Argentina - Provincial Bank Privatization Loan

Document of The World Bank FOR OFFICIAL USE ONLY FILE a' rV Report No. P-6570-AR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROVINCIAL BANK PRIVATIZATION LOAN IN AN AMOUNT EQUIVALENT TO US$500 MILLION TO ARGENTINE REPUBLIC APRIL 20, 1995 This document has a restricted distribution and may be used bv recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS Currency Unit: Argentine Peso (Arg$) Arg$1 = US$1 ACRONYMS AND ABBREVIATIONS BANADE = National Development Bank (Banco Nacional de Desarrollo) BCRA = Central Bank (Banco Central de la Republica Argentina) BHN = National Mortgage Bank (Banco Hipotecario Nacional) BICE = Investment and Trade Bank (Banco de Inversi6n y Comercio Exterior) BNA = Banco de la Naci6n Argentina CIF = Cost Insurance Freight CNV - Comisi6n Nacional de Valores CPI = Consumer Price Index EFF = Extended Fund Facility FSAL = Financial Sector Adjustment Loan FY = Fiscal Year GDP = Gross Domestic Product IBRD = International Bank for Reconstruction and Development IDB = Inter American Development Bank IFC International Finance Corporation IMF International Monetary Fund LIBOR London Interbank Offer Rate MERCOSUR = Southern Cone Trade Bloc (Mercado del Cono Sur) P/E = Price/Earnings PRL = Provincial Reform Loan PSRL = Public Sector Reform Loan SME = Small and Medium Enterprises VAT = Value-Added Tax YPF = YPF Oil Company (Yacimientos Petroliferos Fiscales) WPI = Wholesale Price Index  FOR OFFICIAL USE ONLY ARGENTINA PROVINCIAL BANK PRIVATIZATION LOAN TABLE OF CONTENTS Page No. I. THE SETTING .......................................... 1- Economic Context ........................................ 1 Recent Performance . ....................................... 2 The Mexico Crisis . ....................................... 3 I1. THE FINANCIAL SECTOR ......... ......................... 4 Financial Sector Policy Objectives and Reform ....................... 4 Regulatory Reform ......................................... 5 Sector Restructuring . ....................................... 7 Adjustment in Public Banks .............................. 7 Adjustment in Private Banks .............................. 8 Effects of the Crisis . ....................................... 8 Capital Markets Reaction ................................ 9 Government Response ... 10 Future Prospects ... .................. ............... 11 Provincial Banks ............. ....... 12 Efficiency Impact of Provincial Banks ....................... 12 Confidence Impact of Provincial Banks ...................... 13 Impact of Recent Liquidity Crisis .......................... 13 III. PROVINCIAL BANKS AND PROVINCIAL FINANCES ............... 14 Estimated Costs and Benefits .15 IV. THE PROPOSED- LOAN ................................... 17 Bank Involvement in the Financial Sector .......................... 17 Background .............................. 17 Loan Objectives and Description .............................. 18 Prospects for Provincial Bank Privatization . ....................... 19 Privatization Methodology .............................. 19 Coordination with Multilateral Institutions .......................... 20 Loan Amount .............................. 21 Agreements Reached During Negotiations . ....................... 21 Tranche Conditions .............................. 22 Disbursement, Procurement, Records and Auditing .24 Benefits and Risks ........... ............................ 25 Social Impact . ............. ............................ 26 Environrmental Aspects ............................. 27 This Report is based on the findings of a joint task team of Messrs. Stefan Alber and Mauricio Carrizosa who visited Argentina in February 1995. Other mission members included Hemant Shah (Sr. Financial Sector Economist) and Jacques Morisset (Country Economist). Mr. Danny Leipziger (Lead Economist) and Ms. Diana McNaughton (Peer Reviewer) participated in the mission as well. Ms. Clarisabel Coss has been responsible for report processing. Messrs./Ms. Constance Bernard, Orville Grimes and Gobind T. Nankani are the responsible Chief, Project Advisor and Director, respectively. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  V. RECOMMENDATION .................................... 27 ANNEXES A. Letter of Sectoral Development Policy B. Status of Bank Group Operations C. Status of IFC Investments D. Performance of Public Banks E. The Fiscal Situation in the Provinces F. Provincial Bank Privatization Program G. Privatization Costs H. Role and Operation of the Privatization Trust Fund I. Matrix of Tranche Conditions Map - IBRD No. 25587  ARGENTINA PROVINCIAL BANK PRIVATIZATION LOAN Loan and Program Summary Borrower: The Argentine Republic Beneficiaries: Provincial Governments Amount: US$500 million Terms: At the Bank's standard interest rate with a grace period of five years and a term of fifteen years. Description: Because of past mismanagement and ongoing deposit losses, the equity of provincial banks has turned sharply negative and their liquidity has become precarious. These banks are now draining already weak provincial finances and present a systemic risk to the banking system. Thus the provincial as well as the federal authorities have asked for urgent financial assistance in pursuing privatization as a way to restructure and sell the remaining sound assets and liabilities to the private sector. The proposed adjustment operation is directed at assisting the national government to provide an orderly framework in which federal financial support for costs associated with privatization/closure is provided, subject to: (i) legislative authorization of privatization at the provincial level; (ii) intervention of the Superintendency of Banks; (iii) change of management; (iv) a time-bound, transparent privatization process; (v) timely resolution of residual assets and liabilities; and (vi) bank closure in the event of failed privatization. The loan is expected to support the privatization of some fifteen provincial banks, representing about 10% of total banking or 40% of provincial banking assets. Benefits and Risks: The loan builds on a ten-year policy dialogue in the financial sector. It would help achieve the long-advocated policy objective of significantly reducing public sector presence in the banking system. Provincial banks have been a major and chronic issue, and the current financial crisis is providing a historic opportunity to bring about structural and difficult-to- reverse change. Major specific benefits would include the consolidation of the banking system and a broadening in the reach of banking supervision. Also, provincial finances would  gain through decreased fiscal deficits and improved transparency and discipline. The main risk is that neither privatization nor closure actually occurs. Privatization may not materialize either for lack of buyers or a reversal of political will. Closure of banks may be delayed if essential banking services cannot be contracted out. If in fact, neither privatization nor closure occurs, repayment of all funds lent to provincial goverrnents would be accelerated and become due immediately at a penalty interest. Poverty Category: Not Applicable Estimated Disbursements: The loan would be disbursed in three equal tranches against import documentation and the counterpart proceeds would be deposited into a Privatization Trust Fund. The Interamerican Development Bank is expected to provide US$750 million and disburse pan passu with the Bank. Tranche disbursements would be conditioned on a satisfactory macroeconomic program as well as actions to ensure the appropriate functioning of the Privatization Trust Fund and to provide for a sound banking supervision process. Second and Third Tranches would be conditioned on the full drawdown from the Privatization Trust Fund of the counterpart proceeds of the prior tranche. Drawdowns from the Privatization Trust Fund would be permitted bank by bank only after provincial governments meet a set of strict conditions providing an orderly framework for privatization, and subsequently, against evidence that either privatization or closure has actually occurred. Schedule of Disburselnents: Bank FY 95 96 Annual 167 333 Cumulative 167 500 FSnancing Plan: US$(millions) World Bank 500.0 IDB 750.0 Prov. Governments 50.0 1,300.0 Rate of Return: Not Applicable  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED PROVINCIAL BANK PRIVATIZATION LOAN IN AN AMOUNT EQUIVALENT TO US$500 MILLION TO THE ARGENTINE REPUBLIC 1. I submit for your approval the following report and recommendation on a proposed adjustment loan to support provincial bank privatization to the Argentine Republic for the equivalent of US$500 million to support financial sector as well as fiscal reforms in the provinces. The loan would be at the Bank's standard variable interest rate, with a five-year grace period and a maturity of fifteen years. I. THE SETTING Economic Context' 2. Four years have passed since Argentina, emerging from the severe economic crisis of 1989-90, adopted the Convertibility Plan. This innovative plan restructured Argentina's economic landscape. From extreme hyperinflation, it moved relatively quickly to an annual inflation rate of 3.9 percent in 1994. Output and productivity increases have been remarkable for the last four years, with GDP growth averaging 7.7 percent. The initial consumption-led boom matured into a healthy pattern of investment and export-led growth. Privatization of state assets has been far-reaching, and much more successful than expected. As a result of the economic recovery, poverty levels initially declined significantly, although economic restructuring with a rigid labor market has resulted in increased unemployment; about 12 percent of the labor force by late 1994. The abundance of foreign exchange due to the capital inflows led to a real appreciation of the currency. The Argentine peso appreciated in real terms by about 20 percent between the beginning of the Convertibility Law regime and end-1994; however, after adjustment for tax reductions and other reforms, the loss to export competitiveness may be one-third lower. 3. The Convertibility Plan was part of a comprehensive reform program at the national level"' including reforms of the state and financial institutions, privatization, and liberalization of foreign and domestic credit. Extending these reforms to the provinces continues to present a significant challenge. While fiscal adjustment has occurred at the federal level, provincial fiscal deficits persist, mainly because of the 1/ See the Country Assistance Strategy dated April 10, 1995 for a more comprehensive assessment of Argentina's economic prospects. 2/ Past Bank support for this program entailed various operations in support of financial sector adjustment, capital markets development, privatization, and modernization of the public sector.  continued inability of provincial governments to contain current expenditures and sufficiently increase their own-source revenues. The potential benefits from the decentralization of many federal functions may be significant, but many provinces are not fully prepared to fulfill their increasingly important roles in health, education, security, water and sanitation services, and the strengthening of provincial governments is vital. Recent Performance 4. With the dynamic evolution of the economy, shifting from consumption-- to export-- and investment-led growth, GDP in 1993 and 1994 grew by 6 and 7.1 percent respectively. Gross fixed investment reached 20 percent in 1994, associated with increased national and foreign savings. Exports, which were affected by declining international prices in 1992-93, rose by 20 percent in 1994, with manufactured goods exports exhibiting particular buoyancy, growing at an average of 27 percent in 1993- 94. Better international prices for grains and improved economic conditions in Brazil contributed to the growth in exports. In 1994, imports grew at the fast pace of 26.7 percent. Imports of capital goods led the expansion, indicative of the acceleration in investment and the restructuring of the economy. Financing trade and current account deficits was not difficult, given Argentina's improved access to international financial markets during 1993 and 1994. During the first two months of 1995, exports rose by 35 percent, while imports remained approximately at the previous year's level. 5. With the increased accumulation of international reserves, and the reduction in bank reserve requirements earlier in 1993, monetary aggregates expanded at a fast pace. Bank credit grew at an even faster rate, reflecting the sub-par, but fast improving, monetization of the economy. Interest rates on peso deposits declined from 25 percent in December 1992 to 9 percent by early December 1994, just before the Mexican crisis began. Interest rate spreads, although also declining, remained high, reaching 13 percent, indicative of the continued segmentation and shallowness of the financial system. Towards the end of 1994, approximately half of Argentina's financial transactions were in US dollars, and interest rates and spreads were much lower. Continued capital inflows sustained the growth in aggregate demand. Liquid international reserves at end-November 1994 stood at US$14.5 billion, a significant increase since the end of 1992. Nonetheless, the general instability in world financial markets, which started in early 1994, as well as the more recent crisis in Mexico, have had a negative impact on Argentine financial markets. Reserve accumulation and credit expansion decelerated substantially in the first three quarters of 1994; by early 1995 they were falling as dollarization of the economy accelerated. 6. In August 1994, Argentina reached an accord with Brazil, Uruguay and Paraguay, its MERCOSUR partners, to: (i) eliminate most intra-group tariffs as of January 1, 1995; and (ii) establish a common external tariff covering 85 percent of the positions of the import-tariff nomenclature in January 1995, to be subsequently  - 3 - increased to 97 percent in January 2001. To ease the transition, exemptions have been authorized. Each government may exclude up to 60 positions from MERCOSUR trade and up to 300 positions from the common external tariff. Moreover, the automobile, sugar and telecommunications sectors will continue to benefit temporarily from their existing privileged regimes. Since Argentina's trade in MERCOSUR and resumption of sustainable economic growth is primarily with Brazil, its prospects are closely tied to the continued stabilization of the Brazilian economy, which accounts for 22 percent of Argentina's total trade. The Mexico Crisis 7. Argentina has been particularly vulnerable to the events in Mexico due to Argentina's relatively heavy reliance on foreign capital inflows (financing in 1994 an estimated current account deficit of 3.6 percent of GDP), the inflexibility of its exchange rate regime, and the need for a strong financial system under the Convertibility Plan. Argentina, however, enjoyed several advantages: (a) its current account deficit was less than half that of Mexico's; (b) it had stable political and economic leadership; (c) its level of international reserves remained high; (d) public debt maturities were not concentrated in the short-term spectrum of the market; and (e) many of its structural reforms--privatization, governmental reform, domestic market liberalization, and foreign investment--were deeper. 8. The Government has reacted forcefully to the crisis. During late February and March 1995, it took courageous measures to reestablish a fiscal surplus by cutting expenditures on, inter alia, export subsidies, public sector wages, and social security expenditures, while raising VAT rates and other taxes. Swift action by Congress in approving unpalatable emergency measures added to the credibility of the measures, which were supported by a conditional IMF program. As the Government announced these measures in mid-March, it also assembled an international financial package of approximately US$11 billion in support of the Convertibility Plan. About US$5.4 billion would come from the IMF, Inter-American Bank, and the Bank; an additional US$8.0 million may come from the Eximbank of Japan; about US$2.3 billion is expected from two large bond issues; and US$2.4 billion from projected asset sales. As a result, by early April, financial markets showed signs of stabilization and recovery. Not only have the authorities reacted firmly to the crisis on the eve of presidential elections scheduled for May 14, by announcing measures estimated to yield some US$6.3 billion, equivalent to 2 percent of GDP in the remainder of 1995, but they have received strong political support in Congress, where the fiscal program was approved in record time. 9. The Mexican crisis brought to light important lessons for Argentina. It highlighted the extent of the economy's reliance on volatile capital flows; revealed the need for a strong financial system, including the relevance of a dollar lender of last resort in an increasingly dollarized system; reemphasized the need to sustain the  credibility of the economic program; and clearly illustrated the difficulties in changing the exchange rate during periods of crisis. A more generalized result is the larger perceived risk of emerging economies by the international financial markets. While this higher perceived risk will inevitably reduce capital inflows to countries such as Argentina, the rate of such deceleration will be a function of policy responses to the crisis, both regionally and on a country-by-country basis. 10. The strong and rapid reaction of the Government to the crisis has reduced concerns about its future domestic action but the external environment remains uncertain. Although the initially strong negative reaction of financial markets to the Mexican crisis has now improved, it is clear there remains a reluctance to redirect significant flows towards emerging markets, particularly in Latin America. Moreover, there continues to be a general lack of discrimination between developing countries in this region by the markets. Even under an optimistic scenario, in which the principal countries affected by the crisis adopt appropriate economic policy measures that reestablish credibility in the eyes of international investors in the next few months, access to international financial markets will be only slowly regained beginning in late 1995, and capital inflows will remain below those observed in previous years. 11. If international capital markets remain tepid for a longer period, which appears to be a likely development, net capital inflows, even with the enhanced assistance of multilateral organizations, may be barely positive in 1995, compared to US$10.5 billion in 1994. The reduction in capital inflows, together with an estimated decline in net international reserves of approximately US$3.2 billion would only sustain a severely reduced current account deficit of possibly 1.2 percent of GDP, approximately a third of the deficit in 1994. To achieve this adjustment in the external accounts, economic activity would decelerate sharply, with some recovery in 1996 as capital inflows partially recover. Inflation would continue to decelerate, reducing further the past real appreciation of the peso. A fuller examination of balance of payments prospects is set out in the Country Assistance Strategy dated April 10, 1995. II. THE FINANCIAL SECTOR Financial Sector Policy Objectives and Reform 12. Financial sector reform has been an integral part of Argentina's policy agenda. Since 1990, the Government has sought to increase mobilization of financial resources and thereby contain the cost of capital to meet the needs of the anticipated expansion of consumption and investment demand. The total of currency plus deposits held in the banking system had declined from about 40 percent of GDP in the 1940s and 15 to 20 percent in the 1970s to 5 percent in 1990, the lowest level in Latin America that year. Dwindling resource mobilization reduced the amount of bank credit from around 40 percent of GDP in the early 1940s to 10 percent of GDP in 1989. Furthermore, terms  to maturity on domestic financial instruments had declined from up to three months before 1989 to about a week in 1990, and holdings of medium- or long-term private bonds were virtually nil. Monthly real lending rates were very unstable, hovering between -10 and 10 percent between 1987, when interest rates were liberalized, and early 1991. 13. To increase resource mobilization and reduce real interest rates, the Government implemented policies enhancing confidence in the economy and the financial system. Macroeconomic policies had reduced and stabilized inflation -- thereby reducing the uncertainty of real asset yields -- and increased GDP. Annual inflation declined from 1,972 percent (average of CPI and WPI) in 1990 to 3.9 percent in 1994, and real GDP growth increased from 0.4 percent in 1990 to an average of 7.4 percent during 1991- 94. Both developments increased the demand for financial assets. 14. These policies were very successful in increasing resource mobilization, at least until the end of 1994. With greater interest rate stability and faster growth, currency and bank deposits (including dollar deposits) increased from an average of 5 percent of GDP in 1990 to 19 percent in 1994. Deposit maturities increased from their all time low of seven days in 1990 to 30 to 60 days in 1994. Outstanding bank credit to the private sector also increased, from 10 percent of GDP in 1990 to 17 percent in 1994. The policies were also successful in stabilizing the monthly commercial bank lending rate, with the average real rate declining from about 2.5 percent at the onset of the Convertibility Plan (April 1991) to about 1.5 percent in late 1994. 15. The policies were also successful in increasing corporate equity and bond issues up to the end of 1994. Corporations, including commercial banks, raised an impressive US$9.9 billion in equity issues and registered US$6.5 billion in bond issues during 1990-1993. Bond issues surged after the government removed hefty transaction taxes that had priced bonds out of the Argentine market. The emergence of bond markets permitted commercial banks to extend loans with longer maturities, including mortgage loans of up to ten years. Nevertheless, stock market capitalization remained low, even by emerging market standards, and the bond market was very illiquid. Regulatory Reform 16. In addition, the Government made good progress in strengthening banking and capital market institutions. New banking policies primarily sought to improve the financial soundness of the banking system to help increase confidence in domestic financial institutions and reduce the Government's exposure to losses stemming from bank failures. Increased confidence in domestic financial institutions was required to encourage depositors and investors to exercise their demand for financial assets through these institutions, as opposed to keeping their assets in currency or depositing off- shore. Reduced exposure to losses stemming from bank failure--a major tenet of macroeconomic policy--motivated the Government to forego formal public deposit  - 6 - insurance. Private deposit insurance was intensely debated at that time but, in the end, found no support with the private banking system. 17. To encourage banking institutions to become and remain financially sound, changes to the Law of Financial Institutions increased the threat of closure for weak institutions. Under the reformed Law of Financial Institutions, the Central Bank has the authority to withdraw the operating license of private commercial banks that do not comply with Central Bank technical ratios (i.e., reserve, capital, and provisioning requirements), if the Central Bank's board rejects the commercial bank's plan to achieve the required levels. These policies indeed reduced the solvency risks of the system. The overall share of substandard portfolio in total assets declined from 37 in 1990 to 17 percent in 1993. Nevertheless, capital remained inadequate in some institutions, including public banks, and some cooperative and wholesale banks. Further protection against losses from bank failures resulted from the sale or liquidation of some public banks. 18. The Government has made major strides in banking regulation and supervision during the last three years. Regulatory improvements include: (i) upgrading of capital requirements from the simple asset-liability ratios that prevailed until December 1991 to fully developed risk-based requirements that take account of CAMEL3' ratings of financial institutions; (ii) improvement in portfolio classification provisions, from guarantee-based categories to categories based on capacity to repay (requiring a cash flow analysis of all clients); (iii) strengthening of provisioning requirements, including one percent provisioning on fully performing loans; (iv) strengthening of risk diversification provisions, including establishment of a cap of five percent of capital on an exposure to a controlling shareholder and a cap of three times the capital on the sum of all individual exposures exceeding 10 percent of capital; and (v) consolidation of balance sheets on a line-by-line basis to include subsidiaries and off-shore offices. 19. Furthermore, the structure, staffing, and technology of the Superintendency of Banks have been reformed. The structure is organized around six managers that specialize by type of bank, one of which is also in charge of systems auditing. These managers, who were recruited from international auditing firms and commercial bank credit departments, have in turn been responsible for recruiting 150 junior auditors. Thirty senior auditors lead inspection teams, and each inspection team of up to seven auditors includes a systems auditor who reviews the logic and physical integrity of an institution's systems. Total staffing is 350. Upgrading of systems is being finalized, which will include a network connection with financial institutions. Inspection strategy calls for biannual inspection of large banks (i.e., with assets exceeding $700 million) and banks with a substandard rating. Banks in good rating standing are inspected every nine months. All banks are monitored on a monthly basis. Institutional strengthening 3/ CAMEL stands for Capital adequacy, Asset quality, Management effectiveness, Earnings performance and Liquidity.  - 7 - is a continuing concern and authorities are benefitting from ongoing technical assistance provided by US authorities. In addition, the Bank will be continuing its review and offer technical assistance in on-going and future operations. 20. Similarly, the Government strengthened regulation, supervision, and enforcement in the capital market. A pension reform law was passed that was expected to generate substantial savings for investment in financial assets. Mutual funds legislation was amended to allow for both open and closed funds, to clarify the powers and responsibilities of the fund management company, to allow greater portfolio diversity, and to improve mutual-fund investor protection. Other measures included incentives for capital repatriation and modernized stock market regulations (such as streamlined approval processes for public offerings, and automatic authorization of additional shares and debt securities; establishment of rating requirements on publicly offered securities; and stronger reporting, disclosure, and auditing requirements). 21. A review of the markets' characteristics indicated that trading, depository, clearance, and settlement infrastructure was basically sound and that the legal framework largely complete. Remaining regulatory shortcomings include the lack of a modem insider trading law; excessively costly requirements for publicly offered securities; segmentation of trading systems for stocks and bonds; and inadequate capital requirements for securities trading. Institutional development of the stock market regulatory agency (Comisi6n Nacional de Valores-CNV) is being supported by the Bank's 1993 Capital Market TA Loan (Ln. 3710-AR) through training, regulatory development and hardware and software development. Sector Restructuring 22. Adjustment in Public Banks. Dealing with public banks has proven to be one of the more difficult and intractable challenges for Argentina's financial policy. Argentina has 34 federal, provincial, and municipal banks. In the provincial bank category, there remain 20 banks owned by provincial governments. As public banks were created by federal or provincial/municipal laws, any amendment of such laws requires the approval of the respective legislatures. In the past, the large majority of provincial legislatures have resisted enacting privatization laws. Together, all public banks account for about 40 percent of banking assets. The performance of these banks has been modest or downright poor, contributing to public sector deficits. The activities of these banks distort financial intermediation, essentially by directing funds to less profitable activities for which private banks will not lend. Furthermore, state- owned banks cannot be closed by the Superintendency of Banks when regulatory requirements are not met, as can privately-owned banks. 23. The Government has been increasingly pressing for privatization or liquidation of public banks. It has already achieved privatization of a major national public bank, the Caja Nacional de Ahorro y Seguros, sold with support from the Bank's Financial  - 8 - Sector Adjustment Loan (FSAL, Ln. 3558-AR); liquidation of the Banco Nacional de Desarrollo, also supported by the Bank's FSAL; liquidation of a provincial bank (La Rioja); and privatization/closure of three provincial banks (Chaco, Corrientes, and Entre Rios). For further details on federal public banks, see Annex D. 24. Adjustment in Private Banks. Adjustment in the private banking system continued during 1989-94. The number of private banks declined from 141 in 1989 to 134 in 1994 (August). Employment dropped from 64,000 in 1989 to 58,000 in 1992 and rose back to 64,000 in 1994. Overall, private banks performed better than public banks. Non-performing loans amounted to about 9 percent of total lending in 1994, far less than in public banks (25 percent). Nevertheless, the average rate of return in 1994 (through November) was quite low (4 percent). Private banks benefitted from the high spreads prevailing at the onset of the Convertibility Plan but subsequently had to adapt to lower inflation rates and spreads and, until the end of 1994, to a declining growth of deposits. With stabilization, private banks increasingly lent with longer terms and to a wider client base, a trend which was abruptly interrupted by the recent events. Effects of the Crisis 25. As discussed above, the Argentine financial system enjoyed 3-4 years of rising monetization, increasing bank profits and improving supervision of prudential standards. However, just before the Mexico crisis, the financial system was losing steam, with the growth rate of deposits dropping, and a general drift downward in the stock market due to rising interest rates abroad and lower capital inflows. These developments, in part, reflected a waning of the public's confidence in the economic plan due to the appearance of a small fiscal deficit, the protracted debate on the pension reform bill, gathering doubts about the peso's convertibility, and a sense that the economic plan had not contributed to social equity. 26. Early financial sector malaise surfaced in November 1994, with the bankruptcy of a small but trusted non-bank trader and an increasingly weak bond market. A full crisis unfolded with the December 20, 1994 devaluation in Mexico and the massive withdrawal of foreign investors from Argentina and other Latin American countries. These events weakened the position of the so-called wholesale banks that had significant inventories of government securities. Fear of illiquidity of wholesale banks and of capital losses from their security holdings, as interest rates rose, led to a massive withdrawal of corporate and inter-bank deposits. Financial sector confidence fell rapidly and retail deposits began to decline as well. By February 15, total deposits had dropped some 7 percent, and the ratio of money and deposits to GDP fell from 19 to 17 percent (see graph below). By April 6, deposits had fallen by 17 percent.  PMTIO OF CeCr MO 1POdEIIT TO 0P 2213 - 21. X ilHl IIIII IIIIIIIiIIIIIIIIIIIIIHIIII Jill .: WMr ...... IIIIAIKIIIIII I1 iiii W IT . t l 1 . rm = IIIIIII I I I .T .H.l. IIIL I _' 1 sl = xii X X0. 11111 IZLL ---- 12.O _ m nr1m 2113- III I .WT II iI r IIIIIItTIIL f 1111 19 13 -82199 IT 13 - ~ ~ 1 MGD 27~~~~~~~~'s__. Ths agrgt fiue obcr th widely vayn siutin of difrn baks reflecting depositors' flight to relative quality. The biggest losers were the wholesale banks who suffered deposit losses of over 70 percent through mid-February, a crisis of confidence which most cannot survive. Most of these banks are in the process of slow liquidation, selling their assets at a discount to the prime private commnercial banks. Cooperative banks lost a third of their deposits. Foreign banks lost some of their oaverseas deposits but gained deposits locally. The eight leading private banks all gained deposits, at least until recently, while private retail banks as a whole lost 21 percent of their deposits. With the exception of the major provincial bank of Buenos Aires, all large public banks lost deposits including those of Mendoza (-22 percent) and Cordoba (-15 percent). Overall, the relative positions of different banks are being dramatircally transformned, with the largest private banks appearing to emerge stronger. However, the number of weak institutions (i.e., small banks lacking economies of scale, wholesale banks and weak provincial banks) remains large, and creates some systemic risk. 28. CapiSl Markets Reaction. Stock and bond markets have seen dramatic drops in prices and transaction volumes and a sharp increase in volatility. Overall, the stock market index has fallen over 33 percent since the Mexican crisis, with the market Price/Earnings ratio dropping from 18:1 in November 1994 to around 12:1 at the end of February 1995, while trading volume had decreased almost two-thirds by end January. No new equity, no Eurobond issues, and only one 90-day commercial paper  - 10 - placement in the local markets has occurred since December 20, 1994. While several placements (up to US$1 billion worth) of negotiable obligations are in the process of CNV approval and preparation, it is unlikely that new issues will occur in the near future. With trading volume low and volatility high, most new issues and portfolio management decisions are in limbo. These trends were reflected in the market for government treasury bills as well, which experienced a declining volume of offers and yields rising from 7.58 percent in November 1994 to 11.6 percent in February 1995. 29. The crisis has also increased interest rates (see Table 1). The gap between dollar and peso prime lending rate widened. Nominal interbank rates have hovered around 30-35 percent since the crisis, spiking to 55 percent in early March, compared to 6-9 percent before the Mexican devaluation. Table 1: ARGENTINA - Annual Deposit and Lending Rates 1994-1995 Year Month Dollar Peso Prime Prime Peso Average Dollar Rate on Rate on Lending Lending Peso Monthly Monthly Rate Rate Lending Deposits Deposits Rate 1994 November 5.8% 8.7% 8.3% 10.0% 23.5% 1994 December 6.1% 9.8% 9.8% 13.6% 30.0% 1995 January 6.5% 10.8% 11.3% 17.7% 35.0% 1995 February 7.0% 11.8% 12.1% 19.1% 45.0% 1995 March 8.0% 18.5% 20.0% 28.0% 65.0% 30. There is much variation across banks, with the top eight banks and Banco de la Naci6n quoting rates substantially lower than the rest of the market. 31. Government Response. Authorities have acted promptly to counteract Argentina's vulnerability to negative external shocks, given the nature of the Convertibility Plan under which Argentina's currency needs to be fully backed by international reserves and the Central Bank has more limited resources than other countries to confront a run against bank deposits. 32. A Safety Net was established to address the high demand for last-resort lending that emerged since December 20, 1994. This effort included: (i) integration of an initial "club" of five major private banks in early January 1995; each contributed around US$50 million to purchase illiquid wholesale bank portfolios in exchange for a reduction in their reserve requirements; and (ii) transfer of 2 percent of the November 30, 1994 deposit base (about US$900 million) on January 20, 1995, from the banks' reserves at the Central Bank into a special account with the Banco de la Naci6n; some  - 11 - 25 banks were required to contribute about US$790 million to this operation, the others having suffered deposit losses since November. Banco de la Naci6n, acting as agent for and on instructions of the Central Bank, lent the funds to banks at 16 percent annually against collateral of bank assets and, in some, cases personal guarantees of the owners. As this was a transfer of liquidity reserves, the contributing banks did not receive any interest. This fund is now exhausted. On March 14, 1995, the authorities further increased the liquidity in the financial market by authorizing commercial banks to use 50 percent of their technical reserves to meet their legal reserve requirements. To stem capital outflows, the authorities induced the further dollarization of the banking system (dollar deposits by March 22, 1995 accounted for 54 percent of total deposits). Nevertheless, between the beginning of the crisis and March 22, total deposits in the financial system declined by about US$7 billion, most of them in peso deposits. During this crisis, the Central Bank had to perform a delicate balancing act between averting a run on the currency (by imposing tight liquidity), and avoiding a banking run (by subsequently injecting liquidity), two contradictory policies for two not unrelated risks. 33. The Central Bank's action so far has been markedly different from past crisis episodes, which led to strong monetary emissions and subsequent bouts of high inflation. Eight financial entities have been suspended and one was closed after restructuring plans were found to be inadequate. A new deposit insurance scheme has been established to be financed by contributions of financial entities. Deposits with a maturity below 90 days will be guaranteed up to $10,000, while deposits of more than 90 days will benefit from a guarantee of up to $20,000. 34. Future Prospects. The outlook for the future of financial and capital markets will be shaped by two developments. The key external developments are increases in international interest rates and lower net capital inflows. The key internal development includes the future course of confidence on account of fiscal and financial policies, including reduced expenditures, increased tax collection, and the strengthening of Argentina's battered financial institutions. Declining capital inflows will detract from financial and capital market growth. Expectations, both locally and abroad, will be positively affected by the support programs of the IMF, the Bank and IDB. Stronger fiscal and financial policies will help reduce capital outflows by strengthening confidence in the financial system. Both stock and bond markets should experience an upturn as confidence returns. The equity market activity may revive, perhaps led by new rounds of privatization issuance, including the government-held shares of existing privatized companies, and new privatizations of the nuclear power projects. However, new bond issues are not expected until interest rates fall. A slow revival of foreign investor interest suggests a slow recovery. 35. A major down-sizing is underway and a strengthened banking system may emerge. Although the trend towards consolidation has taken hold before December 1994, the Mexico shock has spurred a wave of liquidations, mergers, and acquisitions.  - 12 - Most affected will be the number of wholesale banks, cooperative banks (already down to 31 in March 1995 from 39 in August 1994), provincial banks, and small private banks. The key financial policies in this regard will be the Central Bank enforcement of capital, provisioning and liquidity requirements as well as incentives for acquisition and merger. Furthermore, as discussed below, the ongoing strain on provincial finances and the poor financial situation of provincial banks will trigger further privatizations or closures of these banks. 36. Moreover, the government is undertaking steps to strengthen the capital position of private banks, through the newly created Capitalization Trust Fund. Capitalization of financial institutions will be closely linked to merger and acquisition transactions that help consolidate banks into a more efficient banking system. The Bank is supporting the government in the operational design of this fund, and is considering provision of US$500 million in financial support. Provincial Banks 37. Efficiency Impact of Provincial Banks. The provincial banks' adverse effects on financial sector efficiency are exposed by their sustained losses, non-competitive allocation of credit, high cost of funds and excessive employment. While the face value of provincial bank assets accounts for 25 percent of total assets of the banking system, provincial bank employment accounts for 33 percent of total employment and provincial bank branches account for 28 percent of total branches. As shown in Table 2, excessive provincial bank employment is evident particularly in branch personnel, and excessive branching is indicated by the low number of accounts and borrowers per branch. Poor credit decisions are of course manifest in the large reported of non- performing portfolio which exceeds by far non-perfonning portfolio in other categories of banks. Moreover, provincial bank credit allocation to inefficient activities, including provincial governments and public provincial enterprises, reflect the lack of arms- length relationships, thereby deflecting the supply of credit away from productive activities.  - 13 - Table 2: Comparisons of Efficiency of Banks (August 1994) Provincial Private Foreign Coop No. of banks 28 64 31 39 No. of branches 778 1143 364 819 Branches/institutions 27.79 17.86 11.74 21.00 No. of employees 23,993 32,612 13,639 17,922 of which: at branches 13,834 16596 4,751 11,373 Total personnel/branch 31 29 37 22 Branch personnel/branch 18 15 13 14 Total Accounts 127,439 468,224 146,010 207,152 Accounts/branch 164 410 401 253 Total borrowers 735,427 1,625,696 539,770 863,028 Borrowers/branch 945 1422 1483 1054 38. Confidence Impact of Provincial Banks. Provincial banks' chronic financial weakness undermines confidence in Argentina's financial system. Although the financial situation differs, provincial banks (the major exception being the Provincial Bank of Buenos Aires) are correctly perceived to suffer from solvency problems undermining their ability to navigate through a liquidity crisis. Under normal market conditions, depositors perceive a provincial bank's inability to meet deposit obligations as an isolated case within an otherwise healthy financial system. Under tight market liquidity conditions, however, depositors are unable to distinguish an isolated provincial bank condition from the general liquidity tightness. Therefore, banks with weak fundamentals, such as provincial banks, increase spillover risks of a deposit run on these banks. 39. Impact of the Recent Liquidity Cisis. Provincial banks have been exposed to more liquidity risks than other banks, with a liquidity gap (liquid liabilities minus liquid assets) amounting to 50 percent. This liquidity gap exceeded those in other categories of banks, including large private banks (13 percent), small private banks (11 percent), foreign banks (1 percent) and also the very vulnerable wholesale banks (16 percent) and cooperative banks (16 percent). Declining deposit growth and deposit withdrawals in the aftermath of the Mexico crisis have affected provincial banks more than the banking system as a whole. In addition, access to the interbank market has remained open only to prime banks and was closed to provincial banks. 40. Provincial banks have not only received liquidity assistance of US$143 million from the BCRA but also about US$300 million from the Safety Net managed by BNA. Currently, they are also about US$640 million short of complying with the reserve requirements, raising their recent liquidity funding needs to US$1.1 billion. Finally, they also have some US$529 million in deposits from provincial governments, which  - 14 - could not be withdrawn and has thus prevented provincial governments from meeting their budget (i.e., mainly salary) commitments. III. PROVINCIAL BANKS AND PROVINCIAL FINANCES 41. The provincial banks have been a major factor in provincial economic instability in recent years, and their privatization/closure will reduce fiscal deficits and improve fiscal management in the provinces. The main benefit would be the elimination of provincial banks' operating losses, which accounted in 1994 for about 30 percent of the consolidated fiscal deficit in the provinces targeted under this project. For further details on the provinces' fiscal situation, see Annex E. Another benefit would be the elimination of the complex cross-subsidies between the banks and the public sector, including public enterprises, which will ultimately provide greater transparency and a better assessment of overall provincial indebtedness. The demise of provincially-owned banks will also limit the public sector's access to preferential financing, forcing improved fiscal discipline. In the absence of immediate action, the fiscal costs are likely to increase rapidly because of provincial banks' continued large operating losses. Ultimately, bankruptcy would ensue, further raising fiscal costs as the judicial liquidation process would yield even lower asset values. 42. Throughout the 1980s, these banks expanded their activity, providing credit principally to their own governments, by resorting to rediscounts from the Central Bank (BCRA) and transfers from the public sector. Between 1985 and 1991, real credit to the public sector increased by 200 percent, while total real credit to the private sector fell. In most provinces, these banks have been a major source of deficit finance for provincial governments. In 1990 for example, they provided more than 60 percent of the credit needs of provincial governments. By late 1990 BCRA was forced to lend massive amounts of new rediscounts to prevent the collapse of several provincial banks, due to poor loan recovery and massive over-staffing. 43. Recently however, provincial banks have turned from financier to a major drain on provincial finances. Lacking Central Bank rediscounts, and given financial mismanagement and losses, provincial banks have had to rely increasingly on their owners for financial stability. Following the Mexico crisis, provincial governments were even forced to abstain from deposit withdrawals so as not to cause their banks to fail. 44. Problems in portfolio quality typically damage provincial banks' finances, reflecting large levels of public sector lending and in some cases -private sector loans made according to non-business criteria. As of November 1994, loans to the public sector (including public enterprises) were equivalent to 19 percent of the total loans in provincial banks, against only 10 percent in the overall banking system (Table 3). The situation, however, varies significantly across provinces, ranging from 1 percent in San  - 15 - Luis to 48 percent in Chubut, and also fluctuates over time depending on the short-term financing needs of the provinces. In many cases, the exposure of provincial banks to its government actually exceeds reported loans, because indebtedness is often hidden in different accounts. For example, treasury overdrafts are recorded as other assets. Table 3: Lending to the Public Sector by the Provincial Banks, 1994 a/ Total Public Total Public Loans Loans (in US$ Million) (In % of Total Loans) MCBA 454 33 Catamarca 20 27 Cordoba 340 21 Chubut 94 48 Formosa 10 4 Jujuy 10 8 Mendoza 77 8 Misiones 165 46 Rio Negro 31 7 Salta 21 5 San Juan 126 40 San Luis I I Santa Cruz 22 10 Santa Fe 65 8 Santiago del Estero 19 7 Tucuman 16 7 Tierra del Fuego 32 18 TOTAL 1502 19 Source: Central Bank- a/ Includes provincial administrations and public enterprises 45. Provincial banks also perform a number of services for which they are not remunerated. They manage the accounts of the provincial governments, collect taxes, provide various administrative services for provincial governments, and serve a number of developmental functions such as maintaining staff and branches to service populations in hard-to-reach places. In exchange, they receive a number of privileges from provincial governments, such as monopolies on financial transactions, public deposits, tax exemptions, and provincial government guarantees on all transactions and deposits. Estimated Costs and Benefits 46. In 1994, the operating losses of the provincial banks were reported at about US$150 million. Adjusted for cash rather than accrued interest, these likely exceeded US$450 million in the participating provinces (Table 4). Most likely, deteriorating loan portfolios have been causing operating losses to surge following the Mexican crisis. 47. The privatization/closure of provincial banks would improve provincial public finances by reducing fiscal deficits. The resulting gain will be equivalent to 30 percent  - 16 - of their fiscal deficit in 1994. Assuming 1995-97 losses at the level of 1994 (a conservative assumption), would raise public expenditure by US$1.4 billion over this period. In the provinces of Formosa, Salta and Mendoza, the gain would exceed 10 percent of their annual current expenditures (Table 4). Table 4: Operating Losses for the Provincial Banks, 1994 a/ US$Million in % of In % of the Current Expenditures b/ Fiscal Balance b/ MCBA -20 -1 96 Catamarca 6 1 7 Cordoba 37 2 13 Chubut 17 4 15 Formosa 75 16 199 Jujuy 1 0 2 Mendoza 136 13 189 Misiones 40 7 45 Rio Negro 34 5 22 Salta 72 10 630 San Juan 8 1 5 San Luis -2 -1 -3 Santa Cruz -2 0 -5 Santa Fe 50 3 688 Santiago del Estero 14 2 18 Tucuman 12 2 9 Tierra del Fuego -4 -1 -4 TOTAL 474 3 31 Source: Central Bank 4 a/ As of October 1994, and on an annual basis b/ From the Non-Financial provincial public sector (-) Is equivalent to operational surplus 48. A crude indication of some of the benefit of privatization/closure arises from the comparison of the discounted cash flow generated by the elimination of operating losses with the privatization costs, indicated an overall rate of return of 39 percent in the group of likely participating provinces. 49. Even more significant benefits associated with the privatization/closure are likely to accrue over time. First, fiscal adjustment will be promoted in the provinces since private bank management will reduce subsidized or politicized lending to  - 17 - provincial governments and public enterprises, forcing them to raise tax collection or to cut expenditures. Second, the privatization process will imply the debt consolidation between the banks and their respective public sector, including public enterprises. More generally, the complex cross-subsidies existing between these public agencies are likely to be eliminated or will become more transparent with private management. IV. THE PROPOSED LOAN Bank Involvement in the Financial Sector 50. Beginning with the 1986 Bank report on the banking sector, the Bank has maintained a longstanding dialogue with the Government on financial sector issues. This dialogue intensified in 1989, when the Bank assisted the Government in the drafting of the Central Bank charter, the development of organization options for the Superintendency of Banks, and the design of action plans for public banks. With this framework in place, the Government proceeded to institute major reforms during the next five years, supported by several Bank operations. Under the 1991 Public Sector Reform Technical Assistance Loan, major organizational improvements (training, technical assistance, information systems, accounting) were carried out in the Central Bank as well as in the Superintendency of Banks. The policy dialogue continued under the 1993 Financial Sector Adjustment Loan which principally supported major reforms of federal public banks such as the national development bank, the housing bank and the national savings and insurance bank. That loan also supported further strengthening of the regulatory environment for all banks but in particular of provincial banks. In 1994, the Bank approved a loan to support strengthening of Argentine capital markets through establishment of a backstop facility with a companion technical assistance loan. The Provincial Reform Loan approved by the Board earlier this year includes support for the finalization of privatization of four provincial banks. Two of these have already been privatized. For a summary of Bank and IFC operations in Argentina, see annexes B and C. Background 51. The recent problems in Argentine financial markets have created an opportunity to address one of the most intransigent policy issues in Argentina, the provincial banks. Because provincial governments are autonomous and provincial banks are immune either legally or politically from certain regulatory actions, the ability of the federal government to achieve changes of policy in this area has been limited by the political will of provincial governments. However, recent events in the financial sector have converted most provincial banks into major financial burdens, since provincial governments are legally liable for deposit withdrawals and other provincial bank liabilities. As their resources became increasingly strained in the wake of deposit losses and the irreversibility of the provincial banks' financial problems became clear, an increasing number of provincial governments have seeking privatization as a solution and have requested assistance from the federal government.  - 18 - 52. The proposed operation is accordingly directed at assisting the federal government in providing an orderly framework in which federal financial support for costs associated with privatization/closure is provided subject to: (i) legislative authorization of privatization at the provincial level; (ii) change in management; (iii) intervention of the Superintendency of Banks; (iv) a time-bound, transparent privatization process vetted by the Superintendency and by the Bank;.(v) orderly and timely resolution of residual assets and liabilities; and (vi) bank closure in the event of failed privatization. The prospect of financial support to help cover the costs incurred in meeting provincial bank liabilities has already induced some provincial governments to seek participation, despite the political costs of such a program in an election year. While the proposed operation is open to any provincial bank meeting the criteria, it is anticipated that privatization of some 15 provincial banks will be accomplished under the loan. Loan Objectives and Description 53. An adjustment loan of US$ 500 million equivalent is proposed to support the privatization or closure of up to fifteeri' provincial banks comprising about 10 percent of total banking or 40 percent of provincial banking assets. Adjustment lending is supported by the latest Country Assistance Strategy dated April 10, 1995 and this operation is fully consistent with such strategy. The Government's macroeconomic and financial sector strategy is set out in a Letter of Development Policy signed April 19, 1995 (see Annex A). The Inter-American Development Bank would provide an additional $750 million to support the operation as well. Counterpart funds generated by these loans would finance a Privatization Trust Fund created in February 1995 to help finance costs related to privatization or closure. The Trust Fund's operations have been limited to only two years to encourage rapid action in regard to privatization. 54. The Trust Fund will provide a set of financial incentives but will leave the initiative and management of privatization per se to the owners of provincial banks, namely provincial governments. The Trust Fund organization will consist of a supervisory board, with the national commercial bank (Banco de la Naci6n) acting as financial agent. The Trust Fund supervisory board is composed of senior officials of the Ministry of Economy, the Central Bank (Superintendency of Banks) and Banco de la Naci6n. This lean organization has been designed to avoid creating a permanent institution which in later years would be difficult to disband. Detailed Operational Guidelines for the Trust Fund will contain governing policies and guidelines for bank privatization, for management of residual assets and liabilities, for the intervention of the Superintendency of Banks and preprivatization holding actions and closing of banks. Privatization guidelines would establish, inter alia, that monopoly rights to manage the provinces' finances would be limited to five years (for Role and Operations of the Trust Fund, please refer to Annex H). 4/ dTwo more banks are being supported under the Provincial Reform Loan. See Annex G.  - 19 - 55. The loan would be disbursed in three equal tranches of about US$167 million equivalent and the counterpart proceeds would be deposited in the Privatization Trust Fund. The Trust Fund would in turn make available an initial drawdown (equivalent to one third of the bank's total allocation) to provinces which have passed legislation authorizing privatization, which have changed bank management, and which have subjected their bank to federal intervention, thus concretely demonstrative political will to privatize or close. A second drawdown (up to two-thirds of the allocation) would be disbursed only when the provincial bank has actually been privatized or closed. Should neither privatization nor closure occur within one year, the initial drawdown would be accelerated and would be repaid at a penalty interest in order to mitigate any tendency of a slowdown in the provinces' resolve to privatize. Trust Fund resources would be applied to the payment of liabilities of the provincial bank and any residual entity. Each provincial bank would be allocated a Trust Fund loan amount on the basis of its assets. 56. All provincial banks determined to privatize or close, and meeting the Trust Fund's conditionality, would be able to access Trust Fund loans. That includes the banks of Buenos Aires, Pampa and Neuquen which, while wishing not to privatize at this time, may reverse their political decisions at a later date. The first three provincial banks to privatize will likely include Mendoza, Formosa, and Misiones. Prospects for Provincial Bank Privatization 57. Despite their financial weaknesses, most provincial banks have privatizable business (see Annex F). Past experience with public bank privatization reveals a variety of results. In the case of the National Development Bank and the provincial bank of La Rioja, the banks had to be fully liquidated, as there was no business that could be privatized into a viable concern. In contrast, the provincial banks of Chaco, Entre Rios and Corrientes, and the national savings and insurance bank offered privatizable segments which were sold to the private sector. Strong private sector interest is likely in the cases of the larger banks in the provinces of Cordoba, Mendoza, in the city of Buenos Aires, each with large deposit and lending networks, which might attract foreign investors. While the private sector is unlikely to be interested in public sector loans, other attractions include managing the provincial accounts, consumer lending and commercial loans. Some investors may be attracted by the provincial banks' names and their appeal to a provincial clientele. Significant deterrents to privatization may include excessively large branch networks, excessive staff, and, most importantly, unfavorable market conditions leading to oversupply of banks for sale at attractive prices as well as liquidity constraints affecting possible purchasers. 58. Pnvatization Methodology. Privatization will require a separation of assets and liabilities between those which, in the context of each privatization, would be attractive to the private sector and those which would not be. This process would be part of a privatization plan required for access to the Fund and would be undertaken under the supervision of the Superintendency of Banks. This process will force a substantial downsizing and yield a privatizable bank which is likely to be only a fraction of its predecessor (for a detailed explanation at this process, see Annex F). The  - 20 - non-privatizable assets and liabilities would be transferred into a residual entity with negative equity. The prompt disposal of this residual entity will require Trust Fund monies to help pay off creditors. 59. The objective is to achieve unconditional management control by the private sector in all cases. To achieve this goal, provincial government will be selling at least 51 percent of their shareholdings. In most cases, it is expected that the percentage of shares sold will be 60 percent or higher. In the case of Misiones, for example, 100 percent of the shares will be sold. In any case, the market will ultimately deterrnine which percentage would attract a sufficient number of private buyers, since the private sector has become sensitive to the continuing influence of the provincial governments not only as shareholder but as the principal customer. 60. Once privatization is completed and there is a residual entity, provincial governments will, as next step, implement a previously prepared plan to liquidate residual assets and liabilities within the shortest possible period but at most within one year. Provincial governments would not be expected to create any new organization but utilize existing branches of their provincial government, possibly supported by consultants. Loans would most likely be auctioned off and real estate would be sold or transferred to other government departments. Trust Fund loan funds would be used to pay off creditors. 61. If privatization is not successful after two attempts, provincial governments are expected to close their respective banks and contract out banking services as needed. Because of their precarious fiscal condition, it is not expected that provinces would have the resources to recapitalize their banks to continue to operate under the Central Bank capital adequacy regulations. The Central Bank would in turn force any undercapitalized provincial bank out of the clearing system and thus effectively causing a suspension of operations, tantamount to closure. Coordination with Multilateral Institutions 62. The Bank has worked closely with the IMF in the design and supervision of adjustment operations in Argentina, in formulating country strategy, and in economic and sector work. The IMF shares our concerns regarding the need to privatize provincial banks because of the potential risks to financial sector fiscal stability. The co-financing of the IDB for this loan is based on close working relationship in a variety of fields, including adjustment and provincial finances (the IDB co-financed both PSRL and Provinces I). The IFC's operations are expected to benefit from this project's aim to strengthen the banking system.  - 21 - Loan Amount 63. Estimates indicate that some fifteen provincial banks--identified as potential candidates for privatization21--require funds ranging from US$1.0 to as much as $2.0 billion to settle liabilities (net of assets) after privatization. More exact estimates, based on market values, will have to await detailed, bank-by-bank, analyses by auditors and financial professionals once privatization is actually under way. At this time, a reasonable point estimate of US$1.3 billion is based on balance sheet adjustments as of December 1994 principally for higher loan loss provisions and the inevitable early retirements (Annex G). 64. To meet financial needs of US$1.3 billion, the Government requests a loan of US$500 million. An additional US$750 million is being requested from the IDB. With this level of financing, the federal government expects be able to allow qualifying provincial governments to meet a large share of the cost of privatization/closure. Should costs eventually rise above $1.3 billion, all financial shortfalls would be the responsibility of provincial governments. This additional financial burden is expected to be managed by negotiating with creditors grace periods and extended repayment schedules. In addition, the Central Government is supporting a wide range of initiatives to strengthen provincial finances, with support from the Bank under Provincial Development I and II as well as the Provincial Reform Loan. In this context, should negotiations yield insufficient results, the Central Government will pressure provinces to speed-up privatization of other provincially-owned enterprises and to take any necessary additional fiscal measures of revenue increases or expenditure reductions. Agreements Reached During Negotiations 65. The Argentine Republic would be the Borrower and implementation would be shared by the Federal Ministries of Economy and Public Works; the Central Bank, including its Superintendency of Banks: and provincial authorities. The counterpart proceeds of disbursements would be deposited into the Privatization Trust Fund. Any provincial government fulfilling prior conditions would be able to access this Privatization Trust Fund. Those provincial banks, to be privatized under the recently approved PRL, will be eligible for Trust Fund financing provided allocated loan amounts are reduced by funds already allocated under PRL. All Privatization Trust Fund lending would be guaranteed by co-participated revenues or other equivalent guarantees. Participating provinces would be required to disclose all co-participated guarantees already granted and provide evidence that additional guarantees to be provided to the Trust Fund have been duly authorized. 66. The Privatization Trust Fund lending rate would be based on its weighted average borrowing rate plus a management commission for the financial agent, Banco 5/ At end-February, the major bank not willing to privatize was the Bank of the Province of Buenos Aires.  - 22 - de la Naci6n. All foreign exchange risks would be passed on to the provinces in full. Interest accrued up to the point of privatization or closure would be capitalized. After privatization/closure, all amounts drawn would be converted into a long term loan with the same term as the foreign borrowing. Tranche Conditions (see Annex I) 67. Release of all Tranches would be subject to compliance with macroeconomic conditionality satisfactory to the Bank. 68. The First Tranche would be released once: * The Federal Government has issued satisfactory Operating Guidelines for the Privatization Trust Fund. Operating Guidelines would contain the Trust Fund's governing policies and principles for privatization, for managing any residual assets and liabilities, for the intervention of the Superintendency of Banks, and pre-privatization financial holding policies, and for bank closing; * The Central Bank has demonstrated that the Superintendency of Banks has appointed inspectors, acceptable in numbers and qualifications to the Bank, to supervise the privatization process of those banks wishing to draw from the Privatization Trust Fund. * At least three provincial governments/banks have signed Privatization Trust Fund agreements in form and substance satisfactory to the Bank. 69. Second and Third Tranches would be released once: * The Privatization Trust Fund has disbursed all counterpart proceeds of the prior tranche. * External auditors have confirmed that the Privatization Trust Fund was managed in line with its Operating Guidelines. * The Central Bank have designated any additional inspectors required to supervise additional privatizations of provincial banks (for the complete Disbursement Conditions Matrix, see Annex I). 70. To qualify for Trust Fund loans, provincial governments would have to meet an initial set of conditions. The most important up-front condition is for the provincial legislature to authorize the sale of a controlling interest (in most cases at least 60 percent of the shares) to the private sector within 180 days. In addition, provincial authorities would be required to nominate a new privatization management team to be approved by the Superintendency of Banks. Additional up-front conditions include an approved privatization plan, with target dates, for:  - 23 - * An initial diagnosis (based on external audits,"' portfolio valuation); * Decision on privatization strategy and on criteria on investor suitability; * Identification of any residual entity and strategic options for speedy and effective liquidation within one year; * Finalization of bidding documents (including for contracting-out banking services, should privatization fail); * Bid invitation; * Bid evaluation; * Signing of transfer contract. 71. A cash flow statement to demonstrate that sufficient funding is available until privatization occurs would also be required. The Superintendency of Banks would approve both the privatization plan and the cash flow. The Superintendency of Banks will also have the right to remove the privatization management team if, in its judgement, performance is not adequate. Once the up-front conditions are met and the Bank has provided its "no-objection", provincial governments would be eligible for a first drawdown not to exceed one-third of the maximum funds allocated to each bank. 72. The maximum funds to be allocated to each bank would be defined by bank size, as per the table below. Banks with Assets of: Maximum Loan Amounts (1) Up to $200 million $50 million (2) Up to $500 million $80 million (3) Up to $800 million $100 million (4) Up to $1,200 million $160 million (5) Above $1,201 million $240 million 73. A second and final drawdown, corresponding to up to two thirds of the allocated funds would be permitted once the provincial bank has been privatized or closed and after the Bank's "no-objection". The size of the final drawdown would be confirmed by the financial diagnosis included in the privatization plan. To provide an incentive to refrain from any unproductive attempt to privatize, all funds would become available in a single drawdown if a provincial bank is closed immediately. Excluded from the final Auditing standards in Argentina are comparable to those in developed countries.  - 24 - drawdown financing would be all liabilities to the provincial public sector itself. Should a province re-establish a new bank after privatization/closure, all disbursed funds would be accelerated and become due immediately (for a tabular display, see below all Privatization Trust Fund Drawdown Conditions). Initial Drawdown Final Drawdown (for 1/3 of the maximum amount) (for up to 2/3 of the maxinum amount) Each Provincial Bank to provide evidence, satisfactory to * Approval of Provincial Law authorizing sale of the the Bank, of: majority of shares; * Provincial authorities to appoint privatization management team with approval of the Superintendency of Banks; * Submission of privatization plan (approved by Superintendency of Banks) to achieve privatization within 180 days; * Submission of audited cash flow for period up to privatization; * Signing of Privatization Trust Fund Agreement; * Submission of eligible provincial expenditures. * Signature of transfer contract to new owner or legal instrument authorizing closure of bank; * Audited balance sheet of residual entity; * Satisfactory impact on provincial finances (i.e., debt service coverage); * Satisfactory one-year liquidation plan; and * Submission of eligible provincial expenditures. 74. Trust Fund monies would be applied as follows: (a) Initial drawdown (one-third of allocation): (i) existing provincial bank liabilities to the Central Bank and Banco de la Naci6n for earlier support; (ii) provincial bank liabilities to the provincial government for private sector deposit withdrawals after December 20, 1994; and (iii) privatization consultancies. (b) Final drawdown (up to two-thirds of allocation) to finance the payment of liabilities of the residual entity but excluding those to the province itself. 75. Disbursement, Procurement, Records and Auditing. Loan proceeds would be used to finance the CIF cost of general imports, except those on a standard negative list. Retroactive financing would be pernitted for eligible imports as of February 16,  - 25 - 1995 (date of pre-appraisal) up to a maximum of US$100 million. Retroactive financing is justified given that reform measures are already under way and the need to maintain momentum in the privatization process. The Central Bank will submit disbursement applications to the Bank and will maintain separate records and accounts. Disbursement requests will be based on customs certificates, a procedure which was reviewed by Bank staff and found to be satisfactory. Withdrawal applications against customs certificates for contracts above US$10,000, but below US$10 million, would be made against Statements of Expenditure (SOEs). Contracts for the procurement of goods estimated to cost the equivalent of US$5 million or more would be awarded through simplified international competitive bidding in accordance with Bank guidelines. Contracts above a threshold of US$10 million would be subject to the Bank's prior review. Contracts below US$5 million would be awarded using procedures acceptable to the Bank. An audit report on the submitted import documentation by independent auditors acceptable to the Bank would be contracted within 30 days and submitted to the Bank within 60 days after disbursement of each tranche. Audit reports would give an opinion with respect to SOEs prepared by the Central Bank. Receipt of a satisfactory audit report of a prior tranche would be a condition of subsequent tranche release. The loan Closing Date would be June 30, 1997. Benefits and Risks 76. As described earlier, the major benefits of privatization are a difficult-to-reverse reduction of the fiscal drain on provincial finances, the consolidation of the banking sector and a broadening in the reach of banking supervision. The loan would assist in the privatization of up to fifteen banks representing about 10 percent of banking system assets. Provincial finances would be improved by substantially reducing fiscal deficits and by making possible greater financial discipline. 77. The main risk is that neither privatization nor closure actually occurs within the timeframe contemplated for operating the Privatization Trust Fund. The biggest hurdle to privatization is that the current trend towards consolidation in the banking system generates an oversupply of banks for sale and that therefore there will be few buyers and low prices. Further, if privatization fails, provincial governments may then hesitate to close the banks as they would be concerned about maintaining essential banking services in their community. These risks are manageable because provincial governments are already strongly motivated to privatize as a way to stop the fiscal drain. However, to further reduce these risks, the loan has been designed with a set of icentives and counter-incentives. While the provincial govermments would be responsible for design and execution of the privatization strategy, the process would be accompanied by the permanent intervention of the Superintendency of Banks. Furthermore, if within one year, the province neither privatizes nor closes, all funds borrowed from the Trust Fund will have to repaid at a penalty interest rate. Accordingly, the risk of an open-ended outcome of no privatization and no closure is reduced by: (i) provinces having to bear the financial burden of having to repay the initial Trust Fund drawdown; and (ii) the Superintendency having the power to remove  - 26 - the bank from the payment clearing system if regulatory requirements are not being met, an action tantamount to closure. 78. A second risk is that the liquidation of any residual entity drags on and is not resolved speedily and/or efficiently. This risk has been reduced by requiring provinces already during the early stages of privatization to develop options on how to best liquidate within one year. As a condition for the final Trust Fund drawndown, an approved plan would have to be in place identifying management, organizational formats, financial resources and strategies. A time limit of one year would be set to accomplish full disposal. Should privatization costs rise above current estimates--as underestimation is a frequent occurrence--and loan resources are insufficient to cover all liabilities, provinces would be expected to first negotiate with creditors. If negotiations yield insufficient results additional privatization action or fiscal measures will be undertaken. 79. Finally, in the event that the two-year period for the Privatization Trust Fund proves insufficient to aid in the privatization of all targeted banks, it is expected that authorities will extend the Trust Fund period by presidential decree. Social Impact 80. To be successful, the program of provincial bank privatization has to be sensitive to the particular situation faced by many of the participating provinces. These vary considerably, as do the prospects for eventual privatization and provision of banking services. The impacts will likely be most negatively felt in those provinces in which the provincial bank may close entirely or see its operations reduced dramatically. These may be among those locations with the dimmest prospects for labor absorption. Poverty incidence varies by region, with the highest rate (40 percent) reported in the northern provinces. As a direct result of the program, many staff out of the total 21,000 employed would be made redundant and banking services may be interrupted as the private banks take time to absorb the markets left unserved. This process ought to be managed so as not to be abrupt. All participating governments are extremely conscious of the need to mitigate negative social impacts and are willing to take necessary steps. These entail making timely redundancy payments to staff, as provided for under local labor agreements. Estimated financing available under the program is US$120 million for such payments. In addition, provinces are committed to ensuring the continuous provision, by contracting out if necessary, essential fiscal services to the public. 81. More generally, provinces are engaged in wide processes of reform which will lead to better prospects for sustainable development. Project support for this is coming from the ongoing PRL and Provincial Development I and II loans. In the meantime, the Bank, IDB, the Central Government, and provincial government have embarked upon several imnportant social sector operations which provide irnprovements to basic social services at the provincial level. In particular, we are developing a US$150 million Social Protection project to support poverty reduction activities in communities in extreme poverty. A proposed Rural Poverty Alleviation project would address the  - 27 - prospects of low-income small farmers in depressed areas to improve productivity and incomes. These targeted projects would be complemented by broader efforts to improve the quality of human resource investments. Working with the Bank, moreover, the Federal Government is endeavoring to use wisely its total budget of US$3 billion annually for some 40 social programs, most of which have targeted beneficiary groups. 82. Environmental Aspects. The program is not expected to have any environmental impact. V. RECOMMENDATION 83. I am satisfied that the proposed loan would comply with the Articles of Agreement of the Bank and would be consistent with the approved guidelines for Bank support. I recommend that the Executive Directors approve it. Lewis T. Preston President By Gautam Kaji Attachments Washington, D.C. April 20, 1995  -28 - ANNEX A ARGENTINA PROVINCIAL BANK PRIVATIZATION LOAN DRAFT LETTER OF DEVELOPMENT POLICY (dated April 19, 1995) Mr. Lewis T. Preston President The World Bank Washington, D.C. Dear Mr. Prston: 1. This leUler of Development Policy describes the economic reform program of the Argentine Govenment as well as specific .steps to deepen further the reforms in the financial sector. To implement these reforms, the Government requests continued financial assistance from the World Bank. The Bank's assistance is particularly needed at this juncture, as a result of the adverse impact that external developments, including the disTuption of Mexico's economy, have had on capital inflows and the stability of the domestic financial sector. We would like to take this opportunity to also present the macroeconomic framework which complements the reform program. 1. Macroeconomic Framework 2. Price stability and sustained growth remain the centerpieces of the Government's economic program. The Government has made an important progress in thcse fields since 1991. To eliminate fiscal deficits that were fueling inflation, the Government initiated profound structural reforms. As a result, monthly price increases dropped from ovcr 30 percent at the beginning of 1991 to international rates in the second semester of 1993. Inflation during 1994 was only 3.9 percent. 3. By laying the basis for price stability, the Government has charted an agenda for the future with the following objectives: the consolidation of stability through strict compliance with Law N' 23928 of March 27. 1991 (the Convcrtibility Law), the preservation of fiscal equilibrium and the  - 29- ANNEX A operation of a market economy with dcregulated and unresu-icted competitive markets, and regulation by the state of non-competitive markets; * Lhe strengthening of economic growth (annual GDP growth ratcs increased from 0.1 percent in 1990 to an average of 7.4 percent during 1991-1994) througlh increased levels of savings, investment, productivity, privatization of public enterprises, pnrvate sector development and exports, and an intensification of trade, financial and technological integration of the Argentine economy into world markets; and * the achievement of higher levels of employment and a more equitable distribution of income, both at a persona) and regional basis, through consolidation of economic stability and growth, substantially increased public investment in human resource development and social services, and measures to promote regional development. 4. Sustained economic recovery and improvements in welfare will continue to be achieved by undertaking lasting structural reforms in the public sector, improvement in national savings, and policy reforms that would keep on fostering private sector activity through gains in productivity, lower domestic taxes, and factor market improvements. To ensure that the private sector remains the leading expansionary force in the economy, the Government is committed to maintain flexible and open markets free of domestic regulations and ma*jor external trade barriers, and with a strong financial sector to improve intermediation. The Government's program of market reforms covers the following areas: (a) Open market economy: The government has totally eliminated controls on prices, wages, interest rates, and capital flows as well as a complex network of subsidies and implicit taxes. The Government is commitled to maintain such policies. Additionally, to facilitate more rational allocation of resources in the economy, and enhance intenational competitiveness through the reduction of production costs and improvement of incentives for productive investment, the Government is committed to promote structural reforms by introducing and supporting legislation for: (a) liberalizing labor markets; (b) streamlining bankruptcy legislation; (c) reforming the health insurance cooperatives; and (d) encouraging the reform of provincial finances, including the reduction of inefficient taxes. (b) Trade Librralization: The Government has made rapid strides towards opening the economy, both in terms of flows of trade, capital, and technology. Taking into account recent measures, by mid 1993 the import tariff structure has been simplified and the average tariff rate (including the statistical tax) was lowered to approximately 18 perccnt. Export taxes have been nearly eliminated, and most quantitative restrictions and other procedures that slowed the entry of trade, capital and technology have been removed. The Government will keep the economy open to international competition and will keep Argentina's antidumping provisions in line with thc respective GATT code. Moreover, the MERCOSUR treaty came into full cffect in  -30 ANNEX A January 1995. As specified in the Trcaty of Asunci6n, the Governmcnt climinatr- most inLxa-MERCOSUR tariffs, dropped all other intra-market trade harriers, and estAblished a common external tariff covering 85 percent of the positons in January 1995. (c) Financial Sector Reform. Financial sector reforms have been aimed at increasing financial deepening and the efficiency of financial intermediation. Following interest rate liberalization in 1987 and the elimination of directed credit by the Central Bank, the Government's strategy has been to increase depositor's and investor's confidence. Price stabilization, liberalized interest rates, and Lighter regulation and enforcement of liquidity, capital adequacy and provisioning requirements werc the chief reforms that permitted financial deepening (M4) to increase from.a low of 5 percent of GDP in 1990 to 19 percent in 1994. Similarly, capital markct reforms, including the elimination of transaction taxcs on securities trading and improvements in the regulation of public offerings encouraged the developmcnt of a major emerging market. Banks and non-bank corporations raised an impressive US$9.9 billion in equity issues and registered USS6.5 billion in bond issues during 1990-1993. The Government is committed to maintain liberalized interest rates, to refrain from directing credit allocation of rinancial institutions, and to further strengthen banking regulation and supervision. -. In the aftermath of the Mexico crisis, the Government's immediate aim is to sustain past achievements through deepening reforms. The Government has already taken far- reaching steps that will consolidate stability and deflect the spillover effects from the crisis. Foremost among these changes are a deepening of public and financial sector reforms. These will strengthen confidence in sovereign debt, the financial sector, and the sustainability of the Convertibility Law. The following sections discuss these reforms as well as upcoming steps of the reform program. nI. Public Sector Finances The Federal Government 6. The Governmcnt has undertaken a major effort to improve revenues through the implemenLation of a much-broader and uniform VAT. The Government is also committed to further improve the efficiency of the tax administration by improving subsLantially audils and controls. The increased reliance on more efficient taxes will continue allowing the Govcrnment to elimninate or reduce distortionary taxes, while observing the fiscal targets established in paragraphs 8 and 18. The Govemment obtained Congress approval of a law broadening the coverage of the personal assets tax, submicLed to Congress legislation to further rcstructure the public sector, and limit expenditures to the social security system.  7. The Government believes that the impact on Argentina of the external shock Ihat is affecting Latin America will be restrained and transitory in nature, as the fundarncntals of the economy remain strong. The reform process is deeply rooted, fiscal and monetary policies arc sound and the country's medium term prospects have been strengthened. Exports are rising and investment increased by 18 percent in 1994. Nevertheless, the Govemment recognizes that the international situation remains unsetted and that the declinc in privatc capital inflows is likely to reduce GDP growth. The Government has recast its fiscal program lor 1995 so as to withstand a reduction in capital inflows and continue to service its maturing obligalions. 8. The 1995 budget was drawn up in the framework of a decline in the ratio of public expenditure to GDP and a strong cffort to reduce tax evasion. This budget also incorporated the government's intention to further rationalize thc national administration, including the privaLi2ation of nuclear power stations. Fiscal policies have been adjusted to generate an overall surplus in the national non-financial public sector (excluding provinces) of Arg$2 billion, a surplus that will be used to amortize public debt. In addition, the Government expects to raise US$2.4 billion during 1995 from privaLization, including sales of the Government's remaining holdings in a number of already privatized enterprises and the sale of petrochemical plants and hydroelectrical and nuclear power plants. The fiscal measures announced by the Government in late February and Mid-March 1995 will yield some ArgS6.3 billion (2 percent of GDP) in the remainder of 1995, or Arg$8S5 (2.75 percent of GDP) billion on an annual basis. These measures were presented by the executivc and approved by Congress in only twvo weeks, a clear signal of decisiveness and political consensus. The measures included: R. expenditure cuts, including reductions in salaries of public employe,s earning $2,000 a month or more, with an expected yield of ArgSL.O billion in the remainder of 1995; b. a temporary increase (to be excluded from revenue-sharing witl the provinces) of 3 percentage points to 21 percent in the Value Added Tax. rate with an expected yield of ArgS2.2 billion; c. import tariff increases with an expected yield of Arg$0. 7 billion; d. a partial roll-back of certain previous reductions in social security contributions for agriculture, industry, and tourism, coupled with a lowering of contribution rates for the services sector, with an expected net yield of ArgS0.4 billion; and e. a broadening of the base of the VAT and income taxes, a broadening of the base and lowering of the rate of the wealth tax, new facilitics for regularizing tax arrears, and a number of smaller measurcs, largely in the area of social sccurity, with an expected overall yield of Arg$2.0 hillion for 1995.  - 3- ANNEX A If required by circumstances, the Govcrnment will adopt further expenditurc rTsCt-ains to achieve the basic principle of maintaining equilibrium in Lhe public finances. 9. The government's program for 1995 will continue and deepen structural reforms. The Congress is presently considering three important laws which (i) modify the regulations on collectivc bargaining contracLs and associated employment risks, thereby improving the flexibility in the labor market and reducing labor costs; and (ii) govern the reorganization of enterprises in bankruptcy proceedings. The newly approved Social Security Solidarity Law, will reestablish maximum limits for all beneficiaries, eliminatc the automatic adjustment of benefits, apply the provisions of the Convertibility Law to the determination of pensioners, and modify the associated legal proceedings. It will also allow the establishment of a limit, that will decline as the number of pensions under the former social security system diminishes, on pension outlays, which have been an important cause of macroeconomic instability in recent years. The program of provincial reforms discussed below should reduce distortions in the tax system and result in a permanenr reduction in the size of the public sector that will improve the allocation of resources and increase overall economic efficiency. These and other reforms, together with the progressive extension of institutional changes to all governmental jurisdictions, will help to further strengthen the profound institutional transformation of our countzy. The Provincial Governments 10. Throughout the 1980s, deficits generated by provincial governments were major contributors to the chronic instability of the Argentine public sector. Over the last three years, fiscal adjustinent, essential to the recovery of the economy, has occurred snainly at the federal level. The increase in provincial government expenditures has exceeded the rise in revenucs received from the Federal Treasury under the revenue sharing arrangements andi from their own resources, resulting in operational primary deficits in the provinces of about 0.7 percent of GDP in 1993 and 1994. At the same time that provincial governmcnts have lagged in making necessary fiscal adjustment, their role within the economy has grown as the result of the decentralization of many federal functions, notably secondary education and public health. Provinces are now the major providers of core public services in health, education, security, water and sanitation, electricity, and other infrastructure. However, most provinces are ill prepared to fulfill their increasingly important role, with negative implications for future economic growth and meeting the needs of the poor. !I. A major adjustment of provincial finances is expected for 1995, for sources of provincial delicit financing are now exhausted. Provincial deficits in 1993 and 1994 were  - 33- ANNEX A largely financed by the regularization of dcebs owed by the National Administralion to the provinces, by their sharc of the proceeds from the sale of YPF, and in 1994 by issues of Treasury bonds amounting to ARGSO.6 billion, secured by shared revenues. These sources are now exhausted. In view of the current situation, the Treasury will issue no bonds from now onwards on behalf of, or directed to the provinces and the Central Bank will not approve any additional domestic borrowing by the provinces, including loans guaranteed by shared revenues. Issues of debt for regularization of federal arrears will be limited to an amount that does not excecd rcductionLs in outstanding debt via the new tax moratorium, discharged wiLh public bonds, and debt-equity swaps from privatizations in excess of the USS2.4 billion mentioned above (para. 8). 12. To assist in the adjustment of provincial finances, tbe Federal Government launched in the early 1990s a concerted efort to regularize the transfer of co-participated 1ederal revenues, reducc unconditional discrctionary transfers that reward poor fiscal performers, improve local resource mobilization, modernize and downsize public administration, improve the provision of social services in health and education, assume responsibility for, and reform, provincial social security systems, privatize or close inefficient public enterprises, eliminate Central Bank rediscounts, promote privatization of provincial banks, and more generally improve the efficiency of allocation of resources in the provincial public sector. 13. To attain these objectives, the Federal Government's strategy for provincial reforms is based on: (a) the Transformation Fund approved in April 1993; (b) the 'Fiscal Pact' signed on August 1993; (c) the Provincial Development Trust Fund (discussed in Section Jll). 14. The Transformation Fund. ln April 1993, a Transformation Fund funded chiefly by the World Bank was established to finance structural adjustment measures in the provinces, funded, inter alia, by further privatizations at the federal level. To have access to the Transformation Fund, adjusting provinces must enter into an agreement with the Ministry of Interior taking measures aiming at: (a) improvements in local resource mobilization; (b) improvements in the efficiency of cxpenditures; and (c) reduction in the size of thc provincial banking sector. % 15. Fiscal Pact. In August 1993, the Federal Government proposed a "Fiscal Pact", which principally calls for reforms in provincial tax systems to reduce producer costs, and increase local tax revenues, consistent with the earlier proposed Transformation Fund. In return, the Federal Govenment agreed to increase minimum co-participated trans{ters, postpone, and possibly forego, certain' provincial debt obligations, and take over responsibility for funding provincial social security systems. 16. To reduce tax and other regulatory distortions and improve the fiscal situaLion and performance of the provinces, the Federal Government, in context of the 1993 'Fiscal Pact", is seeking from provinces to:  -34- ANNEX A a. substitutc the turnover tax by a consumption tax in order to reduce the cascading nature of the provincial turnover tax h. eliminate the highly distortionary provincial starnp tax; c. reduce property taxes to 1.2 percent for rural properties, 1.35 percent for semi-rural properties, and 1.5 percent for urban properties. The maximum fiscal value of properties is fixed at 80 percent of their market value. d. eliminate provincial labor, financial, and energy taxes; e. use co-participating transfer exceeding an agreed amount, to cancel debt obligations, finance investments, or provincial adjustment programs thal hase been approved by lhe national government; f. intensify tax collection and control, with provinces adopting a uniform system of tax reporling and collection, as developed by the national DGI; and g. deregulate professional activities, eliminate restrictions on wholesale and retail sales, deregulate further the transport sector, and make compatible federal and provincial regulations of the medicine and food markets. 17. In the context of the Fiscal Pact, the Federal Government has the obligation to accept the transfer of provincial social security systems, and harmonize contributions and pensions with the newly approved national social security system. Additionally, the Federal Government will support the privatization of public enterprises, and reduce Lhe role of provincial banks through privatization of ownership and control.. Consolidated Public Finances 18. To sustain low levels of inflation, and the stability of the financial system, thc federal authorities are committed to seek a consolidated (including provinces) public sector fiscal balance or surplus, excluding privatization revenues, over the 1995-97 period. 19. To further strengthen fiscal accountability at the provincial level, the redera Government by end of 1995 will scek to standardize budgetary reporting from all provinces, including both current and capital expenditures, and their financing, according to the principles contained in Law of Financial Management and Performance Control (Law N' 24.156). Standardized provincial financial statements when available will be made publicly availahle by the I;ederal Government, which will also present on an annual basis the financial condition of the consolidated public sector.  -35- ANNEX A Ill. The Financial Sector 20. Argentina's financial sector includes 30 public banks, mostly provincial banks, about 30 foreign owned banks, some 30 or so cooperatives, and about 70 private banks. There arc significant differences in size, with the top 20 banks accounting for about 60 perccnt o1' deposits. There are major differences in profitability, with the provincial banks showing the lowest rates of return. Differences in profitability are largely due to differences in costs and credit policies. Small banks and provincial banks tend to have higher costs and public banks tend to have a higher non-performing portfolio. Low profitability in several banks has generated a consolidation process in the banking system that has taken place for several years, with several banks being liquidated and others being merged or acquired to form stronger institutions. The Government believes that privatization of public commercial banks and consolidation will be healthy for the banking system, by enhancing efficiency and financial soundness. Nevcrtheless, the Government will remain in control of Banco de la Nacidn Argentina to be able to meet unexpected financial needs. In the longer term, when stabilization is frmly established, this position could be reconsidered. The policies described below will implement an orderly process of privatization of provincial banks and absorption or liquidation of the weaker institutions that contributes to strengthen confidence in the banking system. 21. These policies are particularly urgent in view of recent events in international capital narkets. Argentina's financial and capital markets suffered a major setback as a result of the disruption of Mexico's economy in latc 1994. The spillover effects on depositor's and investor's confidence led to a 20 percent decline in hank deposits between December 20, 1994 and March 21, 1995, to a standstill in corporate bond issues and to wide swings in the stock market. The outflow of deposits led to sharp increases in interest rates, with prime rates rising to 33 percent in U.S. doUars and 49 percent in Argentinc pesos in mid-March (increases of 25- 33 percentage points since December), and call money rates which at times reached over 70 percent. Despite progress achieved in raising the capital adequacy of financial instiptions, some institutions in certain segments of the banking system, including small wholesale banks, credit cooperatives, and provincial banks, remained too weak to withstand the loss of depositor confidence. A combination of illiquidity and loan default in these banks has now paved the way for a major restructuring of the banking system, including privatization of provincial banks and consolidation of private banks. 22. To help banks meet deposit losses, the Central Bank created somc ARGS5.8 billion in additional liquidity, through lowering reserve requirements in several smges, creating a facility for assisting distressed banks through Banco de la Naci6n, and exLending swapxs and rediscounts. Average reserve holdings (including cash-in-vault) declined from 21 percent at end-Deceinber 1994 to about 14 percent in mid-Marcb 1995. About ArgS4 billion in liquidity were provided through these reductions. To fund the facility managed by Banco de Ia NaciSn, the Central Bank assigned 2 percentage points of reserve requirements (equivalent to about  - 36 - ANNEX A Arg$800 million in additional liquidity). Finally, additional liquidity of Arg$l billion has becn supplied Lhrough Central Bank swaps and rediscounts. Liquidity assistance through Central Bank rediscounts was leveraged by amending the Central Bank's Charter to allow the Central Bank to extend rediscounts for periods exceeding 30 days and for amounts in exccss of each commercial bank's net worth. All liquidity assistance has been extended within the constraints imposed by the Convertibility Law. 23. While the liquidity package aborted a deeper crisis, it does not address the stmctural maladies of the banking system. The Government's aim is to ensure that commercial banks will be stronger than they have been to withstand the shocks that may come from time to time as a result of external events. The recent crises prompts a unique opportunity for a commercial bank restructuring program that strengthens confidence in the system. 24. To restructure the banking system, the Government will implement: (i) a trust fund to privatize provincial banks and (ii) a trust fund to assist in the restructuring of private banks. Tlhe Governmcat expects to finance these funds with new loans from the World Bank, IDB, and EXIMBANK of Japan, with bonds (Bonos Argenuinos) in the amount of $2 billion being floated in the domestic markcet and abroad, and possibly with bridge loans obtained through pledging YPF shares. The authorities have earmarked these rcsources to finance privatization of provincial banks and restructuring of private banks. None of these resources will he used to finance any olher public sector operations or to mct liquidity needs of the banking system. The liquidity needs of the banking system will continue to be financed by the Central Bank swap and rediscount facilities within the constaints of those facilities and of the Convertibility Law. Provincial Bank Privatization 25. One central objective of the Government's financial sector restructuring policy program is to achieve privatizaLion of provincial banks. It is the policy of the Government to encourage provincial governments to sell all of their shareholdings in provincial banks, if possible. ' In all cases, the percentage sold to the private sector will cxceed 51 percent. In most cases this percentagc will not fall below 60 percent to assure reasonable robustness of the privatization as provincial governments will continue to exercise added influcnce by virtue of remaining the most important customer in many cases. 26. PrivatizaLion will be implemented through the Provincial Development Trust Fund (Fondo para el Desarrollo Provincial). This fund wiUl extend adjustment loans to provinces or provincial banks that agree to scll a majority share and transfer lull control of their banks to private shareholders. The timetable for privatization of provincial banks cannot he specified as it depends on sovereign provincial decisions. Nevcrtheless, given the incentives to be provided by the Provincial Development Trust Fund, the Government expects that some fifteen provincial banks will bc privatized within the next two years. The authorities have  - 37 - ANNEX A understandably set a two ycar limit for the Provincial Development Trust Fund which appears desirable and achievable. However, should the envisaged limit prove to be insu1ficient to complete the privatization of all targeted provincial banks, the Trust Fund's operations would be extended appropriately. The first three provinces to privatize their banks are likely to include Mendoza, Misiones and Formosa. 27. The Provincial Development Trust Fund will carefully review privatization plans which include monopoly arrangements for newly privatized banks to manage the finances of thc provinces. if such arrangements are contemplated, these should bc extended for a maximum ot three to five years and their pricing should be part of the bidding process. 28. Privatization will address the long-standing poor performance of provincial hanks, which undermined financial sector efficiency and made fiscal balance more difficult. Accounting for 2.5% of assets in the banking system, these banks not only have higher costs of operation, but also have followed imprudent lending policies. These have tramslated into losses to provincial governments, further undermining their own very poor financial performance. Further, slower overall deposit growth in 1994 and major deposit withdrawals during January-March 1995 severely undermined their liquidity positions. 29. Through privatization it is expected that the newly emerging private banks will focus on profit maximization and financial soundness and that the Central Bank supervision and enforcement of liquidity, capital adequacy, and provisioning requirements for thcse banks will be more effective. The newly privatized banks will he subject to the regulatory framework established by the Superintendency of Financial Entities, which will have the power to close the privaLized banks. Stronger management and supervision of provincial banks will reduce the risk that these banks generate systemic runs on bank deposits. Stronger supervision will bc supported by continuing improvements of the regulatory framework and institutional development of the Superintendency of Financial Entities, which will continuc to seek technical assistance as needed. Furthermore, privatization will improve provincial finances by eliminating the continuing losses that provincial bank generate. 30. If privatization does not matcrialize and provincial authorities do not act on cloure, the Central Bank will promptly (within one year) apply sanctions, including withdrawal of the provincial bank from the clearing mechanism, to provincial banks that do not meet required liquidity or capital ratios. Furthermore, the Central Bank will not extend operating licenses to new provincial government banks. PrivaUzation or closure is expected to bring about a downsizing as only a limited share of assets and liabilities is likely to he acquired by the private sector. All non-privatizable assets and liabilities would be translerred to a residual entity which the provincial governments would liquidate. Special attention will be given to the timely and efficient disposal of any residual assets and liabilities. Provincial Governments will he requested to define -specific additional financing plans, should the assigned financing (para. 24) be insufficient to cover all residual liabilities.  - 38 - ANNEX A Private Bank Recapitalization 31. Another central objective of the Government's financial sector restucturing policy program is to strengthen the capital position of private banks. Recapitalization will he achieved through the newly created Capitalization Trust Fund (Fondo Fiduciario de Capiralfwci6n). Capitalization of financial institutions will be closely linked to merger and acquisition transactions that help consolidate banks into a more efficient banking system. The fund will be liquidated following implementation of its objectives or two years aftcr its establishment, whichever comes first. 32. The private bank rccapitalization program will assist in the ongoing consolidation of Argentina's highly fragmented banking system. Only 20 of Argentina's 100 or so private commercial and cooperative banks have assets above ArgS250 million and only 6 banks have asses in excess of ArgSl billion. Consolidation had already begun before the current crisis and was initially triggered by declining deposit growth and lower intermediation spreads. It is now being accelerated by liquidity and solvency problems of the smaller banks caused by investor reallocation of deposits to the larger and bettcr hanks. Many cooperatives have begun consolidating through mergers and mosL wholesale banks, which have becn selling thcir assets to prime private commercial banks, are unlikely to survive unless acquired by other hanks. The Government has set up the Capitalization Trust Fund to implement an orderly down-sizing capitalization of the banking sector without creating further crises of confidence. The fund will support mergers and acquisitions that result in stronger banks and the Central Bank will close remaining banks that do not meet required liquidity and solvency ratios. 33. To provide further protection, the Law of Financial Entities has been changed to allow that the Central Bank establish a private deposit insurance system. The system would be providing limited coverage per person per institution up to a sum of $20,000. The Fund will be established with mandatory contributions from all financial insttutions. Contributions would be different across banks according to risk ratings assigned by the Superintendency. In addition, the government has strengthencd the protection provided by article 48 of the Law of Financial Entities. The new provision assigns the total amounts deposited at the Central Bank under reserve requirements to cover deposits up to $5,000 per person. 34. It remains the Government's policy to revoke the operating license ol a financial institution that fails to meet liquidity and capital requirements. In defense of depositors, [he government has allowed the Central Bank to restructure a failing financial institution prior to revoking its license. Two instruments are provided. One allows the Central Bank to mandate reductions or increasms of the institution's capital as well as the sale of equity shares to other authorized investors or shareholders. The other allows the Central Bank to exclude assets and liabilitics 1rom a financial institution to transfer them to another institution and lo approvc proposals to match the maturities of asscts and liabilities of both financial institutions.  - 39 - ANNEX A IV. Monetary Policy 35. Monetary policy will continue to be governed by the Convertibility Law, which rcquires full backing of the monctary base with international reserves. According to the law, U.S. dollar-denominated Governmeni bonds held by the Central Bank can he used to cover up to 20 percent (33 percent in emergency sitwations) of the monetary base. The Government is commiucd to have policies and programs under implementation which are fully consistent with the Convertibility Law. Consistent with the underpinnings of the Convertibility Law, credit expansion by the Central Bank to the public sector and the financial sector will he limited in accordance with the above mentioned Central Bank Law. 36. The Government is confident that with the measures that have been taken to .trengthen fiscal and financial policies - and the support of the IMF, the World Bank, the IDB, and other institutions - confidence will bc restored and capital outflows reversed, strengthcning bank liquidity. During the remaindcr of the year (April-December). broad money is expected to recover by around 18.5 percent, raising the ratio of M4 to GDP to 20.4 percent by the end of the year, approximately the level at the end of 1994. In this context, the Central Bank during the balance of the ycar expects to reduce outstanding swaps and rediscounts, and gradually restore legal reserve requiremens so as to recover an adequate margin of liquidity, which would be reflected in a recovery in its holdings of gross international reserves. It is expected that the recent measure (March 10, 1995) allowing banks to bold part of the reserve requirements in the form of cash-in-vault will be reversed partly by end-June, and fully by end-November. 11. WORLD BANK SUPPORT 37. The above presentation demonstrates the depth of the Government's overall public sector and financial sector reform programs. The Government believes that financial assistance from the World Bank is essential to implement financial sector structural ,cforms. Implementation of the proposed measures would improve the fiscal balance of the provincial governments and confidence in the fnancial sector, thereby reducing threats to macroeconomic stability. Sincerely, yours, A//