Argentina - Special Structural Adjustment Loan and Special Repurchase Facility Support Loan Projects

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-7268-AR REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE EXECUTIVE DIRECTORS ON A PROPOSED SPECIAL STRUCTURAL ADJUSTMENT LOAN IN THE AMOUNT OF US$ 2.52525 BILLION AND ON A PROPOSED SPECIAL REPURCHASE FACILITY SUPPORT LOAN IN THE AMOUNT OF US$505.05 MILLION TO THE ARGENTINE REPUBLIC November 3, 1998 Poverty Reduction and Economic Management Unit Latin America and the Caribbean Region This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS (as of November 3. 1998) Currency Unit = Argentina Peso (ArgOS Arg$1 US$1 WEIGHTS AND MEASURES Metric System FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS AGN - General Auditor's Office ASOMA - Solidarity Assistance to the Elderly ATN - National Treasury Grants BCRA - Central Bank of Argentina BANADE - National Development Bank CAMEL - Capital Assets Management Earnings and Liquidity CAS - Country Assistance Strategy CNV - National Securities Commission EFF - Extended Fund Facility FEDEI - Federal Rural Electrification Fund FONAVI - National Housing Fund FOPAR - Participatory Social Investment Fund GDP - Gross Domestic Product IBRD - International Bank for Reconstruction and Development IDB - Inter-American Development Bank IMF - International Monetary Fund INDEC - National Institute of Statistics and Census INDER - National Reinsurance Agency LIBOR - London Interbank Offer Rate LIL - Learning and Innovation Loan LSMS - Living Standards Measurement Study MEyOSP - Ministry of Economy and Public Works and Seri'ices NBI - Unsatisfied Basic Needs Index OECD - Organization for Economic Cooperation Development PAMI - Integrated Program of Medical Care PRANI - Youths Nutritional Program PROMIN - Program for Maternal and Child Health and Nutrition SAFJP - Superintendent of Administrators of Pensions and Retirement Funds SAL - Structural Adjustment Loan SART - Superintendent of Workers' Compensation SCL - Single Currency Loan SECAL - Sectoral Adjustment Loan SEDESA - Deposit Insurance Corporation SIEMPRO - System of Information, Monitoring and Evaluation of Social Programs SISFAM - Social Program Targeting System SME - Small and Medium Enterprise SSAL - Special Structural Adjustment Loan SSN - National Superintendent of Insurance TRABAJAR - Employment Support Program VAT - Value Added Tax Vice President: Mr. Shahid Javed Burki, LCRVP Country Director: Ms. Myrna Alexander, LCC7C Sector Manager: Mr. Guillermo Perry, LCSPR Lead Economist: Mr. Paul Levy, LCC7A  FOR OFFICIAL USE ONLY ARGENTINE REPUBLIC SPECIAL STRUCTURAL ADJUSTMENT LOAN AND REPURCHASE FACILITY SUPPORT LOAN Loans and Program Summary Borrower: Argentine Republic Amount and Terms: SSAL: $2.52525 billion-LIBOR-based Single Currency Loan (SCL) in US Dollars. with special terms: 5-vear maturity. including 3 years of grace. at 400 basis points over LIBOR. A I percent front end fee. and a 75 basis point commitment charge will apply, without waivers. Special Repurchase (Repo) Facility Support Loan: $505.05 million -Contingent Loan with the same special terms as above. Description: The proposed loans will support the continued efforts of the Government of Argentina to transform its economy and to protect the gains achieved thus far. As one of Latin America's most successful reformers. Argentina has achieved price stability, opened its borders to trade, privatized public enterprises, restructured public administration, reformed the pension system and has started the process of restoring social services. Argentina is now focusing on reforms on investment in human capital, improved regulation, modem financial market supervision, and quality public administration and govemnance. The government showed its resolve during the 1995 Tequila crisis, not only to continue with but to accelerate reforms particularly in terms of the financial sector. The result has been a much stronger banking system which has held firm despite recent problems encountered by Argentina and all emerging markets in accessing international capital. The operations are preventive, aimed at mitigating the deleterious effect of the current international financial instability on the economy and protecting vulnerable groups. Preventive actions are advisable due to iii 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.  Argentina's currency board arrangement, and the fact that foreign reserve losses translate into a liquidity crunch in the banking system. The authorities have taken additional precautionary actions, including an innovative contingent repurchase facility with private banks, measures to restrain fiscal expenditures, and a precautionary Extended Fund Facility with the IMF. The Bank's support would be co- financed by the Inter-American Development Bank (US$2 billion for the SSAL, and US$0.2 billion for the repo facility). Benefits and Risks: The SSAL loan will help meet critical foreign exchange needs of the Government and allow it to remain focussed on longer term reform issues. This would prevent the drastic negative impacts. especially on vulnerable groups, that the abrupt absence of external financing would have on the economy and the social gains achieved thus far. In conjunction with the SSAL, the contingent loan in support of the "repo" facility will strengthen the financial system's safety net and similarly safeguard economic and social achievements. A risk is that reforms could be delayed due to the upcoming elections. However. this is offset by the sense of urgency and consensus that measures must be taken to avoid a repeat of the Tequila crisis. In addition, if access to international capital markets is not restored by mid- 1999, the financial package currently assembled might not be sufficient to meet external needs resulting in a severe economic adjustment. The Bank and the other international financial institutions will continue to work with Argentina, as well as globally, to react to any deepening of the global financial crisis. Poverty Category: Program of Targeted Intervention Estimated Disbursements: SSAL: FY99-US$ 2.02525 billion (including capitalized front- end fee) FY00 - US$ 0.5 billion Repurchase Facility Support Loan: FYOO-US$ 505.05 million Project ID Number: SSAL -- AR-PE-62991 Repurchase Facility Support Loan - AR-PE-62992 iv  ARGENTINE REPUBLIC SPECIAL STRUCTURAL ADJUSTMENT LOAN AND SPECIAL REPURCHASE FACILITY SUPPORT LOAN CONTENTS 1. INTRODUCTION ............. , . .............................. 1 2. THE ECONOMY ............. . . . ............................... 2 A. The Convertibility Plan ..................................................... B. The 1994-1995 Regional Crisis ..................................................2 C. Recent Economic Performance ....................................................4 D. The Current International Crisis and Its Impact on Argentina ....................5 E. Medium-term Prospects and Financing Plan ................................................6 3. THE COUNTRY'S ADJUSTMENT PROGRAM ................... 9 A. Advancing The Reform Agenda ....................................................9 B. Quality Investment in Human Capital ................................................... 10 C. Efficient Financial Markets ................................................... 17 D. Enhanced Regulatory Environment ...................................... 25 E. Quality Public Administration and Fiscal Strengthening ........................... 27 4. THE PROPOSED LOANSS .................................................... 31 A. Rationale and Objectives ................................................... 31 B. Terms and Conditions ................................................... 33 C. Benefits and Risks ................................................... 35 5. BANK GROUP STRATEGY .................................. 37 6. RECOMMENDATION ...................................... 38 TABLES Table 1: Argentina - Key Macroeconomic Indicators ............. ................. 8 ANNEXES Annex A: Social Indicators of Development Annex B: Key Economic Indicators Annex C: External Financing Requirements and Sources of Financing Annex D: Status of Bank Group Operations Annex E: Matrix of Policy Actions Annex F: Letter of Development Policy Annex G: Argentina at a Glance v  ARGENTINE REPUBLIC SPECIAL STRUCTURAL ADJUSTMENT LOAN AND SPECIAL REPURCHASE FACILITY SUPPORT LOAN 1. INTRODUCTION 1. I submit for your approval the following report and recommendation on two proposed loans: (1) a Special Structural Adjustment Loan (SSAL) to Argentina of US$ 2.52525 billion (single currency) in support of continued economic reforms; and (2) a contingent loan of US$ 505.05 million (single currency) to strengthen the repurchase (repo) facility that the Central Bank has with commercial banks. Both loans would be at the special rate (LIBOR + 400 basis points), with a maturity of five years, including three years of grace, a one percent up-front fee and a commitment charge of 75 basis points without waivers. The SSAL would be disbursed in three tranches: a first and second tranche of US$1.0 billion each; and the third tranche of $500 million. Effectiveness of the repo facility loan would be based on the effectiveness of the SSAL, satisfactory progress in carrying out the adjustment operation, and a macroeconomic policy framework that is consistent with the objectives of that operation. The contingent loan would disburse on activation of the repo facility, but not before July 1, 1999. 2. Argentina is in the latter stages of a successful economic transformation. Since 1989, the government has shed public enterprises and removed barriers to domestic and international trade and capital. It instituted monetary and fiscal discipline, transforming the hyperinflation of the 1980s into one of the lowest inflation rates in the world. Productivity gains and rapid economic growth have followed. The government took advantage of the Tequila crisis in 1995 to take stringent measures to strengthen the banking system. At the same time, the government began the process of restoring social services, especially social safety nets, education and health, with attendant impacts on the poor, especially women and children. Public spending on social programs has increased considerably, up 20 percent per capita in real terms since the mid-1980s. 3. Despite these achievements, the country's history of high external indebtedness relative to its export base leaves it exposed to the effects of the present turbulence in international financial markets. Special support serves the purpose of mitigating an unnecessary setback to the country's economic progress. Concomitantly, it supports the government's efforts to move ahead with the structural reforms. 4. The Inter-American Developmeat Bank (IDB) is cofinancing the Bank's loans. In addition, the Bank proposes to support complementary reforms at the provincial level via a proposed Third Provincial Reform Loan, scheduled for FY 00. Argentina is currently in the first year of a three-year Extended Fund Facility with the International Monetary Fund (IMF), and Argentina is in compliance with IMF conditions to date. 1  2. THE ECONOMY A. THE CONVERTIBILITY PLAN 5. Argentina's reform agenda builds upon a successful program of "first-generation" reforms accomplished under the government's convertibility plan. The plan'. launched in March of 1991, consisted of the following five main pillars: (a) monetary reform, through the Convertibility Law, subsequently supplemented by the new charter of the Central Bank; (b) fiscal reform, initially through a sharp improvement in the administration of the tax system and later through a redefinition of tax instruments and rates; (c) public sector reform, through debt restructuring, civil service reform, fiscal restructuring and an ambitious and successful plan of divestiture and deregulation of factor and product markets; (d) social security reform, allowing for a new capitalization mechanism operated by the private sector; and (e) trade reform, through the elimination of export taxes and most quantitative restrictions on imports, and the reduction of the level and range of import tariffs. Entry into MERCOSUR followed. 6. The monetary reform established a currency board-type arrangement and full convertibility of the peso. The monetary base must be backed by foreign exchange reserves by at least a two-thirds ratio (up to one-third may be dollar-denominated government bonds), thus strongly restricting financing of fiscal deficits. 7. Long-sought stabilization of prices followed the implementation of the reform. The fiscal, public sector, and social security reforms led to a re-definition of the role of the state, dramatically improving economic efficiency and allowing the government to focus on the core social safety net and regulatory functions. Trade reform allowed local companies improved access to state-of-art foreign technology, and it unleashed a renewed dynamism in exports, with exports doubling from 1992 to 1997. The immediate impact on economic performance was to achieve average annual GDP growth of 8.5 percent over the 1991-1994 period. Consumer price inflation fell to less than 4 percent by mid-1994. B. THE 1994-1995 REGIONAL CRISIS 8. Argentina's macroeconomic stability depends on both foreign and domestic confidence in the currency board arrangement instituted under the convertibility plan. Under this system, a decline in international reserves translates into a monetary Two prior (1989) pieces of legislation had opened the road to deregulation and privatization: "Ley de Emergencia Economica."'and "Ley de Reforma del Estado." 2  contraction, as occurred in 1995, during the aftermath of the Tequila crisis.2 As a consequence, there is a symbiotic relationship between the convertibility plan and the financial system, requiring strength to the financial system. Weaknesses in the banking system were quickly revealed in 1995, and emergency actions were required to stabilize the situation - with support from the IMF, IDB and the Bank. The economy contracted by 4.0 percent in 1995, and the unemployment rate soared to 18.4 percent. Nevertheless, the government's commitment to the currency board arrangement was reaffirmed and the Convertibility plan emerged stronger from that crisis. 9. The Tequila crisis, as the first true test of the convertibility plan, brought to light important lessons for Argentina: (a) as for any emerging country, it highlighted the importance of a sound banking system supported by strong, prudential regulation and banking supervision. The crisis revealed weaknesses related to the limited nature of a dollar lender-of-last- resort in an increasingly dollarized system, particularly when the government's access to international credit is interrupted (although the absence of a full safety net was a strong incentive for responsible belhavior by the banks). Increased capital mobility, while welcome in re-monetizing the Argentine economy, has also made the economy more vulnerable to external shocks and the banking system, the agent of transmission of financial crises; (b) it reemphasized the need to sustain sound macroeconomic policies. Just before the 1994-1995 crisis, there was a slippage in the fiscal accounts and a growing current account deficit, both impacting the credibility of the convertibility plan; (c) it highlighted the extent of the real economy's vulnerability to volatile capital flows under a currency board, particularly in view of remaining rigidities in factor markets (labor markets in particular); (d) the Mexican experience highlighted the difficulties in changing the exchange rate regime during periods of crisis, particularly in a highly dollarized economy where the majority of private sector liabilities, government debt, and banking credit is in US dollars. It was a widely held belief in Argentina during the crisis, and rightly so, that a devaluation of the currency would have had much worse consequences than the ensuing recession. As a consequence, during the crisis, no serious proposal was raised to abandon the currency board; and (e) lessons for the banking system underline the need for substantial liquid assets to withstand liquidity shocks and the lack of access to international credit. Some contagion effects were observed and a limited privately funded deposit insurance scheme was introduced to limit that problem among depositors. Other relevant experiences include: (i) time deposits proved more fickle than sight 2 The Central Bank has some flexibilitv. in that its charter allows it to substitute up to one-third of foreign reserves with dollar-denominated govemment bonds. 3  deposits, and banks with no sight deposits suffered acute liquidity problems; (ii) banks with standardized loans and good documentation marketed loan portfolios easier; and (iii) market risk capital requirements were seen as an important complement to the high counter party risk capital requirements that had already been implemented. 10. Argentina's reaction to the 1995 crisis sent strong signals to the markets about its long-run credibility. This was specially true with respect to its decisions to: (a) remain with the currency board despite a rapid decline in the money supply and high unemployment; (b) allow some banks to fail and some bank depositors to lose money; and (c) react to the crisis by tightening market discipline over banks and moving to strengthen the credibility of the currency board (for example, by moving bank and Central Bank effective 'reserves' offshore). Even at the worst moments of the 1995 crisis, the Convertibility Law (in particular its mandated coverage of high powered money by international reserves) was never breached. While at the heiglht of the crisis usage of dollar denominated bonds reached its legal limitations as a share of total reserves, the usage of bonds was quickly reduced following the crisis. 11. Aftermath to the 1995 Crisis. Despite serious prior efforts to strengthen the financial system, the 1995 crisis increased the urgency for reform since the financial system came close to the point of collapse. As a result, following the crisis, Central Bank authorities took a number of measures to build on the growing strength of the banking system both from the regulatory and supervisory perspectives (which also mitigate the need for lender-of-last-resort functions). and increasing the liquidity in the system, actual and contingent. C. RECENT ECONOMIC PERFORMANCE 12. Investment-led growth returned quickly following the 1995 crisis. The Argentine economy expanded by 4.3 percent in 1996 and by an impressive 8.6 percent in 1997. By May 1998, the unemployment rate had improved to a still-high 13.2 percent. Preliminary estimates for the first half of 1998 indicate GDP growth of 7 percent. 13. External Balance. After running small trade surpluses in 1995 and 1996, a trade deficit of under 1.5 percent of GDP appeared in 1997, partially driven by booming imports of capital goods. A terms-of-trade shock related to primary commodity price declines has played a role: the IMF estimates a decline of 1.5 percent and 4.1 percent in the terms of trade in 1997 and 1998 respectively. So far in 1998, there has been a further deterioration in the trade balance, as well as some deterioration on services accounts. The government estimates that the fall in the value of exports due to lower export prices will total about $2.5 billion, or about 0.7 percent of GDP. The current account deficit reached 3.5 percent of GDP in 1997, and it could reach about 4.3 percent of GDP this year. About one-third of the current account deficit was financed by foreign direct investment in 1997, and this share may be maintained this year. 14. Improved Fiscal Balance. The government has attempted to relieve demand pressures on the current account through an improved fiscal balance. The overall public 4  sector deficit (federal plus provincial) has declined from just over 3 percent of GDP in 1996, to about 2 percent in 1997. The federal deficit, driven largely by the transition costs of the newly "privatized" pension system, constituted about three-fourths of that deficit, while the provinces' deficit constituted one-fourth. For 1998. the consolidated fiscal deficit is projected to fall to about 1.5 percent. D. THE CURRENT INTERNATIONAL CRISIS AND ITS IMPACT ON ARGENTINA 15. The recent turmoil in international financial markets is having an impact on the Argentine economy in various ways: the temporary closing of access to foreign borrowing; a fall in the prices of major exports; and a sharp decline in the local stock market. Confidence in the currency board and in the banking system, however, remains strong. International reserves have held fairly steady, at about $24 billion. Although this level is slightly lower than the $25 billion reached in early August, it is still about 7 percent higher than the level of reserves held at the end of 1997. Deposits in the banking system have also held steady, but the rapid expansion of credit in the first half of 1998 has now slowed to near zero. 16. Argentina is highly dependent upon access to international capital markets due to its large foreign debt relative to its export base. Foreign debt service-to-export ratios for upcoming years are projected to be over 60 percent, despite the lengthening of maturities of public external debt. Prior to the current crisis, Argentina had been able to lengthen the average maturity of its stock of public debt to over eight years. In recent weeks, however, foreign private lenders have expressed no interest in extending new credits to emerging markets, including Argentina. Although the export base doubled from 1992 to 1997, exports of goods and non-factor services represent only about 9 percent of GDP, up from 6.3 percent in 1993, and it will take sustained fiscal discipline and continued productivity improvements to lower Argentina's high debt-service-to-export ratio. 17. The domestic stock market has fallen dramatically. The Merval stock index has fallen by about one-third over the last six months (as of mid-October). The uncertain business environment and restricted access to foreign capital have driven up domestic interest rates sharply. Spreads on Argentine Brady bonds soared to well over 10 percent - compared to the 3-4 percent spreads during much of 1997. The prime rate for 30 day loans in pesos reached 17.5 percent (mid-September). This figure compares to 9.1 percent on average during 1997. Deposit rates have increased to a much lesser degree than lending rates. 18. The adoption of important reforms in the financial system, further fiscal strengthening, and the deepening of structural reforms, have been instrumental in deflecting the critical early stages of the recent Asian crisis. Despite the decline in equity and bond values, and the initial brief dip in reserves, the financial markets have remained relatively stable. The government has taken additional fiscal measures, reducing in August planned expenditures in 1998 by one billion pesos from what was approved in the 1998 budget. These same levels - or less if need be-were presented to Congress in the 5  draft 1999 budget. This has sent a clear signal to the markets that the government is prepared to maintain fiscal discipline. 19. With markets closed and capital flows disrupted, Argentina will not be able to finance its deficit nor refinance its external debt as maturities come due. In order to make these payments, there would have to be a significant contraction in international reserves, starting in the fourth quarter of 1998. Such contraction would produce a severe recession, increases in unemployment, and would result in fiscal cuts that would go beyond what is feasible or advisable given the timeframe available for making the adjustment. Such drastic action would result in a collapse of government services and critical social programs. The significant loss of reserves would threaten monetary and fiscal stability. The financial system would come under stress. It is not unlikely for the economy to experience a repeat of the Tequila crisis, when the economy contracted by 4 percent, and unemployment rose to over 18 percent. Under extreme circumstances, such a scenario could undermine the viability of the convertibility plan. 20. To avoid this severe scenario, the government has requested extraordinary assistance from the Bank and IDB to complement the precautionary Extended Fund Facility (EFF) put in place with the IMF. The request is based on the country's strong track record in undertaking reforms and the quality of its macro-economic policies. It is also prepared to undertake additional measures to advance to the next stage of structural reforms. With the requested assistance, the government would be able to transcend the immediate disruption of the international capital markets, facilitate reentry, and mitigate the effects of the financial crisis on the economy, especially the poor and vulnerable groups. E. MEDIUM-TERM PROSPECTS AND FINANCING PLAN 21. Although GDP growth for the first half of 1998 was about 7 percent (preliminary estimates), there are clear signs the economy is decelerating rapidly. Industrial production growth has fallen to less than 2 percent annual growth in recent months and preliminary figures for employment growth indicate that it has fallen to zero. Fourth quarter economic growth will likely be close to 2.5 percent, with no improvement expected for next year, depending upon external circumstances. 22. Argentina's financing needs are significant but manageable under normal market conditions. For the fourth quarter of 1998, public sector financing needs amount to $4.9 billion. While prudent prior borrowing and other sources of financing has secured $1.7 billion of such financing, the government still requires another $3.2 billion to satisfy its financing needs in 1998. Based on the official economic program, the public sector deficit for next year would amount to $2.7 billion. Amortization of $1 1 billion, and other financing needs of $0.5 billion bring the total public financing requirement to $14.2 billion in 1999. 23. Total external financing needs -via the balance of payments are larger. Capital inflows required to finance 1999 foreign debt amortizations (private and public), as well as a projected current account deficit of US$14.8 billion, amount to about US$28 billion. 6  The government has access to a US$ 2.8 billion Extended Fund Facility with the IMF. With support from the World Bank, the IDB, and bilateral agencies, along with the above-mentioned facility, the external financing needs for the first half of 1999 could be met. More details of the financing plan are provided in Annex C. 24. The following is considered a likely macro-economic scenario. It assumes that international markets remain closed in the first part of 1999 but that extraordinary financing from multilateral organizations and other sources, such as the domestic pension funds, enable Argentina to meet its financing requirements. It further assumes that, in the second half of the year, international markets gradually reopen to emerging economies but continuing support from the multilateral organizations, especially from the IMF, would be available. In such a scenario, the planned multilateral support (including the IDB and IMF) aims at keeping Argentina from losing reserves to any significant degree, and thus prevent a severe contraction and demonetization of the economy, or the weakening of the convertibility plan. At the same time, economic activity would be maintained, albeit at more moderate rate, with 1999 growth projected at 2 percent (see Table 1). 25. There are many uncertainties to this scenario. Argentina must continue to differentiate itself in the market in order to regain its access to international capital. Clearly, if access to those markets is not restored in the second half of 1999, financing needs would go beyond what is presently covered in Argentina's financing plan and likely sources, including augmented support by the IMF. A decline in foreign reserves might be inevitable. A monetary shock and a much more severe recession could result. On the other hand, an earlier opening of the financial markets would allow Argentina to regain more normal financing and to grow faster. Such a scenario could result in growth in the range of 4 to 5 percent for 1999. 7  Table 1: Argentina - Key Macroeconomic Indicators Base Scenario (Percent of GDP) Projected: 1997 1998 1999 2000 National Accounts Real GDP growth 8.6 5.0 2.0 4.5 Total Investment 20.1 21.5 21.1 22.5 National Savings 16.6 17.1 16.8 18.2 Foreign Savings 3.5 4.4 4.3 4.3 Public Sector Primary Surplus (- indicates deficit) 0.4 1.0 1.1 I .1 Interest Payments 1.8 2.2 2.5 2.4 Domestic 0.4 0.6 0.6 0.5 Foreign 1.4 1.6 1.9 1.9 Balance (- indicates deficit) -1.4 -1.2 -1.4 -1.3 Balance of Payments Resource Balance -1.7 -2.5 -2.3 -2.2 Current Account Balance -3.5 -4.4 -4.3 -4.3 Capital Account/b 4.4 4.8 3.8 5.3 Gross International Reserves in months of 6.0 5.7 5.5 5.6 imports (of goods and services /c) Memo: GDP (US$ billion) 325.0 345.0 356.5 378.1 a! Federal Government. Provincial govemments' aggregate deficit was 0.4 percent of GDP in 1997, and it is projected to be in the 0.4 to 0.6 percent over the 1998-2000 period. b/ Net flows. Difference between current account deficit and capital account surplus is change in net international reserves, as a fraction of GDP. C/ Goods, non-factor services and factor services 8  3. THE COUNTRY'S ADJUSTMENT PROGRAM A. ADVANCING THE REFORM AGENDA 26. The Argentine experience so far centered in changing macroeconomic rules, reducing the size and drastically narrowing the scope of the state by dismantling institutions that promoted protectionism and statism. In the case of Argentina. privatization of state assets has been far reaching. and far more successful than expected. The effort to curtail an inefficient state apparatus was the result of the prior discrediting of the state, both in Argentina and broadly in Latin America, following a long period of economic decline. 27. Argentina has embarked upon a new stage of reform which shifts priorities to the consolidation of macroeconomic stabilily'. sutstcaining high r ates of growth, and the challenge oflpoverty reduiction. The pursuit of poverty reduction has been elusive in Argentina despite relatively high growth. Following a dramatic decline in poverty in the first years of the convertibility plan from a peak of over 40 percent of households in 1989 to about 17 percent in 1993, it started rising again, reaching about 26 percent of households in 1997. This happened for two reasons: the lack of flexibility in the labor markets to absorb the reallocation of resources set off by reforms requiring firms to be efficient and the recession following the Tequila crisis. Both factors contributed to a growth in unemployment, which peaked at 18.4 percent in May 1995, and has since dropped to 13.2 percent. 28. The challenge of poverty reduction in the context of a stable and growing economy is the priority for the next several years. The agenda comprises the following five broad policy areas: (a) Quality Investment in Human Capital (b) Efficient Financial Markets (c) Enhanced Regulatory Environment (d) Quality Public Administration and Fiscal Strengthening 29. The proposed reforms are embedded in global trends and sustainability of reforms already implemented, and address issues in some of the remaining structural deficiencies in the economy. The proposed reforms reflect not only Argentina's own experience but have been enriched by the experiences of other Latin American, East Asian, and OECD countries. There is a very close interconnection among the reforms: both the reduction in poverty, which is the first priority of the Argentine Government, and economic growth 9  would depend on reforms in the above five areas. Ultimately, the reforms can be seen as instruments for achieving the primary goals of sustainable growth and poverty reduction. 30. The government is committed to pursuing this new, expanded reform agenda. Below, more details are provided for each of the five general categories of reform. The government's commitment is expressed in the Letter of Development Policy (Annex F) and the Policy Matrix (Annex E). B. QUALITY INVESTMENT IN HUNMAN CAPITAL 31. For a long time, Argentina has enjoyed a high quality of humnan capital as reflected in social indicators which are ahead of many of its Latin American neighbors and other merging markets. This is especially true in terms of access to education, literacy, and average life span, thanks to social investments made early in its development and an abundance of natural resources which have allowed high standards of living. With a per capita income of about $8,600 in 1997, Argentina ranks among the upper-middle income countries in the developing world. 32. Despite a relatively high level of per capita income, Argentina has significant levels of poverty and a highly skewed distribution of income which are exacerbated by the impact of globalization on the demand for low-skilled workers and labor market rigidities. In the area of greater Buenos Aires alone, 26 percent of the population is estimated to be in poverty (October 1997). This is an increase from 17 percent in 1993. Poverty rates outside of greater Buenos Aires are no doubt even higher: a survey of rural poverty carried out by the Bank in two provinces showed rates twice the urban levels. Income distribution is characterized by an upper decile with 44 percent of total income, while the lower three deciles receive approximately II percent of total income. (Income figures, however, exclude the impact of many social programs that deliver services free or below cost.) 33. Argentina has an extensive system of public social programs, including health care, housing, nutrition and education that are often available without charge and it has the means to make the needed investment in human capital. But there is an important agenda ahead to restore the quality social services, to instill greater equity in those services and to reduce poverty through concerted and expanded investment in human capital. Targeting of existing programs tends to be inefficient, and in some cases the majority of the benefits go to the non-poor. Access to clean water and sanitation, among other things, lags far behind. Health services, especially for the poor, are inadequate and education has lost its relevance especially for those in lower income groups. The deterioration in social services and conditions has been a long process: it is primarily the result of under investment during the protracted period of economic and political instability and the failure of the state to fulfill its mandate especially in terms of the inequalities in public spending that have persisted for many decades. 34. Addressing these issues, the government has moved ahead on reforms in the social sectors and there have been a number of dramatic changes. Social spending has increased considerably from the lows in the mid 1 980s: per capita spending is up 20 10  percent on average. Social programs now account for 78 percent of total public expenditures by the federal and provincial governments. 35. One of the important areas of reform has been the social security system. The public, pay-as-you- go system, which at the worst point of macro-crisis of the early 1 990s was badly in arrears and not adjusted to changes in cost of living, represents the largest share of this spending. A private system has been put in place; some provincial pensions have been included in the national system with the support of the Bank, while the minimum benefits for the continuing public system, albeit still relatively low compared to the cost-of-living, have been increased to $ 152 per month. Beneficiaries receive their public payments on time. Social security is now the single largest social program, accounting for 40 percent of total federal public expenditures. 36. Turning to the other major sectors-first. social safety nets--there have been significant improvement in the design and impact of these programs, especially to since the Tequila crisis. That crisis served to concentrate government attention to vulnerable groups, with Bank support under the first of a series of Social Protection loans. An information system on social programs and beneficiaries (SIEMPRO) has been put in place; impact evaluations of a several social programs (TRABAJAR, FOPAR, ASOMA, PROMINE, etc) have been completed; and a new social survey (Encuesta Social- a LSMS-type survey) has been conducted. 37. These efforts are starting to have an impact on the quality of social expenditures. The government's TRABAJAR program, which funds the wage component of local public works in high poverty areas, provides employment for about 1-2 percent of the country's labor force. Recent impact evaluations indicate that it is extremely well targeted with some 40 percent of the resources supporting the unemployed from the bottom 5 percent of the income distribution. The Bank has supported the TRABAJAR program with three loans (the most recent was approved in June 1998). 38. In addition, more social programs are being done in a participatory manner, involving local communities. The FOPAR program, which finances basic health, water supply and other social projects responding to local initiatives, shows a very high level of community ownership and satisfaction. Some 95 percent of FOPAR's beneficiaries are below the poverty line. The Bank has supported FOPAR with two loans (the most recent in October 1998). There are several other important targeted social programs, such as ASOMA, a nutrition program for the elderly, PRANI, providing nutrition support for children, slum upgrading programs, and programs for youths and children living in the streets, which are clearly needed to protect vulnerable groups. 39. In education, there have been significant changes in the structure of the system, especially at the secondary level. Secondary schools were decentralized to the provinces in 1991. Compulsory education has increased from seven to ten years; changes to the curricula for primary and secondary education began in 1996 and the content is in the process of being modernized; a network of continuing teacher training has been put in place; standardized testing has been introduced; and administrative reforms, particularly addressing abuse of medical absences and poor control over attendance, are being 11  implemented. In order to accommodate the school population because of the extension of the mandatory years of schooling and more generally to upgrade the system and instill greater equity, the government has also helped the provinces with additional financing. Under the Pacto Federal Educativo, $ 400 million has been provided from 1995 to 1998 for secondary school expansion and, under the Plan Social Educativ'o, $ 300 million has been spent to upgrade schools and to provide texts and other pedagogical resources in deprived areas. 40. At the same time as these system-wide reforms are taking effect, additional compensatory programs to retain students from low-income families and to provide remedial support have been started in disadvantaged areas. Only 50 percent of youthls from poor households are enrolled in secondary schools and the graduation rate for secondary students is very low, at about 33 percent. as compared to 80 percent in OECD countries. This high drop-out rate is of particular concern. Among the programs in place to address these problems, a IDB-funded program, Prograina Ncicional de Becas Estudiantiles, of direct subsidies of $ 600 per year to poor families with students attending schools seems to be having the desired effect of keeping these students in school. A pilot program of full-day classes, patterned after Chile's experience, is also being implemented, with Bank support. in the Province of Buenos Aires in order to offset the learning disadvantages that students from poor families encounter. 41. The results of these efforts are starting to bear fruit: recent evaluation of student achievement at the primary level show that attainment among students in the poorest provinces has increased even though their overall achievement still trails that of students in wealthier provinces. Still. Argentina is working against the clock. In particular, investment in the educational system has been historically low since the 1 980s. A the same time, the demand for skilled workers continues to rise and average education attainment levels are low, especially in public schools. Unemployment among workers with tertiary education is thirty percent less than the level for workers with only secondary education while the differential in unemployment rates between those with less than secondary education and completed secondary education is very little indicating, among other things. the poor quality and relevance of secondary education and the high expectations of the market place. A recent review by the Bank of the status of education in Argentina is presently being shared with local authorities with the goal of both taking stock of where we are and to highlight the challenges ahead. 42. In the health sector, there have also been major changes. While total health care expenditures have long been high, some seven to ten percent of GDP, the results as measured in terms of indicators or public satisfaction with quality of care do not match the level of spending. Since the early 1 990s, the government has been implementing a series of sweeping and promising reforms to improve the efficiency of the health financing and delivery systems. In the area of health financing, the main reform has been to liberalize the market for health insurance among workers who contribute to the mandatory union-run health system. This reform, supported by the Bank, allows choice for workers, thereby creating competition among the union-run health plans. The reform also mandates a minimum health care package that must be provided; thus guaranteeing workers a specific level of service from their health plan. Finally the reform improved 12  the system of off-setting automatic subsidies in the case of poor workers whose contributions are not sufficient to finance the minimum package. At the same time, this was intended to curb the use of these funds to finance the operating deficits and compensate for poor management by the health plans, as happened in the past. A series of regulations are being adopted to ensure portability of service, quality of service, and minimum prudential and financial standards for the union-run insurance system. These union plans themselves have been the object of restructuring and consolidation. So far, some 28 health plans, with 3.4 million beneficiaries (43 percent of total), have been restructured, with attendant improvements in their financial situation and quality of service. This has restored faith by the workers that they will be able to receive medical attention and by the health providers that they will get paid. A similar restructuring effort took place with PAMI, the health insurer/provider for the retired. Through cost cutting measures, PAMI has reduced costs by almost $ 1 billion per year. 43. Other reforms have focused on health care delivery in the public sector and programs for the poor. The major change has been the introduction of hospital autonomy: public hospitals, all operated at the provincial level following decentralization in the early 1 990s, are now allowed to collect and retain fees paid by insurers (whether union-run or otherwise). This has been coupled with programs, financed by the Bank, to train hospital managers. implement cost-accounting systems, license health care professionals, and ensure quality assurance and accreditation. While still young, these reforms are gradually permeating the system and more than 70 percent of the public hospitals have introduced cost-recovery. 44. The program which has had the most visible impact thus far in terms of quality of public health care especially for the poor is that for maternal and child care services. This program, launched in 1993 with Bank assistance, finances facilities and services in the poorest communities in 15 provinces. In addition to improving access and utilization among the poorest, the program has been successful in shifting health care delivery from passive, on-demand, clinical ambulatory care towards more effective, pro-active community and family interventions which focus priority on health promotion and disease prevention. In part, this explains the dramatic reduction in infant mortality from 26 deaths per 1000 births in 1990 to 19 deaths per 1000 births in 1997. 45. Against this backdrop of many good initiatives but with more time needed for results, the government intends to take actions to advance the agenda in several key areas while continuing to work on systemic institutional changes under on-going operations. The key areas are: (i) to improve the targeting of social programs for the poor, including adding to our understanding of who are poor; and (ii) to increase the equity and efficiency of existing social sector programs in education, health and nutrition. In parallel, the Bank is undertaking a Poverty Assessment (the previous poverty report was prepared in 1995) which would be used as the basis for engaging the government in a policy dialogue on further improvements to its poverty-related policies and programs. Among other things, the poverty assessment will examine access to social programs by the poor and the role of gender in the effectiveness of social programs. 13  46. Poverty Measurement. Targeting of social programs has been hindered by the absence of a national poverty line and data on poverty outside of greater Buenos Aires. Many of the survey tools used by the national statistical agency (INDEC) have not been revised for more than 25 years. Improvements are underway with support from the Bank and IDB, under the regional program to strengthen poverty related data as well as under specific social protection operations. Data on 1996 and 1997 consumption and prices (Encuesta de gastos) outside of Buenos Aires have recently become available. With these data, the government will be able to construct poverty line for six regions and, in conjunction with the existing household survey, provide poverty estimates for all urban areas. In addition, it will undertake an evaluation of its unsatisfied basic needs index (NBI - Necesidades Bisicas Insatisfechas), in order to improve its utility as a poverty measure. The Bank undertook a critique of the NBI, at the request of the government, and proposed several areas for improvement. The current index combines various indices of basic needs, but excludes measures of health and education. A working group has been established to agree on revised national poverty lines (for both urban and rural areas) and the revision of the components of the NBI index. This will be done as a condition of third tranche. A new Poverty Map. based on the new NBI. will be available for the targeting of social programs after the census in 2000. 47. In the meantime, more extensive use will be made of other measures of social needs and tracking of program participants. At present, SISFAM, basically a system for determining eligibility for social programs, is being used successfully in four IDB- financed social programs. The government has prepared a plan to expand the use of SISFAM and will progressively expand its use in at least six other programs according to that plan by third tranche. 48. Social Sector Expenditures. While overall social spending levels have increased significantly, there are concerns about efficiency; the potential for duplication is high among diverse agencies; and targeting is not always present, or according to an explicit criteria or systematically applied across programs. At the federal level, these targeted programs, in total about $ 2 billion per year including unemployment insurance, account for a relatively small share of total spending (in contrast to social security and universal programs in health and education) but they are important in terms of poverty reduction. Because of this, the government has undertaken a review of the beneficiary incidence of social spending, financed under the Social Protection I Loan, and plans to undertake a comprehensive review its public spending, with financing provided under the Public Investment Strengthening Loan, in 1999. The Secretariat of Social Development, with Bank support, has already contracted an external review of its programs to ensure that they are being efficiently managed. Based on that review, a time-bound action plan will be agreed to implement administrative and managerial improvements. 49. One specific area-nutrition--has been highlighted as having a high potential for improving impact and efficiency. There has been a rapid expansion and proliferation of these programs in recent years and the knowledge base on which to design these programs is weak. Under the Bank-financed Maternal and Child Health Loan, the government expects to undertake the first ever national survey of nutrition. As a first step in improving the management of these programs, the government will consolidate 14  nutrition programs under one management unit in the Secretariat of Social Development, as a condition of second tranche, and eventually consolidate all nutrition programs into a single program, targeted on the basis of beneficiary income levels and health or nutrition indicators, as a condition of third tranche. Another program which has been identified as having a high potential for improved efficiency and targeting is the government's program of non-contributory pensions which are granted at the discretion of the executive and legislative branches. The government will undertake a review of the program, as a condition of second tranche, and prepare new criteria on the allocation and eligibility of beneficiaries according to poverty criteria as a condition of third tranche. 50. At this time of crisis, it is also important to safeguard those programs which are critical for the poor. The government has identified a select number of health, education and social development programs, on the basis of their effective targeting and acknowledged quality, to be safeguarded during this time of fiscal restraint. These progams include spending on basic education, maternal and child health care, nutrition, vaccination, chagas eradication, AIDS, rural poverty and emergency employment programs (Policy Matrix, Table 1 of Annex D). The total amount dedicated to these programs will be protected from any new budget cutbacks relative to the amount spend in 1998, estimated to be at least $ 680 million. This would be verified as conditions of both second and third tranche. In parallel, as part of the provincial programs, budget reforms will be made to ensure that funds transferred to the provinces for social programs are not diverted to other purposes. 51 Education. Existing Bank and IDB loans are helping to improve the quality of education in the primary and secondary education areas-working directly with provincial governments. There is still a long way to go to improve educational quality at all levels and it will take time and cost money. At present, spending on education at 3.4 percent of GDP is lower than the average for the region and significantly below spending by OECD members. To address this, the government is committed to increase spending and has done so: as a percentage of total public spending, education's share has increased from 11 percent to 13.4 percent. However, the demand for additional resources for the system-including that needed to improve teacher incentives and to cope with demands for skilled labor-are increasingly difficult to accommodate within the public resource envelop. 52. Besides striving for continued efficiency improvements throughout the system, additional cost recovery is necessary in tertiary education. Savings should be channeled into the lower levels and to scholarships for poor students. At present, substantial resources from the education budget go to support an expensive system of higher education, which for most students is virtually free, and benefits largely the non-poor. Per student spending in universities is estimated to be 2.5 times what it was in 1980, while per student spending on primary and secondary education are below 1980 levels in real terms. Moreover, this spending is increasingly regressive: recent statistics indicate that only 10 percent of the youths from the poorest families attend university--this is down from about 21 percent in 1990-while almost 50 percent of students from the richest families attend university, up from 38 percent in 1990. The dependence on public universities remains high: while some 30 percent of student attend private primary 15  schools, only 12 percent of students attend private universities. At the same time, university students are taking longer and longer to complete their studies (the average is now more than eight years) adding to the cost of the system. 53. A serious debate on the equity of the present system, the level of public funding for universities and the role of tuition fees to recover costs has yet to take place in Argentina. A start has made with the passage of the new federal law in 1995: this law provides for quality assurance and accreditation of institutions of higher learning and allows universities to charge fees, especially for post-graduate studies. In addition, the Bank has provided financing, under the Higher Education loan, to support improvements in the quality of public university education through a competitive fund, FOMEC. However, there is a need to move more rapidly on transforming the system. The government will formulate a specific policy and strategy, as a condition of second tranche, to carry the debate forward. 54. Although the bulk of public university funding (about 85 percent) is directly allocated by the Congress. the government has begun to apply eligibility criteria to the direct funding by the Ministry of Education. Since 1997, it has been agreed that any budget increases to universities will be managed by the Ministry and allocated according to specific criteria. Besides criteria such as quality and accreditation, the government proposes that the allocation of funds under two programs (quality improvements and infrastructure) totaling $ 10 million per year in 1999 (because of budget cuts, the level of spending has been reduced from $ 50 mlillion in 1998) will be based on measures by the recipient universities to cost-recovery for post-graduate programs, provide scholarships based on merit for students from low income families, and present a consolidated budget which indicates all sources of revenues and expenses. These revised criteria will be applied to the budget for 1999 and will be verified as a condition of second tranche. Extended the recently introduced national evaluation system, the government will undertake an evaluation of all fifth year secondary students, as a condition of second tranche, and extend that evaluation for third year poli-modal students in 1998 and 1999 and record the results of the evaluation in the respective official school records, as a condition of third tranche. 55. Health. As noted above, Argentina has underway a program to reform the health insurance system. The strategy is to continue to support that process by extending it to provincial health insurance programs (for provincial government employees) and other specialized programs (e.g., the Armed Forces) later in 2000. In parallel, the strategy is to work with a few provincial governments to pilot programs to put provincial spending for the uninsured poor on a capita basis and offer more choice in services to the poor. While this strategy is being put in place, there are several refinements to the on-going reform program which would enhance its effectiveness. 56. First, efforts to improve the cost-effectiveness of the government's health program for the retired. PAMI, will be expanded by the competitive out-sourcing of health care among major private health providers. As a condition of second tranche, a reputable external consultant will have been contracted to undertake the evaluation of the bids received for the out-sourcing and, as a condition of third tranche, the related 16  contracts would have been signed. The governrment will also ensure that new regulations. designed and issued under the on-going reform program, with Bank support, will be applied consistently. The application of specific regulations will be verified as a condition of second and third tranche. In addition, the Superindency will issue norms on crisis resolution of the health plans as condition of third tranche. Finally, to add to the transparency and increase consumer awareness, the government will prepare and publicly release a report on the status of the restructured union-run health plans, as a condition of second tranche. It will carry out a survey of consumer satisfaction, as a condition of second tranche, and make the results publicly available as a condition of third tranche. 57. Unemployment Insurance and Labor Reform. A major concern in Argentina, because of the currency board arrangement, is how to enhance productivity, especially in view of the country's traditionally strong labor unions, rigidities in the labor market and existing highly centralized collective agreements. On the fiscal side, the government has taken steps to reduce non-wage labor charges and plans to continue that process as part of a new tax reform. However, as of now, there is no national consensus on the next steps on labor reform, and groups which desire to liberalize the current labor law are counterbalanced by those which seek an even more restrictive environment which would protect existing employment and further raise labor costs. A reflection of this debate is the recent adoption of a new labor law that eliminated temporary contracts, reduced the probation period for new employees, and further centralized collective bargaining at the same time as reducing severance costs for workers with little seniority, eliminating selected special regimes (e.g., taxi drivers, domestic workers), and mandating arbitration for expired collective agreements to be started in two years. While there are some positive features, the negative impact of these reforms on temporary contracts is particularly worrisome in the current economic environment. A window of opportunity exists to continue to lower severance costs, through the introduction of a new fully capitalized unemployment insurance scheme based on individual accounts. A study of such a scheme will be done by the government as a conditon of second tranche and based on that study a proposal prepared on how to enact the scheme as a condition of third tranche. Care has to be taken to ensure that the new scheme would eliminate severance payments, and lower overall labor costs and uncertainty. C. EFFICIENT FINANCIAL MARKETS 58. The financial sector has made significant progress since the beginning of the convertibility plan: institutions have adapted their policies and products to a low- inflation environment and the sector is an active participant in global financial markets. A recent review of the financial sector by the Bank (report no. 1 7864-AR, dated September 28, 1998) shows that the system is in a much better shape than at the time of the Tequila crisis and, especially in terms of supervision and regulation, standards are among the highest in the developing world. However, progress has been uneven: while the banking sector has been strengthened, development of the capital market has lagged behind. This has an important impact on the country's long term ability to increase its domestic savings rate and to reduce its dependence on foreign capital. Additional reforms are also needed to improve access to credit for small and medium scale 17  enterprises. The proposed operation provides an opportunity for the government to address some of the most pressing impediments to development of a sound and robust financial system. 59. The Banking Sector. As documented in the Bank's recent review, Argentina's banking sector has gone through a number of changes. In particular, since the Tequila crisis, there has been substantial consolidation, privatization. and increased entry by foreign institutions. The sector is in the midst of a restructuring process which saw the number of financial entities in the banking system cut by a third to about 1 10 entities at present. Based on current policy to treat foreign capital in a similar vein to domestic capital, the additional entry of solid, diversified foreign banks should strengthen the system further. 60. In assessing the systemic risks facing the sector, it is important to differentiate among banks. Relative to domestic banks, foreign ones are larger, are growing more rapidly, and have much higlher portfolio quality than domestic ones (either public or private). There is also variation in the quality of the private domestic banlks, and it is the smallest ones (but certainly not all small banks) that appear to pose the greatest risks of failure. Moreover, the weakest banks, both public and domestic private, tend to be smaller and to have lower ratios of liquid to total assets. The combination of weak portfolios and low liquidity implies that these banks are most vulnerable to exogenous shocks. The portfolio quality results are reflected in 1997 profitability figures. Concerns over the low profitability of the banking system appear to be structural, reflecting more the problematic state of public banks and small banks, with the ten largest banks having a return-to-equity of 15.3 percent in 1997. 61. There has been a fast expansion of deposits and credit which in an of itself carries risks in terms of portfolio quality and management. In 1997, Argentine deposits increased by 28 percent and credit, by 16 percent. However, this expansion has to be seen in the context of an economy that still suffers from low monetization (M2 accounts for only 25 percent of GDP) and relatively low debt-to-equity ratios in the corporate sector. The global financial crisis, moreover, has dampened that expansion and the growth of deposits has since been modest and credit expansion halted in mid-1 998. 62. Privatization of Public Banks. Efforts should continue to reduce the presence of public banks in the system, including national, provincial and municipal banks. These banks are still a significant share of total deposits and, in terms of the quality of the system, the public banks have posed the biggest problem: The main issues with such banks are the misallocation of resources associated with non-performing loans, about 22 percent of their portfolios, and the lack of fiscal discipline in the public banks' dealings with their state owners. Their portfolio quality is low regardless of size, and this could worsen after more rigorous audits. While posing a lesser systemic risk, they do pose a fiscal burden and present a high opportunity cost to the government. If a financial crisis is associated to a fiscal crisis, public banks could create a systemic risk as well. 63. So far, the federal government has taken steps, with Bank support, to cleanup a part of its banking portfolio by closing BANADE (the former development bank) and 18  putting its second-tier housing mortgage bank up for sale. The law authorizing that sale of the latter has already been passed and the prospectus ready to go; however, market conditions are not conducive to the sale, and the government expects to offer the bank once market conditions are more favorable. This would be done as a condition of second tranche, subject to market conditions. On the provincial level, fifteen public banks have been sold, with the support of the Bank, and several more are possible candidates. This process will be further facilitated by amending the terms of the agreement with the provinces to require sale of the residual (poorly performing) portfolios of the privatized provincial banks. Additional privatization would be supported as part of the proposed Provincial Reform III operation. 64. Despite advances in provincial bank privatization, there is strong public resistance to privatize the remaining federal bank, the Banco de la Naci6n, which carries symbolic importance and is seen by the agricultural sector as its only source of financing. As a result, it is unlikely that the political support for privatization can be mobilized, despite the government's willingness. The government, nevertheless, is committed to ensure that banking regulations and standards apply equally to both public and private banks and will review its supervisory practices accordingly as a condition of second tranche, and present a plan of action by third tranche. The Central Bank is currently completing a comprehensive public audit of Banco de Ia Naci6n, that will provide a clearer picture of its financial health. That audit is expected to be completed in late 1999. Also as a condition of second tranche, the government will further issue a public document detailing all of the explicit and implicit guarantees that it maintains in support of the Banco de la Naci6n. 65. Small Business Access to Credit. Another major weakness in the financial sector relates to the access to credit by small and medium scale enterprises (SME). The 1990s have provided significant advances in availability of competitively priced credit for large corporations, including access to foreign capital markets. However, the middle market firms and small businesses have yet to fully benefit from liberalization of the financial sector. Factors responsible for consistently high interest rates and limited availability of credit for SMEs include a weak credit culture and legal and institutional constraints. 66. Secured Transactions. One of the most important barriers to the development of new credit instruments for SMEs is the inadequate legal protection provided to lenders, especially with regard to secured transactions. The current legal framework restricts the use of many types of goods as collateral, has high costs for verifying title and registering collateral and is difficult and costly to enforce. A modified law for secured transactions, based on the type of legal framework employed in common law countries, has been developed by the Central Bank. The new law would establish a clear legal foundation for lending to SMEs on the basis of equipment purchases, inventories, accounts receivable and letters of credit, which is now almost nonexistent in Argentina. It is the government's intention to submit this law to Congress as a condition of second tranche. 67. Leasing. Small businesses in Argentina also lack access to non-bank sources of finance which may offer more flexible terms than traditional loan contracts. One of the most important of these alternatives is equipment leasing. In 1997, equipment leases 19  worth approximately $250 million were written but, given the size of the economy, this is only a fraction of potential demand. Both the legal and tax treatment of leasing have restricted the industry's growth. The 1995 law, which provides the legal foundation for leasing, poses several problems, including a restrictive definition on goods which can be leased, limits on who can extend leases and excessive regulation of leasing contract terms and conditions. The government has drafted a revised leasing law which will be submitted to Congress as a condition of second tranche. 68. Improving the Regulatory Framework. The Central Bank has introduced a very sound framework of prudential regulations, some of them novel, aimed primarily at the systemic risks facing the banking system. An international comparison of regulation of various banking systems in Latin America and East Asia by using extended CAMEL standards shows that Singapore, Argentina, and Hong Kong stand out as having the strongest banking regulations. Across virtually all categories, Argentina dominates the East Asian countries that have been beset by financial crises. Thus, whereas no banking system is ever immune to sufficiently large shocks, the Argentine regulatory system appears to be among the most robust, as it needs to be, given the constraint on official intervention inherent under the convertibility plan. 69. As a key part of the process of improving the framework for sound banking, the Argentine financial authorities made a number of regulatory changes aimed at making the banking system more resilient to shocks. The principal reforms adopted by the government were: * the increase in the minimum capital ratio to 11.5 percent of risk weighted assets, to discourage excessive risk-taking; e a boost in liquidity requirements, to 20 percent of (most) bank liabilities as of February, 1998, from 15 percent two years earlier. These requirements now can be held in a variety of forms. Thus, although high liquidity requirements normally constitute a burden, these are remunerated and flexible; * enhanced disclosure on borrowers. Information is collected and distributed through two Central Bank facilities - the Central de Riesgo (which tracks large corporate entities) and the Central de Informaci6n Crediticia (which provides information on loans of greater than $50 to individuals and small firms); * the subordinated debt requirement, which creates a class of bank debt holders with the incentive to monitor bank performance; and * a contingent repurchase (repo) facility, which gives the Central Bank the option to sell dollar-denominated bonds to banks subject a buy-back clause. 70. Mechanisms for bank failure resolution are constrained by institutional and legal impediments. To facilitate the creation of a more effective early intervention infrastructure, there will be a review and presentation of a plan of action under this loan of such processes, including relations between the Superintendency of Banks, the Central 20  Bank, and the deposit insurance fund (SEDESA). Such action will be complemented by presentation of draft legislation protecting from personal liability financial sector supervisors and regulators for good faith actions taken in the performance of their official duties, a legal impediment which creates moral hazards in current bank failure resolution efforts. Furthermore, authorities will review regulatory guidelines for proper bank governance, affecting owners, management, and outside directors, and present a plan of action to strengthen corporate disclosure and governance. 71. The Repurchase Facility. The last item above is one of the most novel features of the changes since 1995 in creating confidence in Argentina's banking system. To guard against a repeat of the Tequila crisis, when domestic banks lost some 18 percent of their deposit base and credit to all but the best borrowers was severely curtailed, the Central Bank (Banco Central de la RepzTblica Argentina-BCRA) has created a new line of defense for the financial system. Such defense creates a needed cushion to the system, first by preventing a shock to the system by maintaining confidence and reducing the probability of a run, and secondly, in the event of an actual liquidity shock, by reducing the impact on banks' balance sheets. The Central Bank's repo facility acts as the last line of defense in dealing with such liquidity shocks. 72. The repo facility allows the BCRA to engage in repurchase transactions with a syndicate of private commercial banks. It has the option of selling dollar-denominated government bonds to the participating banks, with an agreement to buy them back in two to five years, depending on the terms agreed with the individual banks (with an embedded implicit interest rate). Thus, the facility permits the BCRA to engage in discount lending effectively without "creating money" and allows the BCRA to act as a lender of last resort without violating its commitment to maintain a 100 percent dollar reserve against liabilities. These options may be exercised at any time by the Central Bank, except if Argentina defaults on an international debt commitment. In case the facility is called, Argentina will have to post collateral in bonds exceeding by 25 percent the amount of credit provided by the international banks. Also, in case the international price of the bonds held as collateral drops by more than 5 percent, the Central Bank will have to meet margin calls. Repos are thus over-collateralized by 20 percent to prevent the banks from bearing the risk of loss from depreciation of the underlying securities during the period they hold those instruments. The intent is to move down the liquidity and risk continuum from pure government debt to low-risk private debt. 73. As of June 1998, repo contracts were written on bonds for $6.2 billion with 13 banks. The target is to maintain the repo facility equal to approximately 10 percent of the deposit base of the banking system. The duration of the option contracts - that is the period over which the strike price has been locked in - varies from 2 to 5 years, depending on the issuing bank. The contracts bind both sides over their duration. Extensions to the agreements (beyond the contracted durations) can be negotiated every three months. The BCRA's strategy is to maintain a window of option for a minimum of two years. 74. The facility effectively permits the BCRA to borrow at an average of LIBOR plus 2 percent but the individual commercial bank contracts are not priced identically. Rather 21  than determine a single price at auction, the BCRA ranked contracts by price and awarded them until it had reached a price that it was unwilling to pay. The Central Bank is likely to exercise its options (if ever) on a pro-rata basis for all the options, rather than to exercise on a progressive cost basis (using the cheapest ones first). 75. In the event of a liquidity crisis, the Central Bank would transfer the funds received by exercising the facility to domestic banks facing a liquidity crisis, these banks in turn would presumably use the funds to pay deposit withdrawals. Banks would transfer the underlying securities involved in the repo to the BCRA as collateral for the loans offered by the BCRA to the banks, and the funds lent by the BCRA would be the funds received by the BCRA from the exercise of its options. 76. In this time of increased market uncertainty and volatility, it is important that the facility be enhanced specially since Argentina has a weak lender of last resort. First, the size of the facility must keep pace with the size of the deposit base (the target is about 10 percent of deposits). The Central Bank is actively engaged in discussions with private banks in order to maintain that level, and believes that Bank support is essential in maintaining the attractiveness of the facility. One of the ways of doing this is to ensure that there are adequate resources to respect the margin requirements. There are two risks associated with those requirements: first, that the value of the bonds falls beyond five percent; and second, that sufficient bonds or cash would be available for BCRA to make up the lose in value. To address this latter risk, the government has requested special support from the World Bank and the IDB. 77. Capital Markets. The Argentine capital markets have developed significantly in recent years but are still less developed than the banking system. Despite the difference in the speed of development, they form an integral part of the Argentine financial system. particularly since financial holding companies provide both investment and banking services. While the development of the capital markets has been slow, the future prospects for capital markets growth are excellent, particularly in view of the emergence of institutional investors. Since 1994, the emergence of such investors has been spearheaded by the new capitalized private pension fund system, and more recently by the increased participation of mutual funds. 78. Insurance. The insurance sector began to modernize in the early 1 990s which resulted in the closure of the state reinsurance company (INDER), privatization of the Ca/a de Ahorros y Seguros (the largest insurance company) and substitution of premium and product controls with solvency monitoring. Despite these advances, the industry remains one of the weaker segments of the market. Entry of new firms of the insurance industry has been prohibited for the past two decades. Although existing firms could be sold to new investors, the restriction served to reduce competition and encourage the continued operation of more than 250 companies. Many of these firms are no more than brokers, selling assets to re-insurers, but the fragmentation of the market has contributed to high operating and marketing costs and poor customer service as measured by low loss ratios (ratio of claims settled to net premiums). In 1997, the industry reported losses of 15 percent on book value. The lack of development of the sector is also evident in the 22  continued dominance of automobile insurance (41 percent of the total insurance market) and low penetration of life insurance (7 percent of the total). 79. The government has taken steps to strengthen the insurance market. It let the prohibition on entry expire in October 1998. Another measure is that it has gradually increased the minimum capital requirement for existing firms from $550,000 to $3 million beginning September 30, 1998. The government is committed to prepare an action plan as condition of second tranche and put in place a satisfactory system of enforcement of these new capital requirements as a condition of third tranche. These measures will force weak institutions out of the market and encourage consolidations. The transition to a more competitive, open market also requires modernizing the legal framework for insurance. The government also intends to replace the existing legal framework which reflects a market structure based on a state re-insurer and provide virtually no treatment of life and annuity products. 80. The supervision of insurance firms is being strengthened to ensure that regulators have access to timely and accurate information and the capability to enforce prudential requirements. The government has adopted a "fit and proper" standard for managers and owners and enacted new regulations on reserve management to limit risky investments. The tax on insurance premiums, which represented an excessive tax on the business, is being gradually reduced from 8.5 percent to 0.1 percent by July 2002. A review of the legal framework for insurance and an initial consultancy to strengthen the Superintendency of Insurance (SSN) have also been undertaken by the government, financed with Bank assistance under the Capital Markets TA loan. The government will submit to Congress a draft law which improves the legal framework for the industry, including the solvency monitoring of insurance companies, separating insurance businesses from other business units, adopting an early warning/detection system, strengthening the process of resolving insurance companies, and establishing protection of insurance consumers, as a condition of third tranche. 81. Mutual Funds and Securities. The mutual fund industry has grown very rapidly in Argentina since the Tequila crisis. The industry reported total assets of $ 5.4 billion at the end of 1997, distributed between approximately 200 funds, up from only $ 300 million in assets in 1994. However, the Law for Mutual Funds restricted fund investments outside the country to 25 percent of the total. Even though the local securities commission, CNV, interpreted this restriction more broadly, including any Mercosur member nation as a domestic investment, restriction on investments in foreign markets reduces diversification and tends to increase volatility. It also limits the product choices of potential investors and thereby weakens the industry. To address this problem, the government will submit to Congress a modified law which removes the geographic restriction on mutual fund investments as a condition of second tranche. 82. Excessive reliance on rating agencies is another factor which is increasing the cost of equity finance. All bonds and short-term commercial paper must be rated by two agencies before being emitted. This creates a captive market for the rating agencies and significantly adds to the cost of accessing the capital markets. Securities must also be rated if they are to be purchased directly by the pension funds. Since the rating 23  requirement specifies that the rating agencies must operate in Argentina to be considered valid, this requirement forces firms which are listed in foreign exchanges and rated by international agencies to obtain additional ratings in Argentina. The government will undertake a review of these regulations, as a condition of second tranche, and prepare an action plan to reform the rating industry, taking into account the conclusions of that review as a condition of third tranche. Satisfactory progress in implementing that plan is also expected as a condition of third tranche, including if necessary passage of resolutions by the relevant regulatory bodies such as CNV and the Central Bank. 83. Harmonizing Taxes in the Financial Sector. There are numerous inconsistencies and contradictions in the tax structure which discriminates between financial service providers and instruments in Argentina. Two examples are the leasing industry and insurance. In the case of leasing, the differential impact of the value-added tax (IVA) on banks and specialized leasing companies is reported to create an advantage of 200 basis points for the former. The tax disincentive for leasing has discouraged foreign investment, including IFC participation. and has reduced the growth of dedicated firms. In the case of the insurance industry, taxes on premiums are very high, reducing the competitiveness of insurance products. Although the federal tax on premiums are being reduced (see para. 80), there are still municipal taxes of 0.5-1.0 percent on premiums. 84. In general, the tax system should strive for neutrality, so that market forces are driving the financial market and not tax rules. A comprehensive study, according to terms of reference which have already been agreed, will be undertaken by the government as a condition of second tranche. By release of the third tranche, the government will have submitted to Congress proposed amendments in order to introduce greater neutrality. 85. Regulatory Coordination. The coordination of regulations and supervision of financial intermediaries also needs to be strengthened. Increasingly, financial intermediaries are involved in several lines of business supervised by separate regulatory agencies: the Central Bank; the National Securities Commission (CNV); the Superintendent of Insurance (SSN); the Superintendent of Pension Funds (SAFJP); and the Superintendent of Worker's Compensation (SART). Most banks also have securities operations and the largest financial conglomerates combine banking, insurance, pension funds and securities dealings. Such conglomerates complicate the task of supervisors by providing opportunities for shifting risks between firms in the group. Holding companies also make it more difficult to detect violations of regulations, such as prohibitions on insider trading and connected lending. In fact, local law does not define what constitutes a common economic group, although the Central Bank has established criteria designed to restrict connected lending. Conglomerates also facilitate regulatory arbitrage by concentrating activities where regulation is weakest or supervision most relaxed. 86. The financial sector regulatory bodies need to begin to develop protocols for managing financial conglomerates. A first step is to develop mechanisms to share information and establish regular meetings to discuss general problems or issues concerning specific institutions. Another key step is to provide greater protection to financial regulators from legal action related to the good-faith discharge of their official 24  duties. This has proven to be a major impediment in the timely resolution of banking failures, for example, and puts regulatory staff at personal risk. The government will therefore present to Congress a draft law which provides such protection, as a condition of third tranche. D. ENHANCED REGULATORY ENVIRONMENT 87. In both developed and developing countries, there is overwhelming evidence of significant potential gains from effective regulatory reform. Such reforms are designed to eliminate barriers to economic activity and reduce administrative procedures and costs, while regulate natural monopolies, and ensure effective competition in markets while protecting consumer rights from a health, safety and environment point of view. 88. Argentina has implemented one of the world's most ambitious and successful structural reform in these areas. As part of its overall reform program, it has introduced effective competition in the domestic market by opening up its trade regime, removing barriers to foreign investment, liberalizing domestic goods and capital markets and broadly deregulating the economy. In addition, Argentina has also been one of the forerunners in introducing competition in infrastructure services through sector reforms and introduction of private participation through divestment and concession contracts. Since 1989, private participation has been invited in virtually all major infrastructure sectors - telecommunications, electricitv, gas, ports, railroads, toll roads, airports and water. Within the overall objectives of competition, promotion of entry and efficiency, state monopolies have been unbundled and privatized, sectors restructured and regulatory framework have been introduced in most sub-sectors. 89. Argentina's achievements have been impressive in electricity, gas, transport and telecommunications. In electricity, the sector was divided between generation, transmission and distribution, and 25 new business units were created to introduce competition. The competitive segments of generation and production were opened to entry without detailed regulatory scrutiny, while transmission and distribution are regulated under a price-cap regime. The restructured electricity and gas industries now have non-discriminatory access to their transmission networks. In telecommunications, the sector was privatized, and two regional monopolies were created with initial exclusivity for the provision of basic services; this arrangement is now set to expire in 1999. Value added and cellular services were immediately opened to competitive entry. A decree has been issued to phase in full liberalization of the telecom sector, and a new law is being prepared to embody those measures. 90. In the transport sector, Argentina has entered into concessions in virtually all sub-sectors -- railways, ports, toll roads and airports. Port restructuring and privatization fostered competition both between ports and within ports. In the port of Buenos Aires, for example, all terminals compete for cargo movement and handling. Key port activities were further liberalized. In the railroad sector, the freight network was partitioned into 25  six sub-networks which were then concessioned. Both in passenger and freight services, the state remains the owner of the fixed facilities, including track, stations and the rolling stock. In the water sector, Argentina was a pioneer with the concessioning of the Buenos Aires water services company and followed by several other municipal water services. 91. Rationalization of the Regulatory System. Given that virtually all infrastructure services in Argentina are provided by private providers, the need for an effective regulatory framework is key to promoting efficiency. Although Argentina set up regulatory entities in all infrastructure sectors when private participation was introduced. the overall performance of these regulatory institutions has been mixed. The system has evolved piecemeal and in a fragmented fashion; it lacks consistency in the agency structures, administrative procedures and economic and technical criteria. Additionally, as most of the regulatory entities have been created by decree rather than law, the gas and electricity regulatory agencies being the exception, the system lacks stability because the agency structure, the tenure of the regulators and their administrative procedures can be changed by decree. Not unexpectedly, the gas and electricity agencies, which have been created by law, have shown better performance than some of the others. 92. A corollary issue is the lack of autonomy of the regulatory agencies from the executive branch. Under their legal framework, they are subject to oversight by the executive branch and to an automatic executive review of their decisions in case of an appeal. Regulators perceive this automatic review, combined with their own insecurity of tenure, as limiting their operation. As a further symbol of the lack of independence of the regulatory agencies, though their financing sources are often specified in the concession contracts, their actual operating budgets are often subject to decisions by the executive branch. On the other side of the coin, the regulatory agencies are not accountable for their performance and there is a general perception that, in most sectors, they have not been adequately pro-active in monitoring compliance with contractual obligations and sector performance. Thus far, there has been little review of the effectiveness or appropriateness of regulatory procedures or the impact of their decisions. 93. The government is committed to rationalizing its regulatory entities. It will submit a draft law to Congress, as a condition of third tranche, to harmonize administrative procedures, economic and technical approaches followed by utilities, rights and process of non-binding consultation with consumers, process of appealing regulatory decisions and public disclosure of information, including requirements for annual review of operational procedures and impact of regulatory decisions to be undertaken by independent firms. The same draft law (or equivalent legal instrument) will include a provision allowing the executive branch to forego its right to hear appeals if such appeals are based on technical and analytical decisions. In addition, the government will prepare an action plan , as a condition of third tranche, to address the issues of independence of regulators and financial resources. 94. Regulation of The Transport Sector. One of the most noticeable areas of fragmented regulation is in transport. The different sub-sectors that move freight cargo, such as roads, ports, railroads, are under different regulators, whose approaches and policies differ and do not always work to promote efficient multi-modal transportation. 26  The government, based on an agreement to be reached with the Bank on the overall structure as a condition of second tranche, will determine the general structure and responsibilities of a new regulatory agency or agencies, as a condition of third tranche. E. QUALITY PUBLIC ADMINISTRATION AND FISCAL STRENGTHENING 95. The process of reforming the state is far from complete. Argentina is a federal country, with a complex set of fiscal relations and strongly entrenched provincial rights and responsibilities over natural resources, among other things. Provincial responsibilities, moreover, have increased, relative to the federal government, as the result of decentralization, especially in health and education. Provinces now account for almost half of public expenditures and face their own problems of public administration, fiscal equity and governance which are being addressed in parallel through a series of provincial development and reforms loans and monitoring through non-lending services. At the same time, the role of the federal government, particularly in infrastructure as noted above, has dramatically been altered as a result of privatization and deregulation. This transition to an economy dominated by private, rather than public, decisions has placed higher demands on the quality of the public service. According to various cross- country indicators, levels of institutional performance and integrity, while they are improving, are perceived to be low. 96. The issue of fiscal equity is the critical feature of Argentina's reform program. On the side of expenditures, the government remains firm in its efforts to control public spending, especially at this time of uncertainty (see para. 18). On the other side of the equation, revenues, Argentina has successfully eliminated many distortionary taxes and reduced its reliance on tax handles. A major achievement was the reduction of export tariffs and duties on imports, which for years had been a main source of public revenue. A value-added-tax (IVA) was implemented and efforts are underway to generalize that tax. Changes to tax administration, with the support of the Bank and IDB, have helped to build the tax authority's capacity. Still, there are serious problems: VAT charges, at 21 percent, are high and tax evasion persists, with only about 50 percent of possible taxes actually collected; the courts are ill-equipped to handle tax fraud and evasion cases; and consumption and asset taxes account for a disproportionately large share of total revenues as compared to taxes on corporate profit and earned income. As noted earlier (see paras. 57 and 83), there are specific problems in the area of non-wage labor taxes and harmonization taxes in the financial sector, among other areas. Reforms addressing reducing evasion, extending the value-added tax, and increasing profit and income taxes are underway or contemplated under the government's letter of intent with the Fund. 97. Reform of intergovernmental fiscal relations. Argentina's federalism is grounded in the sharing of fiscal revenues. Total transfers to the provinces were $18.2 billion in 1997, just under 6 percent of GDP, and financing about 56 percent of total provincial government expenditures. The current system of "coparticipation" is a complex mix of one large revenue-sharing pool (generating $11.5 billion or 41 percent of provincial current revenues in 1997) and a series of tax-sharing programs. The distribution of the general revenue-sharing fund is according to percentages that were fixed in place by a 27  1988 law while many of the specific programs, although distributed automatically, are earmarked legally for uses such as housing or home mortgages (FONAVI -- $900 million) or providing electricity service to remote rural areas (FEDEI). There are a number of discretionary transfers (ATNs -- $538 million) as well as some specific social sector assistance programs and investment programs. Some of these programs follow fairly reasonable need-based criteria while others do not. 98. The final result is a large diversity in the level of shared revenues per capita-a five-fold difference in revenues per capita for the highest and lowest provinces. This dispersion is difficult to justify in terms of needs and/or cost differentials. Changes to the system, however, have been hard to realize even though there is wide-spread awareness of its inadequacy. The 1994 Constitutional Reform called on Congress to enact a new coparticipation law by the end of 1996. Congress later extended this deadline by two years, and this deadline will probably have to be extended again. 99. A consensus view has emerged from a series of Bank analytical reports, academic papers, and recent government proposals for reform. The three problems to be addressed by any reform of intergovernmental fiscal relations are: (1) simplify the complicated tax- sharing/revenue-sharing system, consolidating programs into one fund, to improve transparency; (2) introduce a rational formula-almost any rational formula-for distributing resources across provinces; and (3) increase the degree of correspondence between the provincial tax payer and the provincial services he/she receives. The latter would involve some form of decentralization of tax powers, either through more provincially administered taxes or provincial surcharges on federally collected taxes. 100. The government has advanced in its technical proposal for reform based on principles agreed with the Bank. The proposal includes: (I) putting all federally collected taxes into a single revenue-sharing pool, including payroll contributions for the social security system (with the minor exceptions of trade taxes and a few specialized charges); (2) separating out sector programs and eliminate their automatic financing, making them discretionary line items in the federal budget, in order to give more flexibility to the federal budget; and (3) distributing funds on the basis of a formula which includes a "derivation/devolution" component plus compensation for poor provinces, and smooths the application to the new system (for those provinces with smaller shares in the future). 101. The government expects to be ready in several months with the details of its proposal, which will be reviewed with the Bank as a condition of second tranche, and to initiate a serious round of discussions with the provincial governments. The success of these negotiations are predicated on guaranteeing that no province will lose in terms of revenues on the short run. As a first step, therefore, the government will have to agree with each of the provinces on the baseline figure. Based on past experience-in 1988 when the last revision to the system was made-negotiations will be difficult and there is no guarantee of successful buy-in by the provinces. As a condition of third tranche, the government will have presented its proposal to all of the provinces and carried out a meeting of all provinces to adopt the proposal. 28  102. Provincial Tax Reform. An additional, long-standing problem in Argentina has been the search for a substitute for the distortionary provincial gross receipts (turnover) tax. This tax is multi-stage sales tax that accumulates across the stages of production, since, unlike the value-added tax, there is no crediting for tax paid on the purchase of inputs. Several years ago, as part of the federal fiscal pact, the provinces agreed to begin to grant exemptions to primary stages of production on this tax, as part of a process of eventually reaching a provincial retail sales tax. The final form of the retail sales tax never emerged, and this area of tax reform has been stalled for the last two years. 103. Progress has been made, with Bank technical assistance, in exploring the possibility of a provincial VAT surcharge as a substitute for the gross receipts tax. This provincial VAT also could be used as an instrument for further tax decentralization whereby the federal government would make tax room by reducing its VAT rate and allowing the provinces to increase their rate (if they wish) in exchange for reduced shares of coparticipation. The longer-term objective is to establish fiscally strong provinces - provinces with the capacity to raise a high share of their revenues on their own and set their own tax rates. At the same time, the system of intergovernmental relations would assure that transfers compensate provinces with less innate capacity to raise revenues due to poorer tax bases. Any new provincial tax instruments must be designed so as to avoid distortions in the location of economic activity and avoid the possibility of a province's residents "exporting" their tax burden to residents of other jurisdictions. The government is committed to completing the preparation of the detailed proposals, to be reviewed with the Bank as a condition of second tranche, on the elimination of the gross receipts tax and on tax decentralization and engaging the provincial governments on their adoption and to make satisfactory progress in reaching agreement with the provinces, as a condition of third tranche. 104. Governance and Public Ethics. The first generation of reforms already taken in Argentina have drastically changed the role and responsibilities of the state. Among the most important achievements was the privatization of major part of the economy. Not only did this open new opportunities for investment, productivity improvement and the infusion of new technology and management, privatization has basically eliminated the potential for unethical and corrupt dealings by public officials in these enterprises. The other change has been the deregulation of the economy. With the elimination of controls over imports, foreign currency and many other areas of economic activity, the scope for unethical behavior by government officials has been severely curtailed. In addition, internal control and external auditing agencies have been restructured, with the support of the Bank, and there is generally much more information on government programs made available to the public, especially with the use of Internet. 105. Despite these reforms, more needs to be done to restore confidence in public agencies and to promote integrity as a positive attribute of the public administration. In a series of actions since the 1994 constitutional amendment, culminating in the creation of the National Office of Public Ethics, the government has declared its intention to fight corruption. Integrity actions such as the establishment of an ethic office, however, can be ineffective if they are not set in the context of broader public sector reform and improvements to the judicial system. To that end, the government has asked the Bank's 29  support to build the capacity of the National Public Ethics Office, with an Institutional Development Grant, and to modernize the judicial system. A Model Court Development loan (LIL) has already been approved and further support for the judicial system is under preparation. In addition, the Bank and government have agreed to undertake jointly a study on governance and integrity in Argentina and develop a common strategy. 30  4. THE PROPOSED LOANS 106. The proposed special assistance to Argentina will help to preserve the achievements of the reforms undertaken by President Menem's administration since 1989. It complements the preventive measures already taken by the government over the past year to ward off the contagion effects of the East Asian crisis. Most importantly. the. proposed support helps to carry the government's reform agenda forward to a next stage by supporting measures to improve social protection and the quality of social services, strengthen the financial sector, improve effectiveness of the regulatory framework and restructure and refocus federal-provincial fiscal relations. Underlying all of these measures is the need for Argentina to incorporate equity and poverty considerations into a consistent set of public policies and programs. A. RATIONALE AND OBJECTIVES 107. The Bank's special structural adjustment support aims to help Argentina to reduce its vulnerability to external financial shocks at the same time as increasing its capacity for sustainable and equitable growth. Specifically, the proposed operations are intended to: (i) facilitate the reentry of Argentina to the international capital markets and avoid the great social and economic costs, as experienced during the Tequila crisis, associated with the alternative of drastically contracting expenditures and depleting reserves in order to meet the country's financial commitments while countries, such as Argentina, are shut out from the international capital market; (ii) protect vulnerable groups during this present period of high uncertainty; (iii) add to the lines of defense of the banking system in order to deter and, if need be, withstand liquidity shocks; and (iv) continue Argentina's successful reform program, particularl) with a focus on the long-term issues of savings and capital market development, efficiency in the financial sector, and public policies with respect to regulation, tax and fiscal equity, the efficiency of social spending and quality investment in human capital. 108. The proposed support for Argentina meets the criteria set out for special structural adjustment lending (see R98-249, dated October 2, 1998). First, in terms of the structural dimensions, Argentina still has a high dependence on external financing which has come into relief now that the international capital markets suddenly have closed to emerging markets. Argentina's reliance on external financing is historic and the result of decades of high inflation--and bouts of hyper-inflation-- which have eroded confidence in financial institutions and demonetized the economy. With macro-stability achieved, that confidence is being restored; however, M2 still only accounts for 25 percent of GDP and capital market development has lagged. In addition, for decades, the predominant model of economic development was a closed and protected one based on import-substitution. The economy has since been liberalized and protection lowered. Discriminatory taxes on 31  exports have been removed and exports have been growing rapidly, from 6.3 percent in 1993 to 9 percent of GDP in 1997. Nevertheless, exports remain a small percentage of the total economy. In addition, the public sector has not yet been able to sustain a fiscal surplus and continued efforts are needed to increase public savings. But, not only is it important to increase public savings, adjustments to public spending and the distribution of public resources must be done in such a way as to promote social equity, quality and efficiency. This is particularly true in the area of social services where much still needs to be done. Finally, reducing the country's vulnerability is critically dependent on improving productivity and efficiency especially in the key infrastructure services that contribute to export expansion. Now that these services have been privatized, sound regulatory performance is critical. 109. To address structural challenges facing Argentina, these loans incorporate the following: (a) measures to reduce poverty and unemployment, both by protecting key social safety net programs, and advancing reforms in health and education; (b) provinces are key actors in the provision of social services, and this loan promotes the rationalization of intergovernmental fiscal relations, as well as provincial tax reform; (c) further reforms in the regulatory area are recommended, following massive privatization of public enterprises in transportation, electricity, telecommunications, and in the financial sector; (d) strengthening the banking sector, improving access of small and medium enterprises to credit, and deepening the capital markets are priorities, particularly in view of the country's variable access to international credit, and the self imposed discipline of the convertibility law; and (e) support of the repo facility is a key instrument for reducing Argentina's vulnerability to external shocks. 110. Argentina also satisfies the second main criteria for special structural adjustment support, a strong policy program, as demonstrated by its track record and its intended reform measures. Argentina achieved macro-stability with the introduction of the convertibility plan in 1991 and since then has maintained a sound macro-economic framework. Moreover, its current record in satisfying the conditions of Bank adjustment loans has been excellent. The Bank has extended US$ 3.8 billion in nine such operations since 1990.3 Completed adjustment operations-- Public Sector Reform Loan (PSRL, Ln. 3394-AR), Public Enterprise Reform I and II (Loans 3291-AR and 6012-AR), the Financial Sector Adjustment Loan (In. 3558-AR), the Provincial Pension Reform Loan (Ln. 4116-AR) and the Provincial Reform Loan I (Ln. 3836-AR)--met all major objectives in a timely manner. The Provincial Bank Privatization Loan (Ln. 3878-AR) and the Banking Sector Reform Loan (Ln. 3926-AR) are both fully disbursed (completion report pending). The Second Provincial Reform Loans (Loans 4218, 4219, 4220, 4221-AR) and Health Insurance I Loans (Ln.4002/4003-AR) are still under implementation and are being implemented satisfactorily. In addition, the proposed program, as set out in the government's letter of development policy, provides the content of the continuing reform program and specifies the measures that the government intends to take to address some of the remaining key structural issues. 3 Not including a free-standing FY93 Debt and Debt Service Reduction Loan, Ln. 3556-AR. 32  111. The other criteria are met. The proposed program is part of a concerted international support package which includes the Inter-American Development Bank as well as the International Monetary Fund. All three institutions have made available similar amounts of financing. Additional financing may be forthcoming from bilateral sources. An important feature of the overall program is the support from the private sector through the Central Bank's Repurchase Facility. This facility provides $ 6.7 billion in private financing from the international banks to support Argentina's banking system in the event of a liquidity crisis. In terms of the country 's external financing plan, that plan is sustainable over the medium term, as Argentina's external public debt amounts to only 30 percent of GDP, with short term debt alone to only I percent of GDP and debt service within acceptable limits. The proposed support from the Bank for Argentina, an IBRD eligible borrower, also falls within creditworthiness and exposure limits. It is evident, however, that a worsening of the global financial crisis facing emerging markets and a further protraction in the reopening of capital markets - beyond what is presently anticipated-would call for a reassessment of Argentina's financing plan and the contribution of multilateral institutions, particularly the IMF. 112. At the end of FY98, IBRD debt outstanding and disbursed to Argentina amounted to $5.5 billion, equivalent to 5.1 percent of total IBRD debt outstanding and disbursed. In FY99, net disbursements are projected to total $2.4 billion, bringing IBRD's total debt outstanding and disbursed to Argentina up to $7.9 billion or 6.5 percent of total IBRD debt outstanding and disbursed. These aggregates reflect planned commitments of $3.4 billion, including $3 billion of adjustment lending, and gross disbursements of $2.8 billion, including $2.5 billion in adjustment lending. The net disbursements exceed the ranges envisaged in the March 17, 1998 CAS Progress Report by roughly $2 billion for FY99 and $1.6 billion for FY00. Based on current projections, net disbursements to Argentina in FY99 will account for around 20 percent of total IBRD net disbursements, which are now projected at close to $13 billion. This high share of net disbursements to Argentina in total net disbursements reflects the large volume of planned adjustment lending. Commitments to Argentina for FY99 are projected to account for around 10 percent of total IBRD commitments, which are currently projected at $32 billion. These amounts are consistent with IBRD's aggregate financial capacity.4 B. TERMS AND CONDITIONS 113. Loan Amounts. The SSAL would be a three-tranche loan of US$2.52525 billion. The first tranche of $1.02525 billion (including the capitalized front-end charge) would be made available upon effectiveness, anticipated for November 1998. The second tranche for $1.0 billion would be anticipated for March 1999, and the third tranche of $500 million, no sooner than July 1999. The closing date of the loan would be December 31, 1999. 114. To support the repo facility, a contingent loan of US$505.05 million would be made to the borrower Argentine Republic, with the proceeds made available by the 4 Programmatic and Emergency Adjustment Lending: World Bank Guidelines, R98-249, October 2, 1998 33  borrower to the Central Bank. It would be drawn only if and when the repurchase facility is triggered, and would be deposited in a special account at the Central Bank to be used only by the Central Bank to meet margin calls or repurchases from repo buyers (or to invest in highly liquid securities during periods when margin calls are not necessary, with proceeds to be redeposited in the special account). If the margins move favorably, the reflows would replenish the special account. If the repo facility is not used, the loan would not be drawn and could be cancelled upon request by the Borrower. Given the contingent nature of the loan, and the need to be able to provide the enhancement in a very short time frame once the margin calls are made, the disbursement of the Repo Facility Support loan would not depend on satisfactory progress in the program supported by the SSAL, once the repo has been made effective. However, effectiveness conditions include effectiveness of the SSAL, satisfactory progress in carrying out the adjustment operation, and a macroeconomic policy framework that is consistent with the objectives of the adjustment operation. Thus, the Repo Facility Support Loan is structured as the equivalent of part of the first tranche of the SSAL, supported by the same program conditionality as the SSAL, and potentially disbursable at any time after June 30, 1999 as long as the SSAL first tranche has been released. As an ingredient essential to the intended support of the repo facility, the availability of such disbursement of the Repo Facility Support Loan is virtually irrevocable once the Repo Facility Support Loan becomes effective (except for the potential impact of standard Bank remedies set forth in the Bank's General Conditions). The closing date of the loan would be September 15, 2003. 115. Terms and Conditions. Consistent with the exceptional circumstances facing the country, the proposed SSAL and Repo Facility Support Loan would be priced according to the special terms agreed by the Board (see report R98.249, dated October 2, 1998, discussed October 22, 1998). Thus the two loans would have five-year maturity, including three years of grace, and interest rate of LIBOR plus 400 basis points. Commitment and other standards fees would apply without waivers. At the request of the government, and consistent with the country's external debt management policy, the proposed loans would be LIBOR-based Single Currency Loans (SCL) in US dollars. 116. Disbursement and Procurement. Loan disbursements would be made under simplified SAL/SECAL disbursements. For the SSAL, proceeds will be disbursed against satisfactory implementation of the adjustment program, including compliance with stipulated tranche release conditions. In the case of the contingent loan to support the repo facility, proceeds would be disbursed only if the repo facility is activated and if the SSAL is effective. Disbursements will not be linked to specific purchases, and supporting evidence for disbursements is therefore not required. If after deposit is made in the Deposit Account the proceeds of the loan and any part thereof is used for ineligible purposes as defined in the Loan Agreement, the Bank will require the borrower to either (a) return the amount to the Deposit Account for use for eligible purposes, or (b) refund the amount directly to the Bank, in which case the Bank will cancel an equivalent undisbursed amount of the loan. Tranche release review and program supervision will ensure that the program supported by the SSAL is carried out as agreed. Additionally, the status of the repo facility would be reviewed periodically. 34  117. Accounts and Audit. The Ministry of Economy, Public Works and Services (MEyOSP), on behalf of the Government, will maintain the accounts for the Special Structural Adjustment Loan, and the Central Bank of Argentina for the contingent Special Repurchase Facility Support Loan, in accordance with sound accounting practices. The Bank reserves the option to audit the special deposit account established for the Special Structural Adjustment Loan, consistent with normal structural adjustment operation rules. Upon the Bank's request, the Argentine Republic will audit the deposit account established for the Special Repurchase Facility Support Loan, in accordance with appropriate auditing principles, by independent auditors acceptable to the Bank. The Bank has already undertaken a review of the auditing practices and standards of the government's independent audit agency (AGN) and finds that these are acceptable to the Bank and conform to international practices and norms for public auditing. In addition, the Bank is about to embark on a review of the government's internal financial management systems, including the adequacy of internal controls. These systems were last revised in 1992 with Bank assistance. 118. Monitoring Arrangement. The Ministry of Economy, Public Works and Services (MEyOSP) and the Chief of Cabinet's Office will be responsible for monitoring progress. 119. Environmental Assessment Requirements. In accordance with the Bank's Operational Directive on Environmental Assessment (OD 4.00, Annex A), the proposed operation has been placed in Category "U" and will not require an environmental assessment. C. BENEFITS AND RiSKS 120. Benefits. Long-run benefits of the structural reforms supported by the operation are anticipated economy-wide. Reforms in the federal-provincial fiscal relations, in particular, are expected to engender greater regional equity and efficiency in the allocation of fiscal resources and ultimately stimulate improved revenue mobilization thorough devolution to the provinces. A stronger financial sector, with appropriate prudential and regulatory frameworks, is expected; this would, along with development of the capital markets, serve to stimulate private savings and provide greater access by small and medium scale enterprises to credit and alternative financial instruments. This should be a stimulus to employment creation and exports. The specific regulatory reforms to be undertaken under the program are aimed at promoting efficiency in the provision of infrastructure services and to address equity considerations among consumers and providers/owners. Finally, the reforms included in the program in the area of social protection, education and health are expected to advance the ability of policy makers to design and implement poverty focused programs, stimulate greater equity in the access to social programs, and improve the quality and efficiency of those programs as part of a broadly focused agenda to reduce poverty and invest in human capital. 121. On the short run, the program is expected to facilitate Argentina's reentry to the international capital markets and help avoid a sharp economic downturn, which in the case of the last financial crisis in 1995 resulted in a decline in GDP of 4 percent and a 35  sharp increase in unemployment to 18.4 percent. With unemployment still over 13 percent, many Argentines, especially those with less marketable skills, have not yet recovered from that crisis. In particular, the proposed operation will benefit vulnerable groups whose access to the social programs would be safeguarded under the program. 122. Adding to the lines of defense in the banking system is of paramount importance. The lessons of the Tequila crisis in 1995 and the present situation in East Asia demonstrate that actions need to be taken to reduce stress in the banking system. Preventive actions are especially advisable in the case of Argentina due to the currency board arrangement, and its implication that foreign reserve losses translate directly into a liquidity shortage in the banking system. Thus, the specific benefits of the contingent loan to support the Central Bank's repo facility are two fold. In the first instance, the enhancement to the facility is expected to reduce in the probability of default, thus making the facility more attractive to international banks. This would , in turn, increase the probability of maintaining the size of the facility in relation to the deposit base. In the second instance, that of a liquidity shock and the activation of the repurchase facility by the Central Bank, the benefit would be mitigating the impact of a severe liquidity shortage. Liquidity is critical to preserve reforms in banking sector and assure access to credit of SMEs and other borrowers in time of a systemic credit crunch. SMEs, as major generators of employment, are usually disproportionately affected by credit restrictions. As a contingent loan with the goal of preventing a crisis, it would only be disbursed if the Central Bank exercises its option with the private banks. The Central Bank does not expect that this will be the case as the total coverage that the system has through other means which would precede the activation of the repo facility are equivalent to 30 percent of deposits. 123. Risks. If access to international capital markets is not restored by mid-1999, the financial package currently assembled might not be sufficient to meet external needs, resulting in a severe economic adjustment. This could put pressure on resources available for social safety nets and cause the poor and disadvantaged to suffer even more. Moreover, this could result in countries such as Argentina having to take additional measure to alleviate their respective debt servicing burdens. An additional risk is that the reform process could be delayed by the upcoming national elections. While this risk has to be acknowledged, experience during the 1994-1995 financial crisis, which also coincided with presidential elections, was to the contrary and the reform process actually accelerated. A third risk is that access to international financial markets is regained soon, the impetus for reform wanes. Given the advanced state of many of the reforms, and the outstanding commitment by the government in several areas, mostly notably changing to federal-provincial revenue sharing, the prospects for continuing the program remain high. A fourth risk is that the current international and Argentine economic scenario deteriorates faster than anticipated, resulting in capital outflows that weaken the banking system. The support for the repo facility is intended to alleviate such pressures. Nevertheless, the risks of the crisis worsening and the impact on the Argentina economy being much more severe than anticipated are significant. That makes the preventive measures supported under the two operations even more critical. 36  5. BANK GROUP STRATEGY 124. The last progress report on the FY97-00 CAS was discussed by the Board on March 17, 1998. At that time, Argentina was weathering the initial effects of the Asia crisis, but there was a clear need to continue to monitor the situation. In particular, we noted the increased risk associated with Argentina's ability to access international financial markets to roll over its debt and to finance the fiscal deficit. We indicated that we would work with the Government in identifying measure to help mitigate the spillover effects were the crisis to persist and deepen. 125. The proposed package of emergency support is consistent with that strategy and reflects the nature of the crisis facing Argentina. An update on the country assistance strategy, which accompanies this report, provides additional detail on the impact that such emergency assistance has on the Bank's program and IFC's activities in the country. 126. Collaboration with the IDB. In recognition of the critical situation facing many countries in the Latin America and Caribbean Region, the IDB and the Bank have been collaborating in order to a joint response to borrower requests for special support. In the case of Argentina, the two proposed loans have been closely coordinated with the IDB during identification and preparation. Both institutions conducted joint identification missions, and a continuous dialogue was established during their preparation and negotiations. 127. Collaboration with the IMF. The IMF has an Extended Fund Facility with Argentina for $2.8 billion. This facility is part of a continuing effort by the Fund to mitigate the impact of external crises. In entering into this program in February 1998, the Government's intention-and message to the markets-was that the program was precautionary and it would be drawn down only if the country was in crisis. This facility, therefore, is regarded as an integral part of the current special multilateral support to Argentina. As of this point, the program is on track. The Fund's next review is scheduled for early December, at which point the country's situation and financing requirements for 1999 will be reassessed. Close coordination between the IMF and the Bank took place in the development and review of that program and has continued in the preparation of the proposed loans. This has been the case throughout the series of Fund and Bank adjustment programs with Argentina in recent years. Frequent consultations on economic conditions and prospects took place during the preparation of these loans. 37  6. RECOMMENDATION 128. I am satisfied that the proposed loans comply with the Articles of Agreement of the Bank, and I recommend that the Executive Directors approve them. James D. Wolfensohn President Washington, D.C. November 3, 1998 38  ARGENTINA: Special Structural Adjustment Loan Annex A: Social Indicators and Special Repurchase Support Loan of Development Argentina Social Indicators Latest single year Same regiontincome group Latin America & Upper-middle- 1970-75 1980-85 1990-96 Caribbean income POPULATION Total population, mid-year (millions) 26.0 30.3 35.2 485.8 473.2 Growth rate (% annual average) 1.7 1.5 1.3 1.7 1.5 Urban population (% of population) 80.7 84.8 88.4 73.7 73.0 Total fertility rate (births per woman) 3.2 3.1 2.7 2.7 2.6 POVERTY (% of population) National headcount index .. 25.5 Urban headcount index Rural headcount index INCOME GNP per capita (US$) 2,680 2,660 8,380 3,710 4,600 Consumer price index (1987=100) 0 23 1,376,469 631 506 Food price index (1987=100) .. 22 1,201,924 INCOMEICONSUMPTION DISTRIBUTION (% of income or consumption) Lowest quintile 4.4 .. Highest quintile 50.3 .. SOCIAL INDICATORS Public expenditure Health (% of GDP) .. 4.3 3.0 3.4 Education (% of GNP) 1.5 3.8 3.9 5.0 Social security and welfare (% of GDP) 5.8 4.8 Net primary school enrollment rate (% of age group) Total 96 .. 91 91 Male Female Access to safe water (% of population) Total 66 55 64 73 76 Urban 76 63 73 84 87 Rural 26 17 17 43 42 Immunization rate (% under 12 months) Measles 67 76 84 84 DPT 63 82 86 88 Child malnutrtion (% under 5 years) .. 2 Life expectancy at birth (years) Total 67 68 73 70 70 Male 64 65 69 66 66 Female 71 72 77 73 73 Mortality Infant (per thousand live births) 48 29 22 33 30 Under 5 (per thousand live births) 71 38 25 41 36 Adult (15-59) Male (per 1,000 population) 212 205 176 182 181 Female (per 1,000 population) 116 102 84 114 107 Matemal (per 100,000 live births) .. 85 100 World Development Indicators 1998 CD-ROM, World Bank  Annex B: Key Economic Indicators Page 1 of 3 Argentina - Key Economic Indicators Actual Estimate Projected Indicator 1993 1994 1995 1996 1997 1998 1999 2000 2001 National accounts (as % GDP at current market prices) Gross domestic product 100.0 10(.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Agriculture' 6.7 6.4 7.0 6.9 7.0 7.7 7.6 7.6 7.5 Industry' 32.6 32.3 32.1 32.1 32.1 35.5 35.2 35.0 34.7 Services' 51.2 51.6 51.3 51.4 51.4 47.1 47.5 47.6 48.0 Total Consumption 83.6 82.4 81.6 81.9 81.6 80.9 81.2 79.7 78.7 Gross domestic fixed 18.2 19.9 18.3 18.5 20.1 21.6 21.1 22.5 23.3 investment Government investment 1.5 1.4 1.1 1.2 1.2 0.8 0.9 1.1 1.2 Private investment 16.8 18.5 17.2 17.3 18.9 20.8 20.2 21.4 22.1 (includes increase in stocks) Exports (GNFS)b 6.3 0.8 8.5 8.9 9.0 8.7 8.8 9.2 9.7 Imports (GNFS) 8.1 (.1 8.5 9.2 10.7 11,2 11.1 11.5 11.7 Gross domestic savings 16.4 17.6 18.4 18.1 18.4 19.1 18.8 20.3 21.3 Gross national savings' .. 16.4 16.9 16.5 16.6 17.1 16.8 18.2 19.0 Alemorandum items Gross domestic product 257.841 281.925 281,060 298.734 325,012 345.016 356,492 378,122 402,983 (US$ million at current prices) Gross national product per 7,260 8.140 8.050 8.370 8,770 9,520 9,680 10,110 10,630 capita (US$, Atlas method) Real annual growth rates (%, calculated from 1986 prices) Gross domestic product at 5.7% 8.0% -4.0% 4.8% 8.6% 5.0% 2.0% 4.5% 5.0% market prices Gross Domestic Income 6.3% 8.4% -3.8% 5.8% 9.0% 4.4% 2.1% 4.7% 5.1% Real annual per capita growth rates (%. calculated from 1986 prices) Gross domestic product at 4.4% 6.7% -5.1% 3.8% 6.3% 3.8% 0.8% 3.3% 3.8% market prices Total consumption .. 8.5% -9.9% 6.1% 10.2% 3.2% 1.1% 1.6% 2.4% Private consumption .. 8.8% -10.2% 6.4% 10.5% 3.2% 1.2% 1.5% 2.4% (Continued)  Annex B: Key Economic Indicators Page 2 of 3 Argentina - Key Economic Indicators (Continued) Actual Estimate Projected Indicator 1993 1994 1995 1996 1997 1998 1999 2000 2001 Balance of Payments (US$m) Exports(GNFS)b 15.572 18.437 23,824 27,037 29.318 29,968 31,337 34,963 39,002 Merchandise FOB 13.269 16.023 21.162 24.043 26,217 26.489 27,649 30,827 34,202 Imports (GNFS)b 20.728 25.616 23,808 27.910 34.899 38.541 39,607 43,322 47,193 Merchandise FOB 15.632 20.162 18.804 22,282 28,489 31.583 32,436 35,633 38,933 Resource balance (5,156) (7.179) 16 (873) (5.581) (8,573) (8.271) (8,359) (8,192) Netcurrenttransfers 411 320 432 334 517 350 350 350 360 (including official current transfers) Current account balance (7.672) (10.117) (2.768) (3.787) (11,459) (15,290) (15.251) (16,181) (17,205) (after official capital grants) Net private foreign direct 2.515 3.117 4.783 5,090 5,895 5,644 4,000 6,184 6,200 investment Long-term loans (net) 16,971 12.803 19.156 18.960 13.236 11,145 7,669 11,643 12,896 Official 2.667 1.497 2.466 1.449 758 2,214 4,026 2,629 2,497 Private 14.304 11.306 16.690 17.511 12,478 8,931 3,643 9,014 10,398 Other capital (net, including (7.334) (5,242) (21.234) (16.487) (4,610) (134) 1,662 2,326 2,146 errors and omissions) Change in reservesd (4.480) (561) 63 (3.776) (3,062) (1,364) 1,920 (3,972) (4,037) Memorandum items Resource balance (% of -2.0% -2.5% 0.0% -0.3% -1.7% -2.5% -2.3% -2.2% -2.0% GDP at current market prices) Real annual growth rates (1986 prices) Merchandise exports 7.9% 15.7% 27.1% 7.2% 7.0% 6.6% 2.0% 8.0% 8.6% (FOB) Primary -1.2%o 7.4% 27.1% 7.2% 7.0% 12.0% 3.0% 9.0% 13.0% Manufactures 12.7% 16.7% 27.1% 7.2% 7.0% 2.0% 1.0% 7.1% 4.2% Merchandise imports 12.3% 25.0% -11.6% 6.1% 37.0% 12.0% 1.0% 6.8% 6.4% (CIF) Public finance (as % of GDP at current market prices)' Current revenues 17.4 16.9 17.5 15.4 16.6 17.0 17.1 17.3 17.5 Current expenditures 15.6 16.2 17.3 16.2 16.9 17.5 17.7 17.6 17.6 (Continued)  Annex B: Key Economic Indicators Page 3 of 3 Argentina - Key Economic Indicators (Continued) Actual Estimate Projected Indicator 1993 1994 1995 1996 1997 1998 1999 2000 2001 Current account surplus (+) 1.8 0.7 0.2 -0.8 -0.4 -0.5 -0.6 -0.3 -0.1 or deficit (-) Capital expenditure 1.0 1.0 1.1 1.2 1.2 0.8 0.9 1.1 1.2 Foreign financing 0.2 0.5 0.8 2.4 3.4 2.2 2.2 1.2 0.9 Monetary indicators M2/GDP (at current market 17.6 19.0 18.5 20.7 24.6 25.0 25.0 25.0 25.0 prices) Growth ofM2 (%) 46.5 17.6 -2.8 18.8 29.3 8.1 3.3 6.1 6.6 Private sector credit growth! 127.4 71.2 268.8 13.8 88.8 66.4 99.5 99.5 99.5 total credit growth (%) Price indices( 1986 =100) Merchandise export price 113.2 118.2 123.1 128.6 127.8 127.1 130.1 134.3 137.2 index Merchandise import price 112.0 115.3 121.5 126.3 126.3 125.0 127.0 130.7 134.2 index Merchandise terms of trade 101.0 102.5 101.3 101.8 101.2 101.7 102.4 102.8 102.2 index Real exchange rate 48.9 49.1 48.2 48.2 48.2 48.2 48.2 48.7 49.3 (US$/LCU)l Real interest rates Consumer price index 10.6% 4.2% 3.4% 0.2% 0.5% 1.5% 1.2% 1.5% 1.5% (% growth rate) GDP deflator 7.5% 1.2% 3.9% 1.5% 0.2% 1.1% 1.3% 1.5% 1.5% (% growth rate) a. If GDP components are estimated at factor cost. a footnoote indicating this fact should be added. b. "GNFS" denotes "goods and nonfactor services." c. Includes net unrequited transfers excluding official capital grants. d. Includes use of IMF resources. e. Should indicate the level of the government to which the data refer. f "LCU" denotes "local currenc) units." An increase in US$/LCU denotes appreciation.  Annex C: Argentina: Emergency Structural Adjustment Loan Annex C: External Financing Requirement and Projected Sources of Financing (in mnillions of U.S. dollars) Category 1998-4"' Quarter 1999 1998-V + 1999 Financing requirements: 1. Current Account Deficit 3,250 15,251 18,501 2. Long term external debt amortizationsa 3.600 13,553 17,153 a. Public and Publicly guaranteed 2,100 7,580 9,680 b. Private 1,500 5,973 7,473 3. Change in gross reserves (- decline) -1,000 67 -930 4. Gross Financing Requirements 5,850 28,871 34,724 (I +2+3) Sources of Financing 5. Private investment flows (net) 500 5,000 5,500 6. Multilateral and Bilateral Gross 4,000 8,500 12,500 Disbursementsb o/w World Bank 1,250 2,685 3,935 7. Additional private debt flows 1,350 15,371 16,724 8. Total Sources of Financing 5,850 28,871 34,724 (5 + 6 + 7) a. In addition, there is an estimated US$17,988 million (DECDG) to 31,000 million (B.l.S) in short-term external debt, which must be rolled over in 1998 and 1999. Of this amount, an estimated 10,000 million is in the form of trade credits. b. Includes IMF.  MOP Schedule D Generated: 1 1/02/98 Status of Bank Group Operations in Argentina Operations Portfolio Differerice Between expected Original Amount in USS Millions and actual Fiscal disbursements a/ Project ID Year Borrower Purpose IBRD IDA Cancellations Undisbursed Orig Frm Rev'd Number of Closed Projects: 55 Active Projects AR-PE-6058 1999 REPUBLIC OF ARGENTINA SOC.PROTECT 4 90.75 0.00 0.00 90.75 0.00 0.00 AR-PE-49269 1998 ARGENTINE REPUBLIC SOC PROTEC 3 284.00 0.00 0.00 284.00 0.00 0.00 AR-PE-50713 1998 MINISTRY OF ECONOMY MODEL COURT DEV. 5.00 0.00 0.00 5.00 .60 0.00 AR-PE-50714 1998 REPUBLIC OF ARGENTINA SECOND.ED 3 119.00 0.00 0.00 119.00 77.85 0.00 AR-PE-51693 1998 GOVERNMENT P.RFM(SALTA) 75.00 0.00 0.00 30.00 0.00 0.00 AR-PE-51694 1998 GOVERNMENT P.RFM(S.JUAN) 50.00 0.00 0.00 40.00 25.00 0.00 AR-PE-51695 1998 GOVERNMENT P.RFM(R.NEGRO) 75.00 0.00 0.00 50.00 25.00 0.00 AR-PE-52590 1998 REPUBLIC OF ARGENTINA NAT HWY REHAB6MAINT 450.00 0.00 0.00 450.00 198.66 0.00 AR-PE-55477 1998 GOVT OF ARGENTINA MINING TA 39.50 0.00 0.00 39.50 11.10 0.00 AR-PE-55935 1998 GOVERNMENT EL NINO EMERGENCY 42.00 0.00 0.00 42.00 12.00 0.00 AR-PE-6006 1998 MIN. OF ECONOMY P.RFM(TUCUMAN) 100.00 0.00 0.00 45.00 0.00 0.00 AR-PE-6041 1998 GOVERNMENT SMALL FARMER DV. 75.00 0.00 0.00 75 .00 14.12 9.00 AR-PE-6050 1998 REP OF ARGENTINA POLLUTION MGT. 18.00 0.00 0.00 18.00 .86 0.00 AR-PE-39584 1997 GOVT OF ARGENTINA B.A.URB.TSP 200.00 0.00 0.00 177.66 17. 67 0.00 AR-PE-40808 1997 GOA N.FOREST/PROTC 19.50 0.00 0.00 18.13 -.77 0.00 AR-PE-43418 1997 REPUBLIC OF ARG AIDS PREV.6STD CTRL 15.00 0.00 0.00 10.94 -.32 0.00 AR-PE-46821 1997 GOVT.OF ARG PENSION TA 20.00 0.00 0.00 15.37 2.74 0.00 AR-PE-49268 1997 ARGENTINE REPUBLIC SOC.PROTECT.2 200.00 0.00 0.00 22.89 -52.11 0.00 AR-PE-5980 1997 GOVT OF ARGENTINA PROV ROADS 300.00 0.00 0.00 296.94 51.93 0.00 AR-PE-6010 1997 GOA PROV AG DEVT I 125.00 0.00 0.00 122.15 6.85 0.00 AR-PE-6052 1997 GOVT OF ARGENTINA FLOOD PROTECTION 200.00 0.00 0.00 196.26 14.28 0.00 AR-PE-6059 1997 ARGENTINE REPUBLIC MTL.CHD.HTH.2 100.00 0.00 0.00 93.51 3.50 0.00 AR-PE-34091 1996 REP OF ARGENTINA HIGHER ED REFORM 165.00 0.00 0.00 127.57 85.58 61.58 AR-PE-37049 1996 GOVT OF ARGENTINA PUB.INV.STRENGTHG 16.00 0.00 0.00 15.32 10.32 0.00 AR-PE-38883 1996 REPUBLIC OF ARGENTINA ENT.EXPORT DV. 38.50 0.00 0.00 18.90 18.89 -.33 AR-PE-40904 1996 REPUBLIC OF ARGENTINA BANK REFORM 500.00 0.00 0.00 166.00 166.00 0.00 AR-PE-40909 1996 REP. OF ARGENTINA N. INSURANCE REFORM 350.00 0.00 0.00 100.00 125.00 0.00 AR-PE-45687 1996 REP. OF ARGRNTINA H.INSURANCE TA 25.00 0.00 0.00 5.52 -.58 0.00 AR-PE-6030 1996 REPUB OF ARGENTINA PROVCL HLTH SCTR 101.40 0.00 0.00 85.33 49.62 0.00 DEV AR-PE-6040 1996 GOVERNMENT FORESTRY/DV 16.00 0.00 0.00 12.43 .74 0.00 AR-PE-6055 1996 GOVT. OF ARGENTINA MINING SCTR DEVT 30.00 0.00 0.00 7.48 -1.42 0.00 AR-PE-6057 1996 GOV'T OF ARGENTINA SECNDARY ED 2 115.50 0.00 0.00 100.55 46.90 -14.95 AR-PE-5992 1995 GOVT OF ARGENTINA INA SECONDARY ED I 190.00 0.00 0.00 136.29 112.00 0.00 AR-PE-6018 1995 ARGENTINE REPUBLIC PROV DEVT II 225.00 0.00 0.00 192.56 21.57 0.00 AR-PE-6060 1995 GOVT OF ARGENTINA MUNIC DEVT II 210.00 0.00 0.00 162.42 --18.31 0.00 AR-PE-6025 1994 GOVT OF ARGENTINA INA MTNAL CHILD HLTH 6 100.00 0.00 0.00 12.56 6.26 0.00 N AR-PE-6062 1994 MIN OF ECONOMY CAPITAL MKT TA 8.50 0.00 0.00 2.45 2.43 0.00 AR-PE-6003 1993 GOVT OF ARGENTINA INA RD MAINT & REHAB 340.00 0.00 0. 00 38.90 28.37 0.00 SCT AR-PE-6036 1993 GOVERNMENT YACYRETA II 300.00 0.00 0.00 1.01 1.00 0.00 AR-PE-5977 1991 ARGENTINE REPUBLIC WTR SUPPLY II 100.00 0.00 36.00 19.90 55.91 19.91 AR-PE-6005 1991 REPUBLIC OF ARGENTINA PROVINC DEV PROJ 200.00 0.00 0.00 12.89 11.87 0.00 AR-PE-5968 1987 SEGBA SEGBA V 276.00 0.00 0.00 55.62 55.61 0.00 Generated by the Operations Information System (OIS) Page I  MOP Schedule D Generated: 11/02/98 Differerce Between expected Original Amount in US5 Millions and actual Fiscal disbursemernts a/ Project ID Year Borrower Purpose IBRD IDA Cancellations Urndisbursed Oria Frm Rev'd Total 5,909.65 0.00 36.00 3,514.80 1,186. 75.21 '72 Active Proiects Closed Projects Total Total Disbursed (IBRD and IDA): 2,358.82 7,143.55 9,502.37 of which has been repaid: 228.38 3,237.76 3,466.14 Total now held by IBRD and IDA: 5,645.25 3,909.31 9,554.56 Amount sold . 0.00 12.79 12.79 Of which repaid : 0.00 12.79 12.79 Total Undisbursed : 3,514.80 3.49 3,518.29 a. Intended disbursements to date minus actual disbursements to date as projected at appraisal. Note: Disbursement data is updated at the end of the first week of the month. Generated by the Operations Information System (OIS) Page 2  MOP Schedule D Argentina STATEMENT OF IFC's Committed and Disbursed Portfolio As of 30-Sep-98 (In US Dollar Millions) Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1960/95/97 Acindar 35.00 16.43 10.00 61.11 10.00 16.43 10.00 11.11 1977/84/86/88/94/96 Alpargatas 24.23 6.05 6.37 89.29 19.23 6.05 6.37 48.79 1978/81/86/87/91/93/96 Minetti 10.00 0.00 10.00 27.27 10.00 0.00 10.00 27.27 1986/89/91/97 Banco Roberts-AL 10.00 0.00 0.00 0.00 10.00 0.00 0.00 0.00 1987 BGN-TBR .11 0.00 0.00 0.00 .11 0.00 0.00 0.00 1987/89 BGN-Bolland .13 0.00 0.00 0.00 .13 0.00 0.00 0.00 1987/89/90/96/97 Terminal 6 18.53 0.00 0.00 17.87 17.23 0.00 0.00 16.17 1987/92 BRLP 7.53 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1988/93 Bunge y Born 2.66 0.00 0.00 20.05 2.66 0.00 0.00 20.05 1989 BGN-Algodonera .16 0.00 0.00 0.00 .16 0.00 0.00 0.00 1989 BGN-Ferrum .50 0.00 0.00 0.00 .50 0.00 0.00 0.00 1989 BGN-FRIGOTOBA .08 0.00 0.00 0.00 .08 0.00 0.00 0.00 1989 BGN-Interpack .15 0.00 0.00 0.00 .15 0.00 0.00 0.00 1989 BGN-Parafina .38 0.00 0.00 0.00 .38 0.00 0.00 0.00 1989 BGN-Willmor .41 0.00 0.00 0.00 .41 0.00 0.00 0.00 1989 ROB-COMESI .09 0.00 0.00 0.00 .09 0.00 0.00 0.00 1989 ROB-INTA .09 0.00 0.00 0.00 .09 0.00 0.00 0.00 1989/96 Banco Frances 4.82 0.00 0.00 .13 4.82 0.00 0.00 .13 1990 CIP 0.00 .08 0.00 0.00 0.00 .08 0.00 0.00 1990/94 Petroken 19.39 0.00 5.00 3.65 19.39 0.00 5.00 3.65 1991 BCA .39 0.00 0.00 .50 .39 0.00 0.00 .50 1991 ROB-Longvie .11 0.00 0.00 0.00 .11 0.00 0.00 0.00 1992 FEPSA 6.95 0.00 0.00 5.87 6.95 0.00 0.00 5.87 1992 Oleaginosa Oeste 4.58 0.00 5.00 5.60 4.58 0.00 5.00 5.60 1992 Rioplatense 5.33 1.00 0.00 1.67 5.33 1.00 0.00 1.67 1992 San Jorge 0.00 27.00 0.00 0.00 0.00 0.00 0.00 0.00 1992/93/96 Malteria Pampa 11.49 0.00 1.00 9.20 11.49 0.00 1.00 9.20 1992/95 Bridas 32.26 0.00 0.00 51.38 32.26 0.00 0.00 51.38 1993 Argentina Equity 0.00 4.00 0.00 0.00 0.00 4.00 0.00 0.00 1993 Nuevo Central 5.63 3.00 0.00 8.75 5.63 3.00 0.00 8.75 1993 Yacylec 7.15 5.04 0.00 18.96 7.15 5.04 0.00 18.96 1993/94 Molinos 0.00 5.55 0.00 0.00 0.00 5.55 0.00 0.00 1994 AceiteraChabas 0.00 3.10 0.00 0.00 0.00 3.10 0.00 0.00 1994 Aceitera General 12.50 6.90 0.00 0.00 12.50 6.90 0.00 0.00 1994 BGN 12.00 0.00 3.00 0.00 12.00 0.00 3.00 0.00 1994 LBAR 0.00 1.17 0.00 0.00 0.00 1.06 0.00 0.00 1994 LBAV 0.00 3.62 0.00 0.00 0.00 3.62 0.00 0.00 1994 Quilmes 10.28 0.00 0.00 7.50 10.28 0.00 0.00 7.50 1994/95 EDENOR 14.63 0.00 15.00 23.50 14.63 0.00 15.00 23.50 1994/95/96 Aguas 66.85 7.00 0.00 198.61 66.85 7.00 0.00 198.61 1994/95/97 La Maxima 0.00 16.49 1.90 0.00 0.00 14.22 1.86 0.00 1995 Banco Roberts 0.00 0.00 20.00 0.00 0.00 0.00 20.00 0.00 1995 CEPA 10.33 0.00 0.00 1.80 10.33 0.00 0.00 1.80 1995 Mastellone 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1995 Nahuelsat 25.00 5.00 0.00 0.00 25.00 5.00 0.00 0.00 1995 SanCor 17.50 0.00 20.00 21.00 17.50 0.00 20.00 21.00 1995 Socma 18.75 0.00 0.00 45.00 18.75 0.00 0.00 45.00 Generated by the Operations Information System (OIS) on 11/02/98  MOP Schedule D Committed Disbursed IFC IFC FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1995 SIDECO 0.00 15.00 0.00 0.00 0.00 15.00 0.00 0.00 1995 Terminales Port. 8.50 2.00 0.00 0.00 8.50 2.00 0.00 0.00 1995 Tower Fund 0.00 15.73 0.00 0.00 0.00 10.15 0.00 0.00 1995 Tower Fund Mgr 0.00 .14 0.00 0.00 0.00 .06 0.00 0.00 1995/97 Kleppe/Caldero 10.93 0.00 0.00 0.00 8.93 0.00 0.00 0.00 1996 Banco Galicia 30.00 0.00 0.00 200.00 30.00 0.00 0.00 200.00 1996 Bansud 25.00 0.00 0.00 0.00 4.90 0,00 0.00 0.00 1996 Brahma - ARG 17.79 0.00 0.00 29.70 17.79 0.00 0.00 29.70 1996 CAPSA 12.00 0.00 5.00 33.00 12.00 0.00 5.00 33.00 1996 Grunbaum 7.00 0.00 2.00 5.00 7.00 0.00 2.00 5.00 1996 MBA 0.00 .16 0.00 0.00 0.00 .16 0.00 0.00 1996 Neuquen Basin 0.00 26.40 0.00 0.00 0.00 21.89 0.00 0.00 1996 Refisan 20.00 0.00 0.00 27.00 20.00 0.00 0.00 27.00 1996 Transconor 24.95 0.00 20.00 207.88 24.95 0.00 20.00 207.88 1996 Zanon 12.83 0.00 6.00 0.00 12.83 0.00 6.00 0.00 1997 FRIAR 10.00 0.00 2.50 7.00 10.00 0.00 2.50 7.00 1997 Guipeba 15.00 0.00 5.00 0.00 15.00 0.00 5.00 0.00 1997 Milkaut 9.38 0.00 10.00 4.50 9.38 0.00 10.00 4.50 1997 Suquia 0.00 0.00 10.00 0.00 0.00 0.00 10.00 0.00 1997 T61 10.00 0.00 5.00 30.00 10.00 0.00 5.00 30.00 1997 Vicentin 25.00 0.00 0.00 10.00 25.00 0.00 0.00 10.00 1998 FAID 0.00 5.00 0.00 0.00 0.00 2.75 0.00 0.00 1998 Hospital Privado 9.60 0.00 0.00 0.00 0.00 0.00 0.00 0.00 1998 Patagonia 5.00 0.00 1.00 0.00 2.00 0.00 1.00 0.00 1998 Patagonia Fund 0.00 30.00 0.00 0.00 0.00 0.00 0.00 0.00 Total Portfolio: 648.97 205.86 163.77 1,172. 575.44 134.06 163.73 1,080. 79 59 Approvals Pending Commitment Loan Eqity Quasi Partic 1996 AGUAS III - INC 15.00 0.00 0.00 75.00 1997 ARGIE MAE 0.00 .40 0.00 65.00 1998 AUTCL 12.00 0.00 0.00 0.00 1998 F.V. S.A. 12.00 0.00 4.00 0.00 1993 FEPSA (11) 0.00 0.00 0.00 4.00 1998 HOSPITAL PRIVADO 1.00 0.00 0.00 0.00 1998 MERCANTIL ARG. 20.00 0.00 15.00 0.00 1999 MINETTI-ANDINO 30.00 0.00 14.00 70.00 1998 SUQUIA CL 30.00 0.00 0.00 50.00 1999 SUQUIA CL 11 5.00 0.00 0.00 0.00 1997 TGN 11 BLINC 0.00 0.00 0.00 10.00 1998 U.BELGRANO 22.00 0.00 0.00 0.00 Total Pending Commitment: 147.00 .40 33.00 274.00 Generated by the Operations Information System (OIS) on 11/02/98  ANNEX E: Matrix of Policy Actions / PageI ARGENTINA Policy Matrix for Actions to be Taken under a SSAL Special Structural Adjustment Loan November 1998  ANNEX E: Matrix of Policy Actions / Page 2 A. REFORM OF INTERGOVERNMENTAL FISCAL RELATIONS Objectives Issues Main reforms to date Second Tranche Third Tranche I) Simplification of the a)Eliminate special Fiscal "Pacts" I and 11: Prepare proposal (ante- -Satisfactory progress on an agreement system of intergovernmental funds - Completed proyecto) for the between the federal government and the transfers: "primary decentralization to the simplification of primary provinces. distribution". This system is b)Eliminate differential provinces of health services distribution. established via the main incentives for federal and primary and secondary -Formal presentation of Government's coparticipation Law 23.548 tax administration by education -In proposal, at least 70 proposal to all provincial Governors. and Laws 24.699, 23.906, establishing that all percent of federal- 24.621, 24.065 and federal taxes enter the -Implemented a variety of provincial automatic modifications. general revenue-haring measures to deregulate transfers would be pool transport, retail and distributed according to one professional service sectors "fund" and one distribution at the provincial level rule II) New formula for a) Increase -Began to incorporate Prepare proposal (ante- - Satisfactory progress on an agreement allocating transfers across Correspondence, provincial public employee proyecto) for the creation of between the federal government and the provinces: "secondary promoting Constitutional pension systems into the a new secondary provinces. distribution" - as established concept of "solidarity" in reformed national pension distribution formula. in Law 23.548, and Laws the sense that more system. -Formal presentation of Government's 24.699, 23.906, 24.62 1, resources remain with the -In the proposal: proposal to all provincial Governors (as 24.065 and modifications. population -Federal leadership in One component of formnula above). variety of provincial is a proxy for b) Improve Equity, as structural reforms, via "derivation/devolution" -Improve measurement of provincial promoted in the provincial reform projects (which means allocating own tax bases by the Ministry of Constitution and provincial development resources to a jurisdiction Economy. projects. in proportion to the c) Introduce revenues collected in that "Equalization" - transfers jurisdiction) and another that compensate compoenet is a new provinces with lower per formula which compensates capita revenue-raising provinces that have lower capacity per capita tax bases.  ANNEX E: Matrix of Policy Actions / Page 3 Objectives Issues Main reforms Second Tranche Third Tranche to date III) Eliminate a) Introduce -Through Prepare a proposal incorporating the following features. - Satisfactory progress on Gross Receipts residence-based second fiscal an agreement between the tax and create taxation to the extent pact, began to -A clear definition of tax base and clear administrative guidelines federal government and the adequate possible eliminate -New proposed tax should tax consumption or income on a residence provinces. substitute distortionary basis, and it should avoid taxing production and the earning of income b) Maintain fiscal impact of the (i.e. origin of income) -Formal presentation of autonomy gross receipts -Any substitute tax on consumption should not have a "cascading" Government's proposal to ("turnover") effect - that is, its incidence should not be cumulative across stages of all provincial Governors (as c) Establish general, tax, by production. above). broad-based exempting -Any substitute tax on consumption should involve lower consumption tax primary stages administrative costs than the current parallel taxation of sales (e.g. VAT of production. along with Gross Receipts) -Any substitute tax on consumption should induce incentives for -Second Fiscal automatic compliance by creating an opposition of interests between Pact the vendor and purchaser with respect to reporting sales. eliminated -New tax proposed should allow provinces to set their own rates provincial payroll taxes. Feasibility study completed to show that new tax could raise at least as much revenues as current Gross Receipts tax. IV) Tax a) Maintain -Improved Develop a proposal for the eventual decentralization of at least one - Satisfactory progress on Decentralization residence-based provincial tax major federal tax (decentralization could mean provincial surcharge) an agreement between the taxation to the extent administration and a time-bound plan for its enactment. federal government and the possible through provinces. federal -Proposed decentralized tax should be residence based, and it should b) Improve fiscal technical avoid taxing production and the earning of income (i.e. origin of -Formal presentation of autonomy via power assistance income) Government's proposal to to set rates and programs, e.g. -Proposed decentralized tax should allow provinces to set their own all provincial Governors (as greater own-source Provincial rates above). revenues Development Project, and others.  ANNEX E: Matrix of Policy Actions / Page 4 B. FINANCIAL SECTOR Objectives Issues Main reforms to date Second Tranche Third Tranche I) Harmonization of Differential tax treatments Various taxes on transactions Completion of a Tax reform project submitted to Congress Financial Sector Tax distort financial markets. (eg. Checks) have been study by the resulting in approximate tax neutrality in the Treatment. reduced or eliminated. borrower on tax treatment of financial instruments. treatment of Taxes on dividends and financial capital gains have been intermediation reduced and discriminatory in Argentina. treatment of foreign investors eliminated. Agreement on terms of reference for a comprehensive review of financial sector taxes. II) Empower financial sector Supervisory and regulatory Submit draft law to Congress which provides regulatory and supervisory authorities lack adequate protection from personal liability for financial authorities. protection from legal actions sector supervisors and regulators for good- related to the good-faith faith actions taken in the performance of their discharge of official duties. official duties. III) Coordination of Financial Lack of coordinated sectoral Establish Committee fully operational in accordance to Sector Regulation and policies result in arbitrage pernanent inter- its terms of reference. Progress in Supervision. opportunities across financial agency implementing the report's recommendations. instruments. Supervision of Committee of financial markets fragmented, financial not able to address regulatory conglomerates and agencies under connnected lending. agreed terms of reference. Will review and report on the consistency of current regulatory practices.  ANNEX E: Matrix of Policy Actions / Page 5 1. Banking Sector Reform Objectives Issues Main reforms to date Second Tranche Third Tranche I) Reduce the size of public Public sector banks BANADE closed. Bringing Banco Hipotecario to Issuance of a public document sector involvement in the are injecting an the point of sale by formal detailing all the explicit and implicit banking system unwarranted degree 15 out of 24 provincial solicitation of bids from the guarantees the Borrower maintains in of inefficiency in the banks privatized or closed. private sector for at least support of BNA. banking system controlling share (subject to Law for the privatization of normalization of international Banco Hipotecario passed. market conditions, defined as the ability of a Latin American First ever audit of the Banco company to undertake an Initial de la Nacion underway by Public Offering.) the Central Bank. Present plan of action on the basis of Review homogeneity of that supervisory review. supervisory rigor of public and private banks by the Government and the Central Bank. 11) Increase resilience of Difficulties in Substantial consolidation, Form an interagency committee Review with the Bank committee's banking system to external exiting the banking privatization, increased entry to review: (a) bank failure recommendations, and present an shocks, and facilitate the exit system have the of foreign banks, and resolution processes, including implementation plan of action on both of weak banks from the potential to increase tightening of regulation and the relations between issues. system its systemic risks supervision. Superintendency of Banks, the Central Bank and SEDESA, and Need to strengthen Reduction of the number of (b) regulatory guidelines for early intervention banks by one-third to about proper bank governance, affecting infrastructure. 110 entities. owners, management, and outside directors. The committee should Need to strengthen Adopted and implemented include at least two international interagency supervisory strategy experts in the field and coordination and including the institutional representatives from the supervision to development of the Argentine private banking sector. address issues of Superintendency of bank governance, Financial Institutions. connected lending and financial Limited private deposit conglomerates. insurance scheme introduced. Banking regulation has been enhanced through:  ANNEX E: Matrix of Policy Actions / Page 6 Banking Sector Reform (cont') Objectives Issues Main reforms to date Second Tranche Third Tranche --Increased minilnum capital ratio to 11.5% of risk weighted assets --Liquidity requirement increased to 20% of most bank liabilities --Enhanced disclosure on borrowers, establishing Central de Deudores --Introduced a subordinated debt requirement to banks Central Bank signed a contingent repo facility with international banks equal to 10 percent of deposits. Enhance the Privatization of the Amendment of the provisions marketability of administration of residual governing operations of federal residual bank portfolios of newly public banks to allow the sale of portfolios to privatized provincial banks loan portfolios of liquidated stimulate future incorporated in most recent federal banks in the possession of privatizations. privatizations. federal public banks.  ANNEX E: Matrix of Policy Actions / Page 7 2. Improving SME Access to Credit Objectives Issues Main reforms to date Second Tranche Third Tranche I) Develop a competitive The current law for Submit the leasing industry. leasing, No. 24.441, revised leasing discourages the growth of law prepared by lease finance. the Under Secretary of Banks and Insurance to Congress. II) Establish a strong legal Existing laws in the Civil Submit a new framework for the use of and Commercial Code secured movable collateral (secured discourage the use of transactions law transactions) in credit contracts. movable collateral as the to Congress, primary guarantee in credit following Bank transactions. review. 3. Capital Markets Objectives Issuess Main reforms to date Second Tranche Third Tranche I) Deepen capital markets, Mutual funds are restricted Laws passed introducing private Submit an Diversity financial instruments to investments in Argentina pension funds, expanding and amendment to the and Improve portfolio and Mercosur assets, which encouraging mutual funds and Fund Law diversification for mutual prevents adequate liberalizing the insurance sector. (24.083) to funds diversification due to high Congress to correlation of returns (Law Law passed to facilitate issuance of remove 24.083) corporate bonds, commercial paper geographic and convertible debentures. restrictions on mutual fund investments II) Improve the quality and Ratings now required but Present plan (concerning ratings competitiveness of the rating rating firms are of mixed firms-as in tranche 2) and industry quality and current incentive Contract a review satisfactory progress in the structure discourages of laws and implementation of such plan, including objective ratings regulations passage of resolutions by agencies as concerning necessary-SAFJP, CNV, SSN, ratings firms Central Bank.  ANNEX E: Matrix of Policy Actions / Page 8 4. Insurance Sector Objectives Issues Main reforms to date Second Tranche Third Tranche Revise legal framework to Laws 17418 and 20091 State reinsurance company Present revised laws to Congress. allow greater competition and dealing with the insurance (INDER) closed. Laws should include the following: to introduce modem contract and prudential - adoption of solvency monitoring supervision and regulation. regulations respectively are Caja de Ahorros y Seguros (the and free-market approach; outdated. largest insurance company) - separation of life and non-life privatized business; - early-warning tests and Premium and product controls empowerment of SSN to take substituted with solvency remedial actions; monitoring. - strengthen resolution process; -establish mechanism to ensure Prohibition to entry expired. proper consumer protection. Tax on insurance premiums being reduced progressively. Standards for managers and owners, and new regulations on reserve management to limit risk investment adopted. Adoption of an early warning detection Draft laws modify existing codes system in the Superintendency of 17418 and 20091 discussed with the Insurance (SSN). Passage of necessary insurance industry. resolutions to establish this system, compliance by firms and integration of Strengthen preventive Need to improve collection early warning system in core supervision and analysis of information supervision activity. on insurance firms, so as to detect potential problems in Satisfactory enforcement of new a timely manner capital requirements. Secure adequate capitalization Inadequate minimum capital Res. No. 25.804 passed to increase Adoption of an requirement (see SSN capital requirement form $550,000 action plan by the Resolution No. 21.523) to $3 million for existing firms and SSN to enforce to $5 million for new life firms and new capital up to $10 million for new property requirements & casualty firms  ANNEX E: Matrix of Policy Actions / Page 9 C. Human Development 1. Poverty, Social Protection and Labor Objectives Issues Main reforms to date Second Tranche Third Tranche Improve the targeting and Social programs are Participating in the regional IBRD-IDB Propose a new poverty line and efficiency of various targeted using the program to improve the collection of basic methodology for a new NBI index. social programs designed NBI index, which is social statistical information, using LSMS Establish specific objectives for targeted to reduce poverty. an inexact measure of techniques. social programs poverty; there is no national poverty line. Completed first ever survey of consumption expenditures (Encuesta de Gastos) in 1996 and 1997 and the survey of social indicators and use of social programs (Encuesta Social) in 1997. The SISFAM is Implemented an information system, currently being used, SIEMPRO, to track social programs and under the norms of undertook a program of training provincial SINTyS, to identify authorities in the use of the system. beneficiaries and insure proper Convened a working group of experts to targeting in four review and revise the methodology to programs. measure poverty (Index of Unsatisfied Basic Needs and Poverty Line). Introduce SISFAM as agreed to improve Agreed to a plan and budget to extend targeting in six additional programs in the SISFAM to additional poverty targeted Secretariat of Social Development, as per programs. plan. Improve evaluation of Social programs are Completed first budgetary review of social Merge all Consolidate existing food/nutrition programs by often overlapping and public spending and complied inventory of nutrition/food programs (PRANI, ASOMA, PRO- institutionalizing public need improved social programs. programs under HUERTA, RAF) into a Integrated Food expenditure reviews. targeting on the poor. the Secretariat of Program which will target its services Completed impact evaluations of Social according to: TRABAJAR, ASOMA, PROMIN, and Development * income level, FOPAR. under a single * health or nutrition indicators management unit, TORs agreed for a review of the efficiency sharing all and internal management of programs run by administrative the Secretariat of Social Development support services  ANNEX E: Matrix of Policy Actions / Page 10 Objectives Issues Main reforms to date Second Tranche Third Tranche Ensure minimum safety Benefits of non- Pension administration improved, payments Review the Propose a new criteria for eligibility net for the elderly poor contributory pensions made in a timely fashion and minimum level distribution of non- for non-contributory pensions that need better targeting increased to $... per month. contributory pensions improves targeting to the poor. (including pensiones graciables) Maintain spending levels Budget support for Social spending, particularly for social Maintain spending Maintain spending levels for key in key social programs targeted programs security benefits, increased by 20 percent per levels for key programs (Table 1) in 1999 Budget important to the poor needs to be capita in real terms since mid-I 980s. programs (Table I) in at the level of the total 1998 Budget maintained against 1999 Budget at the of $680 million for those programs. further cuts. Introduced new targeted social protection level of the total 1998 programs, such as TRABAJAR and FOPAR, Budget of $ 680 to cope with increased unemployment and million for those social needs of the poor. programs. Implemented a targeted program of maternal and child health care, PROMIN, in 15 provinces. Agreed to a list of key programs for protection, including those in basic health, education and employment that focus on the poor and vulnerable groups ( Annex A) Improve system of Present system of Employer and employee contributions Complete a study by Propose legal instrument for the unemployment insurance severance payments (aportes), which add to non-wage labor an international replacement of severance payments and lower non-wage labor and unemployment costs, reduced in 1996. Proposal in Congress consulting firm of and introduction of a fully funded costs. insurance leads to to reduce these contributions further. various options for a capitalized unemployment insurance excessive labor costs, fully capitalized scheme. lacks portability, and New labor law adopted which, among other unemployment increases uncertainty. things, lowers severance payments for insurance scheme, workers with little tenure; however, which will eliminate severance payments remain high for workers severance payments with more years of service. and reduce labor costs, and could be based on individual accounts. Prior review of terms of reference.  ANNEX E: Matrix of Policy Actions / Page 11 2. Education Objectives Issues Main reforms to date Second Tranche Third Tranche Improve the equity and Higher education's Secondary schools decentralized to the Formulate a policy efficiency of the public share of provinces and strategy plan education investment expenditures is high on higher education in relation to that of Compulsory education increased from 7 to financing. primary and 10 years secondary education Issue a Secretarial and there is little Curricula for primary and secondary resolution directing cost recovery at that education are being modernized discretional funds level. allocated to the Increased federal funding allocated to MCyE, to the upgrade rural schools and to provide texts introduction of and pedagogical materials ($ 300 million incentives for the between 1995 and 1998) establishment of: * cost recovery Increased federal funding to accommodate for post- expansion of years of mandatory schooling graduate and ($ 400 million between 1995 and 1998). undergraduate education Standardized testing, on a sample basis, programs introduced along with a network of * scholarship continuous teacher training. programs based on merit for Introduced compensatory program of students from scholarships for poor families to retain low income disadvantaged students families. The Passed Federal law on higher education presentation of requiring accreditation and allowing a consolidated universities to recover costs for post-graduate budget of each programs. university, including all sources of revenues.  ANNEX E: Matrix of Policy Actions / Page 12 Education (cont') Improve the quality of There is no universal Universal evaluation of fifth year secondary Universal Universal evaluation of all third year higher education merit system to enter education students introduced in 1997. evaluation of all 1998/1999 polimodal students, and the university. 1998 fifth year incorporation of the respective grade in Quality of freshman secondary their secondary education certificate in very low, forcing education students the second semester of 1999. universities to organize a remedial education cycle  ANNEX E: Matrix of Policy Actions / Page 13 3. Health Objectives Issues Main reforms to date Second Tranche Third Tranche Strengthen the There are insufficient Initiated implementation of market The Superintendency of Health The SHS: regulatory framework prudential and liberalization reforms of the union System (SHS) has: * is applying the prudential and for Health Insurance consumer protection run health plans, Obras Sociales. * Implemented prudential and consumer protection norms in a norms, and consumer protection norms satisfactory manner, and insufficient Mandated a minimum package of related to: * has issued norms for crisis resolution information on Obras health care which must be provided --beneficiaries' services; related to the Obras Sociales available to by the union-run health plans. --regulation of medical (liquidations, mergers, etc) consumers programs; . publish consumer satisfaction poll. Extended the period of time when --regulation of marketing; employees could change union-run and health plans from two months to --regulation of sanctions any time during the year. and penalties; * Has issued a public report Sponsored the restructuring of ... on the basic characteristics union-run health plans, covering and performance of the workers and their families. Obras Sociales (to become an annual publication) Introduced autonomy in the * Conducted consumer financial and management areas for satisfaction polls public hospitals. Approval by the Superintendency of Health Services (the Ministry of Health, or other Ministries where appropriate) of a specific regulatory framework incorporating the rights accorded by the Constitution (art. 42), and those prescribed by the Consumer Protection Act No. 24.240 and Antitrust Law. Develop a Pensioners had Improved cost effectiveness of INSSJP will engage consultants Contracts with the out-sourced health competitive managed limited choice of INSSJP (the government's health specializing in procurement to providers to administer services care market for providers and INSSJP program for the retired) by reducing undertake technical and (entidades administradoras) have been providing health care had to manage a costs by almost $ 1 billion. financial evaluation of bids for signed and are effective. to pensioners multitude of the out-sourcing of services to individual health care major health providers and to provider contracts provide its recommendations to INSSJP's board.  ANNEX E: Matrix of Policy Actions / Page 14 Table 1: ARGENTINA SAL PROTECTED PROGRAMS - 1998 Budget Levels (mil. $) Food and Nutrition: PRANI (Prog. Alimentario Nac. Infantil) ASOMA(Apoyo Solidario a los Mayores) MATERNO INFANTIL PROMIN PROHUERTA Disease Control: CONTROL DE ENFERMEDADES CRONICAS VIGILANCIA Y CONTROL DEL COLERA PAI (vaccinations) PROG. DE CHAGAS LUSIDA (AIDS Control) EMERGENCIAS SANITARIAS Emergency Employment: TRABAJAR II Education: PSE (Plan Social Educativo) BECAS PRISE (primary education -IDB) PRODYMES II Social Fund: FOPAR Programs for Vulnerable Groups: PROG. CONSEJO MENOR Y LA FAMILIA MENORES EN CIRCUN. DIFICILES PROG. APOYO A GRUPOS VULNERABLES PROYECTO JOVEN (capacitacion-IDB)) PROINDER INAI MEJORMIENTO DE BARRIOS (IDB) TOTAL 680  ANNEX E: Matrix of Policy Actions / Page 15 D. REGULATORY REFORMS Objective Issue Main reforms to date Second tranche Third tranche Improving Rationalization Deregulation, opening up the trade Submit legislation to Congress to harmonize regulatory standards efficiency of and regime, removing barriers to of federal electricity, telecommunications, gas, water and the harmonization foreign investment, liberalizing transport agencies in order to ensure consistency of (a) infrastructure of the domestic good and capital markets. administrative procedures for approval of tariffs, sanctions and services regulatory State monopolies have been fines, collection and use of fees, treatment of non-payment; (b) entities for unbundled and privatized, sectors economic and technical standards for the analysis of tariff, cost of greater restructured and a regulatory capital, quality of regulated service and access; (c) consultation consistency and framework has been introduced in with provinces and consumer groups regarding regulatory improved most sectors. decisions; (d) processes for hearing appeals; (e) prompt performance publication of annual audited financial accounts; (f) routine and efficiency. In electricity, the sector was public disclosure of information (including information on which vertically disintegrated and 25 regulatory decisions are made); and (g) hearing and resolving business units created. consumer complaints. In telecommunications, the sector Prepare a time-bound action plan, consistent with point I above, was privatized, two monopolies to increase the autonomy and independence of these federal created with an initial exclusivity arrangement for basic services; this regulatory agencies by: (a) establishing rules for the selection of exclusivity arrangement expires in regulators, terms and protection of their tenure, and processes for 1999. Value added and cellular removing them for cause; and (b) defining their financing sources services were immediately opened Issuance by the and budgeting procedures and measures to ensure their financial to competition. A Decree has been Procurador del Tesoro de independence. issued to phase in full la Naci6n of an opinion liberalization and a new on the appropriate legal Subject to the legal opinion, submit draft legislation allowing the Telecommunications Law is being instrument allowing the executive branch no longer to hear appeals of decisions of any prepared. executive to forego the regulatory agencies, if such appeals relate to technical and In the water sector, concessioning requirement to hear analytical decisions. of the Buenos Aires water services appeals (as per the third company, and it was followed by tranche conditions). the concessioning of several other municipalities and provinces. Enhance Absence of an In the transport sector, Argentina Assessment of options Present the design and implementation plan of a federal transport integrated provided concessions in virtually and technical proposal for regulatory agency for freight transport services, which entity regulation approach to all sub-sectors - railways, ports, structure and would regulate port, airport, rail and trucking sectors under an regulation in toll roads and airports. responsibilities of an integrated framework aimed at encouraging multi-modality in the transport integrated federal agency use of transport services. services. for freight transport services.  Annex F Page I of 12 ARGENTINA SPECIAL STRUCTURAL ADJUSTMENT LOAN LEITTER OF DEVELOPMENT POLICY DEEPENING OF SOCIAL AND ECONOMIC REFORMS Mr. James D. Wolfensohn President The World Bank Washington D. C. Dear Mr. Wolfensohn: 1. This Letter of Development Policy describes the economic reform program of Argentiaa as well as spccific steps to deepen the second-generation reforms that tbc Govemment is ia the process or implemcnting during a period of unsettled intemational financial conditions. To implement these reforms under the current conditions, the Government requests financial assistance from the World Bank and the Inter-American Development Bank. We would like to takc this opportunity to also present thc macrocconomic framework that complements the reform program. I. Macroeconomic Framework 2. Seven years have passed since Argentina adopted the Convertibility Plan. This has been Argentina's most successful economic program in decades, anid its achievements, durability, and contiinued public support are a testimony to its success. Inflation, the scourge of Argentina for decades has been defeated, and economic growth during these past seven years, despite the sharp 1995 setback, averaged an annual 6.2 percent. Productivity has been increasing very fast thanks to the broad liberalization of the economy, aad the initial consLunption-lcd boom matured in recent years into a healthy pattem of investment-led and export-led growth. Whilc povcity has declined since the inception of this plan, unemployment remains an issue of concern, highlighting the need, and the Government's commitment towards continued reforms. 3. By laying the basis for price stability, the Govemment has charted En agenda for the future with the fbllowing objectives: 4.  Annex F Page 2 of 12 the consolidation of stability through strict compliance with Law 23928 of MNarch 27, 1991 (the Convertibility Law), the prescrvation of fscal restraint, the operation of a competi6tic market economy, and regulation by the state of non-competitive markets; * the strengthening of economic growth trough increased levels of savings, investment, productivity, privatization of public enterprises, private sector development and exports as well as intensirication of trade, financial and technological integration of the Argentine economy with world markcts and, $ the achievement of higher levels of employment and a more equitable distribution of income, both at a personal and regional basis, through consolidation of economic stability and growth, increased public investment in human resource developnient aLnd social serviccs, and measures to promote regional development. 4. 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 domcstic regulations and of major external trade barriers, and with a strong financial sector to improve intermediatiorL The Government's program of market reforrns covers the following areas: * Competitivc Market Economy: The Government has eliminated controls on prices, wages, interest rates, and capital flows as well as a complex nctwork of subsidies and implicit taxes. The Govcmment is committed to maintain such policics. Thirough its privatization program, the Governmient has successfully withdrawni from direct involvcment in economic production that had reduced the country's growth potential. Leaving this role to the private sector, the govenment can now focus on a more clearly defined role, in terms of enhancing the regulatory environment for private sector development, providing thc basic requirements of the social safety net, assuring improved quality of human capital development, and providing assistance to provincial and municipal govemmclts in the reform of the sub-national public sector. * Trade Liberalization: The Government has made rapid strides towards opening thc economy to trade, capital and technology. The import taxiff structure has been simplified and the average tariffrate was lowered to approximately 8 percent. Export taxes have been nearly climinated, and most quantitative restrictions and othcr procedures that slowed the entry of imporLs, capital and technology have been removed. The Goverunent will keep the economy open to international competition and its antidumping provisions  Annex F Page 3 of 12 wiU be administered in line with the WTO/GATT code. Moreover, the MERCOSUR treaty came into full effect in January 1995. As specified in the Treaty of Asunci6n. the Government eliminated most intra-MERCOSUR tariffs, and established a common external tariff covering 85 percent of thc positions in January 1995. Financial Sector Reform: Financial sector reforns have been aimed at increasing financial deepening and the efficiency of fimancial intermediation. Following interest rate liberalization and the elimination of directed credit by the Central Bank, the Government's strategy has been to increase depositor and investor confidence under the Convertibility Law. Pricc stabilization, liberalized interest rates and tighter regulation and enforcement of liquidity, capital adequacy and provisioning requirements were the chief refonns that permitted financial deepening. Similarly, capital nmarket reforms including the elimination of transaction taxes on securities trading and improvenments in the regulation of public offerings, encouraged the developmcnt of a major emerging market. In recent years, the authorities took sign"ficant mcasures to facilitate, tbrough the establishment of two Fiduciary Funds, the restructuring of provincial and private banks affected by the 1995 crisis. nITc result has been the privatization of over a dozen public banks and a significant consolidation and strcngthening of the banking system. The Government is committed to maintain liberalized interest rates and to refrain from directing credit allocation of financial institutions. It is also committed to continue strengthening ban}king supervision, and deepeniing capital markets. 5. Since the financial crisis of 1994/95, the Governmnent's objective has been to sustain past achievements by deepening refoTns in the public and financial sectors. These measures arc aimed at reducing country risk by strengthcning Convertibility. The following sections discuss these reforms as well as upconing steps of the economic program. II. The Reform Agenda 6. Thc Government's program for 1999 is to maintain and deepen structural reforms. The Argentine experience so far contains mostly the so-called '"first generation reforms". The reform strategy in Argentina has centered in changing macroeconomic rules, reducing the size and drastically narrowing the scope of the state by dismantling institutions that promoted protectionism and statism. Privatization of state assets has been far-reaching, and far more successfull than expected. However, the task of enhancing the institutional capacity of the state and  Annex F Page 4 of 12 limiting its scope of intervention is not finished as we are still faced with the difficult task of creating or rehabilitating indispensable public sector institutions. 7. This new stage of reforms shifts priorities to the consolidation of macroeconomic stability, sustaining high rates of growlh, and the challenge of poverty reduction. Following a dramatic decline in poverty in the first years of the Convertibility Plan, it started rising agan in 1994 mainly for two reasons: the lack of flexibility in the labor markets to absorb the reallocation of resources set off by reforms, and the recession following the "tequila crisis". Both factors contributed to a growth in unemployment, which peaked at 18.4 percent in May 1995 (reduced to 16.1 percent in May 1997, with the onset of economic recovery, and currently at 13.2 percent). 8. The challenge of poverty reduction in the context of a stable and growing economy is the priority that drives the reform agenda for the next several years. This agenda, comprises the following four broad policy areas: (a) Quality Investment in Human Capital (b) Efficienr Financial Markets (c) Enhanced Regulatory Environment (d) Quality Public Administration, and Fiscal Strengthening 9. Clearly, the above areas are closely interconnected. Both the reduction in poverty, which is the first priority of the Argentine Government and economic growth would benefit from, or more likely critically depend on, reforms in the above areas. Furthermore, it is essenttial to maintain the gains achieved under what we called first generation reforms. Ultimately, the above categories of refomi can be secn as instruments for achieving the primary goal of higher sustainable growth and poverty reduction. 10. The goverment is committed to pursuing this agenda of second-generation reforms. Below, more details are provided for each of the general categories of reform. (A) QUALITY INVESTMENT IN HUMAN CAPITAL 11. The success of the govemment's economic program led to a sharp reduction in poverty levels during thc early 1990s. Infant mortality rates and adult iUiteracy are  Annex F Page 5 of 12 well below the average for upper-middle-income countries, while life expectancy and school enrollment rates (at all levels of education) are above average for upper- middle-income countries. Despite these achievcments, thc fight against poverty and the challcnge of improving the distribution of income continue to be important development goals. Argentina has an extensive system of social programs including health care, housing, nuLrition and education that are available without charge. In this context, this loan will support Govemment actions to improve the targeting of social programs for the poor, and increase the efficiency of existing programs in education, health and nutrition including the following specific steps: ) The Govemment will develop a national poverty line standard of measurement and a poverty map; >r The Government will review and revise its social sector spending, and undertake to improve the efficiency of overlapping and poorly targeted programs; > The Government will identify key programs in health, education and social development that particularly impact on the poor and vulnerable groups including basic education, maternal and child health care, vaccination programs, and emergency employnent programs. These programs will be protected from budget cutbacks relative to the amounts allocated in the CY98 budget. )' The Government will continue to work with provincial authorities to provide assistance in improving the qualily and efficiency of primary and secondary education programs (a provincial area of responsibility); > The Govemrnment will address the problem of cost-recovery in public tertiary education, and incentives will be put in place that will encourage the collection of fees from students who can pay, and establish scholarships for those who camnot; > The Government will continue to provide temporary employment to workers who have not yct found a place in the newly re-structured economy, through the TRABAJAR program, which provides funds for local projects of public works in high poverty areas throughout the country; ) The Governmcnt will continue in its reform of the health care financing system. To date, the health insurance market has bcen partially liberalized, and a comprehensive regulatory framework has been introduced; a redistribution fund has been established to compensate existing health plans for the costs of insuring workers with lower incomes, and the Governient's health progranm for the retircd, the INNSJP, has been restruclured and refinanced to increase its internal  Annex F Page 6 of 12 efficiency, improve equity, and put the system on a sound financial footing. Under the present operation, the Govemment will undertake a number of "second generation" reforms in thc health sector, designed to deepen and extend the past reforms. Ini addition, the Government will continue to provide support to thc provinces in their efforts to improve provincial health services. (B) EFFICIENT FINANCIAL MARKETS 12. Priority Issues for Reom _ in the Financial Sector. The government's policy of opening up financial markets to competition, along with prudent regu latory practices has resulted in significant progress in financial sector dcvelcpment since the beginning of thc Convertibility Plan. Financial institutions have adapted their policies and products to a low-inflation environment, and the sector is an active participant in global financial markets. The banking sector was strengthened, especially in thc aftlermath of the Tequila Crisis in 1994/95. The Goven,mcnt recognizes, however, that capital market development has becn less profound. In terms of institutional investors, the Govemment is committed to resolving important issues regarding insurance, pension and mutual fund companies. Additional reforms are also needed to improve access to crodit for small borrowcrs, especially for small businesses. Thcre arc also important institutional issucs to address for the sector as a whole, including thc need for coordination aniong financial market regulators and a tax policy that does not discriminate against certain financial instrumcnits. 13. The Government views the Special Structural Adjustment Loan as an opportunity to address sonme of the mnost pressing institutional and legal ihpediiiments to the developm1ent of a sound and robust financial system. The actions to be taken are focused in the following areas: banking reform; strengthening institutional investors (insurance, pension funds, mutual funds); SME access to credit (lease finance and secured transactions); and improved regulatory and tax policy coordination. > In an international comparison of regulation of various banking systems in Latin America and East Asia, Singapore, Argentina, and Hong Kong stand out as having thc strongest banking regulations. Across virtually all categorics, Argentina dominates the East Asian countries that have been beset by financial crises. Thus, whereas no banking system is evcr immune to sufficiently large shocks, the Argentinc regulatory system appears to be among the most robust, as it needs to comply with the constraints imposed by Convertibility Law. To furthcr strengthen the supervisory process, the Government is committed to: (a) improve failure resolution mcchanisms; (b) pass legislation protecting officials in the exercise of thcir public duties, to facilitate the restructuring of the banking  Annex F Page 7 of 12 system; (c) subject publicly owned banks to the same supervisory rigor and regulatory cnforcement as private banks and, (d) strengthen guidelines for proper bank govemance, affecting owners, management, and outside directors. > Institutional investors. The Government initiated a modemization program for the insurance industry in thc first half of the 1990s, which resulted in thie closure of the state reinsurance company (INDER), the privatizatioii of thc Caja de Ahorros y Seguros (the largest insurance company), and the substitution of premium and product controls with solvency monitoring. Despite these advances, the industry has not reached its full potential. The supervision of insuranice finns will be strengthencd to ensure that regulators have access to timcly and accurate information as well as the capability to enforce prudential regullations. The mutual fund industry has grown rapidly in Argentina since the Tequila crisis; however, a number of issues will be addressed, so as to improve the efficiency of this market segment. The current compulsory rating requirement creates captive marker for the rating agencies and significantly adds to the cost of accessing the capital markets. This system will be dropped, so that these services arc contracted based on their merit and the value-added they provide to potential investors in evaluating new securities. In addition, geographic restrictions on mutual fund overseas investments will be removcd, allowing thosc companies to further diversify their investments. > Another weakness in the financial sector which the Government is committed to address, is SME access to credit. The medium and small businesses have yet to fully benefit from liberalization of the financial sector. Factors responsible for consistently high interest rates and lirnited availability of credit for SMEs include a weak credit culture and legal and institutional constraints. The GovernmenL will advancc in legislation to provide for better means of secured transactions for SMEs, as well as removing legal and tax impediments to the development of the leasing industry. > The Government is cornmitted to moving towards neutrality in the impact of tax policies on financial instrumeints, so that market forces arc driving the financial marketplace and not arbitrary tax rules. A comprehensive study will bc conducted to review the tax treatment of financial intermediaries and instruments, and recommend changcs to the tax law to introduce greater neutrality. The tax treatment of leasing is also slowing development of the indusiry. The main tax issue concems the differential inmpact of value-added tax (IVA) on leasing when performcd by leasing companies vs. commercial banks. This tax disincentive will be addressed in the reform program.  Annex F Page 8 of 12 14. The Contingent'!Repo" Fgilitv. Although the Tequila Crisis had its short- term costs, the Government used the crisis as an opportunity to accelerate rcforms in the fimancial sector, contributing to the emergence of a system that is more resilien lo extemal shocks. As a result, despite unease in the early stages of the more recent Asian crisis, the resolve and measures introduced by the nmonetay authorities since the Tequila Crisis (e.g. in staying with the Convertibility Plan, and allowing banks to fail), contributed to an early recovery of confidence in the banking system. 15. Banking regulation and supervision help linit the possibility of extensive loss on bank deposits. Importantly, the authoritics have made their capital and reserve rcquirements risk-sensilive- Argentina's banking system still remains somewhat exposed to the negative influence of external shocks, as occurred in 1995, duLe to the limitations inherent in a currency-board monetary system. As a result, the Central Baink nioved ahead in implementing an iniovative contingent financing arrangement with private commercial banks, described below. 16. To guard against a repeat of the 1995 tequila crisis where credit to SMEs was severely curtailed generating an important effect on economic activity and a disproportionate negative effect on employment and poverty levels, the Central Baink has adopted a liquidity policy for the financial system. This policy consists of two main instruments: liquidity requirements for commercial banks, and the Conitingent Liquidity Facility (the repo facility). This facility gives the Central Bauk (BCRAb), the option to sell dollar-denominated govemment bonds to international baliks subject io a buy-back clause (with an embedded implicit interest rate). In June 1998, the repo was written on bonds ($6.2 bn., 13 banks) and mortgages (S500 m., I bank) with a repo on loans to provinces under negotiation (letter of intent signed). The target is to maintain a repo facility approximately equivalent to 10 percent of the deposit base of the banking system. 17. The Central Bank intends to transfer the state-contingent profits from exercising the facility to the commercial banks facing the liquidity crisis, whiclh in turn would presumably use the funds to pay deposit witbdrawals. Banks would transfer the underlying securities involved in the repo to the BCRA as collateral for the loans offcred, and the funds lent by the BCRA would be those received from the exercise of its options. Thus, the facility pemits the BCRA to engage in discount lending effectively, without "creating money" - the facility permits the BCRA to act as a lender of last resort without violating its current implicit comrnitnient to maintain a 100 percent reserves against its liabilities.  Annex F Page 9 of 12 18. Part of the idea of the facility, of course, is that having it in place reduces the likelihood that it will be necessary. That is, the probability that depositors will run banks is reduced by the presence of the facility. (C) ENHANCED REGULATORY ENVIRONMENT 19. Argentina's profound structural adjustment program implied significant reforms aimed at introducing efrective conmpetition in the domestic market such as opening up its trade regime, removing barriers to foreign investment, liberalizing domestic goods and capital markets, and broadly deregulating its economy. In its quest for greater efficiency and restructuring the role of the statc, Argentina has also becn one of the forerunners in introducing competition and private participation in infrastructure services through outright privatization and concession contracts in all infastructure subsectors. Since 1989, virtually all major infrastructure sectors such as telecommunications, electricity, gas, ports, railroads, toll roads, airports arnd water have been affected. State monopolies have been unbundled and dismantled and privatized, sectors have been restructured. A regulatory framework has been introduced in most of the subsectors, all with the objective to promote entry, competition and efficiency in delivery of services. In eiectricity for example, the sector was unbundled between generation, transmission and distibution and twenty five business units created to introduce competition in the market. ln telecommunlications, the sector was completely privatized with an initial exclusivity arrangcment now set to expire in 1999, after which the market will be opened to new operators. A new Telecommunications Law to establish the framcwork for this is now being prepared. Argentina also provided sweeping concessions in virtually all transport sectors in railways, ports, toll roads and airports. In the watcr sector, again, Argentina was one of the pioncers with the concessioning of the Buenos Aires water services company and it was followed by the concessioning of several municipalities in the provinces. 20. In the eight years since Argentina began these reforms, much has been achieved, but equally, some issues have now emerged that must be addressed for the continued improvement in the growth and efficiency in the provision of infrastructure services. These include the improvement of the regulatory framework (establishing autonomy of regulatory agencies from the cxecutive branch), introduction of a Competition Law and an institutional framework to implement it, and the need of a systemn for speedy and efficient resolution of disputes among concessionaires anid the Govemment and/or the rcgulatory agency. The Govenmment is committed to develop legislation to address these issues, in particular, establisbing a specialized tribunal for  Annex F Page 10 of 12 the resolution of conflicts amongst concessionaires and the Government and/or regulatory agencies. (D) QUALITY PUBuIC ADMINUSTRATION, AND FISCAL STRENGTHENING 21. The Goverwnent will build upon the progress made in earlier programs to reform the state sector, rationalizing its administrative structure and improving the efficiency of the civil scrvice. The Govcmment is committed to advancing further in these reforms and in continuing to improve transparency. > Public Exoenditure Review and Medium-Term Expenditure Framework. To improve the predictability of resource-availability, the strategic allocation of rcsources amorng priorities, and the efficiency of resource use, the government is committed to conducting a public expenditurc review and to move fuirthcr towards applying concepts of a medium-term expenditure framework (MTEF) and performance-oriented management. The public expendirure review would focus on strategic issues in re-aligning the public administration to the changing role of the government in Arge-ntina. An MTEF involves top-down, multi-year budget planning, and bottom-up policy planning. tansparency, In recent years, the Government has advanced in improving the quality of fiscal and economic data, as well as its dissemination, via publications and in the intemet. An additional measure included in the plan of work is an accounting of "tax expenditures" - the tax exeniptions granted to private companies on a sectoral or regional basis. > Law of FiscalRaenonsibilitv. The Government is also developing a new law for assuring fiscal discipline by the federal govemnncnt, setting limits on public indebtedness. Thc Government has shown its commitment to meeting IMF fiscal targcts during 1998, and the proposed budget for 1999 includcs CUts of approximately US$ I billion, compared to 1998. In addition, to help achieve these goals, the Government is ncgotiating a new collectivc bargaining agreement with public employees to provide more flexibility to labor relations in the public sector. Other measures to improve the efficiency of public expenditures were mentioned in the human development section above. ? Provincial govemen Provincial governments, through their now-dominant role in the provision of educational, health, and welfare services, account for alrnost  Annex F Page 11 of 12 haLf of total public expenditure in Argentina. They have gencrally lagged behind central government in fiscal performance and adjustment of their public sectors. But thcre is now a strong wave of reform, if at different speeds in different provinces. This has been demonstrated through recent reforms in the fiscal, privatiz.tion, deregulation, and pcnsion areas. Since 1996 the ccntral govertunment has promoted this process by cencouraging civil service refomi, fiscal and debt- management reform, aad greater efficiency and equity in public spending. * Federal tax reform. Congress is considering legislation that would: (1) lower employer payroll contributions; (2) broaden the value-added tax to include magazines, cable television, and private health care services; (3) chiange the corporate income tax, so that its base includcs distnbuted profits, worldwide rents and export tax refunds; limit deductibility of interest costs; and introduce a tax on firms' assets - to function as a minimum tax. Reform of intergoveenmental fiscal relations. The current system of "coparticipation", as it is known in Argentina, is a complex mix of one large revenue-sharing pool and R series of tax-sharing programs. Total budgetary transfers to the provinces were SI 8.2 billion in 1997, just under 6 percent of GDP, and financing about 56 percent of total provincial government expenditures. The distribution of the general revenue-sharing fund is according to percentages that were fixed in place by a 1988 law. Some of the sectoral programs follow fairly reasonablc need-based criteria, while others do not. The final result is a large diversity in revenucs per capita -- a five-fold difference in reveinues per capita for the highest and lowest provinces. This dispersion is difficult to justify in temis of needs and/or cost differentials. Three problems that necd to be addressed in the reform of intergovernmental fiscal relations arc: (1) simplificationi of the complicated multiple tax-sharing/revenue-sharing system and consolidation of the programs into one fund, to improve transparency; (2) introduction of a more rational formula for distributing thcse resources across provinces; and (3) increase the degree of correspondence between the provincial tax payer and the provincial services he/she receives. The latter would involve some form of decentralization of tax powcrs, either through more provincially administered taxes, or provincial surcharges on federally collected taxes. > Provincial TaxReforM. An additional long-standing problem in provincial finance in Argentina has been the search for a substitute for the distortionazy provincial "gross receipts" (tumover) tax. This tax is multi-stage sales tax that accumulates ("cascades') across the stages of production, since unlike the value- added tax, there is no crediting for tax paid on the purchase of inputs. The  Annex F Page 12 of 12 Government has been exploring the possibility of a provincial VAT surcharge as a substitute for thc gross receipts tax. Later, it also could be used as an instrumeint for furEher tax decentralization (where the federal govenmuent would make tax room by reducing its VAT rate, the provinces would increase their rate (if they wish) in exchange for reduced points of coparticipation). V. World Bank and Inter-American Bank Support 22. The above presentation demonstrates the depth of the Goverranent's ovcrall economic rcform program. Financial assistance from the World Bank and the Inter- Amcrican Development Bank is essential to allow thc Government to remain focussed on its reform agenda, and to continue to strcngthen the quality of core govermnmert functions in the social, financial and regulatory sectors. Sincerely yours, BUENOS AIPES, rloverib-er, 02 1990. Dr. ROXUJ##41 N EZ M- JS * S PUI..dCO IWIA;S Y SLAV iPUL;  Annex G Argentina at a glance Pag9/6198of 2 Latin Upper- POVERTY and SOCIAL America middle- Argentina & Carib. Income Developmwnt dlamond 1997 Population, mid-year (mRlsons) 35.2 494 571 Life expectancy GNP per capita (Atlas method, US$) 8,570 3,880 4,520 GNP (Atlas method, US$ billions) 302.0 1,917 2,584 Average annual growth, 1991-97 Population (%) 1.1 1.7 1.5 GNP Gross Labor force (%) 1.9 2.3 1.9 p Gro per primary Most recent estimate (latest year available, 1991-97) capita enrollment Poverty (% of population below nationel poverty fine) 26 Urban population (% of total population) 88 74 73 Life expectancy at birth (years) 73 70 70 Infant mortality (per 1,000 live births) 22 32 30 Child malnutrition (% of children under 5) 2 Access to safe water Access to safe water (% of population) 64 73 79 Illiteracy (% of population age 15+) 4 13 15 Gross primary enrollment (% of schoor-age population) 107 111 107 -Argenina Male Upper-middle-inc group Female KEY ECONOMIC RATIOS and LONG-TERM TRENDS 1978 1986 1996 1997 Economic ratUoa GOP (USS bilions) 51.2 110.9 298.7 322.7 Gross domestc investment/GOP 30.7 17.5 18.5 18.9 Trade Exports of goods and services/GDP 9.2 8.2 8.9 8.7 Gross domestic savings/GDP 34.0 19.3 18.1 18.2 Gross national savings/GDP 34.1 14.8 16.5 16.4 Current account balance/GDP 1.3 -2.6 -1.3 -2.9 Domestic - _ Interest payments/GDP 0.9 3.3 1.9 2.0 Savings Investment Total debt/GDP 18.1 47.3 32.4 32.4 \vn Total debt service/exports 34.4 82.8 47.2 49.3 / Present value of debt/GDP 29.5 Present value of debt/exports 277.7 Indebtedness 19764t6 1987-97 1996 1997 1998-02 (average annual growth) GDP 0.6 3.8 4.8 8.6 4.0 -A rgenlina GNP per capita -1.9 2.9 3.7 7.1 3.1 Upper-middle-income group Exports of goods and services 2.8 8.5 6.7 9.1 6.5 STRUCTURE of the ECONOMYW 1976 1986 1996 1997 Growthratoaofoutputandlnvewtment(%) (% of GDP) Agriculture 8.2 7.8 7.7 7.3 Industry 50.9 37.4 35.5 36.4 20 . Manufacturing 39.1 27.4 24.7 24.8 Services 41.0 54.8 56.8 56.3 0 I92 93 94f 98r 97 Private consumption 56.6 20 -.9.. .29 General government consumption 9.4 i GDl GDP Imports of goods and services 5.9 6.3 9.2 9.4 1976486 1987-97 1996 1997 Growth rates of exports and Imports %) (average annusl growmth) Agriculture 1.2 2.8 3.0 3.3 100 Industry -1.5 3.5 5.0 11.2 so Manufacturing -1.3 3.0 5.3 9.2 so Services 2.1 4.1 4.9 7.7 40 Private consumption 20 .. General govemment consumption o 9 9 Gross domestic investment -4.8 7.5 8.8 26.5 -20 - 2 93 94 93 97 Imports of goods and services 1.1 19.5 18.2 27.1 Exports --.Imports Gross national product -0.4 4.2 4.6 8.1 Note: 1997 data are preliminary estimates. The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete.  Annex G Page 2 of 2 Argentina PRICES and GOVERNMENT FINANCE 176 1916 166 1197 InftIon (%) Donmsdcpdc 20 (% change) 200 Consumer prices .. .. 0.2 0.S ts Implicit GOP deflator 433.3 75.7 1.5 -05 10. Govenmnt finance 50 (% of GDP, includes currewt grants) o Current revenue .. .. 15.4 16.7 -- 92 93 94 95 g 97 Current budget balance .. .. -0.8 -0.4 -GDP de