Republic of Armenia: Fourth Review under the Poverty Reduction and Growth Facility and Request for Waiver of Performance Criterion

Armenia showed strong economic performance owing to its prudent macroeconomic policies and structural reforms, under the Poverty Reduction Growth Facility (PRGF) Arrangement. Executive Directors welcomed this development, and stressed the need to strengthen the tax system, structural reform agenda, and implement an effective anticorruption strategy. They emphasized the need to improve monetary stance, the legal financial sector framework, and banking supervision. They agreed that Armenia has successfully completed the fourth review under the PRGF program, and approved waiver.

Abstract

Armenia showed strong economic performance owing to its prudent macroeconomic policies and structural reforms, under the Poverty Reduction Growth Facility (PRGF) Arrangement. Executive Directors welcomed this development, and stressed the need to strengthen the tax system, structural reform agenda, and implement an effective anticorruption strategy. They emphasized the need to improve monetary stance, the legal financial sector framework, and banking supervision. They agreed that Armenia has successfully completed the fourth review under the PRGF program, and approved waiver.

I. Introduction

1. The Executive Board concluded the third review under the Poverty Reduction and Growth Facility (PRGF) arrangement on April 2, 2003 (IMF Country Report No. 03/93).1 At that time, Directors commended the authorities for the successful implementation of macroeconomic and structural policies that had kept inflation low, reduced the fiscal and external current account deficits, and created an environment conducive to strong economic growth. Directors encouraged the authorities to improve tax and customs administration and budget reporting, strengthen banking supervision, proceed with further reforms in the energy sector, and prepare an effective anti-corruption strategy.

2. Discussions on the fourth review of the PRGF arrangement were held in Yerevan during missions in July and September 2003.2 In the attached Letter of Intent (Attachment I), the authorities request the completion of the fourth review and seek a waiver for the nonobservance of the end-June 2003 performance criterion on the stock of domestic expenditure arrears. The accompanying Memorandum of Economic and Financial Policies (Attachment II) describes the progress made this year in implementing the program and sets out the policy framework through June 2004. The program is broadly in line with the recently approved PRSP. Armenia’s structural reform agenda is also supported by the World Bank Group, the European Bank for Reconstruction and Development (EBRD), and international donors. Appendix I summarizes Armenia’s relations with the Fund including technical assistance provided and assessments of Standards and Codes. Appendices II and III describe relations with the World Bank and the EBRD, respectively. Appendix IV discusses the quality and timeliness of key economic data.

II. Recent Developments and Performance Under the Program

3. The political situation has stabilized after contentious general elections earlier this year. Following the May 25 parliamentary elections, the National Assembly endorsed a pro-presidential three-party coalition, the Prime Minister and the Minister of Finance were reconfirmed in their positions, and the sporadic demonstrations by the opposition subsided. The new government’s program, endorsed by parliament in July, maintains a pro-reform policy stance and is in line with the PRSP. Negotiations with Azerbaijan on the Nagorno-Karabakh conflict have not yet resumed. There have been discussions with Turkish officials on possible steps to improve relations, but the lifting of the trade blockade remains uncertain.

4. Armenia’s economic performance has continued to exceed expectations. Real GDP growth accelerated to 15.2 percent during the first 9 months of 2003. About one-half of such growth originates in the unusually high level of donor-financed investment, while the rest reflects a booming export sector and deepening import substitution.3 The twelve-month rate of inflation rose from 2 percent at the end of 2002 to 7.5 percent in September 2003, reflecting a 17 percent increase in the price of bread between June and September.4 All the other CPI components displayed little change during the twelve months through September. For the year as a whole, the projections for real GDP growth and inflation have been revised upwards to 12 percent and 4 percent, respectively (Table 2).

A01fig01

GDP Growth in Armenia and other CIS countries

(In percent, annual growth)

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

Armenia: Main Economic Indicators, 2000–04

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Sources: Armenian authorities: and Fund staff estimates.
Table 1.

Armenia: Fund Disbursements and Timing of Reviews, 2001–04

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Sources: Finance Department (IMF); and Fund staff.
Table 2.

Armenia: Selected Economic and Financial Indicators, 1999–2004

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

End of period.

Data for 2003 is based on actual data for September.

Data for 1999–02 include the electricity distribution company. Armelner, which was privatized in late-2002. Data for 2003–04 exclude Armelner and two generation companies that were also privatized.

In U.S. dollars terms.

Net present value of debt in percent of a three-year moving average of exports of goods and services, the latter centered on the previous year.

In percent of exports of goods and services.

Gross international reserves in months of next year’s imports of goods and services.

A positive sign denotes appreciation. Base year 1995=100. Data for 2003 displays the change between December 2002 and August 2003. The calculations are based on 1999–2001 average trade weights.

5. The PRGF-supported program remained on track during the first half of 2003. All but one of the quantitative performance criteria for end-June 2003 were met and all structural measures envisaged for implementation during April 2003–June 2003 were carried out on time or implemented with a small delay (Tables 3 and 4). The end-June 2003 performance criterion on the stock of domestic expenditure arrears (targeted at zero) was exceeded by a small margin because of verification and technical problems in handling some expenditures. As envisaged under the program, the authorities adopted measures in the second quarter of 2003 to strengthen expenditure control and the stock of arrears at end-August 2003 fell to AMD 0.2 billion.5

Table 3.

Armenia: Quantitative Targets, December 2002 - June 2003 1/

(End of period ceilings on stocks, unless otherwise specified)

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The definitions of the line items and the adjusters on the fiscal balance and the stock of domestic arrears are specified in the Technical Memorandum of Understanding (TMU) (IMF Country Report No. 03/93, Attachment III).

Indicative target.

Performance criterion.

At program exchange rates as specified in the TMU.

Cumulative flow from the beginning of the calendar year until the end of the month indicated.

As specified in the TMU, the March and the June targets have been increased by AMD 3.5 billion and AMD 8.5 billion, respectively, on account of a shortfall in externally financed disbursements.

Excluding the balance of the privatized electricity distribution company.

Obligations with maturity of less than one year, excluding normal import-related credit and sales of treasury bills to nonresidents.

Table 4.

Armenia: Structural Measures Under the Fourth Review

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End of period.

Information on the date of implementation will be provided before the Board meeting.

6. Fiscal policy remained prudent in the first half of 2003 and the targets on the cash deficit and nominal tax revenues were met. The fiscal deficit on a commitment basis during the first half of 2003 was equivalent to 1.7 percent of GDP compared to 3.1 percent under the program. This reflected lower-than-budgeted expenditures because of capacity constraints in project implementation units and a harsh winter (Table 5). The fiscal deficit for the year as a whole is projected at 2 percent of GDP. Although tax revenues increased by 12.7 percent in the first three quarters of 2003 compared with the same period last year, they are not keeping up with the unanticipated expansion in economic activity because of high growth in nontaxed sectors as well as weaknesses in tax and customs administration (Box 1).

Table 5.

Armenia: Central Government Operations, 2001-04

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Table 5.

Armenia: Central Government Operations, 2000-04 (concluded)

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Sources: Ministry of Finance, Central Bank of Armenia, and Fund staff estimates.

To facilitate the comparison of figures, the composition of expenditures for 2002 and the program columns for the first half of 2003 have been adjusted to reflect changes in expenditure allegories brought about by the reclassification of budgetary institutions as non-commercial enterprises in 2003.

Net lending figures in 2003 have been adjusted to reflect the share of loans from the Lincy Foundation intermediated through the banking system.

Excluding external arrears on principal which are included in external financing.

In the second half of 2003 the amount of non-bank; financing reflects the cancellation of arrears as a result of the debt-equity swap with Russia.

The Stock of domestic arrears after June 2003 differs from the program’s performance criterion of zero arrears (Attachment II, Table 1) as defined in the Technical Memorandum of “Understanding (Attachment III). This is due to the recurrence of a negligible amount of arrears of a technical nature.

Armenia’s Tax Revenue Performance

While nominal tax revenue has been improving since 2000, performance relative to GDP has been disappointing. This reflects weaknesses in tax administration as well as recent high growth in nontaxed activities such as re-exports of processed diamonds and grant-financed construction.

Profit tax collection in recent years has been particularly poor, showing a nominal decline of 11 percent year-on-year through September 2003. Moreover, the effective collection rate has been declining and is estimated at 6 percent in 2002, well below the statutory rate of 20 percent. Such weak performance is especially difficult to fathom given the booming economy and it reflects limited capacity of tax auditors, creative accounting practices by companies, and generous tax deductions.

Other taxes including the VAT have performed relatively better. VAT collections grew by 13 percent. year-on-year through September 2003. Still, the tax base for the VAT (calculated by staff excluding value added in nontaxed sectors) shows that there is room for improvement in tax administration. Further, VAT exemptions on imports of selected intermediate inputs and capital goods (equivalent to about 15 percent of total imports) undermine the integrity of the tax system, distort price signals, and create an uneven playing field among importers.

Armenia: Tax Revenues

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Profits are derived from national accounts data.

The VAT tax base is calculated as nominal GDP minus the estimated share of nontaxed value added in agriculture, construction, and commerce.

7. Monetary policy has been on track and all monetary targets were met. The target on the net domestic assets (NDA) of the central bank was met comfortably because of lower-than-anticipated government spending. During the twelve months through September 2003, broad money grew by 19.2 percent (Table 6). Official net international reserves (N1R) exceeded the programmed level by a wide margin in June and gross reserves remained at around 3.7 months of imports throughout the year.

Table 6.

Armenia: Monetary Accounts, 2002-04

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Sources: Central Bank of Armenia; and Fund staff estimates.

The NFA series has been adjusted to include the special privatization account (SPA).

At actual exchange rates, excluding the SPA.

At program exchange rates. The 2003-04 program is based on end-December 2002 exchange rates (Attachment III, Table 1). Excluding the SPA.

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

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

A01fig02

Monetary Growth and Inflation

(In percent, 12-month rate)

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

A01fig03

International Reserves

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

8. The performance of the banking sector has been mixed. While the overall level of capitalization and liquidity are ample and profitability is adequate, asset quality remains weak as evidenced by a rise in nonperforming loans during the first three quarters of 2003. An average lending-deposit rate spread of nearly 1240 basis points continues to reflect inefficiencies in the system and difficulties in recovering collateral. As part of a medium-term strategy to restructure the banking system, minimum capital requirements were raised from US$1.65 million to US$2 million in July 2003 and the central bank started collecting premia for a deposit insurance scheme that will become operational in mid-2005.

Armenia: Selected Banking System Indicators, 2000-03

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Source: Central Rank of Armenia.

Regulatory capital to risk-weighted assets.

Liquid assets to total assets.

Profits to period average assets.

A01fig04

Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

9. The external current account deficit has weakened this year, but the exchange rate has remained stable. During the first half of the year, merchandise exports grew by 40 percent driven by increased sales of processed diamonds, food products, and non-precious metals. At the same time, import growth accelerated to 50 percent because of higher imports of raw diamonds and equipment. As a result of these developments, the current account deficit is projected to rise from 6.6 percent of GDP in 2002 to 7.7 percent in 2003 (Table 7). After a small depreciation in 2002, the dram has remained broadly stable in both nominal and real effective terms this year.

Table 7.

Armenia: Balance of Payments, 2001–06

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

Includes errors and omissions.

These claims are assumed settled by the end of the third quarter of 2003.

Excludes amortization of short-term debt, deposits held by nonresidents, and debt acquired domestically by nonresidents.

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

The increase in the estimated NPV of external debt in 2003 compared to the original program figure is due to an improved methodology used to calculate the net present value of future loan disbursements.

Using a three year average of goods and services exports, centered on the previous year.

A01fig05

Real and Nominal Effective Exchange Rates

(Index: 1995=100)

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

A01fig06

Exports, lmports, and the Current Account

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2003, 379; 10.5089/9781451801545.002.A001

10. Armenia’s external debt indicators are improving further this year. The outstanding debt to Turkmenistan (US$11 million) was repaid in kind and the entire debt to Russia (US$94 million) was exchanged for equity in Armenian companies. As a result, Armenia’s net present value (NPV) of debt-to-exports ratio is projected to fall from 131 percent at end-2002 to 94 percent at end-2003.6

11. The authorities have made good progress with the main structural reforms envisaged under the program. These were:

  • Public sector reforms aimed at enhancing expenditure control, tax and customs administration, and fiscal transparency. The authorities amended the budget law to improve expenditure control, devised a plan to facilitate the monitoring and reporting of noncommercial enterprises (NCEs), established internal audit units and reporting requirements at the State Tax Service (STS) and the Customs Committee, and begun setting up a post-clearance verification program at customs.

  • Financial sector reforms geared toward resolving the situation of three banks that have been under central bank administration for more than a year. One of these banks (Ardshinbank) was resolved through a purchase and assumption transaction earlier this year7 and another bank (Credit Yerevan) is expected to be put forward for liquidation by end-November. A resolution strategy for the third bank (Armcommunications) and its main debtor, the state-owned chemical plant Nairit, has been formulated but discussions with a potential foreign investor for both the bank and Nairit are still in progress.8 Financial sector legislative reforms to date aimed at enhancing the ability of the central bank to execute bank resolution strategies, to more effectively create and enforce pledges, and to specify the modalities of the deposit insurance scheme.

  • Energy sector reforms aimed at addressing a fragile financial situation, mismanagement, and corruption in state-owned companies. Two electricity-generating plants were privatized in 2003 and the financial management of the nuclear power plant was handed over to a foreign company. In the midstream sector, the transmission, dispatch, and settlement functions were separated and new companies formed. Reflecting improved performance of the privatized distribution company, collection rates have been at almost 100 percent throughout this year. Reforms on the water and irrigation sectors have been very limited, however, and the financial situation of the state-owned companies in these sectors will not improve until tariff rates are raised in 2004.9

Armenia: Performance of the Energy, Water, and Irrigation Sectors, 2000–03

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Sources: Armenian authorities: and Fund staff estimates.

III. Policy Discussions

The discussions focused on the medium-term macroeconomic framework, the 2004 budget, and fiscal, banking, and energy sector reforms. In the fiscal area, understandings were reached on measures to modernize the tax system and increase revenue collection and to improve budget management and reporting.

A. Medium-Term Framework and the PRSP

12. The medium-term macroeconomic framework is broadly in line with the PRSP.10 Driven by productivity growth and investment in the tradable goods sector, real GDP growth is projected at 7 percent in 2004 and 6 percent a year over the medium term (Table 8). Annual inflation is projected at 3 percent. The current account is forecast to narrow gradually over time in response to strong export growth and gross official reserves are expected to remain at 3.5 months of imports or more. These developments would be underpinned by fiscal consolidation based on increasing tax revenues and rationalizing expenditures, which would lead to a reduction of the fiscal deficit from 2.5 percent of GDP in 2004 to 2 percent in 2005-08 and to a further gradual decline thereafter.

Table 8.

Armenia: Medium-Term Macroeconomic Framework, 2003–08

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

Defined as tota1 expenditure on health, education, and social security.

A negative figure indicates an increase.

13. Tangible financing commitments from donors and external development partners will be needed to finance the PRSP. As noted below, financing from a private donor for some investments identified in the PRSP have not yet been secured for 2004 and external financing of about 2 percent of GDP per year will be needed over the medium term.

B. Fiscal Policy and Public Sector Reform

14. The proposed 2004 budget envisions a deficit of 2.5 percent of GDP, slightly above the projected outturn for 2002 (Table 5). On the revenue side, tax revenues are expected to increase by about 0.5 percent of GDP based on new policy measures and improvements in tax administration (see below). However, the authorities indicated that they were still unsure about commitments on external grants from private sources for 2004 of up to 1.9 percent of GDP and that, in light of this uncertainty, they would prepare a draft budget with a prudent assumption that such grants will amount to 0.4 percent of GDP (which corresponds to relatively more secure commitments).11

Armenia: Selected Fiscal Indicators, 2000-04

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Sources: Ministry of Finance; and Fund staff estimates.

15. On the expenditure side, in light of the possible reduction in external capital grants of up to 3 percent of GDP, the staff urged the authorities to increase domestically-financed capital expenditures and rationalize current expenditures. This is required to keep an appropriate balance between current and capital outlays while aligning the budget with the PRSP priorities on social and infrastructure spending. Lower subsidies to public utilities (especially water and irrigation companies) are expected to yield savings of 0.2 percent of GDP in 2004. In addition, the authorities succeeded in identifying nonpriority current expenditures equivalent to 0.2 percent of GDP and shifted those resources toward investment in road construction and housing. Understandings were also reached to moderate the nominal increase in public sector wages, certain subsidies, and outlays for other goods and services in 2004. These savings are large enough to allow for an increase in social expenditures equivalent to 0.4 percent of GDP as well as an increase in domestically-financed capital expenditures of 0.3 percent of GDP. The increases in social expenditures are in line with those envisaged in the PRSP. Overall, current expenditures are expected to decline by 0.3 percent of GDP in 2004.

Armenia: Functional Classification of Government Expenditures. 2002-08

(In percent of GDP)

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Sources: Ministry of Finance; and Fund staff estimates and projections.

16. The program includes a number of measures to protect its fiscal objectives. The main areas covered are:

Tax policy and administration. The authorities acknowledge the presence of serious weaknesses in revenue collection (especially on profit taxes) and a lack of equality of treatment among taxpayers. They envisage changes in tax policy and administration in both the near and the medium term to address these problems. Tax policy changes for 2004 include the introduction of a minimum profit tax based on one percent of companies’ turnover, a revision of the profit tax law to limit deductions and loss carry-over provisions, a 10 percent increase in revenues from presumptive taxes, and a stamp system to levy taxes on beer. These and other tax policy measures are expected to yield about 0.4 percent of GDP of additional revenues in 2004. Additional gains of 0.1 percent of GDP are expected from improvements in tax administration. Tax administration changes include reviewing accounting procedures by companies, enhancing the withholding of income taxes, and strengthening the administration of the simplified tax. The authorities also intend to finalize by year-end a medium-term program of tax reforms in consultation with Fund staff.12 The staff encouraged the authorities to explore ways to eliminate simplified and presumptive taxes and expand the base for the VAT, to review the property lax system with a view to making it more progressive, and to deepen reforms in tax and customs administration.

VAT exemptions. A number of exemptions have been eliminated in 2002 and 2003 and the staff proposed that at least a similar step be taken in 2004. The authorities see these exemptions as a tool of industrial policy and have been hesitant to remove them. The staff noted that the exemptions, however, have many negative effects and that they undermine the integrity of the tax system, discriminate among importers, and discourage other import-competing activities. In the event, understandings were reached to remove exemptions on about one-fourth of the potentially taxable imports that are currently exempt (by value) in January 2004. To alleviate the financial burden on exporters and on importers of large capital goods, the authorities intend to expand the use of the temporary admission system for inward processing of raw materials in export sectors and introduce a VAT deferral system for imports of large capital goods in mid-2004.

Customs administration. There is an urgent need to improve transparency and efficiency in customs operations in order to combat corruption and increase revenues. Understandings were reached to establish a system of post-clearance field audit visits by year-end and to eliminate loopholes in the legislation related to customs declaration procedures and the development of the valuation database with invoice values. The latter is required to comply with WTO rules and reduce discretion by customs officials in the valuation of imports. In addition, the authorities plan to reduce documentation requirements and eliminate the certification fee for exports.

Budget management and reporting. The authorities acknowledge the need to strengthen transparency and accountability of the budget. They plan to set up a forward-looking cash management and financial planning system and enhance the internal audit function of the Treasury. To facilitate the production of consolidated government accounts in an efficient manner, the government envisages developing the legal basis for monitoring and budget reporting of noncommercial enterprises, including criteria under which these entities would be considered part of the general government. By April 2004, the system is expected to be operational and consolidated general government accounts including noncommercial enterprises, local governments, and the State Fund for Social Insurance (SFSI), would be reported.

C. Monetary and Financial Sector Issues

17. The central bank intends to maintain its anti-inflation stance to avoid accommodating recent and prospective increases in certain prices. While the recent hike in inflation was due to a supply-induced increase in the price of bread, the central bank has begun to adjust monetary policy in early October to avoid monetizing the recent increase in the price level and ensure that inflation does not exceed 3 percent in 2004. This is particularly important in light of the forthcoming increase in water tariffs. The program for 2004 foresees an increase in broad money of 12 percent. In case of stronger-than-programmed capital inflows, the staff stressed the need to refrain from intervening in the foreign exchange market and allow the exchange rate to appreciate in response to market forces.13

18. The staff urged the authorities to resolve the situation of the two remaining intervened banks without further delays. It noted that in light of the difficulties encountered in recovering their assets there is little justification for continuing to keep these banks under central bank administration. The authorities intend to initiate the liquidation of Credit Yerevan by end-November 2003. The situation of Armcommunications hinges on the successful completion of negotiations with a foreign investor to take over both the chemical plant Nairit and the bank. If the negotiations fail, the central bank will initiate the liquidation of Armcommunications by end-November 2003. Lastly, to continue strengthening banking supervision and enhancing the legal framework governing the financial sector, the authorities have recently upgraded supervisory procedures (new onsite and offsite inspection manuals), and envisage adoption of various legal amendments by year-end as well as more vigorous enforcement of prudential norms.

D. External Sector

19. After increasing in 2003, the current account deficit is projected to fall next year. While unusually large grant-financed investments led to a surge in imports of construction material, machinery, and equipment in 2003, lower donor-financed investments in 2004 along with continued export growth should lead to a reduction in the current account deficit. At the same time, the services balance is expected to improve gradually on account of tourism and the growing export-oriented software industry. Gross international reserves are projected to remain at or above 3.5 months of imports.

E. Other Structural Policies

20. The continued implementation of the structural reform agenda remains a key element for sustaining economic growth over the medium term. In addition to the aforementioned reforms in tax and customs administration, the agenda includes efforts to combat corruption and enhance governance and transparency. In this regard, the authorities intend to finalize an anti-corruption strategy by year-end. The strategy is expected to analyze the nature of corruption in Armenia and contain a time-bound action plan of measures to deal with the problem.

21. As regards the energy sector, further efforts will be required to deal with past debts of state-owned energy companies and ensure sound management. In early November, the government is expected to approve the Integrated Financial Rehabilitation Plan and pass a resolution to enforce its implementation (prior action for the fourth review). Measures set forth in the plan include: (i) institutional reforms, including phasing out management functions currently vested in the Ministry of Energy; (ii) restructuring of the energy sector debt; and (iii) moving toward direct contracting between power generators and the privatized distribution company. In addition, the plan envisages the complete restructuring of the midstream sector (comprising settlement, dispatch, and transmission companies) in 2004 by putting in place a sound corporate governance framework and adopting private management contracts.

IV. Program Monitoring and Capacity to Repay the Fund

22. The quality and timeliness of data generally permit effective program monitoring. There has been substantial progress in improving the quality and timeliness of economic data in recent years and the subscription to the Fund’s Special Data Dissemination Standard (SDDS) is imminent.14 However, further efforts are needed with respect to the quality and transparency of fiscal data.15 Program implementation will be monitored according to quantitative performance criteria for end-December 2003 and indicative targets for the first half of 2004 (Attachment I, Table 1) as well as structural performance criteria and benchmarks for up to June 2004 (Attachment I, Table 2).16 Box 2 highlights the approach to structural conditionality. The performance criteria on the stock of domestic arrears of the central government and the State Fund for Social Insurance have been collapsed into a single performance criterion, with the definition of domestic arrears modified to take into account the persistence of a small amount of technical arrears (Technical Memorandum of Understanding Attachment III). The TMU outlines definitions and reporting requirements.

23. Armenia has a strong record of servicing its obligations to the Fund and should face no problems in servicing future obligations (Table 9). The conclusions of the debt sustainability analysis (DSA) conducted in April of this year (IMF Country Report No. 03/93) are still valid. The results indicated that Armenia’s external debt is sustainable if prudent fiscal policies continue to be pursued.

Table 9.

Armenia: Indicators of Fund Credit, 2002-08

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Sources: Armenian authorities and Fund staff estimates.

End of period.

Exports of goods and services.