Republic of Armenia
Request for Stand-By Arrangement-Staff Report; Staff Supplements and Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia.

This paper discusses Armenia’s request for a Stand-By Arrangement (SBA) with exceptional access of 400 percent of quota. Given the urgency of the situation, the request is being considered under the Emergency Financing Mechanism. The new program aims to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor. The authorities have also committed to a set of policies in the exchange rate, monetary and financial, and fiscal areas as well as on maintaining its ongoing structural reform program.

Abstract

This paper discusses Armenia’s request for a Stand-By Arrangement (SBA) with exceptional access of 400 percent of quota. Given the urgency of the situation, the request is being considered under the Emergency Financing Mechanism. The new program aims to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor. The authorities have also committed to a set of policies in the exchange rate, monetary and financial, and fiscal areas as well as on maintaining its ongoing structural reform program.

I. Background

1. Until recently, Armenia had enjoyed a long period of strong economic performance. Positive regional spillovers and prudent policies underpinned rapid GDP growth and large capital inflows in a context of macroeconomic stability. Prudent fiscal policies led to a reduction of government debt as a share of GDP, while a flexible exchange rate and a well-designed monetary framework helped maintain low inflation. On the basis of Armenia’s impressive track record of successful implementation of Fund-supported programs, the Fund’s Executive Board approved on November 17, 2008 the authorities’ request for a new low-access PRGF arrangement. Directors endorsed this request, but noted that the deteriorating global conditions could have implications for Armenia’s economic outlook and financing requirements.

2. Amidst political uncertainty and regional instability, the Armenian economy was showing signs of overheating in the first part of 2008. The new coalition government installed in April 2008 following controversial presidential elections pressed ahead with an ambitious reform agenda, but unresolved tensions with the opposition weakened its political support. The war between neighboring Georgia and Russia in August 2008 led to severe, although temporary, disruptions in trade flows and fuel shortages. Nevertheless, real GDP increased by some 10½ percent through September, supported by remittances and FDI, with brisk activity in construction and services. High import prices and strong domestic demand pushed inflation to 11½ percent in August.

II. The Impact of the Global Crisis

3. The global crisis has confronted Armenia with a number of strong external shocks. Although sheltered from direct contagion effects by the limited international integration of its financial system, Armenia has been hit by a set of adverse shocks to the current and capital accounts, particularly emanating from Russia. Remittances and capital inflows, which sustained the construction boom in recent years, have decelerated markedly. Falling international commodity prices adversely affected mining, a key export sector, and several mines have ceased operations. GDP growth came to a halt in the fourth quarter, and fell to 6.8 percent for the year as a whole (Table 1, Figure 1). Following the rapid unwinding of international prices and domestic demand, annual CPI inflation fell to 1 percent in February 2009. With exports being hit by the global downturn and imports growing strongly through October, the external current account deficit rose to an estimated 12½ percent of GDP in 2008 (Table 2).

Table 1.

Armenia: Selected Economic and Financial Indicators, 2006–10

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

Including the gas subsidy in 2006-2008.

Overall balance excluding grants and external interest payments.

Excluding the special privatization account (SPA).

Gross international reserves in months of next year’s imports of goods and services, without the use of Fund resources.

A positive sign denotes appreciation. Base year 1995=100. The calculations are based on 1999–2001 average trade weights.

Figure 1.
Figure 1.

Armenia: Recent Economic Developments

GDP growth will be affected by the expected decline in remittances and construction activity.

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: Armenian authorities; and Fund staff estimates.1/ Remittances are defined as the sum of compensation of employees, workers’ remittances, and other nongovernment current transfers. 2008 figures are estimated.2/ 2009:Q1 to 2009:Q4 data are projections.
Table 2.

Armenia: Balance of Payments, 2007–12

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

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

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

Based on government and government-guaranteed debt.

Based on low-income country debt sustainability analysis.

Armenia: Shortfall in Foreign Exchange Earnings

(millions of US dollars)

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

See Country Report No. 09/29.

4. The de facto fixed exchange rate policy has contributed to an emerging confidence problem in the exchange rate and financial system. Depreciation pressures on the dram have increased, as depositors started converting local currency deposits into foreign currency deposits, and dram cash holdings into foreign currency cash. The Central Bank of Armenia (CBA) has been selling about $50 million a week (now about 5 percent of gross reserves) in recent months, with net international reserves (according to the program definition, which excludes foreign currency deposits of commercial banks at the central bank) falling from $1,084 million at end-December to $627 million as of February 27, 2009. The authorities have resisted depreciation pressures, out of concerns that a devaluation would precipitate a rapid and destabilizing shift in local to foreign currency deposits and trigger substantial deposit withdrawals from the banking system.

5. As a result of the de facto peg, the exchange rate has become increasingly misaligned. Staff’s current assessment indicates that the real exchange rate is about 20-30 percent above its equilibrium value (Figure 2). This assessment contrasts with that made at the time of Armenia’s 2008 Article IV consultation, which found that the exchange rate was only slightly above its equilibrium value. The External Sustainability (ES) approach now suggests an overvaluation of about 20 percent at end-2008. Based on the purchasing power parity (PPP) approach, the real exchange rate is currently around 30 percent above equilibrium, while the behavioral equilibrium exchange rate (BEER) approach suggests that the dram was overvalued by 21 percent at end-2008. These results are in line with those obtained by the CBA using a similar approach.

Figure 2.
Figure 2.

Armenia: Estimated Real Exchange Rate Misalignment

(In percent)

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: CBA and Fund staff estimates.

6. Despite the depreciation pressures, the CBA cut the repo rate to 6.75 percent in three steps from December to February, in line with the more benign inflation developments. The growth in monetary aggregates has slowed considerably, and broad money fell in the first part of 2009 (Table 3, Figure 3).

Table 3.

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 the program exchange rate.

Following the agreement between the CBA and the Ministry of Finance, the issue of new CBA bills was terminated in 2008.

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.

Armenia: Recent Monetary and Financial Sector Developments

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: Armenian authorities; and Fund staff estimates.

7. In the face of redollarization and disintermediation, the financial sector has come under mounting stress as the dram became increasingly overvalued. Despite high capital adequacy ratios (CAR)(Table 4), more than double the minimum 12 percent, and low levels of non performing loans, banks could be vulnerable to liquidity problems, reflecting the fragile confidence of the public in the banking system due to previous episodes of devaluations and bank runs in Armenia.

Table 4.

Armenia: Financial Soundness Indicators for the Banking Sector, 2004–08

(In percent, unless otherwise indicated)

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Source: Central Bank of Armenia.

8. In these circumstances, banks are restructuring their balance sheets to avoid large currency and liquidity mismatches. Given the local currency shortage, banks have reduced their lending activities in drams, particularly by not rolling over such loans as they fall due and are trying to pass the exchange rate risk to borrowers by switching to dollar loans. Dram lending is now largely funded by a number of initiatives by multilateral and bilateral donors to promote local currency lending to the SME sector. The result is an unfolding credit crunch in dram lending, which notably finances consumer loans and mortgages, with a risk of increased dollar lending to borrowers without dollar incomes. At the same time, however, banks have also accumulated high levels of dollar liquidity (placed both at the CBA or overseas with correspondent banks) (Box 1).

Armenia: Financial Sector Stability Issues

The banking system, comprising 22 banks, has been strengthened in recent years with the entry of foreign banks from the European Union as well as Russia, which are amongst the largest banks in Armenia. Based on latest data from the CBA, the system’s CAR of 27.9 percent is well above the minimum 12 percent requirement and non-performing loans are low at around 5 percent of total loans. Encouragingly, the banks have limited external borrowing or debt issuance and most liabilities to nonresidents are long term to multilateral and bilateral donors. The CBA has also put in place aspects of a modern risk-based prudential framework and a Deposit Guarantee Fund (DGF) was established in 2004.

However, despite these positives, there are serious structural weaknesses in the system which the effects of the on-going exogenous shocks have exposed. The system remains very small, with deposits equivalent to about 15 percent of GDP. This compares to the CBA’s estimate of dollar cash-in-circulation of about 35 percent of GDP. The system was unable to fully mobilize the local deposit base during the recent years of strong economic growth, despite a positive trend of dedollarization, due to lingering fears related to the historical experience in the initial chaotic years after independence. Now that economic conditions have deteriorated, such fears have again come to the fore and depositors are switching at a rapid rate from dram to dollar accounts, and are accelerating their withdrawals of cash dollars to add to the high stock of “mattress money.”

Although stress testing by the CBA indicates that solvency is not at risk, for prudential reasons the CBA is putting in place measures for long-term support for weak banks. This is especially important as their shareholders may be unable to fund the resources to do so in the context of a global crisis. International experience has shown that banks can be stabilized through the placements of long-term deposits, which can be backed by the issuance of subordinated debt with an option to convert into equity if necessary. Forward planning should also assess what would happen if a large bank were to become insolvent. The creation of the DGF was a positive step in 2004. Staff suggested that a broadening of the guarantee would be positive in boosting confidence in the banking system and preventing deposit runs.

9. Fiscal policy remained prudent throughout 2008. The overall deficit was contained at 1.7 percent of GDP, well below its budgeted level, with an improvement of 0.6 percent of GDP compared to the 2007 budget outturn (Table 5, Figure 4). The improved fiscal position reflected both revenue-enhancing and expenditure-reducing measures. On the revenue side, tax collection was well above expectations, in particular for VAT, reflecting some progress in tax administration and the continued accumulation of tax credits. On the expenditure side, the elimination of the gas subsidy in May 2008 and the slowdown in the implementation of capital projects contributed to a lower-than-budgeted outturn. Government debt remained at a comfortable level.

Table 5.

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.

Overall balance excluding net lending.