September 15, 1999

Dear Mr. Camdessus,

The new government of Armenia, formed after the parliamentary elections held in May 1999, is committed to implementing the macroeconomic policies and structural reforms supported by the third annual ESAF arrangement. Accordingly, the government's program, whose general principles were presented to parliament on June 18, 1999, aims at creating the conditions for high and sustained growth in the medium term. The program thus seeks to ensure price stability, enhance Armenia's external competitiveness, deepen the restructuring of the energy and financial sectors, reform the education and health systems, and accelerate the privatization process.

The adverse external conditions which we have experienced since August 1998 had a more serious impact on our economy in 1999 than was originally expected. The negative effects of this external shock were heightened by a prevailing climate of political uncertainty associated with the parliamentary elections. Against this background, it became increasingly difficult to fully implement the policies envisaged in the program, and as a result significant deviations from program targets emerged. Finding an adequate response to the difficulties faced was a long and protracted process, and thus it has taken more time than expected to complete the discussions for the mid-term review of the third annual ESAF program.

In the accompanying Supplement to the Memorandum of Economic and Financial Policies agreed in December 1998, we describe the modifications to our economic program for the remainder of 1999. The revised program assumes that the main 1999 annual targets contained in the program presented to the IMF Executive Board are still broadly within reach. The cornerstone of our program is the revision to the State budget which was approved by parliament on August 28, 1999. Prior to approval of the amended budget, the conduct of public finance was guided by three decrees that contained revenue-increasing measures and one that froze expenditure authorizations to a level consistent with the amended budget. This fiscal effort will be supported by continued pursuit of a tight credit policy in the context of a flexible exchange rate. In addition, we have started to implement a number of measures aimed at accelerating the process of restoring the financial viability of the energy sector, and we will intensify the financial monitoring of enterprises in the public sector so as to harden their budget constraints and reduce the quasi-fiscal expenditures associated with the operation of such enterprises. The attached document also elaborates on the steps we are taking to strengthen banking supervision and to provide renewed impetus to our privatization program. If necessary, we are prepared to take further measures to ensure the success of our program, after consulting with the Fund.

In support of these policies, the government of Armenia hereby requests waivers for non-observance of the end-March 1999 performance criteria for net international reserves and state budget tax revenues, and the continuous performance criterion on accumulation of domestic expenditure arrears. We also request the completion of the mid-term review, and the last disbursement under the third annual ESAF arrangement.

1.  A combination of external factors beyond our control, as well as some regrettable slippages in policy implementation, caused our economic reforms to go somewhat off track in the first half of 1999. Below we describe the steps the Armenian government and the Central Bank of Armenia (CBA) intend to take--and in many cases, have already taken--to correct these slippages and ensure that our program targets are achieved.

2.  These commitments are in addition to those in our original Memorandum of Economic and Financial Policies (MEFP), dated December 8, 1998. The government remains determined to implement the policies in the original memorandum, which remain valid unless they are superceded by new commitments described below. In particular, during the program period, neither the government nor the central bank will impose or intensify any exchange restrictions, introduce or modify any multiple currency practices, conclude any bilateral payments agreements that are inconsistent with Article VIII, or impose or intensify any import restrictions for balance of payments purposes.

3.  Economic developments in Armenia have been dominated by the Russian crisis, which has had a larger impact on our economy than had been envisioned at the time of the IMF Board discussion of the third annual ESAF program. Industrial production, output in the transport and services sectors, exports, and workers remittances and transfers have all been adversely affected by the Russian crisis. In addition, non-residents' demand for Armenian government treasury bills has declined, and foreign investment inflows have slowed considerably. Had it not been for the strong performance in the construction sector in the first part of 1999, real GDP growth in 1999 would be weaker than programmed.

4.  We recognize, however, that the difficulties encountered have not been entirely due to factors beyond our control. In our effort to contain the damage from the Russian crisis, we tried to maintain the level of aggregate demand by keeping public expenditure commitments unchanged, without regard to weakening tax revenue developments. This led to a substantial accumulation of expenditure arrears. Moreover, we took steps to avoid large movements in nominal exchange and interest rates, resorting to sizable official intervention in the foreign exchange market and setting low cutoff rates in treasury bill auctions. As a result of these developments and policies, the state budget revenue and net international reserves targets for end-March 1999 were missed, and the continuous performance criterion on non-accumulation of budgetary arrears was not observed. Dram broad money and reserve money were consistently well below the indicative program targets, reflecting a flight to foreign currency denominated assets (Table 1). The real exchange rate appreciated and real interest rates continued rising, contributing to a further deterioration of the overall fiscal position. We also faced difficulties in implementing critical aspects of the energy sector reform strategy (most notably, there was slow progress in improving collections); privatization slowed considerably, as evidenced by a rising share of firms not sold in the first attempt and a noticeable slowdown in the implementation of the privatization program through international tenders; and there was an increase in the number of commercial banks failing to observe prudential requirements, mostly due to growing non-performing loans to public enterprises.

Program Objectives

5.  The package of measures described below has been designed to sharply reduce the macroeconomic imbalances that originated in the first half of 1999; strengthen budgetary discipline of state-owned enterprises and key sectors receiving budgetary support, while taking steps to end the culture of non-payment; improve the coordination of fiscal and monetary policies; and provide a renewed impetus to structural reforms in key areas. Given the need to bring the program back on track as quickly as possible, a number of policy measures, detailed in Table 2, have been or will have been implemented prior to the IMF Executive Board's consideration of our request for a completion of the mid-term review under the third annual ESAF arrangement. Despite the short period since the inception of the revised program, there are already signs of improvement, reflected in some recovery in revenues, greater control in expenditures, a reduction in the stock of expenditure arrears, and rising billing collections in the energy sector.

6.  The revised program is consistent with achieving real GDP growth in 1999 of about 4 percent, close to the original program target, while containing inflation to no more than 8 percent during the year, down from the program target of 10 percent. The revised quantitative targets for the remainder of 1999 are presented in Table 1, and remain as defined in EBS/98/213 and EBS/98/213 Supplement 1, except where modified in the attached Supplement to the Technical Annex to the MEFP. In addition, structural benchmarks have been set for end-September 1999 (Table 3).

7.  Our general fiscal strategy calls for limiting the state and republican budget deficit to about 6 percent of GDP in 1999, unchanged from the original program. Given weakening revenues and higher fiscal and quasi-fiscal expenditure needs in some areas, deficit target, in the absence of corrective measures, would have been exceeded by about dram 37¾ billion, or 3¾ percent of GDP.¹ To ensure the achievement of our deficit target, the government introduced on August 1, 1999 several revenue-increasing measures (as described in paragraph 8), and took an administrative decision to freeze expenditures at a level consistent with the revised annual targets on August 17, 1999. Subsequently, the government submitted amendments to the 1999 Budget Law to an extraordinary session of Parliament on August 23, 1999, which were approved on August 28, 1999. The amended budget leaves roughly unchanged the nominal level of expenditures approved in the 1999 Budget Law, while reducing some current and capital appropriations to make room for quasi-fiscal expenditures related to the energy sector and other extraordinary expenses. The plan also allows for clearing, during the third quarter of 1999, all budget and pension arrears outstanding as of July 1, 1999.² The government is committed to take steps to ensure that no new expenditure arrears will be accumulated during the remainder of the year.

8.  In closing the fiscal gap identified above, the government has implemented revenue measures with an expected yield of dram 12.5 billion, or about 1¼ percent of GDP. The government decree that became effective August 1, 1999, provided for (i) an increase in the excise tax per 1,000 imported, domestic filtered, and domestic non-filtered cigarettes, from their current levels of $4.3, dram 1,900, and dram 800, respectively, to $15, $12 and dram 1,100; and (ii) an increase in the hazardous materials duty on gasoline from 2 percent to 44 percent. In addition, the new Ministry of State Revenues has started implementing a series of tax administration measures, specified in consultation with the IMF staff, which will increase revenues in the last half of 1999 by at least dram 800 million (about 0.1 percent of GDP).

9.  The amended 1999 budget includes cuts in expenditures previously approved in the original 1999 budget, amounting to about dram 25 billion (2½ percent of GDP, or almost 10 percent of the expenditures in the original budget law). These cuts imply that for the second half of 1999 most domestically financed capital projects will be suspended, and unexecuted budgeted current expenditures will be reduced by about 8½ percent.

10.  To ensure the sustainability of the fiscal effort, the government intends to tighten expenditure control considerably. To this end, a new monthly reporting framework for payments is being implemented and the 2000 budget is being prepared based on a recently adopted unified chart of accounts. Steps are also being taken to increase the pace of automation of the treasury and continue its organizational restructuring, including by reducing the number of local treasury branches. Zero-balance accounts will become effective in December, 1999, and all residual republican and local government accounts in commercial banks will be closed by December 31, 1999, except for one zero-balance account for each local field treasury in an agency bank. The number of extrabudgetary accounts will also be reduced from 358 at the end of July to 100 by year end.

11.  Local governments will need to address the deterioration in their financial position without additional budget support. On current trends, local revenues in 1999 will be about 35 percent below their budgeted levels (although they will be 15 percent above the level of 1998). Since the government will not provide transfers or budgetary loans, beyond what was provided for in the 1999 budget, and the law prohibiting borrowing by local governments will continue to be enforced, the revenue shortfall of the local governments will have to be met by an equal cut in expenditures.

12.  The Government is committed to address the problem confronting the State Fund for Social Insurance (SFSI) due to low collections in the first half of 1999, associated with rising wage arrears in state-owned enterprises. As a result of these low collections, about dram 3½ billion in pension arrears were accumulated in the first half of the year. The government has instructed the SFSI to repay all outstanding pension arrears during the third quarter of 1999. To ensure that this decision is implemented, the government has taken administrative measures to ensure prompt payment of wage arrears and associated pension contributions by state-owned enterprises, and will proceed forcefully in liquidating confiscated property and initiating bankruptcy proceedings of debtors, as appropriate. The SFSI expects that these measures will be sufficient to allow the repayment of all pension arrears. However, as a precautionary step, and to meet the deadline for clearing pension arrears by end-September 1999, budgetary support to the SFSI have been raised by dram 1.8 billion, to be released as needed during the third quarter of this year.

13.  Since a large part of the fiscal gap for 1999 was due to the emergence of unbudgeted expenditures related to the consumption of energy by a major chemical plant (Nairit), the drinking water and irrigation sectors, and district heating, the government has decided to take steps to reduce (and eventually eliminate) the budgeting inadequacy of these sectors. As a first step, the cabinet issued instructions on July 29 assigning responsibilities for the design, management, implementation, and monitoring of financial plans for each of these sectors. In addition, on August 31, the government submitted to the IMF and the World Bank preliminary action plans for each of these sectors. These action plans include cash flows for the period 1999-2000, and identify potential financial gaps and possible sources of financing to close them. The government is committed to not using any form of noncash operations or new expenditure arrears in closing the identified gaps. The action plans also include short-term measures to deal with any problems encountered. Quarterly reporting of actual cash flows for each of these sectors, to the Ministry of Finance and the IMF, have already started.

14.  The government and the CBA will endeavor to enhance the coordination of fiscal and monetary policy. To this end, on July 20, 1999, the Ministry of Finance and the CBA formalized procedures for coordinating and monitoring the weekly execution of the budget and the liquidity program of the CBA, and providing input for the decision on the amount and maturity structure of the Treasury bills to be issued in the primary auctions. Provisions have also been made to ensure a timely exchange of fiscal and monetary information and projections between the CBA and the MOF.

15.  Consistent with the lower inflation target for 1999 and to achieve the NIR target, the revised monetary program for the second half of 1999 calls for an expansion in net domestic assets of the CBA by about 4 percent of reserve money at the end of June 1999, somewhat lower than in the original program. This expansion of credit would imply reserve money growth of about 19 percent in the last half of the year which, combined with a moderate decline in the multiplier--as commercial banks increase demand for reserves to meet prudential regulatory requirements--would accommodate an expansion of dram broad money of 15 percent, somewhat higher than in the original program. The CBA will not extend any direct credit to the government on a quarterly basis. CBA intra-quarter net lending to the government, if any, will be done by acquiring treasury bills in the secondary market. The stock of CBA net credit will not be allowed to exceed the end-quarter target by more than 10 percent of the projected cumulative monthly revenues within the quarter, at any point during the quarter.

16.  While the CBA will continue to target credit as the main instrument of monetary control, day to day monetary operations will be guided by an indicative corridor for reserve money, as defined in the Supplement to the Technical Annex of the MEFP. If at any point reserve money reaches the upper or lower limit of the corridor, the CBA will undertake corrective measures.

17.   The revised monetary program will be implemented in the context of greater exchange rate and interest rate flexibility than has been observed in the recent past. In particular, the CBA will allow for increased flexibility in the exchange rate, with net intervention limited to the level necessary for the achievement of the NIR floor and keeping reserve money on target and within the boundaries of the corridor specified in the program. In addition, interest rates on treasury bills will be fully market determined; the practice temporarily adopted in early 1999 of rejecting bids on treasury bills when the total amount of bills offered has not been sold, has been stopped.

18.  The adverse external developments have weakened the export and private transfers outlook for 1999 and heightened Armenia's dependence on foreign savings. Against this background, the government will intensify its efforts to strengthen the management and monitoring of external grants and the contracting of public and publicly guaranteed loans. As a first step, a decision has been made not to contract any new nonconcessional external borrowing or to provide external guarantees for the remainder of 1999. We have also created a unit in the Ministry of Finance responsible for coordinating the negotiation, contracting and monitoring of all external grants and public and publicly guaranteed loans. Looking ahead, we will endeavor to develop and start to implement, by end-September 1999, a comprehensive external borrowing strategy, in consultation with IMF staff, which will guide all future contracting of government loans or extension of sovereign guarantees. The government will also undertake all necessary efforts, with the government of Russia, to settle the unresolved external financial issues regarding mutual arrears between Armenian and Russian companies, disbursements under the 1997 and 1998 interstate agreements on the provision of loans to Armenia, and any other unsettled financial obligations.

19.  To avoid the recurrence of problems encountered in 1998 and 1999 with regard to the forbearance of prudential regulatory requirements for some commercial banks, the CBA has decided, effective August 9, 1999, to raise penalties applicable to noncompliance cases, and will refrain from extending any exemptions from these penalties in the future. The CBA will enforce the existing plans agreed with the commercial banks which had violated the prudential requirements, and will exercise its right to initiate liquidation procedures against those banks which fail to meet the targets specified in the agreed plans. The government and the CBA will also implement, before end-year, new loan-loss provisioning procedures, prepared in consultation with the IMF staff, including allowing for the tax deductibility of such provisions beginning in the 2000 budget. During the remainder of 1999, the government and the CBA will also take steps to develop the legal and institutional framework for the securities market and seek the adoption by parliament of a Law on Securities Market.

20.  Despite recent improvements, the energy sector will face in 1999 a financing gap, before debt rescheduling, of about dram 51 billion (or about 5 percent of GDP). To close this gap the government will continue its efforts to reduce losses and improve collections and generation efficiency, and will rely on (i) additional budgetary appropriations, as discussed in paragraph 7; (ii) suspension of services to budgetary organizations which attempt to consume electricity beyond approved levels; (iii) suspension of service to customers with payments arrears; and (iv) comprehensive domestic debt workouts. Given the results of the recently concluded domestic debt restructuring exercise, there will be no need for a tariff increase in 1999. However, the government remains committed to take any additional measures that may be necessary to avoid the reemergence of a financial gap in the remainder of 1999, including to improve collections and reduce operational expenditures further. If unavoidable, we will consider imposing a temporary surcharge on the existing tariff structure, pending a comprehensive review of the adequacy of the existing tariffs. The government has also contracted a consulting firm to prepare, by October 15, 1999, a 3-year maintenance plan and annual maintenance budget for the power sector enterprises, and to update the government's least cost power investment plan, including financing proposals. The 3-year maintenance plan and annual budget will not be financed using government contracted or guaranteed nonconcessional debts. The government will also seek to adopt IAS-based accounting and auditing procedures for key companies in the energy sector, in line with the agreements with the World Bank.

21.   The government is determined to restore the momentum of privatization and ensure an appropriate use of privatization proceeds. To this end, steps will be taken to preserve the market valuation of all privatized assets, and to privatize enterprises in accordance with the timetable agreed with the World Bank and adopted by parliament. The government has partially modified the privatization strategy in order to expedite the sale of selected enterprises which do not sell in the first attempt. Instead of waiting 30 days for offering for sale any enterprise that failed to sell in the first attempt, decisions will be made in a limited number of cases (identified in consultation with the World Bank) to (i) promptly offer them for sale a second time, (ii) restructure the enterprise to increase its sales prospects before offering it for sale a second time, or (iii) immediately proceed with the enterprise's liquidation. These new procedures will not be allowed to slow the pace of privatization. As in the past, all enterprises in the privatization program which are not sold after three attempts will be liquidated. The government intends to broaden the scope and frequency of reports on each privatization transaction to both parliament and the public at large. The medium term strategy for the use of privatization proceeds, which is being prepared in consultation with the IMF and the World Bank, will be approved by end-1999.

22.  The government intends to broaden the number of enterprises which remain under public ownership that are subject to financial monitoring, and the scope of the such monitoring. Preliminary cash flow outcomes for the period January-June 1999 of the 12 largest enterprises subject to monitoring have already been made public, and the number of enterprises to be monitored will be increased to at least 17 by end-September 1999. The initial cash flow reporting of the additional enterprises will start in October, 1999.

23.  We believe that the policies and measures set forth above, combined with those in the original memorandum, are adequate to achieve the objectives of the program, but we will take any further measures that may be necessary for this purpose. We will remain in close consultation with the IMF. During the remainder of the program period, we will consult with the Managing Director on the adoption of any measures that may be appropriate, at our initiative or whenever the Managing Director requests a consultation. Moreover, after the period of the program and while the Republic of Armenia has outstanding financial obligations to the Fund arising from loans under the third annual arrangement, we will consult with the Fund from time to time, at our initiative or whenever the Managing Director requests consultation on the Republic of Armenia's economic and financial policies.

Table 2. Armenia--Prior Actions

Banking sector: (i) The CBA will establish new banking regulations regarding (a) loan classification guidelines that include factors other than number of delinquent days and require banks to establish a more comprehensive loan loss reserve methodology; and (b) classification and appraisal guidelines to determine the overall quality of banks' investment portfolios. The government, in consultation with the CBA, will submit to parliament amendments to the Banking Law to give bank regulators the power to restrict dividend payments when banks are experiencing financial difficulties; and (ii) the external audit of the Savings Bank will be completed and the government will define a strategy to be pursued for restructuring the bank, in consultation with the staffs of the World Bank and IMF.

Social safety net: The government will (i) issue a resolution stating its commitment to develop a pension reform strategy. The resolution will include the main principles of such strategy; (ii) approve a plan for the rationalization of both collection of payroll taxes and payments of pensions to recipients; and (iii) develop and approve a three-year strategic plan for the health sector.

Data Dissemination: The Ministry of Finance will begin publishing more detailed quarterly reports on external grants and loans in kind received, as well as the monetization of such grants and loans. These reports should follow the principles described in Presidential Decree No. 20 of January 19, 1998. In particular, the report should provide information on the nature and quantity of the goods monetized, the average sales price, names of the entities buying the goods, and the schedule of monetization.

ANNEX

This is a supplement to the technical annex contained in EBS/98/213, Supplement 1, which remains in effect except for the modifications indicated below.

1.  The definition of gross reserve assets has been modified to clarify that such assets must be owned by the CBA, highly liquid (less than one year in maturity), and without any attachments.

2.  The indicative target for reserve money will be subject to a monthly corridor, consisting of upper and lower limits on the reserve money path. The width of the corridor, for each of the remaining quarters in 1999, has been determined based on the average standard deviation of excess reserves held by banks in each quarter during the period 1996-1998, estimated as follows:

3.  Thus, the corridor for the third quarter of 1999 allows for deviations of reserve money from the program path of up to 2.65 percent. Whenever reserve money approaches either limit of the corridor, the CBA will adopt corrective measures.

4.  The program ceilings on the contracting and guaranteeing of new nonconcessional medium and long-term external debt, by the government or by the CBA, will apply to all forms of obligations that generate, or may potentially generate, liabilities to nonresidents with maturity greater than 1 year. The only liabilities excluded are those related to concessional loans as defined in EBS/98/213, Supplement 1 and to sales of treasury bills to nonresidents, provided the sales go through the regular auction mechanism and involve no exchange rate guarantees.

5.  The previous floors on core expenditures have been replaced with a continuous requirement that the government incur no new arrears on any expenditure of the republican budget or the SFSI after June 30, 1999. In addition, all arrears outstanding as of June 30, 1999 must be cleared by September 30, 1999. With respect to wages, pension payments, family allowances, all other transfers, and interest payments, expenditure arrears occur if claims are not paid by the end of the month in which these payments were due. For all other expenditure categories, arrears are defined as the stock of unpaid verified claims outstanding more than 30 days. Expenditure arrears of the republican budget and the SFSI will be monitored on a monthly basis according to the classification indicated in Table A1.

6.  The government is committed to ensure full enforcement of the regular reporting requirements agreed in the program, as specified in Table A2.

7.  The information on budgetary and pension arrears will be reported to the Fund no later than the 15^th (or the following working day in case of a weekend or holiday) of the subsequent month for wages, pension payments, family allowances, other transfers and interest payments, and no later than 45 days (or the following work day) for all other expenditures.

8.  The information on the restructuring of the energy sector debt and payables was reported on September 10, 1999, and will be summarized according to Table A3. Any future restructuring agreement will be reported according to this format, including the accompanying signed document. In addition, the Ministry of Energy will provide the Resident Representative a copy of all signed restructuring agreements.