The economic outlook for Armenia has changed abruptly since last November and the authorities are grateful for the prompt response from the IMF. They would like to express their appreciation to the MCD team for their hard work and especially to Mr. Perez.

First, the mining sector was affected by the sharp drop in commodity prices and in external demand. Then, construction activities have started to slow down, responding to lower inflows of investment, capital, and remittances. The country is now facing a severe shock to growth that was running at over 10 percent last September, and now, a year later, it is expected to be in negative territory. Negative expectations were also strengthened by the growing difficulties among economic partners in the region.

Challenges from the short-term outlook affect the overall confidence and threaten financial stability. Depressed commodity prices and weaker inflows have put pressure on the balance of payments, despite lower domestic demand, and capital outflows picked up. With negative expectations gaining strength, the Central Bank faced unexpectedly high demand for foreign exchange, while credit growth slowed down, responding to declining deposits and uncertain prospects of some borrowers. Inflation also slowed remarkably, but the new trend of redollarization presents risks for financial stability and challenges for monetary policy implementation. Finally, fiscal revenues will likely be affected by the economic slowdown; however, the authorities remain committed not only to fiscal prudence, but also to preserving achievements of the recent years in reducing poverty.

The long-term horizon of the proposed arrangement should give sufficient room for completing the authorities’ structural reform agenda, notably in the areas of tax policy and tax administration. Resolving long standing problems of tax credits and delayed tax refunds will also provide additional stimulus during the recession. Thus, structural reforms of the new arrangement demonstrate continuity with the previous PRGF. In addition, the proposed reforms in the financial sector are needed and timely.

The important new element is the urgent need to address the sizeable financing gap that emerged due to a contagion from the global crisis. The exceptional access is consistent with the size of the gap and the need to preserve financial stability. Large assistance packages by the World Bank, the Russian Federation, as well as possible support from the Asian Development Bank and the European Union are very helpful in this respect. Armenia needs a large boost of confidence, but it will also have to undertake a more substantial upfront adjustment than was expected under the previous program. A projected increase in external debt, including from the Fund, is manageable, given that the NPV of external debt to exports is projected to reach the levels of about five years ago (not to mention the levels of 10 years ago, which were twice as high, when Armenia was considered a relatively indebted country). Armenia’s public debt at under 18 percent is now one of the lowest among its peers, and we consider that repayment risks to the Fund are low.

A return to the flexible exchange rate arrangement presents the most viable adjustment option under the current circumstances, especially in light of sizeable depreciations of exchange rates among other emerging market economies of the region. Staff share the authorities’ concerns about possible distress in the financial sector, especially in the case of initial exchange rate overshooting, which could not be excluded. The small size of the financial sector, with deposits at only 15 percent of GDP, and the uncommonly high capitalization levels, at 28 percent, should mitigate financial sector risks from the depreciation. The authorities, in consultation with staff, are also preparing targeted contingency measures to respond to the banking sector problems–should they materialize.

Unfortunately, memories of violent economic and political crises of the first few years of Armenian independence and the political tensions in the region magnify risks to confidence and may require quick reaction from the authorities. To this end, the authorities established a high-level committee to monitor the developments in the economy and to coordinate the policy response to the ongoing economic challenges.

So far, the first few days since the exchange rate was allowed to float are generally encouraging, while the upside potential of further exchange rate movements should address the risks associated with one-way bets by market participants. The authorities are committed to ensure that the exchange rate is flexible in both directions.

The Armenian economy proved resilient to the shocks of the past, is flexible, and there remains a likelihood of upside risks to the outlook this time as well, especially if regional trade restrictions are lifted. Armenia has a long history of successful implementation of Fund programs, and we expect that implementation of the proposed stand-by arrangement will likewise be successful.