Transcript of an IMF Book Forum -- Growth and Poverty Reduction in Armenia
January 13, 2006Friday, January 13, 2006
International Monetary Fund
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Mohsin S. Khan, Director, Middle East and Central Asia Department, IMF
Enrique Gelbard, Deputy Division Chief and former Mission Chief to Armenia, IMF
Johannes Linn, Executive Director, Wolfensohn Initiative, The Brookings Institution
Saumya Mitra, Lead Economist, Europe and Central Asia Region, The World Bank
MR. KHAN: Good afternoon. I think we can get started now. Let me start by welcoming you to this Book Forum on Armenia. This event provides a good opportunity to discuss a number of interesting issues regarding Armenia's economic performance and the challenges that lie ahead. Let me also mention that this weekend there is a conference on Armenia organized by the Armenia International Policy Research Group, being held at the World Bank.
In my introduction, I want to touch on some of the main issues raised by the book. I will then give the floor to the three panelists for their interventions and we will end up with some time for an open discussion.
The book assesses the country's economic transformation in the last decade, focusing on the recent period of economic stability, strong economic growth, and poverty reduction, and on the remaining challenges. Market-based economic reforms were initiated between 1994 and 1998, with critical fiscal consolidation and selected structural reforms undertaken between 2001 and 2004. In addition, the implementation of a poverty reduction strategy since 2002 has complemented the effect of economic growth on reducing poverty.
The first decade of transition was certainly difficult for Armenia. A severe earthquake, the breakup of the Soviet Union, and disputes with neighbors led to a drastic decline in standards of living, high unemployment, triple-digit inflation, and large-scale emigration.
As the 1990s ended, a number of remaining imbalances continued to constrain economic performance and over 50 percent of the population still lived in poverty. The fiscal position was weak and hampered by the accumulation of internal and external payments' arrears and large deficits in state-owned energy and water companies. These state-owned utilities were plagued by corruption and mismanagement which generated tax and payments' arrears and contributed to a build-up of public debt. Furthermore, the banking sector entered into a difficult period that saw the collapse of about one-third of the commercial banks.
A new wave of reforms to tackle these problems began in 2001. 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 reforms consolidated macroeconomic stability, improved confidence, and enabled a virtuous cycle of higher investment, foreign financing, donor assistance, and high economic growth. Exports boomed alongside a marked improvement in real GDP and reductions in poverty and inequality. In addition, governance improved as reflected by Armenia's international standing in various ratings by the World Bank, Transparency International, and the Heritage Foundation. The main lagging areas were tax and customs administration, where spotty progress slowed the growth of tax revenues.
This recount of developments brings us to the present, when despite the progress made, income per capita in Armenia is about US$1,000 per year. And while economic growth remained robust in 2005, the sustainability of such growth over the long-run is not assured. In fact, the experience of other countries show that while jumpstarting an economy after adverse shocks is feasible, it is much more difficult to sustain high economic growth over periods of five years or more. Also, going by the most recent index of economic freedom compiled by the Heritage Foundation, Armenia ranked 27th, even surpassing developed countries like France, Norway, and Spain.
So what can Armenia do to maximize its chances of success? In addition to the importance of maintaining macroeconomic stability, the book argues that Armenia's fiscal framework and the banking system have to play a more prominent role than in the past in supporting private sector development and channeling resources to their best possible use. In addition, the proper functioning of key economic institutions can support long-run growth by lowering transaction costs and increasing rates of return on investment. Armenia has indeed made substantial progress in setting up these institutions, but some are not yet functioning well and the reform agenda remains to be completed.
Beyond the proper implementation of fiscal and banking sector reforms, the book explores the extent to which Armenia's economic potential is constrained by closed borders. While the precise effect is difficult to quantify, simulation techniques suggest that regional integration through a removal of artificial trade barriers could increase trade by about one-third. This highlights the importance of resolving outstanding disagreements with both Turkey and Azerbaijan.
Let me just conclude with a broader reflection on today's discussion. While our understanding of the set of policies and conditions behind sustained economic growth in low-income countries and the complex linkages between growth and poverty reduction is still incomplete, we know that such growth does not take place in an environment of macroeconomic instability, low investment, financial underdevelopment, distorting trade barriers, or weak economic institutions. We also know that country experiences reveal substantial differences in initial conditions, constraints, and institutions, and that much of the work in designing economic policies must take into account these country-specific characteristics. The discussion today can also be an opportunity to look at the extent to which Armenia fits these views and to reflect more broadly on what Armenia's development strategy can teach us about transition.
Let me just briefly turn to introduce the panelists that we have here today. We have on my immediate left Enrique Gelbard who is the Deputy Division Chief at the Middle Eastern and Central Asia Department. Mr. Gelbard has led until last year the missions to Armenia. He coordinated the production of the book and is one of the principal authors. On my right is Johannes Linn who is the Wolfensohn Initiative Executive Director, Global Economy and Development Center at the Brookings Institution. Johannes is currently working on the transition experience in Central and Southeastern Europe and the former Soviet Union. To my left is Samoa Mitra who is currently lead economist in the Europe and Central Asia Region at the World Bank. He heads the Bank's missions to Armenia and has previously led missions to countries in the Balkans and in Latin America.
With that introduction, let me floor over to Enrique, please.
MR. GELBARD: Thank you Mohsin. Let me begin by explaining the motivation for the paper. As the Fund has been involved with Armenia since 1994 through technical assistance and financial support, it was important for us to take stock of what the country has achieved and what remains to be done. At the same time, the case of Armenia is interesting because of its exceptionally strong economic performance despite a lack of natural resources and regional isolation.
In my intervention, I will comment on the assessment of the reforms undertaken, and summarize the main lessons and challenges ahead as they are presented in the book.
As Mr. Khan mentioned in his introduction, Armenia has come a long way from a state-run economy in the mid-1990s to a prosperous market economy today. In the paper, we begin with an analysis of the policies in the mid-1990s and then focus on the factors behind the more recent period of double-digit economic growth. In this regard, we look at the constraints identified in 2001 and examine the importance of implementing new tax legislation, moving to prudent budgets, repaying a large stock of domestic and external payments' arrears, eradicating financial imbalances from state-owned energy and water companies, cleaning up the banking system, and removing impediments to private sector investment.
We look at tax reforms between 2001 and 2003 that helped to improve the business environment and transparency. The reforms included changes to the simplified tax, lower corporate and income tax rates, the removal of some tax exemptions, and dissemination of laws and regulations.
Similarly, prudent budgets and the repayment of arrears since 2001 aimed at restoring confidence in fiscal management. Government budgets cut nonpriority expenditures and carried out sensible increases in subsidies and public sector wages. In addition, in conjunction with the preparation of the PRSP in 2002, the authorities began integrating the policies envisaged in that strategy into the budget process and increased expenditures in public infrastructures and in the social sectors. Lastly, a two-year arrears repayment plan cleared all outstanding domestic and external government obligations by mid-2003. Once the plan was completed, interest rates and government debt service fell.
Another source of economic instability was the energy sector, which was troubled by corruption and inefficiencies that threatened fiscal sustainability and contaminated the whole economy. A fundamental shift in ownership and corporate governance was needed to address these deficits, and the authorities moved to restructure the sector, introduce new audit and cash management systems, and privatize key companies.
Financial mismanagement in the energy sector also exacerbated problems in an already vulnerable banking system. The central bank intervened and subsequently closed or rehabilitated eight problem banks, and began to break the link between banks and energy companies. It introduced a new bankruptcy law and stronger provisioning requirements that encouraged banks to reduce their exposure to the energy sector and risky borrowers. It also improved banking supervision which helped to begin dealing with problems of connected lending and fraud.
Lastly, actions such as simplifying the licensing of companies, streamlining property registration procedures, sharing credit information, shortening the time for enforcing court judgments in the settling of economic disputes, and introducing a new criminal code were essential to improve the business environment.
At the end of this process, several surveys revealed improved confidence in fiscal management and in the economy. The review of transition indicators compiled by the European Bank for Reconstruction and Development showed that by end-2004 Armenia topped the CIS states in nearly all areas of structural reforms. The only lagging areas were tax and customs administration. Similar results are seen in the survey of governance indicators compiled by the World Bank's and in the Heritage Foundation index of economic freedoms.
Economic indicators also showed impressive results. Between 2001 and 2005, the deficit of the general government was cut down from 6 percent of GDP to 2 percent, the deficit of the energy and water sectors fell from 4.4 percent of GDP to near balance, the external debt to exports ratio fell from 132 percent to 60 percent, the investment to GDP ratio rose from 20 percent to an average of 23 percent, economic growth averaged 11 percent per year, inflation 3 percent per year, and quite importantly, poverty and inequality fell by about one-third.
So what are the lessons from this process? What seem to be the factors behind Armenia's successful experience so far?
First, the policy package. Focus on a relatively well-sequenced set of reforms and on the right mix of policies to stabilize and deregulate the economy appeared to have paid off well. For instance, the sequencing of reforms in the mid-1990s through price, trade, and foreign exchange liberalization followed by a steady privatization process were essential to change relative prices and incentives and set the stage for the subsequent period of economic transformation. Similarly, the policy package adopted in 2001-02 was based on a careful diagnosis of the problems at the time and set the stage for the high-growth period that followed.
Second, commitment to reforms. Despite occasional slippages, there was a strong commitment by the authorities to the reform process. Similarly, despite political problems in 1999 and 2000, the government recognized that macroeconomic stability was a precondition for success and moved decisively afterwards to eliminate fiscal and quasi-fiscal imbalances.
Third, minimal intervention. An important feature of the Armenian experience is minimal government intervention in the economy. This encompasses low and rather uniform profit tax rates and trade taxes, a restricted role for the state as a producer of goods and services, minor non-tariff barriers, and a non-intrusive industrial policy where the government does not pick winners but rather acts to remove bottlenecks and facilitate investments.
Fourth, public investment. At a time of fiscal restraint, investment in the public infrastructure rose. Between 2000 and 2003, total government spending fell from 27 percent of GDP to 22 percent, while capital expenditures rose from 5 percent of GDP to 6 percent. Public investment generated a number of externalities that encouraged private sector growth.
Fifth, the role of the diaspora. The Armenian diaspora has been an important factor in strengthening commercial linkages and complementing domestic investment. Remittances have also become more important in recent years and contributed to higher domestic demand.
Lastly, beyond the provision of financial and technical support, international financial institutions also seem to have played a useful role by strengthening the hand of reformers in the country, which in turn facilitated the implementation of at times difficult policies.
Looking ahead, simulation of growth and poverty indicators show that under a medium-term per capita growth assumption of 5 percent and with an unchanged distribution of income, Armenia can achieve its poverty reduction goal of 20 percent (down from 47 percent in 2001) by 2011. This would happen even sooner if growth is higher or income inequality falls. The other MDG indicators are also within reach.
However, we argue that the sustainability of high rates of growth is not assured and will depend on maintaining economic stability and ensuring the proper functioning of certain institutions, including the judiciary. In addition, growth in the medium-term will depend more on capital accumulation and technical change than on improved resource allocation. As external resources are not likely to contribute to the growth process as much as in the past, financial institutions will also have to play a more prominent role.
Thus one key challenge is to further improve the effectiveness of certain fiscal institutions. Here the prime targets are tax and customs administration. Both agencies could function with greater transparency and accountability, and collections could be based on risk-based methods instead of targets and discretion. In addition, in line with the PRSP, budget allocations should prioritize health, education, water services, and the public infrastructure, especially in areas outside Yerevan. Lastly, we mention the importance of planning ahead and save fiscal resources for the decommissioning of the nuclear power plant and for funding of the the pension system.
A second important challenge is to increase financial intermediation with improvements in corporate governance of banks at the top of the agenda. Bank ownership and borrowers' financial conditions could be made more transparent, and the judiciary could enforce creditor rights and collateral recovery more efficiently. These actions will help lower interest rates and bolster financial intermediation.
A third challenge is to sustain the recent export expansion. Beyond measures to further improve the business environment, a critical development would be the normalization of trade relations with Turkey and Azerbaijan. Our simulations suggest that the effect of opening Armenia's borders could be quite significant.
To wrap up, we make the case that Armenia's success so far owes a lot to a good packaging of reforms adapted to local needs and constraints as well as commitment in implementation. We also contend that going ahead with the remaining reforms and ensuring the proper functioning of key institutions are critical to provide the foundation for sustained growth in the future, and that these actions require a renewed dose of political resolve.
MR. KHAN: Thank you very much, Enrique. I'll turn now to Johannes Linn.
MR. LINN: Thank you very much. It's a great pleasure to be here today. Thank you for the invitation to comment. I have to make somewhat of a disclaimer to start with. I am no longer, if I ever was, an expert on Armenia. I've sort of used this invitation to come here actually as a way to catch up. I retired from the World Bank in 2003 and since then I'm been working more on Central Asia, but actually catching up with Armenia was a very good opportunity because there are obviously interesting relationships between the experience in a South Caucuses country and those in Central Asia.
With that as a disclaimer, let me proceed. I really enjoyed reading the book. I have to say congratulations. It's a readable and very effective summary of the transition over the last 15 years, and particularly the account of reforms that have take place. It's as one would expect from an IMF document, of course, particularly good on the microanalytical side, and I particularly was happy to see a selective but very useful comparison with other countries where that was appropriate and, indeed, is a good example for other reports of this kind to follow.
Finally, I thought there was a good balance between what I would call the glass half-full and the glass half-empty sort of presentation, although I have to say, and this is not a critique, it's maybe a matter of perception, I would have given Armenia and the Armenian policy makers more credit for the glass, whether half, three-quarters, one-third full part of it because, and I'll come back to that as my first substantive point in a minute, the transition process for Armenia was for many reasons particularly difficult, made more difficult than in many of the other CIS countries, and of course the transition process as such was extraordinarily difficult, and I think the fact that Armenia has come through the way it has is an incredible credit to the country, to the people and to the decision makers that were generally engaged in a progressive and remarkably stable way of moving the country forward. So I would just like to posit this and maybe leave it at this, except that as you come to my own summary of the report and it's main findings is that it's a good-but kind of presentation which is useful because the but of course is important for looking forward and where is the remaining agenda.
So it's good restructuring but more to be done, investment in export-driven growth is really quite strong, but we have a low investment ratio and the exports are quite vulnerable, we have a complete energy sector restructuring adjustment, but we have some more decommissioning coming up there. We've got good fiscal adjustment, but the revenue ratio of course is too low, and the public investments are too low. We've got good social progress and recovery, but we have still too high poverty and high unemployment. And finally, the growth prospects are generally good, but they are vulnerable. So this is my personal summary of the report, and actually I have very little disagreement with that.
Where I would perhaps want to spend a few more minutes is to drill down into a couple of areas that I think where I would have liked to see in a way the report to drill down more, but then of course it's not a drilling-down kind of report, but it's an overview, sort of a helicopter analogy, you had to be and wanted to be fairly high up. But let me give you if one had brought the helicopter down where would I have drilled down so to speak, to mix metaphors.
The first I would have liked to see, and frankly this to me is feedback to the IMF and my World Bank colleagues more generally having now spent a few years outside the Bank, I would have liked to see more and more careful analysis of the collapse of the Armenian economy and then of course it's recovery process which is what you focused on a lot looking back. I think the dog that didn't bark in your presentation is the 92 percent figure. I mean the fact that after I don't know how many years of very good growth, we estimate, and they're rough estimates, that in 2004 the Armenian economy is still only 92 percent of the Armenian economy in 1989 is in a way shocking. After all this good performance, after all this good growth over the last few years, we're still only at 92 percent. That I think begs especially for I want to us because obviously I was engaged myself, it begs for an explanation.
Now you have a few sentences on the collapse of the Soviet Union, I would add the Russia crisis obviously had a major impact on the war, the blockade, immigration and so on. I would argue that needs to be much better understood and its impact analyzed perhaps along the lines of Avernesian and Frankman [?] who did I think a very good job, probably the best job that I've seen, and you cite the paper but you don't actually summarize their analysis, disentangling the economic impact on Armenia of the collapse of the disintegration process and then trying to figure out what is the benefit that Armenia reaped, not the cost, but the benefit, from reforms. And they actually point out that the economic impact of the collapse of the Soviet Union was actually much larger than the actual impact measured through the actual trajectory of GDP because in fact policy reform managed to offset and mitigate some of the effects of the disintegration.
I think this is very important to understand where Armenia is today and where it's coming from because it will in fact reinforce the tremendous importance of the benefits of policy reform, the tremendous benefits from peace and integration looking forward because in fact a lot of the loss of GDP was due to the integration and of course the war experience. If you want a counterfactual, I actually think more could have been made of the counterfactual of Albania because Albania did not suffer from the disintegration process, it did not suffer from war, et cetera, and if you look at the per capita income of Albania and compare it where it was in 1989 or 1990, Albania has done much better than all the CIS countries, in fact, much, much better, even though its policy performance as such as not much better, in fact, you could argue it was quite a bit worse.
I would urge us particularly as we look back but partly also as we look forward at these economies to really make an effort to understand better the disintegration and the process of collapse because I think only from a better understanding of that process can you then interpret what happened in the most recent years and why is it that with all the good stuff that these countries have done they are still not really where they should be in the broader sense.
That is one general point I wanted to make. I have a few specific points, I don't want to take too much time, but let me just flag a few areas where I think maybe forward looking, and maybe this is for your Bank colleagues rather than for the IMF, to work on.
I thought the low investment ratio and what can be done about it is an open question still. There are obvious links to the investment climate and governance links to the financial sector and links to regional integration, but which are the levers to actually get to this increased investment performance that you point at as necessary? The high unemployment, 15 to 25 percent, we don't even know exactly what it is, what are the reasons and what can be done about it. You mentioned passing microcredits. That's a bit I would say limp in terms of a response to what is clearly a major problem.
The low tax ratio, I have to say there I thought the analysis was actually to my mind surprising for an IMF document the weakest because you presume that the low tax ratio is a problem. I would argue that's to be proven, it could actually be a good thing. You link it to what's needed of course on the expenditures side and so on, but to base it largely on a comparison with tax ratios in other CIS countries frankly did not convince me very much. I would also say that for the whole discussion of tax administration, a better understanding of the political economy at least pointing in that direction would be very important because I suspect the kind of mutual complaints that you hear when you talk to tax collectors and to businesses are really quite phony and they're all in bed together as we well know. So getting them to complain about each other in a sense is only the merest of the surface.
Finally, I think the democratic challenge probably should be maybe in some different context further explored, and I won't go into the details, but it's obviously a major, major issue for Armenia.
My last point that I wanted to make is on the political economy, coming back to that point. I personally feel reports such as this if they don't at least begin to touch on the political economy, what accounts for the sustained reforms in Armenia compared to stop-go elsewhere, perhaps? Where are the obstacles for further process? Who are the winners and the losers? What needs to be done to get a social compact, maybe to continue with a social compact, for continued policy reform? If you don't begin to at least address this, you really don't have a good answer to whether or not growth is sustainable and which one of the alternative scenarios that you very likely put forward are in fact appropriate?
In conclusion let me just say I think the prospects from my personal perspective in reading this and a few other things recently, Armenia has good prospects and that's very reassuring. It is vulnerable being landlocked in a very difficult neighborhood. My own sense is if I look back at Armenia, the up side is integration, the down side is isolation. That to me is shorthand. If Armenia is allowed to and manages to integrate with its neighbors and the rest of the world as it has started to, being very constrained, I think it has great potential. If it is isolating itself or isolated by its neighbors and the two, frankly, are related, and I think here the question one could, maybe this is not to address this, but how Armenia can contribute to the peace process because without the peace process, the integration process will not happen very likely is to my mind the key question that for Armenians I suspect is perhaps at the core of whether or not the future looks bad or the future is more problematic. Thank you.
MR. KHAN: Thank you very much, Johannes. Now I turn to Samoa Mitra.
MR. MITRA: Thank you, Moshin. I'm delighted to be a member of this panel and I join Johannes in applauding Enrique's book and that of his colleagues.
I think the book provides an insightful account of Armenia's achievements as well as of the tasks that lie ahead if growth with its poverty-fighting orientation is to be maintained. The book also conveys a strong sense of Armenia's economic success and social stability which is notable not only in the context of the CIS countries where it is the best, but it is also comparable to the achievements of the countries that have recently acceded to the European Union such as the Baltics, Hungary and Poland. Therefore, in its record of steady growth and low inflation, Armenia ranks amongst the best performers in Europe and Asia Minor. And its record of structural reforms, while it's not quite as strong as those in the new E.U. countries, is still pace-setting within the CIS. Just look at the EDRD's most recent transition report, Armenia enjoyed upgrades in three structural reform indicator scores, more than in any other country but one.
So is Armenia the South Caucasian Tiger? Certainly it has grown at rates reminiscent of East Asian Tiger economies on the basis of its reforms and macroeconomic stability. Here perhaps I dissent slightly from what Johannes has been saying in the comparison he made with the post-Soviet output of Armenia and that according to the data, we have only gone to about 92 percent of the output prior to the dissolution of the Soviet Union. I think the profession really is quite divided as to the meaningfulness of comparing output in Armenia in the pre-Soviet period and today particularly given the command nature of the economy and the specialized military nature of production in Armenia. Though I entirely agree with the points he made about the importance of disentangling the various factors that have produced growth, in particular good policies, and that bring out the importance of good policies even more strongly.
But despite high growth over the past decade or so, Armenia remains poor. Its GDP per capita is only about a quarter of that in the Baltics. Nevertheless, growth has begun to make a significant dent on poverty as the book reports. Overall poverty has fallen from over half the population 5 years ago, to one-third today, and extreme poverty from over a fifth of the population 5 years ago, to only about 6 percent today.
The book points out that rapid productivity advances will eventually be exhausted and that investment needs to rise to support current rates of growth. Our work at the Bank suggests that for investment to respond, the next wave of reforms should be directed at sharpening the comparative framework of the economy, achieving closer integration in its national trade and capital markets, deepening financial markets and creating the conditions for the absorption of knowledge on the path to higher technical sophistication. I will focus the rest of my remarks on what we believe the shape of future policy should be.
Experience has shown not least amongst the Southeast Asian Tigers that rapid growth over prolonged periods can conceal underlying weaknesses in an economy and blunt the incentives for reform. Armenia has begun to address the second generation of reform somewhat fitfully. Utility reform and privatization have proceeded, some corrections in the business environment have been made, but a weak state of corporate governance, poor property rights enforcement, arbitrary practices in tax and customs administration, distortions associated with corruption and stunted financial markets all act to impose a large risk premium on investment.
Addressing the reform agenda will also lead to a greater impact on employment than we have seen thus far, a point that was raised by Johannes a moment ago. Deficiencies in the business environment, some rigidities in the employment regime and inadequate financial markets have led to a dual labor market, one of rising real wages on the strength of impressive productivity gains in the organized sector, where a larger informal labor market has been stagnant and immobile.
We believe that the reforms must center on strengthening competition which today is hobbled by weaknesses in law and in its application such as the competition law and the law on contracts, and on informal and formal institutions and their ways of working such as corporate governance arrangements and by business regulation and governance rules and practices such as arbitrary and unpredictable behavior by the tax authorities and customs authorities. The competition law needs to be strengthened both in its structure and implementation, and its implementation has to be supported by strengthening the commission itself and by enhancing its legal powers.
In corporate governance, laws, regulations and institutions are weak. On several key transparency issues, notably public access to the company register and lists of founders and shareholders, Armenia lags the CIS countries. The quality of corporate financial reporting also remains weak. These weak corporate governance practices reinforce the dominant position of a limited number of businessmen and undermines investor confidence.
Despite satisfactory indicators under a number of categories that measure the ease of doing business such as the ease of formal entry, hiring employees and business exit, Armenia's weakest areas are in registering property, access to credit, property rights and large severance payments for labor. Overall, however, even in the most streamlined and reformed areas, the level is below best practice in transition economies.
Moving on to financial intermediation, confidence in bank is affected by some of these shortcomings in corporate governance that I have been talking about, notably by lack of transparency in the ownership and control of banks which make it difficult for the banking sector to access risks on corporate-sector exposures. Official disclosures of direct and indirect ownership are substantially weaker than seen in other transition economies. Notably, no disclosure of beneficial owners is required under Armenian law. Clearly this inhibits banking activity.
On international integration and its promise for economic growth in the future, it is true that Armenia today enjoys an admirably open regime in trade in goods and services in capital and investment flows. No legal restrictions are in place on foreign capital flows, and the foreign investment regime provides for national treatment, MFN and so on, and tariffs are low. Yet neither commitments under the WTO agreements nor legal provisions protecting private investors and enforcing contracts are enough to ensure how contestability of Armenia's domestic markets because, first, the capacity of the courts remains weak. Secondly, customs administration remains archaic, though recently improving, and customs procedures yet have to achieve WTO standards of transparency.
Weakness in the provision of backbone services, transport, communications and so on, add greatly to the cost of participating in the emerging division of labor. Falling transportation and communication costs creates opportunities for outsourcing, just-in-time production and supply chain management. High transport and communication costs in Armenia are barriers to international trade.
I will limit myself to two examples, telecommunications and civil air transport. The government's decision to grant a legal monopoly until 2009 to a foreign investor in telecommunications has led to greatly increased costs and to lowered quality of service in this key economic sector. Armenia has a surprisingly low number of Internet users, well below the CIS average. Freight shipped by air from Yerevan fell between 1997 and 2003 by more than two-thirds which is a dramatic development considering that the value of exports over the same period rose nearly 3-1/2 times. This can be attributed to a restrictive aviation policy. We believe that for a small landlocked economy aiming to maximize its long-term economic growth rate, the best aviation policy would be to eliminate government-imposed entry barriers to air transport. Armenia could gain considerably from an open-skies arrangement model such as that of Chile or of the European Union Civil Aviation Area model.
We hope that the discussion in Armenia and in policy-making circles will focus on some of these key reform areas that I have been talking about this year and beyond as they are necessary if we are to lock in the stellar economic performance of this country for years ahead. Thank you.
MR. KHAN: Thank you very much. If each of you want to respond, we'll open it up. It's up to you.
MR. GELBARD: Thank you. Just a couple of points on the issue of unemployment and output statistics and relative output performance.
On the unemployment side, while the data is very sketchy and not very reliable, there is a substantial amount of employment in the shadow economy that is not captured by the unemployment statistics. It is widely believed that many employed workers in retail, construction and other small businesses are not counted because the owners of businesses themselves have an interest in remaining outside the formal tax system. So the issue of unemployment is quite difficult to read and it seems to be that the increasing employment in the informal economy in the last few years has been quite massive and that it masks the actual statistics that we see on unemployment.
On the output statistics, it's difficult to make a comparison between the Soviet times and post-Soviet times. The fact of the matter is, in the case of Armenia, we do not see entirely a process of refurbishing the same old factories and a return to the same industrial structure that prevailed in the Soviet era. In the late-1990s a new configuration of economic activities emerged and the export-led and import substitution industries that emerged were new and not necessarily a part of the Soviet era. So it also makes it very difficult to compare when one sees the growth process one level of output in 1990, let's say, and another level output in 2000. We're looking at two fundamentally different economies.
MR. KHAN: Thank you very much, Enrique. The floor is open for any questions or comments.
QUESTION: I have a question for Enrique. Thank you very much for a very interesting presentation. I saw in the challenges ahead one area that maybe you could briefly discuss is also what would be an appropriate monetary framework and exchange rate regime for Armenia going forward—and what would they like to do because I think that the market-based monetary instruments are also not fully developed at the same time they are considering inflation targeting at some future points. If you could discuss that and how it would support the growth that you outlined.
MR. GELBARD: On the monetary framework, yes, I haven't worked in Armenia for almost a year by now, but I understand the authorities are considering inflation targeting, but at the same time not all of the conditions are in place so it's going to take some time until that is actually effected.
The main challenges on monetary policy as we documented in the book have to do with ensuring greater coordination between the Ministry of Finance or the Treasury and the Central Bank, deepening the market for government securities and/or issue Central Bank bonds, and ensuring that the Central Bank has a sufficient stock of indirect instruments to manage monetary policy and liquidity. So I think that that's basically what the Central Bank has been engaged in and the government, too, in the last few years, and recent issues of bonds have gone deeper in terms of maturities and interest rates have fallen further.
On the exchange regime, Armenia had a fairly flexible exchange regime throughout the last 15 years. There were times where the exchange rate was quiet or surprisingly quiet for a while, but overall, the Central Bank has allowed for exchange rate pressures to be revealed in the price of foreign exchange. We argue in the book that it has served them very well and I think from what I understand so far, they intend to keep that system going.
QUESTION: Thank you very much. I would like to press a little bit on the point mentioned by Mr. Linn on the political economy aspect. The issue that came up while you were speaking and explaining the success of the reform process in Armenia was how was the government able to mobilize enough support to maintain the reform momentum? What were the obstacles in terms of public opinion? How were those obstacles negotiated? How do you see the situation from that perspective into the future?
Perhaps to clarify, Mr. Linn made a reference—
MR. GELBARD: Some of these interests have enough influence to ensure that for some time they do not fully comply with the tax laws. That is precisely the key political economic issue going forward, the extent to which the authorities can reform these tax collection agencies, so that they no longer become so discretionary and favor certain parties against others.
QUESTION: Thank you for the opportunity. I'd like to stress some stuff that Johannes Linn had to say about isolation and sustainment of growth or potential growth when he talks about the impediments of low investments and high unemployment, the isolation. Your growth and your dependency has to do a lot with the unresolved conflict, what are we doing, what are you doing to try to resolve that, because there's tremendous growth potential with your neighbors.
MR. GELBARD: You're referring to the dispute with Turkey and Azerbaijan?
MR. GELBARD: At the Fund, we do not interfere into these political issues, so what the analysis shows here is that through a number of simulations if you remove the artificial borders you could increase the volume of trade by about one-third, and that's basically the approach that we're taking. I understand that lately there have been some discussions between the governments of Armenia and Azerbaijan on this issue, but it remains a very contentious issue.
MR. KHAN: If I could just mention, the way I see it is the closed borders are going to be a constraint on growth in the future. You have a country here that for the last 4 or 5 years has had double-digit growth rates, and that's pretty phenomenal. So the close borders have not been a binding constraint on growth because the economy is doing extremely well. The fact of the matter is that this cannot continue and that's where I think the issue of closed borders becomes a constraint and in the future will become more and more so.
I think the point that Enrique wants to stress is that trade has to be a very important part of Armenia's future growth rate and if you have closed borders, this is constrained. Where the solution is going to come from obviously is political, too, but I think our job and I think that the paper does this and that book does this is to point that if you were to have open borders or to open the borders, what is the potential for trade and, therefore, what is the potential for growth.
QUESTION: When you talk about double-digit growth, you're fudging some numbers here. Double-digit growth from nothing or disseminated—is that real growth or is that recouping what you've lost over the years?
MR. KHAN: Your recouping is growth, too, because the fact of the matter is, the economy is growing. I don't know whether you call it fudging numbers of not. I personally think that, yes, you have 13-1/2 percent growth last year or something like that. Where is that coming from? There's something happening in that economy that leads to 13-1/2 as compared to the year before.
The point we're making is there's a catch-up, obviously. Of course there is, but I think at the same time, so far just in the process of catching up, the closed borders is not posed to be a tremendous constraint on the economic, but will be.
QUESTION: My question is for Mr. Mitra. When you referenced the need for liberalization of aviation and air transport, you mentioned the need for new entrants. Did you mean entrance of current existing air transport corporations or did you mean locally owned? If so, what do you think the economic impact of a liberalized air transport sector would be? In any event, have there been any studies done on that?
MR. MITRA: Yes, we have done a study on that which we hope to release within the next month or so. So if you send me an Email I'll make sure you have it.
New entrants foreign and domestic, yes, if there are additional domestic airlines that want to participate. You probably know that today Armenia actually protects its national airline, but it is not a publicly owned airline, it's a privately owned airline, so it's actually protecting certain private interests in Armenia by seeking to protect civil aviation activities.
Our work shows that liberalizing civil aviation services as to both volumes and prices and allowing airlines freedom such as a fifth freedom to carry passengers beyond Yerevan once they land in Yerevan would lead to greatly lowered costs. Costs of civil aviation services today in Armenia are much, much higher than in comparable countries or comparable distances and so on, and so obviously that will be a great benefit to the economy both in goods and services.
QUESTION: In looking at the report I noticed that you disaggregate the sources of growth by sector, and I was wondering if any of you could give me any further insights into the potential for agriculture to be one of the sectors that would lead growth more greatly in the future particularly in terms of exports, in terms of the land reform and possible aggregation of land holdings and also because of the fact that there are so many people who were forced to do small farming when the industrial structure of the economy fell apart.
MS. MITRA: I can give you a general answer to that. As you know, the agricultural sector in Armenia was somewhat special in the sense that there was a large movement of labor into agriculture in the beginning of the post-Soviet period and there was a large growth in subsistence farming activities as a defense measure on the part of the population. This is beginning now to be slowly reversed and Armenia does have a comparative advantage in a number of agricultural activities, particularly fruits and vegetables, although they are highly dependent on irrigation. So investments in irrigation being supported by the Millennium Challenge Account is going to be important. Just as important is going to be proper pricing of water so we actually have efficient agricultural production.
But our work also shows that there are two major constraints to expanding future agricultural activity and agricultural exports. One is lack of extension services, and in particular the translation of research results into actual practical applications for farmers, and the government is making some efforts in that area.
The second is lack of an appropriate form of certification and standards because, as you know, fruits, vegetables and other products have to meet certain European standards and other standards if they are to be sold in Amsterdam or Frankfurt or wherever else, and the government through passing a new seeds law that provides for higher standards in seeds, for example, and for testing of agricultural products is also moving in the direction to address that deficiency.
MR. LINN: I would just maybe add that this links, of course, with the earlier discussion of opening up trade or reducing trade or barriers to trade because agriculture presumably, Samoa, correct me if I'm wrong, that increased agricultural production would have to be significantly ultimately also for exports.
Which brings me back to this discussion that we just also had on integration. We just finished a major report for UDP on Central Asia that looked at integration in Central Asia and for the rest of the world including its neighbors and we estimated that if appropriate policies were followed across a range of areas, by the way, not just transport and trade facilitation, but very importantly, Central Asian economies could double their size relative to where they will be without effective integration over a 10-year period.
I am very glad to see that you've made some explicit estimates of the benefits from increased trade and a lot of the specific trade, Saumya, including on air freight and so on and to telecoms, for example, so that you can properly integrate in communications.
From my perspective, for a country like Armenia that's small and landlocked, those issues are absolutely core. Having a liberal trade policy environment is great, but that's not going to be enough. You really have to go--even once the borders are open again, you have a lot of work to do in Armenia on trade facilitation, on behind the border policies that affect trade and trading costs, transit and so on. I'm happy to see that that's being addressed in part.
Let me just maybe since I have the microphone come back to the point, Enrique, that you made about the GDP numbers. I agree with you that those GDP numbers, 89, 90, are weak, and of course the transformation of the structure of the economy is absolutely at the core of those whole transition process. But we really can't have it as analysts both ways. We can't publish a report that in two tables, one table and one graph, shows the numbers and say, well, but they're meaningless. If we're serious analysts, we put the numbers in and then we make a serious point of interpreting them or we leave them out and explain why we don't interpret them. So I just don't think that's a good answer, I'm sorry. I do feel for these countries, that transition, that collapse is such an important part of their recent economic history, and it I believe from my own personal discussions with people in the countries remains so much part of today's understanding of the debate about policies and whether or not policies have worked, whether or not the international institutions have provided good or bad advice, whether or not the poverty that's still there is poverty that was avoidable or not, that we really have to get on top of this.
I've personally done some work because, as you can tell, I'm engaged on this as an issue and I'd be happy to share it with you, but I feel when you do a report like this I just hope we could do a bit more work on it. That's my only wish, because I do feel it's important.
QUESTION: I certainly agree I think looking at the historical background of the region and Armenia being a former Russian entity, there are consequences for that. However, I think that the point that Mr. Mitra just made was in the fact that the possibility of—actually, it's more of a comment then going into a question for you. The possibility of opening up markets, obviously there is an historical issue with that region, with Armenia and Turkey, and you've seen the recent 13 percent growth in the economy as a result of engaging with other economies whether it's through the European sector, whether it's having specialists coming into Armenia to train Armenians on European standards as you have mentioned is one of the challenges, or just different challenges on productivity, presentation of goods, things of that sort.
My question then leading to your comments earlier is how would exactly it being landlocked affect its economic potential when there could be a linkage to other markets? It seems to me there's more of a growth heading towards that way as opposed to—because you made a comment that that could actually influence of change the growth rate, but I'm not sure exactly how that would happen when most of its growth has been its economic interactions with other countries apart from the two countries it has issues with.
MR. GELBARD: The main attraction for Armenia is actually the Turkish market. It's Turkey that has the big market and the distance is lower and transport costs are very, very low if you open the borders. So that is where the potential gain is.
What you have now is a country that has very high transport costs which makes prices of several goods almost prohibitive for exportation or importation. What Armenia has done in recent years is develop an export sector that's based on light industry such as diamonds that they can fly out of the country.
Another complication was Georgia that had a very inefficient system of customs administration and until at last year that was a problem because of transport barriers. The gains are thus potentially large, at least for a number of years. Could this change the steady state growth rate of the economy 50 ears down the road? Probably not, but opening the borders will definitely have an impact on the first 10 to 20 years of integration.
MR. KHAN: Any further questions?
QUESTION: A quick question about the capital and the kind of constraints it may impose on the economy. There are issues of trade, corporate governance, taxation and so forth, yet in Armenia you couldn't find a single textbook on finance and we worry about financial markets and there's no single textbook on corporate finance, public finance, econometrics, whatever, the actuarial sciences.
The question I pose to you is the growth we've seen right now, who has managing that growth? And the growth that you foresee in the future, who would be the managers? Where is the resources coming from in terms of the technical expertise, the financial expertise?
MR. GELBARD: You have the domestic human capital base which is quite rich, and you also have a lot of foreign investment recently with new technologies, so between those two you have a powerful source of growth. I suspect that that remains through going forward.
MR. KHAN: Do you have anything?
MR. MITRA: I don't think no one is managing the growth. I don't think the growth is being managed. I think the government has very appropriately limited itself to a small size in the economy. It has moved almost entirely out of the productive sector. One of the things the book points out is that a number of reforms have been impressive, but particularly impressive has been the energy sector reforms in Armenia where I think it's the leader. Energy is almost entirely in private hands; not entirely in private hands in generation, but in transmission and distribution it is. Here I should note that the Fund actually played a very helpful role in promoting energy-sector reforms over a number of years which leads me to make the plug that the Fund should not entirely out of structural reform issues as some people seem to be arguing.
The government has limited its role in the economy, and as Enrique pointed out, it's the private sector that's been leading the growth. There has been some diaspora funding, there's been foreign direct investment particularly associated with large privatizations. But in the future, the investment rate has to increase as the total productivity improvements will necessarily fall off from the stratospheric levels you see today, and the entire debate I think is what is necessary, what are the preconditions for that to happen, and I think the book points out and I try to point out in my paper some of those reforms that have to be followed for that to happen.
QUESTION: I wanted to belabor the civil aviation point because it's the first I've heard of it. I didn't quite get how it increased costs. It sounded like you were talking about transportation within the country, and as far as I'm aware, there is only an airport in Yerevan and no where else. Or are you talking about landing rights at the airport for international transport? I'm interested in your study. How does it increase the cost?
MR. MITRA: We'll send you our study, too, but I was talking about international civil aviation, not domestic, and the effect that the restrictive attitude of government policy today has on the costs and the volumes of international civil aviation.
MR. KHAN: We have one last question.
QUESTION: In the book you comment several times about the important role that the diaspora played getting Armenia to this point. Can you speak a little bit further about what role you see the diaspora playing in the future growth that's necessary in Armenia?
MR. GELBARD: I think it could still play the same role in the future, the role of facilitating investment, connecting diaspora investors abroad with investments at home, the know-how transfer that takes place out of that, the trade facilitation aspect of having the diaspora. Those things are likely to continue.
Remittances instead are subject to economic cycles in the neighboring countries, especially Russia, so it remains to be seen whether the recent trend of huge remittances from Russia will continue.
MR. KHAN: I think we can end now. Thank you all very much. I thank the panelists for their presentations.
I'm told that there are light refreshments outside. I'm not sure what light means, buy why don't you go ahead and check it out yourselves?