SPECIAL REPORT

ARMENIA:Averting anEconomicCatastrophe

This report is a joint product of a team ofPFA members and outside experts. Theviews expressed in the report do not nec-essarily represent those of every PFA mem-ber. Neither the authors nor the reviewersof this report have received any compen-sation for their contributions.

February 2012

© 2012 Policy Forum Armenia

Individual sections of this report are availablefor reprinting upon request.

Reprints must be properly acknowledged.

Visit: www.pf-armenia.orgContact: forum@pf-armenia.org

Armenia is beginning to show signs of a classic balance-of-payments crisis in the making.An unsustainable de facto exchange rate peg and structural policies are resulting in massive ex-ternal imbalances, which will eventually lead to abandonment of the peg (i.e., devaluation) withvery serious implications for the over-exposed banking sector and already high public debt lev-els. Huge external repayments scheduled for 2012-14 and adverse developments in Europe aremaking the situation much worse and are likely to accelerate the process. Unless drastic changesin the economic policy direction and political-economy landscape are carried out, we estimatethe likelihood of a large devaluation of the dram and/or debt default within the next 3 years tobe very high.

In 2009, Armenia underwent one of the worst economic declines in the world following the2007-08 global crisis. But while the outcome in 2009 was mainly a result of the global turmoilmade worse by domestic problems, what is transpiring now is largely due to domestic problems,which will be amplified by external shocks. These home-grown problems—much of which are inthe realm of political will, rather than lack of resources or geography—are the main focus of thereport. In it, we point out that the economy has not adjusted to the global shocks of 2007-08 andthat there are clear signs of more pain to come exacerbated by new headwinds from Europe.

The country’s political leadership needs to fully internalize these problems and related risksand address them expeditiously. So far it appears that the lessons of 2009 have largely beenwasted and no significant change in policy direction was pursued, which may have better pre-pared Armenia for what is likely to come next. Instead, the elements of the same crony capital-ist practices—where a select few have used their disproportionate access to power and influenceover economic decision-making for their personal gain—have been reinforced, at the expense ofgrowth, public health, education, and national security. This is not only immoral but in manyways also illegal and needs to change. Armenia’s window of opportunity to build a viable econ-omy and address its severe social and demographic problems is closing rapidly.

The effective handling of challenges facing the country should begin by forming a legitimateauthority to oversee the new policy course on behalf of the people of Armenia. The upcom-ing parliamentary election provides that opportunity. Allowing people to exercise their free willand creating a sense of moral justice would enhance the public buy-in and—all other thingsbeing equal—would make policy measures more effective. On the contrary, yet another fraudu-lent election will undoubtedly lead to more political tension, social upheavals, and more chal-lenges to be tackled down the road, many of which may prove unmanageable for the rulingregime this time around. The situation requires a true government of national unity that wouldlay out a workable agenda and reach out to all constructive forces in Armenia and the Diasporato help accomplish that. These efforts would require adequate professional skills but also theair-cover of a truly national and clean political leadership to be successful.

EXECUTIVE SUMMARY

3

INTRODUCTION

The Summit of European leaders that tookplace in Brussels on December 8-9, 2011 didnot result in the quick fix everyone in Europewas longing for. Despite the fact that theagreement reached in Brussels carried withit the promise of averting the large-scale fi-nancial disaster hanging over Europe’s head,the continent’s economy is already projectedto expect a recession in 2012 with a slow re-covery in 2013. With little promise on the up-side, a failure of politicians to act quicklyenough hereafter poses a considerable risk: asizable contraction of output accompanied bythe departure of some peripheral countriesfrom the Eurozone (with the possible aban-donment of the Euro as the single currency ofthe region), bank failures and financial re-pression, more fiscal austerity, and social un-rest. Depending on the magnitude andsequence of these events, a disintegration ofthe global financial system as we know itwould not be unthinkable.

The Eurozone is Armenia’s largest tradingpartner and has traditionally been thesource of most of its budgetary grants andsome bilateral loans. Conditions in Europe—those that have already been factored intothe projections of analysts and internationalfinancial institutions, and those that couldstill surprise everyone by their scale andscope—will have serious implications for Ar-menia’s economy, both directly as well as in-directly through their impact on Russia,Armenia’s largest source of remittances. Re-mittances, of course, remain a critical lifelinefor Armenia’s fragile economy and its cur-rency, at times reaching 20 percent of itsGross Domestic Product (GDP) annually.

In its 2008 report on “Implications of theWorld’s Financial Crisis for Armenia’s Econ-omy”, published in December 2008, PolicyForum Armenia warned of the imminent dan-gers for Armenia as a result of the financialcrisis, which began showing signs of distressglobally in late-2007. Armenia’s leadership ig-nored most of the multifaceted policy recom-mendations contained in the report and insteadopted out for a fix that consisted largely of for-eign debt-funded fiscal stimulus. Despite a siz-able injection of resources into the economy,the outcome was a devastating 14.2 percentdecline in GDP—one of the worst performancesin the world since 2007. Sadly, not much haschanged in terms of policy direction since then.

The current report takes a step further. In ad-dition to purely economic policy measures thatare likely to mitigate the impact of the secondwave of the crisis on Armenia’s economy, inSection I we lay out a series of political-econ-omy recommendations to address issues,which were behind the policy failures in 2008-09, and which are likely to haunt the economyfor many years to come if left unaddressed.

The remainder of this report is structured in thefollowing way. Section II outlines the main vul-nerabilities of what is seen as a much weakerArmenian economy compared to that in 2008.It highlights major policy inconsistencies ob-served since the beginning of the global crisisand their counterproductive impact on keymacroeconomic indicators. Section III offers adetailed set of recommendations that, ifadopted, would help mitigate the impact of theEuropean recession in the short term and ad-dress the economy’s fundamental and poten-tially deadly weaknesses in the medium term.

The fiscal stim-ulus financedthrough mas-sive external

borrowing wasineffective and

short-lived.

4

Output, social conditions,and inflationAfter a deep contraction in 2009, the Ar-menian economy grew at an average rate of3.3 percent in 2010-11, which is significantlylower than pre-crisis growth levels, and whichstill leaves GDP below its 2007 level. The weakrecovery is supported by a rebound in agricul-ture, industry, and services sectors, while thestagnant construction sector has put brakes onthe recovery. The outcome in the agriculturebenefited from a base effect (i.e., poor weatherconditions in 2010). The growth in the indus-try was due to increased activity in the manu-facturing (including processing) and miningsectors.1 The services sector benefited from re-sumed growth in remittances. All in all, thetradable sector has not grown fast enough inrecent years, and the economy still relies ondomestic demand fueled by foreign savings. Ingeneral, economic activity remained con-strained by corruption and administrative ha-rassment, weak contract enforcement, and anuneven playing field.

These developments have taken placeagainst the backdrop of dramatically wors-ening social conditions. Poverty has grownsteadily since 2008: official statistics put 35.8percent of population below the poverty line in2010, compared to 27.6 in 2008 (NSS, 2011).

Given the rather low official poverty threshold($89.7 per adult per month), these statisticsare likely understating the true number of peo-ple experiencing hardship. The overall socialsafety net remains inadequate, and there arereports of increased suicide rates (IWPR,2011). Official data on unemployment is noto-riously unreliable, but anecdotal evidencepoints to a massive increase in the number ofpeople left without jobs since 2008. Along withthe events of 2008 and their aftermath, theworsening social conditions have led to re-newed outflow of population.2

Declining global demand and commodityprices were not adequately reflected in Ar-menia’s inflation developments, while upwardadjustments in the global commodity priceswere quickly factored in. In early 2009, the an-nual inflation rate in Armenia declined toaround one percent, only partially reflecting thedecline in world commodity prices. Towards theend of the year, the inflation rate notably accel-erated, despite relatively low world prices anda widening output gap. In contrast, increasedworld commodity prices, amplified by a weakeragricultural output domestically, quickly pushedthe inflation rate above nine percent in 2010.3This pattern in Armenia’s inflation—an easy up-ward adjustment but strong downward rigidi-ties—signals a highly concentrated marketstructure with some agents having enough mar-

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

Armenia needsto repay its external creditors over$1 billion inprincipal andinterest in2012-14.

5

1 The latter had a double-digit growth driven by the surge in metal prices (particularly, copper).

2 Over a million people have left Armenia since independence, making it the number one population-exporting coun-try in the world, if measured as a percentage of the original (i.e., pre-migration) population.

3 The annual inflation decelerated in 2011 owing to a base effect of the previous year’s price shocks and better weatherconditions compared with 2010.

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

ket power to set prices. This pattern is likely toseriously undermine the effectiveness of anyexisting anti-crisis macroeconomic policies: anattempt to stimulate the aggregate demand viamonetary expansion will likely have more nom-inal rather than real effects.

Fiscal developments andpublic debtYears of a highly pro-cyclical fiscal policy duringthe boom left Armenia without any precaution-ary fiscal buffers, which could have helped tomitigate the impact of the global recession. Ar-menia reacted to the crisis by a massive fiscalstimulus that was largely financed through ex-ternal borrowing. However, not only did the stim-ulus not prevent the economy from nose-divingin 2009, but its effects were short-lived. Moreimportantly, the foreign funding borrowed to fi-nance this stimulus (and to replenish the cen-tral bank’s foreign reserves, see below) morethan doubled Armenia’s public debt in 2009-10and almost completely exhausted its borrowingcapacity for years to come. This effectively im-

posed a ban on much-needed infrastructureprojects (including the nuclear power plant) withthe involvement of direct government borrow-ing or guarantees. Having reached 40 percentof GDP, Armenia’s debt has come dangerouslyclose to the default threshold for developingcountries. It should also be noted that in con-trast to the debt accumulated before the crisis,new debt is less concessional both in terms ofinterest rate and maturity.

Apart from the volume of sovereign debt, twoadditional issues are of major concern here.First, Armenia's repayment profile is concen-trated: in the next 3 years (2012-14), the coun-try needs to repay its external creditors over $1billion in principal and interest (see Fitch Rat-ings, 2011), of which $600 million is owed tothe International Monetary Fund.8 Debt serv-ice of such magnitude will seriously undermineboth Armenia’s foreign exchange reserves andthe available fiscal space. Given the presentlyobserved external imbalances, debt restruc-turing in some way or another would appear in-evitable.9 This is likely to further aggravate the

By pegging theexchange rate

the CBA hascontributed toloss of ¾ of its

pre-crisis grossexternal re-

serves.

6

4 GDP growth in the 3rd and 4th quarters of 2010 turned negative in year-on-year terms.

5 In addition, the use of borrowed funds (especially the on-lending to the private sector) was not transparent, with itsrationale often unclear.

6 Given the imminent closure of the nuclear power plant, the inability of the budget to borrow more to finance the con-struction of a new plant should put additional pressures to increase tax collection and improve the business envi-ronment to enable more private financing of energy projects down the road.

7 Finger and Mecagni (2007) show that most recent sovereign debt crisis took place with debt levels above 39 percent.

8 See here for Armenia’s debt to IMF (in millions of Special Drawing Rights, or SDR). At the time this report was writ-ten, the exchange rate between SDR and $US was approximately $1.53/SDR.

9 This may be true despite the fact that most of its debt is owed to official creditors.

internal social and economic conditions and toundermine Armenia’s position regionally. Sec-ond, Armenia’s debt profile is very sensitive toshocks, most importantly to possible outputand exchange rate shocks. According to oursimulations (see chart below and table in theappendix), a moderate decline in GDP in 2012(which is not ruled out given expected deterio-ration of the external environment and largeimbalances that Armenia must address) maydrive debt-to-GDP ratio above 50 percent.Given the fact that almost 90 percent of Ar-menia’s debt is in foreign currency, the outlook

will be much worse if the dram is abruptly de-valued. In the case of 30 percent devaluation,Armenia’s debt-to-GDP ratio will reach 60 per-cent. A combined shock—with GDP decline anddevaluation taken together (not shown on thechart)—will drive the debt-to-GDP ratio well over70 percent.

Alarmed by the deteriorating debt outlookand in spite of sluggish recovery since 2009,the government embarked on fiscal consoli-dation in 2011. The key feature of this pre-mature fiscal consolidation in Armenia is that

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

7

70

65

60

55

50

45

40

35

30

252010 2011 2012 2013 2014

Armenia: Public Debt Profile under Various Shock Scenarios(PERCENT OF GDP)

Sources: IMF (2011); and PFA calculationsNote: See Appendix for assumptions behind each of the shock scenarios

No Shock(baseline)

Zero Growth Mild Recession 30% Devaluation

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

its burden almost entirely falls on expenditures,both current and capital. Most expenditure cat-egories have been stagnant in real terms since2009, and capital expenditures are under sub-stantial strain. Almost nothing has been doneto improve revenue mobilization, and tax-to-GDP ratio in Armenia remains one of the lowestin CIS, reflecting large-scale tax evasion ratherthan low statutory tax rates. In fact, most taxrates in Armenia are at par with, or higher than,the rates in countries of the region and othercomparators that have a higher tax-to-GDPratio (see table below).10

There are widespread concerns about cor-ruption in the tax and customs agency aswell as about failures to collect taxes fromgovernment-connected oligarchs. Recent ef-forts to improve revenue generation have fo-cused on increasing income tax rates forhigh-income earners and increasing collectionfrom the small and medium sized enterprises,most of which have already been subjected toadvance tax withholding and other unorthodoxcollection practices. Contrary to this, top gov-ernment officials and parliamentarians, whoare known to be very wealthy but declare only

The overvaluedexchange rateharms Arme-

nia’s export potential,

delays neces-sary external

adjustment,and conceals

the true indebtedness.

8

Tax Revenue and Select Statutory Tax Rates, 2011 11

10 See Davoodi and Grigorian (2007) and IMF (2010) for more on this issue.

11 Source: Tax revenue-to-GDP figures from various IMF reports available here; Profit Tax figures (except Georgia andMoldova) are from “Corporate & Indirect Tax Survey 2011”, KPMG (2011). For Georgia: here; for Moldova: here. VATfigures are from here.

Tax revenue(percent of GDP)

Corporate ProfitTax (percent)

VAT(percent)

ARMENIA 16.3 20 20

CHILE 18.1 20 19

CYPRUS 25.9 10 15

GEORGIA 24.9 15 18

IRELAND 44.3 12.5 21

LATVIA 27.7 15 22

MOLDOVA 31.4 15 20

PARAGUAY 14.1 10 10

ROMANIA 28.2 16 24

RUSSIA (NON-OIL) 22.1 20 18

SERBIA 33.7 10 18

small fractions of their income and wealth, willcontinue to stay off of the radar screen of Ar-menia’s tax collectors. On the expenditure side,according to the World Bank (2009), single-source procurement of public expenditures re-mains very high (around 80 percent), openingsizable room for corruption. In all, several hun-dred million dollars are embezzled annually inthe form of non-payment of taxes and outrightbudgetary theft (PFA, 2010; Box 6).

Monetary and exchangerate policies and the finan-cial sectorMonetary policy priorities have shifted fre-quently since the beginning of the crisis, andthe central bank’s response to inflation haslagged behind. It appears that in its initial re-sponse to the crisis, the Central Bank of Arme-nia (CBA) actually abandoned its inflationstabilization policy and focused heavily on sta-bilizing output. It also acted contrary to its un-declared objective of pegging the exchangerate (which would have required the monetarypolicy to be passive and driven by decliningmoney demand) and by doing so, the CBA con-tributed to the loss of foreign exchange re-serves (see below).12 This was probably areflection of the lack of operational independ-

ence of the CBA from political considerations.However, perhaps after realizing that its policyfueled inflation expectations, prevented down-ward price adjustments, and led to loss of itsreserves—all instead of supporting the recov-ery—the CBA returned to inflation targetingagain, hiking the monetary policy interest rateby 2.25 percent during Jan–May 2010. By thistime, however, inflationary pressures had ei-ther already died or reversed their course.

CBA’s de facto peg—put in place despitepressures on the exchange rate—resulted insubstantial reserve losses. The one-off deval-uation of approximately 20 percent in March2009—effectively a pre-condition for IMF’semergency support—eased the pressures butonly for a limited period. In late 2009, ex-change rate pressures reemerged.13 In total,the CBA has lost $1.2 billion—or ¾ of its pre-cri-sis gross external reserves—in foreign ex-change interventions since the onset of thecrisis, of which around $0.5 billion was lostafter the March 2009 devaluation. It should benoted that the CBA’s operations in foreign ex-change markets are very asymmetric: it re-sponds aggressively to devaluation pressureswhile allowing appreciation pressures of alargely seasonal nature to be reflected in theexchange rate.

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

Conditions inthe bankingsector are worrisome and risks arebuilding up.

9

12 In a fixed/pegged exchange rate arrangement, any expansion of the reserve money beyond the increase in demandfor money typically leads to a loss of foreign exchange reserves.

13 IMF (2011)’s estimate of the dram’s overvaluation (10-15 percent; see page 5)—while in our view somewhat opti-mistic—would still require a sizable nominal depreciation/devaluation to be eliminated (depending on the pass-througheffect on domestic prices).

At present, the overvalued exchange rateharms Armenia’s export potential, delaysnecessary external adjustment, and concealsthe true (external) indebtedness. Any adjust-ment observed in 2010-11 resulted largelyfrom fiscal consolidation and an increase inprices for exported minerals and not throughprivate sector consumption/investment pat-terns. The CBA argues that the main rationalefor pegging the exchange rate is to control in-flationary pressures arising, among other fac-tors, from external price shocks (see IMF,2011). Apart from the fact that pegged ex-change rate regimes are not an effective mech-anism for controlling inflationary pressures,there is empirical evidence that “fear of float-ing” (and the resulting pegging of exchangerates) may in fact strengthen the pass-throughof external price shocks to domestic prices,whereas flexible exchange rate regimes mayhelp to absorb the shocks (through profit mar-gins and factor prices). In addition, the fact thatthe CBA continued to intervene asymmetricallyin the foreign exchange market, even after in-flationary pressures subsided, may suggestthat there may be other factors at play behindexchange rate policy choices (such as keeping

the dram artificially overvalued to support gov-ernment-connected importers).

Despite the official claims about the health ofthe financial sector, the conditions are worri-some and risks are building up. First, thelegacy of the 2009 recession is beginning toshow in non-performing loans (NPLs). While theofficially reported NPLs have been rising, thetrue quality of banks’ loan portfolios is likely tobe masked by the lax loan classification stan-dards.14 Second, while credit has been shrink-ing almost everywhere else in the world,Armenia’s banking sector has seen a massivecredit growth since early 2008,15 much of whichhas been via borrowing from abroad, with bankshaving built sizable debt to creditors abroad.16

Due to its rapid expansion, the quality of lend-ing remains questionable.17 Third, much of thisacceleration in lending to the private sector isattributed to foreign exchange loans (constitut-ing 60 percent of its total loan portfolio, ac-cording to IMF, 2011; Table 4), which haveraised the vulnerability of the system to poten-tial dram devaluation. Deposit dollarization, too,remains high, limiting the effectiveness of mon-etary policy. Fourth, the ownership in the bank-ing sector remains very murky, a key factor

14 Armenian banks are required to classify a loan as a loss only when the payments on it have been overdue by 270 days.In most countries of Eastern Europe, loans are classified as losses after 180 days of overdue payments.

15 Private sector credit grew by 37 percent through September 2011 compared to the same period in 2010 (IMF, 2011).

16 While some of this could be borrowing by the non-financial private sector, IMF (2011) estimates that Armenia’s pri-vate sector external debt is at $2.9 billion as of the end of 2011.

17 The massive credit growth could have conceivably been part of the authorities’ plan to boost the economy in 2009-2010, for which they directed the connected banks to borrow abroad.

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

The inability to deliver ameaningful

external adjustment is

the main policy

shortcoming ofrecent years.

10

behind the lack of competition in the sector andthe high prevailing interest rate mark-upscharged by the banks. The highly politicized na-ture of the banks’ ownership also limits theCBA’s independence and its ability to conductits supervisory functions, a situation which theCBA does not seem to mind.

External imbalancesThe economy is much more vulnerable to bothcurrent and capital account shocks (that couldbe triggered by events in Europe) than it was in2008. Armenia is the only country in EasternEurope and Central Asia that runs a larger cur-rent account deficit than it did before the crisis:its current account deficit is estimated to havecrossed the 12 percent mark of GDP in 2011,a far cry from the average of 3.3 percent forthe five years preceding 2008. The deficit is ex-pected to decline only moderately in the yearsto come. Armenia’s trade account is expectedto record a deficit of a staggering 21 percentof GDP, with imports exceeding exports by afactor of almost 4 to 1, despite sizable growthin exports of metals and minerals since2009.18 This growth, however, was not a result

of improved competitiveness (or external ad-justment), but was driven by higher external de-mand and prices. The inability to deliver ameaningful external adjustment—which hasleft the economy much more vulnerable to ex-ternal shocks than it was prior to the start ofthe global crisis—is the main policy shortcom-ing of recent years.

To finance these sizable current accountdeficits, Armenia has three options: it needsto attract foreign private investment, secure of-ficial loans, or draw down on its foreign cur-rency reserves. The distorted businessenvironment, weak contract enforcement, anddeclining purchasing power of its population19

will have an impact on the economy’s ability toattract foreign private investment. In any case,Armenia remains cut off from the private capi-tal markets, and given the current global envi-ronment, it is unlikely to be able to issue aninternational sovereign bond at fiscally prudentinterest rates any time soon. In turn, when itcomes to official financing, Armenia hasreached most of its borrowing limits with theinternational financial institutions (e.g., WorldBank and IMF), while its traditional bilateral

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

18 A European recession will undoubtedly put a downward pressure on prices of metals worldwide, with implications forArmenia, where mining was the single most important factor behind the post-2009 recovery accounting for about 60percent of exports. In addition, crisis in Europe that spills over to Russia may have implications for Armenia’s remit-tances, which during 2009 have declined by an estimated 30 percent and was a key factor behind the collapse ofGDP in 2009.

19 This is also driven by sizable emigration that is rumored to have intensified in the past 2-3 years.

11

RECENT ECONOMIC DEVELOPMENTS AND UNDERLYING WEAKNESSES

20 To date, Armenia remains heavily dependent on disbursements from the International Financial Institutions, both forits balance-of-payments as well as fiscal financing needs.

21 The Central Bank’s reserves are estimated to have declined to $1.8 billion by the end of December 2011 from its high-est end-year level of $2.0 billion as of the end of December 2009.

lenders/grantors in Europe are under a pile ofproblems of their own, making any sizable lend-ing to Armenia unlikely any time soon.20 Thisleaves drawing down on Central Bank’s foreignreserves as the only feasible option for Arme-nia during the times of economic stress. Theproblem with this option, however, is that the

external debt repayments scheduled over thenext three years leave less room for maneu-vering.21 Weaker foreign reserve coverage willmake a sizable depreciation or devaluation ofthe dram (similar to the devaluation that tookplace in March 2009) a very likely outcome inthe near future.

12

Political economy considerations The effective handling of challenges facingthe country should begin by forming a legiti-mate authority to oversee the new policycourse on behalf of the people of Armenia.The 2012 parliamentary election providesthat window. Allowing people to exercise theirfree will and creating a sense of moral jus-tice would enhance the public buy-in and—allother things equal—would make policy meas-ures more effective. Yet another fraudulentelection will undoubtedly lead to more politi-cal tension, social upheavals, and more chal-lenges to be tackled down the road, many ofwhich may prove unmanageable for the rul-ing regime this time around.

The government must urgently roll out a na-tional program of ending the social hardshipand putting the economy on a path to mean-ingful growth. The most important pre-condi-tions for this should include: (i) a credibleroadmap to eliminating all monopolies in pro-duction and import of goods and services, (ii)creating a level playing field for all entrepre-neurs, and (iii) minimizing the interference ofoligarchs in economic policymaking. The pro-gram should also address the following pre-requisites: (i) tax collection and subsequentlythe ability of the budget to spend on the so-cial safety net, public investment, education,and health, (ii) financial sector imperfectionsto reduce the (lending) interest rates, and (iii)corruption and administrative harassment.

For the above measures to be effective, acomplete revamping of the cabinet would be

required. The current cabinet as a wholelacks vision, capacity, and stamina to ad-dress the above concerns. In addition to re-shaping the cabinet, as we proposed in ourDecember 2008 Report, a Crisis PreventionTeam (CPT) should be established as a high-level policy advisory body to the government.The CPT could report directly to the primeminister and should consist of economistsand financial sector professionals with strongreputations and experience in dealing withcrisis countries. To be considered credible,the CPT should include Diaspora (and possi-bly non-Armenian) professionals and shouldbe non-partisan.

Building public buy-in would also requirecredible reform in the judicial system, whichin turn would require far-reaching measuresto clean up the top levels of the ProsecutorGeneral’s office and the Ministry of Justiceas well as the courts. The business commu-nity and other civil society stakeholdersshould be brought in to play a role in this re-form agenda.

Corruption in Armenia has names and ad-dresses, and most of these belong to peoplehigh up in the corridors of formal power. Aprocess of prosecuting senior government of-ficials, who have used public office for per-sonal wealth accumulation and clearly livebeyond their official income, should be initi-ated as soon as possible. This will send astrong signal about the credibility of the re-form effort and translate into a better busi-ness and administrative environment fairlyquickly, since most money received by cor-rupt government officials results from either

Recommendations

13

Recommendations

indirect ownership of businesses or provisionof cover to other businesses for a fee. Apartfrom being unlawful and immoral, these ac-tivities distort the playing field and preventefficient resource allocation.

Combating money laundering is of criticalimportance. Many top-level officials own lu-crative business ventures, and most of themhave accomplished that through repatriatingfunds from Armenia, registering offshore en-tities, and reinvesting the funds in Armeniathrough the back door. Among other things,this allows them to reap the benefits grantedby the law to foreign investors and use publicoffice to lobby for their businesses. Despiteample anecdotal evidence of wrongdoings byadministration officials in this respect, nocases of financial fraud or money launderinghave been brought to public’s attention in re-cent years. The agency that deals with moneylaundering should be made independent andthe compensation of its staff should be madeperformance-based.

The latest episodes of administrative harassment of Diaspora investors may haveresulted in a critical blow to the relations be-tween the Diaspora and Armenia. To avoid afurther confrontation with, and be able tobetter utilize the potential of, the Diaspora,we propose the formation of an independentDiaspora-led commission to be tasked—on aregular/rolling basis—with the evaluation ofArmenia’s business environment and thecompilation of a list of Diaspora-based can-didates for high-level civil service positionsin Armenia.

Fiscal/budgetary measuresLeaks from, and corruption within, thebudget should be curtailed. A much largershare of budget procurement should be han-dled through competitive bidding, and safe-guards should be instituted to reduce theparticipation of firms connected to governmentofficials. The Prosecutor’s Office should initi-ate legal proceedings against violations identi-fied in the latest report by the Audit Chamber.Parliament should be updated on the progresson these proceedings at least quarterly.

Under-collection of tax and customs rev-enues should be addressed head-on andwithout delay. This should begin with sweep-ing management and staffing changes in thestate tax and customs agency, which, in ad-dition to being seen as corrupt, is also usedas a tool of political score-settling by the rul-ing regime. Strengthened with additionalpowers of enforcement, the restructuredagency should be given revenue collection tar-gets benchmarked against international bestpractice and calibrated for Armenia’s taxregime. Its senior staff should be fired if tar-gets for the first year are substantially missedand mid- to lower-level employees should behired on shorter-term and performance-basedpay contracts.

In addition to enforcement, tax and customsrules and regulations should be madeclearer, less subjective, and less prone torent-seeking. It should be noted that increas-ing statutory tax rates and tightening tax ad-

14

ministration for individuals and businessesthat are already under a substantial burdenwill further depress economic activity and re-inforce the widely held notion that taxation inArmenia is unjust.

These new tax administration and expendi-ture management measures will open up asignificant fiscal space—hundreds of millionsof dollars annually—for investment in public in-frastructure, education, research and develop-ment, social security, and defense. All of theseexpenditure categories remain grossly under-funded, and addressing this issue expedi-tiously and meaningfully is Armenia’s onlyticket to future growth and prosperity.

Monetary and exchangerate policies and the financial sectorDespite the March 2009 devaluation of thedram, Armenia’s economy has not adjustedadequately since the start of the crisis. Un-less and until a sizable adjustment takesplace, Armenia will continue to lose its foreignreserves and accumulate debt, and will be un-able to grow. This adjustment should bedriven by gradual exchange rate depreciation(as opposed to sudden devaluation, to avoidan impact on the banks’ balance sheets andun-hedged foreign currency borrowers) with

the target of completely eliminating thedram’s overvaluation within 1 to 1.5 years.Given the output gap and the eventual de-preciation-induced reduction in the volume ofimported goods, the effective pass-throughfrom exchange rate to prices will be minimal.Abandoning the de facto exchange rate pegwill also strengthen the monetary policy chan-nel and make monetary easing effective asopposed to only contributing to the loss of re-serves and inflation.

The current trends in the banking sector can-not be sustained for much longer. Going for-ward, the expansion of credit should beweighed against the risks of financial instabil-ity and subsequent social unrest. Conditionscould worsen if the banks are forced by credi-tors to repay the foreign credit lines (or if bankshave difficulties rolling them over), a patternpresently observed across Eastern Europe.Apart from developments in Europe, this couldalso be triggered by continued deterioration ofthe bank lending portfolio in Armenia or bychanges in depositor sentiment triggered byevents both domestically and abroad.22

Structural reformsTo be competitive globally, more of Armenia’seconomic growth should come from increasedproductivity and innovations. Yet, the country’s

Recommendations

15

22 Further downgrades of Armenia (and almost automatically of commercial banks) by rating agencies could also resultin additional margin calls from these creditors and/or higher fees and interest charged to maintain them.

Recommendations

once-prominent edge in science and technol-ogy has seriously—if not irreversibly—erodeddue to large-scale migration and the govern-ment’s outright neglect of higher education. Topartially overcome this, in addition to swift andacross-the-board reduction in red tape and im-provement in the business environment, Armenia needs to improve conditions for inno-vation via focused measures, such as devel-oping technology centers, amelioratinginnovation funding, and enhancing entrepre-neurial expertise. The latter could include pair-ing Diaspora professionals with localbusinesses in targeted sectors, a programwhich PFA could help develop.

Increased competition through the demise ofmonopolies will allow capital to seek new/un-explored sectors for higher profits. Meanwhile,

it will both increase flexibility of nominal indi-cators and make them act as shock absorbersinstead of as shock amplifiers.

The rapid expansion in the mining sector—the government’s pick for the frontrunner to re-place the once-favorite construction sector—should be stopped immediately until: (i) allleakages for the budget are identified, (ii) trans-parency in the ownership structure of key en-terprises is established (with the objective ofbringing to justice those who have acquiredmining interests while in public office), and (iii)sufficient and credible environmental safe-guards have been established. The govern-ment should understand that leaving naturalwealth in the ground for future generations (orperhaps until such time when more moderntechnologies for mining and processing be-

16

come available) can also be a viable economicsolution under a wide range of economic andfinancial conditions and assumptions.

While Armenia requires significant changes tomake its economy viable and to regain the trustof its people, this will not happen without sig-nificant civil society pressure from withinand/or external pressure, including the Dias-pora and Armenia’s main creditors, the IMFand the World Bank. The latter need to movefrom their toothless program design and en-forcement—factors that, in our view, have sig-nificantly worsened the moral hazard andweakened the incentives for the administrationin Armenia to undertake reform—to a tougher,more effective stance towards policy slippagesand lack of political will to reform.23 Rolling overthe government’s external debt maturing in the

next three years, without seeing significantchanges in policy conduct, would be tanta-mount to pursuing the same old approach, andtherefore should be avoided.

Recently, the ARF-Dashnaktsutyun—a formercoalition partner and presently a parliamentaryopposition party—has called for the resignationof the cabinet. We believe this move, even ifundertaken, will not accomplish much unless itis accompanied by political changes at the top.What is required to move forward is a true gov-ernment of national unity to lay out a workableagenda and to reach out to all constructiveforces in Armenia and the Diaspora to help ac-complish that. These efforts would require pro-fessional credibility and the support of a trulynational and clean political leadership, whichArmenia unfortunately lacks at the moment.

Recommendations

17

23 The fact that the latest IMF report (IMF, 2011; paragraph 23) has taken up the issue of Nairit is indicative of the frus-tration that is increasing among the International Financial Institutions with the current administration’s handling ofArmenia’s economic affairs. This is perhaps the single most important change that has taken place since 2008.

Appendix: Macroeconomic Conditions under Various Shock Scenarios, 2010-14

Note: Green cells are exogenous assumptions; yellow cells contain calculations. For simplicity, expenditures are assumed unchanged relative to the baseline scenario, which is adopted from IMF (2011). It assumes some repaymentof debt falling due. In contrast, 100 percent roll-over of existing obligations is assumed under all three shock scenarios.

18

2010 2011 2012 2013 2014Baseline ScenarioREVENUES 734.3 840.4 888.4 972.8 1,057.5

EXPENDITURES 906.6 980.9 1,019.9 1,076.3 1,226.1

DEFICIT -172.3 -140.5 -131.5 -103.5 -168.6

FINANCING GAP 0.0 0.0 0.0 64.2 80.0

DEBT-TO-GDP (%) 39.2 40.0 43.1 41.8 38.5

NOMINAL GDP 3,502.0 3,871.0 4,219.0 4,583.0 4,978.4

GDP DEFLATOR (%) 9.2 5.7 4.8 4.4 4.4

REAL GDP GROWTH (%) 2.1 4.6 4.0 4.0 4.0

Shock Scenario I (Zero GDP growth)REVENUES 734.3 840.4 825.2 841.7 893.0

EXPENDITURES 906.6 980.9 1,019.9 1,076.3 1,226.1

DEFICIT -172.3 -140.5 -194.7 -234.6 -333.1

FINANCING GAP 0.0 0.0 63.2 195.3 244.5

DEBT-TO-GDP (%) 39.2 40.0 47.7 50.8 48.7

NOMINAL GDP 3,502.0 3,871.0 3,948.4 4,027.4 4,272.7

GDP DEFLATOR (%) 9.2 5.7 2.0 2.0 3.0

REAL GDP GROWTH (%) 2.1 4.6 0.0 0.0 3.0

(In billions of drams, unless otherwise indicated)

Shock Scenario II (Mild recession in 2012)REVENUES 734.3 840.4 776.3 791.8 840.0

EXPENDITURES 906.6 980.9 1,019.9 1,076.3 1,226.1

DEFICIT -172.3 -140.5 -243.6 -284.5 -386.1

FINANCING GAP 0.0 0.0 112.1 245.2 297.5

DEBT-TO-GDP (%) 39.2 40.0 52.0 55.3 53.1

NOMINAL GDP 3,502.0 3,871.0 3,714.2 3,788.5 4,019.2

GDP DEFLATOR (%) 9.2 5.7 1.0 2.0 3.0

REAL GDP GROWTH (%) 2.1 4.6 -5.0 0.0 3.0

Shock Scenario III (Dram is devalued by 30 percent)DEBT-TO-GDP (%) 39.2 40.0 54.4 56.5 58.6

DRAM/USD (E.O.P.) 363.4 375 487.5 509.2 531.8

SHARE OF EXTERNAL DEBT 87.4 87.5 87.4 85.2 85.2

REFERENCES

19

Davoodi, H. and D. Grigorian (2007). “Tax Potential vs. Tax Effort: A Cross-Country Analysis of Armenia'sStubbornly Low Tax Collection,” IMF Working Paper No. 07/106. Available via:http://www.imf.org/external/pubs/cat/longres.aspx?sk=20642.0.

Finger, H. and M. Mecagni (2007). "Sovereign Debt Restructuring and Debt Sustainability: An Analysis ofRecent Cross-Country Experience," IMF Occasional Paper 255, Washington D.C.

Fitch Ratings (2011). “Armenia: Full Rating Report,” September. Available via: www.fitchratings.com.

IMF (2011). (Armenia) Country Report No. 11/366. Available via:http://www.imf.org/external/pubs/cat/longres.aspx?sk=25455.0.

IMF (2010). “How does Armenia’s Tax Revenue Compare to Its Peers?“ Mimeo. Available via:www.imf.org/Yerevan (under "Analysis" section).

Institute for War and Peace Reporting (2011). “Alarm at Rising Suicide Rate in Armenia,” June 17. Available via: http://www.unhcr.org/refworld/docid/4e0070ff2.html.

KPMG (2011). “Corporate & Indirect Tax Survey 2011.” Available here.

National Statistical Service (2011). “Main Findings of the 2010 Integrated Living Conditions Survey,”Press Release, November. Available here.

Policy Forum Armenia (2010). “ Armenia-Diaspora relations: 20 Years Since Independence,” a State ofthe Nation Report. Available via: www.pf-armenia.org/reports.

Policy Forum Armenia (2008). “Implications of the World Financial Crisis for Armenia’s Economy,” PFASpecial Report. Available via: www.pf-armenia.org/reports.

World Bank (2009). “Armenia—Country Procurement Assessment Report.” Available here.

Policy Forum Armenia1250 I (Eye) Street N.W., Suite 710

Washington, D.C. 20005, USAforum@pf-armenia.org

www.pr-armenia.org