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The Economic Transition in Armenia

John Odling-Smee
Director, European II Department
International Monetary Fund
Speech given at the American University of Armenia
Yerevan, July 31, 2001

1. I would first like to thank the American University of Armenia for providing this opportunity to speak here about the economic transition in Armenia from a centrally planned to a market economy.

2. In sharing my thoughts with you, as the Director of the Department in the IMF which has direct responsibility for our relations with Armenia and the other countries of the former Soviet Union, I would like to focus on two broad issues. First, I will discuss economic developments in Armenia since independence ten years ago, setting them in the context of the overall changes in the region after the dissolution of the Soviet Union in 1991. Second, I want to discuss the challenges for the future, especially how to place the economy on a path of sustained economic growth and poverty reduction. Here I will pay special attention to the problem of governance. Finally, I will say a few words about relations between the IMF and Armenia.

I. Economic Developments in Armenia Since 1991

3. Many of the economic consequences of achieving independence and taking the decision to reorient Armenia in the direction of a market economy have yielded tangible and significant benefits. The liberalization of prices eliminated the queues and the forced saving that had become endemic in the closing years of the old system. The liberalization of economic activities more generally meant that ordinary people - and not just those with special connections - were no longer denied access to the goods and services they really wanted.

4. However, we all know that the early years of transition were not an unmixed blessing for the Armenian people. As elsewhere in the region, output collapsed and inflation soared. Armenia actually suffered three major shocks during this early period of the transition. First, the old central planning system fell apart, and many Armenian enterprises -some very large- which had been established to serve most or all of the entire Soviet Union, almost overnight lost their markets. Second, as an energy importer, Armenia was hit by a sharp deterioration in its terms of trade as the price of energy it imported rose sharply relative to the prices of its exports. Third, the war over Nagorno-Karabakh represented a major drain on the economy and was accompanied by blockades and other disruptions to trade, some of which persist to this day. As a result, by 1993, GDP in Armenia had declined to only 47 percent of its level in 1990, although the measure of output in late-Soviet times overstates the low level of economic welfare because of price distortions, frequent long queues, and other factors.

5. With the exception of neighboring Georgia, where as the result of civil war GDP had fallen in 1994-95 by an even greater percentage, the output collapse in Armenia was the worst in the entire region. This of course meant an increase in unemployment, sizable outward migration, and a sharp increase in poverty among those remaining in the country. The proportion of the Armenian population living under the poverty line increased from around 20 percent in 1988 to around 55 percent by 1996. Income inequality is also generally considered to have sharply increased.

6. By the middle part of the 1990s, through the close cooperation of the government and the Central Bank of Armenia (CBA) in implementing strong monetary and fiscal policies, hyperinflation in Armenia had been tamed. Average consumer price inflation was brought down from over 5,000 percent in 1994 to 175 percent in 1995. Indeed, Armenia was one of the true success stories of the region.

7. From 1996 to 1999, Armenia succeeded in fundamentally stabilizing prices (average inflation fell from 175 percent in 1995 to less than 1 percent in 1999), and the economy grew on average by around 5 percent a year. Nevertheless, structural and institutional reforms lagged in some important areas, and the inability to generate rapid export growth meant that Armenia continued to run large current account deficits and built up a very sizable amount of external debt.

8. Armenia was of course hit by the fallout from the Russian crisis of August 1998. The crisis led to a pronounced decline in Russian demand for many neighboring countries' exports, and the contractionary effect of this caused trade among these countries also to suffer. The temporary collapse of the payments system in Russia in August and September 1998 also affected trade and payments, and there were some contagion effects in neighboring countries' financial systems as well. Finally, Armenia and other countries that are heavily dependent on workers' remittances from Russia were also affected as Russian GDP fell by around 5 percent in 1998.

9. But while GDP in Russia declined absolutely in 1998, the weighted average rate of economic growth in the other 11 CIS states as a whole remained broadly unchanged in 1998, and GDP growth actually accelerated in Armenia, to over 7 percent. In 1999, when GDP growth resumed in Russia, average growth increased a bit in the other CIS states. Average inflation also rose in most of these countries, however, in part due to currency depreciations in response to the balance of payments pressures following the Russian crisis. In Armenia, the continued sound monetary policy of the CBA helped to keep inflation at a negligible level, but economic growth in Armenia also slowed to around 3% in 1999 from 7% in 1998. In addition, there was a collapse in budgetary revenues and in key external financing for the budget as important structural reforms were delayed. As a result, budgetary expenditure arrears, which had been reduced to well below 1 percent of GDP by the third quarter of 1999, rose precipitously to around 5 percent of GDP by end-September 2000. The main reason for the slowdown and budgetary difficulties in 1999 and early 2000 was the political uncertainty, especially following the tragic event in the parliament in October 1999. The uncertainty also contributed to weaker economic reforms.

10. With the restoration of political stability since mid-2000, economic stability has also gradually been regained, and the government has proceeded with a new momentum on its reform agenda. In March of this year it launched its Poverty Reduction Strategy in consultation with local non-governmental organizations (NGOs), the IMF, the World Bank and members of the international donor community. With improving tax collections and increased expenditure control, the government has been able to reduce its budgetary expenditure arrears to around 3 percent of GDP, and more progress is expected in this area in the coming months. This improved fiscal performance, together with continued efforts by the CBA to ensure price stability and renewed reform momentum, enabled the IMF Executive Board to approve on May 23 a new three-year loan to Armenia under the Poverty Reduction and Growth Facility.

11. What can we learn from Armenia's experience during 10 years of independence, and from that of other countries in transition? I would suggest the following broad conclusions. First, the collapse in output and the resulting increase in poverty is not the result of the economic reforms themselves. Part of the decline in output was the inevitable outcome of the transition, as has been shown in virtually all the 25 transition countries. A particularly difficult aspect of this was the major increase in the price of imported energy. An additional factor in Armenia's case was the direct and indirect cost of the Nagorno-Karabakh conflict. Second, the recovery in living standards and production levels will be a long process. GDP in Armenia grew at an average annual rate of 5.5% over the seven-year period from 1993 to 2000, which is fairly high by international standards. Yet the level of GDP in 2000 was still only two-thirds of its 1990 level, which - by the laws of arithmetic - would not be reached until towards the end of this decade at a continuation of the growth rate of the last seven years. Third, judging by the experience of the last six or seven years, and that of other transition countries, most of the growth will come from new enterprises and restructured old enterprises operating in a market economy. Simply going back to the old system or trying to resuscitate the old, huge, insolvent enterprises that once served the entire Soviet economy, just won't work. The advantages of a market economy, if the right institutions are firmly in place, are too clear to give up. And in an ever-changing world economy, only slimmed down and fundamentally restructured enterprises have any chance of successfully competing with foreign firms or those in the new private sector. Fourth, growth since the mid-1990's has not been broad-based enough to provide growing employment opportunities. Moreover, governance problems and corruption have caused the fruits of this growth to be concentrated in the hands of a relatively small segment of the population.

II. CHALLENGES FOR THE FUTURE: Good Governance

12. The main challenge is to put the economy onto a higher sustainable growth path, so as to reduce poverty and unemployment and slow down emigration. This in turn requires the growth of private economic activity, based primarily on new investments. In other words, everything possible must be done to create a healthy environment for private business, especially new business entities. This is best seen as an incremental process, but unless big steps in terms of promoting a stable and friendly environment for business are taken now, increases in private domestic and foreign direct investment, a broadening of the narrow export base, sustained economic growth, the creation of new jobs, and a serious reduction in poverty are simply not going to happen anytime soon.

13. While improving the environment for private business is probably the single most important thing the authorities can do to improve Armenia's competitiveness and its prospects for sustained growth and poverty reduction, we should not overlook the importance of also fostering improved regional economic relations. The benefits from this should be obvious to everyone. Indeed, some observers are surprised that Armenia has done as well economically as it has since independence, given its difficult trade and other economic links with its neighbors. At the recent Consultative Group meeting in Paris of the government of Armenia with international organizations and various donor countries, several donors were quite emphatic about how important it was to achieve a lasting settlement of the Nagorno-Karabakh problem. They also said that a higher level of donor support for Armenia could be expected with such a settlement. That private investors - both domestic and foreign - would be more interested in investing in an Armenia at peace with all its neighbors goes without saying.

14. The Government's Poverty Reduction Strategy rightly emphasizes the central importance of economic reforms that will improve the climate for business and investment, especially the protection of property rights and strengthening the rule of law. It also includes the continuation of privatization in a transparent manner, the promotion of competition, and the reform of the financial sector. These are all critically important reforms for the development of a healthy market economy. Most important of all, the Poverty Reduction Strategy focuses on the creation of an efficient governance system. Indeed the public administration and anti-corruption program is one of the three pillars of the whole Poverty Reduction Strategy, along with the achievement of sustainable and equitable economic growth and the human development program. Improved governance and reduced corruption are not only essential to encourage more investment and growth, but they will also produce a more equitable income distribution and reduced poverty for any given level of aggregate GDP. I would like to look in more detail at this critical issue of "governance" reforms.

15. What I have in mind by "governance" is the manner in which the government discharges its responsibilities. That is, are its operations fully transparent? Is the government held accountable for its actions (or inaction)? Does it limit its scope and operations to what is really essential to providing a supportive environment for private economic activities? Whatever the scope of its operations, does it manage these operations well? If the answers to some of these questions are "no", as in Armenia, then one should conclude that there are serious governance problems and that corruption probably is prevalent, if not rampant. Although governance problems are widespread in Armenia, I will concentrate here on a few areas that are of particular interest to the IMF.

16. First, while the improvement over the past twelve months in tax collections is welcome news, much more needs to be done. Armenia cannot go on forever relying so heavily on budgetary financing from external sources. If it is going to be able to afford the size of government it now has, it will simply have to collect the taxes to support those expenditures. Reforms in tax administration are already under way, but they need to be expanded and accelerated. The government needs to make it absolutely clear that it is not only morally wrong to knowingly understate or to fail to honor one's tax liability, but that it is illegal and it will be punished, without favoritism. Moreover, tax liabilities must be calculated according to the law, and not negotiated between the government and taxpayers. Such negotiations typically lead to a loss of revenues, as well as involving corruption. At the same time, the government needs to take further steps to make the tax system fair to all, by broadening the tax base and reducing the incentive to evade taxes. Toleration of an unfair tax system, full of exemptions and negotiated settlements, has a major corrosive influence on the moral authority of the government, and discourages the development of a competitive and broad-based private sector.

17. Second, much more can be done to strengthen and make more transparent the process by which expenditure priorities are decided. Hard choices will have to be made, and should be approached in an environment of openness and competition of ideas. Moreover, once the annual budget is approved, better controls are needed over the making of expenditure commitments (in the light of evolving revenue and financing developments) to ensure that there are no new expenditure arrears. Again, it is difficult to think of anything more corrosive to the moral authority of the government than for it not to pay its own bills. Finally, it is important that adequate auditing procedures be in place, to ensure that those expenditures that are made are the ones really intended, and that real "value" was obtained for these expenditures.

18. Third, given the need to improve the quality of public administration and reduce corruption, the civil service reform law and the recently adopted financial disclosure law for government officials are very important. These measures, partly aimed at fostering increased trust in government, will be important in giving potential investors more confidence in Armenia.

19. Fourth, there is a need to push ahead as rapidly as possible with the elimination of unnecessary regulations and harassment of small private businesses, and to implement other concrete measures designed to reduce the role of the government in economic life and the opportunities for corruption, and more generally improve the business environment. At the same time, and with a view to achieving better functioning business and banking sectors, it will be important to move expeditiously with judicial reform.

20. Finally, there needs to be better management of the assets that belong to the government itself. An area of particular importance to Armenia is the energy sector, which is a major cause of non-payments in the economy and a constant source of the buildup of external debt to energy suppliers. We frequently refer to this as a quasi-fiscal deficit problem, since the government tolerates these continued losses and yet does not show them explicitly in the budget.

21. In most cases, significantly better management will probably only be ensured by the privatization of these assets. Since the government and the parliament some time ago took the fundamental decision to privatize Armenia's electricity distribution companies, and in a fully transparent way, it will now be important to complete the privatization process as quickly and transparently as possible. This will help rid Armenia of a huge financial drain -through waste and theft - and also provide an important signal to the world that Armenia is seriously interested in attracting foreign direct investment. Where sales of state enterprises are linked to the reduction in the government's external indebtedness, steps should be taken to ensure that the best price is obtained for the enterprises. This objective as well as the objective of good governance both point to the superiority of open, competitive bidding over non- transparent negotiations.

22. This brief review of some of the problems in the governance area indicates that there is a need to move forward in many directions at once. If there is a single unifying theme, it is that business interests are able to influence economic policy-making and the administration of the country. This development often goes hand-in-hand with growing corruption. Few of the major institutions of the state - whether the government, the Parliament, or the judicial system - are presently immune from excessive pressures from vested interests. Experience around the world shows that a dynamic, competitive market economy cannot be built in this way. Growth is stifled if vested interests are able to prevent free competition and level playing fields. Moreover, the government's ability to finance the social system and improve the position of the poorest in society is seriously compromised if it cannot collect the revenues due to it. Armenia must find a way to improve governance in the ways I have mentioned and to ensure that the government serves the interests of all, not just the few, if the good growth rates of recent years are to be sustained and exceeded, and poverty in the country reduced.

III Relations between Armenia and the IMF

23. The IMF has been working closely with Armenia since Armenia became a member nine years ago. The first IMF loan to Armenia was made in 1994 and total lending has now reached about $210m or 20% of the authorities' total external debt. Most of this lending has been under our Poverty Reduction and Growth Facility (PRGF), which used to be called the Enhanced Structural Adjustment Facility (ESAF). This is available only to low income member countries and interest is paid at a low, subsidized rate. The IMF can only lend if it is satisfied that Armenia is pursuing economic policies that will improve the economic situation and ensure that Armenia will be able to repay us on time. This is why we spend so much time discussing economic policies with the government and the Central Bank.

24. Under the PRGF, we wish to see Armenia following policies that will lead to improved growth and the reduction of poverty. The experience of other transition economies shows that macroeconomic stability and structural reforms to create a competitive market economy are essential prerequisites for this. It also shows that reforms succeed only if there is support for them in the country. This is why we need evidence that the government's own poverty reduction strategy is widely supported in Armenia if we are to continue to make disbursements under the PRGF. To mobilize such support requires a broad public debate about economic reforms. The IMF is happy to contribute to these debates and I hope that my speaking to you today will be seen in this light.

25. The IMF's Executive Board approved a new three year loan under the PRGF in May 2001. The loan was made in support of the government's poverty reduction strategy, which we think addresses the key problems of today. We now have a mission in Yerevan assessing the progress during the first few months of the PRGF. We will continue to work closely with Armenia during the rest of the three-year period and beyond. I hope that the poverty reduction strategy will be fully implemented, because, if it is, the economic situation in Armenia will improve significantly. Certainly, the IMF intends to work with Armenia to do all it can to bring about a successful transition, sustained economic growth and the reduction of poverty.


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