On behalf of the Armenian authorities we thank the IMF team, headed by Mr. Hossein Samiei, for the candid, constructive and friendly dialogue during their mission in Yerevan and for their valuable advice.

The authorities broadly agree with staffs assessment and recommendations in the report. They recognize that strengthening the fiscal position, improving the business environment, and harmonizing monetary and financial policies are among their main challenges. Progress along these policy fronts and improvement of the external conditions will pave the way for putting the Armenian economy on a viable growth path.

Program performance continues to improve, and all end-June and continuous performance criteria were met. Nevertheless, fiscal conditions remain fragile and the authorities request a modification of the end-December 2016 fiscal balance target. The expected deviation from the fiscal target performance criterion is a result of revenues shortfall due to weaker-than-expected economic conditions and capital expenditures (foreign-financed at concessional rates) that will support potential growth going forward. The program objectives — fostering strong economic growth, reducing fiscal and external vulnerabilities, and preserving macroeconomic and financial stability — remain the authorities' priorities.

Economic Activity and the External Sector

With exports accounting for nearly 30 percent of GDP and domestic consumption relying heavily on remittances income, the external conditions, especially in Russia, continue to play a major role in Armenia's economic performance. During the first half of 2016 remittances inflow fell by 13.4 percent (in dollar terms) relative to the same period a year ago, and by 41.1 percent relative to the first half of 2014 prior to the recession in Russia. Remittances are a significant source of income that finance domestic consumption. To give perspective of their magnitude, we note that during the first half of 2014 their value was equivalent to 19.5 percent of GDP, and that share declined to 12.3 percent during the first half of this year. As a result, households' consumption contracted for five consecutive quarters since the beginning of 2015 (in YoY terms to account for substantial seasonality). It finally started to stabilize during the second quarter of 2016. Exports, on the other hand, have been remarkably resilient with only a temporary dent at the beginning of 2015. As described by staff, geographical diversification, the opening of a new copper mine, and in 2016 also a rebound in exports to Russia, have helped to maintain a robust exports performance.

The weighing of external conditions is also evident in the composition of the CPI. While domestic demand is fragile, deflationary pressures are largely associated with the tradable sector. Headline CPI has declined by 0.9 percent in October (YoY) on the back of deflation in consumption goods (-2.1 percent YoY), while service prices have increased by 1.3 percent over the same period. While the latter is clearly lower than in previous years, reflecting the worsening of domestic economic conditions, these rates are indicative to the external roots of the economic weakness. We also note, albeit with caution, that headline CPI has recently started edging up, which could point to initial signs of some economic strengthening.

With resilient exports, stabilizing consumption and prices, accelerated execution of infrastructure projects alongside reforms to improve the business environment (as elaborated below), and projected recovery of the Russian economy (WEO), we see an accumulation of tailwinds that will certainly help to improve the economic environment.

Public Finances

Lower-than expected tax revenues and accelerated execution of capital expenditures have led to a widening of the fiscal deficit in 2016 relative to the projected level during the third review. Overall, the fiscal deficit in 2016 is expected to reach 5.9 percent of GDP. Nevertheless, going forward, fiscal consolidation in 2017 will be substantial and the current draft budget envisages a deficit of 2.8 percent of GDP.

The composition of growth in 2016, with stronger exports and subdued consumption, has significantly impacted tax revenues, which are expected to fall short by approximately one percent of GDP relative to the estimates during the third review. To partially offset the effect on the deficit, the government identified potential savings in current expenditure of about 0.2 percent of GDP. The authorities also take structural measures to augment their tax policy and increase revenues. After three years of preparations the National Assembly has recently approved the new Tax Code. The new Tax Code reduces tax distortions, closes previous loopholes, improves progressiveness, broadens the tax base, and reduces compliance costs. It is expected to raise the tax collection by 2 percent of GDP by 2021, with the largest revenue increase in 2018-19. The authorities are committed to the full implementation of the Tax Code, and in addition, they take revenue administration measures to improve compliance and reduce tax evasion.

Over-execution of capital spending is also expected to contribute about 1 percent of GDP to the fiscal deficit this year. With the resolution of technical and legal obstacles that previously delayed the implementation of some large foreign-financed infrastructure projects, the authorities are pushing forward with their implementation. We note that these projects are foreign-financed at concessional rates, thereby putting limited crowding out pressures on other investment opportunities. In addition, due to previous delays, the authorities are urged by their IFIs partners to catch-up with the implementation of these projects. Moreover, at this juncture, we see the execution of infrastructure projects as a counter-cyclical support to the economy that will also boost potential growth. We note that given the long-term nature of the investment projects, the exact timing of the expenditure (e.g. end-2016 or early-2017), while having implications for the size of the deficit in the current year and on meeting the end-December performance criterion, has little economic significance. That said, the authorities are taking steps to ensure that execution remains within the budget, including the enhancement of program monitoring and closure of project implementation offices to increase efficiency, they also suspend engagement in new foreign-financed projects.

Going forward, a debt-brake mechanism will go into effect in 2017 regardless of the program conditionality. The Law on Public Debt prevents general government debt from exceeding 60 percent of GDP, and once the debt ratio reaches 50 percent, as expected by end-2016, a braking mechanism is triggered. This mechanism limits the fiscal deficit in the following year to three

percent of the average GDP for the previous three years. The draft budget for 2017 already entails significant consolidation measures with a deficit target of 2.8 percent of GDP.

Monetary and Exchange Rate Policy

Since the last review, the CBA has continued to gradually cut the policy interest rate in order to ease monetary conditions in the face of subdued economic activity, negative inflation rate, and the expected cut in public spending. In mid-November, the CBA's governing board cut the policy rate by an additional 0.25 percentage point to 6.5 percent, the lowest level in more than five years. Moreover, the reserve requirement against FX deposits (held in drams) was reduced, which is also expected to ease monetary conditions as it adds liquidity to the market. Nevertheless, the CBA notes that mainly supply factors weigh on economic activity. Therefore, and given the continuous easing cycle during the last two years, the economic slowdown does not necessarily imply excess supply and further rate cuts. We note that this view is also consistent with the composition of the CPI pointing to mainly imported deflation, as discussed above. As such, the authorities stress that future policy decisions remain, as always, data-dependent. For this reason, they are somewhat uncomfortable with the implied forward guidance for additional monetary easing as expressed in the staff report.

The authorities continue to ensure a two-way flexibility of the exchange rate. Narrowing current account deficit and favorable seasonal developments have created comfortable conditions for the CBA to rebuild its foreign reserves, and net purchases in the second and third quarters have exceeded the net sales made in the first quarter. Gross foreign reserves have increased around 22 percent since end-2014, when they were put under pressure due to a major external shock. Reserves are now estimated to cover five months of next year imports and are considered adequate. The authorities also consider the dram exchange rate to be close to its equilibrium level, and they are committed to maintaining a floating exchange rate regime, while standing ready to deploy limited interventions to smooth excessive exchange rate fluctuations. Exchange rate flexibility will also play an important role in helping to improve the transmission mechanism of monetary policy.

Finally, the CBA is taking steps to build a coherent and coordinated policy framework that will integrate its dual mandate of price and financial stability. The CBA envisages a framework which incorporates the interlinkages of monetary policy and financial stability, given the high level of financial dollarization, both during normal and crisis times. Furthermore, this will strengthen policy communication, which the CBA recognizes as one of its main policy tools. With the help of an IMF TA (conditional on financing), the CBA continues to develop its analytical tools, improve the incorporation of judgement in its policy decisions, and enhance coordination between relevant departments.

Structural Reforms

Improving the business environment is high on the new government's agenda and it takes directed measures to strengthen identified areas of weakness. Specifically, the authorities continue to strengthen the electricity sector by encouraging greater involvement of the private sector, strengthening the financial soundness of the sector, moving forward with the modernization of the nuclear power plant and exploring options for building new thermal power plants to replace maturing facilities. These measures will improve supply reliability and reduce electricity costs. To improve competition and regulatory framework, the authorities have prepared amendments to the law on economic competition protection to strengthen the antitrust framework, and the National Assembly has already approved amendments to the bankruptcy law. On international integration, the authorities continue to make progress with improving Armenia's connectivity via the "open skies" policy and the economic cooperation with its main trade partners, the EEU and the EU. In particular, negotiations of a trade treaty with the EU is ongoing. Finally, we note that in other areas, like starting a business and registering property, Armenia is ranked quite high — at or close to the top ten — in the World Bank's doing business indicators.