Chapter

CHAPTER 1. Armenia After a Decade of Reform

Author(s):
Christian Beddies, Enrique Gelbard, James McHugh, Laure Redifer, and Garbis Iradian
Published Date:
November 2005
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This chapter contains an assessment of Armenia’s transition from a state-dominated economy to a market-oriented one during the past 10 years. It begins with a brief discussion of the economic background and continues with an analysis of the main reforms undertaken, the process of economic stabilization, and economic performance. The chapter revolves around three main issues: (1) Armenia’s strong economic performance compared to similar transition countries, especially since 2001; (2) the main factors behind the ignition of the growth process; and (3) the challenges to sustaining high rates of economic growth in the future.

A. Background

Before 1990, central planning and a disregard for economic incentives characterized Armenia’s economy, as was the case in most Soviet bloc countries. The country received substantial financial support (transfers and subsidies on imported products) from Russia, and its industrial sector was quite important, accounting for about half of GDP. Armenia’s human capital was also in high demand in Russia. The most important industrial (and export) activities were electronics, heavy machinery, and chemicals.1 These activities were the ones that suffered most from the disintegration of the Soviet Union after 1990.

Between 1988 and 1994, the economy was severely affected by an earthquake, the collapse of the Soviet Union, and the Nagorno-Karakakh conflict.2 Trade routes were disrupted, subsidies on energy and other inputs imported from the Soviet Union were eliminated, Russian demand for Armenia’s goods virtually disappeared, and transportation costs skyrocketed.3 These factors led to an estimated 55 percent decline in Armenia’s GDP during this period (compared to a 50 percent average decline in the rest of the former Soviet Union) (Table 1.1).4 By 1994, annual inflation escalated to 5,300 percent, the result of massive fiscal imbalances financed with money creation. The fiscal and external current account deficits rose to 17 percent and 36 percent of GDP, respectively.

Table 1.1.Composition and Level of GDP, 1989–2004(In percent)
1989199419992004
Agriculture15442720
Industry50292122
Construction217815
Transport4486
Trade and services11173637
Real GDP (Index 1991 = 100)455692
Income per capita (U.S. dollars)1735661,135
Source: Armenian authorities.
Source: Armenian authorities.

The shocks of the late 1980s and early 1990s led to massive unemployment and a large emigration to the countryside and to other countries. An estimated 17 percent of the 1990 population of nearly 3.5 million people emigrated abroad.5 Since the late 1990s, Armenia’s diaspora has become an important source of remittances and transfers (estimated at an average of 8 percent of GDP per year during the period 2000–04), and has been a contributing factor to the recent surge in trade and investment.6

As in other countries of the former Soviet Union, powerful business interests have emerged in the transition to a market economy. These interests have been exerting increasing influence in public decision making, leading to legally sanctioned tax privileges, nontransparent privatizations, and tax evasion. These developments are worrisome as they put at risk the country’s prospects for lasting reform and sustained growth. In response to public pressure to deal with corruption in the public sector and the judiciary, the government approved a three-year anticorruption strategy in November 2003.

B. Economic Reforms

The 1994 cease-fire with Azerbaijan allowed the authorities to focus on the economic agenda, and a stabilization program was adopted in 1994 with support from the IMF, the World Bank, and other donors. Since then, and despite a difficult political environment and policy slippages (especially during 1999–2001), Armenian policymakers have maintained a commitment to macroeconomic stability, market-oriented reforms, and the country’s integration with international markets.7

A wide range of economic reforms has been undertaken during the past 10 years (Table 1.2). Economic reforms in the early 1990s focused on land privatization, small-scale privatization of firms, and the liberalization of prices, trade, and the foreign exchange regime. Reforms in the late 1990s and in the early 2000s covered medium- and large-scale privatization, the tax and banking systems, the business environment, and the energy and water sectors.

Table 1.2.Chronology of Main Economic Reforms, 1991–20041
1991–941995–971998–20002001–04Status as of End-2004
Liberalization of domestic pricesCompleted, regulated prices retained for selected utilities and urban transport
Elimination of subsidiesAdvanced, water and irrigation subsidies remain and are expected to be eliminated by 2007
Land reform and privatization of landCompleted
Trade and foreign exchange liberalizationCompleted
Capital account liberalizationCompleted
Small-scale privatizationAdvanced, to be completed by mid-2005
Large-scale privatizationAdvanced, to be completed by mid-2005
Tax policy reformAdvanced, a tax code and further rationalization of taxes are pending
Tax and customs administrationIncomplete, deficiencies remain in the structure of the respective agencies and implementation of existing procedures
Expenditure managementAdvanced, new fiscal risks emerged in 2003 from the creation of government-owned noncommercial organizations
Banking system legislationAdvanced, further enhancements are needed regarding corporate governance and collateral and creditor rights
Banking supervisionAdvanced, there is a need for a faster resolution of problem banks and a more efficient judicial system
Securities’ markets and nonbanksIncomplete, insurance legislation needs alignment with best international practice
Competition policy and bureaucracyAdvanced, some bureaucratic practices and enforcement problems remain
Infrastructure and telecommunicationsLargely completed, although telecommunications is not cost-effective and competitive enough
Water and irrigationIncomplete, tariff increases and further reforms (especially in irrigation) planned for 2005–06
Energy sector reformsAdvanced, settlement of debts and other reforms should be completed in 2005
Sources: IMF staff reports, 1991–2004; EBRD transition reports, 1993–2004.

Darker areas denote the periods when the most significant reforms took place. Blanks indicate little or no reforms during the period.

Sources: IMF staff reports, 1991–2004; EBRD transition reports, 1993–2004.

Darker areas denote the periods when the most significant reforms took place. Blanks indicate little or no reforms during the period.

By end-2004, the European Bank for Reconstruction and Development (EBRD) transition indicators positioned Armenia ahead of other CIS countries (although below Central European and Baltic States) on all dimensions of structural reforms (Figure 1.1). IMF staff concurs with this assessment and considers that the strength and sequencing of the reforms (initially price and exchange rate liberalization, followed by a steady land and enterprise privatization program), while painful at the beginning, was essential to changing relative prices and incentives and setting the stage for a subsequent period of market-driven capital formation. Nevertheless, this overall positive assessment of reforms is tempered by some delays and weak implementation in some areas.8

Figure 1.1.EBRD Transition Indicators, 2004

Source: European Bank for Reconstruction and Development.

The privatization process is almost completed. Land reform led to the creation of about 300,000 private and collective farms as well as to the tradability of land.9 The privatization process comprised an initial privatization of 3,963 small enterprises from 1992 to 1996, and 1,513 medium and large enterprises from 1995 to 1999. A final privatization program comprising the last 900 state-owned enterprises began in 2000 and is expected to be complete by end-2005.10

The exchange regime and consumer prices were liberalized early in the transition. A domestic currency (the dram) was introduced in 1993 within a liberal foreign exchange regime and its value has fluctuated without major interventions by the central bank. By 1995, most prices of goods and services had been liberalized (except for bread, utilities, urban transport, and pharmaceutical products) and many subsidies had been reduced or eliminated. Further price liberalization took place in 1995.

By the mid-1990s, Armenia had put in place open trade and investment regimes (Table 1.3). Trade policies included the removal of quantitative restrictions on imports, the adoption of a simple import tariff regime with a single 10 percent tariff for most consumer goods and no tariff for the remaining goods, the elimination of export surrender requirements, the adoption of a liberal foreign direct investment regime, and full current account convertibility. Armenia joined the World Trade Organization (WTO) in 2003. Notwithstanding this impressive progress on trade liberalization, inefficiencies and corruption at customs have constrained trade, tax collection, and private sector development in general.

Table 1.3.Index of Trade Restrictiveness1
19972004
Armenia1.01.0
CIS (average)3.72.6
Developing countries5.14.0
Source: Trade Policy Information Database, IMF.

Reflects both tariff and nontariff barriers. Ranges from 1 (most liberal) to 10 (highly restrictive).

Source: Trade Policy Information Database, IMF.

Reflects both tariff and nontariff barriers. Ranges from 1 (most liberal) to 10 (highly restrictive).

A modern tax system with low rates was introduced in the 1990s. The tax system was revamped during 1992–96, with the introduction of a value-added tax (VAT), a personal income tax, a system of excise taxes, and a reformed profit tax. Further improvements in the tax system took place in 1997 with the move of VAT payments on many imports to the point of entry (rather than after sale in the domestic market), the introduction of a new profit tax law, and increases in excise taxes. At the same time, a system of presumptive taxes was introduced to capture activities whose profitability was deemed difficult to monitor. The system included a simplified tax for small retailers, and the activities covered by this system were excluded from the normal regime of VAT and profit taxes. In 1999, income taxes were reduced, a single profit tax rate with new depreciation allowances was introduced, and profit tax holidays for foreign investments were added.11

Tax and customs administration has improved gradually in the past decade. Capacity constraints in these agencies combined with lax management practices led to discretionary treatment of taxpayers, nontransparent practices, and low collection rates. These problems, along with an inefficient judiciary, resulted in the accumulation of tax arrears by companies as well as of VAT refund arrears from the government.12 Tax arrears (excluding penalties) peaked at 4.5 percent of GDP in mid-2003. On the tax refund side, arrears on VAT to exporters peaked at 0.5 percent of GDP at end-2002. The situation has improved gradually since mid-2003, after the strengthening of administrative procedures and the introduction of codes of conduct and an internal audit unit (Box 1.1).

Expenditure management has improved during the past 10 years, although challenges remain. A key reform was the introduction of a single treasury account in 1997. However, the treasury system remained weak until 2001, as evidenced by a cumbersome system of controls and accumulation of expenditure arrears. The system improved substantially since 2002. Commitment control procedures have been introduced, all arrears have been paid, and no further arrears have accumulated. Recent decentralization policies in the health, education, and water sectors have the potential to improve the quality of services, but these policies have not yet been accompanied by a sufficient increase in capacity, transparency, or accountability.13 Lastly, while central government expenditures are relatively well managed, local governments suffer from capacity constraints and lack of transparency.14

The efficiency of government services has been a major constraint on Armenia’s development. A civil service reform was initiated in 2001 aimed at improving capacity, better aligning salaries and skills, and reducing corruption. The process needs to be deepened to ensure an efficient provision of public services, the elimination of nepotism and political appointments in technical positions, and salary increases as envisaged in the PRSP.

After the privatization of banks in the early 1990s, banking sector reforms proceeded at a gradual pace. Basic laws on the central bank, commercial banking, and insolvency were introduced in 1996. Banking regulations were aligned with the Basel Core Principles in 1997, and a chart of accounts and international accounting standards for banks were adopted in 1998. A weak legal framework and occasional political interference with the supervisory authorities weakened the effectiveness of banking supervision and led to cases of forbearance when prudential requirements were breached. Higher minimum capital requirements and connected lending in some banks contributed to the collapse of 10 commercial banks between 1999 and 2001. While the situation of these banks has now been resolved, the process could have been faster and confidence in the system would have returned earlier. Another serious constraint to financial system development has been difficulties in recovering collateral owing to distorted exit mechanisms and an inefficient and corrupt judiciary. Some legislation was adopted in 2003, but further amendments to the civil code are needed to strengthen creditor rights.

Box 1.1.Armenia’s Tax System

Weaknesses in tax and customs administration remain the main constraint to revenue collection. A large gap between actual and potential collection is evidence of Armenia’s tax revenue potential. Reforms during the past two years focused on putting in place codes of conduct and internal audit units in the tax and customs agencies, disseminating tax laws and regulations, and enhancing the authority of the tax service to collect arrears. However, organizational improvements and the effective implementation of laws and regulations have been lagging. In 2004, the large taxpayers unit collected about 23 percent of total revenues, whereas it could potentially collect up to 75 percent. Discretionary behavior and organizational deficiencies within the tax service and creative accounting practices by companies all contribute to this disappointing performance. Looking ahead, it will be critical to revamp the internal organization of the tax service and implement risk-based systems for audit and administration of VAT refunds. A similar set of considerations applies to customs operations. In addition, bringing tax and customs under the control of the Ministry of Finance would improve coordination and ensure consistency between policies and administration.

While improving tax and customs administration is a priority, there is also room to improve the tax policy environment. Armenia’s tax system is generally well designed and characterized by low and uniform rates. The main tax policy reforms in the past three years focused on reducing VAT exemptions on imports and improving legislation to limit the erosion of the tax base. In the medium term, there is room to streamline a number of overlapping taxes that lead to a fragmentation of the tax base. First, there is a simplified tax intended for small taxpayers, which has lower rates than the regular tax regime (profit, income, and value-added taxes). However, it has provided incentives for the fragmentation of large businesses that take advantage of its lower rates and switch between regimes to minimize tax liabilities. Second, presumptive taxes on certain products were introduced in the mid-1990s because of administrative difficulties in covering them under the regular regime. There will soon be scope to begin covering these activities with the VAT. Third, a rather complex set of laws and regulations has emerged in recent years highlighting the importance of compiling a unified tax code. Fourth, the remaining VAT exemptions on imports of selected intermediate inputs and capital goods (equivalent to about 15 percent of total imports) could be removed, as they undermine the integrity of the tax system, distort price signals, and create an uneven playing field among importers. Lastly, it would be useful not to renew the profit tax holiday for foreign investments beyond its expiration in 2007.

Energy sector reforms began in 1997 with the setting up of the basic regulatory framework, the establishment of the Energy Regulatory Commission, and increases in tariffs toward cost-recovery levels. While some improvements in performance were noted by 2000, the sector remained a drain on budgetary resources and a source of interenterprise arrears. The situation was aggravated during 2000–01 by mismanagement and corruption in state-owned companies. A number of corrective actions have been undertaken since 2001, including improvements in technical and financial management, a reduction of staffing by almost one-quarter, a linking of wages to performance, and enforcement of interruption of service to nonpaying customers. In addition, the government privatized the electricity distribution company and two power plants in 2002 and 2003, respectively.

Energy sector reforms have been successful. The loss arising from technical deficiencies and theft fell from more than 20 percent of generation during 1998–2002 to an estimated 2 percent in 2004. During the same period, collection rates rose to almost 100 percent, and the primary deficit of the energy sector (a measure of quasi-fiscal losses) turned into a surplus (Table 1.4). While the most significant reforms in the energy sector have already been adopted, a few remaining state-owned enterprises still need to be privatized, and years of erratic management have left a stock of (public) debt of US$34 million (1 percent of GDP). To deal with remaining reforms and past debts, the government began implementing in 2004 a financial rehabilitation plan covering the energy, water, and transport sectors.15

Table 1.4.Key Indicators of the Energy Sector, 1998–2004(In percent of GDP, unless otherwise indicated)
1998–992000–01200220032004
Technical and other losses126.022.022.04.22.3
Collection rate2242348101106
Overall financial balance3–3.3–2.8–1.7–0.6–0.4
Primary balance3,4–1.7–1.9–0.40.00.2
Source: Armenian authorities.

Technical deficiencies in percent of generation (state-owned companies).

In percent of billings.

State-owned companies.

Excluding interest and foreign-financed capital expenditures.

Source: Armenian authorities.

Technical deficiencies in percent of generation (state-owned companies).

In percent of billings.

State-owned companies.

Excluding interest and foreign-financed capital expenditures.

Water and irrigation services have improved only gradually (Table 1.5). Some reforms have been undertaken since the mid-1990s, including privatization and tariff increases, which have helped to improve efficiency and reduce reliance on government subsidies, loans, and arrears. However, more remains to be done to reduce technical losses and theft and ensure the viability of these sectors. The pace of tariff increases should be stepped up as planned to reach cost-recovery by 2007. In addition, the water infrastructure needs to be developed, and efficiency and governance should be improved in the users’ associations that manage the irrigation infrastructure.

Table 1.5.Indicators of the Water and Irrigation Sector, 2000–041(In percent of GDP, unless otherwise indicated)
2000–01200220032004
Technical losses251555859
Collection rate334487666
Overall financial balance–1.6–1.0–0.8–0.4
Primary balance4–1.2–0.9–0.6–0.3
Source: Armenian authorities.

Averages of the state-owned water and irrigation companies.

In percent of output. The recent increase is explained by improved metering.

In percent of billings.

Excluding interest and foreign-financed capital expenditures.

Source: Armenian authorities.

Averages of the state-owned water and irrigation companies.

In percent of output. The recent increase is explained by improved metering.

In percent of billings.

Excluding interest and foreign-financed capital expenditures.

Since 2001, the government has focused on deregulating the environment for private sector activity and on measures to reduce transaction costs. The quality of regulations was improved, licensing procedures were simplified, a new criminal code was introduced, and laws and regulations were more widely disseminated. These changes led to an improvement in the business environment and put Armenia ahead of most CIS countries in a variety of governance indicators (Box 1.2). However, corruption remains a problem, especially in tax and customs agencies, the health sector, and the judiciary.

Box 1.2.Governance in Armenia

Armenia’s standing in Transparency International rankings improved from the 80th percentile in 1999 to the 50th percentile in 2004. Similar progress can be noted in the World Bank’s governance indicators, the EBRD business environment surveys, and the Heritage Foundation indices of economic freedom. This reflects a number of reforms introduced during the past three years, including the simplification of licensing procedures, civil service reform, a new criminal code, privatization in the energy sector, and dissemination of laws and regulations. Notwithstanding these improvements, corruption indicators in Armenia are still higher than in other countries of Eastern Europe and the Baltic States. In a recent public opinion poll, Armenians said they were mostly concerned with corruption in the judiciary, tax and customs operations, the defense and security forces, and the health sector.

Source: World Bank Business Environment and Enterprise Performance Surveys, 2002

After much preparation, the authorities finalized an anticorruption strategy at end-2003. The strategy contains a three-year action plan with measures to be implemented, including:

  • Harmonizing legislation to specify sanctions for corruption, protect witnesses, and improve access to information;

  • Carrying out reforms on tax and customs administration and the judiciary; and

  • Introducing financial audit standards in the public sector and strengthening parliament’s role in the audit process.

Implementation of the strategy needs to gain momentum, and further efforts are required to fully involve civil society in the process and specify benchmarks for most activities. There is also a need to identify enforcement mechanisms, work on whistle-blower protection regulations, and increase the transparency and accountability of local governments.

C. Macroeconomic Stabilization

Prudent management of fiscal and monetary policy coupled with economic reforms set the foundation for growth and sustained macroeconomic stability. Armenia’s economic indicators displayed a marked improvement, especially after 2001. The reduction in the fiscal and quasi-fiscal deficits played a key role in lowering inflation to single-digit levels and in stabilizing the value of the dram.16 Another key factor was the presence of a largely independent central bank. Monetary policy followed strict targets on the net domestic assets of the central bank and minimal accumulation of bank credit to the government. This led to a rapid deceleration of the growth in both reserve money and broad money (Figure 1.2). After inflation fell to single-digit levels in 1999, real money demand began to increase, and a virtuous circle of gradual re-monetization and low inflation was inaugurated. A flexible exchange rate gave authorities the necessary control over the money supply in an environment of free capital mobility, real and nominal interest rates fell in response to macroeconomic stability, and international reserves rose.

Figure 1.2.Monetary Growth and Inflation September 1995–December 2004

(12-month percentage change)

Source: Armenian authorities.

The magnitude of Armenia’s fiscal adjustment is noteworthy. The general government deficit fell from 17 percent of GDP in 1994, to 6 percent in 2000, and to an estimated 1.6 percent in 2004 (Figure 1.3). The financial balances of the energy, water, and irrigation sectors also fell drastically, contributing to overall fiscal consolidation and macroeconomic stability (Table 1.6).17 This process was accompanied by a debt management strategy that prioritized the use of concessional financing and grants and led to a reduction in debt ratios.

Figure 1.3.Fiscal and External Account Deficits, 1994–2004

(In percent of GDP)

Source: Armenian authorities; IMF staff estimates.

Table 1.6.Fiscal and Quasi-Fiscal Adjustment and External Debt(In percent of GDP, unless otherwise noted)
1998–992000–01200220032004 Est.
Fiscal and quasi-fiscal balances–11.7–9.3–3.0–2.5–2.6
General government–6.4–5.0–0.3–1.1–1.6
Quasi-fiscal1–5.3–4.3–2.7–1.4–0.8
Net present value of debt/exports21511351318775
Source: Armenian authorities.

Comprising the energy, water, and irrigation sectors and the chemical company, Nairit.

About 98 percent of Armenia’s public debt is external, making this concept the most representative. The ratio is expressed in percent of the three-year moving average of exports of goods and services.

Source: Armenian authorities.

Comprising the energy, water, and irrigation sectors and the chemical company, Nairit.

About 98 percent of Armenia’s public debt is external, making this concept the most representative. The ratio is expressed in percent of the three-year moving average of exports of goods and services.

However, fiscal adjustment was primarily achieved through expenditure compression, with little contribution from the revenue side. While tax revenues grew rapidly in both nominal and real terms during the past five years, the ratio of tax revenues to GDP did not improve (Table 1.7). Four main factors explain this: (1) strong growth in activities that are tax-exempt because of international agreements (e.g., grant-financed construction), (2) a reduction in income and profit tax rates since 1999, (3) profit tax exemptions for foreign investment, and (4) lingering weaknesses in tax and customs administration.

Table 1.7.Tax-to-GDP Ratios(In percent of GDP, unless otherwise noted)
1995–971998–20002001–0220032004 Est.
Tax revenue, general government13.918.617.817.217.4
Of which: VAT3.86.56.86.66.3
Profit tax3.01.81.31.11.7
Payroll2.33.12.92.82.8
Excises1.52.32.62.42.2
Tax revenue-to-estimated tax base115.120.219.820.020.3
Source: Armenian authorities.

The tax base is estimated as GDP minus 90 percent of the value added in construction, which is largely tax-exempt due to international agreements with donors.

Source: Armenian authorities.

The tax base is estimated as GDP minus 90 percent of the value added in construction, which is largely tax-exempt due to international agreements with donors.

The road to macroeconomic stabilization has not been without obstacles. A stabilization program supported by an IMF Stand-By Arrangement during 1995–96 helped reduce the fiscal deficit by almost 9 percent of GDP and brought inflation down from 5,273 percent in 1994 to 19 percent in 1996. However, the Russian financial crisis of 1998 and the Armenian political assassinations in 1999 led to a period of political uncertainty and a slowdown in the reform effort and economic activity in 1999–2000. Exports, transfers, and remittances fell, the fiscal deficit rose again, and domestic and external payment arrears grew rapidly.

Between 2001 and 2004, a new three-year economic program supported by the IMF’s PRGF led to fiscal consolidation and a deepening of structural reforms (Box 1.3). The program aimed at reducing the fiscal and quasi-fiscal deficits, changing the composition of government expenditures in light of a decline in social spending during 1999–2001, repaying domestic and foreign arrears, lowering debt ratios, and running a cautious monetary policy in a flexible exchange rate environment. The structural reform agenda was geared to support stabilization efforts, reduce vulnerabilities, and sustain medium-term growth prospects. It focused on improving the business environment; strengthening the banking system, tax and customs administration, and expenditure management; and increasing efficiency in the energy and water sectors.

Box 1.3.Armenia’s Poverty Reduction Strategy

In early 2001, the government prepared an interim PSRP laying out a program for redirecting public resources toward fighting poverty. In mid-2002, the government launched a consultation process within the government and with NGOs, trade unions, and donor organizations to finalize the poverty reduction strategy. The government asked these bodies to submit their priorities to a PRSP working group comprising senior government officials and representatives of civil society. The process culminated with the PRSP, a multiyear program of economic and social reforms. The government formally adopted the PRSP in August 2003.

The strategy comprises five key policy objectives:

  • Sustain high economic growth by deepening market-oriented reforms, paying particular attention to the business environment for small and medium-sized enterprises.

  • Ensure high levels of public investment. The strategy recognizes rural roads, water supply, and irrigation as priority areas.

  • Strengthen the social safety net by increasing expenditures on health, education, and social welfare.

  • Maintain macroeconomic stability through sound monetary and fiscal policies. The program reconciles this objective with the higher public expenditures by progressively increasing tax collection by about 0.4 percentage points of GDP per year.

  • Improve governance at all levels of government and in the judiciary.

The strategy contains a number of poverty, income inequality, and human development targets, consistent with the MDGs.

Main PRSP Targets1
2001 Actual2015
Poverty rate (percent)4720
Population living on less than US$2 per day (percent)247
Income inequality (Gini coefficient)0.540.44
Child morality per 1,000 live births3519
Primary enrollment ratio97100
Accessibility to drinking water in rural areas (percent)4270
Source: Armenian authorities.

The targets are based on 2001 data. The PRSP is expected to be revised in late 2005.

Source: Armenian authorities.

The targets are based on 2001 data. The PRSP is expected to be revised in late 2005.

The program was aligned with Armenia’s Poverty Reduction Strategy (Box 1.3).18 The policies and programs envisaged in the PRSP have been progressively integrated into the program and the budget process. The authorities have changed expenditure priorities in the budget, implemented reforms in the areas of health and education, and proceeded to develop monitoring indicators.19 They also have been refocusing their efforts on social policies and the rural economy.

D. Economic Performance

Macroeconomic stabilization and reforms contributed to an improved business environment and higher levels of investment, foreign financing, and donor assistance. The availability of foreign resources (loans, transfers) helped supplement low domestic savings and facilitated the observed higher levels of consumption and investment.

Growth was ignited by higher investment and a rapid increase in total factor productivity (Chapter 2). Total investment grew from 19 percent of GDP in 2000 to nearly 25 percent in 2003 (Table 1.8). As a result, annual real GDP grew by an average 12 percent during 2001–04 (Figure 1.4). While official employment data shows a decline in total employment, the change fails to capture the expansion of the informal sector, estimated at 45 percent of GDP in 2001 (Shiells and Sattar, 2004). According to official data, unemployment has declined slightly in recent years. Official unemployment in 2004 was 10 percent, though unofficial estimates suggest a figure between 15 and 25 percent.

Table 1.8.Investment and Official Employment
Averages
1996–981999–200120022003Est. 2004
Investment (percent of GDP)19.418.921.724.722.5
Official employment (thousands)1,3821,2801,1061,1121,201
Source: Armenian authorities.
Source: Armenian authorities.

Figure 1.4.Annual Average Real GDP Growth in Armenia and Other CIS Countries,1 1991–2004

(Annual average, in percent)

Source: IMF World Economic Outlook database.

1 Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.

The structure of the economy suffered a radical transformation since the early 1990s. The composition of output shifted from heavy industry to agricultural production in the mid-1990s, and to light manufacturing in the second half of the 1990s. Most activities that thrived during the Soviet period (chemicals and heavy machinery) contracted sharply and new ones (food processing, nonmetallic minerals, jewelry, and textiles) started to emerge. Since the late 1990s, import substitution intensified in light industries, and an export boom began in the precious stones sector followed by agricultural products, processed foods, and textiles. The observed progressive broadening of the structure of production (and exports) is consistent with recent empirical research on diversification and growth showing that at low income levels the two are positively correlated over time (Imbs and Wacziarg, 2003). As a result, exports of goods and services increased from an average of 21 percent of GDP during 1998–2000 to 29 percent during 2002–04 (Figure 1.5). Similarly, the current account deficit fell drastically during the same period.

Figure 1.5.Trade Ratios

(In percent of GDP)

Source: Armenian authorities.

High economic growth and improvements in social policies since 2002 contributed to a reduction in poverty rates and income inequality (Table 1.9). Extreme poverty fell even faster than overall poverty. Improvements in social policies since 2002, especially a well-targeted family benefits program, have helped the most disadvantaged groups in society.

Table 1.9.Poverty and Inequality in Armenia(Percent of total population, unless otherwise noted)
1996199920012003
Overall poverty rate56.756.347.032.0
Rural poverty49.047.746.033.9
Extreme poverty27.726.116.25.5
Gini coefficient (income)10.60.590.540.44
Gini coefficient (consumption)10.40.370.380.33
Source: Based on Household Surveys, 1996, 1999, 2001, 2003. All figures except 1996 reflect a new methodology applied by the World Bank.

Ranges from 0 (perfect equality) to 1 (total inequality).

Source: Based on Household Surveys, 1996, 1999, 2001, 2003. All figures except 1996 reflect a new methodology applied by the World Bank.

Ranges from 0 (perfect equality) to 1 (total inequality).

As noted above, the central bank’s monetary policy was focused on price stability and was complemented with a prudent fiscal policy and exchange rate flexibility. The exchange rate appreciated appropriately during and after the Russian financial crisis with minimal central bank intervention (Figure 1.6). The real exchange rate then depreciated by nearly 25 percent between 2000 and 2003 (mainly because of a concomitant real effective appreciation of the Russian ruble). Since productivity growth in tradable sectors accelerated during 2001–04 (see Chapter 2), competitiveness remains high despite an estimated 15 percent real effective appreciation of the dram in 2004.

Figure 1.6.Nominal and Real Effective Exchange Rates, 1995–2004

(Index, 1995 = 100)

Source: IMF Information Notice System.

Real interest rates and spreads have been falling in recent years, although they remain high (Figure 1.7). As expected, lower inflation brought about higher levels of monetization after 1996, but financial intermediation stagnated between 2000 and 2003. This reflects lower confidence in the banking system after the collapse of 10 banks during 1999–2001 and the relatively slow pace of banking sector reforms. Confidence in the banking system has recovered since mid-2003 following the resolution of eight banks that the central bank had intervened. During 2004, financial intermediation increased, with bank deposits and credit to the private sector growing by 32 percent and 38 percent, respectively. This trend has been continuing in the first half of 2005.

Figure 1.7.Interest Rate Spread and Real Lending Rate, 1995–2004

(In percent)

Source: Armenian authorities.

E. Remaining Challenges

During the past 10 years, a combination of well-sequenced reforms and persistent commitment to macroeconomic stability has ignited growth. The structure of the economy has been transformed through a major reduction of the role of the state as a producer of goods and services, improvements in the legal and regulatory environment, and a reorientation of economic activities towards exports and import substitution. Key reforms included the liberalization of prices, trade, investment, and the foreign exchange regime; privatization; deregulation; creation of an independent central bank; and the reduction of fiscal and quasi-fiscal imbalances. Progress in other areas was slower, including tax and customs administration, banking, judicial, and water sector reforms.

Many low-income countries have been able to achieve macroeconomic stabilization and jump-start economic growth, like Armenia, but most have had difficulty sustaining high growth rates for longer than five years. Recent research suggests that the presence and proper functioning of economic institutions can play a key role in long-run growth by lowering transaction costs and increasing the rate of return on investment (see, for example, Acemoglu, Johnson, and Robinson, 2001 and 2004). Armenia has made substantial progress in setting up such economic institutions, but some of these are not yet functioning properly and the reform agenda in certain areas remains to be completed.

During the next few years, economic growth, exports, and capital formation should become more broad-based and generate employment. Since such growth cannot be exclusively financed with foreign resources, Armenia’s fiscal framework and financial system will have to play a more prominent role in fostering private sector development and channeling resources towards small and medium-sized enterprises. Fiscal prudence should be maintained, and expenditure increases should be tied to improvements in transparency, efficiency, and accountability. Further reforms are needed to develop mortgage, securities, and insurance markets. For all this to happen, a critical step would be consolidation of an institutional setup that ensures the rule of law and fights corruption.

The tax and customs systems should function adequately, and the state should become a more efficient provider of social services and public investment. A large shadow economy should be progressively brought into the formal economy through an efficient tax administration, enforcement of accounting standards, and improvements in corporate governance. Rural and regional imbalances need to be mitigated by devoting more resources to capital expenditures in rural areas and urban centers outside the capital, Yerevan. In addition, further investments and reforms are needed to improve the water and irrigation sectors. While Armenia has already put in place the basic legal and institutional arrangements present in modern tax and banking systems, it is now clear that most of the observed weaknesses in these areas are related to deficient implementation. This also involves the judicial system. Improved transparency and reduced corruption in the public sector and in the judicial system will be essential to encourage efficient investments, foster growth, and contribute to a more equitable distribution of income. Political will, more than technical assistance, will be required to address these challenges.

Armenia’s economic potential lies in an export-led development growth process, and further integration with its neighbors and main trading partners should remain a top priority. Such potential will be realized when the barriers to regional integration are removed, including discretion in customs administration and border closures.

This chapter has shed light on the main successes of the past decade and the main challenges facing the country. This review reveals four important areas that deserve a closer examination: growth and poverty, the role of fiscal reforms, the importance of financial intermediation, and prospects for tradable sectors and trade integration. These are covered in Chapters 25.

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Output was produced mainly in large plants and exchanged with other countries of the former Soviet Union, primarily Russia. See Avanesyan and Freinkman (2003).

The 1988 earthquake is estimated to have left more than 25,000 people dead and many more homeless. The war with Azerbaijan was motivated by tensions over the disputed Nagorno-Karabakh region. The war began in 1991 and a cease-fire was reached in 1994. Since then, Armenia’s borders with Azerbaijan and Turkey have remained closed. This has constrained Armenia’s trade prospects because of the higher costs of transportation to Europe (via Georgia). Negotiations on the settlement of the territorial conflict between Armenia and Azerbaijan are continuing. However, restoration of economic and transportation links remains a contentious issue.

A railway blockade and the closure of the energy pipeline proved to be quite damaging for Armenia’s industry. In addition, the route through Georgia was also unstable.

Armenia, Ministry of Statistics (1998). It is estimated that about 4 million Armenians live outside the country (most of them in Russia, the United States, France, and the Middle East).

Unofficial estimates suggest remittances and transfers range between 15 and 25 percent of GDP (U.S. Agency for International Development/Armenia, 2004).

Armenia has a turbulent political history. Political assassinations in 1999 involved the killings of the prime minister, the speaker of parliament, and five other parliamentarians.

For instance, there have been delays in the resolution of problem banks in recent years, and the implementation of tax and customs administration reforms has been deficient (see below). This reflected choices made by the authorities (e.g., prolonged period of intervention of commercial banks) as well as the influence of vested interests and capacity constraints (e.g., discretion and inefficiency in tax and customs administration).

Despite the overall positive impact of land privatization, there were weaknesses in implementation, especially because of the lack of input markets. These and other problems have constrained agricultural productivity growth.

There has been some concern in the public domain about lack of transparency in some privatizations, such as the debt-equity swap with Russia and the privatization and subsequent handling of rights in telecommunications.

As in most countries, profit tax holidays have proven to be an inefficient and costly way of providing incentives. The annual revenue loss in Armenia is estimated at 0.5 percent of GDP. Furthermore, the presence of accelerated depreciation allowances in Armenia also makes redundant this exemption (set to expire in 2007).

Armenia’s judicial system is perceived as nontransparent and partial. The improvements in this area envisaged in the authorities’ anticorruption strategy require political commitment at the highest levels of government.

In early 2003, about 5,000 budgetary organizations (nearly 15 percent of the budget) were given a different legal status as part of a wide decentralization reform. Most of these entities are schools and hospitals and were not subject to sufficient auditing and reporting procedures, rendering their activities less transparent. The authorities have recently approved a regulatory framework for these entities and have begun implementing a reporting and monitoring system to compensate for the loss of budgetary control.

Furthermore, budget coverage and budget presentation (budget and budget execution reports) could be more transparent and include extra-budgetary funds, all types of grants, and consolidated balances of state-owned noncommercial organizations and enterprises.

Measures already taken in the energy sector include phasing out management functions previously vested in the Ministry of Energy, restructuring the midstream sector (including settlement, dispatch, and transmission companies), introducing an improved governance framework, and establishing direct contracting between power generators and the privatized distribution company. A restructuring of energy sector debt is also under way.

An additional factor was the formal prohibition of central bank net lending to the government since 1998.

For an alternative approach in estimating the extent of fiscal and quasi-fiscal adjustment in Armenia, see Avanesyan and Freinkman (2003).

In early 2005, the authorities prepared a draft Annual Progress Report of PRSP implementation. The draft outlines the policies adopted during the past year, including the additional allocations for poverty-reducing expenditures and the improvement in poverty indicators.

The Armenian diaspora represents an extraordinary source of development resources. Private transfers from abroad were estimated at between 15 and 25 percent of GDP in 2003–04. Between 1990 and 2003, an estimated one million Armenians left the country. Almost two-thirds of the migrants are well-educated men of active working age (20–44 years).

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