Despite geographical isolation, trade blockades, and occasional political upheaval, Armenia’s economic performance during the past four years has been remarkable. Growth has averaged nearly 12 percent and poverty has fallen. The country has become a reform leader among CIS countries. This performance reflects a combination of factors, namely a sustained commitment to macroeconomic stability, structural measures undertaken since the mid-1990s, minimal government intervention in the economy, a focus on poverty-reducing policies since 2002, and support from the Armenian diaspora. These factors led to higher domestic and foreign investment, improvements in competitiveness, and a market-driven process of import substitution.

However, the sustainability of growth and further poverty reduction is not yet assured. Examples abound of countries that achieve higher rates of economic growth but are unable to maintain the momentum for more than a few years. The presence and proper functioning of economic institutions will likely condition Armenia’s long-term growth, and we have highlighted earlier those institutions that still need to meet that test, namely, tax and customs operations, the financial sector, and the judicial system. Furthermore, the extent of Armenia’s integration with the world economy is below its potential.

In coming years, economic growth and capital formation should be broad-based and generate employment. Such growth cannot continue to rely almost entirely on foreign financing, highlighting the importance of fiscal management and financial intermediation. The tax and customs systems will have to function adequately and the state should become an efficient provider of social services and public investment. This would generate additional tax revenues to ensure fiscal sustainability and help finance growth-enhancing public expenditures. As envisaged in the PRSP, rural and regional imbalances will have to be mitigated and the government will need to devote more resources to these areas as well as to strengthening the public infrastructure. Lastly, Armenia’s economic potential lies with an export-led development growth process, and further integration with its neighbors and main trading partners should be a priority. Such potential will only be realized when the artificial barriers to regional integration are removed.

The analysis in the previous sections regarding the key remaining reforms needed to sustain growth and achieve poverty reduction objectives can be summarized as follows:

• Tax policy: Armenia has relatively good tax legislation with moderate tax rates, although some aspects of the tax system need to be revisited, most notably the simplified tax. First, the authorities should review the simplified tax and presumptive taxes with a view to expanding the tax base. Second, they should focus on compiling a unified tax code—this is important because of the number of amendments and supplementary provisions for different taxes made over the past six years. Third, it is important to allow the current profit tax exemptions for large foreign investments to end as projected in 2007.

• Tax and customs administration: While progress has been made in the past few years, the discretionary activities of collection agencies remain a key obstacle to a better business environment. Collections are based on targets, and businesses complain about bribes demanded by officials and discrimination among taxpayers. There is a need to make wide use of risk-based methods for audit, VAT refunds, arrears collection, and import clearance. An additional distortion arises from insufficient communication between the agencies and their lack of integration with the Ministry of Finance. The authorities should proceed to reorganize these agencies and unify them under the Ministry of Finance.

• Public sector efficiency and expenditure management: The government needs to ensure the efficient provision of health, education, water, and sanitation services and to finance improvements in the basic infrastructure. This requires additional capacity building, transparency, and accountability. The recent tendency to prioritize current expenditures in the medium-term expenditure framework and the budget is misguided and appropriate weight should be given (as envisaged in the PRSP) to improving the public infrastructure, especially in rural areas and cities besides Yerevan. In this regard, a public investment program should be prepared. Lastly, a public expenditure review should look closely at nonpriority expenditures and budget classifications.

• Financial intermediation: The key factors limiting the development of the banking system in Armenia are weak corporate governance and poor enforcement of financial contracts. Bank ownership should be made more clear, capacity in banks should be enhanced to develop new financial products, borrowers’ financial conditions should be made transparent, and the judiciary should be more efficient to facilitate creditor rights and collateral recovery. These actions will all serve to lower real interest rates and spreads, discourage adverse selection, and increase financial intermediation.

• Trade integration: The loss of markets in the former Soviet Union combined with the trade blockade severely disrupted Armenia’s trade opportunities. Despite the recent export boom, exports remain relatively low and concentrated in a few categories. The structure of trade has also shifted towards goods with low transport costs. Looking ahead, the main challenges are to improve customs administration, normalize trade relations with Turkey, and reach a peaceful solution to the conflict with Azerbaijan.

Armenia is now at a crucial phase of its development. The completion of the reform agenda and the implementation of the policies envisaged in the PRSP will likely allow Armenia to be one of the few low-income countries to achieve the Millennium Development Goals within the next 10 years. On the other hand, failure to tackle the above-mentioned issues could expose the country to a vicious circle of low tax collection, insufficient social and infrastructure investment, and persistently high levels of poverty and inequality. Since many of the remaining reforms are opposed by vested interests, overcoming these challenges will require a new dose of leadership and political resolve at the highest levels of government. As a reinforcing factor, improved prospects for integration with the European Union could also help to strengthen institutions and the role of reformers in the country.