81137 Republic of Armenia Accumulation, Competition, and Connectivity April 2013 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Republic of Armenia Accumulation, Competition, and Connectivity April 2013 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Contents Acknowledgments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ix Acronyms and Abbreviations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xi Executive Summary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiii Armenia’s New Growth Model. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xiv Higher Investment, and Better Financial Intermediation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv Better Use of Human Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xvii Enhancing Competition in Armenia’s Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xix Improving Land Connectivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxiii Improving Air Connectivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxiv Improving Internet and Communication Technology (ICT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxvi Previous Growth Studies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxvii Overview. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxvii 1. Macroeconomic Developments and Outlook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Economic Growth Before the Global Financial Crisis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 The Global Economic Crisis and Armenia’s Recovery 2009–12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 Macroeconomic Outlook. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 2. Saving, Investment and Financial Intermediation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Determinants of Aggregate Private Saving. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 Microeconomic Determinants of Household Saving. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Financial Sector Development. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15 Foreign Direct Investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26 3. Human Resources . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Labor Market Trends. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29 Challenges to Armenia’s Labor Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Promoting Diaspora Engagement Contents | v 4. Competition. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Competition Indicators. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Barriers to Competition in Key Economic Sectors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Sector Case Study: Prices of Food Products . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 The Competition Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 61 5. Land Connectivity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 63 The Transit Situation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Comparison of Road Transit Options. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Logistics and Trucking Services . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69 6. Air Connectivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Institutional Set-up . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71 Business Environment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72 Benchmarking Armenia’s Air Connectivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Likely Impacts of Liberalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 82 Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 84 7. Internet and Communications Technology (ICT) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 The IT-based Services Industry in Armenia. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 Policy Recommendations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100 References. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 103 Tables Table 1. Price Differences for Food Articles, Armenia and selected CIS countries, 2010. . . . . . . . . . . . . . . . . . . . xxi Table 2. Summary of Policy Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxix Table 1.1. Macroeconomic Trends and Projections. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2 GDP Growth Decomposition from Employment Changes, 2003–08. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Table 1.2.  Table 1.3. Debt Reducing Primary Balances. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Table 2.1. Determinants of Aggregate Saving (2002q1–2011q2). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Table 2.2. Error Correction Model Specification . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13 Table 2.3. Monthly Household Income, Consumption and Saving. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14 Table 3.1. Impact of Diaspora Members: Armenia in Light of Relevant Benchmarks . . . . . . . . . . . . . . . . . . . . . . . . 40 Table 4.1. Presence of State Owned Enterprises. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Table 4.2. Summary of Main Market Characteristics and Results of Price Comparisons Industry . . . . . . . . . . . . . . 50 Table 4.3 Price Comparison Analysis, Armenia vs. CIS Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Table 4.4. Price Differences for Selected Food Products, as Compared to Selected CIS Countries . . . . . . . . . . . 51 Table 4.5. A Comprehensive Competition Policy Framework . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Table 4.6. Defining an “Economic Entity” for the Implementation of the Competition Law. . . . . . . . . . . . . . . . . . 56 vi  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 4.7. Elements For Designing Merger Control Policies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Table 4.8. Competition Indicators for Select Markets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Table 4.9. Example of Direct and Indirect Support to Firms . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Table 5.1. Armenia’s Merchandise Trade Partners, by Region, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Table 5.2. Trade Complementarity Index, Armenia and Selected Trading Partners, 2008–10. . . . . . . . . . . . . . . . . 66 . . . . . . . . . . . . . . . . . . . . . . . . . 67 Table 5.3. Estimated Costs to Export One Truckload: Yerevan to Moscow (via Poti) Table 5.4. Ro-Ro Service Average Rates for a Full Truck. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68 Table 5.5. Import Costs from China to Yerevan (via Bandar Abbas), 20' and 40' Containers, 2012. . . . . . . . . . . . . 68 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 81 Table 6.1. Base of Operations and Size of Selected Carriers in CIS Countries Table A6.1. Pooled OLS Regression Results, Aggregate Fare Elasticities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 85 Table A6.2. Pooled OLS Regression Results, Economy and Business Class Fare Elasticities. . . . . . . . . . . . . . . . . . 87 Table A6.3. Instrumental Variables Regression Results, Aggregate Fare Elasticities. . . . . . . . . . . . . . . . . . . . . . . . . 88 Table A6.4. OLS Regression Results, Fare Elasticities by Market. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88 Table A6.5. Pooled OLS Regression Results, Determinants of Fares. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90 Table 6.2. Summary of Selected Studies on Air Transport Liberalization . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 93 Figures Figure 1. Saving, Armenia and Selected Countries, 2003–10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xv Figure 2. Lending-to-Deposit Rate Spreads, Armenia and Selected Countries, 2010 . . . . . . . . . . . . . . . . . . . . . . xvi Figure 3. Armenia: Labor Force Participation and Employment, 2000–2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . xviii Figure 4. Number of Firms in Each Sector, Market, or Market Segment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xx Figure 5. Concentration Levels for Selected Armenian Food Products, HHI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxii Figure 6. Merchandise Trade by Mode of Transport, 2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxiii Figure 7. Number of Destinations by Frequency of Service from CIS Countries’ Capitals, 2012. . . . . . . . . . . . . xxiv Figure 8. Lowest Available Fares from (left) and to (right) Yerevan and Tbilisi Direct and non-stop routes. . . . . xxv Figure 9. Total Turnaround Charges, for an Airbus A320-200. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . xxvi Figure 1.1. Growth, Capital Formation, Exports, and Consumption in Armenia and Low Income Countries . . . . . 3 Figure 1.2. Current Account Balance, Construction, Investment, and Components of Growth . . . . . . . . . . . . . . . . 4 Figure 1.3. Real GDP and its Components, Q1-2008 to Q2-2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 Figure 1.4. External Trade and Capital Flows, 2006–11. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6 Figure 1.5. Key Fiscal Indicators, 2008–2012. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 Figure 1.6. Policy Rate and 12-month Inflation, 2008–2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 Figure 1.7. Public Sector Debt, 2012–32. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9 Figure 2.1. Saving, Armenia and Selected Countries, 2003–10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Figure 2.2. Armenia : Composition of Domestic Saving, 2002–10. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12 Figure 2.3. Armenia: Peer Comparison on Financial Sector Depth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Figure 2.4. Composition of Bank Deposits, 2000–12. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16 Figure 2.5. Corporate Leverage Ratios, Armenia and Selected Countries, 2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . 17 Figure 2.6. Lending-to-Deposit Rate Spreads, Armenia and Selected Countries, 2010. . . . . . . . . . . . . . . . . . . . . . 18 Contents | vii Figure 2.7. Government Bond Yields and Lending Rates, Armenia and Regional Comparators, 2011 . . . . . . . . . 19 Figure 2.8. Stock Market Capitalization, Armenia and Selected Countries, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Figure 2.9. Projection of Individual Pension Invested Funds, 2014–2020. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 Figure 2.10. Armenia: Savings Gap and Foreign Direct Investment, 2001–2011. . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 Figure 2.11. Armenia: FDI Inflows during the 2000s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 Figure 2.12. Capital Accumulation and FDI Inflows, 2000–2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 Figure 2.13. Sectoral Contribution to Total Gross value Added, 2000–2010 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25 Figure 3.1. Armenia: Labor Force Participation and Employment, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 Figure 3.2. Armenia’s Drivers of Employment, by Sector, 2002–10 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Figure 3.3. Employment Ratios in International Comparison . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32 Figure 3.4. Skills and Labor Demand, 2008. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34 Figure 3.5. Armenia: Labor Force Participation and Employment, 2010. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 Figure 4.1. Number of Firms in Each Sector, Market, or Market Segment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Figure 4.2. Market Structure, 2009. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Figure 4.3. Price Controls Across Professions in the EU and OECD Countries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48 Figure 4.4. Concentration Levels for Selected Armenian Food Products, HHI . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49 Figure 4.5. The Role of Competition Policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Figure 5.1. Merchandise Trade by Mode of Transport, 2011 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64 Figure 5.2. Armenia Trade and Transport Facilitation Performance, 2007–2012 . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65 Figure 6.1. Capacity Distribution (seats) from Yerevan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 73 Figure 6.2. Number of Destinations by Frequency of Service from Yerevan . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74 Figure 6.3. Number of Destinations by Frequency of Service from CIS Countries’ Capitals . . . . . . . . . . . . . . . . . . 74 Figure 6.4. Lowest Available Fares. Yerevan and Tbilisi Direct and non-stop routes. . . . . . . . . . . . . . . . . . . . . . . . . 75 Figure 6.5. Lowest Available Fares from Yerevan, Tbilisi, Baku and Almaty Direct and non-stop routes . . . . . . . . 77 Figure 6.6. Turnaround Costs for an Airbus A320-200 Paid by Airlines. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 77 Figure 6.7. Total Turnaround Charges paid by Passengers for an Airbus A320-200 . . . . . . . . . . . . . . . . . . . . . . . . . 78 Figure 6.8. Total Turnaround Charges, for an Airbus A320-200. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79 Figure 6.9. Spatial Concentration and Schedule (time) Coordination of CIS Carrier Operations . . . . . . . . . . . . . . 82 Figure 7.1. Overall Location Readiness Index (LRI) for IT/ITES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Figure 7.2. Armenia’s Ready-to-Hire Population . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Figure 7.3. Armenia Cost of Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Boxes . . . . . . . . . . . . . . . . 41 Box 3.1. First Mover Institutions in Emerging Economies Created with the Help of Diasporas Box 4.1. Review of the current draft of the amendments to Armenia’s Competition Law . . . . . . . . . . . . . . . . . . . . 55 Box 4.2. EU Assessment Methodology and Checklist to Ensure That State Aid is Non-distortionary . . . . . . . . . . 60 Box 6.1. Criteria for Counting Valid ‘hits’ on Connecting Flights. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 80 viii  |  Republic of Armenia: Accumulation, Competition, and Connectivity Acknowledgments This report was prepared by a team initially led by Sou- The study benefited from regular feedback from the leymane Coulibaly and then by Ulrich Bartsch from the Republic of Armenia‘s Ministry of Finance, the Ministry World Bank‘s Eastern Europe and Central Asia (ECA) of Economy, the General Directorate of Civil Aviation regional department. The lead authors have a large and the Central Bank of Armenia. Useful comments team to thank for their inputs and insights, including were also received from the IMF and USAID. colleagues from inside and outside the World Bank. We wish to extend our gratitude to Tania Begazo, The Bank‘s team benefited also from the guidance Mohamed Diaby, Gohar Gyulumyan, Artsvi Khacha- and comments of senior World Bank managers tryan, Tigran Kostanyan, Yevgeny Kuznetsov, Martha and colleagues, including Asad Alam, Henry Kerali, Martinez Licetti, Vilas Pathikonda, Iulian Pogor, Geor- Yvonne Tsikata, Kazi Matin, Ivailo Izvorski, Pedro Luis giana Pop, Siddhartha Raja, Sandra Sargent, Daniel Rodriguez, Rashmi Shankar, Jean-Michel Happi, Palo- Saslavsky, Evgenia Shumilkina, Ramya Sundaram, Er- ma Anos Casero, Daniel Ledermann, Ndiame Diop, win Tiongson and staff of EV consulting. Deepak Mishra, Pablo Saavedra, and Raju Singh. Zakia Nekaien-Nowrouz and Nelli Kachatryan provided ex- cellent support to the team. Acknowledgments  | ix Acronyms and Abbreviations ACRA Accounting and Corporate Regulatory ILO International Labor Organization Authority IMF International Monetary Fund ADB Asian Development Bank IT Information Technology AEA Armavia and Atlantis European Airways ITES IT-Enabled Services ASA Air Service Agreement LPI Logistics Performance Index AMD Armenian Dram LRI Location Readiness Index ASM Average Seat Miles MNC Multinational Corporation AUA American University of Armenia MSME Micro, Small and Medium Enterprise BEEPS Business Environment and Enterprise NACE National Association of Colleges and Performance Survey Empoyers CBA Central Bank of Armenia NGO Non-governmental Organization CEE Central and Eastern European Countries NSRC North-South Road Corridor CIS Commonwealth Independent State NSS National Statistical Service CPI Consumer Price Index OECD Organization for Economic Development CSA Czech Airlines PER Public Expenditure Review DSA Debt Sustainability Analysis PES Armenia’s Public Employment Services ECA Europe and Central Asia PPP Public Private Partnership ECF Extended Credit Facility PMR Product Market Regulations EFF Extended Fund Facility PSRC Public Service Regulatory Commission EIF Enterprise Incubator foundation R&D Research and Development ETF European Training Foundation ROA Republic of Armenia EU European Union SCPEC State Commission for the Protection of FBP Family Benefit Program Competition FDI Foreign Direct Investment SRC State Revenue Commission GCI Global Competitiveness Index SME Small and Medium Enterprise GDCA General Department of Civil Aviation SOE State-owned enterprises GDP Gross Domestic Product TA Technical Assistance GFCF Gross Fixed Capital Formation USAID United States Agency for International GVA Gross Value Added Development IFS International Financial Statistics USD US dollar ICT Information and Communication Technology VAT Value Added Tax IDA International Development Association WTO World Trade Organization ILCS Integrated Living Conditions Survey WEF World Economic Forum Acronyms and Abbreviations  |  xi Executive Summary By 2013, the Armenian economy has left behind higher investment and better financial intermediation most of the hangover from the global financial crisis between savers and investors. Second, better utiliza- and a look at medium- to long-term growth driv- tion of the labor force, including the largely untapped ers is therefore in order. Real GDP growth reached resource of Armenians abroad. Third, stronger com- 7.2 percent in 2012, and the current account deficit petitive pressures in the markets for goods and ser- narrowed, although it remained high. Macroeconom- vices, which will improve incentives for companies to ic buffers have been rebuilt to some extent, although innovate, adopt new technologies, and become more the public debt-to-GDP ratio, at 44  percent, remains efficient. Fourth, enhanced connections of the land- too high to relax fiscal restraints. The rebound came locked Armenian economy with world markets, includ- after a severe recession in 2009 and low but increasing ing through land, air, and through internet and com- growth rates in 2010 and 2011. Still, the double-digit munication technologies. growth performance before the global crisis seems a long way off, and the altered international environ- The return to decent growth rates therefore should ment means that a return to the same pattern of high not lead to complacency: Armenia’s government growth is unlikely. now needs to act to reach its goals. The growth spurt of 2003–08 was narrowly based on an expansion The central tenet of this report is that the govern- of residential construction, domestic services, and for- ment’s job creation agenda requires a different eign exchange inflows. Although many jobs were cre- growth model than the one followed before the ated in the construction sector, overall employment global crisis. The government’s Armenia Development expanded very little, and unemployment continued to Strategy (ADS) for 2012–25 gives highest priority to job be rampant, in particular among young job seekers. creation. It emphasizes strong employment expansion Moreover, the boom ended in a massive contraction in “high-quality and decently paid” jobs. The strategy in 2009 when capital inflows stopped and investor rightly highlights the need to improve the business en- confidence nose-dived. The downturn of course led vironment and investment climate, through strength- to a significant increase in unemployment, and set the ening financial intermediation, investment promotion, clock back by several years with regards to poverty and competition policy enforcement. We point out in reduction efforts. The goal is now to create favorable this report that the high growth before the global crisis conditions for a different, more sustainable pattern of failed to solve Armenia’s employment problem, and economic growth by increasing Armenia’s internation- that unsustainable macroeconomic imbalances were al competitiveness. built up. The high growth was based on a foreign fi- nanced expansion of the construction sector and do- Uncertainties in the international economic envi- mestic services, while exports lagged behind. ronment make it more urgent to design policies in support of the new growth model. Armenia’s Reaching the goals of the government’s strategy economy faces important headwinds, in particular will require a combination of four factors. First, a possible new recession in its main trading partner, Executive Summary | xiii the European Union. In addition, adjustments of 1. Post independence. The economy contracted the still-too-large construction sector will continue, by half between 1990 and 1993, because of the and agricultural sector growth, which buoyed over- break-down of the Soviet Union’s production val- all growth in 2011–12, will return to its historic 3–4 ue chains. Economic displacement and structur- percent annual expansion pace. Growth drivers will al transformation continued until the end of the therefore have to be industry and modern services 1990s. competing in international markets. Within industry, 2. Transition. Strong economic growth during 1999– the manufacturing sector is the most likely sector to 2003 was built on high productivity growth and create employment. Labor productivity is significantly exports. Favorable inflation and exchange rate dy- higher in manufacturing than in, for example, agricul- namics led to a depreciation of the real exchange ture, and its production technology is much more la- rate by 15 percent. The economy regained its bor intensive than that of heavy industry and modern pre-independence size in about 2003. services. The manufacturing sector is therefore rightly 3. Irrational exuberance.1 In 2003, the government targeted in the ADS as the sector in which high quali- started actively seeking investments from Arme- ty, decently paid jobs will be created. Higher produc- nians living abroad (the diaspora) into real estate tivity in this context means higher growth and faster in Armenia. This created a construction-centered poverty reduction. growth model supported by foreign exchange in- flows. Double-digit economic growth rates were This report’s theoretical framework emphasizes underpinned by high rates of investment, which structural reforms to drive growth. Economic growth peaked at 35 percent of GDP. High growth was theory distinguishes between accumulation of the fac- led by residential construction and domestic ser- tors of production and enhancing the productivity with vices. Construction sector value-added multiplied which these factors are employed. Both need to work 5.5 times and accounted for more than a third of in tandem for economic growth to occur and be sus- real GDP growth. The real exchange rate appre- tainable. The report highlights that this was not the ciated by nearly 60 percent and outward orienta- case in the run-up to and during the global financial tion of the economy declined. Despite the rapid crisis. Going forward, growth should be broader based construction of residential units, prices increased and led by tradable sectors capable of creating jobs manifold, which in turn increased the attractive- for the large number of—mostly young—unemployed ness of real estate for investors—a classic bubble. Armenians. The currency appreciation going along with for- eign exchange inflows hampered export expan- The choice of topics follows the logic of developing sion. Productivity growth sagged, and unemploy- policies for structural reforms in line with the goals ment remained high despite impressive job cre- of the ADS. The chapters therefore support higher ation in the construction industry. When the global accumulation of factors of production—capital and financial crisis at the end of 2008 brought a sharp labor—and making them more productive through decline in remittances and investor sentiment, the more competition and better connectivity of the Ar- construction industry collapsed and the economy menian economy with the rest of the world. In the rest shrank by 14 percent. of this summary, we present the main areas of analysis, 4. Recession and recovery. As a result of the global and the policy messages resulting from them. economic crisis, Armenia’s economy contracted by 14 percent in 2009. In that year, remittances declined by 35 percent, investment declined 31 Armenia’s New Growth Model percent, and the construction industry contract- Armenia’s economy grew by 3 percent per year on ed by 41.6 percent. Since then, a modest, but average between 1991 and 2012, but the average masks large fluctuations. Armenia outperformed oth- er lower middle income countries, but was hit harder 1 Phrase coined by US Federal Reserve Chairman Alan Greenspan in December 1996 during the dotcom bubble. The than others by the global crisis in 2008–09. We can dis- phrase was interpreted as a warning that the market was over- tinguish four phases: valued. xiv  |  Republic of Armenia: Accumulation, Competition, and Connectivity accelerating recovery has taken hold. Real GDP Higher Investment, and Better expanded by 4.7 percent in 2011 and 7.2 percent Financial Intermediation in 2012 buoyed by high prices for base metals and high agricultural output. The decline in the con- Investment was very high before the global crisis, struction sector seems to have bottomed out, and but most of it was not directed to productive sec- a strong growth in exports contributed to an im- tors. Domestic saving increased from around 5 per- proving external balance. The average growth rate cent of GDP in the beginning of the decade, to 35 per- of merchandise exports was 45 percent in US dol- cent of GDP in 2006, significantly above regional peers lar terms during 2010–2011, while imports grew by (Figure 1). Public saving contributed about 5 percent only 14 percent. Merchandise exports expanded of GDP to this rise. Foreign direct investment signifi- strongly partly because of high commodity prices cantly supplemented domestic savings. The global for Armenia’s metals and minerals. financial crisis led to a fall in the saving-to-GDP and investment-to-GDP ratios by about 15 percentage Coming out of the crisis, the dependence of the points during 2009–11, but the level of saving is still economy on domestic demand is easing. The con- higher than the regional average. Public saving de- traction of domestic consumption and exchange rate clined when revenue dropped in line with falling GDP depreciation allowed exports to expand. Net ex- and spending was maintained in an attempt to sup- ports contributed 1 percent to GDP growth in 2012, a port aggregate demand. strong turn-around from the negative contribution to GDP growth of about 10 percent in 2007 and 2008. In Figure 1. Saving, Armenia and Selected the wake of the crisis, exports grew significantly faster Countries, 2003–10 than GDP, and the export to GDP ratio rose quickly (in percent of GDP) to about 25 percent in 2012. The construction sec- tor stabilized in 2012. However, it is still significantly Armenia Moldova Georgia larger than construction sectors in other lower middle Albania Estonia Macedonia, FYR Poland income countries. 40 Slower growth abroad, and a return to trend in ag- 30 ricultural growth suggest a slowdown of economic 20 growth over the medium term. With the effects of 10 the good agricultural harvest waning, GDP growth is projected to moderate to 5 percent during 2013– 0 2003 2004 2008 2006 2007 2008 2009 2010 2015. With a modest outlook for construction and the agriculture sector’s return to its historic 3–4 percent Sources: WDI. annual expansion pace, growth drivers will have to come from industry and modern services. Public investment in infrastructure is low and has been falling. While public investment was increased The current account deficit is expected to improve to 6.7 percent of GDP in 2009 from 5.1 percent in 2008, with growing remittances and as a result of struc- it has since fallen to 3.8 percent of GDP in 2012. From tural shifts in the economy. Policies geared to in- 22.4 percent of total spending in 2008, capital spend- dustrial development and export promotion should ing was only 13.2 percent of total spending in 2012. lead to faster growth of tradable sectors. Together Armenia is ranked 71st in quality of infrastructure in the with continuing growth in remittance inflows, this Global Competitiveness Report 2012–13. will support a reduction in the current account defi- cit to single digits. The macroeconomic framework High investment and a stable, manageable cur- also takes into account gradual depreciation of the rent account deficit are crucial for high economic exchange rate to support an improvement in the cur- growth rates. As the Growth Report (2008) pointed rent account balance. out, economies that had sustained 7 percent or higher growth since the 1950s had investment rates of 20–25 Executive Summary | xv percent, while maintaining the current account deficit enterprises’ (MSMEs) face difficulties accessing loans. at manageable levels. Foreign saving is an imperfect MSMEs often lack the necessary skills to be consid- substitute for domestic saving, because of the vulner- ered creditworthy because of insufficient accounting ability to capital flow volatility that it creates. Foreign and reporting, and difficulties in posting collateral. direct investment (FDI) has often proved less volatile While the collateral regime has improved in recent than other forms of foreign saving, and high domestic years, shortcomings remain in several areas, including saving and FDI are therefore important inputs to high registration and foreclosure. and stable growth rates. Figure 2. Lending-to-Deposit Rate Spreads, Armenia’s recent experience has shown that the Armenia and Selected Countries, 2010 sectoral allocation of investment matters and there- (in percent) fore the intermediation between saving and invest- ment. The residential investment boom of 2003–08 World left the economy vulnerable to the external shock of Middle income countries Lower middle income countries the global crisis. Armenia’s financial system is dom- Estonia inated by banks, while equity and securities markets Poland* are rudimentary. Banks account for 92 percent of the Macedonia financial system’s assets, while credit organizations ac- Ukraine Moldova count for 5.5 percent. The public bond market is more Albania established than the private bond market, and the Ar- Georgia menian government has created a system of regular Armenia 2010 public bond placements in the primary market, which Armenia 2012** 0% 2% 4% 6% 8% 10% 12% 14% 16% mainly consists of banks. The volume of public debt outstanding has been increasing at a rate of about 20 percent per annum over recent years to reach about Source: CBA, WDI. 6 percent of GDP in 2012 compared with 3 percent in Financial market development will likely receive 2003. The private bond market capitalization is less a significant boost from the inflow of funds ex- than 1 percent of GDP. pected from the new mandatory individual pen- sion accounts. Investible resources are projected to The banking system is sound and has been grow- rise to nearly $2 billion by 2020, a significant sum for ing rapidly, but it still lags behind most of its peers Armenia, where total banking assets in 2010 were in size, efficiency, and innovation. The banking about $6 billion. The new pension accounts provide system is fragmented with 21 relatively small banks. tremendous opportunities, but the government and Private sector credit to GDP remains relatively low the CBA still have to design the rules and regulations at about 38 percent compared to the median of the and the financial infrastructure to make them a suc- ECA region of 42 percent in 2010.2 Armenia compares cess. unfavorably to similar countries in terms of indicators for financial system efficiency (interest rate spreads, Reforms to boost investment cover four areas: the net interest margin, and overhead-to-assets ratio, macroeconomic environment, financial interme- Figure 2). Deposits are predominantly held in U.S. diation, remittances, and FDI. The significance of dollars, and access to donor funds reduces banks’ income in determining the saving rate implies that incentives to offer attractive saving rates. The banks a growth-enabling macroeconomic environment is give mostly plain vanilla corporate loans to large a necessary condition for high domestic saving and corporate clients, and micro, small and medium reduces reliance on foreign capital for investment. A macroeconomic environment that ensures low infla- 2 World Development Indicators database for 2010. CBA re- tion, a sustainable fiscal deficit and a sustainable cur- ports 38 percent credit to GDP for 2012, but the methodology is rent account deficit enables growth. Monetary, fiscal not the same and shows a higher ratio than the one calculated and trade policies need to be closely coordinated. for WDI. xvi  |  Republic of Armenia: Accumulation, Competition, and Connectivity Deeper financial intermediation stimulates invest- Better Use of Human Resources ment. Credit services are available to a relatively small group of companies, which are mostly large, modern Being a small country, Armenia can ill afford not sector entities, while micro-, small-, and medium-scale using a large proportion of its labor force. High companies rely to a large extent on retained earnings unemployment and low labor force participation to finance working capital and expansions. Micro-sav- combine to make the employment-to-population ra- ings and -credit institutions can overcome size con- tio lower than in most European countries (Figure 3). straints, particularly in small towns and rural areas. To At 53 percent, this ratio is far below the European further expand credit services, measures could include average of 60 percent. Simulations suggest that in- the following: creasing employment of Armenians to the European average would lift GDP by about 8 percent. However, ¾¾ Building capacity with MSMEs and banks on how higher growth is not the only potential benefit: labor to access credit and provide loans. market activities are important drivers of poverty re- ¾¾ Improving the collateral registration and realiza- duction. tion process. ¾¾ Promotion and expansion of microfinance. Unemployment soared after the global crisis, with ¾¾ Regulatory modifications to expand financial ser- young men and women bearing a disproportion- vices and credit products, including hedging, fac- ate burden of this employment shock. Labor mar- toring, and leasing. ket conditions have improved somewhat in 2011–12, ¾¾ Outreach, awareness building, and financial litera- but the rate of joblessness remains high at 18 per- cy initiatives to deepen understanding of financial cent in 2012, which is well above the regional aver- products. age of about 12 percent. International migration has been an important feature of Armenia’s economic Equity and securities markets could supplement fi- landscape and it has been an important safety valve nancial intermediation offered through banks. De- for the Armenian labor market: many of the migrants veloping initiatives for increasing the supply of capital were unemployed just prior to emigration. Remit- market securities will require a multi-pronged effort tances of those migrants amount to 15 percent of versus a traditional ‘organic’ growth of markets. This GDP. may include: Low levels of employment result from low job cre- ¾¾ Securities regulation to increase financial market ation on the one hand, and a mismatch of workers access and product development. and jobs on the other. Job creation is low because ¾¾ Institution-specific initiatives, such as increasing Armenia lacks a critical mass of small, dynamic and job the role of the national mortgage company and creating enterprises. Data from the Life in Transition Pan Armenian Bank in issuing securities. Survey (2010) suggest that only about 12 percent of ¾¾ Deeper government debt management to in- people in the labor force have ever attempted to start crease the depth of AMD government securities a business and less than 6 percent have succeeded. to provide a benchmark for indexed bonds. This contributes to a lack of small firms, which lead ¾¾ Using cashflow backed project bonds to finance job-creation in the years ahead of the crisis. On the public infrastructure investments. demand side, many firms report that inadequate skills constitute an important obstacle to doing business. Attracting more FDI requires improving the invest- This is particularly true among enterprises that are ment climate and the connectivity to external mar- more modern and innovative—that is, firms that invest kets. Armenia’s size disadvantage calls for being prag- in research and development, introducing new prod- matic and realistic: establish a target list of reputable ucts, or upgrading existing products. About a third of multinationals in manufacturing and tradable services these firms complain that they are constrained by the and lobby them to relocate some of their activities to lack of skilled workers. Armenia. Executive Summary | xvii Figure 3. Armenia: Labor Force Participation and Employment, 2000–2010 a: Employment by sector, thousand b: Participation and employment rates, percent, 2009 1200 Non-tradable Services 70 Kazakhstan 1000 Kyrgyz Public Administration Azerbaijan Employment rate 60 800 Russia Tradable Services Czech Belarus 600 Bulgaria ECA Georgia Estonia Mining and quarrying 50 Latvia 400 Croatia Armenia Moldova Albania BiH Manufacturing 200 40 0 Electricity, gas and water 40 50 60 70 80 Participation rate 2002 2003 2004 2005 2006 2007 2008 2009 2010 c: Youth vs. adult employment rates, percent d: Female vs. male employment rates, percent 45 44.5 60 45 44.5 60 44 44 50 50 42.8 42.8 43 42.5 43 42.5 42.0 42.0 40 41.6 40 42 41.2 41.2 42 41.6 40.8 41.2 41.3 41.2 41.2 40.8 30 41 40.4 40.2 30 41 40.4 40.2 40 20 20 40 39 39 10 10 38 38 0 37 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total (LHS) Youth (RHS) Adult (RHS) Total (LHS) Female (RHS) Male (RHS) Source: WDI, ILO and NSS. In this environment, Armenia’s Public Employment Addressing low employment will require a multi- Services (PES) have played a very limited role. Few pronged approach. The labor market is character- of the unemployed workers—less than 10 percent— ized by weak labor demand, an inadequately qualified find it worthwhile to register with the PES. A smaller workforce and the poor matching of job seekers to fraction use PES resources to find jobs, relying instead employers. As a result, a large proportion of Armenia’s on friends and family members to obtain information human resources are not productively employed. on jobs vacancies. In fact, the effectiveness of PES job placement services is severely limited. Currently, there ¾¾ The creation of employment in the modern econ- are 11 to 12 unemployed workers per vacancy report- omy requires lower impediments to firm entry ed to the PES office (the so-called unemployment/va- and business start-ups, and an improved busi- cancy ratio), suggesting that at best the PES office can ness environment. Crucially, more competition in place less than a 10th of unemployed workers. the Armenian market for goods and services is xviii  |  Republic of Armenia: Accumulation, Competition, and Connectivity likely to promote innovation, and allow new, more of firms (Figure 4). Indicators for Armenia of the inten- productive firms to enter markets which are now sity of local market competition, the extent of market dominated by old, slow companies not likely to dominance, and the effectiveness of competition pol- create many new jobs. Better connectivity of the icy therefore lag behind other countries in the region. Armenian economy with the rest of the world will According to the Global Competitiveness Index (GCI), increase pressures on Armenian firms to compete Armenia ranks lowest among ECA countries in the ef- with the rest of the world. fectiveness of antimonopoly policy and the intensity of ¾¾ The quality of Armenia’s workforce needs to be local competition. This low ranking goes a long way to strengthened by engaging employers in the de- explaining the lack of dynamism of the Armenian econ- sign of academic curricula, instituting apprentice- omy, which leads to low employment and low incomes. ships, and creating quality assurance mechanisms. Insufficient competition affects regulated sectors such However, with the generally high level of educa- as utilities and natural monopolies, and certain markets tion already achieved, learning on the job would with a small number of firms, such as petroleum, sugar, be the most efficient way of enhancing human wheat, and cut flowers. Competition is limited because capital, and hence, this brings us back to the pre- of barriers to entry, ownership concentration, market vious point on job creation. dominance, and vertical and horizontal integration. ¾¾ Job matching services provided by PES need to be improved. Pro-competition sectoral reforms and effective im- plementation of antitrust rules can lead to signifi- One way to overcome institutional bottlenecks and cant productivity gains and consumer savings. Ro- skill shortages is Armenia’s diaspora. Members of the bust competition provides firms with strong incentives diaspora are best placed to identify opportunities in Ar- to reduce costs and innovate to become more efficient menia with their combination of outside know-how and and productive. Competition may be stifled by the be- intimate knowledge of the home country. They can be havior of market participants, for example through the an important source for innovation, and can work with formation of cartels and price fixing, through product policymakers to alleviate constraints. The usual policy market regulation, distortive state aid, and the pres- focus of home country authorities when looking at large ence of powerful state-owned enterprises. Regulations diaspora populations—encourage return of talent to have an impact on market structure—for example, by the home country—is often neither realistic nor neces- limiting the number of competitors or raising barriers sary: members of skilled diasporas can just as effectively to entry—and also on the firms’ ability to compete, engage in joint projects with the home country without through price controls and coercive regulations which permanently relocating back to it. The key conceptual do not create incentives for efficiency. framework is to look at diaspora engagement as pro- moting search networks, and help them scale up and State-owned enterprises (SOEs) and government institutionalize innovative ideas—a concept described participation still play a dominant role in many im- as guided serendipity. The goal would be to introduce portant sectors. The government owns the largest linkages between members of the diaspora and home firms in electricity generation and transmission, water, country agencies to benefit from the dynamism and postal services, railways, and operation of road infra- external experience in shaping domestic institutions, structure. The Armenian nuclear power plant and the removing barriers to growth, and fostering innovation. water systems of national relevance are considered of strategic importance.3 National, state or provincial governments control at least one firm in 5 sectors. Enhancing Competition in While SOE presence is not unusual in certain econo- Armenia’s Markets mies, especially in certain segments of network indus- tries, the Armenian government should not intervene In Armenia’s small market with important barriers to trade, domestic competition is of crucial importance for the dynamism of the economy. Key sectors of the 3 Law on Energy of the Republic of Armenia, Article 6 and Armenian economy are dominated by limited numbers Water Code of the Republic of Armenia, Article 4, respectively. Executive Summary | xix Figure 4. Number of Firms in Each Sector, Market, or Market Segment Many firms Few firms One firm Mining Oil and gas Agriculture Forestry Light manufacturing Food products Pharmaceuticals Fixed line infrastructure Fixed line telephony Wireless/mobile infrastructure Wireless/mobile services Coal generation Hydro generation Biomass generation Solar generation Wind generation Transmission Distribution Banking Insurance Railway freight International air Airport operation Television broadcasting Newspaper Construction Healthcare Retail distribution services Tourism Waste managmt and recycling Mining, Agri, Manufacturing Telecom Electric power Financial Transport Media Other services oil, gas forestry sector Source: Investment Across Borders, 2010. in sectors and market segments that are typically open and Atlantis European Airways (AEA).4 With the to private sector. exception of Russian routes, only one carrier per country (either Armavia or AEA on the Armenian The Armenian government has granted state aid to side) is allowed to operate on a reciprocal basis in support economic entities, but the selection process a particular market. Lack of competition leads to lacks clear criteria to analyze impacts on competition. significantly higher ticket prices to and from Arme- State aid has consisted of deferral of tax payments, sub- nia compared to similar countries. sidies, guarantees, government loans, and subsidies for ¾¾ Railways: There is only one railway operator, which interest payments. Business projects that satisfy certain has a concession for providing rail services. While criteria can benefit from government support programs, in principle open access to the infrastructure exists, including both financial and technical assistance. methods for calculation of access charges and the actual charges have not yet been published, and no Barriers to competition exist in different sectors, competitor has been established. Vertical integra- partly because of the characteristics of government tion of the railway operator, SCR, with major ferry contracts, discriminatory rules and inadequate reg- and trucking companies further curtails competition. ulations, and particular aspects of market structure. ¾¾ Gas: Only one company imports and distributes A few selected sectors described here provide import- gas.5 The current regulatory framework is not pro- ant inputs for production in Armenia, and also prod- ucts and services directly to households. 4 Armavia ceased operations in April 2013 after this report was finalized. Atlantis European Airways serves as a marketing ¾¾ Air transport: Policy making, its implementation, agent of Austrian Airlines and Czech Airlines and does not oper- and economic and technical regulation are carried ate any aircraft itself. out by the General Department of Civil Aviation 5 Armenia does not produce natural gas. Import of gas is be- (GDCA), an unusual concentration of power. The ing conducted by Russian-Armenian CJSC “Hay-RusGazArd” in which the Armenian Government has 10 percent equity share. current regulatory practices favor the two Arme- Previously the government had 20 percent equity share; 10 per- nian incumbents in the aviation sector, Armavia cent was sold to the major shareholder. xx  |  Republic of Armenia: Accumulation, Competition, and Connectivity viding adequate, non-discriminatory third-party competitors of comparable size, while only one and access to the gas transmission grid. two important firms operate in the markets for sugar ¾¾ Electricity: There are numerous generators of and wheat flour, respectively (Figure 5). This highlights electricity in Armenia, but transmission and distri- that other factors determine effective competition: the bution is in the hands of only one company. The economic characteristics of the production process, sector does not have a retail choice provision and the functioning of the supply chain, and the strategic liberalized electricity wholesale pool, which re- behavior of firms. Furthermore, prices are only one of strain consumers’ choices. the variables on which firms decide. The product is a ¾¾ Professional services: Armenia imposes binding combination of price, quality, intangible value, cus- minimum prices for some services of architects and tomer service, and other features that are selected by engineers. The procedure of cost calculation of the firm to compete successfully in the market. As a re- preparing urban development documents applies sult, the level and behavior of prices do not necessarily to participants of urban development.6 At that, the indicate the intensity of competition, and it becomes majority of EU and OECD countries do not have necessary to look at market behavior. any regulations of prices in these professions. ¾¾ Retail: Proposed sectoral regulations set regula- Table 1. Price Differences for Food Articles, tory restrictions to the development of retail busi- Armenia and selected CIS countries, 2010 ness (targeting large commercial outlets). In par- (in percent) ticular, retailers‘ ability to expand further would be limited through special permits from the regional Bread 36 authorities and restrictions on areas for large com- Butter 23 mercial outlets. Eggs 25 A case study of food markets in 2010 detected Milk 33 significantly higher prices in Armenia compared to Rye bread 45 similar countries. Prices in Armenia are about 17 per- Percentage by which prices are lower in Armenia (average) cent higher on average than in CIS counterpart coun- Sugar 9 tries. Price differences are product-specific, with some products registering higher prices and others lower Source: Authors’ calculations. relative prices (Table 1). The analysis takes into account differences in per-capita GDP, import costs, product Properly enforced competition policy therefore type, taxes and time effects. However, it is important does not target firm size but threats to and actual to note that comparing prices poses challenges such distortions of the competitive process and resource as finding comparable products across countries and allocation. Concentration of ownership in itself is not ensuring that the selected products are representative necessarily anti-competitive. Competition policy be- of each market. Also, many of the selected comparator comes important in cases where a firm that exhibits countries do not feature ideal competitive markets, in- significant market power (defined as the ability to raise cluding Azerbaijan, Georgia, and Tajikistan, which sug- prices above marginal costs) acts in ways that distort gests that the calculated price differences may actually the playing field, with potential harmful effects on con- understate potential price differentials. sumers. Competition policy must take into account the technological characteristics of markets, as there can Market structure is only one of the ingredients be instances in which consumers prefer concentrated determining price levels and competition. Market markets with a small number of firms because of net- structures for food items range from a large number work externalities. For instance, many communications of participants to one unique player. For example, and infrastructure services such as telephones and rail- the meat and dairy industries are served by many ways exhibit network externalities. 6 The Order of the Urban Development Minister of the Re- Armenia’s State Commission for the Protection public of Armenia N. 19-N from February 15, 2008. of Competition (SCPEC) faces some important Executive Summary | xxi Figure 5. Concentration Levels for Selected Armenian Food Products, HHI * Meat products Unconcentrated Macaroni HHI<1500 Cheese Sausages Egg Rice Moderately Sunflower seed oil concentrated 2500>HHI>1500 Butter Coffee Wheat for food Pasteurized milk Highly concentrated Wheat flour HHI>2500 Olive oil Sugar 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 Source: SCPEC and authors‘ calculations. Thresholds based on US Merger Guidelines (2010). * Based on HHI levels (US Merger Guidelines, 2010), markets are usually classified as: •  Unconcentrated Markets: HHI below 1500; •  Moderately Concentrated Markets: HHI between 1500 and 2500; •  Highly Concentrated Markets: HHI above 2500.HHI for monopoly equals 10,000. institutional challenges. The SCPEC‘s role is to en- legislation will need to introduce a number of addi- force competition rules, deter anticompetitive behav- tional details: ior, ensure that state aid to firms does not distort com- petition, and advocate and promote a broader under- ¾¾ The treatment of economic groups, the assess- standing of competition rules and benefits. Yet, some ment of direct and indirect control of firms with aspects of the legal framework limit the effectiveness ownership links, and a definition of an economy of its implementation, particularly concerning the as- entity. sessment of market dominance, the structure of fines, ¾¾ A definition of independence, including that the mergers and concentrations. The SCPEC also has an economic entity is entitled and has powers to de- undue focus on price levels rather than anticompeti- fine its competitive strategy without interference tive conduct, and lacks investigative powers. or influence from another economic entity. ¾¾ The concept of control. The concept of a group of There is significant scope to achieve efficiency gains persons in the Competition Law does not explicitly from pro-competitive sector policies and more ef- contemplate the notion of control as the basis for fective economy-wide competition policy enforce- the existence of the group. ment. Removal of barriers to entry and competition is ¾¾ In order to be able to define economic entities for particularly warranted. In addition, competition prin- the implementation of the Competition Law, the ciples need to be fully mainstreamed within broader SCPEC needs to have access to ownership infor- government policies. Improvements to the antitrust mation for the companies under investigation. and state aid framework would complement measures This will require maintaining information channels to reduce restrictive product market regulation. with the State Registry, Credit Registry, and Cen- tral Depository. Memoranda of understanding that The 2010 Competition Law introduced import- define protocols for gaining and granting access ant provisions for dealing with economic groups, to information managed by other entities could be but key areas still require clarification. Secondary a useful tool in this regard. xxii  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 6. Merchandise Trade by Mode of Transport, 2011 Rail Road Air Stationary (i.e. pipeline, transmission line) 70 60 50 40 Percent Share 30 20 10 0 IM EX IM EX By Value (%) By Weight (%) Source: Armenian Customs Service. ¾¾ To improve merger control policy, merger notifi- Despite the geopolitical challenges, more than 80 cation procedures should be simplified and cur- percent of goods exported from Armenia travel rent thresholds for merger notification should be over land. Roads account for about 32 percent of Ar- revised. menia’s exports by value (Figure 6), while the railway line ¾¾ The current structure of fines and sanctions and to Georgia carries 40 percent, mainly resource-based SCPEC‘s investigative powers are too limited to exports such as stones and mining products. Electric- deter anticompetitive conduct; efforts are under- ity accounts for about 8 percent of exports and uses way to define fine calculation methods in the sec- high-voltage transmission lines. Air transport is used ondary legislation.7 for a limited set of items with a high value-to-weight ¾¾ The SCPEC’s implementation of competition pol- ratio such as fresh fruit, diamonds and jewelry, and ac- icy should refocus on market contestability rather counts for about 19 percent of exports. than on price monitoring. ¾¾ The SCPEC does not have the necessary instru- The trucking industry in Armenia consists of 2–3 ments to pursue advocacy vis-à-vis sector regula- sizeable firms and a handful of smaller players. For- tors and other government bodies. eign operators are present, especially Georgian, Turk- ish and Iranian firms. Fixed costs for Armenian truck- ing companies are high and they are spread over few Improving Land Connectivity shipments. Trucking companies complain that acquir- Armenia has few options for transporting goods ing more trucks is difficult. In particular, they point out over land. With closed borders with Turkey and Azer- that obtaining bank financing is difficult and rates can baijan, exports can only use transit corridors to the range up to 15 percent, and that customs duties and north through Georgia, and to the south through Iran. VAT add significant costs. Market regulation may be a On both routes, Armenia’s mountainous terrain poses factor that limits competition and raises prices. Export- additional challenges, and roads become impassable ers on the other hand feel they are being overcharged at times in the winter. In addition to the roads, a railway by trucking companies. line extends to Georgia and the Black Sea coast. Ratifying all relevant international conventions could increase Armenia’s leverage over transit partners. Armenia has not signed the UN Conven- 7 SCPEC is currently developing guidelines on fines calcula- tion on Transit Trade of Landlocked States, one of a tion to address these concerns, particularly to take into account small number of landlocked countries which have not the nature of the infringement, its gravity and duration. Executive Summary | xxiii Figure 7. Number of Destinations by Frequency of Service from CIS Countries’ Capitals, 2012 (as percentage of total destinations served) CIS Extra-CIS Domestic .8 .6 .4 .2 .0 an os y M ow Bis insk sh ek As Tb be Ta aba i sh d Kie t Ba v Ye ku Bi an sh ad Ye nbe sh k Tb nt Ba si Ku M iev Al nsk os y w hk be Ye bad Ta evan Ba t Bis insk Alm ek Tb ty i M Kiev w M ku sh n nt M Kiev Ba w Du Tbi u As sha isi ha e Alm ad Bis aty M ek k ilis h s n n M mat M mat Ta shke k ins co hk nb hk ili a Ta eva k ili co ke co ke hk ke As shan Du hk ke rev an rev Du hab l hk b c ha os i sh a os r Al r Ye hk Du As 1–2 3–6 7–13 14+ Graphs by year Source: Authors’ calculations based on DIIO data (June 2012). done so. This agreement offers signatories the right to while prices are relatively high because of the restrictive “freedom of transit”, and specifies, inter alia, that tran- environment in which the sector operates. Different lev- sit goods should not be subject to any customs duty or els of restrictiveness are currently in force for different special taxes and should have access to storage facili- markets, giving a confusing picture of Armenia’s avia- ties as would domestic goods. tion policy. While competition is present on the Russian routes, most destinations are served by one Armenian Armenian trade would greatly benefit from im- and one foreign airline on a reciprocal basis. provements on the transit route through Georgia. These would include upgrades to the road to Batumi Flights to and from Armenia offer lower flexibili- port as an alternative to Poti, road-clearing services ty compared with regional peers. Among major CIS at the Upper Lars crossing to Russia to allow for year- capitals, Yerevan offers the lowest levels of flexibility, round operations, and a dedicated freight pavilion in measured by the share of markets served with two Poti for goods traveling to and from Armenia. Nego- weekly frequencies or less (highest in the sample), and tiations could also aim at improving the reliability and the percentage of routes with two or more daily fre- reducing the costs of the Black Sea ferries. The new quencies (lowest in the sample, see Figure 7). More- Baku-Tbilisi-Kars railway line, which bypasses Armenia, over, few choices are available in terms of carriers from could nevertheless open a new transit route when it is Yerevan: a sole market is served by four airlines (Mos- completed in the near future, if Armenian trucks were cow), followed by three other markets within Russia, to shuttle goods to Akhalkalaki in Georgia. where three carriers operate (Rostov, Sochi and Miner- alnye Vody). In turn, seventy percent of the markets are served by one or two carriers at most. Effective com- Improving Air Connectivity petition in the densest markets might be even lower: There is little Armenia’s policy makers can do about due to the protective stance towards Armavia, capac- it being a landlocked country, however, it is currently ity in Air Service Agreements (ASAs) is split artificially “policy locked” as well through restrictive policies in between airlines, or commercial agreements on code- aviation. Frequency and capacity of air links between sharing and blockspacing consolidate seat inventory Armenia and the rest of the world are relatively low, and reduce competition. xxiv  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 8. Lowest Available Fares from (left) and to (right) Yerevan and Tbilisi Direct and non-stop routes (in US dollars/km) 0.7 0.7 EVN EVN 0.6 0.6 TBS TBS 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0 0 500 1000 1500 2000 2500 3000 3500 4000 0 500 1000 1500 2000 2500 3000 3500 4000 Source: Authors, based on available published fares of airlines (third week of November 2012 or closest date available) Note: Fares do not include air charges, security fees or taxes. Flights to and from Armenia are significantly more and goods. Our estimates show that a reduction in expensive than to and from neighboring Georgia. In concentration by half on a specific destination reduces contrast with Armenia, Georgia imposes no restrictions observed prices for the economy class segment in the on capacity, airline and point designation. The compar- range of 20 to 28 percent on average. Assuming an ison shows that the lowest fares to and from Yerevan overall reduction of 25 percent in price and an aver- are systematically higher than those to and from Tbilisi age elasticity between –0.9 and –1.08, the aggregate across the selected sample of markets (Figure 8). When welfare gains for the consumer would add up to 1.4 compared with other CIS capitals such as Almaty and percent of GDP. The welfare gain would obviously be Baku, outbound flights are also found to be more ex- quite small for travel to and from Russia, because the pensive in Yerevan. In spite of the increased compe- competitive environment on these routes means liber- tition in connecting markets via major hubs, average alization would not lead to big changes. fares continue to be higher from Yerevan as compared to Tbilisi, although the premium seems lower. This is The restrictive aviation environment is largely de- the result of a benchmarking of air fares in 47 direct termined by the practice of regulation of the sec- and non-stop markets from the Armenian capital and tor. Currently, all decision making, monitoring and 28 markets from Georgia, equivalent to 99 percent of regulation of the aviation sector is concentrated in one all available destinations for the traveler in each case. agency, and restrictive practices protect the two Ar- menian airlines against competition. All governmental A benchmarking exercise of infrastructure and matters regarding aviation are handled by the Gener- non-infrastructure charges at Yerevan airport shows al Department of Civil Aviation (GDCA). It is de facto that charges are relatively high, although compara- policy maker and regulator. It negotiates ASAs, des- ble to those in Tbilisi and Baku. Yerevan stands after ignates Armenian carriers, and defines all market ac- Baku as the third most expensive airport in the sample cess rules for airlines (frequencies, number of allowed with over $5,000 in total charges, and followed closely destinations, etc). It also carries out the functions of by Tbilisi (approx. $4,400) and Minsk ($4,100) (Figure 9). technical regulator (licensing, monitoring and enforce- ment of safety and security) and manages the PPP con- Higher prices and limited flexibility impose costs tract with the company that won the airport conces- on air passengers and cargo, and on the economy sion in 2001. Armavia, the ‘national flag carrier’, plays through lost opportunities for connecting people an unofficial but nevertheless large role in influencing Executive Summary | xxv Figure 9. Total Turnaround Charges, for an Airbus A320-200 (in US dollars) a: without fuel costs b: with fuel costs Other OPS Handling Navigation Other OPS Fuel Handling Landing and Passenger Navigation Landing Passenger Parking (PFC+security and Parking (PFC+security +Oth. Taxes) +Oth. Taxes) 12,000 35,000 10,000 30,000 25,000 8,000 20,000 6,000 15,000 4,000 10,000 2,000 5,000 0 0 Ta ty Du nt Bi e k Ye k an i As aku t E) O) ev As ku t E) O) ev aty nt be k Ye k an i ilis ba ilis ba ke ins b ke ins a M ke M Ki (SV ke rev an Ki (SV Ba rev an Alm ha Alm Tb sh ha B Tb sh (D M (D sh M sh sh sh hg hg w Bi w w Ta w Du co co co co os os os os M M M M Source: Authors based on ICAO and IATA Manual on Airport and Air Navigation Charges Manual and country AIPs. regulatory decisions, as well as discussions of bilateral ¾¾ Greater transparency with regard to contracts and air services agreements. Armavia won exclusive rights agreements to level the playing field for actual and through an investment agreement with the govern- potential market participants. ment in 2003 for a period of ten years. Liberalization of aviation would boost growth in air Improving Internet and passenger and cargo traffic in Armenia, and boost Communication Technology (ICT) economic growth. Liberalization of Armenia’s aviation sector requires: While exports of goods are facing an uphill struggle against Armenia’s high transport costs, exports of ¾¾ A clear policy statement outlining the govern- services, especially those offered through ICT, have ment’s commitment to a competitive environment, tremendous potential. Although Armenia’s ICT sec- ¾¾ A better separation of policy making and its im- tor is comparatively small, its rapid development and plementation, prospects attract foreign investments. Local compa- ¾¾ Independence of regulators from interference nies are starting to become more active in engineer- from regulated entities, ing, systems development, and R&D. In 2010, the size ¾¾ Industry consultation and complaint handling of the domestic market totaled $91 million and the mechanisms, turnover of the software and services sector reached ¾¾ Capacity building to help the Armenian regulator $150 million and the sector employed nearly 5,000 pro- better monitor and enforce contracts, including fessionals with above-average salaries. the airport management concession, and xxvi  |  Republic of Armenia: Accumulation, Competition, and Connectivity The ICT sector can play an important role in boost- Previous Growth Studies ing economic growth. It can support job creation, es- pecially in information technology (IT) and IT-enabled The 2007 Country Economic Memorandum ti- services (ITES). It can also foster economic integration tled “The Caucasian Tiger: Sustaining Economic by ensuring ubiquitous, high-quality, and affordable Growth in Armenia” focused on the double-digit telecommunications regionally and domestically. In- real growth phase. The study made the case that deed, by reducing the economic distance between this impressively consistent performance was to be Armenia and global markets and overcoming domes- attributed to the steadfast pursuit of market-oriented tic and international division, ICT promotes economic reforms, assisted by large external inflows on grant density.8 or soft terms. This economic success reduced pov- erty as seen in the sharp increase in consumption of The ICT sector in Armenia has an opportunity for poorer quintiles facilitated by an effective safety net expansion. Innovative strategies could help it to break program, the Family Poverty Benefit, although the into the league of leading global destinations. The impact on employment was somehow muted. The strategies should address policies, processes and in- study identified the causes of the weak response of stitutions, access to finance, infrastructure, and skills employment to investment and growth to lie in in- development. flexible labor, inadequate skills among unemployed and incomplete structural reforms and inadequate in- ¾¾ Improve intellectual property protection and stitutions and practices that encourage competition. ensure business data confidentiality, as well as The study concluded that reforms were needed to strengthen relevant regulation and law enforce- improve the business environment and fight corrup- ment to raise the confidence of foreign and do- tion, redirect budget resources to public investments, mestic investors in the country’s IT-based services sharpen competition and create infrastructures en- sector. couraging firms to engage in international trade ¾¾ Intensify its export and industry promotion efforts (World Bank 2007). to raise awareness of foreign investors about the opportunities in the Armenian IT-based services The 2002 Country Economic Memorandum titled market and as a result increase the country’s in- “Growth Challenges and Government Policies in volvement in the global market for IT products and Armenia” covered the transition catch-up phase of services. the Armenian economy. The study made the case ¾¾ Create incentives for the private sector to engage that economic expansion in 1995–2000 was fueled by with higher education institutions to better incor- a recovery from the severe contraction of the early porate the changing demands of the fast devel- 1990s. The factors that contributed to growth includ- oping industry through developing joint programs ed the recovery in electricity supply, the expansion and initiatives. of external private transfers stimulating domestic ¾¾ Work further to identify specific market niche op- demand and a large aid inflow complementing low portunities in the IT-based services industry where domestic savings to maintain investments at a com- Armenia has strong competitive advantages com- fortable level. Economic growth was also supported pared to other markets in terms of labor costs and by a relatively strong recovery in agriculture backed professional skills. by a privatization of rural land early in transition and ¾¾ Stimulate competition and reduce barriers to considerable import substitution in food consump- entry to create internal demand for advanced IT tion. The study concluded that these factors were products and high-value services, as well as to not long-term engines of economy-wide growth and make these products and services competitive recommended to strengthen the quality of macro- internationally. economic management, improve the quality of the business environment, expand training opportunities in management and business owners, and establish 8 See World Development Report Framework (2009), institutions to facilitate economic restructuring and http://siteresources.worldbank.org/INTWDR2009/Resources/ new entry (World Bank 2002). Outline.pdf. Executive Summary | xxvii Overview The following four chapters highlight structural im- pediments to high factor productivity growth. We The report starts in chapter 1 with a presentation point out avenues for increasing the competitiveness of recent economic developments. Growth has re- of the Armenian economy, and in particular that of the covered to 7.2 percent in 2012, up from 4.7 percent tradable sectors. in 2011. Macroeconomic buffers have largely been re- built, although public debt remains on the high side. Chapter 4 discusses competition in Armenia’s markets Looking forward, growth is likely to weaken because of for goods and services. While market structure is relat- return to trend of agricultural growth and global eco- ed to the small size of the Armenian economy, more nomic headwinds. sectors are dominated by one or two companies than could be expected. We discuss the impact of state Chapter 2 presents challenges to capital accumula- owned enterprises, rules and regulations, and state aid tion. The report investigates the determinants of ag- on competition. We also present a case study of com- gregate and household saving. It also highlights the petition in food markets, which concludes that prices low state of development of financial and capital mar- of a number of important food items are significantly kets, which is an impediment to growth. These markets higher in Armenia than could be expected. could develop to better intermediate between savers and investors, and make sure that funds are invested Chapter 5 looks at the costs of transporting goods in sectors producing high economic and social returns. through Georgia by road and rail, and through Iran We propose reforms which would increase access to by road. We propose a set of policy initiatives which credit, and improve the environment for corporate Armenia could pursue with neighboring countries to debt and equity issues. We also discuss FDI flows to lower these costs. Policies are clearly important in de- Armenia. termining Armenia’s air connectivity. Chapter 3 looks at labor market outcomes. Labor Chapter 6 points out that compared with similar air- force participation in Armenia is low, and unemploy- ports in the region, flying in and out of Yerevan airport ment is high. There are challenges to labor demand, is significantly more expensive and Yerevan has rela- supply, and matching of jobs and workers. Labor tively few and infrequent connections, with less flexibil- demand is subdued because of a lack of dynamism ity for onward connections. The institutional structure of domestic firms. Entrepreneurship is low, as evi- of governance of aviation issues gives rise for con- denced by a low rate of new business registration, cerns, because it concentrates all matters in one agen- and a low survival rate of new businesses. On the cy, the General Department of Civil Aviation, which is labor supply side, firms complain about insufficient policy maker, implementer, and economic and safety availability of skilled labor. There is also evidence of regulator at the same time. low domestic mobility of workers, as evidenced by persistent wage differences. The chapter also high- Chapter 7 is devoted to information and communi- lights opportunities for engaging Armenia’s large cation technology. The digital revolution has trans- diaspora better in shaping domestic institutions and formed businesses around the world since the start of supporting innovation. the Millennium. We look at Armenia’s readiness to join the world of digital commerce. xxviii  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 2. Summary of Policy Recommendations Objective Policy Instruments Higher Investment, Macroeconomic Closely coordinate monetary, fiscal and trade policies. Better Financial stability: low inflation, a Maintain the inflation targeting policy of the Central Bank. Intermediation sustainable fiscal deficit and a sustainable Maintain a competitive real exchange rate and low (imported) inflation. current account deficit Maintain a sustainable fiscal stance, with the debt ratio contained below 50 percent of the previous year’s GDP (as per the fiscal rules adopted by the Government of Armenia).(A) Deeper financial Restore the link between deposits and credits; credit lines from donors should not distort the market. intermediation to Support micro-saving and -credit institutions to overcome size constraints, particularly in small towns and mobilize domestic rural areas. saving, and channel investment into Further consolidate small banks, and promote innovative technology and automation to reduce productive sectors operational and overhead costs. Improve the collateral realization process. Introduce regulatory modifications for the development of leasing (providing equal tax treatment of lease financing and loan financing, developing leasing capacity and technical know-how in banks and credit organizations, and developing a leasing law following international good practice). Initiatives for Develop factoring (receivables securitization) and reverse factoring markets to provide well rated fixed increasing the supply income instruments. This will also require, inter alia, streamlining the floating security interest regime. of capital market Provide securitization options for pooled SME business revenues and receivables to free up lending securities capital and generate new fixed income instruments with collateral backing. Create a private equity framework to allow capital transactions to occur within a less transactional- and disclosure-intensive procedure amongst qualified players, and permit transactions via an over-the-counter market. A deeper government debt management program could increase the depth of AMD government securities at key segments of the yield curve, and once achieved, provide a benchmark for indexed bonds. The government could also develop instruments to securitize future project revenue flows to finance major public infrastructure projects (railways, hydropower, energy, other) instead of using bank or IFI financing, to capture domestic institutional and retail investor funding. Institution-Specific The national mortgage company could increase the issuance of mortgage covered bonds or Initiatives securitizations. The mandate and portfolio of the Pan Armenian Bank could be diversified to include structured securities. Pan Armenian Bank could act as a market innovator, introducing new market products that commercial banks are currently unwilling to offer. Strengthen institutions to channel remittances into productive sectors. Attracting more FDI Scale up skills, improving the investment climate, and connectivity to external market. Establish a target list of reputable multinationals in manufacturing and tradable services and lobby them to relocate some of their activities to Armenia. (continued on next page) Executive Summary | xxix Objective Policy Instruments Generosity of incentives (fiscal benefits, serviced land provision, risk guarantees) should be in line with the potential impact and spillovers on the domestic economy in terms of job creation, knowledge transfer, and supply-demand linkages with SMEs. Better Use of Human Employment creation Improve the business environment (reducing the costs of doing business, limiting the number of Resources business inspections and opportunities for extortion, and reducing incentives to join the informal sector). Enhance competition to create more economic dynamism, encourage the entry and growth of new firms. Enhancing skills Engage employers in the design of academic curricula, instituting apprenticeships, and creating quality assurance mechanisms that allow both students and employers to assess the relevance and quality of academic training provided by various institutions. Improve job matching Build the Public Employment Services’ capacity to provide intermediation services, including training and job counseling. Engage the diaspora Support search networks to pair dynamic domestic institutions with skilled diaspora. Be proactive in creating more selective diaspora leadership groups with more strategic views of home country development in line with the model of alumni organizations of US universities. Create a competitive contest to fund innovative pilot activities following clear principles (focus on knowledge rather than money as entry point; on joint project rather than the return of the diaspora; and on sectoral ministries as focal points rather than foreign or diaspora ministries). Enhancing Limiting potential Remove barriers to entry and competition. Competition anticompetitive behavior and ensuring a level playing field Mainstream competition principles within broader government policies. Improve the antitrust and state aid framework with complementary measures to reduce restrictive product market regulation. Improve the competition environment in transportation (airlines and railroads). Eliminate barriers to competition in professional services. Improve competition in electricity and gas markets. Refrain from adopting unnecessary restrictive regulation in the retail sector. Increase the effectiveness of the competition framework and its implementation (specific amendments to the competition law and its enforcement aimed at clarifying the definition of economic entities, anticompetitive agreements and market dominance, updating the criteria to determine the existence of a dominant firm, strengthening the investigation powers of the agency and improving the structure of and criteria for imposing fines). SCPEC needs to move away from focusing on price fluctuations in favor of focusing on actual and potential barriers to entry and market contestability (including during public procurement). Systematically and pro-actively pursue advocacy activities by strengthening SCPEC‘s advocacy mandate to tackle anticompetitive government interventions and regulations that harm the development of competition. Strengthen the state aid provisions and their enforcement to minimize potential distortive effects on competition; promote a better understanding of competition principles vis-à-vis other government bodies, public procurement officials and judges. Introduce transparency and access to data to guarantee competitive neutrality between market participants to avoid market distortions. (continued on next page) xxx  |  Republic of Armenia: Accumulation, Competition, and Connectivity Objective Policy Instruments Improving Land Working more closely Sign bilateral transit agreements (tackle the issue of road tax in Iran). Connectivity with bilateral partners Ratify relevant international conventions to gain leverage over transit partners (e.g. UN Convention on Transit Trade of Landlocked Countries). Negotiate improvements on the transit route through Georgia, a dedicated freight terminal in Poti, improving the reliability of the Black Sea ferries. Access new Baku-Tbilisi-Kars railway line in Georgia. Improving Air Liberalization of Issue a clear policy statement outlining the government’s commitment to a competitive environment. Connectivity aviation Provide a better separation of policy making and its implementation. Ensure independence of regulators from interference from regulated entities. Introduce industry consultation and complaint handling mechanisms. Build capacity to help the Armenian regulator better monitor and enforce contracts, including the airport management concession. Create greater transparency with regard to contracts and agreements to level the playing field for actual and potential market participants. Improving Internet Innovative strategies Improve intellectual property protection and ensure business data confidentiality, as well as strengthen and Communications to help Armenia relevant regulation and law enforcement to raise the confidence of foreign and domestic investors in the Technology join the league of country’s IT-based services sector. leading investment destinations Intensify export and industry promotion efforts to raise awareness of foreign investors about the opportunities in the Armenian IT-based services market and as a result increase the country’s involvement in the global market for IT products and services. Create incentives for the private sector to engage with higher education institutions to better incorporate the changing demands of the fast developing industry through developing joint programs and initiatives. Identify specific market niche opportunities in the IT-based services industry where Armenia has strong competitive advantages compared to other markets in terms of labor costs and professional skills. Increase bandwidth and improve connectivity. Stimulate infrastructure sharing. Build on the experience of other countries in developing ICT parks. (A) Armenia adopted a rule in 2008, which stipulates that debt cannot exceed 60 percent of GDP; if debt exceeds 50 percent of GDP, then the fiscal balance Executive Summary | xxxi 1. Macroeconomic Developments and Outlook By 2013, the Armenian economy had left behind formation as a share of GDP consistently exceeded most of the hangover from the global financial cri- that of other lower middle income countries, and it sis. Real GDP growth reached 7.2 percent in 2012, and peaked at about 35 percent in 2008. However, in line the current account deficit narrowed, although it re- with the domestic focus of growth, the exports-to- mained high (Table 1.1). Macroeconomic buffers have GDP ratio declined significantly during 2003–08, and been rebuilt to some extent, although the public debt- was only a little over half that of the average in 2008. to-GDP ratio, at 44 percent, remains too high to relax While exports per capita stagnated, consumption rose fiscal restraints. The rebound came after double-digit from about $900 per capita in 2003 to about $1,500 per growth rates in the 2003–08 period, a severe recession capita in 2008. in 2009, and low but increasing growth rates in 2010 and 2011. This chapter gives an overview of Armenia’s The real estate boom and foreign inflows led to a economic growth story starting in the 1990s, and some sharp appreciation of the real exchange rate. Af- pointers for likely developments in the medium term. ter depreciating in the early 2000s, the real effective exchange (REER) appreciated by nearly 60 percent between 2003 and 2008. The decline in outward orien- Economic Growth Before the tation, which the Armenian economy experienced in Global Financial Crisis these years, is a reflection of this loss of competitive- ness of the tradable sectors. Remarkably, the global Armenia’s economy outperformed those of similar financial crisis and sharp recession in Armenia led to countries once it had overcome its post- indepen- depreciation in the real exchange rate by only about 8 dence slump (Figure 1.1).9 The economy contracted percent in 2009, and it has remained stable at that high by half between 1990 and 1993, because of the break- level since. The IMF in its 2012 Article IV consultation down of the Soviet Union’s production value chains. with Armenia considered the nominal exchange rate Economic displacement and structural transformation overvalued by about 10 percent. continued until the end of the 1990s. However, strong economic growth during 1999–2003 was built on high Investable resources to a large extent were chan- productivity growth and exports. The economy re- neled into construction. In 2003, the government gained its pre-independence size in about 2003. started actively seeking investments from Armenians living abroad (the diaspora) into real estate in Armenia. Economic growth and investment rates were high This created a construction-centered growth model in the 2000s, but outward orientation of the econ- supported by foreign exchange inflows. Double-dig- omy declined. Since 2003, Armenia’s gross capital it economic growth rates were underpinned by high rates of investment, which peaked at 35 percent of GDP (Figure 1.2). High growth was led by residential con- 9 The World Bank defines lower middle income countries struction and domestic services, and with real exchange as those with average per capita incomes of $1,006 to $3,975 rate appreciation came a decline in outward orientation (2011). There are 54 lower middle income countries. Macroeconomic Developments and Outlook  |  1 Table 1.1. Macroeconomic Trends and Projections (in percent of GDP unless otherwise specified) 2008 2009 2010 2011 2012 2013 2014 2015 In percent of GDP, unless otherwise specified Actuals Projections National income and prices Real GDP (percent change) 6.9 –14.1 2.2 4.7 7.2 5.0 5.0 5.0 Gross domestic product 11,662 8,648 9,260 10,142 9,950 10,609 11,440 12,335 (in millions of US dollars) Gross national income per capita, 3,330 3,080 3,240 3,340 3,540 3,730 3,880 4,200 Atlas method (in US dollars) Consumer price index (percent change) 9.0 3.4 8.2 7.7 2.6 3.6 4.2 4.6 Investment and saving Investment 39.8 36.4 33.4 26.3 26.6 27.7 28.0 32.2 Public 5.1 6.7 5.5 4.6 3.8 4.2 4.4 4.5 Private 34.7 29.7 27.9 21.6 22.8 23.5 23.6 27.7 National savings 29.1 18.5 18.1 16.9 17.8 20.3 21.0 25.4 Domestic savings 15.3 7.1 8.4 4.3 6.7 7.8 7.3 10.0 Government operations Revenue and grants 22.0 21.5 21.6 23.3 22.7 23.5 24.2 24.8 Of which: tax revenue 19.7 19.4 19.3 20.6 22.0 22.7 23.4 24.3 grants 0.4 0.7 0.9 1.6 0.4 0.4 0.3 0.2 Expenditures 22.7 29.2 26.6 26.1 24.4 26.2 26.4 26.7 Current expenditures 20.1 22.4 21.1 21.5 21.7 21.9 21.9 22.1 Of which: interest payments 0.3 0.5 0.9 0.3 1.0 1.4 1.4 1.4 Capital expenditures 2.6 6.7 5.5 4.6 2.7 4.3 4.5 4.6 Overall balance –0.7 –7.6 –5.0 –2.8 –1.7 –2.7 –2.2 –1.9 Primary balance –0.4 –7.1 –4.1 –2.5 –0.7 –1.2 –0.8 –0.5 External sector Exports of goods and services 15.1 15.5 20.9 23.7 24.5 28.3 27.9 27.6 Imports of goods and services 40.7 42.6 45.5 47.3 49.2 50.3 50.7 52.0 Net remittances 13.2 10.4 8.7 11.1 10.9 12.0 13.0 14.8 Current account –11.8 –15.8 –14.8 –10.9 –10.6 –9.6 –9.4 –9.4 Net foreign direct investments 7.9 8.4 6.1 4.4 4.4 4.3 4.4 4.5 Change in gross international reserves 233.5 –600.3 111.5 –132.9 — — — — (in millions of US dollars) Gross international reserves 4.0 6.5 5.3 5.6 5.0 4.6 4.6 4.6 (in months of imports) Public debt 16.1 40.2 39.2 42.1 44.4 43.1 41.7 39.5 Sources: Armenian authorities and Bank staff calculations. 2  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 1.1. Growth, Capital Formation, Exports, and Consumption in Armenia and Low Income Countries a: Real growth rate, percent b: Gross Capital Formation, percent of GDP Armenia Lower middle income countries Armenia Lower middle income countries 20 45 15 40 10 35 30 5 25 0 20 –5 15 –10 10 –15 5 –20 0 00 01 02 03 04 05 06 07 08 09 10 11 00 01 02 03 04 05 06 07 08 09 10 11 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 20 c: Export of Goods and Services, percent of GDP d: Consumption and Exports, in US dollars per capita Armenia Lower middle income countries GDP per capita, constant 2000 USD 35 Export per capita, constant 2000 USD 1600 30 1400 25 1200 20 1000 15 800 600 10 400 5 200 0 0 00 01 02 03 04 05 06 07 08 09 10 11 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 20 20 20 20 20 20 20 20 20 20 20 20 19 19 19 20 20 20 20 20 20 20 20 20 20 20 20 Source: World Bank Development Indicators, 2012. of the economy. The inward orientation of the econ- The construction and domestic services boom was omy resulted in a rising current account deficit. While accompanied by a decline in factor productivity the current account deficit was closing before 2003, the growth. A growth decomposition exercise indicates trend reversed thereafter. The construction sector saw that during 1997–2002, factor productivity growth an unusual expansion in the run-up to the global cri- contributed 92 percent of GDP growth, while physi- sis. It expanded 5.5 times in real terms and contributed cal capital accumulation and human capital (years of more than one third to real GDP growth over 2003–08. schooling) contributed 12 and 5 percent, respectively. The number of people employed in this sector and Employment contracted during these years, and the its share in total employment increased by around 67 impact on growth was a negative 10 percent. During percent during the same period. Despite the building 2003–08, the contribution of total factor productivity boom, mostly of high-end apartments in Yerevan, real to growth decreased to 39 percent, while the contri- estate prices increased 8.4 times in U.S. dollar terms bution of physical capital increased to reach 46 per- during 2003–08, which in turn increased the attractive- cent. ness of real estate for investors—a classic bubble. Macroeconomic Developments and Outlook  |  3 Figure 1.2. Current Account Balance, Construction, Investment, and Components of Growth Current Account Balance, percent of GDP a:  Total Investment, percent of GDP c:  (4-quarter moving average) (4-quarter moving average) 5 50 0 45 –5 40 –10 35 30 –15 25 –20 20 –25 15 –30 10 –35 5 –40 0 1993:1 1993:4 1994:3 1995:2 1996:1 1996:4 1997:3 1998:2 1999:1 1999:4 2000:3 2001:2 2002:1 2002:4 2003:3 2004:2 2005:1 2005:4 2006:3 2007:2 2008:1 2008:4 2009:3 2010:2 2011:1 2011:4 1993:1 1994:1 1995:1 1996:1 1997:1 1998:1 1999:1 2000:1 2001:1 2002:1 2003:1 2004:1 2005:1 2006:1 2007:1 2008:1 2009:1 2010:1 2011:1 b: Construction, percent of GDP d: Contribution to Growth (Growth = 100) 30 25 Physical Capital Human Capital Labor TFP 120 20 100 80 15 60 40 10 20 5 0 –20 0 1997–2003 2004–2008 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Source: Ministry of Finance, World Development Indicators 2012 and authors’ calculations. The inward shift can also be seen in the rising im- or the construction sector, which was enjoying the portance of employment in non-tradable sectors in highest intra-sectoral productivity. the growth performance (Table 1.2). While growth was broad-based during 1997–2002, it became con- centrated in the non-tradable sector thereafter. This The Global Economic Crisis and explains the large contribution of the construction Armenia’s Recovery 2009–12 sector in the increase of labor productivity during that period. Although labor shedding continued in agricul- The impact of the global economic crisis on Ar- ture, workers who left the sector moved to the energy menia was a 14 percent economic contraction in and mining sector, rather than the manufacturing sec- 2009. In that year, remittances declined by 35 percent, tors, which are the traditional labor-intensive sectors, investment declined 31 percent, and the construc- tion industry contracted by 41.6 percent. Household 4  |  Republic of Armenia: Accumulation, Competition, and Connectivity  DP Growth Decomposition from Employment Changes, 2003–08 Table 1.2. G (in percent) Contribution of within Contribution sector changes in output of changes in Contributions of inter- per worker employment sectoral shifts Total Agriculture 16.6 –3.9 1.0 13.7 Manufacturing 7.5 –2.9 –2.2 2.5 Construction 22.3 –0.8 –1.8 19.7 Energy and Mining 9.9 2.6 9.9 22.5 Transport and Communications 2.1 –0.1 0.0 2.0 Trade 5.7 0.0 –0.1 5.6 Other Services 24.9 2.0 0.0 26.9 Total 89.0 –3.0 6.8 92.8 Source: National Statistics Service and authors’ calculations. consumption also contracted, although to a lesser ex- rates, and a stabilization of the construction sector, tent (–1 percent of GDP), while fiscal stimulus compen- which expanded by 3 percent in 2012 compared with sated somewhat for the downturn, with a contribution a 12.5 percent decline in 2011 (Figure 1.3). High prices to GDP growth of 2 percent. for base metals have supported growth in the mining sector. The mining sector grew by 22.5 percent in real The recovery from the 2009 recession is ongoing. terms in 2011, and grown by 15.5 percent in 2012. Ag- Real GDP expanded by 4.7 percent in 2011, and growth riculture recovered robustly after a 16 percent slump reached 7.2 percent for 2012. Growth was driven by in 2010, with growth of 14 and 9.5 percent in 2011 and industry and manufacturing with double digit growth 2012, respectively. Figure 1.3. Real GDP and its Components, 2008 Q1–2012 Q3 (year-on-year change in percent) GDP Agriculture Industry Services 40 30 20 10 0 –10 –20 –30 –40 –50 –60 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 Source: NSS data and Bank staff calculations. Macroeconomic Developments and Outlook  |  5 The decline in the construction sector seems to returned to the central bank’s target band in August have bottomed out. After more than three years of of 2011. Another good harvest in 2012 contributed to contraction, the sector grew by 3.3 percent in 2012, further downwards adjustment of prices, with CPI in- partly because of the start of construction of the Ar- flation (year-on-year change of the monthly indicator) menian part of the North-South transit corridor. More in negative territory throughout much of the year and active support of donors such as the Eurasian Devel- reaching 3.2 percent in December 2012. International opment Bank in road construction projects is expected prices had a neutral effect on Armenia during much of to support continued growth in the medium term. the year, but increasing food prices following droughts in major wheat producing regions will put upward Recent inflation dynamics followed developments pressure on Armenian prices going forward. in agricultural production. When agriculture con- tracted by 16.2 percent in real terms in 2010, inflation Strong growth of exports contributed to improving soared to double-digits in early 2011. Recovery of ag- external balances. The average growth rate of mer- riculture brought prices down gradually and inflation chandise exports was 45 percent in US dollar terms Figure 1.4. External Trade and Capital Flows, 2006–11 Trade deficit, export and import growth (in millions a:  b: Remittances (in millions of US dollars) of US dollars, and year-on-year percent change) CAD, USD mln Net remittances, USD mln Trade deficit Export growth Import growth 2000 180 3000 1800 160 1600 2500 140 1400 120 2000 1200 100 1000 1500 80 800 60 1000 600 40 400 500 20 200 0 0 0 2006 2007 2008 2009 2010 2011 2006 2007 2008 2009 2010 2011 Foreign Direct Investment (in millions of c:  Foreign Direct Investment, (on a net basis, d:  US dollars) 2008 Q1–2012 Q3, in percent of GDP) 1000 450 900 400 800 350 700 300 600 250 500 200 400 150 300 100 200 50 100 0 2008Q1 2008Q2 2008Q3 2008Q4 2009Q1 2009Q2 2009Q3 2009Q4 2010Q1 2010Q2 2010Q3 2010Q4 2011Q1 2011Q2 2011Q3 2011Q4 2012Q1 2012Q2 2012Q3 0 2006 2007 2008 2009 2010 2011 Source: NSS data and Bank staff calculations. 6  |  Republic of Armenia: Accumulation, Competition, and Connectivity during 2010–2011, while imports grew by only 14 per- Figure 1.5. Key Fiscal Indicators, 2008–2012 cent (Figure 1.4). The high growth of exports helped nar- (percent of GDP) row the trade deficit from 24.1 percent of GDP in 2009 Revenues and grants Tax revenue to 20.5 percent in 2011. After shrinking by 30 percent during the crisis, inflows of remittances revived quickly Expenditures Overall balance 35 to a level about 11 percent below the pre-crisis maxi- 30 mum. Remittances helped ease pressures on the current 25 account, which is gradually narrowing after reaching 15.8 20 percent of GDP in 2009. The strong growth of export 15 and continuing recovery of remittances will contribute 10 to further improvement of the current account deficit, 5 0 which narrowed to 10.6 percent of GDP in 2012. 2008 2009 2010 2011 2012 –5 –10 At the same time, FDI inflows remained weak, in particular those from Russia. During 2012, FDI in- Source: MOF, NSS and Bank staff calculations. flows reached $489.4 million, declining by 6.9 percent year-on-year. FDI went primarily into the mining sector (including production of base metals) and the telecom Higher tax revenue helped reduce government industry, which attracted 16.7 percent and 49.8 percent borrowing. Macroeconomic recovery allowed meet- of FDI inflows in the real sector, respectively. ing the nominal targets for tax revenues in 2010– 2011. For 2012, the government set an ambitious Foreign exchange reserves increased slightly during target of increasing tax revenues by AMD 100 billion 2012. When ‘leaning against the wind’ became un- supported by amendments to the tax legislation. tenable in March 2009, the Central Bank of Armenia The amendments included bringing taxation of fuel (CBA) allowed a one-off 20 percent depreciation of under the general tax regime, a higher personal in- the dram against the U.S. dollar. Once the CBA halted come tax rate for salaries exceeding AMD 2 million, heavy interventions in currency markets to stem depre- and introduction of excise tax on luxury cars. After ciation of the dram, multilateral and bilateral partners large increases during the crisis, net borrowing from extended financial support to Armenia which resulted abroad declined to $214 million and the external in an increase in gross official reserves by $600 million public debt-to-GDP ratio stayed at 35.2 percent in in 2009. In 2012, pressure on the exchange rate result- 2011. The public debt increased slightly to about 38 ed in some unexpected reserve losses in June 2012, percent of GDP in 2012. but they were reversed toward the end of the year. The CBA’s foreign exchange reserves reached $1.8 billion Monetary policy has followed the CBA’s inflation at end-2012. In its latest Article IV consultation based targeting regime. With inflation decelerating to be- on discussions in September 2012, the IMF considered low the CBA’s target band (year-on-year CPI inflation the exchange rate overvalued by 5–10 percent. of 4 percent, plus or minus 1.5 percent), the policy in- terest rate was lowered by 50 basis points to 8 percent Fiscal consolidation is continuing at a faster-than-ex- in September 2011. The rate has remained unchanged pected pace. The fiscal deficit declined to 2.8 percent since then. The CBA pointed out that exchange rate of GDP in 2011, well below the initial target of 4.1 per- depreciation during May-June 2012 had already eased cent, and contracted to 1.7 percent of GDP in 2012 monetary conditions and a further lowering or rates (Figure 1.5). The fiscal consolidation was achieved was not warranted because of likely pass-through mainly through expenditure compression. Expendi- effects of the depreciation on inflation. The financial ture compression of 4.3 percent of GDP during the sector remained buoyant and well capitalized. Despite 2010–12 period was achieved through under-spending some increase in non-performing loans during 2012, on capital, while priority social spending was largely the banking sector remains sound. The capital ade- protected. Lending from multilateral and bilateral do- quacy ratios are generally higher than required by the nors remains the key source of deficit financing. central bank’s regulations. Macroeconomic Developments and Outlook  |  7 Macroeconomic Outlook Figure 1.6. Policy Rate and 12-month Inflation, 2008–2012 Coming out of the crisis, the inward orientation (in percent) of the economy is reversing. The contraction of do- mestic consumption and exchange rate depreciation 12-months inflation Policy rate allowed exports to expand. Net exports contribut- 14 ed 1 percent to GDP growth in 2012, a strong turn- 12 around from the negative contribution to GDP growth 10 of about 10 percent in 2007 and 2008. In the wake of 8 the crisis, exports grew significantly faster than GDP, 6 and the ratio rose quickly to about 25 percent in 2012. 4 The construction sector stabilized in 2012. However, it 2 is still significantly larger than construction sectors in 0 other lower middle income countries. 2008:1 2008:4 2008:7 2008:10 2009:1 2009:4 2009:7 2009:10 2010:1 20010:4 2010:7 2010:10 2011:1 2011:4 2011:7 2011:10 2012:1 2012:4 2012:7 2012:10 2013:1 Slower growth abroad, and a return to trend in ag- ricultural growth suggest a slowdown of economic Source: CBA. growth over the medium term. With the effects of the good agricultural harvest waning, GDP growth is Fiscal consolidation based largely on reducing cap- projected to moderate to 5 percent during 2013–2015. ital expenditure—as happened in recent years—is With a modest outlook for construction and the agri- not sustainable. Protection of social spending is im- culture sector’s return to its historic 3–4 percent annual portant to alleviate poverty which has been worsening expansion pace, growth drivers will have to come from during 2009–10, but continuous overlooking of capital industry and modern services. spending may undermine growth prospects, as well as put additional pressures on the state budget, when the The current account deficit is expected to improve infrastructure would require higher maintenance costs. with growing remittances and as a result of structur- The government is conscious of the need to increase al shifts in the economy. Policies geared to industri- public investment to crowd in private investment. To al development and export promotion should lead to balance the need for adequate capital funding with faster growth of tradable sectors. Together with con- fiscal consolidation and pro-poor stance, the govern- tinuing growth in remittance inflows, this will support a ment needs to continue the reforms in public finance reduction in the current account deficit to single digits. management to ensure higher value for money. The macroeconomic framework also takes into account gradual depreciation of the exchange rate to support The latest debt sustainability analysis (DSA) con- an improvement in the current account balance. ducted jointly with the IMF identified a low level of debt distress, even after taking into account the Moderation in growth and fiscal consolidation will significant private sector debt burden. The public ensure low inflation, but international food prices sector DSA suggests that Armenia’s overall public sec- will remain a source of external shocks. In the me- tor debt dynamics are sustainable in light of the cur- dium term, inflation is expected to stabilize around rent size of the debt stock. the CBA’s target of 4 percent as a result of a narrow- ing current account deficit, and fiscal consolidation. Nevertheless, the rapid accumulation of public debt In this case, the CBA will maintain its interest rate at since the onset of the global crisis calls for continu- 8 percent, which it considers a neutral policy stance ing the pursuit of fiscal consolidation over the me- (Figure 1.6). However, pass-through of rising world dium term. Public external debt was only about 16 food prices, especially for wheat following unfavorable percent of GDP at end-2008, but reached 35 percent weather conditions in 2012 in Russia, Kazakhstan, and of GDP at end-2011, and is expected to decline if fis- the United States, is expected to become evident in cal consolidation is successful and economic growth Armenia in 2013. remains buoyant. While the projected debt-to-GDP 8  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 1.3. Debt Reducing Primary Balances (to reduce debt to 30 percent of GDP in 10 years)   Real Interest Rate, Percent Real Growth, Percent 0.00 1.00 2.00 3.00 4.00 5.00 2.00 –2.33 –1.97 –1.60 –1.23 –0.86 –0.48 3.00 –2.69 –2.33 –1.96 –1.60 –1.23 –0.86 4.00 –3.03 –2.68 –2.32 –1.96 –1.60 –1.24 5.00 –3.37 –3.02 –2.67 –2.31 –1.96 –1.60 Source: Armenia PER (2012). levels do not breach the indicative thresholds, the ra- Mid-Term Review, Armenia and a few similar countries tios remain at much higher levels than prior to the cri- were deemed ineligible for concessional financing un- sis, pointing to a permanently lower resilience of the der IDA-17.10 However, Armenia applied for deferral of Armenian economy to exogenous shocks. its graduation. Eventually, lending terms are projected to harden as Armenia graduates from IFI concessional By targeting a fiscal deficit of less than 2 percent financing into the non-concessional lending windows over the long term, the authorities could rebuild the over the medium term, and then further harden as macroeconomic buffers used during the crisis and Armenia begins to access the commercial bond mar- increase the resilience of the economy. A one per- kets. The DSA assumes that the government gradu- cent deficit, for example, would reduce the ratio of the ally begins to access loans on fully commercial terms present value (PV) of debt to GDP by half compared from 2018 onwards, although official non-concessional to the baseline scenario by the end of the projection financing is expected to make up the bulk of the bor- period in 2032 (Table 1.3 and Figure 1.7). However, this rowing until the late 2020s. would come at the cost of either compressing expen- ditures further, or making more strenuous efforts to Figure 1.7. Public Sector Debt, 2012–32 increase the revenue-to-GDP ratio. Alternatively, if Ar- (simulations, in percent of GDP) menia was able to attain a higher growth trajectory, a two percent deficit target would allow for an increase in Baseline 1% deficit 6% growth fiscal space and a more rapid increase in buffers. If real 40 PV of Debt-to-GDP Ratio 35 GDP growth were to average 6 percent rather than the 30 4 percent assumed in the baseline, which would still be 25 significantly under the 10-year historical average, the 20 PV debt-to-GDP ratio would fall steadily from 35 per- 15 cent of GDP in 2012 to 26 percent at the end of the pro- 10 5 jection period, instead of remaining broadly constant 0 as under the baseline. 2012 2014 2016 2018 2020 2022 2014 2016 2018 2030 2032 Gross external financing is assumed to average just Source: Armenia: 2012 Article IV Staff Report, IMF (2012). under 3 percent of GDP in line with the average in the decade prior to the crisis. This implies net external financing of about two percent of GDP after 10 IDA (2012), “IDA16 Mid-Term Review Graduation Pa- amortization or one percent after amortization and per”, Concessional Finance and Global Partnership (CFP), Armenian external lending. During the recent IDA-16 World Bank, September 2012. Macroeconomic Developments and Outlook  |  9 2. Saving, Investment and Financial Intermediation High investment and a stable, manageable cur- the microeconomic determinants of saving. Section C rent account deficit are crucial for high economic discusses aspects of financial and capital market de- growth rates. As the Growth Report (2008) pointed velopment. Section D looks at the composition and out, economies that had sustained 7 percent or higher effects of foreign direct investment. The last section growth since the 1950s had investment rates of 20–25 gives policy recommendations. percent, while maintaining the current account deficit at manageable levels. Foreign saving is an imperfect substitute for domestic saving, because of the vulner- Determinants of Aggregate ability to capital flow volatility that it creates. Foreign Private Saving direct investment (FDI) has often proved less volatile than other forms of foreign saving, and high domestic Over the last decade, Armenia has seen a tremen- saving and FDI are therefore important inputs to high dous rise in domestic saving and investment fol- and stable growth rates. However, Armenia’s recent lowed by a precipitous decline. Domestic saving experience has shown that the sectoral allocation of increased from around 5 percent of GDP in the begin- investment matters: the residential investment boom ning of the decade, to 35 percent of GDP in 2006 (see of 2003–08 left the economy vulnerable to the external Figure 2.1). Private investment increased in a similar shock of the global crisis. Hence, the financial system fashion by 20 percentage points of GDP over the same and capital markets, which intermediate between sav- period and reached 35 percent of GDP in 2008. The ing and investment, come under scrutiny. strong rise in domestic saving was supplemented by growing inflows of remittances and good export per- Armenia’s financial market is dominated by banks, formance, and the current account deficit narrowed while equity and bond markets are rudimentary. up to 2008. The global financial crisis led to a fall in Banks are relatively inefficient, do not innovate, and the saving-to-GDP and investment-to-GDP ratios by small businesses in particular face difficulties accessing about 15 percentage points during 2009–11. loans. Government bonds are sold mostly to banks, but are not auctioned effectively for the establishment A part of the increase in overall saving was due to of a benchmark yield curve. Private bond and equity the improvement in public saving. The fiscal balance issues suffer from weak corporate governance and improved from negative rates in 2002 to around 3 per- transparency. The recent introduction of mandatory in- cent of GDP on average from then on until the global dividual pension accounts will create significant long- crisis (Figure 2.2). Following the global crisis, public term funds for investment in the capital markets. saving became negative with the deterioration of fiscal balances in 2009, but has since increased to 2 percent This chapter looks at the determinants of saving of GDP because of strong efforts at fiscal consolida- and financial and capital market development. tion. Household saving was negative except during Section A looks at aggregate saving in the short and the boom years 2006–08, while the bulk of saving was long run. Section B analyses household data to find provided by non-financial corporations. Saving, Investment and Financial Intermediation  |  11 Figure 2.1. Saving, Armenia and Selected ¾¾ The time deposit rate has an ambiguous impact: Countries, 2003–10 on the one hand, higher interest rates lead to an (in percent of GDP) increase in saving as they become more attractive relative to consumption (substitution effect), on Armenia Moldova Georgia the other hand, higher interest rates lead to higher Albania Estonia Macedonia, FYR incomes for those who saved in the past, and they Poland could be enticed to spend more of it on consump- 40 tion (income effect). The effect of interest rates on 30 saving therefore depends on whether the substitu- 20 tion or income effect dominates. ¾¾ Openness has a positive impact through its stim- 10 ulation of GDP (most studies show a positive rela- 0 2003 2004 2008 2006 2007 2008 2009 2010 tion between a higher proportion of trade relative to GDP and the level of GDP). ¾¾ Real appreciation has a positive impact on sav- Sources: NSS, WDI. ing, because it increases the wealth of individuals (wealth effect). Figure 2.2. Armenia : Composition of Domestic ¾¾ The public deficit has a positive impact on private Saving, 2002–10 saving, because it creates the expectation that (in millions of US dollars, left, and in percent public debt will have to be repaid at some point of GDP, right) and taxes therefore will have to be raised (Ricard- Public savings Households savings ian equivalence). Non-financial corporations savings Financial corporations savings Gross savings, share in GDP The Long-Run Saving Rate 4,000 35% 3,000 30% 25% The determinants of aggregate saving in Arme- 2,000 20% nia conform to those highlighted in the literature. 1,000 15% Based on our regressions, the aggregate saving rate 0 10% –1,000 5% (saving as a percentage of GDP) is determined by –2,000 2002 2003 2004 2005 2006 2007 2008 2009 2010 0% GDP per capita, the time deposit rate and the real exchange rate. A dummy variable for the global fi- nancial crisis (with a value 0 before 2009 and 1 after- Source: NSS. ward) is also found to be significant (Table 2.1).11 GDP Determinants of private household saving have per capita and the time deposit rate have a positive been the subject of a large body of research. The impact on the saving rate, while real appreciation and theoretical and empirical literature on this topic has the crisis have negative impacts. We also estimate a relied mainly on the life cycle model developed by significant negative impact of the crisis on the sav- Modigliani (1970) according to which rational agents ing rate, which indicates that households believed save in order to smooth consumption and maximize the reduction in incomes they experienced during inter-temporal utility. The literature finds that aggre- the crisis was temporary, and that they reduced their gate saving are usually determined by GDP per capita, saving to maintain the desired consumption level the time deposit rate, openness of the economy, the through the crisis. From this, we would expect saving real exchange rate, and the public deficit (see for ex- to recover with the economic recovery once house- ample, Jongwanich, 2009; Montiel and Servèn, 2007). holds have reached incomes similar to what they had The results of numerous studies of the determinants of prior to the crisis. saving can be summarized as follows: ¾¾ GDP per capita has a positive impact on saving— 11 GDP per capita and the real effective exchange rate are higher incomes result in higher saving. entered in logs. 12  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 2.1. Determinants of Aggregate Saving exports and aggregate output, which in turn decreases (2002 q1–2011 q2) the saving rate. However, intuitive determinants such as openness of the economy and the public deficit do Constant –2.88 (0.27) not appear to have significant effects on saving in the GDP per capita 0.37 (0.02) long run. This might be due to the fact that these vari- Time deposit rate 0.02 (0.006) ables have experienced dramatic changes during and after the crisis, so that their effects are directly cap- Real Effective Exchange Rate –0.36 (0.066) tured by the crisis dummy variable. Crisis dummy –0.2 (0.025) Source: Authors. The Short-Run Saving Rate Note: Figures in brackets show standard errors. No. obs. = 38; R2 = 0.90; F(4;33 ) = 77.85; Durbin Watson = 2.2, Dickey Fuller on residuals test statistic = –6.8 (critical In the short-run, only changes in GDP per capita value at 1% = –3.67); Johansen Test trace statistic (for rank 0) = 193.6 (critical value and economic openness matter. This results from an at 1% = 68.5). analysis of an Error Correction Model to find the de- terminants of the change in gross domestic saving, with As expected, an increase in GDP per capita has the change in GDP per capita, economic openness, the a positive impact on saving. In our specification, a real exchange rate, and the time deposit rate as inde- 10 percent increase in GDP per capita leads to a 3.7 pendent variables. In addition, we added the lag of the percentage points increase in the saving rate in the residuals of the long-run relationship to measure the long run (i.e. if the initial saving rate was 5 percent, speed of return to the long-run relationship after a uni- after a 10 percent increase in GDP per capita, the sav- tary shock (Table 2.2).12 The estimated coefficients for ing rate becomes 8.7 percent). Also, a 1 percentage the change in GDP per capita and the long-run relation- point increase in the time deposit rate leads to a 0.02 ship suggest a strong short-run reaction of the saving percentage points increase in the total saving rate. A rate to a shock and a quick return to the long-run equi- positive sign on the coefficient for the time deposit librium. The positive coefficient for openness shows rate shows that the substitution effect dominates the that for instance a surge in minerals exports leads to income effect. This might be explained by low initial an increase in the aggregate saving rate if the resulting assets resulting in a smaller income effect. There is surge in foreign currency is sterilized. also a negative and significant impact of the real ex- change rate (REER). In fact, we found that a 10 percent increase in the REER (appreciation) leads to a 3.7 per- centage point decrease in the saving rate in the long 12 This coefficient must be negative in order to ensure a return run. The transmission of REER changes and saving is to the long run relationship, which is the case (see Hamilton, via exports: an appreciation of the REER decreases net 1994). Table 2.2. Error Correction Model Specification Dependent variable ∆s = –0.012 + 0.49 g + 0.15 ∆open – 0.94 ECM-1 ∆(sr) Independent variable Coefficient t statistic Constant –0.012** –2.1 ∆(gdpc) = growth rate g of GDP per capita 0.49*** 13.5 ∆(OPEN) 0.15** 2.0 lag(ECM) –0.94*** –6.1 Period: 2002q2–2011q2; N° observation = 37; R = 0.96; Durbin Watson = 1.96; *** 1%; ** 5% significance Source: Authors' calculations. Saving, Investment and Financial Intermediation  |  13 Table 2.3. Monthly Household Income, Consumption and Saving (deflated values, base year 2004) Value (drams) 2004 2006 2008 2010 Y 89,887.6 105,866.9 101,334.2 90,062.76 (303,483.9) (235,371.6) (148,615.7) (156,364.9) C 57,329.02 64,118.47 70,669.8 61,480.02 (50,038.2) (52,684.3) (52,111.26) (44,842.79) S 32,558.6 41,748.47 30,664.44 28,582.74 (299,965.9) (231,837.3) (140,565.8) (151,807.7) Saving Rate 0.0845 0.111 0.124 0.130 (0.526) (0.490) (0.393) (0.343) N (Households) 6,122 4,752 7,545 7,453 Source: ILCS, various years, authors’ calculation. Note: Standard deviation in brackets. Microeconomic Determinants Appendix A2.1 presents the full list of the variables. We estimated the function using a pooled multivari- of Household Saving ate regression, and tested robustness using alternative Households save for heterogeneous motives. Mod- specifications. Armenia’s Integrated Living Conditions els of the inter-temporal allocation of resources pre- Surveys (ILCS) conducted in 2004, 2006, 2008 and 2010 dict that saving should respond positively to higher provided the data on household income and spend- incomes, as well as to higher uncertainty in future in- ing behavior, and parameters measuring household come. Household characteristics such as education or characteristics. Saving rates are imputed from house- employment types viewed as securing a more stable hold diaries by taking the difference between report- flow of income should decrease saving (assuming a ed household disposable income and detailed con- constant income level). The availability of financial in- sumption records observed during a month. Following struments, assets such as land, livestock, machines and Kulikov et al. (2007) and Denizer et al. (2002), both in- cash-holdings and liquidity constraints are important come and consumption exclude the purchase or sale determinants of saving (Schmidt-Hebbel et al., 1996; of lumpy goods such as real-estate, land, vehicles or Kulikov et al., 2007; Abdelkhalek et al., 2009). Educa- electro-domestic appliances.13 tional levels along with the number of children per working adult are also important predictors of house- The determinants of saving at the individual house- hold saving (Edwards, 1996; Horioka and Wan, 2007). hold level are in line with those of aggregate saving Finally, Kulikov et al. (2007) find that urbanization, a (Table 2.3). Inflation-adjusted household income and proxy for income stability, and ownership of large du- saving rates increased in all four periods. Kernel density rable goods such as vehicles and real estate negatively plots of household saving rates suggest a similar evo- impact saving. lution of saving over time, with an upward trend of the mean household saving rate. Saving rates increase by These determinants are modeled by a multivariate between 3.7 and 4.1 percentage points when incomes function, which is estimated with various cross-sec- increase by 10 percent. Variables approximating the tion econometric models. Household saving are modeled as a linear function of five general classes of 13 The monthly saving rate is constrained between -150 per- determinants: income, volatility of income, volatility cent and (by definition) 100 percent to minimize the effect of of financial returns on potential investment, house- outliers. The excluded observations are re-introduced in the hold characteristics, and regional and time dummies. least absolute deviations (LAD) specifications that are less sensi- tive to extremes. 14  |  Republic of Armenia: Accumulation, Competition, and Connectivity variability of income yield mixed results: for instance, Financial Sector Development indicators of the type of work undertaken by the head of the household show no consistent pattern as the Armenia’s financial sector is dominated by banks, income stream expected from a class of work becomes while bond and equity markets are rudimentary. more variable.14 The education level displays consis- Banks account for 92 percent of the financial system’s tently negative and significant coefficients, confirm- assets, while credit organizations account for 5.5 per- ing that it is a good proxy for a secure future income cent. The public bond market is more established than stream. the private bond market, and the Armenian govern- ment has established a system of regular public bond Access to financial products lowers the saving placements in the primary market, which mainly con- rate. While this may be presented as evidence that sists of banks. The volume of public debt outstanding households with access to formal or informal cred- has been increasing at a rate of about 20 percent per it find it less necessary to save, it may also be ex- annum over recent years to reach about 6 percent of plained by a number of other mechanisms. For ex- GDP in 2012 compared with 3 percent in 2003. The pri- ample, it seems likely that households taking on debt vate bond market capitalization is less than 1 percent perceive some greater need for present liquidity. If of GDP. In January 2013, only 8 private bonds were list- these households are more likely to spend all avail- ed on Armenia’s exchange, Nasdaq-OMX, with matur- able resources (either on consumption or debt ser- ities ranging from 6 months to 3 years. Private bonds vicing payments), estimated coefficients should be in foreign currencies were allowed in 2012, and there negative. Remittances, however, seem to be treat- have been three issues since then. They offer yields ed as income with a positive effect on saving rather 3–4 percentage points lower than domestic currency than an access to finance, in which case their impact bonds. would have been negative. Households who own homes of higher quality are less likely to save, which Status of the Financial Sector indicates on the one hand that saving are accumulat- ed to purchase durable assets, and on the other that The banking system has been growing rapidly ownership of assets reduces incentives for saving for and is sound, however, it still lags behind most of precautionary reasons. its peers in size and efficiency. Between 2005 and 2012 banking assets grew over 6-fold. There are 21 Household characteristics have differentiated im- commercial banks in Armenia and one development pacts on saving. Larger households, both in terms of bank as of January 2013, which together own more number of children and number of adults, appear to than 90 percent of the country’s financial assets, thus save less. The larger number of people in a household dominating the financial system. There are 32 credit increases the probability of having some future income organizations, however, they account for a tiny share streams, and offspring secure retirement income.15 in a country’s financial assets. Private sector credit to There are life-cycle effects on saving, with younger GDP reached about 38 percent in 2012,16 compared to people saving significantly less than older ones, while the ECA17 median of 41.9 percent. Lending is concen- there is also evidence of generational change with trated in Yerevan: about one-third of the adult popu- older cohorts acting more frugally than younger ones. lation resides in Yerevan, but Yerevan accounts for 66 Life-cycle and generational changes are influenced by percent of bank lending and 56 percent for credit or- changes in the national pension system. ganizations. Armenia ranks 51th among 144 countries in WEF’s Global Competitiveness Report 2012–13 by 14 Note that the work class omitted to avoid perfect collin- earity is salaried employment. It would then be expected, for consistency with the permanent income hypothesis, that riskier 16 Regional comparison based on WDI data for 2010. Data for employment types be associated with higher saving levels. No Armenia for 2012 is from CBA, which uses a different methodol- consistent pattern of this kind is observed, although the number ogy from WDI resulting in a higher ratio. of individuals reporting to be in each income class is quite small. 17 Europe and Central Asia (“Europe” includes only EU new 15 See also Orteba, 2006, for this explanation. member states). Saving, Investment and Financial Intermediation  |  15 soundness of banks indicator, and is thus ahead most are partly due to high levels of remittances from Di- of its peers and behind only Estonia. aspora and partly to general distrust toward national currency and fear of devaluation. Due to the targeted The penetration of deposit services in Armenia re- policy of the central bank the dollarization in the econ- mains among the lowest in the region. Banks are omy had been decreasing before the crisis. After the the only licensed providers of deposit services in the national currency’s devaluation in the crisis year of 2009 country. At end 2010, the deposit-to-GDP ratio was 23 the savings in dollar again jumped in share, although percent, compared to the ECA median of 40.3 percent it remains lower than a decade ago. The interest rate (Figure 2.3). In 2010, there were 589 deposit accounts differential between loans (deposits) denominated in per 1,000 adults, compared to 914 for ECA. Deposits the national currency and in US dollars averaged 4–6 are held mostly in US dollars because of low confi- percent. dence in the local currency following the 2009 deval- uation. As a result, the cost of mobilizing deposits is Figure 2.4. Composition of Bank Deposits, high. About 10 percent of bank funding comes from 2000–12 low-cost credit lines through the German Armenian (in percentage share, and US dollars and AMD) Fund.18 Such credit lines have the potential to crowd out AMD deposits unless they are priced according- Deposits in US$ Deposits in AMD ly with interest rates proportional to such lines’ longer 100% maturities. Only 5 of the 29 universal credit (and micro- 80% finance) organizations are able to tap into the German 60% Armenian Fund, compared to 19 of 21 banks. 40% 20% Figure 2.3. Armenia: Peer Comparison on Financial Sector Depth 0% 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 World 41% Middle income countries 33% Source: CBA, EV analysis. Lower middle income countries 30% Poland* 43% Estonia 100% 36% Deposits in US$, million Deposits in AMD, billion Albania 2,500 Ukraine 62% Macedonia 44% 2,000 Moldova 32% 1,500 Georgia 29% Armenia 2010** 23% 1,000 Armenia 2012** 38% 500 0% 20% 40% 60% 80% 100% 120% 0 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 Source: CBA, WDI. Household saving in the banking system are high- Source: CBA, EV analysis. ly dollarized. Deposits in US dollars make up about 70 percent of all deposits in Armenian banking sector Corporate loans dominate the banks’ loan portfo- (Figure 2.4). The high rates of dollarization of savings lio. Corporate loans make up two–thirds of the banks’ lending portfolio, making them the biggest product group for banks. Introduction of new financial products is slow due to low awareness levels of the corporate 18 The German Armenian Fund was established in 2001 by CBA to administer an SME credit line from KfW. It has since sector and the high costs of educating and promoting evolved to administer other credit lines. It currently administers for the banks. Plain-vanilla collateral-backed loans are eight active credit lines, including five from KfW, one from the therefore the dominant lending instrument on offer. World Bank, and two from the government. Outstanding loans as of January 31, 2012, amount to AMD 116 billion. Credit instruments such as factoring and leasing make 16  |  Republic of Armenia: Accumulation, Competition, and Connectivity up less than 1 percent of the banking sector assets. Mi- as branches of international companies that finance cro, small, and medium sized enterprises (MSMEs) find operations through international sources. Low levels it difficult to access formal credit. About 22 percent of of leverage at Armenian companies indicate that busi- banking sector lending and 33 percent of corporate ness lending absorption capacity is still high. However, lending goes to MSMEs.19 However, this is lower than many businesses find bank lending conditions to be the share of MSMEs contribution to GDP, which is highly unfavorable. High interest rate and collateral re- about 40–50 percent. quirements are the two main factors cited by Armenian businesses that impede their access to bank loans. Figure 2.5. Corporate Leverage Ratios, Armenia and Selected Countries, 2011 Micro, small and medium enterprises’ (MSMEs) ac- cess to loans is limited due to lack of capacity and Quoted shares-to-equity ratio Debt-to-equity ratio* mistrust both in MSMEs and lenders. MSMEs often Greece lack the necessary skills to be considered creditworthy. Norway For example, they may lack technical know-how or Spain Ireland skills in financial management and marketing. They Finland may also either lack skills to produce reliable financial Slovenia Austria reports on which a lender can rely, or they may be sus- Portugal picious of sharing financial information with a bank or Italy credit organizations. In turn, lenders often have low Australia Germany trust in the information provided by MSME loan appli- Sweden cants, or lack the skills to work with MSMEs to assess Netherlands Estonia their credit applications. Moreover, many lenders are Denmark somewhat complacent, being satisfied to compete for Slovak Republic Armenia a relatively narrow pool of proven good clients. While Poland there are MSME development programs in place to Chile Hungary support access to finance, they have not achieved sig- France nificant scale due to the costs of expanding.20 Luxembourg Belgium Czech Republic While the collateral regime has improved in recent United Kingdom years, shortcomings remain in several areas, lim- United States iting the realization of using collateral to expand 0.00 0.20 0.40 0.60 0.80 1.00 1.20 1.40 1.60 1.80 credit. First, there appears to be a limitation in law or Source: OECD. practice on the registration of floating security inter- * The debt-to-equity ratio is calculated as the ratio of long-term bank loans and bor- ests (e.g., accounts receivable or inventory). Either le- rowings to the total equity. The sample included 450 of the largest companies in Armenia. The source of information is the published financial reports. The statistics gal amendments should be adopted to allow security is calculated for non-financial organizations. interests to attach to such classes of goods, or train- ing of judges and financial institutions should be con- Armenia’s corporate sector has low levels of lever- ducted to clarify that it is already allowed. Second, the age compared to those in similar countries. The process of registering collateral is costly and time-con- debt-to-equity ratio in Armenian companies was suming, requiring several steps that typically take over about 0.4 as of 2011 (Figure 2.5). Although the average a week and several physical movements of the lender ratio is low for Armenia, the distribution of companies and borrower to deliver or retrieve documents. The is highly polarized with several sectors having close to cadaster is in the process of establishing an online zero level of leverage and with others having very high registration system, to be rolled out in March 2012, fol- levels of leverage. The sectors with low level of lever- lowing pending government authorizations. However, ages are those with high profits (such as mining) as well 20 For example, the SME National Development Center pro- 19 Beck et al (2008) show that about 20 percent of bank lend- vides TA and loan guarantees to about 800 SMEs, but this rep- ing goes to MSMEs in emerging markets. resents less than 1 percent of Armenia’s registered SMEs. Saving, Investment and Financial Intermediation  |  17 the online system will still require similar steps, some Banking System of which would be considered unnecessary by inter- Armenia’s banking sector is fragmented and on national standards (e.g., obtaining a report of non-en- the whole has low efficiency. The concentration of cumbrance, obtaining notarization of the contract, and assets among the banks is relatively low with the share obtaining a decision to accept or reject the registra- of three leading banks in total assets being only 30.2 tion by the cadaster). The cadaster and the authorities percent as of 2012. Most banks are small, and even should continue to study international good practice the biggest bank in Armenia has shareholder capital to simplify and accelerate the process. of only about $100 million. Considering single-borrow- er exposure limits at 20 percent, the largest loan the The process of foreclosing on the collateral of a de- biggest bank can give will be lower than $20 million. faulting borrower, taking possession of the prop- The local commercial banks are therefore not well po- erty, and selling it is risky and time-consuming. sitioned to finance large-scale investment projects. The step of foreclosure has been partially addressed According to experts, there is a potential to decrease through the option of arbitration rather than going the interest rate by up to 1.5 percent by increasing the through the courts. Once there is an arbitration deci- sector’s efficiency with improvements such as introduc- sion and confirmation by the court which is conducted tion of advanced IT technologies. Also, the small size relatively speedily, the process of taking possession of banks results in high operational overheads. The and selling the collateral, however, is a second stage overhead costs to assets ratio for Armenian banks is and reverts to the court requiring notification to the about 4.2 compared to 3.8 on average in lower mid- borrower, which can easily be evaded. Banks and dle income countries, while the return on assets (ROA) credit organizations report that the entire process can is 1.7 compared to 1.3 for the lower middle income take up to three years. The costly and time-consuming country group. process has adverse effects on lending. First, it makes lenders excessively conservative in their lending deci- Figure 2.6. Lending-to-Deposit Rate Spreads, sions, approving loans only to the highest-quality and Armenia and Selected Countries, 2010 well known borrowers. Indeed, some banks reported (in percent) that competition among banks is largely limited to these borrowers, rather than expanding to new bor- World 6.3 rowers. Second, it limits the use of moveable collateral Middle income countries 6.3 to secure loans, as moveable collateral is more subject Lower middle income countries 8.0 to reductions in value, or being hidden or sold, during Estonia 6.7 the lengthy process. Lenders therefore often lend only Poland* 3.2 to premium clients with high-quality immoveable col- Macedonia 2.4 lateral, resulting in low NPLs but commensurately low Ukraine 5.3 outreach. Moldova 8.7 Albania 6.4 All of the shortcomings in the collateral regime also Georgia 15.0 affect the development of leasing. Indeed, despite Armenia 2010 10.3 the fact that a leasing company maintains legal owner- Armenia 2012** 8.2 ship of the leased property throughout the life of the lease, notification to the lessee is required to retake 0% 2% 4% 6% 8% 10% 12% 14% 16% possession of the collateral. Moreover, leases may be registered only in the cadaster’s Yerevan office. Leas- Source: CBA and WDI. ing is also currently subjected to a disadvantageous Notes: *Data for Poland is for 2006, ** Armenia 2012 is CBA data. tax treatment compared to traditional bank borrowing: Interest rate spread is still high, but shows a de- If a firm leases equipment, then the leasing compa- clining trend, affected by increasing competition ny must immediately pay the VAT, but if a firm takes among banks. The weighted average cost of fund- a bank loan and purchases equipment, the firm may ing for Armenian banks has been growing over recent defer the VAT for up to three years. 18  |  Republic of Armenia: Accumulation, Competition, and Connectivity years and was about 6.5 percent at end-2012. Over the longer-maturity loans are only given to prime clients, last decade, the interest rate spread has declined and who pay lower interests rates). The government often the trend seems to continue. Armenia’s spread indica- redeems long-maturity bonds after 2–3 years, which tor is now more favorable than that of Georgia, howev- makes high-yield, long bonds effectively 2–3-year ma- er, it is still higher than in some of its peers (Figure 2.6). turity bonds with distortive effects on the yield curve. Still high spreads can be explained by abundantly accessible financing from international financial insti- Figure 2.7. Government Bond Yields and Lending tutions limiting banks’ competition for deposits. One Rates, Armenia and Regional Comparators, 2011 of the implications is a very high credit-to-deposits ra- tio. There is also increasing competition among banks Lending interest rate T-bills yield for larger customers. Banks often offer lower rates to selected, big customers because of cost efficiency of Estonia serving big clients and cross-selling opportunities. There is a notable certain difference of spreads be- Poland* tween the consumer loans and corporate loans, which Albania reflects the competition for big clients. Moldova Bond Market Armenia The market is dominated by primary auctions of 0% 5% 10% 15% 20% public bonds. These follow pre-determined annu- al schedules, and semi-annual and annual reports on Source: IMF. public debt management are published. The law on * Data for Poland is for 2006. public debt of 2008 regulates the sector. Banks are the main players in the market, holding about 60 percent The development of a private bond market is im- of the total bonds outstanding, while the CBA holds peded by a number of factors. These relate to the about 30, which it acquires in the secondary market or general investment climate, with challenges in investor through its repo window. protection and corporate governance and transparen- cy, and institutional issues, including the absence of Liquidity in the secondary market is low with most the benchmark yield curve usually provided by gov- investors holding bonds to maturity or exchang- ernment bonds, the small size of institutional investors, ing them bilaterally without using the exchange. In and extensive paperwork and long processing times at 2011, the CBA conducted 73 transactions in the sec- the central depository. ondary public bond market with a total value of AMD 13.6 million, or about 6 percent of total public bonds outstanding. Less than 5 percent of secondary trans- Equity Market actions are carried out on the exchange. This impedes The equity market is virtually non-existent. Arme- the development of market forces and liquidity in sec- nia lags behind its peers in stock market capitaliza- ondary markets. tion, which is only about 1 percent of GDP (Figure 2.8). The arrival of a foreign investor in the market, Nas- Government bonds offer relatively high yield and daq-OMX in 2009 has so far not resulted in a major crowd out private bonds. A regional comparison revival despite a number of technical improvements shows that both Armenian public bond yields and to the trading platform. The central depository which lending rates are significantly higher than those in Es- deals with securities clearance and settlement, how- tonia, Poland, and Albania, but lower than in Moldo- ever, still needs some operational improvements and va (Figure 2.7). The yield curve for government bonds particularly reduction of paperwork and operations shows higher yields for longer maturities, while corpo- processing time. The low liquidity is the consequence rate loans are priced in opposite fashion (this may re- of a rudimentary state of the market forces including flect a selection bias in corporate loan pricing, whereby lack of institutional investors managing long money, Saving, Investment and Financial Intermediation  |  19 Figure 2.8. Stock Market Capitalization, Armenia and Selected Countries, 2010 a: in relation to GDP, in percent b: in relation to private credit-to-GDP ratio Stock market capitalization to GDP ratio 40 benchmark, 2010* Poland 35 Poland 30 Stock Market Cap. Ukraine 25 Macedonia Ukraine Macedonia 20 Estonia 15 Estonia Georgia 10 Georgia 5 Armenia Armenia 0 0% 5% 10% 15% 20% 25% 30% 35% 40% 0 20 40 60 80 100 120 Credit to GDP Ratio Source: World Bank’s Global Financial Development database. and lack of transparency of companies. For compa- will create demand for more financial instruments nies, costs of going public still outweigh the perceived (Figure 2.9). The government and CBA are putting benefits. They do not have a sufficient level of maturity in place rules and regulations and the infrastructure in terms of corporate governance and other manage- needed to administer the individual accounts and ment issues, in order to qualify for stock market place- safely invest funds. Over the next five years, invested ment. They do not have the will nor feel the pressure funds are projected to rise to close to $2 billion, which to go public. The corporate sector is still predominant- is a very sizeable amount given that total banking as- ly family owned who are not embracing the culture of sets are around $6 billion today. The projections show diversifying the shareholding, as well as separating the both the opportunities created by the pension reform management from the ownership. and the urgency to move ahead with the accompany- ing reforms in order to create the financial assets for Stock market development was impeded by the pension funds, because otherwise the funds can only failure to channel privatization through the capi- be invested in government bonds. Such an outcome tal markets. Privatization had a significant role in the would negate the benefits of the pension reform, be- development of the capital market in many transition cause it would not allow moving pension liabilities economies, in particular through listing of formerly away from the government budget. state owned infrastructure companies. However, many of the currently government owned companies in Ar- Figure 2.9. Projection of Individual Pension menia are making losses and are not attractive enough Invested Funds, 2014–2020 for a successful public placement. Only 3–4 of about (in millions of U.S. dollars) 100 state owned companies today can be identified as possible targets for public placement. 1,807.8 2,000 1,378.3 1,500 1,012.7 Lack of institutional investors with long-term invest- 707.6 1,000 ment profiles has been one of the major hurdles 460.3 500 113.3 264.6 up to now. There have been promising reforms in the 0 insurance sector which would lead to the emergence 2014 2015 2016 2017 2018 2019 2020 of life insurance, which is generally a major source for capital market investments. The pension fund reform Source: USAID Pension and Labor Market Reform Project. with individual investment accounts to start in 2014 20  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 2.10. Armenia: Savings Gap and Foreign Direct Investment, 2001–2011 a: Saving, Investment and CAB, percent of GDP b: Capital Flows CAB, in millions of US dollars Savings Investments (gross capital formation) CAB Portfolio invetsment FDI CAD 600 45.0 0.0 40.0 -2.0 400 35.0 -4.0 200 30.0 -6.0 0 25.0 -8.0 20.0 -10.0 –200 15.0 -12.0 –400 10.0 -14.0 –600 5.0 -16.0 2007:1 2007:2 2007:3 2007:4 2008:1 2008:2 2008:3 2008:4 2009:1 2009:2 2009:3 2009:4 2010:1 2010:2 2010:3 2010:4 2011:1 2011:2 2011:3 2011:4 2005 2006 0.0 -18.0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 c: FDI Aggregate Distribution, percent d: FDI in Tradables, in million of US dollars FDI in tradables Non tradable 500 100% 90% 400 80% 70% 300 60% 50% 200 40% 30% 100 20% 10% 0 0% 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 Post and telecommunications Real estate activities Financial intermediation Other tradables (incl. computer, R&D) Mining and quarrying Agriculture, forestry and fishing Manufacturing FDI in tradables Source: Armenia National Statistical Service and authors’ calculations. Foreign Direct Investment Armenia needs to attract foreign saving into the FDI has positive productivity spillovers in the man- tradable sectors to grow sustainably. Since 2005, ufacturing sector. Multiple surveys suggest a posi- the gap between domestic saving and investment has tive relationship between FDI and economic growth, been widening as shown by the deteriorating current stressing its role in supplying capital to countries with account balance (Figure 2.10). The current account low domestic saving and inefficient financial interme- deficit was mainly financed by FDI inflows. To maintain diation mechanisms, and its technology transfer ef- a high level of investment, domestic saving need to fects. Multinational corporations (MNCs) are seen to be complemented with a steady flow of FDI. To grow sustainably, FDI has to be channeled to the tradable sectors. Yet, the share of FDI flowing to the tradable sectors sharply decreased during 2003–08. Saving, Investment and Financial Intermediation  |  21 be a vital source of up-to-date technologies, and ben- years, economic activity dropped significantly and FDI efit from scale economies.21 plummeted (Figure 2.11). Since the 2009 crisis, there is a shift of FDI toward Figure 2.11. Armenia: FDI Inflows during the 2000s the manufacturing sector. Before the 2009 crisis, tele- com, finance and mining were attracting the most FDI a: FDI inflows by period, percent of GDP inflows to the tradables sector. After the crisis, manu- facturing ranked among the top-3 tradable sectors at- 18% Montenegro tracting FDI. But the share of FDI going to the tradable 16% Bulgaria sectors as a whole is still significantly below its peak Inward FDI 2006–2010,% of GDP 14% level of 91 percent in 2003. 12% Georgia Turkmenistan 10% Kazakhstan Based on the characteristics of Armenia’s FDI in- Estonia Moldova flows, this chapter proposes policies to sustain the 8% Armenia Albania Macedonia Croatia shift of FDI toward manufacturing. After analyzing 6% Kyrgyz Republic Ukraine Tajikistan Latvia the impact of FDI inflows on growth and uncovering Poland Russia Hungary Romania 4% FDI patterns across multiple dimensions, some policy Serbia BelarusLithuania Czech Republic 2% Slovak Republic measures are proposed to stimulate job creation. Turkey Slovenia Uzbekistan OECD members 0% –2% 3% 8% 13% 18% FDI and Growth in Armenia –2% Inward FDI 2000–2005,% of GDP –4% Armenia has attracted much more FDI in the sec- ond half of the 2000s compared to the first half. FDI inflows picked up from 2005 and constituted sizeable b: GDP per capita and FDI inflows amounts in proportion to GDP. During 2006–10, cumu- 1,000 20 14.1 13.6 lative FDI inflows stood at about 7.5 percent of GDP, a 13.7 13.1 13.4 10.4 900 9.1 9.9 8.2 remarkable level that positioned Armenia among the 8.0 10 7.6 6.4 6.7 4.6 3.9 800 1.9 –6.6 top performers in the Commonwealth of Independent 700 0 States (CIS) and Central and Eastern European (CEE) 600 –10 countries.22 500 –14.3 400 –20 Growth has been positively correlated with FDI 300 –30 200 inflows. Generally, high growth periods were accom- –40 100 1992 –40.8 panied with increasing but more volatile FDI inflows. 0 –50 During 2001–05, high growth rates were associated 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 with increasing but still moderate volumes of FDI. In GDP per capita annual growth, % Inward FDI flows, mln USD the subsequent three years, FDI picked up as the con- struction-led growth model was thriving. In the crisis Source: UnctadStat, WDI. Capital Accumulation and FDI Inflows 21 The literature is quite positive on higher productivity of foreign firms, e.g. Lipsey, 2002. However, the evidence on pro- Armenia’s recent growth was driven by capital ac- ductivity spillovers is mixed and depends on a number of fac- cumulation. During 2000–10, Armenia’s capital accu- tors including the sector, the host country policies and financial mulation rate was around 33 percent higher than in development level, see e.g. Alfaro, 2003. Alfaro’s cross-country CIS, CEE and OECD countries, except for Belarus and study suggests that FDI had positive impact on manufacturing, negative on primary industries and mixed on services. Turkmenistan (Figure 2.12). However, the construction 22 This should be assessed on the backdrop of the sharpest sector represented between 51 and 68 percent of decline in GDP in 2009, one of the largest among the bench- the gross fixed capital formation. While its share has marked countries. 22  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 2.12. Capital Accumulation and FDI Inflows, 2000–2010 a: Gross Fixed Capital Formation (GFCF), 2000–10 Groups with highest gross capital formation Turkmenistan 35.4% Benchmark countries and country Belarus 33.5% Armenia 33.4% Estonia 30.3% Latvia 30.2% CIS average 26.7% CEE average 25.9% OECD members 20.3% Gross capital formation,% of GDP b: GFCF and Construction, 2000–10 80.0% 68.2% 68.9% 70.0% 65.1% 65.9% 66.4% 63.6% 59.8% 60.0% 55.5% 54.7% 51.1% 51.8% 50.0% 39.8% 35.5% 36.9% 36.4% 40.0% 33.1% 29.8% 30.0% 23.0% 23.9% 21.1% 18.4% 17.7% 28.0% 20.0% 26.4% 26.8% 21.2% 20.4% 17.0% 18.9% 10.0% 16.7% 13.8% 11.1% 10.6% 0.0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Construction, % of GFCF Gross fixed capital formation, % of GDP Construction,% of GDP c: Companies in Armenia with FDI participation 5,000 8% 7.1% 6.8% 6.6% 7% 6.3% 4,000 6.0% 5.5% 6% 5.0% 4.5% 4.6% 5% 3,000 4.1% 3.3% 4% 4,324 2,000 4,042 3,373 3,721 3% 3,133 2,482 2,821 2,197 2% 1,000 2,171 1,424 1,899 1% 0 0% 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Number of companies with FDI participation Proportion of companies with FDI participation in the total companies' stock in Armenia Saving, Investment and Financial Intermediation  |  23 d: Gross Savings and GFCF, 2000–10 50% Turkmenistan Kazakhstan 40% Russian Federation Slovenia 30% Estonia Belarus Czech Republic Hungary Slovak Republic Gross Savings, % of GDP 20% Poland Latvia OECD members Croatia Romania Ukraine Turkey Armenia Bulgaria Lithuania 10% Macedonia Georgia Albania Serbia Kyrgyz Republic 0% 0% 5% 10% 15% 20% 25% 30% 35% 40% 45% 50% Montenegro –10% Moldova Tajikistan –20% Gross fixed capital, % of GDP Source: WDI, NSS. dropped after the crisis, it still accounts for nearly 50 FDI Inflow and Sectoral Productivity percent of GFCF. Construction in Armenia expanded Four sectors attract most of the FDI. These are trans- due to the boost of residential construction mainly in port and telecommunication, electricity, gas and water, Yerevan and road construction supported by donor financial intermediation and mining. Together they ac- funding. However, capital accumulation was mainly counted for 72.5 percent of total cumulative FDI over driven by foreign savings. Domestic savings rates were 2000–2010 (Figure 2.13). FDI levels in these sectors relatively low. have been high in relation to their respective gross val- ue added on cumulative terms - from 71 percent in fi- As a result, the number of companies with FDI in- nancial intermediation to 102 percent in electricity, gas creased substantially. FDI volume growth has been & water sector. In terms of FDI per employee, these accompanied by the growth of the share of companies sectors also outpace the rest.24 with foreign capital in the total universe of companies in Armenia. Since 2000, this share steadily increased from 3.3 to 7.1 percent implying that the growth in the number of companies with FDI participation signifi- 24 The industry classification is based on NACE 1.1, GVA fig- cantly exceeded the rate of creation of “purely local” ures are available only for first level industry categories which companies. This is an indication of increasing dyna- significantly limits the depth of the analysis. Thus, for example IT industry is distinguished with a high presence of foreign capital mism of the business with enhanced interest from for- and high productivity. However, GVA figures and accurate FDI eign investors.23 statistics are not available for the industry. The official statistics states that in the period of 1998–2010 the sector of software development and IT services attracted over $65 million of FDI to the economy which accounted for 1 percent of the country’s 23 However, this must be interpreted with caution given that total FDI for the same period. However, this maybe a substantial many non-resident company founders are former Armenian citi- underestimate given the nature of foreign investment transac- zens who migrated out. tions in the industry. 24  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 2.13. Sectoral Contribution to Gross Value Added, 2000–2010 a: Contribution to total GVA growth b: Cumulative share in GVA Construction 22.3% Construction 21.1% Agriculture 16.3% Agriculture 20.8% Wholesale and retail trade 16.0% Wholesale and retail trade 12.7% Transport and communications 7.4% Transport and communications 7.2% Manufacturing 7.1% Manufacturing 12.4% Real estate, renting and business services 5.4% Real estate, renting and 4.3% Real Sectors of Industry business services Real Sectors of Industry Financial intermediation 4.9% Financial intermediation 2.8% Health and social work 4.6% Health and social work 2.9% Public administration 4.4% Public administration 3.3% Education 3.6% Education 3.4% Mining and quarrying 3.6% Mining and quarrying 2.3% Social and personal service activities, other 1.9% Social and personal service activities, 1.7% Electricity, water and gas 1.1% other Restaurants and hotels 1.0% Electricity, water and gas 4.7% Fishery 0.4% Restaurants and hotels 0.5% Other 0.0% Fishery 0.1% Sector contribution to GDP change Sector contribution to GDP change c: Sector’s GVA growth Construction 469% Agriculture 151% Wholesale and retail trade 347% Transport and communications 219% Manufacturing 91% Real estate, renting and 259% Real Sectors of Industry business services Financial intermediation 560% Health and social work 809% Public administration 282% Education 223% Mining and quarrying 1012% Social and personal service activities, 199% other Electricity, water and gas 30% Restaurants and hotels 841% Fishery 4056% Sector contribution to GDP change Source: NSS. Saving, Investment and Financial Intermediation  |  25 However, the contribution of these sectors to eco- Deeper financial intermediation stimulates saving. nomic growth during 2000–10 has been modest. While households seem to borrow more when they They contributed only 12 percent to the total growth have access to the banking system, the banking sec- in the observed period, due to their relatively small tor currently receives sizeable funds from donors in the size in the economy. For instance, mining which grew form of credit lines. To the extent that these credit lines by 1012 percent contributed only 3.6 percent to total are priced below market, they reduce the banks’ in- Gross Value Added (GVA) growth. By virtue of their centives to offer attractive deposit rates to savers. Mi- large share in GDP, the largest contributors to the total cro-saving and -credit institutions can overcome size GVA growth were construction, agriculture and whole- constraints, particularly in small towns and rural areas. sale and retail trade. Banking for Armenia’s corporate sector could expand significantly. Lead FDI sectors have been net contributors to job creation. Despite high growth, net job creation in the High intermediation spreads seem to be a result 2000s was insignificant, while intra-sectoral shifts have of the characteristics of the financial system. They been significant. Thus, manufacturing shed jobs, as well are a function of the additional risk charges on holding as the service sectors. The biggest job creation took dollar denominated assets and loans, an insufficiency place in construction and the public sector. Lead FDI of dram deposit funding, and the relatively small size sectors created about 20,000 jobs during this period. of banks with commensurate larger operational over- heads. As such, the main feasible area for cost reduc- tion, which the authorities could consider supporting Policy Recommendations would be further consolidation of small banks where Reform areas to boost saving and investment cov- feasible, and promoting innovative technology and er four areas: the macroeconomic environment, fi- automation to reduce operational and overhead costs, nancial intermediation, remittances, and FDI. The and secure electronic based service delivery channels significance of income in determining the saving rate that could enhance efficiency and reduce operational implies that a growth-enabling macroeconomic envi- and administrative costs. ronment is a necessary condition for high domestic saving. Thus, real appreciation and the 2009 crisis had To further expand credit and deposit services, mea- a strong negative impact on the aggregate saving rate. sures could include the following: Interest rates on time deposits stimulate saving, as do remittances. A macroeconomic environment that en- ¾¾ Improving the Collateral Realization Process. sures low inflation, a sustainable fiscal deficit and a Modernizing registering and repossessing collat- sustainable current account deficit enables growth. eral (foreclosure, seizure, and sale of collateral) Monetary, fiscal and trade policies need to be closely could greatly expand access to credit by SMEs. coordinated. The inflation targeting policy of the Cen- ¾¾ Promotion and Expansion of Microfinance. De- tral Bank should be maintained and strengthened to fining ‘microfinance’ in the law, regulations and anchor inflation expectations. The exchange rate pol- sector references and including the universal cred- icy needs to support an export-led growth strategy, it organizations more clearly as microfinance insti- with a competitive real exchange rate and low (import- tutions would raise their profile. Qualified univer- ed) inflation. The fiscal stance needs to be sustainable, sal credit organizations should also have a greater with the debt ratio contained below 50 percent of the role in donor and government credit programs. previous year’s GDP (as per the fiscal rules adopted by Technical assistance programs and possibly credit the Government of Armenia).25 Revenue mobilization guarantee schemes to SMEs would enhance their efforts would help increase fiscal saving and invest- bankability—areas for technical assistance could ment into growth-enhancing infrastructure and human include accounting, financial management, busi- capital. ness planning, and marketing. ¾¾ Regulatory Modifications to Expand Financial Services and Credit Products. The development 25 Armenia adopted a rule in 2008, which stipulates that debt cannot exceed 60 percent of GDP then the fiscal balance. of leasing would benefit from: (i) providing at least 26  |  Republic of Armenia: Accumulation, Competition, and Connectivity equal tax treatment of lease financing and loan fi- ¾¾ Government Sector Strategic Initiatives. A deeper nancing; (ii) developing leasing capacity and tech- government debt management program could in- nical know-how in banks and credit organizations, crease the depth of AMD government securities at either in-house or from international donors; and key segments of the yield curve, and once achieved, (iii) developing a leasing law following internation- provide a benchmark for indexed bonds.26 al good practice. ¾¾ Infrastructure Financing with Project Bonds. To increase the availability of long-maturity bonds, Equity and securities markets could supplement the government could finance major public infra- financial intermediation offered through banks. structure projects with semi-private bonds secured The recent pension reform will create individual, de- with project cashflow (e.g. road tolls, or fees) rath- fined-contribution pension funds from 2014. Devel- er than budgetary resources. The government oping initiatives for increasing the supply of capital would set up special purpose vehicles, possibly as market securities will require a multi-pronged effort public-private partnerships, and could kick-start versus a traditional ‘organic’ growth of markets giv- project finance and give a major impetus to bond en Armenia’s small ‘financial space’ and should thus market development.27 include various simultaneous initiatives to generate competition and innovation in the sector. These may With regard to foreign saving, remittances can be include several spheres of intervention to generate channeled to productive activities if the proper in- more liquidity and competition in securities markets: stitutions are put in place. More than 80 percent of Armenia’s remittances come from Russia. Nearly 10 per- ¾¾ Securities Regulation. To increase financial mar- cent of these inflows are already being used for business ket access and product development, factoring investment. Another 10 percent going to ‘other’ uses (receivables securitization) and reverse factoring can be channeled to investment if the right institutions markets could develop safe and well-rated fixed are in place. As of now, remittances come into Armenia income instruments and generate additional local through narrow banking channels which do not offer the securities in the market. This will also require, inter full range of services of deposit taking banks. alia, streamlining the floating security interest re- gime. Exploring securitization options for pooled Attracting more FDI requires scaling up skills, im- SME business revenues and receivables could proving the investment climate, and connectivity free up lending capital and generate new fixed to external market. This means being pragmatic income instruments with collateral backing. The and realistic: establish a target list of reputable mul- development of a private equity framework could tinationals in manufacturing and tradable services allow capital transactions to occur within a less and lobby them to relocate some of their activities transactional- and disclosure-intensive procedure to Armenia. amongst qualified players, and permit transac- tions via an over-the-counter market. Once some The government needs to be proactive and bold of these instruments have started to develop, and to be successful in its FDI attraction policy. The equities or bonds increase in circulation, the de- generosity of incentives (fiscal benefits, serviced land sign of an Armenian market index fund of major provision, risk guarantees) should be in line with the securities should be developed as a benchmark potential impact and spillovers on the domestic econ- index for the domestic market. omy in terms of job creation, knowledge transfer, and ¾¾ Institution-Specific Initiatives. The national mort- supply-demand linkages with SMEs. gage company could increase the issuance of mortgage covered bonds or securitizations. The mandate and portfolio of the Pan Armenian Bank could be diversified to include structured secu- 26 An IMF/World Bank Team produced a technical advisory re- port covering several such issues: “Developing a Medium Term rities. Pan Armenian Bank could act as a market Debt Management Strategy,” December 2011. innovator, introducing new market products that 27 This idea was first proposed in the 2012 IMF/WB Financial commercial banks are currently unwilling to offer. Sector Assessment Program discussions. Saving, Investment and Financial Intermediation  |  27 3. Human Resources28 Armenia’s economy has been sluggish in producing of academic curricula, instituting apprenticeships, and jobs, even in the high-growth period in the 2000s. creating quality assurance mechanisms. Faced with increasing demand for output, firms raised labor productivity, rather than employment. The rate of This chapter draws from recent analyses of the la- joblessness soared after the global crisis, and even af- bor force and the enterprise sector. The first sec- ter the improvements over three years of recovery, un- tion reviews recent developments in the labor market employment still affects 18 percent of the labor force through the global financial crisis. The second section in 2012. High unemployment and low labor force par- reviews current challenges facing Armenia’s labor mar- ticipation combine to make the employment-to-popu- ket, and the third section discusses policy options. lation ratio lower than in most European countries. At 53 percent, this ratio is far below the European aver- This chapter also provides a fresh look at an aspect age of 60 percent. of Armenian human resources, which is usually not included in this concept: the Armenian diaspora. It High rates of unemployment, and low-productivi- represents a largely untapped resource, but the right ty employment have adverse implications for both approach for engaging them has to be found. Many economic growth and poverty reduction. To sustain engagements are about entrepreneurship and risk growth in economic activity, human resources need to taking in expectation of higher than usual returns. As be used efficiently and allocated to the most produc- such, it can and should not be mandated, adminis- tive sectors. In contrast, Armenia’s labor market shows tered or directed by the state. However, it can be nour- very little reallocation from agriculture to modern sec- ished and supported. The literature refers to this as the tors of the economy, and high differences in rural and paradox of guided serendipity—creating a framework urban unemployment suggest little spatial mobility of where unplanned innovations thrive. The fourth sec- labor. At the same time, labor market activities are im- tion therefore looks at ways to engage the dynamism portant drivers of poverty reduction. and outside experiences of the Armenian diaspora as an extension of the Armenian labor force. Armenia’s labor market confronts challenges that affect demand (number of jobs), supply (number of workers) and matching of the two. Given the high Labor Market Trends unemployment, the emphasis should fall squarely on Starting in 2006, overall employment increased the first. Job creation will respond to removal of imped- for the first time since Armenia’s emergence from iments to firm entry and business start-ups, because the Soviet Union. For most of the transition process, new firms are mostly more innovative and creative and create more jobs than existing firms. Improvements 28 This chapter draws heavily on Rutkowski, Jan (2012), Promot- to the business environment enhance competitive- ing Productive Employment in Armenia, Report No. 72907-AM; ness and help all firms. On the supply side, improv- analysis of emigration and the labor force in CIS countries by Sau- ing skills requires engaging employers in the design mik Paul, and analysis of BEEPS data by Charles Udomsaph. Human Resources | 29 Figure 3.1. Armenia: Labor Force Participation and Employment, 2010 a: Employment by sector, thousand b: Participation and employment rates, percent, 2009 1200 Non-tradable Services 70 Kazakhstan 1000 Public Administration Kyrgyz Azerbaijan Employment rate 800 60 Tradable Services Russia Czech 600 Belarus Bulgaria ECA Georgia Estonia Mining and quarrying 50 400 Latvia Croatia Armenia Moldova Albania BiH Manufacturing 200 40 0 Electricity, gas and water 40 50 60 70 80 Participation rate 2002 2003 2004 2005 2006 2007 2008 2009 2010 c: Youth vs. adult employment rates, percent d: Female vs. male employment rates, percent 45 44.5 60 45 44.5 60 44 44 50 50 42.8 42.8 43 42.5 43 42.5 42.0 42.0 40 41.6 40 42 41.2 41.2 42 41.6 40.8 41.2 41.3 41.2 41.2 40.8 30 41 40.4 40.2 30 41 40.4 40.2 40 20 20 40 39 39 10 10 38 38 0 37 0 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Total (LHS) Youth (RHS) Adult (RHS) Total (LHS) Female (RHS) Male (RHS) Source: WDI, ILO and NSS. Armenia shed jobs, mainly in the public sector, when million just before the global financial crisis in 2008. unprofitable enterprises shut down, and even surviv- Data from the enterprise sector suggest that employ- ing firms reduced employment. Employment plunged ment growth was led by newly-created firms: Arme- from about 1.6 million in 1990 to 1.1 million in 2006 nian enterprises created after 2003 increased employ- along with substantial structural changes in the econo- ment by over 20 percent, far above the ECA average my. This is consistent with the experience of other tran- of about 12 percent.29 sition countries, where job flows mirrored enterprise restructuring. Between 2006 and 2008, Armenia ex- perienced a modest recovery in employment, fueled 29 BEEPS data from the 2008–09 round are weighted and are in large part by the construction boom. Employment deemed to be representative of the enterprise sector in each country. The most recent round of the BEEPS is being conduct- increased modestly from 1.092 million in 2006 to 1.117 ed this year. 30  |  Republic of Armenia: Accumulation, Competition, and Connectivity The incipient job creation was overtaken by the (BEEPS) show that employment in construction firms global crisis and a modest recovery. The unemploy- grew by 18 percent between 2004 and 2007, which is ment rate soared after the crisis, with young men and well above the average employment growth of 13 per- women bearing a disproportionate burden of this em- cent for all reporting firms in Armenia, and in the re- ployment shock. Although labor market conditions gion. The rate of employment growth in the construc- have improved in 2011–12, the rate of joblessness re- tion sector of the EU10 was 5 percent, the Western Bal- mains high. Meanwhile, many of Armenia’s workers— kans 7 percent, and the CIS countries 5 to 7 percent. including highly-educated workers—find themselves employed in low-paid, low-productivity sectors and Despite the construction boom, the unemployment occupations. rate remained high up to 2008, and expanded again after the global financial crisis. Household sur- Employment growth was driven mainly by the con- vey data indicates that it grew to 19 percent in 2010,30 struction boom. Between 2000 and 2008, the construc- which is well above the regional average of about 12 tion sector’s share of GDP surged from 10 to 25 per- percent.31 In 2011, the unemployment rate fell slight- cent. This rapid expansion went along with a doubling ly to 18.4 and some further decline is likely for 2012. of employment in the sector, which offset employment In addition to the survey-based unemployment rate, decreases elsewhere (such as in agriculture and man- another measure of unemployment—the ‘augment- ufacturing, Figure 3.2). Anecdotal evidence suggests ed’ unemployment rate, which takes into account the that the real employment effects of the construction number of people who are available for work but re- boom may have been underreported, because of the port themselves to be not actively looking for jobs be- difficulties in capturing a high share of informality in cause they are already discouraged and do not expect the sector in the official data. to find jobs—indicates joblessness affects close to 30 percent of working age individuals.32 Figure 3.2. Armenia’s Drivers of Employment, by Sector, 2002–10 The youth have been disproportionately affected by the crisis. Youth unemployment soared in 2009 and re- Employment 2010 mains high.33 The unemployment rate grew from about Public administration 40 percent to 60 percent, among workers age 15–19, Transport and communications and from 35 to 36 percent among workers age 20–24. Restaurants and hotels This compares unfavorably with the global average of Wholesale and retail trade Real estate, renting and youth unemployment (age 15–24), which was about 13 Financial intermediation percent in the same year. Youth unemployment in ad- Fishery vanced countries was 12 percent on average in 2009, Electricity and water Agriculture Mining and quarrying 30 Statistical Yearbook of Armenia (various issues). There is a Social and personal service statistical break as the NSS calculated the unemployment rate Education based on the standard ILO definition only from 2008 onwards, Health and social work thus restricting comparisons over time. Manufacturing 31 Koettl and others (2011). Employment 2002 32 There is a third measure of unemployment, the registered –50000 –30000 –10000 10000 30000 unemployment rate (sometimes referred to as the “official” unemployment rate), which is based on the number of people registered with the public employment services office. This rate Source: NSS. held steady at 7 percent in 2009–10 and then fell slightly thereaf- ter. Unlike other countries in the region, officially registered un- employment in Armenia is lower than survey-based unemploy- Enterprise sector data provides complementary ment. The disparity may reflect differences in the generosity of evidence of the role played by construction firms unemployment benefits—namely, the cash assistance to unem- in the growth of employment. Data from the Busi- ployed workers. In other words, workers do not feel compelled to register, because the unemployment benefits are too low. ness Environment and Enterprise Performance Survey 33 Statistical Yearbook of Armenia (various issues). Human Resources | 31 Figure 3.3. Employment Ratios in International Comparison (in percent) 80 70 60 50 40 30 20 10 0 ia Hu ia Lit ary ia ly ain Ro ia ia d a ce ria d Be ia um gia Cz e Po R. Slo al Fin a Ge d y Au . Sw a De en th rk ds K an tvi ni i nc lan lan lan Ita en t an k an ton g str Ne ma U. ee an oa h ed lga va ng or rtu Sp ve lgi Fra La rm ec hu m m Po Ire Gr erl Cr Es n Slo Ge Bu Ar Source: ILO. while in other ECA countries it was 21 percent.34 The about 8 percent. At the time, it was also estimated that youth unemployment rate in Armenia has since fallen about 120,000 jobs were needed to sustain labor force marginally; in absolute terms, however, the number of participation rates between 2008 and 2015. About unemployed youth rose from 75,000 to 76,000. 320,000 jobs would be needed to raise participation rates to EU15 levels.36 High youth unemployment also reflects difficulties in labor market entry. Evidence from the 2010 round An education does not guarantee employment. of the Integrated Living Conditions Survey (ILCS, a Individuals with general secondary education but no household survey) suggests that the majority of unem- technical skills represent the largest fraction of the un- ployed workers are new entrants to the labor market. employed, but many unemployed also have technical, A new Labor Code enacted in 2004 to facilitate job occupation-specific skills. In urban areas, about a quar- flows has made it easier to terminate contracts, but ter of all unemployed workers have secondary, and/or also put new restrictions on fixed-term hiring. A recent technical education and another quarter finished ter- assessment, using aggregate time-series data analysis tiary education. In rural areas, the fraction of skilled through 2009, provides some evidence that the new individuals among the unemployed is smaller, but Code may have hampered hiring activities.35 remains substantial. There is no evidence that social programs, such as the Family Benefit Program (FBP), High unemployment and low labor force participa- create disincentives to work.37 tion combine to make the employment-to-popula- tion ratio lower than in most European countries. At 53 percent, this ratio is far below the European 36 World Bank (2007). This is based on the working-age pop- average of 60 percent (Figure 3.3). Simulations from ulation forecast then of 2.4 million by 2015 and a constant em- 2007 suggest that increasing employment of Arme- ployment-to-population rate of 56 percent. Raising participation levels to those of the EU15 assumed a 65 percent employment nians to the European average would lift GDP by rate. These were simulations through 2015 produced in 2007; the need for significant numbers of new jobs may possibly be offset by the projected decline of the economically active popu- 34 ILO (2011). lation through the longer-run. See Table 9 in World Bank (2007). 35 Hartwell (2010). 37 World Bank (2011b). 32  |  Republic of Armenia: Accumulation, Competition, and Connectivity Complementary evidence also suggests a high Challenges to Armenia’s Labor Market 40 underemployment rate in Armenia. Recent data from a global survey conducted by Gallup to mea- This section explores the challenges of labor de- sure underemployment rates—or the percentage of mand, supply, and matching of workers and jobs. It workers who would prefer to work longer hours but draws on the analysis of ILCS data and refers to recent, cannot, for one reason or another—indicate that the related empirical literature whenever relevant. In addi- incidence of underemployment in Armenia is high. tion, it explores the role of the regulatory environment, In 2011, the world underemployment rate was about where applicable, and whether social programs distort 17 percent, with the ECA region comparing favorably job-seeking behavior. Finally, it explores the role of with other regions in the world. However, Armenia is labor mobility—both domestic and international mi- counted among those with very high underemploy- gration—and whether such geographic movement, ment rates, estimated to be 35 percent or higher, or lack thereof, ease or exacerbate labor market pres- along with other economies in the South Caucasus sures. region. Weak Labor Demand Moreover, many of Armenia’s workers remain employed in low-productivity jobs.38 Close to half Job creation in the formal sector has not kept pace of all employed workers are in agriculture, a sector with the growth of the working age population. Sus- which has not recovered its pre-transition productivi- tained economic growth prior to the global financial ty level. The consequences for aggregate productiv- crisis did not produce a sufficient number of new jobs; ity are substantial. instead, gains in labor productivity led to rising wages. The construction boom prior to the crisis translated into It is not clear what role domestic and internation- employment growth, but proved unsustainable. al labor mobility has played in easing (or exacer- bating) labor market pressures in recent years. In- Armenia lacks a critical mass of small, dynamic and ternational migration has been an important feature job creating enterprises. New, small firms led job-cre- of Armenia’s economic landscape and remittances ation in the years ahead of the crisis, according to BEEPS represent 15 percent of GDP. However, the share data. As new business registration fell in 2008 and 2009 of households with international migrant members because of the global crisis, job creation in Armenia has has fallen from about 20 percent before the crisis to become more challenging. The lack of small firms is 12 percent in 2009.39 The majority of Armenian mi- partly explained by a low level of entrepreneurship: few grants are in Russia (about three quarters) and Rus- in Armenia’s labor force ever attempt to start a business sia’s economy experienced a 12 percent contraction and among those who do, few succeed. Data from the in 2009. Life in Transition Survey (2010) suggest that only about 12 percent of the labor force has ever attempted to start a business and less than 6 percent have succeeded. This contributes to a lack of small firms that can generate enough new jobs to offset job losses in the older, more traditional sectors. Low entrepreneurship and lack of 38 World Bank (2007). See also ETF (2010). small dynamic firms are also indicators of a difficult busi- 39 Karapetyan, Susanna and others (2011) “Armenia: Social ness environment; barriers to growth such as the com- Protection and Social Inclusion” (Caucasus Research Resource petition environment and connectivity are discussed in Centers). The World Bank’s Migration and Remittances Factbook 2011 reports that about 870,000 are currently abroad, represent- the other chapters of this report. ing 28 percent of the population. The number of emigrants is difficult to estimate, given the extent of undocumented migra- Chapter 4 of this report points out that more robust tion and the disparity between administrative and survey data. competition would contribute to the dynamism The number of emigrants abroad also include permanent mi- grants, including entire households that have moved overseas. Thus the smaller percentage of households with international migrants, reflects in part the difference between seasonal and 40 Unless otherwise indicated, this section is drawn mostly permanent migration. from Rutkowski (2012). Human Resources | 33 needed to increase employment. Competition pro- including both skilled and unskilled workers alike. We vides firms with strong incentives to reduce costs and explore each possibility below. innovate to become more efficient and productive. They offer competitive prices, higher quality, and Individuals with general secondary education— new and better services for the benefit of the entire with no technical skills—represent the largest economy. In addition, well-functioning complemen- fraction of unemployed workers. Detailed profiles tary markets (for example, logistics services and util- on the unemployed drawn from ILCS data suggest ities) contribute to firms’ efficiency, which in compet- that workers with no technical skills abound in both itive markets is reflected in lower prices and better urban and rural areas alike. In urban areas, such work- deals for consumers. Innovation and cost cutting also ers represent about 40 percent of the unemployed enable firms to compete globally. Experience shows and in rural areas, 60 percent of the unemployed. that pro-competition sectoral reforms and effective Meanwhile, nearly 10 percent of unemployed work- implementation of antitrust rules lead to significant ers in both urban and rural areas have little or no ed- productivity gains and consumer savings.41 ucation. Figure 3.4. Skills and Labor Demand, 2008 Deficiencies in the Quality of Labor Supply (percentage of firms which identified inadequately Many firms report that inadequate skills constitute educated workforce as an obstacle) an important obstacle to doing business.42 This is particularly true among enterprises that are more Major obstacle Very severe obstacle 35 modern and innovative—that is, firms that have been found to be investing in research and development, 30 introducing new products, or upgrading existing products (Figure 3.4). About a third of these firms 25 complain that they are constrained by the lack of 20 skilled workers. At the same time, about 10–20 per- cent of the more traditional firms also complain about 15 the quality of workers. 10 It is not immediately clear what explains the lack of 5 skilled workers. There are several possibilities: First, more detailed characteristics of unemployed workers 0 —particularly their educational attainment and what Yes No Yes No Yes No fraction possesses technical skills likely to be of use Invested in R&D Introduced new products Upgraded existing product to expanding firms—may help shed light on the qual- ity of the workforce. Second, the quality of education Source: BEEPS, 2008. matters—that is, unemployed workers may have the required diplomas, but not necessarily the specific On the other hand, many unemployed possess skills required by firms.43 Third, government programs technical, occupation-specific skills. In urban areas, may be affecting the incentive to seek employment, about a quarter of all unemployed workers have sec- ondary, technical education and another quarter fin- ished tertiary education. In rural areas, the fraction of skilled individuals among the unemployed is smaller, 41 For a detailed summary of the impact of competition pol- icies, see Kitzmuller, M. and Licetti, M. Competition Policy- En- about 35 percent, but remains substantial. For these couraging Thriving Markets for Development. Viewpoint # 331. workers, the challenge then is securing jobs that match World Bank Group, August 2012. their skills (see the next sub-section, on Matching). On 42 It should be noted, however, that the level of complaints in the other hand, some workers may possess the re- Armenia is lower than the average for the ECA region. quired qualifications on paper, but lack the actual skills 43 That is, “skills, not diplomas” are critical, following the 2011 demanded by modern firms. The challenge for the ECA Flagship Report on Skills. 34  |  Republic of Armenia: Accumulation, Competition, and Connectivity educational system therefore is to identify skills that In this environment, Armenia’s Public Employment are required by employers. Services (PES) office has played a very limited role. In principle, PES offices can play a key role in facil- The skills shortage is not likely due to any work itating matches between job seekers and jobs that disincentives created by existing social programs. match their qualifications. In addition, PES can pro- Some have suggested that beneficiaries of govern- vide additional training to reduce skills mismatches ment transfers may be deliberately withdrawing from and skills shortages. In the case of Armenia, how- the labor force, including individuals who are otherwise ever, few of the unemployed workers—less than 10 qualified and employable among those currently job- percent—find it worthwhile to register with the PES less. However, there is no evidence to date that social office. A smaller fraction use PES resources to find programs, such as the Family Benefit Program (FBP), jobs, relying instead on friends and family members creates disincentives to work.44 In fact, less than a fifth to obtain information on jobs vacancies. In fact, the of members of FBP beneficiary households can be con- effectiveness of PES job placement services is severe- sidered able-bodied,45 working age individuals; most of ly limited. Currently there are 11 to 12 unemployed these beneficiary households have higher numbers of workers per vacancy reported to the PES office (the dependents compared to the average households. Fur- so-called unemployment/vacancy ratio), suggesting thermore, the labor market characteristics of members that at best the PES office can place less than a 10th of beneficiary households—in particular, those who are of unemployed workers. able-bodied and are of working age—are essentially the same as those of their counterparts in non-beneficiary Migration and the Domestic Labor Force households. In other words, they are as equally likely to be employed, unemployed or inactive as members The large discrepancy in urban and rural unemploy- of non-beneficiary households, though the employed ment rates is consistent with a limited role played workers among the FBP beneficiaries are more likely to by domestic labor mobility. Although some of this be working part-time and in the informal sector. disparity in labor market outcomes is masked by the quality of employment in rural areas, as discussed in the previous section, the persistence of such disparity Poor Matching and the Employment of Workers may reflect in the part the limited number of workers in Low-Productivity Sectors moving to where job opportunities are available. The There are large geographic disparities in employ- emerging results of ongoing analyses of geographic ment rates as well as the quality of employment. immobility in the ECA region suggest that about two- The employment rate in rural areas is 69 percent, which thirds of the adult population in Armenia surveyed compares favorably with those of other countries, in the 2010 wave of the Life in Transition Survey have while the urban employment rate is 44 percent. The lived in the same community since birth. Although this unemployment rate in urban areas is, at 28 percent, is about equal to the ECA average, it is double that of over 4 times the rural unemployment rate. However, the European comparator average. these figures conceal some of the disparities in the quality of employment. Most rural work tends to be The links between international emigration and the seasonal, part-time, and low-paid.46 The 2007 Armenia domestic labor market are not clear. A large frac- labor market assessment found that only about two- tion of households receive remittances—until recent- thirds of employed workers have permanent jobs; the ly about a third of households—and remittances may rest have temporary jobs or are engaged in seasonal cushion households from adverse shocks, such as the work, mostly in the informal sector. financial crisis, but they may also alter their job search and labor market incentives. Emigration (and remit- tance inflows) may raise domestic reservation wages 44 World Bank (2011b). and thus dampen labor market activity. More gener- ally, an emigration shock can be modeled as a labor 45 About a quarter of the inactive population are reportedly disabled (Armenia Statistical Yearbook, various issues). supply shock; the wages of workers in the domestic la- 46 World Bank (2007). bor market should therefore rise, holding other things Human Resources | 35 Figure 3.5. Armenia: Labor Force Participation and Employment, 2010 Sectoral Employment and Productivity, a:  HH Labor Force Participation with and b:  2004–09 without Migration 9,000 All HH w. migrants 8,000 Industry HH w. seasonal migrants 0.408 Sectoral Productivity (2000 US$) 7,000 HH w. permanent migrants 6,000 5,000 4,000 3,000 Services 2,000 –0.32 –0.31 –0.43 –0.37 –0.41 –0.45 1,000 Agriculture –0.6 –0.56 –0.73 –0.68 0 0 10 20 30 40 50 60 70 80 90 100 –0.91 Armenia Azerbaijan Kyrgyz Republic Tajikistan Cumulative Sectoral Shares of Employment Source: NSS, ADB. constant. Alternatively, emigration may promote great- of CIS economies before the global financial crisis. er entrepreneurship and thus promote job creation. They preclude a more detailed analysis of the impact While there are no necessary policy implications from of emigration over time. the labor market patterns associated with emigration —as these are labor market activities reflecting private This could be driven by income and selection ef- choices and preferences—a deeper understanding of fects. The decline in labor market activity could come the links between emigration and domestic labor mar- from income effects as households can afford to work ket activity may serve to clarify distinct features of the fewer hours when they receive remittances. The effect Armenian labor market. is likely to be more pronounced among households with permanent migrants with larger and more stable Some evidence suggests measurable declines in remittances. Another possibility is that it is in fact the domestic labor market activity among members of most productive members of households who leave migrant households. Using household survey data, for work overseas. Their emigration is associated with we find evidence of declining labor market activity diminished labor market activity among household among members of migrant households in Armenia as members left behind in the domestic market. well as in other neighboring countries in the region. The analysis is based on a probit regression analysis, At the same time, there is little evidence to suggest including selected household and individual-level that emigration flows have been associated with control variables.47 The labor market effects are much rising wages in Armenia (Figure 3.5). This is in stark more pronounced among households with permanent contrast with recent evidence drawn from Moldova migrants. The data are from a cross-sectional survey and Lithuania and in countries outside the ECA region collected by the Asian Development Bank in a sample (Mexico and Puerto Rico) that suggests measurable in- creases in domestic wages associated with emigration of the domestic labor force. Armenia’s experience may 47 This is from an ongoing analysis of household survey data be explained in part by the profile of the emigrants: led by Saumik Paul. As is well known, such an analysis is subject many of them were in fact unemployed just prior to to selection bias. The research paper (forthcoming) controls for such biases using statistical matching methods. emigration. Compared to other migrant-sending 36  |  Republic of Armenia: Accumulation, Competition, and Connectivity countries, Armenia’s emigrants also tend to be older. to find qualified workers also boosts employer In this respect, at least, emigration may be helping confidence in the PES. All these require build- ease labor market pressures, without elevating domes- ing the PES capacity to provide intermediation tic wage levels. services, including training and job counseling. They also need to be complemented by similar efforts in the private sector. Policy Recommendations Armenia’s labor market confronts multiple challeng- es which will require a multi-pronged response. The Promoting Diaspora Engagement labor market is characterized by weak labor demand, Armenia’s talent pool is small and it therefore faces an inadequately qualified workforce and the poor a shortage of competent individuals. However, there matching of job seekers to employers. As a result, a are many skilled Armenian’s abroad—the diaspora. As large proportion of Armenia’s human resources are not in many other countries, the best and brightest, which productively employed. are crucial for innovation and growth, have often left the country in search of better opportunities. The ¾¾ The creation of employment in the modern sec- usual policy focus—encourage return of talent to the tor is a priority. This requires the removal of im- home country—is often neither realistic nor necessary: pediments to firm entry and business start-ups. A members of skilled diasporas can just as effectively en- major role will have to be played by competition gage in joint projects with the home country without advocacy and enforcement, as outlined in Chap- permanently relocating to it: a phenomenon called ter 4. Better connectivity of the Armenian econ- ‘brain circulation.’ omy will increase competitiveness, as discussed in Chapters 5–7. Efforts to improve the business Mobilization of diasporas has shown a tremendous environment—such as by reducing the costs of potential, yet putting this promise into practice has doing business, limiting the number of business proven to be elusive. This frustration is particularly inspections and opportunities for extortion, and visible in Armenia: diaspora initiatives beyond financial reducing incentives to join the informal sector— transfers (remittances and philanthropy) proved to be can also help raise the rate of firm entry and job difficult to sustain. There is also a promise: the history creation. of diaspora engagement reveals a diverse portfolio of ¾¾ The quality of Armenia’s workforce needs be promising private-public initiatives in the IT sector, fi- strengthened. This would require engaging nancial sector, and tourism. employers in the design of academic curricula, instituting apprenticeships, and creating quality Armenia needs to confront two central paradoxes assurance mechanisms that allow both students of diaspora engagement. First, many diaspora proj- and employers to assess the relevance and quali- ects are about entrepreneurship. This entails risk-tak- ty of academic training provided by various insti- ing in expectation of higher than usual returns, which tutions. can be defined in non-monetary terms such as rec- ¾¾ Job matching services provided by PES need ognition, self-esteem and intrinsic motivation. Hence to be improved. Two forces are mutually rein- it cannot be mandated, administered or directed but forcing: First, employers need to be satisfied can be nourished and supported. Second, all the with the services that PES provides and report strength and brilliance of the diaspora notwithstand- a large proportion of existing vacancies to PES ing, domestic institutions appear to determine the (in other words, a high vacancy penetration ra- success of diaspora projects, particularly of complex tio). Second, the unemployed need to be confi- and long-term projects. To articulate projects with dent that PES will indeed help secure jobs com- high development impact, diaspora members need mensurate with their expertise so that more job to search for people and institutions to engage with. seekers will register with PES. A high vacancy Diaspora members thus can help to identify dynamic penetration ratio helps ensure that more of the domestic institutions and individuals to unblock bind- unemployed workers find jobs. The ability of PES ing constraints on development. Human Resources | 37 The diaspora is defined in many ways, but the most managed by US-educated overseas Chinese who important factor is a deep attachment to the home- received invitations to relocate to Taiwan. Once land. We define diaspora as a non-resident population the first venture funds proved successful, do- who share a national, civic or ethnic identity with their mestic IT firms created their own VC funds. Once homeland through being born there and migrating or those started to pay-off, even the conservative being the descendants of emigrants. One implication family groups started to invest in VC funds and IT of this definition is the heterogeneity of diasporas and businesses. an imperative to focus on a small, dynamic and entre- ¾¾ Armenia can boast similar promising and success- preneurial segment of diasporas. ful cases. The first international five-star hotel was opened with the help of the Armenian diaspora Diasporas do not need to be large to produce an in 2001 (Yerevan Marriott). Medium-term success impact. The fact that skilled expatriates can create and even more significant long-term promise of enormous benefits for their countries of origin has the Armenian IT cluster are unthinkable without come to attention in recent years through the contri- the first-generation diaspora. Significantly, Ar- butions that the large, highly skilled, manifestly pros- menia shows examples of the first-mover role of perous and well organized Chinese and Indian dias- the diaspora in creating new private industries poras have made to their home countries, but smaller similar to the Taiwanese venture capital story. For countries also have benefited from their much smaller instance, high achievers from the diaspora were diasporas. For example: instrumental in creating a credit reporting indus- try in Armenia. In January 2004, ACRA Credit re- ¾¾ Ramón L. García, a Chilean applied geneticist porting LLC, the first credit bureau in Armenia was and biotechnology entrepreneur, contacted Fun- founded. Only one year after its foundation, ACRA dación Chile, a private-public entity charged with already attracted reputable institutional investors, technology transfer in the area of renewable re- Dun and Bradstreet International (USA) and D&B sources in 1997. After jointly reviewing their port- SAME (UAE). Today, ACRA is owned by leading lo- folios of initiatives, Fundación and Ramón’s com- cal banks and the Central Bank. pany Interlink, founded a new, co-owned compa- ¾¾ More recently, the Tumo Center for Creative Tech- ny to undertake long term R&D projects. These nologies opened its doors to teenagers and pre- projects were needed to transfer technologies to teens interested in activities at the intersection of Chile that was a key to the continuing competi- technology and art. This is an initiative of the Si- tiveness of its rapidly growing agribusiness sector. monian Educational Foundation led by the New Without Ramón’s combination of deep knowl- York-based Diaspora-Armenian Sam Simonyan.48 edge of Chile, advanced US education, exposure Since August 2011, the center has been offering to US managerial practice and experience as an children an intensive exposure to new ways of entrepreneur, the new company would have been working and new tools of learning, planting the inconceivable. seeds of a career in a competitive field. The center ¾¾ When the Taiwanese government decided to pro- is focusing on four areas that are attractive to kids mote the venture capital (VC) industry in the be- and have career potential: digital video and audio, ginning of the 80s, it had neither the capabilities, game design, computer animation and web devel- nor a blueprint to do that. Many were opposed to opment. The center is equipped with a state of the the idea because the concept of venture capital art computer center, cinema hall, game room and was foreign to traditional Taiwanese investment cafeteria. practices, in which family members closely con- trolled all of a business’ financial affairs. Through a process of intense interactions with the Taiwanese Diaspora in Silicon Valley, a Seed Fund provided 48 This resource center is located in one of the central Ajap- matching capital contributions to private venture nyak districts of Yerevan. It aims at providing professional ed- ucational programs for youth aged between 12–18 years on a capital (VC) funds. Two American-style venture completely free of charge basis and boosts the IT sector in the funds were also created in the mid-80s. They were future. 38  |  Republic of Armenia: Accumulation, Competition, and Connectivity Conceptual Framework of Diaspora Engagement Another prominent example for this approach is Ire- land, which relies on the diaspora in many areas: FDI The key conceptual framework is to look at dias- promotion, education, science and technology. Rele- pora engagement as promoting search networks. vant government agencies incorporate the diaspora In the case of Taiwan, the search network consisted into everyday management practice by promoting a initially of key dynamic and forward-looking members variety of search networks, which are not diaspora net- of the Taiwanese government and leading overseas works per se but include diaspora members. Chinese engineers in Silicon Valley who were central in the emergence of this modern VC industry in a place Rather than promoting search networks, govern- dominated by conservative and risk-averse business ments are often proactive, establishing a bewilder- groups.49 ing number of programs and institutions. In part, the variety of programs reflects the sheer diversity The extension from co-founding joint firms to of forms of diaspora engagement and contributions co-creating institutional infrastructure with the help (Table 3.1). However, the diversity and contextuality of the diaspora is natural. The initial objectives of Ra- of engagement makes most centralized interventions mon Garcia and his peers from Taiwan were both mod- too crude to be successful. They tend to stifle rather est and specific: to advance their professional interests than promote innovation, and consolidate entrenched by setting up technology firms in their home countries. interests rather than coordinate. Yet as the constraints of the home country institutional environment became apparent to them, they engaged in advancing institutional reform to remedy some of Micro-Reforms and How to Scale Them Up the constraints. Significant in this transition is that only Armenia does not lack examples of micro-reforms a small number of diaspora members with knowledge, in specific sectors and fields. Marriott was such a motivation and institutional resources are involved. Yet micro-reform, which brought international best prac- it is not possible to rely on the bottom-up creativity of tices to the hotel industry. Enterprise Incubator Foun- diaspora members and their networks alone. To have dation (EIF), which collaborates closely with the di- an impact, informal networks need to be scaled up aspora in Silicon Valley, brought many micro-reforms and institutionalized. to the IT industry. American University of Armenia (AUA), led traditionally by prominent diaspora mem- Properly leveraged, the diaspora is part of a coun- bers, is a micro-reform in Armenian higher education: try’s endowment. Relevant expertise can be drawn it is a paragon of many international best practices upon for peer review of proposals and mentoring of and programs. their subsequent implementation. For example, in the biotechnology department of India’s Ministry of Sci- The challenge is to make sure those micro-reforms ence and Technology, diaspora members are relied diffuse and scale up. Domestic institutions and the upon as ‘sounding boards’ and ‘antennas’ when deci- domestic environment need to be conducive to diffu- sions are made on allocation of funds for research and sion and scaling up. The institutional environment of technology development. Engagement with diaspora Armenia can be made more conducive to such micro has become a routine part of the department’s orga- reforms: diaspora members capable of learning and nizational practices. Skilled diasporas are viewed and searching need to find partners and pragmatic ways to relied upon pragmatically, for specific tools and pur- diffuse their efforts. There are always better performing poses, as an extension and continuation of sector-spe- and more dynamic segments. Through a collaborative cific agendas. As such, engagement with diasporas effort between such domestic dynamic segments and becomes a part of everyday management practice. high achievers from the diaspora, many constraints of the domestic environment can be unblocked. 49 A search network in this context is defined as a network to Some sectors are more conducive than others to identify successive constraints and then people or institutions achieve pragmatic consensus for action and to con- that help mitigate, at least in part, the difficulties associated with these constraints. struct problem-solving search networks. Education Human Resources | 39 Table 3.1. Impact of Diaspora Members: Armenia in Light of Relevant Benchmarks Country paragons and numbers Type of Entrepreneurship and their Type of impact involved (A) Armenia motivation Remittances El Salvador diaspora, 1.3 million, Armenian diaspora 7 mln, remittances of Subsistence entrepreneur: (typically) remittances of 3.6 US$B (15.7% of GDP) $1.8 bn (18 percent of GDP) (B) subsistence motivation. Lebanese diaspora remittances, 8.1 US$B, (22% of GDP). Donations Mexican municipalities matching Millions of ethnic Armenians worldwide ‘Feel Good’ entrepreneur: motivation and collective program of collective remittances for contribute to large charities, such as to belong. remittances public investments. Hayastan Foundation, that primarily finance projects in Armenia (cumulatively over $235.8 mln since its establishment in 1992).(C) Investments Chinese diaspora of 8.3M includes FDI flows are 3 times less than remittances Conventional (conservative) entrepreneur. thousands of investors in mainland. received by the country. The infrastructure Profit maximization. and telecom sectors – recipients of more than 70 percent of FDI. The share of Diaspora-driven FDI still tiny and centered around a few projects (Airport, Logistics Center). Knowledge and India. The diaspora equates to only Good track-record of the American Technology entrepreneur and senior innovation agenda 0.9% of Indian population, but 4.3% University of Armenia (AUA) manager. of the India’s tertiary educated live California-based affiliate. Professional credibility and growth. abroad, and remittances are 3.9% of French University, Slavonic University. GDP. Influential Indians in the US have been very instrumental in influencing US multinationals to start knowledge- Knowledge transfer, managerial skills process outsourcing in India, see transfer and innovation made by IT Kuznetsov, 2006 for overview. companies (Synopsys). Institutional Taiwan and India, see Saxenian, 2008 Armenia: Credit bureau (see below) Institutional and policy entrepreneurs. development and for an overview. Self-actualization. reform agenda Source: Migration and Remittances Fact book 2011. Second edition. The World Bank. (A) Data refers to 2010 unless stated otherwise. (B) Data refers to 2011. (C) The cumulative data refers to January 2012 and more generally skill development in higher educa- for solutions and search networks which help to find tion is particularly promising. Higher education orga- such solutions. ‘Diasporas for what?’ is a key question nizations such as AUA can become crucial institutional of the instrumental approach. It can be contrasted platforms to diffuse higher education reforms. Box 3.1 with diaspora engagement as an end in itself, which illustrates how this can be done in institutional environ- is the administrative diaspora agenda. It includes fa- ments which are similar to the one in Armenia. miliar diaspora ministries, Ministries of Foreign Re- lations and related NGOs. These are entry points of diaspora engagement that also play a coordination Administrative to Instrumental Approaches role: advocate a reasonable institutional environment Administrative and instrumental diaspora policies for diaspora engagement and maintain dialogue with are both needed and they complement each other. diasporas. These are diaspora ‘embassies’ in the home Instrumental approaches focus on a pragmatic search countries. But just like embassies are just entry points 40  |  Republic of Armenia: Accumulation, Competition, and Connectivity Box 3.1. First Mover Institutions in Emerging Economies Created with the Help of Diasporas Morocco: International University of Rabat In the Middle East region, the International University of Rabat (IUR) is one of the first private universities in Moroc- co. It is led by a member of the Moroccan diaspora, a former professor at the Polytechnic University of Nantes. Started in 2006 in the framework of a new law, the IUR is an internationally oriented, R&D-driven university housed in the Technopolis of Rabat, an industrial area that aspires to host high-tech industries. The university began providing its first undergraduate and graduate courses in English and French in 2012, at high ($10,000) but inter- nationally competitive fees. The target is mostly elite students from the whole African continent, who would nor- mally study in Europe. UIR is under contract with the Government of Morocco, a public-private partnership which allows it to use academic personnel from the public sector and acquire recognition on the part of the Ministry of higher education of its degrees and diplomas. In addition, the university enjoys the patronage of a powerful segment of the local economy: it is built on land donated by the King, and counts leading local financial institu- tions and companies among its board and financers. However, the institution’s autonomous status is the crucial element of its success. IUR draws extensively from the Moroccan diaspora, leveraging attractive salaries (roughly double of that given in public universities), good working conditions and other intangibles. More than 90 percent of its current teaching staff is Moroccans working in various parts of the world. The CCME (Conseil de la Communauté Marocaine à l’Etranger) proved to be highly useful on top of personal contacts the academic staff has. Indian Business School (IBS) In 1996, an eminent group of business leaders and academicians recognized the need for a top-ranked and distinctive business school in India. Among those, a good number of what we consider to be the typical over- achiever such as Rajat Kumar Gupta, a member of the Indian Diaspora and McKinsey’s first managing director born outside of the US. Through their collective networks, the founders inspired the very best in business and ac- ademia to see their vision and join their cause. These champions of the diaspora matched with home-country champions of institutional change and leadership. In less than a year, the Executive Board was formed to be followed shortly by the formation of the International Academic Council. Diaspora members such as Gupta himself were involved in the board. Things moved fast from then on, with academic associations with two of the world leading business schools - Kellogg School of Management and the Wharton School. The London Business School followed closely before the launch of the first Post Graduate Program. The Government of Andhra Pradesh welcomed the ISB into Hyderabad, laying the foundation stone for the campus in 1999. The Post Graduate Program was launched in 2001 with the first batch of 128 students, followed shortly by the launch of the first Executive Education programs. In the course of the last few years, the school has set up five Centers of Excellence, each with a particular focus on issues relevant to emerging markets. The Centers work closely with industry through conferences, seminars and workshops creating a vibrant research environment at the School. Sirindhorn International Institute of Technology (SIIT), Thailand SIIT is a top-tier school in Thailand. It was founded about 12 years ago with an enormous involvement of the Thai Diaspora. Among others, a former US-based IBM High level employee was involved. SIIT’s mission was to create an efficient, autonomous university, which, at that point, constituted a novelty in Thailand. Negotiation of the Diaspora-members brought SIIT to the point of autonomy. They strategically used their knowledge of the coun- try and their relations, and cultural awareness to reach their objective. For instances they named the university buildings after the current Thai-princess at the time, Sirindhorn, to indicate their sub ordinance in a demonstrative way, while at the same time remaining independent in their management, curricula and funding. Source: Authors. Human Resources | 41 to the governments, one needs a diaspora agenda in Formation of alumni leadership groups according the instrumental sense, that is, a process of engage- to these principles could be difficult for many dias- ment with specialized government agencies (Minis- pora communities. The leaders of many expatriate as- tries of Health, Education, Science and Technology) sociations are volunteers (often political appointees), and agents to elicit credible commitments between but their status and resources do not qualify them to the agents with resources and expertise at home and be major development partners. Most diaspora orga- relevant diaspora members. nizations were created to support the local needs of expatriate communities in their new countries, not to support development of the homeland. Developing a Portfolio of Promising Stories Alumni mobilization programs of Ivy League uni- While leveraging the diaspora offers important op- versities in the US provide a useful benchmark of portunities, it also presents challenges. Many en- diaspora mobilization. Diaspora networks can be gagements are about entrepreneurship and risk taking usefully compared with alumni networks.50 Well-run in expectation of higher than usual returns. As such, it alumni programs generate substantial contributions. can and should not be mandated, administered or di- As in venture capital networks, financial contributions rected by the state. However, it can be nourished and are important, but they are not the only crucial factor: supported. The literature refers to this as the paradox defining a promising project is as important as financ- of guided serendipity—creating a framework where ing it. Successful alumni programs at elite institutions unplanned occurrences can occur on a regular basis. can bring in contributions worth many times the cost of running the program. The goal of guided serendipity is to introduce link- ages between diaspora and home country agen- While all alumni are asked for support, actual sup- cies. This can take the form of building on established port is highly concentrated. Typically, 1 percent of links, broadening the range of existing activities or in- the alumni base provides 90 percent of contributed troducing new activities to an established partnership, resources. The universities are highly skilled at iden- or be a first time relationship between new partners. tifying this group of alumni and maintaining contacts with them through individually crafted programs. A way to overcome these paradoxes is to create a More specifically, universities are very careful in select- competitive contest to fund innovative pilot activi- ing and cultivating a small core of alumni who form ties. It would focus on a pragmatic search for solutions a group of intellectual leaders for the entire alumni to sector specific needs of domestic agents and on di- community. These intellectual leaders can be critically aspora search networks as institutions that help to find important for the success of alumni mobilization. This such solutions. 51 The contest would invite innovative core group consists of an exclusive community of the solutions emerging from collaboration between indi- institution’s most valuable supporters. The alumni as viduals and or institutions in more than one country. a whole must have high regard for these members’ professional achievements. Intensive personal inter- The contests should follow clear principles. They action among group members leads to major syner- should focus on knowledge rather than money as en- gies: through group discussions, members gain better try point; on joint project rather than the return of the understanding of the needs of their universities. This diaspora; and on sectoral ministries as focal points helps them to produce better institutional develop- rather than foreign or diaspora ministries. Consortia of ment proposals and ultimately, they will become more this type have become an established part of interna- generous in their financial support. Internal competi- tional collaborations in academic and pre-competitive tion within the group often increases the average size research programs, such as those funded through the of members’ contributions. EU S&T Framework program. 51 To remind, search networks are defined as a network to 50 The discussion of alumni mobilization program is due to identify successive constraints and then people or institutions Lev Freinkman and Richard Devane. that can help mitigate the these constraints. 42  |  Republic of Armenia: Accumulation, Competition, and Connectivity 4. Competition Competition in Armenia‘s markets for goods and rules lead to significant productivity gains and con- services is hampered by market structure, restric- sumer savings.52 tive regulation, distortive state aid, the presence of strong state-owned companies, and ineffective The State Commission for the Protection of Eco- enforcement of competition rules. According to nomic Competition (SCPEC) is charged with en- the Global Competitiveness Index (GCI), Armenia hancing competition, but it faces some important ranks lowest among ECA countries in the effective- institutional challenges in achieving this mandate. ness of antimonopoly policy and the intensity of lo- The SCPEC‘s role is to enforce competition rules, cal competition. This low ranking goes a long way deter anticompetitive behavior, ensure that state aid to explaining the lack of dynamism of the Armenian to firms does not distort competition, and advocate economy, which leads to low employment and low in- and promote a broader understanding of competition comes. Key sectors are dominated by one or a small rules and benefits. Yet the current legal framework is number of firms to a stronger degree than in other, insufficient, and the SCPEC faces capacity constraints. comparable countries. State regulation and govern- ment contracts create barriers to entry for new firms There is significant scope to achieve efficiency and therefore to competition in several sectors, in- gains from pro-competition sector policies and cluding, crucially, in aviation, railways, and profes- more effective economy-wide competition poli- sional services. State aid has consisted of deferral of cy enforcement. In a case study, we show that food tax payments, guarantees, government loans, and prices in Armenia are significantly higher than in com- subsidies for interest payments. Finally, the govern- parable countries. Removal of barriers to entry and ment owns the largest firms in electricity generation competition is particularly warranted. In addition, and transmission, water, postal services, railways, and competition principles need to be fully mainstreamed operation of road infrastructure. within broader government policies. Finally, improve- ments to the antitrust and state aid framework would Robust competition provides firms with strong in- complement measures to reduce restrictive product centives to reduce costs and innovate to become market regulation. more efficient and productive. They offer competi- tive prices, higher quality, and new and better services This chapter looks at competition in product and for the benefit of the entire economy. In addition, service markets in Armenia. It provides insights into well-functioning complementary markets (for exam- competition and government regulations and policies ple, logistics services and utilities) contribute to firms’ that affect competition, including the effectiveness of efficiency, which in competitive markets is reflected in lower prices and better deals for consumers. Inno- vation and cost cutting also enable firms to compete 52 For a detailed summary of the impact of competition pol- globally. Experience shows that pro-competition sec- icies, see Kitzmuller, M. and Licetti, M. Competition Policy- En- toral reforms and effective implementation of antitrust couraging Thriving Markets for Development. Viewpoint # 331. World Bank Group, August 2012. Competition | 43 Figure 4.1. Number of Firms in Each Sector, Market, or Market Segment Many firms Few firms One firm Mining Oil and gas Agriculture Forestry Light manufacturing Food products Pharmaceuticals Fixed line infrastructure Fixed line telephony Wireless/mobile infrastructure Wireless/mobile services Coal generation Hydro generation Biomass generation Solar generation Wind generation Transmission Distribution Banking Insurance Railway freight International air Airport operation Television broadcasting Newspaper Construction Healthcare Retail distribution services Tourism Waste managmt and recycling Mining, Agri, Manufacturing Telecom Electric power Financial Transport Media Other services oil, gas forestry sector Source: Investment Across Borders, 2010. the competition and antitrust framework. The first sec- Competition Indicators tion gives an overview of competition in Armenia, fol- lowed by a look at barriers to competition in selected Key sectors of the Armenian economy are domi- sectors. We then present a case study of the prices of nated by a limited number of firms. Market struc- food products. The fourth section presents Armenia’s ture—the number of firms and the size of firms com- competition policy framework, which encompasses pared to their competitors’ sizes—affects the degree economy-wide and sector specific regulatory provi- of competition that can be attained, though it is not sions, followed by conclusions and recommendations. the only determinant. In Armenia, important sectors The chapter builds on competition policy assessments that provide key inputs for other activities and where developed by the World Bank, in particular the Com- there is potential for competition—telecommunica- petition Policy Approach53 and the Viewpoint Note tions, and transport—consist of few firms or only one on Competition Policy.54 It benefited from guidance firm (Figure 4.1). provided by the methodology of the OECD Regula- tory indicators questionnaire developed for the OECD Armenia has a greater share of monopolies than Product Market Regulation (PMR). The PMR measures other economies in the region. According to the the degree to which policies promote or inhibit com- latest Business Environment and Enterprise Perfor- petition in areas of the product market where compe- mance Survey (BEEPS), markets exhibit high levels of tition is viable. concentration (Figure 4.2), and 19 percent of markets are dominated by monopolies, as compared to an av- erage of 6 percent for other economies in the region. Moreover, 60 percent of Armenian markets covered in the survey exhibit an oligopolistic or monopolistic 53 World Bank Investment Climate Competition Practice market structure. A small number of firms should not “Competition Policy to improve the Investment Climate”, 2011. come as a surprise in an economy as small as that of 54 Kitzmuller M. and M. Licetti, “Competition Policy: Encour- Armenia, however, there are examples of small econo- aging Thriving Markets for Development” Viewpoint Note Num- ber 331, World Bank Group Financial and Private Sector Devel- mies with fewer monopolies, with FYR Macedonia and opment Vice Presidency, August 2012. Montenegro providing two such examples. 44  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 4.2. Market Structure, 2009 (market shares in percent) More than 6 Oligopoly (3–6) Duopoly Monopoly 100 90 80 70 60 50 40 30 20 10 0 p. a an ia n d ro lia ia ina a ia a ia nia ary vo . ia ria ia . ep ep ov ssi tvi lan sta ton on an an rb Re eg en so go aij lga ng ov ve hR old La kR Ru Se kh m hu ed Po Ko ten m erb on yz Es Slo eg Hu Bu Ro ec za M va Ar ac Lit rg M on erz Az Cz Ka Slo RM Ky M dH FY an ia sn Bo Source: BEEPS. Indicators of the intensity of local market compe- network industries. The government owns the largest tition, the extent of market dominance, and the firms in electricity generation and transmission, water, effectiveness of competition policy lag behind oth- postal services, railways, and operation of road infra- er countries in the region. According to the Global structure Table 4.1). The Armenian nuclear power plant Competitiveness Index (GCI), Armenia ranks lowest and the water systems of national relevance are consid- among ECA countries in the effectiveness of antimo- ered of strategic importance.56 National, state or provin- nopoly policy and the intensity of local competition. cial governments control at least one firm in 7 sectors. Insufficient competition affects regulated sectors such as utilities and natural monopolies, and certain markets Particularly relevant is the SOE presence in services with a small number of firms, such as petroleum, sugar, that are typically open to competition and private wheat, and cut flowers. Competition is limited because sector participation. Even though the SOEs’ market of barriers to entry, ownership concentration, market shares appear to be relatively low, direct participation dominance, and vertical and horizontal integration. in restaurants and hotels, financial institutions, and other business activities, including construction ser- State-owned enterprises (SOEs55) and government vices is prevalent.57 However, SOEs have market shares participation are present in several sectors and above 50 percent in at least one segment or market of the electricity and railroad sectors. The state also owns some restaurants, hotels and financial institutions. 55 SOE is defined as a company where state or provincial gov- ernments (not including local governments or municipalities) hold, either directly or indirectly through a government-con- trolled company, the largest single share of the firm‘s equity 56 Law on Energy of the Republic of Armenia, Article 6 and capital. Publicly-controlled firms include also government enti- Water Code of the Republic of Armenia, Article 4, respectively. ties not organized as companies, but operating in business or 57 SOE is defined as a company where the state has 50 per- market activities. cent or more of equity shares. Competition | 45 Table 4.1. Presence of State Owned Enterprises National, state or provincial government controls at least one firm in: Yes No Manufacture of refined petroleum products X Manufacture of basic metals X Manufacture of fabricated metal products X Electricity generation/import, electricity transmission, electricity distribution, electricity supply X Gas production/import, gas transmission, gas distribution, gas supply X Wholesale trade, incl. motor vehicles X Restaurants and hotels X Railways passenger transport, freight railway transport, operation of railway infrastructure X Other urban, suburban and interurban passenger transport X Freight transport by road X Operation of road infrastructure X Air transport X Operation of air transport infrastructure X Telecommunications fixed-line services, fixed-line services X Water transport, operation of water transport infrastructure X Financial institutions (not central banks) X Insurance X Motion picture distribution and projection X Total 5 13 Source: PMR (OECD) template survey 2012 conducting for Armenia by EV consulting. In addition to government participation, foreign described in this section. These sectors are important ownership is restricted in some sectors. Limitations input providers for production in Armenia, and also to foreign ownership reduce the possibility of entry in provide products and services directly to households. these sectors, which may have a negative effect on the The lack of competition in these crucial sectors raises development of competition. In Armenia’s oil and gas the general price level, which lowers consumer wel- and transportation sectors, foreign owners are not al- fare and the competitiveness of Armenian production lowed to control firms (the maximum shareholding is relative to other countries. The lack of innovation that 49 percent). In forestry, no private participation is al- the monopoly positions allow incumbent companies lowed. In principle, there are no limits to foreign own- reduces growth of the Armenian economy. ership in other sectors. Air Transport58 Barriers to Competition in Key The provision of passenger air transportation ser- Economic Sectors vices is characterized by a number of restrictions that serve to protect the interests of the two Arme- Barriers to competition exist in different sectors, nian airlines, Armavia and Atlantis European Airways partly because of government contracts, rules, and regulations, partly because of particular as- pects of market structure. A few selected sectors are 58 For a more detailed discussion see chapter 6. 46  |  Republic of Armenia: Accumulation, Competition, and Connectivity (AEA).59 With the exception of Russian routes, only one and trucking companies, allowing it to offer multi- carrier per country (either Armavia or AEA on the Arme- modal services and new routes. Another example of nian side) is allowed to operate on a reciprocal basis in potential competition problems is the integration of a particular market. In case of Russian routes, four carri- transport and customs warehousing services provided ers serve the Yerevan-Moscow route, and three carriers by the freight forwarding company, Apaven, at SCR’s serve routes to other Russian cities. Yerevan station, which gives the company a location advantage. Current regulatory practices favor incumbents in the aviation sector. The General Department of Civil Avia- The PSRC is in charge of developing and approv- tion (GDCA) negotiates bilateral air service agreements ing the methodology for calculating and approving (ASAs) with other countries. Although the ASAs with fees. Fee calculations should include operation and most countries allow for multiple airlines, the GDCA maintenance expenses, depreciation, justified loan designates either Armavia or AEA for any given route, services, insurance, costs of compliance with environ- and the partner country designates one airline from mental standards, and reasonable profit. Rather than its side on a reciprocal basis. In 2003, the government presenting clear rules and fees based thereupon, the entered into an investment agreement with Armavia, PSRC has issued a regulation, which provides for re- which gives it certain exclusive rights as the ‘national view of fees recommended by SCR.60 carrier’. Since then, Armavia’s consent is usually sought regarding any changes in bilateral agreements, which Gas and Electricity provides the incumbent with protection and advantag- es to the detriment of developing competition. In spite of the fact that the Armenian government opened gas import and distribution to the private sector, there is only one company serving the sec- Railways tor.61 An integrated company imports gas and distrib- There is only one railway operator despite open utes if households and businesses. In this case, an ade- access provisions. The company, SCR, manages Ar- quate regulatory framework would prevent abusive or menian Railways, which is owned by the government unfair behavior that might have a negative impact on as a concession. According to the concession agree- end consumers, but the regulatory framework is cur- ment, open access charges are set by the Public Ser- rently not facilitating new entrants in the gas sector. vice Regulatory Commission (PSRC), but the methods It is not providing adequate, non-discriminatory third for their calculation and the actual charges have not party access to the gas transmission grid. yet been published. The Railways Law expands on the principles for setting infrastructure usage fees and of- In the case of electricity, additional measures will fers guidelines on the procedures for setting tariffs and support the development of efficient electricity fees, mentioning non-discriminatory treatment as a markets and increase consumer choices. There are key principle. Limited competition in ground transpor- numerous generators of electricity in Armenia, but tation for bulk cargo affects the cost of final products, transmission and distribution is in the hands of only particularly bread given that inadequately regulated one company. The sector does not have a retail choice prices for railway services are paid to transport wheat provision and liberalized electricity wholesale pool, and there is no alternative transport due to its volume. which restrain consumers’ choices. Vertical integration along transport routes may fur- ther restrain competition. SCR has signed coopera- tion agreements with and owns shares in major ferry 60 Public Services Regulatory Commission of the Republic of Armenia, Decision 2008 No. 731A, December 24, 2008. 61 There is no gas production in Armenia. Import of gas is 59 Armavia ceased operations in April 2013 after this report being conducted by Russian-Armenian CJSC “Hay-RusGazArd” was finalized. Atlantis European Airways serves as a marketing where the Armenian Government has 10 percent equity share. agent of Austrian Airlines and Czech Airlines and does not oper- Previously the government had 20 percent equity share; 10 per- ate any aircraft itself. cent was sold to the major shareholder. Competition | 47 Retail sector Figure 4.3. Price Controls Across Professions in the EU and OECD Countries It is important to ensure that the regulatory frame- work of the retail sector enhances competition. Pro- Accountants Architects posed regulations of the retail sector (namely, the draft amendments to the Law on Trade and Services and the draft Law on Specification of Location Criteria for Big Commercial Objects in Yerevan City) institute regulatory restrictions to the development of retail business. These 61.8% will include special permits from the regional authorities 82.4% and impose restrictions on areas for large commercial outlets. According to the OECD (2008), planning and zoning regulation creates the most severe competition problems when regulations: (i) prevent new firms from Engineers Lawyers entering in markets where there is market power; (ii) im- pede low-cost firms from entering in markets where ex- isting firms exhibit high-cost; (iii) reduce the total supply of a good or service; (iv) unduly delay the arrival of a good or service that consumers would value (such as 64.7% 58.8% one resulting from innovation or differentiation). Professional Services No regulation Maximum prices on all services Armenia imposes binding minimum prices for some Other regulation Maximum prices on some services services of architects and engineers. A procedure of Non-binding recommended Minimum prices on all services prices on all services cost calculation of preparing urban development doc- Non-binding recommended Minimum prices on some services uments applies to participants in urban development prices on some services projects.62 At that, the majority of EU and OECD coun- tries do not have any regulations of prices in these pro- Source: OECD Product Market Regulation Database, 2008. fessions (Figure 4.3). The empirical and econometric analysis explores Sector Case Study: whether food prices in Armenia are higher than in Prices of Food Products comparable countries and, if so, what the effects are in terms of consumer welfare. The analysis takes This section presents a systematic review of price into account differences in per-capita GDP, import levels in the food sector in Armenia relative to oth- costs, product type, and time effects. However, it is er countries in the region. The analysis focuses on important to note that comparing prices poses chal- the food sector for three reasons: (i) complaints about lenges such as finding comparable products across high prices center mostly on food products; (ii) food countries and ensuring that the selected products are products are important for the average Armenian con- representative of each market. sumer, accounting for nearly half of the consumption basket; and (iii) food processing is an important sec- The selection of products was therefore done with tor in Armenia, with food manufacturing comprising great care. Food products were selected on the ba- one-third of industrial production and food products sis of: (i) their importance in the consumption basket; accounting for 60 percent of retail trade. (ii) public concerns about high prices for the product; (iii) data availability; (iv) ease of comparability among different markets; and (v) the variability of market con- 62 The Order of the Urban Development Minister of the Re- ditions. We conducted two studies, the first comparing public of Armenia N. 19-N from February 15, 2008. 48  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 4.4. Concentration Levels for Selected Armenian Food Products, HHI Meat products Unconcentrated Macaroni HHI<1500 Cheese Sausages Egg Rice Moderately Sunflower seed oil concentrated 2500>HHI>1500 Butter Coffee Wheat for food Pasteurized milk Highly concentrated Wheat flour HHI>2500 Olive oil Sugar 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000 Source: SCPEC and authors‘ calculations. Thresholds based on US Merger Guidelines (2010). * Based on HHI levels (US Merger Guidelines, 2010), markets are usually classified as: •  Unconcentrated Markets: HHI below 1500; •  Moderately Concentrated Markets: HHI between 1500 and 2500; •  Highly Concentrated Markets: HHI above 2500.HHI for monopoly equals 10,000. prices across countries, and the second comparing on imports, whereas eggs, bread, and dairy are mostly prices across cities in Armenia. The products included produced at home. in the cross-country sample represent 16.9 percent of the consumption basket in Armenia, and those con- As in the selection of products, it is necessary to sidered for comparing across cities account for 25.6 choose countries for which price comparisons are percent of the consumption basket. meaningful. Prices may differ across countries for several reasons, including demand and supply of the Competition concerns have been raised in the se- products in the area. To determine whether prices in lected markets. Armenia’s competition commission, Armenia are relatively high or low, it is therefore use- SCPEC, has assessed the markets for sugar, wheat ful to draw comparisons with countries that share a flour, sunflower seeds, oil, eggs, and dairy, the first four similar economic environment. For this reason, the of which were evaluated as a result of apparent anti- comparison group includes the other CIS countries. competitive practices. In addition, recent news reports These countries are related geographically and share have called attention to the prices of bread, eggs, common economic ties, so that in the absence of eco- beef, and sugar. We have included only products for nomic barriers one might expect prices to be similar which monthly data were available for all CIS coun- across countries. Consumer preferences are also ex- tries or for major Armenian cities from January 2005 pected to be similar across these nations, increasing to July 2010. The analysis considers that average cal- the comparability of prices across markets. Finally, the culated prices refer to a similar product, thus focusing data on CIS countries were gathered from a single on products that are relatively homogenous in order source (CISStat), which applied a common method- to reduce differences associated with price discrimina- ology in gathering price data across countries, thus tion and product characteristics. The products belong bolstering the comparability of price information used to markets with varying structures and competition in this analysis. conditions. For example, meat and dairy markets are less concentrated than sugar or wheat flour markets. It is important to note, however, that many of the Sugar, wheat flour, rice, and coffee markets depend selected countries do not feature ideal competitive Competition | 49 Table 4.2. Summary of Main Market Characteristics and Results of Price Comparisons Industry Market Share of the Main Player in the Product Segment/Market Armenian Prices vs. Number of Importance of CIS Counterparts Products Competitors Imports (percent) (2005–2010) Meat Beef, poultry, pork High Medium n.a. Difference not statistically significant Dairy products Milk, cheese Relatively high Low Milk: 44.54, Higher for milk Curd Cheese: 77.5 Wheat products (bread, White bread, rye bread High Low n.a. Higher for bread; not pasta) of high and low (first) statistically different quality wheat flour, for pasta macaroni Wheat flour Wheat flour of high and Low High 47.3 Higher for wheat flour low (first) quality Sugar Granulated sugar Low (monopoly) High 99.9 Lower Eggs Hen’s eggs in shell Relatively high Low 26.06 Higher Butter and oils Butter, sunflower oil, Relatively low High Butter: 35.04 Higher but only olive oil statistically significant Sunflower & corn oil: 7.5 for butter Olive oil: 66 Source: Business Survey 2009, SCPEC (Oct. 2010), UN ComTrade, NSS. Table 4.3 Price Comparison Analysis, Armenia vs. CIS Countries Variable Regression with controls Regression with controls 2 Regression with controls 3 Coeff t-stat Coeff t-stat Coeff t-stat Armenia Dummy 0.1085 (**) 2.7 0.1565 (**) 2.92 0.1179 (***) 4.63 Log (GDPpc) 0.0927 (**) 2.7 0.1158 (**) 3.17 0.0916 (***) 3.47 Log (Cost of import) 0.1821 (*) 2.42 Log (Distance to coast or river) 0.0471 (**) 2.75 Specification includes: Year fixed effects X X X Monthly fixed effects X X X Product fixed effects X X X Year*month fixed effects X X X Source: Authors’ calculations. Note: (***) Significance at 99%, (**) Significance at 95%, (*) Significance at 90%. 50  |  Republic of Armenia: Accumulation, Competition, and Connectivity markets. Several of the comparison countries are near statistically different from those in other CIS countries. the bottom of rankings on the intensity of competition These results hold after controlling for other factors in local markets and the effectiveness of antimonopoly that may affect price levels. policy, including Azerbaijan, Georgia, and Tajikistan, which rank only slightly above Armenia. The poor eco- Table 4.4. Price Differences for Selected Food nomic climate in comparison countries may elevate Products, as Compared to Selected CIS Countries prices in those countries, which suggests that the cal- Percentage by which prices are higher in Armenia culated price differences may actually understate po- (average) tential price differentials. Bread 36 Agriculture and food processing are important Butter 23 economic activities in Armenia, and the latter de- Eggs 25 pends significantly on international trade. Togeth- Milk 33 er, these activities account for around 40 percent of Rye bread 45 GDP. Armenia is a net importer of food products, and imports are valued about 5 times higher than exports. Percentage by which prices are lower in Armenia (average) The main imported food products serve as inputs for Sugar 9 key goods in the household consumption basket. In Source: Authors’ calculations. particular, wheat products such as bread, flour, and macaroni represent almost 13 percent of the con- The results are robust to various control variables sumption basket (about one-third of the food prod- that account for differences in market demand, ucts basket). Poultry accounts for 1.84 percent, sugar access to international markets, and tax burden. for 1.44 percent, and sunflower oil for 1.25 percent of Per-capita GDP accounts for consumers’ capacity to the consumption basket. pay in each country. Controlling for population or GDP as a proxy for market size does not change the con- The market structure of these diverse food prod- clusion that prices are higher in Armenia than in CIS ucts ranges from markets with a large number of counterparts. Because Armenia is landlocked and dis- participants to those with one unique player. The tant from major waterways, the cost of importing con- meat and dairy industries are served by many com- tainerized cargo was used as a control variable. In ad- petitors of comparable size, while only one and two dition, geography variables such as kilometers of coast important firms operate in the markets for sugar and and distance to the coast and main rivers were used wheat flour, respectively (Figure 4.4 and Table 4.2). to account for geographic disadvantages. Differences in tax rates could also affect price levels by increasing Taken together, the prices for selected products are operating costs; therefore, various tax rates were used higher than comparable prices in other CIS coun- as proxies for the overall tax burden faced by firms. tries. Price levels in Armenia are higher relative to the other countries after adjusting for per-capita GDP, cost Differences in the tax burden do not explain high- of imports, product variables, and time control vari- er price. Tax measures are lower in Armenia than in ables (Table 4.3). The results indicate that prices in Ar- other CIS countries. Furthermore, because several menia are about 17 percent higher on average than countries have specific tax rates for the food sector, in CIS counterpart countries. Differences in per-capita the standard tax rates may not be relevant to the anal- GDP and import conditions do not explain the differ- ysis. The tax burden varies across food items and is ence in price levels. subject to different exemptions in Armenia, Moldova, Belarus, and Russia. Some countries, including Ar- Price differences are product-specific, with some menia, Georgia, and Russia, have a threshold below products registering higher prices and others low- which businesses are exempt from VAT. Tax measures er relative prices (Table 4.4). Prices for sunflower oil, that reflect the overall tax level of the economy (such beef, and macaroni in Armenia do not seem to be as the Doing Business indicator on total tax rate and Competition | 51 Figure 4.5. The Role of Competition Policy CP “sets rules of the game” — Principles Level playing field (non- Elimination of barriers to Firms compete in their merits discrimination, competitive entry and expansion neutrality, equal access) CP guarantees that market agents play by the rules Horizontal and cartel agreements Unnecessary barriers to entry, expansion and exit Mergers and State aid towards specific firms/sectors Governments do not Firms do not concentrations impose cartelize and anti-competitive Restrictions to FDI and Trade abuse Abuse of regulation/policies dominance Regulation of Infrastructure and Service Sector that restraints competition Vertical Procurement rules that facilitate cartels restraints If effective Markets are efficient and firm’s productivity increases. Firms can focus on “how to play the best” (competitiveness/innovation). Source: Authors. revenue as a share of GDP) can statistically explain the production process, the functioning of the supply price differences across CIS countries. However, when chain, and the strategic behavior of firms can affect using more specific tax measures as a control variable, the relationship between market concentration and such as reduced VAT levels for the food sector, the tax price levels. Furthermore, prices are only one of the burden does not explain price differences. Controlling variables on which firms decide. The product is a com- for VAT, Armenia‘s food prices are 13–14 percent high- bination of price, quality, intangible value, customer er than in comparable CIS countries. The same result service, and other features that are selected by the holds when controlling for the level of corporate tax- firm to compete successfully in the market. When mar- es. Variations in the time required to comply with tax ket rigidities impede a firm‘s ability to vary prices, the regulations do not change the main results of the firm may compete by adjusting these non-price vari- price analysis. ables. One company might increase its expenditure on advertising to raise brand loyalty and market sales, Based on the results of the price analysis, consumer while another company offers better after-sales service welfare losses due to above-average prices amount to gain market share, and yet another company im- to about $290 million per year. Even if consumers proves its product bundle (through better packaging do not respond to lower prices by expanding their de- or special flavors, for example). As a result, the level mand for food products, the annual consumer welfare and behavior of prices do not necessarily indicate the loss is $87.7 per capita, about 2.3 percent of per-capita intensity of competition, and it becomes necessary to GDP and 4.2 percent of per-capita consumption. look at market behavior. This conclusion is particularly relevant to inform the economic analysis of Armenian The analysis of prices and market structure at the Competition Authority (SCPEC) and its current em- production level of the supply chain might be mis- phasis on the level of prices rather than on the anti- leading, however, as other factors determine ef- competitive behavior of firms and distortive effects of fective competition. The economic characteristics of government interventions. 52  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 4.5. A Comprehensive Competition Policy Framework Opening Markets and Removing Anti-competitive Sectoral Regulation Enforcing Competition Law and Rules Remove restrictions to the number of firms, statutory monopolies or Tackle cartel agreements that raise the costs of key inputs and final products bans towards private investment Prevent anticompetitive mergers Eliminate controls on prices and other market variables that increase Strengthen antitrust framework to combat anticompetitive conduct business risk Control state aid to avoid favoritism and ensure competitive neutrality Guarantee a level playing field and non-discriminatory treatment against certain firms Source: Kitzmuller, M. and Licetti, M, “Competition Policy: Encouraging Thriving Markets for Development” Viewpoint Note Number 331, World Bank Group Financial and Private Sector Development Vice Presidency, August 2012. The Competition Policy Framework in which consumers prefer concentrated markets with a small number of firms because of network exter- An effective competition policy framework levels nalities. For instance, many communications and in- the playing field for all firms, facilitates entry of frastructure services such as telephones and railways new firms, and penalizes anticompetitive behav- exhibit network externalities. ior (Figure 4.5). The competition policy framework comprises of policies and laws that ensure that com- The competition policy framework can bring sub- petition in the marketplace is not restricted in such a stantial economic gains by promoting competition. way as to reduce economic welfare. In practical terms, Analysis of the competition policy framework is based competition policy usually involves the enforcement on two complementary pillars: (i) opening markets to of antitrust laws (typically rules against abuse of dom- entry and competition by addressing sector specific inance and anticompetitive agreements, and mergers constraints; and (ii) effective enforcement of competi- regulation) and the promotion of measures to enable tion policy (Table 4.5). Both pillars rely on an effective firm entry and rivalry, typically called competition ad- institutional set up that is able to foster and guaran- vocacy. The former is targeted at firms, while the latter tee healthy market conduct. In developing countries, involves government bodies. One of the most import- experience shows the importance of de facto inde- ant components of a successful competition policy is pendence and autonomy of decisions of the competi- ensuring that government policies do not generate tion authority. An institutional emphasis on promoting unnecessary barriers to entry or distort the playing competition, rather than consumer protection issues, field by favoring specific firms. seems to play a crucial role in driving total factor pro- ductivity growth. Properly enforced competition policy does not target firm size but threats to—and actual distor- Enforcement of competition policy and law can tions of—the competitive process and resource al- gradually trigger positive changes in market struc- location. Concentration of ownership in itself is not ture and reduce concentration. Effective control of necessarily anti-competitive. Competition policy be- mergers can prevent concentrations which stifle com- comes important in cases where a firm that exhibits petition. Meaningful enforcement of antitrust law will significant market power (in that it has the ability to discourage behavior that hampers competition. Ad- raise prices above a marginal cost) acts in ways that dressing and tackling cartel behavior will also deter distort the playing field, with potential harmful effects harmful anticompetitive behavior. Even if pro-com- on consumers. This is more likely to be the case if petitive regulations are implemented, they need to be consumers cannot substitute with other products or complemented by effective enforcement of competi- suppliers in the event of a price increase. Competi- tion rules. tion policy must take into account the technological characteristics of markets, as there can be instances Competition | 53 A level playing field needs to be guaranteed among important institutional challenges in achieving this all market participants. Competitive neutrality occurs mandate. The SCPEC‘s role is to enforce competition when no entity operating in a market is subject to un- rules, deter anticompetitive behavior, ensure that state due competitive advantages or disadvantages. The aid to firms does not distort competition, and advo- rationale for pursuing competitive neutrality is both cate and promote a broader understanding of com- political and economic. The main economic rationale petition rules and benefits. Yet the agency has faced is that it enhances allocative efficiency throughout the institutional obstacles to addressing deficiencies in the economy—where economic agents (whether state- current competition framework. owned or private) are put at an undue disadvantage, goods and services are no longer produced by those Armenia’s National Assembly enacted meaning- who can do it most efficiently. Governments should be ful amendments to the Competition Law and re- universal regulators and ensure that economic actors lated legislation in 2011, but these changes were are ‘playing fair’, including where state-owned corpo- incomplete (Box 4.1). The new framework gives a rate assets are concerned and vis-à-vis other market clear mandate to tackle discriminatory treatment at participants, while also ensuring that public service ob- the hands of government officials and potentially ligations are being met.63 distortive state aid. However, several aspects of the legal framework continue to limit the effectiveness The price analysis for food products indicates of its implementation, particularly concerning the as- that some markets with only one player have low- sessment of market dominance, the structure of fines, er prices and some with many competitors have mergers and concentrations, an extreme focus on higher prices (Figure 4.5). There is a range of po- price levels rather than anticompetitive conduct, and tential explanations for this observation. Structural the SCPEC‘s lack of investigative powers. A proposal barriers such as economies of scale may play a role. for useful amendments to the law submitted by the Concentration of suppliers often follows in markets SCPEC was modified during parliamentary approval, where economies of scale exist. In fact, one large however, eliminating or minimizing the effect of key competitor may have a more efficient cost structure recommendations. and may offer lower prices relative to a market with more competitors. Higher prices for final products In the case of market dominance, the competition may be associated with market conditions in input policy framework does not take into account the markets. In the bread market, for example, prices are contestability of markets and market evolution over higher relative to CIS counterpart countries despite time. The definition of dominance is based on the a significant number of market players. This may be possibility that a firm could act independently of com- the result of many competitors in the market facing petitors, consumers, and other market participants. In the same constraints: higher regulatory costs or high- Armenia’s law, however, the assessment of dominance er input prices. Lower prices, on the other hand, do is based on a static definition of market shares at one not necessarily indicate the absence of competitive period of time. Though market shares are the first step concerns but may instead point to strategic firm be- in analyzing market structure, they are usually comple- havior. Finally, concentrated markets can still register mented by an analysis of entry barriers in assessing high levels of competition in the absence of barriers market dominance. Market shares and concentration to entry (as in the case of mobile telecommunications are more relevant if they have been stable over time, operators worldwide), while significant market power as a firm’s ability to retain market share after increasing can still be exercised in markets with more competi- its prices relative to rivals offers a better indicator of tors due to anticompetitive behavior. market power than a snapshot of market shares alone. High concentration with significant changes in market The SCPEC is charged with managing Armenia’s shares over time would be less of a cause for concern. competition policy framework, but faces some However, this dynamic approach is not considered in the current version of the law. In addition, the threat of potential entry is a factor that is disregarded under the 63 OECD (2012). “Competitive Neutrality. Maintaining a level playing field between public and private business”. current practice. 54  |  Republic of Armenia: Accumulation, Competition, and Connectivity Box 4.1. Review of the current draft of the amendments to Armenia’s Competition Law Article 4: Definitions Notion of independence is still not part of the definition of economic entity for the purpose of merger control Article 5: Anticompetitive Agreements A. Remains the lack of precision concerning the criteria for assessing anticompetitive agreements (horizontal and vertical) B. Vertical agreements are still unlawful even if none of the participants has market power. Article 6: Monopolistic or Dominant Position C. Absence of potential competition and temporal criteria from the definition of dominant position D. Low threshold for determining dominance E. Dominance scenarios are based only on quantitative factors (market shares alone do not determine dominance) F. Contradictory thresholds for determining dominance based on market shares Article 7: Practices related with prices G. The Law still includes unjustified increase of prices as a case of dominant position H. The Law still states unjustified decrease of prices as a case of dominant position I. The Law still states unjustified maintenance of price as a case of abuse of a dominant position Chapter 4: Concentrations J. Definition of concentration is not exclusively based on change of control and it is over inclusive K. In case of acquisitions of shares or assets the seller is still treated as participant in the concentration L. The threshold to notify an economic concentration is not fixed Article 36: Definition and amount of fines M. Still inconsistent treatment of fines in some cases (no differentiation between penalties applied for infringing administrative procedures and those for anticompetitive behavior) N. The treatment of infringements should be according to the seriousness of the offense O. Differentiate penalties when they are applied against firms and individuals, respectively P. Penalties against individuals are not included (although the criminal law covers this case, but it is essential to ensure harmonization of any conflicting provisions) Q. Leniency provisions still: (1) offer immunity regardless of whether the applicant has been the leader or the instigator of the anticompetitive behavior (a leniency program should only offer financial penalties reductions for leaders and/or instigators); (2) do not define whether the applicant to lenient treatment can request guarantee of confidentiality; and (3) not clarify whether the competition law only fines or also initiates criminal prosecution against the members to an agreement and their directors, officials, etc. Source: WBG Competition Policy Team analysis. Competition | 55 Treatment of Economic Groups In order to be able to define economic entities for the implementation of the Competition Law, the The Competition Law introduced important pro- SCPEC needs to have access to ownership infor- visions for dealing with economic groups. Accord- mation for the companies under investigation. This ing to Article 4 of Armenia’s new Competition Law, will require maintaining information channels with the the definition of an economic entity64 encompasses State Registry, Credit Registry, and Central Depository. the concept of a ‘group of persons,’ itself defined as Memoranda of understanding that define protocols for ‘a group of legal entities and/or individuals which act gaining and granting access to information managed through concerted actions based on common eco- by other entities could be a useful tool in this regard. nomic interest and/or with respect to which at least one of 14 conditions is met’ (Table 4.6). This key fea- Table 4.6. Importance of Defining an “Economic ture was introduced recently. While the recent draft Entity” for the Implementation of the Competition amendments improve the definition of group of per- Law sons,65 they do not provide the explicit definitions of independence and concept of control.66 Element of the Competition However, the law and its secondary legislation will Law Importance of defining “economic entity” need to introduce a number of additional clarifica- Merger control Identify when concentration is taking place, since it tions: can be argued that merging parties are already part of a single economic entity. ¾¾ The treatment of economic groups, the assessment Assess the unilateral and coordinated effects of of direct and indirect control of firms with owner- mergers by correctly identifying the extent of the ship links, and a definition of an ‘economy entity’.67 economic entity.1 ¾¾ A definition of independence, including that the Abuse of Assess market dominance by correctly identifying all economic entity is entitled and has powers to de- dominance the activities undertaken by the economic entity fine its competitive strategy without interference Restrictive Identify separate economic entities in order to be able or influence from another economic entity. practices to assess the anticompetitive effects of agreements, ¾¾ The concept of control. The concept of a group of (anticompetitive since it can be argued that agreements take place persons in the Competition Law does not explicitly agreements) within a single economic entity contemplate the notion of control as the basis for Source: Authors. the existence of the group. Note: 1 Unilateral effects include the possibility of exercising significant market power by one firm. Coordinated effects refer to the likelihood that a merger would facilitate collusive behavior among competitors. 64 An economic entity is defined as follows: patent fee pay- er, individual, entrepreneur, legal person, other entity, its rep- Merger Control Procedures resentative, representative office or branch, group of persons, commercial network. For concentrations stipulated in this law, The introduction of simplified merger notification natural persons are also treated as economic entities. procedures and the revision of current thresholds 65 The recent draft amendments clarify that "the Commission for merger notification would improve the effective- shall be entitled not to consider a group of legal and (or) natural persons as a group of persons within the meaning of this Law, if ness of merger control policy. Merger reviews should there is no actual interconnection or control between the legal be designed in such a way that the costs for govern- and (or) natural persons". ment and businesses are proportionate (Table 4.7). If 66 Neither these concepts are explicitly included in other rel- not appropriately designed, merger reviews can dis- evant articles (including articles on monopolistic or dominant place investigations on actual anticompetitive behav- position and concentrations of economic entities). ior, thus reducing the effectiveness of the competition 67 Only reorganizations among firms that depend totally on the control of an individual or a legal entity do not constitute framework. Overly burdensome information require- concentrations. Conversely, reorganizations between two firms ments, long review processes, and an unclear and that do not depend on the total control of the same individual/ broad scope of merger reviews would increase admin- legal entity should be deemed a concentration, as this reorgani- istrative costs, and business risks. zation could imply a relevant change in the character of control over these firms. 56  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 4.7. Elements For Designing Merger Control Policies Components Key areas  efining transactions that will be 1. D Voluntary or mandatory, ex-ante or ex-post notification. evaluated Definition of economic concentration: definition of control and change in control, types of transactions. Thresholds for merger notification: variables, values, and calculation method.  stablishing formal procedures 2. E Timeframe: time limits, staggered process (phases for less and more complex cases). for merger review Required documentation and confidential treatment of information. Required payments: calculation of merger filing fees. Due process: transparency, consistency, accountability.  etting the economic framework 3. S Criteria for evaluating potential anticompetitive effects: unilateral and coordinated effects. for analysis Treatment of efficiencies, pass through to consumers and compensation of anticompetitive effects. Criteria to set remedies or conditions that can remove anticompetitive concerns. 4. Addressing institutional Availability of resources to conduct merger review. constraints Optimization of organization structure for effective enforcement. Source: Authors. Enforcement of Competition shares.68 In some cases, markets are defined narrow- ly (for example, cigarettes with and without filters are The current structure of fines and sanctions and separated into two markets, another example is a sep- SCPEC’s investigative powers are too limited to arate market for juices predominantly consumed by deter anticompetitive conduct. International best children). At the same time, this registry had diverted practice suggests that sanctions for severe anti- the attention of staff away from more effective means competitive conduct such as price fixing and mar- to detect anticompetitive conduct while burdening ket allocation agreements among competitors are firms with an additional reporting requirement. It is most effective if set at about 10 percent of a firm‘s therefore possible that some of the firms registered by turnover. In Armenia, fines represent, on average, a the SCPEC would not be seen as dominant according maximum of 1.5 percent of the average turnover of to international standards, and vice versa. the 100 largest taxpayers. Moreover, the response to infringements is not commensurate with the serious- Other factors besides prices need to be considered ness of the offense, with lower penalties for cartel be- in determining whether firms are exerting signifi- havior than for less severe transgressions. Compared cant market power. A competition agency should to other competition agencies around the world, the determine whether or not anticompetitive conduct SCPEC’s lack of power to investigate anticompetitive has happened and is feasible given market conditions, practices limits its ability to detect anticompetitive including entry conditions and level of market contest- conduct. Currently, the SCPEC is drafting secondary ability. The level of prices can fluctuate because of de- legislation on fines guidelines to provide clarity on mand and supply conditions. the fines calculation methods and take into account the nature of the anticompetitive conduct, its severi- It would be desirable that SCPEC focus its operation- ty and duration. al activities more the typical determinants of dom- inance, some of which are included in the current It would be beneficial to refocus the SCPEC’s imple- mentation of competition policy from price moni- toring to market contestability. The SCPEC used to 68 According to the SCPEC, the new provision on eradication keep a registry of dominant firms identified using its of the register of dominant firms is envisaged in the draft law limited definition of dominance based on rigid market presented to the RA Government. Competition | 57 Table 4.8. Competition Indicators for Select Markets Sugar import and Ground transportation of Indicator Bread production Flour production production imported bulk cargo Number of companies High (500+) High (51) Low (6) High in road transport Increased (43 in 2006) Declined (21 in 2006) (80+), low in railways (1) Market share of largest NA 47.3 99.9% 67.0% player Concentration Low High High High (<100) (3459) (9980) (about 4500) Consumer/user prices High compared to other High compared to other Low compared to other High compared to other countries countries countries countries Asymmetric pass-through of Asymmetric pass-through of Asymmetric pass-through of flour prices to bread prices flour prices to bread prices flour prices to bread prices Quality and product variety High product variety Medium product variety Low product variety Low quality of service compared to other countries Concerns related to vertical Low Medium High Medium relationships Strategic conduct None Perception of the existence Potential price squeezing Horizontal agreements of customs benefits for Strategic investments to Lower tariffs in segments that selected market participants preempt entry face competition (containers) and higher tariffs for bulk cargo Barriers to entry Low Medium High Low for road transport, high for railways Entry observed in 2010 Level of competition High Limited Strongly limited Limited Source: Authors Law. In particular, Article 6 (2) mentions, for example, application of the well-recognized methodologies, that an economic entity shall be considered as having such as the OECD competition assessment toolkit69 to dominant position on product market if it has market the examination of the existing and draft regulations power on the given product market, in particular, does can be beneficial. Currently, SCPEC‘s record in issuing nor encounter any significant competition as a seller or opinions on anticompetitive sector-level regulation to acquirer, and (or), based on its financial standing or oth- other government bodies is limited. According to the er qualities, has the opportunity to have decisive influ- SCPEC, the Commission identifies existing anticom- ence on the general product turnover in the given prod- petitive policies based on complaints from different uct market and (or) oust other economic entity out from stakeholders (e.g. business societies, unions, cham- the given product market and (or) impede the entry into bers of commerce). The Law on the Legal Acts pro- the given product market. (Table 4.8) presents examples vides a framework to examine the impact of proposed of other variables that are useful for evaluating the exis- laws and regulations on market competition.70 If a draft tence of a dominant firm in a product market. is relevant to competition, SCPEC is obliged to carry out a regulatory impact assessment of the implemen- Competition Advocacy The SPEC does not have all the necessary instru- 69 http://www.oecd.org/competition/assessment-toolkit.htm. ments to pursue advocacy vis-à-vis sector regula- 70 Law of the Republic of Armenia on Legal Acts. Adopted on tors and other government bodies. A systematic 3 April 2002. 58  |  Republic of Armenia: Accumulation, Competition, and Connectivity tation of proposed draft and submit a report with the exemptions, reductions, or deferrals of fee and tax potential effects on competition to the body elabo- payments, guarantees, and preferential granting of rating the draft. However, SCPEC‘s opinions are not loans. Support can also involve providing economic binding in nature, and there is limited monitoring of advantages—for example, allowing a firm to buy or their effects. Lack of clearly defined competition-relat- rent publicly owned land at less than the market price ed advocacy powers may constrain the effectiveness, or giving a firm privileged access to infrastructure with- and ultimately the impact, of policy advocacy to open out charging a fee.71 General measures are not regard- markets to competition. ed as state aid because they apply to all companies regardless of their size, location, or sector. The SPEC has signed protocols with public institu- tions (e.g. sector regulators,) in order to foster col- State aid needs to be controlled to limit the nega- laboration and coordination between institutions tive effects on competition. Control of state aid typ- that could constitute a key mechanism to improve ically includes: (i) relevant criteria for identifying state competition in markets. For example, SCPEC and aid measures; (ii) application of exemption rules in PSRC, Armenia’s sector regulator for energy, water specific sectors; (iii) assessment of prohibited state aid and telecommunications markets, have signed a mem- and its potential impact on competition; and (iv) defi- orandum of understanding that provides a general nition of characteristics of the enforcement procedure. framework of cooperation; however it is not focused Armenia’s current competition law includes provisions on specific market regulation. One aspect that the on the control of state aid, but the scope needs to be SCPEC could evaluate is to include in these Protocols expanded to ensure effective enforcement. specific ways of cooperation that will lead to signifi- cant improvements in market conditions. For instance, The Armenian government has implemented a the SCPEC in coordination with the sector regulator or number of measures to support economic entities, public authority could commit to review the regulato- but the selection process lacks clear criteria to an- ry framework in order to introduce regulatory reforms alyze impacts on competition. State aid has consist- that promote competition or increase the quality of ed of deferral of tax payments, subsidies, guarantees, regulated services. Some protocols will benefit from government loans, and subsidies for interest pay- moredefined rules and provisions regarding their im- ments. Business projects that satisfy certain criteria plementation (e.g., the type of information exchanged, can benefit from government support programs, in- criteria for participation in joint assessments). Likewise, cluding both financial and technical assistance. Project protocols with procurement officials could help detect selection criteria include: (i) the potential contribution and identify bid rigging practices. to regional development; (ii) the creation of new jobs; (iii) export orientation; (iv) an innovative approach; (v) the adequacy of skills and employee know-how; and State Aid Regulations (vi) low risk. The government’s website publishes a list Governments often provide a variety of subsidies of requirements, selection criteria, and a scoring sys- and direct aid to firms. State aid and subsidies can be tem for potential beneficiaries,72 but potential distor- implemented to address market failures, support edu- tions to competition are not considered. Aid has been cation, foster innovation and promote green technolo- given to companies operating in construction, metals, gies to preserve the environment, and others. However, and mining sectors. targeted aid toward specific firms may result in signif- icant distortions to market competition. Privileges for The definition of the scope and purpose of state specific types of firms can damage long-term private aid in Armenia’s legislation needs to be strength- sector development, because they bestow these firms ened. It would also be beneficial for the scope and with a comparative advantage over their competitors, purpose of state aid to be explored in greater detail in which is not necessarily associated with their efficiency. State aid comes in many forms. Measures may in- 71 EC Directorate-General for Competition, 2008. clude subsidies, debt write-offs or takeover of losses, 72 http://www.gov.am/files/docs/469.pdf Competition | 59 Table 4.9. Example of Direct and Indirect Support to Firms State aid (in million Company Sector State aid type US dollars) Importance Copper Molybdenum Factory of Zangezour Production of black and Loans as of end 2009 15.00 34% of loans in 2009 nonferrous metals Armenian Molybdenum Production Production of metal goods Loans as of end 2009 15.00 34% of loans in 2009 Armavia Air Company Air transport Tax arrears as of 0.18 4.48% of total tax end 2009 arrears in 2009 Mika Cement Manufacturing of cement Tax arrears as of 0.78 1.61% of total tax end 2010 arrears in 2009 Ararat Cement Manufacturing of cement Tax arrears as of 0.46 0.95% of total tax end 2011 arrears in 2009 Source: Government of Armenia, 2011. secondary legislation. Armenia’s competition law en- Policy Recommendations titles the entity initiating the provision of state aid or the economic entity applying for aid to apply to the The analyses of ownership and competition iden- SCPEC to receive its conclusion prior to provision of tified several bottlenecks to the development of aid or applying for such aid. a healthy competitive environment in Armenia. Considering the current market structure, which is An analysis of the beneficiaries of government sup- characterized by concentration and vertical integra- port indicates the patterns of state aid. Large com- tion, and ownership links in the economy, special panies account for 68 percent of the loans granted by attention needs to be paid to limiting potential an- the government. Two companies in particular received ticompetitive behavior and ensuring a level playing significant credit support. Three other companies ac- field. In general terms, recommendations encom- count for a sizeable portion of outstanding tax arrears pass pro-competitive regulations and measures to (Table 4.9). improve the effectiveness of the competition policy framework. Transparency regarding state aid and government support could be improved. Even if the Armenian There is significant scope to achieve efficiency gains government has decided to support specific sectors, from pro-competitive sector policies and more ef- it is recommended to follow the principles of trans- fective economy-wide competition policy enforce- parency and non-discrimination in the granting of ment. Removal of barriers to entry and competition is state aid. An inventory of current state aid schemes, particularly warranted. In addition, competition prin- particularly in sensitive sectors such as construction, ciples need to be fully mainstreamed within broader transportation and food processing, would help iden- government policies. Finally, improvements to the an- tify their potential impacts on competition and trade. titrust and state aid framework will complement mea- The inventory should include the list of the state aid sures to reduce restrictive product market regulation. grantors, as well as the amount, type, and recipient Reform areas are outlined below. of state aid. Acknowledging this requirement, SCPEC has initiated the creation of an inventory of state aid ¾¾ Improve the competition environment in trans- but it does not have the formal authority to require all portation (airlines and railroads). The removal of the government bodies to provide such information, restrictions in the number of firms that can partici- which may represent a limitation on its state aid mon- pate in the market as well as regulatory protection itoring activities. to incumbent firms would foster competition. In the case of railways, improvement of open access 60  |  Republic of Armenia: Accumulation, Competition, and Connectivity Box 4.2. EU Assessment Methodology and Checklist to Ensure That State Aid is Non-distortionary The EU uses a balancing test for the assessment of compatibility of state aid. This test is based on the assessment of both the positive effects of state aid, such as contributions to the achievement of a well-defined objective of common interest, and its negative effects, including the distortion of competition and trade. Aid will be compat- ible only if it is necessary and proportional to achieve a particular objective of common interest. The main ele- ments of the balancing test are listed below: §§ Well-defined objective of the common interest. Aid should be aimed at a well-defined objective of common interest (such as growth, employment, cohesion, or environmental protection). This includes the assessment of both efficiency (correcting a market failure, including externalities, imperfect information, and coordination problems) and equity (measures such as employment of disabled workers or setting up factories in disadvan- taged regions). §§ Well-designed instrument. Ascertaining that the aid is well designed to deliver the objective identified above involves evaluating the counterfactual scenario in which aid is not granted. This evaluation includes the follow- ing criteria: ŸŸ Appropriateness: state aid should be used where the advantages of using a selective instrument (such as state aid) are established and demonstrated; ŸŸ Incentive effect: state aid should not be granted for activities the beneficiary would still carry out to the same extent if the aid were not granted; and ŸŸ Proportionality: the amount and intensity of the aid should be limited to the minimum necessary to tackle the identified problem. §§ Balancing of the positive and the negative effects. The possible negative effects of the aid (distortive effects on competition and trade) and their magnitude should be sufficiently offset by positive effects. The impact of both effects is expressed in qualitative and, if possible, quantitative terms. The overall outcome depends on several characteristics of the proposed aid measure and is assessed on a case-by-case basis for measures subject to the detailed assessment. Roller et. al. (2010) propose the following checklist for evaluating state aid from an economic point of view: §§ Does aid qualify as State Aid? ŸŸ Is the aid (for example, grants, interest and tax relief, guarantees, government holdings of all or part of a company, or the provision of goods and services on preferential terms) funded by state resources? ŸŸ Does the funding provide an advantage to a firm? ŸŸ Is the funding available only to a select number of firms? ŸŸ Is there a potential or real distortive effect on competition and trade? §§ Are investors aware of state aid schemes? ŸŸ Is there an inventory of state aid schemes publicly available? Who are the main beneficiaries? ŸŸ Is the process for granting state aid clear and transparent? §§ Is aid available to all market participants? §§ Are there any mechanisms for monitoring compliance and illegal state aid? §§ Have aid schemes led to the desired outcomes? Sources: European Commission, Roller et. al (2010). Competition | 61 regulations for railway transportation, adequate potential competition distortions in key sectors of tariff regulation in non-competitive services such the economy (such as infrastructure or profession- as bulk cargo transportation, and institution- al services) public procurement and open markets al measures to strengthen regulatory oversight to competition. The SCPEC could also help to de- would support a competitive environment. ter the enactment of anticompetitive regulation ¾¾ Eliminate barriers to competition in profession- by increasing the awareness of other government al services. Reforms in professional services would agencies and regulators on the distortive effects have three main objectives: (i) increasing produc- of specific regulatory provisions. Working closely tivity by allowing entry and competition across with other sectoral regulators will also avoid over- professional services; (ii) incentivizing competitive lap of competencies in the competition space and and efficient pricing; and (iii) lowering costs to us- tackle more effectively anticompetitive regulation. ers of professional services across the economy. ¾¾ Strengthen the state aid provisions and their ¾¾ Improve competition in electricity and gas mar- enforcement to minimize potential distortive kets. The measures should include review of third effects on competition. The introduction of a party access policies as well as opening the retail comprehensive state aid framework could ensure market to entry of new firms in both sectors. a level playing field for firms and avoid the use of ¾¾ Refrain from introducing restrictive regulation public funds to support distortive schemes that in the retail sector. If proposed regulations of would discourage the entry of new investors. This the sector are adopted, they should not impose approach would redirect aid to economy-wide ob- restrictions to the development of retail business, jectives, such as R&D and innovation, risk capital, especially because the latter may reduce efficien- training, renewable energy/climate change and cies, productivity gains and potential for employ- other measures for the protection of the environ- ment creation in the sector. ment. Setting up a state aid inventory will help en- ¾¾ Increase the effectiveness of the competition sure transparency and accountability in the use of framework and its implementation. Specific public funds. amendments to the competition law and its en- ¾¾ Introduce transparency and access to data to forcement could be aimed at clarifying the defini- guarantee competitive neutrality between mar- tion of economic entities, anticompetitive agree- ket participants to avoid market distortions. As ments and market dominance, updating the cri- a start, ensuring transparency and access to data teria to determine the existence of a dominant for competition enforcement and state aid control firm, strengthening the investigation powers of the is needed. The SCPEC can play a key role in in- agency and improving the structure of and criteria creasing public awareness on the anticompetitive for imposing fines. They would also define the con- effects of government interventions while making cepts of independence and control in relation to an its decisions and opinions public in a systematic economic entity. From the implementation point of way. Such reforms would also foster a more pre- view, the SCPEC needs to move away from focusing dictable and transparent business environment. on price fluctuations in favor of focusing on actual In the medium term, the Armenian Government and potential barriers to entry and contestability. could evaluate the design and adoption of a Greater attention to market conditions may allow comprehensive regulatory framework to achieve the competition authority to focus on markets that competitive neutrality among all market players. are more prone to restrictive practices. Strengthening information disclosure to unveil ¾¾ Pursue advocacy activities to tackle anticompet- the advantages received by certain firms will pro- itive government interventions and regulations mote competition. The disclosure of three types that harm the development of competition. of firm-level information is particularly important By strengthening the SCPEC’s advocacy man- in Armenia: financial information, non-financial date, it would be able to prevent and address any disclosures, and trade data. 62  |  Republic of Armenia: Accumulation, Competition, and Connectivity 5. Land Connectivity Landlocked Armenia has few options for trans- Previous studies have shown that exports could porting goods over land, and infrastructure and benefit greatly from trade facilitation measures regulatory bottlenecks increase time and cost of even within the existing geopolitical constraints. exporting. With closed borders with Turkey and A crucial aspect of enhancing the competitive- Azerbaijan, exports can only use transit corridors ness of Armenian exports relates to improving the to the north through Georgia, and to the south transport and logistics performance on the trade through Iran. The northern route offers access to corridors linking it to global markets. Shepotylo the Black Sea, while the southern route offers ac- (2011) shows that moderate trade facilitation mea- cess to the Gulf of Oman and the Indian Ocean. On sures could have increased exports from Armenia both routes, Armenia’s mountainous terrain poses by 58 percent during 2000–07. 73 Consistent with additional challenges, and roads become impass- this, Jensen and Tarr (2011) show that trade facilita- able at times in the winter season. The Upper Lars tion would provide greater gains to Armenia than border between Russia and Georgia is closed in would service sector liberalization or harmonizing winter, and does not allow excisable goods even standards. in the summer. Iran, on the other hand, closes its border to two important Armenian exports, ciga- This chapter proposes some ideas to improve rettes and brandy, and levies road taxes on Arme- Armenia’s land connectivity. The first section nian trucks. Much of Armenian trade therefore uses provides an overview of the current transit situa- Black Sea ferries, although they are perceived as tion. The second section provides a comparative unreliable and costly. assessment of Armenia’s north-south road transit options. The third section provides policy options While Armenia can’t change its geography and to improve the transit situation. The observations breakthroughs in the geopolitical constraints and conclusions in this report are based on inter- will take time, the government could engage views with exporters, freight forwarders, trucking more with its neighbors and sign international companies, and government agencies during Feb- treaties to facilitate trade. Bilateral trade agree- ruary–June 2012. The study also used the World ments could speed up trade and lower costs, in Bank’s Trade and Transport Facilitation Assess- particular with Iran, while discussions with Geor- ment toolkit. gia would focus on enhancing road capacity, and creating dedicated facilities at the Poti port. Rat- ifying all relevant international conventions could increase Armenia’s leverage over transit partners. 73 The paper compares trade scenarios with actual transport costs during 2000–10 on the one hand, and hypothetically lower In particular, signing the UN Convention on Transit transport costs based on a significant reduction in the number of Trade of Landlocked States could put Armenia in a documents and time required to export from 2000 on the other. better position to defend its rights with regard to The trade facilitation reforms simulated from 2000 onwards were free transit of goods. actually introduced in 2010. The results are driven by a 150 per- cent increase in textile exports. Land Connectivity | 63 Figure 5.1. Merchandise Trade by Mode of Transport, 2011 Rail Road Air Stationary (i.e. pipeline, transmission line) 70 59.6 60 54.2 50 40.2 36.4 40.1 40 Percent Share 32.3 33 30 23.8 19.4 23.4 20 12.3 9.7 8.1 6.9 10 0.1 0.6 0 IM EX IM EX By Value (%) By Weight (%) Source: Armenian Customs Service. The Transit Situation of international operators. Armenia’s logistics perfor- mance ranking improved from 131 in 2007 to 100 in Despite the geopolitical challenges, more than 80 2012 (Figure 5.2, panel b). This leaves quite a bit of percent of goods exported from Armenia travel over room for improvement, but also suggests consistent land. Roads account for about 32 percent of Armenia’s progress over recent years. exports by value (Figure 5.1), while the railway line to Georgia carries 40 percent, mainly resource-based ex- ports such as stones and mining products (Figure 5.1). Comparison of Road Transit Options Electricity accounts for about 8 percent of exports and uses high-voltage transmission lines. Air transport is Table 5.1. Armenia’s Merchandise Trade Partners, used for a limited set of items with a high value-to- by Region, 2010 weight ratio such as fresh fruit, diamonds and jewelry, (percent) and accounts for about 19 percent of exports. Export Share Import Share Time and costs of exporting are clearly related, Markets to the North 89 68 but costs stand out more in a regional compari- EU27 54 30 son. Armenia fares quite well in comparison to other landlocked countries and even many non-landlocked Russian Federation 18 26 countries in Europe and Central Asia despite its moun- North America 13 4 tainous terrain and bad roads.74 Its exports face the Turkey 0 7 lowest costs and fastest times of all the landlocked Georgia 3 1 countries in the ECA region. Relative to non-land- locked countries in the region, costs of exporting are Markets to the South and East 10 31 high in Armenia, but not the time required to export East Asia 4 19 (see Figure 5.2, panel a). On a broader measure, Ar- MENA 5 9 menia’s logistics performance is improving as shown South Asia 0 2 by improvements in its ranking based on perceptions Central Asia 1 1 Source: Calculations based on data from UN Comtrade. 74 This is measured from packing the goods into the container at the warehouse to their departure from the port of exit. 64  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 5.2. Armenia Trade and Transport Facilitation Performance, 2007–2012 a: Time vs. cost to export, 2012 Landlocked ECA Other ECA Linear (Landlocked ECA) Linear (Other ECA) 5,000 Cost to Exports ($ per container) Tajikistan 4,000 Kyrgyz Republic Uzbekistan Azerbaijan 3,000 Belarus Kazakhstan 2,000 Armenia Kosovo Russian Federation Serbia Ukraine Macedonia Bulgaria Romania 1,000 Georgia Croatia Moldova Lithuania BiH Montenegro Latvia Turkey Albania 0 0 10 20 30 40 50 60 70 80 90 Time to Export (Days) b: Logistics performance index 0 Armenia Georgia Iran 20 40 Global Rank 60 77 78 80 93 100 103 100 111 112 120 131 140 07 10 12 07 10 12 07 10 12 20 20 20 20 20 20 20 20 20 Source: World Bank Doing Business Indicators, 2012; World Bank LPI, 2012. Armenia’s two transit options—Georgia and Iran— There is a large potential for increasing trade give access to very different markets. The biggest with countries to the South and East of Armenia. factor in corridor choice is therefore location of destina- Table 5.2 shows bilateral trade complementarity indi- tion market. Most of Armenia’s exports go to countries ces based on the disaggregated trade shares of Arme- to the North and West, which makes Georgia by far nia and relevant trading partners. Germany and Russia the more important route (Table 5.1). Only 10 percent are included as current trading partners. Georgia and of exports reach markets in East Asia, MENA, South Iran are included as they are transit partners and po- Asia and Central Asia, consistent with the minimal use tential trading partners. China and India are two im- of the southern corridor through Iran (Table 5.1). Be- portant global growth poles and represent potential yond this, however, even when it might be preferable sources of expanding trade. Relative to other export- to transit through Armenia’s southern corridor, often ers, Armenia’s exports are not as complementary to this does not happen, even with respect to goods to or the imports of the countries shown here, but there are from Asia. In fact, the southern route sees so little traf- important variations. In particular, Armenia exports are fic that freight forwarders are usually not familiar with more complementary with both India and China than it. The reasons will be described later in this chapter. with Germany and Russia, yet currently Germany and Land Connectivity | 65 Table 5.2. Trade Complementarity Index, Armenia and Selected Trading Partners, 2008–10 Importers Armenia Germany Russia China India Iran Georgia Exporters : Armenia 6.45 5.99 6.59 9.39 4.47 6.36 Germany 36.91 55.99 37.42 27.50 47.29 42.60 Russia 25.86 24.72 26.65 40.36 15.36 25.64 China 27.15 43.84 40.23 24.95 34.65 30.59 India 29.92 30.21 27.10 23.79 29.10 34.18 Iran 7.02 14.15 4.49 22.28 35.05 6.38 Georgia 15.98 15.67 15.33 12.07 10.79 12.62 Source: Calculations based on data from UN Comtrade; mirror data used for Iran. Note: Scale is from 0–100; Higher index reflects greater complementarity based on structure of trade at the HS six-digit level. Russia take much greater share as markets for Armenia. initiatives to improve Armenia’s connectivity with exter- In addition, it is important to note that, out of these nal markets and to improve diversification of Armenia’s countries, the import structure of Iran has the least cor- exports. For local traders, Poti is the port they travel to respondence with the exports of Armenia, which limits the most and therefore the route through Poti is their trade between the two neighbors. There seems to be central concern. However, costs, time and reliability all greater potential, however, for Iran to serve as a transit seem to be problems, especially during certain peak country for Armenian goods, or perhaps, for Armenia times or during months of bad weather. It also does to serve as a transit country for exports to Iran from not accommodate large ships, so small feeder vessels Russia or Georgia. from Istanbul as well as ferries must be used. Invest- ments to modernize and increase the capacity of Poti are underway. In addition to the higher costs of using Transit through Georgia feeder vessels, overstretched capacity at Istanbul pres- Traders are overall positive about the ease with ents a bottleneck, with shipments sometimes waiting which they can move goods to Georgian ports. They there for up to two weeks during the busy season at highlight improved border infrastructure, customs per- the end of the year. Costs incurred beyond Poti can formance, road conditions and unofficial payments. make up almost 80 percent of the total cost of export- The main Georgian port Poti, can be reached from ing (Table 5.3). two crossings on the Armenian-Georgian border, cor- responding to two alternative roads through Georgia. Transit through Georgia has been improving. Im- Some goods are sent to the Russian border crossing at provements are noted in terms of border infrastruc- Upper Lars, rather than to the port and onto Black Sea ture and customs performance, road conditions and ferries (more to the land route to Russia below). lower unofficial payments. Substantial progress has been made in improving traders’ experience at the The Georgian port of Poti is the major entry and border. Customs has gradually moved to modern im- exit point for dry goods. Poti lies on the shortest port procedures, including streamlining of control and land route from Central Asia to Western Europe and processes, computerization, risk management and ef- has efficient rail, land and sea linkages. Poti is larger fective post-release checks. Current plans for integrat- than Georgia’s other major Black Sea port of Batumi ed border management will help various government and is an all-purpose port as compared to Batumi’s fo- agencies present on each side of the border work cus on crude oil and oil products, so Poti is integral to more harmoniously with one another. 66  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 5.3. Estimated Costs to Export One has a contract with a Georgian company to clear this Truckload: Yerevan to Moscow (via Poti) route for passage during the winter months. (in US dollars) Yerevan to Poti (Inland Costs) 1000 Transit through Iran Formulation 130 Transit through Iran faces challenging bottlenecks. Fuel 500 The location of current trading partners, treacherous terrain in southern Armenia, the distance needed to Salary/per diem 270 reach Bandar Abbas port, and bans on some of Arme- Port Fees 100 nia’s main exports—brandy, wine, and cigarettes—all Poti to Novorossiysk (Black Sea Ferry) 2100 decrease the attractiveness of this route. Armenian Novorossiysk to Moscow (Russian Territory) 1500 trucks are at a competitive disadvantage because of a road tax (usually around $600 which is assessed accord- Total 4600 ing to both weight and distance) and fuel subsidies to Source: Interviews. Iranian trucks, and goods are therefore transferred to Iranian trucks at the border. Working with Iranian truck- Most goods traveling to or from Armenia use Black ing companies is perceived as difficult because of high Sea ferries at Poti or Batumi ports. They utilize the and unpredictable trucking rates, lack of truck traffic multi-modal transport offered by the roll on, roll off at needed times, and unreliable timing of delivery. On (Ro-Ro) services in the Black Sea. Ro-Ro ferries operate the other hand, costs for utilizing Bandar Abbas are between ports in Turkey, Ukraine, Russia and Georgia. quite low, and capacity is large. Ferries most in demand from Poti are those to Novo- rossyisk (Russia) and Ukraine (Illichysk). There are eight vessels meant to load trucks, each vessel with a capacity Comparison of Georgia and Iran Transit Routes to load 20–25 trucks. Ferries are a bottleneck because Generating a comparative assessment of road tran- of the high cost, time delays and lack of reliability. sit through Iran and Georgia is complicated by sev- eral factors. Volume of exports from Armenia on its The Upper Lars border crossing between Georgia own is low, as total exports constitute less than 20 per- and Russia does not allow excise goods (Armenian cent of GDP. Because of this, many transport compa- Brandy) and is closed in winter. This limits the avail- nies and freight forwarders focus entirely on imports. ability of a land route as an alternative to the Black Sea Furthermore, exports that transit by road are less than ferry system. Exporting from Yerevan to Moscow via half of overall exports. Finally, as discussed, most of Upper Lars is roughly 30 percent cheaper than export- this export volume by road leaves through Georgia ing through Poti because of ferry costs and time de- rather than Iran, making it difficult to find freight for- lays. However, only one Armenian trucking company warders familiar with the southern route. We therefore Table 5.4. Ro-Ro Service Average Rates for a Full Truck (in US dollars) Port of Shipment Port of Destination Service rate Service rate for excise goods Poti (Georgia) Novorossiysk (Russia) 2,000 2,500 Poti (Georgia) Kerch, Ilichevsk (Ukraine) 1,700 1,700 Memoranda: Samsun (Turkey) Novorossiysk (Russia) 800 800 Zonguldak (Turkey) Kerch, Ilichevsk (Ukraine) 1,000 1,000 Source: ICHR (2011). Land Connectivity | 67 use the costs of importing in standard shipping con- that obtaining bank financing is difficult and rates can tainers from China to compare the two transit options. range up to 15 percent, and that customs duties and VAT add significant costs. Market regulation may be a Despite the closer proximity to China, the Ban- factor that limits competition and raises prices. Export- dar Abbas transit route is not always cheaper. As ers on the other hand feel they are being overcharged shown in the example (Table 5.5), importing a 20- by trucking companies. foot container from China through Iran costs about $5,000, while the same container through Poti costs Freight forwarders provide much of what Armenian about $4,000. This is a remarkable fact considering exporters need but services could be more exten- the geography: transit through Bandar Abbas in Iran is sive and professionalized. Armenia ranks quite high about two weeks faster than through Poti in Georgia, on the logistics competence indicator in the World according to freight forwarders interviewed for this Bank Logistics Performance Index, with a rank of 79 study. The reason for the higher cost through Bandar out of 155. Trucking companies are increasingly trying Abbas are the poor business conditions that lead to to provide freight forwarding services, rather than rely informal payments plus the fact that export backhaul on third-party freight forwarders. cannot be arranged easily, given the low volume of trade and switching of trucks at the Armenian border. Shipments from different producers are rarely con- With a larger container, much lower sea freight costs solidated into one larger shipment. Many products trump the above factors, making the Iran option more from smaller producers, such as handicrafts, textiles, competitive: it is cheaper to bring a 40-feet container and other products that could potentially be exported through Iran, rather than through Georgia. There are by SMEs, may not be currently exported because ship- reasons to expect the competitive advantage of Poti ment costs are too high for small shipments on their to increase: the creation of the Poti free economic own. Low scale itself makes consolidation more diffi- zone, the increasing ease of transit through Georgia, cult because of the time it takes to assemble enough and the impact of sanctions on Iran. The sanctions tonnage, and the costs of having trucks wait until ful- create important disincentives for freight forwarders, ly loaded. Customs regulations also do not support including the lack of insurance for shipments, limited freight forwarders in serving as agents for the consign- access to international shipping lines, and the inability or, as the consignor must specify vehicle information to work with Iranian banks. on the customs declaration and therefore must be present at the time of departure. Table 5.5. Import Costs from China to Yerevan (via Bandar Abbas), 20' and 40' Containers, 2012 Two logistics hubs may contribute to more con- (in US dollars) solidation of shipments and enhance the level of services by attracting international logistics compa- Sea Inland Total Via Poti nies. The Yerevan Logistics Center at Zvartnots airport 20' 1,600 3,400 5,000 4,000 is set to be completed in 2015, although investments in rail line and road infrastructure are still required. The 40' 2,000 3,400 5,400 6,500 airport has added to its air freight capabilities by in- Source: Interviews. vesting in cold storage for fresh fruits as part of the free economic zone. Another proposed logistics hub Logistics and Trucking Services would be located at Akhuryan outside of Gyumri. The trucking industry in Armenia consists of 2–3 sizeable firms and a handful of smaller players. For- Policy Recommendations eign operators are present, especially Georgian, Turk- Bilateral transit agreements could ease the transit ish and Iranian firms. Fixed costs for Armenian truck- situation. The high road tax levied on Armenian trucks ing companies are high and they are spread over few transiting through Iran significantly increases costs. A shipments. Trucking companies complain that acquir- reciprocal arrangement between Armenia and Geor- ing more trucks is difficult. In particular, they point out gia waives any transit fees or road taxes on trucks from 68  |  Republic of Armenia: Accumulation, Competition, and Connectivity both sides, although some freight forwarders indicat- ratification, Armenia may be in a better position to de- ed that this may not be applied evenly. The Armenian fend its rights with regard to free transit of goods. Ar- government could enter into negotiations with Iran to menia is, however, party to the UN Convention on the lower the road tax levied on Iranian trucks. Law of the Sea, which also offers signatories the right to defend freedom of transit. Georgia has ratified both Ratifying all relevant international conventions agreements but Iran has not ratified either. could increase Armenia’s leverage over transit partners. Armenia has not signed the UN Conven- Armenian trade would greatly benefit from im- tion on Transit Trade of Landlocked States, one of a provements on the transit route through Georgia. small number of landlocked countries which have not These would include upgrades to the road to Batumi done so. This agreement offers signatories the right port as an alternative to Poti, road-clearing services to “freedom of transit”, and specifies, inter alia, that at the Upper Lars crossing to Russia to allow for year- transit goods should not be subject to any customs round operations, and a dedicated freight pavilion in duty or special taxes and should have access to stor- Poti for goods traveling to and from Armenia. Nego- age facilities as would domestic goods. Freedom of tiations could also aim at improving the reliability and transit is subject to negotiation in sensitive areas such reducing the costs of the Black Sea ferries. The new as health and security, and transit can be denied when Baku-Tbilisi-Kars railway line, which bypasses Armenia, concerning matters of “national security.” Although could nevertheless open a new transit route when it is there is some skepticism among government offi- completed in the near future, if Armenian trucks were cials that signing the treaty will have any impact, with to shuttle goods to Akhalkalaki in Georgia. Land Connectivity | 69 6. Air Connectivity Armenia’s air connectivity is low, an unfortunate sit- policy recommendations to enhance connectivity in uation for Armenia with very limited connectivity the last section. on land routes. Flying to and from Armenia is more expensive than to neighboring Georgia, and flight connection to and from Armenia have less capacity Institutional Set-up and flexibility than to similar countries in the region. Currently, all governmental matters regarding avi- The higher prices and lower connectivity impose costs ation are handled by the General Department of on the Armenian economy, both direct costs borne by Civil Aviation (GDCA). It is de facto policy maker travelers, and indirect costs through loss of connec- and regulator. It negotiates Air Services Agreements tions of people and ideas. (ASAs), designates Armenian carriers, and defines all market access rules for airlines (frequencies, number The Armenian government can change air connec- of allowed destinations, etc). It also carries out the tivity quickly by opening the sector to more compe- functions of technical regulator (monitoring and en- tition. International experience shows that liberaliza- forcement of safety and security) and manages the tion allows air travel to grow rapidly, and that this has PPP contract with the company that won the airport significant effects on overall GDP growth. Higher pas- concession in 2001. senger traffic connects businesses, brings new ideas, and opens up new areas for trade, including exports of Since 2001, airport infrastructure has been substan- perishable agricultural products and tourism. Air con- tially upgraded. Infrastructure investment in the Ar- nectivity to and from Armenia is low because of the re- menian aviation sector was minimal between 1991 and strictive environment in which the sector operates. In- 2001. In December 2001, however, a 30-year manage- deed, Armenia’s effective aviation policy imposes lim- ment concession for Zvartnots International Airport its on capacity (number of permitted flight frequencies outside of Yerevan was awarded to the local affiliate or seats) and the number of airlines that can connect it of the Argentinian Corporacion America Company with other countries. The restrictive environment pro- (CAC), which operates airports in several countries. As tects the two private Armenian airlines, Armavia and part of the concession, it invested in a new airport ter- Atlantis European Airways. The restrictions increase minal, which was subsequently opened in 2002. the costs for passengers and shippers of cargo. Two airlines are providing flights to and from Arme- This chapter examines aviation policies and their re- nia, Armavia and AEA. The former is designated a ‘na- sults, and suggests ways to improve air connectivi- tional carrier’. It operates a substantial route network ty. To do so, we first assess the institutional set-up and from Yerevan using a variety of planes. In contrast, AEA the business environment, then benchmark aviation in does not own or lease planes, but markets seats on Armenia with respect to similar countries in the region, Austrian Airlines and Czech Airlines (CSA) flights to Vi- and in the fourth section calculate the welfare effects enna and Prague. Armavia plays an unofficial but nev- of the restrictive aviation environment. We propose ertheless large role in influencing regulatory decisions, Air Connectivity | 71 as well as discussions of bilateral air services agree- ¾¾ The ASAs with Austria and the Czech Republic ments. Flight control over Armenian territory is provid- define a maximum number of four weekly flights ed by an independent, government owned company. per side, although Czech Airlines (CSA) and Aus- trian Airlines are currently operating five and six frequencies per week, respectively, presumably on Business Environment the basis of ad hoc permits issued by the GDCA. International air transport is typically governed by Armavia ceded these routes to AEA. Since AEA bilateral Air Service Agreements (ASAs). They reg- does not own or operate any aircraft itself, it acts ulate the supply of air services and establish market as a marketing agent, which means it sells a fixed access conditions for both countries under reciprocity number of seats on Austrian and CSA flights (a principles. The conditions usually include: practice known as ‘block-spacing’). ¾¾ The ASA with France specifies a limit of 4-weekly ¾¾ Single or multiple airline designations, which de- frequencies per side, which are used in full by Air fine the number of airlines that are allowed to en- France during high season. Armavia operated two ter the market. Single designation ASAs do not codeshare frequencies per week to Paris with Air allow competition between carriers; France, but the codeshare agreement was recently ¾¾ Point designations, which determine specific suspended.75 routes and airports to be used. ¾¾ After the withdrawal of BMI from the Armenian ¾¾ Capacity designations, which specify the maxi- market in October 2012, no UK carrier is making mum number of flight frequencies, seats or max- use of the 7 frequencies allowed by the bilateral imum aircraft size. agreement between Armenia and the UK. ¾¾ Agreements on the extent of pricing freedom for ¾¾ Other routes are served by single designated carriers. airlines, and restrictions on their ownership. These include Istanbul, Beirut, Tehran, and others. Different levels of restrictiveness are currently in Armenia therefore has single designations on most force for different markets. The different practices routes. Multiple airline designations are permitted in give a confusing picture of Armenia’s aviation pol- many of the bilateral ASAs but most routes are still icy. Main routes are operated under the following served by only one foreign and one Armenian airline. conditions. The only—albeit important—exception is routes to Russia, where multiple airlines compete for passen- ¾¾ The Russian market accounts for more than 50 per- gers and cargo. The restrictive practice is at least par- cent of all air passenger traffic in Armenia. It is the tially explained by an investment agreement between only one in which designation of multiple carriers Armavia and the government, which gives it some pro- per country exists, allowing competition between tection from competition.76 Capacity restrictions pro- airlines. Until 2007, capacity was regulated by set- tect the private ‘national carrier’ and AEA to the det- ting a maximum number of seats per year, peri- riment of travelers to and from Armenia. The practice odically adjusted based on demand projections. overrides more liberal provisions in ASAs. Nonetheless, this was later replaced by placing a limit on weekly frequencies. Currently, capacity 75 It should be noted that in virtue of the Horizontal Agree- restrictions have been set on an interim basis al- ment between Armenia and the European Union, all bilateral lowing up to 49 flights per week and three carriers agreements with EU countries have been amended to introduce per side on the Moscow-Yerevan route. For other the Community carrier designation clause. As a consequence, routes up to three carriers are allowed and there any EU Member State can designate any EU carrier, provided that it is owned, directly or through majority ownership; and it are no restrictions on frequencies. Recent Russian is effectively controlled by member states and or nationals of requests to eliminate all capacity restrictions (in- member states; and or by Norway, Liechtenstein, Switzerland, cluding frequency, airline and point designations) Iceland or by nationals from these states. Agreement between the European Community and the Republic of Armenia on cer- have been rejected by the GDCA, which suggest- tain aspects of air services. OJ L 50, 21.2.2009, p. 22–29. ed unsuccessfully that frequencies and carriers 76 The investment agreement has not been disclosed and its currently available should instead be reduced. provisions are therefore not clear. 72  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 6.1. Capacity Distribution (seats) from Yerevan 1% 2% Eurasia (Eastern Europe) 2% Russia 3% 7% 7% Western Europe Czech Republic 3% Middle East United Kingdom 3% 21% France Eurasia (Asia) 3% Austria 5% 67% United Arab Emirates 71% 5% Iran Italy Ukraine Others Moscow Armavia 2% Prague 12% 2% 20% London 3% Siberia Airlines 2% 32% Rostov 3% 2% 44% Aeroflot Vienna 3% 3% Paris 3% 3% bmi Dubai 3% 3% 3% 13% St. Petersburg JSC Don Avia 3% 5% 12% 3% 4% 5% 5% Mineralnye Vody 4% 3% Teheran Austrian Airlines Source: DIIO data (June 2012). Author’s calculations. Note: In October 2012, BMI discontinued its Yerevan-London operations. Benchmarking Armenia’s Yerevan does not provide a wide range of choices with enough flexibility (Figure 6.2). About 30 mar- Air Connectivity kets are served with at most two frequencies per week (about 70 percent of all markets available out of Yere- Flight Connections van); four markets with at least a daily flight (Rostov, Yerevan airport is connected mainly with Eurasian Krasnodar, Mineralnye Vody, with 7 to 13 frequencies cities. As shown in Figure 6.1, the Eurasian market per week) and a single route with two or more daily has 71 percent of the seat capacity from Yerevan, flights (Moscow). Of the destinations served with at whereas Western European markets account for least one daily flight, only Moscow is considered a suit- about a quarter of all available capacity from Yerevan, able connecting hub, served by 10 daily flights from and the remaining few in the Middle East (7 percent). Yerevan. After the withdrawal of BMI from the Arme- The bulk of the seat count is oriented to Russia (69 nian market, which removed access to London Heath- percent). Out of 45 destinations served, the Russian row’s vast connections, Paris Charles de Gaulle, Frank- capital is the most relevant market. Moscow’s three furt and Istanbul Ataturk airports are the remaining airports account for almost half of the seats out of global hubs connected to Yerevan, albeit only served Yerevan. Out of 25 carriers, Armavia has the largest once or twice a week during low season. Alitalia’s new- share of the seats out of Yerevan (about one third of ly established service between Rome and Yerevan also the total). operates only twice per week. Air Connectivity | 73 Figure 6.2. Number of Destinations by Frequency of Service from Yerevan (in absolute number – left; as a percentage of total destinations – right), 2000–12 Yerevan, 2000 Yerevan, 2012 Yerevan, 2000 Yerevan, 2012 30 .8 CIS CIS Extra-CIS Extra-CIS .6 20 .4 10 .2 0 0 1–2 3–4 14+ 1–2 3–6 7–13 14+ 1–2 3–4 14+ 1–2 3–6 7–13 14+ Source: Author based on DIIO data (March 2000 and June 2012). Yerevan offers lower flexibility compared with re- are available in terms of carriers from Yerevan: a sole gional peers. Among major CIS capitals, Yerevan of- market is served by four airlines (Moscow), followed by fers the lowest levels of flexibility, measured by the three other markets within Russia, where three carriers share of markets served with two weekly frequencies operate (Rostov, Sochi and Mineralnye Vody). In turn, or less (highest in the sample), and the percentage seventy percent of the markets are served by one or of routes with two or more daily frequencies (lowest two carriers at most. According to USAID (2011), ef- in the sample, see Figure 6.3). Moreover, few choices fective competition in the densest markets might be Figure 6.3. Number of Destinations by Frequency of Service from CIS Countries’ Capitals (as percentage of total destinations served), 2000–12 CIS Extra-CIS Domestic .8 .6 .4 .2 .0 an os y M ow Bis insk sh ek As Tb be Ta aba i sh d Kie t Ba v Ye ku Bi an sh ad Ye nbe sh k Tb nt Ba si Ku M iev Al nsk os y w hk be Ye bad Ta evan Ba t Bis insk Alm ek Tb ty i M Kiev w M ku sh n nt M Kiev Ba w Du Tbi u As sha isi ha e Alm ad Bis aty M ek k ilis h s n n M mat M mat Ta shke k ins co hk nb hk ili a Ta eva k ili co ke co ke hk ke As shan Du hk ke rev an rev Du hab l hk b c ha os i sh a os r Al r Ye hk Du As 1–2 3–6 7–13 14+ Graphs by year Source: Author based on DIIO data (June 2012). 74  |  Republic of Armenia: Accumulation, Competition, and Connectivity even lower: due to the protective stance towards Ar- equipment (25 percent of total transit cargo), spare mavia capacity in ASAs is split artificially between air- parts (25 percent) and other consolidated cargo (16 lines, or commercial agreements on codesharing and percent). According to some air freight forwarders, de- blockspacing consolidate seat inventory and reduce lays in the customs clearance procedures in Moscow competition. make Yerevan marginally more attractive as a transit point for Russian imported goods destined for Siberia Yerevan also handles relatively modest volumes of and the Russian Far East, although handled volumes air cargo. In 2011, total air cargo throughput amount- are still low. ed to 9,500 tons, with approximately equal amounts for exports and imports. As a result, capacity utiliza- Regular freighter services to Yerevan are only pro- tion of the new cargo facilities at Zvartnots airport is vided by Air Armenia and Air Cargo Germany (ACG). at 25 percent at best. Around 80 percent of the total Air Armenia, a local company, has two scheduled week- cargo volume is carried in passenger aircraft, and only ly flights between Yerevan and Frankfurt Hahn (using 20 percent in freighter aircraft. Less than ten products Antonov-12 aircraft) whereas Air Cargo Germany serves account for over 55 percent of the total exports leav- Yerevan once per week with a Boeing 747-400 freight- ing Armenia by air, live crayfish (25 percent of total ex- er. Non-regular cargo services also exist to markets in ported air cargo), fruits (16 percent) and frozen fish (5 Central Asia such as Ashghabat, Dushanbe and Aktau. percent). Approximately 55 percent of the exports are Other air cargo companies such as Cargolux, Silk Way destined for Moscow, and 18 percent to Europe. Con- Airlines and Coyne Airways, run road feeder services to versely, 45 percent of imported air cargo comes from and from Tbilisi, connecting to their international net- Europe (this includes all transit cargo from different or- work within the region and beyond. Reportedly, there igins), and close to 30 percent from Moscow. are no regulatory constraints for air cargo. Transit air freight is limited as well. In terms of tran- Competitiveness sit cargo, approximately 140 tons per year are carried from Europe to other destinations in the region via Fares in Yerevan are significantly more expensive Yerevan (from Frankfurt Hahn to Tbilisi and Ashgha- than in neighboring Tbilisi. A benchmarking of air bat). The main products are computer supplies and fares was conducted in 47 direct and non-stop markets Figure 6.4. Lowest Available Fares from (left) and to (right) Yerevan and Tbilisi Direct and Non-stop Routes (in US dollars/km) 0.7 0.7 EVN EVN 0.6 0.6 TBS TBS 0.5 0.5 0.4 0.4 0.3 0.3 0.2 0.2 0.1 0.1 0 0 0 500 1000 1500 2000 2500 3000 3500 4000 0 500 1000 1500 2000 2500 3000 3500 4000 Source: Author’s calculations, based on 3rd week of November 2012. Note: Fares do not include air charges, security fees or taxes. Air Connectivity | 75 from the Armenian capital and 28 markets from Geor- parking fees, navigation charges (air traffic control ser- gia, equivalent to 99 percent of all available destina- vices for aircraft approaching or departing Yerevan, or tions for the traveler in each case. The comparison transiting through Armenian airspace), or any other in- with the Georgian case can be helpful to illustrate the frastructure related charges (use of boarding bridges, likely effects of less restrictive aviation policies on air meteorological services, etc.). It also includes all costs fares in markets with similar traffic patterns. In contrast borne by passengers, whether in the form of passen- with Armenia, Georgia imposes no restrictions on ca- ger facility charges or terminal use charges, security pacity, airline and point designation. Results show fees, or other duties which are ultimately paid by the that the lowest fares subject to inventory availability traveler –either levied by the airport or the airlines. On to and from Yerevan are systematically higher than the other hand, non-regulated charges usually com- those to and from Tbilisi across the selected sample prise handling costs, both for passenger and ramp of markets on a per-kilometer basis (Figure 6.4). For a services, as well as fuel.77 Comparisons were made typical distance of 1900 km, average yields per kilo- on a per-passenger basis (where applicable) and for meter in Yerevan add up to $0.20 per km, compared a typical turnaround operation of an Airbus A320-200 to $0.13–0.15 per km in Tbilisi, constituting a premium aircraft (Figure 6.6). of 33 to 50 percent for the traveler flying in and out of the Armenian capital. The comparison results hold Turnaround costs borne by airlines in Yerevan are for different points in time (February/March and May). comparable to those in Tbilisi and Baku, albe- Moreover, when fees and taxes levied on the passen- it higher than in other Eurasian airports. Yerevan ger (passenger facility charges, departure taxes, etc.) stands after Baku as the third most expensive airport are added to the fares in both cases, the overall re- in the sample with over $5,000 in total charges, and sults remain unchanged. followed closely by Tbilisi (approx. $4,400) and Minsk ($4,100). In turn, Kiev is the most expensive airport for The benchmarking exercise was also extended to airlines with $5,730 in charges. As far as the individual other CIS countries and connecting markets, yield- components, landing fees in Yerevan are the second ing similar results. When compared with other CIS most expensive in the sample ($5.8/ton per each land- capitals such as Almaty and Baku, outbound yields ing and each takeoff, adding up to $1,135) exceeding are also found to be more expensive in Yerevan based Baku and Tbilisi by 30 and 95 percent, respectively. on the lowest available fare (Figure 6.5). In the case of Approach charges in Yerevan add up to $590 ($6 per connecting markets, only online connections via ma- ton), similar to Tbilisi ($578) but more expensive than jor hubs were considered (i.e. Air France connections Baku ($391), exceeding by 30 percent the sample av- via Paris, or Turkish Airlines via Istanbul) to beyond erage of $455. Navigation charges in Armenia of $204 destinations in North America, Europe and Asia. The are far below the sample average, but close to Tbili- exercise shows lower and more volatile yields dis- si’s $182 and much cheaper than Baku’s $274. Ground tinctive of connecting markets as compared to non- handling charges in Yerevan appear to be competi- stop markets. In spite of the increased competition tive within the sub-region when compared to Tbilisi in connecting markets via major hubs, average yields (both airports stand close to $2,100 per turnaround) continue to be higher from Yerevan as compared to Tbilisi, although the premium seems much lower (around 10 percent for a typical market in excess of 77 Some initial conditions must be held constant considering that rate structures vary according to the specific charge; wether 2000 miles). by aircraft size (usually based on the Maximum takeoff weight), time (turnaround times for parking fee calculations, and time of A benchmarking exercise of infrastructure and day for any night surcharges), or the number of passengers (any non-infrastructure charges was conducted in order charge based on the number of passengers enplaning or de- planing the aircraft). Consequently, the base scenario employed to compare the costs borne by airlines and passen- for the comparison uses an Airbus 320-200 operation (77 tons gers across Eurasian airports, including Yerevan. Maximum takeoff weight or MTOW) with a 60 percent load fac- These charges can be divided in two broad groups: tor (with 100 revenue passengers out of the possible 164 at a typical pitch configuration) during daytime hours, and a 2-hour regulated and non-regulated charges. Typically the turnaround time (the time on the ground between arrival and first group would include landing fees and surcharges, departure). 76  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 6.5. Lowest Available Fares from Yerevan, Tbilisi, Baku and Almaty Direct and Non-stop Routes (in US dollars/km) EVN TBS GYD ALA 0.7 0.6 0.5 0.4 0.3 0.2 0.1 0 0 500 1000 1500 2000 2500 3000 3500 4000 4500 Source: Author’s calculations, based on 3rd week of November, 2012. Note: Fares do not include airport charges, security fees or taxes. Figure 6.6. Turnaround Costs for an Airbus A320-200 Paid by Airlines (in US dollars) a: without fuel costs b: with fuel costs Other OPS Handling Other OPS Fuel Handling Navigation Landing and Navigation Landing Parking and Parking 7,000 30,000 6,000 25,000 5,000 20,000 4,000 15,000 3,000 10,000 2,000 1,000 5,000 0 0 w ) O) v aty nt be ek Ye k an i As ku t w ) O) v aty nt be ek Ye k an i As aku t ilis os ME ba ilis os ME ba Kie ins Kie ins ke ke (SV hk Ba rev an (SV hk rev an Alm Alm ha ha Tb Tb B (D M (D M sh sh Bis sh Bis sh hg hg Ta w Ta w Du Du co co co co os os M M M M Source: Author’s calculations based on ICAO and IATA Manual on Airport and Air Navigation Charges and country AIPs. Note: Based on daylight operations, 2-hour turnaround time. Air Connectivity | 77 Figure 6.7. Total Turnaround Charges paid by Passengers for an Airbus A320-200 (in US dollars) a: levied by airport, without state tax and duties b: with related state taxes and duties Other PFC PFC Security (MTOW based) Security (pax based) Security (MTOW based) Security (pax based) 6,000 6,000 5,000 5,000 4,000 4,000 3,000 3,000 2,000 2,000 1,000 1,000 0 0 E) O) t be Du nt E) O) an ek Ta y k i As ku t v be Du nt an ek aty k i u v ba ilis ba ilis at Kie ins Kie ins M k M ke (SV ke (SV hk an rev hk Ba an rev Ba Alm ha Alm ha Tb (D Tb (D M sh M sh Bis sh Bis sh Ye hg Ye hg w w w w Ta co co co co As os os os os M M M M Source: Author’s calculations based on ICAO and IATA Manual on Airport and Air Navigation Charges and country AIPs. and Baku (around $2,590). However, in June 2012, Ye- very close to Baku as the most expensive airport in the revan had the third most expensive fuel in the sample region, exceeding the $5,000 mark, and surpassing the ($1,394 per ton), impacting directly on the turnaround sample average by 75 percent. cost computations. Total turnaround costs paid by airlines and passen- Airport charges and fees paid by passengers in Ye- gers in Yerevan are still higher than in most airports revan are in line with other airports in the region in the region. Fuel costs constitute the bulk of the to- when government duties are excluded from the tal turnaround costs, as shown in (Figure 6.8). Together comparison. The Government of Armenia levies a with the State Air Exit Duty, these two elements are the State Air Exit Duty of AMD10,000 (equivalent to $25) on largest source of premiums associated to air travel in departing passengers. This is not related to infrastruc- Armenia, as compared to the other airports. A study ture recovery costs or the provision of airport services by USAID (2011) shows that, when compared to a dif- by the operator, but collected by the airlines and incor- ferent set of airports in Eastern and Western Europe, porated in final ticket prices. Other similar cases can the results are qualitatively the same.79 As far as the in- be found in Baku and Kiev, in the form of a civil avia- cidence of passenger charges in Armenia, these tend tion tax (of $1.5 per passenger) or government tax ($2 to represent between 10 and 13 percent of the final per passenger). When the State Air Duty is excluded price of a ticket for medium and long-haul air travel from the computations, passenger charges levied by Yerevan airport are very similar to that in other airports including Tbilisi, and almost 50 percent cheaper than 79 “Competitiveness of the Armenian Air Transport Sector” in Baku (Figure 6.7).78 Conversely, when the State Air USAID, 2008. Small variations between the two studies emerge Exit Duty is added to the final cost for the passenger from the cost of fuel (which varies rapidly according to market conditions) and ground handling. In the latter case, airlines usu- traveling in and out of Armenia, Yerevan stands out ally enter in contracts with different service providers at a dis- count, and hence slightly different quotations might be consid- ered as a valid. Different aircraft seat configurations also might 78 EUR 2 per passenger in Security fees and EUR 18 per pas- impact the cost for ground handling. In this case, we use the senger in Passenger Facility Charges, plus $3 per passenger for official published value provided by the airport through public check-in services. sources or via consultations with airports and airlines. 78  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 6.8. Total Turnaround Charges, for an Airbus A320-200 (in US dollars) a: without fuel costs b: with fuel costs Other OPS Handling Navigation Other OPS Fuel Handling Landing and Passenger Navigation Landing Passenger Parking (PFC+security and Parking (PFC+security +Oth. Taxes) +Oth. Taxes) 12,000 35,000 10,000 30,000 25,000 8,000 20,000 6,000 15,000 4,000 10,000 2,000 5,000 0 0 O) ev aty nt be k Ye k an i As ku t E) k Ye k an i As aku t E) O) ev aty Du ent Bi e ilis ba ilis ba ke ins ke ins b M ke M Ki (SV Ba rev an Ki (SV rev an Alm ha Alm Tb sh ha k Tb sh (D B M (D sh M sh sh sh hg Bi hg w w Ta w Ta w Du co co co co os os os os M M M M Source: Author’s calculations based on ICAO and IATA Manual on Airport and Air Navigation Charges and country AIPs. (including the State Air Exit Duty).80 When the State Air expertise available to the commission is unclear. The Exit Duty is not considered, charges and fees levied commission is chaired by the Director General of the on passengers account for 6 to 10 percent of the final GDCA. The arrangement lacks formal consultation or ticket price. complaint handling mechanisms for the users of the infrastructure and there is need for a better defined The institutional environment for the economic reg- economic regulatory framework in regard to ancillary ulation of the airport concession needs to be better services, with a clear role for competition law and its defined. Formally, GDCA is the state agency respon- enforcement. sible for approving the fees and charges to be paid by carriers and passengers, and the monitoring body Transit Hub Potential for the operator’s compliance with the airport con- cession agreement, acting in its capacity of economic Network connectivity measures can be used to as- regulator. As far as airport pricing regulation is con- sess the transit hub potential of Yerevan vis-à-vis cerned, an intergovernmental commission was creat- other airports in the region. In previous sections, an ed in 2004 to monitor all charges and fee adjustments analysis of direct connectivity from Yerevan was per- proposed by the operator in accordance with the con- formed by assessing the number of flights and fre- cession agreement, although the level of technical quency of service by destination from the Armenian capital. Alternative definitions of connectivity focus on a central node on a given network, and its capabilities 80 Respectively, based on a two-way fare for a 3500 and 2000 kilometer route. Air Connectivity | 79 to serve as a transit point for passengers or cargo. In recent literature, the latter is referred to as hub Box 6.1. Criteria for Counting Valid ‘hits’ on connectivity.81 Connecting Flights §§ A minimum time separation must be met be- Two synthetic indicators can summarize the con- tween the landing and departing connection. This is to allow passengers to deplane and transfer nectivity capabilities of an airline hub: the spatial within or between terminals, and assure that any concentration of its network, and the time coordi- baggage or cargo can be unloaded and load- nation of flight schedules.82 One metric commonly ed to the new aircraft in time. This minimum time utilized to represent the spatial concentration of a separation is defined by Minimum Connect Time (MCT) rules, which depend on a multiplicity of network is Freeman’s (1979) betweenness centrality factors: some of them reflect infrastructure issues index.83 In principle, pure radial networks provide like lengthy transfer times between terminals, the better capabilities for carriers to hub since they max- efficiency of baggage handling, or the need for extra time due to heightened security measures, imize the number of possible connecting markets etc. Usually, the complexity of MCT rules is directly with the minimum number of inbound and outbound proportional to the size of the hub; a good exam- flights. In turn, different metrics have been proposed ple of that is Charles de Gaulle (CDG) airport in to capture the scheduling practices of carriers.84 The Paris, which shows very complex MCTs. Although the literature has used typical values for MCTs (90 basic rationale behind them is to count the number minutes for domestic departures and two hours of competitive ‘hits’ or suitable connections at a spe- for international departures) in order to compute cific airport, provided that they comply with a set of the number of suitable connections at a hub, this operational and practical rules (see Box 6.1). Once calculation uses real MCT rules for all carriers and airports considered in the sample. all valid ‘hits’ are counted, only the number of con- nected markets is considered; and later normalized §§ A routing factor is introduced to measure the de- by the maximum possible number of connecting viation from the great circle distance between origin and destination; this avoids the validation markets that can be served by that carrier at that air- of connecting routes with a significant degree port, so as to avoid any bias introduced by network of backtracking. A detour of up to 30 percent of the non-stop great circle distance is usually accepted. §§ A Maximum Connect Time (MaCT) is also intro- duced as a way to prevent the counting of con- 81 Unless indicated otherwise, the use of the term hub follows nections which are neither competitive nor con- the accepted definitions in the literature (see Burghouwt 2007; venient for passengers. Holloway 2009). The spatial structure of an airline network can unveil some core characteristics about its operations. Hubbed Source: Adapted from Boostma (1997), Burghouwt (2007) and Goedeking (2011). networks “add a temporal dimension to the radial form, as they exist not just by virtue of (spatial) network design, but also as a result of scheduling decisions”. Timing and coordination of inbound and outbound flights out of the hub are then carefully size.85 A higher time coordination ratio indicates bet- managed so as to present a wide range of competitive connec- ter aptitudes to provide seamless connections and is tions for transit passengers. On the other side of the spectrum, usually indicative of a hubbed network structure. In linear or grid-type network structures are more in line with the business model of point-to-point carriers, typical of the pre de- order to draw a comparison between different carri- regulation 1970s air transport markets, and that of low cost car- ers, eight different airline-airport pairs in the region riers (LCCs) or regional carriers. Of course, this is not to say that were chosen as comparators, along with other seven all airlines with radial network structures can be associated with based in Europe (Table 6.1). hub-type operations, or that all point-to-point structures do not exploit any transit traffic. Ultimately, this depends on the carriers’ business proposition, whether segment-based (point-to-point) or journey-based (hubbed). 82 Nijkamp et al 2007. 85 The maximum number of markets that can be served from a specific airline hub follows the formula of n!/(n-2)! where n is the 83 The Freeman index measures the “degree of inequality or number of markets excluding the hub. Assuming a network with variance in the network” as compared to a pure radial configu- a single hub and spokes A,B,C and, D, 12 market combinations ration, adopting the maximum value possible (equal to 1) for a (assuming directional markets) can be formed. Hence if there are pure radial architecture, and 0 for pure point-to-point network. only 3 valid hits via the hub (connecting markets A–B, C–D, and 84 See Burghouwt 2007, Boostma 1997, Nijkamp et al 2007. B–D), then the scheduling coordination index would equal 1/3. 80  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table 6.1. Base of Operations and Size of Selected Carriers in CIS Countries Carrier Country Base Monthly ASMs* Aerosvit Ukraine Kiev (KBP) 574.7 Air Astana Kazakhstan Almaty(ALA)*/ Astana (TSE) 527.9 Turkmenistan Airlines Turkmenistan Ashghabat (ASB) 138.2 Belavia Belarus Minsk (MSQ) 127.3 AZAL Azerbaijan Baku (GYD) 213.0 Georgian Airways Georgia Tbilisi (TBS) 28.0 Uzbekistan Airways Uzbekistan Tashkent (TAS) 462.0 Armavia Armenia Yerevan (EVN) 94.3 *available seat miles. Source: Authors. Armavia has the most concentrated spatial structure Under the current conditions, Yerevan’s chances to be- along with Belavia, since it does not operate any come a regional hub appear to be slim. First, Armavia routes between spokes. In contrast, Air Astana exhib- appears to have the most concentrated spatial structure its the lowest spatial concentration in the region, given in the sample (Figure 6.9). The carrier’s network is purely the fact that it operates both from Almaty and Astana air- radial and does not operate routes between spokes. In ports. As far as the legacy carriers such as Lufthansa, their contrast, Air Astana exhibits the lowest spatial concen- lower spatial concentration is explained by their double tration in the sample, since the Kazakh airline operates hub structure (Frankfurt and Munich). On the other hand, both from Almaty and Astana airport. As far as Europe- Armavia shows the lowest degree of schedule coordina- an carriers, their lower spatial concentration can be ex- tion as compared to the other carriers in the region, sug- plained by their double hub structure (such as the case of gesting that a smaller number of connecting markets can Lufthansa, in Frankfurt and Munich, or the point-to-point be served via Yerevan seamlessly, relative to the size of structure of low cost carriers). Second, Armavia shows the its network; only low cost carriers in Europe (Easyjet, Ry- lowest degree of schedule coordination as compared anair and Air Berlin) with a marked orientation towards a to other airlines in the region and most legacy carriers point-to-point structure show lower time coordination in- that operate successful hubs in Europe, indicating that a dicators. Although there is nothing inherently wrong with smaller number of connecting markets can be served via such strategy—as many successful carriers around the Yerevan relative to the size of its network. Only European world do not configure their networks around the idea low cost carriers (Easyjet, Ryanair and Air Berlin) with a of connecting traffic—Yerevan’s chances of becoming a segment-based business model show lower time coordi- successful regional transit hub seem unrealistic under the nation. Although there is nothing inherently wrong with present conditions. In fact, transit passengers account such a strategy, as many successful carriers around the for less than 0.2 percent of total passenger movement world do not configure their networks around the idea of at Zvartnots, a negligible amount by industry standards.86 connecting traffic, Yerevan’s chances of becoming a re- The current restrictive aviation policies and the compara- gional transit hub are low under the present conditions. tively higher costs for airlines and passengers in Yerevan In fact, transit passengers account for less than 0.2 per- make matters worse in that respect. cent of total passenger movement at Zvartnots.87 86 For instance, transit traffic in airlines such as Air Astana, Ice- 87 For instance, transit traffic in airlines such as Air Astana, Ice- landair and LOT represents some 20, 39 and 45 percent of total land air and LOT represents some 20, 39 and 45 percent of total traffic, carrying some 2.0, 0.6 and 1.4 million O&D passengers, traffic, carrying some 2.0, 0.6 and 1.4 million O&D passengers, respectively (figures based on different years, extracted from in- respectively (figures based on different years, extracted from in- dustry publications). dustry publications). Air Connectivity | 81 Figure 6.9. Spatial Concentration and Schedule section quantifies the welfare effects of airline desig- (time) Coordination of CIS Carrier Operations nation restrictions and capacity constraints from high- er air fares. Air Astana Uzbekistan Airways British Airways Turkmenistan Airlines Airzena Air France Two elements are needed to estimate the welfare AZAL Armavia Easyjet effect of liberalizing air transportation. First, a pric- Belavia Iberia Ryanair Aerosvit Lufthansa Air Berlin ing equation able to capture fare responses related 1 to market power and route concentration, along with other explanatory variables that proxy for airline costs, 0.9 market demand characteristics and quality of service, 0.8 among others. Second, a set of own-price demand 0.7 elasticities is needed to predict any likely traffic re- Time Coordination 0.6 sponses to variations in air fares. 0.5 0.4 Price Elasticity Estimations 0.3 0.2 Two specifications are used to estimate price elas- 0.1 ticities for markets connected to Yerevan by air. 0 First, we estimate a single elasticity coefficient by 0.48 0.58 0.68 0.78 0.88 0.98 travel distance segment to account for differences between regional and international long-haul travel Spatial Concentration (0=Point to Point; 1=Radial) patterns. Second, following Hsiao (1986), we introduce a varying coefficient functional form to capture elas- Source: Author’s calculations. ticities by booking class segment, hence factoring in Note: Data points for Iberia, Lufthansa, Air France, British Airways, Air France, Easyjet, Ryanair, and Air Berlin were taken from Nijkamp et al (2007) for 2004. differences in business and leisure or “Visiting Friend and Relatives” (VFR) travelers’ demand and their cor- Two additional factors might hinder Yerevan’s as- responding sensitivity to price. In order to rule out any pirations of becoming a successful airline hub. On endogeneity bias, we also test these same effects us- one hand, origin and destination traffic is still low and ing instrumental variables. might not provide a solid base to allow yield dilution, since connecting markets usually are priced at a dis- The median elasticity for short and medium haul is count to attract passengers from non-stop sectors.88 estimated at 1.15, and at 0.85 for long haul mar- And second, directionality has to be such that con- kets. Tables A6.1 and A6.2 present results for the first necting trajectories do not pose significant backtrack- specification on medium- (less than 2600 miles) and ing for passengers, especially in short and medium long-haul routes (more than 2600 miles). On medi- haul markets. Currently, Armavia’s network structure um-haul routes (Table A6.1), all elasticities have the is mostly focused on Russian destinations, with only a expected signs and are statistically significant and be- few markets served in South Asia.89 tween –1.04 and –1.37. In the case of long-haul routes (Table A6.2) the elasticity coefficients range between –0.67 and –0.79 and are statistically significant in all Likely Impacts of Liberalization cases. The magnitudes of the elasticity coefficients are Higher prices and limited flexibility in air traffic to fairly robust to different controls. These results are con- and from Armenia impose costs on air passengers sistent with theoretical and empirical evidence found and cargo, and on the economy through lost op- in other studies as reported by Gillen et al. 2003.90 portunities for connecting people and goods. This Upon a review of 254 elasticity estimates, we find that the median elasticity for short- and medium-haul is 88 See Holloway 2009. 90 See Oum, Waters and Yong (1990) for further evidence and 89 Goedeking 2011. methodology on air travel demand elasticity estimation. 82  |  Republic of Armenia: Accumulation, Competition, and Connectivity estimated at 1.15, whilst that in long haul markets is The route level concentration coefficient is statistically estimated at 0.85. significant in all cases and robust to different controls, ranging between 0.44 and 0.63. A second specification This result is confirmed when running the regres- tries to capture the differentiated effects of market lev- sions distinguishing booking class segments. el concentration by booking class (equations 5–7) us- Table A6.3 presents the regression results for the vary- ing a varying coefficient functional form (Hsiao 1986). ing coefficient model in order to account for differenc- The Herfindahl coefficients for economy and business es in booking class segments (economy and business class tickets are statistically significant and range be- travelers). Both coefficients turn out to be statistically tween 0.52 and 0.63, higher than in similar applications significant in all but two cases, and with the expected (Borenstein 1989). The exact opposite happens with signs. Own-price elasticities for higher booking class- the Herfindahl coefficient associated to the discount es range between –0.37 and –0.65, which is consis- economy segment. Finally, a third specification is in- tent with the fact that business travelers’ demand is troduced in order to control for market dominance in less sensitive to variations in price. On the other hand, the destination market. The signs on the route concen- economy class elasticities (capturing the leisure and tration coefficients remain invariant for the most part, VFR segment) range between –1.4 and –1.7. It should except for the discount economy class, which turns be noted that the latter exercise was performed using significant and higher in magnitude. Alternatively, an the entire dataset and for long haul routes. Although instrumental variables model was computed (using economy class elasticities remained within the men- lagged variables of the Herfindahl index as instrument) tioned values, the coefficients associated to business in order to rule out any endogeneity issues in the con- class did not turn out to be significant in many cases. centration-price relationship, as suggested by Evans, Froeb and Werden (1993). Although the results are not The result is valid when correcting for endogeneity. reported here, no substantial differences in the sign, We turn to the results for the instrumental variables (IV) significance and magnitude of the coefficients were model, in order to account for any possible bias due to found compared to the pooled OLS model. Simula- endogeneity in the fare coefficient (Table A6.4).91 Two tions using the estimated coefficients indicate that a instruments were used: per capita Gross Domestic reduction of concentration by half on a specific market Product and the geographical distance to markets.92 (for instance, when a new entrant matches the capacity The results indicate that the elasticity coefficient rang- offered by a single incumbent), might lead to a drop in es between –0.88 and –1.6, depending on the specifi- the range of 20 to 28 percent in observed prices for the cation used. Furthermore, in all cases the hypothesis economy class segment. 94 that the fare is exogenous cannot be rejected.93 Fur- thermore, it is deemed that instruments are sufficiently A 25-percent reduction in price could add up to strong as indicated by the F-statistic. 1.4 percent of GDP. The methodology employed by Brattle (2002) is useful to compute the aggregate eco- nomic benefit of a liberalized market for passengers. Determinants of Air Fares Depending on the level of detail, different elasticities The estimations show that if concentration is re- can be used by routes and booking class. Although duced by half on a specific market, observed prices it might provide a more insightful picture of the likely for the economy class segment might drop in the effects of liberalization, it also requires additional as- range of 20 to 28 percent in average. Table A6.5 sumptions based on passenger traffic, which might not presents all estimation results of air fare determinants, be readily available. Assuming an overall reduction of for a number of markets connected to Yerevan by air. 25 percent in price and an average elasticity between –0.9 and –1.08, the aggregate welfare gains for the 91 See Gillen et al (2008) for a more detailed account of en- dogeneity issues when estimating air travel demand elasticities. 94 Assuming that there is no significant change in the overall 92 See Intervistas 2006 for a detailed discussion on choosing market share at the destination airport for any entrant carrier, instruments for air travel demand elasticity estimation. and that fares are determined freely (neither collusion nor filing 93 As indicated by the chi(2) p-value at 5 percent significance. restrictions are in place). Air Connectivity | 83 consumer would add up to 1.4 percent of GDP. The an elimination of capacity restrictions, including sin- welfare gain would obviously be quite small for travel gle designations, might contribute to welfare gains of to and from Russia, because the competitive environ- up to 1.4 percent of GDP by lowering fares by 25–30 ment on these routes means liberalization would not percent. Liberalization of Armenia’s aviation sector re- lead to big changes. quires: A clear policy statement outlining the govern- Policy Recommendations ¾¾ ment’s commitment to a competitive environment, A range of empirical studies have shown the positive ¾¾ A better separation of policy making and its im- effects of liberalization of aviation in a wide range plementation, of countries. Empirical and analytical work shows a ¾¾ Independence of regulators from interference strong positive link between air transport liberalization from regulated entities, and traffic growth. A wide array of methodologies and ¾¾ Industry consultation and complaint handling datasets has been employed to test the likely effects mechanisms, of more open air transport policies on passenger traf- ¾¾ Capacity building to help the Armenian regulator fic, tourism growth and job creation. Many case stud- better monitor and enforce contracts, including ies and simulation exercises are based on the experi- the airport management concession, and ence with liberalization and structural reform programs ¾¾ Greater transparency with regard to contracts and since the early 1990s. In highly regulated environments agreements to level the playing field for actual and where supply is artificially constrained, removing ca- potential market participants. pacity restrictions and single designation provisions can have decisive effects on air transport: new routes A review of aviation policy should lead to a are flown, more seats and frequencies become avail- well-defined strategy for the sector. The current in- able to the consumer, and fares drop as competition stitutional set-up needs to be broken up, because it increases. For example, Piermartini and Rousova (2008) is not conducive to the development of the aviation conduct a cross country study linking restrictiveness of sector. A clear policy statement outlining the govern- the aviation business environment to passenger traffic ment’s commitment to increasing competition be- volumes. The results show that an increase in the de- tween airlines, and improving connectivity for Arme- gree of liberalization from the 25th percentile to the 75th nia should therefore be published. Moreover, clear increases passenger traffic volumes between countries institutional responsibilities should be delineated for with direct air services by approximately 30 per cent. policy making, implementation, and monitoring and For air cargo, Micco and Serebrisky (2006) compare air enforcement of policies in the strategy. The overlap cargo rates from US import data. They estimate that an of functions and concentration of decision making open skies agreement reduces air transport rates by discretion in the GDCA are detrimental to democratic 9 percent, and increases the amount of cargo arriving oversight, clarity of business environment, and gov- by air by 7 percent on average (for a broader literature ernance. Technical capacity may have to be strength- overview see Table 6.2). ened for more effective oversight of conditions and charges and fees, both charges by airlines and the Liberalization of aviation would boost growth in air airport. With regard to the airport, the regulatory passenger and cargo traffic in Armenia, and boost framework pertaining to ancillary services should also economic growth. Our estimates have shown that be reviewed. 84  |  Republic of Armenia: Accumulation, Competition, and Connectivity Appendix Table A6.1. Pooled OLS Regression Results, Aggregate Fare Elasticities (1) (2) (3) (4) (5) (6) (7) lpax lpax lpax lpax lpax lpax lpax lfare –1.043 –1.040 –1.095 –1.098 –1.099 –1.372 –1.103 (7.89)** (7.87)** (8.53)** (8.50)** (8.55)** (10.41)** (8.53)** lrate –9.423 –9.436 –9.471 –31.629 –9.467 –34.200 –31.459 (1.86) (1.87) (1.94) (1.39) (1.93) (1.41) (1.38) lpop_total 2.361 8.951 1.011 8.940 0.359 0.965 (1.32) (4.09)** (6.61)** (4.08)** (2.51)* (5.99)** lweo_gdpcusd 4.314 (4.92)** lweo_econ 4.293 –0.088 –0.086 (4.89)** (0.87) (0.91) lweo_busi 4.376 (4.96)** ldist 28.261 28.251 (6.75)** (6.74)** Constant 68.945 33.444 –103.836 –18.157 –104.172 223.839 –18.393 (2.12)* (0.79) (2.10)* (0.12) (2.10)* (1.42) (0.12) Observations 355 355 355 355 355 355 355 R-squared 0.59 0.60 0.62 0.74 0.62 0.70 0.74 DUMMY VARIABLES YEAR YES YES YES YES YES YES YES QUARTER YES YES YES YES YES YES YES MARKET YES YES YES YES YES YES YES YEAR-QUARTER YES YES YES YES YES YES YES FARE CLASS YES YES YES YES YES YES YES YR-Q-ORG NO NO NO NO YES YES YES DISTANCE (Miles) MED MED MED MED MED MED MED (continued on next page) Air Connectivity | 85 Table A6.1. Pooled OLS Regression Results, Aggregate Fare Elasticities (cont'd.) (8) (9) (10) (11) (12) (13) (14) lpax lpax lpax lpax lpax lpax lpax lfare –0.673 –0.673 –0.686 –0.796 –0.796 –0.796 –0.782 (5.46)** (5.45)** (5.55)** (5.71)** (5.71)** (5.71)** (5.61)** lrate –2.457 –2.479 –2.323 3.004 3.004 3.004 3.277 (0.45) (0.45) (0.42) (0.10) (0.10) (0.10) (0.11) lpop_total 12.214 7.597 0.516 0.516 0.516 0.567 (0.59) (0.36) (1.09) (1.09) (1.09) (1.20) lweo_gdpcusd lweo_econ 2.743 –1.142 –1.142 –1.142 (0.63) (1.38) (1.38) (1.38) lweo_busi 3.882 (0.88) ldist Constant 23.271 –180.193 –127.485 –9.661 –9.661 –9.661 –23.200 (0.66) (0.52) (0.37) (0.05) (0.05) (0.05) (0.12) Observations 423 423 423 423 423 423 423 R-squared 0.35 0.35 0.35 0.39 0.39 0.39 0.39 DUMMY VARIABLES YEAR YES YES YES YES YES YES YES QUARTER YES YES YES YES YES YES YES MARKET YES YES YES YES YES YES YES YEAR-QUARTER YES YES YES YES YES YES YES FARE CLASS YES YES YES YES YES YES YES YR-Q-ORG NO NO NO NO YES YES YES DISTANCE (Miles) LONG LONG LONG LONG LONG LONG LONG Source: Authors. 86  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table A6.2. Pooled OLS Regression Results, Economy and Business Class Fare Elasticities (1) (2) (3) (4) (5) (6) (7) lpax lpax lpax lpax lpax lpax lpax lfare_economy –1.453 –1.452 –1.487 –1.414 –1.540 –1.757 –1.450 (9.48)** (9.49)** (10.03)** (9.70)** (10.13)** (11.70)** (9.72)** lfare_busi –0.372 –0.361 –0.443 –0.587 –0.333 –0.652 –0.511 (1.97)* (1.92) (2.42)* (3.38)** (1.69) (3.32)** (2.75)** lrate –9.974 –9.994 –10.003 –32.703 –10.095 –35.864 –33.080 (2.03)* (2.04)* (2.11)* (1.48) (2.14)* (1.53) (1.50) lpop_total 2.607 8.901 0.965 8.917 0.478 1.021 (1.51) (4.20)** (6.47)** (4.21)** (3.41)** (6.50)** lweo_gdpcusd 4.128 (4.85)** lweo_busi 3.965 (4.63)** ldist 26.371 26.129 (6.43)** (6.37)** Constant 68.616 29.404 –101.765 0.695 –100.719 228.263 3.567 (2.18)* (0.72) (2.12)* (0.00) (2.11)* (1.50) (0.02) Observations 355 355 355 355 355 355 355 R-squared 0.62 0.62 0.65 0.75 0.65 0.72 0.76 DUMMY VARIABLES YEAR YES YES YES YES YES YES YES QUARTER YES YES YES YES YES YES YES MARKET YES YES YES YES YES YES YES YEAR-QUARTER YES YES YES YES YES YES YES FARE CLASS YES YES YES YES YES YES YES YR-Q-ORG NO NO NO YES YES YES NO DISTANCE (Miles) MED MED MED MED MED MED MED Source: Authors. Air Connectivity | 87 Table A6.3. Instrumental Variables Regression Results, Aggregate Fare Elasticities   1 2 3 4   lpax lpax lpax lpax lfare –0.899 –0.857 –1.082 –1.6 (4.35)** –1.61 (4.38)** –1.68 lpop 0.631 0.637 0.628 0.565 (10.50)** (6.99)** (11.92)** (4.80)** ldist –0.045 0.541 –0.09 –0.65 Constant –0.836 –0.822 0.258 0.121 –0.48 –0.47 –0.13 –0.06 Observations 570 570 822 822 Chi(2) p-value 0.5 0.8 0.06 0.23 Robust F 62.6 14.6 85.6 8.4 DUMMY VARIABLES         YEAR YES YES YES YES QUARTER YES YES YES YES MARKET NO NO NO NO YEAR-QUARTER YES YES YES YES FARE CLASS YES YES YES YES YR-Q-MKT NO NO NO NO Instruments: # carrier # carrier GDP GDP   GDP GDP     Source: Authors. Table A6.4. OLS Regression Results, Fare Elasticities by Market 1 2 3 4 lfare_busi 0.344 0.386 0.354   (9.34)** (6.83)** (6.93)** (org==BRU)*lfare_busi 0.392 (6.60)** (org==CDG)*lfare_busi 0.291 (5.04)** (org==DXB)*lfare_busi 0.18 (3.20)** (org==FCO)*lfare_busi 0.287 (4.96)** (continued on next page) 88  |  Republic of Armenia: Accumulation, Competition, and Connectivity Table A6.4. OLS Regression Results, Fare Elasticities by Market (continued) 1 2 3 4 (org==FRA)*lfare_busi 0.211 (3.82)** (org==LHR)*lfare_busi 0.651 (9.38)** (org==MOW)*lfare_busi 0.436 (4.89)** (org==PRG)*lfare_busi 0.266 (3.74)** (org==VIE)*lfare_busi 0.461 (7.61)** (org==BRU)*lfare –1.31 –1.288 –1.626 (4.04)** (3.52)** (4.37)** (org==CDG)*lfare –0.962 –0.916 –0.907 (3.91)** (3.31)** (3.38)** (org==DXB)*lfare –0.616 –0.546 –0.562 (1.36) (1.4) (1.28) (org==FCO)*lfare –0.418 –0.443 –0.384 (1.43) (1.36) (1.36) (org==FRA)*lfare –0.757 –0.734 –0.53 (3.02)** (2.62)** (2.04)* (org==LHR)*lfare –1.376 –1.415 –2.721 (6.03)** (5.29)** (8.23)** (org==MOW)*lfare –1.286 –1.306 –1.33 (5.49)** (6.58)** (5.87)** (org==PRG)*lfare –1.578 –1.607 –1.332 (5.66)** (6.74)** (4.34)** (org==VIE)*lfare –1.29 –1.292 –1.724 (5.01)** (5.72)** (6.01)** Lrate –8.456 –10.366 –6.598 –9.007 (2.33)* (2.22)* –1.24 (2.57)* lpop_total 3.272 1.596 3.248 –2.018 (3.08)** (2.33)* (2.90)** (1.57) lweo_econ –0.311 0.008 –4.833 (0.29) (0.08) (4.27)** lweo_busi –0.257 1.755 –4.482 (0.24) (2.20)* (3.90)** Observations 822 366 456 822 R-squared 0.56 0.7 0.43 0.6 Source: Authors. Air Connectivity | 89 Table A6.5. Pooled OLS Regression Results, Determinants of Fares (1) (2) (3) (4) (5) (6) (7) (8) (9) lfare lfare lfare lfare lfare lfare lfare lfare lfare ldist –10.058 –10.058 0.365 0.341 –10.027 –10.027 0.367 0.344 1.125 (396.55)** (396.55)** (0.73) (0.68) (556.27)** (556.27)** (0.73) (0.68) (4.42)** lhhi 0.445 0.445 0.439 0.635 (2.85)* (2.85)* (3.53)** (4.93)** lweo_gdpcusd 2.163 2.556 0.083 0.036 2.160 2.551 0.085 0.039 0.856 (50.54)** (64.83)** (1.37) (0.80) (48.05)** (60.14)** (1.45) (0.87) (2.49)* lpop_total –0.444 –0.442 (111.55)** (145.05)** lhhi_coach 0.525 0.525 0.518 0.714 0.572 (3.35)* (3.35)* (3.24)* (4.17)** (6.55)** lhhi_disc 0.170 0.170 0.163 0.359 0.399 (1.46) (1.46) (1.18) (1.84) (5.41)** lhhi_busi 0.637 0.637 0.633 0.829 1.054 (2.61)* (2.61)* (3.91)** (11.05)** (7.10)** ls_coach 0.067 (4.45)** ls_disc 0.001 (0.03) ls_busi 0.082 (3.71)* Constant 71.456 60.258 –1.548 –2.586 69.493 58.173 –3.480 –4.370 –19.418 (96.11)** (65.05)** (0.51) (0.99) (41.35)** (33.18)** (0.92) (1.28) (3.49)* Observations 537 537 537 537 537 537 537 537 394 R-squared 0.64 0.64 0.60 0.59 0.65 0.65 0.62 0.61 0.62 DUMMY VARIABLES BOOKING CLASS YES YES YES YES YES YES YES YES YES YEAR YES YES YES YES YES YES YES YES YES QUARTER YES YES YES NO YES YES YES NO NO DESTINATION YES YES NO NO YES YES NO NO NO YEAR-Q-DEST YES YES YES YES YES YES YES YES YES Source: Authors. 90  |  Republic of Armenia: Accumulation, Competition, and Connectivity Econometric models The first pricing equation to be estimated follows the market, booking class, and time of the year, whereas the basic functional form adapted from Borenstein (1989) coefficient associated to fares can be interpreted as the and Brueckner, Dyer and Spiller (1992) using a pooled elasticity. The equation below exhibits the other vari- OLS regression. Each observation includes the aver- ables used as controls and to capture structural charac- age price paid by all passengers in a specific booking teristics of air travel demand, including any unobserv- class, as well as the total passenger count in that class, ables and specific market and time shocks, as before. for each year/quarter and market. The specification in- cludes a number of variables capturing market demand ln Paxijk = α + β1 ln DISTANCEi +β2 ln POPULATIONij + β3 characteristics (distance, income, population mass), and ln GDPij + β4 ln FAREij + β5 ln FXij + ∑z βz DTIMEj + ∑u βu factors that seemingly determine market power (con- DDESTINATIONi + ∑n βn DYEARDESTij + ∑e βe DCLASSk + εijk centration by market, and by airport, measured by the highest share from all carriers operating in that market). A similar approach is to use the varying coefficient In this particular model, a single coefficient is estimat- model to capture different own-price elasticities by ed for the market (route) concentration (captured by booking class, where each fare is interacted with the the coefficient associated to HHI). A series of dummies corresponding dummy variable. It should be noted are included to control for market specific inobserv- that the generic variable DCLASS is exactly equivalent ables, fixed effects by booking class, as well as seasonal to the booking class dummies (DECON, DDISC and shocks and market specific-time shocks. DBUSI) and enunciated in such form only due to nota- tion purposes. ln FAREijk = α + β1 ln DISTANCEi + β2 ln POPULATIONij + β3 ln GDPij + β4 ln HHIij + ∑z βz DTIMEj + ∑u ln Paxijk = α + β1 ln DISTANCEi + β2 ln POPULATIONij + βuDDESTINATIONi + ∑n βnDYEARDESTij + ∑e βeDCLASSk+ εijk β3 ln GDPij + DECON * β4 ln FAREij + DDISC * β5 ln FAREij + DBUSI * β6 ln FAREij +β7 ln FXij + ∑z βzDTIMEj + A second specification was introduced in order to ∑u βuDDESTINATIONi + ∑n βnDYEARDESTij + account for market concentration effects on fares by booking class, using a varying coefficient model (Hsiao ∑e βeDCLASSk + εijk 1986). Instead of running separate regressions for each booking class, the Herfindhal index is interacted with Now that all models have been described, it is important each booking class dummy as depicted in the equa- to turn to a number of known estimation and data related tion below. Furthermore, the highest market share at issues that might affect the estimation. We reproduce the the destination computed for all carriers operating in following from Oum, Waters and Yong (1990): a particular route is included to control for any pre- miums associated with airport market power (see also ¾¾ Intermodal competition: Air travel demand can be Stavins 1996 in addition to the mentioned articles). affected by changes in the prices and service qual- ity of other modes. For short-haul routes (markets) the relative price and service attributes of auto and ln FAREijk = α + β1 ln DISTANCEi + β2 ln POPULATIONij + train would need to be included in any model; par- β3 ln GDPj + DECON * β4 ln HHIij + DDISC * β5 ln HHIij + ticularly for short-haul markets. Failure to include DBUSI * β6 ln HHIij + DECON * β7 ln SHAREij + DDISC * β8 the price and service attributes of substitutes will ln SHAREij + DBUSI * β9 ln SHAREij + ∑z βzDTIMEj + ∑u βu bias the elasticity. For example, if airfares increase DDESTINATIONi + ∑n βnDYEARDESTij + ∑e βeDCLASSk + εijk and auto costs are also increasing, the airfare elas- ticity would be overestimated if auto costs were In order to estimate the own-price elasticities we use excluded. a log linear travel demand functional form commonly ¾¾ Market aggregation: As the level of aggregation used in the literature (see Intervistas 2006; Gillen et al increases the amount of variation in the elastici- 2003) using a pooled OLS regression approach. In this ty estimates decreases. This occurs because ag- case, the dependent variable is Passenger traffic by gregation averages out some of the underlying Air Connectivity | 91 variation relating to specific contexts. Since air or time-series although more recently panels travel market segments may differ significant- have become available. A panel is a combina- ly in character, competition and dominance of tion of cross-section and time-series—informa- trip purpose, interpreting a reduction in vari- tion on several routes for a multi-year period is ation through aggregation as a good thing a panel. Cross-sectional information is general- would be erroneous. Such estimates might ly regarded as indicating short run elasticities have relatively low standard deviations but while time-series data is interpreted as long run would be also be relatively inaccurate when elasticities. In time-series data the information used to assess the effect of changes in fares in reflects changes in markets, growth in income, a specific market. changes in competitive circumstances, for ex- ¾¾ Identification problem: In most cases only de- ample. Policy changes should rely on long run mand functions are estimated in attempts to elasticities since these are long run impacts that measure the demand elasticity of interest. How- are being modelled. Short run elasticities be- ever, it is well known that the demand function come important when considering the compet- is part of a simultaneous equations system con- itive position of firms in a highly dynamic and sisting of both supply and demand functions. competitive industry. Therefore, a straightforward estimation of only the demand equation will produce biased and Dataset inconsistent estimates. The problem of iden- tification can be illustrated by describing the Fares and Passenger Traffic process by which fares and travel, for example, The dataset comprises CRS MIDT fares and pas- are determined in the origin-destination market senger traffic for 13 markets connected to Yerevan simultaneously. To model this process in its en- by air (including Brussels, Paris, Dusseldorf, Dubai, tirety, we must develop a quantitative estimate Rome, Frankfurt, New York, London Heathrow, of both the demand and supply functions in a Moscow Dedomodevo and Sheremetyevo, Prague, system. If, in the past, the supply curve has been and Vienna), between May 2002 and April 2005. shifting due to changes in production and cost The markets were chosen on the basis of largest conditions for example, while the demand curve non-stop capacity share from Yerevan, excluding has remained fixed, the resultant intersection those segments shorter than 1400km to avoid bi- points will trace out the demand function. On ases in yield. the contrary, if the demand curve has shifted due to changes in personal income, while the This includes all traffic bookings from two economy supply curve has remained the same, the inter- class fares (coach and discount), business and first section points will trace out the supply curve. (the latter not used in the estimations though) ac- The most likely outcome, however, is movement quired from a CRS (Computer Reservation System) of both curves yielding a pattern of fare, quan- and excludes all taxes from the fare computation. It tity intersection points from which it will be dif- does not include pre-CRS methods like visiting an ficult, without further information, to distinguish airline office –common in Armenia- and post-CRS the demand curve from the supply curve or esti- methods such as direct internet purchases. mate the parameters of either. ¾¾ Cross-sectional data: In the long run demand elasticities for non-durable goods and services Other variables are larger in absolute terms, than in the short The population and per capita GDP variables were run. This follows because in the long run there obtained from IMF World Economic Outlook Data- are many more substitution possibilities that can bases. Whereas the concentration and market share be used to avoid price increases or service qual- variables were constructed with DIIO data on airline ity decreases. In effect there are more opportu- level-route capacity for all relevant periods. Dis- nities to avoid these changes with substitution tance between markets was obtained from the same possibilities. Data tends to be cross-sectional source. 92  |  Republic of Armenia: Accumulation, Competition, and Connectivity Variables FARE: average paid fare for roundtrip ticket between GDP: combined current per capita GDP (in US dollars) Yerevan and market i, for booking class k on year and of Armenia and market i on year and quarter j quarter j FX: exchange rate between Armenian Drams with mar- PAX: passenger traffic count between Yerevan and ket’s i on on year and quarter j market i, for booking class k on year and quarter j DECON, DDISC, DBUSI: dummy variable for economy HHI: Herfindahl concentration index for market i, on (coach), discount and business class passenger count/ year and quarter j (HHI=10000 indicates a single carrier fare operates in that market) DCLASS: dummy variable for economy, discount and SHARE: maximum market share of all carriers operat- business class segments k ing between Yerevd market i, on year and quarter j DTIME: year/quarter j dummy DISTANCE: distance in kilometers between Yerevan DDESTINATION: market i dummy and market i DYEARDEST: year/quarter-market dummy POPULATION: total population mass of Armenia and market i (proxied by total country population) on year and quarter j Table 6.2. Summary of Selected Studies on Air Transport Liberalization Author Tested Effects/ Methodology Results Hummels et al (2010) Effect of US Open Skies Agreements on Traffic growth in new routes following three years after the liberalization passenger traffic, based on Difference in reaches 6% and close to 9% after the third year. Traffic growth rates after Difference estimator. year 3 increase 7.2% in new routes. Piermartini and Rousova (2008) Effects of liberalization on passenger An increase in the degree of liberalization from the 25th percentile traffic, using a synthetic air liberalization to the 75th percentile (using a synthetic indicator of restrictiveness) index (ALI) as independent variable increases passenger traffic volumes between countries with direct air (WTO/QUASAR database). services by approximately 30 per cent. Traffic increases are higher when cabotage, seventh freedom, free determination of capacity and multiple designation provisions are included. Warnock-Smith and Morrell (2008) Country-pair case studies (Caribbean- Positive relationship between more liberal bilateral agreements and US). Study estimates the effects of entry and traffic/ capacity growth, suggesting a direct link between liberalization on passenger traffic (based liberalization and incoming tourism to the region. Positive statistical on US DOT T-100 database). relationship between liberalization and traffic/capacity growth; carrier entry leads to greater output and competition levels. The number of effective competitors and LCC entry has also been greater in those markets with lower entry barriers. Micco and Serebrisky (2006) Effect of Open Skies Agreements on Open Skies Agreements on average reduces airfares by 9 percent average air cargo rates based on U.S. and increases the share of imports arriving by air by 7 percent three import data. years after the OSA is signed (in developed and upper-middle income countries). Clougherty, Dresner and Oum Effect on Canadian air passenger traffic of Dual designation can increase traffic up to 280,000 passengers/year (2001) dual designation and partially liberalized for Canadian carriers and up to 270,000 for foreign carriers. Liberalized ASAs, based on panel data for 33 bilateral bilateral can increase total traffic up to 240,000 passengers/year. markets. Oluwakoya (2011) Impact of Deregulation and liberalization Freight and passenger traffic increased 54 percent and 9.4 percent per in Nigerian air transport industry. Based annum, respectively, during the period 2000 to 2004. on documentary research. Air Connectivity | 93 Annex 6.2. Summary of Selected Studies on Air Transport Liberalization (cont'd.) Author Tested Effects/ Methodology Results Button (1998) Impact of deregulation in US domestic In the decade after 1978’s Airline Deregulation Act, U.S. domestic markets since 1978’s Airline Deregulation market passenger enplanements rose by 55 percent, scheduled revenue Act. Based on documentary research. passenger-miles grew by over 60 percent, and employment in the industry increased by 32 percent. Real costs of travel fell by about 17 percent on major routes. Air travelers have gained an estimated $12.4 billion annually (in 1998 dollars) from lower fares and another $10.3 billion from reduced travel time between 1978–1998. INTERVISTAS (2006) Impact in traffic growth of liberalization Traffic growth subsequent to liberalization of air services agreements of United States-United Kingdom, intra between countries typically averaged between 12% and 35%, European Union, United Arab Emirates- significantly greater than during years preceding liberalization. In a U.K. and Germany, Australia-New Zealand number of situations, growth was at rates exceeding 50%, and in some and Malaysia-Thailand markets. Based on cases reached almost 100% of the pre-liberalization rates. documentary evidence. CAA Impact of UK-India liberalization based The capacity limit on airlines operating between India and the UK on the on documentary evidence. core routes between Delhi-Mumbai and London Heathrow more than tripled between 2004 and 2006. The number of direct services between India and the UK rose from 34 to 112 services per week. The increase in services has been provided by a combination of carriers already serving the market (British Airways, Virgin and Air India) and new entrants. Passenger numbers on direct services have doubled in the period since liberalisation, from around 87,000 to 181,000 between 2004 and 2006. The increase in capacity and competition has led to significant reductions in the fares for travel between the UK and India. ComMark Trust (2006) Impact of air transport liberalization in Monthly passenger volumes increased by 69 percent between 2000 and African countries based on documentary, 2005 over the pre-liberalisation trend on the Nairobi–Johannesburg econometric and statistical evidence. route. During the 1990s and early 2000s passenger volumes on domestic routes in South Africa increased by more than 80 percent. Liberalisation allowed for the entry of two low-cost airlines. Based on econometric evidence comprising 56 routes on 12 SADC member states, results show that air fares are 18 percent lower on liberalized routes. Impact of liberalization on passenger volumes from 1999 to 2004 on 16 routes between Johannesburg and other destinations in SADC shows that in country pairs with more liberal bilateral agreements, passenger volumes increased by an average of 23 percent, and that large, once-off increases in capacity allowed by the bilateral agreements further increased passenger volumes by an average of 12 percent. Dresner and Tretheway (1992) Impact on air fares of liberalization in US Liberal bilateral agreements had a substantial effect in fare reduction for international routes for 1976–1981. the discount economy fare segment, whereas competitive routes showed 35 percent lower fares than non competitive routes Maillebiau and Hansen (1995) Impact of liberalization in Transatlantic Liberalization increased service accessibility (measured by the total air travel demand, between US and UK, number of enplanements per year on those gateways with non-stop France, West Germany, the Netherlands services to the partner country) by 55 percent; yields are 35 percent and Italy between 1970–1989. lower. Dresner and Windle (1992) Effect of US partial liberal agreements US liberal agreements increased passenger traffic by 11 percent vis-à-vis compared to liberal agreements between partially-liberal bilateral air service agreements. 1976–1987. 94  |  Republic of Armenia: Accumulation, Competition, and Connectivity 7. Internet and Communications Technology (ICT) The development of the Armenian ICT sector has key to unlock that potential. This will require reforms to seen rapid progress in recent years. Although its size build confidence of foreign and domestic investors. It is still comparatively small, its rapid development and would be achieved through strengthening the regula- prospects attract foreign investments. The sector is cre- tory and law enforcement environment especially in the ating jobs, and 35 percent of the workers are women. areas of intellectual property and data confidentiality Armenia has a comparative advantage in a number of and promotion activities to raise awareness of foreign areas important for ICT sector development, such as a investors about the opportunities. At the same time, ef- high number of graduates of higher education and a forts should be made to reduce barriers to growth, by very competitive cost base. The ICT sector as a whole addressing the low level of competition in the telecom may be characterized as relatively matured, which pro- market, introducing a more favorable tax regime and vides the opportunity for further expansion. At the same strengthening labor force skills in line with the changing time, Armenia is facing a number of competitive disad- demands of the fast developing industry. vantages, which keeps it from benefiting from the full potential of the ICT sector. Among such disadvantag- This chapter assesses Armenia’s readiness for the fur- es are a monopolistic market structure of the telecom ther expansion of the ICT sector and identifies gaps sector, poor connectivity, lack of good office space, and and weaknesses in number of areas. The first section overall a rather high risk profile of the country. gives an overview of the status of the sector. The sec- ond section looks at its readiness for expansion based The ICT sector has been an engine of growth in on the Location Readiness Index (LRI), a tool developed many countries. Between 2000 and 2009, ICT invest- by the World Bank in partnership with McKinsey & Co. ments were more important for growth than non-ICT Armenia’s performance is being benchmarked against investments in OECD countries.95 The economic litera- India (global industry leader), USA (major market), and ture has identified multiple channels through which the Indonesia (case study country), with both the USA and ICT sector can have an impact on growth and economic Russia considered as two main destination markets. The integration. In particular, broadband infrastructure and third section highlights reform recommendations. IT-based services are recognized as key enablers for do- mestic productivity, competitiveness, job creation and economic diversification, a tool to foster cross border The IT-based Services Industry trade, foreign direct investment (FDI) and regional eco- in Armenia nomic integration. Status of the Information Technology The ICT sector could play a key role in Armenia’s in- Sector in Armenia tegration into the global economy. It holds impressive Historically, Armenia had a strong standing in tech- potential and further investments into the sector are the nological research and development activities in the region. Since 1991, the sector has shifted its focus 95 OECD, 2011. towards development of software and applications, Internet and Communications Technology (ICT)  |  95 outsourcing, IT-based services and modernizing tele- outlining the strategy is the ICT Master Strategy. It communication infrastructure. In the early 2000s, active aims to create a vibrant and sustainable ICT industry development of the IT sector began when the govern- that promotes growth in other sectors of the Arme- ment declared it as one of the main priorities for the nian economy and positions Armenia in the global country’s economic development. Nearly 80 percent knowledge economy.97 The strategy suggests lever- of the companies now active in the sector were started aging the capacities of national IT professionals and during 2000–10, both local start-ups and branches of creating a favorable environment for collaboration international companies. In 2010, the number of op- and competition among IT firms. The government erating IT companies reached 200, of which 72 were also supports ICT infrastructure, computer literacy, subsidiaries of foreign companies with a market share computer saturation and internet access, and use of of 52 percent. e-services systems. The sector is mostly oriented towards exporting Readiness for an Extension of the IT Sector software. The majority of the IT firms specialize in in- ternet services, web development and IT consulting. The Location Readiness Index (LRI) can be used Internet services generated over 34 percent of the sec- to assess Armenia’s readiness for an expansion tor’s revenues in 2010. Local companies are starting to of the IT sector. The LRI is a modeling tool devel- become more active in engineering, systems develop- oped by the World Bank in partnership with McK- ment, and research and development (R&D). In 2010, insey designed to help countries identify existing the size of the domestic market totaled $91million, gaps and weaknesses. 98 It allows policy makers to and the turnover of the software and services sector prioritize areas important for increasing the country’s reached $150 million. Most of the foreign investments attractiveness for IT investment. Six criteria are eval- in the sector come from North America. uated: talent pool availability, cost structure, qual- ity of infrastructure, key risks, overall environment, The sector is also creating jobs, with a significant and sector maturity. Scores along these six criteria share going to women. In 2008–10, the sector em- range between 1 and 5, with 1 meaning ‘extremely ployed nearly 5,000 professionals, 83 percent of which favorable’ and 5 meaning ‘not ready’. An assessment are technical specialists and 17 percent are business was conducted for Armenia in comparison with India and management specialists. Interestingly, 53 percent (global industry leader), USA (major market), and In- of the workers are employed by foreign companies donesia (case study country), with both the USA and and 35 percent of the total workers are female. The Russia considered as two main destination markets average monthly salary of IT specialists is $1,200–1,500 (Figure 7.1). which is 4–5 times higher than the average salary.96 The talent pool index shows opportunities as well The IT industry is contributing to exports, although as challenges to the growth of the Armenian IT sec- at a small scale. The sector’s contribution to total ex- tor. A competitive telecommunications market and ports reached 8.5 percent in 2010, 82 percent of which the availability of skilled talent are the most important was generated by foreign companies. The largest por- factors in the growth of an IT-based services industry. tion of exports go to the United States and Canada Based on the numbers of the 2012 Statistical Yearbook (70 percent), 19 percent go to Europe and around 8 of Armenia, there are about 34,000 graduates each percent to Russia and CIS markets. year who may be employed in the ICT industry. The talent pool assessment in the LRI diagnostic calculates The government has adopted a strategy to expand the IT sector, with some specific initiatives already being implemented. The main policy document 97 United Nations Asian and Pacific Training Center for Informa- tion and Communication Technology for Development, “ICT Mas- ter Strategy for Republic of Armenia”, http://www.unapcict.org/ 96 The Open Society Institute, EurasiaNet.org, “Armenia ecohub/resources/ict-master-strategy-for-republic-of-armenia. aimed to become post-soviet Silicon Valley”, http://russian.eur- 98 The World Bank, Location Readiness Index (LRI) Toolkit, asianet.org/node/59057. http://www.infodev.org/en/Publication.986.html. 96  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 7.1. Overall Location Readiness Index (LRI) for IT/ITES Generalists - Data Generalists - Voice Location Readiness Location Readiness Index Index 3.5 Industry Maturity 5.0 3.1 Talent Industry Maturity 5.0 3.0 4.4 Talent 4.2 3.0 2.3 4.2 2.8 1.8 3.1 2.7 2.8 1.9 1.8 1.0 1.0 1.0 1.0 1.9 1.6 1.5 3.5 1.6 3.7 Environment 3.0 1.4 1.5 2.1 Cost Environment 3.7 3.0 1.4 1.5 1.6 2.2 Cost 3.7 2.9 2.5 2.5 2.9 2.9 2.9 3.3 3.3 3.3 3.3 4.1 4.1 Risk Infrastructure Risk Infrastructure Armenia LRI=3.08 India LRI=1.8 Armenia LRI=3.18 India LRI=2.3 Indonesia LRI=3.13 USA LRI=1.9 Indonesia LRI=3.52 USA LRI=1.9 Knowledge Process IT Services Location Readiness Location Readiness Index Index 3.7 3.5 Industry Maturity 5.0 Industry Maturity 5.0 4.9 Talent 3.2 4.8 Talent 3.0 4.7 3.2 2.0 3.8 4.3 2.8 2.2 3.3 2.8 1.6 1.0 2.2 1.1 1.0 1.6 2.0 1.6 1.8 2.3 4.8 3.0 2.2 3.0 1.4 1.5 Environment 1.4 1.5 1.9 Cost Environment 3.7 Cost 3.7 4.8 2.5 2.5 2.9 2.9 2.9 2.9 3.3 3.3 3.3 3.3 4.1 4.1 Risk Infrastructure Risk Infrastructure Armenia LRI=3.10 India LRI=2.2 Armenia LRI=3.12 India LRI=2 Indonesia LRI=3.72 USA LRI=3 Indonesia LRI=3.52 USA LRI=3.1 Source: Authors. the: (i) suitability; (ii) willingness; (iii) accessibility; and Armenia has an advantage in voice services rel- (iv) trainability of university graduates in subjects that ative to data and knowledge processing and IT may be of interest to IT/ITES companies. Calculations services. With a score of 4.2, Armenia appears to be were carried out for each of the four traditional ICT better endowed than Indonesia in terms of the pro- business lines: data processing, voice processing, portion of graduates suitable for voice services. This is knowledge processing and IT services. largely due to a relatively high number of graduates in Internet and Communications Technology (ICT)  |  97 Figure 7.2. Armenia’s Ready-to-Hire Population Graduate Total Suitability Accessibility Willingness Ready to hire Trainability Trainable category graduates (percent) (percent) (percent) (thousands) (percent) (thousands) (thousands) Generalists 26 50 80 70 70 7.3 16.5 Data Generalists 26 50 80 70 7.3 70 16.5 Voice Knowledge 6.5 50 80 70 1.8 70 4.1 Processors IT Specialists 1.6 50 80 70 0.4 70 1.0 TOTAL 18.6 38.1 Source: Authors. general disciplines who speak well Russian and English Armenia has a very competitive cost base, largely (about 7,300). The talent pool index for data services due to the relatively low wages. Four cost categories is assessed at 4.2 as well, but this is much lower com- are considered: labor; facilities; IT/Telecommunica- pared to Indonesia (3.1), India (1.0) and the USA (1.0) tions; and selling, general, and administrative (SG&A) for the same group. Knowledge processing (4.81) and expenses (Figure 7.3).100 Labor costs, which account IT Services (4.95) are two groups where Armenia has for more than half of the total cost, include not only to improve the most in terms of talent pool readiness. the salaries for direct employers, but also salaries for management and support staff. Note that the compar- Although Armenia produced a large number of high- atively low cost of employment of engineers in the IT er education graduates, only a small number is read- sector is due to their low support and management ily employable in the IT sector. Armenian tertiary insti- expenses. This gives the ICT sector in Armenia a very tutions produce around 6,500 graduates with degrees prominent position. in business management and economics who are of in- terest to the knowledge processing sector, and anoth- Despite decreasing connectivity costs, Armenia re- er 1,600 with IT related degrees employable in the IT mains at a competitive disadvantage because of the sector. Nonetheless, the ready-to-hire population for monopolistic market structure of the telecom sec- knowledge (1,800) and IT groups (500) is very small. Of tor. After price cuts in recent years for broadband, the the 34,000 graduates with potential to be employed connectivity costs dropped significantly. According to in the ICT sectors, only 18,600 are actually ready to be hired, and 38,100 could become suitable if given train- ing of a maximum of six months (Figure 7.2)99 100 The cost index calculation of the LRI is made up of two main components. The first component, “hourly cost of doing business,” takes into account the hourly cost per full time work- 99 The suitability, accessibility, willingness, and trainability esti- er doing a particular job needed to keep an IT-based services mates are based on the insights from the interviews with compa- firm running. The second component measures the incentives nies such as EBS Llynx, OMD, National Instruments and Integrator offered by the government authorities to companies operating conducted by the Enterprise Incubator Foundation (EIF, 2010). in the IT/ITES industry. 98  |  Republic of Armenia: Accumulation, Competition, and Connectivity Figure 7.3. Armenia Cost of Operations (full time equivalent per hour, in US dollars) Generalists - Data Generalists - Voice Knowledge Process IT Services Labor 5.57 6.70 8.14 4.7 Facilities 3.13 .049 3.77 4.06 IT/Telecommunications 0.5 5.57 0.5 0.5 SG&A 1.08 1.20 1.45 1.11 TOTAL 10.2 11.3 13.8 10.3 Source: Authors' calculations. TeleGeography, a 1Mbps international transit TCP/IP takes into account the readiness of transport such as traffic service reached the price of $217.2 per month. quality of roads, railways, ports, and air transportation. However, the Armenian communications sector still Fixed-broadband penetration is low (around 3 per- suffers from a lack of competition on the domestic cent), but there are many positive signs for growth in wholesale internet market. The two monopolistic play- Armenia’s broadband sector. The Ministry of Economy ers, as reported by the State Commission for the Pro- of Armenia plans to build and expand a mixture of fi- tection of Economic Competition of Armenia, are PTO ber-optic, WiMAX, and satellite technologies working ArmenTel and FiberNet Communications. to develop the country’s high-speed broadband net- work at a cost of approximately $24 million.102 The LRI analysis suggests that the quality of in- frastructure in Armenia is favorable. The quality of Armenia’s risk profile is on the higher side. The coun- infrastructure was measured along four different cate- try risk component of the LRI measures three areas: gories, collecting a total of nine indicators to analyze transparency, stability, and predictability of a coun- the availability, quality and reliability of Armenia’s tele- try’s regulatory environment (regulatory risk); macro- communications, real estate, power supply, and trans- economic and currency stability and capital freedom portation infrastructure. With an overall score of 2.45, (country investment risk); and the adequacy of intellec- Armenia performs better than Indonesia (2.91) and In- tual property and data protection (data risk). With this dia (3.28), but its infrastructure readiness has not yet decomposition, Armenia’s overall risk profile is high reached the level of the USA (1.45), which is a model compared to India and USA, but is lower than Indo- country for infrastructure development. nesia’s. Armenia needs major improvements in trans- parency and fairness of the legal system, the business Armenia suffers from poor connectivity, lack of regulatory environment, data risk, currency exchange good office space, and inadequate roads and rail- stability, bureaucracy and macroeconomic Stability. ways. Armenia ranked 71st (out of 144 countries) in terms of infrastructure development in the latest Armenia needs further improvements of business Global Competitiveness Report,101 which in addition and living environment. By combining an assessment to communications and power supply infrastructure of general government support of business (including 101 World Economic Forum, The Global Competitiveness Re- 102 See port 2012–2013, http://www3.weforum.org/docs/WEF_Global- http://www.itu.int/ITU-D/ict/newslog/Ministry+Reveals+High+- CompetitivenessReport_2012–13.pdf Speed+Broadband+Network+Plan+Armenia.aspx Internet and Communications Technology (ICT)  |  99 bureaucratic burden and corruption), overall business data and intellectual property protection would in- environment, quality of life (including desirability of crease investor confidence. Entrepreneurs in Armenia location, disease burden, and crime), and accessibil- note that although the necessary laws and regulations ity to the main markets where services are expected may already be in place, their implementation is un- to be delivered (including flight time and frequency), even. Partially, these challenges can be addressed Armenia appears to be better performing than Indo- through closer partnerships with industry associations nesia and India, but it is behind the US. In particular, and research and analytical organizations which regu- Armenia needs more progress in reducing bureaucrat- larly collect relevant data, organize customer surveys ic barriers, adopting employer-friendly labor laws, and and possess hands-on knowledge on the day-to-day decreasing its economic distance from the major IT business processes in the domestic market. markets through appropriate stimulating measures. Support for competition and innovation. Compe- The IT sector in Armenia seems to be fairly mature, tition policies need to make sure that measures are and hence provides an opportunity for expansion. taken to promote contestability and reduce barriers to The maturity index describes how well developed the entry. Currently, the industry focuses mostly on devel- country’s IT-based services industry already are, how oping software, applications, and providing web-de- many IT-based businesses are being done, and wheth- sign services. Stimulating the internal demand for ad- er there is an active business association to coordinate vanced IT products and incentivizing high-value ser- private and public sector activity and promote the in- vices could encourage the ICT sector. Higher quality dustry to investors. The Enterprise Incubator Founda- and more advanced IT products would raise demand tion (EIF) reports that ICT GDP represents 5.4 percent for Armenian IT products from abroad. Export promo- of Armenia’s total services GDP. This figure is very high tion of Armenia IT products would raise awareness of even compared to India and US where it constitutes foreign investors about the advantages and opportu- around 3 percent. According to the EIF, Armenian IT nities in the Armenian market. industry is one of the most dynamic and promising sectors of the economy.103 However, the percentage of Providing a more favorable tax regime and other employees in ICT industry as part of Armenia’s total forms of support. Tax breaks can further improve the employees in non-agriculture sectors represents only competitiveness of Armenian IT products abroad and 1.6 percent, as reported by the EIF. This is low com- also in the domestic market. A special tax regime could pared to India (4.5 percent) and USA (6.6 percent), and be defined for technology start-ups, and tax breaks to may be caused by a short supply of qualified special- build, maintain, and improve R&D facilities. Promoting ists in the country. the Armenian IT sector abroad will help attract more FDI and venture investors looking for promising op- portunities in the emerging markets. Private compa- Policy Recommendations nies’ donations and/or assistance to educational insti- The ICT sector has shown impressive potential for tutions should be exempted of VAT. For the sake of development, but innovative strategies could help raising competitiveness of the Armenian technology it to break into the league of leading destinations. professionals, private companies’ training costs made We will in the following present recommended actions outside of Armenia should be considered as expenses around areas of policies, processes and institutions, ac- deductible from revenue. cess to finance, infrastructure, and skills development. The Armenian diaspora has been an important Strengthening intellectual property rights protec- source of FDI and has demonstrated keen inter- tion and law enforcement. Although initial safeguards est in supporting the IT industry. The government protecting business data are already in place, stronger may consider strengthening ties with the diaspora in their efforts to expand in international markets, and promote the Armenian IT industry abroad. It may also 103 Enterprise Incubator Foundation. “Armenian Information consider allowing 100 percent FDI in ICT industry and Technology Sector, Software and Services”. 2010 Industry Re- port. IT parks. 100  |  Republic of Armenia: Accumulation, Competition, and Connectivity Introducing additional measures to improve labor levels, including student exchanges, management productivity and increase investor confidence in enrichment programs should be encouraged. Compa- the industry. As another important step, PPP models nies should be encouraged to incorporate employee may be considered to strengthen revenue streams and training in employee contracts to encourage individu- help jumpstart the ICT industry. Shortening the time al and workforce skill growth. Technical skills could be needed for export and import of technological prod- developed through collaboration with foreign venture ucts is key to decreasing the economic distance be- capital and incubating firms (e.g. Y-Combinator, Beta- tween Armenia and major global IT hubs. works, IdeaLabs) and linking aspiring entrepreneurs in Armenia to global start-ups. This will allow them to Targeted and general infrastructure growth has ac- acquire cutting-edge technology and business skills in companied the rise of countries as an outsourcing the process and provide them experience working in destination for IT-based services. Increased com- an international environment, which is critical for suc- petition in the telecom sector lowers the cost of ICT cess in today’s global market. infrastructure. Increasing bandwidth and improving connectivity will allow for faster and more secure infor- To summarize, Armenia has seen quite impressive mation exchange and will improve the overall business developments of its IT-based services sector, but processes. Stimulating infrastructure sharing can help it may still need to adopt targeted strategies to make a better use of available infrastructure and low- break into the league of leading destinations. Build- er infrastructure investments costs for industry incum- ing the right skills, investment incentives and institu- bents. Other targeted infrastructure developments tional forms, can provide the foundation for IT-based for IT-based services would include the development services industry development. In this context, Arme- of technology parks. Armenia could learn from other nia may need to: countries how ICT parks have been developed. For ex- ample, Software Technology Parks of India (STPI) has ¾¾ Improve intellectual property protection and played a seminal role in establishing over 20 technol- ensure business data confidentiality, as well as ogy parks throughout the nation. Other countries are strengthen relevant regulation and law enforce- establishing ICT parks that could help attract foreign ment to raise the confidence of foreign and do- investment and foster growth of a local IT-based ser- mestic investors in the country’s IT-based services vices industry. sector. ¾¾ Intensify its export and industry promotion efforts to IT industry would benefit from an increased supply raise awareness of foreign investors about the op- of qualified technical and business professionals portunities in the Armenian IT-based services market and improved quality of education. The curricula at and as a result increase the country’s involvement in Armenian universities may be revised to incorporate the global market for IT products and services. the changing demands of the fast developing indus- ¾¾ Create incentives for the private sector to engage try. More continuous education and training programs with higher education institutions to better incor- will allow professionals to stay on the cutting edge of porate the changing demands of the fast devel- the industry. Armenia may consider more investments oping industry through developing joint programs in higher education institutions, e.g. equipment infra- and initiatives. structure, training, curriculum resources and support ¾¾ Work further to identify specific market niche op- particularly outside the capital region. 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