Argentina - Economic position and prospects

RETUFZN TO RESTRICTED RETURN TO DFlEL COPYl Report No. WH-175a REPORTS DESK IILL tUf 1 IWITHIN ONE WE. K_ This report was prepared for use within the Bank and its affiliated organizations. They do not accept responsibility for its accuracy or completeness. The report moy not be published nor may it be quoted as representing their views. INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION ECONOMIC POSITION AND PROSPECTS OF ARGENTINA November 21, 1967 Western Hemisphere Department  CURRENCY EQUIVALENTS U.S. $1 350 pesos 1 peso (M$N) = U.S. $0. 00285 1 billion pesos = U.S. $2, 850, 000  TABIE OF CONTENTS Page Number BASIC DATA ...................... 12e.o.e 1-2 SUMMARY AND CONCLUSIONS ........................ o. . . i*iv I. INTRODUCTION *.............................e......e 1 II. RECENT TRENDS IN ECONOMIC PERFORMANCE AND POIICY . 2 Performance . *.***.*.e*,@**e**o,*. 2 Policy . *0***** *o *.... c.* *e. eo.. * 6 III. THE 1967 STABnLIZATION PROGRAM .......................... 8 The Budget *....... ... 8 Savings and Investment in the Public Sector.......... 14 Ilonetary Policy ..... ..*.*.....0... . ................ --. 18 Wages and Prices ....... .. ............... ...... 19 The Balance of Payments *...e........e...,.oooo. 21 IV. DEVELOPMENT PROBLEMS AND POLICIES ........................ 25 The Private Sector and Economic Recovery ............. 25 Public Sector Savings *......9... ......... ......... 27 Investment Decisions .****.....*...........*.*.*.*.*. * 30 V. PERFORMAANCE PROSPECTS AND CREDITWORTHINESS ............... 33 Growth Prospects ............ ..... .. . 33 The Stabilization Program .......-....-...........-. 35 Balance of Payments and Creditworthiness . 38 STATISTICAI APPENDIX This report is based on finding of a mission to Buenos -Aires-in April-May 1967 composed of Messrs. Ross, Dosik and Pichler.  BASIC DATA Area: 2.8 million km (1.1 million sq.miles) Population (1966) 22,871,000 Growth Rate (195o/51-1965/66) 1l8 percent Gross Domestic Product (1966): N$i* 4,043.4 million Real Growth Rate (19505/1-1965166) 3.0 percent Per Capita GDP $650-750 Origins of Gross Domestic Prodtuct (1966): Percent of GDP Industry 31 % Agriculture 14 a Commerce 12 % Transport and Communication 8% Expenditure on Gross Domestic Product (1966): Percent of GDP Gross Fixed Investment 17.9 % Private Consumption 68.8 % Public Consumption 11.5 % Current Account Balance 2.0 % Cost of Living: Annual Average Percent Change 196h 22.1 % 1965 28.6 % 1966 31.9 % 1967 (Jan-July, seasonal-ly adj.) 19.8 % Money !upply: N1Nj End of Period Percent Change 1964 395 39.6 % 1965 498 26.1 % 1966 672 3h.9 d 1967 (June) 746 11.0 %  Public Sector Finances: Percent of GDP 1965 1966 Budget and Decentralized Agencies Current Revenue 10.1 9'9 Current Expenditure 9.1 10.0 Total Public Revenue (incl. social security) 15.7 16.2 Public Saving 1.4 - 0 5 Public Investment 3.7 3.7 Balance of Payments ($ million): 1965 1966 1967, eget- Exports 1,493 1,593 1,550 Imports -1,198 -1 124 -1,075 Trade Balance 295 469 7 Invisibles -111 -216 -225 Current Account Balance 164 1 253 250 Foreign Exchange Reserves ($ million): 1965 1966 1967,Sept. Assets, Central Bank 250 223 702 Net Position, Incl. Treasury Liabilities -167 -157 216 Foreign Debt (December, 1966): $ million Total Debt (Central Bank estimate) 2,662.9 Public Debt (as reported by IBRD) 1,704.5 Debt Service Ratio, Total Debt (1966) 35% Debt Service Ratio, Public Debt (1966) 21%  SU4MMARY AND CONCtUSIONS 1. In no country in Latin America has the shortfall between de- velopment potential and actual economic performance been as striking as in Argentina over the past 15-20 years. During the first four decades of this century, Argentina enjoyed an enviable growth record and achieved the highest per capita income in Latin America, but the record since World War II has been one of slow and unsteady growth, endemic inflation, and recurring balance of payments crises. To an important extent, these difficulties reflect the deep damage done to the Argentine economr during the Peron era but, especially in more recent years, the failure to consis- tently maintain the economic policies necessary to stabilize prices and strengthen the balance of payments have imparted a stop-go character to economic growth which has effectively precluded any sustained expansion. After two years of recession, a new boom got under way late in 1963 and an expansionary monetary policy plus bumper wheat harvests made 196h-65 the most rapid period of expansion since the 1920's. However, monetary policy had to be tightened after mid-1965 to protect the balance of pay- ments, the wheat harvest returned to more normal levels and, with the two principal stimuli to expansion gone, the economy slipped into recession once again last year. 2. When the present Government took power in June 1966, one of its principal objectives was to bring about a radical improvement in economic performance. Following the appointment of a new economic team in January of this year, rapid progress was made in developing and putting into effect a comprehensive stabilization program; the peso was devalued by 40 percent to M$N350 to the dollar and complementary stabilization measures were taken in the fields of fiscal, monetary, foreign trade, wage and price policy. The 1967 program is pragmatic and well balanced, promises substantial pro- gress toward stabilization and, in so doing, to help in laying the foun- dations for more rapid and sustained economic growth. However, the best grounds for hoping that the present program will have both a greater measure of success and a more durable impact than preceding stabilization efforts lies in the determination and the ability of the present Government to carry it through. 3. The Budget is clearly the most crucial element in the stabili- zation program. To achieve a 5.0 percent reduction to M$N75 billion in the budget deficit, the Government prepared a fiscal program calling for an increase of nearly 70 percent in revenues and only 23 percent in expen- ditures, (i.e., virtually no increase at all in real terms). The most important revenue measure taken to implement this program was the imposi- tion, following the devaluation, of heavy taxes on major exports, a traditional Argentine fiscal device. On the expenditure side, the budget was based on the Government's decision to limit wage increases for public employees to 15 percent, compared to raises of more than 30 percent granted in 1966, and to hold transfers to the state enterprises to the 1966 level.  -ii - To make the latter possible, smeeping tariff increases were granted to most of the state enterprises early in the year. However, the major fiscal problem in the state enterprise sector this year, as in the past, is the huge deficit of the railways and whether the combination of higher tariffs and limited wage increases would, in fact, suffice to bring about the improvement in the railways finances required by the fiscal program appeared very much an open question. 4. Actual budget results through the end of June showed total revenue and expenditure moving very much in line with the Government's targets and, for the full year, revenues could exceed the projected level by an amount sufficient to offset any additional requirement for transfers to the state enterprises. Achievement of the principal targets of the fiscal program would also mean an impressive rehabilitation of public finances in terms of the public sector's ability to finance its investments from its own savings. In contrast to net dissaving in the public sector in 1966, this year's program provides for public savings totalling M$N157 billion, more than three times the level achieved in 1965, the best previous year on record. At the projected level, public savings would cover more than 60 percent of investment this year, even though the Government's plans call for an increase in investment of more than two-thirds. 5. In making an effective incomes policy a keystone of its program, and dealing firmly with labor, the Govermient has clearly recognized a major shortcoming of previous stabilization efforts. While wage increases in the public sector are to be held to 15 percent, for the private sector provision was made for a round of graduated wage increases in April and May of this year to be followed by a total wage freeze until the end of 1968. Real wages rose sharply through June but, with further increases barred, real wages will inevitably decline in the latter part of the year, making this a crucial testing time for the Government's wage policy. 6. GDP is expected to rise by about 3 percent this year, mainly as a result of a larger wheat harvest and a bumper corn crop. However, through mid-year there was no clear evidence of a general recovery from the recession in industry. Although the cost of living rose by 20 percent on a seasonally adjusted basis through July, or somewhat more than in the corresponding 1966 period, a large increase in prices this year was unavoid- able in view of the sharp devaluation and there was a steep rise in food prices at mid-year reflecting frost damage to the crops. 7. 1967 promises to be the best year for the balance of payments in recent experience, with exports continuing near the record $1.6 billion level reached in 1966 and another current account surplus of some $250 million in prospect. The devaluation was accompanied by the virtual elimi- nation of all quantitative restrictions on imports and by substantial tariff cuts on a wide range of commodities. While the immediate impact of the devaluation on Argentina's foreign trade was cushioned by the export taxes and the tariff cuts, the move from an over-valued peso to what was clearly regarded as an under-valued one succeeded in attracting a massive inflow of capital from abroad. In the first six months of the year, the Central sank's gross foreign exchange reserves rose by nearly $450 million to $670 million.  81 As important as the achievement of this year's stabilization targets is, Argentine experience clearly indicates that success in the fight against inflation is likely to be short-lived and of little signi- ficance in terms of economic development unless accompanied by measures to promote growth and to deal with the basic structural problems of the economy. IWith its stabilization program in operation, the Government has in recent months been concentrating on measures to stimulate recovery from the recession and to promote the redeployment of resources to more productive employment that is essential to more rapid and sustained long- term growth. The Government s most immediate concern vis-a-vis the private sector has been to bring about a recovery of private investment in industry and agriculture and a variety of measures, including generous tax credits for investors, have been introduced for this purpose. In the public sector, the key development problem lies in the inadequacy and instability of public savings, with the railway deficit and the failure to take full advantage of the possibilities of generating savings in the petroleum sector being the major weak points. The Government realizes that public finances will remain precarious as long as the budget must carry the burden of a large number of redundant public employees, and, in July, a law was enacted establishing the legal basis for rationalizing public sector employment. However, implementation of a rationalization program is likely to prove as difficult as it is essential, not only because of the inherent diffi- culties of the problem, but because of the vested interest in the status quo built up over the years in the government bureaucracy and in the state enterprises, as well as in the unions. 9. The realization of the promise of this year's stabilization program will depend on the maintenance and reinforcement where necessary in 1968 of the-existing policies of restraint in the fiscal, monetary and incomes fields. However, the Government may well face a more difficult fiscal situation in 1968 than was the case this year in that, without the extraordinary revenue possibilities opened up by the devaluation and other emergency measures, greater emphasis will have to be given to the,in many ways,more difficult problem of expenditure control. A strenuous effort to increase public savings next year would appear to be required for immediate budgetary reasons, as well as to further the long term process of strengthening the fiscal structure to meet development needs. This will call for a broad effort to tighten budgetary controls in the Central Administration and Decentralized Agencies and to improve the current position of the state enterprises but, in the final analysis, the possibility of achieving meaningful savings on the expenditure side will depend on the progress that can be made in implementing the labor force rationalization program. A substantial reduction in the railway deficit is essential to satisfactory fiscal performance in 1968 and will require the rapid formulation and implementation of a definitive program for reducing railway employment and eliminating uneconomic branch lines and other services. Unless the rationalization program can be put into operation on a substantial scale in the railways and elsewhere in the months immediately ahead, it will have little fiscal impact in 1968. However, even on the most favorable assumptions, economies in current expenditure can be expected to meet only a limited part of the need for increased public savings in 1968,  - iv - and increases in state enterprise tariffs and new tax measures will also be required. Tax policy will have to be shaped in the context of how well the economy is responding to the stimuli administered this year, of the Government's plans for expanding public investment, and of the possibilities of financing the savings gap through non-inflationary borrowing at home and/or abroad. 10. The balance of payments outlook for the next several years appears favorable, assuming the maintenance of a realistic exchange rate, prudent debt management, and a suitable domestic stabilization and development policies. While exports may not rise as rapidly as during the 1961-65 period, the growth of foreign exchange earnings should be sufficient to permit the increased imports that will be needed in an expanding economy, and to generate substantial current account surplus. However, Argentina's foreign debt totalled more than $2.6 billion at the end of last year and some 75 percent of this amount was scheduled for repayment within five years. Given the heavy debt service burden, a gross capital inflow of some $1.3 billion wall be required to balance Argentina's external accounts during the 1968-71 period, although the annual requirements will decline sharply as the debt burden is worked down. A net reduction in Argentinats extermal debt over the next four years of upwards of $800 million, or more than 25 percent, should be possible. However, if full advantage is to be taken of the opportunity for reducing the onerous debt service burden, a determined effort will have to be made to ensure that the new borrowing that will be necessary in the coming years is done on much more favorable terms than has been the case in the past. Assuming this is done, the debt service ratio may be expected to decline from 38 percent in 1968 to 20 percent, or less, in 1971.  I. INTRODUCTION 1. In no country in Latin America has the shortfall between development potential and actual economic performance been as striking as in Argentina over the past 15-20 years. During the first four decades of this century Argentina enjoyed an enviable growth record and at the end of W4orld liar II it could count among its basic assets, in addition to the favorable geography and climate upon which its prosperity had been based, the highest per capita income in latin America, a homogeneous and well educated population, sizeable foreign exchange reserves, and sound financial institutions. Despite these formidable advantages the actual economic record since the war has been one of slow and unsteady growth, endemic inflation, and recurring balance of payments crises. To an important extent, these difficulties reflect the deep damage done to the Argentine economy, and particularly to agriculture and the balance of payments, by the pursuit of industrialization at any price, the constant pushing up of real wages and the building up of the trade unions into a dominant political force during the Peron era. However, especially in more recent years, the authorities' inability, in the face of political instability and trade union and other pressures, to maintain consistently the policies necessary to internal and external financial stability has been a major factor in the disappointing performance of the economy. The alternation of periods of restraint and relaxation has imparted a stop-go character to economic growth which has effectively precluded any sustained expansion. 2. 1Then the present Government took power in June 1966, one of its principal objectives was to bring about a radical improvement in economic performance. Following the appointment of a new economic team in January of this year, rapid progress was made in developing and putting into effect a comprehensive stabilization program comprising measures in the fields of fiscal, monetary, foreign exchange, wage and price policy. With its 1967 "action program" largely in operation, the Government has in recent months been concentrating on measures to stimulate a revival of economic activity and to promote the basic structural reforms and redeployment of resources essential to put the economy on the road to more rapid and sustained long-run growth. 3. This report focuses on the prospects for success of the stabi- lization program as an essential pre-condition for the restoration of the growth process, on the Government's major development problems, and on the principal issues for economic policy in 1968. This report should be read in conjunction with the earlier ones which have discussed in depth the characteristics of economy, its long-run growth, potential, and development problems and policies in the major sectors.&/ 1/ The last report distributed to the Executive Directors was WH-144a, "The Economic Position and Prospects of Argentina," May 5, 1965. A subsequent draft report, NH-162a, June 1966 was overtaken by the change in government and not completed.  II. RECENT TRENDS IN ECONOMIC PERFORMANCE ANID POLICY Performance 4. Since 1950 gross domestic product has grown by an average of just 3 percent yearly. Thus, while population pressure in Argentina is relatively light, the annual increase being estimated at about 1.8 percent, GDP per capita has risen by only about 1 percent per year as a result of the slow expansion of output. W4hile production has expanded quite rapidly in some years, the periods of expansion have been repeatedly cut short by recessions during which the earlier gains have largely been lost. Indeed, GDP has actually declined in six of the past 16 years and three of the past seven years. A very sharp recession in 1959 was followed by two years of rapid growth stimiulated by an investment boom financed largely by the inflow of foreign capital. This boom collapsed toward the end of 1961 when the capital inflow dried up as confidence was undermined by balance of payments difficulties and growing political instability. After two years of recession, a neti boom got under way late in 1963 and an expansionary monetary policy plus two bumper wheat harvests made 1964-1965 the most rapid period of expansion for the Argentine economy since the 1920's. However, monetary policy had to be tightened after mid-1965 to protect the balance of payments, the wheat harvest returned to more normal levels and, with the two principal stimuli to expansion gone, the econorm slipped into recession once again in 1966. 5. Manufacturing is the largest single sector of the economy, accounting for nearly one-third of GDP, and it has long been the most favored one. High tariff barriers, an over-valued exchange rate making imported inputs relatively cheap, and direct government promotion through tax incentives for investment and other measures have provided powerful incentives for manufacturers to take maximum advantage of opportunities for import substitution across a broad field. Argentine industry is now capable not only of providing virtually all of the countryts consumer goods, but also of meeting the bulk of its requirements for capital goods. But, while the growth of manufacturing has outpaced that of the rest of the economy, production has fluctuated widely through the periods of overall economic expansion and contraction, and the average annual rate of growth of manufacturing since 1960 has been a relatively modest 4 percent. In recent years, motor vehicles, metals, and machinery have been among the fastest growing lines of industry. However, they have also been the ones most susceptible to cyclical influences, and the 1966 recession was concentrated in these fields. 6. Agriculture has been the most laggard sector of the economy, output having expanded by an average of only a bit more than 2 percent per year since 1950. Year-to-year fluctuations around the trend have been sharp in periods of particularly favorable or unfavorable weather, and the changes in agricultural production have had an important impact on the overall fluctuations of the economy, as was evident most recently  - 3 - in the role of the extraordinary wiheat harvests in the 196h-1965 boom. On balance, a significant strengthening in the trend of agricultural production has been discernible over the past several years as discrimi- natory exchange rate and price policies have been replaced by measures which have shifted the internal terms of trade in favor of agriculture. In addition, agriculture has benefited in recent years from tax and credit policies designed to stimulate investment, and from the related progress in the adoption of more modern technology. Among the principal crops, the gains in wheat production have been modest, apart from years in which the weather was exceptionally favorable, but there has been a strong upward trend in corn, with the harvests in the past two years nearly double those of the 1960-1961 period. The cattle herd has been increased rapidly in recent years to an estimated 48-49 million head, a level wihich seems adequate to support considerably expanded beef production for export plus the high level of consumption demanded by the home market. 7. Investment has run at a relatively high level throughout the period, an average ratio of gross fixed investment to GDP of nearly 20 percent being indicated by the national income accounts. While there is good reason to bel'eve that these figures considerably over- state the investment rate,&/ there can be little doubt that the level of investment has been out of all proportion to the growth of the economy. That much investment has been "wasted" in terms of its con- tribution to growth has been an inevitable consequence of the failure to achieve sustained economic expansion and therefore to make full use of the productive capacity built into the economy. However, the un- favorable capital-output relation undoubtedly also reflects the fact that a good deal of investment has gone into inefficient industries in the public and private sectors. Such industries, sheltered from foreign competition and operating in an inflationary environment, have had little incentive to maximize output or labor and managerial efficiency. Public investment has accounted for an average of 15 percent of total capital spending and in recent years has remained relatively constant at some 3-h percent of GDP. On the other hand, fluctuations in private invest- ment have played a major role in the swings in overall economic activity. Private investment rose to over 19 percent of GDP in the boom of the early t6Os, but then fell back sharply to the 14 percent level at the bottom of the subsequent recession. The revival of demand in 1964-65 was largely consumption-oriented, the relatively modest rise in investment probably reflecting the extent to which productive capacity had been built out ahead of requirements in the investment boom. At the height of the boom in 1965, manufacturing industries were still operating at only a reported 70 percent of capacity. 1/ Because of the relatively high price of capital goods in Argentina.  - h - 8. Inflation, not growth, has been the most persistent theme in Argentine economic history over the past 15-20 years. Since 1950, the cost of living has increased by an average of 28 percent per year; in none of the last ten years was inflation less than 14 percent. Even more striking is the fact that the rate of inflation has appeared to be quite independent of the overall state of the economy, actually dis- playing a distinct tendency to speed up as the economy has slowed down. In recent years, the sharpest rise in prices, more than 100 percent, occurred during the most severe slump (1959), while the closest approxi- mation to price stability was achieved during the 1960-1961 boom when price increases averaged 14 percent. Last year, in the recession, prices rose by 32 percent. Along with the inexorable rise in the general price level there has been a substantial shift in relative prices in favor of the agricultural sector. Since 1950 wholesale prices of agricultural commodities have risen 325 percent, while prices of manufactured and other goods increased 265 percent indicating an improve- ment of some 23 percent in the terms of trade of agriculture. 9. The perverse behavior of prices in periods of falling output underscores the fact that Argentinals inflationary fever has been symp- tomatic of something more than a simple case of excess demand. Endemic inflation, in Argentina as elsewhere, reflects the interaction of a complex of demand-pull and cost-push factors, of domestic and balance of payments considerations, of expectations, and of social and political pressures. The major elements in the Argentine inflation have been fiscal weakness, wage pressure, and the successive devaluations of the currency. Public savings tended to deteriorate markedly after 1957, mainly owing to a sharp decline in real revenues, with the result that increasing recourse had to be made to the banking system for the financing of public investment, even though the latter was not being expanded in real terms. On the cost-push side, the wage price spiral has played a key role in the Argentine inflation. Since 1958, industrial wages have risen by some 34 percent per year, speeding up or slowing down from year to year in parallel with the changes in the pace of inflation. The increase in wages has tended to lag behind the rise in prices in periods of particularly sharp price increases while, in years of rela- tively moderate inflation, wages have tended to outpace prices. After advancing over the l950-l958 period, real wages fell sharply during the 1959 inflation. Since then, however, wages have risen more rapidly than prices in every year but one. Iast year, real wages were some 23 percent above the 1960 level, although still below their 1958 peak. 10. The relationship between prices and the exchange rate has clearly been a special factor in the Argentine inflation. The peso depreciated by an average of some 21 percent per year between 1950 and 1966, the exchange rate actually rising by more than 30 percent in several years. While repeated devaluations have been necessary to keep exports moving in the face of rising domestic prices and costs, the exchange rate adjustments have, in turn, entered powerfully into the inflationary process owing to the fact that Argentinats principal  - 5 - exports are basic foodstuffs whose prices weigh heavily in the cost of living. Devaluation has, of course, also increased the cost of imported raw materials and equipment upon which so much of Argentine industrial production depends. Taken together, the items which have a high export or import component appear to have a weight of at least 50 percent in the cost of living index, and it is thus not surprising that the major recent devaluations, in 1959 and 1962, were followed by the sharpest inflation. 11. The frequent devaluations have reflected the underlying balance of payments constraint to economic growth. Forced industrialization at the expense of agricultuire in the Peron era resulted in a stagnation of exports during the 50ts which made 4t impossible for Argentina to earn the foreign exchange necessary to keep its economr fully employed and growing. In the past five years, however, export performance has vastly improved as a result of favorable trends in foreign markets as well as the domestic policies favoring agriculture already mentioned, After having remained around the $1 billion level up to 1961, exports rose by some 60 percent over the 1962-1966 period, nearly reaching $1.6 billion last year. About $160 million of the increase was the result of a rise in meat exports, attributable to both increased volume and higher prices; wheat and corn accounted for roughly $200 million and $100 million, respectively, of the export gain, mainly on higher volume; and miscella- neous exports, including manufactured products, also gained sharply. Capital goods imports have been sharply lower since the early 60's and, with the total import bill remaining within the $1.0-$1.2 billion range over the last four years, there have been trade surpluses of $300-$400 million. 12. Despite the impressive export performance in recent years, the balance of payments constraint has remained very much a fact of Argentine economic life owing to the onerous debt service burden which has con- sumed the bulk of the increase in foreign exchange earnings. While exports lagged, Argentina had to have increasingly heavy recourse to foreign borrow%ing in a process which culminated in the 1959-1962 period in the acquisition of more than $800 million of new debt, raising the total foreign debt to some $3 billion. The debt, much of it in the form of supplierst credits, was contracted on unfavorably short terms and this gave rise to the need for successive partial refinancings. These took place in 1961 and 1962 and, again, as recently as 1965 when the Paris Club countries agreed to extend over a five-year period 60 percent of the-maturities falling due in that year on guaranteed suppliers credits. However, as useful as they were, the refinancings had the effect of "bunching-up" payments in future years and in 1966 more than $600 million, an amount equivalent to about one-third of Argentinats gross foreign exchange earnings, had to be paid out for debt service. All told, the Central Bank estimates that some $500 million of debt has been repaid, net, since 1963, reducing the total outstanding on December 31, 1966 to some $2.6 billion, of which some two-thirds was public debt. Little, if any, improvement has been made in the term structure of the debt and about 75 percent of the  outstanding amount was scheduled for repayment during 1967-71. Some Increase in Argentina's sorely depleted foreign exchange reserves has been possible in recent years, although at the end of 1966 the Central ]3ank's gross gold and foreign exchange holdings were only $222 million, an amount sufficient to cover about two months' imports. Calculated net of foreign exchange liabilities (including the Treasury's) the reserves were a negative $157 million. Policy 13. Stabilization efforts have been under way during most of the period since 1958. In 1962-1963, the effects of the tight monetary policy imposed to deal with the critical balance of payments situation were distorted by soaring budget deficits resulting from a sharp decline in revenues during the business recession. The calling of foreign loans contributed to the paralysis of a commercial paper market that had assumed major proportions and, with a severe liquidity squeeze on the private sector but no effective overall monetary restraint, output fell while inflation accelerated. The futility of this course, together with an easing of the balance of payments situation, led at the end of 1963 to a switch to a policy of monetary expansion which undoubtedly contributed importantly to the rapid revival of the economy in the succeeding year. In 1965 a broadly based anti-.inflationary program was undertaken with the aim of tapering off the boom into a period of sustained economic growth. Based on the diagnosis of Argentipa'ls economic ills contained in the National Development Plan for 1965-1969,Y/ the Government's efforts in 1965 and 1966 focused on the achievement of clearly established targets for groith, for monetary and fiscal policy, and for wage and price restraint. 14. While certain of the targets of the 1965 program were achieved, overall performance was uneven. The most impressive accomplishment was the recovery of public finances as new taxes and the general economic expansion boosted revenues by 65 percent (26 percent in real terms). The budget deficit was cut by more than 25 percent. Looking at the public sector as a whole, savings rose sharply to the equivalent of 39 percent of public investment. This was, nonetheless, short of the Government's savings target owing to the disappointing financial performance of the Decentralized Agencies, the social security system and the state enter- prises. With the budget in hand, monetary expansion was held close to targeted levels, but the other major elements in the stabilization program - wage and price restraint - proved inoperative. The Government's wage policy, based on voluntary guidelines not announced until mid-year, was vitiated in both the public and private sectors, and money wages rose by 35 percent compared with the 22 percent targeted. Prices followed suit, with the rate of inflation accelerating sharply in the second half of the year. With credit to the private sector restricted, a severe liquidity squeeze began to develop. 1/ This Plan, analyzed in the 1965 iconomic Report, has been a dead letter since the change in government in mid-1966.  - 7 - 15. To meet the challenge of inflation, the Government planned for 1966 a considerably tighter fiscal policy, with greater emphasis on expenditure control, a more restrictive monetary policy, and a much more serious effort to limit wage and price increases. Success in the latter area was crucial since, without a substantial slowing of inflation, the planned monetary program implied a further tightening of liquidity in- consistent with continued growth. In practice, however, the Government was unable to carry out its wage policy. Under strong pressure from the trade unions it yielded up 30 percent wage increases, double its target, in the state enterprises (where sizeable increases had already been granted in 1965) and in so doing set the pattern for the rest of the economy. The continued rapid rise in prices intensified the liquidity squeeze, and while the monetary program was abandoned after mid-year, output and employment had already turned down. In these circumstances, fiscal performance also deteriorated sharply, with budgetary expenditures far exceeding the targeted level and an increase of more than 60 percent (22 percent in real terms) in the treasury deficit. As regards the rest of the public sector, the railway deficit rose sharply, while the savings performance of the other major state enterprises fell far short of expectations, with the result that public savings as a whole were negative.  III. THE 1967 STABIIIZATION PROGRAM 16. The Governmentts "Action Program" for 1967 is based on the principle that inflation must be attacked immediately and simultaneously on all fronts. A truly comprehensive approach was deemed essential, not only to avoid the economic pitfalls which upset previous stabilization efforts, but also in order to alter expectations decisively and build confidence at home and abroad, an aspect of its policy to which the Government attaches great importance. The foundation for the program was laid by a thoroughgoing revision and tightening of the 1967 budget, enacted in January. This was quickly followed up by the adoption of a monetary program in agreement with the IMF, by legislation to limit wage increases, and by a program of price restraint. On the external side, the action taken was, if anything, even more sweeping. A 40 percent devaluation of the peso to PON 350 to the dollar was announced on March 13 and accompanied by the virtual elimination of all quantitative restrictions on trade and payments and by substantial tariff cuts affecting a wide range of co,mmodities. In support of its program, the Government was able to obtain more than $400 million of "stand-by credits" from the IMF, the US Treasury, and American, European and Japanese commercial banks. 17. The 1967 program is a pragmatic and well-balanced one which promises to bring about substantial progress toward stabilization and, in so doing, to help lay the foundations for more rapid and sustained economic growth, In making a marked improvement in fiscal performance and an effective incomes policy the keystone of its efforts, the economic team clearly recognized the major shortcomings of economic policy in past years. However, the real strength of the program now under way, and the best grounds for hoping that it will have both a greater measure of succeos and a more durable impact than preceding stabilization efforts, lies in the determination and ability of the present Government to carry it through. The Budget 18. The budget is clearly the most crucial and, at the same time, the most difficult element in the 1967 program. The basic decision taken in preparing the program was that the budgetary deficit would have to be cut back by more than 50 percent to a maximum of M$N75 billion if there was to be a significant reduction in inflationary pressures. To achieve an improvement of this magnitude in one year would be a formidable task anywhere, and particularly so in the Argentine situation given the com- bination of a structurally weak fiscal system and a depressed economy. The price inelasticity of the tax system, reflected in the fact that tax collections in real terms had dropped again in 1966 and were some 20 percent below the level attained five years earlier, meant that the creation of major new sources of revenue would be indispensable. In addition, measures would be required to boost collections sharply by  - 9 - putting them on a more current basis and by inproving administration, the latter being particularly important in view of the past tendency for collections to drop precipitously in recession years as hard-pressed businessmen found non-payment of taxes a ready way out of their financial difficulties. Expenditure control posed equally serious problems. More than one-third of budgetary expenditure consists of transfers to finance the deficits of the Decentralized Agencies, Special Accounts, and State Economic Enterprises over whose spending the governments have had little effective authority. The Government's ability to control the other one- third of budgetary expenditures going to wages and salaries, which had risen nearly 20 percent in the real terms over the preceding five years, also appeared problematical. 19. The budget constructed in the face of these difficulties calls for an increase of nearly 70 percent in revenues. As the table below shows, the bulk of the targeted increase is to come from new taxes, from increases in the rates of existing taxes, and from specific steps taken to increase collections. The magnitude of the planned revenue effort is reflected in the fact that new measures are expected to account for more than one-quarter of this year's total income. PROJECTED REVETUE INCREASES, 1967 (billions of pesos) 1. 1966 Revenues 284 2. "Vegetative" Increase 70 3. New Tax Measures 115 Export taxes 52 Internal taxes 35 Real Estate (20) Loans ( 6) lubricants ( 6) Excises ( 3) Increased collections 28 Sales tax Pay-As-You-Go (12) Greater Federal Participation (16) 4. Improved Administration 9 5. 1967 Revenues 478  - 10 - 20. It was the devaluation which made possible the single most important revenue measure - the imposition of heavy taxes (retentions) on exports, a traditional Argentine fiscal device. These taxes, imposed at the rate of 25 percent on the major export products, are expected to provide nearly 50 percent of the additional revenues to be generated by the new measures. In estimating the yield from the export taxes, allowance was made for the fact that the rates initially established left exporters of traditional products with only limited benefits from the devaluation, and that it would, as in the past, undoubtedly be necessary to adjust the rates downward from time to time in order to keep exports moving in the face of rising domestic costs. On the domestic side, special "emergency taxes", to be applied in 1967 only were imposed on real estate (1 percent of assessed valuations) and loans (2 percent per annum on outstanding-balances), and various excise taxes were increased by differing amounts. A substantial amount of additional internal revenue is also sought through increased collections resulting from the placing of the sales tax on a Pay-As-You-Go basis and from legislation which increased the participation of the National Government from 54 to 59 percent in several important taxes which are shared with the provinces. An important contribution to the tax drive is also expected from the program for improving tax administration which has been under way for some time with the aid of technical experts from abroad. In addition, the Government undertook to adopt additional revenue measures if this appeared necessary to compensate for any shortage of revenue or excess of expenditure at midyear. 21. The revenue targets appear reasonable on the whole, and actual collections in the first half of the year were up an impressive 68 percent over the 1966 level, or just about in line with the targeted gain for the full year. Moreover, the trend of receipts rose steeply in the second quarter of the year as collection of the new taxes got under way; compared with the corresponding 1966 months, revenues nearly doubled during April- June compared with a gain of only 30 percent in the first three months. Partial data for the third quarter pointed to a continuation of the favorable trend in tax collections and, indeed, made it seem that the year's revenue target might well be exceeded by a modest amount. No important adjustments were made in the export taxes until the end of September, by which time nearly M$N 50 billion had been collected, making it appear certain that the yearts revenue from this source would substantially exceed the budget estimates. In addition, the real estate tax yielded a good deal more than expected in the first of the two installments in which it was being collected and monthly income tax receipts were also running ahead of the projected level, the latter presumably reflecting the fact that the enforcement drive was proving even more effective than had been hoped. These trends would more than compensate for the dropping of the tax on loans in July in order to reduce borrowing costs as part of the GovernmentWs effort to stimulate the economy.  22. On the expenditure side, the budget is built on the proposition that total spending nust be held to about the 1966 level in real terms, an increase of only 23 percent in money terms being allowed for. The expenditure target is based, in the first instance, on the Government's decision to limit the 1967 salary increase of all public sector employees to no more than 15 percent, compared with the increases of more than 30 percent granted in 1966. To enforce the ceiling, all salary increases throughout the public sector were made subject to prior review by a special commission wqhich decided that, for the Central Administration, they would take effect from July 1. Coming on top of the very substantial raise granted in the second half of last year, the effect would be to boost the average level of wages this year by some 25 percent, an increase which seems to have been adequately allowed for in the budget. The 15 percent ceiling applies to the rest of the public sector as well, but in the case of the state enterprises its application to the various wage contracts requires case-by-case decisions -- e.g., it was announced in July that the railway workerst 15 percent increase would be retroactive to the expiration of the previous wage contract at the end of January. 23. The second, and most crucial, element on the expenditure side was the decision to impose a severe limit on budgetary transfers to the State Economic Enterprises. The Government has specifically undertaken to limit transfers to the enterprises to M$N 105 billion, an amount just about equal to the 1966 level which, of course, implies a sharp reduction in real terms. The major action taken to reduce the enterprises' depend- ence on the budget was the granting early in the year of sweeping tariff increases amounting, for example, to 66 percent in the case of the railways, 58 percent in electric power rates and 75 percent for telephone charges. The Government does not intend to authorize further tariff increases this year and is looking to economies in the enterprises' budgets to bring their financial performance to the required level. Measures to improve operating efficiency by restoring labor discipline and revising work rules have been applied in several enterprises and notable results were quickly apparent in the railways and ports, whose management was placed in the hands of the armed forces. In addition, the Government was seeking (perhaps for the first time) to carefully review the budgets of the individual enterprises with the aim of adjusting their current expenditures and/or investment programs as necessary to fit them into the overall fiscal program.  - 12 - FINANCING OF STATE ECONOMIC ENTERPRISES, 1967 (billions of pesos) Railways YPF/Gas Other Total Indicated Financing "Gap" 94 55 27 176 Special Financing Assumed - 29 15 44 Reduction Working Capital - 15 - 15 Central Bank Credit - 14 - 14 Energy Fund - - 15 15 Budgetary Transfers 74 16 12 102 Economies Required 20 10 - 30 Source: Ministry of Economy and Mission Estimates 24. The Governmentts budgetary planning, as the table above shows, was to hold transfers within the ceiling by allocating no more than M$N 74 billion to the railways, M$N 12 billion to other transport enter- prises and M$N 16 billion to the enterprises in the energy sector (with M$N 3 billion left unallocated for contingencies). The problem therefore focuses, as in the past, mainly on the huge deficit of the railwJays. Over the 1961-66 period, the railways'drain on the budget rose by nearly one quarter in real terms and last year transfers to the railways accounted for 18 percent of total budgetary expenditures compared with 14 percent five years earlier. This underscores the magnitude of the economy effort in the railways implied by the ceiling on transfers, since the M$N 70 bil- lion allotted for ordinary expenditures (M$N t billion would be to cover increased costs resulting from the devaluation) would be actually 10 per- cent lower than the railways required in 1966 in current prices, and about 30 percent less in real terms. The extent to which the combination of limited wage increases and sharply higher tariffs this year would contri- bute to the necessary turnaround in the railways finances appeared very much an open question at the time of the Mission's visit, owing to the paucity of up-to-date information on the enterprise's accounts, but what evidence there was pointed to the need for substantial economies if the railways were to live within the budget ceiling. While a financial plan for the railways consistent with the Government's budget strategy had not been prepared through mid-May, the first rough estimates of the railway accounts that were available to the mission indicated that planned expen- ditures have to be reduced by some M$N 20 billion and that this would, very tentatively, require a M$N 7 billion, or one-third, cut in planned  - 13 - investments and the postponement of M$N 13 billion of debt repayments falling due this year. 25. After the railwJays, the most important enterprises from the viewpoint of the budget are those in the energy sector, particularly the State Petroleum Company (YPF) and the State Gas Company. These enter- prises run substantial current account surpluses, but depend on the budget for financing a portion of their investment programs, which they planned to increase very sharply this year. The Governmentts budgetary planning allocated transfers totalling no more than M$N 16 billion to these enter- prises to cover the estimated cost of the devaluation, although this would leave an unfinanced "gap" of some M$N 10 billion according to the enter- prises' financial projections. The latter projections, moreover, assumed that no less than M$N 15 billion in financing could be made available by freeing working capital through a program to reduce drastically the large backlog of unpaid bills owed these enterprises by their clients in both the public and private sectors.!/ The financing needs of the other enter- prises in this sector (the water and power company and the coal company), while substantial, would be met by transfers from the lhergy Fund. In sum, then, even assuming that all of the projected special financing is forth- coming, the maintenance of the planned ceiling on transfers to the state enterprises appeared to require the achievement of economies of at least M$N 20 billion by the railways and M$N 10 billion by YPF and the gas company. 26. Actual budgetary expenditures in the first half of the year were within the Government's planning targets for the period. The increase in current expenditures compared with the monthly average 1966 level was such as to indicate that the projected increase for the full year should not be exceeded, provided that salary increases in the second half do not, in fact, exceed the 15 percent already granted. Transfers to the state enterprises through the end of June were, in total, also at a level con- sistent with the year's budgetary goals, although there was evidence of pressures that presaged greater difficulties in the latter part of the year, Transfers to the railways totaled M$N 34 billion, less than half the amount allocated for the year. In the second half of the year, however, the railways would have to pay a 15 percent wage increase retro- active to February 1, while there would presumably be less scope for holding down the need for transfers from the Treasury by running down working balances and deferring payments to suppliers, devices to which the railways had to have extensive recourse during January-June judging by the complaints voiced by both its management and those to whom it 1/ In addition, it should be noted that the enterprises' financial pro- jections also counted on the use of some M$N 14 billion in Central Bank credit to finance purchases from domestic suppliers. The monetary implications of such financing would be no different than drawing on the Treasury.  owed money. Moreover, while the new management had m!ade the trains run on time. little, if any, action appeared to be in the offing in the way of labor force redictions or other measures which would produce substantial savings this year. An additional factor was that the need for transfers to the State Enterprises during the first half of the year was moderated by the fact that YPF and the gas company made only negligible claims on the Treasury, a situation which cannot be expected to continue in the latter part of the year, as noted above. 27. With both revenues and expenditures very nearly on target, the budget deficit in the first half of the year did not exceed the M$N 50 billion planned for this period. For the full year, transfers to the state enter- prises may exceed the Governmentts ceiling, as just discussed, but the budget seemed to contain some cushion against suLch an eventuality in the fact that approximately M$N 14 billion of investment funds had been set aside in an unallocated reserve. In addition, the Government sought to bolster its budgetary position by delaying any major adjustment in export taxes until the latter part of-the year and, as indicated above, revenues could exceed the planned level. All in all, achievement of the basic fiscal target of holding the 1967 budget deficit to M$N 75 billion seemed to be well within reach. Savings and Investment in the Public Sector 28e The fiscal program also entails an impressive rehabilitation of public finances when viewed in terms of the improvement planned in the public sectorts ability to finance its investments from its own savings. In 1966, the budgetary position deteriorated to the point where revenues barely covered current expenditures, while the current deficit of the state enterprises as a group rose sharply. As a result, the public sector as a whole had to turn to the banking system to finance a portion of its operating expenditures, as well as all of its investments. In contrast to the net dissaving in 1966, this year2s program, as the table below shows, provides for public savings totalling 1$N 157 billion, more than three timles the level achieved in 1965, the best previous year on record. At the projected level, public savings would cover more than 60 percent of investment this year, even though the Governmentts plans called for an increase in investment of more than two-thirds to the M$N 255 billion level. In practice, the savings ratio achieved may be even higher than planned since, while actual savings are likely to closely approximate the target amount, investment may well fall short of the planning level owing to the administrative difficulties of implementing so large an increase in one year, and also to the financial pressures on some of the enterprises. Be this as it may, there is no reason to doubt that savings performnsuce will show a vast improvement, not only from the collapse of the savings effort last year, but also compared to 1965, when a savings ratio of nearly 40 percent was achieved. In absolute terms, the savings-investment gap this year would be reduced some 40 percent to less than M$N 100 billion.  SAVINGS AND INVESTPIENT OF THE NATIONAL GOVERNMENT, 1964-67 (in billions of pesos) 1964 1965 1966 1967 (Actual) Planned Actual Planned Actual (Planned) SAVINGS I. Central Administration (Budget) - 30.0 6.8 25.2 47.0 2.9 136.0 Revenues 123.4 211.0 223.8 300.0 283.9 478.0 Current Expenditures -153.4!! -204.21/ -198 . 61/ -253.0 -281.0 -342.0 II. Decentralized Agencies - Special Accounts 18.1 3.2 8.6 - 3.0 - 7.8 - 2.4 Revenues 80.2 72.0 106.4 107.0 116.22/ 198.0 Current Expenditures - 62.1L/ - 68.81/ - 97.8L/ -110.0 -124.0 -200.4 III. Energy Fund 8.o 14.0 10.0 16.0 11.4 18.5 IV. Social Security System 12.2 35.0 11.4 11.0 - 6.6 n.a. Colle ctions 98.4 141. 0 135.6 190.0 168.3 n.a. Payments - 86.2 -106.0 -124.2 -179.0 -174.9 n.a. V. State Economic Enterprises -19.0 - L.0 -7.8 4.0 -21.0 5.4 State Railways n.a. -39.0 -40.6 - 40.0 -57.7 -52.0 State Petroleum (YIF) n.a. 28.0 23.7 48.0 30.6 32.5 VI. Total Public Savings (I-V) -10.7 55.0 47.4 75.o - 20.9 157.0 INVESTMENT 3/ VII. Central Administration n.a. C ( ( 14.0 31.0 ( 40.0 (46.8 (48.0 VIII. Decentralized Agencies - Special Accounts n.a. ( ( ( 36.1 64.7 IX. State Economic Ehterprises n.a. 84.0 74.0 119.0 99.2 158.9 X. Total Public Investment (VII-IX) 99.0 124.0 120.8 167.0 149.3 254.6 SAVINGS/INVESTMENT "GAP" Xi. Total Public Sector (X minus VI) 109.7 69.0 73.4 92.0 170.2 97.6 XII. Savings as per cent of Investment - 44.4% 39.2% 44.9% - 61.6% Note: Columns may not add to totals because of rounding. 1/ Mission estimates 2/ Excludes K$N 20.6 billion of revenues assumed to Ihve been utilized-in "financial investment." 3/ Includes M$N 14 billion of unallocated funds. Source: Ministry of Economy  - 16 - 29. Virtually all of the proposed saving is to be done through the budget which is expected to produce a current surplus of M$N 136 billion this year, compared with less than M$N 3 billion in 1966. The basic realism of the savings target was indicated by the foregoing dis- cussion of the revenue and expenditure measures taken, and actual trends this year. The bulk of the budgetary savings would be transferred to the rest of the public sector, since investment by budgetary entities is relatively modest and only a small increase was planned for this year (allowing for the fact that the reported total of budgetary investment includes some M$N 14 billion that was actually being held as a contin- gency reserve and would most likely be used for transfers). 30. The Decentralized Agencies as a group are expected to show a net operating deficit only slightly smaller than in 1966, despite much higher revenues (mainly earmarked t,axes), because of a projected sharp increase in current expenditures.)L/ The major agencies in this group are the National Highway Authority, Sanitary WpJorks, the development banks and the universities. Only partial information on their budgets was available at the time of the missionts visit, but it appeared that most of the major agencies expected to generate current surpluses, the negative savings for the group as a whole being mainly attributable to the large operating deficits of the universities. Investments by the Decentralized Agencies were expected to increase by more than 80 percent, most of the planned expansion being in highways and water and sewer projects in line with the enphasis the Government had put on expanding public works activities which would have an immediate impact in increasing employment, particularly in urban areas. With their savings performance negative, the planned increase in investments could only be financed by drawing on the Treasury and a rO percent increase to M$N 75 billion in budgetary transfers to the Decentralized Agencies was budgeted for this year. 31. In the past, the social security system generally contributed a substantial volume of savings to the financing of the rest of the public sector. Last year, however, collections lagged far behind the increase in payments and the social security accounts showed a deficit for the first time in ten years. The lag in collections was a reflection not only of the 1966 recession, but also of the gross inadequacies of the entire social security mechanism and the general lack of public confidence in it. The Government early this year launched a vigorous campaign to bring contributions up to date by waiving penalties for those complying 1] While much of the Governmentts budgetary data for the Decentralized Agencies had to be estimated, and the rise in current expenditures may not be as great as projected, savings performance is not likely to be substantially better since experience indicates that, in practice, variations in current expenditure tend to be closely linked to available income.  - 17 - within a given period, and threatening stiff sanctions against those who did not. This effort apparently met with great success, as a result of which collections in the first half of the year rose very sharply and there was a substantial surplus of income over outgo. While benefits were raised substantially in June, it appeared possible that a considerable amount of savings, not included in the official projections shown in the table, might be generated in this sector. 32. The State Economic Enterprises as a group are expected to generate savings of about M$N 5 billion, compared with their combined operating deficit of some M.$N 21 billion in 1966. The expectation of a significant turn-around in savings performance in this sector is under- pinned by the sharp tariff increases put into effect and, while the amount of savings envisioned is modest, it would be the first time that any net savings have been generated by the enterprises since collection of data in this form began in 196h. On the other hand, state enterprise investments were programmed to increase by some 60 percent to the M$N 160 billion level; about two-thirds of the rise in total public investment planned for 1967 would thus be taking place in this sector. The gap between the savings generated by the state enterprises as a group and their investments would grow to about M$N 165 billion, some M$N 30 billion more than in 1966. 33. YPF is both the largest source of savings and the heaviest investor among the state enterprises. BEt, while its savings were expected to increase only slightly this year, owing principally to the fact that petroleum prices were not significantly raised, YPF planned to nearly double its investment expenditures to about M$N 60 billion, thus accounting for nearly one-quarter of total public investment. At the planned level, YPF's investments would exceed its projected savings by some M$N 28 billion. A slightly larger gap appears in the projected accounts of the gas company, the other major enterprise in the petroleum sector, which planned to increase its capital spending by some M$N 10 billion while expecting some decline in its modest savings. The railways had intended to increase investment by 50 percent to about M$N 20 billion but, as noted above, budgetary considerations would appear to dictate a maximum effort to pare these plans. The other principal investors among the State enterprises, the lWater and Power Agency and the National Tele- phone Company, would have sufficient savings available to cover planned increases in capital spending; the former would be able to draw on the Energy Fund (a mechanism for channeling earmarked taxes on petroleum and electricity to enterprises in the power sector) for this purpose, while the latter would generate sufficient savings of its own.  Monetary Policy 34. The test of monetary policy in 1967 will be the authorities' ability to impose the degree of credit restraint required for the success of the stabilization program and the maintenance of a strong balance of payments position. Insofar as the domestic credit operations of the Central Bank are concerned, the upper limits to expansion are fixed by the authorities' undertaking to the IMF to limit the increase in the Bank's net lending to the public and private sectors to M$N 110 billion, equivalent to an increase of about 25 percent over the December 1966 level. WIithin this total, Central Bank financing of the Treasury is not to exceed YMN 80 billion, which would be 20 percent less than in 1966. While these ceilings appear adequately to circumscribe the growth of Central Bank credit, the massive inflow of foreign exchange which has been under way since the devaluation could provide the basis for an excessive monetary expansion. From mid-1wch through June 30, the Central Bank's net foreign exchange purchases exceeded M$N 100 billion equivalent. As a result, although Central Bank advances to the Treasury were negli- gible after March, and Central Bank credit to both the public and private sectors was well under the programmed levels for the first half of the year, the money supply rose by nearly 15 percent during January-June compared with an increase of 10 percent a year earlier. Even assuming no substantial additional foreign exchange inflow in the second half of the year, the liquidity build-up which has already taken place could, according to Central Bank estimates, provide the basis for a credit expansion of 35 percent or more. 35. The authorities are fully aware that an expansion of this magnitude would be incompatible with the stabilization program, and of the difficult problem of monetary management with which they are faced. However, through mid-yrear the task of monetary policy was greatly eased by the fact that the banks, uncertain as to how long they might continue to enjoy their sudden affluence, were taking a cautious attitude toward expanding their credit operations. More than half of the increase in the banks' deposits was put into their cash reserves and loan expansion was relatively modest. In these circumstances, the climate of monetary ease resulting from the foreign exchange inflow could be considered a positive development in the context of the Governmentts desire to stimu- late a revival of economic activity and to see costs reduced. Interest rates on the extra-bank market, which provides a substantial part of the financing for business, came down sharply in the second quarter of the year to the point where the rates charged were generally reported to be not much in excess of the effective cost of borrowing at the banks. Tnus, through mid-year, there appeared to be no pressing need for across the board measures to reduce the liquidity overhang, and the strategy being pursued by the authorities was mainly to seek to counter the impact of the foreign exchange inflow through reductions in the planned expansion of Central Bank credit.  - 19 - 36. The principal measure adopted was to take advantage of the existing situation to undertake open market sales of short-term Governmient securities in order both to absorb excess liquidity in the banking system and to limit the Treasury's need to have recourse to the Central Bank. Sales of 15-360 day Treasury bills were begun toward the end of April and met with considerable success,as it proved possible in the ensuing months to readily sell an average of more than M$N 4 billion in regular biweekly tenders. Yarket interest has been mainly in the shorter maturities in the 30-90 day range which were being sold at a relatively low (for Argentina) average annual interest cost of 6-9 percent. Net Treasury bill sales through June 30 totalled more than M$N 12 billion and this, together with the success in holding the line on the budget deficit, made it possible for the Treasury to make substantial repayments to the Central Bank in the second quarter of the year and thereby play an important absorptive role in the monetary situation. As another means of limiting potential for credit expansion, the Central Bank has sought to reduce its rediscount operations with the private sector and during the second quarter of the year rediscounts were cut by M$N 9 billion. IWages and Prices 37. As discussed earlier, wage pressures were a major factor in undermining Argentina's stabilization efforts in the past and it is the Government's demonstrated firmness in dealing with labor so far, together with the comprehensive incomes policy it has established that, perhaps more than anything else, provides grounds for hope that the present pro- gram will be carried through more successfully than its predecessors. As previously mentioned, wage increases in the public sector are to be held to 15 percent. For the private sector, a law passed at the end of March provided for the granting of a round of graduated wage increases in April and May this year and then a total wage freeze until the end of 1968. The increases permitted this year range from 8-24 percent depending on the expiration date of the existing wage contracts in different indus- tries, with workers who received their previous adjustments most recently being allowed the smallest raises in 1967. Taking into account that this year's raises will in many cases come on top of sizeable adjustments granted in the latter part of 1966, an increase of at least 27 percent in the average level of wages this year is indicated. As large as this appears to be, it would nonetheless be a step forward, since wages are estimated to have risen by about 35 percent last year. During the first six months of this year, industrial wages in Buenos Aires rose by 24 per- cent, or about 17 percent in real terms after allowing for the cost of living increase during the period. However, with wages frozen after the end of May, the real wage will inevitably decline in the latter part of the year and little improvement is likely to remain at the year end.  - 20 - 38. With real wages falling, and probably quite sharply, the last half of the year will be a crucial testing time for wage policy. The success the Government has had in overcoming union resistance to its policies in the railways and the ports, and particularly its decisive action in turning back the central labor organization's "Battle Plan" in IMarch, seems to have engendered a new attitude of compliance on the part of labor which makes a frontal attack on the wage program appear most unlikely now. It will, nevertheless, be most important for the Government to review individual settlements for compatibility with the law and to resist pressures for exceptions, keeping the latter to a minimum and allowing them only where special circumstances do, in fact, exist. The Government appears to recognize this and, in approving an extra 10 percent wage increase in the construction trades, went to some lengths to point out that it had only done so after having verified that there would be a definite and measurable net saving in labor costs as the result of the unionts agreement to the elimination of the special severance pay practices in the industry. 39. For prices, like wages, 1967 can best be regarded as a transi- tional year during which progress must be measured more in terms of the laying of the bases for stabilization than of the actual slowing of inflation in statistical terms. The absence of a specific price target in the stabilization program may be taken as a reflection of the difficulty of realistically assessing the short-term price effects of the many mea- sures taken this year. Tne extent and timing of the impact of the deval- uation is clearly the major imponderable in the current price picture. A 40 percent devaluation could, on the basis of the experience discussed earlier, be expected to exert a major upward push on the price level. However, in the present case, the immediate repercussions on the domestic prices of major export commodities was narrowly limited by the high export taxes imposed, while the impact on the cost of imported goods was partially cushioned by the tariff reductions. Moreover, with the devaluation taking place in the context of a comprehensive stabilization program in which there was substantial public confidence, there was also a cushioning of the psychological impact which devaluation often has ib stimulating in-- flationaiy expectations. 40. In the circumstances, the 6.1 percent rise in the cost of living in the first six months of the year, no more than in the corresponding 1966 period, could be regarded as encouraging. However, prices rose by more than 4 percent in June and this was followied by a 5 percent increase in Jully. bWhile these rises were apparently attributable in the main to sharply higher food prices resulting from frost damage to certain crops, they nonetheless cast a pall over the price outlook. On a seasonally adjusted basis giving better grounds for judging the outlook for the year as a whole, the price increase through July was nearly 20 percent. More- over, the full price effects of the devaluation, and the year's round of wage increases, were undoubtedly still to be felt, and it will not be until the impact of these factors has been absorbed, and probably not until next year, that a marked slowing of the pace of inflation can be expected.  - 21 - 41. WIhile it is particularly concerned with the trend of prices, not only because of its implications for wage policy, but also because of its importance to general public confidence, the Government has eschewed direct price controls as both ineffective and inconsistent with its general philosophy of restoring competition and the role of the price mechanism in the Argentine economy. Thus, the Government's major effort in the price field took the form of a program for enlisting the full cooperation of the private sector in holding the line on prices on a voluntary basis. In May, the nation's businesses were invited to subscribe to a set of price guide- lines established by the Government which provide, basically, that the enterprises shall absrob three percentage points of the rise in costs over the next six months, raising prices during this period only to the extent that the increase in costs since the beginning of the year exceeds this amount. Within a short time after the announcement of the program, vir- tually all major business firms and many smaller ones had pledged them- selves to adhere to the price guidelines. While stressing the voluntary character of the program, the Government made it clear that it intends to make a major effort to ensure compliance. Firms wishing to raise prices during the six months' period must give the authorities 15 days advance notice together with a justification of the intended increase in terms of the guidelines. Although Government approval is not required for putting price increases into effect, firms making "unjustified" increases are to be subject to sanctions ranging from the withholding of Government purchases and restriction of their access to bank credit to, in extreme cases, the free importation of the items in question. The Balance of Payments 42. 1967 promises to be the best year for the balance of tpayments in recent experience. With exports expected to continue near record levels, another substantial current account surplus seems assured. However, it is in the capital account that a major change in the balance of payments pic- ture is to be expected this year as a result of the inflow of foreign exchange which got under way after the devaluation in mid-March. The decision to undertake a sweeping devaluation of the peso was, insofar as the balance of payments was concerned, based principally on the Government's desire to establish an exchange rate which could clearly be held for a considerable time as a means of generating confidence and attracting an inflow of capital from abroad. That the move from an overvalued peso to what was clearly regarded as an undervalued one has served this purpose, and to perhaps an even greater extent than had been hoped, was clearly reflected in a very sharp increase in foreign exchange reserves.  - 22 - 43. As regards Argentina's foreign trade, the devaluation is not likely to have a major impact this year owing to the compensatory charac- ter of the accompanying measures affecting both exports and imports. On the export side, a tax of 25 percent was levied on the major traditional exports including meats, grains, wool and hides; other traditional items such as fresh fruit, dairy products and processed meat were subject to taxes of 20 percent or 16 percent. For the great bulk of Argentine exports in the first category, the tax meant that the effect of the devaluation, in terms of the actual peso returns to exporters on their sales abroad, was to raise the rate ornly to about 262.50, or just some 9 percent above the pre-existing level, as shown in the table below. Exports of non- traditional products, mainly manufactured goods and other items accounting for some 10-15 percent of total exports in recent years, were not taxed and so return a full YON 350 per US$1. However,-the tax reimbursement facilities ranging from 6 to 18 percent of F.OB. values which exporters of these products previously enjoyed were uuspended at the time of the devaluation, so that in practice the stimulus given to these exports was more on the order of 20 percent than 40 percent. Across the whole export list, the Central Bank estimated that the devaluation gave a net advantage of about 9 percent on a weighted average basis. W4hile this was sufficient to keep exports moving to market at high levels in the short run, it was clear that the limited benefits afforded by the devaluation with export taxes at the rates initially established would be subject to erosion by domestic cost increases within a relatively short time. Indeed, as wages and other costs rose in the months subsequent to the devaluation so, inevitably, did the claims of the agricultural sector for tax relief. The Government began to readjust the export taxes at the end of September and reductions for most major products had been announced by early November. The effect of the reductions was to replace the initial 25/20/16 percent rate structure with a new 18/12/8 percent one, thus increasing peso returns to exporters by a further 9-10 percent. "REAL" EXPORT EXCHANGE RATES (pesos per US dollar) Post-Devaluation After Tax Reductions Percent Percent Export Taxes (%) Real Rates Change Export Taxes (%) Real Rates Change 25 262.50 8.9 18 287.oo 9.3 20 280.oo 6.7 J 12 308.oo 10.0 16 294.oo 5.