IMF PUBLISHED CONCLUDING STATEMENT OF ITS MISSION IN ARMENIA

RIA OREANDA
June 23 2008
Russia

Yerevan. OREANDA-NEWS . On 23 June 2008 was announced, that an IMF
staff team visited Yerevan during June 11-17, 2008, to review recent
economic developments and discuss macroeconomic policies and structural
reform priorities for the remainder of 2008 and the medium term. The
team met with the newly-appointed government, Central Bank of Armenia
(CBA) staff, parliamentarians, and representatives from the business
and international donor communities. The discussions pave the ground
for negotiations of a new IMF-supported program during the 2008
Article IV consultations in September.

The team was pleased with the new government’s strong impetus
for reform. The emphasis on tax administration/policy reform is
particularly encouraging, and should contribute to improving the
business environment and promoting broad-based growth. The new
government’s efforts to improve fiscal analysis and strengthen the
fiscal framework are also welcome, as this will make fiscal policy
a more effective demand management tool and improve coordination
between the monetary and fiscal authorities.

I. Macroeconomic Performance and Outlook

Armenia appears to be set for another year of double-digit real GDP
growth. Economic performance in the first five months of 2008 remained
robust, and growth during the rest of the year will continue to be
driven by the ongoing boom in the construction sector. Risks are
mainly on the upside, as agricultural production may well turn out
to be better than currently projected, and some investment projects
not yet included in the forecast may materialize in 2008.

CPI inflation has risen sharply in recent months, despite a gradual
tightening of monetary policy and a moderate fiscal stance. While
the surge in inflation to around 10 percent was mainly due to higher
food import prices, non-food inflation has picked up as well, amid
high international oil prices and strong domestic demand. End-year
CPI inflation is expected to be close to 7 percent, exceeding the
announced inflation target (4 1.5 percent), but still lower than in
neighboring countries.

Fiscal developments have been positive, creating space for fiscal
tightening. Tax revenues gained strength, driven by strong VAT
performance. Based on the assumption that higher-than-expected tax
revenues will be saved, the fiscal deficit is projected to be around
1.2 percent of GDP, significantly lower than budgeted (2.6 percent
of GDP). This will limit the fiscal impulse and help contain real
exchange rate appreciation.

The trade deficit widened further in the first four months of 2008 on
the heels of surging imports. Although private transfer inflows are
expected to grow at a robust pace, the external current account deficit
is projected to widen to around 8.6 percent in 2008. With appreciation
pressures diminished by rising import demand, the dram/dollar exchange
rate has remained broadly stable since December 2007.

II. Policy Discussions

Discussions focused on key policy challenges relevant for the upcoming
program negotiations: (i) controlling inflation in the face of supply
shocks and rising demand pressures; (ii) the urgent need to tackle
the unfinished tax policy and administration reform agenda; (iii)
the effectiveness of foreign exchange intervention by the CBA; and
(iv) the increased vulnerability to medium-term fiscal risks.

Controlling inflation in the face of supply shocks and rising demand
pressures

Given the magnitude of potential supply shocks and growing inflationary
pressures from the demand side, further monetary and fiscal tightening
will be needed. Rising energy and food import prices, recent and
planned pension and wage increases, and rapid credit growth will likely
keep inflationary pressures high, worsen the terms of trade, and widen
the current account deficit. Against this background, the challenge for
monetary policy is to limit the second-round effects of higher food and
energy prices, and thus contain inflationary expectations. This is no
easy task, given the weak monetary transmission mechanism, calling for
supportive fiscal policy and efforts to enhance domestic competition.

In the current economic environment, fiscal policy will play a key
role in containing inflationary pressures while sustaining long-term
growth. After an initial phase of significant adjustment (until
2002), fiscal policy has become moderately pro-cyclical in recent
years. The more challenging international economic environment,
together with the persistence of double-digit domestic growth and a
widening current account deficit call for a counter-cyclical fiscal
stance. To create fiscal space for dealing with medium-term risks,
it will be important to save any revenue over performance in 2008, as
well as to better prioritize competing expenditure projects. Dampening
inflationary pressures through expenditure restraint will help sustain
real increases in pensioners’ income over the medium-term, as well as
free up funds for targeted temporary assistance to those vulnerable
groups who are disproportionably affected by higher food prices.

Finally, discontinuing monopolistic practices in the import
sector would allow consumers to benefit from potential further dram
appreciation in the form of lower import prices. Our estimates indicate
a significantly lower pass-through for exchange rate appreciation
(10 percent) than for depreciation (31 percent), supporting the
anecdotal evidence of limited competition between importers.

The unfinished tax policy and administration reform agenda

There is broad consensus on the need to complete the tax reform
agenda. Despite a notable improvement in 2007, the tax-to-GDP ratio
in Armenia is still lower than in most transition countries, and well
below potential. The momentum for reform has gathered pace since the
new government took office, with priority given to a number of key
tax policy and administration initiatives. To address tax policy
deficiencies, steps are underway to introduce a VAT threshold and
provide small businesses (those below the VAT threshold) with simpler
procedures to assess and pay their taxes. To address tax administration
weaknesses, the State Tax Service (STS) has developed a comprehensive
plan to modernize tax administration, in line with previous advice from
the IMF and other donors. We fully support the immediate priorities
reflected in the plan, including restructuring the STS organization,
addressing corruption, strengthening large taxpayer administration, and
enhancing taxpayer services, particularly for small businesses. Adding
to these initiatives, we would also encourage the authorities to take
early steps to introduce risk-based VAT refund processing. This will
improve exporters’ competitiveness.

The government’s ambitious tax reform agenda is encouraging, but
it requires firm political commitment to be successful, including
appropriate funding for the STS reform program. It also requires
simultaneous efforts to reshape the tax policy framework to ensure
a level playing field for businesses. Privileged tax regimes (such
as the introduction of new tax holidays and the current presumptive
taxes for fuel and tobacco) are inconsistent with this aim, and risk
undermining the reform effort.

Effectiveness of foreign exchange intervention

As in other countries, controlling inflation in the face of
appreciation pressures has become a policy challenge. While the
authorities remain committed to a flexible exchange rate regime,
significant dram appreciation between 2003 and 2007 has raised concerns
about external competitiveness, and the CBA has increasingly engaged
in foreign exchange interventions. International experience has shown
that intervention is likely to be ineffective when there is a conflict
between exchange rate and inflation objectives. While acknowledging
that a significant part of interventions were conducted to accommodate
dedollarization, this may have been the case in Armenia in 2006 and
2007. As the extent of cash dedollarization is inherently difficult
to quantify, large-scale unsterilized foreign exchange purchases may
have contributed to inflationary pressures. Foreign exchange sales
in 2008 so far have been more in line with the tightening of monetary
policy needed to curb inflation.

Preliminary empirical evidence suggests that CBA foreign exchange
market intervention has had only a limited impact on the level of the
exchange rate. While this is in line with the stated CBA objective
of maintaining a flexible exchange rate, foreign exchange market
interventions also seem not to have significantly reduced exchange
rate volatility. It may well be, however, that interventions have
contributed to reducing intraday exchange rate volatility, thereby
allowing the dram to appreciate in an orderly manner.

Increased vulnerability to fiscal risks

We support the plans to modernize Armenia’s pension system, and
recognize that raising the replacement ratio will necessarily entail
fiscal costs. However, all costs involved should be realistically
estimated and weighed against competing priorities by including them in
the medium-term expenditure framework and budget discussions. Finally,
since investment in new systems and procedures will be required,
adequate time needs to be given for effective planning and
implementation before the new pension system can be in place.

Additional macro-fiscal risks are associated with the conversion of
budgetary institutions (particularly schools) into noncommercial
organizations (NCOs) outside the treasury system. While the
authorities’ efforts to address these risks are welcome, further
measures and resources for the NCO unit will be needed for the
implementation of effective reporting and control systems.

III. Toward a New IMF-Supported Program

The IMF team will negotiate terms of a new IMF-supported program with
the government in September 2008. The focus of the prospective program
should be on strengthening the fiscal and monetary policy frameworks,
while deepening productivity-enhancing structural reforms, notably by
making tax administration and tax policy more fair and transparent,,
increasing domestic competition, and diversifying the economy. An
up-to-date Poverty Reduction Strategy Paper is required before a new
PRGF arrangement can be considered by the IMF Executive Board.

In terms of program design, the measurement of the fiscal stance
and the monetary policy targets may need to be modified compared to
previous programs:

The increasing importance of macro-fiscal controls in overall economic
management requires a better measure of the fiscal stance. Such
a measure should capture the impact of fiscal actions on relevant
policy variables (growth, inflation, debt sustainability, etc.) more
accurately than the overall balance of the central government.

The adoption of inflation targeting (IT) by the CBA calls for a
modified approach to monetary conditionality, as monetary targets
are not compatible with the IT strategy. IMF-supported programs
in IT countries have aimed at complementing traditional monetary
conditionality with a "reviews-based" approach, including a periodic
assessment of monetary policy in the context of the IT framework,
and an agreement on a defined set of indicators on which reviews are
primarily based. This approach would require at least broad agreement
between IMF staff and the CBA on the appropriate monetary policy
reaction to a range of possible eventualities.

In case a new program will not be agreed upon soon, Armenia would
be expected to engage in Post Program Monitoring (PPM) with the
IMF, as long as its outstanding credit exceeds 100 percent of
quota. PPM would entail frequent consultations with IMF staff,
with a particular focus on macroeconomic and structural policies
that have a bearing on external liability, including a quantified
macroeconomic framework. There are normally two Board discussions in
a twelve-month period.