This paper discusses Armenia's Third Review Under the Extended Arrangement, and Request for Waiver and Modification of Performance Criteria (PC). Growth in Armenia is expected to remain subdued as recession in Russia continues and as the base effects of the 2015 one-off factors dissipate. The program performance has been broadly satisfactory. All end-December 2015 PCs, except for the fiscal deficit PC, and all the continuous PCs were met. The fiscal deficit PC was missed by 0.3 percent of GDP. The IMF staff supports completion of the review and the authorities' request for a purchase in an amount equivalent to SDR 15.65 million.
Mr. Snel and Ms. Hubic submitted the following statement:
The Armenian authorities would like to thank the IMF team, headed by Mr. Hossein Samiei, for the constructive dialogue and valuable advice during their mission in Yerevan. The authorities broadly agree with staff’s assessment and policy recommendations provided in the report. The program implementation has improved and its 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
Since late 2014, the economic performance has been strongly affected by weaker external conditions, in particular due to the slowdown in Russia and lower copper prices. Remittances declined sharply, although recently, they have somewhat evened out. Domestic demand has also weakened, largely reflecting lower purchasing power and continued external uncertainty. Nevertheless, real GDP growth in 2015 was higher than expected, supported by fiscal policy and specific industrial developments. Also, favorable weather conditions have improved agricultural output. Unfortunately, this increase was not reflected in government revenue, which is expected to decrease in 2015 and 2016 - as some sectors that contributed to growth are exempt from taxes, and imports continue to decline. The external current account adjusted significantly in 2015, and recorded a deficit of 2.6 percent of GDP, down from 7.3 in 2014. This positive adjustment is explained by the dram depreciation, lower remittances and imports, and strong growth of real exports. Over the medium term, the current account deficit is expected to remain low at about 3 percent of GDP. The outlook remains challenging as the economic performance is closely linked to still turbulent/weak external conditions, and lower metal prices. On a more positive note, in the event of improved economic conditions in Iran with international sanctions being lifted, the Armenian economy could benefit via higher investment opportunities and increased tourism.
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 2015 and 2016, -4.8 and -4.1 percent of GDP respectively, and in an increase of public debt. The authorities had to take remedial fiscal actions, including some expansion of domestic lending programs and countercyclical capital spending. The budgetary lending was channeled mostly to support SMEs in agriculture and urban developments. Also, the implementation of important infrastructure projects improved markedly last year, including the execution of donor-financed projects delayed from previous years. The weak internal and external environment resulted in a revenue shortfall of about 1.5 percent of GDP compared to the adopted budget. All these elements led to the weakening of the fiscal positon in 2015.
Meeting the 2016 budget target of 3.5 percent of GDP has proven difficult, in an environment of below-potential growth and low inflation, fiscal policy remains contractionary as planned. The nominal GDP is estimated to be lower by 2.7 percent relative to the budget, with tax revenues now expected to be below the target by about 2 percent. In addition, foreign financed capital spending as well as budgetary lending will be increased, each by about 0.15 percent of GDP. This would lead to a projected fiscal deficit of about 4.1 percent to GDP in 2016, with a cyclically-adjusted deficit decrease by more than 1 percent of GDP compared to 2015.
The authorities consider strengthening the debt sustainability a top priority and therefore remain committed to pursuing medium-term fiscal consolidation, while continuing to address social and capital investment needs. This consolidation will be achieved by combining revenue increasing measures and improved expenditure efficiency. Also, to further strengthen the credibility of the program, the authorities will prioritize some of the planned revenue-enhancing measures in the new Tax Code. In addition, they will introduce revenue administration measures to boost tax collection.
In view of ensuring debt sustainability, the authorities have submitted to the National Assembly a draft Tax Code that consolidates the existing legislation, addresses a number of structural weaknesses in the current tax system by reducing exemptions and increasing coverage, and generates additional revenue in the medium term. This new Tax Code is expected to be approved by the end of year and the authorities estimate it will increase the tax-to-GDP ratio by 2 percentage points by 2021. Improved administration is also expected to further increase the revenue collection. The authorities would also like to emphasize that tax policy measures will be complemented by tax administration measures by increasing the transparency and efficiency of the tax system, reducing compliance costs and supporting revenue collection.
Notwithstanding the recent progress, the poverty rate remains high. The authorities continue to put poverty reduction and a strengthened and targeted social spending high on their agenda. Unfortunately, the consolidation needs in the coming years will make it difficult to expand the current expenditure envelope, and the authorities’ efforts will be mainly focused on increasing the efficiency and quality of spending. The authorities aim to at least maintain the level of expenditures under the social programs. Support could increase if more fiscal space becomes available through a better revenue outlook.
The flagship pension reform is progressing well. About 140,000 workers have enrolled since the revised pension law was approved in 2014. In line with their action plan -aiming to further support the implementation of the report- the authorities have, inter alia, increased the outreach campaign through TV commercials, printed materials and direct education campaigns. They will continue to increase awareness and make preparations for the expansion of the reform in July 2018 when participation will become mandatory for all workers covered by the law. The 2017 Budget will maintain funding for this purpose.
The authorities are making progress toward introduction of program budgeting. They prepared a plan to start fully-fledged program budgeting in the 2019 budget, including appropriations by individual programs. They will also continue to address the recent TA mission’s suggestions about enhancing the comprehensiveness, clarity, timing and sequencing of the plan.
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. Tightening of monetary policy in December 2014, and foreign exchange market decisions of last year, have ensured that inflation remains under control and that financial stability is preserved. More recently, the inflation has turned slightly negative. With an objective to bring it closer to the CBA’s target in the next three-year horizon, the CBA reduced its refinancing rate by 2.5 pp to 7.75 since Q4 2015. It will look to further easing of monetary conditions, as expected economic developments unfold and no additional risks emerge in external and domestic sectors.
The exchange rate remains relatively stable as imports have fallen further and the volume of transactions in the FX market has declined. The CBA emphasizes that maintaining a flexible exchange rate regime and strengthening external reserve buffers remain key policy objectives. Given the significant narrowing of the current account deficit in 2015 and early 2016, it considers that the dram is close to its equilibrium level. Going forward, the CBA’s policy will be to mitigate excessive, transitory exchange rate pressures, while allowing the dram to respond to structural changes in both directions. Consistent with this approach, the CBA expects its external reserve buffers to strengthen in the coming months.
The CBA is taking important steps to build a coherent and coordinated policy framework that will integrate the two main objectives of price and financial stability. With these two objectives, it will continue to develop its analytical framework and capacity to improve policy judgement, focusing on developing an internal operational financial stability index, introducing a financial sector module into the CBA’s macroeconomic model, as well as enhancing coordination between relevant departments. In this context, we take this opportunity to seek technical assistance from the Fund to integrate the two mandates, and this building on the assistance already received from the Fund’s research department.
In line with an agreement with the Fund, as of the June 2016 test date, the NDA performance criterion will be replaced by a monetary policy consultation clause based on the agreed quarterly inflation path within the +-1.5pp tolerance range. The MPCC would be better aligned with the CBA inflation targeting framework.
Improving resilience to shocks and ensuring further financial deepening remain at the core of financial sector policies. Given the strains that the current environment is placing on local banks, the CBA is implementing measures to consolidate and strengthen the banking sector’s resilience and efficiency. On January 1, 2017, a new minimum capital requirement will become effective. The objective of this new requirement is to increase capital buffers and efficiency and enhance banking services via greater economies of scale. Some banks have already fulfilled this new requirement – either by increasing their capital levels or through a merger - while others continue their efforts. In order to ensure a smooth transition as well as to preserve financial stability, the CBA has requested banks that are not yet complying to present a revised strategy by end-June 2016 regarding their plans to achieve the required capital by January 1, 2017. Moreover, the CBA informed them that non-compliant banks will have their bank licenses revoked. The CBA stressed that it will not provide financial support, except in cases when such loans to banks are allowed under lender-of-last-resort or systemic provisions of CBA Law. Also, the CBA is conducting a viability analysis to ensure that only mergers and acquisitions that lead to stronger institutions and a sounder financial sector are permitted to take place. In addition, the CBA will prepare contingency plans to deal with banks that do not manage to comply with this new minimum capital requirement.
The CBA continues to improve its regulatory macroprudential framework with an objective to mitigate risks to bank balance sheets. In this regard, the CBA is preparing a draft supplement to the Law on Banks and Banking that would allow it to define additional capital charges for systemically important banking institutions and establish permissible thresholds above the ratio limits of the key prudential standards, in line with Basel III macroprudential requirements.
Also, the CBA is seeking to divest its shares in the PanArmenian Bank (PAB). As suggested by the IMF staff, by end-December 2016, the CBA will prepare a comprehensive plan for this full divestment. The investors will be asked to present solid business and funding plans for the PAB and would need to commit to purchase all CBA’s shares within a defined timeframe. The CBA will ensure that the PAB continues to meet prudential requirements at par with international best practices. In order to ensure that the debt remains under control during the period in which the CBA remains a shareholder, any debt issuance by the PAB will need to be submitted to and approved by the CBA, and in consultation with IMF staff.
Although challenges on the structural front remain numerous, progress has been made in several areas, namely: adoption of a comprehensive plan to strengthen the financial position of Armenia’s energy sector, submission to the National Assembly of a new Tax Code, expansion of connectivity with the rest of the world through the open skies policy, strengthening of regional integration through the accession to the Eurasian Economic Union (EEU), and strengthening of policies to foster domestic competition. In other words, the focus of the authorities’ plans is, on the one hand, on reforming the energy sector and related public enterprises, and on the other hand, on strengthening public revenue, improving the business environment and making the economy more competitive and integrated.
The energy 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. For this reason, the authorities decided to put a specific and immediate focus on this sector. As a first step in this process, they hired in late-2015 an international audit firm to review the most recent tariff settings decision. The audit upheld the decision on electricity tariff increase taken last summer by the Public Sector Regulatory Commission (PSRC). In February, the government passed a government decree outlining a program for the financial strengthening of the state companies involved in the country’s energy sector. This program includes refinancing high-interest commercial short term debt owed by state companies with lower-interest and longer term debts with the WB and eliminates expenditures of state companies outside their core business. In the coming months, the PSRC will be conducting a revision of current electricity tariffs and the government will halt the payment of the temporary electricity subsidy introduced in the second semester of 2015. The government will also advance the resolution of other state companies. Throughout this process, the public sector will not absorb losses or liabilities or make payments on behalf of utility companies, and the budgetary spending on Nairit will be limited on maintaining the public safety of the industrial site. In this regard, the government plans to decommission the Nairit chemical plant within one year.
The authorities continue to improve domestic 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 Report, the highest among EEU members. They are introducing legislative changes to support domestic competition and improved bankruptcy procedures, while at the same time continuing to support streamlining business procedures via the Regulatory Guillotine initiative and regulatory impact assessments. They also continue to work on civil aviation reforms.
The Armenian authorities would like to thank the Fund for the 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 indispensable to achieve the reform objectives.