Republic of Armenia
Request for Three-Year Arrangement Under the Extended Fund Facility and Extended Credit Facility, and Cancellation of the Stand-By Arrangement: Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia.

Economic activity appears to be recovering, underpinned by a strong policy response. Fiscal consolidation will be crucial to maintain debt sustainability and support the envisaged external adjustment over the medium term. Sound monetary and exchange rate policies are essential to maintain macroeconomic stability. Improvements in tax administration are needed to achieve the program’s goals of sound public finances and stronger economic growth. Broader efforts to strengthen the business environment are crucial to boost medium-term growth prospects. Risks to the program are manageable.


Economic activity appears to be recovering, underpinned by a strong policy response. Fiscal consolidation will be crucial to maintain debt sustainability and support the envisaged external adjustment over the medium term. Sound monetary and exchange rate policies are essential to maintain macroeconomic stability. Improvements in tax administration are needed to achieve the program’s goals of sound public finances and stronger economic growth. Broader efforts to strengthen the business environment are crucial to boost medium-term growth prospects. Risks to the program are manageable.

I. Staff Appraisal

1. Economic activity appears to be recovering, underpinned by a strong policy response. After a deep contraction in 2009, the economy now appears to be returning to broad-based growth. Public finances are steadily improving, credit to the private sector is rising, and banks’ profitability and asset quality are recovering. Anti-crisis policies supported under the SBA—notably the return to a floating exchange rate regime, an accommodative monetary stance, and countercyclical fiscal policies to help cushion the output loss—were instrumental in maintaining economic and financial stability and mitigating the impact of the crisis on the poor.

2. Looking ahead, a shift in focus to emerging medium-term challenges is warranted. While the SBA helped the authorities achieve their key objectives of maintaining macroeconomic and financial stability, and program performance remained strong, the crisis unmasked important medium-term weaknesses. These are best addressed by a new three-year EFF/ECF arrangement, which will provide a renewed focus on the macroeconomic policies and structural reforms to achieve solid medium-term growth, fiscal and debt sustainability, and financial sector stability.

3. Fiscal consolidation will be crucial to maintain debt sustainability and support the envisaged external adjustment over the medium term. Armenia’s public debt has increased dramatically in the last two years. While this debt burden remains sustainable, fiscal policy in the period ahead should be anchored on ensuring that public debt is firmly put on a downward path. Thus, as the crisis winds down, the fiscal impulse should be withdrawn. Higher revenues from increased economic activity and improvements in tax administration, coupled with expenditure restraint, will allow the government to bring the deficit down to sustainable levels during the program period. The targeting and efficiency of current spending should be improved in order to achieve the necessary adjustment while ensuring adequate room for pro-poor and capital spending. Armenia should continue working with its external partners to increase the concessionality of donor support.

4. Sound monetary and exchange rate policies will remain essential to maintain macroeconomic stability. The Central Bank of Armenia (CBA) needs to strike the right balance between a monetary stance that does not endanger the incipient recovery, but is adequately tight to contain possible inflationary pressures as the output gap is closed. Moreover, further efforts are needed to strengthen the monetary framework, which at times appears over-determined. CBA’s open market operations and intervention strategy need to fully support the stance given by the policy rate. In particular, the CBA should provide sufficient liquidity to minimize the gap between its announced policy rate and the interbank rates, and refrain from large one-sided interventions in the foreign exchange market. Greater exchange rate flexibility will remain critical to help achieve external sustainability and support the dedollarization of the economy.

5. Improvements in tax administration will be needed to achieve the program’s goals of sound public finances and stronger economic growth. An ambitious reform program is envisaged that would significantly increase incentives for tax compliance and widen the tax net, while enhancing the business environment. The overarching objective is to boost revenue while increasing perceived fairness and equity in the tax system.

6. Broader efforts to strengthen the business environment will be crucial to boost medium-term growth prospects. As noted, the proposed program appropriately focuses on tackling weaknesses in the tax system. In addition, the authorities are urged to continue broader efforts—with support of international partners—to address corruption, strengthen the regulatory environment, and improve domestic competition.

7. While Armenia’s financial sector is sound and resilient to shocks, the authorities should remain vigilant. The banking system has weathered the crisis well. However, continued steps are needed to strengthen financial sector supervision and crisis management, all within the framework of improving risk management in the sector.

8. Risks to the program are manageable. Armenia remains vulnerable to shifts in the external outlook, and it would not be immune to a deterioration of conditions in Europe and Russia. These effects would be felt via real sector channels, and more broadly, through continued weaknesses in the balance of payments. In addition, the public finance position remains vulnerable to potential delays in improvements in tax administration. Nonetheless, Armenia has a long history of strong performance under Fund programs, including under the SBA, and policies under the proposed program aim to address the country’s vulnerabilities. On this basis, staff supports the authorities’ request for arrangements under the EFF and ECF and the cancellation of the current SBA.

Armenia: Characteristics of the New EFF/ECF Blend Arrangement

Objective: The program objectives are to restore fiscal and external sustainability, preserve financial stability, and support growth and poverty reduction.

Access: SDR 266.80 million (290 percent of quota) split evenly between the EFF (145.00 percent of quota) and the ECF (145.00 percent of quota).

Term and phasing: The length of the new EFF/ECF arrangement would be 36 months—running through June 2013—with semiannual reviews.

Program monitoring: The program will be monitored through semi-annual reviews, quantitative performance criteria, indicative targets, and structural benchmarks.

Conditionality: Structural conditionality is focused on the program’s objectives, with a particular focus on tax policy and administration, fiscal and debt sustainability, and financial stability.

Safeguards assessment: The new arrangement will require an update of the safeguards assessment.

PRSP: The authorities issued their current PRSP in November 2008. They are in the process of updating it, to be issued to the Board by the time of the second review.

II. Exiting the Crisis

The worst is hopefully behind

9. Armenia is emerging from a severe economic downturn. Driven by counter-cyclical policies and the recovery of external demand that is buoying prices for Armenia’s exports such as copper, preliminary data indicate that real GDP grew by 5.5 percent year-over–year in the first quarter of 2010. Credit has picked up due to strong deposit growth and the government’s onlending activities (Box 2). Remittances and exports are also rebounding, facilitated by the rapid recovery of the Russian economy.


Contributions to Growth

(In percent, production side)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001


Output Gap Estimates

(In percent deviation from potential)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001


CPI Inflation

(Year-on-year growth, in percent)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001


Remittances 1/

(In millions of U.S. dollars)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

1/ Remittances are defined as the sum of compensation of employees, workers’ remittances, and other nongovernment current transfers.
Sources: Armenian authorities; and Fund staff estimates.

10. Headline inflation remains above target, but inflationary pressures are under control. After spiking earlier this year—due in part to lagged pass-through from last year’s sharp depreciation—yearly inflation fell to 6.8 percent in April. Staff estimates indicate that the output gap has remained negative, suggesting there are little signs of demand pressures that would warrant a stronger policy response.

11. The current account deficit remained high in 2009. In spite of the significant weakening of the dram and a deep recession that led to a contraction in imports, the current account deficit failed to adjust in the wake of a steep decline in exports and remittances. In recent months, exports and remittances have shown signs of strong recovery, but so have imports, the counterpart to sizable inflows of foreign assistance. Encouragingly, external imbalances have not created a material increase in private sector external debt, as the current account deficit has so far been financed mainly through donor assistance and foreign direct investment.

12. The fiscal position is improving alongside economic activity. During the first four months, tax revenues improved by about 20 percent year-on–year, in line with the increase in nominal GDP. Expenditures, especially foreign-financed capital investment, have increased noticeably compared to last year, but remained below budgeted levels and are set to fall later in the year.


Revenue and Expenditure

(In billions of AMD)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: Armenian authorities.

13. The banking sector balance sheet continues to improve. Capital and liquidity ratios continue to be high and the leverage ratio low, providing a strong buffer to any adverse developments, as reflected by the CBA’s latest stress tests. Nonperforming loans have declined relative to mid–2009 levels, but still remain high by historical standards. The deposit base has continued to expand throughout the crisis, although mostly on account of dollar deposits. Lending growth has started to recover, reflecting the improved economic outlook.

Armenia: Financial Sector Indicators, 2008–10

(In percent)

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Source: Armenian authorities.

14. On the political front, progress on the opening of the land border with Turkey has stalled. There has been little movement since the signing of the protocols between Armenia and Turkey in October 2009, and the timetable for proceeding is uncertain. Looking further ahead, Armenia has parliamentary elections in 2012 and presidential elections in 2013.

The outlook has strengthened

15. The economic outlook has improved, in line with global economic conditions. Real GDP is now expected to grow by about 4–5 percent in 2010, and remain around this level over the medium term. Industry and services are likely to remain the drivers of the recovery, although construction activity has also recently picked up. Risks to the outlook remain, reflecting uncertainty about the pace of recovery of the Russian economy, which could be affected by the turmoil in Europe. While direct effects from developments in the Euro area are likely to be limited, possible indirect effects through lower commodity prices and lower flows of remittances from Russia are of a greater concern.

16. Inflation is likely to continue to recede. Inflation is expected to gradually converge toward the CBA target band of 4±1½ percent as exogenous effects—such as the lagged pass through from last year’s depreciation—recede. However, as output returns to potential, risks are to the upside. Food prices are expected to remain volatile, especially given unfavorable weather conditions in April and May.

Critical challenges remain

17. While the crisis has receded, important medium-term challenges have emerged in its wake. Some of these, such as the need to boost potential output and improve the business environment, were masked by the years of unsustainably high growth over the last decade. Others, including the rapidly rising debt ratios, derive in part from the policy response to the crisis. The proposed EFF/ECF supported program is designed to help the authorities overcome these challenges, setting the stage for sustained growth and poverty reduction.


Current Account and Key Components

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and Fund staff estimates.

18. External imbalances are expected to narrow in the medium term, albeit gradually. The large current account deficit is expected to be reduced on the back of fiscal and exchange rate adjustments and stepped up structural reforms geared to improving competitiveness. Current account deficits are expected to be comfortably financed with donor assistance and foreign direct investment, with private sector external debt expected to remain low and banking sector external liabilities limited.


Net Foreign Assets

(In billions of USD)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: NSS; and Fund Staff Estimates

Armenia: Macroeconomic Outlook, 2009–13

(In percent of GDP, unless otherwise indicated)

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

III. Facing the Medium Term: The Authorities’ EFF/ECF Program

19. The authorities recognize the importance of addressing Armenia’s weaknesses, and to this end, have committed to a strong program aimed at achieving fiscal and external sustainability, financial stability, and strong growth and poverty reduction. Policies supported under the program will target stronger public finances, in particular through improved tax administration; continued improvements to the monetary framework paired with exchange rate flexibility; a further bolstering of financial sector supervision; and structural reforms to improve the business environment and improved social services.

A. Sound Public Finances

Targeting lower deficits

20. The authorities’ program reflects a strong commitment to a sustainable fiscal position. Staff argued that as the output gap is set to close faster than expected—and with limited financing sources and rising debt sustainability concerns—there was a strong case to bring the deficit down faster than envisaged under the SBA, with less risks to the recovery from a negative fiscal impulse in 2010. Thus, the authorities intend to scale back the deficit by 3 percent of GDP in 2010, which implies an adjustment of more than 2 percent in the structural primary balance. Thereafter, the overall deficit would be reduced by about 1 percent of GDP annually over 2011–13. This approach relies in part on steady improvements in revenue collection, primarily through tax administration gains. It will also entail limiting the growth of nominal expenditure, reflecting in part lower volumes of donor-financed spending, including in 2010. Nonetheless, the fiscal targets will allow Armenia to boost spending on needed expenditure on investment in physical and human capital. Revenue over performance would in part be saved, and in part used to boost spending in critical areas (MEFP, ¶¶7–8).


Fiscal Impulse

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and Fund staff estimates.

Armenia: Central Government Operations, 2009–13

(In percent of GDP)

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

Better tax administration is essential for stronger public finances and economic growth

21. The medium-term plans rely on a strong tax administration reform program. The authorities underscored the importance of far-reaching reforms with meaningful effects on the level of tax collection. Staff agreed on the scope for significant improvement, and highlighted the stakes involved in this process. If efforts were to fail, the government would face very difficult choices in terms of reducing spending from already low levels. The key principles of the reform effort are to improve the integrity of the tax system, achieve important efficiency gains, and ultimately cast the tax net as widely as possible. Modernizing the tax administration will be a core element of this strategy. In addition, strengthening taxpayers rights and curtailing the discretionary authority of the tax agency (the State Revenue Committee—SRC) will lower the cost for businesses to join the formal sector and reduce corruption among tax officials, thereby increasing taxpayers’ incentives to comply with tax obligations and thus boosting collections. To these ends, reforms—on top of ongoing efforts to strengthen the large taxpayers’ unit and extend e-filing—will include (MEFP, ¶¶20–23, and MEFP, Table 2):

  • Set up an Appeals Committee in the Ministry of Finance distinct from the SRC (Structural benchmark, September 2010);

  • Require the SRC to publish clear new guidelines to existing complex tax legislation to be approved by the Ministry of Finance (Structural benchmark, July 2010);

  • Developing manuals for tax audits for usage starting in January 2011 (Structural benchmark, December 2010).

  • Considerably simplify tax reporting requirements (Structural benchmark, December 2010); and

  • Minimize the contact between taxpayers and tax officials by introducing a risk-based approach for VAT refunds.

Table 1.

Armenia: Selected Economic and Financial Indicators, 2006–13

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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 holdings.

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 holdings.

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

Based on government and government-guaranteed debt.

Strong medium-term expenditure and debt frameworks are needed

22. Staff and authorities agreed on the need to reinstate the medium-term expenditure framework. The new medium-term expenditure framework (Structural benchmark, August 2010) is being developed in cooperation with the World Bank, and paired with stepped-up efforts in debt management (MEFP, ¶25). The authorities recently adopted a time-bound action plan to develop and implement a comprehensive debt management strategy. The plan particularly focuses on overhauling the debt recording IT platform, revamping the internal organization of the debt unit, and developing a primary market for debt.

23. On this basis, public debt is expected to decline to more comfortable levels in the medium term from its peak of 49 percent in 2011. With economic activity rebounding, sustained fiscal consolidation should put public debt on a downward trajectory. Staff also noted that by year-end, public debt could exceed 50 percent of GDP, which, under Armenian legislation,1 would entail a reduction of the deficit next year beyond what is envisaged under the program. Looking forward, the authorities should strive to attract concessional resources, while limiting nonconcessional borrowing to financially viable projects.


Public Sector Debt

(In percent of GDP)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and Fund staff estimates.

24. Staff underscored the importance of protecting social spending. In light of the effects of the crisis on the most vulnerable segments of society and the limited resource envelope in upcoming years, staff emphasized the need to protect spending in related areas. To this end, the authorities agreed to set a floor on expenditures on the Family Benefits program—Armenia’s social safety net (MEFP, ¶30, MEFP, Table 1). In addition, the government will continue to provide support to the poor through pensions and other programs, including unemployment benefits and paid public works (Box 3).

B. Monetary, Exchange Rate, and Financial Policies

Exchange rate flexibility will remain a pillar of the authorities’ program

25. Staff and the authorities agreed that greater exchange rate flexibility is needed to maintain competitiveness and facilitate the needed external adjustments over the medium term. In addition, by allowing the exchange rate to follow fundamental trends, the central bank can ease the burden of the adjustment on interest rates, reduce depreciation expectations, increase incentives to dedollarize, and restore the appetite for much-needed domestic currency lending.


FX Intervention and Exchange Rate

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: Armenian authorities.

26. Two-way intervention to smooth excessive volatility remains warranted. With the FX market very thin, staff argued that interventions are justified at times of one-off portfolio shifts in either direction such as those that took place in March (rapid dollarization of private portfolios) and April (increased dram positions by banks to meet new reserve requirements). However, the CBA’s response to these events has sometimes been asymmetric, with decisions tilted toward preventing depreciation, motivated in part by concerns for the rapid pass-through of the exchange rate to inflation. Staff also emphasized that given the global environment and Armenia’s dependence on external borrowing, accumulating reserves is also warranted (MEFP, ¶13) to provide increased buffers and strengthen the medium-term external position. While most recently, there has been little pressure one way or another on the foreign exchange market, staff estimates continue to point to a mild overvaluation of the real exchange rate.


Estimated Real Exchange Rate Misalignment

(In percent, quarterly estimates)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and Fund staff estimates.

Continued improvements in the monetary framework are a priority

27. The CBA will continue efforts to revitalize its monetary framework. With dollarization lingering at high levels, the interest rate channel has weakened (Box 4). However, the CBA remains committed to inflation targeting and its chosen operational instrument, the policy rate. To reinforce the transmission mechanism, the CBA has launched several dedollarization measures, including through changes in the currency structure of reserve requirements, financial market development, and prudential regulations (MEFP, ¶¶11–12, 15).

28. Consistent with its inflation targeting framework, monetary policy should be geared toward a neutral stance in the short term. Staff agreed with the increase in the policy rate, now at 7¼ percent or 225 basis points higher than at the beginning of the year. However, recently the CBA has been implementing a monetary policy significantly tighter than the announced policy rate (MEFP, ¶10)—with the rates on the CBA’s actual repo operations and on the interbank market hovering closer to 12 percent. This has had the effect of weakening the signaling function of the announced policy rate. Staff considered the prevailing market rates too high given that inflation pressures do not appear to be present, and that overly tight liquidity conditions could hamper the economic recovery and result in unsustainably steering the exchange rate away from its fundamentals.


Interest Rates

(In percent)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: Armenian authorities.

A sound financial system is a cornerstone of the program

29. There was agreement on continuous efforts to safeguard financial stability. With increased dollarization and greater exchange rate flexibility, prudential regulations on foreign currency exposures are being strengthened (MEFP, ¶15, structural benchmark, June 2010). Comprehensive crisis preparedness and contingency planning continue to be improved with technical assistance from the Fund (MEFP, ¶16). In addition, the low level of financial intermediation requires further efforts to enhance financial deepening, encourage banking sector competition and improve functioning of financial markets. As credit growth picks up, continued attention should be paid to unhedged borrowers with loans in foreign exchange and cash flows in local currency. The authorities are requesting a full Financial Sector Assessment Program (FSAP) update to help identify strengths and vulnerabilities of the financial system and development needs to prioritize policy responses.


Credit Growth in CCA

(Year-on–year, in percent)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: REO estimates.

C. Sustained Growth and Poverty Reduction will Require Concerted Efforts

Wide-ranging structural reforms are essential to medium-term growth prospects

30. The business environment has experienced only limited improvements in some areas, and even backsliding in other areas (Figure 1). This has had an economic impact, as evidenced by the secular decline in Armenia’s market share in world’s exports. Corruption remains a deep concern, and public goods, including infrastructure, continue to be seriously under-provisioned given the systematically low tax collections. Moreover, high transport costs due to the fact that Armenia is a landlocked country with very limited transport routes call for significant improvements in competitiveness and the business environment. To this end, considerably simplifying and streamlining the tax regime, regulations and reporting requirements, strengthening standardization and certifications, breaking-up of monopolistic behavior, and stepping-up investments in transport infrastructure and information technology are all critical ingredients in addressing these longer-term challenges, including narrowing the external imbalances. With reforms in many of these areas being supported by Armenia’s donors, conditionality under the EFF/ECF program will focus on the tax administration and compliance areas.

Figure 1.
Figure 1.

Armenia: Structural Reform Progress

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: World Bank, EBRD, and World Economic Forum.1/ A lower score means greater competitiveness. The rankings are calculated from both publicly available data and the Executive Opinion Survey. Rankings are out of 134 and 133 countries in 2008/09 and 2009/10 respectively.2/ Rankings are out of 183 countries, with a lower score indicating greater ease of doing business.3/ A higher score means greater progress in transition.4/ 302 and 374 enterprises were surveyed in 2005 and 2009 respectively.

Share of Armenian Exports in the World

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and Fund staff estimates.

Strengthened efforts are needed to reduce poverty

31. Efforts regarding poverty reduction should return to center stage. In the third quarter of 2009, the year-over–year poverty rate increased to 24.6 percent from 21.7 percent in 2008, with extreme poverty increasing to 5.2 percent from 2.9 percent over the same period. While the targeting of social assistance programs has improved markedly, coverage has remained limited. The authorities are in the process of updating the Sustainable Development Plan (their PRSP), which will provide analytical underpinnings for the growth and poverty reduction strategy. In that context, the efficiency and targeting of education and health spending needs to be significantly improved. Thus, the authorities intend to implement an integrated system for the provision of social protection services (MEFP, ¶30), for which a government decree will be adopted (Structural benchmark, March 2011).


Poverty Rate

(In percent)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Sources: Armenian authorities; and the World Bank.

IV. Program Modalities

A. Access and Phasing

32. Armenia faces large and protracted balance of payment needs. Balance of payments gaps remain over the medium term, reflecting the structural distortions in the Armenian economy that the program aims to address. The current account deficit is expected to remain high over the medium term, with the nascent global economic recovery casting a shadow on Armenia’s exports and remittances inflows. On the capital and financial accounts side, the sharp drop in public disbursements from the exceptional heights of 2009 together with the large amortization falling due during the program period underscore the need for sufficient buffers. To prevent risks from materializing and facilitate the authorities’ adjustments efforts, staff estimates that an access of SDR 266.8 million (or 290 percent of quota), covering the period through June 2013 will be required. Access would be spread evenly over the period of the program. Armenia’s international reserves will decline over the next several years as the counterpart of the sizable foreign assistance in 2009–10 flows back out through the balance of payments. Thus, the proposed access under the program would allow international reserves to be stabilized at around 4 months of imports over the medium term. This level of reserves is appropriate for Armenia, given the volatility of flows in the balance of payments.

Armenia: External Financing Requirements and Sources, 2010–15

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

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

33. An EFF/ECF blend is the appropriate Fund financing instrument for Armenia’s circumstances. In addition to being an instrument better suited to Armenia’s medium-term challenges, the longer repayment period and lower interest charges (for the ECF portion) relative to the SBA will smooth out the bunching of debt service obligations due over the medium term.

34. The program is fully financed through June 2011. Given Armenia’s large current account deficits, its financing needs are substantial. The current account position is expected to adjust by 4 percent of GDP under the program. This adjustment is predicated on the implementation of policy measures under the Fund program, which are expected to slow import growth and stimulate exports. Overall balance of payments deficits will be financed through a moderate drawdown from central bank reserves, which had been buttressed by donor inflows in 2009–10. Financial support from key partners—the World Bank, the European Union, and the Asian Development Bank—is incorporated in program projections.

35. The new EFF/ECF-supported program will be monitored through semi-annual program reviews, with test dates for June and December. Conditionality is focused on achieving the program’s objectives, particularly unwinding domestic and external imbalances, promoting broad-based growth and poverty reduction, and safeguarding financial sector stability. The quantitative performance criteria for June and December 2010 are shown in Table 1 of the MEFP. The structural benchmarks through June 2011 are shown in Table 2 of the MEFP.

B. Risks to the Program

36. Armenia’s debt is expected to be sustainable in the medium term and its repayment capacity is good. Fund exposure is projected to peak at 10 percent of GDP in 2011. Total debt service to the Fund would reach 14.5 percent of total exports in 2013, or 3.2 percent of GDP. Armenia’s debt dynamics are in line with the assessment made at the time of the last review under the SBA (Appendix II), and Armenia’s debt risk rating remains low.

37. Nevertheless, the proposed program is subject to downside risks.

  • Unwinding the external imbalances is contingent on a three-pronged strategy: fiscal consolidation, exchange rate flexibility, and structural reforms. Were this strategy not to materialize, disorderly external adjustment could bring along real exchange rate depreciation that would leave external debt hard to service.

  • If the envisaged tax administration measures do not yield the projected additional tax effort, this would imply either larger-than–envisaged government financing needs—with negative implications for public debt dynamics—or alternatively, compression of expenditure on key development priorities.

  • If the turmoil in Europe deepens, this could affect demand for Armenian exports. Most importantly, were the Russian economy to be materially affected by developments in Europe, the consequences on remittances and exports could be significant.

38. The program contains elements to mitigate the above-mentioned risks. The resources made available under the ECF/EFF will help increase liquidity buffers at a time when current account deficits are large and prevent expectations of disorderly adjustment. In addition, the authorities are committed to further tightening monetary and fiscal policy, if necessary, to preserve macroeconomic stability and ensure fiscal consolidation. Prudent assumptions have been used for donor financing over the medium term. Were higher levels of grant or concessional financing to materialize, this would allow for greater development and social spending without jeopardizing Armenia’s fiscal and debt sustainability objectives. Finally, while tax administration reforms have proved difficult to implement in the past, there now appears to be a stronger political consensus to move forcefully in this area.

Armenia: The Effect of the On-lending Programs

A key measure in the authorities’ anti-crisis package has been to implement an on-lending program to the private sector, drawing on the loan from Russia. About half of the US$500 million loan from Russia has been on-lent to the private sector through different modalities, with the largest share going through the banking system. The policy drew on similar existing smaller scale lending programs from KfW and the World Bank.

The on-lending program appears to have played a significant, albeit not crucial, role in the recent recovery in overall bank credit. Overall banking credit to the private sector grew 18 percent from May 2009 until March 2010, more than offsetting the 6 percent fall that took place between November 2008 and May 2009. The increase in lending through the on-lending program windows accounts for only 37 percent of the total increase in credit. Interestingly, the program was rolled out as bank credit had started growing, which strongly suggests that there was limited substitution of existing credit.


Bank credit to private sector

(In mln dram at constant ER)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001


Bank Credit by Currency

(In mln dram, at constant ER)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

The on-lending program, however, appears to have provided a critical support to domestic currency lending. Foreign currency lending grew almost steadily throughout the crisis. However, domestic currency lending had fallen systematically and considerably since the beginning of the crisis, but started to increase shortly after the program was launched. Notably, the increase in lending since then has been roughly of the same magnitude of on-lending programs, suggesting that these have been instrumental to support this type of credit. Domestic currency lending had been limited by lack of funding given the sharp redollarization of portfolios amid macroeconomic uncertainty.

The on-lending credit appears to have been mostly directed to corporates, mainly in the industrial sector. While there is limited information about the sectoral distribution of the on-lending programs, data for overall credit show that consumer credit growth only contributed 10 percent to the increase in total credit. The largest contribution was to industry at 45 percent of the total increase.

Armenia: Government Social Spending Programs During and After the Crisis

In response to the global economic crisis, the Armenian government increased spending on social programs. These programs include social safety nets, such as the Family Benefit (FB) program, unemployment insurance, paid public works program, and pensions. The increase in social spending in 2009 was largely due to increases in pensions, as well as increases in other social programs, particularly the FB program and unemployment insurance. It is noteworthy that the share of the FB in total spending declined slightly owing to improved targeting of the program resources. The savings were used to provide benefits to the newly poor, and to increase allocations to other social assistance programs, such as unemployment benefits.

The 2010 budget accommodates further increases in social spending, although to a lesser extent compared to the increases observed in 2009. This largely reflects the fact that pensions will be maintained at the same nominal level of 2009, in anticipation of another planned increase in 2011. Similarly, the funds allocated to other social programs will remain broadly unchanged from their respective levels in 2009.

Going forward, the authorities intend to protect social spending. To this end, the Medium–Term Expenditure Framework envisages increases in social spending in 2011 and 2013 on account of planned increases in pensions in those years, while the funds allocated to the FB program and other social programs will be increased in 2011 and protected thereafter.

Government Social Programs

(In billions of drams)

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Government Social Programs

(In percent of total spending)

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Armenia: The Monetary Transmission Mechanism—New Evidence from a Regime Switching VAR Analysis

Developments in recent years, such as the adoption of inflation targeting in 2006 and reduced levels of dollarization between 2005 and 2008, changed the monetary transmission mechanism in Armenia. This result is obtained by estimating Markov-switching vector autoregressions (MSVAR), using monthly data for real GDP, the CPI, the repo rate, the money supply, and the nominal effective exchange rate as endogenous variables. Results from the simple MSVAR and threshold MSVAR, which uses the ratio of foreign currency deposits to total deposits to identify the regime switches, suggest that there was a change in the ability of monetary policy to influence economic activity around 2005–06.

Results show that Armenia’s transmission mechanism strengthened after 2005–06. According to the simple MSVAR, the exchange rate remained highly significant in influencing inflation in both regimes. However, after the regime switch in 2006, the repo rate is more effective in influencing the exchange rate and therefore inflation. Regime-dependent impulse response functions from the threshold MSVAR also support this result. Under the low dollarization regime, corresponding to the period between 2005 and 2008, the repo rate has a stronger impact on both output and inflation. However, its impact on inflation remains insignificant compared to the impact of the exchange rate, reflecting Armenia’s low levels of monetization and financial intermediation and nascent inflation targeting framework.

The return to high dollarization in 2009 implies another change in regime, signifying the weakening of the interest rate channel. To maintain the credibility of the inflation targeting framework, the central bank will have to more effectively manage inflation expectations by enhancing the signaling effect of the policy rate, communicating more precisely if and when the CBA relies on other operating targets, and by intensifying efforts to reduce dollarization levels, including limiting asymmetric interventions.


Ratio of Foreign Currency Deposits to Total Deposits

(In percent)

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

Source: Armenian authorities

Response of Real GDP Growth to a Repo Shock

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

The IRFs are drawn with 95% standard error bands.Source: Fund staff estimates.

Response of Inflation to a Repo Shock

Citation: IMF Staff Country Reports 2010, 223; 10.5089/9781455204571.002.A001

The IRFs are drawn with 95% standard error bands.Source: Fund staff estimates.
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–Q2 is explained by government lending to the economy through commercial banks.

Table 4.

Armenia: Financial Soundness Indicators for the Banking Sector, 2005–10

(In percent, unless otherwise indicated)

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Source: Central Bank of Armenia.