Argentina - Policy Based Guarantee Operation Project

Report No. PID8332 Project Name Argentina Policy Based Guarantee (*) Operation Region Latin America and the Caribbean Sector Guarantee Project ID ARPE68845 Borrower(s) Republic of Argentina Implementing Agency Ministry of Economy Environment Category C Date PID Prepared October 25, 1999 Projected Appraisal Date August 5, 1999 Projected Board Date September 16, 1999 Country Background 1. Argentina is in the latter stages of a successful economic transformation. Since 1989, the government has shed public enterprises and removed barriers to domestic and international trade and capital. It instituted monetary and fiscal discipline, transforming the hyperinflation of the 1980s into one of the lowest inflation rates in the world. Productivity and rapid economic growth have followed. The government took advantage of the Tequila crisis in 1995 to take stringent measures to strengthen the banking system. At the same time, the government began the process of restoring social services, especially social safety nets, education and health, with attendant impacts on the poor, especially women and children. 2. Below are a few examples of the policy actions that the government already has enacted under the program: (i) Reform of Intergovernmental Fiscal Relations -- the government has prepared a proposal for the reform of the system of transfers and provincial taxes, and negotiations have begun with the provinces (called co-participation); (ii) Financial Sector -- the sale of the National Mortgage Bank, creation of an interagency committee to assure consistency in financial sector regulatory practices, and presentation to Congress of draft legislation to remove barriers to the growth of the leasing industry; (iii) Human Development -- budgetary protection for a list of critical social programs, administrative consolidation of all nutrition programs under one unit, and creation of a new plan for higher education financing including cost recovery combined merit-based scholarships for poor students; (iv) Regulatory Reforms -- report prepared for the creation of an integrated freight transport services regulatory agency. 3. The economy has been in a sharp recession since the fourth quarter of last year. GDP Growth was an estimated -3 percent (year-on-year) in the first quarter of 1999. Preliminary unofficial reports indicate growth of - 4.5 percent for the second quarter. This contrasts with average annual growth of 5.8 percent over the 1991-1998 period. Major factors affecting  growth this year: a sharp contraction in the automobile sector linked to intra-Mercosur trade, soft commodity prices and lingering adverse weather conditions for agriculture, as well as higher interest rates due to the various international shocks over the last 9 months. 4. Despite these adverse conditions, the government has remained committed to fiscal prudence. The program with the IMF is on track, and the federal government deficit is expected to widen somewhat to over $5.1 billion or about 1.9 percent of GDP this year. Congress recently approved a "Fiscal Convertibility Law" that commits the government to a timetable for balancing the federal government and creating a fiscal stabilization fund. 5. Argentina's public sector financing needs are significant, but manageable under normal international financial market conditions. For the past year, financial markets have been affected by a number of external shocks (Asia, Russia, Brazil), contributing to intermittent interruptions in Argentina's access to these markets. Currently, the political cycle of presidential elections (October 24) and change in Government (December 10), plus perceived risks to the Y2K problem, have again narrowed access to the markets. The SSAL approved by the Bank last November has played a critical role in meeting Argentina's 1999 financing needs. 6. The Board approved a Special Structural Adjustment Loan (SSAL) - Loan AR-4405, for $2.52525 billion and a Special Repurchase Facility Support Loan for $505.05 million to assist the government through a turbulent period in global capital markets, in November 1998. The first tranche of $1.0 billion of the SSAL was disbursed in November, 1998, after the loan was approved and became effective. All conditions for the release of the second tranche have been met and the tranche released on September 10,1999. 7. For the duration of 1999, Argentina, counting in SSAL resources, has likely met its financing needs. More importantly, however, the new administration, expected to take over on December 10, 1999, will be facing financing needs for the first quarter of 2000 of approximately $4 billion (amortizations plus anticipated fiscal deficit). It is in the context of these needs, and ongoing prudential strategy of pre-financing its needs by a quarter, that the authorities requested the Bank to explore the feasibility of deploying the policy-based guarantee instrument. 8. Argentina's financing needs (amortizations plus fiscal deficit) are expected to remain fairly stable in the next two years, compared to 1999. The IMF is expected to visit Argentina in November to establish a financing plan for the year 2000. Due to shallow domestic capital markets, the government has sought a large share of its financing needs from foreign sources. This has been part of a deliberate strategy to limit crowding out of private firms from domestic credit, given that private companies (and in particular small and medium enterprise) have limited access to international markets. 9. Despite the series of external shocks of the last twelve months, the Central Bank's international reserves have remained quite stable throughout the year, and in September amounted to $24.1 billion . However, in view of the nature of the Convertibility Plan, Argentina cannot utilize such resources as other countries might be tempted to do. A decline in reserves would likely lead to the demonetization of the economy (since the monetary -2 -  base is fully backed by international reserves), and the further deterioration in the level of economic activity. This is particularly serious, at a time when the current recession is already generating social costs, such as the high rate of unemployment, which last May reached 14.5%. Guarantee Objectives 10. The Policy Based Guarantee (PBG) helped Argentina mobilize funds to meet its financing needs at reasonable spreads. Furthermore, in the current market, Argentina does not have access to large issue size and its secondary trading levels have deteriorated substantially. The rolling structure is critical for both leverage and for the investment grade ratings required for effective market access to the institutional investors. The structure achieves low initial exposure that does not increase over the life of the guarantee. Structure of Notes 11. The structure is a series of six separate zero-coupon notes, each for a face value of $250 million to be fully repaid within the five-year period of the SSAL. Five series of notes, mature at the end of year one through five, and one at the end of 18 months. Each series was sold separately. For zero-coupon notes there is only one payment at maturity which represent the principal repayment and the compounded interest payments. Because of this, the proceeds of the issues are discounted at the implied interest rate. In this case, the proceeds were US $1.16 billion. Bank Guarantee 12. The US $250 million of Bank exposure for the PBG would be provided from committed lending through a corresponding cancellation of US$250 million from the second tranche of SSAL (Loan AR-4405), such cancellation occurring concurrently with the issuance of the notes and the Bank's guarantee. Therefore, the PBG would not create any new exposure for the Bank. At any time, the Bank guarantee would cover the repayment of only one outstanding series of notes with a face value of US $250 million. The guarantee exposure in the structure stays at or slightly below US $250 million during the 5-year period. The repayment of principal over five years through the zero-coupon notes, combined with the rolling guarantee, allows for substantial leverage with risk being transferred to the market through the rolling of principal as well as interest. 13. Argentina as the issuer has the primary obligations to ensure timely repayment to the note holders. The Bank guarantees repayment of the face amount of the notes at stated maturity, on a rolling basis. Thus, the Bank's guarantee initially would apply only to the first series of notes, which would mature one year after issuance. If Argentina makes payment when due, then the Bank's guarantee would be automatically "rolled" to the second series of notes and then to each of the subsequent series of notes as long as Argentina pays each current series of notes when due. Should Argentina fail to make such payment, the holders of the notes could call on the Bank's guarantee for repayment of the face amount. Following payment by the Bank under its guarantee, the Bank would have sole discretion to decide whether to require immediate repayment or to extend terms for repayment over time, and in the latter case, would have sole discretion as to the terms to be - 3 -  extended. In either case, Argentina would be obligated to pay interest on the amount owed to the Bank at the same rate as the interest charge then in effect on the SSAL until such amount is repaid to the Bank. If the Bank requires immediate repayment from Argentina, the Bank's guarantee would be reinstated and transferred to the next series of notes provided Argentina has fully reimbursed the Bank and paid the interest then owed to the Bank within (60) days after payment by the Bank under its guarantee. If Argentina failed to do so, the guarantee would not be reinstated and the Bank would not guarantee any subsequent series of notes. If, instead of demanding immediate repayment, the Bank decided to extend repayment terms to Argentina, the Bank's guarantee would be reinstated only if Argentina voluntarily repaid all the amounts due within (60) days after payment by the Bank under its guarantee. Risks 14. The risks for this operation are those associated with the implementation of the policy framework. 15. Risks associated with the reform program are discussed in the PID for the SSAL. Currently, progress in implementing the agreed reform program is satisfactory as evidenced by the release of the second tranche. However, since the approval of the SSAL, the recession has turned out to be longer and deeper than anticipated and Argentina's access to the international capital markets has remained tight. Moreover, the tightness of markets has been compounded by the uncertainties associated with the transition to a new administration in early December 1999 and the policy stance of that new government. Despite these risks, there are indications that the President- elect realizes that Argentina must continue and even intensify its reform efforts in order to put the country back on the path to sustainable growth and poverty reduction. The President-elect is committed to the key elements of Argentina's macro-economic framework and to working with the international financial institutions. 16. Poverty Category - Program of Targeted Intervention 17. Environmental Aspect - In accordance with the Bank's Operational Directive on Environmental Assessments (OD4.00, Annex A), the operation has been placed in Category "C" and does not require an environmental assessment. 18. Project Objective Category - Economic Management. Contact Points: The Infoshop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 Telephone: (202) 458-5454 Fax: (202) 522-1500 Dr. Roque Benjamin Fernandez Minister Ministry of Economy - 4 -  Hipolito Irigoyen 250, Buenos Aires, Argentina Telephone: 54-1-349-8801 Fax: 54-1-349-8815/03/05 Note: This is information on an evolving project. Certain components may not be necessarily included in the final project. Processed by the InfoShop week ending November 5, 1999. - 5 -