On December 22, 2014, the Executive Board of the International Monetary Fund (IMF) completed the first review of Armenia’s economic performance under a three-year program supported by the extended arrangement under the Extended Fund Facility (EFF). The completion of the first review enables the release of SDR 11.74 million (about US$17 million), bringing total disbursements under the arrangement to SDR 23.48 million (about US$34 million). The extended arrangement for SDR 82.21 million (about US$119.1 million was approved on March 7, 2014). In addition, the Executive Board concluded the 2014 Article IV consultation with Armenia and endorsed the staff appraisal without a meeting on a lapse-of-time basis.
After a steady recovery during 2010–12 from the deep 2009 recession, Armenia’s growth softened in 2013 and has remained subdued in 2014. The softening of economic activity has been broad based, as growth of exports and remittances slowed, and government spending was lower than budgeted. Construction, which had declined since the 2009 crisis, was relatively flat. Growth is projected at 2.6 percent in 2014 and is expected to increase only gradually in 2015 and over the medium term in light of expectations of slow growth in key trading partners. In line with the subdued economic activity, inflation fell during the year below the Central Bank of Armenia’s (CBA) target range (4±1.5 percent) but is expected to return to that range, as the recent depreciation of the dram pushes the price of imported goods up.
In the context of regional developments, pressures in the foreign exchange (FX) market emerged in early 2014 and reemerged in late November due to further depreciation of the Russian ruble. The CBA moved to stem these pressures by allowing some depreciation of the dram in line with changes in economic fundamentals, but also increasing its FX supply to the market. On December 8th the CBA activated pre-announced daily FX auctions to help ensure smooth functioning of the FX market. The CBA also tightened dram liquidity conditions by increasing the Lombard rate for repo transactions to 21 percent in early December. As a result, interest rates on the overnight market jumped to over 20 percent from December 1–5. International reserve levels are adequate based on standard import and debt metrics. Reserves also continue to compare well with peer countries.
The banking sector remains sound, but performance has been weakening amid challenging economic conditions. In particular, bank profitability has declined as weaker economic growth has been accompanied by an increase in non-performing loans (NPLs), which reached 6.5 percent in September, and as credit and deposits growth have slowed. The recent tightening of domestic liquidity conditions and FX developments may also put pressure on bank profits going forward. The CBA has continued to monitor financial sector developments closely, and the robust capitalization of the banking sector constitutes an important cushion.
The fiscal deficit is expected to reach 1.5 percent of GDP in 2014, well below the budget (2.3 percent of GDP). This reflects capital under-spending (especially in the multi-donor North-South Highway), lower-than-budgeted matching pension contributions (due to pension reform changes), and less spending on goods and services. Despite lower growth, revenues have been close to budget targets so far this year, and even amid regional uncertainties, Eurobond spreads have remained stable.
The authorities’ policies remain geared toward maintaining macroeconomic stability and fostering sustainable and inclusive growth. The CBA continues to conduct monetary policy under an inflation targeting framework, accompanied by exchange rate flexibility, and to implement policies aimed at maintaining and strengthening financial sector stability. Fiscal policy remains focused on keeping the deficit and debt at manageable levels, while augmenting growth-enhancing expenditures and strengthening social protection. In addition, the authorities are pursuing a structural reform agenda to foster growth. On October 10, the presidents of Armenia, Belarus, Kazakhstan, and Russia signed an agreement on Armenia’s membership in the Eurasian Economic Union (EEU). Armenia is expected to formally join the Union in January, once the treaty is ratified by the four national parliaments.
Executive Board Assessment
In concluding the 2014 Article IV consultation with Armenia, Executive Directors endorsed the staff appraisal in the staff report as follows:
Armenia faces a period of slower growth unless decisive actions are taken. Sound macroeconomic policies since the crisis have helped sustain domestic and external stability in a highly uncertain context. However, going forward, projected growth rates will not be sufficient to generate sufficient jobs and stem emigration. Sluggish investment in recent years, a still-weak
business climate, and the absence of strong growth drivers constrain the capacity of the economy to generate sufficient jobs to stem emigration and reduce poverty. EEU membership could help increase exports to the large EEU market, but medium-term growth prospects for Russia are modest as well. Therefore, more decisive implementation of reforms, as anchored in the Fund-supported program, is needed to reduce vulnerabilities and boost potential growth.
Performance has moderated due to both domestic and regional factors. Growth is
expected to slow to 2.6 percent of GDP in 2014 from 3.5 percent in 2013, while inflation has fallen below the CBA’s target range. Growth of exports and remittances has weakened, but slower growth of imports meant that the FX market remained relatively stable through much of 2014, although pressures emerged in November-December. The banking sector remains well capitalized and liquid, but weakening conditions have been associated with an increase in non-performing loans (NPLs). On a brighter note, while the slowdown has been broadly based, agriculture and tourism are benefitting from investment and structural reforms and are growing at a healthy pace.
Vulnerabilities remain high. While international reserves are adequate, the consolidation of the external current account deficit has slowed in 2014 due to lower-than-expected exports and remittances. Staff estimates that an adjustment of the real exchange rate over the medium term would help facilitate further external adjustment and improve competitiveness. However, the banking system is still highly dollarized, which could imply pressures on bank balance sheets if a disorderly external adjustment occurs.
Armenia faces a high degree of risk. Growth is projected to pick up to 3.3 percent of GDP in 2015, in the context of supportive macroeconomic policies—notably, monetary policy easing in 2013–14 and stronger capital budget execution. However, the short-term outlook is subject to a high degree of uncertainty, especially given regional geopolitical developments and tensions. An intensification of these would lead to further negative spillovers to Armenia’s economy.
The authorities should create fiscal space to boost social and investment spending over the medium term. Efforts should focus on revenues, as underexecution of capital spending has had a negative impact on growth, although staff commends the authorities for not diverting spending into low pay-off areas and welcomes efforts to assess and address reasons for underspending. With lower growth, available financing, and few risks to inflation or sustainability, staff sees merit in a higher deficit in the 2015 budget, with increased spending going to capital outlays. Staff has long pressed for higher tax revenues to support higher social spending and growth-enhancing infrastructure projects. Tax measures should also aim to improve the tax system by eliminating gaps and ensuring greater equity. The upcoming formulation of a comprehensive tax code is an opportunity to broaden the tax base and rationalize exemptions and tax expenditures. EEU common customs pool revenues could provide a further opportunity to build fiscal buffers through savings. However, the revenues must be secured and in any event are transitory, as EEU tariffs are expected to decline over the medium-term. Staff commends the authorities’ cautious approach in evaluating the sustainability of these additional revenues, prior to incorporating them in the budget framework.
Further strengthening of monetary and financial sector policies should remain a priority, building on recent progress. The CBA’s Inflation-Forecast Targeting (IFT) framework has served Armenia well and remains an appropriate anchor for monetary policy. Nonetheless, the effectiveness of the IFT framework should be further strengthened by reducing dollarization, improving monetary policy instruments, and enhancing the CBA’s communication and modeling capabilities. Similarly, the CBA has made noteworthy progress in implementing recommendations of the Financial Sector Assessment Program (FSAP) and Basel III guidance, while strengthening financial sector regulation and resilience. However, further work is needed to incorporate new guidance on large exposures and liquidity requirements, as well as to revisit the dedollarization strategy, and to foster better financial intermediation via improved legislation on registration and execution of collateral.
Exchange rate policy should support external adjustment. The current situation poses challenges to exchange rate policy, notably the recent depreciation of the Russian ruble, uncertainty surrounding regional geopolitical events, and pressures to calm what are perceived as disorderly conditions in a thin market. While limited interventions to mitigate disorderly conditions are warranted, pressures that reflect economic fundamentals should be accommodated. Enhanced central bank communications will be important to provide clarity and guidance. Maintaining robust buffers, together with flexibility of the dram, should support further reduction of the external current account deficit to its sustainable level.
The authorities should implement ambitious reforms to bolster potential growth and promote inclusion. The successful implementation of “open skies” in civil aviation is a good example of how bold policy decisions can have positive results in a relatively short period of time. Recent delays in implementation of reforms in the competition and regulatory areas, while relatively minor, should be reversed. The reform agenda should be implemented decisively to improve Armenia’s capacity to grow, create jobs, and reduce poverty. Business environment reforms should overcome long-standing concerns about uneven competition, unnecessary regulation, high costs, and skills shortages and mismatches. The authorities should move quickly to bolster the pension reform and ensure its long-run success. Reforms in the energy sector should be compatible with long-term fiscal sustainability, involve the private sector, and be transparent and cost-effective, while mitigating the impact on the poor. Finally, the authorities should leverage EEU membership to increase exports, improve standards, enhance domestic competition, and invest in infrastructure. They should also pursue deeper integration beyond the EEU to enhance growth prospects and reduce vulnerabilities.
Policies under the program remain on track. All performance criteria and most indicative targets were met. Competition and regulatory reforms have advanced at a slower-than-expected pace, causing delays in meeting structural benchmarks, mainly due to the government change in mid-2014 rather than a change in policy direction. Going forward, the program will accommodate a modest fiscal stimulus in 2015, while maintaining macroeconomic stability and fiscal sustainability. The Net International Reserves (NIR) targets will help maintain strong buffers. Structural benchmarks for the remainder of 2014 and first half of 2015 are focused on core areas, including tax administration, Public Financial Management (PFM), financial sector development, and central bank operations.
Risks to the program are significant, but manageable, and Armenia’s repayment capacity remains robust. While the short-term outlook is subject to a high degree of uncertainty, and Armenia is vulnerable to geopolitical developments, the authorities have a strong track record of sound macroeconomic policies and program implementation. A low fiscal deficit, moderate public debt, broadly adequate reserves, and growth-supporting reforms embedded in the program reinforce this assessment. Staff supports the authorities’ request for the equivalent of SDR 11.74 million to become available with the completion of the first review.
In addition, the Executive Board endorsed the staff appraisal of the staff supplement as follows:
Staff welcomes the authorities’ move to put in place a clear, transparent, and sustainable FX framework in the face of market pressures. These pressures emanate in large part from external developments that are expected to be more than temporary, calling for ER adjustment. The changes were well communicated, and the authorities have demonstrated their commitment to limiting FX auctions to the daily maximum, in order to establish credibility of the new approach. This has provided a clear cap on CBA intervention, helping the market find a new equilibrium ER, and fostering sales of FX by banks, exporters, and others. The new ER should facilitate external adjustment and improve competitiveness.
Staff welcomes the authorities’ commitments to limit FX sales in 2015, rebuild buffers, and further adjust policies as needed. The authorities are to be commended for limiting intervention and strengthening communications and guidance to market participants. The steps to tighten liquidity should be reversed when pressures have abated. The recently activated auction system provides a framework for managing exchange rate pressures and preventing ad hoc interventions. The auction could also be used to rebuild buffers in 2015, for example, by providing a mechanism for daily FX purchases. As the dram adjustment and the increase of interest rates—combined with slowing growth—could have implications for the banking sector, the authorities should continue to monitor the situation closely, with frequent stress testing and contingency plans in place. If pressures continue, a tightening of monetary and fiscal policies may be needed.
Challenges are likely to continue. The authorities have rightly noted that the period ahead is expected to be characterized by continued uncertainty and volatility, including in the oil markets and the regional geopolitical context. The policy framework of a low fiscal deficit, reinforced exchange rate flexibility, sound buffers, and growth enhancing reforms is appropriate, although as indicated in the staff appraisal, more ER flexibility and decisive structural reform implementation would be desirable.
Staff continues to support the conclusion of the First Review.