International Conference

«Conflicts in the Caucasus: History, the Present and Prospects for Resolution»

Baku (Azerbaijan) 22-23 October, 2012 and Tbilisi (Georgia) 25-26 October, 2012

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ECONOMY

Vaagn KHACHATRIAN

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Vaagn Khachatrian, Advisor to the president of the Republic of Armenia in 1996-1998 (Erevan, Armenia)

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In 2005, the Armenian economy continued to develop at a rapid pace characteristic of the past four years. According to official data, its gross domestic product (GDP) in 2005 exceeded the previous year’s level by 14%. This economic growth was accompanied by deflation (0.2%) and a further rise of the national currency against the leading currencies of the world.

The recovery of the past ten years can be explained by consistent implementation of reforms aimed at creating a market economy, facilitated by large-scale external financing in the form of various grants or favorable conditions. Nevertheless, Armenia remains a poor country with per capita income of $1,400, or a quarter of the figure for the Baltic countries.

Real Sector

Over the past three years, economic growth has accelerated still further. In 2001-2004, average annual growth was twice as fast as in the previous four years.

Table 1

GDP in 2000-2005

	2000	2001	2002	2003	2004	2005
GDP, billion drams	1,031.3	1,175.9	1,302.5	1,624.6	1,896.4	2,168.2
GDP, million dollars	1,911.6	2,118.4	2,376.3	2,807.1	3,555.1	4,756.9
Real GDP growth, %	5.9	9.6	13.2	14.0	10.1	14.0

Source: National Statistical Service (NSS).

According to the U.N. Statistics Division, in 2002-2004 double-digit growth was recorded in only six countries of the world (out of a total of 212 countries), with Armenia ranking fourth in 2002 (13.2%) and third in 2003 (14.0%). An interesting point to note is that average GDP growth in the republic in recent years was roughly twice as high as in the “lower middle income countries,” among which, according to the World Bank classification, Armenia belongs. In absolute terms, GDP in 2004 totaled AMD 1,896.4 billion ($3,551.1 million), and in 2005, AMD 2,168.2 billion ($4,756.9 million). This indicator, which reflects the size of the economy, is much lower than in other countries.

In terms of GDP volume, the Armenian economy in 2004 ranked 134th among 183 countries of the world. In 2005, the growth trend recorded in previous years was sustained. Thus, in the period from January to November, GDP grew by AMD 361.6 billion ($788.8 million). This was due to an increase in construction volume by 32.7% (AMD 1,233.1 billion), agricultural output by 10.9% (AMD 408.9 billion), industrial output by 6.8% (AMD 5,848.8 billion), services by 16.7% (AMD 281.4 billion), power generation by 6.2% (5,706.6 million kWh), foreign trade turnover by 31.7% (AMD 111.9 billion), retail turnover by 90% (AMD 740.3 billion), etc. Household spending increased by 11.7% to AMD 1,199.5 billion ($2.6 billion).

These figures show once again that in recent years serious changes have taken place in the very composition of GDP. Thus, in 2002-2005 agriculture and construction accounted for more than half of the country’s economic growth. As a result, the share of construction in GDP increased from 9.7% in 2001 to 15.5% in 2004 and 18.8% in 2005. The share of industry was virtually unchanged at about 20%, while the share of agriculture decreased from 25.6% in 2001 to 22.5% in 2004 and 21.3% in 2005 (see Tables 2 and 3).

Table 2

Real GDP Growth by Sector in 2000-2005 (%)

	2000	2001	2002	2003	2004	2005	2000-2005 (average)
Industry	106.6	103.9	113.9	115.6	102.1	106.6	108.1
Agriculture	98.9	111.7	103.8	104.2	114.1	110.9	107.3
Construction	128.9	104.8	141.5	145.5	113.4	134.1	128.0
Transport and communications	100.4	115.8	98.3	108.3	116.9	112.9	108.8
Trade	108.8	117.2	119.7	114.1	110.5	109.4	113.3
Other sectors	102.2	106.3	112.0	108.6	112.1	110.6	108.6
Net taxes	113.6	116.9	114.3	107.9	102.4	110.9	111.0
GDP	105.9	109.6	113.2	114.0	110.1	113.5	111.1

Table 3

GDP—Composition by Sector in 2000-2005 (%)

	2000	2001	2002	2003	2004	2005
Industry	21.9	20.1	18.9	19.3	19.1	19.7
Agriculture	23.2	25.5	23.4	21.5	22.6	21.3
Construction	10.3	9.7	12.6	15.7	15.5	18.8
Transport and communications	7.2	7.0	6.1	5.9	6.0	5.3
Trade	9.4	10.2	10.6	10.9	11.2	9.7
Other sectors	18.8	17.8	18.7	17.6	17.2	16.4
Net taxes	9.1	9.7	9.7	9.1	8.4	8.8
GDP	100.0	100.0	100.0	100.0	100.0	100.0

Sectoral Composition of GDP

In view of slower growth in industry, in 2004 its share in GDP fell by 0.2 percentage points compared to 2003 (to 19.1%), whereas in 2005 its growth accelerated and its share increased by 0.6 percentage points compared to 2004 (to 19.7%).

Growth rates in construction were also higher than in 2004. As noted above, in recent years construction has played a key role in GDP growth, boosting the development of the country’s entire economy.

As the tables show, after a certain decline in 2004 industry developed dynamically throughout 2005. The increase in construction volume accounted for about 40% of GDP growth. It should be noted that in 2005 construction made its largest contribution to GDP growth (5.2 percentage points) since Armenia’s independence in 1991.

In previous years, the greatest contribution was made by agriculture, which still has the largest share in the structure of GDP (about 22%).

Agriculture

The year 2005 was almost as successful for agriculture as 2004. Whereas in 2004 growth in agriculture reached 14.1% (a record high for the sector), in 2005 the figure was 10.9%, or AMD 559.0 billion ($120 million). Growth was recorded both in crop production (15.6%) and in livestock production (3.4%), which was largely due to favorable weather conditions.

Financial and Banking Sector

Under the Central Bank’s monetary policy program, inflation in 2005 was to have amounted to 3% compared to December 2004, given a 26% increase in the average annual money supply and a 13.6% increase in the monetary base. In actual fact, as noted above, there was deflation of 0.2%. In 2004, in contrast to previous years (2001-2003), the monetary base amounted to AMD 132.05 billion (as of 30 December), and growth of the money supply slowed down. The recorded increase in the monetary base (by 6.1%) was lower than real GDP growth, an unprecedented phenomenon for Armenia. The year 2005 put things right in this respect. In January-September, the monetary base increased by 3.17% (to AMD 173.8 billion), and at year-end, by another AMD 14 billion. In the first nine months of the year, cash in the banking system and cash deposits increased by 23% and 40%, respectively. Whereas in December 2004 currency in circulation totaled AMD 98,569 million, in September 2005 the figure was AMD 120,983 million (an increase of 22.7%), and in December, AMD 133,801 million (an increase of 37.5%). As regards dram deposits, in December 2004 they totaled AMD 46,919 million, in September 2005 the figure was AMD 65,905 million (an increase of 40.4%), and in December, AMD 73,171 million (an increase of 68.6%).

The latter was due to the following factors:

—high rate of economic growth (about 14%);

—increase in lending in the economy (in January-September, the increase for dram credits was 47.5%, and for foreign currency credits, 23%);

—growing confidence in the national currency, significantly enhanced by its rise against the dollar in the second half of 2004 (in 2003, 1 dollar equaled 577 drams, in 2004, 533 drams, and in 2005, 458 drams);

—implementation of the new Law on Currency Regulation and Currency Control (adopted in July), which helped to expand the sphere of dram circulation;

—final implementation (in July) of a system designed to guarantee the deposits of natural persons, which stimulated an increase in deposits by the middle classes;

—steady increase in gross national savings (in 2004, they grew by 29.6% to 18.6% of GDP, and in 2005, to 19.3% of GDP).

However, the problem of dollarization of the economy in general was not resolved either in 2004 or in 2005. Large volumes of dollar transactions in the economy tend to reduce the effectiveness of monetary policy, because it is impossible to control the supply of foreign currency. Consequently, efforts to control the money supply may fail to produce the expected results. As some studies show, the dollarization of the Armenian economy is growing in view of the dram’s internal and external instability, regardless of whether it strengthens or weakens.

High interest rates are another key problem of the financial market. Although the average interest rate on credit issued by Armenian banks over the past two years has declined, it is still very high: 18.8%. There is also a wide difference between the average lending and deposit rates: 13.7 percentage points (2005). This is a clear indication of high investment risk. Otherwise one could have expected a significant inflow of international capital into the country, which, judging from the figures of the capital and financial account of the balance of payments, has not occurred. Moreover, there is an outflow of financial capital caused by a decline in the value of the dollar in international markets.

Over the past two years, external risks associated with changes in the value of the dollar and financial inflows (especially private transfers) have played a significant role in Armenia’s financial market. The rate of increase in private transfers did not slow down either in 2004 or in 2005. According to some experts, they exceeded $1 billion, exerting additional pressure on the foreign exchange market. As a result, the national currency continued to strengthen in 2005 as well, pushing the dollar down to 458 drams.

To summarize the performance of the financial sector in 2005, let us note that:

—financial intermediation still has a superficial character, while the cost of borrowing remains high;

—in terms of quantitative indicators, the country’s banking system remains among the worst ones in the world. One of its key indicators—total lending as a percentage of GDP—is around 7-7.5%, whereas in the developed countries it exceeds 100% (in Switzerland, over 250%), which means that the banking system in these countries is one of the main institutions promoting economic development;

—among the factors contributing to the high cost of financial intermediation is the inadequate level of the corporate governance sector, where the first stage of reforms aimed at ensuring transparency, identifying property owners and specifying accountability levels has not yet been completed.

Fiscal Sector

In 2004, budget revenues totaled AMD 302.2 billion ($567 million), exceeding the target figure by 2.4%. Of these, budget revenues proper amounted to AMD $288.5 billion, while AMD 13.7 billion came from external sources (in the form of official transfers). Tax revenues for 2004 constituted 13.1% of GDP. And in January-November 2005, state budget revenues and official transfers totaled AMD 325,339.9 million, up 23.1% from the same period of the previous year. In January-November 2005, budget spending amounted to AMD 338,789.3 million, with a deficit of AMD 13,449.4 million. In dollar terms, the picture was as follows: revenues and transfers—$722.9 million; expenditures—$752.8 million; and deficit—$29.9 million.

For 2005 as a whole, the budget deficit amounted to 2.3% of GDP. Compared to previous years, it tended to increase (1.3% in 2003, 1.7% in 2004), but remained within acceptable limits (2.5-3%). In order to avoid problems in the future, it is necessary to broaden the tax base and improve tax performance indicators. This will make it possible to finance basic social needs, allocations for which have tended to increase since 2005. Thus, spending on science and education increased from 14.1% of the budget in 2004 to 15.4% in 2005, and the target figure for 2006 is 16.7%; in health care, the figures are 7.24%, 7.9% and 8.2%, respectively. In view of the limited tax base and dependence on direct taxes, the tax structure is unbalanced and tax collection for funding basic social needs is so far unsatisfactory. In view of this, given a high rate of unemployment and a large shadow economy, it would make sense to focus on direct taxation.

Table 4

Budget Revenues, Expenditures and Deficit in 2001-2005 (million drams)

	2001	2002	2003	2004	2005
Revenues and official transfers, total	193,577.8	228,317.9	292,035.3	302,200.0	351,700.0
As % of GDP	16.5	16.8	18.0	15.9	16.2
Expenditures, total	244,381.5	263,912.4	312,697.8	334,000.0	401,100.0
As % of GDP	20.8	19.4	19.3	17.6	18.5
Deficit financing	50,803.7	35,594.5	20,662.5	31,800	49,400
As % of GDP	–4.3	–2.6	–1.3	–1.7	–2.3
Current revenues	182,682.7	209,534.1	238,293.1	273,387.7	333,276.9
As % of GDP	15.5	15.4	14.7	14.4	15.4
Of which: tax revenues	154,892.3	185,437.4	212,232.8	248,109.9	296,835.4
As % of GDP	13.2	13.6	13.0	13.1	13.7
State duties	13,916.7	13,181.5	15,213.7	16,059.8	17,169.5
As % of GDP	1.2	0.95	0.9	0.8	0.8
Non-tax revenues	13,873.7	10,915.2	10,864.6	9,217.9	19,272.1
As % of GDP	1.2	0.8	0.7	0.5	0.9

Sources: NSS; preliminary data for 2005.

As we find from Table 4, state budget revenues in 2005 amounted to 16.2% of GDP; of this, tax revenues and state duties added up to 14.5%. Tax revenues increased by 18.5% compared to 2004, largely owing to a high rate of collection of direct taxes. The increase in profit tax was 46.5%, and in income tax, 29%. The former was due to changes in the methodology of profit tax computation, which resulted in a significant reduction in the number of loss-making enterprises. And the increase in the income tax indicator was due to significant wage rises in the public and private sectors of the economy (by 24%).

For indirect taxes the picture was as follows: VAT collections increased by 26.6%, and excise tax amounts fell by 5.6%. The former was due to an increase in imports (by 30.4% compared to 2004). Budget expenditures in 2005 constituted 18.5% of GDP, going up by AMD 67,100 billion (20.1%) compared to 2004. Most of these funds went to finance reforms in the social sphere and in government administration, to strengthen the country’s defense and protect public order, and also to assist local government. Capital expenditures increased by as much as 220%, reaching AMD 57.1 billion, while the increase in current expenditures was more modest: by 21.8%.

Such an increase in capital expenditures was due to the implementation of various programs by the country’s government and by international organizations (jointly or separately), World Bank loans, credit programs implemented with the assistance of the German government, etc.

Significant progress was made in the social insurance sector. Compared to 2004, spending in this sector increased by more than AMD 27.1 billion (by 46.5%) to AMD 85.3 billion ($18.6 million), which made it possible to raise pensions to 4,250 drams (from 3,000 drams in 2004), and the value of one insurance year, to 180 drams (from 160 drams in 2004). This was mostly due to a 53.5% increase in mandatory contributions to social funds made by employers (to a total of AMD 65.4 billion). A significant amount was also obtained from the state budget in the form of an official transfer: AMD 19.9 billion (an increase of 27.6%).

External Sector

In January-September, the deficit of the current account of the balance of payments amounted to $114.01 million, decreasing by $36.4 million (by 24.2%) compared to the same period of 2004; as a percentage of GDP, the current account deficit was 3.6% (compared to 6.6% in 2004).

As in previous years, the current account deficit was largely the result of imports, while its reduction was caused by the following factors:

—an increase in foreign direct investment (FDI). Whereas in 2004 FDI totaled $150 million, in 2005 the $150 million mark was already passed in September;

—an increase in current transfers, which reached $254 million in September 2005, exceeding the same indicator for 2004 by $30 million;

—a decrease in the capital account, on the contrary, prevented a reduction in the deficit. In September, it reached $117.7 million compared to $147 million in 2004. This was due to lack of financing by the Lincy Foundation. As noted above, a significant effect on the size of the current account deficit is exerted by imports and the balance of trade, which has been negative in recent years. In September 2005, the trade deficit amounted to $394.8 million, or 12.5% of GDP (owing to rapid growth of GDP: in September, GDP reached $3.1 billion). In relative terms, the trend here has been positive: in 2003, the figure was 15% of GDP, and in 2004, 13.1%. However, as a factor characterizing the economy it shows that imports still have a great influence on the country’s economy, while actual growth in exports so far does little to reduce unemployment or alleviate poverty.

In January-November, the country’s trade turnover totaled $2,449 million, including exports—$867.4 million, and imports—$1,581.6 million, so that the trade balance was negative: $714.2 million. Compared to the same period of 2004, exports rose by 34.2%, imports by 30.4%, and the deficit by 26.1%. In relation to GDP, exports amounted to 20.7%, and imports, to 37.7%. In absolute terms, exports (excluding diamonds) totaled $624.8 million (40% increase), and imports (excluding diamonds), $1,329.3 million (31.9% increase). In Armenia’s foreign trade turnover, the largest share—34.9%—belongs to the countries of the European Union; the CIS republics have 25.1%, and other countries, 40%. Incidentally, compared to the same period of 2004, the share of the CIS countries increased by 5%.

It should be noted that Armenia’s top five partner countries, including Russia, Germany and Belgium, account for about half the total volume of Armenia’s foreign trade.

Table 5

Major Trading Partners (January-November 2005) (%)

	Trade	Imports	Exports
CIS countries	25.1	22.0	18.6
EU countries	34.9	33.6	46.7
Other countries	40.0	44.3	34.7
Individual countries:
Russia	12.9	13.1	12.4
Germany	10.8	8.0	15.7
Belgium	10.2	8.4	13.6
Israel	8.1	6.2	11.7
USA	6.5	6.4	6.7
Great Britain	0.4	0.6	0.0
Iran	4.0	4.7	2.7
Switzerland	3.1	2.8	3.8
Georgia	2.0	1.0	3.9
United Arab Emirates	1.0	0.9	1.1
Turkey	2.3	3.4	0.2
Ukraine	5.1	7.1	1.4
Turkmenistan	4.1	6.3	0.1
Total, thousand dollars	2,448,963.4	1,581,581.3	867,382.3

Source: NSS.

According to NSS data, Armenia’s total external debt at the end of September 2005 stood at $1,819.87 million, having shrunk by $8.16 million in a few months (from the end of June).

Conclusions

In 2005, the Armenian economy continued to develop at a rapid pace characteristic of previous years. GDP growth of almost 14% was coupled with deflation (by 0.2%) and a strengthening of the dram against the world’s leading currencies. Such rapid growth was due, among other things, to the small size of the republic’s economy (in terms of GDP, it ranked 134th among 183 countries).

Per capita GDP was $1,480 compared $1,106 in 2004, which was due both to economic growth and to the above-mentioned rise of the dram against the U.S. currency. Government spending as a percentage of GDP has been relatively stable in recent years (10-11%), which cannot be regarded as an additional incentive to economic growth.

The greatest contribution to GDP growth was made by construction, agriculture and industry (the first two sectors increased GDP by 7%). Rapid growth in industry was generated by the restarting of long-idle enterprises. After a year’s break, construction once again became the country’s economic locomotive, growing by 34% and sustaining the positive trends of the previous two years. For agriculture, 2005 was just as unprecedented as 2004, with rapid growth recorded both in crop production (by 15.6%) and in livestock production (by 3.4%). Gross output increased by 11%.

The average monthly pension constituted 21-22% of the average wage. Compared to 2004, the annual consumer price index showed a tendency toward deflation (0.2%) instead of the 3% inflation projected by the Central Bank. Although the strengthening of the dram was conducive to deflation, preventing a significant rise in the prices of certain goods on the foreign market, its influence on inflation/deflation for the Armenian consumer, in my opinion, was around 1-2%.

The average figure for the economically active population was 1,205.0 thousand, including 98.8 thousand (8.2%) jobless people officially registered as unemployed. According to the methodology of the International Labor Organization, the unemployment rate in Armenia was over 31%. The labor market remains fragmented, and labor mobility in the country is low.

After a year’s break, there was a rapid increase in the monetary base and the dram money supply. Given the instability of the dram (regardless of its rise or fall), the degree of dollarization increased still further to an estimated 82%.

Interest rates on credit provided by commercial banks were reduced, but still remained quite high: at 18.8%. The gap between the lending and deposit rates was significant as well: 13.7% percentage points, which indicates a high degree of investment risk.

The budget deficit amounted to about 2.3% of GDP. Compared to 2004, budget expenditures as a share of GDP increased by about 1 percentage point, with better budget performance for capital than for current expenditures. Gross external debt was reduced by 3.4%, and net external debt, by 16%. The latter amounted to 19.11% of GDP. Compared to 2004, the trade deficit reached $714.2 going up by 26.1%. Owing to GDP growth, the trade deficit fell by 0.3 percentage points to 15% of GDP (from 15.3% in 2004).

Overall, economic growth indicators in Armenia are most impressive and have already had a significant effect on poverty reduction. Extreme poverty was reduced by 21%, and overall poverty, by 17%, although more than a third of the country’s population is still ranked as poor.

Economic growth continues to depend on external funding sources (although the level of domestic savings has continued to grow) and is based more on investments and an increase in productivity than on an increase in employment.

In terms of quantitative indicators, the banking system remains among the worst ones in the world.