Armenia: Armenia Economy Profile 2012

Armenia Economy Profile 2012

Policy Trends

The government’s fiscal position has improved since 2010, owing to improvements to tax collection and only a modest increase in government spending. The Ministry of Finance reported a national budget deficit of Dram6.56bn in the first half of 2011, down from Dram16.9bn in the year-before period.

Furthermore, the deficit was considerably smaller than the Dram56.3bn projected by the government. As such, the government appears to be on course to meet its budget targets for 2011, including a deficit-to-GDP ratio of around 4%. Budget revenue increased robustly in the first half as the economic recovery continued and tax collection improved. According to finance ministry data, revenue rose by 9% year on year, to Dram399.3bn.

The robust increase was driven by a 10% rise in revenue from taxes and other national duties, which generated nearly 80% of total revenue. Proceeds from price-added tax—the single major source of tax revenue—increased by 5.9% year on year, to Dram151bn. Lower than expected government spending as well helped to narrow the budget deficit. Government spending rose by 5.9% year on year, to Dram405.9bn, but it was still equivalent to only 88.5% of the government’s target for the first half. Payment of pensions and other social benefits remained the major spending category, rising by 5.4% year on year, to Dram127.1bn. Although the new budget figures indicate that the government has made significant evolution in tackling tax evasion, there is room for further improvement. Mr Sargsyan acknowledged this during a conference with the leadership of the National Revenue Committee (SRC) on May 27th. The conference focused on concrete actions that could be taken to improve the efficiency of the tax system. The points for discussion stemmed from a three-year plan to improve tax government, which was approved by the presidential National Security Council in late April. Mr Sargsyan said that the SRC taxation procedures must be made “additional acceptable, fair, equal, uncomplicated and friendly for businesses”. They would as well need to raise steadily the tax-to-GDP ratio, which is of the lowest in the former Soviet Union. He as well stressed the importance of reducing corruption part tax and customs officials. The conference came the day after Mr Sargsyan issued a stark warning to leading entrepreneurs. In a speech at the Chamber of Commerce and Industry, the president said that leading entrepreneurs must stop underreporting their earnings and obstructing competition in sectors that they dominate. He did not name any tycoons or businesses that the authorities believe to be involved in tax evasion; however, some of these are likely to have close government connections that have been significant for the success of their business operations.

The Fund remains broadly satisfied with economic policies pursued by the government and the Central Bank of Armenia. In a statement in late June the Fund noted that programme performance has been strong, and praised the authorities’ efforts at moving towards fiscal consolidation and the central bank’s efforts to ensure that risks to the financial sector are mitigated. As a result of Armenia’s ongoing compliance with the Fund’s programme, the Fund released the second tranche, worth US$58m, of a loan under its three-year Extended Fund Facility (EFF) and Extended Credit Facility (ECF) with the country in June 2011. Although the Fund is pleased with Armenia’s evolution under the EFF and ECF, in its new review it highlighted several areas for the authorities to focus on. These include improving the tax system, continuing to pursue fiscal discipline and increasing efforts to improve the business environment. In his speech in May, Mr Sargsyan reaffirmed his government’s commitment to carrying out necessary reforms.

Economic Growth

Real GDP rose by 1.2% year on year in the first quarter, according to the new data from the National Statistical Service (NSS). (At the start of 2011 the NSS switched from providing real GDP data on a monthly basis to a quarterly basis.) During the first quarter services and industry remained the principle drivers of increase. However, economic performance was weighed down by the poor performance of construction and agriculture. Agriculture contracted by 2.5%, although this was an improvement on the steep downturn in the previous quarters.

Construction fell by 3.6% year on year, which can be half accounted for by base effects. However, construction remains weak, as it is still recovering from the negative impact of the world recession, which heavily contributed to its 37.4% contraction in 2009. First-quarter economic performance was considerably below the authorities’ (inclunding the Fund and the World Bank’s) target of annual real GDP increase of 4.6%. Although real GDP increase in the first quarter was below expectations, several indicators show that the economic outlook improved in the second quarter. According to NSS data, industrial production expanded by 24.7% year on year in June and by 20.2% in the second quarter, up significantly from the 4.8% year-on-year expansion in January-March. This was driven by developments in mining and metallurgy, which benefited from higher world prices for base metals in the first half. In June the mining subcomponent rose by 12.9% year on year.

The production of base metals and the manufacture of fabricated metal products increased by 12.1% and 88.5% year on year, respectively. The manufacturing subcomponent was as well boosted by the robust performance of the food-processing sector, the major component of manufacturing. According to NSS data, food-production rose by 36.1% year on year in June and beverage-production increased by 39%. Both food-processing and beverage-production benefited from the improved economic conditions in Russia, Armenia’s major export market for such goods. The outlook for agriculture as well improved in the second quarter. According to NSS data, agricultural output rose by 10.2% year on year in June and by 4% year on year in the second quarter. The sharpest increase was in crop-growing, which increased by 27% year on year in June. This subsector has benefited from much additional favourable weather conditions in 2011. In contrast, in 2010 harvests were poor as hail and a violent storm caused much damage during the growing season in the first part of the year. This heavily contributed to a 13.5% contraction in output in 2010. Agriculture plays an significant role in the Armenian economy. In 2010 it accounted for over 17% of GDP.
Government officials have not recently commented on their expectations for output in 2011. However, before in the year the government estimate that agriculture would grow by 10%, owing to better fruit and vegetable harvests and wide-ranging government measures designed to help farmers.

Inflation

Inflationary pressures have continued to ease in recent months. Year-on-year inflation peaked at 12.4% in February and slowed to 6.3% in July, according to NSS data. Slower food price inflation was the primary driver behind the lower headline figure in July. NSS data show that food prices expanded by 10.6% year on year in July, compared with 15% in June. Higher international food prices since the start of the year—combined with unfavourable weather conditions in 2010, which negatively affected the harvest in that year—have heavily contributed to the increase in consumer prices since late 2010. Non-food prices and services rose by 3.1% and 2.3% year on year, respectively, in July. The government and the central bank continue to stand by their estimate that consumer prices would fall sufficiently in the secon d half to bring full-year inflation closer to their target band of 4% (±1.5 %age points). A statement from the central bank’s monetary policy board stated that it expected a pick-up in agricultural production, inclunding agriculture-driven seasonal deflation that is usually observed in mid-year, to help to bring inflation within the target. As inflationary pressures have continued to ease, the central bank decided to hold the refinancing rate at 8.5% at its new monetary policy conference , in July; it most recently raised the rate (by 0.25 %age points) in April. The Fund praised the authorities’ anti-inflationary measures as timely and effective.

Exchange Rates

In March 2009 the central bank stopped supporting the dram, which then weakened by around 18%, to Dram370:US$1, from Dram305:US$1, where it had traded since late 2007. The authorities were forced to allow the currency to weaken when reserves came under pressure, following a decline in foreign-exchange inflows from exports and remittances. In June 2009 the authorities adopted a strategy that moved the dram towards a free-floating exchange rate by reducing central bank intervention in the foreign-exchange market. Indicating that the authorities are adhering to a free-floating exchange rate, the dram depreciated against the US dollar in the second quarter to average Dram374.3:US$1. Although the dram appreciated to average Dram367.2:US$1 in July, the authorities have reiterated that they wish to prevent appreciation in 2011. Armenia’s foreign-exchange reserves were almost US$1.8bn at the end of the second quarter of 2011, equivalent to around months import cover, which will help to reduce Armenia’s vulnerability to external shocks.

External Account

In the first half the large trade deficit remained essentially unchanged in absolute terms from the year-before period. According to data from the NSS, the trade deficit was US$1.29bn, compared with US$1.25bn a year before .

Export increase of 31.1% year on year outpaced imports increase, of 11%. However, at US$603.3m, exports were dwarfed by imports, which reached US$1.89bn. NSS data show that the sharp increase in exports was driven by large year-on-year increases in exports of minerals, metals and food-processing products. In the first half mineral products such as metal ores and concentrates were Armenia’s major export item. Exports ofmineral products totalled US$204m in January-June, a year-on-year increase of 52%.

This sharp increase reflects the strong performance of the mining industry, which has greatly benefited from higher international prices for such products. Exports of non-ferrous metals—including copper, molybdenum and zinc—totalled US$191.3m, an increase of 21% year on year. Precious stones, metals and jewellery items (the third-major export category) generated US$75.1m in export revenue, a 13.7% year-on-year increase. Like mineral products, these export categories have benefited from higher world prices for metals in the first half. In January-June exports of prepared foodstuffs rose by over 41%, to US$67.7m, as the economic situation in Russia, the major market for these products, improved. Exports of foodstuffs and agricultural products could rise further in the coming years with the expected opening of the first tax-free zone in Armenia, on the premises of the Zvartnots
International Airport in the capital, Yerevan. The government and Corporacion America, an Argentinian company that manages the airport, signed a final agreement to that effect in mid-July month after parliament passed a law on tax havens. The continuing recovery in domestic request led to an 11% year-on-year increase in imports in the first half. Indicating the improvement in domestic request, imports of cars and other transport equipment rose by almost 43% year on year, to US$189.2m. In another significant sign of rising consumer request, textile imports were up by 27.6% year on year, at US$69.5m. Natural gas and other minerals remained the single major import category in January-June; imports of these goods reached US$367.4m, a year-on-year increase of around 20%. However, revealing that the recovery in domestic request is patchy, imports of machines and other industrial equipment fell by almost 14% year on year, to US$258m. Russia remained Armenia’s leading trading partner, accounting for almost 20% of the country’s external trade. The total volume of Russian-Armenian trade grew by 11.5% year on year, to US$497m. The prime minister, Tigran Sargsyan, praised the increase in trade between the nations at a conference in July in the Russian city of Rostov-on-Don of a Russian-Armenian inter-governmental commission on economic co-operation. Enhancing bilateral commercial ties was high on the schedule. The current-account deficit widened to US$432.3m in the first quarter (the new available data) from US$358.5m in the previous quarter and US$321.3m in the first quarter of 2010. This was largely driven by a reduction in the current transfers surplus.
The current transfers surplus typically dips in the first quarter, as Armenians usually send cash or goods back at the end of the year ahead of the Christmas holiday. Remittance inflows rose by 27% year on year in June, to almost US$140m. In the first half remittances increased by additional than 25% year on time(to US$614m). Continuing a long-running trend, Russia remained the major source of remittance inflows, accounting for over 80% of the total. Inflows from Russia rose by 28% year on year in the first half as migrant Armenian workers benefited from the improvement in Russian economic performance.

The Armenian economy is slowly recovering from a sharp downturn of over 14 % last year. While rebounding trade and remittances are reviving industry and services, agriculture has been hit hard by adverse weather conditions. As a consequence, overall economic activity is expected to grow by about 4% in 2010 and 4½ % in 2011. Reflecting the pick-up in activity, credit has also begun to flow to the private sector.

The contraction of agricultural output, together with the spike in imported wheat prices, has translated into higher food prices. With nearly half the weight in the consumer price index, higher food prices have pushed annual inflation to 9.6 percent in August. Looking ahead, inflation is expected to moderate and decline to about 7% by the end of this year.

During the 2009 crisis, the authorities successfully mitigated the negative impact on the population by appropriately pursuing countercyclical fiscal policy. These policies inevitably lead to a widening of the deficit, an increase in public debt, and contributed to the deterioration in the current account balance. With the onset of the global crisis and a postponement of the exchange rate adjustment in 2009, dollarization increased rapidly.

As a consequence of domestic and external developments in 2009 and this year, important medium term challenges have emerged. There is a need to consolidate public finances to ensure fiscal and debt sustainability. Given the fragile economic outlook of its key economic partners—Russia and the European Union—there is greater urgency to step up broad-based structural reforms to boost competitiveness and diversify exports so as to raise growth rates and reduce poverty further. Maintaining macroeconomic and financial stability and deepening financial markets in local currency will be critical in helping to dedollarize the economy and raise the effectiveness of monetary policy.

Policies to secure fiscal and debt sustainability.

With the pick-up in revenue performance in the first eight months of this year, the overall deficit is expected to narrow by more than 3 percent of GDP relative to 2009, reaching about 4¾ percent of Gross Domestic Product (GDP) in 2010.

The main focus of fiscal consolidation should continue to be to strengthen revenue collection in the short and medium term, rather than expenditure compression that could hurt spending on important sectors—education and health—as well as the poor. The authorities’ recent revenue and expenditure reform initiatives are steps in the right direction.

These include: setting up an Appeals Council under the government to deal with tax disputes; establishing greater transparency in interpreting the law; extending e-filing coverage of tax returns; and improving the quality of taxpayer services. The IMF mission calls for further steps to modernize tax administration and reduce tax evasion and corruption, including a revamping of the value added tax (VAT) refund system, stepping up the monitoring of large taxpayers, streamlining the reporting system, and introducing a risk-based system for tax audits. On the expenditure side, the authorities aim to reverse the recent increase in poverty and improve access to social services, including in education and health sectors.

With the right policies, the fiscal deficit is projected to fall to about 2 percent of GDP in the medium term, which will ensure that public debt remains sustainable. The mission welcomes the re-introduction of the medium-term expenditure framework, suspended during the crisis, and the adoption of the new debt management strategy which intends to lower the debt over the medium term.

Policies to strengthen competitiveness of and competition in the economy

Armenia is lagging behind many comparator countries in the area of business environment. Recent initiatives to improve regulations regarding standardization, competition rules, and public procurement, aim at bringing these in line with international best practices. But bolder and deeper reforms are needed to enhance competition, diminish monopolistic behavior, diversify exports, and more generally modernize the economy. The tourism industry remains largely untapped—it could serve as an important engine for raising growth and employment, as well as fiscal revenues and foreign exchange earnings.

Policies to control inflation and raise the effectiveness of monetary policy

While monetary policy will continue to focus on price stability, a small open economy like Armenia will inevitably face temporary shocks that are out of the authorities’ control. The mission shares the authorities’ views that the recent increase in consumer prices is mostly attributed to higher imported wheat prices and domestic food prices following the unfavorable weather conditions earlier in the year. A key goal of monetary policy should be to ensure that such temporary increases in prices do not translate to permanently higher inflation through second-round effects.

The Central Bank of Armenia’s (CBA) policy rate remains appropriate as a signal of the monetary policy stance. To strengthen the interest rate channel of monetary transmission, the CBA should continue to actively manage liquidity by using all available monetary policy instruments to ensure that market rates are close to the policy rate. Measures to strengthen the market for dram instruments and increase the use of dram transactions in the economy are welcome, as these would help fight high dollarization, deepen financial intermediation, and raise the effectiveness of monetary policy. The mission also welcomes the authorities’ commitment to maintaining a flexible exchange rate policy which should continue to aim at smoothing sharp fluctuations in the market, guarding foreign exchange reserves, and ensuring that the economy remains competitive. At the same time, it is important that competition and labor policies are supportive of the CBA’s initiatives to prevent temporary price increases of imported and domestic goods from becoming permanent.

Armenia is the second most densely populated of the former Soviet republics. It is a landlocked country between the Black and the Caspian Seas, bordered on the north by Georgia, to the east by Azerbaijan, on the south by Iran, and to the west by Turkey. Up until independence (1991), Armenia's economy was based largely on industry--chemicals, electronic products, machinery, processed food, synthetic rubber, and textiles--and highly dependent on outside resources. Agriculture accounted for only 20% of net material product and 10% of employment before the breakup of the Soviet Union. In recent years, the construction sector has taken off, fueled by an ambitious government-backed construction project in the capital, and remittances to relatives by ethnic Armenians living in Russia and the United States.

Like other New Independent States of the former Soviet Union, Armenia's economy still suffers from the legacy of a centrally planned economy and the breakdown of former Soviet trading networks. While investment from these states in support of Armenian industry has virtually disappeared, and few major enterprises are still able to function, Russian entities have nevertheless increased their exposure in the mining, energy, telecommunications, and transportation sectors. In addition, the effects of the 1988 earthquake, which killed more than 25,000 people and made 500,000 homeless, are still being felt, though international donors and diaspora Armenian groups continue to fund reconstruction efforts in the earthquake zone.

The structure of Armenia's economy has changed substantially since 1991, with sectors such as construction and services replacing agriculture and industry as the main contributors to the economic growth. The diamond processing industry, which was one of the leading export sectors in 2000-2004 and also a major recipient of foreign investment, faced a dramatic decrease in output since 2005 due to raw material supply problems with Russia and overall decline in international diamond markets. Other industrial sectors driving industrial growth include energy, metallurgy, and food processing.

Despite the Nagorno-Karabakh conflict, the Government of Armenia has been able to carry out wide-ranging economic reforms that have paid off in dramatically lower inflation and steady growth. Armenia registered strong economic growth beginning in 1995, with double-digit GDP growth rates every year from 2002 to 2007.

After rapid expansion in 2001-2007, with average 13% annual GDP growth, economic and financial conditions worsened rapidly in Armenia in 2008, due to a drop in international metals prices and a downturn in the Russian economy following the collapse of oil prices in late 2008. The end of a remittance-fueled construction boom that had driven growth in recent years resulted in a 14.4% drop in real GDP for 2009 (compared to 6.8% GDP growth in 2008), with about 80% of this decline due to a plunge in the construction sector. The economy recorded positive growth rates in the first months of 2010.

Armenia maintains a floating exchange rate regime with no explicit exchange rate target. The nominal exchange rate of the Armenian dram with major currencies was fairly stable between 1998 and 2003. During 2003-2007, the Armenian dram appreciated sharply against the U.S. dollar by around 45%, mainly due to significant growth in remittances, growth of exports in absolute terms, the de-dollarization of the economy, and weakening of the dollar in international markets. The appreciation of the dram negatively affected the traditional export industries, including information technology, diamond cutting, the wine industry, and textiles. Exporters responded to the increased costs by either reducing their production capacity or by reducing their number of employees in order to stay afloat. The exchange rate was mainly stable at around 300 drams per dollar during 2008 and until March 2009, when the Central Bank stopped its heavy intervention in the foreign exchange market and the dram devalued by around 25%. The exchange rate remained broadly stable during 2009, with only a few interventions from the Central Bank to prevent sharp depreciation.

Armenia is highly dependent on import of energy fuel, mainly from Russia. The Armenia Nuclear Power Plant (ANPP) at Metsamor provides around 40% of electricity generation for the country, and hydro and thermal plants provide roughly 30% each. Armenia imports most of its natural gas from Russia, which provided significant discounts to Armenia until 2009. The Russian import gas price rose from $110 to $154 per thousand cubic meters in April 2009, and increased further to $180 in April 2010. However, the current price is still below the international average of over $300, and in the coming years the price is expected to converge with market prices.

In May 2009 Armenia began receiving gas from Iran through a recently constructed pipeline, which is meant to diversify Armenia's gas supply. Much of the Iranian gas is expected to be used for power generation.

Armenia imports nearly all of its refined petroleum products through Georgia. The recent conflict between Russia and Georgia resulted in periodic disruptions of fuel and food imports, and highlighted Armenia's vulnerability to this single transit corridor.

Armenia has received significant support from international institutions. The International Monetary Fund (IMF), World Bank, European Bank for Reconstruction and Development (EBRD), as well as other international financial institutions (IFIs) and foreign countries are extending considerable grants and loans. These loans are targeted at reducing the budget deficit, stabilizing the local currency; developing private businesses; energy; the agriculture, food processing, transportation, and health and education sectors. In 2009 Armenia received more than $1.5 billion in donor financing for budget support and various government-led anti-crisis programs.

Continued progress will depend on the ability of the government to strengthen its macroeconomic management, including increasing revenue collection, improving the investment climate, and making strides against corruption. A liberal foreign investment law was approved in June 1994, and a law on privatization was adopted in 1997, as well as a program on state property privatization. Armenia joined the World Trade Organization on February 5, 2003.