Argentina - Capital Market Development Project

Document of The World Bank FOR OFFICIAL USE ONLY MICROGRAPHICS Report No. 12328-AR Report No: 12328 AR Type: SAR STAFF APPRAISAL REPORT ARGENTIN CAPITAL MARKET DEVELOPMENT PROJECT FEBRUARY 4, 1994 Trade, Finance and Private Sector Development Division Country Department IV Latin America and the Caribbean Regional Office Tbh docment has a reshicted end may be used by r en only In the perfomune of their offiil dutes Its content may n otdlwise be dbulosed ihut WoId Iank attllfn  CURRENCY EQUIVALENTS Currency Unit = Peso US$1.0 = Peso $1.0 GLOSSARY OF ABBREVIATIONS BANADE Banco Nacional de Desarrollo National Development Bank BCRA Banco Central de la Republica Argentina Central Bank of Argentina BICE Banco de Inversi6n y Comercio Exterior Investment and Trade Bank BF Facilidad de Respaldo Financiero Backstop Facility BHN Banco Hipotecario Nacional National Mortgage Bank BNA Banco de la Naci6n Argentina Bank of the Argentine Nation BPBA Banco de la Provincia de Buenos Aires Bank of the Province of Buenos Aires BON Bonos con Respaldo del Fondo Bonds under Backstop Commitments BONEX Bonos Externos External Bonds CNAS Caja Nacionai de Ahorro y Seguros National Insurance and Savings Bank CMTAL Prestamo de Asistencia T6cnica al Capital Market Technical Assistance Desarrollo del Mercado de Capitales Loan CNV Comisi6n Nacional de Valores National Securities Commission CPI Indice de Precios al Consumidor Consumer Price Index FON Bonos Adquiridos por el Fondo Bonds purchased by Backstop Fund Fl InstitucionFinanciera Financial Institution GDP Producto Interno Bruto Gross Domestic Product FSAL Prestamo Sectorial Financiero Financial Sector Adjustment Loan INDER Instituto Nacional de Reaseguro National Reinsurance Institute LFE Ley de Entidades Financieras Law of Financial Entities ON Obligaci6n Negociable Negotiable Obligation OTC Mercado Extrabursatil Over-the-Counter Market PAYG Pago por Sistema de Reparto Pay-as-you-go PB Banco Participante Participating Bank PE Empresa Publica Public Enterprise SCL Prestamo en Moneda Unica Single Currency Loan TEL Pr6stamo a Termino Elegible Term Eligible Loan  JO! O"ITI 115 ONLY ARGENTINA CAPITAL MARKEr DEVELOPMENT PROJECT Table of Contnts Loan and Proect Summary ............................. -i- I. INTRODUCTION ............................... 1 II. RECFNT ECONOMIC DEVELOPMENT AND PROSPECTS.... 2 Background (2); Macroeconomic Consodation in 1991-93 (2); Medium Teim Oudook (4); xermnl Financing Requirements (5); Economic Rik (6) m. THE CAPITAL MARKET DEVEOPMENT PROGRAM ...... 7 Background(7); Ren Developmen and Poficies (11) IV. THEPROPOSED OPERATION ...................... 27 Bank Group Assistance an Satwy (27); Lessons Learned (28); Project Backgroud (30); Projec Objedives (31); Projea Summay (32); Loan AMOUnt (33); Project mplnaon (35); Procrement (55); Envionmental Safeguards,(56); Disbuseme (56); Monioring, Reprt, and Auditing (57); Loan Supervision and Evaluation (58); Benefi and Risks (59) V. AGREEMENTS AND RECOM04ENDATION ............... 60 Agreemes (60);Rw ndadon(62) ANNEIES ............ .......................... 63 A. Key Macroeconomic Indicato (64); B. Condidons of Effectiveness ad Review Pauses 65); C. Capital Market Regulatory Framework (67); D. Summary of Market Charactrisi (74); E. Financiaad Capi Market Developmfnt Data (76); F. Legal Aspects of the Backstop Facility (83); 0. Backstop Fund Projections (101); H. Supervision Plan (108) This veport is based on the fiding of a World Bank appraisal mission tat visited Argentina hi August 1993. The mission consisted of Messrs.Mmes. Maurio Camizosa (mion leader), Pa Meo, and Yavuz Boray (LA4TF); Gary Perlin, Diane McNaughto, and Robert Pardy (FSD); Carlos Betao (LEGLA); David Femira (LGMN/COF); Hemant Shah (LATAD), Denis Sullivan, Edwin Wiliamon, German Feffrzz, Caroline Ban, a George Wilson (consultan). This dacument ha a gesut distibution ud may ud by recpue nt* o tbe ane of their oMcW dutes Its con_tnt my not olthwW iseb dies without Wodd Dank athizak  -i- ARtGENTINA AUUL MARKE DEVINENT PROJECT L and snf &9MU hKrQNm:: Argenie Republic. ERGO= MEW The Fund, an Independent corpation to be estblished by the Government. The financial manager of the Fund would be an international financial instion with a proven ccessful record. The Banco de Iversi6n v Comercio Exdrll3IC), a Goverment-owned second-tier bank, would perform adminstive and oversight functins. 3 S:achnim Prime-rated commercial banks, medium and sma private entprises in all sectors, and buyers of rew commercial or residential buildings. US$500 minion. Im. US dollar, single-currency loan, repayable over 15 years at the Bank's standard LIBOR-based variable itoest rate for US dollar, single-currency loans. Grace period: 7 years. The Argentn Republic would ontend the procseed of the Bank loan to the Fund. . The Fund would implement a Backstop Facility (BF) that would offer prime-rated banks the option to sell to the Fund medium-term US dola-denominaed bonds issued to roll over prior dollar-denominated bonds that bans had issued to support their longer tem loans for producdve purposes. Olher FE_dnp A companion Capital Market Development Technical Assistane Loan (CMTAL) would provide lemey support (see D d s below) in the amount of US$8.5 mllion equivalent. 1DB has approved a credit line in the amount of US$300 milLion for productive purposes, that will be cofinanced by the Export- Import Bank of Japan in an equivalent amouwt.  The prosed operation aims to accelerate capital maret development to help Argentina meet growing investment demand. The operation includes the Backstop Facility (see Qp.ndhing), and an agreed policy and insdtitional develop;ent program. The Bacop Faoi would support long-term lending for productive purposes, by enasring liquidity to bans in the event of bond market disruptions. An agreed policy and institutional developmet program, iuding macroeconomic stability, frey determined interest rates, the removal of eisting inerest rate subsidies, and strgened capital market regulation, supervsion and enforcement, would also help inrease market confidence. Pmgress in the agreed policy-d institutional development program would be reviewed during tWo pauses in cmtes, to be imlemented after 30 percent and 60 percent of the loan has been committed or after 18 and 36 months of effectiveness, whichever comes first. The accompanying CMTAL would help finane iprovements in capital mariet spervision and relaon; training of commercial bans' staff in project financing; and miplemention and operation of the new, reformed pension system. The main benefit of the project world be develoepment of the capital mariet, including increased availability of long term financing for private sector investent, longer bond maturties, developmen of rating agencies, increased liquidity of the bond maket, and inproved quality of commercial banks. The main are resumption of sustand macroeconmic instbilitb, including further sain on the baidg system; extended govermen interventions to lower inrest rates; weak prgress i bank supervision; weak demand for the Backstop Facility; and non-development of BICE. I CoW The total amount of bank bond issues that the Backstop Faciliy would upport over the life of-  the Bank loan depends on the matuites of fte bacdsopped bonds and the perentg of backstop conm mtts exercised by banks. The longer the maturities and the igher the percentage of total bonds sold to the Fund, the lower the amount of bond issues that the Fund would be abie to support. * a: Not applicable. Financing of bond purchas would nmteralize only in the event of a poss%ble fiancial disruption or market developments that undermined a PB's ability to rollover its bonds at a rate below the backstop price. of 1 Not Applicable. t Not Applicable.  ABIGE4MNA CAEl!TA MARNEI DEVEI4Oa PRQJEC STAFF APPRAISAL RET I. INTRODUCTION 1.1 The Goverment of Argentina has undeaken a major reform of economic policy aimed at price stability and sustined eonmic growth. Measures to fos the state on core public fucions and raisqe the efficiency of revenue mobilization bave been essental for improving the fiscal findamentals. Trade liberalization and the deregulation of domestic markets have improved economic efficiency. These refoms bave been stongly encouraged and supported by the World Bank. 1.2 Complementg earlier public sector reforms, the Bank extended two Public Entrprise Reform Adjustment Loans and a Public Sector Reform Lon (1991-92) along with coplemen xy tnical assistance loans (1991). The Government is now in the process of reducig the role of public bans and private banks. To support these reforms the RBank approvQ the Financial Sector Adjustent Loan (FSAL) in February 1993. urthrmore, the Government is enoraging the growth of private scurities markets to help muster the large amount of medium and long term financial tesources needed to finane investnent. The timing is now propitious for securities market development becase the economy has become more stable. 1.3 This report proposes a capital market development project that would help provide tborm finance frm private sources. The loan, in a proposed amount of US$500 million, would suport a bactop facility (BP) that would offer prime-rated banks the option to seil to the BF mediun-term US dollar- denominated bonds which would be issued for the pupose of roilig over prior doilar-denominated bonds hat those banks had issed to support their longer term loans for productive purposes. A policy and instional development program agreed between the Govemment and the Bank would help increase market confidence. A complemeay chnical assistance loan would finace improvements in capital maret supervision and regulation, including enfocem; training of commercial bans to undertake project fianing; and impleation of the new, recently approved pension system. These would help improve the policy framework for the prposed project.  2 2.1 Upon taking office during the July 1989 hyperinflation, the Menem Govenment cognized that reversing Argentn's long-standing economic decline rquired structural reforms to eliminate the chronic fiscal deficits that were driving inflation. The Goveniment launched reforms in federal tax policy and administation, and undertook expenditure reductions that improved the overall public sector primary budget from a deficit of 4.4 percent of GDP in 1988 to a deficit of 1.6 percent of GDP by 1990. The Centrl Bank's large quasi-fiscal deficit was elhimnated, ending the destabilizing practice of Cental Bank money creaton to cover its own interest losses on massive short-term debt. Sales of public enteprise assets and cocessions during 1990/91 produced cash rceipts of about US$600 million and lowered external debt by about-US$7 bilion, while reducing future ubsidies and creting new tax tevenm. Major privatizations and trade liberalization signalled a new development strategy.' With ese reforms, the economy became fundamlly much sounder by the end of 1990, but preses on the exchange rate and a short burst of renewed inflation led to a new stabion effort as well as a new economic team. 2.2 The new stabilization progm that began in February 1991 intrduced tax and revenue measures tht raised the operational primary supls to a level pemting debt service obligations to be met withut resort to inflation. The Converibility, Law of April 1991 legally fixed the peso/dollar exchange rat and required the Cental Bank's moety liabilities to be at least matched by its international reserves, thereby preventig the use of monetary emission to fmance the public sactor. Furher trade liberaliaton and-major domestic deregulation put downward pressure on prices and costs supporting exchange rate-based disn on. The pri on program was both' acceleraed and deepened. Aided by declining foreign ierest rates, tese policies attcted massive capital inflows and resulted in strog economic recovery and a dramatic fial in domestic iee rates. Higher private capital- inflows in 1991 financed a US$4 billion rise in imports and an increase of US$2.8 billion in liquid reserves. Consumer price inflation came down to 83.9 percent in 1991 and 17.6 percent in 1992. Intrest rates on fixed-term deposits declined similarly to 78 percent in 1991 and 11.4 percent in 1992.  3 Led by consmpdon, GDP grew by 8.9 percent In 1991 and 8.7 percent in 1992. 2.3 The strucural and stabilization policies indicated above were undertaken by the Government under a set of Bank adjustment and technical assistce operations. In March 1992, agreeme was reached with the IMF on a three-year EFF program. The Goverment complied with all condtionality under the Bank's Public Euterprie Reform Adjustment Loan (February 1991) and Public Sector Reform Loan (July 1991). Fis-al performance in 1992 exceeded ErP targets, and privatizadons pushed the pimary surplus to 2.2 percent of GDP in 1992. In the first semster of 1993, EFF conditions were met. Most targets-international reserves and foreign debt-were met by wide margins, but the fical perform=ce was slightly below program,- about US$34 million, as the shortfah in tax revenues (partly :sociated with tax reductions) was not quite fully offset by cost in expendiures on pensions and transfers, reduced hinerest outlays, and an improved peformance of public eeprises. However, revenues have pertformed more strongly receny and eenditues coninue to be contolled through strict cash management. 2.4 During 1993~ the Govermment furfter enhaned confidence by providing a longer term fiamework for public finances. The external debt agreement with commercial crditors, signed on April 7,1993, ends the accuulation of arrears, regularizes existng arrears, reduces interest obligations from a projected US$2-3 billion to US$1.4-1.6 billion in the Witial years, and sharply limits interest obligations ii intrational rates rise. The succesfl privatizadon of the state-owned oil company (YPF) enabled the Federal Government to exnuis debt obligations to pensioners (about US$2.7 billion) and to oil-producing provinces (about US$1.2 billion). The liquidity injection from abroad (US$2 billion) was largely sterilized throgh a 3 percenage point mcrease in reserve requrements in mid-August. On August 16, 1993, the Federal Govement, the Federl Capits1, and (16 out of 23) provincial governments amnaed a new revenue sharing agreement thrugh June 1995-the Pacto Fucat-aimecd at s g the fiscal adjustment in provinces, and at eliminating distortionaiy provincil taxes. in retn, the national goverment agreed to ego US$0.9 billion in provincial debt, and to assume responsibilty for the provincial social security systems. Fmally, on-Septembe 23, 1993, the Senate passed the pension security reform law. The law establishes a mixed system of mandatory pension insurac: a public pay-s-you-go (PAYG) scheme offering a uniform basic pension, and a private funded scheme offeing benefits in proportion to idividual contributions and the investment performance of the respecdve pension fund. However, workers may opt for additional PAYG insurance intad of fund memberhp. The law also obliges the state-owned Banco de  4 la Naci6n to offer a pension fund with guaranteed remns m both pesos and dollars and a subsidy component through prohibition of a management fee. It is expected tht the guarante and subsidy componet-which could adversely affect prvate fuds- wmi be dealt with saisfactorily through new conrective legisltion. 2.5 The large capital inflows have produced a real appreciadon of the peso of about 30 percent since the beginnin of the stabilization program, but between a third to a half of the adverse impact on competidveness may have been offset by the elimination of export taxes in 1991 and other meaes described below. The curt account deficit reached US$8.3 billion in 1992, after a US$1.8 billion surplus in 1990 and a US$2.8 billion deficit in 1991. In late October 1992, the Government inreased indirect tax imbusments for exports from an average of 8 percent to 13 percent and raised import tarifs-incling ad valorem tariffs and a flat statstcs tax- from an average of 14.8 percent to 19.8 percent while also reducing taiff iseion. RDuctions im fuel taxes futhe improved the competitiveness of domestic producers. In April and May 1993, to stimulat nveseme the G3overmment anounced a package of measures to reduc the costs of capital goods (dqty free capital goods imports and tax rebates for domestic capital goods prdues) and lower borrowing rates for small and medium industry (paras. 3.25-3.26). During 1993, the Government reintduced for one year limited quanttatve restrictions for paper and footwear and taiff surcharges on wool clothing ipor. Iln mid-August 1993, stascal import duties on agritural and indstial inputs wer reduced from 10 percent to 3 percen Also, the Govenment announced a new set of measures designed to alleviate pressure on the tadeable sectors from the appreciation of the real excne rate, incluing the elimination of the gross asset tax for agriculture and industry and of prepayments agait VAT for the agricultural sector. M_M Term ok 2.6 The Govemene's main macroeconomic objective is -to achieve a long-tem anna growth inEceedg 5 percent, with epanding employment and inion held to inteatonal rates. In the period June-September 1993, the analzed rate of consumer prices inflation fell to less tan 5 percent, and real GDP growth for 1993 is projected at about 6 percent. The primary fiscal surphs before privatization is projected to increase from US$3.0 billion in 1992 to about US$4.5 billion in 1993, about 1.7 percent of GDP (Amex A). This level wold suffice to service interest payment and to obviate the need for a future inflation tax, given foreseeable foreig and domestic borrowing. ITe Government anticipates that its monetary and  ce poliies Wi contiu to be disciplitod by th Convertibility Law ad a now Centr Bank Cater. A dght fisal stance, continui Import compediton, and product and factor market derguation would drive domestic inflth i to tnteraonal rates. 2.7 The Governme Is relying on private capital inflows and increased private domestic savings to finance Invem. The autdh es view the estimated US$50460 billion in private savis of AtgeztI reside held abroad as a reliable source of tWure capital ifw, altho peraps owing in 1993. Futhermore, the Govermt anticipates that the trade balace w1il improe progsvely blning in 1994, in rspoe to condnued tight fiscal policy and furtier actions now ulderway to mahe te economy more compet-ve, ichxding deregultio measures, labor reform (sent to Congress), iNestm in umn capital, m! tax poliy measures. The Govermnt has recenty asd itentiOn to reduce emloyer payroll taxes, curreny equa to 33 percent of gos wages, in povinces that carry. out tax reform. Th authorities epe that contined p v owth in the domestic inusl sector and lower labor costs will improve t trade balane. They alo expect mproved tax collectio'to compensate for the fisa costs of the above measures. 2.8 Ssb y of the adjustmen prom and a spportive Inteatonal envi n are the key variables in Argnias effort to meet its extrnl financing requirm s During. 1993, sWt economic perfome and the debt reduction opeaton opened Argenta's doors to the W I financial marmt; however, access to 8th mabhts nd borowing tm stil remain lmited. 2.9 The adjustment of the public sctor has pr vel shifed the needs of extenal finanng from the public to the pvate sector. Therefore, finawcing of the balace of payments prnipa will be a function of desred saving and investmt in the prvat secor. Improved ineatoal financing of priv invesmet, the remwed abt tO rol-over mauring intnatona obligations, and growing foreig direct invstme are expected to moderate the apected slowdown in the exceptional flow of ivi a.Io proceds from abroad observed in, te last three years, as the progam nears its compledon. In tu, the investment oouni creaed by this prfivatiation program, as well as pottl repatiation of eaings of foreign- hdd private assets, will be addial factors contributg to the canging nature of capital inflows to Ageina. The Wodd Bank and IDB will be  6 Inresing their exposnre in Argentina, but not substantially so after te M- 1990s. The IDE's exposure wi likely decline after the exphation of th 2.10 It is likely that with consistent macroecoomic policies, a sable lntenatial environment, and the continu financial asiae of mullaterl organizations, Argentina's extnal financing rqu for sustainable growth could be met. Ea_MI RlSk 2.11 A key risk for the Argentine economy is ftat if capital flows taper oft, output growth could decline as domestic intrest rates rise and redtions become necesury in import volumes and prices of non-traded goods and assets. Furthermore, a worseng macroeconomc pice or poliicl ee ud trigge a speculafive attack on the peso. With a udden cycle of demonetizaion, very high interest rates and deep recession, the Governmen might be forced to choose between: (i) providing liquidt to prvnt th colpe of the facial systm, thereby puFtt pressue on the exohange rate; and (ii) leting financial institutions collapse with some depositr sRIn losses. Slower growth would create added fiscl pressure. As evenues fall and the interest bil rises, it would be more diffl to achiei. the projected pardal rollover of the Government's domestic debt-rdt bondhlders. 2.12 The probabilit of these adverse events declines as the _ns of publc finnce improve. The past reforms of the public sector, which have nmustered considerable public support, anchor stabiltio and are not likely to be reversed. Furtemo, the fill coverage of the monety base by reserves tends to deter specultve attacks on the peso. 2.13 The proposed Fund will benefit from reduced cuency ridsk as a remt of borrowing on single currency loan (SCL) terms in US dollars (para. 4.21). All of its revenues are expected to be US dollars. Thus, the Fud will be able to match the curncy of its revenues and expenses and avoid the curreny risk it would have faced from curnrncy pool loan terms. The IUBOR intr rate basis of SCLs also allows the Fund to reduce part of it inres rate risk, since is interest ome fom ptcipatig bank bonds wil be LIBOR-based.  7 m. CAPfAL hUTW DOMARNM PROGRA 3.1 There is an urgent need to accelerate the development of Argenin's secunrities markets. With the size of the public sector shatply reduced, foreign and domestic trade liberalized, and tax and subsidy distorons abo reduced, private invesment demand is expected to grow lapily. Viualy all of Argentina's national power, telecommuncatons, gas, water, steel, chemicals, and petroleum industries -- heretofore ste-owned - are now in private bands. So are many in s and trsport activities-por,ts airlines, railways, and highways. Many other firms are also eager to te advantage of the strgthened macroeconomic frmework and expand their activities. A study by a respected Argentine research ititue estmas that the newly piivatized PEs alone will need over US$3 billon yeary in low term funds if their investment reuireme are to be met A recet survey of 250 well-known enterprises estimates an annual growth rate of 19 percent in private busine investment over the nxt five years. In fact, privae investment increased by 32 percent and 37 percet in 1991 and 1992 respectively. 3.2 andal Argentne financial and capital madre were undermined by the poor economic policies of the previous four decades. High inflation and macroeconomic instabily decreased resource mobilization, shortened terms of financial in, and incea nominal and real interest rates. Public sector borowing, high taxes on tading -4 prva securities, controlled interest rates and subsidized credit, governmen conicaton of savings accounts, government monopoly of pension insuranoe and of all reinsrnce, and restrictions on the allocation of inves_mt fund portfolios further discoumaged development of the capital market. Diected and subsidized credit and distorted economic incives contriutd to misallocation of finanial resurces, increased freely detemined real interest rates, and decreased portfolio quality. sIe bfa ktcy protecdon through Ceal Bank icJiscounts, lack of profit-making incentives, and governmen interference in credit decisions prevented public banks (which the banking system) from oprtg soundly and efficinty. There was an inordine physical expansion of banks to capture the inflation tax for ther owners. Finally, weak regulation and enforcement of capital adequacy and provisioning requirements, parcularly with regard to public bank, also contributed to the 4eclining health of the banking sector, leadig to diste borrowing and le . 3.3 I)omstiMbicR q ob Domestic resoure mobilization and private sector finance sffered as a result of these policies. Finani savings in Argentina have been held primarily in forced plac_me of  8 govenme bonds, curreny, and bank depst. As of March 1992, there were some US$6.3 bilion in Government bonds OU ht in the domestic markt (2.8 percent of GDP). Currency and deposits (M2) rached its lowest point ever, approaching 5 percen of GDP (old National Acos) in 1990 down from above 40 percent in the early 1940s and from 20 percent in the mid-1970s (see Annex E). This decline is lnked to higher inflaton, increased uncertint of domestic asset yields, and the desire to retain finaial assets abroad. Nominal intrest rates on domestic currey asset soared frequeny, reflecting the periodic syrocketing of inflatony expeaons. For example, freely determined rates on acceptances, whicb remaind low and fairly stable at a monthly level of aroui 2 percen or less up to 1974, fluctuated between 2 percent and 137 percent between 1975 and 1990. Real int rates on domestic currency asset also showed instbiW in the wake of sccessive speculaion for and agaist the domestic curr 'y and unexpected swigs in iaon. Ex-post monthy real rates on accptances, hovering within -S pecen to 5 percent before 1975, fluctuated between -27 percent and 7 pet between 1975 and 1990. 3.4 l)winding resource mobilization reduced the amount of bank credit from around 40 percent of GDP in the early 1940s to 10 percent of GDP in 1989. About half of this redit went to the public sector. As a result, the role of bank in private financing has been very limited, accounting for less than 10 percent of businss fae. Furtermore, increased unrainty of asset yields also led to declning martuities of domestic financial inumet, from about three months to about a week, and holdings of medium- or long- term priae bonds were viuly nil. Long-em cororate finance relied chiefly on shares held by controHlig shareholders. 3.5 blk aqk. Historically, commeial banking has been domiated by pIorly performing public bak. While public commeril ban number only 36 (7 national, 26 provincial, and 3 ipal -22 percent of the total of 164 bak in the coutry), they provide the major share of bank credit (about 61 percent of total credit), raising a sipificant share of deposits (about 55 pert), owning 45 percet of all brancies and employing 51 percent of all bank staff. The share of dqpsits at public bans increased from 40 percent to 60 percent during the 1988-90 period due to high iterest rates paid to obtain resour for the public sector. 3.6 The public banks' consistent puit of objectives ,ter than profit maximiion, includig financig of the public sector, dictdon of cedit and disbuion of subsidies, led to low-quality loan portfolios, dependene on the Centmal Bank, and losses or low profitability. Non-performing loan portfolios (carera of naional public banks are estmated at 33 percent of the totl portfolio, even tugh lending to the public sector, which amounts to 29 percen of the tot4, is not included in low quality portfoios. Similarly, provincial banks have 34 percent of their portfolios in low qualit loans and 23 percent in lending to the public sector. Cenal Bank  9 rediscunts to national and provincial public banks are 27 percent and 33 percent of deposits, rsetvely. Poor financial maagement of public bank became a burden to the Cental Bank, which iwured subsal losses because its Interst income was below its interest costs and portfolio losses (the quasi-fiscal deficit). Low profitbi in public bank sulted from iterest rate subsidies, poor portfolio performance, and bigh operating costs. Public bank employees compise about 51 perce of total bank employment, and labor costs at naoal ad provincial public ban account for 68 percent and 66 percent of total costs, respectively. In cota, private banis have non-perfoming portfolios of 5 pet for domestic bank in Buenos Aires, 11 percent for domestic banks outside Buenos Aires and 4 percent for foreign banks; little funding to the public sector beyond requred reserves; Central Bank rediscounts of only 3 percent for domesdc banks in Buenos Aires, 1 percent for domestic banks outside Buenos Aires and 2 prcet for foreign banks; and labor costs of about 53 percent of total costs. 3.7 The nationally-owned Banco de l Naci6n Arentn (BNA) is by far the largest bank, with assets of about US$13 billion and about 13 percent of both domestic ledn and deposis. BNA's chief role was that of providing liquidty and credit to the public sector (including public e iss): 70 prcent of total assets are direted to the public sector. Furtemore, BNA bas been required to act as tax and payroll deposioy, undertak emegeny lndig and serve as mardet leader for reducmg ierest rates. BNA had deterioated into a vast bureaucracy with an antiquated organizaion and systems and low proctvity in many of its branches, which has led to high opeao costs. As a rIet, BNA's return on capital has been low. 3.8 Banco Hipotecario Nacional (BN), an imporant pilar of the Government's housing programs since fte 1940s, genally provided housing and consruction credit to middle-income households. High inlation and low deposit mobilization caused BHN to depend on Central Bank loans. Increasing emphasis on social concet led to portfolio yields below funding costs, substandrd collectou performance and high opertig costs. Insolvency set in during 1988/89. 3.9 Baco Nacionl de Desarmollo (BANADE) had been coeated in the 1940s to provide Argenine idustry with long-term loans. BANADE was subject to growing government interferene that led to poor credit policies, lax loan colection, corruption, and a fiancial position beyond re1tiea. 3.10 Caja Naciona de Ahorro y Seguro was created in 1915 as a postal savinpg Insttuion, but has been providng both banking and i e seies. Its banking opeatons have been performig poorly on account of large lending to govertmt and public emerprises. In conast, it insurce  10 oprations were profitable, favored by a large market sbare (13 percent) and its ability to place inswance con directly witout brokers. 3.11 Provincial banks (30 in total) account for about 26 pern of total assets of the banicng system. The largest provincal bank is Banco de la Provincia de Buenos Aires (BPBA), Argentina's oldest commcial bank and the second largest wift 330 branches and 15,000 employees. Generally, the fincial performace of provincal banks has been poor, chiefly as a result of their primay mandate to lend to provincial treasures and entpriws wthout due regard for bang principles. Pessured by the need to fund provincial finances ad low deposit mobilzation, many provicial banks became highly dependent on Cental Bank rediscouns to continue their operatons. Ihe Central Bank, in turn, encountered difficulties in recovering tho rediscounts. Provincial constitons or laws dictag the provinial banks' lending focus, their choice or removal of management, and merger or closure undermined the Cental Baks enforcement actions and collection efforts. 3.12 Prhrt- Between 1950 and 1985, private bank employment tripled wbile real deposits s8td. Excessive physil expaon, icluding over-branchig, was encouaged by subsidized Central Bank credit, controled intrest rates on deposits, and profits from the iflton tax. Furtemore, investors were attracted to the banking sector by the Cetral Bank's 100 perent deposit guarantee regime, which encouraged a high degree of ierlocking ownership with non-finanial fims and banks, as well as excessive risk-taking. 3.13 In the 1980s, -several institutions went bankrupt. Some bankuptcies were the result of portfolio hpairmet that originated in relative pnce changes. Several bankrupties were probably fradulent, and thus took advantage of deposit insurance and deaulted on Cental Bank rediscounts. During the late 1980s, hbalized inte rates, the redction of subsidized credits, incesed taxaon through non-remunerated reserve requirements, and a falling demand for liquid assets, reduced the centives for further baking growth. The number of private band sed from 179 to 141 during 1980"89, and employment at those bans declined slihly from 66,000 to 64,000. 3.14 Mat& The crkical capital market issue is the limited mobiization of long term resourc (size and instuments) from private imveors. The capital marikt in Argentina has been dominated by government bonds. The chronic public sector deficits icreased the volume of public dollar bonds ou&tng fom US$0.3 billion in 1985 to US$10 billion in 1991. Maret transactions in public bonds at the Buenos Aires  11 Stock change amouned to US$1 bilion in 1990. The mai Instrument has been the BONEX, a dollar demin govnment bond that partly stmmed from the Govemn's confiscation of saving deposits in 1990. In contrast, equity market and trading mounted to only US$3.3 billion and US$0.8 billion in 1990, respectvely - small measue for a country with a GDP of US$140 billion. The amount of private coiporat bonds issued domestically was neggble, as these were priced out of the market by prohibitive tsaction taxes. 3.15 In addition to the legacy of macroeconomic instability, which still feeds fears of an unexpected revesal of a thus far sueul stabili, poor mobilizton of long term private resorces has been un ed by (a) the lack of insttutional investors with sources of contactual savings for long term investmet; and (b) shtings of the reglatory framework of the capital maret. The main gap in istitutional inveting has been the Goverment's monopoly of pension iuance. Following the extnction of previous public pension fund savings, the public pension syem opeated on a pay-as-you-go basis since 1968. Anther importat gap was a consaint on non-equity invesments by investment funds. 3.16 Finally, the regulo fmeworlk remains undeveloped. Shortnomings include: (a) lack of enforcement capacity due to weak legition with regad to the Stock Exches; (b) lack of capital adequacy rues for capial markt intemediaries; and (c) lack of suervisory capaciy due to weak developmet of the supervisoy body. These sbortcomings undermine the degee of confidee that is required for the deveo n of bond and equ markets. Recent lloDmem md 1 'i 3.17 The present government has been ssing the long-standing legacy of poor policies. Moderate inflation steming from the ma - - policies discussed earlier is rencing the unainty of real asset yields, and treby reving the demise of resource mobiliztion. Strong icome growh is futer icsing the demand for fncial assets. Inflation declined frm 1,344 percent (CPI) in 1990 to about 8 percent in 1993, and re growth inreased from 0.4 prent in 1990 to 8.9 percent, 8.7 peen, and 5.0 percent in 1991-93. With greater inerest rate stability, M2 increased from an average of 3 percent of GDP (new National Acus, which raised measued GDP by 48 perce in 1990) in 1990 to 11 percent in 1993. D)eposits with mauriies of one month or more increased from 3 percent of totaldeposits in the aftermath of the BONEX conversion (March  12 1990) to 46 percent at the end of 1992. Outstanding bank credit to the private sector has also increased, from 5 percent of GDP in 1989 to 12 percent in 1992. Maitnance of macroeconomic stability and its policy hmdamentals would be a condidon of effectiveness and of renwe commitments under two formal rviews of the operation. he Bank would tin the t to suspend commitments to disburse at any time if raacroeconomic instability resumedA' 3.18 In addition, following the tax exemptions on private corporate bonds introduced in 1989, several banks and corporations have issued corporate bonds, chiefly US dollar denominated, increasing the outsding volume from zero in 1989 to about US$4.1 billion by mid-1992. CNV approvals for publicly offered bond issues amounted to US$3.8 billion and $4.6 billion in 1991 and 1992, respectively. These instruments are mainly held by corporate and baning institutions, and by intemational investors. They are not yet actively traded in domestic markets. Fixed annual intest rates have been as low as 9 percent and sizes of individual issues have been as high as US$100 million. New equity issues on the Buenos Aires Stock Exchange grew from just US$16 million in 1989 to US$116 million in 1990, and to US$355 million in 1991. Moreover equity market capitalization, which stood at US$2.9 billion in 1989, reached US$25 billion by June 1992. The prvatzation process itself is also giving rise to major market offerigs; some 30 percent of equities market apialon is accounted for by the share plcement of the northen and southen telephone companies. 3.19 In spite of these changes, financial deepening is stil much below enational standards. With susained stability, Argetina can expect a further increase in the ratio of M2 to GDP to around 30 percent in the medium tum. A more difficult chaUenge is to increase the demand for medium and long term bonds and perhaps for equity shares as well. It is genalUy acknowledged that there is a latent supply of medium and long term securities that has not developed due to lack of demand. The cited incrase in private business investment plans indicates the latent supply of secuties. Lack of demand for long term securities is tantmount to saying that the yields required by investors are still far above the rate of return on capital. The high reqired yields have been drven by policy-induced risks and uncerainties, transaction costS, lack of investor proctdon, and constraints on the developmen of insdtutional investors. The financial and capital market I/Compliance with the 3-year fiscal and exnal financing program agreed with the IMP and the Bank would satsfy this condition. Following expiration of the program (March 1995), this condtion would require the prmary operational surplus to exceed the interest obligations of the nonfinancial public sector.  13 policies will further improve market performanoe to help meet the economy's growing term fiancing needs. 3.20 IXpros the b of the lg Sg Banking policies have pdmarily sougtk to s btengte the financial sounll S of the ban system and thereby reduce the Govement's exposure to losses stemming from bank failures. The Convertiblt Law, te Central Bank chartr, downsizing and cost reductions in public banks, and stronger reguation, supervision and enforcement of capital and provisioning requem, and improved bank disclose, will help reduce the moral zard to the goverment smming from bank failr. Furdher protection agaist losses from bank fiures wil result from the sale or liquidation of some public bank. These polcies have been Supported by Bank loans, including the Public Sector Refbtm Adjustment Lo, the Public Sectr Reform Technical Assistance Lon, and the PSAL. 3.21 BANADE has now been closed, and BNA acts as a facial age to liquidat its assets. BHN bas been converted into a second-tier bank. Its lending will be priced to cover fnding costs, the cost of operations md a positive return on capital. Cala Naion de MM Y Sus is bing privatizd and the sale of the majority of shares expected in early 1994. 3.22 To maintain financial flexbility and be able to meet unexpected finial needs until the Govemment's stniura reform program is substanally completed, the Govement wishes to retain full control over BNA. At the same time, the Governmen is aware of BNA's inefficiencies and is supporting its raionalizon. It has compled inial measures- most importan y, the number of staff has been reduced from about 18,000 to 14,000 via an early retiment program, geneting operating savings of about US$50 million per year. On-going measures ilude improved contrting procedures, oinal rel and, most importny, negotiation of new incentive-based compensation sches for BNA staff. To strengthn f er ficial discipline, BNA has (under the PSAL condions) dind financial performance staUdards and given priority to the private sector. Its loans to the public sector declined from 17 percent of total credit in 1991 to 7 percent of total credit in 1993. 3.23 Laceng direct jurisdiction, the Govrmen's overall stategy in dealing with the provincial banks has been to tighten financial sndads and supervisory prese tough a r izon of their relationship with the Cental Bank and the S of Banks and to limit their exosure to their rective Govenms. Further, provial banks have not received Cenral Bank rediscounts for purposes other than short-term liqidity needs. Provincial bans are also being required by the Cental Bank to adhere  14 gradualy to the same banlking ratons as the private commercial banks. This pressr is generating t and privadzadon of several bank (Cordoba, Mendoza, San Luis, Salta, Entre Rios, Ch3ibut, and Misiones). A forthming Provincial Reform Adjustment Loan will spport a series of provincial public sector reforms aimed at enhancing the strength of provincial fnances and supporting fr es g of provicial ban. 3.24 Adjusm in the private banking system contued during 1989-92. rj number of private banks dclined from 141 to 128 and employment dopped from 64,000 to 58,000. Overall, private ban have performed better than public banks. Non-perfomn loans amounted to about 7 peet of the total in 1991, far less than in public banks (S0 percent). Private commercial bans had to absorb the shock of the Jamna 1990 conversion of savings deposits into public bonds, and hold large vohlmes of Trasury obligations created in the wake of that conversion. More recendy, they have had to adapt to lower inflation rats and lower spreads. Although the private banking system does not present major risks of failure, one can anticipate further rationalizion, including mergers and some additional closures. Furthermore, it is expected that private banks will increasingly lend with longer terms and with a wider client base. The proposed operation would help accelera this trend, which would help increase the access to term fie by small and medim-sized bushi es. 3.25 Progress in bank regulation and supervision is also belping to icrease t health of the bankng system. Under the Finac Sector Adjustment Lon, the Ceral Bank sted a program to improve reglations and sItregihen supervision. To stregtben the focus on capital adequacy, the Cetal Bank issed new minimum caital rqui s that depend strongly on the riskine of the bank, and also iceased proisioIning ri. To improve inspection, the Ceral Bank issed stringent replations that increase the aoun of indendent audtors. Fmaly, the SEF is undertang an instuational development program to improve its own on-site and off-site ispection practices. To undertake tis program, the SEF is receiving assisace from the Federal Reserve Bank of New York and the US Ofie of the Comptroller of Curey and working with other local cnsultants. Improvements in supervision are being comlemented by more open disclosure rles with regard to the financial condition of banks, which wiUl make it more difficult for banks to conceal inadequ levels of capitlzain 3.26 itet Rte }'ofctes. With the Ceral Bank virtually converted into a monetary board, the Government itself is interening to restain interst rates. The Government's key concerns are the high spreads and the lack of access to credit by small and medium entpriss at reasonable costs. - 5 .~~~~~~~. . \ . 0~~  15 The main ventions thus far include the following: (a) public bank are chging a maximum monthy interest rate on V- loans which seems to be well below rates chargd by private bank; (b) an intrest rate subsidy of four perentage points which is being auctioned off to the banks offering to charge the lowest rates on a total of US$1.8 billion of loans for investent (4-year loan1s of up to US$400,000 per firm), working capita (18-month loans of up to US$80,000 per firm and two- to fth year loans of up to US$100,000 per firm), and texnology (three year loans of up to US$40,000 per fim) benefLitt* from the subsidy; (c) a sbsidy of 30 percent of the interest rate on US$100 million of BNA 7-year investment loans with an intert rate not exeeg the pme rate by more than 6 points (individul loans of up to US$1.0 million); (d) a subsidy of 2 p=erng points on US$150 millon of BNA export loans with an interest rate below 12 percent; (e) negotiation of a Saish goverm credit facility offering subsidized rates to fial borrowers; and (f) a program to provide ubsidizd credit through BNA to busin s hiring staff that leave jobs in provincial goven and thugh MN for acquitn of housing to those staff that change residence as a resut of their cbange in employment. 3.27 While the concern with the high level of interest rates is justified, the recent policy chages may be misguided. With stabilization, monthly nominal lending rates declined to 2.0 percent-3.0 percent. Tbese lending rates awe of course much above international levels in US dollars. They are Partially ted for by high intrest rates (again by intermational sandards) paid to depositors (about 0.7 percent-o.8 percent per month)- which may include country risk and some expecn of devaluation-and also by excessive seads. Exesve spreads (see Annex E) have been widely ackowledged to result from high reseve requiements, a low depst bae, a high budn of the non-performing portfolio, high regulatory costs, and high risk prmia. None of thes problems is addressed by the policies described in para. 3.26. In fact those policies run counter to the objective of achieving capital market development, since the availabilty of cheap official credit wil discourage borrowers an d banks from tapping the market. 3h Govenmznt has agreed that it will no renv the proM s described in pars. 3.26 (b) to fd). whic w be fl commitd by mid-1994. Therefor, the pRams wil bave bee fu}lv committed before the proposed loan becomes oional. Moreover the Government has ageed to noate bilatr export redit re lines ( dita y negotiated trancbe wili Spain) at mark~e rtes to the find borrowers. 3.28 Rebirth of thC alMNke. In size and importance, the securities markets have grown dramatically since 1991, although there have also been dramaic rersals within the period. As an indication of the d e of the eesk