Transcript of meeting of the Executive Directors of the IBRD and IDA, held on Tuesday, February 16, 1993 : Argentina - Financial Sector Adjustment Loan Project

nm STRICTLY CONFIDENTIAL 1 NM INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT INTERNATIONAL DEVELOPMENT ASSOCIATION Tuesday, February 16, 1993 Washington, o.c. The meeting of the Executive Directors was convened at 10:03 a.m. in the Board Room, 1818 H Street, N.W., Washington, D.C., Mr. Attila Karaosmanoglu, Chairman, presiding. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  nm STRICTLY CONFIDENTIAL 2 C O N T E N T s .- ITEM PAGE 1 Proposed Loan - Argentina (Financial Sector Adjustment Loan) (including Country Assistance Strategy) 3 Mr. Collins 9 Mr. Haas 17 Mr. Kawahara 24 Mr. Hosny 27 Mr. Peretz 31 Mr. Grilli 58 0 Mr. Aris 67 Mr. Al-Assaf 71 Mr. Wilson 75 +- Mr. Jalan 7 9(i;;v Mr. Malan 83 Mr. Matambo 91 Mr. Sigrist 94 • Mrs. Herfkens 97. Mr. Potter 101 - MILLER REPORTING CO., INC. 507 C Succt, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 3 nm P R O C E E D I N G S MR. KARAOSMANOGLU: Good morning, ladies and gentlemen. Item one on our agenda is a proposed Financial Sector Adjustment Loan in the amount of $400 million equi- valent to Argentina. This memorandum includes a discussion of country policies and Bank Group assistance strategy for Argentina. We are pleased to welcome Mr. van Beek, Senior Advisor of Western Hemisphere Department of the IMF, who is attending this meeting. Ms. Dowsett-Coirolo of the LAC Region will introduc the assistance strategy and the proposal. Ms. Dowsett-Coirolo, please. MS. DOWSETT-COIROLO: Mr. Chairman, Members of the Board: Argentina has now completed several years of truly remarkable macroeconomic stabilization and structural reform. During this relatively short period, the government has reversed a long-term trend of deteriorating economic perfor- mance which had brought this once very prosperous country to the brink and then over the edge of hyperinflation, fueled by seemingly uncontrollable public sector deficits, massive capital flight and, perhaps most damaging, a complete erosion MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 4 run of confidence in the capacity of government to bring any meaningful improvement to the lives of the vast majority of Argentine citizens. The means by which the Menem administration has arrested this long-term deterioration are summarized in the document before you. The underlying themes were a fundamenta redrawing of the boundaries between Argentina's public and private sectors, and a recasting of the foundations of public finance. The Bank has been an extremely close partner in this effort. Economic and sector work, adjustment and -. technical assistance loans have supported a complete reform of the tax system and its administration; new systems for public sector budgeting, control and auditing; a significant downsizing of the public sector; one of the most impressive privatization programs worldwide, both in terms of coverage and speed of implementation; and a successful conclusion to the external debt crisis, laying the basis to reestablish Argentina's creditworthiness in private markets. While the Bank's role has been instrumental, the IFC has also actively supported Argentina's reemerging private sector through a number of privatization related projects and other assistance to help develop a more competi- MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 5 run tive local industry. The other multilaterals, the IMF and IDB, as well as the Japanese Export-Import Bank, have also given significant adjustment support and technical assistance during this period. Certainly, however, the task of adjustment in Argentina is far from complete. Some major macro management and medium-term development issues lie ahead. First, reforms to restructure provincial finances, improve labor market flexibility, place the social security system on a sound financial basis and ensure that it generates essential resources for capital market development, are all high on the agenda of actions needed to consolidate the government's macroeconomic program. The Bank will be active in all of these areas through our country economic work and, in the case of provincial structural reform, through lending as well Secondly, unlike Mexico and Chile, which have undergone a decade or more of consistent structural reform and fine tuning, Argentina still needs to give greater institutional depth to its adjustment efforts. The long-term economic crisis has taken a tremendous toll on the country's institution, not only at the center, but also at the sub- national level to which must of the responsibility for public service delivery is being decentralized. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546·6666  STRICTLY CONFIDENTIAL nm 6 The challenge for the Bank will be to provide useful analytical support and sectoral advice, and to design lending vehicles that enhance the operational efficiency of institutions of critical importance, especially in the areas of human resource development, poverty alleviation, regulator oversight of private activities, and environmental protection. Finally, Argentina's private sector clearly must play the pivotal role in leading the country's economic recovery. Structural reforms instituted thus far have provided a major stimulus. By helping to reduce the federal government's role in banking, the financial sector adjustment loan before you today would further the development of a sound and transparent financial system, capable of mobilizing resources through longer-term instruments to meet the investment needs of Argentina's private industry. Beyond the FSAL, Bank and IFC assistance will also be needed in the design and establishment of suitable regulatory frameworks, financial intermediation, industrial technology development, and capital market development. In summary then, we see the Bank's role in Argentin changing in several important respects over the next few years. Macro stability and progress in addressing fundamenta structural issues will remain an essential component of our MILLER REPORTING CO., INC. 507 C Sueet, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 7 nm work, but the emphasis will shift increasingly towards institutional strengthening of the public sector, with special attention to social development, poverty and environ- mental issues, and to selective support for private sector development. Adjustment lending would be largely replaced by investment lending. As this occurs, the annual volume of Bank financing would inevitably decline somewhat. Nonethe- less, our program would still be an ambitious one. Of the total $5 billion of lending suggested for FY93-97, about one- third will have been committed after approval of today's financial sector loan, still leaving significant average annual lending over the remaining four years of some $800 million to $900 million., This scale of lending per se should present no issues for the Bank, as our exposure in Argentina is still quite low. Rather, the Bank's willingness to proceed with such a program should be governed by several other considera- tions. First, continued progress on the fiscal fundamental is certainly a sine qua non for the success of the govern- ment's development program. So, we will be looking very closely at the maintenance of an adequate operational primary MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 8 surplus, as well as at maintenance and deepening of trade, financial, public sector and privatization reforms to date. Second, Annex XII of the CAS, country assistance strategy, outlines some key sectoral policy and institutional issues on which we will be maintaining a dialogue -- progress or delays in each case will govern the pace at which we are able to develop specific sector lending operations. Finally, performance in timely implementation of the ongoing portfolio should always be an important criterion I for determining the rate of new lending. Argentina's record has improved steadily over the past few years, helped more than anything by the strengthened macroeconomic environment, but there is still a long way to go. Accelerating disburse- ments and reducing the incidence of completion delays would be important indicators of the rate which Argentina is able to absorb new Bank lending. In closing, let me say that our country assistance strategy is governed by a definite sense of optimism, not only because we see progress in Argentina on all the essentia macroeconomic indicators, impressive though that may be, but because we also see a country whose population is now beginning to show the first signs of renewed confidence in their government's ability to improve their well-being and MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 9 nm - that of future generations. Thank you. MR. KARAOSMANOGLU: Thank you. Mr. Collins, please. MR. COLLINS: Thank you, Mr. Chairman. We had an opportunity to preview briefly the country assistance strategy last month, and of reviewing the second public enterprise reform loan, and now with the full statement of the strategy, we would just like to make a number of points. First, reference in the introduction, consolidating macroeconomic reform, remains a critical goal for Argentina and the Bank today. The recent public enterprise reform loan to today's financial sector adjustment loan and the prospect of a provincial adjustment lending program all testify to the Bank's awareness and commitment to this goal. The assistance strategy includes intentions to strengthen and develop the institution's economic management and to address social security reform and labor reform through economic and sector work. While the institutional strengthening is being addressed through several different loans, the assistance strategy identifies no specific future lending in support of MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 10 either social security reform or labor reform. I just wonder does the Bank plan any specific lending linked to these policy objectives or will the Bank be relying on the overall macroeconomic dialogue? Now, in the areas of health, education, fiscal reform and privatization, the Bank, as noted in the introduc- tion as well, will be working increasingly with the provinces we do agree that, in light of excessive provincial expendi- tures, resulting from legally mandated transfers, that fundamental changes are necessary to provide stronger incen- tives for the provinces to reform. In light of past experience and the findings of the Wapenhans Task Force, the strategy rightfully places emphasis on strong government ownership, substantial institutional strengthening, clear objectives, simple procedures and very carefully selected programs in the provinces. I think paragraph 64 found on page 23 really succinctly conveys these essential points. In proceeding with this agenda, I would be inter- ested in learning how the Bank intends to employ its field office in Buenos Aires. As investment project preparation is likely to encounter difficulties with transfer of respon- sibilities to the provinces, it seems that there could well MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 11 be a clear stepped up role for a local office. We certainly support the special emphasis on poverty alleviation with additional resources devoted to health, education and housing policy formulation. While sound macroeconomic fundamentals remain a prerequisite for effective poverty alleviation programs, the sequencing of targeting vulnerable urban groups first, then tackling the under-developed northern provinces, really strikes us as rather well conceived. Turning now to the environment, the document notes that weak institutional arrangements and ineffective legal and regulatory framework characterize Argentina's environmen- tal policy. We do agree with this assessment, and urge the Bank to use its expertise to help strengthen the country's environmental policymaking and enforcement. We will continue to pay particular attention to energy and infrastructure issues, promotion of demand-side efficiency, and completion of the Yacyreta project and accompanying sewage and sanitation loans in the pipeline. I was also interested in the YPF pollution control program alluded to in the document. I would be interested in perhaps learning a little more about that here. - With Argentina's trade, the Bank and Argentina's MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 12 nm trade and public enterprise reform loans, the Bank has been very active in fostering private sector growth. We would note that in this connection there is always scope for more collaboration with the IFC, and we encourage the IFC and Bank to focus increasingly on domestic savings, and social . J' security reform, as referenced in the document, with attent10, to improved pension fund management. I think there could be some real collaboration between the two institutions on this front. Argentina's dramatic record of privatization, as noted in Ms. Dowsett-Coirolo's introduction, has really set an admirable example for other countries in transition. We are particularly interested in learning more from lessons of this experience, and I believe Pat Coady mentioned something about this in the review of the public enterprise reform loan. And, in particular, how lessons from this experienc may apply in other contexts. So, accordingly, we think that a Board seminar, if the Board deems it appropriate, would be very useful to examine the privatization and to discuss the relevance of the lessons learned to privatization underway elsewhere. So, that is something we think would be worth spending a little more time on. - Lastly, on the country assistance strategy, MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 13 paragraph 65 in closing notes that within a short while, really the preponderance of Argentina's assets will be in private hands. This will place a major burden on Argentina's capital markets, and resources might not, in fact, be forthcoming. Argentina certainly has accomplished a great deal in two years, in some respects what has been accomplished in other countries in at least a decade or so. And, accordingly it is no surprise that the transition does remain somewhat fragile, and that the Bank has indicated in closing will need to seek perhaps some innovative approaches. I saw this as a little bit of a teaser in that there wasn't any real specificity provided to what precisely these innovative approaches might be. No doubt, this Chair has taken interest in one of the apprriaches, namely the ECO Program, which we think has been somewhat misguided. We are wondering a little more specifically what other instruments may be contemplated here, and would be interested in learning about that. I think, having said that, I will turn to the financial sector adjustment loan, which we are very pleased to support in light of the significant measures undertaken by the Argentine authorities in past years to strengthen the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 14 nation's financial system. The loan is really largely frontloaded in terms of conditionality and supports the continuation of a program well underway. And, a particular number of achievements underpin the emergence of a financial sector capable of fueling sustained economic growth. Interest rates were decontrolled in 1987; the practice of using monetary policy as an instrument for funding the government's budget deficit has virtually halted. The reorganization and divestiture of state-owned banks is proceeding, and a new central bank charter provides a legal foundation for an effective and - independent monetary policy. The loan document notes that the Central Bank institutionally needs substantial strengthening. In this regard, we would encourage acceleration of the schedule for implementation of the new accounting system. Implementation prior to the third tranche, for example, seems desirable. In addition, are there any other steps that can be taken to strengthen this Central Bank institutionally? The program calls for strict measures to halt the funding of government deficits through borrowing from the four state-owned national banks. This will be accomplished through the liquidation of one bank, the divestiture of MILLER REPORTING CO., INC. S07 C Street, N.E. Washington, D.C. 20002 (202) S46-6666  STRICTLY CONFIDENTIAL run 15 another and the restructuring of the remaining two. Now, the restructuring operations include plans for commercializing the two remaining banks. In this regard, it appears that the commercialization of Banco Hipotecario Nacional is more clearly defined than that of Banco de la Nacion Argentina. In particular, second and third tranche release conditions prohibit Banco Hipotecario from lending on terms which do not allow for full cost recovery, plus a positive return on capital. The conditions for Banco de la Nacion are somewhat more vague, and we wonder why did these conditions not apply to the BNA as well. Also, why does Banco Hipotecario condition not call for a market return on capital rather than just a positive one? Conditions regarding the commercialization of provincial banks appear somewhat less stringent. Tranche released conditions restricting the level of lending by these banks to provincial and municipal governments are appropriate. However, there are no restrictions aimed at ensuring that lending is on commercial terms. Restrictions on the terms of lending would have been appropriate here. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 16 Prudential regulation is an essential element of any financial sector reform program, and we appreciate the measures included in the proposed program to address the issue of deposit insurance and to strengthen the regulator's supervisory capacity in Argentina. Now, this loan does not address a problem that exists in certain countries, namely requirements that Bank hold investments only in government securities and not commercial ones. Does such a requirement exist in Argentina? And, if such a requirement exists, what steps could be taken to provide banks the opportunity to invest in private securities? In addition, this loan includes no measures that explicitly address the term of Bank lending. We would be interested in hearing what measures might usefully be implemented to develop medium and long-term lending in Argentina. The recent Government of Argentina establishment of 30 day minimum for deposits up from 70 days demonstrates a desire to lengthen the term structure of lending. Finally, Mr. Chairman, this financial sector loan, together with policies elaborated in the country assistance strategy, we believe, will support a very sound program of continuing reform. And, we certainly wish the Government of MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 17 Argentina and the Bank every success in pursuing this strategy. Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Collins. Mr. Haas, please. MR. HAAS: Thank you, Mr. Chairman. As Mark Collins just said, we had an opportunity to comment on Argentina's global economic situation, and its remarkable achievements in the macro framework recently. So, today, I would like to focus on the country assistance strategy and say a word then on the financial sector loan. On the country assistance strategy, let me first focus on the objectives, namely on the investments needed, the reforms needed on the real side, and then turn to the financing side and the lending volume. On the objectives, first, let me say that I share most of the priorities stated in the country assistance strategy that was discussed this morning. In particular, I cannot but support the emphasis put on the budgetary dis- cipline and on the control of domestic price increase. I think those are necessary conditions to restore confidence of both domestic and international capital markets in the Argentine economy, and to be able to finance the large MILLER REPORTING CO., INC. )07 C Street, N.E. Washington, D.C. 20002 (202) )46-6666  STRICTLY CONFIDENTIAL 18 nm investment necessary to achieve growth. I must say that in this respect I very much welcome that the fiscal consolidation should take place both at the federal and at the provincial levels. I particularly welcome the fact that the Bank is preparing an adjustment operation for reforms of the provincial economic management. And, in this regard, I expect that these approaches will be bold approaches, including notably not only institutional aspects but also all financial aspects of this kind of management reforms. On the deregulation of the labor market, I would - say that I was very interested to read what was suggested in the document. It is true that it is particularly critical to the success of the economic stabilization and to the improve- ment of external competitiveness within the context of a fixed interest rate policy. Important measures have already taken place for small and medium enterprises, and it would be important to extend those measures to larger firms. But, at the same time, I know that it is a very critical and difficult issue and that it is very important not only to fix the target of addressing the deregulation of the labor market but also to reflect in depth on how to MILLER REPORTING CO., INC. 507 C Street. N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 19 achieve it. I would like to very much welcome the views of staff on the instruments best targeted, and I think that we will probably have to benefit from this experience that has to be led in Argentina. At least, let me say that I believe it is necessary to establish some social safety nets in order to smooth the transitions to a more deregulated labor environment. And, on this specific instrument, I would like to hear some staff comments. More generally, I think that the social sectors deserve specific attention of the recession and the very high inflation rates in the 1980s, resulting in doubling of the number of peop under the poverty line. I guess that price stability, macro stabilization, coupled with well-targeted social programs, are certainly the best way to address the poverty issues. , This involves certairily major social programs, such I as affordable health care and education, that should be provided to all categories of the population and also, of course, education efforts which are, I understand, under discussion between the Bank, the government for a new loan to help provincial authorities, and which is very welcomed. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL nm 20 Before I turn to the financing side, let me say that I looked at the projection for economic growth. I noted that they were very, let's say, optimistic or, let's say, high simply. And, I guess that these prospects provide Argentina with a very good opportunity to increase resources directed to social sectors and to reduce poverty, but all in all and more generally, gives kind of a momentum probably to achieve all these reforms and proceed with all these adjust- ment modifications that are needed and that I just mentioned. On the financing side, I welcome the fact that the Bank is planning a large amount of commitment in the next ,- five years. I think that this has to be looked at in a more general framework. If we look at the domestic finance sources, there the constraints are very clear not only in terms of budgetary\ discipline or budget but also in terms of internal savings. So, we have to look at the external finance situation, and there I would say, first, that it is very encouraging that Argentina regained access to international capital markets and is now able to borrow from private sources. However, we should not forget that private capital flows can be extremely volatile. And, I think that, given the operation that is taking place on the external debt, now MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 21 the external debt management should be handled with extreme care. So, the constraints there are also important. So, I guess that non-debt creating flows would be the most important sources of financing. In this respect, I would like to say that we welcome the encouragement given to foreign direct investment. I would like maybe to know some more about the prospects and the targets, if I may say, in this respect, because the increase of FDI is absolutely critical to financing of the whole program. But, of course, in this framework, having said all that, I guess that bearing in mind that the usual World Bank exposure ratios remain well under the informal guidelines that we have in mind, I think that the World Bank has a primary role to play in financing Argentina's economy for the corning years along the lines that I just mentioned. Now, a few words, if you will allow me, on the financial sector loan. Indeed, capital markets and resource mobilization, banking intermediation and the whole sector have indeed particularly suffered from the years of high inflation, resulting in a dramatic reduction in the size of the financial system in the country. And, it is urgent to - now restore the public confidence in this sector. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 22 We particularly welcome the strengthening of banking supervision, notably the adoption of the Basel stan- dard. we would like to also emphasize the crucial importance of restructuring commercial banks. I would like also to mention that we can see some kind of difference of treatment between measures proposed for some banks and measures proposed for the largest bank of the country, Banco de la Nacion. I suppose that the restructurin of Banco de la Nacion is less dramatic and most of the reforms are only a third-tranche condition. I am convinced that the solution is not necessarily - privatization. I very much understand that the Argentine authorities would be willing to retain Banco de la Nacion into the public sector. But, I am sure, at the same time, that public ownership and increased efficiency are perfectly compatible. I would like to remain confident that the necessary measures in that respect will be certainly taken, no matter what is decided on the ownership side. Finally, let me say a word about the broader issue of domestic capital market development. I think that the revitalization of the domestic capital markets, both equity and bond markets, are an essential complement to the banking MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 23 .- sector restructuring, and should help provide longer-term financing to the private sector. So, we welcome the fact that the Bank is considerin a capital market operation and the possible reform of the social security system would also largely contribute to 1 generate a supply of long-term financial savings and together with the increased supply of securities in relation with the privatization would help deepen the capital markets. I would probably have only one question in this regard, which is that the sequencing in which you address those questions is a very crucial question. You have to make sure that you have all the elements of such a very ambitious program before you put it in place in terms of availability of resources, potential liquidity of the market, presence of the players, organization rules, et cetera. I think that in this area, as well, there would probably be a lot to gain from the Argentine experience. And, having said that, of course, I very much hope that this program will be financed as we see that it is supposed to be, and that the reforms will be undertaken as swiftly as possible along the lines proposed by the govern- ment, together with the Bank. - Thank you very much, Mr. Chairman. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 24 ·-· MR. KARAOSMANOGLU: Thank you, Mr. Haas. Mr Kawahara, please. MR. KAWAHARA: Thank you, Mr. Chairman. Argentina has been making great progress during the past few years in achieving strong economic growth and sound macroeconomic environment, especially low interest rate of dollars, I think. These are the fruits of rigorous macroeconomic reform and stabilization efforts conducted by the government. Wide-ranged liberalization and deregulation measures, including foreign exchange and trade liberalization, provided the basis for broad-based economic growth, which in turn fostered stability by restoring confidence in the economy and led to higher private capital inflows, which was enough to create an increase of $2.7 billion U.S. in liquid reserves after financing $1 billion rice in imports in 1991. I believe deficit reduction and austerity alone would not have been enough to achieve such results, and I hope that this lesson will be applied to dialogues with other borrowing countries as well. I have three comments, including one question, perhaps not so important, regarding the country assistance strategy. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 25 According to the paper, foreign direct investment is projected to substantially increase at about 8 percent annually and a steady flow of private short-term capital is also expected. This is a most welcome trend. But, in order for this to contribute to sustainable economic development, it goes without saying that such capital inflow should be utilized for productive capital investments more than speculative investments and import of consumer goods. I would appreciate comments from the staff, if possible, if any, on how the management views the prospects on this point. The recent trend of sharp decrease in the govern- ment's military expenditures is commendable. This is a crucial move to meet the increasing demand for funds in a more productive industrial sector, as well as basic social services. I welcome the fact that roughly 60 percent of the fiscal year 1993-97 program would be devoted to improving the public capacity to provide the social and productive services. This is particularly important, given the rapid decentraliza- tion of various public services to the provincial level and also the weak managerial and implementation capacities of -- those provinces. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 26 Furthermore, such initiatives should be supplemente by increased attention to: one, the coordinating role of the Central Government; two, designing simpler projects in terms of both procedure and substance; and three, strengthening ownership at all levels of the government. Turning to the financial sector adjustment, the Export-Import Bank of Japan is cofinancing this loan in an amount of U.S.$200 million equivalent. I appreciate Ms. Dowsett-Coirolo for having kindly referred to this cofinanc- ing. I would like to make a couple of comments on the - - financial sector reform program. The main thrust of the reform is to reduce the public sector's involvement in banking. Capital structure and fiscal basis of the banking institutions will be strengthened through increased super- vision by the authorities. I hope that these measures will bring about efficient financial intermediation by the private banking sector. This, in turn, will not only contribute to vitaliz- ing private investment through an increase in available financial assets, but will also be crucial in securing the efficiency of investment activities. Reform of the Banco de la Nacion Argentina, which MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546,6666  STRICTLY CONFIDENTIAL 27 nm is the largest bank in Argentina, must be one of the priority areas of the reform program, but the reform has just begun, and I urge management to carefully monitor the process, especially as to how the BNA's function as a fiscal agent will be modified. Thank you very much. MR. KARAOSMANOGLU: Thank you, Mr. Kawahara. Mr. Hosny, please. MR. HOSNY: Thank you, Mr. Chairman. We also made comments on the report on country policies and Bank Group assistance strategy during the Board discussion on January 5th of two important loans to Argentina. On that occasion, we have underlined our high appreciation of the strong commitment of the Argentine Government to its bold and comprehensive structural adjustment program, as demon- strated by its success in maintaining macroeconomic stability while implementing far-reaching sector and institutional reforms. I shall, therefore, confine my following comments to the proposed financial sector adjustment loan, which we fully endorse. Mr. Chairman, the financial sector reform supported by this operation would serve a basic objective of govern- MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 28 ment's reform efforts and Bank's assistance strategy for achieving urgently needed improvements and modernization of Argentina financial institutions, both public and private. The set aside amount of up to $200 million for debt and debt service reduction would also support the government' efforts to normalize the relations with commercial creditors and improve Argentina's access to international capital markets. Having said that, Mr. Chairman, I have the followin observations. First, I commend the adoption of the convertibility law of April 1991 that required the Central Bank's monetary liabilities to be fully covered by international reserves. The convertibility law has pegged the exchange rate at one peso to the U.S. dollar. However, we noted in paragraphs 10 and 12 that the expectations of exchange rate stability and the relatively low international interest rates produced a real appreciation in the peso of about 20 percent. Consequently, the balance of trade deteriorated sharply, which prompted government to take remedial measures, including raising import tariffs. My question is whether such remedies will be sustainable in the longer term, in view of Argentina's MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 29 commitment to trade liberalization and its international and regional trading relationships, including government's intention to reduce all intra-MERCOSUR tariffs to zero by January 1995. Second, we note in Annex VIII of the report that provincial banks have been a major source of macroeconomic instability due to excessive credit expansion which was made possible through rediscounts by the Central Bank, and virtual bailouts to several provincial banks. We welcome that the Central Bank has taken several measures to tighten financial standards and supervisory pressure on the provincial banks that are presently required to adhere gradually to the same banking regulations as the commercial banks and to meet the Basel capital standards. But, in view of the recognized institutional weaknesses of the provincial banks, we would like to underline the urgent need to provide these banks with the technical assistance that is required to build their institutional capacity, thus enabling them to perform their new role in financing the private sector under stringent discipline and supervision. Likewise, with the cessation of access to bank credits, provincial governments would need technical support - to revitalize their tax administration and introduce new MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 30 revenue instruments and collection mechanisms, particularly as a major shift of responsibility from the federal to the provincial level has taken place for the provision of core public services, including health, education, public utilitie and infrastructure. Third, it is apparent from Annex VI to the report that the insurance market in Argentina has a significant potential for the mobilization of investment resources that could also strengthen and widen the scope of Argentina's capital market. Alternatively, the realization of this potential would require further improvements in the regulator framework and a consolidation of the supervisory and enforce- ment capacity of the insurance superintendency. We, therefore, urge that the insurance sector in Argentina be given its well-deserved attention in the continuing dialogue on financial sector reforms. Fourth, we noted in paragraph 102 that the cost of reducing national public banks' staffing by 12,000 employees was about $180 million in total or an average of $15,000 per individual employee, mostly for severance pay. Annex IV, paragraph 4, also confirms this average cost per employee with regard to the early retirement program offered by the Banco de la Nacion Argentina, BNA, involving 4,000 employees MILLER REPORTING CO., INC. ;07 C Street, N.E. Washington, D.C. 20002 (202) )46-6666  STRICTLY CONFIDENTIAL 31 nm at a total cost of about $60 million. The program is expected to result in a decrease in annual personnel costs by about $50 million; in other words, the cost of the early retirement program would be recovered in about 14 months only. This is a noteworthy outcome that could encourage other banks and public sector enterprises to follow suit, even where more generous severance packages may be required. Finally, Mr. Chairman, despite the arguments in the seventh annex of the report with regard to the cessation of explicit protection of deposits with private banks, I still feel that this would place the private domestically owned banks at a comparative disadvantage relative to the national and provincial official banks, which enjoy protection of all deposits by virtue of the legally-mandated and backing by the federal and provincial governments. It would, therefore, be important to minimize that disadvantageous position of the private domestically-owned banks through an effective private deposit protection program. Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Hosny. Mr. Peretz, please. MR. PERETZ: Thank you, Mr. Chairman. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 32 nm As others have said, Argentina's recent economic performance in many ways sets an example for other countries. Difficult but sensible policy decisions, both macroeconomic and structural reform, have revived investor confidence, produced a high level of capital inflows and reflows, and paved the way to last month's IMF and World Bank support for the debt and debt service reduction agreement. I see no reason so long as sensible policies continue to fear a sudden reversal of private sector flows. Indeed, many of those inflows, in fact, simply represent a repatriation of domestic savings that were previously held abroad. As others have said, we have had an opportunity to discuss macroeconomic issues at an earlier Board discussion, and I will just comment on two macroeconomic points, and then I have some points to make about the country assistance strategy. On macroeconomic policy, the first point I want to make is that I think the introduction of what were inefficien and protectionist trade incentives in November was a mistake. And, the market reaction, which followed, was not entirely surprising, although confidence has now been regained. I was, therefore, a little concerned that the staff MIL'..ER REPORTING CO., tNC. 507 C Street, N.E. Washington, D .C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL run 33 report did not envisage an early reversal of these measures, and perhaps that is something the staff might comment on. Secondly, there is the delay in pension reform, which is a matter of concern not least because of the potential contribution to efforts to address the private savings investment balance and the development of domestic capital markets. The deadline for passage of this law was, I think, only extended to the end of this month. And again, I would welcome a progress report. Mr. Chairman, those are the two comments on macro policies. Others have discussed the financial sector loan at some length. So, I will just stick to some comments on the country assistance strategy, with which I should say I broadly agree in terms of its thrust, and it seems to me it is a complement to the authorities and priorities fairly well.' Just one general point, I did wonder whether the proposed increase in the Bank's exposure to around $5 billion may not prove rather high, given two points: first, as Argentina's own increasing access to private capital markets; and second, there is the diminishing role and financing needs of public sector enterprises, which, as we all know, in- creasingly move to the private sector. I know, and we heard this morning, that it is MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 34 nm intended to shift the balance away from adjustment lending towards investment lending, but I wonder whether we ought to keep an eye in the future on the balance between investment lending or indeed any kind of large-sea lending, on the one hand, and enhanced technical assistance in economic and sector work on the other, it seems to me. I am not saying this is an immediate point, but it seems to me it is somethin that should be watched for the future as Argentina moves ahead. Turning to specific points on the strategy, I would like to take the opportunity to comment on some of the issues - we would hope to see addressed in Bank operations in differen sectors as they come forward. I agree, by the way, with Mr. Collins, that Argentina might well be a good candidate for trying the approach of a strengthened field office, which would take on some of the functions at present carried out in Washington. The first point on the strategy is the role of provincial governments, and others have touched on this. They have had a recent large windfall revenue gain to provinces and, at the same time, there has been a decision to devolve an increasing expenditure responsibility. And, both these seem to me to increase the need for MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 35 nm improved financial management at the provincial level. I have in mind both strengthening of revenue collection and better monitoring and control of expenditure. So, I wonder how soon we can expect the proposed adjustment loan to support reforms in this area. I wonder further whether there might be a case for a smaller technical assistance project in the shorter term. And, I wonder what can be done to extend to the provinces the discipline of budgetary ceilings which have recently been introduced in the Central Government in Argentina. Second, there is a question of support for privati- zed enterprises. The success of the privatization program means that many future infrastructure investments will be undertaken in the private sector. Two things follow. First, the proposed loans to support the developmen of regulatory and environmental institutions must be seen as among the most important in the Bank's assistance program. Second, something has to be done, as the paper says, to improve the availability of long-term finance to the private sector. This, indeed, is a problem that many developing countries share, and I think, if Argentina can show a way forward, it may well be of interest to others to follow. MILLER REPORTING CO., INC. 507 C Stceet, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 36 nm The country assistance strategy shows an awareness of the problem, but it is a little light on suggesting solutions to it. Indeed, the details of the financial sector adjustment loan, which focuses on the weaknesses of the banking system rather than the capital markets and the staff's admission that the Bank's own experience with capital market projects is limited both suggest to me that the key role within the Bank Group in deepening and widening access to domestic capital markets for the privatized businesses in Argentina might well be for the IFC rather than the Bank. I don't know whether there is anybody from the IFC here today, Mr. Chairman. MR. KARAOSMANOGLU: Yes. MR. PERETZ: Well, I am glad that there is. Certainly, it seems to me, before trying too many innovative approaches by the Bank, we ought to explore every possible way that the IFC can help. And, I hope the IFC will be closely involved with the Bank's assistance program and MIGA, as well, I should say. And, indeed, it would have been helpful if a bit more could have been said about this in the country assistance strategy. A third and more detailed point, I certainly agree - it is right for the Bank to be considering a road maintenance MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 37 nm project rather than the building of new roads. But, we would nevertheless expect such a project to deal with issues such as road user , road safety and environmental concerns, including fuel prices, unleaded petrol and vehicle emission controls. Fourth, another more detailed point, I note that two operations have been planned to improve agriculture and industrial services -- it is in paragraph 43. I wonder whether the private sector will be asked to pay for some or all of the services it will receive from these projects. Fifth, it seems surprising that little has been achieved on social security reform, apart from the draft pension law when studies in this area were started as long ago as 1988. Do the government and the Bank know what more needs to be done, particularly to address the f al costs? And, is a consensus being built to achieve wide support for necessary reforms? And, I had in mind the delay there has been with the pension reform, which was partly a result of not having that consensus in place. Next, on labor markets, a point Mr. Haas made, I agree with. I am not sure I am entirely right, but I suspect it is union resistance which has inhibited attempts to tackle excessively rigid labor practices, which is one area where MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 38 nm - very little by way of structural reform has been accomplished so far. The question though for us is how can the Bank best assist in this area? Next, and most important, I find it depressing that the Bank has continued to provide substantial and fungible adjustment lending to Argentina at the same time as -- and this appears in paragraph 37 of the report -- at the same time as the middle class in Argentina has been able to keep a firm grip on annual housing subsidies to the value of $1 billion a year, and resisted any attempts to divert that subsidy towards the poorer members of the country. This the sort of situation which provides ammunition to the Bank's critics. And, I do hope something could be done about it. That said, I strongly support the emphasis on continued stabilization and adjustment to provide the basis of poverty reduction. There is a nice section in paragraph 50, which points out that eliminating inflation has been a key step in protecting the position of the poor. And, r think this is a general truth. I have said this before in the Board, and I take this opportunity to say it again, it is - a genuine truth we should not forget. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 39 nm The studies outlined on poverty reduction in paragraph 52 set out what seems to me to a sensible plan for identifying targeted interventions by the Bank. The paper suggests that around $1 billion will be spent on poverty alleviation projects during the period FY93-97. I support that. It is a substantial allocation, but I think it is right. Is there though an indicative program for poverty projects? The current monthly operations summary shows only around $390 million worth of projects in the social sector. I would hope to see development of a strong pipeline of poverty projects, and I hope this will be given high priority Finally, Mr. Chairman, we do, of course, welcome the strong action taken to rationalize the portfolio, including cancellation of some moribund project. It might be useful if in future country assistance strategies contained a critical evaluation of performance of projects to date, a more of an evaluation of performance projects to date, not so that we could spend time discussing the failures, but if there are any lessons to be learned, if we could bear them in mind when we discuss the future assistance strategy. Mr. Chairman, others have commented on the loan, and I won't. I would just like to thank the staff for a MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 40 run thought-provoking country assistance strategy and say I do support the loan. MR. KARAOSMANOGLU: Thank you very much, Mr. Peretz. I think this may be a good point to turn to my colleagues and try to answer some of the questions that have been posed. Could you start, Ms. Dowsett-Coirolo? MS. DOWSETT-COIROLO: I will begin with Mr. Collins' comments and then move on to the others. I will address those that have to do with the country assistance strategy and some of the general ones on the financial sector; some of the more specific questions on the financial sector, I will pass to the Task Manager for that operation. On the issue of social security form and labor market flexibility, are we planning any lending in this respect or only dialogue on the issues in the context of our country economic work? First, I should point out that one existing loan, which the social sector management technica assistance loan of 1988 was, in fact, the loan that financed most of the basic studies that were used to come up with the reformulation of the social security system. Also that loan, in fact, financed the studies that underpinned the reform of the health financing system, and several other major initia- MILLER REPORTING CO., INC. 507 C Street, N.E. Wa,hington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 41 nm tives underway right now in Argentina. For the future though, we don't have any particular loan in mind to finance the reform of the social security system or labor market reform other than the general dialogue in our country economic work. Work with the provinces, how do we intend to employ our field office, yes, certainly as we move from adjustment lending into more intensive investment lending and a closer relationship not only with provinces but with a large number of provinces across the whole array of very difficult issues ranging from adjustment at the provincial level to social sector development and the like, the role for our field office will be changing. It has already been changing somewhat in this past year. Our field office has been doing quite a bit of work in advanced preparation of the provincial adjustment project, for instance, have consultants working out of the field office with various of the provinces, doing some of the preliminary analysis needed to define their adjustment programs. We have plans to place additional consultants through the field office. It is obviously a resource; we need much closer contact with them, a much wider array of MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 42 nm players. As the lending program diversifies and moves to the provincial levels, so, yes, the field office role would certainly step up there. On the environment, weak institutions, yes. This is an area where over the last couple of years the government has been coming to the realization of the cost of environmen- tal degradation thus far. There has been some limited progress in the last two years. The government has es- tablished a Secretariat for Natural Resources and Human Environment in the Office of the Presidency. The Bank has provided some support through several of our operations. We financed some consultants to that entity that would provide this sort of national coordinating focus for environmental work in Argentina. This is one area though I should say, the Inter- American Development Bank is preparing a larger technical assistance project, and we will be working very intensively at that central level with that Secretariat. Our emphasis, besides some of this initial support that we have provided through consultants that I mentioned has been more through some of our sectoral operations, development and incorporation of environmental considerations in regulatory guidelines, in the regulatory frameworks for MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 43 various of the privatized sectors. We are also doing some work under our ongoing provincial loan, and we will be doing further work under the provincial adjustment loan and several of the other operation to develop institutional capacity for monitoring environmenta assessments at the provincial level while the IDB concentrate more at the institutional development of the central agency. I take note of the point on Yacyreta. The environ- mental program for Yacyreta is on schedule. The Yacyreta project itself is on schedule. The government is meeting its financial commitments. The physical implementation is on schedule. The development of the sewerage and sanitation project for Posadas (Phonetic) is also on schedu , and will most likely be funded partly out of SEGBA (Phonetic) resource and partly out of our ongoing water supply project with COFAPIS (Phonetic). And, we will be bringing those to you over the next few months. In the interim, since the Bank considered the Yacyreta project, we have also been working very closely with the IDB in the development of their loan for resettlement and we will be providing the note that was agreed at the time of the Yacyreta presentation, the note to the Board on a general MILLER REPORTING CO., INC. ,01 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL nm 44 - progress statement, later this spring before the IDB project goes to its Board. On privatization and the request for a Board seminar, on this issue, I think -- MR. HUSAIN: We will be happy to raise this issue with the Executive Directors. MS. DOWSETT-COIROLO: All right. Mr. Haas' question on provincial reform, on the Bank's work in provincial development, will our efforts involve not only institutional development but also provincia adjustment? Yes. We are developing a provincial adjustment loan, which in answer to one of the other questions we hope to have ready for the Board by the middle of this coming fiscal year. We are selecting a couple of provinces which have significant adjustment tasks in front of them. That project will deal with some of the same kinds of adjustment sues that you have been seeing dealt with at the central level through other Bank adjustment operations. You will be dealing with privatization of some of the provincial entities, downsizing the provincial governments, improvements in provincial tax administration and so on. In answer to a related question, is there a case MILLER REPORTING CO., INC. 507 C Street. N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 45 nm for an interim technical assistance project, there would be if there were no other instruments available. But, we have been using the resources of our ongoing Provincial I project to, in fact, do a lot of the preparatory work, improvements in provincial tax administration. And, that loan will be used to finance some of the studies in the individual provinces as they design their provincial reform programs. Labor market instruments, labor market issues generally: The CAS outlines essentially some of the issues confronting the government as it seeks to achieve greater labor market flexibility. Perhaps, the most important step was taken at the time of the convertibility law, when indexing of wage contracts was removed, and that was a first and fundamental step. Then, there has been labor legislation -- that is outlined in the CAS -- developed to permit greater use of fixed-term contracts, to permit local industry negotiations as opposed to nationwide collective bargaining arrangements. This legislation is in Congress. It is highly political. Yes, it will be certainly desirable to extend it also to a wider array of firms. The government has been doing what it is able to in - terms of ing to develop a consensus towards the need for MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 46 nm passage not only of this legislation but also of the law of labor associations, which is on the books. The Bank has financed again some basic studies under the social sector management/technical assistance loan, which generate information and analysis that has been helpful in the dialogue with the interested parties. Perhaps the most telling argument that the govern- ment is trying to convey to its Congress, on the one hand, and to the unions, on the other, is to educate them on the absolute need for wage flexibility if this reform program is to hold together. There has been relatively little union activity over the last year-and-a-half, barring a general strike this fall. There has been relatively little union activity in terms of national strikes and so on, and general support for the thrust of the government's development program. The task now is to get the unions and Congress to understand the relationship between the continued implementation of that program and the need for wage and price flexibility. And, they are working at doing that. Private capital inflows, Mr. Haas' point about their being volatile. Yes, they are volatile. It is our view that, as long as the government shows clear signs of MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 47 nm continued commitment to a prudent fiscal policy, on fiscal stance and continues to make progress on the various points raised in the CAS social security reform, the labor market reform, health financing reform, and refrains from even moving towards this situation of needing deficit financing, which is legally precluded from resorting to under the convertibility law, but as long as it maintains a convincing posture on this, there is no reason to expect any major decline in private inflows. They probably are peaking this past year and this year because you have the normal process of private capital coming back into Argentina as confidence develops, but this has also been enhanced by the privatization process. And, the privatization process, of course, the bulk of that is taking place now and will be continued in 1993. So, you would have normally some decline in private inflows associated with that phase coming to an end. But, it is our expectation that again, provided there is continued sound performance on the fiscal front, that private capital inflows should continue at a somewhat reduced rate from this year but certainly well above their historic averages for the last ten years. MR. HUSAIN: Could you comment on the capital MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 48 run market development project? MS. DOWSETT-COIROLO: The capital market developmen project: There are several aspects to capital market development. Obviously, the entire reform program that has been supported through the various adjustment loans has laid the basis for possible capital market development in Argen- tina. The financial sector adjustment loan before you today takes that one step further. As you have significant amounts of private capital coming back to Argentina, on the one hand, and the prospect over the next couple of years as the government successfully implements, we hope, the social security reform and capita- lizes social security and generation of a large amount of investable resources from that, the task is to find instru- ments to have this capital find its way to longer-term instruments to support the medium and long-term development needs of Argentina's industry and infrastructure. We have been working over the course of the last year to look at ways in which the Bank could contribute further to capital market development. We have just had a mission back now, which has included staff from our region and also from the new Finance and Private Sector Development - Vice Presidency, jointly trying to design an operation which MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 49 nm would be feasible to carry out in Argentina and which might also be path-breaking in terms of lessons to be learned for application in other countries. The design of the project, which is still very the reason it is not detailed in the CAS, as Mr. Collins asked, is because it is still really undergoing early evolution, if you will. But, it probably includes three areas. One is technical assistance, and this is technical assistance for a variety of institutions -- the stock exchange, technical assistance in development of stock exchange, training. It also is likely to include a component which would provide a backup fund. This would be to encourag investors in bonds to be willing to put their funds into longer-term bonds or conceivably to stand as a backup fund if those bonds cannot be rolled over after four years. There may also be financing under this project or associated with it for that category of investors who are not your Blue Chip Triple A investors and, therefore, need longer-term financing through more conventional Bank inter- mediation work. MR. KARAOSMANOGLU: What is the involvement of IFC in this undertaking? MILLER REPORTING CO., INC. S07 C Street, N.E. Washington, D.C. 20002 (202) S46-6666  STRICTLY CONFIDENTIAL 50 nm MS. DOWSETT-COIROLO: Well, the IFC has been collaborating with us in these preparatory discussions, and we have been holding meetings with them. The IFC is itself also -- and they can speak to this -- but they also are pursuing capital market development activities. But, there has been a lot of close consultation and discussion through the whole preparatory phase of this. So, I don't think we see here any problems of duplication. On the contrary, the effort has been entirely to try to complement each other in this area. MR. HUSAIN: Let me just supplement this issue because the whole question of the financing of the private sector, particularly of the financing of the privatized infrastructure, is going to be a critical issue in the development in Argentina and other Latin American countries. There are no ready-made answers that we have at this stage. On the one side, you had the experience of Chile, where the capital market has a sufficient depth now that large amounts can be raised by Chilean companies on the domestic capital market at competitive rates. We know of cases where power companies have been able to raise twenty- five year money at internationally competitive rates on the Chilean capital market. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 51 nm But, we should remember that Chilean adjustment is about fifteen years old, and has been on track. Clearly, a lot will have to be done in the case of Argentina to support this thing, because in areas like telecommunications, electric power and transportation and railways, there will be need for large investments and, if these investments are not undertaken, there may be a break in the economic growth that we talk about. On the other hand, we don't want such a heavy- handed intervention of the World Bank that the entire development of the capital market itself will be stymied. We are not in favor of a quick use of ECO for the simple reason that we think that at this stage of Argentina's development, it would be a mistake to pass on any significant liability of financing the private sector to the government. We have just gone through a long period in which the government has been pulled back from guaranteeing the private sector flows, and I think that gain has to be maintained. And, that is why the Bank's intervention has to be selective; it has to be for innovative instruments, basically for the domestic mobilization of capital, for the mobilizatio - of the large amount that the Argentineans themselves hold MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 52 run abroad. And, the thrust of our work is going to be on the development of investment banking functions in Argentina, basically to step in in the lengthening of maturities of domestic paper and improving the quality of the paper and projects that come, possibly in the stimulus to a stronger secondary market. But, these are thoughts at an initial stage, and they will mature over the next few months. We are engaged in very detailed work on this in full cooperation, of course, with the new Vice Presidency on Private Sector Development and IFC. MR. KARAOSMANOGLU: Mr. Peretz. MR. PERETZ: Mr. Chairman, do you want to continue discussion on this point, because I want to come back on it, or do you want to wait until all the questions have been answered? MR. KARAOSMANOGLU: Could we finish first the answers. Then, we may have a short discussion, if possible, on the subject and then continue with the others. Yes. MS. DOWSETT-COIROLO: Several Chairs mentioned the delay in the passage of the social security legislation. The legislation is in Congress. We are now expecting that it MILLER REPORTING CO., INC. S07 C Street, N.E. Washington, D.C. 20002 (202) S46-6666  STRICTLY CONFIDENTIAL 53 nm will be passed within the next six to nine weeks. It is a third-quarter target for the Fund's EFF Program. And, we expect, as the government does, that that will be met- So, hopefully the social security legislation will have been passed by the end of the first quarter. Several Chairs also mentioned the trade measures taken by Argentina in November. These trade measures did result in a slight increase in temporary tariffs. They also involved some tightening of fiscal accounts, in making tax rebates on exports more efficient, and involved a reduction in the disbursement of the tariffs. So, the entire package needs to be looked at. But, yes, the authorities have suggested that the increase in the statistical tax is a temporary measure, and we are also hoping to see that that is pulled back during the coming year, and that recourse to that sort of technique is not again necessary. On the question about our agricultural and in- dustrial services projects that are mentioned in the CAS, will the private sector pay a share of the costs? Yes. It is anticipated in the design that there would be cost recovery from the private sector. Indeed, the ongoing agricultural services project, MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 54 nm which is also doing some work in this area, has a small cost recovery provision in it with private sector paying for some of the development work there. Housing subsidies, we could not agree more that that is unfortunate. It is a highly political area, and we are pressing the government at every conceivable opportunity to deal with it. I think there is no disagreement from the government side on the need to do so. It is a question of timing and polit al feasibility at the same time that they are dealing with social security reform, health financing reform and so on. So, we hope to see movement on these various fronts, and housing subsidies would certainly be one of them. Is there an indicative program for our poverty projects since you see only a few of them in the operational summary? That is because we usually only include in that our projects coming up in the next year or two. But, yes, the indicative program over the next four years would be at least two operations in health, one targeted on maternal child health case; a second, a more comprehensive health reform project for the Buenos Aires Province; possibly a third, but we haven't included it yet in these figures, possibly a third, taking the Buenos Aires' approach to some of the poor MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 55 nm northern provinces; and two education projects, the f t dealing with secondary education, issues at the provincial • I level and the second, possibly dealing with those same issues l I in a separate group of provinces but hopefully by that stage, as this is the outer period over the next four years, also able to be dealing with some of the higher education issues in Argentina. And then, there is another project which we have only begun to try to identify, together with IFAD, and this would be a rural development project for the poorer northern provinces, which have many poverty characteristics that make them seem much more similar to rural areas in low-income countries elsewhere in Latin America, confront serious issues of the need to diversify out of the kinds of crops that they are growing now, which are tobacco, sugar and cotton, at very low social indicators. So, at least one of those projects is under our provincial adjustment program, but beyond that, we are again looking with IFAD at the possibility of a rural development project, oriented to the diversification needs of those northern provinces. So, that is the indicative program of our poverty ·- projects. MILLER REPORTING CO., INC. S07 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 56 nm MR. KARAOSMANOGLU: Thank you, Ms. Dowsett-Coirolo. Mr. Peretz, maybe we can return to the issue of capital market development. MR. PERETZ: Well, I would just like to say thank you for all those answers too which were very helpful. Mr. Husain says you don't want government interven- tion in recently privatized businesses. And, I could not agree more. Indeed, that was one of the reasons I still think that IFC involvement is probably very appropriate. There are plenty of things the government itself can do. One of them, I would suggest -- I don't know if you - are thinking about this -- is just help develop the market present debt, because by developing a longer-term bond market, the government debt, you also create a longer-term bond market which the private sector can tap. I mean, that is the experience of my own country anyway. But, my concern is that the whole resources of the Bank Group should be brought to bear on this issue in the best possible way. And, I know you said you are talking to the IFC. I wonder, to put it more specifically, we shouldn't be thinking in terms of a joint operation between the Bank and the IFC in this area, where the IFC would have certain things to do and the Bank would have certain things to do, or MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 57 nm at least two complementary operations coming to the Boards at the same time. That is a suggestion but it seems to me that the role of the IFC ought to be very important. By making small or even medium-sized loans to privatize businesses, they can help catalyze private sector flows; they can help develop the private bond market for those companies at the same time. And, there are quite a large number of things which the IFC can do because of its charter that the Bank cannot do. If you put the two together, you ought to produce something which is better than the two halves. MR. KARAOSMANOGLU: Thank you, Mr. Peretz. Mr. Husain. MR. HUSAIN: Let me just say that I fully agree with Mr. Peretz that the whole resources of the Bank Group have to be brought to bear on this issue, and we are working on that, IFC, the Bank and within the Bank the skills of the region and the central organization. Clearly, there are three aspects on which we are working: overall policy issues; regulatory environment; and institutional issues. It is going to be a very difficult operation to put together because our experience in these areas is very, very limited. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 58 nm So, I just want to assure you that the Bank Group will move in unison on this issue. MR. KARAOSMANOGLU: Thank you. I think, in fact, this issue goes beyond Argentina as well, because our studies show that there is a major change in the composition of capital flows to developing countries and, increasingly, equity type of capital and private flows are increasing, especially in Latin America. And, in that sense, capital market developments will have to be a central point of attention and concern of this institu- tion as well. Mr. Grilli. MR. GRILLI: Thank you, Mr. Karaosmanoglu. Let me first and mostly focus on the country strategy for Argentina and then let me make some observation on the proposed loan. It has been noted this morning and before that Argentina has made very large progress in returning to macroeconomic stability and in changing the policies that brought it to the verge of economic collapse just a few years ago. This progress is remarkable, has been recognized, and we fully support it. Most importantly, Argentina has to stay the course MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 59 nm that it has chosen. Today's discussion of the Bank strategy towards Argentina, in my view, comes at a critical juncture. It comes when sights have to be raised from the achievement of short-term financial stability in Argentina to the sustainmen of medium-term economic growth. We are at that stage. We must, therefore, ask ourselves: What are the key conditions for fast growth to continue in Argentina? What can the Bank do to foster this progress, which one should hasten to say always depends critically on domestic efforts, on domestic commitment, on domestic policies? What are the risks surrounding the medium-term? And, how much of these risks can the Bank prudently take? Looking at the information contained in the President's Report and at the discussion surrounding the Bank's strategy, one is struck -- at least I was struck -- by two things: first, the apparent fragility of the medium-term growth scenarios that underl the strategy; and two, the concentration of the discussion of risks, on short-term risks. Since we are focusing on a five-year lending strategy, more attention to the conditions underpinning medium-term growth for Argentina and the risks attached to - their fulfillment might have been warranted, this without any MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 60 nm chance of affecting the review of the SAL, whose justificatio is largely to be found in the current strategy of macro- economic consolidation that we are pursuing. The medium-term growth scenario for Argentina, spelled out in the table in Annex I, rests in my view on three critical assumptions: one, that Argentina trade imbalance is progressively reduced and turned into a sizable surplus, which in turn implies continued export competitive- ness, with growth in volume terms, growth of exports in volume terms at about 7 percent a year, and also a very moderate growth of imports, at least than 5 percent a year at ,- only slightly above the rate of growth of GDP. Two, it implies the maintenance of a substantial budgetary surplus, primary surplus, of the order of 2.5 percent of GDP, and this is necessary to leave room for debt service and for enough savings to go into investments. The third scenario based on a continued and very large inflows of capital, that would allow both the financing of the large current account deficit, which is connected to the external debt service, and the growth of domestic money supply in line with the needs. Mr. Chairman, these are strong assumptions, whose realization is necessarily fraught with uncertainties and MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 61 nm surrounded with risks. For example, the implied export growth is large, is optimistic, in the light of both dete- riorating external market conditions and perhaps, more importantly, in light of the loss of competitiveness that has occurred, given the continued appreciation of the real exchange rates in Argentina, 20 percent since March 1991, but more than 100 percent since March 1990. Of course, productivity gains must have occurred and I am sure they did occur. And, one can think that these might have upset some of the negative effect on competitive- ness of the real exchange rate appreciation, but we have no - measure of such factors. I must say that I was not reassured by the explicit assumption of cost and the real exchange rate between 1993 and 2001. What should ask under what conditions is this likely to materialize? Or even better, one should ask what would happen if it did not? What are, in other words, the risks surrounding this c ical policy assumption? The implied flow of external capitals, even when taken net of private investments, are largely in excess of the likely magnitudes of interest repatriation from Argen- tinean assets held abroad. They imply, in other words, a substantial and sustained shift in-bound of capital to be MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C, 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 62 nm transferred overseas by Argentineans. This again is a very strong assumption and easier to meet under low interest rates on u.s. denominated assets than under conditions of higher interest rates. In the longer run, however, continued growth in Argentina will depend critically on the recovery and main- tenance of private sector investments. To sustain the steady growth, I think two conditions are essential: continued fiscal surplus, the maintenance of which cannot for too long rely on expenditure cuts or sales of assets but has to be based on increased tax revenue relative to GDP; and (b) increased rates of savings in the private sector at large. To put it succinctly, Mr. Chairman, an economy where private savings to GDP ratios are in the 10, 15 percent range and tax revenue to GDP is not expected to go much above 18 percent in the medium-term must either be able to generate a lot of productivity improvements or attract a lot of outside savings, or both, to be able to sustain the GDP growth of 4 to 5 percent a year in the medium-term. The strong sense that one derives from the report is the critical question of the adequacy of the fiscal stance in the medium term, including f land other incentives to savings, is not convincingly addressed. There valuable MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 {202) 546-6666  STRICTLY CONFIDENTIAL 63 nm information on this in the gray cover report, which has been just released. It is a pity that it was not more fully integrated in the country strategy write-up. The President's Report does highlight risks, a recession triggered by either interest rate increases or a speculative attack on the peso, but these are short-term risks. If I turn to what is envisaged in the Bank over the next five years, what I see is a still fairly sizable lending program, about $1 billion, to support three goals: consoli- dation of macroeconomic reform; strengthening of Argentinean institutions; and fostering private sector development. I believe that these goals are sensible. We plan to support fiscal adjustment in the provinces by another and last adjustment operation. Social security reform and improved labor market flexibility are left to the Government of Argentina to achieve, hopefully in the short-term. What I find missing from our strategy is direct and explicit support to the continuation and completion off al reform. When I mean fiscal reform, I mean fiscal reform through structural improvements in the modes of taxation, now MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 64 nm almost totally based on indirect taxes, and for permanent incentives to private sector savings to be built into it. There are two issues here. One is the sufficiency of the tax yield, to which I was referring previously; the other is the social sustainability of a system of taxation, which is largely based of indirect taxes. In the strategy, I applaud the intention that we intend to give to the improvement of social services, especially health and education. Here again, I wonder seriously how these desirable objectives can be achieved and sustained without an increase in tax revenue relative to GDP. Certainly, external borrowing to fund these objectives, structural objectives, is, in my view, neither desirable nor feasible. The Bank should not encourage it. I feel that we have done enough fiscal financing during the current stage of our relationship with Argentina. Two things, Mr. Chairman, I found missing in the report, and they are of a general nature. One is the profile of the expected lending flow and of Bank exposure. This should be a standard requirement for any documentation supporting a country strategy discussion, together with the expected yearly evolution of the standard Bank risk in- -~'- dicators. MILLEA REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 65 nm And, this is not a quibble, I believe. You know, in this particular case, this information would have been very useful. Why? Our exposure towards Argentina has risen recently and will continue to do so for a few years. Also, there has been debt reduction operation and the share of preferred creditors in the total has sen and will rise considerably, together with the growing importance for Argentina of bond-funded debt; the share of that that cannot be restructured in the total portfolio of the country has increased and, thus, have our risks. According to my estimates, the share of debt service going to unrestructurable debt has reached about 55 percent of the total in 1992, and will remain about 40 percent until 1997. These are important indications of financial risks. Also, I think that normally provided should be country debt indicators based on exports, that is on effectiv capacity to pay instead of simply on GDP, which is potential capacity to pay. In the case of Argentina, this information would have highlighted that the country's external debt service is still 40 percent of exports, and will not fall below 30 until - year 2000. MILLER REPORTING CO., INC. S07 C Street, N .E. Washington, D.C. 20002 (202) S46-6666  STRICTLY CONFIDENTIAL 66 nm Let me turn very briefly to the proposed loan. I understand that its total size is related to the support that is to be extended to the debt service reduction operation just concluded by Argentina, which was very important. But, even considering what in a way goes to underwrite financial sector reform, basically half of the loan, one wonders whether what I call the policy multiplier that the operation will generate is really large enough to justify it, particularly in the absence of any clear balance of payments need at this stage. Reserves in Argentina are about $10 billion. Specifically, there are some important improvements that are foreseen, particularly in the supervision of commercial banks as well as improvement in the capitalization ratios of the banks. These are good things. But, on the other, the privatization component by - the loan is limited. Bolder action on this front would have made this loan more attractive and perhaps also more useful to Argentina. The justification given in the report for the refusal of the government to proceed rapidly with the privatization of BNA, for example, is weak, is almost reluctant. There must be more behind it than what is said in MILLER REPORTING CO., INC. 507 C Scree,, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 67 run the report. I certainly would like the staff to shed some light on this point and on why we accepted the government position; also, the preservation of the restructured BHN, even as a second tier lender only, is puzzling. What really for, one wonders? Having said all this, my conclusion is that there are at least in my mind more doubts about the country strategy, as presented in the President's Report, than on the proposed loan, which I support in the current phase of our country assistance strategy. I look forward, in other words, Mr. Chairman, to .- the continuation of the discussion this morning at the Board and, of course, to the answers of the staff. But, I also look forward to the next country strategy discussion, when I hope that some of the key long-term issues, not fully considered in this year, will hopefully be addressed. I also look forward to the progressive improvement in the information basis provided to the Board for these discussions. Thank you. MR. KARAOSMANOGLU: Thank you very much, Mr. Grilli. Mr. Aris, please. - MR. ARIS: Mr. Chairman, Argentina is now wreaking MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 68 nm in the havoc of its post-1989 structural reforms carried out in different key areas of the economy. Inflation has fallen; capital is returning, and the creditworthiness of the government has improved. We welcome this opportunity to discuss today the CAS for Argentina and the financial sector adjustment loan. we believe that the Government of Argentina is doing the right things, and we should firmly pursue its current economic policies. We would also like to express our support to the Bank's assistance strategy by the efforts to consolidate the macroeconomic reforms and by strengthening Argentina's weaker institutions and by fostering the development of the private sector. We do wish to make the following observations. First, we think further increase in the primary surplus must remain a crucial task to be accomplished, given the fragility of the macroeconomic situation, especially at a still high rate of inflation. The surplus would improve the overall performance of the economy by reducing government demand on financial resources. The consequent reduction of inflationary pressures would also tend to enhance further the confidence of the MILLEA REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 69 nm private sector that is badly needed. In addition, lowering inflation rate is not only a macroeconomic stability require- ment but also a necessity to mitigate the effect of the inflation on the poor, owing to its highly repressive impact on their real wages and possible saving. Second, we highly support the emphasis on the improvement of the institutional capacity of the government to implement reforms and provide high quality services, particularly in social sectors, transportation, water and other infrastructure. Aside from its beneficial impact on poverty, this would also stimulate private investment and growth in the long-term. Third, we are concerned by the deterioration of the resource balance. In Table 1 on page 8 of the paper, a negative trade balance of $1,139 million U.S. is shown for 1992. But, according to the announcement that the Argentine Government made at the end of January, the 1992 trade deficit could be as large as $2.5 billion. It is also indicated that the deficit for the first nine months of the year was already at $1.5 billion. We would like to hear from the staff how credible these figures are and what the real situation is. Fourth, we notice several inconsistencies in the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 70 nm figure used on primary surplus in para. 18, Table 1 on page 8, and Annex Table 1 on page 49 for 1992 and 1993. There is also a big jump after 1992 of lagged ICOR in Annex Table 1 on page 49 for which we would appreciate staff's explanation. Lastly, Argentina's financial system is actually characterized by manifestations of weakness. Chronic high and volatile inflation and interest rates with the forced 1990 conversion of savings deficits into lower-valued public bonds have resulted in lack of trust in the financial sector. The ratio of M2 to GDP reached, indeed, its lowest point ever of 5 percent in 1990. The overstaffing of banking institutions and rush punch networks, in particular those of public banks, has resulted in a very high operating cost of banks, causing adverse effects on the spread between lending and borrowing interest rates. The private sector has been almost completely crowded out due to heavy internal borrowing by the Central Bank and the government through the banking system. Due to the macroeconomic instability and high transition costs in the stock exchange, there is little trade in the stock market. Investors in corporations are reluctant to make MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 71 nm financial commitments on a long-term basis. Under such circumstances, it is obvious that the financial system cannot fulfill properly its proper function. It is, therefore, urgent for Argentina's financial sector to take appropriate reforms. In this regard, we have no problem to lend our full support to the proposed financial sector adjustment loan before us. Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Aris. Mr. Al-Assaf. MR. AL-ASSAF: Thank you, Mr. Chairman. - I will focus my comments mainly on the country assistance strategy. I agree with the previous speakers that efforts to stabilize the Argentinean economy, as shown by fiscal and monetary discipline, are commendable. The extent and speed of reform of the incentive structure, which would enhance private sector activity and growth are also impressive. The Bank assistance strategy benefitted from the close and, in my view, very successful association between the Bank and Argentina. This strategy which aimed at sustaining achieved results and deepening reform is ap- propriate. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 72 nm I agree generally with the focus on fiscal adjust- ment, especially at the provincial level, introduction of greater flexibility in the labor market and improving institutional capacity to deliver better social services to the poor. I also agree with the view that maintaining economic growth going hand in hand with low inflation is a prerequisite for continuing to reduce poverty. Mr. Chairman, let me touch on the issue of the external environment of the document. Discussion of the effect of the development in the external environment on the economy is clear and straight-forward. Without losing sight of the fact that the main problems facing the country continue to be internal, issues related to the effect of growth in world markets, conclusion of the Uruguay Round, the need to reduce, quote/unquote, "large fiscal imbalances" in a number of countries, the resulting effect on world credit markets, and expected development in terms of trade have been rightly addressed in the document. Still discussions of the external envirorunent would not be complete without the analysis of development in specific traditional export markets, and the feasibility of shifting the direction of trade if adverse circumstances MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 73 nm emerge. For example, I expected to see some discussion of the shift of wheat exports from the former Soviet Union republics to other countries, the effect on the country. Incidentally, I was surprised to see that the document uses the IMF world economic growth projections rather than the Bank global economic prospects. MR. KARAOSMANOGLU: Which is under preparation. MR. AL-ASSAF: I am sure Mr. Peretz would agree with me that the global economic prospects are more realistic, no offense to our friend from the IMF. (Laughter.) MR. AL-ASSAF: Mr. Chairman, I read with interest that external financial requirements in the foreseeable future are expected to be met basically through substantial private reflows. If, however, private capital reflows tend to be more than envisaged under the scenario presented in Table 1, appreciation pressures on the real exchange rate could then mount with, of course, adverse impact on export prospects. Of course, this has been touched on by other speakers. So, I don't want to ask for further comments from the staff. As acknowledged in the document, such a case is not remote. Consumption-driven growth in the past two years, the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 74 nm $5 billion proceeds to the Treasury from privatization, substantive debt and debt reduction rel f and recent talk about windfall consequences of recent economic liberalization I only add to the vulnerability of the reform process to private capital reflows. The Bank strategy clearly goes over the important issues related to restoring competitiveness, such as recent adjustment in trade incentives, reduction of fuel taxes, introducing greater flexibility in the labor market, and improving public services for the potential tractable agricul- ture and industrial sectors. However, I would have liked the Bank's strategy to analyze in more details issues of price liberalization and the policies needed to induce a shift in the internal terms of trade in favor of tradables. On Bank lending strategy itself, I do agree with the introductory statement by the staff mainly shifting to investment projects. However, the vulnerability, especially related to equity and portfolio investment flows and reflows, as well as exchange rate risks, require flexibility in the size, composition and timing of the Bank lending program. Coming, finally, to the loan itself, I can support - it. Timely financial sector reform boosts confidence in the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 75 reform program. It also supports the current domestic resource mobilization efforts and enhances the ongoing privatization drive with both the financial sector and the economy in general. Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Al-Assaf. Mr. Wilson, please. MR. WILSON: Thank you, Mr. Chairman. As a lot of people have said this morning, Argentin has carried out a very bold and coherent series of economic reforms over recent years. That reform program deserves our support, and I am happy to support both the country assistanc strategy and the loan before us this morning. I have got some comments on the assistance strategy I and some on the loan itself. The paper identifies essentially two major and linked risks to the reform program, as I understand them. Firstly, the capital inflows will lead to an unsustainable appreciation of the real exchange rate and, secondly, that domestic prices might take too long to adjust to such an environment. Now, it seems to me -- and as some people have already suggested this morning -- we have some of the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002  STRICTLY CONFIDENTIAL nm 76 problems already of real exchange rate appreciation, which has led the government to increase export support and to introduce increased import duties. I understand the logic behind both of those proposals, but they certainly seem a second-best solution, as the staff responded. What I really would be interested in is if the staff have any comments on the longer-term strategic approaches to enhancing external competitiveness, because obviously that is a critical issue for maintaining Argentina' reform program. Obviously, also, I would note the importance to Argentina, along with other of the Bank's borrowers, of reform of agricultural trade and of a good outcome to the Uruguay Round. To date, Argentina's reform program appears to have been put in place without significant short-term output losses for the economy as a whole. That is a very positive achievement, and I wonder if there are lessons for other reform programs and how Argentina has actually succeeded in doing that. I note the dramatic fall in federal government employment. Perhaps much of that has been devolved to the states, certainly maybe a slightly spurious number. I would MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002  STRICTLY CONFIDENTIAL nm 77 have liked to have seen some more data on employment trends generally both as a measure of the social impact of the adjustment process and also as background to the potential for labor market reform. On the areas that the Bank is proposing to work on, one comment on energy and infrastructure, the paper discusses a possible regulatory loan to strengthen its regulatory institutions. And, I note that there have been problems with regulatory institutions in the past. It seems to me that in a country where skilled administrators and regulators are in short supply, there are some serious doubts about setting up separate regulatory agencies to regulate each monopoly. There is a lot to be said for an across-the-board approach to regulation, which would allow those skills to be spread across the economy as a I whole. I guess what I am saying is that we should be wary of applying the U.S. regulatory model where it is perhaps not relevant. On the loan itself, there is obviously no doubt that reform of the finance sector is crucial for development. In this case, it will ensure that the capital flow is put to productive use. But, on two aspects of the loan, I am a MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 /?O? \ \4,<;.,;r,r,r,  STRICTLY CONFIDENTIAL nm 78 little disappointed. Firstly, I don't know if I can describe these banks by their initials, on BHN, this seems to me to be part of a highly distorted public housing policy. I am left unsure of the purpose of this organization, and equally unsure of the logic of it remaining in the public sector. I note the last sentence of Annex V, which says rather coyly that privatization may ultimately be required. And, I wonder if the staff could comment on that. Secondly, on BNA, I am worried by the first sentence in paragraph 90 of the text, which says, "The government wishes to retain full control over the BNA", which is Argentina's largest bank. One of the successes of Argentine policy has been fiscal reform, flowing from reducing the demands from public sector trading agencies. But here, we seem to be opening ourselves up to continued fiscal demands from the BNA. It seems to me and in my own country we have experience of this -- that owning banks during process of financial liberalization is a highly risky thing to do. So, I would have been happier to have seen a plan for privatization of the BNA. With those comments, Mr. Chairman, I can support MILLER REPORTING CO., INC. '>07 C Street, N.E. Washington, D.C. 20002 (202) '>46-6666  STRICTLY CONFIDENTIAL nm 79 both the assistance strategy and the loan. Thank you,. MR. KARAOSMANOGLU: Thank you, Mr. Wilson. Mr. Jalan, please. MR. JALAN: Thank you, Mr. Chairman. Most of the issues pertinent both to the economy as well as to the country strategy have been raised already, and I do not propose to take much of your time. I find the document quite comprehensive and interesting, and also I was very glad to see that it responds to the kind of problems which were raised by Mr. Shahid Husain during his Latin American briefing about a month ago, the problems of poverty, infrastructure, institution-building as well as environment. So, I can easily support this document. The Argentinean Government deserves our congratula- tions and support for all the measures that have been taken. So, we are happy to support both the loan, as well as the country assistance strategy document. I have only two points to make. Number one is in regard to the structure of external financing envisaged during the rest of this decade. Apart from foreign private investment or the equity investment, there is a very substan- MILLER REPORTING CO., INC. 507 C Street, N.E. Washingt0n, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 80 tial reliance on short-term private capital flows, as far as I can see from this document. This point has already been raised in the earlier discussion, but I think the issue needs to be perhaps further focused, because I do detect a certain sense of complacency in the document about both the sus- tainability of the such large volumes of debt .pcia.rat;8' capital and also the desirability of the sort of accumulation of private debt, which these inflows imply. And, what we are seeing in Argentina is that you have a shift from accumulation of public debt to accumulation of private debt both on the domestic side, as well as on the ~~"°"' J;g;i;;gi:~ side. I wonder, in the light of the experience that we have had in the 1970s and ~the ensuing public debt crisis, whether the kind of projection which is implicit here with regard to accumulation of build-up of private debt is the sort of thing~ilh ::J &ould be a little more cautious about, perhaps . I\ a little more debate. I don't find this issue being discussed, except a very sort of casual -- "casual" is p~rhaps the wrong word or ~ it I ,.t. J not a very polite word -- reference that this would happen A because of reflows arising out of repatriation of private capital. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 81 ~ I think this issue requires discussion;a'fflt" probably this is not the time or we don't have the time to discuss it, but I would urge the department to look into this issue somewhat more closely, both the sustainability and the desirability issue in regard to build-up of this vast volume J,JJ-- JJJ. of private s.pj:le.l, short-term private capitgl of roughly $3.7 billion to $4 billion a year. I,weaA, lere is at least some potential danger in this. Whether the government guarantees it or not, the flows are volatile. Whether the government guarantees or not, if (p,. ~ they disappear, i t ~ a major crisis• hifllicit @zisa.s. I am ,... not trying to be unduly alarmist. The only point I would make is, just as we have sort of learned to be cautious about public debt and most of ,,...,,,,. ..a-tT' documents have a tremendous amount of discussion of public debt, in the Argentinean situation perhaps similar discussion of the private debt issue or the build-up ieelci..i9- .iWte~il..to the next ten years is necessary and desirable. In that context, I do feel -- and here I disagree with David - that I think the Bank should probably play a larger rather than""lesser r o l e • ~ ~ terms of the mix of /t ~ financing, we he: e e seen j R :&Jet t ertm~ almost insignificant net flows from the Bank Group. This, to my mind, is something MILLER FIEPOFITING CO., INC. 507 C Street, N.E. Washington. D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 82 which we should be concerned about . • prudent J. J d sks and so an aiad 1a@ f@J!t'h. In terms ol,oo volumes, I don't think one can say the Bank is doing .;l;-E) much. In fact, i-aw sa~iDQ I am of the view that the Bank is doing too little. So, this is one point that I am highlighting for consideration. The second issue is relatively minor but it is still an interesting one. In regard to BANADE • I hope I am p1011e!!H8:i.A'3' 8-~ »A D l!l y ightl, a-- tt seems that the Bank has been very deeply involved in financing this development financial institution. If I understand correctly, four loans have been given; the latest loan was disbursed in 1992. I am sure when these loans came to the Board, BANADE must have been held up I as a very fine institution which is financing private capital, playing a very important intermediation role. And here, we see as part of the conditionality of this loan, the closure of BANADE is being proposed by the i-~k same 88:Rlrn - not the same in terms of individuals but by the same department. There is perhaps a lesson to be learned here. I mean, what happened? And, I think it will be interesting to MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546,6666  STRICTLY CONFIDENTIAL nm 83 understand the dynamics of the growth of BANADE, that from a fine institution, worthy of World Bank support, it has suddenly become an institution whose closure is a condition for World Bank assistance! Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Jalan. Times change. (Laughter.) MR. KARAOSMANOGLU: Mr. Malan. MR. MALAN: Thank you, Mr. Chairman. The proposed operation before us, which of course we support, proposes three things. First of all, to express the support of the World Bank to Argentinean debt agreement with commercial bank creditors, since half of the proceeds of the loan are supposed to go for the constitution of col- lateral. Secondly, to continue the support of the World Bank to the Argentineans' efforts to consolidate the macroeconomic gains of the recent years and to strengthen institutions. And thirdly, the specific financial sector reform program. I have specific comments which I would like to make. Some of them are questions. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 84 First of all, given the importance of the conver- tibility law and the exchange rate as an anchor in the whole stabilization effort, like Mr. Grilli, I was also expecting a more in-depth discussion about not only the short but the medium-term prospects as far as exchange rate policy is concerned. The discussion on paragraph 20, page 9, is too cryptic. We are told that the government anticipates that a trade balance will improve progressively beginning in 1993 in response to continued tight fiscal policy and the commercial policy measures of November 1992, which increased the price of imports and exports in pesos. I presume that the reference here is to the increase in import tariffs and the increase in indirect tax reimbursement for exports, which was adopted in October last year, and the report notes somewhere that this is equivalent to an effective real devaluation of around 5 percent, which is the increase in price of imports and exports in pesos. Now, this has to be seen against the background of an observation which is somewhere also in the report, that the real appreciation of the peso since the beginning of the stabilization program was around 20 percent when these measures were enacted. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 {202) 546-6666  STRICTLY CONFIDENTIAL 85 nm Of course, we know -- and this was noted by some speakers -- that there are some measures taken place in terms of structural reform. Port modernization, increasing produc- tivity in the tractable sector in Argentina will have to be taken into account. But, nonetheless, I think it would be extremely helpful to have a more in-depth discussion about the exchange rate policy over the medium term and its prospects, especially in the light of the balance of payments projections, which are presented in the annexes in the document before us, especially in the light that the report itself comments about the extent to which the Argentinean economy is --- and I quote -- "unusually vulnerable to swift changes in private expectations and portfolio shifts". The other point I would like to raise is in regard to domestic debt. We are told more than once in this report that it was a bold decision taken by the Argentinean authori- ties in late December, early January, late December 1989, early January 1990, which was a forced conversion of short- term high interest government obligations into long-term dollar-denominated bonds, the BONEX-bearing LIBOR-based rates. The report notes more than once -- and the same point is made in the gray covered report, extremely useful, which was distributed recently -- that this generated some MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 86 nm - confidence, some eroded confidence in the financial system and penalized savers. At the same time, it notes that it virtually eliminated the Central Bank's quasi-fiscal deficit and the monetary mission necessary to finance it. It is not clear, reading this report or the other one, the gray covered one, what is the World Bank's staff assessment on balance of the measure taken. Was it, under the circumstances -- and that distinction should never be generalized -- under the cir- cumstances facing Argentina in late 1989, early 1990, was it .- a policy measure with some bold implications for the future that on balance was justifiable? It is not at all clear that World Bank analysis comes out of this assessment. The same thing on a more recent -- and, by the way, I think this must be a misprint here on paragraph 8, which talks about internal debt of $23 billion at the end of 1991; it should be 2.3, but increasing to $18 billion at the end of 1992. Again, this is a result of a very bold and coura- geous measures of recognizing some arrears and some obliga- tions of the public sector which was undisguised and they MILLER REPORTING CO., INC. 507 C Street, N.E. Washington. D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 87 nm have been consolidated, so to speak, through a new consolida- tion bond, but which made transparent a very sharp significan increase in Argentinean domestic public debt. Now, the question is the following: When I look at the interest, interest payments on domestic debt on Table 1, we have a sort of almost eight-fold increase in domestic public debt from end 1991 to end 1992, while interest payments on such increased debt, by more than nearly eight- fold, increases by only slightly more than four times. And, I wonder what are the nature of the underlying assumptions about the fall in domestic interest rates which are associate with such projections. And, this, of course, brings me to my last question on this particular topic, which is the observation on paragraph 18 that the primary surplus of 2.8 percent of GDP, and I quote, "will be sufficient to service interest payments and to obviate the need for a future inflation tax, given foreseeable foreign and domestic borrowing". In fact, it is more than that, because any assump- tion about a given level of primary surplus will be enough depends on underlying assumptions about interest rates, the non-interest current account balance, domestic interest rates, the rate of growth of domestic debt, the share of debt MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 88 nm to GDP, the rate of growth of monetary base and the share of base money to GDP, which we have to try to guess to the information provided here. But, it will be nice to have a more in-depth discussion about the broad assertion that 2.8 will be more than enough for the foreseeable future to keep the public finance in order in Argentina. Now, paragraphs 27 to 43 on consolidating macro- economic reform and institutional strengthening I think are very well taken, and they show that the extent to which a lot remains to be done in terms of consolidating the gains and moving towards institutional strengthening I think is worth reading. And, I should like also to commend the gray covered report on public finance from insolvency to growth in Argentina, which I think will be widely read in Argentina, and I could assure you in some other countries in Latin America as well. I think it is an important contribution from the World Bank through its economic and sector work to the policy discussions in the region. I have no specific comments on that, except to note that paragraphs 64 on page 23 made a comment which is relevant in connection of our Wapenhans Report discussion, when it says that the shift in the near future country MILLER REPORTING CO., INC. 507 C Street. N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 89 nm strategy, and an emphasis on investment lending under the decentralization of most public services to the provinces would place greater demands on institutional capacity of the government and coordination problems in project design and implementation, would expand geometrically with a number of independent actors. I will quote. "This puts a premium on designing projects with simple procedures and strong government ownership. It also limits the ability to implement the nationwide programs involving all the provinces." I think th point is very well taken. Coming to the financial sector reform program, the report notes that the Bank's own experience at capital market projects is limited. So far, there is no major problem with this. But, the point on which I would like to have some comment is that, when it comes to the national banks, BNA, BHN, BANADE and Caja, I think that a more clearly-defined agenda has been set. When it comes to the provincial banks, the agenda is less clear. And, mind you, in addition to the Banco de la Provincia de Buenos Aires, we are told there are 29 other provincial banks. Paragraph 77 in this report notes that the Central Mil.LEA REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 90 nm Bank has found difficulty in closing non-performing provincia banks since many are governed by provincial constitutions and/or laws which often mandate their existence. I think this is not a special particular problem of Argentina, but it is a question that has to be addressed in other republics in the region as well. But, it is a problem which requires a lot of imagination and building up of constituency for reform and political coalitions. It is not going to be sorted out simply by the imposition of the World Bank as a tranched conditionality. It requires a continuation of the policy dialogue and the demonstration of the damage to the stabili- zation effort that allows uncontrolled provincial banks to function the way they have been functioning in the past. But, that is an assay in persuasion here, an important one. On the private banks and Bank supervision, I couldn't agree more of the important role that the World Bank could play in technical assistance to that particular project So, let me conclude, Mr. Chairman, by praising the World Bank staff for their economic and sector work with Argentina over the years, by praising the report, the gray covered report we just received and read with great interest, from public finance in Argentina, from insolvency to growth. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 91 nm Just to conclude, I would like to say that I think that Mr. Grilli's comments and concerns about some more medium and long-term discussion would have been extremely welcomed in this context. Thank you. MR. KARAOSMANOGLU: Thank you, Mr. Malan. When we start the staff response, I will ask Mr. Newfarmer to start with that issue, and then we can cover other subjects. Mr. Matambo, please. MR. MATAMBO: Thank you, Mr. Chairman. Mr. Chairman, like the previous speakers, I am pleased to extend my support to this operation for Argentina. We believe that the loan is very crucial for financial sector reform, and also for reestablishing Argentina's creditworthi- ness in the international financial markets, which will provide the substantial support to the government efforts to establish an efficient banking system through privatization, as well as in enhancing the role of the Central Bank. This operation will also help in addressing the serious debt problem that Argentina has been suffering for a long time. We believe, Mr. Chairman, that the Argentine MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 92 nm authorities deserve to be commended for their impressive efforts during the past few years in the areas of macro- economic management, privatization, legal and regulatory framework, labor legislation, decentralization and liberali- zation of the trade and price systems. We note, in particular, efforts so far undertaken to tackle inflation through pursuing prudent fiscal and monetary policies. While we feel that the impressive achievements reflected in paragraphs 5 to 12 lay a good foundation for further reform, we share the view that a lot remains to be ·- done to address Argentina's chronic economic imbalances. In this connection, we attach special importance to speeding up the implementation of the recently concluded debt reduction agreement between Argentina and its commercial bank creditors We also welcome the new codes enacted to strengthen the supervisory role of the Central Bank and to restore monetary discipline. We believe that the program is consistent with the Bank's country assistance strategy. On that point, let me now turn to the Bank's country assistance strategy. We broadly agree with the proposed strategy. - However, let me make three short comments. MILLER REPORTING CO., INC. S07 C Sueet, N.E. Washington, D.C. 20002 (202) 546·6666  STRICTLY CONFIDENTIAL 93 nm First, on provincial adjustment, while we do not have any difficulties with the proposed reforms, we believe that there is an urgent need for a clearly defined arrangemen that will govern the financial relations between the federal government and the provinces. As provinces are a major source of the financial and monetary distortions, there is a risk that the absence of such an arrangement might undermine the whole reform. We I believe that intensive dialogue with the government is needed I in this regard to put the appropriate legal and administrativ, framework in place. My second observation relates to the labor market which other people have also touched upon. While we ap- preciate the steps so far taken to liberalize the market, we believe that for attracting private capital and encouraging the return of flight capital, more flexible labor laws are needed. We hope that the Bank's planned economic sector work will help in achieving this objective. Our third concern relates to the sharp increase in the number of the poor during the last decade, and the inadequacy of poverty reduction programs. Although we note the Bank's strategy focuses on the social sector, we believe - that much more needs to be done. The availability of MILLER REPORTING CO., INC. 507 C Street. N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 94 nm reliable data is a major prerequisite for any poverty reduction strategy. With the situation that the footnote on page 18 reflects in this regard, we feel that identifying targeted interventions to alleviate poverty may not be adequately covered, particularly in the short-run. We, therefore, urge that high priority should be given to data collection. Lastly, we note the steady improvement in the implementation of projects in portfolio management. The efforts undertaken by the government to tighten the link between the investment program and the budget is also commendable. We believe that this is extremely crucial for restoring financial and monetary discipline. In conclusion, Mr. Chairman, I would like to wish the Argentine authorities all success in their endeavors to restructure their economy, and I also wish to commend the staff of the Bank for this well-prepared document. Thank you. MR. KARAOSMANOGLU: Thank you, Mr. Matambo. Mr. Sigrist, please. MR. SIGRIST: Thank you, Mr. Chairman. We support the proposed adjustment operation. I would like to concentrate my comments on the macroeconomic MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D .C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 95 nm policy and on the country assistance strategy, and confine myself to two points. First, on the stabilization efforts and the exchange rate and trade policies, my authorities, as other speakers, commend the stabilization efforts undertaken so far by the Argentine authorities. Yet, as many other speakers, we would like to voice some concern about the recent trade policy measures. I would like to invite staff for some more detailed comments on the costs and benefits of the 1991 convertibility law, pegging the peso to the U.S. dollar at a one to one rate In view of the sharply deteriorated trade balance, paragraph 45 of the document seems to imply that the Bank endorses the increase of average protection levels to correct these trade balances. As other speakers, I would like to better understand why trade measures and not exchange rate adjustments are considered to be the best policy choice in these circumstances. And, secondly, I would like to ask for an assessmen of how long such protectionist measure policies are intended to be pursued. Annex III predicts a dramatic decrease in the rate of growth of imports from 43 to only 1 percent, and a respective increase of export growth from 2 to 8 percent MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202} 546-6666  STRICTLY CONFIDENTIAL 96 nm within only one year .. It seems to me that this is a rather optimistic assumption. Second, on the assistance strategy, we generally support the outlined future lending strategy and also welcome the overview of the policy issues in proposed FY93-95 lending given in Annex XII. I have two comments here. First, in reference to paragraph 21, I would like to ask staff for an order of magnitude on the Bank's exposure to Argentina over the next five years in relation to total IBRD lending. Second, we think that the information on the proposed lending level and sequencing remains too vague. And here, we follow an observation that was also made by Mr. Collins on the sequencing. It would also have been useful to be more specific on the performance criteria for future lending, outlined in paragraph 57. I would like to recall assurances received from staff during the discussions on the Yacyreta project that overall lending levels would also be guided by the implementation performance of ongoing projects. I support Mr. Peretz' comments that it would be useful to have more information on ongoing projects to learn lessons for future MILLER REPORTING CO., INC. ~07 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 97 nm lending. Thank you, Mr. Chairman. MR. KARAOSMANOGLU: Thank you, Mr. Sigrist. Mrs. Herfkens, please. MRS. HERFKENS: Thank you, Mr. Chairman. At this stage of the debate, I only wanted to make a few points, particularly where I doubt that I can join the consensus. But, of course, like everybody, I would like to commend the Government of Argentina on the impressive achievements in the macroeconomic field and also to commend Bank staff who has been very involved in this, of course. Like Mr. Jalan, I also wanted to question the desirability of a strategy so reliant on private inflows, and I agree with him, and disagree with others then, on the point he made about the net flow to Argentina. The second point I want to make is on privatization When Pat Coady raised the last time we discussed Argentina that this was such a remarkable policy and maybe lessons learned, et cetera, were relevant and suggested a seminar, I also already stated that I feel that it still remains to be seen if this strategy, which is indeed very radical, is relevant for other parts of the world, and that I still feel that the issue of ownership is not the issue, but that the MILLER REPORTING CO., INC. ,01 C Street, N.E. Washington, D. C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL nm 98 real issue in this debate is one of economic management. So, I don't feel that much that a seminar should be held about this, but let's discuss it in the Steering Committee. The third point I wanted to make is labor market flexibility. It is noted everywhere in the report and everybody seems to agree with that. I do understand that Argentina has one of the most rigid sets of labor laws in the hemisphere. But, I would like to hear to what extent Argentina' current labor regulations, for instance, compare with other - regions like Europe or with ILO standards 1 because 1 to be honest, I was a bit surprised about the strong negative notion or assessment, for instance, of the collective bargaining system, which is quite common in many European countries, and where we feel very happy with. But, I cannot really compare to what extent that Argentina is so much worse than Europe, for instance. But, I would like to hear something about that. Then on the poverty strategy, most around the table were happy that it took such a strong place in the country assistance strategy, but I was more like Mr. Matambo a bit disappointed, because it is all the way down in the pipeline. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 99 nm r feel that, as the report recognizes that the number of poor in the 1980s have increased dramatically, in fact have doubled, that in an earlier stage poverty alleviation could have been part of the country assistance strategy, although I, of course, agree with David Peretz that doing something about inflation is helpful for the poor, but that doesn't mean that the Bank should not have incorporated in its lending program in an earlier stage ~the poverty alleviatio issue. Although I am aware of the fact that the ministries concerned are very weak, and that that has been a problem for staff, I still feel more could have been done. On education, I wondered why not focus first on primary education. I recall that in the case of Chile, the Bank staff very much insisted primary education first before we move into secondary education. I think in Argentina there is even much more reason than actually there was in Chile. Then, the external environment, I would like to join Mr. Al-Assaf. I think it is a very good paragraph. It doesn't solely focus on trade. It also raises other issues which I think are interesting. I just want to ask why is not NAFTA mentioned, because I recall that in the country assistance strategy for MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 100 nm was it Indonesia -- an Asian country, the impact of NAFTA on that country was mentioned. And, I would think that countries in the Western Hemisphere would be affected more than a country like Indonesia. On the other hand, if wheat is the major export product -- maybe it is not, I cannot judge it -- I would have liked to have seen something on that. Then, on the loan itself, on the project itself, I really only have two questions, a bit detailed questions. The role of the Central Bank in implementation is crucial. Most of the conditionalities are geared to what the Central Bank should be doing. Why then is the Ministry of Economic Affairs the sole implementing agency? I wondered if that is a good idea or not. Then, on the conditionalities, one of the condition for the second tranche release is compliance on adherence by provincial banks to regulations setting new reserve require- ments. Th' document makes mention of the Basel standards. fr-. --Hu.se., } E~ A t.: ~ standards are extremely high in the ~hasfr;.... ~ that are under discussion now for countries in transi- tion, more gradualism in reaching those standards is being allowed. And, I wondered if the conditions here for the second tranche are realistic and thus feasible. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 101 nm Thank you. MR. KARAOSMANOGLU: Thank you, Mrs. Herfkens. Yes, Mr. Potter, please. MR. POTTER: I wasn't on the list, but I would like to add a couple of questions if I could. But, before doing so, I navigate somewhere between Mr. Grilli's comments, which were taken up by Mr. Malan, concerning the country strategy, and my own reaction, which was that I thought that this was one of the better country strategies which we have seen, and I would like to make that point to the authors. I thought it was still wanting, if I am say so, in the discussion of criteria by which success will be judged, but that is a common observation of mine. I thought Mr. Grilli made a good point, which I hope we will take up as a matter of routine, which had to do with exposure guidelines and our exposure to countries. I would like to add a couple of questions to the list, having to do with the loan itself, the first of which has to do with real interest rates. The Operational Directive on the Financial Sector, I think, invites authors of transactions to analyze and discuss real interest rates when they are in excess, I think, of 10 percent or something like that. I would have thought MILLER REPORTING CO., INC. 507 C Sueet, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 102 nm that in this case this is a loan in which an examination of the constituents as we see them, the causes of these real interest rates might be in order, and also perspectively what actions we think this loan will lead to, which might have some effect upon them. The way in which this loan is designed presumably will get some of the overheads, quite excessive overheads in the banking system, which presumably will compress costs and do something about spreads. But, it would be interesting to look at that and taxes and other constituents, reserve requirements and stamp taxes, that sort of thing. The other thing which I would like to add to the list, I think, is akin to a point made by Mr. Grilli, and that has to do with the fact that the financial system is surprisingly shallow, and one looks at it in terms of the standard measurements. And, it is projected to remain in a not very different state in terms of scale and size over the medium term. And, that gives rise then to the question of how well we can expect this system to provide the kind of financial services to an economy which we expect to grow reasonably vigorously over the longer-term. And, a companion to that has to do with the access MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 103 nm of small and medium-term borrowers to the system. At present, they have to look pretty much to internally-generate funds or privately-accessed funds in order to finance themselves. The lion's share of institutionalized credit seems to go to the bigger players. And, one would think that that might be an issue that we have our eye on and it might be one of those criteria by which we would measure the effect of what we are doing. But, I would like to hear that discussed. But, if I may return to my original point, I thought it was a good country strategy. Thank you. MR. KARAOSMANOGLU: Thank you, Mr. Potter. MR. HUSAIN: Let me ask Ms. Dowsett-Coirolo to start with the strategy issues and perhaps then Mr. Alber can address some of the issues about the financial system that Mr. Potter raised. And then, I will ask Mr. Newfarmer, the country economist, to address the more basic issues raised by Mr. Grilli and some others on the whole issue of the viabilit of the current economic system, and Mr. Malan. MS. DOWSETT-COIROLO: All right. Several Chairs, Mr. Wilson, Mr. Matambo, Mrs. Herfkens, raised the issue of poverty, what has happened with MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 104 nm poverty, how acute it is, whether more social safety net interventions would have been desirable over the last couple of years, whether the Bank's strategy has been the proper one, whether our interventions perhaps could have come sooner First, to try to put the poverty situation in Argentina in perspective, the footnote to which one of you referred does talk about a poverty level of only about 7 percent in Argentina, and we made the point with that footnote, saying that we had used those statistics because they are drawn from a regional source that has been used for various other comparative studies by the Bank. - But, we consider that most likely the trend of a doubling of poverty during the 1980s is correct. The absolute level indicated by that source is most likely understated. There are various studies that have been carried out over the last couple of years, including under our own social sector management and technical assistance loan. And, they range quite a bit, depending on the assumptions used about income levels or access to social services that would be desirable or that would mark the cut-off point between acute poverty and other income levels. - Overall, we are using internally for our own MILLEA REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 105 nm planning a rate of about 15 percent currently, in terms of what we assume to be the level of poverty in Argentina, and that is heavily concentrated in some of the areas surrounding Buenos Aires and a couple of the larger cities. It is also concentrated in the northern provinces, to which I referred to earlier, and then, thirdly, in a sort of under-class of transitory migrant workers, part of whom originate from the northern provinces, and part of whom come from neighboring countries, who are present in the better-to-do provinces to the south. The various studies, while they differ in terms of the calculation of the total number of the poor in Argentina, show a couple of things. They all show a worsening of poverty, an acute worsening of poverty over the 1980s. Most of them show a doubling of poverty. Those that go back earlier than the 1980s show this trend of deterioration, starting earlier in the 1970s. They also show, however, in the last two years a gradual recuperation. They show a worsening of poverty; they also show a differential worsening of the high inflationary period on the poor, inflation tax having been much more severe for the poor than for the upper quarter of Argentine society in terms of income. But, all the studies also MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 106 nm indicate some recuperation over the last two years. There are signs of marginal increases in employment, which is impressive, taking into account the large amount of divestment of employment from the public sector. But, nonetheless, there is a net increase in employment. Also, real wages show significant improvement since the 1988-89 period, and that is across most subsectors, except for the public service itself, national administration itself. The Bank did very little in the social sectors historically in Argentina. There was a vocational training project in the late 1970s, early 1980s, which was finally cancelled with very little disbursed. And, our first real entree was around 1987, when we did produce a study, social sectors in crisis, that provided a lot of the data and analytical underpinnings for the conclusion that there had been a major deterioration both in poverty and particularly in access to social services during the 1970s and 1980s. That was used with government very effectively to generate interest in a series of studies, which we then supported under the social sector management/technical assistance loan, which has been our main vehicle for dialogue on social sector issues over the last couple of years. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 107 nm And, as Mrs. Herfkens pointed out, it has been extremely difficult because there has been rapid turnover in the management of various of the social sector ministries, which were weak ministries to begin with, at the same time that there has been a decentralization in process of various services. So, the dialogue hasn't been easy. We have been maintaining it under that loan. We do have what we consider to be a rather ambitiou set of operations, which will build on a lot of the work in that social sector management project over the next couple of years. And, we are looking forward to being able to leverage that analytical work into quite a substantial increase in direct Bank involvement in these areas. On exposure indicators, yes, we should have included the exposure indicators in the country assistance strategy. We had some of them in the President's Report on the debt service operation last month, but the country assistance strategy is supposed to be a self-contained document. And, we should certainly have included them. We did circulate them to several Chairs whose offices called and asked for the information, and they are - available to the others. MILLER REPORTING CO., INC, 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 108 nm In answer to the specific question that one Chair raised on the share of IBRD debt service and total debt service, we have got a series here from 1992 to the year 2000. It ranges in the 5 to 6 percent area year-by-year. On Mr. Grilli's point about the total volume of unrestructurable debt being much higher than the total volume of preferred debt to debt service, the ratio of preferred debt to debt service, that is true, of course, of certain shares. A significant share of that unrestructurable debt is backed up by collateral, and that has to be taken into account in analysis of those numbers. Preferred debt, per se, to total debt service peaks at around 25 percent in 1996 and then declines towards the year 2000 and again these figures are available to whoever would like them. Mr. Newfarmer will deal with the issue of the assumptions underlying our medium-term scenario. I will just comment briefly on the points raised on the external environ-· ment, trade flows, which ties in with the feasibility of the export assumptions in here. The export assumptions are rather ambitious, and from the standpoint of the external environment certainly will be influenced by the outcome of the Uruguay Round and MILLER REPORTING CO., INC. S07 C Street, N.E. Washington, D.C. 20002 (202) S46-6666  STRICTLY CONFIDENTIAL 109 nm the GATT negotiations. Argentina is a major exporter of grains and oilseeds and probably no more than half of the world oilseed crop is traded, more than 20 percent of the world grain crop is traded, and Argentina is already an extremely competitive producer, a low-cost producer in both fields. So, given a more level playing field, its ability to compete and expand exports dramatically is there. Now, by the same token, we have not used those assumptions in this series. We haven't assumed a certain outcome to the Uruguay Round. We have relied on the Bank's corrunodity price projections, which take into account the effects on the grain market of the former Soviet Union republics, the change in their trading patterns in the area of grain. But, both for grains and soybeans, which are the two crops of critical importance to Argentina, beyond the crops into which it is diversifying, the price trends projected by the Bank on the soybeans, on the oilseeds side are quite reasonably positive over the rest of this decade. In grains, they hold about level; they expand a bit in the latter part of the century and then drop off again. The expansion is largely due to increased consump- MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 110 nm tion by the Asian and Pacific-rim countries. MR. HUSAIN: Mr. Alber first. MR. KARAOSMANOGLU: Mr. Alber. MR. ALBER: Several questions were asked around the specifics of the financial sector loan, basically, around the reform of the national banks. There were questions on the provincial banks. There were questions on the Central Bank, and there were questions on explicit deposit insurance. First, the national banks, if I may, let me give you some background on the reforms of the national banks. We have been at this task for many years, and have contributed through our own staff and through consulting efforts in narrowing down the options for reform. Eventually I am glad to say that the Bank was able to contribute towards the closure of BANADE, as you see it here under the loan, to move the Banco Hipotecario into the second tier, to contributl to the privatization of the Caja de Ahorro, which is also a major bank, and to commence a discussion on the major bank, namely the Banco de la Nacion. The reason why we were able to define more precisel the option of second tier for Banco Hipotecario was the Banco Hipotecario is a simple institution. It has one lending -- purpose, namely lending for housing, plus it has clearly MILLER REPORTING CO., INC. 507 C Street, N-E- Washington, D.C 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 111 nm failed in the first year. So, it was easier to move it into second tier. As far as Banco de la Nacion is concerned, this is a complex, large financial institution. And, the government has not yet developed, let's say, the full consensus to engage in a radical reform of this bank. But, both for Banco Hipotecario and for Banco de la Nacion, we have chosen a vehicle for further discussion, namely these performance agreements, not that we entirely believe that performance agreements will eventually develop, but we believe that this is a very useful process where we will look at the costs and benefits of further options. We have successfully used the strategy in our privatization loan, where we had in our conditionality performance agreements for the oil company, for the Metropo- litan Railway Company, et cetera, where in fact then the government moved much quicker into more dramatic action. And, this is fully explained in one of the transfer list documents which you also have seen. So, our hope is that reform in Banco de la Nacion will further be defined in the context of this loan, and we will be able to have, let's say, in reality a more radical and a bolder ultimate solution. The government certainly has MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 112 nm shown boldness in many other major companies, and related privatization. As far as provincial banks are concerned, we have to recognize that provincial banks are owned by provincial governments, and, as long as these provincial governments are not yet ready to make substantial changes with the banks, we will not be effective. And, this is why we have chosen under this loan to be rather modest in pursuing provincial bank reform. We will have additional lending operations where we will focus on those provinces where their will for reform has clearly been demonstrated. The Bank cannot substitute for the basic will; we can only support the basic will. On Central Bank, this loan is a complement to some other loans, which also have dealt with the Central Bank. And, we have a technical assistance loan, which runs in parallel where reforms are being pursued in the information systems, automation systems. And, this loan merely deals with one outstanding issue which had not been covered under previous loans. This is why it is proper for the Ministry of Economy to be the implementing agency. But, we definitely have the Central Bank in mind in our other activities. MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 113 nm Explicit deposit insurance, well, the fact is that Argentina has had very bad experience with explicit deposit insurances. Its institutions have totally lost credibility, and it would not have seemed a good idea to follow a course which has failed in the past. And, therefore, the Argentines, and we agree with them, have chosen to look for alternate solutions. And, we will have to see whether this works, namely to have sort of minimal protection, but combined with better supervision, banking supervision and with better access to information on the performance of the banks, namely to place more of a burden on depositors, investors and managers. As far as interest rates are concerned, I think we have to recognize that the high real rates in the Argentine context are the result of the shrinking of the financial system over the last few years, and also the avoidance of making loans. Banks have become financial services enter- prises, and we would expect that, as the financial system expands in the future, these spreads will become lower. MR. HUSAIN: Can you answer Mr. Potter's question about the shallowness of the system and how will this contribute to making it deeper? MR. ALBER: Well, the shallowness of the system is MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 114 nm the result of the failed macroeconomic policies and inflation No financial system resists that type of inflationary events and ultimately which resulted in hyperinflation in mid-1990. MR. KARAOSMANOGLU: Mr. Potter. MR. POTTER: We know how we got here, but the ques- tion is what is the prospect, what is the outlook? I think I am right in saying I won't find it here if I go looking right now that the outlook was the dimensions of the system were not going to change materially. And, the question is whether a system that was going to remain relatively modest could do the job for the economy? MR. HUSAIN: Let me draw Mr. Potter's attention to the largest sector report that has already been distributed to the Board on the financial developments in Argentina. And, it is worth reading. And there, it is discussed at some length. There already has been a certain deepening of the market, which means that people are able to raise, for example, two-year money, which would have been totally unheard of about two years ago. If we look at the example of Chile, then one can expect that, if the macroeconomic management is maintained and, therefore, confidence continues in the continuity of the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 115 nm economic policy, one should see a further deepening of the financial institutions. Now, the question that you raised, Mr. Potter, about the lack of access of medium and small entrepreneurs to the financing is a real question. And, this is one of the issues we are going to focus on as a part of our work on the capital markets. Mr. Newfarmer. MR. KARAOSMANOGLU: Mr. Newfarmer. Mr. Peretz, yes. MR. PERETZ: Well, I was just going to add that I thought -- I may be wrong but I thought the pension reform proposals in Argentina, which if I am right will end up privatizing a lot of the pension business, it will actually, as it was in Chile, be a major contributor to the growth of the capital markets. That is a further point, but I -- MR. HUSAIN: A very important issue, I think, was raised by Mr. Haas on the whole question of sequencing in this regard, because, yes, the pension funds should float through the private market, but simultaneously the regulatory framework and the institutional framework will be critical - for this. And, this is one of the areas we are addressing MILLEA REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) H6-6666  STRICTLY CONFIDENTIAL 116 nm through our capital market work. MR. KARAOSMANOGLU: Mr. Newfarmer. MR. NEWFARMER: Several speakers expressed concern about the emerging macroeconomic imbalance in the private sector, as manifested in the trade deficit. And, Mr. Malan, Mr. Jalan, Mr. Peretz, Mr. Grilli, Mr. Al-Assaf, Mr. Aris and Mr. Wilson were the ones that I noted and perhaps it is on the minds of others as well. Certainly, it is on the mind of Bank staff. The number for 1992 is indeed $2.S billion. This is based on I fourth quarter numbers that just came in and are still :! estimates, but it does look like the trade deficit will be of lj that size. It is important to understand the characteristics and makeup of what has happened in the trade balance. Exports have continued to grow and indeed are higher in 1992 than they were in the previous two and three years. What has happened on the trade balance has been basically the story on the import side. Imports have more than tripled since 1990. This reflects a number of factors. First of all, we have to remember that during the 1980s, the economy grew very little; in fact, in per capita terms, it actually declined. So, there was a large amount of MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 117 nm repressed consumption. Secondly, firms after the stabilization program of 1991 began to rebuild inventories. And, thirdly, I think there is a generalized reflection of confidence in economic management. And so, what we see in recent quarters is an increasing dominance of investment goods in the total import basket, a development which we consider to be quite salutary. Nonetheless, I think there is reason to be cautious at least about the projections that this paper has, and we have tried to be quite candid with you in reflecting our own cautions about those projections. These are based on the government's view of its own economic program, as agreed with the IMF. And, basically, projects a rather smooth landing from the high value of the peso, as growth in 1993 will perhaps slow somewhat from the very high rates in 1991, in 1992, and thereby bring down wages and nominal prices and effect a slow adjustment in the trade accounts, while at the same time capital inflows, largely reflecting the external savings of Argentines, continue to support slower growing but nonetheless high levels of imports. It should be noted that this scenario does have some credibility. A 3 percent economic growth, which is the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D,C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 118 nm projection in 1993, per capita consumption, average private consumption will actually decline by 1.8 percent. And, this, it is envisaged, will take some of the burden off of wage price inflation that we see in Argentina. But, the fact is that in order for us to have a clear view of the scenario, it would be nice to have some questions answered, which unfortunately we cannot answer. We cannot answer the question, for example, how much and how long will the capital inflows, based upon private savings abroad, continue to come into Argentina. This is an issue that Mr. Grilli pointed to. We just don't know what the behavior of the private sector is going to be. Secondly, we don't know if capital inflows do fall, how much the economy will have to slow down in order to effect an adjustment on import demand and the trade balance and also wages and prices domestically in order to rectify the trade balance. We have actually run some econometric models based upon elasticities and parameters that were prevalent in the 1980s, but these mean very little because those relationships by definition don't pertain to today. The third question is the fiscal effects of any MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 119 nm economic slowdown. And here, we have highlighted this in the public finance review as an issue which we have put on the table in front of the government to discuss with them; namely, what happens to revenues if economic growth slows, and what sort of adjustment would have to occur on the expenditure side of the fiscal accounts. Our analysis -- and is based upon simply sensitivit analysis -- suggests that there is room on the expenditure side for contraction in the event that revenues do fall, but this will be something that we have to look at as time goes on. -- And the final uncertainty that I think is important to signal here is the capacity of the government to influence the real exchange rate. The German Chair, I believe, alluded to the fact or raised the question of why not adjust the exchange rate in order to solve the problem? In fact, it is very doubtful that the Argentine Government has a great deal ! of power to affect the real exchange rate. This economy is very indexed. The movement of the exchange rate will immediately be reflected in prices down to the retail level, as small businessmen, as price setters in the economy look at the exchange rate as the portent of future inflation. For these reasons, we have opted to focus on MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 {202) 546-6666  STRICTLY CONFIDENTIAL 120 nm fundamentals. Let's look at precisely those things that Mr. Grilli indicated, that will foment private investment over the long-term, that will increase private savings, and that will increase the productivity over all of the economy. In fact, we have seen enormous productivity gains in the last eighteen months to twenty months, as the g has worked very hard to reduce costs. This has been particularly the case in financial costs, but also costs of ports, costs of transportation and costs of public utilities have fallen very dramatically to the private sector. It should also be noted that savings domestically have increased. They are still quite low, as Mr. Grilli quite rightly points out. But, one has to remember that Argentina is a very internationalized economy, and for the last twenty years, Argentine wealth holders have saved abroad. Now, what we see not only are they saving abroad, but they are actually repatriating some of that saving and investing domestically. And, I think that is a salutary sign Let me mention one other things on the fundamentals Our strategy is, therefore, to focus on public sector reform, as being the key issue over the medium-term, and for that reason we have highlighted the importance of social security reform, reform of the provinces and in this loan, reform of MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 121 nm the financial sector. MR. KARAOSMANOGLU: Thank you, Mr. Newfarmer. Mr. Husain. MR. HUSAIN: I just want to conclude, Mr. Chairman, with some very brief remarks on how we see Argentina overall, a little comment on the Bank's role. What Argentina has achieved over the last two years is remarkable. But, let me say that some of the most difficult tasks still remain ahead, and the most difficult tasks are basically the reform, fiscal reform and the implementation capacity of the state governments. That is where a large proportion of the national resources are going to flow. That is where the fundamental task ahead of focus on social services is going to be. Unfortunately, the capacity of these levels of government are much weaker than they were at the Central Government level. There is a large number of provinces with differing management ability, and clearly their decisions are going to be much more politicized in these areas than had been at the Central Government. Let me also remind you that Argentina has been able to implement these reforms in the last two years in a remarkable environment of political consensus. But, as the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 122 nm sense of crisis abates, that strength of political consensus is not going to endure. And, what will happen in Argentina is what one should expect almost in any country, which means that the resistance to change will be greater, and divested interest to change will assert themselves. And therefore, the Bank will have to develop a greater capacity to understand the political economy of change. We see that partly in this loan because, yes, ideally it would have been nice to sort of privatize the Banco de la Nacion. Ideally, people should have completely phased out middle-income subsidies for housing. But, in political economy terms, those extra steps might have jeopardized all the other reforms that we are talking about. And, therefore, we should think much more in terms of not what is desirable in the extreme, but what sort of compromises and trade-offs the government had to make in order to achieve the larger goal. And, I think we are going to have to engage increasingly in that. Given that, the Bank's task ahead is going to be more difficult than the task that we have done in the last two or three years, although I think what the Bank has done is remarkable. And, I cannot think of many countries where MILLER REPORTING CO., INC. 507 C Street, N .E. Washington, D.C. 20002 ( 20 2) 546-6666  STRICTLY CONFIDENTIAL 123 nm the Bank's impact on economic change has been of the same order as in Argentina. But, now we shall have to concern ourselves a lot more not just with policy changes but institutional changes, and work on institutional changes is always more difficult. You are much more concerned about people, about habits, about group interactions and so on. So, we should expect to see greater difficulty and perhaps a certain amount of slowdown in our lending. I am a little concerned, I think Mr. Peretz mentioned that the Bank is going to extend its exposure in Argentina by $5 billion in the next five years. That is not correct. Our lending will be $5 billion, but our exposure will not increase by $5 billion. In fact, the repayments by Argentina are increasing very sharply, and the average net disbursement of the Bank in Argentina will be only $300 million. And, I would like to point to what Mrs. Herfkens said, that it is important that private capital should come in; it is important that govern- ments should not assume any significant part of the liability of private capital flows, but by the same token, there are essential things to be done in the public sector. And while the state should be small, what remains MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 124 nm of the state has to be strong. And, in fact, one of the critical tasks ahead for the Argentineans and for the Bank is the rehabilitation of the state, particularly in the delivery of social services. And that requires not simply intellectua work but financial flows. And, that is the aim that we have ahead of us. One issue raised by Mr. Jalan was not answered, namely that we made four loans to BANADE and now we are instrumental in asking for BANADE to be closed. My view is that we made four loans too many to BANADE, which means that the essential design of the thing was wrong; namely, sort of side-tracking the capital markets and the possibility of the capital markets, using a government institution in a country where the instruments of answerability were not there, which was the rule by military governments for most of this period to channel large resources to industries through a publicly- held bank. And what happened was naturally in this case, which means that most of them were behest loans, politicized loans. Many of them were not paid, and it was a massive subsidy to the privileged groups. So, I am glad that we have accepted our mistake in - this case. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C, 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 125 nm MR. KARAOSMANOGLU: Thank you, Mr. Husain. Mrs. Herfkens. MRS. HERFKENS: I still had three questions which were not answered. But, it's okay with me if that could be in a written fashion because of the time. And, I very much appreciate the last statement of Mr. Husain. But still, I would like to have some information about the impact of NAFTA. I would like to have some information on labor regulations, how sinful those would be, if you don't compare them with the Western Hemisphere but, for instance, with Europe or ILO standards. Third, why not focus on primary education first because of its impact on poverty. I don't have to have those answers now because I see everybody wants to leave and, of course, it is lunchtime, but maybe in a written fashion. MR. KARAOSMANOGLU: Thank you. MR. HUSAIN: We shall ask the staff to meet you, Mrs. Herfkens. MR. KARAOSMANOGLU: Mr. Peretz. MR. PERETZ: Other Directors will be interested in the answers also. MR. KARAOSMANOGLU: Mr. Grilli. MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 ( 202) 546-6666  STRICTLY CONFIDENTIAL 126 nm I' MR. GRILLI: Yes, Mr. Chairman, on this question of exposure, of course, you know, our exposure to Argentina is not going to increase by the same amount of our lending. But, it still doubles between 1992 and 1996 or 1997 from about 2.5 to 5 percent. And, that is a fairly large increase. MR. KARAOSMANOGLU: Yes. But, before closing this issue, I think we will continue to grope for a better statement of the country strategies and the Bank's approach to this issue. However, I hope this doesn't lead us to include certain items by definition in all the country strategy discussions, because then we will not be able to present you a meaningful discussion of country strategy, especially when it comes to complex economies, where the situations change over time and the issues to be concentrated on may be different from time to time. And, when it comes to the exposure limits, I wonder if we really have to put it even when there are no exposure issues in a country which we are discussing as a country strategy. But, this is something which we can continue paying attention to. The loan is approved on the terms proposed, and the MILLER REPORTING CO., INC. 507 C Street, N.E. Washington, D.C. 20002 (202) 546-6666  STRICTLY CONFIDENTIAL 127 run Chairman's. concluding remarks will be circulated. MILLER REPORTING CO., INC. 507 C Sucet, N.E. Washington, D.C. 20002 (202) S46-6666