Republic of Armenia: Staff Report for the 2004 Article IV Consultation, Sixth Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria
Author: International Monetary Fund
Publication Date:
17 Dec 2004
eISBN:
9781451801507
Language:
English
Keywords:
ISCR; CR; intervened bank; staff appraisal; PRGF; first reading of a bill; market value; monetary management; banking system; capital expenditure; broad money; General government balance; central bank
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This paper examines Armenia’s 2004 Article IV Consultation, Sixth Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria. Armenia’s strong economic performance has been continuing in 2004. In January–September, the year-over-year rate of GDP growth was 10 percent, fueled by increases in agricultural production, housing construction, and services. Since mid-2003, banking sector performance has improved, and there has been a gradual return of confidence toward banks following the resolution of eight intervened banks.

Abstract

This paper examines Armenia’s 2004 Article IV Consultation, Sixth Review Under the Poverty Reduction and Growth Facility, and Request for Waiver of Performance Criteria. Armenia’s strong economic performance has been continuing in 2004. In January–September, the year-over-year rate of GDP growth was 10 percent, fueled by increases in agricultural production, housing construction, and services. Since mid-2003, banking sector performance has improved, and there has been a gradual return of confidence toward banks following the resolution of eight intervened banks.

I. Introduction

1. Discussions on the 2004 Article IV consultation and the sixth review under the Poverty Reduction and Growth Facility (PRGF) were held in Yerevan from August 26 to September 9, 2004.1 Armenia’s three-year PRGF arrangement for SDR 69 million (75 percent of quota) was approved on May 23, 2001 (IMF Country Report No. 02/73). The equivalent of SDR 60 million has been disbursed, and the equivalent of SDR 9 million will be available upon completion of this review (Table 1). The arrangement expires on December 31, 2004.

Table 1.

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

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

2. The thrust of the Fund’s policy advice in previous Article IV consultations has been broadly implemented, especially in the areas of macroeconomic stabilization and quasi-fiscal reforms. In concluding the 2002 Article IV consultation on September 25, 2002 (Armenia is on a 24-month consultation cycle), Directors commended the authorities for their success in maintaining macroeconomic stability and welcomed the envisaged reduction in the fiscal deficit. They expressed concern that there had been slippages in the implementation of key structural policies and emphasized the importance of improving tax administration, clearing budgetary arrears, and pursuing reforms to restructure the banking system and improve performance in the energy and water sectors. Most recommendations made in the context of the Article IV consultation overlapped with conditionality in the PRGF-supported program (Appendix I).

3. Given Armenia’s long-term program engagement with the Fund, the staff has prepared an ex post assessment of past involvement.2 The assessment concludes that Armenia’s engagement with the Fund has been beneficial to policymaking and has facilitated access to external financing.3 The authorities have expressed interest in continued Fund support through a successor PRGF arrangement. In the attached Letter of Intent (Attachment I), the authorities request the completion of the sixth review and a waiver for the nonobservance of end-July 2004 energy sector performance criteria. In the accompanying Memorandum of Economic Policies (Attachment II), the authorities describe a set of policies designed to maintain the reform momentum in coming months.

II. Stocktaking of Performance in Recent Years

4. Armenia is reaping the benefits of a decade of reforms. After an initial sharp contraction of output in the early 1990s, the policy path on which Armenia embarked since the mid-1990s created a stable economic environment and the conditions for a resumption of economic growth and poverty reduction. Real economic growth averaged 9 percent over the past 6 years in a low inflation environment, and real per capita income stands now at more than twice its 1997 level.

uA01tfig01

GDP Growth in CIS Countries

(In percent, annual growth)

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

5. Notwithstanding these achievements, progress was not smooth and a number of challenges remain. Political instability and indecision in the government during the period 1999-2001 led to a slowdown of the reform momentum and of economic activity. The situation has improved since 2001 and the country has enjoyed unprecedented levels of investment and foreign financing (including support from the Armenian diaspora). Nevertheless, Armenia’s reform agenda remains to be finished, poverty is high, and trade prospects are crippled because of unresolved disputes with Turkey and Azerbaijan.4

6. The PRGF-supported program has focused on measures necessary for sustained macroeconomic stability and a deepening of structural reforms. The program aimed at reducing the fiscal and quasi-fiscal deficits, repaying domestic and foreign arrears, lowering debt ratios, and running a cautious monetary policy in a flexible exchange rate environment. The structural reform agenda was geared to support stabilization efforts, reduce vulnerabilities, and sustain medium-term growth prospects. It focused on improving the business environment, strengthening the banking system, tax and customs administration, and expenditure management, as well as increasing efficiency in the energy and water sectors (Appendix I).

7. The program has been consistent with Armenia’s PRSP.5 The policies and programs envisaged in the PRSP have been progressively integrated into the Medium-Term Expenditure Framework (MTEF) and the budget process. The authorities have changed expenditure priorities in the budget, implemented reforms in the areas of health and education, and proceeded to develop monitoring indicators.6 They have also been refocusing their efforts on social policies and the rural economy.

8. The policies supported by the program have been remarkably successful on the macroeconomic front. Annual real GDP growth averaged 12 percent between 2001 and 2003 and poverty rates fell. Growth, fueled by grant and privately financed investment and exports, was broad-based. The external current account deficit fell in response to strong export growth and import substitution. The pattern and the geographical composition of trade also changed, with trade flows shifting away from the Commonwealth of Independent States (CIS) and into European Union countries. Fiscal and quasi-fiscal deficits were significantly reduced and inflation remained in single digits. In addition, competitiveness and debt ratios improved markedly.

Armenia: Main Economic Indicators, 1998-2003

(In percent of GDP, unless otherwise indicated)

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Sources: Armenian authorities; and Fund staff estimates.

Percent of population. The data in the first column correspond to the 1998/99 household survey results. The data for 2003 are preliminary.

9. However, tax revenue performance has been disappointing. While tax revenues increased rapidly in both real and nominal terms since 2000, they have not fared well as a share of GDP. Four factors affected tax revenues in recent years: (i) income tax rates were reduced in 2000; (ii) profit tax holidays were granted to large foreign investments;7 (iii) part of the increase in economic activity during 2002-03 was financed with foreign grants and loans in activities that are not taxed because of international agreements; and (iv) tax and customs administration did not improve sufficiently.

Armenia: Tax-to-GDP Ratios

(In percent of GDP, unless otherwise noted)

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Deflated by the GDP deflator

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

10. Most of the envisaged structural reforms were carried out, but some suffered from delays and weak implementation. There was good progress in strengthening expenditure control, reducing red tape, and improving efficiency in the energy and water sectors. By mid-2004, EBRD transition indicators showed that Armenia fared quite well compared to other CIS countries on all dimensions of structural reforms. Still, this positive assessment is tempered by some delays and weak implementation. For instance, there have been delays in the resolution of problem banks, and the actual implementation of tax and customs administration reforms have been insufficient to bring about the intended results.8

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EBRD Transition Indicators, 2004

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

III. Recent Developments

11. The political situation is stable but the influence of vested interests is a concern. The government coalition remains firmly in control following anti-government demonstrations in April. At that time, the opposition contested the legitimacy of President Kocharian’s re election in 2003. More recently, the increasing influence of vested interests in parliament led to the stalling of pieces of tax legislation and the granting of tax privileges.9 These developments are worrisome as they put the country’s prospects for lasting reform at risk. On the international arena, the European Union has recently included Armenia in the configuration of the “wider Europe” initiative, an event that in the long term could foster economic integration and contribute to a diplomatic solution to the Nagorno-Karabakh conflict.10 The latter, however, cannot be easily resolved because of deep-rooted sensitivities in both Armenia and Azerbaijan.

12. Armenia’s strong macroeconomic performance has continued in 2004. In the period January-September, the year-on-year rate of GDP growth was 10 percent. The growth momentum has been maintained despite a reduction in external private grants, fueled by increases in agricultural production, housing construction, and services. GDP growth for the year as a whole is projected at 9 percent (Table 2). The 12-month rate of inflation fell from 8.6 percent in December 2003 to 6.1 percent in September. The central bank’s inflation objective of 3 percent for 2004 is within reach, although it may be exceeded slightly because of recent increases in the price of imported fuels.

Table 2.

Armenia: Selected Economic and Financial Indicators, 2001-05

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

End of period. The figure for 2004 correspond to data in September.

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

Net present value of debt in percent of the three-year moving average of exports of goods and services.

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. The calculations are based on 1999-2001 average trade weights. The figure for 2004 corresponds to the 12-month change up to August 2004.

uA01tfig03

Economic Activity

(In percent, year-on-year growth)

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

13. Poverty and income inequality have been falling, but they still remain high. The improvements are much smaller in cities other than Yerevan and in rural areas. The overall poverty rate fell from 51 percent in 2001 to an estimated 43 percent in 2003.11 Gini coefficients of inequality also fell during the same period. Health and education services have improved gradually, but remain below standard. The rural infrastructure, especially roads and water supply, remains deficient. Looking ahead, and assuming implementation of the policies envisaged in the PRSP, Armenia is well positioned to achieve most of the Millennium Development Goals by 2015 (Table 3).

Table 3.

Armenia: Poverty Indicators and Millennium Development Goals, 1990-2015

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Source: World Development Indicators database, April 2002Goal 1: Halve, between 1990 and 2015, the proportion of people whose income is less than US$2.15 a day. Halve, between 1990 and 2015, the proportion of people who suffer from hunger.Goal 2: Ensure that, by 2015, children everywhere, boys and girls alike, will be able to complete a full course of primary schooling.Goal 3: Eliminate gender disparity in primary and secondary education preferably by 2005 and to all levels of education no laterGoal 4: Reduce by two-thirds, between 1990 and 2015, the under-five mortality rate.Goal 5: Reduce by three-quarters, between 1990 and 2015, the maternal mortality ratio.Goal 6: Have halted by 2015, and begun to reverse, the spread of HIV/AIDS. Have halted by 2015, and begun to reverse, the incidence of malaria and other major diseases.Goal 7: Integrate the principles of sustainable development into country policies and programs and reverse the loss of environmental resources. Halve, by 2015, the proportion of people without sustainable access to safe drinking water.Goal 8: Develop further an open, rule-based, predictable, non-discriminatory trading and financial system. Address the Special Needs of landlocked countries and small island developing states. Deal comprehensively with the debt problems of developing countries through national and international measures in order to make debt sustainable in the long term. In cooperation with developing countries, develop and implement strategies for decent and productive work for youth.

Armenia: Poverty and Inequality, 1999-2003

(Percent of total population, unless otherwise noted)

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Source: Armenian authorites; based on data from Household Surveys.

Preliminary estimates.

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

14. Fiscal policy has remained prudent, with somewhat higher-than-programmed tax revenues and lower-than-programmed expenditures. Tax revenues through September 2004 increased by 21 percent over the same period last year.12 In June, Parliament approved a supplementary budget allocation entailing an increase in expenditures of 0.7 percent of GDP. The higher expenditures focus on priority capital expenditures and will be executed during a 12-month period. Notwithstanding the additional allocation, the fiscal deficit is projected at 1.3 percent of GDP in 2004 because of under-execution of expenditures (Table 4). The under-execution reflects a combination of factors, including optimistic assumptions about the timing for implementation of donor-financed projects and capacity constraints.13

Table 4.

Armenia: Central Government Operations, 2001-05

(continued)

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

For better comparability, the composition of expenditures for 2001-03 have been adjusted to reflect changes in expenditure categories brought about by the reclassification of budgetary institutions as non-commercial enterprises in 2003 and the reclassification of public order and safety wages previously classified in goods and services.

Includes expenditure authorized by the supplementary budget, but not included in the original program.

The projected increase in 2005 is mostly due to the envisaged increases in education and health.

The figure for 2005 includes US$20 million in estimated grant disbursements from the Millenium Challenge Account. The actual figure will be reflected in the budget after it is confirmed.

The figure for 2003 includes a recapitalization of state-owned water companies amounting to 0.3 percent of GDP.

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

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

Excluding domestic expenditure arrears.

15. Monetary policy has also been prudent. Money demand has been increasing in light of strong economic activity and improved confidence in the banking system. In 2004, reserve money and broad money are projected to grow at about 4 percent and 15 percent, respectively (Table 5).

Table 5.

Armenia: Monetary Accounts, 2003-05

(In billions of drams, unless otherwise indicated)

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

The projected decline in 2005 is related to additional privatization proceeds primarily from the sale of a copper company. These proceeds will be saved in the special privatization account which is a separate account at the CBA and is subject to regular audit by Parliament. Those proceeds are not reflected in the fiscal accounts until funds are earmarked for spending within the budget.

At actual exchange rates, excluding the SPA.

At program exchange rates. March and June figures are based on end-December 2003 exchange rates (IMF Country Report No. 04/136, Attachment III, Table 1). September and December figures are based on end-June exchange rates.

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

Ratio of foreign currency deposits to broad money (in percent).

uA01tfig04

Monetary Growth and Inflation

(In percent, 12-month rate)

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

16. The external current account balance and debt ratios are improving. After a slight deterioration in 2003, the current account deficit is expected to narrow to 5.6 percent of GDP in 2004 because of higher workers’ remittances.14 Both import and export growth will be lower this year than in 2003, as last year’s grant-induced surge in imports dissipates and diamond export growth is hindered by increased competition from other countries. Despite lower capital grants, the capital and financial account remain well supported by continued increases in foreign investment. Gross international reserves are expected to remain slightly below four months of imports. Lastly, Armenia’s debt management strategy during the last two years has been successful, and external debt ratios are projected to decline further in 2004-05 (Table 6).15

Table 6.

Armenia: Balance of Payments, 2001-07

(in millions of USD, unless otherwise indicated)

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Sources: Data provided by the Armenian authorities; and staff estimates.

The figure for 2003 reflects a Lincy foundation loan onlent to small- and medium-sized enterprises. The government repaid US$15 million of the US$18 million loan and expects to pay the remainder in 2004. The Lincy Foundation has agreed to wait for the repayment.

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

Three-year moving average of exports of goods and services centered on the previous year.

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Exports, Imports, and the Current Account

(In percent of GDP)

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

17. Flexible trade and exchange regimes have served Armenia well in recent years.16 Since late 2003, strong capital inflows and higher remittances have contributed to an appreciation of the dram. In the 12-months to August 2004, the real exchange rate appreciated by 11 percent, helping to mitigate the effect of recent hikes in the prices of imported fuels on inflation and on real income. The appreciation does not pose a threat to export competitiveness because (i) the real exchange rate had depreciated by more than 25 percent between 2000 and 2003 and (ii) productivity gains are boosting exports and real wages and are thus compatible with the recent real appreciation.17

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Real and Nominal Effective Exchange Rates

(Index: 1995=100)

Citation: IMF Staff Country Reports 2004, 410; 10.5089/9781451801507.002.A001

18. Banking sector performance has improved, especially during the last year, and there has been a gradual return of confidence toward banks following the resolution of eight banks that had been intervened by the government (Table 7). The last intervened institution to be resolved, Armcommunications Bank, was recapitalized by a new investor in October 2004.18 Since mid-2003, monetization has been rising, the currency-to-deposits ratio has been falling, and interest rates have continued their gradual declining trend. Private sector credit grew by 43 percent in the year through September, albeit from a low base. However, dollarization (measured by the ratio of foreign currency deposits to total deposits) remains at over 70 percent. Overall, banking system soundness has improved, although weak corporate governance and the prevalence of foreign currency lending to unhedged borrowers are a concern (Box 1).

Table 7.

Armenia: Financial Soundness Indicators for the Commercial Banks, December 2001-June 2004 1/

(In percent unless otherwise indicated)

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Sources: CBA; and Fund staff estimates.

Excludes banks under CBA provisional administration.

Includes one bank that was brought under CBA provisional administration on December 24.

Loans exclude correspondent accounts and other interbank deposits. Definition of nonperforming loans amended from that in IMF Country Report No. 04/136, Attachment III, Table 4 to exclude watch loans but include loss loans; nonperforming loans now include all loans overdue by more than 90 days.

Classification category introduced on January 1, 2002.

Assumes 100 percent coverage of loss loans.

Average assets are calculated as a simple average of quarterly data. Profit is the undistributed post-tax profit from the income statement. In the calculation of return on earnings and return on assets, the annualized profit figure (quarterly profit multiplied by 4) is taken.

Liquid assets include cash, correspondent accounts and other interbank deposits, and Republic of Armenia treasury bills.

Short-term liabilities include demand liabilities and overdue liabilities.

Customer deposits include bank accounts, demand deposits, and term deposits of individuals, legal entities, and nonbank financial institutions.

Loans include correspondent accounts and other interbank deposits.