Armenia - Structural Adjustment Credit Project

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6782-AM REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT IN AN AMOUNT OF SDR 40.4 MILLION TO THE REPUBLIC OF ARMENIA January 31, 1996 This document has a restricted distribution and may be used by recipients only in the performnance 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 = 403 Dram (as of December 1, 1995) WEIGHTS AND MEASURES Metric System FISCAL YEAR January 1 - December 31 ACRONYMS AND ABBREVIATIONS ACMC - Aid Coordination and Management Center ANM - Armenian National Movement CAS - Country Assistance Strategy CBA - Central Bank of Armenia CG - Consultative Group ESAF - Enhanced Structural Adjustment Facility 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 ICB - International Competitive Bidding IS - International Shopping LDP - Letter of Development Policy NMP - Net Material Product O&M - Operational & maintenance OSCE - Organization for Security and Cooperation in Europe PFP - Policy Framework Paper SAC - Structural Adjustment Credit SATAC - Structural Adjustment Technical Assistance Credit SBA - Stand-By Arrangement STF - Systemic Transformation Facility  FOR OFFICIAL USE ONLY REPUBLIC OF ARMENIA STRUCTURAL ADJUSTMENT CREDIT Credit and Program Summary Borrower: Republic of Armenia Amount: SDR 40.4 million (US$60 million equivalent) Terms: Payable over 35 years, including 10 years of grace, on standard IDA terms Objectives and Description: The primary objective of the proposed credit is 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. This will be achieved through (i) provision of foreign exchange for the purchase of critical imports, particularly for the private sector; (ii) budgetary support, especially for the strengthening of the social safety net for the most vulnerable groups; and (iii) providing a framework for urgently-needed financial assistance from other donors. The program includes policies that: (a) reorient the role of the state away from direct management of the economy towards support of private sector development; (b) result in improved financial discipline for enterprises and banks; and (c) improve the targeting of the social services and benefits to the most needy. Poverty categ,or: Poverty-focused. The proposed Structural Adjustment Credit would support improvements in the targeting of social benefits to the poorest groups and in the provision of primary health care. Benefits: The implementation of the structural reforms supported by the proposed credit will promote reorientation of the Armenian state away from direct intervention in the economy. Enterprises will be stimulated to adjust to the new incentive framework and the conditions will be created for the private sector to become the engine of growth. At the same time, efficiency gains in social service provision and improved targeting of protection for the most vulnerable groups in society will promote human resource development and poverty alleviation. Fiscal adjustment and financial discipline of enterprises will increase both public and private savings, thereby promoting price stability, investment and growth. Risks: There is a risk of stabilization and structural reform being undermined by sociopolitical opposition if economic recovery does not proceed fast enough to satisfy rising expectations (presidential elections are to be held in September 1996). However, this will be mitigated by 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 improved targeting of social assistance and by continued humanitarian assistance from donors and the Armenian diaspora. The implementation of the reform program could be undermined by institutional deficiencies, although the ongoing reorganization of the public administration and the provision of technical assistance by the World Bank Group and by other donors will help to counteract this risk. There is a substantial risk of the international community providing insufficient balance of payments financing in support of stabilization and structural reform, which would entail an unsustainable level of poverty. 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 continue to move in a positive direction and economic recovery is increasing popular support for peace. Estimated Disbursement: The proceeds of the proposed Structural Adjustment Credit would be released in two tranches. SDR 8.08 million (or 20 percent of the credit) will be disbursed against Armenia's actual imports (excluding items covered by the negative list) since November 1, 1995, i.e. four months prior to the expected date of signature of the credit agreement. This retroactive financing is justified by the up-front action already taken by the Government on many important elements of the reform program. Proiect ID Number: AM-PA-42793 This report is based on missions which visited Armenia between June and November 1995, comprising Messrs./Mmes. Jonathan Walters (country economist, mission leader), Jeanine Braithwaite (social sectors), Stephen Lister (civil service reform), Alexandre Marc (social sectors), Cyril Muller (trade), Alan Roe (banking), Melinda Roth Alexandrowicz (enterprise reform), Onno Ruhl (economic management), and Salman Zaheer (energy). Afsaneh Farzin assisted in developing the macroeconomic framework. Una Raymond provided secretarial support. Documents were reviewed by Andrew Ewing and Alan Gelb. 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 STRUCTURAL ADJUSTMENT CREDIT TO THE REPUBLIC OF ARMENIA TABLE OF CONTENTS PART I. RECENT DEVELOPMENTS AND PROSPECTS FOR THE FUTURE .... 1 A. Background ...................................... 1 B. Recent Economic Developments .......................... 3 C. Challenges for the Future .............................. 4 D. Macroeconomic Prospects ............................. 5 PART II. THE GOVERNMENT'S PROGRAM OF STABILIZATION AND STRUCTURAL REFORM ................. 8 A. Stabilization. 8 B. Structural Reform - the Achievements Thus Far. 9 Price Liberalization ............................. 11 Energy Sector Pricing and Payments ................... 11 Reform of the External Trade and Payments Regime ......... 11 Private Enterprise Development . . .12 Privatization . . . 12 Financial Discipline . . .12 Financial Sector . . .13 Social Assistance .............................. 13 Labor Market ................................ 13 C. Structural Reform - the Agenda Ahead . . .14 (a) Financial Discipline of Enterprises .14 Energy Sector Policy . . .14 Trade Policy and Enterprise Adjustment .15 Enterprise Privatization . . .17 Enterprise Restructuring and Bankruptcy . . .18 Financial Sector Reform . . ... ..... 19 (b) Improving the Efficiency of Public Spending .20 Targeting of Social Assistance . . .20 Health Sector Reform ............................ 22 Education Sector Reform . . .23 Pay and Employment Reform in the Public Service ... 24 PART III. BANK ASSISTANCE STRATEGY .. 26 A. Background and Objectives .26 B. Bank/IDA Assistance to Date .26 C. The Lending Program .28 D. Coordination of External Assistance, MIGA and IFC Activities .29  2 PART IV. THE PROPOSED STRUCTURAL ADJUSTMENT CREDIT ....................... 30 A. Program Implementation and Credit Conditions ................ 30 B. The Proposed Project ................................ 32 C. Benefits and Risks .................................. 35 PART V. RECOMMENDATION ................................. 35 Annex 1 Main Economic Indicators ............................. 36 Annex 2 Status of Bank Group Operations ......................... 39 Annex 3 Timetable of Key Processing Events ....................... 40 Annex 4 Policy Matrix . ..................................... 41 Annex 5 Letter of Development Policy ........................... 50  REPORT AND RECOMMENDATION OF THE PRESIDENT OF IDA TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT 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 40.4 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 or parallel financing for balance of payments assistance is being sought. The proposed Structural Adjustment Credit (SAC) has been prepared in parallel to an Enhanced Structural Adjustment Facility (ESAF) (SDR 101 million) from the IMF. Total external financing requirements of about US$366 million are projected for 1996, of which US$193 million is projected to come from multilateral sources and US$173 million from bilateral donors (although not all identified financing is fully confirmed). 2. Financing for technical assistance to support a number of measures in the Government's reform program will be provided by the Bank's ongoing Institution Building Loan and by the proposed Structural Adjustment Technical Assistance Credit (SATAC). 3. Armenia became a member of IBRD in September 1992, and became eligible for IDA terms in August 1993. The country joined IFC in March 1995 and MIGA in December 1995. PART I. RECENT DEVELOPMENTS AND PROSPECTS FOR THE FUTURE A. Background 4. Armenia is a country of 3.7 million people situated on a crossroads between Europe, the former Soviet Union, and the Middle East. Turkey lies to the west, Georgia to the north, Iran to the south, and Azerbaijan to the east and south-west. Armenia has depended for its economic growth on its highly educated population and strong entrepreneurial traditions, in the face of limited natural resources. 5. Since Independence in September 1991, the Armenian Government has been drawn primarily from the Armenian National Movement (ANM); few Soviet-era senior officials have remained in office. The ANM has pursued the objectives of consolidating national independence and promoting market reform. The President, Levon Ter-Petrossian, was elected to a five-year term in October 1991 with 80 percent of the popular vote. Presidential powers were strengthened by the first post-Soviet Constitution, approved by plebiscite in July 1995; at the same time parliamentary elections returned an ANM majority for a five year term. Political continuity means that most key economic decision makers have now accumulated considerable post-Independence experience.  2 6. However, Armenia's economic development is highly constrained by the legacy of Soviet central planning. Armenia's production structure yielded a high degree of dependence on trade with the rest of the Former Soviet Union (FSU) (exports and imports represented over 50 percent of GDP during the 1980s) and on industry (which constituted about 60 percent of Net Material Product (NMP)). In the absence of raw materials and primary processing facilities, Armenia had to rely heavily on imports of semi-finished goods and critical inputs, particularly of primary energy resources. Armenia also had a disproportionate share of the Soviet military-industrial complex. This high degree of integration into the FSU economy induced economic collapse in Armenia when the intra-FSU trade, payments and financial system broke down. More fundamentally, the elimination of non-market pricing in trade between FSU states imposed a severe terms of trade shock on Armenia, particularly due to the sharp rise in energy import prices. The lack of comparative advantage of significant parts of Armenia's productive base was exposed. 7. In addition, until recently, the structure of government was largely that inherited from the Soviet Union: a multiplicity of ministries organized to manage the productive sectors of the economy. Nevertheless, a strong commitment to a reorientation of the role of government away from direct intervention in production has been established, particularly in the core economic management agencies: the Prime Minister's office, the Ministries of Finance and Economy, and the Central Bank of Armenia (CBA). Furthermore, the implementation of a comprehensive stabilization and structural reform program since early 1994 has served to reinforce the coordination between ministries to a significant extent. Moreover, the adoption of the new Constitution has initiated a radical restructuring of government agencies. 8. Progress on reorienting government in the transition to the market economy has accelerated with an easing of the regional political situation. The conflict over Nagorno- Karabakh 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 were compounded by civil strife in Georgia. However, there have been several recent positive developments in Armenia's relations with its neighbors. 9. Of greatest importance is the progress towards peace in the 7-year-old Karabakh 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 immediate commencement of negotiations of a comprehensive peace agreement. In parallel, there have been signs of a rapprochement between Armenia and Turkey. These developments offer a real prospect of a lifting of the blockade in the near future. In addition, rapidly-growing trade with Iran and greater stability in Georgia have significantly eased Armenia's isolation (the latter is of particular importance for improved transit of energy supplies). This reduction in regional tension has allowed the Government to move away from management of a siege economy towards the implementation of a comprehensive stabilization and structural reform program.  3 B. Recent Economic Developments 10. Inflation is declining. Until late 1993, Armenia's membership of the ruble area, in which most countries were conducting expansionary monetary and fiscal policy, severeiy limited the authorities' capacity to reduce inflation. Furthermore, 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. In consequence, the Government loosened financial policies to allow the stockpiling of imported inputs. This was effected through massive net lending to enterprises (equivalent to 17.6 percent of GDP) from the Government budget; the budget deficit rose to 48 percent of GDP (from 27 percent in 1992), largely financed by the central bank. In addition, 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. 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). 11. However, beginning in the second quarter of 1994, the authorities took vigorous measures to bring inflation under control. Public expenditures were limited to priority items (entailing a sharp reduction in fiscal transfers to enterprises) and revenue collection was increased. In consequence, central bank financing of the fiscal deficit was curtailed. At the same time, interest rates on central bank refinancing of commercial bank credit were allowed to become highly positive in real terms to further restrain monetary growth. In December 1994, this fiscal and monetary restraint was enhanced by an eleven-fold increase in the administered price of bread and the consequent elimination of a substantial part of the bread subsidy (this subsidy was estimated to be equivalent to 10-12 percent of GDP in 1994). The bread subsidy was subsequently abolished (in June 1995). In addition, from end-1994 the authorities' anti-inflationary stance was greatly reinforced by inflows of external financing from the IMF and the Bank. The fiscal deficit declined from 48.2 percent of GDP in 1993 to 16.4 percent in 1994; a deficit of 8.7 percent is projected in 1995. 12. As a consequence of fiscal and monetary restraint, inflation fell sharply. In 1995, inflation averaged 2 percent per month as compared to 46 percent per month in the first quarter of 1994, just before the stabilization program began. This has been accompanied by broad stability in the nominal exchange rate since the Spring of 1994, which has enhanced confidence in the new currency. 13. GDP is growing and external adjustnent is beginning. After an estimated 60 percent decline in GDP in 1991-93, growth of 5.4 percent was recorded in 1994. Much of this growth comes from the services sector (particularly trading), but enterprise survey data show that industry has begun restructuring and diversifying into new markets. Preliminary data suggest that GDP growth was 5 percent in 1995. Investment is beginning to revive from near-zero levels, although most investment is still in the public sector (largely financed by donor resources).  4 14. The current account deficit (excluding official transfers) declined to 26.4 percent of GDP in 1995 from 35.5 percent in 1994. This has been accompanied by an accumulation of foreign exchange reserves equivalent to 1.5 months of imports (twice the 1994 level). The current account deficit and reserve accumulation have been financed primarily by IMF and donor resources with a high degree of concessionality (in 1995, official transfers alone are expected to cover 52 percent of the current account deficit). Although the direction of change is encouraging, it is clear that the level of the current account deficit and the associated external financing is unsustainable over the medium term; more adjustment is needed. 15. However, export trends are encouraging. Export growth in value terms of 22 percent over 1994 levels is projected for 1995 on the basis of data for the first nine months of the year. At the same time, export data show diversification into non-traditional markets; exports to non-FSU countries are projected to be 78 percent higher than in 1994 (from 31 percent of total exports to 46 percent) while exports to FSU countries fell by 7 percent. This export growth projection is supported by enterprise survey information, as is the recorded export market diversification. In addition, some foreign direct investment is beginning to take place as the privatization program accelerates. However, these achievements in GDP growth and external adjustment remain fragile. 16. Living standards have yet to recover. Poverty has become pervasive in Armenia since 1991 (particularly in urban areas, where people have limited access to agricultural land). Average monthly wages in the state sector were about US$17 in July 1995 (in the budgetary sector they were only about US$8) and average old age pensions about US$5. Although wages are often supplemented by informal sector income, social assistance, remittances from abroad, and humanitarian aid, survey data reveal consumption levels barely above subsistence for large parts of the population. Recorded unemployment is 5 percent of the labor force and a further 15 to 30 percent are estimated to be on involuntary unpaid leave or reduced pay for shortened working hours. C. Challenges for the Future 17. The challenge facing Armenia is to achieve an increase in living standards and a reduction in poverty through a sustained recovery in economic growth and employment. This recovery will be sustainable only if it is accompanied by significant investment in productive capacity, infrastructure and human resource development. At the same time, increases in investment and consumption levels must be consistent with balance of payments viability and with low inflation. To achieve external and internal balance will require substantial increases in savings. 18. Armenia has had some success in attracting foreign savings. Humanitarian aid flows have been substantial, as has adjustment financing, but these aid flows are not sustainable indefinitely. Foreign private flows, whether through loans or direct investment, can only be expected to become substantial once the economic recovery and restructuring are more  5 advanced, and there is greater regional stability (although there is some potential for relatively early investment from the Armenian diaspora). 19. Increasing domestic savings, therefore, must be a central component of Armenia's economic strategy. The economic crisis has generated substantial dissaving, both public and private, in an attempt to avoid a total collapse of consumption. However, since early i994, the stabilization and structural reform program has begun the process of increasing public savings through a reduction of the budget deficit and stimulating private saving by hardening budget constraints for loss-making enterprises. The key challenge today is to consolidate and deepen this process. 20. At the core of meeting this challenge will be a radical restructuring of the role of the state in Armenia. The Government has begun the process of reorienting the state away from the direct management of production and provision of generalized producer and consumer subsidies towards support for private sector development and a targeting of social expenditures to the poorest. Extending this process will require a profound restructuring of fiscal expenditures and measures to promote increased financial discipline of enterprises. 21. Efficiency gains will need to be made in key fiscal areas: public employment policy, the delivery of health and education services, and the provision of social assistance, while revenue mobilization will need to be increased. At the same time, enterprise budget constraints will need to be hardened in order to generate a supply response to new market conditions and to mitigate the risk that loss-making enterprises will undermine fiscal adjustment through pressure for subsidies. This will require that a range of interrelated measures be taken to enhance financial discipline of enterprises through privatization, - financial sector reform, external trade liberalization, energy sector reform and enforcement of creditors' rights. D. Macroeconomic Prospects 22. Growth prospects. Output is projected to continue to grow after strong performance in 1994 and 1995, as the reform program deepens and as regional tensions ease (which will remove constraints on external trade, sharply decrease transport and energy costs and enhance access to external financing). During the past 12-18 months, Armenia's isolation has been significantly lessened by inter alia greater stability in Georgia, increased access to supplies in Iran, the commencement of passenger transport between Turkey and Armenia, the opening of an air corridor across Turkey, and greatly increased informal trade at the crossroads market between Azerbaijan, Armenia and Georgia (Sadakhlo). It is expected that multilateral and bilateral negotiations will lead to a further easing in the near future; this could come, for example, by a reopening of the railroads through Abkhazia to Russia or through Nakhichevan to the Persian Gulf, by an opening of the Turkish border to trade, or by the reopening of the Azerbaijani border. Detailed medium-term projections based on an  6 easing of regional tensions and the sustained implementation of a stabilization and structural reform program are presented in Annex 1. 23. Annual GDP growth of 6-7 percent is projected over the period 1996-2005. In early years, these high levels of GDP growth will result primarily from higher capacity utilization (currently estimated at about 30 percent) and rapid private sector development. It should be noted that a substantial proportion of existing capacity may no longer be serviceable or may be for products for which markets have disappeared; however, high growth in output remains possible in the initial period given the very low levels of capacity utilization. Growth is expected to be led by export demand both in FSU markets, as those economies recover, and by increasing penetration of non-traditional markets, such as the Middle East and Europe. Export growth (in volume terms) of 11 percent in 1996 and 20 percent in 1997 is projected following the easing of regional tensions expected during 1996 falling to 7 percent by 2005. 24. 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 greater financial discipline is imposed, particularly 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 services and, to a lesser extent, from agroprocessing;l 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. 25. Real incomes are projected to rise through GDP growth and through an appreciation of the real exchange rate. This appreciation is expected to occur as macroeconomic stabilization induces reverse currency substitution and the return of flight capital. A real appreciation is consistent with an expansion of exports because many of the structural impediments currently increasing the cost of exports are expected to be removed (principally the blockade and public sector inefficiencies). As incomes rise and incentives to save are improved (by the reduction in inflationary expectations and by enhanced confidence and competition in the financial sector), private savings will progressively recover (after years of substantial dissaving); this will be accompanied by an increase in public savings as fiscal deficits are reduced. 1/ 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 current transport cost disadvantage, and low energy intensity reduces the significance of Armenia's high energy costs. Armenia has also developed a significant software industry benefitting from its abundant technical skills. The high-quality construction materials industry remains constrained by transport costs but could be expected to regain markets once transport costs fall.  7 26. 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 Armenian 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 16.4 percent of GDP in 1994 to a deficit of 2.7 percent by 2005) will release substantial resources to the private sector. Tax revenue to GDP rises from 12.3 percent to 18.8 percent over the 1996-2005 period, and expenditure to GDP falls from 23.8 to 22.6 percent (with a rising proportion of capital expenditure). Public investment will 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. 27. 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 regional situation improves will do much to redress the initial external imbalances. 28. Substantial financing requirements to cover current account deficits, debt amortization and modest reserve accumulation are projected for the medium term. However, on the basis of current projections, debt indicators remain moderate over the period with the debt service- to-export ratio declining from 18 percent in 1996 to 15.4 percent in 2005. In 1995, debt service is projected at 19.7 percent of exports; this high level is due almost entirely to the repayment due on a European Union (EU) credit contracted three years earlier and repayable in one tranche. The debt service-to-export ratio in 1996 reflects a similar bullet repayment due on a second EU credit. The ratios excluding these two bullet repayments would be 3.1 percent and 10.4 percent in 1995 and 1996 respectively. During the 1996-2005 period'debt- to-export ratios range between 103.6 percent to 178.9 percent and debt-to-GDP ratios from 22 percent to 38 percent. Although domestic savings are restored to positive levels only by 1999 and the share of preferred creditors in total debt service is high, the capacity to service external debt is significantly enhanced by the high degree of average concessionality of external financing and the initial stock of debt. Armenia inherited no debt on the break-up of the Soviet Union by agreeing to the "zero option" (whereby Russia assumed Armenia's share of the external assets and liabilities of the Soviet Union). 29. Since Armenia will only achieve full commercial creditworthiness over time, the bulk of external resources would have to come from official sources in the medium terni. In the near term, 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). 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  8 foreign private credit and direct investment (particularly from the Armenian diaspora) is expected to become more important.2 PART II. THE GOVERNMENT'S PROGRAM OF STABILIZATION AND STRUCTURAL REFORM A. Stabilization 30. The Armenian authorities initiated their stabilization program in the Spring of 1994 without significant external financial support, due to the constraints on such support that were imposed by the Nagorno-Karabakh conflict at that time. However, the early successes of that program and the formalization of the ceasefire in July 1994 allowed approval of a Systemic Transformation Facility (STF) in December 1994. This was followed in June 1995 by the approval of a Stand-By Arrangement (SBA). The first purchase under the STF approved on December 14, 1994 was for SDR 16.875 million (equivalent to 25 percent of Armenia's IMF quota). The SBA approved on June 28, 1995 was for SDR 43.875 million (65 percent of quota) over a program period of June 1995 - June 1996, and was accompanied by a second purchase of SDR 16.875 million under the STF. An ESAF is now under preparation (Board presentation is scheduled for February 1996). The ESAF is intended to achieve greater integration of stabilization and structural reform policies than previous arrangements through programming over the medium term (1996-98). 31. The stabilization program is an ambitious one. It reduced inflation (on an end-period basis) to 26 percent in 1995 (from 1,885 percent in 1994), and aims to reduce it further to below 20 percent in 1996. At the core of the program is sharp fiscal adjustment and tight credit conditions to restrain monetary expansion. The fiscal deficit declined to 8.7 percent of GDP in 1995 (after 48.2 percent in 1993 and 16.4 percent in 1994) and is targeted to fall to 7.6 percent in 1996.3 The deficit will be financed largely from external sources (and to the extent possible from domestic bond sales) to avoid recourse to inflationary bank financing. Deficit reduction will be achieved through a combination of reduction in recurrent 2/ The Armenian diaspora is estimated at approximately 4 million people (outside of Armenia), of whom about 1 million in the United States, and substantial numbers in France, the Middle East, and the former Soviet Union. 3/ These deficits are on a quasi-accrual basis; expenditures reflect commitments, although revenues reflect only actual receipts. The fiscal deficit on a cash basis in 1995 was 10.9 percent of GDP - the difference reflecting the elimination of expenditure arrears accrued in previous years (all these arrears were domestic). In 1996, the cash and accrual defici tare expected to be the same reflecting the full clearance of arrears in 1995.  9 expenditure, increased reliance on consumption taxes, and improved tax and customs administration.4 32. The Central Bank maintains interest rates at levels it judges to be consistent with the inflation-reduction objective through the auctioning of refinancing credit to the commercial banks rather than through direct controls (in the fall of 1995 the auction interest rate was 60- 80 percent per annum). High interest rates, along with increasing confidence in the dram and some Central Bank sales in the foreign exchange market, also appear to have contributed to the broad stability of the exchange rate experienced since the Spring of 1994. Since. inflation has remained above the average level of Armenia's trading partners during this period, this nominal stability has entailed a sharp real appreciation (the real effective exchange rate is estimated to have appreciated by 90 percent in the 12 months to December 1995). However, purchasing power parity estimates suggest that the currency may still be substantially undervalued and that further appreciation would not necessarily give rise to competitiveness concerns. Average wages in the state-owned enterprise sector were only about US$25 per month in mid-1995 and 1994 GDP per capita was only US$176 when valued at the prevailing market exchange rate. This contrasts with per capita GDP of US$670 when measured using the Atlas methodology which compensates for differences between market exchange rates and rates which better reflect purchasing power parity. B. Structural Reform - the Achievements Thus Far 33. At Independence in 1991, the Government of Armenia initiated a comprehensive structural reform program. Prices of most goods and services were liberalized in January 1992. The collective farm system was quickly broken up and land was privatized to small- holders (87 percent of agricultural land is now privately owned). In parallel, privatization of small enterprises began: 335 enterprises, mainly shops, had been privatized by mid-1992, although the legal basis for this was not yet fully developed. 34. These early successes could not immediately be consolidated due to the siege conditions imposed by war and blockade. However, with the easing of the conflict and the development of alternative trade routes, the Government was able to reinvigorate the structural reform program in early 1994. The first objective was to promote a stable economic environment, to allow producers and consumers to operate without having to fear a resurgence of inflation. To achieve this objective, the Government implemented tight fiscal and monetary policies, as well as wage restraint. A second key objective was to improve the allocation of resources through macroeconomic stability and the promotion of competitive markets. Policy measures to that effect included: liberalization of prices (in particular, in the energy sector) and of foreign trade and exchange; and the removal of undue restrictions on the emerging private sector. The third objective was to accelerate ownership change through privatization and to harden budget constraints on enterprises to encourage them to respond to 4/ Improvements in tax and customs administration will be supported by the Institution Building Loan and the SATAC.  10 the new market forces. The final objective was to improve targeting of the safety net, to protect the sections of the population most affected by the removal of general subsidies and to allow the recovery to be socially sustainable. 35. During the second half of 1994, there was intensive dialogue between the authorities and the Bank on the design of a structural reform program. This culminated in the preparation of a Letter of Development Policy (LDP) and the approval of a Rehabilitation Credit (Credit No. 2683-AM) by IDA in February 1995 to support implementation of the LDP. The LDP included policies that: (a) promoted the development of competitive markets and of the private sector, through privatization, liberalization and regulatory reform; (b) enhanced financial discipline for enterprises and banks; and (c) improved the targeting of the social safety net to the most needy. 36. Prior to Board presentation of the Rehabilitation Credit measures were taken to: (i) accelerate small scale privatization; (ii) complete the legal framework for the commencement of medium- to large-scale privatization; (iii) monitor enterprise arrears; (iv) facilitate enterprise asset sales; (v) remove a range of export restrictions5; (vi) restrict interstate barter clearing agreements concluded for 1995 to imports of only natural gas, crude oil and mazout; and (vii) initiate pension reform to effect a phased increase in the retirement age and to flatten the structure of pensions. The holding of the first privatization auction for medium- to large-scale enterprises (which opened on March 1, 1995) was a condition of effectiveness of the credit. 37. Implementation of the program during 1995 has been generally strong, with major achievements in the privatization of small-scale enterprises and of housing, the elimination of consumer subsidies (with targeted compensation) and establishment of a legal framework to support private sector development. Privatization of medium- to large scale enterprises has been slower than expected due primarily to the complexity of the approvals process6 and inexperience of the staff involved, but the process now has substantial momentum. The pace of privatization over the last few months has been good and should be sustained throughout 1996. 38. More specifically, the progress on the measures contained in the LDP (which covered the period from March through December 1995) is as follows: 5! The restrictions abolished included: export licensing (except for those on health and environmental grounds); export tax on goods invoiced below reference prices (i.e. the use of minimum reference prices was discontinued), except for metals and scrap metal (for which reference prices were abolished at end-1995); all prohibitions affecting inter-enterprise barter transactions; and the 25 percent mandatory prepayment for private sector exports. 6/ This complexity is in response to the collapse under the weight of corruption allegations of the first attempt at privatization in 1991/2.  11 Price Liberalization * Subsidies on bread, municipal electric transport and garbage removal and the cross- subsidies on water and sewerage have been eliminated. The subsidies on district heating and hot water (the only remaining consumer subsidies) remain under review. In the case of district heating, which less than one-third of households actually receive, the issue of provision of targeted heating subsidies to vulnerable groups will be resolved as part of the overall reform of social assistance. All administered prices have been adjusted on a regular basis to maintain their real value.' Energy Sector Pricing and Payments * Average electricity tariffs have increased by 25 percent in real terms during 1995 although they do not yet cover operational and maintenance (O&M) costs. Enforcement of payments for electricity consumption has improved (collections from the productive and budgetary ssctors having risen from 62 percent of consumption in 1994 to 70 percent in the first nine months of 1995 and for households from 10 percent to 33 percent over the same period). A mechanism for collective payment by the residents of apartment buildings and villages has been instituted on a pilot basis. Under this mechanism, buildings or villages are guaranteed at least 10-12 hours of electricity a day (instead of the normal 2-4 hours per day) if they pay their electricity bills collectively (in part through prepayment). Failure to make the collective payment results in all residents of that building or village being disconnected. Reform of the External Trade and Payments Regime * Clearing trade now plays a smaller role in external trade, with the discontinuation of the arrangement with Russia in early 1995. However, the arrangement with Turkmenistan for natural gas imports remains in force; participation by enterprises in the interstate barter arrangements is now voluntary, although some evidence of moral suasion exists. Moreover, although Armcontract's and Armturtrade's procurement prices are freely negotiable there are still implicit taxes and subsidies to enterprises involved in clearing trade, particularly through the accumulation of payment arrears.8 7/ Prices of electricity, drinking water, irrigation, urban transport, telephone services, garbage removal, sewerage, hot water, gas, and heating remain administered (since they are all supplied by state-owned monopolies) as does rent in state-owned housing. The only remaining direct price control is on flour (through the setting of maximum profit margins for flour mills). 8/ In early 1995, Armcontract's responsibility for the clearing trade with Turkmenistan was taken over by the newly-created Armturtrade (under the Ministry of Energy). Armcontract remained under the Ministry of Material Resources (which was merged with the Ministry of Trade in July 1995). Both Armcontract and Armturtade are state-owned trading companies.  12 * The surrender requirement of 30 percent of foreign exchange earnings by exporters was eliminated in April 1995. Private Enterprise Development * A real property code which clarifies the legal framework for private property sales (left unclear by the rapid land privatization of 1991/2) has been adopted and a new companies code has been submitted to Parliament. In order to provide increased security for contracts (in particular bank lending), a law on collateral was adopted by Parliament in June 1995; to facilitate closure, a bankruptcy law was adopted by Parliament at the same time. An anti-monopoly law has been prepared but the need for such a broad-based law is currently under review within the Government.9 Privatization * Privatization of small-scale enterprises is well underway -- by end December 1995, 1812 small enterprises had been privatized (although achievement of the end-1995 target of 3,000 small enterprises privatized will be delayed until early 1996). * Privatization of medium- to large-scale enterprises is also well underway (although the ambitious end-1995 target of 900 enterprises privatized will be achievable only in 1996). The first public subscription for ten enterprises was opened on March 1; 1995 and closed two months later with all enterprises sold. By end December, 355 enterprises had been offered for sale (such an offering being the criterion of progress stipulated in the LDP). The majority were offered by public subscription; some were sold directly to their employees (mainly enterprises which had previously been leased by the employees) and a few were sold by auction. In addition, twelve enterprises have been selected for sale by tender to strategic investors and recruitment of an investment bank to handle this process is underway. Financial Discipline * Eleven highly-indebted enterprises have been placed in an enterprise restructuring program. This is designed to operate as a pilot bankruptcy program in which the modalities of debtor reorganization and liquidation, as well as the willingness of the Government to see bankruptcy procedures initiated for state-owned enterprises, will be demonstrated. 2/ Key anti-monopoly issues will be addressed in the legal framework pertaining to natural monopolies (including the energy law currently under preparation); this approach may be sufficient in view of the limited role played by monopolies in Armenia.  13 Financial Sector * Considerable progress was made in 1995 in strengthening the legal and regulatory arrangements for banks and in defining the supervisory role and functions of the CBA. Measures taken include: introduction of guidelines for aggregate limits on large exposures, for lending to shareholders, and for foreign exchange exposure; increase in minimum capital requirements for banks (to US$100,000 equivalent); and a complete portfolio review of all the banks (to be completed by early April 1996). These measures led to the much-needed closure of some of the weakest banks (26 banks have closed siilce March 1994), thus initiating the process of consolidation of the banking sector. However, the Savings Bank is not yet in compliance with capital adequacy and other prudential regulations and will be subject to restructuring. Social Assistance * Compensation for the increases in the prices of bread and electricity, which took place as generalized subsidies were eliminated, was effected through those cash transfers which were judged to reflect categories of the most needy: children, the unemployed, and pensioners dependent on administered incomes. The Government increased child allowances, unemployment benefit, pensions (and wages to lower-paid employees in the budgetary sphere) by an amount calculated to reflect the incremental cost of a lifeline consumption of bread and electricity. Those registered as unemployed but who have exceeded the 6-month eligibility period for unemployment benefit received essential foodstuffs through humanitarian aid programs. Legislation has been submitted to Parliament to allow cash payments to this group to replace the food program. Labor Market 3 Housing privatization is essential to stimulate labor mobility and about 60 percent of the formerly state-owned housing stock has now been privatized. A Government Decision on Condominiums was adopted in May 1995 to make provision for maintenance of common areas in apartment buildings; this should help accelerate the housing privatization process. In addition, rents in state-owned housing were raised at end-1995 to accelerate the privatization process.'