Abstract
This paper discusses Armenia's Second Review Under the Extended Arrangement and Request for Waivers of Nonobservance and Rephasing. Since late 2014, Armenia's economic performance has been affected by significantly weaker external conditions, as the slowdown of the Russian economy, the weakening of the ruble, lower metals prices, and the strengthening of the dollar have led to pressures on external receipts, particularly remittances. Performance under the program has come under strain. Three performance criteria (PCs) were missed both at end-December 2014 and end-June 2015. The authorities are requesting waivers of nonobservance for the missed June and continuous PCs. The IMF staff supports completion of the review.
Mr. Snel and Ms. Hubic submitted the following statement:
The Armenian authorities would like to thank the IMF team, headed by Mr. Mark Horton, for the constructive dialogue and valuable advice in recent years. The authorities broadly agree with staff’s assessment and policy recommendations provided in the report. The program’s objectives to foster strong economic growth, reduce fiscal and external vulnerability, and preserve macroeconomic and financial stability remain the authorities’ priorities.
Recent economic developments and outlook
Economic growth in recent years has been subdued to around 3.5 percent of GDP. Moreover, in late 2014 and 2015, the economic performance has particularly been affected by weaker external conditions, including the slowdown in Russia, ruble depreciation and lower copper prices. Remittances have declined sharply. Domestic conditions have also somewhat weakened. On a more positive front, favorable weather and strong agricultural output (following significant greenhouse investments), along with the opening of a new copper mine, have contributed to a positive growth in 2015. Unfortunately, this growth was not reflected in government revenue, which is expected to decrease, as some sectors that contributed to growth are exempt from taxes. In 2014, the fiscal deficit registered 2.1 percent of GDP, and is expected to increase to around 4 percent of GDP in 2015. This will increase financing needs and bring public debt close to 50 percent of GDP. The external current account adjusted significantly in 2015, and recorded a deficit of 4.9 percent of GDP, down from 7.3 in 2014. This positive adjustment is explained by the dram depreciation, lower remittances and hydrocarbon prices and volumes. The outlook remains challenging as the economic performance is closely linked to still turbulent/weak external conditions.
Public finances
After a successful fiscal consolidation in period 2011-2013, the weak internal and external conditions, together with some policy changes, have put significant pressure on public finances. This resulted in a higher than projected budget deficit in 2014 and 2015, −2.1 and −3.9 percent of GDP, respectively, and in an increasing level of public debt.
The authorities emphasize that meeting the 2015 budget target of 2.3 percent of GDP has proven difficult, since the budget implementation was aimed at supporting the weak economic activity. The budget was based on a relatively optimistic growth forecast, and revenue shortfalls were experienced due to both weaker activity and some policy changes. The expected transfers from the Eurasian Economic Union (EEU) customs pool have also been smaller than expected, due to a contraction of EEU imports this year. The expenditures were somewhat higher than budgeted mostly due to better execution of the previously approved financing programs from international financial institutions (e.g. on roads, on school modernization, and defense procurement).
The authorities consider the strengthening of debt sustainability a top priority and therefore aim to start consolidating the budget in 2016, with some further consolidation during 2017-2018, while continuing to address social and capital investment needs. This consolidation will be achieved by combining revenue measures and expenditure restraints.
On the revenue side, among other numerous measures, the authorities decided to adjust excise tax rates and to broaden the tax base by eliminating exemptions and gaps –measures expected to have a low impact on growth. On October 29, the National Assembly approved an increase of excise tax rates on gasoline and diesel fuel, vodka and cigarettes, and a new excise tax on compressed natural gas, expected to generate additional revenues in 2016. In order to bring excise tax rates in line with rates in other EEU member states, more tax rate increases are planned for 2017 and beyond. The Armenian authorities stand ready to take additional measures to offset revenue shortfalls.
Also, in order to address long-standing tax policy and revenue administration issues, the authorities have drafted a new tax code. The new tax code envisages a shift to greater taxation of consumption, a reduction of tax expenditures by reducing non-targeted VAT and income tax exemptions and incentives. Its draft version has been published for public comments in October. At the request of the government, a Fund TA mission will take place end of November 2015. A final proposed code will be submitted to the National Assembly early 2016.
On the expenditure side, the authorities will continue to improve the investment budget execution. Several important capital projects are moving ahead, including the vital ‘North South’ and M6 highways.
Notwithstanding recent progress, the poverty rate remains high, and the authorities continue to place importance on poverty reduction and targeted social spending. Social spending was increased by around 11 percent in the 2015 budget compared to the 2014 budget outturn. The difficult budget situation described above is likely to reflect on current spending in the coming years. However, the authorities aim to at least maintain the level of expenditures under the social programs, and if possible, even increase it.
Monetary and exchange rate policies
The Central Bank of Armenia (CBA) continues to implement monetary policy within an inflation-targeting framework with exchange-rate flexibility. The monetary and foreign exchange market decisive policy actions taken in 2014 and 2015 aimed to mitigate excessive volatility, reduce risks to inflation and preserve financial stability. While the CBA was mindful that its Q1 2015 intervention exceeded the foreign exchange sales envisaged in its December understanding with Fund staff, it considered that a larger intervention was needed to prevent disorderly adjustment. Since then, the external position has improved and the foreign exchange market has largely stabilized. The exchange rate continues to move according to fundamentals and supports the external adjustment.
The CBA believes that its exchange rate should not be related to non-floating regime. During the last 12 months the dram depreciated by 15 percent and there were more than 2 percent intraweek depreciations and appreciations. Therefore, the CBA does not share the staff’s view that it is leaning against the wind.
According to the CBA, the dram is at an adequate level. Going forward, the CBA’s policy is to mitigate excessive, transitory exchange rate pressures, while allowing the dram to respond to structural changes in both directions. If unexpected strong and sustained pressures emerge, the CBA will allow the dram to move to a new equilibrium level, with limited interventions to smooth excessive fluctuations.
Despite a decrease of foreign reserves following recent policy actions, the level remains above adequacy benchmarks. In this regard, the CBA continues to place high importance on enhancing reserve buffers, and stands ready to build reserves without affecting general market trends when market conditions provide the opportunity. The authorities remain confident that their policies will help in gradually reducing dollarization of savings, thereby providing an additional opportunity to acquire reserves.
The CBA remains committed to continue with strengthening the operational framework for monetary policy. As uncertainties remain high, it believes that a transparent and active communication with the financial sector, the business community and the public, both in terms of explaining ongoing developments and assessing forward-looking prospects and risks through regular press conferences and other mass-market channels will help in providing more guidance on policy actions and ensure that inflation stays within the target range. The CBA has finalized rules for an interbank money market for one- and seven-day collateralized instruments, which will play a key role in Armenian monetary infrastructure once the market develops. The CBA is also assessing mechanisms for bank rating to help clarify risks.
In the context of strengthening the CBAs independence and operations, as part of the constitutional referendum, the National Assembly is set to approve legal changes that will strengthen the CBA’s mandate to pursue financial stability and the process for appointing CBA Board members. In the same context, the CBA decided that it will divest ownership of the Pan-Armenian Bank, a development bank established in 2009.
Financial sector
Improving resilience to shocks and ensuring further financial deepening remain at the core of financial sector policies. The current environment is accelerating this process. Given the strains that the current environment is placing on local banks, the CBA is implementing measures to strengthen the banking sector’s resilience and efficiency. Effective January 1, 2017, a minimum capital requirement will be raised six-fold to increase capital buffers and efficiency and enhance banking services via greater economies of scale. Some banks have already increased capital, while others are raising funding or considering mergers. The CBA continues to strengthen safety nets and improve strategic risk management by requiring banks to prepare contingency plans. Additional steps have also been taken to improve and enhance the CBA’s stress testing framework, including continuous assessment of adequacy of key stress testing parameters and development of new scenarios based on alternative default probabilities and macroeconomic assumptions. Also, in line with the Basel III guidance for transitioning to a risk-based supervision framework, the CBA has adopted the methodology on systemically important domestic banking institutions, with additional supervisory resources being devoted to these institutions.
Structural reforms
Although challenges on the structural front remain numerous, progress has been made in several areas. A fiscal risk assessment division was established at the Ministry of Finance, a taxpayer compliance program was prepared and an action plan to enhance tax compliance in selected sectors was completed. In addition, a policy paper on CBA liquidity and reserve management was completed, and legislation was prepared to improve the bankruptcy process. Given that the current developments might affect not only the short-term outlook but also the potential growth, the authorities decided to step up their capital spending (within the limit of available budget), but also to implement more firmly the comprehensive reforms set out in the Armenian Development Strategy.
On energy sector, the authorities are aware that the sector is going through some challenging times. In particular, the local energy companies have experienced financial pressures, due to the depreciation of the dram, slowing growth, lags in tariff adjustment and short-term borrowing. To mitigate short-term impacts, the authorities adjusted tariffs and negotiated with Russia and Gazprom lower gas prices. A decision to increase electricity tariffs was followed by public protests. Consequently, the authorities suspended the application of the higher tariffs for households and SMEs, pending completion of the external audit. The latter upheld the authorities’ initial decision to increase tariffs. However, given the financial hardships of the year, the authorities decided to temporarily continue financing tariff differentials for one year, for a strict maximum of US$12 million.
The flagship pension reform is progressing well. A significant number of workers have enrolled since the revised pension law was approved in 2014. To further support the implementation of the reform, the authorities have issued an action plan with technical and policy measures, and aim to strengthen their outreach campaign in the coming months (e.g. with TV commercials, the internet, information hotlines….). Also, the 2016 budget includes funding for the Pension System Awareness Center and the outreach campaign.
The authorities continue to improve competition and the business environment. Armenia has improved its rankings from 2015 by 3 points and ranks 35th of 189 countries in the World Bank’s 2016 Doing business ranking, the highest among EEU members. Recently, the authorities introduced collateral and bankruptcy reforms and SME action plans, and continued with regulatory streamlining and civil aviation reforms.
Other issues
On January 2, 2015, Armenia joined the Eurasian Economic Union. Although the current economic turbulences in the region deter the immediate benefits, the authorities expect that the Armenian EEU membership will create significant economic opportunities, including lower import prices for energy, and enhanced access for Armenian exports through the removal of customs and non-trade barriers. The authorities also expect that this membership will help mobilize new external financing for important infrastructure projects, including in energy, railroad and mobile networks, as well as improve prospects for FDI in other sectors.
The authorities remain strongly committed to further strengthening the relationship with the EU, and are working on a new framework agreement. To the extent possible, they intend to move forward with reforms aimed at harmonization with EU standards and institutions as long as these are compatible with their EEU membership. These reforms are expected to support the modernization of the economy and contribute to higher economic growth. The EU just received a new mandate from the Member States for further negotiations with Armenia. The authorities expect to continue cooperation under the Eastern Partnership Initiative and look forward to continued technical assistance and macro-financial support.
Concluding remarks
The worsening of external and domestic conditions led to some unfortunate delays in the second review of the program. Several performance criteria, agreed before this worsening, were missed. At the same time, the policy actions that have been taken have helped forestall a potentially disorderly adjustment and maintain stability. The Armenian authorities would like to reassure the Board that they remain committed to pursuing their long track record of sound and prudent macroeconomic policies, address challenges and reduce vulnerabilities through the steadfast implementation of complex policy measures included in the program and in this review.
In light of this delay, the authorities are requesting waivers of nonobservance for the missed June and continuous performance criteria. They also request that the remaining purchases under the arrangement be rephased, leaving two remaining purchases equivalent to SDR15.65 million, and subject to two reviews and SDR15.59 million subject to the last review. The arrangement will expire as planned in May 2017.
Lastly, the Armenian authorities would like to thank the Fund for the provided TA that continues to play a crucial role in supporting the reform agenda. They are looking forward to further broad TA support, which they view as indispensible for the achievement of their reform objectives.