Argentina - Country assistance strategy progress report

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 22049-AR MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT AND THE INTERNATIONAL FINANCE CORPORATION TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT OF THE WORLD BANK GROUP FOR THE ARGENTINE REPUBLIC June 25, 2001 Argentina, Chile, Paraguay and Uruguay Country 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.  The last Country Assistance Strate(y for Argentina was discussed by the Executive Directors on June 27, 2000 (Report No. 20354-AR, dated September 8, 2000). CURRENCY AND EQUIVALENTS Currency Unit: Argentina Peso (Arg.$) ARG$1= US$1 WEIGHTS AND MEASURES Metric System FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS AAA Non-Lending Services AFIP Federal Tax Authority AGN National Extemal Audit Agency ANSES National Social Security Agency APL Adaptable Program Loan CFAA Country Financial Accountability Assessment DNPOIC Directorate for Externally Financed Projects ESW Economic and Sector Work FOPAR Social Development Fund Project FSAP Financial Sector Assessment Program ICR Implementation Completion Report IDB Inter-American Development Bank IDF Institutional Development Fund IMF International Monetary Fund LIL Learning and Innovation Loan LUSIDA AIDS/STD Control Project MECOVI Regional Program to Improve Poverty Measurement MERCOSUR Southern Cone Common Market WB Managers and Staff Responsible for this CAS Vice President Mr. David de Ferranti Country Director Ms. Myrna Alexander Lead Economist Mr. Paul Levy Country Economist Mr. David Rosenblatt Task Manager/Country Officer Mr. Mark Hagerstrom IFC Managers and Staff Responsible for this CAS Vice President, Investment Operations Mr. Assaad Jabre LAC Director Mr. Karl Voltaire Task Manager/Chief Mr. Toshiya Masuoka  FOR OFFICLIL USE ONLY NAFTA North American Free Trade Area NGO Non-Governmental Organization OECD Organization of Economic Cooperation and Development OED Operations Evaluation Department PAMI National Retired Persons Medical Insurance PDP Provincial Development Project PER Public Expenditure Review PHRD Program for Human Resource Development PRESSAL Provincial Health Sector Development Project PRL Provincial Reform Loan PRODYMES Secondary Education Project PROFAM Family Capacity Building Project PROMIN Maternal and Child Health and Nutrition Project PROSAP Provincial Agricultural Development Project PROINDER Small Farner Development Project PSAL Programmatic Structural Adjustment Loan SDR Special Drawing Rights SIEMPRO Poverty Monitoring and Analysis Unit SfNTyS National Tax and Social Identification Project SME Small and Medium Size Enterprises TRABAJAR Public W'orks Employment Scheme UNDP United Nations Development Program VAT Value Added Tax VIGIA Public Health Surveillance and Disease Control Project Y2K Year 2000 Project This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.   THE ARGENTINE REPUBLIC COUNTRY ASSISTANCE STRATEGY PROGRESS REPORT TABLE OF CONTENTS EXECUTIVE SUMMARY iii - vi A. INTRODUCTION I B. ECONOMIC AND SOCIAL PERFORMANCE 1 Background 1 Recent Economic Perforrnance 2 Social Concerns 5 C. RESPONDING TO THE CHALLENGE 6 The Reform Agenda 6 Renewing the Effort 6 Sources of Growth and Prospects 9 International Support 11 D. PROGRESS IN ACHIEVING CAS OBJECTIVES 12 Social Development 12 Provincial Reform and Development 15 Sustainable Growth 16 Overall Program Monitoring 18 Portfolio Performance 19 Lending/Investments/Guarantees/Non-Lending 22 E. FUTURE OUTLOOK AND RISKS 27 Solvency, Growth and Poverty Reduction 27 Alternative Scenarios 28 Risks and Risk Mitigation 28 i  TABLES Table I Fiscal performance at Federal and Provincial Levels Table 2 Monitoring the Progress Table 3 Program Triggers FIGURES Figure I Inter-annual GDP Growth Rates - 1998-1 to 2000-1 ANNEXES Annex Al Key Economic & Program Indicators - Change from Last CAS Annex A2 Country At a Glance Annex B2 Selected Indicators of Bank Portfolio Performance and Management Annex B3 Bank Group Program Summary Annex B3 IFC and MIGA Program Annex B4 Summary of Non-Lending Services Annex B6 Key Economic Indicators Annex B7 Key Exposure Indicators/Supplementary Table Annex B8 IBRD Operations Portfolio Annex B8 Statement of IFC's Held and Disbursed Portfolio Annex B9 CAS Program Matrix MAP IBRD 29348 ii  Argentine Republic Country Assistance Strategy Progress Report FYO1 Executive Summary 1. The Joint IBRD-IFC Country Assistance Strategy, covering FY 01-04, was considered by the Board in June 2000 when the new administration had recently taken office. The country was facing an economic dowvnturn which began in late 1998, resulting in increased unemployment, deteriorating social indicators andfiscal accounts. Initial expectations were that the economy would benefit from the vigor of the new administration and a more positive external environment. However, that was not to be the case: Argentina remains in the midst of a three year recession and is confronted with problems of competitiveness, fiscal vulnerability and uncertainty, along with the related social consequences. Development Chlallenges 2. Although there has been progress in meeting development objectives, the inability to return to a growth path that saw the economy expand by an average of 4.8 percent per year during the 1990s is undermining achievements in social development and exacerbating poverty. The economy shrank by 3.4 percent in 1999 followed by a drop of 0.5 percent in 2000. Only now are there some signs of recovery. Over the past three years, Argentina has been hit by a series of external shocks: the Asia crisis (1997), the Russian default (1998), the Brazilian devaluation (1999), the US dollar appreciation and low commodity prices. While the corporate sector in general has been weathering the recession with its traditionally conservative balance sheet, economic uncertainty, reflected in the lack of domestic credit expansion, has affected new investment. Small and medium size firms, the main source of employment and largely oriented to the domestic market, have been particularly negatively affected Since the path by which the economy reacts to shocks is constrained under the Convertibility Plan, there are few options: fiscal policy constitutes the main instrument at the Government's disposal, with the economy responding through changes in prices, wages and employment. The key to restoring growth rests with measures to increase productivity, reduce the fiscal drain on the economy and restore investor and consumer confidence. 3. In late 2000, in reaction to deteriorating access to international capital markets and continuing lack of growth, the Government initiated a new set of economic reforms to strengthen its fiscal position, including that of provincial governments. To provide a financing cushion and to bolster confidence, the Government negotiated a package of international financial support of $39.7 billion, with about halffrom the private sector. The package also included an augmented stand-by arrangement of $13. 7 billion with the Fund. In the case of the Bank, this includes already planned lending under the FYOJ-04 CAS, with up to $900 million in quick-disbursing programmatic lending comprised of $400 million shifted within the base case, plus $500 million subject to triggering of the high case as outlined in the CAS. The announcement of the international package provided immediate relief into 2001, as country risk and interest rates fell. However, this iii  provides breathing room only. Once again, fiscal performance in the first three months of 2001 did not meet expectations. The Minister of Economy resigned in early March 2001 and a newt economic team was brought in. By mid-March, this economic team too was replaced. Country risk spreads jumped once again, and the urgency in addressing Argentina's economic difficulties mounted 4. The new team is headed by Minister of Economy, Domingo Cavallo, previously Minister during the 1991-1996 period and the architect of the Convertibility Plan. Minister Cavallo has put in place an economic recovery strategy based on three pillars: (a) strengthening political cohesion and support for reform; (b) securing financing to dispel risks of default; and (c) promoting economic policies that address fundamental fiscal and economic growth challenges. Congress granted the Executive Branch special powers to enact economic measures by decree. A debt swap was implemented to lower debt service obligations over the next five years, with much of the savings accruing during the next eighteen months. To stimulate growth, a number of sectoral agreements were reached to lower fiscal and regulatory impacts on external competitiveness. In addition, the Government has embarked on a concerted effort to strengthen tax administration, and improve key social services to address better the needs of the poor and to reinforce investment in human capital. At the same time, provincial governments will continue to accompany the Federal Government in reducing fiscal deficits. The main elements of this new program, supported by Congress, have been agreed with the International Monetary Fund and endorsed by the Fund's Board Recently, additional complementary measures were announced, aiming to: (a) increase competitiveness through a trade compensatory system offiscal incentives and disincentives; (b) stimulate consumption and growth through the reduction of income taxes to low and medium- income persons; and (c) improve the collection ofpast-due taxes and reduce evasion. 5. These measures greatly improve the outlook for the remainder of 2001 and for 2002, with growth expected to recover in the later half of 2001. Nevertheless, the situation in Argentina remains fragile with country risk perceptions still above their pre- crisis levels. It is apparent that the international capital markets have reached the limit of their financing of Argentina 's fiscal deficits. Thus, the challenge remains to restore growth and establish afiscal equilibrium. Progress in CAS Implementation 6. Looking back at the past year, the long recession set back progress towards realizing Argentina's long-term development goals. This is particularly evident in poverty levels, which have most likely deteriorated, as the incidence of poverty is highly dependent on growth. Nevertheless, there has been progress on many fronts during the year, as discussed in this report, even if there is still a long way to go to complete the development agenda set out for the Bank's collaboration with Argentina. Despite the setbacks, the goals set out in the last CAS remain valid and the strategy appropriate, focusing on consolidating structural reforms, enhancing social development, strengthening social services and social safety nets, and improving public sector capacities, including sub-national governments. In fact, the recession and increasing social problems validate these priorities and reinforce the need to address underlying iv  structural deficiencies. At the same time, persistently high tnemployment reinforces the need for the Government to continue its strategy of increasing competitiveness, wt ith IDB and Bank support, andfor the IFC to continue to focus on improving access to investment financing for companies that generate growith and emnployment, and activities that demonstrate tangible benefits of growth and reform. 7. During FY01, the mainstay of the Bank's lending program was support to the provinces for reform of social services and fiscal management, as the cornerstone for improvements to the quality, equity and efficiency of health and education services at the same time as reinforcing fiscal responsibility. The program also included pilot efforts in sustainable fisheries management, indigenous peoples andfamily capacity building, and support for secondary education at the provincial level. These programs conform to the priorities identified in the current CAS, albeit at lower levels than originally anticipated 8. Performance of the Bank 's portfolio, with 45 active loans, $4.5 billion in commitments and $2.5 billion undisbursed, has deteriorated but remains strong. The deterioration is largely due to the constraints on indebtedness and counterpart funding, offset by determined action by the current administration to manage actively the portfolio. Delays have also been associated with the change in administration, the establishment of new structures, and the time needed to reformulate project teams and determine new priorities. At present, 10 percent of the portfolio is considered as unsatisfactory and 12 percent at risk. At the same time, the track record on achieving project objectives shows that development effectiveness of the portfolio remains high. 9. Reflecting the prolonged recession and the fact that IFC investments in Argentina continue to be in 'frontier" sectors, the overall quality of IFC's portfolio has somewhat decreased but remained acceptable. As of March 31, 2001, 9.5 percent of the loan portfolio was in non-accrual status and interest rate collection was 89.8 percent (compared with 7.4 percent and 91.9 percent, respectively, at the time of the CAS). 10. Looking to the coming year, the main shift in the proposed Bank program, as anticipated in the informal Board briefings in late 2000, is the inclusion of a proposed programmatic loan to support the Government 's intensified effort to consolidate structural reforms and to enhance social policies. This follows the agenda laid out in the CAS for the high case lending scenario, and will likely consist of a combination of poverty focused reforms in the social sectors, pension system, health insurance, plus federal-provincialfiscal relations and modernization of the state. In addition, because of the need to continue to support poverty alleviation, the plan is to extend Bank support to the temporary public works program (TRABAJAR). The Bank will also consider ways to support Argentina's competitiveness, especially in the infrastructure. The proposed lending program has been adjusted to reflect progress in specific sectors and on-going implementation. With these adjustments, the total program for FY 02 stands at about $1.0-1.5 billion depending on project preparation and on whether triggers for the high case lending scenario are met. 11. With regard to IFC, in FYO, the focus has been in the area of domestic financial market development, SME financing through financial and other intermediaries, v  education, provincial infrastructure, and housing finance. IFC will continue to focus on these and other priority sectors specified in the CAS, namely middle-sized companies that have impact on growvth and job creation but currently lacking access to long-term financing, and credit enhancement structuredfinance. 12. In terms of analytical/advisory work, the programi is on track and builds on wvork done for the CAS-- the FYOO Poverty Assessment and the Government's 1999 Public Social Expenditure Review. Additional work is planned on Argentina 's fiscal and debt sustainability, sources of economic growth and trade relations. Tracking of provincial finances remains an essential part of our analytical wvork. Studies of different dimensions of social development have been completed and work on transport-infrastructure, rural infrastructure, SMEs, and municipal finance and services is underway, building our knowledge for future operations and policy advice to remove bottlenecks to growth and improving services, especially for the poor. A joint Bank-Fund assessment of the financial sector is also underway. Fiduciary aspects are being addressed in updates of the Country Financial Accountability and Procurement Assessments. Prospects and Risks 13. Argentina continues to face a difficult economic and social situation with its options limited by the Convertibility plan and the country's willingness and ability to tolerate the costs of transition. The prevailing policy stance gives major wveight to stimulating economic activity which should have a positive impact on employment and poverty reduction. The reluctance of the capital markets to continue to finance the fiscal deficit, however, reinforces the imperative of closing the fiscal gap. The economic and social consequences of a failed economic program, on top of already high levels of poverty and unemployment, would be serious. The situation in Argentina is particularly critical as external and domestic shocks have implications for Argentina's long-term solvency. External indebtedness is only moderately high by international comparisons but, due to a small export base, the external debt service to export ratio is one of the highest among emerging markets. A series of simulation exercises for this progress report show that simultaneous long run solvency at the external sector and public federal and provincial administrations can be achieved at a real economic growth rate of about 2.9 percent. This should be attainable, but economic reforms to enhance competitiveness and productivity gains are required. Moreover, on the fiscal side, the measures to control nominal growth of primary expenditures at both levels of government are a necessary condition for debt ratios to stabilize, even if economic growth were higher. 14. The new measures currently being implemented create the conditions for a much needed economic turnaround There are signs that the economy is responding but the coming months are critical with close monitoring by the international financial institutions of the economic and social situation. A number of possible scenarios are outlined in the report. At this point, we are proposing no deviationsfrom the parameters for the program outlined in the CAS Should conditions warrant, as the situation in Argentina evolves, the CAS would be updated as appropriate. vi  Argentine Republic Country Assistance Strategy Progress Report FY01 A. INTRODUCTION 1. The most recent Joint IBRD-IFC Country Assistance Strategy (CAS) was considered by the Board in June 2000. The development strategy for the FYO1-04 period, spanning the term of the new Administration of President De la Rua, focuses on: (i) enhancing social development; including poverty alleviation and human resource development; (ii) improving the performance of the state, particularly at the sub-national level; and (iii) consolidating structural reforms. Total lending was projected to be about $3 billion for the period, about half the level of earlier years, with the possibility of increasing total lending over the FY 01-04 period to $3.5 billion should the triggers be met. 2. The CAS was considered at the point when the new Administration was confronting the challenges of an economic downturn which began in late 1998, resulting in increased unemployment, deteriorating social indicators and fiscal accounts. Against this backdrop, the progress report reviews economic and social performance, achievement in meeting CAS objectives, and the support offered by the major partners, the IMF and the IDB. It highlights initiatives by the Government to respond to the current challenges and outlines the proposed support from the international community. Finally, it assesses the sustainability of the economic program and the risks. B. ECONOMIC AND SOCIAL PERFORMANCE Background 3. Since the launch of the Convertibility Plan in 1991, the economy has been transformed through a sweeping set of structural reforms that altered the monetary system (establishing a currency board arrangement with the Argentine peso pegged one-to-one to the US dollar), liberalized trade, and redefined the role of the state. The latter was achieved through privatization, decentralization to the provinces, and reform of the social security system. All of this was intended to reverse the long-term trends of slow growth, low labor productivity, state domination, low domestic savings, weak investment, high economic volatility, and chronic inflation which culminated in hyperinflation and the incidence of poverty reaching over 40 percent inl989. 4. The economic results of the Government's program during the 1990s were dramatic. Argentina had average economic growth of 4.8 percent over 1991-1999, despite the Tequila crisis in 1995 and the external shocks and ensuing recession since 1998. In contrast to previous bouts of hyperinflation, during the past decade Argentina had one of the world's lowest rates of inflation, with price deflation in the past two years. The Federal Government's fiscal deficit receded from an average of about 6 to 8 percent of GDP for most of the 1980s to 1.4 percent in 1998 and 2.6 percent in 1999. Total foreign debt--about $147 billion-- is moderate as a share of GDP (equivalent to 52 1  percent) but large when compared to the country's export base. As a result, external debt represents more than four times the annual base of exports of goods and services, and debt service has represented 60 to 90 percent of total exports in recent years. 5. Nonetheless, Argentina's external indebtedness and dependence on external capital to finance public sector deficits and private investments reflect the currency regime, under which both the dollar and the peso has equal legal status, and the relatively underdeveloped state of the capital markets. This leaves the economy vulnerable to external shocks and changing perceptions of the international capital markets. This happened during 1994-95 with the Tequila crisis, and again with the Asia crisis of 1997, the Russia crisis of 1998 followed by the Brazil devaluation in 1999. All of these shocks have had negative impacts on the economy's ability to create employment and reduce poverty, particularly as much of the adjustment depends on productivity improvements and flexible labor markets. Poverty has risen to about 29 percent after falling in the early 1990s and unemployment has remained stubbornly high at 14-15 percent. Moreover, the pace and intensity of economic reform waned in the latter part of the 1990s, and the end of the decade saw a noticeable deterioration of the fiscal accounts at both levels of government in 1999, an election year. The deterioration of public accounts created additional pressures on the level of country risk and the cost of borrowing for the country as a whole, aggravating the length and depth of the economic recession. Recent Economic Performance 6. Argentina has been facing an external environment characterized by high international interest rates, low commodity prices, adverse realignment of other currencies, declining confidence and limited access to international financial markets. Economic performance in 1999, with a decline of 3.4 percent of GDP, was the worst since the hyper-inflationary period of 1989. At the start of 2000, when the CAS was prepared, the economy appeared to be recovering but these incipient signs of growth were short-lived and the pace of economic recovery remained slow through 2000 (Figure 1). Consumers and investors were wary and investment has dropped from 20 percent in 1998 to 16 percent of GDP in 2000. Figure 1 Interannual GDP Growth Rates, 1998-1 to 2001-1 80% 60% 4. 0% _ / _ 2.0% _- 0.0% I N f X -weE11 -20.% i -4.0% -6.0% 2  7. The year 2000 ended with a decline of 0.5 percent of GDP even though exports in aggregate grew by 13 percent, and manufactured exports in particular by 18 percent. The current account deficit improved significantly from 4.4 percent of GDP in 1999 to 3.3 percent in 2000, with strong export growth and slack import demand offsetting the rise in foreign interest payments. Unemployment registered 14.7 percent in October 2000 and poverty levels may have worsened. Despite the recession, there was improvement on the fiscal front: the aggregate provincial deficit was 1.2 percent of GDP (down from 1.6 % in 1999)' which together with the federal deficit of 2.4 percent of GDP (roughly the same in 1999 but with a $3 billion cut in primary expenditures accommnodating the increase in interest obligations), represented an improvement over 1999 (Table 1). In total, the consolidated primary public deficit was reduced by 0.6 percent of GDP in 2000. Table 1: Fiscal Performance at Federal and Provincial Levels Est. 1995 1996 1997 1998 1999 2000 Millions ofpesos Federal Government -2,545 -5,889 -4,341 -4,170 -7,348 -6,974 Provincial -3,530 -1,840 -1,377 -2,488 -4,633 -3,517* Administrations o/w Buenos Aires -270 -581 -808 -1,355 -2,150 -1,868 Province Total -6,075 -7,729 -5,718 -6,529 -11,981 -10,491 Shares of GDP (%Y) Federal Government -1.0 -2.2 -1.5 -1.4 -2.6 -2.4 Provincial -1.4 -0.7 -0.5 -0.8 -1.6 -1.2 Administrations Total -2.4 -2.8 -2.0 -2.2 -4.2 -3.6 Note: Deficits exclude privatization proceeds as revenues Sources: Ministry of Economy, IMF *Bank Staff Estimate 8. International capital markets became increasingly wary of the capacity and willingness of Argentina to meet its obligations as the year 2000 unfolded which led to a sharp rise in country risk. In October-November 2000, external debt markets closed for Argentine public borrowing, and domestic interest rates rose sharply, although not comparable to the worst of the Tequila crisis. The markets were calmed by the swift action by the Government and the IMF to mobilize international financing, called the blindaje, (see para. 33). With these new reforms and the support package, financial variables improved substantially at the start of 2001. The Government returned to the international bond market with a $4.2 billion debt swap and new issues were launched. IThese estimates are still to be confirmed. The government estimates that the fiscal effort by the provinces was somewhat greater-about 0.55 percent of GDP. 3  9. But these developments were short lived and the initial positive reactions by the international capital markets to the blindaje could not be sustained when early results for January and February 2001 showed that fiscal deficit was larger than the indicative targets agreed with the Fund. In March 2001, the economy was hit by the resignations of two Ministers of Economy in succession. After the first Minister's resignation. the new economic team proposed a program to cut $2 billion from the federal budoet. The program, while focused on inefficiencies in federal spending, failed to received adequate political backing. This Minister was replaced with an economic team headed by Minister Domingo Cavallo who has been Minister of Economy from 1991 to 1996. 10. Continuous access to international capital markets is critical for Argentina to finance its deficit and the roll-over of its external debt. Thus, when these events occurred, it was just at the point that the Federal Government had hoped to access the capital markets to fill its financing plan for the second quarter of 2001. With the markets effectively closed again as of March 2001-with country risk spreads remaining over 1000 basis points-the Government had no recourse but to tap the domestic market with a $3.5 billion placement. Included was the issue of a one-year bond for $2 billion that local banks can compute towards their liquidity requirements which were lowered from 20 to 18 percent of deposits. The recent voluntary swap of about $30 billion in public debt reduced the Federal Government's liquidity requirements in the coming years--by $16 billion over the next five years and $7.8 billion over the next 18 months.2 11. Throughout most of 2000, confidence in the domestic banking system remained strong, as the monetary authorities had implemented prudent banking policies, strengthening the system since the Tequila crisis. Overall, the banking system continues to be highly dollarized with dollar accounts at 63 percent of total deposits far outweighing peso accounts and the majority of domestic credit is nominated in dollars. The system has maintained its deposit base in both pesos and dollars, exhibiting growth of 7 percent growth in the first half of 2000. However, deposits declined by about 5 percent in the face of the political uncertainty in October and November 2000 and then recovered only to decline once again by about 6 percent or $5.5 billion through to May 2001, before stabilizing and showing signs of recovery in the second half of May and early June.3 International reserves fell by about $7 billion between the end of 2000 and May 2001, but remain strong, totaling $25.4 billion, and fully back the money supply, a requirement to maintain convertibility and the integrity of the currency board system. 12. The recession and the mounting fiscal pressures have had an impact on interest rates and on credit demand. As the markets began to increase country risks, inter-bank rates spiked in October 2000 and again in March 2001. With low investment and consumer confidence, the banks, reflecting a lack of demand for credit at the prevailing 2 The net cost of this operation is estimated to be 35 basis points in incremental yields on the stock of debt swapped and the extension of maturities of such debt by 2.8 years, plus the increase in indebtedness by $2.2 billion. On a net-present-value-basis, this swap is considered very successful. 3In contrast, during the Tequila crisis, 18 percent of deposits were withdrawn from the system and a significant number of banks were forced to close, restructure and/or merge. 4  high interest rates, have been increasingly shifting their asset composition towards public sector debt. Credit to the private sector declined during 2000, to reach about $62 billion, or roughly 22 percent of GDP. In the first four months of 2001, credit declined further to $60 billion with prime rates jumping from 8 percent to 24 percent during March 2001. The Government's switch from external to domestic sources of financing further complicates this panorama further by crowding out private borrowing. In addition, the continuing stagnation of the economy has led to an inevitable deterioration in the quality of bank portfolios albeit this deterioration remains modest, and private banks are generally heavily provisioned. Social Concerns 13. While many social indicators have improved in the past ten years--including a drop in infant mortality from 25 deaths per 1,000 births in 1991 to about 18 deaths in 2000--poverty levels have stubbornly stayed high after having fallen in the immediate recovery period of the early 1990s. The Bank's estimates for 1998 put poverty at about 29 percent of the urban population, down from the peak of 41 percent in 1990 but up from the pre-Tequila crisis level of 22 percent in 1994.4 (Poverty is likely much higher in the rural areas and not likely to have improved in the past two years.) This situation is compounded by rising income inequality, underemployment and unemployment, especially for the unskilled, indicating that the benefits of growth have not been widely shared. Income for the unskilled has been stagnate for the past 10 years as productivity increases benefited workers with higher human capital, and much of the burden of reacting to external shocks has come through reductions in unit labor costs. Moreover, as a coping strategy, many firms and employees are opting out of the formal social security system, with about 45 percent of the labor force currently not contributing to pension or health insurance programs adding to social vulnerability. 14. The poor have been affected the most during the current economic downturn and the greatest gain in terms of poverty reduction will likely be attained by rapidly restoring sustainable, investment-led growth. As shown in the FYOO Poverty Assessment, Argentina needs sustained growth, combined with no further deterioration in income inequality, to reduce poverty levels significantly over the next ten years: for example, per capita income growth of 1.8 percent per year for the next ten years (or annual growth of about 3.3 percent of GDP) could reduce poverty to the 21-24 percent levels. Similarly, reviving employment creation and reducing unemployment helps: full employment could reduce poverty by some 6-8 percentage points. 15. While this analysis shows that a significant drop in poverty is attainable with sustained growth and employment creation, reduction of poverty in Argentina is also very dependent on improving human capital. Previous studies show that improving educational levels may be the single most powerful way to reduce poverty levels as incomes for the unskilled have stagnated during the 1990s, while those with superior levels of education continue to do relatively better. Thus, human capital formation 4See the Bank's most recent Poverty Assessment for Argentina, Report No. 19992-AR; March 23, 2000. 5  remains at the center of social policies. Given that social services are shared between the federal and provincial administrations, the provinces are key players in maintaining social services, especially the delivery of primary and secondary education, public hospitals and clinics, housing, and a variety of social protection programs and social expenditures. These services comprise about 53 percent of provincial spending. C. RESPONDING TO THE CHALLENGE 16. Since it took over in December 1999, the Administration of President De la Rua has faced the challenge of overcoming three main drags in the economy: (i) the latest competitiveness shocks caused by the January 1999 devaluation of Brazil, and the on- going appreciation of the US dollar; (ii) fiscal vulnerability given fiscal slippage in 1999 and high volume and cost of the roll-over of debt which has been mostly financed externally because of low levels of domestic savings and intermediation; and (iii) low consumer and investor confidence. The Reform Agenda 17. At the outset, the new Administration put forward a program of economic and social reforms designed to restore growth and promote greater social equity while being fiscally responsible and retaining the Convertibility Plan. These principles still hold but the results of the Government's efforts have yet to bear fruit. In late 2000, in response to the deteriorating economic situation described earlier, the Government initiated new measures to strengthen its fiscal position, including that of provincial governments; promote financial access, particularly for small and medium size firms, deepen public sector reform, accelerate reform of health care financing, alter the pension system, and strengthen the social safety net. Importantly, the Federal Government secured the agreement of the provinces to advance on reforms at that level, including steps on revising the existing system of federal-provincial revenue sharing, co-participaci6n. This new Federal-Provincial Agreement, which has the status of a law and was signed by all but one province, includes a number of commitments on improved fiscal management by the provinces, in line with federal policies and programs, and a freeze primary expenditures in those provinces with fiscal deficits until 2005. In addition, the Government negotiated an international package, the blindaje, to address external financing needs for 2001 and to restore market confidence. Renewing the Effort 18. Taking over the economic portfolio in mid-March, 2001, Minister Cavallo, the architect of the Convertibility Plan, launched a series of measures based on three fundamental pillars: (a) strengthening political cohesion and support for reform; (b) securing financing to dispel risks of default; and (c) promoting economic policies that address the fundamental fiscal and economic growth challenges. The new Minister secured in short order legislative endorsement of the new Law of Competitiveness and the Law on Delegation of Powers. The latter provided the executive branch with powers to modify the Law of Defense of Competition, improve regulation of the capital markets, eliminate exemptions to income and profit taxes, generalize the VAT, and for those 6  activities covered by new competitiveness plans eliminate the minimum presumed income tax on businesses, the tax on interest and employer labor charges. In practice, these competitiveness plans are intended to rationalize and reduce gradually the tax. burden with the goal of eventually converging the tax system to a core of the VAT and income tax, thus eliminating differential tax treatment among sectors and provinces within a two year period. Accompanying these measures was an increase in import tariffs to 35 percent on goods outside the MERCOSUR area, a reduction of duty on capital goods imports to zero, and a halving of VAT rates for selected sectors. Increased tariff dispersion is expected to be reversed within a two year period. 19. Under the Law of Competitiveness, the new Tax on Financial Transactions provides a rapid injection of revenue and sets the stage for Argentina to meet its fiscal target which allows for a deficit of $6.5 billion in 2001. The new tax is expected to generate revenues of about $2.7 billion for the remainder of 2001. As all transactions over $1,000 now must be processed through the banking system, this tax and the banking system have become important pieces for a medium term program to control tax evasion. Along with increasing revenues via the new tax and elimination of exemptions on VAT, the new team also has enacted expenditure cuts in the order of $860 million. Together, these measures are expected to contribute in meeting the year end fiscal targets. 20. The Government also indicated its intention to continue with the Convertibility Plan but has also announced that it would alter the currency mix to include the EURO in equal amount to the US dollar. Legislation authorizing this shift to take place when the US dollar and the EURO reach parity was recently approved by Congress. The rationale for this is to reduce the fluctuations in the real value of the peso and its vulnerability to international monetary shocks and to reflect better the destination of Argentina's exports-currently about 17 percent to the European community and 15 percent for NAFTA countries. The new system would retain the core features of the Convertibility Plan, namely, full backing of the monetary base with reserves and strict limits on monetary policy. 21. In June, the Government successfully concluded a debt exchange with the private sector that delayed debt service on approximately $30 billion worth of public debt. With this innovation, the debt service burden will be reduced over the next five years by $16 billion, with much of the reduced financing needs accruing over the next 18 months. The financial relief allows the Government to regain its focus on economic reforms. In mid- June, new measures were announced, to complete the "Competitiveness Plan." These measures include: tax relief to middle-income families, as a stimulus to consumption; a new export subsidy (import tax) to improve competitiveness; and measures to improve tax collection. 22. The intent of these policies is to enhance competitiveness. The Government has clearly targeted the elimination of distortionary taxes and the excessive tax burden on those who pay taxes, thus, working towards a more efficient and equitable tax system. In addition, past studies also indicate that there remains considerable potential, particularly in the area of transport and logistics to reduce production costs. A recent measure was aimed to reduce and even out toll charges for road traffic. There is also much to do to 7  lower the transaction costs imposed on business by the state which will be addressed through the modernization of the state program. On the fiscal side, structural changes are being pursued by reducing fraud and better management of the social security system. There are also reforms to be put in place to improve public procurement, reduce cost