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Country focus: Armenia’s stepped-up reforms pave way for sustained growth

Author(s):
International Monetary Fund. External Relations Dept.
Published Date:
July 2005
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Over the past four years, real GDP growth in Armenia has outpaced that of its neighbors and other low-income countries, averaging 12 percent a year (see chart). Also, since 2001, inflation has been low, at an annual average rate of 4 percent, and poverty and inequality have fallen rapidly. The government’s sustained commitment to economic stability and reform, especially since 2001, has been a critical element in this progress. Armenia is now at a cusp—more reforms can spur further gains, but faltering could put them at risk.

Like many other constituent states of the former Soviet Union, Armenia experienced a major economic downturn after the Union’s dissolution. Several early reforms, initiated in 1994-98, attempted to revitalize the economy. The reforms focused on privatizing land holdings and small-scale enterprises, and liberalizing prices, trade, and the foreign exchange regime. These policies allowed a shift to market prices and incentives, setting the stage for a period of market-driven capital formation. The economy rebounded in the second half of the 1990s, and annual inflation declined from triple to single-digit levels.

More ambitious reforms

As the 1990s ended, however, it was clear that imbalances continued to constrain economic performance. Over 50 percent of the population still lived below the poverty line, and emigration continued. Armenia’s fiscal position was weak and hampered by a continuous accumulation of internal and external payments arrears. The banking sector also saw the collapse of about one-third of the country’s commercial banks. Lastly, corruption in state-owned energy and water companies generated large inter-enterprise arrears and a sizable quasi-fiscal deficit.

In the face of these concerns, the authorities launched a renewed stabilization and reform effort in 2001 supported by the IMF’s Poverty Reduction and Growth Facility. Selected reforms were introduced in the fiscal, banking, and energy sectors, and these reforms were later aligned with a poverty reduction strategy paper (PRSP). The goals were to boost growth through tax reform and deregulation, restore confidence in fiscal management and improve expenditure control, restructure the energy sector, and clean up the banking system.

Tax reform. Armenia simplified and reduced its corporate and income tax rates, removed some exemptions, and introduced a turnover-based tax for small businesses. To improve the environment for private sector activity, the government also took steps to improve tax legislation, simplify licensing procedures, introduce a new criminal code, and disseminate pertinent laws and regulations.

Bolstering confidence in fiscal management. To restore confidence in fiscal management, Armenia needed to control expenditure, realign budget priorities, and clear domestic and external arrears. The authorities implemented a two-year arrears repayment plan that cleared all arrears by mid-2003. Once the plan was completed, interest rates and government debt service fell. After 2001, government budgets became more prudent, which meant cuts in nonpriority expenditures and sensible increases in subsidies and public sector wages. In conjunction with the preparation of the PRSP, the authorities also began to integrate the policies envisaged in that strategy into the budget process and raised the budget allocations for health care, education, and social security.

Restructuring the energy sector. Corruption, inefficiency, and interenterprise arrears had contributed to a decade of large quasi-fiscal deficits. A fundamental shift in ownership and corporate governance was needed to address these deficits, and the authorities responded by reforming and/or privatizing state-owned companies, introducing new audit and cash management systems, and improving financial management.

Cleaning up the banking sector. Financial mismanagement in the energy sector had also exacerbated an already vulnerable banking sector. The central bank had to intervene in, and subsequently close or rehabilitate, eight problem banks, while breaking the link between the banks and key state-owned energy companies. The authorities also moved to shore up the sector—introducing a new bank bankruptcy law and enforcing stronger provisioning requirements that encouraged banks to reduce their exposure to the energy sector. Improved banking supervision also helped confront the underlying sources of the banking crisis—namely, connected lending and fraud.

Growth takes off

Growth takes off Since 2001, Armenia’s economic growth has outpaced other CIS and low-income countries.

Citation: 34, 13; 10.5089/9781451938715.023.A005

Data: IMF, World Economic Outlook database.

The country moves forward

By the end of 2004, the European Bank for Reconstruction and Development’s transition indicators showed that Armenia had topped the Commonwealth of Independent States in nearly all areas of structural reforms. The only lagging areas were tax and customs administration, where spotty progress slowed the growth of tax revenues.

On the fiscal side, the magnitude of Armenia’s adjustment is noteworthy. The deficit of the general government fell from 6 percent of GDP in 2000 to 1 percent in 2004. Between 2001 and 2003, the government cleared its entire stock of domestic and external payments arrears and drastically improved the financial balances of companies in the energy and water sectors. A debt-management strategy that prioritized the use of low-cost concessional financing and grants also contributed to a notable reduction in debt ratios (see table).

More broadly, a stable economy and determined reforms laid the groundwork for an improved business environment and higher levels of investment, foreign financing, and donor assistance. Foreign resources (loans and transfers) helped supplement domestic savings and facilitate higher consumption and investment. A boom in exports also contributed to a marked improvement in growth performance and to reductions in poverty and inequality.

But more remains to be done

There is still considerable scope, however, for further reforms, especially in strengthening selected institutions and fighting corruption. Over the next few years, economic growth, exports, and capital formation will need to become more broad-based and generate more jobs. Since such growth cannot be financed exclusively with foreign resources, Armenia’s fiscal framework and the banking system will have to play a more prominent role in supporting private sector development and channeling resources toward their best possible use. At the same time, Armenia’s economic potential relies on an export-led development process that would benefit significantly from improved customs administration, normalized trade relations with Turkey, and a peaceful solution to the territorial dispute with Azerbaijan.

Armenia1996-981999-20012002-04
(Annual average in percent of GDP,
unless otherwise noted)
Public sector balance1-12.7-10.2-2.7
External debt-to-exports ratio185.6142.797.3
Investment18.519.323.4
Exports of goods and services20.723.229.7
Poverty rate (percent of population)254.747.032.0
Income inequality2,30.60.50.4

In the fiscal area, revenue administration remains a challenge, with corruption in collection agencies a major obstacle to a better business environment. The authorities can solve these problems by revamping tax and customs administration and adopting modern auditing techniques. To ensure the most productive use of government expenditures, the government is focusing on the efficient provision of health care, education, water, and sanitation services, and improvements in basic infrastructure. This will require additional capacity building, as well as greater transparency and accountability. A public investment program needs to be prepared, and appropriate weight given (as envisaged in the PRSP) to improving the public infrastructure, especially in rural areas and cities beyond the capital, Yerevan.

Although the banking system has strengthened in recent years, financial intermediation could be increased by improving corporate governance and the enforcement of financial contracts. Bank ownership and borrowers’ financial conditions should be made more transparent, and the judiciary needs to enforce creditor rights and collateral recovery more efficiently. These actions will help lower lending interest rates and bolster financial intermediation.

Armenia is now at a crucial phase of its development. The implementation of pending reforms and the policies envisaged in the PRSP will help sustain high economic growth and allow the country to achieve the Millennium Development Goals by 2015. With many of these reforms opposed by vested interests, however, the government will need a renewed dose of political resolve to see them take effect. The stakes are high, as a failure to tackle the remaining agenda could lead to poor tax collection, unproductive public investment, lower growth, and lack of further progress in reducing poverty.

For more information, please see the forthcoming “Growth and Poverty Reduction in Armenia: Achievements and Challenges,” by E. Gelbard, J. McHugh, G. Iradian, C. Beddies, and L. Redifer (expected September 2005).

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