Armenia - Country economic memorandum (Vol. 2 of 2) : Annexes

Report No. 11274-AM Armenia Country Economic Memorandum (In Two Volumes) Volume II 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 I - 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: = International 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: = Organization 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 OMCUAL USE ONLY VOLUME I ANNEXES The attached set of Annexes covers sector-specific issues in more detail than the main text. For a review of the agricultural sector, the reader is referred to the docment Armenia: Introduction to the Agricultural Sector,published by Agricultur, Industry and Finance Division, country department m, Europe and Central Asia Region, on June 23, 1992. Page No. AANEXI ....................................................... 1 TRADE AND TRADE POLICY ............... ..1.................. A. Role of Trade in the Economy ............................. 1 B. Current Trade Regime ................................... 3 C. Issues ............................................. 8 D. Recommendations ............. 13 A.Y 11 .28 THE FINANCIAL SYSTEM IN ARMENIA .28 A. Overview of the Financial Sector .28 B. Financial Institutions ......................... 29 C. Current Performance of the System .34 Declining Real Credt...34 D. The Reform Agenda .36 E. Sequencing of Policy Reforms .46 ANNEX III ...................................................... 49 INDUSTRY: BETWEEN PLAN AND MARKET .49 A. Armenian Industry and its Role in the USSR .49 B. Oversight of the Industrial Sector .52 C. Concentration and Monopoly .53 D. Performance in 1991 and 1992 ..54 E. Employment, Wages and Prices .56 F. The Financial Position of Enteprises .60 G. Between Plan and Market ..61 H. Enterprise Reform: Policy Recommendations .64 ANNEXIV .66 PRIVATE SECTOR DEVELOPMENT ..66 A. The Enabling Environment .66 B. Privatizaion .68 C. The Voucher Scheme .74 AMVE V .76 This document has a restricted distribution and may be used by recipients on:y in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  LEGALFRAMEWORKIN THEREPUBUC OFARMEMNA . ............... 76 A. nrduction ......................................... 76 B. Constitutional Law ...... 76 C. Judiclalnstutions ........................ ............. 78 D. PKoperty Law . 79 E. ConIAnyL.aw . 81 F. Andt-Moronopoly law . 83 G. BankruptcyLaw . 84 H. Foreigninveies ... . . . 85 1. ConctLaw ... . 86 J. Condusions and Reco..n..ai. ... 87 ANNEX VI ...................................................... 90 THE LABOR MARKET ........................................ 90 A. Characteristics of the Amenin Labor Market ...... .............. 90 B. Recent Trends: e Beginning of Labor Reallocation ..... ........... 94 C. Curet Labor Market Policies and Practices ..................... 95 D. Recommendations on Wage and Employment Policies ............... 97 E. Proactive Employment Pgrams ......... ................... 99 ANEX V. ........................................... 113 PROTECTNG THE NEEDY-THE SOClALSAFETY NET ................. 113 A. Who are the Needy and How Much Protection? ................... 113 B. Armenia's Cash Benefits . . ......................... 114 C. SocWsAssistance .................................... . 117 D. Health .................................... 119 B. Housing ..................................... 120 A77'Aa1v 1 7V ANNEX I .. ... 124 A POVERTY LINE FOR ARMENIA .......... ...................... 124 ATTACWNT2 70 AMVEX Iq ........................................ 126 A. The Old-Age-hidity Program .. .......................... 126 B. lhe Sicness-Maenity Program .......... .................. 128 C. Unemployment Insurance-Employment. Seies . . ................. 129 A7TAChMF.ENT 3 70 AMVEX WI . ............................ 134 JMPROVED TARGETING OFCASH BENEFS ........................ 134 A. Old-Age-Invaidity Program ... .............................. 135 B. Sickness-MtienityP am .........rog. .................... 136 C. Unemploymenturan andTraining ........ ................. 136 D. Children's Allowances and Student .....................St id137 ANhEXV ........... 142 ENERGYSECTOR ........................................ 142 A. Introduction ........................................ 142 B. Situdond Anlysi andEnergySectorIssues ............... ..... 142 C. Eney Supply and Demad ............................... 144 D. FuturenErySconaiosan DemandProjections ................. 147  E. B towericPow. ad DiDii Heatin t H.tor .................... 149 F. PeloluSubscor .............................. 153 G. NaturaG SubsS^strN ................................. 156 H. P ities In E gy Sector ............................. 161 CEM TABLES  AMNEXI TRADE AND TRADE POLICY 1. This chapter examines questions related to trade and trade policy. The first section explores the role of trade in the Anmenian economy, discussing the contribution of trade to domestic output, the structure of exports and imports, and the relative importance of trading partners. The second section describes the current trade regime and its institutional framework. The third section discusses the issues facing the Armenian Government and the fourth presents some recommendations. A. Role of Trade in the Economy 2. Armenia is a small, relatively industrialized county with a trade-dependent economy and a highly-skilled labor force. While the share of Economic Indicators trade in GDP has been declining since 1988 when it stood at over I 1989 1990 1991 1992 50%, Armenia is still an open economy with imports and Cm million arrent rubles) exports representing;n 1991 37% GDP 8054 9490 9692 15937 70138 and 24% of GDP, respectively Impors 5389 4898 4662 5809 10333/1 (55.7% and 38.7% of GDP for Expo 3813 3691 3523 3732 7184/1 the first two quars of 1992). Current data show that the deciine (as % of GDP) in trade (in real terms) in 1991 imports 66.9 51.6 48.1 36.4 55.7 was almost twice the contraction Exports 47.3 38.9 36.3 23.4 38.7 experienced by the economy at C cosa 90 ruble.) large (see box). Severe GDP 9692 7957 3686 reductions in trade volumes are i 4662 2900 also projected for 1992, given a Exprt 3523 1863 combination of events with adverse economic consequences. (% change in rea term) Prominent among these are: the GDP -17.9 -52.0 disruptions in Armenia's trade Imports -38 routes through both Georgia and Expous -47 Azerbaijan; the virtual collapse of the payment system for interrepublican trade; and the 1L Fi half of 1992. No groth rtes have be projected for demise of Vneshekonombank, the e sad imporbsfor 1992. only financial institution with _ correspondent accounts abroad, with the subsequent freezing (in December 1991) of all of Armenia's foreign exchange reserves.'/ .1/ Total claims (public and private) of Armenia on this bank are esimad at 53 million convertible rubles and about US$ 12 million, including US$ 5 million in earthquake relief and US$ 7.2 million in deposits of the Yerevan branch.  2 AEXI Preliminary information on the first four months of 1992 indicates a more thn 50% contaion in rail import volumes compared to the cormsponding petiod in 1991. 3. The former centralized system resulted in production and trade patterns among the republics which were not always justified on the grounds of comparative advantage. Under this system, Armenia was placed in the position of producing industa itermediate finished goods. The o3untry is not well-endowed with raw materials and has not developed primary processing facilities; as a result, it relies on imports of semi-finished goods as inputs into domestic indusby. Armenia exports mainly light industrial goods, processed foodstuffs, machines and chemicis; thes four categories of goods accounted for 85% of total exports in 1990 (see Table Alb) -1991 also - see table A2. Imports are mainly energy, semi-finished products and foodstuffs; some 80% of imports in 1991 were classified as industrial goods. 4. Since the 1988 earthquake destroyed substnl producdve cpacity, Armenia has consistently been running a trade deficit. This deficit extends to all sectors of activity with the exception of light industry (and "other"). The biggest deficits ae on ener products and foodsbtf, with the two sectors accounting for more than half the trade deficit in 1990. Furthr adjustmts in the prices of imported fuel and gas to bring them in line with intnatioa prices would widen this deficit. In the absence of unit values, it has not been possible to do a calcation of the impact of changes in the tenm of trade on Armenian economy. However, it is qute liely that as a net mporter of raw materials, Armenia has experienced and will coninue to be affcted by substa erms of trade shocks. 5. important for evaluating various options for fumre Trade l1sr trade policy is the high level of integration of the Armenian economy into the FSU market. 199 199/ FSU trade dominates Armenia's (f mlhaz cw mbko) trade flows, as shown in the box m miS3o9 4n 4662 S809 10333 table. The former Soviet Union Ite licaen 4531 3842 3S08 4428 10282 market constitudes practically the oreIgn 859 106 1154 1382 51 only destination for Armenian Export 3813 3691 3523 3732 7184 exports, accounting for about 97% Intepublican 3729 3598 3428 3613 7090 of total exports in the 1988-91 Forega 84 93 95 120 94 period. Interrepublican transactions also account for more than 75% of (as % ol total imports (FSU imports orts accounted for 99.5% of total ipt 84.1 78.4 753 76.2 99.5 imports for the first 6 months of 1992). Foodstuffs and inputs xPo 97.8 97.5 97.3 96.8 98.6 destined for Armenia's light and 1/ Fust two quatws of 1992 food industries constitute the bulk of foreign (non-FSU) imports. The table also shows that the foreign trade imbalance drives Armensia' trade defcit accnting for more than 90% of the total in 1990  AANEX I 3 (60.7% in 1991 and there is a surplus of R 42.8 million on the foreign trade account for the first half of 1992). 6. Detailed data obtained for production and trade in inTermediate industrial goods (for 78 product categories) show that more than 50% of tot domestic production (in value) in 1991 was destined for the FSU market (see table). Eliminating from the database those goods which are consumed totally by the domestic market shows that more than two-thirds of total production for the remaining 57 products (1,361 million rubles) is exported to )ther republics. A sizeable segment of the country's industrial sector appeas to have been designed to supply the former Soviet Union market. Unless trade in these commodities reflects Armenia's comparative advantage (which seems unlikely), these enterprises will have to be radically reduced in size or closed down once this market is fully liberalized. 7. Within the FSU zone, two countries dominate Armenia's trade. Direction of trade data show that Russia and the Ukraine accounted respectively for 60% and 20% of Armenia's intermediate industrial goods exports to :he FSU in 1991. An additional 10% of such exports weft to Kazakhstan, Georgia and Belarus. Information obtained from the 1991 Plan covering all trade (intermediate and final goods) confirms this picture for exports. It also shows that Russia and the Ukraine were expected to account for a similarly large share of imports, with Kazakhstan, Uzbekistan and Turkmenistan assuming greater importance given their role as raw material and energy exporters. (see table 3.6). B. Cumnt Trade Reghu 8. Armenia's current trade policy is largely consistent with the Agreement on the Principles of Customs Policy signed on March 13, 1992 by eight of the former Soviet republics.1 This Agreement aims to preserve and strengthen the common economic space of the FSU countries by providing for the free movement of goods within the area and by conducting a coordinated customs policy, including harmonized customs regulations and procedures, with respect to third countries. To implement these goals, the Agreement calls for the creation of a Customs Union among the contracting parties with a general customs tariff and duty-free intra-Union trade, and seeks uniform domestic taxation of inrational trade. Accordingly, Armenia exempts from duty imports from FSU counties (mcluding from non-signatory cnes) and applies the former Soviet Union tariff rates on imports from third countries. However, Armenia mainuans licensing requirements for some exports, including to Union countries, imposing in effect quanitative restrictions on such trade. 9. The etent to which other countries adhere to the Agreement at present is unclear. While no information could be obtained on external tariff rates applied by other countries, authorities confirmed that trade within the FSU was indeed conducted duty-free. This indicates the existence, for the time being, of at least a free trade area and possibly of a customs union. This angement could, however, be short-lived if Russia starts imposing duties also on imports from FSU countries as heralded by its June declaration. No meanifl regional preferential trade arrangements can exist v,1 Other signatories ame: Banis, Russia, Kazakhstmn, Kirgsin, Tjikdst, Turkmenistan and Uzbekbstan.  4 AWEX I without Russian participation and the recent announcement reduces substantially the likelihood that the March 13 Agreement will be upheld. 1. Insitutional Context 10. The main agency in charge of making and implementing trade policy in Armenia is the Deparanent of Foreign Economic Relations of the Ministry of Economy. This Department has two divisions responsible respectively for Inter-Republican Economic Relations and for Foreign Trade. In addition, the Licensing Agency is in charge of delivering export and import licenses. Projections of future trade flows and negotiations of trade arrangements with other countries are done by the Department of Foreign Economic Relations while the State Committee on Statistics of the Minisry of Economy is in charge of tabulating historical trade data. 11. The Customs Department has been set up only since January 1992 to take over the responsibilities previously assumed by the centralized Soviet Customs agency. In the current institutional set up, the Customs Department reports directly to Parliament through the Prime Minister. It is, as a result, completely independent of the Ministry of Finance and the Ministry of Economy; furthermore, the organizational structure does not provide for interfice with the Tax Inspectorate (also headed by an official of Ministerial rank) at the level of the administration. 12. Procedures are still in the process of being put in place for customs clearance, transit trade, and data collection. Some of these currently fall within the purview of the Customs Council, established by Agreement on the Principles of Customs Policy. Two separate Agreements stipulate rules governing transit trade. The first, signed by 11 FSU states on February 8, 1992, I/ sets the gene-al conditions for the treatment of transit trade, exempting such goods: from customs duties, taxes and customs clearing fees in the states of transit; from the need to obtain authorizations for transit; and from customs ih .pection. The second, signed on April 2, 1992, establishes detailed implementing regulations, iualuding documentation and reporting requirements and verification procedures for transit and re-export trade. 13. The Customs Department has no historical data on international trade. It started collecting data on trade with non-FSU countries in January 1992 when it was set up. However, intra- FSU transactions have been recorded only since May 1992, when the obligation to fill out customs declaration forms - waived until recently in view of exemption from customs duties - was also extended to such trade. However, all customs clearing and data tabulation are done manually at present, increasing the risks of errors and fraudulent reporting. 14. Armenia's trade links with the outside world are assured largely through two railroad connections passing through Georgia and Azerbaijan. In the past, railways accounted for approximately 70% of all international traffic. At present, links with Georgia are frequently interrupted reflecting unstable political conditions in this country; also, recently the flow of supplies from Russia appears to be affected by the. conflict between those two countries over ethnic minorities. The trade route through Azerbaijan, which accounted for the bulk of Armenia's international freight 3/ Only Goga and the Baltic states arm not signaries.  AMVEX 5 transport, remains almost completely disrupted given the intensification of conflicts over the enclave of Nagorno-Karabakh. The authorities do not expect this situation to change any time soon. They believe that the opening of the border with !ran (the reconstruction of a connecting bridge was completed in May) provides the most realistic means of obtaining an alternative link to the outside world as the conflict with Azerbaijan also appears to be inhibiting the establishment of normal trading relations with Turkey Armenia has also reached agreement with Iran on the creation of Armenian zones for transshipme.t of goods at two Iranian ports opening on to the Caspian Sea and the Persian Gulf. Discussions are underway for obtaining similar treatment at the port of Poti in Georgia. 2. Inter-republican Trade 15. Current arrangements for inter-republican trade remain largely unchanged from those prevailing under the Soviet regime. This is due to the authorities' desire to avoid disrupting traditional trade links before new ones have been forged. In the absence of these conventional markets and suppliers, the concern is that domestic production might come to a complete halt. 16. No duties are levied on imports originating from other FSU countries and Armenia's exports benefit from reciprocal treatment. Inter-republican trade is dominated by the system of state orders and bilateral trade protocols. No import licenses are required but exports are subject to multiple restrictions (see below). 17. It appears that rules of origin are used to determine eligibility for preferential tariff treatment. It is worth noting that a full-fledged customs union with a common external tariff vis-a-vis third countries would not need rules of origin to regulate intra-Union trade. Under a customs union, any good imported from another member country would be entitled to duty-free treatment under the assumption that either the good is 100% domesdcally produced or that if it is imported or produced using imported inputs, the imports in question have paid the common external tariff at !te point of entry into the Union. By contrast, rules of origin are essential for determining eligibility for preferential treatment in the context of a Free Trade Association where member countries practice national tariff rates. 18. Inter-republican trade is governed by bilateral arrangements with each of the countries in the former Soviet Union. These trade protocols specify Armenia's imports and exports by volume. While price qiotations are included in some protocols (world prices are used to the extent possible, especially for internationally traded commodities), these are only indicative; only volumes are 'binding." Enterp.ises have been given responsibility for negotiating prices, with the explicit intention of increasing enterprise autonomy and moving increasingly towards market-oriented prices. However, there is some inconsistency in these arrangements; prices cannot be freely negotiated if the volumes are truly binding and volumes are not binding if the delivery fails to take place because no mutual agreement is reached on prices. In practice, the implementation of the trade protocols appears to be subject to discretionary control by the authorities depending on the nature of the goods in  6 AAWEX I question, with the state resorting to dictating prices if necessary to secure the purchase of strategic goods. 4/ 19. Substantial decentralization has occurred in the execution of the bilateral greeme. While in the past, all intra-Union trade was carried out by centralized trading institutiom organized along product lines, enteprises are now responsible for the receipt and delivery of goods themselves. As a result, some direct links appear to have been established among enterprises of the FSU, even while inter-republican trade corlinues to be subject to planning within a highly centalized and circumscribed framework. 20. The basis for the current trade protocols is provided by the bartet arrangements of 1990. These were based on an artificial division of production and trade imposed by the Soviet authorities, requiring delivery of pre-set volumes without any reference to "market" values. As such, the ttade protocols may yield significant trade imbalances between Armenia and its trading partners when the terms of trade are evaluated with reference to market or world prices. Given the sharp increases in the prices of raw material imports in particular, it is expected that Armenia will run a large trade deficit on interrepublican trade in 1992 (R 3192 million for the first half of 1992). Even though clearing arrangements have been signed with some countries (Russia, Ukraine, Turkmenistan), the authorities had not yet determined how these trade imbalances would be settled. 21. While no import licenses are required for inter-republican trade, r -umber of restrictions remains on exports. The most important are the obligatory deliveries of enterprise output to the state; these represent in effect production and export quotas. The institutional arrangements in this area differ only marginally from past practices. 22. On the basis of information provided through various sectoral ministries on the Republic's "needs" and in view of the trade protocols signed with other republics, the Ministry of &conomy determines the country's production priorities. It then stipulates to domestic enterprises the Government's demand for output and engages in turn to furnish the necessary inputs. While in the past Government demand accounted for 100 percent of local production, this figure has reportedly now dedcined to 50-60 percent and vares depending on the product, ranging from 100 percent for "sensitive" products, such as foodstffs and medication, to insignificant amounts for some consumer goods. Once the enterprise has delivered to the Government the production required for the domestic market (for distribution through the Government's wholesale and retail distribution network), has shipped to other republics the amounts stipulated in trade agreements and met the requirements of the stabilization fumd 5/, it is free to dispose of its remaining output as it sees fit. In principle, the Goverment's undertaking to frnish inputs extends only to the output demanded, for any production 4/ The mission was advised, for examle, that an Armenian entrprise unwilling to deliver pumps to a firm in Tajikian at the price proposed by the latter was instucted by the authorities to proCOeed with the transaction so as not to jeopardize deliveries of cotton - a 'strateic' good - from another enteprise in the same republic. I/ Ihe stabilization fund represents Government claims on enterprist production (the percentages vary across products) which can be used at a later date for bart tranctions. Ihe fund was set up for fuel, butter, grain and sugar and slated for elimination at the end of the year.  AMVEX 1 7 over and above that amount the entcrprise being lef. to its own devices to find suppliers and markets. In the current circumstances, field visits revealed that entrprises were obliged to find their own sources in view of the Government's inability to cany out its commitments. 23. In addition to the quantitative restric0tons on exports implicit in the arrangements discussed above, a license is required for the export (both within and outside the FSU) of 56 product categories. There appear to be two reasons for requiring licenses: V) to monitor that enterprises are fulfilling their obligations to supply the domestic market; and ii) to ensure that Armenia is obtaining a fair value for its strategic exports. Some of the goods which are subject to export license requirements represent products for which Armenia was the sole centralized producer under the Soviet regime. In light of this historical prolduction monopoly, the Government of Armenia wishes to ensure that export contracts involving these products take full advantage of the premium these goods should command within the FSU. As a result, in order to obtain an export license, an enterprise has to present to tne, Licensing Agency of the Ministry of Economy a copy of the sales contract, including the nature of goods imported as a counterpart to the export. The export license can be denied if local demand has not been met or if the terms of the contract are unsatisfactory, including if the goods to be imported are not considered a 'priority' for the country at the time. 24. While the boad framework for the conduct of inter-republican trade remains unchanged, the system has undergone some transformation - in part involuntary and in part due to explicit policy changes. The developments have been largely positive in that they are paving the way for a transition to a more market-based approach. These include: i) the decline in the share of state orders in total production; ii) enterprise-level negotiation of prices for trade specified in state protocols; iii) enterprise responsibility for delivery of the barter goods to other FSU countries although the Ministries and their agencies continue to handle domestic trade; iv) the breakdown of the system of Government delivery/guarantee of raw materials and the consequent need for enterprises to fend for themselves. All these encourage the development of enterprise to enterprise links and reduce reliance on the state for supplies as well as markets. 25. While central control over trade transactions has weakened and factors such as inertia, lack of competitiveness and the relative facility of transacting within the ruble zone are important incentives for continuing to trade with the FSU zone, the system of state orders and the bilateral trade agreements continue to bias trading decisions by acting as quantitative restrictions on exports outside the ruble zone. They impose a very high implicit tax on imports since by discouraging exports, Armenia deprives itself (or increases the cost) of the foreign currency which it needs to be able to import. This results in significant protection for import competing industries despite a relatively liberal system of imports. 3. Foreign Trade 26. Armenia applies the former USSR rates on imports from outside the FSU zone; these rates range from 0 to 15%. Import duties are collected at the Armenian border and Armenian goods transit through Russia and Georgia free of customs duties. Relations with Russia on transit matters are conducted within the framework of the multilateral agreements mentioned earlier. The authorities plan on negotiating a bilateral agreement with Georgia to provide a similar legal basis for current practices. Import declaration forms, accompanied by supporting documentation, contain the necessary  8 ANNEXI information to allow customs officials to distinguish between goods in transit and goods originating from other republics. In addition, detailed and coordinated verification procedures are designed to ensure proper follow through of goods in transit. 27. No import licenses are required except for health and safety reasons. A foreign exchange tax on exports was eliminated early this year but export licenses continue to be required for 56 products (the same as for interrepublican exports). As already discussed, export licensing requirements together with the state order system act as a disincentive to exports. At a time when Armenian enterprises should be encouraged to seek alternative outlets for their products, these restrictions are a particularly costly way of subsidizing domestic consumption. Export restrictions also serve to perpeuate the foreign exchange shortage created by the freezing of Armenian accounts in Vneshekonombank-Moscow (about $12 million and 53 million convertible rubles), thereby contributing to a severe contraction in imports. 28. Foreign exchange unavailability rather than governmental regulations hamper enterprises' ability to import. 100% retention of foreign exchange is allowed and on May 14, a new law was adopted which extends the right to open foreign exchange accounts to all residents. While some restrictions are applied on individuals (only for foreign travel etc), enterprises have legal access to foreign exchange for their foreign trade transactions. However, in the absence of foreign exchange in the banking system and a very limited unofficial market, enterprises which require imports are obliged either to export or to procure foreign exchange in other countries of the ruble zone. 29. Institutional wealness reinforces the financial constraints on foreign trade transactions. The severing of ties with the centralized trading organizations appears to have resulted in a loss of expertise and of commercial ties with companies abroad. Local companies will require time and assistance to establish such commercial links and to acquire marketing know-how. In addition, arrangements for freight forwarding appear to be disrupted, further hampering the development of international trade. In view of this institutional and financial hiatus, this year the Government decided to engage in government to government trade arrangements with a number of countries outside the PSU, including with Kuwait, Iran, Mongolia, Poland, Bulgaria, Hungary, Rumania and Cuba. All of these agreements are based on barter. While the authorities indicated that there have been some private imports and exports this year, they were unable to provide any data or details. C. sue 30. The main issue that is examined in this section is the appropriate trade policy for a land-locked, highly trade dependent country such as Armenia. In this context, special considerations for the short-term are highlighted. The discussion of trade policy encompasses the tariff regime, the state order system and other quantitative restrictions on trade, the institutional context and the taxation of international trade. 31. The Armenian Govermnent is in the process of reexamining its foreign trade policy and evaluating the merits of different courses of action. in making its assessment, the Government will have to consider a number of factors over which it has litde control: i) the future of the ruble zone; ii) the trade policies of other FSU countries; ard iii) the evolution of domestic prices and exchange rate movement. Other features of Armenia's current economic and trading environment  ANNEX I 9 will also require special consideration. As already discussed in Section A, trade accounts for a large share of gross national product and trade with FSU countries for an overwhelming share of total trade and total production in some subsectors. The Armenian industrial structure is facing upheaval due to a disruption in the system of state orders, a crisis in the financial system, a transport blockade, energy shortages and high levels of inflation. The conjunction of a high level of dependence on intra-FSU trade, lack of familiarity with alternative markets and suppliers, uncertainty about the ability of Armenian industries to compete on international markets and a rapidly changing business environment at home calls for caution in the design of trade policy. While an open trading economy based on low import tariffs is an important medium-term objective, some transitional measures may be required in an interim period to cushion the impact of reform on domestic industries. In particular, preferential access to the FSU market is likely to be a primary consideration in this transition period, which Armenian enterprises could use to prepare themselves for full competition on world markets. 1. Options for Trade Policy. 32, The trade policy options available to Armenia to manage the transition from the current highly-regulated and rigid system to an open and fully liberal one are explored in the following paragraphs. Decisions on trade policy are interlinked with the expected evolution in the exchange rate and in the monetary union. While the current undervaluation of the currency (620 rubles:US$1 in February 1993) provides substandal protection to Armenian (and FSUJ) industry, this situation can not be expected to continue. In view of other considerations which militate against recommending the introduction of a national currency in the short term (see paras. 66-69 in Vol 1, chapter II), the discussion below assumes that Armenia will stay in the ruble zone during the period of transition (12 months), and that the ruble will become a convertible currency with a more realistic rate of. -thange in the near future. 33. In the current circumstances, there are three possible options for trade policy: L. completely independent trade policy - i.e. Armenia sets its own tariffs applicable to all imports. ii. Customs Union with FSU countries - i.e. a common external tariff with duty-free trade among the Union members. iii. Free Trade Association with FSU countries - i.e. country specific customs tariffs but duty-free trade within the Free Trade Area. 34. The relative merits of the three options are examined below: L. A decision to pursue an independent trade policy means that Armenia would face positive tariff rates on its exports to the FSU countries. In light of the country's dependence on FSU countries as export markets, the main issue for consideration is whedter this would be the best course of action given on the one hand the importance of mintning domestic production at the present diffkult time and on the other the need to diversify trade partners. Would Armenia be able to compete with third  10 ANAEX I countries in FSU markets without the befit of preferential access to those markets? Would FSU trade losses be offset by increased trade with other countries in the &hort run? This issue is particularly relevant in the present context of rapid change in the economic environment where the ability of the enterprises to find new sources of supply and new outlets for their producs is limited. iH. Participation in a Customs Union implies an obligation to negotiate a conunon external tariff. The risk here is that the tariff structure which emerges from multilateral negotiations may not be to Armenia's liking - that is, the levels ana variance of tariff rates may be too high. In this case, the Government will have to evaluate the benefits of staying within the Customs Union which would permit duty- free import of raw materials from the FSU countries and preferential access to the Union markets for exports against the increased cost of raw materials and consumer goods imported from outside the FSU and the absence of incentives for Armenian industry to enhance efficiency so as to become competitive on world markets. iii. A Free Trade Association (PTA) has a number of advantages over a Customs Union, in particular for a small country which is unlikely to be able to influence the outcome of negotiations on a common external tariff. An FTA would in principle allow Armenia to set its own tariff rates and, by its nature, would incorporate an incentive for member countries to competitively reduce externa tariffs so as to capture a larger share of the region's foreign trade.' An FTA raises two central issues for Armenia - i) to what extent would other republics be intrested in participating in such an arrangement; and ii) to what extent can Armenia pursue a tariff policy which is independent of Russia's given that the latter accounts for 60% of Armenia's trade with the FSU? Assuming Armenia were to pitch its tariffs at a level lower than Russia's, trade between the two countries would be expected to equalize prices across the two countries. Given the relative sizes of the economies, the equalization would be likely to occur at Russia's price levels rather than Armenia's. This would mean that Armenian consumers would face higher prices despite the lower tariffs while the Government would have forgone potential tariff revenues in favor of transferring them to Armenian and Russian traders. The potential loss in Govermment revenues would be offset to the extent that Armenia's lower tariffs induce a diversion of Russian imports through Armenia. 2. Tariff rates. 35. Given that Armenia is a small, trade-ependent, enclave country, the medium term objective should be low and relatively uniform tariffs. In the short-term, however, in the face of urgent revenue requirements and the imperative of protecig the taxable base and preventing further falls in output, there may be a need for moderate tariffs - in the region of 20-25% - to protect