Argentina - Reforms for price stability and growth (Vol. 1 of 2) : Volume one

Report No. 7994-AR Argentina: Reforms for Price Stability and Growth (In Two Volumes) Volume I Setember 8, 198S Latin America and the Caribbean Region Country Operations Department IV FOR OFFICIAL USE ONLY Docment of the World Bank This document has a restricted distribution and may be used by recipients only in the performnar~e of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  OURRENCY EWJIVAlENTS Currency Unit - Austral (AS) Exchange Rates Effective August 15, 1989 Official US$1.00 = ASS60 Parallel Exchange Rate (Montevideo) US1.OO = AU685/690 FISCAL YEAR January 1 - December 31 GLOSSARY OF AOREVIATINS AND ACRONYMS ANA Administracion Nacional de Aduanas National Customs Administration AyEE Agua y Energia Electrica Water and Electrical Energy Company BANADE Banco Nacional de Desarrollo National Development Bank BCRA Banco Central de la Republica Central Bank of Argentina Argentina BHN Banco H;potecario Nacional National Housing Bank BONAVI Bonos Nacionales de Intereses Variable Interest Rate Bonds Variables CEN l rporacion de Empress. Nacionales Corporation of National Enterprises COGASCO Compallia de Gas Centro-Oeste Center-Osste Gas Company CQNADE Con-sjo Nacional de Desarrollo National Development Corporation CRM Cuenta de Regulacion Monetaria Monetary Regulation Account DEP Directorio de Empresas Publics Public Enterprise Board DOI Direccion eaneral Impositiva General Tax Administration DNPC D;reccion Nacional de Promocion National Directorate of Commercial Comercial Promotion ELMA Empress de Lineas Maritimas International Shipping Company ENTEL Empress Nacional de National Telephone Company Telecommunicaciones ODE Gas del Estado State Gas Company HISPASAN Steel Company HIDRONOR Hidroelectrica Norpatagonia North Patagonia Hydroelectric Company INOS Instituto Nacional de Obras Sociales National Institute of Social Insurance Funds IVA Impuesto tl Valor Agregado Value-Added Tax (VAT) JNG Junta Nac;onal de Granos National Grain Board MCBA Municipalidad de la Ciudad de Municipality of the City of Buenos Aires Buenos Aires NFPS Nonfinancial Public Sector OSN Obras Sanitar;as Nacional National Sewage Company PEs Public Enterprises PRESEX (PEEX) Programas Especiales de Exportacion Special Export Program SEGOA Servicios Electricos del Gran Electric Services of Greater Buenos Buenos Aires Buenos Aires SICEP Sindicatura General de Empresas General Comptroller of Public Publicas Enterprises TAR Temporary Admission Regime '.CF Yacim;entos Carbonales Fiscales State Coal Company YPF Yacimientos Petroliferos Flsca'es State Oil Company  PREFACE On July 8. 1989, Carlos Saul Menem was inaugurated as President of Argentina. This report was completed on the eve of the transition, based on a a World Bank macroeconomic mission that visited Argentina from January 31 through February 14. 1989. The mission comprised the following members: Richard Newfarmer (Mission Leader, Macro, Extemal Finance) Luca Barbone (Macro, Fiscal and Monetary Policy) Paul Beckerman (Monetary and Financial Policy) Luc Everaert (Public Enterprise) Egbert Gerken (Trade and Industrial Policy) Other people have made contributions to this report. Including James Hicks and David Vetter (provincial govemment finance), WiMam McGreevey (social security), Dale Gray (energy sector), Steven Oliver (agriculture), and Luis Riveros (labor markets). Roberto Manrique provided research assistance for the external finance sections. and Ann Mitchell prepared the projections and statistical appendix. Diane Blevenour and Alexandra Blackhurst provided secretarial support. The day after assuming office, the new Government ar.nounced a sweeping program of structural reforms and stabilization efforts. Its broad scope and recent enactment preclude any analysis of the new measures In this report. However, it Is important to note that the Government's program touches nearly every area of pubic policy that had been at the heart of Argentine Inflation and recession. The Government's structural reform program as announced Included: (I) an ambitious program of total and partial divestitures of many of the country's largest state enterprises; (11) temporary suspension of industrial promotion schemes, Including Tierra del Fuego; (l1) a new tax reform that would broaden the base of the countrys' value-added tax, allowing the country to replace the heavy export taxes (20-30 percent) and excessive taxes on energy; (iv) continued efforts to Improve tax collections through heavy penalties for noncompflance and involving tile banking system In tax collection; (v) elimination of a major portion of the subsidy Implicit In the Buy Argentina legislation that Impedes virtually any Import of the public sector competing with domestic production; and (vi) a reform of the Central Bank to grant It independence from the Government, place legal limits on its ability to Increase the money supply, and defnk the Central Bank from the inefficient public banks; in addition, the Central Bank has legalized dollar deposits with low reserve requirements to be heid In a designated bank abroad so as to fadlitate flows of lower-cost credit to the private sector as well as to add a further discipline to the nonflnancial public sector. The program Is designed to shrink the size of the pubic sector, make It more efficient, and reduce the countless subsidles to specific Interest groups. At the same time, the Govemment announced several measures to stabilize the economy: (I) a devaluation In the nominal exchange rate from A$303 to the US dollar to a new fixed rate of A$650, a real exchange rate roughly 50 percent higher (i.e., devalued) relative to the average for 1987; (11) the continuation of exp'rt taxes of 20 percent on Industrial products and 30 percent on agricultural products as well as other taxes; (iii) suspension of tax expenditures in the form of export rebates; (iv) massive increases In the prices of pubsc enterprises, amounting to a real Increase of 90 percent relative to May rates, followed by a price freeze at the new levels; and (v) a price freeze negotiated with leading Industrialists at 20 percent below the July 15 price levels. Besides fixing the exchange rate and the pukce freeze, the Treasury Is operating on a monthly cash budget intended to produce slight operating surpluses after service on domestic debt and preferred creditors; the Government has promised that the Central Bank would end all financing to the public sector after August 31, 1985. and permit monetary expansion only as a consequence of reserve Increases thereafter. 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.  As of this w.iting, It was still too csrlv to assess whether the stabilization package woutd be successful In reducing the enormous deficit of the combined pubflc sector and bringing about price stability. The deficit of the nonfinandal publ1c sector--driven by tax evasion and falling real value of revenues--had surpassed 10 percent of GDP In the second quarter of 1989: high real interest rates on the domestic debt of the Central Bank and the huge real devaluation drove the quasi-flscal defidt to over 15 percent of GDP In the second quarter. The structural adjustment program, while extraordinarily promising. Is still in the process of being elaborated. As of this writing, many Important measures were only temporary. others require Congressional a-tlon and yet others have only been announced and remain to be implemented.  TABLE OF CONTENTS Page Nos. GLOSSARY OF ACRONYMS COUrTRY DATA EXECUTIVE SUMMARY i - xxii VOLUME I - MAIN REPORT CHAPTER Is STATE-LED GROWTH AND INFLATION ................. 1 A. Background ............. 1 B Growth, Inveitment and Savings ....................... 1 C. Adjustment and External Transfers .................... 3 D. Public Sector Deficits and Inflation ................. 6 CHAPTER II: STABILIZATION EFFORTS AND EMERGENCE OF HYPERINFLATION ................................ 12 A. Stabilization Efforts from 1984 to 1987 .............. 12 B. The Plan Ptimavera: August 1988-February 1989 ....... 15 C. Performance Under the Program (August 1988- February 1989) ..................................... 17 D. Recent Developments: Emergence of Hyperinflation .... 19 E. Main Short-Term Problems ............................. 22 F. Short-Term Options ................................... 24 CHAPTER III: FISCAL POLICY AND PUBLIC FINANCE ............. 30 A. Introduction ......................................... 30 B. The Public Sector: Struggling with the Deficit ...... 30 C. The Tax System: Problems,and Reforms ................ 34 D. Federal-Provincial Relationships ..................... 40 E. Finances of the Social Security System ............... 41 F. Public Sector Enterprises ......... . ................ 43 G. Recommendations ...................................... 45 CHAPTER IV: MONETARY POLICY: DEALING WITH FISCAL AND QUASI-FISCAL DEFICITS ....................... 52 A. The Central Bank in the Financial System ............. 52 B. Dealing with the Quasi-Fiscal Deficit: 1985-1989 ..... 55 C. Constraints on the Operation of Monetary Policy ...... 58 D. Recommendations ...................................... 61 CHAPTER V: MEDIUM-TERM PRICE STABILITY AND EXTERNAL FIRNANCE 63 A. Domestic Macroeconomic Objectives .................... 64 B. External Financing .................................. 72  VOLUME II - ANNEXES PUBLIC SECTOR ANNEX CHAPTER I: PUBLIC ENTERPRISES ....................... 1 A. M-lain Issues .......................................... 1 B. Revenues: Pricing Policy ............................ 7 C. Expenditures ......................................... 10 D. Transfers ............................................ 17 E. Budgetary Process and Cor.trol ........................ 23 F. Performance Issues in 1988-89 ........................ 25 G. rolicy Recommendations ............................... 25 ANNEX CHAPTER Is: PROVINCIAL GOVERNMENT FINANCE ........... 30 A. Overview ............................................. 30 B. Intergorernmental Fiscal Relations ................... 32 C. Provincial Revenues .................................. 35 D. Provincial Expenditures .............................. 37 E. Deficit/Surplus and Sources of Credit ................ 40 F. Recommendations ...................................... 40 ANNEX CHAPTER IIIs SOCIAL SECURITY ........................ 43 A. Introduction ......................................... 43 B. Pension Program ...................................... 43 C. The Social Funds and Health Services ................. 49 SECTORAL ISSUES ANNEX CHAPTER IV: FINANCIAL SECTOR ........................ 51 A. Overview ............................................. 51 B. The Present Structure of the Financial System ........ 53 C. Financial Liberalization and Centralization .......... 55 D. Principal Financial Sector Policy Issues ............. 59 E. Recommendatlons ....... ................................ 64 ANNEX CHAPTER V: EMPLOYMENT AND LABOR. ........... ........ 68 A. Introduction ......................................... 68 B. Productivity, Wage Trends, and Vrge Determination .... 68 C. Employment and Unemployment Trends ................... 72 D. Labor Market Regulation and Efficiency ............... 74 E. Protective Regulations and Equity .................... 75 F. Recommendations ...................................... 75  ANNEX CHAP TER Vlt TRADE POLICY ........................... 77 A. Trade Performance ..77 B. Import-Substitution Strategy. . 77 C. Policy Refom .80 ANNEX CHAPTER VII INDUSTRIAL POICY .88 A. Sector Performance ..88 B. Policy Impact ..89 C. Recent Developments ..90 ANNEX CHAPTER VIII: THE ENERGY SECTOR . .93 A. Overview ..93 B. Energy Subsidies, Pricing,and Taxation . .95 C. Petroleum and Gas Supply ..99 D. Natural Gas Utilization ..101 E. Refining Operations ..104 F. Electric Power Sector ..106 G. Energy Planning ..108 ANNE CHAPTER TX: AGRICULTURE .. 110 A. Agriculture in the Economy ..110 B. Agricultural Potential ............... 110 C. Disincentives to Agricultureal Investment. 112 D. Principal Policy Requirements . . 113 ANNEX CHAPTER X: ANALYTICAL APPENDICES A. Medium-Term Projections .. 116 B. Macroeconomic Consistency .123 STATISTICAL APPENDIX Tables 1.1 - 9.4 ..132-215 i/  CtWUy DATA - ARBINA AREA POLATDI oO mu5y *l 2766.9 thous. aq.a. 82.0 million (1988) 10.7 pe aq.ks 1.1 waual Growth 16.9 per q9-k of arable land fPULATION C SARACTERISTICS */ WEALTH b/ Crud. Birth Ibt. (pr 1000) 2S.6 Population pvr physician (thou..) 0.5 Crud DOcwth Rat* (p.r 1000) 8.9 Populmtion per hospital bad (thou..) 0.2 Infant No'tality (per 1000 live births) 34.4 INCI DI*TRIIO bl DISIRIBITlO OF weD OWNRHIP I of national intcome highest quintile S0.31 S owned by top 10 of land owners S of national noom. lowest quintilI 4.45 U owned by eamll.st 105 of land oewn ACC98 TO SAFE VATER (1980) ACCS TO ELEKTRICITY (1989) * of population - urban go I of populati-;n O S of population - rural 17 rMlfITION / EDUCATION Calorie Intake a. I of requirnt 119.27 Adult literacy rate * (1980) 9OS PFr cepite protein intake (teral per d'y) 99.7 Priinr echool enrol lmnt I .i 1002 OW PER CAPITA IN I"S c/ 2537 NATIIOAL PtROUCT DN 1_8 d/ ___________________________--__- - - M94AS AL CR RATeS (U conetant prices) US8 1n. af 0 --------------------------------- (current pric.a) 1970-7S 197J-80 1960-90 1980 OIP at wrket price. 78620.6 100.0 2.9 1.6 -3.4 -0.7 Gross Domestic Inveoteet 10095.4 1S.4 1.9 4.4 -16.2 -4.7 Groes National Savings 7498.2 9.9 0.8 2.0 -1S8. 29.9 Current Account Balanc -2639.2 4I.S Exporte of Cooda A NFS 1037.8 18.7 -4.7 14.1 8.2 8l. 6 Imports of Goods A NFS 7649.4 10.4 0.6 13.8 -18.0 -4.5 (IT. LASUI FO ANCE 0 P crIVtTY IN 1968 Volue Added (constant pricoe) Labor Force e/ V.A. Par Vorker U ln. Sef total Thoueande S U Agriculture 10697 15.2 1870 12.0 7951.0 Induatry 24291 34.0 3599 81.4 6773.6 Services 8s68 80.8 6 e4 6.6 5624.3 Total GDP at Factor Coet 71844 100.0 11421 100.0 6264.4 G0VERMIT FINANCE f/ Consolidated Nonfinancial Public Sector of Central Governwant Aut. in. Si of ODP Au-t.. tn. I of CDP 1967 1967 193-47 1987 19S7 1983 -87 Current Revenues 54661 30.6 35.1 185S8 10.5 9 1 Currant Expenditures 59995 J3.9 87.8 20527 11.6 8.0 Current Balance -5384 -3.0 -2.7 -1939 -1.1 1.1 Cap;tal xspenditures 9102 5.1 7.4 551 0.3 0.4 Surplus h/ -13079 -7.4 -9.3 -12728 -7.2 -8.9 Externl F;nancing (not) 7411 4.2 1.8 6660 3.8 1 8 a/ For the period 192-1983. b/ For th peried 1970-1976. c/ Current US dollare. Estimated ucing Bank Atlas -thodolopy. d/ Current US dollar estimates. calculated fro date in constant 1970 au1tral*a. */ Calculated by applying 1960 cwo. sharee- to 1986 population. f/ F.acuted budget eatimtee in current australae. v provinciel governments  CMIwn DATA - ARBTFINA ROEY, DiT m NO tAICEB 19t0 191 1t8 198e 1964 196 1988 17 1988 (Mil ions of oustrales; end o period) money and Quasi toiy 8.0 16.0 88.3 193. 6 1193.5 T82.5 16m29 44433 2403M Dosetic Bunk Credit to Public Sector ;.7 6.4 22.6 76.4 596.68 2m5.1 5710 18624 8274 Domsetic Batk Credit to Privets ctor 8.3 22 2 68.9 2Ji0.8 1902.1 896o.6 16498 48819 222373 Roney and Quasi Mtoney *a I of IP 22.8 21.0 15. a 15.2 12.2 14.2 17.1 i 5.9 17.4 whotcale Price Indc (19M5e100) 0.067 0.168 0.775 o.961i 28.747 133.4 210.t 59J.7 3165.9 Annual percentag change* in: Qeneral Wholeele Price Index 8.e8 1I0.o 312.2 411.1 625.6 3a4.0 57.9 181.6 431.6 Bank Credit to PubliC Sector e9.6 282.8 251.7 237.2 681.6 376.7 100.7 226.2 3a3.2 Sank Credit to Private Sector 106.5 166.0 210.5 321.9 554.1 372.1 63.7 198.0 355.5 BALANE OF PPETSi 1975 1930 1988 d 198i8 ICK SE EXPOT (Averege 1984-1988) (UStt tilliona) USII 141n. I of Tot I ExportA of Qooda, N98 3704 1076l 10242 11301 Acriculturet good. d/ 3822.9 49.2 Imp*rts of Goods. 1P8 4518 14024 891 7789 lafnuf. goods of agric. orig. e/ 2004.5 21i.8 Resojrce Balance -814 -3259 4381 3812 Monuf. of industrial origin fV 1942.8 26.0 Total larchandi.ae tport. 7770.2 100.0 Intcreat Paymants (net) -460 -947 -4679 -44t7 Other Fector Payaentc (n*a) a/ -1l -5d4 -425 -680 EXTiStiAL 9T (as of Dec.31, 1988) a/ lNS Win. t4- Currant Tranefora 5 28 0 0 ------------------------------------- -------- 8 lance on Current Account -1284 -4767 -953 -1615 Total Debt Outetand;ng * Dteburced (000) 89810 im 2268 Direct Investment .. 78i 919 1147 mle 2263 119F 873 Total HALT Loans (not) -12 3400 2786 -252 Wilateral. 5a85 Oleburac_nt. 1018 8809 7564 - Bond 29as Amortization 103o 2409 4778 - Comercial B ank 42089 Oth-r Capital (not) b/ 189 -2217 -m81 2506 DEi SERVICE RATIO. 1988 h/ eS.8i Ch_ang in re farva (- a Incra,.) ll0 279 -1871 -1785 --------------------------- --- Internct service ratio (l of *spor;. O3FS) 42.31S Oroae RAgerves (end year) c/ 464 6743 4801 4979 Not RAeeeine (end yeer) -520 m724 -7873 -15429 I=/WA LE0NDl0 DECi62 31, 1988 (Mlin. US) RATe OF .C-WM _/ IDA 1980 1988 Outstending & Oldaured 2285 L-ndi*burd -d USiJ 1.00 * AS 0.00016 LOS 1.00 a Al 8.7703 Outstoding Intl. Vidlaburwed Al 1.00 -i5 i3S2 Al 1.00 - tUS11 0.1140 */ Direct Investment Income pIu othet factor service Income. b/ Include. short-tore capitol, not D1 reaurecs. chngeu in arrears, and valuation dju-atm.nta. c/ Includes v,luatlon and other adju-tmante. d/ BCRO. ctegories I, II and III: livestock end other animl products. agricultural products; fVto nd olla. s/ 801A categorics IV. VIII, and XI: I.-. manutfctured food. bkoragw, end tobacco; leather, fur, and related products; textiles and clothing. f/ All other eanvfactured goods cctegories. g/ Preliminary eatiset*. h/ Amortiztion -d interet peyment on _edium- and long-term (16T) debt a- c percentagc of ewports of 0a1S. Lscludes arrears; Includes rescheduling af debt. I/ period average.  ARGENTINA: EXECUTIVE SUMMARY A. Introduction 1. In his inaugural address of July 8, 1989, President Carlos Menem emphasized that Argentina is facing the most difficult economic situation in its modern history, and promised the country only "sacrifice, work and hope." Inflation had surpassed 100 percent monthly, output was stagnating, unemployment was rising, and the Government was unable to mobilize credit either domestically or abroad. The current situation is the culmination of long-term .rends emerging in the 1970s--slow growth in productivity and secular falls in savings and investment. Savings and investment ratios are about half their mid-1970 levels. In spite of efforts at reform in recent years, gross national income per capita is about 23 percent less today than in 1977. Foreign debt, once quite small relative to GDP, has climbed to nearly 100 percent of GDP. 2. The experience of the last two decades indicates that without a permanent reduction in inflation, Argentine savings will not be invested in Argentina. Five stabilization programs in the 1984-89 period have failed, largely because of insufficient adjustment in the public sector. Each time inflation returned and surged tu higher levels than on the previous occa- sion. Lack of social consensus and entrenched business and union power, together with the burden posed by the external debt servicing, conspire to maintain the demands on the public sector beyond its ability to garner resources--thus creating a chronic deficit. The key to controlling infla- tion is an immediate and sustained reduction in the deficit through a com- prehensive reform of the public sector. 3. But controlling inflation mal -ot be sufficient to unleash the enormous productive potential of the country--and thereby provide the basis for increasing real wages over the long term. To reverse declining trends in labor productivity and the productivity of investment, the Government as part of its comprehensive reform must remove price distortions and other policy interventions that have discouraged investment and job creation throughout the country. While achieving price stability is the first order of business, the Government must do so on the basis of a comprehensive public sector reform that makes financial stability permanent and permits sustained increases in productivity and income. Background 4. The growth of state spending daring the 1970s contained three seeds of the crisis that was to become manifest in the 1980s. First, increases in public spending--public expenditures rose from about 25 per- cent of GDP in 1970-72 to over 38 percent in 1981-83--were not matched by a conronitant expansion of revenues, and so large deficits became comnon- pl. e, ranging from 5 to 16 percent of GDP in 1973-83. After 1980, weak teA administration, excessive tax exemptions, low public enterprise prices and falling real revenues associated with inflation initiated a secular cLeterioration in public revenues relative to GDP that has continued until the present.  - ii - J. Deficits in the late 1970s were initially financed through foreign and domestic borrowing and then, with the crisis in the financial system in 1980-82, the Government assumed the foreign debt of the private sector. The build-up in foreign debt during this period created an enormous external and internal transfer problem which hampered efforts at deficit reduction, and has made both foreign and domestic creditors increasingly reluctant to lend to the Government. 6. A third problem associated with the growth of the state was the proliferation of costly suibsidies and associated economic distortions: Industrial promotion schemes subsidized domestic industry at a cost to public finances of roughly 5 percent of GDP. Consumers of public services enjoyed subsidies from tariffs that were often below costs. Many borrowers from public banks enjoyed implicit subsidies to housing, industrial invest- ments, and other uses. Only a small portion of these subsidies went to low-income families or the truly needy. At the same time, Government policies raised barriers to competition in several sectors, and other inef- ficient regulations created additional economic distortions. The need to finance fiscal losses created a highly distorted financial system wherein the Central Bank was used to tap resources from financial intermediaries and channel them to loss-making public banks and the nonfinancial public sector, thus discouraging savings and efficient investment. These policies had the collective effect of directing investment into low productivity areas, and lowering the procuctivity of the whole economy. Recent Reform Efforts 7. Inheriting a distorted economy, the Alfonsin administration (1983-89) initiated several reforms that had considerable effect in reducing the external and internal deficits. By keeping the exchange rate generally competitive after the Plan Austral in 1985, the deficit on current account of the balance of payments improved from over 4 percent of GDP in 1983 to under 2 percent in 1988. At the same time, expenditure compression, new tax measures, sporadic improvement in public enterprise pricing, and some adjustment in provincial public sector finance contributed to reducing the deficit of the combined public sector. Deficits of the combined public sector fell from over 20 percent of GDP in 1983 to under 7 percent in 1988. 8. But policies were not always consistent or sufficiently enduring to stabilize the economy. The new taxes, although easy to collect, were often inefficient and seen as temporary; export and energy taxes, for example, were among the most important new measures. Contending political demands prevented coherent action in controlling public finances; 1987 marked a severe setback to the gains in the previous two years, especially in expanding subsidies through the PuAblic Housing Bank (BHN) and Industrial Bank (BANADE). Moreover, insufficient early attention was devoted to the structural problems that were the legacy of the previous decade. 9. The Plan Primavera, initiated in August 1988 against a backdrop of accelerating inflation reaching 30 percent monthly, attempted to remedy some of these problems. By introducing some structural measures--control  - iii - (a) (c) GDP Growth: Long-Term Trend Origin of Saving: 197087 (10 Year Moving Average) S of aoP 6% ev I - ,40 4% 2% 1% l~~~~~~~~~~~~~~~~~~~~~~~~~~~ 0%' -101 .. .. 1030 1940 1060 108 1970 l0go 1070 1074 178 "a to" (b) (d) Investment and Saving: 197087 Public Sector Primary Surplus and External Interest 1970-87 % of GOP % of GOP 35 28 ~~~~~~~~~~~~~~~~~~~- 0p bt :e _ 1070 1974 1907 187 179r4 W7 t 8 Wot.: PriaeZ sauplus equals public sector balance befo latoS t paytant. Thi deficit ehoub includea of  I - iv - of rediscounts and quasi-fiscal expenditures through the Central Bank, a tax reform designed to circumscribe some of the industrial subsidies, and a trade reform to open the economy--the program sought to introduce permanent changes in the state sector, intending to bring down the deficit of the combined public sector from 6.7 percent to under 3 percent in 1989. The trade reform succeeded in lowering the average level of protection and reducing the coverage of quantitative restrictions; financial sector reforms 'hiad substantially reduced the flow of rediscounts and maintained the regime of liberalized interest rates initiated in late 1987. By the end of the year inflation had fallen to single digits. 10. However, the political consensus to implement the announced fiscal measures and structural actions affecting the public sector was absent. Underadjustment in the fiscal accounts, as with the Plan Austral, threw the burden of stabilization on monetary policy; the Central Bank had to increase its debt to support the interest- and exchange-rate mix. The private sector, acutely aware that the structural fiscal deficit had not been eliminated, fearing the uncertainty of Argentina's first post-war democratic political transition, and doubting the capacity of the Central Bank to service its debt and support the exchange rate, began shifting its portfolio out of assets denominated in the domestic currency in mid-January 1989. This triggered a self-feeding run on the austral by the end of the month, which the outgoing government was powerless to stop. The free market exchange rate fell from A$16.8 per US dollar in January to A$380 in June. Monthly inflatinn rose every month to reach 123 percent by June and 203 percent in July. B. Short-Term Problens and Options Problems 11. The new economic team taking office on July 8, 1989 confronted four immediate economic problems: hyperinflation, instability in the financial Pystem, price misalignment in the public sector, and the threat of a major recession. 12. Hyperinflation. By May, the cash deficit of the Treasury had become extraordinarily large. Widespread tax evasion and falling real tariffs of public enterprises had driven revenues down. But more impor- tant, both 'iscal and monetary policy had become almost completely endoge- nous to the inflationary process. The deficit continued to widen because of inflation itself: real revenues were falling and, given low and falling demand for money, public finances were unable to balance through the infla- tion tax, setting off an inherently unstable process. 13. Similarly, accelerating inflation produced destabilizing monetary expansion through the losses of the Central Bank. This is beLause interest expenditures on Central Bank liabilities exceed Central Bank interest earn- ings by an amount that tends to increase with inflation. Interest earnings are dominated by loans to the public banks, which carry a fixed interest spread above inflation, while liabilities are dominated by forced invest- ments from the commercial banks, and are priced at market rates; so higher  nominal interest rates associated with accelerating inflation increase the quasi-fiscal deficit of the Central Bank. Moreover, the lag in interest earnings means that during periods of rising inflation, the quasi-fiscal deficit widens. 14. This situation created a massive imbalance between demand for and supply of money in the first six months of 1989, while the inflationary process left the Central Bank without instruments to deal with it. The collapse of the exchange rate led those who held dollar-denominated deposits in the domestic financial system to shift them abroad, putting pressure on Central Bank reserves and heightening fears about the future exchange rate. Also, the public debt, estimated at 16 percent of GDP, continued to grow explosively because high interest payment obligations by the Central Bank on the forced investments of the financial system were capitalized into new forced investments. Moreover, the Central Bank was being required to finance the payment of maturing government bonds that could not be rolled over. As inflation gathered momentum and confidence waned, the public shifted its portfolio rapidly out of austral-denominated assets in order to avoid the inflation tax and the threat of default. With the demand for money falling, the Central Bank was forced to try to absorb the excess supply, but had to rely on ever higher reserve requirements (i.e. forced investments)--which bear interest and therefore ultimately require monetary expansion--to absorb money. The Government was left with the choice between hyperinflation and financial sector collapse. 15. Financial System. The proximate cause of the stress in the finan- cial system was the flight of austral-denominated deposits to dollars and other assets. Withdrawals have put enormous pressure on commercial banks, since the forced deposits of the commercial banks with the Central Bank are not formal reserve requirements and are not automatically released pari passu with deposit withdrawals. Moreover, other assets of the banks' port- folio were not performing, as many firms were reportedly unable to service debt with the banks and were receiving rollovers. The Central Bank pro- vided new rediscounts, eased forced investment requirements, and decreed sporadic bank holidays and limits on deposit withdrawals during May and June. 16. Price Misalignment. Public enterprise prices were severely mis- aligned. By end-June, real public enterprise prices were roughly 60 per- cent below levels prevailing at end-year 1988, the level necessary to gen- erate positive savings. This is the reason why the Government more than doubled real prices as a principal measure in its new program. Realigning these prices will necessarily affect the price level because of their own heavy weight in price indices as well as the fact that so many private sector prices are indexed to these. 17. Recession. At the same time, the real economy, already in its second year of recession, was contracting further. The appreciation of the austral in the waning days of the Plan Primavera had led to a mini-boom in external travel and import purchases of consumer durables, and the flight from australes to goods in February produced some increase in demand for industrial goods. However, the hyperinflation compounded the effects of  the high interest rates on real sectors. The sharp reduction in real wages in February-June which cut private consumption, the shortage of trade credit and the inability of many business owners to determine what their own prices should be have led to a slowdown in economic activity. Designing Stabilization Programss Lessons of the Past 18. The experience of the last five years suggests three principles for the design of a program to stabilize the economy. First, the short- term plan must be built upon a jrogram of structural reforms that provides confidence for investors and the public at large that changes in the con- duct of public finances are indeed permanent. Second, the nominal public sector borrowing requirement must be credibly and immediately reduced to levels that can be financed through foreign credit--recognizing that in the immediate weeks ahead, until an agreement with external creditors can be put in place, the predominant foreign source will necessarily be a con- tinual accumulation of arrears. Third, the monetary component of the stabilization package will have to ensure that the public sector will not use the inflation tax to balance its accounts in the future. 19. As the Henem Government implicitly recognized in its July 9 pro- gram, past experience argues strongly that the Government take several structural measures prior to--or simultaneously with--putting the stabili- zation program formally into place. Indeed, the Government began formulat- ing its structural reform program immediately and announced key measures. This strategy inverts the past approach of first trying to close the fiscal gap with ad hoc revenue and other measures, and deferring structural measures until after stabilization is achieved. Simultaneous efforts at structural reform are necessary because the deficit remains high relative to available domestic and foreign finance, while the demand for austral- denominated assets remains low and volatile. As long as the deficit is seen to be eliminated in sustainable form through structural measures, the private sector will have no faith in the sustainability of the program. Lack of private sector confidence has also resulted in a secular decline in the holdings of financial instruments denominated in domestic currency, and increased the responsiveness of portfolio shifts and money velocity to inflationary expectations. The base of the inflation tax has been narrowed beyond a point where it can help close the accounts of the public sector. Furthermore, early elaboration of a comprehensive medium-term program and successful implementation will credibly convey a sense that price stability will be endurinig and that the economy can recover. 20. A companion lesson from past stabilization attempts is that prices of public enterprises cannot be used as a mainstay of stabilization for any length of time. If real prices are allowed to deteriorate, it becomes virtually impossible for the sector to maintain savings at a level con- sistent with deficit reduction objectives. After the stabilization plans of recent years, falling real prices now raise inflationary expectations since the private sector is aware that tariffs will eventually have to be increased, and may even anticipate these with large price movements of their own.  - vji - 21. Past experience also indicates that a heterodox program--a social pact on prices, some adjustment in fiscal accounts, and tight monetary policy--entails important pitfalls. The major strength of a heterodox plan, the ability co abruptly bring to a halt inflation through the imposi- tion of wage and prices controls and/or som'a other form of social con- sensus, is also its fundamental weakness. In both the Austral and Primavera programs, the magnitude of the reform task was underestimated: The fact that the benefits of the program occurred at its inception removed pressure from the authorities and Congress, who then balked at paying the political price for some of the less popular measures. Once it became evident to the public that the structure and behavior of public finance had not changed fundamentally, inflationary expectations began refueling, the exchange rate-domestic inflation cycle took its course, the positive Olivera-Tanzi effect reversed, and the resulting deterioration in fiscal performance displaced whatever measures of a structural nature may have been under implementation. Policy Options 22. A thorough stabilization must therefore be predicated upon mutually reenforcing reforms of the public sector, monetary policy, the exchange rate, and external finance. Achieving objectives described below could be attained through various strategies. The kc, elements of each approach, however, must be the same: up-front fiscal reforms that include difficult-to-reverse structural measures, clear and transparent monetary and exchange rate rules, and an eventual accord with external creditors. 23. Public Finance Reform. The cornerstone of the program must be explicit political agreement on a comprehensive reform of public finances. The agreement would have to signal a complete change in policy regime: as such it would have to offer to the public concrete guarantees against reversal. The central component of the package would be a sharply declin- ing fiscal deficit which would remove the need to use the inflation tax; the objective would be an immediate primary surplus to service domestic internal debt and eventually recapitalize the Central Bank. This would be built upon integrated reforms aimed at reducing expenditures, rebuilding the tax base, and reducing the deficits of the public enterprises, social security system, and provinces. This would be enforced by the adoption of a transparent monetary rule stating that future currency emissions would be limited to increases in foreign reserves of the Central Bank. As a con- sequence, substantial and immediate adjustment of the public sector and public banks would be necessary, so as to reduce the public sector deficit to a level equal to net new borrowings of foreign resources. 24. Monetary Reform and PolicZ. A strong monetary reform that per- mitted monetary expansion solely as a function of increases in interna- tional reserves would provide the public confidence necessary to slow inflation. Monetary policy would be assigned a purely passive role. The policy would be based on an ex-ante judgment that the risk that this firm monetary rule might create a prolonged recession, and thus erode public support for the program, is less than the danger that the private sector will not believe the program is sustainable and will maintain its infla- tionary expectations.  - viii - 25. Monetary reform would also involve a restructuring of the domestic internal debt, and eventually recapitalizing the Central Bank. This could be done through exchanges of debt instruments with the Central Government. The outstanding stock of forced investments from the commercial banks deposited with the Central Bank would be converted into long-term secur- ities of the Government carrying a fixed nominal interest rate. To service these obligations, the Treasury has to mobilize a sufficient surplus to pay interest and amortization at the rate consistent with the stabilization strategy and targets. The only alternative is to write down the value of these asset3, with its adverse implication for future creditworthiness. 26. Exchange Rate. The monetary reform (including the new rule on monetary expansion), together with the change in the fiscal policy regime, would allow the Government to maintain a fixed exchange rate against the dollar or a basket of currencies. This would provide the nominal anchor necessary to op-rate a successful stabilization after hyperinflation. Since international reserves are low, an important element for success is the availability of foreign resources to provide reserves to back the new exchange regime. An early arrangement with the IMF is therefore particularly important. 27. External Finance. Garnering foreign support will be difficult. External creditors, like their domestic counterparts, have no alternative but to recognize the limited capacity of the Argentine state to service its obligations. As shown in the projections in Chapter V, it seems unlikely that Argentina can fully service its private commercial debts in the medium term; a strong fiscal program predicated on sharp deficit reduction has extremely limited scope for normal debt servicing in the years immediately ahead. Nonetheless, all external creditors share with the Government a fundamental interest in Argentina's medium-term price stability, growth and restored creditworthiness. Sustained price stability may eventually attract back some of the enormous capital flight that has occurred since 1980. In the short term, however, net transfers to commercial creditors will have to be restricted to a minimum; nonetheless, soon after a comprehensive medium-term program is in place and the stabilization is underway, the Government should initiate negotiations with the commercial banks to explore solutions to Argentina's long-term financing problem so that external transfers can be tailored to the country's capacity to pay at a time when the need for sustained growth is paramount. C. Main Components of Structural Refonm Program: A Comprehensive Refonm of the Public Sector 28. Deficit spending of the Argentine public sector has plagued econo- mic management in Argentina for decades. Noninterest expenditures as a share of GDP rose in the late 1970s because of increases in social security and provincial spending, and then rose even more sharply in the early 1980s, driven by continued provincial spending and the South Atlantic War. After the public sector absorbed the private foreign debt, interest expen- ditures put increasing pressure on public finances; interest payments rose from under 3 percent of current expenditures to over 20 percent.  - ix - 29. After reaching a peak in 1980, tax revenues began a secular de- cline that has been offset from time to time only with inefficient and trarsitory measures, including most notably export taxes, but also taxes on petroleum products, savings, checks, cigarettes as well as compulsory savings. While many of these had the advantage of being readily collect- able, they have progressively introduced significant distortions that dis- courage exports and reduce international competitiveness, discourage sav- ings and channel investment into low productivity areas. 30. At the heart of the inability to contain public finances has been the weak control over the various components of the public sector outside the central administration, including public enterprises, social security and provincial finance as well as the disguised fiscal expenditures through the Central Bank. At the beginning of 1988, the Government adopted a new principle for fiscal policy that enhanced accountability of these govern- mental sectors: It established clear guidelines for transfers between the sectors and established a rule of sectoral self-sufficiency. At the same time, the Government reduced discretionary expenditures through the Central Bank by slashing rediscounts to public banks and terminating the practice of allowing provincial banks to overdraw their accounts at the Central Bank. 31. These efforts have increased transparency and political awareness of the problem, but have not remedied the deficit of the public sector. For that, a comprehensive reform of the public sector is necessary. This would entail efforts to reduce expenditures, improve taxation, and reform public enterprises, federal provincial financial relationships, and social security. (Structural measures that would markedly enhance the strength of the stabilization program if announced prior to or simultaneously with the program are denoted with an asterisk.) Expenditure Reductions 32. Expenditures of the nonfinancial public sector have fallen by about 10 percentage points of GDP since 1983. However, present expenditure levels at 30 percent of GDP are still high relative to capacity for mobi- lizing tax resources as well as relative to other countries at similar levels of per capita income. The process since 1983 has not been part of conscious government policy, but the result of successive marginal con- traction imposed by the threat of inflation; consequently, the pace of expenditure reduction has always been too slow to achieve stabilization goals and the process itself has been inefficient. Too often the Govern- ment has chosen to contract investment in the hopes that the fiscal crisis would pass, rather than make the difficult cuts in public employment and inefficient programs and subsidies. 33. A major component of a structural reform program would involve expenditure reductions. This would have to focus on employment reduction throughout the public sector. Employment increased by 20 percent in 1983-88 in the central administration and 28 percent in the provinces --despite acute budgetary constraints. Since average public sector wages  - x - have fallen to very low levels, employment reductions should be deep enough to permit some increase in average wages even with some gains in reducing the overall wage bill. The Government should strive to mitigate the hardship imposed by lay-offs through programs of early retirement with full pensiou, severance pay, and temporary income-maintenance in accordance with workers' length of service. 34. Similarly, the Government must mount a comprehensive effort to identify programs that could be cut to achieve savings and improve the efficiency of the public sector. In the central administration, the health, education and housing budgets should be carefully scrutinized since there is a need for greater efficiency in delivering these services at the same time for additional savings are needed; in education, for example, expenditures for primary and secondary education have been reduced far more than expenditures on higher education, even though the latter entail sub- sidies to the relatively wealthy and could be supported through a combina- tion of increased direct charges with more scholarships and loans for poor youth who would otherwise qualify for entrance. In transportation, the Government could consider partial divestiture of the port facilities, which are inefficient and costly; greater reliance on toll roads and privately constructed toll roads could increase badly needed investment in this sector as well as reduce the cost to the budget. In agriculture, reforming the National Grain Board (Junta Nacional de Granos) along the lines sug- gested in Annex Chapter IX would provide some savings. Additional expend- iture reductions can be achieved through measures in the public enterprise sector, such as divestitures and employment reduction, and in social secur- ity; these are discussed below. 35. These reductions in expe"ditures as well as other public sector reforms necessarily involve abrupt and disruptive changes in the lives of some Argentines--workers who are laid off from inefficient government pro- grams or enterprises, recipients of subsidies, and consumers of state enterprise products and services whose prices may be increased. While these social costs are relatively small when compared to the alternative of rampant inflation and prolonged stagnation, the Government should make every effort to maintain and strengthen the social support services for the poor--the social "safety net." This means carefully targeting remaining subsidies on low-income groups, improving the efficiency of delivery for existing social services, introducing user charges to recover costs from those who are able to pay, and improving collection and financial manage- ment of earmarked revenues. It also means improving the efficiency of regulations governing the private sector in the provision of these services. Finally, it entails channelling that component of shared revenues destined to service the poor to those provinces with a larger number of low-income families.l/ These efforts could substantially mitigate the human costs of stabilization and reform. 1/ While these ideas are not developed in this report, detailed suggestions to strengthen the social safety net are presented in the World Bank's report, Ar entina: Social Sectors in Crisis, June 1988.  - xi - The Tax System 36. The Argentine tax system has become increasingly deficient. Taxes have fallen and new taxes have been neither efficient nor equitable. The system has shown a relatively low buoyancy, largely because of the increas- ed use of the tax system to promote regional and sectoral industrial development. Ad hoc taxes have been imposed on several occasions; the Government has repeatedly granted tax amnesties, with lower revenue results. Meanwhile, the administration of taxes, beset by lack of resour- ces and excessive variability in legislation and management, deteriorated substantially. 37. Important changes were introduced through a tax package in December 1988. Although Congress rejected a proposal to generalize the value-added tax (VAT), the Government introduced changes in direct taxes that modified the industrial promotion system; if sustained and implemented they could lead to a significant reduction of tax avoidance and evasion and of the economic distortions generated by industrial promotion. Still, these efforts did not go far enough. 38. A comprehensive tax reform is therefore necessa-y to overhaul the tax system. It should be guided by principles such as tiose outlined in the Law of Economics Emergency introduced as part of the July 9 program: namely, that all subsidies through the state be eliminated, except for those directed at poverty alleviation. A program of structural reform in tax regime would include: * (a) A reform of the value-added tax that would lower the rate and broaden the base as well as revamp the income tax to broaden its coverage and enforce its application. (This reform would encompass some of the other measures described below.) * (b) The permanent suspension of the general and the provincial industrial promotion regime to replace the proposed temporary and partial suspension (laws 21.608, 22.021, 22.702 and 22.973). * (c) The phase-out of the tax exemption regime for Tierra del Fuego. Some temporary financial transfers to the provincial budget could help compensate workers; benefits in the form of tariff exemptions could be retained if the Government wished to convert the island to an export processing zone. * (d) Acquired rights of beneficiaries under the above industrial promotion could be capitalized via the issuance of secur- ities; these should be paid on the basis of audited state- ments of projected production, (i.e., the "theoretical cost") made at the time of original application for benefits. * (e) The permanent abolition of promotional schemes for exports --including the PEEX program and the export subsidies. The competitive exchange rate already provides sufficient incentive for exports and the fiscal savings are substantial.  - xii - 39. Measures that would at the same time promote a more efficient utilization of resources, foster public enterprise reform and increase public sector revenues in the area of taxation of the energy sector, would include: (a) The imposition of VAT on all oil products; a simplification of excise taxes to be replaced by only one ad valorem tax, fixed on the supply price at the plant. (b) The state oil company, YPF, should be subject to income taxes and, if public finances require additional transfers, the Government should use its power to pay dividends as the means to extract profits from the sector. 40. Trade taxes distort investment and, therefore, the move away from them should be pursued with determination. (a) The exemptions from import tariffs on capital goods and other imports should be abolished. This would reduce the dispersion of effective protection rates, increase revenues, and increase employment. * (b) Product-specific export taxes should be rapidly replaced with a general tax reform that includes the agricultural sector. In the interim, export tax payments should be credited against value added tax obligations of producers. 41. Solving the problems of the tax administration will involve a determined medium-term effort on the part of the Government, as well as the implementation of measures in the tax system to simplify its administra- tion. This will involve among other things: * (a) Measures to increase General Tax Administration's (DGI) internal technical ability through improved organization, data processing, and better personnel procedures. * (b) Strengthen administration measures that would reduce the complexity of the tax system, through the abolition of low- yield nationally administered taxes. * (c) Abolishing the simplified VAT system and approving laws pen- ding in Congress that would substantially increase DGI's powers, including meaningful and appropriatz sanctions for noncompliance by taxpayers. Public Sector Enterprises 42. Public sector enterprises have contributed substantially to the overall deficit of thle public sector--about half on average during the 1980s. This poor performance is the result of sporadic reliance on public enterprise price adjustments to achieve (temporary) macroeconomic stability as well as the use of the sector as a source of resources to channel  - xiii - subsidies to the private sector. The Government has pursued pricing pol- icies that have oscillated between providing sufficient resources to cover costs and compressing prices to achieve anti-inflation objectives as in the: Austral and Primavera Plans. Legal constraints have been imposed on public procurement through the buy-Argentina law (Compre Argentino), resulting in inflated costs and massive subsidies to private industry and other sup- pliers. Similarly, entrenched unions have exploited their political power to saddle the sector with excessive employment, especially in the railways. Finally, pricing distortions have been accentuated by the use of the energy sector as tax collector to cross-subsidize losses in the railways, social security system, and provinces. 4^-. To deal with these problems, the Argentine Government has pursued a dual strategy. rhe first element consisted of clearly delineating the rules for the transfer policy to the sector. This was based upon limiting Treasury contributions to cover the servicing of medium-term commercial bank external debt and what is due on account of special funds. The second element of the strategy was the full or partial divestiture of selected enterprises. The most important efforts were the proposed partial privat- ization of ENTEL (the state telephone company) and of Aerolineas Argentirias, although these have not yet been carried out. Several smaller privatizations were concluded for smaller government equity holdings owned through Fabricaciones Militares, the armed forces' holding company. Through the Petroplan and the Plan Houston, the Government has relaxed the monopoly of the state oil company (YPF) on potentially oil-rich areas so as to permit private participation in oil exploration. However, additional measures to increase the role of the private sector are needed to increase further revenues for the Treasury as well as expand production. 44. These efforts permitted a substantial reduction of the value of transfers from the Central Government in 1988, to only 1.1 percent of GDP. However, insulating the central administration from the public enterprise sector has required an internal cross-subsidy system, whereby the profit- making enterprises (essentially YPF) have provided funds to finance the loss-making ones (essentially the railways). The continued viability of this system depends on guaranteeing sufficiently high real prices and reducing the deficit of loss-making enterprises. Strains have already appeared, as the Government has a perennial conflict between anti-infla- tionary targets and revenue needs; other unresolved issues (such as royalty payments to the provinces from the oil company that involve a strong sub- sidy element) also threaten the ability to generate sufficient resources. But the more fundamental problem with this approach is that it leads to greater distortions in prices and discourages investment in one of the country's highest return sectors, oil and gas, in order to maintain con- sumption in the railways, social security, and provincial governments. 45. A medium-term program of structural reforms would contain several urgent elements, which if enacted would markedly improve the basis for stabilization and growth: * (a) Prices. The Government needs to maintain the post-July level of real prices of output, which implies future adjustmients that keep pace with increases in costs. By 1990, tariffs in  - xiv - the sector need to be sufficiently high relative to costs so as to generate a surplus on their noninterest current account equal to about 3 percent of GDP, thereby covering about half of their investment after interest expenses. Improvements over present levels could come from a combination of either expenditure reductions or real tariff increases. * (b) As it adjusts prices, the Government should formulate the new pricing structure to reflect an efficient resource alloca- tion, at least in terms of producer prices. (c) Royalties. The issue of ronalty payments to the provinces on petroleum and gas entails a heavy inmplicit tax on the sector to support provincial finances. The current reference price on which these royalties are paid dates from the early 1980s and is too high; it should be reduced to international levels as soon as possible. (d) Budgetary Control. The Governmen' needs to enhance budgetary control over the public enterprises. The respective roles of the successor to DEP (if any), the Ministry of Economy, the SIGEP and the various Secretariats in the Ministry of Public Works should be clearly delineated. The collective budget for the public enterprises, the Ministry of Economy's cash ar4. 'ommitment budgets and the financial slttements should all be drawn up within the framework of a uniform information system. (e) Institutional Framework. The market structure and regulatory framework of each sector requires definition so that enter- prises are subjected either to the discipline of the market or well-defined regulations regarding pricing. For those enterprises designated to function as regulated monopolies, the regulatory framework should be clearly established in the law so as to permit maximum managerial discretion within a carefully elaborated legal framework, thus minimizing the imposition of pc'itical and noncommercial objectives. (f) Entermrise Restructurinj. Without enacting internal reforms within each enterprise to induce managerial responsibility, accountability, and autonomy, changes in the regulatory and competitive environment will not have their full desired effects. The Government should therefore continue and accel- erate restructuring programs currently under discussion to etrengthen management, improve personnel policies, and enhance financial controls. Management could be strengthened by restricting political appointments to boards of directors and/or a few senior-level posts as well as providing improved salaries, attention to qualifications in appointments and promotions, and sound training. These efforts could permit considerable reduction in expenditures and improvements itn long-term efficiency.  - xv - * (g) Procurement. The Compre Argentino law should be modified to allow foreign competition in the bidding for contracts of the public sector, restricting the advantages of domestic firms to the level of the ad valorem tariff. This would effec- tively abolish the implicit subsidy ystem to the private sector and reduce the operating costs of the public enter- prises. * (h) Employment Rationalization. Redefining the role of public enterprises surfaces the need to examine employment levels and ways to redutce public employment without causing affected wcrkers unnecessary hardships. The Government should examine programs of early retirement; in the railways alone, one- third of the workforce is over the age of 55. It should also consider programs of severance pay and/or programs of income maintenance for laid-off workers in accordance to their tenure with the enterprise. (i) Cross-Subsidies. The Government needs to redefine the mechanisms and degree of cross-subsidization among the public enterprises and needs to establish a transparent scheme for resource transfers. If the Government wants to subsidize selected loss-making enterprises, it should transfer these to the budget so that these expenditures are annually subjected to the budgetary review process. Highest priority should be given to reducing the demand for expenditures in Ferrocarriles, which absorbs most of the cross-subsidies and accumulates losses of nearly one percent of GDP annually. I * (j) Divestiture. The Government should accelerate planned privatizations and review for possible inclusion remaining enterprises and activities that could be privatized. In the process, it should establish clearly defined legal procedures to ensure an unbiased selection of private investors and competitive bidding. Federal-Provincial Relationships 46. Prior to the new coparticipation (i.e. revenue sharing) law passed in late 1987, the distribution of federally-collected revenues had become subject to political discretion. This was the culmination of years of unclear rules over revenue sharing. In addition, provincial governments had for years relied on provincially-owned public banks to fund short-term deficits; the provincial banks could in turn appeal to the Central Bank for rediscounts whose repayment would subsequently be capitalized. The system of irregular and highly politicized transfers invited provincial adminis- trations to increase spending with minimal concern for revenues. It is no surprise that provinces have been the largest single source of increases in noninterest expenditures of the consolidated public expenditures. No less important, provinces have made too little effort in improving their own revenue collections, which have languished over the last decade.  - xvi - .47. The new coparticipatien law that took effect in 1988 was designed to chenge this ir. entive framework. It increased the provincial share of coparticipated revenues to 57.5 percent. and set clear limits -in discre- tionary contributions from the Treasury to a maximum of 1 percent of GDP. The law also provided a political mechanism for secondary distribution of the resources. The approval of the law was one of the crucial elements for the success of the "separation" strategy pursued by the previous adminis- tration. This agreement was also reinforced by the closing of the redis- count window for the provincial banks at the Central Bank, which had been an important source of deficit finance, particularly in 1987. However, the arrangement has proved tenuous. The previnces, unable or unwilling to increase revenues and reduce expenditures, requested and were granted addi- tional funding twice in 1988. 48. A program of structural reform would transform the provinces into agents of development which generate surpluses that they can invest wisely to increase total provincial product, thereby augmenting their future tax revenues. Specifically, this would include: * (a) Improving the information on provincial public finance. A first step in improving public sector finances for general macroeconomic planning should be to require the provinces to report existing data on their finances to the Central Govern- ment. Provincial governments should be required by law to report to the Treasury expenditures on a cash and commitment basis every quarter as a condition for receiving their share of revenues under the coparticipation agreements. The Treasury should establish an efficient information system for the collection and analysis of the provincial budget data. Fourth, information on the provincial banks' net asset posi- tion with provincial governments should be reported regularly to the Central Bank; * (b) The Government should declare its intention to maintain the current revenue sharing law, halt any further transfers, and oppose any additional appropriations in Congress during the budget year; (c) The Federal Government should work with the provinces to increase their own revenues, reduce expenditures and increase their efficiency. Revenue collection and personnel policy is of highest priority in the provincial governments. The Government could design an incentives system as part of future revenue sharing laws or investment financing from external credit sources to encourage these provincial efforts; and * (d) Disallowing Central Bank financing to provincial banks as a means of financing the provincial governments, including reintroduction of overdraft facilities and rediscounts.  - xtvii - Finances of the Social Security System 49. The social security system has had a strategic role in defining the shape of Argentina's public finances. The aging of the population has caught up with the system; the ratio of the economically active population to the number of retired beneficiaries fell by 13 percent between 1970 and 1985, and is expected to fall even further. X the same time, the petnsion program had virtually no earnings from invested capital, since the sur- pluses of the early years of operation of the system had been consumed by the inflationary episodes of the 1960s and 1970s. To make matters worse, the heavy burden of wage taxes--55 percent of net wages--has led to wide- spread evasion and under-reporting; moreover, inadequate atte.ation to revenue record-keeping has permitted widespread abuse of potential benefits. 50. The initial reaction to the crisis consisted of arbitrary reduc- tion of benefits and increasing recourse to transfers by the central administration. From their legal level of between 70 and 85 percent of sal&cy, payments have fallen to under 40 percent of salary in recent years. In 1987-88, the Government undertook several revenue measures, with the dual objective of gradually restoring benefits to their legal level and insulating the central administration from transEers to the social security system. The measures were comprised of increase3 in wage-related contri- butions to the social security system and the earmarking of taxes on cer- tain goods provided by public enterprises (gasoline, telephone, electri- cit)'). 51. The additional revenues allowed the gradual closing of the finan- cial gap in the social security accounts in the very near term. However, projections of the medium-term deficit at current benefit levels imply that either contributions must keep rising, or that the revenues from the ear- marked taxes on goods must rise in real terms, or both. However, the scope for either of these measures is virtually nonexistent because wage taxes for social security and other programs are already very high. A continued increase in earmarked revenues would imply a continued undesirable increase in relative prices of the goods to whose prices the taxes are linked. Adjustments aimed at mobilizing more resources for the current system--such as increasing formal-sector employment and reducing the current transfer of 10 percent of social security income to the health insurance fund for retired persons--offer no hope for increasing system revenues. 52. A program of structural reforms might focus on constructing a different pattern of benefits that would sharply reduce pension obligations at higher income levels to substitute for entitlements that will be unsus- tainable in the future. Benefits could be reduced in a way that could actually increase both the efficiency and equity of the benefits package: (a) Present low retirement ages--age 55 for women and 60 for men--drive the system towards deficit, even at high quota rates. There is no alternative to increasing retirement age by 5 or 10 years so that years of contribution would rise relative to years of receiving benefits; alternatively, the Government could offer substantially lower benefits for an optional retirement at the earlier ages;  - xviii - (b) Reduce the rate of salary replacement from 8Z to about 40 percent; alternatively, the government could permit a low, basic rate of salary replacement with voluntary purchase of additional coverage. This should be implemented with a tran- sition period to account for acquired rights; and (c) Use an extended salary base for calculating pension rights in lieu of the last salary--for example, a 10 year real average. D. Structural Reform Programs Monetary Policy and Finance 53. For decades, the financial system was accustomed to sequestering private financial savings to fund the public sector deficit. As part of this process, the Central Bank became over time a vehicle for channelling subsidies from private commercial banks to the general government and to the inefficient public banks. The Central Bank used forced investments as a way of tapping into depositors' funds. These were then channelled to: (i) the general government via payment of expiring public sector bonds and balancing of a short-term float to the social security system administered through the commercial banks; and (ii) via rediscounts to money-losing public banks, most notably the National Mortgage Bank (BHN), the National Development Bank (BANADE), and to provincial banks. These institutions in turn channelled substantial sutsidies to middle-class loan recipients, industries and other activities as well as some provincial governments. Losses in these intermediation activities have become the quasi-fiscal deficit of the Central Bank.2/ 54. The consequences of this structure have been twofold. First, the scope of the Central Bank to pursue anti-cyclical stabilization has been tightly constrained by the need to secure financing for the nonfinancial public sector deficit and its own deficit. By adding a source of expansion to the monetary base, the operating losses of the Central Bank complicate the difficulties of managing monetary aggregates in the presence of excep- tionally narrow austral-denominated financial markets. Second, the financing requirements of its own quasi-fiscal deficit have added to the burden on domestic savings produced by the public sector deficit. The resources drawn from the commercial banks have gone to finance relatively inefficient public-sector activities, leaving the private sector starved of resources essential for working-capital and commercial finance. The scarcity of such finance has contributed to Argentina's disappointing real economic performance over the past 15 years. 55. Both the interest rate rules for Central Bank assets and the inherent quality of those assets have contributed to the Central Bank's deficit. The external component is the interest paid on external obliga- tions (incurred as part of the 1981-87 debt refinancings) less interest 2/ This is defined as comprising the operating loss (or profit) of the Central Bank on account of intermediation operations, plus any adjustments necessary to take into account the fact that some rediscounts issued to the financial system and other entities may never be recoverable, i.e., they represent subsidies that should be part of the NFPS budgetary allocation.  - xix - earned on gross international reserves. The domestic component is the loss (or profit) on account of domestic operations. Most Central Bank assets are rediscounts to failed financial institutions or to public banks such as BHN and BANADE, which are unable to service the lebt; the interest on these assets has been set at inflation plus some slight mark-up. Nonmonetary domestic liabilities are dominated by forced investments from commercial banks, which pay market interest rates. During periods of high real interest rates, the domestic component of the quasi-fiscal deficit tends to widen; for example, in December 1988, the average rate of interest on assets was 8.2 per( nt per month while that on liabilities was 11.4 per- cent. These losse. also include provisions for bad or nonperforuiing loans. 56. A program of structural reform to end irnflation and revitalize the financial system must limit the power of the Government to fund its deficit through capturing resources from the financial system. The best way to do this after the failed experiences of the Plan Austral and Plan Primavera is to limit the powers of the Central Bank to create money as well as sever the ties of intermediated cross-subsidies between the private commercial banks and the public banks. While this would depend heavily on the choice of stabilization program, the most effective structural reforms are those implicit in the program outlined above, including: * (a) Strict limitations on the power of the Central Bank to create money through reforms that would tie money creation to increases in international reserve*v * (b) Making the Board of Directors fully independent of the Government (i.e., removable only through an impeachment pro- cess for misconduct, and thus able to deny commercial-bank and government credit requests without fear of dismissal). * (c) Recapitalizing the Central Bank through exchanging existing liabilities for new longer-term liabilities; this would end the Central Bank's current intermediation nexus that creates the quasi-fiscal deficit. * (d) The external component of the quasi-fiscal deficit could be substantially reduced by transferring the foreign liabilities associated with the 1983-87 commercial debt restructurings (including the "new money" operations) to the Central Govern- ment. While this has no effect on the combined public sector deficit, it does make the operations of the Central Bank and nonfinancial public sector more transparent, and facilitates the conversion of the Central Bank into a stronger monetary authority. And for the financial system: (e) The net flow of all Central Bank credits to the BHN, BANADE, and other public banks should cease immediately. This, together with the reforms of the Central Bank, would sever  - xx - the intermediation relationship between the Central Bank and the public banks. It would also imply that restructuring plans already contemplated for these banks would have to be accelerated or the institutions would have to be closed. E. Structural Reform Program: Trade and Industry 57. Argentina's postwar experience of persistent macroeconomic insta- bility and secular decline was preceded by the closure of its economy to foreign trade. Prior to the Great Depression the share of imports in GDP kept close to 50 percent. This indicator of openness fell to 5 percent at the end of World War II, and again in the mid-1950s. Since then, the import share has remained near 10 percent. Exports as a share of GDP, while fluctuating due to weather and domestic demand conditions, have fol- lowed che general downward trend of imports. 58. Inward-oriented trade and industrial policies initiated during the 1930s were maintained and intensified in the 1950s, a time when other coun- tries then at Argentina's level of development were removing their external trade barriers and taking advantage of the rapid expansion of international trade. Successive governments opted for import-substitution through import restrictions hoping to foster investment and productivity growth through accelerated domestic industrialization. Instead, the economy became more dependent on selected machinery imports for industrial growth and on agri- *.ultural commodities for export growth. Recurrent balance of payments crises frequently cut short industrial expansion and led to recession because imports vital during the second stage of import substitutione for expansion became unavailable. Total factor productivity in the nonagricul- tural sectors (excluding government) has grown at less than two thirds of the rate achieved in the agriculttral sector, and during the 19709 and 1980s, total factor productivity in industry has actually declined. While the share of industry in GDP has grown substantially in neighboring eco- nomies over the last decades, the industrial sector in Argentina remains at about the same level as four decades ago. 59. The closure of the Argentine economy, instead of reducing macro- economic instability, has contributed to the secular increase in the infla- tion rate and to the instability of the real exchange rate. The share of exports and imports in GDP turned out to be less important for the coun- try's exposure to trade shocks than the mechanisms that enable the open economy to cope with them. A price elastic aggregate import demand and capital flows tend to absorb a good part of the shock impact on the real exchange rate and thus on relative prices, while the discipline of intense competition keeps relative price changes from turning into a source of inflation. These mechanisms have been weakened. Increasing the import share of non-substitutable primary inputs and intermediates rendered aggre- gate import demand prices inelastic; intermittent balance of payments crises impaired the country's access to external credit; and the creation of sheltered domestic markets fostered a pricing behavior that has added an inertial component to inflation. Moreover, pricing in entrenched oligo- polies undisciplined by competition has probably acted to accelerate infla- tionary impulses through expectation-based mark-up pricing.  - xxi - 60. Also, trad a-id industrial policies undermined stability by adding to the deficit. Trade tax revenues have been an unstable part of the government budget. Revenues foregone, through industrial promotion incen- tives and overcharging on public sector purchases resulting from the "buy national" obligation of public procurement, have added up to 5 percent of CDP to the deficit. 61. Beginning in early 1987, the Government began to transform the consensus that the import-substitution strategy had run its course into an active reform policy. To have started and continued the reform is a major achievement because of the long-standing resistance of powerful vested interests. The new reform emphasized free trade status for exporters early in the reform process, coupled with a phase-out of various specific export promotion measures; a negotiated sector-by-sector approach to import liberalization; and an attempt, though not always successful, to maintain a competitive exchiange rate for trade transacti3ns. As a consequence, the average production-weighted tariff was lowered from 43 to 28 percent; quota coverage was reduced from 30 to 18 percent; and discretionary import licensing procedures were provisionally circumscribed. 62. A program of structural reform that would support sustained price stability and growth therefore requires that trade and industry reform not be postponed. In addition to the termination of the industrial promotion regime and of export taxation cited above, a program for structural reform would include: (a) The replacement of all quantitative restrictions that were exempted from the 1987-88 reform with ad valorem tariffs, and a subsequent tariff adjustment to bring the rates within the general tariff band. (b) The removal of specific tariffs; only for seasonal products should specific tariffs at non-prohibitive levels be consi- dered. (c) A narrowing of the tariff band a.ad reduction in average tariff levels; the band should be narrowed as soon as possi- ble from 0-40 percent to 10-40 percent; a program should be announced to reduce the band to 10-20 percent in two years to reach an average of about 15 percent. (d) Removal of export license requirements. F. New Sources of Growth 63. As President Menem indicated in his inaugural address, there is every reason to believe that the sacrifice and work implicit in an ambi- tious program of deep-seated reforms would be rewarded with economic recovery and sustained growth. Argentina's productive potential in abundant resources, agricultural lands, and skilled labor is perhaps unsur- passed in Latin America. A sound program of consistent reforms could not only put people back to work, but create new jobs at a much higher rate than during the last decade.  - xxii - 64. With macroeconomic stability resulting from a comprehensive reform of the public sector and a program of structural reforms that removes price and other distortions, it is entirely possible to foresee a rather rapid recovery from the recession of 1988-89. Output could conservatively be estimated to expand at rates in excess of 3.0 percent annually for the 1990-94 period. If the Government's reform program were especially strong --extending to trade, finance, and the real sectors (energy, agriculture and industry)--it is entirely possible that foreign savings of Argentines would be attracted back, allowing for even more rapid rates of growth. Argentine holdings abroad are estimated to be about US$45-60 billion--about the same size as its foreign debt; if only the annual income on these assets were to return, these flows could provide savings tc fund a much more rapid and enduring recovery. 65. Stabilizing the economy--the most immediate priority--will permit the recuperation of domestic savings and investment. If stability is to be sustained, savings--led by the public sector during the initial phase of recovery--must roughly double from their present extremely low rates by 1994 to finance increased domestic investment in productive activities. Private savings could well be a driving force financing growth in the financial system to channel savings to highly productive investments and inspire confidence among private savers and investors that their efforts will be rewarded. 66. The private sector would be a leading force during this period, increasing investment in response to new growth opportunities, exports and efficient import substitution. Such improvements in both saving and investment depend critically upon private sector confidence in the macro and sectoral policy framework and on the stability of these policies over time. 67. Exports would become one leading sector, based on industrial goods and nontraditional and processed agricultural goods. Assuming a consis- tently competitive exchange rate, there is also some room for the growth of agricultural exports beyond the growth of consumption in industrialized countries, as Argentina could readily regain the market share it has lost in recent years due to domestic supply factors. Nontraditional exports, led by new capacity in chemicals, plastics, machinery and transport pro- ducts, could grow at over 7 percent annually for the period. Industry too could be expected to grow in response to new demand for exports and effi- cient import-substitution activities. Finally, new investment would also provide a strong impetus to growth. If these possibilities come to pass, they could indeed mean that the sacrifice and work of today would unleash the abundant productive potential of the Argentina of tomorrow.  CHAPTER Is STATE-LED GROWTH AND INFLATION A. Background 1.01 State-led growth in Argentina has now come irretrievably to an end in a wave of macroeconomic instability and inflation. In the late 1940s, the State began to expand its role in the economy--to become ever more important as a net borrower of funds, investor, and source of subsidy for favored activities and interest groups. Subsidies took the form of tax exemptions and hidden transfers through the financial system. These eroded the tax base and with other factors compelled the state to rely increas- ingly on borrowing and the inflation tax. Large and chronic fiscal deficits became a central feature of the Argentine economy, and during the mid-19709 and early 1980s they exceeded 10 percent of GDP. State-led growth could therefore be sustained only through foreign borrowing and money creation. 1.02 The other dimensions of this state-led model were high protection for domestic industry and concentrated formal labor markets. High nominal tariffs, import prohibitions, quantitative restrictions, and opaque sub- sidies to industry (such as the tax exemptions in industrial promotion legislation and buy-Argentina policy of state enterprises) insulated the sector from international competition. Not only did the resulting price structure channel investment into activities with low productivity, it also reduced the importance of trade, enhanced the oligopolistic price setting power of industry, and made the economy more vulnerable to external price shocks. The highly organized labor sector succeeded in capturing some of the rent from the industrial system--through demanas that the public sector increase employment as well as wages. This was possible as long as the economy was expanding. As the economy slipped into long-term stagnation, the system produced conflicts over income shares with sporadic destabiliz- ing effects on the price level. These policy interventions and structural characteristics of the economy led to declining trends in the productivity of labor and investment that would heighten the country's vulnerability to financial instability. B. Growth, Investment and Savings 1.03 The state-led model began to exhaust itself in the mid-1970s when the long-run growth path of the economy--as measured in the 10 year moving average of GDP growth--turned sharply downward (Figure 1.1). Investment, traditionally 20-23 percent of constant price GDP, began a sustained fall to 11-13 percent. While investment by the public sector has stabilized at low levels only slightly less than the early 1970s, the private sector has recovered to only 50-60 percent of those earlier levels. The investment rates of the economy are now so low that they are barely sufficient to replace depreciating capital stock, portending low growth for some years to come. 1.04 The savings performance of the economy also reflects serious structural problems. National savings rates have fallen from about 20 per- cent of GDP in the early 1970s to under 10 percent. Trends in public and private savings provide a clue to the erosion in national savings. Public savings fell steadily from 1970 to 1975, and then again from 1977 to 1982, with only partial recovery thereafter. Public savings before interest  - 2 - Figure 1.1 Investment Savings (a) (c) GDP Growtht Long-Term Trend (10 Year Moving Average) Origin of Saving. 1970-87 % of GOP 6% _ . 40 Aj tW;E { C 4~~~~~~~~~~~0 Na,,t l \X0 4% 20 as 10 2% 90s , ,,40V -10 ............... 1030 1940 1060 '160 1070 1980 1970 1974 1078 1906 1066 (b) (d) Investment and Saving: 1970-87 Public Sector Primary Surplus and External Interest 1970-87