Republic of Armenia—Letter of Intent, Memorandum of Economic and Financial Policies, and Technical Memorandum of Understanding

October 30, 2003

The following item is a Letter of Intent of the government of the Republic of Armenia, which describes the policies that the Republic of Armenia intends to implement in the context of its request for financial support from the IMF. The document, which is the property of the Republic of Armenia, is being made available on the IMF website by agreement with the member as a service to users of the IMF website.

Mr. Horst Köhler
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. Köhler:

The purpose of this letter and the attached Memorandum of Economic and Financial Policies (MEFP) is to inform you of progress in implementing the program supported by the Poverty Reduction and Growth Facility (PRGF), request a waiver for the nonobservance of the June performance criterion on domestic arrears, and set out the policies for the third annual program under the arrangement.

Based on discussions held with Fund staff during July-September 2003 on the fourth review of the PRGF arrangement, the MEFP reviews economic developments and policy implementation through September 2003, updates the macroeconomic framework, and discusses the financial policies and structural reform program for the period July 2003-June 2004. The government intends to make these understandings public and authorizes the IMF to publish this letter, the attached memorandum, the Joint Staff Assessment of the Poverty Reduction Strategy Paper (PRSP), and the staff report.

The structural performance criteria and all except one of the quantitative performance criteria for the first half of 2003 were observed. The end-June 2003 performance criterion on the stock of domestic expenditure arrears was exceeded by a small margin because of difficulties in expenditure control. To address this problem, we adopted earlier this year amendments to the budget law to enhance commitment control.

The government's economic program aims at providing the conditions for continued high real economic, maintaining inflation at no more than 3 percent, and enhancing tax revenue collection. The program focuses on five key areas: (i) monetary policy focused on price stability; (ii) fundamental improvements in tax and customs administration; (iii) enhanced control, reporting, and prioritization of government expenditures; (iv) reforms of the key state-owned companies in the energy, water, and irrigation sectors; and (v) reduction in administrative barriers and opportunities for corruption. The government is also committed to pursue the objectives set out in the PRSP. The paper is the centerpiece of the development strategy of Armenia and will be regularly updated to reflect ongoing developments and evolving priorities.

The government believes that the policies and measures described in the MEFP are adequate to achieve the objectives of the program, but it stands ready to take any additional measures that may be required. The government will consult with the Fund in advance of the adoption of any such measures or on any revision of the policies covered in the MEFP in accordance with the Fund's procedures for such consultations. It will also provide the Fund with the information required to assess progress in implementing the program.

Sincerely yours,

GOVERNMENT OF ARMENIA
MEMORANDUM OF ECONOMIC AND FINANCIAL POLICIES

This memorandum sets forth the government's economic objectives and policies for the period July 2003 to June 2004, the third year of the program supported under the Poverty Reduction and Growth Facility (PRGF). These policies constitute an integral part of the government's medium-term strategy for poverty reduction as envisaged in the recently approved Poverty Reduction Strategy Paper (PRSP).

Recent Developments and Performance Under the Program

1. The Armenian economy continues its strong performance in 2003. Real GDP grew by 15.2 percent in the first nine months of the year compared with the same period last year, bolstered by higher construction activity and a robust increase in the output of metals and precious and semi-precious stones. The 12-month rate of inflation rose from 2 percent at end-2002 to 7.5 percent in September 2003 mainly reflecting a large increase in the price of bread in June and September of this year.¹

2. During the twelve months through September 2003, reserve and broad money grew by 29 percent and 19 percent, respectively. Official net international reserves continued to be at a comfortable level and the dram remained broadly stable in both nominal and real terms this year.

3. Fiscal policy remained broadly on track in the first half of 2003, with tax revenues rising to AMD 100 billion. Both current and capital expenditures were somewhat lower than projected, the latter reflecting capacity constraints in project implementation units and a harsh winter. As a result, the deficit of the central government on a commitment basis amounted to just AMD 7 billion in the first half of the year compared with a programmed level of AMD 15 billion.

4. With regard to the main monetary and fiscal quantitative targets under the program, all but one of the end-June 2003 performance criteria were observed. The performance criterion on the stock of domestic expenditure arrears was missed by a small margin because of technical problems in the execution of expenditures.

5. On the structural side, the two performance criteria and most of the benchmarks scheduled for implementation under the fourth review of the program have been met. Three structural measures scheduled for June 2003 suffered a delay but two of them (issuing an order establishing a post-clearance verification program at customs and preparing a report on the audit operations of customs) have been implemented since then. The financial rehabilitation plan for the energy sector will be adopted by November 6, 2003 (prior action).

6. Developments in the banking system were mixed. A few banks continued to incur losses, reflecting weak asset quality. At the same time, commercial banks' exposure to the energy sector declined substantially. As planned, minimum capital requirements were raised from US$1.65 million to US$2 million in July 2003. Furthermore, the central bank submitted to the government amendments to the Law on Bankruptcy of Banks to execute more effectively bank resolution strategies; the Law on the Central Bank of Armenia to include specific clauses on the deposit insurance scheme; and the Civil Code to more effectively create, register, and enforce pledges. The amendments to the Civil Code have already been approved by parliament.

7. Further progress was made toward resolving the situation of the remaining three large intervened banks. Ardshinbank has been resolved through a purchase and assumption transaction and two least-cost analyses have been formulated for Armcommunications bank. The second least-cost test is based on a different set of assumptions regarding the chemical plant Nairit, the primary debtor of the bank. One key assumption is that a large infusion of private capital will be made to Nairit and enable the company to repay its loan to Armcommunications. The process of resolving the situation of the bank, however, has been rather slow, as the new foreign investor has tentatively agreed to operate Nairit pending further evaluation of the feasibility of the deal and the results of an audit of the company. Lastly, progress continues toward reducing the liabilities of Credit Yerevan, the third large intervened bank.

8. The envisaged reforms in the fiscal area were also implemented. In April 2003, the government amended the budget law with a view to enhancing expenditure control and began working on a plan to facilitate the proper monitoring and reporting of noncommercial enterprises (NCEs).² The administration of the value-added tax (VAT) is gradually improving: the processing time for exporters with a good compliance history has been shortened and the first quarterly report on outstanding VAT refunds has been published. The internal audit unit of the State Tax Service has published its first quarterly report and a similar report has recently been prepared by customs. Lastly, the latest version of the automated system of customs data (ASYCUDA) has been introduced at all customs' houses and customs' points.

9. The energy sector is undergoing significant reforms. As part of the debt-equity swap with Russia and in exchange for outstanding debt for nuclear fuel to a Russian supplier, the financial management of the nuclear power plant, the Hrazdan thermal power plant, and the Sevan-Hrazdan Cascade hydropower plant have been privatized. In the midstream sector, the transmission, dispatch and settlement functions have been separated. Reflecting improved performance of the privatized distribution company, collection rates have been at almost 100 percent throughout this year. The consolidated primary balance of the state-owned energy companies worsened in the second quarter of 2003, reflecting a delay in the delivery of nuclear fuel and higher use of more expensive thermal generation. As a result, the indicative target on the primary balance of the energy sector was missed by a small margin.

II. The Program for the Period July 2003-June 2004

10. Economic objectives and policies. The government's economic program aims at achieving the following core objectives:

• Providing the conditions for real economic growth of at least 12 percent in 2003 and 7 percent in 2004 so as to improve real per capita income and reduce the incidence of poverty;

• Maintaining the 12-month rate of inflation at no more than 3 percent and gross international reserves at more than 3.5 months of imports; and

• Further enhancing tax revenue collection in order to realize higher levels of social spending and public sector investment while controlling the fiscal deficit and public debt ratios.

The program for the coming year focuses on five key areas: (i) maintaining an independent monetary policy focused on price stability; (ii) reforming tax and customs administration; (iii) enhancing control, reporting, and prioritization of government expenditures; (iv) restructuring key state-owned companies in the energy, water, and irrigation sectors; and (v) reducing administrative barriers and opportunities for corruption.

11. Monetary policy. The overriding macroeconomic objective of the central bank will remain price stability. To this end, the Central Bank of Armenia (CBA) will use all instruments at its disposal to maintain inflation at no more than 3 percent while allowing the exchange rate to be market-determined. This will require a more cautious monetary policy in the remainder of 2003 and close monitoring of inflation, particularly because of a likely increase in administered prices (electricity, gas, and water). The monetary program for the remainder of 2003 and 2004 reflects this objective but anticipates further increases in the demand for money based on the remonetization of the economy and a gradual return of confidence towards the banking system. Broad money is projected to grow by about 12 percent in each year (2003 and 2004).

12. Fiscal stance and expenditure policy. Fiscal policy will remain prudent and no further domestic or external expenditure arrears will be incurred. The fiscal deficit on a commitment basis is projected at 2-2.5 percent of GDP in 2003 and 2004. In 2003, while nominal tax revenue targets will be met, tax revenues are likely to decrease as a share of GDP. This is due to strong GDP growth in nontaxed sectors such as construction as well as protracted weaknesses in tax and customs administration. The latter problems will be tackled forcefully from now on to ensure a satisfactory revenue performance and achieve an increase in tax collections in 2004 of about 0.5 percentage points of GDP. The nominal tax target for 2004 could be subject to revision in light of new developments during the year and a supplementary budget could be prepared as needed. The budgeted level of social expenditures (health, education, and social security) will be fully executed in 2003 and those expenditures will increase by 0.4 percent of GDP.

13. The 2004 budget. The budget for 2004 will be based on total domestic (tax, nontax, capital) revenues of AMD 261 billion, current expenditures of AMD 238.2 billion, and a fiscal deficit on a commitment basis (after grants) capped at AMD 43 billion. With regard to capital expenditures, we will improve the execution of programmed capital spending by raising efficiency in project implementation units. After the exceptionally high levels attained in 2002-03, externally financed public investment could decline by as much as 2.6 percent of GDP in 2004 because of lower private capital grants. This will be partially compensated by an increase in domestically financed capital expenditures from 1.1 percent of GDP in 2003 to 1.4 percent (AMD 23.5 billion) in 2004. If external capital grants are secured by the time the budget is finalized, such grants will be added to the budget figures but the amount of domestically financed capital expenditures will be maintained. This will ensure a level of capital expenditures closer to the public investment needs envisaged in the PRSP and the provision of adequate financing for maintenance costs of public investment projects.

14. Tax policy. During the program period, we will undertake a number of measures to achieve our tax revenue target and improve the tax system. This will include reforming the VAT to improve its efficiency and reduce distortions. The main tax policy measures are:

• Introducing a minimum profit tax of 1 percent of companies' gross sales (expected yield: AMD 3 billion). Legislation on this tax will be passed by parliament by year-end and the tax will be enforced effective April 1, 2004;

• Amending the profit tax law in line with best international practice by March 2004. The amendments will include limiting the amount of interest deductibility to prevent thin capitalization or to limit interest payments if they exceed interest rates set by the CBA, enforcing withholding rules on employees, tightening loss carryover provisions, eliminating deductions for indirect taxes (especially the VAT), and ensuring that depreciation rules distinguish between expenses related to repairs and improvements that should be amortized (expected yield: AMD 1 billion)

• Increasing presumptive taxes on certain activities by January 1, 2004 so that overall presumptive tax revenue increases by 10 percent next year (expected yield: AMD 0.3 billion). These tax payments currently apply to various goods (such as cigarettes and diesel fuel) and services (such as haircuts), and have not been raised since their introduction in 1998;

• Make the presumptive tax on natural gas used by vehicles a function of sales, while increasing the minimum tax on each pump from 1 million drams per month to 1.5 million drams per month (expected yield: 0.4 billion drams);

• To ensure that the incentives to use natural gas are not eroded, we will introduce a presumptive tax on petrol stations based on the number of gasoline pumps, as it is currently done for natural gas (expected yield: AMD 0.3 billion).

• Introducing a stamp system to collect the excise tax on beer and bring such collection in line with that of other alcoholic beverages facing similar taxes (expected yield: AMD 0.3 billion).

15. VAT exemptions on imports. We will take a phased approach to reforming the VAT, in line with our institutional capacity and availability of technical assistance. First, we will approve legislation to reduce the coverage of imports currently exempt from VAT at the border effective January 1, 2004 (expected yield: AMD 1 billion). This reduction will amount to at least 282 customs lines representing 23 percent of the value of the potentially taxable imports in 2002 (AMD 19.5 billion). Second, we intend to expand the use of the current regime of temporary imports for processing of imported raw materials and intermediate goods destined primarily for exportation. At the same time, we will eliminate the penalty imposed on manufacturers who do not export 100 percent of their production. This penalty will only be applied to manufacturers who export less than 70 percent of their production. The last two measures will help alleviate some of the financial burden now faced by some importers and create incentives to expand production for both the export and the domestic market thus reducing the distortion imposed by these exemptions. Third, we intend to further reform the VAT regime by developing a deferral payment system for large imported capital goods (valued at more than US$100,000). These capital goods are currently exempt from VAT liability at the border as a way to reduce the transaction costs of these imports. A commission (comprising representatives from the Ministry of Finance, Ministry of Trade and Development, State Tax Service, and State Customs Committee) will establish the information and technical criteria for granting a deferral in early 2004. By mid-2004, we intend to implement this deferral system on a pilot basis. The criteria for determining the items that will be covered under the pilot project will be developed in consultation with Fund staff.

16. Tax administration. During the program period, the government will step up its efforts to improve tax administration and remove remaining loopholes in the tax system to enhance equity, efficiency, and boost collections. To improve the withholding of income tax, we will amend legislation to oblige employers to provide detailed information on their employees. We will also improve the registration and accounting of business inventories and sales and revise the Enterprise Profit Tax form to include information on companies' balance sheets. By end-December 2003, we will clarify Article 4 of the Law on Simplified Tax so that it applies to taxpayers and not activities in order to limit the fragmentation and erosion of the profit tax base. In this context, we will also limit the ability to move between the profit tax and the simplified tax system. To enhance transparency, we will publish a list of delinquent taxpayers in the official gazette and the media. Lastly, we will regulate the use of cash registers and register traders as businesses in large retail markets to increase tax revenues from these markets.

17. Budget management and reporting. Based on Fund technical assistance, we will implement a forward looking financial planning and cash management procedure. A draft manual that governs internal audit in line ministries and subordinate organizations will be completed this year. To ensure transparency and efficiency in the operations of NCEs, we will develop procedures for supervising and monitoring these enterprises. By end-November 2003, we will adopt the legal basis for a reporting system for NCEs and designate a monitoring unit for these entities within the Ministry of Finance. Minimum criteria will be developed for deciding when an NCE should be considered as part of the general government or as part of the public corporations sector (the activities of the latter will not be consolidated into the general government accounts). Steps will also be taken to prohibit NCEs from borrowing and ensure that their activities are subject to random audits. Furthermore, all NCEs will submit budgets and begin regular reporting of revenues and expenditures. This will enable the preparation of consolidated government reports by the treasury, combining both budgetary institutions and NCEs. By April 2004, the budget execution reporting by NCEs and the consolidation of their activities at the general government level will be operational.

18. Customs administration. There is an urgent need to improve transparency and efficiency of the customs service and eliminate loopholes and inconsistencies in legislation. As mentioned above, all customs houses and customs points have been updated with the latest version of ASYCUDA. Later this year all customs houses and passport-reading machines will be networked by a single system.³ Despite lack of progress in populating the valuation database with invoice values, we will ensure that the share of commercial imports whose approved customs value is determined by the transaction price will increase to at least 25 percent by December 2003 and 50 percent by mid-2004. As more imports are valued at transaction prices, a system of post-clearance audits is required. This program will become operational by the end of this year. As part of the ASYCUDA upgrade, beginning January 2004, we will implement a system whereby commercial importers and brokers will be able to prepare their own customs declarations at the time of importation using the customs computer system.⁴ By year-end, we will review legislation with a view to reducing document requirements and eliminating the certification fee for exports. We will also eliminate a provision in the customs code (Article 105.5) that allows importers to circumvent paying customs duties by removing the manufacturers' labels of goods carried when entering Armenia. Finally, we will pass legislation to ensure that customs clearance of all petrol imports is undertaken at the point of entry in order to reduce smuggling.

19. Banking supervision and problem banks. The CBA will continue to strengthen banking supervision, act decisively against banks that violate prudential norms, and ensure that all market participants operate on equal terms. In this regard, the CBA is preparing an offsite inspection manual that will enhance day-to-day supervision. In addition, a manual on interim administration will be drafted with a view to enhancing the efficiency of resolutions of problem banks. Following the purchase and assumption of the major share of the assets and liabilities of Ardshinbank by a new bank, the remains of Ardshinbank are in the process of being liquidated. By end-November 2003, the CBA will revoke the license and nominate a liquidator for Credit Yerevan. By that time, we will also make a final decision on the future of Armcommunications. Assuming an agreement is reached with the investor for Nairit, the CBA will prepare a detailed and time-bound action plan—including resources paid and committed by the potential investor—that will demonstrate the viability of the potential transaction, i.e. a decline in Nairit's outstanding liabilities and a replenishment of the capital of the bank. If the agreement fails, the CBA will nominate liquidators for Armcommunications by end-November 2003.

20. Financial sector legislation. Enhancing the legal framework of the financial system and the functioning of the judiciary remains a key priority for financial sector development. Following the submission to the cabinet of draft amendments to the Law on Bank Bankruptcy and the Central Bank Law, we expect these amendments to be adopted by parliament by end-2003. In addition, before the end of the year we plan to submit to parliament new legislation on the mandatory registration of the title of movable property. The CBA will also draft amendments to various legal acts on corporate governance in line with best practice to enhance the management, transparency, and accountability of commercial banks.

21. Balance of payments. The current account deficit as a share of GDP is expected to deteriorate in 2003, reflecting strong import growth. Such import growth is partly associated with unusually large grant-financed investments that led to a surge in imports of construction material, machinery, and equipment during the first half of the year. Grant-financed investment is expected to fall rapidly after 2003 and contribute to a reduction in the current account deficit as a share of GDP in 2004. At the same time, the services balance is projected to improve because of higher tourism receipts and the growing export-oriented software industry. Gross international reserves are targeted to remain at over 3.5 months of imports of goods and services in 2003 and beyond.

22. External debt. The government will not accumulate external nonconcessional debt or external payments arrears of any sort during the program period. The debt-equity swap with Russia has just been finalized thereby exchanging about US$94 million in debt for assets in Armenian companies. Similarly, the outstanding debt to Turkmenistan of US$11 million has been paid through the provision of goods.

23. Trade and foreign exchange regime. Armenia became a member of the World Trade Organization in February 2003. We will ensure that recently passed legislation adhering to WTO rules is fully enforced. Furthermore, no distinctions will be made between WTO members and other countries when applying customs valuation methods. Armenia will maintain a floating exchange rate regime and a liberal trade regime with no restrictions in the making of payments and transfers for current international transactions. The latter are in conformity with Article VIII of the IMF's Articles of Agreement.

24. Energy Sector. By early November, the government will approve the Integrated Financial Rehabilitation Plan for the energy, water, and transport sectors and pass a resolution to enforce the implementation of institutional reforms and debt restructuring measures recommended in the plan. The plan is the centerpiece of future reforms of the sector in light of the recent privatization of the distribution company and a major power plant and the need to address protracted problems of mismanagement. In this regard, the energy sector is moving away from a single-buyer approach towards a model with direct or pooled-direct contracting of energy purchases between the distribution company and the power generators. By February 2004, the structure of the existing settlement, dispatch, and transmission companies in the midstream energy sector will be based on the recommendations of the plan, and a corporate governance structure will be established with independent board of directors and internal and external audit mechanisms. At the same time, Armenergo will be removed from the contracting process and by end-June 2004 Armenergo will be liquidated and all of Armenergo's outstanding liabilities to the government will be written off and the remaining debt will be restructured to arrive at a manageable debt burden. By mid-2004, the management of midstream operations will be governed by private performance-based management contracts. The government also intends to privatize the Vorotan Cascade hydropower plant and, eventually, the Yerevan Thermal Power Plant, based on transparent and competitive international tenders. As part of our reform of the energy sector, by January 2004, the Ministry of Energy will be transformed into a policy-making body and all business management functions will be vacated.⁵ Lastly, the newly reorganized regulatory commission for natural monopolies will regulate, oversee, and set the tariffs for the power and water sectors. It will ensure that proper and adequate regulation is in place to enhance transparency in these sectors.

25. Water and irrigation sectors. By the end of this year, the government will issue a tender to privatize the management of the Armenia Water and Waste Company. Water tariffs will gradually rise over the next few years to reach operations and maintenance cost recovery levels by 2007. In the irrigation sector, the management of infrastructure will be transferred to user associations over the medium term. Such a decentralized approach is expected to increase the efficiency of operations. Over the next few years, tariffs for bulk and end-users are expected to increase gradually, approaching cost recovery levels by 2007. The government will actively monitor the impact on the poor of these increases, and will stand ready to increase family support benefits if needed to compensate for such increases.

26. Anti-corruption. As part of our renewed efforts to root out corruption, we will finalize an anti-corruption strategy covering a wide range of measures in November 2003 and make the document available for comments from parliament and international donors. The strategy will lay out the main sources of corruption in Armenia and include a time-bound action plan with measures derived from the strategy. Particular emphasis will be placed on ensuring a sound legal framework (covering legislation that treats corruption as a criminal offense, freedom of information acts, and "whistle blower" protection legislation) and including measures to improve transparency in the judicial system, the police, and in customs and tax administration. The government will also ensure public scrutiny of the strategy and update it periodically in response to feedback from civil society.

27. Program monitoring. Program monitoring will be carried out according to semi-annual quantitative performance criteria (end-December 2003) and quarterly indicative targets for the first half of 2004 (Table 1) and structural performance criteria and benchmarks (Table 2). The quantitative performance criteria include ceilings on the net domestic assets (NDA) of the CBA, net banking system credit to the government, domestic expenditure arrears of the central government and the SFSI, net disbursements of short-term external debt, contracting and guaranteeing of new non-concessional medium- and long-term external debt, and external arrears. They also include floors on net official international reserves of the central bank, tax revenues of the central government, and the cash balance of the central government. There is an indicative band on reserve money, and an indicative floor on the primary balance of the energy sector. Details on the definitions, monitoring, and adjustors of quantitative performance criteria are contained in the attached Technical Memorandum of Understanding (TMU). A request for the sixth disbursement under the PRGF arrangement is contingent upon the observance of the performance criteria set out in Tables 1-2, and the completion of the fifth review under the program expected on April 15, 2004.

28. Compilation and provision of information. To insure the effective monitoring of the program, the relevant ministries, the CBA, and the National Statistics Service (NSS) will compile and share with Fund staff all core economic data on a timely basis as specified in the TMU.

¹ This item alone accounts for close to one-fifth of the consumer price index.

² In early 2003, about 5,000 budgetary institutions were converted into non-commercial enterprises as part of a fiscal decentralization plan. These units, however, are not subject to standard reporting and auditing requirements, making it difficult for the government to assess their performance, the use of public funds, and the associated fiscal risks.

³ Once this network is put in place, the customs code will be amended to set a 48-hour minimum stay in a foreign country in order to become eligible for duty free exemptions.

⁴ Once the information is inserted into the customs computer system at customs houses, it will be printed and signed by the importer.

⁵ Up until now, the Ministry of Energy has been engaged in financial and strategic decisions affecting state-owned companies including external debt transactions.

GOVERNMENT OF ARMENIA
TECHNICAL MEMORANDUM OF UNDERSTANDING

This memorandum defines the benchmarks, performance criteria, adjustors, and reporting modalities referred to in the Memorandum of Economic and Financial Policies (MEFP).

I. Quantitative Targets

1. The program targets a minimum level of net official international reserves (NIR) of the Central Bank of Armenia (CBA). The stock of such reserves will be calculated as the difference between total official gross international reserves and official reserve liabilities. Total gross official international reserves are defined as the CBA's holdings of monetary gold (excluding amounts pledged as collateral or in swaps), holdings of Special Drawing Rights (SDRs), any reserve position in the IMF, and holdings of convertible currencies in cash or in nonresident financial institutions (deposits, securities, or other financial instruments). Gross reserves held in the form of securities are marked to market. Gross reserves are reported separate from the balance on the government's Special Privatization Account (SPA) and excluding capital subscriptions in foreign financial institutions and illiquid foreign assets. There is no reporting on financial derivatives and other off balance sheet positions, as the CBA does not currently trade in such instruments. If the CBA decides to commence such trading it will promptly notify the IMF staff in order to establish reporting requirements in this regard. Official reserve liabilities shall be defined as outstanding liabilities to the IMF and convertible currency liabilities of the CBA to nonresidents with an original maturity of up to and including one year. NIR is monitored in U.S. dollars, and, for program monitoring purposes, assets and liabilities in currencies other than the U.S. dollar shall be converted into dollar-equivalent values using the exchange rates as of December 31, 2002 (Attachment III, Table 1).

2. The program targets a maximum level of net domestic assets (NDA) of the CBA. For program purposes, NDA is defined as reserve money minus Net International Reserves (NIR) plus medium- and long-term liabilities of the CBA. To evaluate program targets, the dram-equivalent values of NIR and medium- and long-term liabilities are calculated at the end-2002 official exchange rate of dram 584.9 per U.S. dollar. NDA is composed of net credit to the general government; outstanding credit to domestic banks by the CBA (including overdrafts) minus liabilities not included in reserve money (exclusive of accrued interest), and other items net.

3. Reserve money targets are indicative and include a floor and a ceiling. They are subject to a daily bound of plus or minus 2 percent computed from the quarterly average standard deviation of excess reserves held by banks in percent of quarterly reserve money during the previous four years. Reserve money is defined as the sum of currency issue and required and excess reserves and current and time deposit accounts of certain resident agents.¹

4. The stock of credit from the CBA to the government includes the CBA's holdings of treasury bills and treasury bonds less all types of government deposits (including deposits of donor-financed project implementation units, the Lincy foundation, and balances of proceeds from the sale of humanitarian assistance). Treasury bonds are valued at the purchase price and treasury bills are valued at the purchase price plus the implicit accrued interest.

5. Net credit from commercial banks to the government includes: (1) gross credit to the government less government deposits (including the counterpart funds of certain government onlending to the economy financed by the Lincy Foundation and the World Bank); and (2) banks' holdings of treasury bonds (valued at the purchase price and excluding accrued interest) and treasury bills (valued at the purchase price plus the implicit accrued interest). Net credit of the banking system to the government is the sum of net credit from the CBA and net credit from commercial banks.

6. External debt limits apply to all forms of new nonconcessional medium- and long-term external debt² with original maturities of more than one year, which are contracted or guaranteed by the government or the CBA. Excluded from the limits are changes in indebtedness resulting from refinancing credits or rescheduling operations, sales of treasury bills or treasury bonds to nonresidents (provided the sales go through the regular auction mechanism and involve no exchange rate guarantees), concessional loans, and credits extended by the IMF.³ Except for normal import-related credits, there is a zero limit on short-term external debt (obligations with original maturities of up to one year) contracted or guaranteed by the government or the CBA. Transactions subject to debt ceilings shall be valued in the contracted currencies and converted into U.S. dollars at the average monthly market exchange rate in the month when the commitment was contracted.

7. External arrears will consist of all overdue debt-service obligations (i.e., payments of principal and interest) arising in respect of public sector loans contracted or guaranteed including unpaid penalties or interest charges associated with these arrears.

8. The balance of the central government on a cash basis is defined as the sum of domestic banking system net financing, domestic nonbank net financing, and external net financing to the government. Net banking system credit to the government equals the change during the period of net credit to the government. Nonbank net financing equals the sum of: (1) the change during the period of outstanding treasury bills and bonds to nonbanks (including accrued interest for treasury bills and excluding accrued interest for treasury bonds);⁴ and (2) any other disbursement or transaction that increases nonbanks' claims on the central government plus withdrawals from the SPA, less amortizations made by the central government to private resident nonbank agents. External net financing equals total debt-increasing disbursements from non-residents to the central government less total amortizations from the central government to non-residents. All foreign-currency denominated transactions are recorded in drams using the prevailing exchange rate at the time of the transaction.

9. The US-based Lincy Foundation extends grants to finance various investment projects. The project implementation units, which carry out Lincy-financed projects, maintain accounts at the CBA. These grants are recorded in the fiscal accounts as external grants on the revenue side and as foreign-financed capital expenditure on the expenditure side. In addition, the US-based Lincy foundation extends loans to finance investments. To the extent that these loans are intermediated through the banking system, they are recorded in the financial accounts as a financing item below the line and are thus excluded from net lending.

10. Proceeds from selling enterprises are deposited into the SPA. The account is held at the CBA and the proceeds are invested abroad together with the CBA's international reserves. These proceeds are included in the definition of the monetary accounts of the CBA as part of net foreign assets with a counter entry in other items net. Any budgeted withdrawal from the SPA will be accounted for as privatization proceeds used to finance the budget and will be recorded below the line. Any unanticipated withdrawal from the SPA will be recorded below the line as privatization receipts; these withdrawals, however, will be replenished during the same fiscal year.

11. Tax revenues are defined in accordance with Government Financial Statistics (GFS), 1986, section IV.A.1. Total revenues collected by the State Tax Service (STS) and the Customs Committee (CC) are classified as follows: VAT (of which: presumptive tax on cigarettes, petroleum, and diesel), excises (of which: presumptive tax on cigarettes, petroleum, and diesel), enterprise profit tax, personal income tax, land tax, customs duties (of which: presumptive tax on cigarettes), other presumptive taxes, simplified tax, property tax, and other taxes (of which stamp duties and environmental taxes).

12. The program targets maximum levels for the stock of domestic arrears of the central government and the State Fund for Social Insurance (SFSI). Domestic arrears are defined as follows. With respect to wages, contributions to the pension fund, family allowances, and amortization and domestic interest payments, the stock of arrears is defined as all unpaid claims outstanding at the end of the month. This excludes technical arrears of up to AMD 0.5 billion that could arise because of minor delays in the execution of these expenditures. For all other expenditure categories, arrears are defined as the stock of unpaid claims, as verified by the recipient of the goods and services, which has been outstanding for more than 30 days as of the end of the month. However, at year-end all outstanding claims must be settled as required in the budget law.

13. The program targets the primary balance of the energy sector, which is defined as current total revenues less total expenditures excluding interest payments and foreign-financed capital expenditures. The government will provide a detailed quarterly cash flow for the energy sector. The energy sector is defined by the following state-owned companies: (1) Yerevan thermal power plant; (2) Metsamor nuclear power plant; (3) Vorotan hydro-power plants system; (4) High Voltage Electricity Network; (5) Armenergo; (6) the Settlement Center; (7) the Dispatch Company; and (8) Armgasard.

II. Adjusters

14. The quantitative performance criteria and benchmarks under the program are subject to the following adjusters:

• Foreign-financed project disbursements: the target on the cash balance of the central government will be adjusted downward (upward) by the full amount of cumulative higher (lower) than programmed foreign-financed project disbursements. The programmed amounts are shown in Table 2 below.

• Structural adjustment lending from the World Bank: the following targets for December 2003 will be adjusted by the full amount of a lower than programmed SAC disbursement: NIR (downward), NDA of the CBA (upward), net credit to the government (upward), and the cash balance of the government (upward). The programmed amount is shown in Table 3 below.

• KfW loans: the target on the stock of net domestic assets of the CBA will be adjusted upward (downward) by the amount of any disbursement (repayment) from (to) KfW. The adjustment will be made at program exchange rates.

• Lincy loans: the following targets will be adjusted by the full amount of any conversion to grants or debt forgiveness of the outstanding stock of debt to the Lincy Foundation: net credit to government (downward) cash balance of the government (downward), NIR (upward), and NDA of the CBA (downward). The adjustment will be made at program exchange rates.

III. Structural Performance Criteria and Benchmarks

15. VAT deferral system. The information and technical criteria for granting deferrals need to be determined by the new commission. Among other things, this commission will determine the goods or activities that would be covered by the deferral system; whether all or specific enterprises are to be eligible; documentation requirements; the length of deferral (no more than 12 months); and the scope of the pilot project (selected activities or selected taxpayers). In addition, the exchange of information, specified in the memorandum of understanding between the Customs Committee and the State Tax Service, would include identification of taxpayer, content of information, format of data, form of transmittal, and frequency. Under the deferral system, Customs would allow imports without payment of VAT based on established criteria and provide documentation to the State Tax Service. The Tax Service would develop procedures to establish a liability record, revise tax forms to account for deferred VAT, and monitor compliance of taxpayers.

16. Post clearance verification. To make the post-clearance verification program operational will require the preparation of an audit procedures manual; staffing the audit unit with qualified staff based on specific criteria; and developing risk assessment selection profiles.

17. Budget reporting of noncommercial enterprises. Minimum criteria will be developed for deciding when an NCE should be considered as part of the general government or as part of the public corporations sector. The government will institute a system under which the enterprises will report data on an aggregated GFS basis on revenues, expenditures and arrears. The definition of arrears will be the same as that applying to budget institutions and the nature of the aggregation will be discussed with Fund staff. All noncommercial enterprises will disclose their budgets to the Ministry of Finance and Economy on the same basis as they will be reporting. This information will be reflected in the annual budget. Beginning with the first quarter of 2004, all NCEs will be required to submit quarterly reports no later than 30 days after the end of each quarter. A Government Decree will be issued under which the scope of the internal audit function of line Ministries will be expanded to incorporate the audit of NCEs. The Ministry of Finance and Economy will specify reporting and audit requirements in an appropriate regulation or by amending the Budget System law as needed.

18. Resolution strategy for intervened banks. The CBA will provide monthly data within 30 days of the end of each month on (i) the balance sheet of Armcommunications (ii) detailed information on cash flows/transactions between the Armcommunications, Nairit, and third parties, (iii), any supplementary agreements between the investor and the authorities.

IV. Data Reporting

19. The government will provide the IMF the information specified in the following table.

¹ Compared to the IFS definition, transactions under repurchase agreements and the CBA's deposit facility are not included in reserve money.

² The term "debt" shall have the meaning set forth in Section 9(a) of the Guidelines on performance criteria on external debt, as modified by the Executive Board Decision No. 12274-(00/85) of August 24, 2000, and shall include all current (noncontingent) liabilities, which are created under a contractual arrangement through the provision of economic value in the form of financial or nonfinancial assets (including currency) or services, and/or income, and which require the debtor to make one or more payments in the form of such assets (including currency) or services at some future point(s) in time to discharge the principal and/or interest liabilities incurred under the contract. In particular, all instruments that share the characteristics of debt enumerated above (including loans, suppliers' credits, and leases) will be included in the performance criterion on external debt.

³ For program purposes, a loan is considered concessional if the grant element is at least 35 percent calculated using a discount factor based on the Commercial Interest Reference Rates (CIRRs) published by the OECD plus margins depending on the loan maturity. The margins are: 0.75 percent for repayment periods of less than 15 years, 1 percent for 15-19 years, 1.15 percent for 20-29 years, and 1.25 percent for 30 years or more. The average of the CIRRs over the last ten years will be used for loans with a maturity of at least 15 years and the average of the CIRRs for the preceding six months will be used for shorter maturities.

⁴ Domestic nonbank holdings of treasury bills and treasury bonds are defined as total outstanding treasury bills and bonds less holdings by the banking system and the SFSI.

⁵ As defined in CBA resolution No. 201 (December 6, 1999).

⁶ The table is in summary form. A more comprehensive table has been agreed in the form of an Excel workbook.