Republic of Armenia
Third Review Under the Stand-By Arrangement, Request for Waiver of Nonobservance of Performance Criterion, and Modification of Performance Criteria: Staff Report; Press Release on the Executive Board Discussion; and Statement by the Alternate Executive Director and Advisor for the Republic of Armenia.
Author:
International Monetary Fund
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Publication Date:
23 Apr 2010
eISBN:
9781455204564
Language:
English
Keywords:
ISCR; CR; monetary policy; regime; exchange rate; supportive monetary policy; inflation pressure; debt service; foreign exchange; banking system; potential GDP; transmission mechanism; Exchange rate flexibility
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Armenia’s third review under the Stand-By Arrangement and its request for Waiver of Nonobservance of Performance Criterion are discussed. The uptick in inflation was largely driven by exogenous factors, but it is important that these do not feed into further inflationary expectations. The financial sector has been resilient to the crisis and almost all banks are well capitalized. The fiscal stimulus has appropriately supported the economy during the crisis and maintaining priority public spending has been critical for mitigating the impact of the crisis on the poor

Abstract

Armenia’s third review under the Stand-By Arrangement and its request for Waiver of Nonobservance of Performance Criterion are discussed. The uptick in inflation was largely driven by exogenous factors, but it is important that these do not feed into further inflationary expectations. The financial sector has been resilient to the crisis and almost all banks are well capitalized. The fiscal stimulus has appropriately supported the economy during the crisis and maintaining priority public spending has been critical for mitigating the impact of the crisis on the poor

I. Staff Appraisal

1. The deep recession appears to have bottomed out, yet important challenges remain. The dramatic fall in output and inflows appears to be over, but output growth will likely remain low in the face of a weak external environment and the unlikely return of the earlier remittance-fueled construction boom. Thus, the main challenge will be to support the fragile economic recovery while gradually adjusting policies in light of the external outlook.

2. Performance under the program has been good. Program targets were largely met, with the target on net domestic assets of the Central Bank of Armenia (CBA) missed by only a small margin, and structural reforms continued. The authorities have adjusted policies in a manner consistent with macroeconomic stability, and are clearly aware of the challenges ahead.

3. Looking forward, greater exchange rate flexibility will be essential to a sound policy mix. While the authorities remain committed to the flexible exchange rate regime, they have, at times, influenced the exchange rate to mitigate potential inflation pressures. While intervention to avoid sharp exchange rate movements and allow some absorption of the sizable foreign assistance inflows is warranted, this should not come at the expense of long-term macroeconomic stability and underlying trends. Staff supports the CBA’s plans to strengthen foreign exchange-related prudential regulations, including measures to enhance foreign exchange risk management.

4. The shift from an accommodative to a more neutral monetary policy, supported by a more transparent monetary framework and effective communication strategy, is warranted. The recent uptick in inflation was largely driven by exogenous factors, but it is important that these do not feed into further inflationary expectations. Thus, adjusting the policy rate so that it becomes positive in real terms is appropriate. In addition, the planned steps to strengthen the transmission mechanism are needed and welcome, complemented by measures to discourage dollarization. Nonetheless, and mindful of the need for increased exchange rate flexibility, the outlook for inflation will remain challenging, raising valid questions about the appropriate monetary framework. In this regard, staff supports CBA’s efforts to strengthen its inflation targeting framework, underpinned by a sound communication strategy. At the same time, the authorities should avoid relying on the exchange rate to stabilize inflation expectations and also avoid frequently changing the monetary regime, which could undermine the credibility of the central bank.

5. Continued close supervision of the financial sector will be critical. The financial sector has been resilient to the crisis and almost all banks are well capitalized. Nonetheless, risks remain, notably on the credit side. The authorities’ efforts to tighten foreign exchange-related prudential regulations and to improve crisis preparedness and contingency planning are welcome.

6. On fiscal policy, supportive policies are warranted in the short term, but deficits should be brought down over the medium term. The fiscal stimulus has appropriately supported the economy during the crisis and maintaining priority public spending has been critical for mitigating the impact of the crisis on the poor. As the recovery gains strength, fiscal consolidation will be needed, with the aim of bringing the budget deficit below 3 percent of GDP in 3–4 years. In addition, staff encouraged the authorities to adopt an appropriate social indicator to help monitor the effectiveness of social policies in reducing poverty.

7. Renewed reforms will be essential to strengthening the medium-term fiscal position and the provision of public goods. Efforts to strengthen tax administration and advance tax policy reforms have had mixed success. Progress in these areas will be critical to sustained improvements to Armenia’s currently low tax-to-GDP ratio, and it is important that the authorities avoid further delays. Likewise, restoring the medium-term expenditure framework (MTEF) will be needed in situating public spending consistent with fiscal sustainability over the medium term.

8. Staff supports the authorities’ request for completion of the third review. Staff also supports a waiver of nonobservance of performance criterion, modification of performance criteria for end-March 2010, and setting of performance criteria for end-June 2010. Risks to the program are broadly balanced. Reflecting in large part uncertainties over the external outlook, there are upside and downside risks to economic growth. The medium-term balance of payments remains an important concern, although policies under the program are aimed at addressing these weaknesses. Armenia’s capacity to repay the Fund broadly remains good.

II. Economic Context

9. The crisis appears to be over as the economy is showing signs of recovery.

  • After a deep downturn, output is stabilizing. Real GDP contracted by 14.4 percent in 2009, but started recovering by the fourth quarter. The construction and real estate sectors are improving, but continue to drag down GDP growth. Rising metal prices have spurred greater activity in the mining sector, and services and retail trade continue to be resilient.

  • External inflows have started to recover, but remain weak. Despite signs of improvement during the second half of the year, the external position deteriorated in 2009. The current account deficit widened to 13.8 percent of GDP as exports and remittances contracted by one-third while imports dropped by a quarter. However, with sizable financial inflows, particularly government borrowing, official reserves remained at a comfortable level.

  • Public finances are recovering gradually as revenue picked up in recent months. After a dramatic drop earlier in 2009, 12-month tax revenue growth edged up in the fourth quarter. Expenditures, including higher capital spending, were in line with program targets. As expected, the deficit widened to 7½ percent of GDP, up from about 1½ percent in 2008.

uA01fig01

Construction Sector Contribution to Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig02

Exports and Imports

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig03

Remittances 1/

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

1/ Defined as non-commercial private transfers through the banking system.
uA01fig04

Tax Revenue

(In billions of AMD)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

10. Recently, inflation pressures have emerged as a concern.

  • CPI inflation edged up by end-2009. It reached 6½ percent in December, exceeding the CBA target of 4±1½ percent and continued to rise through end-February 2010, reaching 9 percent. It has been largely driven by increases in world commodity prices, pass-through effects from the March 2009 depreciation, and increases in administrative prices (see Appendix, Section A).

11. Financial conditions have been broadly stable, but dollarization remains high.

  • The dram has been trading in a relatively narrow range against the dollar. Exchange rate pressures emerged in the fourth quarter, mainly reflecting seasonal factors and outflows due to public spending. In real effective terms, the dram is 19 percent below its February 2009 peak, although updated estimates of the equilibrium real exchange rate suggest that a small overvaluation remains.

  • The credit crunch had eased by end-2009. Increasing economic activity and improving loan portfolios, along with continued government-led refinancing programs, helped spur banks to increase lending in the last quarter of 2009. However, dram lending continues to be subdued; with the high dollarization of bank deposits, banks try to minimize their risks and balance their foreign currency positions.

uA01fig05

CPI Inflation

(Year-on-year growth, in percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig06

CCA Exchange Rates: March 9, 2010

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig07

REER and NEER

(Index, 2000=100)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig08

Estimated Real Exchange Rate Misalignment

(In percent, quarterly estimates)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

12. Program performance was on track.

  • Almost all quantitative and structural targets for end-December were met. Targets for the fiscal deficit (including for end-September, which had been granted a waiver at the time of the last review), net banking system credit to the government, and net international reserves were met. The target on net domestic assets of the CBA was narrowly and temporarily missed for end-December given the high liquidity demand ahead of a new 10-day holiday at the beginning of January 2010. Also, the indicative target on the stock of tax credits for end-December was missed. Structural benchmarks were implemented largely as planned (LOI ¶2 and Table 2).

III. Discussions with the Authorities

13. With a better global and regional outlook, prospects for recovery have improved, but important weaknesses remain for 2010 and the medium term.

  • Real GDP is expected to grow by about 2 percent in 2010, with risks to the outlook broadly balanced. Potential output in Armenia has been affected through adverse effects on capital inflows, remittances, and exports. The resulting plunge in private investment has reduced potential GDP through a fall in the capital stock, which will take time to rebuild. Thus, despite higher external demand, notably from Russia, the pace of Armenian recovery is uncertain. With the construction sector providing a negative contribution to GDP growth in 2010, industry and services are likely to be the main drivers of the recovery. Risks to medium-term growth remain two-sided, reflecting the outlook for the regional and global recovery. The possible reopening of the Turkish-Armenian land border represents an important upside risk.

  • Inflation is expected to stay outside the CBA’s target range in 2010, but is projected to revert in 2011. Given lags in the exogenous factors, inflation is expected to remain elevated through mid-2010. However, with output below potential and prudent macroeconomic policies, there is less chance of sustained inflation, which is projected to return to the target zone from mid-2011 onwards.

  • External imbalances are expected to persist in 2010, gradually receding over the medium term. The current account deficit is projected to narrow slightly to 13 percent of GDP against the backdrop of a still fragile recovery in external demand and remittances, offsetting rising imports bolstered by externally-financed public spending in 2009–10. Over the medium term, the current account is projected to gradually narrow, but will require substantial gains in competitiveness through additional commitments to exchange rate flexibility and acceleration in structural reforms.

  • Rising public debt and a bulging debt service profile have emerged as concerns. With the authorities’ crisis response having been financed in good part by public borrowing, external public debt has increased sharply, and is projected to peak at 45 percent of GDP in 2011 before gradually declining. Debt service, due in part to repayments to the Fund, is also expected to be high in 2012–14 before falling thereafter. While restored growth and current account adjustment should ensure public debt sustainability over the medium term, the debt outlook remains sensitive to a real exchange rate shock (LOI ¶18). Thus, sound debt management will be crucial (see Appendix, Section D).

uA01fig09

Real GDP Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.
uA01fig10

CPI and Selected Components

(Year-on-year, percent change, eop)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig11

Current Account and Key Components

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig12

Public Sector External Debt, 2009

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig13

Public Sector Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

14. Further exchange rate flexibility will be critical to addressing the policy challenges…

  • While the authorities remain committed to the flexible exchange rate regime, recent interventions may be more than is needed to smooth volatility. The CBA is concerned that with inflation picking up, more rapid depreciation might lead to a high and persistent inflation. Staff stressed that intervening to avoid sharp exchange rate movements and allowing some absorption of sizable foreign assistance inflows was warranted, but it is important not to resist the underlying trends. Moreover, excessive focus on short-term stability of the exchange rate could come at the expense of long-term macroeconomic stability.

uA01fig14

FX Intervention and Exchange Rate

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

15. …supported by sound monetary policies…

  • The CBA is gradually shifting to a more neutral stance. The CBA believes that some excess demand from last year’s expansionary policies has contributed to inflationary pressures. The CBA has already increased its policy rate in three steps by 150 basis points since January and intends to continue increases until it becomes positive in real terms based on inflation expectations. In addition, it has tightened liquidity, including by reducing the stock of repos, which caused the market rates to rise above the policy rate.

  • The CBA is taking steps to strengthen its inflation targeting framework. It is initiating dedollarization measures, introducing trading mechanisms to deepen the secondary market, and using available instruments to manage liquidity (LOI ¶8). However, the public’s persistently high preference for foreign currency has reduced the effectiveness of monetary policy. As a result, some consideration has been given to reverting to targeting monetary aggregates. Staff underlined that there were important limitations to any regime in the current setting, but that frequently changing monetary regimes undermines policy credibility. Moreover, targeting the monetary base has proved ineffective in the past, cannot overcome the underlying weaknesses of the transmission mechanism, and risks over-determining monetary and exchange rate policies.

uA01fig15

Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

uA01fig16

Money Growth

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

16. …and measures to limit vulnerabilities in the banking system to safeguard financial stability.

  • The authorities are taking further steps to enhance banking supervision and regulations (LOI ¶11). The system remains highly capitalized with improved asset quality and profitability (see Appendix, Section C). However, significant risks remain from foreign currency exposure to unhedged borrowers. The CBA is thus planning to tighten foreign exchange-related prudential regulations regarding loan-loss provisioning and capital requirements (structural benchmark, June 2010) to enhance banks’ risk management as well as encourage dedollarization.

  • The CBA continues to improve its crisis preparedness and contingency planning. This year, the CBA plans to formalize the Committee for Financial Stability and require banks to prepare their contingency plans (structural benchmarks for September and December 2010, respectively).

uA01fig17

Capital Adequacy and Liquidity Ratios

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

17. Fiscal policy will need to balance short and medium-term concerns, while maintaining adequate social spending.

  • The overall fiscal stance is appropriate in 2010. Narrowing the fiscal deficit to about 5½ percent of GDP strikes a balance between the need to start bringing down the deficit—in light of debt sustainability and financing concerns—and avoiding an overly negative impulse to economic activity. The deficit target implies a slightly contractionary stance, given the output gap cycle (see Appendix, Section B). The authorities intend to implement contingency measures should revenue diverge from projections (LOI ¶13). In particular, in the event of revenue shortfalls, non-priority expenditure would be cut or postponed. On the other hand, any revenue overperformance would largely be saved.

  • The authorities agreed that the deficit should gradually decline below 3 percent of GDP over the medium term. This would imply an annual adjustment of about 1 percent of GDP in 2011–13, which would come mainly from higher revenue due to enhanced tax administration and limiting spending increases in nominal terms.

  • Social spending will be protected in 2010. With poverty picking up in the wake of the crisis, average pensions and family benefits have increased over the past two years, while targeting of the latter has improved. Going forward, to protect the poor, the authorities aim to maintain social spending in 2010 broadly at the nominal level of 2009. This would allow savings from enhanced targeting of the family benefit program to be extended to other eligible families. Moreover, the authorities plan to establish a social indicator that would help assess the effectiveness of their social policies in reducing poverty (LOI ¶20).

uA01fig18

Measures of Poverty

(In percent)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

18. The authorities should step up their structural reforms to bolster macroeconomic stability and boost growth.

  • Progress in tax reforms has been mixed. On tax administration, while delays in VAT refunds have been shortened, the introduction of risk-based auditing and e-filing is progressing slowly, and the challenge of reducing tax credits persists. Continued efforts are being directed at boosting collections from large taxpayers. Regarding tax policy, the authorities plan to abolish the current presumptive taxation regimes for all products, notably for tobacco and fuel, by January 2011 (LOI ¶ 17), and will introduce a number of other tax policy changes in a revised tax code, which is expected to be submitted to parliament by end-2010.

  • The fast erosion of fiscal space calls for an early adoption of a debt management strategy. Although Armenia’s debt is expected to remain sustainable over the medium term, future official borrowing needs to be selective in terms of ensuring adequate concessionality and efficiency and a manageable schedule of debt service payments. To this end, a strengthened MTEF for 2011–13 will be reintroduced this year (structural benchmark, July 2010, LOI ¶14 and Table 2) and an action plan for implementing a debt management strategy will be adopted by June (LOI ¶ 18).

  • The authorities are committed to other broad-based structural reforms to enhance productive capacity and promote long-term growth. These include maintaining an open trade regime, improving the business environment, focusing on the ease of doing business and anti-corruption efforts, and increasing competition to eliminate market domination in key sectors (LOI ¶19).

IV. Program Issues

19. Risks to the program have lessened somewhat, but still subsist. Policymakers face several challenges, in particular the need to support the fragile economic recovery, address external vulnerabilities—including rising external debt and debt service obligations—as well as the need to advance with a credible fiscal consolidation plan over the medium term.

20. The attached LOI describes the authorities’ progress in implementing their economic program, and sets out conditionality through end-2010:

  • The authorities request a waiver of nonobservance for the end-December performance criterion on net domestic assets of the central bank, which was narrowly missed due to strong temporary liquidity demands in the last few days of the year in advance of the unusually long holiday period.

  • The LOI sets quantitative performance criteria for end-June 2010 and new structural benchmarks for the year. Also, given the changing economic outlook, the authorities are requesting the modification of the end-March performance criteria. In addition, the authorities would like to reintroduce the indicative target on reserve money.

21. Armenia’s capacity to repay the Fund broadly remains good and is in line with the assessment made at the time of the last review. The CBA and the ministry of finance have signed a Memorandum of Understanding to safeguard Fund resources directed for budget support.

22. The authorities have signaled their interest in possibly moving to a new program at the time of the next review (LOI ¶22). Staff agrees that as the crisis recedes and important medium-term challenges emerge, shifting to a Fund facility more tailored to such challenges could be warranted. On this basis, and in light of the new blend criteria, the new arrangement would likely be an EFF/ECF blend. Several changes to program design would be considered, including revising the targets on debt limits in line with the recently adopted debt limit framework.

Table 1.

Armenia: Selected Economic and Financial Indicators, 2006–10

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

For 2009, Q3 preliminary estimates.

Including the gas subsidy in 2006–08.

Based on government and government-guaranteed debt.

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

Gross international reserves in months of next year’s imports of goods and services, including the SDR allocation.

A positive sign denotes appreciation.

Table 2.

Armenia: Balance of Payments, 2007–15

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

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

Gross international reserves include the SDR allocation.

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

Based on government and government-guaranteed debt.

Table 3.

Armenia: Monetary Accounts, 2006–10

(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).

Discrepancy between the fiscal and monetary accounts in 2009Q3–Q4, 2010Q1 is explained by government lending to the economy through commercial banks.

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.
Table 5.

Armenia: Central Government Operations, 2008–10

(In billions of drams)

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

Discrepancy between the fiscal and monetary accounts in 2009Q3–Q4, 2010Q1 is explained by government lending to the economy through commercial banks.

Includes IMF budget support.

The program balance until 2009 is measured as below-the-line overall balance minus net lending. From 2010 (Proj.), it is measured as in 2009 less project financing.

Table 6.

Armenia: Central Government Operations, 2008–10

(In percent of GDP, unless otherwise specified)

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

Discrepancy between the fiscal and monetary accounts in 2009Q3–Q4, 2010Q1 is explained by government lending to the economy through commercial banks.

Includes IMF budget support.

The program balance until 2009 is measured as below-the-line overall balance minus net lending. From 2010 (Proj.), it is measured as in 2009 less project financing.

Table 7.

Armenia: Public Sector Debt Sustainability Framework, 2005–15

(In percent of GDP, unless otherwise indicated)

article image

Indicate coverage of public sector, (e.g., general government or nonfinancial public sector). Also whether net or gross debt is used.

Derived as [(r - π(1+g) - g + αε(1+r)]/(1+g+π+gπ)) times previous period debt ratio, with r = interest rate; π = growth rate of GDP deflator; g = real GDP growth rate; a = share of foreign-currency denominated debt; and ε = nominal exchange rate depreciation (measured by increase 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 the numerator in footnote 2/ as αε(1+r).

For projections, this line includes exchange rate changes.

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

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

Derived as nominal interest expenditure divided by previous period debt stock.

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

Table 8.

Armenia: External Debt Sustainability Framework, 2005–15

(In percent of GDP, unless otherwise indicated)

article image

Derived as [r - g - r(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 GDP deflator in US dollar terms, g = real GDP growth rate, ε = nominal appreciation (increase in dollar value of domestic currency), and α = share of domestic-currency denominated debt in total external debt.

The contribution from price and exchange rate changes is defined as [-ρ(1+g) + εα(1+r)]/(1+g+ρ+gρ) times previous period debt stock. ρ increases with an appreciating domestic currency (ε > 0) and rising inflation (based on GDP deflator).

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 of previous period.

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

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

Table 9.

Armenia: Medium-Term Macroeconomic Framework, 2007–15

(In percent of GDP, unless otherwise specified)

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

A negative figure indicates an increase.

Table 10.

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.

This review is the combination of the second and third reviews under the original program.

Table 11.

Armenia: Indicators of Capacity to Repay the Fund, 2010–15 1/

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Source: Fund staff estimates and projections.

Indicators cover both GRA and PRGF credit.

Total debt service includes IMF repurchases and repayments.

Table 12.

Armenia: Macro-Criticality of Structural Benchmarks

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Appendix: Analytical Background

A. Price Developments in 2009 and Projections for Inflation in 2010–11

1. End-of-period inflation in 2009 exceeded the authorities’ target of 4 ± 1.5 percent. The component of the CPI driving inflation was in particular the rent and fuel and power (RFP) subindex, for which average inflation was 14 percent.1 Looking at other components of the CPI, transport and communication (TC) prices increased by only 2 percent, although the contribution of TC to inflation increased sharply in the last quarter of 2009, with an average year-on-year inflation of 10 percent. Food prices have been stable on average, with a period average inflation of -0.9, but their contribution to inflation increased in the last two months of 2009 and January 2010. Medical care and recreation, entertainment, and education prices have also recently shown some pickup.

2. These price developments are largely explained by pass-through effects of the March 2009 exchange rate depreciation, developments in world commodity prices, and administrative price increases. Food price developments in Armenia are closely linked to international food prices, with a lag of approximately 3 months. The TC component of CPI shows sharp month-on-month increases in March, April, and November 2009, which are explained by world petrol prices and exchange rates since airfare is a large component of transport. RFP prices are determined by administrative tariffs. Month-on-month RFP prices spiked in May 2008 and April 2009 due to adjustments to administrative prices, but have otherwise remained constant.

3. CPI projections indicate that end-of-period inflation in 2010 will continue to exceed the authorities’ target range, but will fall within the range from mid-2011 onwards. These forecasts are based on regressions of food and TC prices on world commodity prices. Given that food prices have a weight of 48 percent in the CPI basket, it is not surprising that the projected series of food price inflation predicts the direction of actual inflation in Armenia. With the exception of RFP, the average month-on-month price increase for all other CPI components over the last two years is used to estimate the month-on-month increases in 2010 and 2011. As a result of administrative tariff increases, RFP prices are assumed to show a month-on-month increase in April 2010, which is equal to the average of the month-on-month increases in May 2008 and April 2009.

Figure 1.
Figure 1.

Armenia: Inflation Developments

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities, WEO, and Fund staff estimates.

B. Estimating the Output Gap and the Cyclically-Adjusted Fiscal Balance

4. This section attempts to estimate the cyclically-adjusted fiscal balance for Armenia using estimates of the output gap based on different econometric methods: (i) the HP filter; (ii) the production function approach; (iii) a simple univariate Kalman filter; (iv) a multivariate Kalman filter; and (v) a Bayesian multivariate Kalman filter. The output gap in these estimations is measured as the percent deviation of real seasonally-adjusted GDP from its potential.

5. Armenia’s GDP is estimated to have dropped below potential in 2009–10. All econometric methods show that the negative output gap in 2006 narrows considerably in 2007 and turns positive in 2008. It then becomes significantly negative in 2009 in the face of the global economic crisis. However, econometric techniques based on a variant of the Kalman filter suggest significantly less overheating of the economy in 2008 and a smaller and a less negative output gap in 2009. These differences are partly due to the end-point bias of the HP filter and the production function approach, which is based on an HP filter methodology. Another possible explanation is that the growth rate of potential GDP has not been constant over time. The Kalman filter and Bayesian methodologies treat the growth rate of potential as time-varying and are able to extract cyclical fluctuations from the data. However, as a result, potential output may see large swings. Projections based on the Kalman filter and Bayesian methodologies indicate broadly similar results, with the output gap remaining significantly negative for a number of years.

uapp01fig01

Armenia: Output Gap Estimates

(In percent deviation from potential)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.
uapp01fig02

Armenia: Output Gap Projections

(In percent deviation from potential)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

6. Estimates of the underlying fiscal stance confirm that fiscal policy was expansionary in 2009 as the cyclically-adjusted primary balance shows a considerable fiscal stimulus in 2009. The deterioration in the structural primary balance in 2009 under the Kalman filter and Bayesian methodologies is about 5 percentage points of GDP on average.

7. As output has stabilized and economic recovery is under way, fiscal policy is expected to play less of a role in boosting the country’s output in 2010. With debt sustainability and financing concerns emerging, a slight tightening in the underlying fiscal stance by about 1 percent of GDP is projected for 2010. Furthermore, continued adjustment is projected over the medium term to put the fiscal position on a sustainable path.

uapp01fig03

Fiscal Impulse and Output Gap

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

8. Measures of the fiscal policy stance shown in the table below are based on the Bayesian methodology. The Bayesian methodology is the most robust of these econometric techniques because it estimates by maximum likelihood a structural model of the Armenian economy, including core inflation, GDP, and unemployment. And while there is inherently some uncertainty in such estimates, the results show the relatively large fiscal impulse in 2009 compared to the size of automatic stabilizers, which are relatively weak in Armenia. It further confirms the contractionary stance in 2010, given the output gap.

Armenia: Fiscal Policy Measurement

(In percent of GDP)

article image
Sources: Armenian authorities; and Fund staff estimates.

Primary Balance is defined as the overall balance excluding other revenues, grants, and interest payments.

The Structural Primary Balance is calculated assuming revenue elasticity of one and spending elasticity of zero.

The Cyclical Primary Balance is calculated as the difference between the primary balance and the structural primary balance.

First difference in the cyclical primary balance. A deterioration in the cyclical primary balance implies the operation of automatic stabilizers.

First difference in the structural primary balance. A deterioration in the primary structural balance implies a positive fiscal impulse.

The output gap is calculated using the Baeysian Multivariate Kalman Filter.

C. Resilience in the Banking Sector

9. The Armenian banking sector has proved resilient to the crisis. Substantial capital and liquidity buffers, due in part to low leverage ratios, have enabled the banking sector to absorb shocks. Despite a significant increase in NPLs and considerable losses from the dram depreciation last March, the aggregate capital adequacy ratio remained strong at 28.3 percent at end-2009, more than double the prudential minimum of 12 percent. As of end-December 2009, only 3 of the sector’s 22 banks had capital ratios below 20 percent. Liquidity ratios remained well above minimum prudential requirements throughout the year. On top of an effective supervision framework, the authorities have implemented measures to help contain the negative impact of the crisis. For example, they have strengthened the financial safety nets (lender of last resort facility and deposit insurance scheme), tightened prudential regulations (reinstating foreign currency exposure limits), and encouraged capital injections to provide increased cushion through its subordinated debt facility.2

uapp01fig04

Banking System Leverage Ratios

(In multiple of capital)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Source: GFSR. In the GFSR, leverage is depicted by the ratio of capital to total assets. Here, the leverage ratio is defined as total assets divided by capital.

10. Banking sector balance sheets have improved since September 2009. After a marked deterioration during the first 8 months of 2009, NPLs under both the CBA and the IMF definitions have fallen to 7 percent in January 2010. Profitability improved, but remains low. Profits turned positive in September 2009 for the first time since March 2009, although the ROA and ROE at end-2009 were 0.75 and 3.4 percent respectively, still significantly less than the figures of 3.1 and 13.6 percent at end-2008.

uapp01fig05

Nonperforming Loans in Percent of Total Loans 1/

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

1/ CBA methodology includes loans that are 1 to 90 days past due, and excludes loans that are 270 days past due and are written off.Sources: Armenian authorities; and Fund staff estimates.

11. Latest stress test results indicate that banks are able to withstand a variety of shocks, thanks to the relatively high capitalization. The large capital cushion allows most banks to absorb losses and remain adequately capitalized even under extreme credit shock scenarios. Under all scenarios except for combined shocks, the CAR would decline by no more than 4 percentage points for the system as a whole. A few banks, however, appear to be more vulnerable than others to various risks, due to their relatively low capitalization level. However, the risks are contained and low, as capital injections appear to be readily available for these banks. The CBA is closely monitoring these cases.

12. However, continued vigilance is still needed as risks to balance sheets from indirect foreign currency exposure remain. Since March 2009, deposit and loan dollarization have stabilized at around 70 and 50 percent, respectively. Exposure to unhedged borrowers represents a main source of vulnerability in the banking sector, especially in light of increased exchange rate flexibility. The CBA is in the process of strengthening prudential regulations to specifically address indirect FX risks by increasing provisioning requirements and risk weights in capital requirements for foreign currency loans. This will also provide the CBA with adequate information on the extent of unhedged lending by banks to enhance supervisory monitoring.

13. In addition, efforts to encourage banking sector competition should continue to increase efficiency and enhance financial deepening. The high capital or low leverage in the banking sector is a source of resilience, but it has led to high interest rate spreads and hampered financial deepening. By regional standards, financial intermediation in Armenia is relatively low, with bank loans-to-GDP ratio at 22 percent in 2009, up from 17 percent in 2008 largely as a result of GDP decline.

uapp01fig06

CCA Credit to GDP Ratios

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.A001

Sources: Armenian authorities; and Fund staff estimates.

D. External Debt Analysis

14. Since the onset of the global crisis, Armenia’s debt dynamics—driven by external debt, which accounts for 95 percent of public debt—have evolved, and its rapid accumulation calls for initiating fiscal consolidation over the medium term. The external debt stock, which was only 13 percent of GDP at end-2008, had almost tripled by end-2009, reaching 34 percent of GDP and is expected to peak at about 45 percent of GDP in 2011, before gradually declining over the medium term. The projected debt-to-GDP levels do not appear excessive, and standard stress tests show that Armenia’s debt remains sustainable. However, rollover risk is high, mainly due to the short maturity of Fund financing with repurchase obligations during 2012–14.

15. While debt levels are manageable under the current policy scenario, the outlook is subject to risks. The standard bound tests show that the combined shocks lead to an increase in the debt-to-GDP ratio by several percentage points, to almost 50 percent of GDP. However, the effect of a real exchange rate shock is particularly pronounced, reflecting the rising weight of external debt in total public debt.

Figure 2.
Figure 2.

Armenia: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)

Citation: IMF Staff Country Reports 2010, 097; 10.5089/9781455204564.002.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 2010.

Attachment I. Armenia: Letter of Intent

March 10, 2010

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C. 20431

Dear Mr. Strauss-Kahn:

1. On the back of a strong policy response, Armenia is leaving behind a crisis of enormous proportions. Since the last review, our continued fiscal and monetary stimulus has stabilized the economy. Our exchange rate policy stabilized the dollarization process and has been instrumental in allaying concerns for financial stability. Structural reforms in the program are building the foundation for increased tax collection and improving safety nets to minimize the effects of the crisis on the poor.

2. Our performance under the program continues to be very strong. Almost all quantitative targets for end-December were met. The fiscal deficit, while providing key support to the economy, has been kept under control, allowing us to attain the end-December targets for the fiscal balance and net banking system credit to the government. We also met the end-September target for fiscal balance, for which, with provisional data, we had cautiously asked for a waiver of nonobservance at the time of the last review. The net international reserves target was comfortably met. However, despite our prudent monetary policy, the end-December performance criterion on net domestic assets of the Central Bank was narrowly missed due to strong temporary liquidity demands in the last few days of the year in advance of the unusually long holiday period. Also, the indicative target on the stock of tax credits for end-December was missed. As outlined below, structural benchmarks were implemented largely as planned.

3. This Letter of Intent builds on these achievements, laying out an agenda for 2010 that supports the exit path from the crisis. Our macroeconomic policies will need to strike a balance between the risk of choking off economic recovery and containing macroeconomic pressures that may emerge. We will also continue efforts on structural reforms to increase tax revenue, develop a sound financial system, and build the foundations for sustained diversified economic growth and poverty reduction. We remain committed to implementing the measures contained in previous letters of intent.

Recent Developments and Outlook for 2010

4. Economic activity has stabilized, while inflation has increased. Domestic demand, mainly for non-durable goods, has held steady thanks to our stimulus package. Recovery is evident in some sectors, including the mining and metallurgy industries. Inflation has increased on the basis of strengthening international commodity prices, some lagged pass-through effects from the exchange rate depreciation observed in the first part of 2009, and initial signs of pressure in selected services.

5. We expect a mild recovery in 2010. Prospects for the world economy and the Russian economy in particular have improved moderately, providing support for remittances and the tradable sector. Financial sector intermediation is picking up, and will support growth and domestic demand. Changes in private consumption and investment, which were contributing to the negative GDP growth in 2009, should make a positive contribution in 2010, whilst public consumption is expected to continue to show positive growth.

6. The external position remains vulnerable, but we aim to reduce the current account deficit over time. Despite the contraction in domestic demand and real depreciation, the 2009 current account deficit diminished only moderately in dollar terms and stands close to 14 percent of GDP, strongly influenced by the effect of regional trends in exports and remittances. External imbalances are expected to persist in 2010, reflecting the weak recovery of our main trading partners and continued strong public investment, while our gross financing needs broadly remain as envisaged in the beginning of the program.

Monetary, Exchange Rate and Financial Policies

7. We are adjusting our monetary stance in line with inflation developments. Inflation has now fallen out of our target band, so consistent with our price stability objective, we increased our policy rate by 100 basis points since the beginning of the year. We have also decreased the amount of outstanding repos significantly, while tight liquidity conditions have created a moderate wedge between our policy and market rates. We will further gradually adjust the policy rate to become positive in real terms. In this setting, inflation will come down from highs in the first quarter, and we will continue pursuing policies to bring it within the target band in the near future.

8. We will continue to strengthen our monetary framework. In light of increased dollarization, we will pay more attention to monetary aggregates, including base money, and consider the effectiveness of current rules of monetary policy implementation and communication in consultation with the Fund, including if necessary on-site discussions, assistance or studies by IMF experts. We aim to strengthen the transmission mechanism by implementing several dedollarization measures. And to enhance the effectiveness of our policy rate, we will use more frequently our available instruments to offset government’s lumpy spending, therefore reducing the volatility of short-term market rates. To deepen the secondary market, we will also introduce an overnight interbank market trading platform in NASDAQ-OMX. Lastly, we will outline an effective communications strategy to explain to the public the temporary nature of price developments behind the headline index.

9. We remain committed to the floating exchange rate regime. We have intervened in the foreign exchange market to smooth excessive volatility and counter speculative pressures to prevent large depreciations from threatening monetary and financial stability. We will continue to allow increased flexibility in exchange rate movements aiming at creating two-way risks in the market. In order to facilitate economic adjustments needed to maintain external stability, we will not intervene to resist fundamental trends in the exchange rate.

10. The health of the banking sector is improving, but we continue to closely monitor the situation. Banking sector balance sheets are improving steadily. Non-performing loans have been falling and profitability has turned positive since September. Lending activities have started recovering in recent months, fueled in part by our on-lending programs. We expect lending to continue to grow in 2010, although only at a moderate pace because of current and prospective prudential regulations. In the near term, dram lending is likely to be limited by high dollarization of deposits (as banks strive to balance their foreign currency position), but will still be supported by the continuation of the government’s refinancing operations through the banking system. Capital and liquidity ratios remain strong and latest stress tests continue to show financial soundness.

11. We have taken concrete steps to limit vulnerabilities of the financial sector and we continue to improve our crisis preparedness and contingency planning. In April 2010, the limits on net open foreign exchange positions of +/- 7 percent of capital will come into full effect. We also plan to strengthen prudential regulations to address currency-induced credit risk to ensure that banks’ capital buffer would be sufficient to deal with a deterioration in the FX loan portfolio. In particular, loan-loss provisioning requirements and risk weights in capital requirements for foreign currency loans will be increased (structural benchmark, June 2010). This year, we plan to formalize the Committee for Financial Stability (structural benchmark, September 2010), after we receive further assistance from Fund TA on contingency planning, specifically to set out modalities for policy makers to coordinate their policies and responses, including the division of responsibilities and information sharing among stakeholders (CBA, MOF, and DGF). We will also issue a prudential regulation requiring banks to prepare their contingency plans (structural benchmark, December 2010). Furthermore, we would welcome the opportunity to undergo a Stability FSAP Module to help diagnose and address remaining vulnerabilities.

12. Given these improvements, we plan to phase out the temporary crisis-related supporting measures this year. Specifically, the capital injection-matching subordinated debt facility and guarantee on interbank lending are no longer needed and will be discontinued to minimize risks to the CBA’s balance sheet and potential conflict of interest.

Fiscal Policy

13. The fiscal deficit will be reduced in 2010, whilst social and capital spending will be maintained at an adequate level. We recognize that early withdrawal of fiscal stimulus could break the virtuous circle associated with an economic recovery. However, given positive signs in economic activity and debt sustainability concerns, we do not plan to increase the stimulus further. As such, the 2010 budget envisages broadly stable spending in nominal terms, while revenues will increase due to greater economic activity and improved tax administration. This will still imply a lowering in the deficit to around 6 percent of GDP, down from 7.5 percent of GDP in 2009. We intend to save any revenue over-performance above budgeted amounts. In the unlikely event that revenues fall below expectations, we will implement contingency measures to ensure that the deficit target is respected. In absolute terms, the deficit will continue to be significant, but financing is already secured through external support from donors, and we intend to issue t-bills to cover the remaining financing needs.

14. We remain firmly committed to medium-term fiscal sustainability. To this end, our fiscal consolidation program envisages a gradual reduction in the deficit. We will meet the requirements of our law that the deficit must be brought below 3 percent of the average last three years’ GDP when debt levels surpass 50 percent of GDP. The medium-term adjustment will rely on both revenue and expenditure measures, while ensuring sufficient social and capital spending. In order to strengthen our fiscal framework, we will submit to the government a medium term budget framework for 2011–13 laying out our revenue projections, assumptions, and risks, spending priorities, funding sources, debt dynamics, as well as specific measures to deal with transitory shocks and/or the materialization of contingent liabilities (structural benchmark, July 2010).

Fiscal Structural Reforms

15. The crisis did not hinder progress on our ambitious tax administration reforms. All VAT refund claims filed in 2009 have been processed within the statutory 90-day processing deadline, with the exception of a few cases in which delays were temporary due to taxpayers’ failure to provide necessary documentation. We will continue to process them within that timeframe during 2010. We have also made progress in implementing reforms in other areas, including (i) the introduction of mandatory e-filing of tax returns in 2009 for large taxpayers, which will be expanded over the course of 2010 to all other taxpayers; (ii) the development of a concept note on risk-based selection of taxpayers subject to audit, which was approved by the cabinet; and (iii) the improvement of analytical capacity of the tax agents. In addition, in close cooperation with CBA, we aim to start efforts at the SRC to enforce currency regulations.

16. Going forward, we remain committed to our revenue administration reforms to enhance the business environment and ensure a sustainable revenue base. The overall stock of tax credits was marginally reduced in 2009, although the indicative target for end-December 2009 was missed. Nonetheless, we remain strongly committed to addressing the systemic problems underlying tax credits, and to implement measures to ensure that unwarranted advance tax payments do not arise. Moreover, we will continue to focus on further strengthening VAT refund processing, including by implementing a fully functional risk-management approaches in VAT refund processing for which we will (i) submit legislation to parliament to allow only high risk VAT refunds to be subject to review (structural benchmark, March 2010), and (ii) adopt a government decree establishing a mechanism for implementing such a system (structural benchmark, December 2010 with actual implementation taking place by June 2011). To further strengthen the penalty regime, we will submit legislation to parliament allowing consolidation of VAT returns and refund claims in a single application, which will also contribute to streamlining the process. Fund TA is helping us in all these efforts, and we welcome the support provided by an IMF tax administration resident advisor who will commence his duties in March 2010.

17. Progress has been also made in tax policy to increase tax collection over the medium term. Specifically, and in line with our commitment to abolishing presumptive taxation for fuel and tobacco products, we have submitted legislation to parliament to bring these products within the regular VAT regime effective January 2011. Moreover, we will submit legislation to parliament to abolish the presumptive taxation regime for certain activities (structural benchmark, September 2010). Finally, we intend to review the selection criteria to optimize the amount of taxpayers in the large taxpayers unit.

18. We are committed to strengthening public financial management and our medium-term debt management capacity. We intend to move the accounts of the Project Implementation Units (PIUs) from commercial banks to treasury accounts. As such, we intend to strengthen our debt monitoring and planning capacity, in line with our objectives set at the time of the last review. Furthermore, we will adopt a time-bound action plan to develop and implement a comprehensive medium-term debt management strategy. Reflecting the adjustment of the current account and the projected rebound in growth, the external debt-to-GDP ratio is expected to remain sustainable despite the rapid rise in public debt in the last two years.

Other Reforms

19. We will continue our efforts to deepen structural reforms that will sustain economic recovery, enhance the productive capacity of the economy, and promote long-term economic growth. These reforms include substantial investments in transportation infrastructure and information technology. We continue to be committed to maintaining an open trade regime. We are carrying out a number of initiatives to improve Armenia’s business environment, with a focus on improving the capacity of regulatory bodies and the ease of doing business. We also intend to continue our anti-corruption efforts, notably by addressing conflict of interest issues involving public officials. Finally, we are considering measures to increase competition and level the playing field, with a view to eliminating market domination in key sectors. We expect that structural reforms will result in considerable competitiveness gains over the medium term.

20. We remain committed to reducing poverty and protecting the poorest members of our society. To that effect, and in collaboration with the World Bank, we have developed a strategy to further strengthen the targeting of social safety nets. Going forward, we intend to identify an indicator that reflects spending efforts in this area, which will enable us to assess the effectiveness of our social policies in tackling poverty.

Conclusion

21. We request the completion of the Third Review under the Stand-By Arrangement in light of the performance under the program and our continued commitment to strong policies. Given the changed outlook, we also request modification of the end-March performance criteria for net international reserves, net domestic assets of the CBA, net banking system credit to the government, and the program fiscal balance. On the latter, we request a change in its definition to ease monitoring. In addition, we wish to reintroduce the indicative target on reserve money ceiling starting March 2010. Finally, we request the establishment of performance criteria for end-June 2010, and a waiver for the end-December 2009 performance criterion on net domestic assets of the CBA, given that the deviation was minor and temporary. We expect to complete the fourth review on or after May 14, 2010, and the fifth review on or after August 15. We will maintain the close policy dialogue with the Fund and stand ready to take additional measures, as appropriate, to ensure the achievement of the government social and economic objectives under the Stand-By Agreement. We will continue to consult with the Fund on the adoption of measures, and in advance of revisions of the policies contained in the LOI, in accordance with the Fund’s policies on such consultation. We will also provide the Fund with information it requests for monitoring progress during program implementation. The program’s quantitative performance criteria and indicative targets for 2010 and structural benchmarks are set out in Tables 1 and 2.

22. As we enter the post-crisis period, we are considering the merits of shifting to a Fund facility more tailored to our medium term challenges. In particular, weaknesses in our balance of payments and a large structural reform agenda will remain, and we will be in close contact with Fund staff on the facility most appropriate to address these challenges.

23. We authorize the IMF to publish the Letter of Intent and its attachments as well as the accompanying staff report.

Very truly yours,

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Table 1.

Armenia: Quantitative Targets, 2008–10 1/

(In billions of drams, at program exchange rates, 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.

Indicative targets for September and December.

Below-the-line overall balance excluding net lending until 2009. Below-the-line overall balance excluding net lending and project financing from 2010.

Reintroduced starting March 2010.

Indicative target up to end-March 2010.

For 2009, cumulative beginning the second half and therefore excludes the Russian loan contracted in June 2009.

Table 2.

Armenia: Structural Benchmarks for the Third and Fourth Reviews

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Attachment II. Armenia: Technical Memorandum of Understanding

1. This memorandum sets out the understandings between the Armenian authorities and the IMF staff regarding the definition of performance criteria and indicative targets, their adjusters, and data reporting requirements for the Stand-by Arrangement. This memorandum updates and replaces the TMU dated October 14, 2009. It sets out the definitions for quantitative performance criteria, indicative targets, benchmarks, adjusters, as well as the reporting modalities referred to in the Letter of Intent dated March 10, 2010, under which Armenia’s performance under the program supported by the Stand-by Arrangement (SBA) will be assessed.

2. For program monitoring purposes, all foreign currency-related assets, liabilities, and flows in the monetary accounts will be evaluated at program exchange rates. The program exchange rate of the Armenian dram to the U.S. dollar is set at dram 385 per one U.S. dollar. The cross-rates for other foreign currencies are provided in Table 1.

Table 1.

Armenia: (Program) Exchange Rates of the CBA

(As of December 31, 2008 in U.S. dollars per currency rates)

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3. For purpose of monitoring, the central government is defined as general government less local government and less off-budget funds.

I. Quantitative Targets

4. The program sets performance criteria and indicative targets for defined test dates (see Table 1 in the Letter of Intent dated March 10, 2010). The program sets the following performance criteria:

  • Floor on the net official international reserves (NIR) of the Central Bank of Armenia (CBA);

  • Ceiling on the net domestic assets (NDA) of the CBA;

  • Ceiling on the net banking system credit to the general government;

  • Ceiling on external public debt arrears (continuous);

  • Floor on the program fiscal balance;

The program sets the following indicative targets:

  • Ceiling on reserve money;

  • Ceiling on tax credits stock;

  • Ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector.

5. The net official international reserves (stock) will be calculated as the difference between total gross official international reserves (excluding reserve money denominated in foreign currencies) and gross official 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), including the August 28, 2009 General allocation and the September 9, 2009 Special allocation, 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 excluding the balance on the government’s Special Privatization Account (SPA) 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.

6. The net domestic assets are 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 to the government account at the CBA. 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, 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. 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.

7. The banking system credit to the general government is defined as the sum of net credit from the CBA and net credit from commercial banks to the general government.

  • The stock of net credit from the CBA to the general government 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, 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 general government includes: (1) gross commercial bank credit to the general government less general government deposits with commercial banks; 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).

8. External public debt arrears are 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.1 The ceiling on external payment arrears is set at zero.

9. The program fiscal balance is cumulative from the beginning of the fiscal year and is measured from the financing side as the negative of the sum of net domestic banking system credit to the central government, net domestic nonbank financing, and net external financing to the central government (excluding net project financing). 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 central government equals the change during the period of net credit to the central government. Central government is defined as general government less local government and less off-budget funds.

  • Net nonbank 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);2 (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 drams, less amortization paid by the central government to private resident nonbank agents.

  • Net external 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 amortization 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.

10. Those project implementation units, that carry out projects financed by the US-based Lincy Foundation, or other budget-related project implementation units maintain accounts at the CBA. The 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 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.

11. 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.

12. The program sets a ceiling on reserve money. Reserve money is defined as the sum of currency issued, required and excess reserves, and current and time deposit accounts of certain resident agents. The ceiling will be considered as met if the outcome is within AMD 5 billion of the indicative target set in Table 1 attached to the Letter of Intent dated March 10, 2010.

13. The stock of tax credits (indicative target) is 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.

14. The program sets a ceiling on contracting or guaranteeing of new nonconcessional external debt by the public sector. The definition of debt, for the purposes of the program, is set out in Executive Board Decision No. 12274, Point 9, as revised on August 24, 2000. For program purposes, nonconcessional external loans are defined as loans from lenders other than the IMF with a grant element of less than 35 percent of the value of the loan. The grant element is to be calculated as follows: the grant element of a debt is the difference between the net present value (NPV) of debt and its nominal value, expressed as a percentage of the nominal value of the debt. The NPV of debt at the time of its contracting is calculated by discounting the future stream of payments of debt service due on this debt. The discount rates used for this purpose are the currency specific commercial interest reference rates (CIRRs), published by the Organization for Economic Cooperation Development (OECD). For debt with a maturity of at least 15 years, the ten-year-average CIRR will be used to calculate the NPV of debt and, hence, its grant element. For debt with a maturity of less than 15 years, the six month average CIRR will be used. For both the ten-year and six-month averages, the same margins for differing repayment periods as those used by the OECD would continue to be added (0.75 percent for repayment periods of less than 15 years, 1 percent for 15 to 19 years, 1.15 percent for 20 to 29 years, and 1.25 percent for 30 years or more). Loans provided by a private entity will not be considered concessional unless accompanied by a grant or grant element provided by a foreign official entity, such as both components constitute an integrated financing package with a combined grant element equal to at least 35 percent. Previously contracted nonconcessional external debt that has been rescheduled will be excluded from the definition of “new debt” for the purposes of this performance criterion.

II. Adjusters

15. 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 deposits subject to reserve requirements 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 donors for budget support, and the $500 million Russian loan disbursed in 2009 (including Fund purchases credited directly to the government accounts at the CBA), with the exception of the KfW and World Bank disbursements mentioned above:

Table 2.

Armenia: KfW and IBRD SME Loan Disbursments, 2009–10 1/

(In millions of U.S. dollars)

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Cumulative from the end of the previous year.

  • 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) 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 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 budget support 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 budget support financing compared to programmed amounts (Table 3). The floor on the program fiscal balance will be adjusted downward by the amount of any shortfall in receipt of grants under the European Union budget support program.

Table 3.

Armenia: External Financing to the Public Sector, 2009–10 (program) 1/

(In billions of drams)

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Cumulative from the end of the previous year, excluding grants.

  • 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.

III. Data Reporting

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

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IV. Guidelines on the Indicative Benchmark with Respect to Foreign Debt

Excerpt from Executive Board Decision No. 12274, as revised on August 24, 2000.

  • (a) For the purpose of this guideline, the term “debt” will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows:

    • (i) loans, that is, advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans, and buyers’ credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements);

    • (ii) suppliers’ credits, that is, contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and

    • (iii) leases, that is, arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the lessor retains the title to the property. For the purpose of the guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair or maintenance of the property.

  • (b) Under the definition of debt set out in point 9 (a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (for example, payment on delivery) will not give rise to debt.
1

The rent in the RFP component of CPI mostly comprises utilities.

2

The CBA intends to terminate the capital injection-matching subordinated debt facility to minimize risk to its balance sheet and potential conflict of interest. In 2009, the CBA extended a total of approximately AMD 15 billion in 5-year subordinated loans under this facility to 4 banks, amounting to around 5 percent of total capital of the banking sector. These loans also helped improve banks’ access to long-term funding.

1

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.

2

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 State Fund for Social Insurance.

3

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

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Cover IMF Staff Country Reports
Republic of Armenia: Third Review Under the Stand-By Arrangement, Request for Waiver of Nonobservance of Performance Criterion, and Modification of Performance Criteria: Staff Report; Press Release on the Executive Board Discussion; and Statement by the Alternate Executive Director and Advisor for the Republic of Armenia.
Author:
International Monetary Fund
Volume/Issue:
Volume 2010: Issue 097
Publisher:
International Monetary Fund
ISBN:
9781455204564
ISSN:
1934-7685
Pages:
72
DOI:
https://doi.org/10.5089/9781455204564.002

Construction Sector Contribution to Real GDP Growth

(In percent)

Exports and Imports

(In millions of U.S. dollars)

Remittances 1/

(In millions of U.S. dollars)

Tax Revenue

(In billions of AMD)

CPI Inflation

(Year-on-year growth, in percent)

CCA Exchange Rates: March 9, 2010

REER and NEER

(Index, 2000=100)

Estimated Real Exchange Rate Misalignment

(In percent, quarterly estimates)

Real GDP Growth

(In percent)

CPI and Selected Components

(Year-on-year, percent change, eop)

Current Account and Key Components

(In percent of GDP)

Public Sector External Debt, 2009

(In percent)

Public Sector Debt

(In percent of GDP)

FX Intervention and Exchange Rate

Interest Rates

(In percent)

Money Growth

(In percent)

Capital Adequacy and Liquidity Ratios

Measures of Poverty

(In percent)
Figure 1.

Armenia: Inflation Developments

Armenia: Output Gap Estimates

(In percent deviation from potential)

Armenia: Output Gap Projections

(In percent deviation from potential)

Fiscal Impulse and Output Gap

(In percent of GDP)

Banking System Leverage Ratios

(In multiple of capital)

Nonperforming Loans in Percent of Total Loans 1/

CCA Credit to GDP Ratios
Figure 2.

Armenia: External Debt Sustainability: Bound Tests 1/

(External debt in percent of GDP)