Report to the Executive Directors Argentina - Buenos Aires Infrastructure Sustainable Development Project (Loan 7268)

1. The purpose o f this report i s to inform the Executive Directors about the implementation status and the decision taken by Bank Management to activate the water and sanitation component under the referenced project, the f i rst phase o f an Adaptable Program Lending (APL) Loan to the Province o f Buenos Aires (PBA) approved by the Board on December 7, 2004 (Report No. 29432-AR). During Board presentation o f the referenced project, the Executive Directors requested to be informed about the status o f overall fulfillment o f the conditions under the loan and, in particular, the latest developments on the water and sewerage components, including relevant legislation, regulation, and the status o f concession renegotiations. The report i s divided in three sections: (i) recent economic developments in the PBA; (ii) status o f project implementation and recent developments in the roads and water components; and (iii) progress in the renegotiation o f water concessions.

I. Recent Economic Developments in the PBA

2. The PBA is benefiting from strong economic performance as it continues to recover from the 2001-02 economic crisis. The Province was hit hard during the crisis, wi th above-average increases in unemployment and poverty, and a steep decline in income per capita (Table 1). The social situation was compounded by the fact that, prior to the crisis, the Province already suffered from social indicators below the average for Argentina as a whole. Today, following three consecutive years o f sustained economic growth above the national average, the real GDP o f the Province i s estimated to have recovered to pre-crisis levels. The unemployment rate has declined to 12 percent, down from over 20 percent during the crisis and below i t s pre-crisis level. Poverty has also declined but remains very high, affecting some 45 percent o f the provincial population as o f June 2005.

Table 1: Province of Buenos Aires Economic Indicators 2000 2001 2002 2003 2004 2005e

Economic Activity Real Provincial GDP growth, percent Provincial GDP as a share o f National GDP, percent

Social Indicators Unemployment Rate, percent 1\ GDP per capita in Buenos Aires, USD thousand Poverty Rate in Greater Buenos Aires, percent 2\

Public Sector Finances 3\ Revenues, AR$ bn. Primary Expenditures, AR$ bn. Primary Balance, AR$ bn.

Primary balance as a percentage o f national GDP Primary balance as a percentage o f Buenos Aires GDP

Public Debt incl. Past due interest, USD bn. 4\ Pubic Debt, percentage o f Buenos A i m GDP

-2.0 -5.0 33.8 34.0

16.7 20.8 7.0 6.6

35.0 43.2

9.1 7.9 10.6 10.4 -1.5 -2.5

-0.5 -0.9 -1.5 -2.7

6.9 10.9 7.2 11.9

-10.6 10.6 9.9 9.0 31.1 33.9 32.8 33.4

20.4 17.8 14.9 12.0 2.5 3.1 3.6 4.2

64.4 61.3 50.9 45.1

8.8 11.5 15.4 19.6 9.6 11.2 14.4 18.9

-0.8 0.3 1.0 0.7

-0.3 0.1 0.2 0.1 -0.9 0.3 0.7 0.4

8.4 10.2 11.1 11.3 26.5 23.1 22.1 18.8

I\ Unemployement reported in 2005 is as of the 3rd quarter, as estimated by Indec. I t includes recipients of the Heads ofHousehold Program as employed The national unemployment rate under this definition in third quarte 2005 was 11 1 percent 2\ Poverty rate of Greater Buenos Aim, excluding the Capital city Data for the first semester of each year Starting in 2003 unemployment rates are calculated based on a new methodology set by Indec.

3\ As reported in the Ministry of Economy website. Estimates for 2005 by World Bank staff, except for Fiscal Outcomes which 41 Debt stock reported is prior to debt restructuring, as this was legally settled in January 2006. The estimated debt stock aRer rebtructuring i s UWO billion. Source: MinistryofEconomyofArgentina, MnistwofEconomyof theprovince ofBuenosAires and WorldBank estimates.

35304

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

3. Improved public sector finances have been a key pillar underpinning the Province’s recovery. The provincial authorities responded to the economic crisis with a major adjustment in the Province’s fiscal stance. Primary expenditures were cut by some 10 percent in nominal terms between 2000 and 2002. Revenues began to increase sharply in 2002 and more than doubled in nominal terms by 2005 fueled by a combination o f the recovery in economic activity and a p ick up in inflation. Primary expenditures recovered in 2004 and 2005 with growth rates o f 29 and 3 1 percent in nominal terms, respectively (23 and 19 percent in real terms). As a result, the Province has generated small primary surpluses o f 0.7 and 0.4 as a share o f Provincial GDP in 2004 and 2005, respectively, in sharp contrast to the persistent deficits recorded earlier. The Province has adhered to the Fiscal Responsibility Law (FRL), approved in 2004 in an effort to establish an intergovernmental framework for maintaining fiscal discipline.

4. As part of the fiscal turnaround, in December 2005, the Province successfully completed a restructuring of its public debt. The restructuring offer covered exchange o f US$2.7 b i l l ion o f debt principal in default, and included the recognition o f past due interest up to December 2001 plus additional 2 percent interest on capital in default through 2002-2005, for a total recognized interest amount o f about US$400 mill ion. Total acceptance o f the debt exchange offer was 94 percent. New bonds and amounts issued were: (a) US$1.1 bi l l ion o f long-term par bonds, (b) US$ 750 mi l l ion o f medium-term par bonds, and (c) US$500 mi l l ion o f discount bonds. The f i rst two instruments offered no reduction in capital, while the third offered a reduction in capital o f 61 percent. The offer involved an estimated reduction o f about 50 percent in net present value terms at a 10 percent discount rate. The terms and outcome o f the exchange differ substantially f i om those o f the Federal government debt exchange in 2005 which involved an estimated reduction o f 75 percent in net present value terms and resulted in a 76 percent participation rate (Table 2). In addition to about US$170 mi l l ion in holdouts fkom the exchange, the Province remains in arrears with bilateral creditors for approximately US$136 mil l ion (taken together, this represents about 3 percent o f total provincial debt). The estimated debt stock after debt restructuring i s about US$lO bi l l ion (including debt arrears), down from an estimated stock o f US$11.3 b i l l ion as o f end-2005, that is, before the debt exchange settlement.

Table 2: National and Buenos Aires Province Debt Restructuring Amount in Participation Estimated Default I\ in debt exchange NPV reduction 2\ (US$ bn.) (percentage) (percentage)

Federal Government 102.6 76 75

Province o f Buenos Aires 3.1 94 52

1\ Includes capital and interest in arrears. 2\ Based on discount rates o f 10 percent. Source: National and Provincial authorities and World Bank s t a f f estimates.

5. After the debt exchange, the Province’s financing prospects have improved moderately, with the biggest impact being in 2006. O f the Province’s financial obligations coming due in the short to medium term, approximately 80 percent are to the Federal government. As a result, financing prospects remain dependent on the Province remaining eligible for refinancing o f i t s financial obligations under the provisions o f the FRL which authorizes the Federal government to provide financing through bilateral agreements (Programa de Financiamiento Ordenado) to provinces adhering to the Law. Through the PFOs, the Province i s eligible to receive federal funds on favorable terms to cover maturing debt.

2 o f 7

11. Status of Project Implementation and Recent Developments

Institutional Strengthening Component

6. The project includes a set o f monitoring fiscal indicators for the execution period covering the years 2004-2015. Table 3 displays the outcomes for 2004 and preliminary results for 2005. The indicators show that the Province remains generally in line with the fiscal performance projected by the Provincial authorities. Most indicators show better performance than projected, especially the primary balance, which roughly doubled the originally projected values for 2004 and 2005. It i s worth emphasizing that this i s the key performance indicator for debt sustainability. One indicator with lower-than-projected performance i s that o f own revenues as a share o f current revenues (net o f transfers to municipalities so as to capture the amount of resources available to the Provincial Administration). This reflects better than anticipated performance in transfers through coparticipation, as the Province’s own tax revenues performed according to expectations. Another indicator with lower performance than projected i s that o f debt stock as a share o f net current revenues. Given debt restructuring in January 2006 explained above, the debt ratio i s expected to decline by about 10 percent as a result o f the debt restructuring.

Table 3: Fiscal Monitoring Indicators for PBA (percent, unless otherwise indicated)

Target Actual 2004 2005 2004 2005e

Own Revenues/Current Revenues NMT* 56 57 48 49 PersonneUCunent Revenues NMT 52 53 52 58 Current Savings/Current Revenues NMT 10 8 14 9 Capital Expenditures/Total Expenditures NMT 11 11 10 9 Primary Balance, millions o f constant 2003 pesos 462 328 950 599 Debt StocWCurrent Revenues NMT 220 180 223 185 Debt Service/Current Revenues NMT 11 17 12 14

* NMT: Net o f Municipal Transfers Data for 2005 i s preliminary. Source: Ministry o f Economy of the Province o f Buenos Aires.

7. Some slippage occurred in the ratio o f personnel expenditures to net current revenues which increased to 58 percent, as opposed to a target o f 53 percent. Public sector wages had fallen significantly - by about a third - below pre-crisis levels and both the national and provincial governments, including the PBA, responded to strong pressures from public sector workers to raise remunerations in 2005. With the salary increases implemented in 2004 and 2005, the provincial public sector salaries have recuperated much o f the ground lost during the crisis, and wages today are approximately 9 percent below those o f 200 1 in real terms. The large increase in personnel expenditures in 2005 i s also l ikely to result in some slippage with respect to one o f the provisions o f the FRL. In order to encourage balanced fiscal accounts, the FRL stipulates that nominal primary spending, excluding capital spending for basic infrastructure, should grow at a rate equal to or smaller than the rate o f growth o f nominal GDP. Preliminary estimates indicate that nominal GDP growth in 2005 was about 17 percent, while primary spending i s estimated to have grown by 24 percent.

Roads Component

8. Adequateprogress has been made in the implementation of the roads component. Since the loan was declared effective in June 2005, the P B A has awarded 8 contracts for a total amount o f US$26.1 mill ion. Although the contracts have already been signed and works are under execution, loan disbursements are expected to take place from 2006 onwards after a phase o f pre- financing by PBA. N o w that most o f the contracts within the Conurbano Bonaerense' have been awarded, the main focus i s to launch the bidding o f the roads belonging to the primary interurban paved network, and the accesses to localities and ports. The total estimated cost o f the remaining road program under APLl i s US$lOO mill ion. The Province i s working to complete two additional bidding processes during this calendar semester (representing US$30 mi l l ion and US$40 mi l l ion each). The Bank i s discussing with the Province the technical standards and costs associated with this remaining program taking into account the high unpredictability o f prices evidenced in the sector since the beginning o f 2004.

9. Concern with the significant price increase of road projects. The outcomes o f the f i rst bidding processes have confirmed a significant price increase for road works in Argentina (in the order o f 30 to 40 percent) mainly due to: (i) inflation on cost o f materials (in particular asphalt), gas-oil, labor, and transport; and (ii) the imbalance between the capacity o f the construction industry (eroded after the 2001 economic crisis) and the high demand for road works during the period. The PBA has had a proactive response to this situation, initiating a dialogue to identify actions to encourage increased competition in the sector and establish mechanisms to monitor the construction industry's response to bidding processes, not only for road works but in general, for al l public works within the Province. Through Decree 1803/05 the Province created a Special Commission to analyze and monitor the evolution o f prices o f the main inputs intervening in the implementation o f c iv i l works. In view o f the sharp increase in the cost of road works in Argentina in general, the physical targets that were contemplated during appraisal will not be met with the available funds by an estimated amount o f 30 to 50 percent. The volatility in the cost o f road works has also resulted in a longer than expected timeline for the preparation o f projects and no objection processes, as staff has closely examined the reasons for the substantial cost increases in accordance with Bank fiduciary standards.

Water and Sewerage Component

10. First investments under the water and sewerage component are ready to begin. Taking advantage o f the flexibility built in the project design, the Borrower worked to fulfill the loan conditions related to the water and sewerage component while initiating implementation o f the road component. At this moment, the Borrower has presented an Executed Agreement2 in support o f the eligibility o f Aguas Bonaerenses SA. (ABSA)3 and similar agreements4 for three municipal operators'. I t i s expected that all the requirements established under the loan conditions for the water component for these operators, including the requirements for ensuring their financial

' Refers to the Greater Buenos Aires Metropolitan area which i s inhabited by about 10 mi l l ion people. Renegotiation (readecuacidn) o f a previously existing agreement with ABSA that ensures the provision o f

water and sewerage services. Public corporation 90 percent owned by the Province (1 0 percent owned by employees) that provides

services to about 2 mi l l ion people in 72 localities within the PBA. Evidence was submitted for each o f the three municipal operators to demonstrate that they are financially

and administratively autonomous and to ensure that they can provide water and sewerage services in a context o f economic/financial sustainability.

These municipalities account for a total combined population o f about 500,000.

4 o f 7

sustainability, will be fulf i l led in the next few weeks, allowing for bidding and awarding of contracts to start during the third quarter o f FY06. In accordance with appraisal estimates, about US$42 mi l l ion i s expected to be committed within the following twelve months based upon the 16 subprojects evaluated for these operators during appraisal. These subprojects will provide sewerage services up to 500,000 l o w income people, mostly in the Conurbano Bonaerense, who are exposed to health and environmental risks.

1 1. Implementation of the regulatory framework is progressing well but its application to all water operators in the Province will remain a challenge. The PBA remains committed to the enforcement o f i t s regulatory framework and has taken key steps to ensure sector sustainability and equal regulatory treatment o f al l service providers. However, the ultimate objective o f providing efficient and sustainable services to all o f the population will require the continuity o f this enforcement and the application o f the regulatory framework to all o f the operators. Success will depend on enactment o f appropriate regulations and the existence o f an institutional setup capable o f enforcement. The Bank will continue to follow up on progress during supervision missions and i s currently working with P B A on the institutional strengthening o f regulatory and control entities under the loan. The PBA has formally adopted the policies and strategy for the sustainability o f the sector included in the Sector Development Letter and the conditions o f the Loan Agreement with the enactment o f Provincial Law 132966 and has pledged to use it for any future investments in the sector, regardless o f the source o f funds. The PBA issued the core regulations for the regulatory framework in December 22, 2004’. The satisfactory enactment o f regulations on the provincial regulatory framework i s one o f the conditions to proceed with APL2. The Control Entity (OCABA) has been adequately staffed and i t s personnel are being trained in order respond to the new challenges as the regulatory framework i s ultimately adopted by al l water operators in the PBA. Progress has been made in this regard with the voluntary adoption o f the regulatory framework by five large municipal water operators (four public and one private) and 130 cooperatives serving small water systems.

12. Key steps have been taken to ensure oversight of the implementation of the regulatory framework. One o f the key challenges faced by the P B A in the enforcement o f the provincial regulatory framework will be to ensure equal treatment among al l operators, be these provincial or municipal entities, private concessionaries, mixed entities or cooperatives o f organized users. By agreeing to engage international experts to audit on a regular basis the effectiveness o f the regulatory outcomes the PBA has taken a step forward to “level the playing field” between operators and to promote transparency and accountability. This will be further encouraged with the public dissemination o f key performance indicators o f water operators in the PBA that will also promote efficiency among operators. Efforts in this direction are already omgoing*, and supplementary support i s contemplated under the institutional strengthening component o f the project.

’

13. Tarwfs remain an important sticking point in the development of sector policy. AI though provinces have autonomy in regard to tariff setting for provincial operators, the national government freeze on water tariffs for the national concessiong exerts a significant influence on them. This i s particularly fe l t by the PBA since hal f o f the population i s served by the national

Ac t through which the loan was approved by Congress in January 2005.

OCABA has signed an agreement w i th the Statistical Department o f the Province and i s in the process o f

Supported by the Economic Emergency L a w (25.561) which has been extended by Congress until

’ Decree 3289104, published on January 14,2005.

increasing their capacity to process data.

December 3 1,2006.

concessionaire Aguas Argentinas S.A. (AASA)". Under these circumstances the recent tari f f increase" o f about 25 percent to non-residential customers served by ABSA and AGBA'* represents a step forward in the commitment o f the PBA to provide long-term financial sustainability to water operators. The regulatory framework requires that the operational and maintenance equilibrium o f water operators should be achieved mainly through tariffs. Consistent with this policy and pending a decision by the national government to authorize a tariff increase to residential customers for the national concession, the PBA has included in i t s 2006 budget a capital transfer subsidy13 o f AR$2 1 mil l ion to ABSA that represents about 18 percent o f projected tariff revenues. Concerned with the variety o f operators and the different socio-economic conditions o f the people they serve, the PBA has agreed to design a transparent subsidy policy for al l operators under the regulatory framework with the support o f the institutional strengthening component o f the loan.

14. Expansion of water and especially sewerage services to the poor living in the Conurbano remains a challenge and apriority for the PBA. The loan remains the main source o f funds for this expansion and the only source in the case o f sewerage. The execution o f the 16 subprojects whose contracts are expected to be awarded this calendar year will benefit up to 500,000 poor people. Since the P B A accounts for about 40 percent o f the population o f the country and i s one o f the provinces with lowest coverage ratios in water and especially in sanitation, this loan will also be instrumental in the achievement o f the Millennium Development Goals. With regard to the provision o f water services to the poor, the P B A has been able to benefit over 300,000 poor people through the "Agua + Trabajo" Pr~gra rn . '~ Prioritization o f future investments will benefit from the recently completed mapping o f water quality and household vulnerability in the PBA.

111. Renegotiation o f W a t e r Concessions

15, Progress towards renegotiation of water concessions has been limited. After months o f negotiations between the national government and AASA, on September 19, 2005 the Board o f Directors o f the latter recommended to i t s shareholders the termination o f the concession contract. A majority o f A A S A shareholders" approved the recommendation o f i t s Board during a special meeting held four days later. AASA notified the shareholders' decision to the national government and offered i ts collaboration for an orderly transfer while maintaining the operation of the system for at least the minimum o f 90 working days established in the terms o f the contract. AASA has been in conversations with prospective buyers during this period that i s about to reach the 90 day mark. N o investments were envisaged in the concession area o f AASA under APL1. However, a significant percentage o f the unserved poor l ive in the territory under A A S A concession, and most provincial governments have been waiting for the outcome o f the national

lo AASA i s responsible for services to about 6.5 mi l l ion persons l iv ing in 17 municipalities within the PBA. Decree 3573 dated December 29, 2005. The Decree approves an increase on tariffs for metered and non

metered service for non-residential costumers served by ABSA and AGBA. The new tariffs are effective as o f January 1,2006. l2 AGBA i s a private concession run by an Italian-Spanish consortium that provides water and sanitation services to about 1.7 mi l l ion people in 7 departments within the Conurbano Bonaerense. l3 The primary expenditure o f 2005 included a capital transfer o f AW23.1 mi l l ion to ABSA. These transfers do not pose a fiscal burden on the budget and are expected to decline over time, so as to be eliminated in about a 3-4 year period, on the expectation that tariffs to residential consumers wil l be gradually increased. l4 Program executed in collaboration with the national government that aims to increase water access while promoting j ob creation. I t has successfully established 100 cooperatives within the PBA and benefited over 300,000 people. l5 Local shareholder Banco de Galicia (representing 8.26 percent o f shares) opposed the decision.

6 o f 7

concession in order to complete renegotiation o f their provincial water concessions. In regard to provincial concessionaire AGBA, the PBA has a mandate16 to complete the renegotiation by June 30, 200617. Since the execution o f a renegotiated contract i s a condition for eligibility o f the operators under this loan, no investments can be financed by the Bank at this moment in the territory served by AGBA.

l 6 2006 Provincial Budget Law. ” Although that deadline could be extended until December 3 1,2006 in accordance with the law.

7 o f 7