Republic of Armenia
Request for Stand-By Arrangement-Staff Report; Staff Supplements and Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia.
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International Monetary Fund
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Publication Date:
08 May 2009
eISBN:
9781451801743
Language:
English
Keywords:
ISCR; CR; dollar sale; Armenia; dollar; fund; debt; debt service; banking system; foreign currency; balance of payments; current account; International reserves
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This paper discusses Armenia’s request for a Stand-By Arrangement (SBA) with exceptional access of 400 percent of quota. Given the urgency of the situation, the request is being considered under the Emergency Financing Mechanism. The new program aims to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor. The authorities have also committed to a set of policies in the exchange rate, monetary and financial, and fiscal areas as well as on maintaining its ongoing structural reform program.

Abstract

This paper discusses Armenia’s request for a Stand-By Arrangement (SBA) with exceptional access of 400 percent of quota. Given the urgency of the situation, the request is being considered under the Emergency Financing Mechanism. The new program aims to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor. The authorities have also committed to a set of policies in the exchange rate, monetary and financial, and fiscal areas as well as on maintaining its ongoing structural reform program.

I. Background

1. Until recently, Armenia had enjoyed a long period of strong economic performance. Positive regional spillovers and prudent policies underpinned rapid GDP growth and large capital inflows in a context of macroeconomic stability. Prudent fiscal policies led to a reduction of government debt as a share of GDP, while a flexible exchange rate and a well-designed monetary framework helped maintain low inflation. On the basis of Armenia’s impressive track record of successful implementation of Fund-supported programs, the Fund’s Executive Board approved on November 17, 2008 the authorities’ request for a new low-access PRGF arrangement. Directors endorsed this request, but noted that the deteriorating global conditions could have implications for Armenia’s economic outlook and financing requirements.

2. Amidst political uncertainty and regional instability, the Armenian economy was showing signs of overheating in the first part of 2008. The new coalition government installed in April 2008 following controversial presidential elections pressed ahead with an ambitious reform agenda, but unresolved tensions with the opposition weakened its political support. The war between neighboring Georgia and Russia in August 2008 led to severe, although temporary, disruptions in trade flows and fuel shortages. Nevertheless, real GDP increased by some 10½ percent through September, supported by remittances and FDI, with brisk activity in construction and services. High import prices and strong domestic demand pushed inflation to 11½ percent in August.

II. The Impact of the Global Crisis

3. The global crisis has confronted Armenia with a number of strong external shocks. Although sheltered from direct contagion effects by the limited international integration of its financial system, Armenia has been hit by a set of adverse shocks to the current and capital accounts, particularly emanating from Russia. Remittances and capital inflows, which sustained the construction boom in recent years, have decelerated markedly. Falling international commodity prices adversely affected mining, a key export sector, and several mines have ceased operations. GDP growth came to a halt in the fourth quarter, and fell to 6.8 percent for the year as a whole (Table 1, Figure 1). Following the rapid unwinding of international prices and domestic demand, annual CPI inflation fell to 1 percent in February 2009. With exports being hit by the global downturn and imports growing strongly through October, the external current account deficit rose to an estimated 12½ percent of GDP in 2008 (Table 2).

Table 1.

Armenia: Selected Economic and Financial Indicators, 2006–10

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Sources: Armenian authorities; and Fund staff estimates and projections.

Including the gas subsidy in 2006-2008.

Overall balance excluding grants and external interest payments.

Excluding the special privatization account (SPA).

Gross international reserves in months of next year’s imports of goods and services, without the use of Fund resources.

A positive sign denotes appreciation. Base year 1995=100. The calculations are based on 1999–2001 average trade weights.

Figure 1.
Figure 1.

Armenia: Recent Economic Developments

GDP growth will be affected by the expected decline in remittances and construction activity.

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: Armenian authorities; and Fund staff estimates.1/ Remittances are defined as the sum of compensation of employees, workers’ remittances, and other nongovernment current transfers. 2008 figures are estimated.2/ 2009:Q1 to 2009:Q4 data are projections.
Table 2.

Armenia: Balance of Payments, 2007–12

(in millions of U.S. dollars, unless otherwise indicated)

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Sources: Armenian authorities; and Fund staff estimates and projections.

Debt relief from the United Kingdom through 2015 (in respect of IDA credits).

Based on government and government-guaranteed debt.

Based on low-income country debt sustainability analysis.

Armenia: Shortfall in Foreign Exchange Earnings

(millions of US dollars)

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Sources: Armenian authorities; and Fund staff estimates and projections.

See Country Report No. 09/29.

4. The de facto fixed exchange rate policy has contributed to an emerging confidence problem in the exchange rate and financial system. Depreciation pressures on the dram have increased, as depositors started converting local currency deposits into foreign currency deposits, and dram cash holdings into foreign currency cash. The Central Bank of Armenia (CBA) has been selling about $50 million a week (now about 5 percent of gross reserves) in recent months, with net international reserves (according to the program definition, which excludes foreign currency deposits of commercial banks at the central bank) falling from $1,084 million at end-December to $627 million as of February 27, 2009. The authorities have resisted depreciation pressures, out of concerns that a devaluation would precipitate a rapid and destabilizing shift in local to foreign currency deposits and trigger substantial deposit withdrawals from the banking system.

5. As a result of the de facto peg, the exchange rate has become increasingly misaligned. Staff’s current assessment indicates that the real exchange rate is about 20-30 percent above its equilibrium value (Figure 2). This assessment contrasts with that made at the time of Armenia’s 2008 Article IV consultation, which found that the exchange rate was only slightly above its equilibrium value. The External Sustainability (ES) approach now suggests an overvaluation of about 20 percent at end-2008. Based on the purchasing power parity (PPP) approach, the real exchange rate is currently around 30 percent above equilibrium, while the behavioral equilibrium exchange rate (BEER) approach suggests that the dram was overvalued by 21 percent at end-2008. These results are in line with those obtained by the CBA using a similar approach.

Figure 2.
Figure 2.

Armenia: Estimated Real Exchange Rate Misalignment

(In percent)

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: CBA and Fund staff estimates.

6. Despite the depreciation pressures, the CBA cut the repo rate to 6.75 percent in three steps from December to February, in line with the more benign inflation developments. The growth in monetary aggregates has slowed considerably, and broad money fell in the first part of 2009 (Table 3, Figure 3).

Table 3.

Armenia: Monetary Accounts, 2006–09

(in billions of AMD, unless otherwise indicated)

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Sources: Central Bank of Armenia; and Fund staff estimates and projections.

At the program exchange rate.

Following the agreement between the CBA and the Ministry of Finance, the issue of new CBA bills was terminated in 2008.

At program exchange rates, excluding the SPA and foreign currency reserve money.

Defined as reserve money minus NIR plus medium- and long-term liabilities.

Ratio of foreign currency deposits to total deposits (in percent).

Ratio of foreign currency deposits to broad money (in percent).

Figure 3.

Armenia: Recent Monetary and Financial Sector Developments

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: Armenian authorities; and Fund staff estimates.

7. In the face of redollarization and disintermediation, the financial sector has come under mounting stress as the dram became increasingly overvalued. Despite high capital adequacy ratios (CAR)(Table 4), more than double the minimum 12 percent, and low levels of non performing loans, banks could be vulnerable to liquidity problems, reflecting the fragile confidence of the public in the banking system due to previous episodes of devaluations and bank runs in Armenia.

Table 4.

Armenia: Financial Soundness Indicators for the Banking Sector, 2004–08

(In percent, unless otherwise indicated)

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Source: Central Bank of Armenia.

8. In these circumstances, banks are restructuring their balance sheets to avoid large currency and liquidity mismatches. Given the local currency shortage, banks have reduced their lending activities in drams, particularly by not rolling over such loans as they fall due and are trying to pass the exchange rate risk to borrowers by switching to dollar loans. Dram lending is now largely funded by a number of initiatives by multilateral and bilateral donors to promote local currency lending to the SME sector. The result is an unfolding credit crunch in dram lending, which notably finances consumer loans and mortgages, with a risk of increased dollar lending to borrowers without dollar incomes. At the same time, however, banks have also accumulated high levels of dollar liquidity (placed both at the CBA or overseas with correspondent banks) (Box 1).

Armenia: Financial Sector Stability Issues

The banking system, comprising 22 banks, has been strengthened in recent years with the entry of foreign banks from the European Union as well as Russia, which are amongst the largest banks in Armenia. Based on latest data from the CBA, the system’s CAR of 27.9 percent is well above the minimum 12 percent requirement and non-performing loans are low at around 5 percent of total loans. Encouragingly, the banks have limited external borrowing or debt issuance and most liabilities to nonresidents are long term to multilateral and bilateral donors. The CBA has also put in place aspects of a modern risk-based prudential framework and a Deposit Guarantee Fund (DGF) was established in 2004.

However, despite these positives, there are serious structural weaknesses in the system which the effects of the on-going exogenous shocks have exposed. The system remains very small, with deposits equivalent to about 15 percent of GDP. This compares to the CBA’s estimate of dollar cash-in-circulation of about 35 percent of GDP. The system was unable to fully mobilize the local deposit base during the recent years of strong economic growth, despite a positive trend of dedollarization, due to lingering fears related to the historical experience in the initial chaotic years after independence. Now that economic conditions have deteriorated, such fears have again come to the fore and depositors are switching at a rapid rate from dram to dollar accounts, and are accelerating their withdrawals of cash dollars to add to the high stock of “mattress money.”

Although stress testing by the CBA indicates that solvency is not at risk, for prudential reasons the CBA is putting in place measures for long-term support for weak banks. This is especially important as their shareholders may be unable to fund the resources to do so in the context of a global crisis. International experience has shown that banks can be stabilized through the placements of long-term deposits, which can be backed by the issuance of subordinated debt with an option to convert into equity if necessary. Forward planning should also assess what would happen if a large bank were to become insolvent. The creation of the DGF was a positive step in 2004. Staff suggested that a broadening of the guarantee would be positive in boosting confidence in the banking system and preventing deposit runs.

9. Fiscal policy remained prudent throughout 2008. The overall deficit was contained at 1.7 percent of GDP, well below its budgeted level, with an improvement of 0.6 percent of GDP compared to the 2007 budget outturn (Table 5, Figure 4). The improved fiscal position reflected both revenue-enhancing and expenditure-reducing measures. On the revenue side, tax collection was well above expectations, in particular for VAT, reflecting some progress in tax administration and the continued accumulation of tax credits. On the expenditure side, the elimination of the gas subsidy in May 2008 and the slowdown in the implementation of capital projects contributed to a lower-than-budgeted outturn. Government debt remained at a comfortable level.

Table 5.

Armenia: Central Government Operations, 2006–09

(in billions of drams)

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Sources: Ministry of Finance and Economy, Central Bank of Armenia, and Fund staff estimates and projections.

Relative to the budget, the staff presentation reclassifies estimated military wages from other goods and services and other expenditure to wages.

Underlying balance is defined as overall balance before grants, and excluding external interest payments.

Overall balance excluding net lending.

Figure 4.

Armenia: Recent Fiscal Developments 1/

Citation: IMF Staff Country Reports 2009, 140; 10.5089/9781451801743.002.A001

Sources: Armenian authorities; and Fund staff estimates.1/ All figures are in percent of GDP.

10. Nonetheless, the rapid and unexpected deterioration of the economic situation had a strong impact on program performance under the PRGF arrangement. Most of the end-December 2008 quantitative performance criteria were missed. Due to the large foreign currency sales and the need to provide liquidity to banks, both the end-2008 targets for international reserves and net domestic assets of the CBA were missed. In addition, the target on net banking system credit to the government, as well as that on the underlying fiscal balance, were missed (Table 6). The authorities, recognizing the changed circumstances and the large increase in their financing needs, have requested the Stand-By arrangement and also requested the cancellation of the PRGF arrangement.

Table 6.

Armenia: Quantitative Targets under the PRGF Program, 2008 1/

(End of period ceilings on stocks, unless otherwise specified)

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All items as defined in Country Report No. 09/29.

Performance criterion.

At program exchange rates (357 dram per dollar in 2007 and 304.2 dram per dollar in 2008).

Overall balance before grants, and excluding external interest payments. Cumulative flow from the beginning of the calendar year until the end of the month indicated.

Indicative target.

Includes debt with maturity of more than a year as well as obligations with maturity of one year or less, excluding normal import-related credit and sales of treasury bills to nonresidents.

III. The Authorities’ Program

11. The new program aims to achieve the necessary external adjustment, restore confidence in the domestic currency and the banking sector, and protect the poor. The authorities recognize that postponing the necessary adjustment in the exchange rate has deepened the external imbalances and the lack of confidence in the currency. Therefore, they feel that it is desirable to return to a floating regime and address the confidence crisis with a strong program backed by the Fund. Their program is based on a consistent set of policies in the exchange rate, monetary, financial, and fiscal areas as well continued structural reforms.

12. The short-term macroeconomic outlook is very challenging. The significant slowdown experienced by Russia and other countries will cause remittances to fall, with a negative impact on domestic demand. Activity in the construction sector is expected to decelerate dramatically, and difficulties in mining are bound to persist. Against this backdrop, real GDP is projected to decline by 1½ percent in 2009, and significant job losses are expected. Reflecting a combination of exchange rate depreciation, a decline in international prices, and a drop in domestic demand, imports are expected to fall. Despite weak exports and remittances, the current account deficit will narrow by more than 1 percent of GDP to 11½ percent of GDP. Depending on global developments, a gradual recovery may be possible starting in 2010 (Table 7), but downside risks are prevalent. Although price pressures continue to dissipate, this will be offset in part by pass-through as the exchange rate moves in line with its fundamentals.

Table 7.

Armenia: Medium-Term Macroeconomic Framework, 2007–12

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Sources: Armenian authorities; and Fund staff estimates and projections.

For 2007-09, the figures include projections for disbursements under the U.S. Millennium Challenge Account.

Underlying balance is defined as overall balance before grants and excluding external interest payments.

A negative figure indicates an increase.

Armenia: Macroeconomic Outlook, 2008-12

(In percent of GDP, unless otherwise indicated)

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Sources: Armenian authorities; and Fund staff estimates and projections.

Excluding grants and external interest payments.

Monetary and exchange rate policies

13. As part of the program, the authorities are returning to a flexible exchange rate regime. In particular, the authorities will indicate that they will no longer intervene in the market, except to smooth extreme volatility. At the outset, it is expected that the dram will adjust downward in line with the exchange rate’s equilibrium rate, but some overshooting is possible. The depreciation will be accompanied by a 100-basis points increase in the policy rate and a coordinated and transparent communication campaign involving the CBA, the government, and the Fund. The authorities are ready to raise interest rates by at least a further 100 basis points shortly thereafter should market conditions prove unstable. This will help support demand for dram-denominated assets, fight capital outflows, mitigate potential inflationary pressures stemming from depreciation, and restore confidence in the financial sector. When normal market functioning is restored, the exchange rate policy will be a managed float with no predetermined path. The authorities will only intervene to smooth excessive market volatility and to increase international reserves as a secondary objective.

14. Under a managed float, the authorities would gradually return to their inflation-targeting framework. In the short term, increased dollarization will hamper the implementation of monetary policy. The quantitative targets under the program will guide the formulation of monetary policy until conditions for a return to inflation targeting are fulfilled. To this purpose, the authorities will further strengthen the monetary transmission mechanism by pursuing more active liquidity management and fostering the development of the money market, which will require closer coordination between the Ministry of Finance and the CBA (MEFP ¶12).

Financial sector policy

15. Strengthening financial stability will be a key part of the authorities’ program. The immediate priority will be to restore stability and confidence and to support banks while they adjust to the new situation. The authorities clearly recognize that the banking system will be adversely affected by the depreciation of the dram and they are committed to take all appropriate measures to ensure that banks remain able to meet all liabilities as they fall due. This will be done through short-term emergency measures to stabilize the system, while at the same time enacting more structural measures to ensure the soundness of the system going forward (MEFP ¶11).

16. The authorities’ principal immediate concern is liquidity. Demand for dollar and dram liquidity may surge following the return to the floating exchange rate, and the authorities intend to ensure that this demand is adequately addressed. One particular source of risk is that all deposits held by individuals are immediately callable, including term deposits, but the banks are short of liquid dram assets with which to repay the depositors. Another issue is the adequate provision of dollar cash to accommodate dollar deposit withdrawals. This will be mitigated to the extent banks are facilitating the opening of foreign exchange accounts, so that individuals can change the currency denomination of their deposits without having to move into cash.

17. While the banking system as a whole is resilient, solvency concerns may emerge over time for some banks. The first round impact of a sharp depreciation on banks’ balance sheets, in terms of valuation effects, is likely to be mild. Taking into account the current net open foreign exchange position of the banking system of about 7 percent of capital (with dram assets now exceeding dram liabilities, and the inverse for dollars), this would lead to a decline in the capital adequacy ratio (CAR) of just under 1 percent to 27.1 percent. According to the CBA’s stress tests even under a scenario that includes conservative estimates of the second round effects of a substantial deterioration in credit quality, the CAR for the system as a whole would remain comfortable. However, several banks would fall below the 12 percent CAR minimum, requiring remedial action including recapitalization.

18. The CBA is formulating a comprehensive and actionable contingency plan to ensure a timely and consistent policy response. The plan will include plans for dealing with banks’ illiquidity as well as solvency problems if necessary. The CBA will consult with the government as needed on the preparation of this contingency plan and the roles of the relevant agencies will be clearly specified. Key aspects that will be addressed in this plan are:

  • Liquidity support operations: The CBA is committed to providing sufficient liquidity to banks on a temporary basis, after depreciation, in exchange for adequate collateral. In consultation with the recommendations of IMF technical assistance, the CBA will accept a wider range of collateral.

  • Addressing bank restructuring issues: If financial conditions in any bank appear to be deteriorating, the CBA will agree with bank management and shareholders on a restructuring plan to resolve the difficulties and the existing shareholders will be required to inject new capital. If a bank is judged to be viable, the authorities would consider providing long-term funding and/or taking an equity stake. Otherwise, bank mergers will be encouraged where appropriate with closures the final option. Should circumstances warrant it, the coverage of the DGF will be increased. To this end, the authorities will approve a plan to increase the resources of the DGF by end-June 2009.

  • Enhanced banking supervision: Bank supervision will be strengthened with more intensive on-site and off-site surveillance and monitoring. The CBA will also tighten prudential standards, particularly regarding foreign currency exposures, and will progressively work to reduce banks’ net open positions.

Fiscal policy

19. Fiscal policy will contribute to macroeconomic stability, while protecting social outlays and public investment. For 2009, revenue in nominal terms is projected to be significantly lower than in the budget, reflecting the downturn in revenue-generating sectors such as mining. To partly offset the anticipated revenue shortfall, the authorities intend to cut back on non-priority spending and introduce some tax policy measures. On spending cuts, key measures include cuts in areas where execution has been slow, and other non-priority spending such as representation and other administrative costs. These measures are expected to yield savings of about 0.8 percent of GDP. Accordingly, the program aims at limiting the deficit, excluding non-programmed externally financed investment projects, to 2.8 percent of GDP compared to a deficit target of 1 percent of GDP in the announced budget. The program accommodates an increase in social spending of 0.3 percent of GDP, relative to the budget, to protect the poor through well-targeted social safety nets.

20. The program also provides room for additional infrastructure and investment spending as foreign financing materializes. The authorities expect additional resources to be available from external donors and partners, notably from Russia, on top of what is currently projected. While much of these resources are only partially concessional, they would provide scope to finance additional public investment in 2009, and potentially expand credit lines for small and medium enterprises. The program envisages a cap on spending out of these resources of $200 million in 2009 on top of what is included in the program. The program, therefore, includes an upward adjuster on the fiscal deficit target up to this amount.

21. The authorities have decided to raise customs tariffs, against staff recommendations. Custom tariffs on a wide range of consumer goods are being increased from 10 to 15 percent, mainly to soothe domestic political pressure for protectionist measures, and to enhance revenues (about 0.3 percent of GDP in 2009); average effective tariffs are expected to increase from 3 to 5 percent. In their discussions with staff, the authorities argued that these tariff increases are within Armenia’s bindings with the WTO, and will be limited to a certain number of goods for which Armenian substitutes exist (MEFP ¶16). They have signaled their intention to revert to the original levels of tariffs within a few years.

22. The authorities plan other tax policy changes, including an increase in presumptive taxes on tobacco products and in excise taxes on imported alcoholic beverages. Going forward, the authorities indicated their readiness to abolish presumptive taxation for tobacco and fuel and bring these sectors within the regular tax regimes (excise tax, customs duties, profit tax, and VAT) by January 2011 (MEFP ¶16).

Structural policies

23. The authorities will continue their wide-ranging structural reform agenda outlined in their Sustainable Development Program. This agenda is aimed at deepening productivity-enhancing structural reforms, and improving governance. A key area will be continued efforts to strengthen the business environment, with a focus on tax administration reforms and the fight against corruption.

24. The authorities are planning to advance the reform agenda in tax policy and tax administration. They have made progress towards modernizing tax administration, and remain committed to their comprehensive reform agenda in this area (MEFP ¶18). More importantly, they intend to address two long-standing problems in the tax administration area, namely the large amount of outstanding tax credits, and the long delays in VAT refund processing to exporters. Both issues are included in the program’s conditionality because resolving these concerns would have a positive impact on public finances, the business environment, and economic growth (Box 2)(MEFP ¶17).

Armenia: Structural Conditionality, 2009–10

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25. Staff and the authorities agreed on the importance of establishing a comprehensive approach to analyzing fiscal risks, as this would strengthen budget process and enhance fiscal policy credibility. This would be all the more important in view of the authorities’ plan to introduce a funded pension pillar by January 2010. To this end, the authorities intend to strengthen the fiscal framework by publishing an annual report on medium-term fiscal risks and contingency plans in the context of the Medium-Term Expenditure Framework (MEFP ¶19).

26. The authorities will expedite their financial sector reforms. In parallel with the above-mentioned urgent measures aimed at ensuring financial stability, the authorities will continue improving the financial soundness of commercial banks, including by enhancing their risk management capacity and strengthening supervision. They will also enhance credit availability and financial intermediation, and launch a campaign to educate consumers about financial products and services. In order to develop the securities market, the authorities will submit to parliament an amendment to Article 11 of the “Law on the Central Bank of the Republic of Armenia” to allow a gradual recapitalization of the CBA with marketable interest bearing securities (MEFP ¶20

IV. Program Modalities

Program access and financing

27. Armenia faces high financing needs from 2009 through 2011. Gross external financing requirements are projected at about $1.6 billion for 2009, and will remain elevated through 2011, albeit with a slight downward trend. Capital outflows are projected to contribute significantly to the financing gap in 2009, with a turnaround projected in 2010. Import coverage would decline to well below 3 months of imports but recover gradually over the program period.

Armenia: External Financing Requirements and Sources, 2008–2011

(In millions of U.S. dollars, unless otherwise indicated)

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Sources: Armenian authorities; and Fund staff estimates.

Includes portfolio investment and net errors and omissions.

Includes debt deferal from the Lincy Foundation in 2003, and debt relief from Turkmenistan in 2003 and from the United Kingdom from 2006 to 2008.

28. These financing requirements are unlikely to be met from traditional sources (FDI and bank flows) given the deteriorating global economic environment. Foreign direct investment will contract, reflecting the decline in economic activity in Russia, from where most FDI flows originate. The financing pressures could actually worsen with continued deposit outflows given the uncertain policy environment. The World Bank has already signaled an increase in financing with a $525 million dollar package to be disbursed over the period 2009-2012 with some front-loading. The authorities are in negotiations with the Russian government for a $500 million dollar loan to boost investment spending and credit programs to small and medium-sized enterprises. Other agencies such as the Asian Development Bank are considering increasing their financing envelope, while a Fund-supported program could trigger additional financing by the European Union. Financing of existing external debt obligations is minimal and does not exert a strong effect on the current financing requirement.

29. The remainder of the financing gap can only be closed by significant domestic adjustment and funding from other sources. The current account position is expected to adjust by 1.2 percent of GDP under the program, improving by $288 million relative to the baseline in 2009. The adjustment in the current account is predicated on the implementation of the policy measures under a Fund program, which is expected to curtail import growth. However, in the absence of Fund financing, reserves coverage would fall below 3 months of imports.

30. The proposed Stand-By Arrangement would involve frontloaded and exceptional access from the Fund of 400 percent of quota (SDR 368 million or about $544 million). The objective of providing sufficient liquidity buffer to the banking system, preserve import coverage at a desirable level, while sending a powerful signal to depositors would not be achieved within the current access limits. This level of access would allow for a first purchase of 175.6 percent of quota (SDR 161.5 million, or about $239 million) to be made available upon approval. The remaining 224.4 percent of quota would be disbursed between May 2009 and June 2011 (Table 8). The arrangement is subject to the exceptional access framework. Armenia is experiencing large shocks to both the current and capital account, with the relative weight of the shocks suggesting this case is more of a capital account crisis. Box 3 presents an assessment relative to the four substantive criteria, and on this basis, staff considers that all four criteria are met.2

Table 8.

Armenia: Fund Disbursements and Timing of Reviews Under the Twenty-Eight Month Stand-By Arrangement, 2009-11

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Source: Fund staff estimates and projections.

Armenia: Exceptional Access Criteria

1. Armenia’s exceptional financing need is a result of the large shocks it is experiencing to both the current and capital accounts. Under the Fund’s policy on exceptional access, Armenia would need to satisfy four substantive criteria:

  • Criterion 1—exceptional balance of payments pressure in the capital account. In addition to large current account pressures, Armenia is currently experiencing a sharp contraction in prospective FDI financing paired with capital outflows. A disorderly response to policy adjustments could precipitate a substantial withdrawal of deposits from the banking system. The corresponding capital outflow would generate exceptional balance of payments pressures.

  • Criterion 2—sustainable debt position. An assessment by staff indicates that debt will remain sustainable according to the calculations of both external and public debt. Armenia’s total external and domestic debt is relatively low at about 18 percent of GDP as of end 2008. Drawdown of the full amount of the proposed SBA and nonconcessional borrowing from IBRD would increase the public debt-to-GDP ratio over the medium term to about 22 percent of GDP—all debt indicators would remain well below prudential levels. Standard stress tests indicate that Armenia’s debt outlook would remain favorable in the context of a one-time 30 percent real depreciation of the exchange rate.

  • Criterion 3—access to private capital markets. Armenia private sector firms have undertaken limited borrowing on international capital markets to date, although the government has not. Successful implementation of a Fund program is expected to allow Armenia to regain access to private capital markets by the time repurchase obligations to the Fund become due. By that time, the substantial adjustment of the current account and anticipated recoveries in Armenia’s main trading partners should significantly strengthen the economy.

  • Criterion 4—strong economic policy program. Armenia has a long track record of sound macroeconomic management—notwithstanding the recent difficulties on exchange rate policy—and has a strong commitment to the policies that underpin this program. The authorities would have to implement robust policy measures, which would demonstrate the authorities’ commitment and institutional and political capacity to deliver. On this basis, staff consider that the program has a strong likelihood of success.

31. Fund financing would cover Armenia’s projected unfinanced balance of payments needs during the first 12 months of the program. After the Fund resources, an unfinanced gap of about $51 million remains in 2010, and $10 million in 2011, but this could be covered by as yet unidentified resources from other external sources, or from measures to be implemented during 2010-2011. Fund financing would be utilized to buffer against liquidity strains and increase reserve coverage to about 3 months of imports of goods and services, a necessary level given the degree of uncertainty.

Capacity to Repay the Fund

32. While Fund financing of this amount presents some risks, Armenia’s capacity to repay is expected to be good. The capacity to repay is based on the government’s strong commitment to macroeconomic stability, reflected in sound fiscal policy, which has kept public debt relatively low (about 18 percent of GDP). By the end of the arrangement, Fund exposure is expected to remain at 5.4 percent of GDP, and about 49.7 percent of gross reserves. There is a marginal increase in public debt ratios over the duration of the program, partially on account of a slowing economy, but debt service will remain low and manageable (Table 9). However, there are some risks associated with the relatively high Fund exposure in relation to peak debt service as a percent of export of goods and services. Armenia’s strong commitment to the program, likely improvement in external conditions over the medium term, and excellent repayment history provide strong assurances that Armenia will be in a position to discharge its Fund obligations.

Table 9.

Armenia: Indicators of Capacity to Repay the Fund, 2008–15

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Sources: IMF staff estimates and projections.

Includes prospective SBA purchase of SDR 368 million (400 percent of quota).

Program Monitoring and Conditionality

33. The SBA would run over 28 months from March 2009 to July 2011. The size and timing of the disbursements were chosen to help anchor expectations in advance of a major policy shift, buffer against a liquidity crisis in the early stages of adjustment while shoring up import reserve coverage. The authorities will be in frequent consultation with staff for the duration of the program and will constantly update staff of any emerging risk, and decide on necessary policy changes to achieve the goals of the program.

34. Program performance will be monitored through quarterly reviews. The first review under the program will be set for mid-May 2009, based on end-March 2009 performance criteria, the second review is proposed for mid-August 2009, based on end-June 2009 targets, while the third review is proposed for mid-November 2009 based on end-September targets. Conditionality focuses on measures critical to address macroeconomic vulnerabilities. The importance of continued reforms in the financial sector and public finance areas to underpin macroeconomic adjustment implies that some structural conditionality is appropriate. The quantitative and structural performance criteria and benchmarks are indicated in Tables 1 and 2 of the Memorandum of Economic and Financial Policies.

Risks to the program

35. There are several risks to the program. Global growth may turn out to be slower than expected and a more severe regional downturn, led by a deterioration of economic conditions in Russia, is quite possible. A sharper economic slowdown in Armenia would pose substantial downside risks to revenues and to the fiscal program. Armenia is vulnerable to changes in external conditions owing to its dependence on remittances and capital inflows. A shortfall in these inflows would imply a larger adjustment in the exchange rate. The return to a flexible exchange rate may destabilize the financial system in the short run, which could in turn impact economic activity. Lack of political support could hamper progress on structural reforms.

V. Staff Appraisal

36. Armenia’s external outlook has changed dramatically in recent months, and there are growing pressures on the financial system. The deterioration in the balance of payments due to the shocks to the current and capital accounts will require a significant adjustment in the context of a deep growth slowdown. At the same time, the already fragile confidence in the banking system is weakening, risking rapid redollarization and deposit withdrawals, which could be destabilizing.

37. The proposed Stand-by Arrangement is a strong and credible package that can help maintain macroeconomic, financial, and social stability. The proposed program is based on exchange rate flexibility, with supportive fiscal, financial sector, and structural policies.

38. Central to this strategy is the return to a flexible exchange rate regime. Given the nature of its economy and potential shocks, Armenia is well-served by a flexible regime, which will help narrow external imbalances and support economic recovery. Effectively pegging the exchange rate has proved both costly to maintain and a source of growing risk to the economy and the financial sector. Accompanying policies—including on interest rates, intervention policy, fiscal restraint, and communication with the public—will be crucial to ensure that the return to a floating regime is a success. The authorities should stand ready to adjust policies as needed should the exchange rate overshoot.

39. Strengthening financial stability will be crucial. The program is designed to ensure sufficient liquidity to the banking sector—recognizing that such needs may surge in the immediate future—and thus serve to underpin confidence in the banking system. Appropriate contingency plans for the liquidity and capital needs of banks, enhanced bank supervision, and possible modifications to the deposit guarantee system, should help address specific problems and boost confidence in the system.

40. Sound fiscal policy, with room for public investment and social spending, is a key pillar of the strategy. Despite a sharp drop in revenue linked to the global slowdown and the recession in Armenia, the authorities will appropriately restrain the fiscal deficit in support of a flexible exchange rate regime. At the same time, externally-financed public investment will be maintained, which will be important both to offset the economic downturn and lay the basis for strong growth over the medium term. In addition, sufficient allocations will be made to maintain social services and increased targeted support for the poor as necessary, which will be essential to mitigating the impact of the economic crisis on the poor.

41. The structural reforms in the program will likewise be important for buttressing the objectives of the program. The authorities have made good progress on their tax administration reform program, although work remains to be done to ensure that Armenia has a broad-based, equitable, and efficient tax system that serves as a stable source of revenue. Continued financial sector reforms will also be important to steadily deepen financial intermediation and reduce risks emanating from the banking system. In addition, the authorities are encouraged to continue their broader reform efforts. While not covered by this program, sectoral reforms and efforts to reduce corruption will be essential to boosting productivity and making the economy more resilient to shocks.

42. The decision to raise customs tariffs is regrettable. This measure only increases distortions in the economy and, from a competitiveness standpoint, is less effective than correcting the exchange rate misalignment. While the new tariff rates are within the WTO bindings, the authorities are encouraged to retract the increases as soon as possible.

43. The exceptional access proposed under the program is consistent with the shocks faced by Armenia and the need to preserve financial stability. The proposed access would ensure that reserves coverage remains over three months of imports over the program period, a prudent target given the immense uncertainties and downside risks to the outlook, while policies would allow the necessary external adjustment to take place. The potential liquidity needs of the financial system are large, and Fund resources would also help ensure that a surge in liquidity pressures could be met. Equally important, the signaling effect of such a commitment from the Fund would provide a large boost of confidence and help stabilize the foreign exchange market and financial system.

44. The risks to the program are manageable. There are significant risks to the outlook, particularly regarding a deeper impact from the downturn in Russia. In addition, escalated political tensions in the region could prove a hindrance to economic activity in Armenia. Nonetheless, Armenia has a long track record of sound macroeconomic management—notwithstanding the recent missteps on exchange rate policy—and has a strong commitment to the policies that underpin this program. Moreover, with a low debt and debt service burden, and a strong repayment record to the Fund, Armenia is very unlikely to experience payment difficulties with regard to its Fund obligations.

45. In light of Armenia’s balance of payments needs and concerns for financial stability, and the strong policy package being implemented by the authorities, staff support the authorities’ request for a stand-by arrangement.

Table 10.

Armenia: Proposed Access, 2009-2011

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Source: Executive Board documents, MONA database, and Fund staff estimates and projections.

High access cases include all available data at approval and on augmentation for the 35 requests to the Board since 1994 which involved the use of the exceptional circumstances clause or SRF resources. Exceptional access augmentations are counted as separate observations. For the purpose of measuring access as a ratio of different metrics, access includes augmentations and previously approved and drawn amounts.

The data used to calculate ratios is the actual value for the year prior to approval for public and short-term debt, and the projection at the time of program approval for the year in which the program was approved for all other variables.

Defined as debt of the central government and debt guaranteed by the central government

Attachment I. Armenia: Letter of Intent

March 2, 2009

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C. 20431

Dear Mr. Strauss-Kahn:

The Government of the Republic of Armenia has made significant progress on economic and structural reforms in recent years, with impressive gains in growth and poverty reduction in a context of low inflation. The IMF has accompanied these efforts, and we have successfully implemented a sequence of arrangements under the Poverty Reduction and Growth Facility (PRGF). A new low-access PRGF arrangement was approved by the IMF’s Executive Board on November 17, 2008 to support Armenia’s macroeconomic and reform objectives for the 2008-11 period.

Since last fall, the global outlook has deteriorated substantially, with sharp downturns experienced by Armenia’s key trade partners. As a result, Armenia’s balance of payments inflows have contracted dramatically and capital outflows have picked up, putting significant pressure on the exchange rate and significantly reducing our international reserves. This situation has placed the financial sector in a vulnerable position.

To help address this situation, the Government of Armenia requests a Stand-By Arrangement in the amount of SDR 368 million (400 percent of quota or $544 million) for the period March 2009 through June 2011. These resources should help us to ensure economic and financial stability by stabilizing the international reserves position and the banking system, and allowing for a sound implementation of our budget while protecting the poor. In support of these objectives, we have committed to a set of policies outlined in the attached Memorandum of Economic and Financial Policies. We will continue to implement the structural reforms that underpinned our PRGF-supported program and will be crucial to strengthening our medium-term public finance position. However, given the changed outlook and financing needs, we request cancellation of the PRGF arrangement.

The Government believes that the policies set forth in the attached MEFP are adequate to achieve the objectives of the program, but it will take other measures that may become necessary for this purpose. The Government will consult with the Fund on the adoption of these measures, and in advance of revisions to the policies contained in the MEFP, in accordance with the Fund’s policies on such consultation. Moreover, after the period of the arrangement, and while Armenia has outstanding financial obligations to the Fund from purchases and loans on earlier arrangements, the Government will consult with the Fund on Armenia’s economic and financial policies from time to time, at the initiative of the Government or at the request of the Managing Director. We expect to complete the first quarterly review under the proposed arrangement by June 2009. Finally, we grant our permission for the publication on the IMF’s website of the staff report and this letter.

Very truly yours,

/s/

Tigran Sargsyan

Prime Minister

Republic of Armenia

/s/

Tigran Davtyan

Minister of Finance

Republic of Armenia

/s/

Artur Javadyan

Chairman of the Central Bank

Republic of Armenia

Attachment II. Armenia: Memorandum of Economic and Financial Policies

(March 2, 2009)

I. Recent Macroeconomic Performance and Outlook for 2009-10

1. Armenia is now facing significant challenges following a long period of macroeconomic success and stability. Under the PRGF arrangement that covered the period 2005–08, prudent macroeconomic policies and structural reforms contributed to double digit GDP growth, low inflation, and a significant reduction in poverty rates. Despite a widening external current account deficit, international reserves continued to increase, owing to large foreign exchange inflows and dedollarization, and external debt remained low. The overall fiscal deficit was contained, and additional revenues arising from improvements in tax administration could be used to finance poverty-reducing expenditures. Government debt remained stable. The monetary framework was strengthened, contributing, with a flexible exchange rate, to maintaining low inflation.

2. In the first three quarters of 2008, growth remained strong, with GDP increasing by 10.4 percent through September. Driven by international prices and strong domestic demand, inflation rose to a high of 11.5 percent in August, and the current account deficit continued to worsen. In response to these signs of overheating, monetary policy was progressively tightened.

3. The economic outlook changed abruptly as the global financial crisis deepened in October. Owing to its relative international isolation, the financial sector was not directly affected. However, the mining sector and exports were severely hit by the sharp drop in international commodity prices, with many mines stopping operations. In addition, remittances and capital inflows slowed considerably, which had a major impact on the construction sector. As a consequence, growth came to a halt, with annual GDP growth falling to 6.8 percent for the year as a whole, and the external current account deficit rising to an estimated 12.6 percent of GDP. In the wake of falling international prices and rapidly slowing domestic demand, inflation fell to 4 percent in January 2009.

4. Out of concerns for the impact of a crisis in confidence on financial stability, the Central Bank of Armenia (CBA) intervened repeatedly to stabilize the exchange rate in the last part of 2008 and in early 2009. With expectations for a depreciation of the dram gaining strength, the CBA faced strong pressures, leading to a rapid decline in international reserves. With a significant amount of deposits being converted to foreign currency, and overall deposits declining slightly, banks came under pressure to reduce lending. In this context, and in line with the changed inflation outlook, the CBA eased monetary policy, cutting the policy rate from 7.75 in November 2008 to 6.75 percent in February 2009.

5. As a result of the commodity price shock and our attempt to preserve financial stability, we missed most of the end-December targets under the PRGF arrangement. Due to unexpectedly large foreign currency sales, both the end-2008 targets for international reserves and net domestic assets of the CBA were missed. In addition, the target on net banking system credit to the government, as well as that on the underlying fiscal balance, were also missed. Other targets under the program were respected.

6. The short-term economic outlook presents enormous challenges. Difficulties in many sectors, including mining and construction, are affecting growth prospects and weakening the labor market. GDP growth in 2009 is projected to fall considerably with respect to 2008, and unemployment is expected to increase. Depressed international commodity prices, falling remittances, and weaker capital inflows are putting pressure on the balance of payments, despite falling domestic demand. The redollarization of the financial system presents risks for financial stability and challenges for monetary policy. We are expecting a gradual recovery in 2010, but this is highly dependent on global economic developments, and downside risks are prevalent. A strong policy response is needed to restore confidence, stop the loss of international reserves, and maintain macroeconomic stability.

II. The Program for 2009

7. The policies outlined below are designed to tackle the economic and financial challenges now confronting Armenia. These policies, which would form the basis for a new 28-month stand-by arrangement from the Fund, are aimed at preserving economic and financial stability, while mitigating the impact of the global crisis and economic downturn on the poor. Central to this strategy is the return to a flexible exchange rate regime supported by appropriate monetary policies. We are also vigilant to possible distress in the financial sector, and will respond rapidly should more targeted measures be needed. A sound fiscal policy will underpin our commitment to macroeconomic stability, while ensuring that growthpromoting public investment moves forward. In addition, we want to preserve the impressive gains Armenia has made in reducing poverty in recent years. To this end, we will ensure that the level of social services is maintained, and that programs to protect the poor are expanded as needed. We will continue our ambitious structural reform program aimed at strengthening public finances, boosting productivity, and increasing the resilience of the economy.

8. We will establish a high-level committee to monitor developments in the economy and coordinate the policy response of the authorities to the ongoing economic challenges. This committee will be chaired by the Prime Minister, and will include representatives from the Ministry of Finance, Ministry of Economy, the CBA, and the State Revenue Committee.

A. Monetary, Exchange Rate, and Financial Sector Policies

9. We are committed to return to a flexible exchange rate regime in the immediate future. Since the deepening of the global financial crisis in October 2008, intervention has been necessary to prevent a crisis of confidence that was threatening the stability of the financial system. However, we recognize that the maintenance of a soft peg has led to a large loss of international reserves and significant redollarization without stemming expectations of a dram depreciation. This, in turn, has undermined the credibility of our inflation-targeting framework and the effectiveness of monetary policy, which we are committed to restoring. Since October 2008, our exchange rate misalignment has increased significantly, owing to the worsening economic outlook and the currency depreciation experienced by many of our trade partners. We expect the exchange rate to move to a value in line with its fundamentals when we return to a floating regime. When normal market functioning is restored, our exchange rate policy will be a managed float with no predetermined path. We are committed to intervening only to smooth excessive market volatility and to increase international reserves.

10. Monetary policy will be geared towards supporting the return to a flexible exchange rate regime. As outlined below, we will take any emergency measures necessary to address banks’ liquidity shortages in order to avoid any risks of bank runs. The CBA will raise policy interest rates at the time we return to a flexible regime. This will support demand for dram-denominated assets, fight capital outflows, mitigate any inflationary pressures stemming from depreciation, and restore confidence in the financial sector. Throughout this transition period, we will conduct an open and transparent communication campaign to explain to the public the reasons behind the depreciation and any additional measures needed to preserve financial stability.

11. Strengthening financial stability will be a critical part of the program:

  • To ensure a timely and consistent policy response, the CBA will prepare a comprehensive and actionable contingency plan for the financial sector. This plan will contain the explicit policy responses to all likely developments, including liquidity shortages in the banking sector, with responsibilities of various parties clearly defined. The CBA will consult with the government as needed on the preparation of this contingency plan.

  • We recognize that the banking system will be adversely affected by the depreciation of the dram and will take all appropriate measures to ensure that banks remain able to meet all liabilities as they fall due. The CBA stands ready to provide liquidity to banks on a temporary basis in exchange for adequate collateral. The CBA will on a temporary basis accept a wider range of collateral, including pledged fixed assets, bank shares, and high quality bank loans if necessary.

  • Should circumstances warrant it, the coverage of the Deposit Guarantee Fund will be increased. In addition, the authorities will approve a plan to increase the resources of the Deposit Guarantee Fund (performance criterion for end-June 2009).

  • Bank supervision will be enhanced with more intensive on-site and off-site surveillance and monitoring. If financial conditions in any banks appear to be deteriorating, we will agree with bank management and shareholders on a restructuring plan to resolve the difficulties. In the first instance, we would expect the banks’ shareholders to recapitalize the bank to adequate levels. However, we will also set out a framework for using public resources if this approach proves to be inadequate. In exceptional cases, we will provide banks with long-term funds. In order to protect taxpayers’ interests, the banks will issue subordinated debt, with an option to convert such debt into bank equity. We will also tighten prudential standards, particularly regarding foreign currency exposures, and will progressively work to reduce banks’ net open positions.

12. As market conditions stabilize, we will return to our inflation-targeting framework. In the short term, increased dollarization will hamper the implementation of monetary policy. Therefore, it will be particularly important to further strengthen the monetary transmission mechanism, pursue more active liquidity management, and foster the development of the money market. To enhance monetary operations and debt management, the Ministry of Finance (MoF) and CBA will closely coordinate their liquidity forecasting and MoF debt issuance to take account of both budget financing and liquidity management needs. Furthermore, the CBA will continue to conduct repo operations, and will not go back to issuing its own securities. At the same time, the treasury will maintain its issuance of short-term T- bills, including three-month and six-month T-bills, consistent with the recent memorandum of understanding between the CBA and the MoF. The CBA also plans to increase its holdings of treasury securities over the medium term in order to strengthen its capacity to conduct reverse repo operations.

B. Fiscal Policy

13. Fiscal policy will support macroeconomic stability, while allowing for continued public investment and protection of social services. To this end, we intend to limit the overall fiscal deficit in 2009 to around 3 percent of GDP, excluding nonprogrammed externally-financed investment projects (see below). The deterioration in the deficit target relative to the 1 percent of GDP budget objective is due to the fact that revenue is projected to be significantly lower than the projection in the budget, reflecting the contraction in economic activity, particularly the downturn in revenue-generating sectors such as mining. As discussed below, the revenue shortfall will be offset in part by restrained spending and some tax policy measures.

14. On spending, we plan to restrict non-priority expenditure, while protecting social outlays and allowing for higher investment as foreign financing materializes. To this end, we expect substantial savings on nonessential spending and areas where execution has been slow. At the same time, we intend to boost spending on social protection programs, and are in discussions with partners, notably the World Bank, on how to strengthen these programs.

15. Our aim is to restrict spending financed by domestic resources and instead rely on external financing to fund the increase in capital spending. We expect additional resources to become available from external donors and partners on top of what is currently projected by the IMF. While much of these resources are only partially concessional, they would allow us to finance more public investment projects, and potentially set up credit lines for small and medium enterprises. To this end, we propose to spend up to $200 million from those additional resources on public investment in 2009, with which would allow us to increase our deficit target accordingly. We are committed to maintaining transparency in the use of such resources by channeling any additional spending through the budget. We will also limit the use of government cash deposits to finance the budget, as we recognize the need to have a cushion for cash-flow management purposes, and possibly for future needs.

16. We are implementing some changes to tax policy. Given the weak revenue outlook and the difficult conditions facing Armenian firms with respect to trading partners, we plan to raise temporarily customs tariffs for some goods. We recognize the distortionary impact of such a policy, and the negative impact on the poor. However, the changes in tariff rates are within our commitments to the WTO, and will be limited to a certain number of goods for which Armenian substitutes exist. In terms of revenue impact, we expect this measure to generate an additional AMD 10 billion in receipts in 2009. In addition, we have recently raised presumptive taxes on tobacco products, we plan to raise excise taxes on imported alcoholic beverages, and are considering raising presumptive taxes on petroleum products. Looking forward, we maintain our objective of abolishing presumptive taxation for tobacco and fuel, and to this end, we will submit legislation to parliament by December 2009 to bring petroleum and tobacco products within the regular tax regimes (excise tax, customs duties, profit tax, and VAT), effective January 1, 2011.

17. In 2009, we intend to address two long-standing problems in the tax area:

  • The large amount of outstanding tax credits (AMD 154.4 billion at end-December 2008) is associated with ad-hoc collection practices in earlier periods, including requests for advance tax payments. Halting these practices and offsetting advance payments against future tax liabilities will provide an important stimulus during the recession. Therefore, we will not accumulate additional tax credits during 2009, and, more generally, we are committed to analyzing and fixing the systemic problems underlying these tax credits in the context of our comprehensive tax administration reform. We have included in the program a quantitative indicative target on the stock of tax credits.

  • We remain committed to introducing best practices in VAT refund processing to exporters by: (i) meeting the statutory 90-day processing deadline for all VAT refund claims filed in 2009, (ii) clearing the stock of late refund claims, (iii) implementing risk management approaches (i.e. taxpayers with good compliance histories to get fast-track refunds, while risky cases face pre-refund audits); (iv) implementing a forecasting system to anticipate refund levels so that funds are available to pay legitimate refund claims as they occur; and (v) submitting legislation to parliament to strengthen penalties for false refund claims and pay interest on legitimate late refunds arising from claims filed after December 2009, with interest to be paid out of VAT revenues (structural benchmark for December 2009). We have already significantly reduced the stock of refund claims and plan to completely eliminate it over the next few months.

C. Structural Reforms

Public finances

18. We remain committed to our ambitious tax administration reform agenda. To this end, we restructured the tax administration organization by adopting a function-based organizational structure, merging the four specialist inspectorates into a single large taxpayer inspectorate, and closing 11 tax inspectorates, all of which became effective in February 2009. We expect these changes to generate savings and enhance cost-effectiveness, while securing a sustainable revenue base. Going forward, we intend to continue consolidating the regional tax inspectorates. We have also completed the merger of the State Customs Service with the State Tax Service into a new organization named State Revenue Committee (SRC). The merger is expected to generate efficiency gains through information sharing and administrative support functions, such as human resources and IT, while the core functions of customs and tax administration will not be integrated.

19. On other fiscal reforms, we plan to introduce a funded pension pillar on January 1, 2010. We intend to revise our estimates of the costs of this reform, as well as those associated with the planned increase in basic pensions, taking into consideration the weakening economic environment. Legislation on the new pension system, including on the unification of income tax and social contributions, will be submitted to parliament by mid-2009. The SRC will assume the task of collecting and reconciling individual contributions. In the context of the Medium Term Expenditure Framework (MTEF), we intend to produce an analytical report on medium-term fiscal risks, including those arising from the introduction of the funded pillar and the costs associated with the planned increase in basic and average pensions over the next few years. To further improve our fiscal framework, we intend to improve the MTEF by including a section on debt management, which will help align policy decisions over the medium term, with their long-term fiscal implications. Finally, we plan to complete the specific part of the unified tax code by June 2009.

Financial sector

20. We remain committed to the financial sector reforms outlined in the Memorandum of Economic and Financial Policies underpinning our November 2008 PRGF request. In the current crisis, our focus is on ensuring financial stability, including through the adoption of the measures discussed above. Nonetheless, we will continue to implement our reform agenda, including:

  • Foster the development of commercial banks’ risk management capacity, and integrate an assessment of banks’ risk management systems into the CBA’s regular supervisory activity.

  • Enhance credit availability and improve financial intermediation;

  • Launch our campaign to educate consumers about financial terms, products, and services; and

  • Further develop the securities market as laid out in our capital market development action plan. To increase the stock of government securities available for open market operations, we will amend Article 11 of the “Law on the Central Bank of the Republic of Armenia” to allow a gradual recapitalization of the CBA with marketable interest-bearing securities (structural benchmark for end-September 2009).

Other structural reforms

21. Despite the difficult economic climate, we will continue our wide-ranging structural reform agenda outlined in our Sustainable Development Program. This agenda is aimed at deepening productivity-enhancing structural reforms, and improving governance. A key area will be continued efforts to strengthen the business environment. The tax administration reforms outlined above will help in this regard, and we will continue our fight against corruption.

III. Program Financing

22. Armenia faces significant financing needs during the program period. Our estimates suggest that a large financing gap in 2009 is likely, due to a significant reduction in export earnings, private transfers, and private capital inflows. The decline in export earnings reflects the sharp drop in base metals prices and weakening external demand, while the steep drop in private transfers and capital inflows is particularly associated with the sharp contraction of the Russian economy, from which the majority of both remittances and FDI originate.

23. In the current global climate there are limited available sources of financing. Foreign direct investment is projected to slow considerably in line with the expected weakening of the Russian economy, the main source of such inflows. The bulk of official external financing included in the program will be provided by the World Bank.

24. The resulting financing gap can only be partially financed from domestic adjustment. The current account position is expected to adjust significantly under the program scenario, declining by close to $300 million relative to the program concluded with the Fund in November 2008. Nevertheless, absent Fund financing, official foreign exchange reserves would fall below the desirable minimum level, and cover less than 3 months of imports.

IV. Program Monitoring

25. In the context of significant external financing needs associated with severe external shocks, we would like to request a 28-month Stand-By Arrangement in the amount of SDR 368 million. The funding requested would cover the remaining projected balance of payments needs during 2009 and part of the projected financing gaps in 2010-11. The IMF financing would be utilized to assure financial stability and to maintain Armenia’s gross international reserves at a level sufficient to cover about 3 months of imports of goods and services at the end of the program.

26. The program will be monitored via quarterly performance criteria and structural benchmarks. Progress in implementing the program will be monitored through quantitative criteria and indicative targets outlined in Table 1 as well as structural performance criteria and benchmarks as listed in Table 2. The structural measures discussed above that are not mentioned in Table 2 are part of the authorities’ overall reform effort, but are not part of conditionality under this program. The first review of the program is expected to be completed on or after May 15, 2009, the second review on or after August 15, 2009, the third review on or after November 15, 2009, and the fourth review on or after February 15, 2010.

Table 1.

Armenia: Quantitative Targets, 2009 1/

(End of period ceilings on stocks, unless otherwise specified)

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All items as defined in.

Performance criterion.

At program exchange rates.

Overall balance before grants, and excluding external interest payments. Cumulative flow from the beginning of the calendar year until the end of the month indicated.

Indicative target.

Table 2.

Proposed Structural Conditionality for 2009

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Attachment III. Armenia: Technical Memorandum of Understanding

This memorandum defines the benchmarks, performance criteria, indicative targets, adjustors, and reporting modalities referred to in the Memorandum of Economic and Financial Policies (MEFP).

I. Quantitative Targets

1. The program targets a minimum level of net official international reserves (NIR) of the Central Bank of Armenia (CBA). The stock of such reserves will be calculated as the difference between total official gross international reserves (excluding reserve money denominated in foreign currencies) and official gross 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 Special Drawing Rights (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 and other financial instruments are marked to market. Gross reserves are reported separate from the balance on the government’s Special Privatization Account (SPA) and the Millennium Challenge Account (MCA) and exclude capital subscriptions in foreign financial institutions and illiquid foreign assets. 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 specified in Table 1.

Table 1.

Armenia: (Program) Exchange Rates of the CBA

(As of December 31, 2008 for dollars per currency rates)

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2. The program targets a maximum level of net domestic assets (NDA) of the CBA. For program purposes, NDA is defined as reserve money minus NIR, minus reserve money denominated in foreign currencies, and plus medium- and long-term liabilities (i.e. liabilities with a maturity of one year or more) of the CBA. To evaluate program targets, the dram-equivalent values of NIR, medium- and long-term liabilities, and reserve money in U.S. dollar are calculated at the program exchange rate of dram 385 per U.S. dollar. The dram-equivalent value of reserve money in euro is calculated at the program exchange rate specified in Table 1. NDA is composed of net CBA 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.

1. The program’s ceiling on reserve money is an indicative target. Reserve money is defined as the sum of currency issued, required and excess reserves, and current and time deposit accounts of certain resident agents.1

2. The program targets a maximum level of net credit of the banking system to the government, which is the sum of net credit from the CBA and net credit from commercial banks to the central government.

3. The stock of net credit from the CBA to the government includes the CBA’s holdings of treasury bills and treasury bonds less all types of government deposits with the CBA (including the deposits in the Treasury Single Account, 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 excluding accrued interest and treasury bills are valued at the purchase price plus the implicit accrued interest.

4. Net credit from commercial banks to the government includes: (1) gross commercial bank credit to the central government less government deposits with commercial banks (including the counterpart funds of certain government on lending to the economy financed by the Lincy Foundation and the World Bank); and (2) bank 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).

5. External payment arrears will consist of all unpaid debt-service obligations (i.e., payments of principal and interest) arising in respect of public sector loans contracted or guaranteed including unpaid penalties or interest charges associated with these obligations that are overdue beyond 30 days after the due date.2

6. The program fiscal balance is defined as the negative of the sum of domestic banking system net financing, domestic nonbank net financing, and external net financing to the government. Should a general subsidy be introduced off-budget, the overall balance will be measured including the subsidy as part of government spending. Net banking system credit to the government equals the change during the period of net credit to the government. Nonbank net financing equals the sum of: (1) the change during the period of outstanding treasury bills and bonds to nonbanks (including accrued interest for treasury bills and excluding accrued interest for treasury bonds);3 (2) any other disbursement or transaction that increases nonbanks’ claims on the central government plus withdrawals from the special privatization account or the treasury sub-account containing privatization proceeds in dram, less amortizations made by the central government to private resident nonbank agents. External net financing equals 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.

7. The project implementation units, which carry out projects financed by the US-based Lincy Foundation, 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. In addition, any loans extended by the US-based Lincy foundation to finance investments and that are intermediated through the banking system are recorded in the financial accounts as a financing item below the line and are thus excluded from net lending.

8. Foreign currency proceeds from selling enterprises are deposited into the Special Privatization Account (SPA). The account is held at the CBA and the proceeds are invested abroad together with the CBA’s international reserves. These proceeds are included in the definition of the monetary accounts of the CBA as part of net foreign assets with a counter entry in other items net. Any budgeted withdrawal from the SPA will be accounted for as privatization proceeds used to finance the budget and will be recorded below the line. Any unanticipated withdrawal from the SPA will be recorded below the line as privatization receipts; these withdrawals, however, will be replenished during the same fiscal year. Domestic currency proceeds from selling enterprises to residents are deposited in a sub-account of the treasury single account.

9. The stock of tax credits is defined as the sum of outstanding accumulated credit by the State Revenue Committee (SRC) of all types of tax revenues (VAT, profit tax, excises, income tax, presumptive payments, and others) resulting from advanced tax payments to be offset against future tax liabilities.

II. Adjusters

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

  • Changes in reserve requirements: The ceilings on the NDA of the CBA will be adjusted upward/downward by the amount of banks’ reserves freed/seized by any reduction/increase of the reserve requirement ratio on both domestic currency and foreign currency deposits relative to the baseline assumption as per the following formula: ΔNDA = ΔrB, where B denotes the level of the reservable deposits in the initial definition and Δr is the change in the reserve requirement ratio. The ceilings on the reserve money of the CBA will be adjusted upward/downward by the amount of banks’ reserves freed/seized by any reduction/increase of the reserve requirement ratio relative to the baseline assumption as per the following formula: Δreserve money = ΔrB, where B denotes the level of the reservable foreign currency deposits in the initial definition and Δr is the change in the reserve requirement ratio.

  • KfW loan disbursements: the target on the NDA of the CBA will be adjusted upward by the full amount of any non-programmed disbursement from KfW. The adjustment will be made at program exchange rates. The programmed amount is shown in Table 2 below.

Table 2.

Armenia: KfW Loan Disbursements 1/

(In billions of dram)

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Cumulative from December 2008, at program exchange rates.

  • Other external financing: The floor on the overall fiscal balance on a cash basis is subject to an automatic adjuster, based on deviations of external financing (defined as disbursements of loans from bilateral and multilateral agencies not explicitly mentioned above to government for budget or project support) from program projections (shown in Table 3 below). If external financing exceeds the program projections, the floor on the fiscal balance will be adjusted downward by the amount of the cumulative positive difference between actual and programmed external financing up to a maximum of $200 million (as in Table 4 below).

Table 3.

Armenia: Other External Financing (Program) 1/

(in billions of drams)

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Cumulative from December 2008, at program exchange rates.

Table 4.

Armenia: Other External Financing (Additional) 1/

(in billions of drams)

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Cumulative from December 2008, at program exchange rates.

  • Recapitalization of the CBA: the target on the net credit of the banking system to the government will be adjusted upward by the full amount of the recapitalization of the CBA.

III. Structural Performance Criteria and Benchmarks

11. Approve a plan to increase the resources of the Deposit Guarantee Fund (DGF) (performance criterion, end-June 2009).

12. Submit to parliament an amendment to Article 11 of the “Law on the Central Bank of the Republic of Armenia” to allow a gradual recapitalization of the CBA with marketable interest bearing securities (structural benchmark, end-September 2009). See paragraph 20 of the MEFP.

13. Introduce best practices in VAT refund processing to exporters by (i) clearing the stock of late refund claims, while meeting the statutory 90-day processing deadline for all claims filed in 2009; (ii) implementing risk-management approaches;4 (iii) implementing a forecasting system to anticipate refund levels so that funds are available to pay legitimate refund claims as they occur; and (iv) submitting legislation to parliament to strengthen penalties for false refund claims and pay interest on legitimate refunds not paid on time (interest will apply only to new claims filed after December 31, 2009), (structural benchmark, end December 2009). See paragraph 17 of the MEFP.

IV. Data Reporting

The government will provide the IMF the information specified in the following table.

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

2

The staff proposes that this exceptional access be on credit tranche terms. Normally, there is a presumption that exceptional access in capital account crises will be provided using resources of the Supplemental Reserve Facility (SRF) where SRF conditions apply. However, the SRF is geared towards “a large short-term financing need resulting from a sudden and disruptive loss of confidence reflected in pressure on the capital account and the member’s reserves” and given the seriousness of Armenia’s problems and uncertain global financial markets, the balance of payments difficulties will likely have a longer duration than envisaged by the SRF.

1

Liquidity absorbing transactions under reverse repurchase agreements, the CBA’s deposit facility, foreign currency swaps, and securities issued by the CBA are netted out from claims on banks, i.e., they are excluded from the reserve money definition.

2

The public sector is defined following the Government Financial Statistics Manual (GFS 2001) and System of National Accounts (1993 SNA). It includes the general government and nonfinancial public enterprises.

3

Domestic nonbank 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

The implementation by the tax administration of a risk-management approach to administering VAT refunds will be evidenced by: (i) a documented risk-based audit strategy, plan, and methodology; (ii) regular risk assessments and maintenance of risk profiles for all exporters making VAT refund claims, using information in tax and customs databases and from third parties; (iii) payment of refunds within 14 days to exporters assessed as low-risk (i.e. those with sound compliance histories in relation to VAT and other taxes), supported by selective post-refund audits; and (iv) pre-refund audits within the statutory 90-day processing period to verify claims of exporters categorized as high-risk (i.e. those with a poor compliance history).

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Cover IMF Staff Country Reports
Republic of Armenia: Request for Stand-By Arrangement-Staff Report; Staff Supplements and Statement; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia.
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 140
Publisher:
International Monetary Fund
ISBN:
9781451801743
ISSN:
1934-7685
Pages:
105
DOI:
https://doi.org/10.5089/9781451801743.002
  • Figure 1.
    View in gallery
    Figure 1.

    Armenia: Recent Economic Developments

    GDP growth will be affected by the expected decline in remittances and construction activity.

  • Figure 2.
    View in gallery
    Figure 2.

    Armenia: Estimated Real Exchange Rate Misalignment

    (In percent)

  • Figure 3.
    View in gallery
    Figure 3.

    Armenia: Recent Monetary and Financial Sector Developments

  • Figure 4.
    View in gallery
    Figure 4.

    Armenia: Recent Fiscal Developments 1/

Figure 1.

Armenia: Recent Economic Developments

GDP growth will be affected by the expected decline in remittances and construction activity.
Figure 2.

Armenia: Estimated Real Exchange Rate Misalignment

(In percent)
Figure 3.

Armenia: Recent Monetary and Financial Sector Developments
Figure 4.

Armenia: Recent Fiscal Developments 1/