Republic of Armenia: Staff Report for the 2002 Article IV Consultation, First and Second Reviews Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria
Author: International Monetary Fund
Publication Date:
17 Oct 2002
eISBN:
9781451801552
Language:
English
Keywords:
ISCR; CR; PRGF arrangement; support poverty reduction effort; staff appraisal; interest arrears; value; Armenian authorities; government balance; customs regime; renewed commitment; government decree; Arrears; Energy sector
Download PDF (3.2 MB)

This paper focuses on the Republic of Armenia’s 2002 Article IV Consultation, First and Second Reviews Under the Poverty Reduction and Growth Facility (PRGF), and a Request for Waiver of Performance Criteria. The PRGF-supported program approved in 2001 focuses on revenue mobilization, the clearance of government arrears, and a decline in the deficit of the energy sector. Performance during the first year of the program was mixed. Tax collection was sluggish, and delays with structural reforms in the energy, water, and irrigation sectors led to the nonobservance of several quantitative performance criteria under the program.

Abstract

This paper focuses on the Republic of Armenia’s 2002 Article IV Consultation, First and Second Reviews Under the Poverty Reduction and Growth Facility (PRGF), and a Request for Waiver of Performance Criteria. The PRGF-supported program approved in 2001 focuses on revenue mobilization, the clearance of government arrears, and a decline in the deficit of the energy sector. Performance during the first year of the program was mixed. Tax collection was sluggish, and delays with structural reforms in the energy, water, and irrigation sectors led to the nonobservance of several quantitative performance criteria under the program.

I. Introduction

1. Discussions for the 2002 Article IV consultation and the first and second reviews under the Poverty Reduction and Growth Facility (PRGF) were completed in Yerevan during July 3–18, 2002, following three rounds of discussions on the reviews in July 2001, October 2001, and February 2002.1 The missions met with President Kocharian; the Minister of Finance and Economy, Mr. Khachatryan; the Chairman of the Central Bank, Mr. Sargsyan; the Minister of State Revenue, Mr. Zakharyan; the Minister of Energy, Mr. Movsesian; the Chairman of the Customs Committee, Mr. Avetisyan; other senior officials; representatives of the donor community; and private sector representatives.

2. At the conclusion of the 2001 Article IV consultation on May 21, 2001, Directors commended the authorities for their success in maintaining macroeconomic stability but stressed the need to adopt stronger revenue-enhancing measures, eliminate budgetary arrears, and protect social expenditures. Noting remaining weaknesses in the banking system, they encouraged the authorities to further strengthen prudential regulations. Lastly, Directors urged the authorities to move ahead with the privatization of the energy distribution companies (EDCs), and emphasized the importance of financial rehabilitation of state-owned companies in the energy, water, and irrigation sectors.

3. A three-year PRGF arrangement in the amount of SDR 69 million (75 percent of quota) was approved on May 23, 2001.2 SDR 10 million was disbursed at the time of approval, with another SDR 20 million to be disbursed upon completion of the combined first and second reviews (Table 1). Given Armenia’s low tax-revenue ratios, its history of high fiscal deficits, inadequate social spending, and high level of domestic arrears, the PRGF-supported program focuses on revenue mobilization and the clearance of arrears, with a view to laying the foundation for sustainable economic growth. It also seeks to curtail chronically high deficits in the energy, water, and irrigation sectors, which have been a drain on the government budget. A disappointing revenue collection and a weak performance of the energy sector in 2001 led to substantial deviations from the program targets, prompting frequent exchanges with the authorities on measures required to bring the program back on track and delays in completing discussions on the reviews under the program. In the end, understandings were reached on corrective measures undertaken during the first half of 2002 and on an economic program for the period July 2002-June 2003.

Table 1.

Armenia: Expected Fund Disbursements and Timing of Reviews

article image

4. In a letter to the Managing Director dated September 11, 2002 (Attachment I), and in the accompanying Memorandum of Economic and Financial Policies (MEFP) (Attachments II and III), the government of Armenia describes the implementation of its economic program through end-December 2001 and requests waivers for the nonobservance of performance criteria at end-June and end-December 2001. The MEFP also presents the second annual program extending until June 2003. Armenia’s adjustment efforts continue to be supported by the World Bank Group and international donors. Armenia’s relations with the Fund, the World Bank Group, and the European Bank for Reconstruction and Development (EBRD) are summarized in Appendices I and II.

II. Background and Key Challenges

5. The Armenian economy has experienced a rapid transformation since the mid-1990s. Following a massive output contraction in the early 1990s and high inflation up until 1997, successful stabilization and structural reforms have led to a sustained recovery in output, price stability, and, more recently, improvements in poverty indicators. During the last five years, the authorities have carried out a number of financial system reforms, modernized the tax and customs regimes, undertaken a large privatization program, rationalized public sector employment, and reformed the legal system. Despite these achievements, poverty remains pervasive, the fiscal deficit remained above 4 percent of GDP until 2001, tax and expenditure arrears have accumulated, and a number of commercial banks began to experience problems in 2000. The investment climate has also been hampered by governance problems and red tape and by the lack of trade relations with Turkey and Azerbaijan.

6. Against this background, the main challenges facing Armenia are to increase fiscal revenue, eliminate domestic expenditure arrears, reorient public spending toward the social sectors, restructure the banking system, reduce corruption, improve the efficiency of the judicial system, and reform the energy, water, and irrigation sectors. Progress in these areas will be a precondition for sustainable growth and poverty reduction.

III. Recent Developments and Performance Under the Program

7. The political situation has stabilized since the assassination of the prime minister, the speaker of parliament, and six members of parliament in October 1999. President Kocharian enjoys a stable parliamentary majority and is the leading candidate in the upcoming presidential election scheduled for February 2003. Parliamentary elections will be held by June 2003. Political and economic relations with Russia are strengthening, but the lack of a permanent solution for the Nagorno-Karabakh region continues to weigh on Armenia’s relations with Azerbaijan and Turkey.

8. The growth and inflation objectives of the program for 2001 were achieved, and economic performance in 2002 has been reassuring so far (Table 2). Real GDP grew by 9.6 percent in 2001 and by 9.7 percent year-on-year in the first seven months of 2002. Recent growth has been driven by advances in agricultural production, diamond cutting, food processing, construction, and increased tourism related to the 1,700-year anniversary of the adoption of Christianity as the state religion (Box 1). The 12-month rate of inflation was 3 percent in December 2001 and 1.2 percent in July 2002.

Table 2.

Armenia: Selected Economic and Financial Indicators, 1998–2003

article image
Sources: Armenian authorities; and Fund staff estimates and projections.

End of period. For 2002, the column displays the actual for June.

In percent of the three-year moving average of exports of goods and services centered on the previous year.

In percent of exports of goods and services.

Gross international reserves in months of import of goods and services.

A positive sign denotes appreciation.

Armenia: Main Economic Indicators, 1999–2002

article image
Sources: Armenian authorities, and staff estimates.

For the first half of 2002, the year-on-year growth rate is displayed.

Perspectives on the Growth Process

After a decline in real GDP of about 60 percent in 1991–93, a steady recovery began in 1994. Real GDP grew at an average of 6 percent per year during 1994–2001, a rate consistently higher than in most other CIS countries. Growth has been resilient despite several shocks, namely the 1998 Russian financial crisis, the 1999 political assassinations, the mass exodus of skilled youth, and the continued economic blockade by Turkey and Azerbaijan, two of Armenia’s four neighboring countries. Notwithstanding this high growth, output in 2001 was about 25 percent below its 1991 level.

After the break-up of the Soviet Union, 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. During the last five years, the most dynamic sectors have been food processing, non-metallic minerals, jewelry, and construction. Exports and donor-financed investment have been driving growth in recent years, with exports increasing from 12 percent of GDP in 1998 to 17 percent in 2001.

A01fig01

Real GDP Growth in Armenia and Other CIS Countries

(Annual average, in percent)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

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

This positive growth performance can be attributed to the natural catching up process after the collapse in output in the early 1990s and to radical economic reforms carried out since 1995. These reforms, implemented with the support of the Fund and the World Bank, led to significant capital inflows, improvements in competitiveness, and a continued process of market-driven import substitution.

While medium-term growth prospects for the country remain favorable, the forecasts need to be tempered by a number of risks and potential barriers, such as a high concentration of exports of processed diamonds, a low level of financial intermediation, limited managerial skills, and the inconsistent application of laws and bankruptcy procedures.

9. Program implementation in 2001 was mixed. Current non-interest expenditures were rationalized in 2001, allowing for savings off 1.2 percent of GDP. The fiscal deficit on a commitment basis narrowed to 3.9 percent from 6.4 percent of GDP in 2000. However, tax revenues fell short of expectations, reflecting insufficient improvements in tax administration.3 The stock of domestic budgetary arrears also exceeded the program ceilings, mainly because of delays in World Bank financing which were, in turn, partly related to the failure to privatize the electricity distribution companies (EDCs). Pension fund arrears were significantly reduced in 2001, although not completely eliminated as envisaged under the program. Overall, nine quantitative and one structural performance criteria were not observed in 2001, mainly reflecting a disappointing tax revenue collection and poor performance of the energy sector.4

Armenia: Selected Fiscal and Quasi-Fiscal Indicators, 1999–2002

article image
Sources: Armenian authorities; staff estimates and projections.

10. Delays with structural reforms in the energy and other quasi-fiscal sectors5 continued to be a major constraint on their financial performance. A second attempt to privatize the EDCs—a condition under the World Bank’s fourth structural adjustment credit (SAC IV) floating tranche—failed in that year because of the poor financial situation of these companies and the deterioration in the global investment climate following the terrorist attacks in the United States. The four EDCs were subsequently merged into one company in early 2002 and tender offers for a management contract or privatization of the merged company were launched. The primary deficit of the energy sector widened to 2.5 percent of GDP in 2001 (compared to equilibrium under the program) amid lower collection rates and low tariffs, while the combined primary deficit of the energy and other quasi-fiscal sectors increased from 2.6 percent of GDP in 2000 to 3.6 percent in 2001. Preliminary data indicate a rapid improvement in the primary balance of the energy sector in the first half of 2002, the result of new efficiency measures, a frontloading of subsidies to irrigation and water companies, and heavy rains which allowed for increased hydroelectric generation. In February 2002, an agreement was signed with a private manager for the state-owned chemical company Nairit, a notorious nonpayer of taxes and electricity supply.

11. Missions in July and October 2001 were unable to complete discussions on the first review because of insufficient reductions in budgetary arrears and lack of understanding on measures to improve revenue performance in 2002. Corrective measures began to be implemented in 2002. The authorities included a number of important tax and customs policy and administration measures in the 2002 budget, and a mission in February 2002 reached understandings on a program for 2002 including a set of prior actions and quantitative targets. However, the emergence of non-programmed expenditures and revenue concerns in March 2002 raised doubts about the ability to meet the tax revenue and budgetary arrears targets, leading to a further delay in the completion of the discussions on the reviews.6 While a cause of concern, these overruns do not appear to have compromised the annual budgetary targets, as the authorities utilized budgeted amounts from the reserve fund. Past experience also points to a good track record of adhering to annual budgeted appropriations despite sporadic overruns during the first three quarters of the year. By mid-2002, tax revenues were in line with projections,7 energy sector performance showed signs of improvement, and the authorities had implemented key measures in the areas of tax and customs administration and governance (Table 3 and Attachment n, Table 2) on the basis of which they are requesting waivers for the nonobservance of the performance criteria in 2001 (Tables 4 and 5).

Table 3.

Armenia: Fiscal Measures for 2002–03

article image
article image

Structural performance criterion or structural benchmark under the July 2002-June 2003 program.

Table 4.

Armenia: Quantitative Performance Criteria and Indicative Targets, 2001

article image

Benchmarks.

Performance criteria.

The ceiling for March 2001 has been adjusted downwards by higher-than-programmed grants of US$ 2.2 million. For June 2001, the ceiling has been adjusted upwards by lower-than-programmed grants of US$0.01 million and non-receipt of amortization due from Georgia of US$1.9 million. For September and December, the ceilings have been adjusted upwards by non-receipt of amortization due from Georgia of US$ 1.9 million and US$ 3.8 million, respectively. The program exchange rate of dram 550 per US dollar was used for the conversions.

The actual figure for the end-December 2000 stock of arears has been included, replacing the original program figure of dram 44.4 bilion. The December 2000 primary balance of the energy sector was also revised from the earlier preliminary figure of dram 0.2 billion.

Cumulative during the year.

The ceiling for March 2001 has been adjusted upwards by higher-than-programmed grants of US$2.2 million. For June 2001, the ceiling has been adjusted downwards by lower-than-programmed grants of US$ 0.01 million. For September and December, the ceilings have been adjusted downwards by lower-than-programmed grants of US$0.8 million and US$4.3 million, respectively. The program exchange rate of dram 550 per US dollar was used for the conversions.

As per the original agreement, there are two distinct performance criteria on external arrears, one on the stock of arrears and a continuous criterion on the non-accumulation of new arrears. The authorities had a deferral from external creditors between May and November 2001. At the expiration of the deferral, the authorities began to accumulate new arrears. As a result, the performance criteria on both the new and the existing stock of external arrears were not observed at end-December 2001.

Table 5.

Armenia: Structural Performance Criteria and Benchmarks 2001

article image

12. Monetary policy over the past 18 months has continued to focus on maintaining price stability. The central bank of Armenia (CBA) sought to keep reserve money within a target corridor and, more recently, it began monitoring inflation developments closely in order to fine-tune monetary policy and counteract unanticipated shifts in the demand for money. Concerns about deflationary pressures stemming in part from an unexpected decline in the price level between June and September 2001 prompted the central bank to ease monetary policy in the last quarter of that year. This, together with a larger-man-programmed profit transfer to the government to settle an unanticipated foreign debt payment, led to the nonobservance of the end-December net domestic assets target. Monetary policy was somewhat tightened in the second quarter of 2002 to dampen incipient price pressures as the 12-month rate of inflation rose to 3.7 percent in June. Net international reserves of the CBA exceeded the program floor at end-December 2001, and gross international reserves continued to exceed 3.5 months of imports of goods and services. Bank lending and deposit rates have declined in recent years, but they remain high in real terms mainly because of significant credit default risks.

A01fig02

Monetary Growth and Inflation

(In percent, 12-month rate)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

A01fig03

International Reserves

(ID millions of US. dollars)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

A01fig04

Interest Rates of Commercial Banks

(In Percent)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

13. The 2000 Financial Sector Assessment Program (FSAP) concluded that the financial sector could be vulnerable to potential internal and external shocks, but that a systemic crisis was unlikely and would have only a limited effect on the economy given the small size of the banking system. The report identified the need for further consolidation of the system and changes in provisioning and supervision procedures. Most of these recommendations have been implemented to date. There was a decline in nonperforming loans during the last three years mainly as a result of loan write offs and more cautious lending policies by commercial banks. Nevertheless, a number of commercial banks continued to struggle with low-quality loan portfolios, weak profitability, and worsening indicators of capital adequacy, liquidity, and solvency (Appendix IV). Between November 2000 and December 2001, the central bank liquidated two banks and placed seven others under interim administration. Most of these problems occurred as a result of insider abuse. In early 2002, the CBA merged two commercial banks, placed the merged bank under interim administration (bringing the number of intervened banks to eight), and extended a US$5.5 million credit line in its support. The eight banks under temporary administration account for 18 percent of the banking system’s assets.8 The central bank is taking steps to reinforce its supervision, and has created a bank resolution department to deal with problem banks. The staffs of the Fund and the Bank have been monitoring developments in this area and have concluded that while the current situation does not pose an imminent systemic threat (all but one of the intervened banks are currently non-operational), more frequent on-site inspections will be required to monitor performance and to adopt appropriate measures against banks that fail to comply with prudential requirements.

Armenia: Indicators of Banking System Soundness, 1998–2002

(End-of-period ratios, in percent)

article image
Source: Central Bank of Armenia.

These figures reflect the exclusion of seven banks currently in interim administration.

14. The authorities have made progress in implementing fiscal and financial sector reforms during the last year. All measures scheduled for implementation in 2001 were carried out, although in a few cases with delays (Table 5). The key measures implemented include passing a financial disclosure law for senior public officials and a treasury law, setting up an automated audit system for the value-added tax (VAT), and introducing legislation aimed at strengthening the CBA’s ability to deal with problem banks. In addition, the authorities approved a new civil service law, established an internal audit unit at customs, and set up a government committee to work on an anti-corruption strategy in cooperation with donors. Further reforms in the areas of tax and customs administration and governance have been implemented since January 2002 (Table 3). These include a reduction in the number of goods exempted from VAT at the border effective January 1, 2003, the introduction of penalty rates for over-reporting of losses for profit tax purposes, the establishment of a large taxpayers unit (LTU), and amendments to the law on inspections to ease restrictions on audits of individual taxpayers and accelerate enforcement of penalties against fraudulent taxpayers.

15. The external current account deficit remains wide but, since 1998, it has narrowed significantiy based on strong export growth, an upswing in tourism receipts, and subdued import demand. Both the trade balance and the current account have improved further in the first half of 2002, with merchandise exports growing by 40 percent. While emigration has deprived the country of a well-educated portion of the population, remittances have become a major source of income amounting to about 4 percent of GDP a year. Supported by the continued low-inflation environment, the dram has been stable in nominal effective terms in recent years. However, a real appreciation of the Russian ruble between December 1999 and June 2002 was matched by a 19 percent real depreciation of the dram during the same period. This real depreciation combined with high productivity growth in the tradable sector and relatively low real wages have been the driving forces behind recent improvements in competitiveness and the observed narrowing of the current account deficit.9

A01fig05

Exports, Imports, and the Current Account

(In percent of GDP)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

A01fig06

Real and Nominal Effective Exchange Rates

(Index: 1995=100)

Citation: IMF Staff Country Reports 2002, 228; 10.5089/9781451801552.002.A001

16. External debt indicators have been gradually improving since 1999 (Table 2). At end-2001, Armenia’s stock of external public debt amounted to US$587 million in net present value (NPV) terms (129 percent of exports of goods and services), of which US$17 million was in arrears to Russia and Turkmenistan. The authorities have been renegotiating Armenia’s public debt to Russia and Turkmenistan, which amounts to 18 percent of the country’s external debt in net present value terms. Pending final agreement, debt service was interrupted between September 2001 and August 2002. A 10-year program on economic cooperation with Russia was signed in 2001, and an agreement was subsequently reached on a debt-equity swap whereby all of Armenia’s public debt to Russia (about US$100 million) will be exchanged for Russian stakes in Armenian state-owned enterprises by early 2003. The debt service savings in 2003 as a result of this agreement will amount to 0.5 percent of GDP. The authorities have also been negotiating a rescheduling agreement with Turkmenistan under which they will commit to pay the outstanding stock of debt by end-2003. Prior to the Executive Board meeting, it is expected that the authorities will have effectively regularized their external arrears to these creditors through cash payments and/or deferrals.

IV. Policy Discussions

17. Discussions for the 2002 Article IV consultation and the first and second reviews under the PRGF arrangement focused on policies required to bring the program back on track and address the key challenges facing the country. The authorities agreed that sound fiscal policies and an acceleration of reforms were essential for these purposes. The discussions covered (i) macroeconomic prospects and policies for the second annual program (July 2002-June 2003) and the medium term; (ii) fiscal and monetary policies and banking system reforms; (iii) the balance of payments and external debt outlook; (iv) reforms in the energy, water, and irrigation sectors; and (v) measures to increase transparency and strengthen governance.

A. Macroeconomic Objectives and Policies for 2002–03 and the Medium Term

18. The medium-term strategy envisaged in the interim poverty reduction strategy paper (I-PRSP) and aimed at maintaining high economic growth and reducing poverty remains unchanged. The PRSP is expected to be finalized by end-2002. The program for 2002–03 is centered on continued prudent macroeconomic policies and selected reforms in the areas of tax and customs administration, banking system, transparency, and governance. Within the context of the PRGF arrangement, the authorities are committed to increasing fiscal revenue, prioritizing expenditures, and improving governance. Reforms in the energy, water, and irrigation sectors are included under World Bank conditionality.

19. While the recent quick pace of economic activity bodes well for the future, the authorities recognize several uncertainties and have carefully formulated their growth assumptions. Real GDP growth is projected at 7.5 percent in 2002 and 6 percent in 2003–07, and inflation is targeted at no more than 3 percent a year. Growth will be driven by the development of technology-intensive and mineral and food-processing activities, aided by external grants channeled to investment and reconstruction. Fiscal policy will continue to be directed at increasing tax revenue in order to keep the budget deficit under control while increasing poverty-reducing expenditures and eliminating domestic payment arrears. The current account deficit is expected to narrow further toward 6 percent of GDP over the next five years, and gross international reserves are projected to remain at about 3.7 months of imports.

Armenia: Main Economic Indicators, 2001–07

(In percent of GDP, unless otherwise indicated)

article image
Sources: Armenian authorities; and Fund staff estimates and projections.

Defined as current expenditure on health, education, and transfers to local authorities.

B. Fiscal Policy

20. The fiscal deficit on a commitment basis is projected to decline further to 2.1 percent of GDP in 2002 and to increase slightly to 2.5 percent of GDP in 2003, on the basis of continued efforts to mobilize revenue and prioritize expenditures (Table 6). The deficit on a cash basis is somewhat higher than the one on a commitment basis because of payments to settle domestic expenditure arrears. Tax revenues are projected to increase by about 0.5 percent of GDP a year. Current spending as a share of GDP will continue to fall in 2002 because of lower interest costs, further rationalization of employment, and better targeting of social allowances.10 Contingent on clearing budgetary arrears related to existing commitments first, the room created by increased revenues in 2003 will allow for an increase in current expenditures and public sector wages in real terms. The authorities are also committed to increase social expenditures by about 0.3 percent of GDP in 2003, in line with the priorities identified in the Public Expenditure Review (PER) and the interim PRSP. Public investment is expected to increase by 1.6 percent of GDP in 2002 and by an additional 1.5 percent of GDP in 2003; much of the increase is being financed by grants from the American-based Lincy foundation.11

Table 6.

Armenia: Central Government Operations, 2000–03

Sources: Armenian authorities; and Fund staff estimates and projections.
Sources: Armenian authorities; and staff estimates and projections.

Agreed with the authorities during the February 2002 mission.

Budget estimates adjusted to include the proceeds from monetization of commodity grants.

Excluding external arrears on principal.

Armenia: Functional Classification of Government Expenditures, 1997–2007

(In percent of GDP, unless otherwise indicated)

article image
Sources: Armenian authorities; and staff estimates.

21. The authorities agreed that increasing revenues is essential to meet expenditure needs and facilitate the clearing of expenditure arrears. The tax and customs measures implemented during the first half of 2002 have set the stage for increased collections in the years ahead. The staff noted, however, that additional training of tax inspectors would help strengthen tax enforcement. It also underscored that tax liabilities should be strictly based on objective and transparent criteria rather than negotiated in an ad-hoc fashion, thereby preventing discriminatory treatment across taxpayers. Understandings were reached on a package of additional measures to be implemented during the program period aimed at enhancing transparency in tax and customs collection, reducing the room for discretion, and increasing revenue. These measures range from setting up fully operational audit units at the Ministry of State Revenue (MSR) and customs, to establishing a computerized customs valuation database (Box 2).

Tax and Customs Administration Measures, September 2002-June 2003

  • Review the law on the simplified tax with a view to eliminate remaining loopholes.

  • Establish fully operational audit unit at the MSR and prepare quarterly audit reports at the MSR and at customs.

  • Improve administration of VAT refunds by simplifying procedures, reducing processing time, and preparing reports on amounts of VAT due.

  • Adopt codes of conduct for MSR and customs officials.

  • Establish a computerized database on import valuation.

  • Establish websites at the MFE, the MSR, and customs, displaying fiscal execution figures, tax and customs laws and regulations, and guidelines for staff.

  • Reduce the bi-annual individual duty-free exemption from US$500 to US$300 and introduce mobile passport reading machines to enforce the limits on duty-free exemptions.

  • Initiate a review of customs code regulations with a view to making their interpretation and implementation transparent.

  • Introduce a system for random checking of goods at customs and improved management reporting.

  • Introduce a post-clearance verification program at customs’ headquarters.

  • Expand the customs’ consultative committee to include business representatives and external advisors.

22. A free-trade zone (FTZ) will be established at the Yerevan airport, exempting exporters operating in the zone from profit taxes. Since existing business may seek to move to the zone, the staff cautioned against a potential erosion of the tax base and suggested less distortionary tax incentives, such as investment allowances. The authorities were, however, confident that the FTZ would mainly attract new businesses that would have otherwise not come to Armenia, and that the zone would be sealed to prevent leakages. Understandings were reached to review the revenue implications (and, if necessary, the incentive scheme) of this initiative one year after the FTZ has begun its operations.

23. Further reforms are also expected in the areas of expenditure control and budget management. Building on the recent approval of the new treasury law and of procedures to improve public procurement, further measures envisaged in the program include implementing commitment control procedures, improving the budget reporting system, establishing an internal audit unit at the Ministry of Finance and Economy (MFE), and setting up a system to account for external grants to the government. The PER and the forthcoming medium-term expenditure framework (MTEF)12, both developed in collaboration with the World Bank, will lay the ground for an improved composition and prioritization of public spending, particularly toward social programs.

C. Monetary Policy and Financial Sector Issues

24. The monetary program for 2002–03 seeks to preserve price stability. It assumes an increase in the demand for broad money of about 14 percent and 13 percent in 2002 and 2003 respectively (Table 7). Reserve money is programmed to grow by 10 percent a year, with the money multiplier increasing slightly alongside increasing confidence in the banking system. Because of the usual uncertainties surrounding the demand for money and the transmission mechanism, the central bank will, in addition to tracking intermediate monetary targets, continue monitoring inflation developments closely.

Table 7.

Armenia: Monetary Accounts, 2000–03

article image
Sources: Armenian authorities; and staff estimates and projections.

Beginning November 2001, the broad money figures have been revised downward to exclude deposit liabilities of banks placed under interim administration.

At actual exchange rates.

At program exchange rates, as specified in the technical memorandum of understanding.

Ratio of foreign currency deposits to total deposits (in percent).

Ratio of currency in circulation to deposits (in percent).

25. The staff noted that weakness in the legal system hampers the collection of collateral by banks and the enforcement of bankruptcy procedures. This, in turn, keeps credit risks and real lending rates high. The authorities acknowledged this problem, and stated their commitment to review the legislation on collection of collateral and on bankruptcy and seek to ensure the efficient functioning of the legal system.

26. The staff urged the authorities to take decisive steps to resolve the situation of the eight problem banks under interim administration, possibly through liquidation, and to ensure a rapid and orderly reduction in the number of banks in the system. While seven of the intervened banks are non-operating and do not pose a systemic risk, the staff noted that the situation of the largest one needed to be resolved promptly as this bank was reportedly insolvent but still operational. The staff also noted that a prolonged resolution process by the CBA for these banks may increase uncertainty and reduce confidence in the banking system. The authorities argued, however, that in light of the inefficiencies of the legal system, the central bank needed more time to maximize asset recovery and compensate depositors. Understandings were subsequently reached to revoke the licenses and hand over to the courts the five smallest banks under interim administration by February 2003, to prepare guidelines on temporary intervention and resolution of problem banks by February 2003, to conduct least-cost diagnostic analyses and formulate resolution strategies for the remaining three banks by April 2003, and to resolve the situation of the largest bank under interim administration by end-June 2003.

27. The authorities agreed on the need to strengthen banking supervision and fully enforce prudential regulations. To facilitate the restructuring of banks, the authorities will increase minimum capital requirements for existing banks from US$1.65 million to US$2 million in mid-2003, and to US$5 million (the same level as for new banks) in mid-2005. The authorities also plan to introduce a deposit insurance scheme by mid-2005, and premiums will start to be collected next year. MAE has endorsed the scheme, which will exclude the banks under interim administration. The central bank is developing a credit registry to facilitate the screening of borrowers, and there is a need for commercial banks to adopt this system as soon as possible.

28. The authorities have recently completed the Fund’s Anti-Money Laundering/Combating the Financing of Terrorism questionnaire, which identified the need for changes in the legal and institutional frameworks. The authorities have recently adopted a resolution on anti-money laundering and established a committee to continue working on the issue. They are also evaluating the need for technical assistance. Lastly, legislation has been passed on non-bank financial institutions, and the CBA is preparing the regulatory framework for their operations and supervision. In this context, the staff recommended that the functions of non-bank financial institutions be clearly defined to ensure that they do not become de-facto banks subject to less strict supervision.

D. External Sector and Capacity to Repay the Fund

29. The balance of payments, although still vulnerable, should continue to improve during the program period. The current account deficit is projected to narrow further in 2002 and remain unchanged in 2003 mainly as a result of continued growth in exports of minerals, processed diamonds, agricultural products, textiles and information technology. Capital transfers will be bolstered by grants from the Lincy foundation, and gross international reserves are expected to increase slightly to 3.8 months of imports in 2002–03 (Table 8). The remaining financing gap would be financed by IMF disbursements under the PRGF arrangement and structural adjustment loans from the World Bank.

Table 8.

Armenia: Balance of Payments, 2000–07

article image
Sources: Armenian authorities; and Fund staff estimates and projections.

Includes errors and omissions.

Excluding prospective PRGF disbursements which are included in the financing gap.

Accumulation and clearance of arrears and, in third and fourth quarters of 2002, also including debt relief based on the July 17, 2002 agreement with Russia that is expected to be finalized in 2003.

In 2000, debt relief. In 2001–02, accumulation and clearance of arrears.

Imports of goods and services.

Government and government-guaranteed medium and long-term debt.

A three-year moving average of exports of goods and services (centered on the previous year).

For 2002, the table shows a technical accumulation of arrears as a result of the debt agreement with Russia that is expected to be finalized in early 2003. This figure differs from the one in Attachment II, Table 1, because of the deferral obtained from the Russian authorities in July 2002.