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
At the outset, on behalf of the Armenian authorities, we would like to thank staff for productive consultations held in Yerevan and management for their continued support and constructive engagement with Armenia.
The performance under the program remains strong. All performance criteria for end-December were met, except for the target on net domestic assets of the Central Bank of Armenia (CBA). It was temporarily missed by a narrow margin on the last day of December, owing to the fact that the Central Bank tried to ease high liquidity pressures ahead of a 10-day long holiday in January 2010.
Armenia is gradually recovering from a severe economic contraction of 14.4 percent in 2009. The economy started showing signs of improvement after bottoming out late last year, and already in January posted small economic growth. Yet, there are many challenges ahead as fiscal deficit remains high, inflation pressures are elevated, and the remittance-fueled construction sector, one of the main drivers of the economic boom in the past few years, has yet to recover from a plunge of more than 40 percent last year. The GDP is projected to grow by about 2 percent in 2010, and the authorities believe that in the absence of negative external shocks they can reach an even higher growth.
In the medium term, in order to undergo a smoother and less challenging adjustment in the balance of payments, the authorities are considering a shift to the EFF/ECF blend.
Fiscal Policy
The authorities front-loaded a substantial fiscal stimulus to support economic activity, to protect the socially vulnerable and to overcome the negative consequences of diminished external demand and a sharp fall in remittances. Armenia has been successfully fighting poverty already for several years under the PRGF program, bringing it down to 23.5 percent before the crisis from 55 percent in 1999. The current Stand-By Arrangement helped the authorities mostly to avoid undoing previous efforts in this regard.
Although external public debt is projected to increase in coming years, it will remain at a level that will not expose the country to large debt sustainability concerns. The government is also constrained by the Law on Public Debt adopted in May 2008, which forces the government to plan the following year’s budget so that the deficit does not exceed 3 percent of the average of the last three years’ GDP, whenever the debt level reaches 50 percent of GDP.
Armenian authorities are committed to decreasing the fiscal deficit to 6 percent of GDP in 2010 from 7.5 percent last year. This will be achieved both by mobilizing higher revenues from an anticipated increase in economic activity and from improved tax collection, and by keeping expenditures at broadly the same level as in 2009 in nominal terms. Should revenues turn out to be higher than the level necessary to bring the budget deficit to 6 percent of GDP, the authorities intend to save the funds rather than increase spending. In the medium term, the authorities are committed to implement gradual fiscal consolidation on both revenue and expenditure sides, while making sure that an appropriate level of social and capital spending is in place. The authorities are committed to implementing the numerous measures in tax administration and other fiscal structural reforms that are at the core of the current program.
Monetary Policy
The CBA sees price stability as its main objective. Monetary policy is underpinned by the inflation-targeting framework. When inflation increased above the targeted band, the CBA reacted by gradually increasing the interest rates by 150 basis points since the beginning of the year. The authorities will continue gradual adjustment of the policy rate in response to unfolding price developments to ensure that the real interest rate stays in the positive territory, and inflation is contained within the target range.
At the same time, the authorities acknowledge weaknesses in the transmission mechanism due to increased dollarization. They are paying more attention to evolution of monetary aggregates as well as to enhancing the current framework of monetary policy. This includes a revision of the current rules of monetary policy implementation and of the CBA’s communication strategy. To increase effectiveness of monetary policy, the authorities also plan to implement measures aimed at decreasing the dollarization rate and at deepening the secondary market for domestic interest rate instruments.
The authorities recognize that a flexible exchange rate serves the economy well, and will intervene in the foreign exchange market only to smooth out sharp movements. The foreign exchange market in Armenia still remains shallow and at times discrete: large demand causes exchange rate spikes in the market. The Central Bank agrees that interventions should not resist fundamental trends in exchange rate.
Financial Sector
Since the previous review in September of last year, the balance sheet of the banking system shows considerable improvement. The share of non-performing loans has been decreasing, while lending activity picked up somewhat, partly due to on-lending programs supported by the government. Recent stress tests show that financial system remains sound. Therefore, the authorities in line with the IMF advice, are planning a gradual phase out of the crisis-related supporting measures to the banking system, such as capital-matching subordinated debt and the guarantee on interbank lending.
Armenian authorities have also taken measures to mitigate vulnerabilities in the financial system. Specifically, several prudential and normative measures were introduced that would ensure that banks remain well capitalized, and banks’ exposure to net open foreign exchange positions is limited. In particular, beginning in April 2010, the limit of +/- 7 percent of capital on net open positions will come into effect. Another measure, an increase in risk weights in capital requirements for foreign currency loans, will come into effect in June 2010.