Armenia - Country economic memorandum (Vol. 1 of 2) : Main Report

Report No. 11274-AM Armenia Country Economic Memorandum (In Two Volumes) Volume I March 24, 1993 Country Operations Division 2 Country Department IV Europe and Central Asia Region FOR OFFICIAL USE ONLY Document of the World Bank This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EOUIVALENTS Currency Unit = Ruble US$1.0 = Rb 620 (as of February, 1993) FISCAL YEAR January 1 - December 31 ACRONYMS AND ABBREVIATIONS AR: Armenian Railways CEEC: - Central and Eastern European Countries ECA: = Europe and Central Asia FSU: = Former Soviet Union GDP: Gross Domestic Product GNFS: Goods and Non-Factor Services GNP: Gross National Product IAEA: Interr.ational Atomic Energy Agency MOT: Ministry of Transport NBA: - National Bank of Armenia NGOs: = Non-Governmental Organizations NMP: Net Material Product NPP: = Nuclear Power Plant OECD: = Organ!zation for Economic Cooperation and Development SNA: = System of National Accounts SOE: = State Owned Enterprise SPERBANK: = State Savings Bank USAID: - U.S. Agency for International Development VAT: = Value added tax VEB: = Vneshekonombank  FOR OMCIAL USE ONLY ACVNOWDGEDMENTS Tbis report is based on the findings of a May 1992 CEM mission which was led by Chris Hall and comprised Jan Isaksen (macro); Tamar Manelyan Atinc (trade); Alan Gelb, Mary Shirley and Annette Brown rivaization, private sector development, enterprise reform, and industry); Jo Ann Paulson (financial sector); Josph Gilling (energy); and Martha de Meto, Milan Vodopivec and Wayne Vroman (social safety net and labor market). Ketli Bhagwati and Joanna Bardakas contributed to the Statistical Annex, and Danny Munoz, Rosario Hablero and Lenora Suld provided setaial services. Helen Sutch was the principal author of the report. / This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosd without Woftd Bank autho_r_aton.   ARMENIA COUNTRY ECONOMIC MEMORANDUM VOLUME I Table of Contents ACRONYMS ACKNOWLEDGEMENT EXECUTIVE SUMMARY ............ .................................. (i) CHAPTERI ..................................................... 1 WHERE ARMENIA HAS COME FROM AND WHERE IT IS HEADED .... ..... 1 CHAPTER II ......... 9 HALTING THE OUTPUT DECLINE WHILE PROMOTING MACROECONOMIC STABILITY .9 A Macroeconomic overview. 9 B Fiscal policy - the first priority. 9 C Money, credit and prices .14 D Balance of payments, exchange rate and currency option .17 E Trade policy .21 CHAPTER III ....... 26 ARMENIA NEEDS TO PROVIDE AN ENABLING ENVIRONMENT FOR ITS GROWING PRIVATE SECTOR ..26 A Price liberalization .26 B Legal framework .26 C Lifting constraints on private sector activity .27 D Progress with privatization .28 E Enterprise reform: the industrial sector .29 F Financial sector .36 G Labor market .41 CHAPTERV ........,.43 BUILDING A SOCIETY THAT CARES FOR THE POO1R AND CASUALTIES OF THE TRANSION .................. .................... 43 A Income Maintenance ................................. 43 B Health .......................................... 46 C Housing .......... 48 CHAPTER V ....... 51  ACTIVE POLICIES TO PROMOTE SUPPLY RESPONSE AND SUSTAINABLE GROPTH ...... 51 A TanspWt ... 51 B Enviroment ........ 53 C Agrcutue ......... 55 D Eny.gy. 57 E Inh .a.truct re.. 60 A7AC7 ENT I *.................................................. 61 MACROECONOMIC SCENARIOS FOR ARMENIA ....................... 61 ATTACNMF.NT2 ......................................................... 64 MANAGEMENT OF THE TRANSION: INSTITUTIONS AND SKILLS .... .... 64 A7TAC ENT3 ................................................... 70 HOUSING PRIVATIZATION AND DEVELOPMENT OF A HOUSING MARKET ... 70  EXECU77VE SUARY i. Armenia is a small, mountainous, landlocked county with a rich cultural and literay tradition dating back to several ceuries B.C. Turkey lies to the west, Georgia to the north, hran to the south, and Azerbaijan to the east with one province also to the south-west of Armena. Its land area is 29,800 square kilometers, and the ethnically homogeneowus population numbers 3.5 million. With few resources and stony land, Armenians have learned to survive through skill, ingenuity, and trade with those around them. Tne level of educadon is high, and the Armenian diaspora has a strong tradition of successful entrepreneurship which should work to the country's advantage in the difficult times ahead. ii. Within the former Soviet Union, Armenia is a pioneer in reform: no other republic has moved so far or so fast. The county has swept the old guard from power and elected a naw liberal-minded Govemment which is puting in place a subshta l and far-reaching program of reforms. Agricultural land has already been privatized and the Government is moving ahead with tax, pricing and legislative reform, creating a sound framework for private sector development. lhe country's position at the intersection of regional trading routes is a potential strength. Despite its good long-term prospects, however, Armenia now faces extreme adversity. iii. Two problems dominate the immediate fiuture. First, Armenia is an economy under siege. Trade routes have been blocked because of internal disruption in Georgia over South Ossetia and Abkhazia and conflict with Azerbaijan over the enclave of Nagorno-Karabakh, with the result that Armenia's trade, and, most importanly, its energy imports, have been cut to a trickle. During the 1991192 winter, most of inistry had to be shut down and heating for homes cut off in sub-freezing temperatures. It was not possible to iplenish fuel supplies adequately in the summer and the 1992/93 winter was even worse. Problems were compounded by the harshest weather conditions in 46 years. Death-rates for c 'people and children rose sharply, and premine conditions developed. Widespread starvation was only averted by humaniarin grain shipments. Second, in common with all the countries of the former Soviet Union (FSU), Armenia is experiencing falling output (see Table 1) due in part to the disruption of the Soviet monetary, payments, trade and transport systems. Although a small country at the edge of the empire, Armenia was one of the most highly intrated republics in the Soviet system of production and trade and is suffering correspondingly now. Rece economic develgp-el iv. Due to the progressive deterioration of Soviet production, trade and payment arrangements in the second half of the 1980s, real GDP sarted falling in 1987. lhen in December 1988, Armenia experienced a severe earthquake, which caused at least 25,000 deaths and widespread destruction of fuel pipelines and industrial plant, and left 500,000 homeless. Many people are still living in metal containers and disused fuel tanks. The county's nuclear reactor was shut down after the earthquake as a safety precaution, reducing generating capacity by about onethird. Apart from a rebound in real GDP in 1989 caused by the short-lived post earthquake construction boom, each year after 1986 has shown an accelerating decline. Privatization of agricultual land, which began in 1991, produced a 15% surge in output in that sector in 1991. But the recovery in agriculture could not outweigh the decline in other sectors caused by the disruption of the former Soviet economy and now aggravated by lack of foreign exchange, fiscal shofaills, a sharp reduction in real credit, a 60% fall in real wages, the absence of functioning financial and other systems appropriate to a private  (ii EXECUTIVE SUMMARY enterprise economy, and, overall, by the shock of change. Compounding all these problems is the blockade, which has cut imports and exports sharply and has denied the country vital food, fuel and medical supplies. The Government's reform program v. Despite these extreme difficulties, the Government is attempting to set in place a comprehensive reform program with the objectives of attaining: (i) macroeconomic stability; (ii) a largely privately run and owned economy where individuals and companies are free to transact at market determined prices and contracts are enforceable; (iii) a society which takes care of vulnerable groups of the population; (iv) an economy with an effective and efficient public sector that provides public goods and services and implements policies that promote sustainable growth. However, the Government must also address the immediate reality, tailoring its measures in such a way that they also help move the economy and society in the desired medium-term direction. Short-term imperatives and constraints vi. The reality that Armenia faces is one of sharply rising prices, falling output, worsening unemployment, lack of fuel for industry, schools, hospitals and home heating, fiscal crisis, and severely restricted trade; all of which mean considerable suffering for the population and which provide a fertile recruiting ground for radical movements. Refugees are flowing into the country from Azerbaijan, adding to the hundreds of thousands made homeless by the 1988 earthquake. The immediate choices and judgements about managing the transition must be made by a Government overwhelmed by these immediate difficulties, not yet familiar with a market economy, and which cannot afford to lose the public support and popular constituency for reform that now exist. vii. The starting point is an economy heavily constrained by the legacy of central planning, with distorted prices and wages, command institutions, and an uneconomic and deteriorating capital stock. The structure of the economy still mainly corresponds to the centrally determined pattern of production and trade with a large industrial sector and relatively small services sector. Reforms so far have produced positive results in agriculture but macroeconomic stability has been compromised by an unfortunate sequencing of fiscal and financial sector reforms. The previous system of taxation was removed before a replacement tax structure had been designed and implemented. The consequent drastic fall in tax revenue, particularly from the enterprise sector, produced a large fiscal deficit. At the same time, removal of controls from State banks enabled an expansion of credit associated with a high risk, low return loan portfolio that has compromised future financial stability and may result in heavy charges on the government budget in the future. viii. The tension between the vision outlined in the Government's reform program and the constraints of the current situation demands of the Government that it adopt a strategy to achieve the medium term objectives while also managing the next six to twenty-four months in a way that moderates human social and economic costs - yet fits in with and promotes the medium term strategy. Careful design, sequencing and implementation of reforms will be crucial. To help achieve these goals, it will be important for the international community to provide Armenia with aid resources with some degree of concessionality. In the near term, Armenia will require considerable external financing while it is narrowing its current account deficit, particularly in view of the  EXECUlTVE SUMMARY aii) enormous increase under way in energy import prices. In the medium-term, however, the prospects for competitiveness, growth and creditworthiness are good. Macroeconomic overview ix. The Government's highest priority is to avert a free fall in output while reasserting control over money and credit to the extent possible and running an effective fiscal policy so that Government arrears and claims on bank credit do not further destabilize the economy. In the longer run, it will need to restore aggregate demand in conditions of macroeconomic stability, which in turn will require institutions capable of exercising effective monetary and credit control and of performing expenditure and revenue functions in the framework of a Government budget linked to a view of the requirements of the macroeconomy. In due course, it will have to deal with issues of currency and exchange rate management. Fiscal policy - the first prioritv x. Government revenue has fallen from over 50% of GDP in 1989 to an estimated 18% in 1992. Falling revenue and a growing deficit seriously jeopardise the Government's capacity to carry out the reform program, maintain income support and medical services, and create conditions for macroeconomic stability. Consequences for public investment are also adverse, implying further losses of output in the future. Armenia moved too quickly to a new tax system, introducing VAT and excise taxes. Strengthening of the tax administration is now urgently needed, with particular focus on the VAT, where returns are only one-third of forecast levels. A Customs function must be set up, and VAT, excise taxes and import duties must be collected on non-FSU imports. It would also be advisable to raise the corporate income tax and highest personal income tax rates to at least 35 %. Substantial, if not full, cost recovery should be introduced for maintenance of housing, communal services (heating, gas and water) and electricity. Money. credit and prices xi. Prices have increased rapidly over the last year, with the main surge occurring in the first four months of 1992 when retail prices increased by 642.5% compared to the first four months in 1991. By the end of 1992, the average annual increase in prices over the previous year was 828% while the December quarter increase was 1219% on the same quarter a year before. Soaring prices have created a decline in real money balances that is reinforced by lack of liquidity in the banking sector. Real credit has also declined sharply. xii. Information on the components of the retail price index shows that the rate of increase is still high for inter-republican exports but appears to have come down for domestic goods, while wages and benefits have increased much less rapidly. For the second half of 1992, the minimum wage was 600 rubles per month as compared with 900 rubles per month in Russia, and average wages are below two-thirds of the Russian level. Recent figures indicate that the retail price index actually declined in August 1992 when decreases in farm product prices outweighed increases in other prices.  eZv) EXCECUil SUMMdARY xiii. A number of factors could help account for these disparate price developments, including the improved supply response in agriculture since land priaizaton, the continued monopsony of State buying organizations, and real wage discipline. But it seems probable that the divergence also reflects the extent to which price increases can be validated by money and by credit growth, which in tum depends on whether the activity takes place in the cash or the credit economy. Differential capacity to extract high prices for output is generatig a split in the real economy, with worrying consequences. It appears that the casb economy is subjec to tighter monetary conditions than the credit economy and is responding better to the new relative price signals; credit is also tight but - at least when fuel supplies are available - tends to maintain the existing composition of SOE output, permitting inventory accumulation estimated at 6 billion rubles in May 1992. At the same time, both segments of the market are oriented to short-term return in the absence of instruments and incentives that would promote intermediation and medium-term investment xiv. 'Me risk is that the claim on resources of the enterprise credit economy, with its ability to earn higher prices and accumulate stocks, will undermine the emerging strength of the cash economy and its greater competitiveness and allocative efficiency. This dangerous development underlines the high priority of imposing financial discipline on enerprises and introducing market eraluation and control techniques to the banking sector. Balance of payments. exchange rate and currency option xv. In the short term, Armenia faces a problem of current account sustainability, with a structure of trade inherited from the Soviet regime that generates large extern deficits. Inter- republican trade was normally in balance in the period before the earthquake. Now there is no immediate prospect that extrn deficits of the order needed to restore output to previous levels could be financed by corresponding capital inflows. The potendal balance of payments deficit will widen once prices have moved to world market levels, when a severe deterioration in Armenia's terms of trade is expected, but in the short run the country is able to exploit its monopoly advantage in a number of products for FSU markets. It is also finding substantial demand for its products in markets outside the FSU, indicating that its balance of payments deficit can in time be overcome. Meanwhile, foreign financing is urgently needed to sustain a level of imports that could halt and help turn around the output decline but may take time to materialize given the lack of macroeconomic stability and high level of uncertainty about immediate prospects. In the short run, export promotion is required but is hampered by the difficulty of ensuring contiued supply. Exchange rate policy is the only other instrument potentially available but its use would requir radical decisions which Armenia is not yet willing nor well prepared to take. In the immediate future, Armenia will continue to be dependent on Russia for oil imports and for access to trade credit. It should use this time to build up the macroeconomic policy and implementation capacity to manage its own currency: in particular, capacity to control the money supply and the fiscal deficit, while pursuing the systemic reforms that will underpin macroeconomic stability. Trade poli xvi. Armenia wishes to seek full integration in the world economy as a trading nation, and in the medium-term, is likely to develop as a center for trade and services in the region. In the  EXECU7IVE SUMMARY (v) immediate future, however, its trading activities are severely constrained by the blockade and by lack of foreign exchange. The country's heavy dependence on tade, and external imports in particular, makes it imperative to address this situation in the near term in a way that will promote exports, especially in hard currency. 'his objective implies early attenon to privatization in agricultural sup- rt industries and agro-processing, and to the establishment of an enabling environment for private sector activity, including improvement in airport facilities and trade facilitation procedures. xvii. In the near term, the country cannot afford to relinquish the inter-republican trade that remains, and in most cases will have to accept the trading conditions imposed on it by more powerful trading partners, particulary where food and fuel are concerned. However, retention of the old system at the country-to-country procurement level does not prevent liberalization of the domestic transactions related to state orders as a way of preparing the ground for full-scale competition in the future. The Government has already moved to a system whereby goods purchased under state orders are auctioned, and suppliers are invited to submit bids in open competition to fulfill orders. It should be possible to privatize transport and distribution of these goods on the domestic market in the near future. Enterprises have considerable freedom over pricing and will continue to expand their ties and be responsible for negotiating prices and deliveries. xviii. A strategy for trade policy must be developed. At least in the near future, it wiUl be advisable for Armenia to retain preferenti access to the FSU market, which implies that it will impose tariffs only imports from outside the FSU. Rather than keer the old FSU tariff, however, it would make sense to adopt a uniform tariff of about 20% for the nex few years while tho need for revenue is particularly pressing, with a stated plan to reduce rates to 5-10% in the medium-term. Measures to implement zero-rating of exports should be introduced. xix. Effective institutional underpinning will be required if Armenia is successfully to become a diversified and open trading nation. Ibis alls for an agency, not necessarily within Government, to provide information on markets and help establish trading contacts, and also a Customs agency to facilitate trade, collect revenue, and supply data needs for economic policy- making. Private sector development: the enabling environment xx. Substantial progress has already been made with price liberalization - an essenti prerequisite for the development of private markets. Armenia is also well launched on the project of developing the legal environment necessary for a fully functioning market economy, with the legal framework already established for land reform, privatization, free entry and competition, together with a property law, company code and commercW code, and financial sector law. xxi. It is now important to press ahead with the draft legislation under discussion on foreign investment and licensing of exports and other economic activity, anti-monopoly, and bankruptcy and collateral. Attention will also be needed to the regulatory underpinning for legislation and capacity for implementation will need to be built up, including specialised courts. Social, health and safety, and environmental law affecting the private sector should be clarified, especially as uncerw nty about their future responsibilities could inhibit foreign investors. To support the  (W) EXECU7E SUMMARY development of land markets, land registration offices and cadastral surveys aro needed, and th8 Government should reduce or eliminate the three year waitng period before land sales are pemitted. xxii. Ihe Government has already reduced licensig requirements and would do well to go further and switch to a system of certificadon for most activities. Registration requirements could also be reduced and moved to a default basis, whereby registratdo would become automatic in the absence of official objecions during a set time after deposition of documents. Access to space for commercial use should be facilitated in the period before full privaizaton of cewal and municipal enterprises creates a market for operating space. In order to smooth the way and lower uansacto costs for private investors and, in particular, foreign invests, it would be useful to have a 'one-stop shop" or agency supplying information on all requirement for crying on a business in Armenia and where all application and registration r-ocedures could take place. Progress with pDrivatization xxiii. Armenia has already completed privatzation of 90% of agriculturail land and is now moving ahead with the privatization of retail trade and distribution, which will fa1iliate the expansion of activity in the agricultural and industrial sectors. A Privaization Commission and Board have been set up, and a variety of techniques for privatization are envisaged, including use of vouchers for up to 30% of the value of assets being released on the market It wi now be Important to deermine clear priorities for privatization, as it will not be logistically possible to taclde the bulk of public sector enterprises simultaneously. A high priority must be the privatization of agricutural inputs, services and distribution of goods, to build on the progress already achieved in ihis sector, help feed the population, and promote agricultural exports. The objective of export promotion will also be served by the early privaaizaton of a small nber of key industrW enterse with export potential, particularly light and high-tech goods that can be exported by air, given the blockade of land transport Enternrse reform: taclding the industrial sector xxiv. Further improvements in the capacity for supply response are now needed to allow price signals to be translated into effective and efficient allocative decisions. Two fictors in particular impede the development of a well-functioning private sector: the continuing dominae of the state industrial enterprise sector, largely untaclded as yet; and the highly precarious and shrinking financial sector, discussed below. xxV. While the Government has already gone a long way to hardening the budget constaint on SOEs by withdrawing cash subsidies, the impact on these enterprises has been diluted in many cases by their ability to charge monopoly prices and avoid taxation. The rapid growth of inter- enterprise credit and to a lesser extent, bank credit, both frequently extended without regard to financial risk, has also insulated many enteaprises from the budget constraint. The issues of enterprise and financial sector reform are thus closely linked and will for that reason have to be developed in tandem.  EXECUIV SUMMARY (Vi) xxvi. In the short run, the Government must grapple with an enterprise sector fre of central control and simultaneousy free of any semblance of normal market disciplines. Many of the enterprises enjoy monopoly power within the FSU and have raised prices many dmes firther dt the average increase in the price level. A number of enterprises are principal sareholders in banks and therefore have access to a tame credit supply, enabling them to avoid adjustment while continig to produce for inventory and pay above-market wages. At the same time, however, enterprse are highly vulnerable to the mntfinctioning payments system within the FSU and to fuel and other Input shortages due to the blockade. To the extent possible, the Government wil need to ensure contnued supplies of fuel and essential consumer products through the next year to eighteen months while also moving forward to change the ownership and structure ot enterprises and the framework In wbich they Operate. xxvii. Action will be required at several levels. The authorities need to establish a legal and operaing environment based on property rights and freedom of contract, while also ensuring an open trade and competition policy and promoting the development of sound financial markets and institutions providing a range of instruments and services. At the enterprise level, the objective is improved allocative, managerW and technical efficiency. In the majority of cases, this will mean privaizaton leading to the establishment of competitive firms. This will involve not only the transfer of ownership but also measures designed to improve corporate governance and action to deal with monopolistic structures. The Government will also want to ensure efficient management of fims awaiting privatization and firms which remain in the public sector. xxviii. To start with, some triage is necessary. Neither the Government nor the recenty set up Privatzation Commission can possibly deal simultaneously with the large number of enterprises in this sector, whether this involves restructring, privatization or liquidaion. The fiast priority is an immediate review to classify enterprises into four main groups: those which are good candidates for oarly privatization because they have export prospects and can be sold with minimal preparaion; uneconomic enterprises which should be closed immediately to prevent a fiurer claim on bank credit and drain on scarce imported inputs; enterprises to be retained in the public sector; and a remaining large group in which an order of priorities must be struck for introducing improved corporate management while the enterpise is prepared for restructuring or privatizaton. Financal sg= xxix. Direct government control over the financial sector was reduced quickly after independence without, however, creating a basis for future financial sector development. It is now urgent to restore confidence in the banking sector and establish the inastructure and banking practice for commercial operations in the future. Xxx. The financial sector is currently operating within an extremely distorted economic environment, with a low level of skils and weak operating procedures. Resources are not being allocated on a commercial basis, and the formal financial sector is playing only a small role in intermediation. Within that sector, both State banks and new banks are lending with little capacity to evaluate risk or return. Most financial institutions are effectively controlled by public enterprises which themselves are operating in an autonomous fashion, and credit is allocated primarily to shareholders of the banks, related enties and inherited public enteprise clients. A large amount  (viii) EXECTIVEE SUMMARY of credit allocation is also taking place duough the infirmal expansion of int-enterprIse credits. Since the eownomy h zame severely consined by the blockade, crdi has bee centrally allocae to survival idustries (opits, bakeries) and a small number of industies with export oders. xxxi. Managemet of the financial system during the transition betwe a staw controlled and a mtket economy is going to be extmely difficult since the policies to decenalize and liberaize tke banking system can lead to perveseo outcomes as long a the economy is not stabiized, part of the economy is under direct controls, most enterprises are still public, prices are distorted and input a rationed, making it difficu to assess the commercial viablity of eneprises. xxxi,. The speed with whicb the banking system can begin opeaig on a commercial basis depends on cuting the direct and indirect links betwen the bas and the unviable public enterprise clients. Many of the enterprises now being financed will and should become casuaties of the economic restrucring process. But the Government will not want to risk sending the economy into free fail by acceleratng enlerprise collapses before activity begins to respond to new signals and new relative prices - including in paticlar oil price and excdage rate developments, which will coinue to exert strong restuctring pressure. In the interim perod while the restrucrn process works itself trwugh, the Govenment wants to maintain activity in the most economicaly and financially sound way possible. Decisions will be reqaired to close irrdeemably uneconomic eateprises rather than continuing to allocate subsidies and bank credit to them. lhese decisions will have to be taken by the Government or by a restucting agency unt the bans start to operate in a commercial way. xxxiii. Within the baking sector, the Governent will need to re-assert some controls over the State banks as an immediate prioity, where restaints on lending have been lifted without the recogniion of corresponding prudeal responsibilities and in an enironment of perverse incentives including highly negative real iterest rates. No further sale of shares in Stae banks should take place and their unsafe practices should be stopped: selling shares in insolvent banks, lending to shareholders, on-lending Savings Bank household deposits to high risk bank, and any lending to unviable clients. Over time diagnostic studies should be launched of the large state banks so these can be restructured, privatzed, or liquidated. In the interim, the state banks should be under management contracts to enforce commercializat of opeations. It may be advisable to approach reputable foreign banks for assistance with strengoening management. xxxiv. Also required immediately is a halt to the licensing of new banks on the current basis where licensing requements are lax and capital standards inadequate. To curtail the risks posed by existing cowboy' banks it will be important to insist that: licensing requirements are fulfilled (ncluding chract rquieame); the minimum capital requirement of 40 million rubles should be ildexed to infaon immediately; and minimum capital/deposit ratios should be upheld (recommended ratio 1:8, to be raised to 1:10 after one year). Before any now banks are licensed, technical and chater requirements should be stengthened, requirin- previous experience in financi management. xXXv. Since it will be imperative to monitor tie ban system and the financial insfitutions closely while contiu to move away from direct controls on the system, an essenti ingredient of the reform program wil be to atrengthen the Information management, economic analysis, operationa, ad superision capacity In the National Bank of Armenia. The NBA should prepare to respond to the evolving economic situation by adjusing available monetuy and financial policy  EXECU77VE SUMMARY CIx) instruments and reglations on the banks. The NBA should prpare the ruaions to support the nw Banking Law as soon as possible, and should rquire bas to adopt internstiona& accounting sandards. xxxvi. Tho Govenment needs to implement is plan to honor the liabilities of the Sav Bank as soon as possible to preveat the fiuther erosion of credibiity In the facial system. lhe Government should assume responsibility for blocked household deposits and the accrued interst from the Savings Bank, recogizing tt the payments will need to be spread over many years. 'ne repayment plan may combine cash, goverment bonds, long-tem WVig um, and privatization bonds. The plan should be put In place very soon to allow households to take part in the mall-scale privatization program. Since the Savins Bank has an extensive branch network, it should be reorganized, restructued, and recapitalized or the faciities should be sold to other banks withi the next few years. Labor market xxxvii. The labor market is key to a successfu ition in Armenia from the point of view of efficient adjustment as wel as of welfare. Armenia must now move from the past system involving umnerous rigidities to a freely functioning labor market with a well-trained and mobile labor force. A high priority for the Government will be an active labor market policy. lbis will mean measures to idetify vacacies and employers' skill requirements, counsel displaced workers, speed placement, provide appropriate taining in new prive sector skills, and, where possible, promote labor force atachment and income support thrgh employmoa a public wors. Given te shortage of budget funds this could best be done witb financW support from extern agencies, including the many bilateral agencies involved in earthquake recouction and relief. xxxviii. To support an active labor market policy, and also to keep fiscal control and prevent abuse of the unemployment bendit system once labor mobility is permitted, the Govenment must also ensmre that it has an efficient record system and well-functg employmen offices. xxxix. Policies to improve labor market flexibility wfll also be required. In 1993, at the same time that it stas to privadze the housing market, the Goverment plans to remove the *propisWa law" which confines workers to a 60km radius of their residence in their search for jobs. Inlcoime Miea xl. In the short run, the Goverment needs to d_ae tangible support for the poor, including earthquake victims, refugees, and the mny casalties of the econmic disrptio following the disintegration of the FSU. However, t is unable to find the fl resources to ustain its social programs as revenue coinues to faU and more and more pwile fall below the poverty line. Some fine-tuning has already taken place but appears that a more radical Wproach will prov necessary. xli. Sharper targeting is essenial if dwindling budget resources ar to be directed to those in great need, esecily given the evidence of severe matit and, in some cases, dow  (x) EXECU77VE SUMM Y stavation. in the immediate fiture, the Government should define a minimum social benefi linked to a subsistence food basket to provide a safety net for those most in need, including low-income people not eligible for pensions or unemployment compensation. Meanwhile pensions and unemployment compensation should be reduced to the same flat-rate benefit level (tis can be done fairly easily as benefit diffeentials are already being progressively eroded with each round of partial indexing) and paid only where w other income was available. To provide additional gross savings, the age of redrement would be raised in stages. At the same time, it wIll be Important to improve information on who the poor are, drawing on statistical surveys and the knowledge of local agencies and non- govn ien orions. xlii. In the longer run, Armenia wUI need to consider what role the Government should play in income support. A range of possibilities is available. It could gear up to provide a traditional social insurance program, partally or fully funded, with income payments related to work history, contributions made and previous levels of income earned. Or it could keep only the role of minimum provider of social assistance geared to need, leaving income replacement above that level to the private sector or to an optional second-tier government scheme (e.g., Canada). Experience in OECD countries indicates that social insurance programs tend to generate high non-wage labor costs without providing full coverage at an adequate level for the population as a whole, and tend to be disadvantageous to women. ITis can lead to pressure for subsidies from general revenue or for the creation of a subsidiary scheme, raising budgat costs. It is inadvisable to link social insurance to the workplace as this can also undermine labor market flexibility if benefits are not portable; and, at a time of economic upheaval, is is preferale not to tie entitlements to the performance of specific firms or industries. For fiscal, efficiency and welfare reasons, Armenia will want to consider the options carefully before determining the structure of income suppor in the fuure. xliii. 'Me blockade has added lack of adequate food and hypothermia - due to lack of winter heating - to the health problemns associated with homelessness and inadequate temporary housing arising since the 1988 earthquake and the inflow of refugees. Atmospheric chemical polluhion causes respiratory i11ness and smoking is a serious public health problem. Medical supplies and equipment are 1acking, and the top health priority in the near term will be the search for humaniarin assismance for vaccines, drugs and medical supplies. Urgent efforts should also be made to provide peranen housing and sanitation in the earthquake zone. xliv. The Gov ernt wishes to establish a national health scheme with unvrsal access, but wkhin that framework will have a number of issues to resolve regarding organization and financing. In due course it will also need to address the problems it faces owing to excessive centralization of health sector management, less adequate provision in ru areas and poor incentive stmcesm including drastic under-payment of doctors and other professionals (the average wage in the health sector is two-thirds that in industry). idv. In the housing sector, the Government will need to move ahead with the privatization of housing in line with the removal of the "propiskaW law that prevents labor mobility. The planned program envisages the transfer of dwelling units to their current occupant and a quick redicution of housing subsidies, with the intention of releasing funds for new construction.  EXECU77VE SUMMARY (X) Active policies to proMQIMMX res .ne and sustainable growth xlvi. The reform program is already setting the ler;al and policy framework for efficient and effective supply response throughout the economy. In addition, positive policies for transport services and infrastructure will be required to facilitate private sector development. Econornic pricing and other measures will be needed to deal with environmental costs, promote efficient allocation of resources, and prevent erosion of the natural resource base. Specific sector policies will also be needed in agriculture and energy to reform sectoral policies, practices and institutions and ensure that the economic growth that emerges is sustainable. xtvii. Beside urgent rehabilitation in the energy and water sectors, Armenia has considerable need for infrastructure investment. A higher priority in the short term will be to ensure maintenance of the road network and other existing infrastructure, rather than to seek to launch new investnents, especially before capacity to evaluate investment projects in a macroeconomic context is better advanced. Much can be achieved by better organization of existing facilities, especially in the transport sector, and reform is urgently needed of the the airport system. Critical spares and material will be needed in the energy, transport, industry and agricultural sectors; to get the most out of existing infrastructure. xlviii. Once the blockade is lifted, Armenia can realistically seek external financial support for large-scale investments. The energy sector is a high priority, although the initial need will be for investment in energy-efficient replacement capacity and and storage, rather than a rapid increase in overall capacity. Investment requirements in the energy sector over the next five years are roughly estimated at US$ 200 million. Substantial investment will also be required in the water sector to replace worn-out and inefficient systems. Careful attention is required to the impact on debt service and recurrent costs of such a program. xlix. Trapo. Short-term priorites should focus on essential maitance to keep open the road and raid networks needed for trade, together with investment in alternaive trading routes to the south and west. Privatization of truck and taxi fleets should continue. Meanwhile the longer-term framework for an efficient transport sector should be developed. Such a framework will include corporatization of airport management and operations, inter-modal planning, competent regutatory authorities, adequate technical and safety standards, and capacity to evaluate and rank investment proposals. Inffastructure and rolling stock will largely be privatized or managed commercially. Any State subsidies for social purposes will be identifiable contributions from the budget. In the near future, however, the priorities will be essential maitnace of aircraf, trucks and rail rolling stock and the track that they use. The Government is already working on defining activities that could be privatized and a schedule for privatization. This should proceed as soon as possible. 1. Edrotnment. Concern for the environment is strong in Armenia and environmental legislation has already been passed by Parliament. Environmental damage has inflicted severe costs on the economy (especially in agriculture) and is creating risks to health. If Armenia is to achieve sustainable growth it wJIl have to ensure than eviromenw costs are intenalized and that provision is made to safeguard and where possible restore its Onatural capital". This will involve pricing policies based on long-term cost considerations, and a regulatory framework covering pollution limits and penalties, together with the technical and scientific capacity to define and monitor standards.  (xii) EXECU7E SUMMARY Desalinization of agriculural land and environmental clean-up is required, and a decision will also have to be taken on the nuclear plant. Ii. The main environmental issue In Armenia is the decline In the water level of Lake Sevan and its consequences, which include a reduced flow of good quality water to service the agricultural, industrial, urban and power sectors. It is a high priority to develop and review the national water plan from an economic, technical and enviromental point of view. Armenia will also need an overall environmental assessment leading to an environmental action plan covering land management, agriculture, industry, urban conditions and public health. Iii. Aggiture. More progress has been made to privatize and liberalize in agriculture than in any other sector, with excellent initial resuts in terms of output and a shift to more efficient composition of activity and allocation of resources. Great scope exists to raise agicultural performance, but much remains to be done to sustain the transformaton and improve productivity. Given Armenia's need to expand exports and provide adequate food for the population, the highest priorities in this sector are privatization of distnrution and transport systems. Pricing of agricultural inputs and parts and machinery must be brought into line with economic costs. Armenia also has an urgent need for pesticides and other chemicals to stem crop losses and maintain the expansion in agricultural output. The irrigation system Is badly in need of redesign and repair. Water charges were introduced into the agricultural sector in early 1992, which should reduce wastefll use, but the irrigation canals lose up to 50% of water carried. In addition, to help switch production from the livestock industry towards more profitable horticulture and crops, and to expand agricultural production and markets, Armenia will need a combination of investment at the farm and plant level, poliv advice, instutional development, technical assistance and training, marketing advice and info rnz'wi. Iiii. E gy. It is clear that the situation arising from the blockade is not sustainable for either the energy sector or the rest of the economy. Energy supplies are inadequate even for the summer period of reduced demand let alone for the winter. Energy supply is critical not only for survival but also as an essenti input to permit increased economic production. However, even if the blockade were lifted, Armenia would still face serious problems in the sector arising from the dilapidated infrastructure, lack of economic pricing, and poor institutional management and design of facilities. liv. The urgent immediate priority is to increase and diversify energy supply; improve the efficiency of use of available energy supplies including hydro resources; ensure continued service from existing plant and equipment; and provide nea energy-efficient investment to replace old equipment, thereby increasing total effective capacity. However, the capital stock in this sector is deteriorating rapidly. If it is left to do so, rehabilitation wUIl soon become an even higher priority than the search for new fuel supplies.  EXECU17VE SUMMARY (xU) Immediate policy imperatives Iv. Armenia has a wide-ranging and impressive program for reform. However, resources and expertise to implement the program are limited, especially in the short term, so that it will be important to focus on the immediate priorities needed to strengthen the economy and protect the population. These priorities should be as follows. Ivi. First are key actions needed to promote exports, facilitate supply response and increase food supply. This translates into some immediate priorities within the privatization program: privatization of agricultura inputs, marketing and distribution to build on the positive supply response that has already resulted from land privatization; privatization of retail trade and transport, in order to generate a consistent supply response, harness entrepreneurial talent and demonstrae real change to the population; and privatization of a small number of key industrial enterprises with export prospects - in current circumstances, probably those with high value, low bulk products that can be exported by air - and closure of hopeless cases to prevent a further drain on resources. Ivii. Second, measures are urgently needed to raise tax revenue so as to finance the reform program and social safety net and lay the foundations for macroeconomic stabilty. This will require early action to strengthen the tax administion, focusing particularly on collections from enterpris; it will also require changes to some taxes and tax rates. Iviii. 7hW, measures must be put In place to lay the foundations for a modern financid sector, incorporating market disciplines under the oversight of an effective central bank. The links between insolvent banks and non-viable enterprises will need to be phased out in the context of effective enterprise reform. Meanwhile the National Bank of Armenia will need to establish sound licensing and prudential policies and deal with widespread insolvency in the existing system. Close monitoring will also be needed of the restructuring programs for the State banks, whose weak portfolios are dominated by public enterprises scheduled for privatization. Iix. Fourth, wth unemployment rising and hardship Irsing, the Govrmen wUl need to work out how to restructure the socil safet net so as to target avaableafinds to need. This will mean cutting back on income-related supplements, income-testing of benefits, and the introduction of a minimum benefit, so as to look after those who are most in need. It will also be important to gear up capacity in employment offices so as to cope with rising numbers of unemployed people. Ihese measures should be in place before the next winter. Ix. In brief, the Government must mainain output and welfare in the short run without sacrificing the liberalized future; and it must at the same time create the foundations for that future. Successful management of this balance is a major theme of this report. What it requires in specific contexts is furter explored in each chapter of the report. Sectoral and issue-specific areas are dealt with in Annexes to the report.  (dv) EXECU7IVE SUMARY Table 1. ARMENIA: Main Econondc and Soca Indicators Socl ad demogphic indicas (19) Area 29,800 sqkm. Popultion 3.645 millon (Januay) Urban 2.5 mSion (68.9%) Rurd 1.1 milion (31.1%) Population Density 120.8 per sqkm. Life EBp _any at birth 70.7 yeas in 1990 Infut mortality rate 17.3 per thousand in 1990 Gross domesi product (GDP) (1992) 70,138 mllion rubles GDP per capita 19,242 rubleo 1988 1989 1990 1991 1992 Annual Changes of Real Ouput In % Gross Domestic Product 40.7 12.4 -7.4 -17.3 -52.6 Net material product (NMP) -2.6 14.2 -8.5 -11.8 -49.9 Indus"q -1.6 2.3 0.5 8.5 -51.9 Agictu -43.1 17.2 -13.2 15.2 -29.1 Compon of NNP In % Industry 54.6 50.2 45.4 48.3 41.4 Agriulu 18.5 14.4 17.3 25.7 45.6 Construction 10.8 21.2 25A 15.3 4.7 Transport and Communiation 4.1 3. 4.1 2.2 1.5 Other sectos 12.0 10.7 7.8 9.2 6.7 Average Price Change (1992) Wholeal price incorese 3.2 12.7 4.8 219.7 - Retil price increase 3.0 4.0 12.0 274.1 1345.5 Aveage monthly wag (rad changp) 3.2 12.7 4.8 -47.9 - lnterubkan an fomeg rade n billions of ruble at domestic prc) Export 3.8 3.7 3.5 5.5 7.18 Impors 4.9 4.9 4.9 8.0 10.34 Trade balance -1.1 -1.2 -1.1 -2.5 -3.16 Trade balance in % of GDP -13.7 -12.6 -11A -16.0 -4.5 Central govnwwme budget Revenuo 4.9 4.1 4.6 12.53 Expenditures 4.7 3.5 4.5 22.58 Oveal balance 0.2 0.7 0.1 -10.0O In percent of GDP 2.1 7.2 0.6 -14% Mon and credit (end of peiod Total deposit 4.6 7.3 8.2 11.4 23.90 Totl domestic credit 3.8 3.5 4.7 9.8 32 Net crodit to the Govemment -1.0 -1.0 -0.6 0.3 6.7* Source: Data provided by authorities, and staff calculao. * Figues eand of period, November 1992  WHERE ARMNIEEA HAS COME FROM AND WHERE IT IS HEADED Backeround 1. Armenia is a siking example of the Soviet beaief in economies of scale, central plamnng, and the achievemet of political control through economic Interdepence. This belief led to extreme specialization within the former Soviet Union and meant that industri unts were large. Heavy industry was seen as the vehicle of economic development. lhe artficially low price of energy favored uneconomic activities and waste, and promoted the use of transport over long dsances at great economic cost. The nature of trade and production that was assigned to Armenia on this basis has little in common with its comparative advantage. This means tbat the county has been saddled with a structure of highly concentrated production that corrsponds only weakly with the composition of activity that is likely to evolve in a free market fuure. TABLE 2. AamENA-. Commodity Composiion of Trade In 19t POwer 0.45 0.00 0.44 0.85 0.00 0.74 o and Gas 000 0.00 0.00 19.76 0.00 17.05 Cod 0.00 0.00 0.00 0.39 0.00 0.34 Other Fue 0.00 0.00 0.00 0.00 0.00 0.00 FTnous 0.87 0.31 0.86 7.88 0.60 6.88 Non-PFet. 6.86 8.54 6.92 4.55 3.70 4.43 Chemicalb 8.81 9.94 8.84 7.56 10.64 7.98 Machiney 39.72 64.60 40.50 26.72 18.22 25.56 Wood & Pape 0.29 0.00 0.28 2.29 8.12 3.08 Consir. mat. 2.36 0.00 2.29 1S4 1.56 1.55 Lig9h bdustry 24.36 10.40 23.92 8.71 14.70 9.53 Fbod PFod. 3.43 5.28 3.49 5.32 27.47 835 Odher Ind. 11.56 0.47 11.22 4.25 0.88 3.79 Asticuhkut 0.20 0.31 0.20 2.3S 14.04 3.95 Odher Food 1.05 0.16 1.02 7.83 0.08 6.77 * Pcnage aebasd on tade f ows in foreign-trad pris. Each column totas to 100% 2. Armenias product cmposion also yields a high degree of dependence on trade with other republics, with both exports and impo"s representing over SD% of GDP durng the 1980s. Armenia's role in the USSR economy was to process inmediate goods and materials procured from other republics and to supply a wide range of consumer and non-speiized producer goods. Mhe country developed substantial capacity in light industry (te s, knitwear and shoes), food procesing, and also heavy industry, exporting vehicle tires, caustic soda, synthetic rubber, and a large quanity of electric motors and cables and metal-cutting machine tools. For this, the county was dependat on imports of energy, agricultal and chemical inputs, wood and paper and other bntmediate goods (see Table 2). Armenia also had a disprportionae share of the Soviet miliay- idusti complex, supplyig high technology lasers and electronics.  2 CHaPER 3. Under the assigned production structure, industry constituted about 60% of net material product (see Table 3 on sectoral NMP). Most activity took place under the system of State orders and inter-republican trade protocols, whereby the State determined production and export quotas and agreed on the volume and type of trade with other republics. State sector employment was predominant, though the proportion has eroded since its peak in 1987 due to the growth of employment in cooperatives and private farms. But by 1992 the state still employed 973 million workers, or something over 63% of the labor force. Industry absorbed 23% of workers, agricuture 26%, and services 51 %. Privatization of most agricultura land has already occurred and is taking place in retail trade and distribution, but not in industrial enterprises thus far. Tale 3. AJMNLrUA Not MlateriaPrduc at CmutaM (1983) Pa Setord yea Sc NMP Is couaN (1983) pa Grow&b In setur NW a ceutni (1983 1987 1958 193* 199 191 IM99 1748 49 3 901 914 7 Induary cI.ummovertax) 3611.4 35S3.7 3636.3 36S4.5 3343.9 1607 -1.6 23 0.5 4.5 -51.9 -11.4 Agriculture 849.S 783.6 S66.7 491.9 S66.7 401 *43.1 17.2 -13.2 IS.2 -29.1 -12.9 Co_ndtion 704.9 618.S 1457.1 1081.2 722.2 119 -12.3 13S.6 -2S.8 -33.2 43.S -22.1 Trqpo a communicat 199.1 239.4 243.1 2052 1873 S4 20.2 1.S -1S.6 -8.7 -71.1 -19.1 Tradeandcateing 241.0 217.9 311.6 331.9 253.0 43 -9.6 43.0 6S -23.8 -63.2 -11.4 Oher mat. spere baches 41.3 488.8 S22.1 399.S 366.0 210 8.3 6.8 -235 -8.4 -42.6 -13.2 NEI MATERIAL PRODUCr TOTAL 607.2 5901.9 6736.9 6164.2 S439.1 272S.29 -2.6 14.2 -45 -11.8 -49.9 -11.63 &go n9mb" M , Yw UN The output decline and its causes 4. Armenia's outstanding immediate problem is the severe fal inoutput. Set in motion by the progressive deterioration of Soviet production, trade and payment arrangements in the second half of the 1980s, real GDP started falling in 1987. Apart from a rebound in 1989 cused by the short-ived post earthquake construction boom, eah year after 1986 has shown an accelerating declineO. Privatization of agricultural land, which began in 1991, produced a 15% surge in output in that sector in 1991.2 However, the recovery in agriculture coud nOt outweigh the decline in other sectors caused by the disruption of the former Soviet economy and aggrvated by the factors noted in paagraphs 5-10 below. [/ Shown also by the track of Net Material Product in Table 3. 2/ The output increase also included a response to chging relative prices, as there was a 30% increase in crop production and a decline in less profitable beef and pig farming, a promising sign of the evenua potent once the rest of the economy is on a private market basis.  CHA IER I 3 5. Armenia lacks the foreign excban for impored inputs that are essential to maintin production. Although the country exported the bulk of Its exports to the FSU (99% in the firt half of 1992), it obtained no less than a quarter of its imports from external sources, for which the central government used to supply the required hard currency. The proportion of dollar imports rose to from 16% in 1988 to 25% In 1990 when supplies of ruble Imports were disrupted. It has since fallen to less than 1 % in the first half of 1992. Thus the country enters the period of transformation with a built-in extenal trade deficit. Hard currency exports cannot be quicldy expanded so as to finance external imports at the previous level, and possibilities for substituting ruble for external imports are small. Hence, even In the absence of the blockade, Iports wovud be severely constrained. As 80% of imports in 1991 were capital goods and intermediate goods needed to sustain production (see Table 4), there are consequent further losses of fautre as well as current output. Table 4. ARMENUI Structural Features of Exports and Imports 1991 MEM bis 1991 ?Pert of-Tdal . . Imporb Exports Imports Expots IQI&Ls 5852 3732 100.0 100.0 of which: Inter-republin 4471 3612 76.4 96.8 of which: Industral Goods ') 3627 990 62.0 26.5 Consumer Goods 843 2622 14.4 70.3 Extenal 1381 119 23.6 3.2 of which: Induswtrial Goodso 1067 14 18.2 0.4 Consumer Goods 314 104 5.4 2.8 8arm D _mt.at ob Ter4 Yeand .ua uIam 1) Icluding fintrmediate and ap goods 6. The decline in economic activity is aggravated by fiscal shorfalLwhich mean that the Government cannot finmce public investment or industrial production at the same level as in the past. The output fall itself, together with defiscalization of enterprise profits and weak administration of new and unfamiliar taxes, has sent Government revenue from over 50% of GDP in 1989 to an estimated 18% in 1992. In an effort to keep the fiscal deficit tD 4% of GDP in 1992, the Government has already eliminatd almost all subsidies to enterprises and has cut public investment to the bone, reducingfuture as wel as current output. 7. A further arvating factor is the credi nh. Real money and credit have declined sharply in the wake of the surge in prices which started in the first quarter of 1991. A second surge occurred in the first quarter of 1992 with the liberalization of almost all prices and removal of margin controls. Real credit declined sharply In 1991 and contracted further in the first half of 1992, when inflation was estimated at over 600% and GDP in real terms was about half of the 2/ Evea so, the deficit target is unlikely to be reached, with a resting buildup of areaus and continued eliance an borfowing from the central bank.  4 CHAPTER I level in the first six months of 1991. Over the same period, credit to enterprises rose only 40% in nominal terms. Even when adjusted by estimates of the expansion of inter-enterprise credits, the credit crunch is severe (see chapter II and Annex 2). 8. Meanwhile, wage policy has not been accommodating. Unlike Russia, Armenia has succeeded in holding the growth of public sector wages and benefits far below the increase in prices. (Wages increased by just over 200% and prices by over 500% between June 1991 and June 1992). While this decline in real wages shows public solidarity with the reform process and is promising for future competitiveness, it also further lowers aggregate demand and contributes to the build up of stocks in the present. The Department of Economic Reform estimates that 80% of the expenditure of most households is now on food. 9. To these factors must be added the impact of the shock of change. Although Armenians had more contact than many other inhabitants of the FSU with foreign cultures and markets through family members of the diaspora, they are still profoundly shaken by the crumbling of the Soviet Union, the transformation of the economic operating environment, and the surge in uncertainty which has followed. Old systems are failing them and new systems are not yet workable. Banks, including the central bank, are just starting to experiment with new operating procedures; trading banks are not functioning in a commercial way; state owned enterprises exist in a limbo in which they can operate with substantial autonomy, free of both central controls and the disciplines of the market; the legal framework for contracts and employment relations is unclear and insecure; new relative price signals are swamped by the huge increase in the price level; infrastructure is deteriorating. The struggle for survival under these conditions results in declining output and especially investment, and in many cases produces perverse results in economic terms. Table S. ARMENIA: Economic Indicators INDICATOR PERCENTAGE CHANGE Consumer Price Index: 1992 over 1991. 828.7 Price Index for services: 1992 over 1991. 1140.5 Consumer Price Index: On monthly rate of inflatibn during Aug'92 -2.2% Price Index for services: August 1992. +0.6% Rail transport (tonnes) Jan-Aug 1992 in per cent of Jan-Aug 1991 22.8 Road transport (tonnes) Jan-Aug 1992 in per cent of Jan-Aug 1991 21.1 Air transport (tonnes) Jan-Aug 1992 in per cent of Jan-Aug 1991 79.2 Source: Department of Statistics, Yerevan, September 1992 10. Overshadowing all these problems is the blockade. During the winter of 1991/92, economic activities were heavily constrained by the transport blockade imposed by Azerbaijan and civil strife in Georgia, blocking Armenia's second major transport route. Lack of fuel and other imported inputs closed two-thirds of enterprises but, with the improvement of the situation in  CHAPTER I S Georgia, supply conditions eased somewhat from the middle of March 1992. However, railway bridges and other key installations in Georgia were blown up at irregular intervals and road transport through Georgia was often subject to attacks and looting, resulting in sharp frequent reductions in Armenian imports of fuel, food, raw materials and other inputs, and leading in turn to closures in a large number of state enterprises. Overall, during the first four months of 1992, road and rail transport fell to 18% and industrial production fell to 48% of the levels of the same period in 1991. These proportions recovered slightly by August 1992, as shown in Table 5. But by September 1992, industry was still operating at only 20% of capacity. 11. By November 1992, fuel reserves had been exhausted. The country's isolation worsened as Georgia came under pressure to extend the blockade on Armenia, though some supplies continued to get through. The gas pipeline was blown up repeatedly by saboteurs on the Georgian side of the border, further reducing Armenia's energy resources. A bleak situation was compounded by the harshest winter for 46 years, with temperatures between 0 and 5 degrees Fahrenheit until late February. Most homes were without heat, as the price of kerosene heaters and kerosene put them beyond the reach of all but a few families, and electricity was restricted to few hours per day. Trees in city parks and streets have been cut for firewood. Survey findings by the Centre for Disease Control, a United States agency, showed pre-famine conditions in December 1992, and widespread starvation was only averted by humanitarian grain shipments delivered through Georgia and Turkey. Even so, death rates were reported to have increased 30% for old age pensioners and 20% for children in January 1993 relative to the same month a year previously. 12. Industry was almost at a standstill. The Government used hydroelectricity to keep essential industries going: hospitals, bakeries, and a small number of key industries with export orders. In February 1993, the Minister of Finance estimated that about 700,000 people were effectively unemployed in industry in addition to the 60,000 officially registered as unemployed. Falling tax revenue meant that pensions and unemployment benefits could only be paid intermittently. Concerned about the spiral downwards of economic activity and tax revenue, and the effect on people of intense cold and lack of work, the Government raised the volumes of water flowing from Lake Sevan, the country's main water source, through the hydroelectric power stations in an effort to get industry back to work. By March 1993, the number of industries operating had increased from 3 to 34. However, even at maximum use, hydroelectricity can only supply a fraction of Armenia's energy needs; and use at this rate is not sustainable as water resources are being depleted faster than they can be replenished. And Lake Sevan is not normally considered as an available resource for these purposes given the need to restore lake levels for ecological reasons. 13. In order to get around the blockade, both public and private sectors have been exploring alternative trade routes for fuel, other imports, and exports. Some petroleum products have been flown in from Russia and small amounts come from Iran by truck, as well as unpredictable amounts through Georgia which are subject to a 25-30% transit tax. The Government plans to expand exports by air and to send some surface exports to Russia out through Iran and across the Caspian Sea. Armenia continues to have a high level of export orders from both inside and outside the FSU, and it appears that, without the blockade, the economy would be operating at a high level of activity. Under siege conditions, however, trade by means of the few available routes is limited and high cost, and domestic activity is correspondingly meagre. By the end of 1992, GDP had fallen to almost a third of its level in 1989.  6 CALPIER I Fuue descari 14. The path the economy takes in the next year and into the future is heavily dependent on prospec for lifting the blockade and the degree to which effective new FSU monetary, trade and payment systems can be established, together with the timing of these two crucial developments. There is no central tendency here: the alternatives and their consequences are clear-cut. 15. Prospects of peace and stability will also condition Armenia's ability to attrac external financing and in particular funds for investment. 'Me economy will be sbaped, too, by the country's capacity to deal with the challenges of the transition to a market economy: the creation of a new framework of laws and property rights; development of the institutions and skills required by core government and by the private sector; and the ability to deal with the closures and other social and economic problems associated with the imperative to re-orient economic activity to the new set of relative prices and integrate Armenia into the world economy. 16. The following three scenarios trace the country's GDP path according to specific assumptions about the speed with which the first two constrains - the blockade and disruption in FSU systems - can be removed or alleviated. As far as policy commitment is concerned, experience so far indicates that the determination, if not always the capacity, exists to deal positively with the challenges of the transion. This factor is therefore held constant in each scenario. It is further assumed that the flow of investment funds will be contingent on success in lifting the two principal constraints. Variants of these scenarios could be constucted - for insance, with different degrees of success in policy design and implementation - but the three presented below probably represent the upper and lower bounds available together with a medium case, which has been taken as the base case for extemal financing projections. (See Attachment 1 on macroeconomic scenarios).  CHAPIER 1 7 17. Pessimii scenario. If the transport constraint is not removed before the Arme(Ga Macro Econotmi ProRection mid 90s, entrprise activity will continue to be severely constrained by lack of energy and other a inputs.4 A siege economy will become entrenched, with consequent deterioration and . .. loss of capital equipment. The economy will shift towards a subsistence basis, depending on 4......... .......................... domestic labor-intensive activities that require litte capital, intermediate goods, or energy * input. See Figure 1. a so 09 " ex "S Flgure 1 18. MedigT scenarEio. The _ _ _ transport blockade is relieved in mid-1993, but (Gi Maco Economic ProJecRion trade and investment are hampered by iurther deterioration and disruption within the FSU, and continuing depreciation of the ruble. However Armenia starts to reorient its trade to the west, o ..!. .. and foreign investment as the situation becomes more setled. A large proportion of existing 4......... ................... capacity is restored to use, the situation stabilizes in the mid-90s, and the real growth . . rate is 5% the last few years of thedecade. See Figure 2. Meoh O taS4S5S Ie 19. Optimistic scenario. The transport blockade is lifted in mid-1993, inter- Figure 2 republican trade and payments systems stabilize, and the ruble slide is halted5. This leads to a rapid upward shift in production in 1994 and 1995 as existing capacity is brought back into use. There is then some stowing in the rate of growth of aggregate activity from 1996 onwards while investment capital flows in, there are substantial changes in the composition of output and some degree of macroeconomic stabilization. From 1998 real growth occurs at between 7 and 8% per year, leading to a restoration of the 1989 level of output by the year 2000 (Figure 3). A/ The construction of a gas pipeline through Iran would provide alternative energy supplies and, under the other scenarios, would also provide a much needed opportunity to close down hydro-electric power stations and restore the level of water resources. However, it has not been assumed for the purpose of this projection. I/ Or Armenia successfully establishes its own currency.  8 CHAPTER I 20. The Government's performance Armenia: Macro Economic Projection so far indicates that it will do its utmost to (GOP Eon o 1991 Rub. MiiProct) relieve the constraints blocking the economy and release the economy on to a new growth path. However, some of the constraints are largely or wholly beyond its control; and even a......... on optimistic assumptions, it will be a long haul before economic growth is restored and living 4........ ..................... standards begin to rise. These conditions will affect the way the reform program is designed 2-.............---------- .................... and implemented. 21. In the near term, the reform 90 91 S2 9 a4r96 84 9 99 2000 program will vary depending on the speed with Ost,IaI.,c Oo.a*e. which the blockade can be lifted. For instance, iigure 3 it may be necessary to impose fuel rationing next winter to safeguard against hypothermia and ensure that a critical minimum of industry and agriculture can continue to operate. In the absence of a well-functioning central bank and financial sector, controls may need to be reimposed on State banks to ensure that credit is allocated to activities essential for survival (and to halt lending for unwanted inventory accumulation). Sectoral priorities are also likely to vary depending on the extent to which Armenia is battening down for survival or is able to expand trading and other opportunities in the near future. In all cases, however, the Government will need to design short-term stopgap measures in such as way as to minimize the cost to its longer term strategy and, where possible, to promote the changes required for its successful implementation. 22. It will also be important to communicate with the population, explain that the reform program is moving in the right direction, and look after people who are casualties during the transition. These issues are further addressed in chapter IV below.  CHAPTER II HALTING THE OUTPUT DECLINE WIULE PROMOTING MACROECONOMIC STABILITY A Macroeconomic overview 23. The Government's highest priority is to avert a free fall in output while reasserting control over money and credit to the extent possible and running an effective fiscal policy so that Government arrears and claim on credit do not further destabilize the economy. In the longer run, it will need to restore aggregate demand in conditions of macroeconomic stability, which in turn will require institutions capable of exercising effective monetary and credit control and of performing expenditure and revenue functions in the framework of a Government budget linked to a view of the requirements of the macroeconomy. In due course, it will have to deal with issues of currency and exchange rate management. 24. The immediate challenge is to devise ways of slowing the output decline which will also contribute to the attainment of longer-term objectives. However, as explained in paragraphs 4-13 above, the output decline is provoked by a variety of causes, not all of which are under the Government's control. For instance, as a member of the ruble zone, Armenia does not have an independent monetary policy. In this context, what instruments does the Government have at its disposal? To what extent can it use fiscal, financial, trade and exchange rate policy? Issues and strategy for each instrument are reviewed below. B Fiscal policy - the first priority 25. The fiscal collapse is disabling. It deserves the Government's State Government Budget immediate attention. Lack of revenue Selected Indicators and a growing deficit undermine its capacity to maintain the reform program