Report No. PID7126 Project Name Argentina-Special Repurchase Facility Support... Loan (REPO) Region Latin America and the Caribbean Sector Finance Project ID ARPE62992 Borrower Argentine Republic Implementing Agency Banco Central de la Republic de Argentina Address: Reconquista 266 (1003) Buenos Aires, Argentina Dr. Pedro Pou, President Telephone: 54-1 348-3715 Fax: 54-1 394-0976 Date PID Prepared November 13, 1998 Appraisal Date September 1998 Board Date November 10, 1998 1. Country and Sector Background - The Convertibility Plan: Argentina's reform agenda builds upon a successful program of reforms accomplished under the government's convertibility plan. The plan , launched in March of 1991, consisted of the following five main pillars: (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; and (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. Entry into MERCOSUR followed. 2. The monetary reform established a currency board-type arrangement and full convertibility of the peso. The monetary base must be backed by foreign exchange reserves by at least a two-thirds ratio (up to one-third may be dollar-denominated government bonds), thus strongly restricting financing of fiscal deficits. 3. Long-sought stabilization of prices followed the implementation of the reform. The fiscal, public sector, and social security reforms led to a re- definition of the role of the state, dramatically improving economic efficiency and allowing the government to focus on the core social safety net and regulatory functions. Trade reform allowed local companies improved access to state-of-art foreign technology, and it unleashed a renewed dynamism in exports, with exports doubling from 1992 to 1997. The immediate impact on economic performance was to achieve average annual GDP growth of 8.5 percent over the 1991-1994 period. Consumer price inflation fell to less than 4 percent by mid-1994. 4. The 1994-1995 Regional Crisis: Argentina's macroeconomic stability depends on both foreign and domestic confidence in the currency board arrangement instituted under the convertibility plan. Under this system, a decline in international reserves translates into a monetary contraction, as occurred in 1995, during the aftermath of the Tequila crisis. As a consequence, there is a symbiotic relationship between the convertibility plan and the financial system, requiring strength to the financial system. Weaknesses in the banking system were quickly revealed in 1995, and emergency actions were required to stabilize the situation - with support from the IMF, IDB and the Bank. The economy contracted by 4.0 percent in 1995, and the unemployment rate soared to 18.4 percent. Nevertheless, the government's commitment to the currency board arrangement was reaffirmed and the Convertibility plan emerged stronger from that crisis. 5. Argentina's reaction to the 1995 crisis sent strong signals to the markets about its long-run credibility. This was specially true with respect to its decisions to: (a) remain with the currency board despite a rapid decline in the money supply and high unemployment; (b) allow some banks to fail and some bank depositors to lose money; and (c) react to the crisis by tightening market discipline over banks and moving to strengthen the credibility of the currency board (for example, by moving bank and Central Bank effective 'reserves' offshore). Even at the worst moments of the 1995 crisis, the Convertibility Law (in particular its mandated coverage of high powered money by international reserves) was never breached. While at the height of the crisis usage of dollar denominated bonds reached its legal limitations as a share of total reserves, the usage of bonds was quickly reduced following the crisis. 6 Aftermath to the 1995 Crisis: Despite serious prior efforts to strengthen the financial system, the 1995 crisis increased the urgency for reform since the financial system came close to the point of collapse. As a result, following the crisis, Central Bank authorities took a number of measures to build on the growing strength of the banking system both from the regulatory and supervisory perspectives (which also mitigate the need for lender-of-last-resort functions), and increasing the liquidity in the system, actual and contingent. 7. Recent Economic Performance: Investment-led growth returned quickly following the 1995 crisis. The Argentine economy expanded by 4.8 percent in 1996 and by an impressive 8.6 percent in 1997. By May 1998, the unemployment rate had improved to a still-high 13.2 percent. Preliminary estimates for the first half of 1998 indicate GDP growth of 7 percent. 8. External Balance: After running small trade surpluses in 1995 and 1996, a trade deficit of under 1.5 percent of GDP appeared in 1997, partially driven by booming imports of capital goods. So far in 1998, there has been a further deterioration in the trade balance, as well as some deterioration on services accounts. The current account deficit reached 3.5 percent of GDP in 1997, and it could reach about 4.3 percent of GDP this year. About one-third of the current account deficit was financed by foreign direct investment in 1997, and this share may be maintained this year. - 2- 9. Improved Fiscal Balance: The government has attempted to relieve demand pressures on the current account through an improved fiscal balance. The overall public sector deficit (federal plus provincial) has declined from just over 3 percent of GDP in 1996, to about 2 percent in 1997. The federal deficit, driven largely by the transition costs of the newly "privatized" pension system, constituted about three-fourths of that deficit, while the provinces' deficit constituted one-fourth. For 1998, the consolidated fiscal deficit is projected to fall to about 1.5 percent. 10. The Current International Financial Instability and Its Impact on Argentina: The recent turmoil in international financial markets is having an impact on the Argentine economy in various ways: the temporary closing of access to foreign borrowing; a fall in the prices of major exports; and a sharp decline in the local stock market. Confidence in the currency board and in the banking system, however, remains strong. International reserves have held fairly steady, at about $24 billion. Although this level is slightly lower than the $25 billion reached in early August, it is still about 7 percent higher than the level of reserves held at the end of 1997. Deposits in the banking system have also held steady, but the rapid expansion of credit in the first half of 1998 has now slowed to near zero. 11. Argentina is highly dependent upon access to international capital markets due to its large foreign debt relative to its export base. Foreign debt service-to-export ratios for upcoming years are projected to be over 60 percent, despite the lengthening of maturities of public external debt. Prior to the current crisis, Argentina had been able to lengthen the average maturity of its stock of public debt to over eight years. In recent weeks, however, foreign private lenders have expressed no interest in extending new credits to emerging markets, including Argentina. Although the export base doubled from 1992 to 1997, exports of goods and non-factor services represent only about 9 percent of GDP, up from 6.3 percent in 1993, and it will take sustained fiscal discipline and continued productivity improvements to lower Argentina's high debt-service-to-export ratio. 12. The adoption of important reforms in the financial system, further fiscal strengthening, and the deepening of structural reforms, have been instrumental in deflecting the critical early stages of the recent Asian crisis. Despite the decline in equity and bond values, and the initial brief dip in reserves, the financial markets have remained relatively stable. The government has taken additional fiscal measures, reducing in August planned expenditures in 1998 by one billion pesos from what was approved in the 1998 budget. These same levels - or less if need be--were presented to Congress in the draft 1999 budget. This has sent a clear signal to the markets that the government is prepared to maintain fiscal discipline. 13. With markets closed and capital flows disrupted, Argentina will not be able to finance its deficit and refinance its external debt as maturities come due. In order to make these payments, there would have to be a significant contraction in international reserves, starting in the fourth quarter of 1998. Such contraction would produce a severe recession, increases in unemployment, and would result in fiscal cuts that would go beyond what is feasible or advisable given the timeframe available for making the adjustment. Such drastic action would result in the curtailment of government services and critical social programs. The significant loss of reserves would threaten monetary and fiscal stability. The financial system would come under stress. - 3 - 14. To avoid this severe scenario, the government has requested extraordinary assistance from the Bank and IDB. The request is based on the country's strong track record in undertaking reforms and the quality of its macro- economic policies. It is also prepared to undertake additional measures to advance to the next stage of structural reforms. With the requested assistance, the government would be able to bridge the immediate disruption of the international capital markets and mitigate the effects of the financial crisis on the economy, especially the poor and vulnerable groups. 15. Loan Objectives - The SSAL, in conjunction with the REPO loan listed below, will support the continued efforts of the Government of Argentina to transform its economy and to protect gains achieved thus far. The project's operations are preventative, aimed at mitigating the deleterious effect of the current international financial instability on the economy and protecting vulnerable groups. This project will help meet critical foreign exchange needs of the Government and will allow it to remain focused on longer term reform issues. 16. In conjunction with the SSAL, the Special Repurchase Facility Support Loan (REPO) will strengthen the Argentine financial system's safety net and will safeguard economic and social achievements. 17. Project Description - The US$2.5 billion Special Structural Adjustment Loan (SSAL) consists of a package of reforms in four main areas: (a) stimulating confidence in the domestic banking system, deepening the capital markets, expanding access to credit, especially for small- and medium-scale businesses; (b) enhancing the efficiency of regulatory institutions; (c) strengthening intergovernmental fiscal relations; and, most importantly (d) the reform package also has measures to safeguard current social protection programs, which in a time of financial stress might be vulnerable, and to advance reforms in health and education. 18. The Repo facility allows the Central Bank to engage in repurchase transactions with a syndicate of commercial banks in the event of a crisis. The US$500 million Special Repurchase Facility Support Loan (REPO) would be made to the Argentine Republic, with the proceeds made available by the borrower to the Central Bank. The proceeds could be drawn only if and when the repurchase facility is triggered, and would be deposited in a special account at the Central Bank to be used only by the Central Bank to meet margin calls or repurchases from repo buyers (or to invest in highly liquid securities during periods when margin calls are not necessary, with proceeds to be redeposited in the special account). If the margins move favorably, the reflows would replenish the special account. If the repo facility is not used, the loan would not be drawn and could be cancelled upon request by the borrower. 19. Financing - The SSAL would be a three-tranche loan of US$2.5 billion. The first tranche of $1.0 billion would be made available upon effectiveness, in November 1998. The second tranche for $1.0 billion would be anticipated for March 1999, and the third tranche of $500 million, no sooner than July 1999. 20. The contingent REPO loan of US$505.05 million would be made to the borrower Argentine Republic, with the proceeds made available by the Central Bank. Both loans carry special financing terms, and are part of a coordinated - 4 - multilateral support effort. 21. Project Implementation - For the SSAL, proceeds will be disbursed against satisfactory implementation of the adjustment program, including compliance with stipulated tranche release conditions. In the case of the contingent loan to support the repurchase facility, proceeds would be disbursed only if the repurchase facility is activated and if the SSAL is effective. Tranche release review and program supervision will ensure that the program supported by the SSAL is carried out as agreed. 22. Lessons Learned from Past Operations - Argentina's record in satisfying the conditions of Bank adjustment loans has been excellent. The Bank has extended US$3.8 billion in nine such operations since 1990. Completed adjustment operations--Public Sector Reform Loan (Ln. 3394-AR), Public Enterprise Reform Loans I and II (Ln. 3291-AR and Ln. 3556-AR), the Financial Sector Adjustment Loan (Ln. 3558-AR), the Provincial Pension Reform Loan (Ln. 4116-AR) and the Provincial Reform Loan ( (Ln. 3836-AR)--met all major objectives in a timely manner. The Provincial Bank Privatization Loan (Ln. 3878-AR) and the Banking Sector Reform Loan (Ln. 3926-AR) are both fully disbursed. The Second Provincial Performance Loans (Ln. 4218-AR, Ln. 4219-AR, Ln. 4220-AR, and Ln. 4221-AR) and Health Insurance I Loans (Ln. 4002-AR and Ln. 4003-AR) are still under implementation and are being implemented satisfactorily. 23. Poverty Category - Program of Targeted Intervention 24. Environmental Aspects - In accordance with the Bank's Operational Directive on Environmental Assessments (OD4.00, Annex A), the operations have been placed in Category "U" and do not require an environmental assessment. 25. Program Objective Categories - Economic Management/Poverty Reduction 26. Benefits - The SSAL loan will help meet critical foreign exchange needs of the Government of Argentina, and allow it to remain focused on longer term reform issues. This would prevent the drastic negative impacts, especially on vulnerable groups, that the abrupt absence of external financing would have on the economy and the social gains achieved thus far. In conjunction with the SSAL, the contingent loan in support of the "repo" facility will strengthen the financial system's safety net and similarly contribute to safeguarding economic and social achievements. 27. Risks - A risk is that reforms could be delayed due to the upcoming elections. However, this is offset by the sense of urgency and consensus that measures must be taken to avoid a repeat of the impact of the Tequila crisis. In addition, if access to international capital markets is not restored by mid-1999, the financial package currently assembled might not be sufficient to meet external needs resulting in a severe economic adjustment. The Bank and the other international financial institutions will continue to work with Argentina, as well as globally, to react to any deepening of the financial crisis. Contact Point: The InfoShop The World Bank 1818 H Street, N.W. Washington, D.C. 20433 - 5 - Telephone No. (202)458 5454 Fax No. (202) 522 1500 Note: This is information on an evolving project. Certain activities and/or components may not be included in the final project. Processed by the InfoShop week ending December 4, 1998. 1/ Two prior (1989) pieces of legislation had opened the road to deregulation and privatization: "Ley de Emergencia Economica,"and "Ley de Reforma del Estado." - 6 -