAGRO also proposes expansion of traditional and higher- value activities, opening new areas for cultivation of grains and other exportable items, agro-based infrastructure, and integrated rural development. National initiatives geared to complement zonal programs would include: encouraging greater use of fertilizer and herbicides, enhancing agricultural research and extension efforts, fostering better crop rotations and soil preparation practices to conserve soil textures and productivity, upgrading meat processing and storage facilities, and recapitalizing the banking sect4r to enable substantially higher and vitally needed private investmeat in agriculture. Complementary rail and deep-water port development programs are underway to enhance efficiency in transport, handling, and export. Principal Non-Financial Institutions in the Sector 2.4 The Secretariat of Agriculture. Livestock, and Fisheries (SAGYP) is responsible for establishing and implementing agricultural policy. SAGyP is administratively within the Ministry of Economy. SAGyP ;a receiving assistance under the Bank-financed Public Sector Management Technical Assistance Project (Ln. 2172-AR) to design and implement a sectoral information system, strengthen investment programming, and establish a system of project monitoring and evaluation. Under SAGyP's purview is the National Institute of Agricultural Technologv (INTA), Argentina's principal agricultural research agency. Since April 1984 INTA has been financed by a special surcharge of 1.52 on agricultural exports. INTA is receiving assistance from the Inter-American Development Bank (IDB) for a research and extension project. In additiorn to its regular technical role in disseminating technical publications, INTA'i research activities serve as an important resource for private and public extension technicians who service producers and producer organizations. 2.5 The National Grain Board (JNG), an autonomous agency of S.&GyP, establishes grading systems and marketing regulations for the grain trade, administers and manages public grain elevators and storage facilities, and participates in domestic and foreign trade. JNG was the sole buyer and exporter of major grains in the mid-1970s until GOA liberalized the grain trade and shifted emphasis to development of private marketing. JNG nonetheless is authorized to operate in the domestic market to ensure adequate domestic supplies and to meet government-to-government commitments. JNG can also fix support prices for grain, but has generally limited this activity. GOA is now contemplating a future restructuring of JNG involving privatization of JNG grain elevators. modernization of its commercial activities, and streamlining and strengthening of institutional capacity, for which it has requested IBRD assistance.  - 5 - 2.6 The National Meat Board (JJC) is an autonomous agency of SAGyP with control and service functions in cattle, pig, and sheep slaughter industries. It has responsibility for sanitary control of slaughter facilities, livestock yard-sale supervision, meat classification, export quality control, live animal and meat statistical and market information, and industry economic investigation A slaughterhouse levy of 12 of animal v#lue provides most of the resources required to run JNC. which receives no budgetary allocation. 2.7 Argentina is fortunate to have a highly educated and talented cadre of c'vil servants assigned to agricultural institutions. The change to civilian authority in December 1983 and the major economic crisis with which the new government was confronted, however, have caused dislocations In staffing, eelays in defining priorities for economic and soctoral development, a serious lack of public investment funds, and limited resources to attract and provide incentives to public officials. The latter, unfortunately, has resulted in short tenures in key positions with associated policy and personnel disruptions. The Bankina Sector 2.8 In the last 15 years, Argentina's banking sector has been subject to extreme instability and drastic policy reversals and has operated in an overall framework of macroeconomic instability. This situation has created a weakened sector characterized by high real interest rates, large spreads, and segmentation of credit lines. The sector suffers from low operating returns due to high administrative costs and weak loan portfolios. Prudential regulation of the banking system, a responsibility of the Central Bank, is inadequate in many areas including accounting rules on accrual of interest, recognition of losses, information disclosure, supervision of public banks, and the intervention and liquidation of problem banks. Since 1980, 77 banks and other financial institutions, all private, have been either intervened or liquidated. 2.9 The Central Bank has the key role in allocating credit within the bankirng system. It used high reserve requirements and forced investments to appropriate the equivalent of 66Z of sector deposits as of March 1987. Much of these funds were then recycled mostly to public banks in the form of Central Bank rediscount lines for mandated purposes. Since March 1987 the Central Bank has been steadily reducing its rediscount credit lines to the banking sector. Bank of the Argentine Nation (BRA) has been the largest net provider of deposit funds to the Central Bank, and its use of rediscounts has dropped in proportion to the Central Bank's ovez.ll reduction. 2.10 The Banking Sector Adjustment Loan (Ln. 2923-AR), approved by the Board on March 29, 1988, has the following ob'ectives: (a) increase confidence and deposit mobilization; (b) improve the allocation of credit; and (c) reduce the cost of credit. The proposed Agricultural Credit Project II supports these efforts by establishing a rediscount facility for the banking sector independent of the Central Bank. This credit would be allocated by market demand ani by the efficiency of financial intermediaries to provide it.  Agricultural Credit 2.11 As of end-1986, commercial banks controlled 76Z of banking sector assets, down from 822 in 1983. The 158 domestic private banks had the largest share (332) of commercial bank assets, followed by 25 provincial banks with a 262 share, and federal government banks with 192. About 1OS of total banking credit was directed to the agricultural sector in 1986, down from 13.52 in 1982. BHA has been the single largest lender to the sector with a share of 19Z in 1986. up from 172 in 1984. 2.12 Financial assistance to the agricultural sector during the past 20 years has mainly been for short-term credit. Madium- and long-term credit has been dependent on the availability of funds from multilateral financial entities, chiefly IDB, or derived from suppliers' credit or rollover of short-term financing. BHA is currently implementing two projects in the sector, one assisted by the Bank (para. 2.17) and the other, by IDB. The four-year IDB-assisted project (USS1SO million) provides credit for farm machinery, livestock investments, fertilizers, and herbicides. The IDB loan is currently 752 disbursed and, with recent strengthening of farmgate prices, the project is expected to be completed before its 1989 closing date. In general, however, there are insufficient resources in the banking sector to meet the investment needs of agriculture. Bank of the Araentine Nation (BNA) 2.13 BNA, in addition to being the largest bank in the country, has been a main channel of credit to the agricultural sector along with provincial bdanks. It operates nationwide with 562 offices, and has 20 offices abroad. Its operations are conducted in both local and foreign currencies. As of June 30, 1987 its outstanding loan portfolio was equivalent to about US$5,400 million and accounted for about 602 of its total assets. This portfolio is composed of loans to governmrfnt entities (612), loans to financial entities (32), and loans to private entities (36?). About 722 of its outstanding loan portfolio consists of overseas operations primarily for government entities. The remaining 282 of loans has been granted locally, with agriculture accounting for 402, industry and commerce 202 each, and other credit operations the remaining 202. GOA has recently indicated a desire that BHA specialize more on agricultural operations in the future and reduce participation in lending to other sectors, the responsibility for which would be assumed by other national specialized banks. BNA would become the only government bank dealing 'lith the sector. 2.14 BNA has been a relatively efficient and profitable institution. It has had profitable operations si$ice 1981 and earned over 72 on its net worth at end.-1986 after inflation adjustments. While its administrative costs are high by international standards, averaging 14Z of total deposits in 1986, this ratio compares favorably with the average for domestic private banks in Argentina of 22Z. BRA has a staff of 19,400 employees, down 72 from 1984, and its administrative costs were 7.92 of total average domestic assets in 1986. flie domestic banking system's high administrative costs result from high inflation which makes operating costs rise faster than intermediated resources. The economic uncertainty has caused extremely short maturities of financial contracts with increased rollover and administrative burden. BNA is addressing the latter problem with a program to computerize its entire branch banking system over the next few years.  2.15 As with all Argentine banks, BNA has experienced a deterioration in its loan portfolio during the past two years. reflecting poor domestic economic conditions. BNA's irregular loansl equaled 20.3Z of its domestic private sector loan portfolio on Juuie 30, 1987, compared to an average ratio of 16% for domestic private banks and 37Z for provincial banks. Provisions for bad debts were 6.42 of its domestic private portfolio on the same date, compared with an average of 4.32 for domestic private banks. These provisions were sdfficient to cover 32S of irregular loans. Although many of BNA's arrears ratios are less favorable than the avetages for private banks, BNA's provisions for loss are relatively larger. The arrears situation of BNA's governmeut-owned clients is unclear; BNA refinances them without classifying such loans as arrears becauise they are unconditionally guaranteed by GOA. 2.16 From a solvency point of view BNA's financial position is acceptable. GOA is BNA's owner and the guarantor of its public sector assets, which amount to 60? of its loan portfolio. Domestic private sector loans in a:rears, less provisions for loan losses, amount to 212 of BNA's net worth as of end-1986. BNA has a high level of liquidity and its deposit liabilities are matched by loans of similar maturities. As of June 30, 1987, BNA's total liabilities were seven times its net worth. A detailed review of BNA and its financial condition are presented in Annex 1. IBRD's Experience in Lending for Agriculture 2.17 Past Bank lending to agriculture has been sporadic because of periodic economic and sectoral difficulties. In recent years sectoral lending has been limited to three projects and one sectoral adjustment loan. Approved in 1967, the Balcarce Livestock Development Project (Ln. 505-AR) was designed to en:ourage adoption of new technology in pasture production and management and in animal health practices. This project was imp.emented over the 1968-80 period--a span that saw high rates of inflation, eztreme shifts in livestock policies, swings in the cattle cycle, frequent changes in credit policies. and economic policies non- conducive to sectoral investment. An Agricultural Credit Project (Ln. 1564-AR) was approved in May 1978 to provide medium- and long-term credit for on-farm investments. This loan was cancelled in 1980 without disbursement because of: (a) tmfavorable environment for investment due to high inflation and overvaluation of the local currency, (b) large inflows of competitive low-cost capital from foreign commercial banks. The ongoing Grain Storage Project (Ln. 1!21-AR), expanding nationwide storage capacity and complementary rail and port transportlhandling facilities, contains a credit component for private investments in grain storage and related facilities. BNA has successfully implemented this component. 2.18 In April 1986 an Agricultural Sector Loan (Ln. 2675-AR) was approved to support sectoral adjustments fostering increased agricultural production and exports. The policy package sought to: (a) reduce export taxes on agricultural products; (b) implement compensatory measures to l/ Irregular loans, as defined by the Central Bank, include loans past due more tha.n nine days, loans to potentially insolvent clients, as well as loans under legal proceedings, bankruptcy, or liquidation.  8 - preclude deterioration of fiscal revenues, including introduction of a federal land tax; and (c) rationalize import tariffs and regulations on agricultural inputs. In addition, a number of studies are being funded under the loan and Ldministered through UNDP to improve sectoral planning and performance. including development of producer-oriented market intelligence services within JNG and JNC. 2.19 GOA has exceeded reductions in export taxes projected under the Sector Loan becavuse of deteriorating world commodity prices. However, while much of the technical basis for the federal land tax has been established (cadasters, soil classifications), passage of required legislation has not yet taken place. Quantitative restrictions on imports of tractors and other agricultural machinery were removed in May 1988. The surcharge on imports of agricultural chemicals has not been removed, but will be addressed vithin the context of the general tariff structure under a proposed Trade Sector Loan II (FY89). 2.20 Other projects affecting agricultural development have been funded by the Ban4 Group. As described in para. 2.4, SAGyP is a beneficiary of the Public Sector Management Technical Assistance Loan (Ln. 2712-AR) for US$18.5 million seeking to strengthen GOA's general management of the economy. In April 1987 the Bank approved a US$125.0 million loan to support a Small- and Medium-Scale Industry Credit Project (Ln. 2793-AR) being implemented by BANADE. This US$250.0 million project is financing working capital and investments in, inter alia, agroindustries, wood processing, and fishing and fish processing. In June 1987 the Board approved a US$30.0 million IFC loan to support an agri-business credit line implemented by Banco Rio, a major commercial bank in Argentina; this line covers working. capital and investments to modernize and expand port grain-handling facilities, refrigerated seed silos, cold storage, cheese factories, dehydration plants, and hide processing facilities. A recently completed Second Railways Project (Ln. 1677-AR) assisted in rehabilitating the rail network and upgrading rolling stock and the locomotive fleet, thereby improving transport of agricultural goods. The Bahia Blanca Port I Project (Ln. 2805-AR) includes rehabilitation of existing grain storage infrastructure as a first phase in deep-water port development. The Banking Sector Adjustment Loan (Ln. 2923-AR) aims to increase deposit mobilization, improve credit allocation, reduce the cost of credit, and provide technical assistance in various aspects of bank supervision (para. 2.10). IIS. THE PROJECT OriKin and Rationale for Bank Involvement 3.1 The proposed project was prepared by SAGyP with assistance from the Inter-American Institute of Cooperation for Agriculture (IICA). This preparation effort was supported by two PPFs. Three Bank preparation missions visited Argentina in February, April-May, and August-September 1987, the last two jointly conducted with IDB, the proposed cofinincier. The project was appraised by the Bank in November 1987 with IDB participation. Bank loan negotiations took place in Washington during February 16-19, 1988. Mr. Ramon da Bouza led the Argentine delegation.  - 9 - 3.2 The project would be consistent with the Bank's efforts to assist Argentina to boost agricultural growth, erpand export earnings, and foster structural adjustment. It would also be consistent with recommendations made in the most recent CEM2 advocating a moderate increase in investment with not.-inflationary financing and resource mobilization to complement broad st.-uctural reforms. The project would aim to increase growth in a vital sector with underutl1ized potential and substantial importance for foreign exchange earnings. By modernizing the machinery and adopting newer technology, Argentine agriculture is expected to become more efficient and cost-effective. In addition. the development of an apex lending operation would directly support an important objective of the proposed banking sector adjustment operation. A further objective of the banking sector loan is to restrict the growth of Central Bank rediscounts to credit institutions. The proposed project would channel all its funds at cost through financial intermediaries at the same time that the Central Bank ls reducing its rediscounts for the agricultural sector. Proiect Obiectives and Description 3.3 The project would increase agricultural growth through modernization of the farm machinery pool, livestock development, and adoption of cost-effective, efficient technology consistent with growth, diversification, and soil conservation. In this context, the project would provide needed investment capital to the sector. The project would attempt to draw private and provincial banks into investment lending for the sector through the proposed apex lending operation. 3.4 To accomplish these objectives the project would include a nationwide general line of medium- and long-term credit. This would finance such investments as modern agricultural machinery, on- and off-farm grain storage facilities, land improvements, orchard establishment, livestock development, small-scale agro-processing facilities, and short- term inputs complementary to investments. The project would also include a monitoring and evaluation component to track the credit flows and to provide feedback to SAGyP planning units establishing sectoral policies and priorities. Pro ect Implementation 3.5 The credit line would be implemented by BNA and by participating private and provincial banks. BNA would comit loan proceeds over a four- year period through a rediscounting unit to be established within its Finance Department. This department would act as liaison between the Bank and BRA. It would have the functions of a second-tier bank, rediscounting subloans granted by participating financial intermediaries including BNA in its additional capacity as first-tier bank. Participating provincial and private banks, as well as BHA's first-tier branches, would grant subloans under conditions included in Credit Regulations (Reglamento de Credito). A draft of such regulations was aRreed at negotiations (Annex 2a). Specific functions, responsibilities, and modus operandi of BNA's rediscounting unit, together with administrative and technical support needed for its efficient operation, were #greed at neaotiations. Confirmation that this 2/ IBRD, ARGENTINA: Economic Recovery and Growth, No. 6467-AR, May 1987.  - 10 - unit has been duly established would be a condition of loan effectiveness. Prior to signature of subsidiary agreements with participating banks, the institutional capability of each financial intermediary would be evaluated by BNA's rediscounting unit on the basis of eligibility criteria agreed at negotiations (Annex 2b). A draft participation agreement between BNA and a participating financial intermediary was agreed at negotiations (Annex 2c). Assurances were obtained at negotiations that BNA as second-tier bank would make every effort to enroll other banks as first-tier banks in the lending scheme proposed. During project preparation and appraisal ten private and provincial banks were contacted to assess their interest in participation. Based on these interviews at least five retail banks other than BNA are expected to participate under the terms envisaged (paras 3.7-3.8, Annex 5). 3.6 SAGyP would implement the monitoring and evaluation component, for which SAGyP would sign a subsidiary loan agreement with BNA to receive loan funds. A draft subsidiary loan agreement was reviewed at negotiations and necessary revisions agreed. Presentation to the Bank of the signed subsidiary loan agreement would be a condition of disbursement for the component. SAGyP proposes to strengthen its Monitoring and Evaluation Unit to assume these incremental responsibilities related to the project through short- and medium-term training of SAGyP staff by consultants. Detailed cost estimates for this component are presented in Annex 3a, and draft terms Pf reference for required consulting services are found in Annex 3b. Lending Terms and Conditions 3.7 Second-Tier. The Borrower would be BNA, which would assume the foreign excharge risk of the proposed loan. BNA would on-lend proceeds of the proposed IBRD and IDB loans in dollar-denominated local currency by rediscounting 822 of subloan amounts granted by financial intermediaries (para. 3.13). BNA would charge a variable interest spread to cover its cost of funds, administrative expenses, credit risk, as well as cross- currency exchange risk. Given the uncertainty of the precise cross- currency risk, reflecting the fluctuations of exchange rates and composition of the basket of currencies in which IBRD and IDB loans are denominated, the spread for such risk, initially to be set at two percentage points, would be reviewed every six months to determine if the margin remains adequate. It was agreed at negotiations that BNA would open a special Currency Risk Fund by May 31, 1989 into which payments of the cross-currency exchange risk margin would be placed. This fund would be administered in accordance with a Currency Risk Regulation, acceptable to the Bank, to be issued not later than February 28, 1989. The objectives and management principles of this fund were discussed at negotiations. BNA plans to produce a draft Currency Risk Regulation by end-July 1988 for subsequent review with a Bank supervision mission. If the funds in this account prove insufficient to meet the actual cross-currency obligation of the Borrower, GOA would compensate BNA for any deficiency. Such cover would be governed by a Currency Risk Agreement between the Borrower and GOA. It was agreed at negotiations that such an Agreement would be entered into by May 31, 1989. GOA's commitment to supply such cover is provided for in the Guarantee Agreement for the loan. 3.8 First-Tier. Participating financial intermediaries, including BNA as a retail bank, would receive US dollar-denominated local currency funds  - iI - from the second-tier at a cost 2-4 percentage points higher than IBRD's lending rate (Annex 5). Each first-tier bank would have the flexibility to tailor spreads on subloans to individual clients and their investments, taking into account different administrative costs, credit risks, and the indices chosen to maintain the value of principal. These indices could include the: (a) official Austral-US dollar exchange rate; (b) general wholesale prices; (c) general wholesale crop prices; (d) general wholesale livestock prices; and (e) wholesale crop-livestock prices. A first-tier bank willing to use (b)-(e) above would be assuming a funding risk, while final borrowers might be attracted by an alternative which matches a commodity they produce. It is anticipated that first-tier banks would need an average spread of about three percentage points, implying a cost of about 14Z p.a. real interest for project credit. Using alternative (a) above, this rate would be about two percentage points higher than the one currently charged by private banks in Argentina using IFC credit lines for agri-businesses at similar maturities. The two percentage point difference would be used by BNA to provide for the cross-currency exchange risk (para. 3.7). Schematic presentations of the proposed flow of funds and the structure of interest rates are given in Annexes 4 and 5. 3.9 Eligibility criteria for subloans specified in the Credit Regulations would include, inter alia, satisfactory technical, financial, and environmental feasibility. Subloans would be appraised on the basis of investment plans with assistance where necessary from private extension technicians, the cost of which could be capitalized into subloans. Thresholds for Bank/IDB review and approval of subloans would be specified in the Credit Regulations (US$1.0 million for individuals and US$2.5 million for cooperatives or pro-.acer associations). Ihe Bank and IDB would also review the first three subloans made by BNA over US$100,000 equivalent and the first subloan made by each of the other participating financial interiediaries over US$100,000 equivalent. Basic parameters specified in the Credit Regulations, such as BNA intermediation spread minima and maxima and the set of indices for maintenance of principal value, would be reviewed every six months. Proiect Costs and Financing 3.10 Project cost, excluding taxes and duties, is estimated at US$355.5 million equivalent, of which about 20? represents foreign exchange costs. This total would consist of credit-assisted investments (US$354.0 million) and a monitoring and evaluation component (US$1.5 million). 3.11 It is expected that the Bank and IDB would jointly finance the project's credit component. Monitoring and evaluation would be financed only by the Bank (para. 3.13). Regarding credit, retail banks would finance about 12.5? of the project (18? of subloan amounts), and sub- borrowers would finance at least 15? of each subproject and on average 282 of the project. The Bank and IDB would each cover about 30? of total project costF. The aggregate level of external financing (60?) is considered justified by the chronic shortage of counterpart funds available, in part resulting from heavy external debt servicing, and by the critical need for infusion of investment capital into the banking system. A condition of loan effectiveness would be the reciprocal effectiveness of the IDB loan. The financing plan is summarized below:  - 12 - USS Million Z Sub-borrowers a/ 99.0 27.8 Participating Banks bl 45.0 12.6 IDB 105.0 29.6 IBRD 106.5 30.0 Total 355.5 100.0 a/ Based on historical experience from ongoing IDB credit project where sub-borrowers have contributed on average 282 of investment financing. b/ 18.02 of subloans. Procurement 3.12 Goods, survices, and civil works financed with project credit would be diverse and procured by a large number of sub-borrowers. Most of these are expected to be supplied locally. BRA and participating banks would be responsible for ensuring the competitiveness in price and quality ot goods and works procured and their suitability for the purposes intended. For goods and works costing less than US$3.0 million, sub-borrowers would purchase items in the local market according to established commercial practices acceptable to the Bank. Records of procurement by sub-borrowers under such procedures would be reviewed by Bank missions on a random sample basis. For goods or works costing US$3.0 million or more, ICB procurement would be conducted according to Bank guidelines. For the monitoring and evaluation component, purchases of goods would be limited to office furniture, three typewriters, one photocopier, three micro-computers, and two vehicles at an estimated total cost of US$83,000, and would be procured under local procedures acceptable to the Bank. Consultant services, estimated at 14 man-months, would be selected according to Bank guidelines. All ICB procurement and procurement of goods for the monitoring and evaluation component would be subject to the Bank's prior review. Disbursements 3.13 Loan proceeds would be disbursed in about eight years, consistent with the standard disbursement profile for credit projects in the Region. Disbursements would be made against: (a) 41Z of subloan amounts rediscounted by BNA; and (b) 1002 of expenditures for monitoring and evaluation. To enhance the probability of success of the apex lending operation, 20Z of funds under (a) would be reserved for rediscounts from participating banks other than BRA. IDB would also disburse against 412 of subloan amounts (para. 3.7). Separate withdrawal applications for credit rediscounts compatible with agreed Credit Regulations would be submitted to IDB and IBRD. If, for whatever reason, one external lender could not honor a specific withdrawal request, the other could still disburse up to its 41? level. Only expenditures made no more than 180 days prior to the receipt by the Bank of a corresponding financing request would be eligible for reimbursements under the proposed loan. This extension of the Bank's normal 90-day limit would be justified given that the apex arrangement would be new and may initially create delays. A Special Account would be  - 13 - established with an initial deposit equivalent to US$10.5 million. Bank disbursements to replenish the Special Account would be made on the basis of statements of expenditure. Relevant documentation in support of such statements would not be submitted to the Bank, but would be retained by each retail financial intermediary and made available to Bank review missions. An estimated schedule of loan disbursement is presented in Annex 6. The final date for approval of subloan proposals would be Hay 31, 1992 and the closing date, June 30, 1996, which is consistent with the standard profile. Regarding loan repayments, because of the large number of subloans expected under the project and the potential number of participating banks, the use of a composite amortization schedule is impractical. The proposed loan would therefore have a fixed 15-year maturity including three years of grace. AccountinR and Audits 3.14 BNA and SAGyP would maintain separate accounts and necessary supporting documentation to record project expenditures. Financial statements of BNA and project accounts (including the Special Account), would be audited annually in accordance with appropriate auditing principles consistently applied by external independent auditors acceptable to the Bank and with terms of reference approved by the Bank. In the case of BNA, the Public Enterprise Auditor (Siidicatura General de Empresas P4blicas (SGEP)) is considered indeperndent and is currently acceptable to the Bank. BNA would annually require all participating first-tier banks to provide a certification by their independent auditor that the related subloan disbursements were made by the respective banks in accordance with the conditions of its participation agreement with BNA. BNA would provide an annual SGEP-cbrtified opinion for all SOE's presented to the Bank. BNA would submit these avcounts to the Bank not later than four months after the end of each fiscal year. SAGyP's monitoring unit would submit to BNA audited project accounts annually no later than three months after the end of its fiscal year. The independent audit of the latter would be carried out by the National Court of Audits (Tribunal de Cuentas de la Nacion). Reporting ; 3.15 Each financial intermediary, including BNA, would submit semi- annually to BNA's rediscounting unit a report including: (a) amounts committed; (b) number and type of subloans granted; (c) subloan disbursements made; (d) subloan repayments and repayments to BNA; and (e) amounts in arrears. BNA would consolidate this information and submit not ; later than September 30 and Harch 31 of each year to the Bank a semi-annual report on the progress of the project as of June 30 and December 31 of each year. SAGyP's monitoring unit would submit to the Bank progress reports ! not later than February 28 and August 31 of each year. BNA and SAGyP would jointly prepare and submit to the Bank a project completion report not later than six months after the closing date of the proposed loan. The format and content of progress reports were agreed at negotiations. Key * indicators for tracking project progress are presented in Annex 7.  - 14 - Financial Analysis of Investment Models 3.16 To analyze the viability of likely investments and proposed technological improvements and their financial attractiveness to producers, eight illustrative investment plans have been modeled. These include machinery upgrading with improved tillage and fertilization, fruit plantation, dairying, beef and wool production, on- and off-farm grain storage, and fruit packing and storage. Expected financial costs and benefits are based on current domestic market prices. Although recovery of prices from the current low levels is anticipated for most of the commodities concerned, the modeling exercise conservatively assumes no real price increases. Under these assumptions, internal rates of return before financing range between 18Z and 412. Sensitivity tests indicate that the viability of those models in the lowar range of IRRs, in particular machinery upgrading for grain production, would be highly vulnerable to adverse movements in commodity prices or increases in export tax levels. Details of models analyzed are presented in Annex 8. Proiect Risks 3.17 Major project risks include: (a) Demand Risks. To assess likely demand for project credit, a number of surveys were carried out. Specifically, four surveys were conducted before appraisal, with samples ranging from 140 to 790 persons, to assess investment needs in the sector. At appraisal 180 BNA clients were interviewed about likely credit demand under various terms and conditions. The proposed project size was then determined taking these results into account. A conservative approach was adopted considering that: (i) samples of the last survey was representative of only about 50 of BNA's total agricultural clientele; and (ii) potential demand through banks other than BNA was not considered. There is no doubt that the demand for credit may be constrained by the high cost of the non-subsidized credit offered under the project (about 14Z p.a. real interest). Demand for investment credit will also be affected by the confidence prospective borrowers have in the macroeconomic environment, and more specifically, in GOA's ability to stabilize the economy. Despite these uncertainties, the likelihood of project success is enhanced by: ti) the critical need for capital improvementstreplacements; (ii) declining soil productivity; (iii) the extreme scarcity of alternative investment credit in the banking system for the sector (para. 2.9); (iv) the flexible credit terms and conditions built into project; and (v) the high anticipated financial rates of return. (b) Participatini Banks' Liquidity Risks. Legal reserve requirements and forced investments (purchase of Central Bank non-tradable securities) resulting from the currently overregulated banking sector have undermined liquidity levels of financial intermediaries. The Central Bank has recently lowered reserve requirements on incremental deposits to only 3Z. If recent  - 15 - changes in GOA policy succeed in reversing the flight into hard assets (i.e., remonetizing the economy), there should be a corresponding reduction in average reserve requirements and additional liquidity for the banking system. Environmental Impact 3.18 The proposed investments in modern agricultural equipment and specific activities would address entrenched problems in Argentine agriculture such as erosion, breakdown of soil texture, and loss of organic maLtar and fertility. GOA proposes a sound extension program to complement the credit program which would stress conservation tillage, terracing, green manuring, cross-sloping, and contouring. Associated research and extension efforts are being assisted in part under an IDB-financed project being implemented by INTA. GOA is also considering another technical assistance operation to reinforce these activities which it plans to present for external assistance. While good research has been done, communication and coordination with farmers are considered weak. GOA is aware of the problem and has already begun an information program to launch its soil conservation effort. INTA has also recently signed an agreement with a foreign agricultural university to obtain technical assistance in extension and transfer of technology, adaptation of promising experimental results, and further studies in soil conservation. IV. SUMMARY OF AGREEMENTS REACHED AND RECOMMENDATION 4.1 The following agreements were obtained at negotiations: (a) Appropriate credit regulations (para. 3.5); (b) Specific functions, responsibilities, and modus operandi of BNA's re-discounting unit and needed administrative and technical support (para. 3.5); (c) Eligibility criteria for participating financial intermediaries (para. 3.5); (d) Participation agreement between BNA and a participating financial intermediary (para. 3.5); (e) That BNA as second-tier bank would make every effort to enroll other banks as first-tier banks in the lending scheme proposed (para. 3.5); (f) Subsidiary loan agreement between BNA and SAGyP for the monitoring and evaluation component (para. 3.6); (g) Currency Risk Fund to be established by Hay 31, 1989 (para. 3.7); (h) Currency Risk Regulation to be finalized by February 28, 1989 (para. 3.7); (i) Currency Risk Agreement to be signed by May 31, 1989 (para. 3.7); and  - 16 - (j) Content and format of progress reports (para. 3.15). 4.2 Conditions of loan effectiveness would bet (a) Confirmation that BNA's rediscounting unit has been established (para. 3.5); and (b) Reciprocal effectiveness of the IDB loan (para. 3.11). 4.3 A condition of disbursement for the monitoring and evaluation component would be presentation to the Bank of the signed subsidiary loan agreement between BNA and SAGyP (para. 3.6). 4.4 With the above assurances, the proposed project would be suitable for a Bank loan of US$106.5 million on standard terms for Argentina. May 17, 1988.  - 17 - ANNEX 1 Page 1 of 8 ARGENTINA AGRICULTURAL C-EDIT PROTECT II Bank of the Argentine Nation (BNA) Legal Status and Obiectives 1. BNA is an autonomous official commercial bank operating under the legal framework of the laws regulating the Argentine financial system. It was created in 1891 under Law No. 2831 dated October 15 of that year. Its revised by-laws were approved in June 1978 by Law No. 21799. As per its by-laws, BNA's main objectives are: (a) support agricultural production and promote its efficient evolution; (b) facilitate the settlement of rural farmers, and subject to priorities established under available lines of credit, facilitate their rights to land ownership; (c) finance efficient processing of agricultural outputs and their marketing at all levels of processing; (d) promote and support external trade, particularly export of goods, services and local technology, exerting all efforts to promote its growth; (e) take care of all needs of trade, industry, service and other sectors of the economy; and (f) promote a balanced regional development. For the fulfillment of these objectives, BNA was enabled to operate locally and internationally, and in addition to all standard banking activities it is empowered to issue securities and to enter into borrowing agreements in local and in foreign currency. Operations 2. As of December 31, 1986, BNA was operating through 562 branches, including its headquarters in Buenos Aires and 20 offices overseas. In addition, it has eight contact (representatives) offices overseas in cities where no branch offices are yet established. During 1986 BNA represented official and private banks of Argentina in negotiations with the Southern Cone countries in debt to Argentine banks. 3. During the decade 1977-86, BNA has maintained its position as the largest bank in the domestic banking market. BNA's share of the system's total lending remained stable at about 1OZ over the period, while its share of total deposits increased from 14Z to 172 (see Table 1). During 1984-86 BNA's domestic loan portfolio as a share of its total loan portfolio increased from 19Z to 28Z (see Table 6). As of December 31, 1986 domestic loans including accrued interest amounted to the equivalent of US$1,556.6 million. 4. As a response to local economic conditions, most of BNA's domestic lending has been increasingly of a short-term nature. Average turn-over of total domestic lending operations was almost six times/year in 1983 and about 13 times/year in 1986. This is also reflected in the composition of outstanding loan balances at the end of calendar years 1983 and 1986 where  - 18 - ANNEX 1 Page 2 of 8 loans with maturities shorter than one year accounted for 742 and 962 of total domestic loan portfolio, respectively. The preponderance of short- term lending is for commercial operations of 15 days or less. 5. Overseas lending operations are longer-term and constitute the majority of BNA's overall lending. About 402 of this amount had a maturity of less than one year with 202 maturing in more than six years. As of December 31, 1986, the outstanding balances of foreign lending at end-of-year exchange rates were equivalent to about US$4,103 million. The share of overseas lending in BNA's total loan portfolio has declined in recent years. In addition to short-term trade financing, most of these operations involved longer-term financing associated with rescheduling of Argentine government agencies' foreign debts. 6. As of June 30, 1987, BNA had 19,400 permanent staff members (7Z less than in 1984), of which close to 2,000 were in management positions (about 1,050 at headquarters). About 30Z of the staff (including managers) were stationed at headquarters in Buenos Aires. The remaining 70X of the staff were working at the branch offices (an average of 24 staff members per branch office). Although BNA appears over-staffed, rigid public sector regulations on job stability have limited BNA to following a policy of attrition. About 852 of the staff has been on duty for over five years, despite salary levels that are based on public-service salary structure and are below the levels of salaries paid by the private banks (average cost per employee/month as of June 30, 1987 was equ._valent to US$700). 7. Training activities are intensive and appear adequate to the size of BNA operations. Most training is given through its own training institute. Over 2,000 employees per year participated in training courses during the 1984-86 period, and an average of 12,600 hours/year were devoted to training activities. Most training is addressed to updating the staff skills in management as well as financial and banking aspects, including electronic data processing. Organization and Management 8. The current organization structure of BNA (Annex 1, Chart 1) includes its Board of Directors, a general manager, 5 deputy general managers, 16 departmental managers, and over 500 branch managers. The Board of Directors has one president (chairman of the Board), one vice- president, and 10 directors. All members of the Board are appointed by the Executive Power of the Federal Government for a four-year period, and their re-appointment for a second term is allowed. The Central Management level--composed of the general manager, deputy general managers, and departmental managers--is appointed by the Board of Directors. Policy decisions are made by the Board of Directors and implemented by the general manager and his in-line managers. Branch management is quite independent, but compliance with procedures developed by central management are closely monitored. Among the domestic branches there are some with regional responsibilities.  - 19 - ANNEX 1 Page 3 of 8 Lending Procedures 9. BNA's lending procedures, which have been applied under the Grain Storage Project (Ln. 1521-AR), are acceptable for the purposes of the proposed project. Branch managers are allowed to authorize loans and financial transactions up to limits (threstolds) apprcved by central management and revised from time to time. Current thresholds are considered low. Regional managers may approve transactions up to US$75,000 equivalent; and other branch managers, up to US$63,000 equivalent. Central managers have larger approval thresholds, ranging from about US$90,000 equivalent for departmental managers to about US$140,000 for the general manager. 10. First-time clients are required to submit documentation to demo3nstrate their creditworthiness. Clients with established credit require simple verification of their updated financial condition. Loan applications are accompanied by technical justification and documentation supporting the application. After technical scrutiny, the loan is approved by the branch manager or sent for approval by the regional or the central manager as required by the approval thresholds. Disbursement is authorized upon submission of satisfactory guarantee, which could be in the form of collateral (mortgage/fixed assets) or plain signature of notes (or submission of third-party notes). Loans may be granted with or without maintenance-of-value clauses. Interest rates under ths former scheme are determined by the cost of funds, and under the second scheme are usually variable (adjusted monthly) and equal to the market reate, or in some cases slightly lower than market rate if allowed by the cost of funds. Maintenance-of-value adjustments are computed and recorded monthly in the borrower's loan account. Agricultural Credit 11. BNA uses its ezt-nsive system of domestic branch offices to service the needs of the agriculture sector. Since 1973 it has also maintained a parallel staff group of technical specialists (agronomists) to review loan requests originated at the branch office level. About 30 branches with the most agricultural credit operations have an agronomist assigned for this purpose. These professionals report to one of six zone coordinators for administrative purposes and to the appraisal division of the central credit department for technical matters. There is also a unit of six technical advisors assigned to the head office for quality control and review of the larger projects. Agronomists are responsible for making appraisal and supervision field visits for loan requests above US$10,000. Below this level BNA employs consultant agronomists from a national pool of 300 for field visits to those clients closest to them. Staff agronomists are also responsible for advising clients on their farm plans, coordinating with sector interest groups, and promoting BNA's credit programs for the sector. 12. BNA has been supporting the agricultural sector since inception. During the past 20 years, it was almost the only source for medium- and  - 20 - ANNEX 1 Page 4 of 8 long-term financing. During this period BNA managed long-term funds made available by the GOA through borrowings from multilateral financial entities, mainly TDB and the Bank, and from bilateral agencies, mainly USAID. These funds were used to finance investments worth about US$630 million, of which about US$240 million equivalent was contributed by BNA from its own resources. As of March 31, 1986 BNA's share of total banking sector loans outstanding to the agricultural sector amounted to 192. 13. BNA's portfolio of loans to the sector has increased significantly in absolute terms from US$184 million equivalent in 1983 to US$339 million equivalent in 1986. The sector's share of BNA's total domestic loan portfolio has also increased from 29Z in 1983 to 39Z in 1986 (Table 2). On average about 83Z of its agricultural loan portfolio over this period financed current expenditures for farm inputs. An additional 9Z on average financed tractors and other farm machinery. Despite the longer-term financing previously provided by GOA and international development institutions, BNA's average maturity of loans for agriculture was only five months in 1986. Accounting and Auditing 14. Current accounting practices in BNA are acceptable for the proposed project. Accounting procedures and records are detailed and cumbersome due to the nature and variety of its operations. Accrued basis of accounting is used. Each branch office does its own accounting. Accounts consolidation at headquarters is done monthly. Due to the hyperinflation prevailing dur.ing the last decade, inflation accounting procedures were established beginning in 1984. Accounts are adjusted for inflation on a monthly basis to reflect changes in wholesale prices. Accounts of branch offices overseas are translated into local currency at exchanges rates prevailing at end of each month. Gains or losses due to inflation adjustments and from currency translation are reflected in the income statements. The switch to inflrtion accounting makes comparison of financial statements prior to 1984 difficult. 15. BNA uses a central computer system for consolidating accounts and providing basic management information. However, most accounting at the branch level and much of the central office accounting analysis are still done by hand. A cost accounting system has yet to be developed as management does not operate under private sector incentives. Never:heless, BNA is striving to improve its efficiency by developing its computer capabilities. In close cooperation with its external auditors and IBM, BNA is implementing a program to computerize all its branch network. A pilot study to computerize three branches has been completed successfully, and BNA plans to convert the others gradually as it gains experience. IBRD and IDB would require BNA under the proposed project to provide financial and operational information on subloans that is not easily available from its present computer system. BNA intends to purchase a micro-computer and software for the exclusive use of the apex unit so it can provide this information.  -21 - ANNEX I Page 5 of 8 16. Internal auditing is conducted by the general auditor (internal) who reports directly to the general manager. He is assisted by two deputy departmentAl managers in charge of two units: regional and specialized audits. Under the former, internal auditors make sure that branch offices are carrying out operations according to procedures set by central management. Under the latter, specialized staff make sure that internal control procedures are adenuae e ad that compliance with institutional policies is adequate. Overall Internal control procedures appear satisfactory. 17. F%ternal auditing is performed by the Public Enterprise Auditor (SGEP) that appoints a full-time resident auditor for this purpose. Since 1984 SGEP has relied primarily on private audit firmsl to conduct the audit of domestic operations and of the consolidation of the private audits of BNA's foreign branches. SGEP's resident auditor coordinates and supervises the work of the private firms and provides a quarterly opinion in accordance with central bank regulations as well as an annual opinion based on generally accepted accounting principles. All have been issued within eight weeks of closing, and the annual audits have been unqualified, except for a minor exception concerning an inflation adjustment instructed by the Central Bank in June 1985 that resulted in a minor undervaluation of assets and equity. 18. The Pank has found these audit arrangements acceptable for previous operations with BNA, and the proposed project would also use them. SGEP's audit of SOEs would follow a new procedure, as BNA would be acting as apex institution above other participating financial intermediaries. BNA will require annually that each participating bank provide certification by their independent auditor that the related subloan disbursements were mada in accordance with the conditions in ita participatory agreement with BNA. BNA would provide a separate SGEP- certified opinion for all SOE's presented to the Bank. Audited project accounts and BNA's consolidated financial statements would have to be submitted to the Bank no latter than April 30 of each of the years in which disbursements of Bank funds are still being made. Financial Position 13. BNA's total assets have grown about 8Z p.a. in real terms (Table 5) over the January 1, 1985 to June 30, 1987 period. High domestic reserve requirements made interbank transaction balances, which are primarily Central Bank reserve accounts, grow at a compounded rate of 282 p.a., and have limited the growth of BNA's domestic loan portfolio to a 1/ The three firms are currently Harteneck Lopez (local representative of Coopers and Lybrand), Gonzalez-Fischer, and Bertora y Asociados.  - 22 - ANNEX 1 Page 6 of 8 compound rate of 4Z p.a. While its total domestic assets have remained about equal to foreign assets (Table 6), their composition is strikingly different. As shown in Table 7, at end-1986 BNA's domestic loan portfolio made up only 34Z of domestic assets, up from 29.71 in 1984. On the other hand, its foreign loan portfolio makes up 87.9Z of its foreign assets. About 122 of domestic liabilities are to Government agencies or companies and 172 to the Central Bank. The latter involve special c.edit lines for Government companies and foreign exchange advances for clients. 20. As of June 30, 1987 about 15Z of domestic branch assets were denominated in foreign exchange, compared with 172 of liabilities and capital. The uncovered difference amounted to US$100 million equivalent. An additional 4! of liabilities and capital are represented by uncovered Central Bank advances of foreign exchange totaling about US$200 million equivalent. BNA's foreign branches operate only in foreign exchange. 21. Almost all of BNA's fixed assets are domestic and make up 10 of total domestic assets and 5.1! of consolidated assets. Fixed assets have been revalued according to the wholesale price index, and it is hard to say that they are currently overvalued relative to market. Wholesale prices have been well below the level of retail prices, and the construction price index has been higher than the wholesale price index since August 1986. The dollar-equivalent value of BNA's fixed assets was US$455 million at end-1986, or US$0.8 million per branch office, which does not seem unreasonable considering the high quality standards of construction preferred by BNA. As a sensitivity test, if BNA's fixed assets were overvalued by 25!, they would be equal to 10 of its net worth. Portfolio Quality 22. On June 30, 1987, ENA's total loan portfolio net of provisions amounted to US$5.35 billion equivalent. About 61S of this total consisted of loans to Government agencies or companies, which are totally and unconditionally guaranteed by the Ministry of Finance. BNA does not appear to have centralized monitoring of arrears that develop on this portion of its portfolio. Such arrears are often rescheduled, and BNA, in accordxa.ce with Central Bank regulations, does not provision for possible losses on GOA-guaranteed loans. About 72! of BNA's loan portfolio is booked through its foreign branches in foreign currency. BNA must account for these loans using the banking reguiations in the country where the branch office is located. Almost 742 of its foreign branch loans have been made to GOA agencies or companies, often to refinance their foreign debts. If foreign banks are required by their own banking regulations to provision against loans made to Argentina, BNA branches in the same countries may be required to do the same. Though BNA's independent auditors currently are not aware of any branches that will be required to provision against these loans, such an occurrence might cause BNA to recognize substantial losses. 23. The remainder of BNA's foreign branch loan portfolio, amounting to about 262 of the total, is made to foreign banks, Argentine private companies, and other South American sovereign clients. BNA reports arrears equal to 1.8! of this portfolio compared to loan loss provisions of 4! as of June 30, 1987. Reported arrears do not include amounts rescheduled and current as of this date.  - 23 - ANNEX 1 Page 7 of 8 24. About US$1.4 billion equivalent, or up 282 of BNA's total loan portfolio, is held by its domestic branch system. An analysis of the arrears situation for the 65Z of this portfolio outstanding to the non-financial private sector is provided in Table 9. Loans in bankruptcy, legal action, or with risk of insolvency made up 1.9Z of this portfolio on Decemnber 31, 1985 and 3.5% on June 30, 1987. This compares favorably to an average ratio of 92 for the domestically-owned private banking system.2 If, those loans in arrears more than 10 days are included, BNA's loans in arrears increase from 1.82 on December 31, 1985 to 20.3Z on June 30, 1987, compared to an average of 162 for private domestic banks and 372 for provincial banks. If rescheduled loans are included, arrears for BNA's domestic private sector loans as of June 30, 1987 increase to 23.92, coz.pared with an average of 212 for domestic private banks and 43Z for provincial banks. Provisions for bad debts were 6.42 of BNA's private sector portfolio as of June 30, 1987, compared with an average of 4.3Z for domestic banks.3 These provisions were sufficient to almost cover loans in ba-kruptcy, legal action, risk of insolvency, and rescheduling, assuming no recoveries from these loans though 522 of irregular loans are covered by preferred collateral. Provisions equaled 27Z of all loans in arrears more than ten days no matter what their status. 25. Loans outstanding to its fifty largest domestic clients amount to 80Z of BNA's net worth as of June 30, 1987. Its top five clients are all Government companies, which together have loans outstanding equal to 332 of BNA's net worth. The remaining 45 clients are mostly private sector with none having loan exposure higher than 3Z of BNA'i, net worth. About 802 of the loan portfolio of this group is covered by preferred collateral. Additionally, BNA has provided contingent guarantees for its clients which are customarily covered by counter guarantees in the form of pledged collateral assets or government guarantees. Outstanding contingent guarantees for its fifty largest clients equaled 1002 of its net worth and were fully counter-guaranteed. 26. As is the case with other banks in Argentina, BNA is exper!encing a deteriorating trend in the arrears position of its domestic loan portfolio. Although BNA's irregular loans as a percent of total portfolio are a little higher than the average for private domestic banks, BNA's provisions are relatively larger. From a solvency point of view BNA's financial position seems strong. As shown in Table 4, total domestic loan portfolio in arrears minus its loan loss reserve amounted to only 21.0Z of net worth as of December 31, 1986. Balance sheet leverage is low with total debt equal to seven times net worth. BNA's liquidity is high with short-term assets double short-term liabilities. As of June 30, 1987 BNA had no need to use Central Bank re-discount facilities to provide liquidity. 2/ Data as of November 30, 1986 as provided in Banking Sector Adjustment Loan July 1987 Bank Mission BTO Report. 3/ Data as of November 30, 1986 as provided in Ibid.  - 24 - ANNEX 1 Page 8 of 8 Financial Performance 27. BNA has beer in a net income position since 1981. Selected financial indicators (Table 4) computed for the years 1985-86 to analyze its performance in its local operations md in its consolidated results (domestic and overseas) show a satisfactory financial performance. Table 5 provides summarized financial statements for the years 1984-86 and as of June 30, 1987, restated to show accounts in constant local currency as of June 30, 1987. Revenues from lending operations were sufficient to cover: (a) the costs of funds; (b) provisions for bad debt; and (c) administrative expenses. The relative size of BNA*s provisions for loan losses seem appropriate, having risen at a faster pace than BNA's loans in arrears. Net inflation adjustments have been consistently negative, therefore reducing BNA's reported net income. 28. Net return on assets has dropped from 1.3? in 1985 to 0.9Z in 1986, but remains healthy. This return converts to a net return on equity of 10.82 and 7.1? in the same years. Although BNA's opera&.L.g spread, the difference between its cost of borrowing and its return on earning assets, increased from 3.6Z in 1985 to 4? in 1986, profitability suffered from an increase in administrative costs, which grew from 2.62 of total assets to 3.4Z during the period. This increase in administrative costs resulted from a catch-up in wages during 1986 to compensate for a drop in wages in real terms which occurred during 1985 (Table 5). 29. The quality of flnancial revenues in the Argentine domestic banking sector is suspect due to the general practice of accruing interest on loans in arrears or rescheduled. BNA's accrued interest on such loans in domestic currency equals 5.8? of domestic financial income and 93? of consolidated net income. Though most of these accruals will probably be collected, provisions for bad debts would cover them by 113?.  -25 - ANNEX 1 Table 1 ARGENTINA AGRICULTURAL CREDIT PROJECT II BNA Share of Domestic BankinR Market Year Lending Deposits (Z Share) (2 Share) 1977 10.2 13.9 1978 9.9 12.5 1979 8.6 101 1980 11.5 12.6 1981 11.4 11.9 1982 10.7 18.0 1983 10.3 14.5 1984 9.6 12.7 1985 11.4 22.0 1986 10.1 17.0 Source: Central Bank, Estado de Entidades Financieras, as quoted in BNA annual report for 1986.  - 26 - ANNEX 1 Table 2 ARGENTINA AGRICULTURAL CREDIT PROJECT II ONA'. Domestic Lendina Operations (Expressed in US$ Million Equivalont) !/ Loans Outstandina at end of Year - Stock 1988 X 1984 X 1985 X 1986 % Agriculture 184.2 29.1 128.4 81.0 194.4 26.0 839.2 89.2 Indus'.ry 162.4 26.7 109.6 26.6 247.8 J8.1 171.2 19.8 Trado 83.6 18.2 ".1 16.0 76.6 10.1 98.2 11.4 Construction 20.0 8.2 4.8 1.2 48.2 5.8 20.7 2.4 Services aI 64.2 10.2 B8.8 8.8 74.6 10.0 41.2 4.8 Energy 26.4 4.2 11.5 2.8 7.1 9.6 4.0 0.6 Mining 2.4 0.4 0.6 0.7 6.0 6.7 1.8 0.2 Othor c/d/ 89.4 14.1 56.7 18.7 100.9 18.5 188.4 21.8 Total 682.6 100.0 418.8 100.0 748.5 114.7 864.7 100.0 Aariculturo Loans Outstanding - Broakdown by end use 1983-1986 1988 % 1984 X 1986 U 1986 X Current Costs 152.2 82.6 90.4 77.4 177.6 91.3 267.4 78.8 Improvements 6.6 8.8 6.6 6.1 5.8 2.7 8.9 2.8 Tractors 6.7 8.6 8.9 6.9 4.1 2.1 28.5 7.8 Implements and Vohielea 6.4 8.6 5.6 4.4 2.4 1.2 27.4 8.1 Land Aequisition 8.4 1.8 8.8 8.0 1.1 .6 .8 .1 Storage Facilities .1 .1 .1 .1 .1 .1 .1 .1 Other 8.8 4.8 4.1 8.2 8.9 2.0 8.7 2.8 Total 184.2 100.0 128.4 100.0 194.4 100.0 889.2 100.0 a/ Exchange rates (A per US81.00): 198 = 0.02827; 1984 a 0.17881; 1986 m 0.801; 1988 = 1.269. b/ Includes loans to financial institutions. c/ Includes very short-term financial transactions (i.e. purchase of drafts, current account overdrafts). / Includes transactions explained in g/ above, amounts due and not paid within 10 days, rescheduled loans, and loans In arroears.  - 27 - ANNEX 1 Tabl- B ARGENTINA AGRICULTURAL CREDIT PROJECT II Agriculture Loans Outstanding for 1986 Breakdown by End Us and Type of Forming (Exproessd In USS Million Eqdivalont) Mixed CrOD Livestock F rmino Foretry Total Current Costs 164.4 60.6 60.6 1.9 267.4 Improvements .4 8.8 .2 -- 8.9 Tractors 28.0 .5 8.0 -- 26.5 Impiements and Vehicles 21.8 .1 5.9 -- 27.4 Land Acquisition .1 -- .2 -- . Storage Facilities -- .1 -- -- .1 Other 6.5 1.4 .76 -- 8.7 Total 215.7 60.9 60.8 1.9 889.2  - 28 - ANNiEX 1 Tablo 4 ARGENTINA AGRICULTURAL CREDIT PROJECT II BNA - Performance Indicators DomesticO rations Consolidated 12/a1/86 12/31/86 12/31/8S 12/18 Solvency Loans In Arrears/Net Worth ?j V (X) 14.8 21.0 NA NA Fixed Assets/Net Worth (X) 44.0 40.0 44.0 41.0 Debt to Equity Ratio (times) 3.4 3.2 7.4 7.1 Liquidity Liquidity Ratio t/ (times) 1.6 1.8 2.8 2.0 Acid Test Ratio (times) 1.2 1.4 1.1 0.8 Asset Quality 3/ Loans In Arrears/Loan Portfolio (X) 21.4 27.0 NA NA Provisions/High Risk Arrears 6/ (X) 62.0 68.0 NA NA Provisions/Loans in Arrears (U) 12.5 14.8 NA NA Arrears on Interest/Loan Portfolio (U) 4.0 6.4 NA NA Profitability 7] Not Return on Equity (M) NA NA 10.8 7.1 Operating Spread 4 (N) NA NA 3.6 4.0 Return on Assets (Net) (X) 1.9 1.0 1.3 0.9 Efficiency Loan Flow per Employee (AxlO8) 0.2 0.6 NA NA Administrative Cost/Total Assets 7/ (1) 4.9 6.3 2.6 3.4 sJ The ratios provided below are based on data In analytical balance sheets and Income statements In curront Australes which differ from the Information provided in Table 5. V Refers to BNAbs private soctor portfolio. / Includes short-term loans, and deposits on inter-bank transactions.