ECONOMIC MONITOR ARMENIA Issue 1 | October 2019 [updated] Overview • Economic growth in Q1-19 (7.2%) and Q2-19 (6.5%) significantly higher than expected • Budget surplus in 7M2019 due to high revenues & under-execution of capital expenditures • Inflation forecast for 2019 at 2.1%; low inflation key ingredient of macroeconomic stability ➢ Stable macroeconomic situation • Significant jump of current account deficit in 2018 to 9.4% of GDP; quite high • FDI only at 2.1% in 2018, not sufficient for financing the current account deficit • Imports (+21.4%) increased much stronger than exports (+7.8%) in 2018 ➢ Export promotion and FDI attraction key for external stability • Mid-term fiscal consolidation: budget deficit ≈ 2% and central gov debt < 50% of GDP • At the same time: lower tax rates and higher expenditures on social & investment planned ➢ Ambitious mid-term fiscal plans Special topics • Recent political events • Fight against corruption • Energy: challenges and government plans • FDI attraction: focus on most promising target groups and institutional framework Basic indicators Armenia Azerbaijan Georgia Belarus Ukraine Russia GDP, USD bn 13.1 45.2 17.2 61.0 134.9 1,610.4 GDP/capita, USD 4,381 4,498 4,661 6,477 3,221 11,191 Population, m 3.0 10.0 3.7 9.4 41.9 143.9 Source: IMF WEO from April 2019; Forecast 2019 Trade structure Exports Imports EU 28% | Russia 28% | Switzerland 14% | Others 30% EU 23% | Russia 25% | China 13% | Others 39% Others Copper ores Others Machinery/ 19% 22% 24% Electrical Vegetable and 19% animal products Mineral 6% Motor vehicles Metals products 6% Textiles 12% 14% 10% Textiles Gold 6% 7% Metals Animal and Spirits 7% vegetable 8% Mineral products Tobacco Chemicals products (excl. Foodstuffs 8% 11% copper ores) 8% 8% Source: Armstat 2018; Note: trade in goods 5% Source: Armstat 2018; Note: trade in goods 2 Economic growth Real GDP growth Economic growth 8 % yoy • 2018: growth down to 5.2%, mainly due 6 to lower gov capital spending in H2-18 • Q1-19: 7.2%, Q2-19: 6.5%, significantly 4 higher than forecast 2 Opportunities for mid-term higher growth 0 • Gov plans reforms on tax policy, 2016 2017 2018 2019* 2020* governance and labour market Source: IMF; *Forecast. Note: forecast 2019 to be revised upwards • If these reforms are well implemented, medium term growth should be higher Long-term GDP impact of successful reforms Reform measure Impact, % of GDP Downside risks Revenue-neutral tax policy reform 0.4 • Lower growth of trading partners • Increase of regional geopolitical tensions Governance 1.5 (US-Iran, Nagorno-Karabakh) Labour market reforms 2.5 Source: IMF Country Report from June 2019 Mid-term growth depends to a large extent on successful implementation of reforms, i.e. on internal factors 3 Sectoral perspective Composition of economy Agriculture Industry Others 20% • Weak performance in the last three 24% Education years; contraction in 2018 3% Agriculture • Structural problems in agriculture Public 15% administration Mining 5% IT • 2018: copper mine Teghut and foundry 4% Construction temporarily closed; negative impact on 7% Real estate, Retail trade and renting and repair business exports and growth business activities 13% Source: Armstat; 2018 9% • Recently: Teghut re-started operations Manufacturing Sectoral dynamics • 50 % yoy Positive contribution to GDP 40 Services 30 • Dynamic sector, considerable 20 contribution to growth in 2018 10 • IT: 4% of GDP; quite substantial 0 -10 ➢ In general: important role of mining 2016 2017 2018 Agriculture Mining Manufacturing Services Source: Armstat ➢ 2018: manufacturing & services offset contraction in agro & mining 4 Inflation and monetary policy % yoy Inflation Monetary policy 4 • Central Bank of Armenia (CBA) 3 implements “inflation targeting” 2 • Medium-term target is 4%, with a 1 tolerance band of +/-1.5% 0 • Jul 2019: inflation rate at 1.7% yoy -1 • Overall: CBA successful in keeping -2 2016 2017 2018 2019* 2020* inflation under control Source: IMF; *Forecast; Note: annual average (consumer prices) Policy rate CBA policy rate • 2019: policy rate was reduced twice % p.a. 9 by 25bp in the context of low inflation • Current policy rate: 5.5% 8 Main challenges for monetary policy 7 • Improve policy credibility and better 6 anchor inflation expectations 5 • Reduction of dollarisation • Development of capital markets Jul-16 Jul-17 Jul-18 Jul-19 Jan-16 Jan-17 Jan-18 Jan-19 Sep-16 Sep-17 Sep-18 Sep-19 Nov-16 Nov-17 Nov-18 Mar-16 Mar-17 Mar-18 Mar-19 May-16 May-17 May-18 May-19 Source: Central Bank of Armenia ➢ Stable and low inflation; key ingredient of macro stability 5 Current account and exchange rate % of GDP Current account 0 Current account • 2018: jump in current account deficit -2 (CAD) to 9.4% of GDP; quite high -4 Reasons -6 • Imports of goods grew much stronger -8 (+21.4%) than exports (+7.8%) in 2018 -10 • Temporary closure of copper mine and 2016 2017 2018 2019* 2020* foundry contributed to weak exports Source: IMF; *Forecast • High repatriation of profits Exchange rate and international reserves Capital account USD bn AMD/USD 2.5 495 • FDI only 2.1% of GDP (USD 266 m) in 2.0 490 2018 and strong decline in 6m2019 1.5 485 • FDI not sufficient for financing CAD 1.0 480 0.5 475 ➢ Need to increase exports and attract 0.0 470 more FDI to ensure external stability Jul-16 Jul-17 Jul-18 Jul-19 Jan-16 Jan-17 Jan-18 Jan-19 Sep-16 Sep-17 Sep-18 Nov-16 Nov-17 Nov-18 Mar-16 Mar-17 Mar-18 Mar-19 May-16 May-17 May-18 May-19 International FX reserves International reserves (left scale) Exchange rate (right scale) Source: Central Bank of Armenia • Aug 2019: USD 2.3 bn or about 3.9 months of imports of goods and services 6 Trade in goods Export by countries Other Regional structure of trade Georgia 13% 3% • EU and Russia are main export Russia Iran 28% destinations, with a share of 28% 4% each in total exports China 4% • Large share of Switzerland (14%) due Iraq to exports of gold and copper 6% EU ➢ Switzerland Regional trade rather limited, 28% 14% despite being a landlocked country Source: Armstat, 2018; Note: Trade in goods Reasons • No trade with Azerbaijan and limited Exports of mining products and metals in 2018 (indirect) trade with Turkey USD m % of total exports • But also: concentrated commodity Copper ores 525.5 21.8% composition of exports; mining and Other mineral products 119.2 4.9% metals 46% of total exports Metals 296.6 12.3% ➢ Diversification of commodity Gold 176.9 7.3% composition of exports important to Sum 1,118.2 46.3% reduce external vulnerability Source: Armstat, Note: Trade in goods 7 Trade in services Export of goods and services Goods vs services 5 USD bn ▪ Exports of goods, 2018: USD 2.6 bn 4 ▪ Exports of services, 2018: USD 2.1 bn • Services account for 44% of total 3 exports, rather high 2 Main exports of services, 2018 1 • Tourism: USD 1,208 m 0 • Transport: USD 256 2016 2017 2018 • IT: USD 252 m Source: Central Bank of Armenia Goods Services • Construction: USD 191 m Importance of exports of services – international comparison Reasons for strong exports of services Share of services in total exports, 2018 • Georgia 51% Limited regional trade Armenia 44% • Landlocked country with relatively high USA 33% transportation cost for goods Ukraine 27% • Tourism: strong link to large diaspora Azerbaijan 23% • IT: strong link to FDI in IT sector Germany 18% Strong performance of services’ exports Russia 13% makes economic sense Source: central banks of respective countries 8 Public finances and government debt % of GDP Budget deficit 2015-2017 0 • High budget deficits after shock in 2014 2018 -2 • Revenues at 21.7% of GDP, as planned • Expenditure only 23.5% of GDP, due to -4 under-execution of capital expenditure • Result: budget deficit only 1.8% of GDP; -6 key contributor to lower GDP growth 2016 2017 2018 2019* 2020* Source: IMF; *Forecast. Note: 2019 likely to be revised updwards (i.e. lower deficit) 7M2019 • Considerable under-execution of capital Central government debt 55 % of GDP expenditure leads to a budget surplus ➢ Low capital expenditure is an issue, as it reduces mid-term growth perspectives 50 Mid-term outlook • Medium term reduction of deficit to ≈ 2% • Central gov debt < 50% (end 2017: 53.7%) 45 • Context: IMF programme 2016 2017 2018 2019* 2020* Source: IMF; *Forecast ➢ Fiscal consolidation planned 9 Revenue and expenditure plans Budget 2020 ff: revenue side Revenue side from 2020 onwards • Lower personal income tax rate Tax Current Planned • Lower corporate income tax flat • Very high threshold for VAT participation Personal progressive 2020: 23% • Practically no taxation of microbusiness income 2021: 22% tax 23-36% 2022: 21% Planned expenditures in 2019 2023: 20% • Higher social expenditure & public investment Corporate income 20% 18% Key question tax • Compatible with fiscal consolidation? Source: multiple sources Government approach Budget 2019: expenditure side • Higher taxes for alcohol, tobacco, etc. as part of a general shift from direct to indirect taxes Social spending +9% • Strengthening tax administration Capital spending +27% • Stronger property taxation Source: IMF • FDI attraction and job creation • Possibly: Laffer curve effect, i.e. lower tax rates lead to higher tax revenues ➢ Ambitious plans in the fiscal sphere 10 Bilateral trade between Germany and Armenia EUR m German trade with Armenia Turnover 200 • 2018: EUR 344 m, increase by 30% 100 • Germany is Armenia‘s most important 0 trading partner in the EU, followed by -100 Bulgaria and Italy • 7M2019: decrease by 26% -200 2016 2017 2018