Armenia - Rehabilitation Credit Project

Document of The World Bank FOR OMCAL USE ONLY Report No. P-651 9-AM REPORT AND RECOMMENDATION O THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT IN AN AMOUNT OF SDR 41.5 MILLION TO THE REPUBLIC OF ARMENIA FEBRUARY 2, 1995 M ICROGRAPH I CS Report No: P- 6519 AM Type: PR 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 EQUIVALENTS Currency Unit = Dram EXCHANGE RATE US$1.0 = 406 Dram (as of January 23, 1995) FISCAL YEAR January 1 - December 31 ACRONYMS AND ABBREVIATIONS CBA - Central Bank of Armenia CIS - Commonwealth of Independent States CG - Consultative Group ESW - Economic and sector work EU - European Union EU TACIS - EU Technical Assistance to the CIS FSU - Former Soviet Union GDP Gross Domestic Product GNP - Gross National Product IBL - Institution Building Loan LDP - Letter of Development Policy NMP - Net Material Product O&M - Operations & Maintenance SIF - Soc.ial Investment Fund STF - Svst.emic Transformation Facility  FOR OFFICIAL USE ONLY REPUBLIC OF ARMENIA REHABILITATION CREDIT Credit and Program Summary Borrower: Republic of Armenia Amount: SDR 41.5 million (US$60 million equivalent) Terms: Payable over 35 years, including 10 years of grace, on standard IDA terms Objectives and Description: The objectives of the proposed credit are: (i) to support the Government's reform program to stabilize the economy and create the conditions for a resumption of growth and an improvement in living standards; (ii) to provide foreign exchange for the purchase of critical imports, particularly for the private sector; (iii) to provide budgetary support, especially for the strengthening of the social safety net for the most vulnerable groups; and (iv) to provide a framework for urgently- needed financial assistance from other donors. The program includes policies that: (a) promote the development of competitive markets and of the private sector, through privatization, liberalization and regulatory reform; (b) result in improved financial discipline for enterpriP-s and banks; and (c) improve the targeting of the social safety net t. the most needy. Poverty categorv: Poverty-focused. The proposed credit would support improvements in the targeting of social benefits to the poorest groups: the elderly, children, the low-paid, and the unemployed. In the near tern, benefits provided by the state to those groups will be increased; in the mediun term, the pension system will be restructured to provide higher benefits to those without alternative means of support. Benefits: The structural reform program supported by the proposed credit will, in conjunction with macroeconomic stabilization supported by the IMF, foster the development of a competitive market economy, led by the private sector. This will promote the efficient allocation of resources to underpin economic growth and a reduction of poverty. The credit will provide critical import support to allow economic recovery and to stem the decline in living standards, particularly of the poorest, and will do so through market mechanisms. The credit should serve to catalyze similar financing from other donors. 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.  ii Risks: There is a risk of slippage in both stabilization and structural reform in the face of sociopolitical opposition if economic recovery does not proceed fast enough to satisfy rising expectations (parliamentary elections are to be held in May 1995). However, this will be mitigated by improved targeting of the social safety net and continued humanitarian assistance from donors and from the Armenian diaspora. The implementation of the reform program could be undermined by institutional weaknesses, although the provision of technical assistance through the Institution Building Loan and support from other donors will help to offset this risk. There is a significant risk of the donor conummunity providing insufficient balance of payments financing in support of stabilization and structural reform, which would entail an unsustainable reduction in living standards. However, the Consultative Group process is designed to mitigate this risk. An additional risk is that aggregate demand will recover only slowly in Armenia's FSU markets, and that access to non-traditional export markets will be undermined by protectionism. A further risk is the resumption of hostilities over Nagorno-Karabakh, and the consequent continuation of Armenia's economic isolation. However, the current peace negotiations appear to be moving in a positive direction and economic recovery should increase popular support for peace. Estimated Disbursement: The proceeds of the proposed credit would be released upon effectiveness in one tranche. Out of the proposed credit, SDR 12.45 million (or 30 percent of the total credit) will be disbursed against Armenia's actual imports (excluding items covered by the negative list) since October 31, 1994, i.e., four months prior to the expected date of effectiveness. This retroactive financing is justified by the up- front action already taken by the Government on many important elements of the reform program. This report is based on missions which visited Armenia between June and October 1994, comprising Messrs./Mmes. Jonathan Walters (country economist, mission leader), Jeanine Braithwaite (social sectors), Lily Chu (banking), Alan Gelb (enterprise/financial linkages), Victor Leonov (trade), Cyril Muller (trade), David Phillips (private sector development), Melinda Roth Alexandrowicz (enterprise reform), Onno Ruhl (economic management), and Randi Ryterman (enterpriselfinancial linkages). Una Raymond provided secretarial support and Ludmilla Talmatskaya provided translation services. Documents were reviewed by Martha de Melo and Desmond McCarthy. Basil Kavalsky and Wafik Grais are, respectively, the Director of the Country Department, and Division Chief of the Country Operations Division, responsible for Armenia in the Europe and Central Asia region.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT TO THE REPUBLIC OF ARMENIA TABLE OF CONTENTS PART I. RECENT DEVELOPMENTS AND PROSPECTS FOR THE FUTURE 1 A. Background ...................................... 1 Progress towards regional stability .............. 2 Monetary and fiscal expansion is beginning to be controlled ... . 2 Output decline appears to be levelling off ........... . 3 C. Challenges and Prospects for the Future ..................... 4 Overcoming resource misallocation and the terms of trade shock . 4 Growth prospects .............................. 4 External Financing, Debt and Creditworthiness .......... 6 PART II. THE GOVERNMENT'S PROGRAM OF STABILIZATION AND STRUCTURAL REFORMS ...... ................. . 7 A. Achieving Macroeconomic Stability ............ . 7 B. Promoting the Development of Markets and Increasing their Efficiency . . 8 Price Liberalization .. 8 Reform of the external regime .. 8 Financial sector reform .. 9 The regulatory framework for private sector development ...... 10 C. Hardening Enterprise Budget Constraints .................... 12 Privatization ............... .................. 12 Financial Discipline and Restructuring ....... .......... 14 D. Ensuring a Minimtun Level of Social Protection for the Poorest ..... 15 PART m. BANK ASSISTANCE STRATEGY ..18 A. Background and Objectives .18 B. Bank/IDA Assistance to Date ..... 18 C. The Lending Program ................................ 19 D. Coordination of External Assistance, MIGA and IFC Activities .22 PART IV. THE PROPOSED REHABILITATION CREDIT .23 A. Program Implementation and Credit Conditions ....... ......... 23 Hardening Budget Constraints ......... ............. 23 Promoting Competitive Markets ......... ............ 24 Ensuring the Provision of an Adequate Social Safety Net ...... 24 B. The Proposed Project ............... ................. 24 Credit amount and borrower ........ .. ............. 24  2 Project management ............................. 25 Procurement .................................. 25 Eligible expenditures ............................ 26 Disbursement . ............................... 26 Reporting, Accounting, and Auditing .................. 26 Closing date .................................. 26 Environmental category .......................... 27 C. Benefits and Risks ................................... 27 Benefits ..................................... 27 Risks ...................................... 27 PART V. RECOMNENDATION . ............................... 27 Schedule A Timetable of Key Processing Events .... ...... ........ 28 Annex 1 Key Economic Indicators ......................... 29 Annex 2 Letter of Development Policy ....................... 33 Annex 3 Policy Matrix .46  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT TO THE REPUBLIC OF ARMENIA 1. I submit for your approval the following report and recommendation on a proposed credit to the Republic of Armenia for SDR 41.5 million (the equivalent of US$ 60 million) to provide support for the Government's economic reform program. The credit would be on standard IDA terms, with a maturity of 35 years including a grace period of 10 years. Cofinancing to the amount of 5 million guilders from the Government of the Netherlands has been identified for the proposed credit. Further co-financing or parallel financing for quick-disbursing balance of payments assistance is being sought; at the Consultative Group Meeting held on November 22, 1994, pledges were made equal to two-thirds of Armenia's estimated financing needs for 1995. Financing for technical assistance to support a number of measures in the Govermnent's reform program will be provided by the Bank's Institution Building Loan or by other donors. 2. Armenia became a member of IBRD in September 1992, and became eligible for IDA terms in August 1993. The country is in the process of joining IFC and is considering membership of MIGA. PART I. RECENT DEVELOPMENTS AND PROSPECTS FOR THE FUTURE A. Background 3. Armeriia is a small, landlocked country with a land area of 29,800 square kilometers, and a population of 3.65 million. Turkey lies to the west, Georgia to the north, Iran to the south, and Azerbaijan to the east. GNP per capita was estimated at US$ 660 in 1993.' With few natural resources and stony land, the Armenians have survived through strong traditions of education and of entrepreneurship. Armenia formally declared independence on September 23, 1991. The President, Levon Ter-Petrossian, was elected to a five year term in October 1991 with 80 percent of the popular vote, and the Parliament of 260 members was elected in May 1990, also with a five year term. 4. Armenia's development into a modem economy is constrained by the legacy of Soviet central planning. It has inherited a structure of production and trade that is out of line with its comparative advantage to a considerable extent. Armenia's product composition yielded a high degree of dependence on trade with other republics, with exports and imports representing over 50 percent of GDP during the 1980s. Industry constituted about 60 percent of NMP. Under the Soviet regime, Armenia exported large volumes of light industrial goods (40 percent of total exports in 1991), but also substantial heavy industrial products as well as foodstuffs and semi- I Atlas methodology; estimates for economies of the former Soviet Union are subject to more than the usual range of uncertainty and should be regarded as preliminary.  2 finished goods, mainly for the FSU mar"et. In the absence of raw materials and primary processing faczlities, Armenia had to rely heavily on imports of semi-finished goods as critical inputs into domestic industry (25 percent of imports in 1991) and the country was a net importer of food. Armenia also had a disproportionate share of the Soviet military-industrial complex, supplying high technology lasers and electronics. B. Recent Economic and Political Developments 5. Progress towards regional stability. Like other countries in the region, Armenia is still experiencing severe economic difficulties arising from the breakdown of the trade, payments and financial system of the former Soviet Union (and the consequent severe terms of trade shock). In addition, the conflict over Nagorno-Karabakh has led to a trade and transport blockade by Azerbaijan (traditionally Armenia's principal transit route for oil, gas and other products) and the closure of the Turkish border. The effects of this have been compounded by civil strife in Georgia. From the winter of 1991/2 on, Armenia's effective isolation highly constrained economic activity. 6. However, there have been several recent positive developments in Annenia's relations with its neighbors. Of greatest importance is the progress towards peace in the 6-year-old Karabalh conflict: on July 27, 1994, Azerbaijan, Karabakh, and Armenia signed an agreement in Moscow formalizing the ceasefire (which has held since May 1994) and providing for the inmediate commencement of negotiations of a comprehensive peace agreement. This development offers a real prospect of a lifting of the blockade in the near future.2 In addition, mpidly-growing trade with Iran, which is now second in importance only to that with Russia, and increasing stability in Georgia have significantly eased Armenia's isolation (the latter is of particular importance for improved transit of energy supplies). 7. Monetary and fiscal expansion is beginning to be controlled. Until late 1993, Armenia's continued membership of the ruble area, in which most members were conducting highly expansionary financial policy, severely limited its capacity to reduce inflation, thereby undermining monetary and fiscal discipline. In addition, during 1993 the old ruble area was disintegrating without any clear prospect for Armenia to join a new ruble area or to receive adequate external financing; consequently, the Armenian Government substantially loosened financial policies in order to permit the stockpiling of imported inputs. This was effected largely through massive net lending to enterprises (equivalent to 17.6 nercent of GDP) from the Government budget; the budget deficit rose to 56 percent of GDP (from 27 percent in 1992), almost 70 percent of which was financed by the central bank. 2 The December 1994 meeting in Budapest of the Organization for Security and Cooperation in Europe (O.S.C.E.) decided to send a multilateral peacekeeping force to Nagomo-Karabakh and to enhance the coordination between the O.S.C.E. and Russia on the Nagomo-Karabalk issue.  3 8. In late 1993, 'Armenia was flooded with pre-1993 rubles which were being withdrawn from circulation elsewhere in the FSU, which fuelled inflation even further as currency substitution intensified. On November 22, 1993, a national currency, the dram, was introduced against a background of severe financial imbalance and negligible foreign exchange reserves. In the last two months of 1993, consumer prices rose by 900 percent (compared to a monthly average of 26 percent in the first 10 months of the year). 9. However, faced with rampant inflation, and enjoying monetary independence for the first time, the authorities began to tighten financial policies. Beginning in the second quarter of 1994, public expenditures were linited to priority itcms (which included a drastic reduction in net lending and subsidies to enterprises), and revenue collection was enhanced; consequently, monetary growth declined and the central bank refinance rate became highly positive in real terms. Inflation declined from an average of 46 percent per month in the first quarter of 1994 to less than 3 percent per month in the third quarter.3 Monetary tightness has also been reflected in the stability of the nominal exchange rate since May and the sharp appreciation of the dram in real terms over the same period. 10. Output decline aWvears to be levelling off. Armenia has experienced an enormous decline in output since the break-up of the Soviet Union. GDP fell by 52 percent in 1992 (to about one third of its 1989 level), and a further 15 percent in 1993. Even allowing for non-recorded growth in the infonnal sector, it is clear that the effects of the blockade have severely compounded the FSU-wide output collapse. The massive increase in the costs of transport and energy consequent on the blockade have induced a corresponding shift in the structure of production; food production for domestic consumption and light industrial exports with low energy and transport costs, such as jewelry, have grown at the expense of bulky export goods, such as machinery. 11. In the first half of 1994, real GDP is estimated by the Government to have grown by 2-3 percent (compared to the same period in 1993); the increase probably reflects the development of alternative trade routes in the face of the blockade and possibly the effects of the previous net lending to enterprises. The sustainability of this increase is therefore in question as the drastic reduction in transfers to enterprises takes full effect. 12. Poverty is widespread. Living standards have plummeted in Annenia in recent years and a substantial proportion of the population are living in poverty (a household survey I1OW underway and a Poverty Assessment for which preparatory work has commenced will yield more precise data). Average real wages at the end of 1993 had fallen to about 6 percent of their level two years earlier. In June, 1994, the average wage in the state sector stood at about US$ 2 a month (equivalent, for example, to one kilo of meat) and US$ 4-5 economy-wide; the average 3 Prices rose again in the fourth quarter of 1994 (by 11 percent in October, 14 percent in November, and an estimated 60 percent in December), in large part as a result of substantial increases in administered prices (most significantly the price of bread).  4 monthly pension was about US$ 1. Registered unemployment reached almost 7 percent of the labor force in May 1994, and an estimnated 12 percent were on short-time working or forced leave. Severe energy shortages have sharply reduced the availability of electricity and heating to households, particularly in winter. The bulk of the population appears to be living on remittances from the diaspora, humanitarian aid, and income from informal sector activity (much of it in subsistence agriculture). C. Challenges and Prospects for the Future 13. Overcoming resource misallocation and the terms of trade shock. Like many other FSU states, Armenia faces the consequences of a permanent adverse terms of trade shock following the breakup of the command economy of the Soviet Union. Its economy does so burdened by substantial resource misallocation, compounded by recent extreme macroeconomic instability, an economic blockade and severe financial constraints. The authorities recognize that a comprehensive program of stabili7ation and structural reforms is the only alternative to continued stagnation and dire poverty. 14. The Govenmment's program underway since early 1994 contains a number of interdependent elements. First, a stable environment is required so that producers and consumers can make sound decisions without fear of major macroeconomic disruptions. Stabilization will rest upon continued tight fiscal and monetary policies, and wage restraint. Second, competition in markets is essential to an efficient allocation of resources. The promotion of open markets will require a variety of policies: the further liberalization of prices (in particular, in the energy sector) as well as of the foreign exchange and trade regime; and the elimination of the state's direct role in external trade through interstate barter. The removal of remaining undue restrictions on the emerging private sector will also be necessary to encourage new private activity and to integrate the substantial informal sector into the formal economy. 15. Third, the continued hardening of enterprise budget constraints will encourage enterprises to respond to the new market forces. This shift in behavior will be induced through accelerated privatization and improved enforceability of creditor rights (including the enactment and enforcement of a bankruptcy law). Strict financial policy, the improved prudential regulation of the fragile banking sector, clearing of enterprise arrears and a program to isolate and restructure or liquidate major loss-makers will serve to support the changes at the enterprise level that are expected. Finally, the targeting of the social safety net will be significantly improved in order to protect the sections of the population most affected by the removal of bread and electricity subsidies, and to allow the pension system to be more effective and affordable in the medium term. 16. Growth prospects. Output is expected to grow as the reform program begins to have an impact on the economy and as the blockade is lifted (the lifting of the blockade, expected during 1995, will remove constraints on external trade, sharply decrease tansport and energy  5 costs and enhance access to external financing).4 An initial GDP growth spurt of 10 percent projected for 1995 declines to 6 percent by 2003. 17. In early years, the rapid GDP growth will result primarily from higher capacity utilization (currently estimated at only 20-30 percent) and rapid private sector development. Growth is expected to be led by export demand in FSU markets, as those economies recover, and by increasing penetration of nontraditional markets, such as the Middle East and Europe. Export growth of 6.5 percent in 1995 and 14 percent in 1996 is predicted following the lifting of the blockade during 1995 falling to 8 percent by 2003. Export growth and diversification will be stimulated by the improvement in the incentives framework induced by the reform program; in particular, average productivity is expected to increase substantially as the role of the private sector is enlarged and as financial discipline is imposed on the public sector. Infrastructure investments designed to overcome Armenia's poor transport and communications connections with neighboring countries will significantly facilitate growth in external trade. Export growth is expected to come primarily from light industry and, to a lesser extent, from services and agroprocessing;5 the importance of heavy industry is likely to continue to diminish as compared to its traditional role due to the increased real price of energy and other inputs. The satisfaction of the previously repressed demand for services in the domestic market is also likely to make a major contribution to growth. 18. Private consumption will also recover as incomes rise and as the real exchange rate appreciates as a consequence of macroeconomic stabilization.' The initial growth in private consumption can be expected to be quite rapid (11 percent in 1995) after several years of very low consumption levels; however, the increase is expected to tail off in later years as savings are first restored (after very substantial dissaving) and then increased as incentives to save are improved (by the reduction in inflationary expectations, and by enhanced confidence and competition in the financial sector). 4 Detailed medium-term projections based on the sustained implementation of a stabilization and structural reform program are presented in Annex 1. 5 As an example of a subsector with potential for expansion, Armenia has already developed a large jewelry industry in which high value production mitigates the transport cost disadvantage, and low energy intensity reduces the signif ;ance of Armenia's high energy costs. Armenia has also developed a significant software industry benefitting from its abundant technical skills. 6 A substantial appreciation of the real exchange rate is projected. In 1995, this is a consequence of monetary tightening and the sharp increase in the price of bread, a nontraded good on which expenditure is a very high proportion of total consumption. Over the medium term, the appreciation reflects a substantial increase in real wages from extremely depressed initial levels (average wages in 1994 were US$ 4-5 per month).  6 19. Investment in new capacity will play an increasing role in generating growth as the potential for increased capacity utilization is gradually exhausted. This will occur as private sector confidence, both domestic and foreign (including from the diaspora), responds to the improved investment climate, and as the financial sector plays a more effective role in channeling savings into investment. The reduction in the overall fiscal deficit (from 23.7 percent of GDP in 1994 to a surplus of 0.8 percent by 2003) will release substantial resources to the private sector. Public investment will initially increase as accumulated infrastructure rehabilitation needs are large; however, at the same time public investment will be reoriented away from direct production to playing a role complementary to private sector development. 20. External Financing. Debt and Creditworthiness. Armenia will require substantial external capital inflows to finance its transition to a market economy and the alleviation of poverty. Rapid export growth and an improvement in the terms of trade as the blockade lifts, investments in transport and communications infrastructure are made, and productivity in the export sectors increases, will do much to redress the initial external imbalances.7 However, substantial financing requirements to cover current account deficits, debt amortization and modest reserve accumulation are projected for the medium term. Nevertheless, on the basis of current projections, debt indicators remain acceptable over the period with the debt service-to-export ratio declining from 17 percent in 1996 to 13 percent in 2003.9 In 1995, debt service is projected at 24 percent of exports; this high level is due almost entirely to the repayment of a European Union credit contracted three years earlier and repayable in one tranche. 21. Since Armenia will only achieve commercial creditworthiness gradually, the bulk of external resources would have to come from official sources in the medium term. In the near tern, the substantial humanitarian aid Armenia has been receiving on a grant basis is expected to be replaced progressively by official lending (partly on concessional terms) beginning in. 1995. As confidence in the Armenian economy grows, and the external position strengthens, the weight of official sources in the financing package should gradually diminish. Financing from foreign private credit and direct investment (particularly from the Armenian diaspora) is expected to become more important.9 See tables in Annex 1. 8 Debt-to-export ratios are considered more meaningful than debt-to-GDP ratios given the considerable uncertainty over projections of the real exchange rate in Armenia. 9 The Armemian diaspora is estimated at 4 million people (outside of Armenia), of whom 1 million in the U.S.A., and substantial numbers in France, the Middle East, and the former Soviet Union.  7 PART II. THE GOVERNMENT'S PROGRAM OF STABILIZATION AND STRUCTURAL REFORMS 22. The strategy of the Government is to accelerate the transition to a market-oriented economy. EnhancAd prospects for peace are allowing the Govermnent's attention to be redirected from management of a siege economy, in which energy security issues play a dominant role, to the implementation of more forward-looking policy. Within this framework, the economic program aims to break inflationary expectations, promote a sustained recovery in economic growth, and improve the living standards of the poorest sections of the population. The elements of the program are outlined below. A. Achieving Macroeconomic Stability 23. The Government has designed, in consultation with the IMF, a package of financial policies to achieve macroeconomic stability. The program is supported by a Systemic Transformation Facility (STF) (approved by the IMF Board on December 14, 1994), to be complemented possibly by a Stand-by Arrangement and/or an Enhanced Structural Adjustment Facility in 1995. 24. The principal objectives of the stabilization program are to (i) reduce monthly inflation to 1 percent by end-1995; (ii) strengthen the gross reserve position of the central bank to reach 1.6 months of imports by end-1995; and (iii) remove existing distortions affecting interest and exchange rates. To achieve these objectives a combination of tight monetary and fiscal policies, and trade and price liberalization are required. 25. In the fiscal area, the program aims to reduce the fiscal deficit (on a commitments basis) to 12 percent of GDP in 1995 (a deficit of 24 percent is estimated for 1994). 10 On expenditures, the subsidy on bread and other consumer goods and services will be removed rapidly. Other expenditures will be kept under tight control, particularly those on transfers to enterprises, wages, and defense. On the revenue side, tax exemptions will be reduced, excise rates will be increased, and collection efforts enhanced. ` 26. Monetary policy has been designed to achieve the targeted decline in inflation while laying the foundations for output recovery. The role of interest rates in financial savings and expenditure decisions will be promoted by ensuring that rates remain positive in real terms. In pursuit of this objective, the central bank's refinance rate will be determined in credit auctions '