Report No. 15402-AR Argentina The Convertibility Plan: Assessment and Potential Prospects (In Two Volumes) Volume l: The Main Report July 12, 1996 Country Operations Unit II Country Department I Latin America and the Caribbean Regional Office Q)ocu*nnt of the World Ba4nk Currcncy Equivalents Currency Unit: Peso (As of July 1996) US$ 1 = ARG$1 Fiscal Year January 1 - December 31 Glossary of Acronyms APC State Employment Agencies' Program ATN Treasury Grants B.A. Buenos Aires BCRA Central Bank of the Republic of Argentina BHN Housing Bank BIS Bank of International Settlements BOCON Government Debt Consolidation Bonds BONEX Dollar denominated Treasury Bonds CET Common External Tariff CGE Computerized General Equilibrium Model CPI Consumer Price Index EFF Extended Fund Facility ENTel National Telecommunication Enterprise EPH National Household Survey FDI Foreign Direct Investment FEDEI National Electric Development Fund FIEL Foundation for Latin American Economic Research FONAVI National Housing Fund GATT General Agreement on Trade & Tariffs GDP Gross Domestic Product HUBN Households with Unsatisfied Basic Needs IMF International Monetarn Fund INDEC National Statistics & Census institute LAIA Latin American Integration Association LFP Labor Force Participation LIBOR London Interbank Offer Rate MERCOSUR Southern Cone Common Market NTC National Trade Commission OECD Organization for Economic Cooperation & Development PAYG Pay as you go PEP Partial Subsidy for Private Employment PPF Production Possibility Frontier PRENO Public Sector Social Program PROAS Public Sector Social Program PROEDIS Public Sector Social Program PRONOPAS Staging Study Abroad PYMES Small and Medium Enterprises QR Quantitative Restriction SEGBA Water Company SIGEN Government Internal Auditors TBILL Treasury Bill TFP Total Factor Productivity USA United States of America VAT Value Added Tax WTO World Trade Organization YPF Oil Company COUNTRY DATA - ARGENTINA AREA POPULATION DENSITY 2766.9 thous. sq.km. 34.2 million (mid-1994) Country density 1991 11.7 hab.per aq.km 1.2% annual growth Rural density a. 16.9 hab. per sq.km of arable land POPULATION CHARACTERISTICS aI HEALTH bl Crude Birth Rate (per 1000-1992) 20.5 Population per physician (thous.) 0.4 Crude Death Rate (per 1000 - 1992) 7.9 Populabon per hospital bed (thous.) 0.2 Infant Mortality (per 1000 live births -1992) 23.6 INCOME DISTRIBUTION bI DISTRIBUTION OF LAND OWNERSHIP % of nabonal income, highest quintile 51.0% % owned by top 10% of land owners % of national income, lowest quinble 5.0% % owned by smallest 1 0% of land owners ACCESS TO SAFE WATER (1991) ACCESS TO ELECTRICITY 11989) % of populabon - urban 72% % of populaton 95% % of populabon - rural 17% NUTRITION al EDUCATION Calorie intake as % of requirements 119.2% Adult literacy rate % (1980) 95% Per capita protein intake (grams per day) 99.7 Primary school enrollment % a/ 100% GNP PER CAPITA IN 1994 dl 8,060 GROSS DOMESTIC PRODUCT IN 1995 di ANNUAL GROWTH RATES (% constant prFIes) USS Bill. % (current prices of GDP 1965-73 197340 19B0-94 1995 GDP at market prices 276.0 100.0 4.3 2.2 1.3 -4.4 Gross Domestc Investment 49.1 17.8 6.8 4.3 0.1 -15.9 GrossNabonalSavings 45.3 16.4 2.5 2.3 -18.3 4.1 Current Account Balance -2.3 -1. 4 ExportsofGoods&NFS 23.9 8.9 -4.7 141 5.2 26.1 ImportsofGoods&NFS 23.7 8.7 0.6 13.3 -13.0 -10.5 OUTPUT, LABOR FORCE AND PRODUCTIVITY IN 1995 Value Added (constant prices) Labor Force ti VA. Per Worker Arg $ Thousand % of Total Thousands % Arg S Agriculture 915 7.5 2,964 12.0 309 Industry 4,346 35.8 7,755 31.4 560 Services 74,721 615.1 13,978 56.6 5,346 TotalGDPatFactorCost 12,148 658.4 24,697 100.0 492 GOVERNMENT FINANCE g/ Federal Government Provincial Government Million Pesos %ofGDP Million Pesos %oOGDP 1995 1995 1995 1995 Current Revenues 49,038 16.9 Current Revenues 24.093 8.7 Current Expenditures 48,449 16.8 Current Expenditures 27,492 10.0 Capital Revenues 1,256 0.3 Capital Revenues 239 0.1 Capital Expenditures 3,218 0.4 Capital Expenditures 3,999 1.4 Surplus -1,373 0.0 Surplus -3,179 -1.2 a/ For the period 1982-1985. b/ For the period 1970-1976. c For the period 1987-1992. d/ Current US dollars. Estmated using Bank Atas methodology. a/ Current US dollar estimates, calculated from data in constant Arg S 1986. f/ Calculated by applying 1980 census shares to 1994 populabon. gl Cash Basis in current Pesos, includes Central Administration, Social Security and Public Enterpnses. COUNTRY DATA . AROENTINA MONEY, CREIXT AND PRICE 16 192 1993 1994 165 (_ o Paw ; erd of p.1o4) Momn OoASr moneye/ 11,003 17.467 24,682 27,535 Damnsdo BaBnCndi to Pbc edorf a 15,004 12,010 14,871 18,052 Do i Bt CrMto*Pi sebBdoWro 22,046 34.261 43.243 52,130 Momny andC Mony ss % dODP 6.1 7.7 9.6 9.8 Wh_FeeIPcdes1apIlUI-.100) di 90.8 104.7 106.4 107.1 115.4 Ain pwweu Ir_ hI: GulW loee Pib mau/ 110.7 6.0 1.6 0.7 7.7 BS Cre d to Pubk Sedm .. -20.0 23.8 7.9 BStnkCredloPrlto Sedor .. 55.5 26.1 20.6 .. MERCHANDIS8EEXPORTS(Avwag.1661-1665)b/ LLANCEOFPAYMENTSbi 1962 1993 1994 1"5 US$SM %atTotal Prinury product 3723.0 25.1 Men. of agsliurnl oigin 5584.3 37.7 EngoiaofGoods. NFS 15,272 15,624 18,507 23.657 Menu. of kd *dodgin 4121.5 27.8 bhpt of Goods. NFS 18,817 20.684 25,591 23,724 Fuels 1381.8 9.3 Resouce B9aie -3,545 -5,060 -7,084 133 Total Merchidso Exports 14810.6 100.0 ftaed Paynieri (nol) -2,695 -1,109 -1,277 -1,218 OlerFedor Payeubi(nel)at -845 -1,273 -1,270 -1,624 TddPlbktDl OuleO l*ilgA Disburad (EndINS)bf Ur1S11 m Not Cmd Transfr 749 411 320 432 Balnce an Caret Accot -4.336 -7,031 -9,311 -2,277 Total 87091 IBRD 4462 CaprftalAccoLt 10.162 11,408 9,668 2,206 IDB 4791 IMF 6120 FiNls Se dor 6.632 7.065 6,376 4.996 Biataluls 11614 Pulbc Ssdor 1.530 4.343 3,492 7.206 BonrJ 58340 Conmerdal Baits 1764 Chlng.s In Gros Rea. ( s * h ) 3.826 4,377 557 -69 DEBT SERVICE RATIO, 1994 55.7% RATE OF EXCHANE IBRDADA LENDING, DECEMBER 31, 1995 (1M U3S) bl US# 1. Ag.6 I IRD IDA OWistandng a DIslsed 4462 i/Sourc: IMF. bv Soure: MUrdiy of Ec00mw c/So : INDEC d/Aveng Mai for ts year. zt Based on fI avwage lo der for yew. Source: Mistry of Econory. TABLE OF CONTENTS Page Number Executive Summary ...........................................i Resumen Ejecutivo .. ........................................ vi CHAPTER I: Defining the Convertibility Plan . ...........................1 A. Origins of the Crisis Leading to the Convertibility Plan ............................1 B. The Convertibility Plan ..........................................2 The Convertibility Law .......................................3 Public Sector Reform ........................................4 Debt Restructuring .......................................7 Social Security Reform ........................................8 Trade Reforms ........................................9 CHAPTER II: Economic Performance and Macroeconomic Implications of the Convertibility Plan .............................. 11 A. Economic Performance (1991-94) .11 Public Sector Performance (1991-94) .12 Capital Inflows, the Current Account and the Real Exchange Rate. 1 5 Effects on Financial Markets .17 Monetization and Dollarization .18 The Response of Trade Flows to Liberalization .18 Investment: Recent Trends and International Comparison .21 Savings: Recent Trends and International Comparison .23 Evolution of Productivity and Competitiveness .24 B. Impact of the 1995 Mexican Crisis .. ........................ 27 CHAPTER 11: Sustaining High Economic Growth . ............................... 31 A. Simulating a Pattern of Sustainable High Growth ................................... 31 B. Policies Conducive to Higher Economic Growth ..................................... 34 Investment .................................... 34 Private Saving ................................... 36 International Trade Regime ................................... 40 C. The Unfinished Reform Agenda ....................... 45 Argentina's Provinces: New Priorities for Public Sector Reform ......... ... 45 Provincial Expenditure Efficiency ............................................ 45 Recommendations for Reform ............................................ 48 Relations between Provincial Governments and the Financial Sector . 51 Labor Markets and Institutions .................. ........................... 52 Employment Performance ............................................. 52 Wage and Earnings Performance ............................................. 54 Determinants of Unemployment ............................. ................ 54 Prospects ............................................. 55 Recommended Course of Action ............................................. 56 Financial Markets ............................................. 58 The Banking Sector ............................................. 59 The Capital Markets ............................................. 62 D. End Note ............................................. 63 Statistical Appendix (in volume II) EXECUTIVE SUMMARY 1. Five years have passed since Argentina, faced with the most severe of a series of economic crises characterizing the eighties decade, adopted the Convertibility Plan. This courageous and innovative plan restructured the country's economic landscape, generating prospects for unprecedented stability and economic growth. The purpose of this report is to review the achievements and challenges that this Plan has brought to the Argentine economy over 1991-94, and then assess prospects for economic growth in the wake of the economic turbulence that beset Latin America in 1995. The 1991-94 Record 2. Argentina has had one of the most successful of recent stabilization and reform efforts. From one of the most extreme hyperinflations by historical standards in 1989, it moved relatively quickly by 1994 to an annual inflation rate of 3.9 percent. Output and productivity growth have been remarkable in the first four years of the Plan, with GDP growth averaging 7.7 percent. The initial consumption-led boom matured by 1994 into a healthy pattern of investment- and export-led growth. Privatization of state assets was far reaching, and far more successful than expected. As a result of the economic recovery, poverty levels declined significantly between 1989 and 1994, although economic restructuring with a rigid labor market resulted in increased unemployment: 12.2 percent of the labor force by October 1994. 3. Trade reforms and economic recovery boosted imports from barely US$4 billion in 1990 to over US$21 billion in 1994. The import boom was financed by capital inflows, including large scale foreign direct investment and portfolio investments that quickly responded to the signals of structural adjustment. The abundance of foreign exchange due to the capital inflows led to a real appreciation of the currency. This appreciation began reversing itself in the latter half of 1993, due to decelerating inflation and currency realignments among Argentina's major trading partners. The impact of the currency's appreciation was further mitigated by wide-ranging productivity increases, deregulation and tax reductions. As a result, export growth, particularly of industrial exports, accelerated. 4. There is growing evidence that Argentina underwent an important adjustment in response to the radical restructuring and liberalization of its economy. Productivity (both of labor and capital) increased, and particularly in 1993 and 1994 the growth of investments (financed by growing national and foreign savings) and exports, which are the key determining variables for the ultimate success of the Convertibility Program, has accelerated. The main focus of this report is Argentina's experience with the Convertibility Plan, and potential prospects for sustained high rates of economic growth. Contributors to this report were Messrs./Mmes. P.Levy (task manager and main author), J.L. Guasch (labor), C. Sapelli (productivity), S. Rajapatirana (international trade), J. Morisset (public finance, investment, saving), J. Hicks and D. Rosenblatt (fiscal federalism), H. Shah (financial sector), C. Revoredo (data management and projections). Mr. Carlos Rodriguez (Convertibility Plan), FIEL (labor, trade, tax issues, saving, investment), and ALPHA Consultants (productivity) prepared background papers for this report. - ii - 5. The Convertibility Plan, named after the Convertibility Law that changed the Central Bank into a monetary board, is an internally consistent and complex economic program. Other pillars to the Plan, in addition to monetary reform, include fiscal reform, state reform, trade reform, and social security reform. Such a radical adjustment of the economy is an ongoing process that cannot be completed in a short time span. As a result, the economy, despite its significant progress, remains vulnerable to a variety of shocks. The Mexican Crisis' Aftermath 6. As the economic crisis in Latin America early in 1995 brought to sharper focus, the Convertibility Plan remains particularly sensitive to foreign capital flows. With the reversal of capital flows, the Argentine economy suffered a contraction in 1995 of an estimated 4.4 percent. The sharp recession caused an increase in unemployment, and strained the performance of the financial system. The regional financial crisis was the first severe test of the Convertibility Plan. Yet, by the end of 1995, there were signs that Argentina was pulling out of its recession without serious damage to the Convertibility Plan. To the contrary, significant pressures to deviate from it were met by efforts to further strengthen it during the crisis, indicative of the Plan's popularity and staying power. It can be claimed in some respects, that the credibility of the Convertibility Plan was strengthened from the 1995 crisis. 7. The immediate aftermath of the 1995 financial crisis has been reassuring. The Government, with the strong support of Congress and the electorate, opted for the continuation of the reform process in the context of the Convertibility Plan. The determination to eschew populist policies in times of crisis, while redoubling efforts to pursue a renewed reform agenda, is a testament to the fundamental attitudinal changes sweeping through the new Argentina, becoming an example to the region as a whole. The reelection of President Menem for a second term in May, 1995 vindicated his reform policies and demonstrated that effective stabilization can bring with it political rewards. Future Prospects 8. Argentina, endowed with plentiful natural resources and a good stock of human capital, both underutili.ed on account of past misguided economic policies, has, in the context of the Convertibility Plan, created the foundations for unleashing its economic potential. With solid fundamentals already in place, Argentina has a unique opportunity to strengthen its economic adjustment process, creating the conditions for high and sustainable economic growth. Taking a page from the East Asia miracle story, a stable pattern of high economic growth--possibly of 7 percent--would be characterized by sharp increases in national saving and investment, and continuous productivity gains. To achieve sustained high economic growth, the Argentine economy should be led by export and investment growth, with these two key contributors growing, in a simulated consistency model, twice as fast as the economy as a whole. The underlying premise in such a high growth scenario is that the fiscal accounts would remain balanced. 9. It is in that framework of reachable ambitious targets, and a united view both by the Government and the public towards further modernization and reform, that this document has reviewed policies affecting investment, saving, and exports. The assessment is that the fundamental policy structures directly affecting investment, saving, and exports are fundamentally sound. Nevertheless, there is scope for improvement in a number of areas, both in fine tuning the trade regime and more fundamental reforms, for the ambitious growth targets set out in this report to have a chance to materialize. - Hi - 10. Regarding the international trade regime, there is a need for greater simplicity, transparency and automaticity of economic policies. It is recommended that the Government reexamine the automotive regime and the "industrial specialization" regimes. It is recommended that the mirror principle be eliminated, in order to provide neutrality between exports and import substituting industries. Alternative mechanisms to promote regional development are proposed, rather than the use of trade preferences. The National Trade Commission should be strengthened to adopt the new rules for safeguards, anti-dumping and countervailing actions that are consistent with the new World Trade Organization, and rely more on the safeguard mechanism rather than on anti-dumping actions. It is recommended that Argentina's position in MERCOSUR should favor the adoption of a uniform and low common external tariff, bring the 15 percent of the tariff lines outside the common external tariff (CET) under the CET, and harmonize regulatory framneworks. Maintaining the Momentum of Reform 11. As is well understood by the authorities, the Argentine reform agenda has remaining gaps, which require attention, if the economy's potential is to materialize. Despite its achievements, the economy is still facing a number of hurdles before it resumes a sustainable and strong pattern of economic growth: (a) the financial system is still undergoing major restructuring, slowing the financial intermediation process; (b) most provinces will still need to undergo painful adjustments; and (c) labor markets under the weight of restrictive legislation face an uncomfortably high rate of unemployment, and are in urgent need of liberalization. Reform of the factor markets would contribute to improved productivity, and mitigate economic instability, which are crucial factors for the expansion of saving, investment and exports. A stable political environment, and fiscal prudence, are equally important prerequisites for achieving high and sustainable economic growth. 12. In the unfinished reform agenda mentioned above, extending economic reforms to the provinces remains a priority. While fiscal adjustment has occurred at the federal level, provincial reforms continue to lag, although the 1995 crisis prompted a number of provinces to initiate this long-delayed adjustment. Lack of adjustment is reflected in the continued unwillingness of many provincial governments to contain current expenditures, increase sufficiently their own-source revenues, and more importantly improve the efficiency of public spending. As a result of decentralization and privatization of many federal functions, provinces remain ill-prepared to fulfill their increasingly important role in health, education, security, water and sanitation services, with potential negative implications for economic growth and poverty reduction. 13. Two broad areas of reform, intergovernmental fiscal relations and access of subnational governments to the financial sector, are fundamental for the restructuring of provincial finances. Structural reform addressing poor provincial expenditure efficiency includes expanding the provincial own-source revenue base to bring it more in line with provincial expenditure responsibilities, and decreasing the high dependence of provinces on fiscal transfers by devolving national tax bases to the subnational level. This would prompt provincial authorities to confront their constituents with the costs of their preferences, and promote enhanced efficiency in resource allocation. To further increase accountability, but also meet equity objectives, intergovernmental transfers should be conditional on effective service delivery, based on transparent indicators. Towards that objective, transfers to provinces outside the coparticipation system could be consolidated into a program of grants allocated to provinces on the basis of their performance. It is also recommended that a transition strategy be developed to support market-based subnational government access to the financial markets, in order to facilitate the - iv - financing of subnational government investment needs. It is strongly recommended that the federal government eschew financial assistance, including debt restructuring, beyond legal obligations under the coparticipation agreement/law, to non-reforming provinces. 14. The federal government has taken initial measures to liberalize the labor markets. However, given the importance of reallocating resources in the economy, the acceleration of labor market liberalization becomes imperative. The urgency of these measures became more pronounced during the recent recession which compounded the growing unemployment problem observed in the course of restructuring the economy. The implementation of structural reforms and resumption of economic growth could reduce unemployment at a fast pace. Key policy reforms to consider, to that effect, are the reduction in labor costs, improved contractual flexibility, strengthened unemployment insurance, and decentralized collective bargaining. Additionally, it is highly recommended to develop an information system and analysis of the service sector, which is the major source of employment. 15. Regarding labor costs, it is recommended that non-wage labor costs continue to be reduced. In this context, Government should consider extending fiscal exemptions to young employees and the long- term unemployed, and permitting the unrestricted use of temporary and fixed term contracts. Regarding unemployment insurance, the authorities should consider modifying the severance payments system, since having both unemployment insurance and a severance payment scheme dissuades the unemployed from actively seeking employment and firms from optimally adjusting their labor force. The authorities should consider decentralizing collective bargaining, rescinding the concept of "ultractividad", eliminating the monopoly over the provision of welfare services for employees by unions, and streamlining training programs. 16. Argentina has both the need and potential for development of financial markets approaching developed country standards. Since the Convertibility Plan, the authorities have radically improved the regulatory and economic environment for banking and capital markets. However, problems arising from institutional underdevelopment, and lack of market and product development have proven more intractable. Thus, financial markets remain shallow, intermediation costs, margins and inefficiencies are high and act as a strong deterrent to both saving and investment. Cost of credit remains high, the aggregate credit extension low, and access to formal credit particularly difficult for small businesses and farmers. A consolidation/restructuring of the banking system, both private and public, is imperative for the remonetization and improved financial intermediation in the economy. The development of capital markets will be equally critical in improving this intermediation process. 17. In order to consolidate confidence and liquidity in the banking system, raise the volume and maturity of savings and loans, augment access to credit, particularly to small and medium enterprises, and deepen capital markets, the following actions are recommended: (a) facilitate/promote the accelerated restructuring and consolidation of private banks through the adequate funding and institutional strengthening of the Bank Capitalization Trust Fund; strengthening the Central Bank's inspection and enforcement authority; encouraging bank mergers with stronger institutions; and eliminating regulatory forbearance; (b) reduce banking costs and spreads through the reduction of taxes on financial transactions; dismantling barriers to competition; establishment of a continuous and liquid benchmark yield curve; strengthening the functioning of the Deposit Insurance mechanism; improving credit analysis capabilities of banks; and facilitating the use of collateral; (c) facilitate the privatization of provincial banks or their closure through the adequate funding of the Privatization Trust Fund; avoiding federal fiscal support that would prop up provincial banks; and strengthening the Superintendency of Banks' legal v - capacity to enforce prudential norms on provincial banks; and (d) proceed with the privatization offederal bankcs. 18. It is worth emphasizing the relevance of macroeconomic conditions and framework in the performance and prospects for development of the financial system. Given vulnerability to abrupt shifts in capital flows, the following alternatives may strengthen the lender of last resort capacity of the system beyond those currently in existence: the Central Bank may enter into swap arrangements with other Central Banks that can act as lenders of last resort, impose higher reserve requirements to improve the response capacity of the financial system, the financial system may gravitate towards multinational financial institutions if they are perceived as providing lender of last resort capacity, and build over time significant excess international reserves. 19. From the challenges ahead, none could be as important as the need to attend to growing social needs, as Argentina addresses the impact of the recent external crisis. Renewed economic growth remains the linchpin to the alleviation of poverty. Structural reforms, such as those proposed above, particularly the liberalization of labor markets, would reduce unemployment and accelerate the moderation of social pressures, while simultaneously contributing to higher economic growth. Furthermore, the reassessment of public finances, federal and provincial, should permit efficiency gains to allow for more targeted social programs to address the needs of the poor, without undermining fiscal prudence. Economic growth, more efficient allocation of public spending, and reduction in tax evasion should allow for the planned reversal in the recently increased tax rates, in a balanced budget environment. Continued reforms at the federal government level, reflected in the Second Reform of the State program expected for 1996, are another reminder that reform is a continuous process that needs vigilance and nurturing. - vi - RESUMEN EJECUTIVO 1. Han pasado cinco afios desde que la Argentina adopt6 el Plan de Convertibilidad, luego de afrontar una serie de severas crisis econ6micas que caracterizaron la d6cada de los aflos ochenta. Este valiente e innovador plan reestructur6 el panorama econ6mico del pafs, generando perspectivas de estabilidad y crecimiento econ6mico sin precedentes. El objetivo de este informe consiste en examinar los logros y desaffos que dicho plan incorpor6 a la economia argentina durante el perfodo 1991-94, asf como tambien evaluar las perspectivas de crecimiento econ6mico dentro del marco de turbulencia econ6mica que asedi6 a America Latina en 1995. El Record 1991-94 2. Argentina protagoniz6 uno de los mas exitosos esfuerzos recientes de reformas y estabilizaci6n. Habiendo partido en 1989 de una de las hiperinflaciones hist6ricamente mas extremas, la economia se condujo relativamente rapido hacia una inflaci6n anual del 3,9 porciento en 1994. Tanto el crecimiento del producto como el aumento de la productividad han sido notables durante los primeros aflos del Plan, con un crecimiento promedio del PBI de 7,7 porciento. El boom inicial de consumo madur6 hacia 1994 en un sano patr6n de crecimiento guiado por inversiones y exportaciones. La privatizaci6n de activos del Estado fue intensa y mucho mas exitosa de lo esperado. Como resultado de la recuperaci6n econ6mica, los niveles de pobreza declinaron significativainente entre 1989 y 1994; aunque la reestructuraci6n econ6mica con un mercado laboral rigido llev6 a un aumento en el desempleo: 12,2 porciento de la poblaci6n econ6micamente activa en octubre de 1994. 3. Las reformas comerciales y la recuperaci6n econ6mica impulsaron las importaciones, que crecieron de US$4 mil millones en 1990 a mas de US$21 mil millones en 1994. El boom de importaciones fue financiado por el ingreso de capitales, incluyendo inversiones directas e inversiones de cartera de gran escala, que respondieron rapidamente a las sefiales de ajuste estructural. La abundancia de moneda extranjera que produjo el ingreso de capitales llev6 a una apreciaci6n del tipo de caambio real. Dicha apreciaci6n comenz6 a revertirse hacia fines de la segunda niitad de 1993 como consecuencia de una inflaci6n decreciente y realineamientos en el tipo de cambio de los principales socios comerciales de la Argentina. El impacto de la apreciaci6n del tipo de cambio fue mitigado auin nas por el aumento generalizado de la productividad, la desregulaci6n, y reducciones en los impuestos. Como resultado, se aceler6 el crecimiento de las exportaciones, y en particular el de las industriales. El principal objetivo de este informe es analizar la experiencia Argentina con el Plan de Convertibilidad y las perspectivas potenciales para una elevada y sostenida tasa de crecimiento econ6mico. Contribuyeron en la realizaci6n de este informe los Sres.: P. Levy (director del proyecto y autor principal), J.L Guash (trabajo), C. Sapelli (productividad), S. Rajapatirana (comercio internacional), J. Morisset (finanzas pimblicas, inversi6n, ahorro), J. Hicks y D. Rosenblatt (federalismo fiscal), H. Shah (sector financiero), C. Revoredo (manejo de datos y proyecciones). El Sr. Carlos Rodrfquez (Plan de Convertibilidad), FIEL (trabajo, comercio, impuestos, ahorro, inversi6n), y consultores de ALPHA (productividad) prepararon el material de apoyo para este informe. - vii - 4. Existe cada vez mAs evidencia que demuestra que la Argentina experiment6 un ajuste importante en respuesta a la reestructuraci6n radical y a la liberalizaci6n de su economia. La productividad (tanto del trabajo como del capital) aurnent6; y en particular, entre 1993 y 1994, se aceler6 el crecimiento de las inversiones (financiadas tanto por el incremento en el ahorro nacional como externo) y las exportaciones, variables claves en el exito definitivo del Plan de Convertibilidad. 5. El Plan de Convertibilidad, Ilamado asi por la Ley de Convertibilidad que transform6 al Banco Central en una caja de conversi6n, es un programa econ6mico internamente consistente y complejo. Adenas de la reforma monetaria, otros pilares del Plan incluyen: la reforma fiscal, la reforma estatal, la reforma comercial y la reforma del sistemna de seguridad social. Un ajuste tan radical de la economifa es un proceso que no puede ser completado en un corto plazo. Como consecuencia, y a pesar del significativo progreso obtenido, la economia permanece vulnerable a shocks. Consecuencias de la Crisis de Mejico 6. La crisis econ6mica en America Latina de principios de 1995 puso en evidencia que el Plan de Convertibilidad permanece particularmente sensible al flujo de capitales externos. La economia argentina sufri6 una contracci6n de aproximadamente un 4,4 porciento como consecuencia de la salida de capitales. La marcada recesi6n llev6 a un aumento en el desempleo y perjudic6 el desempenio del sistema financiero. La crisis financiera regional fue la primera prueba de envergadura a la que fue sometido el Plan de Convertibilidad. Sin embargo, hacia fines de 1995, comenzaron a verse sefiales de que la Argentina estaba saliendo de la recesi6n, sin mayores dafhos al Plan de Convertibilidad. Al contrario, las fuertes presiones para desviarse del plan, fueron contrarrestadas por medidas para fortalecerlo tomadas durante la crisis. Esto es indicativo de la popularidad y poder de permanencia del Plan. Puede afirmarse en cierta medida que la credibilidad en el Plan de Convertibilidad fue afianzada a partir de la crisis de 1995. 7. Las consecuencias inmediatas de la crisis financiera de 1995 han sido alentadoras. El Gobierno, junto con un fuerte apoyo del Congreso y del electorado, opt6 por continuar con el proceso de reforma dentro del contexto del Plan de Convertibilidad. La decisi6n de evitar politicas populistas en tiempos de crisis, redoblando esfuerzos para continuar con una nueva agenda de reformas, es prueba fehaciente de los cambios fundamentales de actitud que se estan generalizando en la nueva Argentina, lo que la convirte en un ejemplo para toda la regi6n. La reelecci6n del Presidente Menem en mayo de 1995 para un segundo perfodo vindic6 su politica de reforma y demostr6 que una estabilizaci6n efectiva puede traer recompensas polfticas. Perspectivas Futuras 8. La Argentina, dotada con abundantes recursos naturales y un buen stock de capital humano ambos desaprovechados por polfticas econ6micas previas desencaminadas, ha generado, en el contexto del Plan de Convertibilidad, los fundamentos para desencadenar su potencial econ6mico. Con una s6lida base en pie, la Argentina posee una oportunidad unica para fortalecer su proceso de ajuste econ6mico, creando condiciones para un crecimiento econ6mico elevado y sostenido. Tomando como antecedente la historia del milagro del Este Asigtico, un patr6n estable de crecimiento econ6mico elevado--posiblemente del 7 porciento--podria caracterizarse por marcados incrementos en el ahorro nacional y en la inversi6n, y por continuas ganancias de productividad. Con el fin de alcanzar un desarrollo econ6mico elevado y sostenido, la economia Argentina deberfa basarse en el crecimiento de sus exportaciones v de la inversi6n; el crecimiento de dichas variables, dentro de un modelo de consistencia simulado, deberia duplicar al de la economifa en su conjunto. La premisa subyacente en tal escenario es que las cuentas fiscales se mantendran equilibradas. 9. En este marco de objetivos ambiciosos y alcanzables, y con una visi6n compartida por el Gobierno y el publico sobre la necesidad de mayores reformas y modernizaci6n, este documento ha analizado las polfticas que afectan a la inversi6n, el ahorro y las exportaciones. El analisis indica que la - viii - estructura de las poifticas que afectan directamente la inversi6n, el ahorro y las exportaciones, es fundamentalmente la apropiada. Sin embargo, hay margen para mejoras en varias areas, tanto en ajustes al r6gimen de comercio como en reformas mas fundamentales, para que las ambiciosas tasas de crecimiento establecidas por este informe puedan materializarse. 10. Con respecto al regimen de comercio internacional, hace falta una mayor simplificaci6n, transparencia y automaticidad de las poifticas econ6micas. Se recomienda que el gobiemo reexamine el regimen automotor y los regimenes de "especializaci6n industrial". Se recomienda que el "principio espejo" sea eliminado, permitiendo la neutralidad entre las industrias de exportacion y las sustitutivas de importaciones. Se proponen mecanismos alternativos para promover el desarrollo regional, en vez del uso de preferencias comerciales. La Comisi6n Nacional de Comercio deberia ser fortalecida para que pueda adoptar los nuevos reglamentos para evitar el dumping y las acciones compensatorias, consistentes con la nueva Organizaci6n Mundial de Comercio, apoyandose mas en los mecanismos de salvaguarda del comercio sefialados por dicha organizaci6n que en las medidas anti-dumping tradicionales. Se recomienda que la Argentina apoye la adopci6n de un arancel externo comuin bajo y uniforme, en el MERCOSUR; que incorpore el 15 porciento de las lineas arancelarias que se encuentran fuera del regimen de arancel externo comuin (AEC) al AEC, y que armonice los marcos regulatorios. Manteniendo el Impetu de la Reforma 11. Como es bien sabido por las autoridades, la agenda de reformas de Argentina cuenta con temas pendientes que deben ser atendidos si se quiere materializar el potencial de la economia. A pesar de sus logros, la economia debe sortear una serie de vallas antes de reanudar un patr6n de crecimiento econ6mico fuerte y sostenido: (a) el sistema financiero esta experimentando una fuerte reestructuraci6n, que retrasa el proceso de intermediaci6n financiera; (b) la mayoria de las provincias debera pasar todavfa por ajustes penosos; y (c) el mercado laboral, bajo el peso de una legislaci6n restrictiva, afronta una alta e indeseada tasa de desempleo, y necesita urgentemente una liberalizaci6n. Las reformas en los mercados de factores contribuirian a mejorar la productividad, y mitigar la inestabilidad econ6mica, factores cruciales para la expansi6n del ahorro, de la inversi6n y de las exportaciones. Un entorno de estabilidad politica y de prudencia fiscal son prerrequisitos igualmente importantes para lograr un crecimiento econ6mico elevado y sostenido. 12. En la agenda de reformas pendiente, mencionada anteriormente, sigue siendo prioritaria la reforna de las economias provinciales. Aunque el ajuste fiscal ha ocurrido a nivel federal, las reformas provinciales estan retrasadas, si bien es cierto que la crisis de 1995 impuls6 a algunas provincias a que inicien sus procesos de ajuste. La falta de ajuste se ve reflejada en la continua falta de voluntad de los gobiernos provinciales en contener los gastos corrientes, en incrementar en forma suficiente sus propias fuentes de ingresos; y, lo que es mas importante, en mejorar la eficiencia del gasto puiblico. Como resultado de la descentralizaci6n y la privatizaci6n de muchas de las funciones federales, las provincias se encuentran mal preparadas para asumir su importante y creciente rol en la educaci6n, la seguridad, los servicios sanitarios y los servicios de agua corriente; esto impacta negativamente sobre el crecimiento econ6mico y la reducci6n de la pobreza. 13. Existen dos areas de reforma que son fundamentales para la reestructuraci6n de las finanzas provinciales: las relaciones fiscales intergubernamentales y el acceso de los gobiernos provinciales al sector financiero. Las reformas estructurales que se encaren para combatir la escasa eficiencia del gasto a nivel provincial, deben apuntar a expandir la base de ingresos propios, acercandola a las responsabilidades de gasto provincial; ademas, debe disminuirse la elevada dependencia sobre transferencias fiscales en las provincias mediante la devoluci6n de bases impositivas que actualmente se encuentran en manos del gobierno nacional. Esto Ilevaria a las autoridades provinciales a confrontar al electorado con los costos de sus preferencias y promover una mayor eficiencia en la asignaci6n de recursos. Tanto para incrementar la responsabilidad en el gasto, como para alcanzar objetivos de equidad, las transferencias intergubernamentales deberian estar condicionadas a la provisi6n de servicios - Lx - eficientes, basados en indicadores transparentes. Con el fin de alcanzar dicho objetivo, las transferencias a las provincias que se encuentran fuera del sistema de coparticipaci6n podrian ser consolidadas en un programa de transferencias donde 6stas se otorguen en funcion del desempefio de cada provincia. Tainbien se recomienda el desarrollo de una estrategia de transici6n que facilite el acceso de los gobiernos subnacionales a los mercados financieros dentro de un marco competitivo, ayudando asi al financiamiento de las necesidades de inversi6n de los gobiernos subnacionales. Se recomienda especialmente que el gobierno nacional evite la asistencia financiera, incluyendo la reestructuraci6n de deuda, a aquellas provincias que no inicien la reforma, mas alla de las obligaciones legales que surgen de la ley de coparticipaci6n. 14. El gobierno federal ha tomado medidas iniciales para la liberalizaci6n del mercado laboral. Sin embargo, dada la importancia de la reasignaci6n de recursos en la economia, la aceleraci6n de la liberalizaci6n del mercado laboral se vuelve imperativa. La urgencia en la efectivizaci6n de dichas medidas se ha hecho auin mAs pronunciada con la reciente recesi6n, que complic6 aun mas el creciente problema de desempleo observado durante el curso de la reestructuracion econ6mica. La implementaci6n de reformas estructurales y el reinicio del crecimiento econ6mico podrian reducir el desempleo en forma rapida. A tales efectos, se deberfan tomar las siguentes medidas: la reducci6n de los costos laborales, una mayor flexibilidad en los contratos, reforzar el seguro de desempleo, y descentralizar las negociaciones colectivas. Adicionalmente, se recomienda enfaticamente desarrollar un sistema de informaci6n y analisis del sector de servicios, que es la mayor fuente de empleo. 15. Con respecto a los costos laborales, se recomienda seguir reduciendo los costos laborales no salariales. Dentro de este contexto, el gobierno deberfa considerar extender exenciones fiscales a empleados j6venes y a los desempleados a largo plazo, asi como permitir el uso irrestricto de contratos temporales y de plazo fijo. Con respecto al seguro de desempleo, las autoridades deberian considerar una modificaci6n en el sistema de indemnizaci6n por despido, debido a que la coexistencia del seguro de desempleo y la indemnizaci6n por despido desalienta a los desempleados a buscar trabajo activamente, y a las empresas a ajustar 6ptimamnente su fuerza de trabajo. Las autoridades deberfan considerar descentralizar las convenciones colectivas de trabajo, rescindir el concepto de ultractividad, eliminar el monopolio de los sindicatos sobre la provisi6n de servicios sociales para los trabajadores, y modernizar los programas de entrenamiento. 16. Argentina tiene la necesidad y el potencial para el desarrollo de mercados financieros similares a los de los paises desarrollados. Desde la puesta en marcha del Plan de Convertibilidad, las autoridades han mejorado radicalmente el entorno regulatorio y econ6mico de los bancos y los mercados de capitales. Sin embargo, los problemas ocasionados por el subdesarrollo institucional y la falta de desarrollo de mercados y de productos, se han vuelto dificiles de tratar. Por lo tanto, los mercados financieros siguen siendo de poco desarrollados; tanto los gastos de intermediaci6n, como los margenes y la ineficiencia son elevados y desalientan fuertemente el ahorro y la inversi6n. El costo del credito permanece elevado, el volumen de cr6dito es bajo, y el acceso al credito formal es particularmente dificil para empresas pequefias y los productores agropecuarios. Una consolidaci6n/reestructuraci6n del sistema financiero, tanto privado como pCblico, es imperativa para la remonetizaci6n y el desarrollo de la intermediaci6n barcaria de la economia. Es igualmente critico el desarrollo de mercados de capitales para mejorar el proceso de intermediaci6n. 17. Se recomiendan las siguientes medidas para consolidar la confianza y la liquidez del sistema bancario, incrementar el volumen y la madurez de ahorros y prestamos, facilitar el acceso al credito, en particular para pequenias y medianas empresas, y desarrollar los mercados de capitales: (a) facilitar/promover la acelerada reestructuraci6n y consolidaci6n de los bancos privados a trav6s del adecuado financiamiento y fortalecimiento institucional del Fondo Fiduciario de Capitalizaci6n Bancaria; fortalecer la capacidad de inspecci6n y de control del Banco Central; promover la fusi6n de bancos con instituciones mas fuertes; y eliminar tolerancias regulatorias; (b) reducir los costos bancarios y el margen entre tasas de interes activas y pasivas, mediante la reducci6n de los impuestos sobre las transacciones - x - financieras; el desmantelamiento de barreras a la competencia; el establecimiento de una curva de rendimientos (yield curve) continua y liquida; fortalecer el funcionamiento del mecanismo de Garantfas sobre Dep6sitos; mejorar la capacidad de analisis crediticio de los bancos; y promover el uso de garantias bancarias; (c) facilitar la privatizaci6n o el cierre de bancos provinciales, a traves del uso de financiamiento adecuado del Fondo Fiduciario de Privatizaci6n; evitar ayuda fiscal federal que apuntale a los bancos provinciales; y fortalecer la capacidad legal de la Superintendencia de Bancos para hacer cumplir las normas prudenciales que se dicten sobre los bancos provinciales; y (d) proseguir con la privatizaci6n de bancos federales. 18. Vale la pena enfatizar la importancia de las condiciones macroecon6micas en el desempefio y perspectivas de desarrollo del sistema financiero. Dada la vulnerabilidad existente frente a los bruscos cambios en los flujos de capitales, las siguientes altemativas podrian fortalecer la capacidad del sistema como prestamista de uiltima instancia: el Banco Central podria iniciar acuerdos de canje (swaps) con otros Bancos Centrales que actuen como prestamistas de uiltima instancia, imponer requisitos de reservas mas elevados para mejorar la capacidad de respuesta del sistema financiero; el sistema financiero podria tender hacia una mayor participaci6n de instituciones financieras multinacionales, en la medida en que 6stas sean percibidas como entidades capaces de cumplir con el rol de prestamistas de uiltima instancia, y generar a lo largo del tiempo excedentes significativos de reservas internacionales. 19. Tras afrontar el impacto de la creciente crisis externa, la Argentina debe asumir una serie de desafios, aunque ninguno es tan importante como el atender las crecientes necesidades sociales. Un resurgimiento del crecimiento econ6mico es fundamental para aliviar la pobreza. Reformas estructurales como las antes propuestas, en particular la liberalizaci6n del mercado de trabajo, reducirian el desempleo y acelerarian la moderaci6n de presiones sociales, contribuyendo a la vez a un crecimiento econ6mico mas elevado. Mas aun, las mejoras en eficiencia a partir de la reevaluaci6n de las finanzas puiblicas federales y provinciales, permitirian la puesta en marcha de programas sociales mejor enfocados para afrontar las necesidades de los pobres, sin socavar la prudencia fiscal. El crecimiento econ6mico, junto con una nas eficiente asignaci6n del gasto puiblico, y la reducci6n de la evasi6n fiscal, deberian permitir la planeada reducci6n de las tasas impositivas (recientemente incrementadas), en un contexto de equilibrio presupuestario. La continuaci6n de las reformas en el gobierno federal, reflejadas en el programa de la Segunda Reforma del Estado previstas para 1996, son otro indicador de que reformar es un proceso continuo que requiere ser vigilado y fomentado. CHAPTER I DEFINING THE CONVERTIBILITY PLAN A. Origins of the Crisis Leading to the Convertibility Plan 1.1 The economic ills that the Convertibility Plan set out to correct date back to the 1940s, when statist GDP Growth a hnd Inflateon 19I 1994 and inward-looking growth strategies took effect, ...- resulting in massive public sector deficits, accelerated . 3000 inflation and economic stagnation. By the mid-1970s, s . ..00 the country's long-term growth declined noticeably, I,, 2000 and in the last half of the 1980s, the country suffered I from its longest period of stagnation in the century. I I 502 Savings and investment rates fell precipitously from I 00 0 the mid-1970s until 1989. Argentines, responding to ., .0. the unstable macroeconomic environment, increasingly it9 _ L . ; Is.so D saved and invested abroad. Labor productivity fell -G75 19BD 1 1991 and poverty worsened. GCP Giowli |IIInOI 1.2 This economic performance was traceable to Figure 1 chronic public sector deficits and endemic inflation. After the return to constitutional democracy in 1983, public demands to control inflation were translated into four successive stabilization programs. All failed to eradicate inflation, and each ended in a more virulent inflation than the one preceding it. The main reason for these failures was the inability of the stabilization programs to redress rapidly and permanently the structural deficit of the public sector. 1.3 Structural deficits emerged from the post-war Federal Government Overall Balance organization of the economy. Since the 1940s, Percentage of GDP economic policy favored powerful interest groups. Unionized labor benefitted from high wages, guaranteed employment, and rigid rules governing o hiring and dismissals. Industry benefitted from highly protected markets, tax exemptions through special .s l.ii.... i... promotion regimes, subsidized credit (or even effective grants since many loans were not collected), 10 .. ... ........... ........................ subsidized inputs from public enterprises, and high prices on sales to public enterprises. Housing 1. . ......................................... contractors and selected middle class home buyers benefitted from enormous public transfers through *200 N 190 181 f0s f88e earmarked taxes and effective grants through the 86ree MlIettlnt ye Iofomy Housing Bank (BHN). Tobacco growers benefitted from special taxes, as did the sugar growers, the Figure 2 merchant marine, and other small interest groups. Consumers enjoyed below-cost tariffs from public enterprises and lax collection practices. Provincial governments could avail themselves of costless credit from the provincial banks, which the Central Bank would reimburse. The military enjoyed expanding budgets, especially in 1976-82, as well as management perquisites in state companies they controlled. By 1989, subsidies through the budget, tax exemptions, agricultural regulations, public enterprise tariffs, and central bank rediscounts were estimated to amount to US$8 billion. -2 - 1.4 The growth of the state and concomitant rents and subsidies, along with the capital flight provoked by an inconsistent exchange rate policy, had been financed during the late 1970s largely by external borrowing, through the expanding Eurodollar market at low or even negative real international interest rates. This permitted the Govermnent to run large deficits and sustain a revalued exchange rate with relatively low levels of inflation in the second half of the 1970s. However, the abrupt end to voluntary foreign commercial credit in the early 1980s the decline in commodity prices and the sudden rise in real international interest rates provoked a financial collapse and placed additional pressure on public finances. The situation was complicated by the South Atlantic War. 1.5 The loss of external finance and lack of adjustment meant the Treasury had to resort to increased inflationary finance through monetary creation (aggravated by quasi-fiscal deficit). The private sector, in an effort to avoid the resulting inflation tax, gradually withdrew its resources from the financial system and reduced its real holdings of currency; this, together with the negative effects of inflation on real tax collections, made the macroeconomy progressively more unstable in the 1980s. Even though the level of the deficit fell from near 20 percent of GDP in the early 1980s to an average of about 10 percent in 1987-89, the base for the inflation tax shrank even faster--efforts to reduce the deficit were not fast or permanent enough to convince the private sector that their savings in domestic currency would not be taxed by inflation. Inflation became high and unpredictable, and thus became the main impediment to the recovery of private savings and investment. The decade ended with two episodes of hyperinflation in 1989. B. The Convertibility Plan 1.6 As an aftermath to the 1989-90 hyperinflations, and the collapse of the monetary system, on March 1991 the authorities announced a new monetary system, based on a fully convertible fixed exchange rate regime. While many of the policies which later became part of the Convertibility Plan started taking shape with the Menem Administration during 1989-90, a consistent and well defined economic strategy of stabilization and structural reform only took place after Minister Domingo Cavallo announced this new set of monetary measures on March 21, 1991. After this initial announcement, a complete set of consistent measures started to be implemented, becoming what is known as the Convertibility Plan. While this plan gets its name after the most popular instrument, the Convertibility Law, it represents a much wider set of measures aiming at the complete and permanent structural adjustment of the economy and public sector reform. The main pillars of the Convertibility Plan are: (a) Monetary Reform, through the Convertibility Law, subsequently supplemented by the new Charter of the Central Bank; (b) Fiscal Reform, initially through a sharp improvement in the administration of the tax system and later through a redefinition of tax instruments and rates; (c) Public Sector Reform, through debt restructuring, civil service reform, fiscal restructuring and an ambitious and successful plan of divestiture, and deregulation of factor and product markets; (d) Social Security Reform, allowing for a new capitalization mechanism operated by the private sector; - 3 - (e) Trade Reform, through the elimination of export taxes and most quantitative restrictions on imports, and the reduction of the level and range of import tariffs. The Convertibility Law 1.7 The Convertibility Law of April 1991, fixed the rate of the Austral at 10,000:1 to the dollar. On January 1992, the Austral was replaced by the Peso at the fixed rate of 1:1 to the US dollar. The Law also established that the monetary base could not exceed the dollar value of international reserves, and prohibited all indexation in the goods and labor markets. 1.8 The Convertibility Law, in practice, made the Central Bank into a Currency Board by mandating a 100 percent reserve requirement for the issue of high-powered money. By removing the power to devalue from the Ministry of Economy, and placing it with Congress, the Law attempts to remove the instrument of devaluation from the set of easily available instruments and thus provide more credibility to the new currency. However, the Central Bank can exert some discretion through the use of variable bank reserve requirements, and excess international reserves. To ensure the full reserve backing, other conditions were set on the behavior of the monetary authorities through the new Charter of the Central Bank. This Charter, approved by Congress on September 1992, established the independence of the Board of Directors, all of whom are ratified by Congress and provides fixed terms of tenure for the appointees, including the President of the Central Bank. 1.9 The Charter originally allowed a maximum of 20 percent of international reserves backing the monetary base to be in dollar denominated government bonds, which currently has been raised to 33.3 percent. Issuing base against BONEX allows the Central Bank to regulate short run fluctuations in market liquidity by swapping between pesos and BONEX. Additionally, the Charter dictates that the Central Bank cannot take any new interest earning liabilities, and it cannot remunerate reserve requirements. These measures eliminate the possibility of generating a quasifiscal deficit through the servicing of Central Bank debt. Consistent with the restrictions for generating Central Bank liabilities other than those used to acquire international reserves, the Charter does not allow the Central Bank to significantly guarantee commercial bank deposits, i.e. deposit insurance. This substantially reduces the role of the Central Bank as a lender of last resort, both for the peso and for the domestic dollar deposits system. Nevertheless, in an emergency the Central Bank can provide, for a limited time, liquidity up to 100 percent of a bank's capital. 1.10 Under the convertibility system, international reserves are backing the monetary base, and cannot be considered as precautionary reserves (see figure 3). Also, under this system, variations in international reserves have a direct impact on the economy through changes in the money supply, and the real interest rate. 1.11 An important feature of the Convertibility Plan is its bi-monetary nature, which permits the use of foreign exchange for market transactions, or the holding of foreign exchange denominated liquid assets in the domestic financial system. Since 1989, commercial banks have been allowed to open dollar denominated accounts and to issue certificates of deposit. The reserve requirements against dollar deposits at commercial banks are to be deposited abroad and are not counted as part of international reserves. Since 1993 commercial banks are allowed to form their reserve requirements against peso or dollar deposits in either currency, and at the same rate, thus increasing the substitution from the supply side between both currencies. In the face of the Mexican financial crisis, in January 10, 1995, further -4- measures were taken to facilitate the dollarization of the economy and strengthen the Convertibility Plan. Ratio oseroes to Monetary Bag e 1991-94 The Central Bank required banks to keep reserve 200 requirements on peso deposits only in US dollars, equalized the Central Bank's buying and selling exchange rate at 1 dollar: 1 peso (eliminating costs of transaction), and reduced dollar reserve requirements to match the temporary reduction in peso reserve . . ....................................... requirements. Dollarization has contributed to enhancing the credibility of exchange rate policy, . _ since it reduced vulnerability under a fixed exchange rate, because portfolio shifts from domestic currency 0 deposits to foreign currency denominated deposits, or 1901 102 10 3 vice versa, would not necessarily involve a reduction I in total domestic bank deposits. Figure 3 1.12 Under a dollarized system, where fractional reserve requirements are in effect, the concept of lender of last resort takes a different dimension, since part of the liabilities of the banking system are dollar denominated, and the Central Bank cannot print dollars to fulfil that function. In a crisis, high bank reserve requirements, excess international reserves, or a foreign lender of last resort are needed to fulfil that function. 1.13 Financial Reform. In conjunction with the above mentioned monetary reform, which established a firm constraint on the Central Bank's ability to extend credit to the banking system, the primary instrument for increasing resource mobilization and reduce high interest rates has been the implementation of policies enhancing confidence in the economy and the financial system. In addition, the Government strengthened banking and capital market institutions. New banking policies primarily sought to improve the financial soundness of the banking system to help increase confidence in domestic financial institutions and reduce the Government's exposure to losses stemming from bank failures. To improve the soundness of the banking system, the Law of Financial Institutions was changed, allowing the Central Bank to withdraw the operating license of private commercial banks that do not comply with its technical ratios (i.e., reserve, capital, and provisioning requirements) and when its board rejects the bank's plan to achieve appropriate compliance. To reduce the public sector's exposure to losses stemming from bank failures, the Government decided to forego formal public deposit insurance. The Government also made major strides in banking regulation and supervision, and reformed the structure, staffing, and technology of the Superintendency of Banks. The Government has been increasingly pressing for, and facilitating through Trust Funds the restructuring of the private banking sector and the privatization or liquidation of public banks. By the first quarter of 1996 the Government had privatized a major national public bank, the Caja Nacional de Ahorro y Seguros, liquidated the Banco Nacional de Desarrollo, and five provincial banks were privatized (with another ten in the process of privatization). Similarly, the Government strengthened regulation, supervision, and enforcement in the capital markets. Public Sector Reforn 1.14 The Menem administration took office in July 1989 during a traumatic hyperinflation--July inflation alone was 200 percent. This culminated a decade-long crisis in public finance. The new team inherited weak public institutions accustomed to deficit spending and with an institutionalized reliance on the inflation tax. In addition, claims on the state's revenues were far greater than its capacity to mobilize resources--in short, the Argentine state was insolvent. 1.15 In response to the crisis, the Menem administration undertook two stabilization programs in 1989 and 1990. Neither succeeded, principally because of the intractability of the fiscal deficit. The first terminated in a new hyperinflation at the end of 1989 and early 1990. The second lasted from March 1990-December 1990 and ended in a new inflationary outburst but, unlike the previous breakdowns, the economy did not spin into hyperinflation. Instead, a new fiscal package in February 1991 was sufficient to close the remaining fiscal gap. This was followed by the April 1, 1991 Law of Convertibility, effectively proscribing money creation other than to buy net foreign reserves, thereby limiting the powers of the Government to finance its deficit through inflation. 1.16 Since 1991, the Government has sustained structural reform efforts that had progressively improved the foundations of public finance. The Government had undertaken difficult-to-reverse reforms in the legal framework, institutions, and policies. This process included institutional reforms of the Federal Government, privatizations, as well as restructuring of liabilities with domestic and foreign creditors to adjust them to serviceable levels. Other reforms have helped elicit efficient private investment, notably trade, deregulation and financial sector reform. 1.17 Revenue Mobilization The Government Tax Revenues undertook a major effort to improve revenues through Ta of GOP) the implementation of a much-broadened and uniform 25 VAT, first to goods in February 1990, and later extended to services in November 1990. The 20 ....................... ............... Government in 1989 also undertook to improve the 15 . efficiency of the tax administration--establishing a . control system for the largest taxpayers; improving audits and controls substantially. The tax penalty law, 5. adopted by Congress in 1990, provided much needed a 3 2 sanctions for tax non-compliance. The tax package of I so I 91 Z 92 1 93 1 94 1 95 I February 1991 improved the quality of the revenue Eica TangCM {0IeloIe Taxes 9 Social Seocuity mobilization substantially because it eliniinated export 5 ' ci Eeirsy taxes--which had been reduced progressively during 1990 and early 1991--deducted higher taxes on Figure 4 financial transactions from the income/asset tax, and removed several minor taxes. In early 1992, the VAT rate was raised to 18 percent and the corporate income tax to 30 percent. The increase in VAT collection has allowed the Government to eliminate inefficient taxes Lcn as the gas-oil tax and the federal stamp tax in November 1992. In December 1992, subsidies to indu.scrial promotion were substantially cut through the replacement of the self-monitored tax deductions with a tax bond program. These efforts cumulatively produced dramatic rises in tax collections. -6 - 1.18 Administrative Reform Because the wage Employment of the National bill dominated expenditures, the Government set up AdmInIstration the legal and administrative machinery to reduce the size of the federal bureaucracy in November 1990. Federal employment decreased from 671,000 to aoo 284,000. Of the 387,000 reductions, 103,000 were lay-offs and 284,000 were transfers of teachers and seo health workers to the provinces. This effort was 400 based on a ministerial reorganization that focused federal activities on core objectives, and 200 improvements in the civil service system through an improved salary structure and efficiency measures. - The Government was able to increase average salaries 196B 1096 1990 1991 1992 1993 1994 and partially restore salary differentials. During _____________t_y___________ 1996, the Government has received congressional Figure 5 authorization to proceed with a second administrative reforn to improve further its organization, performance, accountability and transparency. 1.19 Divestiture The Menem Government has Privntization Revonues 1990*94 followed an accelerated timetable for privatization or US$ Million partial divestiture of most of its enterprises. The Tkeusends objective was to reduce the budgetary burden of the 7 enterprises on the Treasury, make the firms more a 5.710 competitive, and increase the volume and efficiency of 5 new investment. The privatization program, in the 4 3661 works since 1988, gained credibility with the sale of 3 ENTel in November 1990. The program removed _9_ politics from price setting in the formerly vast 2 1.5 segment of the economy covered by the state. The * 05 change in the institutional organization of these oil sectors cut off public subsidies to consumers and labor 1990 1901 1992 1993 1994 S,mre r, MIulory ol Ecomomy groups benefitting from high wages and excess I__________Ministry____________ staffing, and transfers for investment. The program Figure 6 also improves public finances: transitionally with more than US$2.5 billion in capital receipts to help close fiscal accounts in 1991 and 1992, more permanently by eliminating transfers and increasing tax revenues. 1.20 The Government has sold two television stations, ENTel, the national telephone company, and Aerolineas Argentinas. In mid-1991, it began the first comprehensive restructuring of the petroleum industry in Latin America by auctioning off selected areas of YPF. It granted road and railroad concessions to the private sector and privatized long distance cargo lines, and reduced the railway's work force by 15 percent. The Government privatized in 1992 defense industries, the nation's largest distributor of electricity (SEGBA), ports, reinsurance and major parts of the power sector. In July 1993, the successful privatization of state-owned oil company (YPF) enabled the Government to cancel obligations to pensioners (about US$2.7 billion) and to oil producing provinces (about US$1.2 billion). The Government is currently in the process of privatizing airports, nuclear power plants, and the hydroelectric plant, Yacyreta. - 7 - 1.21 Deregulation A major domestic deregulation decree was issued in October 1991. This ended a series of market impeding rules, dissolved several regulatory bodies and unified pension and health insurance payments to reduce evasion. Subsequent decrees have deregulated pharmaceutical imports and ports. The industrial promotion program and subsidies to Tierra del Fuego were markedly reduced by a recent decree in November 1992, though it was partially reverted in December 1993. Deregulation is projected to be extended in the provinces through the recent Pacto Fiscal. 1.22 Provincial Reforms The Federal Government's ability to effect reforms in provincial public finances is constrained by lack of direct jurisdiction. Still, since the Convertibility Plan was initiated in 1991, the Federal Government has launched a concerted effort to promote fiscal adjustment in the provinces by regularizing the transfer of co-participated federal revenues; reducing discretionary transfers that historically have rewarded poor fiscal performers; transferring responsibility for the provision of most social services in health and education to the provinces; reforming and assuming responsibility for provincial social security systems; improving local resource mobilization; modernizing and downsizing provincial public administration; eliminating Central Bank rediscounts; and promoting the privatization of provincial banks. This strategy was initiated in August 1992, when the Federal Government reached an agreement (Pacto Fiscal I) with the provinces whereby 15 percent of co-participated funds would be diverted to finance the transition costs of national social security reform. In return, federal authorities agreed to compensate the provinces partially by guaranteeing a minimum of US$725 million per month in co-participated transfers. 1.23 Further modifications were reached under the Pacto Fiscal II of August 1993. The Pact calls for reforms in provincial tax systems to replace distortionary taxes. In return the Federal Government agreed to increase the minimum monthly co-participated transfers to US$740 million, forego the debt accumulated by the provinces under the August 1992 agreement, gradually eliminate the federal asset tax, and take over responsibility for government employee pension systems from willing provinces.' 1.24 Finally, the Federal Government moved to shut off provincial access to private sector borrowing to support current expenditures. Domestic banks have had to obtain BCRA authorization before lending to the non-financial provincial public sector, since the mid-1980s. In November 1993, the Government also began requiring authorization for provincial banks to borrow abroad, in order to head off further loans from foreign banks backed by co-participated revenues. Debt Restructuring 1.25 Debt with the Financial System and Quasifiscal Deficit. On January 1, 1990, faced with rising Central Bank deficits and the renewed threat of hyperinflation, the Government took the drastic action of converting the domestic, short-term (mainly seven day), interest-bearing obligations of the Central Bank into US$3.5 billion 10 year dollar denominated Treasury bonds (BONEX). This virtually eliminated the Central Bank's quasifiscal deficit and the monetary emission necessary to finance it--at the cost of penalizing savers and reducing the already low confidence in the financial system. 1. As a follow-up to increase the incentives for the provinces, in December 1993 the Federal Government announced that employer wage taxes would be reduced in those provinces carrying out the proposed tax reforms. -8 - 1.26 External Debt. In April 1988, the Government suspended payment on its external debt to commercial creditors. By 1992, it had accumulated US$9.2 billion in arrears as part of a US$30 billion medium-term commercial bank debt. Public external debt was US$58 billion. The progressive improvement in fiscal fundamentals in 1990-91 allowed the Government to begin negotiations with commercial banks on a debt reduction deal. The external debt agreement with commercial creditors, signed on April 7, 1993, ended the accumulation of arrears, regularized existing arrears, reduced interest obligations in the initial years, and sharply limits interest obligations when international rates rise. The agreement formalized arrears in a 12-year uncollateralized bond at LIBOR with a 3 year grace period, after a US$700 million downpayment; existing debt was exchanged for a collateralized par bond with a fixed interest rate, or a collateralized discount bond at 65 percent of face value paying LIBOR; the collateralized bonds have a 12 month rolling interest guarantee. 1.27 Arrears to Pensioners and Others. For most of the last decade, the Government has paid only about half the legally mandated pensions owed to social security recipients. In order to stop the accumulation of arrears, the Government modified the coparticipation of tax revenues in favor of the social security system in August 1992. The Government also accumulated arrears in 1990 with suppliers through the formal suspension of payment on goods and services already provided, and the health funds have arrears with their service providers which will also result in new debt. To settle these claims, Congress authorized the Government to issue consolidation bonds (BOCONs) with terms of 10 to 16 years (with shorter terms for social security recipients) and a five year grace on principal and interest. The service of the debt will be capitalized until 1997, but payments on the order of US$3 billion will be required in the last years of this decade. The proceeds of the privatization of the state oil company allowed the Government to cancel part of its debt with pensioners (about US$4.5 billion) during the course of 1993. At the end of 1994, US$7.7 billion of issued bonds were outstanding to the above claimants. Social Security Reform 1.28 Argentina's mandatory public pension insurance became financially unviable during the 1970s, resulting in severe underpayment of pensions. In 1991, the Government concluded that adequate benefits and financial viability could only be restored with a systemic reform that would reverse the steeply increasing trend of the dependency ratio (pensioners/contributors), which was primarily the result of an increasing evasion of contributions. As an initial step leading up to the actual operation of the system in July 1994, the Government took measures enabling the National Pension System, to gradually raise benefits to their mandated level. These included the earmarking of coparticipated tax revenues, a reform of the collection function, and an increase in the minimum years of contributions from 15 to 22, which slowed the increase in the number of pensioners. In addition, the Government issued consolidation bonds in recognition of pension arrears estimated at about US$10 billion. 1.29 Central to the reform is the combination of public schemes on a pay-as-you go (PAYG) basis with private or public pension funds in an integrated system of mandatory pension insurance. Employers and independent workers will contribute 16 percent of, respectively, gross salary and income to the PAYG system. The scheme provides a basic, uniform pension of about 28 percent of average salary, which may be increased only by additional years of contribution beyond the 30 year minimum. All workers contribute 11 percent of salary or income to either the PAYG scheme or a pension fund with the right to change affiliation twice a year. Expected benefits will be strictly proportional to contributions and--in the case of pension funds--the fund's investment performance. These rules are expected to lower evasion - 9 - by linking expected benefits to contributions. Further measures to reduce the dependency ratio include a gradual increase in the retirement age by 5 years, a further increase in the minimum years of contributions to 30, and stricter rules for disability claims. In the context of provincial reforms, the Governrment has initiated the consolidation of inefficient provincial social security systems with the national system. Trade Reforms 1.30 One of the main pillars of the Convertibility Plan has been Trade Reform, which eliminated export taxes and most quantitative restrictions on imports, while reducing the level and range of import tariffs. Reduction in tariffs and non-tariff barriers, starting during President Menem's Administration, have been dramatic when put in the context of Argentina's protectionist history, stemming from the import-substituting strategy of over 40 years. 1.31 As a result of protracted protectionist policies, the degree of openness of the economy which Openness Coelicrent 1979 - 1994 averaged 35 percent in the 1920's was reduced to 0.14 about 6 percent during 1970's. This ratio was 0.12 . increased during the Convertibility Plan to an average 01. of 11 percent.2 1.32 The trade regime underwent radical changes D . . | since the late 1980s. The import regime was l transformed from a highly protectionist regime to a liberal regime. The most fundamental change in the 0.02 . import regime was the replacement of quantitative o . . . 1090 restrictions with tariffs, which in itself is a significant 197D 075 ,9BD 0 85 ., trade liberalization. However, quantitative restrictions sONIC# M.,.,,y o Ecolow were maintained for automobiles, sugar, and some Figure 7 paper items. The average nominal tariff on imports (including the statistical tax) was reduced from 30 percent at the end of 1989, to 14 percent on April 1995. However, following the initial strong liberalization, the trade regime acquired increased complexity. The February 1991 import regime was simple and consisted of only three tiers; by late 1994, the import regime had seven tariff tiers, and it became linked to the export performance. However, protection remained low as did the variance, although the latter would have increased in terms of effective protection rates. 1.33 Trade liberalization also has a strong regional bias. Argentina is a member of MERCOSUR (common market), establishing a common external tariff. Argentina adopted a common external tariff (CET) of 20 percent on January 1, 1995 under the MERCOSUR Agreement. However, the CET applied to some 85 percent of the harmonized tariff lines. The remaining 15 percent of the tariff lines were to converge to the CET over time. Additionally, trade inside the MERCOSUR area is free from import tariffs, with exceptions. This arrangement stands in contrast to the earlier regional arrangements undertaken under the aegis of the Latin American Integration Association (LAIA) when preferences were 2. Defined as exports plus imports over GDP. - 10- used to restrict trade outside the regional arrangements rather than liberalize trade in what can be called GATT- plus basis. The new trade policy led to a rapid opening of the economy-both in terms of trade, as well as capital and technology flows, since foreign investors were extended the same legal rights as domestic investors. 1.34 Like the import regime, the export regime was also transformed. In the late 1980s exports were subject to taxes and licensing and there was an extensive array of export promotion and subsidy schemes. These included the duty free status accorded to capital goods imports based on multi-annual export contracts, a temporary admission regime for intermediate goods, a 15% export subsidy on items under the special export program aimed at promoting non-traditional exports, and subsidized export financing. Export taxes, primarily falling on agricultural exports were around 10-12 percent of export value, and constituted a significant part of government revenue. 1.35 With the reforms of the early 1990s, most export subsidies and taxes were removed. But that regime also subsequently becarne more complex with the "mirror export subsidies" program which granted to each export product the same rate of subsidy as that corresponding to imports of the same product, sectoral performance agreements, and attempts to balance exports and imports by industry. In 1992, the rules of the automobile regime were extended to a few other industries. This was called a regime of "industrial specialization". Any industry could enter into an agreement with the Secretary of Industry and Commerce specifying a target export figure for the coming years. Such firms would receive import licenses with reduced tariffs up to the export target that had been agreed upon. Four periods were considered for industrial specialization: 1993-96, 1997, 1998 and 1999. In the first period, the tariff rate would be 2%, after 1996 a specified formula would be used to calculate the reduced tariffs. The exchange rate reform and the reduction of import tariffs helped reduce the bias against exports. 1.36 Previous attempts to liberalize the trade regime could not be sustained due mostly to macroeconomic instability, lack of commitment to free trade, and resistance from domestic industries that had thrived under protectionist trade regimes. Moreover, the earlier attempts were not combined with strong privatizations or regulatory reforms and could not support the resource movements that are needed to reallocate resources following a reduction in protection. The trade liberalization launched in the late 1980s and accelerated in the early 1990s, succeeded to a large extent due to the remarkable macroeconomic stability achieved by the Convertibility Plan. - 11 - CHAPTER II ECONOMIC PERFORMANCE AND MACROECONOMIC IMPLICATIONS OF TIE CONVERTIBILITY PLAN A. Economic Performance (1991-94) 2.1 This chapter reviews the main macroeconomic implications of the Convertibility Plan. Economic performance under the Convertibility Plan is separated here into two periods; the 1991-94 growth period, and the crisis year of 1995. This separation in warranted, since the crisis was generated primarily by external factors, and both periods have different lessons to offer to the future evolution of the Convertibility Plan. 2.2 The results of the Convertibility Plan during 1991-94 have been impressive. With dedicated public sector reforms that led to dramatic improvement in the federal Government's finances, and monetary policy guided by the Convertibility Law, the credibility of the Convertibility Plan was quickly established. Inflation, measured in consumer prices, decelerated from 1,343 percent in 1990 to only 3.9 percent in 1994. With the decline in perceived country risk and a hospitable international financial environment, capital inflows accelerated, fueling an economic expansion. Between 1991 and 1994, real GDP grew at an average rate of 7.7 percent. 2.3 The consumption-led growth in the first two years of the Plan, which is a common occurrence in exchange rate stabilization programs, was more importantly supplanted in 1993 and 1994 by an export- and investment-led economic growth. Over the 1993-94 period, exports grew in real terms by 14.8 percent and investment by 19 percent. By 1994, gross fixed investment reached 19.9 percent of GDP, associated with increased national and foreign savings. Exports, which were affected by declining international prices in 1992-93, rose by 20 percent in 1994, with manufactured goods exports exhibiting particular buoyancy, growing at an average 27 percent in 1993-94. This transformation, which occurred in the face of the peso's appreciation3, was the result of improvements in productivity. Over 1993-94, imports of capital goods led the strong expansion of overall imports, indicative of the acceleration in investment and the restructuring of the economy. As a result of the economic recovery, poverty levels4 declined significantly. Nevertheless, as discussed in the next chapter, economic restructuring with a rigid labor market resulted in the increase in unemployment to 12.2 percent of the labor force by late 1994. 3. The Argentine peso appreciated in real terms by about 20 percent between the beginning of the Convertibility Law regime and end-1994; however, after adjustment for tax reductions and other reforms, losses to export competitiveness may have been one third lower that amount. 4. A detailed review of poverty issues in Argentina can be found in the Bank's 1995 Report No. 13318-AR, titled "Argentina's Poor: a Profile". - 12 - Table 1: Economic Performance 1991 1992 1993 1994 1995 d/ Mational Accounts (X of GDP) GDP Growth (X) 8.9 8.7 6.0 7.4 -4.4 Total Investment 14.6 16.7 18.4 19.9 17.8 National Savings 15.2 14.3 15.9 16.9 16.4 Foreign Savings -0.5 2.4 2.5 3.6 1.4 Fiscal Accounts (Federal Goverrnent) a/ (X of GDP) Total Revenues 17.9 17.9 17.7 17.2 16.5 Total Expenditure 15.3 17.5 16.6 17.2 16.4 Primary Surplus 1.8 2.2 2.2 1.1 0.6 Overall BaLance b/ 0.2 0.4 1.1 -0.0 -1.0 Balance of Payments (Billion USS) Trade balance 3.7 -2.6 -3.7 -5.7 0.9 Exports 12.0 12.3 13.1 15.8 20.9 Imnports 8.3 14.9 16.8 21.5 20.0 Current Account -0.3 -6.3 -7.3 -10.3 -3.8 Capital Account 3.0 10.2 12.1 10.5 1.9 Balance of Payments Result 2.7 3.8 4.8 0.2 -1.9 Inflation (X) S/ 84.0 17.5 7.4 3.9 1.6 Source: Ministry of Economy a/ On a Cash Basis. b/ Without CentraL Bank quasi-fiscal surplus. c/ December-December change. d/ Preliminary Public Sector Performance (1991-1994) 2.4 In 1991-94, the performance of the Argentine public sector was commendable in many respects. First, following a decade of public deficits, the Government was able to achieve an overall surplus of the consolidated public sector in 1992 and 1993, eliminating the need for inflationary finance. Second, a series of difficult to reverse reforms in the legal framework, institutions, and policies reduced the size of the public sector to 27.4 percent of GDP in 1994, down from an average of 33 percent of GDP during the eighties decade, and substantially lower than the 40 percent average rate in OECD, and other Latin American countries (for example 31 percent of GDP in Chile and 34 percent in Brazil).6 2.5 The composition of the public sector also changed significantly with privatizations, the decentralization process initiated in 1991, and the reform of the social security system in 1993 (Table 2). The share of the national administration (including public enterprises) declined from 48 percent of total public expenditures in 1980-83 to only 23 percent in 1994. The social security system expenditures gradually increased from 22 percent in 1980-83 to almost 31 percent in 1994. The most significant development during this period has been the decentralization process with expenditures of local governments increasing from 29 percent in 1980-83, to 46 percent of total public expenditures in 1994. 5. For a more detailed review of public finances during the 1980s and early 1990s, see "Argentina - Public Finance Review: From Insolvency to Growth", IBRD No. 10827-AR, February 11, 1993. 6. See: World Bank, "World Development Report, 1988". - 13 - Table 2: Level and Composition of Total Government Spending (Percentage of GDP) c/ 1980/83 1984/88 1989 1990 1991 1992 1993 1994 Totat Goverrnment expend. 32.52 33.05 35.61 27.77 29.33 28.73 28.61 27.39 National Goverrnment a/ 23.10 21.84 25.17 19.04 17.85 16.34 15.21 14.84 Provincial and municipal 9.42 11.21 10.44 8.73 11.48 12.39 13.40 12.55 Social Security 2/ 4.99 5.57 5.28 6.51 7.37 7.48 7.02 7.08 Total Gov. without Soc. 27.53 27.48 30.33 21.26 21.96 21.25 21.59 20.31 Source: Argentina en Crecimiento, Ministry of Economy, 1995. a/ Includes National Acdinistration, Public Enterprises and Social Security System b/ Total Social Security System (National Goverrmient and Provincial Governments) c/ The figures are on accrued basis. 2.6 The Federal Govermnent The initial success of the Convertibility Plan is largely due to the severe fiscal adjustment at the Federal level in 1991-93. The overall surplus averaged 0.6 percent of GDP during this period, reaching 1.1 percent of GDP in 1993. As a result, the inflation rate declined abruptly and the Government's credibility was gradually restored both in the domestic and international financial markets. In 1994, a surge in expenditures, including the increased costs of the social security reform, brought the federal public sector accounts to a balance. 2.7 The strong performance of the Federal Government was primarily the result of large increases in current revenues, an increase of 3.4 percentage points of GDP between 1990 and 1994, associated with the reduction in inflation, better institutional revenue collection capabilities, and the resumption of economic growth. VAT collections (with the VAT raised at a uniform rate of 18 percent) showed the fastest growth, reaching 6 percent of GDP, more than twice the 2.5 percent average of the eighties decade. Massive privatizations also became a primary source of revenue, averaging about 0.7 percent of GDP annually between 1991-93, when the bulk of the privatizations occurred. Of the $18 billion raised through privatizations between 1990-93, half was received in cash, and the rest in bonds and transfer of liabilities. 2.8 On the expenditure side, spending by the national administration declined by only 0.1 percentage point of GDP between 1990 and 1994, including, however, higher transfers to the provinces and the social security system. Expenditures, as a share of GDP, declined significantly when compared to the eighties period. but the major cut in public spending took place during the hyperinflation of 1989. The national administration benefitted from the growth of the economy, raising its expenditures between 1990 and 1994 by a real 32 percent. Concurrently, by 1994, the share of social expenditures to total federal public expenditures, reached 64 percent. During this period, the Government was able to increase average salaries and partially restore salary differentials.7 As regards consolidated public sector employment levels, evidence suggests that any adjustment was done exclusively with respect to the sale of public enterprises, since the increase in public employment in the provinces more than compensated for any reductions in permanent federal employees (excluding public enterprises). 7. The transfer of education and health responsibilities to the provinces accounted for an important reduction in the number of positions in the Federal Government. However, it is worth underscoring that the cost of the transfer continue to be covered by the federal authorities, as part of the Pacto Federal, which assigned about US$1.5 billion in revenues to the provinces annually for their additional responsibilities. - 14 - 2.9 Public social expenditure under the Convertibility Plan has been growing in absolute and relative terms. Consolidated public social expenditure has increased form 16.4 percent of GDP in the 1984-88 period, to 18.4 percent of GDP in 1994. With the overall decline in the size of the public sector in the 1989-94 period, overall social spending as a share of total expenditure has risen from 49.5 percent in the 1984-89 period, to 67.2 percent in 1994. Within the social areas, in 1994 more than half of the budget (57.3 percent) was devoted to social insurance programs--expenditures in these programs have been growing the fastest--including old age and disability pensions, health insurance, family allowances, and unemployment insurance. With increased decentralization of functions, in 1994, 62.6 percent of public social expenditure (excluding social security) was executed by provinces and municipalities. 2.10 Provincial Governments Argentine provinces vary widely in population, physical endowment, and institutional capacity. Throughout the 1980s, deficits generated by provincial governments and their official banks were major contributors to the chronic instability of the Argentine public sector. The fiscal adjustment at the central level as well as economic growth generated an unprecedented increase in coparticipated revenues in 1991-92 which allowed provincial governments to improve their fiscal accounts. Since 1992, however, expenditures increased much more rapidly than revenues resulting in fiscal deficits of 0.8-0.9 percent of GDP over the 1993-1995 period (table 3). The provincial deficit has been only partially financed, contributing to an unstable economic and social situation in many of the northern provinces. Fiscal difficulties led to violent demonstrations in several provinces during in recent years. Table 3: ProvinciaL Governments--Executed Budgets (% of GDP) 1991 1992 1993 1994 1995 Current Revenues 8.2 9.6 9.6 9.5 9.4 Provincial origin 3.0 3.8 4.0 4.0 3.9 Federal origin 5.2 5.9 5.6 5.4 5.5 Capital Revenues 0.0 0.1 0.1 0.1 0.1 Current Expenditure 7.8 8.8 9.2 9.1 9.2 CapitaL Expenditures 1.2 1.1 1.3 1.4 1.4 Overall BaLance -0.7 -0.2 -0.8 -0.9 -1.1 Source: Ministry of Economy 2.11 Provincial revenues, which amounted to US$25 billion in 1994 and 1995, are characterized by low revenue mobilization from provincial sources and a correspondingly high dependence on revenue transfers from the Federal Government. Federal transfers financed an estimated 53 percent of total provincial spending in 1995, ranging from a high of 92 percent of total expenditures in La Rioja to a low of 40 percent of spending in the Province of Buenos Aires (not including MCBA's unusually low ratio of 6.9 percent). Transfers include co-participated funds (69 percent), royalties (4 percent), and a combination of discretionary grants and sector-specific transfers (27 percent) -- the latter of which largely are financed out of earmarked gas, energy, and assets taxes. 2.12 At the same time that provincial governments have lagged in making necessary fiscal adjustments, their role within the economy has grown as a result of decentralization and the privatization of many federal functions. In 1995, provincial governments (including the Municipality of Buenos Aires) spent 11 percent more than the federal government on goods and services and total provincial employee payrolls were more than twice the level of employee expenditures at the federal level. Provinces are now the major providers of core public services in health, education, security, water and sanitation, electricity, and other infrastructure. Provinces also have their own banks and a large variety of public enterprises. - 15 - 2.13 The aggregate deficit of the provinces has been persistent and large throughout the Convertibility period, at almost one percent of GDP and 10 percent of total revenues. Recent estimates put the stock of provincial debt at approximately Arg$14-15 billion. The situation varies dramatically across provinces, where some provinces maintained small deficits or even surpluses, while others consistently ran deficits on the order of 20 to 30 percent of revenues. Many provinces increased their borrowing from the domestic financial market, their own provincial banks, and the Federal Government, mostly on short terms (less than 2 years), in spite of the massive financing received through the debt consolidation process with the Federal Government, equivalent to over US$3.0 billion in 1993-94.8 When the financial crisis hit in early 1995, the chronic-deficit provinces were faced with large debt service bills, the hard-to-break habit of high spending, and provincial banks on the verge of bankruptcy. These provinces suffered the most from the impact of the crisis. Capital Inflows, the Current Account and the Real Exchange Rate 2.14 The Convertibility Plan generated enough credibility, internal and external, to significantly reduce the country's risk premium (measured by the difference between BONEX rates and LIBOR) to about 4 percent in 1994, from an average of 20 percent in 1990. Factors contributing to the fall in country risk can be associated with the overall market oriented strategy of structural adjustment, including monetary and fiscal reforms, the steps taken to refinance the external debt (under the Brady Plan), trade reform and privatizations. Capital inflows are significantly correlated to the country's risk premium. In general, the fall in country risk can be associated with an increase in the rate of capital inflows9. 2.15 There have been various sources of capital inflows during the Convertibility Plan. By far, the most significant has been the repatriation of dollars that Argentines held abroad. Under the new financial rules, commercial banks were allowed to capture dollar deposits and relend them, subject to a marginal reserve requirement. As the country risk decreased, Argentines saw fit to bring back their dollars which made up the major component of capital inflow for the period, as seen in Table 4. 2.16 During the three calendar years 1991-94, accumulated capital inflows amounted to 36 billion dollars out of which 20 billion were from asset repatriation, measured by the increase in dollar deposits at commercial banks. Of the remaining $16 billion, privatizations and direct investment represented $14 billion. The remaining $2 billion was from International Organizations. 2.17 The accumulated US$36 billion in capital inflows seem to have been entirely voluntary as they financed not only US$24 billion in current account deficits but also reserve accumulation to the order of almost US$12 billion. 8. The total bonds received by the provincial governments in 1993-94 reached US$4.0 billion but about US$1.1 billion was used to cancel the debt of the provincial banks with the BCRA. 9. In a regression with data from 1988.1 to 1994.9, shows that one point reduction in the country risk rate was associated with 440 million annual increase in capital inflows. Since the country risk was reduced from an average of about 20% in 1990 to just over 5% by year end 1991, the contributionof this factor to the rate of capital inflows must have been substantial. - 16 - Table 4: Composition of Capital Inflows 1991-94 (USS miLlion) 1991 1992 1993 1994 1991-94 ArgendoLtars 3,659 4,376 7,157 4,936 20,128 Privatizations 1,974 3,661 5,718 605 11,958 Direct Investment 305 465 587 677 2,034 InternationaL Organiz. 312 (207) 1,952 (66) 1,991 Others (3,263) 1,867 (3,292) 4,460 (228) Capital inflows 2,987 10,162 12,122 10,612 35,883 Current account (259) (6,336) (7,288) (10,074) (23,957) Reserve accumulation 2,728 3,826 4,834 538 11,926 Source: Ministry of Economy 2.18 An analysis of capital inflows to Argentina has to take into consideration the fact that the economy's performance in the 1991-94 period reflects not only the inflows phenomenon but also the major disinflation that emerged as a result of the Convertibility Plan. This is especially relevant for comparisons with Chile and Mexico, where stabilization plans (and disinflation) preceded the arrival of capital inflows. Accordingly, the observed real exchange rate appreciation, increased economic growth, monetization, and increased current account deficit in Argentina capture the effects of both exchange-rate- based disinflation and the surge in capital inflows, and it is very difficult to quantitatively assess their separate impact. Similarly, given the coincidence of capital inflows and disinflation, it is difficult to ascertain the quantitative importance of external versus internal factors in accounting for the rise in inflows. 2.19 The rapid reduction in Argentine inflation and devaluation expectations, as well as country risk, have been reflected in a strong decline in interest rates. A key additional element to these developments has been the policy of monetization and lack of sterilization adopted in the context of the Convertibility Plan. The non-sterilization of capital inflows contributed to a substantial reduction in domestic interest rates (faster to that of Mexico and Chile in a similar phase of inflows), and a marked increase in domestic liquidity (most of it demand induced). In addition, the Argentine authorities avoided sizable quasi-fiscal implications of sterilization observed in other countries, precisely at a time that establishing fiscal balance and fiscal credibility were of major importance. 2.20 The large inflows of capital helped finance a credit boom that was a determining factor of the real growth experienced since 1991. A regression analysis suggests that over a five year period (1988-94) a US$1 billion in annual capital inflow may have been associated with a 10 percent rise in the index of industrial production. Capital inflows affected both real production and relative prices. An expansion in the supply of foreign exchange will reduce the relative price of traded goods in terms of non-traded goods. Thus, there should be a real appreciation of the currency. The more closed the economy is, and the more inflexible its factor markets, the larger will be the appreciation of the currency in response to a capital inflow. Evidence suggests a strongly negative relationship between the real exchange rate and capital inflows, suggesting that capital inflows, coupled with the inflexibility in the goods and factor markets, may be at the core of the real appreciation experienced early in the Convertibility Plan. 2.21 To summarize, the stylized facts of the macroeconomic implications of the first four years of the Convertibility Plan can be described as follows: the perception of structural adjustment reduced the country risk premium which in turn induced capital inflows, mainly from assets repatriation and privatizations. Capital inflows increased both the supply of credit and aggregate demand and ended up financing current account deficits thus requiring a real appreciation for the resource shift to occur. The - 17 - high inflexibility of goods and factors markets in Argentina implied that small rates of capital inflows required large changes in relative prices for transfers to occur. 2.22 Effects on Financial Markets The reduction in inflation, monetary reforms, and the surge of capital inflows had unprecedented effects on the financial markets. After a decade of basically operating as a barter economy, credit reappeared and interest rates fell sharply and fast. Table 5 shows a simple decomposition of peso lending rates into their main components: international rate, country risk, credibility, and lending spread. Credibility, or the expectation of devaluation (measured by the difference between the peso and dollar deposit rates at commercial banks) fell sharply after the implementation of monetary reform, helped by the virtual creation of a Currency Board. Country risk was not a significant component of the high real rates, as it never exceeded an annual 7 percent. Nevertheless it did fall, reaching levels which were low for a country that until recently had not regularly serviced its foreign debt. Following the 1995 crisis, when interest rates surged sharply, in the first quarter of 1996 interest rates come down quite fast, reaching the lowest levels since the beginning of the Convertibility Plan. While country risk has been coming down fast, even more impressive has been the decline in the devaluation risk, which in February 1996 also reached its lowest rate since the beginning of the Convertibility Plan. Table 5: Interest Rates and Stabilization: Argentina after May 1991 (percent) Decomposition of Average Peso Lending Rates Average Peso Lending Borrowing Spread Foreign Quarter Lending Rate Spread Devaluation Country Interest Risk Risk Rate (X (X a/ (X b/ (% c/ (X 9/ 11-91 51.4 11.6 17.5 9.4 5.6 111-91 44.8 5.9 21.3 7.0 5.4 IV-91 40.8 13.1 13.4 4.9 4.6 1-92 34.9 8.9 12.3 6.2 3.9 11-92 30.9 13.5 5.4 5.5 3.7 111-92 31.7 13.4 5.5 6.8 3.1 IV-92 30.9 -2.0 19.7 8.2 3.1 1-93 28.5 7.9 7.3 7.8 3.0 11-93 24.5 9.4 5.4 4.8 3.0 111-93 23.0 10.6 4.2 3.6 3.0 IV-93 22.6 11.9 3.3 2.8 3.1 1-94 21.3 11.5 2.1 3.2 3.2 11-94 22.5 10.2 2.3 4.4 4.0 111-94 23.0 11.1 2.4 3.5 4.5 IV-94 25.3 12.0 2.8 3.4 5.3 1-95 47.8 25.2 5.4 5.9 5.8 11-95 44.8 23.4 5.8 5.1 5.6 111-95 28.0 14.5 2.2 3.8 5.4 IV-95 25.3 12.1 2.3 3.9 5.3 1-96 e/ 21.0 10.0 1.8 2.9 5.0 Source: The World Bank. a/ Difference between Average Peso Lending Rate and Credibility, Country Risk, and Foreign Interest Rate Indicators. b/ Measured as the difference between fixed term deposits in locaL currency and in dollars. c/ Measured as the difference between Bonex 89 internal rate of return and 180-day LIBOR (annualized). a/ Corresponds to Treasury Bill Interest Rate. e/ January and February average. 2.23 Local currency loans rates, though, remain high. Given the observed decline in devaluation expectations and country risk, these high lending spreads represent a risk premium associated with the relatively low credit rating of local currency borrowers and the relatively high intermediation costs in this segment of the market. Similar high lending spreads have been observed in other countries such as Bolivia, Mexico, and Uruguay. A substantial part of the renewed capital inflows contributed to an expansion in the level of credit and a reduction in its cost--especially in the dollar segment of the market. - 18 - However, low-credit-rating, and liquidity-constrained, domestic-currency borrowers probably experienced less direct benefits from the capital inflows phenomenon. 2.24 Monetization and Dollarization Hyperinflation and the BONEX plan had all but melted away the local peso system. The historical minimum of the economy's monetization was reached following the BONEX plan ( January 1990), when the ratio of money (M2 in pesos) to GDP reached a mere 2.5 percent. The stabilization achieved with the Convertibility Plan assisted in the quick remonetization of the economy. However, the levels of monetization achieved under the Convertibility Plan did not reach the levels in previous decades, or that prevailing in early 1989, just before hyperinflation started. The main reason for the lack of complete recovery to the pre-hyperinflation monetization levels, is the increasing degree of currency substitution and dollarization that the economy started experiencing since the early 1980's. Although monetization in pesos has stopped growing since late 1993, after reaching a maximum of 11.5 percent of GDP, dollar deposits continued growing in relation to GDP. 2.25 For decades Argentines had resorted to holding dollars as a hedge against monetary instability in their own currency. As inflation worsened during the 80s, transactions started being stipulated in dollars and the economy started a dollarization process, with dollars being a store of value and increasingly the standard of value and the mean of transaction. When banks were allowed to open foreign currency accounts, Argentines started bringing their foreign currency holdings that were safely deposited abroad into the local system. Dollarization is now evident, as the ratio of dollar deposits to peso deposits has grown persistently. From values in the order to 40 percent prior to the Convertibility, dollar deposits have reached the same level as peso deposits in 1994, and have surpassed them in 1995. The stabilization of inflation at rates similar to those of the US dollar does not seem to have stopped the dollarization process. 2.26 Dollarization may have actually increased stability in the financial system. The monetary strategy has favored dollarization through the fixed exchange rate, the 100 percent reserve backing and by allowing banks to settle reserve requirements in either currency. Whenever requested, the monetary authorities have not hesitated to sell dollars in exchange for any amount of outstanding pesos, as required by the Convertibility Law. Thus, in instances of economic uncertainty, depositors, by shifting peso funds to dollar deposits, mitigated capital outflows. The Response of Trade Flows to Liberalization 2.27 Trade reforms led to a greater opening of the Argentine economy in two important ways. First, domestic relative prices in Argentina became more responsive to international prices, an effect that was further strengthened by the adoption of a fixed exchange rate. Second, the tradable sector expanded significantly, although their ratio to GDP remained low, due to the appreciation of the peso. 2.28 Following the path of net capital inflows, which increased from a near zero rate in 1990 to annual rates of $11-12 billion in 1993 and 1994, the trade balance has had a growing deficit since 1992, when it reached $2.6 billion. The deficit increased to $3.7 billion in 1993, and reached $5.8 billion in 1994. Imports have reacted quickly to the availability of foreign credit, whereas the growth in exports has been more closely determined by the path of structural adjustment and changes in the external environment. 2.29 In 1995, when foreign capital inflows were curtailed, imports declined, while exports accelerated further, benefiting from sluggish domestic demand, increases in productivity, and the fast pace of growth of the Brazilian economy. The improvement in relative prices (tradables over non-tradables) and the sharp reversal from a trade deficit to a trade surplus in 1995, in the aftermath of the stagnation in capital - 19 - inflows, have been very encouraging signs that the economy has started reacting relatively quickly to exogenous shocks, in the absence of a flexible exchange rate. 2.30 As a result of the reduction in import protection, Argentina's imports rose rapidly starting in the early 1990s (Table 6). This in turn was the result of three reinforcing factors. There was a phenomenon of import catch-up following years of import restrictions and uncertain import policies. Another factor was the strong capital inflow. A third interrelated factor was the recovery of income, facilitated by capital inflows, and the increase in confidence brought about by the Convertibility Plan. The perception that the new economic regime would usher a new period of prosperity, led in the first two years of the program, which incidentally followed a period of recession, to a consumption led boom, accommodated by the expansion of imports. Imports which had fallen with the recessions in 1989 and 1990, recovered strongly since then. Nominal import levels quintupled between 1990 and 1994, reaching $21.5 billion. Despite such growth, imports of goods and services still accounted for 9.2 percent of GDP in 1994, a moderate level by international standards for an economy as open as Argentina's. 2.31 There were significant changes in the composition of imports following the liberalization of the trade regime. Years of past high protection and economic stagnation had led to the increasing aging of the capital stock. Additionally, the change in relative prices brought about by the nominal fixity of the exchange rate, increased the need for higher productivity, and replacement of capital became necessary and profitable. This desire for new technology incorporated in new capital led to impressive increases in capital good imports. Capital good imports after growing rapidly since 1991, increased their share in total imports from 36 percent on average in the 1980-89 period, to 44 percent in 1994. The manufacturing sector was the largest importer of capital goods followed by the transportation and communications sectors. 2.32 The composition of the origin of imports changed following the trade reforms. Argentina increased its imports from Brazil rapidly since 1990, from about 17.6 percent of total imports, to 19.9 percent in 1994, after reaching a peak of 22.5 percent in 1992. The reduction of Argentina's trade barriers and the relative decline in the peso price of Brazilian goods, at least until early 1993, due to the relative depreciation of the latter's currency, helped to raise imports from Brazil. With the adoption of the Real plan in 1994 in Brazil and the resultant appreciation of the real, its goods become relatively more expensive; that led to the relative slowing down of exports growth to Argentina. Price effects had come to override income effects at the margin, to lead to this result. The automobile agreement with Brazil, also was a factor in the changing composition of imports from Brazil. There were large increases in Argentina's non-traditional exports, despite the withdrawal of special subsidies for them. The other significant change in the composition of imports was the increasing trade with USA. The progressive liberalization of the import regime led to increasing imports from that relatively cheap source of capital goods. The tying of the peso directly with the US dollar helped reduce exchange rate uncertainty in general, and the US dollar in particular. 2.33 A comparison of export performance between 1981-89 and 1990-94 shows strong export growth following the trade reforms. The average real export growth rate during the former period was 2.0 percent while for the latter it was 9.6 percent, with a significant acceleration evident in the 1993-94 period, which was further fueled in 1995. Despite the strong export performance, 1994 exports as a share to GDP reached 6.8 percent, suggestive of only an early stage of opening of the Argentine economy. While the recovery of exports in 1990 was related to the improvement in agricultural prices and the decline in domestic demand due to the recession of that year, the resumption of strong export growth over the last two years also reflected the increased competitiveness of the economy. - 20 - 2.34 The composition of exports changed with the trade reforms. Industrial manufactures became the strongest growing export category during 1991-94, followed by manufactures of agricultural origin. Exports of manufactures of industrial origin have been growing at an average annual rate of 26.3 percent in 1993-94, contributing to the growth in their share in total exports from an average of 21 percent over the 1980-89 period, to 29 percent in 1994. Over the same period, the share of primary products declined from 37 percent to 24 percent. Table 6: Evolution of Exports and Imports (USS million) 1990 1991 1992 1993 1994 1995 Total imports 4,077 8,275 14,872 16,786 21,589 19,968 Capital goods 636 1,435 3,095 4,115 6,011 4,842 Others 3,441 6,840 11,777 12,671 15,578 15,126 Total exports 12,352 11,977 12,235 13,118 15,839 20,893 Primary 3,339 3,300 3,500 3,279 3,741 4,008 FueLs 985 766 1,082 1,236 1,651 2,159 Agricultural manufactures 4,664 4,927 4,830 4,925 5,799 7,446 Industrial manufactures 3,364 2,984 2,823 3,679 4,647 6,487 Trade Balance 8,275 3,702 (2,637) (3,668) (5,749) 925 Annual growth rates (X change) Total imports -3.0 103.0 79.7 12.9 28.6 -7.5 Capital goods -14.6 125.6 115.7 33.0 46.1 -19.4 Others -0.5 98.8 72.2 7.6 22.9 -2.9 TotaL exports 28.9 -3.0 2.2 7.2 20.7 31.9 Primary 63.4 -1.2 6.1 -6.3 14.1 7.1 Fuels 187.2 -22.2 41.3 14.2 33.6 30.7 Agricultural manufactures 16.4 5.6 -2.0 2.0 17.7 28.4 Industrial manufactures 5.6 -11.3 -5.4 30.3 26.3 39.6 Memo: Cap. goods/ Total import 15.6 17.3 20.8 24.5 27.8 24.2 Ind. exp./Totat exports 27.2 24.9 23.1 28.0 29.3 31.0 Source: INDEC 2.35 The composition of exports by destination also changed in the early 1990s. Exports to Brazil grew rapidly and their share in Argentine exports rose from 5.9 percent in 1984, to 11.9 percent in 1990, and 23.1 percent in 1994. This was facilitated by the Mercosur agreement, by which nearly all Argentine exports to Brazil enter free of tariffs. Additionally, with the Real plan in Brazil, which stabilized that country's nominal exchange rate and accelerated the pace of economic activity, consumption good exports to Brazil increased rapidly. Table 7: Trade with Mercosur (USS million) 1990 1991 1992 1993 1994 1995 Total Imports 4,077.0 8,276.0 14,872.0 16,786.0 21,589.2 19,968.6 Mercosur Share (X) 21.5 21.8 25.2 25.1 23.8 22.5 Mercosur 876.0 1,804.4 3,754.7 4,213.6 5,128.9 4,511.3 Brazil 718.0 1,526.4 3,338.8 3,569.9 4,280.1 4,158.0 Paraguay 42.0 43.0 64.7 72.9 69.1 80.4 Uruguay 116.0 235.0 351.2 570.8 779.7 272.9 Other 3,201.0 6,471.6 11,117.3 12,572.4 16,415.1 15,457.3 Total Exports 12,352.5 11,977.8 12,234.9 13,117.6 15,839.2 20,893.3 Nercosur Share (X) 14.8 16.5 19.0 28.1 30.1 32.2 Mercosur 1,833.0 1,976.5 2,326.8 3,684.7 4,739.9 6,733.4 Brazil 1,423.0 1,488.5 1,671.3 2,814.2 3,654.8 5,458.5 Paraguay 147.0 178.0 271.9 357.8 498.5 629.3 Uruguay 263.0 310.0 383.6 512.7 649.6 645.6 Other 10,519.5 10,001.3 9,908.1 9,432.9 11,099.3 14,159.9 Trade balance 8,275.5 3,701.8 (2,637.1) (3,668.4) (5,804.8) 924.7 With Mercosur 957.0 172.1 (1,427.9) (528.9) (389.0) 2,222.1 With Other 7.318.5 3,529.7 (1,209.2) (3,139.5) (5,415.8) (1.297.4) Source: Informe Economico 1995, Ministry of Economy. - 21 - 2.36 Trade diversion to MERCOSUR countries has been significant. While Argentine overall trade more than doubled between 1990 and 1994, trade with MERCOSUR increased twice as fast, primarily through Argentina's increase in imports from its regional partners. By 1994, trade with MERCOSUR accounted for 26.4 percent of Argentina's trade, up from 14.3 percent in 1990. The lion's share of that trade, 21.2 percent, is with Brazil. Closer links to MERCOSUR have their benefits, as the recent impact of Real plan suggests, but also carry risks, since Argentina's trade performance is more sensitive to changes in economic growth and movements in the exchange rate of its main trading partner, Brazil, than the other way around. Investment: Recent Trends and International Comparison 2.37 Under the first four years of the Convertibility Plan, investment rose sharply (see Table 8). After falling in real terms in the late 1980s, the level of gross domestic investment grew at the impressive pace of 86 percent in real terms between 1990 and 1993, faster than GDP and consumption, and close to 20 percent in 1994. As a result, the share of investment in GDP reached 20 percent in 1994. Nonetheless, in percentage of GDP, it only recovered to its pre-hyperinflationary level, and remained about 5 percent of GDP lower than its level in 1980. This increase is explained by the recovery of private investment (up 6 percent of GDP between 1990 and 1994), while public investment declined by about 2.5 percent during the same period. This decline in public investment is principally the result of the privatization process which automatically transferred about 2.5 percent of GDP from public to private investment. Table 8: Gross Domestic Investment (Percent of GDP) 1983-6 1987-90 1991 1992 1993 1994 1995 c/ Totat 18.7 16.8 14.6 16.7 18.4 19.9 17.8 Private 13.8 12.2 12.5 14.8 16.0 17.5 15.4 Public 4.9 4.6 2.1 1.9 2.4 2.4 2.4 P.Enterprises .. 2.5 a/ 0.8 0.5 0.6 n.a. n.a. Others b/ .. 2.1 1.3 1.4 1.8 n.a. n.a. Source: Ministry of Economy A/ Based on the 1988-90 average. bl Includes national administration, decentralized agencies, and local governments. */ Estimate 2.38 In spite of the impressive recent recovery, the level of gross domestic investment rate in Argentina still appears extremely low by international standards. Not only was the 1994 investment rate in Argentina lower than in East Asia (20 percent vs. 33.8 percent), but it was also about 1.0 percent of GDP lower than the regional average (21.1 percent). The gap is even larger when the comparison is limited to Chile and Mexico, where investment rates reached 26.5 percent and 24.7 percent of GDP, respectively, in 1994. Public investment in Argentina (2.3 percent) is significantly lower than the regional average (5.9 percent). As noted earlier, the low level of public investment is principally explained by the well-advanced privatization process in Argentina. The level of private investment in Argentina (17.7 percent) is in line with other Latin American countries (average of 16.4 percent). However, this comparison is biased because the average private investment rates in Latin America is notoriously low by international comparison, with the notable exception of Chile (22.9 percent) and Mexico (20.5 percent). 2.39 Foreign Direct Investment. Government policy toward direct foreign investment (FDI) has been extremely open. So far, however, direct investment has been modest. One reason is that foreign firms have entered the economy primarily in the form of purchasing state firms being privatized. Otherwise, much of FDI has been in takeovers of Argentine firms, rather than new investment projects. Much of - 22 - future plans involve production for the integrated MERCOSUR market, and thus will also depend on the future evolution of the Argentina's trade partners. 2.40 Investment Allocation. The absence of statistics prevents a good assessment of the allocation of investment in Argentina. Nevertheless, partial evidence, as discussed below, indicates that investment has principally taken place in the non-tradable sector such as utilities and services and large companies such as the automobile and the oil sectors. The key reason for this allocation are the higher rates of return and higher output growth rates in the non-tradable than in the tradable sectors. Another reason is the concentration process in some sectors (for example the food processing sector), and the easier access to domestic and foreign financing by large corporations than by small and medium enterprises. Finally, it may also result from distortions such as the protective regime in the automobile sector. 2.41 Because of the lack of statistics on the allocation of investment, four alternative indicators were used to depict the allocation of investment in the last few years: (i) capital goods imports, (ii) foreign direct investment (FDI), (iii) public investment, and (iv) information on recently privatized enterprises. While none of these indicators is completely satisfactory, all of them seem to indicate that investment took place in the non-tradeable sector and large enterprises. (a) Capital goods imports (equivalent to about 15 percent of gross domestic investment in 1993) increased by 548 percent between 1990 and 1993. This surge took place principally in the nontradable sectors (Table 9). The bulk of imported capital goods in the 1991-93 period were office equipment, trucks, communication equipment, television, and airplanes, suggesting that the increase in investment mostly reflects changes in firms' organization and management rather than large investment in equipment and machinery. This is consistent with the microeconomic evidence. (b) There is no systematic information on FDI in Argentina since the complete liberalization of the regime in the beginning of 1993. Partial evidence indicates that the most privileged sectors have been non-traded sectors such as the food processing sector (Nabisco), the retail sector (Wal Mart), the automobile sector (Toyota), and the recently privatized enterprises, including telecommunications, electricity and gas. (c) Total public investment (about 20 percent of total gross investment) grew by about 137 percent between 1991 and 1993, adjusting for public enterprises which were transferred to the private sector. This increase took place almost exclusively in non-tradeable sectors such as housing, road, and utilities. (d) Privatized enterprises registered an unprecedented increase in investment of about 292 percent between 1990 and 1994, reaching US$3.8 billion in 1994. These enterprises principally produce non-traded goods such as electricity, gas and telecommunications, with the notable exception of oil (YPF). - 23 - Table 9: The Sectoral Composition of Capital Good Imports, 1986-94 1986 1994 TotaL 100.0 100.0 Tradable Sectors 44.9 36.4 AgricuLture 0.8 3.0 Mining 0.5 0.4 Industry 43.6 33.0 Non-Tradable Sectors 55.1 63.6 Utilities 10.5 6.1 Construction 11.2 8.1 Transports 4.9 19.4 Banks and Insurance 10.7 9.1 Communications 8.1 15.3 Others 9.7 5.5 Source: INDEC. Savings: Recent Trends and International Comparison 2.42 Under the Convertibility Plan, total--foreign and domestic--savings in Argentina have risen dramatically, recovering from 14.6 percent of GDP in 1991 to 20 percent in 1994 (Table 10). Between 1991 and 1992, this increase was principally the result of foreign savings, which increased by 2.2 percent of GDP between 1991 and 1992. In a second phase, national savings recovered by 3.4 percent of GDP in 1992-94, while foreign savings remained globally stable as a percentage of GDP. In spite of this spectacular recent increase, the level of total savings remains lower than in most of the 1970, when it averaged over 23 percent of GDP. Table 10: Saving by Sectors (percent of GDP) 1983-6 1987-90 1991 1992 1993 1994 1995 bl/ Total Savings 18.7 16.8 14.6 16.7 18.3 19.9 17.8 Foreign Savings 2.1 2.3 1.5 3.7 3.1 3.6 1.4 Nat. Savings 16.6 14.5 13.1 13.0 15.2 16.3 16.4 Public p/ -0.2 -1.6 0.0 2.1 1.5 1.2 0.0 Private 16.8 16.1 13.1 10.9 13.7 15.1 16.4 Source: Ministry of Economy. g/ CentraL Goverrnent. b/ Estimate. 2.43 In 1991-92, the level of national savings fell slightly due to the strong decline in private savings, down by 2.1 percent of GDP during this period. This temporary decline can be explained by the long postponement of purchases of consumer durables in particular. At the same time, the severe fiscal adjustment contributed to a rise in the level of public savings by 2.1 percent of GDP. In 1992-94, the level of national savings recovered by 3.4 percent of GDP as the result of the unprecedented increase in private savings (up 5 percent of GDP). 2.44 In an international perspective, the 1994 level of savings in Argentina (19.9 percent) remained low, but the contribution of foreign savings, though historically high, appears comparable with the expe- rience in other countries over the last two decades. Not only was the actual national saving rate in Ar- gentina (16.3 percent) in 1994 15 percentage points of GDP lower than in East Asia (31.9 percent), but it was also below the Latin American average (17.7 percent). The actual poor performance is partially - 24 - explained by the low private saving rate, about 4 percentage point lower than in Chile, and partially by the low public savings rate. 2.45 Allocation of Savings. In Argentina, a significant fraction of private savings has traditionally been used to finance public deficits, and capital flight. As a result, private saving and private investment were not significantly correlated over the 1983-93 period in Argentina.'" Although the success of the Convertibility Plan between 1991 and 1994 in stabilizing the economy and controlling the fiscal situation has contributed to (a) an important shift from foreign assets to domestic assets and (b) a reduction in the crowding-out of private resources by the public sector, private savings remain low, undermining real investment. An important contributing factor in that outcome is that banks have been inefficient in their internediary role between financial savings and productive investment. Evolution of Productivity and Competitiveness 2.46 In view of the appreciation of the peso in the initial years of the Convertibility Plan, this section attempts to address whether there is evidence that the Argentine economy has shown signs of adjustment to the Convertibility Plan. The present section provides evidence of large gains in productivity in Argentina during the 1991-94 period. It shows increases in average labor productivity and total factor productivity for the economy as a whole. However, case studies show that productivity indicators behaved differently amnong economic sectors". An important caveat for this analysis: data for a comprehensive productivity study are scarce. The present analysis has utilized national account data (at a very aggregate level) and survey data from private sources (FIEL). In addition, to corroborate and substantiate the results, we have also used case studies. 2.47 Average Labor Productivity (ALP). Between 1990 and 1994, average labor productivity (ALP) grew by 21 percent, at a cumulative annual rate of 4.9 percent. This indicator of productivity has gone through a roller coaster in the last twenty years. ALP grew at very volatile rates form the end of the Great depression until 1974. It stopped growing at that point and stagnated until the debt crisis of 1982, when it began to drop rapidly. It finally bottomed in 1989. Despite the surge of the early 90's, ALP at end-1994 was still 2.6 percent below its peak. Large gains in average labor productivity (per worker) are somewhat tempered once one takes into account that (i) hours per worker have increased, and (ii) capacity utilization has expanded at an even higher rate than hours. For example, productivity per hour worked (as opposed to per worker) grew by 12.4 percent in 1990-93, about a third of the growth in productivity per worker. 2.48 Sectoral productivity diverged widely from the economy's average in the 1990-93 period. For example, while overall ALP grew 15.5 percent in 1990-93, ALP grew 38.5 percent in industry, 42.8 percent in construction, and fell 2 percent in other (than conmmerce, transport, and financial) services. Most of the increase, particularly in manufacturing, was through labor shedding. 2.49 Total Factor Productivity (TFP). Between 1990 and 1994, total factor productivity increased between 5.5 and 7.5 percent per year. The detailed study of eight subsectors yields an average 5.6 10. The correlation coefficient between private savings and private investment was only 22 percent during the last decade. 11. A simple average increase in productivity among all sectors may underestimate real gains in productivity, since it includes sectors from which resources are (and should be) moving out. - 25 - percent TFP growth, while the point TFP estimate following a regression method gives 7.4 percent. When these figures are adjusted to take account of the increase in capacity utilization, they drop to a range between 3.5 and 5.5 percent a year. 2.50 The time series compatible with the 7.4 percent growth shows that TFP increased in the 1970s, declined in the 1980s, and have resumed growth in the 1990s. Between 1973 and 1980, TFP increased at an average annual rate of 1.5 percent; then between 1980 and 1990 it declined at a cumulative annual rate of 4.3 percent. Thus the average for the period 1973-90 reveals a decline of 1.7 percent per year, at a time when the average OECD TFP growth for the 1973-93 period was 0.7 percent per year. 2.51 The stagnation and later fall in TFP during the 1970s and 1980s reflects the stagnation of GDP during those years. This fall and the recuperation in the early 1990s can be attributed to policy changes. Results of regression analysis indicate that TFP is negatively affected by inflation, and by the size of the public deficit (as a share of GDP). Although these are preliminary results, the implication is that if inflation and the deficit had been zero throughout the period, the average annual growth of TFP could have been 3.1 percent for the 1960-94 period. This would indicate that there are important prerequisites for the macroeconomic policy framework to sustain TFP growth. 2.52 Although the growth rate has been high in the 1991-94 period, the TFP level remains below historic highs for Argentina, and far below international levels. The level reached in 1994 is 9 percent below the 1980 peak. But reaching that peak sets the hurdle too low. The challenge ahead is to erase the slump of the 1960s through the 1980s. If TFP had grown at the OECD average, by 1994 the level of TFP would have been 47 percent higher. 2.53 Case Studies. Total factor productivity was analyzed in eight sectors. These sectors were milk production, dairy processing, orchards, cellulose, paper, plastics, and large supermarkets. These were selected to cover different degrees of tradeability, capital/labor ratios, regional contexts, and degree of technological modernization. The largest corporations supplying these products (sample accounting in most case, with the exception of supermarkets, over 70 percent of market share) were the primary source of information. In all sectors TFP grew in the 1991-94 period. Rates go from 3.5 to 45.4 percent, with an 18 percent average. A TFP growth rate of 18 percent over three years averages an annual 5.6 percent, which is close to the 7.4 percent obtained from the regression analysis. Neither of the two measures is adjusted for capacity utilization, which could explain two points of TFP growth. 2.54 The sectors with the largest increase in productivity were those recording the largest increase in scale of production (through greater demand and/or concentration processes) and which benefited from aggressive deregulation, lower tax pressure and privatization policies. In particular, dairy products, cellulose paste,plastics and supermarkets benefitted from a large increase in demand. Dairy farms, petrochemicals and plastics enjoyed the benefits of deregulation/elimination of distortive taxes. On the other hand, in certain sectors, productivity gains coincided with the process of concentration, as small companies which lacked adequate scale and/or technology for competing in an open economy disappeared. This was important in the paper and dairy sectors. 2.55 International Comparisons of Competitiveness. A 1994 McKinsey and Co. report compared productivity in Argentina with that in other countries. The report presented average labor productivity in the steel, food, and banking sectors, and total factor productivity in telecommunications. It showed that from 1987 to 1992 productivity in the food producing sector increased only by 1 percent. However, from 1989 to 1993 average labor productivity in the steel sector increased by 68 percent, while in the telecommunications sector increased 164 percent. - 26 - 2.56 Despite the large increases in productivity in Argentina, average labor productivity in the sectors considered still lags behind the USA and other countries in Latin America. Argentina's ALP is 30, 52, and 19 percent of the USA's ALP in steel, food and banking respectively. In telecommunications, Argentina's TFP is only 55 percent of that in the USA. In banking and telecommunications, Argentina's productivity indicators are also below the average in Brazil, Colombia, Mexico and Venezuela (see Table 11) Table I 1: Average Labor Productivity Comparison' (Index US=100, 1992) Steel Food Bankint Telecom Argentina 30 52 19 55 Brazil 44 29 31 89 Colombia 15 36 30 101 Mexico 32 27 28 67 Venezuela 29 29 25 85 Latin America average 37 34 29 80 Source: McKinsey Rewrt, 1994. TFP for TELECOMs. 2.57 Unit labor costs estimated form data contained in the report suggest that it is cheaper to produce food in Argentina than in the USA and other Latin American countries, but more expensive to produce in the other three sectors (see Table 12) Table 12: Unit Labor Cost (US=100. 1992) Argentina Brazil Mexico Colombia Venezuela Food 84 85 90 84 89 Steel 104 90 89 103 90 Telecom 103 68 96 62 63 Telecom (adjusted for quality) 121 92 108 83 73 Banking 156 127 123 90 90 Source: McKinsey Report, 1994. 2.58 Competitiveness Alpha Consultants have been monitoring the evolution of industrial costs, tracking the peso costs of a unit of output produced with a fixed input mix and a given technology. Unit costs are proxied by a weighted average of several cost categories. This proxy would overestimate unit costs since as long as there is some leeway to substitute towards cheaper inputs, or to benefit from improvements in technology, effective unit costs would be smaller. 2.59 Although labor costs increased by 14 percent from the first quarter of 1991 to the second quarter of 1994, Alpha's unit costs for industry as a whole have fallen by 8 percent. Lower financial charges, utility tariffs, taxes and imported goods prices prevailed over higher transport fees and labor costs. The behavior of Alpha's unit costs for specific subsectors depended on how intensive their use of capital relative to labor was. The unit costs of those goods that are more capital intensive have been favored more, experiencing larger drops in unit costs. Additionally, many sectors show unit labor costs increasing much faster than in the industrial sector. This is the case of services. - 27 - 2.60 What emerges from the sample analyzed is that tradeables appear to fare quite well (especially import competing goods). More importantly, the sectoral analysis shows that it is mainly policy reforms and productivity growth that compensate for the sharp increases in unit labor costs, hence contributing to an increase of the international competitiveness of those sectors. 2.61 The widespread deregulation processes have had an effect not only on productivity but also on prices, reinforcing the effect on competitiveness through both sides of unit costs (more production from the same inputs; cheaper inputs). However, many of the effects of deregulation are once and for all, and it should be expected that in the future unit costs will not be so much affected form the price side, but rather for the physical productivity side. 2.62 Looking toward the future, there appears to be margin for further concentration of supply and in particular for further deregulation (specially to further permit reallocation of resources between sectors), and this would contribute to TFP growth even without substantial investment. Of course, technological change through the continuation of investment and the renewal of capital stock are at the heart of productivity growth prospects in the long run. For this process to continue, the key challenge appears to be the credibility and permanence of the broad rules of the game. These rules include very prominently the commitment to low inflation and fiscal prudence, and the permanency and direction of certain reform processes such as trade liberalization. B. Impact of the 1995 Mexican Crisis 2.63 Following the fast expansion of the first four years of the Convertibility Plan, in 1995 the Argentine economy suffered a recession. The main reason behind this contraction was the impact of the Mexican economic crisis, that reverberated throughout Latin America. The sharp recession caused an increase in unemployment, and strained the performance of the financial system. The regional financial crisis was the first severe test of the Convertibility Plan. Yet, by the end of 1995, there were signs that Argentina was pulling out of its recession without serious damage to the Convertibility Plan. To the contrary, significant pressures to deviate from it were met by efforts to further strengthen it during the crisis, indicative of the Plan's popularity and staying power. It can be claimed that in some respects, the credibility of the Convertibility Plan was strengthened from the 1995 crisis. 2.64 Economic Performance. Preliminary data suggest that, during 1995, the Argentine economy suffered a recession of approximately 4.4 percent of GDP. The initial shock, generating a confidence crisis, contributed to capital outflows, which for the first four months of the crisis prior to the May Presidential elections caused a 17.6 percent loss in banking deposits (US$8 billion), with liquid international reserves declining by 30 percent (US$4.8 billion). Under the Convertibility Plan, where the monetary base has to be fully backed by international reserves, capital outflows resulted in the demonetization of the economy. This demonetization affected both the performance of the financial system, but also real economic activity. There was increasing evidence however, that the economy ceased to deteriorate in the fourth quarter of 1995. Expectations improved considerably: the stock and bond markets rebounded strongly, deposits and international reserves recovered the losses suffered early in the crisis. Furthermore, for 1995 as a whole, cumulative inflation was 1.6 percent, the lowest rate in 51 years. 2.65 As the economy slipped into recession, investment retracted as well (approximately by -16 percent in real terms), and unemployment surged, first rising to 18.4 percent (May, 1995), and later, with the decline in labor force participation, reached 16.6 percent (October, 1995). The number of bankruptcies surged, reportedly doubling the rate of the previous four years taken together. The impact of the shock - 28 - was moderated by a strong foreign trade performance. A combination of good international commodity prices, the contracting domestic economy, the continuous real depreciation of the peso, and the fast pace of economic expansion in Brazil, resulted in a 32.4 percent growth in exports. With the deepening recession, imports declined by 6.8 percent, producing a sharp improvement in the trade balance, which shifted form a US$5.6 billion deficit in 1994, into a US$0.8 billion surplus in 1995. As a result, the current account deficit was cut to US$2.3 billion, less than third the 1994 level, or 0.8 percent of GDP. Despite the improvement in the current account, the sharp reduction in net capital inflows resulted in a reduction of US$69 million in net international reserves. 2.66 Fiscal performance was also detrimentally affected by the recession. Despite effort to rein in expenditures, the shortfall in revenues generated a fiscal deficit equivalent to one percent of GDP, or US$2.8 billion (including privatization receipts of US$1.1 billion). Half of that deficit was financed by a tax amnesty program announce in November 1995, and the remainder from other sources. Total federal public sector debt rose by US$6.4 billion in 1995, most of it foreign, reaching a level of US$87.0 billion. In addition to the federal fiscal deficit, preliminary estimates put provincial fiscal deficits at 1.1 percent of GDP, bringing their debt level to over US$11 billion. In a crisis year, where provincial banks faced disproportionatley larger difficulties than the rest of the financial system, provincial deficits were increasingly financed through arrears to providers, salaries and pensions. 2.67 Implications of the Crisis. In the first months of the Mexican crisis, the financial markets' reaction suggested that Argentina was perceived being more vulnerable to the external shock than most other Latin American countries. In addition to the decline in deposits and international reserves mentioned above, between the end of 1994 and mid-March the stock market index declined by 30 percent, as did dollar-denominated Government bond prices. Argentina's greater perceived vulnerability was to its relatively heavy reliance on foreign capital inflows, the inflexibility of its exchange rate regime, and the weakness of its financial system. The structural conditions of the banking sector--no deposit insurance, absence of a lender of last resort, and a segmented and inefficient system, as well as the memories of many previous financial crises that ended in asset confiscation-- fueled a mini-run on deposits and a flight to quality among many depositors in the system. Simultaneously, interbank market access shrank down to top private sector banks and the interbank rate increased sharply, pushing several solvent but illiquid institutions to the brink of failure. 2.68 The Mexican crisis brought to light important lessons for Argentina: (a) it highlighted the extent of the economy's reliance on volatile capital flows; (b) revealed the need for a strong financial system, including the relevance of a dollar lender of last resort in an increasingly dollarized system; (c) reemphasized the need to sustain credibility of the economic program; and (d) made obvious the difficulties in changing the exchange rate during periods of crisis. 2.69 Vulnerability. The Convertibility Plan had so far served Argentina well. Nevertheless, under the fixed exchange rate regime, the economy remains vulnerable to sharp swings in capital flows. During periods of decelerating or declining capital flows, lags in the adjustment in relative (domestic to foreign) prices will create a slowdown in economic activity. An economy with a weak financial system and rigid labor markets is even more vulnerable to shocks, particularly under a fixed exchange rate regime where changes in capital flows could be more pronounced. Financial vulnerability could cause great damage in a short period of time since it magnifies the deleterious effects of negative random shocks. As the recent experience in Argentina shows, capital movements usually affect the weakest financial institutions first, creating problems that could subsequently affect the entire financial system, thus reinforcing the effect of negative capital movements. - 29 - 2.70 A further dimension of this financial vulnerability under the Convertibility Plan is that the Central Bank, under a fractional reserve requirement system, is a weak "lender of last resort", since its dollar reserves are not enough to stem a serious banking run. To reduce the risks of a financial crisis in an increasingly dollarized system, there is a need, for example, to get explicit support from other central banks, possibly via swaps. However, while such a facility may be desirable, it is unlikely that a variation of the Mexican emergency support program is replicable. 2.71 The Exchange Rate Regime. Under a fixed exchange rate regime, where capital flows could be volatile since changes in relative prices are more difficult to generate, crisis management in a fractional reserve requirement system requires either the Central Bank to hold large international reserves, or international support needs to be assured in order to provide a lender of last resort to the financial system. Flexible exchange rates, however, are less attractive in a highly dollarized economy, and, in any case may lead to undue volatility in the real exchange rate, as the Mexican experience made all too obvious. In the case of Argentina, approximately three-quarters of private sector liabilities, four-fifths of government debt, and over half of bank credit is in US dollars, and a devaluation would have a further destabilizing effect on the banking system, as well as on corporate and public finances. A devaluation under crisis conditions could prove to be highly counterproductive, deepening the crisis it is intended to correct. It could discredit hard won gains obtained under the Convertibility Plan, and would result in capital outflows, a banking crisis, higher inflation, and a possible economic depression. 2.72 Credibility. With a vulnerable financial sector it is imperative to strengthen the credibility of the economic program. This is another lesson one can draw from the recent Mexican crisis. While the Argentine adjustment process remains robust, and reforms to make financial and labor markets more flexible were proposed, since mid-1993 there was a hiatus, with some important reforms deferred pending legislative or provincial approval and implementation. Additionally, during the second half of 1994, the national government's fiscal surplus was reversed, primarily on account of social security reform efforts and higher expenditures. National deficits compounded provincial deficits, reversing an improving trend in consolidated fiscal accounts. While longer term, inter-generational transfers may in one sense justify the higher transitory net costs of the reforming social security system, in retrospect, short-term considerations regarding the credibility of the adjustment program showed that a relaxation of fiscal policy was premature. Thus, when the Mexican crisis erupted, the Government had to address both the vulnerability of the financial system as well as the credibility of its economic program. 2.73 The Government's Response. The Government reacted forcefully to the crisis. Early on, it took strong measures to redress the fiscal balance by cutting expenditures on, among others, export subsidies, public sector wages, and social security expenditures, while raising temporarily VAT rates (by three percentage points to 21 percent) and other taxes. Swift action by Congress in approving unpalatable emergency measures at the early months of the crisis, added to the credibility of the measures, which were supported by programs of multilateral institutions. As the Government was announcing these measures in mid-March, it also assembled an international financial package of approximately US$11 billion in support of the Convertibility Plan. The announcements effectively stopped the accelerated decline in bank deposits. 2.74 During the crisis, the Government successfully resisted growing pressures to reverse the economy's liberalization. To its credit, it decided to deepen this process and further accelerate economic adjustment, through labor, social security, and fiscal reforms. In the labor area, Congress approved a law flexibilizing labor legislation for small and medium enterprises, a work-related accidents law, and a Bankruptcy Law. Congress also approved the Social Security Solidarity Law, to reestablish maximum limits for all beneficiaries, eliminate the automatic adjustment of benefits, apply the provisions of the - 30 - Convertibility Law to the determination of pensioners, and modify the associated legal proceedings. It will also allow the establishment of a limit on pension outlays, which have been an important cause of macroeconomic instability in recent years. 2.75 In the fiscal area, the Government obtained Congressional approval for implementing during 1996 a Second Public Sector Reform (streamlining public administration, increasing its efficiency and predictability), and another law giving extraordinary authority to the Executive for 1996 to resolve fiscal shortfalls without further recourse to Congress, including broadening the personal assets tax, and the extension for a second year the temporary increase of the VAT to 21 percent). Additionally, it implemented a successful tax moratorium, generating a flow of $4 billion in revenues over the following 30-35 months. The announcement of such measures, and the continuity of the Convertibility Plan, were well received by the markets. Were it not for internal political difficulties that emerged in the second half of 1995, and later subsided, it is likely that economic activity in Argentina would have recovered earlier. 2.76 On the financial side, immediately after the Mexican crisis erupted, the Central Bank tightened liquidity to prevent a currency run. It subsequently set up facilities to assist small banks in crisis. To counter the risk of further bank failures, it also facilitated the use of interbank credit, and reduced temporarily reserve requirements in both dollar and peso deposits, and used rediscounts at a faster pace. The use of excess reserves, and the reduction of the reserve requirement (established for prudential reasons earlier, but not a requirement for the Convertibility Plan) at the height of the crisis, provided limited but badly needed margins of liquidity that the absence of a lender of last resort could not provide. The Government, with the assistance of two World Bank loans, established a Trust Fund for Privatization to handle the workout of provincial banks, and a Bank Capitalization Trust Fund to handle the recapitalization/restructuring of distressed private banks. These Trust Funds made a significant contribution to averting a full scale systemic banking crisis. Measures were also taken to strengthen the supervision of the financial system. To stem capital inflows, the authorities facilitated the further dollarization of the banking system, by further limiting distinctions between dollar and peso deposits. 2.77 At the provincial level, the national crisis aggravated an already problematic situation, in view of the absence of meaningful reforms in the early years of the Convertibility Plan. Faced with a serious deterioration in their fiscal affairs, and social unrest in a number of provinces, in 1995 various local goveinments, assisted by the Federal Government's incremental support to the provincial reform effort, accelerated their adjustment process: five provincial banks were privatized (with another 10 in the process of privatization), three social security systems were transferred to the streamlined national system, salaries were cut, and a number of redundant public employees were let go (contributing to the rise in unemployment). Additionally, a significant number of public enterprises, particularly in provinces committed to a reform program, were privatized. Of the total of 35 enterprises slated for privatization in eight such provinces, 17 were privatized by early 1996, and privatization laws have been passed for all of the rest. - 31 - CHAPTER III SUSTAINING HIGH ECONOMIC GROWTH 3.1 Over the 1991-94 period, the Convertibility Plan contributed to the achievement of high economic growth, averaging 7.7 percent. This performance was sidetracked in 1995, mainly on account of the regional financial crisis. In these four years, the economy has undergone significant restructuring, creating a framework for future sustainable economic growth. Looking beyond the current crisis, the issue raised here, is whether, and under what conditions can the Argentine economy sustain high rates of economic growth, similar to those observed in high-performing East Asian economies, and how the 1995 Mexican crisis and its aftershock affected those prospects. 3.2 Bank research'2 shows that East Asia's extraordinary growth--per capita GNP of 5.5 percent spanning three decades-- was supported by sound basic policy fundamentals, i.e. policies that provided a stable macroeconomic environment and a reliable legal framework to promote domestic and international competition, an orientation toward international trade, and basic absence of distortionary policies such as price controls. With the right policy fundamentals, most of this sustained high growth has been shown to be due to superior accumulation of physical and human capital. These economies were also better able to achieve high levels of productivity growth by allocating physical and human resources to highly productive investments and by acquiring and mastering foreign technology. These high- performing East Asian economies have been able to achieve high per capita income growth while improving at the same time their income distribution. 3.3 It is fundamental to stress that the recent regional financial crisis, despite its severity, has not undermined the public's trust in the need to stay the economic course set by the Convertibility Plan, as the May 1995 election results indicate. Consequently, the Government has a solid foundation of policy reforms to build upon, and if anything, the current crisis has provided further incentives to quicken and deepen reforms, necessary to meet conditions of solid and sustained economic growth. The recent rise in unemployment above 16 percent is an additional policy challenge, and an added incentive to deepen the recommended reforms. 3.4 This chapter is not indented as a comprehensive treatment of conditions for sustaining high economic growth in Argentina. It is rather, a compendium of issues and policy recommendations that could contribute in moving the economy in that direction. Fundamental issues, such as poverty alleviation and the development of social sectors, the environment, gender issues, the legal framework, and sectoral issues are not included in this discussion, in view of the narrow focus of this report, or because they are being treated in separate World Bank reports. A. Simulating a Pattern of Sustainable High Growth 3.5 The fundamental premise is that, Argentina, endowed with plentiful natural resources and a good stock of human capital, both underutilized on account of past misguided economic policies, has, in the context of the Convertibility Plan, created the foundations for unleashing its economic potential. With 12. "The East Asian Miracle: Economic Growth and Public Policy", A World Bank Policy Research Report, 1993. - 32 - solid fundamentals already in place, Argentina has a unique opportunity to strengthen its economic adjustment process, creating the conditions for high and sustainable economic growth. 3.6 Prior to discussing specific issues and policy recommendations, it could be useful to present a simulated growth pattern that would give some sense of the challenges ahead. The aim in this simulation (Table 13) is to reach sustainable economic growth of 7 percent fairly quickly--in four to five years. Taking a page from the East Asia miracle story, the projected stable pattern of high economic growth is characterized by sharp increases in national savings and investment, and continuous productivity gains. Such productivity gains, particularly in the context of the Convertibility Plan where the nominal exchange rate cannot be counted on to change relative prices between tradeables and non-tradeables, and in a framework of a liberal trade regime, would contribute to the substantial growth of exports. The time frame is the next two Administrations, until the year 2,004. 3.7 In this simulation, a key prerequisite for reaching a sustainable growth rate of 7 percent is a fairly quick acceleration in investment rates--averaging a real growth rate of 10.4 percent during this period--to reach a 26.5 percent share of GDP by the turn of the century. Nearly all that increase is expected from the private sector in view of the limited scope for public sector spending and the need to maximize investment efficiency; private investment will need to rise from 17.5 percent of GDP reached in 1994, to 24.3 percent of GDP by the turn of the century. The 1995 crisis did produce a setback in investment, and it may take until 1997 for the economy to regain 1994 levels, before resuming a high growth trend. Public investment, despite its relative stagnation as a share of GDP, is expected to increase in real terms to finance needed infrastructure and complement private investment. 3.8 The financing of that incremental investment will have to come entirely from national savings, since foreign savings face significant limitations, and are actually expected to decline as a share of GDP from levels reached in 1994 in order to reduce the economy's vulnerability to external shocks, similar to those experienced in 1995 (when foreign savings were cut to less than half the 1994 rate). As in the case of investment, incremental savings will have to be created overwhelmingly in the private sector, rising from a rate of approximately 15.1 percent of GDP in 1994, to over 23 percent by the turn of the century. Despite the sharp increase in savings, consumption, although lagging economic growth, continues to grow in real terms. 3.9 In this simulation, it is the private sector that provides the impetus to growth, as the public sector, burdened by its past legacy, restricts itself to playing the important role of providing basic social services to the poor, keeping law and order, providing infrastructure investment complementary to private investment, and sustaining the appropriate institutional regulatory and legal framework setting clear rules and protecting property rights, supportive of private enterprise. Given the severely limited domestic borrowing ability of the public sector under the Convertibility Plan, the fundamental assumption all along in this simulation exercise is that consolidated public sector finances will be balanced. 3.10 The further opening of the economy to international trade is another basic prerequisite for sustaining high economic growth. As reviewed in the previous chapter, Argentina's low share of exports to GDP suggests a very closed economy by international standards. There are various implications to that phenomenon: a narrow export base leaves the economy vulnerable to external shocks; curtails the related magnitude of imports with their corollary impact on technology transfer and productivity growth; even with a relatively moderate level of external debt, debt service becomes particularly onerous, raising the country's credit risk, depriving Argentina from broader access to the international financial markets. - 33 - 3.11 In the time horizon contemplated here, Argentina's exports (GNFS) as a share to GDP are raised from 6.8 percent in 1994, to over 12.5 percent by the turn of the century, still a moderate share by international standards. Reaching that degree of openness implies double-digit real export growth rates, averaging approximately 14 percent. The fast expansion of exports in 1995 was a welcome development, that needs to be build upon. Export growth rates of that magnitude would allow, or rather require, imports to grow at double-digit rates as well, albeit at a moderately lower pace than exports. Fast export growth would provide a tremendously salutary effect to the Argentine economy, but increasing the productivity and competitiveness of the overall economy is a necessary condition for that outcome. Opening the economy to levels indicated above, would cut foreign debt service to export ratios in half by the end of the eight year simulation period, greatly improving Argentina's standing in the international financial community. Capital inflows would be associated with increasing foreign direct investment and trade, facilitated by the repatriation of Argentine capital deposited abroad. Table 13: Argentina - Simulation of Key Macroeconomic Indicators High Economic Growth Scenario (Percent of GDP) Illustrative Proiections 1994 1995 Average (est.) 1996 1997 1998 1999 2000-2004 National Account GDP Average Annual Growth 7.4 -4.4 2.5 5.5 6.0 6.5 7.0 Totat Investment 19.9 17.8 18.9 21.0 23.0 25.0 26.5 Private 17.4 15.4 16.9 19.1 21.1 23.0 24.2 PubLic 2.4 2.4 2.0 1.9 1.9 2.0 2.3 Nationat Savings 16.4 16.4 17.3 19.3 21.4 23.5 25.1 Foreign Savings 3.5 1.4 1.6 1.7 1.6 1.5 1.5 Public Sector (Federal Government) Primary SurpLus 1.1 0.5 1.3 1.8 1.7 1.6 1.2 Interest Paymnt 1.1 1.5 1.7 1.8 1.7 1.6 1.2 Overall Balance -0.0 -1.0 -0.3 0.0 0.0 0.0 0.0 Balance of Payments Trade Balance -2.1 0.3 0.2 0.2 0.2 0.2 0.1 Exports 5.6 7.6 8.1 8.7 9.5 10.4 13.0 Imports 7.7 7.2 7.9 8.5 9.4 10.3 12.9 Current Account Balance -3.7 -1.4 -1.6 -1.7 -1.6 -1.5 -1.5 Capital Account 3.7 0.7 2.2 2.4 2.2 2.2 2.0 Debt Indicators Total Debt 35.1 38.9 38.0 36.0 33.3 31.1 26.2 Debt Service/GNFS Exports 55.4 55.8 57.4 58.9 51.8 48.3 35.0 Memo: GDP (USS billion) 280.5 276.0 290.0 314.4 342.6 375.5 504.0 Total Public Debt (USS billion) 80.7 88.4 90.7 91.5 91.4 91.3 90.8 Source: World Bank. 3.12 In short, to achieve sustained high economic growth, the Argentine economy should be led by export and investment growth, with these two key contributors growing twice as fast as the economy as a whole. The targets are ambitious but reachable, as success stories in East Asia, and Argentina's neighbor, Chile, have shown. Actually the simulated opening of the economy is much below that achieve in East Asia and Chile, and investment and savings ratios remain well below those observed in East Asia. Already, Argentina has made major strides in building solid foundations towards achieving the potential for such growth. While the 1995 crisis created a temporary setback in a pattern of rising investment, and generated higher unemployment, the Government's strong and decisive measures in deflecting the regional crisis while staying the economic course, and recent electoral results that rejected nostalgia towards populism, statism and control, provided further impetus to the dramatic transformation of the Argentine economy. 3.13 It is in that framework, of reachable ambitious targets, and a united view both by the Government and the public towards the further modernization and reform-oriented process in Argentina, that this report now turns to selected policies which can assist in making those targets a reality. - 34 - B. Policies Conducive to Higher Economic Growth 3.14 This section will review a number of policies, and make recommendations which could facilitate the growth of key variables such as investment, saving, and exports. This section is followed by a review of Argentina's unfinished reform agenda, covering needed reforms in the provinces, and reforms in the factor markets, i.e. labor and capital. While economic reform is a continuous process, the unfinished reform agenda demands particularly urgent attention, since it forms part of the foundations of the reform process in Argentina; in their absence, progress could falter. Investnent 3.15 The major policy challenge is to increase the traditionally low private investment rate in Argentina. The focus is principally on private investment because of the new limited role of the public sector and the small base for public investment which accounted for only 15 percent of total investment in 1994. Below is a discussion of the principal factors influencing the private investment behavior in Argentina. 3.16 The most important general incentive to private investment lies in the success of the government to maintain a stable and growing macroeconomic environment. The success of the Convertibility Plan in its first four years of implementation has been in its capacity to restore economic growth. This strong recovery was associated with growing investment demand, though this effect was delayed due to the low utilization capacity in most sectors at the beginning of the economic recovery. The sharp reduction in macroeconomic instability, reduced price uncertainty, as well as the reduction in ad hoc policy intervention also contributed to the increase in investment. 3.17 The Government has moved to reduce taxes that lower profitability and are disincentives to investment. Specifically, the Government instituted a shift from production-based towards consumption- based taxes as the revised tax structure relies heavily on the value-added tax. As a result consumption- based taxes accounted for 52 percent of total tax revenues in 1994 versus only 35 percent in 1990. The authorities also suspended many sectoral and regional promotion programs and implemented deregulation in several sectors of the economy aimed at reducing the "Argentine cost". Overall, the price of capital declined by 11 percent relative to the GDP deflator between 1990 and 1993, reducing the quantity of saving required to finance an unit value of investment. 13 The cost of capital also declined in comparison with the cost of labor, though the Government has also started to reduce the cost of labor by reducing the employer's wage taxes and reforming the social security system in 1994. Finally, the reduction in public investment, principally through the recent privatization process, also explains partially the increase in private investment. The increase in private investment observed between 1991-94 was also the result of the virtually unprecedented boom in foreign and domestic credit. In this area, the Convertibility Plan has done far better than previous stabilization plans. 3.18 In the longer run, the capacity of the Argentine economy to increase its investment rate on a sustainable basis will greatly depend on its capacity to improve the level of technology and the human capital stock. The close link between the accumulation of physical capital and technological change has 13. A closer look indicates that this reduction is due to the decline in the price of imported capital goods (as the result of trade liberalization and the appreciation of the exchange rate) and in the price of domestically produced capital goods. In contrast, the cost of construction increased by 52.5 percent between April 1991 and April 1994. - 35 - been prominently emphasized and empirically documented in a number of countries. Better technology will not only require new investment in capital goods, but also improve productivity. Therefore, encouraging research and development should be one of the priorities of the Government in the next few years. Improving the stock of human capital through education will also encourage long-term investment in physical capital in Argentina". Policies for Encouraging Investment 3.19 The economic environment in Argentina presents relatively few distortions against investment as a result of the trade and financial liberalization process. Few exceptions remain and they are described below. In short, the Government should maintain a stable macroeconomic and policy environment, eliminate distortionary promotion programs, encourage technological innovations, and reduce distortions in the allocation of banking credit. 3.20 Stable and Growing Macroeconomic Environment. Historical experience and international comparisons indicate that investment is extremely sensitive to changes in the macroeconomic environment. For this reason, the authorities should ensure: (a) the equilibrium of fiscal accounts in order to control inflation and to limit the crowding out of private resources; (b) the restricted use of ad hoc interventions in tax and trade policy. Each change in these policies increases uncertainty and postpones investment decisions. Empirical evidence suggests that price incentives have to be unreasonably large to compensate for the negative impact of uncertainty on investment. 3.21 Tax Policy. The current tax system does not contain major distortions, to the contrary it seems to be extremely favorable to investment and savings. The major tax incentives are: the exemption of capital gains and of interest received on deposits from the income tax, and the deduction of interest paid on debt from the income tax. At this stage, the main recommendation is to eliminate or limit a series of remaining promotion programs which distort the allocation of resources, and are fiscally costly. The Government should: (a) eliminate the Tobacco Fund which both introduce distortions and is fiscally costly (about US$180 million); (b) gradually eliminate the current tax incentives in Tierra del Fuego. At least, the Government should eliminate the special regime for new investments and attempts to introduce ceilings on the benefits of existing programs (following the example of the old industrial promotion program); (c) eliminate, or at least not extent, (agro)industrial promotion program adopted in the Prov- inces of La Rioja, Catamarca and San Juan which have a high annual fiscal cost; (d) eliminate permanently the old promotion program for new investment; (e) reduce the protection of the automobile industry (see Trade section for more specific recommendations); (e reduce tax rates (specifically of labor taxes and provincial taxes), while maintaining tax revenues through reduction in tax evasion, in order to limit price distortions and improve the allocation of investment between the official and unofficial sectors. Such a strategy will favor the export sector which is mainly composed of large tax paying firms; and (g) eliminate the double deduction of new investment in mining. 14. A recent line of research has focused on the complementarities between investment in physical and human capital: new and technologically advances machines and equipment need to be operated by workers with adequate skills and education. - 36 - 3.22 Research and Development and Education Policies. Encouraging the development and adaptation of foreign technology, and education, is primordial for long-run private investment in Argentina. The Government has an important role to play in both areas. A recent World Bank report has evaluated the research and development policy in Argentina and the following major recommendations have been proposed: (i) administrative reforms to improve the efficiency of research and development agencies; (ii) institutional reforms including privatization of several activities; and (iii) financial reforms to increase the share of demand-driven projects. An important related issue is the poor treatment of property rights in Argentina, even if the Government recently passed a new legislation in the beginning of 1995. There is no question about the importance of property rights for investment, but it is also important that these rights will be complemented by measures aimed at improving proper contract enforcement, otherwise property rights will be only good on paper, raising the costs of doing business and the risks of corruption. 3.23 Financial Policy. Finally, investment is affected by the availability of financing resources. The well functioning of the domestic financial system is essential for providing resources to investors. Better allocation of financial resources through the reduction of the still significant public sector banking system would be an important step in that direction. High spreads can be decreased by reducing operating cost of the banking system, primarily by increasing its efficiency, and the reduction in the country risk premium (for more detailed review of policies see section on Financial Markets). Private Saving 3.24 Public and foreign saving have led the recovery of total saving in the initial phase of recovery in Argentina, but private saving is projected to be the main financing source of capital investment growth in the second phase. The reasons for this expected recovery, which started taking place in 1994 but interrupted from the 1995 crisis, are (i) the delayed response of private saving to the economic recovery as it generally takes time for households to adjust to a shock (of a changed economic framework); (ii) the partial substitution of public savings by private savings as the result of reduced taxes (principally labor taxes); (iii) the reform of the social security system; (iv) the development of the financial system which has positive impact on growth and thus on savings, compensating for the initial substitution effect of the boom in (foreign and domestic) credit; and (v) in the longer run the evolution of demographic variables as the dependency ratio which is projected to decrease from 60 percent in 1990 to 55 percent in 2000, principally because of the reduction in the percentage of young people.'5 3.25 Economic Growth. There appears to exist a significant and positive correlation between private saving and economic growth in Argentina during the period 1983-93, though this correlation seems to be lower than in recent cross-country studies. The most interesting aspect of these economic results is that the effect of a variation in economic growth seems to be delayed over time as only 20 percent of the 15. Demographic factors play an important role in the life-cycle models as both young and old people generally save less than middle-age working people. The decline in the dependency ratio is expected to contribute to an increase in the saving rate. There is a considerable debate about the magnitude of such effect in the empirical literature, but a rough estimate is that the saving rate will increase by about 2.2 percent of GDP during this period. This figure is based on the coefficient estimated by Edwards (1994) in a cross-country study. - 37 - total effect takes place in the first quarter6. The low response of private saving to economic growth in Argentina during the period 1991-93 suggests that consumption adjusts gradually to its new level, or it takes time for consumers to understand that a shock occurred. As a result, consumption growth rates have already decelerated in 1993, and future growth rates in consumption could moderate further. The delayed response of savings to variations in economic growth can be caused by a variety of economic factors. Consumption is expected to overshoot in a less than fully credible fixed exchange rate-based stabilization program as it may have happened in the first stage of the Convertibility Plan. 3.26 The recent literature has also emphasized uncertainty and habit formation as two of the main reasons for this delay. Given a previous habit stock, saving adjusts upward only sluggishly in response to an increase in income, this slow adjustment being reinforced in the presence of uncertainty. Finally, there are also statistical reasons for this delay. The most important reason is that people initially invest in durable goods such as cars and housewares after the reform, which increased by 340 percent and 180 percent, respectively, between 1991 and 1993, and only later invest in physical capital --durable goods should be counted as savings, but are not. As a conclusion, with the acceleration in economic growth, and the continued improvement in the credibility of the exchange rate regime, private savings are expected to grow. 3.27 Fiscal Policy. Fiscal policies can affect private saving in many ways. The most important instruments are: (i) changes in the level of public saving, (ii) shifts in the composition of taxes, and (iii) the reform the social security system. 3.28 Private and public saving appear to be highly substitutable in Argentina because private consumers have learned over the past decade to internalize the government intertemporal budget constraint, and thus they save more when the public sector saves less in anticipation of higher taxes or debt reimbursement". Therefore, reducing public saving through, for example the reduction of taxes, appears to be a powerful instrument to increase private saving in Argentina'8. However, the Government should assess carefully the tradeoff between private and public savings; a significant deterioration in fiscal accounts may lead to a reduction in private savings through a deterioration in the economic environment. Lower public saving may also reduce public investment. 3.29 Shifting the composition of taxes is generally considered as an effective policy option to encourage private savings. Replacing taxes on production and on factor's income by a consumption tax increases the propensity to save because the latter tax does not distort the choice between present and future consumption. In addition, a compensated shift from an income tax to a consumption tax would increase current saving because individuals would have to save more during their working period to maintain the same level of consumption in retirement. Over the past few years, the Government has 16. A simple Granger causality test cannot reject the hypothesis that growth increases first, followed by an increase in private saving, which is also consistent with the experience in East Asian countries. 17. In a regression identifying determinants of private domestic savings in Argentina, the coefficient associated with public savings is not statistically different from one. 18. In the recent years, the substitutability between private and public saving has been accentuated by the recent sales of public enterprises. For example, the sale of YPF in mid-1993 resulted in an automatic transfer of savings from the public to the private sector of 0.3 percent of GDP. - 38 - followed this strategy by increasing the share of consumption-based taxes in total taxes from 35 percent in 1990 to 52 percent in 1994. The major recommendation would be to strengthen this effort by replacing the provincial turnover tax by a consumption tax. However, the low efficiency of tax administration in the provinces has to improve in order to benefit from that change. Box 1: Impact of the Reform of the Social Security System on Savings The positive impact of the reform on gross domestic savings will be higher if (a) the number of contributors opting for the private system gradually increases over time; (b) the government is successful in reducing evasion; (c) the transitory deficit of the public system is tax-financed rather than bond-financed; (d) savings in pension funds will not substitute other forms of savings. A simulation exercisea/ indicates that the short-run impact of the reform on gross domestic savings will range from 0.5 percent of GDP if the fiscal deficit is tax-financed to 0 percent of GDP if it is bond-financed (in the absence of the Ricardian equivalence). The positive impact will increase gradually over time, reaching 1 percent after 10 years, because of the gradual decline in the deficit of the public system. Similarly, the reform affects the composition of savings since, in the first year, it implies a shift of 0.6 percent of GDP from public to private savings, equivalent to about US$2.0 billion. The medium-term impact on private savings will closely depend on the degree of substitutability between alternative forms of private savings and the instrument used to finance the public deficit. The reform is expected to enhance the development of the domestic financial sector because: (a) the private sector is generally more efficient than the public sector in allocating resources; and (b) it will promote long-term investment. In that respect, the experience of Chile might be revealing since the value of the portfolio of the pension funds increased from 3.6 percent of GDP in 1982 to 35.4 percent in 1992, with important shares invested in treasury bonds, mortgage bonds, and corporate equities. a/ The simulation is based on the following assumptions:(a) the initial fraction of contributors opting for the private system is 55 percent, subsequently increasing by 1.5 per year; (b) the evasion rate will be reduced by 3 percent annually in the five first years following the reform and remain constant thereafter; (c) the fiscal deficit is either completely tax-financed or bond-financed; (d) the degree of substitutability between alternative forms of private savings range from 10 percent in the first two years, gradually increasing to 40 percent in 1999. 3.30 In contrast, the Government should not extend the existing tax saving programs, such as incentives for retirement accounts. First, it is increasingly recognized that these programs do not significantly increase the volume of private saving. Second, they have a fiscal cost as well as they complicate tax administration; this would be particularly unfortunate at time when the authorities attempt to reduce tax evasion. Finally, the Government's ability to modify the net return of private savings - 39 - instruments and, thus, to affect the households portfolio choice is greatly limited in Argentina by the current level of evasion. 3.31 The recent reform of the social security system could stimulate gross domestic savings as the future contributions of the new capitalized pension fund system are unlikely to be offset one-to-one by reduced savings in other instruments (see above Box) . However, the effect of the reform on total savings will certainly be limited ranging between 0-0.5 percent of GDP. Notice that the positive effect is accentuated if the transitory public deficit is tax-financed and if the savings in private pension funds do not substitute alternative forms of private savings. More important seems to be the effect of the social security system reform on the composition of savings. First, it implies a shift from public saving to private saving, equivalent to about 0.6 percent of GDP in the first years of the reform. Second, private pension funds have certainly a longer term horizon than other private investors and thus they could favor long-term saving instruments. For example, in the first year of operation, Argentina's social security system started to generate a large pool of long-term financial resources, to the equivalent of $2 billion, approximately 0.7 percent of GDP. The resulting longer-term effect, based on the example of Chile, is that the domestic financial market will deepen and thus make additional resources available for investment. Effective regulation and supervision of this system, and reduction in pervasive evasion would greatly strengthen the new social security system, and its impact on saving and investment. 3.32 Financial Policy. In the long-run, financial policies are likely to have a positive impact on private saving through their impact on economic growth. The recent literature on economic growth has emphasized that financial development, as measured by the monetization of the economy for example, is one the most important factors explaining economic growth. However, financial policies are generally ineffective in raising private saving in the short-term. To the contrary, they are likely to reduce saving because of the relaxation of borrowing constraints and the ambiguous effect of interest rates. 3.33 There is a considerable debate about the effect of variations in interest rates on savings. Most empirical studies are unable to find a significant correlation between these two variables because of contradictory effects. Similarly, in the case of Argentina, the impact of interest rates on private saving has been found to be insignificant over the last decade. This result can be due to the presence of liquidity constraints, which are likely to be important in Argentina, limiting the response of private investors to variations in the interest rates. 3.34 The boom in domestic credit, and the greater access to foreign savings have reduced significantly borrowing constraints in Argentina. The increase in foreign saving is estimated to have reduced private savings by 1.0-1.3 percent of GDP between 1991 and 1993 because non-liquidity-constrained consumers have to accumulate less wealth to purchase durable goods.'9 Yet, it is important to point out that if the massive capital inflow has partially substituted domestic saving through the relaxation of borrowing constraint and the financing of consumption activities, it has also resulted in a dramatic change in the 19. The estimated parameter associated with foreign capital should be taken with caution because the relationship between domestic and foreign savings may be more incidental than causal. To illustrate this point in the case of Argentina, the fiscal adjustment in 1990-93 affected both foreign and domestic (private) savings but in opposite directions. The impact on foreign saving was positive because the fiscal adjustment improved the country's international creditworthiness, while the impact on private domestic savings was negative because public and private savings are highly substitutable. As a result, the correlation between domestic private savings and foreign savings is negative, though there is no causal link between these two variables. - 40 - composition of private saving in favor of domestic assets and away from capital flight. This improvement in the portfolio allocation will gradually offset the negative initial impact of foreign savings on domestic savings and investment. 3.35 The Argentine Government is pursuing a strong effort to develop the domestic capital market by increasing the range of financial instruments, the quality of the financial sector regulation and solvency- enhancing supervision. However, if capital market reforms typically lead to an increase in financial savings, they do not necessarily increase overall private saving. In the longer-term, financial reforms may contribute to overall saving through their indirect positive impact on growth. 3.36 Broadening the range of financial instruments will contribute to economic growth by making additional resources available to investment. Reforms such as trade liberalization, enterprise privatization, and pension reform have improved the allocation of resources by increasing the proportion of households savings invested in the financial system. The Government can accelerate this process through reforms in the banking system and capital markets (presented in the Financial Markets section)'. International Trade Regime 3.37 Since the late eighties, Argentina has achieved a radical change in its trade regime. The change is seen in nearly all the traditional measures of trade liberalization. Nominal protection has been significantly reduced, with the average nominal import tariff declining from 30 percent in 1989 to 14 percent in March 1995. The variance in nominal protection has also been reduced. The trade regime has been liberalized and QRs substantially reduced. The bias against exports has also been considerably reduced. As discussed in the previous chapter, trade liberalization has led, in the context of the Convertibility Plan, to the acceleration in exports and economic growth. 3.38 Other policies have also been conducive to the expansion of trade. Tax policies, for example, are relatively favorable to exports. The income tax rate, at 30 percent, is lower than in most developed and some less developed countries and taxes on consumption have increased their share in the total tax bill, accounting for half of the total revenue of the national and provincial governments. The most important tax on consumption is the VAT which allows for border tax adjustments, while the impact of other indirect taxes is more than offset by tax reimbursements on exports. 3.39 Financial policies have been questioned as a deterrent of exports in Argentina because of unusually high banking spreads. However, large exporters usually pay the lowest rates in the market, similar to international rates plus the country risk premium, because they have a good collateral in export contracts. For small and medium size firms that might encounter difficulties in getting access to credit, the Government has launched several loan programs that favor increases in exports. These programs charge interest rates that are lower than actual market rates in Argentina, but are higher than international rates. 3.40 Despite policies that are conducive to the expansion of trade, since October 1991 there has also been an increasing complexity of the trade regime. First, the number of tariff tiers has increased progressively from three to seven. Second, quantitative restrictions were extended from the automobile 20. A series of recommendation have also been proposed in the recent Capital Market Study (June 1994). - 41 - regime to other industries and attempts have been made to tie access to imports to export performance. New non-tariff barriers have allowed for more bureaucratic discretionality; licenses for quotas and for special benefits ar examples of these non-automatic policies. The increasing complexity of the trade regime led to greater widening of effective protection, even though the average level has remained low by historical standards. Additionally, the fiscal cost of these policies has also increased. 3.41 There have also been attempts to fine-tune the trade regime on the export side with the adoption of the mirror principle which has increased discretionality. The existing tariff structure tends to protect the local production of those goods in which the country is relatively more inefficient. The 1992 instituted system of "mirror export subsidies" grants to each export product the same rate of subsidy as that corresponding to imports of the same product. Since import duties are larger the more inefficient the industry is, the new system of export subsidies grants larger subsidies to the more inefficient industries and smaller subsidies to the more efficient industries. This system maximizes the losses from protection since it aims to expand production in the inefficient sectors (e.g. the automobile sector), and to contract production in those which are efficient (e.g. agriculture or agro-industrial products which receive little or no subsidy since they receive no import duties). 3.42 The mirror principle has an important annual fiscal cost. Prior to the recent reduction in export reimbursements, tax rebates on exports reduced tax revenues by $1 billion annually; since they were exempt from income taxes, there was an additional subsidy of about $300 million. A second related problem is that tax reimbursements on exports can be used together with the temporary admission program and were fixed at levels that reach 20 percent for some industrial products2". They clearly overestimate the indirect tax incidence allowed by the GATT rules and might be subject to retaliation from foreign countries. 3.43 Even though effective protection estimates are not available for the early 1990s to establish the results of the reforms on levels of effective protection and its dispersion, a limited sample estimate shows that traditional exportables had negative protection compared to importable manufactures. Moreover, the variance appears to be considerable. For example, traditional exportables had a negative effective protection rate of 2.5 percent compared to positive protection rate to manufactures importables of 39 percent.' This wide variance suggests that traditional exports are considerably disadvantaged compared to industrial products. Resource movements induced by this variance could lead to reduced overall economic efficiency.23 21. Exporters should be allowed to use either temporary admission or tax reimbursements, and not both as occurs in Argentina. 22. The low effective protection of traditional exportables is caused by: (a) the subsidies on exports received by their main (exportable) inputs that increase the price they pay for their in the domestic market above intemational prices; and (b) primary products cannot use the temporary admission program for the purchase of inputs because of the long gestation period of their production that usually exceeds the maximum number of days (180 days) that imported inputs are allowed to be held free of duty in Argentina before being reexported. 23. A computable general equilibrium (CGE) model was run to assess the impact of three alternative policies: (a) the introduction of a uniform import tariff of 10 percent and a 50 percent reduction of tax reimbursements on exports; (b) the immediate elimination of all employers' contributions to social security compensating the loss in fiscal revenues with a higher VAT rate; and (c) the replacement of the provincial turnover sales tax by a retail sales (continued...) - 42 - 3.44 There are other implicit subsidies to exports hidden in industrial specialization programs. Firms can benefit from a reduction in the tariff on imports of their inputs or competing products purchased directly by them if they increase their exports. The impact of these programs has been small, but they have a fiscal cost and contribute to the concentration of the Argentine industry. The most important specialization program is the automobile industry regime that enjoys a subsidy for the reduction of import tariffs of their inputs or for own imports of finished cars of almost $300 million per year. 3.45 Attempts to manage sectoral trade incentives, as in the automobile regime, could prove to be costly. The automobile regime itself is inordinately complex. There is no good economic reason why that industry should have a special regime, especially in a patently liberalizing atmosphere. Moreover, the balancing of exports with imports by industry is not desirable in a multilateral and multi-commodity trade system, since increased inefficiency arising from one industry can spread quickly into other industries through input-output relations and through groups lobbying to receive concessions that become available in the political market. 3.46 The use of quantitative restrictions and antidumping during 1993 and 1994 has also affected some exporters because they have to pay higher prices for some of their inputs. In particular, some preventive antidumping actions have been applied which are difficult to justify from an economic point of view. Nevertheless, quantitative restrictions and antidumping have affected a small group of goods, and a few of them, particularly quantitative restrictions, have not been extended after their expiration. 3.47 Another policy issue relates to the continuing concessions granted to the special areas such as Tierra del Fuego and Patagonia. Trade instruments are being used to provide incentives for regional development, through higher reimbursements for exports from these areas and reduced tariffs on capital goods imports. The trade instrument is not appropriate for supporting regional development. 3.48 Finally, trade issues relating to MERCOSUR could pose important challenges for Argentina's policy makers. Increasing trade links with Brazil pose issues of coordination of macroeconomic policies and the harmonization of regulatory environments to maintain balance of payments viability with Brazil and to increase competition among the Mercosur group of countries, respectively. To the extent macroeconomic coordination issues are not reconciled there will be tensions in the trade relations between these two countries. This might give rise to use of non-competitive remedies such as the use of anti- dumping, quantitative restrictions, ad hoc tariffs, and taxes, which could damage the liberal trade regime. 3.49 These policies already carry important fiscal and efficiency costs to the economy, at a time when the Administration is faced with the growing challenge of improving its fiscal accounts. For example, 23.(. . .continued) tax. Results are as follows: In alternative (a), the introduction of a more neutral policy of import substitution and export promotion allows real exports to growth by 17 percent and investment by 2.5 percent. In alternative (b), the impact of accelerating the reduction in labor taxes for all economic sectors, but maintaining tax revenues constant by increasing the VAT, is an increase in total exports by 17.4 percent, and investment by 1.5 percent. In alternative (c), exports grew by 8.5 percent, and investment by 1.4 percent, after the introduction of a more neutral tax that replaces the cascading provincial sales tax. The three alternatives suggest that there is an important gain in export potential and social welfare that might be achieved if improved economic policies are adopted. - 43 - annual fiscal cost of the various export promotion programs in effect during 1994, have been estimated at $1.6 billion, up from $630 million in 1990. These fiscal costs do not include the impact of subsidized export credit programs, provided through the financial system. Furthermore, the above costs do not include the cost to consumers; the automobile industry alone, adding consumer to the fiscal costs of the industrial regime, create a joint transfer cost of $1.7 to billion, annually. In 1995 and early 1996, the Government took measures to cut export reimbursements. 3.50 Frequent changes in trade policy as those observed in Argentina during 1993 and 1995 have a negative impact on export and investment potential, since their profitability becomes more uncertain. Moreover, they tend to give mixed signals to businessmen by assigning a higher value to rent seeking activities, compared to a system of more automatic policies. Recommendations 3.51 A fundamental recommendation is the maintenance of macroeconomic stability as the first line of defense in keeping the trade regime open. Macroeconomic instability can unravel even the most liberal of trade regimes. This has been the experience of Argentina in the past as well as countries around the world. The track record of stable and consistent macroeconomic policies of the last five years is reassuring that such macroeconomic stability is achievable. 3.52 Exports are a function of structural reforms, such as the size of the public sector and labor reform. High labor cost due to wage taxes and regulation, coupled with high protection of other basic input industries add to the "argentine cost" and restrain export potential. With a slowdown in capital inflows, resources should move into the export sector and imports should decelerate requiring a change in relative prices. Change in relative prices will depend crucially on the degree of market flexibility. In a highly regulated system, a small shift of resources requires large changes in relative prices: this is what normally happened in Argentina in response to change in demand: resources moved little and prices experienced drastic movements. The optimal response for Argentina, thus, seems to be to continue with the path of structural adjustment,adding flexibility to the economy, so as to minimize the need for real exchange rate adjustment in case of a slowdown in capital inflows. 3.53 Considering the overall consequences of trade and indirect tax policies on exports, there is a need for change towards simplicity, transparency and automaticity of economic policy instruments. The creation of a stable and predictable trade regime would benefit significantly the growth of exports and investment. In that context, the following more specific recommendations are worth considering: (a) First, the automobile regime and the "industrial specialization" regimes require re- examination. They detract from neutral incentives, introduce unnecessary complexity and provide opportunities for discretion that could be damaging for liberal trade. Additionally, as mentioned above, the rent transferred to automobile producers is substantial. Eliminating the benefits that go beyond the maximum tariff will cut this rent by about 40 percent. As was discussed above, there is no need to tie export performance to import concessions. While these are not strictly QRs, they would begin to operate as QRs and limit the role of prices in allocating resources. Moreover, the automobile regime and the "industrial specialization" regimes introduce rigidities into the production structure and make future adjustments more difficult. The government could announce now the discontinuation of the regimes beyond 1999 when the "industrialization specialization" regimes are to be reviewed, in order to prepare the ground for a level playing field. - 44 - (b) Second, it would be advisable to do away with mirror principle altogether as the means to provide neutrality between exports and import substituting industries. There are easier and more efficient ways of providing neutrality for exports. This could be done through a low general tariff, and automatic reimbursement of tariff paid on inputs used for the production of exports. This automaticity would help to reduce the rigidity of a finely tuned system and also help to prevent rent seeking involved in the reimbursements when some imports could be misclassified to create rents. (c) Third, there is little justification to use trade policy to promote regional development. The special concessions granted to Tierra del Fuego and Patagonian provinces through the trade regime is a vestige of past protectionist regimes. Moreover, subsidies of this type are not consistent with the new rules of WTO. However, the new rules do provide support for regional development using non-trade related instruments. Argentina needs to consider the appropriate instrument to promote the development of these regions and desist the pressures to subsidize particular exports. Regional grants, infrastructure creation and such means are superior instruments of regional policy. Besides, they do not distort the trade regime. (d) Fourth, with the creation of the National Trade Commission (NTC), Argentina has established the institutional means to consider trade policy making and to make decisions on contingent protection on a nationwide basis. The work of the Commission could prove to be very important in a post trade liberalization era, by giving permanence to the liberalized trade regime. Therefore, the Commission should be strengthened in its technical capacity, its representation made independent and balanced to consider requests for contingent protection with the interest of consumers in mind. The commission could adopt the new rules for safeguards, anti-dumping and countervailing actions consistent with new World Trade Organization rules. These rules could indeed be improved upon to rely more on the safeguard mechanism rather than on preventive anti-dumping actions which had increased in recent years. (e) Finally, Argentina should consider a smooth transition to the Mercosur CET and use its good offices to increase international competition of the group as well as among the member countries. It is highly recommended that Argentina's position in MERCOSUR shift towards the adoption of a uniform and low common external tariff. Argentina should also consider whether the 20 percent across the board tariff is appropriate when many of its competitors such as Chile, Colombia and Mexico have lower tariffs. In this regard, it would be necessary to bring the 15 percent of the tariff lines outside the CET under the CET and resist pressures in the interim period to apply rules of origin to increase protection. In order to increase competition within the Mercosur agreement, it would be necessary to harmonize regulatory frameworks as well as resist pressure to use contingent protection within the group. It would be possible to balance consumer and producer interests in trade policy working as a means of maintaining liberal trade. This could be done through the newly established National Trade Commission, by adopting WTO consistent rules for transparent trade decision making. This should provide consistency among the WTO, Mercosur and domestic rules and give greater credibility to the liberal trade regime. - 45 - C. The Unfinished Reform Agenda 3.54 The review of policies affecting investment, saving, and exports suggests that, while there is room for improvement, the fundamental policy structures directly affecting them, are sound. Yet, the Argentine reform agenda has significant gaps, that require immediate attention, if the economy's potential is to materialize. Provinces, accounting for the majority of public spending, despite encouraging signs of reform, have considerable ways to go in reforming of their fiscal management and the efficiency characterizing their expenditures. Lack of progress in provincial refomis could undermine reforms efforts at the Federal Government level, and as a consequence, the Convertibility Plan. Beyond the public finance issue, the Argentine economy would benefit from the liberalization of its labor markets, and the reform of its financial system. The reform of its factor markets is imperative, for the economy to gain flexibility, in order to respond to the challenges that the Convertibility Plan imposes to an open economy, and enable it to absorb better external shocks, such as those recently experienced. Reform of the factor markets would contribute to improved productivity, and mitigate economic instability, which are crucial factors for the expansion of saving, investment and exports. Argentina's Provinces: New Priorities for Public Sector Reform Provincial Expenditure Efficiency 3.55 Efficiency of the public sector depends on meeting three, generally accepted criteria for intergovernmental relations: (a) adequacy and clarity in assignment of responsibilities; (b) adequacy of provincial revenues, both own-source and transfers, to meet assigned responsibilities; and (c) accountability of provincial officials for their use of resources to meet assigned responsibilities. 3.56 Provinces are now the major providers of core public services in health, education, security, water and sanitation, electricity, and other infrastructure. Although this policy of widespread decentralization of delivery responsibility is clear, considerable concems remain regarding the efficiency with which decentralized, provincial goods and services are delivered, as will be discussed below. 3.57 Adequacy of revenues has at least two important dimensions. First is adequacy to meet expenditures mandated to the provinces. Second is whether the sources of revenues provide incentives to spend resources efficiently. With respect to the first dimension, the aggregate provincial deficits of recent years do not seem to result from insufficient transfers from the federal govenmment. The deficits arose during a period when total provincial revenues increased by 34 percent in real terms (1991-1994), and the transfer of additional social sector responsibilities added no more than 5-10 percent to aggregate provincial expenditures. 3.58 The second dimension is closely related to the degree of accountability of public officials,and how that accountability is affected by the system of intergovernmental relations. This issue often arises when provinces are spending what appears to be "other people's money." The degree of fiscal - 46 - dependence varies widely across Argentine provinces, with own revenues financing the following shares of total expenditures: 60 percent in "advanced" provinces, 36 percent in low population density provinces, 39 percent in "intermediate" provinces, and 21 percent in underdeveloped provinces. A number of studies have revealed inefficiencies at the provincial level which have resulted in the large aggregate deficits of recent years. A lack of clear correspondence between the payers and recipients of services is likely part of the incentive problem behind these deficits. 3.59 Another important issue is the fairness of the distribution of transfers across provinces. The data on Table 14 point to a strong regional redistribution of provincial expenditures, due in large part to the coparticipation regime (complemented by other central grant transfers). Provinces are grouped according to categories frequently used in Argentina for provincial analysis. Advanced provinces, characterized by large populations and high provincial product, receive substantially less per capita coparticipation revenues than provinces of the other groups. This suggests that the adequacy of provincial revenues is not a key issue, at least from the perspective of regional redistribution of income to provinces outside the advanced group. As concluded in a recent Bank study, "the regional redistribution of income probably has been excessive in Argentina."24 TabLe 14: Basic Data on Provinces Provinces PopuLation Fiscal Bat. 1995 $ per cap. (e) Debt Stock(1995) 1994 X 1995(e) % Coparti Other Total Total S MiLl. % of (Thou.) $ MiLL. Total cipation Trans Expen. Exp.over TotaL Revenues Revenues fers ditures own Revenues Revenues Advanced MCBA 2,977.1 8.7 28 1.1 52.9 20.0 854.0 1.0 Buenos Aires 13,112.7 38.5 (280) (3.7) 192.0 82.0 629.0 2.2 2,930 38.8 Cordoba 2,873.5 8.4 (397) (19.8) 309.0 55.0 868.0 2.8 1,600 80.7 Mendoza 1,478.0 4.3 (34) (3.2) 308.0 124.0 784.0 2.8 800 78.4 Santa Fe 2,896.8 8.5 (215) (10.5) 334.0 77.0 809.0 2.7 187 9.0 Low Density Chubut 388.2 1.1 (202) (41.1) 464.0 645.0 1943.0 11.3 101 21.1 La Pampa 276.2 0.8 (3) (0.6) 720.0 441.0 1792.0 3.6 22 4.9 Neuquen 441.6 1.3 (256) (28.6) 444.0 1120.0 2958.0 6.2 58 7.2 Rio Negro 546.9 1.6 (208) (37.5) 474.0 349.0 1506.0 6.2 445 77.5 Santa Cruz 174.9 0.5 (38) (7.0) 938.0 1721.0 3629.0 11.4 77 15.7 T. del Fuego 87.7 0.3 (66) (21.8) 1051.0 2362.0 5319.0 15.4 24 7.6 Intermediate Entre Rios 1,053.1 3.1 (160) (17.5) 494.0 123.0 1055.0 3.2 590 59.5 Salta 931.7 2.7 (99) (13.7) 442.0 176.0 948.0 5.9 282 39.6 San Juan 547.2 1.6 (164) (31.1) 629.0 222.0 1309.0 9.4 239 45.9 San Luis 310.0 0.9 50 11.1 778.6 385.0 1400.0 6.9 17 4.0 Tucuman 1,193.2 3.5 (227) (29.2) 421.0 116.0 880.0 7.3 607 78.3 UnderdeveLoped Catamarca 282.2 0.8 (64) (17.4) 1013.3 275.0 1635.0 66.7 193 51.9 Chaco 881.9 2.6 (110) (15.6) 571.4 138.0 968.0 11.3 560 80.4 Corrientes 836.7 2.5 (60) (10.1) 466.0 163.0 822.0 9.9 638 108.4 Formosa 432.1 1.3 (151) (30.2) 869.0 288.0 1634.0 126.9 365 72.3 Jujuy 544.4 1.6 (193) (37.9) 561.0 206.0 1370.0 8.4 324 65.0 La Rioja 239.3 0.7 (53) (9.9) 931.0 1375.0 2673.0 337.6 542 99.9 Misiones 854.4 2.5 (145) (25.3) 417.7 174.0 909.0 11.7 255 44.7 S. del Estero 694.7 2.0 (23) (3.8) 596.9 187.0 933.0 11.4 310 52.6 24 Jurisdictions 34,054.5 100.0 (3040) (11.7) 319.0 146.0 902.0 28.4 11,166 47.6 Source: Ministry of Economy; Ministry of Interior; Staff Estimates. e: Estimate 24. See "Argentina: Towards a New Federalism", Report No. 10612 (Green Cover), June 17, 1992, p. 27. - 47 - 3.60 One of the most important criteria for evaluating intergovernmental fiscal relations is the degree to which each level of government has adequate resources to provide certain minimum standards of services to all citizens, independently of the jurisdiction in which they reside. This is especially important for human resource services, not only for their inherent importance for development, but also because once "capitalized" within the individual, they may migrate between jurisdictions. Table 15 presents the allocation of provincial social expenditures by provincial group. Table 15 indicates significantly higher social expenditures per capita outside the advanced group, especially in Low Density and Underdeveloped provinces. This reinforces the conclusions derived from Table 14 data and suggests that social spending is not being undermined in non-advanced provinces. 3.61 Efficiency of Expenditures and the Wage Bill. Although data are inadequate to evaluate the performance of provincial expenditure programs (e.g. education, health, transport), there is evidence that serious inefficiencies exist in some types of overhead expenditures. For example, provincial wage bills constitute a heavy burden on many provincial treasuries, such as the provinces of La Rioja, Catamarca, Corrientes, Formosa, Neuquen, Santa Cruz, and Tierra del Fuego where about one fifth of employed workers were in the public sector in 1992. In particular, public education has been used extensively to provide jobs, and in most provinces accounts for more than 40 percent of total public employment. With inadequate administrative controls, nontenured positions for teachers tripled during the past decade as did leaves of absence. As a result, the average number of students per teacher in the provinces is 11, as compared to 19 students in Chile and 22 students in Spain. Such apparent coverage, however, has not improved the quality of education, as reflected by most surveys. One part of this problem, in many provinces, is the excessive use of substitute teachers, and even substitutes for substitutes, to a level well beyond any normal degree of absenteeism. On any given day, there may be several teachers being paid to teach one class. Table 15: Sectorat Composition of Provincial Social Expenditures Per Capita Average Index for the Country = 100 Provinces PubLic social Expenditure Education Health SociaL Welfare Housing per capita (1990) (1991) (1991) (1991) (1991) Advanced 84 87 96 89 42 Low Density 223 206 184 185 410 Intermediate 104 104 98 132 129 Underdeveloped 127 121 91 96 249 Source: "Argentina's Poor: a ProfiLe", W. Bank, 1995. 3.62 The evidence suggests, therefore, that the key issue for evaluating provincial fiscal adequacy to meet assigned responsibilities is in the area of expenditure efficiency. The issue is less the amount of provincial revenues than in how efficiently existing revenues are allocated. To address the issue of expenditure efficiency, the criterion of the accountability of provincial officials should be examined. 3.63 In summary, a key issue for intergovernmental relations that promote improvement in provincial fiscal performance is lack of accountability of many provincial officials. This stems from a high level of central financing of provincial expenditures, and the lack of incentive for provincial authorities to confront their citizens with the costs of their preferences. Weak accountability undermines incentives for provincial fiscal balance (with notable exceptions) and for provincial expenditure efficiency (apparently widespread). At stake is the quality and coverage of basic services in the areas of infrastructure, social services and poverty alleviation. - 48 - Recommendations for Reform 3.64 Two broad areas of reform, intergovernmental fiscal relations and access of subnational governments to the financial sector, are discussed below, with specific recommendations. Intergovernmental Fiscal Relations 3.65 Throughout this section, issues resulting from Argentina's current system of intergovernmental fiscal transfers have been emphasized. These include the mismatch between provincial expenditure responsibilities and own-source revenue authority, and the resulting lack of incentives for many provinces to be concerned with (i) the quality of their expenditures or (ii) revenue effort on their current revenue base. 3.66 To address these issues, two basic reform strategies are discussed below. The first may be termed a "structural reform" in intergovernmental relations, with fundamental changes in the rules of the game for intergovernmental relations. The second strategy may be considered "reforms at the margin". This strategy accepts the fundamental rules of the game currently in place for intergovernmental fiscal relations, but it seeks to identify areas of policy "fine tuning" that would provide incentives for better provincial service delivery and financial management. These two strategies are not necessarily mutually exclusive; the second may serve as a transition vehicle to the first. 3.67 Structural Reform. What should be the medium-term "vision" of intergovernmental fiscal relations that promote provincial expenditure efficiency and accountability, and what reforms in the structure of these relations will be required to achieve these objectives? As a general vision of this reform, it is recommended that the following be considered: expenditure decentralization to the maximum extent compatible with the efficient delivery of public goods. This is consistent with the "principle of subsidiarity", that the provision of public services should be assigned to the lowest level of government that can finance them at the least cost, administer them efficiently, and achieve their public purposes effectively. 3.68 Reform based on the principle of subsidiarity also would need to take into account the following important considerations. (a) Fiscal accountability, seeking to promote allocative efficiency through having the jurisdiction that provides services pay for them to the maximum extent feasible through own-source revenues. In other words, finance should follow function in order to promote accountability through confronting beneficiaries with the costs of their preferences. In this regard, alternatives to the current system of coparticipation need to be explored, such as the devolution of some national tax bases to the subnational level, including the option of discretionary provincial surcharges ("piggy-backing"), for such taxes as income, excise and fuel. (b) Distributional policy, seeking to promote equality of opportunity and reductions in extreme poverty. When devolution and/or sharing (e.g., piggy-backing) of national tax bases are not sufficient to promote these equity objectives, then a system of intergovernmental fiscal transfers targeted on these objectives needs to be defined. The current coparticipation system tends to focus on the territorial jurisdiction of the provinces as the object of fiscal transfers. To promote distributional objectives, this focus needs to be complemented by the household - 49 - A PROVINCIAL REFORM AGENDA: THE CASE OF CORDOBA 1. C6rdoba is the third largest provincial economy. Its public sector is facing a financial crisis with a detrimental impact on its economy. Cordoba's fiscal situation deteriorated in the early nineties, despite significant increases in coparticipated revenues and own tax revenues, resulting from the stabilization and recovery of the national economy. Sharp increases in expenditures across the board, led to overall deficits averaging 19.5 percent of current expenditures in both 1993 and 1994. The role of the public sector needs to be recast from an inhibitor to overall economic growth, to a legitimate provider of affordable social goods, and supporter of economic growth. There is a need for a profound reallocation of resources from the public to the private sectors, that will strengthen both sectors. As a consequence of this reallocation, Cordoba will be able to attain a first goal of financial creditworthiness, primarily by strengthening public finances, fulfilling in that process conditions for sustained development. A second, equally important goal would be to increase the efficiency of public expenditures, allowing for the improved delivery of social services in the context of fiscal balance. A leaner and more efficient public sector would be to the benefit of Cordoba's economy. 2. The recent Latin American crisis accentuated the province's financial problems, and in the midst of social unrest, the previous administration left office in July, 1995, five months earlier than anticipated. A new administration was forced to engage immediately in crisis management, taking strong measures to curtail fiscal spending through the implementation of an Emergency Law. While the national economic crisis affected C6rdoba's economy, the causes of Cordoba's economic crisis go deeper, and are the result of locally grown imbalances. There is need for a fundamental reform of the public sector, not only to address the current crisis, but strengthen future economic prospects as well. While the transition costs of the adjustment could be important, an immediate transition would mitigate its future larger costs. Recommendations for the reform of the province include: Reforms for the Short Term -- Replace the Emergency Law in 1996 with a sustainable fiscal savings plan. -- Cease the use of bonds as means of payment in the context of a fiscal and debt workout; -- Cut personnel expenditures to balance the budget; -- To facilitate the adjustment and increase efficiency, privatize banks and other public enterprises; -- Sign the Pacto Fiscal, to access the minimum coparticipation guarantee; -- Transfer the Social Security System to the National Government and -- Create a more effective Social Safety Net. Reforms for the Medium Term -- Implement health reform, by providing health insurance rather than free care in public hospitals; -- Implement education reform through effective control over personnel expenditures, increased student/teacher ratio, reoriented expenditures to educational services, improved equity with richer students paying more for education, and modernized curricula; -- Implement Social Welfare reform by significantly improving targeting; -- Implement Civil Service Reform, by creating merit based mechanisms, such as a competitive selection process and a results-oriented assessment process, by decentralizing managerial responsibility, and introducing technological innovations that reduce labor requirements. -- Streamline municipal coparticipation by simplifying the transfer formula, further decentralizing functions, and eliminating distortive incentives; -- Increase revenues by amplifying the tax base and improving tax collections, while decreasing tax rates to support private sector development and employment; -- Increase capital expenditures to support the growth of the private sector; -- Establish an economic, statistical, and financial data base for the public sector and the province. - 50 - as the object of fiscal transfers. This indicates that intergovernmental fiscal transfers need to be allocated primarily according to a measure of poverty distribution for the financing of primary and secondary education and health, as well as other programs of national priority, primarily for poverty alleviation (e.g., housing, potable water and nutrition). Closely linking implementation of minimum levels of national social program objectives through subnational governments also may require much higher degrees of earmarking for intergovernmental fiscal transfers than now is the case. 3.69 Potential conflicts should be recognized, between the different intergovernmental fiscal reform objectives and measures noted above. The first potential conflict is between subnational fiscal accountability and redistributional policies that result in central fiscal transfers to implement national social policies. The response proposed is to make these transfers (i) conditional on effective service delivery, and (ii) based on indicators that could not be easily distorted, such as census data on population, poverty measures, and number of students. A minimum level of subnational government counterpart financing for social expenditures, especially programs that are difficult to monitor from the center, also would be required under the proposal. The basic thrust is to guarantee minimum national standards for social policy programs, financed with fiscal transfers, that may be complemented through local fiscal effort so that the allocative efficiency benefits of fiscal accountability may be achieved. Another potential conflict is with decentralization and allocative efficiency. The reform should seek to eliminate possibilities of subnational governments providing fiscal or other artificial incentives (e.g., provincial versions of "promocion industrial") to influence the location of productive activities. 3.70 In sunmary, structural reform to address the issue of poor provincial expenditure efficiency includes expanding the provincial own-source revenue base to bring it more in line with provincial expenditure responsibilities, and decreasing the high dependence of provinces on fiscal transfers. Requiring provincial authorities to confront their constituents with the costs of their preferences may be expected to promote enhanced efficiency in the allocation of resources and greater economy with which these resources are used in the provision of public goods and services. 3.71 Reforms at the Margin. One option for reform "at the margin" is to recast the approximately US$4.8 billion that are transferred to provinces outside the coparticipation system. Most of these transfers are made through special purpose funds, such as the FONAVI housing program and the Electricity and National Highway Funds. With the agreement of the provinces, some or all of these resources could be consolidated into a program of grants allocated to provinces on the basis of their performance. Provincial performance criteria might include current savings, effectiveness in meeting expenditure responsibilities, especially in education, health and poverty alleviation, and/or streamlining provincial administrations (in which case the incremental grants could finance adjustment costs such as severance payments). Such a performance-based grant program, at the margin of coparticipation, could provide incentives for better provincial performance in discharging their responsibilities. It would require, however, clear and broadly accepted provincial performance indicators measured with transparent and reasonably accurate data. 3.72 Although probably more politically difficult than the first option, a second option could be reforms in the participation of each province in coparticipation taxes. As noted above, central transfers favor heavily those provinces outside the advanced region, and social expenditures per capita generally are significantly higher in those provinces. Yet, almost 60 percent of Argentina's poor live in the advanced provinces. This proportion may increase as liberalized market forces attract more poor families to areas of expanding employment. - 51 - 3.73 Starting from the premise that the central government's first responsibility in designing an intergovernmental fiscal system is to ensure financing (transfers and subnational own-source) for basic human services, with broadly equal access by all citizens regardless of the jurisdiction in which they reside, the Government should re-examine the distributional formula for coparticipation to ensure that national objectives for interpersonal equity are being met. Relations between Provincial Governments and the Financial Sector 3.74 The most productive and sustainable relationship between provincial governments and Argentina's financial sector should be beneficial to both the financial sector and provincial development. A general recommendations would be that provinces should finance their investment programs through their current account saving balances leveraged, when appropriate, with borrowing from the capital markets. Provinces should compete with alternative borrowers (e.g., agriculture, industry, commerce) with no special privileges that would handicap other public or private sector investors with potentially more productive use of resources. 3.75 Provinces (and other subnational government units) could borrow responsibly to finance partially their investment needs competitively, and prudently to promote at least three important benefits: (a) Expenditure efficiency, as borrowing promotes economies of scale and lower unit costs of construction for lumpy investments when compared to pay-as-you-go financing. (b) Interpersonal equity, as payment of costs corresponds more closely to the flow of benefits, and this is a significant concern at the subnational level because of migrations across local jurisdictions. For newcomers, the free-rider issue is reduced (even if local public investment benefits are capitalized in private property values) as they should pay for investment costs during the period they are receiving benefits from them. (c) In order to have access to the capital markets, provinces will need to have accurate and appropriate financial accounting and reporting systems, as well as investment programs that are properly designed, financed and operated, as noted above. Also, there must be full disclosure of this information to the public domain. This increase in transparency promotes public accountability and market discipline on government decisions. 3.76 In order to better link the demand for investment financing of subnational government with the potential supply of loans from the private financial sector, several regulatory prerequisites need to be in place. These include the following: (a) Severely curtail the use of coparticipated funds guarantee as collateral, which has been widely used for borrowing in the financial markets, irrespective of the destination of funds; (b) Generate appropriate data on subnational investment executing entities, including overall financial performance, as well as evaluation of the technical and rinancial quality of specific investment projects for which loan financing is sought; (c) The legal and regulatory framework needs to be strengthened, but this framework needs to be strengthened and expanded to facilitate subnational government access to the capital markets, as well as to provide safeguards for macroeconomic policies. - 52 - 3.77 The quality of subnational government investment proposals and of general subnational financial management, and the financial sector's capacity to respond to subnational government investment financing demands is not currently at a level consistent with a significant financial sector response to these investment financing needs. However, the prospects of a significant response are considerably greater than just a few years ago. A transition strategy should support market-based appropriate subnational government access to the financial markets. Labor Markets and Institutions 3.78 The onset of the Convertibility Plan, with its significant structural reforms and the opening of the economy presaged a shakeup of the labor market. Reasons can be found in the pre-existing structure, employment, productivity and competitiveness of firms. During the 1980s, average yearly GDP growth dropped to -1 percent, yet over the period yearly employment growth averaged 1 percent, and total factor productivity declined at an annual average rate of 4.3 percent. As a consequence, most enterprises (particularly in the public sector) and the administration became bloated with excess labor while they continued to experience low productivity levels. When the economy was deregulated and competition increased through the opening of the trade regime, the expected sectoral shocks and labor turnover occurred, a desirable outcome from an efficiency standpoint. However, a highly centralized and rigid labor market hindered mobility, shifts, reabsorption of displaced labor, and wage flexibility, which made the adjustment to a new equilibrium both costlier and longer. Increases in real wages and increasing incidence of heads of household unemployment, led to rapid surges in labor force participation particularly of women. In addition, the new exchange rate parity, decreases in the relative price of capital, low inflation, and nominal wage and labor market rigidities favored quantitative adjustments (reduction of labor force) over price adjustments. All those factors, led to record high levels of unemployment, reaching in October 1995, a recession year, an unemployment rate of 16.6 percent. Employment Performance2' 3.79 The increase in GDP during the Convertibility Plan period was accompanied by employment growth during the first two years of the Plan, 1991 and 1992, and a decline beginning toward the end of 1993 and continuing in 1994 and 1995. Despite the Argentine economy's impressive growth performance of 31 percent between 1991 and 1994, the increase in net jobs created for the period was only 3.7 percent (about 427,000). In 1994, a net decrease in total employment occurred of nearly 2 percent, despite GDP growth of over 7 percent. More distressing is that in both 1993 and 1994, the number of full time jobs decreased while the number of underemployed--which statistically are counted as "employed"--has increased by nearly 8 percent, particularly in the Greater Buenos Aires. Not surprisingly and consistent with global trends, employment shifted from manufacturing (19.9 percent) to services (61.4 percent). Also as expected, the sectors losing the most employment were the more vulnerable and less efficient tradeable sectors, such as textiles and clothing. Job creation, and particularly full time jobs, has been lagging behind. Job creation has mainly taken place in the food industry and 25. Some of the data on which unemployment and wage analyses are based are not always reliable, e.g., they may underestimate employment creation and earnings in relatively informal activities such as domestic service. Recent initiatives to improve labor market data are welcome steps in improving the reliability of data, especially for unemployment rates and duration. - 53 - service sector and mostly in small and medium size enterprises; however, it has not been nearly enough to cover losses in other sectors and to absorb increases in population and labor force participation. 3.80 The unemployment rate reached a historic high of 18.6% country wide and 20.2% in GBA in Unemployment Rates May 1995, accompanied by increased duration of Urban Cugbmeratsm rd Grealer B.A unemployment spells and structural unemployment. This increase was also related to significant increases in labor force participation in 1995 reaching levels of 2 45.9 percent. 3.81 The average duration of an unemployment spell has increase significantly reaching in 1995, over , 45 weeks, up from 32.2 weeks in 1994, and 12.9 weeks in 1991, with nearly 20% of the unemployed , remaining unemployed for over a year. This is a concern since long-term unemployment is far more ,34 +X/|d A- Q .W!1 '1Yk 7W b Al 5(. 3' 2 damaging than short-term. Those affected often ; 14 ,5 X VC7r (e-I C19 OEC M 1 iE3 .84 M05; Cos X CcO (.;1 0r NI : become separated permanently from the labor force. G Groaiw e A& - Urb8,C-r:.rrQraaD Since economic and sectoral adjustments are not yet completed, a return of employment output elasticity to Source data: INDEC its "normal" levels (0.30 to 0. 15) is still pending--for Figure 8 example, sectors such as financial and other services, commerce, agriculture, and some manufacturing are still in the process of restructuring and can be expected to further substitute capital for labor. Most sectors show employment contraction, with the exception of services and commerce. In the wake of the economic slowdown in early 1995, a number of yet unrestructured sectors have further reduced their employment levels (e.g., financial, commerce, and services), and labor force participation increased further, contributing to the further increase and records in unemployment. Table 16: Unemployment Rates by Age and Sex Category GBA, EPH OCT OCT MAY OCT MAY OCT MAY OCT MAY 87 91 92 92 93 93 94 94 95 Males 15-19 14.3 16.9 12.9 17.3 19.4 21.8 28.9 31.4 46.8 20-34 4.2 4.7 7.6 6.4 8.3 8.1 8.9 10.4 15.3 35-49 2.9 3.5 4.0 4.4 7.1 6.1 6.6 6.8 11.9 50-64 3.8 3.3 4.0 7.1 9.1 6.2 8.2 12.7 16.3 15-64 4.4 4.9 6.0 6.8 8.9 8.0 9.6 11.4 17.1 Females 15-19 17.3 17.5 21.9 14.3 33.0 40.3 33.0 38.9 58.9 20-34 7.3 6.7 9.0 7.2 13.7 12.6 12.4 15.1 25.2 35-49 4.2 3.9 5.8 4.2 7.9 10.5 10.4 13.2 19.0 50-64 3.0 2.8 2.2 5.7 14.2 5.4 11.9 10.2 17.4 15-64 6.3 5.9 7.9 6.4 13.2 12.6 13.3 15.4 24.8 ALL 5.1 5.3 6.7 6.6 10.6 9.8 11.0 12.9 20.2 Source data: INDEC-EPH - 54 - 3.82 The Govermnent has responded with labor institutional reforms and aggressive but not very efficient job-creation program, which accounted for nearly 50,000 jobs in 1993 and an additional 100,000 in 1994. Despite this effort, the employment\unemployment picture remains problematic. The data of October 1995, showing a decrease in unemployment to the 16.6% level, may indicate the beginning of a recovery. However, the decrease has been mostly due to a decrease in labor force participation from 45.9% to 44.2%, since there was no job creation to speak of from May to October 1995. Moreover, the October data indicates a jump in the unemployment rate of heads of households to 11.5 percent, up from 9.3 percent in May, and an increase in monthly unemployment insurance claims from 100,000 to 145,000. Wage and Earnings Performance 3.83 Despite the significant increases in labor supply and unemployment, real wages and earnings have been increasing steadily between 1991 and 1994, revealing an unresponsiveness to labor market conditions and a downside rigidity in real wage adjustment and premiums for scarce skilled labor. Only in the third quarter of 1994 did real wages for blue-collar workers in the manufacturing and construction sectors appear to show a slight decrease. The market now seeks highly skilled workers and younger skilled or unskilled, motivated, trainable workers to complement the newly acquired capital goods and to secure most needed higher productive efficiency. As a result, wage gaps and labor segmentation have increased significantly, as seen in the sharp increase in the return to tertiary education (reaching 25 % in 1994), and by continuous real wage increases for skilled positions. During the 1995 recession, however, preliminary indications suggest that wages did show some decline in real terms. Determinants of Unemployment 3.84 There are several factors contributing to the growing unemployment picture. The main determinants are: (i) the increase in labor force participation. The overall labor force participation rate increased from 40.8% in 1991 to 43.3% in 1994, to 45.9% in 1995 (May) and fell to 44.2% in 1995 (October). An important factor was the growing participation of women in the labor force, which increased from 43 percent in 1987 to 49 percent in May 1994 in the Great Buenos Aires area and from 24.7 percent in 1989 to 31.9 percent in the country as a whole; (ii) the changes in incentives and the competitive (trade) regime that caused significant sectoral shifts and firms to seek cost reductions and productivity gains (through labor shedding); (iii) failure of wages to adjust to labor market conditions (increase in labor supply and unemployment); the adjustments have been in the form of employment reduction rather than through wage reductions; (iv) the 40 percent decline in the relative capital-labor price since 1991, induced mostly by opening the trade regime, has furthered the replacement of labor with capital; (v) recent migration patterns from abroad had a significant impact (18%) on labor flows and labor force; (vi) significant mismatches between skills offered and those in demand; and (vii) excessive non- wage labor costs and institutional aspects of the labor market impose (selective) rigidities, discourage labor force expansion, and slow the speed of adjustment to meet observed sectoral shifts. 3.85 The institutional constraints with the greatest effect on wages and employment practices are: (i) restrictions on temporary or fixed-term contracts; (ii) significant mandated severance payments; (iii) centralized collective bargaining, particularly in the service sector, that denies firms geographical and subsector flexibility to respond to emerging needs and labor market conditions; (iv) the tendency to perpetuate lapsed collective bargaining agreements (most of which were negotiated during the hyperinflationary years) embedded in legislation that discourages renegotiation of collective bargaining agreements; (v) a significant level of nonwage labor costs, increasing labor costs over gross worker - 55 - remuneration by 53 %, and 72.4 % when measured in terms of labor cost per efficiency unit of time; (vi) the framework for employee accident compensation and lack of a regulatory framework for insurance, leading to an imputed cost on wages of 3 %, and excessively high risk-bearing, especially for small firms, which potentially after a few instances can bankrupt them (new legislation is now in congress to remedy this situation); (vii) coexistence of mandated severance payments and unemployment insurance at a cost to the firm of 6.5 % of gross wages. Real Earnings Prices Sept. 1989 Dollar Earnings Maiss 25-64 E PH IN DEC Maess25-64 EPH INDEC Source data: INDEC Source data: INDEC Figure 9 Figure 10 Prospects 3.86 Improvements in employment will come about only from increased economic activity, and particularly from lower labor costs, and increased flexibility in contracting and collective bargaining. .Since sectoral adjustments, technological replacements, and restructuring of firms are not yet completed, it is likely that without further labor reforms, the employment\unemployment picture might not improve m-uch in the short term (unless there is a sharp reduction in labor force participation as it occurred in the second semester of 1995). There are sectors--agricultural and livestock, financial and other services sectors (i.e., retailing)--that are only now beginning the restructuring process in earnest; in the course of this restructuring, there may be another wave of labor-shedding. Some sectors, such as pharmaceutical and cosmetics, vulnerable to competition, are replacing production lines with imported products, which also brings further reductions in employment. And perhaps of great impact is the replacement of obsolete capital stock (circa 1970), which accounts for over three-fifths of total stock, and has yet to be undertaken intensively. This, generating high labor savings will put additional pressure on employment levels. Moreover, the current labor force participation rate in Argentina, of 43.3 % is quite low by international standards and the country's level of development (Chile 58%, Mexico 59.9%, Uruguay 67.7%)"6, indicating likely continued increases in labor supply and thus further unemployment pressures. 3.87 On the bright side, there is room to decrease unit costs of production and stimulate economic activity, and thus job creation. The largest and potentially lasting employment initiative will come from labor policy reform. The Government of Argentina has already taken substantial measures to address the 26. Source: OIT, 1994. - 56 - unemployment issue, such as the passage of the Law of Modalidades de Contratacion, Law of PYMES, and Law of Seguros de Accidentes de Trabajo (Workmen Insurance Compensation), and geographically discriminatory reductions on labor taxes (reductions ranging from 30% to 80% starting January 1996, with the lowest reductions being in the GBA area which accounts for nearly 50% of total employment). Yet significant improvements still need to be made, to have an impact on the current employment/unemployment situation. 3.88 The following measures would improve the functioning of labor markets, lower the cost of labor, and thus increase employment levels. While current rates of unemployment are high, both for structural and cyclical reasons and short term prospects may be discouraging, the implementation of structural reforms and resumption of economic growth could reduce unemployment at a fast pace, as the Chilean experience of the late 1980s indicates. Recommended Course of Action Nonwage Labor Costs and Contractual Flexibility Reduce direct labor costs beyond the current 32% tax reduction. The current cost remains high by international standards and by the level of benefits secured. Consider extending fiscal exemptions (labor tax and unemployment insurance contributions) to (i) all persons up to the age of 24, who at the same time would be excluded from unemployment benefits and family allowances; and (ii) all long-term unemployed (over one year) for a one-to-two year period. These jobs might come at the expense of those already in low-paying jobs, so the number of workers experiencing short-term employment might rise; however, this is preferable to letting one group of increasingly disaffected workers languish on the margins of society. Permit the unrestricted use of temporary and fixed term contracts Unemployment Insurance and Severance Payments lThe unemployment insurance scheme is not financially self-sustaining. As eligibility and unemployment increased, the insurance program showed a current deficit of over US$28 million in 1994, and exceeded in 1995 as unemployment increased. The benefit levels will need to be reduced to minimum wage levels and adjusted for severance payment benefits, with the qualifying age for unemployment benefits raised to 24. Eliminate either unemployment insurance or severance payment obligations. Having both is counterproductive, in that it elicits two perverse incentives: it dissuades the unemployed from actively seeking employment and firms from adjusting their labor force optimally. Provided that the appropriate institutional capacity is secured, a more comprehensive unemployment insurance scheme should be developed. In the short term, limit the amount of severance payments to six monthly salaries for current workers; gradually, eliminate severance payment obligations; and eliminate all firms' severance payments obligations for new workers, and freeze severance payment obligations to now-employed workers at current levels. - 57 - Unions and Collective Bargaining Decentralize collective bargaining to the firm level. The power of the Ministry of Labor to authorize (i.e., extend to all members of the trade) collective bargaining agreements should be eliminated. This would necessitate modifying Laws 14250 and 23456. If maintained, it should enforce the uniform application of collective bargaining salary increase clauses to apply only in cases of productivity gains (currently unenforced). The concept of "ultractividad," which permits collective bargaining agreements to remain in effect in perpetuity, should be rescinded, i.e., once an agreement expires, all clauses lapse. Priority should be given to direct agreements between parties instead of agreements made outside the company (collective agreements of any other type, professional statutes or acts, etc.). This will require amending Law 20744. Eliminate the legal power of collective bargaining agreements at any level (activity or branch of activity, national, regional or local) to set contributions on the basis of profits, sales, or deposits in the financial system, with all dues binding on companies and workers not members of a Chamber or a union, which results from the official approval of the contract. The monopoly over the provision of welfare services for employees currently held by the unions should be eliminated, since it is expensive and service is poor. In its place competition among all service providers should be introduced. Wages, Workmen's Compensation, and Public Information * Minimum Wage. The current minimum wage (200 pesos) should be maintained until it reaches a minimum relationship of 3.5 relative to the average factory (blue-collar) wage (currently 3). Public Information: Disseminate information about rates of return to education. This should induce longer stays in school, reducing the supply of labor in the short term and increasing skilled labor in the medium and longer term. Develop within EPH a unit specifically dealing with the service sector. There is little information and analysis on the service sector, which is the only sector experiencing job growth, and now accounts for over 60% of total employment. Conclusion 3.89 While growth resumption should improve the employment outlook, it might not be enough, particularly in the short and medium term to have much of an impact on employment. The employment output elasticity for Argentina has been estimated at around 0.25, meaning that, ceteris paribus, to increase employment by 1 percent, a 4 percent GDP growth would be needed. To improve significantly the employment outlook, reductions in labor costs and decentralization of collective bargaining are the key policy reforms to consider. It has been estimated that a reduction of labor costs by 10 percent would - 58 - increase employment by between 5 percent and 10 percent, and a decentralization of collective bargaining to the firm level could, in the long term and based on international experience, increase private sector employment by between 15 percent and 30 percent27. Financial Markets 3.90 The dramatic macroeconomic reforms of the last four years created conditions for rapid economic growth. Investments necessary for such growth were largely financed by the return of flight capital, privatizations, and foreign capital inflows, which must be increasingly replaced by domestic savings. The simulations, provided earlier in this chapter, indicate the need for domestic savings to rise significantly by the turn of the century, with the share of private investments rising steadily. Thus, the ability of the financial sector to mobilize such savings and investments is pivotal to the realization of high levels of economic growth. 3.91 Argentina has both the need and potential for development of financial markets approaching developed country standards. Since 1990, the authorities has radically improved the regulatory and economic environment for banking and capital markets. By 1994, most of the "stroke of the pen" reforms were implemented with impressive commitment and dispatch. But problems arising from institutional (under)development, federal-provincial relations and public finance, and lack of market and product development have proven more intractable. 3.92 Thus, by 1995, financial markets remained shallow -- even by developing country standards -- as measured by banking system penetration, capitalization, trading, liquidity and volatility of marketable securities, new security issuance, number of listed stocks, presence of institutional investors, the size and liquidity of long term debt market, and variety of financial instruments. Intermediation costs, margins and inefficiencies were very high and acted as a strong deterrent to both savings and investments. Cost of credit was very high, the aggregate credit extension low, and access to formal credit particularly difficult for small businesses and farmers. Substantial improvements in collateral legislation and registries were still needed. Despite numerous banks (albeit small), competition was not deeply ingrained among banks, or between banks and capital market institutions and financial products. Severe structural problems remained in the banking sector, and to a lesser extent in the insurance industry, stock and bond markets, and in government securities market. While substantial progress was made in enabling legislation and regulation in several of these areas, regulatory capacity and enforcement standards remained deficient in most of them. 3.93 The events following the Mexican peso devaluation have further weakened the financial sector considerably and exposed its vulnerability. They reversed the deposit growth (currently deposit levels regained lost ground), shortened the maturity of deposit base, and subjected a fragmented banking sector to significant problems of liquidity, solvency (for some institutions), and systemic confidence. On the positive side, they have also unleashed substantial banking sector reforms and concrete measures to help consolidate the banking system. 3.94 In this context, the primary financial sector objectives include: (i) consolidating confidence, liquidity and solvency in the banking system by an orderly transfer of assets and deposits from weak banks to stronger ones; (ii) raising the volume and maturities of savings and loans; (iii) augmenting the 27. W. Bank study on "Analysis of Impact of Labor Policy Reforms in Argentina". - 59 - access to credit, particularly by small and medium enterprises; (iv) improving further the supervision and regulation of the banking sector and capital markets; and (v) deepening capital markets and expanding the choice of financial instruments. This strategy calls for strong support for the Argentine Government's efforts to safeguard its banking system and invigorate its capital markets. The Banking Sector 3.95 Argentina's financial sector consists primarily of commercial banks, which are allowed to extend a full scope of financial services. Consolidation of the banking system, which proceeded at a fast pace following the financial crisis of the early 1980s, slowed after 1990, as economic stabilization and remonetization increased the capacity of commercial banks to mobilize deposits and increase their lending. Nevertheless, macroeconomic stabilization, financial sector policies, and improved regulation and supervision encouraged banks to become more efficient, and larger institutions gained in market share. Since 1994, the pace of commercial banks consolidation has resumed as deposit growth has declined, and is expected to continue in the foreseeable future, stimulated further by the flight to quality of deposits during the recent crisis. 3.96 The recent crisis has accentuated the fragility of Argentina's smaller banks, and is accelerating the process of consolidation. During 1995, eighteen banks were intervened, of which four are under liquidation, eight were suspended and the remaining six are undergoing workouts at various stages of completion. By December 1995, there were 164 financial institutions operating in the Argentine market, down from 203 in December 1994, as a result of mergers and closures. Of those institutions, 132 were commercial banks which accounted for 94 percent of total financial sector assets. The remaining institutions were finance companies or savings institutions that do not offer checking account services. Overall, in 1995 private banks accounted for about 60 percent of total assets and deposits. The 9 largest private banks accounted for between 27 and 28 percent of total assets, loans and deposits. The entire sector suffers from excessive fragmentation (of the six leading Latin American countries, the Argentine banking sector has the least degree of concentrationr), low penetration29, excessive operating costs, high financial spreads, lack of economies of scale (the two largest banks have assets of less than $5 billion, and only six have more than $1 billion), weaknesses in the interbank market (during the crisis, wholesale banks had no funding sources, and many were closed), and slow pace of innovation (Argentina is well behind Chile and Brazil in electronic banking and other cost-cutting technological innovations). These structural problems--compounded by inadequate lender of last resort capacity--have contributed to the liquidity crisis following the Mexican peso devaluation. 3.97 From a capital viewpoint, the ten largest private banks would be best placed to act as acquiring banks in merger transactions. Some large banks are undertaking acquisitions, including acquisitions of selected assets and branches of regional banks. The more likely acquirers are intermediate-size banks wishing to increase market share, although caution should be exercised not to create larger weak banks. A small number of banks may also be capable of restructuring themselves with outside financial assistance. The restructuring and consolidation of private banks could be facilitated through the Bank Capitalization Trust Fund. 28. As measured by the Herfindhal-Hirschman Index 29. As a ratio of deposits to GDP. - 60 - 3.98 Dealing with public banks has proven to be one of the more difficult and intractable challenges for Argentina's financial policy. The performance of provincial and municipal banks has been modest or downright poor (many provincial banks are technically bankrupt). As public banks were created by federal or provincial/municipal laws, any amendment of such laws requires the approval of the respective legislature. In the past, the large majority of provincial legislatures has resisted enacting privatization laws. At the start of 1995, Argentina had 32 federal, provincial, and municipal banks. In the course of the 1995 and the first quarter of 1996, financial crisis, however, when the financial burden of these banks became too onerous to bear, 9 provincial banks were privatized. From the remaining 15 banks owned by provincial governments, 10 are under way of privatization. Provincial and municipal banks not in the process of privatization, however, still account for 69 percent of total provincial and municipal bank assets. Together, as of September 1995, all public banks accounted for 41 percent of the system's assets, 43 percent of net loans, 40 percent of deposits and almost 49 percent of shareholders' equity. 3.99 Overall, private banks performed better than public banks. Non-performing private bank loans amounted to about 9 percent of total lending in 1994, far less than the 25 percent in public banks. The activities of public banks distort financial intermediation, essentially by directing funds to less profitable activities for which private banks will not lend. Furthermore, provincial banks cannot be closed by the Superintendency of Banks when regulatory requirements are not met, as can privately-owned banks. The provincial banks' adverse effects on financial sector efficiency are exposed by their sustained losses, non- competitive allocation of credit, high cost of funds and excessive employment. Poor credit decisions are manifested in their large reported non-performing portfolio which exceeds by far non-performing portfolios in other categories of banks. Moreover, provincial bank credit allocation to inefficient activities, including provincial governments and public provincial enterprises, reflect the lack of arms- length relationships, thereby deflecting the supply of credit away from productive activities. 3. 100 The recent financial crisis, affecting both provincial governments, and the federal government's ability to assist them, created a unique opportunity for the restructuring of provincial banks, since they have become a net liability to provincial finances. It is imperative that the federal Government resist any fiscal support that would prop up provincial banks, and guide provinces to the utilization of existing facilities, i.e. the Provincial Development Trust Fund, which provide financing conditional to the restructuring of such banks. Provincial governments should preferably sell all their shareholdings in provincial banks; as a minimum, they should sell a majority share of such banks and transfer control to private shareholders. Through privatization it is expected that the newly emerging private banks will focus on profit maximization and financial soundness and that the Central Bank supervision and enforcement of liquidity, capital adequacy, and provisioning requirements for these banks will be more effective. 3.101 With forceful implementation of prudential norms, and greater competition, the number of Argentine banks in the coming five years may be halved from those at the beginning of 1995. Such consolidation will still leave Argentina with proportionately more banks than in Mexico, Chile or Brazil, and thus is not likely to reduce competition. The retrenchment would force the banks to cut costs, rationalize their branch networks and introduce better technology. However, at present only about six of the banks are publicly listed, and progress in terms of greater public shareholding, reduction of family controls and professionalization of top management will take longer. 3.102 It is recommended that the restructuring of private banks proceeds on an accelerated basis, with the assistance of the authorities' Trust Funds created for that purpose, in order for the financial system to recover from the recent crisis, and better prepare it to address any future occurrence of external - 61 - shocks. Delays in that restructuring could unduly postpone the recovery of deposits growth in the financial system, and, more importantly the resumption of credit expansion. 3.103 The authorities could strengthen the private banks' incentives for cost cutting in two ways. First, through rigorous enforcement of prudential norms -- particularly of loan classification, provisioning and bank rating. Such enforcement would ultimately cause cost-inefficient banks to raise additional equity which may lead to new owners, better management, mergers and greater economy of scale, or better business strategies. Second, the authorities can increase competitive pressures on the banks by dismantling barriers to competition (i) among banks, (ii) between banks and capital market products and institutions, and (iii) encouraging competitive "shopping" and pressures from bank clients. Restrictions on branch expansion, new entry, foreign banks, and money market funds have been liberalized since 1994. However, those on leasing, securitization by non-banks, commercial paper and private placements continue to protect the banking sector and should be eased. "Truth in lending" type statements -- for mortgage and other consumer loans -- need to be instituted to facilitate greater consumer awareness and comparison shopping by clients. 3.104 The current consolidation plans will not remove all of the "overhang" of weak institutions. Once the crisis is under control, the Government need also commit to the privatization of federal banks, including Banco de la Nacion, and should start implementing credible restructuring plans to facilitate such privatization. 3.105 To summarize the main recommendations for banking sector reform, with the view to meeting the objectives in paragraph 3.93 above, it is worth emphasizing the need to: Facilitate/promote the accelerated restructuring and consolidation of private banks, through, among others, (a) adequate funding of the Bank Capitalization Trust Fund; (b) further strengthening of the Superintendency of Banks' institutional development; (c) elimination of regulatory forbearance; (d) the legal strengthening of the Central Bank's inspection and enforcement authority; (e) encouragement of bank merging with stronger institutions; and (f) further strengthening of the institutional capacity of the Bank Capitalization Trust Fund. Reduce banking costs and spreads through (a) the reduction of taxes on financial transactions; (b) dismantling barriers to competition, including the liberalization of restrictions on leasing, securitization by non-banks, commercial paper and private placements that protect the banking sector; (c) the establishment of a continuous and liquid benchmark yield curve through the programming of T-bill issuance; (d) the creation of a central risk reporting entity; (e) strengthening the functioning of the Deposit Insurance mechanism; (f) instituting "truth in lending" type statements for mortgage and consumer loans; (g) facilitating the use of collateral; and (h) improving credit analysis capabilities of banks through better training, and introduction of greater automation and other industry related technological innovations. Facilitate the privatization of provincial banks or their closure by (a) adequately funding of the Privatization Trust Fund; (b) resisting any federal fiscal support that would, directly or indirectly (through the provincial governments), prop up provincial banks, including the restructuring of their debts and access to coparticipated guarantees; and (c) strengthening the Superintendency of Banks' legal capacity to enforce prudential norms on provincial banks. Proceed with the privatization of federal banks, which control a significant portion of the banking system, to reduce distortive allocation of financial resources. - 62 - 3.106 Finally, it is worth emphasizing the relevance of macroeconomic conditions and framework in the performance and prospects for development of the financial system. Taking the Convertibility framework as given, this economy, in its limited ability to provide a lender of last resort function, remains vulnerable to abrupt shifts in capital flows which endanger the stability of the banking system. A number of alternatives may strengthen the lender of last resort capacity of the system, beyond those currently in existence: (i) the Central Bank may want to explore entering into a swap arrangement with other Central Banks, the BIS, or other multilateral institutions that can act as lenders of last resort; (ii) during the recent crisis, pre-existing high reserve requirements acted as a shock absorber to the capital outflow, easing the demonetization of the economy. In order to improve the response capacity of the financial system to other systemic capital outflows, it may be desirable to impose even higher reserve requirements, possibly reaching gradually 100 percent of short term deposits. While this will increase direct costs to the financial system, higher reserve requirements will reduce other risk-related costs to the system; (iii) the financial system may gravitate towards multinational financial institutions, if it is perceived that foreign parent companies will provide a lender of last resort function to their affiliates; and (iv) build over time significant excess international reserves, primarily through public sector surpluses, so that the public sector does not become, during crises, a net drain to the system. The Capital Markets 3.107 Although Argentine capital markets are relatively under-developed, some two-thirds of all Argentine financial assets (certificates of deposit, bonds, stocks, mutual funds, etc.) are already in the form of capital market securities. Capital markets will play an even greater role in aggregate financial intermediation, in improving cost-efficiency of such intermediation, in reducing cost of capital, and ultimately in realizing national investment and economic growth targets. While the recent crisis makes the banking sector the short term focus of regulatory attention, in the long term the development of capital markets will be equally critical. 3.108 Stock Markets At about 160, the number of listed stocks in Argentina is very small, new equity issuance even smaller, and the number of actively traded stocks is less than 30. The principal issuer- related problems are the owners' unwillingness to dilute control, the deeper problem of underreporting of assets and profits by some of the small and medium businesses, the lack of profitability of many industries during the structural adjustment process, the unused debt capacity of many corporations, and the high concentration and fragmentation among issuers. The major institutional and market-related problems are the prevalence of insider trading and speculation, the consequent skepticism of equity financing and investment, the lack of market makers, the underdevelopment of investment banks, and lack of liquidity in all but the top 20-30 stocks. The principal regulatory problem remains the delay in enactment of a modern insider trading law. Issuance and transaction costs, taxation, and listing requirements are no longer important problems. 3.109 The suggested remedies include passage of strict and effective insider trading laws (a bill has been submitted to Congress), more stringent disclosure and penalties for insider violations; the enactment of modern standards of due diligence and liability for corporate executives, accountants, lawyers and investment bankers concerning new security issuance; enforcement of full corporate income disclosure through vigorous enforcement of income tax laws (particularly among companies with listing potential) and improvement in auditing standards and responsibility; the education of controlling shareholders concerning the issuance and wider distribution of new equity and further improvement in disclosure standards; and possible introduction of market maker functions to improve liquidity. - 63 - 3.110 Bond Markets, Commercial Paper Markets, and Private Placement Bond and commercial paper markets suffer from more serious legislative hurdles at present. The Argentine law offers a very favorable tax treatment to publicly offered securities, for which a regime of public offer, listing, prospectus, and mandatory rating requirements is specified. These provisions are excessive and somewhat incompatible with the development of private placement and commercial paper markets where corporate borrowers can obtain short term finance at competitive rates primarily from institutional investors. These hurdles raise the cost of borrowing, particularly for small and medium companies, for whom the institutional rather than retail investors are the natural funding source. They also reduce the ability of institutional investors, all of whom are poised to grow, to compete effectively against commercial banks. 3.111 It is recommended that the authorities modify the Negotiable Obligations Law to pennit true private placement of bonds, commercial paper and other securities with substantially the same tax treatment as that of publicly offered securities, with reduced prospectus, rating and other disclosure requirements to qualified institutional investors along the lines of US SEC Rule 144-A; remove or substantially relax the public offer, listing, and rating requirements from short term (below 1 year) commercial paper; relax the mandatory rating requirements on issuers after the rating agencies have had a chance to establish themselves; and permit rapid enforcement of pagares and other floating rate claims not meeting the definition of negotiable obligations through the acci6n ejecutiva process. 3.112 All debt markets suffer considerably from the problem of inadequate interest rate benchmarks--a lack of a continuous and liquid benchmark yield curve--which causes great confusion in interest rate determination and permits lack of competition among banks. Due to historical accidents, the bulk of sovereign debt has been issued in various debt conversion bonds, and with numerous variations of terms. As a result, sovereign debt with very similar maturity and financial terms tends to trade at yields as much as 10-15 percent apart. Absent a Central Bank discount rate, secondary yield of Treasury securities must provide such a benchmark rate. To establish a continuous and liquid market that can generate a good benchmark, T-bill issuance needs to be programmed, with regular issuance of similar quantities with homogenous terms. There are great benefits to consolidating much of government debt, or swapping it through market operations, into homogeneous securities. It would also be useful to issue them through discriminatory price auctions to 15-30 pre-qualified primary dealers, with the non-competing bids being accepted for retail investors only 30. D. End Note 3.113 The Covertibility Plan has produced a fundamental restructuring of the Argentine economy, and sown the seeds for high and sustained economic growth. The recent Mexican crisis, has shown that, despite the social cost that this external shock has created, domestic confidence in the Convertibility Plan has remained high. To alleviate the social cost of that crisis, it is imperative to resume economic growth in an environment of greater flexibility of factor markets, labor and capital. Additionally, economic reforms in the provinces have to match a renewed federal effort to invigorate the state apparatus, and regain fiscal strength. Policy consistency and coherence, which were probably the biggest achievements of the current Administration in its successful effort to overcome the greatest challenge so far to this Plan, will remain the linchpin to future economic recovery and growth. 30. A detailed discussion of Stock and Bond Markets, Trading and Settlement Systems, Asset Backed Securitization, Pension Funds, the Insurance Sector, and Mutual Funds, with policy recommendations, can be found in "Argentina: Capital Markets Study", World Bank Report No. 12963-AR. IBRD 26842 'i70 \ BOLIVIA 60° 50' PARAGUAY Sn Salvodor EJ de Jujuy Sahlta 0Tucumn6n Santiago Resistencca% B RAZ I L I del Estero 0', Posoda Catomarca SD Es La Rioia0 '' 30'- / && La Plato Santa Rosa u L Mar del Platao0 \J _, Bahia Blonca o 7 / Neuquene J U J ^.< j ~~A R G E N T I N A _' Cormende 0 Selected Cities 40 PatagonesPrvneC picl V edma S Province Capitals National Capital , + i Rawsoni .. fiA- . Province Boundaries International Boundaries MILES 0 100 200 300 400 500 KILOMETERS 0 200 400 600 800 FALKLAND ISLANDS (MA LVINASJ 50 5 Rio Gallegos' r The boundories, colors, 50 - 0 's--(b-G denominations and any other information shown 51fieJn5 lF.'S eCIr.'NCG S 0TY over rHe on this man do not U r AOICISrTers imply, on the part of The World Bank Group, any judgment on the legal stotus of any territory, -ushruiuq or any endorsement or acceptance of such L_=A 19boundaries. 80' 70° ' 60' 50 I - - I I - - I ~~~~~~~~~~~~~~~~APRIL I 9975 "No I r 44