Republic of Armenia: Staff Report for the 2006 Article IV Consultation and Third Review Under the Poverty Reduction and Growth Facility
Author: International Monetary Fund
Publication Date:
11 Dec 2006
eISBN:
9781451801644
Language:
English
Keywords:
ISCR; CR; executive board discussion; fiscal policy; prudent fiscal policy; equivalent of SDR; poverty rate; unsterilized Central Bank of Armenia; managed float; growth performance; US$ rate; rate of change
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Armenia’s economy continues to perform strongly. Prudent fiscal and monetary policies and ongoing structural reforms have contributed to double-digit growth in a low-inflation environment, a continued reduction in poverty, and a notable improvement in tax performance. The Poverty Reduction and Growth Facility (PRGF)-supported program is on track. Policy discussions centered around the appropriate monetary, exchange rate, and fiscal policy mix to maintain macroeconomic stability in the context of sizable foreign exchange inflows and on measures needed over the medium term to sustain and broaden economic growth.

Abstract

Armenia’s economy continues to perform strongly. Prudent fiscal and monetary policies and ongoing structural reforms have contributed to double-digit growth in a low-inflation environment, a continued reduction in poverty, and a notable improvement in tax performance. The Poverty Reduction and Growth Facility (PRGF)-supported program is on track. Policy discussions centered around the appropriate monetary, exchange rate, and fiscal policy mix to maintain macroeconomic stability in the context of sizable foreign exchange inflows and on measures needed over the medium term to sustain and broaden economic growth.

I. Introduction

1. The performance of the Armenian economy continues to be very strong. Prudent fiscal and monetary policies, large external inflows, and ongoing structural reforms have contributed to double-digit growth in a low-inflation environment, a sustainable external current account and debt position, and a notable reduction in poverty1 and unemployment (Table 1). Real per capita income in U.S. dollars has tripled since 2000. Nevertheless, the significant dram appreciation resulting from foreign exchange inflows is weakening external competitiveness and harming segments of the population that rely on dollar-denominated remittances and hold savings in dollars.

Table 1.

Armenia: Selected Economic and Financial Indicators, 2001–06

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

Comprises state-owned energy companies. Data for 2001–02 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.

In percent of exports of goods and services.

Gross international reserves excluding the special privatization account (SPA).

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.

2. The PRGF-supported program remains on track. All end-June 2006 quantitative and structural performance criteria were met and all end-June structural benchmarks were observed (MEFP, ¶5–6; Tables 2 and 3).2

Table 2.

Armenia: Quantitative Targets, December 2005–June 2006 1/

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

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All items as defined in the Technical Memorandum of Understanding.

Performance criterion.

Indicative target.

At program exchange rate of 500 dram per U.S. dollar for 2005 and program exchange rate of 450 dram per U.S. dollar for 2006.

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

Includes debt with maturity of more than a year as well as obligations with maturity of one year or less, excluding normal import-related credit and sales of treasury bills to nonresidents.

Table 3.

Armenia: Status of Structural Measures for the Third Review under the PRGF

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This structural performance criterion is for the third review under the PRGF arrangement.

3. The political scene is dominated by the parliamentary and presidential elections that will take place in May 2007 and early 2008, respectively. A new round of talks between Armenia and Azerbaijan was recently initiated in an attempt to kick-start the deadlocked peace process over Nagorno-Karabakh.

4. The discussions on the near-term challenges focused on the appropriate monetary, exchange rate, and fiscal policy mix to maintain macroeconomic stability in the context of sizable foreign exchange inflows that are likely to continue (see the accompanying Selected Issues (SI) Chapter 1). Policy discussions on medium-term issues centered around measures needed to sustain economic growth and further reduce poverty, in particular:

  • The importance of accelerating fiscal reforms to increase budget revenues in a transparent and nondiscretionary manner to finance infrastructure projects and expand essential poverty-reducing services;

  • The need for continued financial sector reforms to improve the quality and depth of financial intermediation, strengthen monetary policy implementation, and increase market efficiency.

5. The authorities have concurred with the thrust of the Fund’s economic assessment and broadly followed its policy advice (Country Report No. 04/410) to maintain macroeconomic stability and accelerate structural reforms. On fiscal reforms, important progress has been made in strengthening tax and customs administrations, but revenue mobilization could be further enhanced. On financial sector reforms, prudential regulations and oversight have been strengthened and reforms undertaken to improve corporate governance of banks, but financial intermediation is still low.

II. Macroeconomic Policies

A. Recent Growth and Outlook

6. Real GDP grew by over 12.5 percent in the first nine months of 2006, driven by strong growth in the nontradables sector, particularly the construction sector, which grew by almost 40 percent in real terms and accounted for about half of total GDP growth. Nevertheless, agricultural and industrial output declined in real terms. Gross fixed capital formation increased by 31 percent year-on-year in the first half of 2006, aided by improved execution of public investment projects.

uA01fig01

Armenia: Economic Activity and Inflation

(In percent, year-on-year growth)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

7. Sustaining high economic growth is a key policy challenge. The strengthening of market institutions and an open trade regime have generated large increases in total factor productivity (TFP) in recent years (Box 1). The challenge will be to foster significant increases in high quality, productivity-enhancing investments and to improve the business climate to promote further growth.3

8. At the same time, growth has been uneven, driven primarily by buoyant domestic demand, and underpinned by strong foreign exchange inflows (remittances, foreign aid, and FDI) and an expansion of the nontradables sector, in particular construction. In contrast, the contribution of industry has been modest. While exports expanded rapidly until 2005, their structure is not sufficiently diversified, relying to a large extent on two industries (precious stones and base metals), which makes export earnings vulnerable to world commodity price developments and industry-specific shocks.

Sources of Growth

Armenia’s growth performance over the past five years has been impressive. Following the sharp contraction of the early 90’s, economic growth averaged around 5 percent for the period 1996–2000, before accelerating to 12 percent during 2001–05. Growth has been driven primarily by buoyant domestic demand, fueled by strong foreign exchange inflows, and the expansion of nontradable sectors, notably construction and services. In contrast, the contribution of industry has been modest and, notwithstanding their recent expansion, exports remain undiversified.

uA01bx01fig01

Contributions to Real GDP Growth by Expenditures, 2001-05

(in percent)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

Armenia: Sources of Growth

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Sources: Armenian authorities; and Fund staff estimates.

Economic liberalization, privatization, and a liberal trade regime have generated large total factor productivity (TFP) gains through a reallocation of resources since the start of transition. Growth accounting based on factor shares suggests that a large share of the recent high growth originates from TFP gains. However, TFP growth may reflect an increase in factor utilization following the collapse of output, and will likely decline in the coming years. The contribution of capital accumulation to growth, while increasing, has been lower. Further productivity growth will, therefore, depend on advancing market reforms and improving the business climate. The potential of labor in ensuring rapid growth is limited as labor supply is reduced by emigration and the negative incentives on labor supply of large-scale remittances. As a result, the potential for capital accumulation in boosting growth will become more important over the medium term.

uA01bx01fig02

Armenia: Contribution to Growth, 1994-2004

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

9. Demand pressures, stemming from the rapid growth of incomes, appear to have been limited so far, but there are risks. While strong domestic demand has contributed to an increase in imports in recent years, the current account deficit narrowed from 6 to 4 percent of GDP between 2002 and 2005 reflecting trade gains, and the external position remains sustainable. Moreover, most of the increase in imports has been in intermediate and capital goods, in part related to foreign-financed public investment programs. Going forward, there may be risks of overheating (as evidenced by the pick-up in inflation in the second quarter of 2006 and increasing real estate prices) which will require cautious management of domestic demand.

10. The authorities believe that medium-term economic prospects continue to be strong, although they are concerned about the potential negative effects of rapid real appreciation on growth and external competitiveness. They aim to temper these negative effects by means of an appropriate economic policy mix focused on macroeconomic stability, together with structural reforms and investments in infrastructure supportive of private sector development. These will serve to foster productivity gains and create an environment conducive to continued robust growth. The authorities place particular emphasis on promoting the development of rural areas, including rural infrastructure under the aegis of the Millennium Challenge Account (MCA).

11. Reflecting the solid growth performance in the year to date, the program projects real GDP to grow by 11 percent in 2006 and 9 percent in 2007 on the back of continued buoyant activity in the construction and services sectors and an expected recovery in industry (MEFP, ¶13). Notwithstanding somewhat lower public investment rates, productivity gains resulting from increased share of private investment and improvements in infrastructure are expected to generate sustainable growth rates of 6 percent over the medium term.

B. Inflation, Monetary, and Exchange Rate Policies

12. Year-on-year inflation increased to almost 6 percent in September on account of higher energy and food prices, while average inflation was comparatively low at 1.5 percent. Broad money growth (M2X) slowed to about 15 percent in August, largely due to the base effect of last year’s strong growth and a recent drop in the value of foreign currency deposits (Table 4). After decelerating during the second quarter of 2006, reserve money growth picked up again in September to nearly 30 percent, owing to extensive unsterilized Central Bank of Armenia (CBA) foreign exchange intervention and a decline in government deposits with the CBA.4 The repurchase rate has been raised three times, cumulatively by 75 basis points since July, reaching 4.75 percent in October.

Table 4.

Armenia: Monetary Accounts, 2005–07

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

At program exchange rate of 450 dram/US$.

See footnote 5 of Table 2.

At actual exchange rates, excluding the SPA and foreign currency reserve money.

At program exchange rates, excluding the SPA and foreign currency reserve money.

Defined as reserve money minus NIR plus medium- and long-term liabilities.

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

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

uA01fig02

Armenia: Monetary Aggregates

(In percent, 12-month rate)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

uA01fig03

Armenia: Base Money Growth, 2005–06

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

13. The dram has faced appreciation pressures since mid-May 2006, reflecting strong growth of remittances, foreign investment in real estate, cash dedollarization, and the weakening of the U.S. dollar vis-à-vis other major currencies (Box 2). It appreciated by 15 percent against the U.S. dollar in the year through end-September, despite sizable CBA foreign exchange intervention since June (during the first nine months of the year net purchases amounted to US$115 million, equivalent to over 14 percent of gross international reserves).

uA01fig04

Armenia: Gross International Reserves and Nominal Exchange Rate

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

1/ Gross International Reserves including Special Privatization Account (SPA)

14. Progress has been made in strengthening the institutional prerequisites in support of an inflation targeting (IT) monetary framework. The CBA has significantly improved its new operational framework (introduced in March 2006), with the support of Fund technical assistance.5 It has begun issuing quarterly inflation reports and publishing the minutes of its monthly board meetings on monetary policy. The CBA is also currently in the process of developing a quarterly inflation projection model, to be used in the first half of 2007.

15. There is a trade-off between resisting nominal appreciation pressures and maintaining low inflation. With a large share of the population relying on U.S. dollar-denominated remittances and savings, and rising concerns about external competitiveness, pressures to limit the nominal appreciation of the dram are increasing (Box 3). Until recently, the CBA had largely resisted these demands; however, since June 2006 it has heavily intervened in the foreign exchange market to limit the appreciation of the dram. Given the limited potential to sterilize interventions and absorb liquidity through open market operations, combined with inflationary pressures from both the demand side (strong income growth) and the supply side (energy and agricultural prices), the original end-year inflation target of 3 percent is almost certain to be exceeded.

Recent Exchange Rate Developments

Since end-2003, the dram has been under appreciation pressure owing to sizable foreign exchange inflows (in the form of rising remittances, foreign aid, and FDI) and a global weakening of the U.S. dollar. By end-September 2006, the dram had appreciated by 33 percent in nominal terms against the U.S. dollar (about 22 percent in real effective terms through July 2006). Periodically, the CBA has engaged in foreign exchange interventions, but until recently interventions were moderate and two-sided, with no evidence that the CBA has targeted a specific level or path for the exchange rate.

uA01bx02fig01

Armenia: Real Effective Exchange Rates

(2003=100)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

uA01bx02fig02

Armenia: Exchange Rate Development against US$

(January 1995 = 100)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

According to its monetary policy statement, the CBA is committed to conducting “an independently floating exchange rate regime which is consistent with the principles of liberalized capital account and implementation of an independent monetary policy.” It recognizes the importance of allowing the exchange rate to be market-determined and to limit intervention in the foreign exchange market to “moderating the rate of change and preventing undue fluctuations in the exchange rate, rather than establishing a level for it.”

uA01bx02fig03

Armenia: FOREX Intervention and Exchange Rate

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

The dram/US$ exchange rate has fluctuated considerably over the past years, not radically different from the movement of the euro/US$ rate. Monthly volatility (measured as coefficient of variation) of the former has not been much lower than the latter during the time periods 1995–2006 or 2005–06.

External Competitiveness—Is Appreciation the Major Concern?

The real appreciation of the dram in recent years appears to have had a limited impact on external competitiveness so far. Armenia’s share in world exports, which had doubled between 2001 and 2003, is broadly unchanged after two years of appreciation. Temporary setbacks in diamond exports were due to industry-specific factors (e.g., supply disruptions) and were quickly offset by rising exports of base metals. The base metal sector benefited from sizable foreign direct investment and rising world metal prices. The upward trend of other exports remained intact in 2005 and the first half of 2006.

uA01bx03fig01

Armenia: REER and World Export Share

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

uA01bx03fig02

Armenia: “Other Exports”: Food Products, Textiles, and Other Manufactures

(2000=100)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

uA01bx03fig03

Armenian Precious Stones and Metals Exports

(2000 = 100)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

uA01bx03fig04

Armenian Base Metal and Mineral Exports and World Metal Prices

(2000=100)

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

There is no clear evidence yet that the dram is overvalued. One approach to determine the equilibrium real exchange rate in Armenia is to estimate the “equilibrium distance” to Purchasing Power Parity (PPP). Based on a simple loglinear regression for a sample of 180 countries, an equilibrium relationship was estimated between the real exchange rate and GDP per capita, which is a proxy for productivity. The solid line indicates the implied equilibrium real exchange rate path for Armenia, while the dashed line plots the actual evolution of Armenia’s real exchange rate against its GDP per capita. The difference between the dashed and dotted lines can be interpreted as a measure of real exchange rate misalignment while the vertical axis indicates the distance to PPP. The results indicate that the real exchange rate is close to equilibrium. The estimates, which should be treated with caution given the large standard errors, suggest that the dram was approximately in equilibrium during 1995–98. Between 1998 and 2003, however, the dram became undervalued because the equilibrium exchange rate appreciated, while the actual real exchange rate remained constant. Since 2003, the dram has been converging back toward its equilibrium rate.

uA01bx03fig05

Armenia: Equilibrium and Actual Real Exchange Rate Path

Citation: IMF Staff Country Reports 2006, 433; 10.5089/9781451801644.002.A001

Sources: WEO; IFS; and IMF staff estimates.

Factors other than the exchange rate also pose serious threats to Armenia’s overall export performance and limit the potential for export-led growth. Because of the undiversified structure of exports, the trade balance is vulnerable to exogenous shocks affecting individual industries, such as supply disruptions in diamond processing or price volatility in commodity markets. At the same time, the potential for diversification remains limited due to structural factors (such as high transport costs) and weaknesses relating to technology, management, finance, and marketing.

16. There is evidence that the CBA’s new operating procedures have led to an increase in interbank repo volumes, but further development of the money market will be crucial to strengthen monetary policy transmission. The CBA has been increasingly successful in maintaining short-term rates at or near the announced policy rate. Nevertheless, there still appears to be a significant level of excess liquidity in the banking system.

17. The CBA remains committed to maintaining price stability. However, given increased inflationary pressures, the authorities were concerned that an overly tight policy stance would be needed to reach the original end-2006 inflation target of 3 percent. In particular, the CBA would have to increase aggressively interest rates and conduct large-scale foreign exchange sales, which could trigger additional appreciation pressures, jeopardize financial stability by raising the interest rates on government bonds, deposits and loans, and eventually harm economic growth. Consequently, the CBA, while mindful of the implications for monetary policy credibility, proposed to raise the end-year inflation target to 5 percent in 2006 and 4 percent in 2007 (with a band of ±1.5 percentage points). The CBA is aware of the need to explain the reasons behind changes of the inflation target to the public.

18. The authorities also underlined their commitment to a flexible exchange rate regime. Noting the recent strong appreciation pressures, they pointed to the need for periodical interventions in the foreign exchange market aimed at moderating the rate of change and preventing undue volatility in the exchange rate, rather than targeting a particular level or rate. They agreed that their de facto exchange rate regime could be characterized as a managed float without a predetermined path.

19. The authorities acknowledged that the substantial excess liquidity in the banking system impedes monetary policy effectiveness and discourages the development of interbank money markets and secondary markets in government securities. However, they argued that it would be difficult to reduce this excess liquidity over the short term, as the room for the issuance of additional CBA securities or for foreign exchange sales for this purpose is very limited under the current circumstances.

20. The revised monetary program for the remainder of 2006 envisages reserve and broad money growth of 25 percent and 27 percent respectively, and end-year inflation of 5 percent (with a band of ±1.5 percentage points) (MEFP, ¶17). The monetary program for 2007 will target end-year inflation of 4 percent with a band of ±1.5 percentage points on account of inflationary pressures, notably large end-year fiscal expenditures and foreign exchange inflows, and a rise in telecommunication tariffs in early 2007 (MEFP, ¶18). Reserve money growth is programmed to slow to 20 percent in 2007, while broad money is expected to grow by 22.5 percent. During the transition to full-fledged IT, the program will retain the existing conditionality on monetary targets, in line with the authorities’ approach (MEFP, ¶19).

C. Fiscal Policy

21. Fiscal performance remained sound in the first half of 2006, with the overall fiscal deficit on a commitment basis significantly smaller than programmed (AMD 12 billion compared to AMD 32 billion under the program), largely on account of strong revenue performance (Table 5). Tax revenue grew on account of improved collections of corporate and personal income taxes. While current expenditures were lower than programmed owing to capacity constraints in procurement, execution of capital spending improved relative to previous years.6

Table 5.

Armenia: Central Government Operations, 2006–07

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Table 5.

Armenia: Central Government Operations, 2006–07 (concluded)

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

“Prog.” refers to the program agreed to in March 2006. Relative to the budget, the staff presentation makes the following adjustments: (i) estimated military wages are reclassified from Other goods and services to Wages; (ii) external grants, external interest, and external financing are converted at the program exchange rate of AMD 450 per US dollar and AMD 504 per euro.

According to the draft budget as of 10/17/06.

As the SPA is not included in net claims on central government (NCCG), timing differences between the conversion of SPA funds into domestic currency deposits (which are included in NCCG) and their spending can affect the consistency between the CBA financing in the fiscal accounts and the change in NCCG in the monetary accounts.