Growth and Poverty Reduction in Armenia...GROWTH AND POVERTY REDUCTION IN ARMENIA: ACHIEVEMENTS AND...

Growth and Poverty Reduction in Armenia Achievements and Challenges

Enrique Gelbard, Jimmy McHugh, Garbis Iradian,Christian Beddies, and Laure Redifer

International Monetary Fund Washington, DC

©International Monetary Fund. Not for Redistribution

©2005 International Monetary Fund

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Cataloging-In-Publication Data

Growth and poverty reduction in Armenia: achievements and challenges / Enrique Gelbard . . . [et al.] — Washington, D.C.: International Monetary Fund, 2005].

p. cm.

ISBN 1-58906-451-8

1. Armenia — Economic conditions. 2. Armenia — Economic conditions — Statistics. 3. Armenia — Economic policy. I. Gelbard, E. (Enrique). II. International Monetary Fund.

HC415.17.G76 2005

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iii

Contents

Preface vii

Overview ix

1. Armenia After a Decade of Reform 1 A. Background 1 B. Economic Reforms 3 C. Macroeconomic Stabilization 11 D. Economic Performance 16 E. Remaining Challenges 20 References 21

2. Growth and Poverty Reduction 23A. Economic Restructuring and Growth 23 B. Total Factor Productivity 26 C. Poverty, Inequality, and Employment 32 D. Concluding Comments 40 References 41

3. Fiscal Adjustment 43A. Fiscal Developments 43 B. Expenditure Policies 46 C. Why Has Revenue Performance Been Disappointing? 48 D. The Quasi-Fiscal Sectors 54 E. Long-Term Fiscal Challenges 57 F. Fiscal Consolidation, Tax Reforms, and Growth 61 G. Future Reform Priorities 62 H. Concluding Comments 63 References 63

4. The Financial System and Growth 65A. The Financial System in Armenia 65 B. Regulation and Supervision 72 C. Why Has Financial Intermediation Been So Low? 73 D. Key Challenges for the Coming Years 75 E. Concluding Comments 82 References 83

5. International Integration 85A. Trade and External Debt 85


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GROWTH AND POVERTY REDUCTION IN ARMENIA: ACHIEVEMENTS AND CHALLENGES

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B. Changes in Trade Patterns 87 C. Investment, Exports, and the Role of the Government 90 D. Diamond Processing 92 E. Closed Borders and Transport Costs 93 F. Concluding Comments 96 References 97

6. Summary 99

Boxes1.1. Armenia’s Tax System 8 1.2. Governance in Armenia 11 1.3. Armenia’s Poverty Reduction Strategy 15 2.1. Determinants of Growth: Cross-Country Evidence 30 3.1. Tax Administration and the Business Environment 53 4.1. Developing Markets for Debt: Country Experiences 80

Figures 1.1. EBRD Transition Indicators, 2004 5 1.2. Monetary Growth and Inflation, September

1995–December 2004 12 1.3. Fiscal and External Account Deficits, 1994–2004 13 1.4. Annual Average Real GDP Growth in Armenia and Other CIS Countries, 1991–2004 17 1.5. Trade Ratios 18 1.6. Nominal and Real Effective Exchange Rates, 1995–2004 19 1.7. Interest Rate Spread and Real Lending Rate, 1995–2004 20 2.1. Index of Real GDP in CIS Countries 24 2.2. Capital and Labor Productivity 28 2.3. Investment and Savings 31 3.1. Fiscal Indicators, 1994–2004 47 3.2. Tax Revenue Performance, 1997–2004 49 3.3. Former Soviet Union Countries: General Government Tax Revenue, 1999–2003 50 3.4. Fiscal Implications of Environmental Cleanup Costs, 2005–20 60 4.1. Former Soviet Union and Central Europe: Assets and Deposits to GDP, 2004 67 4.2. Former Soviet Union and Central Europe: Dollarization, 2004 70 4.3. Former Soviet Union and Central Europe: Composition of Assets, 2004 71 4.4. Former Soviet Union and Central Europe: Average Lending Deposit Rate Spread, 2004 72 4.5. Asset Shares in the Banking System, End-2004 77 4.6. Bond Issues in International Markets, Cumulative 1995–2004 82


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Contents

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5.1. Current Account, 1994–2004 87 5.2. Direction of Trade, 1996–2004 89 5.3. Composition of Exports, 1994–2004 90 5.4. Composition of Imports, 1994–2004 91

Tables1.1. Composition and Level of GDP, 1989–2004 2 1.2. Chronology of Main Economic Reforms, 1991–2004 4 1.3. Index of Trade Restrictiveness 6 1.4. Key Indicators of the Energy Sector, 1998–2004 10 1.5. Indicators of the Water and Irrigation Sector, 2000–04 10 1.6. Fiscal and Quasi-Fiscal Adjustment and External Debt 14 1.7. Tax-to-GDP Ratios 14 1.8. Investment and Official Employment 17 1.9. Poverty and Inequality in Armenia 19 2.1. Structure of Output and Employment 25 2.2. Sources of Growth 26 2.3. Components of GDP by Expenditure 26 2.4. Output and Total Factor Productivity Growth 27 2.5. Illustrative Scenarios for Per Capita Real GDP Growth 32 2.6. Poverty, Inequality, and Unemployment 34 2.7. Progress in Poverty and Inequality in Selected Countries 37 2.8. Human Development Indicators 38 2.9. Poverty Indicators and Millennium Development Goals, 1990–2015 39

2.10. Projection of Poverty Under Different Per Capita Growth Rates 40 3.1. Consolidated General Government, 1994–2004 44 3.2. Expenditure Arrears, 2000–04 46 3.3. Central Government Expenditure by Major Function, 1997–2003 48 3.4. Structure of General Government Tax Revenues, 1997–2004 52 3.5. Key Indicators of the Energy, Water, and Irrigation Sectors, 1998–2004 55 3.6. Financial Balances in the Energy, Water, and Irrigation Sectors, 1998–2004 57 3.7 Long-Term Fiscal Projections, 2005–20 59 4.1. Ownership Structure of the Banking System, 1994–2004 68 4.2. Selected Financial Sector Indicators, 1998–2004 69 4.3. Liability Structure of the Enterprise Sector, 1999–2003 74 4.4. Key Insurance Indicators, 1999–2004 78 5.1. Trade and Investment Indicators 86 5.2. Public External Debt Services Indicators, 2001–03 88 5.3. Results from Openness Model 94 5.4. Gravity Model Simulations 96


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This map was produced by the Map Design Unit of The World Bank. The boundaries, colors, denominations and any other informationshown on this map do not imply, on the part of The World BankGroup, any judgment on the legal status of any territory, or anyendorsement or acceptance of such boundaries.

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vii

Preface

During the past three years, Armenia has emerged as a reform leader within the Commonwealth of Independent States, and its economic performance has surpassed that of other low-income countries. The key factors behind Armenia’s economic performance are prudent monetary and fiscal policies, liberal trade and foreign exchange regimes, rapid and relatively well-sequenced structural reforms, and support from the Armenian diaspora.

Many reforms were initiated between 1994 and 1998, with critical fiscal and quasi-fiscal consolidation and structural reforms undertaken between 2001 and 2005. In addition, the implementation of a poverty reduction strategy since 2002 has complemented the effect of economic growth on reducing poverty. This paper assesses the country’s economic transformation during the past 10 years, focusing on the recent period of economic stability, strong economic growth, and poverty reduction, and on the challenges to sustaining these successes.

This paper is a collaborative work coordinated by Enrique Gelbard. The other principal authors are Jimmy McHugh, Garbis Iradian, Christian Beddies, and Laure Redifer. The authors would like to thank Julian Berengaut for his guidance on this project. We are also indebted to Jean Le Dem, Vahram Stepanyan, Gohar Minasyan, Vitali Kramarenko, Eric Mottu, Jerome Vandenbussche,David Grigorian, Nerses Yeritsyan, Armine Khachatryan, Hajime Takizawa, David Hauner, and Shuang Ding for their helpful comments on an earlier draft of the paper. Cecilia Lon compiled the document and provided invaluable administrative assistance. Special thanks to Debbie Chungu for her effective research assistance and to Linda Griffin Kean and Alicia Etchebarne-Bourdin in the External Relations Department of the Fund for their contributions in editing and coordinating the publication of the paper.

The views expressed here are solely those of the authors and do not necessarily reflect those of the International Monetary Fund, its Executive Board, or its management.


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ix

Overview

The first decade of transition was difficult for Armenia. A severe earthquake, the breakup of the Soviet Union, and disputes with neighbors led to a drastic decline in output in the early 1990s. Unemployment rose sharply, real wages fell, and a shrinking tax base constrained government expenditures. The government suffered from persistent cash shortages that generated large external and domestic expenditure arrears. Declining living standards and rising poverty levels forced many of Armenia’s most productive workers to migrate.

Several early reforms, initiated between 1994 and 1998, attempted to revitalize the economy. The reforms focused on privatizing land holdings and small-scale enterprises, and liberalizing prices, trade, and the foreign exchange regime. These policies adjusted relative prices and incentives, setting the stage for a period of market-driven capital formation. The economy rebounded in the second half of the 1990s, and inflation declined to single-digit levels.

As the 1990s ended, however, it became clear that a number of imbalances continued to constrain economic performance. Over 50 percent of the population still lived in poverty and emigration to other countries continued. Armenia’s fiscal position was weak and was hampered by a continuous accumulation of internal and external payments’ arrears. Furthermore, the banking sector entered into a difficult period that saw the collapse of about one-third of the country’s commercial banks. Lastly, corruption in state-owned energy and water companies generated large interenterprise arrears and a sizable quasi-fiscal deficit.

In the face of these concerns, the authorities launched in 2001 a renewed stabilization and reform effort supported by the IMF’s Poverty Reduction and Growth Facility (PRGF). Comprehensive reforms were introduced in the fiscal, banking, and energy sectors and these reforms were later aligned with a Poverty Reduction Strategy Paper (PRSP). The key goals were to boost growth through tax reform and deregulation, restore confidence in fiscal management and improve expenditure control, restructure the energy sector, and clean up the banking system.

The results have been impressive. Real economic growth has averaged 11 percent per year, annual inflation has averaged 3 percent, and poverty and inequality have fallen. The country has outperformed other low-income countries including those in the Commonwealth of Independent States (CIS). This is particularly important given the geographic location of Armenia, the closure of two critical borders, and occasional political turmoil. Notwithstanding these achievements,



x

per capita income is about US$1,000, poverty rates are still high, and the structural reform agenda remains to be completed. Furthermore, the country’s institutions need to be strengthened, and corruption remains a problem.

This paper evaluates Armenia’s economic transformation since the early 1990s and identifies the issues and policies that deserve further attention to sustain growth and further reduce poverty. The first chapter contains an analysis of the path toward macroeconomic stabilization, the sequencing of reforms, and the successes and disappointments after a decade of transition. This analysis reveals four areas that are covered in the remaining chapters, namely, the growth process, the role of fiscal reforms, the importance of the financial sector, and trade integration.

Chapter 2 estimates productivity growth, analyzes changes in poverty and inequality, and looks at whether increase income levels in Armenia are likely to increase in line with the Millennium Development Goals (MDGs). Chapter 3 discusses fiscal and quasi-fiscal adjustment, the remaining priorities in the areas of tax and expenditure policies, and key long-term challenges. Chapter 4 deals with the barriers to financial sector development and ways to increase financial intermediation, while Chapter 5 describes recent changes in the pattern of trade, including the boom in exports and the potential effects of opening Armenia’s borders. A concluding chapter summarizes the remaining reform agenda.


1

CHAPTER

Armenia After a Decade of Reform

This chapter contains an assessment of Armenia’s transition from a state-dominated economy to a market-oriented one during the past 10 years. It begins with a brief discussion of the economic background and continues with an analysis of the main reforms undertaken, the process of economic stabilization, and economic performance. The chapter revolves around three main issues: (1) Armenia’s strong economic performance compared to similar transition countries, especially since 2001; (2) the main factors behind the ignition of the growth process; and (3) the challenges to sustaining high rates of economic growth in the future.

A. Background

Before 1990, central planning and a disregard for economic incentives characterized Armenia’s economy, as was the case in most Soviet bloc countries. The country received substantial financial support (transfers and subsidies on imported products) from Russia, and its industrial sector was quite important, accounting for about half of GDP. Armenia’s human capital was also in high demand in Russia. The most important industrial (and export) activities were electronics, heavy machinery, and chemicals.1 These activities were the ones that suffered most from the disintegration of the Soviet Union after 1990.

Between 1988 and 1994, the economy was severely affected by an earthquake, the collapse of the Soviet Union, and the Nagorno-Karakakh conflict.2 Trade

1Output was produced mainly in large plants and exchanged with other countries of the former Soviet Union, primarily Russia. See Avanesyan and Freinkman (2003). 2The 1988 earthquake is estimated to have left more than 25,000 people dead and many more homeless. The war with Azerbaijan was motivated by tensions over the disputed Nagorno-Karabakh region. The war began in 1991 and a cease-fire was reached in 1994. Since then, Armenia’s borders with Azerbaijan and Turkey have remained closed. This has constrained Armenia’s trade prospects because of the higher costs of transportation to Europe (via Georgia). Negotiations on the settlement of the territorial conflict between Armenia and Azerbaijan are continuing. However, restoration of economic and transportation links remains a contentious issue.

1



2

Table 1.1. Composition and Level of GDP, 1989–2004 (In percent)

1989 1994 1999 2004

Agriculture 15 44 27 20 Industry 50 29 21 22 Construction 21 7 8 15 Transport 4 4 8 6 Trade and services 11 17 36 37

Real GDP (Index 1991 = 100) . . . 45 56 92 Income per capita (U.S. dollars) . . . 173 566 1,135

Source: Armenian authorities.

routes were disrupted, subsidies on energy and other inputs imported from the Soviet Union were eliminated, Russian demand for Armenia’s goods virtually disappeared, and transportation costs skyrocketed.3 These factors led to an estimated 55 percent decline in Armenia’s GDP during this period (compared to a 50 percent average decline in the rest of the former Soviet Union) (Table 1.1).4By 1994, annual inflation escalated to 5,300 percent, the result of massive fiscal imbalances financed with money creation. The fiscal and external current account deficits rose to 17 percent and 36 percent of GDP, respectively.

The shocks of the late 1980s and early 1990s led to massive unemployment and a large emigration to the countryside and to other countries. An estimated 17 percent of the 1990 population of nearly 3.5 million people emigrated abroad.5 Since the late 1990s, Armenia’s diaspora has become an important source of remittances and transfers (estimated at an average of 8 percent of GDP per year during the period 2000–04), and has been a contributing factor to the recent surge in trade and investment.6

3A railway blockade and the closure of the energy pipeline proved to be quite damaging for Armenia’s industry. In addition, the route through Georgia was also unstable. 4See World Bank (2001). 5Armenia, Ministry of Statistics (1998). It is estimated that about 4 million Armenians live outside the country (most of them in Russia, the United States, France, and the Middle East). 6Unofficial estimates suggest remittances and transfers range between 15 and 25 percent of GDP (U.S. Agency for International Development/Armenia, 2004).



3

As in other countries of the former Soviet Union, powerful business interests have emerged in the transition to a market economy. These interests have been exerting increasing influence in public decision making, leading to legally sanctioned tax privileges, nontransparent privatizations, and tax evasion. These developments are worrisome as they put at risk the country’s prospects for lasting reform and sustained growth. In response to public pressure to deal with corruption in the public sector and the judiciary, the government approved a three-year anticorruption strategy in November 2003.

B. Economic Reforms

The 1994 cease-fire with Azerbaijan allowed the authorities to focus on the economic agenda, and a stabilization program was adopted in 1994 with support from the IMF, the World Bank, and other donors. Since then, and despite a difficult political environment and policy slippages (especially during 1999–2001), Armenian policymakers have maintained a commitment to macroeconomic stability, market-oriented reforms, and the country’s integration with international markets.7

A wide range of economic reforms has been undertaken during the past 10 years (Table 1.2). Economic reforms in the early 1990s focused on land privatization, small-scale privatization of firms, and the liberalization of prices, trade, and the foreign exchange regime. Reforms in the late 1990s and in the early 2000s covered medium- and large-scale privatization, the tax and banking systems, the business environment, and the energy and water sectors.

By end-2004, the European Bank for Reconstruction and Development (EBRD) transition indicators positioned Armenia ahead of other CIS countries (although below Central European and Baltic States) on all dimensions of structural reforms (Figure 1.1). IMF staff concurs with this assessment and considers that the strength and sequencing of the reforms (initially price and exchange rate liberalization, followed by a steady land and enterprise privatization program), while painful at the beginning, was essential to changing relative prices and incentives and setting the stage for a subsequent period of market-driven capital formation. Nevertheless, this overall positive

7Armenia has a turbulent political history. Political assassinations in 1999 involved the killings of the prime minister, the speaker of parliament, and five other parliamentarians.


1991–94 1995–97 1998–2000 2001–04 Status as of End-2004

Liberalization of domestic prices Completed, regulated prices retained for selected utilities and urban transport

Elimination of subsidies Advanced, water and irrigation subsidies remain and are expected to be eliminated by 2007

Land reform and privatization of land Completed

Trade and foreign exchange liberalization Completed

Capital account liberalization Completed

Small-scale privatization Advanced, to be completed by mid-2005

Large-scale privatization Advanced, to be completed by mid-2005

Tax policy reform Advanced, a tax code and further rationalization of taxes are pending

Tax and customs administration Incomplete, deficiencies remain in the structure of the respective agencies and implementation of existing procedures

Expenditure management Advanced, new fiscal risks emerged in 2003 from the creation of government-owned noncommercial organizations

Banking system legislation Advanced, further enhancements are needed regarding corporate governance and collateral and creditor rights

Banking supervision Advanced, there is a need for a faster resolution of problem banks and a more efficient judicial system

Securities’ markets and nonbanks Incomplete, insurance legislation needs alignment with best international practice

Competition policy and bureaucracy Advanced, some bureaucratic practices and enforcement problems remain

Infrastructure and telecommunications Largely completed, although telecommunications is not cost-effective and competitive enough

Water and irrigation Incomplete, tariff increases and further reforms (especially in irrigation) planned for 2005–06

Energy sector reforms Advanced, settlement of debts and other reforms should be completed in 2005

Sources: IMF staff reports, 1991–2004; EBRD transition reports, 1993–2004.1Darker areas denote the periods when the most significant reforms took place. Blanks indicate little or no reforms during the period.

Table 1.2. Chronology of Main Economic Reforms, 1991–20041

4

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OW

TH AN

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ENIA: ACH

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5

Source: European Bank for Reconstruction and Development.

assessment of reforms is tempered by some delays and weak implementation in some areas.8

The privatization process is almost completed. Land reform led to the creation of about 300,000 private and collective farms as well as to the tradability of land.9The privatization process comprised an initial privatization of 3,963 small enterprises from 1992 to 1996, and 1,513 medium and large enterprises from 1995 to 1999. A final privatization program comprising the last 900 state-owned enterprises began in 2000 and is expected to be complete by end-2005.10

The exchange regime and consumer prices were liberalized early in the transition. A domestic currency (the dram) was introduced in 1993 within a liberal foreign

8For instance, there have been delays in the resolution of problem banks in recent years, and the implementation of tax and customs administration reforms has been deficient (see below). This reflected choices made by the authorities (e.g., prolonged period of intervention of commercial banks) as well as the influence of vested interests and capacity constraints (e.g., discretion and inefficiency in tax and customs administration). 9Despite the overall positive impact of land privatization, there were weaknesses in implementation, especially because of the lack of input markets. These and other problems have constrained agricultural productivity growth. 10There has been some concern in the public domain about lack of transparency in some privatizations, such as the debt-equity swap with Russia and the privatization and subsequent handling of rights in telecommunications.

Figure 1.1. EBRD Transition Indicators, 2004

0.0

1.0

2.0

3.0

4.0

5.0Privatization

Enterprise restructuring

Price and foreign exchange marketliberalization

Competition policyBanking system and securities markets

Infrastructure reform

Overall index

Armenia

CIS excludingArmeniaBaltic countries

Degree of progress is measured on a 0 to 5 scale



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Table 1.3. Index of Trade Restrictiveness1

1997 2004

Armenia 1.0 1.0 CIS (average) 3.7 2.6 Developing countries 5.1 4.0

Source: Trade Policy Information Database, IMF. 1Reflects both tariff and nontariff barriers. Ranges from 1 (most liberal) to 10 (highly restrictive).

exchange regime and its value has fluctuated without major interventions by the central bank. By 1995, most prices of goods and services had been liberalized (except for bread, utilities, urban transport, and pharmaceutical products) and many subsidies had been reduced or eliminated. Further price liberalization took place in 1995.

By the mid-1990s, Armenia had put in place open trade and investment regimes (Table 1.3). Trade policies included the removal of quantitative restrictions on imports, the adoption of a simple import tariff regime with a single 10 percent tariff for most consumer goods and no tariff for the remaining goods, the elimination of export surrender requirements, the adoption of a liberal foreign direct investment regime, and full current account convertibility. Armenia joined the World Trade Organization (WTO) in 2003. Notwithstanding this impressive progress on trade liberalization, inefficiencies and corruption at customs have constrained trade, tax collection, and private sector development in general.

A modern tax system with low rates was introduced in the 1990s. The tax system was revamped during 1992–96, with the introduction of a value-added tax (VAT), a personal income tax, a system of excise taxes, and a reformed profit tax. Further improvements in the tax system took place in 1997 with the move of VAT payments on many imports to the point of entry (rather than after sale in the domestic market), the introduction of a new profit tax law, and increases in excise taxes. At the same time, a system of presumptive taxes was introduced to capture activities whose profitability was deemed difficult to monitor. The system included a simplified tax for small retailers, and the activities covered by this system were excluded from the normal regime of VAT and profit taxes. In 1999, income taxes were reduced, a single profit tax rate with new depreciation allowances was introduced, and profit tax holidays for foreign investments were added.11

11As in most countries, profit tax holidays have proven to be an inefficient and costly way of providing incentives. The annual revenue loss in Armenia is estimated at 0.5 percent of GDP. Furthermore, the presence of accelerated depreciation allowances in Armenia also makes redundant this exemption (set to expire in 2007).



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Tax and customs administration has improved gradually in the past decade. Capacity constraints in these agencies combined with lax management practices led to discretionary treatment of taxpayers, nontransparent practices, and low collection rates. These problems, along with an inefficient judiciary, resulted in the accumulation of tax arrears by companies as well as of VAT refundarrears from the government.12 Tax arrears (excluding penalties) peaked at 4.5 percent of GDP in mid-2003. On the tax refund side, arrears on VAT to exporters peaked at 0.5 percent of GDP at end-2002. The situation has improved gradually since mid-2003, after the strengthening of administrative procedures and the introduction of codes of conduct and an internal audit unit (Box 1.1).

Expenditure management has improved during the past 10 years, although challenges remain. A key reform was the introduction of a single treasury account in 1997. However, the treasury system remained weak until 2001, as evidenced by a cumbersome system of controls and accumulation of expenditure arrears. The system improved substantially since 2002. Commitment control procedures have been introduced, all arrears have been paid, and no further arrears have accumulated. Recent decentralization policies in the health, education, and water sectors have the potential to improve the quality of services, but these policies have not yet been accompanied by a sufficient increase in capacity, transparency, or accountability.13 Lastly, while central government expenditures are relatively well managed, local governments suffer from capacity constraints and lack of transparency.14

The efficiency of government services has been a major constraint on Armenia’s development. A civil service reform was initiated in 2001 aimed at improving capacity, better aligning salaries and skills, and reducing corruption. The process needs to be deepened to ensure an efficient provision of public services, the elimination of nepotism and political appointments in technical positions, and salary increases as envisaged in the PRSP.

After the privatization of banks in the early 1990s, banking sector reforms proceeded at a gradual pace. Basic laws on the central bank, commercial banking,

12Armenia’s judicial system is perceived as nontransparent and partial. The improvements in this area envisaged in the authorities’ anticorruption strategy require political commitment at the highest levels of government. 13In early 2003, about 5,000 budgetary organizations (nearly 15 percent of the budget) were given a different legal status as part of a wide decentralization reform. Most of these entities are schools and hospitals and were not subject to sufficient auditing and reporting procedures, rendering their activities less transparent. The authorities have recently approved a regulatory framework for these entities and have begun implementing a reporting and monitoring system to compensate for the loss of budgetary control. 14Furthermore, budget coverage and budget presentation (budget and budget execution reports) could be more transparent and include extra-budgetary funds, all types of grants, and consolidated balances of state-owned noncommercial organizations and enterprises.



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Box 1.1. Armenia’s Tax System

Weaknesses in tax and customs administration remain the main constraint to revenue collection. A large gap between actual and potential collection is evidence of Armenia’s tax revenue potential. Reforms during the past two years focused on putting in place codes of conduct and internal audit units in the tax and customs agencies, disseminating tax laws and regulations, and enhancing the authority of the tax service to collect arrears. However, organizational improvements and the effective implementation of laws and regulations have been lagging. In 2004, the large taxpayers unit collected about 23 percent of total revenues, whereas it could potentially collect up to 75 percent. Discretionary behavior and organizational deficiencies within the tax service and creative accounting practices by companies all contribute to this disappointing performance. Looking ahead, it will be critical to revamp the internal organization of the tax service and implement risk-based systems for audit and administration of VAT refunds. A similar set of considerations applies to customs operations. In addition, bringing tax and customs under the control of the Ministry of Finance would improve coordination and ensure consistency between policies and administration.

While improving tax and customs administration is a priority, there is also room to improve the tax policy environment. Armenia’s tax system is generally well designed and characterized by low and uniform rates. The main tax policy reforms in the past three years focused on reducing VAT exemptions on imports and improving legislation to limit the erosion of the tax base. In the medium term, there is room to streamline a number of overlapping taxes that lead to a fragmentation of the tax base. First, there is a simplified tax intended for small taxpayers, which has lower rates than the regular tax regime (profit, income, and value-added taxes). However, it has provided incentives for the fragmentation of large businesses that take advantage of its lower rates and switch between regimes to minimize tax liabilities. Second, presumptive taxes on certain products were introduced in the mid-1990s because of administrative difficulties in covering them under the regular regime. There will soon be scope to begin covering these activities with the VAT. Third, a rather complex set of laws and regulations has emerged in recent years highlighting the importance of compiling a unified tax code. Fourth, the remaining VAT exemptions on imports of selected intermediate inputs and capital goods (equivalent to about 15 percent of total imports) could be removed, as they undermine the integrity of the tax system, distort price signals, and create an uneven playing field among importers. Lastly, it would be useful not to renew the profit tax holiday for foreign investments beyond its expiration in 2007.

and insolvency were introduced in 1996. Banking regulations were aligned with the Basel Core Principles in 1997, and a chart of accounts and international accounting standards for banks were adopted in 1998. A weak legal framework and occasional political interference with the supervisory authorities weakened the effectiveness of banking supervision and led to cases of forbearance when prudential requirements were breached. Higher minimum capital requirements and connected lending in some banks contributed to the collapse of10 commercial banks between 1999 and 2001. While the situation of these banks has now been resolved, the process could have been faster and confidence in the system would have returned earlier. Another serious constraint to financial



9

system development has been difficulties in recovering collateral owing to distorted exit mechanisms and an inefficient and corrupt judiciary. Some legislation was adopted in 2003, but further amendments to the civil code are needed to strengthen creditor rights.

Energy sector reforms began in 1997 with the setting up of the basic regulatory framework, the establishment of the Energy Regulatory Commission, and increases in tariffs toward cost-recovery levels. While some improvements in performance were noted by 2000, the sector remained a drain on budgetary resources and a source of interenterprise arrears. The situation was aggravated during 2000–01 by mismanagement and corruption in state-owned companies. A number of corrective actions have been undertaken since 2001, including improvements in technical and financial management, a reduction of staffing by almost one-quarter, a linking of wages to performance, and enforcement of interruption of service to nonpaying customers. In addition, the government privatized the electricity distribution company and two power plants in 2002 and 2003, respectively.

Energy sector reforms have been successful. The loss arising from technical deficiencies and theft fell from more than 20 percent of generation during1998–2002 to an estimated 2 percent in 2004. During the same period, collection rates rose to almost 100 percent, and the primary deficit of the energy sector (a measure of quasi-fiscal losses) turned into a surplus (Table 1.4). While the most significant reforms in the energy sector have already been adopted, a few remaining state-owned enterprises still need to be privatized, and years of erratic management have left a stock of (public) debt of US$34 million (1 percent of GDP). To deal with remaining reforms and past debts, the government began implementing in 2004 a financial rehabilitation plan covering the energy, water, and transport sectors.15

Water and irrigation services have improved only gradually (Table 1.5). Some reforms have been undertaken since the mid-1990s, including privatization and tariff increases, which have helped to improve efficiency and reduce reliance on government subsidies, loans, and arrears. However, more remains to be done to reduce technical losses and theft and ensure the viability of these sectors. The pace of tariff increases should be stepped up as planned to reach cost-recovery by 2007. In addition, the water infrastructure needs to be developed, and efficiency and governance should be improved in the users’ associations that manage the irrigation infrastructure.

15Measures already taken in the energy sector include phasing out management functions previously vested in the Ministry of Energy, restructuring the midstream sector (including settlement, dispatch, and transmission companies), introducing an improved governance framework, and establishing direct contracting between power generators and the privatized distribution company. A restructuring of energy sector debt is also under way.



10

Table 1.4. Key Indicators of the Energy Sector, 1998–2004 (In percent of GDP, unless otherwise indicated)

1998–99 2000–01 2002 2003 2004

Technical and other losses1 26.0 22.0 22.0 4.2 2.3 Collection rate2 24 23 48 101 106 Overall financial balance3 –3.3 –2.8 –1.7 –0.6 –0.4 Primary balance3, 4 –1.7 –1.9 –0.4 0.0 0.2

Source: Armenian authorities. 1Technical deficiencies in percent of generation (state-owned companies).2In percent of billings.3State-owned companies.4Excluding interest and foreign-financed capital expenditures.

Table 1.5. Indicators of the Water and Irrigation Sector, 2000–041

(In percent of GDP, unless otherwise indicated)

2000–01 2002 2003 2004

Technical losses2 51 55 58 59 Collection rate3 34 48 76 66 Overall financial balance –1.6 –1.0 –0.8 –0.4 Primary balance4 –1.2 –0.9 –0.6 –0.3

Source: Armenian authorities. 1Averages of the state-owned water and irrigation companies. 2In percent of output. The recent increase is explained by improved metering. 3In percent of billings. 4Excluding interest and foreign-financed capital expenditures.

Since 2001, the government has focused on deregulating the environment for private sector activity and on measures to reduce transaction costs. The quality of regulations was improved, licensing procedures were simplified, a new criminal code was introduced, and laws and regulations were more widely disseminated. These changes led to an improvement in the business environment and put Armenia ahead of most CIS countries in a variety of governance indicators (Box 1.2). However, corruption remains a problem, especially in tax and customs agencies, the health sector, and the judiciary.



11

Box 1.2. Governance in Armenia

Armenia’s standing in Transparency International rankings improved from the 80th percentile in 1999 to the 50th percentile in 2004. Similar progress can be noted in the World Bank’s governance indicators, the EBRD business environment surveys, and the Heritage Foundation indices of economic freedom. This reflects a number of reforms introduced during the past three years, including the simplification of licensing procedures, civil service reform, a new criminal code, privatization in the energy sector, and dissemination of laws and regulations. Notwithstanding these improvements, corruption indicators in Armenia are still higher than in other countries of Eastern Europe and the Baltic States. In a recent public opinion poll, Armenians said they were mostly concerned with corruption in the judiciary, tax and customs operations, the defense and security forces, and the health sector.

After much preparation, the authorities finalized an anticorruption strategy at end-2003. The strategy contains a three-year action plan with measures to be implemented, including:

Harmonizing legislation to specify sanctions for corruption, protect witnesses, and improve access to information;

Carrying out reforms on tax and customs administration and the judiciary; and

Introducing financial audit standards in the public sector and strengthening parliament’s role in the audit process.

Implementation of the strategy needs to gain momentum, and further efforts are required to fully involve civil society in the process and specify benchmarks for most activities. There is also a need to identify enforcement mechanisms, work on whistle-blower protection regulations, and increase the transparency and accountability of local governments.

C. Macroeconomic Stabilization

Prudent management of fiscal and monetary policy coupled with economic reforms set the foundation for growth and sustained macroeconomic stability. Armenia’s economic indicators displayed a marked improvement, especially after 2001. The reduction in the fiscal and quasi-fiscal deficits played a key role in

Armenia: Governance Indicators

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100Voice and Accountability

Political Stability

Government Effectiveness

Regulatory Quality

Rule of Law

Control of Corruption

ArmeniaCISEastern Europe

Source: World Bank Business Env ironment and Enterprise Performance Surv ey s, 2002



12


lowering inflation to single-digit levels and in stabilizing the value of the dram.16

Another key factor was the presence of a largely independent central bank. Monetary policy followed strict targets on the net domestic assets of the central bank and minimal accumulation of bank credit to the government. This led to a rapid deceleration of the growth in both reserve money and broad money (Figure 1.2). After inflation fell to single-digit levels in 1999, real money demand began to increase, and a virtuous circle of gradual re-monetization and low inflation was inaugurated. A flexible exchange rate gave authorities the necessary control over the money supply in an environment of free capital mobility, real and nominal interest rates fell in response to macroeconomic stability, and international reserves rose.

The magnitude of Armenia’s fiscal adjustment is noteworthy. The general government deficit fell from 17 percent of GDP in 1994, to 6 percent in 2000,

16An additional factor was the formal prohibition of central bank net lending to the government since 1998.

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Figure 1.2. Monetary Growth and Inflation September 1995–December 2004(12-month percentage change)



13

Source: Armenian authorities; IMF staff estimates.

and to an estimated 1.6 percent in 2004 (Figure 1.3). The financial balances of the energy, water, and irrigation sectors also fell drastically, contributing to overall fiscal consolidation and macroeconomic stability (Table 1.6).17 This process was accompanied by a debt management strategy that prioritized the use of concessional financing and grants and led to a reduction in debt ratios.

However, fiscal adjustment was primarily achieved through expenditure compression, with little contribution from the revenue side. While tax revenues grew rapidly in both nominal and real terms during the past five years, the ratio of tax revenues to GDP did not improve (Table 1.7). Four main factors explain this: (1) strong growth in activities that are tax-exempt because of international agreements (e.g., grant-financed construction), (2) a reduction in income and profit tax rates since 1999, (3) profit tax exemptions for foreign investment, and (4) lingering weaknesses in tax and customs administration.

The road to macroeconomic stabilization has not been without obstacles. A stabilization program supported by an IMF Stand-By Arrangement during 1995–96 helped reduce the fiscal deficit by almost 9 percent of GDP and brought inflation down from 5,273 percent in 1994 to 19 percent in 1996. However, the Russian financial crisis of 1998 and the Armenian political assassinations in 1999 led to a period of political uncertainty and a slowdown in the reform effort and economic activity in 1999–2000. Exports, transfers, and remittances fell, the fiscal deficit rose again, and domestic and external payment arrears grew rapidly.

17For an alternative approach in estimating the extent of fiscal and quasi-fiscal adjustment in Armenia, see Avanesyan and Freinkman (2003).

(In percent of GDP)

05

10152025303540

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

General government deficit on a commitment basis

External current account deficit

Figure 1.3. Fiscal and External Account Deficits, 1994–2004



14

Table 1.6. Fiscal and Quasi-Fiscal Adjustment and External Debt (In percent of GDP, unless otherwise noted)

2004 1998–99 2000–01 2002 2003 Est.

Fiscal and quasi-fiscal balances –11.7 –9.3 –3.0 –2.5 –2.6 General government –6.4 –5.0 –0.3 –1.1 –1.6 Quasi-fiscal1 –5.3 –4.3 –2.7 –1.4 –0.8

Net present value of debt/exports2 151 135 131 87 75

Source: Armenian authorities. 1Comprising the energy, water, and irrigation sectors and the chemical company, Nairit. 2About 98 percent of Armenia’s public debt is external, making this concept the most representative. The ratio is expressed in percent of the three-year moving average of exports of goods and services.

Table 1.7. Tax-to-GDP Ratios (In percent of GDP, unless otherwise noted)

2004 1995–97 1998–2000 2001–02 2003 Est.

Tax revenue, general government 13.9 18.6 17.8 17.2 17.4 Of which: VAT 3.8 6.5 6.8 6.6 6.3

Profit tax 3.0 1.8 1.3 1.1 1.7 Payroll 2.3 3.1 2.9 2.8 2.8 Excises 1.5 2.3 2.6 2.4 2.2

Tax revenue-to-estimated tax base1 15.1 20.2 19.8 20.0 20.3

Source: Armenian authorities.1The tax base is estimated as GDP minus 90 percent of the value added in construction, which is largely tax-exempt due to international agreements with donors.

Between 2001 and 2004, a new three-year economic program supported by the IMF’s PRGF led to fiscal consolidation and a deepening of structural reforms (Box 1.3). The program aimed at reducing the fiscal and quasi-fiscal deficits, changing the composition of government expenditures in light of a decline in social spending during 1999–2001, repaying domestic and foreign arrears, lowering debt ratios, and running a cautious monetary policy in a flexible exchange rate environment. The structural reform agenda was geared to support stabilization efforts, reduce vulnerabilities, and sustain medium-term growth prospects. It focused on improving the business environment; strengthening the



15

Box 1.3. Armenia’s Poverty Reduction Strategy

In early 2001, the government prepared an interim PSRP laying out a program for redirecting public resources toward fighting poverty. In mid-2002, the government launched a consultation process within the government and with NGOs, trade unions, and donor organizations to finalize the poverty reduction strategy. The government asked these bodies to submit their priorities to a PRSP working group comprising senior government officials and representatives of civil society. The process culminated with the PRSP, a multiyear program of economic and social reforms. The government formally adopted the PRSP in August 2003.

The strategy comprises five key policy objectives:

Sustain high economic growth by deepening market-oriented reforms, paying particular attention to the business environment for small and medium-sized enterprises.

Ensure high levels of public investment. The strategy recognizes rural roads, water supply, and irrigation as priority areas.

Strengthen the social safety net by increasing expenditures on health, education, and social welfare.

Maintain macroeconomic stability through sound monetary and fiscal policies. The program reconciles this objective with the higher public expenditures by progressively increasing tax collection by about 0.4 percentage points of GDP per year.

Improve governance at all levels of government and in the judiciary.

The strategy contains a number of poverty, income inequality, and human development targets, consistent with the MDGs.

Main PRSP Targets1

___________________________________________________________________________________

2001 Actual 2015 __________________________________________________________________________________

Poverty rate (percent) 47 20 Population living on less than US$2 per day (percent) 24 7 Income inequality (Gini coefficient) 0.54 0.44 Child morality per 1,000 live births 35 19 Primary enrollment ratio 97 100 Accessibility to drinking water in rural areas (percent) 42 70 __________________________________________________________________________ Source: Armenian authorities. 1The targets are based on 2001 data. The PRSP is expected to be revised in late 2005.



16

banking system, tax and customs administration, and expenditure management; and increasing efficiency in the energy and water sectors.

The program was aligned with Armenia’s Poverty Reduction Strategy (Box 1.3).18

The policies and programs envisaged in the PRSP have been progressively integrated into the program and the budget process. The authorities have changed expenditure priorities in the budget, implemented reforms in the areas of health and education, and proceeded to develop monitoring indicators.19 They also have been refocusing their efforts on social policies and the rural economy.

D. Economic Performance

Macroeconomic stabilization and reforms contributed to an improved business environment and higher levels of investment, foreign financing, and donor assistance. The availability of foreign resources (loans, transfers) helped supplement low domestic savings and facilitated the observed higher levels of consumption and investment.

Growth was ignited by higher investment and a rapid increase in total factor productivity (Chapter 2). Total investment grew from 19 percent of GDP in 2000 to nearly 25 percent in 2003 (Table 1.8). As a result, annual real GDP grew by an average 12 percent during 2001–04 (Figure 1.4). While official employment data shows a decline in total employment, the change fails to capture the expansion of the informal sector, estimated at 45 percent of GDP in 2001 (Shiells and Sattar, 2004). According to official data, unemployment has declined slightly in recent years. Official unemployment in 2004 was 10 percent, though unofficial estimates suggest a figure between 15 and 25 percent.

The structure of the economy suffered a radical transformation since the early 1990s. The composition of output shifted from heavy industry to agricultural production in the mid-1990s, and to light manufacturing in the second half of the 1990s. Most activities that thrived during the Soviet period (chemicals and heavy machinery) contracted sharply and new ones (food processing, nonmetallic minerals, jewelry, and textiles) started to emerge. Since the late 1990s, import substitution intensified in light industries, and an export boom began in the precious stones sector followed by agricultural products, processed foods, and textiles. The observed progressive broadening of the structure of production

18International Monetary Fund (2003a). 19In early 2005, the authorities prepared a draft Annual Progress Report of PRSP implementation. The draft outlines the policies adopted during the past year, including the additional allocations for poverty-reducing expenditures and the improvement in poverty indicators.



17

Est.1996–98 1999–2001 2002 2003 2004

Investment (percent of GDP) 19.4 18.9 21.7 24.7 22.5Official employment (thousands) 1,382 1,280 1,106 1,112 1,201


Averages

Table 1.8. Investment and Official Employment

(and exports) is consistent with recent empirical research on diversification and growth showing that at low income levels the two are positively correlated over time (Imbs and Wacziarg, 2003). As a result, exports of goods and services increased from an average of 21 percent of GDP during 1998–2000 to 29 percent during 2002–04 (Figure 1.5). Similarly, the current account deficit fell drastically during the same period.

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ArmeniaCIS average

Figure 1.4. Annual Average Real GDP Growth in Armenia and Other CIS Countries,1 1991–2004(Annual average, in percent)

Source: IMF World Economic Outlook database. 1Azerbaijan, Belarus, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, Russia, Tajikistan, Turkmenistan, Ukraine, and Uzbekistan.



18


High economic growth and improvements in social policies since 2002 contributed to a reduction in poverty rates and income inequality (Table 1.9). Extreme poverty fell even faster than overall poverty. Improvements in social policies since 2002, especially a well-targeted family benefits program, have helped the most disadvantaged groups in society.

As noted above, the central bank’s monetary policy was focused on price stability and was complemented with a prudent fiscal policy and exchange rate flexibility. The exchange rate appreciated appropriately during and after the Russian financial crisis with minimal central bank intervention (Figure 1.6). The real exchange rate then depreciated by nearly 25 percent between 2000 and 2003 (mainly because of a concomitant real effective appreciation of the Russian ruble). Since productivity growth in tradable sectors accelerated during 2001–04 (see Chapter 2), competitiveness remains high despite an estimated 15 percent real effective appreciation of the dram in 2004.

Real interest rates and spreads have been falling in recent years, although they remain high (Figure 1.7). As expected, lower inflation brought about higher levels of monetization after 1996, but financial intermediation stagnated between 2000 and 2003. This reflects lower confidence in the banking system after the collapse of 10 banks during 1999–2001 and the relatively slow pace of banking sector reforms. Confidence in the banking system has recovered since mid-2003 following the resolution of eight banks that the central bank had intervened. During 2004, financial intermediation increased, with bank deposits and credit to the private sector growing by 32 percent and 38 percent, respectively. This trend has been continuing in the first half of 2005.

Figure 1.5. Trade Ratios(In percent of GDP)

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Exports ofgoods andservicesImports ofgoods andservices



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1996 1999 2001 2003

Overall poverty rate 56.7 56.3 47.0 32.0Rural poverty 49.0 47.7 46.0 33.9Extreme poverty 27.7 26.1 16.2 5.5Gini coefficient (income)1 0.6 0.59 0.54 0.44Gini coefficient (consumption)1 0.4 0.37 0.38 0.33

Source: Based on Household Surveys, 1996, 1999, 2001, 2003. All figures except 1996 reflect a new methodology applied by the World Bank.

1Ranges from 0 (perfect equality) to 1 (total inequality).

Table 1.9. Poverty and Inequality in Armenia

(Percent of total population, unless otherwise noted)

Source: IMF Information Notice System.

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Figure 1.6. Nominal and Real Effective Exchange Rates, 1995–2004

(Index, 1995 = 100)



20


E. Remaining Challenges During the past 10 years, a combination of well-sequenced reforms and persistent commitment to macroeconomic stability has ignited growth. The structure of the economy has been transformed through a major reduction of the role of the state as a producer of goods and services, improvements in the legal and regulatory environment, and a reorientation of economic activities towards exports and import substitution. Key reforms included the liberalization of prices, trade, investment, and the foreign exchange regime; privatization; deregulation; creation of an independent central bank; and the reduction of fiscal and quasi-fiscal imbalances. Progress in other areas was slower, including tax and customs administration, banking, judicial, and water sector reforms.

Many low-income countries have been able to achieve macroeconomic stabilization and jump-start economic growth, like Armenia, but most have had difficulty sustaining high growth rates for longer than five years. Recent research suggests that the presence and proper functioning of economic institutions can play a key role in long-run growth by lowering transaction costs and increasing the rate of return on investment (see, for example, Acemoglu, Johnson, and Robinson, 2001 and 2004). Armenia has made substantial progress in setting up such economic institutions, but some of these are not yet functioning properly and the reform agenda in certain areas remains to be completed.

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Figure 1.7. Interest Rate Spread and Real Lending Rate, 1995–2004

(In percent)



21

During the next few years, economic growth, exports, and capital formation should become more broad-based and generate employment. Since such growth cannot be exclusively financed with foreign resources, Armenia’s fiscal framework and financial system will have to play a more prominent role in fostering private sector development and channeling resources towards small and medium-sized enterprises. Fiscal prudence should be maintained, and expenditure increases should be tied to improvements in transparency, efficiency, and accountability. Further reforms are needed to develop mortgage, securities, and insurance markets. For all this to happen, a critical step would be consolidation of an institutional setup that ensures the rule of law and fights corruption.

The tax and customs systems should function adequately, and the state should become a more efficient provider of social services and public investment. A large shadow economy should be progressively brought into the formal economy through an efficient tax administration, enforcement of accounting standards, and improvements in corporate governance. Rural and regional imbalances need to be mitigated by devoting more resources to capital expenditures in rural areas and urban centers outside the capital, Yerevan. In addition, further investments and reforms are needed to improve the water and irrigation sectors. While Armenia has already put in place the basic legal and institutional arrangements present in modern tax and banking systems, it is now clear that most of the observed weaknesses in these areas are related to deficient implementation. This also involves the judicial system. Improved transparency and reduced corruption in the public sector and in the judicial system will be essential to encourage efficient investments, foster growth, and contribute to a more equitable distribution of income. Political will, more than technical assistance, will be required to address these challenges.

Armenia’s economic potential lies in an export-led development growth process, and further integration with its neighbors and main trading partners should remain a top priority. Such potential will be realized when the barriers to regional integration are removed, including discretion in customs administration and border closures.

This chapter has shed light on the main successes of the past decade and the main challenges facing the country. This review reveals four important areas that deserve a closer examination: growth and poverty, the role of fiscal reforms, the importance of financial intermediation, and prospects for tradable sectors and trade integration. These are covered in Chapters 2–5.

References Acemoglu, Daron, Simon Johnson, and James Robinson, 2001, “The Colonial Origins of Comparative Development: An Empirical Investigation,” American Economic Review, Vol. 91, No. 5, pp. 1369–1401.



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————, 2004, “Institutions as the Fundamental Cause of Long-Run Growth,” Discussion Paper No. 4458 (London: Centre for Economic Policy Research). Armenia, Ministry of Statistics, 1998, “State Register and Analysis of the Republic of Armenia, Analytical Report: Social Snapshot and Poverty in Armenia” (Yerevan). Avanesyan, Vahram, and Lev Freinkman, 2003, “Costing out the Big Bang, Impact of External Shocks in the Armenian Economy at the Outset of Transition,” Armenian Journal of Public Policy, Vol. 1 (September), pp. 1–33. Barnett, David, 2000, “Stabilization Policy in Post-Soviet Armenia,” Post-SovietGeography and Economics, Vol. 41, No. 41, pp. 30–47. De Waal, Thomas, 2003, Armenia and Azerbaijan Through Peace and War (New York: New York University Press). EBRD (European Bank for Reconstruction and Development), 2004, Transition Report (London).Imbs, Jean, and Roman Wacziarg, 2003, “Stages of Diversification,” American Economic Review, Vol. 93, No. 1, pp. 63–86. International Monetary Fund, 2003a, Republic of Armenia: Poverty Reduction Strategy Paper, IMF Country Report No. 03/362 (Washington). ————, 2003b, “Growth and Institutions,” in World Economic Outlook, April 2003 (Washington). Freinkman, Lev, Gohar Gyulumyan, and Artak Kyurumyan, 2003, “Quasi-Fiscal Activities, Hidden Government, and Fiscal Adjustment in Armenia,” World Bank Working Paper No. 16 (Washington: World Bank). Petri, Martin, Gunther Taube, and Aleh Tsyvinski, 2002, “Energy Sector Quasi-Fiscal Activities in the Countries of the Former Soviet Union,” IMF Working Paper 02/60 (Washington: International Monetary Fund).Shiells, Clinton, and Sarosh Sattar, eds., 2004, The Low-Income Countries in the Commonwealth of Independent States (Washington: International Monetary Fund and World Bank).Steves, Franklin, Samuel Fakhauser, and Alan Rousso, 2004, The Business Environment in the CIS-7 Countries (London: European Bank for Reconstruction and Development). U.S. Agency for International Development/Armenia, 2004, “Remittances in Armenia: Size, Impacts, and Measures to Enhance Their Contribution to Development,” Report No. PCE-I-820-98-00012-0 (Yerevan). World Bank, 2001, “Armenia, Growth Challenges and Government Policies,” Report No. 22854-AM (Washington). ————, 2003, “Armenia, Public Expenditure Review,” Report No. 24434-AM Washington).


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CHAPTER

Growth and Poverty Reduction

This chapter reviews Armenia’s growth performance and poverty indicators since the early 1990s. It seeks to respond to the following four questions: What were the sources of growth? Can the recent rapid growth be sustained? How responsive was poverty reduction to economic growth? What is the minimum annual growth needed for Armenia to reach its poverty target by 2015? The analysis is based on a growth accounting exercise and the results of recent household surveys.

Armenia’s growth since the mid-1990s has been impressive. During 1995–98, Armenia’s real GDP growth was 5.8 percent per year. Growth rose to an average of 11.6 percent per year during 2001–04. The contraction in output during 1990–94, however, was quite deep, and real GDP took almost 15 years to get back to its 1990 level (Figure 2.1).

Poverty and inequality indicators have improved significantly in recent years. Extreme poverty fell faster than overall poverty. Gains have not been shared by all regions, however, and have been smaller in rural and in urban areas outside Yerevan. In August 2003, the Armenian authorities endorsed their PRSP, laying out a comprehensive program for sustaining high economic growth and directing public resources toward fighting poverty.

A. Economic Restructuring and Growth

Sustained rapid real income growth largely reflects the effects of structural and macroeconomic reforms that increased total factor productivity (TFP). In the late 1990s, growth was mostly driven by consumption and was financed by external borrowing and income from the underground economy. Since 2001, growth resulted from a strong expansion of exports and investment. Grant-financed public and private investment in both construction and industry played a key role in a new wave of capital accumulation. At the same time,

2



24

Sources: Author's calculations using real GDP growth rates from the WEO database. 1CIS-6: Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Tajikistan, and Uzbekistan.

diaspora investors and entrepreneurs played an important role in channeling foreign direct investment (FDI), setting up joint ventures, and promoting exports.20

The sectoral composition of output and employment changed radically during the past decade (Table 2.1). In the 1990s, industry contracted rapidly and agriculture became more labor-intensive. By 2003, agriculture accounted for 42 percent of total employment but only 21 percent of GDP. With a large influx of workers from industry to a relatively fixed amount of land, labor productivity in agriculture declined. At the same time, a modest rate of growth in agricultural output was offset by a decline in relative prices of agricultural goods.

20The Armenian diaspora represents an extraordinary source of development resources. Private transfers from abroad were estimated at between 15 and 25 percent of GDP in 2003–04. Between 1990 and 2003, an estimated one million Armenians left the country. Almost two-thirds of the migrants are well-educated men of active working age (20–44 years).

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Average for Estonia, Latvia, LithuaniaArmeniaRussiaCIS6 average

Figure 2.1. Index of Real GDP in CIS Countries(1990 = 100)

1



25

Table 2.1. Structure of Output and Employment

Share of Production Share of Employment (In percent of GDP) (In percent of total) —————————————— ————————————— 1990 1994 1999 2003 1990 1994 1999 2003

Agriculture 13 43 27 21 17 34 43 42 Industry 45 29 27 20 31 24 15 15 Construction 18 7 8 16 12 7 4 4 Services 24 21 38 43 40 35 38 39 Total 100 100 100 100 100 100 100 100


Growth in the industry and construction sectors fell in the 1990s but rebounded in recent years. During the past decade, these sectors’ share in total employment fell to 15 percent and 4 percent, respectively. The recent growth in industrial output was driven by food processing, jewelry making, and mineral production. The boom in construction provided significant employment opportunities as evidenced by the sharp increase in hourly rates for workers in this sector.

The services sector has been the fastest growing segment of the economy since the late 1990s, especially wholesale and retail trade (Table 2.2). While official employment data indicate that the sector had a limited role in absorbing labor released by industry, this is likely to be associated with deficiencies in the employment data, as many businesses opt not to report their employees to avoid taxation.21

An analysis of the expenditure components of GDP shows that, contrary to previous years, the economic boom since 2000 has been driven by net exports and investment rather than by consumption. The share of consumption in GDP fell from 114 percent during 1995–97 to 99 percent during 2001–04 (Table 2.3). The improvement in net exports in recent years reflects the sharp increase in exports of precious stones, metals, and processed food products.

21GDP data contain an estimate of the size of the informal sector, but employment data do not.



26

Table 2.2. Sources of Growth

Average Annual Real Growth Contribution to Growth (In percent) (Annual averages, in percent) ——————————————— ——————————————— 1990–93 1994–98 1999–2004 1990–93 1994–98 1999–2004

Agriculture –6.1 3.5 6.1 –1.5 1.2 1.5 Industry –18.3 2.5 7.7 –5.0 0.4 1.7 Construction –29.8 7.9 23.0 –2.9 0.4 2.6 Services –22.7 10.4 10.1 –8.6 3.7 3.6 Total –18.4 5.6 9.3 –18.0 5.7 9.4

Sources: Armenian authorities.

Table 2.3. Components of GDP by Expenditure (In percent of GDP)

1995–97 1998–2000 2001–04

Consumption 114.1 109.5 98.5 Private 101.4 97.5 88.5 Public 12.7 11.9 10.0

Fixed investment 16.5 18.7 22.2 Private 12.4 14.3 17.7 Public 4.1 4.4 4.6

Net exports –33.7 –30.1 –17.8

Sources: Armenian authorities; IMF staff estimates.

B. Total Factor Productivity

Economic growth in Armenia since 1994 has been driven primarily by high rates of TFP growth (i.e., by the improved allocation of resources). As in most transition economies, while capital accumulation had been the main factor behind economic growth in the Soviet era, efficiency gains became the main source of growth in recent years.



27

Table 2.4. Output and Total Factor Productivity Growth (Average Annual Percentage Changes)

Output Capital Labor TFP Labor Period Growth Growth Growth Growth Productivity Rate Rate1 Rate Rate Growth Rate

Armenia 1990–93 –17.3 –1.0 –3.2 –15.4 –16.7 1994–97 5.4 0.9 –2.9 6.0 8.1 1998–2000 5.5 1.9 –2.3 5.3 8.0 2001–04 11.6 5.9 –0.7 8.4 12.5

Albania 1990–92 –15.3 –7.9 0.6 –10.8 … 1993–96 9.3 0.2 –0.4 9.3 … 1998–2001 7.4 1.3 0.4 6.4 … 2002–03 5.4 2.7 0.8 3.4 …

Azerbaijan 1990–95 –12.0 3.4 –1.2 –13.5 –3.1 1996–98 5.7 9.5 0.8 –0.3 4.9 1999–2004 9.9 10.2 0.3 3.6 9.7

Sources: Authors’ estimates for Armenia and Azerbaijan following the methodology of De Broeck and Koen (2000); for Albania, World Bank (2004).

Note: Elasticities of output with respect to capital and labor are set equal to 0.6 and 0.4, respectively, and the annual depreciation rate of the capital stock is 4 percent.

1Capital K is calculated by the conventional perpetual inventory method, as discussed in Barro and Sala-i-Martin (2000): K (t+1) = I(t) + (1-d)K(t), where I is the level of real investment and d is the rate of depreciation of the existing capital stock.

The growth accounting framework distinguishes between growth arising from increases in inputs (capital and labor) and growth arising from higher efficiency (technological change) in the use of those inputs (TFP). Our estimates show that Armenia’s TFP grew at an average rate of 5.3 percent and 8.4 percent per year during 1998–2000 and 2001–04, respectively (Table 2.4). This result—that the initial contraction and the subsequent growth in real GDP were primarily driven by large negative and subsequently large positive rates of TFP growth—is consistent with the findings of De Broeck and Koen (2000) and Campos and Coricelli (2002) for other transition economies.



28

TFP increases accounted for more than three-fourths of GDP growth since 1998.22 The analysis also shows that both capital and labor productivity, defined as real GDP to capital and real GDP to labor, bottomed out in 1993 and improved steadily thereafter (Figure 2.2). By 2004, labor productivity far exceeded its 1990 level (although capital productivity was slightly lower).

The figures show a distinct V-shaped pattern in TFP growth. TFP growth in Armenia was sharply negative in the early years of the transition (1990–93) but turned positive after the mid-1990s, indicating that part of the initial sharp productivity decline was temporary, with production factors being less than fully used. Factors such as trade disruptions and the war with Azerbaijan explain a large part of the fall in TFP in the early 1990s. TFP captures increases in productivity, but it also reflects increases in capacity utilization, changes in hidden employment, and the increase in GDP on account of estimated informal sector activity.

For comparison, Table 2.4 also shows the results of the growth accounting framework for Albania and Azerbaijan. Like Armenia, Albania’s movements in real GDP growth were mainly driven by movements in TFP. During the sharp contraction of 1990–92, TFP fell dramatically. During the subsequent strong recovery, economic growth in Albania has been driven primarily by high rates of

22These results are subject to some caveats, such as data weaknesses due to difficulties in the measurement of formal sector activity, labor hoarding, capacity utilization, and the depreciation rate of capital.

Source: IMF staff estimates.

405060708090100110120130

1990 1992 1994 1996 1998 2000 2002 2004

Capital ProductivityLabor Productivity

Figure 2.2. Capital and Labor Productivity(1990 = 100)



29

TFP growth. The TFP growth, however, appears to be gradually declining in recent years in Albania as the effect of post-transition reallocation ends. In contrast to Armenia and Albania, more than one-half of the growth in Azerbaijan has been driven by accumulation of capital (mainly in the form of FDI in the oil and gas sectors).

Can the recent growth be sustained?

While Armenia’s performance has been impressive, there are some concerns about the sustainability of high growth in the medium to long run. Empirical evidence for several countries indicates that TFP growth is unlikely to remain high for a long time.23 As post-transition reallocation gradually tapers off, the country must raise its investment further in order to sustain high rates of GDP growth.

Long-term rapid growth will be increasingly dependent on physical and human capital accumulation. Most investment will originate in the private sector but the government should also contribute with investment in the public infrastructure and the social sectors. As foreign savings are expected to decline gradually over the years, the increased investment will need to be financed with domestic savings (Box 2.1).

While higher domestic savings would strengthen the foundations for sustained economic expansion, the unfavorable demographic trends of low birth rates and recent emigration of the young will make it difficult for Armenia to attain and maintain savings rates as high as those recorded by the most rapidly growing economies. Therefore, foreign financing will remain a significant, albeit declining, source of financing in the medium term.

Continued structural reform can affect TFP through two channels. First, existing resources may be allocated to uses that are more productive. This requires policies that facilitate resource mobility, for example, greater efficiency in financial intermediation. As noted in Chapter 4, there is a need to improve confidence in banks and increase the number of financial instruments. In addition, policy actions could reduce the cost of engaging in economic activities, for example, improvements in the tax and legal systems and a reduction of corruption.24

23See Campos and Corcelli (2002). 24Corruption has emerged as a threat to growth and equity in Armenia. Recent surveys indicate that corruption is a major constraint on the business environment and allows for the granting of economic favors or privileges to elites to the detriment of equity and efficiency. Weak governance in public services delivery also affects the poor directly. The problem is compounded by low wages in the public sector and the absence of a proper law enforcement mechanism.



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Box 2.1. Determinants of Growth: Cross-Country Evidence

In constructing a long-term growth scenario for Armenia, it is useful to look at experiences of growth in other transition and developing economies. Some of the conditions that led to the rapid growth in certain periods in other countries also are present in Armenia, but others are not. A recent paper by Iradian (2003a) concludes that:

The catching-up process explains only a small share of recent growth in Armenia. Following the sharp fall in output in the early 1990s, the catching up accounts for no more than one-third of real economic growth during the last eight years. As the economy moves closer to its production possibility frontier, Armenia will need to maintain macroeconomic stability and raise financial intermediation and investment rates. Investment (private and public) should be raised to 23 percent of GDP or more to ensure high rates of growth in coming years. During 2001–04, the average investment ratio rose from under 20 percent of GDP to 22.7 percent. These investment rates have been lower than in other countries with comparable rapid real GDP growth (China, Vietnam, and South Korea).

The authorities’ medium-term economic framework projects an investment-to-GDP ratio of 23–25 percent based on the gradual implementation of economic reforms during the next three years (baseline scenario). Still, immediate and

Armenia Baltics1 CIS62 Vietnam China1996–2003 1996–2003 1996–2003 1996–2003 1990–2000 1970–85 1986–95

GNP per capita (in US$)3 2,265 7,243 1,962 2,122 3,164 2,299 7,866

Real per capita GDP growth 7.7 5.4 5.1 5.9 8.7 8.5 6.1

Of which: Catching up4 2.7 1.1 1.9 … … … …

Investment/GDP 20.0 24.0 19.0 28.0 34.0 30.0 34.0

Inflation 4.0 4.0 15.0 7.0 6.0 12.0 5.0

Government consumption/GDP 12.0 21.0 16.0 13.0 13.0 11.0 12.0

Broad money/GDP 14.0 32.0 14.0 21.0 104.0 24.0 45.0

Secondary school enrollment 86.0 88.0 80.0 55.0 64.0 75.0 90.0

Source: Iradian (2003b).1Simple average for Estonia, Latvia, and Lithuania.2Simple average for Azerbaijan, Georgia, Kyrgyz Republic, Moldova, Tajikistan, and Uzbekistan.3In U.S. dollars at 1993 prices, adjusted for purchasing power parity (PPP).4Impact of the catching-up process after the sharp fall in output in the early 1990s. Empirical evidence shows that

countries would tend to grow faster following a sharp fall in output because of starting from a lower base of GDP.

South Korea

Factors Affecting Growth: Armenia in Global Perspective(Rounded Annual Averages in Percent)



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Figure 2.3 Investment and Savings (In percent of GDP)

Sources: Armenian authorities; and IMF staff estimates.

deeper structural reforms could generate even faster growth.25 Based on the growth accounting framework, we calculate GDP growth rates under two scenarios (baseline and accelerated) under differing assumptions about TFP growth and investment rates (Table 2.5). The baseline and the accelerated scenarios assume that TFP growth is 3 percent and 4 percent, respectively. These rates are lower than the average growth experienced during 2001–04 because the impact of structural reforms on factor productivity growth is likely to be smaller given that the most significant reforms have already been implemented. Under the accelerated scenario, the investment rate goes up to 27 percent by 2010 and generates an additional 2 percent in annual growth as compared with the base case.

Assuming Armenia’s border with Turkey remains closed, the structure of the economy is unlikely to undergo drastic changes in the next few years. In the medium term, income growth is expected to be driven by increased activity in the agro-business industry, exports of light manufacturing, and, to a lesser extent, tourism.

25Sound policies will not only increase the level of investment, but also improve its efficiency (as reflected in higher TFP). Other important factors influencing the business environment and the growth process are regional relations and the functioning of the legal system.

-20

-10

0

10

20

30

40

1998 1999 2000 2001 2002 2003 2004

National savingsForeign savingsInvestment



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2001–04 2005 2006 2007 2008 2009 2010Actual

Base growth scenario TFP = 8.4Real GDP growth 11.6 6.4 6.1 5.8 5.9 6.0 6.1 Of which: Catching-up effect2 2.0 1.0 0.5 0.0 0.0 0.0 0.0Investment as percent of GDP 22.7 23.5 23.7 23.9 24.1 24.3 24.5

Accelerated growth scenario TFP = 8.4Real GDP growth 11.6 8.2 7.9 7.8 8.0 8.2 8.3Of which: Catching-up effect2 2.0 1.0 0.5 0.0 0.0 0.0 0.0

Investment as percent of GDP 22.7 24.0 24.6 25.2 25.8 26.4 27.0

Source: IMF staff estimates.1GDP growth is based on a growth-accounting framework assuming annual labor growth of 0.6 percent in the base

scenario and 1.3 percent in the high scenario, and a capital depreciation rate of 4 percent.2The catching-up effect for 1999–2006 is based on Iradian (2003a) and is assumed to be worn off gradually by 2007, when

Armenia reaches its real GDP of 1990.

Table 2.5. Illustrative Scenarios for Per Capita Real GDP Growth1

Projection

TFP = 3.0

TFP = 4.0

• Agriculture is the largest employer in the country and accounts for one-fifth of GDP. The country produces a wide variety of high-quality fruits and vegetables. Moreover, many of the more promising industrial activities, such as production of wine, brandy, beer, and mineral water, are in food processing.

• A second promising sector is information technology (IT), which seems well placed to take advantage of the country’s specialization in electronics from Soviet times and the involvement of the Armenian diaspora in IT in such places as California’s Silicon Valley.

• Third, the tourism sector is also seen as a potential source of growth in Armenia. Income from tourism has grown from under 2 percent of GDP prior to 2000 to an average of 2.7 percent of GDP during 2001–04.

C. Poverty, Inequality, and Employment

Like most former Soviet Republics, Armenia experienced a dramatic rise in both poverty and inequality in the early 1990s. Although economic growth resumed in the mid-1990s, poverty did not begin to fall until the end of the decade. Between 1999 and 2003, all measures of poverty, especially extreme poverty, declined significantly.



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Causes of poverty in Armenia

The causes of poverty and the increase in income inequality in the early 1990s are attributed to the sharp decline in output, the displacement of workers to the countryside (into subsistence-type agriculture), and the collapse of the system of social benefits.

A decline in the real value of pension benefits contributed to higher poverty during the early years of transition. The number of pensioners is relatively large, about 15 percent of the population. The ratio of the value of pensions to average wages fell from 33 percent in 1996 to 19 percent in 2001, and rose slightly to 21 percent in 2003. For pensioners with no other source of income, current pension levels are below the extreme poverty line.

Results of recent household surveys

Poverty in Armenia has declined strongly since 1998, with a particularly notable fall in extreme poverty (Table 2.6).26 Estimates for 2003 show that overall poverty has declined from 56 percent in 1998 to 32 percent in 2003. These positive developments are mainly due to the strong economic growth registered since 2001 and the improvements in targeted social policies in recent years. The broadening of the growth pattern in 2002–03 to embrace construction, industry, and services also helped to spread the benefits of rising economic activity in and around Yerevan. Remittances, particularly from Armenian workers in Russia, have been an important factor as well.

The reduction in poverty in recent years was larger in Yerevan than in other urban or rural areas. In 2003, poverty in Yerevan was only 22 percent compared with 38 percent in other urban areas and 33 percent in rural areas.27 Poor urban households outside Yerevan enjoyed few economic opportunities. Less than one-half of their income came from wages, self-employment, and farming. Almost half of their income is derived from remittances, transfers, and selling household assets.

Extreme poverty also fell markedly in recent years from 27.7 percent in 1996 to 5.5 percent in 2003. This performance is due to rising incomes and better access to the minimum food basket, especially in rural communities. There have also

26The incidence of poverty is the share of poor people in the population; the poverty gap indicates how far below the poverty line poor households are; and the severity of poverty captures inequality among the poor. 27In terms of a regional breakdown of poverty, the provinces of Shirak and Aragatsotn recorded the highest poverty rates. Both provinces are located in the earthquake zone.



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Table 2.6. Poverty, Inequality, and Unemployment

1996 1998–99 2003

Poverty as percent of population1 National average 56.7 56.3 32.0

Urban 58.8 62.7 30.7 Yerevan 58.2 58.7 22.0

Rural 49.0 47.7 33.9 Poverty gap3 21.5 17.1 5.8 Severity of poverty4 11.1 7.0 1.6

Extreme poverty as percent of population4 National average 27.7 26.1 5.5

Urban 29.6 32.1 6.2 Rural 24.4 34.5 4.5

Poverty gap2 … 5.8 0.2 Severity of poverty3 … 1.9 0.0

Inequality measure5 Gini coefficient (income based) 0.60 0.59 0.44 Gini coefficient (expenditure based) 0.44 0.37 0.33

Unemployment rate (in percent) 9.3 11.2 10.1

Sources: National Statistical Service of Armenia based on World Bank’s methodology. 1Defined as household expenditures of less than US$24 per month. 2Defined as the aggregate income shortfall of the poor as percentage of consumption, that is, the amount of

money needed to bring all the poor up to the poverty line as a share of income. A poverty gap of 6 percent means that average poor person’s expenditure is 94 percent of the poverty line.

3This index gives greater weight to those furthest below the poverty line (this accounts for the inequality among the poor by giving more weight to those that are far below the poverty line).

4Household expenditures of less than $16 per month. 50 implies perfect inequality and 1 perfect inequality.

been improvements in the depth and severity of poverty. The increasingly important role played by the family poverty benefit, with real increases in the benefit and improved targeting in recent years, facilitated the efficient transfer of resources to those living under extreme poverty.

The relatively small decline in poverty in rural areas reflects the slow increase in agricultural output during 1999–2004 and raises the question of how to deal with rural poverty in coming years. For the poor and nonpoor alike, farm income is the dominant, but declining, source of income, and nearly 40 percent of Armenia’s working population is employed in agriculture.



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Despite the declining trend in poverty, unemployment remains high. New job creation has not yet fully compensated for the earlier labor shedding arising from the shocks in the early 1990s.28 According to a nonofficial survey, overall unemployment was about 30 percent in 2003. According to the official data, unemployment fell from 11.2 percent in 1999 to 10 percent in 2004. Weaknesses have been detected in both surveys, and experts estimate that the true figure lies between 15 and 25 percent.

Emigration and remittances have played an important role as a safety net for many households with unemployed workers. The 2003 household survey revealed that transfers, mainly assistance from relatives abroad, accounted for 16.1 percent of household income, compared to earnings from employment of 26.1 percent of income. Official benefits and state pensions accounted for 9.9 percent of household income. The role of transfers underlines the importance of economic conditions in other countries, especially in the Russian Federation.

Notwithstanding the relevance of private and public transfers as a source of income for poor households, a more sustainable mechanism for poverty alleviation is warranted. Along these lines, microcredits, which provide poor households and small entrepreneurs with small loans, can help generate employment for those excluded from the formal banking sector in rural and urban areas outside Yerevan.

An improvement in income distribution has accompanied the decline in poverty in recent years. The Gini coefficient of income inequality rose from 0.27 in 1989, to about 0.59 in 1999, and then fell to 0.44 in 2003. The expenditure-based Gini coefficient also fell from 0.37 in 1999 to 0.33 in 2003. The expenditure-based measure of income inequality is lower than the income-based inequality because of higher savings rates of upper-income classes, the large size of the shadow economy, and large private transfers (particularly from the diaspora).29

28After the collapse of the Soviet Union, unemployment increased sharply. In the 1990s, industry and services combined lost about 650,000 workers (more than one-third of the labor force) whereas agriculture absorbed about 250,000 workers. The remaining 400,000 left the country or joined the informal sector. 29Weaknesses in the data and sampling differences across services call for some caution in interpreting these results. For instance, the reported improvement in income distribution in 2002 is due to a 22 percent decline in income in the richest decile. However, wealthier households often refuse to participate in surveys or tend to answer questionnaires dishonestly, partly out of fear that their answers can provide grounds for the tax authorities to uncover tax evasion.



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Policies going forward

Despite the positive trends described above, there are segments of the Armenian population that have not yet benefited from the recent growth. This is a common problem in developing countries that has led many governments to emphasize policies and programs targeting the poor. In this regard, further attention is warranted on certain activities identified in the PRSP, namely public infrastructure in agriculture, water resources, education, and housing. In addition, pro-poor policies could be designed to protect the most disadvantaged regions of the country (e.g., Aragatsotn, Gegharkunik, Kotayk, and Shirak).

International comparison

The incidence of poverty in Armenia can be compared with other countries using a poverty line of US$1 per day per person converted to “purchasing power parity.” This measure shows that the incidence of poverty in Armenia is lower than in Azerbaijan and Georgia, but somewhat higher than in Albania and Vietnam (Table 2.7).

The speed and extent of poverty reduction depends on the quality of growth, the initial level of income inequality, and changes in income distribution. For a given growth rate, poverty should fall faster in countries where the distribution of income becomes more equal than in countries where it becomes less equal.30

Armenia’s estimated elasticity of poverty with respect to growth is –0.82. That is, a 1 percent increase in real per capita income has led to a 0.82 decline in the incidence of poverty. An econometric analysis of a panel data for 70 developing and transition countries estimates the average growth elasticity of poverty at –1.08.31

Armenia’s poverty is induced primarily by an inadequacy of income rather than of human development (a broader socioeconomic measure). The 2002 United Nations’ Human Development Index ranked Armenia 82nd out of 177 countries, placing it in the “medium” human development category.32 In fact,

30As a guide, the impressive record of poverty reduction in China, India, Malaysia, and Vietnam has been attributed to two factors: (1) rapid growth of labor-absorbing industries coupled with macroeconomic stability; and (2) poverty reduction programs targeted at specific groups in rural as well as in urban areas, including facilitating access to credit, subsidies for health and education, safety nets for the very poor, and, in some cases, redistribution of assets. 31Iradian (2005, p. 21). 32The Human Development Index (HDI) for Armenia was 0.754. The index, measured on a scale of 0 to 1, is a composite of three measures: health, as proxied by life expectancy; knowledge, as proxied by literacy rate; and standard of living, as proxied by real per capita income.



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Country (period) Annual Cumul. GrowthFirst Second First Second Per Capita Per Capita ElasticityYear Year Year Year Growth Growth of Poverty

Albania (2002) … 25.4 … 28.0 … … …Armenia (1996, 2003) 56.7 32.0 44.0 33.0 7.4 51.8 –0.82Azerbaijan (1995, 2002) 61.6 49.0 45.0 36.5 5.1 35.7 –0.62Georgia (1995, 2002) 60.0 50.0 41.6 38.9 5.1 35.7 –0.56Kyrgyz Republic (1996, 2003) 68.1 41.0 40.5 31.0 4.8 26.6 –1.53Tajikistan (1999, 2003) 65.4 57.0 34.7 36.0 6.0 24.0 –0.68

China (1981, 1990) 63.8 33.0 32.0 31.4 8.8 79.2 –0.65China (1990, 2001) 33.0 16.6 34.6 44.7 8.3 91.3 –0.68India (1978, 1988) 55.8 46.3 33.1 31.2 2.3 23.0 –0.87India (1988, 2000) 46.3 34.7 31.2 32.5 3.8 45.6 –0.68Indonesia (1970, 1980) 58.0 29.0 30.7 35.6 5.6 56.0 –0.98Indonesia (1980, 1993) 29.9 14.8 35.6 31.7 4.5 58.5 –0.92Malaysia (1970, 1980) 49.3 32.5 51.3 49.1 4.6 46.0 –0.86Malaysia (1980, 1995) 32.5 9.3 49.1 45.6 4.5 67.5 –1.16South Korea (1965, 1975) 41.4 20.0 34.3 38.0 8.1 81.0 –0.72South Korea (1975, 1990) 20.0 7.4 38.0 33.6 6.4 96.0 –0.73Thailand (1985, 1996) 27.0 3.0 47.4 43.4 7.2 79.2 –1.22Vietnam (1993, 2002) 50.9 28.9 35.7 36.4 4.4 39.6 –1.20

Egypt (1990, 2000) 25.0 16.7 34.0 34.4 2.5 24.5 –1.70Ghana (1992, 1999) 50.8 42.6 38.9 36.0 2.4 16.8 –1.17Madagascar (1979, 2001) 49.3 69.5 46.9 47.5 –4.1 –4.1 –0.88Uganda (1992, 2000) 56.0 35.0 39.2 40.5 4.5 36.0 –1.17Zambia (1990, 1998) 58.6 72.9 48.3 52.6 –4.1 –4.1 –0.98

Average 50.3 36.5 41.2 41.3 5.1 48.3 –0.99

Sources: Armenian authorities, World Bank database, and IMF PRSP and staff reports.1Difference across countries should be interpreted with caution because national poverty lines may vary considerably.2Inequality figures are based on expenditure Gini-coefficient, except for Malaysia and South Korea.

Poverty1 Inequality2

(Gini index)

Table 2.7. Progress in Poverty and Inequality in Selected Countries

(Percent of population)

some important human development indicators in Armenia are now high by international standards: there is universal literacy, infant mortality is low (30 per 1,000 live births in 2003 as compared with 42 in 1999), and life expectancy is similar to that in industrialized countries (Table 2.8).



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Achieving the Millenium Development Goals

Armenia is well positioned to achieve most of the MDGs by 2015 (Table 2.9). The MDGs provide a framework in which low-income countries attempt to reduce poverty, provide adequate education for all, improve health indicators, and preserve the environment. The MDGs center on poverty reduction and human development as the main preconditions for sustained social progress.

The target of reducing overall poverty to 20 percent by 2015 is well within reach. Table 2.10 contains two scenarios. The first scenario assumes a growth elasticity of poverty of –0.82 (same as the historical elasticity) and unchanged income distribution. In the second scenario, income distribution is assumed to improve modestly, declining from 0.44 in 2003 to 0.39 by 2015. In the first scenario, Armenia will achieve its poverty reduction goal by 2012 with per capita real GDP growth of 5 percent. The second scenario shows that the poverty goal will be achieved even earlier (by 2010) for the same per capita growth due to the combined effect of growth and improvement in income distribution. Table 2.10 also shows that a minimum per capita growth rate of 3 percent to 4 percent a

HDI

Rank2

1990 2002 2002

Estonia 0.82 0.85 36Latvia 0.81 0.82 50Bulgaria 0.80 0.80 56Russia 0.82 0.80 57Albania 0.73 0.78 65Romania 0.80 0.78 69Ukraine 0.80 0.78 70Armenia 0.75 0.75 82Turkey 0.68 0.75 88Azerbaijan 0.74 0.75 91Georgia … 0.74 97Kyrgyz Republic 0.72 0.70 110Vietnam 0.61 0.69 112Moldova 0.76 0.68 113Uganda 0.45 0.49 146

Source: United Nations Development Program (2004).1A higher index indicates improved human development indicators.2Out of 177 countries.

Table 2.8. Human Development Indicators

Human Development

Index (HDI)1



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Table 2.9. Poverty Indicators and Millennium Development Goals, 1990–2015

2015 1998–99 2001 2003 Target

1. Eradicate extreme poverty and hunger Population below US$2 (PPP) a day 32.3 24.3 9.9 6.8 Overall poverty rate 56.3 47.0 32.0 19.7 Extreme poverty 26.1 16.2 5.5 4.1

2. Achieve universal primary education Net primary enrollment ratio (in percent of relevant age group) . . . 97 . . . 100 Percentage of cohort reaching grade 5 (in percent) . . . 100 . . . 100 Youth literacy rate (in percent of group ages 15–24) . . . 100 . . . 100

3. Promote gender equality Ratio of girls to boys in primary and secondary education (in percent) . . . 102 . . . 100 Ratio of young literate females to males (in percent of group ages 15–24) 99.8 100 . . . 100

4. Reduce child mortality Under 5 mortality rate (per 1,000) 47.0 37.0 35.0 19.3 Infant mortality rate (per 1,000 live births) 42.0 32.0 30.0 16.7

5. Improve maternal health Maternal mortality ratio (modeled estimate, per 100,000 live births) 29.0 . . . . . . 13.2 Births attended by skilled health staff

(in percent of total) 97.4 96.8 . . . . . .

6. Combat HIV/AIDS, malaria, and other diseases Incidence of tuberculosis (per 100,000 people) . . . 77.0 . . . Reduce Tuberculosis cases detected under DOTS (in percent) 8.0 . . . . . . Reduce

7. Ensure environmental sustainability Nationally protected areas (in percent of total land area) 7.4 7.6 . . . . . . CO2 emissions (metric tons per capita) 1.0 . . . . . . . . .

8. Develop a global partnership for development Fixed line and mobile telephones (per 1,000 people) 153.3 . . . . . . . . .

General indicators Life expectancy at birth (years) 73.0 73.6 . . . . . .

Sources: World Development Indicators database, April 2002; Armenia household surveys.



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IncomeGini

3% 4% 5% 6% 7% 2% 3% 4% 5% 6% 7% Coeff.

2005 30 30 29 28 28 30 29 29 28 28 27.0 0.432009 27 25 23 21 19 26 24 22 21 19 16.9 0.422010 26 24 22 19 17 25 23 21 19 16 14.4 0.412011 25 22 20 18 15 24 21 19 17 14 11.9 0.412012 24 21 19 16 13 23 20 17 15 12 9.4 0.402013 23 20 17 14 11 22 19 16 13 10 6.9 0.402014 22 19 16 12 9 21 18 14 11 8 4.3 0.402015 21 18 14 10 7 20 16 13 9 5 1.8 0.39

Source: Authors’ calculations.

Table 2.10. Projection of Poverty Under Different Per Capita Growth Rates

Scenario IInequality remains constant at 0.44

Scenario IIInequality declines to 0.39 by 2015

(Assuming growth elasticity of poverty of –0.82 and income elasticity of 1.3)

year is needed to achieve the poverty reduction goal by 2015 under the assumption of unchanged income distribution. If income distribution deteriorates, then a higher growth rate will be needed to achieve the poverty goal.

Other MDG indicators can also be achieved. This is largely because the expected higher level of income will be associated with better social services, but also because the different dimensions of poverty are interrelated. For example, the mortality rate of children under five years old is largely associated with maternal and child malnutrition, lack of access to safe water, low immunization, and a generally low level of education among mothers, all of which are MDG indicators in their own right. Thus, efforts and associated spending aimed at improving health delivery, raising educational attainment, and empowering women will allow for mutually reinforcing positive effects on the different facets of human development.

D. Concluding Comments

Armenia’s growth is likely to continue in coming years, albeit at a slightly slower pace than in the past. This outlook assumes no policy reversals and the appropriate implementation of recent and pending reforms. Growth will depend more on physical and human capital accumulation than on improved resource allocation. Both domestic and foreign investment (with embodied technical change) will be essential to sustain high growth. This, in turn, will require continued sound macroeconomic policies and actions focused on improving financial intermediation, reducing discretion in tax and customs administration, and ensuring the effectiveness of the judicial system.



41

The evidence from the growth accounting exercise for several other transition economies indicates that TFP growth from post-transition reallocation could gradually decline in the coming years. The contribution of capital accumulation in Armenia has picked up only recently and modestly. This suggests that in order to sustain high growth, Armenia must seek to further raise its investment rate and improve the business climate.

Based on current trends and assuming a continued reform effort, Armenia is well positioned to achieve the MDGs by 2015 or much earlier. The extent of further poverty reduction, in addition to sustained rapid economic growth, will also depend on the policies envisaged in the PRSP, especially those aimed at rebuilding the transport and water infrastructure, improving health and education outcomes, and developing the agricultural sector. A simple analysis suggests that a per capita real GDP growth of at least 3 to 4 percent is needed for Armenia to achieve its target of reducing overall poverty to 20 percent by 2015 (assuming unchanged income distribution). Improved governance and reduced corruption are not only critical to foster productive investment, they are also important to induce a more equitable distribution of income. Poverty reduction could remain on a fast track if—

• Growth is broad-based and pro-poor policies are implemented. The latter should include measures that promote social inclusion, human resource development, and social protection. In addition, steps are needed to improve governance, reduce corruption, and support the formation of small and medium enterprises and rural development.

• Social and infrastructure expenditures are given priority. Roads, sanitation, education, water, and health facilities should be upgraded, especially in underdeveloped regions and in rural areas. Average pensions should also be increased as envisaged in the PRSP.

References

Barro, Robert J., and Xavier Sala-i-Martin, 2000, Economic Growth (New York: McGraw-Hill).Berg, A., and others, 1999, “The Evolution of Output in Transition Economies: Explaining the Difference,” IMF Working Paper 99/73 (Washington: International Monetary Fund). Campos, N.F., and F. Corcelli, 2002, “Growth in Transition: What We Know, What We Don’t and What We Should,” Journal of Economic Literature, Vol. XL, pp. 793–836.De Broeck, M., and V. Koen, 2000, “The Great Contractions in Russia, the Baltics and the Other Countries of the Former Soviet Union: A View from the



42

Supply Side,” IMF Working Paper 00/32 (Washington: International Monetary Fund).Dollar, David, and Aart Kraay, 2002, “Growth is Good for the Poor,” Journal of Economic Growth, Vol. 7, No. 3, pp. 195–225. International Monetary Fund, International Financial Statistics, various issues (Washington).International Monetary Fund and World Bank, 2002, “Poverty Reduction, Growth, and Debt Sustainability in Low Income CIS Countries” (Washington). Iradian, Garbis, 2003a, “Armenia: The Road to Sustained Rapid Growth, Cross-Country Evidence,” Armenian Journal of Public Policy, Vol. 1, No. 1, pp. 35–57. ———, 2003b, “Armenia: The Road to Sustained Rapid Growth—Cross-Country Evidence,” IMF Working Paper 03/153 (Washington: International Monetary Fund). ———, 2005, “Poverty, Inequality, and Growth: Cross Country Evidence,” IMF Working Paper 05/28 (Washington: International Monetary Fund). Ravallion, M., 2001, “Growth, Inequality, and Poverty: Looking Beyond Averages,” World Development, Vol. 29, No. 11, pp. 1803–15. United Nations Development Program, 2004, Human Development Report 2004(New York: Oxford University Press). World Bank, 2004, “Albania: Sustaining Growth Beyond the Transition,” Report No. 29257 (Washington).


43

CHAPTER

Fiscal Adjustment

Fiscal consolidation has been the cornerstone of Armenia’s successful stabilization. Between 1995 and 2000, the fiscal adjustment was primarily an expenditure-based phenomenon, and the quasi-fiscal sectors (energy, water, and irrigation) remained a major source of subsidies, arrears, and contingent liabilities. By 2000, Armenia still had a sizable fiscal deficit, a weak tax base, and a large stock of domestic and external expenditure arrears. Since 2001, the authorities have renewed their efforts to rein in lax expenditure controls and fiscal and quasi-fiscal deficits. From the point of view of fiscal consolidation and macroeconomic stability, these policies were remarkably successful. Fiscal deficits declined, debt sustainability indicators improved, and both domestic and external expenditure arrears were eliminated. Furthermore, the quasi-fiscal deficit was progressively reduced.

This section describes Armenia’s fiscal developments, including an analysis of tax revenue performance and the role of the quasi-fiscal sectors. It also discusses Armenia’s long-term fiscal challenges and the remaining measures needed to ensure fiscal sustainability.

A. Fiscal Developments

Severe political and economic disruptions in the late 1980s and early 1990s generated large fiscal and quasi-fiscal imbalances (Table 3.1). In 1994, the general government deficit stood at nearly 17 percent of GDP, largely financed with increases in the money supply. Moreover, the government revenue base was severely constrained, and domestic expenditure arrears were widespread. The quasi-fiscal sector suffered from collection problems that generated large interenterprise arrears, particularly in the energy, water, and irrigation sectors. Vested interests captured state-owned enterprises and benefited from a climate of financial chaos and corruption.

The end of hostilities in Karabakh provided the first serious opportunity to confront these difficulties. In 1995, the government reduced its dependence on central bank financing, introduced more effective expenditure control, and

3



44

Table 3.1. Consolidated General Government, 1994–2004 (In percent of GDP)

2004 1994 1996 1998 2000 2001 2002 2003 Est.

Total revenue and grants 28.0 18.5 21.1 20.3 20.8 22.4 21.3 18.8 Total revenue 16.2 17.1 20.1 19.7 19.2 18.9 18.0 18.1

Tax revenue 13.5 13.8 17.4 18.5 17.7 17.9 17.2 17.4 Nontax revenues 2.8 3.0 2.7 1.3 1.3 0.9 0.6 0.6 Capital revenue 0.0 0.3 0.0 0.0 0.1 0.1 0.2 0.1

Grants 11.8 1.5 0.9 0.6 1.6 3.5 3.2 0.7

Total expenditure 44.9 26.8 26.4 26.7 24.5 22.7 22.2 20.4 Current expenditure 34.6 20.3 20.3 21.3 19.3 17.2 16.0 16.3

Wages 1.8 2.9 3.1 3.5 2.6 2.6 2.6 2.4 Subsidies 12.8 0.1 0.1 0.8 0.6 0.6 0.9 0.8 Interest 1.9 2.6 2.0 1.7 1.2 0.8 0.7 0.6 Transfers 4.5 5.6 6.4 7.2 6.5 5.8 5.0 5.5 Goods and services 13.6 9.1 8.9 8.0 8.4 7.3 6.7 7.0

Capital expenditure and net lending 10.2 6.5 5.9 5.4 5.2 5.6 6.2 4.1

Overall balance (commitment) –16.8 –8.2 –5.3 –6.4 –3.7 –0.3 –1.0 –1.5 Net clearance of arrears 6.3 –0.7 0.7 1.3 –0.4 –2.2 –0.4 0.0 Statistical discrepancy 0.4 –0.5 0.1 0.5 –0.2 –0.1 0.0 0.0

Overall balance (cash) –10.1 –9.5 –4.5 –4.5 –4.3 –2.7 –1.4 –1.5

Financing 10.1 9.5 4.5 4.5 4.3 2.7 1.4 1.5 Domestic financing 3.6 3.0 2.0 2.4 1.6 –0.4 –0.3 –0.2 External financing 6.5 6.5 2.6 2.2 2.7 3.1 1.7 1.7


enacted an arrears clearance program. Early results were promising: the deficit fell to 8.2 percent of GDP in 1996 and the government repaid most of the arrears built up during 1993–94.

Though the reduction in the overall deficit in the mid-1990s seemed impressive, the underlying fiscal position remained weak. The tax base was shrinking. The causes of the declining revenue base were manifold, but chief among them was poor tax administration and archaic tax legislation. Tax arrears and exemptions were widespread. Acute problems also emerged on the expenditure side. In 1996, public sector wages increased sharply, while net lending—primarily to ailing state-owned enterprises—accounted for 9 percent of the budget. These pressures threatened a return to macroeconomic instability and brought to the forefront the need for a revenue mobilization effort.


Fiscal Adjustment

45

The 1997 budget marked the beginning of a more comprehensive adjustment effort with a central objective of increased revenues. The authorities introduced the destination principle for VAT and moved some VAT collection to the border. The parliament passed new laws that simplified customs duties and excises, and the profit tax was simplified. On the tax administration side, taxpayer identification numbers were introduced. The single treasury account became operational. Thanks to these reforms, tax revenues recovered. VAT reforms were particularly effective, with revenues almost doubling in two years. However, the tax arrears payments scheme failed, while tax netting-out operations continued, putting pressure on the government’s cash position.

Political instability gradually derailed the 1997 reform program and the fiscal position weakened further in the run-up to the May 1999 parliamentary elections. Many firms delayed payments hoping for a tax amnesty, and the authorities started again to accumulate domestic and external expenditure arrears. Efforts to ensure fiscal sustainability faltered following the October 1999 assassinations in parliament. As the fiscal situation worsened, the government began to rely on domestic sources for financing the deficit, and interest rates rose sharply. Ironically, tax revenue performance in 1999 seems like a high-water mark, when the tax-to-GDP ratio reached 18.5 percent of GDP. However, a series of netting-out operations and an extension of the tax year into 2000 seriously distorted revenue performance. These bookkeeping operations added about 2 percent of GDP to tax collection.

After mid-2000, the political environment calmed and the adjustment effort resumed on the revenue side. A series of tax reforms was introduced, coupled with reductions in tax rates. For small businesses, the authorities inaugurated a turnover-based tax—known as the simplified tax. It offered an alternative to regular taxation. The authorities also reformed the excise tax law. A single 20 percent corporate profit tax rate replaced the multiple tax rates under the old law. The authorities also abolished some VAT exemptions. At the same time, the VAT threshold was increased threefold. However, the expenditure arrears problem became more severe (Table 3.2). During 2000–01, arrears on health expenditures accounted for approximately one-third of all arrears.

The adjustment effort on the expenditure side resumed in 2001. The 2001 budget was led by strengthened expenditure control. Both subsidies and the public sector wage bill were cut and family benefits and pensions were reduced. The authorities started to tackle financial indiscipline and formulated a plan to reduce the stock of domestic expenditure arrears. By the summer of 2003, the authorities had paid off all expenditure arrears. The improvement in the main fiscal indicators was impressive. Between 2000 and 2003, the general government deficit fell by 3.2 percentage points of GDP (Figure 3.1).



46

Table 3.2. Expenditure Arrears, 2000–04 (In billions of drams)

2000 2001 2002 2003 2004

Total expenditure arrears 37 40 7 0 0 Current expenditures 35 35 5 0 0 Transfers 9 8 0 0 0 Goods and services 21 22 5 0 0

Of which: Health 13 13 … 0 0 Education 2 3 1 0 0

Capital expenditures 3 5 2 0 0 External amortization arrears 7 6 0 0 0

Memorandum Items: Arrears in percent of GDP 3.6 3.4 0.5 0.0 0.0


B. Expenditure Policies

Viewed in a medium-term perspective, Armenia’s fiscal position adjusted significantly. Since 1999, the consolidated general government deficit has fallen by 6.5 percentage points of GDP. Despite this success, there is some concern about the emphasis of the adjustment effort on certain expenditure categories rather than increases in revenues.33 In 1999, total expenditures were 30 percent of GDP (see Table 3.1). In the subsequent five years, expenditures fell by 8.6 percent of GDP, with the bulk of the adjustment taking place during 2000–01.

Current expenditures and, to a lesser extent, social expenditures bore the brunt of the adjustment. Table 3.3 shows an index of real expenditures between 1997 and 2003.34 In the early stages of the adjustment effort, social expenditures suffered cuts in real terms. During 2000–01, expenditures on social security, science, and housing fell in real terms. By 2003, these cuts had been reversed.

In 2002, the PRSP process began to influence the government’s spending priorities, and social expenditures have increased at a faster pace since then. The

33For a further discussion of public expenditure issues in Armenia, see World Bank (2003). 34Current expenditures deflated by the GDP deflator.


Fiscal Adjustment

47

Figure 3.1. Fiscal Indicators, 1994–2004(In percent of GDP)

Sources: Ministry of Finance; IMF staff estim ates. 1Negative num ber indicates repaym ent of arrears.

General Government Overall Balance, Commitment Basis

-18-16-14-12-10-8-6-4-20

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

General Government Balance, Cash Basis

-12

-10

-8

-6

-4

-2

0

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Flow of Expenditure of Arrears1

-3-2-101234567

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004



48

1997 1999 2001 2003

Total expenditure 100 144 131 167 Of which: General public services 100 132 149 160

Defense 100 105 103 116Public order and safety 100 118 121 155Education 100 134 176 194Science 100 93 84 134Health 100 129 145 181Social security 100 187 182 201Recreation, culture, and religion 100 104 148 375Housing and public utilities 100 201 103 471Fuel and energy 100 72 102 171

Memorandum Items:Nominal GDP 804 988 1,176 1,618GDP deflator 100 111 114 122

Sources: Armenian authorities; IMF staff estimates.1Deflated by the GDP deflator.

Table 3.3. Central Government Expenditure by Major Function, 1997–2003

(Index 1997 = 100) 1

PRSP envisages increasing social expenditures to 12 percent of GDP by 2015, compared to 8.7 percent in 2003. This commitment will require a concomitant expansion of tax revenues that could be achieved by resolving remaining weaknesses in tax and customs administration.

C. Why Has Revenue Performance Been Disappointing?

Despite efforts to increase the tax base, the overall tax revenue performance has been rather disappointing. During the early transition years, an archaic tax code and economic difficulties hampered tax collection. These factors declined in significance over time, as the authorities adopted a modern system of tax legislation. More recently, however, a combination of lower tax rates, tax administration weaknesses, tax holidays, and weak corporate accounting practices has prevented revenues from responding to the enhanced legal framework and the surge in economic activity.

Armenia’s tax-to-GDP ratio remains low. Tax revenues increased rapidly in both real and nominal terms in recent years, especially since 2000. Since 2002, tax revenues increased by 64 percent in nominal terms and by 31 percent in real terms (Figure 3.2). However, economic growth has also been extremely rapid, suggesting that there is a large untapped source of tax revenues. In 2004, the tax-to-GDP ratio was just marginally higher than in 1997 (see Table 3.1).


Fiscal Adjustment

49

Figure 3.2. Tax Revenue Performance, 1997–2004

Sources: Ministry of Finance; IMF staff estim ates. 1Deflated by the GDP deflator.

Nominal Tax Revenue Performance(Index 2000 = 100)

50

70

90

110

130

150

170

190

1997 1998 1999 2000 2001 2002 2003 2004

Total taxes

VAT

Profit tax

Income tax

Real Tax Revenue Performance1

(Index 2000 = 100)

50

70

90

110

130

150

170

1997 1998 1999 2000 2001 2002 2003 2004

Total taxesVATProfit taxIncome tax



50

Source: World Economic Outlook database, IMF.

Furthermore, Armenia’s recent performance compares unfavorably to its neighbors in the former Soviet Union (Figure 3.3). In 2003, the region’s unweighted average tax-to-GDP ratio was 22.9 percent, which is 4.9 percentage points higher than Armenia’s. Only three countries have lower ratios: Azerbaijan, Georgia, and Tajikistan. Moreover, over the past three years, Azerbaijan and Tajikistan have improved their tax collection efforts.35 Of the remaining eight countries, five have improved their collection efforts, while two (Russia and Belarus) have stabilized their collections at around 35 percent of GDP.36 What are the factors behind Armenia’s rather weak performance?

In the first six years of transition, economic difficulties and poorly designed legislation restricted revenue growth. A weak and unreconstructed enterprise sector generated substantial tax and interenterprise arrears, domestic tax exemptions were commonplace, and ineffective legislation encumbered the tax authorities. After 1996, economic growth returned and the restructuring ofstate-owned enterprises accelerated. Interenterprise arrears disappeared except in the energy and water sectors. While tax arrears continued to grow, the problem was largely confined to the quasi-fiscal sectors. The authorities comprehensively redrafted tax legislation, putting in place modern profits and income tax laws. While there is some room for improvement, Armenia now possesses a

35For 2004, it is expected that Georgia will have increased its tax-to-GDP ratio by more than 3 percentage points. 36For a survey of recent tax reform efforts in the Former Soviet Union, see Stepanyan (2003).

0

10

20

30

40

Russia

Ukraine

Moldova

Kazakh

stan

Uzbeki

stan

Turkmen

istan

Kyrgyz

Repub

lic

Armen

ia

Azerbaija

n

Tajikist

an

Georgi

a

Figure 3.3. Former Soviet Union Countries: General Government

Tax Revenue, 1999–2003(Annual Average In percent of GDP)


Fiscal Adjustment

51

well-designed body of tax legislation. The profit tax is consistent with international accounting standards. Both profit and income tax rates are low and provide a favorable environment for enterprise growth. In short, neither legislative weaknesses nor economic difficulties account for the relatively low tax collection in recent years.

Four factors contributed to lackluster tax collection in recent years. First, theintroduction of the simplified tax in 2001, coupled with cuts in profit and income tax rates, reduced direct tax collection. Second, foreign investments enjoy generous profit-tax holidays. Third, some of the recent growth in the economy was financed with foreign grants and loans, and those activities are not taxed through international agreements. Finally, notwithstanding some improvements in administration, tax and customs administration made limited progress toward countering a widespread culture of tax evasion.

The profit and income tax rate cut—introduced in 2000—also reduced direct tax collections. After the introduction of a single 20 percent tax rate and new depreciation allowances, which replaced a two-tier regime of 15 and 25 percent, profit tax collection fell by almost 23 percent. At the same time, income tax collection fell by 28 percent. Taken together, direct tax revenues fell by 1.1 percent of GDP.

Initially, the simplified tax was envisaged as a mechanism for including small enterprises in the tax base. However, many medium-sized companies quickly began to use it as a vehicle for minimizing their tax liabilities.37 The simplified tax generates a negligible amount of revenues (0.3 percent of GDP in 2003).

Because of the above-mentioned cuts, the burden of taxation moved toward indirect sources.38 The share of VAT in total revenues increased from 29 percent in 1997 to 37 percent in 2004 (Table 3.4). Over the same period, excise taxes were an important source of revenues. Meanwhile, direct taxes—such as profit and income taxes—became less significant. In 1997, profit taxes accounted for 11.9 percent of all revenues; by 2004, they accounted for just over 8 percent. The share of income and payroll taxes also fell during this period.

Tax holidays to foreign investors give considerable advantages to foreign companies, provided their investment is greater than $500,000. This threshold is quite low and cumulative. In order to meet the threshold, investors can make

37Rather than remain in the regular tax regime, many firms exploit the high thresholds in order to reconfigure their operations into a collection of “small” enterprises. Shone (2004) outlines many of the administrative difficulties arising from special taxes levied on small taxpayers. 38For further details, see Brown (2003).



52

Table 3.4. Structure of General Government Tax Revenues, 1997–2004 (Percent of total tax revenues)

20041

1997 2000 2003 Est.

Tax revenue 100.0 100.0 100.0 100.0 Value-added tax 29.2 35.0 38.6 37.0 Excises 13.9 13.7 14.0 12.6 Enterprise profits tax 11.9 10.7 6.3 8.2 Personal income tax 10.9 7.8 6.0 6.5 Land tax 2.0 0.8 0.7 0.9 Customs duties 7.9 4.6 3.8 3.7 Payroll taxes 19.3 16.5 16.0 17.0 Other taxes 3.7 7.4 8.4 7.2 Presumptive income tax 0.5 2.1 2.9 3.8 Simplified tax 0.0 0.1 1.8 2.3 Property tax 0.8 1.4 1.4 1.5

Memorandum items: Direct taxes 22.8 18.4 12.3 14.6 Indirect taxes 77.2 81.6 87.7 85.4


investments over time. These incentives may have cost more than 0.5 percent of GDP in forgone revenues and may have had a marginal effect in attracting investment. Moreover, a significant proportion of imported goods enjoyed VAT exemptions at the border. These exemptions have been curtailed in recent years, but the remaining ones damage the integrity of the VAT chain of credits.

Tax evasion is widespread. Despite double-digit economic growth, many of Armenia’s largest enterprises have reported massive losses. In 2002, the corporate sector recorded losses amounting to 20 percent of GDP, and many enterprises are effectively outside the tax system.39

Tax administration problems have played a central role in limiting revenue collection (Box 3.1). The institutional structure of the tax and customs services is

39The law on tax audits is a remaining area of legislative weakness. The current law prevents effective auditing of large enterprises. The tax authorities are limited to just one audit per year and have just five weeks to complete an audit. The tax authorities are further constrained by the requirement that they must report their findings three business days after the audit is concluded. Audits on large enterprises are typically complex and time-consuming, especially with enterprises reporting large losses. Inevitably, tax evaders benefit from this legal restriction on tax audits. Unsurprisingly, the collection rate for audit-generated reassessments is low.


Fiscal Adjustment

53

problematic. The state tax service and the customs committee are two independent agencies, and the heads of both agencies are appointed by the president and report to the prime minister. The two agencies operate under separate tax “targets” and, in practice, compete against each other. This competition has tended to promote an aggressive style of short-term revenue

Box 3.1. Tax Administration and the Business Environment

Despite the progress made in recent years, many firms complain about tax and customs administration. The World Bank regularly conducts business surveys in these areas, and the three most recent surveys point to serious administration problems. While these problems are found to be more severe in other CIS countries, they nonetheless are an obstacle to a better business environment in Armenia.

The surveys show that demands for extralegal advance payments seem widespread. Over half of firms surveyed say that the frequency of changes in rules and rates presented an obstacle to business, and almost a third of them complain about tax inspections, the frequency of payments, and excessive reporting requirements.

At the same time, the tax service also complains about the behavior of enterprises. Turnover and profits are often underreported. Many interenterprise transactions are conducted without invoices or paperwork, making the task of properly assessing taxes more difficult.

A move to a more rules-based tax administration will improve the business environment. In particular, more effective audit procedures would remove discretion from individual tax inspectors and remove the potential for rent-seeking behavior. Better administration would also improve corporate governance and tax compliance.

2002 2003 2004

Extralegal requirements for advance payments of taxes 66.8 57.7 58.6Frequency of changes in rules and rates 57.2 51.7 53.7Availability of information updates on tax requirements 37.6 44.4 42.3Inspections audits 31.2 37.0 37.3Frequency of payments 27.6 26.4 30.3Frequency of reporting 29.2 30.4 30.0Tax accounting 20.4 27.7 26.0Tax forms, filing 18.4 30.3 25.3Payment methods 19.2 20.7 23.0

Source: World Bank, Annual Regulatory and Administrative Cost Surveys, 2003, 2004.

Dissatisfaction with Tax Administration(Percentage of firms reporting major or moderate obstacles)



54

maximization, largely comprising confrontational tax inspections and customs overvaluations. While in the past this strategy stabilized revenues, the authorities need to move toward a tax regime based upon taxpayer self-assessment,risk-based audits, and better information exchange. This could be better achieved if the two revenue agencies were brought under the control of the Ministry of Finance and Economy.40

Superficial and poorly managed audits are a big part of the tax administration problem. Responsibility for tax audits is diffused throughout the state tax service, and the auditing process lacks strategic management. Since audits tend to be resource-intensive, this lack of coherence weakens their overall effectiveness. Furthermore, the large taxpayers’ unit has been underperforming. The work of this unit would benefit if its audit capacity were strengthened. Lastly, technical difficulties, especially outdated information technology, also inhibit the work of the tax service. These difficulties mean that the service has only a limited facility to select audit cases effectively.

The tax authorities responded to these difficulties by increasing the number of random tax inspections, which take place in the absence of any risk-profiling mechanisms. Consequently, tax inspections proved to be a burden on many enterprises. More recently, the tax authorities started to develop risk-assessment procedures. However, these innovations are still evolving, and it will take a strong political will to ensure they are fully implemented.

D. The Quasi-Fiscal Sectors

The 1992–94 crisis in the energy sector forced a chaotic but rapid closure of many state-owned enterprises. This was painful in terms of employment and living standards, but eliminated a potential source of fiscal vulnerability. However, a core of large enterprises survived the crisis, particularly within the energy, chemicals, and water sectors. Due to collection difficulties and corruption, these firms incurred sizable financial losses and arrears (Table 3.5).41

At times, the authorities felt compelled to bail out these firms through implicit subsidies and credits at below-market rates. Since 2001, the government’s reform efforts have been focused on privatization and on improving the financial position and corporate governance in these enterprises.

40At present, the Ministry of Finance and Economy is responsible for tax policy yet has only an indirect influence on policy implementation. 41For an estimation of quasi-fiscal deficits in Armenia, see Freinkman, Gyulumyan, and Kyurumyan (2003).


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55

Table 3.5. Key Indicators of the Energy, Water, and Irrigation Sectors, 1998–2004

1998 1999 2000 2001 2002 2003 2004

Loss rate (as percent of supply) Energy sector

Technical losses 15.2 14.8 15.0 15.4 14.5 4.2 2.3 Excess losses 15.5 10.0 10.6 11.1 11.3 … …

Yerevan Water and Sewer Company … 59 72 72 72 76 80 Armenia Water and Sewer Company … 37 51 51 54 63 74 Irrigation … 31 30 30 38 36 23

Collection rate (percent of billings) Energy sector 77 89 89 81 90 101 106 Yerevan Water and Sewer Company … 24 19 27 48 102 71 Armenia Water and Sewer Company … 30 31 40 46 69 50 Irrigation … 50 38 53 50 55 77


Energy sector

Historically, the energy sector was the greatest source of quasi-fiscal problems.The state-owned enterprise—Armenergo—was at the center of these difficulties. In its heyday, the company was responsible for distributing electricity and handling all cash transactions within the sector. Its finances were chaotic. Many of its leading customers, particularly state-owned enterprises and institutions, were unable or unwilling to pay their electricity bills. These nonpayment difficulties meant that Armenergo could not fully pay the generators for the electricity they produced. The lack of payment stability created additional interenterprise arrears and tax arrears. In this atmosphere of nonpayment and turbid financial practices, there were considerable opportunities for corruption, which further compounded the difficulties of the sector.

As part of the 1997 reform effort, the authorities tried to restore some financial discipline to the sector. A new energy law established the Energy Regulatory Commission and separated Armenergo into generation, transmission, and distribution companies. However, these efforts met with only limited success and serious financial difficulties remained. Barter trade remained a primary way of settling debts, and the government continued to bail out the sector with loans.

After 2001, the authorities tried again to tackle these problems. They adopted a four-stage reform package. During the first phase, the authorities introduced some simple measures to ensure the financial viability of the sector. Tariff rates were raised, collection discipline was improved, and direct access to budgetary



56

resources was curtailed. The privatization of the electricity distribution company to foreign investors in the autumn of 2002 marked another important effort to tackle the problems. The privatization agreement stabilized intra-industry financial flows and created the basis for resolving many sectoral debt issues. The new owners of the distribution company were committed to paying 100 percent for all delivered electricity and to dealing with electricity theft. Payments discipline improved drastically as nonpaying customers became subject to immediate service cutoffs. The authorities also transferred the ownership of two of the five main electricity generation companies to Russia.

In 2003, the authorities created separate midstream companies for financial settlements, electricity dispatch, and high-voltage distribution, and set up independent boards of directors for the new companies. The authorities also developed a medium-term strategy for the sector, which envisaged a move away from the single wholesale buyer structure based around Armenergo and move toward direct contracting among market participants.

After some delay, Armenergo was finally removed from all cash transactions in October 2004. Armenergo will soon be liquidated. In the future, the distribution company will purchase electricity directly from the generation companies. All financial settlements are expected to go through transparent and easily monitored settlement accounts.

These reforms met with considerable success. Collection rates improved and the sector’s deficit fell from 4.1 percent of GDP in 1998 to 0.6 percent in 2003. Over the same period, the primary deficit fell from 2.6 percent of GDP to zero (Table 3.6).

A remaining issue is how to handle the debts the sector has accumulated in recent years. In mid-2004, this debt amounted to US$35 million. The authorities approved a financial rehabilitation plan for the energy, water, and transport sectors in 2003. The plan envisages the cancellation of cross-debts as well as further privatization in these sectors, and repayment of much of the remaining debt through collection of receivables.

Water and irrigation

Reforms in the water sector have been broadly successful, with the primary deficit of the water sector reduced to 0.3 percent of GDP in 2004. In 2000, a foreign management company signed a performance management contract for the Yerevan Water and Sewage Company (YWSC). This reform led to almost 100 percent collection rates, thanks to a successful metering program in which about 87 percent of customers now have installed meters. However, YWSC’s technical losses remain unacceptably high. A similar contract for the Armenian water company, which provides water to customers outside the capital, has been introduced in 2005.


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57

Table 3.6. Financial Balances in the Energy, Water, and Irrigation Sectors, 1998–2004

(In percent of GDP, unless otherwise indicated)

1998 Estimated 1999 2000 2001 2002 2003 2004

Overall Balance Energy –4.1 –2.4 –2.1 –3.5 –1.7 –0.6 –0.4 Irrigation … –1.2 –1.1 –0.5 –0.4 –0.1 0.0 Yerevan Water and Sewer Company … –0.5 –0.6 –0.5 –0.4 –0.6 –0.3 Armenia Water and Sewer Company … –0.3 –0.2 –0.1 –0.1 –0.1 –0.1

Primary Balance Energy –2.6 –0.8 –1.3 –2.5 –0.4 0.0 0.2 Irrigation … –0.7 –0.6 –0.5 –0.4 –0.1 0.0 Yerevan Water and Sewer Company … –0.5 –0.5 –0.5 –0.3 –0.4 –0.2 Armenia Water and Sewer Company … –0.3 –0.2 –0.1 –0.1 –0.1 –0.1

Sum of all overall balances … –4.3 –4.1 –4.6 –2.7 –1.4 –0.8 Sum of all primary deficits … –2.3 –2.6 –3.6 –1.2 –0.6 –0.1

Memorandum item: Nominal GDP (in billions of drams) 959 988 1,031 1,175 1,356 1,618 1,618


Progress has also been made with reforms in the irrigation sector. There is now greater transparency in terms of fiscal support as subsidies are explicitly included in the budget. In 2004, technical losses were almost 23 percent of water distributed, compared with 31 percent in 1999. Collection rates rose to 77 percent in 2004. Nonetheless, further reforms are needed to reduce corruption and ensure the long-term financial viability of the sector. Despite a recent increase in tariffs, they remain below cost–recovery levels.

E. Long-Term Fiscal Challenges

Like most transition and industrial countries, Armenia has an aging population. In fact, severe demographic pressures are already evident. During the 1990s, many younger and more productive workers went abroad in search of work. This has reduced the ratio of workers to pensioners and accelerated the fiscal pressures associated with the aging population. These pressures were resolved by



58

cuts in pension levels. These cuts increased poverty levels among the old, although they stabilized the financial position of the system.42

Notwithstanding the currently limited fiscal pressure arising from pension entitlement, Armenia can expect further fiscal pressures due to demographic change. The timing of this change is slightly later than in industrialized countries. The low number of births during the 1941–45 war means that the number of retirees will temporarily stabilize over the next 10 to 15 years and will rapidly start to increase after 2020.

Nevertheless, the energy sector poses the largest threat to long-term fiscal sustainability. Within the next 12 years, Armenia will have to decommission the Metzamor nuclear power plant, which produces about one-third of Armenia’s total electricity supply. While there is some uncertainty about the precise magnitude of the costs, most estimates range between $700 million and $1.2 billion.43

The closure of Metzamor will generate four types of costs. First is the cost of physically dismantling the plant. Given the obvious safety implications, this task will require enormous external technical assistance. Second are the processing costs associated with the nuclear waste. Armenia does not have any capacity to process nuclear waste, and therefore will have to rely on external contractors. Third, the processed material will generate considerable and ongoing storage costs. Fourth, Metzamor will need to be replaced, given the country’s supply needs and the fact that the remaining generation capacity will also be approaching obsolescence.

In order to illustrate the magnitude of these costs, we present two long-term fiscal scenarios: a baseline scenario consistent with the PRSP macroeconomic framework and an alternative scenario that adds the costs of closing Metzamor (Table 3.7). The baseline scenario assumes that Armenia maintains its current prudent fiscal policy framework but that economic growth will gradually slow to rates that are more moderate. In line with PRSP targets, tax to GDP increases by 4 percentage points of GDP, allowing for the gradual reduction of the deficit. This projection also includes moderate increases in social and investment expenditures in line with PRSP targets. As per capita GDP increases, external lending and grants are expected to decline. In the medium term, domestic debt instruments take an increasing role in financing the remaining fiscal deficit, resulting in a modest increase in the debt-to-GDP ratio. Over the long term, the

42In 2001, PADCO (a U.S. consulting firm implementing Armenia’s Social Transition Reform Program) provided a detailed financial and actuarial forecast of Armenia’s pension system. The study concluded that the current system is sustainable and does not engender any major risks for the fiscal system over the medium term. 43These costs are expressed in 2002 prices. The estimates are provided by EU TACIS, a USAID-financed project, and by the Ministry of Energy.


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Table 3.7. Long–Term Fiscal Projections, 2005–20 (In percent of GDP, unless otherwise stated)

2005 2010 2015 2020

Baseline scenario Total revenues and grants 19.3 21.1 22.8 24.5

Of which: Tax revenues 17.8 19.8 21.8 23.8 Total expenditures 21.8 23.0 24.3 25.7 Overall deficit (commitment basis) –2.5 –1.9 –1.6 –1.2 Government debt (in percent of GDP)1 31.0 29.1 29.8 30.5 External debt-to-GDP ratio 28.1 25.8 26.4 27.4 External debt service (in percent of exports) 7.1 6.6 7.5 7.6

Environmental cleanup scenario Total revenues and grants 19.3 21.1 22.8 24.5

Of which: Tax revenues 17.8 19.8 21.8 23.8 Total expenditures 21.8 23.0 24.3 27.8 Overall deficit (commitment basis) –2.5 –1.9 –1.6 –3.3

Government debt (in percent of GDP)1 31.0 29.1 29.8 37.9

External debt-to-GDP ratio 28.1 25.8 26.4 34.7 External debt service (in percent of exports) 7.1 6.6 7.5 9.3

Memorandum Item: Real GDP growth (percent change) 8.0 5.0 4.0 4.0

Source: IMF staff estimates. 1Domestic and external debt.

debt-to-GDP ratio stabilizes at around 31 percent of GDP. External debt servicing is projected to remain broadly unchanged at around 7 percent of exports.

The environmental cleanup scenario assumes that the plant will close in 2016. It is generally accepted that the plant may be able to continue for another 10 years. The scenario takes a conservative estimate of $800 million in 2004 prices for the decommissioning and replacement costs. This cost is spread over five years, peaking in 2020. The macroeconomic and fiscal policy assumptions are identical to the baseline scenario and external borrowing finance the closure of the plant. This leads to a rapid worsening of the fiscal balance and deteriorating debt ratios. By 2021, Armenia’s debt-to-GDP ratio is projected to be 9 percentage points higher than under the baseline scenario (Figure 3.4).



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Source: IMF staff estimates. 1External and dom estic debt.

General Government Deficit

-3.5

-3.0

-2.5

-2.0

-1.5

-1.0

-0.5

0.0

2005 2008 2011 2014 2017 2020

Environmental Cleanup Costs

Baseline

Government Debt1

25

30

35

40

2005 2008 2011 2014 2017 2020

Environmental Cleanup Costs

Baseline

Figure 3.4. Fiscal Implications of Environmental Cleanup Costs, 2005–20(In percent of GDP)


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The cleanup scenario assumes a benign macroeconomic environment. If there are other shocks, or if fiscal policy is not progressively tightened, the final burden could be much higher. The cleanup scenario highlights the need to take a proactive approach to address Metzamor’s decommissioning costs. One option would be to save some of the current receipts from privatizations. A complementary option would be to create a decommissioning fund financed from higher electricity tariffs. Once the decommission starts, the fund would be used to partly finance the plant’s closure. Lastly, donors can also be approached to fill in any remaining gap. Failure to plan in advance and save some of Armenia’s wealth to pay for these costs could endanger fiscal and debt sustainability.

F. Fiscal Consolidation, Tax Reforms, and Growth

Over the past five years, Armenia has enjoyed an unparalleled period of economic growth and a strong fiscal consolidation. However, the tax base has not increased, and therefore the burden of adjustment has fallen on expenditures. This raises some difficult questions about the relationship between a low revenue base and the sustainability of growth.

The 2000–01 tax reforms were explicitly designed to enhance private sector growth, particularly through reductions in profit tax rates and the small enterprises simplified tax. The simplified tax has boosted the growth of small enterprises. In particular, the profit tax has been conducive to increased investment. The uniform profit tax rate of 20 percent is among the lowest in the region. The law also contains generous loss carry-forward and accelerated depreciation allowances. Notwithstanding these reforms, current tax legislation still permits generous tax holidays for foreign investments, which significantly weakens the tax base.

The tax regime also has been favorable for exporters. Certain exporters, particularly within the diamond sector, received preferential tax treatment. Armenia operates a highly open trade regime, with many goods entering duty-free. This is important, given the high import content of Armenian exports. However, many exporters suffered from delays in receiving VAT refunds in 2002–03.

Fiscal consolidation also prompted a fall in interest rates on government treasury bills. The fall was particularly marked after the government repaid all its outstanding domestic and external arrears. However, due to the slow development of the banking system, lending rates remained high and domestic credit expansion was muted until mid-2003. This process was reversed in mid-2003; lending rates started to fall and private sector lending has taken off.

Looking ahead, however, the implications of a weak tax base, evasion, and generous tax holidays are serious. A weak tax base will limit future increases in



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public investment and social expenditures. Over the long term, Armenia will face significant fiscal costs, which will put further pressure on public investment. In the end, growth could be jeopardized if the tax base is not strengthened.

G. Future Reform Priorities

Going forward, improving tax and customs administration is the single greatest challenge. Second, the authorities need to improve the quality of expenditures in line with PRSP priorities in social and infrastructure spending. Third, reforms in the quasi-fiscal sector—particularly the irrigation sector—need to be completed. Lastly, the authorities must confront the volatility of donor flows. Since the bulk of recent inflows have been directed toward capital expenditures, it would be prudent for the authorities to give the proper priority to public investment in the medium-term expenditure framework and ensure that higher amounts are financed from domestic sources.

Tax compliance reform needs to address two difficulties. First, the authorities need to select their subjects for inspection through effective risk profiling. Second, the legislative framework could be revisited to facilitate the ability of the authorities to counter corporate-sector evasion.

Better tax compliance will recalibrate the structure of taxation. At present, there is an excessive dependence on simplified and presumptive tax regimes. Over the long run, Armenia needs to incorporate more firms into the VAT and profit and income tax regimes. Given that tax evasion is greater in profit and income tax, better compliance would boost the relative importance of direct taxes and would reduce the necessity for presumptive and simplified taxes. Over time, the latter should be eliminated.

The authorities need to continue efforts to reform the quasi-fiscal sectors. In the energy sector, an ambitious reform agenda is reaching closure but a few outstanding issues remain. Armenergo needs to be liquidated and the sector’s debts cleared. In addition, the water and irrigation sector reforms should be accelerated and tariffs should be raised to cost-recovery levels.

The authorities need to adjust the composition of expenditures. In the short run, further generous infusions of donor assistance and private grants may continue to finance some of the much-needed public investment. Still, the government should maintain a proper balance in expenditures by moving resources away from current expenditures and toward public investment. In the long run, Armenia must finance the closure of its nuclear power plant, while rising numbers of retirees, particularly after 2020, will put additional pressure on social expenditures. Robust economic growth during the next 15 years could actually provide much of the resources needed to meet these challenges.


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H. Concluding Comments

Over the past decade, Armenia has won a difficult battle to achieve fiscal sustainability. Tax legislation was modernized and the overall fiscal deficit declined drastically. However, underlying structural weaknesses and political instability during the late 1990s led to reversals and new macroeconomic imbalances. The reform momentum resumed after 2000 and a virtuous cycle finally took hold after 2001. However, the effort was somewhat unbalanced, with the burden of adjustment falling on expenditures and limited progress on the revenue side.

Overall, fiscal adjustment supported economic growth. Low tax rates encouraged enterprise formation. Lower fiscal deficits reduced interest rates. Over time, however, the composition of fiscal expenditures has become biased toward current rather than capital expenditures. This needs to be corrected, especially in light of the prospective externalities to be generated.

The authorities need to implement the remaining reform agenda aimed at reinvigorating tax collection. In particular, they need to overhaul tax and customs administration through making wider use of risk-based methods for auditing, improving transparency, and treating all taxpayers equally. The tax base could be expanded by revamping the operations of the large taxpayers unit and tackling transactions in the informal sector, in particular within the large open-air retail markets. In addition, the recently approved codes of conduct for tax and customs operations should be fully implemented. The authorities have explicitly recognized this fact in their poverty reduction strategy. Over the medium term, the PRSP has set ambitious targets in social and infrastructure spending. This can only be financed with higher tax revenue collection.

References

Brown, Annette, 2003, “Tax Policy and Poverty in Armenia,” Working Paper No. 03/05 (Washington: Armenian International Policy Research Group).

Freinkman, Lev, Gohar Gyulumyan, and Artak Kyurumyan, 2003, “Quasi-Fiscal Activities, Hidden Government, and Fiscal Adjustment in Armenia,” World Bank Working Paper No. 16 (Washington: World Bank).

FIAS, 2004, Fifth Annual Regulator and Administrative Costs Survey: Armenia(Washington: World Bank).

Keyan, M., and J. Delphia, 2002, Armenia: Least Cost Generation Plan (Washington: PA Government Services).

PADCO, 2001, “Financial and Actuarial Analysis of the Armenian Pension System,” Armenia Social Transition Program, Report No. 35 (Yerevan).

Poverty Reduction Strategy Paper, Republic of Armenia, November 2003.



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Shone, Parathasathi, 2004, “Tax Administration and the Small Taxpayer,” IMF Policy Discussion Paper No. 04/2 (Washington: International Monetary Fund).

Stepanyan, V., 2003, “Reforming Tax Systems: Experience of the Baltics, Russia, and Other Countries of the Former Soviet Union,” Working Paper 03/173 (Washington: International Monetary Fund).

TACIS Nuclear Safety Program, 2002, “The Closure of the Metzamor Nuclear Power Plant: A Least Cost Study of the Armenian Power Sector” (Brussels: European Commission).

World Bank, 2003, “Armenia, Public Expenditure Review,” Report Number 24434-AM (Washington).


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CHAPTER

The Financial System and Growth

It is generally accepted that the financial system plays a pivotal role in economic development by mobilizing funds for investment projects with the highest probability of success. In fact, a well-functioning financial system is a key component of a modern economy, facilitating the exchange of goods and services, mobilizing savings, allocating scarce resources, mitigating market imperfections, and helping to diversify risks.44

Given the importance of the finance-growth nexus, this chapter assesses the development of Armenia’s financial system. In particular, it attempts to identify those obstacles that hamper the proper functioning of financial markets. It then explores avenues to develop new financial products that will augment the sector’s growth. Finally, it outlines some policies to ensure a sound financial sector framework to support growth and poverty reduction over the medium term.

A. The Financial System in Armenia

Armenia is in many ways confronted with challenges similar to those faced by small open economies with nascent financial systems. Banking services dominate the sector, while nonbank financial services, such as leasing and insurance, remain insignificant. At end-2004, the banking system accounted for about 97 percent of financial system assets. Regarding financial sector supervision, three agencies are involved: (1) the central bank, charged with banking supervision and the supervision of other depository institutions and leasing companies; (2) the insurance inspectorate in the Ministry of Finance and Economy; and (3) the securities market commission responsible for capital market participants.

Over the past four years, Armenia experienced strong economic growth, but the financial sector played a limited role in this process. Growth was largely financed

44See Levine (2004). This does not exclude the possibility that growth in real activity and incomes may in turn foster financial sector development as the demand for financial services increases. For a comprehensive review of the finance-growth nexus, see de Nicoló, Geadah, and Rozhkov (2003) and Wachtel (2003).

4



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by retained earnings of firms and by external financing. Nonetheless, efficiency gains from mere resource reallocation or increased resource use have their limits. Privatization is almost completed, and foreign assistance is expected to decrease over time. As noted in Chapter 2, future sustained productivity growth will increasingly depend on further capital deepening and on how new technologies are adopted. In this context, the financial system will have to play a more prominent role than in the past.

The banking system

Over the past decade, Armenia’s banking system has undergone significant changes. After the dissolution of the Soviet Union, the mono-bank system of the Soviet era was broken into a two-tier banking system, consisting of the central bank and commercial banks. The elimination of the mono-bank system was followed by a rapid expansion of the banking sector. As in other countries of the former Soviet Union, Armenia’s strategy was to increase competition and bring interest rates down by granting licenses liberally with little regard to prudential requirements and supervision (Berglof and Bolton, 2002).

This emphasis on development without regard to supervision produced a banking system prone to crises. In addition to bad debts from the old regime, banks and enterprises lacked familiarity with a market economy, and lending practices often lacked the needed economic rationale. At the same time, banking supervision and regulation were still in their infancy, and bankers, inexperienced themselves, received little guidance from regulators. Since the mid-1990s, the regulatory framework has undergone a major overhaul and the legal environment has been adjusting to the demands of a modern financial system. Nonetheless, the 10 bank failures over the past few years created serious political difficulties and proved time-consuming to the authorities.45

Despite comprising most of the financial system, Armenia’s banking sector is small relative to the size of the economy. At end-2004, total banking system assets accounted for 19 percent of GDP. By comparison, the average size of the banking system in the CIS (excluding Armenia) was about 30 percent of GDP (Figure 4.1). On the deposit side, Central European countries also display far more financial depth than Armenia does.46

45The Central Bank administered and resolved eight banks; one bank was converted into a nonbank financial institution; and another one self-liquidated. 46The Baltics include Estonia, Latvia, and Lithuania. Other Europe includes Belarus, Moldova, Russia, and Ukraine. The Caucasus includes Armenia, Azerbaijan, and Georgia. Central Europe includes Bulgaria, Cyprus, Czech Republic, Hungary, Poland, the Slovak Republic, and Slovenia. Central Asia contains Kazakhstan, the Kyrgyz Republic, Tajikistan, Turkmenistan, and Uzbekistan.



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Foreign entry by well-established international banks has been limited, although foreign ownership accounts for about 53 percent of commercial banks’ capital. Only one international bank operates in Armenia; it has 18 percent of the system’s assets and a quarter of the deposits. In this context, there is scope for entry by reputable foreign institutions with a view to upgrading banking operations, trust among clients, and stability.

Over the past three years, the banking system experienced significant consolidation. The number of banks dropped from 31 at end-2000 to 20 at end-2004 (Table 4.1). The gradual increase in capital requirements to US$2 million in July 2003 contributed to the exit of some of the banks, but many banks also left the system because of weak governance and subsequent failure. The bank failures in 2000 and 2001 had a considerable impact on profitability ratios. As asset quality began to deteriorate, aggregate losses in the system led to a negative average return on equity of about 79 percent by end-2001 (Table 4.2). The losses wiped out a large share of banks’ capital, with capital adequacy dropping from 25 percent in 2000 to about 14 percent by the end of 2001. Subsequent, albeit slow, resolution of the failed banks led to a gradual improvement in system-wide asset quality and profitability.

0

20

40

60

80

100

Armenia Baltics Caucasus Central Europe Central Asia

Assets Deposits

Source: IMF International Financial Statistics.

Figure 4.1 Former Soviet Union and Central Europe: Assets and Deposits to GDP, 2004(In percent)



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1994 1996 1998 2000 2002 2004

Number of banks 55 35 31 31 25 20 Private … … 29 29 25 20 Resident … … 19 18 15 11 Nonresident … … 10 11 10 9 State-owned … … 2 2 0 0

Memorandum items:Total capital (in billions of drams) 3.6 12.3 18.8 29.5 42.7 39.9

Of which:Nonresident … … 7.9 12.6 21.6 21.0Resident … … 10.9 16.9 21.0 18.9

Of which:State-owned … … 1.3 1.5 0.5 0.0

Minimum (tier 1) capital requirement (in millions of U.S. dollars) 0.0 0.4 0.6 1.0 1.7 2.0

Source: Central Bank of Armenia.

Table 4.1. Ownership Structure of the Banking System, 1994–2004

At end-2004, concentration was moderate. The top three banks accounted for about 40 percent of the system’s assets. It is remarkable that so many banks could survive in such a small market. Part of the answer lies with the close economic ties to Russia, including through bank ownership. This has facilitated the development of a segmented banking system; some banks derive their profits primarily from money transfers and other services while other banks provide more traditional, albeit limited, lending services.

Another feature of the Armenian banking system is the high degree of both asset and liability dollarization. At end-2004, about 75 percent of banking system deposits were denominated in foreign currency. At the same time, foreign currency lending accounted for some 70 percent of total lending (Figure 4.2). Given the problems associated with high dollarization, Armenian banks are in a difficult position to lend prudently in domestic currency.47

47See, for example, Havrylyshyn and Beddies (2003) on the implications of high dollarization in the former Soviet Union.



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1998 1999 2000 2001 2002 2003 2004

Capital adequacyTotal regulatory capital to risk-weighted assets 29.8 27.8 25.0 13.6 30.5 33.8 32.3Tier I regulatory capital to risk-weighted assets 27.2 25.9 23.3 12.3 28.8 32.2 30.2Capital (net worth) to assets 16.5 17.3 14.3 8.8 18.4 18.1 17.8Capital and reserves (in billions of drams) 26.3 33.1 33.6 20.4 42.1 51.7 64.7

LiquidityLiquid assets to total assets 37.8 39.7 30.5 33.1 44.5 47.5 47.1Liquid assets to total short-term liabilities 83.3 100.1 86.1 80.4 108.8 101.3 98.7Customer deposits to total (noninterbank) loans 111.0 125.5 146.4 198.4 195.3 177.1 177.3Foreign exchange liabilities to total liabilities 74.6 79.7 80.6 79.7 72.2 73.2 73.3Excess reserves to total reserves 10.6 10.1 8.8 9.1 11.9 23.2 28.1

Asset quality

Total loans (billions of drams)1 … 140.4 167.1 157.4 154.8 194.6 194.6Standard loans … 134.8 158.1 147.3 149.3 187.3 187.3

Nonperforming loans (in billions of drams) … 5.6 8.9 10.0 5.6 7.3 7.3 Watch (up to 90 days past due) … … … … 2.8 5.3 5.3 Substandard (91–180 days past due) … 3.3 5.2 5.5 1.9 1.0 1.0 Doubtful (181–270 days past due) … 2.3 3.7 4.6 0.9 1.0 1.0 Loss (>270 days past due) … 13.5 20.1 41.1 14.8 15.6 15.6

Non-performing loans to gross loans 10.6 4.3 17.5 24.4 12.5 9.9 7.2Interbank borrowing spread in dram 57.0 59.5 46.7 29.0 7.8 2.6 2.0Interbank borrowing spread in foreign currency 59.0 39.9 35.0 22.0 3.6 3.7 1.0

ProfitabilityROA (profits to period average assets) 3.4 2.3 –1.9 –9.1 3.9 2.7 3.2ROE (profits to period average equity) 20.5 13.4 –12.3 –78.6 21.6 14.4 18.4Interest margin to gross income 41.7 40.3 30.7 27.8 37.6 42.0 44.2Noninterest expenses to gross income 36.0 33.8 36.4 42.7 49.6 48.5 47.2

Income from fees/gross incomeLoans and deposits

Loans to deposits 102.4 91.2 83.9 58.7 63.6 65.1 62.7Loans to total assets 48.4 48.9 51.6 42.6 44.2 43.2 40.4Foreign exchange loans to total loans 85.2 80.0 85.9 84.7 78.3 72.7 70.4Foreign exchange deposits to total deposits 75.1 81.0 81.6 81.0 76.7 77.2 78.6

Nominal interest rate spread (in dram)2 23.5 11.5 13.5 11.8 11.3 14.8 13.8Nominal interest rate spread (in foreign currency)2 21.0 15.4 17.2 15.8 14.9 15.6 15.5

Sensitivity to market risk Gross open positions in foreign exchange to capital 17.3 13.8 22.5 88.3 15.3 13.8 7.4

Concentration 3

Three largest banks 41.7 35.2 31.2 35.3 40.3 40.5 39.6Five largest banks 55.9 50.3 46.8 48.4 54.1 54.5 56.1

Memorandum items:Stock market capitalization to GDP … … … 0.1 0.4 1.0 …Total assets to GDP 16.7 19.3 22.9 19.8 13.7 17.7 19.2Deposits (residents) to GDP 5.9 7.1 10.3 10.6 8.7 9.0 8.7

Source: Central Bank of Armenia.1Loans exclude correspondent accounts and other interbank deposits. 2Commercial bank lending-deposit spread for 12-month average of 3-month maturities.3Concentration is defined as the asset share of the three and five largest banks in the system.

Table 4.2. Selected Financial Sector Indicators, 1998 –2004

(In percent, unless otherwise indicated)



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Foreign assets play an important role in banks’ balance sheets (Figure 4.3). Limited domestic investment opportunities at given interest rates often make investments in foreign currency assets the most prudent choice. In terms of credit, loans to the trade and services sector, which are presumably short-term, and industry loans accounted for the bulk of lending at end-2003 (23 percent and 20 percent, respectively), with mortgage lending just emerging.

Armenia’s interest rate spreads between lending and deposit rates have come down in recent years, although they are above spreads in other Eastern European and Baltic countries (Figure 4.4). In general, the level of the spread is driven by (1) funding, operating, and regulatory costs; (2) the degree of credit risk; and (3) market power.48 In the Armenian context, cost and efficiency considerations and the degree of credit risk are key factors explaining high spreads. The high cost of loans (averaging about 20 percent) points to inefficiencies in the banking system and high credit risk. These inefficiencies are primarily related to weak financial reporting by banks and firms and poor enforcement of creditor rights.

48See, for example, de Nicolo, Geadah, and Rozhkov (2003).

0

10

20

30

40

50

60

70

80

90

Armenia Baltics Caucasus Central Europe Central Asia

Foreign-currency deposits to totaldeposits

Foreign-currency deposits to broadmoney

Source: IMF FSU database.

Figure 4.2 Former Soviet Union and Central Europe: Dollarization, 2004(In percent)



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Nonbank financial institutions and capital markets

The nonbank financial sector comprises insurance companies, leasing companies, credit institutions, and pawnshops. While nonbank financial institutions play an insignificant role at this time, they are slowly beginning to grow. In particular, leasing activity could provide a useful vehicle for financing small and medium enterprises. Unlike bank loans, leasing operations do not require collateral and typically involve a lower downpayment.

Capital markets are virtually nonexistent. At end–2004, stock market capitalization accounted for 1 percent of GDP while capitalization of corporate securities accounted for 3 percent of GDP. There is almost no trading, as evidenced by the low turnover of 0.4 billion dram. At the same time, there are virtually no institutional investors except for 22 insurance companies with assets amounting to 0.3 percent of GDP. The insurance industry is at an embryonic

0

10

20

30

40

50

60

70

80

90

100

110

Armenia Baltics Caucasus Central Europe Central AsiaForeign assets Private sector credit Credit to government Other assets


Figure 4.3 Former Soviet Union and Central Europe: Composition of Assets, 2004(In percent of total assets)



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0 2 4 6 8 10 12 14

Central Europe

Baltics

Central Asia

CIS excluding Armenia

Armenia


Figure 4.4. Former Soviet Union and Central Europe: Average Lending Deposit Rate Spread, 2004(In percent)

stage, with most companies just meeting minimum capital requirements under Armenian law, namely 50 million dram (US$95,000).49

B. Regulation and Supervision

Recent studies have found that the key to successful financial intermediation is the creation of a level playing field, a sound legal framework, and well-governed financial institutions.50 A sensible approach toward financial sector supervision in good times is equally important as a well-defined resolution process in times of distress.

Armenia has made significant progress in recent years to put in place the basic legal framework governing the financial system. Key legislation comprises the

49For a recent study covering the insurance sector, see Mu and others (2004). 50See, for example, Levine (2002) and Claessens, Djankov, and Klingebiel (2000).



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Law on the Central Bank, the Law on Banks and Banking, and the Law on Bankruptcy of Banks. Insurance activities are covered by the Law on Insurance, which was redrafted recently, while securities market activity is based on the Securities Market Regulation Law of Armenia. In addition, supervisory capacity has improved markedly in recent years. Nonetheless, some shortcomings in the financial sector infrastructure, as discussed in the next chapter, should be addressed to provide the basis for financial sector growth in the future.

C. Why Has Financial Intermediation Been So Low?

Conventional measures of monetization suggest that Armenia compares poorly to other countries. Taking into account the central bank’s estimate on cash dollarization, the ratio of broad money to GDP at end-2004 would be higher at about 32 percent.51 The low level of banking system deposits can only be increased if confidence in the banking system improves. In addition, recent bank resolutions have been prolonged, creating uncertainties as to regulators’ resolve in dealing with unsound institutions and undermining the public’s confidence in the banking system. In an encouraging sign, credit growth has risen by 38 percent in 2004, although the ratio of private sector credit to GDP remains low at 7.5 percent.

Increased confidence in the banking system will require addressing some pending issues. Banking sector problems are rooted in a weak credit culture, fragile corporate governance, a lack of scale economies, insufficient creditor rights, and a feeble judicial system. There is no clear distinction between management and owners, and some banks still engage in connected lending or serve as “pocket” banks. In some instances, the true owners of banks cannot be identified despite the best efforts of the supervisory authority. This lack of transparency hampers the central bank’s ability to supervise banking institutions. The true risks of certain operations may not be fully visible until it is too late, which puts the institution and ultimately its depositors at risk.

In addition, financial reporting by enterprises—a critical element of making informed lending decisions—is still deficient, and there is a large underground economy. Unsurprisingly, about one-third of enterprises in Armenia find it hard to access bank credit. Capital accounts for 48 percent of firms’ balance sheets

51Feige (2003) studies the implications of cash dollarization in the former Soviet Union and Central Europe and finds “true” monetization to be much larger than reported in official statistics because of sizable foreign currency holdings.



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while bank credits (domestic) account for just 19 percent (Table 4.3).52At the same time, high lending rates render many otherwise viable projects cost-inefficient, particularly for small and medium enterprises, and may potentially result in adverse selection.

52The high degree of dollarization also makes prudent lending difficult as many borrowers lack foreign currency income.

1999 2000 2001 2002 20036

Equity capital 49.4 41.6 41.8 46.7 47.7Liabilities 50.6 58.4 58.2 53.3 52.3

Of which:Short-term liabilities 38.7 42.3 40.4 35.1 31.5Bank credits (domestic) 9.9 13.3 14.4 15.7 19.2

Debt to equity ratio 102.3 140.3 139.1 114.0 109.7

Memorandum items:Profitability1

Commercial2 –22.0 –31.0 –14.7 –11.0 –13.4Economic3 –8.2 –11.1 –5.6 –4.2 –6.8Financial4 –16.2 –23.7 –13.1 –9.4 –13.9Total profits (billions of drams) –108.0 –163.0 –77.4 –59.3 –99.5

Total assets (billions of drams) 1,375.9 1,419.6 1,393.8 1,466.5 1399.5Of which: State-owned5 1,058.7 908.4 857.5 908.5 …

Number of enterprises included 1,223 1,167 1,038 1,050 1,176

Source: Armenian authorities.1Profitablity is based on the sum of total profits before tax.2Profit before taxes divided by net turnover.3Profit before taxes divided by mean value of balance sheet assets.4Profit before taxes divided by mean value of equity capital.

6The base of indices for 2003 is the monitoring of data characterizing financial results of large and mediumcommercial organizations’ (included in business register of 2002) activities.

(In percent of assets unless otherwise indicated, end-of-period)

5Only enterprises with 100 prcent state ownership are included.

Table 4.3. Liability Structure of the Enterprise Sector, 1999–2003



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Credit policy is largely based on collateral, which many companies do not have, especially small and medium enterprises. At the same time, recovery of collateral is often difficult owing to the shortcomings in the judiciary. There is still a lack of experience in banking. Technology and knowledge transfer is limited. This makes sound financial data even more important. Better information will enable banks, as they gain experience, to lend based on business plans and expected cash flows. Ultimately, cash flow and creditworthiness will become an integral part of credit decisions.53

D. Key Challenges for the Coming Years

There is potential for the financial system to play a more active role in Armenia’s development. The banking system and, subsequently, capital markets can play a key role in assessing the efficiency of investments and contribute to faster economic growth.

Financial sector infrastructure, players, and regulators

The authorities can play a pivotal role in providing the infrastructure that supports the development of competitive markets. The basic infrastructure needed for successful financial sector growth includes strong legal rights for creditors and shareholders, sufficient disclosure standards and high-quality information, well-governed institutional investors, and support for private and public institutions. In Armenia, most of the legal preconditions for success are in place, though further enhancements to the system of creditor rights are warranted. What is really needed is the political commitment to ensure that the judicial system will enforce creditor rights and that bank managers and companies will be properly penalized for weak or nontransparent accounting and business practices. Only this commitment will provide the basis for long-term contracts and ensure a level playing field where the government and private agents compete for savings.

As noted above, Armenia has come a long way in providing a supportive legal infrastructure. Still, further amendments to the system of contractual relationships will help. These include improving procedural rules for creating, registering, and enforcing collateral (Civil Code); refining procedural aspects of court proceedings to facilitate a speedy recovery of loans (Civil Procedures

53Reported aggregate losses of companies, however, are quite high, casting doubts as to whether cash-flow-based lending is feasible at this time.



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Code); and enhancing the enforcement of court decisions (Law on Compulsory Enforcement of Court Decisions and Law on Public Auctions).54

Given that banking is the most important financial service in Armenia, improving confidence in banks should be the primary objective. In this context, the regulators need to ensure that banking supervision follows a transparent approach. Financial institutions should be treated equally, regardless of vested interests. Problem banks should be resolved in a timely and transparent fashion. In this context, the central bank is in a unique position to improve confidence by increasing the transparency of its own operations and policies. It should act forcefully towards banks that do not comply with prudential standards and limit the period of temporary administration of banks, that is, swiftly clean up the system of unsound institutions. Recent central bank proposals to beef up the regulatory framework, most notably by tightening exposure limits and adjusting the system of risk weights, will contribute over time to a healthier and more trusted banking system.

The authorities plan to implement a new corporate governance framework following international best practice.55 Banks are leveraged institutions and shareholders have small stakes relative to the deposit base, and depositors are important stakeholders whose interests need to be protected. This implies, for example, that shareholders, directors, and depositors should have access to information pertaining to banks’ activities and financial condition. At the same time, regulators need to ensure that financial reporting follows international accounting standards (IAS) as mandated by law.

The new credit registry under the central bank is a step in the right direction. The authorities could now encourage the establishment of private credit rating agencies to provide more comprehensive credit evaluation services. Contrary to the credit registry, credit rating agencies would also take into account areas such as timely utilities payments. In this context, it is also important that the central bank does not compete with services that could be provided efficiently by the private sector.

In general, scale economies suggest that fewer, larger institutions are more likely to help raise intermediation than smaller ones.56 Most banks in Armenia have a small share of an already small market (Figure 4.5). In this context, banks cannot finance larger projects unless they cooperate with other players, for example

54The implementation of these recommendations is foreseen under the World Bank’s Poverty Reduction Support Credit. 55Corporate governance principles (designed by the OECD) capture the allocation of rights and responsibilities between shareholders and the board of directors. 56The drawback to fewer larger institutions, however, is that institutions may become too big to be allowed to fail or exert market power.



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through loan syndications. While Armenian banking legislation permits loan syndication, in practice it is nonexistent. The imminent increase in capital requirements to US$5 million in mid-2005 will help facilitate consolidation through mergers, acquisitions, recapitalizations, or exits.

Entry by reputable international financial institutions has the potential to bolster know-how in the banking system, promote good corporate governance, facilitate closing the funding gap (for example through credit lines from parent banks), and play a catalytic role in restructuring the domestic banking system through the provision of additional capital and potential integration with the European Union.57 Foreign entry can also play a pivotal role in promoting capacity building in overall bank management. Foreign entry can introduce better risk management and loan evaluation techniques. It can also enhance competition, facilitate the development of new financial products, raise and allocate long-term funds, and broaden the revenue base for banks. In order to facilitate entries by well-known institutions or prevent further entries by smaller banks with limited experience in banking, the authorities could limit the licensing of smaller banks and raise capital requirements further.

57Foreign participation in banking systems in the Baltic countries is a good example of this.

Figure 4.5. Asset Shares in the Banking System, End-2004

0 5 10 15 20 25

International Investment Bank

ITB International Trade Bank

Prometey Bank

Commercial Bank of Greece (Armenia)

Mellat Bank

Areximbank

Inecobank

Arminvestbank

Armenian Development Bank

Artsakhbank

Armimpexbank

Unibank

Anelik Bank

Agricultural Cooperative Bank

Armeconombank

Ardshininvestbank

Armsavingsbank

Converse Bank

HSBC

Source: ARKA (private Armenian agency).



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Despite the insignificance of nonbank financial institutions, there is potential for future growth. In particular, the insurance sector with just US$7.3 million in written premiums at end-2004—almost entirely nonlife insurance—remains nascent (Table 4.4). This suggests that there is plenty of scope for consolidation in the sector, especially since most insurance companies just meet the low capital requirement under the existing law. The new law on insurance addresses capitalization requirements as well as issues related to investment rules and reinsurance. The next step is to issue regulations to improve accounting, reporting, and auditing. Another important step is the adoption of compulsory types of insurance, such as for motor vehicles. Lastly, weaknesses in corporate governance equally apply to the insurance sector and need to be addressed as well.

The mortgage market also needs to be developed. Recent trends point to a surge of mortgage activity, although it represents about 2 percent of commercial banks’ assets. Looking ahead, training and regulatory incentives should pave the way for improving underwriting and standards for mortgages. There is an urgent need to adopt legislation prepared in 2004 to strengthen the legal basis for mortgage markets, including ensuring that mortgage contracts can be enforced and that the process for transferring titles is efficient. These measures should be enough to foster market development; other proposals to involve government guarantees or government lines of credit seem redundant at this point, given the lack of basic

1999 2001 2002 2003 2004

Volume of gross premiums (in millions of US$) 2.1 3.8 4.3 4.7 7.3 Life 0.03 0.03 0.03 0.03 0.03 Nonlife 2.0 3.7 4.3 4.7 7.3

Gross premiums per capita (in US$) 0.5 1.2 1.3 1.5 2.3Gross premiums as a share of GDP 0.11 0.18 0.18 0.17 0.21

Memorandum items: Number of insurance companies 21.0 25.0 23.0 22 26

Total assets (in billions of drams) 2.4 3.7 4.0 4.2 6.4 Total assets (in millions of US$) 4.7 6.6 6.8 7.5 11.9 Exchange rate (end of period) 523.8 561.8 584.9 566.0 485.8


Table 4.4 . Key Insurance Indicators, 1999–2004



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preconditions for the functioning of the primary mortgage market, and could generate moral hazard and contingent fiscal liabilities.

The virtually nonexistent stock market activity in Armenia is not surprising. Such markets are relatively small in all low-income countries. This, however, does not mean that Armenia cannot access the services of stock markets in other countries.58 Several recent developments in international capital markets—such as cross-border trade in financial services, harmonization of international practices for global capital raising and trading, and stronger technological links—should make it easier for any large corporations to list its stock and raise capital in the market that offers the best conditions.59

Markets for debt: active government policy?

The government securities market in Armenia is still thin, and the domestic debt-to-GDP ratio remains low at 2.7 percent (end-2003).60 Given that Armenia has so far largely relied on international financial institutions and other foreign donors to fund investment projects, there is an argument for tapping domestic savings more aggressively to eventually “graduate” from aid dependence. In addition, a deeper and liquid government securities market has the potential to facilitate monetary management.

There are several positive spillover effects associated with a developed government debt market. The market infrastructure provided by the debt market could be used for issuing private sector debt. Government debt would create a benchmark and, more generally, facilitate long-term financing in domestic currency instruments, including bank credit. From a financial sector perspective, a sound and liquid government debt market has the potential to improve the functioning of financial markets more generally. Deep financial markets would create market rates that reflect the opportunity cost of funds at each maturity (see Bank for International Settlements, 2002). Armenia could actually issue more debt beyond its financing need to accelerate the creation of this benchmark. A summary of other countries’ experiences is presented in Box 4.1.

58As pointed out by Claessens, Djankov, and Klingebiel (2000), the fact that there is limited scope for domestic stock market development does not automatically imply that transition economies will lack access to the services offered by stock exchanges. 59Steil (2002) argues that creating a local stock market or ensuring local ownership may not necessarily be the best way of allocating domestic resources. 60To date, maturities have been extended to five years and the issuance of 10-year paper is envisaged, but the volumes are still quite small and auctions are consistently oversubscribed.



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Box 4.1. Developing Markets for Debt: Country Experiences

A number of countries have actively developed government securities markets to create benchmarks, develop a market infrastructure, and thereby facilitate the formation of corporate debt markets (Fry, 1997; and Bank for International Settlements, 2002). For example, some Asian countries had to rethink market strategies in the aftermath of the Asian crisis. Many believe that the crisis was partly caused by companies’ overreliance on the banking system. Companies often resorted to highly volatile short-term funding, often in foreign currency, which left them vulnerable. Domestic savings would have been sufficient to finance companies, and if debt markets had been more mature, some of these savings could have been channeled into domestic investment.

The Hong Kong Monetary Authority has developed a government debt market, despite the fact that the government did not need the funds raised. This, however, requires strong fiscal discipline to avoid moral hazard (i.e., the extra funds could finance new spending).

In Jamaica, a reference rate was established that could be used for pricing in the markets for commercial paper, certificates of deposits, interbank claims, and other repo markets.

In Malaysia, the infrastructure and procedures established for the government debt market served as models for private sector debt markets.

In Mexico, brokerage houses started operations in government securities and then expanded their activities using the same techniques to develop markets for private debt.

Due to a string of fiscal surpluses, Chile’s government has seldom issued debt. The central bank, however, has been issuing domestic government bonds to manage liquidity and establish a benchmark yield curve.

The Monetary Authority of Singapore (MAS) actively pursued the development of a liquid bond market. Like Greenspan (2000), the MAS took the view that an overdependence on the banking system has the potential to exacerbate problems for borrowers in a crisis, with the Asian crisis being a good example. To make available to investors a broader range of financial assets of varying credit risk and maturities, the following steps were taken to develop the Singapore dollar bond market: building and extending a benchmark yield curve through issuing government securities—a 10-year maturity in 1998 and a 15-year maturity in 2001; increasing the size of the issues per tranche; and establishing a repo facility to support primary dealers because repo markets are important to support secondary market activity.

Source: Schipke and others (2004).

While establishing a sound banking system should be a priority, the overall strategy for the financial sector should also focus on debt market development. Given the small size of Armenia’s debt market, a first step would be to increase



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volumes and extend maturities of government debt.61 Debt markets will provide a vehicle for long-term finance. Furthermore, a functioning corporate debt market can then serve as a substitute to bank financing. This would ameliorate the potential adverse effects of a credit crunch. Currency or maturity mismatches that may hamper growth could be reduced. Likewise, a debt market with long maturities will limit the potential bias towards short-term projects. Lastly, an efficient corporate bond market helps firms to lower their financing costs and provides competitive pressure for banks to lower their charges.

Government debt markets and monetary policy

A deep and liquid government debt market has far-reaching implications. Central banks have multiple interests in the development of a government debt market. Government securities provide a noninflationary financing vehicle and facilitate the implementation of monetary policy. In addition, as the transition process is accompanied by sizable capital inflows, the availability of domestic debt instruments facilitates the sterilization of such flows and liquidity management in general.

Armenia has benefited from significant capital inflows over the past few years. Cumulative net capital inflows during 1998 and 2003 totaled US$1.7 billion. While this has had significant developmental benefits, it complicated monetary policy, as the central bank was, and still is, lacking domestic instruments to absorb effectively the excess liquidity in the system. The solution here also lies in the issuance of additional treasury (or central bank) bills to boost the stock of dram monetary instruments. In any case, for sterilization of excess liquidity to be successful, closer cooperation and coordination between the Ministry of Finance and the central bank will also be required.

Increasing the presence on the international arena

Some transition countries have successfully launched bonds in international markets (Figure 4.6). While there is currently no pressing financing need in Armenia, a limited international bond issue could begin to raise investor awareness. It is worth pointing out, however, that a sovereign rating could be obtained without issuing a bond. Both could have positive spillover effects in the medium term. It would encourage the use of international corporate credit ratings for banks and corporations alike. Moreover, it would increase investor interest in the country and ultimately reduce aid dependence.

61Evidence suggests that both bank-based and market-based financial systems can contribute to growth (Levine, 2002).



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E. Concluding Comments

Armenia’s financial system is small and dominated by the banking sector. The limited role the sector has played in the growth process is mainly the result of the lack of transparency in banks and borrowers coupled with poor enforcement of creditor rights and a weak judiciary. Looking ahead, as foreign assistance becomes less important, the financial system will need to assume its proper role in supporting future growth. This will require improvements in the above-mentioned areas, together with the entry of reputable (likely foreign-owned) banks.

When financial markets fail, it is critical to assess the reasons for such failure and to address them at their source. In many countries, including Armenia, the challenge is to ensure that the institutions governing the financial market are trusted by its participants. In this regard, the government should focus on setting the rules of the game rather than on interfering with the markets. It should provide the proper legal and institutional infrastructure and attack any distortions that impede market development. Lastly, the central bank should also shield itself

Figure 4.6. Bond Issues in International Markets, Cumulative 1995–2004(In billions of US$)

0 5 10 15 20 25 30 35 40 45 50

Moldova

Malta

Latvia

Bulgaria

Estonia

Slovenia

Lithuania

Kazakhstan

Cyprus

Romania

Ukraine

Slovak Republic

Croatia

Czech Republic

Hungary

Poland

Russia

Turkey

Source: Capital Data.



83

from vested interests and political interference in its activities, especially banking supervision.

The recent large increase in deposits in the banking system and credit bode well for the much-needed increase in financial intermediation. A key task going forward is to build further confidence in the financial system by promptly removing troubled banks, strengthening banking supervision, pressing ahead with improvements in corporate governance and financial reporting in banks and enterprises, and implementing remaining legislation on creditors’ rights. In addition, the authorities need to actively promote foreign entry and further increase minimum capital requirements.

Capital markets in Armenia, given their early stage of development, are unable to provide financing for the economy. While banks are better placed to allocate savings during the transition process and to protect creditor rights, sole reliance on them carries its own risks. Thus, Armenia should further deepen the market for government securities because this can serve as a platform for private issues. By fostering the creation of a yield curve, bank credit maturities will also increase. Lastly, increasing attention needs to be devoted to creating the right environment for the development of insurance and primary mortgage markets.

References

Bank for International Settlements (BIS), 2002, “The Development of Bond Markets in Emerging Economies,” BIS Papers No. 11 (Basel).

Berglof, Erik, and Patrick Bolton, 2002, “The Great Divide and Beyond: Financial Architecture in Transition,” Journal of Economic Perspectives, Vol. 16 (Winter), pp. 77–100.

Claessens, Stijn, Simeon Djankov, and Daniela Klingebiel, 2001, “Stock Markets in Transition Economies,” Financial Sector Discussion Paper, No. 5 (Washington: World Bank).

Feige, Edward, 2003, “Dynamics of Currency Substitution, Asset Substitution and De facto Dollarisation and Euroisation in Transition Countries,” Comparative Economic Studies, Vol. 45, pp. 358–83.

Fry, Maxwell, J., 1997, Emancipating the Banking System and Developing Markets for Government Debt (London: Bank of England).

Greenspan, Alan, 2000, “Global Challenges,” Remarks at the Financial Crisis Conference, Council on Foreign Relations, New York, July 12.

Grigorian, David A., 2003, “Banking Sector in Armenia: What Would It Take to Turn a Basket Case into a Beauty Case?” Armenian Journal of Public Policy, Vol. 1 (September), pp. 57–77.



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Havrylyshyn, Oleh, and Christian H. Beddies, 2003, “Dollarization in the Former Soviet Union: From Hysteria to Hysteresis” Comparative Economic Studies, Vol. 45, pp. 329–57.

Hong Kong Monetary Authority, 2001, “Cost-Benefit Analysis of Developing Debt Markets,” Quarterly Bulletin (November), pp. 1–18.

Khan, Mohsin S., and Abdelhak S. Senhadji, 2000, “Financial Development and Economic Growth: An Overview,” IMF Research Paper No. 9138 (Washington: International Monetary Fund).

Levine, Ross, 2002, “Bank-Based or Market-Based Financial Systems: Which Is Better?” William Davidson Institute Working Paper No. 442 (Ann Arbor, Michigan: William Davidson Institute).

———, 2004, “Finance and Growth: Theory and Evidence,” NBER Working Paper No. 10766 (Cambridge, Massachusetts: National Bureau of Economic Research).

Mu, Yibin, Ramin Shojai, Serap O. Gonulal, and Lia Aghamyan, 2004, “Armenia Banking and Insurance Sector: Key Issues and Recommendations for Development” (mimeo; Washington: World Bank).

Nicoló, Gianni de, Sami Geadah, and Dmitry Rozhkov, 2003, “Financial Development in the CIS-7 Countries: Bridging the Great Divide” IMF Working Paper No. 03/205 (Washington: International Monetary Fund).

Schipke, Alfred, Christian Beddies, Susan M. George, and Niamh Sheridan, 2004, Capital Markets and Financial Intermediation in the Baltics, IMF Occasional PaperNo. 228 (Washington: International Monetary Fund).

Steil, Benn, 2002, “Creating Securities Markets in Developing Countries: A New Approach for the Age of Automated Trading,” International Finance, Vol. No. 2, 4, pp. 257–78.

Wachtel, Paul, 2003, “How Much Do We Really Know about Growth and Finance?” Federal Reserve Bank of Atlanta Economic Review, Vol. 88, No. 1,pp. 33–47.


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CHAPTER

International Integration

Armenia’s high growth rates over the past three years have been fueled by fast-growing exports, donor inflows, remittances, and FDI. Strong export-led growth is rather surprising in a country that lacks natural resources, has been subject to a trade blockade from two important neighbors, and has poor transportation routes. This chapter analyzes changes in Armenia’s trade patterns in recent years, the role of government policies, the success of the diamond industry, and the costs and consequences of the trade blockade.

The main ingredients of Armenia’s trade success are a liberal trade and investment regime, a well-educated but low-cost labor force, a committed diaspora that promotes investment, and enabling but not overly interventionist government policies. Given high transport costs to major markets, Armenian exports are concentrated on lightweight, high-value products that can be flown out of the country. If the political issues that have led to the trade blockade with Turkey and Azerbaijan could be resolved, the positive effect on Armenian trade and income levels are expected to be significant.

A. Trade and External Debt

As noted in Chapter 1, the conflict between Armenia and Azerbaijan led to the closure by Turkey and Azerbaijan of their borders with Armenia.62 Under pressure from the European Union, Russia, and the United States, there have been numerous attempts to work out a peace settlement, but no agreement has been reached to date. If an agreement were to be reached, some infrastructure to facilitate trade exists, such as unused road networks with Turkey on the western Armenian border.

62Although the border is closed, there are no bilateral restrictions on trade between Turkey and Armenia. Thus, Armenia has limited imports of cigarettes, oil products, processed food, wheat, chemicals, and electronic devices from Turkey. This trade goes via Georgia, significantly raising transportation costs.

5



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Table 5.1. Trade and Investment Indicators

1995–97 1998–2000 2001–04

(Annual percent change)

Merchandise exports, f.o.b. 4.9 9.9 24.8 Merchandise imports, c.i.f. 34.6 –0.5 11.6 Exports of goods and services 14.3 10.8 20.6 Imports of goods and services 30.6 0.7 11.6

(In percent of GDP)

Foreign direct investment1 2.1 5.5 4.6 Memorandum item: Real GDP growth (annual percent change) 5.3 5.5 11.7

Sources: Armenian authorities; and IMF staff estimates.1Includes privatizations.

Armenia’s north and south borders, while open, are not hospitable. The main road from the Islamic Republic of Iran is treacherous, traversing a mountain range that is frequently impassable in winter. The single main transport road into Armenia from Georgia is passable year-round. The main rail line into Armenia runs through Georgia from Russia, but unrest in northern Georgia has often rendered large swaths of it unusable. Imports from Russia, notably oil, must therefore skirt northern Georgia by ship on the Black Sea and reconnect with the rail line further south. As a result, a high share of trade is conducted by air.

In contrast to existing political and physical barriers to trade, Armenia has one of the most liberal trade regimes in the world. Most imports are duty-free, and consumer goods have a flat tariff of 10 percent. The trade-weighted average tariff rate is 3.0 percent. There are no trade processing fees or nontariff barriers. One complicating factor is the prevalence of discretionary practices by customs on the valuation of imports. Such practices raise import costs. Armenia joined the World Trade Organization (WTO) in February 2003 and belongs to the Black Sea Economic Cooperation (BSEC).

Armenia’s current account deficit narrowed to an estimated 5.8 percent of GDP in 2004, from 21.3 percent of GDP in 1998, as a result of booming exports and strong import substitution activity. Over the same period, the trade deficit narrowed from more than 30.5 percent of GDP to 15.5 percent of GDP(Figure 5.1). The still relatively large trade deficit is (partially) offset by private



87

sector remittances within the current account.63 The level of remittances has been particularly high since 2003 because of high income growth in Russia.

During the past four years, Armenia managed to bring its external debt position to sustainable levels by lowering its net present value of debt-to-exports ratio below 100 percent. Looking ahead, stress tests reveal that such a level is resilient to a variety of shocks through 2015.64 As discussed in Chapter 3, a key challenge after 2015 will be the cost of decommissioning the nuclear power plant. Booming exports and debt swap agreements with Russia and Turkmenistan in 2003 were instrumental in cutting debt ratios by almost one-half in just a few years (Table 5.2).

B. Changes in Trade Patterns

The dismantling of the Soviet Union and the concomitant change in relative prices and demand caused a drastic reorientation of Armenia’s trade in the past

63While export data is relatively accurate, data on imports and remittances are not reliable. Unofficial estimates suggest they may be two or three times higher than the official statistics. This would imply, all else equal, that Armenia has a current account surplus. Most of the unrecorded inflows are thought to be in the form of “pocket money” from Armenians working in Russia. 64Debt calculations until 2015 are presented in Mathieu (2004) and in IMF (2004).

-40-30

-20-10

0

1020

3040

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Trade balance Income and transfersCurrent account

Figure 5.1. Current Account, 1994–2004

(In percent of GDP)




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decade. The share of trade with the European Union, the United States, and Israel increased rapidly, while trade with the CIS countries and the Islamic Republic of Iran decreased substantially (Figure 5.2).

The composition of exports changed radically, and export growth has been unprecedented. Exports of industrial goods such as machinery, rubber, chemicals, and electronics virtually disappeared, and a new set of activities gradually emerged. At the same time, exports became more concentrated. Since 1999, a radical transformation of the diamond industry has led to a boom in diamond processing, with diamond exports increasing by 450 percent. Other dynamic sectors were agricultural products, foodstuffs, textiles, minerals, base metals, and instruments (Figure 5.3). While export growth began to pick up in the late 1990s, most of the growth took place between 2000 and 2004, when merchandise exports grew by 130 percent.

Exports of services also rose in recent years, but their value remains well below that of merchandise exports. There has been an increase in exports of information technology products (mainly software) which benefited from Armenia’s human capital base. Tourism receipts have improved somewhat, but they remain hampered by an inadequate transportation infrastructure.

2001 2002 2003

Debt service to exportsArmenia 9.7 9.9 8.6CIS-7 Average 17.8 17.9 14.4

Debt service to central government revenueArmenia 15.3 18.5 18.8CIS-7 Average 49.2 49.4 38.2

Public External Debt to GDPArmenia 42.2 43.2 38.9CIS-7 Average 73.3 70.4 66.3

Net Present Value of Public External Debt to ExportsArmenia 165 131 87CIS-7 Average 179 156 140

Source: Mathieu (2004).

Table 5.2. Public External Debt Services Indicators, 2001–03

(In percent)



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The composition of imports also changed because of the shocks in the early 1990s and the subsequent surge of the diamond industry. Imports grew by 256 percent during 1994–2004, although the growth rate slowed after 2000 owing to import substitution. Import growth was particularly strong in raw diamonds (to service the diamond processing industry), machinery, equipment, paper, and chemical products. Imports of foodstuffs and minerals decreased as a share of total imports, reflecting import substitution by emerging domestic activities (Figure 5.4).

The observed increase in imports of services reflects transport costs associated with higher imports. Telecommunications services did not expand because of perverse monopoly rights granted to a single foreign investor (communication costs remain an impediment to business in Armenia and a constraint on trade). Some of these monopoly rights (for mobile services) have been recently rescinded, although a deeper restructuring of the sector is needed to bring costs towards competitive levels.

Figure 5.2. Direction of Trade, 1996–2004

Source: IMF International Financial Statist ics .

1996 ExportsEU and accession

countries

U.S.2%

CIS 43%

Iran15%

Other16%

2000 Exports

U.S.13%

CIS24%

Iran10%

Other16%

EU and accession countries

2004 ExportsEU and accession

countries41%

Other5%Iran

10%

U.S. 8%

CIS22%

Israel14%

1996 Imports

Other19%

Iran17%

U.S.12%

CIS33%

EU and access ion countries19%

2000 Imports

Other18%

Iran9%

U.S. 12%CIS20%

EU and accession countries41%

2004 Imports

Other17%

Iran10%

U.S.8%

CIS22%

EU and access ion countries

Israel 9%

24% 37%

34%



90


C. Investment, Exports, and the Role of the Government

Armenia has experienced relatively high levels of domestic and foreign investment in recent years. FDI averaged 5 percent of GDP during 1999–04, compared to an average of 4 percent for other CIS countries. These levels of investment are relatively high given the location of the country, its small domestic market, and the trade blockade. Several factors seem to have contributed to this outcome, namely the improvement in the business environment in response to prudent economic policies and deregulation, the role of the diaspora in intermediating investments and exports, and Armenia’s low level of wages and skilled labor force.

Foreign investment in export sectors was channeled toward human capital-intensive activities with high value-added, low volume and weight, and minimal use of raw materials. Besides diamond processing, the most recent investments have been in energy, software, jewelry making, watches, processed food, wine and liqueurs, and textiles. In addition, a large project related to airport improvement is under way, and the state copper company will be privatized in late 2005 with mandatory investment clauses for the next few years.65

65Recent literature on FDI highlights two main modalities of participation: “horizontal” investments geared to the size of the potential market or “vertical” intra-industry integration that parcels out the chain of production among different countries (Garibaldi, 2002; Lim, 2001; and Campos and Kinoshita and others, 2003). The latter has been the predominant form of activity in the last two decades in most countries, and while data limitations prevent a disaggregated analysis for Armenia, most emerging activities seem to have this feature (e.g., diamonds, textiles).

0100200300400500600700800

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Base m etals and instrum entsTextilesMinerals and precious stonesAgriculture and foodstuffs Other

Figure 5.3. Composition of Exports, 1994–2004(In millions of U.S. dollars)



91


In light of the success of Armenia’s exports so far, we explore below the extent to which dynamic (compared to static) factors such as increasing returns to scale and the domestic market played a role in the process. A skilled labor force and a long-standing tradition of artisanship in diamond polishing are Armenia’s sources of comparative advantage. Modern trade theory emphasizes the importance of economies of scale and market size in shaping comparative advantage (see Feenstra, 2004). While most of Armenia’s emerging exports (diamonds, foodstuffs, textiles, minerals, base metals, and instruments) are subject to economies of scale at the firm level, the size of the exporting firms in these sectors has not changed much over the last few years and is lower than in developed countries. Furthermore, the size of the domestic market is still too small to make a difference on unit costs and affect comparative advantage. Therefore, Armenia’s export boom seems to be associated with its traditional sources of comparative advantage (a high-skilled, low-wage labor force) and with an appropriate incentive structure (i.e., enabling tax and trade regimes).

Regarding the extent of government intervention as a factor behind the recent export boom, models of trade under imperfect competition point to a possible beneficial effect of industrial policy via subsidies or trade protection, although these results are often contingent on model specification and the empirical evidence on the matter remains ambiguous (see Lancaster, 1996; and Perdikis and Kerr, 1998). These models suggest that, under certain market imperfections or externalities, government intervention can serve as a catalyst to jump-start

0

200

400

600

800

1000

1200

1400

1600

1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Paper and chemicalsBase m etals and instrum entsMachinery and transport equipm entMinerals and precious stonesOther

Figure 5.4. Composition of Imports, 1994–2004

(In millions of U.S. dollars)



92

private sector activities that investors may otherwise avoid. In the case of Armenia, and except for a rather minor degree of government support to the diamond sector (see below), the overall environment has not been characterized by policy interventions (e.g., subsidies, import protection, monopoly rights). Foreign investors enjoy temporary exemptions from profit taxes (until 2007), but such incentives are similar to those present in most developing countries. Beyond profit tax exemptions, Armenia’s tax rates are relatively low and uniform, and there are no subsidies or other advantages granted to exporting firms.

D. Diamond Processing

Lack of market incentives during the Soviet era prevented diamond processing from flourishing in Armenia. In the late 1960s, a large diamond processing factory was established in Armenia to exploit domestic know-how and service the Soviet market.66 However, the factory was a victim of inefficient state management and its costs were relatively high by international standards. By the late 1990s, the state-owned factory was still operating, thanks to Armenia’s traditional expertise in diamond polishing and cutting, combined with labor costs that were six to eight times lower than in other countries.

Since the late 1990s, a favorable domestic and international environment were the key factors behind the successful transformation of Armenia’s diamond industry. The industry drew many investors, including firms from Belgium and Israel, with output increasing from US$100 million in 2000 to more than US$250 million in 2004. By 2004, approximately 60 companies engaged in diamond processing. The largest 15 companies account for 90 percent of total output, employ 4,200 people, and pay an average salary 1.5 times the average for the country. Nearly all output is sold abroad, and its value-added is about 10 percent.

The government did not actively subsidize the sector, although by ensuring a stable supply of raw materials it may have provided a positive signal to some investors. In 1998, the government signed an agreement with Russia that ensured a minimum volume of raw diamonds to be supplied to Armenia. The agreement sought to assure investors of a stable supply of raw diamonds, but it did not specify prices. Prices were supposed to be negotiated directly between the importer and the Russian suppliers. In the end, the contract was never fully used as many firms developed their own supply sources, although it may have played a useful signaling role that some investors needed to commit resources to a remote country like Armenia.

66Armenia has a long history of artisanship in diamonds and jewelry.



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The only tax revenue the industry generates is income taxes from its employees. Imports are duty-free and there are no value-added taxes because almost all output is exported. Under the Kimberley certification process, raw diamond import values are assessed only on transaction values. In fact, profits in diamond processing are difficult to ascertain given that more than half of the incoming product is turned into waste in the polishing process. The international standard is a turnover tax, but this is also difficult to implement, and the authorities decided not to apply it in Armenia.

Looking ahead, the sector is unlikely to grow as quickly as in recent years. Export growth already fell in 2004 owing to higher prices for raw diamonds. The higher price of raw diamonds caused many of the smaller firms that rely mostly on manual labor to stop operations. The larger companies remain competitive as they enjoy better prices for their large purchases of inputs and use newer technologies.

E. Closed Borders and Transport Costs

Opening Armenia’s border with Turkey and Azerbaijan would increase the volume of trade, change its composition and orientation, and lower tradable goods’ prices. Expanded rail and road routes would lower transport costs and enable both trade of heavier items and tourism.67 These developments would be extremely positive for Armenia and eastern Turkey, and to a lesser extent for Azerbaijan. The proximity of the large Turkish market and Armenia’s lower wages would provide incentives for new investments and the development of new export activities. The impact on import prices would also be significant. For instance, energy prices in Armenia are higher than elsewhere in the region, and so opening up new opportunities in the sector (particularly for natural gas imports from Azerbaijan to replace some Russian imports) could lower import prices.

Views on the constraint caused by the closed borders are mixed, but on balance, the effects are expected to be significant, especially considering the political uncertainty regarding the unresolved territorial dispute with Azerbaijan. Discussions with government officials suggest a profound impact, with wide-reaching effects that would effectively reinvent the structure of the economy. Two empirical models can be estimated to gauge the extent to which trade is constrained: the openness model and the gravity model. Based on the model estimated by Freinkman, Polyakov, and Revenco (2004), Table 5.3 displays the simulation results for 2004 from two typical openness models that

67Transport costs can be estimated by the ratio of freight costs to the value of exports, which in the case of Armenia is 9.3 percent. The corresponding ratio for the European Union is 1.5 percent (Polyakov, 2001). However, the Armenian figure is pushed downward by a trade structure that favors low-weight, high-value items.



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Table 5.3. Results from Openness Model

Simulation results 2004

Actual trade-to-GDP ratio 54.2Predicted trade-to-GDP ratio 115.2Actual exports-to-GDP ratio 20.6Predicted exports-to-GDP ratio 52.3

Source: Authors’ calculations.

(In percent)

attempt to explain trade levels as a function of GDP per capita, population, and regional dummy variables. The two models differ with respect to their explanatory variables: one uses the trade-to-GDP ratio, the other uses the exports-to-GDP ratio.68

The gravity model has also been used extensively in the trade literature, primarily with a view to analyzing the extent and direction of trade among countries.69 The model has performed relatively well empirically, and despite some initial controversy regarding its theoretical underpinnings, its basic specification has been shown to be consistent with modern trade theory (Helpman and Krugman, 1985; Deardoff, 1998). Recent versions of the model have been expanded to estimate the impact of institutions, common currencies, and the trade potential of being a member of key international organizations (de Groot and others, 2004; Frankel and Rose, 2002). We used Kukharchuk and Maurel’s (2004) model to estimate Armenia’s trade potential (assuming open borders and appropriate trade routes) and the impact of institutional constraints on trade. Two important features of this model are the inclusion of CIS countries in the sample and the

68The models were estimated with data for 149 countries from the World Development Indicators database covering the period 1994–2001. The two-stage least squares procedure was used to deal with possible endogeneity between GDP and the openness measures. The first model is specified as Trade/GDP = 119.8 + 12.7*ln (GDP per capita) – 14.5*ln (population) + 23.7 (CIS dummy). All of the above are statistically significant at the 99 percent confidence level. The second model is specified as Exports/GDP = 32.7 + 8.3*ln (GDP per capita) + -6.2*ln (population) + 11.6 (CIS dummy). In the latter model, all variables except the dummy and the intercept are statistically significant at the 99 percent confidence level. The dummy and the intercept are significant at the 95 percent confidence level. 69The gravity model specifies bilateral trade as a function of the countries’ relative sizes (measured by GDP or population) and their distance from each other. The name is derived from Newton’s analysis of gravity in physics, where the gravity force between two objects is proportional to their masses and inversely related to their distance.



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introduction of measures of institutional quality in the trade equation. The basic specification of the model is:

Tij = 0 + 1Yi + 2Yj + 3 Dij + 3 VOLij 4

Dummyij + k k INSi + k k INSj + ij;

where i and j denote country pairs, and T and Y are the natural logarithm of bilateral trade flows and national income, respectively. D is the distance between i and j, VOL measures exchange rate volatility, and Dummy represents binary variables for different trading blocks, namely the European Union (EU), the Commonwealth of Independent States (CIS), and the Central and Eastern European Countries (CEEC).70 INS represents the institutional environment and is captured by five variables: trade restrictions, foreign investment restrictions, restrictions on financial and banking transactions, property rights, and shadow market activities.71 The data panel used in the estimation has 13,712 observations from 42 countries over an eight-year period since 1994. The simulation results for Armenia, displayed in Table 5.4, suggest that its “potential” level of trade could be 39 percent higher than the actual trade.72 The increase is somewhat larger than the one suggested in a previous study by Polyakov (2001).73

While both the openness and the gravity models suggest that opening Armenia’s borders and improving trade routes would lead to a much higher level of international trade, the role of the institutional environment to facilitate trade and investment should not be overlooked. The gravity model used above also allows us to gauge the effect on trade volumes of an improvement in the institutional environment.74 We simulated in Table 5.4 the effect on Armenia’s

70Trade, income, and distance data are from the Direction of Trade Statistics, the Fund’s World Economic Outlook database, and the Chelem-CEPII dataset. VOL is calculated as the standard deviation of the ratio between the monthly nominal exchange rate and its annual average (International Financial Statistics).71The values for these variables are taken from the Heritage Foundation’s Indices of Economic Freedom (www.heritage.org/research/features/index) and are measured on a 1–5 scale, with a value of 1 representing the optimal environment. The variables are scaled as deviations from their mean. 72The estimated equation (using generalized least squares) is Ln Tij = 0.87Yi + 0.93Yj – 1.02Dij - 0.13VOLij +2.49Dummy (CIS) – 0.04 Tradej – 0.08 Tradei – 0.01Investmenti – 0.03Investmentj – 0.07 Bankingj – 0.03 Bankingi – 0.12 Property rightsj – 0.07 Property rightsi – 0.11 Shadow Economij – 0.09 Shadow Economyi + 2.49 CIS + 0.44 EU + 0.28 CEEC + ij . All but two variables are statistically significant at the 99 percent confidence level. The remaining two variables (foreign investment and CEEC dummy) are statistically significant at the 90 percent level. 73Polyakov (2001) also used a gravity model to estimate the costs of the blockade, and the results suggested that opening the borders and improving transportation networks could double Armenian exports and increase GDP by about 30 percent. The model contains a traditional gravity equation that includes income, distance, and population as explanatory variables. 74As noted in previous chapters, much remains to be done to improve governance and the business environment in Armenia. A recent World Bank survey of investment climate indicates that the tax system, political and policy uncertainty, corruption, and the functioning of the judiciary remain key impediments to doing business in Armenia (World Bank, 2004).


www.heritage.org/research/features/index


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Actual level of trade (2004) 1,945 Predicted level of trade 2,707 Difference between predicted and actual trade (in percent) 39.2

Increase in total trade in response to improved institutional environment 34.8

Memorandum items:Selected scores for institutional environment1 Armenia CIS EU

Trade 2.0 3.5 2.0Foreign investment 2.0 3.5 1.8Banking 2.0 4.0 2.1Property rights 3.0 3.8 1.4Shadow economy 4.0 4.5 1.4

Sources: Authors’ calculations; and Heritage Foundation database.1Scores range from 1 to 5, with 5 being the worst environment.

Table 5.4. Gravity Model Simulations

(In millions of U.S. dollars)

trade of an improvement in the institutional environment to the level of EU countries. The results show that the increase in trade is almost as high as the difference between actual and “potential” levels.

F. Concluding Comments

Armenia’s tradable sector has thrived in recent years as a result of macroeconomic stability, improvements in the business environment, help from the Armenian diaspora, and a low-wage, highly skilled labor force. A successful process of import substitution and export-led growth has been taking place in an environment of low and rather uniform tax rates and minimal government intervention. The government did not grant subsidies or other advantages to firms (e.g., import protection, monopoly rights, or export subsidies), although it is possible that the diamond sector benefited initially through a government-engineered supply contract that ensured a stable supply of raw materials from Russia.

Over the medium term, more will need to be done for the country to further develop its export sectors and remain competitive. The opening up of Armenia’s borders could have a significant role in fostering trade and regional integration. For the time being, however, the current situation should be viewed as an opportunity to improve the existing trade and investment environment. The



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latter can be achieved by strengthening the quality of Armenia’s institutions, especially by making tax and customs agencies more efficient, improving the financial sector, ensuring an independent judiciary, and adopting effective anti-corruption practices at all levels of government.

References

Campos, Nauro, and Yuko Kinoshita, 2003, “Why Does FDI Go Where it Goes? New Evidence from the Transition Economies,” IMF Working Paper 03/228 (Washington: International Monetary Fund).

Deardoff, Allan, 1998, “Determinants of Bilateral Trade: Does Gravity Work in a Neoclassical World,” in The Regionalization of the World Economy, ed. by J. Frankel (Chicago: University of Chicago Press).

De Groot, Henri, Gert-Jan Linders, Piet Rietveld, and Uma Subramanian, 2004, “The Institutional Determinants of Trade Patterns,” Kyklos, Vol. 57, Fasc. 1, pp. 103–24.

Feenstra, Robert, 2004, Advanced International Trade: Theory and Evidence (Princeton, New Jersey: Princeton University Press).

Frankel, Jeffrey, and Andrew Rose, 2002, “An Estimate of the Effect of Common Currencies on Trade and Income,” Quarterly Journal of Economics, May, pp. 437–66.

Freinkman, Lev, Evgeny Polyakov, and Carolina Revenco, 2004, “Armenia’s Trade Performance and the Effect of Closed Borders: A Cross-Country Perspective,” Armenian Journal of Public Policy, Vol. 1, No. 2, pp. 185–212.

Giragosian, Richard, 2003, “Geopolitics and the Formation of Foreign Policy in the South Caucasus: An Examination of Armenia, Azerbaijan, and Georgia,” Working Paper 03/19 (Washington: Armenian International Policy Research Group).

Garibaldi, Pietro, Nada Mora, Ratna Sahay, and Jeromin Zettelmeyer, 2002, “What Moves Capital to Transition Economies?” IMF Working Paper 02/64 (Washington: International Monetary Fund).

Hausman, David, A. Kraay, and P. Zoido-Lobaton, 2002, “Governance Matters II: Updated Indicators for 2001–02,” World Bank Policy Research Working Paper No. 2772 (Washington: World Bank).

Helpman, Ellhanan, and Paul Krugman, 1985, Market Structure and Foreign Trade (Cambridge, Massachusetts: MIT Press).

Kukharchuk, Oxana, and Mathilde Maurel, 2004, “Russia’s Accession to the WTO: The Potential for Trade Increase,” Journal of Comparative Economics, Vol. 32, pp. 680–699.



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Lancaster, Kevin, 1996, Trade, Markets, and Welfare, (Brookfield, Vermont: Elgar, distributed by Ashgate).

Lim, Ewe-Ghee, 2001, “Determinants of, and the Relation Between, Foreign Direct Investment and Growth: A Summary of the Recent Literature,” IMF Working Paper 01/175 (Washington: International Monetary Fund).

Mathieu, Paul, 2004, “The Sustainability of Public External Debt in the Five Highly-Indebted CIS Countries: A Background Paper for the CIS-7 Initiative,” EBS/04/56, 4/29/04 (Washington: International Monetary Fund).

Perdikis, Nicholas, and William Kerr, 1998, Trade Theories and Empirical Evidence (Manchester, England: Manchester University Press).

Polyakov, Evgeny, 2001, Changing Trade Patterns after Conflict Resolution in South Caucasus (Washington: World Bank).

Republic of Armenia Fifth Review Under the Poverty Reduction and Growth Facility and Request for Extension of the Arrangement, IMF Country Report No. 04/136 (Washington: International Monetary Fund).

Ross, Andrew, 2005, “Which International Institutions Promote International Trade,” Review of International Economics (forthcoming).

Samuelian, Thomas, 2003, “Implementing Country Competitiveness as a Standard for Law and Policy Making,” Group Working Paper 03/16 (Washington: Armenian International Policy Research Group).

Shiells, Clinton, 2003, “FDI and the Investment Climate in the CIS Countries,” PDP/03/5 (Washington: International Monetary Fund).

World Bank, 2004, Doing Business: Understanding Regulation (New York: Oxford University Press).


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CHAPTER

Summary

Despite geographical isolation, trade blockades, and occasional political upheaval, Armenia’s economic performance during the past four years has been remarkable. Growth has averaged nearly 12 percent and poverty has fallen. The country has become a reform leader among CIS countries. This performance reflects a combination of factors, namely a sustained commitment to macroeconomic stability, structural measures undertaken since the mid-1990s, minimal government intervention in the economy, a focus on poverty-reducing policies since 2002, and support from the Armenian diaspora. These factors led to higher domestic and foreign investment, improvements in competitiveness, and a market-driven process of import substitution.

However, the sustainability of growth and further poverty reduction is not yet assured. Examples abound of countries that achieve higher rates of economic growth but are unable to maintain the momentum for more than a few years. The presence and proper functioning of economic institutions will likely condition Armenia’s long-term growth, and we have highlighted earlier those institutions that still need to meet that test, namely, tax and customs operations, the financial sector, and the judicial system. Furthermore, the extent of Armenia’s integration with the world economy is below its potential.

In coming years, economic growth and capital formation should be broad-based and generate employment. Such growth cannot continue to rely almost entirely on foreign financing, highlighting the importance of fiscal management and financial intermediation. The tax and customs systems will have to function adequately and the state should become an efficient provider of social services and public investment. This would generate additional tax revenues to ensure fiscal sustainability and help finance growth-enhancing public expenditures. As envisaged in the PRSP, rural and regional imbalances will have to be mitigated and the government will need to devote more resources to these areas as well as to strengthening the public infrastructure. Lastly, Armenia’s economic potential lies with an export-led development growth process, and further integrationwith its neighbors and main trading partners should be a priority. Such potential will only be realized when the artificial barriers to regional integration are removed.

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The analysis in the previous sections regarding the key remaining reforms needed to sustain growth and achieve poverty reduction objectives can be summarized as follows:

Tax policy: Armenia has relatively good tax legislation with moderate tax rates, although some aspects of the tax system need to be revisited, most notably the simplified tax. First, the authorities should review the simplified tax and presumptive taxes with a view to expanding the tax base. Second, they should focus on compiling a unified tax code—this is important because of the number of amendments and supplementary provisions for different taxes made over the past six years. Third, it is important to allow the current profit tax exemptions for large foreign investments to end as projected in 2007.

Tax and customs administration: While progress has been made in the past few years, the discretionary activities of collection agencies remain a key obstacle to a better business environment. Collections are based on targets, and businesses complain about bribes demanded by officials and discrimination among taxpayers. There is a need to make wide use of risk-based methods for audit, VAT refunds, arrears collection, and import clearance. An additional distortion arises from insufficient communication between the agencies and their lack of integration with the Ministry of Finance. The authorities should proceed to reorganize these agencies and unify them under the Ministry of Finance.

Public sector efficiency and expenditure management: The government needs to ensure the efficient provision of health, education, water, and sanitation services and to finance improvements in the basic infrastructure. This requires additional capacity building, transparency, and accountability. The recent tendency to prioritize current expenditures in the medium-term expenditure framework and the budget is misguided and appropriate weight should be given (as envisaged in the PRSP) to improving the public infrastructure, especially in rural areas and cities besides Yerevan. In this regard, a public investment program should be prepared. Lastly, a public expenditure review should look closely at nonpriority expenditures and budget classifications.

Financial intermediation: The key factors limiting the development of the banking system in Armenia are weak corporate governance and poor enforcement of financial contracts. Bank ownership should be made more clear, capacity in banks should be enhanced to develop new financial products, borrowers’ financial conditions should be made transparent, and the judiciary should be more efficient to facilitate creditor rights and collateral recovery. These actions will all serve to lower real interest rates and spreads, discourage adverse selection, and increase financial intermediation.


Summary

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Trade integration: The loss of markets in the former Soviet Union combined with the trade blockade severely disrupted Armenia’s trade opportunities. Despite the recent export boom, exports remain relatively low and concentrated in a few categories. The structure of trade has also shifted towards goods with low transport costs. Looking ahead, the main challenges are to improve customs administration, normalize trade relations with Turkey, and reach a peaceful solution to the conflict with Azerbaijan.

Armenia is now at a crucial phase of its development. The completion of the reform agenda and the implementation of the policies envisaged in the PRSP will likely allow Armenia to be one of the few low-income countries to achieve the Millennium Development Goals within the next 10 years. On the other hand, failure to tackle the above-mentioned issues could expose the country to a vicious circle of low tax collection, insufficient social and infrastructure investment, and persistently high levels of poverty and inequality. Since many of the remaining reforms are opposed by vested interests, overcoming these challenges will require a new dose of leadership and political resolve at the highest levels of government. As a reinforcing factor, improved prospects for integration with the European Union could also help to strengthen institutions and the role of reformers in the country.


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