Armenia: Concluding Statement of the IMF Mission
June 20, 2008
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
An IMF staff team visited Yerevan during June 11-17, 2008, to review recent economic developments and discuss macroeconomic policies and structural reform priorities for the remainder of 2008 and the medium term. The team met with the newly-appointed government, Central Bank of Armenia (CBA) staff, parliamentarians, and representatives from the business and international donor communities. The discussions pave the ground for negotiations of a new IMF-supported program during the 2008 Article IV consultations in September.
The team was pleased with the new government's strong impetus for reform. The emphasis on tax administration/policy reform is particularly encouraging, and should contribute to improving the business environment and promoting broad-based growth. The new government's efforts to improve fiscal analysis and strengthen the fiscal framework are also welcome, as this will make fiscal policy a more effective demand management tool and improve coordination between the monetary and fiscal authorities.
I. Macroeconomic Performance and Outlook
Armenia appears to be set for another year of double-digit real GDP growth. Economic performance in the first five months of 2008 remained robust, and growth during the rest of the year will continue to be driven by the ongoing boom in the construction sector. Risks are mainly on the upside, as agricultural production may well turn out to be better than currently projected, and some investment projects not yet included in the forecast may materialize in 2008.
CPI inflation has risen sharply in recent months, despite a gradual tightening of monetary policy and a moderate fiscal stance. While the surge in inflation to around 10 percent was mainly due to higher food import prices, non-food inflation has picked up as well, amid high international oil prices and strong domestic demand. End-year CPI inflation is expected to be close to 7 percent, exceeding the announced inflation target (4 ±1.5 percent), but still lower than in neighboring countries.
Fiscal developments have been positive, creating space for fiscal tightening. Tax revenues gained strength, driven by strong VAT performance. Based on the assumption that higher-than-expected tax revenues will be saved, the fiscal deficit is projected to be around 1.2 percent of GDP, significantly lower than budgeted (2.6 percent of GDP). This will limit the fiscal impulse and help contain real exchange rate appreciation.
The trade deficit widened further in the first four months of 2008 on the heels of surging imports. Although private transfer inflows are expected to grow at a robust pace, the external current account deficit is projected to widen to around 8.6 percent in 2008. With appreciation pressures diminished by rising import demand, the dram/dollar exchange rate has remained broadly stable since December 2007.
II. Policy Discussions
Discussions focused on key policy challenges relevant for the upcoming program negotiations: (i) controlling inflation in the face of supply shocks and rising demand pressures; (ii) the urgent need to tackle the unfinished tax policy and administration reform agenda; (iii) the effectiveness of foreign exchange intervention by the CBA; and (iv) the increased vulnerability to medium-term fiscal risks.
Controlling inflation in the face of supply shocks and rising demand pressures
Given the magnitude of potential supply shocks and growing inflationary pressures from the demand side, further monetary and fiscal tightening will be needed. Rising energy and food import prices, recent and planned pension and wage increases, and rapid credit growth will likely keep inflationary pressures high, worsen the terms of trade, and widen the current account deficit. Against this background, the challenge for monetary policy is to limit the second-round effects of higher food and energy prices, and thus contain inflationary expectations. This is no easy task, given the weak monetary transmission mechanism, calling for supportive fiscal policy and efforts to enhance domestic competition.
In the current economic environment, fiscal policy will play a key role in containing inflationary pressures while sustaining long-term growth. After an initial phase of significant adjustment (until 2002), fiscal policy has become moderately pro-cyclical in recent years. The more challenging international economic environment, together with the persistence of double-digit domestic growth and a widening current account deficit call for a counter-cyclical fiscal stance. To create fiscal space for dealing with medium-term risks, it will be important to save any revenue over performance in 2008, as well as to better prioritize competing expenditure projects. Dampening inflationary pressures through expenditure restraint will help sustain real increases in pensioners' income over the medium-term, as well as free up funds for targeted temporary assistance to those vulnerable groups who are disproportionably affected by higher food prices.
Finally, discontinuing monopolistic practices in the import sector would allow consumers to benefit from potential further dram appreciation in the form of lower import prices. Our estimates indicate a significantly lower pass-through for exchange rate appreciation (10 percent) than for depreciation (31 percent), supporting the anecdotal evidence of limited competition between importers.
The unfinished tax policy and administration reform agenda
There is broad consensus on the need to complete the tax reform agenda. Despite a notable improvement in 2007, the tax-to-GDP ratio in Armenia is still lower than in most transition countries, and well below potential. The momentum for reform has gathered pace since the new government took office, with priority given to a number of key tax policy and administration initiatives. To address tax policy deficiencies, steps are underway to introduce a VAT threshold and provide small businesses (those below the VAT threshold) with simpler procedures to assess and pay their taxes. To address tax administration weaknesses, the State Tax Service (STS) has developed a comprehensive plan to modernize tax administration, in line with previous advice from the IMF and other donors. We fully support the immediate priorities reflected in the plan, including restructuring the STS organization, addressing corruption, strengthening large taxpayer administration, and enhancing taxpayer services, particularly for small businesses. Adding to these initiatives, we would also encourage the authorities to take early steps to introduce risk-based VAT refund processing. This will improve exporters' competitiveness.
The government's ambitious tax reform agenda is encouraging, but it requires firm political commitment to be successful, including appropriate funding for the STS reform program. It also requires simultaneous efforts to reshape the tax policy framework to ensure a level playing field for businesses. Privileged tax regimes (such as the introduction of new tax holidays and the current presumptive taxes for fuel and tobacco) are inconsistent with this aim, and risk undermining the reform effort.
Effectiveness of foreign exchange intervention
As in other countries, controlling inflation in the face of appreciation pressures has become a policy challenge. While the authorities remain committed to a flexible exchange rate regime, significant dram appreciation between 2003 and 2007 has raised concerns about external competitiveness, and the CBA has increasingly engaged in foreign exchange interventions. International experience has shown that intervention is likely to be ineffective when there is a conflict between exchange rate and inflation objectives. While acknowledging that a significant part of interventions were conducted to accommodate dedollarization, this may have been the case in Armenia in 2006 and 2007. As the extent of cash dedollarization is inherently difficult to quantify, large-scale unsterilized foreign exchange purchases may have contributed to inflationary pressures. Foreign exchange sales in 2008 so far have been more in line with the tightening of monetary policy needed to curb inflation.
Preliminary empirical evidence suggests that CBA foreign exchange market intervention has had only a limited impact on the level of the exchange rate. While this is in line with the stated CBA objective of maintaining a flexible exchange rate, foreign exchange market interventions also seem not to have significantly reduced exchange rate volatility. It may well be, however, that interventions have contributed to reducing intraday exchange rate volatility, thereby allowing the dram to appreciate in an orderly manner.
Increased vulnerability to fiscal risks
We support the plans to modernize Armenia's pension system, and recognize that raising the replacement ratio will necessarily entail fiscal costs. However, all costs involved should be realistically estimated and weighed against competing priorities by including them in the medium-term expenditure framework and budget discussions. Finally, since investment in new systems and procedures will be required, adequate time needs to be given for effective planning and implementation before the new pension system can be in place.
Additional macro-fiscal risks are associated with the conversion of budgetary institutions (particularly schools) into noncommercial organizations (NCOs) outside the treasury system. While the authorities' efforts to address these risks are welcome, further measures and resources for the NCO unit will be needed for the implementation of effective reporting and control systems.
III. Toward a New IMF-Supported Program
The IMF team will negotiate terms of a new IMF-supported program with the government in September 2008. The focus of the prospective program should be on strengthening the fiscal and monetary policy frameworks, while deepening productivity-enhancing structural reforms, notably by making tax administration and tax policy more fair and transparent,, increasing domestic competition, and diversifying the economy. An up-to-date Poverty Reduction Strategy Paper is required before a new PRGF arrangement can be considered by the IMF Executive Board.
In terms of program design, the measurement of the fiscal stance and the monetary policy targets may need to be modified compared to previous programs:
• The increasing importance of macro-fiscal controls in overall economic management requires a better measure of the fiscal stance. Such a measure should capture the impact of fiscal actions on relevant policy variables (growth, inflation, debt sustainability, etc.) more accurately than the overall balance of the central government.
• The adoption of inflation targeting (IT) by the CBA calls for a modified approach to monetary conditionality, as monetary targets are not compatible with the IT strategy. IMF-supported programs in IT countries have aimed at complementing traditional monetary conditionality with a "reviews-based" approach, including a periodic assessment of monetary policy in the context of the IT framework, and an agreement on a defined set of indicators on which reviews are primarily based. This approach would require at least broad agreement between IMF staff and the CBA on the appropriate monetary policy reaction to a range of possible eventualities.
In case a new program will not be agreed upon soon, Armenia would be expected to engage in Post Program Monitoring (PPM) with the IMF, as long as its outstanding credit exceeds 100 percent of quota. PPM would entail frequent consultations with IMF staff, with a particular focus on macroeconomic and structural policies that have a bearing on external liability, including a quantified macroeconomic framework. There are normally two Board discussions in a twelve-month period.