In an interview to Armenian News-NEWS.am, resident representative of the International Monetary fund in Armenia, Mr. Guillermo Tolosa, shares his expectations on the recovery in agriculture, which had contracted by 13,5% in 2010. This may ramp up the whole GDP and, consequently, Armenia’s ranking on Forbes’ list. At the same time, efficiency of tax collection is still an issue...

How tightly, in your opinion, today’s economic rebound in Armenia is linked to the worldwide non-ferrous metal prices?

Armenia’s recovery is certainly linked from higher metal prices, as this development has helped mining and manufacturing industries. However, other important forces have also been at play. For example, an increase in remittances has supported domestic consumption and is benefiting various sectors of the economy like retail trade, hotels and restaurants and transport and communication. Also, there has been notable growth in bank lending that has helped consumption and investment.

Do you think that prudential measures by the CBA on dedollarization of loan portfolio of the banking system can prove efficient, when it comes to lending to local industry and trade? (Both are still heavily dependent on foreign currency to finance their production costs and trade transactions).

Prudential measures of CBA go in the right direction regarding the de-dollarization of loan portfolio, as they increase the cost for banks to intermediate in foreign currency. However, dollarization of deposits is still very high so banks have limited room to lend in domestic currency without breaching regulatory limits for open positions. Also, the stability of the exchange rate over the last two years –unusual for a flexible exchange rate regime- has apparently led banks and firms to underestimate foreign exchange risk and maintain elevated foreign currency exposures.  Continued adherence of the CBA with flexible rate policy will most likely lead to larger variations in the exchange rate that are set to shine a more clear light on the relative unattractiveness of financial contracts in foreign currency. It is worth noting these larger variations can happen in any direction, and the commitment of the CBA flexible exchange rate policy will guarantee there will be any abrupt sudden changes in the exchange rate as in the past.

To what extent is Armenian banking system exposed to indirect credit risks, with the present rate of currency lending?      

Yes, it is exposed to considerable indirect credit risks because of foreign currency lending. However, household debt in foreign currency remains limited, as the situation affects mostly corporate sector, which should be able to better withstand shocks. Also, this should not compromise banking system stability as banks have a considerable capital cushion to absorb the possible losses associated even with potentially large shocks.

Over the last 10 months (Jun 10 to Apr 11), capital adequacy ratio of the banking system has declined by 8 percentage points. Do you think banks have improved their assets by simply tightening their credit scoring?

The main reason for the decline in the ratio of capital to risk weighted assets for the period was the introduction of higher risk weights for foreign exchange assets last which created an automatic increase in the denominator of this ratio. This automatic effect alone explained the decline in capital adequacy ratio (CAR) by about 5 percentage points in Sept-Oct 2010.

The remaining decline in CAR of the banking system was due to the sharp increase of bank lending made possible by the existence of excess reserves originated because of overly tight lending policies. In any event, as stated above, the current level of CAR of the banking system continues to be very high in the international comparison after the decrease.

What prospects do you see for the inflation rate to return within the target band, given that there are no signs for the food prices (both international and local) to decline?

High inflation has already stopped in Armenia. As a matter of fact, in the last four months Armenia has experienced mild deflation on the basis of the end of the rising trend in international commodity prices, and stabilizing domestic prices arising from a relatively more normal harvest this year. The annual inflation reading is still high because of the low basis of comparison: international prices had not surged yet in the first semester of last year. While sharp international price rises may not reemerge, and prices of locally-produced also appear likely to continue its moderation (which could sharply lower annual inflation later in the year as it starts to be computed against a higher basis of comparison), risks remain going forward. These may call for the CBA to again take decisive action, as they did during earlier this year with interest rate rises and stepped-up efforts to manage liquidity.

Do you think that the State has enough fiscal space for pro-poor measures, and do you think they will be effective with the current inflation pressure?

The government has done a commendable effort to protect pro-poor spending from the effects of the crisis. However, Armenia’s fiscal space is unfortunately very limited, leaving little room for the government to implement new pro-poor measures to offset the effect of higher food prices (with some notable exceptions, like the subsidies for gas). We think however there is considerable room to increasing the fiscal space by improving the tax collection (both through changing tax legislation and stepping up tax administration efforts).

Recently there have been several statements and presentations on the cumulative pension reform in Armenia. Once the new system is adopted in 2014, do you expect a mass outflow of funds from Armenia into foreign capital markets? 

After the pension reform Armenians will be saving more money for retirement. These savings will, over time, translate into large accumulation of assets. In order to diversify risk, a minority fraction of this newly created capital will be placed abroad. But in net terms the effect of the reform will certainly be to increase the amount of capital available for Armenian productive development. In particular, the pension reform is likely to make available currently inexistent long-term resources for Armenian firms, badly needed to improve investment prospects.

What is your opinion on the draft of the new Mining code, which implies changes to taxation regime? Do you think the State needs to cast a wider tax net on the mining sector?

We have a broadly positive assessment of the new Mining code, which will improve conditions in this key strategic sector for the Armenian economy while increasing revenue collections for the government. We think however that even further adjustments to the legislation in the profit tax are called for to reduce the quite considerable opportunities for tax avoidance that the current framework offers. In addition, further improvements may be needed on the treatment of environmental cleanup costs.

One of your recent statements, on the undesirability of favorable tax regime towards innovation industry, met sharp criticism by the local IT industry. Do you think the government will pursue the forced development of this sector anyway?

Tax incentives could lead to significant revenue losses to the government. International experience shows that the creation of these loopholes in the tax regime can imply that the losses go well beyond the taxes received from the sector being targeted. Such losses would be particularly untimely: Armenia needs to undertake large efforts to bring down its already large deficit and thereby avoid compromising macroeconomic stability, which is a key strategic asset for the IT industry and the country as a whole. On top of that already difficult challenge, Armenia needs to create extra fiscal space for pro-poor and pro-development spending, which are at pretty depressed levels. Finally, opening the doors of sector-wide tax breaks could lead to a dangerous precedent that could put the government in a difficult situation to resist the pressure of other deserving strategic sectors.

Do you think that Armenia will improve its position on the Forbes ranking once the downturn in agriculture is restored, and so does GDP per capita?   

Under the current macroeconomic policy framework, which is supported by the IMF, moderate improvements in economic conditions are taking place and continue to be expected. As a consequence, Armenia will tend to go up considerably in world economic rankings, including Forbes’. For example, as close as 2008, Armenia would have ranked around 110th worst economy in Forbes ranking (Editorial – in contrast to 2nd worst, as in recent 2011 ranking). We expect output to recover on the basis of a rebound of the agricultural sector and continued strong performance of manufacturing and trade. But we also expect improvements in the other key components of the ranking: the current account balance is expected to fall on the back of continuous fiscal adjustment and exchange rate flexibility, while inflation will also come down as discussed above.

In your opinion as an international expert, is the ranking a significant guide for foreign investors on whether to do business in a given country?

The Forbes ranking does offer a reminder of how difficult a ride the Armenian economy has had over the last couple of years as it went through a very unusual set of external shocks. However, it is important to put the recent article in perspective: it was not intended to be an in-depth, cross-country comparative analysis of the business environment, but rather a short, simple and provocative look at a handful of key macro indicators. There are other widely recognized measures of the business environment, such as WB Doing Business or the WEF Global Competitiveness Indicator, where Armenia ranks 48th and 98th best economy in the world respectively. While investors should, of course, be informed of recent macroeconomic variables, such as growth, inflation, and the current account balance, this is just the starting point. They should aware of future prospects - especially for improvement after the crisis - and undertake a deeper and more comprehensive analysis of the business and institutional environment. Here, I am convinced that Armenia, even when in need of important reforms, scores much better.

How does external debt of the USA can affect countries which benefit from their foreign aid?

The United States will need to undertake a very significant fiscal adjustment over the next years. The nature of it is currently being debated and it is too early to determine if it will affect US’s foreign aid and hence recipient countries’ economies.

Thank you

By Aram Gareginyan