Republic of Armenia: Selected Issues

Although Armenia itself has a population of only about 3 million, an estimated 8 million Armenians live abroad. In this paper, the size and the sources of remittances to Armenia are first discussed. Then, the appropriate definition of remittances and subsequently present estimates of the macroeconomic effects of remittances to Armenia are outlined. Remittances play a significant role in the Armenian economy. They amount to between US$250 million and US$1 billion per year, and constitute from 25 percent to 80 percent of remittance receivers’ incomes.

Abstract

Although Armenia itself has a population of only about 3 million, an estimated 8 million Armenians live abroad. In this paper, the size and the sources of remittances to Armenia are first discussed. Then, the appropriate definition of remittances and subsequently present estimates of the macroeconomic effects of remittances to Armenia are outlined. Remittances play a significant role in the Armenian economy. They amount to between US$250 million and US$1 billion per year, and constitute from 25 percent to 80 percent of remittance receivers’ incomes.

III. Armenia’s Financial System: Why is it Small and What Reforms are Needed?25

A. Overview

52. This chapter describes recent developments in the Armenian financial system, provides an overview of the roots of financial sector underdevelopment, and discusses measures to foster financial deepening in the medium term. It finds that financial sector development appears to be accelerating lately, and concludes that—while important risks remain—both the financial system and the regulatory and supervisory framework are increasingly well prepared to manage rapid credit growth and increasing competition, and provide a wider range of financial services.

53. Armenia has experienced an impressive economic expansion, with double-digit growth rates since 2001. Until recently, however, rapid income growth has not been accompanied by a significant development of the financial sector. Financial intermediation through banks is small, while the nonbank financial sector and capital markets are still in their infancy. Financial depth as measured by monetization (M2X/GDP) is lower than in other CIS countries.26

Figure III.1.
Figure III.1.

Financial Depth: M2X/GDP

(In percent)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

M2-to-GDP Ratio

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Sources: WEO and IFS databases.

54. Given the well-established significance of financial development for economic growth, deepening financial intermediation and improving financial market efficiency will be important for sustaining the current growth momentum in Armenia over the medium term. A sophisticated financial system would promote future growth by (i) efficiently mobilizing and pooling savings; (ii) channeling investments towards activities with high returns; (iii) facilitating risk management by providing risk diversification services; and (iv) exerting corporate governance through monitoring borrowers (Levine, Loayza, and Beck, 2000).

B. Size, Structure and Stability of the Financial Sector

55. The depth of financial intermediation, as measured by financial sector assets to GDP, is still low at around 20 percent and is considerably below the CIS average of more than 30 percent. Armenia also lags other CIS and Baltic countries in the development of private sector credit and bank deposits.

Figure III.2.
Figure III.2.

Total Bank Assets/GDP

(In percent)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Sources: WEO, IFS, and MBTS (Money and Banking) databases. Unweighted averages for country groups.

Bank Asset-to-GDP Ratio

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Sources: WEO and IFS databases.
Figure III.3.
Figure III.3.

Bank Credit to Private Sector

(In percent)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Sources: WEO and MBTS (Money and Banking) databases. Unweighted averages for country groups.

Credit to Private Sector - GDP Ratio

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Sources: WEO and MBTS databases.
Figure III.4.
Figure III.4.

Bank Deposits/GDP

(In percent)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Sources: WEO and MBTS (Money and Banking) databases. Unweighted averages for country groups.

Bank Deposits-to-GDP Ratio

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Sources: WEO and MBTS databases.

56. The preference for liquid assets is high. A comparatively large share of bank assets consists of cash, interbank balances, and investments in securities, while the share of loans in total bank assets is small by international standards. Although a trend towards higher use of domestic currency has emerged, the economy is still heavily dollarized, relying on foreign currency cash for transactions. The majority of loans and deposits are still denominated in foreign currency, which could trigger currency mismatches for commercial banks and impedes the central bank’s capability to conduct effective monetary policy. Banks’ capacity to attract deposits has been traditionally low, indicating little provision of financial services in the form of payment services and saving vehicles.

Figure III.5.
Figure III.5.

Liquidity and Dollarization Indicators

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Source: WEO and MBTS databases.

57. The banking sector is the central pillar of financial intermediation, with banking sector assets accounting for about 97 percent of total financial sector assets. There are currently 21 banks, all privately owned.27 Foreign participation in the banking system increased following the removal of limits on foreign ownership in the mid-1990s. However, with one key exception, foreign investors were mainly Armenian expatriate individuals without the benefit of foreign banking expertise. Recently, some banks from other CIS countries have entered the Armenian market by taking over existing local banks.

58. Concentration in the banking sector is relatively low. Herfindahl-Hirshman Indices (HHI) indicate low concentration of total bank assets and credit, while deposit concentration is moderate.28 The higher concentration indicators for bank deposits are mainly due to the dominant position of the only international bank in demand deposits, with a market share in this segment of more than 50 percent.

Figure III.6.
Figure III.6.

Banking System Concentration

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Source: ARKA.

59. Lending-deposit spreads, measured as the difference between average domestic currency lending and deposit rates, remain high. They exceed 10 percent and are well above those in most other CIS countries. Continued high spreads, associated with high real lending rates and collateral requirements, are particularly harmful for small and medium-sized enterprises.

Figure III.7.
Figure III.7.

Lending-Deposit Spreads

(In percent)

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Sources: WEO and MBTS (Money and Banking) databases. Unweighted averages for country groups.

Domestic Currency Lending-Deposit Spread

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Sources: WEO and MBTS databases.

60. Despite the sizable lending-deposit spreads, transformation ratios are high on average. However, this appears to be less an indication of banks’ success in efficiently intermediating funds between savers and investors, but rather of the continued difficulty many banks face to attract deposits, owing to low trust in the banking system and the widespread use of cash, mainly related to the sizable shadow economy. Transformation rates have generally increased in recent years. At the same time, they continue to differ widely across banks, indicating a high level of market segmentation.

Figure III.8.
Figure III.8.

Intermediation Indicators

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Source: ARKA.

61. The structure of bank credits and deposits is gradually changing with respect to the customer base, currency denomination, and maturities: Corporate loans still account for the majority of private sector credit, but the market share of loans to individuals has been increasing steadily. Growth of mortgage lending has taken off lately, although from a low base.29 Aided both by efforts of the central bank to promote the use of domestic currency and the continuing appreciation of the dram, the shares of foreign exchange denominated loans and deposits are on the decline. Credit maturities are lengthening. The share of long-term loans (with maturities of more than one year) has increased from less than 45 percent in 2002 to 65 percent in mid-2006.

Figure III.9.

Structure of Bank Credits and Deposits

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Sources: Armenian authorities; and MBTS database.

62. Financial Soundness Indicators (FSI) indicate that the Armenian banks are generally well capitalized, profitable, and liquid, with a satisfactory level of asset quality. Despite recent credit growth, average capital adequacy ratios have not declined significantly, indicating high retained earnings. Bank profitability is high, with average return ratios well above international standards.30 Bank profitability has benefited from continued high interest rate margins and broadly conservative strategies of commercial banks in the recent past. Most banks have liquid asset ratios well above the prudential limits. The share of nonperforming loans (NPL) was still comparatively low at 3 percent in mid-2006, but has risen somewhat since 2005.31 Most of the increase was in the category of “watch” loans.

Figure III.10.
Figure III.10.

Financial Soundness Indicators

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Source: Armenian authorities.

63. Indications are that financial deepening has been accelerating since 2004. Private sector credit growth has averaged at more than 30 percent. Bank deposit growth, while more volatile and somewhat lower, has exceeded 20 percent on average. While these developments are welcome, they also call for close monitoring of attendant risks and a strengthening of financial sector institutions with a view to maintaining macroeconomic and financial stability. The acceleration of growth in bank deposits and credit may contribute to a build-up in credit risk, which could stretch banks’ capacity to assess and manage credit risks due to the increased volume of loans, especially if banks’ investment in risk assessment does not keep pace with the rise in the volume of loans and shortcomings in corporate governance, accounting and reporting are not resolved.

Table III.1.

Other Financial Institutions (2005)

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Figure III.11.
Figure III.11.

Credit and Deposit Growth

Citation: IMF Staff Country Reports 2006, 434; 10.5089/9781451801651.002.A003

Source: MBTS database.

64. Nonbank financial intermediaries play a negligible role in Armenia. Insurance companies, microfinance institutions, credit cooperatives, and pension funds account for only around 3 percent of the total financial system assets. The insurance sector is small and underdeveloped, with annual premiums of only 0.1 percent of GDP. The vast majority of insurance contracts are reinsured abroad. Compulsory insurance (such as third-party liability auto insurance) has not yet been introduced.

Table III.2.

Insurance Sector (2005)

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65. Stock market capitalization is very low and trading thin in both equity and debt securities. Foreign exchange trading was introduced at the Armenian stock exchange (Armex) in November 2005. Despite the relative large number of shares admitted to trading at Armex, actual trading remains rudimentary.32 The low turnover of individual shares makes it virtually impossible for brokers to rely on market prices as an indicator for the true value of a share. To date, the securities market has scarcely been used by companies to raise capital. The first corporate bond was listed in December 2005. In the future, further progress in privatization and the development of an equity culture may increase the supply of equity securities. Plans to develop pension and equity funds may in turn increase the demand for securities in the medium term.

Table III.3.

Capital Market (2005)

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C. Obstacles to Financial Sector Development

66. Armenia has a large shadow economy that does not rely on the formal banking sector for financial intermediation. Firms and individuals in the informal sector rely to a large extent on cash for transactions, partly to evade taxes. This significantly diminishes the potential deposit base of the banking system and the market for products offered by banks and other financial institutions. The substantial and rising inflows of remittances from abroad also provides a source of funds that reduces the need to obtain financing from the financial sector.

67. Depositor trust in the banking systems is still comparatively low, possibly resulting in high funding costs for local banks. The main reasons for the lack of trust appear to be the experience of bank failures in recent years and lack of bank transparency and accountability.

68. High banking spreads result in either a high cost of credit, which discourages borrowing, or a low remuneration of deposits, which discourages intermediation of savings, or both. The level of spreads in Armenia is mainly determined by (1) high perceived credit risk; (2) rents accruing from banks’ market power on both the lending and deposit side; and (3) high funding and operating costs for smaller banks.

  • Credit risk: High credit risk appears unrelated to macroeconomic conditions. Rather, it stems from the lack of a developed credit culture and weaknesses in the institutional infrastructure, which may inhibit the adoption of best practices in lending. Banks’ ability to properly assess creditworthiness of borrowers and monitor credit risk is limited by insufficient risk management capabilities and the lack of reliable accounting and reporting standards. Weak creditor protection and judicial systems inhibit banks to rapidly repossess collateral in case of default. In addition, the banking sector still suffers from weak governance. Nontransparent ownership structures favor connected lending, which may result in either heightened risk or crowding out of borrowers seeking finance for potentially productive projects.

  • Market power: Low banking competition owing to market segmentation tends to increase deposit-lending spreads because they enable banks to extract rents from borrowers and depositors. The only first-tier international bank operating in Armenia greatly benefits from its reputation and is market leader in the deposit business even though it doesn’t pay interest on deposits and charges hefty fees for new deposits.

  • Operating and funding costs: Some banks may incur higher operating costs because they are not large enough to exploit scale economies. Smaller local banks may incur higher funding costs in the form of a “confidence premium” to attract deposits, as compensation for high perceived risk. 33

D. Financial Sector Reforms

69. Armenia has achieved significant progress in bank supervision in recent years. The CBA conducts a rigorous supervisory process, with enforcement grounded in legislation, regulatory reporting, and prudential norms. Recent amendments to banking legislation have enhanced the regulatory and supervisory processes, as well as improved auditing and risk management. As a result, banking supervision legislation is now largely compliant with the Basel core principles. Ongoing regulatory reforms deal with further improving bank corporate governance, including the opaque bank ownership structures.

Table III.4.

EBRD Transition Index and Financial Sector Reform

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Source: EBRD.

70. In contrast to progress in banking supervision, regulation and supervision of the nonbank financial sector is still in an early stage. In this regard, the recent establishment of a consolidated financial sector supervision framework is a stepping stone to improving supervision of both bank and nonbank financial institutions. New insurance legislation and securities market regulations in line with international standards as well as a major overhaul of the pension system are under preparation.

Table III.5.

World Bank Doing Business 2007 and Financial Sector Reform

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Source: World Bank

71. Apart from various reforms of the regulatory and supervisory framework, the authorities have taken a number of important steps to foster the deepening of financial intermediation and to increase confidence in the Armenian banking system (CBA 2006):

  • Deposit insurance: A new mandatory deposit insurance commenced coverage in 2005. The Deposit Insurance Law provides limited coverage of deposits of individuals (up to AMD 2 million [about US$5,300]). The scheme is funded mainly by premiums paid by banks that are a fixed percentage of their deposits (currently 0.5 percent).

  • Credit registry and credit bureau: A credit registry was introduced in Armenia in 2003, and a private credit bureau was established in 2004. These institutions reduce credit risk by creating an information system on the creditworthiness of borrowers.

  • Strengthening creditor rights: Procedures on foreclosure of collateral were simplified and a procedure for the off-court foreclosure of collateral introduced during 2004–2005. In addition, a register for movable property collateral was created.

  • Minimum capital requirements of banks were increased from US$1 million to US$5 million, with the purpose to foster banking sector consolidation and increase banks’ resilience against credit risk.

  • Measures to reduce the use of cash in transactions are being contemplated in an effort to contain activities in the informal economy and promote financial intermediation.

  • Regulations to foster the use of domestic currency were introduced, including the prohibition of pricing and payment in foreign exchange in the retail sector and a strengthening of the oversight of foreign exchange offices. Bank reserves are now required to match the currency denomination of bank deposits, which has shifted the supply of loanable funds from foreign to domestic currency.

  • Armenia has obtained sovereign credit ratings from renowned international rating agencies. In 2006, Moody’s and Fitch assigned sovereign ratings of Ba2 and BB-, respectively. The ratings will improve local banks’ access to external sources of financing and are a prerequisite for the rating of Armenian corporations.

  • AML/CFT framework: The AML/CFT framework is recognized as largely compliant with Basel Core Principles. Further improvements are being implemented with the help of Fund technical assistance.

72. A crucial step towards further improving financial intermediation will be the entry of additional top-tier international banks in the Armenian market. Increased foreign ownership would increase confidence in the banking sector by improving governance practices, competition, and technical and management expertise, in particular in the area of risk management. The recent purchase of 28% shares of ACBA by French Credit Agricole banking group and the announcement that Dutch ING group will provide consultative postal and postal-banking services for Armpost are welcome in this regard. Further consolidation of the banking sector may be required, but should proceed in a market-driven process.

73. Progress in tax administration reform will be crucial to promote the legalization of the informal economy.34 The large shadow economy remains one of the main obstacles to financial sector development. While the CBA is considering various measures to limit the use of cash and foreign exchange in transactions, improved tax administration would be the single most important measure to reduce the shadow economy.

74. Successful implementation of the planned pension reform and reforms in the insurance sector could contribute to the development of the financial system and capital markets in the longer term. An increase in the pension contribution rate would generate a large increase in savings that could be intermediated by the financial sector. At the same time, this creates risks, as the financial system is not yet well equipped to manage large additional savings. This points to the importance of the entry of reputable international market participants providing the needed asset management capacity.

75. However, growth in nonbank financial markets appears to be less crucial than progress in the banking sector at the current stage of economic development. Domestic equity and private debt markets and nonbank financial institutions do not appear to have played a major role in the first phase of financial development of the most successful transition economies in Central and Eastern Europe. The expansion of private bond markets and nonbank financial institutions, such as insurance and pension funds, has commenced only much later (De Nicoló, Geadah, and Rozhkov, 2003).

E. Conclusions

76. Financial sector development in Armenia has lagged behind that in other transition countries in the past, and the financial sector has not contributed significantly to the strong economic growth performance of the Armenian economy. However, indications are that financial deepening is finally taking hold. Financial soundness indicators have been improving; confidence in the banking sector appears to be finally increasing as important financial sector reforms are taking effect; dedollarization is gaining momentum; and both private sector credit and deposit growth rates have accelerated. The envisaged entry of additional reputable international banks will enhance efficiency, competition, and confidence in the banking system.

77. Further strengthening and streamlining of the regulatory framework and prudential oversight is desirable to address the remaining obstacles to financial sector development and to limit emerging risks. The authorities’ reform program increasingly focuses on the development of the nonbank financial sector. Tax administration reform will be crucial to contain the shadow economy and foster financial deepening.

78. While the immediate risks appear to be low, as banks are well capitalized and liquid, continued rapid credit growth without close monitoring and controlling the attendant risks would have the potential to compromise both macroeconomic and financial system stability. Credit quality may be heavily dependent on favorable macroeconomic conditions. Increased risks to financial stability may not become fully apparent until economic growth slows (Hilbers, Otker-Robe, Pazarbasioglu, and Johnsen, 2005).

References

  • CBA, 2006, “Financial Sector Reforms,” mimeo., Central Bank of Armenia.

  • Cottarelli, Carlo, Giovanni Dell’Ariccia, Ivanna Vladkova-Hollar, 2003, “Early Birds, Late Risers, and Sleeping Beauties: Bank Credit Growth to the Private Sector in Central and Eastern Europe and the Balkans,” IMF Working Paper No. WP/03/213 (Washington: International Monetary Fund).

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  • De Nicoló, Sami Geadah, and Dimitriy Rozhkov, 2003, “Financial Development in the CIS-7 Countries: Bridging the Great Divide,” IMF Working Paper No. WP/03/205 (Washington: International Monetary Fund).

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  • Hilbers, Paul, Inci Otker-Robe, Ceyla Pazarbasioglu, and Gudrun Johnsen, 2005, “Assessing and Managing Rapid Credit Growth and the Role of Supervisory and Prudential Policies,” IMF Working Paper No. WP/05/151 (Washington: International Monetary Fund).

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  • Levine, Ross, Norman Loayza, and Thorsten Beck, 2000, “Financial Intermediation and Growth: Causality and Causes,” Journal of Monetary Economics, Vol. 46 (1), pp. 31 –77.

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25

Prepared by Holger Floerkemeier.

26

Actual monetization, however, may be much higher due to substantial cash dollarization. Foreign currency cash holdings are estimated to exceed US$1 billion, an amount far higher than the M2X measure (broad money including foreign currency deposits).

27

The banking system has consolidated in recent years. The gradual tightening of prudential regulations and a serious banking crisis between 2000 and 2002 contributed to a reduction of the number of banks from 74 in 1994 to 21 currently.

28

The Herfindahl-Hirschman Index is defined as the sum of squared market shares of all firms competing in a market. The HHI takes into account the relative size and distribution of the firms and increases both as the number of firms in the market decreases and as the disparity in size between those firms increases. The U.S. Department of Justice considers markets in which the HHI is between 1000 and 1800 points to be moderately concentrated, and those in which the HHI is in excess of 1800 points concentrated.

29

In the first half of 2006, mortgage loans grew by more than 50 percent in dram terms to AMD 17 billion.

30

By mid-2006, only one bank had negative return ratios, while four banks reported losses at end-2005. Generally, the larger banks have more favorable profitability indicators than most of the smaller banks.

31

The CBA definition of NPLs includes watch loans but excludes loss loans. Until recently, there had been a significant backlog of loss loans, which were however fully provisioned.

32

Many companies were listed only because of privatization during the mid-1990s. The number of listed companies was reduced significantly in 2006 by removing inactive companies and companies in liquidation.

33

The leading bank in Armenia, a subsidiary of a large first-tier international bank, enjoys low average cost of funding, as depositors are willing to accept very low interest rates because of the perceived safety of deposits in this bank. In contrast, many domestic banks must offer much higher interest rates to attract deposits.

34

According to the World Bank’s Doing Business 2007 report, Armenia’s tax administration is very weak from an international perspective. In a ranking of 175 countries, Armenia is situated close to the bottom, 147th position in the area of tax administration and 171st on time and efforts for preparing of tax declarations.

Republic of Armenia: Selected Issues
Author: International Monetary Fund