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 staff’s assessment and recommendations in the report. They recognize that strengthening the fiscal position, modernizing the fiscal framework, improving the business environment and reducing poverty are among the main challenges they face ahead. Progress along these fronts and improvement of the external conditions will pave the way for putting the Armenian economy on a viable growth path.

Program performance since the previous review was satisfactory, and all quantitative performance criteria, indicative targets and structural benchmarks were met. In particular, the authorities have established a mechanism to strengthen the monitoring and prioritizing of foreign-financed capital projects (December 2016 SB) and built a centralized database of all ongoing, planned, and pledged projects (March 2017 SB); the 2017 budget secured funding for the Pension System Awareness Center (December 2016 SB), and the CBA has prepared a plan for the divestment of PanArmenian Bank (December 2016 SB).

Economic Activity

Economic recovery is underway, but the economy remains vulnerable to external shocks.

With exports accounting for 30 percent of GDP and domestic consumption relying heavily on remittances income, external conditions play a major role in the performance of the Armenian economy. In 2016 remittances inflow fell 6.9 percent (in dollar terms) relative to 2015, and by 34.3 percent relative to 2014 prior to the external shock. Remittances are a significant source of income that finance domestic consumption (12.6 percent of GDP in 2016). In 2016 the economy grew by only 0.2 percent, reflecting weak domestic consumption and investment demand due to low remittances and low international copper prices. As a result, deflationary pressures persisted with CPI inflation at −1.1 percent in 2016. Nevertheless, the external balance remained robust, with a current account deficit of 2.7 percent of GDP, due to lower import demand and diversification efforts and one-off factors supporting exports. Against this subdued economic environment, the fiscal deficit widened to 5.6 percent in 2016, and the CBA continued to ease monetary conditions.

Going forward, the authorities and staff expect economic activity to accelerate in 2017. This is already reflected in the recovery of the economic activity index since late 2016 and in better-than-expected tax revenues since the beginning in 2017. In addition, exports have continued growing and remittances appear to be picking up. Headline CPI inflation turned positive and reached 1.5 percent yoy in May. Rising copper price and a better economic outlook in major trading partners, especially Russia, also support the positive outlook.

Fiscal Policy

In 2017 a debt-brake mechanism was activated, imposing sharp fiscal consolidation measures. The fiscal framework is now reevaluated with the support of an IMF TA.

Lower-than expected tax revenues and countercyclical over-execution of foreign-financed capital expenditures have led to widening of the fiscal deficit to 5.6 percent of GDP in 2016, relative to the (revised) program target of 5.9 percent of GDP. This brought the general government debt over 50 percent of GDP and activated the debt-brake mechanism. The Law on Public Debt prevents general government debt from exceeding 60 percent of GDP, and once the debt ratio reaches 50 percent a braking mechanism limits the fiscal deficit in the following year to three percent of the average GDP in the previous three years. Accordingly, the 2017 budget envisages a substantial fiscal consolidation with a target deficit of 2.8 percent of 2017 GDP.

With already thin public expenditures, to meet the consolidation requirements the authorities have initiated a substantial reduction in foreign-financed capital expenditure. They have also introduced a moratorium on signing new foreign-financed projects and entered discussions with donors on the scope to postpone or restructure some projects. Nevertheless, overperformance in tax collection since the beginning of the year (around 0.25 percent of GDP in the first quarter) may allow for milder cuts in capital expenditure. The favorable revenue performance is due to efforts by the State Revenue Committee aimed to improve tax administration and target the informal sector, and improved economic activity. The authorities now estimate overperformance of tax collection for the year to reach 1 percent of GDP. This allows raising the level of foreign-financed capital expenditure already in the pipeline, while complying with the target deficit. Nevertheless, the authorities recognize the downside risks for their estimate of tax revenues and stand ready to scale down expenditure in case adverse risks materialize.

While being constrained by the Law on Public Debt, the authorities agree with staff that the implementation of the fiscal rule is overly contractionary at this conjunction. From legislative perspective, the current fiscal framework relies only on a debt ceiling, which is quite a unique arrangement in the international landscape.¹ We note that such a framework does not provide a useful anchor when debt is sufficiently below the ceiling and, as indicated by staff, is likely to bind when economic activity is weak, resulting in a procyclical bias – as experienced in the current episode. This may therefore aggravate the economic downturn and thereby undermine the credibility of the fiscal framework. The authorities are currently being assisted by an IMF TA to revise and modernize their fiscal rule and strengthen the credibility of the fiscal framework. Their objective is to send a draft of a new fiscal rule to the National Assembly by October 2017 alongside the draft budget for 2018.

Monetary and Financial Sector Policies

The CBA balances monetary expansion to increase inflation and financial stability considerations.

Since the last review, the CBA has continued to cut the policy interest rate gradually in order to ease monetary conditions in face of subdued economic activity, low inflation rate and fiscal consolidation headwinds. In mid-February, the CBA’s governing board cut the policy rate by additional 0.25 percentage points to 6.0 percent, the lowest level in seven years. While inflation (1.5 percent YoY in May) is still below the target (4 percent), it has pick-up relatively fast from negative territory and economic activity has been stronger than expected since the beginning of 2017. Against this background, the CBA is evaluating the impact of the recent rate cuts and policy actions, and stands ready to adjust monetary conditions as needed to ensure that the inflation path remains on track. Furthermore, there is a concern that a too fast rate reduction would result in a rapid exchange rate depreciation and a fast rise in inflation expectations that would undermine long-term price stability and financial stability objectives and aggravate dollarization.

The authorities continue to ensure two-way flexibility of the exchange rate, while using limited intervention to smooth excessive fluctuations and to offset transitory pressures. Exchange rate flexibility is also important for improving the monetary policy transmission mechanism. Narrowing current account deficit and favorable external developments have created comfortable conditions for the CBA to rebuild its foreign reserves to $2.2 billion at end-2016 (5.2 months of 2017 projected imports), and reserves are now considered at an adequate level.

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 banking system is well capitalized, and while NPL ratio and banks’ profitability remain a challenge, both have been improving over the past year. High dollarization level is also a challenge for financial stability and effective monetary policy. To improve its monitoring and risk assessment practices and to ensure the soundness of the financial system, the CBA has requested a Financial Sector Assessment Program (FSAP) for 2018.

Structural Reforms

The authorities have made progress in promoting competition, improving Armenia’s integration in the global economy, fighting corruption, and strengthening the energy sector.

Improving the business environment is placed high on the authorities’ agenda and they are taking 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, move forward with the modernization of the nuclear power plant and explore 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 submitted amendments to the law on protection of economic competition to the National Assembly in late 2016, which are expected to be adopted by the end of this year.

The authorities continue to make progress on international integration by improving Armenia’s connectivity via “open skies” policy and through economic cooperation with its main trade partners, the EEU and the EU. The government has also recently established the Center for Strategic Initiatives, to encourage and analyze key reforms to attract FDI and to foster public-private partnerships.

Finally, to fight corruption the authorities have strengthened the law on procurement and improved substantially procurement transparency; they improved tax and customs administration; criminalized illicit enrichment and established a new investigatory approach to corruption crimes; the authorities have also developed legislative amendments to reduce cash transactions and tackle the shadow economy.

Conclusion

Armenia has made substantial progress under the EFF program: public financial management has improved through a review of lending operations and the strengthening of the monitoring system of foreign financed projects; a pension reform to enhance long-term fiscal sustainability is underway; a new tax code was adopted; progress has been made in legislation for promoting domestic competition and developing the financial markets; the CBA is in the process of incorporating financial stability considerations into the operational policy framework, and the inflation targeting regime has been strengthen.

Nevertheless, challenges remain, including a revision of the medium-term fiscal framework, reducing dollarization, further integration into the global economy and reducing poverty. The authorities greatly appreciate the long-lasting cooperation with the Fund and its valuable advice and are considering the possibility of a successor program. They look forward to initiating discussions on this matter later this year.