IMF PLEASED WITH NEW ARMENIAN GOVERNMENT’S REFORM DRIVE
Venla Sipila

World Markets Research Centre
Global Insight
June 23, 2008

The IMF and Armenia are preparing for a new assistance programme,
with focus on tax reforms and compatibility of macroeconomic policies.

A team of the International Monetary Fund (IMF) visited the Armenian
capital Yerevan over 11-17 June, to review the country’s recent
economic developments and discuss macroeconomic policies and reform
priorities in the future with the new government, the parliament,
the Central Bank of Armenia (CBA), and representatives of the business
community and of international donors.

The IMF commended the new Armenian government’s strong impetus for
reform. In particular, the Fund welcomed the emphasis put on reform
of tax administration and tax policy, noting that this will help
in improving the business environment and in promoting broad-based
growth. In addition, the IMF is pleased with the government’s efforts
to improve fiscal analysis and framework, as this will enable more
efficient use of fiscal policy in demand management and allow for
better coordination with monetary policy.

Global Insight Perspective: The newest discussions between the IMF and
Armenian officials pave the way for negotiations of a new assistance
programme to be planned during the coming Article IV Consultation in
September this year.

Significance: The discussions concentrated on issues relevant to
the approaching negotiations over a new Armenia-IMF programme. In
particular, the international lender calls for measures to control
inflation, determined completion of tax reforms, careful evaluation
of the effectiveness of currency market interventions and medium-term
fiscal risks, especially in the face of the planned pension reforms.

Implications: The IMF and the Armenian authorities plan to negotiate
terms of a new assistance programme in September. Given the remaining
reform needs in the Armenian economy, agreement is important.

Outlook: Policy discussions concentrated on four main issues, relevant
for the approaching negotiations over a new IMF-assisted development
programme, as outlined below.

Inflation Control

The IMF sees that, given the current continued and growing inflation
pressure from the demand side, combined with the potential for
supply shocks, booth monetary and fiscal policy should be further
tightened. Monetary policy should be designed to curb second-round
inflationary effects from higher food and energy prices. This
will be challenging given the recent and planned pension and wage
increases. Moreover, the effect of monetary policy will be limited
due to the weakness of the monetary transmission mechanism. Thus,
monetary policy needs to be supported by fiscal measures and efforts
to develop competition in the Armenian economy.

Indeed, fiscal policy will be crucial in containing inflationary
pressures at present. In addition, looking forward, it will play an
important role in supporting long-term economic growth.

The IMF notes that Armenian fiscal policy has in recent years
become moderately pro-cyclical. However, given the persistence
of very high growth, the widening current account deficit and the
challenges posed by the international economic environment at present,
a counter-cyclical fiscal stance would be advisable. In addition,
fiscal restraint should be exercised this year, in order to generate
fiscal room to deal with medium term risks affecting the public
finances. Responsible fiscal spending will also dampen inflationary
pressures, sustaining the real value of pension increases in the medium
term, while also allowing to direct funds for temporary assistance for
groups that are particularly affected by the currently very high food
prices. The Fund also recommends abolishing monopolistic practices
in the import sector, as this would allow consumers to benefit from
potential further appreciation of the dram exchange rate.

Tax Policy and Administration Reform

The Fund observes that Armenian tax reform momentum has intensified
since the new government took office. However, more remains to be done
on this front as, although the tax-to-GDP ratio in Armenia improved
last year, it still remains considerably below potential and also
lower than in most transition economies. The Armenian government is
going to introduce a value added tax (VAT) threshold in order to
address tax policy deficiencies, and the State Tax Service (STS)
has developed a plan for modernising the tax administration, in
accordance with previous advice from the IMF and other donors. The
IMF gives its full support to priorities reflected in the plan.

However, the Fund also notes that while the ambitious tax reform
plans are encouraging, successful implementation of the measures
calls for strong political commitment. In addition, the tax policy
framework should be simultaneously reformed, in order to ensure a level
playing field for all businesses. The prevalence of some privileged
tax regimes is undermining the efforts to reform the tax system.

Currency Market Interventions

Controlling inflation at the same time as the domestic currency is
subject to strong appreciation pressures has become challenging. The
Armenian monetary authorities remain committed to a flexible exchange
rate regime, but in the wake of considerable dram strengthening,
concerns over external competitiveness have arisen, and the Central
Bank of Armenia (CBA) has to an increasing extent intervened in the
currency markets to curb appreciation in the face of strong foreign
exchange inflows. However, when monetary authorities are attempting
to target both the inflation rate and the exchange rate, a conflict
between these objectives arises, and currency market interventions
are likely to prove ineffective. Indeed, the IMF adds that according
to preliminary empirical evidence, the CBA’s currency interventions
are likely to have only had a limited effect on the exchange rate.

Medium-Term Fiscal Risks

The IMF argues that Armenia has become increasingly vulnerable to
medium-term fiscal risks. The international lender supports the
authorities’ plans to modernise the pension system, recognising that
increasing the replacement ratio will involve fiscal costs. However,
the Fund urges policy makers to realistically estimate all of these
costs, while also carefully weighing the benefits and costs against
those involved in alternative policies, by including them in the
medium-term expenditure framework and budget discussions. Risks
are also involved in the conversion of budgetary institutions into
non-commercial organisations outside the treasury system.

Outlook and Implications

The IMF and Armenia are going to negotiate terms of the new assistance
programme in September 2008. The Fund concludes that the focus of the
new programme should be strengthening of the monetary and fiscal policy
frameworks and deepening of structural reforms, in order to enhance
productivity of the economy. Above all, fulfilling the latter goal
calls for making the tax policy more fair and transparent, increasing
domestic competition and diversifying the economy.

The IMF requires the Armenian authorities to submit an up-to-date
Poverty Reduction Strategy Paper before approval of a new Poverty
Reduction and Growth Facility (PRGF) arrangement can be considered by
the IMF’s Executive Board. The Fund adds that the measurement of the
fiscal stance and the monetary policy targets may need to be modified
in the new arrangement compared to the previous PRGF programme.

If the Armenian authorities and the IMF will not be able to agree
on the terms of a new programme soon, Armenia would be expected to
start Post-Programme Monitoring (PPM) with the international lender,
for as long as the country’s outstanding credit exceeds 100% of quota.

The IMF in May completed its final review of Armenia’s performance
under the current PRGF facility, approving a disbursement of 3.3
billion Special Drawing Rights (SDR, some $5US.4 billion), bringing the
total amount paid under the programme to 23 million SDR (see Armenia:
22 May 2008: ).

Given Armenia’s relatively good progress with structural reforms so far
and the new government’s apparent willingness to continue on this path,
a new assistance programme with the IMF seems likely. However, the
task of improving tax administration continues to present significant
challenges, and given its importance in strengthening the Armenian
business environment, the stress given to issues related to tax policy
and fiscal administration is no surprise. While recognising Armenia’s
progress in these areas, the IMF has also repeatedly noted that a
lot still remains to be achieved. Most recently, the Fund noted the
inconsistent and fragmentary nature of these reforms (see Armenia:
19 June 2008: ).

Fiscal revenue collection in Armenia is still suppressed by
the widespread shadow economy, and reducing this remains a key
task. Increasing the general competitiveness of the industrial sector
also has a connection to the tax policy in that reforms in the system
of tax rebates and fixed payments would be needed in order to create a
level playing field for producers, and to support efficient allocation
of resources.

Moreover, the need to increase competitiveness also is connected to
exchange rate developments, as although the strong lari appreciation
is not yet a substantial threat to competitiveness, it may become one
going forward. The risk of contradictory macroeconomic policies in
the presence of substantial inflation pressures further underlines
the need to enhance competitiveness by additional reforms, so that
competitiveness does not need to be supported by exchange rate policy
measures.

The rising energy and food prices, together with planned further
increases in fiscal spending, and rapid credit growth are likely to
maintain a strong inflation push and to further widen the current
account deficit. Given the challenges in macroeconomic policy design,
in enhancing competitiveness and in diversifying the economy, it is
important that agreement on terms of a new programme between the IMF
and the new Armenian government will be found. At present, this also
seems likely.