Republic of Armenia
2008 Article IV Consultation and Request for a Three-Year Arrangement Under the Poverty Reduction and Growth Facility: Staff Report; Staff Supplement; Staff Statement; Public Information Notice and Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia.

This 2008 Article IV Consultation highlights that Armenia’s recent economic performance has remained strong, and the economy is poised for another year of double-digit growth. Rising inflation, a widening current account deficit, and rapid credit growth have raised concerns about overheating. Executive Directors have commended the authorities for the successful implementation of macroeconomic policies under the Poverty Reduction and Growth Facility (PRGF)-supported program that expired in May 2008. Directors have also welcomed the authorities’ intention to withdraw fiscal stimulus during 2008–09 to address current imbalances.

Abstract

This 2008 Article IV Consultation highlights that Armenia’s recent economic performance has remained strong, and the economy is poised for another year of double-digit growth. Rising inflation, a widening current account deficit, and rapid credit growth have raised concerns about overheating. Executive Directors have commended the authorities for the successful implementation of macroeconomic policies under the Poverty Reduction and Growth Facility (PRGF)-supported program that expired in May 2008. Directors have also welcomed the authorities’ intention to withdraw fiscal stimulus during 2008–09 to address current imbalances.

I. Introduction

1. Under the 2005-08 PRGF-supported program, Armenia achieved a marked reduction in poverty within a high-growth and low-inflation macroeconomic environment. This strong performance was underpinned by sustained macroeconomic discipline, but also reflected a favorable global environment, and large-scale foreign exchange inflows. Meanwhile, progress with structural reforms was uneven: reforms in the financial area, where ownership was strong, were more successful than in tax policy and tax/customs administration, where vested interests resisted the comprehensive approach necessary to create an efficient and fair tax system (Box 1).

Armenia’s Third PRGF-supported Program—Objectives and Achievements

Objectives: (i) maintain macroeconomic stability through prudent monetary and fiscal policies; (ii) generate additional domestic resources to finance poverty-reducing and growth-enhancing expenditures, in particular by strengthening tax and customs administration; and (iii) boost private sector activities by fostering financial sector development, and improving public and corporate governance.

Achievements: These objectives have been achieved to a large extent. Program conditionality and staff policy advice helped the authorities to implement prudent monetary and fiscal policies and make progress on structural reforms in an environment of strong growth, low inflation, rising real incomes, and declining poverty rates. Nominal revenue targets were consistently exceeded, and the tax-to-GDP ratio increased by two percentage points amid double-digit GDP growth. Financial sector infrastructure, regulation, and supervision improved markedly during the program period. Financial intermediation almost doubled in relation to GDP, and progress was made in money and capital market development.

It can be argued, however, that structural conditionality—constrained by political limitations and ownership considerations—could have been more ambitious and comprehensive, in particular regarding tax policy, and tax/customs administration. While the piecemeal approach adopted in these areas addressed specific shortcomings, it failed to create an efficient and fair tax system.

2. On the surveillance side, response to Fund advice has been generally positive (Box 2). In particular, the new government (in office since April) has demonstrated strong impetus for reform. In line with previous staff recommendations, the authorities are moving ahead with several initiatives aimed at strengthening tax and customs administration, addressing tax policy weaknesses, and improving the business environment.

3. The recent war in neighboring Georgia and the global financial turmoil are unlikely to affect the short-term growth outlook significantly, but downside risks are rising. While the conflict demonstrated Armenia’s vulnerability to disruptions in transport (70 percent of Armenian imports are shipped through Georgia), fuel shortages and trade interruptions were temporary and had limited impact on production, consumer confidence, and domestic prices. At the same time, the conflict served as a catalyst for preliminary talks with Turkey, which could eventually lead to the opening of the border between the two countries—a highly desirable scenario for land-locked Armenia. Given its limited integration with the international financial system, Armenia is not directly affected by the recent turmoil, but is likely to suffer from any serious deterioration in Russia’s economic prospects.

Armenia: Response to Fund Advice

Fiscal Policy: The authorities followed Fund recommendations to achieve lower-than-budgeted deficits during the past two years by prudent expenditure execution and saving of revenue overperformance. Response to Fund advice in tax policy and administration—notably regarding presumptive tax regimes, tax incentives for companies listing in the stock market, and modernizing tax administration—has been mixed, but recent moves are encouraging.

Monetary Policy: In line with Fund advice, the Central Bank of Armenia (CBA) committed to a preannounced three-year inflation target and tightened monetary policy in response to heightened inflationary pressures. The fiscal and monetary authorities improved policy coordination in monetary operations and debt management following Fund recommendations.

Financial Sector: Bank corporate governance was strengthened in line with the 2005 FSAP update, and the financial sector infrastructure was bolstered through improved market transparency, creditor rights, and consumer protection. The authorities also introduced risk-based supervision.

4. The authorities have requested a low-access PRGF arrangement to support their ambitious reform agenda. A new Fund program is seen as crucial to safeguard macroeconomic stability, and signal to donors, creditors, and foreign investors that policy implementation is on track—especially in light of increasing risks. Importantly, the new program will support the completion of politically difficult tax reforms, essential to improve the business environment and promote broad-based growth. Moreover, Armenia’s narrow export base and heavy reliance on remittances suggest that additional Fund resources could be needed even in the absence of a significant exogenous shock. While the authorities have been successful in reducing poverty, the overall poverty level is still high, and more progress is needed to reach the Millennium Development Goals (Table 1).

Table 1.

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

(In percent of total population, unless otherwise indicated)

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Sources: World Bank; and Armenian authorities.Goal 1: Halve, between 1990 and 2015, the proportion of people whose income is less than $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 later than 2015.Goal 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.

2000 and 2003 poverty surveys based on different methodology than in other years.

II. Background

5. Armenia is poised for another year of double-digit growth, but inflation and external imbalances are growing (Figure 1). Notwithstanding the temporary trade disruptions during the Georgia conflict, annual real GDP grew by 10.4 percent in the nine months to September, and is projected to remain around 10 percent this year, assuming continued strong activity in construction and services. Annual inflation has remained high but, at 11.3 percent in September, is still lower than in neighboring countries, thanks to a gradual tightening of monetary policy, exchange rate flexibility, and a moderate fiscal stance. While inflation was driven mainly by the global spike in food and energy prices (including the elimination of the off-budget subsidy to end-users of natural gas last May), demand pressures have played an increasing role. Indeed, rising wages, persistently large foreign exchange inflows, rapid credit growth, and a sharply widening current account deficit have raised concerns about overheating (Table 2).

Figure 1
Figure 1

Armenia: Recent Economic Developments

Citation: IMF Staff Country Reports 2009, 029; 10.5089/9781451801729.002.A001

Sources: Armenian authorities; and Fund staff estimates.1/ Remittances are defined as the sum of compensation of employees, workers’ remittances, and other non-government current transfers.

Armenia: Main Economic Indicators, 2005–08

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Source: Armenian authorities; and Fund staff estimates.

Excluding grants and external interest payments.

Table 2.

Armenia: Selected Economic and Financial Indicators, 2003–09

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

The 2004-2006 external current account figures were revised following changes in methodology.

Tax revenues in 2007 include 0.2 percent of GDP in tax arrears paid by Armentel, which were not part of the official target.

Including the gas subsidy during 2006–08.

Overall balance excluding grants and external interest payments.

With the exception of gross international reserves, figures for 2007 are estimates.

Private external debt included since 2006.

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.

6. Budget execution in 2008 has been prudent (Table 3). Tax collection has been well above expectations, driven by a surge in VAT revenue partly associated with high import growth (Figure 2). Limited implementation capacity for capital projects and the postponement of a $50 million disbursement from the Millennium Challenge Corporation (MCC) resulted in significant spending underexecution, notwithstanding a 60-percent increase in average pensions included in the 2008 budget. The shortfall in MCC-financed rural road construction was partly offset with domestic resources within the same budgetary envelope. As a result, the overall budget remained close to balance through July. This may reverse the previous deterioration in the underlying fiscal balance (including the gas subsidy, but excluding grants and external interest payments), which provides a better measure of the impact of fiscal policy on domestic demand (Box 3).

Table 3.

Armenia: Central Government Operations, 2006–09

(In billions of drams)

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

Relative to the budget, the staff presentation reclassifies estimated military wages from Other goods and services and Other expenditure to Wages.

Underlying balance is defined as overall balance before grants, and excluding external interest payments.

Old definition.

Figure 2
Figure 2

Armenia: Recent Fiscal Developments 1/

Citation: IMF Staff Country Reports 2009, 029; 10.5089/9781451801729.002.A001

1/ All figures are in percent of GDP.Source: Armenian authorities; and Fund staff estimates.

7. Monetary policy has been tightened to address rising inflationary pressures. To limit the second-round effects of higher food and energy prices, the CBA raised the repurchase rate gradually from 4.5 percent in June 2007 to 7.75 percent in September 2008, but left the rate unchanged in October, in response to the uncertain external economic environment. Broad money growth has remained robust, reflecting continued remonetization and surging private sector credit (Table 4). Reserve money growth moderated slightly during the first eight months of 2008 on account of larger government deposits with the CBA and higher-than-usual foreign exchange sales during the first half of the year (Figure 3).

Table 4.

Armenia: Monetary Accounts, 2006–09

(In billions of AMD, unless otherwise indicated)

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

At program exchange rate of 304.22 dram per U.S. dollar for 2008 and 2009.

At actual exchange rates, excluding the Special Privatization Account 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).

Figure 3
Figure 3

Armenia: Recent Monetary Developments

Citation: IMF Staff Country Reports 2009, 029; 10.5089/9781451801729.002.A001

Source: Central Bank of Armenia.

8. Despite large private transfers, the current account has continued to deteriorate. Imports have surged on the back of high international food and energy prices and buoyant demand, while export performance has been disappointing (Table 5). Weak exports reflect declining competitiveness in diamond-processing, and temporary shortfalls in base metals output, but also the high cost of doing business in Armenia. With appreciation pressures dampened by rising import demand, the dram/dollar exchange rate has been broadly stable since December 2007. International reserve coverage dropped somewhat, but remains adequate, at 3½ months of imports.

Table 5.

Armenia: Balance of Payments, 2006–12

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Armenian authorities; and Fund staff estimates.

Debt relief from the United Kingdom through 2015 (in respect of IDA credits).

Starting from 2006, based on government, government-guaranteed, and private sector medium- and long-term debt.

Based on low-income country debt sustainability analysis.