Documt of

The World Bank

FOR OMCLAL USE ONLY

Repot No. P-5862-AR

REPORT AND RECOMMENATION

OF THE

PRESIDENT OF THE

INTERNATIONL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ONA

PROPOSED FINANCIAL SECTOR

ADJUSTMENT LOAN

IN N AMOUNT EQUIVALENT TO US$400 MILLION

TO

THE ARGENTINE REPUBLIC

JANUARY 25, 1993

MICROFICHE COPY

Report (N!o. :P- 5862-AR Tvpe: (PR)Title: FINAlNCIAL SFCTOR ADJUSTMENT LOAuuthor: STEFAN Al.BERExt. :30C16 Room:I 61555 DeDt. :LA4Tr

This document has a resticted d;stribution and may be wsed by recipients only in the performance oftbeit official duties. Its contents may not otherwise be disclosed without World Bank authorization.

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Currency ArMgntne Unit - Peso

Since April 1, 1991, the exchange rate has been, by law, Peso 1.00 = US$1.00

Fiscl Year

J- ;a 1 - December 31

Princi^al Abbreviations and Acrnm s:

AFP Administradores de Fondos de Jubilaciones y Pensiones - Pension Fund AdministratorsBANADE Banco Nacional de Desarrollo - National Development BankBCRA Banco Central de la Repaiblica Argentina - Argentine Central BankB1N Banca Hipotecario Nacional - National Housing BankBNA Banco de la Nacion Argewina - Argentine National Commercial BankBPBA Banco de la Provincia de Buenos Aires - Bank of the Province of Buenos AiresCAJA Caja Nacional de Ahorro y Seguro - National Savings and Insurance BankCNV Comisi6n Nacional de Valores - National Securities CommissionDDSR - Debt and Debt Service ReductionDGI Direccidn General de Impuestos - National Tax AuthorityEFF - Extended Fund FacilityESW - Economic and Sector WorkFONAVI Fondo Nacional de la Vivienda - National Housing FundGDP - Gross Domestic ProductIDB - Inter-American Development BankIFC - International Finance CorporationIMF - International Monetary FundLIBOR - London Interbank Offerred RatePE - Public EnterprisePERAL - Public Enterprise Reform Adjustment

LoanPEREL - Public Enterprise Reform Execution

LoanPSRL - Public Sector Reform LoanPSRTAL - Public Sector Reform Technical

Assistance LoanSECAL - Sector Adjustment LoanSEF Superintendencia de Entidades Financieras - Superintendency of BanksSSIMTAL - Social Sector Management Technical

Assistance LoanVAT - Value Added Tax

FOR OFCIAL US ONy

ARGENTINAFINANCLAL SECTOR ADJUSTNDWT LOAN

TABLE OF CONTENTSPag No,

I. COUNTRY POLICIES AND BANK ASSITANCE STRATEGY ............... 1A. Recent Perfrmance ............... I

Origins of Macroenomic Istability and Decin e..Structural djustment, Stabiliation and Bank Support ................ 2

B. Argentina's Extna Environment. 6C. The Bank's Comtry Assistance Stategy. . 7

Argentna's Development Objecives and Eted Financing Requirements ... 7Bank Assistance: Objecdves and Activities ...... ................ 11Levels of Bank Assistance and Relons with Other Creditors .... ....... 20Issues for the Lending Staegy .............................. 22

II. TaEFINANCIAL SECrOR ...... .. ......................... *.*. 23A. Resource Mobilzation ........................................ 23B. Ihe Banking System ........................................ 26

The Central Bank ...................................... 26PublicBas ......................................... 26Private Banks and Bank Supervision ...... ..................... 28Capitl Markets ........................................ 29

mI. THE FINANCIAL SECTOR REiORM PROGRAM ... .............. 29A. Overview .. 29B. Reduced Involvement of the Public Sector in Banking . .30C. Strengtiened Bankdng Sector and Bank Supervisory Framework . .32D. Revitalzaion of the Capitl Market .. 33E. Fiscal Impact of Refrm Meures ... 34

IV. T* HE PROPOSED LOAN .......... 3.. .................. . 35A. Background .......... ...... ............... 35B. Loan Amount, Borrower and IlementingAgency .. 35C. LoanConditions ............... 35D. Disbursemen Procrment, Audit..t 38E. Benefit and Ris ......................... 38

V. RECOhl MENDATION ... 4...... .........*G**4*4*.*****4***4 39

'h pou is bad oa te flnda of Appa Mssi of I . SMissio nmamb Icludms. S. Aba dOom Load. ad Tas ManeSsO. M.Cad. (otl Econois). C. FPot (Tiil Analyst), D. Sott enior FInancial Ssislls), D. Cadam Boommls4 Reside Ofce Agm, P. Doty(Ihu ft u )S,posltoauta),andM. Lab. PubflloBankSpeasia.Cnaultsnt. spot ta y C. Css and L. NaU. M

This document has a restricted distribution and may be used by tecipients only in the perfonnanceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

Annexes:

I. MattixofFinanalSeCtDRefom Poliicies ........................... 40H. DoveopmetPolicy Ltter ................................ 42m. Key Maraoeconomicndicators ................................ 49IV. Banco delaNaci6nArgentina ................................ 50V. Analysis of Basco Naona iotecario ............... ...... 52VI. CajaNadond deAhorfoySegr ................................ 56VJ. Deposit Protection ................................ 64VIIL PfoincalBak ............................. ... ...... 71IX. SuplemetaryLoan DataSheet ................................ 77X. StatementofBank Loans ................................ 78XM. StaterentofWC lvestmets ................................ 79XH. Poficy ssuesinProosdFY93-97L fdtg .......................... 80

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ARGENTIAIlINANCLIAL SECT(R ADREDOT LOAN

Lo and fa=m &Imma

Ign.ro.wm: The Argeaine Republic

Bolar: I-The Argentine Republic

Amount: US$400 million equivalent

Temm: Repayable in 15 years, including 5 years of grace, at the standard variable rate.

Qbjec¢tves: The proposed loan, another building block of the Bank's support for theGovernment's ambitious stmuctra adjustment program, will assist in: (i) reducingthe role of the state in the financial sector, (ii) strngthening the banking sector andits supervisory framework, and (iii) providing resourcer for Argentina's debt anddebt service reduction arrangements.

lfi* andifka: T.he major benefits of the financial sector reform progtam include: (i) a more

competitive private banling system which is expected to improve resourcemobilization and to increase the efficiency of resource allocation, and (ii) fiscal andquasi-fiscal savings as a result of the reduced role of public banks, including theCentral Bank. Indirectly, provincial banks will be encouraged to restructure, closeor privatize, thus genating provincial savings and lessening pressures on anyemergency fibancing by the Federal Government and/or Central. Bank. The majorrisk is a return to economic instability that would undermine a reform program stillvulnerable to shifts in confidence. Instability, and accompanying inflation, couldslow the renewed growth of private banks, affect the strengthening of the capitalmarket and dim the prospects of restruring/priatzation of national and provincialbanks. A furter risk is the bureaucratic lehargy which could affect the progress inthe institutional reform of the Central Bank and Superintendency of Banks. Popularsupport for the goal of macroeconomic stabilty, and the instruments being employedto achieve it, and the strong support of the Bank in respect of institional reformsmitigate against these risks in the short/medium term.

EFitmatedDisbursements: The loan would be disbursed in three tranches. Additionally, there would be a set-

aside of up to US$200 mfillion to provide resources for Argentna's debt and debtservice reduction arrangements. Funds not needed for set-asides would bereallocated to the First Tranche. If all of the US$200 million are required for set-asides, the First Tranche would amount to US$5 million. The Second Tranche is setat US$95 million and the Third Tranche at US$100 mfllion. l1e First Tranche andany set-asides would be available upon effctiveness. The Second and ThirdTranches would be disbursed as and when the respective conditions have been met.Retroactive financing is proposed for 20% of the loan amount excluding set-asides.

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nkhmm,mt _ US$ MillionBank FY '93 94 9

Annual 205 95 100Cumulative 205 300 400

RateRetun: Not applicable

REPORT AND RECOMMINDATION OF THE PRESIDENTOF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPIENT

TO THE ECIV DIRECRS ON APROPOSED FINANCIAL SECTOR ADJUSTMENT LOANIN AN AMOUsNT EQUIVALENT TO US$400 MIUON

TO THE ARGENT1NE RIEBLIC

1. I submit for your approval the following report and recommedaton on a proposedFinancial Sector Adjustment Loan to the Argentine Republic for the equivalent of US$400million to support reforms in the financial sector and to provide resources for Argentinais debtand debt semce reduction arrangements. The loan would be at the Bank's stdard vaiableinterest rate, with a maturity of 15 years, including 5 years of grace. The Export-Import Bankof Japan is cofinancig this adjustment loan in an amount of US$200 million equivalent

PART L COUNTRY IPOLICIES AND BANK ASSISTANCE STRATEGY

A. Recent Perfonnance

Orgins of Macroeconomic Instabity and Deline

2. During a half century of slow economic growth, Argentina gradually fell from the ranksof the world's most prospou nations. This weak performance can be traced mainly to anincreased reliance since the 1940s on a stategy of state-led growth, with assocated chronicpublic sector deficits and endemic inflaton. Economic policy was used all too frequently topwpge rules and tnsfers favoring the interests of successive groups with access to power-unionized labor, privileged indusialists, hvusing conttors and selected middle class homebuyers, some pwvincidal governments, and the military. Public expenditu surpassed 50percent of GDP, and high levels of etenal pre compounded the misallocation ofresources.

3. The abrupt end of voluntary foreign commercial credit in the early 1980s and the suddenrise in real inteonal interest rates, coupled with the effects of the 1982 South Atlantic War,provoked a financial colapse that forced the Government to assume responibility for all foreigndebt-placig addiXtonal pressure on public finances. Ihe loss of extevia finance and thenegative impact of inflaton on real revenue collection led the Treasury to resort increasingly tomoney creaion. The private sector, in an effort to avoid the inflation tax, gradually withdrewit resources from the fimancial system and reduced its real holdings of currncy. The

1 The Eecuve Directors havo rceived recnt -pdates on th oeconoc situatioa in Pant I of thePreddens Report on ot Debt and Debt-Service Reduction Lon (P-5914-AR dated Deembe 11, 1992

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macroeconomy became progressvely more unsable, and by the mid-1980's the country entredits longest period of stagnition of any ime in this century. Saving and investment rates fellas Argentines increasingly saved and invested abroad. Labor productivity fell, povertyworsened, and high and unprediktable infladon became the main impediment to the rcvery ofprivate savings and investment. .By the late 1980's, subsidies through the budget, taxexemptions, agricultural regulations, public enteprises, and cental bank rediscounts wereestimatd to amount to roughly 8 percent of GDP; average tariffs exceeded 40 pert; andquantitative restrictions protected some 60 percent of domestic production.

Structural Adjustment, Stabatlou and Bank Suppnrt

4. The Menem Govcrnment took ofice in July 1989, as montily inflation hit 200 percentand the economy was in the throes of a decade-long stagnation. The new adminitationrecognized that reversing Argentina's economic decline required profound structual reform toeliminate the chronic fiscal deficits that were driving inflation. The Government had todownsize and divest itself of non-core functions of the public sector to reduce the deficit andrelease resources for private development. Finally, it had to end regulaty and other policiesthat had stifled private investment. Improvng the fiscal position would then create space toregularize mounting arrears with creditors and reestablish Argentina's creditworthiness. TheBank has helped the Government develop and implement specific policies towards achievingthese ends through an intensive program of economic and sector work (ESW)2 and adjustmentlending.

5. Structa reforms of the federal government and the monetary authority weresupported by the Bank's Public Sector Refonn Loan (PSRL, US$325 million, July 1991),cofinanced by the Inter-American Development Bank, and the complementary TaxAdmiraionTechnical Assistance Loan (US$6 million, January 1989) and Publ Sector Rebfonn TedmiailAssisance Loan (US$18 million, July 1989). Under these loans, the Government enacted majorreforms affecting revenue mobffization, expenditures, and iiaancing of the public secr. TheVAT was extended to virtually all sectors in 1989-90. Tax rolls were reconsucted and taxadministration was improved substanfally, producing greater revenues. Taxes on exports andbank checks were eiminated or reduced. Tax subsidies to industral finns were brought underfiscal control and reduced. New expenditure controls were enacted, and discretionary transfsto the provinces and to public enterprises were reduced. The Government cut the size and scopeof the federal public administion-including a net retrenchment of positions of about 15percent and transfer of about 40 percent more to the provinces-while modernizing the civilsevice. A Law of Public Financial Management, passed by Congress in September 1992, recagthe basis for budgeting, internal control and auditing. Simultaneously, the Government re-established the monetary authority as a force for price stability. First, it eliminated the quasi-fiscal deficit of the Central Bank by a forced conversion of short-term, high-interest deposits into

Studies prepared for the new Govermet include Soda Sea= I CinS (1988), Tax Poliy r.Stabia D(1989), Reform fir Pice Sabt and Grot (1989), and Prvinda Gownt Ace(199), as well as setora tudies on agiculte, idustry, enr, transporta, and wat.

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long-term dollar, bonds (caled BON) bearing LIBOR-based rates in January 1990; thisreduced confidence in the finail sector, but ended the destabiliing pactiwe of Central Bankmoney creation to cover its own inteest losses on masive shrt-term debt Then, theConvertibilitY Law (paa. 9) established a new monetary policy regime as of April 1991. Thepassge of the Centrl Bank Cat in September 1992, reinforced the Coverbility Law andpaves te way for an indepdent, disciplined monetary authority. A cmmendaton on therdease of the second tranche of the PSRL is exected shordy.

Fed"d Eipl@meMa/t0 Te RevesuPw.md

000.000 30.00

600.00 2 6.0o

700.000

500000~~~~~~~~~~~~~~00

4000_ = £ > _ = -U _, l25.0010.00

200,000 00

100.000

i I I g I OEfffoi Tae UTaxHn ss OsawSAAy,1 N it a 4 hi r U i Ad t b m I p g . _ d _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

6. The Government aLso undertook a ma,jor privatizaon progm, supported by theBan's PUblic Eipnrse r)rimAduswnemtLoan (PMRAL I, US$300 million in February 1991).Initial laws enacted by the Menem Govenment suspended costy subsi and providedauthity to pivatize vtly aU public enteprises. The meas of 1990-sale of the airlinemd tepbone system, concession of some hydrocarbon deposits, and deglaon of thehydrocarbon sector-let much-needed early credbility to d development srtegy. Theprivatiton amprogm continues, affectns the railways, the stte oil and gas companies, thepower and water cmpni, ports, and the merchant fleet. Two tawhes of the Bank's loanhave been released; the third is expected soon. The Government alo recently began to privatze90 percent of the enteie assets controlled by the Ministy of Defnse; these span the steel,petrochemil, and ms industries, and are suppoted by the PERAL H (US$300 million inJanuary 1993).3

3 For a mor lea}ed disuo Sme t Predents Reprt on te Scond PUbLiC ntpre R1om Loan (p-5811-AR), dased DecOmbe 10, 1992.

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7. To further Improve lpipeves for private investven, the Govemment continued toaccelerate trade liberalization, an effort begun in 1987 with the support of two Trde PolicyLoans (1987 and 1988, toaling US$600 million). Export taxes were eliminat and indirect

tax reimbursements for exports established;quantitative import restrictions werremoved except for automobiles; speificimport duties were abolished, and the anti-

LeeL of Extena Protectn dumping regime brought in line with the70 respective GATI Code; the maximum ad60 QWltt valorem tarff rate was reduced to 20

50 percent. Beginning in 1991, theAVmu gTaTitfb. Government also initiated a program of

40 dergulation by ending restrictions on the30 s'ipply and marketing of numerou goods

and services, including professional,transport and port services, thus reducing

10 significantly the costs of doing business ino _ _> 1 ,- 1, " Argentina. Legislation increasing labor

a I I I a a flexibility and improving collective_ -tovm bi- bargaining has been enacted, and further

legislation is pending.

8. Once the fiscal situation permitted, the Government initiated steps to reestablishArgentina's creditworthiness in private markets. It ended the suspension of debt servicepayments in April 1988, and in June 1990 began making partidal payments to the commercialbanks. This paved the way for a debt agreement in 1992 that reduced the commercial bank debtby abow 37 percent. the World Bank supportad this ffort mith a Debt and Debt SericeReducton Loan (US$450 million, January 1993) and set-a3ides of US$100 million in the PERALH and up to US$200 million in the proposed Financial Sector Adjustment Loan.Simultaneously,the Government took steps to end the mounting arrears with pensioners,suppliers, and the health system, as well as to compensate taxpayers for changes in the losscarry-forward provisions of the income tax, through a new domestic bond (BOCON)denominated in foreign or domestic currency at the option of the recipient. These measures haveincreased its domesfic debt from about US$23 billion at end-1991 to about US$18 billion at end-1992. Funds from the privatization of the state oil company are intended to be used forrepurchasing a major part of these bonds.

9. To bring inflaton under control, a major stabilization program began in February 1991.The effort inherited the best initial condition of any stabilization program during the 1980s: bythat time the fiscal accounts were in near balance, the Government could collect taxes andcontrol subsidies to public enterprises, and liquid international reserves were five times greaterthan the average for programw begun in the 1980s. The program was designed around new taxmeasures and expenditure controls that raised the fiscal surplus to a level obviating the need forinflation financing. Monetary policy was disciplined by the April 1991 Convertibility Law that

legally fixed the exchange rate at one peso to the US dollar, formally deindexed contrcts,facilitated the use of US dollars in transactions, and, most importantly, required the CentrBank's monetary liabilities (the money base) to be fully backed by its international reserves.Money growth therefore became effectively constrained to inflows of foreign capital, endingCentral Bank financing of deficits.

10. The expectations of exchange rate stability and the openness of the economy produceda sharp deceleration in inflation, remonetization and, together with a substantial fall in interestrates, an expansion of consumer credit. Coufidence was further bolstered in July 1001, by anIMF Standby and the Bank _ Public SeaorReform Loan (para. 5); and later in the yea * majoradvances in deregulation. Nominal deposit rates fell to 10 percent per annum, the lowc.Ni levelin 30 years. Stock market prices and secondary market prices for Argentine external debtincreased sharply, reflecting increased confidence and declining internatial interest rates.Higher private capital inflows in 1991, financed a US$4 billion rise in imports (andcorresponding reduction of the trade suiplus) and an increase of US$2.7 billion in liquidreserves. Led by consumption, the economy grew by 8.5 percent in 1991, and 6-7 percent in1992.

Non Finaria Public Seto Bane a/ lndusvlaW Producson Index 1S%of GDP |(O1990-100)

2 SINFPSB p 9 1 7C146.0

0 ~~~~~~~~~~~~~~~135.0

-4 ~~~~~~~~~~~~~~~115.0-6 ~~~~~~~~~~~~~~~106.0-8 a/ Acomal basi 9~~~~~~~~5.0

-10 ~~~~~~~~~~~~~~~86.0

I HI~~~~~~~I7.

11. In early 1992, the Govemment reached an agreement with the Intemational MonetaryFund (IMF) on a three-year program under the Extended Fund Facility (EFF). ITe EFFprogram was designed around a prinmary surplus before privatization (i.e., operational pnmarysurplus) of about 2 percent of GDP, to meet debt service obligations without recourse to theinflation tax. Fiscal performance to date has exceeded EFF targets, and privatizations pushedthe primary surplus over 3 percent of GDP in 1992.

12. The large capital inflows-a product of low intenational interest rates and new confidencein Argentine policy-produced a real appreciation of the peso of about 20 percent since thebeginning of the stabilization. The trade balance deteriorated sharply as a consequence.

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Uti Moon ned Redl "ltigo t Concerns about the trade balance prompted2500 250 the Government in late October 1992 to2000 ' increae indireC tax reimbursements for

'A/\ exports from an average of 8 percent to 131500 lw };' % "percent and to raise import tariffs-including1000 100 ad valorem tariffs and a flat stadstcs tax-500 ISO ~~-~~>--_ 50from an avenge of 14.8 percent to 19.8

CL .,0 ,, t percet, while also reducing tariff.60 dispersion. Reducdon in fu e lxes er'-2-2 2e 20 imprved the compettiveness of domestic

Tre badabe ----- BftgtoWMthUS produC&. These measur produced an_e_ effective real devaluation of about 5 percet.

B. Argentia's Externa Environmt

13. Three aspects of the extemal environment affect Argentina's macroeconomic prospects:the growth of world markets, commodity terms of trade, and the cost of international capital.Following the stagnation of 1991-92, world growth is expected to recover at the moderate paceof 3 percent in 1993.4 Consequently, the prspect for growth in the volume of world trade in1992-93 are better than they were in 1991, and with them the dmand for Argentina's exports,which the Governent exects to increase at about 7 percent annually for the rest of the decade.Nonetheless, important im nts to a stronger formance remain. First, the UruguayRound of negoations on tariff reductions has not yet been completed; as a major producer ofgrans and other agricultural exports, Argentina would ctainly benefit from a reduction insubsidies of selected industrial countries to these tmpete climate products. Indeed, Bankstudies indicate Argentina would be among the largest beneficiaries from a successful conclusionof the Round. Argentina'-, efforts to establish a regional free trade with Brazil, Uruguay andParaguay-the MERCOSUR area-would also provide new impetus to the trade growth ifsuccessl (para. 43). Second, world demand may recover slowly. Several industral countresrequire balance sheet adjustments to unwind the effects of earlier speculative excesses in realestate and other asset markets. Also, the persistence of large budgetary imbalances in a numberof countries adversely affects business and consmer confidence. Major efforts to reduce fiscalimbalnces are urgently needed in many countries to strengthen glob economic prospects,which would in turn provide greater opporunities for Argentina's exports.

14. Argentina's terms of trade, aftr a 3 percent deterioration in 1992, are projected toimprove gradually as a result of global demand conditions, according to Bank commodity pnceforecasts. Real agicultural and raw mateial pes have been relatively stable over the last

4 This section is based upon te analysis provided in te IM8's World &oomc Owlok, October 1992.

three years, hoveing around 80 percent of their 1987 peak. The weakness in nonfuelcommodity prices is attributed to the recet decline in inflation worldwide, but grain demand isprojected to rise because of the increased demand for wheat in the Republics of the formerUSSR and low world gain stocks. Because Argentina is energy self-sufflcient, expectedchanges in tuel prices will have a relatively small nacrconomic effect.

15. Conditions in world credit markets wil also affect Argentina's fiscal and balmce ofpayments position. A one percentage point change in international interest rates would producea US$550 million annual increase or decrease in its public interest bill. Although the demandfor credit has remained high because of persistent fiscal imbalances in the US, Germany, andother OECD countries, the recession sharply reduced private credit demand; this, together withan easing of monetary policy, brought interest rates to new lows in 1992. The IIBOR in 1992was 3.8 percent, half of the 8.4 percent rate prevailing in 1990; the Bank projects a long termrate averaging 6.8 percent during 1993-2000. Reductions in the public demand for credit mayease the upward pressures on long-term rates if the added fiscal efforts reduce existing budgetdeficits in the OECD countries. These external risks are manageable, and are offset by thestronger domestic policy in Argentina and the DDSR agreement which will fix the interest rateon nearly US$14 billion of Argentina's external debt. While developments in these areas couldbrighter or dim Argentina's development prospects, the main problems facing the countrycontinue to be intemal.

C. The Bank's Country Assistance Strategy

Argentina's Development Objectives and External Financing Requirments

16. President Menem has made it a national goal to reWn Argentina to the ranks of theworld's more developed economies by the early 21st century. He recognized early in hisadministraion that this required a fundamental redrawing of the boundanes between the publicand pnvate sectors, elimination of the chronic imbalances within the public sector to endinflation, and acceleration of Argentina's integrtion into the world economy. The size andscope of the Federal Government were to be reduced through far-reaching privaization anddecentraliation of functions to the provinces, with the public sector focusing on its corefunctions of providing essential public services. Given sufficient space and proper incentives,the private sector would replace the state as the engine of economic prosperity.

17. The first 42 months of the Menem administration witnessed a massive reform of thepublic sector to lay the basis for price stability, coupled with an extremely ambitiousprivatization program. With the main policy actions now in place, the Government has chartedfor itself an agenda basee upon consolidating and deepening these reforms efforts, improvingthe institutions of the public sector with specidal attention to the plight of low income groups, andenhancing the development of the private sector. Consolidating publie sector reforms will allowthe Government to conduct a balanced fiscal policy and a predictable monetary policy.Combined with proper price incentives associated with an open trade regime and market

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deregation, this would unleash the potential of Argen a's abundant resources-fertile land,a highly literate labor force growing at manageable rates, and a sizeable and reasonably weUlintegrted domestic market. Newly privatized sectors, together with the agriculture andresource-based industries in which Argentina has a natural compam*ive advantage but in whichthere has been histonc under-investment, should be strong sources of grwth in the future.

18. edal and Monetary Poliy. The Govement's main macoeconmic objective is toachieve a robust long-term annual growth rate of 4-5 percent, with expanding enmloyment andinflation held to intenational rates. The opeaonal pimary surplus is prqected to increasefrom US$2.4 billion in 1992 to about US$4.4 billion in 1993, about 2.8 percent of GDP (Table1). This level would be sufficient to service interest payments and to obviate the need for afuture inflation tax, given foreseeable foreign and domestic borrowing. The Governmentanticipates no change in its monetary and exchange rate policies, which will continue to bedisciplined by the Converdbility Law and the new Central Bank Charter. A ight fiscal stance,continuing import competition, product and factor market deregulation, and new entrants inhetofore oligopolistic markets would drive domestic inflation to internation rates.

TAb AGENTI - KEY MACROEONOMIC INICATORS(US$ uflInW

Aveaw Aveaug1990 1991 12 199-199S 1996-2000

PA-Y SUIPIUS 2.012 2.857 5.178 4.029 5.633lura otb $A5,4S9 4586 2.731 3.847 4,4S3

Dotmeao 229 322 160 704 1.198Porc*gnbt 5,230 4.264 2,5 3.143 3.25S

Bahac (- - defiO -3,448 .1.729 2447 182 1,181Do_entio F}aong 4.483 -897 .2,563 201 -S96FofcipPhmnohgo/ *1,036 2,626 116 -383 -284

TWOBOSIM ai8.51 4,007 -1.139 38 2.595CurtadAwoutldance, 1.754 -2.748 *6,779 -S.55 .5,766CapilW Accomutdi 161 4,330 10.216 6.115 5.801

PabUe Swior -1.036 2.626 116 -383 -284MDO/ 169 18 248 675 73

IDB e 225 242 527 460 345Bonds -226 395 -233 -548 *235Iw el -185 661 338 348 -764CamndarBonb -1,289 0 -127 -175 695

lncm_m fo DDSR - 1.236 -Bilatzb Sugpliisu Odm d fl 270 2.512 437 94 921

Privati Sea 1.197 1.704 10.100 6.498 6.085

GDP Avue AnavAl R ell Graw60.4 S.S 6.5 3.7 4.2GDP(USW$ bW 105.5 35.4 153.2 182.6 248.6TOWal J.vnu(% GDM 8.4 12.5 14.0 16.0 18.0Na11l Savig (U GM 10.0 10.4 9.6 13.0 15.7FogaSavinp(D GDP -1.6 2.1 4.4 3.0 2.3

of ADflaumsfo,pMoffima balanof pqmztsmnatb/ hwhadesquasi-iamulbahnoeofCowlBankd J W*hdesIMA finanalo.d/ etbiosamfin P.ingofu.of InoiseasMu wd additioalein 1.1993 fr ahncumrnA.V Enclacdeunidledf nschWof0. psmnt of GDP par year fin 199-2000.

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19. Balance of Payments. The Govenment's progam relies on private capital inflows andincreasing private domestic saving to finance investment. ight fiscal policy and passive butpredictable monetary policy would continue to make investment in Argentine financial and realassets attractive. The country's rich, unrealized potential would offer high returns to inm entfor some time. The authorities view the estimated US$50-60 billion in private savings ofArgentine residents held abroad as a reliable source of future capital inflow, though perhapsslowing in 1993. This would, of course, require continuance of current econonic policies.

20. The Goverment anticipates that the trade balance will improve progrssively begingin 1993, in response to continued tight fiscal policy and the commercia policy measures ofNovember 1992-which inreased the pnce of imports and exports in pesos. These wereintended to help switch resources from nontradeables back to tradeables as demand for importsdeclines and demand for competing domestic goods and export demand increase. Thds switchwould be strengthened by continued productivity growth in tradeables due to deregulationmeasures. Nominal wages in the nontradeable sector would fal relative to the tradeable sector.Capital inflows would slow gradually. As the demand for consumer credit weakens, creditwould be channelled into investments in productive activites fthat satisfy the new demand in netexports and internationally compedtitve domestic activities. The resulting trade balance, and realexchange rate, would be a reflection of capital inflows to finance imports and the demand forArgentine assets.

21. Exteral Fuancing Requirements. The capital account in the balance of paymentsreflects the projected changes in the net foreign asset position of the public and private sectors.The public sector's net external borrowing requirement is negative, as the net flows assiatedwith the collateral purchase as wel as partal amortization of bonds and commercial debt exceednet inflows from international financial institutions by about US$383 million. Much as withMexico after its turiing point in the late 1980s, the World Bank and IDB would increase theirexposure in Argentina, but not substantially so after the mid-1990s. The IMP's exposure woulddecline after the exiration of the EFF. Prvate bondholders, including holders of BONEX, willbe net recipients of funds, although the Government expects to refinance roughly three-quartersof bonds coming due. Commercial banks are projected to be net recipients of funds on the debtthat replaces existing arrears under the Debt Ageement.

22. The private sector is projected to substantially increase its net investment in Argentina.Foreign direct investment is expected to increase at about 8 percent annually, to average aboutUS$2.7 billion. Private short-term capital flows are projected to average about US$3.7 billion-about 1.5 percent of GDP-to satisfy the demand for additional imports and domestic assets; thiswould finance the projected current account deficit over 1993-2000. The vast investmentopportmities created by the privatztion progmm as well as potential repatiation of eamingson foreign-held private assets make this feasible. Nonetheless, since the Government hasidentified vitay all of its financing, the actual finmcing from the private sector for thebalance of payments will be a function of the desired savings-investment balance in the privatesector.

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23. Possible Risks. Te above scenario is attainable if the Government continues to improveits fiscal position, and if private markets generate a smooth transition to a sustnable balanceof payments and growth path. However, even with adequate er ante fiscal adjustment, it shouldbe recognzed that near-term growth rates could be lower than prqjected. Slower growth or evena recession could come about through two related mechanisms. Capital inflows may drive upimport volumes, and prices of non-tradeables and domestic assets to unsustainably high levels;then, as the correction ensued, private capital flows would tr off or even reverse, pushingup domestic inter rates. (Rising international interest rates could also slow capital inflowssharply.) The first response would be higher domestic interest rates which would dampengrowth. Also, domestic prices may be slow to converge to competitive international levels;price setters, long used to markup pricing in oligopolistic enionments, might take severalmonths of slow sales before startng to cut prices to the degree necessary to adjust the overallprice level and thus the real exchange rate. Slower growth woud evenually produce the priceconvergence necessary to sustain the exchange rate regime and rekandle export-led growth,although it would also undoubtedly creae added fiscal pressure. As revenues fall and theinterest bill rises, the speed of the central government adjustment in reducing expenditures woulddetermine the size of any increase in the Government's net borrowing requirement, making itmore difficult to achieve the projected partidal rollover of its domestic debt with bondholders.A short recession would probably pose no major threat to the Government's macroeconomicprogram; though modifications may be required, it would be unlikely to derail the fundamentalstructural reforms.

24. It also has to be recognized that a worsening macroeconomic panorama-or politicalevents-could trigger a speculative attack on the peso. The ease of capital mobility betweencurrencies and across borders, superimposed on a small monetary base, means that the economyis unusually vulnerable to swift changes in private expectations and portfolio shifts. A suddencycle of demonetization, very high interest rates and deep recession could produce cracks in thefinancial system. The Government might then be forced to choose between: (i) providingemergency liquidity to prevent the collapse of the financial system, thereby putting pressure onthe exchange rate; and (ii) letting financial institutions collapse with some depositors sufferinglosses, while sharp increases in interest rates drive the economy into recesson. In thesecicumstances, there would be great pressure to alter the policy framework.

25. The probability of these adverse events declines as the Government progresses on reformsthat improve the fundamentals of public finance. The past reforms of the public sector anchorstabilization and are unliky to be reversed during any financial turbulence. Also, reserves arethe highest in a decade and cover the monetary base (although not the deposit base), which tendsto deter a speculative attack on the peso. Even ff the events outined in para. 24 were tomateialize, thereby creating great pressure to alter the policy framework, in all likelihood anyemerging policy regime would of necessity focus on maintaining fiscal balance and policiesconducive to private investment, as recent history attests. Over the last few year, the countryhas enacted serious and difficult structual reforms with considerable public support. The lackof alternatives to fiscal discipline and price stability, and memories of the hyperinflon of 1989-

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90, have made stability politically popular. These cs are powerfu balmast that is likely to keepthe ship of structural adjustment headed in the same direcdon, even in a financial storm.

Bank Assistance: Objectives and Actsvla

26. The Bank has been, and will remain, a strong supporter of the ambitious Argentinereform program launched by the Menem Govemnment Our fiuture stategy will be to supportthe effort to consolidate the macrenomi reforms and deepen their impact, making themmore permanent by stgthening Argentna's greatly weaked institutions, and by fosteringthe development of the private sector, with particular attention to resource mobilization andintermediation issues. The widely acclaimed reforms of the Mexican and Chilean economiesbegan 10-15 years ago; by contast, the Argentine process is still only a few years old. Whilethe speed of the fiscal, monetary and public enterprise reforms has been astonishing, the processstill remains a frgie one. Sustained stablhty and growth zequir continued attention to thefisca fundamentals. The Govnment must continue the momentum of current structuareforms and deal with pending issues of povincia finmces, soci security reform, and the needfor greater labor market flexibility. Although much important legislation has been passed,strengthening the institutions of economic management and the fleshing out of new insdtutionsare still major tasks. After years of neglect, wage repression and politicization, Argenina'sinstitutions remain quite weak. The maceonomic reforms have begun to create the fiscalspace necessary to address longstnding health and education needs, but the national andprovincial institutions charged with providing these resources remains deficient. An excellentstart has been made by drscally reducing the size of the cental admiistion, but thedevelopment of a well-paid, professional civil service has only begun. Like Mexico and Chile,future Argentine growth will now be dependent on the dynamism of private sector advity inleading the economic recovery. A credible and deepened progam, and a healthier and morestable work force, can enhance investors' expectatons, but the pivate sector will need tomarshall unprecedented foreign and domestic resources to address the backog of deferred vitalinvestments and the needs of the newly prvatized sectors. Yet Argentina's capital markets-and,again, the institutions asisting these markets-will need to be strengthened.

Consoldag Macneconoec Refonm

27. While the insdtutional and policy framework has substantially improved themacroeconomic fundamentals, there are stll some significant policy issues which need to beaddressed. Also, the reform process itslf is relatively young and therefore needs to benurtured, fine tuned and reinforced until it h more fuly intenalized in publc and privatebehavior. The agenda of pending efforts is ambitious, yet essental to attaining Argenina'sdevelopment objectives. The Bank will assist this effort by contiuing to provide theGovernment with timely macroeconomic work on the institutional and structural underpinningsto fiscal and monetary policy. In addition, proposed adjustment lending would support fiscalreform efforts at the provincial level, and ESW would addre social secuty reform and labormarket policy issues.

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28. Provincial Ad4ustment. Fiscal adjustment in the provinces, which now spend nearly 50percent more than the national adminstration and are increasgly becoming the main providersof core public services, has become urgent. Revenue collections have lagged, and wageexpenditures and pension schemes are inflated, with some of the smaller provinces employingmore ta 30 percent of the work force in the public sector. At the same time, capitalexpenditures have declined from about 30 percent of total expenditures in the early 1980s to lessthan 15 percent at present. A sharp increase in the volume of legally mandated transfers,resultng from the Federal Govemment's success in raising revenues, has had the unintendedeffect of reducing the pressure on provincial authorities to adjust. The ongoing ProwncialDevelopment Loan (US$200 million, December 1990), after a long gestation period during whichthe technical infrastructure to implement the project was created, is now paying dividends interms of better financial programming in the provinces; the loan is disbursing at an adequatepace. The Bank has also maintained a robust sector work program that has provided guidanceto the Federal authorities on neceay provincial reforms.5 In the future, firther changes willbe needed in legislation on revenue shanng and other mandated transfers, to provide strongerincentives for the provinces to reform. All provinces will need technical assistance to modernizetheir administrative apparatus and enable them to take up the new responsibilities. Since theprovinces are now pivotal to the attainment of long-term fiscal stability in Argentina, the Bankis discussing a possible adjustment loan to support structuml reforms in provincial tax collection,reductions in staffing, privatization of provincial enterpnses, and reduction of currentexpenditures.

29. Social Security Reform. The public pension insurance system, which comprises aboutone-third of federal public expenditures in Argentina, is performing extremely poorly. Despitean excessive payroll tax of 26 percent of gross salary and earmarked tax revenues of aboutUS$85 million per month, the system accumulated debt through unmet legal obligations topensioners at a rate of about US$200 million per month, reaching some US$9 billion at end-1991. The Government has opted for a major change that would maintain mandatory pensioninsurance while privatizing its supply and replacing pay-as-you-go financing with individualcapitalized accounts. The state would provide an additional tax-financed uniform pensionadequate to support reidred low-wage workers. Besides reducing the onerous payroll taxes thatdiscourage formal sector employment, such a reform would also generate a supply of long-termfinancial savings. However, only some reduction of existing benefits based on introduction ofan actuarially fair benefit formula would contain fiscal costs during the transiton to manageablelevels without requiring excessive compulsory bond issues to the private pension funds. Themain studies that provided the data base for the design of the social security reform werefinanced under the Social Sector Management TechndcaAssistance Loan (1988, US$28 million),and technical discussions will continue through the Bak's regular macroeconomic dialogue withthe Government and specific sector work planned for this year.

The Bank has discumsed with authonties two studies Arenina Proinndal Goveent Finance (1990) anda recently completed report Argentina Towards a New Fedemlsm (1992), a summary of which can befound in Argenina: Public Finance Review-From Inslvency to Growtu (1993).

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30. Labor Market Flexibility. In the context of its fixed exchange rate system, prices andwages must be flexible to permit adjustment in Argentina's external accounts to the availabilityof capital flows. If the present high price level in pesos which results in cheap imports andexpensive exports is to change, employers must be able to set wages and prices in response tomarket conditions. Until recently, however, Argentina had one of the most rigid sets of laborlaws in the hemisphere, which virtually excluded the downward adjustment of labor costsCentralized industry-specific unions and associations held a monopoly for collective bargaining;the Minister of Labor had to register all collective agreements-or impose a settlement-andenforce them throughout the country without allowing for varations among regions or firms(i.e., any wage reduction would therefore require a new industry-wide agreement or settlement).Employers were discouraged from adjusting their work force in response to changes in marketconditions not perceived as permanent, because fixed-term contracts were excluded even forapprentices, and workers had the right to high severance pay without a probationary period orconsideration for unsatisfactory job performance; and the law on work accident compensationgenerated fraudulent claims because employers were responsible for the legal expenses of bothparties to a dispute without limits, despite the outcome. Consequently, ever greater numbersof employers and workers were driven into informal, often illicit arrangements.

31. Beginning in 1988, to improve wage and employment flexibility the Government ceasedimposing wage settlements, thereby compelling unions and associations to come to terms withoutrelying on political pressure. In November 1991, Congress passed new labor legislation whichhas significantly reduced the costs and risks of litigation, and in February 1992, a decree

tablished apprenticeships outside the restrictions of labor contract law. Finally, theGovernment has drafted a new law on labor flexibility to allow small and medium-scale firms(those with up to 200 employees, representing about 60 percent of the labor force) to have fixed-term contract without the sanction of collective agreements; to replace the ngid severance paysystem with individual capitalizon accounts filled by contributions of 4 percent of nominalsalary; and to give firm-level agreements precedence over industry-wide collective agreementsand enable employers who are paries to such agreements to reduce wages or lay off personnelin case of distress. Nonetheless, national union leaderships would still negotiate each laborcontract. Since unions have virtally no internal democratic procedures, local workers are noteffectively represented. Therefore, while the changes to date are significant and the newlegation would be a step in the directin of increased flexibility, amending the law of laborassociations remains the main unfinished business.6 The Bank suppots the Government'sobjective of intoducing greater flexblity into the labor market so as to create moreopporunities, especially for low income workers, and will be undertaking ESW to analyze morefuly the implications of the new legsative proposals and related labor market issues.

The iDnovations of the employment law-fixed-rm contracts, firm-level agreemes, nd industy-ideunemployment insrance-wer hobbled by tbe failure to amend the law of labor iations. As a rest.i firms can offer fixed-erm contas only if sanctioned by collective agreements on the national level; (i)

fim-level wag agreements must be negotiated with natonal unions rather than local wkers'representatives; and (m) unemployment insurance must be intoduced dhro collective agreements andcannot replace severance pay obligatios.

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Insitutienal Sth"Sqte'dng

32. Rekdndling growth requires not only reforning public finances, policies, and entisesbut also improving the institutional capacity of government to implement the refoms and providehigh-uality sexces This is not only vital to help the private sector become moreinternationally compettive, it is also necessary to improve the welfare and productivity ofArgenina's citizens. The poor, after a decade of slow growth, require access to improved socialservices to increase their skills, productivity and inoome leveis. This can be done only ifArgentina's public institutions can either recover from years of neglect or (in the case of newresponsibilities) be rapidly developed-particularly in the areas of public education and health,regulatory capacity, technology transfer, and environmental enfoxcement.

33. Sodal Services. Argentina's social services have been particulady affected by weak orchanged institutions. Poor targeting and the austerity-induced erosion of basic heakh seiceshave stalled progress in reducing maternal and infant mortality and malnutrition. The povertybelts surrounding the cities of Buenos Aires and Rosario and in the less developed northernprovinces have been hardest hit. The Government has also recently decentalized majorresponsibility for health services to the provincial level. To be successfid in enhancing servicedelivery, however, the provinces will require assistance to improve teir aemet capability.

34. Beginning with a proposed project ta help the provinces provide better health andnutrition assistance to mothers and children, Bank assistance would target vulnerable groups inthe uban poverty belts and the underdeveloped northern provines, in close collaboration withprvincial authorites. This would be followed by more comprehsive regional projects,beginning with the Greater Buenos Aires region (where the largest conce.tration of poor lives),and then expandig to the poor Northwest provinces, and later to additional regions asnecessary.

35. The Bank is also concemed with national health care issues. At present, the unionsadminister a compuLsry wage tax of 4.3 percent of GDP with minimal public supoeion, highadminisve costs, and poor service. Since coverage is mosdy for unionized labor,approximately half of the population is left without access to public health insnce. A reformof this system would allow affihiates to choose their isurance companes, permit new entry,mandate a minimum benefit package for a uniform preum, provide a sound regulatoryframework, and make access to a national health insuance progam universal Under theSSMTAL, the Government has prepared a draft law that would break the monopoly of unions onthe supply of mandatory health inace. Although poltal opposition to such changes isstong, and the challenge which the Government will face in trying to obtain the necessarylgidaftive support should not be undersmated, our dlge will continue in 1993.

36. Public educadon serices have also both deteriorated and been devolved to the provinces.The Bank is working with the Government on a possible loan to help provincial authoritiesimprove secondary education, responsibility for which was transferred in late 1992. At theuniversity level the authorities are preparing a major financing reform to introduce tuition

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charges and student loans for low-income students. This is needed to improve the quality ofhigher education and reduce implicit subsidies to the educated middle-class (1.7 percent ofGDP), an action the Bank has long advocated.

37. The federa govenment spends about US$1 bllion annually on houshg subsidies throughits FONAVI program, among the laqest of its public investment programs. In effect, theprogram provides middle class housing subsidies to builders and buyers because of excessivecontractual costs and poor collection perfornce. The Government tried with the help of theBank in the late 1980s to redirect the program towards the poor, but the effort failed. Not onlywere vested interests politically strong, an already weak fedeal housing institution wasundermined by a greater decentliion of the housing program to the provinces. The latteroften have even weaker housing institutions. The Bank was eventually forced to cncel a relatedhousing loan. Nonetheless, in its Public Fnance Reiew and on-going discussions, the Bankcontinues to maintain a dialogue on the issues.

38. Energy and lnr. Endowed with substantial deposits of hydrocbons,particularly gas, past governments reserved development of these resources to state-owned gasand oil companies. Development was slow and considerable resource rents were passed on tofavored suppliers and private oil companies. Electricity service deteriorated gradually thrughpoor management, prices were suppressed as part of unsuccessul stabilization efforts, andincreasingly costly hydropower projects raised public investment requirements.

39. Argentina has undertaken major changes in its energy institutions since 1989; it now isamong the most advanced of developing counties in privatizing state energy enterpnses, and hasalso done some innovaive work on regulatory frameworks to guide competitively the newlyprivatized firms. New legislation has been passed for deddlty, gas, and pdmklewa. In allthree areas, production has been atomized to permit competition between producers of gas, crudepetroleum, and electicity. In electricity and gas, the transmission systems have been or arebeing sold to owners with limited links to producdon firms, and the distribution systems soldconsistent with regulatory oversight of prices and qualit. The international and domestic saleof petroleum and petroleum products was greatly libealzed. The state oil company, YPF, hasbeen restructued while seling off marginal assets. YPF is the only state enterprise theGovernment will keep as a going concern and privatize via gradual share sales, beginning in1993. The Bank has supported these efforts via PENAL I and H, as well as intensive supervisionof SEGBA V.

40. For the new systems to work, the Govemment must rapidly develop and stengthen thenew regulatory institutions. The first effort to develop an autonomous reguatory agency-intelecommunications-demonstrated the difficulties that must be confronted. A poor choice ofcommissioners combined with the difficulties the new agency faced forced the Government tointervene the telecommunications commission, use a consulting firm to cover its responsibilities,and gradually restaff the commision. The Bank is discussing with the authorities a possibleregulatory loan to follow up the development and s ening of these new agencies. TheBank would also continue to support the completion of already advanced energy projects to

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ensure that ultimately prvatized sectors do not suffer from supply or environmental problems.The Govemment, with support from the Bank and the IDB, is expediting completion of theYacyreta Hydroelectric Project, which will help prevent supply shortages. The Bank and IFCare also worlkng with YPF to develop a pollution program that would be supported both beforeand after its privatization.

41. For decades, public investment in tMnspoeadon, water and other WAnfit hasbeen too low, and public assets have deteriorated along with the services they provide. TheGovernment has completely rrgazed the institutional responsibilities for these sectors throughprivatization-railways, airlines, Buenos Aires' water and sewerage, ports, and selected roadconcessons-and decentralization of responsibilities for roads and water and sewerage to theprovinces. Efforts are continuing to privatize the national maritime comipany. The provinceswill have an increasing role in most of these sectors. While the Federal authorities continue toadminister the national roads system, the provincial governments are expected to participate,particularly in road and port system planning and maintenance. In water supply and sewage,decentralization began earlier in 1980s.

42. The Bank's objectives are to help reinforce provincial authorities' administative capacityto perform their new roles as well as help establish adequate competitive and/or regulatoryframeworks. For the provinces, the Bank would seek to build their institutional capacity througha series of loans to enable these governments to cope with their extended responsibilities forinfrastructure in the wake of public sector reform. This will be inidated with a proposed projectin road maintenance scheduled for PY94, followed by others in rural infrastructure (irrigationdevelopment), and water and sewage. For the privatized sectors, the Bank will focus on helpingin the privatization process, and the development of regulatory frameworks. The proposedregulatory loan would likely include some transport and water agencies, although provincialagencies would best be assisted through provincial operations.

43. Public Services for Agriculture and Industry. Argentina's natural resource-intensiveand skill-intensive tradeable sectors stand to gain from trade lbealiation, deration,improved access to investment finance and infrstructure development. However, thedeterioration of public services-such as agricultural research and extension, technologydissemination, standardization, quality testing, and vocational training-has led to a loss ofcompetitiveness by local producers. The deterioration in the supply of these services needs tobe reversed to unlock the full gowth potential of tradeable sectors. The Bank plans twoopratons (for agricultural and indistrial services resectively) to help restore the supply ofresearch, technology transfer, quality control and vocational trining.

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Foste,ing Pdvate Sector Growth

44. As its public sector is reduced in both scope and impact, Argentina's future growth willdepend on an expanding and dynamic private sector. The Government has begun well a processto end the many distortons ta repressed and misguided past private economic activity; it isnow attempting to improve the few key public serces that can support modern privateenterprise. But the key to private investment-which will be vital for the sustaining the ecoaomicrecovery just beginning-will be the capacity of private investors to marshall unprecedented sumsfrom Argentina's still weak capital markets.

45. Over the past four years, the Government has implemented successive reductions inaverage tariff levels, quantitative restrictions, and other nontariff barriers to international trade,while deregulating the barriers to domestic trade and investment. For short-term macroeconomicreasons, it incr4ased average protection levels last November by about 5 percent, but remainscommitted to an open trade policy and has indicated its intention of bringing protection downas the trade balance improves. The Government also mitigated trade dispersion by lowerng themaximum effective rate from 38 percent to 30 percent (ariffs plus statistical tax) and raisingminimum rates from 3 to 10 percent. At the same time, average export tax rebates were raisedfrom 8 to 13 percent, and the system was rationalized to offset the cascading effect of the importtaxes on exports.

46. During the past two years, the Gov ernment also undertook a major effort to end themajor distortions deterring domestic commerce and investment. The Bank has supported theseefforts; two Trade Policy Loans (1987-88) were instrumental in launching the trade reformeffort, and some of our ESW had underlined the cost of many state regulations deternngeconomic activity. Argentina has also been one of the proponents of a regional common market,PMCOSUR, with Brazil, Uruguay and Paraguay. If brought to fruition as planned by 1995,this ambitious effort would permit free trade in goods, services and factor flows amongmembers, and is viewed by Argentina as a first step toward a hemispheric common marketarrangement. These efforts are far advanced and the Bank will continue to support theGovernment in maintaining an open economy, primarily through our future macroeconomicdialogue. After an exhaustive review, the Government also abrogated a long senes ofrlations that hac restricted entrance to a variety of activities ranging from gasoline stationsto pharmacies, from steel wholesaling to professional licenses. Finally, it has revised laborregulations that had detefred employment generation. As noted earlier, more important laborliberalization will begin once Congrss finishes consideration of new labor legislation.

47. Nonetheless, as elaboWed in Part II of this report, decades of high inflation have leftArgentina with a shrunken capital market and a banking system geared to financing the publicsector. While major reforms of the banking system and capital markets are underway, these arebeing tested rapidly. Not only are the newly privatized firms in need of major investments, tomake up for the years of neglect by the public sector, many prior private firms are eager to takeadvantage of the strengthened macroeconomic framework and expand their activities. Untilrecently, the Argentine financial markets were able to marshall only modest resources compared

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to the country's GDP; over US$SO billion was hld abroad by Argentine savers, and thecurrency had lost all credibilit even as a unit of account, let alone as a store of value,Argentina's stock market was used almost wholly for bond trnactions, and virtually aU of thosewere in US dollars.

48. While the major macroeconomic refirms have reversed this siuation, the need now isfor a rapid development of a rigorous capac to supervise finamcial markets--to bringtransparency to a sector still dominated by weak financial institutions-and enhance its credibilityto support longer term instruments needed by expanding enterprises. Only some large and well-run firms are now able to obtain t year terms, while the rest obtain far shorter terms. Onthe othe hand, a recent study by a respected Argentine research institute e3timates that only thenewly privadtiz PEs will need to borrow over US$3 billion yearly in long-tem funds if theirinvestment requirements are to be met.

49. The Bank is strongly supporting efforts that strengthen the mobilization of domesticsavings and their efficient intermediain to investnent. The reform program embodied in theproposed Fnancial Sector Adjusmem Loan is the cometone of this strategy. As stabilitybecomes consolidated, the financial system will become stronger, and the demand for long-terminvestment resources will increase. Therefoxe the Bank is also now preparing capital marketsdevelopment opeaons that would both acceleate the development of longer-term instrumentsin the Argentine capital market and improve the regulatory ftamework of the capital marketiself.

Some Arms of Specda Eqpha*

50. Poverty Alle'4on. The proporion of Argendnes living in poverty doubled from 1980to 1989.7 This was because growth of employment was stagnant, especally in the peripheryof the major urban areas, and because inflation had a higly regressive impact on real wages ofthe poor and their peso savings. The poor are not able to bargain effectively with employrs,nor are they able to shift savings out of pesos as rapidly as wealthier Argentines. At the sametime, social services failed to cushion the fal of many Argentines into poverty-because fewprograms were targeted to the poor even at their highest spending levels, and because fiscalausterity and inadequate budgetay p mming contributed to their deterioration throughoutthe 1980s.

51. The stuctnul reforms have already made an imporant contribution to poverty reducdonthrough their effects on pnce stability and growth. The inflation tax, which routnely averaged

7 World Bank Poveny Ad Iome D1fion s Lain Amca& Dhe &o,y f the 198*, December 1992,based on UN ECLA and Governmen houseold sorvey, while estimated poverty at only about 7 percent in1989. Becau of inherent methodologica problems m estimating an absolute poverty line, the trend isprobably more reliable than the exact number. While Argeni's resource and demogrhic configurationmake its absoolut poverty rats among the lowes in the hemisphere, tis esfimate is most probalyunderstaed.

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4-6 percent of GDP annually, has been replaced by efficient taxes, whose incidence fallsprop yotatey greater on the middle and upper classes. New imvestment has already increasedthe demand for low-skilled labao in constructon in many urban areas. While openunemployment is sdll high at 6.9 percent, it has faLlen somewhat from its peak of nearly 8peroent in 1989, thus incoating nearly 150,000 new worke into the labor force.Maintaining economic grow based on a low inflation tax is a prerequisite for continuing toreduce absolute poverty.

52. As the fundamentals of the macroconomic program improve, the Bank's objective is todevote more resources to assist in sector policy formulation--in health, education and housing-that wil reduce poverty. Some of this has already been done, through the Sodal SetorsManagmem TAL, the Bank has financed studies of health, education, and social security; thePublic FYnance Review (1993) has prvided a framework for federal social expenditures, andongoing poverty study will identify targeted interventions that would specifically contribute topoverty alleviation. Building on this work, and as indicated in paras. 34 and 36, the Bankintends to prepare projects to help strengthen the provision of health and education, whererelatively low expenditures can have a marked impact on the quality of life and productivity ofthe poor. Indeed, as adjusment lending is phased out, our future emphasis in the social sectorswil be guided by poverty issues.

53. Envronment. As the economic crisis recedes, the Government is becoming moresenitive to the adverse long-term environmental impact of existing patterns of natral resourceuse and indusil and urban wate disposal. in urban environment, water pollution ssues,including industrial contaminat and the state of water supply/treament systems, areconsidered most urgent, pardcularly for the greater Buenos Aires area. In rural areas, linkagesbetween agrcultural pracices and environmental quality (e.g. sodl erosion, control of pesticideuse, forestry production) are prorties. In addition, the preservaion of natural habitats andspecies is seen as requiring permanent vigilance and effort.

54. The ability of the Government to deal with these issues is hampered by weak institutionalarrangements, and a lega and regulatory framework chameteried by numerous laws andregulations with little effective enforcement. The lack of Government resolve to police itself hashampered enforcement; in the past, the exent of public monopoly and control over key sectorsof the economy resulted in the Government being the pnncipal contaminator of the environment.There are also junsdictional problems in frming and enforcing environmental legislation whichvests most power with individual provinces and not the federal government.

55. An Environmental Assessment in 1991 identified an agenda of problems that need to beaddressed, as macroeconomic and fiscal constraints abate, thus freeing up both senior managerialtime as well as providing resources. The Government has already begun to deal with industrialpollution via the PERAL 11 wad PEREL. The latter is being used to prepare a project tostrengthen the newly created Secrtaiat of the Environment, an effort the IDB is also interestedin supporting. As noted, the Bank will begin to address YPF's pollution with a possible projecteven before its privadzation. Future Bank ESW will focus on areas to support the Government

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in developing a lega framework that would allow for effective regulation and market-basedsolutions. In agriculture, ESW now underway in forestry will review resource managementissues and provide the analytical basis for future lending in forestry and soil conservation.

Levels of Bank Assistance and Relations with Other Crediors

Lening Levels and Composidon

56. Although an early member of the Bretton Woods institutions, Argentina borrowedrelatively little from the Bank until the mid-1980s, by which time total lending net ofcancelation was only about US$1.6 billion (about 60 percent in energy, 25 percent ininfrastructure, and the balance in agriculture and industrial development). Lending picked upduring 1986-88, with the approval of some adjustment operations, continued heavy support forenergy, and a few projects distributed among other sectors (totalling US$2.4 billion net ofcancellations). The early adjustment loans, in particular those for trade policy reform, yieldedsome useful reforms but their overall impact was constrained by the Goverment's inability tostabilize the economy and control mounting hyperinflation. During 1989-90, new lending wasresaticted to a smaUl tax administration project, although the Bank maintained a very closeelationship with the new Menem Government durng these two years, base on an intensive ESW

program and active dialogue on macroeconomic issues. Since 1991, the Bank has again steppedup leading to Argentina, for a total of about US$2.6 billion, slightly more than half of whichhas been for adjustment support and related technical assistance operatons (excluding theproposed Financial Sector A4,usiment Loan). Assuming strong macroeconomic and policyperformance, Bank lending to Argentina for FY93-97 could reach a maximum of aboutUS$5 billion. In the near-term, about half of the program would be devoted to adjustmentlending, but this would phase out in FY94 to be replaced in the outer years by only investmentoperations. Roughly 20 percent of the FY93-97 program would be devoted to consolidatingmacroeconomic, 60 percent to improving the public capacity to provide social and productiveservices (of which one-third would directly alleviate poverty), and the remainder to fosteringprivate sector growth. Annex XII provides a matrix of the policy issues which are being, orwould be, addressed in the FY93-97 lending program.

57. Acual lending levels will be dependent on maintenance of a macroeconomic program thatdoes not resort to the inflation tax. Argentina's transition to sustained stability and high growthcan succeed only with strong fiscal polic) based on the completion of public sector reforms anddetemined. The Bank wil therefore maintain an active macroeconomic work program anddialogue to help the Government in keeping its program on track. Particular attention will bepaid to the quality of fiscal adjustment, as evidenced by improvements in the tax strucre,expenditure composition, social security reform, and adjustment in the provinces, as well asmaintenance of trade and financial reforms to date.

58. Unexpected delays in implementing the reform program could stretch out the period overwhich loans could be presented to the Board, and might therefore reduce actual lending belowthe maximum US$5 billion five-year lending estimate. A less positive fiscal performance might

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slow the progress in improving management capacity and in mobilizing counterpart funds,requiring a slower-an-anticipated project sequencing. Also, investment project preparation islikely to encounter difficulties as the transfer of responsibilities to the provinces implies that wewill work with uncertin mechanisms of coordination between junsdictions.

Potefolo Management Issues

59. The implementation of mnvestment and technical assistance loans approved prior to 1989suffered from macroeconomic instability, counterpart funding constraints, poor management andfrequent changes in personnel. As the economy stabilized, these difficulties have abated, thoughthe Government still lacks an investment process on a par with those of other hemisphericleaders in adjustment. On the positive side, the Government has improved its savingsmobilization, relieving the constraints on counterpart funding. Second, it has steadily improvedits investment programming through preparation of an investment program tightly linked to thebudget. Tbird, through the civil service reform and associated salary increases, managementin the public sector has been gradually improved, although much remais to be done. TheGovenmment and Bank have held two Country Portfolio Performance Reviews since 1990, andaddressed a seies of implementatdon issues. Since then, improved performance can be seen inagricultural opeations, in technical assistance for power engineering, public enterprise, taxadministration, as well as in the municipal and provincial development projects. In addition, theportfolio of poorly perfoming prjects designed prior to the reform process was made consistentwith the new strategy during FY92, and moribund projects--Small and Medium Scale Credit,Housing Sector, and Bahia Blanca Port loans--were cancelled, while loans for electric powerand socil sector management were redesigned. After slight changes, two loans-Gas Utilizatonand Technical Assistance and Water Supply-were used by the Government to privatizeArgentina's gas company and the Buenos Aires waterworks. For these reasons, the quality ofthe portfolio has improved, and the pace of loan implementation has quickened.

60. However, many tak still lie ahead, such as improving the speed of loan activation andiniation, and the monitoring by federal authorities of large projects and those with externalfinancing to ensure timely implementation. Through our Public Sector Reform TechnicalAssistance Loan, we are providing support at the federal level for improving procurement,budgeting, and monitoring; although, it will take some time before these efforts bear fruit. Atthe provincial level, public sector management is weaker still, and will require significantsupport. Nevertheless, implementation of many key projects is having a major impact onArgentina's development prospects. For these reasons, the Region continues to allocate amongthe highest resources per project to the Argentine portfolio, both by Headquarters and fieldoffice staff.

Cooperadon with Other Multilaterml Insttutons

61. The Bank has worked closely with the IRf in the design and supervision of adjustmentoperations, in formulaing the country assistance strategy, and in ESW. For example, in 1990-92, Bank and Fund staff have routinely scheduled parallel missions for the PSRL and Standby

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reviews, exchanged information, projections and analyses, and held veral briefings in areas ofmutual expertise. To ensure collaboration, the Bank's Board has invited IMF staff to attend itsmeetings, and the IMP Board has done likewise; Bank Regional management routinely invitesIMF staff to attend inenal decision-making meetings on major loans and strategy sessions.There has also been extensive cor,sultation with the IDB, which has cofinanced a number ofinvestment and adjustment operaons.

IFC and MIGA Activites

62. IFC's investment strategy in Argentina is to continue to help develop industrialcompetitiveness in the face of rapid economic liberalization. The Corporation is helping export-oriented projects in agro and forestry processing, hydrocarbon devAlopment and infrastrucuresuch as railroad maintenance and pons. Domestic industries are being aided throughrstructunngs and expansions with complementary support for infrastructure espeiallytelecommunications, roads and power. In addition, IFC would support privatization orrestructring projects tirough fee-based advisory services, direct investment, foreign resourcemobilization, and an actual participation in the management of a privatization fund. IFC is alsoconsidering activities to deepen the securities market through local and international equityissues, support to local underwritings, investments in closed companies to be eventually opened,and participation in stockbroker houses. Moreover, IEFC is considering the development of newproducts in Argentna, such as leasing and pnvate pension fund maagement. IFC has made 77direct investments in Argentina, totalling US$768.4 million, of which US$324. 1 million has beenrepaid, cancelled or sold. In FY92, there were investments in chemicals, capital markets,energy, railroads, food and agnbusiness, and malt production. For FY93, approvals forinvestments for IFC's own account should exceed US$225 million and twice this amount in IFCloan syndications. These investments would again cover a wide gamut of activities, with thelargest portion in recently privatized companies including electricit generation, transmission,and distribution, gas and oil pipelines, railroads, telecommunications and water treatment.MIGA has also been active in Argentina. including projs in the pipeline, almost US$150million has already been provided in coverage for opeations in banking and in pulp and paper.

Issues for the Lending Strategy

63. Consolidating macroeconomic stability is a prerequisite for progress in institutionalstrengthing and fostering private sector-led growth. In the short-tern, the emergingimbalances in the current account of the balance of paymants portend a future adjustment which,as noted above, may take a different form than that foreseen in the Government's presentprogram. It is the view of both the MP and Bank staff that at present no change in the policyfrmework is warranted other than continued efforts to improve the primary balance. The Bankwill therefore continue to press the agenda outlined above on public sector reform and labormarket flexibility. As in the pas, progress on the fuentals-tat is, the structural reformagenda-holds the key to lasting price stability. This has been the Bank's stategy since I88,and te progressive convergence toward prce stabiity and renewed growth leads us to persistwith this approach.

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64. Sgtning institutions also presents particar challeges to the Banl. The post-adjustment phase in Argentina, with more emphasis on investment lending and thedecentralization of most public services to te provinces, will place greater demands on theinstitutiona cacity of the Government, and coordination problems m project design and

plementation will eand geometncally wihi the number of indpendent acts. Bxpeziencewi the provinces under the ongoing PWncdal and Munkipat Deopmem Procs sueststhat many have only a weak capacity to carry out their new soclal sector responsbilities, andneed substantial institutional strengthening. This puts a premium on designing prjects withsimple procedures and strong govemment ownership. It also limits the ability to implementnationwide progams involving all the provinces. Effective Bank assistance, then, may requirefocusing initial efforts on selected provinces-especially those with the highest number ofabsolute poor and those with the greatest fiscal imbalances, although we will also have to taleinto consideration implementation capacity. Even then, opaions outside Buenos Aires willrequire gater supervision intensity on the part of the Bank.

65. Within a short while, vrtually all of Argentina's national power, telecommunications,gas, water, steel, chemicals, and petroleum industries will be in private hands. So will manyinfraructure and transport activities-ports, airlines, railways, and the merchant fleet. Asindicated earlier, this will place a major burden on the still-recovering Argentn capital markets,While limitng direct Bank lending. The Bank will be strongly supportng the Govenment'sefforts to renvigorate the capital markets, but it is possible that the resources required forneeded private investments may not be forthcoming. Argentina's social security reform is stillto be passed by its legislat. Moreover, Argentina's financial histy has been more volatlethan Mexico's or Chile's; it may, therefore, take longer for foreig and domestic savers toaccept the risk of longer-term instruments. The Bank's own exerience with capital marketprqjects is limited; we shall thus be seekdng innovative approaches to the difficult issuesconfronting Argentine hJnancial markets.

PART IIL THE HINANCIAL SECTOR

66. This section identifies the problems and constraints hindering financial developmentaddressed in the financial sector reform program (described in Part o). In recent decades,Argentina's financial sector has been marked by a steady decline in resource mobilization.Public sector financial institutions have grown to dominate the financial landscape. For decades,the Central Bank has been the ultmate source of funds for the public sector and subsidies forthe private sector. Both the Central Bank and public treasuries have suffered from the weakfiances of national and povincida public banks. Private financial instudtns have, futhermore,been undermined by the poor macoeoomic and finmcial policies pursed by successvegovernments.

A. Resource Mobo

67. Over the last four decades, monetary expansion and segmentation of resources from thefinancial system to finance public sector deficib and subsidies led to increasing uncerainty with

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regard to prces and xcange rates; this uncerainty, in tun, undermied financialintermediation and stifled term savings and lending. Hyperinfl and the forced 1990conversion of savings depst into lower-valued public bonds damaged confidence in thefinancial sstem. The size of the finandal system (mead by the ratio of M2 to GDP) reachedits lowest point ever in 1990, approaching 5 percent, down from over 40 percent in the early1940s (see Graph 1). The total amount of bank credit declined from around 40 percent of GDPin the early 1940s to 10 percent of GDP in 1989, with about half being chmnneled to the publicsector. Argentine bank provided less than 10 percent of business finance and virtually noresources were generated by the equity and bond markets (see paras. 82 and 83). As a result,owners' equity became the primary source of finance for productive mvestments. Corporate andpersonal savings were channelld into either real assets or off-shore financial instruments. Infact, holdings of Argentine financial assets abroad are above twose held in the domestic financialinstitution Since these responsive capital movements quickly arbitraged interest ratedifferentals and erors in economic policy, they undermined investment financing by banks,which restricted themselves exclusively to short-term loans.

Graph 1

ARGENTINA - LIQUID ASSET TRENDS1940-1991

ao% ; 0 i I .IIII - ST -::1 I

30%: ::: I: I --I: III: :: I: I10%

40 46 60 66 60 a5 70 76 80 86 91

- Mi/GDP - M2/GDP

68. Pwor macrecoomic policie also distorted interest rates. Unstale inflation led towidely flucng intrest rates, frequently soarng in response to shaply increased expectationsof inflation (see Graph 2). By way of example, free rates (bankers acceptances) remained lowand stable at a monthy level of around 2 percent up to the mid-1970s, but fluchd from 2percent to 139 percent between 1975 and 1990. Succesitve speclation about the value of thedomestic currency, coupled with unexpeced swgs in inflation, also led to unstable real rates,whih varied from -5 ptent to 5 percent before 1975 and flucuated subsequently betwn -27percent and 7 percen between 1975 and 1990 (see Graph 3). Monthly ntermediation spreadsof above 2 percent were common since 1990, resulting from high lending risks and

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intermedatin costs. Unetanty of asset yields brought about the shor^t of matdit ofdomestc l in m to about one week efctvely hlting al aciviis in bondmarke.

Grph 2

Monthly Inflation and Lending Rate1988-1992

Percentage Points

88.6 88.12 89.8 89.12 90.6 90.12 91.6 91.12

Year and Month

Inflation Rate Lending Rate

G>raph 3

Real Lending Rate1988-1992

Percentage Points

100

sCo

88.6 88.12 89.6 89.12 90.6 90.12 91.6 91.12

Year and Month

Real Monthly Rate

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B. The Banking System

The Central Bank

69. During recent decades, the Centrl Bank acted as an important istument of governmentintervention. In the mid-1970s, baning intermediation was centralized, with commercial bankspasg deposits to the Central Bank and then providing credit on the basis of allocated CentralBank rediscounts. After the mid-1980s, the Central Bank became an important source ofservicing government bonds and of rediscounts to finance public ban (primarily for housingand pocal enditures). Because of noa-performing Central Bank rediscounts/loans, aliability struct demanding payments on the basis of market interest rates, and the need tofinance an ever-increasing interest bill by new borrowing, the Central Bank becme severelydecapitalized and incapable of carrying out monetary policy, contributing to the causes of theDecember 1989 hyperinflation. The Central Bank's domestic debt was subsequently eliminatedby the forced converion of commercial lank savings deposits into long-term external Treasuybonds salled BONEX. About 4 percent of GDP was forcibly converted into the long-termbonds-which were denominated in US dollars but had a market value initally less than half theirface value-thereby diminating Central Bank losses which had been generated by interest dueto commercial banks.

70. The 1991 reform, via the Convertbility Law, essentially tuned the Central Bank intoa currency board, limiting its domestic lending through the requement that the monetary basenot exceed iteratonal resev. To reestabLish the Central Bank as an effective monetayauthority free of non-monety functons (e.g., tradefinancing and liquidator of bans) andachieve its depoliticization, a new Charter was debated in Congrss during much of 1992 andwas finally approved in September 1992.

Public Banks

71. Argentine bankig has been dominated by national and provincial public banks, holdingabout 60 prcent of credit and deposits and owning about 40 percent of all branches. The shareof deposits at public banb increased from 40 percent to 60 percent during 1988-1990, as a resutof the relatively higher interest ates 1hey offered to secure resrces for the public sector.Tbese public bank have conitetly sought objectives other than profit maximizaton, includingthe financing of public budgets and public entepises, politically-motivated credit allocation andthe distribudon of subsidies in the form of loan amounts, interest rates, maturities and collectionefforts. Politically motivated decisions and de-fct bankrtcy protection led to a disregard foradverse financial results. Sub-standard loans of public banb were recently estimated at 52percent of their total loans, as compared to 9 perct in the prvate bank. Profitability of publicbanks is also poor due to oversafing and other iniiencie. Public bank employees amountedrecenty to about 57 percent of total bank employment, and public bank employees per branchexceed those of private bank levels by about 60 percent As a result, labor costs at public banksaccount fOf Up to 80 percent of operating costs, compaed to about 50 percent for all privatebank.

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72. As a result of poor resource mobilization and performance, public banis came to dependheavily on Central Bank financing. By mid-1991, Cental Bank rdiscounts to public banksrepresented 37 percent of the public banks' liabilities as conmwed to 2.6 percent in the case ofpnvate banks. The inadequate financial management of public bank became a burden to theCentral Bank, which made substantial losses (the quasi-fiscal deficit) because its interest incomewas below its interest costs and portfolio losses (see also pam. 5).

73. National Baks. Banco de la Naci6n Argentina (BNA) is by far the largest bank, withassets of about US$10 billion and about 13 percent of both domestic lending and deposits.BNA's operations, fully guaranteed by the Government, have served the agricultural and foreigntrade sectors, but its chief role has been diverted to that of a lender to the public sector: 70percent of total assets are directed to the public sector. BNA has been required to perform thedual role of a development and commercial bank. Development baing included acting as taxand payroll depository, providing liquidity and credit to the public sector (inluding publicenterprises), undertaldng emergency lending and acting as market leader for the modeating ofinterest rates. This emphasis on development banlang has led to a loss of focus on financialresults and caused BNA to yield a low return on capital and to deteriorate into a vastbureaucracy with an antiquated organization and systems. Operating costs are bigh, manybranches have a low productivity, and credit management is poor. (For further details on BNA,see Annex IV.)

74. Banco lipotecario Nacional (BHN) has served as an important pillar of the Government'shousing programs since the 1940s. While the Fondo Nacional de la Vivienda (FONAVI) wasintended to fund lower-income segments, BHN generally provided housing and constrctioncredit to middle-income households. High inflation and low deposi mobiliation caused theCentral Bank to become BHN's sole financier by the late 1980s. The increasing emphasis onsocial concems provoked a weakening of BHNs financial status, leading to portfolio yieldsbelow funding costs, sub-standard collecon performance and high opeating costs. Insolvencyset in during 1988/89, requiring a major resucuring of its debt to the Central Bak, operationsand lending stategies. (For a full account on BHN, see Annex V.)

75. Banco Nacional de Desanrollo (BANADE), with assets of US$4.4 billion, was createdin the 1940s to provide Argentine industry with long-term loans. As in many other developingcounties, BANADE, as a Govenment-owned bank, suffered growing government interfrencewhich led to poor credit policies, lax loan collection, and outright corruption. Res ngefforts to convert it into a second-tier institution were abandoned and closure is under way.

76. Caja Nacional de Ahorro y Seguro enceforth called WCaja") with consolidated assetof US$1.4 billion, was created in 1915 as a postal savings institution, but now provides bothbankng and insurance services. Its banking operations have been performing poorly on accountof large lending to govermnt and public enterpnses. In contrast, insurance operatins appearprofitable, favored by a large market sbare (13 percent) and its ability to place insurancecontacts directly without brokers. Caja serves a mass clientele and counts on about 5 millioncustomers. (For a full account on Caja, see Annex VL)

77. Provincial B . Princial ba play a major role, accounting for about 26 percentof total system assets. The provincial banks comprise one major bank in the province of BuenosAires itself, Banco de la Prvincia de Buenos Aires (BPBA), and a furer 29 (including

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municipal banks) in the other provinces. While there is some variability within the provincialbanks, in general they are in poor financial condition as judged by their capital adequacy, assetquality and efficiency. BPBA is Argentina's oldest commercial bank and the second lrgest with330 branches and 15,000 employees, but it remains financially precarious. The financial declineof the provincial banks can be attibuted to their primary mandate to lend to provincial treasuriesand enteprises without due regard for banlkng pnnciples. More than 60 percent of the creditneeds of provincial governments were satisfied by provincial banks in 1990. Pressured by theneed to fund provincial finances and low deposit mobilization, many provincial banks becamehighly dependent on Central Bank rediscounts to continue their operations. At their peak, suchrediscounts stood at about US$1.6 billion in June 1991. The Central Bank has encountereddifficulties in recovering rediscounts from the provincial banks, in one recent case-theliquidation of the provincial bank of La Rioja--it recovered none of its outstanding loans. In thepast, the Central Bank has found it difficult to close non-performing provincial banks since manyare governed by provincial constitutions and/or laws which often mandate their existence. Inpractice, provincial constitutions or laws dictate the key factors influencing provincial bankoperations-juridic form, choice of management and their removal, and merger or closure-sothat provincial laws have usually prevailed. The redressing of the precarious provincial publicfinances is a precondition of a lasting rehabilitation of provincial banks. (For further detaUils,see Annex VIII.)

Private Banks and Bank Supervision

78. Banking Structure and Performance. Between 1950 and 1985, private bankemployment tripled while real deposits stagnated. Excessive physical expanson, including over-branching, was encouraged by subsidized Central Bank credit, controlled interest rates ondeposits, and profits from the inflation tax. Furthermore, investors were attracted to the bankingsector by the Central Bank's 100 percent deposit guarantee regime, which encouraged a highdegree of interlocking ownership with non-financial firms and banks, as well as excessive nsktaking (see Annex VII for an analysis of deposit protection).

79. In the early 1980s, several institutions went bankrupt as a result of portfolio impairmentdue to sharp changes in relative pnces (some of the bankruptcies may have been encouraged bythe then applicable 100 percent deposit guarantee). During the later 1980s, libralized interestrates, the reduction of subsidized credits, and increased taxation through non-remuneratedreserve requirements, reduced the incentives for fuirther banldng growth. Although the numberOf private banks thus decreased from 179 to 139 during the decade, and employment decinedfrom 66,000 to 60,000, the number of branches increased from 3,800 to 4,500.

80. Overall, private banks have performed better than public 's. Non-performing loansamount to 9 percent of their total loans, far less than in public banks (52 percent). Private bankshave come to rely on fees for financial services as a main source of revenues. Today, privatecommercial banks are still recovering from the shock of the January 1990 conversion of savingsdeposits into public bonds, and hold large volumes of Treasury obligations created in the wakeof that conversion. Furthermore, they are suffering as a result of lower inflation rates andlower spreads. Hyperinflation had previously endowed banks with part of the inflation tax ondemand deposits. As prices stabilized, this important component of bank profits has beenremoved.

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81. Bank Supervision. The poor capitalition of the baning system has been furitherencouraged by traditionally weak regulton and lax enforcement of prudential standards. TheSuPerintendency of Financial Entities (SEP), a departnent of the Central Bank, has been a weakinstitution and received little managerial attention as a result of an apparent lack of Govenmuentcommitment to supervision. Historically, SEF's practies regarding loan classification andprovisioning were both lenient and inconsistently applied. Various norms regarding accounting,liquidity and solvency, control systems, credit evaluation, liability regulation became overlycomplicated and increasingly ineffective. Inadequate intenal or zation, staffing and dataprocessing contrbuted to ineffective processes.

Capital Markets

82. Although a market for equities and bonds has existed in Argentina for many years, it wasvirtually dormant for much of the last three decades. In 1991, the value of the daily volume ofequities trading was, for instance, only US$4 million compared with a figure of US$50-60million in the 1940s and 1950s. Furthermore, the number of firms listed on the stock exchangedeclined from a peak of 620 in the 1960s to about 170 today.

83. Until recently, holdings of private marketable securities had been virally non-existent.Most eqwties were held by controlling shareholders and issues of corporate bonds had beenexceptional. Several factors explain the weak private capital marlet. Macreconomic policies,which created risks with regard to interest rates, foreign exchange rates, foreig exchangeavailability, and government creditworthiness, discouraged investors and coporations fromfinancial commitments on a long-term basis. Taxes on capital market transactions amountingto between 3 percent to 4 percent of the value of the asset in a round trip transaction (buyingand selling) have discouraged new issuance of secuntes and have dnven securities-tradingoff-shore. The structure and incidence of withholding and capital gains taxes have also createdincentives for investment in government securities or bank deposits. Meover, developmentof contactual savings was discouraged by legal and regulatory constraints, which hindered thedevelopment of institutional investors such as pension and investment funds. The forcedplacement of government secunties to finance the public sector deficit also crowded out theprvate securities market. The securities markets have also not, until relatively recently, beensubject to a legal and reguatory framework.

PART ]IL FINANCLAL SECTOR REFORM PROGRAM

A. Overview

84. Major financial sector policy reforms, principally to reduce the public sector'sinvolvement in baning, have already been initiated. Interest rates of private banks have beendetmined freely since 1987, directed credit has been waning, mnetay emission has beenrestrcted through the Convertibility Law and major capital market distortions have beenremoved. The downsizing of national and provincial public banks is under way. Structuralreforms, however, are not complete, and need to be extended and mantained at the institutionallevel. Additional reform measures aim to shift financial intermediation away from inefficientand insolvent public sector banks towards private financial institutions and markets. Financialinstitutions will, in tum, be subject to more thorough supervision; they will be required to meet

- 30 -

minimum capital requrements of the "Basle" standard and minimum provisioning requirements.These reforms will both encourage sector efficiency as well as reduce the moral hazard to thegovemment emerging from failing financial institutions.

85. The Argentine Congress approved, in September 1992, a new Central Bank Charterwhich prohibits the Central Bank from issuing bonds, paying interest on deposits, lending tofinancial institutions for purposes other than short-term liquidity and increasing its holdings oftreasuty oblgations by more thn 10 percent per year. No explicit deposit insurance willhenceforth be provided to limit bail-outs at the public sector's expense, a cause of large lossesin the past. The new Central Bank Charter, drawn up with Bank assitance, increasescommitment to stengthened banking supervision and enforcement. Institutionally, however, theCentral Bank needs substantial strengthening. New organizational strutures, improvedcompensation levels and staff rationalizations have been initiated, but positive results can onlybe expected in the medium term. A major deficiency pertains to the accounting system whichhas been considered insufficient for an external audit. As a first step, accounts will bereconstructed to allow auditing and subsequently a new accounting system will be introduced.This work is being carried out in cooperation with the IM and is being supported by thePSRTAL. As a Second Tranche condition of this LoaIn, the accounts of the Central Bankas of December 31,1992, wil have been audited in a manner satisfctory to the Bank. Asa Thrd Tranche condition, the Centnl Bank will have approved a new accounting systemand a pbla for Its Implemeation.

B. Reduced Involvement of the Public Sector In Banking

86. To limit the need for any future Central Bank and/or budgetay commitments, theGovernment is reducing its ownership of financial institutions. BANADE is being closed andCaia is in the process of being privatized. BNA and BHN will stay within the public sector butbe further rationalized. Specific restuctunng at the level of individual public banks has beenunder way since 1991.

87. BANADE. Major staff reductions (from 3,000 to 600) and branch closings have beencompleted. An exhaustive revw of the feasibility of converting BANADE into a second-tierbank yielded the conclusion that BANADE had deterioated irretrevably. Therefore, theGovnment decided to cease aU BANADE opewatons. The method of lihqidating BANADEincludes: (i) transferring the BANADE function-of supporting industrial development-to BNA;and (ii) selling or otherwise disposing of BANADE's assets and liabilities. The sound assets(about 25 percent of the total) will be taken over by BNA and the remainder will be liquidatedby the Central Bank.

88. BHN. In addition to major staff reductions (from 4,100 to about 1,000) and branchclosings, BHNs debt to the Central Bank has been renegotated snd reduced substantaly. Asa consequence of this debt reduction, improved portfolio recoveies and lower operating costs,BHN's dsposable cash flow (after debt service and opetg epenses) was consderablystrngthened and is esfimated at about US$150 million for 1992. This new cash flow willprimrily serve to complete the funing of its yet uncompleted housing progams (about 20,000units). New BHN lending commitments will be on a second-tier basis only, and at tems tocover fnding costs, the cost of operons and a positive return on capital (for further detailssee Annex V). As Second and Thh Tranche condiions, cnim be provided that

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no first-tier leding has occurred. Further, as Second and Third Tranche conditions, anyBHN lending sball be through financl i es (so-caled "Second-Tier Lending")and granted only on the basis of terms covering borrowing costs, operating expemses anda positive return on capital Fially, as a Second Tranche condition, BHN wlll designrnanial perfornnce standards to be applied to BHN management and to be monitoredby the Government as owner of BEN. As a Thrd Tranche conditlon, BEN will Implementthe financial performance standards.

89. CaJa. The privatization process is well underway. Major staff reductions have alreadyoccurred (from 5,000 to 3,000) and a law has been approved by Congress sanctioning itspiivatzaton. Legal advisors, auditors and financial advisors have alrezdy been retained and thepreparation of bid documents is under way. Market interest appears substantial and the plan isto complete sale of the majority of shares during the second half of 1993. As a SecondTranche condition, the Government shall issue bid documents offering the sale of themajority of the shares of Caja. As a Third Tranche, the sale of Caja shall have beencompleted.

90. BNA. To maintain financial flexibility and to be able to meet unexpected financial needsuntil the Govenment's strucural reform program is substantially completed, the Governmentwishes to retain full control over BNA. At the same time, the Govemment is aware of BNA'sinefficiencies and is supporting its ronaization. BNA has completed initial and decisivemeasures: most importandy staff has been reduced from about 18,000 to 14,000, via an earlyretirement program, geneting opeting savings of about US$50 million per year. On-goingmeasures include improved contacting procedures, organi realignments and, mostimportantly, negotiation of new incentive-based compenson schemes for BNA staff. Tostrengthen further financial discipline, BNA will be defining financial perfomance standards(e.g., earning an adequate return on the government's equity) limiting financial semvices to thesmall- and medium-size productive sector; this would leave to the prvate banks the largecorpoate sector. In additon, to clarfy BNA's commercal bank competitiveness, its servicesto the Government will be eviewed for their costs and benefits (the so-called "GovernmentServices Study"). As a Second Tranche Condition, the Government will provide evidence,satisfactory to the Bank, to limit BNA's role and giving priority to private sector lending,define rinincial efficiency standards, and continue Ike rationaliation plan. As ThirdTrancbe Condiion, BNA wM have compLed with the earlier coients on a morelmited role, efficiency standards and rtonalon plan and have completed theGovernment Services Study, Inluding an action plan for its implnn.

91. Provincil Banks. Lacing direct juisdiion, the Govemment's overall strategy indealing with the provincial bans has been to tighten financial standards and survismy pressurethrough a regaizaton of their relatonship witi the Central Bank and the Superintendency ofBanks and to liit their exosure to their respective Govenments. As of February 1992, theCental Bank restricted provincial and municipal bank lending to their respective public sectorsto the sum of their own resources (equty minus fixed assets) plus public deposits. As Secondand hid Tranche, release conditions, the Central Bank would account for the complianceby the provincial banks with this lending limation. As noted above, the provincial bankshave been virtually cut off from access to Central Bank rediscounts. Even the rediscountwindow for liquidity shortages is not available for most provincial banks as the mammum thatcan be borrowed for up to seven days-6 percent of deposits-is below their outstanding

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rediscount amounts. Since January 1992, the Central Bank has initiated a program of loanrecovery from the provincial banks. This will requi-e the provincial banks to repay graduallyall rediscounts. These banks are also being required by the Centrl Bank to adhere graduallyto the same banidng regulations as the commercial banks. This means that provincial banksultimately must: (i) maintain reserve requirements on public sector deposits (which are currentlyexempt) at levels equivalent to those paid by commercial banks on similar deposits; and (ii) meetthe "Basle" capital standards. The Central Bank is proposing a phased period of adjustment onboth regulations. As Second and Third Tranche conditions, the Central Bank will: ()confiwr that rediscounts have been granted only for liquidity purposes; and (ii) account forthe compliance by provincial banks with new reserve requirements on public deposits.Reforms at the national level have spread to the provincial banks. At least four banks (San Luis,Corrientes, Rio Negro and Chaco) are being privatized. Other major provincial banks(Mendoza) are pursuing significant restructring. A forthcoming Provincial Reform AdjustmentLoan will support a series of provincial public sector reforms aimed at enhancing the strengthof provincial finances and supporting further restructuring of provincial banks.

C. Strengthened Banking Sector and Bank Supervisory Framework

92. The need for improved bank supervision is made even more recessary as explicit depositinsurance by the Central Bank has been eiminated. Under the Convertibility Law and the newCentral Bank Charter, the Central Bank will be unable to assist insolvent banls and insuredepositors. Insolvent banks will need to restructure, or close, and depositors will merely receivelimited protection (up to US$3,000) through first-claim-rights on Central Bank reserves of thefailing bank and third-claim-rights (after secured debtors and labor) on other assets. Experiencein Argentina has taught that explicit deposit insurance has not achieved its goal of maintainingconfidence and has caused large Central Bank losses. The Government has concluded that a newexplicit system, administered by a new organization separate from the Central Bank, would ruma high risk of repeating past public bailouts. Improving supervision-cum-ttansparency isconsidered a better alternative which would promote prudential behavior by bank managers andowners, and depositors. The Government will keep this new deposit protection system underreview and promote appropriate private sector insurance schemes (for furither details see AnnexVII). To ensure transparency for investors, as a Third Tranhe condition, wide publicationof frnancial statements by financial institutions will have been introduced.

93. The Govemment has committed itself to move towards a type of supervision that willincreasngly stress on-site inspection by the external auditors of financial institutions. Under thsapproach, the SEF's off-site supervision would identify institutions with substandard indicators.These institutions would then be inspected by one of SEF's on-site inspection teams. This tea-mwould assess both the institution's financial condition as well as the work of the institution'sexternal auditor. SEF would implement on-site inspection of other financial institutions on arandom sample basis. Inspection by sampling would reduce costs to the SEF, which currentlyaims at 100 percent annual coverage.

94. This model is appropriate for Argentina given its still weak civil service and budgetconstraints. Greater involvement by extenal auditors for on-site inspection is made possible bythe well developed private auditing profession in Argentina. Implementation of this model willtake place in a regulatory environment that already provides for mandatory extemal auditing butwhere SEF inspection has been insufficient in both quantity and quality. A key requirement of

- 33 -

is approach is a strengthening of the external auditing function to ensure that it effectivelyimproves the depth and quality of the information (particularly by subnittang long-form auditreports). The Cenural Bank has already prepared new draft regulations in consultation with theBank. As a Second Tranche condition, a satisfactory new auditing regulation will have beenmade effective.

95. The Government's commitment to supervision is set out in the new Central Bank Charter,which will entrust the task of supervision to a superintendent appointed by the Executive Branch,and with strong enforcement powers. Bank closure will be the only remedy delegated to theCentral Bank Board. The Superintendent will be able to issue cease-and-desist orders; to removeor suspend bank management; and to request closure to the Central Bank board. These keyenforcement powers are presently entrusted to the Central Bank President. As Second Trancheand Third Trache conditions, the Central Bank wi confirm that SEF has undertaken fulinspections of virtually alU public and private banks and that remedies have been appliedon public and private banks which are not in compliance with, inter alia, capital andprovisioning requirements.

96. Minimum provisioning requirements were improved. Previously, these requirementswere limited to non-guaranteed loans under judicial proceedings or to bankrupt borrowers, andto guaranteed loans to bankrupt borrowers. New prudental regulations establish minimumaverage provisioning rates on loans as an increasing function of the level of default risk.

97. The Govemment also intends to improve inspection methodology and tools, by exertinga better quality control over external auditors, introducing improved and uniform on- and off-siteinspection procedures. Improved quality control of external audits will be achieved throughmore stringent training requirements for eligible external auditors and periodic supervision ofauditors' work. Uniform on-site inspection reports will replace the existing haphazard formats;this will be done in the context of the new supervision manual which SEF is currently preparing.Improvements in off-site supervision methods should achieve earlier identification of poorlyperforming banks.

98. While the quantity of manpower at SEF is adequate, it will be necessary to increase bothcommitment and skldl levels. Increased commitment will be encouraged by SEF's strongerinstitutional role and by improvements in salaries, which have substantially declined. Skills willbe improved through 'tJing programs that are being designed in the context of the PSRTALcomponent for SEF. A iull revamping of computer technology used in the ieceipt and analysisof information is another major focus of the PSRTAL.

D. Revitalization of the Capital Market

99. A confluence of positive factors, catalyzed by the initial success of the stabilizatonprogram provided a significant stimulus to capital market activity in 1991. New issuance of bothequities and corporate bonds increased sharply over the lst year. For example, new issuanceof equities on the Buenos Aires Stock Exchange grew from just US$16 million in 1989, toUS$116 million in 1990, and US$355 million in 1991. Moreover equity market capitalizationwhich stood at US$2.9 billion in 1989 reached US$25.0 billion by June 1992. The bond marketis dominated by Argentine Government securities, especially dollar denominated and highlyliquid bonds. As of March 1992, there were some US$6.3 billion in Government securities

- 34 -

outstanding in the market. However, lega changes have also stimulated the corporate bondmarket. Since July 1991, US$788 million have been issued in maturities of up to six years inboth floating and fixed intest rates. Fixed interest rates have been as low as 9 percent andindividual issuances have been as high as US$100 million.

100. On the supply side of the securities markets, the privatization process itself is also givngrise to major market offerings; some 30 percent of equities market capitalization is accountedfor by the share placements of the northern and southern telephone companies. A major supplyof equities is expected in 1993, through the privatization of the national oil company, YPF.Demand by investors was strong up to May 1992. However, market indices have fallen sharplysince then, signaling a major correction following Argentina's best perfonnance of aU emeringmarkets in 1991. In due course, the biggest demand for securities may come from the growinginvestible resources of the pension funds ceated by the proposed reform of the social securitysystem. Under this reform, a pay-as-you-go social secmity system will be parially replaced bya capitalization scheme that will generate a significant pool of long-term financial savings.

101. The securities markets are rcg.Aated by the Comisi6n Nacional de Valores (NationalSecurities Commission or CNV). CN V is organized along the lines of the US Securities andExchange Commission. It regulates all agents that transact in public securities markets and hasthe authority to regulate and control the public offering of all secunties (other than primaryissues of the Govemment). While the CNV oversees the ations of markets, it has, however,encouraged the concept of self regulation by the main mwket bodies. In anticipation of muchgrater activity in the securities markets, CNV is continuing with reforms aimed at facilitaingthe issuance, purchase and tading of securities. CNV has now reorganized to strengtheninvestor protecdon and capital market development functions. Under the new organization,CNV will improve its control procedures through better coordination between the legal clearanceand inspection functions. A specalized judicial area will strengthen enforcement and regulatorydevelopment. Argentina's longer run capital market development efforts include: (i) increasedaccess to intrational marets through agreements with foreign stock exchange markets,improved tax treatment of foreign investments, regional capital markets integration, andintroduction of intnational accounting standards; (ii) development of investor protectionprocedures (control, information disclosure, ing agencia) and regulation of new capitalmarket products and capital market specialists; (iii) development of new sources of demand forsecurities, including privately managed pension funds and investment funds; and (iv) improvedrules for competition among traders to decrease intmediton costs. IFC is becomingincreasingly involved in capital market tansactions, while the institutional development of CNVis being supported by the US Securities and Exchange Commission.

E. FSscal lmpact of Reform Meaures

102. Future incremental fiscal benefits are aepected to exceed substntially the fiscal costs.To a large extent, this positive balance results because major costs have already been incurred.For insnce, staffing in the national public banks has already been reduced by 12,000 at a costof about US$180 million, mostly for severance pay. Another major cost which has already beenincurred are the capital losses of national and provincial public banks. Estimates indicate thatas much as US$3 billion may have been lost on account of poorly performing public bank loans.On account of bank liquidations the Central Bank is esimatd to have lost at least US$16 billionin respect of pay-offs to depositors, bank employee swverance payments and funds for continued

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bank operto. At tWis stWe of the reform process, ineremental costs involve minorexpendite related to isutional stenging (Central Bank, Superintendecy of Banks,BNA and BHN), privatzaton costs in respect of Caja and liquidation costs for BANADE. Onthe benefit side, the Central Bank will be relieved of aU bank liquidation activities as these willnow be managed by the judiciary system. Thus, the Central Bank will not be subject topolitically motivated bail-out demands. Further, the Supenntendency will be better able toanticipate a crisis and therefore be able to intervene at a time when weak banks can so berestructued or merged. Lastly, the institutional strengthening of BNA and BHN can beexpected to increase the yield on the public sector's equity capital. It is conservatively estimatedthat the privatization proceeds of Caja will at least cover all its liabilities. Private banksrequiring restucturing wi}l not be entitled to any fiscal privileges.

PART IV. THE PROPOSED LOAN

A. Background

103. The Bank's first comprehensive financial sector review of Argenfina dates back to 1986.A US$400 million Banlkng Sector Loan was approved by the Board in 1988 but was never

pigned becuse of a faltering macro economy. Another major sector review was completed in1989 and otier intermittent support was given for public bank restuctug. Learning from pastlessons this new operation is being timed to accompany and reinforce economic stabilizaion.Also, the loan builds on Cental Bank reforms supported by PSRL and the technical assistanceprovided by PSRTAL for institutional support to the Central Bank and Superintendency ofBanks. The Export-Import Bank of Japan is cofinancing this adjustment loan in an amount ofUS$200 million equivalent.

B. Loan Amount, Borrower and Implementing Agency

104. A fast-disbursing loan of US$400 million equivalent is proposed. The loan woulddisburse in three tranches. In addition, there would be set-asides of up to US$200 million. Anyfunds not neded for set-asides would be reallocated to the First Tranche. Asumig that allUS$200 million would be required for the set-aside, then the First Tranche would amount toUS$5.0 milion. The Second Tranche is set at US$95 million and the Third Tanche at US$100million. Because of many significant str a reforms already caried out and the need for thegovernment to assemble import documentation, it is proposed to permit retoactive financing forup to 20 percent of the loan amount (excluding set-asides) for payments made on or afterOctober 15, 1992; depending on the size of set-asides, retroactive financing may thus range froma minimum US$40 milLion to a maximum US$80 million. The borower would be the ArgentineRepublic and the implementing agency the Ministry of Economy and Pubbic Works and Services(hereaftr, referred to as the Ministry of Economy).

C. Lean Conditions

105. The Second and Third Tranches would be conditioned on the Govenmeut maintaininga satisfactory macroeconomic performance as detailed in the Letter of Development Policy(Anne II) and a public expenditure program consistent with the IMF's Extended Mund Pacility.The Development Policy Letter further detils financial sectr issues affecting Banco de la

- 36 -

Nacidn, Prvincial Bans, Superintendency of Banks and Deposit Protection. The Secretauy ofEconomy of the Ministry of Economy was designated to both monitor and ensure progress, byte different instituttons in meetng the Second and Third Tranche conditionality.

I. Conditions for Second Tranche Release:

A. Government to:

* confirm that all prior key sector reforms have not been reversed. The Ieyreforms are understood to be: (i) liberalization of interest rates; (ii) eliminationof forced investments and directed credit; (iii) adherence of Central Bank to newCharter; (iv) issue of regulations on "Basle" capital requirements; (v) issue ofregulation on provisioning; (vi) closure of BANADE; (vii) effectiveness ofregulation limiting provincial bank lending to the public sector; (viii) effectivenessof regulation equalizing reserve requirements between public and private banks;(Lx) effectiveness of regulation providing for repayment of provincial bank debtsto the Central Bank; and (x) divestiture of public banks.

B. Concerning Central Bank:

s submit satisfactory audit of its balance sheet as of December 31, 1992;* confirm that virtually all banks have been fully inspected by SEF, or external

auditor, and that SEF has applied remedies on public as well as private banks notin compliance with capital and provisioning requirements.

i issue regulations, satisfactory to Bank, to strngdten external auditing functions;* confirm that no rediscounts have been provided to provincial banks other than for

liquidity;* account for compliance by provincial banks on adherence to lending limitations

to the public sector;* account for compliance on adherence by provincial banks to regulations setting

new reserve requirements.

C. Concerning Caja:

* confirm that bidding documents for the sale of the majority of shares have beenissued.

D. Concerning BHN:

* confirm that no first-tier lending has occurred;* confirm that any second-tier lending has been at terms coveing borrowing costs,

operating expenses and a positive return on capital;* design financial pefomnce standards.

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E. Concerning RNA:

* comply with initial reform program; provide evidence, satisfactory to the Bank,to: (i) limit BNA role to give priority to private sector lending;(ii) design financial performance standards; and (ill) continue the raonalizaonpla.

II. Conditions for Thrd Tranche Release:

A. Government to:

* confirm that all prior key reforms have not been reversed. The key reforms areunderstood to be: (i) liberalization of interest rates; (ii) elimination of forcedinvestments and directed credit; (iii) adherence of Central Bank to new Charter;(iv) effectiveness of regulation on "Basle" capital requirements; (v) effectivenessof regulation on provisioning; (vi) closure of BANADE; (vii) effectiveness ofregulation limiting provincial bank lending to the public sector; (viii) effectivenessof regulation equadizing reserve requirements between public and private banks;(ix) effecdveness of regulation providing for repayment of provincial bank debtsto the Central Bank; and (x) divestiture of public banks.

B. Concerning Central Bank:

* confirm that new accounting system and implementation plan has been adopted;* confirm that virually all banks have been fully inspected by SEP, or extemal

auditor, and that SEF has applied remedies on public as well as private banks notcomplying with capital and provisioning requirements;

* confim that regular disclosure of financial statements of financial institutions hasbeen implemented;

* confirm that no rediscounts have been provided other than for liquidity;* account for compliance by provincial banks on adherence to lending limitations

to the public sector;* account for compliance by provincial banks on adherence to new regulaons

setting new reserve requirements.

C. Concerning BHN:

* confirm that no first-tier lending has occurred;* confirm that any second-tier lending is at terms providing a positive retun on

capital;* implement financial perfomance standards.

D. Concerning DNA:

* comply with earlier commitment on limited role, adopt financal efficiencystandards and ionali plan;

* complete -Government Services Study" and provide action plan to implementrecommendation.

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D. Procurement, Disbus , and Audit

106. Prorement and Disbusement. Loan proceeds-other than those needed forsetasides-would be used to finance the foreign exchange cost of general import (goods andrelevant foreig services), excluding goods financed by other bilateal agencies, luxury goods,military equipment and other goods specificaly prohibited in a negative list defined under theStandard International Trade Classification (SITC) or equivalent classification. Contracts belowUS$5,000 would not be eligible for Bank financing: this threshold would be consstent withsaisactory access by small- and medium-size importers. For commodity imports under existingcontracts, relevant expenditures would qualify for reimbursement under the loan in an amountnot to exceed the reference average per unit FOB price published in international commoditymarkets. The Closing Date would be December 31, 1995.

107. A Bank pourement assessment concluded that the public sector, government agencies,autonomous entities, and large private firms follow competitive procurement practices fuUyacceptable to the Bank. However, small- and medium-sized firms with limited internationalexposure do not nonnally follow acceptable procurement procedures. A new pement law,prepared with the support of the Bank, has recently been submitted to Congress.

108. Therefore, imports made by ministries, public enterprises, and private importers aboveUS$5 million would be procured through simplified ICB procedures in accordance with Bankguidelines. This threshold would be consistent with the anticipated sizes of contracts and theqperience of the borrower with Bank procedures. Pwcurement for contracts below this

threshold will be as follows: (i) public-sector contacts below US$5 million may be caried outaccording to the standard procedures of the purcasing institutions; and (ii) private-sectorcontacts below US$5 million may follow established commercial practices acceptable to theBank and requinng as a minimum two price quotations solicited from at least two eligiblesuppliers (except cases in which direct contrcting is appropriate under the circumstancesspecified in the Bank Group's procurement guidelines).

109. Accounting and Audking. The Ministry of Economy would be responsible formaintaining loan accounts, and for preparing and submitting withdrawal applications.Disbursements from the proposed loan would be made on the basis of a summary from theMinistry of Economy detailing individual import tansations in each relevant period, togetherwith a certificate of payments of the amount involved, and of the eligibility under the loan.Applications for withdrawals will be consolidated and submitted in amounts not less than US$1million. Contracts valued at above US$5.0 million would be disbursed against fulldocumentation; disbursements would be made against statements of expenditures for contractsbelow that sum. The Mintisty of Economy will maintain sepaate accounts to record andmonitor loan disbursements. All records and accounts in support of statements of expenditureswill be audited in accordance with geneally accepted auditing standards and submitted withinfour months following the disbursement of each Tranche. Second and Third Tranche releaseswill be conditioned to the receipt of the audit referring to the prior tranche.

E. Benefits and Risks

110. Benefits. There are three major benefits stemming from the reform program; fiscal (orquasi-fiscal) savings, an end to distortionary subsidies, and a more agile and efficient financial

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system. The reduced public owneship of bank wil reduce the fical cost requred for thercontinued, inefiint op os. To the exent prvni barnk are encuagd dther tO closeor be sold, the program wil bring fiscal savings and discipline to the provinc as well. Partof the reason Argenina's productive sector is so distorted has be the povsion of subsidizedcredit through the public nationa (and provincial) baking sytem. While subsidized creit hasended, the major institutional reforms now underway will help en there is less capacity orincentive to retogress. Finally, the reform will incre confidence and resoure mobilizonand improve the allocation of financial resources in the economy, thus increasing the oveaefficiency of financial intermediation. This will be achievd by a shift from the public secorto more competitive private sector financial institutions. Tlghter bank regulato and anenhanced superion capability wil lead to a better caitalized and more competitive bakingsystem. Reforms relating to the capital markets will increas the avalbilt of longer-termfunding for the private sector.

111. Risks. The major risk is a return to economic instability that would undermine therefom of a sector that is highly vulnerable to shifts in confidence. ITe financal position ofpublic bank could deteriate, posibly foring a wave of emergency financing by BNA anddimming the prospects of privadzing the Caja. nstability would also lead to furthereteriorion in the quality of commercial bank portfolios and bring about a downturn in activity

in the fledging capital market. It could also intensify the strong politica prees to slowdown the reforms of the public baning system. A further risk is the bureaucrtc letagy thatwould work in favor of the maintenance of the status quo in a financ system that has servedsome interest groups well in the past. Such lethargy might also impede efforts to improve thereguatory and supervisy fiamework for the baning system. The stong support, to date, inthe executive and legisative branches for the Converbility Law and the new Central BlankCharter diminish the probability of these events in the short term.

PART V. RECOMMENDATION

112. I am satisfied that the prposed loan would comply with the Articles of Agreement of theBank and woud be consistent with the approved guidelin for Bank sporL Thereommendations for the inclusion and reeas of debt set-asides up to US$200 million in thisproposd loan has been ommended in the President's Report No. P-5914-AR datd December11, 1992 on Debt and Debt Service Reducton Loan.

Lewis T. PrestonPresident

AUachmtntsJanuary 25, 1993Washingb, D.C.

A ot A DJMN IANMATRIX OF IJIWCIAL SCU RHODE FOUCE

ACIWIIY R IM NACtED r OR SBCNDUTANCEE FOR THUtDIRANCHTO DAT

A. Materecocsnsm ptogram *ASaued to aggegat Slyoa Busca program aW extrn 0 Complhacewith -year raeoecomnde 0Copiaewd3yaracsnolfingwish Wm P ao t DNW k il oaes of MFP program. jPan.

3. Monay Secr isoan 0 la_ es r WeSeahd, morde *regultico 0 Noe aveaubs of key p etin . 0 No evesas otter prer reflom.llberadi:sdlonofrecwca price an muak determined.

* C _al Rank redwsa_t raioaszd.

* Nw rdlacouss fo shoet sum lquiity puQrps Only.

A. Cad Blank Rorm 0A a Cera Dak Chamw was promulgate gIv i BCRA to submit stfctory audit of BCRA to appove gw aoulngsysemant 4tbo Cued BookfNdovial blance sheet of DeceaSes 31, I992. acIon plan for its npleetin 03. Suengsbeulgot8upedutndecyof 0 S e of FinaniBal Sena bas been give a 0 BCRA to onfirm that virU.t all DCAt onfim ta viualy l baUnb habFiancial E bihgher degre of eanfocempower. Regulatioo lad to batb have been bUly inspctd by BEV ao bee foly ipcted by SIer external aior attimprove cailton of bk (lALE standard to be extea audit a tE ht S has a E that S as appled readie en pubisc swel sgrdualy achived by 1996). remedies on publi a we as pivato bank pivet bas whch a- net In eanpliancwith

wh am a In compliance widh capial cpil and proisoigregu. ~~~~~~~~~ ~~~~~~and proiinn - .-* Now gplat oan povisIonIng i-ed.

* Now gplatos an ext aldir sad discsue of * DCRA to lsu rtions, aioe toy 0 DCRA o chieve ads ory regu dislesfiaucal aems drfed ia consultation with Dank to Bank, to rengtben extal audiing of flau_aa atenu of an banks_ _ _ _ _ _ _ S a n d s~~~~~~~~~~~~flatn..

Q DA.co Naelom of Desrolle Sd c

* 1(c ranc cosnscmltd. .*T Liquidaton of DANADE under way.

(I) Ca do Abom y Segu (Ca) * Ca peatzaio low apprved by Conrss. C* to Issu nvatoo to bid for So e Caja to complet lal of m1ajy of Snamajority of Sares.

* Majo stff redluctions completd.

* Preparaion of bid document under way. W__ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _ _

ACIM: DBPORM ENACrED FOR SECOND TRANCJE FMR TOM RtNCHBi______________ __ , , TO DATE

Oli D.ucoRltOsdoNaclAMl tDN Mjor Gtaff inutons om pleted. 0 Conflem tha no "*tlet huIts alsa # Cooflenwiha so ilet.d atla od ha occwuiud

* Msjorbuachcloaingacomplaon.* Joofin dlt any accoed4ot leadlqb *0 Cana dht ay mcand4wlenlp iast tmm* D aaeung bla owcd by Congrany: Uat tm to ye postiv retr on capta. to ie posie ome on aia.

lSdI_b be othalsb of aecoqMlegn.* Dsg fiacia prfamece smandals. 0 Implen tanc ipalpe ousasards.

(0) Daem deo l Nacida Argeti (ONA) * mor aff reto comped. * DNA to coAply wibh ratonulion 0 DNA to comply with Bahd rale, to adoppla; to ppo e gm la of MNA 1a; to fials' petancs" saddso. and to eawtu* Radpesarlo. pla idd. defn fina peane adabrds aioallzaapln

* Tegmof ei c foe sudy, to view cstbefaof 0 DNA to abnk study ea govu n servic aomv m. to in owe wlation _o pe to hInlsa _romlactlaou.

-_ _._. _. __ ,an _ _ _ _

B. R tofPovInalB ns *a * ad. Rway.

* New Cena Danudswcui d aee d. * CRA to coda. th no dlacous_ 0 UCRA to confirm da no rdisc t hav beenha bee proddat Is for lidity pnvi"dd oMe dka fr liq .

* Rqaymme of otading Coen Dak* M Allloa_ under way.

* Su_aWa compl e wih blni imiatis to public S UlA to acoug for coplia e on * CRA toaccot for comp_In onde eto"dct. aece to ledn lmio to publi ledng to pblic o.

rector.

* Subsadn compace wih reas in amv * DCRA to aoun for com e on 0 BCRA to acooent fr compflnce on adherae to.equIremen Pul deposit to acwh equyih Wm adhereto sw resev equemens. new reve rq_ur .

. <'VM ISS . . R

audi for firs eassche. second taa.

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4. Ppg1 of7

y eAady e9 muici e49WwoARGENTINA

FINANCIAL SECTOR ADJUSTMENT LOAN

LETTER OF DEVELOPMENT POLICY

Mr. Lewis T. PrestonPresidentWorld BankWashington, D.C

Dear Mr. Preston:

1. This Letter of Development Policy describes theoverall economic reform program of the Argentine Government 'aswell as specific sz.eps to deepen further the reforms in thefinancial sector. o meet these objectives, the Governmentrequests continued technical and financial assistance from the.World Bank for its full implementation. We would like to takethis opportunity to also present the macroeconomic frameworkwhich complements the reform program.

Macroeconomic Framework

2. Price stability remains the centerpiece of theGovernment's economic program in achieving sustained growth andproductivity. Toward this end, the Government has made importantprogress in 1991 and 1992. Monthly price increases dropped fromover 30% at the beginning of 1991 to approximatelyinternational rates by mid-1992. Although consumer priceinflation rose in the first quarter of 1992, as a result ofdemand pressures associated with the strong recovery in 1991,the increase in the value-added tax (VAT) by 2 percentagepoints, and seasonal factors, the Government has designed itsmonetary and fiscal policies with the objective of reducinginflation to international levels for the remainder of 1992 andinto 1993. The Government intends to achieve an operationalprimary surplus (before asset sales) of US$3,0 billion in 1992,US$4,4 billion in 1993, and US$3,6 billon in 1994. These amountshave been calculated to be sufficient to service projectedinterest obligations once a debt reduction arrangement has beenconcluded and are consistent with projected available financing.If these levels of primary surplus prove insufficient to obviateinflationary financing the Government will undertake furtherfiscal adjustments. Monetary policy, consistent with the Law ofConvertibility passed in April 1991, will be designed to expandthe money base consistent with increased money demand resultingfrom real growth and international inflation, and the associatedincrease in net international reserves.

3. Price stability and sustained recovery of growth willbe achieved only if lasting structural reforms are undertaken in

- 43 -

Pag 2 of 7

the public wectr TeGvenen' veal eom rgrmiy tAoy y a" a46

the public sector. The Governtment 's overall reform program inachieving its objective of price stability is embodied in twobroad areas: (i) structural improvements in the public sector--improvements in fiscal management, revenues and expenditures,and deepening of financial sector reforms, and (ii) policyreforms that would foster private sector activity -- continuedcommitment to maintenance of flexible and open markets free ofdomestic regulations and major external trade barriers, and witha strong financial sector to improve intermediation.

I. Structural Improvements in the Public Sactor

Federal Public Finances

4. The Government has given increasing attention tostructural improvements in public sector revenues andexpenditures.

(a) Federal Revenues. The Government in December 1989implemented a major tax reform that improved efficiencyand provided additional revenues from the VAT; thelegislation would be maintained without allowingadditional exemptions. The Government has providedfiscal bonds for firms that received specialpromotional tax incentives and will reduce benefits forfirms that have not complied with original contractualobligations under the promotion regimes.

Capital revenues from the privatization of public'enterprises and concessions, which yielded US$2,3billion in cash and an additional US$7,2 billion indebt reductions in 1990-91, are expected to generateabout US$l,9 billon in 1992, and will continue to beused to. reduce debt (external and internal) or forlabor indemnizations rather than spent on recurrentcosts.

(b) Federal Expenditures. The Government has givenincreasing attention to restructuring the FederalGovernment. The program includes, among other things:(i) improvements in the incentive system facing federalworkers; (ii) reductions in federal employment in thecentral administration and decentralized agencies(other than teachers and net of increase of DOI staffcomparing to 1990 program, of about 120,000 by end1992); and (iii) establishment of a modern civilservice payments system. To improve its expenditurecontrols and budgetary processes, the Government hassubmitted to Congress and Congress has approved amodern law of Financial Management and PerformanceControl that will provide comprehensive budget limits

- 44 -AN 1E&Page 3 of7

34 CIea4y d A

for the entire nonfinancial public sector, and anadequate internal control systems and ex post externalauditing. Furthermore, the Government has prepared aLaw of Public Procurement and Asset Management thatwill be submitted to Congress, which will eliminatemany of the distortions contained in the Buy Argentinelegislation. At the same time, the Government hasintroduced changes in cash management and accountingsystems, placing government accounts on a moretransparent basis.

For 1992/93, the Government will ensure thatexpenditures are consistent with its projected program,or less, should projected revenues not materialize, asprovided for by Decree 1823/91. For 1993, theGovernment will propose a budget to Congress thatmaintains current expenditures consistent with those inits three year program, and that continues its effortsto improve the quality of expenditures.

Financial Sector Reform

S. Major financial sector policy reforms have been initiated.Interest rates of private banks have been determined freelysince 1987, public sector involvemeait in banking (includingCentral Bank reform) has been reduced, monetary emission wasrestricted and capital market distortions have been removed.This confirms that no reversals are planned vis-a-vis interestrate liberalization, elimination of forced investments anddirected credit, and regulations on "Basle" capitalrequirements. To extend the structural reform, the Governmentwishes to highlight its concern and policies in the followingareas:

* The Banco de la Naci6n Argentina (BNA) has a long historyof having contributed significantly to the economicdevelopment of Argentina. However, the hyperinflationaryprocess and the unstable macroeconomic environment duringthe last decade caused a downgrading of the BNA organizationand administration as happened to most of the bankingsystem.

To rehabilitate the BNA, the Government has already taken anumber of initial and decisive steps to control operatingcosts and target new lending to the private sector. Staffretirement programs and cost reductions in areas ofprocurement were completed and office-technologyimprovements and renegotiation of new and productivity-basedcompensation packages for BNA staff are under way.

The Government wishes to maintain control over DNA toIC complement the private finance system, lending at interest

- 45 -

Page 4 of 7

YAa4y Q9hW6 A1AW

rates which gradually converge to international levels. TheGovernment's mandate of BNA will adjust to the BNA's Charterand will be clarified with a view to set financialperformance standards and to achieve a positive return oncapital. Lending to the Public Sector will be limitedaccording to the BNA'S Charter.

Furthermore, BNA will continue its program of institutionalstrengthening and consolidation aiming at improvedmanagement of loans, overhauling information systems and atenhancing the productivity of its branch network.

* Provincial Banks. In addition to the promotion of fiscaland structural reform at the level of provincialgovernments, the Government will encourage the restructuringof the provincial bank sector. To expose provincial banks tofinancial discipline and competitive forces, the CentralBank will continue demanding the repayment of rediscountsgranted earlier; banking regulations governing theprovincial banking sector will be reviewed further toeliminate any remaining privileges (such as branching) andregulations will be applied by the Superintendency of Banksto ensure even-handed treatment vis-a-vis other banks. Inaddition, major restructuring efforts are required at theinstitutional level of provincial banks: employment costsare high, in many cases exceeding 100% of total income;technology is outdated; branching is exce3sive, driving upother administrative costs. Privatization (i.e.selling morethan 51% of the shares) would be the most effective way tocreate an interest group which would exert constant pressureto generate positive rates of return. The Government will beconsidering providing assistance, financial or otherwise, topromote the privatization and major restructuring ofprovincial banks. Excluded would be measures which aresuject to quick and easy reversal such as mere staffreductions.

* Superintendency of Financial Entities and Exchange Houses.Despite significant efforts in the past, bank supervisionneeds strengthening. The Government has strengthenedregulation through enactment of improved capitalrequirements that are consistent with Basle guidelines;tighter limitations on lending by provincial banks to thepublic sector; uniform regulation, inspection andenforcement for public and private banks; new prudentialprovisioning requirements and expanding the role of externalauditors and making auditors responsive to the needs of theSuperintendency of Banks. The new Central Bank Charter hasendowed the Superintendency of Banks with increasedenforcement powers. In addition, major institutionalimprovements will be carried out by developing inspection

- 46 -^ ~~~~~~~~ANNa n

Page 5 of 7

policies and work programs, making no distinction amongpublic and private banks, by improving skill-levels and bystrengthening the institutional apparatus. TheSuperintendency will be strengthened with updated computertechnology, off-site inspection system, uniform inspectionreports, improved staff capacity and motivation, andtraining in systems auditing and in the update inspectionprocedures. Resources from the World Bank's Public SectorTechnical Assistance loan will be deployed to financetraining (in inspection procedures, financial analysis,banking practices and economic analysis) and design andimplement an automation plan.

* Deposit Protection. The experience in Argentina withexplicit deposit protection has been negative. Large losseswere the consequence. Therefore, the Government has put inplace an implicit system (e.g.giving preferential access toCentral Bank deposit up to US$3,000), which places a greaterresponsibility on depositors, bank owners and managers.Concomitantly, the bank supervision process is beingenhanced and public disclosure of financial informationregarding banks expanded. These actions are being taken toreinforce the overall soundness of banks and to enabledepositors to make better informed decisions regarding thedegree of safety afforded by alternative depositoryinstitutions. At the same time, the government recognizesthe special advantage conferred on public sector banks byvirtue of their state sponsorship, particularly theadvantage enjoyed by public banks in terms of depositsafety. In furtherance of the government's objetive toreduce the role of the state in the financial system,government will monitor the evolution of the system toensure that the growth and soundness of the private bankingsystem has not been jeopardized as a consequence of theseactions. Specifically, in order to safeguard the ability ofthe private banking sector to mobilize an increasing shareof deposits at reasonable costs, the government willmonitor, among other indicators, interest rate differentialson comparable instruments and trends in market share betweenthe public and private banking sectors. Should adversetrends emerge, the government is committed to refinepolicies and to take actions, including supporting effortsby the private bankins system to develop a privatelyoperated system of deposit protection designed to enhancedeposit mobilization and to reduce the risk premiumassociated with such deposits.

+ 1I. Policy Reforms for Promoting Private Sector Activity

Maintenance of an Open and Flexible Economy

6. For the past several years, especially since 1989,

-47 -^ ~~~~ 47 ~~~~~~ ~ANNEX n1Page 6 of 7

Argentina has been engaged in a major overhaul of its economy inorder to eliminate the institutional obstacles that haveconstrained the flexibility and responsiveness of the privatesector. Trade liberalization, public enterprise and open marketreforms constitute the new direction of the economic program.

(a) Trade Liberalization: The Government has made rapidstrides towards opening the economy, both in terms offlows of trade, capital, and technology. Taking intoaccount recent measures, the import tariff structurehas been simplified and the average tariff ratelowered; import tariffs are between 0 and 20 percent.Export taxes have been eliminated, almost allquantitative restrictions and discretionary proceduresthat slowed the entry of trade, capital and technologyhave been removed. The Government will keep the economyopen to international competition; and will bringArgentina's antidumping provisions in line with therespective GATT Code. Moreover, the MERCOSUR treaty isnow being implemented. Two regional tariff cuts havealready taken place, and it is the Government'sintention, as specified in the Treaty of Asunci6n, toreduce all intra-MERCOSUR tariffs to zero by January1995, while eliminating all other Intra-market tradebarriers.

(b) open market economy: The Government has eliminatedsubstantial controls on prices, wages, and interestrates as well as a complex network of subsidies andimplicit taxes. Much still remains to be done on statereforms and opening of the markets. The Government'sreform program is not only to reduce the size of thepublic sector, but also to avoid the transfer of publicto private monopolies when attracting new capital,management and technology. To complement otherpro-competitive initiatives already undertaken-tradeliberalization, privatizations, deregulation-theGovernment Intends to improve the existing CompetitionLaw to avoid undue ownership concentration and be moreproactive to ensure a-dynamic and competitive privatesector.

IyC

- 48 - ANNXR

Page 7 of 7

Q#W&%Id0 we woerni.a

Y4 M - E y 'ER' Qa(4CE

World Bank Sutort

7. The above presentation demostrates the depth of theGovernment's overall public sector reform program. TheGovernment believes that financial assistance from the WorldBank is essential to continue and complete its financial sectorreforms.

since yors

m rf /

December 8, 1992

- 49 -

_inTOi 1: DUINA- Uwa.uswm12-mOonp uiusoURIMwIssqiin"flsd054PM

1s191 IlW tS9S- 1 m 19Iw io 21t000 001

NdlmAceounWwP grot as 6. 0 4.0 4.1 4.1 4.2 4.2 4.5 4. 4

ow1hdpvow1 *np48M wm 6. 0 (14 0.8 1.7 1.7 1.7 1.6 1. 18 2.1MP OtJS bEN 1#UA 15352 16.6 1" 106.s 211.0 220.8 247.0 2. 28.8 312.2% ShwoGOP,

Towl lrNwtm 12.5 14.0 15.S 1o 16.5 17.0 17. 16O 1s5 1t0 190PrIw±. 10.0 12.4 1 14.3 14.7 15.1 15S 15 16.2 16.5 164PiIO 1.8 1.6 2.0 1.7 1.8 1.0 2.0 2.2 21 2. 2.

Nd6w S&*W 10.4 0.6 12.2 13.0 15. 14.2 14.0 15.7 164 172 17.6Pdmb 11.9 7.7 OA 11.7 124 12.e 11 13.4 1t5 14.1 14.1P1bG (00) 1* 2.5 15 12 15s 1 2.3 2.8 .1 3.

Foign Saui 2.1 4.4 .0 2.9 :A 2.6 2. 2.1 18 1AICC oved) 10 t1. 4.7 35. 39 4.0 4.0 42 42 4.2 4.

PSmdaremuhb^m%darutP:TGtiCunenWR.IEIUS- 14.1 17.0 1a1 1a6 186 1Q5 11. 1A4 16A4 1 16TOWOC mt ntEdzwsv 152 15S 1" 1. 158 1is? 156 1t 16.1 14.0 14.7kt E NSpdw 3.4 1. 2.0 2.4 2.4 2.4 2.4 22 2.0 1.n 1.5

s8d"Soua simkp (0.1) 0.5 (0) (1.) (1.) (1.5) (1.1) (04 (04 (0.4 (0A)PE Non-1 1m t Sa*rm 0.5 02 0.5 (4 (04 (1.0) (04 (0 (04 (04 (040P1besing (04 1.9 2A 1. 12 1.5 1.8 2. 2.8 3.1 3.5Caph lRemum 12 1. 0.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0cabiEbenJu 16e 1.6 2.0 1. 1.6 1.9 2.0 22 2.5 2.5 2.8Norig d PtMoSeawr (1.S) 1.6 o (0.4 (04 (0.4 (0.5) 0.1. 0.4 o0 0.9Qum-Fba &M*w 0.0 (04) 0.1 02 02 0. 0. 0.3 0.4 0.4 0.4Ovd s ( 1.6 0.0 ( (0 (0.1) 0.0 0.4 0.8 1.0 1.5MmomP*" W 2.1 SA 2n 8 2.0 1 2.0 2.1 22 2.4 2A 2.5P ixw gU5m MoE"# 2.A86 5,178 4,7 3,6058 5657 4.296 4.856 5.52 6,s5 M4 7,658

PwAdftwPftm &f*9(USSmIsQ 1,221 82 4,403 5,685 5,687 4,26 4,856 s552 SAN .0S4 7.6sefrterAt5EldnowJS Mmw 4.60 2,685 3,425 4,354 4,751 5,060 5,447 5,561 5,812 5223 4,609PMwySuphCWVRadobl s1A 1922 15s8. 842 772 84.4 82 103.7 1225 133.1 156.8

E<a3NF8(magreow1hw 2.2 1.7 aai 0.2 6. 6.t a 7 6.7 6.8 6.8 n 09EsowdGNFF.uROIO5P 11.0 102 10.3 10.7 10.0 112 11A 11.7 12.0 12.3 12.6InoetsNFS (l hrat 65.7 43.2 1 A .3 4. 4.7 4.6 4.6 4.8 4.9 4.0

o 6.7 11.5 11.0 107 10.7 10.6 10.8 1010.9 1 1.J i0 11.0Trade BduoJS wlor 4.,07 (1.139) 84 578 081 1,422 1X3 2,511 5,179 5,968 5,125CMtAooiatB S 4 (,748) (170 (6582 (5.425 (U7 (5091) (6,08 (5,2 (5.60 (5.8 (4.387)CopilA¢oount8QJS$m illX G5,452 9,878 0,S70 025 6.477 6.791 6.82 6SAW ,439 65 5,187P1Mo 5,746 PM 5.142 (45" (114 (54 t6 8V7 20 (150 (1,975Pitha 1,704 10,100 6S 8,675 6 7,124 5.013 5.791 ,251 62M 7,161

Chat ACGdlarmiOWYCUtf GDP (4.4 (3.5) (4 . (148) (11) CL4 (1.) (14h (1.4

DdtioimeTotal DObt J8$wt* 67.09 91,04 01.111 04.195 101,914 106.S3 108,677 110844 112.087 112,420 112M2TOW P1oS.mDebt 6.145 70.16? 75447 75,774 75,428 7,4 78,534 7716 73.805 71,138 67.355Fergdnbt 0.84 6am 60.103 *7 59,7 5MM88 65,145 50,464 5692 58.178 K5w46OamotDt 2SO0 18,s? 15.344 15.817 15,41 17561 1s8 162s2 14,113 12,06 11,400

T*w P OADd*tww1twP 46. 51.7 44.7 41A 58* 562 3s5 0.7 27.7 24.6 21.6T*W Debt m* 0CWt GOP 4A 6o 48 52 65 5.9 6. 62 8.1 6.1 4.9P1dw,ra40WC O PoI .2 o 2. 28 2n. 3.0 S.7 52 .0 2.9 22Pm6ureCmdtria mGor i_Rwa 20.7 16. 14.0 14.8 155 1.1 19 17.4 16.5 16. 12.0PSCagoRioforPr dd.CretM 1793 42.4 297.0 155.1 1. 168s. 160.8 207.8 24.6 275.0 82

Mm_qdPdm;ComuUobiionirdm(umiai>~) 150 11* 7.0 a93.0 5. 5 3A 5 .8 5s sn8PO ,m sRa Mnds (187m1Or 890 .e0a 65. 6n 6a" 6ss ea" esa" on es9 6snUWReI 73 s. 4. 6 02 6 7. 7.0 7.0 7.0 7.0M1g>uNtWOP 5A 7.0 7.1 7.1 7.1 7.1 7.1 7.1 7.1 ?.1 7.1

WTPMbofquu s tt.Tzy1n 109 aPEb ir_c pb/PdmuyS 9 c d Fo t r56Pb@fthP1ic 8r.qtPgm ehOMMOW9kt, 1D. S N0 (at4d/ mnly tm1m 'figl ad _iftmdoelP.dod qU 3R

- 50 -

AIVrwir2

ARGENTIAFINANCIAL SETOR ADJUSTMNT LOAN

BANCO DE LA NACION ARG1NTINA (BNA)

1. Badkgroumd. Alhough DNA has been In exisu ce for more than 100 yeas, its anTCharter dates back to 1978. Its primary objective is one of a development bank supporting the fof agriculture, foreign trade, other commercial nd indust activies and the promotion of an orderlyregional development. While BNA is expected to earn profis, the level of profitability has been asecondary objectve. BNA benefits from a number of privileges, the main being ta all operations ofBNA are guar eed by the Argeine Republic. Other priveges include ta foreign curreny holdingsof state entities be deposited with BNA, exemptions from a number of miscellaneous taxes and restrictionsin lending practices (tax exemption on fixed assets, accelerated foreclosure facilities), and nt beingsubject to the Laws of Financial Entities when BNA opeates abroad as a private corporation. CurntyBNA holds about a 13% share in deposis and loans.

2. FInanal Performane. Summary balance sheets and income statements are presentedbelow:

inIolMxmOF(b*1oUmh1nofUS$)

Fer 9 manls ended YearenledSep30 (u _uk) Dearber3l (sudted)

1991 1990 1989

918,695 676,814 496,772ovunmsdeecuuias 217,194 621,248 434,433

Lam 7,461,005 6,108,5S3 5,167,787BuhLy in other coymanies 5,429 5,638 19,960ak prmlisees, .quein and mnisesansoa" -m 761,400 86,201 3M2467

Oherw em 546,117 967S77 98476Total gusts 9,909,840 9,226,031 7,319,995

Deposis 4,206,816 3,164,725 2,292,3=3Odter Iabfide 3,930,089 4,166,177 3,971,033PAovWiuoM 34,820 36,308 29,468

8,171,725 7,367,206 6,292,034

Caidta stock 229,970 339,481 S22Squlty ad&utmnt=s 1,006,949 927,156 685,447PMoft remysc 489,593 538,246 119,525Retained mad.8 . 11,03 53,938 221,667

1,732,11 1,81 1,027Totsl IAabiUedu aUtl barehlMdn' eq*t 9 3909,540 9,226,031 7,319,995

FrnWAImc kllb 1,098,840 3,043,114 3,052,910naWclalwpeamnlhra (734,342) (1,718,415) (2,122,137)

Lowan lmovio - (60,940) (244.486) (128,524)OCher inoon IS2,654 176,669 44,052Opemtihgexpeases 057,425) (514,838) (231,052)haneko$Minome 38,375 45,882 53,391* oeflmaaa-_ (34,160t (124,813) (104,740)monaxtyadJustmnts MA67) fiQL(MO 10Not Inome -be1n Inloma tsx 12,331 7,552 3541977In-ome tax 0. 0__k GMLNdt beome 12,331 56MAN8 3555

- 51 -

ANNE

3. Main Assets and Liabilities. Of all loans of $6.1 billion as of December 1990, only29% have been directed to the private sectr whereas $4.5 billion or 71% have been benefiting the publicentities and enterprises. These public sector credits, however, include $3 billion for which BNA actedin the past as a funding channel for the Treasury by raising the funds from intrational commercialbanks and then relending them to public sector entities. The terms of the $3 billion public credits followthe principles applied to the refinancing of commercial bank debt of the Argentine Republic and otherpublic sector borrowers: debt service is to commence in 1994 and end in 2006 (the so called GeneralRefinacing Agreement or GRA). Loan loss provisions have been set at 5% of the tot loan portfolio.No loan loss provision was established for credits to the public sector and enterprises as the ArgentineRepublic is the guarantor of such loans. Therefore loan loss provisions are maiy reated to privatesector lending and would account for about 17% of private sector credits. Among the main liabilitiesfigure deposits and other intemational credits. Total deposits of $3.1 billion, raised In domestic andforeign markets in equal proportions, are denominated in foreign C70%) and in local currecy (30%).Liabilities to the intenational public banks such as the Interamerican Development Bank and the WorldBank amount to about $2 billion representing 55% of other liabilities. The Govermment's equity iscarried at a book value of about $1.9 billion.

4. Profitabity. BNA earned in 1990 a profit of $57 mfilion or less than 0.5% on its bookequity. Loss provisions have, most likely, been understated, because of deficiencies in setting provisisns.Foreign branches have been quite profitable and appear to have compensaed losses in domesticoperation. One major reason for poor profitability is the high operating costs which in 1990 reached$510 million or almost than 10% of total loans. By any standard, this is excessive.

S. n ent and Organization. The chief executive, the vice president and all 10detors are nominated by the executdve branch of government. Staff totals about 14,300 of which about2,800 are employed at the head office in Buenos Aires. About 500 employees are active in the foreignbranches. And 11,000 are distnued in more than 500 domestic branches. The organiation is theavy and incmntves for producvy are few. Operating and information systms are outdated andrequire urgent updatng.

6. Iltlal Reform Program. Since the beginning of 1991, BNA has bee implementinginitial reforms with the assisuce of reputable management consultants. An ealy retirement progrmwas put into effect and led to a staff reduction of about 4,000 employees. All fancing was providedfrom internal funds and the total costs was eimated at about $60 million or $15,000 per employee. Asa consequence, annual personnel costs are expected to derease by about $50 million. Other refortsinclude cost reductions in areas such as transfer of funds, transport and cleaning services. Ornizaonalmeasures include the streamlining of managerial levels and the implemention of a new productivity-based on scheme. Reviews are under way to determine the least cost solution to upgradeoffice tehology. Furthermore, the branch system is being studied with a view to detemine levels ofproducivity and consequent branch realignment. In parallel to these Iiti reforms, DNA has beencosidering defining more clearly its role, its relationship to its shareholder and the need to emphaszmore promnently the earning of adequate raes of return on capital.

- 52 -

ANNEXV

ARGENTINAFINANCLAL SECTOR ADJUSTMNT LOAN

BANCO HUP'lECARIO NACIONALSUtMMARY OF ACTIVITIS 1988-1992 AND FUTURE PROSPECTS

I. EVOLUTION TOWARDS AN INSIR1MENT OF NATIONAL HOUSING POLICY

1. The Banco Hipotecario Nacional (BHN), founded in 1886, became a premium mortgagebak in Argentina during the first half of the 20th century with a reputation that pmted issuing bondson foreign exchanges. Commencing in the 1940's, the govemment began to use the BHN as aninstrument to execute its national housing policies. Housing needs were divided into three income basedsegments. The private banks would finance the wealthy; a National Housing Fund, the Fondo Nacionalpara la Vivienda (FONAVI), started in 1973, would house lower income families using fimds collectedfrom a then applicable payroll tax; and the BHN would provide housing for the middle class.

2. BHN's new role was reaffirmed in 1980 with a new charter that explicitly states that theBHN would execute housing initiatives of the executive branch through the Ministry of Economy. By1984, BHN management began to grant loans at concessionary terms to meet a self-imposed definitionof housing affordability. As the BHN began to lose deposits, the Central Bank, the Banco Central de laRep6blica de Argentina (BCRA) rapidly increased its loans to BHN.

3. Excessive costs of a bloated bureaucracy of over 4,100 employees (reduced to 1,200 byJuly 1992) contributed to the increasingly precarious finances during the 1980's, but the BHN becameiretrievably insolvent towards the end of 1988 because the cost of BCRA funds exceeded the yield ofthe mortgage portfolio.

IL =E SLIDE TO INSOLVENCY

The financial crisis of the 1980's

4. Inflation indexation of the mgg= loan potoi, over 80% of BHN's assets, drove paymentsto unaffordable levels. Several concessionary adjustments negotiated with the borrowers that includedinterese rate reductions and maturity extensions, reduced the yield. In spite of these concessions,collection performance did not improve and hovered around 75% of amounts faling due. Delinquentpayers were not vigorously pursued. Dispositions that permitted BHN to foreclose without resortng tothe delays of court proceedings were extremely infrequent. hnflation and lack of finds extended theconstruction peiod and delayed recovery so that by June of 1988, construction loans amounted to 36%of the mortgage portfolio. In summary, low yields, lackduster collection performance and lengthy ordelayed construction amounted to weak portfolio administration.

S. From 1986 to 1988, Ioan became the sole source of BHN financing. Savings deposits decresedfrom US$1,034 million or 48% of liabilities in 1986 to US$349 million or 8% of liabilities in 1988.During this period, loans increased from US$1,069 millions (49% of liabilites) in 1986 to US$3,900millions (89% of liabilities) in 1988. Begining in 1986 BHN was unable to pay interest or capital on

- 53 -

Fag2 ot4

its loans with the BCRA, leading in 1988 to a BCRA freeze of new BHN housing projects and asuspension of financing except for amounts necessary to complete projects under construction. During1989 the BCRA suspended all financing including projects under constuction.

Neative netwot

6. During the three years 1986 to 1988, BHN began a series of annual deficits that resulted in adecrease of net worth from a positive US$212 million to a negative net worth of US$784 million in 1988,a three year loss of US$996 miflion. An endemic interest rate gap between an underperforming andunderindexed mortgage portfolio and the inerest of BHN's obligations to BCRA, coupled with excessiveexpenses created this crisis.

m. IREORGANEZATION AND E :PTLZ IO

Emerffg= M==ure

7. In March of 1990 Decree 435 announced sweeping reforms affecting the financia sector ofArgendna. Articles 1 and 2 prohibited the BCRA from lending additional funds to BHN and orderedBHN to suspend its retail activities.

Permanent measures

a. BHN K1fgfnkhiQ Law

8. TIis law was approved by Congress in September 1992: it ratifies the BCRA renegotiation withBHN (see paragraph 9), provides for a reindexation and debt relief in BHN's loan portfolio, continesincome and capital tax exemptions on housing activities and modifies BHN's charter. The significantchanges to the BHN Charter will:

a. Remove the federal guarantee of futre BHN borrowing;

b. Reduce the Board of Directors from 8 to 6 persons;

c. Stipulate that the BHN will orient ("orienjar) its housing operations as a wholesale bank("banco mayorista);

d. Specify that BHN will finance only social housing ("vivienda social unica-) occupied bythe owner;

e. AuthorLie BHN to borrow domesticaRy or overseas with prior approval of the Executivebranch, but grats the right to issue mortgage secured debt instruments without executiveapproval for amounts not exceeding 50% of the mortgage portfblio;

£ Reestablish the right to open interest bearing deposits;

- 54 -

g. Within a wholesale profile (*perfil mayorista), authorize any acdvity available tocommercal banks;

h. Obligate BHN to initiue foreclosure pmceedinp when delinquency reaches 5installments; and

i. Requre BHN to allocate 15% of its annual dis _for a smal cities housingprogram.

b. Reneodation of BHN deb

9. lhe BCRA conceded a reindxing of BHN's debt from June 1989 to April 1, 1991, the date theConvertibility Law became effective. By applying the BCRA finmce index based on the BCRA interbankinterest rate, the balance of US$4.9 bilion as of March 1991 was reduced to US$802 m im payableover 20 years in increasing montly insllmens sring at US$2.4 milion at 2.6% annual interest fromJuly 1989 to March 1991. Starting April 1991, the annm interest converted to the a e interest rateof BHN's loan portfolio excluding amounts capitalized, approxmately 3% during th period April 1991to March 1992.

10. After applying US$8 million payment and other small adjustmen and the BCRA absorption ofa BHN receivable from the Mitry of Economy of US$92 million, the negouated adjusted balance asOf March 1991 was US$702 million. The BHN has paid the monthly matuities and as of June 1992 hasreduced the debt to BCRA to US$686 million.

c. Adjustent to BHN morge loans

11. The loan portfolio was reduced to reflect the effects of changing the index to a construction index,a special bonus program for advanced repayment and other items. These provisions listed belowamounting to an asunding 56% of the mortgage portfolio, are preliminary estimates prepared in early1992. Subsequent events (such as a rapid recovery of real estate values) indicate these provisions arematerialy overstated and require fiuther study.

Provisions for mortane loans April 1991(millions of US doUars)

Amou4t

Effect of reindeCing to constuction index $ 474Early cancellation bonus and reduction ofbalances to estimated sales value 552

Provis for bad debts 414Special hardship forgiveness 138Provision for builder claims and other 249

Tota Apri 1991 S am

Iation adjusted to December 31, 1991 S L

- 55 -

hp4 .14

d. Net w ea

12. lhb net eff of thesn ad (US$4, 100 million less US$1,827) increases BHNs net worthby US$2,273 million durn the perio 1989-1991. In other words, the accumulateld =gWj n worthof US$784 milon as of December 31, 1988 was ut med ino a net worth of US$ 1,487 byDecember 1991.

IV. 1LQS PS FOR TB

13. Rehnforced collection effot improved loan portfolio monffly cash flow from US$11 mfllion(73% of amounts fing due) in June 1989 to US$18 million (85% of amounts falling due) in March1992. Further, in eary 1992 mangem authorized an ann capiizaon of Ierest of 6% appliedmonhly at .S% per month Ihe average interest rate of mortgag loas as of June 1992 is 3% plus the6% captaliztion for a total of 9%, which stll is wel below the limit of 12% specified in theConverVtily Law. Impwved co o ected to come onse in lat 1993, cooedImovements in collection efforts and an energetic application of the foredosure e shouldresult in a reduction of overdue accounts and further increases in collections. Ihe 1992 budet forecastsIntenal cash flow vlable for lead of approximaely US$150 million, Icuding US$50 million ofmon-mortgag portfolio relaed income such as insurance premiums, renta income and disbrementcommissions from FONAVIT and the Income tax authorities (DG0).

14. The cash flow for 1992 and 1993 wil be used to reactvae stalled projects for some 20,000 uItsrequirin an tmate Invesn of US$109 million each year. BHN did reWond to emergendes withan US$6.0 mion 9% nrascture loan to flooded part of the Prvinc of Cdrdoba and apWved aUS$250 tousand project at 10% to finance homes damaged by a bomb attack tat destroyed the Israeliembasy in eay 1992. Other than these two emergencies, responses, BHN has not aurized any newmajor housig projects, no new retail lending projects are being considered.

BHN prcrto for secod tier lending and issues

15. he lkey test for BHN is to covert sucoeslly from iks tadition of on s ry ralengto a financial instiuton capabls of attng long-term funds from ivests. Divod by law fromgoveent BHN must mow demonstrate a financiad probity to the martlace tcmmands public confidence. BHN wll reWire major 1in ona imprvements to gain investorconfidence. Punvatizaton may ultaely be requied.

- 56 -

Fagols fS

ARGENTINAFINANCLAL SECTOR ADJUSTMENT WAN

PRIVATIZATION OF THE CAJA NACIONAL DE AHORRO Y SEGURO

BACKGROUND

1. ne Caja Nacional de Ahorro y Seguro (henceforth referred to as Caja') is a state-owned,st dat uteed enterprise that performs banking and insurance operations. Created In 1915 with thename of Caja Nacional de Ahorro Postal, during its first years the Caja operated in postal savings, whichoffered a popular vehicle for channeling large amounts of small savings through the postal system andtageting the lower-income segments of the population. These deposits were invested in governmentsecurities. To further its social orientation, the Caja later started making personal loans to low-incomeborrowers.

2. In 1945, the Caja initiated its insurance operations by offering life insurance coverages andintroducing group life in the local insurance market. In the early 50s, it began to sell automobileinsurae, and later on the Caja expanded into other general insurance products. By 1980, the Caja wasalso providng the usual range of banking services.

3. Since it began operating in the insurance field, the Caja records two separate net worthswihin the same institution, one for banling and the other for insurance, each having distinct operatingand accountng structures, although sharing some activities such as finance, accounting and legal.

4. Now, the Caja is a major factor in the Argentine banlkng and insurance markets. With acustomer base of about 5,000,000 dients, its presence is quite considerable throughout Argentina. Cajaenjoys a positive image in the market. Though its banking activities are not profitable, the results of itsinsurance operations are sufficient to make the Caja profitable on a consolidated basis. Conclusionsregarding the profitability and financial standing of Caja are based on unaudited information. Anassessment by qualified independent auditors will be necessary for estimating the financial situation andresults of Caja. In particular, an evaluation of the adequacy of the technical reserves accumulated by itsinsurance operations is essential for this purpose.

S. In general, Caja is subject to the payment of taxes as any other private corporation.According to its Charter, at least 50% of its annual profits must be capitalized; and usually 10% isassigned to social purposes like construction of schools and contributions to hospitals.

6. Significant reduction in personnel has been under way for some time. In July, 1989, it hadS,132 employees. Employees were offered about one monthly salary times the number of years inservice. As of June, 1992, the number of employees has been reduced to 3,100. The effect of thisreduction was an initial loss of efficiency which later has been recovered. The average cost of thisreduction has been approximately US$17,000 per person. The personnel reduction process started withemployees working at the head office and later continued with the branches. Seven branches have beenclosed as a resut of the personnel reduction program.

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Paplofi

7. The head office has 1,800 employees. The branch network comprises 51 offices in all theprovinces with about 1,300 employees. Of these, it is estimated that approximately twotirds arededicated to insurance activities while the balance is allocated to bankdng functions.

ERIVATZATQN PlRQGAM

8. The privatization of Caja is being undertaken within the context of the restucturing ofpublic banks and also would follow the liberalization of its reinsurance market through the recentdissolution of the National Reinsurance Institute MNDER), the state reinsurance monopoly. Ihisliberalization constitutes a fundamental step towards imposing market discipline and improvingcompetitiveness in the insurance sector. INDER's poor management and inadequate underwritingpractices permitted substantial abuse by many local insurance companies. INDER finally went bankruptwith half a billion dollars in insurance premium arrears, and a similar amount of unpaid claims. Ahiberized reinsurance market will be more selective in accepting risks and this situationwill likely forceseveral mergers and closures of poorly-managed insurance companies which sustained their operationson the basis of implicit subsidies obtained from INDER. The basic rationale for the privatization of Cajawould be that the Govermnent would limit its role to that of regulating and supervising adequately theprivate banking and insurance companies mainly to safeguard the interests of depositors andpolicyholders. The privatization of Caja also reflects the Government's decision to make a start inleaving to the private sector the provision of finmacial/insurance services and reflects a rising realizationthat mere internal productivity reforms are subject to reversal under subsequent new managements.

Level of commitment to privatuation

9. The Government has shown a considerable level of commitment to the privadzation and hastaken many significant measures giving due regard to the transparency of the process. In November,1991, the iuovernment issued a decree declaring the Caja subject to privatzation and appointed anInterventor to replace the Board of Directors with the spcific mandate of carrying out the necesaymeasures to implement the privatization of the Caja. A five-person commission for the privatzation wasformed in March, 1992 with two representatives from the Ministry of Economia and ftree from Csja.This commission acts as advisor to the Interventor on the privaiaon process. Finally, the Cajaprivatzation law was approved by Congress in September 1992.

Progress in the Dreparatory work by privaization consultants

10. Ihe legal consultants already have assisted the privatization commission in prepag theterms of reference of the auditing firm and of the financial advisor. They will also provide assistance inthe preparation of the bidding documents and in other legal matters. An important part of their work wilbe dedicated to assessing the magnitude of Caja's liability from outsding lawsuits and selecting thosewhich should be removed and not included in the sale of Caja.

11. The auditing firm and financial advisors have been contracted.

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Stren Of degmiaoscoritrs

12. Ma interest Indicates that potendal investors would be attacted maily by Caja'sisuan portio and the potenti of its customer base of about five millio nts. lhe baklnbusine is affected by a portfolio heavfly burdened with non-pebming oans to the public and privaesectors, and may have to be removed into a separat corporation The banking frachise ad Cain depositbase are conidered to add to its atactiveness to potental buyers.

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lagp 4 as

ATTACHMENT 1

BANING OPERATION

13. As of March 31, 1992, Caja's banking assets mounted to US$932 million. Cash anddeposits were US$126 million and correspond almost totally to reserve reqir . GovernmentsecurWes comprise US$63 million investments in BONEX.

ITal 4: Financial Sun=Bmaniig ionsd

(for the nine months endig March 31, 1992)uU$million

Assets 932Loans (net) 660 Interest income 159

Public sector 476 Other Income 25Private sector 328 Interest expense asLoss provision 145

Other assets 272 Loan lose provision 48Liabilities 879 Operating expenses 37

Deposits 578 Other Expenses 7Borrowings from

financial institutions 274 Net income 4Net Worth 53

Notes The above figures are unaudited.sources Caja

14. Loans to the public sector represent about 60% (US$476 million) of total lending. Thisfigure includes a lobn made in 198647 to the Junta Nacional de Granos (G) of US$230 million madeto fiance n agricultural support prgm. Caja's officials state that this loan is almost fily matdcedby a Central Bank rediscount to the Caja. Of the balance of the public sector loans, about US$177 arenoeforming. However, acordn to legal reguation, loans to the public sector cannot beprovisioned becaw it is asmued that they will be repaid because they are guanteed by theGovernment.

15. Loans to local govern totl nearly US$68 million. Ihis pordon of the portfolio is alsonon-perfoming. A loan of US$56 million to Inberama for an amusement park which now belongs to theMunicipalidad de Buenos Aires is also non-eforing.

16. Ihereare also loans to thpreeprovincial banks amoung to aboutUS$41 million. Of these,US$28 milion to the provinal bank of La Rioja, US$7 million to Rio Negro, and US$5 milion toMisiones. These loans were originally short-term, but have been reflnanced at tenyear maturities.

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ANNE VPage S of 8

17. The portfolio to the public sector also includes a US$12.4 million loan to SEGBA. Thisloan Is past due since Jamnuay, 1989 and should normally be fully provisioned for non-recovery.However, in view of the privatzation of SEGBA, it is expected that this loan will be normalized.

18. Private-sector lending represented US$328 million in March 31, 1992. Ihe loss provisionof US$145 million corresponds entirely to private sector loans.

19. The Caja ranks third in the local banking system in terms of deposits in local currency, andsixth in tems of total deposits. The Caja captures savings largely, 97% of its volume, through its ownoffices. About 3% of small deposits are mobilized through postal offices across the country (about 1,000offices). About twenty years ago, the Caja obtained 30% of its deposits through the postal system.

20. At present, the Caja captures 3.8% of total deposits in Argentina; 4.3% of total depositsin local currency and 1.9% of deposits in foreign currency.

21. About 30% of its deposits are provided to the Caja by its insurance operations; that is, technicalreserves from the insurance business of the Caja are deposited in its banking section. Its deposits aresupplied by a relaively concentrated base; less than three hundred clients provide about two thirds of totaldeposits.

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ANN =Fags 6.11

ATIACHMENT 2

INSURANCE OPERATIONS

Intrducto

22. The Argentine insurance market comprises 215 insurance companies with a total premiumvolume of about US$3 billion. Twenty companies write more than 50% of the total premiums and Cajais by far the largest insurance company in Argentina. It has 13% of the premiums written. It is also thelrgest in assets, net worth, profits, branch network, and number of employees. Since April, 1992,several changes have occurred which will affect the operations of the insurance companies in Argentina.The liberalization of the rei=rce market through the dissolution of the National Reinsurance Institute,the state reinsurance monopoly, will impose well-needed market discipline. This will be reinforced byrecent changes in insurance regulations which have shifted to monitoring of solvency requiremets, andhave liberaized the setting of premium and commission rates. Previously, the market operated underminimum premium rates and maximum commission levels without due regard to monitoring the financialcondition of the insurance companies. The above changes should exert a positive influence in thestructure and performance of the local insurance market. There is still the urgent need to complementthe changes in the regulatory framework with an adequate regulatory implementation capacity to ensureprotection of policyholders. This should be done by strengthening fte supervisory and enforcementcapacity of the Insurance Superintendency. The Insurance Superintendency is currently inadequatelystaffed and thus unable to monitor the status and behavior of the insurance companies with adequate on-site and off-site inspection proceduies.

Table 1: Insurance Market indicatorsLest Local Insace Groups

(for the year ending June 30, 1991)

Premiums Number of Number of Policies(US$ employees policies per

million) employee

Caja 367 13.1 2,033 * 375,070 184Sud America 114 4.1 592 188,594 319omega 102 3.6 628 229,112 365S. Cristobal 96 3.4 728 233,704 321

Mbrket Total 2,795 100 20,283 4,733,333 233

* This refers to the number of employees allocated to insurance operationsin Caja.Source: Caja.

23. In terms of policies per employee, Caja has very large insurance policies mainly writtenfor state companies. These policies include generally multiple lines and consume large personnelresources. Nevertheless, there is sdll considerable opportunity for improvements.

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Premnium hnow, by lSne

24. Automobile inurance represens 38% of the Cjajs insurance portfolio. It is the mostprofitable line of business in Caja. It represents a high proportion of its portfolio becae the Caja sellsthis type of inuce at lower rates than most competitors, insuring approximately 260,000 privatvehicles and 35,000 that are sme-owned. This practice Is profitable because the Caja places its insurancedirectly and not through intermediaries, agents and brokers, thus avoiding the payment of commissions,which nonnally reach 20% of premiums. Furthermore, Caja has an exclusive agreement widh theArgentine Automobile Club to place auto insurance through its offices. Currendy, 30% of Caja'sautomobile business is placed through the Automobile Club. Caja also has a system of transparent andquick seldement of claims. These factors are critical to its strog and profitable position in theautomobile insurance market.

25. Life insurance generates 58% of Caja's premium volume and comprises principally groupinurance, a product tat was introduced by the Caja in dte local markeL Although not as profitable asts automobile business, life insurance is also an Important source of Caja's profits. Ihe Caja presenly

provides life nance to more than five million persons.

Table 2: Premium Volume by Linesfor the nine months ending March 31, 1992

(in thousands)

Automobile US$122,897 38%Life 184,718 58general insurance 12,062 4

Total 319,677 100

Source: Caja

26. Caja's general insurace activities include fire, marine, liabiLity, and other miscellaneousinsurance lines with the exception of automobile insurance which is done by a separate division Geneainsurance operations represent only 4% of its premium income. A private operator would certainlyexploit Caja's customer base to increase production in this lines.

27. The loss ratiok' of the Caja during the first nine months of FY1992 was 74%. Its operatingexpenses (for its insurance section) reached US$61 million during the same period. Ihis implies anxpense ratio, expenses divided by premiums, of 19%. Adding the two ratios prduc a combined ratio

of 93%, which results in an underwritng profit of 7% of premiums. This is better than normal.Usally, hnmce companies produce lower, if not negative, tehi results which are compenated

11 The los ratio is defined as the percentage of incurred losses to eaned prmums. It is a basicindicaor of the underwriting perfomance of an insurance company.

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AN

hg.SofS

by nvestment inoome. The Caja' insurance opations have geneaed net income of US$34 millionduing the first nine months of FY1992.

Table 3: FianCJal SummarYInsurace eron

(fbr the nine months ending Muach 31, 1992)US$ million

Assets 455 Net earned premium8 320Investments 199 Incurred losses 237Premium receivables 115Real Natate 92 Operating expenses 61

Investment results 10Liabilities 250Loss reserve 111 Net inACOme 34Unearned premium reserve 51net Worth 205 _

Note: The above figures are unaudited.Sources Caja

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AN=DPages 1 of

ARGENTINAFINANCIAL SECTOR ADJUSTMENT LOAN

DEPOSIT PROTECIION

1. Over the past decade the authorities have taklen steps to reduce and ultimately eliminate theexplicit protection provided by the Central Bank (BCRA) to bank depositors. The new Central BankCharter represent the final phase in that process, and will result in the elimination of BCRA's explicitprotection for private banks.

2. In rejecting explicit deposit protection, the authorities have opted to rely instead on theirimplicit ability to intervene in the banking system when considered desirable to achieve social oreconomic goals. The analysis presented in the following paragraphs suggests that the rejection of explicitdeposit protection in favor of implicit protection represents a reasonable policy decision in the Argentinecontext. The elimination of explicit protection for private banks should not diminish the ability of theauthorities to resolve bank failures, will likely reduce moral hazards, and will not exacerbate the potentialfor runs on private banks. Government retains the flexibility wo provide ad hoc protection to smalldepositors should conditions warrant. Moreover, the sizeable official banks, access to which is widelyavailable, will continue to enjoy the explicit protection of the national or provincial governments,mitigang to a large extent potential negative consequences for smal depositors.

3. The policy decision to cease BCRA protection of private banls arguably places such banksat a competitive disadvantage relative to the official banks. Such an outcome might run contrary to thegovernment's objective of reducing the role of the state in the financia sector. Ihe extent tD whichprivate banks are disadvantaged will depend largely on depositors ability to ascertin the soundness ofthose institutions, and government is taking concurrent actions to improve financial disclosure andenhance bank supervision. Nonetheless, government will need to monitor financia sector trends todetermine the consequences of this policy, and should stand ready to take actions to minimize any adverseconsequences. One such action might be to support the ability of banks to develop a private depositprotection program.

4. Explicit deposit protection finded and administered by BCRA has existed in Argentina since1946, with 100% protection provided since 1974. The system was reformed in 1979 by requiring banksto pay a premium for the protection and making the system voluntary. Most private locally-owned bankselected initially to continue to participate in the voluntary system. Over the past decade, the level ofexplicit coverage provided under the system has been scaled back several times.

5. BCRA's experience with deposit insurance has been decidedly negative. The moral hazardassociated with BCRA-backed protection contributed to a large number of banking failures. With some100 banksinmrvened in the 1980s, the cost to BCRA has been high, bot in tms of paying outprotected deposits and in terms of the burden on human resources associated with manai the resolution

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Pagel 2 of I

of failed institutions. Although virtually all deposits in failed banks were eventually reimbursed byBCRA, delays in payments to depositors impaired the liquidity of depositors' funds, and duringinflationary periods, impaired their value as well. The explicit protection system thus suffered from alack of public confidence and was not effective in preventing runs on private locally-owned banks. Pardyas a consequence, most banks have now withdrawn from the system. This loss of confidence serves asa impediment to the potential effectiveness of any revised version of explicit protection.

Prior Syste gof Depst ion

6. In Argentina multiple tiers of deposit protection were in existance. Two tiers consisted ofthe national official banks and the provincial official banks, both of which enjoyed protection of alldeposits by virtue of the legally mandated and implicit backing by the national or provincial governments.A third tier consisted of the private foreign-owned banks, which generally benefited from no explicitprotection since they declined to participate in the voluntary BCRA protection program, but many ofwhich enjoyed the confidence of the public by virtue of their perceived financial strength. A fourth tierconsised of the private domestically-owned and cooperative banks = participating in the BCRA programand hus enjoyed no explicit protection. -This group comprised the majority of the private domestically-owned banks. The final tier consisted of eleven banks (primarily cooperatives) participating in the BCRAprogram, and which, for this reason, were generaUy perceived as the weakest in the system.

1e New System

7. The new Central Bank Charter implies only minor substantive change to the earlier systemof deposit protection. The effect is that the limited coverage afforded to the eleven small banks underthe voluntary program will be lost.

8. The new Central Bank Charter includes provisions for the protection of small depositors.Local currency deposits up to $3,000 will have preferential access to the required reserves maintainedby the bank holding the deposit. On average, such reserves approximate 35% of the total assets of banks,and dtus would seem to provide a substantial base of protection. In practice however, such preferentialaccess may afford little protection, due to a likely deficiency in required reserves at the time a decisionis taken to close an insolvent bank. Required reserves are maiained in two forms, the current accountbalance at the BCRA and the bank's own treasury (its cash and balances due from other banks), withapproximately two-thirds of the requirement maintained in the BCRA current account. For severalreasons, it cannot be assured that failing banks would meet the reserve requirement at the time theirlicense is revoked. First, one-third of the requirement is under the discretionary control of the bankitself, and would likely be exhausted prior to failure. Second, the BCRA current account is an operatingaccount used for payments system setdements, and thus can be hasted as part of the routine settlementprocess. Fimally, since at present BCRA utiizes a one month settlement period for required reserves,on any given day the account may be depleted without contravening the reserve requirement.,

9. Thus, the modifications to deposit protection are minor. In effect, they finalize the phase-out of the explicit deposit protecton provided by BCRA that has been taking place over the last decade.

1/ Essentmay, withi any month averge daily deficient reserves can be offset by average daily excess reserves.

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of8n 3 of 7

10. When assessing the co uces of the elimination of explicit depos protection inArgentna, it is important to recognize t the op perate distinction is not between explicit protection andno p cdon, but rather between explick proWction and implick procion Almost invariably,governments will intervene to protect depoiors should conditions waamt, and implicit protecion munstbe prmed to exist. Moreover, then exists no in aional consensus as t which form of depositprotection is preferable. lTe merits of implicit and explicit system must be evaluated in light ofindividual couny c.

11. TIhs section asse implicit protecion in comparison both to explicit deposit protecisystems in geneal, and to the previously existing Argendne systm. The primary focus of analysis ison the manner in which faflures may be resolved, the degree of prtecton affrded small depositors, theextent of moral hazards, and the manner in which the threat of bank rmns will be mitigated. Overall,implicit protection is seen as consistent with the direction of government's financial sectr policy towardraducing fiscd burdens, minimig the role of the state and BCRA, and enhancing the role of the privatesector.

12. Ihe aternative merts of implicit and explicit protection in dealing with bank filures differ,but ex-ante one system is not clearly superior to anotherI Explicit deposit protection systems oftenentai clear mecbhaisms for the resolution of faiing banks, in contrast with implicit protection, wherefailur resolution tends to be more flexible. Since explicit systems usually provide a pool of finds toabsorb losses in bans, they can promote more expedient action. Under implicit protection, the lack ofa preiousy designated pool of resources can cause delays in addressing problems. LackIng a pool ofhimds, the authorities must arrange for the issuance of government paper to absorb the losses, or thecentral bank must create claims on itself. Issuing govermnent paper can be a time-consumig andpolitically-charged process. The creation of claims on the central bank can have direct montayconsequences and can meet with reluctance by central bank managemenL For these reasons, explicitproteion arguably facilitates quicker resolution of failures, whie implicit protction offers the advantageof greater flexibiity.

13. In the Argentine context, the dmnation of explicit desit protecti for private banks doesnot diminish the ability of the authorities to resolve faflures. The explicit protection system did notprovide a smooth failure resolution mechnism, nor was the pool of finds creaed by the systm adequateto deal with the level of lose in the failing bankY BCRA therefor had been mired in diffiltprocesses for resolving failing banks. Shareholders and managers had numerous avenues of recourseagaist BCRA actions, the process was slow and cumbersome, and the costs to BCRA were great.

1 In eerl, ndeer systm dke an duu posie slttivm for usolvig failing bankL a) liquidatwon,ii) assisted purchas or nurge, and ih) capital i*jcton by government, usualy rensatin in ainlti.

I/ Insufficientfuding is not an mommtrat among exphict deposit protetio syaen.

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AwN

14. In cont, the new Centrl Bank Charter specifies in more detail the failure resolutionprocess and make clear the allocation of losses. BCRAis role will be more limited and focused. BCRAis to maetadetemnaionthat the license of a bank should be revoked, and to communicate suchdecision immediately to the court Ihe court thereafter assumes decision-making responsibility withregard to the appropr of BCRAWs actions and the merit of any appeals by the bank, and appointsa liquidator to manage the processA Thus, under the prior policy not only is the role of BCRAminmized, but the need to establish a new state entity to administer falling banks is precluded. Lossesare to be borne by crediors and depositors of the failing bank. in the event of a major crisis however,governmeit's implicit protection will likely be triggered. There must be recognition of the risk that thelack of a previously designated pool of funds under the current policy can give ise to large andunexpected fiscal demands.

Small DqAosito rctn

15. Both explicit deposit protection systems and implicit protection can afford coverage to smalldepositors. With implicit protection, coverage is less assured if threatened depositor losses are of onlya small scale. The larger the scale of threatened losses, the greater the likelihood that implicit coveragewi be trggered. Thus, the absence of explicit protection in Argentina does not imply that smalldepositors wil alwys suffer should a bank fail. The government has the flexibility to provide ad hocprotecdon to any or all classes of depositors should conditions warrant.

16. Beyond implicit protection, for the foreseeable future depositors in Argeina will haveaccess to explicitly pre deposits. National government-backed protecdon is affrded by DNA, andprovicial government-backed protection is afforded by many provincial banks. Between them, BNA andthe provincial banks have an etensive network of branches that provides reasonable access to much ofthe poplati In addition, the private foreign-owned banks afford a source of protection independentof the national and provincial govenmes.

Moral Hazard

17. In comparing explicit deposit protection systems with implicit protecdon, explicit systemsare often viewed as giving rise to moral hazrds with regard to the actions of both depoors and bankmanagers. In large part it was the expeience of severe moral hazards in Argentna th precipitated therjecdon of explicit deposit protection. Private bank shareholders, managers and depositors benefitedfrom government-backed protction while bearing litde of the cost of such protection.

is. Under the letter of the law, this issue has been resolved in Argentina with the rejection ofexplicit protection. Bank shareholders in failed banks will lose their investment, bank managers will losetheir jobs, and bank depositors may lose their deposits. In recognizing the existence of implicitprotection, the potential for moral hazrds will persist, though more from the standpoint of bankmanagers and shareholders. But nonetheless, the withdrawal of explicit protction has been perceivedas giving rise to an increase in discipline among banks over the last few years. Remaining moral hazards

It s fet dt decios ak by the cout wil cary mme weigh, and tus wi ficlit expeditious failuNIwoIUiOL

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ANNEXPages S of 7

can best be mitigated by improved supervision and improved public disclosure, both of which are beigpursued by BCRA.

Bank Runs

19. Explicit deposit protection systems can be more effective than implicit protection in limitingthe potential scope of bank runs. An important factor in the effectiveness of explicit protection incontrolling runs is the credibility of the system.

20. In Argentina, the explicit deposit protection system for private banks suffered from under-funding, which impaired its credibility and thus limited its effectiveness in preventing bank runs. In thissense it differed little from that which might have been experience with implicit protection only. As such,the elimination of explicit protction should not exacerbate the potential for runs against private banks.

The Potential for Private Deposit Protection

21. One conceivable alternative to implicit protection or government-backed explicit depositprotection would be an explicit program funded and administered solely by the banks themselvesY Thissection briefly examines some of the major issues involved in a private deposit protection program inArgentina. A comprehensive analysis of the appropriate design of potential private deposit protectionprograms is not attempted.

22. A private system of deposit protection in Argentina would in effect represent group self-insurance. In the absence of a government-backed system, it is presumed that the main purpose of aprivate program would be to protect small depositors. The program might be voluntary or, alternatively,all banks or certain types of banks might be required to participate. Ihe program might apply only tolocal currency deposits, or to deposits regardless of currency. Since each bank in the program would beto some extent responsible for the losses of any member of the group, banks would need to have a meansto evaluate the financial soundness of members, and have the power to expel members that posedunacceptable risks. Similarly, existing members would need to have the authority to approve or rejectbanks applying for membership. The program might be pre-funded, or alternatively, losses might beabsorbed by charges against the members at the time of loss. The program might entail limited failureresolution mechanisms, though more likely this would be left to BCRA and government.

23. Voluntary private deposit insurance may be of little interest to most of the Argentine bankingsystem. The national and provincial official banks already have explicit and implicit protection, and theprospects for elimination of that protection is limited.Y As such, those banks would have litde incentiveto join the program. Similarly, most foreign-owned banks will see little benefit in the program. In fact,those banks most interested in participating in the program will be those lacking financial soundness. Avoluntary system comprised of such banks would not prove viable.

5/ Anothe altnative, that of bank obaing depoit insurance through indeent third party _ns, haslittle potenial in Argtina at this time, and thus is not evaluad here.

{/ Even if explicit protection was eimiated, these ban woudd still benefit from the cler perception of theimpcit proction aising from their ownehip by the sate.

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24. A mandatory system may be more feasible. 'The acceptability to banks of a adatorysystem will be particularly dependent on the extent to which financially sound members can be calledupon to absorb losses of the financially weak, and the veracity of the means by which the riskWness ofmembers is to be assessed. If the potential demand on the capital of financially sound members is great,or the means of assessing riskiness is subject to doubt, the establishment of a mandatory program willmeet with substantial resistace. The absence in Argentina of well functioning means by which todiffereatiate among the riskiness of banks represet a significant obstacle to the establishment of privatedeposit insurance at this time.

25. Beyond these preconditions, one conceptual alternative is a program that is mandatory onlyfor private domestically-owned banks. But with the backing of only a limited segment of the bankingsystem, such a program potentially would suffer from a lack of credibility and financial capacity, andmight prove ineffective in protecting small depositors or preventing runs on private domestically-ownedbanks. Moreover, it might exacerbate the potential for the transmission of liquidity or solvency problemsamong those banks. To the exent that the progrm is publicly visible, problems in one member bankmight be perceived as creating problems for all members, increasing the potent scope of runs againstprivate domesticaUy-ownedbanks. If the liabilityofmembers ofthe group is stfficiendylarge, problemswith one member may if fact create solvency problems for other members.

26. The madatory inclusion of private foreign-owned banks would likely increase the credibilityand financial capacity of the program, but could also represent an unfair burden on foreign-owned banks.Arguably, foreign-owned banks would be less likely to utilize the protection offered by the program, butat the same time may prove to be the source of financial strength for the system. Nonetheless, a privatedeposit inurance that is mandatory for all non-official banks offers scope for further study.

27. Finally, a mandatory system might be comprised of all banks. In the Argentine context,such a system would be a quasi-public program, given the size of the official banks in the bankingsystem. But given the bacldng of the entire banking system, such a program might reasonably expectedto be credible and exhfibit sufficient financial capacity to absorb losses in a limited mbmher of small tomedium scale bank failures. For this reason, such a system Is worthy of serious consideration. Carewould need to be taken to ensure that the official banks did not abuse their sizeable role in the programto the detriment of the private banks.

28. Government can promote the abilty of the banking system to develop private depositprotection by improving the quality of bank supervision and bank disclosure, and government hascommitted itself to these goals. Improved bank supervision would serve to minimize the potenal thatextraord iy large losses would be allowed to develop i individual banks. Such losses would likelyprove destabilizing to a private deposit protection system. Improved supeision coupled with greaterdisclosure of financial data regardiog banks would promote the ability of the administrators of the systemto assess the financial condition of the membership, facilitating the ability of the system to control itoveral exposure to losses.

E3bhncing the Effectveness of the New Cental Bank CharXr

29. Small depositors have preferential access to the required reserves ma ined by the banktakng the deposit. As noted above, the protection afforded by this provision is likely to be limied.

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Pug.. 7 of 7

Conceptually, this provision could be strengthened if BCRA was tD endeavor to isolate the requiredreserve balance from the bank's current account at BCRA. In practice, however, this presents substantivedifficulties.

30. To ensure efficient operation of the payments system, BCRA must stand ready to supplyliquidity immediately to ilHiquid banks to enable them to sete. Implicit in a decision to supply liquidityis at the bank's illiquidity is temporary, and not a symptom of insolvency. lhis is an extremelydifficult judgement and it can be presumed that liquidity will In some Istances be provided to banks thatevenually prove to be insolvent. Under the new Central Bank Charter, all advances to banks by BCRAmust be secured. Thus, at the instance that liquidity is reqied, It is resonable to expect that thesegregated required reserve account would be tapped to enable the bank to se. If the bank in factproves to be insolvent as well, the BCRA reserve may be exhausted, and thus provide no source ofprotection for small depositors. As an alternatve, previous arrangements could be made for BCRA toadvance fiunds against acceptable collateral for settement purposes. But it would be difficult to ensurethat previously set aside collateral would prove sufficient in the circumstance Inheren i, failing banks,and again the segregated reserve balance would likely be tapped.

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ANV

ARGENllNAFIANCIAL SECTOR ADJUSTMNT LOAN

PROVINCIAL BANKS

A.

1. Tbrougbout the 1980s high and v ble inflation in Argetia produced a shap decline indeposis and a subsequent decline in the volume of len in the commerci baking sector. With highfied operatig costs in the sector, the decline in len activiq produced a sap derioration in profisand forced many private comnercial bans to adjust. The public provincial banks, in contas, avoidedadjustment throughout the decade by resortng to rediscouns fom the Central Bank (BCRA) and tramsfersfrom the public sector. Although overaU commercial banking activiy declined oughout the decade,the provincial banks expanded their activity, which was concentated in provkig credit to theirprovnci govements. Betwee 1985 and 1991, real credit to the public sector through the provindalbanks increased by over 200 percee while total real credit to the private sector fell.

2. The provinca bank mandate was to lend to provincial treasuries and public enterpries, and,to a lesser extent, to provide subsidized credits to favored private firms without consideration of profitcrieria. Given that these deficits have been financed with rediscouns, the provincial banks bave beena sgnificant source of macroeconomic instability, having led to monetary expansion. Moreover, theproval bank financing of provincial budget deficits has pemitted the provincial goverments to finamcetheir exeditr without the need to tax. As a consequence of poor loan recovery and massiveoverstffing, provincial bank pformamce indicators are extremiely poor. Estimated annual operatinglosses for 24 provincial banks amounted to US$983 million for the year ending June 1991.

3. Since the iroduction of the Convertibility Law, in April 1991, the provicia banks' statsvis-a-vis oher banks in the financia system has deteriorated. The BCRA has eiminat new redisoouto the sector and is recovefing debts owed by the provincial banldng sector. Wihout access toredsu prvincial banks have been unable to obtain resources to fince their respective govenme.Furthemore, with higher unit operaing cost and poorer asset, provicial banks have been hard pressedto adjust quicldy to compete with the more efficient private sector in the current economic setig offalling spreads. As the ultimate guarantors of their provincial banks, provincidal gov em now findtheir banks a liability and are now restructuring and, in some cases, divestig.

4. Ihe remainder of this annex presents a brief diagnostic of the provincial banking sector andIdentifies meares which would complement the governmen's ongoing reform program in the sector.Section B provides a description of the sector and how the links between provincial banks and theirprovincial governents have affected fte evoluion of the sector over the second half of the 1980s.Sectton C amlyzee the financial structure of the provincial baks and provies an estimate % operatglosses genated for the period June 1990 through June 1991.

B. Evolution of Provincdl Banks During t 180s

The current structure of the provincial bankig system in Argentina daes back to the 1950sand 1960s when many of the banks were created. Most of the banks were reatd to sevedeom

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ANNE mPose2 of6

needs of their respective provinces and/or the financing requirements of their respective governments.While these criteria are established in the originating provincial bank charters, it was not until the mid-1980s that the provincial banks assumed an increasingly important role in the transfer of credit toprovincial governments and to firms. This section discusses some of the linkages which developed overthe past decade.

JescrliSon of the Sector

6. In June 1991 the provincial banking system represented about 27 percent of total systemdeposits and total assets in the banking system. In total, the provincial banks had 1283 branches and47,212 employees.

Tab1it: COMMERCIAL BANKS' STATISTICS, JUNE 1991

No. of No. of Total TotalBanks Branches Deposits Assets

-USS Milions-

Prov & Mun 30 1283 3899.2 10250.1

Total System 167 4501 14314.9 39474.4

7. The provincial banking system experienced a rapid expansion over the second half of the1980s. Between 1986 and 1991, the sector opened new branches at a rate of 20 per year and employmentincreased by over 3,200. Monthly wage costs escalated to 234 percent of montlly income from servicesand commissions and employee productivity, as measured by deposits managed per employee, declinedto less dtan 50 percent of employee productivity realized in the private commercial banking sector.Clearly the banks became providers of employment, as well as credit for their respective governmen.

ProIncial Governments and Demand for Credit

8. Ihe rapid expansion of the provincial banking system reflected the increasing creditdemands of the provincial administrons and favored firms. With poor prospects for borrowing abroador for placing domestic bonds, provincial governments typically relied on their provincial banks to financetheir growing deficits over the decade. Provinci deficits after transfers doubled from US$800 millionbeteen 1981 and 1985 to US$1600 million for the 1986-1990 period, and averaged US$1.2 biUlion forthe decade. As illustated in the chart below, provincial bank lending to the public sector followed asmilar trnd, with the share of credits to the public sector in total credits increasing steadily from 15

- 73 -

Pge3s oft6

percent in 1987 to nearly 50 percent by June 1989Y This behavior contrat sharply with the pfivatecommercia banks during the same period, where voluntary lending to the public sectr averaged less than2 percent for the period and never amounted to more than 4 percent of totl credits. Lending to thepublic sector from the private bank mostly took the form of compliance with high remunerated reserverequirements.

9. Provincial bank credits to the public sector were ftequently used to finance theadministraion of the respecive provinces and public enterprises. The provincial electric companyServicios Electricos de Buenos Aires (SEBA) has been the primary recipient of over US$2 billion fromthe Provincial Bank of Euenos Aires, and the provincial energy and water companies of Cordoba(Empresa de Energfa de C6rdoba (EPEC) and Empresa Provincial de Obras Sanitrias (EPOS),respectively), represent nearly 40 percent of total credits extended by the Social Bank of Cordoba.Additionally, the City Bank of Buenos Aires and the Provincial Bank of Misiones have extended 34percent and 79 percent of their total credits, respectively, to public enterprises.

10. Governments relied ewxensively on credit through the banking system to finance theirdeficits. In 1990 total direct loans to the provincial governments through the commercial banking systemamounted to uS$1.3 billion, or 92 percent of their total credit needs for the year. National public banksextended approximately 25 percent of the total, but provincial banks were most important, exending overUS$810 million in total direct loans to the provincial governments for the year.i1. In addition to direct loans through the banks, the provinial governments access additionalshort term credit through two principal sources: drawing on official deposits, and the unified provincialchecking account (Pondo Unificado). The unified checking account is a combined balance of all officialaccounts in each province. Treasuries may draw on their respective funds, up to a specified limit of thetotal, to use as a loan without interest charges or a specified maturity. In 1990 Treasuries drew on theseaounts for a total of US$192 million. In addition, governments drew on their deposits to access anaditional US$88 million in credit. The provinces with the largest shares in bank loans were the provinceof Buenos Aires with 29 percent of the total and the province of Corrientes with 24 percent of the total.

Evne ngthe Lrovincial Banks

12. The increase in provincial bank lending during the prolonged detization was madepossible largely through liberal access to BCRA rediscounts. As deposits in the provincial banks declinedby over 100 percent in real terms between March 1986 and December 1989, rediscounts to the sectorgrew, peaking at 140 percent of deposits in 1989 and averaging approximatly 100 percen of totdeposits for the period. The provincial banks/provincial governments made a significant contribution tothe hypa tion of 1989, receiving US$1.7 billion in new rediscounts for the year. The largestbeneficiaries of the rediscounts were the Provincial Bank of Buenos Aires with 6 percent and theProvincial Bank of Mendoza with 12 percent of the total rediscounts.

13. The abrupt chge in BCRA rediscount policy between 1989 and 1990 reflects theattempted stabilization episode implemnuted in the beg _ing of 1990. New rediscounts were eliminatedto the sector and deposits continued to decline throughout the first quarter of the year, but the provincia

G./ Data for tde period under view for the Provincia Bank of Buenos Aires and the Municil Bank of Buenos Aireswere not avilable. As the provindal banik of Buenos Ai were impotnt poviders of credit to the pubHcsaor, pectnta in Fiue I shoud be coonsidered as lower bounds although the trend would not cha.

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?q04 416

banks did not adjust. Given the pressure of enormous provinial govenment deficits, aveagi US$1.6billion for the year Aft transfe, the provinci banks entered the Inte k market to aise fimds- Theirdemnd for funds were a factor in the high real interest rates of the period. BY July 1990 the provicalban of La Rioja, Canca, and the Provincia Bank of Buenos Aires had become highly indebted onthe htbank market. In total, the provincial banks rised more than US$500 million on the Interbankmarket in 1990. However, he provincial bans sufed large deposi losses beginnin in late 1991. TheBCRA intervened to cover the illiquidity and prevent the crisis from spreading, bailing out the provincialbanks with US$430 million in new rediscounts during the last month of 1990 and the first two monthsof 1991. The Provincial Bank of Buenos Aires had become so indebted that its creditor banks in theprivate sector formed a club to recover their debts. First semster firs for 1991 reveal atnotwid i - I', e increase in rediscounts to the sector in the begining of 1991, the BCRA hasrecovered US$76 million by the end of the first semester of 1991.

C. Prvncdal Banks in the Emergng Fliandal Ssm

14. Provincial governents are seeking to limit their exposure to loss making isutionswhich no longer have access to discounts to finance provincial deficits through resturing andlorprivazation. This section analyzes the fmancial structure of provincial banb and provides an estimaof annual operaing losses generated between June 1990 and June 1991.

P8biil Balnk Assets

15. Most pvincal bank assets consist of loans; of these, 55 percent are loans to the publicsector. Prviil banks with the highest ewposure to their governments include the prvincial banks ofCorrientes with 71 pecent, and Catamarca with 88 percent. It Is no coincidence tha these are the sameprovinces which had average annual deficit to GDP raios well above the 1.9 percent average for therovinces throughout the past decade. The Provinci Bank of Buenos Aires, with 62 percent of aU assetsin the public sector is extremely concentrated; most of this exposure has resulted from loans to theprovicia electric company which were partly used to finance construction of a power plant.

16. In the private banks total loans also constitte a large share of assets, at 52.2 percent, butonly 0.5 percent of total assets are loans to the public sector. Provincial banks with loan ratios near theprivae sector average are the municipal bans and the provincial banis of Mendoza, Chaco, Neuquen,and Sua Juan, where the provici bans were partly used to extend agricultua credits and to subsidizeprivate firms. In the case of Chaco loans are highly concentated in the cotton sector.

17. The practice in Argentina has been to condr all loans to the public sector asperforming, evan though they are In many cases well overdue. Even now, reportig procedures varyacross provinci banks and many are not In a position to provision fully against poor debts to he publicsector. In the case of La Rioja (now closed, for example, 98 percent of loans were reported as normaland approxltely the same share of the loan portfolio was extended to the treasury.

ntlW uk UnbNte

18. A review of provici bank liabilities revs the extent to which the banks havedqended on sources of finance othern pdvate deposis to continue opeaton. Based on data for June

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ANNKmpweS Sod6

1991, the provincial banks have been highly dependent on sources of funds other than private deposits,while the private banks finance more than 50 percent of their transactions with deposits from the privatesector liabilities in the bankm belonging to the group of underdeveloped provinces, and least Importantin the provincial banks with the highest concentration of rediscounts in total liabilities are Rio Negro with57 percent, Santa Cruz with 31 percent, Entre Rios with 31 percent, Salta with 61 percent, Tucuman with37 percent, Chaco with 34 percent, Corrientes with 66 pecen and Misiones with 71 percent.

19. Public deposits have been the second most important source of funds In all of theprovincial banks, averaging 11 percent of their total assets. Banks which have a high concentration ofpublic deposits in total liabilities are the Municipal Bank of Rosario at 67.4 percent, Tierra del Fuego at35.3 percent, and San Juan at 33 percent. Public deposits have been most important in The ProvincialBank of Buenos Aires, where they represent as much as 52 percent of total liabilities and 88 percent oftotal deposits in the institution.

20. Piven the regulatory framework which prevails in Argentina, public deposits were alucrative source of funds for the banks since they did not receive intest and they carried, until recendy,a reserve requiremnt of 0 percent. The provincial banks have preferential access to these funds: 62.8percent of total public deposits are mainained in the provincial banks and only 1.5 percent are held inthe private bans.

21. Private commercial banks have been much more successful in attrating dollar depositsan the provincia banks. During June 1991, dollar deposits represented 26 percent of total provincial

deposits, contrasted with 66 percent in the private banks. Seventy percent of total financia system dollardposits are maintained in the private banks, whereas the provincial banks have captured only 16 percentof these deposits. Of the provincial banls, the two banks in Buenos Aires have been the most successfulin capturing doLar deposits, with 3 percent of total deposits in The Provincial Bank of Buenos Aires and6 percent in the Municipal Bank of Buenos Aires.

22. Between April and September 1991 total dolar deposits in the system have grown fiomUS$5.1 billion to US$7.1 billion, with 19 percent of that increase going to the provincial banks, 23percent to federal official banks and 58 percen going to the private banks. The disrbuon of the rapidgrowth in dollar deposits since April 1991 reveals the uncompetidveness of the provincial banking sector.

An Estimation of Ograting msses

23. An estimate of operating losses of the provincial banks yields another measure of thepressure eerted by the faiing baniks on public resources and the extent to which the provincial basneed to adjust in the new envionment. The previous discussion revealed Importa deficiencies in thefinani structre of the banks. A compounding factor on perfomance has been overstg in thesector has also adversely affected performac-labor costs average 70 percen of total cost and icomefrom services and commissions covering only 25 percet of totl opern cost.

24. In 14 of the 24 banks reviewed, financi costs exceeded total income for the year thatis, even if operating costs were zero, these banks would have lost money. The provincial banks ofCorrientes, Misiones, Salta, Entre Rios, and Jujuy had the highest finacial costs in toal income for theperiod June 1990 to June 1991 all exceeding 200 percent. This result is partly due to the practice ofcapitalizing interest payments on debts owed to the BCRA, but it also reflects the impact of distress

- 76 -

ANNEX v

borrowing on operating performance. The results of the calculations show that the total operationaldeficit for the 24 banks for the period June 1990 through June 1991 was US$983 million in 16 of the 24banks. These losses were financed through rediscounts, interbank borrowing, and increases in public andprivate deposits.

25. The share of costs in total income reveals the highly negative impact of overstaffing onoperating performance. In every bank in the sample, labor costs absorbed at least 60 percent of totaladjusted income. In the case of Misiones, labor costs exceed total adjusted income generated for theperiod. Only the provincial banks of Neuquen, Chaco, and Mendoza have reasonable wage costs in totalincome, all below 10 percent.

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ARGENTINA

FINANCLIAL SECrOR ADJUSTMENT LOAN

Supplementary Loan Data Sheet

Ilmetable of KaX Evets

(a) rmie taken to prepare: 10 months (with Bank involvement dating back 5 years)

(b) Prepared by: Argentine Government in cooperation with the Bank

(c) First IBRDi mission: 1987

(d) Appraia mission departure: July 1992

(e) Date of Negotiations: October 1992

(f) Planned Date of Loan Effectiveness: February/March 1993

(g) List of relevant PCRs and PPRs: N.A.

- 78 -

AS=ARG;ENTINA

FINANCIAL SECTOR ADJUSTM LOAN

TIRE STATUS OF IBRD OPERAITONS IN A IASTATEMENT OF BANK LOANS (as of September 30, 1992)1/

Loan or Amount (lessCredit Fiscal cancelatons) UndisbrsedNumber Year Borrower Purpose (US$ milLion) (US$ million

Fully dibrsed Loaws (32) 3,174.9 0.0

2592 1985 YPF Gas Utilization &Techn. Assistance 180.0 35.6

2641 1986 Argentina Water Supply 60.0 36.02751 1987 Argenti_ Power Engineering 14.0 0.22793 1987 Argentina Smal & Med. Scale Cr. 68.1 4.32854 1987 Argentina Power Distribution 276.0 169.22920 1988 Argentina Municipal Development 120.0 94.72970 1988 BNA Agriculture Credit 106.5 1.02984 1989 ArgeMina Social Sector 28.0 13.02997 1989 Argentina Housing Sector 30.0 0.63015 1989 Argenina Tax Admin. T.A. 6.5 1.03280 1991 Argentina Provincial Development 200.0 195.53281 1991 Argentna Water Supply 100.0 99.03291 1991 Argentina PERAL 300.0 148.43292 1991 Argentina PEREL 23.0 17.73297 1991 Argentina Agricultual Senices 33.5 29.93362 1991 Argentina Pub. Sector Refonm T.A. 23.0 20.03394 1992 Argentina Pub. Sector Reform (PSRL) 325.0 162.53416 1992 YPF Sociedad Hydrocarbon Engr. 28.0 24.0

Anonima3460 ai 1992 Argetina Second Tax Administrion 20.0 20.03520 2t 1992 Argetina Yacyreta II 300.0 300.035i1 2a 1992 Argentina Flood Rehabilitation 170.0 170.0

TOTAL 5,586.6of whih has been repad 1,722.1

TOTAL NOW OUTSTANDING 3,864.4

AMOUNT SOLD 12.8of which has been reraid 12.8

TOTAL NOW HELD BY BANK AND IDA 3,851.68==C=

TOTAL UNDISBURSSD 1,542.6

==CS2

1/ Does not reflect tbe final cancellation of the Housing Se&or LoaL

Z/ Not yet effective

-79 -ANEXARGENTINA

STATEMENT OF IFC TNVESTIENTSAs of September 30. 1092

(USS MiSon)

Ordind Gross Comitments Hold Held by UndisbursdrFsa Yea IFO IrC Paftiai- by Partici- (InaludngCommited Oblir Type suwins Loan Equity pants Tol IFC pant Partcipantt)

t16 a/ AclnderSA Stol Produc@s 2.90 - 076 3e6 - - -1960 at Pepelers Rio Pauan* SA. Pulp and Pap 3o00 - - 3.00 - - -161 at FadeaasA MotorVeh. &Aceossoins 1.23 - 0.28 1.51 - - -162 a/ PoeSAlC Petrochemials 3.05 - - 3.OS - - -

1965,72 a/ Ce<lJ Argentina Pulp and Paw S.25 - 425 12.50 - - -

1969 of Editorial CodaS A. Printng and Pubushing 4.60 2.00 0.40 t.00 - - -

1098,75 8/ ODalmSideroSAIC Iron andSSt" 14.75 - 2.25 17.00 - - -

1971,73 aI Calwa Avella.eda $A. Cement 5.50 - - 5.50 - - -

1971484,/a88 Apargals SAIC Texliles and Shoe 37.53 5.00 7.50 W0.43 10.35 - 1.631e97785 a/ SWex S.A Food mndFFood roes 21.00 - - 21.00 - - -J7&'811182f87193 JuanMineW SA. CMet 35.50 4.50 67.5C 107.50 16.60 14.53 4.50i8a$1971/89"i MauhSA. Pulp and Par 24.50 4.2 3.00 31.75 18.40 - 0.08

'1479.2182/792 IpeoA. Petiooehoicals 21.00 1.10 9.00 31.10 1.00 8.25 0.001979183/84 AlpeS SA Food & Food Process 521 1.60 - 8.81 1.61 - -198416 PefoquimicaCuyo SA. Chemicl &Petochem. 21.00 4.00 21.00 46.09 14.55 11.84 0.401986 Rop-a CapitalMarket - 0.05 - 005 0.05 - -

1986 a AtanortSA Chemicels 7.00 1.00 - 8.00 - - -

1956/87 Sadcr Capil Makes - 2.05 - 2.05 2.00 - 1.009i899le Sanc Robet SA. Capita Markets 26.00 2.00 - 28.00 16.57 - 7.40

1908 arovagloyZowraquln GeneralMantuttrw:ng 13.00 - - 13.00 7.58 - -

1987100 Hidra il Crude Petal.&Nat Gas 80.00 - 2760 107.60 13.91 3.841987/9C,91 TerminWa SA. PottfadlltZ. 1Z50 0.00 0.00 12.50 8.54 0001$88 As1 CAPSA Lindero Energy 12.38 - - 12.38 3.75 - -1988 sung* y Sam Food and Food Process 40.00 - - 40.00 24.00 - -

i9S8 Aroor SAIC Genra Manufatuuig 12.00 - - 12.00 6.00 - -

198;93 Bridas LnderoSAPIC Energy 55.60 15.00 60.00 130.60 50.00 - -

19888 SaN Owev.Finance 20.00 - - 20.00 16.89 - 34019"8,2 anoooRioCL(SRLP) Oev.Finance 50.00 - - 50.00 47.00 - 18.051988.92 Chirete Chemlca&Pefrohehm. - 6.62 - 6.62 6.61 - 1.861980 Com. Geraldo lnvesiones FinaneilSevi - 0.10 - 0.10 0.10 - 0.09i989 Chluidoa Energy - 4.5 - 4.95 4.90 - 0.1219S9 AIC Securitiesnanal instt - 2.00 - 2.00 2.00 - 2.001-9i Banco Frances, Owv. Finc 15.00 - - 15.00 15.00 - -1989,92 Astr CAPSA Energy 50.00 - 43.00 93.00 38.55 43.00199 CIP Financial Srvices - 0.07 - 0.07 0.07 - -

1990.91 Petrokn Chemicals& Pekochem. 20.00 - 11.00 31.00 20.00 11.00 -

19.9 Bancode CroditArgentino Financislvlce - 10.00 - 10CO 10.00 - 5.501992 Polbuw Chemieas - 7.00 - 7.00 7.00 - -

1992 PetoleraArgentfe San Jorge Energy - 17.00 - 1700 17.00 - 0.861992 MSA goet CapitalMarkets - 0.18 - 0.18 0.18 - 0 021992 Frigoroo lop4aten Slaughtering. Preparing 12.00 1.00 6.00 1900 13.00 600 6001992 OleaginoosO"to Sunflower Seed Agribus. 20.00 - 15.00 35.00 20.00 15.00

TotalIe C4mm enmt b/ 654.90 91.47 278.63 1025.00Lees: Cancellations. Trminatons. Raymwt & Set 304.50 19.60 165.16 489.26

ToWl Commitnts Now Hdld el 350.40 71.87 113.46 535.73 422.27 113.40 82.90

Po"elnct Commrneitm:

Perolers Argenina San Jorge Energy 15.00 10.00 35.00 eo.00(Huabalo soak)

COeto Chemical & Pctrochernica .00 - 11.00 19.00anam Pie CL (BRLPa Oevelopment Finace - - 20.00 20.00

Malrla Pan" Agribushess 12.00 - 6.00 18.00FenoPrs P-mp_sno lnlrauture 11.00 2.00 16.00 20.00kg. Emerging arket Financial Sevis - 4.00 - 4.00sub-t"Ol 46.00 16.00 8.00 150.00

Todl CommItmen_ Held and Pending Commibens 3040 87.7 201.40 68873Toal Undisbred Commtmnt 40.8S 10.05 2.00 8290

a/ Investmem which hav been fulk cancelled. terminated, written-off sold, redeemed or repaid.

b/ Gross Commitments cwtd Oa Wov*d and signed poActs.c/ Hel Commitmen onsiod dicburid and undisbursed ivefaterme.

-80 - XIIPage 1 of 2

Poi Insues In Proposed FY93-97Lending

Objectivewlnstrument issues

Consolidatng MacroeconomicReonn

Public enterpnse reform * Divestiture of all PEs owned by Ministry ofDefense

* Imprved anti-trust regulation* Improved flexibility of labor contracts

Re-establishment of external * Support for debt agreement between Argentinacreditworthiness and commercial creditors

Provincial adjustment * Reform of provincial finances* Downsizing of provincial governments* Transfer of public service responsibilities to

provinces* Privatization of provincial enterprises and banks

InsIitionid Stiengthening

Energy and Power * Privatization/concessioning of electricitytransmission and distribution

* Restruching of National NuclearCommission/priatization of unfinished nuclearpower project

* Completion and privatization of Yacreta* Establishment of regulatory frameuerks and

agencies

lansport * Road concessioning/transfer to provinces* Privatization of ports* Removal of botlenecks in export corridors

Provincial and municipal * Developing capacity to plan, build and maintaindevelopment infrastructure

Ruml infrastructure water * Improved water managementsupply, and swerage * Improved living conditions and sanitation in urban

poerty areas* Strengthen regulatory ftamererk for priAtized

vytems

Agricultural, industial * Restoration and reform of applied research,services extension, vocational training and quality control

* Restructuring of national institutes includingpartidal user fee financing

* Libetion of trade in consultant services

-81 -Page 2 of 2

Objective/Lnstnmient losuts

Matemal and child healt * rgeting of social assistance on vulnerableand nutrition groups

* Reduction of maternal and infint mortality andmalnutrition

* Improved delivery of social assistance

Health * Tansfer of public services to provinces* Refocusing on basic health care* Reforming national health insurance program

Education * Transfer of secondary education to provinces* Introduction of university tuition

Rural environment * Sustainable use of natural resources* Pricing and regulatory framework in forestryo Management of native forests* Soil conservation and chemical use* Property issues

Urban environment * Market-based solution to water pollution problem* Industrial pollution control

Festedng Pdvate SectorDevelopment

winancial sector adjustment * Liquidation, privatiaton or downsing of federaland provincial commercial banks

* Enforcement of minimum capital and provisioningrequirements

* Improved disclosure of bank financial statements* Implementation of Cental Bank reform

Capital markets development * Improvement in term intermediation performance* Secondary market development* Improved regultory management and enforcement