Argentina - Policy Based Guarantee Operation

Report No. P-7331-AR REPORT AND RECOMMENDATION OF THlE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ONA PROPOSED POLICY BASED GUARANTEE OPERATION IN THE AMOUNT OF. US$ 250.0 MILLION TO THE ARGENTINE REPUBLIC September 10, 1999 Poverty Reduction and Economic Management Unit Latin America and the Caribbean Region   CONTENTS Page I. Introduction .................................. 2 II. Background .................................. 2 III. Policy Based Guarantees .................................. 3 IV. Eligibility for PBG .................................. 3 V. Argentina's Financing Needs .................................. 5 VI. Economic Impact of the Financing Constraint .................................. 7 VII. Proposed Guarantee. 8 VIII. Appraisal Framework ..10 IX. Risks .12 X. Evaluation Framework .13 XI. Amendment to Loan Agreement AR -4505 .14 XII. Processing of Proposal .14 XIII. Recommendation ..14 Attachment I - Indicative Term Sheet Attachment II - Pricing of Zero Coupon Notes Attachment I1I- World Bank Exposure under the Guarantee Attachment IV- Argentina at a Glance Page I   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED POLICY BASED GUARANTEE OPERATION FOR THE REPUBLIC OF ARGENTINA 1. Introduction 1. I submit for your approval the following proposal for an IBRD Policy Based Guarantee (PBG) of US$250 million for the Republic of Argentina. The operation would support the issuance by Argentina of a series of six zero coupon notes. The face amount of each series would be US$ 250 million. The aggregate face amount of all the series of notes would be US $ 1.5 billion, with net proceeds to Argentina of US $1.17 billion. Concurrently with the issuance of the notes and the PBG, Argentina will cancel US $250 million from the second tranche of the Special Structural Adjustment Loan (Loan 4405-AR). Consequently, there will be no increase in the Bank's exposure to Argentina as a result of the provision of the PBG. II. Background 2. 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 $1.02525 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. 3. Argentina is in the latter stages of a successful economic transformation. Since 1989, ihe 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. 4. A full description of the policies that the government has committed to undertake and has undertaken can be found in the President's Report for the SSAL (P-7268-AR) and the notice to the Board concerning the release of the second tranche, dated September 10, 1999. 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 govemment has prepared a proposal for the reform of intergovernmental 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, strengthening bank failure resolution processes, 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 Page 2  nutrition programs under one unit, strengthening health sector reform, 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. 5. 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 and other industries 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, a domestic credit crunch and declining consumer confidence. 6. 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 $5.1 billion or about 1.7 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. 7. With elections on October 24, a new administration is expected to take office on December 10. The current administration is committed to assisting in the transition, in particular, by securing adequate financing for the remainder of this year and attempting to leave a financial cushion for the first quarter of next year. The economic advisors to the main political candidates have expressed their commitment to the currency board arrangement, and an open discussion has begun on implementing reforms for fiscal sustainability early on in the next government. M. Policy Based Guarantees 8. The Board of Executive Directors on April 20, 1999, approved policy-based guarantees as a new instrument of the Bank, to extend the Bank's existing partial credit guarantee program beyond investment projects to sovereign borrowings. The Bank's objective in offering such guarantees is to mobilize private sector financing through targeted and limited support, thus enhancing the Bank's impact by catalyzing private sector participation. After the East Asia crisis and its global impact, international financial markets remain largely constrained or very expensive to most emerging economies-even those with good fundamentals and sound economic policies. The Policy Based Guarantee would help eligible client countries improve their access to private foreign capital in terms of increased volumes, longer maturities, and reduced spreads. IV. Eligibility for PBG 9. PBGs are not for all countries, and not for all times. By themselves, they cannot improve country performance or market assessments of country performance. But, they make a difference for stronger performers whose access to markets is temporarily limited or blocked: they could help reinforce and enhance positive performance and market assessment, as a part of the World Page 3  Bank program. The Board Paper' therefore set out strict eligibility criteria for PBGs. As set out below, Argentina meets these eligibility criteria (C I-C4). (Cl) The country should have a strong track record of performance, and its structural, social, and macroeconomic policy package should be satisfactory. 10. Argentina has a strong policy program as demonstrated by its track record and its continuing reform measures. Argentina achieved macro-stability with the introduction of the Convertibility Plan in 1991 and since then has maintained a sound macro-economic framework. Its current record in implementing the reforms supported by the Bank's adjustment loans is excellent. In addition, the current SSAL program as set out in the Government's Letter of Development Policy provides the content of the continuing reform program and specifies the measures that the government intends to take to address some of the remaining key structural issues. 11. As one of Latin America's most successful reformers, Argentina has achieved price stability, opened its borders to trade, privatized public enterprises, restructured public administration, reforrned the pension systems and has started the process of restoring social services. Argentina is now focussing on reforms on investment in human capital, improved regulation, modern financial market supervision and quality public administration and governments. (C2) The country's external financing needs have important structural, institutional, and social dimensions and its external-financing -plan should be judged likely to be sustainable. 12. The Bank's special structural adjustment support aims to help Argentina to reduce its vulnerability to external financial shocks, while increasing its capacity for sustainable and equitable growth. Specifically the SSAL operation is intended to: (i) facilitate the re-entry of Argentina to the international capital markets and avoid social and economic costs similar to those experienced during the Tequila crisis when drastically contracting expenditures and depleting reserves made it difficult to meet ongoing financial commitments; (ii) protect vulnerable groups during the present period of high uncertainty; (iii) add to the lines of defense of the banking system in-order to deter and if need be withstand liquidity shocks; and (iv) continue Argentina's successful reform program particularly with the focus on long term issues of savings and capital market development, efficiency in the financial sector and public policies with respect to regulation, tax and fiscal equity, efficiency of social spending and quality investment in human capital. 13. Argentina still has a very high dependence on external financing which has come into relief now that the international capital markets have curtailed access for the emerging market countries. Argentina's reliance on external financing is historic and the result of decades of high inflation - and bouts of hyperinflation - which eroded confidence in financial institutions and demonetized the economy. With macro-stability achieved, confidence is gradually being restored. 'See "World Bank Policy-Based Guarantees" (R99-53), April 2, 1999. Page 4  (C3) The country has a coherent borrowing strategy and program for (re) gaining access to international financial markets, to which a Bank PBG can be expected to make an important contribution. The country is expected to (re) establish itself as a borrower in its own name, without guarantees, in the medium term. 14. Argentina has been a consistent and large borrower in the international markets, carefully cultivating its relations with investors. This has resulted inArgentina having an established yield curve in US$ in both the domestic and global bond markets; and receptivity in the new Euro market as well as the yen market. While its financing needs are currently high (see below), its access has become problematic, amplified by the general lack of liquidity for emerging market paper. This current lack of market access is considered temporary and the government is determined to get back to full participation. Besides helping to meet its financial needs, the guarantee would help continue Argentina's presence with investors and help expand the investor base. Usually, Argentina establishes its borrowing program toward the end of the year. Due to the upcoming elections, the government cannot confirm the medium term borrowing strategy at this time but is fully committed to do so right after the elections. (C4) The country should be IBRD-eligible. The magnitude of financial support should be subject to the availability of adequate IBRDfinancial and risk-bearing capacity and to IBRD's concentration limit. 15. Argentina is IBRD eligible, and has requested the use of the PBG with a corresponding cancellation of the equivalent amount from the second tranche of the SSAL, with the result that there would be no change in the Bank's exposure to Argentina. V. Argentina's Financing Needs 16. 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 approaching presidential elections (October 24), change in Government (December 10), and perceived risks of 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. 17. For the duration of 1999, counting in SSAL resources, Argentina is close to meeting its financing needs (depending on the final fiscal outcome, it may require about another $800 million for the year). More importantly, however, the new administration, expected to take office 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 financing needs and Argentina's 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. 18. 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. Taking into consideration the current amortization schedule, plus compliance to the newly approved Fiscal Convertibility Law which limits the size of the fiscal deficit, the financing needs of the Federal Govemment in the year Page 5  2000 are currently estimated at approximately $17.1 billion, similar to the 1999 financing needs. For the year 2001, such needs could potentially be reduced to $16 billion, and in subsequent years, financing needs are projected to decline as a share of GDP. Due to shallow domestic capital markets, the government has sought a large share of its financing needs from foreign sources. This has been part of a deliberate strategy to limit crowding out of private firms from domestic credit, given that private companies (and in particular small and medium enterprise) have limited access to international markets. Gross financing needs of the Federal Government (1997-2002) (USS Millions) 1997 1998 1999 2000 2001 2002 Fiscal Deficit - Federal Government 4,277 4,074 5,100 4,468 3,165 1,346 Amortization ofiPublic Debt (External & Domestic) 10,912 9,917 12,015 12.607 12,610 14,831 Gross Federal Government Financing Need 15,189 13,991 17,115 17,075 15,775 16,177 (As a % of GDP) Fiscal Deficit - Federal Government 1.5% 1.4% 1.8% 1.5% 1.0% 0.4% A.mortization of Public Debt (External & Domestic) 3.7% 3.3% 4.2% 4.2% 4.0% 4.4% Gross Federal Government FinandcnE Need 5.2% 4.7% 5.9% 5.7% 5.0% 4.8% FEDERAL GOVERNMENT GROSS FINANCING NEED 18000 i 1OOO00 .. _........ 14000 12000~- ~ . 10000 .- _ .... _ 8000 A 2000 - ---____.._----- 400 . .. . ....... 1997 1998 1999 2000 2001 2002 Et Fiscal Dcf1cit - Federal Government t Total amsortizations including that of new debt issucd after 1 998 .... . .... . . ... ...... Page 6  ARGENTINE FEDERAL GOVERNMENT DEBT STOCK2 Stock Share ($ million) (June 30, 1999) TOTAL 115,366 100.0% Bilateral 6,278 5.4% Multilateral 18,709 16.2% Rest 90,379 78.3% External 56,024 48.6% Domestic 34,355 29.8% 19. According to the IMF, the authorities can draw up to US $1.5 billion, (till the end of fourth quarter) from the Fund's ongoing EFF, targets of which are being met. However, such a drawing would in itself be insufficient to cover Argentina's precautionary needs, should access to the international financial markets remain constrained. Therefore, it is likely that the incoming authorities might seek an enlargement of the EFF or another facility to secure their needs, particularly for the first year of the new administration. VI. Economic Impact of the Financing Constraint 20. 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 currently amount to $24.1 billion3. However, in view of the nature of the Convertibility Plan, Argentina cannot utilize such resources. A decline in reserves would likely lead to the demonetization of the economy (since the monetary base is fully backed by international reserves), and to a further deterioration in the level of economic activity. This is particularly serious, at a time when the current recession is already generating serious social costs, the most glaring being the high rate of unemployment, which last May reached 14.5%. The Bank's poverty assessment (in the final stages of preparation) estimates that the national poverty rate has deteriorated in recent years, reaching 29 percent of the population. Progress in improving this situation will largely depend on: (i) expanding the limited coverage of government social programs; (ii) improving the quality of education; and (iii) opening up economic opportunities through a more open labor market regime. 2 Source: Argentine Ministry of Economy 3In addition, private banks hold S7 billion overseas as liquidity requirements (Data as of Sept. 3, 1999). The sum of this item plus Central Bank reserves is now about 2 percent higher than at the end of 1998. Page 7  21. On the fiscal side, given Argentina's financial and monetary constraints, its ability to engage in an expansive fiscal policy in the context of the Convertibility Plan, is also not an option. Any further enlargement of the fiscal deficit would undermine the credibility of the Convertibility Plan, leading to a higher country risk premium, further undermining access to the international financial markets. 22. The above analysis suggests that in view of the nature of the Convertibility Plan, the economic authorities have extremely limited degrees of freedom on both monetary and fiscal policy, and at least in the short run, alternative sources of financing, accompanied by conservative fiscal policies, might be the best option in order to prevent a deepening of the recession or the generation of a crisis. Over the longer term, it is expected that the structural reforms supported by the SSAL would facilitate the reduction in Argentina's reliance to external financing, by increasing economic efficiency, and mitigating the social costs of the recession. Argentina's debt service ratios have been growing during the Convertibility Plan, and it would be desirable to reverse that trend in order to reduce Argentina's vulnerability to external shocks. Reforms supported by the SSAL should contribute to the reversal of such a trend. VII. Proposed Guarantee 23. The proposed PBG would help Argentina mobilize the funds to meet its funding needs at reasonable spreads. In the current market, Argentina does not have access to large issue size and its secondary trading levels have deteriorated substantially. Over the past few years, Argentina has accessed the capital markets a number of times and has a well defined yield curve for up to 30 years. Because of the existing yield curve, the proposed guarantee transaction can be structured and priced based on actual secondary market pricing. In the case of Argentina, the proposed rolling structure is critical for both leverage and for the investment grade ratings required for effective market access to the institutional investors. The proposed structure achieves low initial exposure that does not increase over the life of the guarantee. 24. The market became aware in late July that Argentina was considering requesting the Bank to provide a PBG. Two banks competed aggressively to develop innovative structures based on the amortizing and zero coupon bonds using the rolling guarantee. These structures were particularly attractive to Argentina because they could leverage World Bank financial support at a time the country was seeking large amounts of money. The banks have been holding extensive negotiations with the Argentine government, which thoroughly evaluated trade-offs between pricing and leverage. Given Argentina's vast experience in market borrowings, it was well placed to use the competition and negotiated bid process to obtain a transaction that meets its requirements. 25. Structure of Notes: The proposed structure of the guarantee, indicative term sheet and indicative pricing are detailed in Attachment 1. The structure would be a series of six separate zero-coupon notes (Series A through F), each for a face value of US $250 million to be fully repaid within the five-year period of the SSAL. Five series of notes (series A, C, D, E, and F), would mature at the end of year one through five, and one (series B) at the end of 18 months. Each series would be sold separately. For zero-coupon notes there is only one payment at maturity which represents 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 are expected to be about US $1.17 billion. 26. Bank Guarantee: Argentina as the issuer has the primary obligation to ensure timely repayment to the note holders. The Bank would guarantee repayment of the face amount of the Page 8  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 from Argentina or to extend terms for repayment over time, and in the latter case, would have sole discretion as to the terms to be 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. 27. Rating: Argentina's current sovereign rating is Ba3 from Moodys and BB from S&P. This is not sufficient to tap the broad institutional investor base in America, which Argentina sees as critical for its future funding. Enhanced ratings for the guaranteed structure are needed for borrowing from these institutional investors especially for large amount, and its rolling feature is key to the ratings. Ratings for the proposed zero notes would be sought from at least two of the rating agencies and the National Association of Insurance Commissioners (NAIC). Based on preliminary soundings by the investment banks, investment grade ratings are expected for series B through F and a AAA rating for series A (which is the first of the series and would be fully covered by the World Bank guarantee); as well a NAIC 2 rating is expected for series B through F and a NAIC 1 rating for series A (see Attachment 1, lndicative Terms). 28. Guarantee Fees: Consistent with Bank policy,4 the Bank would charge a front-end fee of 1% on the face value of the guarantee amount and a standby fee of 75 basis points per annum (equivalent to the commitment charges for SSALs) on the present value of Bank's exposure (for each series). As Argentina already paid the 1% front-end fee on that portion of the SSAL ($250 million) that would be cancelled and replaced by the PBG, no additional front-end fee would be charged. The present value of the fees is calculated using the Bank's cost of borrowing as the discount rate and collected up front at the time of financial closure. There would be no refund of Bank policy on charging guarantee fees is defined in Mainstreaming of Guarantees as an Operational Tool of the World Bank (R94-145), July 14, 1994 and in World Bank Policy-Based Guarantees (R 99-53), April 2, 1999. The Mainstreaming paper provides that the Bank will charge a standby fee equivalent to the commitment fee on loans for the period when a guarantee is in force but not callable and a guarantee fee at least equivalent to the Bank's spread on loans for the period when the guarantee is callable. The PBG Board paper provides that the level of fees for a PBG made in association with an SSAL program would be at SSAL-equivalent levels. As the proposed PBG for Argentina will not be callable until the stated maturity date of the notes, the Bank would charge a standby fee of 75 basis points (equivalent to the commitment fee for the SSAL) during this period. Consistent with Bank practice for partial credit guarantees with bullet structures, where the guarantee would be callable only for the one-day period of the stated bullet maturity date, the Bank would not charge a guarantee fee. As noted in paragraph 26, if the guarantee were to be called, Argentina would be obligated to pay interest on the amount paid by the Bank from the date of such payment until the Bank is fully reimbursed at the rate payabic under the SSAL. Page 9  any portion of the guarantee fees in the event the Bank's guarantee is not reinstated for any series of notes. 29. Marketing: With the target of American institutional investors, the bonds would normally be registered globally under Argentina's SEC shelf registration. The road show is expected to focus on the insurance companies, pension funds and mutual funds in New York, Hartford, Boston the Mid-West and California. There could also be minority participation from some funds in London and perhaps (building on traditional interest for Argentina paper) in Italy, Germany and Spain. One of the virtues of the proposed structure is that each zero coupon note series can be directed to accounts with specific interest in a certain maturity rather than the full maturity range. There would be substantial demand for the notes as there is little quality paper in the shorter maturities and interest in the longer end from some crossover investors for more Argentina risk. Market soundings by investment banks indicate sufficient interest for all six series of zero coupon notes. These notes, especially for the shorter dated ones, are not expected to actively traded. For each series of notes World Bank guarantee would only be callable in the final year before maturity. VIII. Appraisal Framework 30. The appraisal framework for the PBGs was defined in the Board Paper (R 99-53, April 2, 1999). The following paragraphs review the proposed operation in the context of this framework. 31. Policy and Development Impact: As noted in Section II the proposed PBG operation has been structured under the umbrella of the Special Structural Adjustment Loan (Loan AR-4405) approved by the Board last November, with the objective of allowing the government to remain focused on longer term development issues and critical social programs. The Government has made satisfactory progress in the implementation of the reform measures under the SSAL, as evidenced by the release of the second tranche, which has had a positive impact in the various key sectors of the economy. 32. Market Access: Argentina's public sector financing needs are significant. For the past year, financial markets have been affected by a number of external shocks. The impending change in government, perceived risks of Y21( problem, and tightening of the markets for developing country issuers have narrowed Argentina's access to the international markets mainly to particular niches. General market conditions, as captured by the Emerging Market Bond Index (EMBI), indicate that when the spreads widen beyond a certain range, the market for new issuance becomes very limited. The EMBI broke an important psychological level (at +1200 bps) in August. The spreads for higher-grade paper have also expanded while issuance has diminished. In fact, since April 1999 when it last issued a global US dollar bond, Argentina has had to tap the market for amounts limited to US $ 100-200 million equivalent primarily from the Euro and yen markets with progressively increasing spreads. 33. Argentina's ability to continue to tap the non-US$ market (EUR, JPY, GBP, CHF) is limited by issue size and foreign exchange exposure, in particular in the context of Argentina's linkage to the dollar. Importantly, emerging markets issuers have very limited unsecured credit lines with banks which substantially limits their ability to hedge their foreign exchange exposure to maturity, without costly collateral and mark-to-market arrangements. The domestic market in Argentina, both in dollars and pesos- remains very shallow and accounts for only 17% of total Page IO  public debt. In the case of Chile and Brazil, the domestic debt share stands at 67% and 50%, respectively. In addition, with the savings rate still very low in Argentina and the bank liquidity still high, most of the domestic markets demand comes from the Letes (T-Bill) market where the govemment is reluctant to issue in size for fear of crowding out the private sector. 34. Leverage and Burden Sharing: The proposed operation comprises of six series of zero coupon notes, each series with a face value of US $ 250 million. IBRD would guarantee the payment of the face amount of the first series of zero coupon notes at stated maturity. In the event that there is no default by Argentina on the first series of notes, the Bank's guarantee would roll and apply to the second series of zeros at the stated maturity of that series and so forth (the structure is described in para. 26. Given that the Bank's exposure at any given time would be limited to US$250 million and that the net proceeds would equal US$1.17 billion, the resulting leverage is 4.6 times (with 22% Bank exposure). Argentina's debt stock is dominated (78%) by market creditors, most from extemal borrowings: 6% is from bilaterals and 16% from the multilaterals. 35. Bank Exposure: As noted above, the US $250 million of Bank exposure for the proposed 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 proposed 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 $250million throughout the 5-year SSAL 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. 36. Pricing of the Notes: There is always a trade-off between pricing and leverage and this transaction is primarily driven by its leverage (4.6 times). The overall average price for the transaction would be about 160bp below Argentina's secondary market yield curve. It is possible in the zero structure, to clearly segregate the discrete segments of Argentina and World Bank risk, and to use the secondary market yields for both Argentina and the Bank bonds as the effective discount rate. For example (Attachment II) a holder of the 3-year zero note would face the risk that Argentina would not pay either during the first or second year and that the guarantee would not roll. The appropriate secondary market yield for Argentina at equivalent maturity would be the proxy for this risk. Therefore, the market would price the note utilizing Argentina's secondary market spread on the first two years and World Bank spread for the third year. Indicative pricing for the overall $1.17 billion raised (on an internal rate of return basis) would be about 9.7% per annum. The first zero coupon note series, being fully guaranteed by the Bank, would carry a AAA rating and be priced on the Bank's spread and perhaps with up to a I Obp friction cost because of structure. The final transaction pricing levels could also be affected by the rating and final structure of the notes. In the event Argentina had not used the PBG to mobilize funds from the market, it would have borrowed the US$250mn under the SSAL and the remaining US$920mn from the markets (although, at present, Argentina could not realistically raise such an amount even with a new issue premium). Based on current rates, the cost of such a financing for Argentina would be about 11.3% per annum. Page II  IX. Risks 37. Risks to the Bank: The risks for this operation fall into three categories: risks associated with the implementation of the policy framework; risks of the policy based guarantee instrument; and risks associated with the particular structure of reinstatable rolling guarantees. 38. Risks Associated with the Reform ProgranL Risks associated with the reform program are discussed in the President's Report for the SSAL (report no. P-7268-AR). 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. This means that Argentina continues to face a difficult period in meeting its financing needs for 1999, as the economy moves toward recovery. 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 leading presidential candidates all realize that Argentina must continue and even intensify its reforn efforts in order to put the country back on the path to sustainable growth and poverty reduction. They are committed to the key elements of Argentina's macro-economic framework and to working with the international financial institutions. 39. Risks of the Policy-Based Guarantee: The general risks associated with the policy-based guarantee instrument were discussed in some detail in the A Board paper "World Bank Policy- Based Guarantees" (R99-53), April 2, 1999. In the specific case of the proposed operation, the risks to the Bank from the use of a PBG, are comparable those the SSAL, as the operation would simply convert equivalent Bank exposure under one instrument to another, where both instruments would support the same government program. The strength of Argentina's policy and its fundamental creditworthiness make the credit risk arising from the proposed guarantee manageable. The guarantee would be within country exposure limits. Moreover, with the proposed six series of zero-coupon notes, the Bank's exposure would remain at or slightly below US $250 million. 40. Risks of the Reinstatable Rolling Structure: As had been agreed during the Board discussion of the President's Memorandum on policy-based guarantees on April 20, 1999, Bank Management has taken a "fresh look" at the risks of reinstatable rolling guarantees. A supplementary note will summarize the findings and conclusions of a staff working group undertaking this analysis. Potential risks associated with reinstatable rolling guarantees are: (i) possible perception by creditors' of an indirect extension of the Bank's preferred creditor status from the guaranteed to the un-guaranteed portion of the debt, and the implications of a possible systemic increase in preferred debt (as the Bank may often set trends among multilateral lenders); (ii) apprehension of increased pressure on the Bank to lend or disburse in anticipation of possible financial distress of the borrower, due to increased stakes of private creditors in Argentina's repayment to the Bank in case of a call on the guarantee (the repayment would make the guarantee roll), as compared with nonreinstatable rolling structures; (iii) reduced flexibility in the case of a debt rescheduling or restructuring, not only of the guaranteed but indirectly also of the un-guaranteed portion of the debt; and (iv) the theoretical possibility of implicit valuation of the Bank's credit, especially if reinstatable rolling guarantees were issued frequently and in large amounts. These risks will be mitigated through contractual provisions and selective use of the reinstatable rolling guarantee. Page 12  41. Key Risk Factors: Three factors are most critical for assessing and managing these risks: (i) the quality of borrower's credit, which determines the baseline range for the probability of a call on the guarantee; (ii) the size of the exposure at stake; and (iii) the transparency of the provisions agreed for the case of a call on the guarantee, which reduces the potential for financial and reputational risks that may arise from misunderstandings between the borrower, markets, and the Bank about the nature, magnitude, and terms of the coverage of the Bank guarantee. It is the combination of selectivity (in country eligibility), size (of the guarantee transaction), and the clarity (of contractual arrangements) that matter most for managing the risks of the proposed operation. 42. Risk Assessment: Argentina meets the restrictive eligibility criteria set out in the PBG Board paper (Section IV). The relatively small size of Bank guaranteed exposure and the low share of preferred debt in Argentina's total debt also make the overall risk manageable. This would be the first World Bank PBG, which would have no associated increase in Bank's exposure (without the guarantee, funds would be disbursed under the Bank's SSAL as Argentina has met the conditions for second tranche release). The notes would be offered globally under Argentina's shelf registration (under New York State law). And would not include any so-called collective actions clauses that would allow a super majority of note holders to change in the terms of the bonds. Nevertheless, the guarantee and indemnity agreements would include specific provisions stating explicitly that the Bank's guarantee would only cover the current payment due and separating it clearly from all other non-guaranteed payment obligations. This separability would become instrumental in the event of a rescheduling, as any amendment to the bonds would require the Bank's consent. The agreements would also spell out the Bank's option, at the time of a call on the guarantee, of either demanding immediate repayment or specifying an alternative repayment schedule; they would set out clearly under what conditions the guarantee would roll or lapse in each of these two cases. This clarity would help to substantially limit the risks. 43. In sum, the risks of the specific proposed transaction are limited--givein the particular borrower, the conversion of SSAL into PBG exposure, and the specific guarantee structures. With the use of a reinstatable rolling structure for the Bank's first policy-based guarantee, special concerns arise primarily about the possible growth and extension of PBGs, and in particular of reinstatable rolling guarantees. These risks can be monitored and managed, within the framework set out in the PBG Board paper and through the structure and the contractual framework The first transaction would give market experience of the risks and benefits over time and should be seen in the context of a carefully designed pilot program that is limited to $2 billion in Bank exposure. X. Evaluation Framework 44. The evaluation of the proposed PBG would be carried in the context of the appraisal framework (Section VII). The ex-post assessment would take into account the indicative parameters of the operation under the following categories: * Policy impact would be assessed in the context of the SSAL by monitoring the countries' policies, reforms, and their economic performance after the release of the second tranche and issuance of the guarantees - in the context of regular SSAL supervision. * Financial impact would take into account the volume, maturity, leverage, improvement in market access and costs of the zero coupon notes and subsequent market borrowings by Argentina - monitored on a regular basis. Page 13  * Market Impact would take into account the reception of the transaction in the market, depth and breadth of investor interest and level of subscription - assessed upon completion of the transaction. XI. Amendment to Loan Agreement AR -4505 45. The Bank will enter into an agreement with Argentina to amend the SSAL loan agreement. This agreement would provide that Argentina will reimburse the Bank for any amounts paid under the Guarantee on demand or as the Bank otherwise directs. The agreement will also provide that the Bank will have the sole discretion as to the application of any reimbursement payments received from Argentina in case there are overdues on Bank loans to, or guaranteed by, Argentina. Argentina will be obligated to pay the Bank interest on such amounts at the same rate as for the SSAL until the Bank is fully reimbursed. In addition, the agreement will provide that Argentina will deposit the net proceeds from the bonds in the Deposit Account established for the SSAL. If after such deposit, any part of the net proceeds is used for ineligible purposes, as defined in the SSAL loan agreement, the Bank will require Argentina to either (a) return such amount to the Deposit Account for use for eligible purposes, or (b) if the Bank shall so request, use such amount to redeem or otherwise retire bonds. XII. Processing of Proposal 46. Due to the accelerated consideration of this operation, it has not yet been possible to finalize the legal documentation for the notes, the guarantee or the amendment to the SSAL. After the Board's approval, the legal documentation will be finalized. A road show is expected to be held in America and possibly in UK in late September/early October. The notes are expected to be launched in the US market in early October. XIII. Recommendation 47. 1 recommend that the Executive Directors authorize the Bank to issue a guarantee for the proposed series of zero coupon notes to be issued by the Argentine Republic and the corresponding amnendment to the SSAL loan agreement, substantially in accordance with the terms and conditions described in this Memorandum and in the Attachment hereto. The terms and conditions of the guarantee and the amendment to the SSAL loan shall be as deternined by either the President or the relevant Managing Director, and the Executive Directors will be informed accordingly. If there is any substantial change in the terms and conditions of the guarantee, the notes or the amendment from those described herein, the approval of the Executive Directors will be sought. James D. Wolfensohn President by Sven Sandstrom Page 14  Attachment I Indicative Terms Republic of Argentina USD Serial Zero Coupon Notes With Rolling World Bank Guarantee September 8, 1999 Issuer Republic of Argentina ("Argentina") Guarantor International Bank for Reconstruction and Development (The "World . ~~Bank") Lead Manager To be Mandated. Transaction 6 Zero Coupon Notes maturing serially in one, one and a half, two, three, four and five years after issuance. (Series A, B, C, D, E and F respectively) Currency US Dollars Face Amount of Each Series $250 million Total Proceeds' $1167.853 million Amortizations One payment at final maturity for each Series Maturity Dates Series A - October X, 2000 Series B - April X, 2001 Series C - October X, 2001 Series D - October X, 2002 Series E - October X, 2003 Series F - October X, 2004 Indicative Yields to Maturity Series A - 6.02% for Each Series' Series B - 9.11% Series C - 9.46% Series D - 9.70% Series E - 10.14% Series F - 10.64% Indicative Issue Price for Each Series will be issued at a price discount equal to the present value of Each Series' par repayment at maturity date, discounted at the semi annual Yield to Maturity of the Series as determined at the Pricing Date Series A - 94.24% Series B - 87.49% Series C - 82.75% Series D - 75.78% Series E - 67.32% Series F - 59.56% Coupon Rate and Frequency None Day Count 30/360 Yields and prices shown are those generated by the bidding bank 's model as of September 7h. Page 15  World Bank Guarantee The payment of Series A notes at maturity will be guaranteed by the World Bank. Once Argentina makes timely payment on the Series A notes, the guarantee will be transferred to the Series B notes, and thereafter to each subsequent Series of Notes so long as Argentina makes timely payments on each Series of Notes as it comes due. Should Argentina fail to make any such payment when due, the holders of those notes could call on the Bank's guarantee for repayment of the face amount of those notes. Following payment by the Bank under its guarantee, the Bank would have the right under its reimbursement arrangements with Argentina either to demand immediate reimbursement from Argentina of the full amount paid by the Bank or to permit Argentina to repay the Bank over time. The Bank would have sole discretion to decide whether to require immediate repayment or to extend terms, and in the latter case, would have sole discretion as to the terns to be extended. If the Bank requires immediate repayment from Argentina, the Bank's guarantee would be reinstated and transferred to the next subsequent Series of Notes provided Argentina has fully reimbursed the Bank and paid the interest then owed to the Bank in respect thereof within 60 days after payment by the Bank under its guarantee. If Argentina fails to do so, the guarantee would not be reinstated and thus the subsequent Series of Notes would not be guaranteed by the Bank. 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. In addition, notwithstanding the foregoing, the Bank's guarantee will not be reinstated in any case if any of the notes (of any series) has been accelerated. Fees 0.75% per annum, charged on guaranteed exposure of each series on a present value basis, discounted at the Bank's cost of funds as of the date of launch. The entire fee is payable in advance at the closing date out of the gross proceeds of the notes. Subrogation If the Bank makes any payment under the guarantee and is not fully repaid by Argentina in accordance with the terms of its reimbursement arrangements with the Bank , the Bank will be immediately subrogated to the rights and claims recoverable or receivable by the noteholders Amendments and Waivers Any amendment or waiver of the guarantee provisions or to the related documentation for the notes would require the prior written consent of the Bank. If any such measures are taken without the Bank's prior written consent, the Bank's guarantee would immediately tenninate. Repackaging Arrangements The lead manager and each of the other managers will severally undertake for the benefit of the Bank that, so long as the Bank's guarantee remain in effect, it shall not enter into or perrnit any other member of its group of companies to enter into any Repackaging Arrangement, and the lead manager and each of the other managers will Page 16  severally undertake that, in connection with any sales of notes it makes on or prior to the closing date, it (a) will inform prospective purchasers of such undertaking, and (b) will not sell any bonds to any purchaser with respect to which the relevant salesman of such manager has actual knowledge that the purchaser intends to deal with the notes in a manner which would constitute a breach of the Repackaging Arrangement undertaking, provided that the lead manager and the other managers shall not be obliged to make any inquiries of any prospective purchaser to asceftain such purchaser's intention with respect to the notes. Repackaging Arrangement means any arrangement pursuant to which any security or other like obligation is created or issued, the economic effect of which is the separation of rights of payment under the Bank's guarantee from those of rights of payments from Argentina under the notes. Status of the Notes The Notes will constitute direct, general, unconditional, unsubordinated and unsecured external indebtedness of Argentina ranking pari passu, without any preference among themselves, with all other external indebtedness of Argentina Status of the Word Bank The obligations of the World Bank under the World Bank guarantee will Guarantee constitute direct, unsecured obligations of the World Bank rankingpari passu without any preference among themselves, with all its other obligations that are unsecured and unsubordinated. Negative Pledge The Conditions of the Notes will restrict the ability of Argentina and the World Bank, as the case may be, to create Liens on the property or assets of either of them without equally and ratably securing the Notes or the World Bank Guarantee. Targeted Initial Ratings S&P Duff Fitch NAIC Series A Note: AAA AAA AAA NAIC I Series B-F Notes: BBB BBB+ BBB+ NAIC 2 Listing Luxembourg Stock Exchange Documentation/Markets/ The notes will be offered globally under Argentina's shelf registration Governing Law with the SEC (under NY state law) Optional Redemption The Notes are not redeemable prior to their maturity [except under tax redemption provisions to be defined.] Witholding taxes All payments in respect of the Notes shall be made free and clear of, and without withholding or deduction to Argentine taxes. Expected Announcement Date September 26, 1999 Expected Pricing Date October 7, 1999 Expected Settlement Date October 14, 1999 Page 17  Attachment II Pricing Of Zero Coupon Notes ........................... ....... ...... ................. Face Ami Oiscou~~tftd Discounted iasuer rate atforward appropriat, for first multi- . irda maturity lateral zero. rate Price Prie t~............................., ........... .................... . . Issue Deto First Second ZUrds Z*rds Maturity Maturity AeRktx 08144 OPli9 Q7iS Qf *1/G0ra*La MA tLA ZP/o ffle~ 653>o 11%/ 9 o -1XPk 241E 22173 22YB1 Q I EB Page 18  USS millions R,~~~~a 6 \r  Argentina at a glance 9/16/98 Latin Upper- _ POVERTY and SOCIAL America middle- Argentina & Carib. Income n Development diamond- 1997 Population, mid-year (millions) 35.2 494 571 Life expectancy GNP per capita (Atlas method, US$) 8,570 3,880 4,520 GNP (Atlas method, USS billions) 302.0 1,917 2,584 Average annual growth, 1991-97 Popultion (%) 1.1 1.7 1.5 GNP Gross Labor force (%) 1.9 2.3 1.9 per -> primary Moat recant eislmate (latest ear aailable, 1991-97) capita > enrollrment Poverty % of population below naional poverty line) 26 Urban population (% of total population) 88 74 73 Ufe expectancy at birth (years) 73 70 70 Infant mortality (per 1,000 live births) 22 32 30 Child malnutrition (% of children under 5) 2 Access to safe water Access to safe water (% of populabon) 64 73 79 Illiteracy (% ofpopulation age 15+ 4 13 is Gross primary enrollment (% ofschool-age population) 107 111 107 Argentina Male Upper-middle-income group Female KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1976 1986 1996 1997 Economic rtlo*' GDP (US$ billions) 51.2 110.9 298.7 322.7 Gross domestic investment/GDP 30.7 17.5 18.5 18.9 Exports of goods and services/GOP 9.2 8.2 8.9 8.7 Trade Gross domestic savings/GDP 34.0 19.3 18.1 18.2 Gross national savingstGDP 34.1 14.8 16.5 16.4 Current account balance/GDP 1.3 -2.6 -1.3 -2.9 Dmestic Interest paymentslGDP 0.9 33 1.9 20 Savinic investment Total debtGDP 18.1 473 32.4 32:4 Savigs Total debt servicetexports 34A 82.8 47.2 49.3 Present value of debVGDP . 29.5 Present value of debtlexports 7. .7 Indebtedness 1976-86 1987-97 1996 1997 1998-02 (average annual growth) GDP 0.6 3.8 4.8 8.6 4.0 Argentina GNP per capita -1.9 2.9 3.7 7.1 3.1 Upper-middle-income group Exports of goods and services 2.8 8.5 6.7 9.1 6.5 STRUCTURE of the ECONOMY 1976 1986 1996 1997 I Growth rates of output and Investment(%) (% of GDP) 4 Agriculture 8.2 7.8 7.7 7.3 IndustrV 50.9 37.4 35.5 36.4 20 i Manufacturing 39.1 27.4 24.7 24.8 Services 41.0 54.8 56.8 56.3