For more information, see Republic of Armenia and the IMF

Republic of Armenia: Policy Framework Paper, 1996-1998

Introduction and Recent Developments

Economic and political background

1. The Armenian economy recorded a cumulative decline in measured output between 1990 and 1993 of 75 percent, reflecting a combination of adverse exogenous developments and accommodating macroeconomic policies. The country's infrastructure had been severely damaged by the devastating 1988 earthquake, which also caused a major refugee problem. In addition, Armenia suffered massive losses due to the breakdown of trade arrangements with the FSU and CMEA countries, the economic blockade associated with the conflict in Nagorno-Karabakh, and disruptions of transit routes due to civil strife in Georgia. During 1992-93, Armenia incurred unsustainably high fiscal deficits, and experienced high inflation as a member of the disintegrating ruble area. Against this background, the Government introduced a national currency, the dram, in November 1993, substantially tightened financial policies, and accelerated the pace of structural reform. Also, on July 27, 1994, Azerbaijan, Karabakh, and Armenia signed an agreement in Moscow formalizing the ceasefire (which has held since May 1994) and providing for the immediate commencement of negotiations of a comprehensive peace agreement. As a result, the economy stabilized and growth resumed in 1994. Parliamentary elections in July 1995 returned the previous coalition to power and strengthened the position of the ruling party. The blockade of westward and eastward routes remains in effect, although an air corridor over Turkey has recently been opened.

2. The IMF and the World Bank have been partners of the Government of Armenia since the beginning of the reform process. The Government's comprehensive program of stabilization and structural reform was supported in December 1994 by a first purchase under the Systemic Transformation Facility (STF), coinciding with a Rehabilitation Credit from the World Bank. Additional assistance included large grants from the U.S. and aid from other bilateral and multilateral donors. In June 1995, the Fund approved a 12-month program stand-by arrangement (SBA) in support of Armenia's program for the period from June 1, 1995 to May 31, 1996.

The 1995-96 program

3. The principal objective of the Government's economic program in 1995-96 has been to establish the necessary conditions for sustainable economic growth and to begin a recovery in living standards. Macroeconomic policies under the SBA aimed to: (i) reduce inflation to around 30 percent during 1995, and to 19 percent during 1996; (ii) increase real GDP by at least 5 percent in 1995 and by an even higher rate in 1996; and (iii) ensure that the Central Bank of Armenia's (CBA) gross external reserves position is further bolstered. The main instruments for achieving the stabilization objectives are a further improvement in public finances and the implementation of an appropriately tight monetary policy. Supporting structural reforms to achieve efficiency and raise capacity utilization include further price liberalization, downsizing the civil service, strengthening the administrative capacity of the Government, continued privatization and restructuring of state enterprises, financial sector reform, and further liberalization of the trade and exchange system.

4. Industrial output grew by around 10 percent in 1994 and has continued to grow during the first three quarters of 1995. Agricultural output has increased by 3 percent in 1995. Average monthly inflation fell from over 28 percent in 1994 to 1.9 percent in the first eleven months of 1995, aided by a massive improvement in the fiscal situation and supporting monetary policy. In particular, the fiscal deficit fell from 56 percent of GDP in 1993 to 16 percent in 1994 and is expected to decline to under 9 percent in 1995, driven primarily by sharp cuts in expenditures. Monetary policy managed to keep the growth of monetary aggregates under control in 1995, despite large and less than fully sterilized official capital inflows. The monetary objectives were also aided by an increased demand for drams. Exchange rate policy achieved a remarkably stable nominal exchange rate vis--vis the U.S. dollar of dram 400-410 per U.S. dollar during the first eleven months of 1995, resulting in a slight real appreciation of the currency. The external current account deficit (excluding official transfers) was equivalent to 36 percent of GDP in 1994 and 28 percent in the first three quarters of 1995, while gross official reserves reached 1.7 months of imports of goods and nonfactor services at end-November 1995. External debt increased from US$200 million at end-1994 to US$356 million at end-September, due primarily to disbursements from the World Bank, the EBRD, and Russia. Scheduled debt service increased in 1995, resulting in a debt-service ratio of 19.9 percent for 1995.

5. The Government has made substantial progress in structural reforms: only profit margins of selected monopolistic state-owned enterprises and the prices of a few services, including utilities, rents and urban transport remain under government control. With almost 90 percent of arable land and about 62 percent of formerly state-owned housing stock privately owned as of end-October, and privatization of small-scale enterprises proceeding well, the main problem in privatization has been slow progress with medium- and large-scale enterprises, although efforts have been made to accelerate the process in the last few months. Under the SBA-supported program, the Government undertook to substantially downsize the civil service while raising average budgetary wages over a period of four years. The elimination of restrictions on interbank foreign exchange transactions, on cash withdrawals from banks, and the increased frequency of foreign exchange auctions in 1995 led to the unification of exchange rates. Armenia also maintains a liberal trade regime: the new tariff structure introduced in January 1995 has a weighted average tariff rate of below 5 percent; there are no taxes on exports, and quantitative trade restrictions are limited to goods that pose health, environmental, or security hazards. Clearing trade accounted for under a fifth of total trade in the first half of 1995. The reform of the financial sector led to the abolition of directed credits from the beginning of 1995; as a result, CBA credit auctions became the main means for extending credit to banks. Finally, a substantial strengthening of prudential norms for commercial banks has led to the formal closure of 37 banks (out of a total of 72 resident banks and foreign branches) since early 1994.

Risks and remaining tasks

6. Despite dramatic improvements on both the stabilization and structural fronts, economic prospects in Armenia are subject to a great degree of uncertainty over the medium term. The fiscal situation remains weak, due to tax compliance problems and the absence of a Treasury, which precludes government financial planning or cash management during budget implementation. Soft-budget constraints remain the norm in much of the state enterprise sector, while the share of the private sector in measured output remains modest, although a substantial informal sector exists. The absence of well-functioning markets for real estate and financial assets hinder efficient resource allocation. There is very little confidence in the banking system, which is undercapitalized and inefficient, and is thus relegated to a marginal role in savings mobilization and intermediation. A large portion of banks' assets remain nonperforming, reflecting in part previous policies of directed credit, raising the possibility of a future need for budgetary assistance. A similar situation exists in the energy sector which has become a major source of quasi-fiscal financing for the economy through arrears on payments for energy supplied. Since the bulk of bank credit is short term, investment has to be largely financed from enterprises' retained earnings or from foreign sources. The stock of gross interenterprise arrears in June 1995 was equal to twice the total banking system credit to the economy. The trade embargo, while becoming more permeable, still poses a major impediment to interregional trade, and clearing trade with Turkmenistan remains a major source of distortions in the economy. As the rate of domestic savings is negative, Armenia will need external financing in the next few years, preferably on concessional terms, to finance essential investment in infrastructure. Finally, weaknesses remain in the quality and timely availability of economic and financial data for the formulation and assessment of macroeconomic policies (see paragraph 47).

TABLE OF CONTENTS

Objectives and Policies, 1996-98

Macroeconomic and structural policies

7. The main objectives of the Government's macroeconomic program for the period 1996-98 are to consolidate and deepen the stabilization of the economy, and to further accelerate structural reforms to bolster prospects for sustained and significant growth. Macroeconomic policies under the medium-term program are aimed to reduce inflation further to under 9 percent per annum by the end of the three-year period, relying on tight monetary policy and continued revenue efforts and expenditure reductions in public finances, leading to an increase in the national savings rate. At the same time, a further increase in the level of the CBA's gross external reserves is programmed. The primary means for achieving a strong supply response to policies and for enhancing productivity during the program will be strong systemic reforms; these will take place in the financial sector, through the privatization and restructuring of large state enterprises, in the energy sector, and in the budgetary sphere, with emphasis on improving public expenditure policy and institution building. The program also includes the development of an effective and efficient social safety net to protect the poor, and amendments to the legal and regulatory framework.

8. While some enterprises can expand output quickly relying on unused capacity, sustained economic growth will require considerable new investment. This will have to be financed from external sources during the initial years, while domestic savings of both government and nongovernment sectors recover from the negative levels of the past years. However, it is also expected that, as the growth process gains momentum and tensions with some neighboring countries subside, Armenia will be able to attract private investment both from its widespread diaspora and other investors (see paragraph 25). Based on the strength of the adjustment program, and aided by the remaining slack in the economy due to the exceptionally large drop in output during 1991-93, real GDP growth is expected to increase to 6.5 percent in 1996 and to 7 percent in 1997 and 1998.

Fiscal policy

9. One of the primary objectives of the medium-term program is to reduce the role of government and create an enabling environment for the private sector, which is envisaged to take over as the engine of growth. To this end, the medium-term fiscal program continues to strengthen the fiscal consolidation that has occurred over the past two years. However, in certain cases (including the energy and financial sectors) budgetary expenditures may be necessary in the near term to minimize the risk of greater fiscal exposure in the future. The fiscal deficit is programmed to decline from about 8 percent of GDP in 1996 to under 5 percent in 1998, due to both enhanced domestic resource mobilization and continued compression of current expenditures. Over the program period, total revenues and grants are programmed to increase by about a half percentage point of GDP, with a 1.7 percentage point of GDP increase in tax revenues and a 30 percent decline in external grants to the budget. During the program period, while total expenditure will decrease by 3.1 percentage points of GDP, the level of capital expenditure will stabilize at over 5 percent of GDP and increase thereafter (see paragraph 14). In this context, a public expenditure review will be completed by the World Bank in Spring 1996, leading to rationalized and better targeted expenditures.

Reforms in the fiscal sector

10. The challenges facing the Government include adapting, over the medium term, to the decline in the share of grants in revenue, and reducing current expenditure, while protecting the priority areas of health, education, and the social safety net. On the revenue side, a substantial number of new tax measures have already been introduced. Excise taxes on gasoline and automobiles became effective on December 1, 1995; and excises have been extended to non-CIS goods that transit through a CIS country in December, 1995. However, many of the new rates still remain low by international standards. Tax collections are also expected to benefit from administrative improvements, including the modernization and computerization of the State Tax Inspectorate, and the adoption of strengthened assessment and collection powers by December 31, 1996. In addition, exemptions from the VAT and other taxes will continue to be eliminated. For 1997 and beyond, emphasis will be placed on necessary structural improvements in the tax system; tax collections will also benefit from the elimination of clearing trade and a resolution of the interenterprise arrears problem, both of which have significantly contributed to the growth of tax arrears.

11. The adoption of a Treasury system to improve the authorities' expenditure management capacity will be a critical component of the fiscal program. A treasury system is necessary both to integrate the functions partially carried out by several different institutions, and to develop presently non-existent, but necessary functions. Its gradual introduction will include the following steps: (i) the adoption of a decision to separate budgetary and treasury functions within the Ministry of Finance in early 1996; (ii) the setting up of two separate divisions for budget creation and execution in the Ministry of Finance; (iii) the creation of a ledger system of accounts that will replace the bank accounts of spending agencies; (iv) the consolidation of government bank accounts into a single Treasury Account; and (v) the replacement of the system of cash rationing with a more flexible system of financial planning. In addition, the present system of borrowing from the CBA via fixed contracts will be replaced by a credit line arrangement, which will reduce expenditure and also provide the Ministry of Finance with more accurate information about the position of the Government vis--vis the CBA on a daily basis. The Ministry of Finance will establish a Debt Management Unit that will track all government debt and debt-service obligations, including contingent liabilities. This unit will: become the sole borrowing agent for the Government; be the only government entity with the authority to contract or guarantee new external or domestic government borrowing, and--in close consultation with the CBA--set quarterly limits for external and domestic government debt and determine the timing and volume of treasury bill sales. To further enhance its effectiveness, the CBA, ministries, and state-owned enterprises involved in energy trade will be required to keep this unit informed of all external debt issues in the form of monthly debt reports.

Budgetary sector employment reform

12. To respond to the needs of a market economy, the budgetary sphere will be extensively restructured. The Government will conduct civil service staffing reviews that are expected to lead to a decline in budgetary sector employment to 360,000 by June 1996, 320,000 by June 1997, and 290,000 by June 1998. The sharpest reductions in employment are to come in agriculture and communal services, where employment would fall by approximately 80 percent; in most other budgetary sectors, employment is envisaged to fall by around 30 percent. Achieving the targeted reduction in budgetary sector employment by the end of 1998 will require not only a civil service restructuring plan but also significant changes in the way the Government delivers health and education benefits (see paragraphs 36-37). Technical assistance will be sought from the World Bank and other donors to implement this program. Expenditures related to the civil service restructuring program are included in the fiscal projections, but are expected to be relatively small. Severance benefits (three months of wages) are relatively low; if, as expected, working pensioners will be the main targets for retrenchment, no increase in pension expenditures will occur, since they already receive full pension benefits; moreover, they are ineligible for severance benefits.

Wage and incomes policy

13. The average monthly state sector wage in Armenia at end-September 1995 was about US$17, with the average budgetary sector wage, at around US$8, being only a third of the nonbudgetary sector wage. In conjunction with budgetary employment restructuring, real average budgetary wages are projected to rise by about 74 percent by 1998. Increases in budgetary wages will result in a decompression of the wage scale and an increase in ratio of budgetary to nonbudgetary wages. However, such increases will be: (i) tied to the achievement of the employment targets outlined above; and (ii) consistent with programmed reductions in the level of the budget deficit. At present, the main instrument of incomes policies is the "excess wage tax" imposed on wages exceeding ten times the minimum wage. Since this tax is also an important source of revenue, the Government intends to abolish it only on December 31, 1996, in tandem with increases in the enterprise profit and personal income tax rates so as to remain at least revenue neutral. Projected improvements in tax administration will help to limit the increases in the enterprise profit tax and income tax required to generate the necessary revenues to remain revenue neutral.

Public investment program

14. Since future economic growth depends on the improvement and expansion of Armenia's infrastructure, investment in physical infrastructure will be the top priority of the Government's public investment program. The Government expects to continue to rely on external assistance for many infrastructural projects, although an increasing share of these expenditures will be financed from domestic resources. In 1996, some public investment will be dedicated to the construction of housing, especially in the earthquake area, where the need is especially acute; to upgrading Armenia's electricity generating capacity; and to upgrading irrigation systems as an important measure to boost agricultural output.

Monetary and exchange rate policy

15. The CBA's principal medium-term objective is to develop further its capacity to formulate and implement monetary policy in order to achieve low inflation. At the same time policy will be directed toward facilitating the creation of a banking system that channels domestic and foreign savings efficiently to investment, and provides an improved range and quality of financial services. To achieve these goals, the CBA will develop and enhance indirect instruments of monetary policy while implementing a wide array of structural reform measures designed to consolidate the banking system and increase its currently marginal role, strengthen banks' capital base and prudential standing, improve banks accounting and improve the legal and regulatory framework. These reforms are expected to enhance sustained economic growth by deepening financial intermediation; in particular, by leading to the emergence of term financing, and by imposing a hard-budget constraint on enterprises, through the elimination of quasi-fiscal support via bank financing.

Financial sector reform

16. Development of monetary policy instruments. The CBA will coordinate with the Ministry of Finance in sterilizing large foreign financing inflows and in developing and expanding a primary and secondary Treasury bill market. With respect to the latter, in 1996 the Ministry of Finance will begin to announce regularly a schedule of Treasury bill auctions, including indicative volumes. In an effort to enhance the process, the CBA will: (i) coordinate with the Ministry of Finance, and in particular, the Debt Management Unit within the Treasury when it is established, in working out a domestic debt-management strategy, consistent with budget financing needs; and (ii) introduce a book-entry system to facilitate secondary market trading in T-bills. The CBA will then begin open-market operations, as part of its medium-term strategy of phasing out credit auctions as the primary source of bank liquidity and will provide credit to banks only against collateral. As a first step toward improving banking supervision, a detailed audit of all banks, but with particular emphasis on Ardshinbank, Armagrobank, Armeconombank, and Armimpexbank will be undertaken by the CBA with the assistance of experienced international bank examiners. The World Bank will help the CBA in mobilizing financing for this work. The Bank will also provide assistance for the training of on-site supervisors. This work, which will be designed to evaluate the quality of bank portfolios, thus confirming the appropriateness of bank decisions on loan loss provisions and writeoffs and the quality of bank management and control systems, is due to start in March 1996. In addition, the CBA will develop improved reporting procedures for banks and begin comprehensive training for on-site examiners by end-June 1996. The CBA will foster competition in the banking sector by encouraging the entry of foreign banks into the domestic banking system (on the basis of equal treatment of all banks), and through further technical improvements in the electronic payment, clearing and settlement process, to improve the domestic payments system.

17. The program stresses the importance of strengthening banks' capital bases and of rapid progress in bank restructuring given the fragility of the banking system. Thus, the CBA: (i) has revised loan-loss provisioning rules in conjunction with new tax deductibility regulations for loan-loss write-offs; and (ii) issued a resolution to all banks in December 1995, recommending the stopping of dividend payments from unrealized gains, or by banks that do not meet prescribed prudential regulations, in order to avoid undercapitalized commercial banks being stripped of capital through dividend payments. Provisions for bad loans extended after January 1, 1996 will be classified as expenses and will become tax deductible; write-offs made on bad loans extended before 1996 will be allowed in equal installments on a quarterly basis up to January 1, 1998, and thus will become tax-deductible. International accounting standards will be used to assess whether gains are unrealized or banks are undercapitalized. Moreover, the Government and the CBA will engage in a clarification and improvement of the legal framework in which banks operate. The Government will refrain from recapitalizing banks from budgetary resources until such time as bank restructuring has advanced to a stage where further losses can be avoided. Both the Government and the CBA will continue to refrain from participating in any form of deposit insurance scheme, particularly while bank supervision is less than fully developed and the enforcement of bankruptcy for defaulters is not automatic, because of a great danger of moral hazard and the possible fiscal consequences. Finally, utilizing technical assistance from the World Bank, commercial banks will continuously build up risk assessment expertise in lending departments to help avoid the emergence of future nonperforming assets problems.

18. The current system of relatively high unremunerated reserve requirements imposes a sizable implicit tax on the banking system at the current high level of real interest rates. The Government is committed to bringing about a substantial reduction in this nontransparent tax, which also plays a significant role in high interest rate margins. Reserve requirements will be gradually lowered, as alternative monetary policy tools are developed and become operational. The CBA will consider remunerating required reserves over the medium term. Real interest rates are also expected to decline over the medium term, as improvements in both the banking system and the legislative framework, coupled with continued progress in macroeconomic stabilization, are reflected in lower risk premia.

19. The CBA and the Ministry of Finance will formulate a program to reorganize the Savings Bank. Any reorganization program will rationalize the number of bank branches and staff to reduce operating costs, will strengthen the management and control systems of the bank, and will open up for competition all activities of the bank. In addition, if the restructuring plan retains a program of retail and or government services, these services will be remunerated at least at cost. The program will include a detailed break-even analysis for the bank. Prior to the completion of the reorganization program, the bank's portfolio will be restricted to assets of exceptionally high quality (primarily T-bills). Therefore, the bank has been instructed in December 1995 to halt new lending to enterprises and individuals and the interbank market, pending the adoption and implementation of the restructuring program.

Exchange rate policy and reserves

20. Armenia will pursue a market-oriented exchange rate policy, whereby the exchange rate is determined by supply and demand conditions. One of the aims of Armenia's exchange rate policy throughout 1995 has been the relative stability of the dram. While exchange rate policy will continue to aim for stability of the nominal exchange rate as long as it is consistent with monetary objectives, it will also allow for some flexibility. This is important during the period to come, since large structural changes are expected to occur (including changes in the trade pattern after the lifting of the economic blockade), autonomous capital flows remain unpredictable, and since the dram is likely to be undervalued in real terms at present relative to its long-run equilibrium level. Should demand for drams over the medium term increase more than anticipated, the CBA will respond with a mix of foreign reserve accumulation and exchange rate appreciation.

21. In light of the current relatively modest level of foreign exchange holdings of the CBA, rising debt-service obligations, and continued need for balance of payments support in a volatile external environment, the program targets increases in official reserves. In this regard, the CBA will continue to refine its reserve management strategy throughout the program period. The management of the CBA will present, for approval by its board, an updated strategy on limiting risks. The audit of the CBA will also focus on this activity and the recommendations of the auditors for improving controls and limiting risks will be incorporated into the strategy.

Exchange and trade policies, debt monitoring

22. With the lifting of the restriction on interbank foreign-exchange transactions, the CBA is in a position to set the official exchange rate as a weighted average of the daily interbank foreign-exchange auction rates; this step has been taken in December 1995. In order to enhance the development of the interbank market for foreign exchange, the CBA will progressively withdraw as a regular participant from the foreign-exchange auctions. Moreover, in an effort to encourage development of the nonauction interbank market, the CBA will start to deal in this market with domestic banks. Armenia now maintains a relatively liberal exchange system. During the program period, we intend to eliminate any remaining restrictions on payments and transfers for current international transactions thus paving the way toward accepting the obligations of Article VIII, Sections 2, 3 and 4 of the Fund's Articles of Agreements.

23. On trade reform, the current five-band tariff structure has been streamlined into a regime with two bands at zero and 10 percent in December 1995. To broaden the tax base, the zero-rated products were limited to staple foods, agricultural products, mazut, kerosene, essential pharmaceutical products, basic clothing, shoes, and raw materials used intensively in the production of exports. Technical assistance in making the new tariff regime operational is envisaged from the IMF. The minimum "reference" export prices for basic metals will be used only as a measure to prevent tax evasion. From January 1, 1996, any difference between the reference price and the price specified in the relevant export contract is taxed at the enterprise profit tax rate. Efforts will continue to be made to improve customs administration. Technical assistance and training will be sought from the UNCTAD, the World Bank, and the IMF in this area. A duty drawback scheme will be introduced in 1997. To enhance customs revenue collection while preserving the incentives to export, the duty drawback scheme would be introduced at the same time as the zero rate on intermediate goods and raw materials is lifted. In the event of the reopening of the borders with Turkey and Azerbaijan, Armenia would seize the opportunity to increase exports, and import the urgently needed capital and energy resources for modernization of industries to an extent consistent with the economy's absorptive and payments capacity. In this regard, protectionist pressures that are likely to emerge will be resisted, and no new tariff exemptions will be granted. Finally, to improve market access and the level of integration with the world economy, Armenia is eager to complete the accession process to the World Trade Organization.

24. Clearing trade arrangements. Clearing trade arrangements were set up in 1992 with Russia to trade in oil fuels and with Turkmenistan in natural gas, in response to the imposition of the trade blockade and to guarantee a minimal supply of energy. As new trade routes have been secured in recent months and external constraints, including the availability of foreign exchange, have become less binding, the need for these highly opaque and inefficient methods of trade has diminished. The official clearing trade arrangement with Russia has been eliminated, and the Government's direct involvement in clearing trade with Turkmenistan discontinued by end-1995. Imports of gas will thus be limited to the level that domestic consumers can pay for. The resulting elimination of the associated system of implicit subsidies to and taxes on enterprises involved in clearing trade will require enterprises to adjust to market clearing prices and to reorient their activities according to their comparative advantage--a process which is likely to involve short-term costs for the economy as a whole. The Government, as a general policy, will contemplate temporary financial assistance only for enterprises that clearly demonstrate financial viability (see paragraphs 40-41).

25. A new law establishing a liberal legal framework for foreign direct investment enacted in 1994 provides for incentives including tax benefits for foreign investors. However, recognizing that domestic and foreign-owned enterprises should operate on equal terms, the Government will phase out preferential terms by end-1996 for new investments (preferential terms granted to investors prior to that date will be grandfathered).

26. External debt and arrears. While Armenia will most likely rely on foreign financing for most of its investment in the coming years, the Government intends to strictly limit the contracting and guaranteeing of new external obligations on nonconcessional terms (see paragraph 11). The accumulation of external arrears vis--vis Russia and Turkmenistan by Armenian state enterprises have marred Armenia's previously unblemished payments record. Although none of these arrears were accumulated by the Armenian Government, the Government will take an active role in regularizing these arrears while containing, to the extent possible, its exposure to these obligations. Negotiations with Russia are also ongoing. With the planned rationalization of the electricity tariff during the program period (see paragraph 40) and enhanced collection of fees for energy use, Armenia should be able to avoid the accumulation of new energy arrears, whether official or commercial, related to imports of nuclear cassettes, natural gas, and oil products.

Structural policies

Privatization and enterprise reform

27. The Privatization Program adopted in January 1994 covered three years, setting the goal of privatizing one third of state-owned productive assets each year. This process is seen by the Government as essential to depoliticizing corporate governance and reducing the pressure for subsidies. The Government is taking steps to accelerate the privatization process including modifying the role of the Privatization Commission. The 1996 Privatization Program envisages that the majority of privatization will take place through public subscriptions in which cash or vouchers can be used. By end-1995, 1,800 small-scale enterprises have been privatized; the Government intends to privatize all remaining small-scale enterprises by end-1996. For medium- to large-scale enterprises, the target for end-1995 of 350 enterprises privatized was met; the Government's program targets a further 1200 enterprises in 1996. At a later stage, privatization is envisaged to be extended to parts of the health and education sectors.

28. Enterprise reform. The Bankruptcy Law adopted by Parliament in June 1995 contains serious flaws. It does not adequately provide for reorganizations nor is the location of judicial authority to administer the law made sufficiently clear. A new Bankruptcy Law will be adopted in 1996 (see paragraph 29). However, even if the law is improved, the necessary institution building in the judiciary to implement the law will take some time. In view of these considerations, and against a background of high levels of losses and overdue debts by enterprises, the Government has initiated an enterprise restructuring program. Eleven critical financially-distressed enterprises have been placed in this program, which replicates a bankruptcy process: enterprises will either be reorganized and privatized or will be liquidated.

The enterprises will first be offered for sale; those which fail to be privatized at the first attempt will either be reorganized prior to a second attempt at privatization, or will be liquidated. For enterprises to be reorganized, Creditors' Committees representing principal creditors to the enterprise will be created. Reorganization measures could include divesting underutilized assets, reducing employment, developing new marketing strategies, taking steps to reduce excessive levels of accounts receivable, and improving management control by organizational changes. Such reorganization would not involve new investment. Reorganization plans have already been developed with technical assistance for ten of the enterprises. The Government will appoint an administrator to oversee the restructuring process in each enterprise, rather than create a new agency for this purpose. The administrators will report to the Creditors' Committees and will be supported by technical assistance financed by the proposed SAC. The Government recognizes that enterprise restructuring and debt workouts may require budgetary lending or transfers, but will only consider making such commitments within a restructuring program for a given enterprise and within the constraint of its overall fiscal objectives. The effective restructuring of most of these enterprises and outright liquidation of the rest is expected to have a powerful demonstration effect, by presenting an operational approach to containing losses and a clear signal of the political will to harden enterprises' budget constraints.

Legal and regulatory framework

29. It is essential to establish an appropriate legal and institutional framework for commercial activities. Privatization, land reform, and enterprise restructuring will not have the desired effects on efficiency and growth without clearly defined property rights and a hard-budget constraint for enterprises. The program thus calls for important legislative initiatives with respect to banking system reform, bankruptcy and collateral. In addition, the continuous development of appropriate institutional mechanisms for the implementation and effective enforcement of these laws will remain a goal of the medium-term program.

Environmental policies

30. Armenia is faced with a number of environmental problems, but has severely limited resources to address them. The most urgent problems include: (i) the deterioration of municipal infrastructure for water supply and wastewater treatment due to insufficient maintenance and restricted operations (only about 10-15 percent of sewage is being treated today); (ii) the restarting of the country's nuclear power plant, raising issues of plant safety; (iii) a cumulative reduction in Lake Sevan's water level of 18 meters, leading to a 41 percent loss in water volume; (iv) soil erosion (over 60 percent of Armenia's agricultural land is eroded to some degree), and soil salinization; (v) insufficient and declining forest cover due to illegal and legal timber harvest, solid waste disposal, expansion of roads and livestock farms; and (vi) poorly developed environmental law and regulatory framework. The Government has taken a number of steps to ease environmental degradation, including a reduction in the amount of water drawn from Lake Sevan to generate hydroelectricity. The Government is working closely with the International Atomic Energy Agency and other bilateral donors to strengthen its capacity to regulate the safety of the recently recommissioned Medzamor nuclear power plant. Investment assistance is also being sought to upgrade the safety and monitoring features of the plant to bring it closer to international standards. The Government also plans to draft a National Law on the Environment. Finally, two grants from the World Bank's Institutional Development Fund will contribute to mitigating environmental problems by assisting in prioritizing problems, and develop the regulatory framework and institutional capability to implement regulations. One grant is to develop an action plan to restore Lake Sevan's ecological balance and economic potential; the second, currently under consideration, is to support the preparation of a National Environmental Action Plan.

Improvement in economic data

31. Considerable progress has been made in the compilation and reporting of statistical data with the help of IMF and World Bank technical assistance in the areas of monetary, fiscal, balance of payments and price statistics; and in national account statistics, with OECD assistance. Data on the CPI, exports/imports and overall government balance are now compiled on a monthly basis (with some lag in availability), data on interest rates are available twice a week and data on international reserves, base money and exchange rates are available on a daily basis. Summary banking system information will soon be available on a weekly basis. Nevertheless, weaknesses still remain in several areas especially with regard to international comparability of the data. The State Department of Statistics is receiving assistance from the OECD in reclassifying and re-estimating the national accounts according to SNA methodology and in enhancing coverage to account for the growing presence of the private sector. Several technical assistance missions are planned under the ESAF and the TA component of the SAC to help further improve the quality of statistical data (paragraphs 46-47).

Social safety net, poverty alleviation, human resource development

Social safety net

32. Social safety net reform will be a major structural component of the medium-term program. The Government's ultimate goal is to better target the delivery of humanitarian assistance and, more generally, of all cash transfers, by adopting an incomes-tested system. However, given the costs, implementational complexities, and problems of measurement in a country where informal sector activity and transfers from abroad are important determinants of family income, the Government is improving targeting by category in the short term while developing the informational base for incomes testing.

33. Child allowances. A system of general child allowances paid to each child regardless of family circumstances was introduced in 1992, and has constituted the principal mechanism for targeting cash benefits to the working poor. As recent research suggests that family size is not a good proxy for poverty in Armenia, the Government will move from the present system to one where benefits are tied to an operational measure of family income by end-1996. To better target the families in greatest need of child assistance in the short run, by March 31, 1996 disbursement of child allowances will be restricted to families with children under the age of six, (compared to the age of 18 at present) disabled children, children of single mothers, and children in families which have lost one or both income earners. The size of the allowance will be raised. This approach is based on the observation that: (i) families with very young children tend to have lower incomes; and that (ii) the first years of the child's life are typically characterized by family income loss resulting from one of the parents being out of work to tend for the child.

34. Pension reform. In 1995, pension expenditures are expected to be about 3 percent of GDP. A progressive pension reform program was adopted by Parliament in December 1995. The primary components of the reform package include: (i) a phased increase in the retirement age to 65 years for men and 63 years for women; (ii) a reduction in the number of exemptions granted to various professions for early retirement; (iii) a change in the benefits formula to primarily reflect years of service and not the final wage; (iv) the setting of a legal basis for private pension insurance plans to provide the option of complementing pension income from the Government pension scheme through additional savings; and (v) a reduction of benefits for working pensioners. The underlying theme is to limit government intervention in the economy, while at the same time encouraging the development of a private pension insurance system. The regulatory framework for private pension plans will be drawn up by September 1, 1996.

35. Unemployment benefits. As enterprises are privatized and restructured, substantial increases in unemployment and the concomitant demand for unemployment benefits appear to be unavoidable. Pressures on the Pension and Employment Fund are likely to arise both from a larger pool of unemployed workers and the costs associated with labor market reforms such as devising appropriate methods of assisting job searchers. The Government will submit to Parliament an Employment Law which sets a maximum period of 12 months for the unemployment benefit. New entrants to the labor market will be excluded from the unemployment benefit.

Education

36. Prior to the breakup of the FSU, Armenia had one of the highest levels of education in the FSU. While the educational system is still relatively extensive, the quality of education has dramatically deteriorated in recent years, reflecting severe budgetary constraints. In order to reconstruct the educational system in a cost efficient manner and adjust it to the needs of a market economy, the Government has introduced fees for higher education and has begun streamlining the examination system. Further elements of education reform include: (i) consolidation of schools and reduction in the number of teachers with the aim of achieving cost savings of at least 15 percent to be reallocated to improve the efficiency of general education; (ii) increasing cost recovery in post-secondary education without excluding the poorest students, including student payment for text books and payments of fees for university education; (iii) providing more financial autonomy to educational facilities; (iv) continued curriculum reform and development of programs for teacher training and adoption of a strategy to improve the availability of textbooks; and (v) the definition of protocols and licensing systems in order to facilitate the development of private education, and competition between schools. Stipends will be better targeted to low-income students, with at least 10 percent of stipends going to such students in 1996. At least 30 percent of the stipends in the 1997 budget will go to such students, based on a targeting mechanism to be adopted by the Government. The Government will also finalize the school map to identify the status of primary, secondary, and technical education facilities.

Health

37. The 1988 earthquake and the economic decline that followed the breakup of the FSU resulted in severe shortages in medicines, supplies and equipment, and a deterioration of the health status of the population. The Government aims to improve access, quality and cost efficiency of health care services, and to reorient the system toward preventive care focusing on the provision of primary health services. To this end, the Government will adopt a plan for strengthening primary health care, including primary health care programs and the mechanisms for implementing and financing these programs. The Ministries of Health and Finance will prepare a health financing strategy, which will be incorporated into the 1997 budget and will include: (i) a basic benefit package to be funded by the state budget; (ii) protocols for the treatment of major diseases and the program to be covered under the basic benefits package; (iii) costing mechanisms for the delivery of health care services; and (iv) a program budgetary approach for the financing of health services. The Government will also identify a transitory mechanism for providing low cost treatment to poor patients.

Sectoral policies

Agriculture

38. Agricultural growth has shown remarkable resilience during the early 1990s, primarily due to a successful land reform (see paragraph 5). Reforms implemented over the past four years--including the dismantling of the state order system, liberalization of a substantial part of the producer prices and most input prices, and the elimination of almost all producer and consumer subsidies--created improved incentives for the food and agriculture sector. However, this process was compromised and limited in its effect by the lack of competition in input and output marketing, and by the delay in restructuring and privatizing agricultural industries. The ultimate objective in the sector will be to complete the transition to a market-based agricultural sector and to integrate Armenian agricultural production and agroprocessing into international food markets in order to fully utilize the sector's potential comparative advantage. The Government's sectoral strategy will focus on the development of an efficient structure of private farming with an adequate legal and incentive framework for the development of support services.

39. Achievement of these goals will involve five major building blocks. First, the incentive system will be improved through phasing out remaining price controls (including the profit margin controls on flour) and subsidies (on water); and development of a nondiscriminatory system of land taxation. Second, land reform will be completed to support commercial and family farming through: (i) developing a system of land titling and registration; (ii) revising land ownership laws to establish a land and lease market; and (iii) creating a legal framework to support private farming through establishment of farmer's productive and service cooperatives and associations. Third, agroprocessing will be demonopolized and privatized through: (i) privatization of relevant state enterprises, including foreign trade organizations and the grain parastatals; (ii) promotion of new private ventures and processing cooperatives; and (iii) reduction of barriers to entry by foreign firms, including joint ventures. Fourth, the agriculture supply distribution and service systems will be restructured through: (i) expansion of private and commercial market facilities and services of input supply and product marketing; (ii) facilitation of the development of private extension and advisory services; and (iii) improvement of rural financial intermediation services based on unsubsidized credit, as transitional measures toward fully privatized rural finance. Fifth, the role of government in agriculture will be redefined and public administration of the sector restructured through: (i) establishment of clear lines of responsibility for the development of policy and administration; (ii) dismantling the current centralized government management structure; and (iii) simplification and reduction of the Government organizational structure commensurate with Government's reduced role in the agriculture sector.

Energy

40. The energy sector is in a financially unsustainable situation. The stock of energy arrears to Armenergo (the electricity concern) in October 1995 was equivalent to 2 percent of annual GDP; the current electricity tariff, at 12 drams per Kwh, covers only partly maintenance and operating costs; and the collection rate on current energy consumption remains low, despite recent improvements. In order to remedy this situation, the average tariff for each consumer group will be raised to cover all operating and maintenance costs. Over the medium term, all utility prices will be maintained at levels fully reflecting the marginal costs of production; and by end-1996 they will reflect total (including financial) costs. In addition, the Government will pursue the restructuring of Armenergo and Armgas as follows. Armenergo will separate the generation, transmission and central dispatch, and regional distribution functions (a plan for separation and privatization of the generation companies will be prepared, and the regional distribution companies will be established as independent corporations). The restructuring and privatization plan for Armgas and its subsidiaries will provide for separating pipeline service entities from the core functions of gas transportation, storage and distribution. The corporatization of Armenergo, Armgas and their subsidiaries will be completed in 1996.

41. The Government has issued a decree listing the organizations to which energy supplies cannot be terminated except by the consent of the Government, and will ensure that energy supplies to other non-essential budgetary and nonbudgetary entities will be terminated in the case of nonpayment. Energy suppliers, including Armenergo, will begin implementing this policy from January 1, 1996. Having worked well since their introduction, prepayment scheme and district-based payment mechanism will be continued and the implementation of such practices widened. Workout procedures, including "contingent write-off" schemes--whereby the writing-off will be phased and conditional on satisfactory servicing of current payments--will be applied to reduce the stock of existing domestic energy arrears. Subsidies, if deemed necessary, will henceforth take the form of explicit budgetary outlays.

Transport

42. During the past four years, traffic volumes on most modes of transport declined sharply, and severe budget constraints led to sharp cuts in maintenance expenditures. The transport sector includes the national road network, a railway company, an airline, the Yerevan metro system, an extensive array of municipal (local) and long distance bus, trucking and taxi enterprises, and organizations involved in transport-related maintenance and construction. As a result, the entire system, including maintenance and repair facilities and rolling stock are in need of a substantial overhaul. Vehicle traffic has increased substantially in 1995, owing to economic recovery, and the road maintenance budget has marginally increased. Following the elimination of practically all subsidies for public transport companies, the privatization of most taxi companies and the turning over of the air freight company to a joint venture with a private company, the Government plans to privatize all trucking, taxi and some bus companies, but intends to retain ownership of the railway, the metro system, and the airline, while encouraging the entry of private airlines. As a next step, the Government will begin contracting out road maintenance to private companies, including to district maintenance organizations, which will be privatized in 1996. The World Bank, along with other international creditors, is providing US$35 million for highway reconstruction, involving the building or reconstruction of a total of 1,420 kilometers of roads over a period of four years.

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External Financing Requirement and External Debt

43. In an economic environment fostered by the macroeconomic and structural policies described above, and with further expected improvements in trade relations with neighboring countries and in gas deliveries, both exports and imports are expected to rise substantially during the medium term. Imports are projected to grow at a relatively slow average rate of 5 percent over the medium term, reflecting the country's massive rehabilitation and reconstruction needs but also its balance of payments constraints. Export growth is projected to average 23 percent, and is envisaged to come from two sources. First, from a very low level, exports of traditional products are projected to rise steeply due to the relaxation of the economic blockade. Second, a rapid expansion in human capital-intensive, export-oriented industries (computer software, light machinery) is anticipated, in part reflecting increased foreign investment. In the medium term, rapid export growth will also be propelled by imports of capital goods and the concomitant improvement in productive capacity. As a result, the current account deficit (excluding official transfers) is expected to narrow from 26 percent of GDP in 1995 to about 13 percent by 1998.

44. This scenario assumes strong capital inflows, initially from official sources but increasingly replaced by autonomous, primarily nondebt creating capital inflows. Given past experience with donors, Armenia's export potential and the improving infrastructure, official transfers as well as FDI are likely to be high. Borrowing on commercial terms will be limited to a level consistent with the country's long-run debt service capacity.

45. Projections also suggest that external debt will rise from 29 percent of GDP in 1995 to 37 percent in 1998, and the debt-service ratio, including that arising from potential financing associated with the cumulative financing gap, from 3.0 percent to 10.7 percent in the two respective years. At these levels, the scheduled debt service is deemed to be manageable, and Armenia should be able to discharge its debt obligations in a timely manner.

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Technical Assistance Requirements

46. The IMF and the World Bank will be providing the Armenian authorities with technical assistance in a number of areas. The IMF has assigned a resident advisor to assist the authorities with setting up the Treasury. Both the IMF and the World Bank plan to provide assistance with tax administration, in particular with respect to customs administration and electronic data processing of tax information. UNCTAD will also provide assistance with customs administration, and the U.S. Treasury is prepared to provide assistance with training of auditors in coordination with the IMF. The Monetary and Exchange Affairs department of the IMF has assigned three resident advisors to assist the Central Bank, as general advisor, banking supervision and accounting advisor. USAID is providing assistance on Treasury bill market development and commercial bank and enterprise accounting. The World Bank has been providing and will continue to provide assistance in privatization and restructuring of enterprises, financial sector reform and the restructuring of government expenditure. Both the IMF and the World Bank have promised to provide technical assistance in developing a legal framework compatible with a market economy. Finally, substantial technical assistance needs remain with regard to risk assessment and workout procedures for impaired assets in commercial banks, both areas considered for targeting under the TA component of the World Bank's SAC.

47. In order to eliminate remaining shortcomings in macroeconomic statistical data, the authorities have requested further technical assistance from the IMF in improving government finance, monetary, and trade statistics; and follow-up technical assistance for implementing the reforms suggested earlier regarding producer, export and import price indices. The World Bank will assist statistical data processing. Finally, subject to availability of financing by the JAA, a resident advisor may be assigned to provide assistance with balance of payments statistics to Armenia, Georgia and Moldova, in a shared arrangement.

48. Training of Government officials will continue to be offered by the Joint Vienna Institute (sponsored by the IMF, EBRD, IBRD, OECD), and by the IMF and IBRD Institutes and the OECD's Ankara center. New programs for training of enterprise managers will be developed by TACIS, the World Bank, the American University of Armenia, and NGOs such as the TARA group.

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