Pre-COVID 2019 Shock: Strong Macroeconomic and Program Performance

The Armenian economy was growing at a strong pace, supported by sound macroeconomic and financial policies, when it was hit by the global COVID-19 shock. In 2019, economic growth was exceptionally strong at 7.6%, by far surpassing the expectations, and the highest recorded growth since 2007. On the back of more favorable labor conditions, the unemployment, while remaining high, decreased substantially, and poverty continued to fall. Owing to significant tax revenue overperformance and lower than budgeted capital spending, the fiscal deficit declined to 1.0 percent of GDP, well below the 2019 budget target of 2.2 percent. This helped reduce the central government debt to the medium-term objective of 50 percent of GDP. Inflation remained subdued in 2019, moderately rebounding to 0.9 percent in April 2020. The lower-than-expected inflation prompted the CBA to reduce the policy rate twice during 2019, by 0.25 percentage point each time. The financial system remained well-capitalized, liquid and stable. The external position strengthened, and international reserves increased substantially, remaining broadly adequate. Against this background, Armenia successfully completed the first review of the program on December 17, 2019, with a strong start. All end-June 2019 quantitative performance criteria (QPCs) and structural benchmarks (SBs) were met, with notable progress made in many policy areas.

Impact of the COVID-19 Pandemic

The first COVID-19 case in Armenia was reported on March 1, followed by a rapid spread. As of May 13, the country has 3718 confirmed cases and 48 deaths. The authorities have responded proactively to contain the outbreak of the virus. On March 16, the government declared a national state of emergency with strict containment measures. These include closure of schools and universities, prohibition of public gatherings, travel bans, restrictions on recreational facilities, restaurants, public transportation and internal mobility. The state of emergency was extended until May 14. Effective May 4, the movement restrictions were removed and almost all economic activities were allowed. This decision is considered a test and stricter restrictions may be reinstated depending on the spread of the virus.

The global COVID-19 pandemic is expected to have a large negative effect on Armenia’s near-term outlook, and significantly weaken its fiscal and external position in 2020. On the back of the global trade and supply chain disruptions, exacerbated by the crisis-related restrictions on domestic mobility and activity, growth is expected to decline substantially in 2020 (-1.5 percent), compared to the 5.5 percent pre-crisis projection. Preliminary economic indicators already point to a significant slowdown in March, with economic activity contracting by 4.9 percent (y-o-y), followed by high growth rates of more than 9.0 percent in the first two months of the year. Owing to lower revenues and higher spending on healthcare and economic support, the fiscal deficit is expected to widen to 5.0 percent of GDP (vs the 2020 budget target of 2.3 percent), contributing to the increase in the government debt above 60 percent of GDP in 2020. The current account deficit is expected to widen to 8.6 percent of GDP, resulting in the erosion of foreign reserve buffers.

Looking beyond the pandemic, the medium-term outlook remains favorable, underpinned by the authorities’ comprehensive reform agenda. Economic growth is expected to rebound to 4.8 percent in 2021, once the impact of the pandemic dissipates and the restrictions relax, with inflation gradually converging towards the 4.0 percent target over the medium-term. The external position is expected to strengthen, with the current account deficit gradually converging to its 6.0 percent of GDP norm. The public debt is expected to remain sustainable and decline over the medium term, in line with the fiscal rule. That said, the positive outlook is to a large extent contingent on the expected global recovery in 2021.

Policy Response to COVID-19

In addition to the immediate health measures to contain the spread of virus, the authorities have put in place targeted fiscal, monetary and financial policies to mitigate the social-economic impact of the pandemic. On the fiscal side, the government has adopted a comprehensive set of tailored and temporary measures, estimated at 2 percent of GDP (AMD 150 billion). These measures fall into three broad categories: subsidized government-sponsored loans to SMEs in affected sectors and to agricultural enterprises for co-financing and refinancing; direct labor subsidies to micro enterprises and SMEs to help maintain their employees; and lump-sum transfers to vulnerable households. Looking ahead, the authorities are considering options to support the post-crisis recovery, including investing in innovative sectors through limited convertible equity.

The CBA has also reacted quickly to the shock, balancing the dual mandate of price and financial stability. The policy rate has been reduced by 0.25 percentage point on March 17, and by a further 0.25 percentage point on April 28, bringing it to 5.0 percent; additional liquidity has been provided to the financial markets through repos and FX swap operations; foreign exchange sales have been undertaken to limit excessive dram volatility. On regulatory and supervisory measures, the monetary authorities have enhanced engagement between banks and supervisors; and have encouraged voluntary prudent loan restructuring without relaxing the loan classification and provisioning rules. Also, to alleviate some pressure on banks and the exchange rate, the CBA has temporarily halted the redenomination of FX reserve requirements, planning to design a revised timeline to be put into effect once the crisis abates.

Performance: Request for Completion of the Second Review and Augmentation of Access

Despite the Covid-2019 pandemic, Armenia’s program performance remains broadly on track. All end-December 2019 quantitative performance criteria (QPCs) were met, and all indicative targets (ITs) were observed. Notable progress has been made on structural reforms, including in the areas of capital market development, social and labor policies, tax compliance and anti-corruption framework. That said, to allow more time for technical and public consultations, the authorities request to reset the structural benchmarks (SBs) as outlined in the revised list of the SBs, for a few months to half a year.

Due to temporary supply-side factors, inflation fell below the lower bound of the consultation band, triggering the Monetary Policy Consultation Clause (MPCC) with the IMF Board. However, on the back of monetary and fiscal policies, inflation is expected to gradually converge towards the 4.0 percent target over the medium-term. The CBA closely monitors the macroeconomic developments and stands ready to act accordingly to ensure price and financial stability. Going forward, the authorities request an introduction of an inner staff consultation band into the MPCC to allow earlier consultations with Fund staff as needed. They also request modification of performance criteria on net international reserves, program fiscal balance and ceiling on budget domestic lending.

Against the background of positive program performance, the Covid-2019 shock has created significant external financing needs to cover urgent healthcare needs and support for the economy. In view of the large fiscal gap and urgent balance of payment needs, the Armenian authorities request the completion of the second review, augmentation of access in the order of SDR 128.80 million (100 percent of quota), as well as rephasing of purchases.

The authorities intend to draw on the available resources upon the completion of the second review and request to disburse the financing as direct budget support for 2020. The support from other external partners, including the World Bank, Asian Development Bank and EU, will cover the remaining financing needs, complementing the financing available from domestic capital markets. The authorities are committed to ensuring strong governance and transparency over the use of the borrowed resources, including by arranging an ex-post audit of the on-lending business support schemes by an internationally known independent audit company, and making the results public.

Fiscal Policy and Reforms

On April 29, the Parliament passed the 2020 supplementary budget, with a higher fiscal deficit of 5.0 percent of GDP. This reflects the cyclical impact of the pandemic on tax revenues and the additional spending needed for healthcare and economic support. The authorities are determined to finding savings by reprioritizing and reallocating expenditures within the budget envelop, but given the size of the shock, an additional financing of US$500 million (around 4.0 percent of GDP) is needed to close the 2020 fiscal gap. Looking ahead, the authorities remain committed to preserving medium-term debt sustainability while protecting investment and social spending. They are strongly determined to bring the government debt down to below 50 percent of GDP through gradual fiscal consolidation, in line with the fiscal rule, once the crisis dissipates. This assumes mobilizing additional tax revenue and containing current expenditures over the medium-term, while creating space for additional capital spending.

Structural fiscal reforms remain on track. Notable progress has been made with the property taxation reform, including building of an electronic property tax management system. To this end, the authorities remain committed to starting tax collections under the new regime in 2021. From January 2020, the new tax reform package became effective, introducing a number of measures to promote export-oriented inclusive growth, including flattening of the personal income tax (PIT) structure, reducing the PIT and corporate income tax (CIT) rates, and simplifying special tax regimes. The introduction of the individual income tax declarations from January 2022 remains on track. To further enhance compliance and fight evasion, the authorities are drafting a Compliance Risk Management strategy, with the help of the IMF. Going forward, they remain strongly committed to improving fiscal governance, transparency, and risk management.

Monetary Policy and Financial Stability

Despite the current challenging situation, the CBA remains committed to strengthening financial resilience, in line with FSAP recommendations. Significant progress has been made in this area, including the introduction of the Liquidity coverage ratio (LCR) and Net Stable funding ratio (LCR) in domestic and foreign currency; the reduction of the tier 1 capital adequacy ratio, as well as the introduction of capital conservation and countercyclical buffers, and a surcharge for domestic systemically important banks. The emergency liquidity assistance for solvent but illiquid banks has been operationalized; and the regulations related to the redefinition of nonperforming and restructured loans have been finalized, in line with international best practices. Going forward, the monetary authorities remain determined to further strengthen their macro-prudential toolkit, including by adopting stressed Loan-to-Value (LTV) limits in domestic and foreign currencies by March 2021. They are also working towards the adoption of debt-service-to-income (DSTI) limits.

Capital market development remains a key priority, with notable progress made. The draft capital market development program has been prepared with the help of IMF TA. However, the authorities need more time to comprehensively review all the necessary elements of the program and to bring forward proposals for concrete actions. To this end, they request to slightly postpone the SB on capital market development to May 2020.

Structural Reforms

The authorities continue to put structural reforms high on their agenda, with several important achievements. To this end, the 2019–23 employment strategy to promote the active labor market policy was adopted in December 2019. The annual action plan to address the core issues identified in the 2019 WB Doing Business Report was approved, and the SME development strategy was drafted. The efficiency review of the existing SME support programs is underway, while expected to be completed with a slight delay, due to the outbreak of the health crisis. On social policies, the coverage for the family and welfare benefit allowance was expanded to enhance its adequacy, with a notable progress made in creating self-sustaining income-generating opportunities for vulnerable families. The reforms in the education system are also advancing. The draft law on Higher Education has undergone extensive discussions with all relevant stakeholders and is expected to be submitted to the Parliament by end-June 2020.

Fighting corruption and enhancing governance remain top priorities. In this context, notable progress has been made with strengthening the anti-corruption framework. Most importantly, the revisions in the Criminal Code were drafted, in line with Fund advice, expected to be submitted to the Parliament by June 2020. The migration of the asset declaration system to the new Corruption Prevention Commission (CPC) has been completed and the operationalization of the new platform is underway. The draft law on a single autonomous anti-corruption entity is now in its final stage. However, it is expected to be submitted to the Parliament with some delay (September 2020), due to the extensive discussions with both the public and Fund Staff.

Conclusion

Against the background of strong program performance, Armenia’s economic outlook is expected to deteriorate substantially due to the COVID-19 shock. The crisis has created urgent external and fiscal financing needs. To this end, the Armenian authorities request augmentation of access, rephasing of purchases, and completion of the second review. Access to the IMF financing is essential to help close the external and fiscal financing gaps. Looking ahead, the Armenian authorities reconfirm their strong commitment to the economic policies, quantitative targets and structural benchmarks set under the program, notwithstanding the challenging COVID-19 circumstances. They stand ready to further adjust their policies in accordance with the program objectives as needed, in early consultation with the Fund. The authorities restate their strong determination to maintain the well-established cooperation and close policy dialogue with the Fund to address both the immediate and medium-term policy challenges.