Public Information Notice No. 99/103

Public Information Notice: IMF Concludes 1999 Article IV Consultation with Armenia

November 5, 1999

On October 8, 1999 the IMF Executive Board concluded the 1999 Article IV consultation with Armenia,¹ and completed the mid-term review under the third annual arrangement under the Enhanced Structural Adjustment Facility (ESAF).

Background

Since 1994, Armenia has been in search of macroeconomic stability and structural reform, with the financial support of international financial institutions and donors.² By 1996, inflation had been reduced to single digits and output was growing at an annual rate of about 6 percent. Decisive steps had also been taken to liberalize prices, privatize small and medium term enterprises, and reform the banking, health, and education sectors. However, as a result of some policy slippages in late 1996 and 1997, inflation accelerated in 1997, while real GDP growth slowed in part due to disappointing agricultural production.

In the first eight months of 1998, Armenia's economic performance improved markedly. GDP growth recovered, inflation declined substantially, the current account deficit narrowed, and the exchange rate was stable. The Russian crisis in August 1998, however, hit Armenia hard. Exports, workers' remittances, and transfers fell sharply, leading to declining demand for output in industry, transportation, and services. This was compounded by a drought in late 1998 and by rising political uncertainty in the run up to the May 1999 parliamentary elections. Only a strong performance in the construction sector, driven largely by government investment projects, continued to support real GDP growth. Growth for all of 1998 was more than 7 percent, before declining to just under 5 percent in the first half of 1999. Following a steady decline in the consumer price index in the second and third quarter of 1998, leading to falling prices for the year as a whole, consumer price inflation picked up modestly in late 1998, with 12 month inflation reaching around 5 percent as of end-September 1999.

Weakening tax revenues and lower than expected external financing have contributed to growing fiscal pressures, and starting in late 1998 expenditure arrears began to accumulate. The fiscal deficit reached 5 percent of GDP in 1998 and rose to 6 percent in the first half of 1999. The weakening of tax revenues was due to unexpected shifts in the base for indirect taxes, rising evasion, and lower than anticipated growth and inflation. Revenue collection problems extended to the State Fund for Social Insurance as well, and arrears on pension benefits have mounted.

After a tight monetary policy in the first three quarters of 1998, which contributed to declining inflationary pressures and a stable exchange rate, the Central Bank of Armenia (CBA) responded to the Russian crisis with a sharp expansion of credit in the fourth quarter. This change in the stance of policy fueled pressures on the foreign exchange market. Despite sizable net sales of foreign exchange by the CBA, the exchange rate of the dram relative to the U.S. dollar depreciated 3 percent in the fourth quarter of 1998, and an additional 7 percent in January 1999. Following a renewed tightening of credit policies since February, however, the exchange rate remained broadly unchanged through mid-September 1999.

Armenia's external trade and current account deficits were narrowing until the Russian crisis led to a sharp decline in exports. Exports in the last quarter of 1998 were almost one third lower than in the same period of 1997, and the current account deficit widened to 27 percent of GDP for 1998 as a whole. In the first half of 1999, a resurgence in net exports, together with a modest recovery in private transfers, resulted in a narrowing of the deficit to less than 20 percent of GDP. Foreign direct investment, mostly associated with privatization operations, continues to be the main source of financing, followed by trade credits and official multilateral sources. Efforts to improve the external debt profile continue. Following a debt restructuring agreement with the European Union and the renegotiation of an energy loan from Russia, Armenia's total external debt declined from 50 percent of GDP at end-1997 to about 44 percent of GDP. Since a large proportion of Armenia's external debt is on concessional terms, the net present value stood at about 29 percent of GDP at end-1998.

The unsettled economic environment that ensued at the outset of the Russian crisis also affected developments in the structural area in 1998. International sales of state owned enterprises slowed down, banks' loan portfolios suffered a temporary deterioration (which was not large enough to jeopardize the banking system), and poor cash collection of electricity bills more than offset the gains in efficiency in the energy sector and affected the implementation of the financial rehabilitation strategy for the sector.

By mid-1999 it has become clear that the authorities' policy response to the events that followed the Russian crisis had run its course and some corrective policies were needed to return to the path of stability and growth. To this end, the authorities have adopted a package of corrective measures: an amended budget for 1999, which allows for the full clearance of expenditure arrears and makes transparent sizable quasi-fiscal operations of the energy sector; a tight monetary program whose implementation will be guided by adherence to a reserve money corridor; and enhanced coordination between budget execution and liquidity management. More fundamentally, Armenia remains committed to letting interest and exchange rates be determined by market forces. On the structural front, the authorities are committed to give a renewed impetus to privatization, to further strengthen and strictly enforce the prudential regulatory framework for banks, and to take steps to enhance governance and financial discipline of the energy sector while proceeding with the privatization of the electricity distribution companies. They also intend to maintain a trade and exchange system free of restrictions and will seek to conclude negotiations on accession to the World Trade Organization in 1999.

Executive Board Assessment

Directors noted Armenia's resilience to severe external shocks, including a stronger than anticipated impact of the Russian crisis and a drought, as well as the political uncertainty that prevailed in the run up to the parliamentary elections. There was concern, however, about the policy setbacks that developed in late 1998 and the first half of 1999, and the loss of momentum in the implementation of structural reforms. At the same time, Directors were encouraged by the authorities' reaffirmation of their commitment to economic reform, and they welcomed the corrective actions taken recently to ensure the attainment of the objectives of the program. They stressed that the success of the authorities' strategy depends both on ensuring a stable macroeconomic environment and proceeding with the next stage of structural, legal, and institutional reforms.

Directors commended the decision of the new government to undertake strong corrective fiscal measures. While welcoming the steps to reverse the weakening of revenues, they cautioned against reliance on advance or negotiated tax payments, and called on the authorities to address forcefully the issue of tax arrears. Directors noted the progress to date in clearing expenditure arrears, but regretted that the authorities had not yet been able to clear all arrears, particularly on pension benefits. They urged the authorities to take steps to ensure that the remaining arrears are cleared in October, and emphasized the importance of enhancing expenditure control to avoid the emergence of future arrears. Directors encouraged the authorities to finalize their medium-term expenditure framework, and stressed the need to improve information on the activities of local governments and the monitoring of the operations of the State Fund for Social Security.

Directors welcomed the authorities' pursuit of a tight credit policy and the commitment to strengthening monetary control, but noted with concern the recent deviations of reserve money from indicative targets. Directors stressed the need to further improve the coordination of monetary and fiscal policies.

Directors welcomed the authorities' decision to rely more on market forces to determine exchange and interest rates, and cautioned the authorities against imposing administrative controls of interest rates, as such action would risk suppressing an important signal of macroeconomic imbalances.

Directors noted the deterioration in key prudential indicators of the banking system and expressed concern about the recent cases of forbearance of prudential regulations. They viewed as crucial the authorities' commitment to prevent such cases in the future and to strengthen regulatory enforcement. Directors encouraged the authorities to adopt the new loan-loss provisioning requirements and to strengthen their efforts to improve off-site supervision.

Directors welcomed the progress in reducing the burden of external debt and debt- service and the authorities' cautious approach to external borrowing, while stressing the importance of developing a comprehensive external debt strategy for the medium term. Directors encouraged the authorities to use privatization proceeds to improve the debt-service profile of the country. Directors commended the authorities' commitment to maintaining a liberal trade regime and exchange system.

Directors welcomed the efforts to restore the momentum of privatization. They underscored the need to ensure the transparency of the process. Directors also commended the authorities for the progress made in setting up a financial monitoring scheme for publicly owned enterprises.

Directors expressed concern about the setbacks in the implementation of the financial rehabilitation plan for the energy sector. They emphasized the importance of enforcing cash payments for energy consumption, timely payments of the sector's expenditures, and market-based resolution of overdue domestic debts. Directors considered the authorities' decision to address the quasi-fiscal problems of the sector through the budget in 1999 as a positive development. Directors welcomed the authorities' commitment to privatize the power distribution companies in 2000.

Directors welcomed the progress achieved in improving the production and dissemination of economic and financial information, and the authorities' intention to meet the requirement of the GDDS.