Argentina - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No.: 16505-AR MEMORANDUM OF THE PRESIDENT OF TH- INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR THE ARGENTINE REPIUBLIC April 24, 1997 Country Operations Unit 2 Country Department I Latin America and the Caribbean Regional Office This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank Authorization.  The last Country Assistance Strategy for Argentina was discussed bv the Executivel Directors in Mav 1995 (Report No 14278-AR. dated April ]0, 1995). A Progress Report| (R96-53/1, dated April 4,]1996)VVaS discussed by the Executive Directors in April 19961 CUIRRENCY AND EQUIVALENTS Currency Unit Argentina Peso (ArgS) Arg$l = USSI WEIGHTS AND MEASURES Metric System FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS CAS Country Assistance Strategy CPI Consumer Price Index EDI Economic Development Institution EFF Extended Fund Facility HMO Health Maintenance Organization IDB Inter-American Development Bank IMF International Monetary Fund IFC International Finance Corporation MERCOSUR Southern Cone Common Market MIGA Multilateral Investment Guarantee Agency NGO Non-governmental Organization SERNAH National Environment Secretariat SSP Secretary for Strategic Planning WDR World Development Report Mananers and Staff Responsible for this CAS Vice President. Mr. Shahid Javed Burki Director Mr. Gobind T Nankani Country Operations Chief Mr John Underwood Task Manager Mr Mark Hagerstrom  THE ARGENTINE REPUBLIC FOR OFFICIAL USE ONLY COUNTRY ASSISTANCE STRATEGY Table of Contents A. INTRODUCTION ..................................................... I B. ECONOMIC AND SOCIAL PERFORMANCE ......................................................1 Overview .................................................. 1 The Regional Financial Crisis ...................................................2 Recent Economic Performance ................................................... 3 Social Performance ...................................................4 Human Resource Development ................................................... 5 Infrastructure ............................... ................... 6 Environmental Issues ...................................................6 Macroeconomic Prospects, Risks and External Environment ...................................................7 C. BANK GROUP ASSISTANCE ......................9,....,.............,.9 Progress Towards Objectives in Previous CAS .9 Portfolio Performnance and Management .10 Country Assistance Strategy .......... . ................................................................................................. 11 Poverty Alleviation and Social Development ................................ 12 Provincial Reform .13 Assistance for Environmental Concems .15 Consolidating Macroeconomic Reforms. 6 Creditx'korthiness and Exposure .18 R-isks.18 Graduation.19 Other Bank Group Assistance .19 Other Multilateral Assistance .20 D. AGENDA FOR BoARD DISCUSSION .21 ANNEXES Annex Al Selected Indicators of Bank Portfolio Performnance and Management Annex A2 Bank Group Fact Sheet, FY94-00 Annex A3 Summary of Economic and Sector Work Annex A4 Argentina at a Glance Annex A5 Key Economic Indicators Annex A6 Key Exposure Indicators Annex A7 Status of Bank Group Operations in Argentina Annex B Argentina Country Assistance Strategy Matrix, FY98-00 Annex C Balancing Risks and Rewards, FY98-99 Annex D Portfolio Conmmission Summary Matrix MAP IBRD 26842 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A COUN TRY ASSISTANCE STRATEGY '' THE WORLD BANK GROUP FOR THE ARGENTINE REPUBLIC A. INTRODUCTION 1. The last Country Assistance (CAS) for Argentina, considered by the Board in May 1995, was prepared during the regional financial crisis and focused on supporting the challenge of (i) the consolidation and deepening of fundamental reforms; (ii) the reduction of poverty and development of human resources; and (iii) rebuilding key infrastructure. An update of that strategy was provided to the Board in Ma- 1996. Bank support during FY95-97 focused on strengthening the financial sector and reinforcing the social safety net, as well as responding to emerging opportunities to reinforce provincial fiscal reform. 2. The FY98-00 assistance strategy proposed in this CAS spans the remainder of the current administration and the transition into the next one following presidential elections scheduled for May 1999. This CAS focuses on supporting ongoing Government efforts to consolidate structural reforms, to strengthen the social safety net underpinning the Convertibility Plan and to begin tackling second generation issues in institution building required to reduce poverty, improve governance, and solidify credibility and access to international private capital markets. The next full CAS would be prepared with the participation of the next administration to take office in late 1999. B. ECONOMIC AND SOCIAL PERFORMANCE Overview 3. Six years have passed since Argentina, faced with the severe economic crisis of 1989-90, adopted the Convertibility Plan. This courageous and innovative program restructured Argentina's economic landscape. From extreme hyperinflation, it moved relativelv quickly to an annual inflation of less than 4 percent by 1994. Output and productivity increases were remarkable during the 1991-94 period, with GDP gro,wth averaging 7.7 percent. The initial consumption-led boom matured into a healthy pattern of investment and export-led growth. Privatization of state assets was far reaching, and far more successful than expected. As a result of the economic recovery, poverty levels declined significantly, although unemployment began to steadily increase, reaching about 12 percent of the labor force by late 1994. 4. Trade reforms and economic recovery resulted in imports growing from barely $4 billion in 1990 to over $21 billion in 1994. The import boom was financed by capital inflows, including large scale foreign direct investment and portfolio investments, that quickly responded to the signals of structural adjustment. The abundance of foreign exchange as a result of capital inflows led to a real appreciation of the currency at the start. The appreciation began reversing itself by the latter half of 1993, because of decelerating inflation and currency realignments among Argentina's major trading partners. The impact of the currency's appreciation was further mitigated by wide-ranging productivity increases. As a result, export growth, particularly of industrial goods, began accelerating in 1993-94.  2 ARGENTINA CAS The Regional Financial Crisis 5. The regional financial crisis of 1995 was the first serious test of the Plan. It survived intact, but it became clear as the crisis unfolded that the system was particularly sensitive to foreign-originated shocks. Higher intemational interest rates and a lack of confidence stemming from the crisis in Mexico reduced capital inflows with negative economic, financial, and social consequences. As discussed below, the authorities are fashioning policies that will reduce the negative impact of similar shocks in the future, and the Bank strategy would support these efforts. 6. With the reversal of capital flows, the Argentine economy suffered a contraction in 1995 of an estimated 4.6 percent of GDP. The sharp recession caused an increase in unemrrployment and strained the performance of the financial system. The initial shock, generating a crisis of confidence, contributed to capital outflows, which in the first four months of the year caused a 17.6 percent loss in bank deposits ($8 billion), with liquid international reserves declining by 30 percent ($4.8 billion). Under the Convertibility Plan the monetary base is backed by international reserves. Therefore, capital outflows resulted in the demonetization of the economy. This demonetization affected the financial system and, through it, the real economy. Investment retracted (16 percent in real terms) and unemployment surged. The number of bankruptcies doubled the rate of the previous four years taken together. The impact of the shock, however, was moderated by a strong foreign trade performance. A combination of favorable commodity prices, contracting domestic demand, the continuous real depreciation of the peso, and the fast pace of expansion in Brazil resulted in a 27 percent growth in exports. With the deepening recession, merchandise imports declined by 7 percent, producing a sharp improvement in the trade balance. 7. Fiscal perfornance was also detrimentally affected by the recession. Despite efforts to rein in expenditures, the shortfall in revenues generated a fiscal deficit equivalent to more than one percent of GDP. Total public sector debt rose by $6.5 billion in 1995, reaching a level of $87 billion. In addition to the federal deficit, provincial fiscal deficits rose to 1. 1 percent of GDP, bringing their debt level to over $1 1 billion. With financially weak provincial public banks facing disproportionately larger difficulties, provincial deficits were increasingly financed by arrears to suppliers, provincial workers, and pensioners. 8. The Government reacted forcefully to the crisis. Early on it took strong measures to redress the fiscal balance by cutting expenditures and raising taxes. Swift action by Congress in approving unpalatable emergency measures in the early months of the crisis added to the credibility of the measures. The Government also assembled an international financial package of $11 billion in support of the Convertibility Plan. As a result, the decline in bank deposits was arrested. During the crisis, the Government successfully resisted pressures to reverse the economic liberalization. Indeed, it decided to deepen this process and further accelerate economic adjustment, through important labor, social security, and fiscal reforms. Labor legislation increased flexibility for small and medium-sized firms, and established a work-related accident law and a bankruptcy law. Congress also approved the Social Security Solidarity Law to reestablish maximum benefits for all beneficiaries and eliminate automatic adjustments, allowing the establishment of a limit on pension outlays subject to budgetary constraints. Uncontrolled pension expenditures had been an important cause of macroeconomic instability in past years. 9. On the financial side, the Central Bank tightened liquidity requirements to mitigate a currency run. It also facilitated the use of interbank credit, reduced reserve requirements temporarily, and used rediscounts at a faster pace. These measures helped provide limited but badly needed margins of liquidity. With the assistance of two World Bank loans, the Government established trust funds to handle the liquidation/privatization of provincial banks (co-financed by the IDB) and the restructuring of distressed private banks. Measures were also taken to strengthen the supervision of the financial system. To stem capital outflows, the authorities also eliminated distinctions between dollar and peso deposits.  ARGENTINA CAS 3 10. At the provincial level, the national crisis aggravated an already problematic situation. In the early years of the Convertibility Plan, provincial governments lagged in the introduction of needed reforms. Faced with a serious deterioration in their fiscal balances and social unrest in a number of provinces because of arrears, in 1995 several local governments, assisted by the federal government and with World Bank financing, accelerated their adjustment processes. They privatized provincial banks and other local public enterprises, transferred public employee pension funds to the (reformed) national system, and let go redundant workers. 11. By the end of 1995, Argentina was pulling out of its recession without damage to the Convertibility Plan. To the contrary, significant pressures to deviate from the Plan during the crisis were met by measures to further strengthen it, indicative of its popularity and staying power. It can be rightly claimed the credibility of the Convertibility Plan was strengthened by the 1995 cnsis. Recent Economic Performance 12. Argentina has clearly come out of its recession. Real economic growth in 1996 is estimated to have reached 4.4 percent, CPI inflation was practically nil, and by January 1997 lagging fiscal revenues began to pick up. The private sector continues to respond positively to the new economic environment. Domestic and international enterprises are investing heavily in privatized companies. The corporate sector is implementing important restructuring measures. Performance varies across sectors. In some cases, particularly small and medium-size enterprise (SMEs) which generate the largest share of jobs in the economy, restructuring is slower as access to term finance is limited. Unemployment remains high at about 17 percent, aggravating the poverty situation. Import growth, excluding factor services, of about 18 percent in 1996, reflected the pick-up in economic activity. Expansion in exports continued at about 12 percent and a trade surplus was achieved for the second consecutive year. 13. It is estimated that the consolidated public sector deficit, including the central bank, increased from 2.5 percent of GDP in 1995 to 2.9 percent in 1996. The deficit of the federal government rose from 1.1 percent of GDP in 1995 to 2.4 percent in 1996, despite a moderate recovery in tax revenues with the improving economic situation, because of higher expenditures to cover reform efforts in social security. On the other hand, provincial public finances improved from a deficit of 1.2 percent of GDP in 1995 to 0.4 percent of GDP. The improved provincial performance was the result of higher revenues, expenditure cuts as their reform programs advanced, and the shifting of pension funding responsibilities of eight provinces to the federal government. 14. In the banking system, deposits grew at a healthy pace, 21.1 percent, and the monetization of the economy continues, with M3 conservatively estimated at 21.5 percent GDP at the end of the year. While growth in loans has lagged behind deposits, interest rates for both have continued to drop to pre-crisis levels. The prime lending rate for peso loans by February 1997 averaged 9.6 percent and dollar loans 8.3 percent. In comparison, the equivalent rates in March 1995, during the depths of the financial crisis, were 33.7 percent and 22.7 percent, respectively. 15. Access to intemational financial markets continues to improve. In January, in the most important financial operation since the Brady deal, the Government issued a $2 billion global bond, with a record 20 year maturity, at a yield of about 11.5 percent. Subsequently, in February, for the first time Argentina issued intemationally a 10-year bond in pesos, at a yield of 11.85 percent. Importantly, recent short-term issues of treasury notes in the domestic market in dollars and pesos have been placed with similar yields of around 6.1 percent, indicating a low perceived short-term risk of devaluation. Leading private groups have also improved their access to intemational term finance. However, financing for greenfield projects remains limited. Financing for SMEs and provincial companies and projects is also problematic.  4 ARGENTINA CAS Social Performance 16. Argentina's poor suffered disproportionately from the country's past disappointing economic performance, with those living in poverty doubling from 1980 to 1989, as formal sector employment stagnated and bursts of hyperinflation eroded the real wages of the poor. Social services failed to cushion the fall. Attempts at fiscal austerity and weak administration led to a severe deterioration in social programs throughout the 1980s; moreover, when they did function, few social programs actually reached the truly poor. Poverty levels declined sharply after 1990 with economic growth and macroeconomic stability, but these earlier gains have been partially undermined by the recent recession, which exposed continued weak social assistance delivery to address structural and transitional poverty and a much stronger link between unemployment and poverty than in most developing countries. 17. The Bank's Poverty Assessment indicated that the highest incidence of poverty in Buenos Aires (1993) was found among children, the uneducated, and the unemployed. Further disaggregation showed that the incidence of poverty was highest among children below 10 years old (29 percent in May 1993), because of the low income of their parents. The education level of household heads was highly correlated with poverty incidence: households whose heads have no education had a poverty rate of about 30 percent, and those who completed primary school about 20 percent. Viewed in terms of percentage distribution, about 60 percent of the total poor in 1993 had finished only primary school and close to 30 percent had no schooling at all. Finally, more than 25 percent of the unemployed were below the poverty line in May 1993. Given the strong link between unemployment and poverty, Argentina's urban unemployment rate is worrisome. Since 1992, the unemployment rate has increased, reaching 17.2 percent by October 1996, and more recent poverty data indicates that in 1995, about 55 percent of the unemployed lived in households below the poverty line. (A follow-up poverty assessment is planned in FY98, see Box 1.) Box I Policy Implications of Poverty Assessment The poverty assessment for Argentina (Argentina's Poor: A Profile, June 27, 1995, Report No. 13318-AR) identified three basic groupings of the poor: the vulnerable poor, defined as those with an income level oscillating within a band of.'25 percent above and below the poverty line whose poverty status depends on labor market circumstances; the stagnant poor, whose status depends less upon employment circumstances and more on their lack of education and. limited employability in the formal labor market; and the indigent, whose poverty is characterized as structural. In May 1993, the vulnerable poor were about 14 percent of the Buenos Aires population, the stagnant poor, 6.9 percent, and the indigent, 3.4 percent. Since that time, these levels have likely nsen due to the dynamics of increased unemployment, with particular effects on the vulnerable and stagnant poor. While data on rural poverty is scarce, the report concluded that it appeared to have become relatively more acute. The report indicated that the vulnerable (or cyclical) poor with a good amount of human capital would benefit from growth in employment and improvements in the labor market, with interim support through work schemes and short-term social safety nets. Bank efforts in this area include continued support for structural reforms, including labor markets, and proposed operations to support employment during the transition period. The stagnant poor would require longer-term support through education and training, as is being provided by the combined Bank-IDB efforts to strengthen education and training, and Bank efforts targeting poorer rural areas with support for improving incomes. The indigent require longer-term social assistance. Bank operations in maternal and child health and nutrition and social protection are aimed in part as this group, particularly women (more than one-fourth of families classified as indigent have female household heads). A follow-up poverty assessment now planned for FY98 would review more recent developments, including a possible increase in poverty stemming the increase in unemployment. Argentina has participated in the Regional ISLC Initiative to develop improved data on poverty, and the Bank study will benefit from this data to define much more clearly the level and causes of poverty in Argentina. The study and the information being developed will help the Argentine authoritiestbetter define their poverty policies and better target poverty interventions.  ARGENTINA CAS S 18. There are several factors contributing to the unemployment picture. The main determinants are the following: (i) a significant increase in labor force participation: the overall labor force participation rate increased from 40.8 percent in 1991 to 43.3 percent in 1994, to 45.9 percent in May 1995 and fell to 44.2 percent in October (with the pickup in the economy); an important factor was the growing participation of women in the labor force, which increased from 43 percent in 1987 to 49 percent in May 1994 in the Greater Buenos Aires area and from 24.7 percent in 1989 to 31.9 percent in the country as a whole; (ii) changes in incentives and the competitive (trade) regime that caused significant sectoral shifts: firms, including privatized public enterprises, sought cost reductions and productivity gains through labor shedding; (iii) the failure of wages to adjust to labor market conditions (increase in labor supply and unemployment): adaptations have been in the form of employment reduction rather than through wage adjustments; (iv) the 40 percent decline in the price of capital relative to labor since 1991, induced mostly by opening the trade regime, inducing the replacement of labor with capital; (v) mismatches between skills offered and those in demand; and (vi) excessive nonwage labor costs and institutional aspects of the labor market that impose rigidities, discourage labor force expansion, and slow the speed of adjustment to meet observed sectoral shifts. 19. Moreover, the current labor force participation rate in Argentina, is quite low by intemational standards and the country's level of development (Chile 58 percent, Mexico 59.9 percent, Uruguay 67.7 percent), suggesting that growth in the work force is likely to continue. Economic growth alone is not likely to make a large dent in unemployment in the short term; a four percent increase in output is estimated to increase employment by only one percent. Measures that increase the flexibility in contracting and collective bargaining are likely to have a higher short-term pay-off in terms of job creation (see Box 2). Human Resource Development 20. The authorities recognize that the achievement of better educational outcomes is a key development challenge in terms of improving productivity, international competitiveness, and income distribution. Argentina has traditionally had one of Latin America's most developed educational systems. Enrollment is practically universal at the primary level and 56 percent for secondary. About 20 percent of the population between the ages of 20 to 25 is enrolled in higher education (1991). While this performance compares favorably with that of other countries in the region, Argentina's population is less schooled than those of countries with similar income levels. The average number of years of school of Argentines over 25 was 6.6 (LAC average of 4.4 years) in 1985. Korea, for example, averaged 7.9 years. Moreover, as a consequence of years of low and often misdirected investment, the quality of the system has deteriorated. A survey in 1993 indicated that 40 percent of students completing secondary education did not read and write up to acceptable standards. Another survey in 1992 showed that 80 percent of secondary students had below international-average math skills. To stop the decline in education, the Government is pursuing a strategy of decentralizing schools to local governments to improve accountability and supporting curriculum reform and teacher training. The quality of higher education has declined as well and produces graduates increasingly out of step with the demands of the labor market. While expenditures have increased in recent years, recurrent spending represents almost 95 percent of the total, with little going into needed investments. Further, public outlays to provide free university education represent a major inequity in the system, and the Government has begun to promote improved allocation of fiscal resources and greater financial autonomy. 21. In health, per capita spending is well above that of other middle income countries in the region, but maternal and infant mortality rates are high compared to neighboring Chile and Uruguay, and chronic diseases are still prevalent. Emerging health problems include increases in non-communicable diseases, increased injuries and traumas, and AIDS. About 70 percent of the population has health insurance, but the quality and cost of the system have been negatively affected by a reliance on inefficient HMOs run by labor unions. The uninsured and the poor are serviced by public health facilities that have deteriorated  6 ARGENTINA CAS through lack of investment and poor management. Important inequities exist between public facilities and the insurance system, and among HMOs within the latter. Pre-paid private insurance has increased in recent years but is not adequately regulated. To improve the functioning of the health care system, the Government has initiated major reforms to create a more competitive environment for health insurance and to decentralize and improve public health facilities. The Bank is supporting these reforms. Infrastructure 22. For decades, fiscal crisis and poor management have led to under-funding and deterioration of Argentina's infrastructure. According to the 1994 WDR, in terms of quality and quantity, Argentina was one of the lowest performers among upper-middle income countries. For example, based on 1990 data, Argentina had the lowest share of population with access to safe water and the lowest share of paved roads in good condition. With economic stability, increased fiscal revenues, and important changes in institutional responsibilities through privatization and decentralization since the initiation of the Convertibility Plan, this picture has begun to improve. To date Argentina has gone further than almost any developing country in privatizing infrastructure services. With World Bank Group assistance, ten infrastructure sub-sectors were restructured and privatized during 1992-95, raising $2.1 billion in cash and debt swaps worth $9.5 billion. Privatizations included obligations for private investments, estimated at $12.4 billion, that improved service to customers and turned loss making state agencies into well managed profitable firms. Improvements include bringing clean water and sanitation services to three million previously unserved residents of Buenos Aires, providing telephone service for some 2.7 million new subscribers, improving service for 1.7 million existing telephone users nationwide, rehabilitating four thousand km. of freight rail line, and providing more efficient handling for 44 million tons of imports and exports (about 50 percent of Argentina's total merchandise trade) using the port of Buenos Aires. Argentina's transformation of infrastructure services provides an excellent example of cooperation between IBRD and IFC, with each institution performing the role in which it has a comparative advantage. IBRD lending, sector studies, and technical assistance were critical to providing the appropriate setting. IFC advised on financial restructurings and made investments in eight of the ten sub-sectors resulting in record high levels of IFC activity in Argentina over the last five years. 23. However, much remains to be done. Although infrastructure services have improved in major metropolitan areas, these services remain critically short and inefficient in the rest of the country. Privatizations at the federal level are nearly completed, although the effort to improve regulatory frameworks continues, and the focus of further privatization is shifting to the provinces. The challenge of developing transparent, workable regulatory frameworks to facilitate private financing and management of infrastructure services at sub-national levels remains. Environmental Issues 24. Argentina's ratification of the Biodiversity and Climate Change Conventions reflects its citizens' concern for the global environmental issues of biodiversity conservation and global warming. Within the country, Argentina does not suffer from the acute environmental problems found in many other developing countries, but it has only just begun to establish the environmental standards and regulation befitting a country at its income level and major cities are plagued by localized pollution. Contamination of water resources by industrial and hazardous wastes and the inadequacy of water supply and treatment systems are most severe in Greater Buenos Aires, several provincial cities, and specific isolated industrial locations. Declining fertility, soil loss due to water and wind erosion threaten sustained agricultural development in some areas, and most irrigated areas suffer from drainage problems and salinization. Increased investment in sustainable natural resource development requires a clear and better developed regulatory framework and strengthened public sector oversight. Increased growth and urbanization needs to be matched by development of a framework for environmental regulation with clear jurisdictional responsibilities. Environmental activities are shared between a wide range of institutions, including government ministries  ARGENTINA CAS 7 and agencies at the federal, provincial, and municipal levels, and a variety of non-governmental agencies. Within the three levels of government there are overlapping responsibilities, a lack of coordination, and little institutional capacity. This complexity, as well as the weakness of the legal framework, has hampered the implementation of solutions to environmental problems. Macroeconomic Prospects, Risks and the External Environment 25. The restructuring of the economy under the Convertibility Plan will pay growing dividends in coming years. In the absence of a major external shock, the Argentine economy should be able to achieve growth of at least 5 percent annually to the end of the century. Economic growth is expected to be led by exports and investment. Imports are expected to grow faster than GDP, to facilitate growth in investment, but exports will grow faster, moderating the reliance on foreign savings. Domestic savings will continue to grow because of higher levels of income, the restructuring and strengthening of the financial and social security systems, and sustained confidence in the economy. Foreign debt as a share of GDP may have already reached its peak. Argentina - Key Macroeconomic Indicators (Percent of GDP) a/ 1995 1996 1997 Average (actual) (est.) (ro .) 1998-00 National Accounts GDP Avg. Annual Growth -4.6 4.4 5.1 5.5 Total Investment 18.3 18.5 18.9 19.9 National Savings 16.9 16.5 16.4 17.8 Foreign Savings 1.4 2.0 2.5 2.2 Pubfic Sector5' Primary Surplus 0.3 -0.7 0.5 1.7 Interest Payments 1.5 1.7 2.0 1.8 Domestic 0.1 0.2 0.5 0.4 Foreign 1.4 1.5 1.5 1.4 Balance (- deficit)-" -1.1 -2.4 -1.5 -0.1 Balance of Payments Trade Balance 0.8 0.4 0.1 0.5 Current Account Balance -1.4 -2.0 -2.5 -2.2 Capital Account 0.8 3.0 3.3 2.9 Public Sector 2.3 1.5 1.5 0.6 Private Sector -1.5 1.5 1.8 2.4 Memo: GDP (USS billion) _ 280.8 300.5 324.6 383.0 a/ Unless otherwise stated, all figures for public finances and balance of payments are net. b/ National Administration c/ Includes quasi-fiscal balance of Central Bank. 26. External Environment. Three aspects of the external environment most affect Argentina's macroeconomic prospects: (i) growth in the world economy and Argentina's terms of trade; (ii) the state of the Brazilian economy due to increased interdependence; and (iii) the cost of international capital. The external environment for Latin America in general is expected to be less robust in coming years than it was in the early 1990s, with the terms of trade for the region expected to decline slightly. For Argentina, sustaining recent growth in manufactured exports will be important. As a significant share of these exports have been going to Brazil, policy changes there could also have an important impact on macroeconomic prospects. (Argentina's exports to Brazil accounted for 32 percent of total exports in 1996, up from 20 percent in 1994.) International interest rates are expected to increase moderately in the short-term, but the overall external environment for capital flows is expected to continue to be favorable. Each percentage point change in international rates would produce an approximately $900 million increase in debt service (average for 1997-98), the equivalent of 2.8 percent of the period's average estimated exports of goods and services, or 3.4 percent of international reserves. 27. Deepening Reforms and Mitigating Risks. Under the Convertibility Plan, the authorities have radically improved the regulatory and economic environment for banking and capital markets. Spreads and the cost of credit remain high, however, and access to credit particularly difficult for small businesses and  8 ARGENTINA CAS farmers (as in many countries). Such firms lag behind larger firms in taking advantage of trade and economic liberalization, contributing to increased concentration and uneven regional development. The authorities are working on several initiatives designed to increase efficiency and liquidity (the need for which was demonstrated during the regional financial crisis) in financial and capital markets, including the creation of new instruments and the introduction of secondary markets. The authorities already have an agreement with foreign financial institutions for a $6 billion line of credit (a contingent repo facility representing about 12 percent of deposits) to provide liquidity to the banking system in case of a systemic shortage and have been increasing liquidity requirements and strengthening supervision of banks. 28. The Government is continuing with the process of reform as a means to further enhance growth and employment gains. The problems of rigid labor markets were highlighted during the recession. These rigidities compounded the unemployment problem already observed in the course of restructuring the economy and undermined earlier gains in reducing poverty. Among the areas still requiring reform are improved contractual flexibility, a less distortionary and more effective severance pay system, and decentralized collective bargaining (see Box 2 ). The Government would augment these reforms with temporary employment schemes targeted to the poor (para. 44). Box 2 Labor Reform While the resumption of sustained growth will improve the employment outlook, it will only do so over the longer term. Empirical analysis undertaken by the Bank indicates that the output elasticity of employment in Argentina was :lower than the wage elasticity of demand. The institutional constraints with the greatest effect on wages and employment practices are: (i) centralized collective bargaining that denies firms geographical and subsector flexibility to respond to emerging needs and labor market conditions; (ii) a significant nonwage labor costs, increasing labor costs over gross worker remuneration by 53 percent, and 72.4 percent when measured in terms of labor cost per efficiency unit of time; (iii) significant mandated severance payments; (iv) the tendency to perpetuate expired collective bargaining agreements (many negotiated during the hyperinflationary years) with legislation that discourages renegotiation; and (v) restrictions on temporary or fixed-term contracts. The Report suggested the following reforms: (1) removing the monopoly power over negotiations in the hands of sector unions and decentralizing bargaining to the firm level; (2) further reductions in payroll taxes (difficult in the short-term because of fiscal austerity); and (3) replacement of mandated severance payments by a fully funded system. During the last two years, the Govemnment has implemented labor market reforms, including labor legislation to increased flexibility for small anid medium-sized firms, reducing payroll taxation, and establishing a work-related accident law and a bankruptcy law. In late 1996, presidential decrees were signed to extended flexibility to larger firms by providing for firm level negotiations and the end of the indefinite duration of existing contracts, and legislation to establish a filly funded severance system was introduce to the legislature. The constitutional legality of the decrees is now being reviewed by the Supreme Court and discussion of the severance system continues. These labor market reforms are crucial to the Government's efforts to develop a policy environment which will create more employment opportunities and contribute to the reduction of poverty. The recent increase in poverty is closely related to the increasing rates of unemployment in Argentina. Recent data show that about 40 percent of those in the poorest decile were unemployed, compared to an average unemployment rate of the population as a whole of 17 percent. Bank efforts in support of Government initiatives include a pro-active dissemination strategy to enrich the domestic debate on the merits of labor market reform. In addition, the proposed Employment Support Projects would provide temporary employment for poor workers until the labor market reforms take hold. 29. Fiscal reforn at the federal level has been underway since the initiation of the Convertibility Plan in 1991, and efforts are now directed toward deepening the process of modernizing the state and improving governance. Provincial fiscal reform continues to lag, although the regional financial crisis gave a major boost to efforts to privatize provincial public enterprises and banks.  ARGENTINA CAS 9 C. BANK GROUP ASSISTANCE Progress Towards Objectives in Previous CAS 30. The FY95 CAS was prepared during the regional financial crisis and focused on supporting Government's efforts to restore confidence, mitigate social costs, and deepen the adjustment process. An update of that strategy was presented to the Board in May 1996. Bank assistance during FY96-97 sought to strengthen the financial sector and reinforce the social safety net, as well as respond to the emerging demand to support new and important reforms in health insurance, provincial public finances, and labor markets. These goals were, for the most part, met, thanks to forceful action on the part of the Argentine authorities. The major shortcoming was a decline in the performance of investment operations, as noted below. (Since the last CAS, OED completed a Country Assistance Review for Argentina. See Box 3.) 31. The international package of emergency financial assistance for Argentina in 1995 totaled some $11 billion from the IMF, Bank, Inter-American Development Bank, and the Japanese EXIM Bank. These funds, along with forceful statements in support of the government's program helped to quickly restore confidence and stem the outflow of capital. Under the package, the Fund and JEXIM provided immediate balance of payments support related to macroeconomic targets. Quick-disbursing Bank and IDB funds were tied to reforms in the financial sector, strengthening the social safety net, and reforms in health care financing. In addition, IFC has been a major source of finance for Argentina's private sector in the past two years, bridging the gap created by the regional financial crisis. IFC's FY96 program in Argentina was its largest single-country annual program ever: $400 million net and $1.5 billion gross. 32. Bank support for financial sector strengthening was spearheaded by the Provincial Bank Privatization Loan, to assist the privatization of financially weak provincial public banks, and the Bank Reform Loan to promote the consolidation of private banking. The immediate objective was to avoid a rash of bank closures. Despite a loss of deposits equivalent to that of the United States during the Great Depression, a chain of bank closures was averted. The Bank Reform Loan provided financing for a more orderly consolidation of private banks through mergers. Momentum toward consolidation slowed as the crisis wound down. Because of low demand, the final tranche of the Loan was amended to also permit support for provincial bank privatization. Expanding on an effort initiated under the Provincial Reform Loan, the Provincial Bank Privatization Loan, co-financed by the IDB, provided financing and assistance to over half of the total provincial public banks (representing 30 percent of provincial bank assets). 33. Support for Government efforts to strengthen the social safety net included the Social Protection Loan and an associated adjustment operation by the IDB. In addition to fiscal assistance for key programs, the loan has been supporting improvements in poverty monitoring and targeting, and included a pilot program to test the effectiveness of a social fund approach to reaching the poor. The ongoing Maternal and Child Health and Nutrition Loan was expanded during this period; and its success has provided the basis for a proposed follow-up. Reform of health care financing was initiated under the Health Insurance Reform Loan and a complementary TA operation. The process of restructuring the HMOs is now well underway and the market is scheduled to be opened to private sector by next year. 34. Significant gains were also made in expanding and deepening provincial fiscal reform. The Provincial Reform Loan supported wide scale efforts to privatize provincial public enterprises (37 enterprises), to strengthen local tax collection, and to reduce overstaffing. As noted above the Provincial Bank Privatization Loan supported public bank privatizations, removing the traditional soft-budget financing option for deficit spending in participating provinces. Progress on this front represents a major achievement, given that the need for the federal authorities to bail out provincial banks in the early 1990s scuttled the stabilization program that preceded the Convertibility Plan. Lastly, the Provincial Pension Reform Loan assisted the Government in responding to the an increased disposition of provincial  10 ARGENTINA CAS governments to rid themselves of financially insolvent and badly managed pension systems for provincial public employees. representing is some cases as much as one third of provincial fiscal deficits. So far, eight provinces have transferred their pension funds to the national social security system. The associated National Pension TA Project is supporting institutional strengthening to reduce irregular claims and improve client services. 35. Finally, since the last CAS, the Bank has been actively supporting efforts to enhance the flexibility of labor markets. The authorities are committed to these reforms and have made important progress. Following on its emergency fiscal measures, the Government was also able to introduce initial labor reforms for small and medium-sized firms. To support broader reforms, a strong dissemination effort surrounding a Bank report on the labor market and an EDI seminar involving union representatives in the water sector helped to inforrm the national debate on the employment benefits of greater flexibility. Portfolio Performance and Management 36. Notwithstanding the achievements above since the last CAS, implementation of investment projects began to deteriorate in late 1995. While partly attributable to the constraints on counterpart funding imposed by the fiscal squeeze of the recession, implementation problems also reflected weak institutional development, particularly in the provinces. Because a continued deterioration in implementation progress would threaten to seriously undermine the ability of projects to meet their development objectives, a general review was initiated in 1996 by a joint Argentine-Bank Portfolio Commission to identify problems and put forward recommendations for better portfolio performance. (Annex D provides a summary matrix of problems, recommendations, and actions required on both sides.) 37. Among the salient findings of the Commission is the following. The provincial portfolio, which accounts for about half of lending, is particularly plagued by weak borrower ownership and poor implementation capacity that can be traced back to inadequate design at entry. The urgency to quickly jump start provincial reforms meant that many projects did not allow for sufficient preparation at the sub- project level, which introduced start-up lags of twelve to eighteen months. In the future to avert these problems and to help ensure greater familiarity with Bank procurement procedures at launch, the Commission recommended that provincial projects be required to have at least 20 percent of sub-projects bid-ready by Board presentation. Ownership and counterpart funding should also benefit from continuing implementation of agreed provincial eligibility requirements for access Bank financing and recent efforts to restructure ongoing operations to increase flexibility and generate competition among participating provinces. 38. The Commission also recommended actions to strengthen portfolio management. With the focus on provincial financing and with a number of provinces participating in 5-6 Bank projects concurrently, the traditional project-based approach to supervision needs to be augmented by provincial-level portfolio reviews to identify and resolve generic issues at that level (a similar approach is being implemented in Brazil with good initial results). In addition, particularly problematic sectors, for example education, would also benefit from sector-based portfolio reviews. We expect to initiate provincial-based portfolio reviews before the end of the fiscal year, targeting 2-3 provinces in the initial round, and will undertake a review of education projects early next fiscal year. 39. The report also noted the need for both Argentina and the Bank to enhance their respective institutional capabilities in portfolio monitoring and project supervision. The Government, in line with recent changes in structure, has already begun increasing the role of the Office of the Cabinet Chief, through the Secretariat for Strategic Planning (SSP), in coordinating program planning and implementation, based on its coordination responsibilities across ministries and in federal-provincial relations. In conjunction with the Bank, the SSP has initiated a review of executing agencies in order to  ARGENTINA CAS 11 centralize at the ministerial level common administrative tasks in disbursement and procurement. The SSP is also establishing a reporting system to assist in project monitoring, perrnitting a more pro-active role in ensuring enhanced implementation of both Bank and IDB operations. As for the Bank, the report cited the recent stationing of staff in the field to provide support in procurement for social sector projects and suggested that an even greater role for the resident mission in supervision would be beneficial. The Region, in the context of the ongoing modernization program, will be reviewing together with Government the possibilities for moving the new country department to the field. Box 3 OED - Country Assistance Review (CAR) The Argentina CAR (Report No. 15844, June 28, 1996) evaluated Bank assistance during an initial period characterized by several failed attempts at adjustment (1985-89), followed by a remarkably successfilu and still ongoing program of structural reform (1990-95). The Study finds that the Bank's assistance strategy was relevant throughout the ten-year period covered, but that during 1985-89 effectiveness and efficiency of the Bank strategy was poor. * Adjustment lending over-optimistic regarding Government's willingness and ability to carryout reforms. . Overall project performance was very poor due to the difficult economic environment. * ESW was of good quality and proved useful when new government undertook more drastic reform in the 1990s. During 1990-95, however, the Bank supported and contributed to the restructuring of the country's external debt and restoration access to private capital markets, privatization of public enterprises, improvement in fiscal performance, reform the financial sector, and analysis of capital and labor markets. The Study found, however, that: * The Bank was slow in restoring lending in 1990-91 and anticipated prematurely the end of adjustment lending in 1994. * In the early 1990s, insufficient attention was paid to the social sectors and the Federal Govemment's transfer of responsibilities to provincial level governments without adequate assessment of their financial and institutional capabilities. Key recommendations were that: * Future assistance should continue to be centered on fiscal performance of provincial governments, the social security system and the level and efficiency of expenditures in the social sectors, as well as financial sector reform. * Portfolio management should be improved, including the quality of projects at entry and the use of performance indicators. The lessons and recommendations of the CAR have been incorporated in the current strategy, notably with regard to portfolio management and provincial lending. Country Assistance Strategy 40. The Bank's assistance would continue to focus on supporting Government efforts to: (i) enhance social development, including poverty alleviation and human resource development; (ii) improve the performance and institutional capacity of govemment, particularly subnational govemments, to deliver key social, infrastructure, and environmental services; and (iii) consolidate successful structural reforms, including reforms in public finance, labor markets and the financial sector to ensure successful implementation of the assistance program, and enhance govemance through institution building.  12 ARGENTINA CAS Poverty Alleviation and Social Development 41. Social sector assistance will continue to play a lead role, both because of its contribution to poverty reduction and human resource development, as well as the need for a well-functioning safety net to underpin Argentina's Convertibility Plan. Social lending has increased rapidly in recent years and now accounts for almost one-fourth of the portfolio and almost half of the proposed FY98-00 program. Assistance includes efforts to enhance human resource development to improve competitiveness and the distribution of income, to improve social assistance delivery, and to strengthen the social safety net. Provincial reform is tightly linked to poverty alleviation. Notably, education and health, which receive the bulk of provincial public expenditures, would be the focal point of our next generation of provincial reform operations discussed below. These expenditures are being reviewed under the ongoing Provincial Social Service Delivery Study. 42. Poverty Strategy. Sustained economic growth will provide a basis for future improvement in income levels, as well as dramatically reduce the numbers of cyclically poor. Measures to further reduce market distortions, particularly labor market rigidities, will accelerate this process. Nevertheless, further efforts are required to assist Argentina's poor. Coordination among the various levels of government is key, given that provincial govermnents execute more than 80 percent of social expenditures (excluding social security). These governments, however, are hampered by costly and inefficient delivery mechanisms, a lack of targeting of priority beneficiaries, deficiencies in monitoring the impact of interventions, and a weak history of coordination with the federal government. 43. Ongoing efforts to assist vulnerable people include the Maternal and Child Health and Nutrition Project, which focuses on women and their young children in poorer urban areas and combines this assistance with efforts to improve delivery and coordination between federal and local governments. The proposed MCHN II would expand this program to other areas, as well as include new activities such as child care services. Through these programs the authorities expects a significant increase in the share of low income women and children receiving care. In addition, the ongoing Social Protection Loan is supporting a select group of government assistance programs by providing crucial fiscal support, particularly during the height of the financial crisis. It is also supporting improved poverty assessment and targeting of social assistance. 44. To complement the social assistance approach, support for improving the income-generating opportunities for the poor include the proposed Employment Support Project, with a possible follow-up. These would provide temporary employment for up to 600,000 people during 1997-98 in public works in conjunction with labor market reforms that should help to improve employment opportunities over the medium term. The rural poor would be targeted under the proposed Small Farmer Development Project, which would promote community-based projects to improve infrastructure and productive services. Associated ESW is expected to provide greater insights into rural poverty. In addition, to stimulate greater private sector efforts, the EDI through an innovative program is engaging the participation of NGOs and businesses in local workshops, as well as helping to develop an NGO poverty network. 45. We have been following a pro-active approach to relations with NGOs and other groups representing the poor. An NGO liaison has been posted in the resident mission and a profile of Argentine NGOs was completed. Dialogue has been established and NGO representatives have briefed regional management on social issues confronting the country and the possible role of Bank assistance. The resident mission is serving as the focal point for increasing NGO participation in Bank operations. As a result of these early encounters, the special problems of indigenous groups was identified; and an IDF grant is supporting the strengthening of the existing institutions representing these groups to facilitate their participation in policy discussions. Additionally, the proposed Small Farmer Development Project served as a flagship for Bank participatory project preparation, the ongoing Maternal and Child Health and  ARGENTINA CAS 13 Nutrition Project has NGOs actively involved in implementation, and the proposed AIDS Prevention Project envisages critical participation of NGOs to reach marginal groups. 46. Many of the activities detailed below in education and health would have targeted as well as indirect benefits for the poor. Secondary Education 11, for example, is targeted to schools in poorer areas, and the Health Insurance Reform Loan would provide for implementation of a minimum health benefits package for insured low-income families. Reform of public hospitals is expected to improve services, while decreasing the costs of servicing the uninsured poor. In addition, the proposed AIDS Prevention Project would direct much of its efforts to the poor, who are disproportionately affected by this disease. 47. Human Resource Development. Apart from poverty alleviation and social protection, Bank assistance in the social sectors would support longer-term human resource development required to sustain growth and efforts to enhance the effectiveness of needed investment outlays. In education, the decentralization of secondary schools to the provinces is being supported under ongoing operations, Secondary Education I & I. Assistance is being provided to strengthen provincial institutions with curriculum reformn and improved resource management, as well as to refine the role and improve the performance of the federal ministry. The challenges facing secondary education include an increase in demand from the extension of mandatory education and the need for major investments in teacher training and educational materials following the curriculum reform. Expected benefits under the projects include improved learning outcomes through enhanced resource allocation with reduced administrative expenses and increased spending on textbooks and other teaching materials and teacher training. However, weak institutional capacity has contributed to delays in implementation of these projects and the need for adjustments in project design. Higher education is also a focus. The federal government provides free education in public universities, and equity and efficiency issues are important. The Higher Education Reform Loan is supporting federal government efforts to strengthen the financial autonomy of public universities and to introduce fees. The goal would be to reduce government outlays, and redirect them to primary and secondary levels, and promote the continued development of private university education. The IDB is assisting in the areas of primary education, vocational education, and training. 48. Our assistance strategy in health recognizes that there are essentially two Argentinas with different sets of health profiles and delivery systems. First, there is the Greater Buenos Aires area and larger provinces, where the health profile is broadly similar to that of the developed world and where the private sector plays an important role in health care delivery. Here, the Bank is supporting reform of health care financing to introduce greater competition and promote more efficient and better quality health services through the Health Insurance Reform Loan. A possible operation to reform HMOs for provincial workers would be considered. Competition among the union-run HMOs has been introduced, and we expect a more fully competitive health insurance market by FY99. New opportunities for the private sector are arising rapidly, and IFC is currently considering a health project in Argentina. Other areas of the country, particularly the poorer northern provinces, face a very different health profile. For example, infant mortality rates of 29 per 1000 are almost 70 percent higher than that of Greater Buenos Aires. Further, in these provinces local governments play a predominant in health care delivery, with little effective oversight from the national health ministry. A pilot program to improve services for the non-insured poor is being assisted through the Provincial Health Development Loan. The proposed Provincial Health Development II Loan would expand the pilot program to other areas . Provincial Reform 49. Provincial Strategy. The process of decentralization has increasingly forged a link between the institutional capacity of sub-national governments and the human and infrastructure development required to put the country on a sustained growth path. However, few provinces were prepared to effectively pursue this new role, because of weak public finances, seriously inefficient social service delivery, and poorly managed infrastructure. Combined with long-standing antagonism between federal and provincial  14 ARGENTINA CAS governments and uncertain definition of responsibilities, many national ministries themselves were not in a position to effectively support provincial development. 50. The Bank early on identified the key role and weak capacity of provincial governments and initiated efforts to improve their performance through ESW in the late 1980s which led to the Provincial Development Project co-financed by the IDB. This was essentially an "umbrella" operation which was open to all provinces that met basic requirements and demonstrated the fiscal benefits of their proposed sub-proj ects. Substantial initial delays in implementation were testament to the weakness of institutions and the shallow commitment to reforms in the provinces during the early years of the Convertibility Plan. However, these operations provided an initial basis for rewarding good performers and providing essential technical assistance for those with lesser capacity to develop and implement necessary reforms. The Provincial Reform Loan provided further support for those provinces willing and able to begin implementing fiscal reforms, including privatization of public enterprises and banks, staff downsizing, tax reform and improved administration, and improved financial management systems, already underway at the federal level. This effort, accelerated by the regional financial crisis, was reinforced by operations in Provincial Bank Privatization and Provincial Pension Reform. 51. Non-lending services have also been important in our assistance. Studies in selected provinces, including Tucuman and Cordoba, were used to promote local dialogue on reform. In addition, through the Ministry. of Interior, the Bank provided technical assistance in developing and implementing fiscal pacts between the federal and provincial governments designed to begin reforms of the system for revenue sharing. Much more needs to be done, however, to enhance incentives for improved fiscal performance. T'he Bank would continue to provide non-lending services in this area, following on the recent Provincial Finances Study. 52. The reform process has now spread across most provinces. Almost half were able to achieve a surplus in their current balances in 1996 and most of the rest are actively engaged in reform programs. As a result, the proposed lending strategy would shift among the three windows now providing financing and support for the provinces: (i) umbrella operations (typified by Provincial Development II and Municipal Development II); (ii) reform loans (Provincial Reform I and II) ; and, (iii) sector investment operations (including water, power, agriculture, and roads). While the umbrella window has been crucial in helping to spur provincial adjustment, it has been less successful in deepening sector reforms and links between federal and provincial line ministries. Therefore, we would shift focus toward the other two windows, reform and sector investment operations, which would aim to deepen the reform effort in selected provinces by improving the efficiency of social expenditures, and for sector investment operations in agriculture, roads, water, and renewable energy to finance key investments and promote greater private sector participation. 53. Further, to help ensure availability of counterpart funding and to assist provinces willing and able to implement fiscal reforms, provincial eligibility for participation in Bank loans is based on fiscal indicators that have been established with the authorities (current account balance and sustainable debt) and would require provinces to compete for financing. A key condition for participation in a reform loan is the privatization of provincial banks. Good performance on the existing portfolio is also a condition for access to new loans. Social sector projects, notably those that pass on federal funds as grants to provinces for key targeted interventions would not be depend upon the fiscal situation of the particular provinces were investments are to be made, but they would remain subject to portfolio performnance criteria and rates of return. 54. Given the extent of development needs and the large number of provinces, continued close collaboration with the IDB is required. The IDB is expected to continue to support this process and we are coordinating our assistance. Given the comparative advantages of the two institutions, the Bank would  ARGENTINA CAS 15 continue focus more on poor, less developed provinces plagued by continuing structural deficits in their fiscal accounts. For its part, the IDB provides investment lending to the more advanced provinces that have been able to achieve fiscal equilibrium in recent years. 55. Fiscal Reform. Our assistance strategy for the provinces would continue with an institution- building focus to improve fiscal performance, efficiency of social expenditures and infrastructure development. The Provincial Reform Loan I, together with Provincial Development I and II, helped the federal government to initiate its strategy to promote fiscal reform of provincial governments. A number of provinces are now implementing reform programs, the process of privatizing public enterprises is widespread and the ongoing Provincial Bank Privatization Loan has helped a majority of the provinces to privatize their public banks. The proposed Provincial Reform Loan II, and a possible follow-up operation, would seek to begin a more intensive effort in selected provinces to sustain fiscal reforms and improve the efficiency of expenditures in education and health, which now make up the bulk of provincial public spending. 56. Infrastructure. Our strategy is to pursue support for badly needed infrastructure rehabilitation and development through privatization and concessioning where feasible. This approach has worked well at the federal level, and the experience gained is being disseminated to the provinces and supported under ongoing operations for water supplv and energy. Through advisory services, including EDI, and investment operations we are continuing to support improvements in regulatory frameworks to enhance the benefits of privatization. Follow-up operations, Provincial Water Reform and Renewable Energy, are planned. The approach is generally to tie small initial investments for urgent rehabilitation to greater private sector participation. In transport, the recently approved Provincial Roads Project, which is focused on redefining the role of local government in road construction and maintenance, would be augmented by the proposed National Roads 11 Project to provide continuing assistance for improving federally-owned roads that support development of outlying provinces. Rural infrastructure investment and government divestiture would be supported through the proposed Provincial Agriculture Development Project, co-financed by the IDB, which follows on a successful program to support modernization of federal agriculture services. 57. As regards private financing of infrastructure, the Government's privatization policy has been to require purchasing firms to commit themselves to undertake future investments. Thus, most new owners have either direct access to international financial markets and technology or are in partnership with intemational firms. In some cases financing is provide by the IFC (Buenos Aires Water, for example). As a result, the Government has not shown interest in the use of Bank guarantees. Moreover, the use of guarantees to support smaller-scale privatization efforts in the provinces may be limited because of the unwillingness of the federal government to provide counter-guarantees for the highly autonomous sub- national governments, and because many investments would only attract local firms with local currency investments. Still, discussions are ongoing, particularly in regard to concessions. Assistance for Environmental Concerns 58. Bank ESW and dissemination efforts have helped to bring the spotlight on emerging issues in natural resource management and pollution and to provide the basis for our lending program. The Forest Sector Review has provided the basis for a series of loans: the Forestry Development Project to address issues of soil conservation and erosion control and improved forest plantation management by the private and public sectors; Native Forest and Protected Areas Project to support conservation of forests, improve the management of national parks and, through a GEF grant, expand conservation in eco-regions containing biological specimens of global importance. The Mining Sector Review led to the Mining Sector TA Project to provide environmental safeguards and support the sustainable development of the sector. The recent study on Issues and Options in Environmental Pollution (FY95) generated substantial discussion in Argentina. It detailed the magnitude of the problems and the institutional weaknesses in resolving them,  16 ARGENTINA CAS while providing input into the national environmental action plan. As a result, the proposed Pollution Management Project would pilot approaches to resolving local pollution problems and help the Government strengthen environmental institutions to bring industrial and urban pollution under control. In addition, the Bank has appraised a project for the Reduction of Ozone-Depleting Substances, funded by the Montreal Protocol, and would be following up on the Government's interest in the preparation of projects, particularly in the areas of coastal contamination and climate change, to be submitted to the Global Environmental Facility. 59. Ongoing agricultural and water and sewerage projects include provisions to promote environmental protection, and the 1DB is financing several programs to clean up water courses. The proposed Buenos Aires Urban Transport Project will support the establishment of air quality monitoring. Past energy loans first helped better regulate hydroelectric facility compliance with international norms; the Government later extended these regulations to thermal plants and, more recently, to oil and gas operations. The Yacyreta II Project includes a comprehensive resettlement and environmental management plan, in collaboration with IDB. Prior to raising the height of the reservoir to its current level (76 meters) more than 95 percent of the necessary actions were completed. However, unanticipated delays in raising the height of the reservoir as originally planned to 83 meters has created new environmental impacts that the Government has agreed to mitigate. An Action Plan for this purpose has been adopted. 60. With support from the IDB, the National Environment Secretariat (SERNAH) is beginning to improve sector organizational arrangements and to develop an environmental action plan. It recently won approval for an Environmental Pact, a framework agreement to improve the collaboration between the Federal and provincial levels for policy making and enforcement. The IDB project will strengthen the legal framework and monitoring systems and should ultimately enable the SERNAH to exercise greater oversight of national policy and activities. The National Environmental Action Plan would need to address, inter alia, standards for water quality and pre-treatinent discharge, coordination with the provinces of recently established national legal framework for hazardous wastes, and updating of ambient air quality standards and increased monitoring. Consolidating Macroeconomic Reforms 61. A second generation of important but less profound reforms is underway in Argentina. These reforms, concentrated in factor markets will further enhance growth prospects and the credibility of earlier reforms. Reform of the factor markets would contribute to improved productivity and further insulate the economy from shocks, crucial factors for the expansion of savings, investment, and exports. At the federal level, lending would include support for efforts to strengthen the social safety net, particularly in support of labor market reforms through targeted poverty alleviation programs in poor urban and rural areas, discussed above. Government efforts to deepen improvements in fiscal performance and develop financial and capital markets would be supported through non-lending services that are expected to provide the basis for further lending. 1 On September 30, 1996, the Inspection Panel received a request for a review of Bank staff compliance with Bank procedures in connection with the Yacyreta project. On February 28, 1997, the Board took the following decision: "The Board invites the Inspection Panel to undertake a review of the existing problems of the Yacyreta project in the areas of environment and resettlement and provide an assessment of the adequacy of the Action Plan as agreed between the Bank and the two countries concerned within the next four months." (The project is bi-national, involving Argentina and Paraguay.) The Region will continue to monitor this project carefully and will continue to provide the Board with periodic updates.  ARGENTINA CAS 17 62. The Bank is continuing to support financial market strengthening through the Provincial Bank Privatization Loan. As noted, a pilot program to deepen the banking market through a backstop facility under the Capital Market Development Loan was canceled because of lack of demand. Together with the Government, we will be taking a renewed look at the sector through a Financial Sector Review in FY98, which would help to identify a possible Secondary Financial Markets Project. An additional priority would be accelerating the strengthening of the financial sector, particularly by reducing further the role of the public sector in banking, both at the federal and provincial levels. Meanwhile, efforts under the Technical Assistance Loan continue in support of strengthening, inter alia, the stock market, and the IFC continues to be active in the development of projects in the areas of leasing, securitization, and a market for mortgages. In addition, through ongoing non-lending services, we are assisting in exploring legislative changes needed to facilitate secured transactions particularly as applied to movable collateral, which would improve the access to formal credit by farners and small businesses. Further efforts to increase the access of these entities to financial markets are being undertaken by the IFC and the IDB. 63. Federal govemment measures to strengthen public finances and improve governance are continuing under the State Refonn II initiative, for which the Bank has provided advisory services. This program seeks to further reduce the size of the federal government, as well as to redefine the role of and modemnize federal ministries. The IDB is supporting specific efforts to modernize the legislative branch. The Bank would continue to discuss with Government a possible Judicial Reform Loan, to pilot improvements in court procedures to reduce bottlenecks, particularly with respect to tax cases. The basis for further adjustment lending in support of improved public finances would be reviewed in the context planned ESW during FY97-98 on the fiscal sustainability of structural reforms and tax reform. Further efforts to improve governance include support for the ongoing reform of social security through the National Pension Reform TA Loan. This loan, together with the ongoing Provincial Pension Reform Loan, will help provide increased transparency in an area traditionally subject to extensive evasion and fraudulent claims. Similarly, our operations in support of health reform should help to reduce significantly inefficiencies that have characterized the health care financing system. Finally, the Bank continues to work with the Government to improve public procurement procedures and to increase their transparency. Lending and Non-Lending Services 64. Lending Levels. For FY98-00 lending would continue at the $1.5 billion annual level achieved during the past three years, although a temporary slowdown is likely during FYOO ($1 billion range) in view of presidential elections in 1999 and the transition to the next administration. As indicated, at that time we would propose to present a new CAS to take into account new priorities and opportunities for Bank assistance. To support this process, the program would focus more on non-lending services, to help provide the new administration with information useful in formulating and implementing its economic program. Given the proposed level of lending, Bank resources devoted to Argentina are projected to remain at current levels. Supervision needs, particularly for provincial projects, are expected to remain strong, as will continuing demands for non-lending services. Further, subject to agreement with the Government, plans are to upgrade the resident mission, possibly into a field-based compact country unit. 65. Triggers. The base case presents the most likely lending scenario. Actual lending levels, however, would be triggered by the progress, notably of provincial governments, in implementing satisfactorily their ongoing operations with the Bank and in continuing with reforms. Under this approach, actual provincial lending levels, which account for $2.5 billion of the $4 billion proposed base program, would be triggered in a virtually automatic manner. With eligibility criteria built into the lending agreements, lower effective demand for Bank financing (i.e., inability to meet fiscal and project performance requirements) would result in cancellations of loan amounts and reprogramming of future lending. At the extreme, poor fiscal and portfolio performance by the provinces would result in a lending program only supporting federally implemented efforts ($1.5 billion in the base case), particularly those related to poverty alleviation. Again, however, the federal government's own access to Bank financing would depend upon portfolio  18 ARGENTINA CAS performance. Under a shock scenario, the trigger for considering a higher level of lending would be the speed and quality of adjustment measures, including, as noted above, efforts to further reduce the role of the public sector in banking. 66. Non-Lending Services. ESW will increasingly be oriented toward those second generation reforms in institutional strengthening, regulatory improvements, and fiscal strengthening. This work would build upon the already well-developed dialogue with the new economic team. (The Bank sponsored an Argentina Week here in Washington last November that was successful in generating important insights into these second generation reforms.) Ongoing work has initiated the review of options for needed improvements in federal/provincial fiscal relations. Continuing review of provincial fiscal reforms will assess performance and provide input into our ongoing and planned provincial operations. Dissemination efforts will be enhanced to help stimulate the internal debate on these issues. As noted above, the Bank would also update the latest Poverty Assessment, drawing on the data output of the regional ISLC Initiative. Work in FY97-98 will provide building blocks for a major effort in FY99 to highlight policy options on important economic issues to be faced by the next administration. Creditworthiness and Exposure 67. Fiscal adjustments and the completion of the debt and debt service reduction deal, supported by the Bank, have significantly improved the creditworthiness of Argentina and the resulting interest bill falls within the range of projected fiscal sustainability. The debt agreement also limits increases in the future interest bill if international interest rates rise sharply. In addition, the country's approximate energy balance shields the current account against oil price variation. However, external debt service is relatively high (57 percent of exports) and is not projected to decline until well into the next century. 68. The Bank's exposure to Argentina is US$ 4.9 billion, or about 4.7 percent of the IBRD portfolio. This comparatively low level for a large and active client reflects a history of low lending before 1986 and a 1989-90 hiatus in new lending. Our exposure is projected to rise to a peak of about 5.5 percent of the Bank portfolio by the year 2000, with full implementation of the proposed base case lending program. The portfolio risk is manageable because it would mainly be associated with the implementation of policies with high payoffs in terms of reducing the vulnerability of the economy. Risks 69. Reversal in capital flows remains a risk in relation to a rise in intemational interest rates. Furthermore, policy changes in Brazil could also have a detrimental impact on Argentina in vicw of increasing interdependence between the two countries. The Convertibility Plan has emerged strengthened from the regional financial crisis and efforts, as discussed above, are underway to further reduce the economy's vulnerability to external shocks. The current administration has shown its commitment to the Convertibility Plan and was able to garner support for continued reforms even in the midst of the recent economic downtum. Fiscal prudence, financial and capital market development, and the achievement of greater flexibility in labor markets during the remainder of the term are benchmarks. A possible EFF arrangement with the Fund would support efforts on the fiscal side, and the contingent credit line with private financial institutions provides important support for the financial sector. Some key labor market reforms, which would help mitigate the social costs of adjusting to possible further shocks, are still not in place, but the Government is making a strong effort to implement them in 1997. 70. Looking forward to the elections in 1999, the popularity of the Convertibility Plan is strong and all major political groupings support its maintenance. The political risks, then, lie in small incremental measures that might undermine the foundations of the Plan. These would include failure to maintain fiscal prudence, protectionist measures, or a recourse to the use of the financial system to provide targeted subsidized credit. As regards the Bank, even within a continued favorable macroeconomic scenario, a  AR(Wi,'NTlNA ('AS 19 portfolio focused on social and provincial developmlent plagucd by weak institutional capacitv would present difficult implementation challenges. The Argcntinc-Bank Portfolio Commission reprcscnts a rccognition of this challenge and implcmcnitation of its recommendations would mitigatc this risk. Graduation 71 Argentina's per capita incomc has surpassed the trigger for a rcvicw of a country's overall economic situation in thc contcxt of possiblc graduation. The FY94 CAS rccommended, and the Board agrced. that the ncwncss and fragility of the rapid cconomic gains in Argentina, the unfinished rcform agcnda and continuing institutional wcaknecsscs made considcration of graduation premature at that timc. The subscqucnt regional financial crisis and its negative cffects on Argentina borc out this carlicr caution. It also undcrlined the importancc of agrccing with the Govcrnmcnt on an approach to the graduation issue morc explicitlv incorporating considcrations of the tcrms of access to privatc financial markcts (the Argcntinic Governmcnt currcntly pavs sprcads of 300 to 400 basis points on longer-tcrm bonds) and social and infrastructure indicators, along with thc existing incomc pcr capita triggcr. The Rcgion would propose to follow this approach in discussions with the Govcrnmcnt and rcach agreemcnt on an appropriatc sct of nionitorablc indicators. Other Bank Group Assistance 72. International Finance Corporation. IFC's program continues to complement that of the Bank in its support for the privatc scctor in its efforts to adapt to and develop undcr the new open market policics Collaborationi between the Bank and the IFC has been strong, particularly as regards privatization. Morc rccently. a joint program of support for the developmcnt of the Province of Tucuman was initiatcd following a joint idcntification mission and report to the provincial government. For the IFC, the Projcct Preparation Facility and the sugar sector study launchcd in connection with the Tucuman Initiative arc part of efforts to transfcr crucial knowledge to the SME scctor. IFC also expects to lcvcrage this experiencc with additional work in ncighboring provinccs. in association with the Bank's proposed Provincial Rtefbrm II Loon. 73. In the past two years, IFC has been a major sourcc of finance for Argentina's private sector, bridging the gap created bv the 'tequila effect." Special emphasis has bcn given to large infrastructurc/privatization projects, and to large industrial/agribusiness concerns whcrc IFC's financing could be lcvcraged for maximum impact through resource mobilization. As these companies are starting to enjoy increasing access to funds through Eurobond issues, IFC's strategy needs to change. IFC's focus is shifting to helping finance projects that fulfill development priorities but that have difficulty obtaining financing. This assistance would focus on: * D)evelopment of new capital markets institutions. Non-banking financial markets such as leasing. factoring, insurance, corporate debt and mortgage securitization are at their carly stagcs of developmcnt. Asset securitization, mortgagc securitization and the mutual fund industry wvould devclop debt and equity markets. * Strengthening of the banking sector. Progress has been made in restructuring weaker banks. The banking sector, however, has still some way to go to consolidate improvements and to increase efficiency closer to international standards, particularly among second tier and provincial banks. IFC would seek to provide support in post-privatization and in introducing foreign technical partners. Onlending facilities would focus on less developed regions such as northern Argentina.  20 ARGENTINA CAS * Restructuring and modernization of SMEs. IFC will help finance projects that fulfill development priorities but have difficulty obtaining financing and need to upgrade their technologies: (i) second tier companies aiming to improve international competitiveness. (ii) family-owned companies that need assistance before opening up to capital markets; (iii) sectors with strong comparative advantage but for which funding has been difficult (such as in agribusiness, smaller-scale mining, food processing and greenfield projects). * Provincial infrastructure. Privatizations at the federal level are nearly completed so now the focus is at the provincial level. Developing transparent, workable regulatory frameworks to facilitate private financing and management of infrastructure services at sub-national levels is far more complex than at federal levels but would be an IFC priority. * Initiatives in poor regions. IFC continues to work on the Tucuman Initiative, involving an ongoing Project Preparation Facility. Consideration is being given to extension of this focus to neighboring provinces. IFC will also increase wholesale lending to enterprises in northern Argentina through credit lines. 74. Multilateral Investment Guarantee Agency. Argentina joined MIGA in 1992, and has since been one of its most active countries in Latin America. As of January 1997, MIGA had a total of 29 preliminary applications for Guarantees in Argentina (totaling approximately $2.4 billion in potential investment) and five definite applications totaling an additional $150 million in the areas of banking, insurance, light manufacturing and mining. MIGA's current portfolio in Argentina is $120 million, another $20 million is committed and may be utilized in the near future. MIGA is currently underwriting guarantees for $75 million in investments, which should be added to the portfolio in FY97. Demand for MIGA guarantees is expected to remain strong through FY98. Argentina has also benefited from MIGA's Investment Marketing Services' technical assistance, primarily through capacity building of investment promotion agencies and sectoral ministries. Other Multilateral Assistance 75. Inter-American Development Bank. A close and effective working partnership has been developed with the IDB in supporting the Govenmment's development agenda. The IDB lending program for 1996-98 is expected to total about $4.2 billion. It emphasizes social Improvements, development of the private sector, particularly small and medium sized firms in the provinces, and maintaining macroeconomic stability, and closely complements the Bank's proposed program. 76. The Govemment has played an active role in ensuring coordination of external support and in targeting such assistance based on the relative strengths of the Bank and the IDB. In general. the Bank continues to take the lead in providing financing and analytical support for reforms. in many instance with IDB co-financing. The IDB. itself, focuses on investment operations and assistance for SMEs. Given the scopc of Argentina's development needs and the large number of sub-national jurisdictions responsible for implementation, the Govemment has sought to ensure complementary programming. For example, in the education sector, where the Bank is supporting improvements in secondary and higher education. the IDB is assisting in primary and higher-level technical education. In municipal development. where we are implementing complementary operations, the IDB is pursuing efforts to support development in the larger cities. IDB operations to develop export corridors in roads and ports complement our own efforts in provincial roads. Recent co-financed operations include Provincial Bank Privatization. P'rovincial Pension Relfbrm. and P'rovincial Agriculture Deveiopment and is expected for the proposed Elmployment Support P'roject. With rcgard to future work on provincial development. Bank support for the reform of less developed and intenncdiate provinces would be complemcnted by IDB programs with several of the largcr morc advanccd provinces.  ARGENTINA CAS 21 77. International Monetary Fund. The IMF continues to have a close relation with Argentina. Following on the emergency financing package during the regional financial cnsis. Argentina is currently in compliance with Fund Stand-by conditionality. The Fund is discussing with the Government a three- year Extended Fund Facility, aimed at improving fiscal performance, including tax reforms to improve collections and to reduce the debt burden. As in the past, the Bank will continue to work closely with the Fund under the stand-by and any successor program. D. AGENDA FOR BOARD DISCUSSION 78 The following issues have been identified for Board discussion * Are the proposed program and priorities appropriate? Is the concentration on poverty alleviation and social development and on enhancing the capacity of sub-national governments to deliver key social services a reasonable approach? Is the emphasis on the consolidation of structural reforms, as a means of enabling the continued implementation of the poverty-related assistance, suitable in Argentine context? * Is the portfolio management strategy appropriate? Is the combination of the implementation of the recommendations of the recent Portfolio Commission, including decentralization, combined with portfolio triggers. notably on provincial lending, the best strategy for improved portfolio performance? - Are the risks inherent in the strategy acceptable? The authorities are implementing a range of measures to reduce the vulnerability of Argentina to external shocks. They are also implementing policies and programs designed to reduce unemployment. Is Bank and IFC support of these measures satisfactory for minimizing risk to the Bank? James D. Wolfensohn President by Caio Koch-Weser Managing Director Attachments Washington, D.C. April 24. 1997   Annex Al Argentina - Selected Indicators of Bank Portfolio Performance and Management .......... 6ao............................................................................................................................................................................ ..................................... Indicator 1994 1995 1996 1997 Portfolio Performance Number of Projects under implementation 22 23 31 33 Average implementation period (years)a 3.59 3.14 2.94 3.14 Percent of problem projects rated U or I-Rb (for past years, rated 3 or 4) Development Objectives' 4.55 0.00 3.23 9.09 Implementation Progress (or overall 4.55 13.04 19.35 24.24 status for past years)d Cancelled during FY in US$m 17.66 19.79 4.80 .22 Disbursement ratio (%)e 22.85 22.65 16.17 11.45 Disbursement lag (%)f 20.65 15.37 28.57 16.62 Memorandum item: % completed projects 63.16 52.00 46.67 46.67 rated unsatisfactory by OED Portfolio Management Supervision resources (total US$ thousands) 1,297.89 1,260.28 2,224.16 1,606.24 Average Supervision (US$ thousands/project) 58.99 54.79 71.75 48.67 Supervision resources by location (in %/o)g Percent headquarters na na 72.53 75.41 Percent resident mission na na 27.47 24.59 Supervison resources by rating category (US$ thousands/project) Projects rated HS or S 58.27 49.28 66.48 40.99 Projects rated U or HU 74.28 91.56 93.71 72.69 Memorandum item: date of last/next CPPR a. Average age of projects in the Bank's country portfolio. b. Rating scale: "HS" denotes "Highly Satisfactory", "S" denotes "Satisfactory", "U" denotes "Unsatisfactory", and "HU" denotes "Highly Unsatisfactory". c Extent to which the project will meet its development objective (see OD 13.05, Annex D2, Preparation of Implementation Summary [Form 590]). d. Assessment of overall performance of the project based on the ratings given to individual aspects of project implementation (e.g., management, availability of funds, compliance with legal covenants) and to development objectives (see OD 13.05, Annex D2, Preparation of Implementation Summary [Form 590]). The overall status is not given a better rating than that given to project development objectives. Ratio of disbursements during the year to the undisbursed balance of the Bank's portfolio at the beginning of the year: investment projects only. For all projects comprising the Bank's country portfolio, the percentage difference between actual cumulative disbursements and the cumulative disbursement estimates as given in the "Original SARIPR Forecast" or, if the loan amounts have been modified, in the "Revised Forecast. " The country portfolio disbursement lag is effectively the weighted average of disbursement lags for projects comprising the Bank's country portfolio, where the weights used are the respective project shares in the total cumulative disbursement estimates. 9 Supervision resources data, by location, is only available starting in fiscal year 1996. Note: Disbursement data is updated at the end of the first week of the month. Supervision resources include Salaries, Benefits, and Travel but excludes FAO staff and PCR task costs. Generated by the Operations Information System (OIS) Generated: April 22, 1997 M:argentina/cas/alapr97.doc  Annex A2 Page 1 of 2 Argentina - Bank Group Fact Sheet, FY94-2000 IBRD/IDA Lending Program FY94-2000 Past Current Planned' Category 1994 1995 1996 1997 1998 1999 2000 Commitments (US$m) 608.5 1425.0 1509.4 1479.5 1,500.0 1,500.0 1,000.0 Sector (%/6) Agriculture/Environment 0.0 0.0 1.1 9.8 10.0 0.0 10.0 Aids, Stds 0.0 0.0 0.0 1.0 0.0 0.0 0.0 Capital/Financial Markets Dev 83.6 56.2 0.0 0.0 0.0 10.0 0.0 Education 0.0 13.3 18.6 0.0 10.0 0.0 0.0 Employment 0.0 0.0 0.0 13.5 30.0 0.0 0.0 Industry 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Non-Sector 0.0 0.0 2.6 0.0 0.0 0.0 0.0 Pop/Health/Nutrition 0.0 0.0 33.9 6.8 0.0 25.0 40.0 Power 0.0 0.0 0.0 0.0 10.0 0.0 0.0 Public Sector Manage 0.0 0.0 34.2 21.6 5.0 40.0 0.0 Social Assistance 16.4 0.0 10.1 5.0 0.0 0.0 20.0 Transportation 0.0 0.0 0.0 33.8 20.0 25.0 30.0 Urban 0.0 30.5 0.0 13.5 0.0 0.0 0.0 Water Supply & Sewag 0.0 0.0 0.0 0.0 15.0 0.0 0.0 TOTAL 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Lending instrument (