ReportNo. 15402-AR The : Public Disclosure Authorized Assessmentand Potential Prospects (In Two Volumes) Volume l: The Main Report

July12, 1996

CountryOperations Unit II CountryDepartment I Latin Americaand the CaribbeanRegional Office Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Q)ocu*nntof theWorld Ba4nk Currcncy Equivalents

Currency Unit: Peso (As of July 1996) US$ 1 = ARG$1

Fiscal Year January 1 - December 31

Glossary of Acronyms

APC State Employment Agencies' Program ATN Treasury Grants B.A. Buenos Aires BCRA of the Republic of Argentina BHN Housing Bank BIS Bank of International Settlements BOCON Consolidation Bonds BONEX Dollar denominated Treasury Bonds CET Common External Tariff CGE Computerized General Equilibrium Model CPI Consumer Price Index EFF Extended Fund Facility ENTel National Telecommunication Enterprise EPH National Household Survey FDI Foreign Direct FEDEI National Electric Development Fund FIEL Foundation for Latin American Economic Research FONAVI National Housing Fund GATT General Agreement on Trade & Tariffs GDP HUBN Households with Unsatisfied Basic Needs IMF International Monetarn Fund INDEC National Statistics & Census institute LAIA Latin American Integration Association LFP Labor Force Participation LIBOR London Interbank Offer Rate MERCOSUR Southern Cone Common Market NTC National Trade Commission OECD Organization for Economic Cooperation & Development PAYG Pay as you go PEP Partial Subsidy for Private Employment PPF Production Possibility Frontier PRENO Public Sector Social Program PROAS Public Sector Social Program PROEDIS Public Sector Social Program PRONOPAS Staging Study Abroad PYMES Small and Medium Enterprises QR Quantitative Restriction SEGBA Water Company SIGEN Government Internal Auditors TBILL Treasury Bill TFP Total Factor Productivity USA United States of America VAT Value Added WTO World Trade Organization YPF Oil Company COUNTRYDATA -ARGENTINA

AREA POPULATION DENSITY

2766.9thous. sq.km. 34.2 million(mid-1994) Countrydensity 1991 11.7hab.per aq.km 1.2%annual growth Ruraldensity a. 16.9hab. per sq.kmof arableland

POPULATIONCHARACTERISTICS aI HEALTHbl

CrudeBirth Rate (per 1000-1992) 20.5 Populationper physician (thous.) 0.4 CrudeDeath Rate (per 1000- 1992) 7.9 Populabonper hospital bed (thous.) 0.2 InfantMortality (per 1000live births-1992) 23.6

INCOMEDISTRIBUTION bI DISTRIBUTIONOF LAND OWNERSHIP

% of nabonalincome, highest quintile 51.0% % ownedby top 10%of land owners % of nationalincome, lowest quinble 5.0% % ownedby smallest1 0% of land owners

ACCESSTO SAFEWATER (1991) ACCESSTO ELECTRICITY11989)

% of populabon- urban 72% % of populaton 95% % of populabon- rural 17%

NUTRITIONal EDUCATION

Calorieintake as % of requirements 119.2% Adult literacyrate % (1980) 95% Per capita proteinintake (gramsper day) 99.7 Primaryschool enrollment % a/ 100%

GNPPER CAPITA IN 1994dl 8,060

GROSSDOMESTIC PRODUCT IN 1995 di ANNUAL GROWTHRATES (% constant prFIes) USSBill. % (current prices of GDP 1965-73 197340 19B0-94 1995

GDP at marketprices 276.0 100.0 4.3 2.2 1.3 -4.4 GrossDomestc Investment 49.1 17.8 6.8 4.3 0.1 -15.9 GrossNabonalSavings 45.3 16.4 2.5 2.3 -18.3 4.1 CurrentAccount Balance -2.3 -1.4 ExportsofGoods&NFS 23.9 8.9 -4.7 141 5.2 26.1 ImportsofGoods&NFS 23.7 8.7 0.6 13.3 -13.0 -10.5

OUTPUT,LABOR FORCEAND PRODUCTIVITYIN 1995

Value Added (constant prices) Labor Force ti VA. Per Worker

Arg $ Thousand % of Total Thousands % Arg S

Agriculture 915 7.5 2,964 12.0 309 Industry 4,346 35.8 7,755 31.4 560 Services 74,721 615.1 13,978 56.6 5,346

TotalGDPatFactorCost 12,148 658.4 24,697 100.0 492

GOVERNMENTFINANCE g/

Federal Government Provincial Government

Million Pesos %ofGDP Million Pesos %oOGDP

1995 1995 1995 1995

CurrentRevenues 49,038 16.9 CurrentRevenues 24.093 8.7 CurrentExpenditures 48,449 16.8 CurrentExpenditures 27,492 10.0 CapitalRevenues 1,256 0.3 CapitalRevenues 239 0.1 Capital Expenditures 3,218 0.4 CapitalExpenditures 3,999 1.4 Surplus -1,373 0.0 Surplus -3,179 -1.2

a/ For theperiod 1982-1985. b/ For the period1970-1976. c For the period 1987-1992. d/ CurrentUS dollars.Estmated usingBank Atas methodology. a/Current US dollarestimates, calculated from datain constantArg S 1986. f/ Calculatedby applying1980 census shares to 1994populabon. gl Cash Basisin currentPesos, includes Central Administration, Social Security and PublicEnterpnses. COUNTRYDATA . AROENTINA

MONEY,CREIXT AND PRICE 16 192 1993 1994 165

(_ o Paw; erd of p.1o4)

Momn OoASrmoneye/ 11,003 17.467 24,682 27,535 DamnsdoBaBnCndi to Pbc edorf a 15,004 12,010 14,871 18,052 Do i Bt CrMto*Pi sebBdoWro 22,046 34.261 43.243 52,130

MomnyandC Mony ss % dODP 6.1 7.7 9.6 9.8 Wh_FeeIPcdes1apIlUI-.100) di 90.8 104.7 106.4 107.1 115.4

Ain pwweu Ir_ hI: GulW loee Pib mau/ 110.7 6.0 1.6 0.7 7.7 BS Cred to Pubk Sedm .. -20.0 23.8 7.9 BStnkCredloPrlto Sedor .. 55.5 26.1 20.6 .. MERCHANDIS8EEXPORTS(Avwag.1661-1665)b/

LLANCEOFPAYMENTSbi 1962 1993 1994 1"5 US$SM %atTotal

Prinuryproduct 3723.0 25.1 Men. of agsliurnl oigin 5584.3 37.7 EngoiaofGoods. NFS 15,272 15,624 18,507 23.657 Menu. of kd *dodgin 4121.5 27.8 bhpt of Goods.NFS 18,817 20.684 25,591 23,724 Fuels 1381.8 9.3 Resouce B9aie -3,545 -5,060 -7,084 133 TotalMerchidso 14810.6 100.0 ftaed Paynieri (nol) -2,695 -1,109 -1,277 -1,218 OlerFedor Payeubi(nel)at -845 -1,273 -1,270 -1,624 TddPlbktDl OuleO l*ilgADisburad (EndINS)bf Ur1S11m Not Cmd Transfr 749 411 320 432 Balnce an Caret Accot -4.336 -7,031 -9,311 -2,277 Total 87091 IBRD 4462 CaprftalAccoLt 10.162 11,408 9,668 2,206 IDB 4791 IMF 6120 FiNls Sedor 6.632 7.065 6,376 4.996 Biataluls 11614 PulbcSsdor 1.530 4.343 3,492 7.206 BonrJ 58340 Conmerdal Baits 1764 Chlng.s In Gros Rea. ( * h s ) 3.826 4,377 557 -69 DEBTSERVICE RATIO, 1994 55.7% RATEOF EXCHANE IBRDADALENDING, DECEMBER 31, 1995(1M U3S) bl US# 1. Ag.6 I IRD IDA

OWistandnga DIslsed 4462 i/Sourc: IMF. bvSoure: MUrdiy of Ec00mw c/So : INDEC d/Aveng Mai for ts year. zt Basedon fI avwagelo der for yew. Source:Mistry of Econory. TABLE OF CONTENTS

Page Number

Executive Summary ...... i Resumen Ejecutivo ...... vi

CHAPTER I: Defining the Convertibility Plan ...... 1

A. Origins of the Crisis Leading to the Convertibility Plan ...... 1

B. The Convertibility Plan ...... 2

The Convertibility Law ...... 3

Public Sector Reform...... 4

Debt Restructuring ...... 7

Social Security Reform ...... 8

Trade Reforms...... 9

CHAPTER II: Economic Performance and Macroeconomic Implications of the Convertibility Plan ...... 11

A. Economic Performance (1991-94) .11

Public Sector Performance (1991-94) .12

Capital Inflows, the Current Account and the Real Exchange Rate. 15 Effects on Financial Markets .17 Monetization and Dollarization.18

The Response of Trade Flows to Liberalization.18

Investment: Recent Trends and International Comparison .21

Savings: Recent Trends and International Comparison.23

Evolution of Productivity and Competitiveness.24

B. Impact of the 1995 Mexican Crisis ...... 27 CHAPTER 11: Sustaining High ...... 31

A. Simulating a Pattern of Sustainable High Growth...... 31

B. Policies Conducive to Higher Economic Growth...... 34

Investment ...... 34 Private Saving...... 36 Regime...... 40

C. The Unfinished Reform Agenda ...... 45

Argentina's Provinces: New Priorities for Public Sector Reform ...... 45 Provincial Expenditure Efficiency...... 45 Recommendations for Reform...... 48 Relations between Provincial Governments and the Financial Sector .51

Labor Markets and Institutions ...... 52 Employment Performance ...... 52 Wage and Earnings Performance...... 54 Determinants of ...... 54 Prospects ...... 55 Recommended Course of Action...... 56

Financial Markets ...... 58 The Banking Sector ...... 59 The Capital Markets ...... 62

D. End Note ...... 63

Statistical Appendix (in volume II) EXECUTIVESUMMARY

1. Five years have passed since Argentina, faced with the most severe of a series of economiccrises characterizingthe eightiesdecade, adopted the ConvertibilityPlan. This courageousand innovativeplan restructured the country's economic landscape, generating prospects for unprecedented stability and economicgrowth. The purpose of this report is to review the achievementsand challengesthat this Plan has brought to the Argentine economyover 1991-94, and then assess prospects for economic growth in the wake of the economicturbulence that beset Latin America in 1995.

The 1991-94 Record

2. Argentina has had one of the most successfulof recent stabilizationand reform efforts. From one of the most extreme hyperinflationsby historical standards in 1989, it moved relatively quickly by 1994 to an annual rate of 3.9 percent. Output and productivitygrowth have been remarkable in the first four years of the Plan, with GDP growth averaging7.7 percent. The initial consumption-led boom matured by 1994 into a healthypattern of investment-and -ledgrowth. Privatizationof state assets was far reaching, and far more successfulthan expected. As a result of the economic recovery, poverty levels declinedsignificantly between 1989and 1994, althougheconomic restructuring with a rigid labor market resulted in increasedunemployment: 12.2 percent of the labor force by October 1994.

3. Trade reforms and economicrecovery boostedimports from barely US$4 billion in 1990to over US$21billion in 1994. The importboom was financedby capital inflows, includinglarge scale foreign direct investmentand portfolio investmentsthat quickly respondedto the signalsof structuraladjustment. The abundanceof foreign exchangedue to the capital inflowsled to a real appreciationof the currency. This appreciation began reversing itself in the latter half of 1993, due to decelerating inflation and currency realignments among Argentina's major trading partners. The impact of the currency's appreciation was further mitigated by wide-ranging productivity increases, and tax reductions. As a result, export growth, particularlyof industrialexports, accelerated.

4. There is growing evidence that Argentinaunderwent an important adjustmentin response to the radical restructuringand liberalizationof its economy. Productivity(both of labor and capital) increased, and particularly in 1993 and 1994 the growth of (financed by growing national and foreign savings) and exports, which are the key determining variables for the ultimate success of the ConvertibilityProgram, has accelerated.

The main focus of this report is Argentina's experience with the Convertibility Plan, and potential prospects for sustainedhigh rates of economicgrowth. Contributors to this report were Messrs./Mmes. P.Levy (task manager and main author), J.L. Guasch (labor), C. Sapelli(productivity), S. Rajapatirana(international trade), J. Morisset (public finance, investment,saving), J. Hicks and D. Rosenblatt(fiscal federalism), H. Shah (financial sector), C. Revoredo (data managementand projections). Mr. Carlos Rodriguez (ConvertibilityPlan), FIEL (labor, trade, tax issues, saving, investment),and ALPHA Consultants(productivity) prepared backgroundpapers for this report. - ii -

5. The ConvertibilityPlan, named after the ConvertibilityLaw that changed the Central Bank into a monetary board, is an internally consistentand complexeconomic program. Other pillars to the Plan, in addition to monetary reform, include fiscal reform, state reform, trade reform, and social security reform. Such a radical adjustmentof the economy is an ongoingprocess that cannot be completed in a short time span. As a result, the economy, despite its significant progress, remains vulnerable to a variety of shocks.

The Mexican Crisis' Aftermath

6. As the economiccrisis in Latin Americaearly in 1995brought to sharper focus, the Convertibility Plan remains particularly sensitive to foreign capital flows. With the reversal of capital flows, the Argentine economy suffered a contraction in 1995 of an estimated 4.4 percent. The sharp recession caused an increase in unemployment,and strainedthe performanceof the financialsystem. The regional financial crisis was the first severe test of the ConvertibilityPlan. Yet, by the end of 1995, there were signs that Argentina was pulling out of its recessionwithout serious damage to the ConvertibilityPlan. To the contrary, significantpressures to deviate from it were met by efforts to further strengthenit during the crisis, indicativeof the Plan's popularityand staying power. It can be claimed in some respects, that the credibility of the ConvertibilityPlan was strengthenedfrom the 1995 crisis.

7. The immediateaftermath of the 1995 financialcrisis has been reassuring. The Government, with the strong support of Congress and the electorate, opted for the continuationof the reform process in the context of the ConvertibilityPlan. The determinationto eschewpopulist policies in times of crisis, while redoubling efforts to pursue a renewed reform agenda, is a testament to the fundamental attitudinal changes sweeping through the new Argentina, becoming an example to the region as a whole. The reelection of President Menem for a second term in May, 1995 vindicated his reform policies and demonstratedthat effective stabilizationcan bring with it political rewards.

Future Prospects

8. Argentina, endowedwith plentiful natural resources and a good stock of human capital, both underutili.ed on account of past misguidedeconomic policies, has, in the context of the Convertibility Plan, created the foundationsfor unleashingits economicpotential. With solid fundamentalsalready in place, Argentina has a unique opportunityto strengthen its economic adjustmentprocess, creating the conditionsfor high and sustainableeconomic growth. Taking a page from the East Asia miracle story, a stable pattern of high economic growth--possiblyof 7 percent--wouldbe characterized by sharp increases in nationalsaving and investment,and continuousproductivity gains. To achievesustained high economicgrowth, the Argentineeconomy should be led by export and investmentgrowth, with these two key contributorsgrowing, in a simulatedconsistency model, twice as fast as the economyas a whole. The underlying premise in such a high growth scenario is that the fiscal accounts would remain balanced.

9. It is in that frameworkof reachable ambitioustargets, and a united view both by the Government and the public towards further modernizationand reform, that this document has reviewed policies affecting investment, saving, and exports. The assessment is that the fundamentalpolicy structures directly affectinginvestment, saving, and exports are fundamentallysound. Nevertheless, there is scope for improvement in a number of areas, both in fine tuning the trade regime and more fundamental reforms, for the ambitiousgrowth targets set out in this report to have a chance to materialize. - Hi -

10. Regardingthe internationaltrade regime, there is a need for greater simplicity,transparency and automaticityof economicpolicies. It is recommendedthat the Government reexamine the automotive regime and the "industrial specialization" regimes. It is recommendedthat the mirror principle be eliminated,in order to provide neutralitybetween exportsand import substitutingindustries. Alternative mechanismsto promote regionaldevelopment are proposed, rather than the use of trade preferences. The NationalTrade Commissionshould be strengthenedto adopt the new rules for safeguards,anti-dumping and countervailingactions that are consistentwith the new World Trade Organization,and rely more on the safeguard mechanism rather than on anti-dumpingactions. It is recommended that Argentina's position in MERCOSURshould favor the adoption of a uniform and low common external tariff, bring the 15 percent of the tariff lines outsidethe commonexternal tariff (CET) under the CET, and harmonize regulatoryframneworks.

Maintainingthe Momentumof Reform

11. As is well understoodby the authorities,the Argentinereform agendahas remaininggaps, which require attention, if the economy's potential is to materialize. Despite its achievements,the economy is still facing a number of hurdles before it resumesa sustainableand strong pattern of economicgrowth: (a) the financial system is still undergoing major restructuring, slowing the financial intermediation process; (b) most provinces will still need to undergo painful adjustments;and (c) labor markets under the weight of restrictive legislationface an uncomfortablyhigh rate of unemployment,and are in urgent need of liberalization. Reform of the factor markets would contribute to improved productivity, and mitigate economic instability, which are crucial factors for the expansion of saving, investment and exports. A stable political environment, and fiscal prudence, are equally important prerequisites for achievinghigh and sustainableeconomic growth.

12. In the unfinishedreform agenda mentionedabove, extendingeconomic reforms to the provinces remains a priority. While fiscal adjustmenthas occurred at the federal level, provincial reformscontinue to lag, although the 1995 crisis prompted a number of provincesto initiatethis long-delayedadjustment. Lack of adjustmentis reflected in the continuedunwillingness of many provincialgovernments to contain current expenditures,increase sufficiently their own-sourcerevenues, and more importantlyimprove the efficiencyof public spending. As a result of decentralizationand privatizationof many federal functions, provinces remain ill-prepared to fulfill their increasinglyimportant role in health, education, security, water and sanitation services, with potential negative implicationsfor economic growth and poverty reduction.

13. Two broad areas of reform, intergovernmentalfiscal relations and access of subnational governments to the financial sector, are fundamental for the restructuring of provincial finances. Structural reform addressing poor provincial expenditure efficiency includes expanding the provincial own-source revenue base to bring it more in line with provincial expenditure responsibilities, and decreasing the high dependenceof provinces on fiscal transfers by devolving national tax bases to the subnationallevel. This would prompt provincialauthorities to confront their constituentswith the costs of their preferences, and promote enhanced efficiency in resource allocation. To further increase accountability,but also meet equity objectives, intergovernmentaltransfers should be conditional on effectiveservice delivery, based on transparentindicators. Towardsthat objective, transfersto provinces outside the coparticipationsystem could be consolidatedinto a program of grants allocatedto provinces on the basis of their performance. It is also recommendedthat a transition strategy be developed to support market-basedsubnational government access to the financial markets, in order to facilitate the - iv - financing of subnationalgovernment investment needs. It is strongly recommendedthat the federal governmenteschew financial assistance, includingdebt restructuring,beyond legal obligationsunder the coparticipationagreement/law, to non-reformingprovinces.

14. The federal governmenthas taken initial measures to liberalize the labor markets. However, given the importance of reallocating resources in the economy, the acceleration of labor market liberalizationbecomes imperative. The urgency of these measures became more pronouncedduring the recent recession which compounded the growing unemploymentproblem observed in the course of restructuringthe economy. The implementationof structuralreforms and resumptionof economicgrowth could reduce unemploymentat a fast pace. Key policy reforms to consider, to that effect, are the reduction in labor costs, improved contractualflexibility, strengthenedunemployment insurance, and decentralizedcollective bargaining. Additionally,it is highly recommendedto develop an information system and analysis of the service sector, which is the major source of employment.

15. Regarding labor costs, it is recommendedthat non-wagelabor costs continueto be reduced. In this context, Governmentshould consider extendingfiscal exemptionsto young employeesand the long- term unemployed,and permittingthe unrestricteduse of temporaryand fixed term contracts. Regarding unemploymentinsurance, the authoritiesshould consider modifying the severancepayments system, since having both unemploymentinsurance and a severancepayment scheme dissuades the unemployedfrom actively seekingemployment and firms from optimallyadjusting their labor force. The authoritiesshould consider decentralizingcollective bargaining, rescinding the conceptof "ultractividad", eliminatingthe monopoly over the provision of welfare services for employees by unions, and streamliningtraining programs.

16. Argentina has both the need and potential for developmentof financial markets approaching developedcountry standards. Since the ConvertibilityPlan, the authoritieshave radically improved the regulatoryand economicenvironment for bankingand capital markets. However, problemsarising from institutional underdevelopment, and lack of market and product development have proven more intractable. Thus, financial markets remain shallow, intermediationcosts, margins and inefficienciesare high and act as a strong deterrent to both saving and investment. Cost of credit remains high, the aggregatecredit extension low, and access to formal credit particularlydifficult for smallbusinesses and farmers. A consolidation/restructuringof the banking system, both private and public, is imperativefor the remonetizationand improved financial intermediationin the economy. The developmentof capital markets will be equally critical in improvingthis intermediationprocess.

17. In order to consolidateconfidence and liquidity in the banking system, raise the volume and maturity of savings and loans, augment access to credit, particularlyto small and medium enterprises, and deepen capital markets, the followingactions are recommended:(a) facilitate/promote the accelerated restructuring and consolidation of private banks through the adequate funding and institutional strengtheningof the Bank CapitalizationTrust Fund; strengtheningthe Central Bank's inspection and enforcementauthority; encouragingbank mergers with stronger institutions;and eliminatingregulatory forbearance; (b) reduce banking costs and spreads through the reduction of on financial transactions; dismantlingbarriers to competition; establishmentof a continuousand liquid benchmark yieldcurve; strengtheningthe functioningof the DepositInsurance mechanism; improving credit analysis capabilities of banks; and facilitating the use of collateral; (c) facilitate the of provincial banks or their closure through the adequate funding of the PrivatizationTrust Fund; avoiding federal fiscal support that would prop up provincialbanks; and strengtheningthe Superintendencyof Banks' legal v - capacity to enforce prudentialnorms on provincialbanks; and (d) proceed with the privatizationoffederal bankcs.

18. It is worth emphasizing the relevance of macroeconomicconditions and framework in the performanceand prospects for developmentof the financial system. Given vulnerabilityto abrupt shifts in capital flows, the followingalternatives may strengthenthe capacity of the system beyond those currently in existence: the Central Bank may enter into swap arrangements with other Central Banks that can act as lenders of last resort, imposehigher reserve requirementsto improve the response capacity of the financial system, the financial system may gravitate towards multinational financial institutionsif they are perceivedas providinglender of last resort capacity, and build over time significant excess internationalreserves.

19. From the challenges ahead, none could be as important as the need to attend to growing social needs, as Argentina addresses the impact of the recent external crisis. Renewed economic growth remains the linchpin to the alleviation of poverty. Structural reforms, such as those proposed above, particularlythe liberalizationof labor markets, wouldreduce unemploymentand acceleratethe moderation of social pressures, while simultaneouslycontributing to higher economicgrowth. Furthermore, the reassessmentof public finances, federal and provincial, shouldpermit efficiencygains to allow for more targeted social programs to address the needs of the poor, without undermining fiscal prudence. Economicgrowth, more efficient allocationof public spending,and reductionin tax evasionshould allow for the planned reversal in the recently increasedtax rates, in a balancedbudget environment. Continued reforms at the federal governmentlevel, reflected in the Second Reform of the State program expected for 1996, are another reminder that reform is a continuousprocess that needs vigilance and nurturing.

- vi -

RESUMENEJECUTIVO

1. Han pasado cinco afios desde que la Argentina adopt6 el Plan de Convertibilidad, luego de afrontar una serie de severas crisis econ6micasque caracterizaron la d6cada de los aflos ochenta. Este valiente e innovador plan reestructur6 el panorama econ6mico del pafs, generando perspectivas de estabilidad y crecimientoecon6mico sin precedentes. El objetivode este informe consiste en examinar los logros y desaffos que dicho plan incorpor6 a la economia argentina durante el perfodo 1991-94, asf como tambien evaluar las perspectivas de crecimiento econ6mico dentro del marco de turbulencia econ6micaque asedi6 a America Latina en 1995.

El Record 1991-94

2. Argentina protagoniz6uno de los mas exitososesfuerzos recientesde reformas y estabilizaci6n. Habiendo partido en 1989 de una de las hiperinflacioneshist6ricamente mas extremas, la economia se condujo relativamenterapido hacia una inflaci6nanual del 3,9 porciento en 1994. Tanto el crecimiento del producto como el aumentode la productividadhan sido notablesdurante los primeros aflosdel Plan, con un crecimientopromedio del PBI de 7,7 porciento. El boom inicial de consumomadur6 hacia 1994 en un sano patr6n de crecimientoguiado por inversionesy exportaciones. La privatizaci6nde activos del Estado fue intensa y mucho mas exitosa de lo esperado. Como resultado de la recuperaci6n econ6mica, los niveles de pobreza declinaron significativainenteentre 1989 y 1994; aunque la reestructuraci6necon6mica con un mercado laboral rigido llev6 a un aumento en el desempleo: 12,2 porciento de la poblaci6necon6micamente activa en octubre de 1994.

3. Las reformas comerciales y la recuperaci6n econ6mica impulsaron las importaciones, que crecieron de US$4 mil millones en 1990 a mas de US$21 mil millones en 1994. El boom de importacionesfue financiadopor el ingreso de capitales, incluyendoinversiones directas e inversiones de cartera de gran escala, que respondieron rapidamente a las sefiales de ajuste estructural. La abundanciade moneda extranjera que produjo el ingresode capitales llev6 a una apreciaci6ndel tipo de caambioreal. Dicha apreciaci6ncomenz6 a revertirse hacia fines de la segunda niitad de 1993 como consecuenciade una inflaci6ndecreciente y realineamientosen el tipo de cambiode los principalessocios comercialesde la Argentina. El impactode la apreciaci6ndel tipo de cambio fue mitigado auinnas por el aumento generalizadode la productividad,la desregulaci6n,y reduccionesen los impuestos. Como resultado, se aceler6 el crecimientode las exportaciones,y en particular el de las industriales.

El principal objetivode este informe es analizar la experienciaArgentina con el Plan de Convertibilidady las perspectivaspotenciales para una elevada y sostenida tasa de crecimiento econ6mico. Contribuyeronen la realizaci6nde este informe los Sres.: P. Levy (director del proyecto y autor principal), J.L Guash (trabajo), C. Sapelli(productividad), S. Rajapatirana (comercio internacional),J. Morisset (finanzaspimblicas, inversi6n, ahorro), J. Hicks y D. Rosenblatt(federalismo fiscal), H. Shah (sector financiero),C. Revoredo (manejode datos y proyecciones). El Sr. Carlos Rodrfquez(Plan de Convertibilidad),FIEL (trabajo, comercio, impuestos,ahorro, inversi6n), y consultoresde ALPHA (productividad)prepararon el material de apoyo para este informe. - vii -

4. Existe cada vez mAsevidencia que demuestraque la Argentinaexperiment6 un ajuste importante en respuesta a la reestructuraci6nradical y a la liberalizaci6nde su economia. La productividad(tanto del trabajo como del capital) aurnent6;y en particular,entre 1993y 1994, se aceler6 el crecimientode las inversiones (financiadastanto por el incremento en el ahorro nacional como externo) y las exportaciones,variables claves en el exito definitivodel Plan de Convertibilidad.

5. El Plan de Convertibilidad,Ilamado asi por la Ley de Convertibilidadque transform6al Banco Central en una caja de conversi6n,es un programa econ6micointernamente consistente y complejo. Adenas de la reforma monetaria, otros pilares del Plan incluyen:la reforma fiscal, la reforma estatal, la reforma comercialy la reforma del sistemnade seguridadsocial. Un ajuste tan radicalde la economifa es un proceso que no puede ser completadoen un corto plazo. Como consecuencia,y a pesar del significativoprogreso obtenido, la economiapermanece vulnerable a shocks.

Consecuenciasde la Crisis de Mejico

6. La crisis econ6micaen AmericaLatina de principiosde 1995puso en evidenciaque el Plan de Convertibilidadpermanece particularmente sensible al flujode capitalesexternos. La economiaargentina sufri6 una contracci6nde aproximadamenteun 4,4 porcientocomo consecuencia de la salidade capitales. La marcadarecesi6n llev6 a un aumentoen el desempleoy perjudic6el desempeniodel sistemafinanciero. La crisis financieraregional fue la primera prueba de envergaduraa la que fue sometidoel Plan de Convertibilidad. Sin embargo, hacia fines de 1995, comenzarona verse sefialesde que la Argentina estaba saliendode la recesi6n, sin mayoresdafhos al Plan de Convertibilidad.Al contrario,las fuertes presionespara desviarsedel plan, fueroncontrarrestadas por medidaspara fortalecerlotomadas durante la crisis. Esto es indicativode la popularidady poder de permanenciadel Plan. Puede afirmarseen cierta medidaque la credibilidaden el Plande Convertibilidadfue afianzadaa partir de la crisis de 1995.

7. Las consecuenciasinmediatas de la crisis financierade 1995han sido alentadoras. El Gobierno, junto con un fuerte apoyodel Congresoy del electorado,opt6 por continuarcon el proceso de reforma dentro del contextodel Plan de Convertibilidad.La decisi6nde evitarpoliticas populistas en tiemposde crisis, redoblandoesfuerzos para continuarcon una nueva agendade reformas, es prueba fehacientede los cambiosfundamentales de actitudque se estan generalizandoen la nuevaArgentina, lo que la convirte en un ejemplo para toda la regi6n. La reelecci6ndel Presidente Menem en mayo de 1995 para un segundoperfodo vindic6 su politica de reforma y demostr6que una estabilizaci6nefectiva puede traer recompensaspolfticas.

PerspectivasFuturas

8. La Argentina,dotada con abundantesrecursos naturales y un buen stockde capital humanoambos desaprovechadospor polfticasecon6micas previas desencaminadas, ha generado,en el contextodel Plan de Convertibilidad,los fundamentospara desencadenarsu potencialecon6mico. Conuna s6lida base en pie, la Argentinaposee una oportunidadunica para fortalecersu procesode ajuste econ6mico,creando condicionespara un crecimientoecon6mico elevado y sostenido. Tomandocomo antecedentela historia del milagrodel Este Asigtico,un patr6n establede crecimientoecon6mico elevado--posiblemente del 7 porciento--podriacaracterizarse por marcadosincrementos en el ahorro nacionaly en la inversi6n,y por continuas gananciasde productividad. Con el fin de alcanzar un desarrollo econ6mico elevado y sostenido,la economiaArgentina deberfa basarse en el crecimientode sus exportacionesv de la inversi6n; el crecimientode dichasvariables, dentro de un modelode consistenciasimulado, deberia duplicar al de la economifaen su conjunto. La premisa subyacenteen tal escenario es que las cuentas fiscales se mantendranequilibradas.

9. En este marco de objetivosambiciosos y alcanzables,y con una visi6n compartida por el Gobiernoy el publico sobre la necesidadde mayoresreformas y modernizaci6n,este documentoha analizadolas polfticasque afectan a la inversi6n,el ahorro y las exportaciones.El analisisindica que la - viii - estructura de las poifticas que afectan directamentela inversi6n, el ahorro y las exportaciones,es fundamentalmentela apropiada. Sinembargo, hay margen para mejorasen variasareas, tanto en ajustes al r6gimen de comercio como en reformas mas fundamentales,para que las ambiciosas tasas de crecimientoestablecidas por este informepuedan materializarse.

10. Con respecto al regimen de comercio internacional,hace falta una mayor simplificaci6n, transparenciay automaticidadde las poifticasecon6micas. Se recomiendaque el gobiemoreexamine el regimen automotory los regimenesde "especializaci6nindustrial". Se recomiendaque el "principio espejo" sea eliminado,permitiendo la neutralidadentre las industriasde exportaciony las sustitutivasde importaciones. Se proponenmecanismos alternativos para promoverel desarrollo regional, en vez del uso de preferenciascomerciales. La Comisi6nNacional de Comerciodeberia ser fortalecidapara que pueda adoptar los nuevosreglamentos para evitar el dumpingy las accionescompensatorias, consistentes con la nuevaOrganizaci6n Mundial de Comercio,apoyandose mas en los mecanismosde salvaguardadel comerciosefialados por dicha organizaci6nque en las medidasanti-dumping tradicionales. Se recomienda que la Argentinaapoye la adopci6nde un arancelexterno comuinbajo y uniforme, en el MERCOSUR; que incorpore el 15 porcientode las lineas arancelariasque se encuentranfuera del regimende arancel externo comuin(AEC) al AEC, y que armonicelos marcos regulatorios.

Manteniendo el Impetude la Reforma

11. Como es bien sabidopor las autoridades,la agenda de reformasde Argentinacuenta con temas pendientesque deben ser atendidossi se quiere materializarel potencialde la economia. A pesar de sus logros, la economia debe sortear una serie de vallas antes de reanudar un patr6n de crecimiento econ6micofuerte y sostenido:(a) el sistemafinanciero esta experimentandouna fuerte reestructuraci6n, que retrasa el procesode intermediaci6nfinanciera; (b) la mayoriade las provinciasdebera pasar todavfa por ajustespenosos; y (c) el mercadolaboral, bajo el peso de una legislaci6nrestrictiva, afronta una alta e indeseadatasa de desempleo,y necesitaurgentemente una liberalizaci6n.Las reformasen los mercados de factores contribuiriana mejorar la productividad,y mitigar la inestabilidadecon6mica, factores crucialespara la expansi6ndel ahorro,de la inversi6ny de las exportaciones.Un entornode estabilidad politica y de prudencia fiscal son prerrequisitosigualmente importantes para lograr un crecimiento econ6micoelevado y sostenido.

12. En la agenda de reformas pendiente, mencionadaanteriormente, sigue siendo prioritaria la reforna de las economiasprovinciales. Aunque el ajustefiscal ha ocurridoa nivel federal,las reformas provincialesestan retrasadas, si bien es cierto que la crisis de 1995 impuls6a algunasprovincias a que inicien sus procesosde ajuste. La falta de ajuste se ve reflejadaen la continuafalta de voluntadde los gobiernosprovinciales en contenerlos gastos corrientes,en incrementaren forma suficientesus propias fuentes de ingresos; y, lo que es mas importante,en mejorar la eficienciadel gasto puiblico. Como resultadode la descentralizaci6ny la privatizaci6nde muchasde las funcionesfederales, las provincias se encuentranmal preparadaspara asumir su importantey crecienterol en la educaci6n,la seguridad, los serviciossanitarios y los serviciosde agua corriente;esto impactanegativamente sobre el crecimiento econ6micoy la reducci6nde la pobreza.

13. Existen dos areas de reforma que son fundamentalespara la reestructuraci6nde las finanzas provinciales: las relaciones fiscales intergubernamentalesy el acceso de los gobiernos provinciales al sectorfinanciero. Las reformasestructurales que se encarenpara combatirla escasaeficiencia del gasto a nivel provincial, deben apuntar a expandir la base de ingresos propios, acercandola a las responsabilidadesde gasto provincial; ademas, debe disminuirse la elevada dependencia sobre transferenciasfiscales en las provinciasmediante la devoluci6nde bases impositivasque actualmentese encuentranen manos del gobiernonacional. Esto Ilevariaa las autoridadesprovinciales a confrontaral electorado con los costos de sus preferenciasy promover una mayor eficienciaen la asignaci6nde recursos. Tanto para incrementarla responsabilidaden el gasto, como para alcanzar objetivos de equidad, las transferenciasintergubernamentales deberian estar condicionadasa la provisi6nde servicios - Lx - eficientes,basados en indicadorestransparentes. Con el fin de alcanzardicho objetivo,las transferencias a las provincias que se encuentranfuera del sistemade coparticipaci6npodrian ser consolidadasen un programa de transferenciasdonde 6stas se otorguen en funcion del desempefiode cada provincia. Tainbiense recomiendael desarrollode una estrategiade transici6nque faciliteel acceso de los gobiernos subnacionalesa los mercadosfinancieros dentro de un marco competitivo,ayudando asi al financiamiento de las necesidadesde inversi6nde los gobiernossubnacionales. Se recomiendaespecialmente que el gobierno nacional evite la asistenciafinanciera, incluyendola reestructuraci6nde deuda, a aquellas provincias que no inicien la reforma, mas alla de las obligacioneslegales que surgen de la ley de coparticipaci6n.

14. El gobiernofederal ha tomadomedidas iniciales para la liberalizaci6ndel mercadolaboral. Sin embargo, dada la importanciade la reasignaci6nde recursos en la economia, la aceleraci6nde la liberalizaci6ndel mercado laboral se vuelve imperativa. La urgencia en la efectivizaci6nde dichas medidasse ha hecho auinmAs pronunciada con la recienterecesi6n, que complic6aun mas el creciente problemade desempleoobservado durante el curso de la reestructuracionecon6mica. La implementaci6n de reformasestructurales y el reiniciodel crecimientoecon6mico podrian reducir el desempleoen forma rapida. A tales efectos, se deberfantomar las siguentesmedidas: la reducci6nde los costos laborales, una mayor flexibilidad en los contratos, reforzar el seguro de desempleo, y descentralizar las negociacionescolectivas. Adicionalmente,se recomienda enfaticamentedesarrollar un sistema de informaci6ny analisis del sector de servicios,que es la mayor fuente de empleo.

15. Con respecto a los costos laborales,se recomiendaseguir reduciendolos costos laboralesno salariales. Dentro de este contexto, el gobierno deberfa considerar extender exencionesfiscales a empleadosj6venes y a los desempleadosa largo plazo, asi como permitir el uso irrestrictode contratos temporalesy de plazo fijo. Con respecto al seguro de desempleo,las autoridadesdeberian considerar una modificaci6nen el sistema de indemnizaci6npor despido, debido a que la coexistenciadel seguro de desempleoy la indemnizaci6npor despidodesalienta a los desempleadosa buscartrabajo activamente, y a las empresas a ajustar 6ptimamnentesu fuerza de trabajo. Las autoridadesdeberfan considerar descentralizarlas convencionescolectivas de trabajo, rescindirel conceptode ultractividad,eliminar el monopoliode los sindicatossobre la provisi6nde serviciossociales para los trabajadores,y modernizar los programasde entrenamiento.

16. Argentina tiene la necesidad y el potencial para el desarrollo de mercados financieros similares a losde los paisesdesarrollados. Desde la puestaen marchadel Plan de Convertibilidad,las autoridades han mejoradoradicalmente el entornoregulatorio y econ6micode los bancosy los mercadosde capitales. Sin embargo, los problemas ocasionadospor el subdesarrolloinstitucional y la falta de desarrollo de mercadosy de productos,se han vuelto dificilesde tratar. Por lo tanto, los mercadosfinancieros siguen siendode poco desarrollados;tanto los gastos de intermediaci6n,como los margenesy la ineficienciason elevadosy desalientanfuertemente el ahorro y la inversi6n. El costo del creditopermanece elevado, el volumen de cr6dito es bajo, y el acceso al credito formal es particularmentedificil para empresas pequefiasy los productoresagropecuarios. Una consolidaci6n/reestructuraci6ndel sistema financiero, tanto privado como pCblico,es imperativapara la remonetizaci6ny el desarrollode la intermediaci6n barcaria de la economia. Es igualmentecritico el desarrollode mercadosde capitalespara mejorar el proceso de intermediaci6n.

17. Se recomiendanlas siguientesmedidas para consolidarla confianzay la liquidez del sistema bancario, incrementarel volumeny la madurezde ahorrosy prestamos,facilitar el acceso al credito,en particular para pequenias y medianas empresas, y desarrollar los mercados de capitales: (a) facilitar/promoverla aceleradareestructuraci6n y consolidaci6nde los bancos privados a trav6s del adecuadofinanciamiento y fortalecimientoinstitucional del Fondo Fiduciariode Capitalizaci6nBancaria; fortalecer la capacidadde inspecci6ny de control del BancoCentral; promover la fusi6n de bancoscon institucionesmas fuertes;y eliminartolerancias regulatorias; (b) reducirlos costosbancarios y el margen entre tasas de interes activasy pasivas, mediantela reducci6nde los impuestossobre las transacciones - x - financieras;el desmantelamientode barreras a la competencia;el establecimientode una curva de rendimientos(yield curve) continua y liquida;fortalecer el funcionamientodel mecanismode Garantfas sobreDep6sitos; mejorar la capacidadde analisiscrediticio de losbancos; y promoverel usode garantias bancarias;(c) facilitar la privatizaci6n o el cierre de bancos provinciales, a traves del uso de financiamientoadecuado del Fondo Fiduciario de Privatizaci6n;evitar ayuda fiscal federal que apuntale a los bancos provinciales; y fortalecer la capacidad legal de la Superintendenciade Bancospara hacer cumplir las normas prudencialesque se dicten sobre los bancos provinciales; y (d) proseguir con la privatizaci6n de bancos federales.

18. Vale la pena enfatizar la importancia de las condiciones macroecon6micas en el desempefioy perspectivasde desarrollodel sistema financiero. Dada la vulnerabilidadexistente frente a los bruscos cambios en los flujos de capitales, las siguientes altemativas podrian fortalecer la capacidaddel sistema como prestamistade uiltimainstancia: el Banco Central podria iniciar acuerdos de canje (swaps) con otros Bancos Centralesque actuen como prestamistasde uiltimainstancia, imponer requisitos de reservas mas elevados para mejorar la capacidad de respuesta del sistema financiero; el sistema financiero podria tender hacia una mayor participaci6n de instituciones financieras multinacionales, en la medida en que 6stas sean percibidas como entidadescapaces de cumplir con el rol de prestamistasde uiltimainstancia, y generar a lo largo del tiempo excedentessignificativos de reservas internacionales.

19. Tras afrontar el impacto de la creciente crisis externa, la Argentinadebe asumir una serie de desafios, aunque ninguno es tan importante como el atender las crecientes necesidades sociales. Un resurgimientodel crecimientoecon6mico es fundamentalpara aliviar la pobreza. Reformasestructurales como las antes propuestas, en particular la liberalizaci6ndel mercado de trabajo, reducirian el desempleo y acelerarian la moderaci6n de presiones sociales, contribuyendoa la vez a un crecimiento econ6mico mas elevado. Mas aun, las mejoras en eficienciaa partir de la reevaluaci6nde las finanzaspuiblicas federales y provinciales,permitirian la puesta en marcha de programas socialesmejor enfocadospara afrontar las necesidadesde los pobres, sin socavar la prudencia fiscal. El crecimientoecon6mico, junto con una nas eficiente asignaci6n del gasto puiblico,y la reducci6n de la evasi6n fiscal, deberian permitir la planeada reducci6nde las tasas impositivas(recientemente incrementadas), en un contexto de equilibrio presupuestario. La continuaci6n de las reformas en el gobierno federal, reflejadas en el programa de la Segunda Reforma del Estado previstas para 1996, son otro indicador de que reformar es un proceso continuo que requiere ser vigilado y fomentado.

CHAPTERI

DEFININGTHE CONVERTIBILITYPLAN

A. Origins of the Crisis Leadingto the ConvertibilityPlan

1.1 The economicills that the ConvertibilityPlan set out to correct date back to the 1940s, when statist GDP Growtha Inflateonhnd19I 1994 and inward-looking growth strategies took effect, ...- resulting in massive public sector deficits, accelerated . 3000 inflationand economicstagnation. By the mid-1970s, . s .. 00 the country's long-term growth declined noticeably, I,, 2000 and in the last half of the 1980s, the country suffered I from its longest period of stagnation in the century. I I 502 Savings and investmentrates fell precipitouslyfrom I 000 the mid-1970suntil 1989. Argentines, respondingto ., .0. the unstablemacroeconomic environment, increasingly it9_ L . ; Is.so D saved and invested abroad. Labor productivity fell -G75 19BD 1 1991 and poverty worsened. GCPGiowli |IIInOI

1.2 This economicperformance was traceableto Figure 1 chronic public sector deficits and endemic inflation. After the return to constitutionaldemocracy in 1983, public demands to control inflation were translated into four successivestabilization programs. All failed to eradicateinflation, and each ended in a more virulent inflation than the one preceding it. The main reason for these failures was the inabilityof the stabilizationprograms to redress rapidly and permanentlythe structural deficit of the public sector.

1.3 Structuraldeficits emergedfrom the post-war FederalGovernment Overall Balance organization of the economy. Since the 1940s, Percentageof GDP economic policy favored powerful interest groups. Unionized labor benefitted from high wages, guaranteed employment, and rigid rules governing o hiring and dismissals. Industrybenefitted from highly protected markets, tax exemptions through special .s l.ii....i... promotion regimes, subsidized credit (or even effectivegrants since many loans were not collected), 10...... subsidized inputs from public enterprises, and high prices on sales to public enterprises. Housing 1...... contractors and selected middle class home buyers benefitted from enormous public transfers through *200 N 190181 f0s f88e earmarked taxes and effective grants through the 86reeMlIettlnt ye Iofomy Housing Bank (BHN). Tobacco growers benefitted from special taxes, as did the sugar growers, the Figure 2 merchant marine, and other small interest groups. Consumers enjoyed below-cost tariffs from public enterprises and lax collectionpractices. Provincial governmentscould avail themselvesof costless credit from the provincialbanks, which the Central Bank would reimburse. The militaryenjoyed expandingbudgets, especially in 1976-82,as well as management perquisites in state companiesthey controlled. By 1989, subsidiesthrough the budget, tax exemptions, agriculturalregulations, public enterprisetariffs, and central bank rediscountswere estimatedto amount to US$8 billion. -2 -

1.4 The growth of the state and concomitant rents and subsidies, along with the capital flight provoked by an inconsistentexchange rate policy, had been financed during the late 1970s largely by external borrowing, through the expandingEurodollar market at low or even negative real international interest rates. This permitted the Govermnentto run large deficits and sustain a revalued exchange rate with relatively low levels of inflation in the second half of the 1970s. However, the abrupt end to voluntary foreign commercialcredit in the early 1980s the decline in commodityprices and the sudden rise in real international interest rates provoked a financial collapse and placed additional pressure on public finances. The situationwas complicatedby the South AtlanticWar.

1.5 The loss of external financeand lack of adjustmentmeant the Treasury had to resort to increased inflationary finance through monetary creation (aggravatedby quasi-fiscaldeficit). The private sector, in an effort to avoid the resulting inflationtax, graduallywithdrew its resourcesfrom the financialsystem and reduced its real holdings of currency; this, together with the negative effects of inflation on real tax collections, made the macroeconomyprogressively more unstable in the 1980s. Even though the level of the deficit fell from near 20 percent of GDP in the early 1980s to an average of about 10 percent in 1987-89, the base for the inflation tax shrank even faster--effortsto reduce the deficit were not fast or permanent enough to convince the private sector that their savings in domestic currency would not be taxed by inflation. Inflationbecame high and unpredictable,and thus became the main impedimentto the recovery of private savings and investment. The decade ended with two episodes of in 1989.

B. The Convertibility Plan

1.6 As an aftermath to the 1989-90hyperinflations, and the collapse of the monetary system, on March 1991 the authorities announced a new monetary system, based on a fully convertible fixed exchange rate regime. While many of the policies which later became part of the ConvertibilityPlan started taking shape with the Menem Administrationduring 1989-90, a consistent and well defined economicstrategy of stabilizationand structural reform only took place after Minister DomingoCavallo announcedthis new set of monetary measures on March 21, 1991. After this initial announcement,a complete set of consistent measures started to be implemented, becoming what is known as the ConvertibilityPlan. While this plan gets its name after the most popular instrument, the Convertibility Law, it represents a much wider set of measures aiming at the complete and permanent structural adjustmentof the economyand public sector reform. The main pillars of the ConvertibilityPlan are:

(a) Monetary Reform, through the ConvertibilityLaw, subsequentlysupplemented by the new Charter of the Central Bank;

(b) Fiscal Reform, initially through a sharp improvement in the administrationof the tax system and later through a redefinitionof tax instrumentsand rates;

(c) Public Sector Reform, through debt restructuring, civil service reform, fiscal restructuring and an ambitious and successfulplan of divestiture, and deregulation of factor and product markets;

(d) Social Security Reform, allowing for a new capitalizationmechanism operated by the private sector; - 3 -

(e) Trade Reform, through the eliminationof export taxes and most quantitativerestrictions on imports, and the reduction of the level and range of import tariffs.

The ConvertibilityLaw

1.7 The ConvertibilityLaw of April 1991, fixed the rate of the Austral at 10,000:1 to the dollar. On January 1992, the Austral was replaced by the Peso at the fixed rate of 1:1 to the US dollar. The Law also establishedthat the monetarybase could not exceed the dollar value of internationalreserves, and prohibitedall indexationin the goods and labor markets.

1.8 The ConvertibilityLaw, in practice, made the Central Bank into a by mandating a 100 percent for the issue of high-poweredmoney. By removing the power to devalue from the Ministry of Economy, and placing it with Congress, the Law attempts to remove the instrumentof from the set of easily available instrumentsand thus provide more credibility to the new currency. However, the Central Bank can exert some discretionthrough the use of variable bank reserve requirements,and excess internationalreserves. To ensure the full reserve backing, other conditionswere set on the behavior of the monetaryauthorities through the new Charter of the Central Bank. This Charter, approved by Congress on September 1992, establishedthe independenceof the Board of Directors, all of whom are ratified by Congress and provides fixed terms of tenure for the appointees, includingthe President of the Central Bank.

1.9 The Charter originally allowed a maximum of 20 percent of internationalreserves backing the monetary base to be in dollar denominatedgovernment bonds, which currently has been raised to 33.3 percent. Issuing base against BONEX allows the Central Bank to regulate short run fluctuations in market liquidity by swapping between pesos and BONEX. Additionally, the Charter dictates that the Central Bank cannot take any new interest earning liabilities, and it cannot remunerate reserve requirements. These measures eliminate the possibilityof generating a quasifiscaldeficit through the servicing of Central Bank debt. Consistent with the restrictionsfor generatingCentral Bank liabilities other than those used to acquire internationalreserves, the Charter does not allow the Central Bank to significantlyguarantee commercialbank deposits, i.e. deposit insurance. This substantiallyreduces the role of the Central Bank as a lender of last resort, both for the peso and for the domesticdollar deposits system. Nevertheless, in an emergency the Central Bank can provide, for a limited time, liquidity up to 100 percent of a bank's capital.

1.10 Under the convertibilitysystem, internationalreserves are backingthe monetarybase, and cannot be consideredas precautionaryreserves (see figure 3). Also, under this system, variationsin international reserves have a direct impact on the economy throughchanges in the , and the real .

1.11 An importantfeature of the ConvertibilityPlan is its bi-monetarynature, which permits the use of foreign exchangefor markettransactions, or the holdingof foreign exchangedenominated liquid assets in the domestic financial system. Since 1989, commercialbanks have been allowed to open dollar denominated accounts and to issue certificates of deposit. The reserve requirements against dollar deposits at commercialbanks are to be deposited abroad and are not counted as part of international reserves. Since 1993commercial banks are allowed to form their reserve requirementsagainst peso or dollar deposits in either currency, and at the same rate, thus increasingthe substitutionfrom the supply side between both currencies. In the face of the Mexican financial crisis, in January 10, 1995, further -4- measures were taken to facilitate the dollarizationof the economy and strengthen the ConvertibilityPlan. Ratio oseroesto Monetary Bage 1991-94 The Central Bank required banks to keep reserve 200 requirements on peso deposits only in US dollars, equalized the Central Bank's buying and selling exchange rate at 1 dollar: 1 peso (eliminating costs of transaction), and reduced dollar reserve requirements to match the temporary reduction in peso reserve ...... requirements. Dollarization has contributed to enhancing the credibility of exchange rate policy, . _ since it reduced vulnerabilityunder a fixed exchange rate, because portfolio shifts from domesticcurrency 0 deposits to foreign currency denominateddeposits, or 1901102 10 3 vice versa, would not necessarily involve a reduction I in total domestic bank deposits. Figure 3

1.12 Under a dollarized system, where fractional reserve requirementsare in effect, the concept of lender of last resort takes a different dimension, since part of the liabilitiesof the banking system are dollar denominated, and the Central Bank cannot print dollars to fulfil that function. In a crisis, high bank reserve requirements,excess internationalreserves, or a foreign lender of last resort are needed to fulfil that function.

1.13 FinancialReform. In conjunctionwith the abovementioned monetary reform, whichestablished a firm constraint on the Central Bank's ability to extend credit to the banking system, the primary instrumentfor increasingresource mobilization and reducehigh interest rates has been the implementation of policies enhancingconfidence in the economy and the financial system. In addition, the Government strengthenedbanking and capital market institutions. New banking policiesprimarily soughtto improve the financialsoundness of the banking systemto help increaseconfidence in domesticfinancial institutions and reduce the Government'sexposure to losses stemmingfrom bank failures. To improve the soundness of the banking system, the Law of Financial Institutionswas changed, allowing the Central Bank to withdrawthe operating license of private commercialbanks that do not comply with its technicalratios (i.e., reserve, capital, and provisioning requirements) and when its board rejects the bank's plan to achieve appropriate compliance. To reduce the public sector's exposure to losses stemmingfrom bank failures, the Governmentdecided to forego formal publicdeposit insurance. The Governmentalso made major strides in bankingregulation and supervision,and reformedthe structure, staffing, and technology of the Superintendencyof Banks. The Governmenthas been increasinglypressing for, and facilitating through Trust Funds the restructuringof the private banking sector and the privatization or liquidation of public banks. By the first quarter of 1996 the Governmenthad privatized a major national public bank, the Caja Nacional de Ahorro y Seguros, liquidatedthe Banco Nacional de Desarrollo, and five provincial banks were privatized (with another ten in the process of privatization). Similarly, the Governmentstrengthened regulation, supervision, and enforcementin the capital markets.

Public Sector Reforn

1.14 The Menem administrationtook office in July 1989 during a traumatic hyperinflation--July inflationalone was 200 percent. This culminateda decade-longcrisis in public finance. The new team inherited weak public institutionsaccustomed to deficit spendingand with an institutionalizedreliance on the inflationtax. In addition, claimson the state's revenueswere far greater than its capacity to mobilize resources--inshort, the Argentine state was insolvent.

1.15 In response to the crisis, the Menemadministration undertook two stabilizationprograms in 1989 and 1990. Neither succeeded, principally because of the intractabilityof the fiscal deficit. The first terminatedin a new hyperinflationat the end of 1989 and early 1990. The second lasted from March 1990-December1990 and ended in a new inflationaryoutburst but, unlike the previousbreakdowns, the economydid not spin into hyperinflation. Instead, a new fiscal packagein February 1991 was sufficient to close the remaining fiscal gap. This was followed by the April 1, 1991 Law of Convertibility, effectivelyproscribing money creation other than to buy net foreign reserves, thereby limitingthe powers of the Governmentto finance its deficit through inflation.

1.16 Since 1991, the Government has sustained structural reform efforts that had progressively improvedthe foundationsof public finance. The Governmenthad undertakendifficult-to-reverse reforms in the legal framework, institutions,and policies. This process included institutionalreforms of the Federal Government, , as well as restructuring of liabilities with domestic and foreign creditors to adjust them to serviceable levels. Other reforms have helped elicit efficient private investment, notably trade, deregulationand financial sector reform.

1.17 Revenue Mobilization The Government TaxRevenues undertooka major effort to improve revenuesthrough Ta ofGOP) the implementationof a much-broadenedand uniform 25 VAT, first to goods in February 1990, and later extended to services in November 1990. The 20 ...... Governmentin 1989 also undertook to improve the 15. efficiency of the tax administration--establishinga . control system for the largest taxpayers; improving audits and controls substantially. The tax penalty law, 5. adopted by Congress in 1990, provided much needed a 3 2 sanctionsfor tax non-compliance.The tax packageof I so I 91 Z92 1 93 1 94 1 95 I February 1991 improved the quality of the revenue Eica TangCM{0IeloIe Taxes 9 Social Seocuity mobilizationsubstantially because it eliniinatedexport 5 ' ci Eeirsy taxes--which had been reduced progressively during 1990 and early 1991--deducted higher taxes on Figure 4 financial transactionsfrom the income/assettax, and removed several minor taxes. In early 1992, the VAT rate was raised to 18 percent and the corporate income tax to 30 percent. The increase in VAT collectionhas allowed the Government to eliminate inefficienttaxes Lcn as the gas-oil tax and the federalstamp tax in November 1992. In December1992, subsidiesto indu.scrialpromotion were substantiallycut throughthe replacementof the self-monitoredtax deductions with a tax bond program. These efforts cumulatively produced dramatic rises in tax collections. -6 -

1.18 AdministrativeReform Because the wage Employmentof the National bill dominated expenditures, the Government set up AdmInIstration the legal and administrative machinery to reduce the size of the federal bureaucracy in November 1990. Federal employment decreased from 671,000 to aoo 284,000. Of the 387,000 reductions, 103,000 were lay-offs and 284,000 were transfers of teachers and seo health workers to the provinces. This effort was 400 based on a ministerial reorganization that focused federal activities on core objectives, and 200 improvementsin the civil service system through an

improved salary structure and efficiency measures. - The Governmentwas able to increaseaverage salaries 196B 1096 1990 1991 1992 1993 1994

and partially restore salary differentials. During ______t_y______1996, the Government has received congressional Figure 5 authorizationto proceed with a second administrative reforn to improve further its organization,performance, accountability and transparency.

1.19 Divestiture The Menem Government has PrivntizationRevonues 1990*94 followed an accelerated timetable for privatization or US$Million partial divestiture of most of its enterprises. The Tkeusends objective was to reduce the budgetary burden of the 7 enterprises on the Treasury, make the firms more a 5.710 competitive,and increasethe volumeand efficiencyof 5 new investment. The privatizationprogram, in the 4 3661 works since 1988, gained credibilitywith the sale of 3 ENTel in November 1990. The program removed _9_ politics from price setting in the formerly vast 2 1.5 segment of the economy covered by the state. The * 05 change in the institutional organization of these oil sectors cut off public subsidies to consumers and labor 1990 1901 1992 1993 1994 S,mrer, MIuloryol Ecomomy groups benefitting from high wages and excess I______Ministry______staffing, and transfers for investment. The program Figure 6 also improves public finances: transitionally with more than US$2.5 billion in capital receipts to help close fiscal accounts in 1991 and 1992, more permanently by eliminatingtransfers and increasingtax revenues.

1.20 The Governmenthas sold two television stations, ENTel, the national telephonecompany, and Aerolineas . In mid-1991, it began the first comprehensiverestructuring of the petroleum industry in Latin America by auctioning off selected areas of YPF. It granted road and railroad concessionsto the private sector and privatized longdistance cargo lines, and reduced the railway's work force by 15 percent. The Government privatized in 1992 defense industries, the nation's largest distributorof electricity(SEGBA), ports, reinsuranceand major parts of the power sector. In July 1993, the successful privatization of state-owned oil company (YPF) enabled the Government to cancel obligationsto pensioners (about US$2.7 billion) and to oil producingprovinces (about US$1.2 billion). The Government is currently in the process of privatizing airports, nuclear power plants, and the hydroelectricplant, Yacyreta. - 7 -

1.21 Deregulation A major domestic deregulationdecree was issued in October 1991. This ended a series of market impeding rules, dissolved several regulatory bodies and unified pension and health insurance paymentsto reduce evasion. Subsequentdecrees have deregulatedpharmaceutical imports and ports. The industrialpromotion program and subsidiesto Tierra del Fuego were markedly reduced by a recent decree in November 1992, though it was partially reverted in December 1993. Deregulationis projected to be extended in the provinces through the recent Pacto Fiscal.

1.22 ProvincialReforms The Federal Government's ability to effect reforms in provincial public finances is constrainedby lack of directjurisdiction. Still, since the ConvertibilityPlan was initiated in 1991, the Federal Government has launched a concerted effort to promote fiscal adjustment in the provincesby regularizingthe transfer of co-participatedfederal revenues; reducingdiscretionary transfers that historically have rewarded poor fiscal performers; transferring responsibilityfor the provision of most social services in health and educationto the provinces; reforming and assumingresponsibility for provincial social security systems; improvinglocal resource mobilization;modernizing and downsizing provincial public administration;eliminating Central Bank rediscounts; and promoting the privatization of provincial banks. This strategy was initiatedin August 1992, when the Federal Governmentreached an agreement (Pacto Fiscal I) with the provinces whereby 15 percent of co-participatedfunds would be diverted to finance the transition costs of national social security reform. In return, federal authorities agreed to compensatethe provinces partially by guaranteeinga minimumof US$725 million per month in co-participatedtransfers.

1.23 Further modificationswere reachedunder the Pacto Fiscal II of August 1993. The Pact calls for reforms in provincialtax systemsto replace distortionarytaxes. In return the Federal Governmentagreed to increase the minimum monthly co-participated transfers to US$740 million, forego the debt accumulatedby the provincesunder the August 1992agreement, gradually eliminate the federalasset tax, and take over responsibilityfor governmentemployee pension systems from willingprovinces.'

1.24 Finally, the Federal Governmentmoved to shut off provincialaccess to private sector borrowing to support current expenditures. Domesticbanks have had to obtain BCRAauthorization before lending to the non-financialprovincial public sector, since the mid-1980s. In November 1993, the Government also began requiring authorizationfor provincial banks to borrow abroad, in order to head off further loans from foreign banks backed by co-participatedrevenues.

Debt Restructuring

1.25 Debt with the FinancialSystem and QuasifiscalDeficit. On January 1, 1990, faced with rising Central Bank deficits and the renewed threat of hyperinflation,the Governmenttook the drastic action of converting the domestic, short-term (mainly seven day), interest-bearingobligations of the Central Bank into US$3.5 billion 10 year dollar denominated Treasury bonds (BONEX). This virtually eliminatedthe Central Bank's quasifiscaldeficit and the monetaryemission necessary to finance it--at the cost of penalizing savers and reducing the already low confidencein the financial system.

1. As a follow-upto increasethe incentivesfor the provinces,in December1993 the FederalGovernment announcedthat employerwage taxes would be reducedin thoseprovinces carrying out the proposedtax reforms. -8 -

1.26 External Debt. In April 1988, the Government suspended payment on its external debt to commercialcreditors. By 1992, it had accumulatedUS$9.2 billion in arrears as part of a US$30 billion medium-term commercial bank debt. Public external debt was US$58 billion. The progressive improvement in fiscal fundamentals in 1990-91 allowed the Government to begin negotiations with commercialbanks on a debt reductiondeal. The external debt agreement with commercial creditors, signedon April 7, 1993, ended the accumulationof arrears, regularizedexisting arrears, reduced interest obligationsin the initialyears, and sharply limits interest obligationswhen internationalrates rise. The agreement formalized arrears in a 12-yearuncollateralized bond at LIBOR with a 3 year grace period, after a US$700 million downpayment;existing debt was exchangedfor a collateralizedpar bond with a fixed interest rate, or a collateralizeddiscount bond at 65 percent of face value paying LIBOR; the collateralizedbonds have a 12 month rolling interest guarantee.

1.27 Arrears to Pensionersand Others. For most of the last decade, the Governmenthas paid only about half the legally mandated pensions owed to social security recipients. In order to stop the accumulationof arrears, the Government modifiedthe coparticipationof tax revenues in favor of the social security system in August 1992. The Governmentalso accumulatedarrears in 1990with suppliers through the formal suspensionof paymenton goods and services already provided, and the health funds have arrears with their service providers which will also result in new debt. To settle these claims, Congress authorized the Government to issue consolidationbonds (BOCONs) with terms of 10 to 16 years (with shorter terms for social security recipients)and a five year grace on principal and interest. The service of the debt will be capitalizeduntil 1997,but paymentson the order of US$3 billion will be required in the last years of this decade. The proceeds of the privatizationof the state oil company allowed the Government to cancel part of its debt with pensioners (about US$4.5 billion) during the course of 1993. At the end of 1994, US$7.7 billion of issued bonds were outstandingto the above claimants.

Social Security Reform

1.28 Argentina's mandatorypublic pension insurancebecame financiallyunviable during the 1970s, resultingin severe underpaymentof pensions. In 1991, the Governmentconcluded that adequatebenefits and financial viability could only be restored with a systemic reform that would reverse the steeply increasingtrend of the dependencyratio (pensioners/contributors),which was primarily the result of an increasing evasion of contributions. As an initial step leadingup to the actual operationof the system in July 1994, the Governmenttook measures enabling the National Pension System, to gradually raise benefits to their mandatedlevel. These includedthe earmarkingof coparticipatedtax revenues, a reform of the collectionfunction, and an increase in the minimumyears of contributionsfrom 15 to 22, which slowed the increasein the numberof pensioners. In addition,the Governmentissued consolidation bonds in recognitionof pension arrears estimated at about US$10 billion.

1.29 Centralto the reform is the combinationof publicschemes on a pay-as-yougo (PAYG)basis with private or public pensionfunds in an integratedsystem of mandatorypension insurance. Employers and independentworkers will contribute 16 percent of, respectively, gross salary and income to the PAYG system. The schemeprovides a basic, uniformpension of about28 percent of average salary, which may be increased only by additional years of contribution beyond the 30 year minimum. All workers contribute 11 percent of salary or income to either the PAYG scheme or a pension fund with the right to change affiliationtwice a year. Expectedbenefits will be strictly proportionalto contributionsand--in the case of pension funds--thefund's investmentperformance. These rules are expectedto lower evasion - 9 - by linking expected benefits to contributions. Further measures to reduce the dependencyratio include a gradual increase in the retirement age by 5 years, a further increase in the minimum years of contributionsto 30, and stricter rules for disability claims. In the context of provincial reforms, the Governrmenthas initiated the consolidationof inefficient provincial social security systems with the national system.

Trade Reforms

1.30 One of the main pillars of the ConvertibilityPlan has been Trade Reform, which eliminated export taxes and most quantitativerestrictions on imports, while reducing the level and range of import tariffs. Reductionin tariffs and non-tariff barriers, starting during President Menem's Administration, have been dramatic when put in the context of Argentina's protectionist history, stemming from the import-substitutingstrategy of over 40 years.

1.31 As a result of protractedprotectionist policies, the degree of openness of the economy which OpennessCoelicrent 1979 - 1994 averaged 35 percent in the 1920's was reduced to 0.14 about 6 percent during 1970's. This ratio was 0.12. increasedduring the ConvertibilityPlan to an average 01. of 11percent. 2

1.32 The trade regime underwent radical changes | D . . since the late 1980s. The import regime was l transformed from a highly protectionist regime to a liberal regime. The most fundamentalchange in the 0.02 . import regime was the replacement of quantitative o . . . 1090 restrictions with tariffs, which in itself is a significant 197D ,9BD 075., 0 85 trade liberalization.However, quantitativerestrictions sONIC#M.,.,,y o Ecolow were maintained for automobiles, sugar, and some Figure 7 paper items. The average nominal tariff on imports (includingthe statistical tax) was reduced from 30 percent at the end of 1989, to 14 percent on April 1995. However, following the initial strong liberalization, the trade regime acquired increased complexity. The February 1991 import regime was simple and consisted of only three tiers; by late 1994, the import regime had seven tariff tiers, and it became linked to the export performance. However, protection remained low as did the variance, althoughthe latter would have increasedin terms of effective protection rates.

1.33 Trade liberalizationalso has a strong regional bias. Argentina is a member of MERCOSUR (common market), establishinga common external tariff. Argentina adopted a common external tariff (CET) of 20 percent on January 1, 1995 under the MERCOSURAgreement. However, the CET applied to some 85 percent of the harmonizedtariff lines. The remaining 15 percent of the tariff lines were to converge to the CET over time. Additionally,trade inside the MERCOSUR area is free from import tariffs, with exceptions. This arrangement stands in contrast to the earlier regional arrangements undertakenunder the aegis of the Latin AmericanIntegration Association (LAIA) when preferenceswere

2. Definedas exportsplus imports over GDP. - 10- used to restrict trade outside the regional arrangementsrather than liberalizetrade in what can be called GATT- plus basis. The new trade policy led to a rapid opening of the economy-bothin terms of trade, as well as capital and technology flows, since foreign investorswere extendedthe same legal rights as domestic investors.

1.34 Like the import regime, the export regimewas also transformed. In the late 1980s exports were subject to taxes and licensingand there was an extensivearray of export promotionand subsidy schemes. These included the duty free status accorded to capital goods imports based on multi-annualexport contracts, a temporary admissionregime for intermediategoods, a 15% export subsidy on items under the special export program aimed at promotingnon-traditional exports, and subsidizedexport financing. Export taxes, primarily falling on agriculturalexports were around 10-12 percent of export value, and constituteda significant part of governmentrevenue.

1.35 With the reforms of the early 1990s, most export subsidiesand taxes were removed. But that regime also subsequentlybecarne more complex with the "mirror export subsidies" program which granted to each export product the same rate of subsidy as that correspondingto imports of the same product, sectoral performanceagreements, and attemptsto balance exports and imports by industry. In 1992, the rules of the automobile regime were extendedto a few other industries. This was called a regime of "industrial specialization". Any industry could enter into an agreement with the Secretary of Industry and Commerce specifying a target export figure for the coming years. Such firms would receive import licenses with reduced tariffs up to the export target that had been agreed upon. Four periods were consideredfor industrialspecialization: 1993-96, 1997, 1998 and 1999. In the first period, the tariff rate would be 2%, after 1996 a specifiedformula wouldbe used to calculatethe reduced tariffs. The exchangerate reform and the reductionof import tariffs helped reduce the bias against exports.

1.36 Previous attempts to liberalize the trade regime could not be sustained due mostly to macroeconomicinstability, lack of commitmentto free trade, and resistancefrom domesticindustries that had thrived under protectionisttrade regimes. Moreover, the earlier attempts were not combinedwith strong privatizationsor regulatoryreforms and could not support the resourcemovements that are needed to reallocateresources following a reduction in protection. The trade liberalizationlaunched in the late 1980s and accelerated in the early 1990s, succeeded to a large extent due to the remarkable macroeconomicstability achievedby the ConvertibilityPlan. - 11 - CHAPTERII

ECONOMIC PERFORMANCEAND MACROECONOMICIMPLICATIONS OF TIE CONVERTIBILITYPLAN

A. EconomicPerformance (1991-94)

2.1 This chapter reviewsthe main macroeconomicimplications of the ConvertibilityPlan. Economic performanceunder the ConvertibilityPlan is separatedhere into two periods; the 1991-94growth period, and the crisis year of 1995. This separationin warranted, since the crisis was generated primarily by external factors, and both periods have different lessons to offer to the future evolution of the ConvertibilityPlan.

2.2 The results of the ConvertibilityPlan during 1991-94 have been impressive. With dedicated public sector reforms that led to dramatic improvement in the federal Government's finances, and monetary policy guided by the ConvertibilityLaw, the credibilityof the ConvertibilityPlan was quickly established. Inflation,measured in consumerprices, deceleratedfrom 1,343 percent in 1990 to only 3.9 percent in 1994. With the decline in perceived country risk and a hospitable international financial environment, capital inflowsaccelerated, fueling an economicexpansion. Between 1991 and 1994, real GDP grew at an average rate of 7.7 percent.

2.3 The consumption-ledgrowth in the first two years of the Plan, which is a common occurrence in exchangerate stabilizationprograms, was more importantlysupplanted in 1993and 1994 by an export- and investment-ledeconomic growth. Over the 1993-94 period, exports grew in real terms by 14.8 percent and investmentby 19 percent. By 1994, gross fixed investmentreached 19.9 percent of GDP, associated with increased national and foreign savings. Exports, which were affected by declining internationalprices in 1992-93, rose by 20 percent in 1994, with manufacturedgoods exports exhibiting particular buoyancy,growing at an average27 percent in 1993-94. This transformation,which occurred in the face of the peso's appreciation3 , was the result of improvementsin productivity. Over 1993-94, imports of capital goods led the strong expansion of overall imports, indicative of the acceleration in investmentand the restructuringof the economy. As a result of the economicrecovery, poverty levels4 declined significantly. Nevertheless,as discussedin the next chapter, economicrestructuring with a rigid labor market resulted in the increase in unemploymentto 12.2 percent of the labor force by late 1994.

3. The Argentinepeso appreciatedin real terms by about 20 percent betweenthe beginningof the ConvertibilityLaw regime and end-1994;however, after adjustmentfor tax reductionsand other reforms,losses to exportcompetitiveness may have been one thirdlower that amount. 4. A detailedreview of povertyissues in Argentinacan be foundin the Bank's1995 Report No. 13318-AR, titled"Argentina's Poor: a Profile". - 12 -

Table 1: Economic Performance

1991 1992 1993 1994 1995 d/

Mational Accounts (X of GDP) GDP Growth (X) 8.9 8.7 6.0 7.4 -4.4 Total Investment 14.6 16.7 18.4 19.9 17.8 National Savings 15.2 14.3 15.9 16.9 16.4 Foreign Savings -0.5 2.4 2.5 3.6 1.4 Fiscal Accounts (Federal Goverrnent)a/ (X of GDP) Total Revenues 17.9 17.9 17.7 17.2 16.5 Total Expenditure 15.3 17.5 16.6 17.2 16.4 Primary Surplus 1.8 2.2 2.2 1.1 0.6 Overall BaLance b/ 0.2 0.4 1.1 -0.0 -1.0 (BillionUSS) Trade balance 3.7 -2.6 -3.7 -5.7 0.9 Exports 12.0 12.3 13.1 15.8 20.9 Imnports 8.3 14.9 16.8 21.5 20.0 Current Account -0.3 -6.3 -7.3 -10.3 -3.8 Capital Account 3.0 10.2 12.1 10.5 1.9 Balance of Payments Result 2.7 3.8 4.8 0.2 -1.9 Inflation (X) S/ 84.0 17.5 7.4 3.9 1.6

Source: Ministry of Economy a/ On a Cash Basis. b/ Without CentraL Bank quasi-fiscalsurplus. c/ December-December change. d/ Preliminary Public Sector Performance (1991-1994)

2.4 In 1991-94, the performance of the Argentine public sector was commendable in many respects. First, following a decade of public deficits, the Government was able to achieve an overall surplus of the consolidated public sector in 1992 and 1993, eliminating the need for inflationary finance. Second, a series of difficult to reverse reforms in the legal framework, institutions, and policies reduced the size of the public sector to 27.4 percent of GDP in 1994, down from an average of 33 percent of GDP during the eighties decade, and substantially lower than the 40 percent average rate in OECD, and other Latin American countries (for example 31 percent of GDP in Chile and 34 percent in ).6

2.5 The composition of the public sector also changed significantly with privatizations, the decentralization process initiated in 1991, and the reform of the social security system in 1993 (Table 2). The share of the national administration (including public enterprises) declined from 48 percent of total public expenditures in 1980-83 to only 23 percent in 1994. The social security system expenditures gradually increased from 22 percent in 1980-83 to almost 31 percent in 1994. The most significant development during this period has been the decentralization process with expenditures of local governments increasing from 29 percent in 1980-83, to 46 percent of total public expenditures in 1994.

5. For a more detailed review of public financesduring the 1980sand early 1990s, see "Argentina- Public Finance Review: From Insolvencyto Growth", IBRD No. 10827-AR,February 11, 1993.

6. See: ,"World DevelopmentReport, 1988". - 13 -

Table 2: Level and Compositionof Total GovernmentSpending (Percentageof GDP) c/

1980/83 1984/88 1989 1990 1991 1992 1993 1994

Totat Goverrnmentexpend. 32.52 33.05 35.61 27.77 29.33 28.73 28.61 27.39 National Goverrnmenta/ 23.10 21.84 25.17 19.04 17.85 16.34 15.21 14.84 Provincialand municipal 9.42 11.21 10.44 8.73 11.48 12.39 13.40 12.55 Social Security 2/ 4.99 5.57 5.28 6.51 7.37 7.48 7.02 7.08 Total Gov. without Soc. 27.53 27.48 30.33 21.26 21.96 21.25 21.59 20.31

Source: Argentina en Crecimiento,Ministry of Economy, 1995. a/ Includes National Acdinistration,Public Enterprisesand Social Security System b/ Total Social Security System (NationalGoverrmient and Provincial Governments) c/ The figures are on accrued basis. 2.6 The Federal Govermnent The initial success of the ConvertibilityPlan is largely due to the severe fiscal adjustment at the Federal level in 1991-93. The overall surplus averaged0.6 percent of GDP during this period, reaching 1.1 percent of GDP in 1993. As a result, the inflationrate declined abruptly and the Government'scredibility was gradually restored both in the domestic and international financial markets. In 1994, a surge in expenditures,including the increasedcosts of the social security reform, brought the federal public sector accounts to a balance.

2.7 The strong performance of the Federal Governmentwas primarily the result of large increases in current revenues, an increaseof 3.4 percentagepoints of GDP between 1990 and 1994, associatedwith the reduction in inflation, better institutional revenue collection capabilities, and the resumption of economic growth. VAT collections (with the VAT raised at a uniform rate of 18 percent) showed the fastest growth, reaching 6 percent of GDP, more than twice the 2.5 percent average of the eighties decade. Massive privatizationsalso became a primary source of revenue, averagingabout 0.7 percent of GDP annually between 1991-93, when the bulk of the privatizationsoccurred. Of the $18 billion raised through privatizationsbetween 1990-93, half was received in cash, and the rest in bonds and transfer of liabilities.

2.8 On the expenditureside, spendingby the nationaladministration declined by only 0.1 percentage point of GDP between 1990 and 1994, including, however, higher transfers to the provinces and the social security system. Expenditures,as a share of GDP, declined significantlywhen compared to the eighties period. but the major cut in public spendingtook place during the hyperinflationof 1989. The nationaladministration benefitted from the growth of the economy,raising its expendituresbetween 1990 and 1994 by a real 32 percent. Concurrently,by 1994, the share of social expendituresto total federal public expenditures, reached 64 percent. During this period, the Government was able to increase average salaries and partially restore salary differentials.7 As regards consolidated public sector employmentlevels, evidence suggeststhat any adjustmentwas done exclusivelywith respect to the sale of public enterprises, since the increasein public employmentin the provinces more than compensated for any reductionsin permanent federal employees(excluding public enterprises).

7. The transferof educationand healthresponsibilities to the provincesaccounted for an importantreduction in the numberof positionsin the FederalGovernment. However, it is worthunderscoring that the cost of the transfercontinue to be coveredby the federalauthorities, as part of the PactoFederal, which assigned about US$1.5 billionin revenuesto the provincesannually for their additionalresponsibilities. - 14 - 2.9 Public social expenditureunder the ConvertibilityPlan has been growing in absolute and relative terms. Consolidatedpublic social expenditurehas increased form 16.4 percent of GDP in the 1984-88 period, to 18.4 percent of GDP in 1994. With the overall decline in the size of the public sector in the 1989-94period, overall social spendingas a share of total expenditurehas risen from 49.5 percent in the 1984-89period, to 67.2 percent in 1994. Within the social areas, in 1994 more than half of the budget (57.3 percent) was devoted to social insurance programs--expendituresin these programs have been growing the fastest--includingold age and disabilitypensions, health insurance, family allowances,and unemploymentinsurance. With increaseddecentralization of functions, in 1994, 62.6 percent of public social expenditure (excludingsocial security) was executed by provinces and municipalities.

2.10 ProvincialGovernments Argentine provinces vary widely in population,physical endowment, and institutionalcapacity. Throughoutthe 1980s,deficits generated by provincialgovernments and their officialbanks were major contributorsto the chronic instabilityof the Argentinepublic sector. The fiscal adjustment at the central level as well as economic growth generated an unprecedented increase in coparticipated revenues in 1991-92 which allowed provincial governments to improve their fiscal accounts. Since 1992, however, expendituresincreased much more rapidly than revenues resulting in fiscal deficitsof 0.8-0.9 percent of GDP over the 1993-1995period (table 3). The provincialdeficit has been only partially financed, contributingto an unstable economic and social situation in many of the northern provinces. Fiscal difficultiesled to violentdemonstrations in several provincesduring in recent years.

Table 3: ProvinciaLGovernments--Executed Budgets (% of GDP)

1991 1992 1993 1994 1995

Current Revenues 8.2 9.6 9.6 9.5 9.4 Provincialorigin 3.0 3.8 4.0 4.0 3.9 Federal origin 5.2 5.9 5.6 5.4 5.5 Capital Revenues 0.0 0.1 0.1 0.1 0.1 Current Expenditure 7.8 8.8 9.2 9.1 9.2 CapitaL Expenditures 1.2 1.1 1.3 1.4 1.4 Overall BaLance -0.7 -0.2 -0.8 -0.9 -1.1

Source: Ministry of Economy

2.11 Provincial revenues, which amountedto US$25 billion in 1994 and 1995, are characterizedby low revenue mobilizationfrom provincial sources and a correspondinglyhigh dependence on revenue transfers from the Federal Government. Federal transfers financed an estimated 53 percent of total provincialspending in 1995, ranging from a high of 92 percent of total expendituresin La Rioja to a low of 40 percent of spendingin the Province of Buenos Aires (not includingMCBA's unusually low ratio of 6.9 percent). Transfers include co-participated funds (69 percent), royalties (4 percent), and a combinationof discretionarygrants and sector-specifictransfers (27 percent)-- the latter of which largely are financedout of earmarkedgas, energy, and assets taxes.

2.12 At the same time that provincialgovernments have lagged in makingnecessary fiscal adjustments, their role within the economy has grown as a result of decentralizationand the privatizationof many federal functions. In 1995, provincial governments(including the Municipalityof BuenosAires) spent 11 percent more than the federal government on goods and services and total provincial employee payrolls were more than twice the level of employeeexpenditures at the federal level. Provincesare now the major providersof core public services in health, education,security, water and sanitation,electricity, and other infrastructure. Provincesalso have their own banks and a large variety of public enterprises. - 15 - 2.13 The aggregatedeficit of the provinceshas been persistent and large throughoutthe Convertibility period, at almost one percent of GDP and 10 percent of total revenues. Recent estimatesput the stock of provincialdebt at approximatelyArg$14-15 billion. The situationvaries dramaticallyacross provinces, where some provinces maintainedsmall deficitsor even surpluses, while others consistentlyran deficits on the order of 20 to 30 percent of revenues. Many provinces increased their borrowing from the domestic financial market, their own provincial banks, and the Federal Government, mostly on short terms (less than 2 years), in spite of the massivefinancing received through the debt consolidationprocess with the Federal Government, equivalent to over US$3.0 billion in 1993-94.8 When the financial crisis hit in early 1995, the chronic-deficitprovinces were faced with large debt service bills, the hard-to-break habit of high spending, and provincialbanks on the verge of bankruptcy. These provinces suffered the most from the impact of the crisis.

Capital Inflows,the Current Account and the Real ExchangeRate

2.14 The ConvertibilityPlan generatedenough credibility, internal and external, to significantlyreduce the country's risk premium (measured by the differencebetween BONEX rates and LIBOR) to about 4 percent in 1994, from an average of 20 percent in 1990. Factors contributingto the fall in country risk can be associatedwith the overall market oriented strategy of structural adjustment,including monetary and fiscal reforms, the steps taken to refinancethe external debt (under the Brady Plan), trade reform and privatizations. Capital inflowsare significantlycorrelated to the country's risk premium. In general, the fall in country risk can be associatedwith an increasein the rate of capital inflows9.

2.15 There have been various sources of capital inflowsduring the ConvertibilityPlan. By far, the most significanthas been the repatriationof dollars that Argentinesheld abroad. Under the new financial rules, commercialbanks were allowed to capture dollar deposits and relend them, subject to a marginal reserve requirement. As the country risk decreased, Argentinessaw fit to bring back their dollars which made up the major componentof capital inflowfor the period, as seen in Table 4.

2.16 During the three calendar years 1991-94, accumulatedcapital inflows amounted to 36 billion dollars out of which 20 billion were from asset repatriation,measured by the increase in dollar deposits at commercialbanks. Of the remaining$16 billion, privatizationsand direct investmentrepresented $14 billion. The remaining $2 billion was from InternationalOrganizations.

2.17 The accumulatedUS$36 billion in capital inflowsseem to have been entirely voluntary as they financednot only US$24 billion in current account deficitsbut also reserve accumulationto the order of almost US$12 billion.

8. The total bonds receivedby the provincialgovernments in 1993-94reached US$4.0 billion but about US$1.1billion was usedto cancelthe debtof the provincialbanks with the BCRA. 9. In a regressionwith data from 1988.1to 1994.9,shows that one pointreduction in the countryrisk rate was associatedwith 440 millionannual increase in capitalinflows. Since the countryrisk was reducedfrom an averageof about20% in 1990to just over5% by yearend 1991,the contributionofthis factorto the rate of capital inflowsmust have been substantial. - 16 -

Table 4: Compositionof Capital Inflows 1991-94 (USS miLlion)

1991 1992 1993 1994 1991-94

ArgendoLtars 3,659 4,376 7,157 4,936 20,128 Privatizations 1,974 3,661 5,718 605 11,958 Direct Investment 305 465 587 677 2,034 InternationaLOrganiz. 312 (207) 1,952 (66) 1,991 Others (3,263) 1,867 (3,292) 4,460 (228)

Capital inflows 2,987 10,162 12,122 10,612 35,883 Current account (259) (6,336) (7,288) (10,074) (23,957) Reserve accumulation 2,728 3,826 4,834 538 11,926

Source: Ministry of Economy 2.18 An analysis of capital inflows to Argentina has to take into consideration the fact that the economy's performance in the 1991-94period reflects not only the inflows phenomenon but also the major disinflationthat emerged as a result of the ConvertibilityPlan. This is especially relevant for comparisonswith Chile and Mexico, where stabilizationplans (and disinflation)preceded the arrival of capital inflows. Accordingly,the observedreal exchangerate appreciation, increasedeconomic growth, monetization,and increasedcurrent accountdeficit in Argentinacapture the effectsof both exchange-rate- based disinflationand the surge in capital inflows, and it is very difficultto quantitativelyassess their separate impact. Similarly, given the coincidenceof capital inflows and disinflation, it is difficult to ascertain the quantitative importance of external versus internal factors in accounting for the rise in inflows.

2.19 The rapid reduction in Argentineinflation and devaluationexpectations, as well as country risk, have been reflected in a strong decline in interest rates. A key additional element to these developments has been the policy of monetizationand lack of sterilizationadopted in the context of the Convertibility Plan. The non-sterilizationof capital inflowscontributed to a substantialreduction in domestic interest rates (faster to that of Mexico and Chilein a similar phase of inflows),and a marked increase in domestic liquidity(most of it demand induced). In addition, the Argentine authoritiesavoided sizable quasi-fiscal implicationsof sterilizationobserved in other countries, preciselyat a time that establishingfiscal balance and fiscal credibilitywere of major importance.

2.20 The large inflows of capital helped financea credit boom that was a determiningfactor of the real growth experiencedsince 1991. A regression analysis suggeststhat over a five year period (1988-94)a US$1 billion in annual capital inflowmay have been associated with a 10 percent rise in the index of industrial production. Capital inflows affectedboth real production and relative prices. An expansion in the supply of foreign exchangewill reduce the relative price of traded goods in terms of non-traded goods. Thus, there should be a real appreciationof the currency. The more closed the economy is, and the more inflexibleits factor markets, the larger will be the appreciationof the currency in response to a capital inflow. Evidence suggests a strongly negativerelationship between the real exchange rate and capital inflows, suggesting that capital inflows, coupled with the inflexibilityin the goods and factor markets, may be at the core of the real appreciationexperienced early in the ConvertibilityPlan.

2.21 To summarize,the stylizedfacts of the macroeconomicimplications of the first four years of the Convertibility Plan can be described as follows: the perception of structural adjustment reduced the country risk premium which in turn induced capital inflows, mainly from assets repatriation and privatizations. Capital inflowsincreased both the supplyof credit and aggregate demand and ended up financingcurrent account deficitsthus requiring a real appreciationfor the resource shift to occur. The - 17 - high inflexibilityof goods and factors markets in Argentina implied that small rates of capital inflows required large changes in relative prices for transfers to occur.

2.22 Effects on FinancialMarkets The reduction in inflation,monetary reforms, and the surge of capital inflowshad unprecedentedeffects on the financialmarkets. After a decade of basically operating as a barter economy, credit reappearedand interest rates fell sharply and fast. Table 5 shows a simple decomposition of peso lending rates into their main components: international rate, country risk, credibility,and lending spread. Credibility,or the expectationof devaluation(measured by the difference between the peso and dollar deposit rates at commercialbanks) fell sharply after the implementationof monetaryreform, helped by the virtual creation of a Currency Board. Country risk was not a significant component of the high real rates, as it never exceeded an annual 7 percent. Nevertheless it did fall, reaching levels which were low for a country that until recently had not regularly serviced its foreign debt. Followingthe 1995 crisis, when interest rates surged sharply, in the first quarter of 1996 interest rates come down quite fast, reaching the lowest levels since the beginning of the ConvertibilityPlan. While country risk has been coming down fast, even more impressive has been the decline in the devaluation risk, which in February 1996 also reached its lowest rate since the beginning of the ConvertibilityPlan.

Table 5: InterestRates and Stabilization:Argentina after May 1991 (percent)

Decompositionof Average Peso Lending Rates

Average Peso Lending BorrowingSpread Foreign Quarter Lending Rate Spread Devaluation Country Interest Risk Risk Rate (X (X a/ (X b/ (% c/ (X 9/

11-91 51.4 11.6 17.5 9.4 5.6 111-91 44.8 5.9 21.3 7.0 5.4 IV-91 40.8 13.1 13.4 4.9 4.6 1-92 34.9 8.9 12.3 6.2 3.9 11-92 30.9 13.5 5.4 5.5 3.7 111-92 31.7 13.4 5.5 6.8 3.1 IV-92 30.9 -2.0 19.7 8.2 3.1 1-93 28.5 7.9 7.3 7.8 3.0 11-93 24.5 9.4 5.4 4.8 3.0 111-93 23.0 10.6 4.2 3.6 3.0 IV-93 22.6 11.9 3.3 2.8 3.1 1-94 21.3 11.5 2.1 3.2 3.2 11-94 22.5 10.2 2.3 4.4 4.0 111-94 23.0 11.1 2.4 3.5 4.5 IV-94 25.3 12.0 2.8 3.4 5.3 1-95 47.8 25.2 5.4 5.9 5.8 11-95 44.8 23.4 5.8 5.1 5.6 111-95 28.0 14.5 2.2 3.8 5.4 IV-95 25.3 12.1 2.3 3.9 5.3 1-96 e/ 21.0 10.0 1.8 2.9 5.0

Source: The World Bank. a/ Difference between Average Peso Lending Rate and Credibility,Country Risk, and Foreign InterestRate Indicators. b/ Measured as the difference between fixed term deposits in locaL currency and in dollars. c/ Measured as the difference between Bonex 89 internal rate of return and 180-day LIBOR (annualized). a/ Corresponds to Treasury Bill InterestRate. e/ January and Februaryaverage. 2.23 Local currency loans rates, though, remain high. Given the observed decline in devaluation expectationsand country risk, these high lending spreads represent a risk premium associatedwith the relativelylow credit rating of local currency borrowersand the relativelyhigh intermediationcosts in this segment of the market. Similar high lending spreads have been observed in other countries such as Bolivia, Mexico, and Uruguay. A substantial part of the renewed capital inflows contributed to an expansionin the level of credit and a reductionin its cost--especiallyin the dollar segmentof the market. - 18 - However,low-credit-rating, and liquidity-constrained, domestic-currency borrowers probably experienced less direct benefits from the capital inflowsphenomenon.

2.24 Monetizationand Dollarization Hyperinflationand the BONEXplan had all but melted away the local peso system. The historical minimum of the economy's monetizationwas reached following the BONEXplan ( January 1990), when the ratio of money (M2 in pesos) to GDP reached a mere 2.5 percent. The stabilizationachieved with the ConvertibilityPlan assistedin the quick remonetizationof the economy. However, the levels of monetizationachieved under the ConvertibilityPlan did not reach the levels in previous decades, or that prevailing in early 1989, just before hyperinflationstarted. The main reason for the lack of complete recovery to the pre-hyperinflationmonetization levels, is the increasingdegree of currency substitutionand dollarizationthat the economy started experiencing since the early 1980's. Althoughmonetization in pesos has stopped growing since late 1993, after reaching a maximum of 11.5 percent of GDP, dollar deposits continuedgrowing in relation to GDP.

2.25 For decades Argentines had resorted to holding dollars as a hedge against monetary instability in their own currency. As inflation worsened during the 80s, transactionsstarted being stipulated in dollars and the economy started a dollarization process, with dollars being a store of value and increasinglythe standardof value and the mean of transaction.When banks were allowedto open foreign currency accounts, Argentinesstarted bringing their foreign currencyholdings that were safely deposited abroad into the local system. Dollarizationis now evident, as the ratio of dollar depositsto peso deposits has grown persistently.From values in the order to 40 percent prior to the Convertibility,dollar deposits have reached the same level as peso depositsin 1994, and have surpassedthem in 1995. The stabilization of inflation at rates similar to those of the US dollar does not seem to have stopped the dollarization process.

2.26 Dollarizationmay have actuallyincreased stability in the financialsystem. The monetarystrategy has favored dollarization through the fixed exchange rate, the 100 percent reserve backing and by allowing banks to settle reserve requirements in either currency. Whenever requested, the monetary authoritieshave not hesitatedto sell dollars in exchangefor any amount of outstandingpesos, as required by the ConvertibilityLaw. Thus, in instancesof economicuncertainty, depositors, by shiftingpeso funds to dollar deposits, mitigatedcapital outflows.

The Response of Trade Flows to Liberalization

2.27 Trade reforms led to a greater opening of the Argentineeconomy in two importantways. First, domesticrelative prices in Argentina became more responsiveto internationalprices, an effectthat was further strengthenedby the adoption of a fixed exchange rate. Second, the tradable sector expanded significantly,although their ratio to GDP remainedlow, due to the appreciationof the peso.

2.28 Followingthe path of net capital inflows, whichincreased from a near zero rate in 1990 to annual rates of $11-12 billion in 1993 and 1994, the trade balance has had a growing deficit since 1992, when it reached $2.6 billion. The deficit increasedto $3.7 billion in 1993, and reached $5.8 billion in 1994. Imports have reacted quickly to the availabilityof foreign credit, whereasthe growth in exports has been more closely determinedby the path of structuraladjustment and changes in the external environment.

2.29 In 1995, when foreign capital inflowswere curtailed, importsdeclined, while exports accelerated further, benefitingfrom sluggishdomestic demand, increasesin productivity,and the fast pace of growth of the Brazilian economy. The improvementin relative prices (tradables over non-tradables)and the sharp reversal from a trade deficit to a trade surplus in 1995, in the aftermathof the stagnationin capital - 19 - inflows, have been very encouragingsigns that the economy has started reacting relatively quickly to exogenousshocks, in the absence of a flexibleexchange rate.

2.30 As a result of the reductionin importprotection, Argentina's importsrose rapidly starting in the early 1990s(Table 6). This in turn was the result of three reinforcingfactors. There was a phenomenon of import catch-up followingyears of import restrictionsand uncertain import policies. Another factor was the strong capital inflow. A third interrelated factor was the recovery of income, facilitated by capital inflows, and the increase in confidencebrought about by the ConvertibilityPlan. The perception that the new economic regime would usher a new period of prosperity, led in the first two years of the program, which incidentallyfollowed a period of recession, to a consumptionled boom, accommodated by the expansion of imports. Importswhich had fallen with the recessionsin 1989 and 1990, recovered strongly since then. Nominal import levels quintupledbetween 1990 and 1994, reaching $21.5 billion. Despite such growth, imports of goods and services still accountedfor 9.2 percent of GDP in 1994, a moderate level by internationalstandards for an economyas open as Argentina's.

2.31 There were significantchanges in the compositionof imports followingthe liberalizationof the trade regime. Years of past high protectionand economic stagnationhad led to the increasingaging of the capital stock. Additionally,the change in relative prices brought about by the nominal fixity of the exchange rate, increasedthe need for higher productivity,and replacementof capital became necessary and profitable. This desire for new technologyincorporated in new capital led to impressive increases in capital good imports. Capital good imports after growing rapidly since 1991, increasedtheir share in total imports from 36 percent on average in the 1980-89 period, to 44 percent in 1994. The manufacturing sector was the largest importer of capital goods followed by the transportation and communicationssectors.

2.32 The composition of the origin of imports changed following the trade reforms. Argentina increased its imports from Brazil rapidly since 1990, from about 17.6 percent of total imports, to 19.9 percent in 1994, after reaching a peak of 22.5 percent in 1992. The reduction of Argentina's trade barriers and the relative decline in the peso price of Brazilian goods, at least until early 1993, due to the relative depreciationof the latter's currency, helped to raise imports from Brazil. With the adoption of the Real plan in 1994 in Brazil and the resultant appreciationof the real, its goods become relatively more expensive;that led to the relative slowingdown of exports growth to Argentina. Price effects had come to override income effects at the margin, to lead to this result. The automobile agreement with Brazil, also was a factor in the changingcomposition of imports from Brazil. There were large increases in Argentina's non-traditionalexports, despite the withdrawalof special subsidiesfor them. The other significantchange in the compositionof imports was the increasingtrade with USA. The progressive liberalizationof the import regime led to increasingimports from that relativelycheap source of capital goods. The tying of the peso directly with the US dollar helped reduce exchange rate uncertainty in general, and the US dollar in particular.

2.33 A comparisonof export performancebetween 1981-89and 1990-94shows strong export growth followingthe trade reforms. The average real export growth rate during the former period was 2.0 percent while for the latter it was 9.6 percent, with a significantacceleration evident in the 1993-94 period, which was further fueled in 1995. Despite the strong export performance, 1994 exports as a share to GDP reached 6.8 percent, suggestive of only an early stage of opening of the Argentine economy. While the recovery of exports in 1990 was related to the improvementin agriculturalprices and the decline in domestic demand due to the recession of that year, the resumption of strong export growth over the last two years also reflected the increasedcompetitiveness of the economy. - 20 -

2.34 The composition of exports changed with the trade reforms. Industrial manufactures became the strongest growing export category during 1991-94, followed by manufactures of agricultural origin. Exports of manufactures of industrial origin have been growing at an average annual rate of 26.3 percent in 1993-94, contributing to the growth in their share in total exports from an average of 21 percent over the 1980-89 period, to 29 percent in 1994. Over the same period, the share of primary products declined from 37 percent to 24 percent.

Table 6: Evolutionof Exports and Imports (USS million)

1990 1991 1992 1993 1994 1995

Total imports 4,077 8,275 14,872 16,786 21,589 19,968 Capital goods 636 1,435 3,095 4,115 6,011 4,842 Others 3,441 6,840 11,777 12,671 15,578 15,126 Total exports 12,352 11,977 12,235 13,118 15,839 20,893 Primary 3,339 3,300 3,500 3,279 3,741 4,008 FueLs 985 766 1,082 1,236 1,651 2,159 Agriculturalmanufactures 4,664 4,927 4,830 4,925 5,799 7,446 Industrialmanufactures 3,364 2,984 2,823 3,679 4,647 6,487 Trade Balance 8,275 3,702 (2,637) (3,668) (5,749) 925 Annual growth rates (X change) Total imports -3.0 103.0 79.7 12.9 28.6 -7.5 Capital goods -14.6 125.6 115.7 33.0 46.1 -19.4 Others -0.5 98.8 72.2 7.6 22.9 -2.9 TotaL exports 28.9 -3.0 2.2 7.2 20.7 31.9 Primary 63.4 -1.2 6.1 -6.3 14.1 7.1 Fuels 187.2 -22.2 41.3 14.2 33.6 30.7 Agriculturalmanufactures 16.4 5.6 -2.0 2.0 17.7 28.4 Industrialmanufactures 5.6 -11.3 -5.4 30.3 26.3 39.6 Memo: Cap. goods/ Total import 15.6 17.3 20.8 24.5 27.8 24.2 Ind. exp./Totat exports 27.2 24.9 23.1 28.0 29.3 31.0

Source: INDEC

2.35 The composition of exports by destination also changed in the early 1990s. Exports to Brazil grew rapidly and their share in Argentine exports rose from 5.9 percent in 1984, to 11.9 percent in 1990, and 23.1 percent in 1994. This was facilitated by the Mercosur agreement, by which nearly all Argentine exports to Brazil enter free of tariffs. Additionally, with the Real plan in Brazil, which stabilized that country's nominal exchange rate and accelerated the pace of economic activity, consumption good exports to Brazil increased rapidly.

Table 7: Trade with Mercosur (USS million)

1990 1991 1992 1993 1994 1995

Total Imports 4,077.0 8,276.0 14,872.0 16,786.0 21,589.2 19,968.6 Mercosur Share (X) 21.5 21.8 25.2 25.1 23.8 22.5 Mercosur 876.0 1,804.4 3,754.7 4,213.6 5,128.9 4,511.3 Brazil 718.0 1,526.4 3,338.8 3,569.9 4,280.1 4,158.0 Paraguay 42.0 43.0 64.7 72.9 69.1 80.4 Uruguay 116.0 235.0 351.2 570.8 779.7 272.9 Other 3,201.0 6,471.6 11,117.3 12,572.4 16,415.1 15,457.3 Total Exports 12,352.5 11,977.8 12,234.9 13,117.6 15,839.2 20,893.3 Nercosur Share (X) 14.8 16.5 19.0 28.1 30.1 32.2 Mercosur 1,833.0 1,976.5 2,326.8 3,684.7 4,739.9 6,733.4 Brazil 1,423.0 1,488.5 1,671.3 2,814.2 3,654.8 5,458.5 Paraguay 147.0 178.0 271.9 357.8 498.5 629.3 Uruguay 263.0 310.0 383.6 512.7 649.6 645.6 Other 10,519.5 10,001.3 9,908.1 9,432.9 11,099.3 14,159.9 Trade balance 8,275.5 3,701.8 (2,637.1) (3,668.4) (5,804.8) 924.7 With Mercosur 957.0 172.1 (1,427.9) (528.9) (389.0) 2,222.1 With Other 7.318.5 3,529.7 (1,209.2) (3,139.5) (5,415.8) (1.297.4) Source: Informe Economico 1995, Ministry of Economy. - 21 - 2.36 Trade diversion to MERCOSURcountries has been significant. While Argentine overall trade more than doubled between 1990 and 1994, trade with MERCOSURincreased twice as fast, primarily through Argentina's increase in imports from its regional partners. By 1994, trade with MERCOSUR accounted for 26.4 percent of Argentina'strade, up from 14.3 percent in 1990. The lion's share of that trade, 21.2 percent, is with Brazil. Closer links to MERCOSURhave their benefits, as the recent impact of Real plan suggests, but also carry risks, since Argentina's trade performance is more sensitive to changes in economicgrowth and movementsin the exchangerate of its main trading partner, Brazil, than the other way around.

Investment:Recent Trends and InternationalComparison

2.37 Under the first four years of the ConvertibilityPlan, investmentrose sharply (see Table 8). After falling in real terms in the late 1980s,the level of gross domesticinvestment grew at the impressivepace of 86 percent in real terms between 1990 and 1993, faster than GDP and consumption,and close to 20 percent in 1994. As a result, the share of investmentin GDP reached 20 percent in 1994. Nonetheless, in percentage of GDP, it only recoveredto its pre-hyperinflationarylevel, and remainedabout 5 percent of GDP lower than its level in 1980. This increase is explainedby the recovery of private investment (up 6 percent of GDP between 1990 and 1994), while public investmentdeclined by about 2.5 percent during the same period. This decline in public investmentis principally the result of the privatization process which automaticallytransferred about 2.5 percent of GDP from public to private investment.

Table 8: Gross Domestic Investment (Percent of GDP)

1983-6 1987-90 1991 1992 1993 1994 1995 c/

Totat 18.7 16.8 14.6 16.7 18.4 19.9 17.8 Private 13.8 12.2 12.5 14.8 16.0 17.5 15.4 Public 4.9 4.6 2.1 1.9 2.4 2.4 2.4 P.Enterprises .. 2.5 a/ 0.8 0.5 0.6 n.a. n.a. Others b/ .. 2.1 1.3 1.4 1.8 n.a. n.a.

Source: Ministry of Economy A/ Based on the 1988-90 average. bl Includesnational administration,decentralized agencies, and local governments. */ Estimate 2.38 In spite of the impressive recent recovery, the level of gross domestic investment rate in Argentina still appears extremely low by internationalstandards. Not only was the 1994 investmentrate in Argentina lower than in East Asia (20 percent vs. 33.8 percent), but it was also about 1.0 percent of GDP lower than the regional average (21.1 percent). The gap is even larger when the comparison is limited to Chile and Mexico, where investmentrates reached 26.5 percent and 24.7 percent of GDP, respectively, in 1994. Public investment in Argentina (2.3 percent) is significantly lower than the regional average (5.9 percent). As noted earlier, the low level of public investment is principally explainedby the well-advancedprivatization process in Argentina. The level of private investment in Argentina (17.7 percent) is in line with other Latin American countries (average of 16.4 percent). However, this comparison is biased because the average private investmentrates in Latin America is notoriously low by internationalcomparison, with the notable exception of Chile (22.9 percent) and Mexico (20.5 percent).

2.39 ForeignDirect Investment. Governmentpolicy towarddirect foreign investment(FDI) has been extremely open. So far, however, direct investmenthas been modest. One reason is that foreign firms have entered the economy primarily in the form of purchasingstate firms being privatized. Otherwise, much of FDI has been in takeovers of Argentinefirms, rather than new investmentprojects. Much of - 22 - future plans involve production for the integratedMERCOSUR market, and thus will also depend on the future evolutionof the Argentina's trade partners.

2.40 InvestmentAllocation. The absence of statisticsprevents a good assessmentof the allocation of investmentin Argentina. Nevertheless,partial evidence,as discussed below, indicatesthat investment has principally taken place in the non-tradablesector such as utilities and services and large companies such as the automobile and the oil sectors. The key reason for this allocation are the higher rates of return and higher output growth rates in the non-tradablethan in the tradable sectors. Another reason is the concentrationprocess in some sectors (for example the food processing sector), and the easier access to domestic and foreign financingby large corporations than by small and medium enterprises. Finally, it may also result from distortions such as the protective regime in the automobile sector.

2.41 Because of the lack of statisticson the allocationof investment,four alternative indicatorswere used to depict the allocation of investmentin the last few years: (i) capital goods imports, (ii) foreign direct investment (FDI), (iii) public investment,and (iv) informationon recently privatized enterprises. Whilenone of these indicatorsis completelysatisfactory, all of them seem to indicate that investmenttook place in the non-tradeablesector and large enterprises.

(a) Capital goods imports (equivalentto about 15 percent of gross domestic investment in 1993) increased by 548 percent between 1990 and 1993. This surge took place principally in the nontradablesectors (Table 9). The bulk of importedcapital goods in the 1991-93period were office equipment,trucks, communicationequipment, television, and airplanes, suggestingthat the increasein investmentmostly reflectschanges in firms' organizationand managementrather than large investmentin equipmentand machinery. This is consistentwith the microeconomicevidence.

(b) There is no systematicinformation on FDI in Argentinasince the complete liberalization of the regime in the beginning of 1993. Partial evidence indicates that the most privileged sectors have been non-traded sectors such as the food processing sector (Nabisco), the retail sector (Wal Mart), the automobilesector (Toyota),and the recently privatized enterprises, includingtelecommunications, electricity and gas.

(c) Total public investment(about 20 percent of total gross investment)grew by about 137 percent between 1991 and 1993, adjustingfor public enterpriseswhich were transferred to the private sector. This increasetook place almostexclusively in non-tradeablesectors such as housing, road, and utilities.

(d) Privatized enterprises registered an unprecedentedincrease in investmentof about 292 percent between 1990 and 1994, reaching US$3.8 billion in 1994. These enterprises principally produce non-traded goods such as electricity, gas and telecommunications, with the notable exceptionof oil (YPF). - 23 -

Table 9: The SectoralComposition of Capital Good Imports, 1986-94

1986 1994

TotaL 100.0 100.0 Tradable Sectors 44.9 36.4 AgricuLture 0.8 3.0 Mining 0.5 0.4 Industry 43.6 33.0 Non-TradableSectors 55.1 63.6 Utilities 10.5 6.1 Construction 11.2 8.1 Transports 4.9 19.4 Banks and Insurance 10.7 9.1 Communications 8.1 15.3 Others 9.7 5.5

Source: INDEC.

Savings: Recent Trends and InternationalComparison

2.42 Under the Convertibility Plan, total--foreign and domestic--savingsin Argentina have risen dramatically, recoveringfrom 14.6 percent of GDP in 1991 to 20 percent in 1994 (Table 10). Between 1991and 1992, this increasewas principallythe result of foreign savings, which increasedby 2.2 percent of GDP between 1991 and 1992. In a second phase, national savings recoveredby 3.4 percent of GDP in 1992-94, while foreign savings remained globally stable as a percentage of GDP. In spite of this spectacular recent increase, the level of total savings remains lower than in most of the 1970, when it averaged over 23 percent of GDP.

Table 10: Saving by Sectors (percentof GDP)

1983-6 1987-90 1991 1992 1993 1994 1995 bl/

Total Savings 18.7 16.8 14.6 16.7 18.3 19.9 17.8 Foreign Savings 2.1 2.3 1.5 3.7 3.1 3.6 1.4 Nat. Savings 16.6 14.5 13.1 13.0 15.2 16.3 16.4 Public p/ -0.2 -1.6 0.0 2.1 1.5 1.2 0.0 Private 16.8 16.1 13.1 10.9 13.7 15.1 16.4

Source: Ministry of Economy. g/ CentraL Goverrnent. b/ Estimate.

2.43 In 1991-92, the level of national savings fell slightlydue to the strong decline in private savings, down by 2.1 percent of GDP during this period. This temporary decline can be explainedby the long postponementof purchases of consumer durables in particular. At the same time, the severe fiscal adjustment contributedto a rise in the level of public savings by 2.1 percent of GDP. In 1992-94, the level of national savings recoveredby 3.4 percent of GDP as the result of the unprecedentedincrease in private savings (up 5 percent of GDP).

2.44 In an internationalperspective, the 1994 level of savings in Argentina (19.9 percent) remained low, but the contributionof foreign savings, though historicallyhigh, appears comparablewith the expe- rience in other countries over the last two decades. Not only was the actual national saving rate in Ar- gentina (16.3 percent) in 1994 15 percentagepoints of GDP lower than in East Asia (31.9 percent), but it was also below the Latin American average(17.7 percent). The actual poor performanceis partially - 24 - explainedby the low private saving rate, about 4 percentage point lower than in Chile, and partially by the low public savings rate.

2.45 Allocation of Savings. In Argentina, a significantfraction of private savings has traditionally been used to financepublic deficits,and capital flight. As a result, private saving and private investment were not significantlycorrelated over the 1983-93 period in Argentina.'" Although the success of the ConvertibilityPlan between 1991 and 1994 in stabilizingthe economy and controllingthe fiscal situation has contributedto (a) an importantshift from foreign assets to domesticassets and (b) a reduction in the crowding-out of private resources by the public sector, private savings remain low, undermining real investment. An important contributingfactor in that outcomeis that banks have been inefficientin their internediary role between financialsavings and productiveinvestment.

Evolutionof Productivityand Competitiveness

2.46 In view of the appreciationof the peso in the initialyears of the ConvertibilityPlan, this section attempts to address whether there is evidencethat the Argentineeconomy has shownsigns of adjustment to the Convertibility Plan. The present section provides evidence of large gains in productivity in Argentina during the 1991-94period. It shows increases in average labor productivityand total factor productivity for the economy as a whole. However, case studies show that productivity indicators behaved differently amnongeconomic sectors". An important caveat for this analysis: data for a comprehensiveproductivity study are scarce. The present analysishas utilized national accountdata (at a very aggregate level) and survey data from private sources (FIEL). In addition, to corroborate and substantiatethe results, we have also used case studies.

2.47 AverageLabor Productivity (ALP). Between 1990and 1994, averagelabor productivity(ALP) grew by 21 percent, at a cumulativeannual rate of 4.9 percent. This indicator of productivityhas gone through a roller coaster in the last twenty years. ALP grew at very volatile rates form the end of the Great depressionuntil 1974. It stoppedgrowing at that point and stagnateduntil the debt crisis of 1982, when it began to drop rapidly. It finally bottomed in 1989. Despite the surge of the early 90's, ALP at end-1994was still 2.6 percent below its peak. Large gains in averagelabor productivity (per worker) are somewhattempered once one takes into account that (i) hours per worker have increased, and (ii) capacity utilizationhas expandedat an even higher rate than hours. For example, productivityper hour worked (as opposed to per worker) grew by 12.4 percent in 1990-93, about a third of the growth in productivityper worker.

2.48 Sectoral productivitydiverged widely from the economy's average in the 1990-93period. For example, while overall ALP grew 15.5 percent in 1990-93, ALP grew 38.5 percent in industry, 42.8 percent in construction, and fell 2 percent in other (than conmmerce,transport, and financial) services. Most of the increase, particularlyin manufacturing,was through labor shedding.

2.49 Total Factor Productivity(TFP). Between 1990 and 1994, total factor productivityincreased between 5.5 and 7.5 percent per year. The detailed study of eight subsectors yields an average 5.6

10. The correlationcoefficient between private savings and private investment was only22 percentduring the last decade.

11. A simpleaverage increase in productivityamong all sectorsmay underestimate real gainsin productivity,since it includessectors from which resources are (andshould be) movingout. - 25 - percent TFP growth, while the point TFP estimate following a regression method gives 7.4 percent. When these figures are adjusted to take account of the increase in capacity utilization, they drop to a range between 3.5 and 5.5 percent a year.

2.50 The time series compatiblewith the 7.4 percent growth shows that TFP increased in the 1970s, declined in the 1980s, and have resumed growth in the 1990s. Between 1973 and 1980, TFP increased at an average annual rate of 1.5 percent; then between 1980 and 1990 it declined at a cumulativeannual rate of 4.3 percent. Thus the average for the period 1973-90reveals a decline of 1.7 percent per year, at a time when the average OECD TFP growth for the 1973-93period was 0.7 percent per year.

2.51 The stagnationand later fall in TFP during the 1970s and 1980s reflectsthe stagnationof GDP during those years. This fall and the recuperationin the early 1990scan be attributed to policy changes. Results of regression analysis indicatethat TFP is negativelyaffected by inflation,and by the size of the public deficit (as a share of GDP). Although these are preliminary results, the implication is that if inflationand the deficit had been zero throughoutthe period, the average annual growth of TFP could have been 3.1 percent for the 1960-94period. This would indicatethat there are importantprerequisites for the macroeconomicpolicy frameworkto sustainTFP growth.

2.52 Although the growth rate has been high in the 1991-94 period, the TFP level remains below historic highs for Argentina, and far below internationallevels. The level reached in 1994 is 9 percent below the 1980 peak. But reachingthat peak sets the hurdle too low. The challenge ahead is to erase the slump of the 1960sthrough the 1980s. If TFP had grown at the OECD average, by 1994 the level of TFP would have been 47 percent higher.

2.53 Case Studies. Total factor productivitywas analyzedin eight sectors. These sectors were milk production, dairy processing, orchards, cellulose, paper, plastics, and large supermarkets. These were selected to cover differentdegrees of tradeability, capital/laborratios, regional contexts, and degree of technologicalmodernization. The largest corporations supplyingthese products (sample accountingin most case, with the exceptionof supermarkets,over 70 percent of market share) were the primary source of information. In all sectors TFP grew in the 1991-94period. Rates go from 3.5 to 45.4 percent, with an 18 percent average. A TFP growth rate of 18 percent over three years averages an annual 5.6 percent, which is close to the 7.4 percent obtained from the regression analysis. Neither of the two measures is adjusted for capacity utilization, which could explain two points of TFP growth.

2.54 The sectors with the largest increase in productivitywere those recording the largest increase in scale of production (through greater demand and/or concentrationprocesses) and which benefitedfrom aggressive deregulation, lower tax pressure and privatizationpolicies. In particular, dairy products, cellulose paste,plastics and supermarkets benefitted from a large increase in demand. Dairy farms, petrochemicalsand plastics enjoyed the benefits of deregulation/eliminationof distortive taxes. On the other hand, in certain sectors, productivitygains coincided with the process of concentration,as small companies which lacked adequate scale and/or technology for competing in an open economy disappeared. This was importantin the paper and dairy sectors.

2.55 InternationalComparisons of Competitiveness. A 1994 McKinseyand Co. report compared productivity in Argentina with that in other countries. The report presented average labor productivity in the steel, food, and banking sectors, and total factor productivityin telecommunications. It showed that from 1987 to 1992 productivityin the food producingsector increasedonly by 1 percent. However, from 1989 to 1993 average labor productivityin the steel sector increasedby 68 percent, while in the telecommunicationssector increased 164 percent. - 26 - 2.56 Despitethe large increases in productivityin Argentina, averagelabor productivityin the sectors considered still lags behind the USA and other countries in Latin America. Argentina's ALP is 30, 52, and 19 percent of the USA's ALP in steel, food and banking respectively. In telecommunications, Argentina's TFP is only 55 percent of that in the USA. In bankingand telecommunications,Argentina's productivity indicatorsare also below the average in Brazil, Colombia, Mexico and Venezuela(see Table 11)

Table I 1: AverageLabor ProductivityComparison' (Index US=100, 1992)

Steel Food Bankint Telecom Argentina 30 52 19 55 Brazil 44 29 31 89 Colombia 15 36 30 101 Mexico 32 27 28 67 Venezuela 29 29 25 85 Latin America average 37 34 29 80 Source: McKinseyRewrt, 1994. TFP for TELECOMs.

2.57 Unit labor costs estimatedform data containedin the report suggest that it is cheaper to produce food in Argentina than in the USA and other Latin American countries, but more expensiveto produce in the other three sectors (see Table 12)

Table 12: Unit LaborCost (US=100. 1992) Argentina Brazil Mexico Colombia Venezuela

Food 84 85 90 84 89 Steel 104 90 89 103 90 Telecom 103 68 96 62 63 Telecom(adjusted for quality) 121 92 108 83 73 Banking 156 127 123 90 90

Source:McKinsey Report, 1994. 2.58 Competitiveness Alpha Consultantshave been monitoring the evolution of industrial costs, trackingthe peso costs of a unit of output producedwith a fixed input mix and a given technology. Unit costs are proxied by a weighted average of several cost categories. This proxy would overestimateunit costs since as long as there is some leeway to substitutetowards cheaper inputs, or to benefit from improvementsin technology,effective unit costs would be smaller.

2.59 Althoughlabor costs increasedby 14 percent from the first quarter of 1991 to the secondquarter of 1994, Alpha's unit costs for industry as a whole have fallen by 8 percent. Lower financial charges, utility tariffs, taxes and importedgoods prices prevailed over higher transport fees and labor costs. The behavior of Alpha's unit costs for specific subsectors depended on how intensive their use of capital relative to labor was. The unit costs of those goods that are more capital intensivehave been favored more, experiencing larger drops in unit costs. Additionally, many sectors show unit labor costs increasingmuch faster than in the industrial sector. This is the case of services. - 27 - 2.60 What emerges from the sample analyzed is that tradeables appear to fare quite well (especially import competinggoods). More importantly,the sectoralanalysis shows that it is mainly policy reforms and productivitygrowth that compensatefor the sharp increases in unit labor costs, hence contributing to an increase of the internationalcompetitiveness of those sectors.

2.61 The widespreadderegulation processes have had an effect not only on productivitybut also on prices, reinforcing the effecton competitivenessthrough both sides of unit costs (more production from the same inputs; cheaper inputs). However,many of the effectsof deregulationare once and for all, and it should be expected that in the future unit costs will not be so much affected form the price side, but rather for the physical productivityside.

2.62 Looking toward the future, there appears to be margin for further concentrationof supply and in particular for further deregulation (specially to further permit reallocation of resources between sectors), and this would contribute to TFP growth even without substantial investment. Of course, technologicalchange through the continuationof investmentand the renewal of capital stock are at the heart of productivitygrowth prospects in the long run. For this process to continue, the key challenge appears to be the credibilityand permanence of the broad rules of the game. These rules includevery prominently the commitmentto low inflationand fiscal prudence, and the permanencyand direction of certain reform processes such as trade liberalization.

B. Impact of the 1995 Mexican Crisis

2.63 Following the fast expansion of the first four years of the Convertibility Plan, in 1995 the Argentine economy suffereda recession. The main reason behind this contractionwas the impact of the Mexican economic crisis, that reverberatedthroughout Latin America. The sharp recession caused an increase in unemployment,and strained the performanceof the financialsystem. The regional financial crisis was the first severe test of the ConvertibilityPlan. Yet, by the end of 1995, there were signs that Argentina was pulling out of its recession without serious damage to the ConvertibilityPlan. To the contrary, significantpressures to deviate from it were met by efforts to further strengthen it during the crisis, indicativeof the Plan's popularityand stayingpower. It can be claimed that in some respects, the credibility of the ConvertibilityPlan was strengthenedfrom the 1995 crisis.

2.64 Economic Performance. Preliminary data suggestthat, during 1995, the Argentine economy suffered a recession of approximately4.4 percent of GDP. The initial shock, generating a confidence crisis, contributed to capital outflows, which for the first four months of the crisis prior to the May Presidential elections caused a 17.6 percent loss in banking deposits (US$8 billion), with liquid international reserves declining by 30 percent (US$4.8 billion). Under the ConvertibilityPlan, where the monetary base has to be fully backed by internationalreserves, capital outflows resulted in the demonetization of the economy. This demonetizationaffected both the performance of the financial system, but also real economic activity. There was increasingevidence however, that the economy ceased to deteriorate in the fourth quarter of 1995. Expectationsimproved considerably: the stock and bond markets reboundedstrongly, deposits and internationalreserves recoveredthe losses sufferedearly in the crisis. Furthermore, for 1995 as a whole, cumulativeinflation was 1.6 percent, the lowest rate in 51 years.

2.65 As the economyslipped into recession, investmentretracted as well (approximatelyby -16 percent in real terms), and unemploymentsurged, first rising to 18.4 percent (May, 1995), and later, with the decline in labor force participation,reached 16.6 percent (October, 1995). The number of bankruptcies surged, reportedlydoubling the rate of the previous four years taken together. The impact of the shock - 28 - was moderated by a strong foreign trade performance. A combinationof good internationalcommodity prices, the contractingdomestic economy,the continuousreal depreciationof the peso, and the fast pace of economic expansion in Brazil, resulted in a 32.4 percent growth in exports. With the deepening recession, imports declined by 6.8 percent, producinga sharp improvementin the trade balance, which shifted form a US$5.6 billion deficit in 1994, into a US$0.8 billion surplus in 1995. As a result, the current accountdeficit was cut to US$2.3 billion, less than third the 1994 level, or 0.8 percent of GDP. Despite the improvementin the current account, the sharp reduction in net capital inflows resulted in a reductionof US$69 million in net internationalreserves.

2.66 Fiscal performance was also detrimentallyaffected by the recession. Despite effort to rein in expenditures,the shortfall in revenues generated a fiscal deficit equivalent to one percent of GDP, or US$2.8 billion (includingprivatization receipts of US$1.1 billion). Half of that deficit was financedby a tax amnestyprogram announce in November1995, and the remainderfrom other sources. Total federal public sector debt rose by US$6.4 billion in 1995, most of it foreign, reachinga level of US$87.0billion. In addition to the federal fiscal deficit, preliminary estimatesput provincialfiscal deficits at 1.1 percent of GDP, bringing their debt level to over US$11 billion. In a crisis year, where provincialbanks faced disproportionatley larger difficulties than the rest of the financial system, provincial deficits were increasinglyfinanced through arrears to providers, salaries and pensions.

2.67 Implicationsof the Crisis. In the first months of the Mexican crisis, the financial markets' reaction suggestedthat Argentina was perceived being more vulnerable to the external shock than most other Latin American countries. In addition to the decline in deposits and international reserves mentionedabove, between the end of 1994and mid-Marchthe stock market indexdeclined by 30 percent, as did dollar-denominatedGovernment bond prices. Argentina's greater perceived vulnerabilitywas to its relativelyheavy reliance on foreign capital inflows, the inflexibilityof its exchangerate regime, and the weakness of its financial system. The structural conditions of the banking sector--no deposit insurance, absence of a lender of last resort, and a segmentedand inefficientsystem, as well as the memories of many previous financial crises that ended in asset confiscation--fueled a mini-run on deposits and a flightto quality among many depositorsin the system. Simultaneously,interbank market access shrank down to top private sector banks and the interbankrate increasedsharply, pushingseveral solvent but illiquid institutionsto the brink of failure.

2.68 The Mexican crisis brought to light importantlessons for Argentina:(a) it highlightedthe extent of the economy's reliance on volatile capital flows; (b) revealed the need for a strong financialsystem, including the relevance of a dollar lender of last resort in an increasingly dollarized system; (c) reemphasized the need to sustain credibility of the economic program; and (d) made obvious the difficultiesin changingthe exchangerate during periods of crisis.

2.69 Vulnerability. The ConvertibilityPlan had so far served Argentina well. Nevertheless, under the fixed exchangerate regime, the economyremains vulnerable to sharp swings in capital flows. During periods of deceleratingor decliningcapital flows, lags in the adjustmentin relative (domesticto foreign) prices will create a slowdownin economicactivity. An economy with a weak financialsystem and rigid labor markets is even more vulnerableto shocks, particularlyunder a fixed exchangerate regime where changes in capital flows could be more pronounced. Financialvulnerability could cause great damage in a short period of time since it magnifiesthe deleterious effects of negative random shocks. As the recent experiencein Argentinashows, capital movementsusually affectthe weakest financialinstitutions first, creating problems that could subsequentlyaffect the entire financial system, thus reinforcing the effect of negative capital movements. - 29 - 2.70 A further dimensionof this financialvulnerability under the ConvertibilityPlan is that the Central Bank, under a fractional reserve requirement system, is a weak "lender of last resort", since its dollar reserves are not enough to stem a serious banking run. To reduce the risks of a financial crisis in an increasinglydollarized system, there is a need, for example, to get explicit support from other central banks, possiblyvia swaps. However, while such a facilitymay be desirable, it is unlikely that a variation of the Mexican emergencysupport program is replicable.

2.71 The ExchangeRate Regime. Under a fixed exchange rate regime, where capital flows could be volatile since changes in relative prices are more difficult to generate, crisis management in a fractionalreserve requirementsystem requires either the CentralBank to hold large internationalreserves, or internationalsupport needs to be assured in order to provide a lender of last resort to the financial system. Flexibleexchange rates, however,are less attractivein a highly dollarizedeconomy, and, in any case may lead to undue volatility in the real exchangerate, as the Mexican experience made all too obvious. In the case of Argentina, approximatelythree-quarters of private sector liabilities, four-fifths of governmentdebt, and over half of bank credit is in US dollars, and a devaluationwould have a further destabilizingeffect on the banking system, as well as on corporate and public finances. A devaluation under crisis conditionscould prove to be highly counterproductive,deepening the crisis it is intendedto correct. It could discredit hard won gains obtained under the ConvertibilityPlan, and would result in capital outflows, a banking crisis, higher inflation, and a possible economicdepression.

2.72 Credibility. With a vulnerablefinancial sector it is imperativeto strengthen the credibility of the economicprogram. This is another lesson one can draw from the recent Mexican crisis. While the Argentine adjustment process remains robust, and reforms to make financial and labor markets more flexiblewere proposed, since mid-1993there was a hiatus, with some importantreforms deferred pending legislativeor provincialapproval and implementation. Additionally,during the second half of 1994, the national government'sfiscal surplus was reversed, primarily on accountof social security reform efforts and higher expenditures. Nationaldeficits compounded provincial deficits, reversing an improvingtrend in consolidatedfiscal accounts. While longer term, inter-generationaltransfers may in one sense justify the higher transitory net costs of the reforming social security system, in retrospect, short-term considerationsregarding the credibilityof the adjustmentprogram showedthat a relaxationof fiscal policy was premature. Thus, when the Mexican crisis erupted, the Government had to address both the vulnerabilityof the financial system as well as the credibilityof its economicprogram.

2.73 The Government'sResponse. The Governmentreacted forcefullyto the crisis. Early on, it took strong measures to redress the fiscal balance by cutting expenditureson, among others, export subsidies,public sector wages, and social security expenditures,while raising temporarilyVAT rates (by three percentagepoints to 21 percent)and other taxes. Swiftaction by Congress in approvingunpalatable emergency measures at the early months of the crisis, added to the credibility of the measures, which were supported by programs of multilateral institutions. As the Government was announcing these measures in mid-March, it also assembledan internationalfinancial package of approximatelyUS$11 billion in support of the ConvertibilityPlan. The announcementseffectively stopped the accelerated decline in bank deposits.

2.74 During the crisis, the Government successfully resisted growing pressures to reverse the economy's liberalization. To its credit, it decided to deepen this process and further accelerateeconomic adjustment, through labor, social security, and fiscal reforms. In the labor area, Congress approved a law flexibilizinglabor legislationfor small and medium enterprises, a work-relatedaccidents law, and a BankruptcyLaw. Congress also approved the SocialSecurity SolidarityLaw, to reestablishmaximum limits for all beneficiaries,eliminate the automaticadjustment of benefits, apply the provisions of the - 30 - ConvertibilityLaw to the determinationof pensioners, and modify the associated legal proceedings. It will also allow the establishmentof a limit on pension outlays, which have been an important cause of macroeconomicinstability in recent years.

2.75 In the fiscal area, the Governmentobtained Congressional approval for implementingduring 1996 a Second Public Sector Reform (streamlining public administration, increasing its efficiency and predictability), and another law giving extraordinaryauthority to the Executivefor 1996 to resolve fiscal shortfalls without further recourse to Congress, includingbroadening the personal assets tax, and the extension for a second year the temporary increase of the VAT to 21 percent). Additionally, it implementeda successfultax moratorium,generating a flow of $4 billion in revenues over the following 30-35 months. The announcementof such measures, and the continuityof the ConvertibilityPlan, were well received by the markets. Were it not for internal political difficultiesthat emerged in the second half of 1995, and later subsided, it is likely that economicactivity in Argentina would have recovered earlier.

2.76 On the financial side, immediatelyafter the Mexican crisis erupted, the Central Bank tightened liquidity to prevent a currency run. It subsequentlyset up facilitiesto assist small banks in crisis. To counter the risk of further bank failures, it also facilitated the use of interbank credit, and reduced temporarily reserve requirementsin both dollar and peso deposits, and used rediscountsat a faster pace. The use of excess reserves, and the reduction of the reserve requirement (establishedfor prudential reasons earlier, but not a requirement for the ConvertibilityPlan) at the height of the crisis, provided limitedbut badly needed marginsof liquiditythat the absenceof a lender of last resort could not provide. The Government,with the assistanceof two WorldBank loans, establisheda Trust Fund for Privatization to handle the workout of provincial banks, and a Bank Capitalization Trust Fund to handle the recapitalization/restructuringof distressed private banks. These Trust Funds made a significant contributionto avertinga full scale systemicbanking crisis. Measures were also taken to strengthenthe supervision of the financial system. To stem capital inflows, the authorities facilitated the further dollarization of the banking system, by further limiting distinctionsbetween dollar and peso deposits.

2.77 At the provincial level, the national crisis aggravatedan already problematicsituation, in view of the absence of meaningfulreforms in the early years of the ConvertibilityPlan. Faced with a serious deterioration in their fiscal affairs, and social unrest in a number of provinces, in 1995 various local goveinments,assisted by the Federal Government's incrementalsupport to the provincial reform effort, acceleratedtheir adjustmentprocess: fiveprovincial banks were privatized(with another 10 in the process of privatization),three social security systemswere transferred to the streamlinednational system, salaries were cut, and a number of redundant public employees were let go (contributing to the rise in unemployment). Additionally, a significant number of public enterprises, particularly in provinces committedto a reform program, were privatized. Of the total of 35 enterprises slated for privatization in eight such provinces, 17 were privatized by early 1996, and privatizationlaws have been passed for all of the rest. - 31 - CHAPTERIII

SUSTAINING HIGH ECONOMIC GROWTH

3.1 Over the 1991-94period, the ConvertibilityPlan contributedto the achievementof high economic growth, averaging 7.7 percent. This performancewas sidetracked in 1995, mainly on account of the regional financial crisis. In these four years, the economy has undergone significant restructuring, creating a framework for future sustainableeconomic growth. Looking beyond the current crisis, the issue raised here, is whether, and under what conditionscan the Argentine economy sustain high rates of economic growth, similar to those observedin high-performingEast Asian economies, and how the 1995 Mexican crisis and its aftershock affected those prospects.

3.2 Bank research'2 shows that East Asia's extraordinary growth--per capita GNP of 5.5 percent spanning three decades-- was supportedby sound basic policy fundamentals,i.e. policies that provided a stable macroeconomic environment and a reliable legal framework to promote domestic and international competition,an orientation toward internationaltrade, and basic absence of distortionary policies such as price controls. With the right policy fundamentals,most of this sustained high growth has been shown to be due to superior accumulationof physicaland humancapital. These economieswere also better able to achievehigh levels of productivitygrowth by allocatingphysical and human resources to highly productive investments and by acquiring and mastering foreign technology. These high- performing East Asian economies have been able to achieve high per capita income growth while improvingat the same time their incomedistribution.

3.3 It is fundamentalto stress that the recent regional financial crisis, despite its severity, has not underminedthe public's trust in the need to stay the economiccourse set by the ConvertibilityPlan, as the May 1995 election results indicate. Consequently,the Governmenthas a solid foundationof policy reforms to build upon, and if anything, the current crisis has provided further incentivesto quicken and deepen reforms, necessary to meet conditionsof solid and sustainedeconomic growth. The recent rise in unemploymentabove 16 percent is an additional policy challenge, and an added incentive to deepen the recommendedreforms.

3.4 This chapter is not indented as a comprehensivetreatment of conditions for sustaining high economic growth in Argentina. It is rather, a compendiumof issues and policy recommendationsthat could contribute in moving the economy in that direction. Fundamental issues, such as poverty alleviation and the developmentof social sectors, the environment, gender issues, the legal framework, and sectoral issues are not included in this discussion, in view of the narrow focus of this report, or because they are being treated in separateWorld Bank reports.

A. Simulating a Pattern of Sustainable High Growth

3.5 The fundamentalpremise is that, Argentina, endowedwith plentifulnatural resourcesand a good stock of human capital, both underutilizedon accountof past misguidedeconomic policies, has, in the context of the ConvertibilityPlan, created the foundationsfor unleashing its economic potential. With

12. "TheEast AsianMiracle: Economic Growth and PublicPolicy", A WorldBank Policy Research Report, 1993. - 32 - solid fundamentals already in place, Argentina has a unique opportunity to strengthen its economic adjustmentprocess, creating the conditionsfor high and sustainableeconomic growth.

3.6 Prior to discussing specific issues and policy recommendations,it could be useful to present a simulatedgrowth pattern that would give some sense of the challengesahead. The aim in this simulation (Table 13) is to reach sustainable economicgrowth of 7 percent fairly quickly--in four to five years. Taking a page from the East Asia miracle story, the projected stable pattern of high economicgrowth is characterizedby sharp increases in national savings and investment,and continuousproductivity gains. Such productivitygains, particularlyin the contextof the ConvertibilityPlan where the nominalexchange rate cannot be counted on to change relative prices between tradeables and non-tradeables, and in a framework of a liberal trade regime, would contribute to the substantialgrowth of exports. The time frame is the next two Administrations,until the year 2,004.

3.7 In this simulation,a key prerequisitefor reachinga sustainablegrowth rate of 7 percent is a fairly quick accelerationin investmentrates--averaging a real growth rate of 10.4 percent during this period--to reach a 26.5 percent share of GDP by the turn of the century. Nearly all that increase is expectedfrom the private sector in view of the limited scope for public sector spending and the need to maximize investmentefficiency; private investmentwill need to rise from 17.5 percent of GDP reached in 1994, to 24.3 percent of GDP by the turn of the century. The 1995 crisis did produce a setback in investment, and it may take until 1997 for the economyto regain 1994 levels, before resuming a high growth trend. Public investment,despite its relative stagnationas a share of GDP, is expected to increase in real terms to finance needed infrastructureand complementprivate investment.

3.8 The financingof that incrementalinvestment will have to come entirely from national savings, since foreign savings face significantlimitations, and are actually expected to decline as a share of GDP from levels reached in 1994 in order to reduce the economy's vulnerabilityto external shocks, similar to those experiencedin 1995 (when foreign savingswere cut to less than half the 1994 rate). As in the case of investment, incremental savings will have to be created overwhelminglyin the private sector, rising from a rate of approximately15.1 percent of GDP in 1994, to over 23 percent by the turn of the century. Despite the sharp increase in savings, consumption, although lagging economic growth, continues to grow in real terms.

3.9 In this simulation,it is the private sector that providesthe impetusto growth, as the public sector, burdenedby its past legacy, restricts itself to playing the importantrole of providingbasic social services to the poor, keeping law and order, providing infrastructure investment complementary to private investment,and sustainingthe appropriateinstitutional regulatory and legal framework settingclear rules and protecting property rights, supportive of private enterprise. Given the severely limited domestic borrowing ability of the public sector under the ConvertibilityPlan, the fundamentalassumption all along in this simulationexercise is that consolidatedpublic sector finances will be balanced.

3.10 The further opening of the economy to international trade is another basic prerequisite for sustaininghigh economicgrowth. As reviewedin the previouschapter, Argentina's low share of exports to GDP suggests a very closed economyby internationalstandards. There are various implicationsto that phenomenon:a narrow export base leaves the economy vulnerableto external shocks; curtails the related magnitudeof imports with their corollary impacton technologytransfer and productivitygrowth; even with a relativelymoderate level of external debt, debt service becomesparticularly onerous, raising the country's credit risk, depriving Argentinafrom broader access to the internationalfinancial markets. - 33 - 3.11 In the time horizon contemplatedhere, Argentina'sexports (GNFS) as a share to GDP are raised from 6.8 percent in 1994, to over 12.5 percent by the turn of the century, still a moderate share by internationalstandards. Reachingthat degree of opennessimplies double-digitreal export growth rates, averagingapproximately 14 percent. The fast expansionof exportsin 1995was a welcomedevelopment, that needs to be build upon. Export growth rates of that magnitude would allow, or rather require, importsto grow at double-digitrates as well, albeit at a moderatelylower pace than exports. Fast export growth would provide a tremendouslysalutary effect to the Argentine economy, but increasing the productivity and competitivenessof the overall economy is a necessary condition for that outcome. Opening the economy to levels indicated above, would cut foreign debt service to export ratios in half by the end of the eight year simulationperiod, greatlyimproving Argentina's standingin the international financial community. Capital inflowswould be associatedwith increasingforeign direct investmentand trade, facilitated by the repatriationof Argentine capital deposited abroad.

Table 13: Argentina - Simulation of Key Macroeconomic Indicators High Economic Growth Scenario (Percent of GDP)

IllustrativeProiections 1994 1995 Average (est.) 1996 1997 1998 1999 2000-2004 National Account GDP Average Annual Growth 7.4 -4.4 2.5 5.5 6.0 6.5 7.0 Totat Investment 19.9 17.8 18.9 21.0 23.0 25.0 26.5 Private 17.4 15.4 16.9 19.1 21.1 23.0 24.2 PubLic 2.4 2.4 2.0 1.9 1.9 2.0 2.3 Nationat Savings 16.4 16.4 17.3 19.3 21.4 23.5 25.1 ForeignSavings 3.5 1.4 1.6 1.7 1.6 1.5 1.5 Public Sector (FederalGovernment) Primary SurpLus 1.1 0.5 1.3 1.8 1.7 1.6 1.2 InterestPaymnt 1.1 1.5 1.7 1.8 1.7 1.6 1.2 Overall Balance -0.0 -1.0 -0.3 0.0 0.0 0.0 0.0 Balance of Payments Trade Balance -2.1 0.3 0.2 0.2 0.2 0.2 0.1 Exports 5.6 7.6 8.1 8.7 9.5 10.4 13.0 Imports 7.7 7.2 7.9 8.5 9.4 10.3 12.9 Current Account Balance -3.7 -1.4 -1.6 -1.7 -1.6 -1.5 -1.5 Capital Account 3.7 0.7 2.2 2.4 2.2 2.2 2.0 Debt Indicators Total Debt 35.1 38.9 38.0 36.0 33.3 31.1 26.2 Debt Service/GNFSExports 55.4 55.8 57.4 58.9 51.8 48.3 35.0 Memo: GDP (USS billion) 280.5 276.0 290.0 314.4 342.6 375.5 504.0 Total Public Debt (USS billion) 80.7 88.4 90.7 91.5 91.4 91.3 90.8

Source: World Bank.

3.12 In short, to achieve sustained high economicgrowth, the Argentine economy should be led by export and investmentgrowth, with these two key contributorsgrowing twice as fast as the economy as a whole. The targets are ambitiousbut reachable, as success stories in East Asia, and Argentina's neighbor, Chile, have shown. Actuallythe simulatedopening of the economyis much below that achieve in East Asia and Chile, and investmentand savings ratios remainwell belowthose observed in East Asia. Already, Argentinahas made major strides in buildingsolid foundationstowards achievingthe potential for such growth. While the 1995 crisis created a temporarysetback in a pattern of rising investment,and generatedhigher unemployment,the Government'sstrong and decisivemeasures in deflectingthe regional crisis while staying the economic course, and recent electoral results that rejected nostalgia towards populism, statismand control, providedfurther impetusto the dramatic transformationof the Argentine economy.

3.13 It is in that framework,of reachable ambitioustargets, and a unitedview both by the Government and the public towards the further modernizationand reform-orientedprocess in Argentina, that this report now turns to selected policies which can assist in making those targets a reality. - 34 - B. Policies Conduciveto Higher EconomicGrowth

3.14 This section will review a number of policies, and make recommendationswhich could facilitate the growth of key variablessuch as investment,saving, and exports. This section is followedby a review of Argentina's unfinishedreform agenda, covering needed reforms in the provinces, and reforms in the factor markets, i.e. labor and capital. While economicreform is a continuousprocess, the unfinished reform agenda demands particularlyurgent attention, since it forms part of the foundationsof the reform process in Argentina; in their absence, progress could falter.

Investnent

3.15 The major policy challenge is to increase the traditionally low private investment rate in Argentina. The focus is principally on private investmentbecause of the new limitedrole of the public sector and the small base for public investmentwhich accountedfor only 15 percent of total investment in 1994. Below is a discussionof the principal factors influencingthe private investment behavior in Argentina.

3.16 The most importantgeneral incentiveto private investmentlies in the success of the government to maintain a stable and growing macroeconomicenvironment. The success of the ConvertibilityPlan in its first four years of implementationhas been in its capacityto restore economicgrowth. This strong recovery was associatedwith growing investmentdemand, though this effect was delayed due to the low utilization capacity in most sectors at the beginningof the economic recovery. The sharp reduction in macroeconomic instability, reduced price uncertainty, as well as the reduction in ad hoc policy intervention also contributedto the increase in investment.

3.17 The Government has moved to reduce taxes that lower profitability and are disincentives to investment. Specifically,the Governmentinstituted a shift from production-basedtowards consumption- based taxes as the revised tax structure relies heavily on the value-addedtax. As a result consumption- based taxes accountedfor 52 percent of total tax revenues in 1994 versus only 35 percent in 1990. The authoritiesalso suspendedmany sectoral and regionalpromotion programs and implementedderegulation in several sectors of the economy aimed at reducing the "Argentinecost". Overall, the price of capital declined by 11 percent relative to the GDP deflator between 1990and 1993, reducing the quantity of saving required to finance an unit value of investment.13 The cost of capital also declined in comparison with the cost of labor, though the Governmenthas also started to reduce the cost of labor by reducing the employer's wage taxes and reforming the social security system in 1994. Finally, the reduction in public investment,principally through the recent privatizationprocess, also explainspartially the increase in private investment. The increase in private investmentobserved between 1991-94was also the result of the virtually unprecedentedboom in foreign and domesticcredit. In this area, the ConvertibilityPlan has done far better than previous stabilizationplans.

3.18 In the longer run, the capacity of the Argentine economy to increase its investment rate on a sustainablebasis will greatly depend on its capacity to improve the level of technologyand the human capital stock. The close link between the accumulationof physical capital and technologicalchange has

13. A closerlook indicates that this reductionis due to the declinein the price of importedcapital goods (as the resultof tradeliberalization and the appreciation of theexchange rate) and in the priceof domesticallyproduced capitalgoods. In contrast,the costof constructionincreased by 52.5 percentbetween April 1991and April1994. - 35 - been prominently emphasizedand empiricallydocumented in a number of countries. Better technology will not only require new investment in capital goods, but also improve productivity. Therefore, encouragingresearch and developmentshould be one of the prioritiesof the Governmentin the next few years. Improvingthe stock of humancapital through educationwill also encouragelong-term investment in physical capital in Argentina".

Policiesfor EncouragingInvestment

3.19 The economicenvironment in Argentinapresents relativelyfew distortionsagainst investmentas a result of the trade and financial liberalizationprocess. Few exceptionsremain and they are described below. In short, the Government should maintain a stable macroeconomicand policy environment, eliminate distortionarypromotion programs, encouragetechnological innovations, and reduce distortions in the allocationof banking credit.

3.20 Stable and Growing MacroeconomicEnvironment. Historical experience and international comparisonsindicate that investmentis extremelysensitive to changesin the macroeconomicenvironment. For this reason, the authoritiesshould ensure:

(a) the equilibriumof fiscal accounts in order to control inflation and to limit the crowding out of private resources;

(b) the restricted use of ad hoc interventionsin tax and trade policy. Each change in these policies increases uncertainty and postpones investment decisions. Empirical evidence suggests that price incentiveshave to be unreasonablylarge to compensatefor the negative impact of uncertainty on investment.

3.21 Tax Policy. The current tax system does not containmajor distortions, to the contrary it seems to be extremely favorable to investmentand savings. The major tax incentives are: the exemption of capital gains and of interest receivedon depositsfrom the incometax, and the deductionof interest paid on debt from the income tax. At this stage, the main recommendationis to eliminate or limit a series of remaining promotionprograms which distort the allocationof resources, and are fiscally costly. The Governmentshould: (a) eliminatethe TobaccoFund which both introducedistortions and is fiscallycostly (about US$180million); (b) graduallyeliminate the current tax incentivesin Tierra del Fuego. At least, the Government should eliminate the special regime for new investmentsand attempts to introduce ceilings on the benefits of existing programs (following the example of the old industrial promotion program); (c) eliminate, or at least not extent, (agro)industrialpromotion program adopted in the Prov- inces of La Rioja, Catamarca and San Juan which have a high annual fiscal cost; (d) eliminate permanentlythe old promotionprogram for new investment;(e) reduce the protectionof the automobile industry(see Trade section for more specificrecommendations); (e reduce tax rates (specificallyof labor taxes and provincialtaxes), while maintainingtax revenuesthrough reductionin tax evasion, in order to limit price distortionsand improvethe allocationof investmentbetween the officialand unofficialsectors. Such a strategy will favor the export sector which is mainly composedof large tax paying firms; and (g) eliminate the double deductionof new investmentin mining.

14. A recentline of researchhas focusedon the complementaritiesbetween investment in physicaland human capital:new and technologicallyadvances machines and equipment need to be operatedby workerswith adequate skillsand education. - 36 - 3.22 Research and Development and Education Policies. Encouraging the development and adaptation of foreign technology, and education, is primordial for long-run private investment in Argentina. The Governmenthas an importantrole to play in both areas. A recent World Bank report has evaluatedthe researchand developmentpolicy in Argentinaand the followingmajor recommendations have been proposed: (i) administrativereforms to improve the efficiencyof research and development agencies; (ii) institutionalreforms includingprivatization of several activities; and (iii) financial reforms to increase the share of demand-drivenprojects. An important related issue is the poor treatment of property rights in Argentina, even if the Governmentrecently passed a new legislationin the beginning of 1995. There is no question about the importance of property rights for investment, but it is also important that these rights will be complementedby measures aimed at improving proper contract enforcement, otherwise property rights will be only good on paper, raising the costs of doing business and the risks of corruption.

3.23 FinancialPolicy. Finally, investmentis affectedby the availabilityof financingresources. The well functioningof the domesticfinancial system is essentialfor providing resourcesto investors. Better allocationof financial resourcesthrough the reductionof the still significantpublic sector banking system would be an importantstep in that direction. High spreads can be decreasedby reducing operating cost of the banking system, primarily by increasing its efficiency, and the reduction in the country risk premium (for more detailed review of policies see section on Financial Markets).

Private Saving

3.24 Public and foreign saving have led the recovery of total saving in the initial phase of recovery in Argentina, but private savingis projectedto be the main financingsource of capital investmentgrowth in the second phase. The reasons for this expected recovery, which started taking place in 1994 but interrupted from the 1995 crisis, are (i) the delayedresponse of private saving to the economicrecovery as it generally takes time for householdsto adjust to a shock (of a changed economicframework); (ii) the partial substitutionof public savingsby private savings as the result of reducedtaxes (principallylabor taxes); (iii) the reform of the social security system; (iv) the developmentof the financial system which has positive impact on growth and thus on savings, compensatingfor the initial substitutioneffect of the boom in (foreign and domestic)credit; and (v) in the longer run the evolutionof demographicvariables as the dependencyratio which is projected to decrease from 60 percent in 1990 to 55 percent in 2000, principallybecause of the reduction in the percentage of young people.'5

3.25 EconomicGrowth. There appearsto exist a significantand positivecorrelation between private saving and economic growth in Argentina during the period 1983-93, though this correlation seems to be lower than in recent cross-countrystudies. The most interestingaspect of these economic results is that the effect of a variation in economicgrowth seems to be delayedover time as only 20 percent of the

15. Demographicfactors play an importantrole in the life-cyclemodels as bothyoung and old people generally save less than middle-ageworking people. The declinein the dependencyratio is expectedto contributeto an increasein the savingrate. There is a considerabledebate about the magnitudeof such effectin the empirical literature,but a roughestimate is thatthe savingrate willincrease by about2.2 percentof GDPduring this period. Thisfigure is basedon the coefficientestimated by Edwards(1994) in a cross-countrystudy. - 37 - total effect takes place in the first quarter6 . The low response of private saving to economic growth in Argentina during the period 1991-93suggests that consumptionadjusts gradually to its new level, or it takes time for consumersto understandthat a shock occurred. As a result, consumptiongrowth rates have already decelerated in 1993, and future growth rates in consumptioncould moderate further. The delayed response of savings to variations in economic growth can be caused by a variety of economic factors. Consumptionis expected to overshoot in a less than fully credible fixed exchange rate-based stabilizationprogram as it may have happened in the first stage of the ConvertibilityPlan.

3.26 The recent literature has also emphasizeduncertainty and habit formation as two of the main reasons for this delay. Given a previoushabit stock, saving adjusts upward only sluggishly in response to an increase in income, this slow adjustmentbeing reinforcedin the presence of uncertainty. Finally, there are also statisticalreasons for this delay. The most importantreason is that people initially invest in durable goods such as cars and housewaresafter the reform, which increasedby 340 percent and 180 percent, respectively, between 1991 and 1993, and only later invest in physical capital --durable goods should be counted as savings, but are not. As a conclusion, with the acceleration in economic growth, and the continued improvement in the credibility of the exchange rate regime, private savings are expected to grow.

3.27 Fiscal Policy. Fiscal policies can affect private saving in many ways. The most important instrumentsare: (i) changes in the level of public saving, (ii) shifts in the compositionof taxes, and (iii) the reform the social security system.

3.28 Private and public savingappear to be highly substitutablein Argentinabecause private consumers have learnedover the past decade to internalizethe governmentintertemporal budget constraint,and thus they save more when the public sector saves less in anticipationof higher taxes or debt reimbursement". Therefore, reducing public saving through, for examplethe reductionof taxes, appears to be a powerful instrumentto increaseprivate saving in Argentina'8 . However, the Governmentshould assess carefully the tradeoff between private and public savings;a significantdeterioration in fiscal accounts may lead to a reduction in private savings througha deteriorationin the economicenvironment. Lower public saving may also reduce public investment.

3.29 Shifting the composition of taxes is generally considered as an effective policy option to encourageprivate savings. Replacingtaxes on productionand on factor's income by a consumptiontax increases the propensity to save because the latter tax does not distort the choice between present and future consumption. In addition, a compensatedshift from an incometax to a consumptiontax would increase current saving because individualswould have to save more during their working period to maintain the same level of consumptionin retirement. Over the past few years, the Governmenthas

16. A simpleGranger causality test cannotreject the hypothesisthat growthincreases first, followedby an increasein privatesaving, which is alsoconsistent with the experiencein EastAsian countries. 17. In a regressionidentifying determinants of privatedomestic savings in Argentina,the coefficient associated withpublic savings is not statisticallydifferent from one.

18. In the recentyears, the substitutabilitybetween private and public saving has beenaccentuated by the recent salesof publicenterprises. For example,the saleof YPFin mid-1993resulted in an automatictransfer of savings fromthe publicto the privatesector of 0.3 percentof GDP. - 38 - followedthis strategy by increasingthe share of consumption-basedtaxes in total taxes from 35 percent in 1990 to 52 percent in 1994. The major recommendationwould be to strengthen this effort by replacing the provincial turnover tax by a consumptiontax. However, the low efficiency of tax administrationin the provinces has to improve in order to benefit from that change.

Box 1: Impact of the Reform of the Social Security System on Savings

The positiveimpact of the reform on gross domesticsavings will be higher if (a) the number of contributorsopting for the private system graduallyincreases over time; (b) the governmentis successfulin reducing evasion; (c) the transitory deficit of the public system is tax-financedrather than bond-financed;(d) savings in pension funds will not substituteother forms of savings.

A simulationexercisea/ indicates that the short-run impactof the reform on gross domestic savings will range from 0.5 percent of GDP if the fiscal deficit is tax-financed to 0 percent of GDP if it is bond-financed(in the absence of the Ricardian equivalence). The positive impact will increase gradually over time, reaching 1 percent after 10 years, because of the gradual decline in the deficit of the public system. Similarly, the reform affects the compositionof savings since, in the first year, it implies a shift of 0.6 percent of GDP from public to private savings, equivalentto about US$2.0 billion. The medium-termimpact on private savings will closely depend on the degree of substitutabilitybetween alternative forms of private savings and the instrumentused to finance the public deficit.

The reform is expected to enhance the development of the domestic financial sector because: (a) the private sector is generally more efficient than the public sector in allocatingresources; and (b) it will promote long-terminvestment. In that respect, the experience of Chile might be revealing since the value of the portfolio of the pension funds increasedfrom 3.6 percent of GDP in 1982 to 35.4 percent in 1992, with importantshares investedin treasury bonds, mortgagebonds, and corporate equities.

a/ The simulation is based on the following assumptions:(a) the initial fraction of contributors opting for the private system is 55 percent, subsequently increasing by 1.5 per year; (b) the evasion rate will be reduced by 3 percent annually in the five first years following the reform and remain constant thereafter; (c) the fiscal deficit is either completely tax-financed or bond-financed; (d) the degree of substitutability between alternative forms of private savings range from 10 percent in the first two years, gradually increasing to 40 percent in 1999.

3.30 In contrast, the Government should not extend the existing tax saving programs, such as incentives for retirement accounts. First, it is increasingly recognized that these programs do not significantly increase the volume of private saving. Second, they have a fiscal cost as well as they complicatetax administration;this would be particularlyunfortunate at time when the authoritiesattempt to reduce tax evasion. Finally, the Government's ability to modify the net return of private savings - 39 - instrumentsand, thus, to affect the householdsportfolio choice is greatly limited in Argentina by the current level of evasion.

3.31 The recent reform of the social security system could stimulategross domestic savings as the future contributionsof the new capitalized pension fund system are unlikely to be offset one-to-oneby reduced savings in other instruments(see above Box) . However, the effect of the reform on total savings will certainly be limited ranging between 0-0.5 percent of GDP. Notice that the positive effect is accentuatedif the transitory public deficit is tax-financedand if the savings in private pension funds do not substitutealternative forms of private savings. More importantseems to be the effect of the social security system reform on the compositionof savings. First, it implies a shift from public saving to private saving, equivalent to about 0.6 percent of GDP in the first years of the reform. Second, private pension funds have certainly a longer term horizon than other private investors and thus they could favor long-term saving instruments. For example, in the first year of operation, Argentina's social security system started to generate a large pool of long-termfinancial resources, to the equivalentof $2 billion, approximately0.7 percent of GDP. The resultinglonger-term effect, based on the example of Chile, is that the domestic financial market will deepen and thus make additional resources available for investment. Effectiveregulation and supervisionof this system,and reductionin pervasiveevasion would greatly strengthen the new social security system, and its impact on saving and investment.

3.32 Financial Policy. In the long-run, financial policies are likely to have a positive impact on private savingthrough their impact on economicgrowth. The recent literature on economicgrowth has emphasizedthat financial development, as measured by the monetizationof the economy for example, is one the most importantfactors explainingeconomic growth. However, financialpolicies are generally ineffectivein raising private saving in the short-term. To the contrary, they are likely to reduce saving because of the relaxation of borrowing constraintsand the ambiguouseffect of interest rates.

3.33 There is a considerabledebate about the effect of variationsin interest rates on savings. Most empirical studies are unable to find a significant correlation between these two variables because of contradictoryeffects. Similarly, in the case of Argentina, the impact of interest rates on private saving has been found to be insignificantover the last decade. This result can be due to the presence of liquidity constraints, which are likely to be importantin Argentina, limiting the response of private investors to variations in the interest rates.

3.34 The boom in domesticcredit, and the greater access to foreign savings have reduced significantly borrowing constraints in Argentina. The increasein foreign saving is estimated to have reduced private savingsby 1.0-1.3 percent of GDP between 1991and 1993because non-liquidity-constrainedconsumers have to accumulate less wealth to purchase durable goods.'9 Yet, it is important to point out that if the massive capital inflow has partially substituteddomestic saving through the relaxation of borrowing constraint and the financing of consumptionactivities, it has also resulted in a dramatic change in the

19. The estimatedparameter associated with foreigncapital shouldbe taken with cautionbecause the relationshipbetween domestic and foreignsavings may be moreincidental than causal. To illustratethis pointin the caseof Argentina,the fiscaladjustment in 1990-93affected both foreignand domestic (private) savings but in oppositedirections. The impact on foreignsaving was positive because the fiscal adjustment improved the country's internationalcreditworthiness, while the impacton privatedomestic savings was negative because public and private savingsare highlysubstitutable. As a result,the correlationbetween domestic private savings and foreign savings is negative,though there is no causallink betweenthese two variables. - 40 - compositionof private saving in favor of domesticassets and away from capital flight. This improvement in the portfolio allocationwill graduallyoffset the negativeinitial impact of foreign savings on domestic savings and investment.

3.35 The Argentine Governmentis pursuing a strong effort to develop the domesticcapital market by increasingthe range of financial instruments,the quality of the financial sector regulation and solvency- enhancing supervision. However, if capital market reforms typically lead to an increase in financial savings, they do not necessarily increase overall private saving. In the longer-term, financial reforms may contribute to overall saving through their indirect positiveimpact on growth.

3.36 Broadening the range of financial instruments will contribute to economic growth by making additional resources available to investment. Reforms such as trade liberalization, enterprise privatization, and pensionreform have improvedthe allocationof resourcesby increasingthe proportion of households savings invested in the financial system. The Government can accelerate this process through reforms in the banking system and capital markets (presented in the Financial Markets section)'.

InternationalTrade Regime

3.37 Since the late eighties, Argentina has achieveda radical change in its trade regime. The change is seen in nearly all the traditional measures of trade liberalization. Nominal protection has been significantly reduced, with the average nominal import tariff declining from 30 percent in 1989 to 14 percent in March 1995. The variance in nominalprotection has also been reduced. The trade regime has been liberalized and QRs substantially reduced. The bias against exports has also been considerably reduced. As discussed in the previous chapter, trade liberalizationhas led, in the context of the ConvertibilityPlan, to the accelerationin exports and economicgrowth.

3.38 Other policies have also been conduciveto the expansionof trade. Tax policies, for example, are relativelyfavorable to exports. The income tax rate, at 30 percent, is lower than in most developed and some less developedcountries and taxes on consumptionhave increased their share in the total tax bill, accounting for half of the total revenue of the national and provincial governments. The most importanttax on consumptionis the VAT which allows for border tax adjustments,while the impact of other indirect taxes is more than offset by tax reimbursementson exports.

3.39 Financial policies have been questioned as a deterrent of exports in Argentina because of unusually high banking spreads. However, large exporters usually pay the lowest rates in the market, similarto internationalrates plus the country risk premium,because they have a good collateralin export contracts. For small and medium size firms that might encounterdifficulties in getting access to credit, the Government has launched several loan programs that favor increases in exports. These programs charge interest rates that are lower than actualmarket rates in Argentina, but are higher than international rates.

3.40 Despite policies that are conduciveto the expansionof trade, since October 1991 there has also been an increasing complexity of the trade regime. First, the number of tariff tiers has increased progressivelyfrom three to seven. Second, quantitativerestrictions were extendedfrom the automobile

20. A series of recommendationhave also been proposedin the recent Capital Market Study (June 1994). - 41 -

regime to other industries and attempts have been made to tie access to imports to export performance. New non-tariff barriers have allowed for more bureaucratic discretionality; licenses for quotas and for special benefits ar examples of these non-automatic policies. The increasing complexity of the trade regime led to greater widening of effective protection, even though the average level has remained low by historical standards. Additionally, the fiscal cost of these policies has also increased.

3.41 There have also been attempts to fine-tune the trade regime on the export side with the adoption of the mirror principle which has increased discretionality. The existing tariff structure tends to protect the local production of those goods in which the country is relatively more inefficient. The 1992 instituted system of "mirror export subsidies" grants to each export product the same rate of subsidy as that corresponding to imports of the same product. Since import duties are larger the more inefficient the industry is, the new system of export subsidies grants larger subsidies to the more inefficient industries and smaller subsidies to the more efficient industries. This system maximizes the losses from protection since it aims to expand production in the inefficient sectors (e.g. the automobile sector), and to contract production in those which are efficient (e.g. agriculture or agro-industrial products which receive little or no subsidy since they receive no import duties).

3.42 The mirror principle has an important annual fiscal cost. Prior to the recent reduction in export reimbursements, tax rebates on exports reduced tax revenues by $1 billion annually; since they were exempt from income taxes, there was an additional subsidy of about $300 million. A second related problem is that tax reimbursements on exports can be used together with the temporary admission program and were fixed at levels that reach 20 percent for some industrial products2". They clearly overestimate the indirect tax incidence allowed by the GATT rules and might be subject to retaliation from foreign countries.

3.43 Even though effective protection estimates are not available for the early 1990s to establish the results of the reforms on levels of effective protection and its dispersion, a limited sample estimate shows that traditional exportables had negative protection compared to importable manufactures. Moreover, the variance appears to be considerable. For example, traditional exportables had a negative effective protection rate of 2.5 percent compared to positive protection rate to manufactures importables of 39 percent.' This wide variance suggests that traditional exports are considerably disadvantaged compared to industrial products. Resource movements induced by this variance could lead to reduced overall economic efficiency.23

21. Exporters should be allowed to use either temporaryadmission or tax reimbursements,and not both as occurs in Argentina.

22. The low effectiveprotection of traditionalexportables is caused by: (a) the subsidieson exports received by their main (exportable)inputs that increasethe price they pay for their in the domesticmarket aboveintemational prices; and (b) primary products cannot use the temporaryadmission program for the purchaseof inputs because of the long gestationperiod of their productionthat usually exceeds the maximumnumber of days (180 days) that imported inputs are allowed to be held free of duty in Argentina before being reexported.

23. A computablegeneral equilibrium(CGE) model was run to assess the impactof three alternativepolicies: (a) the introductionof a uniform import tariff of 10 percent and a 50 percent reduction of tax reimbursementson exports; (b) the immediateelimination of all employers' contributionsto social security compensatingthe loss in fiscal revenueswith a higher VAT rate; and (c) the replacementof the provincialturnover sales tax by a retail sales (continued...) - 42 - 3.44 There are other implicit subsidiesto exports hidden in industrialspecialization programs. Firms can benefit from a reduction in the tariff on imports of their inputs or competing products purchased directly by them if they increase their exports. The impact of these programs has been small, but they have a fiscal cost and contribute to the concentrationof the Argentine industry. The most important specializationprogram is the automobileindustry regime that enjoys a subsidy for the reductionof import tariffs of their inputs or for own imports of finishedcars of almost $300 million per year.

3.45 Attempts to manage sectoral trade incentives, as in the automobile regime, could prove to be costly. The automobile regime itself is inordinatelycomplex. There is no good economic reason why that industry should have a special regime, especially in a patently liberalizingatmosphere. Moreover, the balancing of exports with imports by industryis not desirablein a multilateraland multi-commodity trade system, since increased inefficiency arising from one industry can spread quickly into other industriesthrough input-outputrelations and throughgroups lobbyingto receive concessionsthat become available in the political market.

3.46 The use of quantitativerestrictions and antidumpingduring 1993and 1994 has also affected some exporters becausethey have to pay higher prices for some of their inputs. In particular, some preventive antidumpingactions have been applied which are difficult to justify from an economic point of view. Nevertheless, quantitativerestrictions and antidumpinghave affected a small group of goods, and a few of them, particularly quantitativerestrictions, have not been extended after their expiration.

3.47 Another policy issue relates to the continuingconcessions granted to the special areas such as Tierra del Fuego and Patagonia. Trade instrumentsare being used to provide incentives for regional development,through higher reimbursementsfor exports from these areas and reduced tariffs on capital goods imports. The trade instrumentis not appropriatefor supportingregional development.

3.48 Finally, trade issues relating to MERCOSURcould pose important challenges for Argentina's policy makers. Increasingtrade links with Brazil pose issues of coordinationof macroeconomicpolicies and the harmonizationof regulatoryenvironments to maintain balance of paymentsviability with Brazil and to increase competition among the Mercosur group of countries, respectively. To the extent macroeconomiccoordination issues are not reconciledthere will be tensionsin the trade relationsbetween these two countries. This might give rise to use of non-competitiveremedies such as the use of anti- dumping, quantitativerestrictions, ad hoc tariffs, and taxes, whichcould damagethe liberal trade regime.

3.49 These policies already carry importantfiscal and efficiencycosts to the economy, at a time when the Administrationis faced with the growing challengeof improvingits fiscal accounts. For example,

23.(. ..continued) tax. Resultsare as follows: In alternative(a), the introductionof a moreneutral policy of importsubstitution and export promotion allowsreal exportsto growthby 17 percentand investmentby 2.5 percent. In alternative(b), the impactof acceleratingthe reductionin labor taxes for all economicsectors, but maintainingtax revenuesconstant by increasingthe VAT,is an increasein totalexports by 17.4percent, and investmentby 1.5 percent. In alternative (c), exportsgrew by 8.5 percent,and investmentby 1.4 percent,after the introductionof a moreneutral tax that replacesthe cascadingprovincial sales tax. Thethree alternativessuggest that thereis an importantgain in export potentialand socialwelfare that mightbe achievedif improvedeconomic policies are adopted. - 43 - annual fiscal cost of the various export promotionprograms in effect during 1994, have been estimated at $1.6 billion, up from $630 million in 1990. These fiscal costs do not includethe impact of subsidized export credit programs, provided through the financial system. Furthermore, the above costs do not include the cost to consumers;the automobileindustry alone, adding consumerto the fiscal costs of the industrial regime, create a joint transfer cost of $1.7 to billion, annually. In 1995 and early 1996, the Governmenttook measures to cut export reimbursements.

3.50 Frequent changes in trade policy as those observed in Argentina during 1993 and 1995 have a negative impact on export and investmentpotential, since their profitabilitybecomes more uncertain. Moreover, they tend to give mixed signals to businessmenby assigninga higher value to rent seeking activities, comparedto a system of more automaticpolicies.

Recommendations

3.51 A fundamentalrecommendation is the maintenanceof macroeconomicstability as the first line of defense in keeping the trade regimeopen. Macroeconomicinstability can unravel even the most liberal of trade regimes. This has been the experienceof Argentina in the past as well as countries around the world. The track record of stable and consistent macroeconomicpolicies of the last five years is reassuring that such macroeconomicstability is achievable.

3.52 Exports are a function of structural reforms, such as the size of the public sector and labor reform. High labor cost due to wage taxes and regulation, coupled with high protection of other basic input industries add to the "argentine cost" and restrain export potential. With a slowdownin capital inflows, resources should move into the export sector and imports should deceleraterequiring a change in relative prices. Change in relative prices will depend crucially on the degree of market flexibility. In a highly regulated system, a small shift of resources requires large changes in relative prices: this is what normallyhappened in Argentinain responseto change in demand: resourcesmoved little and prices experienceddrastic movements. The optimal response for Argentina, thus, seems to be to continuewith the path of structural adjustment,addingflexibility to the economy, so as to minimizethe need for real exchange rate adjustmentin case of a slowdownin capital inflows.

3.53 Consideringthe overall consequencesof trade and indirecttax policies on exports, there is a need for change towards simplicity, transparency and automaticityof economic policy instruments. The creation of a stable and predictabletrade regime would benefit significantlythe growth of exports and investment. In that context, the followingmore specific recommendationsare worth considering:

(a) First, the automobile regime and the "industrial specialization" regimes require re- examination.They detract from neutral incentives, introduce unnecessary complexity and provide opportunitiesfor discretion that could be damaging for liberal trade. Additionally, as mentionedabove, the rent transferred to automobileproducers is substantial. Eliminating the benefits that go beyond the maximumtariff will cut this rent by about 40 percent. As was discussed above, there is no need to tie export performance to import concessions. While these are not strictly QRs, they would begin to operate as QRs and limit the role of prices in allocating resources. Moreover, the automobile regime and the "industrial specialization" regimes introduce rigidities into the production structure and make future adjustmentsmore difficult. The governmentcould announcenow the discontinuationof the regimes beyond 1999 when the "industrializationspecialization" regimes are to be reviewed, in order to prepare the ground for a level playingfield. - 44 - (b) Second, it would be advisableto do away with mirror principle altogether as the means to provide neutrality between exports and import substitutingindustries. There are easier and more efficient ways of providing neutrality for exports. This could be done through a low general tariff, and automaticreimbursement of tariff paid on inputs used for the production of exports. This automaticitywould help to reduce the rigidity of a finely tuned system and also help to prevent rent seeking involvedin the reimbursements when some imports could be misclassifiedto create rents.

(c) Third, there is little justificationto use trade policy to promote regional development.The special concessionsgranted to Tierra del Fuego and Patagonianprovinces through the trade regime is a vestige of past protectionistregimes. Moreover, subsidiesof this type are not consistent with the new rules of WTO. However, the new rules do provide support for regional developmentusing non-trade related instruments. Argentina needs to consider the appropriateinstrument to promote the developmentof these regions and desist the pressures to subsidize particular exports. Regionalgrants, infrastructurecreation and such means are superior instrumentsof regionalpolicy. Besides, they do not distort the trade regime.

(d) Fourth, with the creation of the National Trade Commission (NTC), Argentina has establishedthe institutionalmeans to considertrade policy making and to make decisionson contingent protection on a nationwidebasis. The work of the Commission could prove to be very importantin a post trade liberalizationera, by giving permanenceto the liberalized trade regime. Therefore, the Commissionshould be strengthenedin its technical capacity, its representation made independent and balanced to consider requests for contingent protectionwith the interestof consumersin mind. The commissioncould adopt the new rules for safeguards, anti-dumpingand countervailing actions consistent with new World Trade Organizationrules. These rules could indeedbe improvedupon to rely more on the safeguard mechanism rather than on preventive anti-dumpingactions which had increased in recent years.

(e) Finally, Argentina shouldconsider a smoothtransition to the Mercosur CET and use its good offices to increase internationalcompetition of the group as well as among the member countries. It is highly recommendedthat Argentina's position in MERCOSURshift towards the adoption of a uniform and low common external tariff. Argentina should also consider whether the 20 percent across the board tariff is appropriate when many of its competitors such as Chile, Colombia and Mexico have lower tariffs. In this regard, it would be necessaryto bring the 15 percent of the tariff lines outside the CET under the CET and resist pressures in the interim period to apply rules of origin to increase protection. In order to increase competitionwithin the Mercosur agreement, it would be necessary to harmonize regulatory frameworks as well as resist pressure to use contingent protection within the group. It would be possible to balance consumer and producer interests in trade policy working as a means of maintainingliberal trade. This could be done through the newly establishedNational Trade Commission,by adopting WTO consistent rules for transparent trade decision making. This should provide consistency among the WTO, Mercosur and domestic rules and give greater credibilityto the liberal trade regime. - 45 - C. The UnfinishedReform Agenda

3.54 The review of policiesaffecting investment, saving, and exportssuggests that, while there is room for improvement, the fundamental policy structures directly affecting them, are sound. Yet, the Argentinereform agenda has significantgaps, that require immediateattention, if the economy's potential is to materialize. Provinces, accountingfor the majority of public spending, despite encouragingsigns of reform, have considerable ways to go in reforming of their fiscal managementand the efficiency characterizingtheir expenditures. Lack of progressin provincialrefomis couldundermine reforms efforts at the Federal Government level, and as a consequence,the ConvertibilityPlan. Beyond the public finance issue, the Argentine economywould benefit from the liberalizationof its labor markets, and the reform of its financial system. The reform of its factor markets is imperative, for the economy to gain flexibility,in order to respond to the challengesthat the ConvertibilityPlan imposesto an open economy, and enable it to absorb better external shocks, such as those recentlyexperienced. Reform of the factor markets would contributeto improvedproductivity, and mitigateeconomic instability, which are crucial factors for the expansion of saving, investmentand exports.

Argentina's Provinces: New Priorities for Public Sector Reform

Provincial Expenditure Efficiency

3.55 Efficiency of the public sector depends on meeting three, generally accepted criteria for intergovernmentalrelations:

(a) adequacyand clarity in assignmentof responsibilities;

(b) adequacy of provincial revenues, both own-source and transfers, to meet assigned responsibilities;and

(c) accountability of provincial officials for their use of resources to meet assigned responsibilities.

3.56 Provinces are now the major providers of core public services in health, education, security, water and sanitation, electricity, and other infrastructure. Although this policy of widespread decentralization of delivery responsibility is clear, considerable concems remain regarding the efficiency with which decentralized, provincial goods and services are delivered, as will be discussed below.

3.57 Adequacy of revenues has at least two important dimensions. First is adequacy to meet expendituresmandated to the provinces. Second is whether the sources of revenues provide incentives to spend resources efficiently. With respect to the first dimension,the aggregate provincial deficits of recent years do not seem to result from insufficienttransfers from the federal govenmment.The deficits arose during a period when total provincialrevenues increasedby 34 percent in real terms (1991-1994), and the transfer of additional social sector responsibilitiesadded no more than 5-10 percent to aggregate provincial expenditures.

3.58 The second dimensionis closely related to the degree of accountabilityof public officials,and how that accountabilityis affected by the systemof intergovernmentalrelations. This issue often arises when provinces are spending what appears to be "other people's money." The degree of fiscal - 46 - dependence varies widely across Argentine provinces, with own revenues financing the following shares of total expenditures: 60 percent in "advanced" provinces, 36 percent in low population density provinces, 39 percent in "intermediate" provinces, and 21 percent in underdeveloped provinces. A number of studies have revealed inefficiencies at the provincial level which have resulted in the large aggregate deficits of recent years. A lack of clear correspondence between the payers and recipients of services is likely part of the incentive problem behind these deficits.

3.59 Another important issue is the fairness of the distribution of transfers across provinces. The data on Table 14 point to a strong regional redistribution of provincial expenditures, due in large part to the coparticipation regime (complemented by other central grant transfers). Provinces are grouped according to categories frequently used in Argentina for provincial analysis. Advanced provinces, characterized by large populations and high provincial product, receive substantially less per capita coparticipation revenues than provinces of the other groups. This suggests that the adequacy of provincial revenues is not a key issue, at least from the perspective of regional redistribution of income to provinces outside the advanced group. As concluded in a recent Bank study, "the regional redistribution of income probably has been excessive in Argentina."24

TabLe 14: Basic Data on Provinces

Provinces PopuLation Fiscal Bat. 1995 $ per cap. (e) Debt Stock(1995) 1994 X 1995(e) % Coparti Other Total Total S MiLl. % of (Thou.) $ MiLL. Total cipation Trans Expen. Exp.over TotaL Revenues Revenues fers ditures own Revenues Revenues

Advanced MCBA 2,977.1 8.7 28 1.1 52.9 20.0 854.0 1.0 Buenos Aires 13,112.7 38.5 (280) (3.7) 192.0 82.0 629.0 2.2 2,930 38.8 Cordoba 2,873.5 8.4 (397) (19.8) 309.0 55.0 868.0 2.8 1,600 80.7 Mendoza 1,478.0 4.3 (34) (3.2) 308.0 124.0 784.0 2.8 800 78.4 Santa Fe 2,896.8 8.5 (215) (10.5) 334.0 77.0 809.0 2.7 187 9.0 Low Density Chubut 388.2 1.1 (202) (41.1) 464.0 645.0 1943.0 11.3 101 21.1 La Pampa 276.2 0.8 (3) (0.6) 720.0 441.0 1792.0 3.6 22 4.9 Neuquen 441.6 1.3 (256) (28.6) 444.0 1120.0 2958.0 6.2 58 7.2 Rio Negro 546.9 1.6 (208) (37.5) 474.0 349.0 1506.0 6.2 445 77.5 Santa Cruz 174.9 0.5 (38) (7.0) 938.0 1721.0 3629.0 11.4 77 15.7 T. del Fuego 87.7 0.3 (66) (21.8) 1051.0 2362.0 5319.0 15.4 24 7.6 Intermediate Entre Rios 1,053.1 3.1 (160) (17.5) 494.0 123.0 1055.0 3.2 590 59.5 Salta 931.7 2.7 (99) (13.7) 442.0 176.0 948.0 5.9 282 39.6 San Juan 547.2 1.6 (164) (31.1) 629.0 222.0 1309.0 9.4 239 45.9 San Luis 310.0 0.9 50 11.1 778.6 385.0 1400.0 6.9 17 4.0 Tucuman 1,193.2 3.5 (227) (29.2) 421.0 116.0 880.0 7.3 607 78.3 UnderdeveLoped Catamarca 282.2 0.8 (64) (17.4) 1013.3 275.0 1635.0 66.7 193 51.9 Chaco 881.9 2.6 (110) (15.6) 571.4 138.0 968.0 11.3 560 80.4 Corrientes 836.7 2.5 (60) (10.1) 466.0 163.0 822.0 9.9 638 108.4 Formosa 432.1 1.3 (151) (30.2) 869.0 288.0 1634.0 126.9 365 72.3 Jujuy 544.4 1.6 (193) (37.9) 561.0 206.0 1370.0 8.4 324 65.0 La Rioja 239.3 0.7 (53) (9.9) 931.0 1375.0 2673.0 337.6 542 99.9 Misiones 854.4 2.5 (145) (25.3) 417.7 174.0 909.0 11.7 255 44.7 S. del Estero 694.7 2.0 (23) (3.8) 596.9 187.0 933.0 11.4 310 52.6 24 Jurisdictions 34,054.5 100.0 (3040) (11.7) 319.0 146.0 902.0 28.4 11,166 47.6

Source: Ministry of Economy; Ministry of Interior;Staff Estimates. e: Estimate

24. See "Argentina:Towards a New Federalism",Report No. 10612 (Green Cover), June 17, 1992, p. 27. - 47 - 3.60 One of the most importantcriteria for evaluatingintergovernmental fiscal relationsis the degree to which each level of governmenthas adequate resources to provide certain minimum standards of services to all citizens, independentlyof the jurisdictionin which they reside. This is especiallyimportant for human resource services, not only for their inherent importancefor development, but also because once "capitalized"within the individual,they may migrate betweenjurisdictions. Table 15 presents the allocationof provincial social expendituresby provincial group. Table 15 indicates significantlyhigher social expendituresper capita outsidethe advancedgroup, especiallyin Low Densityand Underdeveloped provinces. This reinforces the conclusionsderived from Table 14 data and suggeststhat social spending is not being underminedin non-advancedprovinces. 3.61 Efficiency of Expendituresand the Wage Bill. Although data are inadequateto evaluate the performanceof provincialexpenditure programs (e.g. education,health, transport), there is evidencethat serious inefficienciesexist in some types of overhead expenditures. For example, provincial wage bills constitute a heavy burden on many provincialtreasuries, such as the provinces of La Rioja, Catamarca, Corrientes, Formosa, Neuquen, Santa Cruz, and Tierra del Fuego where about one fifth of employed workers were in the public sector in 1992. In particular, public educationhas been used extensivelyto providejobs, and in most provincesaccounts for more than 40 percentof total public employment. With inadequateadministrative controls, nontenuredpositions for teacherstripled during the past decade as did leaves of absence. As a result, the average number of studentsper teacher in the provinces is 11, as compared to 19 studentsin Chile and 22 students in Spain. Such apparent coverage, however, has not improved the quality of education, as reflected by most surveys. One part of this problem, in many provinces, is the excessiveuse of substituteteachers, and even substitutesfor substitutes,to a level well beyond any normal degree of absenteeism. On any given day, there may be several teachers being paid to teach one class.

Table 15: Sectorat Composition of Provincial Social Expenditures Per Capita Average Index for the Country = 100

Provinces PubLic social Expenditure Education Health SociaL Welfare Housing per capita (1990) (1991) (1991) (1991) (1991)

Advanced 84 87 96 89 42 Low Density 223 206 184 185 410 Intermediate 104 104 98 132 129 Underdeveloped 127 121 91 96 249

Source: "Argentina'sPoor: a ProfiLe",W. Bank, 1995.

3.62 The evidence suggests, therefore, that the key issue for evaluatingprovincial fiscal adequacyto meet assigned responsibilitiesis in the area of expenditureefficiency. The issue is less the amount of provincial revenues than in how efficiently existing revenues are allocated. To address the issue of expenditure efficiency, the criterion of the accountabilityof provincialofficials should be examined.

3.63 In summary, a key issue for intergovernmentalrelations that promote improvementin provincial fiscal performance is lack of accountabilityof many provincial officials. This stems from a high level of central financing of provincial expenditures,and the lack of incentive for provincial authorities to confront their citizenswith the costs of their preferences. Weak accountabilityundermines incentives for provincial fiscal balance (with notable exceptions)and for provincial expenditureefficiency (apparently widespread). At stake is the quality and coverage of basic services in the areas of infrastructure,social services and poverty alleviation. - 48 - Recommendationsfor Reform

3.64 Two broad areas of reform, intergovernmental fiscal relations and access of subnational governmentsto the financial sector, are discussed below, with specific recommendations.

IntergovernmentalFiscal Relations

3.65 Throughoutthis section, issues resultingfrom Argentina's current system of intergovernmental fiscal transfers have been emphasized. These include the mismatch between provincial expenditure responsibilitiesand own-sourcerevenue authority,and the resultinglack of incentivesfor many provinces to be concernedwith (i) the quality of their expendituresor (ii) revenue effort on their current revenue base.

3.66 To address these issues, two basic reform strategies are discussed below. The first may be termed a "structuralreform" in intergovernmentalrelations, with fundamentalchanges in the rules of the game for intergovernmentalrelations. The second strategy may be considered "reforms at the margin". This strategy accepts the fundamentalrules of the game currently in place for intergovernmentalfiscal relations, but it seeks to identify areas of policy "fine tuning" that would provide incentivesfor better provincialservice delivery and financialmanagement. These two strategiesare not necessarilymutually exclusive; the second may serve as a transitionvehicle to the first.

3.67 Structural Reform. What should be the medium-term "vision" of intergovernmentalfiscal relations that promote provincial expenditure efficiency and accountability, and what reforms in the structure of these relations will be required to achieve these objectives? As a general vision of this reform, it is recommendedthat the following be considered: expendituredecentralization to the maximum extent compatiblewith the efficient delivery of public goods. This is consistentwith the "principle of subsidiarity", that the provisionof public services shouldbe assignedto the lowest level of governmentthat can finance them at the least cost, administerthem efficiently, and achieve their public purposes effectively.

3.68 Reform based on the principle of subsidiarityalso would need to take into accountthe following importantconsiderations.

(a) Fiscal accountability,seeking to promote allocativeefficiency through having the jurisdiction that provides services pay for them to the maximum extent feasible through own-source revenues. In other words, finance shouldfollow function in order to promote accountability through confronting beneficiaries with the costs of their preferences. In this regard, alternatives to the current system of coparticipation need to be explored, such as the devolution of some national tax bases to the subnational level, including the option of discretionaryprovincial surcharges("piggy-backing"), for such taxes as income, excise and fuel.

(b) Distributionalpolicy, seekingto promote equality of opportunityand reductions in extreme poverty. When devolutionand/or sharing(e.g., piggy-backing)of national tax bases are not sufficient to promote these equity objectives, then a system of intergovernmentalfiscal transfers targeted on these objectivesneeds to be defined. The current coparticipationsystem tends to focus on the territorialjurisdiction of the provinces as the object of fiscal transfers. To promote distributionalobjectives, this focus needs to be complementedby the household - 49 -

A PROVINCIAL REFORM AGENDA: THE CASE OF CORDOBA

1. C6rdoba is the third largest provincialeconomy. Its public sector is facing a financialcrisis with a detrimentalimpact on its economy. Cordoba's fiscal situationdeteriorated in the early nineties, despite significantincreases in coparticipatedrevenues and own tax revenues, resultingfrom the stabilizationand recovery of the national economy. Sharp increases in expendituresacross the board, led to overall deficits averaging 19.5 percent of current expendituresin both 1993 and 1994. The role of the public sector needs to be recast from an inhibitor to overall economic growth, to a legitimate provider of affordablesocial goods, and supporterof economicgrowth. There is a need for a profoundreallocation of resources from the public to the private sectors, that will strengthenboth sectors. As a consequence of this reallocation, Cordoba will be able to attain a first goal of financialcreditworthiness, primarily by strengtheningpublic finances, fulfilling in that process conditions for sustained development. A second, equally important goal would be to increasethe efficiencyof public expenditures,allowing for the improved deliveryof social services in the context of fiscal balance. A leaner and more efficient public sector would be to the benefit of Cordoba's economy. 2. The recent LatinAmerican crisis accentuatedthe province's financialproblems, and in the midst of socialunrest, the previousadministration left officein July, 1995, five monthsearlier than anticipated. A new administrationwas forced to engage immediatelyin crisis management,taking strong measures to curtailfiscal spendingthrough the implementationof an EmergencyLaw. Whilethe nationaleconomic crisis affected C6rdoba's economy,the causes of Cordoba's economic crisis go deeper, and are the result of locally grown imbalances. There is need for a fundamentalreform of the public sector, not only to address the current crisis, but strengthenfuture economic prospects as well. While the transition costs of the adjustmentcould be important,an immediatetransition would mitigateits future larger costs. Recommendationsfor the reform of the province include: Reformsfor the Short Term

-- Replace the EmergencyLaw in 1996 with a sustainablefiscal savings plan. -- Cease the use of bonds as means of payment in the context of a fiscal and debt workout; -- Cut personnelexpenditures to balance the budget; -- To facilitate the adjustment and increase efficiency, privatize banks and other public enterprises; -- Sign the Pacto Fiscal, to access the minimumcoparticipation guarantee; -- Transfer the Social SecuritySystem to the National Governmentand -- Create a more effectiveSocial Safety Net. Reformsfor the Medium Term

-- Implement health reform, by providing health insurance rather than free care in public hospitals; -- Implementeducation reform through effective control over personnelexpenditures, increased student/teacher ratio, reoriented expendituresto educational services, improved equity with richer studentspaying more for education,and modernizedcurricula; -- ImplementSocial Welfare reform by significantlyimproving targeting; -- ImplementCivil ServiceReform, by creating merit basedmechanisms, such as a competitive selection process and a results-orientedassessment process, by decentralizing managerial responsibility,and introducingtechnological innovations that reduce labor requirements. -- Streamline municipal coparticipation by simplifying the transfer formula, further decentralizingfunctions, and eliminatingdistortive incentives; -- Increaserevenues by amplifyingthe tax base and improving tax collections, while decreasing tax rates to support private sector developmentand employment; -- Increase capital expendituresto support the growthof the private sector; -- Establish an economic, statistical, and financial data base for the public sector and the province. - 50 - as the object of fiscal transfers. This indicatesthat intergovernmentalfiscal transfers need to be allocated primarily according to a measure of poverty distribution for the financing of primary and secondary education and health, as well as other programs of national priority, primarily for poverty alleviation (e.g., housing, potable water and nutrition). Closely linking implementationof minimum levels of nationalsocial programobjectives through subnational governments also may require much higher degrees of earmarking for intergovernmentalfiscal transfers than now is the case.

3.69 Potential conflicts should be recognized, between the different intergovernmentalfiscal reform objectives and measures noted above. The first potential conflict is between subnational fiscal accountabilityand redistributionalpolicies that result in central fiscal transfers to implement national social policies. The response proposed is to make these transfers (i) conditionalon effective service delivery, and (ii) based on indicatorsthat could not be easily distorted, such as census data on population, poverty measures, and number of students. A minimum level of subnationalgovernment counterpart financingfor social expenditures,especially programs that are difficult to monitor from the center, also would be required under the proposal. The basic thrust is to guaranteeminimum national standards for social policy programs, financed with fiscal transfers, that may be complementedthrough local fiscal effort so that the allocativeefficiency benefits of fiscal accountabilitymay be achieved. Anotherpotential conflict is with decentralization and allocative efficiency. The reform should seek to eliminate possibilities of subnationalgovernments providing fiscal or other artificial incentives (e.g., provincial versions of "promocionindustrial") to influencethe location of productiveactivities.

3.70 In sunmary, structural reform to address the issue of poor provincial expenditureefficiency includes expanding the provincial own-source revenue base to bring it more in line with provincial expenditure responsibilities, and decreasing the high dependence of provinces on fiscal transfers. Requiringprovincial authorities to confront their constituentswith the costs of their preferences may be expectedto promote enhancedefficiency in the allocationof resourcesand greater economy with which these resources are used in the provision of public goods and services.

3.71 Reforms at the Margin. One option for reform "at the margin" is to recast the approximately US$4.8 billion that are transferred to provinces outside the coparticipationsystem. Most of these transfers are made through special purpose funds, such as the FONAVI housing program and the Electricity and National Highway Funds. With the agreement of the provinces, some or all of these resources could be consolidatedinto a program of grants allocated to provinces on the basis of their performance. Provincialperformance criteria might include current savings, effectivenessin meeting expenditureresponsibilities, especially in education,health and poverty alleviation, and/or streamlining provincial administrations(in which case the incrementalgrants could finance adjustmentcosts such as severancepayments). Such a performance-basedgrant program, at the margin of coparticipation,could provide incentives for better provincial performance in discharging their responsibilities. It would require, however,clear and broadlyaccepted provincial performance indicators measured withtransparent and reasonablyaccurate data.

3.72 Although probably more politically difficult than the first option, a second option could be reforms in the participationof each province in coparticipationtaxes. As noted above, central transfers favor heavily those provincesoutside the advancedregion, and social expendituresper capita generally are significantly higher in those provinces. Yet, almost 60 percent of Argentina's poor live in the advancedprovinces. This proportionmay increaseas liberalizedmarket forces attract more poor families to areas of expandingemployment. - 51 - 3.73 Starting from the premise that the central government's first responsibility in designing an intergovernmentalfiscal system is to ensure financing(transfers and subnationalown-source) for basic human services, with broadly equal access by all citizens regardless of the jurisdiction in which they reside, the Government should re-examine the distributionalformula for coparticipationto ensure that national objectives for interpersonalequity are being met.

Relations between Provincial Governmentsand the Financial Sector

3.74 The mostproductive and sustainablerelationship between provincial governments and Argentina's financial sector shouldbe beneficialto both the financialsector and provincial development. A general recommendationswould be that provincesshould finance their investmentprograms through their current account saving balances leveraged, when appropriate, with borrowing from the capital markets. Provinces should compete with alternative borrowers (e.g., agriculture, industry, commerce) with no special privileges that would handicap other public or private sector investors with potentially more productive use of resources.

3.75 Provinces(and other subnationalgovernment units) couldborrow responsiblyto financepartially their investmentneeds competitively,and prudently to promote at least three importantbenefits:

(a) Expenditureefficiency, as borrowing promotes economiesof scale and lower unit costs of constructionfor lumpy investmentswhen comparedto pay-as-you-gofinancing.

(b) Interpersonalequity, as payment of costs correspondsmore closely to the flow of benefits, and this is a significant concern at the subnationallevel because of migrations across local jurisdictions. For newcomers,the free-rider issue is reduced (even if local public investment benefits are capitalized in private property values) as they should pay for investmentcosts during the period they are receiving benefits from them.

(c) In order to have access to the capital markets, provinces will need to have accurate and appropriate financial accountingand reporting systems,as well as investmentprograms that are properly designed, financed and operated, as noted above. Also, there must be full disclosure of this informationto the public domain. This increasein transparencypromotes public accountabilityand market disciplineon governmentdecisions.

3.76 In order to better link the demand for investmentfinancing of subnationalgovernment with the potential supply of loans from the private financial sector, several regulatoryprerequisites need to be in place. These include the following:

(a) Severely curtail the use of coparticipatedfunds guaranteeas collateral, whichhas been widely used for borrowing in the financialmarkets, irrespectiveof the destinationof funds;

(b) Generate appropriate data on subnationalinvestment executing entities, including overall financialperformance, as well as evaluationof the technical and rinancial qualityof specific investmentprojects for which loan financingis sought;

(c) The legal and regulatory frameworkneeds to be strengthened,but this framework needs to be strengthenedand expanded to facilitate subnationalgovernment access to the capital markets, as well as to provide safeguardsfor macroeconomicpolicies. - 52 -

3.77 The quality of subnational government investment proposals and of general subnational financial management, and the financial sector's capacity to respond to subnational government investment financing demands is not currently at a level consistent with a significant financial sector response to these investment financing needs. However, the prospects of a significant response are considerably greater than just a few years ago. A transition strategy should support market-based appropriate subnational government access to the financial markets.

Labor Markets and Institutions

3.78 The onset of the Convertibility Plan, with its significant structural reforms and the opening of the economy presaged a shakeup of the labor market. Reasons can be found in the pre-existing structure, employment, productivity and competitiveness of firms. During the 1980s, average yearly GDP growth dropped to -1 percent, yet over the period yearly employment growth averaged 1 percent, and total factor productivity declined at an annual average rate of 4.3 percent. As a consequence, most enterprises (particularly in the public sector) and the administration became bloated with excess labor while they continued to experience low productivity levels. When the economy was deregulated and competition increased through the opening of the trade regime, the expected sectoral shocks and labor turnover occurred, a desirable outcome from an efficiency standpoint. However, a highly centralized and rigid labor market hindered mobility, shifts, reabsorption of displaced labor, and wage flexibility, which made the adjustment to a new equilibrium both costlier and longer. Increases in real wages and increasing incidence of heads of household unemployment, led to rapid surges in labor force participation particularly of women. In addition, the new exchange rate parity, decreases in the relative price of capital, low inflation, and nominal wage and labor market rigidities favored quantitative adjustments (reduction of labor force) over price adjustments. All those factors, led to record high levels of unemployment, reaching in October 1995, a recession year, an unemployment rate of 16.6 percent.

Employment Performance2 '

3.79 The increase in GDP during the Convertibility Plan period was accompanied by employment growth during the first two years of the Plan, 1991 and 1992, and a decline beginning toward the end of 1993 and continuing in 1994 and 1995. Despite the Argentine economy's impressive growth performance of 31 percent between 1991 and 1994, the increase in net jobs created for the period was only 3.7 percent (about 427,000). In 1994, a net decrease in total employment occurred of nearly 2 percent, despite GDP growth of over 7 percent. More distressing is that in both 1993 and 1994, the number of full time jobs decreased while the number of underemployed--which statistically are counted as "employed"--has increased by nearly 8 percent, particularly in the Greater Buenos Aires. Not surprisingly and consistent with global trends, employment shifted from manufacturing (19.9 percent) to services (61.4 percent). Also as expected, the sectors losing the most employment were the more vulnerable and less efficient tradeable sectors, such as textiles and clothing. Job creation, and particularly full time jobs, has been lagging behind. Job creation has mainly taken place in the food industry and

25. Some of the data on which unemploymentand wage analysesare based are not always reliable, e.g., they may underestimateemployment creation and earnings in relativelyinformal activities such as domestic service. Recent initiativesto improve labor market data are welcomesteps in improvingthe reliabilityof data, especially for unemploymentrates and duration. - 53 - service sector and mostly in small and mediumsize enterprises;however, it has not been nearly enough to cover losses in other sectors and to absorb increases in populationand labor force participation.

3.80 The unemployment rate reached a historic high of 18.6% country wide and 20.2% in GBA in UnemploymentRates May 1995, accompanied by increased duration of UrbanCugbmeratsm rdGrealer B.A unemploymentspells and structural unemployment. This increase was also related to significantincreases in labor force participationin 1995 reaching levels of 2 45.9 percent.

3.81 The average duration of an unemployment spell has increase significantlyreaching in 1995, over, 45 weeks, up from 32.2 weeks in 1994, and 12.9 weeks in 1991, with nearly 20% of the unemployed , remaining unemployed for over a year. This is a concern since long-term unemployment is far more ,34+X/|d A- .W!1 Al 7W Q '1Yk5(. b3'2 damaging than short-term. Those affected often ; 14 ,5 X VC7r(e-I C19 OEC M1 iE3 .84 M05; CosX CcO (.;10r NI: become separated permanentlyfrom the labor force. GroaiwG e A& - Urb8,C-r:.rrQraaD Since economic and sectoral adjustmentsare not yet completed, a return of employment output elasticity to Sourcedata: INDEC its "normal" levels (0.30 to 0. 15) is still pending--for Figure 8 example, sectors such as financial and other services, commerce, agriculture, and some manufacturing are still in the process of restructuring and can be expected to further substitute capital for labor. Most sectors show employment contraction, with the exceptionof services and commerce. In the wake of the economicslowdown in early 1995, a number of yet unrestructuredsectors have further reduced their employmentlevels (e.g., financial, commerce, and services), and labor force participationincreased further, contributingto the further increase and records in unemployment.

Table 16: Unemployment Rates by Age and Sex Category GBA, EPH

OCT OCT MAY OCT MAY OCT MAY OCT MAY 87 91 92 92 93 93 94 94 95 Males 15-19 14.3 16.9 12.9 17.3 19.4 21.8 28.9 31.4 46.8 20-34 4.2 4.7 7.6 6.4 8.3 8.1 8.9 10.4 15.3 35-49 2.9 3.5 4.0 4.4 7.1 6.1 6.6 6.8 11.9 50-64 3.8 3.3 4.0 7.1 9.1 6.2 8.2 12.7 16.3 15-64 4.4 4.9 6.0 6.8 8.9 8.0 9.6 11.4 17.1 Females 15-19 17.3 17.5 21.9 14.3 33.0 40.3 33.0 38.9 58.9 20-34 7.3 6.7 9.0 7.2 13.7 12.6 12.4 15.1 25.2 35-49 4.2 3.9 5.8 4.2 7.9 10.5 10.4 13.2 19.0 50-64 3.0 2.8 2.2 5.7 14.2 5.4 11.9 10.2 17.4 15-64 6.3 5.9 7.9 6.4 13.2 12.6 13.3 15.4 24.8 ALL 5.1 5.3 6.7 6.6 10.6 9.8 11.0 12.9 20.2 Source data: INDEC-EPH - 54 - 3.82 The Govermnent has responded with labor institutionalreforms and aggressive but not very efficientjob-creation program, which accountedfor nearly 50,000 jobs in 1993and an additional 100,000 in 1994. Despite this effort, the employment\unemploymentpicture remains problematic. The data of October 1995, showing a decrease in unemploymentto the 16.6% level, may indicate the beginning of a recovery. However, the decrease has been mostly due to a decrease in labor force participationfrom 45.9% to 44.2%, since there was no job creation to speak of from May to October 1995. Moreover, the October data indicatesa jump in the unemploymentrate of heads of householdsto 11.5 percent, up from 9.3 percent in May, and an increase in monthly unemployment insurance claims from 100,000 to 145,000.

Wage and Earnings Performance

3.83 Despitethe significantincreases in labor supplyand unemployment,real wagesand earnings have been increasingsteadily between 1991and 1994, revealingan unresponsivenessto labor marketconditions and a downside rigidity in real wage adjustmentand premiums for scarce skilled labor. Only in the third quarter of 1994 did real wages for blue-collar workers in the manufacturingand constructionsectors appear to show a slight decrease. The market now seeks highly skilled workers and younger skilled or unskilled, motivated, trainable workers to complementthe newly acquired capital goods and to secure most needed higher productiveefficiency. As a result, wage gaps and labor segmentationhave increased significantly,as seen in the sharp increase in the return to tertiary education(reaching 25 % in 1994), and by continuousreal wage increasesfor skilledpositions. During the 1995 recession, however, preliminary indicationssuggest that wages did show some decline in real terms.

Determinants of Unemployment

3.84 There are several factors contributing to the growing unemployment picture. The main determinantsare: (i) the increasein labor force participation. The overall labor force participation rate increasedfrom 40.8% in 1991 to 43.3% in 1994, to 45.9% in 1995 (May) and fell to 44.2% in 1995 (October). An important factor was the growing participation of women in the labor force, which increasedfrom 43 percent in 1987 to 49 percent in May 1994 in the Great Buenos Aires area and from 24.7 percent in 1989 to 31.9 percent in the country as a whole; (ii) the changes in incentives and the competitive (trade) regime that caused significantsectoral shifts and firms to seek cost reductions and productivity gains (through labor shedding); (iii) failure of wages to adjust to labor market conditions (increase in labor supply and unemployment);the adjustmentshave been in the form of employment reduction rather than through wage reductions; (iv) the 40 percent decline in the relative capital-labor price since 1991, inducedmostly by openingthe trade regime, has furthered the replacementof labor with capital; (v) recent migrationpatterns from abroad had a significantimpact (18%) on labor flows and labor force; (vi) significantmismatches between skills offered and those in demand; and (vii) excessive non- wage labor costs and institutionalaspects of the labor market impose (selective) rigidities, discourage labor force expansion, and slow the speed of adjustmentto meet observedsectoral shifts.

3.85 The institutionalconstraints with the greatest effect on wages and employmentpractices are: (i) restrictions on temporary or fixed-term contracts; (ii) significant mandated severance payments; (iii) centralized collective bargaining, particularly in the service sector, that denies firms geographicaland subsector flexibility to respond to emerging needs and labor market conditions; (iv) the tendency to perpetuate lapsed collective bargaining agreements (most of which were negotiated during the hyperinflationaryyears) embedded in legislationthat discourages renegotiationof collectivebargaining agreements; (v) a significant level of nonwage labor costs, increasing labor costs over gross worker - 55 - remunerationby 53 %, and 72.4 % when measured in terms of labor cost per efficiencyunit of time; (vi) the framework for employee accident compensationand lack of a regulatory framework for insurance, leadingto an imputedcost on wages of 3%, and excessivelyhigh risk-bearing,especially for small firms, which potentiallyafter a few instancescan bankrupt them (new legislationis now in congress to remedy this situation); (vii) coexistenceof mandatedseverance payments and unemploymentinsurance at a cost to the firm of 6.5 % of gross wages.

RealEarnings Prices Sept. 1989 DollarEarnings Maiss 25-64 EPH IN DEC Maess25-64EPH INDEC

Source data: INDEC Source data: INDEC Figure 9 Figure 10

Prospects

3.86 Improvements in employment will come about only from increased economic activity, and particularly from lower labor costs, and increased flexibility in contracting and collective bargaining. .Since sectoral adjustments, technological replacements, and restructuring of firms are not yet completed, it is likely that without further labor reforms, the employment\unemployment picture might not improve m-uchin the short term (unless there is a sharp reduction in labor force participation as it occurred in the second semester of 1995). There are sectors--agricultural and livestock, financial and other services sectors (i.e., retailing)--that are only now beginning the restructuring process in earnest; in the course of this restructuring, there may be another wave of labor-shedding. Some sectors, such as pharmaceutical and cosmetics, vulnerable to competition, are replacing production lines with imported products, which also brings further reductions in employment. And perhaps of great impact is the replacement of obsolete capital stock (circa 1970), which accounts for over three-fifths of total stock, and has yet to be undertaken intensively. This, generating high labor savings will put additional pressure on employment levels. Moreover, the current labor force participation rate in Argentina, of 43.3 % is quite low by international standards and the country's level of development (Chile 58%, Mexico 59.9%, Uruguay 67.7%)"6, indicating likely continued increases in labor supply and thus further unemployment pressures.

3.87 On the bright side, there is room to decrease unit costs of production and stimulate economic activity, and thus job creation. The largest and potentially lasting employment initiative will come from labor policy reform. The has already taken substantial measures to address the

26. Source: OIT, 1994. - 56 - unemploymentissue, such as the passage of the Law of Modalidadesde Contratacion,Law of PYMES, and Law of Seguros de Accidentesde Trabajo (WorkmenInsurance Compensation), and geographically discriminatory reductions on labor taxes (reductions ranging from 30% to 80% starting January 1996, with the lowest reductionsbeing in the GBA area which accountsfor nearly 50% of total employment). Yet significant improvements still need to be made, to have an impact on the current employment/unemploymentsituation.

3.88 The followingmeasures would improvethe functioningof labor markets, lower the cost of labor, and thus increase employmentlevels. While current rates of unemploymentare high, both for structural and cyclical reasons and short term prospects may be discouraging, the implementationof structural reforms and resumptionof economicgrowth could reduce unemploymentat a fast pace, as the Chilean experience of the late 1980s indicates.

Recommended Course of Action

Nonwage Labor Costs and ContractualFlexibility

Reduce direct labor costs beyond the current 32% tax reduction. The current cost remains high by internationalstandards and by the level of benefits secured.

Considerextending fiscal exemptions(labor tax and unemploymentinsurance contributions) to (i) all persons up to the age of 24, who at the same time would be excludedfrom unemployment benefits and familyallowances; and (ii) all long-termunemployed (over one year) for a one-to-two year period. These jobs might come at the expense of those already in low-payingjobs, so the number of workers experiencingshort-term employmentmight rise; however, this is preferable to letting one group of increasinglydisaffected workers languishon the margins of society.

Permit the unrestricted use of temporaryand fixed term contracts

UnemploymentInsurance and SeverancePayments

lThe unemployment insurance scheme is not financially self-sustaining. As eligibility and unemploymentincreased, the insurance program showed a current deficit of over US$28 million in 1994, and exceeded in 1995 as unemploymentincreased. The benefit levels will need to be reduced to minimumwage levels and adjustedfor severancepayment benefits, with the qualifying age for unemploymentbenefits raised to 24.

Eliminate either unemploymentinsurance or severance payment obligations. Having both is counterproductive,in that it elicits two perverse incentives: it dissuades the unemployed from actively seekingemployment and firms from adjustingtheir labor force optimally.Provided that the appropriate institutionalcapacity is secured, a more comprehensiveunemployment insurance scheme should be developed. In the short term, limit the amount of severancepayments to six monthly salaries for current workers; gradually, eliminate severance payment obligations; and eliminate all firms' severance payments obligations for new workers, and freeze severance payment obligationsto now-employedworkers at current levels. - 57 - Unions and CollectiveBargaining

Decentralizecollective bargaining to the firm level.

The power of the Ministry of Labor to authorize (i.e., extend to all members of the trade) collectivebargaining agreementsshould be eliminated. This would necessitatemodifying Laws 14250 and 23456. If maintained, it should enforce the uniform application of collective bargaining salary increase clauses to apply only in cases of productivity gains (currently unenforced).

The conceptof "ultractividad,"which permits collectivebargaining agreements to remainin effect in perpetuity, should be rescinded, i.e., once an agreement expires, all clauses lapse.

Priority shouldbe given to direct agreementsbetween parties instead of agreementsmade outside the company(collective agreements of any other type, professionalstatutes or acts, etc.). This will require amendingLaw 20744.

Eliminatethe legal power of collectivebargaining agreements at any level (activity or branch of activity, national, regional or local) to set contributionson the basis of profits, sales, or deposits in the financial system, with all dues binding on companies and workers not members of a Chamber or a union, which results from the official approval of the contract.

The monopolyover the provisionof welfare services for employeescurrently held by the unions shouldbe eliminated, since it is expensiveand service is poor. In its place competitionamong all service providers should be introduced.

Wages, Workmen's Compensation,and Public Information

*Minimum Wage. The current minimum wage (200 pesos) should be maintaineduntil it reaches a minimum relationshipof 3.5 relative to the average factory (blue-collar)wage (currently 3).

Public Information:Disseminate information about rates of return to education. This should induce longer stays in school, reducingthe supply of labor in the short term and increasingskilled labor in the medium and longer term.

Develop within EPH a unit specificallydealing with the service sector. There is little information and analysis on the service sector, which is the only sector experiencingjob growth, and now accounts for over 60% of total employment.

Conclusion

3.89 While growth resumption should improve the employment outlook, it might not be enough, particularly in the short and medium term to have much of an impact on employment. The employment output elasticity for Argentina has been estimated at around 0.25, meaning that, ceteris paribus, to increaseemployment by 1 percent, a 4 percent GDP growth would be needed. To improve significantly the employmentoutlook, reductions in labor costs and decentralizationof collective bargaining are the key policy reforms to consider. It has been estimatedthat a reductionof labor costs by 10 percent would - 58 - increaseemployment by between 5 percent and 10 percent, and a decentralizationof collectivebargaining to the firm level could, in the long term and based on internationalexperience, increase private sector employmentby between 15 percent and 30 percent27.

FinancialMarkets

3.90 The dramaticmacroeconomic reforms of the last four years created conditionsfor rapid economic growth. Investments necessary for such growth were largely financedby the return of flight capital, privatizations,and foreign capital inflows, whichmust be increasinglyreplaced by domesticsavings. The simulations,provided earlier in this chapter, indicate the need for domesticsavings to rise significantly by the turn of the century, with the share of private investmentsrising steadily. Thus, the ability of the financial sector to mobilize such savings and investmentsis pivotal to the realization of high levels of economic growth.

3.91 Argentina has both the need and potential for development of financial markets approaching developed country standards. Since 1990, the authorities has radically improved the regulatory and economic environment for banking and capital markets. By 1994, most of the "stroke of the pen" reforms were implemented with impressive commitment and dispatch. But problems arising from institutional(under)development, federal-provincial relations and public finance, and lack of market and product developmenthave proven more intractable.

3.92 Thus, by 1995, financial markets remained shallow -- even by developing country standards -- as measured by banking system penetration, capitalization,trading, liquidityand volatilityof marketable securities, new security issuance, numberof listed stocks, presence of institutionalinvestors, the size and liquidity of long term debt market, and variety of financial instruments. Intermediationcosts, margins and inefficiencieswere very high and acted as a strong deterrent to both savings and investments. Cost of credit was very high, the aggregate credit extension low, and access to formal credit particularly difficultfor smallbusinesses and farmers. Substantialimprovements in collaterallegislation and registries were still needed. Despite numerousbanks (albeit small), competitionwas not deeply ingrained among banks, or between banks and capital market institutionsand financial products. Severe structural problems remained in the banking sector, and to a lesser extent in the insurance industry, stock and bond markets, and in government securities market. While substantial progress was made in enabling legislation and regulation in several of these areas, regulatory capacity and enforcement standards remained deficient in most of them.

3.93 The events followingthe Mexican peso devaluationhave further weakened the financial sector considerablyand exposed its vulnerability. They reversed the deposit growth (currently deposit levels regained lost ground), shortenedthe maturityof depositbase, and subjecteda fragmentedbanking sector to significantproblems of liquidity, solvency(for some institutions),and systemic confidence. On the positive side, they have also unleashedsubstantial banking sector reforms and concretemeasures to help consolidatethe banking system.

3.94 In this context, the primary financial sector objectives include: (i) consolidating confidence, liquidity and solvency in the banking system by an orderly transfer of assets and deposits from weak banks to stronger ones; (ii) raising the volume and maturitiesof savings and loans; (iii) augmentingthe

27. W. Bankstudy on "Analysisof Impactof LaborPolicy Reforms in Argentina". - 59 - access to credit, particularlyby smalland mediumenterprises; (iv) improvingfurther the supervisionand regulation of the banking sector and capital markets; and (v) deepeningcapital markets and expanding the choice of financialinstruments. This strategy calls for strong support for the ArgentineGovernment's efforts to safeguard its banking system and invigorate its capital markets.

The Banking Sector

3.95 Argentina's financialsector consistsprimarily of commercialbanks, which are allowed to extend a full scope of financialservices. Consolidationof the banking system, which proceeded at a fast pace following the financial crisis of the early 1980s, slowed after 1990, as economic stabilization and remonetizationincreased the capacityof commercialbanks to mobilizedeposits and increasetheir lending. Nevertheless, macroeconomic stabilization, financial sector policies, and improved regulation and supervisionencouraged banks to become more efficient, and larger institutionsgained in market share. Since 1994, the pace of commercialbanks consolidationhas resumed as deposit growth has declined, and is expected to continue in the foreseeablefuture, stimulatedfurther by the flight to quality of deposits during the recent crisis.

3.96 The recent crisis has accentuatedthe fragility of Argentina's smaller banks, and is accelerating the process of consolidation. During 1995, eighteen banks were intervened, of which four are under liquidation, eight were suspendedand the remaining six are undergoing workouts at various stages of completion. By December1995, there were 164 financialinstitutions operating in the Argentinemarket, down from 203 in December 1994, as a result of mergers and closures. Of those institutions, 132 were commercial banks which accounted for 94 percent of total financial sector assets. The remaining institutionswere finance companiesor savings institutionsthat do not offer checking account services. Overall, in 1995private banks accountedfor about 60 percent of total assets and deposits. The 9 largest private banks accounted for between 27 and 28 percent of total assets, loans and deposits. The entire sector suffers from excessive fragmentation(of the six leading Latin Americancountries, the Argentine banking sector has the least degree of concentrationr), low penetration29, excessive operating costs, high financial spreads, lack of economiesof scale (the two largest banks have assets of less than $5 billion, and only six have more than $1 billion), weaknessesin the interbankmarket (during the crisis, wholesalebanks had no fundingsources, and many were closed), and slow pace of innovation(Argentina is well behind Chile and Brazil in electronicbanking and other cost-cuttingtechnological innovations). These structuralproblems--compounded by inadequatelender of last resort capacity--havecontributed to the liquidity crisis followingthe Mexican peso devaluation.

3.97 From a capital viewpoint, the ten largest private banks would be best placed to act as acquiring banks in merger transactions. Some large banks are undertakingacquisitions, including acquisitions of selected assets and branches of regional banks. The more likely acquirers are intermediate-sizebanks wishingto increasemarket share, althoughcaution shouldbe exercisednot to create larger weak banks. A small number of banks may also be capable of restructuring themselves with outside financial assistance. The restructuringand consolidationof private banks could be facilitated through the Bank CapitalizationTrust Fund.

28. As measuredby the Herfindhal-HirschmanIndex 29. As a ratio of depositsto GDP. - 60 - 3.98 Dealing with public banks has proven to be one of the more difficult and intractable challenges for Argentina's financialpolicy. The performanceof provincial and municipal banks has been modest or downright poor (many provincial banks are technicallybankrupt). As public banks were created by federal or provincial/municipallaws, any amendmentof such laws requires the approval of the respective legislature. In the past, the large majority of provincial legislatureshas resisted enacting privatization laws. At the start of 1995, Argentinahad 32 federal, provincial, and municipalbanks. In the course of the 1995 and the first quarter of 1996, financialcrisis, however, when the financialburden of these banks became too onerous to bear, 9 provincialbanks were privatized. From the remaining 15 banks owned by provincialgovernments, 10 are under way of privatization. Provincialand municipal banks not in the process of privatization, however, still account for 69 percent of total provincial and municipal bank assets. Together, as of September 1995, all public banks accounted for 41 percent of the system's assets, 43 percent of net loans, 40 percent of deposits and almost 49 percent of shareholders' equity.

3.99 Overall, private banks performed better than public banks. Non-performingprivate bank loans amountedto about 9 percent of total lending in 1994, far less than the 25 percent in public banks. The activitiesof public banks distort financialintermediation, essentially by directing funds to less profitable activities for which private banks will not lend. Furthermore, provincialbanks cannot be closed by the Superintendencyof Banks when regulatoryrequirements are not met, as can privately-ownedbanks. The provincialbanks' adverse effectson financialsector efficiencyare exposedby their sustainedlosses, non- competitiveallocation of credit, high cost of funds and excessiveemployment. Poor credit decisionsare manifested in their large reported non-performing portfolio which exceeds by far non-performing portfolios in other categories of banks. Moreover, provincial bank credit allocation to inefficient activities, includingprovincial governmentsand public provincial enterprises, reflect the lack of arms- length relationships,thereby deflectingthe supply of credit away from productiveactivities.

3. 100 The recent financialcrisis, affectingboth provincialgovernments, and the federal government's ability to assist them, created a unique opportunityfor the restructuringof provincial banks, since they have becomea net liabilityto provincialfinances. It is imperativethat the federalGovernment resist any fiscal support that would prop up provincial banks, and guide provinces to the utilization of existing facilities, i.e. the Provincial Development Trust Fund, which provide financing conditional to the restructuring of such banks. Provincial governmentsshould preferably sell all their shareholdings in provincial banks; as a minimum, they shouldsell a majority share of such banks and transfer control to private shareholders. Through privatizationit is expected that the newly emerging private banks will focus on profit maximization and financial soundness and that the Central Bank supervision and enforcement of liquidity, capital adequacy, and provisioningrequirements for these banks will be more effective.

3.101 With forceful implementationof prudential norms, and greater competition, the number of Argentine banks in the coming five years may be halved from those at the beginning of 1995. Such consolidationwill still leave Argentina with proportionatelymore banks than in Mexico, Chile or Brazil, and thus is not likely to reduce competition. The retrenchmentwould force the banks to cut costs, rationalizetheir branch networks and introducebetter technology. However, at present only about six of the banks are publicly listed, and progress in terms of greater public shareholding, reductionof family controls and professionalizationof top managementwill take longer.

3.102 It is recommendedthat the restructuringof private banks proceeds on an acceleratedbasis, with the assistance of the authorities' Trust Funds created for that purpose, in order for the financial system to recover from the recent crisis, and better prepare it to address any future occurrence of external - 61 - shocks. Delays in that restructuring could unduly postpone the recovery of deposits growth in the financialsystem, and, more importantlythe resumptionof credit expansion.

3.103 The authoritiescould strengthenthe privatebanks' incentivesfor cost cutting in two ways. First, through rigorous enforcementof prudential norms -- particularlyof loan classification,provisioning and bank rating. Such enforcement would ultimatelycause cost-inefficientbanks to raise additional equity which may lead to new owners, better management,mergers and greater economy of scale, or better business strategies. Second, the authorities can increase competitive pressures on the banks by dismantlingbarriers to competition(i) among banks, (ii) between banks and capital market products and institutions,and (iii) encouragingcompetitive "shopping" and pressures from bank clients. Restrictions on branch expansion, new entry, foreign banks, and money market funds have been liberalized since 1994. However, those on leasing, securitizationby non-banks,commercial paper and privateplacements continue to protect the banking sector and should be eased. "Truth in lending" type statements -- for mortgage and other consumerloans -- need to be institutedto facilitate greater consumerawareness and comparisonshopping by clients.

3.104 The current consolidationplans will not remove all of the "overhang"of weak institutions. Once the crisis is under control, the Government need also commit to the privatization of federal banks, includingBanco de la Nacion,and shouldstart implementingcredible restructuringplans to facilitatesuch privatization.

3.105 To summarizethe main recommendationsfor banking sector reform, with the view to meeting the objectivesin paragraph 3.93 above, it is worth emphasizingthe need to:

Facilitate/promotethe acceleratedrestructuring and consolidationof privatebanks, through, among others, (a) adequate funding of the Bank Capitalization Trust Fund; (b) further strengtheningof the Superintendencyof Banks' institutionaldevelopment; (c) elimination of regulatory forbearance; (d) the legal strengthening of the Central Bank's inspection and enforcement authority; (e) encouragementof bank merging with stronger institutions; and (f) further strengtheningof the institutionalcapacity of the Bank CapitalizationTrust Fund.

Reduce bankingcosts and spreads through (a) the reductionof taxes on financialtransactions; (b) dismantling barriers to competition, includingthe liberalizationof restrictions on leasing, securitizationby non-banks, commercialpaper and private placements that protect the banking sector; (c) the establishmentof a continuous and liquid benchmark yield curve through the programming of T-bill issuance; (d) the creation of a central risk reporting entity; (e) strengtheningthe functioningof the Deposit Insurance mechanism; (f) instituting "truth in lending" type statementsfor mortgageand consumer loans; (g) facilitatingthe use of collateral; and (h) improvingcredit analysis capabilitiesof banks through better training, and introduction of greater automationand other industryrelated technologicalinnovations.

Facilitate the privatizationof provincialbanks or their closure by (a) adequately funding of the PrivatizationTrust Fund; (b) resisting any federal fiscal support that would, directly or indirectly (through the provincial governments), prop up provincial banks, including the restructuring of their debts and access to coparticipatedguarantees; and (c) strengtheningthe Superintendencyof Banks' legal capacity to enforce prudentialnorms on provincialbanks.

Proceed with the privatizationof federal banks, which control a significantportion of the banking system, to reduce distortive allocationof financialresources. - 62 - 3.106 Finally, it is worth emphasizingthe relevance of macroeconomicconditions and framework in the performance and prospects for development of the financial system. Taking the Convertibility framework as given, this economy, in its limited ability to provide a lender of last resort function, remains vulnerable to abrupt shifts in capital flows which endanger the stability of the banking system. A number of alternativesmay strengthen the lender of last resort capacity of the system, beyond those currently in existence: (i) the Central Bank may want to explore entering into a swap arrangement with other Central Banks, the BIS, or other multilateralinstitutions that can act as lenders of last resort; (ii) during the recent crisis, pre-existing high reserve requirementsacted as a shock absorber to the capital outflow, easing the demonetizationof the economy. In order to improve the response capacity of the financial system to other systemic capital outflows,it may be desirable to impose even higher reserve requirements,possibly reaching gradually 100 percent of short term deposits. While this will increase direct costs to the financialsystem, higher reserve requirementswill reduce other risk-relatedcosts to the system; (iii) the financial system may gravitate towards multinational financial institutions, if it is perceived that foreign parent companieswill provide a lender of last resort functionto their affiliates;and (iv) build over time significantexcess internationalreserves, primarily through public sector surpluses, so that the public sector does not become, during crises, a net drain to the system.

The Capital Markets

3.107 Although Argentine capital markets are relatively under-developed, some two-thirds of all Argentine financial assets (certificatesof deposit, bonds, stocks, mutual funds, etc.) are already in the form of capital market securities. Capital markets will play an even greater role in aggregate financial intermediation, in improving cost-efficiencyof such intermediation, in reducing cost of capital, and ultimately in realizing national investmentand economicgrowth targets. While the recent crisis makes the banking sector the short term focus of regulatory attention, in the long term the development of capital markets will be equally critical.

3.108 Stock Markets At about 160, the numberof listedstocks in Argentinais very small, new equity issuance even smaller, and the number of actively traded stocks is less than 30. The principal issuer- related problems are the owners' unwillingnessto dilute control, the deeper problem of underreporting of assets and profits by some of the small and medium businesses, the lack of profitability of many industries during the structural adjustmentprocess, the unused debt capacity of many corporations, and the high concentrationand fragmentationamong issuers. The major institutional and market-related problems are the prevalence of insider trading and speculation, the consequent skepticism of equity financingand investment,the lack of marketmakers, the underdevelopmentof investmentbanks, and lack of liquidity in all but the top 20-30 stocks. The principal regulatory problem remains the delay in enactment of a modern insider trading law. Issuance and transaction costs, taxation, and listing requirementsare no longer importantproblems.

3.109 The suggestedremedies include passage of strict and effectiveinsider trading laws (a bill has been submitted to Congress), more stringentdisclosure and penaltiesfor insider violations; the enactmentof modern standards of due diligence and liability for corporate executives, accountants, lawyers and investmentbankers concerningnew security issuance; enforcementof full corporate income disclosure through vigorous enforcementof income tax laws (particularlyamong companieswith listing potential) and improvement in auditing standards and responsibility; the education of controlling shareholders concerning the issuance and wider distribution of new equity and further improvement in disclosure standards; and possible introductionof market maker functionsto improve liquidity. - 63 - 3.110 Bond Markets, CommercialPaper Markets, and Private Placement Bond and commercial paper markets suffer from more serious legislativehurdles at present. The Argentine law offers a very favorable tax treatment to publicly offered securities, for which a regime of public offer, listing, prospectus,and mandatoryrating requirementsis specified. Theseprovisions are excessiveand somewhat incompatiblewith the developmentof privateplacement and commercialpaper markets where corporate borrowers can obtain short term financeat competitiverates primarily from institutionalinvestors. These hurdles raise the cost of borrowing, particularly for small and medium companies, for whom the institutionalrather than retail investors are the natural funding source. They also reduce the ability of institutionalinvestors, all of whom are poised to grow, to compete effectivelyagainst commercialbanks.

3.111 It is recommendedthat the authorities modify the Negotiable ObligationsLaw to pennit true private placement of bonds, commercial paper and other securities with substantially the same tax treatment as that of publicly offered securities, with reduced prospectus, rating and other disclosure requirements to qualified institutional investors along the lines of US SEC Rule 144-A; remove or substantially relax the public offer, listing, and rating requirements from short term (below 1 year) commercialpaper; relax the mandatoryrating requirementson issuers after the rating agencieshave had a chance to establish themselves;and permit rapid enforcementof pagares and other floatingrate claims not meeting the definition of negotiable obligations through the acci6n ejecutiva process.

3.112 All debt markets suffer considerablyfrom the problem of inadequateinterest rate benchmarks--a lack of a continuous and liquid benchmark yield curve--whichcauses great confusion in interest rate determination and permits lack of competitionamong banks. Due to historical accidents, the bulk of sovereigndebt has been issued in various debt conversionbonds, and with numerousvariations of terms. As a result, sovereign debt with very similar maturityand financialterms tends to trade at yields as much as 10-15percent apart. Absent a Central Bankdiscount rate, secondaryyield of Treasury securitiesmust provide such a benchmark rate. To establish a continuousand liquid market that can generate a good benchmark, T-bill issuance needs to be programmed, with regular issuance of similar quantities with homogenousterms. There are great benefitsto consolidatingmuch of governmentdebt, or swapping it through market operations, into homogeneoussecurities. It would also be useful to issue them through discriminatoryprice auctions to 15-30 pre-qualifiedprimary dealers, with the non-competingbids being accepted for retail investorsonly 30.

D. End Note

3.113 The CovertibilityPlan has produced a fundamentalrestructuring of the Argentine economy, and sown the seeds for high and sustained economic growth. The recent Mexican crisis, has shown that, despite the social cost that this external shock has created, domesticconfidence in the ConvertibilityPlan has remained high. To alleviate the social cost of that crisis, it is imperativeto resume economicgrowth in an environment of greater flexibilityof factor markets, labor and capital. Additionally, economic reforms in the provinces have to match a renewed federal effort to invigorate the state apparatus, and regain fiscal strength. Policy consistencyand coherence,which were probably the biggest achievements of the current Administrationin its successfuleffort to overcomethe greatest challengeso far to this Plan, will remain the linchpin to future economicrecovery and growth.

30. A detaileddiscussion of Stock and Bond Markets,Trading and SettlementSystems, Asset Backed Securitization,Pension Funds, the InsuranceSector, and Mutual Funds, with policy recommendations, can befound in "Argentina:Capital Markets Study", World Bank Report No. 12963-AR.

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