Republic of Armenia—Letter of Intent and Memorandum of Economic Policies

October 27, 2004

Rodrigo de Rato
Managing Director
International Monetary Fund
Washington, D.C. 20431

Dear Mr. de Rato:

In May 2001, the Executive Board approved a three-year arrangement for Armenia under the Poverty Reduction and Growth Facility (PRGF). At the time of the fifth review on May 3, 2004, the arrangement was extended through December 2004 to allow additional time in order to implement additional reforms in line with the objectives of the arrangement. The purpose of this letter and the attached Memorandum of Economic and Financial Policies is to inform you of the progress in implementing the program, set out the policies for the period ahead, and request the seventh disbursement under the arrangement following the completion of the sixth review.

Economic performance in 2004 has been in line with program objectives and all quantitative performance criteria for end-June 2004 were met. While the structural reforms scheduled for implementation during the last six months were largely met, some delays occurred in relation to important fiscal and energy sector measures. These include the adoption of legislation to regulate the use of cash registers and register traders at large retail markets, the preparatory work to set up a risk-based system of tax audits, and the adoption of regulations for contracting electricity and for removing the state-owned company Armenergo from the energy sector.

On the basis of completion of the delayed measures and other actions envisaged in the near term and detailed in the attached Memorandum of Economic Policies, we hereby request the completion of the last review under the arrangement. We are also requesting a waiver for the nonobservance of the above-mentioned energy measures (performance criteria for the sixth review), which were delayed because of technical complications but have been implemented on October 1, 2004.

The government would like to continue its fruitful cooperation with the IMF and would like to proceed with discussions on a new PRGF arrangement covering the 2005–08 period after the completion of the sixth review. The policies and measures to be implemented during the next five months are designed to address more forcefully lingering inefficiencies in tax and customs administration and pave the way for continued cooperation under a new three-year arrangement. The government intends to make these understandings public and authorizes the IMF to publish this letter, the attached memorandum, and the staff report including the ex post assessment of long-term program engagement with the Fund.

Memorandum of Economic Policies

1. This memorandum supplements the Memorandum of Economic and Financial Policies (MEFP) of April 2003. It updates the government’s policies for 2004 and outlines the government’s main economic policies for the remainder of 2004 and early 2005.

A. Recent Developments

2. Economic growth continues at high pace. Real GDP in the first eight months of 2004 expanded by 9.7 percent. The 12-month rate of inflation reached 6.1 percent in September. Broad money grew by 18.7 percent in the twelve months through August. In the first half of 2004, the outturn of the fiscal deficit on a cash basis was 1 percent of GDP compared to 3.0 percent of GDP under the program, mainly because of under-execution of expenditures. In June, parliament passed a supplementary budget amounting to an increase of expenditure by 0.6 percent of GDP. The additional expenditures are expected to be executed during a 12 month period.

3. We met all but one of the program’s quantitative targets for end-June. The indicative target on the primary surplus of the energy sector was missed by a small margin because of somewhat lower-than-expected collection rates from export sales (Table 1). We established revised targets for up to end-December 2004. While the structural reforms scheduled for implementation during the last six months were largely met, some delays occurred in relation to important fiscal and energy sector measures. These include the adoption of legislation to regulate the use of cash registers and register traders at large retail markets, the initiation of a deferral system for imports of capital goods, the preparatory work to set up a risk-based system of tax audits, and the adoption of regulations for contracting electricity and for removing the company Armenergo from the energy sector. The latter was delayed because of technical complications in devising market rules and reaching understandings with other energy market participants. Despite those delays, we have taken actions to ensure that the measures envisaged in the context of the sixth review of the PRGF supported program will be implemented by mid-November 2004.

B. Economic Policies in the Period Ahead

4. For the rest of 2004 and 2005, our macroeconomic policies will focus on price stability, a forceful implementation of tax and customs administration reforms, and fiscal transparency. Some of these policies were listed in the April 2003 memorandum of economic and financial policies but will be supplemented by additional policies as noted below and summarized in Tables 1–2.

5. Fiscal policy. The 2005 budget to be submitted to parliament will be based on the following key parameters. Domestic tax and nontax revenues will be targeted at AMD 313 billion of which tax revenues will be at a minimum of AMD 306 billion, representing an increase of at least 0.4 percent of GDP from the previous year. The tax revenue target for 2005 will be adjusted if GDP developments in early 2005 suggest that such an update is warranted. Current expenditures will be at most AMD 290 billion. At the same time, we will limit expenditure increases in areas where capacity constraints, transparency, or the efficiency of expenditure are a concern. To ensure a balanced mix between current and capital expenditures, capital expenditures excluding net lending and those to be financed from the Millennium Challenge Account (MCA) will be at least AMD 70 billion. The figure for capital expenditures will include the carryover of unexecuted expenditures in the 2004 supplementary budget estimated at AMD 4 billion (0.2 percent of GDP). Once assurances are received regarding support from the MCA, those amounts will be included in the budget as additional capital expenditure. The overall deficit of the central government (including grants) will not exceed AMD 47.5 billion, which is a looser stance compared to the estimated outturn for 2004 but allows for priority social and infrastructure spending increases. Finally, the 2005 budget document will include detailed information and data on the budget allocations to noncommercial organizations.

6. Tax and customs administration. Despite some progress in recent years, tax and customs administration still suffer from severe deficiencies. The operations of the large taxpayers unit need to be revamped to improve collection from all large taxpayers and prevent discretionary treatment of taxpayers. To move forward, a major change in direction is required to improve efficiency and transparency in these agencies. As a result, we will finalize, in consultation with Fund staff, a two-year program of priority reforms in the area of tax policy and on tax and customs administration. The program will include a number of legislative and managerial changes to revamp tax administration. On the legislative front, we will enact legislation to facilitate the carrying out of effective tax audits, particularly in relation to large enterprises. In addition, we will enact legislation to prevent further accumulation of VAT refund arrears and will discuss with Fund staff amendments to the law on Bank secrecy to improve compliance with tax payments. On the managerial side, we will move the tax audit function in the STS to the large taxpayers unit and foster the implementation of risk-based management approaches in performing audits, collecting arrears, and processing VAT refunds by the tax and customs agencies.

7. Regarding the existing stock of VAT excess payments owed to exporters and domestic suppliers, we will ascertain the legitimate refund claims and remove from the books the requests of defunct companies, requests that did not follow legislative requirements and appropriate administrative procedures, and requests deemed fraudulent and therefore rejected. We will prepare, by end-November 2004, a complete list of legitimate claimants and amounts owed to each of them. Of the overall stock amounting to AMD 21 billion accumulated prior to December 31, 2003, we estimate that AMD 5.4 billion is legitimately owed to exporters. During 2005, we will repay at least AMD 4 billion in equal quarterly installments, with the remainder to be paid during the first half of 2006. If the legitimate claims owed to exporters exceed AMD 5.4 billion, we will discuss with Fund staff the modality for its repayment to ensure that all outstanding claims are fully repaid by June 2006. At the same time, we will ensure that during 2004 and 2005 there will be no further accumulations of VAT refund arrears exporters.

8. Regarding the stock of tax arrears amounting to AMD 89 billion at end-June 2004, we will take steps to write-off the part of the stock that is non-recoverable in line with recent technical assistance advice from the Fund including enacting the enabling legislation by December 2004. We will collect the recoverable amounts owed by current participants of the tax system, including large enterprises and other active traders and state entities. In particular, we will assign a high-level taskforce to collect arrears from the largest 100 debtors. The task force will prepare a collection plan for the recoverable amounts with targets for 2005–06 by December 2004. Of the total recoverable amounts, we expect to collect at least AMD 4 billion in 2005. Lastly, we will ensure that there are no further increases in the stock of tax arrears by active state-owned companies, including those in the energy sector.

9. To improve the functioning of customs administration, we intend to achieve the following results in the near term. First, consistent with WTO principles, we will ensure that declared transaction values are increasingly used for assessing customs duties and VAT and will begin publishing on our website quarterly information on the use of transactions values. Second, we will strengthen the operations of the internal audit unit and the post-clearance verification audit unit and continue preparing audit reports. Third, we will enact the electronic signature law to make the direct trader input system operational and will conduct a wide campaign to inform traders and companies at large about the direct trader input system. Lastly, we will prepare in consultation with Fund and World Bank staff, terms of reference for an operational review of customs operations to be conducted by a specialized international company.

10. Tax policy. We have begun preparatory work to build a unified tax code containing an internally consistent set of tax laws and regulations. In the near term, the differentiated tax rate structure in the simplified tax will be replaced with one tax rate on turnover and with no deductions for expenses, and action will be taken to remove large taxpayers from the simplified tax regime and move them to the regular regime (VAT and profit tax).

11. Monetary policy. The Central Bank of Armenia (CBA), with full support of the government, will continue pursuing a tight monetary policy and will not stand in the way of an appreciation of the dram in order to ensure that inflation is lowered to its objective of 3 percent. The CBA will follow the current course of increasingly relying on open market operations in the dram money market for the day-to-day conduct of monetary policy. To enhance its implementation capacity, the CBA will continue, in cooperation with the Ministry of Finance and Economy (MFE) to augment its holdings of government securities for use both in direct sales and as collateral in repurchase contracts. To facilitate liquidity management and to develop the domestic debt market, the MFE will increase the aggregate face value of its dram-denominated securities stock by at least 6 billion in 2005.

12. Banking system reforms. The CBA will continue to improve the regulatory framework for commercial banks. The new minimum capital requirement of US$5 million will become effective July 1, 2005, with eligible capital to remain as is currently defined. Banks that fail to meet prudential requirements will be promptly liquidated or converted into nonbank credit organizations. Bank consolidation and new shareholder entry will be encouraged and leading banks with well-established international track record will be given preference in awarding new licenses. By end-2004, the CBA will amend its system of risk weights, making it consistent with Basel Committee recommendations under the standardized approach, and will tighten related-party exposure and large exposure limits. Finally, by end-March 2005, the Civil Code will be amended to further support creditor rights in relation to collateral registration and recovery, and the Civil Procedures Code will be amended to improve court processes governing these rights.

13. Energy sector reforms. As of October 1, 2004, Armenergo has been extricated from all cash and non-cash transactions and is prevented from making any new contracts in the energy sector. By end-November 2004, we will establish, according to the law, a liquidation commission to conduct a fair and transparent liquidation process, a process that would include the sale of assets, the collection of receivables and the payment of debt according to priority rules, and finally, the appropriate handling of remaining Armenergo staff. The commission will consist of experts and trusted appointees who have no interests and no involvement in the energy sector. By end-March 2005, an audit of the company for the year 2004 will be undertaken, and as standard practice, another audit will be conducted at the end of the liquidation. Subsequently, all of Armenergo’s outstanding liabilities to the government will be written off, it’s remaining debt restructured, and the company’s removal from the enterprise registry will be initiated through the court system. In addition, the Public Services Regulatory Commission will pass the remaining elements of market rules including rules governing export sales and swaps to ensure the proper functioning and transparency in the energy sector.

14. The government believes that the policies and measures described in this memorandum are adequate, but it stands ready to take any additional measures that may be required to ensure the success of the intended reforms. The government will continue consulting with the Fund in advance of the adoption of any new policies and will provide the Fund with the information required to assess progress in implementing its program.