Argentina - Structural changes in the industrial sector (Vol. 1 of 2) : Main report

LI iiXlA V30 < Report No. 1977a-AR 4.rgntia IF~~UL~ LAFILE COPY Argentina lF;:it@4-tt&; asb r Structural Changes in the Industrial Sector (In Two Volumes) Volume 1: The Main Report March 30, 1979 Projects Department Latin America and the Caribbean Regional Office FOR OFFICIAL USE ONLY Document of the World Bank 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.  CURRENCY EQUIVALENTS On January 15, 1979 the market rate for the Argentine peso (a$) was: US$1.00 = a$ 1,026 a$1,000 = US$0.9747 LIST OF PRINCIPAL ABBREVIATIONS SEDI - Secretaria de Estado de Desarollo Industrial (Secretariat for Industrial Development) INTI - Instituto Nacional de Tecnologia Industrial (National Industrial Technology Institute) BANADE - Banco Nacional de Desarollo (National Development Bank) DGFM - Direccion General de Fabricaciones Militares IDB - Inter-American Development Bank YPF - Yacimientos Petroleras Fiscales PBB - Petroquimica Bahia Blanca SOMISA - Sociedad Mixta Siderurgia Argentina INDEC - Instituto Nacional de Estadistica y Censos  FOR OFFICIAL USE ONLY ARGENTINA STRUCTURAL CHANGES IN THE INDUSTRIAL SECTOR TABLE OF CONTENTS Page No. SUMMARY OF PRINCIPAL CONCLUSIONS AND RECOMMENDATIONS .... i I. MAIN CHARACTERISTICS OF THE INDUSTRIAL SECTOR .... ....... I A. Introduction ....................................... 1 B. Growth Rates and Structure .................. 2 C. Natural Resource Base .............................. 6 D. Human Resources and Industrial Employment .......... 8 II. FOREIGN TRADE POLICIES AND INDUSTRIALIZATION .... ........ 11 A. Protection of Domestic Output ...................... 11 B. Export Incentives .................................. 21 C. Future Choices for Trade Policies and Industrial Transformation ........................ 28 Appendix A - Credit Incentives for Promoted Exports. 30 Appendix B - Calculations of Shadow Exchange Rates.. 33 III. OTHER POLICY ASPECTS ..................................... 37 A. Restructuring of the Financial Sector .... .......... 37 B. Industrial Promotion Legislation .... ............... 44 C. Public Sector Participation in Industrial Enterprises 53 D. Special Problems of Small and Medium Size Industries 56 IV. EFFICIENCY IN INTERMEDIATE GOODS INDUSTRIES .... ......... 59 A. Introduction ................... .................... 59 B. Steel .............................................. 60 C. Petrochemicals .................. ................... 68 D. Pulp and Paper .................. ................... 80 This report is based on the findings of a mission which visited Argentina from October 24 through November 19, 1977. Participating in the mission during that time were Messrs. Baskind (LCPID), Wogart (LC2), Castaneda (Consultant), Santistevan (Consultant), Knepell (UNIDO) and Ms. Cortes (DED); others who participated for shorter periods of time were Messrs. Walstedt (IPD), Goderez (IDFD), Oberdorfer (IPD), Bastl (Consultant) and Parker (Consultant). 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.  TABLE OF CONTENTS (Continued) Page No. V. EXPORTS OF MANUFACTURES .......... . ............ 88 A. Share of Exports in Industrial Output .* ......... 88 B. Agro-based Manufactured Products .................... 88 C. Metal and Engineering Products .................... 96 D. Geographical Pattern of Manufactured Exports ...... 100 E. The Emerging Structure of Exports 10.................. 1 STATISTICAL APPENDIX ANNEXES I. Technical Development and Technology Exports to Other LDCs II. The Argentine Steel Industry III. Special Problems of Small and Medium Size Industries  - i - SUMMARY OF PRINCIPAL CONCLUSIONS AND RECOMMENDATIONS i. Since March 1976 the Government of Argentina is engaged in a major restructuring effort in order to restore stability and inject new vigor into an economy which has been characterized by erratic and distorted growth patterns for more than one generation during which time its importance in the world economy has considerably diminished. This study of the manufac- turing sector is one of a series of such analyses of key economic sectors in Argentina which the Bank is currently undertaking to: (a) assess the current structure and status of the most important sectors; (b) examine sector policies in the framework of the overall develop- ment strategy; (c) provide indications as to the adequacy of the measures taken; and (d) identify possible needs for additional steps. ii. The focus of this analysis is on the factors which have and will determine economic efficiency in the individual manufacturing branches; these are: (a) government policies in the field of protection, promotion and finance, the directions these policies have taken since March 1976, and future measures which will have to be taken in order to achieve the desired objectives; (b) a structural analysis of major subsectors to identify comparative advantages and disadvantages and their under- lying causes; and (c) the nature of the restructuring process which may be required to meet desired levels of efficiency in certain critical subsectors. While current short-term developments are of concern and have been discussed in some detail, the study focuses on medium and long-term development trends and objectives. Foreign Trade Policies and Industrialization (Chapter II) iii. Foreign trade policies have fostered industrial development and have shaped the industrial structure of Argentina decisively. While the import substitution strategy which was followed after 1950 induced a high initial rate of industrial growth, it resulted in a haphazard distribution of protection--distorting relative prices as compared to those prevailing inter- nationally--and in generally high production costs. Efforts at export promo- tion date back to 1962, but became effective only in 1973/74, when internal price controls and an export incentive system with fixed interest rates for pre- and post-financing of exports made it more profitable to sell in inter- national than in domestic markets.  - ii - iv. Recent policy measures mark an important turn towards a new industrialization strategy, which should lead to a more efficient industrial structure over the next decade. The current administration, since its basic philosophy is to free markets from previous distortions, has curtailed import restrictions and excessive export incentives. Existing regulations are con- tinuously examined as to their appropriateness in furthering industrial devel- opment and exports at lower costs. Major external sector policy measures of the new government which have direct bearing on industry are the following: (a) to free and unify the foreign exchange rate by reducing and finally abolishing export taxes; (b) to liberalize imports by gradually reducing tariffs and by dismantling controls, quotas, and licensing systems; and (c) to harmonize export promotion policy with exchange rate policy by curtailing fiscal incentives as well as abolishing post- financing and linking the interest payments of pre-financing to the movements of the exchange rate. v. The impact of these policies on industrial exports and imports are beginning to be felt in the industrial sector. In the case of industrial exports, the 1977 and 1978 values and volumes were both above the high levels of 1973-74. The most important expansion has taken place among agro-based manufactures but there have also been significant increases in exports of a number of engineering products which have large skilled-labor requirements and little scale economies. In the case of imports, an analysis of nominal and effective protection rates based on legal rates shows that, on the average, they were both halved between 1976 and 1977. Tariffs on a number of imports were further reduced in 1978. In a few industries, foreign manufactured products are now entering the Argentine market but, due to relatively slow expansion of domestic demand, those increases in imports have been small in relation to domestic supply. vi. The Government introduced a policy of "gliding parity" after it unified the exchange rates and set it at a perceived equilibrium level in November 1976. The accumulation of foreign exchange reserves, which reached US$5 billion in March 1978, forced the authorities to revise the policy of continuous devaluation. Though not undesirable in itself, the impact of foreign capital inflows on the monetary base was greater than in 1977, making an anti-inflationary monetary policy very difficult. On May 18, 1978 it was decided to let the exchange rate "float." The float was managed by the monetary authorities in such a way that it lowered import costs relative to domestic prices. Between May and December 1978, devaluation of the peso was 30% whereas wholesale prices rose by 63% and the cost-of-living index advanced by nearly 70%. With an international inflation of 8%, a real peso appreciation of about 30% took place during the second part of 1978. Never- theless, both agricultural and industrial exports have risen substantially again and total exports are estimated to have reached $6.4 billion in 1978 constituting a 40% increase over 1977. With the balance of payments and trade remaining favorable but with unabated inflation in 1978, at the beginning of  - iii - 1979 the Government modified the approach to exchange rate management. It decided to announce in advance the changes in the rate of exchange through August 1979, indicating an intention to lower inflationary expectation and consequently the rate of inflation itself. At the same time, price adjust- ments for public sector enterprises and changes in basic wages were announced. All these indicators, together with domestic credit expansion, are to rise by about 30% during the first 6 months of 1979. Any industry that raises prices well above the guidelines of the above-mentioned cost indicators will face more competition from abroad, attracted through lower import tariffs. vii. Export incentives have also been rationalized during the last three years. Consistent with the need to lower the Treasury deficits and to control credit expansion, tax reimbursement rates and export credit at preferential interest rates have been lowered. At the end of 1977 the average prevailing export incentives were below the difference between domestic and international prices; there was, however, great diversity among the major product groups. Exports of more elaborated manufactured goods such as machinery and transport equipment received tax reimbursemet rates of 25%, tax credits and exemptions, and low interest rates for pre-financing such that the domestic currency equivalence of exports exceeded the domestic/international price ratios; exports of most other goods received incentives falling below those ratios. The Government became aware of the problem and in March 1978 it restored fiscal incentives for some major agro-industrial products to their pre-1977 level. In November of the same year, the Government announced a new scheme of temporary free imports for industrial exporters which will lower input costs for these firms, permitting them to improve their capacity utilization and at the same time encouraging more efficient production among potential domestic suppliers of those inputs. Although the measure is expected to bolster manufactured exports substantially, a continuous reassessment of export incentives within the overall framework of the Government's external sector policy will be necessary, if the goal of continued export growth is to be met. viii. The major issue of foreign trade policy, which will have an impact on both industrial price and output, is the lowering of import controls and external tariffs. On January 28, 1979, the Ministry of Economy published two resolutions which introduced gradual decreases in external tariffs between 1979 and 1984. On average, legal protection will fall from about 50% to 25% in five years, with smaller declines set for the coming two years and acceler- ated reductions envisioned from 1982 on. A 1977 study on nominal and effective protection of the Argentine industry pointed out that the problem has been not only the generally high level of protection but the large dispersion of effective tariff rates ranging from -32% to over +400%. Although the autho- rities did not plan complete unification, reduction of dispersion of the tariff structure is one of the principal goals of a continuous tariff reform. According to the tariff resolutions, the dispersion of legal tariffs will be reduced from the current level of 75% to 40% by the beginning of 1984. ix. The implementation of a continuous tariff reform is simplified by the high degree of similarity between nominal and effective rates. However, additional study has to be undertaken to make the transformation of Argentine industry through foreign trade policy successful. It will be necessary to investigate fully:  - iv - (a) the remaining non-tariff barriers; this would include other fees and payments for imports and the licensing system which still plays a dominant role in the case of steel imports; (b) the effectiveness of the recently enacted anti-dumping legislation; (c) the importance of the list of "official" prices, their relation to actual world market prices and their relevance for the imple- mentation of the "anti-dumping" legislation; and (d) the current and future role of the special agreements under the Latin American Free Trade Association (LAFTA). x. A second set of issues, which will directly result from the imple- mentation of the lowering of import protection but which cannot be solved by the application of foreign trade policies alone are the problems of transition. Given the structural characteristics of numerous industries with high rates of protection (i.e., the co-existence of a few dominating firms with a large number of small firms), a successful transformation towards a more efficient structure will require fewer firms. In addition, it is necessary to reduce input prices particularly those from state controlled basic industries. In the first case, current merger and anti-trust legislation must be examined as to its scope to allow firms to merge and its ability to control price collusion and other "oligopolistic" practices. In the second case, improved efficiency and lower prices cannot and will not be achieved in most "final" industries, unless it will be possible to streamline "basic" industries. Further issues of transitions are in the field of monetary and employment policy, discussed in paragraph vi above and also paragraph xi below. Financial Policies (Chapter III) xi. The financial sector (by its nature) has to be considered in the context of macro-economic policies, which are currently dominated by efforts to reduce the excessive inflationary pressures of the past five years. 1977 was a crucial year for monetary policy when the previously centralized banking system was decentralized. The necessary adjustments for the private banking community, which ranged from the renewed need for banks to attract depositors to the requirement to keep a 45% reserve with the Central Bank, were profound. These adjustments were made more difficult by the rapidly increasing demand for credit from both the private and the public sector. A record agricultural harvest and a recovery in manufacturing and construction required higher levels of credit during the second and third quarters of 1977. In addition, the Treasury's reduction of subsidies to state enterprises forced those entities to look for increased credit in private markets. At the time when these in- creasing demands became most pressing, the monetary entities attempted to limit the increase in the money supply. This led to an increase in interest rates, reaching monthly rates of over 10% for depositors and 14% for borrowers during the last quarter of 1977; during this period monthly inflation rates were 8.5% and 7.9% respectively. The high interest rates attracted external capital and, as a consequence, 1978 was another year in which Argentina accumulated large international reserves, both the capital and current accounts  v recording large surpluses. These inflows, in turn, helped depress interest rates to real levels below 1% in the course of the year. xfi. Though short-term financing problems are being resolved and inter- national lenders provide funds in increasing amounts for periods up to 10 years, what has not yet developed is a steady flow of domestic savings into the market for medium- and long-term funds. The National Development Bank (BANADE) which was able to disburse close to US$500 million between June 1976 and December 1977, generated a substantial proportion through recapitalization, selling shares of industrial enterprises and through loans from abroad. Three private investment banks have begun to channel medium- and long-term funds, mostly obtained from the Eurodollar market, into industrial projects ranging from less than US$100,000 to US$1 million. The increased freedom of commercial banks to pursue lending operations should help to broaden the supply of loan- able funds. The security markets are still small and in a stage of transition. Current problems of management and organization have been extensively studied and the findings are now being implemented. xiii. Future development of the financial sector will be crucial in financing structural change of Argentine industry. At present, too few insti- tutions have either the technical or financial capacity to channel medium- and long-term funds into industrial enterprises and with it influence the modernization and transformation of these enterprises. However, valuable experience from other countries has demonstrated that increased diversifica- tion of financial intermediaries and a strengthening of the capital market will be necessary, if the transition from an "inward-directed" towards a cautiously "outward-looking" industrialization strategy is to be successful. General Sectoral Issues (Chapter III) xiv. The present Government has indicated its intention to stimulate efficient industrial growth largely through global macroeconomic policies described above, reducing sharply its direct investment in enterprises in the sector. It will, however, maintain its interests in the steel and petro- chemical industries, although it has substantially modified a previous restric- tive policy for the latter. There will be continuous emphasis on decentral- ization and stimulating the growth of new industrial poles through new investment incentive legislation. xv. Consistent with this reduced level of direct ownership, there remain many areas of official activities which can help to achieve the basic objec- tives of increasing the efficiency of industry and developing further its export-orientation through medium- and long-term planning and incentives. Of particular importance is the need to develop within the relevant official agencies a capability to articulate long-term development perspectives, with appropriate inputs from the private sector, which would help to provide the bases for rational investment decision-making. A number of western European countries have used various mechanisms for this purpose (e.g., the French Commissariat du Plan and Spain's "Accion Concertada") with generally favorable results. Under the current situation in Argentina, it would be beneficial to initiate this work with some priority sub-sector, in particular to develop  - vi - the specific mechanisms which can achieve the desired results given the local conditions. This is a most propitious moment to undertake such an effort for the steel industry which could serve as an example for other sub-sectoral studies; some further recommendations concerning steel, arising from the mission's analysis of this problem, are described below. Other groups of industries whose problems and prospects should be analyzed as early as possible include petrochemicals and pulp and paper. Some experience in using a mixed public-private group to consider specific industrial problems has already been gained in the case of the automobile industry where the mechanism was used to help elaborate a development strategy. xvi. The sub-sectoral studies would essentially consider long-term per- spectives for the industries, examining alternative growth paths for the next 10 to 20 years, analyzing the overall economic and financial implications as well as their potential for achieving international competitiveness. The groups of manufacturing activities which have been suggested for earliest consideration are essentially the large-scale capital intensive intermediates with substantial investment requirements and with influence on the cost struc- tures of other industries. These are, in fact, the elements which led to the decision to examine in some detail the current and medium-term perspectives of these product groups for this survey. xvii. Other groups of industries could also benefit from a more systematic review of their problems undertaken jointly by the public and private sectors. Their characteristics and requirements would necessitate a different approach. Of particular importance are the engineering industries with a large diversity of products as well as of size of enterprise. One alternative would be to start by considering specific problems of general interest to the industry. Such a mechanism could be an Engineering Industries Export Council which, in the case of India, for example, has been especially useful in helping to focus both official and private sector attention on practical problems in expanding exports of these items as well as on policy issues. Argentina has already had some experience in provincial programs of this type but a better focussed effort with national coverage could have more beneficial results. It should be stressed that none of the institutional arrangements cited above require large bureaucracies and could be staffed from within the existing ministerial secretariats with some changes in assignments (e.g. drawing upon the Secretaria del Estado de Desarrollo Industrial and the Instituto Nacional de Planificacion Economica, as well as on the Secretaria de Comercio Exterior). To a large extent, what is required is a more systematic institutionalization of contacts which are now carried on in an ad hoc manner. Investment Promotion Legislation (Chapter III) xviii. There is no evidence that the fiscal incentives offered through 1973 affected either the total flow or direction of new investment; the channeling of resources to "priority" industries, particularly foreign capital in the early years, responded to other elements associated with import substi- tution policies, largely tariff protection. The massive fiscal incentives offered under the law which was in effect from 1973 until the end of 1977, particularly the complex set of non-indexed tax deferrals for the eligible enterprises and for shareholders in those enterprises, promoted a substantial  - vii - flow of investment but primarily at the expense of fiscal resources. Some decentralization of industry is taking place as a result of the implementation of the projects approved under this law but much of that responds to capital- intensive natural resource development which was in any case evolving due to general economic trends. xix. Limited use was made in 1978 of the revised statute which went into effect at the beginning of that year. Many of the new projects and expansion plans which had been approved under the 1973 law have yet to be implemented or are in the early stages of implementation; a number of the proposals presented for the granting of incentives represented longer-term investment plans of the enterprises and may not be undertaken for some time. Efficiency of Intermediate Goods Industries (Chapter IV) xx. Steel. The industry has advanced to the point where the country's requirements for non-flat products (excluding structurals and rails) can be reasonably efficiently met through local production. Moreover, plants pro- ducing these items have developed some export capability, particularly to neigh- boring countries, aided by export incentives. A time schedule should be set for the reduction of tariff protection, other than against cyclical dumping, for all steel products. The major policy problem facing the Government is the future supply of flat products for which the publicly owned steel mill (SOMISA) is the largest supplier. These products are primarily used in the engineering industries and they represent an important proportion of the pro- duction costs of these goods. To meet expected growing demand for these items, there are two alternative expansion plans being considered - expanding SOMISA's flat capability or establishing a new integrated large-sized mill which at the start might be semi-integrated. Technical data required for making this choice is expected to be available from a recently completed external expert evaluation of SOMISA. Both in the immediate future and for the longer term, costs of production, and consequently prices charged by SOMISA, might be reduced through a financial restructuring, writing down the value of the existing plant to a level on which a reasonable return could be expected at competitive prices (with landed imports) and reasonably efficient operations. The experts' report cited above is also expected to provide important recommendations on improving operating efficiency in this enterprise. xxi. Petrochemicals. This subsector has been one of the principal bene- ficiaries of the import substitution policies followed since the end of the 1950's. The existing industry is characterized by a large number of relatively small sized, older plants producing a wide variety of products and a few newer, larger and more efficient units. The former are able to produce intermediates capable of competing with imports with moderate tariff protection, due to low prices of domestic basic feedstocks and to low capital charges on plant which is all but virtually depreciated. Future growth of the industry will require some rationalization and modernization of these plants and better utilization of the upstream products from the newer facilities. The major expansion effort now under implementation is the Bahia Blanca ethane-ethylene complex producing major intermediates with plant sizes generally offering low cost production possibilities; implementation of plants within this complex is being shared  - viii - by the public and private sectors. Principal long-term issues facing the Government, which has already established overall moderate tariff levels, are the gradual adjustment of feedstock prices within the overall objectives to raise hydrocarbon prices to international price levels (to reflect opportunity costs) and procedures for implementing the policy to increase the share of the private sector in the mixed ventures. However, given the urgent need at the present time to reduce inflationary pressures and expectations, upward adjust- ments in feedstock prices could be postponed. xxii. With regard to fettilizers, efforts are now being made to stimulate more intensive use of these materials by agriculture whose consumption at present is extremely low. Expansion of local production of nitrogenous fertilizer would depend upon demand growth; while there has been an upward trend in use, wide annual fluctuations in recent years make uncertain the nature of future demand growth; in the longer run, however, availability of natural gas provides a favorable production technique with low investment and production costs. xxiii. Pulp and paper. This industry has been favored by special programs to stimulate local production including high protective tariffs; even though these have been reduced recently, they still remain among the highest prevail- ing for industry. Demand has risen sufficiently so that relatively economic size plants are possible for a wide range of products. The present industry is obsolete and output highly dispersed. Modernization and expansion programs are now underway in a number of paper plants, including some backward integra- tion, which will reduce costs. One of the largest new projects in the process of implementation is designed to supply long-fibered chemical pulp, most of which is now imported; current estimates indicate that the plant will produce at internationally competitive prices. A long term policy aimed at reducing the current level of tariff protection should be prepared. xxiv. As regards newsprint, two projects for semi-integrated mills now in the process of implementation appear adequate to meet future demand. In the past, exchange rate/tariff policies had favored relatively high consumption of imported newsprint but in more recent years, revisions in these policies have led to a sharp decline in demand. Further expansion of one of the projects should be postponed until long-term market trends can be more precisely ascertained. Emerging Pattern of Industrial Exports (Chapter V) xxv. The overall policies to stimulate international competitiveness have encouraged an external marketing effort by manufacturers of a wide group of products who had developed production skills satisfying a relatively sophis- ticated internal market. Stability in these policies is essential to maintain current trade flows and to stimulate additional investment for further devel- opment of this trade. Of particular importance is the growing technological content of exports of equipment and also of complete plants, incorporating indigenous technological adaptations which have been found appropriate for other LDCs. Additional measures are required to support this development in areas such as vocational training, research and development facilities and export credit and guarantee mechanisms.  CHAPTER I: MAIN CHARACTERISTICS OF THE INDUSTRIAL SECTOR A. Introduction 1.01 Argentina's current industrial sector, given the country's per capita income level of US$1.580 (1976) and moderate market size of 26 million inhabitants 1/, is a relatively sophisticated one. Its origins are to be found in the late 19th century when a remarkably low cost agricultural export sector led to high income levels. Although data on this matter are limited, general indications are that there was a reasonably good distribution of income. Thus, the growth of industrial activities was favored by a strong and growing local market which, because of its location at a considerable distance from the main world production centers, had a large degree of natural protection. 1.02 Manufacturing now represents the principal sector in the generation of gross domestic product, with its share exceeding 35%. Moreover, the sector's relative importance for the country 's economy appears to be greater than in many developed countries with considerably higher levels of per capita income. In many respects, Argentina's industrial structure is similar to that of the industrialized countries. It is highly diversified with a substantial proportion (exceeding 60%) originating outside of the traditional consumer-goods industries such as foods, textiles, clothing and furniture. 1.03 Nevertheless, the relatively high prices for many of Argentina's products, especially among the modern more dynamic branches, suggest that the value of industrial output on an internationally comparable basis is over- stated; in other words, at international price levels and at the existing exchange rate, the value of industrial output, in particular value added by the industrial sector, is considerably less than the value using domestic prices. While no calculations have been prepared for recent years, an analysis 2/ of Argentine GDP estimates for 1958 showed that if industrial output were revalued at international prices, the sector's actual contribution to total product would be reduced from 31.3% to 22.5%, a reduction of 39%. 1.04 Through the first half of the present century, industrial policies were largely passive, responding to external factors--the two World Wars and the Great Depression of the 1930s. Some attempts to protect local industry during the latter period, through tariffs and "Buy Argentine" legislation, were mainly designed for existing manufacturing activities rather than to channel new resources to the specific subsectors involved. 1.05 The major domestic effort at stimulating the sector began shortly after World War II and was characterized by policies providing substantial protection (both high tariffs and quantitative restrictions), large scale direct and indirect subsidies and an unrealistic exchange rate, as well as 1/ As noted in the subsequent chapters, for a number of intermediate products, whose output is subject to economies of scale, Argentina's natural market area would include its neighbors, Bolivia, Paraguay and Uruguay, as well as Chile and even the southern part of Brazil. 2/ See Little, Scitovsky and Scott, Industry and Trade in Some Developing Countries, (Oxford University Press, 1970), p. 75.  by direct investment by the state in productive enterprises. With only a brief period during the late-1960s when the authorities introduced efficiency criteria in their policies, the period from 1950 through early 1976 was marked by an approach favoring import substitution at virtually any cost, ignoring considerations of international comparative advantage. It is this set of policies that led to the creation of the existing high cost industry. 1.06 The development of an industrial sector, with few exceptions unable to compete in international markets, played a major role in the emergence of a foreign exchange constraint to general economic growth which characterized the 25-year period after 1950. In order to permit overall expansion, a growing level of imports was necessary and Argentina required new export lines, some of which should have been generated within the most dynamic sector--that of industry. But the high prices of most of those products relative to other producers prevented the sector from contributing sufficiently to an expanding export capacity. 1.07 Soon after taking power in March 1976, the present Government announced its intention to dismantle the web of measures which had for so long fostered inefficiency in the industrial sector and to open it up to international competition. Not only was it necessary to deal with the heri- tage of the inward-oriented policies of the previous 25 years, but it was also necessary to cope with the chaotic situation which had emerged from the often-contradictory monetary, fiscal and other macro-economic policies pursued in the previous two years. Thus, the authorities stressed the long-term objectives of achieving a more efficient allocation of resources through a more realistic exchange rate, positive real interest rates, a sharp reduc- tion in the high level of effective protection, a reduction in excessive incen- tives offered to new investment and providing guidelines to achieve efficient operational levels in government-owned enterprises. B. Growth rates and structure of the Industrial Sector 1.08 The main characteristics of industrial growth in Argentina since 1950 have been summarized in two recent Bank publications, Argentina: Reconstruction and Development, (Report No. 1645-AR, August 31, 1977) and, particularly, the "Staff Project Report for the Argentina Industrial Credit Proiect", (Report No. 1521b-AR, May 25, 1977). Manufacturing output rose 4.1% on an annual basis in the 1950s, 5.6% in the 1960s and 5.1% for 1970 to 1975. The peak in output was reached in 1974; since then, industrial production has been below that level (see Statistical Appendix Tables 1 and 3). Over the period since 1955, the averages conceal wide annual fluctuations which have ranged from +20% to -10% (see Chart I). These movements are closely related to the "stop-go" cycle of macro-economic policies followed through 1975 which in turn reflected the foreign exchange constraint on growth resulting from the basic inward-orientation of those policies. Growth rates in industrial activity exceeded 10% in six of the years between 1955 and 1977 and declined or was stagnant in six years. It is characteristic that in each of the five recession years prior to 1975, Argentina suffered not only from acute shortages of foreign exchange  - 3 - CHART I ARGENTINA FLUCTUATIONS IN INDUSTRIAL GROWTH 15 10 0 L L 3 C C -5 C o 1 -c-i 54 56 58 60 62 64 66 68 70 72 74 76 78 YEARS World Bank-19036  - 4 - but also from high inflation. The same strong cyclical fluctuations character- izing industrial output growth are also reflected in the data on overall domestic investment, investment in machinery and equipment and comparative profits of manufacturing enterprises. 1.09 The principal feature of the long-term growth trend has been the expan- sion of the so-called modern branches, the chemical, metal and engineering industries 1/ (see Statistical Appendix Tables 1 and 2). These subsectors more than doubled their output between 1950 and 1960 and further doubled output bet- ween 1960 and 1970, annual growth rates reaching an average of approximately 8%. During the present decade, the annual average growth rate (through 1977) has been over 4%. As a consequence of this expansion, from slightly less than 30% of value added in manufacturing in 1950, the share of these indus- tries rose to slightly over 60% in 1977. However, for the reasons noted above, and as examined in more detail in Chapter II, at international price levels it is likely that these shares would be somewhat smaller. 2/ Index (1960-100) Share of Modern Modern Industries Total Industries in Total 1950 43 67 29.8 1960 100 100 46.9 1970 205 135 55.6 1977 280 216 60.8 Source: Statistical Appendix Tables 1 and 2. 1.10 There are other characteristics of industry which also raise ques- tions as to the real share of that sector in the total product. International comparisons of data on physical per capita consumption for a number of important intermediate goods indicate that Argentina's level of consumption in most cases is below what one would expect given its income level, stage of development and relative share of industry in gross product (see Statistical Appendix Table 22). 1/ ISIC two-digit sub-sectors 35, 37 and 38. 2/ Argentina is currently the only country in Latin America in which value added by these three dynamic branches is larger than the value added by the traditional industries as measured in national accounts. It is likely that there is similar overstatement of value added by the modern industries in countries such as Brazil and Mexico.  - 5 - 1.11 The situation is most striking in the case of the petrochemicals including plastics and synthetic fibers. A recent Bank study, relating per capita income to consumption of five major plastics in 1974-76, suggests that the theoretical "normal" level in Argentina was 50% higher than that actually achieved in the period. Direct comparisons with a sample of semi-industrialized countries show Argentina's consumption generally below that of countries with comparable or even lower income levels. 1/ 1.12 In the case of steel, the situation is somewhat more complex. Argentina's per capita consumption is about equal to that of certain countries with similar income levels (Greece and Portugal) but below that of others with the same income (Yugoslavia) or less income (South Africa). On the other hand, its per capita steel consumption exceeds that of Brazil and Korea with lower income levels. 2/ 1.13 It is significant that a major exception to this generalization is newsprint where, due to its high literacy rate, Argentina's consumption exceeds by a substantial amount that obtaining in the other semi-industrialized countries. Virtually all of its supply is currently imported and the combina- tion of exchange rate-import tariff policies followed until recent years tended to encourage consumption of this particular item. 3/ Exports of Manufactures 1.14 In the early 1960s the sensitivity of the economy to balance of pay- ments crises began to be more widely recognized and officials began to seek policies to encourage export expansion. In 1962, first steps were taken to provide incentives to non-traditional exports; these and subsequent measures which have been adopted to stimulate export development are discussed in detail in Chapter II. Of considerable importance is the increasing contri- bution of industrial exports to growth of total exports, a trend which began in the mid-1960s. In 1965, industrial products amounted to 25% of total exports but by the mid-1970s the share had risen to almost one-half; although agro-based manufactures are the main component of this trade, the share of the non-agro based manufactures has also risen (see Statistical Appendix Table 8). 1.15 The emergence of a substantial volume of exports from Argentine industry could be expected on the basis of historical experiences of other countries. In 1963, exports represented no more than 2% of industrial output at a time when the sector contributed about one-third of G.D.P. By 1973, exports had risen to some 9% of manufacturing output (based on census data), 1/ This is discussed in more detail in Chapter IV. 2/ See also Annex II, Chapter III; Argentina's per capita steel consumption is described as of low intensity by international comparisons. 3/ See also Chapter IV.  - 6 - although if one excludes processed meat the figure would be 6% (see Statistical Appendix Table 7); preliminary estimates for 1977 indicate an export/output ratio exceeding 10%. 1.16 Since the beginning of the present decade, the dollar value of exports of manufactured products has increased by a factor of almost five, representing more than a doubling in volume. In 1977 record levels in both the volume and value of these exports were achieved 1/, surpassing the previous peak reached in 1974 when domestic price controls in the face of internal inflation encouraged producers to maximize export sales. Although the exchange rate adjustments in that year did not compensate for the internal peso infla- tion relative to world prices, there were substantial increases in fiscal and financial incentives so that the effective exchange rate was maintained. (See Chapter II.) 1.17 Exports of manufactures declined in 1975, due to disruption in production as a result of political unrest, as well as to less favorable world demand conditions. In 1976, there was a recovery in trade in these products, reflecting some improvement in external market conditions and the introduction (after March) of more appropriate domestic economic policies. The trade expansion experienced in 1977 encompassed a wide variety of products in spite of some recovery in domestic demand which began to develop in the middle of that year. Detailed consideration of the major export categories and an examination of future growth prospects are contained in Chapter V. 1.18 Of particular significance in the emergence of Argentine industrial exports is the role of transport costs. As noted earlier, an important element in the initial stages of industrial growth was the distance between Argentina and the leading industrialized countries with these transport costs representing a natural protection for many domestically manufactured goods. These transport costs continue to play an important role in determining the viability of many industrial activities in Argentina, particularly for inter- mediate goods which are generally low value in relation to volume even though they lend themselves to bulk handling techniques. 1.19 As regards Argentine exports, transport costs require that goods destined for sale in the principal world markets be produced at sufficiently low costs so that they can absorb the additional transport charges; such is clearly the case with the traditional agricultural exports. But transport costs are now providing Argentina with a natural market in the neighboring countries for a wide variety of manufactured goods. The growth in trade with Uruguay, Paraguay and Bolivia, as well as Brazil, cannot be completely explained by the LAFTA concessions. C. Natural resource base 1.20 The country is endowed with soil and climate conditions providing the basis for a low cost productive agricultural sector which provides a number of important inputs to industry. Traditionally, these have included meat and dairy products and a number of non-food items (e.g. wool and quebracho). In 1/ Preliminary data for 1978 indicate further increases in the total value of these exports.  recent years, however, there has been considerable diversification of agricul- ture, reflecting inter alia land development programs, improved price rela- tionships for agricultural products and general income growth. This has led to the emergence of several major new production lines such as processed foods and vegetables and soybean processing. 1.21 Known availability and actual exploitation of metallic resources is less favorable. At the present time, small quantities of non-ferrous metals (such as copper, zinc and lead), silver and gold are being mined but the bulk of the country's industrial requirements for these products is met through imports. However, there are proposals to develop copper deposits on the eastern slopes of the Andes in the north of the country. 1.22 As regards ferrous materials, a relatively rich iron ore source is now being developed in the southern part of the country (some 1,200 kms. from Buenos Aires) to produce pellets for further reduction. By international standards, however, this is a small project, with capacity of 2 million tons of pellets (69% Fe content), and would meet about one-fourth of the country's current needs for ferrous materials. Historically, the first steel production in the country was based on a small iron ore mine located in the north, using charcoal for reduction. 1.23 Although there are extensive coal deposits in the extreme southern area of the country, these are largely low-grade with limited coking possibili- ties (for use in traditional iron reduction processes). At the same time, the remoteness of the deposits also limits their use for energy purposes. 1.24 Domestic crude petroleum and natural gas deposits, although primarily used for energy, have provided the basis for establishing a petrochemical industry which is now undergoing a major expansion. Natural gas is also being used in the new direct reduction processes for steel making. These hydro- carbons have been found in number of zones in the country and now provide about 85% of petroleum and 80% of natural gas requirements 1/. After experiencing some decline due to political and economic crises in the last few years, exploration to determine new hydrocarbon resources in the land areas as well as offshore are expected to increase in the immediate future. 1.25 Finally, forestry and fishing also provide important resources for industrial activities. It is estimated that natural forests cover some 60 to 70 million hectares of land (approximately 20-25% of the total land area) of which some two-thirds are considered suitable for wood extraction. How- ever, these natural forests present major problems in economic use due to factors such as heterogeneity and irregularity of species and thus are largely 1/ The balance of the natural gas supplies are obtained from Bolivia whose gas fields are so located that Argentina can be considered as the natural market for this item.  - 8 - unutilized; a small portion is being used to provide lumber for construction and related wood products. Recently, attention has been given to the develop- ment of man-made plantations with some 500,000 hectares currently yielding about half of the materials destined for industrial (especially for pulp) and other use. Additional planting programs are now under consideration, devoted to producing long-fibered species which are in short supply in the country and are needed for chemical pulps. 1.26 As regards fishing resources, the current domestic catch of 250-300 thousand tons per annum is only a fraction of the potential given the richness of the ocean coastal and adjacent waters; no estimate is available of the catch obtained by foreign fleets fishing in these areas. There is now considerable interest in extensive development of this potential and exports of fish and shellfish products have rapidly expanded in recent years. 1/ D. Human resources and industrial employment 1.27 Argentina has the highest rate of literacy in the Latin American region, comparable to that achieved in the more developed countries. The educational infrastructure is relatively advanced with an extensive secondary and vocational system as well as university system. 2/ The quality of the potential industrial labor force is considered excellent; a number of multi- national corporations which have chosen to locate production facilities in the country, to serve not only the local market but regional and third country markets as well, cite as one of the principal reasons for that decision the existing availability of skills or the adaptability of the labor force to absorb new skills. 1.28 The industrial sector has, however, offered only limited new oppor- tunities for employment in the last thirty years (see Statistical Appendix Table 6). This has been basically a result of the same factors which have pre- vented rapid employment increases in other countries involved in import substi- tution policies for a long time. First, the new industries and technologies introduced were relatively capital intensive. Secondly, the Government induced an even wider use of capital by subsidizing interest rates and overvaluing the foreign exchange rate for capital goods. Thirdly, labor legislation with its inflexible rules and substantial fringe benefits did not encourage labor intensive production. 1/ A National Fisheries Development Plan is now in the initial stages of implementation; it is aimed at raising both domestic consumption and exports, with a target of a total catch of 1 million tons in 1980. 2/ This is not to imply that there is no room for improvement in the overall educational system. An OECD study in 1967 identified a number of problem areas which required attention.  - 9 - POST-WAR GROWTH OF INDUSTRIAL OUTPUT EMPLOYMENT AND INVESTMENT (average annual rates of growth) Period Ind. Output Employment Investment 1946-54 3.5 2.2 3.4 1955-61 5.2 1.7 2.1 1962-67 5.8 0.9 1.5 1968-75 6.0 3.2 5.1. Source: Mission estimates. 1.29 The rather slow absorption of labor into the industrial sector was particularly marked during the period from the late 1950s through the late 1960s when the bulk of the major investment programs promoted by the Govern- ment came on stream. As the above table shows, employment in manufacturing grew not only substantially less than manufacturing output but also slower than the capital stock, at least until 1967. 1.30 After 1968, however, there was an improvement in this situation reflecting the stability of macroeconomic policies between 1966 and 1969 and the gradual expansion of manufactured exports, many of which are relatively labor intensive. During the early 1970s, two "populist" measures became more important. Firstly, state enterprises experienced a substantial growth in their payrolls; public firms such as the petroleum company, the steel factory, the power and gas company, and other state enterprises hired over 160,000 employees between 1970 and 1975, an increase of 56% within four years. In addition, aggregate consumption expanded rapidly, partly due to liberal wage increases and partly due to the gains from the rapid increases in export prices. 1.31 Employment problems in Argentina are substantially different from that being experienced in most other semi-industrialized areas. The population growth rate in the country has been relatively low, under 2% per annum in the post-World War II period and averaging 1.4% per annum since 1960. While no data are available as to new entrants into the labor market, it is believed that the rate of growth has not been much in excess of the latter figure, even with the recent trend for more women to enter the industrial labor force. In mid-1977, with the growth in industrial employment and with other employment opportunities rising in such sectors as construction, the official estimate of the unemployment rate in major urban centers was less than 3%. 1.32 The increase in public enterprise employment is clearly inconsistent with the current government's intention to raise efficiency of these enterprises and to reduce their deficits. During the recession year 1976, the authorities decreased the excess labor force of government-owned enterprises by less than 4% and asked private firms to keep as many workers as possible on the payrolls. As a result of this policy, the level of unemployment remained low. With some  - 10 - recovery under way in 1977, labor released from the public sector found new job opportunities in industry and other services. In the third quarter many private sector firms reported that they were experiencing shortages of both skilled and unskilled workers. However, as interest rates continued to rise and economic activity began to decline, demand for labor fell. By the end of 1977 and early 1978 press reports indicated a substantial increase in factory closings and layoffs in plants which had had to reduce their output. In May 1978, the official data indicated a slight rise in unemployment, but by the end of that year the figure was again below 3%. 1.33 From the longer-term point of view, with the growth of industrial production in the years to come, particularly in the more labor and skill intensive mechanical and engineering subsectors, employment expansion should contribute to increasing the shift of employment from public services toward more directly productive activities. This should contribute to raise living standards for the whole population without causing an inflationary upsurge.  - 11 - CHAPTER II: FOREIGN TRADE POLICIES AND INDUSTRIALIZATION 2.01 In the past, Argentine foreign trade and investment policies have overwhelmingly been used to foster "inward" directed growth of industry with inadequate attention to considerations of economic efficiency and long- run balance of payments equilibrium. The "import substitution" strategy has been implemented through application of multiple exchange rates, import tariffs and import restrictions, as well as numerous fiscal and credit incen- tives. While the general pattern of trade policies is easily described and summarized, the actual effects of these policies on industrial development are difficult to measure. Output, employment, exports and imports and other macro-variables were subject to a great number of other policy measures, some. of which had very little economic rationale. 2.02 Management of fixed exchange rates in the post-war period turned out to be as problematic for Argentina as for those Latin American countries which experienced substantially higher rates of inflation than industrialized countries. Due to the structural disequilibrium between a low-cost export oriented agricultural sector and a high-cost domestically oriented industrial sector, several Argentine governments opted for multiple exchange rate systems; these were characterized by fixed nominal exchange rates which were adjusted sporadically by substantial jumps, combined with import tariffs and surcharges varying with perceived competition with local production on the one hand, and on the other, varying sets of fiscal and monetary incentives for non- traditional exports. 2.03 In this chapter the analysis concentrates first on policies to protect domestic output; an assessment is made of their impact on industrial structure in Argentina. Next, fiscal and credit incentives for exports are examined. Finally, current attempts to change foreign trade and investment policies are evaluated in the light of their possible impact on future indus- trial development and with it the development of the whole Argentine economy. A. Protection of Domestic Output 2.04 Protective tariffs have existed since 1875, but it has been only with the onset of the Great Depression that a "National Control Commission" raised tariffs to significant levels and established import controls and special exemptions. This system became more prohibitive in World War II and in the early postwar period with the introduction of prior import deposits and bilateral trading agreements. 2.05 Throughout the postwar period Argentina has continued to protect its industry in many different ways, ranging from high nominal tariffs to import prohibitions and exchange surcharges. Although some of these measures were designed to counteract against an overvalued exchange rate, they resulted in a very high level of indiscriminate protection. The anti-export bias led  - 12 - to recurrent balance-of-payments problems which in turn led to frequent import restrictions. They were numerous in the late 1950s and again in 1963/64 and 1974/75. In addition, the Central Bank imposed prior import deposits, further reducing imports during those crisis periods. 2.06 The following paragraphs consider the principal features of protec- tion from the early sixties to the present, emphasizing particularly the two major efforts at rationalizing the tariff system in 1967-69 and in 1976-77. In addition, the evaluation of the current policies and the analysis of effec- tive protection of a sample of industrial products in 1977 will lead to some policy recommendations as to prospects for streamlining these tariff systems and with it to improve the allocation of resources within the industrial sector and raise the efficiency of that sector within the Argentine economy. 2.07 Nominal tariffs were among the major tools of import protection during the early 1960s. The ad valorem duties ranged from 35-60% for most durable and nondurable consumer goods, but were substantially less for raw materials, intermediate goods, and particularly capital goods. Inadvertently, exchange surcharges became the most important means for protecting industry. These surcharges ranged from zero to 235%, according to perceived essentiality of the good in question. Low or zero surcharges were levied on such important inputs as iron ore, rubber, newsprint, fertilizer, coal and petroleum products. On the other hand, consumer goods such as nylon fabrics, light bulbs, TV sets, automobiles and whiskey were charged with rates of over 200%. Due to the overvaluation of the basic import rate this structure of surcharges increased the "effective" protection for many consumer goods even more than "nominal" protection. In addition, special protection was granted to such industries as steel and textiles through the introduction of "official" prices, on which duties were based. 2.08 Actual revenues from import duties were always substantially below the potential indicated by the high rates. Capital goods imports for those industries which the Government wanted to encourage were exempt. In addition, imports from LAFTA countries received preferential treatment, especially if the products were on the "Argentine National List". Finally, government agencies and enterprises were allowed to import duty free, leading to actual tariff collection rates which were often less than 50% of the officially declared tariffs and surcharges. 2.09 In 1964 a tariff commission, consisting of government officials and industry representatives, was appointed to convert the tariff nomenclature to modified Brussels Code and to propose a set of unified rates. With Law 16,690/1965 the Argentine Congress gave the executive the power to make rate adjustments as deemed necessary. It was not until 1967 that a general tariff reform attempted to rationalize the whole protection system according to the extent of import competition, degree of fabrication, and economic end-use. By reducing the extremely high tariffs for certain products, the average legal tariff level was reduced from 119% to 62%; at the same time however, the peso was devalued by 42%. In general, tariffs continued to be set higher for consumer than for industrial inputs or investment goods, and  - 13 - also higher for closer foreign substitutes. This meant that escalation was built into the tariff system which led to substantially higher rates of "effective" than "nominal" protection. Table 1 shows the above-mentioned characteristics very clearly, with highest nominal rates being levied in the manufactured products with high value added, i.e. a higher degree of fabrication. Table 1: NOMINAL & EFFECTIVE PROTECTION, 1969 Nominal Effective Protection Industry Protection Balassa Corden Processed Food 6.8 44.0 34.9 Beverage and Tobacco 50.8 94.5 76.9 Construction Materials 29.1 31.4 26.5 Intermediate Products I 55.9 146.0 109.0 Intermediate Products II 69.3 99.3 96.4 Nondurable Consumer Goods 57.4 49.8 43.5 Durable Consumer Goods 88.7 144.5 112.5 Machinery 89.7 120.3 108.4 Transport Equipment 108.7 207.0 148.3 Manufactured Total 57.1 111.0 89.3 Source: J. Berlinski & D. Schydlowsky, Incentives for Industrialization in Argentina, mimeo, Washington 1976. "Effective" rates were one-and-a-half to two times above the nominal rates, reflecting the fact that imported inputs of raw materials and intermediate inputs were either freed from import duties or were taxed at low rates. 2.10 Most of the other non-tariff barriers were maintained. In 1969, around 3,800 BTN positions were subject to prior import deposits of 40% of the import CIF value for a period of six months. This was estimated to add 3.6% to the CIF value of the imported good. In addition, the official price list remained intact and imports of automobiles and tractors were prohibited. On the other hand, the special preferences for LAFTA imports, as well as the permission for the public enterprises to import duty free or at very low rates, continued. The spread between the actually paid duty rates and the official rates remained close to 50%. 2.11 The tariff reform in 1967 made a start in rationalizing the protec- tive system of Argentine industry but the attempt was reversed by increasingly restrictive foreign trade policies in subsequent years. Tariff rates for most durable consumer goods and those capital goods produced in the country were  - 14 - set at levels of over 100% in the early 1970s. In addition, the authorities designed an increasing number of import controls, import finance restrictions and other disincentives. These impediments included requirements for sworn declarations of firms to the effect that imports were necessary for their production and for advanced foreign financing of 3 months for intermediate goods and up to at least one year for capital goods. Threatened with the balance of payments crisis in 1974, imports of 600 items, mostly consumer goods, were prohibited. Another 1,200 items were added to the prohibited list in 1975; these included a wide range of capital equipment and all used machinery. Importers were furthermore required to deposit a sum equal to 40% of the C.I.F. value at the Central Bank; these prior deposits were raised to 100% at the beginning of 1975. As a consequence, the autarchic character of Argentina's industry became more pronounced than ever. Its industrial import- output ratio of 8% was far below comparable rates for any other "middle-income" country. 2.12 The overall effects of these restrictions on major macroeconomic variables are difficult to ascertain, since substantial increases in export incentives enabled Argentine industry to sell increasing shares of its output abroad. In addition, most of the domestic policies interfered even more with the allocation of resources in Argentine industry. There were first wide ranging price controls for industrial products which discouraged production for the local market. At the same time real wages were raised substantially above increases in productivity, leading to a rapid increase in consumer demand. Finally, there was an increasing direct intervention of the state, which took over financially weakened private enterprises, and a rapid expan- sion of activities in the state-owned enterprises. At the beginning these policies affected industrial growth, exports, and employment positively. Between 1969 and 1973 Argentina enjoyed relatively rapid economic growth which peaked in 1974. However, distortions accumulated, with supply shrinking rapidly and excess demand going into monetary expansion. In 1975 inflation accelerated and a very pronounced recession started in the last quarter of that year, which continued in 1976. 2.13 When the new Government came into power, the basic aim was to free the economy from numerous restrictions. Steps were taken to unify the exchange rate, and imports of most items covered by the 1972 and 1975 prohibited lists were freed in July 1976; the only exceptions were automobiles, motors and tractors. Quantitative restrictions on imports were also reduced in 1976 and were abandoned in 1977. Foreign import financing requirements were modified and the advance import deposit requirement was abolished in 1977. Once these restrictions were diminished it became possible to start with a serious examination of the high tariffs. The first stage of a tariff reform was carried out in November 1976. Tariff rates for 4,000 of 7,600 positions in the tariff schedule were reduced by an average of 25%. Maximum duties for such items as alcoholic beverages and clothing were slashed from 200% to 100%. Reductions for imported inputs were smaller than for final products, which was designed to decrease "effective" protection more rapidly than "nominal" protection. Since the first priority in reducing tariffs was to improve the allocation of scarce resources, the major aim was indeed to reduce potential "effective protection" of Argentine industry.  - 15 - Table 2 AVERAGE 1967, 1976 AND 1979 TARIFF RATES FOR INDUSTRIAL PRODUCTS Degree of Elaboration Low Intermediate High Classes Classes Classes (1-3) (4-5) (6-8) (9-10) Type of Good Consumer Goods 1967 110 120 130 140 and above 1976 80 85 95 100 1979 50 60 75 85 Intermediate Goods 1967 50 75 100 125 1976 37 55 70 90 1979 29 44 46 48 Capital Goods 1967 50 70 83 95 1976 37 50 62 68 1979 .. 46 48 50 Source: Ministry of Economy, Secretariat of Foreign Commerce. 2.14 In 1977, further tariff reductions were prompted by the Government's desire to control inflation more effectively. It appeared that, in order to recover quickly from several years of price control, a large number of manu- facturers raised their prices more often and at higher rates than was justified by cost considerations. Consequently, the Government imposed a so-called "price truce" in March. Since these price controls were, however, designed to last for only 4 to 6 months, the Secretariat of Commerce initiated a number of discussions with individual industry groups and used reductions in import tariffs as a tool to enforce relative price stability. At the end of December 1977 import tariffs for manufactured goods 1/ were brought down from an average of 94% to 53% (see Statistical Appendix Table 14). These reductions decreased the wide spread between high and low rates. As a consequence, the standard deviation from the December 1977 average was almost half the level prevailing in October 1976. 2.15 The "legal" rates of protection cannot provide information on the amount of protection actually used by the domestic manufacturer. It is, therefore, more useful to compare directly the landed value of imported goods 1/ On the other hand, there still remained a number of additional taxes which increased the rate of "natural" protection given by shipping and insurance costs as well as port fees. They consist of a statistical and a consular tax, as well as a tax on shipping costs, which amount in total to between 12% and 15% of the c.i.f. value of imported goods.  - 16 - with the price of domestically produced goods. This comparison was undertaken in 1977 by the Central Bank of Argentina on behalf of the Ministry of Economy. 1/ The sample consisted of a selection of 40 5-digit ISIC industrial branches, which represented the crucial subsectors of Argentine industry. A summary of the results is given in Table 3. Several facts become immediately apparent. Firstly, average nominal protection and effective protection were just under 40%, a rate considerably below the legal rates, which averaged over 50% in mid-1977. Secondly, although effective protection tended to be higher than nominal protection, there was a high and significant correlation between nominal and effective protection for all products. Finally, the degree of protection varied widely among the product groups and bore little relation to overall industrial policy objectives. 2.16 The dispersion among effective protection rates ranged from a negative 15% for chemicals to over 130% for clothing. What is surprising is the fact that there were substantial differences even within certain subgroups. Within the "machinery" sector for example, agricultural equipment and tractors had a negative effective protection between 27 and 35%, whereas communications equipment, scientific apparatus, and calculators showed effective protection rates of 73, 92 and 140% respectively. In the case of nondurable consumer goods, shirts enjoyed an excess of their value added over foreign competition which reached 130%. At the same time socks were subject to negative effective protection, mainly because they had to buy the highly priced domestically produced synthetic material. In the group of intermediate products several examples presented similar differences such as paints and varnishes on the one hand, showing negative effective rates, and synthetic fibers and pesticides on the other hand, which enjoyed effective rates of protection of over 100%. 2.17 These findings led directly to several policy recommendations. Firstly, the comparison between the "imputed" nominal tariff and the "legal" rates indicated that, in spite of continuous tariff reduction, there still seemed to be some "water" in the tariff. Secondly, since the basic weakness of import protection in Argentina was not only the general height but the disper- sion of tariffs, a major aim of a continuous tariff reform was to decrease the existing differences. 2/ Finally, since nominal and effective rates were closely related, it was relatively easy to change towards a more rational tariff system by changing nominal rates, i.e. the administrative problems did not present the usual obstacle to a rational tariff reform. 2.18 In 1978, the Minister of Economy established a Tariff Reform Commission consisting of the Secretary of Coordination and Planning, thle Secretary of Foreign and Domestic Commerce, the Secretary of Industry, the Secretary of Finance, and the President of the Central Bank. The Commission's 1/ The team of researchers was led by J. Berlinski, who was also responsible for the 1969 study of effective protection in Argentina. 2/ The equality of tariff rates assumes that Argentina has a relatively mature industrial structure with few "infant" industries left in the 1970s.  - 17 - Table 3: NOMINAL AND EFFECTIVE RATES OF PROTECTION 1977 (Sample of 40 5-digit ISIC Industries) Effective Average Nominal Protection Legal ISIC INDUSTRY Protection -(Balassa) Rates a/ 321 Textiles 41.1 85.3 57 322 Clothing 79.2 131.6 95 341 Paper & Paper Products 30.8 74.9 29 351 Chemical Substances 36.6 60.0 35 352 Other Chemicals 0.0 -14.8 17 355 Rubber Products 29.6 29.3 45 362 Glass 12.3 14.6 42 369 Cement 0.0 -1.9 11 371 Iron & Steel 60.7 84.5 48 372 Non-Ferrous Metals 47.0 88.0 45 381 Metal Products 10.1 -11.5 46 382 Non-Electrical Machinery 19.7 -4.7 66 383 Electrical Machinery 55.7 77.6 61 384 Transport Material 29.7 3.5 87 385 Scientific & Professional Equipment 73.3 92.6 50 AVERAGE 37.1 39.1 53 Source: J. Berlinski, La Proteccion Efectiva de actividades Seleccionadas de la Industria Manufacturera - Argentina, Buenos Aires 1977. a/ Since the legal rates differ substantially within each 3-digit ISIC group, these averages should be considered approximations; the data were prepared by J. Noguez of the Central Bank in December 1977.  - 18 - recommendations were issued in January 1979 and were included in Resolutions 1633 and 1634 which introduce gradual decreases in external tariffs between 1979 and 1984 (see Statistical Appendix Table 26). On average, legal protec- tion will fall from about 50% in early 1979 to 25% by January 1984. Quarterly reductions are of the order of one percentage point during the first 12 to 18 months, accelerating to two percentage points for most commodity groups in 1982-83. The dispersion of legal tariffs is planned to be reduced from the current level of 75% to 40% by the beginning of 1984. 2.19 Although the implementation of a continuous tariff reform was simplified by the high degree of similarity between nominal and effective rates (i.e. a 10% reduction in the nominal tariff rate should lead to about a 10% reduction in effective protection), additional study has to be under- taken to make the transformation of Argentine industry through foreign trade policy successful. It will be necessary to fully investigate: (a) the remaining "non-tariff" barriers; this would include statistical and consular taxes and other import fees, as well as the licensing system which plays a dominant role in the case of steel imports; (b) the effectiveness of the recently enacted anti-dumping legislation; (c) the importance of the list of "official" prices, their relation to actual world market prices and their relevance for the implementation of the "anti-dumping" legislation; and (d) the current and future role of the special agreements under the Latin American Free Trade Association (LAFTA). A second set of issues, which will directly result from the implementation of the lowering of import protection, but which cannot be solved by the appli- cation of foreign trade policies alone, are the problems of transition, the most important one of which will be the impact the structural transformation of industry will have on concentration of production. 2.20 Table 4 ranks 40 industries according to their nominal tariff rates and compares the relative degree of protection with the relative degree of concentration in each industry's market. 1/ There is a clear indication that higher effective protection is positively associated with higher degrees of concentration, as the rank correlation coefficient of 0.897 suggests. If this is the case, then a decrease in tariffs should simultaneously attack concentration of market power. It is, however, noteworthy that the predominant number of industries with nominal and, even more so, with effective tariff 1/ The data listed in Table 4 are taken from the 1963 Industrial Census, since the information on the 1974 Census has not yet been made available. The degree of concentration has probably increased since then.  - 19 - Table 4: PROTECTION AND DEGREE OF CONCENTRATION IN ARGENTINA Degree of Concentration Protection Market Share 1/ Nominal Effective of largest 8 Group Classification- Office Machinery 121 144 87 2 Motorcycles and Bicycles 109 428 55 2 Synthetic & Artif. Fiber 89 221 95 1 Shirts 79 132 16 4 Scientific Equipment 73 93 55 2 Radio and TV 71 114 38 3 Communications Equipment 70 73 Pesticides 68 160 56 2 Elevators 65 77 63 2 Lamps and Tubes 64 95 74 1 Iron and Steel 61 85 70 2 Batteries 54 104 51 2 Electric Conductors 47 96 86 2 Non-ferrous Metals 47 88 91 1 Textile Yarn 45 118 53 2 Textile Cloth 41 85 53 2 Synthetic Resins 40 67 65 1 N.E, Machinery 37 26 33 3 Electric Machinery 35 29 32 3 Paper 34 83 60 2 Auto Engines 34 10 89 2 Engines and Turbines 33 17 32 3 Rubber Tires 30 29 97 1 Railway Equipment 30 16 75 2 Metal Containers 26 4 52 2 Metal and Woodworking Machinery 25 10 11 4 Chemical Substances 24 37 49 3 Ovens and Heaters 13 -3 47 3 Socks 12 -11 40 3 Glass and Crystals 12 14 60 2 Fertilizers 9 6 Agricultural Machinery c -27 25 3 Tractors 3 -35 91 2 Refrigerators/AC 1 -35 53 2 Cement 0 -2 90 1 Compressed and Liquid Gas 0 -5 56 2 Paints, Varnish 0 -15 51 2 Pulp 0 -17 49 3 Cans 0 -25 41 3 Tanning Materials -21 -30 39 3 Source? J. Berlinski, "La Proteccion Efectiva de Actividades Seleccionadas de Industria Manufacturera Argentina", and Ministerio de Economia, Secretaria de Planeamiento y Accion ole Gobierno, El Desarrollo Industria en la Argentina: Substitucion de Importaciones, Concentracion Economica y Capital Extranger (1950 - 1970 Buenos Aires, 1973. 1/ Class 1: Largest 8 companies sell over 50% in an industry with less than 40 firms. Class 2: Largest 11 companies sell over 50% in an industry with more than 40 firms. Class 3: Largest 11 companies sell between 25% and 49.9%. Class 4: Largest 11 companies sell less than 25% of total sales.  - 20 - rates above the average of 37% and 39% respectively can be classifed under the concentration degree 2, i.e., they belong to those industries in which a small number of large firms, accounting for over 50% of a market, exist together with a large number of small firms. 1/ This would suggest that significant tariff reductions may threaten the survival of a substantial number of small firms and lead to an industrial structure which may become more rather than less concentrated. Consequently, it will become necessary to examine carefully the current legal and institutional possibilities of mergers. Although some inefficient firms in those highly protected industries may well be large, it would seem probable that increased competition from abroad will mainly affect smaller units. On average, it would seem that the gains in efficiency are well above the possible losses from concentration of market power. Argentine industry has been characterized as being heedlessly fragmented, caused by an industrial promotion policy which had been guided by a system in which, within a framework of almost prohibitive import protection plus subsidies, generous entry was permitted to producers. 2/ 2.21 One case in point is the automotive industry which has particularly suffered from the inability to take advantage of scale economies. Major quantitative import restrictions have been imposed in both the automobile and suppliers' industries for over 15 years since it was feared that the elimination of these controls would lead to serious repercussions on output and employment not only within the specific branches involved, but also in the whole manufacturing sector. In November 1976, a mixed public and private commission began studying the possibility of consolidating and restructuring the automobile sector. It is understood that ten firms cannot survive in a market which has absorbed about 250,000 cars annually during years of rela- tively high growth and prosperity. 3/ A new law was issued at the beginning of 1979. It lifts the ban on imports of automobiles, tractors, other transport vehicles and most of their parts, such as engines and electrical equipment, and imposes a temporary import tax until 1982 to give the industry some time to adjust and consolidate. Foreign automobile companies, which were forbidden to produce automobile parts under the previous law (July 21, 1971), are expected either to import or to participate in local production, if they produce and sell at similar prices as their parent companies abroad, and if they export one-third of their output. These exports should be three times the value of the imported inputs which cannot exceed 50% of total automobile parts used in production. 1/ Whereas 60% of the firms with above average protection fall into group 2 and 27% into group 1, for those industries with relatively less protection, 45% fall into group 3 and 41% into group 2. 2/ See David Felix, "The Dilemma of Import Substitution in Argentina"1 in G. Papaneck Development Policy - Theory and Practice, Harvard University Press, 1968. 3/ During the recession year 1976, the Government granted special tax and foreign exchange incentives and likewise decreased steel prices to lower input costs for automobile exports.  - 21 - B. Export Incentives 2.22 During World War II Argentina became a rather important exporter of industrial products. Once world trade began to recover, however, most Argentine industrialists found it more profitable to produce exclusively for the domestic market, which was highly protected from foreign competition. By the early 1960s it was recognized that a pure import substitution policy was insufficient to maintain high and stable rates of industrial growth. Consequently, successive governments have implemented an increasing number of incentives, which were applied to all non-traditional exports, at the same time when traditional products were discouraged by the simultaneous applica- tion of overvalued exchange rates and export retentions. Major measures under- taken included a "draw-back" rebate, exemptions from indirect taxes, reduc- tions of income taxes, global tax reimbursements and credit at preferential interest rates. In 1960, Decree 3.606 exempted all non-traditional exports from sales and excise taxes. This was followed by Decree 8.051 of 1962 which provided the legal framework for the "draw-back" mechanism, a reimbursement of all duties and surcharges paid on imported raw materials which were to be incorporated in the final exported product. Once an exporter had successfully applied for refunds for tariffs paid on a specific input, a classification system standardized the percentage of restitutions to which exports of a certain product were entitled, irrespective of whether or not the product actually incorporated imported materials. During the same year the Central Bank facilitated the financing of non-traditional exports by discounting drafts in foreign currency for a period of five years for capital goods and twelve to eighteen months for other non-traditional exports. There was also some pre- financing available which could be claimed for up to 60% of the export value, to be obtained at 8% interest from the major government banks. 2.23 New significant measures for industrial export promotion were implemented after 1967. As part of the major overhaul of exchange rate, trade and industrial policies in that year, the authorities simplified the exchange rate system, instituted global tax reimbursement of 12% of export value as an alternative to "draw-backs", and negotiated new preference agreements with LAFTA partners in 1967/68. These measures were further bolstered by increased export credit facilities of the Central Bank and by the establishment of an export credit insurance scheme fashioned after similar systems prevailing in industrialized countries. With subsequent increasing overvaluation of the peso, measures were taken during 1970-1974 to raise the tax reimbursements and a range of 10% to 40% was established. In the case of export financing, the system was considerably expanded and three lines of credit were made avail- able. In addition to the pre-financing and actual export credits, a facility was established to offer post-export financing, which was given to exporters for up to 50% of past F.O.B. export values for a period of 180 days at rates slightly above the pre-financing rate of interest. As a consequence, between 1970 and 1974 fiscal subsidies rose nearly three times while export credit more than quadrupled in real terms. After a rather drastic decline in 1975 as exports fell due to the world recession and internal political problems, both incentives recuperated in 1976, returning close to the 1974 levels. As can be seen from Table 5, the global tax reimbursement became the most impor- tant fiscal incentive.  - 22 - Table 5: FISCAL AND MONETARY INCENTIVES FOR MANUFACTURED EXPORTS, 1970-1976 1970 1974 1975 1976 (in mill. 1974 pesos) INSTRUMENTS Fiscal Incentives Drawback 320 170 30 5 Refunds 390 40 0 0 Reimbursements 0 2,020 780 2,123 Exemption from Income Tax 280 620 300 73 Total 990 2,850 1,110 2,201 Credit Incentives /a Pre-financing 20 2,230 1,680 ... Financing 350 1,930 2,390 Post-Financing 770 2,070 1,600 ... Total 1.140 6,230 5670 5,189 /a Volume of credit outstanding at the end of the period. Source: Central Bank and Ministry of Economy, Secretariat of Finance. 2.24 With the formulation of new tariff and exchange rate policies in 1976/77, it also became necessary to examine monetary and fiscal export incen- tives. In the case of the global tax re-imbursement, the need to lower the fiscal deficit made it desirable to decrease these incentives substantially. While most capital goods exports now receive a 25% instead of 35% rebate, other industrial exports' incentives have been cut from 20 and 15% to 10 and 5%. 1/ These are, however, under continuous review and at the beginning of 1978 a number of rates which had been previously reduced were raised slightly. 2.25 Facing considerable expansion of money supply, which was partly caused by rapid increases in exports during the second quarter of 1977, the Central Bank decided to abolish the post-financing facility and to increase interest rates on pre-financing credits. Beginning January 1978 pre-financing loans were granted in dollars with nominal interest rates of 1% per year. As these funds are to be used for the production of export goods, the exchange risk is minimized. Since future exchange rates have been announced (see below), 1/ While most rebate rates have been reduced since 1976, a 40% reimbursement rate is still granted to "turn-key" plant exports. For a discussion of these exports, see Chapter V.  - 23 - the incentive can be estimated as the difference between the international rate of interest charged to industrial exporters of LDCs in general (e.g. Eurodollar financing) and the nominal rate charged to Argentine industrial exporters by the Central Bank. Evaluation of Export Incentives 2.26 The first full evaluation of the overall incentive system of Argentine industry in 1969 came to the conclusion that, in spite of the steps which had been taken in 1967, protection continued at high levels and was widely dis- persed; moreover, there was a definite anti-export bias in the system, which was particularly strong for primary products but also existed for most manufac- tured goods. 1/ An earlier study had found that regressions between the "real effective exchange rate", (i.e. the nominal exchange rate adjusted for all incentives) and manufactured exports between 1956 and 1968 were insignificant. In contrast, underutilized capacity due to recurrent domestic recessions and special concessions made within the LAFTA market were found to be important determinants of manufactured export growth. 2/ 2.27 The anti-export bias was considerably lowered in the following years when the Government introduced stronger incentives to overcome high protection and orientation towards the domestic market, as well as the overvalued exchange rate. In 1973, a World Bank mission estimated the following relationship between export incentives, export prices, and domestic prices: As % of domestic As % of export prices prices Domestic price 100.0 143.9 Sales tax exemption 8.1 11.7 Reimbursement and rebates 14.6 21.1 Income tax exemptions 7.7 11.1 Total fiscal incentives 30.5 43.9 Export price 69.5 100.0 By calculating the value of each type of incentive for 20 product groups, it was estimated that, in order for profits from export and domestic sales to be the same, the average export price in pesos could have been as low as 70% of the domestic price. Comparing the hypothetical data with a survey of 32 export products, it was found that export prices for these goods averaged 77% of domestic prices. Between 1973 and 1974, external inflation probably resulted I/ J. Berlinski and D.M. Schydlowsky, Argentina, Development Strategy in Semi-Industrial Countries (to be published by John Hopkins' Press). 2/ D. Felix, op. cit., pp. 298-305.  - 24 - in increases in export prices, leading to a narrowing of the difference between these prices and domestic prices which were subject to controls, and making exports relatively more attractive. 2.28 In order to estimate the price effects of the different export incen- tives in 1977, the implicit rates of nominal protection, which are by defini- tion the ratio of the domestic over the international prices, were compared with fiscal and credit incentives expressed as percentages of export value (see Table 6). On average,manufacturers' fiscal export incentives (i.e., reimbursements plus tax credits and exemptions) amounted to 60% of the nominal protection provided to the Argentine producer. This difference is, however, heavily influenced by the low incentives provided for intermediate goods. 1/ For the more important capital goods exports, the fiscal incentives sqrpassed the rates of nominal protection. Table 6: PRICE EFFECTS OF IMPORT PROTECTION AND EXPORT INCENTIVES, 1977 (in % of international prices - Argentina border) Export Incentives Tax Credits Nominal and Credit Protection Total Reimbursement Exemptions- Incentives- Non-Durable Consumer Goods 45.6 35.0 19.0 9.6 6.4 Durable Consumer Goods 29.1 33.9 16.7 8.8 8.6 Intermediate Goods 41.0 11.8 1.6 3.8 6.4 Machinery 26.3 50.4 22.6 10.8 17.0 Transport Equipment 33.5 52.0 23.8 11.2 17.0 AVERAGE 37.1 32.8 13.9 7.9 11.0 /a Exporters are given a credit equal to 10% of the total value of exports which can be applied against their tax liabilities; moreover, the reimbursements are tax-exempt. /b For computation of credit incentives, see Appendix A. Source: Computed from the Central Bank study on "effective protection" by J. Berlinski and others. I/ This probably understates the fiscal incentives received by producers of intermediate goods, since many of them use the benefits provided under the draw-back regime rather than the global reimbursement.  - 25 - 2.29 In order to account more precisely for the overall impact of export incentives on export prices, preferential export credits have to be examined in greater detail. As Table 7 shows, maximum interest rates, which were charged for the pre-financing of exports, were not only substantially below the rate of inflation, they were also lower than the subsidized general loans from commercial banks. An attempt has been made to calculate credit incen- tives as percentages of FOB export values for various categories of goods in June 1977. According to the calculation in Appendix A, the credit incentives amounted to 19.4% of export value for the prefinancing of capital goods and 5.3% per dollar of exports for other exported manufactured goods; if these figures are adjusted for the fact that firms did not use maximum possible amounts, the rates decrease to 11.6% and 2.9%. A similar calculation was undertaken to determine the incentives offered through dollar financing of manufacturing exports; these amounted to 7.5% for capital goods, 3.1% for durable consumer goods, and 1.2% for other goods. Table 7: SELECTED INTEREST RATES AND RATES OF INFLATION 1971 - 1977 (in %) Category 1971 1972 1973 1974 1975 1976 1977 Prefinancing of Promoted Exports 8 8 8 15 33 40 50 Dollar financing of Promoted Exports 6 6 7.5 7.5 7.5 7.5 7.5 Other Exports 11 11 8.19 13.22 48 60 General Loans from: Commercial Banks a/ 16 22 18-20 18-23 45-48 47 b/ Finance Companies 22 28 26 27 40 47 b/ Rates of Inflation c/ 39.5 76 30.8 36.1 348.2 386.2 150 d/ a/ Maximum lending rates permitted. b/ Interest rates were freed in 1977, lending rates rose to over 15% per month, i.e. 180% per year. c/ Wholesale prices. d/ Estimated. Source: Central Bank.  - 26 - 2.30 Adding the major fiscal to the monetary incentives, an average incentive of about 33% of export value emerges. It is, however, important to recognize the rather large difference between the incentives granted to capital goods and other goods. As discussed earlier, most capital goods received global reimbursements of 35% in 1976, which were lowered to 25% during the second part of 1977. If one takes 30% as an annual average and adds the monetary incentive of about 17%, these export goods received close to 50% of their export value, whereas the rates for the simple manufactured goods was less than 35% of export value. Comparing relative attractiveness to sell in domestic or foreign markets in 1977, it becomes clear that manu- facturers of machinery and transport equipment and also durable consumer goods were substantially better off in selling abroad than at home, whereas for producers of non-durable consumer goods and intermediate goods the opposite was true. 2.31 Since 1970 Argentina has followed a policy of adjusting the effec- tive rate of foreign exchange for manufactured exports through a combination of nominal exchange rate adjustments and modifications of fiscal and monetary incentives. Whereas the official rate was kept at around 9 pesos per US$1 between the last quarter of 1972 and the first quarter of 1975, a mix of the "commercial" and "financial" rates for promoted exports, as well as increasing fiscal and monetary incentives, helped to keep the "real effective" exchange rate from falling drastically; at that time devaluation was ruled out partly because the export surpluses derived from the improved terms of trade of agri- cultural products was extraordinarily high. Real effective exchange rates have been calculated for a number of products in Table 8, where the major fiscal and credit incentives have been combined with actual exchange rates for different product categories; these are deflated by the relative price index of Argentina and US wholesale prices 1/. Indices for the three major product groups show the deterioration of the real effective exchange rate from the second quarter of 1974 to the second and third quarters of 1975. This trend was most pronounced in the case of basic metals, which reflects the authorities' desire to first supply the domestic market at a time of excess world demand over supply. 2/ After similar declines in the real effective exchange rate during the 1974/75 period, machinery, equipment and transport vehicles enjoyed substantial real increases in their effective exchange rates in late 1975 and the beginning of 1976, which were, however, not powerful enough to overcome the organizational and macroeconomic problems Argentina faced during that period. The most recent experience shows that due to the freeing of interest rates, the export credit incentives became a very important element in determining the price effect in 1977. It should, however, be remembered that the importance of the export credits in the earlier periods was due not so much to rate differentials as compared to the low official interest rates but to the fact that during 1973-75 export credit was a readily available source of medium-term finance for industrialists who also exported. 1/ For an export-weighted real effective exchange range, see Statistical Appendix Table 25. 2/ In mid-1974, exports of steel (excluding wire and seamless tubes) were essentially prohibited.  Table 8 - ARGENTINA: EFFECTIVE EXCHANGE RATES FOR MAJOR MANUFACTURED PRODUCTS 1973-1977 EFFECTIVE EXCHANGE RATE -a/ "REAL" EFFECTIVE EXCHANGE RATE b Actual Exchange Processed Basic Machinery and Processed Basic Machinery and End of Quarter Rate Food Metals Transport Vehicles Food Metals Transport Vehicles 1973 II 9.93 11.23 13.85 15.79 100.0 100 100 III 9.93 11.78 13.85 15.79 106.8 96.9 101.8 IV 9.93 11.78 13.85 15.79 108.1 102.9 103.0 1974 I 9.93 11.76 12.11 15.95 113.9 95.1 109.9 II 9.93 11.76 12.10 15.95 109.8 88.3 102.0 III 9.93 11.76 12.10 15.95 103.9 86.7 100.0 IV 9.93 11.76 12.10 15.95 96.1 80.0 92.5 1975 I 15.05 14.75 15.14 19.57 94.2 78.4 88.3 II 26.00 27.61 23.30 33.83 114.7 68.4 100.0 III 36.40/46.70 50.20 39.42 70.05 124.1 79.0 123.1 IV 60.80 81.78 89.89 103.32 142.0 138.0 139.2 1976 I 133.79 140.52 123.92 181.48 102.4 81.0 103.9 II 198.15 242.37 230.05 315.06 130.3 110.4 132.6 III 225.30 267.42 256.50 349.96 115.1 99.5 119.1 IV 265.13 310.01 295.02 391.25 113.7 97.7 113.6 1977 I 334.20 427.56 369.19 514.36 115.8 101.9 131.9 II 382.00 498.60 433.68 597.52 118.9 113.7 137.4 III 472.00 550.61 510.37 726.84 109.4 101.4 111.2 1Il 597.50 698.48 668.00 898.64 109.9 98.7 108.3 1978 I 721.00 842.85 806.08 1,084.4 105.8 94.6 104.2 II 788.50 921.76 881.54 1,085.9 94.4 84.4 94.0 Source: Central Bank and International Financial Statistics. a/ nominal exchange rate adjusted by monetary and major fiscal subsidies. b/ effective exchange rate deflated by the relative wholesale price between Argentina and the U.S., second quarter 1973, = 100,  - 28 - 2.32 At the present time exchange rate and export promotion policies depart significantly from past efforts, which attempted simultaneously to protect domestic output and to promote exports without creating unnecessary inflationary pressure. Between November 1976 and May 1978 the authorities used the exchange rate as a policy tool to balance the current account of the balance of payments. Consequently, changes in Argentina's foreign exchange rate in US dollars reflected changes of domestic and international inflation as well as changes in international exchange rates. In May 1978, the policy of "gliding parity" was abandoned, and the authorities decided to let the peso float. The decision, which was triggered by the accelerated inflow of external capital in the last quarter of 1977 anid the first quarter of 1978, led to an actual appreciation of the peso in real terms. It represented a step in the direction of using the exchange rate as yet another tool of monetary stabil- ization. This became clearer when the Central Bank in December 1978 announced exchange rate variations for the first eight months of 1979. C. Future Choices for Foreign Trade Policies and Industrial Transformation 2.33 Argentina's external trade pelicies are now at a crucial point of transition. In 1976, the value of the peso was set at a level which was con- sidered realistic; 1/ this level was maintained until May 1978 through the policy of "gliding parity." The establishment of a managed floating system, because of the strong balance of payments position in 1977-78, introduced substantial lags in the adjustments of the exchange rate in relation to internal/external inflation. In the long run, a more freely determined market rate should realistically reflect the changes in both domestic and international prices as well as changes in international exchange rates. 2.34 The simultaneous attack on "excess" protection of domestic producers and "excess" incentives to exporters has indeed not yet affected competition in Argentina or prevented industrial export. As pointed out in Table 3, there seemed still to be some water in the tariff for a number of industries at the end of 1977. Similarly, according to Table 6, it was still profitable to export capital and durable consumers goods in mid-1977. Nevertheless, the measures taken so far have aroused considerable apprehension in the industrial sector. Since the move towards lower protection, higher efficiency and greater competition will represent considerable change in the environment to which most Argentine manufacturing firms are accustomed, the overall strategy and individual policies must be carefully planned and executed. 2.35 For the period of transition, a mix of positive and negative incen- tives will be necessary to help firms adjust towards the new environment. While decreases in import tariffs in many crucial industrial branches may be partially offset by some increases in those industries which had previously either negative or low positive effective rates of protection, the overall direction will be to decrease the average level of tariffs, constituting a "negative" tool to improve efficiency. After this initial streamlining, appli- cation of export incentives should provide a "positive" tool, which will make 1/ For the computation of the shadow exchange rate for Argentina under current conditions, See Appendix B, page 33.  - 29 - it possible to induce increased exports from those branches which have found a comparative advantage and have the ability to maintain it for a number of years. 2.36 Making credit and technical assistance available for re-equipment, training, or reorganization of firms with the aim of lowering costs and improving quality of Argentina's manufactured products would be crucial during the period of transition. Other countries have demonstrated substantial inno- vation in supplying long-term finance at favorable terms, when industrial firms were willing to modernize, merge, improve quality and lower costs. Spain's experience with the "accion concertada" 1/ seems particularly relevant here. In addition, that country's financial sector was able to broaden its institu- tional framework by introducing and promoting special industrial banks, which centered on the medium and sometimes long-term needs of medium-sized indus- trial enterprises. Finally, assistance to displaced workers can be important. Argentina does not have a system of unemployment insurance or other programs to help workers find new jobs. In this situation authorities have understand- ably been reluctant to permit firms to fail, even if these firms were ineffi- cient. During the 1976-78 period, however, several thousand blue and white collar public employees have been absorbed with considerable ease into private sector activities. In the future, displaced workers should be absorbed into construction and related industries, if the active housing program which has been initiated by the Secretariat of Housing and the National Mortgage Bank is fully executed. Thus, fears that measures to increase industrial efficiency may give rise to substantial unemployment should be reduced. This is more so the case if one considers that the future growth of the Argentine labor force is expected to continue at a low rate. 1/ The "accion concertada" refers to joint action by the Government and a group of enterprises in the same industry to achieve certain objectives, such as increases in output for both the domestic and international market and increases in productivity through modernization.  - 30 - APPENDIX A CREDIT INCENTIVES FOR PROMOTED EXPORTS 1/ 1. As discussed in Chapter II, one of the major aims of current monetary policy is to correct the interest rate structure in such a way that it will reflect the real scarcity of capital in the Argentine economy. Due to a combination of strong centralization of monetary decision making and accelerated inflation, interest rates had become sharply negative after 1969. As Table 7 shows, maximum interest rates for commercial loans were substan- tially below the rate of inflation in each year between 1971 and 1976. It has only been since the second semester of 1977, i.e. since the decentralization of the banking system, that interest rates have yielded real positive returns to savers and consequently have also shown up as an important cost item in the financial statements of borrowing business firms. 2. The following analysis is limited to the calculation of the incentive offered through the export credit policy of the Government in 1977; calculations of previous years would have not only to estimate the differences between the export interest rate and the fixed market interest rate, but also the difference between the latter rate and the shadow rate of interest. The basic formula to compute the incentive per unit of dollar exported may be written as follows: ( (1 + i) t where S the incentive per dollar exported; p = the rate of interest for prefinancing of exports; i = the market rate of interest; t = number of months for which prefinancing is received. 3. This simple formula is substantially complicated by the following restrictions: (a) the maximum amount to be financed which depended on the de- gree of fabrication (see Statistical Appendix Table 15); (b) the term of the loan (see Statistical Appendix Table 15); (c) the actual payments of loan amount, which were granted in two steps. 1/ This methodological note is based on the paper, "Los Incentivos Financieros a la Promocion de Exportaciones" prepared by J. Berlinski and J. Somers in the Central Bank.  - 31 - With these stipulations, formula (1) now becomes: (2) S =k h 1 (1 + P)t + (1-h) (1 (1 + P)t2 Where k = proportion of the F.O.B. export value to be financed; h = proportion of funds to be granted as first payment; j = number of months between first and second payment of loan amount. (I .4)12 ( .0)101 (2a) S =7 . (1 12 + .3 (1 - 10) = 19.35% (1 + .07) (1 + .07)1 4. For the prefinancing of capital goods, which have made up between 35% and 40% of Argentine industrial exports in the last few years, 70% of the export value was permitted to be financed at an annual interest rate of 55%, or close to 4% per month, at a time when the market rate of interest averaged 7% per month. The term of the loan was up to one year and the first payment constituted 70% of the total loan amount, followed two months later by the residual 30%. Using these data in equation (2a) results in a credit incentive equal to 19.35% for each dollar of exports. 5. In the case of the other manufactured exports the prefinancing period is shorter, averaging six months, and the maximum amount to be financed varies between 40% and 60% with the majority of goods being close to 55%. Interest rates were higher too, averaging 5% per month. The arrangements with respect to actual receiving of the funds are the same as in the capi- tal goods case, i.e. 30% is paid two months after the first payment of 70% is received. Using these parameters the implied incentive for all manu- factured goods except machinery, equipment and transport vehicles is: (1 1056 _L. 054 (2b) S = .55 7 ( -) + 3 (1 - ___ = 5.28% L1.01.76107 6. The formula for measuring the incentive given to the financing of actual exports, i.e. helping the exporter to extend credit to the foreign buyer, depends on the differential between the interest rate charged to the Argentine buyer by the Central Bank of Argentina and the interest rate he would have to pay if he would receive these funds from the international financial market. In addition amortization schedule and time play an important role. These elements are reflected in the following equation:  - 32 - St = 1 t- 1 e-f3 Where S' = the implicit incentive per dollar of export i = the proportion of the F.O.B. value financed; n = number of periods in which the debt is amortized; t = actual periods of amortization; e = the opportunity cost of capital, i.e. the interest rate Argentina's exporters would have to pay in international markets; f = the interest rate charged by Argentina's Central Bank. 7. The official interest rate was 7.5%; although the Eurodollar rate is currently lower, it is unlikely that Argentina's exporters would be able to obtain export credit for less than 10%. Different calculations are necessary for the various product groups due to different financing and amortization schedules. In the case of capital goods the maximum financing period is eight years for 85% of export value and amortization is annual. The subsidy can be computed to be 7.5% of export value. Consequently, equati.- (3) will become: 1 =85 =-l .10-.075 7.5% t=8 =15 t8- (1.1_t_ 8. If a similar calculation is undertaken in the case of durable con- sumer goods, which have a maximum financing period of three years and a biannual amortization, the subsidy amounts to 3.1%. Finally, for other exported manufactured goods which have only one year of amortization with quarterly payments, the subsidy will reach 1.2%.  - 33 - APPENDIX B CALCULATIONS OF SHADOW EXCHANGE RATES 1. The shadow exchange rate is that rate which would yield the same balance of trade under free trade conditions as the actual one yields in the face of all trade distorting measures, such as tariffs, subsidies, advance import deposits, export taxes as well as any quantitative restrictions. It is consequently measuring the significance of trade restricting policies. The relationship between the shadow and the official exchange rate can be written as follows: 1/ R _ E e!x, (1+S,) Z e iMi (l+Tj) R~~~ i, efX. +iiM. R = the official exchange rate R = the shadow exchange rate f e. = the price elasticity of foreign exchange for product i esx + (edx 1) - sx dx ei + ei T. = the total protection in imports sx ei = the price elasticity of export supply for product i e.x = the effective price elasticity of export demand facing 1 product i, defined as a positive number = the inverse of the country's share of world exports times the aggregate world price elasticity of demand. 1/ For a detailed discussion see: Lyn Squirre and Herman G. van der Tak, Economic Analysis of Projects, Baltimore: John Hopkins University Press, 1975. For the derivation of the formula, see E. Bacha and L. Taylor, "Foreign Exchange Shadow Prices: A Critical Review of Current Theories," Quarterly Journal of Economics, 85:2 (May 1971), pp. 197-224.  - 34 - ei = the price elasticity of demand for imports of product i Xi = exports of product i Mi = imports of product i S = the subsidy on exports of product i as a ratio of the export price (an export tax is considered a negative subsidy) 2. Table I presents the details of the calculations based on 1977 prices and Table 2 shows the four alternative results, depending on different assump- tions and empirical evidence of the price elasticities of foreign exchange for agricultural and manufactured goods, el. The R'/R ratios fell between 1.21 and 1.29, i.e. a shadow exchange of about 25% above the official exchange rate would seem to be adequate to balance the trade accounts if all trade restric- tions were lifted.  Anpendi B- Table 1: ARGENTINA: SIIADOW EXCIhANGE RATE CALCULATIONS World Price Elasticity dx pt ei (e so do + Exports Share in T-dc of REport Demad s i c c 1 iIe (7-l is ta iis Exports Wheat .07 .25 3.57 .20_1.78 .514-4.57 3:77-5.35 2,688 .14-.85 376-2,285 338-2,057 Coca .13 .62 4.77 .47-1.87 1.77 -7.05 5.24_6.64 2,240 .34-1.06 762-2,374 686-2,137 Sorghu= .17 .13 .76 .60 -.14 1.36 1,925 - .10 -193 -174 lye, oats and barley .06 .14 2.53 .60 .8_ 2.93 330 .27 89 80 Reaf .12 ,20-.77 1.67-6.42 .68-.98 .46-5.31 2.35-7.40 2,437 .20- .72 487-1,755 438-1,580 Other Agricalt-sal .10 .15 1.50 .60 .30 2.10 4,081 .14 571 514 I Tdotrial . 5,232 1.0 -4.0 5,232-20,928 7.063-28,252 Total 18,933 7,324-27,804 8,945-34,446 (1) (2) (3) (4) (5) Price Elasticity 7 Imparts (1=2) (14T) [3.4) of Impart DEsasd Z(76-80) I=ports Feed cad othe- -casa-ac geode .8 453 362.4 1.25 453 i xfg. = 1,882 - 6,194 I.ternediate P-odotl .5 14.071 7,035.5 1.33 9,357.2 f Capital G..d. 1,2 4,415 4.856.5 1,50 7,284.8 ei exc. mafg. - 2,092 - 6,681 Total 18,939 12,254 17 095 6i 4i(l+t) - 17,095 ei a 12,254 ei e(l+t)+ ef a(lseac. aslg. 18,977 - 23,289 ei = + ei exc. =afg. = 14,346 - 19,135 lea ea.tiaita - 1.32 high estimate -1.22  Appendix B - Table 2: RATIO OF SHADOW EXCHANGE RATE TO OFFICIAL EXCHANGE RATE UNDER ALTERNATE ASSUMPTIONS Low Agriculturaieifxi High Agricultural-ei xi Low Manufactured