Republic of Armenia
First Review Under the Stand-By Arrangement, Request for Augmentation, Rephasing of Purchases, Waiver of the Nonobservance of Performance Criteria, and Modification of Performance Criteria: Staff Report, Press Release on the Executive Board Discussion, and Statement by the Executive Director for the Republic of Armenia.
Author:
International Monetary Fund
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Publication Date:
20 Jul 2009
eISBN:
9781451801750
Language:
English
Keywords:
ISCR; CR; waiver of the nonobservance of performance criteria; waiver; Armenia; nonobservance; request; current account; debt service; banking system; central bank; private sector; Currencies; Global; credit crunch
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This paper discusses key findings of the First Review under the Stand-By Arrangement for the Republic of Armenia. In light of the large increase in Armenia’s financing needs, the authorities have requested an augmentation of IMF resources in the amount of 180 percent of quota. The revised program maintains the original objectives of responding to the external outlook, strengthening confidence in the domestic currency and the banking sector, and protecting the poor, but would also allow an easing of monetary and fiscal policies to mitigate the severity of the crisis.

Abstract

This paper discusses key findings of the First Review under the Stand-By Arrangement for the Republic of Armenia. In light of the large increase in Armenia’s financing needs, the authorities have requested an augmentation of IMF resources in the amount of 180 percent of quota. The revised program maintains the original objectives of responding to the external outlook, strengthening confidence in the domestic currency and the banking sector, and protecting the poor, but would also allow an easing of monetary and fiscal policies to mitigate the severity of the crisis.

I. Background

1. On March 6, 2009 the Fund’s Executive Board approved a SBA with exceptional access of 400 percent of quota, equivalent to SDR 368 million or about $544 million (Country Report No. 09/140). The main objectives of the SBA-supported program were to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor.

2. Since the approval of the SBA, the economic outlook has deteriorated considerably. The return to a floating exchange rate on March 3—a centerpiece of the SBA-supported program—has been successful. However, Armenia has been strongly affected by the global downturn, notably through its impact on Russia. As a result, while program implementation has generally been good (Box 1), external and fiscal financing gaps have emerged in 2009-10 compared to projections at the time of the SBA approval. In response, the authorities are easing fiscal and monetary policies, implementing measures to improve credit conditions, raise tax revenue, and protect the poor, and reaching out for additional bilateral and multilateral financing to help support these policies and strengthen the international reserves position.

Armenia: Shortfall in Key Foreign Exchange Inflows

(millions of US dollars)

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

Armenia: Performance Under the SBA-Supported Program

Policy implementation under the program was strong, but worse-than-anticipated economic conditions negatively affected some end-March quantitative targets (MEFP Table 1):

  • Despite the postponement of non-essential spending, the authorities could not meet the end-March performance criteria for the program fiscal balance and banking system net credit the government, for which the authorities intend to request waivers. The reduction in outstanding tax credits progressed in line with the indicative target.

  • Thanks to stable financial conditions after the March 3 depreciation, both the CBA’s net domestic assets and net international reserves performance criteria were easily met. However, the reserve money indicative target was not met as banks increased reserves at the central bank in anticipation of the return to the floating exchange rate.

  • There was no accumulation of external arrears.

  • No structural conditionality was envisaged for end March

Table 1.

Armenia: Selected Economic and Financial Indicators, 2006–10

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Sources: Armenian authorities; and Fund staffe stimates and projections.

Including the gas subsidy in 2006-2008.

Based on government and government-guaranteeddebt.

Excluding the special privatization account (SPA), but including the Russian project loan.

Gross international reserves in months of nextyear’s imports of goods and services, including the use of Fund resources.

A positive sign denotes appreciation.

3. In this context, the authorities have requested an augmentation of access amounting to 180 percent of quota, equivalent to SDR 165.6 million, or around $258 million. The additional resources would help close the newly-emerged financing gaps, bolster reserves, and maintain confidence. Given the potential pressure that an easing of fiscal policy would place on the balance of payments, it is anticipated that the resources from the augmentation, together with the June 2009 purchase, would be transferred directly to the government in 2009–2010. With the augmentation, total access under the arrangement would increase to 580 percent of quota. Annual access during the first year of the program is greater than 200 percent of quota, and thus would still qualify as exceptional under the new limits.

II. Recent Developments

4. Economic conditions have worsened further since the SBA approval. The economy is suffering from the drop in remittances, in particular from Russia, which had financed the boom in construction in recent years, notably of residential investment. Construction activity, which accounts for almost 30 percent of GDP, has contracted by 42 percent in the first four months of 2009 relative to the same period of 2008, dragging down overall economic activity, which has fallen by close to 10 percent over the same period. Other sectors, notably mining, are facing significant difficulties in the face of weak external demand and low international commodity prices. In the second half of the year, as the planned easing of policies takes hold, the contraction is expected to level off with the launch of some large infrastructure projects, the increase in competitiveness following the exchange rate depreciation, and the recovery of international copper prices. For 2009 as a whole, real GDP is projected to contract by 9½ percent, and poverty is expected to increase. As global conditions improve, real GDP is projected to rise in 2010, but only by about 1 percent (Table 1).

5. The sharp economic downturn has caused a substantial deterioration of the external and fiscal positions:

  • Large drops in export receipts, remittances, and FDI have widened the gap in the external balance of payments despite the decline in imports associated with weaker economic activity (Table 2).

  • Tax revenues have fallen by 15 percent in the first four months of 2009, and, despite a postponement of expenditures, the authorities were not able to meet the program targets related to the fiscal performance.

Table 2.

Armenia: Balance of Payments, 2007–14

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

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Sources: Armenian authorities; and Fund staffe stimates and projections.

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

Based on government and government-guaranteeddebt.

6. The 22 percent depreciation vis-à-vis the U.S. dollar on March 3 likely removed a significant exchange rate misalignment.1 Since the return to the floating exchange rate, transactions on the foreign exchange market have declined considerably, and the CBA has intervened only on a few occasions—for a total net amount of 3.5 percent of gross international reserves—to smooth exchange rate volatility and facilitate the functioning of the market. Gross reserves were $1.2 billion at end April. The financial sector remains solid, but credit conditions in the economy have tightened (Box 2).

uA01fig01

CCA Exchange Rates

(National currency in US$, June 2008 = 100)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

7. Despite the depreciation, inflationary pressures remain muted. Annual CPI inflation rose to 3.4 percent in May from 1 percent in February and March, reflecting adjustments in utility tariffs and the pass-through from the March depreciation, which mostly affected imported food prices. Owing to ample spare capacity in the economy, inflation is expected to remain low throughout 2009.

III. The Authorities’ Program for 2009 and 2010

8. The authorities have revised their SBA-supported program in response to the worsening of the economic outlook for 2009–10. The revised program maintains the original objectives of the SBA-supported program, but adjusts policies to help offset the collapse in economic activity and lays the basis for the medium-term fiscal consolidation needed to address the build-up in public debt. Thus, the revised program focuses on:

  • Easing monetary policy consistent with the inflation-targeting framework and taking measures to unblock bank lending;

  • Easing the fiscal stance by ringfencing key social programs and supporting development projects through additional external financing;

  • Laying the ground for future fiscal consolidation primarily through measures to strengthen the tax administration and address tax policy weaknesses.

Armenia: Recent Developments in the Banking Sector

Following the return to the floating exchange rate, financial sector conditions have stabilized. Deposit dollarization has leveled off at around 67 percent after having rapidly increased from 35 percent in November 2008, as depositors converted their dram deposits into dollar deposits at a rapid pace in anticipation of the depreciation. Moreover, the depreciation did not trigger deposit outflows. With depositors converting part of their dollar receipts into drams, commercial banks were able to reduce their short foreign currency exposure.

uA01fig02

Dollarization and AMD/$ Exchange Rate

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

The banking system losses from the March 3 depreciation have been contained, also due to the small size of the banking sector relative to the economy. The first round valuation losses for those banks that had not managed to close their short foreign currency positions by March 3 are estimated at AMD 4.7 billion ($12.6 million) or around 15 percent of total 2008 profits and 0.2 percent of GDP.

The economic contraction is affecting the quality of loan portfolios. Nonperforming loans (NPLs) increased to 7.6 percent of gross loans at end March 2009 from 4.4 percent at end 2008. The increase was mainly due to a rise in loans in the “watch” category (up to 90 days past due)—which is likely to anticipate an increase in problem loans later in the year—as borrowers struggle to make payments on business and consumer loans (Table 4).

Despite these shocks, the banking system remains highly capitalized. The aggregate capital adequacy ratio (total regulatory capital to risk-weighted assets) declined from 27.5 percent at end 2008 to 26.1 percent at end March 2009, still more than twice the regulatory requirement of 12 percent.

However, new credit to the private sector has largely stopped. With high deposit dollarization and the resulting scarcity of long-term dram funding, banks are cutting back on their domestic currency assets, both by not rolling over dram-denominated loans and by restructuring them to dollar-denominated loans. At the same time, borrowers, whose income is mostly in domestic currency, are averse to borrowing in foreign currency and taking on the exchange rate risk. Consequently, adjusting for the valuation effect of the March 3 depreciation on the foreign currency loans (around half of the total), annual growth in credit to the private sector slowed down in the first quarter of 2009 to 25 percent compared an average growth of 67 percent in 2008, and contracted by 5 percent from the last quarter of 2008. Moreover, the number of new consumer loans in the first quarter has fallen by more than 40 percent year-on-year.

uA01fig03

12-Month Credit Growth

(In percent)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

Table 3.

Armenia: Monetary Accounts, 2006–09

(In billions of drams, 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.

Ratio of foreign currency deposits to total deposits (in percent).

Ratio of foreign currency deposits to broad money (in percent).

Table 4.

Armenia: Financial Soundness Indicators for the Banking Sector, 2004–09

(In percent, unless otherwise indicated)

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Source: Central Bank of Armenia.

A. Monetary and Exchange Rate Policies

9. The authorities confirmed their commitment to the flexible exchange rate regime. Since the March 3 depreciation, the CBA has intervened sparingly to smooth fluctuations in the foreign exchange market. The authorities remain committed to allowing the dram to move freely in line with the fundamentals. To this end they have agreed in the context of this review to adopt an exchange rate intervention strategy that will ensure consistency between monetary policy, liquidity management and the flexible exchange rate regime (structural benchmark for end June 2009 MEFP, ¶8).

uA01fig04

FX Intervention and Exchange Rate

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

10. The challenge for the CBA will be to address the uncertainty prevailing in the exchange rate market through its intervention and communication strategy. The CBA will need to find a balance between increasing the credibility of the float by allowing two-sided movements of the exchange rate and providing some guidance to stabilize expectations in a thin market subject to large fluctuations. While market perceptions of further movements in the dram vary, recent agreements for large official financing, particularly the approval of the Fund SBA agreement in March and the signing of a $500 million project loan from Russia in May, have alleviated concerns of a shortfall in foreign currency availability.

11. Monetary policy will again be guided by an inflation target. Reduced concerns about the exchange rate and financial stability have allowed the CBA to resume its inflation targeting policy (MEFP, ¶9). End-year inflation is on track to be at the lower end of the CBA’s target range of 4±1.5 percent.

12. Thus, the CBA intends to continue the recent easing of monetary policy. The CBA increased its policy rate by 100 basis points at the time of the return to the float to contain overshooting of the exchange rate and maintain confidence in the dram. However, since then, pressures on the exchange rate have abated, while concerns about economic activity have intensified. Therefore, since the beginning of April, the CBA has cut its policy rate in several steps by a cumulative 150 basis points, to 6.25 percent, and now expects to be able to cut rates further in the coming months, consistent with its inflation objective.

13. However, the normal channels of the transmission of monetary policy have considerably weakened. The steep increase in deposit dollarization in the run-up to the depreciation had already reduced the effectiveness of monetary policy, and the ongoing credit crunch poses new challenges. The authorities therefore see the need of taking steps to unblock credit to the private sector by strengthening monetary policy transmission and facilitate lending in domestic currency to the economy (MEFP, ¶11–13). In particular:

  • The CBA is introducing additional repo instruments with longer maturities than the current 7-day and will purchase long-term government securities in the secondary market to provide longer-term dram liquidity to banks and facilitate lending in drams;

  • Multilateral and bilateral donors (World Bank, the German development bank KfW, Russia) will provide financing to small and medium enterprises (SMEs) through the CBA and commercial banks;

  • The CBA will implement exceptional credit easing operations, including by establishing a secondary mortgage operator with a mixed public-private capital envisaged at around AMD 25 billion (of which AMD 5 billion would be seed money from the CBA) that would provide long-term financing to commercial banks starting in 2010.

uA01fig04a

CPI Inflation

(Year-on-year growth, in percent)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

B. Financial Sector Policies

14. The authorities have considerably strengthened their crisis response capacity. The banking system has been growing in recent years but is small compared to the economy. At the same time, problems in the sector could have systemic implications, such as quasi-fiscal costs and shortages of credit. In anticipation of the return to the floating exchange rate in March, the CBA supplemented the wide array of tools at its disposal with instruments to inject emergency liquidity and facilitate mergers and acquisitions (MEFP, ¶15). Moreover, the CBA intensified its monitoring of individual banks and has been conducting stress tests focusing on credit and market risk on a continuous basis (MEFP, ¶14). Although the feared loss of confidence in the banking system and related liquidity pressures did not materialize, the exercise sharpened the CBA’s supervisory practice and crisis response capability.

uA01fig05

Financial Deepening

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

15. The CBA continues to strengthen bank supervision, in preparation for possible tail risks. Aggregate bank capital is high but could be weakened by a rapid increase in NPLs and provisioning (made more likely by the currency mismatch between bank loans and borrowers’ income)2 and by balance sheet losses caused by further exchange rate depreciation. Therefore, the CBA is continuing to closely monitor the banking system, and is considering tightening prudential regulations, including the reintroduction of a limit on open foreign exchange positions. In addition, the CBA intends to further bolster contingency planning, possibly with the help of Fund technical assistance. The authorities also intend to strengthen the bank resolution framework, and in this context are studying the adequacy of the Deposit Guarantee Fund (DGF) and are preparing options to increase its resources (structural benchmark for end June 2009, MEFP ¶16).

C. Fiscal Policies

16. To mitigate the impact of the crisis, the authorities intend to ease fiscal policy in 2009. This approach is guided by the expectation that the large shocks witnessed this year are mainly temporary and that the easing of the fiscal stance will help smooth the deep contraction. To this end, the program aims at largely compensating for the projected large drop in revenue through additional borrowing while preserving spending at the same level in nominal terms as in the original program. As a result, the fiscal deficit target for 2009 (including projects financed by the Russian loan) will be relaxed from 2.8 percent under the SBA to 6.5 percent of GDP.

17. Fiscal revenues are projected to fall by 1 percent of GDP (about 15 percent in nominal terms) relative to the projections at the time of the SBA (Box 3). Domestic borrowing options are scarce, as demand for government securities is limited and direct government borrowing from the central bank is forbidden by law. As a result, expenditure plans for the year have come under strong pressure. A consolidation of spending in line with the fall in revenues would add an additional contractionary impulse to the economy, further decreasing growth, and exacerbating the impact of the crisis on the poor.

18. Expenditure plans focus on protecting social spending and shifting capital investment to foreign-financed projects. The program aims at preserving social spending at its budgeted levels, which would imply an increase of about 1.5 percent of GDP due to the lower nominal GDP. In anticipation of the increased demands on its social services brought about by the economic contraction, the authorities are also working closely with the World Bank to develop a strategy to further strengthen the targeting of social safety nets (structural benchmark for end December 2009, MEFP, ¶18). Capital spending, financed in part by the $500 million project loan from Russia expected to be disbursed by end June, would be directed in particular to new housing projects in the earthquake zone (Gyumri, Vanadzor, and Spitak). The Russian loan would also fund SME lending via the banking system.

19. In this context, financing needs would remain in 2009–10. Donor financing (including from Russia) and domestic financing, mainly from issuance of government securities, would leave fiscal financing needs of AMD 60 billion (1.8 percent of GDP) in 2009 and AMD 59 billion (1.7 percent of GDP) in 2010, notwithstanding the expected improvement of the fiscal deficit to 5.8 percent of GDP. The proposed augmentation of Fund resources, directed at mitigating the balance of payments pressures, would meet these needs.

20. To strengthen the medium-term fiscal outlook, the authorities are committed to an ambitious tax administration and policy reform agenda and to limiting the growth of spending. With the aim of improving the fiscal position starting in 2010 and opening up fiscal space to better serve the poor, the government has given priority to advancing its reform of tax administration, including by introducing best practices in VAT refund processing (continuous structural benchmark and structural benchmark for end September 2009, MEFP, ¶21) and of tax policy, notably by abolishing the presumptive taxation regime for tobacco and fuel in 2011 through legislation to be submitted to parliament by end 2009 (structural benchmark for end December 2009, MEFP, ¶23). Over the medium term, the authorities aim to pare back nonpriority current spending, helping Armenia to adjust to a more subdued outlook and maintain debt sustainability while enhancing efforts to reduce poverty.

Armenia: The Collapse of Fiscal Revenues

Armenia is experiencing a large fall in fiscal revenues. The first-quarter 17 percent fall in tax revenues is largely due to the sharp decline in the two biggest tax categories in Armenia, i.e., VAT and profit tax, which fell by 20 percent and 21 percent respectively. The fall in VAT revenues reflects in large part a decline in imports, which account for more than two-thirds of VAT collection. Additional factors underlying the decline in revenues are:

  • Increase in VAT non-compliance: Domestic VAT collection has fallen by 32 percent, while private consumption growth is estimated the C-ratio (the ratio of net coll VAT to the maximum VAT recoverable on private consumption), a measure of the overall VAT collection efficiency, is estimated to have declined from around 66 percent at end 2007 to around 50 percen in the first quarter of 2009.

  • Impact of the crisis on large taxes payers: VAT and profit taxes from the 325 largest taxpayers (including the mining companies), which account for about percent of total tax revenues, have fallen in the first quarter by 33 percent, equivalent to 73 percent of the total decline in tax revenues.

  • Changes in tax policy: The threshold below which enterprises need not register for the VAT was set at AMD 58.3 million effective January 2009, leading to estimated revenue losses of up to AMD 6 billion (0.2 percent of GDP) by end 2009. However, the introduction of the threshold should lead to medium-term efficiency gains by reducing the cost of covering a large number of small businesses which do not yield significant revenue.

uA01fig06

Decline in Tax Revenue

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

uA01fig07

C-Ratio

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

Armenia: Structural Conditionality, 2009–10

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IV. Program Modalities

A. Justification for Augmentation

21. Under the worsened economic outlook for 2009–10, Armenia’s financing gaps have widened. The external financing gap for 2009–10 is projected at around $658 million after accounting for identified financing of (i) the $500 million project loan from Russia, (ii) World Bank financing of $545 million in 2009–2012 (with high upfront IDA budget support disbursements of $60 million in 2009), (iii) Asian Development Bank (ADB) financing of about $130 million in 2009–10, from which at least $70 million provided for direct budget support, and (iv) previously-approved, but not yet disbursed, IMF support. 3 The gap—$356 million more for 2009–10 compared to the original SBA4—would be filled by additional IMF resources from the augmentation, with residual financing needs in 2010 to be covered by donors, possibly including the European Union.

Armenia: External Financing Requirements and Sources, 2008–2011

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

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Sources: Data provided by the Armenian authorities; and staff estimates.

Includes portfolio investmentand net errors and omissions.

22. In filling part of the new financing gaps, the requested augmentation would help Armenia preserve the original objectives of the program. Otherwise, Armenia would be forced into a severe external and domestic adjustment that would further worsen growth, threaten the implementation of the SBA-supported program, and impose sizeable cuts in social spending, with a negative impact on the poor. The augmentation, together with the sizeable additional foreign assistance from donors, would also allow the CBA to build up an appropriate reserve buffer in the context of a highly uncertain outlook.

23. Staff’s assessment is that Armenia continues to meet the four criteria for exceptional access:

  • Criterion 1—The member is experiencing or has the potential to experience exceptional balance of payments pressure on the current account or the capital account, resulting in a need for Fund financing that cannot be met within the normal limits. Armenia is facing balance of payments pressures from the external current account, associated with a steep contraction in current and prospective export earnings and remittances, and the capital account, primarily from a sharp contraction in FDI.

  • Criterion 2—A rigorous and systematic analysis indicates that there is a high probability that the member’s public debt is sustainable in the medium term. Standard stress tests indicate that Armenia’s public debt position would remain sustainable in the presence of a variety of shocks (Figure 2 and Table 6). Despite a moderate rise in recent years, the private external debt level, at about 5 percent of GDP, is limited, and possible contingent claims from private external debt remain low.

  • Criterion 3—The member has prospects of gaining or regaining access to private capital markets within the timeframe when Fund resources are outstanding. While Armenia has received significant FDI, including in the banking sector, the government has not borrowed on international capital markets to date. Prior to the economic downturn, Armenia was well positioned to access international markets. Successful implementation of the Fund-supported program, along with the expected economic recovery, will provide the necessary conditions to restore prospects for accessing private capital markets within the next two-three years.

  • Criterion 4—The policy program of the member provides a reasonably strong prospect of success, including not only the member’s adjustment plans but also its institutional and political capacity to deliver that adjustment. Armenia has a long track record of sound macroeconomic management and successful implementation of Fund-supported programs, including in the context of the current SBA. The proposed policy package contained in the program, supplemented by reforms supported by the World Bank and other donors, will help address the current challenges. The program would place the economy on a sustainable recovery path and strengthen fiscal balances in the medium term through the deepening of reforms—notably in the tax administration area, the financial sector, and the private sector by improving the business climate.

Figure 1.
Figure 1.

Armenia: Recent Economic Developments

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.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.
Figure 2.
Figure 2.

Armenia: Public Debt Sustainability: Bound Tests 1/

(Public debt, in percent of GDP)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

Sources: International Monetary Fund, country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and primary balance.3/ One-time real depreciation of 30 percent and 10 percent of GDP shock to contingent liabilities occur in 2009, with real depreciation defined as nominal depreciation (measured by percentage fall in dollar value of local currency) minus domestic inflation (based on GDP deflator).
Figure 3.
Figure 3.

Armenia: External Debt Sustainability: Bound Tests 1/

(External debt, in percent of GDP)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

Sources: International Monetary Fund, Country desk data, and staff estimates.1/ Shaded areas represent actual data. Individual shocks are permanent one-half standard deviation shocks. Figures in the boxes represent average projections for the respective variables in the baseline and scenario being presented. Ten-year historical average for the variable is also shown.2/ Permanent 1/4 standard deviation shocks applied to real interest rate, growth rate, and current account balance.3/ One-time real depreciation of 30 percent occurs in 2009.
Table 5.

Armenia: Central Government Operations, 2007–10

(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 “Goods and services”and “Other expenditure” to “Wages”.

Overall balance before grants, and excluding external interest payments.

The program balance reflects net lending activities and is measured as below-the-line overall balance minus netlending.

Table 6.

Armenia: Public Sector Debt Sustainability Framework, 2004–14

(In percent of GDP, unless otherwise indicated)

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Indicate coverage of public sector, e.g., general government or nonfinancial public sector. Also whether net or gross debt isused.

Derived as [(r - π(1 +g) - g + αε(1 +r)]/(1+g+π+gπ)) times previous period debtratio, with r = interest rate;π = growth rate of GDP deflator; g = real GDP growth rate;α = share of foreign-currency denominated debt; andε = nominal exchange rate depreciation (measured byincrease in local currency value of U.S. dollar).

The real interest rate contribution is derived from the denominator in footnote 2/ as r - π (1+g) and the real growth contribution as -g.

The exchange rate contribution is derived from thenumerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange ratechanges.

Defined as public sector deficit, plus amortization of medium and long-term public sector debt, plus short-term debtat end of previous period.

The key variables include real GDP growth; real interest rate; and primary balance in percent of GDP.

Derived as nominalinterest expenditure divided by previous period debt stock.

Assumes that key variables (real GDP growth, realinterest rate, and other identified debt-creating flows) remain at the levelof the last projection year.

B. Augmentation Modality and Program Monitoring

24. The requested augmentation would increase Fund financing to 580 percent of quota (SDR 533.6 million, or about $830 million) over the 28-month SBA. The requested funding would cover the remaining external financing gap for 2009, and a large portion of the remaining gaps in 2010 and 2011.

25. Fund purchases would increase by SDR 65.87 million, or about $100 million, in 2009 and by SDR 99.73 million, or about $150 million, in 2010. The additional resources under the augmentation scheduled for 2009 would be disbursed in full, following Board completion of the first review of the SBA and the augmentation, together with the planned purchase under the original access amounting to SDR 36.80 million. The remaining balance of the augmentation would be purchased in 2010 in four equal purchases of SDR 24.93 million in parallel with the original schedule of four purchases of SDR 23.55 million.

26. The revised program entails additional conditionality. In line with the need to lay the ground for future fiscal consolidation, strengthen social spending, and improve the effectiveness of monetary policy, the authorities are committing to new structural benchmarks in the area of taxation, social policy, and monetary and exchange rate policy implementation (Box 4 and MEFP Table 2). Consistent with the recent changes to the Fund’s conditionality framework, these measures would be in the form of structural benchmarks, while it is proposed that the existing structural performance criterion (plan to increase resources of the DGF) would be converted into a structural benchmark. It is also proposed to modify end-June, end-September, and end-December quantitative performance criteria in line with the revised macroeconomic outlook. The authorities and staff also agreed to eliminate the indicative target on reserve money in view of the instability of money demand and the reduced concerns regarding inflation.

27. The program will continue to be monitored via quarterly quantitative performance criteria, indicative targets, and structural benchmarks. The quantitative performance criteria and indicative targets and the structural benchmarks are listed in Tables 1 and 2 of the MEFP. The second review of the program is expected to be completed on or after August 15, 2009, the third review on or after November 15, 2009, and the fourth review on or after February 15, 2010.

C. Capacity to Repay the Fund

28. Overall Fund exposure to Armenia is projected to increase over the medium term. Fund debt service indicators peak in 2013, and decline thereafter (Table 10). Thus, total obligations to the Fund would increase from 2.3 percent of exports in 2009 to a peak of 14 percent of exports in 2013 (81 percent of total debt service) but fall sharply to 4.6 percent of exports shortly thereafter (in 2015). Outstanding credit to the Fund would reach a maximum of 9.3 percent of GDP in 2010 but decline to less than 1 percent of GDP by 2015.

Table 7.

Armenia: External Debt Sustainability Framework, 2004-2014

(In percent of GDP, unless otherwise indicated)

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Derived as [r - g - ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ)times previous period debt stock, with r = nominal effective interest rate on external debt; ρ = change in domestic GDPdeflator in US dollar terms, g = real GDP growth ε = nominal appreciation (increase in dollar value ofdomestic currency), andα = share of domestic-currencydenominated debt in total external debt.

The contribution from price and exchange ratechanges is defined as [-p(1+g) + εα(1+r)]/(1+g+p+gp)times previous period debt stock.ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (ba

For projection, line includes the impact of price and exchange rate changes.

Defined as current account deficit, plus amortization on medium- and long-term debt, plus short-term debt at end ofprevious period.

The key variables include real GDP growth; nominal interest rate; dollar deflator growth; and both non-interest current accountand non-debt inflows in percent of GDP.

Long-run, constant balance that stabilizes thedebt ratio assuming that key variables (real GDP growth, nominal interestrate, dollar deflator growth, and non-debt inflows in percent of GDP) remainat their levels of the last projection year.

Table 8.

Armenia: Medium-Term Macroeconomic Framework, 2007–14

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

For 2007 -09, the figures include projections fordisbursements under the U.S. Millennium Challenge Account.

Underlyingbalance is defined as overall balance before grants and excluding externalinterest payments.

A negative figure indicates an increase.

Table 9.

Armenia: Fund Disbursements and Timing of Reviews Under the Twenty Eight -Month Stand-By Arrangement, 2009-11

(SDR millions)

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Source: Fund staff estimates and projections.
Table 10.

Armenia: Indicators of Capacity to Repaythe Fund, 2008–15

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Sources: Fund staff estimates and projections.

Total debt service includes IMF repurchases andrepayments.

Table 11.

Armenia: Proposed Access, 2009

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Source: Executive Board documents, MONA database, and Fund staff estimates.

High access cases include available data atapproval and on augmentation for all the requests to the Board since 1995which involved the use of the exceptional circumstances clause resources. Exceptional access augmentations are counted as separate observations. FCLsare also included. For the purpose of measuring access as a ratio ofdifferent metrics, access augmentations and previously approved and drawnamounts.

The data used to calculate ratios is the actualvalue for the year prior to approval for public and short-term debt, and theprojection at the time of program approval for the year in which program wasapproved for all other variables. In Country Report No. 09/140 the data usedto calculate all the relevant ratios is the actual value for the year (2008)prior to the approval of program.

Refers to residual maturity.

29. Armenia’s capacity to repay the Fund broadly remains good. Relatively low initial debt levels enable Armenia to increase external borrowings to mitigate the effects of the global crisis without unduly threatening medium-term debt sustainability. The rise in repurchase obligations to the Fund during the period 2012–2013 is significant but temporary, reflecting the relatively short maturity profile of Fund lending and the relatively large proportion of the outstanding obligations to the Fund relative to total obligations.

V. Risks and Medium-Term Outlook

30. In the short term, there are significant risks to the program arising from a worsening of global conditions and domestic factors:

  • Risks to economic growth projections in 2009–10 appear evenly balanced, but uncertainty is high. A strong policy response might alleviate the sharp economic downturn, but Armenia is very vulnerable to a further deterioration of global conditions, particularly in Russia.

  • Tax revenues could fall more than expected, especially in case of deepening economic contraction, and could undermine the fiscal program.

  • Balance of payment inflows could turn out to be lower than projected, and the current account could deteriorate further—possibly from higher oil prices—implying increased risks to the international reserves target and forcing further adjustment in the exchange rate.

  • Uncertainty about economic conditions, including expectations regarding the appropriate level of the exchange rate, could worsen the negative feedback between the credit crunch and growth.

31. In the medium term, the macroeconomic situation is expected to improve, but public debt will increase. As global growth resumes, Armenia is expected to gradually move toward a sustainable growth rate of 4–5 percent (Table 8), lower than the growth rates—fueled by construction activity—seen in the recent past. Following the deterioration experienced in recent years, the current account deficit will narrow steadily and international reserves will settle at a comfortable level. With the need for a fiscal stimulus coming to an end, the authorities will be able to strengthen the fiscal position by slowing spending growth and raising tax revenues. But the rise in external borrowing in 2009–10, particularly from the Fund, the World Bank, and Russia, will cause public debt to rise rapidly from the current low levels and peak in 2011 at about 46 percent of GDP, before falling to under 40 percent in 2013.

uA01fig08

Public Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2009, 214; 10.5089/9781451801750.002.A001

32. The debt dynamics are sustainable but remain vulnerable to several shocks. The projected debt-to-GDP levels do not appear excessive, and standard stress tests show that Armenia’s debt remains sustainable (Figures 2 and 3 and Tables 6 and 7). However, rollover risk is high, mainly due to the relatively short maturity of Fund financing. In addition, standard stress tests indicate that the projected increase in borrowing has increased Armenia’s vulnerability to growth and depreciation shocks which, under a broad range of assumptions, could increase the debt-to-GDP ratio to above 50 percent in the coming years. Finally, the debt dynamics would be affected by the emergence of contingent liabilities, in particular related to the introduction of the funded pension pillar.

33. Growth prospects need to be supported by a wide-ranging program of structural reform. In addition to the positive effects on poverty and social indicators, future growth is a key factor in ensuring favorable debt dynamics, pointing to the need for a continuation of the authorities’ extensive program of structural reform. In particular, improvements to the business environment would have the biggest payoff by increasing Armenia’s attractiveness to foreign and domestic investment and promoting more broad-based private sector growth. Efforts in this direction might be hampered by resistance to change by vested interests. Finally, Armenia’s growth outlook could greatly benefit from the opening of the border with Turkey.

VI. Staff Appraisal

34. The economic outlook for Armenia has worsened considerably due to the global economic slowdown. Many of the downside risks identified at the time of the SBA request have materialized. In particular, the downturn in Russia is much deeper, and as a result foreign inflows have fallen dramatically. And with the deep economic contraction in Armenia, revenues have collapsed, opening up a sizable fiscal gap.

35. Despite these difficulties, policy implementation has generally been good. The return to the flexible exchange rate regime has thus far been a success, reversing what had become a significant overvaluation. Moreover, the authorities have so far successfully contained potentially destabilizing effects on the financial system. On public finances, faced with very serious revenue shortfalls, the authorities have thus far kept core government functions going but have compressed non-essential expenditures. Even so, key reforms continue to be implemented. To mitigate the sharp growth slowdown, the authorities are seeking additional financial support from international partners.

36. Looking ahead, the revisions to the authorities’ program are appropriate in view of the very challenging situation. The original objectives of the program remain valid: help Armenia achieve the necessary external adjustment, maintain confidence in the currency and financial system, and protect the poor. Achieving these objectives, however, requires a reorientation of policies, notably an easing of monetary and fiscal policies, and targeted measures to ease credit conditions, raise revenues, facilitate private sector growth, and support social services.

37. Continued exchange rate flexibility is a cornerstone of the authorities’ policy stance. Armenia is well-served by a flexible exchange rate regime. The return to a floating regime is welcome, and the authorities are encouraged to ensure that efforts to limit volatility are not interpreted by the market as a commitment to a particular level or range for the exchange rate. In this regard, careful, consistent, and frequent communication from the CBA is key.

38. With exchange rate and inflation pressures having receded, an easing of monetary policies is warranted. Consistent with the inflation targeting framework, a relaxation of monetary policy would help address the economic contraction—the authorities’ steps in this direction thus far are both timely and welcome. In addition, more active measures to provide liquidity support to the financial system coupled with direct measures to unfreeze credit markets are needed to counteract what is an unfolding credit crunch that would otherwise threaten a deeper and more prolonged economic downturn.

39. Continued close supervision of the financial system is crucial. While the authorities’ monitoring of the financial system is to be commended, the period ahead will be difficult—the banking sector remains highly capitalized, but nonperforming loans will likely continue rising in the coming months. The central bank is encouraged to continue strengthening its contingency planning and crisis preparedness, and, in this regard, the authorities’ efforts to boost the Deposit Guarantee Fund resources are timely.

40. Some easing of fiscal policy is an appropriate response to mitigate the impact of the economic downturn. Compensating for the revenue drop through additional borrowing and maintaining spending in line with the original program will ensure that fiscal policy does not add to contractionary pressures. And increased spending on infrastructure and better targeted social spending will help boost growth and mitigate the impact of the crisis on the poor. At the same time, should the adverse global conditions turn out to be more permanent than temporary, fiscal policy would need to gradually adjust to a less robust economic outlook to prevent a further deterioration in the fiscal and debt dynamics.

41. A strengthening of the tax administration reform program is central to the authorities’ response to the crisis and ensuring fiscal sustainability. To this end, introducing best practices in VAT administration, improved risk-based auditing, and other reforms should help lead to a sustained rise in revenue. Continued reductions in the stock of tax credits and overdue VAT refunds will be important to improving the integrity of the tax system and reducing the costs of the system to the private sector.

42. Likewise, continued structural reforms to boost the climate for private sector activity will be crucial for supporting growth, maintaining macroeconomic stability, and reducing poverty. Armenia’s medium-term outlook is now more subdued, implying lower economic growth, less room for additional public borrowing, and slower poverty reduction. To this end, efforts to improve the business climate will be essential to boost domestic private and foreign direct investment, increase employment, and help spur a rapid and robust economic recovery.

43. Risks to the program have increased, even though the authorities are committed to strengthening and expanding the set of reform measures. The possibility of a significant worsening of economic and fiscal conditions cannot be ruled out. In addition, Armenia will have used up a large part of its borrowing space in a very short period of time. While debt stock indicators are expected to improve from 2011, debt sustainability could be cast into doubt if the fiscal position does not improve and/or growth does not rebound. Repayment risks to the Fund have likewise increased, although, with a still low debt service burden and a strong repayment record, Armenia is expected to meet its payments to the Fund in a timely manner. To address the increased risks, the authorities are committed to implementing additional new measures in monetary policy implementation and tax policy and administration reform.

44. Staff supports the authorities’ request for augmentation and completion of the first review under the stand-by arrangement. In addition, staff supports the waivers of performance criteria on net banking system credit to the government and the program fiscal balance, the modification of end-June, end-September, and end-December quantitative performance criteria, and the conversion of the end-June structural performance criterion on the Deposit Guarantee Fund into and end-June structural benchmark requested by the authorities. Policy implementation under the program has been strong despite the worsened economic situation, and the authorities have implemented corrective actions and adjustments to the program as needed. The proposed policy package under the revised SBA is appropriate to the difficult economic circumstances, and the risks to the program are manageable.

Attachment I. Armenia: Letter of Intent

June 5, 2009

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C. 20431

Dear Mr. Strauss-Kahn:

After many years of strong macroeconomic performance, marked by rapid growth, significant poverty reduction, and low inflation, Armenia has been hit severely by the global economic crisis. The Government of the Republic of Armenia intends to build on the long-lasting partnership with the IMF, which has led to many successes, to strengthen its program with sound macroeconomic policies and structural reforms that would alleviate the impact of the crisis and pave the way to a prompt recovery.

As the crisis was unfolding, a Stand-By Arrangement in the amount of SDR 368 million (400 percent of quota or $544 million) for the period March 2009 through June 2011 was approved by the IMF Executive Board on March 6, 2009. The program supported by the Arrangement envisaged the return to a floating exchange rate on March 3, which has been successful in restoring confidence. The consequences of the dram depreciation on the financial system have been limited and the exchange rate has remained stable without large interventions by the Central Bank of Armenia.

However, the economic outlook has continued to deteriorate, and a larger contraction of economic activity is now expected for 2009. Balance of payments inflows have continued to decline, increasing external financing needs. On the fiscal side, tax revenues have fallen significantly, leading to a delay of budgeted government spending that compounds the drop in private sector demand.

The Government of Armenia requests the completion of the first review under the Stand-By Arrangement. Moreover, we request additional resources under the Stand-By Arrangement in the amount of SDR 165.6 million (180 percent of quota or about $258 million) to cover the increased financing needs in 2009 and 2010. The objectives of the program remain unchanged: to help Armenia adjust to the changed outlook, restore confidence, and protect the poor. But these additional balance of payments resources are necessary to prevent excessive domestic adjustment, and thus preserve economic and financial stability and continued implementation of our budget while maintaining adequate social expenditure.

In addition, we request waivers for the non-observance of the end-March performance criteria on net banking system credit to the government and the program fiscal balance. These targets were missed due to the large unexpected decline in tax revenues, which we are redressing through a strengthening of our tax administration reform program. Furthermore, to adapt the conditionality to the current situation, we request the elimination of the indicative target on base money and the conversion of the end-June structural performance criterion (approval of a plan to increase the resources of the Deposit Guarantee Fund) to a structural benchmark. We also request the modification of end-June 2009, end-September 2009, and end-December 2009 quantitative performance criteria.

The attached Memorandum of Economic and Financial Policies outlines our policies for 2009 and 2010, which have been updated and revised to address the more challenging economic and financial situation. The Government believes that the policies set forth in the attached MEFP are adequate to achieve the objectives of the program, but it will take any other measure that may become necessary for this purpose. The Government will consult with the Fund on the adoption of additional measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the Fund’s policies on such consultation. Moreover, after the end of the arrangement, and as long as Armenia has outstanding financial obligations to the Fund, the Government will consult with the Fund on Armenia’s economic and financial policies from time to time, at the initiative of the Government or at the request of the Managing Director. Finally, we grant our permission for the publication on the IMF’s website of the staff report and this letter.

Very truly yours,

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Attachment II. Armenia: Memorandum of Economic and Financial Policies

(June 5, 2009)

I. Recent Developments and Outlook for 2009-10

1. The economic outlook has deteriorated dramatically for Armenia. The global economic crisis has caused a swift turnaround in our economic prospects. After many years of rapid growth, Armenia is faced with a large contraction of economic activity on the back of declining external inflows and plummeting domestic demand. Falling remittances and rising unemployment are depressing household incomes and causing poverty to rise. In the first quarter of 2009, real GDP fell by 6.1 percent on an annual basis, and the contraction is expected to reach almost 10 percent for the year as a whole, with the construction sector and mining sector bearing the brunt of the crisis. Growth could resume, albeit moderately, in 2010, provided that the expected global recovery materializes.

2. In this context, Armenia’s external position is weakening. Exports are suffering both from the drop in external demand and from falling international commodity prices, and remittances are declining rapidly. This means that despite a fall in imports, the current account deficit is likely to worsen after reaching an estimated 11 percent of GDP in 2008, and the slowdown of capital inflows will add to financing pressures.

3. At the same time, government financing needs are increasing. Tax revenues fell by 15 percent in the first four months of 2009, compared with the same period in 2008. Despite postponement of non-essential expenditures, we were not able to meet the end-March fiscal targets under our IMF stand-by arrangement (SBA). Even with painful expenditure cuts, the fiscal deficit is expected to widen significantly for the year as a whole.

4. Encouragingly, pressures on the exchange rate have waned. On March 3, 2009, the Central Bank of Armenia (CBA) announced that it would return to a floating exchange rate and that it would stop intervening in the foreign exchange market except to smooth excessive volatility. At the same time, the CBA raised the policy rate by 100 basis points. As a result, the dram depreciated by 22 percent vis-à-vis the U.S. dollar and has been fairly stable since, despite limited intervention by the CBA. Bank deposits have remained stable, confirming the depositors’ confidence in the banking system. In fact, banks are well capitalized, and have easily absorbed the balance sheet losses arising from the impact of the depreciation. International reserves have been strengthened by the provision of IMF resources. The conversion of dram deposits into foreign currency deposits, which had been intense prior to the depreciation, has stopped.

5. Despite the recent cuts in the policy rate, inflation is expected to remain low and credit conditions in the economy to remain tight. Year-on-year inflation increased to slightly over 3 percent in April from 1 percent in March—largely driven by increases in utility prices and some pass-through of the exchange rate depreciation—but is expected to remain low on the back of falling domestic demand. In the absence of significant pressures either on the exchange rate or inflation, the CBA started reducing its policy rate in April. Nonetheless, dram liquidity remains scarce, and banks have significantly cut back lending to the private sector, further dampening economic activity.

II. The Program for 2009 and 2010

6. The policies in our program have been updated and revised to reflect the more challenging outlook. The objectives of the program remain unchanged: namely, to help Armenia adjust to the changed external outlook, maintain confidence, and protect the poor. However, the sharp contraction in economic activity, widening fiscal deficit, and difficult conditions in credit markets require a robust policy response which will allow Armenia to return to high growth, a strong balance of payments, and continued progress in poverty reduction.

7. To this end, we intend to pursue the policies outlined below in the monetary and financial, fiscal, and structural areas. In particular, monetary and exchange rate policies are geared toward enabling the economy to adjust to the external shock and boosting confidence. Fiscal policies are likewise aimed at softening the impact of the economic downturn, ensuring medium-term fiscal sustainability, and protecting social services. And structural reforms are targeted at increasing the flexibility of the economy, and laying the basis for renewed growth and macroeconomic stability.

A. Monetary, Exchange Rate, and Financial Sector Policies

8.We are committed to maintaining a flexible exchange rate regime. The CBA will continue its current policy of intervening only to contain excessive volatility of the exchange rate, and will not resist movements that are in line with fundamentals. The CBA will avoid giving the market any perception of resuming targeting an exchange target level or range which could hinder the interplay of demand and supply. To introduce two-way risks in the foreign exchange market, we intend to rely on a coherent intervention strategy to achieve consistent and transparent outcomes. To this end, the CBA will adopt an intervention policy in accordance with the objectives of smoothing excessive movements of exchange rates and rebuilding foreign currency reserves (structural benchmark for end-June 2009). To enhance the transparency of its operations, the CBA commits to only conduct foreign exchange interventions with banks or government entities. Furthermore, to ensure proper exchange rate risk management, the CBA will consider tightening prudential measures regarding foreign currency exposures, both direct and indirect, including imposing limits on banks’ open foreign exchange positions

9. With inflation pressures receding rapidly, the focus of monetary policy has now shifted. At the time of the depreciation, monetary policy was geared towards supporting the return to a flexible exchange rate regime. As the inflationary pressures triggered by the depreciation of the dram and the subsequent increases in utility prices are expected to subside in the face of extremely weak domestic demand, the CBA has been able to lower interest rates, providing some support to economic growth. Consistent with its primary objective of price stability and in line with its inflation forecasts, the CBA will continue to ease policy.

10. However, the economic crisis and the increased preference for foreign currency have reduced the effectiveness of monetary policy. Credit to the private sector has effectively dried up as banks tighten their credit standards and find fewer attractive lending opportunities. In addition, many banks, having experienced a shift toward foreign currency deposits, are trying to reduce the currency mismatch by extending foreign currency loans. On the other hand, borrowers, whose revenues are mostly in local currency, are reluctant to increase their own exchange rate exposure.

11. Therefore, we intend to take steps to unlock the frozen credit market and strengthen the transmission of monetary policy. In the short term, while maintaining sufficient short-term repo lending, we will endeavor to provide longer-term dram liquidity to facilitate banks’ liquidity management by:

  • (i) gradually introducing additional repo maturities of up to one year, including a 3-month repo (structural benchmark for end June 2009);

  • (ii) offering foreign exchange swaps as part of regular monetary instruments; and

  • (iii) continuing to carry out outright purchase operations of government securities to the extent that these accommodate structural liquidity injections.

12. In the medium term, we will continue to develop the securities market as laid out in our capital market development program presented in the Memorandum of Economic and Financial Policies of March 2, 2009. We will increase the issuance of government securities in line with market demand and consistent with the memorandum of understanding between the CBA and the MoF, with a view to extending maturities. In addition, we will amend Article 11 of the “Law on the Central Bank of the Republic of Armenia” to ensure a gradual recapitalization of the CBA with marketable interest-bearing securities (structural benchmark for end September 2009). Finally, to support dedollarization of deposits, we are tightening the enforcement of the prohibition of payments in foreign currency.

13. We are also preparing to undertake exceptional credit easing operations. The CBA will use resources from the World Bank, KfW, and part of the resources from the Russian government to extend long-term domestic currency loans to banks for on-lending to small and medium enterprises (SMEs). We are also planning the creation of a secondary mortgage operator in partnership with the private sector. The new entity will raise financing through the issuance of domestic currency bonds and provide long-term dram loans to banks, collateralized on their mortgage portfolio cash flows.

14. We will continue to closely monitor the banking sector, particularly in light of the increase in nonperforming loans caused by the economic contraction and, to a lesser degree, by the depreciation. We will continue to conduct stress tests on each individual bank, focusing particularly on market, credit, and liquidity risk. The latest stress tests indicated that, even after the balance sheet losses owing to the depreciation, the banking system remains highly capitalized and liquid. In any case, we remain vigilant and ready to take steps to promptly address any potential vulnerabilities in the system.

15. Existing legislation confers on the CBA comprehensive powers for intervening and resolving banks. The CBA has strengthened its capacity to address banking crises by expanding the range of eligible collateral for emergency liquidity assistance. The CBA has also formalized a mechanism to support the recapitalization of banks through a subordinated debt facility matching bank shareholders’ capital injections. The CBA also introduced a temporary loan facility to facilitate mergers and acquisitions. The CBA is securing public resources for this purpose. The CBA is considering requesting Fund technical assistance to further strengthen contingency planning and crisis preparedness.

16. Enhancing the efficacy of the Deposit Guarantee Fund (DGF) will strengthen our banking system safety net. The CBA and the DGF, with the support of technical assistance financed by KfW, will introduce a mechanism to periodically review the appropriate level of coverage of the deposit insurance for both dram and foreign currency deposits, including the possibility of equalizing their coverage. We are finalizing a plan to increase the resources of the DGF (structural benchmark for end June 2009). We are considering requesting technical assistance from the Fund on the possible adoption of risk-adjusted deposit insurance premia.

B. Fiscal Policy

17. We remain committed to fiscal discipline, which is necessary to maintain a sustainable fiscal position in the medium term. Our program under the stand-by arrangement targeted a deficit of around 3 percent of GDP for 2009. As automatic stabilizers on the expenditure side are limited, greater discretionary expenditure is needed to avoid deepening the economic contraction. Therefore, we intend to keep spending in nominal terms in line with the stand-by arrangement, representing an increase as a percent of GDP relative to the program due to the fall in nominal GDP. On this basis, we expect a deficit of about 6.5 percent of GDP. Gradual adjustment will proceed in 2010, and to this end we will increase tax revenue by 0.4 percent of GDP and reduce expenditure by 0.6 percent of GDP, targeting a deficit of 5.8 percent of GDP for 2010.

18. Refocused and better-targeted public spending will be a key element of our response to the crisis. On current spending, we intend to continue critical maintenance and operating expenditures, which will help strengthen public services and provide a positive economic impact. In addition, we are committed to preserving social spending and protecting the poor. Despite the pressures on overall expenditure, we commit to safeguard social spending by keeping the level of expenditure on social allowances and pensions at least as high as in the 2009 budget, which would imply an increase in social spending by 1½ percent of GDP. In addition:

  • In close collaboration with the World Bank, we will develop a strategy to further strengthen the targeting of social safety nets (structural benchmark for end December 2009), and expect to achieve sizable savings in these areas, which will be directed to providing assistance to the newly-unemployed and strengthening the family benefit program.

  • We will increase spending on infrastructure projects such as road rehabilitation—a critical element of our countercyclical response—which will generate employment, notably for the poor.

19. We expect external sources to fund additional capital spending and credit lines for SMEs. We anticipate the disbursement of a $500 million loan from Russia by mid-2009, which will be spent on critical projects, consistent with our capacity to implement these projects. The loan will primarily finance new housing projects in the earthquake-affected zone (Gyumri, Vanadzor, and Spitak), thus resettling the remaining 6,000 families left without permanent housing since the catastrophic 1988 earthquake. The loan will also finance SME lending via the banking system, helping offset the credit freeze, and fund identified infrastructure projects. These measures will provide much-needed stimulus to our economy, help accelerate the path to recovery, and address critical social needs.

20. We intend to increase domestic financing moderately, to address financing needs in addition to supporting financial intermediation. We plan to increase financing from issuing government securities in both 2009 and 2010, subject to market demand. Given the limited appetite currently for longer-maturity securities, we expect that some of these may be purchased by the CBA in the secondary market. Moderate net issuance of government securities is not expected to crowd out the private sector. We will limit the use of government cash deposits to finance the budget, as we recognize the need to have a minimum buffer for cash flow management of at least AMD 30 billion by end 2009.

C. Fiscal structural reforms

21. Our tax administration reform program is a critical element of our response to the crisis and underpins our effort to strengthen fiscal sustainability. In the first quarter, we reduced the stock of tax credits from AMD 154.4 billion to AMD 147 billion, and will further reduce it in the course of 2009, which will also provide stimulus during the downturn. More generally, we are committed to analyzing and fixing the systemic problems underlying these tax credits in the context of our comprehensive tax administration reform. We also remain committed to introducing best practices in VAT refund processing to exporters by:

  • (i) meeting the statutory 90 day processing deadline for all VAT refund claims filed in 2009 (to be monitored on a continuous basis);

  • (ii) Reducing to zero the stock of VAT refund claims that were not processed within the statutory 90-day processing deadline;

  • (iii) implementing risk-based auditing for VAT refunds; and

  • (iv) submitting legislation to parliament to (a) strengthen penalties for overstated VAT refund claims effective January 2010, and (b) pay interest on legitimate late refunds arising from claims filed after December 2009 with interest to be paid out of VAT revenues (structural benchmark for end September 2009).

22. We have also accelerated tax administration reforms in additional areas. In particular: (i) tax return filing commissions have been liquidated and mailboxes installed in tax inspectorates for receiving tax returns; (ii) the new structure and functions of the regional inspectorates have been created; (iii) based on actual performance indicators, we are developing a system for the assessment of tax inspectorates and structural units’ performance, and will continue the consolidation of tax inspectorates after assessing the results of the first round of consolidation; (iv) we are preparing the requirements to perform risk-based audits; and (v) we are introducing electronic filing of taxes.

23. We have introduced some tax policy changes aimed at increasing revenue, including raising the presumptive tax on tobacco. In addition, we remain committed to abolishing the presumptive taxation for tobacco and fuel. To this end, we will submit legislation to parliament to bring all tobacco and petroleum products within the regular tax regimes (excises, custom duties, profit tax and VAT), effective January 2011 (structural benchmark for end December 2009).

24. In addition:

  • We are continuing to progress on the introduction of the funded pension pillar. We will revise our estimates of the costs of this reform, as well as those associated with the planned increase in basic pensions, taking into account the deteriorating economic outlook. Legislation on the new pension system, including on the unification of income tax and social contributions, will be submitted to parliament shortly.

  • We intend to produce an analytical report on medium term fiscal risks, including those arising from the introduction of the funded pillar and the costs associated with the planned increase in basic and average pensions over the next few years. To further improve our fiscal framework, we also intend to strengthen debt management.

  • The special part of the unified tax code—which covers tax policy—has been drafted and is expected to be submitted to Parliament by September 2009.

D. Other structural reforms

25. The government is also taking numerous structural measures to strengthen the business climate as part of its anti-crisis action plan. In particular, we are in the process of creating one-stop shops in the corporate and service sectors, establishing free economic zones at Zvartnots international airport and in the city of Gyumri, and strengthening the Committee on the Protection of Economic Competition to improve domestic competition and reduce import monopolies. The business climate will be further strengthened by the tax administration reforms mentioned above and by our efforts to fight against corruption. Indeed, we are introducing legislative changes on prescribing targeted severe sanctions for senior state officials engaging in business activities. World Bank support in various areas (including regulatory changes, infrastructure development, competition policy, and customs reform) should contribute to enhancing competitiveness.

III. Program Financing

26. Armenia faces larger than anticipated balance of payments financing needs over the next two years. The steep contraction in export earnings and remittances, along with the projected reduction in FDI inflows has severely weakened the economy. Despite a larger than anticipated contraction in imports, projected financing gaps over the program period have increased relative to the original framework of the program by about $350 million for 2009-2010.

27. The amount of resources available from donors is insufficient to cover these gaps. The World Bank plans to provide $545 million in 2009-2012 with high upfront IDA budget support disbursements in 2009. The Asian Development Bank is likely to provide about $130 million in 2009-10, of which at least $70 million will be provided for direct budget support. A portion of these resources are new relative to the original program in 2009, and thus will help to address the increased balance of payments financing needs. In addition, we now anticipate budget support from the European Union in 2010. Finally, the expected Russian loan for project support will be used to provide on-lending to SMEs, infrastructure investment, and housing construction, although it is not intended for budget support. Given the magnitude of the external shock and the marked effect on Armenia’s external and domestic economy, expected resources are insufficient to cover the widening financing gap.

28. The financing needs are particularly acute in 2009 and 2010. Absent additional Fund financing, Armenia has limited options to finance the remaining gap and would experience protracted weakness in the balance of payments, as domestic demand would have to contract by an unsustainably high amount. We anticipate limited financing needs in 2011.

IV. Program Monitoring

29. Given the significant external financing needs, we would like to request an augmentation of the current Stand By Arrangement in the amount of 180 percent of quota (SDR 165.6 million or about $258 million), which would increase Fund financing to SDR 533.6 million, about $830 million. This would result in increased access under the 28-month arrangement to 580 percent of quota. The requested funding would cover the remaining financing gap for 2009 and a large portion of the remaining balance of payments deficit in 2010 and 2011. The increased financing will be used to support international reserves as Armenia adjusts to the worsened economic outlook.

30. The program will continue to be monitored via quarterly performance criteria, indicative targets, and structural benchmarks. The quantitative criteria and indicative targets are outlined in the attached Table 1, and the structural benchmarks are listed in Table 2. The structural measures discussed above that are not mentioned in Table 2 are part of the authorities’ overall reform effort and will be considered in the context of program reviews, but is not part of conditionality under this program. The second review of the program is expected to be completed on or after August 15, 2009, the third review on or after November 15, 2009, and the fourth review on or after February 15, 2010.

Table 1.

Armenia: Quantitative Targets, 2009 1/

(in billions of drams, unless otherwise specified)

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All items as defined in the TMU. The figures in bold indicate when a target has not been met.

At program exchange rates.

Below-the-line overall balance excluding net lending.

Indicative target up to end-March 2009.

Table 2.

Armenia: Proposed Structural Benchmarks for the Second, Third, and Fourth Reviews

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Attachment III. Armenia: Technical Memorandum of Understanding

This memorandum defines the benchmarks, performance criteria, indicative targets, adjusters, and reporting modalities referred to in the Memorandum of Economic and Financial Policies (MEFP).

I. Quantitative Targets

1. The program targets a minimum level of net official international reserves (NIR) of the Central Bank of Armenia (CBA; performance criterion). The stock of such reserves will be calculated as the difference between total official gross international reserves (excluding reserve money denominated in foreign currencies) and official gross reserve liabilities. Total gross official international reserves are defined as the CBA’s holdings of monetary gold (excluding amounts pledged as collateral or in swaps), holdings of Special Drawing Rights (SDRs), any reserve position in the IMF, and holdings of convertible currencies in cash or in nonresident financial institutions (deposits, securities, or other financial instruments). Gross reserves held in the form of securities and other financial instruments are marked to market. Gross reserves are reported separate from the balance on the government’s Special Privatization Account (SPA) and the Millennium Challenge Account (MCA) and exclude capital subscriptions in foreign financial institutions and illiquid foreign assets. Official reserve liabilities shall be defined as the total outstanding liabilities of the government and the CBA to the IMF and convertible currency liabilities of the CBA to nonresidents with an original maturity of up to and including one year. NIR is monitored in U.S. dollars, and, for program monitoring purposes, assets and liabilities in currencies other than the U.S. dollar shall be converted into dollar-equivalent values using the exchange rates as specified in Table 1.

2. The program targets a maximum level of net domestic assets (NDA) of the CBA (performance criterion). For program purposes, NDA is defined as reserve money minus NIR, minus reserve money denominated in foreign currencies, plus medium- and long-term liabilities (i.e. liabilities with a maturity of one year or more) of the CBA, plus the balance of outstanding Fund purchases credited directly to the government account at the CBA. To evaluate program targets, the dram-equivalent values of NIR, medium- and long-term liabilities, and reserve money in U.S. dollar are calculated at the program exchange rate of dram 385 per U.S. dollar. The dram-equivalent value of reserve money in euro is calculated at the program exchange rate specified in Table 1. NDA is composed of net CBA credit to the general government; outstanding credit to domestic banks by the CBA (including overdrafts) minus liabilities not included in reserve money (exclusive of accrued interest), and other items net. Reserve money is defined as the sum of currency issued, required and excess reserves, and current and time deposit accounts of certain resident agents.5

Table 1.

Armenia: (Program) Exchange Rates of the CBA

(As of December 31, 2008 for dollars per currencyrates)

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3. The program targets a maximum level of net banking system credit to the government (performance criterion), defined as the sum of net credit from the CBA and net credit from commercial banks to the central government.

  • The stock of net credit from the CBA to the government, which includes the CBA’s holdings of treasury bills and treasury bonds less all types of government deposits with the CBA (including the deposits in the Treasury Single Account, deposits of donor-financed project implementation units, the Lincy foundation, and balances of proceeds from the sale of humanitarian assistance). Treasury bonds are valued at the purchase price and excluding accrued interest, and treasury bills are valued at the purchase price plus the implicit accrued interest.

  • Net credit from commercial banks to the government includes: (1) gross commercial bank credit to the central government less government deposits with commercial banks (including the counterpart funds of certain government on lending to the economy financed by the Lincy Foundation and the World Bank); and (2) bank holdings of treasury bonds (valued at the purchase price and excluding accrued interest) and treasury bills (valued at the purchase price plus the implicit accrued interest).

4. The program imposes a zero ceiling on external payment arrears (continuous performance criterion) defined as all unpaid debt-service obligations (i.e., payments of principal and interest) arising in respect of public sector loans contracted or guaranteed including unpaid penalties or interest charges associated with these obligations that are overdue beyond 30 days after the due date.6

5. The program targets a minimum level of the program fiscal balance (performance criterion). The fiscal balance is measured as the negative of the sum of net domestic banking system credit to the government, domestic nonbank net financing, and external net financing to the government. Should a general subsidy be introduced off-budget, the overall balance will be measured including the subsidy as part of government spending.

  • Net banking system credit to the government equals the change during the period of net credit to the government.

  • Nonbank net financing equals the sum of: (1) the change during the period of outstanding treasury bills and bonds to nonbanks (including accrued interest for treasury bills and excluding accrued interest for treasury bonds);7 (2) any other disbursement or transaction that increases nonbanks’ claims on the central government plus withdrawals from the special privatization account or the treasury sub-account containing privatization proceeds in dram, less amortizations made by the central government to private resident nonbank agents.

  • External net financing equals total debt-increasing disbursements from non-residents to the central government (including Fund net purchases credited directly to the government accounts at the CBA) less total amortizations from the central government to non-residents. All foreign-currency denominated transactions are recorded in drams using the prevailing exchange rate at the time of the transaction.

6. The project implementation units, which carry out projects financed by the US-based Lincy Foundation, maintain accounts at the CBA. These grants are recorded in the fiscal accounts as external grants on the revenue side and as foreign-financed capital expenditure on the expenditure side. In addition, any loans extended by the U.S.-based Lincy foundation to finance investments and that are intermediated through the banking system are recorded in the financial accounts as a financing item below the line and are thus excluded from net lending.

7. Foreign currency proceeds from selling enterprises are deposited into the Special Privatization Account (SPA). The account is held at the CBA and the proceeds are invested abroad together with the CBA’s international reserves. These proceeds are included in the definition of the monetary accounts of the CBA as part of net foreign assets with a counter entry in other items net. Any budgeted withdrawal from the SPA will be accounted for as privatization proceeds used to finance the budget and will be recorded below the line. Any unanticipated withdrawal from the SPA will be recorded below the line as privatization receipts; these withdrawals, however, will be replenished during the same fiscal year. Domestic currency proceeds from selling enterprises to residents are deposited in a sub-account of the treasury single account.

8. The program targets a maximum level of stock of tax credits (indicative target) defined as the sum of outstanding accumulated credit by the State Revenue Committee (SRC) of all types of tax revenues (VAT, profit tax, excises, income tax, presumptive payments, and others) resulting from advanced tax payments to be offset against future tax liabilities.

II. Adjusters

9. The quantitative performance criteria and indicative targets under the program are subject to the following adjusters, calculated, where relevant, using program exchange rates:

  • Changes in reserve requirements: The ceiling on the NDA of the CBA will be adjusted downward (upward) by the amount of banks’ reserves freed (seized) by any reduction (increase) of the reserve requirement ratio on both domestic currency and foreign currency deposits relative to the baseline assumption as per the following formula: ΔNDA = ΔrB, where B denotes the level of the reservable deposits in the initial definition and Δr is the change in the reserve requirement ratio.

  • KfW and World Bank loan disbursements: the ceiling on the NDA of the CBA will be adjusted upward (downward) by the full amount of any excess (shortfall) of disbursements from the KfW and World Bank loans directed at SME financing compared to programmed amounts (Table 2). The floor on NIR will be adjusted upward (downward) by the cumulative amount of any excess (shortfall) of these disbursements compared to program amounts.

  • External financing to the public sector, defined as disbursements of loans from bilateral and multilateral agencies for budget, project support, and the $500 million Russian loan (including Fund purchases credited directly to the government accounts at the CBA), with the exception of the KfW and World Bank disbursements mentioned above:

    • The floor on NIR will be adjusted upward (downward) by the cumulative amount of any excess (shortfall) of external financing in the form of budget support (excluding Fund disbursements to the government) or the Russian project loan compared to program amounts (Table 3).

    • The ceiling on NDA will be adjusted upward by the amount of any shortfall of external financing in the form of budget support or from the Russian loan compared to program amounts.

    • The ceiling on net banking sector credit to government will be adjusted upward by the cumulative amount of any shortfall of total external financing compared to programmed amounts (Table 3).

    • The floor on the program fiscal balance on a cash basis will be adjusted downward by the cumulative amount of any excess of total external financing compared to programmed amounts (Table 3).

    • Recapitalization of the CBA: the ceiling on net credit of the banking system to the government will be adjusted upward by the full amount of the recapitalization of the CBA.

Table 2.

Armenia: KfW and IBRD SME Loan Disbursements1/

(In billions of dram)

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Cumulative from December 2008, at program exchange rates.

Table 3.

Armenia: External Financing to the Public Sector (Program)1/

(in billions of drams)

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Cumulative from December 2008, at program exchange rates.

III. Data Reporting

The government will provide the IMF the information specified in the following table.

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1

Staff estimates (available at http://www.imf.org/external/pubs/cat/longres.cfm?sk=22783.0) indicate that the exchange rate was overvalued by about 20-30 percent at the end of 2008, prior to the return to the floating exchange rate.

2

According to CBA stress tests, a 25 percent write-off of NPLs would decrease the capital adequacy ratio of the system by 1.7 percent.

3

The Russian loan is expected to have a maturity of 15 years with a grace period of 5 years and interest rate of LIBOR plus 3 percent. The resources provided by the World Bank and ADB will be on highly concessional terms in 2009, and will include a blend of concessional and non-concessional financing in the remaining years.

4

To compare the respective gaps, it is worth noting that the March 2009 purchase from the Fund of $237 million was included in the financing gap under the original SBA, but is now included in financing.

5

Liquidity absorbing transactions under reverse repurchase agreements, the CBA’s deposit facility, foreign currency swaps, and securities issued by the CBA are excluded from the reserve money definition.

6

The public sector is defined following the Government Financial Statistics Manual (GFS 2001) and System of National Accounts (1993 SNA). It includes the general government and nonfinancial public enterprises.

7

Domestic nonbank holdings of treasury bills and treasury bonds are defined as total outstanding treasury bills and bonds less holdings by the banking system and the SFSI.

8

As defined in CBA resolution No. 201 (December 6, 1999).

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Cover IMF Staff Country Reports
Republic of Armenia: First Review Under the Stand-By Arrangement, Request for Augmentation, Rephasing of Purchases, Waiver of the Nonobservance of Performance Criteria, and Modification of Performance Criteria: Staff Report, Press Release on the Executive Board Discussion, and Statement by the Executive Director for the Republic of Armenia.
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 214
Publisher:
International Monetary Fund
ISBN:
9781451801750
ISSN:
1934-7685
Pages:
86
DOI:
https://doi.org/10.5089/9781451801750.002

CCA Exchange Rates

(National currency in US$, June 2008 = 100)

Dollarization and AMD/$ Exchange Rate

12-Month Credit Growth

(In percent)

FX Intervention and Exchange Rate

CPI Inflation

(Year-on-year growth, in percent)

Financial Deepening

Decline in Tax Revenue

C-Ratio
Figure 1.

Armenia: Recent Economic Developments
Figure 2.

Armenia: Public Debt Sustainability: Bound Tests 1/

(Public debt, in percent of GDP)
Figure 3.

Armenia: External Debt Sustainability: Bound Tests 1/

(External debt, in percent of GDP)

Public Debt

(In percent of GDP)