Republic of Armenia and the IMF

News Brief: IMF Completes First and Second Review of Armenia's PRGF Arrangement

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Armenia—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

September 11, 2002

The following item is a Letter of Intent of the government of Armenia, which describes the policies that Armenia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of Armenia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.
 

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

On May 14, 2001, the Executive Board of the Fund approved a three-year arrangement for Armenia under the Poverty Reduction and Growth Facility. The purpose of this letter and the attached Memorandum of Economic and Financial Policies is to inform you of progress in implementing the program and request waivers for nonobservance of nine quantitative and one structural performance criteria pertaining to the first and second reviews under the arrangement. Though the number of required waivers is high, we would like to point out that the nonobservance can be attributed mainly to two developments: unsatisfactory tax revenue performance and insufficient reforms in the energy sector.

Economic performance during the last two years has been positive: real GDP has been growing at an average rate of 8 percent per year, annual inflation has remained below 4 percent, and the central government and external current account deficits have been narrowing. Progress has also been made in reducing poverty and income inequality.

Nevertheless, and despite this good performance, there have been difficulties with tax and customs revenue collection in 2001, as well as delays in implementing structural reforms in the energy, water, and irrigation sectors. In the fiscal area, tax revenues for the year as a whole were below the program target. This shortfall, combined with delays in external disbursements, caused the nonobservance of the June and December ceilings on expenditure arrears, and the December ceilings on the stock and flows of external arrears. The expenditure arrears of the State Fund for Social Insurance were significantly reduced in 2001, but they ended the year slightly above the programmed ceiling.

All targets under the monetary program for 2001 were met, except the December ceiling on the net domestic assets of the central bank, reflecting a larger-than-programmed profit transfer to the government. The cumulative primary deficit of the energy sector, a performance criterion, was also not observed in both June and December 2001 as a result of the failure to privatize the electricity distribution companies and changes in weather and consumption patterns. Lastly, the law on financial disclosure by public officials (the structural performance criterion) was passed two months after its target date of June 2001. All other structural benchmarks and measures under the program were implemented, although in some cases with a small delay.

Since December 2001, the government has successfully undertaken a number of measures to improve tax revenue collection and begun addressing the much-needed reforms in the aforementioned areas. As described in the attached memorandum, we will be moving decisively with our reform agenda during 2002-04. Our strategy is based on fiscal consolidation supported by structural reforms in sectors affected by inefficient state-owned companies, improvements in governance, and actions to strengthen the banking system. We are also committed to eliminate all domestic budgetary arrears by mid-2003. An ambitious rehabilitation program for the energy, water, and irrigation sector will be implemented in consultation with the World Bank. Lastly, we have issued a Poverty Reduction Strategy Paper (PRSP) Preparation Status Report, and the PRSP will be finalized by end-2002.

On this basis, we request completion of the first and second reviews under the arrangement and waivers of nonobservance of: (a) the end-June 2001 quantitative performance criteria on the stock of government arrears and on the primary deficit of the energy sector; (b) the end-June 2001 structural performance criterion on the adoption of the law on financial disclosure by senior public officials; (c) the end-December 2001 quantitative performance criteria on the net domestic assets of the central bank, the tax revenues of the central government, the stock of government arrears, the stock of arrears of the State Fund for Social Insurance, the primary deficit of the energy sector, and the stock of external arrears; and (d) the end-December 2001 continuous performance criterion on non-accumulation of new external arrears.

We are confident that the policies and measures described in the attached memorandum are adequate to achieve the objectives of the program, but will take further measures if deemed necessary. During the remaining period of the arrangement, the government will consult with the Managing Director on additional measures that may become appropriate and provide the Fund with the information required to assess progress in implementing the policies and reaching the objectives of the program. Armenia will conduct with the IMF the third semi-annual review of its program before March 31, 2003, as described in the attached memorandum.

Sincerely yours,

/s/


Andranik Margaryan
Prime Minister
Republic of Armenia

/s/


Vartan Khachatryan
Minister of Finance and Economy

/s/


Tigran S. Sargsyan
Chairman of the Central Bank



GOVERNMENT OF ARMENIA
MEMORANDUM OF ECONOMIC AND FINANCIAL POLICIES

September 11, 2002

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This memorandum sets forth the government of Armenia's economic objectives and policies for the period July 2002 to June 2003, the second year of the program supported under the Poverty Reduction and Growth Facility (PRGF). These objectives and policies are an integral part of the government's medium term strategy for poverty reduction envisaged in the interim Poverty Reduction Strategy Paper (PRSP).

I. Recent Developments and Performance Under the Program

1. The overall performance of the Armenian economy in 2001 and the first half of 2002 has been strong. Real economic growth, after slowing in 1999, accelerated to 9.6 percent in 2001, and it has averaged 6 percent annually since 1994. The robust growth has continued in 2002, with real GDP growing by 10.1 percent in the first half of the year compared with the same period of 2001. The rate of inflation has averaged less than 4 percent during the past four years; the 12-month rate of inflation stood at 3.7 percent in June 2002. The external current account deficit has declined significantly from 21.2 percent of GDP in 1998 to 9.5 percent in 2001. Preliminary data for the first quarter of this year suggest a further narrowing of the current account deficit compared with the same period of 2001, aided by a process of market driven import substitution and strong growth in exports.

2. Despite this overall positive performance, the implementation of the program in 2001 was not entirely successful. During the first half of 2001, the performance criteria on the cash deficit of the government budget, net domestic banking system credit to the government, and tax revenues were observed, but those on the stock of government arrears and the primary balance of the energy sector were not. For the year as a whole, tax revenues were 0.4 percent of GDP below the programmed amount, mainly the result of delays in improving tax and customs administration and poor energy sector performance.

3. In part due to the underperformance in tax revenues, but largely because of a shortfall in external disbursements, the end-December performance criterion on government expenditure arrears was also exceeded (although expenditure arrears were reduced from a peak of some 5 percent of GDP in September 2000 to around 3.6 percent of GDP at end-2001). Similarly, the end-year performance criteria on the stock of external arrears and the non-accumulation of new external arrears were also not observed. The shortfall in external financing was, in turn, partly related to noncompliance with World Bank conditionality on privatizing the electricity distribution companies (EDCs). Reductions in government expenditures during the second half of the year led to a decline in the fiscal deficit on a commitment basis from 6.4 percent of GDP in 2000 to 3.9 percent in 2001. Expenditure arrears of the State Fund for Social Insurance (SFSI) were significantly reduced in 2001 to 0.1 percent of GDP, only marginally above the target of zero arrears; the remaining arrears were cleared during the first half of 2002.

4. All targets under the monetary program for 2001 were met, except the end-December ceiling on the net domestic assets of the Central Bank of Armenia (CBA) (a performance criterion). The ceiling was exceeded by a small margin due to a larger-than-programmed profit transfer to the government to settle an unanticipated foreign debt payment. Net international reserves (NIR) of the CBA (a performance criterion) exceeded the end-year program floor by almost US$10 million.

5. The energy, water and irrigation sectors, along with the large state-owned chemical company, Nairit, continued to be a major source of non-payments in 2001. The management of Nairit was assigned to a private operator, but the planned privatization of the EDCs could not be realized because of the continued financial problems of the sector and the deterioration in the international investment climate after the September 11 terrorist attacks. The four EDCs were subsequently merged into a single company. In 2001, the annual technical loss rate (leakages in generation and transmission) for electricity generation stood at 15 percent, and the excess loss rate (presumably related to theft) was 11 percent, while the overall collection in terms of the amount billed was 81 percent compared to 89 percent in the previous year. The cumulative primary deficit of the energy sector, a performance criterion, exceeded the end-2001 target by 2.5 percent of GDP, while the combined primary deficit of the energy and other quasi-fiscal sectors increased from 2.6 percent of GDP in 2000 to 3.6 percent of GDP in 2001. Reflecting improvements undertaken since then, overall energy collections increased to 90 percent during the first half of 2002, and the sector's cumulative primary deficit declined sharply to 0.2 percent of GDP.

6. The financial disclosure law for senior public officials, a structural performance criterion, was enacted in 2001, although with a slight delay. All measures subject to structural benchmarks were implemented in 2001. These measures comprised the establishment of a comprehensive automated audit system for the VAT, the enactment of a treasury law and a law on the bankruptcy of banks, and the parliamentary approval of amendments to the central bank law and the law on banks and banking activity. Other structural measures implemented in 2001 include the establishment of an internal audit unit at the headquarters of the Customs Committee (CC) and the approval of a civil service law. The government also established a committee for the development of an anti-corruption program in cooperation with international donors. As part of its role as guardian of the stability of the banking system, the CBA placed seven problem banks under interim administration between November 2000 and December 2001, while two other banks were liquidated.

7. All quantitative targets for end-June 2002 discussed with the February IMF mission were met, except for the ceilings on domestic and external arrears (Table 1). Even though expenditures, in particular on subsidies and net lending, exceeded the projections in the first half of 2002, annual expenditure targets will not be affected because spending in the second half of the year (including subsidies) will be contained to ensure that the annual limits are not exceeded. Further structural measures have been taken in 2002, prior to the IMF Executive Board meeting on the combined first and second reviews under the PRGF. These include the publication of key individual data under the financial disclosure law and the introduction of the necessary procedures and regulations for its full enforcement; the ratification of legislation for VAT to be paid at the time of importation on an additional list of products (comprising at least 5 percent of the total value of imports); and the approval of government decrees requiring the Ministry of State Revenue (MSR) and the CC to exchange key information on VAT taxpayers (Table 2). In addition, the AMD 4.9 billion loan extended to the energy sector in the first quarter of 2002 will be repaid to the state budget at least one week in advance of the Executive Board meeting. Finally, legislation was approved on non-bank financial institutions, including micro-finance institutions.

II. Medium-Term Strategy

8. Building on the progress achieved in 2001 and early 2002, we are committed to impart additional impetus to our macroeconomic and structural reform program during the next two years, including improving services and infrastructure, reforming the energy, water, and irrigation sectors, improving the enforcement of laws and regulations, reducing administrative barriers and red tape, and increasing the efficiency and transparency of public sector operations. This program, which has been developed in consultation with the staffs of the IMF and the World Bank, aims at maintaining the conditions for real economic growth of at least 6 percent per year and inflation at no more than 3 percent. Growth will be driven by continued development of export sectors such as technology-intensive and mineral and agricultural processing activities and by increased aid flows channeled to investment on infrastructure and reconstruction. Fiscal policy under the program will continue to be directed at substantially increasing government revenues in order to provide additional resources for poverty reducing expenditures, eliminating domestic payment arrears, and lowering the fiscal deficit to a sustainable medium-term path consistent with stable external-debt ratios.

9. Preliminary data from the 2001 household survey indicate that the share of the population living in poverty has declined to 51 percent from 55 percent in 1998/99 while the share of the population living in extreme poverty has declined to 16 percent from 23 percent. Further progress in these areas will depend not only on continued macroeconomic stability and sustained growth, but also on improvements in the targeting of social expenditures, the quality of public administration, and the integrity and efficiency of the judicial system. There is also the need to improve the business environment, particularly for small and medium-sized businesses and new business entities. Working closely with civil society and external donor organizations, the government has intensified its efforts to prepare a full PRSP by the end of this year. In the meantime, we have prepared a PRSP Preparation Status Report.

10. Fiscal and governance-related reforms will continue to be buttressed by a monetary policy aimed at ensuring price stability. As in the past, this objective will be accomplished through adherence to an indicative reserve money corridor. The CBA will continue to maintain a flexible exchange rate policy and will intervene in the foreign exchange market only to smooth short-term exchange rate fluctuations. Movements of reserve money toward the edges of the corridor provide the CBA with a signal of the need to reassess its short-term credit and foreign exchange market policies. In the event that reserve money moves outside the corridor, the CBA will discuss with IMF staff any need for a change in monetary policy.

11. In the period 2002-03, the government is determined to significantly reduce the non-payments problem of the energy and other quasi-fiscal sectors. To that end, an overall financial rehabilitation plan will be implemented in collaboration with the World Bank and the merged EDC will be privatized by the end of this year. Over the medium-term, tariffs for water and irrigation will be raised towards full cost-recovery levels, and the installation of water meters will be extended to multi-family apartment buildings and single-family units.

III. The Program for the Period July 2002-June 2003

12. Key economic objectives and policies. In line with the medium-term strategy, the government's economic program for July 2002-June 2003 aims at achieving the following core objectives:

· Provide the conditions for real economic growth of at least 6 percent so as to improve the standard of living of the population and slow down emigration;

· Maintain the 12-month rate of inflation at no more than 3 percent and gross international reserves at 3.8 months of imports; and

· Further reduce the fiscal deficit and public debt ratios.

13. The main policies to achieve these objectives are: i) pursuance of an independent monetary policy focused on price stability; ii) improve tax and customs administration to yield higher tax revenues; iii) control and prioritize government expenditures; iv) strengthen the performance of key state-owned utilities in the energy, water, and irrigation sectors; v) protect the health of the banking system and promote financial intermediation; and vi) reduce administrative barriers and opportunities for corruption.

14. Fiscal balance. On the basis of ongoing revenue measures and a more efficient targeting of expenditures, the fiscal deficit on a commitment basis will decline from 3.9 percent of GDP in 2001 to 2-2.5 percent in 2002-03. On a cash basis, the deficit will also decline despite an accelerated repayment of domestic expenditure arrears.

15. Revenue mobilization. The government considers revenue mobilization to be the foundation of a sustainable fiscal platform for Armenia. We are therefore committed to a comprehensive program aimed at removing various loopholes in the tax system, and improving tax and customs administration. Several measures have been taken, and more will be taken in order to increase revenues by at least half a percentage point of GDP per year in 2002-04. The government does not propose to carry out major adjustments in tax rates next year but it will improve tax and customs administration and ensure the equal enforcement of the law on all taxpayers. The government stands ready to take immediate offsetting revenue measures in the event of a revenue shortfall.

16. Tax policy. A comprehensive package of measures designed to improve tax collections has been implemented since December 2001. The legislation that was enacted reduces the potential for fraud in claiming VAT tax exemptions for imports allegedly connected with humanitarian assistance, extends the base for the income and presumptive taxes, and penalizes over-reporting of losses in connection with the profit tax. The law on the simplified tax was streamlined and made more equitable. The law will be reviewed in late 2002 and may be amended again in 2003 with a view to eliminating remaining exemptions and loopholes. The government is also in the process of introducing legislation on real estate and motor vehicles taxes collected by local governments, with tax rates proportional to the market value of the property. The parliament recently passed legislation allowing for the establishment of a free-trade export-processing zone in the vicinity of the Yerevan airport. The government does not intend to establish other free-trade zones in Armenia, and is aware of the potential revenue loss resulting from this initiative. To address the latter concern, it will ensure that the zone remains sealed within a well-defined area and will calculate the loss in profit taxes resulting from the free-trade zone and record it as tax expenditures in the budget. After one year of operation, the government will evaluate the revenue impact and the nature of the tax exemptions.

17. Value-added tax (VAT). In line with international best practice, the government remains committed to the goal of eliminating VAT exemptions at the border for all imported goods (other than goods exempted under specific treaties and agreements entered into with internationally recognized donor organizations or other governments; and goods which constitute humanitarian assistance). Over the next two years, as the administrative capacity for VAT credits and refunds improve and if real lending rates decline significantly, we will make every effort to achieve this objective. These exemptions, excluding those for imports under specific customs procedures for re-export, currently apply to 25 percent of the total value of imports, down from 35 percent in 2000. Effective January 2003, these exemptions will be reduced further and will apply to just 20 percent of imports.

18. Tax administration. Major measures have been or will be taken in the area of tax administration. In January 2002, a large taxpayers unit was established within the MSR, which will significantly reduce tax evasion among the country's largest enterprises. Furthermore, the law on tax inspections has been amended in line with international best practice to remove restrictions on the number and duration of audits of individual taxpayers. In particular, the possibilities for on-site inspections and investigations and the audit powers of the local tax inspectorates have been enhanced. The MSR will adopt a code of conduct for its officials by November 2002, with a view to improving the transparency of tax operations. By the end of the year, the MSR will establish an internal audit unit and post on its website and in other media information including basic tax legislation and regulations covering the major taxes and the corresponding procedures.

19. Customs administration. The government is aware of the need to improve the integrity and efficiency of customs operations, and it has created a fully staffed internal audit unit at the CC headquarters. This unit will soon start preparing quarterly reports. The CC will also adopt a code of conduct for its officials later this year and, by January 2003, establish a website with key information including customs tariffs and import/export procedures. To enhance customs valuation, the customs code will be amended, with a view to cease the current practice of basing customs values on domestic market prices, and a computerized database linked to the Automated System for Customs Data (ASYCUDA) will be established this year to verify values of imported products based on import prices. Furthermore, the authorities will initiate a review, in consultation with external experts, of the secondary legislation pertaining to the customs code, with a view to make its interpretation and implementation more transparent. At the same time, the existing Consultative Committee will be expanded to better reflect the composition of key stakeholders. In addition, mobile passport reading machines will be introduced by December 2002 to enforce the bi-annual limits on individual duty free exemptions; these exemptions will be subsequently reduced from US$500 to US$300. The key measures to be taken during the program period in this area are outlined in Tables 2 and 3.

20. Expenditure policy. The government is committed to clearing all domestic arrears by mid-2003. Given the assumptions on foreign financing, the program envisages the clearing of arrears and an increase in current government expenditure in 2003. The share of social expenditures in the budget (defined as total expenditure on health, education and science, and social security) will be increased by at least 0.3 percent of GDP in 2003. In the event of a financing shortfall, the government will undertake the necessary expenditure cuts within the 2003 budget and will halt the envisaged increase in current expenditures as a share of GDP in order to meet the arrears targets. The 2003 budget may also include about AMD6 billion in the reserve fund as a contingency for payments in late 2003 for supplies to the nuclear power plant. In this regard, the budget will include a provision under which, unless they are utilized for that specific purpose, these funds will be saved in the single treasury account at the CBA and their disposition will be subsequently discussed with the staffs of the Fund and the World Bank. Capital expenditure will increase rapidly in 2002 and 2003, mainly as a result of higher grant-financed public investment. A public expenditure review has been prepared and a medium-term expenditure framework is being prepared in consultation with the World Bank. The design and implementation of the latter, which will be linked to the 2003 budget so as to match sectoral expenditure priorities with resource availability, is an essential element of the PRSP process.

21. Expenditure management and budget reform. In the area of expenditure control, the government has approved regulations and procedures on budget execution under the treasury law that went into effect in January 2002. The government has also approved new procedures to improve the effectiveness of the public procurement process, and will be implementing new commitment control procedures and an improved budget reporting system in October 2002. At the same time, the Ministry of Finance and Economy (MFE) will establish a fully functioning internal audit capacity, effective January 2003, and increase the amount of information displayed on its website to include budget laws, internal audit reports, and quarterly budget execution reports according to both the economic and the functional distribution of expenditures. The government will also begin to identify, and later remove, any impediments to the inclusion in the budget of all external grants where a government decision is involved and irrespective of whether the funds are managed by government units. Lastly, the government will take steps to further enhance the transparency of extrabudgetary funds, data on stocks and flows of tax and expenditure arrears, and, in collaboration with the World Bank, the procedures for utilization of the reserve fund.

22. Social security system. The finances of the SFSI have been placed on a sound footing: all remaining SFSI expenditure arrears were cleared by mid-2002, and the SFSI will remain current on its obligations during the program period. In light of the improved revenue performance, old-age pensions will be increased over the medium term. To enhance the efficiency of the pension system, pensions are now exclusively targeted to recipients residing in the country. Furthermore, the SFSI is undertaking significant technological improvements and reductions in staff. Finally, starting in 2002, citizens will begin to receive personal identification numbers (PIN) and, conditional on the availability of external financing, all citizens should receive a PIN by 2005.

23. Monetary policy. The paramount macroeconomic objective of the CBA is to maintain the rate of inflation at no more than 3 percent per year. The new monetary program covering the period July 2002-June 2003 has been tailored to this objective. The demand for broad money is projected to increase by about 14 percent in 2002 and 13 percent in 2003, above the growth of nominal GDP amid continuing monetization of the economy. Reserve money is targeted to increase by about 10 percent. In particular, in light of the incipient inflation pressures observed in the first half of 2002, the CBA has adjusted its monetary policy with a view to ensuring that the inflation target for this year is attained.

24. Trade and foreign exchange regime. Armenia maintains no restrictions in the making of payments and transfers for current international transactions and a very liberal trade regime. During the program period, the government will not introduce multiple currency practices, impose restrictions on payments and transfers for current transactions, introduce restrictions on imports for balance of payments purposes, or conclude any agreements inconsistent with Article VIII of the Fund's Articles of Agreement. Armenia maintains a freely floating exchange rate regime, contributing to flexibility of relative prices of traded versus nontraded goods and internal and external balance. Reflecting higher projected external disbursements in 2002 and 2003, net international reserves are projected to increase during the program period, keeping the import coverage of gross reserves at about 3.8 months of imports.

25. Banking regulation and supervision. The CBA will continue to improve its banking supervision and prudential regulation capabilities, so as to ensure the stability of the banking system. In that context, the CBA will review the adequacy of the banking system's exposure to balance sheet foreign exchange positions and, if necessary, require additional capital to cover this risk. The minimum capital requirements for existing banks were raised to US$1.65 million effective July 2002, and will be raised further to US$2 million by mid-2003 and US$5 million by mid-2005. The CBA will continue with its plan to introduce a deposit insurance scheme, which will start to collect premiums in 2003. The deposit insurance scheme will exclude the banks under interim administration. In this connection, the CBA will mount a public relations campaign on the scheme. By March 2003, the authorities will agree with commercial banks on a strategy for the sharing of the start-up costs of the scheme, but the CBA will not make regular contributions to the scheme. The CBA will also complete preparations for the establishment of a fully operational credit registry as envisaged under the new CBA law. Furthermore, the CBA board has adopted a resolution on anti-money laundering, and the authorities have formed a committee under the leadership of the CBA chairman. This committee meets regularly to discuss these issues.

26. Banks under interim administration. The CBA will be moving expeditiously towards rehabilitation or liquidation of banks under interim administration. To that end, the CBA has resolved the conflict of interests between its roles in banking supervision and temporary administration of banks. Administrators of banks under interim administration now report to a newly established bank resolution department. The CBA has also prepared a detailed report regarding the situation of the three largest banks held under interim administration, and will discuss the results with the staffs of the Fund and the World Bank. The CBA will also issue clear guidelines for temporary administration of banks and its policy on open bank assistance and resolution of problem banks. In February 2002, two banks were merged and the new bank was placed under interim administration, bringing the total of such banks to eight. By February 2003, the five smallest banks (by size of assets) under interim administration will be liquidated, and least-cost diagnostic analyses of the three largest banks under interim administration and a resolution strategy will be completed by April 2003. These and other measures to be taken in this area are listed in Tables 2 and 3.

27. Non-bank financial institutions. As the financial sector of Armenia evolves, a number of non-bank financial institutions have been or are in the process of being established. Legislation to regulate these institutions, including micro-finance institutions, was approved in May 2002. In implementing the regulatory framework for the operations and supervision of non-bank financial institutions, the CBA will ensure the clear definition of functions and delineation of activities of these institutions to ensure that they do not become de-facto banks subject to less strict supervision.

28. Balance of payments. The current account deficit is projected to narrow further in 2002 and remain unchanged in 2003. Capital transfers will also be high owing to grants from the Lincy foundation. A remaining financing gap would be financed by IMF disbursements under the PRGF arrangement and structural adjustment loans from the World Bank.

29. External debt. The government will not accumulate external payments arrears during the program period, apart from those arising from debt service payments that become due pending the conclusion of the debt-to-equity swap agreement with Russia. This arrangement, which will be completed in a transparent manner in the next few months, will allow for the exchange of the outstanding external debt to Russia for equity positions in Armenian state-owned enterprises and lead to a substantial reduction in the present value of Armenia's external debt. The resulting savings to the government, together with adjustment lending from the World Bank, will help to clear remaining domestic arrears by mid-2003. The government has not been servicing its debt to Turkmenistan since October 2001 pending the conclusion of an agreement on the modalities for settling these obligations. Prior to the Executive Board meeting, all external arrears to Turkmenistan will have been cleared through cash payments, the export of goods, or deferrals by the creditor.

30. Energy sector. Following the merger of the four EDCs into one company earlier this year, the government has recently taken steps to privatize the company. As the new owner is not directly involved in the energy sector the government is discussing with the World Bank the feasibility of contracting a qualified private manager for the company. The transfer of the management of the company to a private operator and the privatization of the company are expected to be finalized by the end of the year. In the meantime, the government is taking strong measures to improve efficiency and reduce waste and theft in the energy sector through better financial management and technical improvements. A large number of energy sector staff has been released from employment in 2002 and the remuneration of employees in key areas such as sales and collection is now tied to achieving performance targets. With these and other measures, including taking a stricter position with respect to cutting off service to nonpaying customers, we anticipate that the annual technical loss rate can be reduced to 14.3 percent in 2002 and the excess loss rate to 10.4 percent, while the overall collection rate can be raised to at least 91 percent. Assuming normal weather conditions and composition of usage across customer groups, the primary deficit of the energy sector is expected to decline to AMD 6.3 billion (0.5 percent of GDP) in 2002.

31. Other key parastatals. In the fourth quarter of this year, the government will approve a financial rehabilitation plan for the energy, water, and irrigation sectors that will ensure further reduction of excess losses and elimination of payment arrears by water and irrigation companies. There will also be a full and detailed inclusion in the 2003 state budget of subsidies to the quasi-fiscal sector and other parastatals. Through tariff increases, technological improvements, and increased metering, the combined primary deficit of the energy and other quasi-fiscal sectors is projected to decline from 3.6 percent of GDP in 2001 to 1.2 percent in 2002. The new private operator for Nairit has committed to a repayment schedule of the company's outstanding debts and arrears, allowing for deferment of repayments for up to five years after an initial operation period of 18 months. Nairit will henceforth stay current on its energy bills or face an immediate interruption of power.

32. Privatization process. While the privatization of small and medium-sized companies was completed in the first years of transition, a number of large enterprises still remain under government control. Some of these companies could be restructured and turned operable by a strategic investor. The government is aware of the burden posed by the remaining state-owned enterprises on the state budget and is committed to resolve this situation within the next two to three years, in cooperation with the World Bank.

33. Civil service reform. Following the adoption of a law to establish a merit-based system for civil service, a council of experts from outside the government has been established and is in the process of drafting the secondary legislation and formulating an action plan consistent with the primary legislation.

34. Governance. The government anti-corruption strategy group, with the support of the World Bank, has prepared an interim report including a time-bound action plan, which is now to be discussed with key stakeholders. Suggested measures include streamlining legislation, public administration reform, enhancing the business climate, downsizing government institutions and, in some cases, replacing them with regulatory bodies. In order to improve budget presentation and enhance transparency of the budgetary process, a quarterly budget bulletin and a citizen's guide are now being published in Armenian and English in collaboration with external donors.

35. Program monitoring. Program monitoring will be carried out on the basis of semi-annual quantitative performance criteria and quarterly quantitative benchmarks (Table 1), structural performance criteria (Table 2), and structural benchmarks (Table 3), with semi-annual reviews based on end-December 2002 and end-June 2003 test dates. The quantitative performance criteria include: ceilings on the net domestic assets of the CBA, net domestic banking system credit to the central government, the overall cash deficit of the central government, domestic arrears of the central government, SFSI arrears, net disbursements of short-term external debt, contracting and guaranteeing of new non-concessional medium- and long-term external debt of more than one year (with a sub-ceiling on debt of 1-5 year maturities), and a continuous performance criterion on the non-accumulation of external arrears of the government. They also include floors on the net official international reserves of the central bank and tax revenues of the central government. There is an indicative floor and ceiling on reserve money, and an indicative floor on the primary balance of the energy sector. The latter was a performance criterion during the first annual program, but it will be treated as an indicative target because the financial performance of the energy sector is subject to a number of factors (e.g. weather patterns) that are outside the control of the authorities. Details on the definition and monitoring (and adjustors) of quantitative performance criteria are contained in the attached TMU.

36. Compilation and provision of information. To insure the effective monitoring of the program, the relevant ministries, the CBA, and the National Statistics Service will compile and share with the staffs of the Fund and the World Bank all core data on a timely basis, as specified in the attached TMU.

37. The government believes that the policies described above are adequate to achieve the objectives of the program, but will stand ready to take any additional measures that may be necessary for this purpose. A request for the fourth disbursement under the PRGF arrangement is contingent upon the observance of the performance criteria set out in Tables 1-2, and the completion of the third review under the program.

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GOVERNMENT OF ARMENIA
TECHNICAL MEMORANDUM OF UNDERSTANDING

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This technical memorandum defines the quantitative benchmarks, performance criteria, adjustors, and reporting modalities established in the Memorandum of Economic and Financial Policies (MEFP) for 2002-03.

I. Quantitative Targets

1. Quantitative targets for 2002-03 are presented in Table 1 of the MEFP and defined below. Benchmarks are set for end-September 2002, performance criteria are set for end-December 2002, and indicative targets are set for end-March and end-June 2003.

2. Reserve money targets are indicative and include a floor and a ceiling. They are subject to a daily band of plus or minus 2 percent computed from the quarterly average standard deviation of excess reserves held by banks in percent of quarterly reserve money during 1998-2001. If reserve money breaches the corridor, the CBA will consult promptly with IMF staff on the appropriate policy response. Reserve money of the Central Bank of Armenia (CBA) is defined as the sum of currency issue, required and excess reserves, and current and time deposit accounts of certain resident agents.

3. The program targets a minimum level of net official international reserves (NIR) of the CBA. The stock of such reserves will be calculated as the difference between total gross international reserves and official reserve liabilities. Total gross official international reserves are defined as the CBA's holdings of monetary gold (excluding amounts pledged as collateral or in swaps), holdings of SDRs, any reserve position in the IMF, and holdings of convertible currencies in cash or in nonresident financial institutions (deposits, securities, or other financial instruments). Gross reserves held in the form of securities are marked to market. Gross reserves are reported net of the balance on the government's Special Privatization Account (SPA). Capital subscriptions in foreign financial institutions and illiquid foreign assets are also excluded. There is no reporting on financial derivatives and other off balance sheet positions, as the CBA does not currently trade in such financial instruments. However, if the CBA decides to commence such trading it will promptly notify the IMF staff in order to establish proper reporting requirements in this regard. Official reserve liabilities shall be defined as outstanding liabilities to the IMF and convertible currency liabilities of the CBA to nonresidents with an original maturity of up to and including one year. NIR is monitored in U.S. dollars, and, for program monitoring purposes, assets and liabilities in currencies other than the U.S. dollar shall be converted into dollar-equivalent values using the exchange rates as of December 31, 2001 (Attachment III, Table 1).

4. The program targets a maximum level of net domestic assets (NDA) of the CBA. NDA is defined as reserve money less NIR plus medium- and long-term liabilities of the CBA, where the dram-equivalent values of NIR and medium- and long-term liabilities are calculated using the end-2001 official exchange rate of dram 561.81 per U.S. dollar. NDA is composed of net credit to the general government; outstanding credit to domestic banks by the CBA (including overdrafts) minus liabilities not included in reserve money (exclusive of accrued interest), and other items net.

5. The government balance refers to the central government (state budget) only. The State Fund for Social Insurance (SFSI), whose overall cash balance must be zero on an annual basis, will be monitored by a separate performance criterion covering the stock of SFSI arrears. Local governments—which are not allowed to borrow either domestically or externally—are excluded from the fiscal accounts, as there are reporting lags on their activities.

6. The US-based Lincy Foundation is helping Armenia's development through the extension of grants to finance various investment projects. The project implementation units, which carry out grant-financed projects, maintain accounts at the CBA. These grants are recorded in the fiscal accounts as external grants on the revenue side and as foreign-financed capital expenditure on the expenditure side.

7. Net credit from the CBA to the central government includes the CBA's holdings of treasury bills and treasury bonds less central government deposits (including deposits of donor-financed project implementation units, the Lincy foundation, and balances of proceeds from the sale of humanitarian assistance). Treasury bonds are valued at the purchase price and treasury bills are valued at the purchase price plus the implicit accrued interest. Except for treasury bills, accrued interest is excluded from net credit. The CBA does not extend direct credit to the central government. The source of the data to be used for program monitoring is specified in Section III below.

8. Net credit from commercial banks to the government includes: (1) gross credit from banks to the central government less central government deposits with banks (excluding accrued interest but including the counterpart funds of certain government onlending to the economy financed by the Lincy Foundation and the World Bank); and (2) banks' holdings of treasury bonds (valued at the purchase price and excluding accrued interest) and treasury bills (valued at the purchase price plus the implicit accrued interest). Accordingly, net credit of the banking system to the central government is the sum of net credit from the CBA and net credit from commercial banks; it was equivalent to dram 9.5 billion on December 31, 2001.

9. External debt limits apply to new medium- and long-term external debt1 with original maturities of more than one year, which are contracted or guaranteed by the government (as defined above) or by the CBA, with a sub-limit on such debt with maturities of more than one year up to and including five years. In addition, there are limits on disbursements of short-term external debt contracted or guaranteed by the government or the CBA; all obligations with original maturities of up to one year fall under this limit, except normal import-related credits.

10. The program ceilings on the contracting and guaranteeing of new nonconcessional medium- and long-term debt, by the government or the CBA, will apply to all forms of external debt with maturity greater than one year. The only liabilities excluded from the limits are sales of treasury bills or treasury bonds to nonresidents, provided the sales go through the regular auction mechanism and involve no exchange rate guarantees; and concessional loans. For program purposes, a loan is considered concessional if the grant element is at least 35 percent calculated using a discount factor based on the Commercial Interest Reference Rates (CIRRs) published by the OECD plus margins depending on the loan maturity.2 The average of the CIRRs over the last ten years will be used for loans with a maturity of at least 15 years and the average of the CIRRs for the preceding six months will be used for shorter maturities. For the purpose of monitoring compliance with the targets, all agreements concluded in respect of rescheduling or refinancing of existing debt shall be excluded from the limits. Transactions subject to these ceilings shall be valued in the contracted currencies and converted into U.S. dollars at the average monthly market exchange rate in the month when the borrowing commitment was contracted.

11. External arrears of the central government or the CBA will consist of all overdue debt-service obligations (i.e., payments of principal and interest) arising in respect of loans contracted or guaranteed by the government or the CBA since Armenia's independence, unpaid penalties or interest charges associated with these arrears, and overdue payments owed by the government or the CBA on imports received subsequent to independence.

12. The central government budget balance is defined from the financing side on a cash basis as the sum of domestic banking system net financing, domestic non-bank net financing, and external net financing to the central government. Domestic banking system net financing is measured as the change during the period of net domestic banking system credit to the government. Domestic non-bank net financing is measured as the sum of: (1) the change during the period of outstanding treasury bills and bonds to non-banks (including accrued interest for treasury bills and excluding accrued interest for treasury bonds);3 and (2) any other disbursement or transaction (other than proceeds from privatizations which are deposited into the SPA) that increases non-banks' claims on the central government, less amortizations made by the central government to private resident non-bank agents. The Ministry of Finance and Economy (MFE) will provide these data in consultation with the CBA. External net financing is measured as total debt—increasing disbursements from non-residents to the central government less total amortizations from the central government to non-residents. All foreign-currency denominated transactions are recorded in drams using the prevailing exchange rate at the time of the transaction.

13. Proceeds stemming from the selling of enterprises in the context of the annual privatization program are deposited into the SPA. The account is held at the CBA and the proceeds are invested abroad together with the CBA's international reserves. However, these proceeds are not included in the definition of the monetary accounts of the banking system. Any withdrawal from the SPA (including accrued interest) will be accounted for as privatization proceeds used to finance the budget. Proceeds from other privatizations are included in the regular budgetary accounts as capital revenue. These proceeds are deposited in a privatization account, held at the CBA and included in the definition of net credit to the central government, or spent for general budgetary purposes.

14. Tax revenue is defined in accordance with Government Financial Statistics (GFS) 1986, section IV.A.1. Total revenues collected by the Ministry of State Revenues and the Customs Committee are classified as follows: VAT (of which: presumptive tax on cigarettes and petroleum), excises (of which: presumptive tax on cigarettes and petroleum), enterprise profit tax, personal income tax, land tax, customs duties (of which: presumptive tax on cigarettes and petroleum), other presumptive taxes, simplified tax, property tax, and other taxes (of which stamp duties and environmental taxes).

15. The program targets maximum levels for the stock of domestic government arrears and the stock of SFSI arrears.4 For program purposes, domestic arrears are defined as follows. With respect to wages, contributions to the pension fund, family allowances, and amortization and interest payments (domestic), the stock of arrears is defined as all unpaid claims outstanding as of the end of the month. For all other expenditure categories, arrears are defined as the stock of unpaid claims, as verified by the recipient of the goods and services, which has been outstanding for more than 30 days as of the end of the month.

16. The government will provide a detailed quarterly cash flow for the energy sector. The energy sector is defined by the following companies: (1) Hrazdan thermal power plant; (2) Yerevan thermal power plant; (3) Metsamor nuclear power plant; (4) Sevan-Hrazdan Cascade hydro-power plant; (5) Vorotan hydro-power plants system; (6) High Voltage Electricity Network; (7) Armenergo; (8) Armenia Electricity Network Company; (9) Armgazprom; and (10) Armtourtrade. The cash flow of the energy sector consists of the consolidation of the cash flows of these enterprises excluding Armgazprom. The program will target the primary balance of the energy sector, where the primary balance is defined as current revenues less total expenditures excluding all interest payments and capital expenditures related to foreign-financed projects.

II. Adjusters

17. The quantitative performance criteria and benchmarks under the program are subject to the following adjusters:

i. Non-programmed foreign-finance project disbursements. The cash balance of the central government will be adjusted downward (upward) by the full amount of cumulative higher (lower) than programmed foreign-financed project disbursements (excluding structural adjustment lending by the World Bank) as shown in Table 2.

ii. Non-programmed World Bank SAC disbursements. During the program period, the ceiling on the stock of arrears and the floor on the cash balance of the government will be adjusted downward (upward) for any financing higher (lower) than the one reported in Table 3 arising from World Bank SAC disbursements. If the funds received exceed the amount required to bring the stock of domestic arrears to zero, the remaining balance will instead translate into an automatic downward adjustment of the net credit to government target, and the authorities will subsequently reach understandings with the staffs of the Fund and the World Bank on the use of this amount in the budget. In case of a shortfall in SAC financing, the ceilings on the stock of arrears will be capped at AMD 26.2 billion at end-December 2002, AMD 23.2 at end-March 2003, and AMD 11.3 at end-June 2003, the cash balance of the government will not be further adjusted, and the government will restrain budgeted expenditure increases as needed to meet the arrears targets.

III. Data Reporting

18. The government, the CBA, and the National Statistics Service (NSS) will provide the IMF with all necessary data to monitor economic developments and program performance. Unless otherwise indicated, the information will provided be in accordance with the definitions elaborated in the previous section.

19. Balance sheet of the CBA. The CBA has provided the IMF staff the chart of accounts and it will notify the staff of any revisions thereto. Weekly (summary5) and monthly end-of-period (by chart of account) data on the balance sheet of the CBA will be reported within seven days of the end of the reporting period.

20. Balance sheet of the banking system. Monthly banking system data, in the form of a monetary survey, as well as the consolidated balance sheet of the commercial banking system (by chart of accounts), will be reported to the IMF within 21 days of the end of each month.

21. Treasury bill and coupon bond financing The CBA will provide monthly data to the IMF within seven days of the end of each month by the following categories of holders: the CBA, resident banks, resident non-banks, and nonresidents.

22. International reserves. The CBA will provide monthly data (by chart of accounts) within 14 days of the end of each month on both gross and net official international reserves. These data will be provided in two variants: (1) at program exchange rates; and (2) at actual official exchange rates.

23. Non-tax and capital revenue. The MFE will report on a monthly basis non-tax revenue, capital revenue, cash grants and proceeds from the sales of humanitarian assistance. This information will be reported within seven days of the end of each month.

24. External debt. The MFE, in collaboration with the CBA, will provide information on the disbursements and outstanding stock of short-term external debt; on contracting and guaranteeing and the outstanding stocks of medium- and long-term external debt of the government and of the CBA; any stock of outstanding arrears on external debt service payments, and the total amount of outstanding government guarantees and external arrears within 21 days of the end of each month.

25. Tax and expenditure arrears. The Ministry of State Revenues will report on an end-of-month basis the amount of outstanding tax arrears, by the end of the following month. The reports on expenditure arrears in the format of the attached Table 4 will be compiled monthly by the MFE for the central government and the SFSI separately, and reported by the MFE to the IMF within 45 days of the end of each month for government arrears and within 10 days for SFSI arrears.

26. Budgetary sector employment. The MFE will provide quarterly updates on employment by ministries and on average wages within one month following the end of each quarter.

27. Budgetary and extra budgetary data. The MFE will report to the IMF, on a monthly basis and within seven days of the end of each month, total revenue collected separately by the SFSI, the Ministry of State Revenue and the Customs Committee. Quarterly data on budgetary execution will be reported to the IMF by the MFE and the SFSI within one month following the end of each quarter. All cash receipts, all cash expenditures (including debt-service payments), and external and domestic borrowing operations will be part of this report. Expenditure data will be provided according to both economic and functional classifications, consistent with GFS methodology. In addition, budgetary financing by the MFE will be reported by economic and functional classification on a monthly basis by the end of the following month.

28. Non-budgetary domestic arrears. The MFE will coordinate—in collaboration with the Ministry of Energy, the CBA, and the NSS—a report to the IMF on a monthly basis on the stock of arrears of the 50 largest enterprise debtors, which are in arrears to the banking system, and energy arrears of households and enterprises. This information is to be provided within 28 days of the end of each month.

29. Balance of payments data. The NSS will provide: (1) on a monthly basis detailed export and import data within 28 days of the end of each month; and (2) on a quarterly basis a balance of payments within two months of the end of each quarter.

30. Energy sector payable and receivable debts. The MFE will provide monthly reports on the end-of-month stock of accounts payables and accounts receivables of the consolidated energy sector (defined in paragraph 19) with a lag of no more than 28 days. It will also provide the cash flow information with a lag of 45 days as displayed in Table 5.6

31. Privatization proceeds. In consultation with the CBA, the MFE will provide to the IMF information on: (1) the balance on the SPA at the end of each month; and (2) all gross additions and gross withdrawals specifying the purpose of each transaction during that month. The information will be provided on a monthly basis no later than seven days after the end of each month.

32. Other financial sector information. The CBA will provide information on the foreign exchange market (including the official, buying, and selling exchange rates, inter-bank turnover, and the volume of CBA sales and purchases) and interest rates by maturities (including the refinance rate, the inter-bank rate and volumes, the treasury bill and coupon bond yields and volumes by maturity, and bank deposit and lending rates by maturity). The CBA will also provide data on commercial banks' prudential ratios (including liquid asset ratios, capital adequacy ratios, open foreign exchange limits, and percentage of classified loans by category). These data will be provided on a monthly basis within 21 days of the end of each month. In addition, the CBA will provide other data as specified in CBA Resolution No. 201 (December 6, 1999).

33. Real sector. The NSS will notify the IMF of the monthly CPI by category by the fifth day of the following month, and convey quarterly GDP estimates within two months of the end of each quarter. The CBA will also submit the monthly index of core inflation within 21 days of the end of each month.


1 The term "debt" shall have the meaning set forth in Section 9(a) of the Guidelines on performance criteria on external debt, as modified by the Executive Board Decision No. 12274-(00/85) of August 24, 2000, and shall include all current (noncontingent) liabilities, which are created under a contractual arrangement through the provision of economic value in the form of financial or nonfinancial assets (including currency) or services, and/or income, and which require the debtor to make one or more payments in the form of such assets (including currency) or services at some future point(s) in time to discharge the principal and/or interest liabilities incurred under the contract. In particular, all instruments that share the characteristics of debt enumerated above (including loans, suppliers' credits, and leases) will be included in the performance criterion on external debt.

2 The margins are: 0.75 percent for repayment periods of less than 15 years, 1 percent for 15-19 years, 1.15 percent for 20-29 years, and 1.25 percent for 30 years or more.

3 Domestic non-bank holdings of treasury bills and treasury bonds are defined as total outstanding treasury bills and bonds less holdings by the banking system and the SFSI.

4 In the first annual program, the performance criterion on the stock of government arrears referred to the sum of domestic and external arrears. To facilitate monitoring, and since there is a separate performance criterion on external arrears, the current program targets only the stock of domestic arrears.

5 As defined in CBA Resolution No. 201 (December 6, 1999).

6 The table is in summary form. A more comprehensive table will be provided in the form of an Excel workbook (the format of which has been agreed with IMF staff).