For more information, see Republic of Armenia and the IMF

Armenia--Enhanced Structural Adjustment Facility
Policy Framework Paper, 1998-2001

I. INTRODUCTION AND RECENT DEVELOPMENTS

A. Economic and Political Background

Since independence in 1991, the Armenian economy has endured the collapse of regional trade and payments agreements, severe term of trade shocks, and disruptions to trade flows caused by the conflict in Nagorno-Karabakh. During 1992 and 1993, output plummeted by over 60 percent and prices rose more than 110 times. The introduction of the national currency, the dram, in November 1993, signaled the first step toward stabilization. Following a cease fire agreement among Azerbaijan, Nagorno-Karabakh, and Armenia in mid-1994, and supported by a succession of IMF and World Bank loans since December 1994, the government has implemented economic programs featuring tight financial policies and far reaching structural reforms. As a result, the consolidated government budget deficit declined from 16 percent of GDP in 1994 to 6 percent in 1997 and the growth in monetary aggregates slowed down dramatically. In this context, inflation fell from over 10,000 percent in 1993 to about 22 percent in 1997, and real GDP growth resumed, averaging an annual rate of 5 percent in the period 1994-97.

While maintaining a stable macroeconomic environment and deepening of structural reforms are crucial for realizing the growth potential of the Armenian economy, the sustainability of high growth rates over the medium term will depend on strengthening regional cooperation and on continuing the dialogue with Armenia's neighbors for a lasting solution to the Nagorno-Karabakh issue.

B. Performance Under the 1997/98 Program and Developments in 1998

The program covering the period April 1997-March 1998 was supported by the second annual arrangement under the IMF's Enhanced Structural Adjustment Facility (ESAF II) and a second Structural Adjustment Credit (SAC II) from the World Bank. The program's immediate goal was to correct the slippages in program implementation in late 1996 through a tightening of financial policies in the first part of 1997. This stabilization effort was to be accompanied by a strengthening and deepening of privatization and enterprise restructuring, financial sector and fiscal reforms, and improvements in the social sector. Progress under the program in 1997 was mixed. Despite a reduction of the deficit of the consolidated government to about 6 percent of GDP in 1997, there was an unanticipated monetary expansion, which led to a resurgence of CPI inflation to about 22 percent on a 12-month basis. Real GDP growth slowed down to about 3 percent, partly due to adverse weather conditions. The external current account deficit (excluding official grants) remained unchanged from its 1996 level at about 28 percent of GDP.

In late 1997, in the context of the mid-term review under ESAF II, the government moved decisively to control the growth of aggregate demand and gave a renewed impetus to structural reforms. The benefits of this move became evident during the first nine months of 1998. Real GDP was over 6 percent higher than in the same period in the previous year; inflation had disappeared by end-September; nominal interest rates declined; and the nominal exchange rate remained stable well into mid-August. Net in ternational reserves strengthened considerably during the summer of 1998, offsetting the loss of earlier months. At the core of these favorable developments there was a reasonable degree of restraint in the growth of reserve money coupled with a low consolidated government budget deficit.

While significant attention was given to stabilization issues in late 1997 and early 1998, the privatization process continued at a rapid pace. Having moved close to complete the small-scale privatization program by end-1997, the government's efforts in 1998 were aimed at selling the remaining medium- and large-scale enterprises, including those through international tenders. By late-October 1998 the sale agreements already concluded through international tenders or in the process of being settled amounted to $115 million (or about 6 percent of GDP). There has also been further progress in strengthening the banking system and in preparing the reform plans in the education and health sectors.

C. Remaining Tasks and Risks

Notwithstanding the achievements made during the last few years, many sources of vulnerability remain, which unless addressed forcefully, may complicate macroeconomic management and delay the transformation of the economy. This task has become even more urgent in light of the unfavorable external environment that has resulted from the crisis in Russia. Four major areas need to be addressed. First, total national savings need to be strengthened so as to reduce the large reliance on external savings and concessional financial assistance. The public sector can contribute by reducing further the size of its fiscal deficits and ensuring that public savings will grow steadily over time. To achieve this, it will be necessary to maintain a strong revenue performance; improve expenditure control and reduce subsidies; increase the cost effectiveness of spending; increase the transparency of fiscal accounts by reducing quasi fiscal operations in sectors like energy and irrigation; and improve further the institutional framework for tax and customs administration and the budgetary process. Second, there is a need to bolster further the banking system. Despite noticeable improvements in complian ce with existing regulatory and supervisory requirements, financial savings continue to be very small reflecting in part lack of confidence in the banks. Further efforts to tighten prudential and regulatory requirements must be made, as well as to monitor banks' financial positions more closely. Third, there is need to enhance the country's debt servicing capacity over the medium term by pursuing policies that set the basis for sustained growth of net exports and by taking steps to improve the external debt and debt service profile, including the use of privatization proceeds. Finally, the social safety net should be enhanced to provide adequate and cost-effective income support to the most vulnerable groups in society. To help in ensuring that sufficient budgetary resources can be channeled to the social safety net, it will be necessary to proceed rapidly with a better targeting of benefits, a further reduction of subsidies, and a comprehensive reform of the civil service.

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II. OBJECTIVES AND POLICIES, 1998-2001

The government's economic reform program for the period 1998-2001 comprises financial, structural, sectoral, and institutional policies aimed at consolidating the macroeconomic stabilization that has been achieved to date and at reducing the sources of vulnerability identified above, so as to create the basis for sustained economic growth over the medium term. Policies will be designed with a view to maintain inflation around 6 percent a year and to foster annual average growth of at least 5 percent. Broad-ranging systemic reforms will continue, but the emphasis will be shifted toward the financial rehabilitation of the energy sector, and the reform of the civil service and the social sectors. Table 1 presents detailed policies for the period 1998-2001. The program envisages intensive use of the technical assistance resources available from multilateral and bilateral sources to improve the design and implementation of these policies.

A. Fiscal Policy

The medium-term program aims at achieving a progressively stronger and sustainable fiscal position. The deficit of the consolidated government is programmed to decline to 3 percent of GDP in 2001 on the strength of revenue measures, both to broaden the tax base and to enhance collections, and additional efforts to improve expenditure control and management. The projected decline in the level of the budget deficit is also commensurate with the reduced availability of concessional external financing for the budget as the transition to a market economy proceeds. Domestically, the financing of the deficit is projected to rely increasingly on nonbank sources ( Table 2).

On the revenue side, policy changes aim at broadening the tax base, simplifying the tax structure, and streamlining tax administration. Tax exemptions will be reduced further, and the VAT will be modified to make it more in line with international standards. The State Tax Inspectorate will be reorganized and adequately equipped with information technology. However, during 1999, a High Level Committee chaired by the prime minister will continue to handle the cases of the 60 enterprises identified in 1998 as having the largest tax arrears. All together these measures are expected to yield nearly 2 percentage point of GDP over the next three years.1

Expenditure policies will be designed in the context of a medium-term public expenditure framework (MTPEF) to be developed and implemented with the assistance of the World Bank. Emphasis will be placed on reducing subsidies, improving expenditure management, reducing budgetary employment, ensuring an adequate balance between budgetary provisions for critical maintenance and new investment expenditures, and limiting the budget's exposure to contingent liabilities. To address the problem of contingent liabilities, the Ministry of Finance and Economy will develop and establish guidelines for assessing the need for loan guarantees and will elaborate further the system for recording such guarantees. It is expected that the full operation of a treasury will allow for better expenditure control. In this connection, the Ministry of Finance and Economy intends to start developing a financial planning exercise on a rolling quarterly basis with the assistance of the Resident Treasury Advisor from the Fund FAD. The monitoring of resources available to the public sector will also be strengthened by establishing monthly reporting to the central treasury by the project management units on the foreign loan disbursements received. The containment of the growth in current expenditures is expected to be facilitated by the progress achieved in reforming other sectors (described below in more detail). In particular, transfers from the budget to cover the costs of energy, and drinking and irrigation water are expected to decline. The retrenchment in budgetary sector employment resulting from an overall civil service reform is also expected to generate some savings over the medium term, that could be used to improve the compensation levels of a smaller and more efficient cadre of civil servants.

Public investment projects will focus on energy, communal services, housing and other construction, transport and communications, and irrigation. Priority will be given to rehabilitation of basic infrastructures, especially in the energy and road sectors. While continuing to be primarily financed from external sources, the budget will provide for domestic funding of investment projects using, in part, the proceeds from privatization. To ensure the most appropriate use of the proceeds from privatization, the government will strengthen its capacity to appraise projects.

The budgetary process also will continue to be improved over the medium term. The 1999 budget will consolidate the operations of the budgets of the republican government and the Pension and Employment Fund and it will include details of the local government budgets as an annex. In addition, the 1999 Budget Law will include provisions to allow the central administration to exercise greater discretion in dealing with both the reallocation of expenditures between categories and the reduction of expenditure in the face of a shortfall in revenue during the year.

B. Monetary and Exchange Rate Policy

The medium-term objectives of the Central Bank of Armenia (CBA) will be to develop further its capacity to formulate and implement monetary policy in order to maintain price stability. The CBA will broaden its use of indirect instruments of monetary control and will continue its policy of not extending net credit to the government. To enhance overall liquidity management in the economy, the CBA will improve the coordination of policies between the CBA and the Treasury. It is expected that the government will increasingly rely on the placement of securities to finance its domestic short-term borrowing requirements, although the transition will be gradual. In the meantime, the CBA will establish nominal limits to the intraquarter direct lending that it will extend to the government at an interest rate higher than the average treasury bill rate. This limits will be consistent with the overall monetary program targets for the program period.

Over the medium term, the CBA will continue to respond to deviations in its monetary targets (and ultimately in its inflation target) by controlling overall credit using market-based indirect instruments and/or by allowing the exchange rate to reflect underlying market conditions. Net official intervention in the foreign exchange market will be limited to the smoothing of exchange rate fluctuations. Given rising debt-service obligations and the continued need for balance of payments support in a volatile external environment, the program aims to maintain official international reserves close to an average of 3 months of imports of goods and nonfactor services during the period 1998-2001.

C. Trade and Exchange Policies and Debt Management

Armenia's trade deficit during 1998-2001 is expected to narrow in relation to GDP from 30 percent to 24 percent reflecting export growth averaging about 13 percent per annum combined with moderate import growth of 4 percent per annum. The growth in exports is expected to be led by minerals, nonprecious metals, and labor intensive light manufactured products facilitated by: (i) successful industrial restructuring and significant foreign investment in export-oriented industries; (ii) better air and land transport routes; and (iii) the accession of Armenia to the WTO. On the other hand, the moderate growth in imports would reflect: (i) import substitution especially in food items; and (ii) a lower fuel import bill as the energy sector improves its efficiency and its access to world energy markets. In light of these developments, the current account deficit (excluding official transfers) is expected to narrow from 23 percent of GDP in 1998 to about 16 percent in 2001.

Throughout the program period the government intends to continue to be prudent in contracting or guaranteeing nonconcessional external loans and to maintain a liberal trade and exchange regime. All requests for official guarantees on external borrowing by publicly owned and private enterprises will be put on hold until the government develops a policy and the technical capacity to evaluate the loans for which these guarantees will be granted in the future, taking into account the impact of such projects on the country's debt servicing capacity and limited budgetary resources.

On trade policy, the government is committed to maintain the present low average level of tariffs and the streamlined tariff regime with two bands at 0 and 10 percent. Efforts will continue to improve and simplify customs administration, with donor technical assistance. The government's strategy to attract foreign direct investment will continue to be based on a liberal foreign investment regime and will be supported by the creation of a one-stop shop for the formation of new businesses and streamlining legal procedures. Over the medium term, foreign investments are gradually expected to become an important source of capital inflows, facilitating the transfer of know-how and capital to Armenian enterprises through joint ventures with foreign partners.

The government's debt management policy will focus on securing foreign assistance on concessional terms in order to maintain a low debt-service burden. The contracting or guaranteeing of debt on nonconcessional terms will be restricted to finance carefully evaluated projects with due account of their impact upon Armenia's debt servicing capacity. The external debt burden will continue to be monitored carefully and the debt management and analysis capacity will be enhanced with the aid of computerized systems expected to be provided by donors. Efforts to enhance the management and transparency of humanitarian assistance programs will be continued. To this end, special departments in the Ministry of Finance and Economy have been created to coordinate with donors and keep them and our public informed of the execution of these programs.

D. Structural Policies

Privatization

Privatization is a key ingredient of the transition process, contributing to the efficiency of resource utilization and the increase in productivity of the economy. The government is committed to move forward with the cash privatization program (as opposed to the voucher based program) and to complete by the year 2000 the privatization program approved by parliament in December 1997. The privatization of all remaining state flour mills and bakeries is in progress and liquidation procedures of those not sold after a third offering will be initiated before end-1998. Privatization of enterprises through international tenders will continue uninterrupted.

The government has delineated clearly which enterprises will remain in the public sector and is developing a framework to monitor the financial operations of these enterprises on a regular basis, starting with a pilot monitoring system of the operations of the five largest of these enterprises. The government has prepared estimates of the size, timing and possible use of privatization proceeds expected over the next several months. With the assistance of the World Bank and the IMF, the government plans to develop a comprehensive strategy for the use of privatization proceeds. In the meantime, the use of these funds for budgetary support will be limited and geared toward financing clearly identified investment projects and critical maintenance expenditures which could not be accommodated in the budget due to resource constraints, as well as for improving the external debt and debt service profile of the country.

Financial sector reform and development

Despite significant progress made in strengthening the financial position of banks, the banking system remains fragile. To address this issue, the CBA will continue strengthening prudential regulations during the period 1998-2001, including: (i) reducing the limit on the open foreign exchange position; (ii) raising the minimum general and core capital ratios; (iii) improving the system of loan classification and loan loss provisioning; and (iv) strengthening regulations on dividends so as to enable bank regulators to limit the payments of dividends by banks experiencing financial difficulties. Guidelines for the classification and appraisal of banks' investment portfolios will also be developed. The CBA will continue to monitor the timeliness and accuracy of the financial reporting by banks and improve the process of banking supervision.

The government and the CBA will establish a Securities and Exchange Commission, and adopt a suitable regulatory framework which will include a code of conduct for primary dealers. Building on the experience gained in developing the treasury bills market so far, the government will establish a comprehensive capital markets infrastructure, including a trading mechanism, a clearance and settlement system, a depository and enhanced registry system.

Energy sector reform

The on-going restructuring and financial rehabilitation of the energy sector aims at improving supply efficiency, quality of service delivery, payments discipline, and to promote greater transparency in the commercial transactions of the sector. To this end, the government intends to ensure strict enforcement of the existing legislation that enables the energy enterprises to suspend services to customers with payments arrears, and to establish both dram and physical consumption limits for strategic consumers receiving budgetary support in 1999. Although energy tariffs were raised in 1997, neither actual operating and maintenance costs were covered, nor were the costs of debt servicing. The recently announced increase in the average tariff to be effective January 1, 1999 is part of the financial plan that will include performance targets on indicators such as improvement in collections and reduction in technical and commercial losses. The adequacy of energy tariffs and the efficacy of the efficiency-enhancing measures will be reviewed every six months. Energy tariffs will be adjusted if necessary so as to allow them to cover depreciation, inflation and exchange rate changes, and an increasing share of capital costs. Average collections will be targeted at about 92 percent for commercial customers in 1999. Over the next three years, the government intends to privatize the electricity distribution enterprises, as well as a majority of the gas storage and distribution system. The latter is to be accomplished through a gas-for-equity swap with foreign energy companies.

Public sector reform

The government recognizes that reform of the public sector will be crucial to the completion of the transition to a market-based economy. Although some measures have been taken over the last two years, reforms in the public service sector are to be accelerated during the program period. The government plans to undertake a comprehensive study to identify the steps needed for an institutional and functional review of the role of the state in a market economy. In this regard, it will be important to strengthen the center of government to ensure that it has sufficient support from both budgetary and human resources, and that it has adequate power to obtain the information necessary to develop, recommend and implement sustainable policy choices. As part of the streamlining of the civil service, the government will undertake a survey of employment with a view toward reducing the size of the public sector. Savings achieved from this action will allow for selective increases in budgetary wages so as to attract and maintain staff of high professional and technical standards. Aware of the responsibility of the public sector to the general public, the government will conduct service delivery surveys to assess user satisfaction and, using the output of the surveys, develop a program for improving service delivery in targeted agencies and/or regions.

Health and education sectors

The government continues to place strong emphasis on maintaining a high level of service in the health and education sectors and will build on past policies to make them more cost effective.2 A rationalization strategy will be undertaken for each sector in which a comprehensive coverage of available funding and detailed reporting of actual spending will be approved. In education, a new Law on Education will inter alia, define school autonomy and expand the role of municipalities in the management of primary and secondary schools. In the health sector, the Basic Benefit Package will be further rationalized, and a three-year strategic plan for the sector will detail the public involvement in the sector as well as give explicit priorities for the restructuring and privatization of hospitals and related services. To address these issues, the draft 1999 budget targets spending in health and education at 22 percent of total current expenditures (Table 3).

E. Social Safety Net and Poverty Alleviation

Over the program period the government will continue to improve the targeting of social allowances, and provide further rationalization of pensions and unemployment benefits. To this end, the government has issued a resolution to start implementing on January 1, 1999 a benefit system based on a means-tested vulnerability benefit. A new Law on Family Benefits regularizing this system is expected to be submitted to parliament for approval in mid-1999. The transition to the new system will be completed in the year 2000. The introduction of this benefit, which uses the PAROS system for identifying needy persons, is expected to reduce the number of families receiving such benefits while increasing the average size of the benefit per family. As part of the overall pension reform strategy,3 a plan for rationalization of both the collection of payroll taxes and the payment of pensions will be approved.

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III. EXTERNAL FINANCING REQUIREMENT AND EXTERNAL DEBT

Implementation of the economic and social program described in this paper will require substantial inflows of concessional assistance in 1998-2001 to supplement the improving domestic savings effort and private capital inflows expected during the period (Table 4). This external assistance will be essential for Armenia to sustain real growth while maintaining a stable macroeconomic environment. The external financing requirement for 1998-2001 is projected at about $1.4 billion. Of this, about 37 percent would be in the form of official grants mostly from bilateral donors. Cumulative disbursements by the World Bank and the EBRD are projected at about $270 million and $69 million during 1998-2001, respectively. After financing from all other sources, residual annual financing gaps are expected to arise in each year during 1998-2001. These are expected to be covered through a combination of additional concessional financing (including multilateral creditors) and official grants, to be arranged through consultative groups.

Armenia's total stock of external debt is projected to reach $801 million, or about 43 percent of GDP, at end-1998 (including outstanding obligations to the IMF). Multilateral creditors accounted for two-thirds of the total, official bilateral creditors accounted for about 28 percent, and the remainder was accounted for by commercial creditors. Under current policies, and assuming the flows of concessional assistance described above, the debt to GDP ratio peaks at about 48 percent around 2001-2002 but the debt-service ratio (on cash basis) is projected to increase from 14 percent of exports of goods and services at end-1998 to about 20 percent at end-2000. In light of the fact that 57 percent of Armenia's external debt is on concessional terms, the net present value (NPV) of external debt to GDP is estimated at 35 percent of GDP at end-1998. This ratio is projected to decline to 33 percent by end-1999. As a ratio to exports of goods and nonfactor services, the NPV of external debt is expected to decline from 175 percent at end-1998 to 158 percent by end-1999.

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IV. TECHNICAL ASSISTANCE REQUIREMENTS

The IMF and the World Bank will continue to provide the Armenian authorities with technical assistance during the period of the program. In addition to resident representatives posted in Armenia by the IMF and the World Bank, the CBA has two IMF resident advisors on banking supervision and monetary policy design, and the Ministry of Finance has an IMF resident advisor on the treasury system. Both the IMF and the World Bank have fielded technical assistance missions in various areas (see Table 5), and have invited government officials to participate in training courses.

While both the quality and availability of data have improved substantially, some key statistics need further improvement. To this end, the government has requested long-term assistance from the Fund in the form of a resident national accounts advisor, who would assist the authorities in improving the underlying methodology and source data in the estimation of annual and quarterly GDP measures in current and constant prices. In addition, the authorities would welcome assistance in improving the measurement of the producer price index and some of the component items of the balance of payments, e.g., foreign direct investment and services.

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V. CONCLUSION

Armenia's transition to a market economy is proceeding at a steady pace. Aside from some temporary setbacks, the stabilization efforts underpinned by tight financial policies and deepening structural reforms have brought about encouraging results. However, as underscored by the recent adverse spillover effects of the Russian crisis, the progress achieved so far is still fragile and additional efforts must be undertaken to consolidate the gains achieved to date. The government intends to implement resolutely the program described above so as to reduce the identified sources of vulnerability and set a sound basis for sustained high growth. Conscious that the process of transition may have some adverse consequences for the most vulnerable groups of the population, the government's program attaches particular importance to developing and implementing a well-targeted and cost-effective social safety net, as well as reforming those sectors with the greatest social incidence including education, health, and the pension system.


1For a detailed list of measures based on the technical recommendations of the Fund FAD Department, see Table 1, measures 1-11.
2A detailed description of the problems affecting these sectors can be found in IDA, August 1997, SACII-Report and Recommendations of the President; pp. 18-19.
3The pension reform is being undertaken in line with the provisions of the Pension Law adopted in December 1995. The main components of the reform are: (i) a gradual increase in the retirement age to 65 years for men and 63 for women (from 55 and 50 years respectively); (ii) a reduction of the number of exemptions granted for early retirement; and (iii) a change in the benefits formula to reflect years of service and not earnings. For further reference see IDA, SAC I - Report and Recommendations of the president; pp. 21-22.

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