Responding to External Shocks Hitting the Economy of Armenia

ASIAN DEVELOPMENT BANK

REGIONAL-CAPACITY DEVELOPMENT TECHNICAL ASSISTANCE (R-CDTA)

STRENGTHENING KNOWLEDGE MANAGEMENT IN CENTRAL AND WEST ASIA

RESPONDING TO EXTERNAL SHOCKS HITTING THE ECONOMY OF ARMENIA

23 February 2017

This report has been prepared under the Region-wide Study, “Good Jobs for Inclusive Growth in Central and West Asia.” The study is undertaken under R-CDTA-8936, “Strengthening Knowledge Management in Central and West Asia.” This report has been prepared by study consultant Armen Nurbekyan and co-authors Aleksandr Shirkhanyan, Martin Galstyan. The overall Study task manager is Giovanni Capannelli, Country Director, KARM, ADB.

TABLE OF CONTENTS

List of Figures ...... i List of Tables ...... ii List of Boxes ...... ii Executive Summary ...... iii 1. Introduction and Background ...... 1 2. The Impact of External Macroeconomic Shocks on the Economy of Armenia ..... 2 2.1. The shock ...... 3 2.2. Trade Channel ...... 3 2.3. Remittances Channel ...... 5 2.4. Financial Channel ...... 9 3. Policy Response ...... 10 3.1 Monetary Policy ...... 10 3.1.1 Risk Premium ...... 11 3.1.2 Inflation Expectations ...... 11 3.2 Fiscal Policy ...... 14 3.3 Structural Policies ...... 20 4. Operational Support from ADB and other IFIs ...... 24 5. Conclusion and Recommendations ...... 26 References ...... 27 Appendix I ...... 29 Appendix II ...... 31

List of Figures Figure 1. Oil Prices ...... 2 Figure 2. Export and Import Growth Rates ...... 4 Figure 3. International Commodity Prices and Structure of Armenia’s Exports ...... 5 Figure 4. Remittances ...... 6 Figure 5. Geographic Distribution of Origin Countries ...... 6 Figure 6. Growth Rates of Remittances and Non-tradeable sector of Russia ...... 7 Figure 7. Net Inflows of Remittances ...... 8 Figure 8. Reduction in Remittances and Savings from Lower Oil Prices in 2015 ...... 8 Figure 9. Eurobond Yields of Russia and South Caucasus countries ...... 9 Figure 10. Share of NPLs in Banking Sector of Armenia ...... 10 Figure 11. Monetary Policy Rates in Armenia and Russia ...... 11 ii

Figure 12. AMD/USD Exchange Rate ...... 12 Figure 13. Inflation Expectations ...... 13 Figure 14. Inflation (12-month) Forecast Probability Distribution Chart for a 3-year horizon ...... 13 Figure 15. General government balances ...... 14 Figure 16. Cyclical adjustment ...... 16 Figure 17. Fiscal stance and impulse ...... 16 Figure 18. Tax revenue components ...... 18 Figure 19. Components of government expenditure ...... 19 Figure 20. Fiscal Indicators ...... 20 Figure 21. Public Debt ...... 20 Figure 22. Armenia’s link with Russia ...... 29 Figure 23. Loan and Deposit Dollarization in Armenia ...... 30

List of Tables Table 1. Fiscal Impulses compared to base year of 2013 ...... 17 Table 2. Structural reforms implemented in Armenia after GFC ...... 31 Table 3. Basic active projects of IFIs in business environment of Armenia...... 37 Table 4. Basic active projects of IFIs in infrastructure of Armenia ...... 38

List of Boxes Box 1. Armenia’s link to Russia and its implications ...... 29 Box 2. Dedollarization policies in Armenia ...... 30

iii

Executive Summary

1. Purpose of the paper. This paper asks three questions. What were the sources of the 2014 oil price shock? How did the decline of oil prices affect the economy of Armenia? How did macroeconomic policy makers respond to the shock? We provide policy recommendations based on the answers to these questions. 2. What were the sources of the 2014 oil price shock? Most of the analysis since the dramatic drop of oil prices suggests that the observed decline was a result of a combination of shocks--namely, demand and supply, attributing higher weight to supply forces.1 Understanding the sources of external shocks plays a key role in determining the right macroeconomic policy mix, because cyclical nature of shocks calls for monetary and fiscal policy response, whereas structural nature of shocks attributes the main role to structural reforms. The story of weak oil demand is based on continuous downward revisions to world growth forecasts and the rebalancing of Chinese economy towards less oil intensive sectors.2 On the supply side, two factors have played a key role: high growth of US shale oil production during the last five years and the strategic decision of Organization of the Oil Exporting Countries (OPEC) to oversupply the market. This suggests that there is a high likelihood of long-lasting effects of the shock and structural changes in the world economy. 3. How did the decline of oil prices affect the economy of Armenia? The 2014 oil price shock had a net negative impact on the Armenian economy. Despite the fact that Armenia is a net oil importing country, savings from lower oil prices were outbalanced by negative spillovers from Russia through trade, remittances, and financial channels. Trade was mainly affected due to Russia’s slowdown, adverse terms of trade developments, and weak domestic demand. Remittances decreased sharply because a huge part of these inflows originates in Russia. Financial channel hit the economy through country risk premium which increased immediately after the shock and stayed high for six quarters. 4. How did macroeconomic policy makers respond to the shock? Fiscal policy was highly expansionary during 2015-2016 buffering the economy from a sharp drop. Monetary policy tightened in the immediate aftermath of the shock in response to rising inflation expectations and country risk premium. Monetary policy started its easing cycle after inflation expectations and risk premium reversed. Structural policies promoting growth were slow to respond. Cyclical policies are constrained by the following three factors: the external shock reflects a fundamental structural change in the oil market, which is likely to be a long-lived change rather than a short-lived cyclical fluctuation; the rise of the country risk premium presents a major challenge for monetary policy as it increases neutral interest rate, and, hence, rates go up in the face of adverse external shock; increasing public debt constrains fiscal policy. 5. Policy recommendations. Structural reforms such as pension reform, product market reforms promoting competition, optimization of public sector have the greatest role to play under the current circumstances. Structural reforms, especially labor market reforms, should be carefully chosen and sequenced not to slow already low growth in the short run. Product market reforms are high on the priority list due to mild and generally positive short-run effects on growth. Labor market reforms, such as optimization of public sector, should be implemented in parallel as their short-run negative effects will be cushioned by product market reforms. In the context of structural adjustments in the economy, international financial institutions (IFIs) can play a key role in facilitating structural transformation through local currency financing and infrastructure projects which support demand in the short run and increase future potential in the long run. We emphasize the importance of local currency

1 See, for example, Arezki and Blanchard (2014) and IMF World Economic Outlook 2016, April, Scenario Box 1. 2 IMF World Economic Outlook is a good example. iv programs because of high level of financial dollarization in Armenia.3 The role of cyclical polices is limited as the underlying growth bottlenecks are structural. The high level of public debt calls for targeted infrastructure investment supporting short-run demand and long-run potential. The effectiveness of infrastructure projects implementation should be increased markedly.

3 This is true for the majority of CWA countries.

1. Introduction and Background

1. Oil prices have fallen dramatically since June 2014 (Figure 1) raising fundamental questions about sources of the shock and future of countries highly-dependent on oil. As a result of the large external shock, growth prospects in Central and West Asia (CWA), where majority of countries are highly dependent on commodity export, have significantly deteriorated posing major challenges for macroeconomic policy makers of countries in the region. Armenia’s economy was not an exception, despite being an oil importer country, because of its high dependence on Russia through trade, remittances, and financial channels. What were the sources of the shock? How did it effect the economy of Armenia? How did macroeconomic policy makers respond to the shock? These are the questions we address in the paper. 2. Understanding the sources of external shocks plays a key role in determining the right macroeconomic policy mix, because cyclical nature of shocks calls for monetary and fiscal policy response, whereas structural nature of shocks attributes the main role to structural reforms. Most of the analysis since the dramatic drop of oil prices suggests that the observed decline was a result of a combination of shocks--namely, demand and supply, attributing higher weight to supply forces.4 The story of weak oil demand is based on continuous downward revisions to world growth forecasts.5 The rebalancing of Chinese economy towards less oil intensive sectors is another crucial factor affecting oil market developments from demand side and will become increasingly important going forward. On the supply side, two factors have played a key role: high growth of US shale oil production during the last five years and the strategic decision of Organization of the Oil Exporting Countries (OPEC) to oversupply the market, to bring down oil prices, and to push out higher-cost oil producers. This suggests that there is a high likelihood of long-lasting effects of the shock and structural changes in the world economy. 3. We argue that monetary policy has a limited ability to buffer the shock due to mostly structural nature of the shock. We see a limited role for fiscal policy as well because of increasing level of public debt and the consequent rise in risk premium. We see a role for countercyclical monetary and fiscal policies to the extent the shock was a result of negative developments in external demand. We conclude that structural reforms are the most important components to ensure inflow of foreign direct investment (FDI) into the country and long-run inclusive growth. We see the full implementation of pension reform as a key structural reform providing infrastructure for long-term domestic savings in Armenia. In the context of structural adjustments in the economy, international financial institutions (IFIs) can play a key role in facilitating structural transformation through local currency SME financing and infrastructure projects which support demand in the short run and increase future potential in the long run. We emphasize the importance of local currency programs because of high level of financial dollarization in Armenia.6 4. The shock had a net negative impact on Armenian economy despite the fact that Armenia is a net oil importing country. The main channel through which the shock has positively affected Armenian economy was the decreased oil imports bill. However, the positive effects were outweighed by the slump of the Russian economy through trade and remittance inflow channels. The negative effects of the shock were further exacerbated by the financial channel through country risk premium, which increased in the immediate aftermath of the shock and stayed high.

4 See, for example, Arezki and Blanchard (2014) and IMF World Economic Outlook 2016, April, Scenario Box 1. 5 IMF World Economic Outlook is a good example. 6 This is true for the majority of CWA countries. 2

Figure 1. Oil Prices (US dollars per barrel)

140

120

100

20 Brent Oil (USD/barrel) 0

Source: Bloomberg Last Observation: 30.09.2016

5. The role of cyclical policies have been fairly limited in addressing the shock due to the following three reasons: the external shock reflects a fundamental structural change in the oil market, which is likely to be a long-lived change rather than a short-lived cyclical fluctuation; the rise of the country risk premium presents a major challenge for monetary policy as it increases neutral interest rate, and, hence, rates go up in the face of adverse external shock; increasing public debt constrains the ability of fiscal policy to buffer the shock. Structural polices such as pension reform, product market reforms promoting competition, optimization of public sector have the greatest role to play under the current circumstances. Importantly, structural reforms, especially labour market reforms, have to be carefully chosen and sequenced not to dampen the already weak demand in the short run. 6. The rest of the paper is organized as follows. Section 2 considers sources of the shock and its short-term impact on the economy of Armenia. Section 3 presents macroeconomic policy response to the shock. Section 4 discusses operational support International Financial Institutions (IFIs) can provide to help in coping with the shock and achieving long-term inclusive growth.

2. The Impact of External Macroeconomic Shocks on the Economy of Armenia

7. Stabilization policy after large external shocks is a key challenge for policy makers in small open economies. Impact of shocks is particularly severe when shocks are persistent and economy’s exports are not well-diversified as it is usually the case for countries highly dependent on commodity exports. Apart from the direct trade channel, an important transmission mechanism of shocks is the financial channel manifesting itself through increasing risk premiums and rising non-performing loans in the banking sector. Increasing risk premiums in many cases are a result of uncertainty after the large shock and increasing levels of external debt. Financial dollarization makes this channel even stronger, as in the presence of financial dollarization the share of non-performing loans typically increases significantly, because large share of households and firms have foreign currency liabilities and earn income in local currency. 3

8. In this section we consider sources of the shock with particular emphasis on the importance of getting the shock right, and three main transmission channels: trade; remittances; and financial.

2.1. The shock 9. The drop of oil prices after June, 2014 gave rise to fundamental uncertainty in the global economy about sources of the shock. We emphasize the importance of understanding the sources of the drop, as the frequently-used term “oil price shock” very often misleads policy makers around the world by masking the underlying causes of the change. Bodenstein et al. (2012) stressed the importance of disentangling the shocks behind the oil price change using a structural approach. The central conclusion is that the macroeconomic policy response to oil price changes depends on the combination of underlying shocks.7 We illustrate the point in the context of the recent drop of oil prices. 10. Two extreme explanations of the oil price slump were suggested by the experts: positive supply shock and negative demand shock. Proponents of the supply-side story argued that the main reason behind the fall was the massive supply shock emanating from the emergence of shale oil production in North America and the subsequent strategic decision by OPEC to increase the production to retain the market share in the oil market. Proponents of the demand-side story saw the slowdown in emerging markets as the main driving force, with particular emphasis on China. 11. The two very different explanations are illustrative of the point made above as they suggest diametrically opposite policy prescriptions: the supply shock story subscribes a very limited role for cyclical policies, whereas the demand side story calls for expansionary cyclical policies. Most of the analysis suggests that the decline of oil prices was a result of a combination of supply and demand shocks with supply shock playing much more important role. 2.2. Trade Channel

12. In this subsection we discuss the main short-term developments of Armenia’s trade after the shock, namely the effects of Russia’s slowdown, adverse terms of trade developments due to decrease of metal prices, and international oil price pass through to domestic economy. 8 13. Russia is Armenia’s major trading partner; in 2015 it accounted for around 25% of total trade, which means that shocks affecting Russia have significant transmission to Armenia. As a result of the oil price drop, Russia’s economy shrank by 3.7% in 2015 causing 26% decrease of exports from Armenia to Russia during the same year (Figure 2a). On imports side, decreased demand in Armenia due to the sharp decline of remittances resulted in about 16% decrease of imports from Russia.9 Going forward, trade channel is likely to become stronger as Armenia has joined the Eurasian Economic Union (EEU) in 2014 implying structural changes which will lead to larger share of trade with Russia.10

7 This statement is true in general for any kind of macroeconomic disturbances, however it is very often overlooked for oil price shocks. 8 See the summary of Russia’s spillovers on Armenia in Box 1 of Appendix I. 9 More detailed analysis on the importance of remittances is presented in the next subsection. 10 The EEU includes Russia, Belarus, Kazakhstan, Armenia, and Kyrgyzstan. 4

Figure 2. Export and Import Growth Rates (in YoY percent change, unless otherwise indicated) (a) Trade with Russia (b) Trade with the EU

40 10

0 20 2012 2013 2014 2015 -10 0 2012 2013 2014 2015 -20 -20 Export growth - Russia -30 Export growth - EU

-40 Import growth - Russia -40 Import growth - EU (c) Overall Trade

-5 2012 2013 2014 2015 Export growth -15 Import growth Trade Balance (% GDP) Current Account Balance (% GDP) -25 Source: National Statistical Service (NSS) and Central Bank of Armenia (CBA)

14. During the same period, oil price decline was accompanied by a slowdown of other commodities. International metal prices have been continuously decreasing since 2011; during the last five years, prices have decreased by around 55% in nominal USD terms (Figure 3). Metals, minerals, and precious metals and stones are the major part of Armenia’s trade constituting around 60% of exports (Figure 3). The combination of these factors together with the oil price shock led to a sizeable hit to the economy as in 2015 the change in terms of trade of Armenia with respect to the previous year was -6.1%. The major part of exports to EU, Armenia’s largest trading partner, is represented by ores and metals. Exports to EU in 2015 decreased by 5.2%. Armenia’s imports from EU were heavily affected as well by decreasing by around 30% in 2015 due to the sharp demand slowdown. 15. Above factors illustrate the negative developments of trade after the shock. We next turn to the transmission of positive effects. 16. Armenia is an oil importing country with imports of oil products fluctuating around 2.5% of GDP. Therefore, oil price decline is a beneficial terms of trade shock for the economy. Ayvazyan, Daban (2015) discuss reasons which may mute positive effects of such shocks. First, a large fraction of transportation has changed the fuel type from gasoline to natural gas. Second, 80% of gas imports are provided by Russia through a five-year agreement where gas prices are pre-agreed and remain stable for that period. Third, a bulk of energy is generated by nuclear power and hydropower stations. The former provides roughly 40% of total energy consumption while energy imports from Russia account for slightly more than 30%.11 These facts make the economy of Armenia less dependent on international oil prices.

11 Regional Economic Outlook, Middle East and Central Asia, IMF, Washington October 2015.

Figure 3. International Commodity Prices and Structure of Armenia’s Exports

Monthly indices, nominal US dollars, 2010=100

200 150 100 50 0 07 12 11 16 10 15 07 12 09 14 07 08 09 12 13 14 09 14 08 13 10 15 11 16 ------Jul Jul Jan Jan Jun Jun Oct Oct Apr Apr Sep Feb Sep Feb Dec Dec Aug Aug Nov Nov Mar Mar May May

Energy Agriculture Metals & Minerals Precious Metals

Share of Commodities in Armenia's Exports (percent in total exports) 70 60 50 40 30 20 10 0

Agriculture Metals & Minerals Precious Metals & Stones

Source: World Bank, National Statistical Service of Armenia

17. To sum up, trade was hugely affected after the shock due to the recession in Russia’s economy, adverse terms of trade developments, and domestic demand slowdown. As a result, the positive effects of oil price decline were muted and even overweighed by the negative side effects.

2.3. Remittances Channel

18. In this subsection we discuss the transmission channel through remittances, with particular emphasis on its shock-amplifying versus shock-absorbing role. We consider remittances in the context of two massive shocks in the recent past: the Global Financial Crisis (GFC) and the 2014 oil price shock.

19. Remittances are an important source of income for Armenian households standing on average at around 16% of GDP during the last decade and covering on average around 44% imports during the same period (Figure 4). Consequently, remittances represent an important transmission channel of external shocks to domestic economy through direct effects on consumption. According to the CBA Remittances Survey of 2015, remittances is the only 6 income source for 9.5% of remittance-receiving households and is more than 50% of income for 47% of them.

Figure 4. Remittances (percent of GDP and Imports)

% of GDP % of Imports

Source: National Statistical Service and Central Bank of Armenia. Note: Data on remittances is taken from Balance of Payments of Armenia.

20. Figure 5 shows that the largest part of remittance income originates from Russia. The lack of diversification across origin countries means that remittances are pro-cyclical and act as shock-amplifying mechanism when shocks to Russia occur. After the recent shock the share of net inflows of remittances from Russia decreased massively from 88.6% to 79.8%. The huge contraction has immediately translated into domestic demand slowdown in Armenia. The fact that remittance-receiving households are low-income and, hence, have a high marginal propensity to consume, makes the transmission strong.

Figure 5. Geographic Distribution of Origin Countries

Source: Central Bank of Armenia (CBA). Note: Data on remittances is taken from CBA surveys where remittances are defined as the sum of (i) non-commercial transfers received from abroad (or sent abroad) by an individual to satisfy current needs and (ii) compensation of employees (remuneration of labour from abroad or paid abroad).

21. We next consider sources of remittances on the sectoral level of Russia’s economy. CBA 2015 Remittances Survey concludes that 90% of Armenian migrants in Russia are involved in non-tradable sector activities (Figure 6), which are in turn strongly correlated with oil price shocks (Stepanyan (2015)). The strong dependence of non-tradeable sector on oil prices points towards procyclicality of remittances. After negative oil price shocks in Russia, the fundamental adjustment of the economy takes place through real exchange rate depreciation which leads to the growth of tradeable sector and squeeze of non-tradable sector. The conclusion that remittances are pro-cyclical is made for the shocks originating from Russia and not necessarily for domestic disturbances, as in that case remittances from Russia can play an insurance role. This means that when domestic shocks hit Armenia remittances could act as an insurance mechanism to cope with the shock, as migrants may remit more. 22. To illustrate the role remittances play after external shocks, we look at two recent episodes, namely the GFC and the 2014 oil-price shock. Oil prices started their rapid increase since the beginning of 2000s reaching a peak of around $140 in 2008 due to the massive increase of oil demand in emerging markets, most notably in China. During that part of commodity cycle, almost all commodity-exporter countries, including Russia, experienced high growth rates. As a result, net inflow of remittances from Russia to Armenia almost quadrupled in nominal USD terms during the five years preceding the GFC (Figure 7). As the GFC hit and oil prices plunged, net inflow of remittances contracted sharply in 2009 decreasing by about 33%. Since then, the inflow has started to climb back gradually reaching its pre-crisis peak in 2012. The same pattern occurred after oil prices started to decline in 2014: net inflow of remittances reached its peak in 2013 and then dropped sharply in 2014 and 2015 by about 10% and 35.6%, respectively. In both cases negative shocks were significantly amplified by the slowdown of remittance inflows.

Figure 6. Growth Rates of Remittances and Non-tradeable sector of Russia (2004 = 100)

450

400

350

300

250

200

150

100 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Remittances Non-Tradable Sector of Russia

Source: Central Bank of Armenia and Federal State Statistics Service of Russia Note: Data on remittances is taken from Balance of Payments of Armenia. The non-tradable sector of Russia includes construction, wholesale and retail trade, car and household appliances repair, restaurants and hotels, transport and communications, financial activities, real estate operations and services, electricity, water, gas production and distribution.

Figure 7. Net Inflows of Remittances (millions of US dollars)

1800 1600 1400 1200 1000 800 600 400 200 0 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015

Net Inflows - Russia Net Inflows - USA Net Inflows - Other Net Inflows

Source: Central Bank of Armenia Note: Data on remittances is taken from CBA surveys where remittances are defined as the sum of (i) non- commercial transfers received from abroad (or sent abroad) by an individual to satisfy current needs and (ii) compensation of employees (remuneration of labour from abroad or paid abroad).

23. Decrease of remittances heavily outweighed the savings from lower oil imports bill (Figure 8). More specifically, lower oil prices resulted in savings of around 1% of 2015 GDP in terms of oil imports, and lower remittance inflows had a negative effect of about 5%. Figure 8. Reduction in Remittances and Savings from Lower Oil Prices in 2015 (percent of GDP)

Net Impact on Current Account

Savings from Lower Oil Prices

Reduction in Remittances

-6 -5 -4 -3 -2 -1 0 1 2

Source: National Statistical Service and Central Bank of Armenia Note: Data on remittances is taken from CBA surveys where remittances are defined as the sum of non- commercial transfers received from abroad (or sent abroad) by an individual to satisfy current needs and compensation of employees (remuneration of labour from abroad or paid abroad).

2.4. Financial Channel

24. Financial channel represents the third transmission channel of the shock. This channel operates mainly through increase of risk premiums and non-performing loans (NPLs) in the banking sector. Endogenous reaction of country risk premiums to shocks is an important factor influencing policy makers’ decisions in developing countries, especially the ones with macroeconomic imbalances in place. The logic is that external, fiscal, or financial imbalances are likely to result in increasing risk premiums when global shocks hit, as investors require higher compensation for the willingness to finance these imbalances during times of high uncertainty and risk aversion. As a result, during bad times local currencies depreciate and neutral interest rates go up.

25. The figure below shows Eurobond Yields for Russia and South Caucasus countries (Armenia, Georgia, Azerbaijan) to illustrate variations of risk premiums of the countries in the region (Figure 9). 12 There are three large shocks included in the figure. The first spike on the figure represents the period of Crimea crisis and imposition of new sanctions against Russia at the end of July 2014. The next spike was caused by the sharp decrease in oil prices which, along with imposed sanctions resulted in substantial balance of payments pressures and in outflow of capital from Russia. The latter, in turn, brought a sharp depreciation of the exchange rate at the end of 2014. The last shock is Russia’s downgrade. Figure 9. Eurobond Yields of Russia and South Caucasus countries

9 Oil shock Russia downgrade

7 Ukraine

Armenia Georgia Azerbaijan Russia

Source: Bloomberg Last Observation: 30.11.2016

26. The evident co-movement of Eurobond yields of the countries in the region during bad times is consistent with the endogenous reaction of risk premiums to negative shocks. That has profound implications for monetary policy as it implies sharp currency movements and increase of neutral interest rates which constrain monetary policy during difficult times. These recent episodes underline the importance of the financial channel as Central Banks had to resort to tight measures when economies were suffering from adverse shocks. In addition, in developing countries inflation expectations can be deanchored after sharp movements in the exchange rate leaving no room for monetary policy to reduce policy rates. This point will be discussed in greater detail in the section about monetary policy.

12 We show the comparison of Eurobond yields to illustrate the movements in risk premiums as there are no good measures of risk premiums in emerging markets with underdeveloped financial markets. 10

Figure 10. Share of NPLs in Banking Sector of Armenia (percent in total loans)

12.0

10.0

8.0

6.0

4.0

2.0

0.0 05 06 07 08 09 10 11 12 13 14 15 16 05 06 07 08 09 10 11 12 13 14 15 16 ------Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jul Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Source: Central Bank of Armenia

27. The second part of the financial channel in Armenia operates through the so-called balance sheet channel as the banking sector is highly dollarized. Despite the CBA’s dedollarization efforts (Box 2 in Appendix I), about 65% of Armenia’s banking sector’s asset and liability sides are denominated in US dollars. When adverse shocks heat necessitating real exchange rate depreciation, they can have negative demand effects besides the traditional positive effects through trade, as households with foreign currency liabilities and local income face increase of their loan payments. As a result, NPLs in the banking sector increase (Figure 10), and household demand slows down because they attribute larger share of their income to repay their debts. The increase of NPLs along with the lower demand may further trigger deleveraging in the banking sector which is likely to have significant real effects.

3. Policy Response 3.1 Monetary Policy 28. Typical monetary policy response to external demand shocks in small open economies (SOEs) is a reduction of policy rate below the neutral rate in order to stimulate demand and bring it back to potential.13 Monetary policy has a smaller role after external supply shocks, as in that case the level of potential is the one which changes. However, there are several factors which can alter standard policy prescriptions in developing economies. These factors include endogenous country premiums and high pass through between exchange rate depreciation and inflation, which are the foci of this subsection.14 29. Risk premiums may increase after negative external shocks because of factors such as imbalances built up in the economy, high levels of external debt, increasing policy uncertainty, change in global risk aversion etc. Fundamentally, the increase of risk premiums reflects the lower willingness of international investors to finance imbalances of the economy. In that context, it is worth noting that the size of the shock can matter as well as after large shocks the amount of uncertainty can increase in non-linear way and, hence affect the behaviour of international investors. 30. The high exchange rate pass through on inflation in emerging markets is another important factor affecting monetary policy. The reasons behind the high pass through are

13 External demand shock referred here is the proportion of the decline of oil price due to negative developments of global growth. 14 Endogenous risk premiums can be related to procyclicality of capital flows in emerging markets. 11 well documented in the literature and include factors such as high share of imported goods in the Consumer Price Index (CPI), not well-anchored inflation expectations, and low credibility of Central Banks. 31. All the mentioned factors illustrate that monetary policy in emerging markets can be different from monetary policy in SOEs which are developed.15 We next discuss how these factors have played out after the 2014 oil price shock. 3.1.1 Risk Premium 32. Endogeneity country risk premiums have direct effects on monetary policy. The main logic is that after a negative external shock endogenous increase in country risk premium causes the neutral interest rate to move in the opposite direction to the required monetary policy response. The increase of the neutral interest rate means that keeping the policy interest rate unchanged implies an easing of monetary policy. In addition, if the increase in the risk premium is accompanied by rising inflation expectations, it would imply policy tightening in the short-run to gain credibility and tame inflation expectations in the face of negative external shock. However, the short-term costs are justified, as early tightening and gain of credibility would facilitate persistently lower interest rates going forward, as risk premium goes down. 33. The apparent co-movement of country risk premiums illustrated in the previous section is consistent with the described transmission. Figure 11 illustrates the point for Armenia and Russia. After the shock of 2014, the CBA increased its policy rate from 6.75% to 10.5% and lombard interest rate from 8.25% to 21%. For further mitigation of the volatility, these moves were accompanied with daily foreign currency auctions to provide foreign currency liquidity to the market and increase of reserve requirements. Since the beginning of 2015, financial market and exchange rate stabilized and the CBA started to gradually reduce the lombard rate and then the key policy rate. A very similar story applies for Russia except for the fact that policy rates remained relatively high after the shock because of higher inflation.

Figure 11. Monetary Policy Rates in Armenia and Russia

25.00

20.00

15.00

10.00

5.00

0.00 14 15 16 14 14 15 15 16 16 14 15 16 14 15 16 14 15 16 ------Jul Jul Jul Jan Jan Jan - - - Sep Sep Sep Nov Nov Nov - - - Mar Mar Mar May May May - - - 1 1 1 ------1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

Repo Rate - Armenia Lombard Rate - Armenia

Lombard Rate - Russia Repo Rate - Russia

Source: Central Banks of Armenia and Russia Last Observation: 30.11.2016

3.1.2 Inflation Expectations 34. Inflation expectations can increase dramatically after large exchange rate depreciation in countries with high exchange rate pass through on inflation. In countries which adopted Inflation Targeting Regime, monetary policy operates through influencing inflation

15 See Frenkel (2010) for an excellent exposition of how monetary policy can be different in emerging markets. 12 expectations which means that if inflation expectations increase after the shock, monetary policy should tighten to re-anchor the system.16 More importantly, if monetary policy fails to tighten enough to bring inflation expectations down, it necessitates higher policy rates going forward. In other words, delays are costly. 35. As we show below, after the shock of December 2014, factors mentioned above played important role in the developments of the economy of Armenia. 36. The large depreciation of Russian Ruble and the volatility in Russian financial markets transmitted to Armenian exchange rate market. Figure 12 shows that the volatility of the exchange rate between Armenian Dram (AMD) and US Dollar (USD) increased dramatically after the shock. Exchange rate overshot in the short run depreciating by around 30% reflecting the uncertainty in the markets. The CBA increased the key refinancing rate, which is the policy rate of the CBA, cumulatively by 3.75 percentage points since December 2014 to February 2015. As the CBA has communicated, policy actions were aimed at reducing the short-run policy uncertainty, partly reflected in the increase in the risk premium, and taming the increasing inflation expectations after the large exchange rate depreciation. Depreciation of the AMD/USD exchange rate between December 2014 and February 2015 amounted to about 15%.

Figure 12. AMD/USD Exchange Rate

550 530 510 490 470 450 430 410 390 370 350 14 15 16 14 15 16 14 15 16 14 15 16 14 15 16 14 15 16 ------Jul Jul Jul Jan Jan Jan - - - Sep Sep Sep Nov Nov Nov - - - Mar Mar Mar May May May - - - 8 8 8 ------8 8 8 8 8 8 8 8 8 8 8 8 8 8 8 Source: Central Bank of Armenia Last Observation: 30.11.2016

37. Figure 13 shows inflation expectations following the shock. After the exchange rate depreciation, inflation expectations increased dramatically. Policy rate was hiked to tame the increasing inflation expectations and was kept constant for two quarters. The CBA started a gradual easing cycle in parallel with the reversal of inflation expectations: policy rates went down from 10.5% in the August 2015 to 7.5% in the July 2016. 38. Figure 14 shows the actual developments of 12-month CPI inflation, which is the CBA’s preferred measure, and CBA expectations about the path of inflation going forward. Inflation was above the target of 4% towards the end of 2014 and has been decreasing since 2015 Q1. There are several factors explaining the decreasing inflation: positive agricultural supply shock, decreasing international commodity prices, and decreasing inflation expectations.

16 Armenia adopted Inflation Targeting in 2006. 13

Figure 13. Inflation Expectations

7 12

6 10 5 8 4 6 3 4 2

1 2

0 0 2014 2014 2014 2014 2015 2015 2015 2015 2016 2016 2016 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3

Inflation Expectations of Financial Organizations Repo Rate (right axis)

Source: Authors’ estimates

Figure 14. Inflation (12-month) Forecast Probability Distribution Chart for a 3-year horizon

Source: Central Bank of Armenia, 2016Q3 Inflation report

39. In summary, monetary policy response to the December 2014 shock reflected two important factors: increase of risk premium and inflation expectations. Monetary policy tightened in the immediate aftermath of the adverse shock reflecting higher neutral interest rate and de-anchored inflation expectations. The sharp response has led to a gradual reduction of inflation expectations freeing space for policy easing. After the decrease of inflation expectations monetary policy has started its easing cycle.

3.2 Fiscal Policy

40. We attempt to answer three key questions in this subsection. Was fiscal policy response to the shock countercyclical? If so, was it done through expenditure or revenue side? How constraining will the public debt be for fiscal policy going forward?

3.2.1 Was fiscal policy countercyclical?

41. Fiscal policy in developing countries is often procyclical. This issue was first raised by Gavin and Perroti (1997). As they argue, fiscal policy failed to be countercyclical in developing economies of Latin America during the last 25 years prior to the study. Kaminsky et al. (2005) come to a similar conclusion for a larger set of developing countries and introduce the “When it rains, it pours” phenomenon to show how capital flows cycles tend to amplify business cycles (particularly in middle-high income countries). Ilzetski and Vegh (2008) emphasize that a large number of papers representing this area fail to account for the potential endogeneity of cyclical indicators to GDP. Still, after introducing instruments for real GDP they conclude that the puzzle holds. 42. We show that Armenia has not been suffering from the procycylicality of fiscal policy. In particular, the responses of fiscal policy to the GFC and the recent slowdown were highly countercyclical. The measure we use to assess fiscal position relative to the business cycle is the fiscal impulse, which we compute based on the IMF methodology. 43. Before discussing results, we describe the methodology and the underlying intuition. The methodology consists of three steps: construction of relevant government balances; adjustment of the balances based on a measure of business cycle, namely output gap (because government revenues are closely linked to economic activity); and comparison of the adjusted measure with a base year where fiscal policy was neutral.

Figure 15. General government balances (percent of GDP)

0 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 -2

-4

-6

-8

-10

Net operating balance Net lending/borrowing

Source: Authors’ Calculations Note: Forecasts after 2015.

44. The starting point is the construction of government balances relevant for our purposes: net operating balance and net lending/borrowing. Net operating balance (NOB) is the difference of government revenues and spending, while net lending/borrowing (NLB) is obtained by deducting the net acquisition of non-financial assets from NOB.17 Figure 15 depicts the general government balances for the period 2008-2017.18 As the figure shows, both measures dropped significantly in 2009 and 2015 when the GFC and the oil price drop hit the economy. We show below that developments in revenues and expenses in 2015 reflect discretionary counter-cyclical fiscal policy. 45. The second step is to remove the cyclical component from the NLB by adjusting government revenues and expenses.19 The cyclically adjusted NLB is obtained using the following formula which takes out cyclical components from revenues and expenditures separately:

1 1 Λ = Λ − �� = � − � = � ∗ − � ∗ ��

46. Here Λ stands for NLB, � stands for revenues, and � stands for government expenditures, which also include public investments represented by net acquisition of non- financial assets. �� is the ratio of actual and potential outputs (output gap), � is the elasticity of revenues with respect to output, and � is the elasticity of expenses. Output gap is a measure summarizing cyclical variations of GDP with respect to its potential. The intuition behind the adjustment of revenues and expenditures with output gap is to remove the components of revenues and expenditures which do not reflect the discretion of the government but rather reflect their change as a result of cyclical change of output.

47. We assume that expenditures do not respond to the cycle, whereas revenues are perfectly correlated with it, which implies that the elasticities of expenses and revenues to the output are 0 and 1, respectively.20 Using these assumptions in the equation above, the formula becomes:

1 Λ = � ∗ − � ��

48. Figure 16 draws the NLB, the cyclically adjusted NLB, and the output gap computed as a percentage deviation of actual output from its potential. 21 As expected, cyclical variations of the NLB are less pronounced after the adjustment. Still, after adjustment, NLB stood at around -6% and -4.2% of potential GDP in 2009 and 2015, respectively.

17 Net acquisition of non-financial assets (NANA) equals acquisition less disposals and consumption of fixed capital. 18 The government authorities started to use GFS (Government Finance Statistics) methodology of IMF for the analysis of general government operations since 2008. 19 Instead of the common indicator - primary NOB, we take NLB to measure fiscal stance since transactions in non-financial assets represent a considerable share of total expenses. 20 For 25 European countries, EU Commission calculated the elasticities of revenue groups (personal, corporate, social contributions and indirect taxes) with respect to output and then took the weighted average of those obtaining an elasticity close to 1. The elasticity of expenses was estimated to be close to 0 (see EU Commission, 2005). More recently, Price, Dang and Guillemette (2014) estimate aggregate tax elasticity (tax weighted) again for the EU and suggest a similar result of 1.15. Princen et al. (2013) obtain an indicator of 1.03 for 24 EU countries for the period 2001-2012. 21 Output gap is taken from the authors’ calculations based on Kalman filter using a semi-structural New Keynesian model. 16

Figure 16. Cyclical adjustment

0 6% 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 -1 4% -2 2% -3 0% -4 -2% -5 -6 -4% -7 -6% -8 -8%

Net lending/borrowing Adjusted NLB Output Gap (right axis)

Source: Authors’ Calculations Note: Forecasts after 2015. NLB and adjusted NLB are in percent of actual and potential GDP, respectively.

49. Finally, to obtain the fiscal stance, we compare the ratio of adjusted-NLB-to-GDP with a base year, when the actual and potential outputs were equal. We take 2004 as a base year and compare each of these adjusted balances to the negative 1.66% of GDP in 2004. Figure 17 depicts the fiscal stance and the fiscal impulse, which is the annual change of the former. Fiscal impulse indicates that fiscal policy was highly expansionary, and hence countercyclical, in response the GFC and the recent oil price shock. In particular, it stood at around 4% and 2.3% of potential GDP in 2009 and 2015, respectively.

Figure 17. Fiscal stance and impulse (percent of potential GDP)

2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 4 3 2 1 0 -1 -2 -3 -4 -5 Fiscal Stance Fiscal Impulse

Source: Authors’ Calculations Note: Forecasts after 2015.

3.2.2 Was the countercyclical fiscal policy achieved through revenue or expenditure side?

50. The expansionary fiscal policy was almost equally reflected in both reduced revenues and increased expenses. Table 1 reports the details on both sides with their contributions to fiscal impulse.

Table 1. Fiscal Impulses compared to base year of 2013 (percent of potential GDP, + refers to expansionary policy)

Percent of potential GDP Fiscal Impulses 2013 2014 2015 2016 2017 2014 2015 2016 2017 proj. proj. proj. proj. Cyclically adjusted 22.98 22.94 21.97 21.20 21.50 0.04 0.97 0.76 -0.30 revenue Indirect taxes1 9.46 10.15 9.12 - - -0.69 1.03 - - Income tax 5.89 6.04 6.02 - - -0.16 0.02 - - Profit tax 2.67 2.08 1.95 - - 0.60 0.13 - - Other taxes 3.45 3.05 3.00 - - 0.39 0.06 - - Other revenues2 1.51 1.62 1.88 - - -0.11 -0.26 - -

Total Expenses 24.52 24.82 26.17 26.26 23.87 0.30 1.34 0.10 -2.39

Compensation of 2.17 2.38 2.62 2.64 2.31 0.22 0.23 0.02 -0.33 employees Purchase of goods and 4.62 4.77 4.80 3.14 2.10 0.15 0.03 -1.66 -1.04 services Net acquisition of non-financial 2.06 2.21 2.49 2.18 1.38 0.15 0.28 -0.32 -0.80 assets Social payments 6.33 6.99 7.26 7.43 7.32 0.66 0.27 0.17 -0.11 Subsidies 0.54 0.57 0.61 2.22 2.06 0.03 0.04 1.60 -0.15 Grants 2.64 2.80 2.84 2.81 2.33 0.17 0.04 -0.03 -0.47 Other expenses3 6.18 5.10 5.54 5.85 6.36 -1.08 0.44 0.31 0.51

Adjusted NLB 1.55 1.88 4.20 5.06 2.37 0.34 2.31 0.86 -2.69

Sources: Government Authorities and own calculations. 1. VAT, excise, and turnover taxes 2. Includes grants, and other revenues 3. Includes interest payments, capital expenses, and other expenditures

51. Indirect taxes contributed the most to the decrease of revenue-to-GDP ratio. In particular, weak domestic demand and plunged imports translated into disappointing results in VAT collection (representing about 40% of tax revenues) in 2015. Registered deflationary trends and recent legislative changes further contributed to subsequent decrease of this indirect component in the first 6 months of 2016 (Figure 18).22 Tax easing policies in the remaining areas of direct and indirect taxes were also in place.23 In summary, expansive tax easing

22 The tax threshold was raised about twofold from 58.35mln drams to 115mln ($240thsd) in the middle of 2015. Firms with production volumes less than the specified amount, are currently subject to turnover tax. In 2016, a number of goods both imported (agricultural goods and cars from the EEU) and domestically produced were stated to be free from VAT. Finally, the date of VAT payment was extended for certain goods importers. 23 The income tax rate was reduced to 10% for IT companies to further stimulate the priority sector in the economy and to 13% for firms engaged in construction sector and operating abroad. To make tax environment attractive for foreign investors and promote exports, the profit tax rate was reduced for relatively large exporting firms with governmentally approved projects. It is now 5% (instead of 20) for those businesses whose annual exports will surpass 40mln dram and 2% for firms having export volumes over 50mln dram ($100 million). Entrepreneurs operating in construction sector and exporting their services abroad are also subject to 5% profit tax. In addition, minimum profits tax was eliminated in 2014. Entrepreneurs doing economic activities in areas contiguous with the 18 policy translated into sizeable decrease mainly in indirect taxes contributing a stimulus of 1.03%, most of which was due to VAT. Figure 18. Tax revenue components (percent in tax revenues)

45 2014 2015 40 Jan-June 2015 Jan-June 2016 35 30 25 20 15 10 5 0

Source: State Revenue Committee (SRC) of the Republic of Armenia Note: “Other” includes patent, transport taxes, fixed fees and other taxes.

51. On the expenditure side, fiscal stimulus included considerable increase in total expenses in all categories. In particular, fiscal policy boosted public capital investment to compensate weakened activities in the private sector, along with broadening social protection and increasing wages of government employees. Figure 19 shows that all the mentioned categories exhibited broadly similar patterns increasing after the shock. 52. Public investments have been decreasing after 2009, as government has increased its capital expenditures dramatically after the GFC than started the gradual phasing out. After the oil price shock, public investments were again increased sizably in 2015, by 18% relative to the previous year, to encourage sluggish private investments. 53. Servicing social protection has been weighing on government expenditures more and more over time. Pensions, social security and assistance benefits, and expenses related to pension reform contributed to sizeable fiscal impulse with 0.27% in 2015 (Figure 19b).24 In 2015 social benefits reached around 7.8% of GDP exceeding the 2009 level of about 7.6%. 54. Some of the increases, such as compensation of public sector employees, were obviously on an upward trend prior to the shock. More specifically, higher public sector wages during two years prior to 2015 were triggered by the adoption of unified system of work remuneration in July 2014. Other expenses net of grants were primarily directed to defense and energy sector and posted an impulse of 0.44% in 2015.

border were declared to be exempt from taxes. Turnover tax rate for retail traders was first reduced to 1% but then again raised 5%. Still, if transactions aimed at buying final goods for resale are documented, then tax rate is 1%. At last, tax privileges were granted for family businesses which is estimated to decrease the tax revenues by 18 billion drams in 2016. Customs revenues are mostly represented by transfers from the EEU common customs pool. With the entry of Kazakhstan Armenia’s share was reduced from 1.13% to 1.11%. 24 To reduce the poverty levels among pensioners, a new regime of labor pension calculation was adopted that brought an increase in labor pension, old age, disability and other types of benefits, except for social assitance contributions. 19

Figure 19. Components of government expenditure (percent of GDP) (a) (b)

9 4.5 8 4 7 3.5 6 3 5 2.5 4 2 3 1.5 2 1 1 0.5 0 0

Use of goods and services Compensation of employees Social benefits Net acquisition of non-financial assets Source: Government Authorities Note: Forecasts after 2015.

3.2.3 How constraining will the public debt be for fiscal policy going forward?

55. Highly expansionary fiscal policy after the GFC and the 2014 oil price shock has resulted in a sizeable buildup of public debt. In 2015, public expenditure highly overbalanced revenues posting a fiscal deficit of 4.8% (Figure 20), which was almost totally financed by external sources.25 Fiscal deficit is expected to reach 5.9% of GDP in 2016. As a result, public debt will exceed 50% of GDP at the end of 2016 (Figure 21). 56. The main sources of financing are external. For example, looking ahead and considering future regional developments coming from slow recovery of oil and commodity prices and disappointing growth potential, fiscal authorities supplemented external borrowing by a $300 million of concessional loan provided by Eurasian Bank for Stability and Development to cover the estimated financing gap for 2015-2017. A similar amount was borrowed from Russia to finance the project on renovation of nuclear power plant. In addition, the government issued a $0.5 billion Eurobonds with ten-year maturity.26 All these factors translated into a considerable increase in public debt that reached to around half of GDP in 2015 (Figure 21). 57. Going forward, strengthening debt sustainability has become the top priority for the new government. More specifically, government authorities plan to bring the headline deficit to 2.8% in 2017, with a further consolidation in subsequent years. Adopted policy of fiscal consolidation and its impact on fiscal stimulus can be observed from Table 1. For example, in 2016 the reprioritization in public expenditures assumes a shift from purchase of goods and services to subsidies directed mostly to governmental organizations. In 2017 fiscal authorities aim at underpinning the debt sustainability by both decreased expenses and increased revenues. Figure 19 illustrates that projected fiscal consolidation targets goods and services and capital expenditure as the main sources of savings and fiscal space expansion over the subsequent period.

25 Only 5% of the fiscal balance was covered with internal financing. 26 Forty percent of these funds were used to buy back a fraction of Eurobond issued in 2013. 20

Figure 20. Fiscal Indicators Figure 21. Public Debt (percent of GDP) (percent of GDP)

35 Revenues 60 Government Domestic Debt Expenses Government External Debt Fiscal Balance CBA External Debt 30 50 25 40 20 15 30

10 20 5 10 0 -5 0 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

-10 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 Source: Government Authorities Note: Forecasts after 2015.

58. Announced fiscal consolidation reflects the fact that public debt is a top priority for fiscal policy in the medium term perspective. This means that the expansionary potential of the fiscal policy may be limited when new shocks hit. In this context, another important factor, which is worth mentioning, is foreign currency denomination of the majority of public debt. The inability of developing countries to borrow from abroad in their own currency is a phenomenon coined as “original sin” by Eichengreen et al (2003). As adverse external shocks hit necessitating real exchange rate adjustment, the problem of original sin exacerbates the negative consequences of the shock, as foreign currency denominated public debt increases. 59. In summary, fiscal policy was highly expansionary after the recent shock. The expansionary policy was achieved both through revenues and expenditure sides. Going forward, debt sustainability is a key priority to free up fiscal space and bring down country risk premium, which in turn will bring international investors to Armenia as a result of increased confidence.

3.3 Structural Policies 60. How did structural policies respond to the shock? How should reforms be prioritized in the current macroeconomic context, when growth is low and external environment is unfavorable? Is there need for coordination of structural and complementary macroeconomic policies? These are the questions we address in this subsection. To provide a longer view, we also construct a list of structural reforms implemented after the GFC (Table 2 in Appendix II).27 61. We find that structural policies were mostly continuation of efforts started before the shock rather than a response to the economic slowdown. We see high priority for product market reforms in the short run, in the context of low-growth environment and unfavorable external conditions, as they do not have negative short-term effects on already weak growth. We conclude that coordination of labor market reforms and targeted fiscal policy is beneficial;

27 This list, to our best knowledge, includes all the major reforms. 21

for example, large infrastructure projects, which create demand in the short run and supply in the long run, reduce the short-term pain implied by more flexible labor markets. 3.3.1 How did structural policies respond to the shock?

62. The government implemented number of reforms during 2015 and 2016 in the fields of tax administration, business environment, small and medium-sized entrepreneurship, trade, and energy sector development. Few of the reforms, however, can be directly traced to the external shock. We discuss the reforms in brief. Tax administration 63. Improvement of tax regulation mechanisms was one of the top priorities of the government in 2015 and 2016. Table 1B shows the major changes in the area during the last two years. In 2016, the National Assembly approved the new Tax Code which aims at reducing tax loopholes, broadening tax base, bringing more progressiveness, and enhancing effectiveness of revenue administration. The new Tax Code will be effective starting from January 2018. In 2015 the National Assembly adopted the new Law on Inspection Bodies creating the Joint Appeals Commission of Inspections. The commission is an independent body which examines and resolves disputes between taxpayers and tax authorities. The goal of the reform is the improvement of tax investigations procedures. In addition, the State Revenue Committee (SRC) reduced number of tax inspectorates in 2016 to optimize the structural subdivision of tax system. The World Bank joint with the local authorities, continued Tax Administration Modernization Project to improve business processes and electronic management of enterprises through financing investments in SRC IT systems. Business environment and SME development 64. In October 2015, government adopted the SME Development Strategy 2016-2018 along with the subsequent Action Plan of 2016. The strategy aims at improving the institutional, legislative, and operational environment for the establishment and development of SMEs. Tools to be used include financial literacy trainings and consultancy services, direct financial support, provision of credit guarantees, support and development of business abilities, support to new entrepreneurs, and stimulation of women entrepreneurship. At the end of 2015, Armenia signed an agreement with the EU on participation in the programme for Competitiveness of Enterprises and Small and Medium-sized Enterprises (COSME) as of January 2016. The participation in this program gives an opportunity to apply for the annual ERASMUS program for young entrepreneurs and take part in various grant competitions. Another agreement with the EU on financing of “Support to SME development in Armenia” was signed and entered into force in December 2015. The purpose of this project is to improve the business and investment environment for SMEs. Trade 65. Armenia joined the Eurasian Economic Union (EEU) in December 2014. According to the World Bank’s Doing Business Report 2016, after becoming a member of the EEU, Armenia greatly reduced the red tapes across the board to Russian Federation in terms of time and costs for border and documentary compliance.28 At the beginning of 2016, the government established the Export Promotion Council. The objective of the council is to identify export-oriented enterprises in certain prioritized areas and provide them with operational and financial support. On the regulatory side, to promote the export-oriented companies, in 2015, the CBA reduced the regulatory risk weights of foreign-currency loans

28 World Bank. 2015. Doing Business 2016: measuring regulatory quality and efficiency - Armenia. Doing Business 2016. Washington, DC: World Bank Group. http://www.doingbusiness.org/~/media/giawb/doing%20business/documents/profiles/country/ARM.pdf 22

of exporting companies.29 The lower risk weight makes the financing for exporters cheaper, as financial institutions set aside less capital for foreign currency loans. Pension Reform 66. The law on Pension Reform was adopted in December 2010. The new pension system is based on three pillars: replacement of existing pay-as-you-go system; compulsory contribution component; and voluntary contribution component. The voluntary pillar became effective in January 2011. The mandatory component was planned to become effective in 2014, but due to political backlash, the law was amended, and participation became mandatory only for public sector employees and new entrants to the job market. As a result, the number of new pension system participants has reached 155 thousand with a private sector share of around 60% as of July 2016. The adoption of the mandatory component for all private sector employees is postponed until July 2018. 67. Pension reform addresses three issues. First, the existing pay-as-you-go system is not sustainable, as increasing life expectancy, decreasing fertility rate, and working age people migration rates result in aging population. As a result, under the pay-as-you-go system the burden of pension puts public finances on an unsustainable path. Second, the lack of domestic savings with long maturities impedes growth. Capital deepening through high rates of long-term investments is a key ingredient of sustained high growth in emerging markets. According to the Commission on Growth and Development’s The Growth Report: Strategies for Sustained Growth and Inclusive Development (December 2010), sustained high investment paths are always backed up by high domestic savings. This does not diminish the role of foreign resources, but underlines that foreign borrowing is risky, after some point resulting in inability to sustain high level of investment. Pension reform provides an infrastructure which channels long-term domestic savings into productive investments in the domestic economy. Third, pension reform catalyzes the development of domestic capital markets. 68. In light of the above discussion, we see the full implementation of pension reform as a key priority.

Infrastructure 69. Large-scale infrastructure projects increase demand in the short run and supply in the long run and, therefore, are well-suited for addressing the current slowdown. One of such projects is the multi-stage “North-South Road Corridor Investment Program” launched in 2011. The North-South Road Corridor is 556 km long highway connecting two borders of the country and providing strategic intercontinental route from Asia to Europe. Expected benefits of the project are high, as Armenia will become a transit country for a major trade rout. The road will also provide better access to Asian and European markets for Armenian exporters. Indirect benefits include the productivity growth due to knowledge transfer in design and construction of high-quality roads. The project donors are the Asian Development Bank (ADB), the European Investment Bank (EIB), the Eurasian Development Bank (EDB), and the European Bank for Reconstruction and Development (EBRD). The estimated cost of the project is $1.5 billion. Energy Sector 70. Regional integration, lifetime extension of the nuclear power plant, privatization of Armenia’s largest hydroelectric complex, and liberalization of the energy market are the major structural reforms in the energy sector during the last two years.

29 Risk weights were reduced to that of local currency loans when exporting firms met certain conditions. 23

71. Armenia has signed a roadmap with Russia, Georgia, and Iran to create an energy corridor that will link up power transmission networks of the countries. The construction of two such lines connecting Armenia with Iran and Georgia has already started and is expected to be finalized in 2018. This is likely to diversify the main energy sources and supply channels and reduce critical dependence on Russia’s energy sector.30 In August 2015, US energy company ContourGlobal acquired Vorotan Hydropower Cascade, a major hydroelectric facility providing almost 15% of Armenia’s electricity generation. This agreement represents the largest US investment in the Armenian economy reaching $250 million and is a critical step towards addressing key infrastructure challenges of Armenian power sector. Earlier the same year, Russia agreed to provide a $300 million concessional loan to extend the life of the main electricity distributor, Metsamor nuclear power plant, by 10 years.31 In October 2016, the Public Service Regulatory Commission (PSRC) liberalized energy market by granting third party access to energy infrastructure. The liberalization means that independent renewable energy producers, such as households using solar panels, are now allowed to produce green energy both for own consumption and for distribution. The reform provides incentives for households and firms to switch to clean energy consumption diversifying the energy infrastructure and leading to efficiency gains with competitive prices in the sector. 72. In 2016, the government devised an energy sector rehabilitation plan with technical and financial support from the World Bank. The aim of the plan is to address the difficulties that energy companies, state-owned and private, have been facing during the last five years. The high levels of accumulated debt of energy producers and Electric Networks of Armenia (ENA) put Armenia’s power sector into financial distress in early 2015 necessitating the rehabilitation plan. According to the plan: (i) non-core business related borrowing, lending and expenses will be strictly forbidden; (ii) debt structure will be redesigned substituting short- term costly loans by long-term inexpensive IFI funding;32 (iii) tariff adjustment mechanism will be revised to minimize the risks of planned vs. actual energy generation mix; (iv) agreement on a repayment plan will be signed to recover the debts to energy suppliers. 3.3.2 How should reforms be prioritized in the current macroeconomic context?

73. We discuss two sets of reforms: product market and labor market deregulation. Product market deregulation essentially increases competition and reduces firm-entry costs, while labor market reforms bring more flexibility in hiring and firing labor. We see product market reforms as the first priority in the current macroeconomic context. The reason is twofold. First, product market reforms do not weigh on growth in the short-run, as they lead to lower price level, and, therefore, do not exacerbate the current slowdown of the economy. Second, as stressed by Blanchard and Giavazzi (2003), sequencing of reforms matters, as lower price level, leading to higher real wage, sets the ground for successful labor market reforms. The intuition is that the higher real wage effects of product market reforms counteract the short-term pain imposed by labor market reforms and hence increase the probability of their successful implementation. The short-term pain of labor market reforms is a result of firms firing employees in the short run, because hiring new employees takes time due to search-and-matching frictions. In the context of Armenia, we see the public sector

30 Iranian gas-fired Armenian thermal power plants account for a large share (over 25%) of the country’s power generation system. However, due to low electricity transmission capacity the gas pipeline is utilized by only 20%. When completed, the new transmission line is expected to quadruple electricity-gas exchange volume between the two economies. 31 The International Energy Corporation CJSC is planning to replace old equipment of Yerevan HPP – 1 with modern generators and runners pledging to invest $40 million. 32 Required funding for financial recovery of the power sector is about $40 million. Based on the reconstruction loan agreement, IBRD (International Bank for Reconstruction and Development) has already provided a $30 million concessional loan with a 14.5-year grace period. 24

optimization as the main focus of labor market reforms, given the large size of public sector employment.

74. When prioritizing the reforms, cyclical conditions matter as well. Cacciatore et al. (2016), in a model-based environment, show that the short-run costs of adjustments after labor market reforms strongly depend on business cycle conditions. More specifically, the short-term pain is higher when the reforms are implemented during bad times. The effects of product market reforms, however, are less dependent on business cycle. In addition, Bouis et al. (2016), using country-industry-level evidence of product market deregulations, do not find significant evidence on short-term negative effects of product market reforms. The result holds under weak macroeconomic conditions. Current macroeconomic conditions, in the light of the above discussion, suggest careful sequencing of reforms putting product market deregulations high on the policy agenda.

3.3.3 Is there a need for coordination of structural and complementary macroeconomic policies?

75. Structural reforms increase economy’s long-term potential. In the short run, however, they can lead to contractionary effects, as in the case of labor market reforms discussed above. In the context of the recent shock, there is a room for coordination of structural and fiscal policies. In particular, we suggest that targeted infrastructure projects which support demand in the short run and increase potential in the long run should be included in fiscal expenditure plans. 76. Government’s fiscal consolidation which starts in 2017 will have sizeable contractionary effects on the short-run growth.33 Taking a step further, the planned consolidation is mainly achieved through cuts in capital expenditures; the share of capital investments in GDP is planned to decrease to 1.8% in 2017 from 3.1% in 2016. Drawing on experience of emerging markets, The Growth Report: Strategies for Sustained Growth and Inclusive Development (December 2010), concludes that reducing fiscal deficits by cutting infrastructure spending may sizably reduce long-term growth. This implies that the consolidation may not only depress growth in the short term but may also have negative consequences for the long-term potential. In this context, we suggest infrastructure projects financed via public-private partnerships. The financial discipline and expertise provided by private sector may be a remedy for public projects suffering from limited resources and mismanagement.

4. Operational Support from ADB and other IFIs 4.1 The Role of IFIs

77. We consider the operational support from ADB and other IFIs in the context of the negative external shock. Longer-term development plan requires an in-depth analysis of Armenia’s growth strategy and should consider fundamental processes behind the growth in developing countries: capital deepening and structural change. The long-term growth strategy is out of the scope of the paper, but, where possible, we touch upon the issue. One thing is clear, however, focused long-term government plan and coordinated IFI support is

33 In addition, as emphasized by Auerbach and Gorodnichenko (2012), fiscal multipliers are higher when the economy is in the downturn. 25

key. Clear communication of the plan will help to front load the benefits of the projects which are by design long-term. 78. We showed above that the GFC and the 2014 oil price shock consumed the major share of monetary and fiscal policy space. More specifically, the countercyclical government response to the shocks cushioned the economy but failed to increase its potential. The result is higher public debt with uncertain growth potential. The lack of demand management policy space and the unfavourable external environment call for targeted operational support from ADB and other IFIs, consistent with the approach we recommended for fiscal and structural policies. IFI support is particularly important in the current macroeconomic environment of fiscal strain and global risk aversion. 79. We make two main points in this section. (1) Highly uncertain external environment puts the implementation of large infrastructure projects such as North-South Road Corridor Investment project high on the agenda. (2) The high level of public debt means that mismanagement of such projects is unaffordable as it may even lead to negative multipliers because of increase in country risk premium and fall in confidence of foreign investors. 80. The first point is that large infrastructure projects are priorities. Taking into account sharp cuts of public capital expenditures, the benefits of large-scale infrastructure projects are especially visible. In addition, such projects should be targeted on the most binding constrains in the economy first. If possible, the projects should be implemented in line with existing industrial policies of the government. In the context of the negative shock, targeted also means prioritization of projects that support growth in the short run. The logic behind the targeted approach is simple: in developing economies with low levels of debt, capital deepening with across-the-board public investment is a major driver of growth, however, when debt levels are high this cannot be afforded, hence investment should focus on areas with highest returns. 81. Our second point is that mismanagement of IFI-financed programs is unaffordable. Risk of mismanagement is especially high in the case of large infrastructure projects. Therefore, in light of our first point, institution development and public sector optimization is the area where the returns are high. In addition, sound institutions and productive public sector boost private returns and attract private investment which has been sluggish since the GFC. IFI-financed secondment projects of public sector employees to IFIs can prove highly beneficial. This will lead to positive knowledge and management spill overs creating agents of change within the public sector. 82. Regardless the areas of IFI-financed projects, local currency financing is highly beneficial. First, it does not increase foreign currency debt and has little effects on country risk premium. Second, it contributes to the development of local capital markets. 4.2 Current Projects

83. IFIs are heavily involved in development projects in Armenia. Cooperation includes wide range of areas: infrastructure; SME development; public sector modernization; water supply management etc. Most of the projects are long-term and aim at improving country’s long-term potential by providing not only financial resources but also critical knowledge and expertise. 84. Through the last 10 years ADB has provided around 1billion USD in loans to Armenia. In 2015 the country partnership strategy (CPS) was approved.34 ADB is a major stakeholder in a landmark North-South Road Corridor Investment project committing $500 million through multi tranche financing facility. Another $400 million, using the same mechanism, was

34 Asian Development Bank. 2014. Armenia - Country partnership strategy for the period 2014 - 2018. Manila; Asian Development Bank. http://www.adb.org/sites/default/files/institutional-document/153661/cps-arm-2014-2018.pdf 26

committed to country’s Sustainable Urban Development Investment Program. Tables 3 and 4 in Appendix II provide the list of major ADB and other IFI-financed projects. 85. More specific recommendations of IFI support require deep knowledge of specific sectors which we do not fully possess. We tackle the issue from the macroeconomic point of view. One thing is certain: at the current juncture no resource can be wasted.

5. Conclusion and Recommendations

86. The 2014 oil price slump negatively affected Armenian economy due to spillovers from Russia through trade, financial, and remittances channels. As a result, exchange rate depreciated sharply, public debt increased to a level which triggered fiscal rule, and inflation expectations jumped. Monetary policy reacted by increasing the policy rate to reflect the sharp increase of country risk premium and rising inflation expectations, then started a long easing cycle which continues to date. Countercyclical fiscal policy cushioned the economy from the sharp fall. The coordinated monetary and fiscal policy response stabilized the economy, and the financial system proved to be resilient. 87. Fundamental questions about the future growth after the shock remain. How much space do monetary, fiscal, and structural policies have? Is there need for coordination? What role should IFIs play in the current macroeconomic context? 88. Monetary and fiscal policies have limited role in generating growth. Monetary policy by definition cannot and should not address deep structural problems of the economy. Fiscal policy is constrained by high level of public debt but should not neglect its role in generating long-term economic potential. Structural reforms are the main determinants of growth in the near future. Prioritization of structural reforms in the context of weak growth is key. Product market reforms, which have positive short-term effects, should be followed by labour market reforms, the benefits of which are longer-term. The main role of fiscal policy is to emphasize capital expenditures creating demand in the short run and potential in the long run. Clear long-term action plan emphasizing reforms and government policies along with measurable outcomes is necessary as it will help front load the benefits of the reforms and create virtuous cycle. 89. The role of IFIs in the low-growth environment is to provide targeted support in the areas of highest return. In addition, large-scale infrastructure projects which create short- term demand and increase productivity in the long run should be prioritized. Public sector optimization is another area with high return as it is complementary to all the policies we recommend above. Here again, focused long-term strategy coordinated with government reform plans will help to front load the positive effects of future productivity gains.

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20. Frankel, J.A., 2010. Monetary policy in emerging markets: A survey (No. w16125). National Bureau of Economic Research. 21. Gavin, M. and Perotti, R., 1997. Fiscal policy in latin america. In NBER Macroeconomics Annual 1997, Volume 12 (pp. 11-72). Mit Press. 22. Ilzetzki, E. and Végh, C.A., 2008. Procyclical fiscal policy in developing countries: Truth or fiction? (No. w14191). National Bureau of Economic Research. 23. International Monetary Fund. 2011. Republic of Armenia: Third Reviews Under the Extended Fund Facility and Extended Credit Facility, and Request for Modification of Performance Criteria—Staff Report; Staff Supplements; Press Release on the Executive Board Discussion; and Statement by the Executive Director for the Republic of Armenia. December 2011. IMF Country Report No. 11/366. Washington DC: IMF. 24. International Monetary Fund. 2013. Republic of Armenia: Sixth Reviews Under the Extended Fund Facility Arrangement and the Extended Credit Facility Arrangement. July 2013, IMF Country Report No. 13/238. Washington DC: IMF. 25. International Monetary Fund. 2015. Republic of Armenia: Second Review Under the Extended Arrangement and Request for Waivers of Nonobservance and Rephasing: Press Release; Staff Report; Supplement; and Statement by the Executive Director for the Republic of Armenia. November 2015, IMF Country Report No. 15/320. Washington DC: IMF. 26. International Monetary Fund. 2016. Republic of Armenia: Third Review Under the Extended Arrangement, and Request for Waiver and Modification of Performance Criteria— Press Release; Staff Report; and Statement by the Executive Director for Republic of Armenia. July 2016, IMF Country Report No. 16/246. Washington DC: IMF. 27. Ize, A. and Yeyati, E.L., 2006. Financial de-dollarization: is it for real? In Financial Dollarization (pp. 38-63). Palgrave Macmillan UK. 28. Kaminsky, G.L., Reinhart, C.M. and Végh, C.A., 2005. When it rains, it pours: procyclical capital flows and macroeconomic policies. In NBER Macroeconomics Annual 2004, Volume 19 (pp. 11-82). MIT Press. 29. Naceur, M.S.B., Hosny, A. and Hadjian, G., 2015. How to De-Dollarize Financial Systems in the Caucasus and Central Asia? (No. 15-203). International Monetary Fund. 30. Price, R.W., Dang, T.T. and Guillemette, Y., 2014. New Tax and Expenditure Elasticity Estimates for EU Budget Surveillance. 31. Princen, S., Mourre, G., Paternoster, D. and Isbasoiu, G.M., 2013. Discretionary tax measures: pattern and impact on tax elasticities. Economic papers, (499), pp.1-25. 32. Regional Economic Outlook, Middle East and Central Asia, IMF, Washington October 2015. 33. Stepanyan, A., 2015. The Spillover Effects of Russia’s Economic Slowdown on Neighboring Countries. International Monetary Fund. 34. U.S. Department of State. 2015 Investment Climate Statement – Armenia. Bureau of Economic and Business Affairs 2015. https://www.state.gov/documents/organization/241675.pdf 35. World Bank. 2015. Doing Business 2016: measuring regulatory quality and efficiency - Armenia. Doing Business 2016. Washington, DC: World Bank Group. http://www.doingbusiness.org/~/media/WBG/DoingBusiness/Documents/Annual- Reports/English/DB16-Full-Report.pdf 36. World Economic Outlook, IMF, Washington April 2016

Appendix I:

Box 1. Armenia’s link to Russia and its implications

Due to large presence of Russia in Armenia’s economy (Figure 22), imposed sanctions and the recent oil price drop had negative spillovers on Armenia mainly through trade, remittances, and financial channels.

Armenia’s trade with Russia in 2015 has decreased sharply. Exports decreased by 26% because of Russia’s 3.7% fall of output. Weak demand in Armenia mostly driven by reduced remittances resulted in 16% drop of imports from Russia. Figure 22. Armenia’s link with Russia Russia is the migration destination (Russia’s share in total, percent) for 90% of Armenian migrants. 100 2014 Migrants are largely engaged in 90 2015 non-tradable sectors (construction, 80 retail trade, hotels, and 70 restaurants). As a result, shocks 60 hitting Russia translate to Armenia 50 40 through remittances channel. Oil 30 price shock caused a sharp 20 depreciation of ruble and a 42% 10 decrease in net inflows of 0 remittances from Russia (in US Imports Exports Remittance FDI net Bank Assets dollars). inflows inflows Source: National Statistical Service and Central Bank of Armenia The third transmission channel is financial. Financial channel has mainly manifested itself through the increase of country risk premium. Close economic ties with Russia caused a sizeable increase of Armenia’s country risk premium in the immediate aftermath of the shock constraining monetary policy. Notably, transmission through banking linkages has been limited.

Box 2. Dedollarization policies in Armenia

Highly dollarized economies suffer from weak transmission mechanism and are prone to “fear of floating” due to balance sheet effects.35 Financial dollarization in Armenia has been relatively volatile over the last two decades. During 2003-2007, shares of foreign exchange denominated credit and deposit decreased twofold. The double-digit growth accompanied with large capital Figure 23. Loan and Deposit Dollarization in inflows (FDI and remittances) and Armenia the appreciation of Armenian (Jan 2000 – Sep 2016) national currency gradually 90 strengthened the confidence in the 80 banking sector and decreased the 70 share of foreign exchange (FX) 60 deposits from as high as 75% to 50 below 40% (Figure 23). However, 40 AMD/USD AMD/USD after the GFC, dollarization spiked to 30 depreciation of depreciation of 36 over 70%. In the context of forced 20 20% 15% dedollarization policies, CBA 10 responded by a gradual 0

incorporation of prudential measures 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16 ------putting the emphasis on raising the Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan Jan opportunity cost of FX deposits.37 Loan Dollarization (%) Deposit Dollarization (%) Namely, reserve requirements (RR) Source: Central Bank of Armenia for FX deposits were denominated in national currency and the difference between national and foreign currency RR rates was consistently increased. The shaded area in the figure shows the start and end of denomination process from March 2010 to December 2011. The denomination was implemented in four stages: from 12% of reserve requirement rate of FX deposits 3% was kept in national currency in the first stage, 6% in the second, 9% in the third, and 12% in the fourth stage. The increase in the difference of reserve requirement rates was a gradual process as well. In April 2013, RR rate for AMD liabilities was decreased from 8% to 4% and in February 2014 from 4% to 2%. As for FX liabilities, the coefficient was 12% until the recent oil price slump rising to 24% during the shock. Currently the RR rate for FX deposits is 16 percentage points higher than that of dram liabilities (18 vs. 2).38 Supervisory measures are also in place: the currency mismatches of banks’ largest borrowers have been kept under systematic review since June 2012. Earlier in 2010, CBA introduced greater risk weights for foreign currency assets: a number of foreign currency assets are exposed to 50% additional risk weights. In January 2015, the Central Bank of Armenia raised minimum capital requirements 6 times to enhance buffers and bank stability.39 Later in the same year, the guaranteed coverage of national currency deposits has been increased from 4 to 10 million drams. On the contrary, that of foreign currency deposits has been raised from 2 to 5 million drams, which is expected to further discourage the use of FX deposits.

35 For a summary of existing theories of de facto financial dollarization, costs and limitations related to the latter and policy recommendations, see Ize and Levy Yeyati (2006). 36 Naceur, Hosny and Hadijan (2015) study the factors of financial dedollarization in Caucasus and Central Asia (CCA) countries concluding that the main drivers of deposit and loan dollarization are respectively highly volatile exchange rate and inflation. 37 Forced dedollarization measures are represented by prohibition of use of foreign currency as a means of payment and extension of consumer loans only in drams. Plus, the interest on foreign currency accounts is to be computed in foreign currency but paid in national one. 31

Appendix II:

Table 2. Structural reforms implemented in Armenia after GFC Measure Date Reform Area Comment

Tax Administration

Government decree Improve July Stipulates clarifications on tax laws, on transparency of transparency of tax 2010 procedures and other obligations. taxes and other duties administration

Creation of Tax October Improve tax Addresses disputes and complaints Appeals Council 2010 investigations of taxpayers.

Preparation of tax Manuals were introduced in the Improve tax audit audit manuals December field of tourism, transportation and and strengthen (guidebooks for SRC 2010 real estate and in cash transfer revenue collection inspectors) machines using sectors.

Reduction of tax reporting frequency and modernization of December Reduce red tapes in

tax forms of VAT, 2010 tax policy income and profits taxes.

A new unified tax system was introduced (effective since January Adoption of new law December 2013) that incorporates social Simplify paying taxes on income tax 2010 contributions of employees and employers and individual income tax.

Implementation of risk based methodology Improve the system 2011 for VAT refund of VAT refund processing

Simplify revenue Use of VAT payer December This is to determine whether the tax collection process of identification number 2011 payer has VAT liability or not. VAT

To reduce the time of customs Introduction of Green January Improve customs procedures self-declaration desks Channel 2012 clearance were introduced.

38 In addition to RR policy changes, CBA imposed minimum FX liquidity requirements to better manage liquidity risk in banking sector. The minimum ratio of “highly liquid assets to total assets” is 4% for foreign currency denominated assets whereas it is 15% at the balance sheet level. Likewise, the bottom of “highly liquid assets to demand liabilities” is 10% while it is 60% at the balance sheet level. 39 Banks are required to have total capital of 30bln (about $60 million) drams instead of 5bln (about $10 million) since January 2017. 32

Since 2010 e-filing system has been consistently extended. At first financial sector organizations and large taxpayers were required to file Modernization of tax Since Improve tax tax returns electronically. Then, all audit 2010 administration the VAT taxpayers were also added to the list in January 2012. Electronic payment of taxes became available the next year.

Stipulates the introduction of Authorized Economic Operators system and enlarges the range of Foster international electronic declaration of goods. Amendments to May trade and improve Earlier in 2010, cross border customs code 2014 business operations were improved by environment simplifying import procedures, documentary compliance requirements and introducing of risk management system.

Stipulates the write-off of Amendments to tax November Reduce red tapes in accounting documents to be based law 2014 tax administration on electronic processing since January 2016.

Upgrade and increase the Aims at analyzing the risks of tax Establishment of Risk February transparency of inspection and enhancing the Management Unit 2014 revenue efficiency of revenue collection. administration Adoption of Law on Examines and resolves disputes Inspection Bodies and January Improve tax between taxpayers and taxation creation of Joint 2015 investigations authorities (tax and customs Appeals Commission bodies). of Inspections

Tax Administration Improves the electronic Modernization Project Extend the tax base management of enterprises through Ongoing (Joint with World and reduce red tapes financing highly important Bank) investments in SRC IT systems. Enhance the transparency and Adoption of the new October The new tax code will enter into effectiveness of tax code 2016 force after January 2018. revenue administration

Capital Market

Compulsory vehicle June Develop capital Was effective after January 2011. insurance 2010 markets 33

The multi-pillar pension system assumed three pillars: first pillar was to replace existing pay-as-you- go system, second and third pillars represented compulsory and voluntary funded pension systems, respectively. The voluntary pillar was effective since January 2011 whereas the mandatory pillar was December Develop capital expected to become effective in Pension Reform 2010 markets January 2014. However, this date was postponed because a number of statements in the pension law were unconstitutional. In June 2014, the revised version of the law made participation to the pension system mandatory for public sector employees. On the contrary, that of private sector workers was postponed till July 2018.

Permission to issue June Improve capital foreign currency 2012 market infrastructure domestic bonds

Armenia issued its first-ever Issuance of Eurobond Integration to September Eurobond ($700 million bond with by Armenian international capital 2013 maturity of 7 years and yield of government markets 6.25%).

Issuance of Armenian IFC was the first non-resident to currency bond by December Develop capital issue Armenian dram bond International Finance 2013 markets (equivalent to $5 million). Corporation (IFC)

EBRD issued a 2 billion Armenian Issuance of Armenian currency bond (almost $5 million). January Develop local capital currency bond by The second dram denominated 2014 markets EBRD bond (about $4 million) was placed in January 2015.

In cooperation with EBRD and ISDA (International Swaps and Derivatives Association) the CBA Amendments to the November Modernize capital prepared a package of laws that law of securities 2016 market infrastructure allow to use derivatives (including market foreign currency and interest rates) to better insure against risks in financial sector.

Energy Sector 34

In August 2015, the third electricity transmission line is agreed to be Iran-Armenia gas May Diversify energy constructed between Armenia and pipeline 2009 infrastructure Iran to increase the capacity of power transmission and Iranian gas imports.

Foundation of The plant is one of the most Improve energy Yerevan Thermal April 2010 efficient energy generators in infrastructure Power Plant Armenia.

Russia provided $300 million Extension of life of February Upgrade nuclear concessional loan to extend the life nuclear power plant 2015 power generation of NPP.

Privatization of Improve the This is the largest-ever US August Vorotan Hydro efficiency in energy investment in Armenia amounting 2015 Cascade sector to $180 million.

The ways of Long- Develop the energy Term (through 2036) December infrastructure and

Development of the 2015 diversify energy Energy System of RA production

The government approved signing of a memorandum on construction Diversify the investor of a new thermal power plant. The Construction of a new February presence in energy British company Grange Power thermal power plant 2016 sector LLC is committed to build the plant within a 30-month period and will invest $220 million. In cooperation with the World Bank the plan considers to redesign Energy Sector March Strengthen energy energy sector debt, revise tariff Rehabilitation Plan 2016 sector sustainability adjustment mechanism and prohibit non-core business related activities.

Enhance the The PSRC adopted a decree Third party access to October competition and price allowing third party renewable energy production 2016 transparency in energy producers to enter the energy sector energy sector.

Business Environment and Regulatory Policies

The one-stop shop and online registration of a company made Introduction of One starting a business much easier. January Reduce costs of firm Stop-One Window Further refinements include 2011 entry registration scheme elimination of registration fees and strengthening post registration procedures in subsequent years. 35

Implementation of the guillotine is ongoing which aims at reducing Reduce the costs of costs of doing business. In March doing business and Introduction of June 2015, the government took simplify the business Regulatory Guillotine 2011 measures to optimize government regulatory and patent processes, tax and mechanism customs administration to further reduce costs.

Reduces the processing time of Amendments to June Improve insolvency insolvency proceedings and bankruptcy law 2011 proceedings improves assignment process of bankruptcy administrators.

Establishment of SME July Improve business Addresses issues of state development council 2011 environment regulation for SME development.

Strengthen the efficiency of the Anti-competitive agreements were SCPEC (State Amendments to April classified (vertical, horizontal and Commission for the competition legislation 2011 mixed) and a qualitative indicator of Protection of market power was introduced. Economic Competition)

Improve the business Strengthens the licensing process Introduction of mining November environment in and increases the transparency of legislation 2011 mining sector taxation of minerals.

Attract FDI and Law on Free May enhance export Economic Zones 2011 volumes

Foster exports of Export Promotion December sectors with

Strategy 2011 competitive advantage

Attract FDI in high Foundation of Alliance July and innovative Free Economic Zone 2013 technologies

Insure exporters against potential Establishment of October Better control of losses related to non-payment of Export Insurance 2013 export risks the other party abroad. Agency Enhance Foundation of April investments in Meridian Free 2014 jewellery and watch Economic Zone making

Requires a randomized match of Amendments to July Improve enforcing cases and judges via a fully judicial legislation 2014 contracts automated system. 36

The body aims at protecting Establishment of consumer rights through disclosure September Protect consumer Market Surveillance of standardization requirement 2015 rights Inspection Body violations of non-food products and services. 2016-2018 Action Improve business October Plan for SME environment and 2015 Development enhance competition

Export Promotion January Trigger exports of

Council 2016 priority goods

Strengthens bankruptcy and Simplify and improve recovery procedures by Amendments to June bankruptcy streamlining judicial specialization bankruptcy law 2016 proceedings and refining qualification criteria of insolvency administrators.

Monetary Sector

Introduction of deposit September Better regulation of Allows the CBA to absorb excess auctions 2011 bank liquidity liquidity of banks.

Improve liquidity Publication of liquidity December Before taking actions, the CBA management of forecasts 2011 publishes dram liquidity projections. banks

The law stipulates the creation of Adoption of the law on electronic database for moveable December Improve access to registration of asset registration and allows SME 2014 finance movable assets to use these assets to for getting credit.

Other Reform Areas

Irrigation system September Improve access to

reconstruction 2008 irrigation system Orange was the third operator to enter Armenian telecommunication Foundation of the third November Enhance competition market. In July 2015; however, it mobile network 2009 in telecommunication was sold to a local Armenian company. The road stretches from southern North South Road Improve the 2011 border of Armenia to northern and Corridor infrastructure totals 556km. 37

If satisfying security standards, local and foreign airlines were allowed to operate in Armenia without special restrictions or Liberalize aviation October authorizations. Ongoing “Open skies” policy market and attract 2013 negotiations of 15 aviation low cost airlines agreements (and the Common Aviation Area Agreement with the EU) will most likely attract low cost carriers. Change the structure Entering the EEU obviously led to Membership to the January of investments, trade reduction of border and EEU 2015 and the entire documentary compliance time and economy costs for trade with Russia. Source: EBRD Transition Report 2009, 2010, 2011, 2012, 2013, 2014, 2015-2016, IMF Country Report No. 11/366, December 2011, IMF Country Report No. 13/238, July 2013, IMF Country Report No. 15/320, November 2015, IMF Country Report No. 16/246, July 2016 and government authorities.

Table 3. Basic active projects of IFIs in business environment of Armenia.

Project Name IFI Date Objectives

Agriculture Kreditanstalt für Support SMEs in agriculture (KfW provides Development Wiederaufbau June 2012 €15mln for this project). Project (KfW)

Improve the entrepreneurial skills of women and Women’s enhancing availability of financial sources for Entrepreneurship October ADB female entrepreneurs (effective since December Support Sector 2012 2013). It also tries to mitigate the gender-related Development challenges of woman entrepreneurship.

Support young entrepreneurs and raises their Productive work for UN Industrial awareness in the business environment. Over Youth in Armenia – Development March the last two years, a number of “Start-up Supporting Young Organization 2013 Business Support” projects were implemented Entrepreneurs (UNIDO) by the program.

United States Agency for August Provide material and financial assistance to rural Rural Prosperity International 2013 communities for 5 years. Development (USAID)

Advanced Rural August Support rural entrepreneurs engaged in food Development USAID 2013 and diary production and develop rural tourism. Initiative

Second Community Support farmers to enhance the productivity of Agricultural livestock and better manage communal pasture June Resource World Bank systems. The program is the continuation of 2014 Management and successfully implemented first CARMAC project Competitiveness and is effective since January 2015. (CARMAC) 38

Enhance the government’s capacity in the field Trade Promotion of FDI attraction and export diversification and July and Quality World Bank improving the quality management services to 2014 Infrastructure entrepreneurs (is active since the beginning of 2015).

Finance SME projects in tourism and agri-food Armenia APEX December sectors (the funding amount is €50mln). In EIB loan for SMEs 2014 November 2016 another €50mln was provided by EIB.

Efficient energy March Finance energy efficiency projects implemented KfW projects promotion 2016 by SMEs (the budget is €20mln).

Table 4. Basic active projects of IFIs in infrastructure of Armenia

Funding Project Name IFI Date Objectives Amount

Energy and Public Sector

Strengthen power transmission network of Armenia and provide Electricity Supply technical assistance. In July World Bank May 2011 $39mln Reliability Project 2014 the budget was increased by $40mln to finance further costs of transmission lines. Program for the Promotion of November Develop renewable energy KfW €40mln Renewable Energies 2012 production in Armenia (Phase III)

Green For Growth December Promote small renewable energy EIB €3.75mln Fund II 2013 projects in the country

Power Transmission Improve the energy network and Rehabilitation ADB July 2014 $37mln enhance transmission capacity Project in Armenia.

Construct high voltage power transmission network with Georgia. Co-financing Caucasus institutions: EIB – a €10mln loan, December Transmission KfW €85.2mln European Union Neighbourhood 2014 Network Investment Facility (NIF) – a €10.4mln grant. The government signed another €83mln loan agreement in December 2015. 39

Upgrade power transmission Electricity lines (includes also rehabilitation Transmission World bank March 2015 $52mln of substations of Yerevan Network Thermal Power Plant and High Improvement Project Voltage Electric Networks).

Geothermal Confirm the availability of Exploratory Drilling World Bank June 2015 0 geothermal energy production in Project Armenia.

Increase the effectiveness of Public Sector public financial management and September Modernization World Bank $21mln reporting. The project II was 2015 Project III launched in 2010 and is still ongoing.

Power Sector Address the financial distress in Financial Recovery World Bank April 2016 $30mln Armenia’s energy sector. Program

Increase the competition in energy sector and improve Infrastructure November public expenditure and Sustainability ADB $90mln 2016 management. Institutional Support Program refinement of water and transport government agencies.

Social Protection and Environment

Improve waste management in Kotayk Solid Waste December EBRD $3.5mln Kotayk region. NIF provided a Management Project 2011 €3.5mln for this project

Second Social Refine the delivery of social Protection protection services and the World Bank March 2014 $21.2mln Administration operational functions of agencies Project delivering these services.

Social Investment Improve the intercommunity and Local World bank March 2015 $30mln infrastructure Development Project Improve solid waste management in Yerevan and 4 Yerevan Solid October surrounding regions. A similar EIB €8mln Waste 2015 amount of loan and grant were provided respectively by EBRD and NIF.

Transport

This is the largest project targeting transport infrastructure North South Road in Armenia ($1.5-2 billion). The Corridor Investment ADB 2009 $500mln road stretches from southern Program: tranches border of Armenia to northern 1, 2, 3. and totals 556km. Co-financing institutions are EIB (€60mln in 40

2013), EDB and EBRD. The project includes a €12mln grant provided by NIF.

Renovate the underground system in Yerevan. Another €5mln were directed to metro Yerevan Metro August EIB €5mln rehabilitation in May 2013. The Rehabilitation I 2010 project is co-financed by EBRD (€5mln). NIF provided another €5mln grant. Construct or upgrade the crossing points with Georgia. Additional €0.5mln funds were Border Crossing and August EIB €30.3mln disbursed in July 2016. Co- Infrastructure 2012 financing institutions: EBRD – a €10.3mln loan, NIF – a €12mln grant.

Rehabilitate Yerevan metro. Co- Yerevan Metro EIB May 2013 €5mln donors: EBRD - a €5mln loan, Rehabilitation II NIF - a €5mln grant.

Improve the important roads Lifeline Road granting rural regions better January Network World Bank $45mln access to local markets. In July 2013 Improvement Project 2015, additional $40mln was directed to this project. Sustainable Urban Improve urban traffic via Development September ADB $113mln reducing congestion and Investment Program: 2015 enhancing transport efficiency. tranches 1, 2.

January Renovate the Armenia-Georgia M6 Interstate Road EIB €51mln 2016 interstate road.

Gyumri Urban Improve the transport and EBRD May 2016 €14.6mln Roads lighting infrastructure of Gyumri.

Water/Sanitation

Water Sector Improve water supply and Communal KfW May 2010 €30mln sewerage systems in Lori and Infrastructure II Shirak regions. Phase II

Water Supply and Improve water supply and Sanitation Sector ADB April 2012 $40mln sewerage systems in Armenia. Project Upgrade the water supply and wastewater system in 17 towns. Armenia Water August EIB €6.5mln Co-financing institutions are Sector Project 2012 EBRD (€6.5mln) and NIF (a €7mln grant) 41

Improve water supply and Yerevan Water sewerage system in Yerevan. Supply Improvement EBRD May 2013 $7mln Co-financing institutions: EIB – a Project $7mln loan, NIF – a €5.5mln grant Irrigation System Enhance irrigation system Enhancement World bank May 2013 $30mln effectiveness. Project Construct and renovate water Water Sector infrastructure in Armenian Communal December KfW €30mln communities. Co-financing Infrastructure II 2013 institutions: EIB – a €25.5mln Phase III loan, NIF – a €15mln grant

Integrated Water Construct a new reservoir and December Resources KfW €50mln extend irrigation system in 2014 Management Armenia.

Education and Healthcare

Improve maternal and child healthcare services and Disease Prevention World Bank March 2013 $35mln enhancing the effectiveness and and Control Project quality of some medical centers in Armenia. Improve the quality of general Education education and upgrading World bank March 2014 $30mln Improvement Project physical conditions of educational institutions. Seismic Safety September Improve the seismic safety of Improvement ADB $88.5mln 2015 Armenian schools. Program

Tax administration

Tax administration Upgrade tax administration of Modernization World Bank July 2012 $12mln Armenia targeting IT systems of Project SRC. A Program for Upgrading The Export- Technologies and ¥155.4mln Import Bank March 2015 Upgrade customs control system Equipment for the (≈$22.5mln) of China System of Customs Inspection

Other Sectors

The Improve rural infrastructure and International provide financial support to Infrastructure and Fund for September farmers. The project is largely Rural Finance $11.4mln Agricultural 2014 co-financed by OPEC Fund for Support Program Development International Development (IFAD) ($25mln) 42

Yerevan Street Upgrade the street lighting EBRD May 2015 $4mln Lighting Project network in Yerevan Upgrade the tourism Local Economy and December infrastructure to ensure larger Infrastructure World Bank $55mln 2015 contribution of tourism to local Development Project economy. Development of Develop housing market in Sustainable Housing KfW March 2016 €20mln Armenia. Market (Phase 4)