news.am, Armenia
July 30 2011

Adverse Forbes ranking should not block the prospective view for Armenia

July 30, 2011 | 12:07

In an interview to Armenian News-NEWS.am, resident representative of
the International Monetary fund in Armenia, Mr. Guillermo Tolosa,
shares his expectations on the recovery in agriculture, which had
contracted by 13,5% in 2010. This may ramp up the whole GDP and,
consequently, Armenia’s ranking on Forbes’ list. At the same time,
efficiency of tax collection is still an issue…

How tightly, in your opinion, today’s economic rebound in Armenia is
linked to the worldwide non-ferrous metal prices?

Armenia’s recovery is certainly linked from higher metal prices, as
this development has helped mining and manufacturing industries.
However, other important forces have also been at play. For example,
an increase in remittances has supported domestic consumption and is
benefiting various sectors of the economy like retail trade, hotels
and restaurants and transport and communication. Also, there has been
notable growth in bank lending that has helped consumption and
investment.

Do you think that prudential measures by the CBA on dedollarization of
loan portfolio of the banking system can prove efficient, when it
comes to lending to local industry and trade? (Both are still heavily
dependent on foreign currency to finance their production costs and
trade transactions).

Prudential measures of CBA go in the right direction regarding the
de-dollarization of loan portfolio, as they increase the cost for
banks to intermediate in foreign currency. However, dollarization of
deposits is still very high so banks have limited room to lend in
domestic currency without breaching regulatory limits for open
positions. Also, the stability of the exchange rate over the last two
years -unusual for a flexible exchange rate regime- has apparently led
banks and firms to underestimate foreign exchange risk and maintain
elevated foreign currency exposures. Continued adherence of the CBA
with flexible rate policy will most likely lead to larger variations
in the exchange rate that are set to shine a more clear light on the
relative unattractiveness of financial contracts in foreign currency.
It is worth noting these larger variations can happen in any
direction, and the commitment of the CBA flexible exchange rate policy
will guarantee there will be any abrupt sudden changes in the exchange
rate as in the past.

To what extent is Armenian banking system exposed to indirect credit
risks, with the present rate of currency lending?

Yes, it is exposed to considerable indirect credit risks because of
foreign currency lending. However, household debt in foreign currency
remains limited, as the situation affects mostly corporate sector,
which should be able to better withstand shocks. Also, this should not
compromise banking system stability as banks have a considerable
capital cushion to absorb the possible losses associated even with
potentially large shocks.

Over the last 10 months (Jun 10 to Apr 11), capital adequacy ratio of
the banking system has declined by 8 percentage points. Do you think
banks have improved their assets by simply tightening their credit
scoring?

The main reason for the decline in the ratio of capital to risk
weighted assets for the period was the introduction of higher risk
weights for foreign exchange assets last which created an automatic
increase in the denominator of this ratio. This automatic effect alone
explained the decline in capital adequacy ratio (CAR) by about 5
percentage points in Sept-Oct 2010.

The remaining decline in CAR of the banking system was due to the
sharp increase of bank lending made possible by the existence of
excess reserves originated because of overly tight lending policies.
In any event, as stated above, the current level of CAR of the banking
system continues to be very high in the international comparison after
the decrease.

What prospects do you see for the inflation rate to return within the
target band, given that there are no signs for the food prices (both
international and local) to decline?

High inflation has already stopped in Armenia. As a matter of fact, in
the last four months Armenia has experienced mild deflation on the
basis of the end of the rising trend in international commodity
prices, and stabilizing domestic prices arising from a relatively more
normal harvest this year. The annual inflation reading is still high
because of the low basis of comparison: international prices had not
surged yet in the first semester of last year. While sharp
international price rises may not reemerge, and prices of
locally-produced also appear likely to continue its moderation (which
could sharply lower annual inflation later in the year as it starts to
be computed against a higher basis of comparison), risks remain going
forward. These may call for the CBA to again take decisive action, as
they did during earlier this year with interest rate rises and
stepped-up efforts to manage liquidity.

Do you think that the State has enough fiscal space for pro-poor
measures, and do you think they will be effective with the current
inflation pressure?

The government has done a commendable effort to protect pro-poor
spending from the effects of the crisis. However, Armenia’s fiscal
space is unfortunately very limited, leaving little room for the
government to implement new pro-poor measures to offset the effect of
higher food prices (with some notable exceptions, like the subsidies
for gas). We think however there is considerable room to increasing
the fiscal space by improving the tax collection (both through
changing tax legislation and stepping up tax administration efforts).

Recently there have been several statements and presentations on the
cumulative pension reform in Armenia. Once the new system is adopted
in 2014, do you expect a mass outflow of funds from Armenia into
foreign capital markets?

After the pension reform Armenians will be saving more money for
retirement. These savings will, over time, translate into large
accumulation of assets. In order to diversify risk, a minority
fraction of this newly created capital will be placed abroad. But in
net terms the effect of the reform will certainly be to increase the
amount of capital available for Armenian productive development. In
particular, the pension reform is likely to make available currently
inexistent long-term resources for Armenian firms, badly needed to
improve investment prospects.

What is your opinion on the draft of the new Mining code, which
implies changes to taxation regime? Do you think the State needs to
cast a wider tax net on the mining sector?

We have a broadly positive assessment of the new Mining code, which
will improve conditions in this key strategic sector for the Armenian
economy while increasing revenue collections for the government. We
think however that even further adjustments to the legislation in the
profit tax are called for to reduce the quite considerable
opportunities for tax avoidance that the current framework offers. In
addition, further improvements may be needed on the treatment of
environmental cleanup costs.

One of your recent statements, on the undesirability of favorable tax
regime towards innovation industry, met sharp criticism by the local
IT industry. Do you think the government will pursue the forced
development of this sector anyway?

Tax incentives could lead to significant revenue losses to the
government. International experience shows that the creation of these
loopholes in the tax regime can imply that the losses go well beyond
the taxes received from the sector being targeted. Such losses would
be particularly untimely: Armenia needs to undertake large efforts to
bring down its already large deficit and thereby avoid compromising
macroeconomic stability, which is a key strategic asset for the IT
industry and the country as a whole. On top of that already difficult
challenge, Armenia needs to create extra fiscal space for pro-poor and
pro-development spending, which are at pretty depressed levels.
Finally, opening the doors of sector-wide tax breaks could lead to a
dangerous precedent that could put the government in a difficult
situation to resist the pressure of other deserving strategic sectors.

Do you think that Armenia will improve its position on the Forbes
ranking once the downturn in agriculture is restored, and so does GDP
per capita?

Under the current macroeconomic policy framework, which is supported
by the IMF, moderate improvements in economic conditions are taking
place and continue to be expected. As a consequence, Armenia will tend
to go up considerably in world economic rankings, including Forbes’.
For example, as close as 2008, Armenia would have ranked around 110th
worst economy in Forbes ranking (Editorial – in contrast to 2nd worst,
as in recent 2011 ranking). We expect output to recover on the basis
of a rebound of the agricultural sector and continued strong
performance of manufacturing and trade. But we also expect
improvements in the other key components of the ranking: the current
account balance is expected to fall on the back of continuous fiscal
adjustment and exchange rate flexibility, while inflation will also
come down as discussed above.

In your opinion as an international expert, is the ranking a
significant guide for foreign investors on whether to do business in a
given country?

The Forbes ranking does offer a reminder of how difficult a ride the
Armenian economy has had over the last couple of years as it went
through a very unusual set of external shocks. However, it is
important to put the recent article in perspective: it was not
intended to be an in-depth, cross-country comparative analysis of the
business environment, but rather a short, simple and provocative look
at a handful of key macro indicators. There are other widely
recognized measures of the business environment, such as WB Doing
Business or the WEF Global Competitiveness Indicator, where Armenia
ranks 48th and 98th best economy in the world respectively. While
investors should, of course, be informed of recent macroeconomic
variables, such as growth, inflation, and the current account balance,
this is just the starting point. They should aware of future prospects
– especially for improvement after the crisis – and undertake a deeper
and more comprehensive analysis of the business and institutional
environment. Here, I am convinced that Armenia, even when in need of
important reforms, scores much better.

How does external debt of the USA can affect countries which benefit
from their foreign aid?

The United States will need to undertake a very significant fiscal
adjustment over the next years. The nature of it is currently being
debated and it is too early to determine if it will affect US’s
foreign aid and hence recipient countries’ economies.

Thank you

By Aram Gareginyan