Chapter

CHAPTER 4. The Financial System and Growth

Author(s):
Christian Beddies, Enrique Gelbard, James McHugh, Laure Redifer, and Garbis Iradian
Published Date:
November 2005
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It is generally accepted that the financial system plays a pivotal role in economic development by mobilizing funds for investment projects with the highest probability of success. In fact, a well-functioning financial system is a key component of a modern economy, facilitating the exchange of goods and services, mobilizing savings, allocating scarce resources, mitigating market imperfections, and helping to diversify risks.44

Given the importance of the finance-growth nexus, this chapter assesses the development of Armenia’s financial system. In particular, it attempts to identify those obstacles that hamper the proper functioning of financial markets. It then explores avenues to develop new financial products that will augment the sector’s growth. Finally, it outlines some policies to ensure a sound financial sector framework to support growth and poverty reduction over the medium term.

A. The Financial System in Armenia

Armenia is in many ways confronted with challenges similar to those faced by small open economies with nascent financial systems. Banking services dominate the sector, while nonbank financial services, such as leasing and insurance, remain insignificant. At end-2004, the banking system accounted for about 97 percent of financial system assets. Regarding financial sector supervision, three agencies are involved: (1) the central bank, charged with banking supervision and the supervision of other depository institutions and leasing companies; (2) the insurance inspectorate in the Ministry of Finance and Economy; and (3) the securities market commission responsible for capital market participants.

Over the past four years, Armenia experienced strong economic growth, but the financial sector played a limited role in this process. Growth was largely financed by retained earnings of firms and by external financing. Nonetheless, efficiency gains from mere resource reallocation or increased resource use have their limits. Privatization is almost completed, and foreign assistance is expected to decrease over time. As noted in Chapter 2, future sustained productivity growth will increasingly depend on further capital deepening and on how new technologies are adopted. In this context, the financial system will have to play a more prominent role than in the past.

The banking system

Over the past decade, Armenia’s banking system has undergone significant changes. After the dissolution of the Soviet Union, the mono-bank system of the Soviet era was broken into a two-tier banking system, consisting of the central bank and commercial banks. The elimination of the mono-bank system was followed by a rapid expansion of the banking sector. As in other countries of the former Soviet Union, Armenia’s strategy was to increase competition and bring interest rates down by granting licenses liberally with little regard to prudential requirements and supervision (Berglof and Bolton, 2002).

This emphasis on development without regard to supervision produced a banking system prone to crises. In addition to bad debts from the old regime, banks and enterprises lacked familiarity with a market economy, and lending practices often lacked the needed economic rationale. At the same time, banking supervision and regulation were still in their infancy, and bankers, inexperienced themselves, received little guidance from regulators. Since the mid-1990s, the regulatory framework has undergone a major overhaul and the legal environment has been adjusting to the demands of a modern financial system. Nonetheless, the 10 bank failures over the past few years created serious political difficulties and proved time-consuming to the authorities.45

Despite comprising most of the financial system, Armenia’s banking sector is small relative to the size of the economy. At end-2004, total banking system assets accounted for 19 percent of GDP. By comparison, the average size of the banking system in the CIS (excluding Armenia) was about 30 percent of GDP (Figure 4.1). On the deposit side, Central European countries also display far more financial depth than Armenia does.46

Figure 4.1.Former Soviet Union and Central Europe: Assets and Deposits to GDP, 2004

(In percent)

Source: IMF International Financial Statistics.

Foreign entry by well-established international banks has been limited, although foreign ownership accounts for about 53 percent of commercial banks’ capital. Only one international bank operates in Armenia; it has 18 percent of the system’s assets and a quarter of the deposits. In this context, there is scope for entry by reputable foreign institutions with a view to upgrading banking operations, trust among clients, and stability.

Over the past three years, the banking system experienced significant consolidation. The number of banks dropped from 31 at end-2000 to 20 at end-2004 (Table 4.1). The gradual increase in capital requirements to US$2 million in July 2003 contributed to the exit of some of the banks, but many banks also left the system because of weak governance and subsequent failure. The bank failures in 2000 and 2001 had a considerable impact on profitability ratios. As asset quality began to deteriorate, aggregate losses in the system led to a negative average return on equity of about 79 percent by end-2001 (Table 4.2). The losses wiped out a large share of banks’ capital, with capital adequacy dropping from 25 percent in 2000 to about 14 percent by the end of 2001. Subsequent, albeit slow, resolution of the failed banks led to a gradual improvement in system-wide asset quality and profitability.

Table 4.1.Ownership Structure of the Banking System, 1994–2004
199419961998200020022004
Number of banks553531312520
Private29292520
Resident19181511
Nonresident1011109
State-owned2200
Memorandum items:
Total capital (in billions of drams)3.612.318.829.542.739.9
Of which:
Nonresident7.912.621.621.0
Resident10.916.921.018.9
Of which:
State-owned1.31.50.50.0
Minimum (tier 1) capital requirement (in millions of U.S. dollars)0.00.40.61.01.72.0
Source: Central Bank of Armenia.
Source: Central Bank of Armenia.
Table 4.2.Selected Financial Sector Indicators, 1998 –2004(In percent, unless otherwise indicated)
1998199920002001200220032004
Capital adequacy
Total regulatory capital to risk-weighted assets29.827.825.013.630.533.832.3
Tier I regulatory capital to risk-weighted assets27.225.923.312.328.832.230.2
Capital (net worth) to assets16.517.314.38.818.418.117.8
Capital and reserves (in billions of drams)26.333.133.620.442.151.764.7
Liquidity
Liquid assets to total assets37.839.730.533.144.547.547.1
Liquid assets to total short-term liabilities83.3100.186.180.4108.8101.398.7
Customer deposits to total (noninterbank) loans111.0125.5146.4198.4195.3177.1177.3
Foreign exchange liabilities to total liabilities74.679.780.679.772.273.273.3
Excess reserves to total reserves10.610.18.89.111.923.228.1
Asset quality
Total loans (billions of drams)1140.4167.1157.4154.8194.6194.6
Standard loans134.8158.1147.3149.3187.3187.3
Nonperforming loans (in billions of drams)5.68.910.05.67.37.3
Watch (up to 90 days past due)2.85.35.3
Substandard (91–180 days past due)3.35.25.51.91.01.0
Doubtful (181–270 days past due)2.33.74.60.91.01.0
Loss (>270 days past due)13.520.141.114.815.615.6
Non-performing loans to gross loans10.64.317.524.412.59.97.2
Interbank borrowing spread in dram57.059.546.729.07.82.62.0
Interbank borrowing spread in foreign currency59.039.935.022.03.63.71.0
Profitability
ROA (profits to period average assets)3.42.3–1.9–9.13.92.73.2
ROE (profits to period average equity)20.513.4–12.3–78.621.614.418.4
Interest margin to gross income41.740.330.727.837.642.044.2
Noninterest expenses to gross income36.033.836.442.749.648.547.2
Income from fees/gross income
Loans and deposits
Loans to deposits102.491.283.958.763.665.162.7
Loans to total assets48.448.951.642.644.243.240.4
Foreign exchange loans to total loans85.280.085.984.778.372.770.4
Foreign exchange deposits to total deposits75.181.081.681.076.777.278.6
Nominal interest rate spread (in dram)223.511.513.511.811.314.813.8
Nominal interest rate spread (in foreign currency)221.015.417.215.814.915.615.5
Sensitivity to market risk
Gross open positions in foreign exchange to capital17.313.822.588.315.313.87.4
Concentration3
Three largest banks41.735.231.235.340.340.539.6
Five largest banks55.950.346.848.454.154.556.1
Memorandum items:
Stock market capitalization to GDP0.10.41.0
Total assets to GDP16.719.322.919.813.717.719.2
Deposits (residents) to GDP5.97.110.310.68.79.08.7
Source: Central Bank of Armenia.

Loans exclude correspondent accounts and other interbank deposits.

Commercial bank lending-deposit spread for 12-month average of 3-month maturities.

Concentration is defined as the asset share of the three and five largest banks in the system.

Source: Central Bank of Armenia.

Loans exclude correspondent accounts and other interbank deposits.

Commercial bank lending-deposit spread for 12-month average of 3-month maturities.

Concentration is defined as the asset share of the three and five largest banks in the system.

At end-2004, concentration was moderate. The top three banks accounted for about 40 percent of the system’s assets. It is remarkable that so many banks could survive in such a small market. Part of the answer lies with the close economic ties to Russia, including through bank ownership. This has facilitated the development of a segmented banking system; some banks derive their profits primarily from money transfers and other services while other banks provide more traditional, albeit limited, lending services.

Another feature of the Armenian banking system is the high degree of both asset and liability dollarization. At end-2004, about 75 percent of banking system deposits were denominated in foreign currency. At the same time, foreign currency lending accounted for some 70 percent of total lending (Figure 4.2). Given the problems associated with high dollarization, Armenian banks are in a difficult position to lend prudently in domestic currency.47

Figure 4.2.Former Soviet Union and Central Europe: Dollarization, 2004

(In percent)

Source: IMF FSU database.

Foreign assets play an important role in banks’ balance sheets (Figure 4.3). Limited domestic investment opportunities at given interest rates often make investments in foreign currency assets the most prudent choice. In terms of credit, loans to the trade and services sector, which are presumably short-term, and industry loans accounted for the bulk of lending at end-2003 (23 percent and 20 percent, respectively), with mortgage lending just emerging.

Figure 4.3.Former Soviet Union and Central Europe: Composition of Assets, 2004

(In percent of total assets)

Source: IMF International Financial Statistics.

Armenia’s interest rate spreads between lending and deposit rates have come down in recent years, although they are above spreads in other Eastern European and Baltic countries (Figure 4.4). In general, the level of the spread is driven by (1) funding, operating, and regulatory costs; (2) the degree of credit risk; and (3) market power.48 In the Armenian context, cost and efficiency considerations and the degree of credit risk are key factors explaining high spreads. The high cost of loans (averaging about 20 percent) points to inefficiencies in the banking system and high credit risk. These inefficiencies are primarily related to weak financial reporting by banks and firms and poor enforcement of creditor rights.

Figure 4.4.Former Soviet Union and Central Europe: Average Lending Deposit Rate Spread, 2004

(In percent)

Source: IMF International Financial Statistics.

Nonbank financial institutions and capital markets

The nonbank financial sector comprises insurance companies, leasing companies, credit institutions, and pawnshops. While nonbank financial institutions play an insignificant role at this time, they are slowly beginning to grow. In particular, leasing activity could provide a useful vehicle for financing small and medium enterprises. Unlike bank loans, leasing operations do not require collateral and typically involve a lower downpayment.

Capital markets are virtually nonexistent. At end–2004, stock market capitalization accounted for 1 percent of GDP while capitalization of corporate securities accounted for 3 percent of GDP. There is almost no trading, as evidenced by the low turnover of 0.4 billion dram. At the same time, there are virtually no institutional investors except for 22 insurance companies with assets amounting to 0.3 percent of GDP. The insurance industry is at an embryonic stage, with most companies just meeting minimum capital requirements under Armenian law, namely 50 million dram (US$95,000).49

B. Regulation and Supervision

Recent studies have found that the key to successful financial intermediation is the creation of a level playing field, a sound legal framework, and well-governed financial institutions.50 A sensible approach toward financial sector supervision in good times is equally important as a well-defined resolution process in times of distress.

Armenia has made significant progress in recent years to put in place the basic legal framework governing the financial system. Key legislation comprises the Law on the Central Bank, the Law on Banks and Banking, and the Law on Bankruptcy of Banks. Insurance activities are covered by the Law on Insurance, which was redrafted recently, while securities market activity is based on the Securities Market Regulation Law of Armenia. In addition, supervisory capacity has improved markedly in recent years. Nonetheless, some shortcomings in the financial sector infrastructure, as discussed in the next chapter, should be addressed to provide the basis for financial sector growth in the future.

C. Why Has Financial Intermediation Been So Low?

Conventional measures of monetization suggest that Armenia compares poorly to other countries. Taking into account the central bank’s estimate on cash dollarization, the ratio of broad money to GDP at end-2004 would be higher at about 32 percent.51 The low level of banking system deposits can only be increased if confidence in the banking system improves. In addition, recent bank resolutions have been prolonged, creating uncertainties as to regulators’ resolve in dealing with unsound institutions and undermining the public’s confidence in the banking system. In an encouraging sign, credit growth has risen by 38 percent in 2004, although the ratio of private sector credit to GDP remains low at 7.5 percent.

Increased confidence in the banking system will require addressing some pending issues. Banking sector problems are rooted in a weak credit culture, fragile corporate governance, a lack of scale economies, insufficient creditor rights, and a feeble judicial system. There is no clear distinction between management and owners, and some banks still engage in connected lending or serve as “pocket” banks. In some instances, the true owners of banks cannot be identified despite the best efforts of the supervisory authority. This lack of transparency hampers the central bank’s ability to supervise banking institutions. The true risks of certain operations may not be fully visible until it is too late, which puts the institution and ultimately its depositors at risk.

In addition, financial reporting by enterprises—a critical element of making informed lending decisions—is still deficient, and there is a large underground economy. Unsurprisingly, about one-third of enterprises in Armenia find it hard to access bank credit. Capital accounts for 48 percent of firms’ balance sheets while bank credits (domestic) account for just 19 percent (Table 4.3).52 At the same time, high lending rates render many otherwise viable projects cost-inefficient, particularly for small and medium enterprises, and may potentially result in adverse selection.

Table 4.3.Liability Structure of the Enterprise Sector, 1999–2003(In percent of assets unless otherwise indicated, end-of-period)
199920002001200220036
Equity capital49.441.641.846.747.7
Liabilities50.658.458.253.352.3
Of which:
Short-term liabilities38.742.340.435.131.5
Bank credits (domestic)9.913.314.415.719.2
Debt to equity ratio102.3140.3139.1114.0109.7
Memorandum items:
Profitability1
Commercial2–22.0–31.0–14.7–11.0–13.4
Economic3–8.2–11.1–5.6–4.2–6.8
Financial4–16.2–23.7–13.1–9.4–13.9
Total profits (billions of drams)–108.0–163.0–77.4–59.3–99.5
Total assets (billions of drams)1,375.91,419.61,393.81,466.51399.5
Of which: State-owned51,058.7908.4857.5908.5
Number of enterprises included1,2231,1671,0381,0501,176
Source: Armenian authorities.

Profitablity is based on the sum of total profits before tax.

Profit before taxes divided by net turnover.

Profit before taxes divided by mean value of balance sheet assets.

Profit before taxes divided by mean value of equity capital.

Only enterprises with 100 prcent state ownership are included.

The base of indices for 2003 is the monitoring of data characterizing financial results of large and medium commercial organizations’ (included in business register of 2002) activities.

Source: Armenian authorities.

Profitablity is based on the sum of total profits before tax.

Profit before taxes divided by net turnover.

Profit before taxes divided by mean value of balance sheet assets.

Profit before taxes divided by mean value of equity capital.

Only enterprises with 100 prcent state ownership are included.

The base of indices for 2003 is the monitoring of data characterizing financial results of large and medium commercial organizations’ (included in business register of 2002) activities.

Credit policy is largely based on collateral, which many companies do not have, especially small and medium enterprises. At the same time, recovery of collateral is often difficult owing to the shortcomings in the judiciary. There is still a lack of experience in banking. Technology and knowledge transfer is limited. This makes sound financial data even more important. Better information will enable banks, as they gain experience, to lend based on business plans and expected cash flows. Ultimately, cash flow and creditworthiness will become an integral part of credit decisions.53

D. Key Challenges for the Coming Years

There is potential for the financial system to play a more active role in Armenia’s development. The banking system and, subsequently, capital markets can play a key role in assessing the efficiency of investments and contribute to faster economic growth.

Financial sector infrastructure, players, and regulators

The authorities can play a pivotal role in providing the infrastructure that supports the development of competitive markets. The basic infrastructure needed for successful financial sector growth includes strong legal rights for creditors and shareholders, sufficient disclosure standards and high-quality information, well-governed institutional investors, and support for private and public institutions. In Armenia, most of the legal preconditions for success are in place, though further enhancements to the system of creditor rights are warranted. What is really needed is the political commitment to ensure that the judicial system will enforce creditor rights and that bank managers and companies will be properly penalized for weak or nontransparent accounting and business practices. Only this commitment will provide the basis for long-term contracts and ensure a level playing field where the government and private agents compete for savings.

As noted above, Armenia has come a long way in providing a supportive legal infrastructure. Still, further amendments to the system of contractual relationships will help. These include improving procedural rules for creating, registering, and enforcing collateral (Civil Code); refining procedural aspects of court proceedings to facilitate a speedy recovery of loans (Civil Procedures Code); and enhancing the enforcement of court decisions (Law on Compulsory Enforcement of Court Decisions and Law on Public Auctions).54

Given that banking is the most important financial service in Armenia, improving confidence in banks should be the primary objective. In this context, the regulators need to ensure that banking supervision follows a transparent approach. Financial institutions should be treated equally, regardless of vested interests. Problem banks should be resolved in a timely and transparent fashion. In this context, the central bank is in a unique position to improve confidence by increasing the transparency of its own operations and policies. It should act forcefully towards banks that do not comply with prudential standards and limit the period of temporary administration of banks, that is, swiftly clean up the system of unsound institutions. Recent central bank proposals to beef up the regulatory framework, most notably by tightening exposure limits and adjusting the system of risk weights, will contribute over time to a healthier and more trusted banking system.

The authorities plan to implement a new corporate governance framework following international best practice.55 Banks are leveraged institutions and shareholders have small stakes relative to the deposit base, and depositors are important stakeholders whose interests need to be protected. This implies, for example, that shareholders, directors, and depositors should have access to information pertaining to banks’ activities and financial condition. At the same time, regulators need to ensure that financial reporting follows international accounting standards (IAS) as mandated by law.

The new credit registry under the central bank is a step in the right direction. The authorities could now encourage the establishment of private credit rating agencies to provide more comprehensive credit evaluation services. Contrary to the credit registry, credit rating agencies would also take into account areas such as timely utilities payments. In this context, it is also important that the central bank does not compete with services that could be provided efficiently by the private sector.

In general, scale economies suggest that fewer, larger institutions are more likely to help raise intermediation than smaller ones.56 Most banks in Armenia have a small share of an already small market (Figure 4.5). In this context, banks cannot finance larger projects unless they cooperate with other players, for example through loan syndications. While Armenian banking legislation permits loan syndication, in practice it is nonexistent. The imminent increase in capital requirements to US$5 million in mid-2005 will help facilitate consolidation through mergers, acquisitions, recapitalizations, or exits.

Figure 4.5.Asset Shares in the Banking System, End-2004

Source: ARKA (private Armenian agency).

Entry by reputable international financial institutions has the potential to bolster know-how in the banking system, promote good corporate governance, facilitate closing the funding gap (for example through credit lines from parent banks), and play a catalytic role in restructuring the domestic banking system through the provision of additional capital and potential integration with the European Union.57 Foreign entry can also play a pivotal role in promoting capacity building in overall bank management. Foreign entry can introduce better risk management and loan evaluation techniques. It can also enhance competition, facilitate the development of new financial products, raise and allocate long-term funds, and broaden the revenue base for banks. In order to facilitate entries by well-known institutions or prevent further entries by smaller banks with limited experience in banking, the authorities could limit the licensing of smaller banks and raise capital requirements further.

Despite the insignificance of nonbank financial institutions, there is potential for future growth. In particular, the insurance sector with just US$7.3 million in written premiums at end-2004—almost entirely nonlife insurance—remains nascent (Table 4.4). This suggests that there is plenty of scope for consolidation in the sector, especially since most insurance companies just meet the low capital requirement under the existing law. The new law on insurance addresses capitalization requirements as well as issues related to investment rules and reinsurance. The next step is to issue regulations to improve accounting, reporting, and auditing. Another important step is the adoption of compulsory types of insurance, such as for motor vehicles. Lastly, weaknesses in corporate governance equally apply to the insurance sector and need to be addressed as well.

Table 4.4.Key Insurance Indicators, 1999–2004
19992001200220032004
Volume of gross premiums (in millions of US$)2.13.84.34.77.3
Life0.030.030.030.030.03
Nonlife2.03.74.34.77.3
Gross premiums per capita (in US$)0.51.21.31.52.3
Gross premiums as a share of GDP0.110.180.180.170.21
Memorandum items:
Number of insurance companies21.025.023.02226
Total assets (in billions of drams)2.43.74.04.26.4
Total assets (in millions of US$)4.76.66.87.511.9
Exchange rate (end of period)523.8561.8584.9566.0485.8
Source: Armenian authorities.
Source: Armenian authorities.

The mortgage market also needs to be developed. Recent trends point to a surge of mortgage activity, although it represents about 2 percent of commercial banks’ assets. Looking ahead, training and regulatory incentives should pave the way for improving underwriting and standards for mortgages. There is an urgent need to adopt legislation prepared in 2004 to strengthen the legal basis for mortgage markets, including ensuring that mortgage contracts can be enforced and that the process for transferring titles is efficient. These measures should be enough to foster market development; other proposals to involve government guarantees or government lines of credit seem redundant at this point, given the lack of basic preconditions for the functioning of the primary mortgage market, and could generate moral hazard and contingent fiscal liabilities.

The virtually nonexistent stock market activity in Armenia is not surprising. Such markets are relatively small in all low-income countries. This, however, does not mean that Armenia cannot access the services of stock markets in other countries.58 Several recent developments in international capital markets—such as cross-border trade in financial services, harmonization of international practices for global capital raising and trading, and stronger technological links— should make it easier for any large corporations to list its stock and raise capital in the market that offers the best conditions.59

Markets for debt: active government policy?

The government securities market in Armenia is still thin, and the domestic debt-to-GDP ratio remains low at 2.7 percent (end-2003).60 Given that Armenia has so far largely relied on international financial institutions and other foreign donors to fund investment projects, there is an argument for tapping domestic savings more aggressively to eventually “graduate” from aid dependence. In addition, a deeper and liquid government securities market has the potential to facilitate monetary management.

There are several positive spillover effects associated with a developed government debt market. The market infrastructure provided by the debt market could be used for issuing private sector debt. Government debt would create a benchmark and, more generally, facilitate long-term financing in domestic currency instruments, including bank credit. From a financial sector perspective, a sound and liquid government debt market has the potential to improve the functioning of financial markets more generally. Deep financial markets would create market rates that reflect the opportunity cost of funds at each maturity (see Bank for International Settlements, 2002). Armenia could actually issue more debt beyond its financing need to accelerate the creation of this benchmark. A summary of other countries’ experiences is presented in Box 4.1.

Box 4.1.Developing Markets for Debt: Country Experiences

A number of countries have actively developed government securities markets to create benchmarks, develop a market infrastructure, and thereby facilitate the formation of corporate debt markets (Fry, 1997; and Bank for International Settlements, 2002). For example, some Asian countries had to rethink market strategies in the aftermath of the Asian crisis. Many believe that the crisis was partly caused by companies’ overreliance on the banking system. Companies often resorted to highly volatile short-term funding, often in foreign currency, which left them vulnerable. Domestic savings would have been sufficient to finance companies, and if debt markets had been more mature, some of these savings could have been channeled into domestic investment.

  • The Hong Kong Monetary Authority has developed a government debt market, despite the fact that the government did not need the funds raised. This, however, requires strong fiscal discipline to avoid moral hazard (i.e., the extra funds could finance new spending).

  • In Jamaica, a reference rate was established that could be used for pricing in the markets for commercial paper, certificates of deposits, interbank claims, and other repo markets.

  • In Malaysia, the infrastructure and procedures established for the government debt market served as models for private sector debt markets.

  • In Mexico, brokerage houses started operations in government securities and then expanded their activities using the same techniques to develop markets for private debt.

  • Due to a string of fiscal surpluses, Chile’s government has seldom issued debt. The central bank, however, has been issuing domestic government bonds to manage liquidity and establish a benchmark yield curve.

  • The Monetary Authority of Singapore (MAS) actively pursued the development of a liquid bond market. Like Greenspan (2000), the MAS took the view that an overdependence on the banking system has the potential to exacerbate problems for borrowers in a crisis, with the Asian crisis being a good example. To make available to investors a broader range of financial assets of varying credit risk and maturities, the following steps were taken to develop the Singapore dollar bond market: building and extending a benchmark yield curve through issuing government securities—a 10-year maturity in 1998 and a 15-year maturity in 2001; increasing the size of the issues per tranche; and establishing a repo facility to support primary dealers because repo markets are important to support secondary market activity.

Source: Schipke and others (2004).

While establishing a sound banking system should be a priority, the overall strategy for the financial sector should also focus on debt market development. Given the small size of Armenia’s debt market, a first step would be to increase volumes and extend maturities of government debt.61 Debt markets will provide a vehicle for long-term finance. Furthermore, a functioning corporate debt market can then serve as a substitute to bank financing. This would ameliorate the potential adverse effects of a credit crunch. Currency or maturity mismatches that may hamper growth could be reduced. Likewise, a debt market with long maturities will limit the potential bias towards short-term projects. Lastly, an efficient corporate bond market helps firms to lower their financing costs and provides competitive pressure for banks to lower their charges.

Government debt markets and monetary policy

A deep and liquid government debt market has far-reaching implications. Central banks have multiple interests in the development of a government debt market. Government securities provide a noninflationary financing vehicle and facilitate the implementation of monetary policy. In addition, as the transition process is accompanied by sizable capital inflows, the availability of domestic debt instruments facilitates the sterilization of such flows and liquidity management in general.

Armenia has benefited from significant capital inflows over the past few years. Cumulative net capital inflows during 1998 and 2003 totaled US$1.7 billion. While this has had significant developmental benefits, it complicated monetary policy, as the central bank was, and still is, lacking domestic instruments to absorb effectively the excess liquidity in the system. The solution here also lies in the issuance of additional treasury (or central bank) bills to boost the stock of dram monetary instruments. In any case, for sterilization of excess liquidity to be successful, closer cooperation and coordination between the Ministry of Finance and the central bank will also be required.

Increasing the presence on the international arena

Some transition countries have successfully launched bonds in international markets (Figure 4.6). While there is currently no pressing financing need in Armenia, a limited international bond issue could begin to raise investor awareness. It is worth pointing out, however, that a sovereign rating could be obtained without issuing a bond. Both could have positive spillover effects in the medium term. It would encourage the use of international corporate credit ratings for banks and corporations alike. Moreover, it would increase investor interest in the country and ultimately reduce aid dependence.

Figure 4.6.Bond Issues in International Markets, Cumulative 1995–2004

(In billions of US$)

Source: Capital Data.

E. Concluding Comments

Armenia’s financial system is small and dominated by the banking sector. The limited role the sector has played in the growth process is mainly the result of the lack of transparency in banks and borrowers coupled with poor enforcement of creditor rights and a weak judiciary. Looking ahead, as foreign assistance becomes less important, the financial system will need to assume its proper role in supporting future growth. This will require improvements in the above-mentioned areas, together with the entry of reputable (likely foreign-owned) banks.

When financial markets fail, it is critical to assess the reasons for such failure and to address them at their source. In many countries, including Armenia, the challenge is to ensure that the institutions governing the financial market are trusted by its participants. In this regard, the government should focus on setting the rules of the game rather than on interfering with the markets. It should provide the proper legal and institutional infrastructure and attack any distortions that impede market development. Lastly, the central bank should also shield itself from vested interests and political interference in its activities, especially banking supervision.

The recent large increase in deposits in the banking system and credit bode well for the much-needed increase in financial intermediation. A key task going forward is to build further confidence in the financial system by promptly removing troubled banks, strengthening banking supervision, pressing ahead with improvements in corporate governance and financial reporting in banks and enterprises, and implementing remaining legislation on creditors’ rights. In addition, the authorities need to actively promote foreign entry and further increase minimum capital requirements.

Capital markets in Armenia, given their early stage of development, are unable to provide financing for the economy. While banks are better placed to allocate savings during the transition process and to protect creditor rights, sole reliance on them carries its own risks. Thus, Armenia should further deepen the market for government securities because this can serve as a platform for private issues. By fostering the creation of a yield curve, bank credit maturities will also increase. Lastly, increasing attention needs to be devoted to creating the right environment for the development of insurance and primary mortgage markets.

References

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    GreenspanAlan2000Global ChallengesRemarks at the Financial Crisis Conference Council on Foreign RelationsNew YorkJuly12.

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The Central Bank administered and resolved eight banks; one bank was converted into a nonbank financial institution; and another one self-liquidated.

The Baltics include Estonia, Latvia, and Lithuania. Other Europe includes Belarus, Moldova, Russia, and Ukraine. The Caucasus includes Armenia, Azerbaijan, and Georgia. Central Europe includes Bulgaria, Cyprus, Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia. Central Asia contains Kazakhstan, the Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan.

See, for example, Havrylyshyn and Beddies (2003) on the implications of high dollarization in the former Soviet Union.

For a recent study covering the insurance sector, see Mu and others (2004).

See, for example, Levine (2002) and Claessens, Djankov, and Klingebiel (2000).

Feige (2003) studies the implications of cash dollarization in the former Soviet Union and Central Europe and finds “true” monetization to be much larger than reported in official statistics because of sizable foreign currency holdings.

The high degree of dollarization also makes prudent lending difficult as many borrowers lack foreign currency income.

Reported aggregate losses of companies, however, are quite high, casting doubts as to whether cash-flow-based lending is feasible at this time.

The implementation of these recommendations is foreseen under the World Bank’s Poverty Reduction Support Credit.

Corporate governance principles (designed by the OECD) capture the allocation of rights and responsibilities between shareholders and the board of directors.

The drawback to fewer larger institutions, however, is that institutions may become too big to be allowed to fail or exert market power.

Foreign participation in banking systems in the Baltic countries is a good example of this.

As pointed out by Claessens, Djankov, and Klingebiel (2000), the fact that there is limited scope for domestic stock market development does not automatically imply that transition economies will lack access to the services offered by stock exchanges.

Steil (2002) argues that creating a local stock market or ensuring local ownership may not necessarily be the best way of allocating domestic resources.

To date, maturities have been extended to five years and the issuance of 10-year paper is envisaged, but the volumes are still quite small and auctions are consistently oversubscribed.

Evidence suggests that both bank-based and market-based financial systems can contribute to growth (Levine, 2002).

Although the border is closed, there are no bilateral restrictions on trade between Turkey and Armenia. Thus, Armenia has limited imports of cigarettes, oil products, processed food, wheat, chemicals, and electronic devices from Turkey. This trade goes via Georgia, significantly raising transportation costs.

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