Statement by Age Bakker, Executive Director, and Grigor Sargsyan, Advisor 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.

Abstract

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.

June 28, 2010

Armenia continues to gradually recover from the deep global downturn and economic recession. This could not have been achieved without timely support from the Fund through a Stand-By Arrangement with exceptional access, and the authorities want to thank Executive Directors and management for their continued support, and staff for their frank and constructive dialogue.

The SBA succeeded in maintaining overall macroeconomic and financial stability, mitigating the impact of the crisis on the poor, and providing the authorities breathing space to implement structural reforms that will secure long-term sustainability. In light of the positive signs of economic recovery in the first few months of this year, both staff and the authorities have revised upward their estimate of output growth to 4–5 percent from around 2 percent at the time of the last review under the SBA. Nevertheless, the authorities see no room for complacency and believe that the main challenges still lay ahead, notably the higher level of public debt, the increased poverty and vulnerabilities in the balance of payments.

To help address these challenges the authorities request a blend of three-year ECF and EFF programs and cancellation of the current SBA. The proposed program, which would help restore fiscal and external sustainability, preserve financial stability, and support growth, represents a strengthening of policies with respect to the SBA, notably through a faster adjustment in the balance of payments and public finances, and deeper structural reforms.

Armenia has a good track record of following Fund advice and has been a good performer under all engagements with the IMF. It is worth mentioning that Armenia, which was considered a heavily indebted country only a decade ago, managed to significantly reduce its debt by consistently implementing prudent and sound economic policies, without any debt restructuring or forgiveness.

Monetary and Exchange Rate Policy

The Central Bank of Armenia (CBA) continues to pursue inflation targeting with the interest rate as the main instrument to control liquidity in the market. In the wake of rising inflation earlier this year the CBA increased its refinancing rate by 225 bp, which helped contain inflationary pressures. Year-on–year inflation decreased to 6.3 percent in May. However, the authorities remain concerned by the weak monetary transmission mechanism because of increased dollarization. To overcome this problem the authorities introduced several dedollarization measures. Particularly, the banks are now required to maintain a fraction of the reserve requirements on foreign currency deposits in Armenian drams, with an intention to increase this fraction in the future. In addition, to increase the intermediary role of financial markets and thereby increase demand for the national currency, the authorities successfully introduced an overnight interest rate trading platform. Longer maturity money market instruments will be introduced to help develop a secondary market.

In order to address the vulnerabilities in the current account the authorities recognize that exchange rate flexibility must be maintained to sustain competitiveness and allow external adjustment. The CBA continues to adhere to its strategy of intervening in the market only to smooth sharp fluctuations. Recently, there have been some appreciation pressures, and consistent with the CBA’s intervention guidelines, the CBA has purchased foreign exchange in the market, while allowing the dram to appreciate. This helps ensure that interventions will not signal any direction to market participants on the desired path or level of the exchange rate.

Financial Sector

The Armenian banking system remains sound and strong. On the whole, it managed to weather the impact of the financial crisis very well. The level of non-performing loans, which had sharply increased during the crisis, gradually started coming down this year. Concerns regarding two banks were addressed decisively by the CBA, as these banks had to recapitalize themselves on a timely basis, thereby reducing the possible emergence of systemic risks. Recent stress tests show that the sector overall remains resilient.

The CBA, which is also the supervisory body of the banking system, has introduced several prudential measures to discourage banks from taking large foreign exchange positions. Specifically, the new regulation imposes higher risk weights for FX loans, and by August 2010 a new limit on net open FX positions of 7 percent of capital will be in force. Overall, these measures also help to bring down the level of dollarization, which has remained the main source of potential risk to the stability of the banking system.

Fiscal Policy and Tax Administration

As the economy recovering, the authorities have embarked on strong fiscal consolidation. The reduction in the budget deficit will be mainly achieved by saving higher revenues, with nominal expenditures maintained as budgeted. Progress in the tax administration is forecast to increase revenues by 0.5 percent of GDP for 2010, with another cumulative 1.2 percent improvement in 2011–2013. Should the revenue collection for 2010 be higher than envisaged in the budget, the authorities are planning to save half of the extra revenues. If on the other hand another deterioration of the global economy would drag down the domestic economy, the authorities have planned contingency measures to cut spending in order to maintain the programmed deficit of 4.8 percent of GDP for 2010.

The authorities fully recognize the need for tax reforms in order to sustain high revenue collection in the long-term and ultimately create more fiscal space. These include not only policy but also administrative measures. Building on efforts to extend best practices in the VAT refund system, broaden the tax base by increasing the number of large taxpayers, and increase e-filing, further work is ongoing to increase the accountability of the State Revenue Committee. This should help boost tax compliance and thus revenue collection, while providing much-needed enhancements to the business environment. The authorities are very much committed to implementing the structural benchmarks in this area as set out in the LOI.

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.
Author: International Monetary Fund