Report No. 15402-AR

ArgentinaThe Convertibility Plan:Assessment and Potential Prospects(In Two Volumes) Volume l: The Main Report

July 12, 1996

Country Operations Unit IICountry Department ILatin America and the Caribbean Regional Office

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Currcncy Equivalents

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

Fiscal YearJanuary 1 - December 31

Glossary of Acronyms

APC State Employment Agencies' ProgramATN Treasury GrantsB.A. Buenos AiresBCRA Central Bank of the Republic of ArgentinaBHN Housing BankBIS Bank of International SettlementsBOCON Government Debt Consolidation BondsBONEX Dollar denominated Treasury BondsCET Common External TariffCGE Computerized General Equilibrium ModelCPI Consumer Price IndexEFF Extended Fund FacilityENTel National Telecommunication EnterpriseEPH National Household SurveyFDI Foreign Direct InvestmentFEDEI National Electric Development FundFIEL Foundation for Latin American Economic ResearchFONAVI National Housing FundGATT General Agreement on Trade & TariffsGDP Gross Domestic ProductHUBN Households with Unsatisfied Basic NeedsIMF International Monetarn FundINDEC National Statistics & Census instituteLAIA Latin American Integration AssociationLFP Labor Force ParticipationLIBOR London Interbank Offer RateMERCOSUR Southern Cone Common MarketNTC National Trade CommissionOECD Organization for Economic Cooperation & DevelopmentPAYG Pay as you goPEP Partial Subsidy for Private EmploymentPPF Production Possibility FrontierPRENO Public Sector Social ProgramPROAS Public Sector Social ProgramPROEDIS Public Sector Social ProgramPRONOPAS Staging Study AbroadPYMES Small and Medium EnterprisesQR Quantitative RestrictionSEGBA Water CompanySIGEN Government Internal AuditorsTBILL Treasury BillTFP Total Factor ProductivityUSA United States of AmericaVAT Value Added TaxWTO World Trade OrganizationYPF Oil Company

COUNTRY DATA -ARGENTINA

AREA POPULATION DENSITY

2766.9 thous. sq.km. 34.2 million (mid-1994) Country density 1991 11.7 hab.per aq.km1.2% annual growth Rural density a. 16.9 hab. per sq.km of arable land

POPULATION CHARACTERISTICS aI HEALTH bl

Crude Birth Rate (per 1000-1992) 20.5 Population per physician (thous.) 0.4Crude Death Rate (per 1000 -1992) 7.9 Populabon per hospital bed (thous.) 0.2Infant Mortality (per 1000 live births -1992) 23.6

INCOME DISTRIBUTION bI DISTRIBUTION OF LAND OWNERSHIP

% of nabonal income, highest quintile 51.0% % owned by top 10% of land owners% of national income, lowest quinble 5.0% % owned by smallest 1 0% of land owners

ACCESS TO SAFE WATER (1991) ACCESS TO ELECTRICITY 11989)

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

NUTRITION al EDUCATION

Calorie intake as % of requirements 119.2% Adult literacy rate % (1980) 95%Per capita protein intake (grams per day) 99.7 Primary school enrollment % a/ 100%

GNP PER CAPITA IN 1994 dl 8,060

GROSS DOMESTIC PRODUCT IN 1995 diANNUAL GROWTH RATES (% constant prFIes)

USS Bill. %(current prices of GDP 1965-73 197340 19B0-94 1995

GDP at market prices 276.0 100.0 4.3 2.2 1.3 -4.4Gross Domestc Investment 49.1 17.8 6.8 4.3 0.1 -15.9GrossNabonalSavings 45.3 16.4 2.5 2.3 -18.3 4.1Current Account Balance -2.3 -1. 4ExportsofGoods&NFS 23.9 8.9 -4.7 141 5.2 26.1ImportsofGoods&NFS 23.7 8.7 0.6 13.3 -13.0 -10.5

OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 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 309Industry 4,346 35.8 7,755 31.4 560Services 74,721 615.1 13,978 56.6 5,346

TotalGDPatFactorCost 12,148 658.4 24,697 100.0 492

GOVERNMENT FINANCE g/

Federal Government Provincial Government

Million Pesos %ofGDP Million Pesos %oOGDP

1995 1995 1995 1995

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

a/ For the period 1982-1985.b/ For the period 1970-1976.c For the period 1987-1992.d/ Current US dollars. Estmated using Bank Atas methodology.a/ Current US dollar estimates, calculated from data in constant Arg S 1986.f/ Calculated by applying 1980 census shares to 1994 populabon.gl Cash Basis in current Pesos, includes Central Administration, Social Security and Public Enterpnses.

COUNTRY DATA . AROENTINA

MONEY, CREIXT AND PRICE 16 192 1993 1994 165

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

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

Momny andC Mony ss % dODP 6.1 7.7 9.6 9.8Wh_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 7.7BS Cre d to Pubk Sedm .. -20.0 23.8 7.9BStnkCredloPrlto Sedor .. 55.5 26.1 20.6 .. MERCHANDIS8EEXPORTS(Avwag.1661-1665)b/

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

Prinury product 3723.0 25.1Men. of agsliurnl oigin 5584.3 37.7

EngoiaofGoods. NFS 15,272 15,624 18,507 23.657 Menu. of kd *dodgin 4121.5 27.8bhpt 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 Total Merchidso Exports 14810.6 100.0

ftaed Paynieri (nol) -2,695 -1,109 -1,277 -1,218OlerFedor Payeubi(nel)at -845 -1,273 -1,270 -1,624 TddPlbktDl OuleO l*ilgA Disburad (EndINS)bf Ur1S11 mNot Cmd Transfr 749 411 320 432Balnce an Caret Accot -4.336 -7,031 -9,311 -2,277 Total 87091

IBRD 4462CaprftalAccoLt 10.162 11,408 9,668 2,206 IDB 4791

IMF 6120FiNls Se dor 6.632 7.065 6,376 4.996 Biataluls 11614Pulbc Ssdor 1.530 4.343 3,492 7.206 BonrJ 58340

Conmerdal Baits 1764Chlng.s In Gros Rea. ( s * h ) 3.826 4,377 557 -69

DEBT SERVICE RATIO, 1994 55.7%RATE OF EXCHANE

IBRDADA LENDING, DECEMBER 31, 1995 (1M U3S) blUS# 1. Ag.6 I

IRD IDA

OWistandng a DIslsed 4462

i/Sourc: IMF.bv Soure: MUrdiy of Ec00mwc/So : INDECd/Aveng Mai for ts year.zt Based on fI avwage lo der for yew. Source: Mistry of Econory.

TABLE OF CONTENTS

Page Number

Executive Summary ........................................... iResumen 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 Implicationsof 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. 1 5Effects on Financial Markets .17Monetization 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 Economic Growth . ............................... 31

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

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

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

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

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

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

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

D. End Note ............................................. 63

Statistical Appendix (in volume II)

EXECUTIVE SUMMARY

1. Five years have passed since Argentina, faced with the most severe of a series of economic crisescharacterizing the eighties decade, adopted the Convertibility Plan. This courageous and innovative planrestructured the country's economic landscape, generating prospects for unprecedented stability andeconomic growth. The purpose of this report is to review the achievements and challenges that this Planhas brought to the Argentine economy over 1991-94, and then assess prospects for economic growth inthe wake of the economic turbulence that beset Latin America in 1995.

The 1991-94 Record

2. Argentina has had one of the most successful of recent stabilization and reform efforts. Fromone of the most extreme hyperinflations by historical standards in 1989, it moved relatively quickly by1994 to an annual inflation rate of 3.9 percent. Output and productivity growth have been remarkablein the first four years of the Plan, with GDP growth averaging 7.7 percent. The initial consumption-ledboom matured by 1994 into a healthy pattern of investment- and export-led growth. Privatization of stateassets was far reaching, and far more successful than expected. As a result of the economic recovery,poverty levels declined significantly between 1989 and 1994, although economic restructuring with a rigidlabor market resulted in increased unemployment: 12.2 percent of the labor force by October 1994.

3. Trade reforms and economic recovery boosted imports from barely US$4 billion in 1990 to overUS$21 billion in 1994. The import boom was financed by capital inflows, including large scale foreigndirect investment and portfolio investments that quickly responded to the signals of structural adjustment.The abundance of foreign exchange due to the capital inflows led to a real appreciation of the currency.This appreciation began reversing itself in the latter half of 1993, due to decelerating inflation andcurrency realignments among Argentina's major trading partners. The impact of the currency'sappreciation was further mitigated by wide-ranging productivity increases, deregulation and taxreductions. As a result, export growth, particularly of industrial exports, accelerated.

4. There is growing evidence that Argentina underwent an important adjustment in response to theradical restructuring and liberalization of its economy. Productivity (both of labor and capital) increased,and particularly in 1993 and 1994 the growth of investments (financed by growing national and foreignsavings) and exports, which are the key determining variables for the ultimate success of theConvertibility Program, has accelerated.

The main focus of this report is Argentina's experience with the ConvertibilityPlan, and potential prospects for sustained high rates of economic growth. Contributors tothis report were Messrs./Mmes. P.Levy (task manager and main author), J.L. Guasch(labor), C. Sapelli (productivity), S. Rajapatirana (international trade), J. Morisset (publicfinance, investment, saving), J. Hicks and D. Rosenblatt (fiscal federalism), H. Shah(financial sector), C. Revoredo (data management and projections). Mr. Carlos Rodriguez(Convertibility Plan), FIEL (labor, trade, tax issues, saving, investment), and ALPHAConsultants (productivity) prepared background papers for this report.

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5. The Convertibility Plan, named after the Convertibility Law that changed the Central Bank intoa monetary board, is an internally consistent and complex economic program. Other pillars to the Plan,in addition to monetary reform, include fiscal reform, state reform, trade reform, and social securityreform. Such a radical adjustment of the economy is an ongoing process that cannot be completed in ashort time span. As a result, the economy, despite its significant progress, remains vulnerable to avariety of shocks.

The Mexican Crisis' Aftermath

6. As the economic crisis in Latin America early in 1995 brought to sharper focus, the ConvertibilityPlan remains particularly sensitive to foreign capital flows. With the reversal of capital flows, theArgentine economy suffered a contraction in 1995 of an estimated 4.4 percent. The sharp recessioncaused an increase in unemployment, and strained the performance of the financial system. The regionalfinancial crisis was the first severe test of the Convertibility Plan. Yet, by the end of 1995, there weresigns that Argentina was pulling out of its recession without serious damage to the Convertibility Plan.To the contrary, significant pressures to deviate from it were met by efforts to further strengthen it duringthe crisis, indicative of the Plan's popularity and staying power. It can be claimed in some respects, thatthe credibility of the Convertibility Plan was strengthened from the 1995 crisis.

7. The immediate aftermath of the 1995 financial crisis has been reassuring. The Government, withthe strong support of Congress and the electorate, opted for the continuation of the reform process in thecontext of the Convertibility Plan. The determination to eschew populist policies in times of crisis, whileredoubling efforts to pursue a renewed reform agenda, is a testament to the fundamental attitudinalchanges sweeping through the new Argentina, becoming an example to the region as a whole. Thereelection of President Menem for a second term in May, 1995 vindicated his reform policies anddemonstrated that effective stabilization can bring with it political rewards.

Future Prospects

8. Argentina, endowed with plentiful natural resources and a good stock of human capital, bothunderutili.ed on account of past misguided economic policies, has, in the context of the ConvertibilityPlan, created the foundations for unleashing its economic potential. With solid fundamentals already inplace, Argentina has a unique opportunity to strengthen its economic adjustment process, creating theconditions for high and sustainable economic growth. Taking a page from the East Asia miracle story,a stable pattern of high economic growth--possibly of 7 percent--would be characterized by sharpincreases in national saving and investment, and continuous productivity gains. To achieve sustained higheconomic growth, the Argentine economy should be led by export and investment growth, with these twokey contributors growing, in a simulated consistency model, twice as fast as the economy as a whole. Theunderlying premise in such a high growth scenario is that the fiscal accounts would remain balanced.

9. It is in that framework of reachable ambitious targets, and a united view both by the Governmentand the public towards further modernization and reform, that this document has reviewed policiesaffecting investment, saving, and exports. The assessment is that the fundamental policy structuresdirectly affecting investment, saving, and exports are fundamentally sound. Nevertheless, there is scopefor improvement in a number of areas, both in fine tuning the trade regime and more fundamentalreforms, for the ambitious growth targets set out in this report to have a chance to materialize.

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10. Regarding the international trade regime, there is a need for greater simplicity, transparency andautomaticity of economic policies. It is recommended that the Government reexamine the automotiveregime and the "industrial specialization" regimes. It is recommended that the mirror principle beeliminated, in order to provide neutrality between exports and import substituting industries. Alternativemechanisms to promote regional development are proposed, rather than the use of trade preferences. TheNational Trade Commission should be strengthened to adopt the new rules for safeguards, anti-dumpingand countervailing actions that are consistent with the new World Trade Organization, and rely more onthe safeguard mechanism rather than on anti-dumping actions. It is recommended that Argentina'sposition in MERCOSUR should favor the adoption of a uniform and low common external tariff, bringthe 15 percent of the tariff lines outside the common external tariff (CET) under the CET, and harmonizeregulatory framneworks.

Maintaining the Momentum of Reform

11. As is well understood by the authorities, the Argentine reform agenda has remaining gaps, whichrequire attention, if the economy's potential is to materialize. Despite its achievements, the economyis still facing a number of hurdles before it resumes a sustainable and strong pattern of economic growth:(a) the financial system is still undergoing major restructuring, slowing the financial intermediationprocess; (b) most provinces will still need to undergo painful adjustments; and (c) labor markets underthe weight of restrictive legislation face an uncomfortably high rate of unemployment, and are in urgentneed of liberalization. Reform of the factor markets would contribute to improved productivity, andmitigate economic instability, which are crucial factors for the expansion of saving, investment andexports. A stable political environment, and fiscal prudence, are equally important prerequisites forachieving high and sustainable economic growth.

12. In the unfinished reform agenda mentioned above, extending economic reforms to the provincesremains a priority. While fiscal adjustment has occurred at the federal level, provincial reforms continueto lag, although the 1995 crisis prompted a number of provinces to initiate this long-delayed adjustment.Lack of adjustment is reflected in the continued unwillingness of many provincial governments to containcurrent expenditures, increase sufficiently their own-source revenues, and more importantly improve theefficiency of public spending. As a result of decentralization and privatization of many federal functions,provinces remain ill-prepared to fulfill their increasingly important role in health, education, security,water and sanitation services, with potential negative implications for economic growth and povertyreduction.

13. Two broad areas of reform, intergovernmental fiscal relations and access of subnationalgovernments to the financial sector, are fundamental for the restructuring of provincial finances.Structural reform addressing poor provincial expenditure efficiency includes expanding the provincialown-source revenue base to bring it more in line with provincial expenditure responsibilities, anddecreasing the high dependence of provinces on fiscal transfers by devolving national tax bases to thesubnational level. This would prompt provincial authorities to confront their constituents with the costsof their preferences, and promote enhanced efficiency in resource allocation. To further increaseaccountability, but also meet equity objectives, intergovernmental transfers should be conditional oneffective service delivery, based on transparent indicators. Towards that objective, transfers to provincesoutside the coparticipation system could be consolidated into a program of grants allocated to provinceson the basis of their performance. It is also recommended that a transition strategy be developed tosupport market-based subnational government access to the financial markets, in order to facilitate the

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financing of subnational government investment needs. It is strongly recommended that the federalgovernment eschew financial assistance, including debt restructuring, beyond legal obligations under thecoparticipation agreement/law, to non-reforming provinces.

14. The federal government has taken initial measures to liberalize the labor markets. However,given the importance of reallocating resources in the economy, the acceleration of labor marketliberalization becomes imperative. The urgency of these measures became more pronounced during therecent recession which compounded the growing unemployment problem observed in the course ofrestructuring the economy. The implementation of structural reforms and resumption of economic growthcould reduce unemployment at a fast pace. Key policy reforms to consider, to that effect, are thereduction in labor costs, improved contractual flexibility, strengthened unemployment insurance, anddecentralized collective bargaining. Additionally, it is highly recommended to develop an informationsystem and analysis of the service sector, which is the major source of employment.

15. Regarding labor costs, it is recommended that non-wage labor costs continue to be reduced. Inthis context, Government should consider extending fiscal exemptions to young employees and the long-term unemployed, and permitting the unrestricted use of temporary and fixed term contracts. Regardingunemployment insurance, the authorities should consider modifying the severance payments system, sincehaving both unemployment insurance and a severance payment scheme dissuades the unemployed fromactively seeking employment and firms from optimally adjusting their labor force. The authorities shouldconsider decentralizing collective bargaining, rescinding the concept of "ultractividad", eliminating themonopoly over the provision of welfare services for employees by unions, and streamlining trainingprograms.

16. Argentina has both the need and potential for development of financial markets approachingdeveloped country standards. Since the Convertibility Plan, the authorities have radically improved theregulatory and economic environment for banking and capital markets. However, problems arising frominstitutional underdevelopment, and lack of market and product development have proven moreintractable. Thus, financial markets remain shallow, intermediation costs, margins and inefficiencies arehigh and act as a strong deterrent to both saving and investment. Cost of credit remains high, theaggregate credit extension low, and access to formal credit particularly difficult for small businesses andfarmers. A consolidation/restructuring of the banking system, both private and public, is imperative forthe remonetization and improved financial intermediation in the economy. The development of capitalmarkets will be equally critical in improving this intermediation process.

17. In order to consolidate confidence and liquidity in the banking system, raise the volume andmaturity of savings and loans, augment access to credit, particularly to small and medium enterprises,and deepen capital markets, the following actions are recommended: (a) facilitate/promote the acceleratedrestructuring and consolidation of private banks through the adequate funding and institutionalstrengthening of the Bank Capitalization Trust Fund; strengthening the Central Bank's inspection andenforcement authority; encouraging bank mergers with stronger institutions; and eliminating regulatoryforbearance; (b) reduce banking costs and spreads through the reduction of taxes on financialtransactions; dismantling barriers to competition; establishment of a continuous and liquid benchmarkyield curve; strengthening the functioning of the Deposit Insurance mechanism; improving credit analysiscapabilities of banks; and facilitating the use of collateral; (c) facilitate the privatization of provincialbanks or their closure through the adequate funding of the Privatization Trust Fund; avoiding federalfiscal support that would prop up provincial banks; and strengthening the Superintendency of Banks' legal

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capacity to enforce prudential norms on provincial banks; and (d) proceed with the privatization offederalbankcs.

18. It is worth emphasizing the relevance of macroeconomic conditions and framework in theperformance and prospects for development of the financial system. Given vulnerability to abrupt shiftsin capital flows, the following alternatives may strengthen the lender of last resort capacity of the systembeyond those currently in existence: the Central Bank may enter into swap arrangements with otherCentral Banks that can act as lenders of last resort, impose higher reserve requirements to improve theresponse capacity of the financial system, the financial system may gravitate towards multinationalfinancial institutions if they are perceived as providing lender of last resort capacity, and build over timesignificant excess international reserves.

19. From the challenges ahead, none could be as important as the need to attend to growing socialneeds, as Argentina addresses the impact of the recent external crisis. Renewed economic growthremains the linchpin to the alleviation of poverty. Structural reforms, such as those proposed above,particularly the liberalization of labor markets, would reduce unemployment and accelerate the moderationof social pressures, while simultaneously contributing to higher economic growth. Furthermore, thereassessment of public finances, federal and provincial, should permit efficiency gains to allow for moretargeted social programs to address the needs of the poor, without undermining fiscal prudence.Economic growth, more efficient allocation of public spending, and reduction in tax evasion should allowfor the planned reversal in the recently increased tax rates, in a balanced budget environment. Continuedreforms at the federal government level, reflected in the Second Reform of the State program expectedfor 1996, are another reminder that reform is a continuous process that needs vigilance and nurturing.

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RESUMEN EJECUTIVO

1. Han pasado cinco afios desde que la Argentina adopt6 el Plan de Convertibilidad, luego deafrontar una serie de severas crisis econ6micas que caracterizaron la d6cada de los aflos ochenta. Estevaliente e innovador plan reestructur6 el panorama econ6mico del pafs, generando perspectivas deestabilidad y crecimiento econ6mico sin precedentes. El objetivo de este informe consiste en examinarlos logros y desaffos que dicho plan incorpor6 a la economia argentina durante el perfodo 1991-94, asfcomo tambien evaluar las perspectivas de crecimiento econ6mico dentro del marco de turbulenciaecon6mica que asedi6 a America Latina en 1995.

El Record 1991-94

2. Argentina protagoniz6 uno de los mas exitosos esfuerzos recientes de reformas y estabilizaci6n.Habiendo partido en 1989 de una de las hiperinflaciones hist6ricamente mas extremas, la economia secondujo relativamente rapido hacia una inflaci6n anual del 3,9 porciento en 1994. Tanto el crecimientodel producto como el aumento de la productividad han sido notables durante los primeros aflos del Plan,con un crecimiento promedio del PBI de 7,7 porciento. El boom inicial de consumo madur6 hacia 1994en un sano patr6n de crecimiento guiado por inversiones y exportaciones. La privatizaci6n de activosdel Estado fue intensa y mucho mas exitosa de lo esperado. Como resultado de la recuperaci6necon6mica, los niveles de pobreza declinaron significativainente entre 1989 y 1994; aunque lareestructuraci6n econ6mica con un mercado laboral rigido llev6 a un aumento en el desempleo: 12,2porciento de la poblaci6n econ6micamente activa en octubre de 1994.

3. Las reformas comerciales y la recuperaci6n econ6mica impulsaron las importaciones, quecrecieron de US$4 mil millones en 1990 a mas de US$21 mil millones en 1994. El boom deimportaciones fue financiado por el ingreso de capitales, incluyendo inversiones directas e inversionesde cartera de gran escala, que respondieron rapidamente a las sefiales de ajuste estructural. Laabundancia de moneda extranjera que produjo el ingreso de capitales llev6 a una apreciaci6n del tipo decaambio real. Dicha apreciaci6n comenz6 a revertirse hacia fines de la segunda niitad de 1993 comoconsecuencia de una inflaci6n decreciente y realineamientos en el tipo de cambio de los principales socioscomerciales de la Argentina. El impacto de la apreciaci6n del tipo de cambio fue mitigado auin nas porel aumento generalizado de la productividad, la desregulaci6n, y reducciones en los impuestos. Comoresultado, se aceler6 el crecimiento de las exportaciones, y en particular el de las industriales.

El principal objetivo de este informe es analizar la experiencia Argentina con el Plan deConvertibilidad y las perspectivas potenciales para una elevada y sostenida tasa de crecimientoecon6mico. Contribuyeron en la realizaci6n de este informe los Sres.: P. Levy (director delproyecto y autor principal), J.L Guash (trabajo), C. Sapelli (productividad), S. Rajapatirana(comercio internacional), J. Morisset (finanzas pimblicas, inversi6n, ahorro), J. Hicks y D.Rosenblatt (federalismo fiscal), H. Shah (sector financiero), C. Revoredo (manejo de datos yproyecciones). El Sr. Carlos Rodrfquez (Plan de Convertibilidad), FIEL (trabajo, comercio,impuestos, ahorro, inversi6n), y consultores de ALPHA (productividad) prepararon el material deapoyo para este informe.

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4. Existe cada vez mAs evidencia que demuestra que la Argentina experiment6 un ajuste importanteen respuesta a la reestructuraci6n radical y a la liberalizaci6n de su economia. La productividad (tantodel trabajo como del capital) aurnent6; y en particular, entre 1993 y 1994, se aceler6 el crecimiento delas inversiones (financiadas tanto por el incremento en el ahorro nacional como externo) y lasexportaciones, variables claves en el exito definitivo del Plan de Convertibilidad.

5. El Plan de Convertibilidad, Ilamado asi por la Ley de Convertibilidad que transform6 al BancoCentral en una caja de conversi6n, es un programa econ6mico internamente consistente y complejo.Adenas de la reforma monetaria, otros pilares del Plan incluyen: la reforma fiscal, la reforma estatal,la reforma comercial y la reforma del sistemna de seguridad social. Un ajuste tan radical de la economifaes un proceso que no puede ser completado en un corto plazo. Como consecuencia, y a pesar delsignificativo progreso obtenido, la economia permanece vulnerable a shocks.

Consecuencias de la Crisis de Mejico

6. La crisis econ6mica en America Latina de principios de 1995 puso en evidencia que el Plan deConvertibilidad permanece particularmente sensible al flujo de capitales externos. La economia argentinasufri6 una contracci6n de aproximadamente un 4,4 porciento como consecuencia de la salida de capitales.La marcada recesi6n llev6 a un aumento en el desempleo y perjudic6 el desempenio del sistema financiero.La crisis financiera regional fue la primera prueba de envergadura a la que fue sometido el Plan deConvertibilidad. Sin embargo, hacia fines de 1995, comenzaron a verse sefiales de que la Argentinaestaba saliendo de la recesi6n, sin mayores dafhos al Plan de Convertibilidad. Al contrario, las fuertespresiones para desviarse del plan, fueron contrarrestadas por medidas para fortalecerlo tomadas durantela crisis. Esto es indicativo de la popularidad y poder de permanencia del Plan. Puede afirmarse encierta medida que la credibilidad en el Plan de Convertibilidad fue afianzada a partir de la crisis de 1995.

7. Las consecuencias inmediatas de la crisis financiera de 1995 han sido alentadoras. El Gobierno,junto con un fuerte apoyo del Congreso y del electorado, opt6 por continuar con el proceso de reformadentro del contexto del Plan de Convertibilidad. La decisi6n de evitar politicas populistas en tiempos decrisis, redoblando esfuerzos para continuar con una nueva agenda de reformas, es prueba fehaciente delos cambios fundamentales de actitud que se estan generalizando en la nueva Argentina, lo que la convirteen un ejemplo para toda la regi6n. La reelecci6n del Presidente Menem en mayo de 1995 para unsegundo perfodo vindic6 su politica de reforma y demostr6 que una estabilizaci6n efectiva puede traerrecompensas polfticas.

Perspectivas Futuras

8. La Argentina, dotada con abundantes recursos naturales y un buen stock de capital humano ambosdesaprovechados por polfticas econ6micas previas desencaminadas, ha generado, en el contexto del Plande Convertibilidad, los fundamentos para desencadenar su potencial econ6mico. Con una s6lida base enpie, la Argentina posee una oportunidad unica para fortalecer su proceso de ajuste econ6mico, creandocondiciones para un crecimiento econ6mico elevado y sostenido. Tomando como antecedente la historiadel milagro del Este Asigtico, un patr6n estable de crecimiento econ6mico elevado--posiblemente del 7porciento--podria caracterizarse por marcados incrementos en el ahorro nacional y en la inversi6n, y porcontinuas ganancias de productividad. Con el fin de alcanzar un desarrollo econ6mico elevado ysostenido, la economia Argentina deberfa basarse en el crecimiento de sus exportaciones v de la inversi6n;el crecimiento de dichas variables, dentro de un modelo de consistencia simulado, deberia duplicar al dela economifa en su conjunto. La premisa subyacente en tal escenario es que las cuentas fiscales semantendran equilibradas.

9. En este marco de objetivos ambiciosos y alcanzables, y con una visi6n compartida por elGobierno y el publico sobre la necesidad de mayores reformas y modernizaci6n, este documento haanalizado las polfticas que afectan a la inversi6n, el ahorro y las exportaciones. El analisis indica que la

- viii -

estructura de las poifticas que afectan directamente la inversi6n, el ahorro y las exportaciones, esfundamentalmente la apropiada. Sin embargo, hay margen para mejoras en varias areas, tanto en ajustesal r6gimen de comercio como en reformas mas fundamentales, para que las ambiciosas tasas decrecimiento establecidas por este informe puedan materializarse.

10. Con respecto al regimen de comercio internacional, hace falta una mayor simplificaci6n,transparencia y automaticidad de las poifticas econ6micas. Se recomienda que el gobiemo reexamine elregimen automotor y los regimenes de "especializaci6n industrial". Se recomienda que el "principioespejo" sea eliminado, permitiendo la neutralidad entre las industrias de exportacion y las sustitutivas deimportaciones. Se proponen mecanismos alternativos para promover el desarrollo regional, en vez deluso de preferencias comerciales. La Comisi6n Nacional de Comercio deberia ser fortalecida para quepueda adoptar los nuevos reglamentos para evitar el dumping y las acciones compensatorias, consistentescon la nueva Organizaci6n Mundial de Comercio, apoyandose mas en los mecanismos de salvaguarda delcomercio sefialados por dicha organizaci6n que en las medidas anti-dumping tradicionales. Se recomiendaque la Argentina apoye la adopci6n de un arancel externo comuin bajo y uniforme, en el MERCOSUR;que incorpore el 15 porciento de las lineas arancelarias que se encuentran fuera del regimen de arancelexterno comuin (AEC) al AEC, y que armonice los marcos regulatorios.

Manteniendo el Impetu de la Reforma

11. Como es bien sabido por las autoridades, la agenda de reformas de Argentina cuenta con temaspendientes que deben ser atendidos si se quiere materializar el potencial de la economia. A pesar de suslogros, la economia debe sortear una serie de vallas antes de reanudar un patr6n de crecimientoecon6mico fuerte y sostenido: (a) el sistema financiero esta experimentando una fuerte reestructuraci6n,que retrasa el proceso de intermediaci6n financiera; (b) la mayoria de las provincias debera pasar todavfapor ajustes penosos; y (c) el mercado laboral, bajo el peso de una legislaci6n restrictiva, afronta una altae indeseada tasa de desempleo, y necesita urgentemente una liberalizaci6n. Las reformas en los mercadosde factores contribuirian a mejorar la productividad, y mitigar la inestabilidad econ6mica, factorescruciales para la expansi6n del ahorro, de la inversi6n y de las exportaciones. Un entorno de estabilidadpolitica y de prudencia fiscal son prerrequisitos igualmente importantes para lograr un crecimientoecon6mico elevado y sostenido.

12. En la agenda de reformas pendiente, mencionada anteriormente, sigue siendo prioritaria lareforna de las economias provinciales. Aunque el ajuste fiscal ha ocurrido a nivel federal, las reformasprovinciales estan retrasadas, si bien es cierto que la crisis de 1995 impuls6 a algunas provincias a queinicien sus procesos de ajuste. La falta de ajuste se ve reflejada en la continua falta de voluntad de losgobiernos provinciales en contener los gastos corrientes, en incrementar en forma suficiente sus propiasfuentes de ingresos; y, lo que es mas importante, en mejorar la eficiencia del gasto puiblico. Comoresultado de la descentralizaci6n y la privatizaci6n de muchas de las funciones federales, las provinciasse encuentran mal preparadas para asumir su importante y creciente rol en la educaci6n, la seguridad,los servicios sanitarios y los servicios de agua corriente; esto impacta negativamente sobre el crecimientoecon6mico y la reducci6n de la pobreza.

13. Existen dos areas de reforma que son fundamentales para la reestructuraci6n de las finanzasprovinciales: las relaciones fiscales intergubernamentales y el acceso de los gobiernos provinciales alsector financiero. Las reformas estructurales que se encaren para combatir la escasa eficiencia del gastoa nivel provincial, deben apuntar a expandir la base de ingresos propios, acercandola a lasresponsabilidades de gasto provincial; ademas, debe disminuirse la elevada dependencia sobretransferencias fiscales en las provincias mediante la devoluci6n de bases impositivas que actualmente seencuentran en manos del gobierno nacional. Esto Ilevaria a las autoridades provinciales a confrontar alelectorado con los costos de sus preferencias y promover una mayor eficiencia en la asignaci6n derecursos. Tanto para incrementar la responsabilidad en el gasto, como para alcanzar objetivos deequidad, las transferencias intergubernamentales deberian estar condicionadas a la provisi6n de servicios

- Lx -

eficientes, basados en indicadores transparentes. Con el fin de alcanzar dicho objetivo, las transferenciasa las provincias que se encuentran fuera del sistema de coparticipaci6n podrian ser consolidadas en unprograma de transferencias donde 6stas se otorguen en funcion del desempefio de cada provincia.Tainbien se recomienda el desarrollo de una estrategia de transici6n que facilite el acceso de los gobiernossubnacionales a los mercados financieros dentro de un marco competitivo, ayudando asi al financiamientode las necesidades de inversi6n de los gobiernos subnacionales. Se recomienda especialmente que elgobierno nacional evite la asistencia financiera, incluyendo la reestructuraci6n de deuda, a aquellasprovincias que no inicien la reforma, mas alla de las obligaciones legales que surgen de la ley decoparticipaci6n.

14. El gobierno federal ha tomado medidas iniciales para la liberalizaci6n del mercado laboral. Sinembargo, dada la importancia de la reasignaci6n de recursos en la economia, la aceleraci6n de laliberalizaci6n del mercado laboral se vuelve imperativa. La urgencia en la efectivizaci6n de dichasmedidas se ha hecho auin mAs pronunciada con la reciente recesi6n, que complic6 aun mas el crecienteproblema de desempleo observado durante el curso de la reestructuracion econ6mica. La implementaci6nde reformas estructurales y el reinicio del crecimiento econ6mico podrian reducir el desempleo en formarapida. A tales efectos, se deberfan tomar las siguentes medidas: la reducci6n de los costos laborales,una mayor flexibilidad en los contratos, reforzar el seguro de desempleo, y descentralizar lasnegociaciones colectivas. Adicionalmente, se recomienda enfaticamente desarrollar un sistema deinformaci6n y analisis del sector de servicios, que es la mayor fuente de empleo.

15. Con respecto a los costos laborales, se recomienda seguir reduciendo los costos laborales nosalariales. Dentro de este contexto, el gobierno deberfa considerar extender exenciones fiscales aempleados j6venes y a los desempleados a largo plazo, asi como permitir el uso irrestricto de contratostemporales y de plazo fijo. Con respecto al seguro de desempleo, las autoridades deberian consideraruna modificaci6n en el sistema de indemnizaci6n por despido, debido a que la coexistencia del segurode desempleo y la indemnizaci6n por despido desalienta a los desempleados a buscar trabajo activamente,y a las empresas a ajustar 6ptimamnente su fuerza de trabajo. Las autoridades deberfan considerardescentralizar las convenciones colectivas de trabajo, rescindir el concepto de ultractividad, eliminar elmonopolio de los sindicatos sobre la provisi6n de servicios sociales para los trabajadores, y modernizarlos programas de entrenamiento.

16. Argentina tiene la necesidad y el potencial para el desarrollo de mercados financieros similaresa los de los paises desarrollados. Desde la puesta en marcha del Plan de Convertibilidad, las autoridadeshan mejorado radicalmente el entorno regulatorio y econ6mico de los bancos y los mercados de capitales.Sin embargo, los problemas ocasionados por el subdesarrollo institucional y la falta de desarrollo demercados y de productos, se han vuelto dificiles de tratar. Por lo tanto, los mercados financieros siguensiendo de poco desarrollados; tanto los gastos de intermediaci6n, como los margenes y la ineficiencia sonelevados y desalientan fuertemente el ahorro y la inversi6n. El costo del credito permanece elevado, elvolumen de cr6dito es bajo, y el acceso al credito formal es particularmente dificil para empresaspequefias y los productores agropecuarios. Una consolidaci6n/reestructuraci6n del sistema financiero,tanto privado como pCblico, es imperativa para la remonetizaci6n y el desarrollo de la intermediaci6nbarcaria de la economia. Es igualmente critico el desarrollo de mercados de capitales para mejorar elproceso de intermediaci6n.

17. Se recomiendan las siguientes medidas para consolidar la confianza y la liquidez del sistemabancario, incrementar el volumen y la madurez de ahorros y prestamos, facilitar el acceso al credito, enparticular para pequenias y medianas empresas, y desarrollar los mercados de capitales: (a)facilitar/promover la acelerada reestructuraci6n y consolidaci6n de los bancos privados a trav6s deladecuado financiamiento y fortalecimiento institucional del Fondo Fiduciario de Capitalizaci6n Bancaria;fortalecer la capacidad de inspecci6n y de control del Banco Central; promover la fusi6n de bancos coninstituciones mas fuertes; y eliminar tolerancias regulatorias; (b) reducir los costos bancarios y el margenentre tasas de interes activas y pasivas, mediante la reducci6n de los impuestos sobre las transacciones

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financieras; el desmantelamiento de barreras a la competencia; el establecimiento de una curva derendimientos (yield curve) continua y liquida; fortalecer el funcionamiento del mecanismo de Garantfassobre Dep6sitos; mejorar la capacidad de analisis crediticio de los bancos; y promover el uso de garantiasbancarias; (c) facilitar la privatizaci6n o el cierre de bancos provinciales, a traves del uso definanciamiento adecuado del Fondo Fiduciario de Privatizaci6n; evitar ayuda fiscal federal queapuntale a los bancos provinciales; y fortalecer la capacidad legal de la Superintendencia deBancos para hacer cumplir las normas prudenciales que 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 eldesempefio y perspectivas de desarrollo del sistema financiero. Dada la vulnerabilidad existentefrente a los bruscos cambios en los flujos de capitales, las siguientes altemativas podrianfortalecer la capacidad del sistema como prestamista de uiltima instancia: el Banco Central podriainiciar acuerdos de canje (swaps) con otros Bancos Centrales que actuen como prestamistas deuiltima instancia, imponer requisitos de reservas mas elevados para mejorar la capacidad derespuesta del sistema financiero; el sistema financiero podria tender hacia una mayorparticipaci6n de instituciones financieras multinacionales, en la medida en que 6stas seanpercibidas como entidades capaces de cumplir con el rol de prestamistas de uiltima instancia, ygenerar a lo largo del tiempo excedentes significativos de reservas internacionales.

19. Tras afrontar el impacto de la creciente crisis externa, la Argentina debe asumir una seriede desafios, aunque ninguno es tan importante como el atender las crecientes necesidadessociales. Un resurgimiento del crecimiento econ6mico es fundamental para aliviar la pobreza.Reformas estructurales como las antes propuestas, en particular la liberalizaci6n del mercado detrabajo, reducirian el desempleo y acelerarian la moderaci6n de presiones sociales,contribuyendo a la vez a un crecimiento econ6mico mas elevado. Mas aun, las mejoras eneficiencia a partir de la reevaluaci6n de las finanzas puiblicas federales y provinciales, permitirianla puesta en marcha de programas sociales mejor enfocados para afrontar las necesidades de lospobres, sin socavar la prudencia fiscal. El crecimiento econ6mico, junto con una nas eficienteasignaci6n del gasto puiblico, y la reducci6n de la evasi6n fiscal, deberian permitir la planeadareducci6n de las tasas impositivas (recientemente incrementadas), en un contexto de equilibriopresupuestario. La continuaci6n de las reformas en el gobierno federal, reflejadas en elprograma de la Segunda Reforma del Estado previstas para 1996, son otro indicador de quereformar es un proceso continuo que requiere ser vigilado y fomentado.

CHAPTER I

DEFINING THE CONVERTIBILITY PLAN

A. Origins of the Crisis Leading to the Convertibility Plan

1.1 The economic ills that the Convertibility Planset out to correct date back to the 1940s, when statist GDP Growth a hnd Inflateon 19I 1994

and inward-looking growth strategies took effect, ...-

resulting in massive public sector deficits, accelerated . 3000

inflation and economic stagnation. By the mid-1970s, s . .. 00

the country's long-term growth declined noticeably, I,, 2000and in the last half of the 1980s, the country suffered I

from its longest period of stagnation in the century. I I 502Savings and investment rates fell precipitously from I 00 0

the mid-1970s until 1989. Argentines, responding to ., .0.the unstable macroeconomic environment, increasingly it9 _ L . ; Is.so D

saved and invested abroad. Labor productivity fell -G75 19BD 1 1991and poverty worsened. GCP Giowli |IIInOI

1.2 This economic performance was traceable to Figure 1chronic public sector deficits and endemic inflation.After the return to constitutional democracy in 1983,public demands to control inflation were translatedinto four successive stabilization programs. All failed to eradicate inflation, and each ended in a morevirulent inflation than the one preceding it. The main reason for these failures was the inability of thestabilization programs to redress rapidly and permanently the structural deficit of the public sector.

1.3 Structural deficits emerged from the post-war Federal Government Overall Balanceorganization of the economy. Since the 1940s, Percentage of GDP

economic policy favored powerful interest groups.Unionized labor benefitted from high wages,guaranteed employment, and rigid rules governing ohiring and dismissals. Industry benefitted from highlyprotected markets, tax exemptions through special .s l.ii.... i...promotion regimes, subsidized credit (or eveneffective grants since many loans were not collected), 10 .. ... ........... ........................subsidized inputs from public enterprises, and highprices on sales to public enterprises. Housing 1. . .........................................contractors and selected middle class home buyersbenefitted from enormous public transfers through *200 N 190 181 f0s f88e

earmarked taxes and effective grants through the 86ree MlIettlnt ye Iofomy

Housing Bank (BHN). Tobacco growers benefittedfrom special taxes, as did the sugar growers, the Figure 2merchant marine, and other small interest groups.Consumers enjoyed below-cost tariffs from public enterprises and lax collection practices. Provincialgovernments could avail themselves of costless credit from the provincial banks, which the Central Bankwould reimburse. The military enjoyed expanding budgets, especially in 1976-82, as well as managementperquisites in state companies they controlled. By 1989, subsidies through the budget, tax exemptions,agricultural regulations, public enterprise tariffs, and central bank rediscounts were estimated to amountto US$8 billion.

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1.4 The growth of the state and concomitant rents and subsidies, along with the capital flightprovoked by an inconsistent exchange rate policy, had been financed during the late 1970s largely byexternal borrowing, through the expanding Eurodollar market at low or even negative real internationalinterest rates. This permitted the Govermnent to run large deficits and sustain a revalued exchange ratewith relatively low levels of inflation in the second half of the 1970s. However, the abrupt end tovoluntary foreign commercial credit in the early 1980s the decline in commodity prices and the suddenrise in real international interest rates provoked a financial collapse and placed additional pressure onpublic finances. The situation was complicated by the South Atlantic War.

1.5 The loss of external finance and lack of adjustment meant the Treasury had to resort to increasedinflationary finance through monetary creation (aggravated by quasi-fiscal deficit). The private sector,in an effort to avoid the resulting inflation tax, gradually withdrew its resources from the financial systemand reduced its real holdings of currency; this, together with the negative effects of inflation on real taxcollections, made the macroeconomy progressively more unstable in the 1980s. Even though the levelof the deficit fell from near 20 percent of GDP in the early 1980s to an average of about 10 percent in1987-89, the base for the inflation tax shrank even faster--efforts to reduce the deficit were not fast orpermanent enough to convince the private sector that their savings in domestic currency would not betaxed by inflation. Inflation became high and unpredictable, and thus became the main impediment tothe recovery of private savings and investment. The decade ended with two episodes of hyperinflationin 1989.

B. The Convertibility Plan

1.6 As an aftermath to the 1989-90 hyperinflations, and the collapse of the monetary system, onMarch 1991 the authorities announced a new monetary system, based on a fully convertible fixedexchange rate regime. While many of the policies which later became part of the Convertibility Planstarted taking shape with the Menem Administration during 1989-90, a consistent and well definedeconomic strategy of stabilization and structural reform only took place after Minister Domingo Cavalloannounced this new set of monetary measures on March 21, 1991. After this initial announcement, acomplete set of consistent measures started to be implemented, becoming what is known as theConvertibility Plan. While this plan gets its name after the most popular instrument, the ConvertibilityLaw, it represents a much wider set of measures aiming at the complete and permanent structuraladjustment of the economy and public sector reform. The main pillars of the Convertibility Plan are:

(a) Monetary Reform, through the Convertibility Law, subsequently supplemented by thenew Charter of the Central Bank;

(b) Fiscal Reform, initially through a sharp improvement in the administration of the taxsystem and later through a redefinition of tax instruments and rates;

(c) Public Sector Reform, through debt restructuring, civil service reform, fiscalrestructuring and an ambitious and successful plan of divestiture, and deregulation offactor and product markets;

(d) Social Security Reform, allowing for a new capitalization mechanism operated by theprivate sector;

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(e) Trade Reform, through the elimination of export taxes and most quantitative restrictionson imports, and the reduction of the level and range of import tariffs.

The Convertibility Law

1.7 The Convertibility Law 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. TheLaw also established that the monetary base could not exceed the dollar value of international reserves,and prohibited all indexation in the goods and labor markets.

1.8 The Convertibility Law, in practice, made the Central Bank into a Currency Board by mandatinga 100 percent reserve requirement for the issue of high-powered money. By removing the power todevalue from the Ministry of Economy, and placing it with Congress, the Law attempts to remove theinstrument of devaluation from the set of easily available instruments and thus provide more credibilityto the new currency. However, the Central Bank can exert some discretion through the use of variablebank reserve requirements, and excess international reserves. To ensure the full reserve backing, otherconditions were set on the behavior of the monetary authorities through the new Charter of the CentralBank. This Charter, approved by Congress on September 1992, established the independence of theBoard of Directors, all of whom are ratified by Congress and provides fixed terms of tenure for theappointees, including the President of the Central Bank.

1.9 The Charter originally allowed a maximum of 20 percent of international reserves backing themonetary base to be in dollar denominated government bonds, which currently has been raised to 33.3percent. Issuing base against BONEX allows the Central Bank to regulate short run fluctuations inmarket liquidity by swapping between pesos and BONEX. Additionally, the Charter dictates that theCentral Bank cannot take any new interest earning liabilities, and it cannot remunerate reserverequirements. These measures eliminate the possibility of generating a quasifiscal deficit through theservicing of Central Bank debt. Consistent with the restrictions for generating Central Bank liabilitiesother than those used to acquire international reserves, the Charter does not allow the Central Bank tosignificantly guarantee commercial bank deposits, i.e. deposit insurance. This substantially reduces therole of the Central Bank as a lender of last resort, both for the peso and for the domestic dollar depositssystem. Nevertheless, in an emergency the Central Bank can provide, for a limited time, liquidity upto 100 percent of a bank's capital.

1.10 Under the convertibility system, international reserves are backing the monetary base, and cannotbe considered as precautionary reserves (see figure 3). Also, under this system, variations in internationalreserves have a direct impact on the economy through changes in the money supply, and the real interestrate.

1.11 An important feature of the Convertibility Plan is its bi-monetary nature, which permits the useof foreign exchange for market transactions, or the holding of foreign exchange denominated liquid assetsin the domestic financial system. Since 1989, commercial banks have been allowed to open dollardenominated accounts and to issue certificates of deposit. The reserve requirements against dollardeposits at commercial banks are to be deposited abroad and are not counted as part of internationalreserves. Since 1993 commercial banks are allowed to form their reserve requirements against peso ordollar deposits in either currency, and at the same rate, thus increasing the substitution from the supplyside between both currencies. In the face of the Mexican financial crisis, in January 10, 1995, further

-4-

measures were taken to facilitate the dollarization ofthe economy and strengthen the Convertibility Plan. Ratio oseroes to Monetary Bag e 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 sellingexchange rate at 1 dollar: 1 peso (eliminating costs oftransaction), and reduced dollar reserve requirementsto match the temporary reduction in peso reserve .........................................requirements. Dollarization has contributed toenhancing the credibility of exchange rate policy, . _

since it reduced vulnerability under a fixed exchangerate, because portfolio shifts from domestic currency 0

deposits to foreign currency denominated deposits, or 1901 102 10 3

vice versa, would not necessarily involve a reduction Iin total domestic bank deposits. Figure 3

1.12 Under a dollarized system, where fractional reserve requirements are in effect, the concept oflender of last resort takes a different dimension, since part of the liabilities of the banking system aredollar denominated, and the Central Bank cannot print dollars to fulfil that function. In a crisis, highbank reserve requirements, excess international reserves, or a foreign lender of last resort are needed tofulfil that function.

1.13 Financial Reform. In conjunction with the above mentioned monetary reform, which establisheda firm constraint on the Central Bank's ability to extend credit to the banking system, the primaryinstrument for increasing resource mobilization and reduce high interest rates has been the implementationof policies enhancing confidence in the economy and the financial system. In addition, the Governmentstrengthened banking and capital market institutions. New banking policies primarily sought to improvethe financial soundness of the banking system to help increase confidence in domestic financial institutionsand reduce the Government's exposure to losses stemming from bank failures. To improve the soundnessof the banking system, the Law of Financial Institutions was changed, allowing the Central Bank towithdraw the operating license of private commercial banks that do not comply with its technical ratios(i.e., reserve, capital, and provisioning requirements) and when its board rejects the bank's plan toachieve appropriate compliance. To reduce the public sector's exposure to losses stemming from bankfailures, the Government decided to forego formal public deposit insurance. The Government also mademajor strides in banking regulation and supervision, and reformed the structure, staffing, and technologyof the Superintendency of Banks. The Government has been increasingly pressing for, and facilitatingthrough Trust Funds the restructuring of the private banking sector and the privatization or liquidationof public banks. By the first quarter of 1996 the Government had privatized a major national publicbank, the Caja Nacional de Ahorro y Seguros, liquidated the Banco Nacional de Desarrollo, and fiveprovincial banks were privatized (with another ten in the process of privatization). Similarly, theGovernment strengthened regulation, supervision, and enforcement in the capital markets.

Public Sector Reforn

1.14 The Menem administration took office in July 1989 during a traumatic hyperinflation--Julyinflation alone was 200 percent. This culminated a decade-long crisis in public finance. The new teaminherited weak public institutions accustomed to deficit spending and with an institutionalized reliance on

the inflation tax. In addition, claims on the state's revenues were far greater than its capacity to mobilizeresources--in short, the Argentine state was insolvent.

1.15 In response to the crisis, the Menem administration undertook two stabilization programs in 1989and 1990. Neither succeeded, principally because of the intractability of the fiscal deficit. The firstterminated in a new hyperinflation at the end of 1989 and early 1990. The second lasted from March1990-December 1990 and ended in a new inflationary outburst but, unlike the previous breakdowns, theeconomy did not spin into hyperinflation. Instead, a new fiscal package in February 1991 was sufficientto close the remaining fiscal gap. This was followed by the April 1, 1991 Law of Convertibility,effectively proscribing money creation other than to buy net foreign reserves, thereby limiting the powersof the Government to finance its deficit through inflation.

1.16 Since 1991, the Government has sustained structural reform efforts that had progressivelyimproved the foundations of public finance. The Government had undertaken difficult-to-reverse reformsin the legal framework, institutions, and policies. This process included institutional reforms of theFederal Government, privatizations, as well as restructuring of liabilities with domestic and foreigncreditors to adjust them to serviceable levels. Other reforms have helped elicit efficient privateinvestment, notably trade, deregulation and financial sector reform.

1.17 Revenue Mobilization The GovernmentTax Revenuesundertook a major effort to improve revenues through Ta of GOP)

the implementation of a much-broadened and uniform 25

VAT, first to goods in February 1990, and laterextended to services in November 1990. The 20 ....................... ...............

Government in 1989 also undertook to improve the 15 .

efficiency of the tax administration--establishing a .control system for the largest taxpayers; improvingaudits and controls substantially. The tax penalty law, 5.

adopted by Congress in 1990, provided much needed a 3 2

sanctions for tax non-compliance. The tax package of I so I 91 Z 92 1 93 1 94 1 95 I

February 1991 improved the quality of the revenue Eica TangCM {0IeloIe Taxes 9 Social Seocuity

mobilization substantially because it eliniinated export 5 ' ci Eeirsy

taxes--which had been reduced progressively during1990 and early 1991--deducted higher taxes on Figure 4financial transactions from the income/asset tax, andremoved several minor taxes. In early 1992, the VAT rate was raised to 18 percent and the corporateincome tax to 30 percent. The increase in VAT collection has allowed the Government to eliminateinefficient taxes Lcn as the gas-oil tax and the federal stamp tax in November 1992. In December 1992,subsidies to indu.scrial promotion were substantially cut through the replacement of the self-monitored taxdeductions with a tax bond program. These efforts cumulatively produced dramatic rises in taxcollections.

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1.18 Administrative Reform Because the wage Employment of the National

bill dominated expenditures, the Government set up AdmInIstrationthe legal and administrative machinery to reduce thesize of the federal bureaucracy in November 1990.Federal employment decreased from 671,000 to aoo284,000. Of the 387,000 reductions, 103,000 werelay-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 focusedfederal activities on core objectives, and 200

improvements in the civil service system through animproved salary structure and efficiency measures. -

The Government was able to increase average salaries 196B 1096 1990 1991 1992 1993 1994

and partially restore salary differentials. During _____________t_y___________

1996, the Government has received congressional Figure 5authorization to proceed with a second administrativereforn to improve further its organization, performance, accountability and transparency.

1.19 Divestiture The Menem Government hasPrivntization Revonues 1990*94followed 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 increase the volume and efficiency of 5new investment. The privatization program, in the 4 3661

works since 1988, gained credibility with 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 oilsectors cut off public subsidies to consumers and labor 1990 1901 1992 1993 1994

S,mre r, MIulory ol Ecomomygroups benefitting from high wages and excess I__________Ministry____________staffing, and transfers for investment. The program Figure 6also improves public finances: transitionally withmore than US$2.5 billion in capital receipts to help close fiscal accounts in 1991 and 1992, morepermanently by eliminating transfers and increasing tax revenues.

1.20 The Government has sold two television stations, ENTel, the national telephone company, andAerolineas Argentinas. In mid-1991, it began the first comprehensive restructuring of the petroleumindustry in Latin America by auctioning off selected areas of YPF. It granted road and railroadconcessions to the private sector and privatized long distance cargo lines, and reduced the railway's workforce by 15 percent. The Government privatized in 1992 defense industries, the nation's largestdistributor of electricity (SEGBA), ports, reinsurance and major parts of the power sector. In July 1993,the successful privatization of state-owned oil company (YPF) enabled the Government to cancelobligations to pensioners (about US$2.7 billion) and to oil producing provinces (about US$1.2 billion).The Government is currently in the process of privatizing airports, nuclear power plants, and thehydroelectric plant, Yacyreta.

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1.21 Deregulation A major domestic deregulation decree was issued in October 1991. This endeda series of market impeding rules, dissolved several regulatory bodies and unified pension and healthinsurance payments to reduce evasion. Subsequent decrees have deregulated pharmaceutical imports andports. The industrial promotion program and subsidies to Tierra del Fuego were markedly reduced bya recent decree in November 1992, though it was partially reverted in December 1993. Deregulation isprojected to be extended in the provinces through the recent Pacto Fiscal.

1.22 Provincial Reforms The Federal Government's ability to effect reforms in provincial publicfinances is constrained by lack of direct jurisdiction. Still, since the Convertibility Plan was initiated in1991, the Federal Government has launched a concerted effort to promote fiscal adjustment in theprovinces by regularizing the transfer of co-participated federal revenues; reducing discretionary transfersthat historically have rewarded poor fiscal performers; transferring responsibility for the provision ofmost social services in health and education to the provinces; reforming and assuming responsibility forprovincial social security systems; improving local resource mobilization; modernizing and downsizingprovincial public administration; eliminating Central Bank rediscounts; and promoting the privatizationof provincial banks. This strategy was initiated in August 1992, when the Federal Government reachedan agreement (Pacto Fiscal I) with the provinces whereby 15 percent of co-participated funds would bediverted to finance the transition costs of national social security reform. In return, federal authoritiesagreed to compensate the provinces partially by guaranteeing a minimum of US$725 million per monthin co-participated transfers.

1.23 Further modifications were reached under the Pacto Fiscal II of August 1993. The Pact calls forreforms in provincial tax systems to replace distortionary taxes. In return the Federal Government agreedto increase the minimum monthly co-participated transfers to US$740 million, forego the debtaccumulated by the provinces under the August 1992 agreement, gradually eliminate the federal asset tax,and take over responsibility for government employee pension systems from willing provinces.'

1.24 Finally, the Federal Government moved to shut off provincial access to private sector borrowingto support current expenditures. Domestic banks have had to obtain BCRA authorization before lendingto the non-financial provincial public sector, since the mid-1980s. In November 1993, the Governmentalso began requiring authorization for provincial banks to borrow abroad, in order to head off furtherloans from foreign banks backed by co-participated revenues.

Debt Restructuring

1.25 Debt with the Financial System and Quasifiscal Deficit. On January 1, 1990, faced with risingCentral Bank deficits and the renewed threat of hyperinflation, the Government took the drastic actionof converting the domestic, short-term (mainly seven day), interest-bearing obligations of the CentralBank into US$3.5 billion 10 year dollar denominated Treasury bonds (BONEX). This virtuallyeliminated the Central Bank's quasifiscal deficit and the monetary emission necessary to finance it--at thecost of penalizing savers and reducing the already low confidence in the financial system.

1. As a follow-up to increase the incentives for the provinces, in December 1993 the Federal Governmentannounced that employer wage taxes would be reduced in those provinces carrying out the proposed tax reforms.

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1.26 External Debt. In April 1988, the Government suspended payment on its external debt tocommercial creditors. By 1992, it had accumulated US$9.2 billion in arrears as part of a US$30 billionmedium-term commercial bank debt. Public external debt was US$58 billion. The progressiveimprovement in fiscal fundamentals in 1990-91 allowed the Government to begin negotiations withcommercial banks on a debt reduction deal. The external debt agreement with commercial creditors,signed on April 7, 1993, ended the accumulation of arrears, regularized existing arrears, reduced interestobligations in the initial years, and sharply limits interest obligations when international rates rise. Theagreement formalized arrears in a 12-year uncollateralized bond at LIBOR with a 3 year grace period,after a US$700 million downpayment; existing debt was exchanged for a collateralized par bond with afixed interest rate, or a collateralized discount bond at 65 percent of face value paying LIBOR; thecollateralized bonds have a 12 month rolling interest guarantee.

1.27 Arrears to Pensioners and Others. For most of the last decade, the Government has paid onlyabout half the legally mandated pensions owed to social security recipients. In order to stop theaccumulation of arrears, the Government modified the coparticipation of tax revenues in favor of thesocial security system in August 1992. The Government also accumulated arrears in 1990 with suppliersthrough the formal suspension of payment on goods and services already provided, and the health fundshave arrears with their service providers which will also result in new debt. To settle these claims,Congress authorized the Government to issue consolidation bonds (BOCONs) with terms of 10 to 16years (with shorter terms for social security recipients) and a five year grace on principal and interest.The service of the debt will be capitalized until 1997, but payments on the order of US$3 billion will berequired in the last years of this decade. The proceeds of the privatization of the state oil companyallowed the Government to cancel part of its debt with pensioners (about US$4.5 billion) during thecourse of 1993. At the end of 1994, US$7.7 billion of issued bonds were outstanding to the aboveclaimants.

Social Security Reform

1.28 Argentina's mandatory public pension insurance became financially unviable during the 1970s,resulting in severe underpayment of pensions. In 1991, the Government concluded that adequate benefitsand financial viability could only be restored with a systemic reform that would reverse the steeplyincreasing trend of the dependency ratio (pensioners/contributors), which was primarily the result of anincreasing evasion of contributions. As an initial step leading up to the actual operation of the systemin July 1994, the Government took measures enabling the National Pension System, to gradually raisebenefits to their mandated level. These included the earmarking of coparticipated tax revenues, a reformof the collection function, and an increase in the minimum years of contributions from 15 to 22, whichslowed the increase in the number of pensioners. In addition, the Government issued consolidation bondsin recognition of pension arrears estimated at about US$10 billion.

1.29 Central to the reform is the combination of public schemes on a pay-as-you go (PAYG) basis withprivate or public pension funds in an integrated system of mandatory pension insurance. Employers andindependent workers will contribute 16 percent of, respectively, gross salary and income to the PAYGsystem. The scheme provides a basic, uniform pension of about 28 percent of average salary, which maybe increased only by additional years of contribution beyond the 30 year minimum. All workerscontribute 11 percent of salary or income to either the PAYG scheme or a pension fund with the rightto change affiliation twice a year. Expected benefits will be strictly proportional to contributions and--inthe case of pension funds--the fund's investment performance. These rules are expected to lower evasion

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by linking expected benefits to contributions. Further measures to reduce the dependency ratio includea gradual increase in the retirement age by 5 years, a further increase in the minimum years ofcontributions to 30, and stricter rules for disability claims. In the context of provincial reforms, theGovernrment has initiated the consolidation of inefficient provincial social security systems with thenational system.

Trade Reforms

1.30 One of the main pillars of the Convertibility Plan has been Trade Reform, which eliminatedexport taxes and most quantitative restrictions on imports, while reducing the level and range of importtariffs. Reduction in 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 theimport-substituting strategy of over 40 years.

1.31 As a result of protracted protectionist policies,the degree of openness of the economy which Openness Coelicrent 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 .increased during the Convertibility Plan to an average 01.of 11 percent.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 aliberal regime. The most fundamental change in the 0.02 .

import regime was the replacement of quantitative o . . . 1090

restrictions with tariffs, which in itself is a significant 197D 075 ,9BD 0 85 .,

trade liberalization. However, quantitative restrictions sONIC# M.,.,,y o Ecolow

were maintained for automobiles, sugar, and some Figure 7paper items. The average nominal tariff on imports(including the statistical tax) was reduced from 30 percent at the end of 1989, to 14 percent on April1995. However, following the initial strong liberalization, the trade regime acquired increasedcomplexity. The February 1991 import regime was simple and consisted of only three tiers; by late1994, the import regime had seven tariff tiers, and it became linked to the export performance.However, protection remained low as did the variance, although the latter would have increased in termsof effective protection rates.

1.33 Trade liberalization also has a strong regional bias. Argentina is a member of MERCOSUR(common market), establishing a common external tariff. Argentina adopted a common external tariff(CET) of 20 percent on January 1, 1995 under the MERCOSUR Agreement. However, the CET appliedto some 85 percent of the harmonized tariff lines. The remaining 15 percent of the tariff lines were toconverge to the CET over time. Additionally, trade inside the MERCOSUR area is free from importtariffs, with exceptions. This arrangement stands in contrast to the earlier regional arrangementsundertaken under the aegis of the Latin American Integration Association (LAIA) when preferences were

2. Defined as exports plus imports over GDP.

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used to restrict trade outside the regional arrangements rather than liberalize trade in what can be calledGATT- plus basis. The new trade policy led to a rapid opening of the economy-both in terms of trade,as well as capital and technology flows, since foreign investors were extended the same legal rights asdomestic investors.

1.34 Like the import regime, the export regime was also transformed. In the late 1980s exports weresubject to taxes and licensing and there was an extensive array of export promotion and subsidy schemes.These included the duty free status accorded to capital goods imports based on multi-annual exportcontracts, a temporary admission regime for intermediate goods, a 15% export subsidy on items underthe special export program aimed at promoting non-traditional exports, and subsidized export financing.Export taxes, primarily falling on agricultural exports were around 10-12 percent of export value, andconstituted a significant part of government revenue.

1.35 With the reforms of the early 1990s, most export subsidies and taxes were removed. But thatregime also subsequently becarne more complex with the "mirror export subsidies" program whichgranted to each export product the same rate of subsidy as that corresponding to imports of the sameproduct, sectoral performance agreements, and attempts to balance exports and imports by industry. In1992, the rules of the automobile regime were extended to a few other industries. This was called aregime of "industrial specialization". Any industry could enter into an agreement with the Secretary ofIndustry and Commerce specifying a target export figure for the coming years. Such firms wouldreceive import licenses with reduced tariffs up to the export target that had been agreed upon. Fourperiods were considered for industrial specialization: 1993-96, 1997, 1998 and 1999. In the first period,the tariff rate would be 2%, after 1996 a specified formula would be used to calculate the reduced tariffs.The exchange rate reform and the reduction of import tariffs helped reduce the bias against exports.

1.36 Previous attempts to liberalize the trade regime could not be sustained due mostly tomacroeconomic instability, lack of commitment to free trade, and resistance from domestic industries thathad thrived under protectionist trade regimes. Moreover, the earlier attempts were not combined withstrong privatizations or regulatory reforms and could not support the resource movements that are neededto reallocate resources following a reduction in protection. The trade liberalization launched in the late1980s and accelerated in the early 1990s, succeeded to a large extent due to the remarkablemacroeconomic stability achieved by the Convertibility Plan.

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CHAPTER II

ECONOMIC PERFORMANCE ANDMACROECONOMIC IMPLICATIONS OF TIE CONVERTIBILITY PLAN

A. Economic Performance (1991-94)

2.1 This chapter reviews the main macroeconomic implications of the Convertibility Plan. Economicperformance under the Convertibility Plan is separated here into two periods; the 1991-94 growth period,and the crisis year of 1995. This separation in warranted, since the crisis was generated primarily byexternal factors, and both periods have different lessons to offer to the future evolution of theConvertibility Plan.

2.2 The results of the Convertibility Plan during 1991-94 have been impressive. With dedicatedpublic sector reforms that led to dramatic improvement in the federal Government's finances, andmonetary policy guided by the Convertibility Law, the credibility of the Convertibility Plan was quicklyestablished. Inflation, measured in consumer prices, decelerated from 1,343 percent in 1990 to only 3.9percent in 1994. With the decline in perceived country risk and a hospitable international financialenvironment, capital inflows accelerated, fueling an economic expansion. Between 1991 and 1994, realGDP grew at an average rate of 7.7 percent.

2.3 The consumption-led growth in the first two years of the Plan, which is a common occurrencein exchange rate stabilization programs, was more importantly supplanted in 1993 and 1994 by an export-and investment-led economic growth. Over the 1993-94 period, exports grew in real terms by 14.8percent and investment by 19 percent. By 1994, gross fixed investment reached 19.9 percent of GDP,associated with increased national and foreign savings. Exports, which were affected by declininginternational prices in 1992-93, rose by 20 percent in 1994, with manufactured goods exports exhibitingparticular buoyancy, growing at an average 27 percent in 1993-94. This transformation, which occurredin the face of the peso's appreciation3 , was the result of improvements in productivity. Over 1993-94,imports of capital goods led the strong expansion of overall imports, indicative of the acceleration ininvestment and the restructuring of the economy. As a result of the economic recovery, poverty levels4declined significantly. Nevertheless, as discussed in the next chapter, economic restructuring with a rigidlabor market resulted in the increase in unemployment to 12.2 percent of the labor force by late 1994.

3. The Argentine peso appreciated in real terms by about 20 percent between the beginning of theConvertibility Law regime and end-1994; however, after adjustment for tax reductions and other reforms, lossesto export competitiveness may have been one third lower that amount.

4. A detailed review of poverty issues in Argentina can be found in the Bank's 1995 Report No. 13318-AR,titled "Argentina's Poor: a Profile".

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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 -4.4Total Investment 14.6 16.7 18.4 19.9 17.8National Savings 15.2 14.3 15.9 16.9 16.4Foreign Savings -0.5 2.4 2.5 3.6 1.4Fiscal Accounts (Federal Goverrnent) a/(X of GDP)Total Revenues 17.9 17.9 17.7 17.2 16.5Total Expenditure 15.3 17.5 16.6 17.2 16.4Primary Surplus 1.8 2.2 2.2 1.1 0.6Overall BaLance b/ 0.2 0.4 1.1 -0.0 -1.0Balance of Payments (Billion USS)Trade balance 3.7 -2.6 -3.7 -5.7 0.9Exports 12.0 12.3 13.1 15.8 20.9Imnports 8.3 14.9 16.8 21.5 20.0

Current Account -0.3 -6.3 -7.3 -10.3 -3.8Capital Account 3.0 10.2 12.1 10.5 1.9Balance of Payments Result 2.7 3.8 4.8 0.2 -1.9Inflation (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-fiscal surplus.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 theconsolidated public sector in 1992 and 1993, eliminating the need for inflationary finance. Second, aseries of difficult to reverse reforms in the legal framework, institutions, and policies reduced the sizeof the public sector to 27.4 percent of GDP in 1994, down from an average of 33 percent of GDP duringthe eighties decade, and substantially lower than the 40 percent average rate in OECD, and other LatinAmerican countries (for example 31 percent of GDP in Chile and 34 percent in Brazil).6

2.5 The composition of the public sector also changed significantly with privatizations, thedecentralization 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 totalpublic expenditures in 1980-83 to only 23 percent in 1994. The social security system expendituresgradually increased from 22 percent in 1980-83 to almost 31 percent in 1994. The most significantdevelopment during this period has been the decentralization process with expenditures of localgovernments increasing from 29 percent in 1980-83, to 46 percent of total public expenditures in 1994.

5. For a more detailed review of public finances during the 1980s and early 1990s, see "Argentina - PublicFinance Review: From Insolvency to Growth", IBRD No. 10827-AR, February 11, 1993.

6. See: World Bank, "World Development Report, 1988".

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Table 2: Level and Composition of Total Government Spending(Percentage of GDP) c/

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

Totat Goverrnment expend. 32.52 33.05 35.61 27.77 29.33 28.73 28.61 27.39National Goverrnment a/ 23.10 21.84 25.17 19.04 17.85 16.34 15.21 14.84Provincial and municipal 9.42 11.21 10.44 8.73 11.48 12.39 13.40 12.55Social Security 2/ 4.99 5.57 5.28 6.51 7.37 7.48 7.02 7.08Total 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 Enterprises and SocialSecurity System

b/ Total Social Security System (National Goverrmient and ProvincialGovernments)

c/ The figures are on accrued basis.

2.6 The Federal Govermnent The initial success of the Convertibility Plan is largely due to thesevere fiscal adjustment at the Federal level in 1991-93. The overall surplus averaged 0.6 percent ofGDP during this period, reaching 1.1 percent of GDP in 1993. As a result, the inflation rate declinedabruptly and the Government's credibility was gradually restored both in the domestic and internationalfinancial markets. In 1994, a surge in expenditures, including the increased costs of the social securityreform, brought the federal public sector accounts to a balance.

2.7 The strong performance of the Federal Government was primarily the result of large increasesin current revenues, an increase of 3.4 percentage points of GDP between 1990 and 1994, associated withthe reduction in inflation, better institutional revenue collection capabilities, and the resumption ofeconomic growth. VAT collections (with the VAT raised at a uniform rate of 18 percent) showed thefastest growth, reaching 6 percent of GDP, more than twice the 2.5 percent average of the eightiesdecade. Massive privatizations also became a primary source of revenue, averaging about 0.7 percentof GDP annually between 1991-93, when the bulk of the privatizations occurred. Of the $18 billionraised through privatizations between 1990-93, half was received in cash, and the rest in bonds andtransfer of liabilities.

2.8 On the expenditure side, spending by the national administration declined by only 0.1 percentagepoint of GDP between 1990 and 1994, including, however, higher transfers to the provinces and thesocial security system. Expenditures, as a share of GDP, declined significantly when compared to theeighties period. but the major cut in public spending took place during the hyperinflation of 1989. Thenational administration benefitted from the growth of the economy, raising its expenditures between 1990and 1994 by a real 32 percent. Concurrently, by 1994, the share of social expenditures to total federalpublic expenditures, reached 64 percent. During this period, the Government was able to increaseaverage salaries and partially restore salary differentials.7 As regards consolidated public sectoremployment levels, evidence suggests that any adjustment was done exclusively with respect to the saleof public enterprises, since the increase in public employment in the provinces more than compensatedfor any reductions in permanent federal employees (excluding public enterprises).

7. The transfer of education and health responsibilities to the provinces accounted for an important reductionin the number of positions in the Federal Government. However, it is worth underscoring that the cost of thetransfer continue to be covered by the federal authorities, as part of the Pacto Federal, which assigned about US$1.5billion in revenues to the provinces annually for their additional responsibilities.

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2.9 Public social expenditure under the Convertibility Plan has been growing in absolute and relativeterms. Consolidated public social expenditure has increased form 16.4 percent of GDP in the 1984-88period, to 18.4 percent of GDP in 1994. With the overall decline in the size of the public sector in the1989-94 period, overall social spending as a share of total expenditure has risen from 49.5 percent in the1984-89 period, 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--expenditures in these programs have beengrowing the fastest--including old age and disability pensions, health insurance, family allowances, andunemployment insurance. With increased decentralization of functions, in 1994, 62.6 percent of publicsocial expenditure (excluding social security) was executed by provinces and municipalities.

2.10 Provincial Governments Argentine provinces vary widely in population, physical endowment,and institutional capacity. Throughout the 1980s, deficits generated by provincial governments and theirofficial banks were major contributors to the chronic instability of the Argentine public sector. The fiscaladjustment at the central level as well as economic growth generated an unprecedented increase incoparticipated revenues in 1991-92 which allowed provincial governments to improve their fiscalaccounts. Since 1992, however, expenditures increased much more rapidly than revenues resulting infiscal deficits of 0.8-0.9 percent of GDP over the 1993-1995 period (table 3). The provincial deficit hasbeen only partially financed, contributing to an unstable economic and social situation in many of thenorthern provinces. Fiscal difficulties led to violent demonstrations in several provinces during in recentyears.

Table 3: ProvinciaL Governments--Executed Budgets(% of GDP)

1991 1992 1993 1994 1995

Current Revenues 8.2 9.6 9.6 9.5 9.4Provincial origin 3.0 3.8 4.0 4.0 3.9Federal origin 5.2 5.9 5.6 5.4 5.5

Capital Revenues 0.0 0.1 0.1 0.1 0.1Current Expenditure 7.8 8.8 9.2 9.1 9.2CapitaL Expenditures 1.2 1.1 1.3 1.4 1.4Overall BaLance -0.7 -0.2 -0.8 -0.9 -1.1

Source: Ministry of Economy

2.11 Provincial revenues, which amounted to US$25 billion in 1994 and 1995, are characterized bylow revenue mobilization from provincial sources and a correspondingly high dependence on revenuetransfers from the Federal Government. Federal transfers financed an estimated 53 percent of totalprovincial spending in 1995, ranging from a high of 92 percent of total expenditures in La Rioja to a lowof 40 percent of spending in the Province of Buenos Aires (not including MCBA's unusually low ratioof 6.9 percent). Transfers include co-participated funds (69 percent), royalties (4 percent), and acombination of discretionary grants and sector-specific transfers (27 percent) -- the latter of which largelyare financed out of earmarked gas, energy, and assets taxes.

2.12 At the same time that provincial governments have lagged in making necessary fiscal adjustments,their role within the economy has grown as a result of decentralization and the privatization of manyfederal functions. In 1995, provincial governments (including the Municipality of Buenos Aires) spent11 percent more than the federal government on goods and services and total provincial employeepayrolls were more than twice the level of employee expenditures at the federal level. Provinces are nowthe major providers of core public services in health, education, security, water and sanitation, electricity,and other infrastructure. Provinces also have their own banks and a large variety of public enterprises.

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2.13 The aggregate deficit of the provinces has been persistent and large throughout the Convertibilityperiod, at almost one percent of GDP and 10 percent of total revenues. Recent estimates put the stockof provincial debt at approximately Arg$14-15 billion. The situation varies dramatically across provinces,where some provinces maintained small deficits or even surpluses, while others consistently ran deficitson the order of 20 to 30 percent of revenues. Many provinces increased their borrowing from thedomestic financial market, their own provincial banks, and the Federal Government, mostly on shortterms (less than 2 years), in spite of the massive financing received through the debt consolidation processwith the Federal Government, equivalent to over US$3.0 billion in 1993-94.8 When the financial crisishit in early 1995, the chronic-deficit provinces were faced with large debt service bills, the hard-to-breakhabit of high spending, and provincial banks on the verge of bankruptcy. These provinces suffered themost from the impact of the crisis.

Capital Inflows, the Current Account and the Real Exchange Rate

2.14 The Convertibility Plan generated enough credibility, internal and external, to significantly reducethe country's risk premium (measured by the difference between BONEX rates and LIBOR) to about 4percent in 1994, from an average of 20 percent in 1990. Factors contributing to the fall in country riskcan be associated with the overall market oriented strategy of structural adjustment, including monetaryand fiscal reforms, the steps taken to refinance the external debt (under the Brady Plan), trade reform andprivatizations. Capital inflows are significantly correlated to the country's risk premium. In general, thefall in country risk can be associated with an increase in the rate of capital inflows9.

2.15 There have been various sources of capital inflows during the Convertibility Plan. By far, themost significant has been the repatriation of dollars that Argentines held abroad. Under the new financialrules, commercial banks were allowed to capture dollar deposits and relend them, subject to a marginalreserve requirement. As the country risk decreased, Argentines saw fit to bring back their dollars whichmade up the major component of capital inflow for the period, as seen in Table 4.

2.16 During the three calendar years 1991-94, accumulated capital inflows amounted to 36 billiondollars out of which 20 billion were from asset repatriation, measured by the increase in dollar depositsat commercial banks. Of the remaining $16 billion, privatizations and direct investment represented $14billion. The remaining $2 billion was from International Organizations.

2.17 The accumulated US$36 billion in capital inflows seem to have been entirely voluntary as theyfinanced not only US$24 billion in current account deficits but also reserve accumulation to the order ofalmost US$12 billion.

8. The total bonds received by the provincial governments in 1993-94 reached US$4.0 billion but aboutUS$1.1 billion was used to cancel the debt of the provincial banks with the BCRA.

9. In a regression with data from 1988.1 to 1994.9, shows that one point reduction in the country risk ratewas associated with 440 million annual increase in capital inflows. Since the country risk was reduced from anaverage of about 20% in 1990 to just over 5% by year end 1991, the contributionof this factor to the rate of capitalinflows must have been substantial.

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

1991 1992 1993 1994 1991-94

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

Capital inflows 2,987 10,162 12,122 10,612 35,883Current 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 theeconomy's performance in the 1991-94 period reflects not only the inflows phenomenon but also themajor disinflation that emerged as a result of the Convertibility Plan. This is especially relevant forcomparisons with Chile and Mexico, where stabilization plans (and disinflation) preceded the arrival ofcapital inflows. Accordingly, the observed real exchange rate appreciation, increased economic growth,monetization, and increased current account deficit in Argentina capture the effects of both exchange-rate-based disinflation and the surge in capital inflows, and it is very difficult to quantitatively assess theirseparate impact. Similarly, given the coincidence of capital inflows and disinflation, it is difficult toascertain the quantitative importance of external versus internal factors in accounting for the rise ininflows.

2.19 The rapid reduction in Argentine inflation and devaluation expectations, as well as country risk,have been reflected in a strong decline in interest rates. A key additional element to these developmentshas been the policy of monetization and lack of sterilization adopted in the context of the ConvertibilityPlan. The non-sterilization of capital inflows contributed to a substantial reduction in domestic interestrates (faster to that of Mexico and Chile in a similar phase of inflows), and a marked increase in domesticliquidity (most of it demand induced). In addition, the Argentine authorities avoided sizable quasi-fiscalimplications of sterilization observed in other countries, precisely at a time that establishing fiscal balanceand fiscal credibility were of major importance.

2.20 The large inflows of capital helped finance a credit boom that was a determining factor of the realgrowth experienced since 1991. A regression analysis suggests that over a five year period (1988-94) aUS$1 billion in annual capital inflow may have been associated with a 10 percent rise in the index ofindustrial production. Capital inflows affected both real production and relative prices. An expansionin the supply of foreign exchange will reduce the relative price of traded goods in terms of non-tradedgoods. Thus, there should be a real appreciation of the currency. The more closed the economy is, andthe more inflexible its factor markets, the larger will be the appreciation of the currency in response toa capital inflow. Evidence suggests a strongly negative relationship between the real exchange rate andcapital inflows, suggesting that capital inflows, coupled with the inflexibility in the goods and factormarkets, may be at the core of the real appreciation experienced early in the Convertibility Plan.

2.21 To summarize, the stylized facts of the macroeconomic implications of the first four years of theConvertibility Plan can be described as follows: the perception of structural adjustment reduced thecountry risk premium which in turn induced capital inflows, mainly from assets repatriation andprivatizations. Capital inflows increased both the supply of credit and aggregate demand and ended upfinancing current account deficits thus requiring a real appreciation for the resource shift to occur. The

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high inflexibility of goods and factors markets in Argentina implied that small rates of capital inflowsrequired large changes in relative prices for transfers to occur.

2.22 Effects on Financial Markets The reduction in inflation, monetary reforms, and the surge ofcapital inflows had unprecedented effects on the financial markets. After a decade of basically operatingas a barter economy, credit reappeared and interest rates fell sharply and fast. Table 5 shows a simpledecomposition of peso lending rates into their main components: international rate, country risk,credibility, and lending spread. Credibility, or the expectation of devaluation (measured by the differencebetween the peso and dollar deposit rates at commercial banks) fell sharply after the implementation ofmonetary reform, helped by the virtual creation of a Currency Board. Country risk was not a significantcomponent 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 foreigndebt. Following the 1995 crisis, when interest rates surged sharply, in the first quarter of 1996 interestrates come down quite fast, reaching the lowest levels since the beginning of the Convertibility Plan.While country risk has been coming down fast, even more impressive has been the decline in thedevaluation risk, which in February 1996 also reached its lowest rate since the beginning of theConvertibility Plan.

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

Decomposition of Average Peso Lending Rates

Average Peso Lending Borrowing Spread ForeignQuarter 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 5.6111-91 44.8 5.9 21.3 7.0 5.4IV-91 40.8 13.1 13.4 4.9 4.61-92 34.9 8.9 12.3 6.2 3.911-92 30.9 13.5 5.4 5.5 3.7111-92 31.7 13.4 5.5 6.8 3.1IV-92 30.9 -2.0 19.7 8.2 3.11-93 28.5 7.9 7.3 7.8 3.011-93 24.5 9.4 5.4 4.8 3.0111-93 23.0 10.6 4.2 3.6 3.0IV-93 22.6 11.9 3.3 2.8 3.11-94 21.3 11.5 2.1 3.2 3.211-94 22.5 10.2 2.3 4.4 4.0111-94 23.0 11.1 2.4 3.5 4.5IV-94 25.3 12.0 2.8 3.4 5.31-95 47.8 25.2 5.4 5.9 5.811-95 44.8 23.4 5.8 5.1 5.6111-95 28.0 14.5 2.2 3.8 5.4IV-95 25.3 12.1 2.3 3.9 5.31-96 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 Interest RateIndicators.

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 Interest Rate.e/ January and February average.

2.23 Local currency loans rates, though, remain high. Given the observed decline in devaluationexpectations and country risk, these high lending spreads represent a risk premium associated with therelatively low credit rating of local currency borrowers and the relatively high intermediation costs in thissegment of the market. Similar high lending spreads have been observed in other countries such asBolivia, Mexico, and Uruguay. A substantial part of the renewed capital inflows contributed to anexpansion in the level of credit and a reduction in its cost--especially in the dollar segment of the market.

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However, low-credit-rating, and liquidity-constrained, domestic-currency borrowers probably experiencedless direct benefits from the capital inflows phenomenon.

2.24 Monetization and Dollarization Hyperinflation and the BONEX plan had all but melted awaythe local peso system. The historical minimum of the economy's monetization was reached followingthe BONEX plan ( January 1990), when the ratio of money (M2 in pesos) to GDP reached a mere 2.5percent. The stabilization achieved with the Convertibility Plan assisted in the quick remonetization ofthe economy. However, the levels of monetization achieved under the Convertibility Plan did not reachthe levels in previous decades, or that prevailing in early 1989, just before hyperinflation started. Themain reason for the lack of complete recovery to the pre-hyperinflation monetization levels, is theincreasing degree of currency substitution and dollarization that the economy started experiencing sincethe early 1980's. Although monetization in pesos has stopped growing since late 1993, after reachinga maximum of 11.5 percent of GDP, dollar deposits continued growing in relation to GDP.

2.25 For decades Argentines had resorted to holding dollars as a hedge against monetary instabilityin their own currency. As inflation worsened during the 80s, transactions started being stipulated indollars and the economy started a dollarization process, with dollars being a store of value andincreasingly the standard of value and the mean of transaction. When banks were allowed to open foreigncurrency accounts, Argentines started bringing their foreign currency holdings that were safely depositedabroad into the local system. Dollarization is now evident, as the ratio of dollar deposits to peso depositshas grown persistently. From values in the order to 40 percent prior to the Convertibility, dollar depositshave reached the same level as peso deposits in 1994, and have surpassed them in 1995. The stabilizationof inflation at rates similar to those of the US dollar does not seem to have stopped the dollarizationprocess.

2.26 Dollarization may have actually increased stability in the financial system. The monetary strategyhas favored dollarization through the fixed exchange rate, the 100 percent reserve backing and byallowing banks to settle reserve requirements in either currency. Whenever requested, the monetaryauthorities have not hesitated to sell dollars in exchange for any amount of outstanding pesos, as requiredby the Convertibility Law. Thus, in instances of economic uncertainty, depositors, by shifting peso fundsto dollar deposits, mitigated capital outflows.

The Response of Trade Flows to Liberalization

2.27 Trade reforms led to a greater opening of the Argentine economy in two important ways. First,domestic relative prices in Argentina became more responsive to international prices, an effect that wasfurther strengthened by the adoption of a fixed exchange rate. Second, the tradable sector expandedsignificantly, although their ratio to GDP remained low, due to the appreciation of the peso.

2.28 Following the path of net capital inflows, which increased from a near zero rate in 1990 to annualrates of $11-12 billion in 1993 and 1994, the trade balance has had a growing deficit since 1992, whenit reached $2.6 billion. The deficit increased to $3.7 billion in 1993, and reached $5.8 billion in 1994.Imports have reacted quickly to the availability of foreign credit, whereas the growth in exports has beenmore closely determined by the path of structural adjustment and changes in the external environment.

2.29 In 1995, when foreign capital inflows were curtailed, imports declined, while exports acceleratedfurther, benefiting from sluggish domestic demand, increases in productivity, and the fast pace of growthof the Brazilian economy. The improvement in relative prices (tradables over non-tradables) and thesharp reversal from a trade deficit to a trade surplus in 1995, in the aftermath of the stagnation in capital

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inflows, have been very encouraging signs that the economy has started reacting relatively quickly toexogenous shocks, in the absence of a flexible exchange rate.

2.30 As a result of the reduction in import protection, Argentina's imports rose rapidly starting in theearly 1990s (Table 6). This in turn was the result of three reinforcing factors. There was a phenomenonof import catch-up following years of import restrictions and uncertain import policies. Another factorwas the strong capital inflow. A third interrelated factor was the recovery of income, facilitated bycapital inflows, and the increase in confidence brought about by the Convertibility Plan. The perceptionthat the new economic regime would usher a new period of prosperity, led in the first two years of theprogram, which incidentally followed a period of recession, to a consumption led boom, accommodatedby the expansion of imports. Imports which had fallen with the recessions in 1989 and 1990, recoveredstrongly since then. Nominal import levels quintupled between 1990 and 1994, reaching $21.5 billion.Despite such growth, imports of goods and services still accounted for 9.2 percent of GDP in 1994, amoderate level by international standards for an economy as open as Argentina's.

2.31 There were significant changes in the composition of imports following the liberalization of thetrade regime. Years of past high protection and economic stagnation had led to the increasing aging ofthe capital stock. Additionally, the change in relative prices brought about by the nominal fixity of theexchange rate, increased the need for higher productivity, and replacement of capital became necessaryand profitable. This desire for new technology incorporated in new capital led to impressive increasesin capital good imports. Capital good imports after growing rapidly since 1991, increased their share intotal imports from 36 percent on average in the 1980-89 period, to 44 percent in 1994. Themanufacturing sector was the largest importer of capital goods followed by the transportation andcommunications sectors.

2.32 The composition of the origin of imports changed following the trade reforms. Argentinaincreased its imports from Brazil rapidly since 1990, from about 17.6 percent of total imports, to 19.9percent in 1994, after reaching a peak of 22.5 percent in 1992. The reduction of Argentina's tradebarriers and the relative decline in the peso price of Brazilian goods, at least until early 1993, due to therelative depreciation of the latter's currency, helped to raise imports from Brazil. With the adoption ofthe Real plan in 1994 in Brazil and the resultant appreciation of the real, its goods become relativelymore expensive; that led to the relative slowing down of exports growth to Argentina. Price effects hadcome to override income effects at the margin, to lead to this result. The automobile agreement withBrazil, also was a factor in the changing composition of imports from Brazil. There were large increasesin Argentina's non-traditional exports, despite the withdrawal of special subsidies for them. The othersignificant change in the composition of imports was the increasing trade with USA. The progressiveliberalization of the import regime led to increasing imports from that relatively cheap source of capitalgoods. The tying of the peso directly with the US dollar helped reduce exchange rate uncertainty ingeneral, and the US dollar in particular.

2.33 A comparison of export performance between 1981-89 and 1990-94 shows strong export growthfollowing the trade reforms. The average real export growth rate during the former period was 2.0percent while for the latter it was 9.6 percent, with a significant acceleration evident in the 1993-94period, which was further fueled in 1995. Despite the strong export performance, 1994 exports as ashare to GDP reached 6.8 percent, suggestive of only an early stage of opening of the Argentineeconomy. While the recovery of exports in 1990 was related to the improvement in agricultural pricesand the decline in domestic demand due to the recession of that year, the resumption of strong exportgrowth over the last two years also reflected the increased competitiveness of the economy.

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2.34 The composition of exports changed with the trade reforms. Industrial manufactures became thestrongest 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 percentin 1993-94, contributing to the growth in their share in total exports from an average of 21 percent overthe 1980-89 period, to 29 percent in 1994. Over the same period, the share of primary products declinedfrom 37 percent to 24 percent.

Table 6: Evolution of Exports and Imports(USS million)

1990 1991 1992 1993 1994 1995

Total imports 4,077 8,275 14,872 16,786 21,589 19,968Capital goods 636 1,435 3,095 4,115 6,011 4,842Others 3,441 6,840 11,777 12,671 15,578 15,126

Total exports 12,352 11,977 12,235 13,118 15,839 20,893Primary 3,339 3,300 3,500 3,279 3,741 4,008FueLs 985 766 1,082 1,236 1,651 2,159Agricultural manufactures 4,664 4,927 4,830 4,925 5,799 7,446Industrial manufactures 3,364 2,984 2,823 3,679 4,647 6,487

Trade Balance 8,275 3,702 (2,637) (3,668) (5,749) 925Annual 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 -19.4Others -0.5 98.8 72.2 7.6 22.9 -2.9

TotaL exports 28.9 -3.0 2.2 7.2 20.7 31.9Primary 63.4 -1.2 6.1 -6.3 14.1 7.1Fuels 187.2 -22.2 41.3 14.2 33.6 30.7Agricultural manufactures 16.4 5.6 -2.0 2.0 17.7 28.4Industrial manufactures 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 24.2Ind. 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 Brazilgrew 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 Argentineexports to Brazil enter free of tariffs. Additionally, with the Real plan in Brazil, which stabilized thatcountry's nominal exchange rate and accelerated the pace of economic activity, consumption goodexports 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 19,968.6Mercosur Share (X) 21.5 21.8 25.2 25.1 23.8 22.5Mercosur 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 4,158.0Paraguay 42.0 43.0 64.7 72.9 69.1 80.4Uruguay 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 15,457.3Total Exports 12,352.5 11,977.8 12,234.9 13,117.6 15,839.2 20,893.3Nercosur Share (X) 14.8 16.5 19.0 28.1 30.1 32.2Mercosur 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 5,458.5Paraguay 147.0 178.0 271.9 357.8 498.5 629.3Uruguay 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 14,159.9Trade 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) 2,222.1With 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.

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2.36 Trade diversion to MERCOSUR countries has been significant. While Argentine overall trademore than doubled between 1990 and 1994, trade with MERCOSUR increased twice as fast, primarilythrough Argentina's increase in imports from its regional partners. By 1994, trade with MERCOSURaccounted for 26.4 percent of Argentina's trade, up from 14.3 percent in 1990. The lion's share of thattrade, 21.2 percent, is with Brazil. Closer links to MERCOSUR have their benefits, as the recent impactof Real plan suggests, but also carry risks, since Argentina's trade performance is more sensitive tochanges in economic growth and movements in the exchange rate of its main trading partner, Brazil, thanthe other way around.

Investment: Recent Trends and International Comparison

2.37 Under the first four years of the Convertibility Plan, investment rose sharply (see Table 8). Afterfalling in real terms in the late 1980s, the level of gross domestic investment grew at the impressive paceof 86 percent in real terms between 1990 and 1993, faster than GDP and consumption, and close to 20percent in 1994. As a result, the share of investment in GDP reached 20 percent in 1994. Nonetheless,in percentage of GDP, it only recovered to its pre-hyperinflationary level, and remained about 5 percentof GDP lower than its level in 1980. This increase is explained by the recovery of private investment(up 6 percent of GDP between 1990 and 1994), while public investment declined by about 2.5 percentduring the same period. This decline in public investment is principally the result of the privatizationprocess which automatically transferred 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 17.8Private 13.8 12.2 12.5 14.8 16.0 17.5 15.4Public 4.9 4.6 2.1 1.9 2.4 2.4 2.4P.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 EconomyA/ Based on the 1988-90 average.bl Includes national administration, decentralized agencies, and local governments.*/ Estimate

2.38 In spite of the impressive recent recovery, the level of gross domestic investment rate inArgentina still appears extremely low by international standards. Not only was the 1994 investment ratein Argentina lower than in East Asia (20 percent vs. 33.8 percent), but it was also about 1.0 percent ofGDP lower than the regional average (21.1 percent). The gap is even larger when the comparison islimited to Chile and Mexico, where investment rates reached 26.5 percent and 24.7 percent of GDP,respectively, in 1994. Public investment in Argentina (2.3 percent) is significantly lower than theregional average (5.9 percent). As noted earlier, the low level of public investment is principallyexplained by the well-advanced privatization process in Argentina. The level of private investment inArgentina (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 investment rates in Latin America isnotoriously low by international comparison, with the notable exception of Chile (22.9 percent) andMexico (20.5 percent).

2.39 Foreign Direct Investment. Government policy toward direct foreign investment (FDI) has beenextremely open. So far, however, direct investment has been modest. One reason is that foreign firmshave entered the economy primarily in the form of purchasing state firms being privatized. Otherwise,much of FDI has been in takeovers of Argentine firms, rather than new investment projects. Much of

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future plans involve production for the integrated MERCOSUR market, and thus will also depend on thefuture evolution of the Argentina's trade partners.

2.40 Investment Allocation. The absence of statistics prevents a good assessment of the allocationof investment in Argentina. Nevertheless, partial evidence, as discussed below, indicates that investmenthas principally taken place in the non-tradable sector such as utilities and services and large companiessuch as the automobile and the oil sectors. The key reason for this allocation are the higher rates ofreturn and higher output growth rates in the non-tradable than in the tradable sectors. Another reasonis the concentration process in some sectors (for example the food processing sector), and the easieraccess to domestic and foreign financing by 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 statistics on the allocation of investment, four alternative indicators wereused to depict the allocation of investment in the last few years: (i) capital goods imports, (ii) foreigndirect investment (FDI), (iii) public investment, and (iv) information on recently privatized enterprises.While none of these indicators is completely satisfactory, all of them seem to indicate that investment tookplace in the non-tradeable sector and large enterprises.

(a) Capital goods imports (equivalent to about 15 percent of gross domestic investment in1993) increased by 548 percent between 1990 and 1993. This surge took placeprincipally in the nontradable sectors (Table 9). The bulk of imported capital goods inthe 1991-93 period were office equipment, trucks, communication equipment, television,and airplanes, suggesting that the increase in investment mostly reflects changes in firms'organization and management rather than large investment in equipment and machinery.This is consistent with the microeconomic evidence.

(b) There is no systematic information on FDI in Argentina since the complete liberalizationof the regime in the beginning of 1993. Partial evidence indicates that the mostprivileged sectors have been non-traded sectors such as the food processing sector(Nabisco), the retail sector (Wal Mart), the automobile sector (Toyota), and the recentlyprivatized enterprises, including telecommunications, electricity and gas.

(c) Total public investment (about 20 percent of total gross investment) grew by about 137percent between 1991 and 1993, adjusting for public enterprises which were transferredto the private sector. This increase took place almost exclusively in non-tradeable sectorssuch as housing, road, and utilities.

(d) Privatized enterprises registered an unprecedented increase in investment of about 292percent between 1990 and 1994, reaching US$3.8 billion in 1994. These enterprisesprincipally produce non-traded goods such as electricity, gas and telecommunications,with the notable exception of oil (YPF).

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Table 9: The Sectoral Composition of CapitalGood Imports, 1986-94

1986 1994

TotaL 100.0 100.0Tradable Sectors 44.9 36.4AgricuLture 0.8 3.0Mining 0.5 0.4Industry 43.6 33.0

Non-Tradable Sectors 55.1 63.6Utilities 10.5 6.1Construction 11.2 8.1Transports 4.9 19.4Banks and Insurance 10.7 9.1Communications 8.1 15.3Others 9.7 5.5

Source: INDEC.

Savings: Recent Trends and International Comparison

2.42 Under the Convertibility Plan, total--foreign and domestic--savings in Argentina have risendramatically, recovering from 14.6 percent of GDP in 1991 to 20 percent in 1994 (Table 10). Between1991 and 1992, this increase was principally the result of foreign savings, which increased by 2.2 percentof GDP between 1991 and 1992. In a second phase, national savings recovered by 3.4 percent of GDPin 1992-94, while foreign savings remained globally stable as a percentage of GDP. In spite of thisspectacular recent increase, the level of total savings remains lower than in most of the 1970, when itaveraged over 23 percent of GDP.

Table 10: Saving by Sectors(percent of 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 17.8Foreign Savings 2.1 2.3 1.5 3.7 3.1 3.6 1.4Nat. Savings 16.6 14.5 13.1 13.0 15.2 16.3 16.4Public p/ -0.2 -1.6 0.0 2.1 1.5 1.2 0.0Private 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 slightly due to the strong decline in private savings,down by 2.1 percent of GDP during this period. This temporary decline can be explained by the longpostponement of purchases of consumer durables in particular. At the same time, the severe fiscaladjustment contributed to a rise in the level of public savings by 2.1 percent of GDP. In 1992-94, thelevel of national savings recovered by 3.4 percent of GDP as the result of the unprecedented increase inprivate savings (up 5 percent of GDP).

2.44 In an international perspective, the 1994 level of savings in Argentina (19.9 percent) remainedlow, but the contribution of foreign savings, though historically high, appears comparable with 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 percentage points of GDP lower than in East Asia (31.9 percent), butit was also below the Latin American average (17.7 percent). The actual poor performance is partially

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explained by the low private saving rate, about 4 percentage point lower than in Chile, and partially bythe low public savings rate.

2.45 Allocation of Savings. In Argentina, a significant fraction of private savings has traditionallybeen used to finance public deficits, and capital flight. As a result, private saving and private investmentwere not significantly correlated over the 1983-93 period in Argentina.'" Although the success of theConvertibility Plan between 1991 and 1994 in stabilizing the economy and controlling the fiscal situationhas contributed to (a) an important shift from foreign assets to domestic assets and (b) a reduction in thecrowding-out of private resources by the public sector, private savings remain low, undermining realinvestment. An important contributing factor in that outcome is that banks have been inefficient in theirinternediary role between financial savings and productive investment.

Evolution of Productivity and Competitiveness

2.46 In view of the appreciation of the peso in the initial years of the Convertibility Plan, this sectionattempts to address whether there is evidence that the Argentine economy has shown signs of adjustmentto the Convertibility Plan. The present section provides evidence of large gains in productivity inArgentina during the 1991-94 period. It shows increases in average labor productivity and total factorproductivity for the economy as a whole. However, case studies show that productivity indicatorsbehaved differently amnong economic sectors". An important caveat for this analysis: data for acomprehensive productivity study are scarce. The present analysis has utilized national account data (ata very aggregate level) and survey data from private sources (FIEL). In addition, to corroborate andsubstantiate the results, we have also used case studies.

2.47 Average Labor Productivity (ALP). Between 1990 and 1994, average labor productivity (ALP)grew by 21 percent, at a cumulative annual rate of 4.9 percent. This indicator of productivity has gonethrough a roller coaster in the last twenty years. ALP grew at very volatile rates form the end of theGreat depression until 1974. It stopped growing at that point and stagnated until the debt crisis of 1982,when it began to drop rapidly. It finally bottomed in 1989. Despite the surge of the early 90's, ALPat end-1994 was still 2.6 percent below its peak. Large gains in average labor productivity (per worker)are somewhat tempered once one takes into account that (i) hours per worker have increased, and (ii)capacity utilization has expanded at an even higher rate than hours. For example, productivity per hourworked (as opposed to per worker) grew by 12.4 percent in 1990-93, about a third of the growth inproductivity per worker.

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

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

10. The correlation coefficient between private savings and private investment was only 22 percent during thelast decade.

11. A simple average increase in productivity among all sectors may underestimate real gains in productivity, sinceit includes sectors from which resources are (and should be) moving out.

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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 arange between 3.5 and 5.5 percent a year.

2.50 The time series compatible with 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 increasedat an average annual rate of 1.5 percent; then between 1980 and 1990 it declined at a cumulative annualrate of 4.3 percent. Thus the average for the period 1973-90 reveals a decline of 1.7 percent per year,at a time when the average OECD TFP growth for the 1973-93 period was 0.7 percent per year.

2.51 The stagnation and later fall in TFP during the 1970s and 1980s reflects the stagnation of GDPduring those years. This fall and the recuperation in the early 1990s can be attributed to policy changes.Results of regression analysis indicate that TFP is negatively affected by inflation, and by the size of thepublic deficit (as a share of GDP). Although these are preliminary results, the implication is that ifinflation and the deficit had been zero throughout the period, the average annual growth of TFP couldhave been 3.1 percent for the 1960-94 period. This would indicate that there are important prerequisitesfor the macroeconomic policy framework to sustain TFP growth.

2.52 Although the growth rate has been high in the 1991-94 period, the TFP level remains belowhistoric highs for Argentina, and far below international levels. The level reached in 1994 is 9 percentbelow the 1980 peak. But reaching that peak sets the hurdle too low. The challenge ahead is to erasethe slump of the 1960s through the 1980s. If TFP had grown at the OECD average, by 1994 the levelof TFP would have been 47 percent higher.

2.53 Case Studies. Total factor productivity was analyzed in eight sectors. These sectors were milkproduction, dairy processing, orchards, cellulose, paper, plastics, and large supermarkets. These wereselected to cover different degrees of tradeability, capital/labor ratios, regional contexts, and degree oftechnological modernization. The largest corporations supplying these products (sample accounting inmost case, with the exception of supermarkets, over 70 percent of market share) were the primary sourceof information. In all sectors TFP grew in the 1991-94 period. Rates go from 3.5 to 45.4 percent, withan 18 percent average. A TFP growth rate of 18 percent over three years averages an annual 5.6percent, which is close to the 7.4 percent obtained from the regression analysis. Neither of the twomeasures is adjusted for capacity utilization, which could explain two points of TFP growth.

2.54 The sectors with the largest increase in productivity were those recording the largest increase inscale of production (through greater demand and/or concentration processes) and which benefited fromaggressive deregulation, lower tax pressure and privatization policies. In particular, dairy products,cellulose paste,plastics and supermarkets benefitted from a large increase in demand. Dairy farms,petrochemicals and plastics enjoyed the benefits of deregulation/elimination of distortive taxes. On theother hand, in certain sectors, productivity gains coincided with the process of concentration, as smallcompanies which lacked adequate scale and/or technology for competing in an open economydisappeared. This was important in the paper and dairy sectors.

2.55 International Comparisons of Competitiveness. A 1994 McKinsey and Co. report comparedproductivity in Argentina with that in other countries. The report presented average labor productivityin the steel, food, and banking sectors, and total factor productivity in telecommunications. It showedthat from 1987 to 1992 productivity in the food producing sector increased only by 1 percent. However,from 1989 to 1993 average labor productivity in the steel sector increased by 68 percent, while in thetelecommunications sector increased 164 percent.

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2.56 Despite the large increases in productivity in Argentina, average labor productivity in the sectorsconsidered 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 banking and telecommunications, Argentina'sproductivity indicators are also below the average in Brazil, Colombia, Mexico and Venezuela (seeTable 11)

Table I 1: Average Labor Productivity Comparison'(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: McKinsey Rewrt, 1994.TFP for TELECOMs.

2.57 Unit labor costs estimated form data contained in the report suggest that it is cheaper to producefood in Argentina than in the USA and other Latin American countries, but more expensive to producein the other three sectors (see Table 12)

Table 12: Unit Labor Cost(US=100. 1992)

Argentina Brazil Mexico Colombia Venezuela

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

Source: McKinsey Report, 1994.

2.58 Competitiveness Alpha Consultants have been monitoring the evolution of industrial costs,tracking the peso costs of a unit of output produced with a fixed input mix and a given technology. Unitcosts are proxied by a weighted average of several cost categories. This proxy would overestimate unitcosts since as long as there is some leeway to substitute towards cheaper inputs, or to benefit fromimprovements in technology, effective unit costs would be smaller.

2.59 Although labor costs increased by 14 percent from the first quarter of 1991 to the second quarterof 1994, Alpha's unit costs for industry as a whole have fallen by 8 percent. Lower financial charges,utility tariffs, taxes and imported goods prices prevailed over higher transport fees and labor costs. Thebehavior of Alpha's unit costs for specific subsectors depended on how intensive their use of capitalrelative to labor was. The unit costs of those goods that are more capital intensive have been favoredmore, experiencing larger drops in unit costs. Additionally, many sectors show unit labor costsincreasing much faster than in the industrial sector. This is the case of services.

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2.60 What emerges from the sample analyzed is that tradeables appear to fare quite well (especiallyimport competing goods). More importantly, the sectoral analysis shows that it is mainly policy reformsand productivity growth that compensate for the sharp increases in unit labor costs, hence contributingto an increase of the international competitiveness of those sectors.

2.61 The widespread deregulation processes have had an effect not only on productivity but also onprices, reinforcing the effect on competitiveness through both sides of unit costs (more production fromthe same inputs; cheaper inputs). However, many of the effects of deregulation are once and for all, andit should be expected that in the future unit costs will not be so much affected form the price side, butrather for the physical productivity side.

2.62 Looking toward the future, there appears to be margin for further concentration of supply andin particular for further deregulation (specially to further permit reallocation of resources betweensectors), and this would contribute to TFP growth even without substantial investment. Of course,technological change through the continuation of investment and the renewal of capital stock are at theheart of productivity growth prospects in the long run. For this process to continue, the key challengeappears to be the credibility and permanence of the broad rules of the game. These rules include veryprominently the commitment to low inflation and fiscal prudence, and the permanency and direction ofcertain 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 theArgentine economy suffered a recession. The main reason behind this contraction was the impact of theMexican economic crisis, that reverberated throughout Latin America. The sharp recession caused anincrease in unemployment, and strained the performance of the financial system. The regional financialcrisis was the first severe test of the Convertibility Plan. Yet, by the end of 1995, there were signs thatArgentina was pulling out of its recession without serious damage to the Convertibility Plan. To thecontrary, significant pressures to deviate from it were met by efforts to further strengthen it during thecrisis, indicative of the Plan's popularity and staying power. It can be claimed that in some respects, thecredibility of the Convertibility Plan was strengthened from the 1995 crisis.

2.64 Economic Performance. Preliminary data suggest that, during 1995, the Argentine economysuffered a recession of approximately 4.4 percent of GDP. The initial shock, generating a confidencecrisis, contributed to capital outflows, which for the first four months of the crisis prior to the MayPresidential elections caused a 17.6 percent loss in banking deposits (US$8 billion), with liquidinternational reserves declining by 30 percent (US$4.8 billion). Under the Convertibility Plan, wherethe monetary base has to be fully backed by international reserves, capital outflows resulted in thedemonetization of the economy. This demonetization affected both the performance of the financialsystem, but also real economic activity. There was increasing evidence however, that the economyceased to deteriorate in the fourth quarter of 1995. Expectations improved considerably: the stock andbond markets rebounded strongly, deposits and international reserves recovered the losses suffered earlyin the crisis. Furthermore, for 1995 as a whole, cumulative inflation was 1.6 percent, the lowest ratein 51 years.

2.65 As the economy slipped into recession, investment retracted as well (approximately by -16 percentin real terms), and unemployment surged, first rising to 18.4 percent (May, 1995), and later, with thedecline in labor force participation, reached 16.6 percent (October, 1995). The number of bankruptciessurged, reportedly doubling the rate of the previous four years taken together. The impact of the shock

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was moderated by a strong foreign trade performance. A combination of good international commodityprices, the contracting domestic economy, the continuous real depreciation of the peso, and the fast paceof economic expansion in Brazil, resulted in a 32.4 percent growth in exports. With the deepeningrecession, imports declined by 6.8 percent, producing a sharp improvement in the trade balance, whichshifted form a US$5.6 billion deficit in 1994, into a US$0.8 billion surplus in 1995. As a result, thecurrent account deficit was cut to US$2.3 billion, less than third the 1994 level, or 0.8 percent of GDP.Despite the improvement in the current account, the sharp reduction in net capital inflows resulted in areduction of US$69 million in net international reserves.

2.66 Fiscal performance was also detrimentally affected by the recession. Despite effort to rein inexpenditures, the shortfall in revenues generated a fiscal deficit equivalent to one percent of GDP, orUS$2.8 billion (including privatization receipts of US$1.1 billion). Half of that deficit was financed bya tax amnesty program announce in November 1995, and the remainder from other sources. Total federalpublic sector debt rose by US$6.4 billion in 1995, most of it foreign, reaching a level of US$87.0 billion.In addition to the federal fiscal deficit, preliminary estimates put provincial fiscal deficits at 1.1 percentof GDP, bringing their debt level to over US$11 billion. In a crisis year, where provincial banks faceddisproportionatley larger difficulties than the rest of the financial system, provincial deficits wereincreasingly financed through arrears to providers, salaries and pensions.

2.67 Implications of the Crisis. In the first months of the Mexican crisis, the financial markets'reaction suggested that Argentina was perceived being more vulnerable to the external shock than mostother Latin American countries. In addition to the decline in deposits and international reservesmentioned above, between the end of 1994 and mid-March the stock market index declined by 30 percent,as did dollar-denominated Government bond prices. Argentina's greater perceived vulnerability was toits relatively heavy reliance on foreign capital inflows, the inflexibility of its exchange rate regime, andthe weakness of its financial system. The structural conditions of the banking sector--no depositinsurance, absence of a lender of last resort, and a segmented and inefficient system, as well as thememories of many previous financial crises that ended in asset confiscation-- fueled a mini-run ondeposits and a flight to quality among many depositors in the system. Simultaneously, interbank marketaccess shrank down to top private sector banks and the interbank rate increased sharply, pushing severalsolvent but illiquid institutions to the brink of failure.

2.68 The Mexican crisis brought to light important lessons for Argentina: (a) it highlighted the extentof the economy's reliance on volatile capital flows; (b) revealed the need for a strong financial system,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 thedifficulties in changing the exchange rate during periods of crisis.

2.69 Vulnerability. The Convertibility Plan had so far served Argentina well. Nevertheless, underthe fixed exchange rate regime, the economy remains vulnerable to sharp swings in capital flows. Duringperiods of decelerating or declining capital flows, lags in the adjustment in relative (domestic to foreign)prices will create a slowdown in economic activity. An economy with a weak financial system and rigidlabor markets is even more vulnerable to shocks, particularly under a fixed exchange rate regime wherechanges in capital flows could be more pronounced. Financial vulnerability could cause great damagein a short period of time since it magnifies the deleterious effects of negative random shocks. As therecent experience in Argentina shows, capital movements usually affect the weakest financial institutionsfirst, creating problems that could subsequently affect the entire financial system, thus reinforcing theeffect of negative capital movements.

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2.70 A further dimension of this financial vulnerability under the Convertibility Plan is that the CentralBank, under a fractional reserve requirement system, is a weak "lender of last resort", since its dollarreserves are not enough to stem a serious banking run. To reduce the risks of a financial crisis in anincreasingly dollarized system, there is a need, for example, to get explicit support from other centralbanks, possibly via swaps. However, while such a facility may be desirable, it is unlikely that a variationof the Mexican emergency support program is replicable.

2.71 The Exchange Rate Regime. Under a fixed exchange rate regime, where capital flows couldbe volatile since changes in relative prices are more difficult to generate, crisis management in afractional reserve requirement system requires either the Central Bank to hold large international reserves,or international support needs to be assured in order to provide a lender of last resort to the financialsystem. Flexible exchange rates, however, are less attractive in a highly dollarized economy, and, in anycase may lead to undue volatility in the real exchange rate, as the Mexican experience made all tooobvious. In the case of Argentina, approximately three-quarters of private sector liabilities, four-fifthsof government debt, and over half of bank credit is in US dollars, and a devaluation would have a furtherdestabilizing effect on the banking system, as well as on corporate and public finances. A devaluationunder crisis conditions could prove to be highly counterproductive, deepening the crisis it is intended tocorrect. It could discredit hard won gains obtained under the Convertibility Plan, and would result incapital outflows, a banking crisis, higher inflation, and a possible economic depression.

2.72 Credibility. With a vulnerable financial sector it is imperative to strengthen the credibility ofthe economic program. This is another lesson one can draw from the recent Mexican crisis. While theArgentine adjustment process remains robust, and reforms to make financial and labor markets moreflexible were proposed, since mid-1993 there was a hiatus, with some important reforms deferred pendinglegislative or provincial approval and implementation. Additionally, during the second half of 1994, thenational government's fiscal surplus was reversed, primarily on account of social security reform effortsand higher expenditures. National deficits compounded provincial deficits, reversing an improving trendin consolidated fiscal accounts. While longer term, inter-generational transfers may in one sense justifythe higher transitory net costs of the reforming social security system, in retrospect, short-termconsiderations regarding the credibility of the adjustment program showed that a relaxation of fiscal policywas premature. Thus, when the Mexican crisis erupted, the Government had to address both thevulnerability of the financial system as well as the credibility of its economic program.

2.73 The Government's Response. The Government reacted forcefully to the crisis. Early on, ittook strong measures to redress the fiscal balance by cutting expenditures on, among others, exportsubsidies, public sector wages, and social security expenditures, while raising temporarily VAT rates (bythree percentage points to 21 percent) and other taxes. Swift action by Congress in approving unpalatableemergency measures at the early months of the crisis, added to the credibility of the measures, whichwere supported by programs of multilateral institutions. As the Government was announcing thesemeasures in mid-March, it also assembled an international financial package of approximately US$11billion in support of the Convertibility Plan. The announcements effectively stopped the accelerateddecline in bank deposits.

2.74 During the crisis, the Government successfully resisted growing pressures to reverse theeconomy's liberalization. To its credit, it decided to deepen this process and further accelerate economicadjustment, through labor, social security, and fiscal reforms. In the labor area, Congress approved alaw flexibilizing labor legislation for small and medium enterprises, a work-related accidents law, anda Bankruptcy Law. Congress also approved the Social Security Solidarity Law, to reestablish maximumlimits for all beneficiaries, eliminate the automatic adjustment of benefits, apply the provisions of the

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Convertibility Law to the determination of pensioners, and modify the associated legal proceedings. Itwill also allow the establishment of a limit on pension outlays, which have been an important cause ofmacroeconomic instability in recent years.

2.75 In the fiscal area, the Government obtained Congressional approval for implementing during 1996a Second Public Sector Reform (streamlining public administration, increasing its efficiency andpredictability), and another law giving extraordinary authority to the Executive for 1996 to resolve fiscalshortfalls without further recourse to Congress, including broadening the personal assets tax, and theextension for a second year the temporary increase of the VAT to 21 percent). Additionally, itimplemented a successful tax moratorium, generating a flow of $4 billion in revenues over the following30-35 months. The announcement of such measures, and the continuity of the Convertibility Plan, werewell received by the markets. Were it not for internal political difficulties that emerged in the secondhalf of 1995, and later subsided, it is likely that economic activity in Argentina would have recoveredearlier.

2.76 On the financial side, immediately after the Mexican crisis erupted, the Central Bank tightenedliquidity to prevent a currency run. It subsequently set up facilities to assist small banks in crisis. Tocounter the risk of further bank failures, it also facilitated the use of interbank credit, and reducedtemporarily reserve requirements in both dollar and peso deposits, and used rediscounts at a faster pace.The use of excess reserves, and the reduction of the reserve requirement (established for prudentialreasons earlier, but not a requirement for the Convertibility Plan) at the height of the crisis, providedlimited but badly needed margins of liquidity that the absence of a lender of last resort could not provide.The Government, with the assistance of two World Bank loans, established a Trust Fund for Privatizationto handle the workout of provincial banks, and a Bank Capitalization Trust Fund to handle therecapitalization/restructuring of distressed private banks. These Trust Funds made a significantcontribution to averting a full scale systemic banking crisis. Measures were also taken to strengthen thesupervision of the financial system. To stem capital inflows, the authorities facilitated the furtherdollarization of the banking system, by further limiting distinctions between dollar and peso deposits.

2.77 At the provincial level, the national crisis aggravated an already problematic situation, in viewof the absence of meaningful reforms in the early years of the Convertibility Plan. Faced with a seriousdeterioration in their fiscal affairs, and social unrest in a number of provinces, in 1995 various localgoveinments, assisted by the Federal Government's incremental support to the provincial reform effort,accelerated their adjustment process: five provincial banks were privatized (with another 10 in the processof privatization), three social security systems were transferred to the streamlined national system, salarieswere cut, and a number of redundant public employees were let go (contributing to the rise inunemployment). Additionally, a significant number of public enterprises, particularly in provincescommitted to a reform program, were privatized. Of the total of 35 enterprises slated for privatizationin eight such provinces, 17 were privatized by early 1996, and privatization laws have been passed forall of the rest.

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CHAPTER III

SUSTAINING HIGH ECONOMIC GROWTH

3.1 Over the 1991-94 period, the Convertibility Plan contributed to the achievement of high economicgrowth, averaging 7.7 percent. This performance was sidetracked in 1995, mainly on account of theregional financial crisis. In these four years, the economy has undergone significant restructuring,creating a framework for future sustainable economic growth. Looking beyond the current crisis, theissue raised here, is whether, and under what conditions can the Argentine economy sustain high ratesof economic growth, similar to those observed in high-performing East Asian economies, and how the1995 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 percentspanning three decades-- was supported by sound basic policy fundamentals, i.e. policies that provideda stable macroeconomic environment and a reliable legal framework to promote domestic andinternational competition, an orientation toward international trade, and basic absence of distortionarypolicies such as price controls. With the right policy fundamentals, most of this sustained high growthhas been shown to be due to superior accumulation of physical and human capital. These economies werealso better able to achieve high levels of productivity growth by allocating physical and human resourcesto 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 whileimproving at the same time their income distribution.

3.3 It is fundamental to stress that the recent regional financial crisis, despite its severity, has notundermined the public's trust in the need to stay the economic course set by the Convertibility Plan, asthe May 1995 election results indicate. Consequently, the Government has a solid foundation of policyreforms to build upon, and if anything, the current crisis has provided further incentives to quicken anddeepen reforms, necessary to meet conditions of solid and sustained economic growth. The recent risein unemployment above 16 percent is an additional policy challenge, and an added incentive to deepenthe recommended reforms.

3.4 This chapter is not indented as a comprehensive treatment of conditions for sustaining higheconomic growth in Argentina. It is rather, a compendium of issues and policy recommendations thatcould contribute in moving the economy in that direction. Fundamental issues, such as povertyalleviation and the development of 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, orbecause they are being treated in separate World Bank reports.

A. Simulating a Pattern of Sustainable High Growth

3.5 The fundamental premise is that, Argentina, endowed with plentiful natural resources and a goodstock of human capital, both underutilized on account of past misguided economic policies, has, in thecontext of the Convertibility Plan, created the foundations for unleashing its economic potential. With

12. "The East Asian Miracle: Economic Growth and Public Policy", A World Bank Policy Research Report,1993.

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solid fundamentals already in place, Argentina has a unique opportunity to strengthen its economicadjustment process, creating the conditions for high and sustainable economic growth.

3.6 Prior to discussing specific issues and policy recommendations, it could be useful to present asimulated growth pattern that would give some sense of the challenges ahead. The aim in this simulation(Table 13) is to reach sustainable economic growth 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 economic growth ischaracterized by sharp increases in national savings and investment, and continuous productivity gains.Such productivity gains, particularly in the context of the Convertibility Plan where the nominal exchangerate cannot be counted on to change relative prices between tradeables and non-tradeables, and in aframework of a liberal trade regime, would contribute to the substantial growth of exports. The timeframe is the next two Administrations, until the year 2,004.

3.7 In this simulation, a key prerequisite for reaching a sustainable growth rate of 7 percent is a fairlyquick acceleration in investment rates--averaging a real growth rate of 10.4 percent during this period--toreach a 26.5 percent share of GDP by the turn of the century. Nearly all that increase is expected fromthe private sector in view of the limited scope for public sector spending and the need to maximizeinvestment efficiency; private investment will 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 economy to regain 1994 levels, before resuming a high growth trend.Public investment, despite its relative stagnation as a share of GDP, is expected to increase in real termsto finance needed infrastructure and complement private investment.

3.8 The financing of that incremental investment will have to come entirely from national savings,since foreign savings face significant limitations, and are actually expected to decline as a share of GDPfrom levels reached in 1994 in order to reduce the economy's vulnerability to external shocks, similarto those experienced in 1995 (when foreign savings were cut to less than half the 1994 rate). As in thecase of investment, incremental savings will have to be created overwhelmingly in the private sector,rising from a rate of approximately 15.1 percent of GDP in 1994, to over 23 percent by the turn of thecentury. 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 provides the impetus to growth, as the public sector,burdened by its past legacy, restricts itself to playing the important role of providing basic social servicesto the poor, keeping law and order, providing infrastructure investment complementary to privateinvestment, and sustaining the appropriate institutional regulatory and legal framework setting clear rulesand protecting property rights, supportive of private enterprise. Given the severely limited domesticborrowing ability of the public sector under the Convertibility Plan, the fundamental assumption all alongin this simulation exercise is that consolidated public sector finances will be balanced.

3.10 The further opening of the economy to international trade is another basic prerequisite forsustaining high economic growth. As reviewed in the previous chapter, Argentina's low share of exportsto GDP suggests a very closed economy by international standards. There are various implications tothat phenomenon: a narrow export base leaves the economy vulnerable to external shocks; curtails therelated magnitude of imports with their corollary impact on technology transfer and productivity growth;even with a relatively moderate level of external debt, debt service becomes particularly onerous, raisingthe country's credit risk, depriving Argentina from broader access to the international financial markets.

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3.11 In the time horizon contemplated here, Argentina's exports (GNFS) as a share to GDP are raisedfrom 6.8 percent in 1994, to over 12.5 percent by the turn of the century, still a moderate share byinternational standards. Reaching that degree of openness implies double-digit real export growth rates,averaging approximately 14 percent. The fast expansion of exports in 1995 was a welcome development,that needs to be build upon. Export growth rates of that magnitude would allow, or rather require,imports to grow at double-digit rates as well, albeit at a moderately lower pace than exports. Fast exportgrowth would provide a tremendously salutary effect to the Argentine economy, but increasing theproductivity and competitiveness of 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 halfby the end of the eight year simulation period, greatly improving Argentina's standing in the internationalfinancial community. Capital inflows would be associated with increasing foreign direct investment andtrade, facilitated by the repatriation of Argentine capital deposited abroad.

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

Illustrative Proiections1994 1995 Average

(est.) 1996 1997 1998 1999 2000-2004

National AccountGDP Average Annual Growth 7.4 -4.4 2.5 5.5 6.0 6.5 7.0Totat 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 24.2PubLic 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 25.1Foreign Savings 3.5 1.4 1.6 1.7 1.6 1.5 1.5

Public Sector (Federal Government)Primary SurpLus 1.1 0.5 1.3 1.8 1.7 1.6 1.2Interest Paymnt 1.1 1.5 1.7 1.8 1.7 1.6 1.2Overall Balance -0.0 -1.0 -0.3 0.0 0.0 0.0 0.0

Balance of PaymentsTrade 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 13.0Imports 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 -1.5Capital Account 3.7 0.7 2.2 2.4 2.2 2.2 2.0

Debt IndicatorsTotal Debt 35.1 38.9 38.0 36.0 33.3 31.1 26.2Debt Service/GNFS Exports 55.4 55.8 57.4 58.9 51.8 48.3 35.0

Memo: GDP (USS billion) 280.5 276.0 290.0 314.4 342.6 375.5 504.0Total 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 economic growth, the Argentine economy should be led byexport and investment growth, with these two key contributors growing twice as fast as the economy asa whole. The targets are ambitious but reachable, as success stories in East Asia, and Argentina'sneighbor, Chile, have shown. Actually the simulated opening of the economy is much below that achievein East Asia and Chile, and investment and savings ratios remain well below those observed in East Asia.Already, Argentina has made major strides in building solid foundations towards achieving the potentialfor such growth. While the 1995 crisis created a temporary setback in a pattern of rising investment, andgenerated higher unemployment, the Government's strong and decisive measures in deflecting the regionalcrisis while staying the economic course, and recent electoral results that rejected nostalgia towardspopulism, statism and control, provided further impetus to the dramatic transformation of the Argentineeconomy.

3.13 It is in that framework, of reachable ambitious targets, and a united view both by the Governmentand the public towards the further modernization and reform-oriented process in Argentina, that thisreport now turns to selected policies which can assist in making those targets a reality.

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B. Policies Conducive to Higher Economic Growth

3.14 This section will review a number of policies, and make recommendations which could facilitatethe growth of key variables such as investment, saving, and exports. This section is followed by a reviewof Argentina's unfinished reform agenda, covering needed reforms in the provinces, and reforms in thefactor markets, i.e. labor and capital. While economic reform is a continuous process, the unfinishedreform agenda demands particularly urgent attention, since it forms part of the foundations of the reformprocess in Argentina; in their absence, progress could falter.

Investnent

3.15 The major policy challenge is to increase the traditionally low private investment rate inArgentina. The focus is principally on private investment because of the new limited role of the publicsector and the small base for public investment which accounted for only 15 percent of total investmentin 1994. Below is a discussion of the principal factors influencing the private investment behavior inArgentina.

3.16 The most important general incentive to private investment lies in the success of the governmentto maintain a stable and growing macroeconomic environment. The success of the Convertibility Planin its first four years of implementation has been in its capacity to restore economic growth. This strongrecovery was associated with growing investment demand, though this effect was delayed due to the lowutilization capacity in most sectors at the beginning of the economic recovery. The sharp reduction inmacroeconomic instability, reduced price uncertainty, as well as the reduction in ad hoc policyintervention also contributed to the increase in investment.

3.17 The Government has moved to reduce taxes that lower profitability and are disincentives toinvestment. Specifically, the Government instituted a shift from production-based towards consumption-based taxes as the revised tax structure relies heavily on the value-added tax. As a result consumption-based taxes accounted for 52 percent of total tax revenues in 1994 versus only 35 percent in 1990. Theauthorities also suspended many sectoral and regional promotion programs and implemented deregulationin several sectors of the economy aimed at reducing the "Argentine cost". Overall, the price of capitaldeclined by 11 percent relative to the GDP deflator between 1990 and 1993, reducing the quantity ofsaving required to finance an unit value of investment. 13 The cost of capital also declined in comparisonwith the cost of labor, though the Government has also started to reduce the cost of labor by reducingthe employer's wage taxes and reforming the social security system in 1994. Finally, the reduction inpublic investment, principally through the recent privatization process, also explains partially the increasein private investment. The increase in private investment observed between 1991-94 was also the resultof the virtually unprecedented boom in foreign and domestic credit. In this area, the Convertibility Planhas done far better than previous stabilization plans.

3.18 In the longer run, the capacity of the Argentine economy to increase its investment rate on asustainable basis will greatly depend on its capacity to improve the level of technology and the humancapital stock. The close link between the accumulation of physical capital and technological change has

13. A closer look indicates that this reduction is due to the decline in the price of imported capital goods (asthe result of trade liberalization and the appreciation of the exchange rate) and in the price of domestically producedcapital goods. In contrast, the cost of construction increased by 52.5 percent between April 1991 and April 1994.

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been prominently emphasized and empirically documented in a number of countries. Better technologywill not only require new investment in capital goods, but also improve productivity. Therefore,encouraging research and development should be one of the priorities of the Government in the next fewyears. Improving the stock of human capital through education will also encourage long-term investmentin physical capital in Argentina".

Policies for Encouraging Investment

3.19 The economic environment in Argentina presents relatively few distortions against investment asa result of the trade and financial liberalization process. Few exceptions remain and they are describedbelow. In short, the Government should maintain a stable macroeconomic and policy environment,eliminate distortionary promotion programs, encourage technological innovations, and reduce distortionsin the allocation of banking credit.

3.20 Stable and Growing Macroeconomic Environment. Historical experience and internationalcomparisons indicate that investment is extremely sensitive to changes in the macroeconomic environment.For this reason, the authorities should ensure:

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

(b) the restricted use of ad hoc interventions in tax and trade policy. Each change in thesepolicies increases uncertainty and postpones investment decisions. Empirical evidencesuggests that price incentives have to be unreasonably large to compensate for the negativeimpact of uncertainty on investment.

3.21 Tax Policy. The current tax system does not contain major distortions, to the contrary it seemsto be extremely favorable to investment and savings. The major tax incentives are: the exemption ofcapital gains and of interest received on deposits from the income tax, and the deduction of interest paidon debt from the income tax. At this stage, the main recommendation is to eliminate or limit a seriesof remaining promotion programs which distort the allocation of resources, and are fiscally costly. TheGovernment should: (a) eliminate the Tobacco Fund which both introduce distortions and is fiscally costly(about US$180 million); (b) gradually eliminate the current tax incentives in Tierra del Fuego. At least,the Government should eliminate the special regime for new investments and attempts to introduceceilings on the benefits of existing programs (following the example of the old industrial promotionprogram); (c) eliminate, or at least not extent, (agro)industrial promotion program adopted in the Prov-inces of La Rioja, Catamarca and San Juan which have a high annual fiscal cost; (d) eliminatepermanently the old promotion program for new investment; (e) reduce the protection of the automobileindustry (see Trade section for more specific recommendations); (e reduce tax rates (specifically of labortaxes and provincial taxes), while maintaining tax revenues through reduction in tax evasion, in order tolimit price distortions and improve the allocation of investment between the official and unofficial sectors.Such a strategy will favor the export sector which is mainly composed of large tax paying firms; and(g) eliminate the double deduction of new investment in mining.

14. A recent line of research has focused on the complementarities between investment in physical and humancapital: new and technologically advances machines and equipment need to be operated by workers with adequateskills and education.

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3.22 Research and Development and Education Policies. Encouraging the development andadaptation of foreign technology, and education, is primordial for long-run private investment inArgentina. The Government has an important role to play in both areas. A recent World Bank reporthas evaluated the research and development policy in Argentina and the following major recommendationshave been proposed: (i) administrative reforms to improve the efficiency of research and developmentagencies; (ii) institutional reforms including privatization of several activities; and (iii) financial reformsto increase the share of demand-driven projects. An important related issue is the poor treatment ofproperty rights in Argentina, even if the Government recently passed a new legislation in the beginningof 1995. There is no question about the importance of property rights for investment, but it is alsoimportant that these rights will be complemented by measures aimed at improving proper contractenforcement, otherwise property rights will be only good on paper, raising the costs of doing businessand the risks of corruption.

3.23 Financial Policy. Finally, investment is affected by the availability of financing resources. Thewell functioning of the domestic financial system is essential for providing resources to investors. Betterallocation of financial resources through the reduction of the still significant public sector banking systemwould be an important step in that direction. High spreads can be decreased by reducing operating costof the banking system, primarily by increasing its efficiency, and the reduction in the country riskpremium (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 recoveryin Argentina, but private saving is projected to be the main financing source of capital investment growthin the second phase. The reasons for this expected recovery, which started taking place in 1994 butinterrupted from the 1995 crisis, are (i) the delayed response of private saving to the economic recoveryas it generally takes time for households to adjust to a shock (of a changed economic framework); (ii)the partial substitution of public savings by private savings as the result of reduced taxes (principally labortaxes); (iii) the reform of the social security system; (iv) the development of the financial system whichhas positive impact on growth and thus on savings, compensating for the initial substitution effect of theboom in (foreign and domestic) credit; and (v) in the longer run the evolution of demographic variablesas the dependency ratio which is projected to decrease from 60 percent in 1990 to 55 percent in 2000,principally because of the reduction in the percentage of young people.'5

3.25 Economic Growth. There appears to exist a significant and positive correlation between privatesaving and economic growth in Argentina during the period 1983-93, though this correlation seems tobe lower than in recent cross-country studies. The most interesting aspect of these economic results isthat the effect of a variation in economic growth seems to be delayed over time as only 20 percent of the

15. Demographic factors play an important role in the life-cycle models as both young and old people generallysave less than middle-age working people. The decline in the dependency ratio is expected to contribute to anincrease in the saving rate. There is a considerable debate about the magnitude of such effect in the empiricalliterature, but a rough estimate is that the saving rate will increase by about 2.2 percent of GDP during this period.This figure is based on the coefficient estimated by Edwards (1994) in a cross-country study.

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total effect takes place in the first quarter6 . The low response of private saving to economic growthin Argentina during the period 1991-93 suggests that consumption adjusts gradually to its new level, orit takes time for consumers to understand that a shock occurred. As a result, consumption growth rateshave already decelerated in 1993, and future growth rates in consumption could moderate further. Thedelayed response of savings to variations in economic growth can be caused by a variety of economicfactors. Consumption is expected to overshoot in a less than fully credible fixed exchange rate-basedstabilization program as it may have happened in the first stage of the Convertibility Plan.

3.26 The recent literature has also emphasized uncertainty and habit formation as two of the mainreasons for this delay. Given a previous habit stock, saving adjusts upward only sluggishly in responseto an increase in income, this slow adjustment being reinforced in the presence of uncertainty. Finally,there are also statistical reasons for this delay. The most important reason is that people initially investin durable goods such as cars and housewares after the reform, which increased by 340 percent and 180percent, respectively, between 1991 and 1993, and only later invest in physical capital --durable goodsshould 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 areexpected to grow.

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

3.28 Private and public saving appear to be highly substitutable in Argentina because private consumershave learned over the past decade to internalize the government intertemporal budget constraint, and thusthey save more when the public sector saves less in anticipation of higher taxes or debt reimbursement".Therefore, reducing public saving through, for example the reduction of taxes, appears to be a powerfulinstrument to increase private saving in Argentina'8 . However, the Government should assess carefullythe tradeoff between private and public savings; a significant deterioration in fiscal accounts may lead toa reduction in private savings through a deterioration in the economic environment. Lower public savingmay also reduce public investment.

3.29 Shifting the composition of taxes is generally considered as an effective policy option toencourage private savings. Replacing taxes on production and on factor's income by a consumption taxincreases the propensity to save because the latter tax does not distort the choice between present andfuture consumption. In addition, a compensated shift from an income tax to a consumption tax wouldincrease current saving because individuals would have to save more during their working period tomaintain the same level of consumption in retirement. Over the past few years, the Government has

16. A simple Granger causality test cannot reject the hypothesis that growth increases first, followed by anincrease in private saving, which is also consistent with the experience in East Asian countries.

17. In a regression identifying determinants of private domestic savings in Argentina, the coefficient associatedwith public savings is not statistically different from one.

18. In the recent years, the substitutability between private and public saving has been accentuated by the recentsales of public enterprises. For example, the sale of YPF in mid-1993 resulted in an automatic transfer of savingsfrom the public to the private sector of 0.3 percent of GDP.

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followed this strategy by increasing the share of consumption-based taxes in total taxes from 35 percentin 1990 to 52 percent in 1994. The major recommendation would be to strengthen this effort byreplacing the provincial turnover tax by a consumption tax. However, the low efficiency of taxadministration in 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 positive impact of the reform on gross domestic savings will be higherif (a) the number of contributors opting for the private system gradually increasesover time; (b) the government is successful in reducing evasion; (c) the transitorydeficit of the public system is tax-financed rather than bond-financed; (d) savingsin pension funds will not substitute other forms of savings.

A simulation exercisea/ indicates that the short-run impact of the reform ongross domestic savings will range from 0.5 percent of GDP if the fiscal deficit istax-financed to 0 percent of GDP if it is bond-financed (in the absence of theRicardian equivalence). The positive impact will increase gradually over time,reaching 1 percent after 10 years, because of the gradual decline in the deficit ofthe public system. Similarly, the reform affects the composition of savings since,in the first year, it implies a shift of 0.6 percent of GDP from public to privatesavings, equivalent to about US$2.0 billion. The medium-term impact on privatesavings will closely depend on the degree of substitutability between alternativeforms of private savings and the instrument used to finance the public deficit.

The reform is expected to enhance the development of the domesticfinancial sector because: (a) the private sector is generally more efficient than thepublic sector in allocating resources; and (b) it will promote long-term investment.In that respect, the experience of Chile might be revealing since the value of theportfolio of the pension funds increased from 3.6 percent of GDP in 1982 to 35.4percent in 1992, with important shares invested in treasury bonds, mortgage bonds,and corporate equities.

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

3.30 In contrast, the Government should not extend the existing tax saving programs, such asincentives for retirement accounts. First, it is increasingly recognized that these programs do notsignificantly increase the volume of private saving. Second, they have a fiscal cost as well as theycomplicate tax administration; this would be particularly unfortunate at time when the authorities attemptto reduce tax evasion. Finally, the Government's ability to modify the net return of private savings

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instruments and, thus, to affect the households portfolio choice is greatly limited in Argentina by thecurrent level of evasion.

3.31 The recent reform of the social security system could stimulate gross domestic savings as thefuture contributions of the new capitalized pension fund system are unlikely to be offset one-to-one byreduced savings in other instruments (see above Box) . However, the effect of the reform on totalsavings will certainly be limited ranging between 0-0.5 percent of GDP. Notice that the positive effectis accentuated if the transitory public deficit is tax-financed and if the savings in private pension fundsdo not substitute alternative forms of private savings. More important seems to be the effect of the socialsecurity system reform on the composition of savings. First, it implies a shift from public saving toprivate saving, equivalent to about 0.6 percent of GDP in the first years of the reform. Second, privatepension funds have certainly a longer term horizon than other private investors and thus they could favorlong-term saving instruments. For example, in the first year of operation, Argentina's social securitysystem started to generate a large pool of long-term financial resources, to the equivalent of $2 billion,approximately 0.7 percent of GDP. The resulting longer-term effect, based on the example of Chile, isthat the domestic financial market will deepen and thus make additional resources available forinvestment. Effective regulation and supervision of this system, and reduction in pervasive evasion wouldgreatly 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 onprivate saving through their impact on economic growth. The recent literature on economic growth hasemphasized that financial development, as measured by the monetization of the economy for example,is one the most important factors explaining economic growth. However, financial policies are generallyineffective in raising private saving in the short-term. To the contrary, they are likely to reduce savingbecause of the relaxation of borrowing constraints and the ambiguous effect of interest rates.

3.33 There is a considerable debate about the effect of variations in interest rates on savings. Mostempirical studies are unable to find a significant correlation between these two variables because ofcontradictory effects. Similarly, in the case of Argentina, the impact of interest rates on private savinghas been found to be insignificant over the last decade. This result can be due to the presence of liquidityconstraints, which are likely to be important in Argentina, limiting the response of private investors tovariations in the interest rates.

3.34 The boom in domestic credit, and the greater access to foreign savings have reduced significantlyborrowing constraints in Argentina. The increase in foreign saving is estimated to have reduced privatesavings by 1.0-1.3 percent of GDP between 1991 and 1993 because non-liquidity-constrained consumershave to accumulate less wealth to purchase durable goods.'9 Yet, it is important to point out that ifthe massive capital inflow has partially substituted domestic saving through the relaxation of borrowingconstraint and the financing of consumption activities, it has also resulted in a dramatic change in the

19. The estimated parameter associated with foreign capital should be taken with caution because therelationship between domestic and foreign savings may be more incidental than causal. To illustrate this point inthe case of Argentina, the fiscal adjustment in 1990-93 affected both foreign and domestic (private) savings but inopposite directions. The impact on foreign saving was positive because the fiscal adjustment improved the country'sinternational creditworthiness, while the impact on private domestic savings was negative because public and privatesavings are highly substitutable. As a result, the correlation between domestic private savings and foreign savingsis negative, though there is no causal link between these two variables.

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composition of private saving in favor of domestic assets and away from capital flight. This improvementin the portfolio allocation will gradually offset the negative initial impact of foreign savings on domesticsavings and investment.

3.35 The Argentine Government is pursuing a strong effort to develop the domestic capital market byincreasing the 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 financialsavings, they do not necessarily increase overall private saving. In the longer-term, financial reformsmay contribute to overall saving through their indirect positive impact on growth.

3.36 Broadening the range of financial instruments will contribute to economic growth by makingadditional resources available to investment. Reforms such as trade liberalization, enterpriseprivatization, and pension reform have improved the allocation of resources by increasing the proportionof households savings invested in the financial system. The Government can accelerate this processthrough reforms in the banking system and capital markets (presented in the Financial Marketssection)'.

International Trade Regime

3.37 Since the late eighties, Argentina has achieved a radical change in its trade regime. The changeis seen in nearly all the traditional measures of trade liberalization. Nominal protection has beensignificantly reduced, with the average nominal import tariff declining from 30 percent in 1989 to 14percent in March 1995. The variance in nominal protection has also been reduced. The trade regime hasbeen liberalized and QRs substantially reduced. The bias against exports has also been considerablyreduced. As discussed in the previous chapter, trade liberalization has led, in the context of theConvertibility Plan, to the acceleration in exports and economic growth.

3.38 Other policies have also been conducive to the expansion of trade. Tax policies, for example,are relatively favorable to exports. The income tax rate, at 30 percent, is lower than in most developedand some less developed countries and taxes on consumption have increased their share in the total taxbill, accounting for half of the total revenue of the national and provincial governments. The mostimportant tax on consumption is the VAT which allows for border tax adjustments, while the impact ofother indirect taxes is more than offset by tax reimbursements on exports.

3.39 Financial policies have been questioned as a deterrent of exports in Argentina because ofunusually high banking spreads. However, large exporters usually pay the lowest rates in the market,similar to international rates plus the country risk premium, because they have a good collateral in exportcontracts. For small and medium size firms that might encounter difficulties in getting access to credit,the Government has launched several loan programs that favor increases in exports. These programscharge interest rates that are lower than actual market rates in Argentina, but are higher than internationalrates.

3.40 Despite policies that are conducive to the expansion of trade, since October 1991 there has alsobeen an increasing complexity of the trade regime. First, the number of tariff tiers has increasedprogressively from three to seven. Second, quantitative restrictions were extended from the automobile

20. A series of recommendation have also been proposed in the recent Capital Market Study (June 1994).

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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 forspecial benefits ar examples of these non-automatic policies. The increasing complexity of the traderegime led to greater widening of effective protection, even though the average level has remained lowby 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 adoptionof the mirror principle which has increased discretionality. The existing tariff structure tends to protectthe local production of those goods in which the country is relatively more inefficient. The 1992instituted system of "mirror export subsidies" grants to each export product the same rate of subsidy asthat corresponding to imports of the same product. Since import duties are larger the more inefficientthe industry is, the new system of export subsidies grants larger subsidies to the more inefficientindustries and smaller subsidies to the more efficient industries. This system maximizes the losses fromprotection since it aims to expand production in the inefficient sectors (e.g. the automobile sector), andto contract production in those which are efficient (e.g. agriculture or agro-industrial products whichreceive 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 exportreimbursements, tax rebates on exports reduced tax revenues by $1 billion annually; since they wereexempt from income taxes, there was an additional subsidy of about $300 million. A second relatedproblem is that tax reimbursements on exports can be used together with the temporary admissionprogram and were fixed at levels that reach 20 percent for some industrial products2". They clearlyoverestimate the indirect tax incidence allowed by the GATT rules and might be subject to retaliationfrom foreign countries.

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

21. Exporters should be allowed to use either temporary admission or tax reimbursements, and not both asoccurs in Argentina.

22. The low effective protection of traditional exportables is caused by: (a) the subsidies on exports receivedby their main (exportable) inputs that increase the price they pay for their in the domestic market above intemationalprices; and (b) primary products cannot use the temporary admission program for the purchase of inputs becauseof the long gestation period of their production that usually exceeds the maximum number of days (180 days) thatimported inputs are allowed to be held free of duty in Argentina before being reexported.

23. A computable general equilibrium (CGE) model was run to assess the impact of three alternative policies:(a) the introduction of a uniform import tariff of 10 percent and a 50 percent reduction of tax reimbursements onexports; (b) the immediate elimination of all employers' contributions to social security compensating the loss infiscal revenues with a higher VAT rate; and (c) the replacement of the provincial turnover sales tax by a retail sales

(continued...)

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3.44 There are other implicit subsidies to exports hidden in industrial specialization programs. Firmscan benefit from a reduction in the tariff on imports of their inputs or competing products purchaseddirectly by them if they increase their exports. The impact of these programs has been small, but theyhave a fiscal cost and contribute to the concentration of the Argentine industry. The most importantspecialization program is the automobile industry regime that enjoys a subsidy for the reduction of importtariffs of their inputs or for own imports of finished cars of almost $300 million per year.

3.45 Attempts to manage sectoral trade incentives, as in the automobile regime, could prove to becostly. The automobile regime itself is inordinately complex. There is no good economic reason whythat industry should have a special regime, especially in a patently liberalizing atmosphere. Moreover,the balancing of exports with imports by industry is not desirable in a multilateral and multi-commoditytrade system, since increased inefficiency arising from one industry can spread quickly into otherindustries through input-output relations and through groups lobbying to receive concessions that becomeavailable in the political market.

3.46 The use of quantitative restrictions and antidumping during 1993 and 1994 has also affected someexporters because they have to pay higher prices for some of their inputs. In particular, some preventiveantidumping actions have been applied which are difficult to justify from an economic point of view.Nevertheless, quantitative restrictions and antidumping have affected a small group of goods, and a fewof them, particularly quantitative restrictions, have not been extended after their expiration.

3.47 Another policy issue relates to the continuing concessions granted to the special areas such asTierra del Fuego and Patagonia. Trade instruments are being used to provide incentives for regionaldevelopment, through higher reimbursements for exports from these areas and reduced tariffs on capitalgoods imports. The trade instrument is not appropriate for supporting regional development.

3.48 Finally, trade issues relating to MERCOSUR could pose important challenges for Argentina'spolicy makers. Increasing trade links with Brazil pose issues of coordination of macroeconomic policiesand the harmonization of regulatory environments to maintain balance of payments viability with Braziland to increase competition among the Mercosur group of countries, respectively. To the extentmacroeconomic coordination issues are not reconciled there will be tensions in the trade relations betweenthese two countries. This might give rise to use of non-competitive remedies such as the use of anti-dumping, quantitative restrictions, ad hoc tariffs, and taxes, which could damage the liberal trade regime.

3.49 These policies already carry important fiscal and efficiency costs to the economy, at a time whenthe Administration is faced with the growing challenge of improving its fiscal accounts. For example,

23.(. ..continued)tax. Results are as follows:

In alternative (a), the introduction of a more neutral policy of import substitution and export promotionallows real exports to growth by 17 percent and investment by 2.5 percent. In alternative (b), the impact ofaccelerating the reduction in labor taxes for all economic sectors, but maintaining tax revenues constant byincreasing the VAT, is an increase in total exports by 17.4 percent, and investment by 1.5 percent. In alternative(c), exports grew by 8.5 percent, and investment by 1.4 percent, after the introduction of a more neutral tax thatreplaces the cascading provincial sales tax. The three alternatives suggest that there is an important gain in exportpotential and social welfare that might be achieved if improved economic policies are adopted.

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annual fiscal cost of the various export promotion programs in effect during 1994, have been estimatedat $1.6 billion, up from $630 million in 1990. These fiscal costs do not include the impact of subsidizedexport credit programs, provided through the financial system. Furthermore, the above costs do notinclude the cost to consumers; the automobile industry alone, adding consumer to the fiscal costs of theindustrial regime, create a joint transfer cost of $1.7 to billion, annually. In 1995 and early 1996, theGovernment took measures to cut export reimbursements.

3.50 Frequent changes in trade policy as those observed in Argentina during 1993 and 1995 have anegative impact on export and investment potential, since their profitability becomes more uncertain.Moreover, they tend to give mixed signals to businessmen by assigning a higher value to rent seekingactivities, compared to a system of more automatic policies.

Recommendations

3.51 A fundamental recommendation is the maintenance of macroeconomic stability as the first lineof defense in keeping the trade regime open. Macroeconomic instability can unravel even the most liberalof trade regimes. This has been the experience of Argentina in the past as well as countries around theworld. The track record of stable and consistent macroeconomic policies of the last five years isreassuring that such macroeconomic stability is achievable.

3.52 Exports are a function of structural reforms, such as the size of the public sector and laborreform. High labor cost due to wage taxes and regulation, coupled with high protection of other basicinput industries add to the "argentine cost" and restrain export potential. With a slowdown in capitalinflows, resources should move into the export sector and imports should decelerate requiring a changein 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 iswhat normally happened in Argentina in response to change in demand: resources moved little and pricesexperienced drastic movements. The optimal response for Argentina, thus, seems to be to continue withthe path of structural adjustment,adding flexibility to the economy, so as to minimize the need for realexchange rate adjustment in case of a slowdown in capital inflows.

3.53 Considering the overall consequences of trade and indirect tax policies on exports, there is a needfor change towards simplicity, transparency and automaticity of economic policy instruments. Thecreation of a stable and predictable trade regime would benefit significantly the growth of exports andinvestment. In that context, the following more specific recommendations are worth considering:

(a) First, the automobile regime and the "industrial specialization" regimes require re-examination. They detract from neutral incentives, introduce unnecessary complexity andprovide opportunities for discretion that could be damaging for liberal trade. Additionally,as mentioned above, the rent transferred to automobile producers is substantial. Eliminatingthe benefits that go beyond the maximum tariff will cut this rent by about 40 percent. Aswas 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 ofprices in allocating resources. Moreover, the automobile regime and the "industrialspecialization" regimes introduce rigidities into the production structure and make futureadjustments more difficult. The government could announce now the discontinuation of theregimes beyond 1999 when the "industrialization specialization" regimes are to be reviewed,in order to prepare the ground for a level playing field.

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(b) Second, it would be advisable to do away with mirror principle altogether as the means toprovide neutrality between exports and import substituting industries. There are easier andmore efficient ways of providing neutrality for exports. This could be done through a lowgeneral tariff, and automatic reimbursement of tariff paid on inputs used for the productionof exports. This automaticity would help to reduce the rigidity of a finely tuned system andalso help to prevent rent seeking involved in the reimbursements when some imports couldbe misclassified to create rents.

(c) Third, there is little justification to use trade policy to promote regional development. Thespecial concessions granted to Tierra del Fuego and Patagonian provinces through the traderegime is a vestige of past protectionist regimes. Moreover, subsidies of this type are notconsistent with the new rules of WTO. However, the new rules do provide support forregional development using non-trade related instruments. Argentina needs to consider theappropriate instrument to promote the development of these regions and desist the pressuresto subsidize particular exports. Regional grants, infrastructure creation and such means aresuperior instruments of regional policy. Besides, they do not distort the trade regime.

(d) Fourth, with the creation of the National Trade Commission (NTC), Argentina hasestablished the institutional means to consider trade policy making and to make decisions oncontingent protection on a nationwide basis. The work of the Commission could prove tobe very important in a post trade liberalization era, by giving permanence to the liberalizedtrade regime. Therefore, the Commission should be strengthened in its technical capacity,its representation made independent and balanced to consider requests for contingentprotection with the interest of consumers in mind. The commission could adopt the new rulesfor safeguards, anti-dumping and countervailing actions consistent with new World TradeOrganization rules. These rules could indeed be improved upon to rely more on the safeguardmechanism rather than on preventive anti-dumping actions which had increased in recentyears.

(e) Finally, Argentina should consider a smooth transition to the Mercosur CET and use its goodoffices to increase international competition of the group as well as among the membercountries. It is highly recommended that Argentina's position in MERCOSUR shift towardsthe adoption of a uniform and low common external tariff. Argentina should also considerwhether the 20 percent across the board tariff is appropriate when many of its competitorssuch as Chile, Colombia and Mexico have lower tariffs. In this regard, it would benecessary to bring the 15 percent of the tariff lines outside the CET under the CET and resistpressures in the interim period to apply rules of origin to increase protection. In order toincrease competition within the Mercosur agreement, it would be necessary to harmonizeregulatory frameworks as well as resist pressure to use contingent protection within thegroup. It would be possible to balance consumer and producer interests in trade policyworking as a means of maintaining liberal trade. This could be done through the newlyestablished National Trade Commission, by adopting WTO consistent rules for transparenttrade decision making. This should provide consistency among the WTO, Mercosur anddomestic rules and give greater credibility to the liberal trade regime.

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C. The Unfinished Reform Agenda

3.54 The review of policies affecting investment, saving, and exports suggests that, while there is roomfor improvement, the fundamental policy structures directly affecting them, are sound. Yet, theArgentine reform agenda has significant gaps, that require immediate attention, if the economy's potentialis to materialize. Provinces, accounting for the majority of public spending, despite encouraging signsof reform, have considerable ways to go in reforming of their fiscal management and the efficiencycharacterizing their expenditures. Lack of progress in provincial refomis could undermine reforms effortsat the Federal Government level, and as a consequence, the Convertibility Plan. Beyond the publicfinance issue, the Argentine economy would benefit from the liberalization of its labor markets, and thereform of its financial system. The reform of its factor markets is imperative, for the economy to gainflexibility, in order to respond to the challenges that the Convertibility Plan imposes to an open economy,and enable it to absorb better external shocks, such as those recently experienced. Reform of the factormarkets would contribute to improved productivity, and mitigate economic instability, which are crucialfactors for the expansion of saving, investment and 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 forintergovernmental relations:

(a) adequacy and clarity in assignment of responsibilities;

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

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

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 widespreaddecentralization of delivery responsibility is clear, considerable concems remain regarding theefficiency with which decentralized, provincial goods and services are delivered, as will be discussedbelow.

3.57 Adequacy of revenues has at least two important dimensions. First is adequacy to meetexpenditures mandated to the provinces. Second is whether the sources of revenues provide incentivesto spend resources efficiently. With respect to the first dimension, the aggregate provincial deficits ofrecent years do not seem to result from insufficient transfers from the federal govenmment. The deficitsarose during a period when total provincial revenues increased by 34 percent in real terms (1991-1994),and the transfer of additional social sector responsibilities added no more than 5-10 percent to aggregateprovincial expenditures.

3.58 The second dimension is closely related to the degree of accountability of public officials,andhow that accountability is affected by the system of intergovernmental relations. This issue often ariseswhen provinces are spending what appears to be "other people's money." The degree of fiscal

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dependence varies widely across Argentine provinces, with own revenues financing the following sharesof total expenditures: 60 percent in "advanced" provinces, 36 percent in low population densityprovinces, 39 percent in "intermediate" provinces, and 21 percent in underdeveloped provinces. Anumber of studies have revealed inefficiencies at the provincial level which have resulted in the largeaggregate deficits of recent years. A lack of clear correspondence between the payers and recipients ofservices 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 dataon Table 14 point to a strong regional redistribution of provincial expenditures, due in large part to thecoparticipation regime (complemented by other central grant transfers). Provinces are grouped accordingto categories frequently used in Argentina for provincial analysis. Advanced provinces, characterizedby large populations and high provincial product, receive substantially less per capita coparticipationrevenues than provinces of the other groups. This suggests that the adequacy of provincial revenues isnot a key issue, at least from the perspective of regional redistribution of income to provinces outside theadvanced group. As concluded in a recent Bank study, "the regional redistribution of income probablyhas 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 TotaLRevenues Revenues fers ditures own Revenues Revenues

AdvancedMCBA 2,977.1 8.7 28 1.1 52.9 20.0 854.0 1.0Buenos Aires 13,112.7 38.5 (280) (3.7) 192.0 82.0 629.0 2.2 2,930 38.8Cordoba 2,873.5 8.4 (397) (19.8) 309.0 55.0 868.0 2.8 1,600 80.7Mendoza 1,478.0 4.3 (34) (3.2) 308.0 124.0 784.0 2.8 800 78.4Santa Fe 2,896.8 8.5 (215) (10.5) 334.0 77.0 809.0 2.7 187 9.0

Low DensityChubut 388.2 1.1 (202) (41.1) 464.0 645.0 1943.0 11.3 101 21.1La Pampa 276.2 0.8 (3) (0.6) 720.0 441.0 1792.0 3.6 22 4.9Neuquen 441.6 1.3 (256) (28.6) 444.0 1120.0 2958.0 6.2 58 7.2Rio Negro 546.9 1.6 (208) (37.5) 474.0 349.0 1506.0 6.2 445 77.5Santa Cruz 174.9 0.5 (38) (7.0) 938.0 1721.0 3629.0 11.4 77 15.7T. del Fuego 87.7 0.3 (66) (21.8) 1051.0 2362.0 5319.0 15.4 24 7.6

IntermediateEntre Rios 1,053.1 3.1 (160) (17.5) 494.0 123.0 1055.0 3.2 590 59.5Salta 931.7 2.7 (99) (13.7) 442.0 176.0 948.0 5.9 282 39.6San Juan 547.2 1.6 (164) (31.1) 629.0 222.0 1309.0 9.4 239 45.9San Luis 310.0 0.9 50 11.1 778.6 385.0 1400.0 6.9 17 4.0Tucuman 1,193.2 3.5 (227) (29.2) 421.0 116.0 880.0 7.3 607 78.3

UnderdeveLopedCatamarca 282.2 0.8 (64) (17.4) 1013.3 275.0 1635.0 66.7 193 51.9Chaco 881.9 2.6 (110) (15.6) 571.4 138.0 968.0 11.3 560 80.4Corrientes 836.7 2.5 (60) (10.1) 466.0 163.0 822.0 9.9 638 108.4Formosa 432.1 1.3 (151) (30.2) 869.0 288.0 1634.0 126.9 365 72.3Jujuy 544.4 1.6 (193) (37.9) 561.0 206.0 1370.0 8.4 324 65.0La Rioja 239.3 0.7 (53) (9.9) 931.0 1375.0 2673.0 337.6 542 99.9Misiones 854.4 2.5 (145) (25.3) 417.7 174.0 909.0 11.7 255 44.7S. 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.

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3.60 One of the most important criteria for evaluating intergovernmental fiscal relations is the degreeto which each level of government has adequate resources to provide certain minimum standards ofservices to all citizens, independently of the jurisdiction in which they reside. This is especially importantfor human resource services, not only for their inherent importance for development, but also becauseonce "capitalized" within the individual, they may migrate between jurisdictions. Table 15 presents theallocation of provincial social expenditures by provincial group. Table 15 indicates significantly highersocial expenditures per capita outside the advanced group, especially in Low Density and Underdevelopedprovinces. This reinforces the conclusions derived from Table 14 data and suggests that social spendingis not being undermined in non-advanced provinces.

3.61 Efficiency of Expenditures and the Wage Bill. Although data are inadequate to evaluate theperformance of provincial expenditure programs (e.g. education, health, transport), there is evidence thatserious inefficiencies exist in some types of overhead expenditures. For example, provincial wage billsconstitute a heavy burden on many provincial treasuries, such as the provinces of La Rioja, Catamarca,Corrientes, Formosa, Neuquen, Santa Cruz, and Tierra del Fuego where about one fifth of employedworkers were in the public sector in 1992. In particular, public education has been used extensively toprovide jobs, and in most provinces accounts for more than 40 percent of total public employment. Withinadequate administrative controls, nontenured positions for teachers tripled during the past decade as didleaves of absence. As a result, the average number of students per teacher in the provinces is 11, ascompared to 19 students in Chile and 22 students in Spain. Such apparent coverage, however, has notimproved the quality of education, as reflected by most surveys. One part of this problem, in manyprovinces, is the excessive use of substitute teachers, and even substitutes for substitutes, to a level wellbeyond any normal degree of absenteeism. On any given day, there may be several teachers being paidto teach one class.

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

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

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

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

3.62 The evidence suggests, therefore, that the key issue for evaluating provincial fiscal adequacy tomeet assigned responsibilities is in the area of expenditure efficiency. The issue is less the amount ofprovincial revenues than in how efficiently existing revenues are allocated. To address the issue ofexpenditure efficiency, the criterion of the accountability of provincial officials should be examined.

3.63 In summary, a key issue for intergovernmental relations that promote improvement in provincialfiscal performance is lack of accountability of many provincial officials. This stems from a high levelof central financing of provincial expenditures, and the lack of incentive for provincial authorities toconfront their citizens with the costs of their preferences. Weak accountability undermines incentives forprovincial fiscal balance (with notable exceptions) and for provincial expenditure efficiency (apparentlywidespread). At stake is the quality and coverage of basic services in the areas of infrastructure, socialservices and poverty alleviation.

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Recommendations for Reform

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

Intergovernmental Fiscal Relations

3.65 Throughout this section, issues resulting from Argentina's current system of intergovernmentalfiscal transfers have been emphasized. These include the mismatch between provincial expenditureresponsibilities and own-source revenue authority, and the resulting lack of incentives for many provincesto be concerned with (i) the quality of their expenditures or (ii) revenue effort on their current revenuebase.

3.66 To address these issues, two basic reform strategies are discussed below. The first may betermed a "structural reform" in intergovernmental relations, with fundamental changes in the rules of thegame for intergovernmental relations. The second strategy may be considered "reforms at the margin".This strategy accepts the fundamental rules of the game currently in place for intergovernmental fiscalrelations, but it seeks to identify areas of policy "fine tuning" that would provide incentives for betterprovincial service delivery and financial management. These two strategies are not necessarily mutuallyexclusive; the second may serve as a transition vehicle to the first.

3.67 Structural Reform. What should be the medium-term "vision" of intergovernmental fiscalrelations that promote provincial expenditure efficiency and accountability, and what reforms in thestructure of these relations will be required to achieve these objectives? As a general vision of thisreform, it is recommended that the following be considered: expenditure decentralization to themaximum extent compatible with the efficient delivery of public goods. This is consistent with the"principle of subsidiarity", that the provision of public services should be assigned to the lowest level ofgovernment that can finance them at the least cost, administer them efficiently, and achieve their publicpurposes effectively.

3.68 Reform based on the principle of subsidiarity also would need to take into account the followingimportant considerations.

(a) Fiscal accountability, seeking to promote allocative efficiency through having the jurisdictionthat provides services pay for them to the maximum extent feasible through own-sourcerevenues. In other words, finance should follow function in order to promote accountabilitythrough confronting beneficiaries with the costs of their preferences. In this regard,alternatives to the current system of coparticipation need to be explored, such as thedevolution of some national tax bases to the subnational level, including the option ofdiscretionary provincial surcharges ("piggy-backing"), for such taxes as income, excise andfuel.

(b) Distributional policy, seeking to promote equality of opportunity and reductions in extremepoverty. When devolution and/or sharing (e.g., piggy-backing) of national tax bases are notsufficient to promote these equity objectives, then a system of intergovernmental fiscaltransfers targeted on these objectives needs to be defined. The current coparticipation systemtends to focus on the territorial jurisdiction of the provinces as the object of fiscal transfers.To promote distributional objectives, this focus needs to be complemented by the household

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A PROVINCIAL REFORM AGENDA: THE CASE OF CORDOBA

1. C6rdoba is the third largest provincial economy. Its public sector is facing a financial crisis witha detrimental impact on its economy. Cordoba's fiscal situation deteriorated in the early nineties, despitesignificant increases in coparticipated revenues and own tax revenues, resulting from the stabilization andrecovery of the national economy. Sharp increases in expenditures across the board, led to overalldeficits averaging 19.5 percent of current expenditures in both 1993 and 1994. The role of the publicsector needs to be recast from an inhibitor to overall economic growth, to a legitimate provider ofaffordable social goods, and supporter of economic growth. There is a need for a profound reallocationof resources from the public to the private sectors, that will strengthen both sectors. As a consequenceof this reallocation, Cordoba will be able to attain a first goal of financial creditworthiness, primarilyby strengthening public finances, fulfilling in that process conditions for sustained development. Asecond, equally important goal would be to increase the efficiency of public expenditures, allowing forthe improved delivery of social services in the context of fiscal balance. A leaner and more efficientpublic sector would be to the benefit of Cordoba's economy.

2. The recent Latin American crisis accentuated the province's financial problems, and in the midstof social unrest, the previous administration left office in July, 1995, five months earlier than anticipated.A new administration was forced to engage immediately in crisis management, taking strong measuresto curtail fiscal spending through the implementation of an Emergency Law. While the national economiccrisis affected C6rdoba's economy, the causes of Cordoba's economic crisis go deeper, and are theresult of locally grown imbalances. There is need for a fundamental reform of the public sector, notonly to address the current crisis, but strengthen future economic prospects as well. While the transitioncosts of the adjustment could be important, an immediate transition would mitigate its future larger costs.Recommendations for the reform of the province include:

Reforms for the Short Term

-- Replace the Emergency Law in 1996 with a sustainable fiscal savings plan.-- Cease the use of bonds as means of payment in the context of a fiscal and debt workout;-- Cut personnel expenditures to balance the budget;-- To facilitate the adjustment and increase efficiency, privatize banks and other public

enterprises;-- Sign the Pacto Fiscal, to access the minimum coparticipation guarantee;-- Transfer the Social Security System to the National Government and-- Create a more effective Social Safety Net.

Reforms for the Medium Term

-- Implement health reform, by providing health insurance rather than free care in publichospitals;

-- Implement education reform through effective control over personnel expenditures, increasedstudent/teacher ratio, reoriented expenditures to educational services, improved equity withricher students paying more for education, and modernized curricula;

-- Implement Social Welfare reform by significantly improving targeting;-- Implement Civil Service Reform, by creating merit based mechanisms, such as a competitive

selection process and a results-oriented assessment process, by decentralizing managerialresponsibility, and introducing technological innovations that reduce labor requirements.

-- Streamline municipal coparticipation by simplifying the transfer formula, furtherdecentralizing functions, and eliminating distortive incentives;

-- Increase revenues by amplifying the tax base and improving tax collections, while decreasingtax rates to support private sector development and employment;

-- Increase capital expenditures to support the growth of the private sector;-- Establish an economic, statistical, and financial data base for the public sector and the

province.

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as the object of fiscal transfers. This indicates that intergovernmental fiscal transfers need to be allocatedprimarily according to a measure of poverty distribution for the financing of primary and secondaryeducation and health, as well as other programs of national priority, primarily for poverty alleviation(e.g., housing, potable water and nutrition). Closely linking implementation of minimum levels ofnational social program objectives through subnational governments also may require much higher degreesof earmarking for intergovernmental fiscal transfers than now is the case.

3.69 Potential conflicts should be recognized, between the different intergovernmental fiscal reformobjectives and measures noted above. The first potential conflict is between subnational fiscalaccountability and redistributional policies that result in central fiscal transfers to implement nationalsocial policies. The response proposed is to make these transfers (i) conditional on effective servicedelivery, and (ii) based on indicators that could not be easily distorted, such as census data on population,poverty measures, and number of students. A minimum level of subnational government counterpartfinancing for social expenditures, especially programs that are difficult to monitor from the center, alsowould be required under the proposal. The basic thrust is to guarantee minimum national standards forsocial policy programs, financed with fiscal transfers, that may be complemented through local fiscaleffort so that the allocative efficiency benefits of fiscal accountability may be achieved. Another potentialconflict is with decentralization and allocative efficiency. The reform should seek to eliminatepossibilities of subnational governments providing fiscal or other artificial incentives (e.g., provincialversions of "promocion industrial") to influence the location of productive activities.

3.70 In sunmary, structural reform to address the issue of poor provincial expenditure efficiencyincludes expanding the provincial own-source revenue base to bring it more in line with provincialexpenditure responsibilities, and decreasing the high dependence of provinces on fiscal transfers.Requiring provincial authorities to confront their constituents with the costs of their preferences may beexpected to promote enhanced efficiency in the allocation of resources and greater economy with whichthese 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 approximatelyUS$4.8 billion that are transferred to provinces outside the coparticipation system. Most of thesetransfers are made through special purpose funds, such as the FONAVI housing program and theElectricity and National Highway Funds. With the agreement of the provinces, some or all of theseresources could be consolidated into a program of grants allocated to provinces on the basis of theirperformance. Provincial performance criteria might include current savings, effectiveness in meetingexpenditure responsibilities, especially in education, health and poverty alleviation, and/or streamliningprovincial administrations (in which case the incremental grants could finance adjustment costs such asseverance payments). Such a performance-based grant program, at the margin of coparticipation, couldprovide incentives for better provincial performance in discharging their responsibilities. It wouldrequire, however, clear and broadly accepted provincial performance indicators measured with transparentand reasonably accurate data.

3.72 Although probably more politically difficult than the first option, a second option could bereforms in the participation of each province in coparticipation taxes. As noted above, central transfersfavor heavily those provinces outside the advanced region, and social expenditures per capita generallyare significantly higher in those provinces. Yet, almost 60 percent of Argentina's poor live in theadvanced provinces. This proportion may increase as liberalized market forces attract more poor familiesto areas of expanding employment.

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3.73 Starting from the premise that the central government's first responsibility in designing anintergovernmental fiscal system is to ensure financing (transfers and subnational own-source) for basichuman services, with broadly equal access by all citizens regardless of the jurisdiction in which theyreside, the Government should re-examine the distributional formula for coparticipation to ensure thatnational objectives for interpersonal equity are being met.

Relations between Provincial Governments and the Financial Sector

3.74 The most productive and sustainable relationship between provincial governments and Argentina'sfinancial sector should be beneficial to both the financial sector and provincial development. A generalrecommendations would be that provinces should finance their investment programs through their currentaccount saving balances leveraged, when appropriate, with borrowing from the capital markets.Provinces should compete with alternative borrowers (e.g., agriculture, industry, commerce) with nospecial privileges that would handicap other public or private sector investors with potentially moreproductive use of resources.

3.75 Provinces (and other subnational government units) could borrow responsibly to finance partiallytheir investment needs competitively, and prudently to promote at least three important benefits:

(a) Expenditure efficiency, as borrowing promotes economies of scale and lower unit costs ofconstruction for lumpy investments when compared to pay-as-you-go financing.

(b) Interpersonal equity, as payment of costs corresponds more closely to the flow of benefits,and this is a significant concern at the subnational level because of migrations across localjurisdictions. For newcomers, the free-rider issue is reduced (even if local public investmentbenefits are capitalized in private property values) as they should pay for investment costsduring the period they are receiving benefits from them.

(c) In order to have access to the capital markets, provinces will need to have accurate andappropriate financial accounting and reporting systems, as well as investment programs thatare properly designed, financed and operated, as noted above. Also, there must be fulldisclosure of this information to the public domain. This increase in transparency promotespublic accountability and market discipline on government decisions.

3.76 In order to better link the demand for investment financing of subnational government with thepotential supply of loans from the private financial sector, several regulatory prerequisites need to be inplace. These include the following:

(a) Severely curtail the use of coparticipated funds guarantee as collateral, which has been widelyused for borrowing in the financial markets, irrespective of the destination of funds;

(b) Generate appropriate data on subnational investment executing entities, including overallfinancial performance, as well as evaluation of the technical and rinancial quality of specificinvestment projects for which loan financing is sought;

(c) The legal and regulatory framework needs to be strengthened, but this framework needsto be strengthened and expanded to facilitate subnational government access to the capitalmarkets, as well as to provide safeguards for macroeconomic policies.

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3.77 The quality of subnational government investment proposals and of general subnational financialmanagement, and the financial sector's capacity to respond to subnational government investmentfinancing demands is not currently at a level consistent with a significant financial sector response to theseinvestment financing needs. However, the prospects of a significant response are considerably greaterthan just a few years ago. A transition strategy should support market-based appropriate subnationalgovernment 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 theeconomy 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 growthdropped to -1 percent, yet over the period yearly employment growth averaged 1 percent, and total factorproductivity 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 theycontinued to experience low productivity levels. When the economy was deregulated and competitionincreased through the opening of the trade regime, the expected sectoral shocks and labor turnoveroccurred, a desirable outcome from an efficiency standpoint. However, a highly centralized and rigidlabor market hindered mobility, shifts, reabsorption of displaced labor, and wage flexibility, which madethe adjustment to a new equilibrium both costlier and longer. Increases in real wages and increasingincidence of heads of household unemployment, led to rapid surges in labor force participationparticularly of women. In addition, the new exchange rate parity, decreases in the relative price ofcapital, 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 ofunemployment, 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 employmentgrowth during the first two years of the Plan, 1991 and 1992, and a decline beginning toward the endof 1993 and continuing in 1994 and 1995. Despite the Argentine economy's impressive growthperformance of 31 percent between 1991 and 1994, the increase in net jobs created for the period wasonly 3.7 percent (about 427,000). In 1994, a net decrease in total employment occurred of nearly 2percent, despite GDP growth of over 7 percent. More distressing is that in both 1993 and 1994, thenumber of full time jobs decreased while the number of underemployed--which statistically are countedas "employed"--has increased by nearly 8 percent, particularly in the Greater Buenos Aires. Notsurprisingly and consistent with global trends, employment shifted from manufacturing (19.9 percent) toservices (61.4 percent). Also as expected, the sectors losing the most employment were the morevulnerable and less efficient tradeable sectors, such as textiles and clothing. Job creation, and particularlyfull time jobs, has been lagging behind. Job creation has mainly taken place in the food industry and

25. Some of the data on which unemployment and wage analyses are based are not always reliable, e.g.,they may underestimate employment creation and earnings in relatively informal activities such as domesticservice. Recent initiatives to improve labor market data are welcome steps in improving the reliability of data,especially for unemployment rates and duration.

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service sector and mostly in small and medium size enterprises; however, it has not been nearly enoughto cover losses in other sectors and to absorb increases in population and labor force participation.

3.80 The unemployment rate reached a historichigh of 18.6% country wide and 20.2% in GBA in Unemployment RatesMay 1995, accompanied by increased duration of Urban Cugbmeratsm rd Grealer B.Aunemployment spells and structural unemployment.This increase was also related to significant increasesin labor force participation in 1995 reaching levels of 2

45.9 percent.

3.81 The average duration of an unemploymentspell has increase significantly reaching in 1995, over ,45 weeks, up from 32.2 weeks in 1994, and 12.9weeks in 1991, with nearly 20% of the unemployed ,remaining unemployed for over a year. This is aconcern since long-term unemployment is far more ,34 +X/|d A- Q .W!1 '1Yk 7W b Al 5(. 3' 2

damaging than short-term. Those affected often ; 14 ,5 X VC7r (e-I C19 OEC M 1 iE3 .84 M05; Cos X CcO (.;1 0r NI :

become separated permanently from the labor force. G Groaiw e A& - Urb8,C-r:.rrQraaD

Since economic and sectoral adjustments are not yetcompleted, a return of employment output elasticity to Source data: INDECits "normal" levels (0.30 to 0. 15) is still pending--for Figure 8example, sectors such as financial and other services,commerce, agriculture, and some manufacturing are still in the process of restructuring and can beexpected to further substitute capital for labor. Most sectors show employment contraction, with theexception of services and commerce. In the wake of the economic slowdown in early 1995, a number ofyet unrestructured sectors have further reduced their employment levels (e.g., financial, commerce, andservices), and labor force participation increased further, contributing to the further increase and recordsin unemployment.

Table 16: Unemployment Rates by Age and Sex CategoryGBA, EPH

OCT OCT MAY OCT MAY OCT MAY OCT MAY87 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

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3.82 The Govermnent has responded with labor institutional reforms and aggressive but not veryefficient job-creation program, which accounted for nearly 50,000 jobs in 1993 and an additional 100,000in 1994. Despite this effort, the employment\unemployment picture remains problematic. The data ofOctober 1995, showing a decrease in unemployment to the 16.6% level, may indicate the beginning ofa recovery. However, the decrease has been mostly due to a decrease in labor force participation from45.9% to 44.2%, since there was no job creation to speak of from May to October 1995. Moreover, theOctober data indicates a jump in the unemployment rate of heads of households to 11.5 percent, up from9.3 percent in May, and an increase in monthly unemployment insurance claims from 100,000 to145,000.

Wage and Earnings Performance

3.83 Despite the significant increases in labor supply and unemployment, real wages and earnings havebeen increasing steadily between 1991 and 1994, revealing an unresponsiveness to labor market conditionsand a downside rigidity in real wage adjustment and premiums for scarce skilled labor. Only in the thirdquarter of 1994 did real wages for blue-collar workers in the manufacturing and construction sectorsappear to show a slight decrease. The market now seeks highly skilled workers and younger skilled orunskilled, motivated, trainable workers to complement the newly acquired capital goods and to securemost needed higher productive efficiency. As a result, wage gaps and labor segmentation have increasedsignificantly, as seen in the sharp increase in the return to tertiary education (reaching 25 % in 1994), andby continuous real wage increases for skilled positions. During the 1995 recession, however, preliminaryindications suggest 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 maindeterminants are: (i) the increase in labor force participation. The overall labor force participation rateincreased from 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, whichincreased from 43 percent in 1987 to 49 percent in May 1994 in the Great Buenos Aires area and from24.7 percent in 1989 to 31.9 percent in the country as a whole; (ii) the changes in incentives and thecompetitive (trade) regime that caused significant sectoral shifts and firms to seek cost reductions andproductivity gains (through labor shedding); (iii) failure of wages to adjust to labor market conditions(increase in labor supply and unemployment); the adjustments have been in the form of employmentreduction rather than through wage reductions; (iv) the 40 percent decline in the relative capital-laborprice since 1991, induced mostly by opening the trade regime, has furthered the replacement of labor withcapital; (v) recent migration patterns from abroad had a significant impact (18%) on labor flows and laborforce; (vi) significant mismatches between skills offered and those in demand; and (vii) excessive non-wage labor costs and institutional aspects of the labor market impose (selective) rigidities, discouragelabor force expansion, and slow the speed of adjustment to meet observed sectoral shifts.

3.85 The institutional constraints with the greatest effect on wages and employment practices 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 geographical andsubsector flexibility to respond to emerging needs and labor market conditions; (iv) the tendency toperpetuate lapsed collective bargaining agreements (most of which were negotiated during thehyperinflationary years) embedded in legislation that discourages renegotiation of collective bargainingagreements; (v) a significant level of nonwage labor costs, increasing labor costs over gross worker

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remuneration by 53 %, and 72.4 % when measured in terms of labor cost per efficiency unit of time; (vi)the framework for employee accident compensation and lack of a regulatory framework for insurance,leading to an imputed cost on wages of 3 %, and excessively high risk-bearing, especially for small firms,which potentially after a few instances can bankrupt them (new legislation is now in congress to remedythis situation); (vii) coexistence of mandated severance payments and unemployment insurance at a costto the firm of 6.5 % of gross wages.

Real Earnings Prices Sept. 1989 Dollar EarningsMaiss 25-64 E PH IN DEC Maess25-64 EPH 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, andparticularly 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 improvem-uch in the short term (unless there is a sharp reduction in labor force participation as it occurred in thesecond semester of 1995). There are sectors--agricultural and livestock, financial and other servicessectors (i.e., retailing)--that are only now beginning the restructuring process in earnest; in the courseof this restructuring, there may be another wave of labor-shedding. Some sectors, such as pharmaceuticaland cosmetics, vulnerable to competition, are replacing production lines with imported products, whichalso brings further reductions in employment. And perhaps of great impact is the replacement of obsoletecapital stock (circa 1970), which accounts for over three-fifths of total stock, and has yet to be undertakenintensively. 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 internationalstandards 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 economicactivity, and thus job creation. The largest and potentially lasting employment initiative will come fromlabor policy reform. The Government of Argentina has already taken substantial measures to address the

26. Source: OIT, 1994.

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unemployment issue, such as the passage of the Law of Modalidades de Contratacion, Law of PYMES,and Law of Seguros de Accidentes de Trabajo (Workmen Insurance Compensation), and geographicallydiscriminatory reductions on labor taxes (reductions ranging from 30% to 80% starting January 1996,with the lowest reductions being in the GBA area which accounts for nearly 50% of total employment).Yet significant improvements still need to be made, to have an impact on the currentemployment/unemployment situation.

3.88 The following measures would improve the functioning of labor markets, lower the cost of labor,and thus increase employment levels. While current rates of unemployment are high, both for structuraland cyclical reasons and short term prospects may be discouraging, the implementation of structuralreforms and resumption of economic growth could reduce unemployment at a fast pace, as the Chileanexperience of the late 1980s indicates.

Recommended Course of Action

Nonwage Labor Costs and Contractual Flexibility

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

Consider extending fiscal exemptions (labor tax and unemployment insurance contributions) to (i)all persons up to the age of 24, who at the same time would be excluded from unemploymentbenefits and family allowances; and (ii) all long-term unemployed (over one year) for a one-to-twoyear period. These jobs might come at the expense of those already in low-paying jobs, so thenumber of workers experiencing short-term employment might rise; however, this is preferableto letting one group of increasingly disaffected workers languish on the margins of society.

Permit the unrestricted use of temporary and fixed term contracts

Unemployment Insurance and Severance Payments

lThe unemployment insurance scheme is not financially self-sustaining. As eligibility andunemployment increased, the insurance program showed a current deficit of over US$28 millionin 1994, and exceeded in 1995 as unemployment increased. The benefit levels will need to bereduced to minimum wage levels and adjusted for severance payment benefits, with the qualifyingage for unemployment benefits raised to 24.

Eliminate either unemployment insurance or severance payment obligations. Having both iscounterproductive, in that it elicits two perverse incentives: it dissuades the unemployed fromactively seeking employment and firms from adjusting their labor force optimally. Provided thatthe appropriate institutional capacity is secured, a more comprehensive unemployment insurancescheme should be developed. In the short term, limit the amount of severance payments to sixmonthly salaries for current workers; gradually, eliminate severance payment obligations; andeliminate all firms' severance payments obligations for new workers, and freeze severancepayment obligations to now-employed workers at current levels.

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Unions and Collective Bargaining

Decentralize collective bargaining to the firm level.

The power of the Ministry of Labor to authorize (i.e., extend to all members of the trade)collective bargaining agreements should be eliminated. This would necessitate modifying Laws14250 and 23456. If maintained, it should enforce the uniform application of collectivebargaining salary increase clauses to apply only in cases of productivity gains (currentlyunenforced).

The concept of "ultractividad," which permits collective bargaining agreements to remain in effectin perpetuity, should be rescinded, i.e., once an agreement expires, all clauses lapse.

Priority should be given to direct agreements between parties instead of agreements made outsidethe company (collective agreements of any other type, professional statutes or acts, etc.). This willrequire amending Law 20744.

Eliminate the legal power of collective bargaining agreements at any level (activity or branch ofactivity, national, regional or local) to set contributions on the basis of profits, sales, or depositsin the financial system, with all dues binding on companies and workers not members of aChamber or a union, which results from the official approval of the contract.

The monopoly over the provision of welfare services for employees currently held by the unionsshould be eliminated, since it is expensive and service is poor. In its place competition among allservice providers should be introduced.

Wages, Workmen's Compensation, and Public Information

* Minimum Wage. The current minimum wage (200 pesos) should be maintained until it reachesa minimum relationship of 3.5 relative to the average factory (blue-collar) wage (currently 3).

Public Information: Disseminate information about rates of return to education. This shouldinduce longer stays in school, reducing the supply of labor in the short term and increasing skilledlabor in the medium and longer term.

Develop within EPH a unit specifically dealing with the service sector. There is little informationand analysis on the service sector, which is the only sector experiencing job growth, and nowaccounts 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 employmentoutput elasticity for Argentina has been estimated at around 0.25, meaning that, ceteris paribus, toincrease employment by 1 percent, a 4 percent GDP growth would be needed. To improve significantlythe employment outlook, reductions in labor costs and decentralization of collective bargaining are thekey policy reforms to consider. It has been estimated that a reduction of labor costs by 10 percent would

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increase employment by between 5 percent and 10 percent, and a decentralization of collective bargainingto the firm level could, in the long term and based on international experience, increase private sectoremployment by between 15 percent and 30 percent27.

Financial Markets

3.90 The dramatic macroeconomic reforms of the last four years created conditions for rapid economicgrowth. Investments necessary for such growth were largely financed by the return of flight capital,privatizations, and foreign capital inflows, which must be increasingly replaced by domestic savings. Thesimulations, provided earlier in this chapter, indicate the need for domestic savings to rise significantlyby the turn of the century, with the share of private investments rising steadily. Thus, the ability of thefinancial sector to mobilize such savings and investments is pivotal to the realization of high levels ofeconomic growth.

3.91 Argentina has both the need and potential for development of financial markets approachingdeveloped country standards. Since 1990, the authorities has radically improved the regulatory andeconomic 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 frominstitutional (under)development, federal-provincial relations and public finance, and lack of market andproduct development have 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, liquidity and volatility of marketablesecurities, new security issuance, number of listed stocks, presence of institutional investors, the size andliquidity of long term debt market, and variety of financial instruments. Intermediation costs, marginsand inefficiencies were very high and acted as a strong deterrent to both savings and investments. Costof credit was very high, the aggregate credit extension low, and access to formal credit particularlydifficult for small businesses and farmers. Substantial improvements in collateral legislation and registrieswere still needed. Despite numerous banks (albeit small), competition was not deeply ingrained amongbanks, or between banks and capital market institutions and financial products. Severe structuralproblems remained in the banking sector, and to a lesser extent in the insurance industry, stock and bondmarkets, and in government securities market. While substantial progress was made in enablinglegislation and regulation in several of these areas, regulatory capacity and enforcement standardsremained deficient in most of them.

3.93 The events following the Mexican peso devaluation have further weakened the financial sectorconsiderably and exposed its vulnerability. They reversed the deposit growth (currently deposit levelsregained lost ground), shortened the maturity of deposit base, and subjected a fragmented banking sectorto significant problems of liquidity, solvency (for some institutions), and systemic confidence. On thepositive side, they have also unleashed substantial banking sector reforms and concrete measures to helpconsolidate the 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 weakbanks to stronger ones; (ii) raising the volume and maturities of savings and loans; (iii) augmenting the

27. W. Bank study on "Analysis of Impact of Labor Policy Reforms in Argentina".

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access to credit, particularly by small and medium enterprises; (iv) improving further the supervision andregulation of the banking sector and capital markets; and (v) deepening capital markets and expandingthe choice of financial instruments. This strategy calls for strong support for the Argentine Government'sefforts to safeguard its banking system and invigorate its capital markets.

The Banking Sector

3.95 Argentina's financial sector consists primarily of commercial banks, which are allowed to extenda full scope of financial services. Consolidation of the banking system, which proceeded at a fast pacefollowing the financial crisis of the early 1980s, slowed after 1990, as economic stabilization andremonetization increased the capacity of commercial banks to mobilize deposits and increase their lending.Nevertheless, macroeconomic stabilization, financial sector policies, and improved regulation andsupervision encouraged banks to become more efficient, and larger institutions gained in market share.Since 1994, the pace of commercial banks consolidation has resumed as deposit growth has declined, andis expected to continue in the foreseeable future, stimulated further by the flight to quality of depositsduring the recent crisis.

3.96 The recent crisis has accentuated the fragility of Argentina's smaller banks, and is acceleratingthe process of consolidation. During 1995, eighteen banks were intervened, of which four are underliquidation, eight were suspended and the remaining six are undergoing workouts at various stages ofcompletion. By December 1995, there were 164 financial institutions operating in the Argentine market,down from 203 in December 1994, as a result of mergers and closures. Of those institutions, 132 werecommercial banks which accounted for 94 percent of total financial sector assets. The remaininginstitutions were finance companies or savings institutions that do not offer checking account services.Overall, in 1995 private banks accounted for about 60 percent of total assets and deposits. The 9 largestprivate banks accounted for between 27 and 28 percent of total assets, loans and deposits. The entiresector suffers from excessive fragmentation (of the six leading Latin American countries, the Argentinebanking sector has the least degree of concentrationr), low penetration29, excessive operating costs,high financial spreads, lack of economies of scale (the two largest banks have assets of less than $5billion, and only six have more than $1 billion), weaknesses in the interbank market (during the crisis,wholesale banks had no funding sources, and many were closed), and slow pace of innovation (Argentinais well behind Chile and Brazil in electronic banking and other cost-cutting technological innovations).These structural problems--compounded by inadequate lender of last resort capacity--have contributed tothe liquidity crisis following the Mexican peso devaluation.

3.97 From a capital viewpoint, the ten largest private banks would be best placed to act as acquiringbanks in merger transactions. Some large banks are undertaking acquisitions, including acquisitions ofselected assets and branches of regional banks. The more likely acquirers are intermediate-size bankswishing to increase market share, although caution should be exercised not to create larger weak banks.A small number of banks may also be capable of restructuring themselves with outside financialassistance. The restructuring and consolidation of private banks could be facilitated through the BankCapitalization Trust Fund.

28. As measured by the Herfindhal-Hirschman Index

29. As a ratio of deposits to GDP.

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3.98 Dealing with public banks has proven to be one of the more difficult and intractable challengesfor Argentina's financial policy. The performance of provincial and municipal banks has been modestor downright poor (many provincial banks are technically bankrupt). As public banks were created byfederal or provincial/municipal laws, any amendment of such laws requires the approval of the respectivelegislature. In the past, the large majority of provincial legislatures has resisted enacting privatizationlaws. At the start of 1995, Argentina had 32 federal, provincial, and municipal banks. In the course ofthe 1995 and the first quarter of 1996, financial crisis, however, when the financial burden of these banksbecame too onerous to bear, 9 provincial banks were privatized. From the remaining 15 banks ownedby provincial governments, 10 are under way of privatization. Provincial and municipal banks not in theprocess of privatization, however, still account for 69 percent of total provincial and municipal bankassets. Together, as of September 1995, all public banks accounted for 41 percent of the system'sassets, 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-performing private bank loansamounted to about 9 percent of total lending in 1994, far less than the 25 percent in public banks. Theactivities of public banks distort financial intermediation, essentially by directing funds to less profitableactivities for which private banks will not lend. Furthermore, provincial banks cannot be closed by theSuperintendency of Banks when regulatory requirements are not met, as can privately-owned banks. Theprovincial banks' adverse effects on financial sector efficiency are exposed by their sustained losses, non-competitive allocation of credit, high cost of funds and excessive employment. Poor credit decisions aremanifested in their large reported non-performing portfolio which exceeds by far non-performingportfolios in other categories of banks. Moreover, provincial bank credit allocation to inefficientactivities, including provincial governments and public provincial enterprises, reflect the lack of arms-length relationships, thereby deflecting the supply of credit away from productive activities.

3. 100 The recent financial crisis, affecting both provincial governments, and the federal government'sability to assist them, created a unique opportunity for the restructuring of provincial banks, since theyhave become a net liability to provincial finances. It is imperative that the federal Government resist anyfiscal support that would prop up provincial banks, and guide provinces to the utilization of existingfacilities, i.e. the Provincial Development Trust Fund, which provide financing conditional to therestructuring of such banks. Provincial governments should preferably sell all their shareholdings inprovincial banks; as a minimum, they should sell a majority share of such banks and transfer control toprivate shareholders. Through privatization it is expected that the newly emerging private banks willfocus on profit maximization and financial soundness and that the Central Bank supervision andenforcement of liquidity, capital adequacy, and provisioning requirements for these banks will be moreeffective.

3.101 With forceful implementation of prudential norms, and greater competition, the number ofArgentine banks in the coming five years may be halved from those at the beginning of 1995. Suchconsolidation will still leave Argentina with proportionately more banks than in Mexico, Chile or Brazil,and thus is not likely to reduce competition. The retrenchment would force the banks to cut costs,rationalize their branch networks and introduce better technology. However, at present only about sixof the banks are publicly listed, and progress in terms of greater public shareholding, reduction of familycontrols and professionalization of top management will take longer.

3.102 It is recommended that the restructuring of private banks proceeds on an accelerated basis, withthe assistance of the authorities' Trust Funds created for that purpose, in order for the financial systemto recover from the recent crisis, and better prepare it to address any future occurrence of external

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shocks. Delays in that restructuring could unduly postpone the recovery of deposits growth in thefinancial system, and, more importantly the resumption of credit expansion.

3.103 The authorities could strengthen the private banks' incentives for cost cutting in two ways. First,through rigorous enforcement of prudential norms -- particularly of loan classification, provisioning andbank rating. Such enforcement would ultimately cause cost-inefficient banks to raise additional equitywhich may lead to new owners, better management, mergers and greater economy of scale, or betterbusiness strategies. Second, the authorities can increase competitive pressures on the banks bydismantling barriers to competition (i) among banks, (ii) between banks and capital market products andinstitutions, and (iii) encouraging competitive "shopping" and pressures from bank clients. Restrictionson branch expansion, new entry, foreign banks, and money market funds have been liberalized since1994. However, those on leasing, securitization by non-banks, commercial paper and private placementscontinue to protect the banking sector and should be eased. "Truth in lending" type statements -- formortgage and other consumer loans -- need to be instituted to facilitate greater consumer awareness andcomparison shopping by clients.

3.104 The current consolidation plans will not remove all of the "overhang" of weak institutions. Oncethe crisis is under control, the Government need also commit to the privatization of federal banks,including Banco de la Nacion, and should start implementing credible restructuring plans to facilitate suchprivatization.

3.105 To summarize the main recommendations for banking sector reform, with the view to meetingthe objectives in paragraph 3.93 above, it is worth emphasizing the need to:

Facilitate/promote the accelerated restructuring and consolidation of private banks, through,among others, (a) adequate funding of the Bank Capitalization Trust Fund; (b) furtherstrengthening of the Superintendency of Banks' institutional development; (c) elimination ofregulatory forbearance; (d) the legal strengthening of the Central Bank's inspection andenforcement authority; (e) encouragement of bank merging with stronger institutions; and(f) further strengthening of the institutional capacity of the Bank Capitalization Trust Fund.

Reduce banking costs and spreads through (a) the reduction of taxes on financial transactions;(b) dismantling barriers to competition, including the liberalization of restrictions on leasing,securitization by non-banks, commercial paper and private placements that protect the bankingsector; (c) the establishment of a continuous and liquid benchmark yield curve through theprogramming of T-bill issuance; (d) the creation of a central risk reporting entity;(e) strengthening the functioning of the Deposit Insurance mechanism; (f) instituting "truth inlending" type statements for mortgage and consumer loans; (g) facilitating the use of collateral;and (h) improving credit analysis capabilities of banks through better training, and introductionof greater automation and other industry related technological innovations.

Facilitate the privatization of provincial banks or their closure by (a) adequately funding ofthe Privatization Trust Fund; (b) resisting any federal fiscal support that would, directly orindirectly (through the provincial governments), prop up provincial banks, including therestructuring of their debts and access to coparticipated guarantees; and (c) strengthening theSuperintendency of Banks' legal capacity to enforce prudential norms on provincial banks.

Proceed with the privatization of federal banks, which control a significant portion of thebanking system, to reduce distortive allocation of financial resources.

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3.106 Finally, it is worth emphasizing the relevance of macroeconomic conditions and framework inthe performance and prospects for development of the financial system. Taking the Convertibilityframework 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 alternatives may strengthen the lender of last resort capacity of the system, beyond thosecurrently in existence: (i) the Central Bank may want to explore entering into a swap arrangement withother Central Banks, the BIS, or other multilateral institutions that can act as lenders of last resort; (ii)during the recent crisis, pre-existing high reserve requirements acted as a shock absorber to the capitaloutflow, easing the demonetization of the economy. In order to improve the response capacity of thefinancial system to other systemic capital outflows, it may be desirable to impose even higher reserverequirements, possibly reaching gradually 100 percent of short term deposits. While this will increasedirect costs to the financial system, higher reserve requirements will reduce other risk-related costs to thesystem; (iii) the financial system may gravitate towards multinational financial institutions, if it isperceived that foreign parent companies will provide a lender of last resort function to their affiliates; and(iv) build over time significant excess international reserves, 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 allArgentine financial assets (certificates of deposit, bonds, stocks, mutual funds, etc.) are already in theform of capital market securities. Capital markets will play an even greater role in aggregate financialintermediation, in improving cost-efficiency of such intermediation, in reducing cost of capital, andultimately in realizing national investment and economic growth targets. While the recent crisis makesthe banking sector the short term focus of regulatory attention, in the long term the development ofcapital markets will be equally critical.

3.108 Stock Markets At about 160, the number of listed stocks in Argentina is very small, new equityissuance even smaller, and the number of actively traded stocks is less than 30. The principal issuer-related problems are the owners' unwillingness to dilute control, the deeper problem of underreportingof assets and profits by some of the small and medium businesses, the lack of profitability of manyindustries during the structural adjustment process, the unused debt capacity of many corporations, andthe high concentration and fragmentation among issuers. The major institutional and market-relatedproblems are the prevalence of insider trading and speculation, the consequent skepticism of equityfinancing and investment, the lack of market makers, the underdevelopment of investment banks, and lackof liquidity in all but the top 20-30 stocks. The principal regulatory problem remains the delay inenactment of a modern insider trading law. Issuance and transaction costs, taxation, and listingrequirements are no longer important problems.

3.109 The suggested remedies include passage of strict and effective insider trading laws (a bill has beensubmitted to Congress), more stringent disclosure and penalties for insider violations; the enactment ofmodern standards of due diligence and liability for corporate executives, accountants, lawyers andinvestment bankers concerning new security issuance; enforcement of full corporate income disclosurethrough vigorous enforcement of income tax laws (particularly among companies with listing potential)and improvement in auditing standards and responsibility; the education of controlling shareholdersconcerning the issuance and wider distribution of new equity and further improvement in disclosurestandards; and possible introduction of market maker functions to improve liquidity.

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3.110 Bond Markets, Commercial Paper Markets, and Private Placement Bond and commercialpaper markets suffer from more serious legislative hurdles at present. The Argentine law offers a veryfavorable tax treatment to publicly offered securities, for which a regime of public offer, listing,prospectus, and mandatory rating requirements is specified. These provisions are excessive and somewhatincompatible with the development of private placement and commercial paper markets where corporateborrowers can obtain short term finance at competitive rates primarily from institutional investors. Thesehurdles raise the cost of borrowing, particularly for small and medium companies, for whom theinstitutional rather than retail investors are the natural funding source. They also reduce the ability ofinstitutional investors, all of whom are poised to grow, to compete effectively against commercial banks.

3.111 It is recommended that the authorities modify the Negotiable Obligations Law to pennit trueprivate placement of bonds, commercial paper and other securities with substantially the same taxtreatment as that of publicly offered securities, with reduced prospectus, rating and other disclosurerequirements to qualified institutional investors along the lines of US SEC Rule 144-A; remove orsubstantially relax the public offer, listing, and rating requirements from short term (below 1 year)commercial paper; relax the mandatory rating requirements on issuers after the rating agencies have hada chance to establish themselves; and permit rapid enforcement of pagares and other floating rate claimsnot meeting the definition of negotiable obligations through the acci6n ejecutiva process.

3.112 All debt markets suffer considerably from the problem of inadequate interest rate benchmarks--alack of a continuous and liquid benchmark yield curve--which causes great confusion in interest ratedetermination and permits lack of competition among banks. Due to historical accidents, the bulk ofsovereign debt has been issued in various debt conversion bonds, and with numerous variations of terms.As a result, sovereign debt with very similar maturity and financial terms tends to trade at yields as muchas 10-15 percent apart. Absent a Central Bank discount rate, secondary yield of Treasury securities mustprovide such a benchmark rate. To establish a continuous and liquid market that can generate a goodbenchmark, T-bill issuance needs to be programmed, with regular issuance of similar quantities withhomogenous terms. There are great benefits to consolidating much of government debt, or swapping itthrough market operations, into homogeneous securities. It would also be useful to issue them throughdiscriminatory price auctions to 15-30 pre-qualified primary dealers, with the non-competing bids beingaccepted for retail investors only 30.

D. End Note

3.113 The Covertibility Plan has produced a fundamental restructuring of the Argentine economy, andsown 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, domestic confidence in the Convertibility Planhas remained high. To alleviate the social cost of that crisis, it is imperative to resume economic growthin an environment of greater flexibility of factor markets, labor and capital. Additionally, economicreforms in the provinces have to match a renewed federal effort to invigorate the state apparatus, andregain fiscal strength. Policy consistency and coherence, which were probably the biggest achievementsof the current Administration in its successful effort to overcome the greatest challenge so far to this Plan,will remain the linchpin to future economic recovery and growth.

30. A detailed discussion of Stock and Bond Markets, Trading and Settlement Systems, Asset BackedSecuritization, Pension Funds, the Insurance Sector, and Mutual Funds, with policy recommendations, can be foundin "Argentina: Capital Markets Study", World Bank Report No. 12963-AR.

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