Abstract
This Selected Issues paper for the Republic of Armenia shows that building up fiscal space during economic expansions is crucial for the effective implementation of stimulatory policies during downturns. Armenia’s tax revenue remains one of the lowest in the region, and significantly below potential. The legislative changes introducing a VAT threshold and a simplified regime for those businesses below the threshold, as well as the adoption of a comprehensive and ambitious modernization plan for revamping tax administration, are promising steps in the right direction.
III. Exchange Rate Appreciation and External Competitiveness in Armenia1
A. Introduction
1. In recent years, the significant appreciation of the dram has raised concerns about the competitiveness of the Armenian economy. While the dram is expected to appreciate as incomes and productivity in Armenia rise, large foreign exchange inflows have led to concerns about a possible overvaluation of the dram. The dramatic appreciation already appears to have had adverse effects on the current account, as well as on households who receive remittances in dollars.
2. This chapter assesses the degree of external and domestic competitiveness of the Armenian economy. Section B begins by discussing recent external developments. This is followed in Section C by a summary of four different equilibrium exchange rate estimates, based on the purchasing power parity (PPP) approach, the behavioral equilibrium exchange rate (BEER) approach, the external sustainability (ES) approach, and the macroeconomic balance (MB) approach. Section D assesses domestic competitiveness by estimating the degree of exchange rate pass-through to import prices, which can be considered a measure of the degree of domestic competitiveness in Armenia. Section E discusses structural competitiveness. Section F concludes.
3. The chapter offers three main conclusions. First, all four approaches for estimating the equilibrium real exchange rate suggest that the recent dramatic appreciation has reduced the previously existing undervaluation and has brought the real exchange rate back to (and possibly slightly above) equilibrium. Second, the pass-through estimates point to significant downward rigidity in import prices in response to exchange rate movements, suggesting that there may be insufficient domestic competition between importers. Third, an acceleration of structural reforms is needed to maintain competitiveness in Armenia.
B. Recent External Developments
4. Armenia’s net international investment position (NIIP) has improved. Net external liabilities have declined steadily over the past five years and compare favorably with neighboring countries (Figure III.1). Armenia’s III stood at negative 7 percent of GDP as of end 2007.
Armenia: Net Investment Position
(Percent of GDP)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Sources: IFS; and Fund staff estimates.5. While the current account deficit narrowed significantly between 1998 and 2004, it has widened again in recent years. Armenia’s external balance has deteriorated amid strong currency appreciation and a surge in imports. Although remittance flows continued to provide a strong boost to the current account in 2006–07, the underlying trade deficit worsened. This reflected a surge in import demand associated with buoyant economic activity and relatively tepid export performance (Figure III.2).
Armenia: External Balance
(In percent of GDP)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Sources: Armenian authorities; and Fund staff estimates.6. One of the possible reasons for the deteriorating trade balance in recent years is the fact that the real exchange rate has appreciated sharply during this period. The CPI-based REER shows a cumulative real appreciation of about 35 percent from 1995 to 2007, indicating a possible worsening of Armenia’s competitiveness (Figure III.3). Changes in the REER were driven by strong appreciation of the nominal effective exchange rate (NEER). REER developments can be examined within three distinct periods:
1995–1998: Armenia experienced an average annual appreciation of about 2 percent.
1999–2002: A depreciation of about 4 percent reversed the appreciation of the proceeding period.
Since 2003: Through end-2007, Armenia’s REER appreciated by 12 percent. From end 2007 to July 2008 the currency appreciated by an additional 3 percent.
Armenia: REER and NEER
(1995–2007)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Source: INS.7. Another indication of a possible deterioriation in competitiveness is that unit labor costs have increased. The period of relatively rapid REER appreciation coincided with a gradual and steady increase in unit labor costs, driven by a steep increase in wages in agriculture and—to a lesser extent—in industry (Figure III.4). This possibly contributed to weakening external competitiveness. However, labor market data for Armenia are not very reliable, due in part to the large size of the informal economy and the common practice to underreport wages. Thus, the observed increase in wages may also be, in part, the result of a reduction in the extent to which wages are underreported.
Armenia: Unit Labor Costs: Average Annual Wage Bill/Nominal GDP
(in AMD)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
C. Exchange Rate Assessment
8. The recent significant appreciation of the dram has raised concerns about export competitiveness. To ascertain whether dram appreciation has resulted in an overvaluation of the real exchange rate, estimates of the equilibrium real exchange rate are derived using three differing approaches. Estimates of the current account norm derived from the macroeconomic balance approach are also presented in this section.
Purchasing Power Parity (PPP) approach
9. Recent PPP estimates (based on 2005 weights) suggest that Armenian prices in U.S. dollar terms increased from about one third to more than one half of U.S. dollar prices, during the past five years (Figure III.5). Assuming that a relative price of 100 percent (PPP exchange rate of one) was defined as the equilibrium real exchange rate, these PPP estimates would imply a dram undervaluation of about 50 percent. However, it would be more reasonable to estimate the “equilibrium distance to PPP,” which would take into account the fact that prices are generally lower in countries with lower incomes and productivity. In the spirit of Balassa (1964) and Samuelson (1964), this implies that we expect the real exchange rate to appreciate in line with the “relative productivity differential.”
Armenia: Local Price Level Relative to U.S. Price Level
(In percent)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Sources: WEO (October 2008); IFS; and Fund staff estimates.10. Consistent with the Balassa-Samuelson hypothesis, the data in Figure III.6 show a positive relationship between the real exchange rate and productivity (proxied by GDP per capita), based on a broad sample of 180 countries. A simple regression shows that, on average, every 1 percent increase in PPP GDP per capita is associated with a real appreciation of 0.39 percent. This result is broadly consistent with that obtained by Rogoff (1996) and De Broeck and Slok (2001).2
Armenia: Relative Price Levels and Relative Incomes
(2004)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Source: IMF World Economic Outlook.11. The results from the PPP estimates suggest that, as of end-2007, the dram was slightly overvalued (Figure III. 7). The PPP estimate of dram misalignment is obtained by comparing the actual real exchange rate (relative price level) with the estimated equilibrium relationship between relative price levels and productivity differentials. The results, shown in Figure 7, suggest that the dram was highly undervalued in 1993, then converged quickly to equilibrium, and remained above equilibrium until after 2000. It then became slightly undervalued during 2002 and 2003, then converged back to equilibrium around 2005, after which it became slightly overvalued.
Armenia: Equilibrium and Actual Real Exchange Rate (PPP approach)
(In Percent)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Source: WEO (October 2008); IFS; and Fund staff estimates.Behavioral Equilibrium Real Exchange Rate (BEER) approach
12. Another approach for estimating the equilibrium real exchange rate is by using a vector auto regression model and estimating a cointegrating relationship between the REER and its main determinants. The determinants of the REER used in the model include: productivity differential3, net international reserves, and government consumption as a percent of GDP. An increase in government consumption (in percent of GDP) is expected to give rise to a real appreciation. While the relationship between NIR and the real exchange rate is generally ambiguous, it is likely to be positive for Armenia.4 The terms of trade, which are often included in BEER models, are omitted from the estimates, since they tend to be exceedingly volatile in small open economies with an undiversified commodity export base. Furthermore, the terms of trade are likely to be correlated with NIR.
13. The measure of “relative productivity differential” can differ according to the classification of sectors as tradable or nontradable. Industrial production is traditionally considered as tradable, and services as nontradable. However, the classification of other sectors, in particular agriculture, is more ambiguous. Since construction could be considered as either nontradable or tradable, following De Broek and Slok (2001), and Coricelli and Jazbec (2001), separate estimates were derived using the alternative measures of productivity.
14. The results from the BEER approach are consistent with that of the PPP approach, in that they suggest that the real exchange rate is currently near or possibly slightly above equilibrium (Figure III.8). A number of alternative specifications were estimated, generating broadly consistent results on the degree of misalignment. The estimated cointegration vectors indicated that all the dependent variables were statistically significant and of the correct sign.
Armenia: Actual and Estimated Equilibrium REER (Equation 1)
(1997=100, in logarithms)
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Sources: INS; and Fund staff estimates.External Sustainability (ES) approach
15. A third approach for estimating the equilibrium exchange rate is the external sustainability (ES) approach, which focuses on the relation between the sustainability of a country’s external stock position, its current account position, and the real exchange rate. The ES approach consists of a simple calibration exercise that requires only a few assumptions about the economy’s potential growth rate, inflation rate, and rates of return on external assets and liabilities.
16. The macroeconomic assumptions underlying the estimates are as follows:
The choice of the NF A/GDP ratio benchmark is a key element of the ES approach but is, to some extent, arbitrary. For the purposes of this analysis, the NF A/GDP position as of end-2006 (-24.2 percent), was used as the benchmark.
The inflation rate of NFA is assumed to be 2.5 percent.
The benchmark GDP growth rate is assumed at 6 percent. To reflect the sensitivity of the estimates to growth assumptions, two alternative scenarios were considered: a low-growth scenario (3 percent), and a high-growth scenario (9 percent).
17. For each of the growth scenarios, the current account deficit required to stabilize the NF A/GDP ratio is as follows:
benchmark growth:-1.9 percent
low growth:-1.3 percent
high growth: -2.5 percent.
18. Like the PPP and the BEER approaches, the ES approach suggests that the real exchange rate is no longer undervalued, and may have become somewhat overvalued in 2007. The required REER adjustment is broadly similar across the three scenarios. The magnitude of the required exchange rate adjustment is obtained by first computing the elasticity of the current account balance with respect to the real exchange rate.
Macroeconomic Balance (MB) approach5
19. The MB approach adapts the Consultative Group on Exchange Rate Issues (CGER) formulation to fit data availability constraints and economic characteristics of the Armenia economy. This version of the MB specification relates the current account (dependent variable) to the fiscal balance, demographics, initial net foreign asset position, oil prices/terms of trade, output growth, and relative income (compared to the U.S.). For non-oil countries such as Armenia, the specification was augmented by adding the real exchange rate and FDI as explanatory variables.
20. Six estimates of the current account “norm” are obtained, ranging from a deficit of about 2 percent GDP to a deficit of 14 percent of GDP. The actual current account level is within the range suggested by these estimates and therefore suggests that the exchange rate was near the equilibrium level. The underlying current account was estimated at a deficit of 5 percent of GDP in 2006. Each specification was estimated using pooled OLS, fixed effects, and GMM estimators. In addition, each specification was estimated—using all three estimation techniques—with the variables expressed as deviations from partner-country averages as well as in (log) levels.
D. Exchange Rate Pass-Through and Domestic Competition
21. There is widespread anecdotal evidence of monopolistic practices in some key import sectors, such as sugar and fuel. This section examines whether monopolistic behavior impacts on the pass-through from exchange rate changes to the domestic price of imported goods. The methodology employed loosely follows the vector autoregressive (VAR) model of McCarthy (2007), using monthly data for the period May 2005 – August 2007 (thus excluding the prestabilization period).
22. The VAR specification has four endogenous variables: price of oil in domestic currency, output gap,6 nominal effective exchange rate, and import prices. Variables are expressed in first differences to guarantee stationarity and are expressed in natural logs (except for the output gap which is already stationary and can be negative). The rationale for the other variables in the model and their ordering is the following: the oil price identifies supply shocks, while the output gap identifies demand shocks. The exchange rate is therefore allowed to respond contemporaneously to supply and demand shocks. The import price index responds contemporaneously not only to supply and demand shocks, but also to exchange rate shocks.
23. The estimates show that import price responses are much larger for exchange rate depreciations than for appreciations (Figure III.9). Furthermore, only the responses to exchange rate depreciations are statistically significant.
Armenia: Impulse Responses of Import Prices to NEER Shocks
Response to Cholesky One S.D. Innovations ± 2 S.E.
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
24. The other main finding is that the exchange rate pass-through is much larger (about three times) for depreciations than for appreciations (Figures III. 10 and III. 11). In terms of speed, the adjustment in import prices to both appreciations and depreciations last about 3 months.
Armenia: Exchange Rate Pass-through to Import Prices
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
Armenia: Speed of Exchange Rate Pass-through to Import Prices
Citation: IMF Staff Country Reports 2008, 375; 10.5089/9781451801699.002.A003
25. The asymmetric pass-through underlying the estimates suggests that there is significant downward rigidity in import prices in response to exchange rate movements. It is highly unlikely that this can be explained by transportation costs only, pointing instead to monopolistic practices in the import sector, which have limited the role of dram appreciation in containing inflationary pressures.
E. Structural Competitiveness
26. With the prospect of continued exchange rate appreciation over the medium term, improving competitiveness will require sustained improvements in productivity. To a large extent, this could be achieved by significantly improving the business environment.
27. While recent trends suggest moderate improvements in the ease of doing business, Armenia’s performance remains weaker than that of a number of comparator countries in the region. Although progress has been made with improving the ease of getting credit, Armenia continues to rank poorly in terms of cross border trade and paying taxes. This outcome highlights the need for Armenia to accelerate the pace of tax administration reforms.
Selected Countries Rankings in the Buisness Enviroment Database
(2006–08)
Selected Countries Rankings in the Buisness Enviroment Database
(2006–08)
| Ease of Doing Business Rank | Getting Credit | Paying Taxes | Trading Across Borders | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Overall | ||||||||||||
| 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | |
| Armenia | 34 | 46 | 39 | 65 | 62 | 36 | 148 | 137 | 143 | 119 | 133 | 118 |
| Georgia | 37 | 35 | 18 | 48 | 62 | 48 | 104 | 103 | 102 | 95 | 59 | 64 |
| Azerbaijan | 99 | 97 | 96 | 21 | 21 | 26 | 136 | 142 | 141 | 158 | 170 | 173 |
| Latvia | 24 | 20 | 22 | 13 | 12 | 13 | 52 | 38 | 20 | 28 | 22 | 19 |
| Lithuania | 16 | 24 | 26 | 33 | 32 | 36 | 40 | 74 | 71 | 32 | 23 | 23 |
| Estonia | 17 | 18 | 17 | 48 | 45 | 48 | 29 | 32 | 31 | 6 | 7 | 7 |
| Ukraine | 128 | 139 | 139 | 65 | 62 | 68 | 174 | 177 | 177 | 106 | 116 | 120 |
Selected Countries Rankings in the Buisness Enviroment Database
(2006–08)
| Ease of Doing Business Rank | Getting Credit | Paying Taxes | Trading Across Borders | |||||||||
|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Overall | ||||||||||||
| 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | 2006 | 2007 | 2008 | |
| Armenia | 34 | 46 | 39 | 65 | 62 | 36 | 148 | 137 | 143 | 119 | 133 | 118 |
| Georgia | 37 | 35 | 18 | 48 | 62 | 48 | 104 | 103 | 102 | 95 | 59 | 64 |
| Azerbaijan | 99 | 97 | 96 | 21 | 21 | 26 | 136 | 142 | 141 | 158 | 170 | 173 |
| Latvia | 24 | 20 | 22 | 13 | 12 | 13 | 52 | 38 | 20 | 28 | 22 | 19 |
| Lithuania | 16 | 24 | 26 | 33 | 32 | 36 | 40 | 74 | 71 | 32 | 23 | 23 |
| Estonia | 17 | 18 | 17 | 48 | 45 | 48 | 29 | 32 | 31 | 6 | 7 | 7 |
| Ukraine | 128 | 139 | 139 | 65 | 62 | 68 | 174 | 177 | 177 | 106 | 116 | 120 |
28. Armenia’s global competitiveness rankings also lag behind that of comparable countries in the region. Armenia is ranked at 93 far above Latvia, Estonia, and Lithuania. Armenia scores poorly on infrastructure, institutions, and financial market sophistication. Given the weak and highly concentrated export base, significant strides are needed in structural reforms to boost competitiveness.
Global Competitiveness Index Ranking and Score, 2007-2008 1/
United State ranks the highest with a GCI score of 5.67, while Chad (131) ranks the lowest with a GCI score of 2.78.
GCI 2007-2008 ranking for Estonia is 27, for Lithuania 38, and for Latvia 45.
Global Competitiveness Index Ranking and Score, 2007-2008 1/
| Armenia | Georgia | Baltics 2/ | |||||
|---|---|---|---|---|---|---|---|
| Rank | Score (out of 7) |
Rank | Score (out of 7) |
Score (out of 7) |
|||
| Overall Index | 93 | 3.76 | 90 | 3.83 | 4.55 | ||
| Of which: | |||||||
| Institutions | 96 | 3.40 | 86 | 3.62 | 4.28 | ||
| Infrastructure | 87 | 2.85 | 83 | 2.92 | 4.11 | ||
| Good market efficiency | 104 | 3.71 | 83 | 3.95 | 4.65 | ||
| Labor market efficiency | 40 | 4.54 | 28 | 4.75 | 4.62 | ||
| Financial market sophistication | 110 | 3.59 | 84 | 3.98 | 4.86 | ||
United State ranks the highest with a GCI score of 5.67, while Chad (131) ranks the lowest with a GCI score of 2.78.
GCI 2007-2008 ranking for Estonia is 27, for Lithuania 38, and for Latvia 45.
Global Competitiveness Index Ranking and Score, 2007-2008 1/
| Armenia | Georgia | Baltics 2/ | |||||
|---|---|---|---|---|---|---|---|
| Rank | Score (out of 7) |
Rank | Score (out of 7) |
Score (out of 7) |
|||
| Overall Index | 93 | 3.76 | 90 | 3.83 | 4.55 | ||
| Of which: | |||||||
| Institutions | 96 | 3.40 | 86 | 3.62 | 4.28 | ||
| Infrastructure | 87 | 2.85 | 83 | 2.92 | 4.11 | ||
| Good market efficiency | 104 | 3.71 | 83 | 3.95 | 4.65 | ||
| Labor market efficiency | 40 | 4.54 | 28 | 4.75 | 4.62 | ||
| Financial market sophistication | 110 | 3.59 | 84 | 3.98 | 4.86 | ||
United State ranks the highest with a GCI score of 5.67, while Chad (131) ranks the lowest with a GCI score of 2.78.
GCI 2007-2008 ranking for Estonia is 27, for Lithuania 38, and for Latvia 45.
F. Conclusions
29. The recent dramatic appreciation of the dram has removed the previously existing undervaluation, bringing the real exchange rate near or possibly slightly above equilibrium. This finding was consistent across the differing methods used to evaluate the degree of exchange rate misalignment. Meanwhile, pass-through estimates suggest that there is significant downward rigidity in import prices in response to exchange rate movements.
30. Safeguarding competitiveness in the context of dramatic dram appreciation calls for a more determined approach to structural reforms so as to improve the business environment, raise productivity, and contain inflationary pressures. Securing productivity gains will require improving tax and customs administration, deepening financial intermediation, reducing corruption, and discontinuing monopolistic practices in the import sector.
References
Balassa, Bela, 1964, “The Purchasing Power Parity Doctrine: A Reappraisal,” Journal of Political Economy, Vol. 72, No. 6, pp. 584–96.
Coricelli, Fabrizio, and Bostjan Jazbec, 2001, “Real Exchange Rate Dynamics in Transition Economies,” CEPR Discussion Paper, No. 2869 (July).
De Broeck, Mark, and Torsten Sløk, 2001, “Interpreting Real Exchange Rate Movements in Transition Countries,” IMF Working Paper 01/56 (Washington: International Monetary Fund).
Égert, Balazs, 2003, “Assessing Equilibrium Exchange Rates in CEE Acceding Countries: Can We Have DEER with BEER without FEER? A Critical Survey of the Literature,” Focus on Transition, Vol. 2, pp. 38–106.
IMF, 2008, “Exchange Rate Assessment,” draft, Middle East and Central Asia Department, (Washington: International Monetary Fund).
McCarthy, Jonatahan, 2007, “Pass-Through of Exchange Rates and Import Prices to Domestic Inflation in some Industrialized Economies,” Eastern Economic Journal, Vol. 33, No. 4 (Fall), pp. 511–37.
Oomes, Nienke, Fernando Gonćalves, and Gohar Minasyan, 2008, “Dealing With Dramatic Appreciation: Is the Armenian Dram Still Competitive?” IMF Working Paper (forthcoming) (Washington: International Monetary Fund).
Rogoff, Kenneth, 1996, “The Purchasing Power Puzzle,” Journal of Economic Literature, Vol. 34, No. 2 (June), pp. 647–68.
Samuelson, Paul A., 1964, “Theoretical Notes on Trade Problems,” Review of Economics and Statistics, Vol. 46, No. 2, pp. 145–54.
Prepared by Reginald Darius, drawing extensively from Oomes, Gonćalves, and Minasyan, 2008.
Log (real exchange rate) = -1.83 + 0.39*Log (PPP GDP per capita). The real exchange rate is measured as the relative price level PE/P*, and productivity is measured as PPP GDP per capita. The sample is taken from the IMF’s WEO database and covers 180 countries. Note that, since the data are in logs, a value of 0 on the y-axis in Figure III.6 corresponds to full PPP.
Since the EU is Armenia’s largest trading partner (accounting for 37 percent of external trade), Armenia’s relative productivity differential is computed by comparing it to that of the EU. Other trade partners were not included due to data limitations and differences in sectoral classification.
As Égert (2003) has argued, transition countries that are still in the catch-up process are likely to have a negative steady-state NIR position, as they finance their growth via foreign capital. While Egert’s arguments are for Net Foreign Assets (NFA), NFA of the Central Bank in Armenia is equivalent to NIR.
This section draws on IMF, 2008.
The output gap is derived by taking the deviations of the log of real GDP (approximated by the industrial production index) from the series smoothed by the Hodrick-Prescott filter.
