Armenia The Second Systematic Country Diagnostic Beyond Boundaries: Unlocking Potential for a Sustainable Tomorrow 2023 Contents Executive Summary ....................................................................................................2 A rapidly changing context .......................................................................................................................................... 2 Key challenges to inclusive and sustainable growth .................................................................................................. 3 Leveraging opportunities ............................................................................................................................................. 5 1. Introduction ............................................................................................................7 2. Background: Sociopolitical Events and Key Reforms since 2017 ......................... 10 3. Trends in Growth, Poverty, and Shared Prosperity .............................................. 12 3.1. Growth Trends .................................................................................................................... 12 3.2. Poverty Trends .................................................................................................................... 16 3.3. Equity Trends ...................................................................................................................... 18 4. Drivers of Growth and Poverty Reduction ........................................................... 19 4.1. Drivers of Growth ............................................................................................................... 20 4.2. Drivers of Poverty Reduction .............................................................................................. 28 5. Key Challenges to Resilient, Sustainable, and Inclusive Growth .......................... 34 5.1. Vulnerability to Shocks and Environmental Risks ............................................................... 35 5.1.1. Fragility and the Risks of Conflict .................................................................................................................... 35 5.1.2. Vulnerability to Economic Shocks ................................................................................................................... 37 5.1.3. Climate Change, Environmental Risks, and Natural Hazards ........................................................................ 40 5.1.4. Risk Differentiation .......................................................................................................................................... 43 5.1.5. Vulnerable Populations and Building Resilience ............................................................................................ 43 5.1.6. Governance and Institutional Bottlenecks – A Related Example in the Water Sector ................................ 45 5.1.7. Binding Constraints.......................................................................................................................................... 45 5.2. Accessing Markets and Trade Integration .......................................................................... 46 5.2.1. Trade Integration and Global Value Chains.................................................................................................... 46 5.2.2. Infrastructure and Border Management ........................................................................................................ 48 5.2.3. Digital Access ................................................................................................................................................... 53 5.2.4. Diasporas as a Catalyst for Enhancing Connectivity ...................................................................................... 54 5.2.5. Governance and Institutional Bottlenecks – A Related Example in the Digital Sector ................................ 55 5.2.6. Binding Constraints.......................................................................................................................................... 56 5.3. Quality of Human Capital .................................................................................................... 56 5.3.1. Access to Learning and Relevant Skills ........................................................................................................... 57 5.3.2. Access to Health Services ................................................................................................................................ 59 5.3.3. Access to High-Quality Jobs ............................................................................................................................ 60 5.3.4. Governance and Institutional Bottlenecks – A Related Example in the Health Sector ............................... 62 5.3.5. Binding Constraints.......................................................................................................................................... 63 5.4. Private Sector Development ............................................................................................... 63 5.4.1. Sectoral Productivity ....................................................................................................................................... 63 5.4.2. Access to Finance and Financial Inclusion ...................................................................................................... 67 i 5.4.3. Competition and Contestability ...................................................................................................................... 71 5.4.4. Governance and Institutional Bottlenecks – A Related Example in Public Procurement ........................... 72 5.4.5. Binding Constraints.......................................................................................................................................... 73 5.5. Cross-Cutting Theme: Governance, Institutions, and Data................................................. 73 5.5.1. Quality of Institutions ...................................................................................................................................... 73 5.5.2. Government Effectiveness .............................................................................................................................. 75 5.5.3. Investment in Data .......................................................................................................................................... 76 5.5.4. Binding Constraints.......................................................................................................................................... 76 6. Policy Priorities and High-Level Outcomes .......................................................... 77 6.1. Approach to Prioritization and Results ............................................................................... 77 6.2. High-Level Outcomes .......................................................................................................... 79 7. References ........................................................................................................... 82 8. Appendixes........................................................................................................... 88 Appendix A. Selected Actions and Policy Reforms since 2017................................................... 88 Appendix B. Government 2021–26 Program (Armenia 2021–26) ............................................. 91 Appendix C. Findings of SCD1 .................................................................................................... 93 Appendix D. Characteristics of the Poor .................................................................................... 94 Appendix E. Selection of Peer Countries.................................................................................... 96 Appendix F. Main Sources of Information and Empirical Data .................................................. 98 Appendix G. Findings and Results from the Stakeholder Consultations .................................... 99 Appendix H. International Benchmarking for Prioritization ..................................................... 103 Appendix I. Call for Papers: Sustainable Economic Growth and Poverty Reduction in Armenia ................................................................................................................................................. 109 Appendix J. Disaster Risk Management Measures Taken after the 1988 Earthquake............. 110 Appendix K. Social Protection System to Build Resilience ....................................................... 111 Appendix L. The Gravity Model to Estimate Export Potential .................................................. 113 Appendix M. Justice Sector and the Private Sector ................................................................. 114 Appendix N. Knowledge Gaps .................................................................................................. 115 Figures Figure 1. Key Constraints and Policy Priority Areas ......................................................................... 9 Figure 2. GDP Growth, Armenia .................................................................................................... 13 Figure 3. GDP per Capita, Peer Comparison .................................................................................. 13 Figure 4. Unemployment............................................................................................................... 15 Figure 5. Employment and Value Added, by Sector ...................................................................... 15 Figure 6. Participation and Employment Rates, 2019 ................................................................... 15 Figure 7. Youth versus Adult Employment Rates .......................................................................... 15 Figure 8. GDP Growth and Emissions Growth ............................................................................... 16 ii Figure 9. Trends in Poverty and GDP ............................................................................................. 17 Figure 10. Poverty by Income Levels, Most Recent Year Available ............................................... 17 Figure 11. Growth Elasticity of Poverty ......................................................................................... 18 Figure 12. Growth Incidence Curve, 2010–16 versus 2016–21..................................................... 18 Figure 13. Shared Prosperity, 2010–16 versus 2016–21 ............................................................... 18 Figure 14. Growth Incidence Curve, 2020–21 ............................................................................... 19 Figure 15. Gini Index...................................................................................................................... 19 Figure 16. Household Budget Allocation 2021 .............................................................................. 19 Figure 17. Contribution to Growth, Demand Side ......................................................................... 20 Figure 18. GDP Structure, Supply Side........................................................................................... 20 Figure 19. Growth Decomposition, Armenia, 2000–22 ................................................................. 21 Figure 20. New Businesses Registered, Armenia, 2010–20........................................................... 21 Figure 21. Gross Capital Formation ............................................................................................... 22 Figure 22. Capital Expenditure, 2016–21 Average ........................................................................ 22 Figure 23. Net FDI Inflows, Armenia.............................................................................................. 22 Figure 24. Demographic and Labor Force Trends, Armenia .......................................................... 22 Figure 25. Growth Decomposition of per Capita Value-Added Growth, Armenia ........................ 23 Figure 26. Sectoral Contribution to GDP Growth, Armenia, 2012–21........................................... 23 Figure 27. Exports of Goods and Services ..................................................................................... 24 Figure 28. Goods Exports, by Destination ..................................................................................... 24 Figure 29. Economic Complexity Index ......................................................................................... 25 Figure 30. New Product Discoveries .............................................................................................. 25 Figure 31. Exports, by Product Type, Armenia .............................................................................. 25 Figure 32. Goods Imports, by Source, Armenia ............................................................................. 26 Figure 33. Commercial Service Exports, Armenia and Peer Countries, 2019 ................................ 26 Figure 34. Commercial Service Export Performance, Excluding Travel and Transport, Armenia and Peer Countries, 2005 = 100 ........................................................................................................... 26 Figure 35. Benchmarking FDI Net Inflows ..................................................................................... 27 Figure 36. Armenia and Peers: Stock of FDI (% of GDP) ................................................................ 27 Figure 37. FDI Stock in Armenia (by Country)................................................................................ 27 Figure 38. Greenfield Investment Projects, Armenia .................................................................... 27 Figure 39. Top Sectors for Greenfield FDI, Number of Projects .................................................... 28 Figure 40. Top Three Sectors by FDI Inflows, 2014–21 ................................................................. 28 Figure 41. Decomposition of Income Poverty Reduction .............................................................. 29 Figure 42. Returns to Schooling .................................................................................................... 30 Figure 43. Sector of Employment by Poverty Status, 2021 ........................................................... 30 Figure 44. Regional Poverty Rates ................................................................................................. 31 Figure 45. Distribution of the Poor, by location ............................................................................ 31 Figure 46. Rural-Urban Divide, Accessibility and Human Capital Outcomes ................................. 32 Figure 47. Educational Outcome: Harmonized Test Scores, by Poverty Status............................. 32 Figure 48. Health Outcome: Termination of Usual Activities, by Poverty Status .......................... 32 Figure 49. Deprivation in Access to Services (%) ........................................................................... 33 Figure 50. Opportunities in Labor Market, by Poverty Status (%) ................................................. 33 Figure 51. Barriers to Growth and Poverty Reduction .................................................................. 34 iii Figure 52. Evolution of Key Challenges for Inclusive and Sustainable Growth from SCD1 to SCD2 ....................................................................................................................................................... 35 Figure 53. GDP Growth in Armenia and Russia and Oil Price ........................................................ 37 Figure 54. Major Imported Agrifood Commodities and Armenia’s Dependency on Supplies from Russia and Ukraine in 2021 ........................................................................................................... 37 Figure 55: Armenia’s Estimated Missing Exports .......................................................................... 38 Figure 56. Inflation and CBA Policy Rate ....................................................................................... 39 Figure 57: Comparison of Growth and Balance Correlations: Correlation Coefficient between Growth and Actual/Structural Balance .......................................................................................... 39 Figure 58. Evolution of Rigidity in Armenia, 2016-2021 ................................................................ 40 Figure 59. Evolution of High Rigidity ............................................................................................. 40 Figure 60. Global Value Chain Upgrading: Per Capita Exported Domestic Value Added, by Country, 2015 ................................................................................................................................ 48 Figure 61. Logistics Performance Index, Armenia ......................................................................... 49 Figure 62. Logistics Performance Index 2023, Armenia versus Peers ........................................... 49 Figure 63. Delays in Clearing Trade Goods through Customs ....................................................... 49 Figure 64. Human Capital Index, Armenia and Peers, 2020 .......................................................... 57 Figure 65. Learning-Adjusted Years of Schooling, Armenia and Peers, 2019 ................................ 57 Figure 66. Prevalence of Stunting, Height for Age ........................................................................ 57 Figure 67. Employment by Educational Attainment (1,000s)........................................................ 58 Figure 68. Average Share of Time Allocated to Labor and Domestic Work, Weekday .................. 59 Figure 69. Out-of-Pocket Expenditure (as % of current health expenditure) ................................ 60 Figure 70. Unemployment Rate (% of Total Labor Force)) ............................................................. 61 Figure 71. Share of the Labor Force Working 20 or More Hours a Week with a Contract............ 61 Figure 72. Share of Youth Not in Education, Employment, or Training (% of population ages 15 – 29) ................................................................................................................................................. 62 Figure 73. Labor Productivity: Output per Worker........................................................................ 64 Figure 74. Tourist Arrivals and Revenues 2010-2022 .................................................................... 66 Figure 75. ICT Service Exports (BoP) .............................................................................................. 66 Figure 76. Firms Experiencing Electrical Outages .......................................................................... 67 Figure 77. Main Obstacles to Doing Business ................................................................................ 67 Figure 78. Obstacles to Doing Business, by Firm Size .................................................................... 67 Figure 79. Credit to the Private Sector .......................................................................................... 68 Figure 80. Sensitivity of Investment to the Cost of Credit ............................................................. 69 Figure 81. Interest Rates on Lending ............................................................................................. 69 Figure 82. Organization of the Market and Competition, Armenia, 2016–22............................... 71 Figure 83. Organization of the Market and Competition, Armenia versus Peers, 2022 ................ 71 Figure 84: Manufacturing Market Structures ................................................................................ 72 Figure 85: Proportion of Oligopolistic Market Structures in Armenia’s Manufacturing Sector .... 72 Figure 86. Government Effectiveness, Armenia and Peers ........................................................... 75 Figure 87. Rankings of Main Areas of Governance, Armenia, 2016–20 ........................................ 75 Figure 88. SCD Prioritization Approach ......................................................................................... 77 iv Tables Table 1. Years of Schooling ............................................................................................................ 30 Table 2. Binding Constraints for Vulnerability to Shocks and Environmental Risks ....................... 46 Table 3. Proportion of Freight Carried by Rail ............................................................................... 51 Table 4. Binding Constraints for Accessing Markets and Trade Integration .................................. 56 Table 5. Human Capital Index, Armenia, 2012, 2017, and 2020 ................................................... 57 Table 6. Binding Constraints to Addressing the Low Quality of Human Capital ............................ 63 Table 7. Binding Constraints for Enhancing Private Sector Development ..................................... 73 Table 8. Binding Constraints for Addressing Institutional Quality and Governance Bottlenecks .. 76 Table 9. Evolution of Policy Priority Areas ..................................................................................... 78 Table 10. High-Level Outcomes ..................................................................................................... 81 Boxes Box 1.Terminologies Used in SCD2 .................................................................................................. 8 Box 2. The Velvet Revolution......................................................................................................... 11 Box 3. Structural Factors of Fragility, Risk, and Resilience............................................................. 36 Box 4. Governance for Digital Transformation .............................................................................. 55 Box 5. Justice Sector Reforms........................................................................................................ 74 Maps Map 1. International Roughness Index, Armenia 2019 ................................................................. 50 Map 2. Accessibility to Yerevan ..................................................................................................... 50 v Acknowledgments This Systematic Country Diagnostic was led by Léa Hakim (Senior Economist, EECM1), Natsuko Kiso Nozaki (Economist, EECPV), and Alan Fuchs Tarlovsky (Lead Economist, EMNPV). The core team also included María Fernanda González Icaza (ET Consultant, EECPV) and Diego Gabriel Lestani (Consultant, EECPV). Below is a full list of focal points and Armenia SCD team members. The report was prepared under the guidance of Rolande Pryce (Country Director, ECCSC), Sebastian-A Molineus (former Country Director, ECCSC), Carolin Geginat (Country Manager, ECCAR), Antonio Nucifora (Practice Manager, EAWM2), Salman Zaidi (former Practice Manager, EECPV), and Ambar Narayan (Practice Manager, EECPV). Support was also provided by Miguel Eduardo Sanchez Martin (Senior Economist, EECDR and EFI Program Leader, South Caucasus Countries), Abdulaziz Faghi (Program Leader, IECDR), Ahmet Levent Yener (Practice Leader, HECDR), Arvind Nair (Senior Economist, EECM1), Armineh Manookian (Senior Economist, EECM1), Olena Bogdan (Economist, DFCII), Artsvi Khachatryan (Consultant, EECM1). The team is also grateful to Carolina Sanchez (Director, Strategy and Operations, ECAVP) and to peer reviewers Christos Kostopoulos (Lead Economist, EECM2), Paulo Guilherme Correa (Program Leader, EAEDR), Samuel Freije-Rodriguez (Lead Economist, EECPV), Tobias Akhtar Haque (Lead Country Economist and Program Leader, ESADR), and Alexandru Cojocaru (Senior Economist, EPVGE) for the advice provided. We are grateful to all focal points and colleagues from the World Bank Global Practices, the Armenia Country Management Unit, and other teams whose inputs, comments, and contributions made this document possible. Contributors included Ranu Sinha and Smita Misra (SCAWA); Arman Vatyan and Daniela V. Felcman, Nane Harutyunyan, and Eva Maria Melis (EECG1), Francesca Recanatini and Vanessa Cheng Matsuno (ELCG2); Amali Rajapaksa, Elena Lungu, and Aymen Ahmed Osman Ali (IECT1); Arusyak Alaverdyan and Jan Joost Nijhoff (SCAAG); Joern Huenteler and Gor Khatchatryan (IECE1); Remi Pelon (IEEXI); Arman Barkhudaryan, Olga Vybornaia, and Arsen Nazaryan (IFC); Susan Josefina Vasquez Plasencia, Gianfilippo Carboni, Bexi Francina Jimenez Mota, and Gabisile Ndlovu (MIGA); Ifeyinwa Uchenna Onugha (FCI); Renata Freitas Lemos (HECED); David Jijelava and Sophia V. Georgieva (SCASO); Adanna Deborah Ugochi Chukwuma and Artemis Ter Sargsyan (HECHN); Lucian Bucur Pop and Lucia Solbes Castro (SPJ); Nora Mirzoyan and Tafadzwa I. Dube (SCAUR); Charles Pierre Marie Hurpy and Himmat Singh Sandhu (IDD01); Elena Strukova Golub, Irina Ghaplanyan, Madhavi M. Pillai, and Anita Hafner (SCAEN); Nadia Fernanda Piffaretti (GTFS1); and Cristina Constantinescu and Mike Nyawo (ETIRI). The team is also grateful for the support of Christina Leb (Senior Counsel, LEGEN), Arpine Azaryan (Program Assistant, ECCAR), Gayane Davtyan (Program Assistant, BPSSE), Nune Gevorgyan (Consultant, ECCAR), Irina Tevosyan (Operations Officer, ECCAR), Armanda Carcani (Program Assistant, EECPV), Minna Hahn Tong and Robert Zimmerman for editing, and Marika Verulashvili for assistance. The team is grateful to the Government of Armenia, as well as representatives of the private sector, civil society, development partners, and academia, for their active engagement and the valuable feedback provided during the consultations held in June 2022 and May 2023. See Appendix G for results from consultations with stakeholders for further detail. vi Abbreviations and Acronyms ALMMs active labor market measures AMD Armenian dram ADB Asian Development Bank ArmStat Statistical Committee of Armenia BACI Base pour l’Analyse du Commerce International (Database for International Trade Analysis) BaTIS Balanced Trade in Services BOP/IIP Balance of Payments and International Investment Position Statistics BPM6 Balance of Payments and International Investment Position Manual, sixth edition BRI Belt and Road Initiative CBA Central Bank of Armenia CIO Chief Information Officer COVID-19 coronavirus disease 2019 CO2 carbon dioxide CPC Corruption Prevention Commission CPF Country Partnership Framework CSO civil society organization EAEU Eurasian Economic Union ECA Europe and Central Asia EEA European Environment Agency ESG environmental, social, and governance EU European Union FAO Food and Agriculture Organization of the United Nations FDI foreign direct investment FTA free trade agreement GDP gross domestic product GHG greenhouse gas GRID green, resilient, and inclusive development GSM global system of mobiles HCI Human Capital Index HLO high-level outcome ICT information and communication technology ILCS Integrated Living Conditions Survey ILO International Labour Organization ILOSTAT International Labour Organization Statistics IMF International Monetary Fund ISMB Information Systems Management Board IT information technology LCU Local Current Unit LPI Logistics Performance Index IFC International Finance Corporation IRI International Republican Institute MHTI Ministry of High-Tech Industry MoLSA Ministry of Labor and Social Affairs MRV monitoring, reporting, and verification MW megawatt vii NCD noncommunicable disease NDC nationally determined contribution NEET not in education, employment, or training OECD Organisation for Economic Cooperation and Development PHC primary health care PPP purchasing power parity PV photovoltaic SCD Systematic Country Diagnostic SMEs small and medium enterprises SOE State Owned Enterprise STEM science, technology, engineering, and mathematics TFA Trade Facilitation Agreement TFP total factor productivity UMIC upper-middle-income country UNCTAD United Nations Conference on Trade and Development UNICEF United Nations International Children’s Emergency Fund WEF World Economic Forum WDI World Development Indicators WHO World Health Organization WTO World Trade Organization viii Executive Summary The Systematic Country Diagnostic (SCD) provides an assessment of the constraints Armenia should address and the opportunities it can embrace to accelerate progress toward the twin goals of ending extreme poverty and promoting shared prosperity. The first-generation SCD in Armenia, published in 2017, highlighted the need for a new growth model grounded in greater productivity, and it identified four main related challenges: (1) poor external sector performance, (2) low private sector productivity, (3) insufficient labor productivity, and (4) key macroeconomic, environmental, and microeconomic vulnerabilities. This second-generation SCD looks into the future by reflecting on the five years that have transpired since 2017. It finds that the challenges identified in SCD1 remain valid, while it highlights new challenges related to fragility, conflict, and violence. It also finds that governance, institutional capacity, and investment in data are cross-sectoral constraints. A rapidly changing context Since 2017, Armenia has seen significant internal and external changes including the Velvet Revolution, an event that led to a dramatic transformation of political sentiments in Armenia. Armenian society’s growing discontent with their government had been building for several years due to perceptions of systemic corruption and a lack of social and political reform. Mass citizen engagement led to a peaceful transition of power in April 2018 which boosted the democratic aspirations of the Armenian people and markedly changed the expectations of the population. The Velvet Revolution also ignited fresh momentum for renewed growth. The new government implemented a range of economic and governance reforms with a focus on bold anti-corruption and justice sector reforms. Pro-competition measures and gains in market liberalization led to gradual improvements in the business environment. Fiscal reforms included tax administration and tax policy reforms which led to an increase in revenues to 23.2 percent of GDP in 2022 and supported deficit containment. Overall, Armenia has made important development gains since 2017, achieving upper-middle income status while demonstrating resilience to economic shocks that have had a relatively limited impact on poverty levels. Government mitigation measures helped contain larger shocks, and the increase in poverty due to the onset of COVID-19 and the military conflict with Azerbaijan in 2020—the twin shocks—was confined to 0.6 percentage points, from 26.4 percent in 2019 to 27.0 percent in 2020. Extreme poverty remained low between 1 percent to 1.5 percent during 201721. Inequality as measured by the Gini index grew slightly from 25 percent in 2020 to 28 percent in 2021 (based on the international measurement) but remains lower than most countries in the region. These improvements were driven mainly by jobs followed by social protection transfers. Improvements were also observed in non-monetary dimensions such as life expectancy and survival rates as reflected in the Human Capital Index of 0.58, higher than comparator countries such as Tunisia, Kosovo, and Bosnia and Herzegovina in 2020. 1 Armenia also made significant progress in closing the gender gap as demonstrated by the improvement in the Gender Gap Index—moving up from 98th place in 2018 to 61st place in 2023 (WEF 2023). The post-revolution euphoria came to a sudden halt in 2020 with the eruption of the military conflict with Azerbaijan in the midst of the COVID-19 pandemic, shifting public attention from the economic and governance issues that were the focus of the revolution to national security. Armenia faced the twin shocks in 2020 which resulted in one of the largest contractions in real gross domestic product (GDP) in the region. On the back of changing sentiment after the 2020 military conflict, a snap election was held in 2021, which the incumbent government won. In 2022, Russia’s invasion of Ukraine and new clashes with Azerbaijan, including in Armenian territory, added to the uncertainty. The unresolved border issues, and the proximity of forces close to the border settlements in Armenia, have weighed on economic activity. The political events of the past five years translated into highly volatile growth performance, driven mostly by consumption growth (or contraction) and reflecting a limited contribution from physical capital. Growth averaged 5.2 percent during 2017–22, but this was a period of significant volatility, with growth contracting by 7.2 percent in 2020 1 World Development Indicators database (World Bank) as of July 2023. 2 due to the twin shocks then rebounding in 2021 and 2022 (12.6 percent), supported by post-COVID-19 recovery and by Russian migrants and money flows, respectively. On the demand side, growth was driven by private consumption followed by investment then government consumption, with a smaller contribution from net exports. However, limited capital expenditures, a declining trend in foreign direct investment (FDI) during 2008–20, and decreasing domestic private investment led to limited physical capital accumulation. On the supply side, structural transformation resumed as the economy continued to shift from agriculture into services. Workers moved from the lower-productivity agricultural sector into higher-productivity industry and services. Key challenges to inclusive and sustainable growth For further poverty reduction in the coming years, job creation remains the biggest development challenge for Armenia. While the economy has been growing, it has not been creating enough quality jobs. This issue is critical, as jobs have been the main driver of poverty reduction in Armenia in the last few years. Improvements in governance and the competitive landscape since 2017 have spurred an increase in firm establishment and some, if limited, job creation. Despite these improvements, the number of good-quality jobs remains substantially lower than in other countries in the region, as indicated by a high level of informality. While 45 percent of the labor force in Europe overall had decent jobs working for 20 hours or more in a week with a contract, the rate was only 22 percent in Armenia in 2015. The challenge is also indicated by the large number of temporary emigrants seeking better employment opportunities and wages abroad. Furthermore, the share of youth not in education, employment, or training is among the highest in the region at 28 percent in 2021. 2 While unemployment has improved from the 18 percent it hovered around for much of 2008–20, it remains high at 13 percent in 2022. Decent jobs are not only scarce but also distributed unevenly, with 47.5 percent of the poor lacking access to such jobs compared to 37 percent of the non-poor in 2021. Especially among the rural poor in the agricultural sector, lack of human capital in terms of education and health has resulted in low labor productivity, hindering their ability to secure decent jobs. This challenge is exacerbated by insufficient connectivity to markets, preventing workers in remote areas from accessing resources and opportunities. The limited mobility of the workforce into higher-productivity sectors is slowing progress in poverty reduction and economic growth. Addressing the structural impediments to job creation, both from the supply and demand sides, will be critical to achieving faster and inclusive growth. On the supply side, greater investments in the skills and health of the existing and potential workforce need to be prioritized. On the demand side, Armenia needs to strengthen the competition environment and investment climate further. Exposure to shocks Lack of economic diversification in terms of trade partners and export products has been a persistent source of growth volatility that will remain a challenge in the coming years. Despite growth averaging 6.2 percent over 2000–22, this period was punctuated by two large slowdowns in growth in 2009 and 2016, largely due to Armenia’s economic structure, its exposure to commodity price fluctuations, and its limited number of trading partners. More than two- thirds of Armenia’s exports are to Russia, the European Union, China, and Switzerland. Primary products from mining— namely copper, molybdenum, and gold—have grown to about 30 percent of exports, both limiting the complexity of Armenia’s exports and exposing Armenia to commodity price shocks. Armenia’s imports are also heavily concentrated. For example, energy supply from gas relies exclusively on imports from Russia, and the high dependence on basic food items poses a risk to food security. The last five years have underscored an increased vulnerability to fragility and conflict. Armenia’s GDP shrank by 7.2 percent, and exports fell by 34.0 percent in 2020 due to the 2020 twin shocks. While Russia’s invasion of Ukraine in 2022 has affected domestic consumption and foreign trade positively, it has also placed upward pressure on fuel, housing and food prices, and affected future opportunities for inclusive growth. These factors, coupled with some volatility stemming from shocks, have led to declining private and public investment rates and FDI which have adversely affected the level of potential growth and economic efficiency. Moreover, as this SCD2 went to print, Armenia was 2 ArmStat Labor Force Survey. 3 experiencing the influx of more than 100,000 displaced ethnic Armenians from Nagorno-Karabakh 3 as a result of a military operation by Azerbaijan. Integrating them into the Armenian society and economy poses a new challenge. Climate change and environmental and natural disasters represent additional sources of risk to Armenia’s prospects for sustainable growth. Such events would not only affect overall growth but are also expected to have distributional impacts that could disproportionately hurt the poor. The average temperature in Armenia has risen more than the global average in recent years, with an increasing rate of acceleration. Sectors such as agriculture, mining, energy, water, and waste management are not sufficiently prepared to adapt to these risks. Moreover, despite some progress and efforts by the government, the disaster risk management system is not well prepared to safeguard the population from shocks such as floods, heat waves, droughts, and earthquakes, to which Armenia is especially prone. Armenia has shown some resilience to shocks amid sound and improved macroeconomic management. Estimates indicate that fiscal policy has contributed to reduced poverty incidence and lower inequality, although it has not been as effective at stimulating short-run growth (World Bank 2023b). In 2020, for example, government mitigation measures helped contain the 2020 twin shocks, with measures to shield both households and firms. Assistance included direct cash transfers to households and workers, wage subsidies, utility subsidies, tax benefits for businesses, state-sponsored loans, and higher investment. Fiscal policy has been countercyclical and progressive, and the measures helped mitigate impoverishment and unemployment. As a result, the poverty rate increased by less than one percentage point in 2020. Real GDP growth rebounded to 5.7 percent in 2021. Nevertheless, resilience to shocks from fragility and conflict, economic causes, and climate change needs to be strengthened to end extreme poverty and boost shared prosperity. The whole population is vulnerable to these shocks, especially people in rural areas, women and girls, the displaced population, and international migrants providing remittances. Increased resilience could be achieved through several actions. For example, to diversify the economy, Armenia can enhance efforts to build on its existing trade relationships and diversify trade products—for example, based on its comparative advantage in metal products, textiles and apparels, food and beverages, and other manufacturing—and trade partners as well as raise the competitiveness of export products and value chain development. To increase resilience to fragility and conflict, Armenia can strengthen emergency preparedness and service delivery for border areas and enhance the registry and delivery mechanisms for social protection. To mitigate exposure to climate change and environmental risks, Armenia will need to adapt to climate change and natural disasters by scaling up risk prevention systems and ramping up climate-smart energy, agriculture, and mining sectors. It will also need to reduce pressures on natural capital by scaling up investments in energy efficiency and renewable energy and by better managing air pollution and land and forests. Structural bottlenecks to growth and inclusion Access to markets within and outside of Armenia is constrained, both physically and digitally. Armenia is a landlocked country (with two borders closed for political reasons) in a region of difficult topography and geopolitical tensions, which constrains access to regional and international trade and integration. Armenia is only exporting a small share of its potential and stands to gain from increased trade from full effective implementation of the WTO Trade Facilitation Agreement. Currently, Armenia’s integration in global value chains is limited to some participation in light manufacturing. While Armenia has scored large improvements in logistics service quality, tracking and tracing, and customs, poor infrastructure within the country constrains access to goods, services, and labor markets. This contributes to spatial disparities and hinders basic public service delivery, inputs for productive activities among firms, and the household accumulation of human capital. Although digital connectivity is high overall, digital adoption in rural areas is constrained by affordability, service quality, access to digital devices, and lack of digital skills and awareness. 3With the reference to Nagorno-Karabakh in this document, the Bank does not intend to make any judgment on the legal or other status of concerned territories or to prejudice the final determination of the parties’ claims. 4 The low quality of human capital in terms of education and health is an important development challenge in achieving sustainable and inclusive growth. A relatively high enrollment rate in schooling is not coupled with high learning outcomes, as demonstrated by the stagnation of international test scores. Achievements are also uneven, reflected in lower access and scores in rural areas and among the poor. Expected years of schooling have remained virtually constant since 2010. Moreover, returns to education have been declining, indicating that the education system has not been responsive to the rapidly changing demands in the labor market. Access to adequate healthcare is often inaccessible and unaffordable to the poor, in part due to the significant share of health expenditure paid out-of-pocket, which is among the highest in the world at almost 85 percent. Enhancing the inclusion of vulnerable groups such as women, youth, and displaced populations would improve the equity and productivity of the labor force. The economy is not as competitive or as innovative as it could be. Some measures of the business climate have improved. For example, since 2016, the perception of competition policy for Armenia has notably improved. However, among the measures related to the organization of the market and competition, competition policy is the area where Armenia most lags its peers, followed by liberalization of foreign trade. In addition, investment, a crucial input, has been declining, the cost of credit is relatively high, and access to finance remains a major constraint to doing business for small and medium firms. Larger firms report being constrained by informality and political instability. Firms are also faced with increased power outages and a deteriorating quality of energy supply. The low quality of human capital and the skills mismatch are also key constraints for the private sector. Governance and institutional constraints A cross-cutting challenge in achieving inclusive and sustainable growth is governance bottlenecks, institutional quality, and a need to invest in data which underlies Armenia’s development challenges. Since 2017, Armenia has made progress in strengthening the quality of its institutions, especially in the areas of anticorruption and transparency in the public sector. And despite the difficult security priorities for the country, the government has continued its commitment to reform. However, institutions remain fragile and vulnerable to shocks. Despite ambition toward an overarching development agenda captured in the government’s 2021-26 program, the institutional framework for planning, monitoring, and evaluation is neither clear nor comprehensive, and strategic planning is weak. Government effectiveness—a bottleneck to inclusive service delivery and growth—is the lowest among peers and has regressed. Greater investment in data collection and management, a prerequisite for government functions, is needed to accelerate the pace of reforms based on evidence-based policy making. Leveraging opportunities Looking forward, Armenia faces high uncertainty in the context of a global megatrend of increasing geopolitical and economic fragmentation, as well as rapid changes in technology. While these megatrends present challenges, they also inspire new opportunities for growth (Box O.1). Box O.1: Capturing Megatrends—Challenges and Opportunities It is critical for Armenia to consider the possible impacts of megatrends on the economy to seize opportunities and prepare for new threats. An understanding of relevant megatrends for Armenia—their pace, interconnectivity, and potential impacts—is a key element in designing policies to achieve inclusive and sustainable growth. It can facilitate the development of strategic action plans that respond to future scenarios, increase resilience to changes, and help capture the advantages and realize potential opportunities. Below are some of the megatrends that may have significant impacts for Armenia. Geopolitical Shifts Connectivity is a pressing issue in Armenia, complicated by the challenging terrain and geopolitical tensions in the region. At the same time, Armenia is vulnerable to economic shocks given that its economy is concentrated in terms of trade partners and products. Should the political climate be amenable, an opening of borders with neighboring countries would be expected to accelerate international trade and integration. This would provide more opportunities to diversify export products, partners, trade routes beyond existing ones with Georgia and Iran. For example, restoring the border with Türkiye could increase freight 5 flows, and reopening the border with Azerbaijan could foster linking Armenia to the Middle Trade and Transit Corridor, a transport corridor connecting China and Europe. Gravity modeling analysis shows important potential export potential for Türkiye. At the same time, it should be noted that although opening of these borders would allow Armenia to improve its trade with current trading partners and diversify trade toward Europe and China, such openings are sensitive and pose significant geopolitical risks. Technological Advancement and Enhanced Connectivity Armenia could build on its dynamic information and communication technology (ICT) sector and better position itself to leverage global digital trends. Armenia aspires to be an ICT hub and has a recent track record of providing outsourcing services to global firms mostly in software programming. This is an important opportunity, as service exports help mitigate Armenia’s physical constraints. ICT service exports as a share of total service exports more than doubled between 2017 and 2021 to 22 percent, and its service exports on a per capita basis outperform those of China and India. It can do more, however, to reach the level of global leaders. To do so, Armenian firms need to branch out to activities that are catalyzed by emerging technologies. The recent relocation of IT firms and talent from Russia presents an additional opportunity for Armenia to seize. Armenia is also a potential network nation, with an important role for its diaspora to boost human capital, investment, and connectivity. The size of the Armenian diaspora is currently estimated at 7 million people in more than 100 countries. Much of the diaspora retains strong links to Armenia. In 2021, around 14 percent of households reported that they received remittances, which can serve as an automatic stabilizer during crises. Diaspora connections and prominent Armenians in various ICT hubs around the world have played a pivotal role in the accelerated development of the ICT sector since the early 2000s by bringing in technological multinational companies to Armenia, setting up local research and development centers, investing in information technology (IT) educational and infrastructure programs, generating leads for local IT companies, and linking with knowledge and funding sources. They can enhance connectivity by promoting trade and FDI, creating businesses, spurring entrepreneurship, and transferring new knowledge and skills. There is also vast untapped potential in the value the diaspora can bring to the science and research ecosystem in Armenia. The scientific community of the diaspora excels in quality and performance. Ways to engage the diaspora in higher value-added activities include stocktaking of strategic connections in priority sectors and building mechanisms for joint projects. Green Transition Armenia can also better seize opportunities from the green transition. Armenia is among the countries that are most vulnerable to risks from climate change, environmental and natural disasters. These risks are amplified by human pressures and a history of unsustainable resource management leading to heightened air, soil, and water pollution and land degradation today. However, moving toward greener growth could—in addition to reducing pressures on domestic natural capital—unlock competitiveness in the private sector through efficiency gains and reduced exposure to future carbon border taxation. Providing financial incentives to promote the green transition, for example, would support integration of the private sector into global value chains. Second, Armenia’s proven reserves of copper and molybdenum and the significant potential for gold and other transition critical minerals that are in high global demand as the world decarbonizes could provide significant near-term revenues. Exploring these opportunities would, in addition to attracting significant investment, require a step-change in environmental, social, and governance-related regulation of the sector to ensure that best practices in minimizing damages are followed and that market prices reflect residual externalities. In conclusion, Armenia needs to build on reform momentum and unlock its potential in the context of fragility and uncertainty. Since 2017, in the face of significant internal and external changes, the country has demonstrated resilience and strong economic recovery through sound macroeconomic management. Going forward, Armenia will need to address critical bottlenecks to create more jobs and higher-quality jobs and to ensure that its development path is sustainable and better prepared to handle shocks from fragility and conflict, economic shocks, and climate change. One key opportunity for Armenia is to go beyond its boundaries and strengthen its links with the world, such as through enhancing its trade partners and products, building on its acumen in ICT, and leveraging its diaspora as a network nation. The policy objectives and reforms identified in this SCD would support Armenia in unlocking its potential to generate higher-quality jobs, enhanced education and health outcomes, improved resilience to shocks, and ultimately, a sustainable tomorrow for all. 6 1. Introduction 1. Armenia has experienced rapid changes in external and internal conditions since 2017. The expectations of Armenians changed with the Velvet Revolution of April 2018, as the country witnessed demonstrations involving peaceful citizen engagement and the democratic process. Armenia has also felt the impacts of external events such as the coronavirus disease 2019 (COVID-19) pandemic; the 2020 military conflict with Azerbaijan; the September 2022 fighting in the border areas of Gegharkunik, Syunik, and Vayots Dzor marzes (provinces); and Russia’s invasion of Ukraine in 2022, which have affected current conditions and future opportunities for inclusive growth. Nonetheless, the Armenian economy has shown resilience to shocks over the last few years, benefiting from a strong track record of macroeconomic management, fiscal discipline, and a sound financial sector, helping to keep extreme poverty low. 2. With its increasingly vulnerable political position, Armenia now seems to be at a crossroads, facing both challenges and opportunities. Armenia faces high stakes and social expectations internally as well as unstable conditions externally, linked to uncertainty in international trade and finance and geopolitical complexities stemming from conflict surrounding its borders and the political implications of Russia’s invasion of Ukraine. The economic impact of the latter, originally forecast to be negative, has so far resulted in an outlier year of economic growth for Armenia, supported by inflows of money transfers and citizens of Russia. However, the outlook remains uncertain with risks mainly to the downside, related to the duration and severity of the conflict and sanctions on Russia, inflationary pressures, and geopolitical tensions around Armenia’s borders (World Bank 2022a). 3. The Systematic Country Diagnostic (SCD) provides a systematic assessment of the constraints Armenia must address and the opportunities it can embrace to accelerate progress toward the twin goals of ending extreme poverty and promoting shared prosperity. SCDs represent the analytical foundation of the World Bank’s country engagement, expressed in the Country Partnership Framework (CPF). The first-generation SCD in Armenia (SCD1) was published in 2017 (World Bank 2017a). SCD1 highlighted the need for a new growth model grounded in greater productivity and identified four main related challenges: (1) poor external sector performance, (2) low private sector productivity, (3) insufficient labor productivity, and (4) key macroeconomic, environmental, and microeconomic vulnerabilities. 4. Many of the challenges identified in SCD1 remain challenges today. Although the Velvet Revolution boosted the reform agenda, implementation is uneven, and the benefits of policy changes may become manifest only in the medium to long term. While Armenians have high levels of educational attainment, the quality of learning is poor. Moreover, despite the economic transition to greater productivity in services, large groups and many locations lack connectivity or access to economic opportunities. A large share of households depends on low-productivity agriculture and transfers, including pensions and remittances. 5. This second-generation SCD (SCD2) identifies the main development challenges that Armenia currently faces under rapidly changing internal and geopolitical circumstances. This new comprehensive SCD revisits and evaluates the persistent and structural constraints identified in SCD1 and identifies emerging challenges from recent developments—including the COVID-19 pandemic, the 2020 military conflict and continued border tensions, Russia’s invasion of Ukraine, and international volatility. However, the analysis was prepared prior to the influx of 100,000 ethnic Armenians in September 2023 from Nagorno-Karabakh, with a data cutoff of July 2023. The analysis considers the green, resilient, and inclusive development (GRID) approach. The economic challenges ahead are difficult to forecast and include inflationary pressures, high volatility in financial and commodity markets, and risks of decreased remittances and capital inflows. Moreover, Armenia—like many other countries—is facing ever-more evident risks from climate change and natural disasters. While some economic and social effects of climate change in Armenia are already visible, the full environmental risks will become more salient in the future. The country’s ability to prepare for, mitigate, and recover from current and future crises is constrained by challenges in government effectiveness and high social expectations for rapid change after the Velvet Revolution. 6. Although Armenia has made important development gains since 2017, the economy is not as competitive or as innovative as it could be. Armenia has been on a structural transformation path since independence and even since 7 SCD1, as the economy has continued to witness a shift from agriculture toward industry and services. While job creation—which is critical to reducing poverty and inequality—has improved since 2017, the economy has not generated enough quality jobs. Unemployment has remained high, especially among youth and women. While some measures of the business climate have improved, investment—a crucial input—has been declining, and the cost of credit is relatively high. The low quality of human capital and the skills mismatch are pervasive constraints for the private sector. Reforms are needed to align the incentives for competition and investment and stimulate a better allocation of resources. To overcome the constraints of being a landlocked country, Armenia needs to modernize its digital and physical infrastructure to improve connectivity within the country and with the world. 7. SCD2 posits that the main challenges discussed in SCD1 still exist, while new and unprecedented challenges have emerged. The terminologies used in SCD2 are described in Box 1. Sustainable, resilient, and inclusive growth is determined by both macroeconomic and microeconomic drivers. Key intersecting challenges between growth and poverty are identified as the major development challenges in Armenia. Overall, the key challenge areas identified in SCD1 remain valid and in alignment with the government’s 2021–26 program, Armenia 2021–26 (Government of Armenia 2021a; World Bank 2017b). In light of recent developments in the country and new evidence, SCD2 identifies four development challenges that must be addressed to achieve the twin goals: (1) vulnerability to shocks and environmental risks, (2) challenges in access to markets and trade integration, (3) low quality of human capital, and (4) low investment and the need to enhance private sector productivity. While these four challenges are related to SCD1-identified challenges, their framing has been updated. For example, within the challenge of vulnerability to shocks, SCD2 introduces the aspect of vulnerability to fragility and conflict. The external sector which was identified as a challenge in SCD1 is reframed as accessing markets to capture connectivity constraints within Armenia as well as those between Armenia and other countries. In addition, one recurrent theme is introduced and considered cross- sectional given its dynamic and simultaneous impact across many development and policy areas: institutional quality and governance bottlenecks and the need to invest in data. Box 1.Terminologies Used in SCD2 Development (or key) challenges: The development challenges are those that are identified through empirical analyses on trends and drivers of growth and poverty reduction in Sections 3 and 4 of this SCD as being priorities to address to achieve sustainable and inclusive growth (Figure 1). Binding constraints: These constraints are the factors that need to change in order to address the key development challenges. These constraints have been identified through empirical analyses, desk review, and discussions with internal and external experts and are discussed in Section 5. Possible policy priority areas: Building on the analysis presented in Section 5, these are policy areas that need further reform to overcome the binding constraints. Among all possible policy priority areas, 11 policy areas that emerged as high priority through the international benchmarking exercise are proposed in Section 6. Details are presented in Appendix H. Additional filters were applied and formal consultation with stakeholders were conducted to validate the results as described in Appendix G. High-level outcomes (HLOs): The 11 priority areas are mapped into high-level outcomes (HLOs).The HLOs were formulated to capture desired improvements in the population’s wellbeing if all policy priority areas are addressed. These HLOs provide options to be adopted in the CPF, which determines the World Bank’s engagement with the government over the next four to six years. Cross-cutting theme: Governance and institutions and the need to invest in data are important determining factors for successful interventions across multiple sectors in Armenia and are thus treated as a cross-cutting theme throughout the diagnostic. This SCD presents some examples of key governance and institutional bottlenecks affecting the progress of reform at the end of each sub-section in Section 5. 8. To address the key challenges to inclusive and sustainable growth, SCD2 identifies 11 policy priority areas. The prioritization process identifies ten high-level priority areas in addition to one cross-cutting priority area. These priority areas reflect the importance of achieving the twin goals and the feasibility and urgency of gaining resilience to reach sustainable and inclusive growth. The priority areas differ slightly between SCD1 and SCD2. The new sets of priorities in SCD2 reflect a greater emphasis on reforms that improve resilience to fragility, conflict, and climate change. The cross-cutting theme of governance bottlenecks, institutional capacity, and data needs is highlighted as a pressing concern and has been identified as a new priority area. Prudent macroeconomic policy will need to be continued in 8 the coming period, although it is no longer as pressing a concern as at the time of SCD1 as the government has demonstrated its ability to manage and cushion the 2020 crises. Changes to the policy priority areas from SCD1 to SCD2 are presented in Section 6. The key challenges and priority areas diagnosed in SCD2 are summarized in Figure 1. Figure 1. Key Constraints and Policy Priority Areas 9. The policy areas were prioritized based on international benchmarking and verified by two additional filters. An international benchmarking exercise was conducted to compare the performance of Armenia against the performance of reference groups such as regional, structural, and aspirational comparator countries. 4 The prioritization process relied on this methodology as it is objective and based on empirical evidence. Results from the international benchmarking were verified by applying a technical feasibility filter to assess the likelihood that the proposed policy areas can be addressed in the next four to six years, considering the technical complexity. The urgency filter was also applied to assess if any delay in addressing a priority area would lead to adverse consequences that would be costly or difficult to reverse. This filter assessed the urgency to act given the complex geopolitical situation, new challenges that have emerged since SCD1, and vulnerability to different types of shocks. Details are provided in Appendixes E and H. 10. SCD2 focuses on the period since SCD1, with a longer time horizon for certain trends or a shorter time period due to data availability. As a second-generation SCD, SCD2 focuses on trends over the past decade, but especially since 2016-17. The macroeconomic context section covers a longer time horizon starting from 2000 to provide context for changes in economic activity and to account for structural breaks in the data, given economic downturn periods. The poverty and equity analyses leverage microdata and estimations from the Statistical Committee of Armenia (ArmStat) 4 This exercise entailed (1) selecting relevant indicators to assess performance, (2) computing the differences between Armenia and the median performance of each reference group, and (3) prioritizing based on the magnitude of the differences computed in step 2. 9 and compare two periods: 2010–16 (the period covered by SCD1) and 2016–21 (the period since SCD1). 5 2016 was also the year of a structural break in the growth trajectory of Armenia. Other periods of analysis are also considered based on data availability for regional and international comparisons. 11. SCD2 is structured as follows. Section 2 summarizes the most recent sociopolitical developments. Understanding Armenia’s current development challenges requires reflecting on the sociopolitical and economic events that have faced the country and the region since 2017. Section 3 discusses overall trends in economic growth and poverty and inequality. Section 4 highlights drivers of growth and poverty reduction in Armenia. Section 5 presents empirical evidence and diagnostics on the main challenges and binding constraints along Armenia’s path toward the twin goals. Section 6 identifies potential policy priorities in addressing the binding constraints, along with high-level outcomes. 2. Background: Sociopolitical Events and Key Reforms since 2017 12. The Velvet Revolution in April 2018 led to a peaceful transition of power and boosted Armenians’ democratic aspirations and civic engagement, although citizens perceive that progress in anticorruption reform has stalled. The new government of Nikol Pashinyan enjoyed a high degree of legitimacy, but it soon faced many challenges (Stronski 2018). Under an anticorruption agenda with strong social support, several former officials were arrested on criminal charges of corruption (Lanskoy and Suthers 2019). Since then, some anticorruption cases have been delayed, and public perception of the anticorruption agenda is mixed. 6 13. The Velvet Revolution ignited fresh momentum for reform amid renewed growth (Box 2). In 2017–19, economic expansion was rapid, and macroeconomic stability was established, aided by effective fiscal policies, an active inflation-targeting regime, and sound financial sector oversight. 7 Monetary and exchange rate policies supported price stability and external adjustment. Annual growth rose to an average of 6.8 percent, recovering from 0.2 percent in 2016. Based on the national income in 2019, Armenia became an upper-middle-income country. The new government focused on a governance and anticorruption agenda. In October 2019, it approved the Anti- Corruption Strategy of the Republic of Armenia and its Action Plan for 2019-2022. It established a new anticorruption architecture: the Corruption Prevention Commission (CPC), Anticorruption Committee, Anticorruption Court, and Anticorruption Chamber of the Court of Cassation, staffed with professionals selected based on merit and provided with infrastructure and resources. 8 Similarly, the government aimed to tackle structural issues in the economy, including high unemployment and regional geopolitical pressures. Pro-competition reforms and gains in market liberalization led to gradual improvement in the business environment. 5 National poverty, inequality, and living conditions are calculated based on the Integrated Living Conditions Survey (ILCS), collected annually by ArmStat. The survey is representative at the national, regional, and urban/rural levels. Changes to the questionnaire and data collection methodology (including the transition to computer-assisted personal interviews) were introduced in 2019. They sought to reflect the changes in living conditions, consumption patterns, and social expectations over the previous decade. In 2020, ArmStat—with technical assistance from the World Bank—redefined the methodology for calculating the consumption aggregate and adopted new national poverty lines based on ILCS 2019 (see ArmStat 2020). Poverty estimation is thus not strictly comparable before and after 2019, but an effort is made to interpret the trends. 6 This is based on a nationwide poll conducted by the International Republican Institute’s Center for Insights in Survey Research, 2023. According to the survey, public perception about the direction of the fight against corruption has declined, from 67 percent of respondents saying that “improved a lot” or “somewhat improved” in October 2019, to 43 percent in March 2023. https://www.iri.org/news/iri-armenia- poll-shows-concerns-over-national-security-sharp-divisions-on-russia-improving-relations-with-turkey/ 7 For example, the introduction of a new fiscal rule in December 2017. 8 The CPC has the mandate to prevent corruption through, for instance, the collection and analysis of asset declarations, following on the protection of incompatibility, conflict of interest, and related regulations deriving from the integrity framework of public service. It also has the mandate of observing compliance with restrictions on accepting gifts by public servants and individuals holding public positions. The Anticorruption Committee is a specialized body for investigating and combating corruption. The Anticorruption Court hears corruption cases related to criminal and civil (confiscation of illicit assets) matters. The Anticorruption Chamber of the Court of Cassation is a specialized chamber in the higher court to hear appeals in civil and criminal corruption cases. 10 Box 2. The Velvet Revolution After Armenia gained independence in 1991, its political system was characterized as hybrid, i.e. a political system that mixes elements of a democratic regime and elements of an authoritarian regime. Formal democratic institutions were accepted as the legitimate means of obtaining and exercising political authority, but political incumbents often failed to comply with conventional standards of democracy (Levitsky and Way 2010). After initial civil protests following accusations of electoral fraud in 1996, Armenia experienced political turmoil and succession challenges. Prime Minister Robert Kocharian established a new authoritarian system after coming to power in 1998 (Lanskoy and Suthers 2019). As with other hybrid regimes, issues of succession emerged in 2008 and 2018. Social discontent increased in 2016 after authorities and elites were blamed for incompetence and corruption in maintaining the armed forces (Iskandaryan 2018). The Velvet Revolution began in April 2018 after civil unrest was sparked in Yerevan following news of President Serzh Sargsyan’s plans to become prime minister and effectively bypass a two-term limit on power. The first protests involved a march from Gyumri, the second-largest city in Armenia, led by Nikol Pashinyan, a former journalist and political prisoner (Foster 2019). A resulting civil disobedience campaign was extensively promoted through social media and joined by thousands of people, including members of the armed forces. The movement led peacefully to Sargsyan’s resignation after only six days. In addition to their grievances over elections, the protestors expressed discontent with other issues, including sluggish economic growth, accusations of corruption, unmet political expectations, and widening inequality (Foster 2019; Stronski 2018). Following the prime minister’s resignation, Pashinyan was elected prime minister in May 2018. Several factors contributed to the success of the Velvet Revolution. Observers argue that the 2018 protests built on the lessons and social networks that had accumulated over the past decades of social and economic protests in Armenia (Lanskoy and Suthers 2019). Other elements that contributed to the success of the Velvet Revolution were the use of social media to mobilize supporters and the relative freedom of nongovernmental organizations (Stronski 2018). 14. Assessment of the impacts of all government reforms since SCD1 is not yet realistic. The new government has implemented a series of reforms since the Velvet Revolution, but evaluating reform outcomes is complicated due to (1) the short time frame to accomplish the intended outcomes; (2) unexpected large shocks that are likely to have affected the outcomes of the reforms (such as the pandemic, armed conflict with Azerbaijan); and (3) complexity in empirically estimating impact under counterfactuals—that is, to assess what the impact of the reform could have been if there were no external shocks. 15. However, examples of successful reforms can be identified. For example, since 2019, the tax authorities have launched tax reforms directed at enhancing transparency and efficiency, thereby attracting foreign investment, and lifting tax revenue. Supported by tax policy and administrative reforms, revenue collection increased from 21.3 percent of gross domestic product (GDP) in 2018 to 23.2 percent of GDP in 2022. Factors that point to success—as indicated by higher ratings among business users—include greater efficiency in business processes through the consolidation and simplification of procedures and increased transparency thanks to the introduction of e-services, which also increased trust in the tax authority among taxpayers. 9 Institutionalizing feedback loops and boosting transparency and efficiency by setting up an e-court platform is another example of successful reform. Other successful reforms include judicial reform, aspects of the policy reform including the establishment of the Ministry of Home Affairs and the establishment of the Patrol Police, and the application of pension reform to the private sector. In February 2023, the CPC launched an upgraded asset declaration system that significantly improves the declaration process, including by pre-filling some information in the declarations from the tax administration platform, providing a more user-friendly interface, and putting the focus on analytics. 16. In 2020, the COVID-19 outbreak and military conflict with Azerbaijan caused social and economic disruption, requiring mitigation. Real GDP shrank by 7.2 percent while exports fell 34 percent in 2020, among the sharpest shocks experienced in Europe and Central Asia (ECA). As in many other countries, the government of Armenia adopted measures to shield households and firms from the economic disruptions. In addition to greater health spending, 25 9 The 2020 Enterprise Survey conducted by the World Bank shows that Armenia’s tax administration performs well compared with other countries in Eastern Europe and Central Asia. 11 policy packages were introduced, involving fiscal expenditures totaling 1.6 percent of GDP (World Bank 2022b). Assistance included direct cash transfers to households and workers, wage subsidies, utility subsidies, tax benefits for businesses, state-sponsored loans, and higher investment. The measures helped partially offset impoverishment and unemployment. Although the fiscal response was among the most conservative among similar economies, real GDP growth rebounded to 5.7 percent in 2021 (Government of Armenia 2022). 17. Unprecedented regional and international events since 2020 have rendered Armenia highly vulnerable. Armenia experienced rising fiscal pressures and debt ratios due to higher spending in response to COVID-19, including higher public spending on defense, a simultaneous fall in revenue, and a decline in GDP as in many other countries. Despite overall economic recovery, risks and regressive trends persist. For example, higher inflation on food items— felt since 2021, but worsening throughout most of 2022—has likely prevented greater reductions in poverty and inequality. 18. Armenia also experienced a domestic political crisis, as heightened political tensions after the 2020 military conflict led to snap elections. Armenia emerged weakened from the conflict due to the loss of close to 3800 lives and influx of displaced people. A Russia-brokered ceasefire was agreed upon in November 2020. With mounting criticism of the government’s handling of the conflict, a political crisis followed in Armenia. Snap elections in June 2021 resulted in the ruling party obtaining the majority of votes and subsequently adopting a new five-year program. 10 19. The government embraced a new five-year action plan—Armenia 2021–26—to shape policy priorities. The action plan establishes strategic goals, measures to achieve them, and the expected results, time frames, and funding sources (see Appendix B). The program contains six pillars: security and foreign policy, the economy (including a sustainable development and green component), infrastructure development, human capital development, law and justice, and institutional development. The plan also embodies the government’s commitments under the Armenia- European Union (EU) Comprehensive and Enhanced Partnership Agreement, programs to be implemented under the EU economic and investment plan, and the main provisions of the Eurasian Economic Union strategic programs. 20. In 2022, the repercussions of Russia’s invasion of Ukraine, coupled with fighting in the border areas of Gegharkunik, Syunik, and Vayots Dzor marzes, led to a paradigm shift in Armenian politics and society. The former has not only exacerbated the geopolitical dynamics but has also moved security issues toward the center of domestic political debate. The 2020 military conflict with Azerbaijan as well as the events since then have shifted public attention away from economics and governance to security. The more recent escalation of fighting in September 2022 has contributed to fears that the 2020 ceasefire agreement will not hold (World Bank 2023c). 3. Trends in Growth, Poverty, and Shared Prosperity 3.1. Growth Trends 21. Since 2000, the economy has been characterized mostly by periods of substantial growth, punctuated by lows that reflect the country’s vulnerability to sizable exogenous shocks. The growth rate averaged 6.2 percent over 2000– 22, although this masks three key slowdowns (Figure 2). The economic development gains helped the country advance to upper-middle-income status in 2018. However, over the past decade, GDP per capita mostly lagged peers (Figure 3). 10The Civil Contract Party has experienced a decreasing approval rating, based on a national poll by the International Republican Institute’s Center for Insights in Survey Research 2023. The approval rate fell from 25 percent in June 2022 to 21 percent in March 2023. 12 Figure 2. GDP Growth, Armenia Figure 3. GDP per Capita, Peer Comparison Source: “GDP growth (annual %),” World Bank, Source: “GDP (Constant 2015 US$): Armenia,” World Bank, https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG. https://data.worldbank.org/indicator/NY.GDP.MKTP.KD. 22. Armenia’s growth trajectory since 2000 is marked by three periods. In 2000–08, Armenia achieved 11 percent average growth underpinned by high investment rates, capturing post-independence reform momentum. Growth was driven by domestic demand and fueled by external inflows, particularly foreign direct investment (FDI), export revenues (predominantly metals and minerals), and remittances. During this time, Armenia experienced a Dutch Disease episode, including a 45 percent appreciation of the real effective exchange rate between 2003–08. The global financial crisis revealed Armenia’s overreliance on commodity export direct flows, remittances, and other flows as liquidity declined and, coupled with the 2008–09 copper price drop, led to a sharp economic contraction of 14.1 percent in 2009. The second period, 2010–16, was a low-growth period and ended with almost zero growth. This slowdown was brought on by the oil price shock that started in mid-2014, affecting external inflows, and the implementation of sanctions on the Russian economy in 2015–16. The third period began after 2016 as the economy started to recover, driven partly by the government’s broad fiscal stimuli, and was characterized by several exogenous shocks, including the 2020 twin shocks. 23. Despite volatility in economic and exchange rate performance, external economic shocks have been better managed since 2017. Volatility in macroeconomic conditions can have major impacts on investment, consumer spending, the risk premium, and policy certainty. Quarterly volatility of economic growth has not changed significantly since 2000, with an average of four negative episodes in each of the three periods discussed. 11 However, fiscal authorities have better managed downturns, including by adopting a revised fiscal rule in 2017, adhering to it (outside of the 2021 exception due to the twin shocks), and actively reacting to implement fiscal response measures, for example to address the twin shocks. As for exchange rates, volatility in key bilateral nominal exchange rates have relatively decreased over time. 12 However, the dram experienced two periods of significant volatility in late 2020–mid 2021 in the post-conflict period and following the onset of Russia’s invasion of Ukraine in February 2022. In both cases, the exchange rate stabilized without significant interventions unlike the former periods. As such, exchange rate flexibility, with limited interventions by the CBA, has served Armenia well. The trend of real effective exchange rate appreciation since 2013 could be the outcome of expanded export potential. However, real exchange appreciation could also be negatively affecting merchandise and service exports in the short-term. In 2022, for example, the real effective exchange rate appreciated by 34 percent, driven by a 90 percent increase in the number of tourists in 2022 11 The frequency of quarterly negative growth compared to the corresponding quarter of the previous year was five quarters for 2000–08, three for 2010–16, and four for 2017–22, the latter which were due to the 2020 twin shocks. 12 For example, monthly changes of +/-5 percent in bilateral nominal exchanges for the dram vis-à-vis the US$, euro, and ruble were 18 months from 2000-08, 35 from 2010-16, and 21 from 2017-22. The AMD/RUB exchange was the most volatile of the three and increasingly so in 2022, with three months in which monthly changes of the nominal exchange rate were +/-10 percent. 13 year on year combined with a three-fold increase in net money transfers from Russia, which bore important costs for firms that provide IT service exports. 24. The economy has more recently weathered unprecedented events that present both risks and opportunities. The Velvet Revolution in 2018 and subsequent momentum for reform opened the door for second-generation reforms and reinvigorated economic growth in 2018–19. The 2020 shocks—the pandemic and the military conflict—had large negative impacts on Armenia. Although the pandemic affected countries and regions across the world in 2020, GDP in Armenia fell by 7.2 percent, among the sharpest contractions in ECA (World Bank 2021b). New risks became manifest in 2022 with Russia’s invasion of Ukraine in February as well as the breakout of fighting in the border areas of Gegharkunik, Syunik and Vayots Dzor marzes in September. These shocks revealed continued vulnerability, including for tourism, investor confidence, and household sentiment. At the same time, the relocation of 2,600 companies, 6,000 individual entrepreneurs, and 113,000 nonresidents to Armenia since March 2022, 13 mostly from Russia, fueled double-digit growth of 12.6 percent in 2022, the highest in the region (World Bank 2023d). 25. Economic growth in Armenia has not been accompanied by job creation. Despite growth at an annual average of 6.2 percent in 2000–22, employment declined by 0.1 percent on a net basis. 14 The rate of employment creation at a given level of growth—the employment elasticity of growth—was −0.1, which indicates that a 1 percent rise in GDP was associated with a 0.1 reduction in jobs. Job creation improved in 2017–22 with an elasticity of 0.4 as employment grew by 127,600. However, the low and negative elasticities stand out compared with upper-middle-income countries (World Bank 2019c). 26. Unemployment rates are high and heterogenous across sociodemographic groups. 15 Armenia has one of the highest unemployment rates in ECA. 16 The rate hovered around 18 percent in 2008–20, although it declined to 13 percent in 2022 partly thanks to strong growth performance (ArmStat). 17 Unemployment in urban areas has been higher than rural unemployment consistently since 2008, but the gap has narrowed because rural unemployment has risen (from 6.6 percent in 2008 to 8.8 percent in 2021) while urban unemployment has dropped (from 23.2 percent to 20.3 percent) (Figure 4). Low unemployment in rural areas may be linked to greater underemployment. The persistent differential suggests little spatial mobility in labor. Women are more likely than men to face unemployment, although the gap has closed over the last five years. Unemployment is high among young people, reaching 30 percent among individuals under age 24 seeking employment. Women, youth, and single people in urban areas are more likely to be unemployed. 13 Data based on Statistical Revenue Committee, Central Bank of Armenia, and IMF staff calculations. 14 Based on ArmStat employment data. 15 This section is based on ArmStat national employment statistics using quarterly data of the Labor Force Survey (ArmStat 2022). 16 Comparisons based on June 2022 data of ILOSTAT (dashboard), International Labour Organization, https://ilostat.ilo.org/. 17 ArmStat national employment statistics using quarterly data of the Labor Force Survey. The unemployment rate is the share of the labor force that is without work but available for and seeking employment. 14 Figure 4. Unemployment Figure 5. Employment and Value Added, by Sector Source: ArmStat Labor Force Survey, Source: Data as of January 2021 of ILOSTAT (dashboard), https://statbank.armstat.am/pxweb/en/ArmStatBank/?rxid=9ba7b0d International Labour Organization, https://ilostat.ilo.org/; 1-2ff8-40fa-a309-fae01ea885bb. ArmStatBank. 27. The shift in employment by sector reflects the transition of the economy from agriculture to services (Figure 5). The share of employment in services grew from 45.1 percent in 2012 to 51.2 percent in 2019 led by wholesale and retail trade and accommodation and food service activities. The share of employed in industry rose from 17.7 percent in 2012 to 24.8 percent by 2019 led by higher employment in construction and manufacturing. In contrast, the share of employed in the agriculture sector fell from 37.3 percent of the population in 2012 to 24.0 percent by 2019. 28. Participation and employment rates are low compared with most peer countries, and youth and women are less likely to be employed. The participation rate of 48.9 percent in 2019 lags most peers (Figure 6). 18 Deterrents to entering the labor force include high reservation wages, remittances, job quality, and a skills mismatch. At 48.9 percent in 2019, Armenia’s employment rate is below most peers. The aggregate employment rate masks striking differences in employment rates across groups. The employment rate among youth averaged 22.6 percent in 2017–21 compared with 53.7 percent among adults (Figure 7). The low employment rate among women has also been a long-standing challenge. Female employment averaged 40.6 percent compared with 58.2 percent among males in 2017–21. Figure 6. Participation and Employment Rates, 2019 Figure 7. Youth versus Adult Employment Rates Sources: World Development Indicators database; ArmStat Labor Source: World Bank staff calculations based on ArmStat Labor Force Force Survey data. Survey data. LHS = left hand side; RHS = right hand side 18 Based on Armstat Labor Force Survey employment data. 15 29. Economic growth in Armenia has not yet Figure 8. GDP Growth and Emissions Growth decoupled from emissions growth, which could affect competitiveness. 19 After the initial drastic decline 350 following the dissolution of the Soviet Union in 1991, Total energy supply greenhouse gas (GHG) emissions have continued to rise. (TES) 300 Historically, Armenia’s GHG emissions are primarily from GDP (PPP, constant 250 the energy sector, comprising electricity and heat 2017) generation, transport and residential sectors, and fugitive 200 Index CO2 emissions emissions from the natural gas system. In the last two 150 decades, CO2 emissions grew in line with energy supply, Carbon intensity of and the carbon intensity of GDP has stagnated since 2010 GDP (CO2 100 emissions/GDP) (Figure 8). 20 This data suggests that there is no trend 50 Carbon intensity of toward increased low-carbon, energy efficient technology energy mix (CO2 from and that significant carbon lock-in 21 occurs, pointing energy/TES) 0 2000 2002 2004 2006 2008 2010 2012 2014 2016 2018 2020 toward risks of asset stranding and loss of competitiveness as peers accelerate decarbonization. 22 Sources: World Development Indicators database; International 30. Looking forward, Russia’s invasion of Ukraine Energy Agency World Energy Balances 2022. represents a new source of uncertainty and pressure on Armenia’s economy and labor market. This development and the associated sanctions on Russia present risks and a changing domestic economic landscape for Armenia. The regional situation remains precarious, and substantial risks remain in the potential of the war to cause disruptions in trade and FDI and exert more upward pressure on international fuel and food prices. Armenia is exposed to shocks in migration and remittances. Russia has traditionally been the main destination for Armenian labor migrants (mostly men ages 25–44 with secondary education). The possibility of declining economic activity in Russia and calls for mobilization might lead to return migration to Armenia and fewer opportunities for prospective migrants to go abroad, thus creating pressure on unemployment and wages in Armenia. 23 At the same time, the influx of migrants and capital into Armenia in 2022 brought in skills and could also generate investment opportunities, particularly in industry and technology services, and spillover for the rest of the economy. 3.2. Poverty Trends 31. Poverty has been decreasing steadily since 2010 (as measured by the national poverty line). 24 After the increase in poverty in 2009 and 2010 following the global financial crisis, poverty measured by the national average 19 Decoupling of emissions growth from economic growth here refers to absolute decoupling, a state where in which absolute emissions decline while GDP grows. It indicates decarbonization progress. 20 Carbon intensity of GDP is defined as the total of estimated annual carbon dioxide emissions divided by GDP. 21 Carbon lock-in refers to long-term investments in carbon-intensive infrastructure, thereby 'locking' a country into a fossil fuel-dependent development pathway. Asset stranding refers to assets losing value in a changed market environment, for example due to changes in global value chains or more ambitious climate policies. 22 Armenia’s Updated Nationally Determined Contribution (NDC) is to reduce GHG emissions by 40 percent from 1990 levels by 2030 and total emissions to 2.07 tCO2eq/capita by 2050 (Government of Armenia 2021b). However, Armenia may exceed its GHG target if the right measures are not taken (IMF 2022a). 23 Simulation analysis conducted by the World Bank’s Social Protection and Jobs team suggests that the Armenian labor market would need to create an additional 12,000 to 25,000 jobs to compensate for reduced outward migration. 24 The national poverty rate is the midpoint between the lower and upper poverty rates. Poverty lines are adjusted each year using year-on-year inflation. Poverty lines in terms of the adult equivalent per month in current prices used to estimate poverty rates were AMD 33,517 (2010), AMD 40,867 (2016), and AMD 48,146 (2021). The poverty and inequality measures are not strictly comparable before and after 2019 due to 16 poverty line decreased uninterruptedly between 2010 and 2016, and the rate of reduction accelerated in 2016–18 when GDP growth was rapid, driven partially by the government’s broad fiscal stimulus (Figure 9). 25 Extreme poverty— defined as those with consumption per adult equivalent below the food poverty line—also declined constantly over 2010–18, from 3 percent to 1 percent (ArmStat 2022a). Figure 9. Trends in Poverty and GDP Figure 10. Poverty by Income Levels, Most Recent Year Available 60% GEO (2021), 55.4% ARM (2021), 51.7% 50% Poverty headcount ratio at $6.85 a day (2017 PPP) (% of population) 40% XKX (2017), 34.2% 30% Upper Middle Income (2019), 23.5% 20% TUN (2015), 17.9% MNE (2018), 18.5% ECA (2019), 15.0% MDA (2019), 14.7% ALB (2019), 10.9% 10% BGR (2019), 7.2% BIH (2011), 5.8% RUS (2020), 4.1% EST (2019), 1.4% 0% $- $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 GDP per capita, PPP (constant 2017 international $) Source: World Bank staff calculations using data from ArmStat, Source: World Development Indicators database as of January 2023. Integrated Living Conditions Survey (ILCS), and World Development Note: The trend line in the figure shows the correlation between GDP Indicators database. per capita (in constant 2017 international $) and poverty headcount Note: Poverty and consumption are not strictly comparable before and ratio using the international poverty line of US$6.85 a day (in 2017 PPP). after 2019 due to revisions in the ILCS questionnaire and data collection The blue line represents the expected level of poverty for each level of methods. The dotted line reflects this gap in the series. GDP per capita. 32. However, the onset of COVID-19 and the military conflict in 2020 stalled the progress in poverty reduction. Government mitigation measures helped contain larger shocks, and the increase in the poverty rate was confined to 0.6 percentage points in 2020, from 26.4 percent in 2019 to 27.0 percent in 2020. Economic recovery in 2021 was associated with poverty reduction, but at a slower pace (a reduction of 0.5 percentage points to 26.5 percent). 33. The poverty reduction achieved in Armenia is commendable, but the incidence of poverty is still higher than expected given Armenia’s level of income (Figure 10). Armenia’s poverty level in 2021 was 51.7 percent (using the US$6.85-a-day poverty line), which is approximately 30 percentage points higher than the expected poverty rate given the country’s GDP per capita of US$14,193 (in constant 2017 international US dollars). Given the high level of poverty by international standards and household vulnerability to shocks, identifying and tackling key development constraints are critical for sustainable poverty reduction. 34. The high international poverty rate is associated with labor market outcomes. While poverty can be affected through multiple channels, the lack of job opportunities is one critical factor driving poverty in Armenia. This is reflected in the high unemployment rate compared to countries such as Moldova with an equivalent level of GDP per capita (12.6 percent in Armenia versus 2.3 percent in Moldova in 2022), 26 and the gap is particularly large among those with intermediate and advanced education. 27 Lack of job opportunities is also demonstrated by the large number of temporary emigrants whose main incentives are wage differentials and better employment opportunities (Garrote- revisions in the ILCS questionnaire and data collection methods. Nonetheless, efforts are made to interpret trends to the extent possible. For example, poverty measured against the upper poverty line is used for years prior to 2019, which are the most comparable rates with national average poverty since 2019. Details are described in ArmStat 2022a. 25 National poverty increased from 27.6 percent of the population in 2008 to 35.8 percent in 2010. 26 Based on a percentage of unemployment among the total labor force (modeled ILO estimate) (World Development Indicators database as of June 2023). 27 In 2021 (the latest data available), the unemployment rates among those with intermediate education in Armenia and Moldova were 10 percent and 0.8 percent, respectively, and 10.7 percent and 1.2 percent, respectively, for those with advanced education. The rates were lower for those with basic education (6.1 percent and 0.5 percent, respectively). These rates are based on World Development Indicators as of June 2023. 17 Sánchez 2022). The quality of jobs is also relatively low Figure 11. Growth Elasticity of Poverty as depicted by relatively high informality—for example, 50.3 percent in Armenia compared to 22.1 percent in Bosnia and Herzegovina in 2018 (Elgin et al. 2021). 35. While reductions in poverty since 2010 have been accompanied by economic growth, the contribution of growth to poverty reduction has declined. The poverty and shared prosperity analysis compares two periods before and after 2016 (2010–16 and 2016–21), as 2016 was the year of a structural break in the GDP growth trajectory as discussed in Section Source: World Bank based on data of the ILCS and World Development 3.1. 28 Figure 11 shows that the growth elasticity of Indicators. poverty—defined as the percentage change in poverty with respect to a 1 percent change in per capita GDP—decreased from 0.79 in 2010–16 to 0.49 in 2016–21, signaling that growth resulted in less poverty reduction in recent years. 29 Decomposition analysis confirms that growth was more important in reducing poverty during 2010–16, while redistribution or a reduction in inequality was more important in 2016–21. The result is also consistent with the improvement in inequality over the years. 3.3. Equity Trends 36. While poverty declined steadily in 2010–16, more rapid growth among well-off households led to higher inequality. As poverty fell during the pre-SCD1 period (2010–16), households in the bottom 40 percent of the welfare distribution (the bottom 40) experienced consumption growth of over 2 percent a year. However, the well-off made even higher gains, as shown by the growth incidence curve which depicts the annualized growth rate of per capita consumption for every decile of the consumption distribution between two time periods (Figure 12). The shared prosperity premium—expressed as the difference between the mean consumption growth of the bottom 40 percent and overall average growth—remained negative, confirming that well-off households benefited disproportionately, leading to the rise in inequality (Figure 13). Figure 12. Growth Incidence Curve, 2010–16 versus 2016–21 Figure 13. Shared Prosperity, 2010–16 versus 2016–21 Source: World Bank staff calculations based on ILCS. Source: World Bank staff calculations based on ILCS. Note: Growth incidence curve depicts the annualized growth rate of Note: The shared prosperity premium (red dots in the figure) is per capita consumption for every decile of the consumption expressed as the difference between the mean consumption growth distribution between two time periods. of the bottom 40 percent of the welfare distribution and overall average growth. 28This coincides with the latest data used for the poverty analysis in SCD1, allowing the SCD2 analysis to compare before and after SCD1. 29The growth elasticity of poverty during 2016–21 was highly volatile, peaking at 1.76 during 2016–18 before dropping to 0.25 in 2019–21. The growth elasticity of poverty in 2020–21 alone was 0.35, accompanied by progress in poverty reduction and strong economic recovery in 2021. 18 37. In 2020, inequality as measured by the Gini index dropped below the level of peer countries, as well-off households were affected more severely by the crisis, mainly through lost wages and a reduction in remittances. However, inequality grew again in 2021 as the rich enjoyed a strong recovery. In contrast to 2010–16, consumption showed signs of pro-poor growth as indicated by the negative slope of the growth incidence curve (Figure 12) and higher consumption growth among the poor, which led to a decline in inequality. However, consumption growth among the poor remained close to zero, indicating that the seemingly pro-poor growth during this period did not fully translate into poverty reduction. Moreover, the strong economic recovery in 2021 appeared to benefit the well-off disproportionately, as illustrated by the upward-sloping growth incidence curve in 2020–21 (Figure 14). Thus, inequality rose again in 2021, despite strong economic growth and the decline in the average poverty rate (Figure 15). Figure 14. Growth Incidence Curve, 2020– Figure 15. Gini Index Figure 16. Household Budget 21 Allocation 2021 Source: World Bank staff calculations based on Source: Poverty and Inequality Platform Source: World Bank staff calculations ILCS 2021. (dashboard), World Bank, based on ILCS 2021. https://pip.worldbank.org/home. 38. Rising food inflation might have prevented the escape from poverty and intensified inequality in 2021. Poorer households are typically more heavily affected by high food inflation since they allocate larger shares of their budgets to food consumption (Figure 16). Microsimulations based on ILCS data suggest that food inflation associated with the twin shocks might have prevented approximately 120,000 Armenians from escaping poverty in 2021 and resulted in an increase in inequality. 4. Drivers of Growth and Poverty Reduction 39. This section identifies binding constraints on growth, poverty reduction, and shared prosperity in Armenia. On growth, the analysis centers on results from Solow and Shapley decompositions. The drivers of poverty reduction are based on the Shapley decomposition. The analysis is also augmented by focusing on the factors considered under the asset-based framework. Applying the asset-based framework, the analysis asks what the binding constraints in each of the following channels are that affect household well-being: (1) asset endowments, especially in human capital accumulation; (2) opportunities to use the accumulated assets, especially in the labor market and in market access; and (3) risks that are prevalent among the poor and that affect the accumulation of assets and the opportunities to use them. Among the known determinants of household welfare, the factors most lacking among the poor and the types of risks to which the poor are disproportionately vulnerable are identified as the most binding constraints on achieving the twin goals. 30 30 The asset-based framework was used similarly in, for example, Cambodia SCD (2017) and El Salvador SCD (2022). 19 4.1. Drivers of Growth Evolving Drivers of Growth 40. Economic growth drivers have shifted significantly in recent years. Since 2000, consumption has been the main driver of growth on the demand side, followed by investment. However, further decompositions show that growth drivers changed significantly during this time. In 2000–09, high growth was based on a foreign-financed expansion of the construction sector and domestic services (World Bank 2013). Consumption was the key contributor to growth, along with investment, as external trade had a negative contribution (Figure 17). External trade then became a major contributor to growth in 2010–16, reflecting an ambition to diversify the economy and focus on export-led growth. An expansion in merchandise exports—partly thanks to a surge in commodity prices for Armenia’s metals and minerals in 2010–14—explains the contribution of net exports during this time. At the same time, investment hindered growth during this period following the bust of the construction sector in 2009 and reversal of the FDI trend. In the most recent period of 2017–22 which witnessed several shocks, consumption resumed a leading contribution to growth, but growth was more broad-based as investment reversed to a net positive contribution—although modest compared to the first decade of the century—followed by net exports and government consumption. 41. On the supply side, services have become ever more important in the last decade as the structure of the economy has increasingly shifted away from agriculture. The share of services in GDP rose from 46 percent in 2012 to 55 percent in 2022. As the industry share has remained rather flat since 2012 at an average of around 26 percent, the increase in importance of services came at the expense of agriculture, which saw a decline in its contribution to GDP from 18 percent in 2012 to 10 percent in 2022 (Figure 18). Nonetheless, while the share of agriculture declined, agricultural output expanded, and it remains an important sector for the economy and employment. 31 Figure 17. Contribution to Growth, Demand Side Figure 18. GDP Structure, Supply Side Source: World Bank staff calculations based on ArmStat data (in constant 2015 LCU). Source: ArmStat National Accounts data NPISH = non-profit institutions serving households 42. Armenia’s growth appears to have been driven predominantly by total factor productivity (TFP), although the impact of TFP is likely to be overestimated. 32 Decomposition analysis suggests that, over 2000–22, TFP rather than factor accumulation was driving growth (Figure 19). Over this period, TFP contributed 56 percent to real GDP growth, followed by 47 percent from capital stock and 2 percent from human capital, while labor detracted 4 percent from 31 There are concerns about the quality of the data on agriculture. Agriculture sector activity may be underestimated by official agriculture data publications, as there appears to be a significant and unreported expansion of perennial crops that can be observed through remote sensing analysis (World Bank 2023d). 32 Total factor productivity is a commonly used measure of productivity. It is calculated as the residual growth that cannot be attributed to the increased use of labor and capital. Part of the overestimation is due to the use of a constant labor share of 55 percent across the decomposition period. However, Armenia’s labor share has declined sharply since 2000 based on Penn World Tables data. Accounting for this would reduce the TFP contribution to growth. 20 growth. 33 The rise in the number of new registered businesses in 2017–19, for example, suggests that TFP may also be capturing reforms to the business environment which include enhanced competition and process and requirements for starting a business (Figure 20). 34 However, it is striking that while TFP results appear to be strong, the economy did not generate more and better jobs. As a residual term, TFP captures innovation, technological change, and managerial capacity but may also capture measurement errors, and for this reason, verification would be needed. For example, critical data gaps related to capital expenditures (including on maintenance spending) and the lack of asset registers and centralized data for domestically financed projects may also signal data measurement issues in the estimations of capital stock (World Bank 2023b). Figure 19. Growth Decomposition, Armenia, 2000–22 Figure 20. New Businesses Registered, Armenia, 2010–20 Source: World Bank staff calculations based on ArmStat GDP and Gross Source: World Bank’s Entrepreneurship Database Fixed Capital Formation data in constant LCU 2015. Human capital is (https://www.worldbank.org/en/programs/entrepreneurship). based on “Average Years of Schooling” from World Bank database on education statistics https://datatopics.worldbank.org/education/ Note: Real GDP growth is in natural log (continuous compounding). Growth rates are weighted according to the income share of capital = 45 percent. Returns to education set at 2 percent based on recent analysis as discussed in section 4.2 43. Physical capital accumulation has become a less important driver of growth since 2009 as a result of limited capital expenditures, a declining trend in FDI, and decreasing domestic private investment. Gross capital formation for Armenia has declined significantly as a share of GDP from 34.4 percent over 2000–10 to 19.7 percent over 2017–21 and is below all peers except Tunisia (Figure 21). Volatility and unpredictability in public investment execution, limited capital investment plans, and small allocated budgets have contributed to the low capital stock in the most recent period. Public investments as a share of GDP averaged 4.3 percent in 2000–09 and dropped to an average of 3.4 percent in 2016–21, below most peers (Figure 22). Lower capital spending reflected in part a commitment from the government to reduce the debt ratio, as capital spending is less rigid than other spending categories. This trend has resulted in a depletion of public capital stock, which fell from 160 percent of GDP at the end of the 1990s to about 60 percent of GDP in 2017. This is lower than public capital stock in neighboring Georgia and Azerbaijan, where the averages are around 80 percent of GDP (Koshima et al. 2019). Lower FDI also contributed to the lower capital stock as net FDI inflows declined from US$944 million in 2008 to US$47 million in 2020 (Figure 23). The construction sector stands out as one driver behind this reduction, as the sector had attracted an important share of FDI before the financial crisis and accounted for 61.7 percent of gross fixed capital formation over 2000–09. Since then, construction’s share of gross fixed capital formation declined to 39 percent over 2017–22. Finally, domestic private investment has 33 Decomposition analysis data assumptions are the same metadata as those in Figure 19. 34 In 2020, Armenia ranked 10th among 190 economies on the starting a business indicator and 47th overall according to 2020 Doing Business. 21 also been declining over time as a share of GDP, from an average of 18.4 percent in 2000–09 to 16.1 percent in 2010– 16 then to 14.6 percent over 2017–22. 35 Figure 21. Gross Capital Formation Figure 22. Capital Expenditure, 2016–21 Figure 23. Net FDI Inflows, Armenia Average Sources: World Bank national accounts data; Sources: Data from ministries of finance; Sources: UNCTAD data; OECD National Accounts data files. World Bank BOOST database; World Bank https://unctadstat.unctad.org/datacentre/first Expenditure Dashboard (2023); World Bank to third quarters of 2022 based on 2023b. Tradingeconomics.com (https://tradingeconomics.com/armenia/foreig n-direct-investment). 44. A shrinking and aging population has affected the labor force and weighed on growth. Armenia’s population has been decreasing annually since 1991, with the Figure 24. Demographic and Labor Force Trends, Armenia exception of 2021-22 which were anomaly years of population growth to reach 2.97 million as of 2022 (Figure 24). 36 This trend mirrors the trend in net migration which was also negative until 2021, with net outward migration declining from an average of 27,757 for 2010–19 to 12,825 in 2021. 37 The labor force, or the population between ages 15-64, shrank from 1.41 million in 2008 to a low of 1.23 million in 2016. It has since picked up slightly to reach 1.31 million in 2022. 45. Human capital has made only a limited contribution to growth as education dividends have plateaued. Since 2010, human capital has had a Source: ArmStat Statistical Indicators and Labor Force Survey. Note: Since 2008 labor force indicators are not comparable with the negligible contribution to growth, which can mostly be data of previous years. Since 2008, ArmStat changed its methodology explained by the stalling of average years of schooling at to calculate unemployment to the ILO standard definition used by EU around 13.1 years. Moreover, once the quality of countries. education is considered, effective years of schooling decrease to 8.0 years (World Bank 2023a). These results also reflect low returns to education and highlight the need to enhance human capital and the quality of education to boost growth. 46. A growth decomposition analysis on the contribution of changes in demographics, the level of employment, and the level of productivity growth sheds light on how much structural transformation has contributed to Armenia in the past decade. The productivity component is divided into a component that measures changes in productivity at 35 Domestic private investment is estimated based on data from ArmStat and the Central Bank of Armenia. 36 Based on ArmStat data. 37 United Nations Population Division. World Population Prospects: 2022 Revision. 22 the sector level (within-sector productivity) and another that reflects labor reallocation between sectors, which points to the speed of structural change (or intersectoral allocation). In 2012–21, within-sector productivity accounted for 83 percent of growth, followed by structural change at 36 percent, employment at 7 percent, and demographic change at 2 percent (Figure 25). 38 The participation rate, measured as a share of the labor force in the working-age population, reduced 28 percent of growth. This has worsened since 2017, reflecting the need to enhance incentives to join the labor force. Structural change, or the reallocation of labor from low-productivity to high-productivity sectors, has been more pronounced since 2017 as the economy emerged from the low growth 2012-16 period and resumed its structural transformation path. Within-sector productivity weighed on growth in 2017-2021 compared to 2012-16, partly because by 2021, the economy had not yet recovered to pre-pandemic GDP. At the sub-sectoral level, this reflects an adjustment across most sectors that had a reduced contribution of within-sector productivity over 2017-21, particularly construction and real estate. Figure 25. Growth Decomposition of per Capita Figure 26. Sectoral Contribution to GDP Growth, Armenia, 2012–21 Value-Added Growth, Armenia Source: World Bank staff calculations based on ArmStat data. Note: GDP at factor prices, in LCU 2015 constant. Financial Intermediary Services Indirectly Measured are pro rata-ed across subsectors. Due to statistical discrepancies, the sum of value added from each sector sometimes does not add up to the total value added. In Figure 23, y = annual growth per capita value added (percent) 47. A GDP decomposition analysis at the sector level reveals that wholesale, retail, and accommodation, followed by manufacturing and the financial sector, were the largest contributors to GDP growth during 2012–21 (Figure 26). These sectors, along with real estate and construction, exhibited the highest share of inter-allocative productivity or structural change. Within-sector productivity advances were led by the agricultural sector as employment moved out of the sector and as agricultural exports rose. Within-sector productivity improvements were followed by manufacturing and by transport and communications, reflecting the burgeoning information technology (IT) sector in Armenia. Enhanced productivity of the manufacturing industries could indicate less barriers to entry in the sector as discussed in Section 5, as well as enhanced production and exports of apparel which became dynamic during this time. A similar sectoral GDP decomposition for the most recent period 2017–21 shows that the construction sector was the leading contributor to growth (47 percent) thanks to structural change and saw the largest reallocation of labor to the sector. This shows a comeback of the sector spurred in part by a government real estate development program. However, the negative within-sector productivity signals the need to enhance the allocation of resources within the sector. A critical knowledge gap limits an understanding of the main constraints on labor mobility within and across sectors. Trade Outcomes 48. Trade is an important share of GDP for Armenia—despite being landlocked with only two of four borders open—but Armenia is not well integrated in the global economy as its share of trade to GDP is fairly low. Armenia is a 38 Given a methodological change in the computation of national accounts data in 2012, this discussion focuses on the period since 2012 for compatibility. 23 small open economy which is landlocked between four countries, two of which have closed borders. Openness to trade, proxied by the share of total exports of goods and services in GDP, reached its peak in 2019 and declined after the twin shocks. The value of goods and services exports as a share of GDP rose to 41.4 percent in 2019, dropped to 29.8 percent in 2020, and has been recovering since then (Figure 27). In recent years, the share has been consistent with the average for countries of similar per capita income but still lower than the share of some peers. Export performance was exceptional in 2022, reaching 46.6 percent of GDP, boosted by Armenia’s transit hub role and re- exportation to Russia. Figure 27. Exports of Goods and Services Figure 28. Goods Exports, by Destination Sources: World Bank national accounts data; OECD National Accounts Source: World Bank staff calculations based on Armenia Statistical data files. Committee external trade database. 49. Armenia’s goods exports have become increasingly concentrated on a few trading partners. Major export destinations include China, the EU countries, Russia, and Switzerland (Figure 28). Because of the Eurasian Economic Union, Armenia started exporting more to Russia as well as China (which has signed a preferential agreement with the Eurasian Economic Union). Exports to Russia increased from an average of 17 percent during 2010-2016 to 23 percent during 2017-21, while exports to China increased from 5 percent to 8 percent. At the same time, Armenia’s exports of gold to Switzerland have increased in recent years such that Switzerland was the second largest export market for Armenia between 2017–2021, with an average 16 percent share of exports. 50. Armenia’s trade is largely focused on mineral exports and services with declining complexity, reflecting the thin manufacturing sector as well as barriers to competitiveness. Armenian goods exports are strongly tilted toward mining and manufacturing products of limited complexity, and the economic complexity of exports has declined since 2012 from an already low-complexity basket. 39 As primary products such as copper, ore, and gold grew in importance over the past two decades, the country’s economic complexity declined, falling 25 positions in the index ranking since 2012 (Figure 29). 40 In 2020, Armenia ranked 77th among 127 countries, with an economic complexity index of −0.37, significantly below peers. Armenia is slightly less complex than expected for its income level. This result has been driven by a lack of diversification, as exports have become more concentrated in primary products. While apparel 39 Economic complexity is a measure of productive expertise—that is, the knowledge in a society as expressed by the amount of goods produced. It combines the diversity in the exports a country produces and the ubiquity of these exports, as reflected by the number of countries able to produce such goods. Countries that can sustain a diverse range of productive expertise—including sophisticated, unique expertise—are found to be able to produce a wide diversity of goods, including complex products that few other countries can make. 40 Economic complexity is associated with economic growth across countries. Armenia’s current index may represent the narrowness of the ability of Armenia to leverage opportunities to diversify production using existing expertise. The government recognizes this limitation and has set a goal of increasing economic complexity from −0.39 to 0.1 points in the medium term and achieving a good ranking among countries with high economic complexity. This is reflected in the Armenia 2021–26 Strategy. 24 exports (in particular, coats and anoraks) experienced increased dynamism and significantly contributed to growth of overall goods exports, new product discoveries have been trending downward for both overall and apparel exports since the mid-2000s (Figure 30). The significant decline in new product discoveries may signal lower competitiveness. Figure 29. Economic Complexity Index Figure 30. New Product Discoveries Source: The Economic Complexity Observatory, Sources: World Bank staff calculations based on data from BACI; Gaulier https://oec.world/en. and Zignago 2010. Note: Simoes and Hidalgo 2011. Note: BACI = Base pour l’ Analyse du Commerce International (Database for International Trade Analysis); see Gaulier and Zignago (2010). HS6 = products at the six-digit level in the harmonized international product nomenclature of the World Customs Organization. Figure 31. Exports, by Product Type, Armenia 51. Mining accounts for the largest exports for Armenia and one-fifth of the industrial sector. The sector’s share of GDP has been rising gradually, increasing from 3.4 percent in 2020 to 4.6 percent in 2022. 41 In 2020, copper ores, gold, and ferroalloys were among Armenia’s top five export products, accounting for almost half of total exports (Figure 31). At a sectoral level, mining’s share of Armenia’s goods exports increased from 12.4 percent in the 2000s to approximately 30 percent on average during 2015–2022. This increase was driven primarily by the emergence of copper, which represented 7.1 percent of Armenia’s goods exports in 2002 and increased to 27.8 percent in 2015–20. 52. Among goods imports, Armenia is heavily reliant on Sources: World Bank calculations based on data from BACI; imported fuels. Industrial supplies and capital goods are also Gaulier and Zignago 2010. essential imports for Armenia. Similar to exports, large shares Note: Shows the evolution of exports by product type. of imports are sourced from a few trading partners, with Russia, China, and Iran leading the ranking in recent years. Of special interest given the current geopolitical context in ECA, Armenia is highly dependent on petroleum, coal, and seed oil imports from Russia and Ukraine, with only a few comparators showing higher dependency ratios (Figure 32). In addition, Armenia is 100 percent dependent on imports for natural gas (mainly from Russia), which accounts for 63 percent of the country’s primary energy supply and is widely used for power generation, heating, and transport. 41 Based on ArmStat national accounts data. The closure of one of the copper mines resulted in a reduced sector share for 2022. 25 Figure 32. Goods Imports, by Source, Armenia a. Petroleum and coal products import dependency on b. Seed oil import dependency on Russian Federation and Ukraine, Russian Federation and Ukraine, 2017 2017 Source: World Bank staff calculations based on GTAP Database. 53. Service exports are a key component of Armenia’s exports and mitigate the challenge of being landlocked. Service exports accounted for more than 40 percent of Armenia’s total exports in 2019 and 35 percent in 2021, with the decline mirroring the disproportionate toll of the COVID-19 crisis on services as opposed to goods trade. Service exports are mostly driven by transport, travel, and IT services (Figure 33). Over time, Armenia’s service exports have been relatively more dynamic compared to peers. This finding holds even when excluding traditional services such as travel and transport, highlighting the importance of IT services for Armenia’s economy (Figure 34). 42 Information and communication technology (ICT) service exports as a share of total service exports more than doubled from 10 percent in 2017 to 22 percent in 2021. Armenia’s share of services trade in GDP (30 percent on average since 2015) also tops the shares of all other landlocked countries, suggesting that Armenia’s skillful diversification of its service exports is helping mitigate the challenge of being landlocked. Figure 33. Commercial Service Exports, Armenia and Peer Figure 34. Commercial Service Export Performance, Excluding Countries, 2019 Travel and Transport, Armenia and Peer Countries, 2005 = 100 Sourcse: World Bank staff calculations based on data of BaTIS Sources: World Bank staff calculations based on data of BaTIS (Balanced (Balanced International Trade in Services, 2005–19) (dataset), International Trade in Services, 2005-19) (dataset), Organisation for Organisation for Economic Co-operation and Development; World Economic Co-operation and Development; World Trade Organization, Trade Organization, https://stats.oecd.org/Index.aspx?DataSetCode=BATIS_EBOPS2010. https://stats.oecd.org/Index.aspx?DataSetCode=BATIS_EBOPS2010. 42 A Trade and Competitiveness Diagnostic, currently under preparation, further examines servicification of Armenia’s manufacturing. 26 Foreign Direct Investment 54. Armenia’s FDI inflows declined gradually starting in 2008 and reached a low during the pandemic, before recovering strongly in 2021. Armenia’s FDI amounted to 2.8 percent of GDP in 2021, up from 0.4 percent of GDP in 2020 which was its lowest share in over two decades and the lowest share of all peers in 2020 (Figure 35). FDI stocks also picked up in 2021, but their dynamism relative to GDP did not. FDI stocks as a share of GDP remained around 40 percent, significantly lower than for most peers and in line with levels since the mid-2010s (Figure 36). Russia is still the largest holder of FDI stocks in Armenia, but its share has declined since 2014 as the shares of the EU, North America, Middle East, and other regions increased (Figure 37). Figure 35. Benchmarking FDI Net Inflows Figure 36. Armenia and Peers: Stock of FDI (% of GDP) Sources: UNCTAD data from Source: UNCTAD data from https://unctadstat.unctad.org/wds/TableViewer/tableView.aspx and; https://unctadstat.unctad.org/wds/TableViewer/tableView.aspx BOP/IIP data from Balance of Payments and International Investment and Position Statistics (dashboard), International Monetary Fund. Note: The figure shows net inflows (new investment inflows, less disinvestment) from foreign investors. 55. Armenia’s FDI inflows and greenfield investments have experienced a strong post-pandemic revival, but it is too soon to gauge whether this trend reversal will be sustained. At US$998 million in 2022, FDI net inflows were 2.6 times those in 2021 (Figure 23). In 2022, greenfield investment had an equally strong showing, several multinationals with operations in Russia moved their offices to Armenia, while an influx of Russian citizens to the country brought in new talent. Foreign investors announced a record 24 FDI projects in Armenia in 2022, a three-fold increase over 2021 (Figure 38). However, it is too early to determine whether these recent developments signify a reversal in trend or whether they reflect a catching up for COVID-era stalled investment and the exceptional inflows to Armenia related to the Russian influx in 2022. Figure 37. FDI Stock in Armenia (by Country) Figure 38. Greenfield Investment Projects, Armenia Source: IMF Coordinated Direct Investment Survey. Source: FDI Markets database from the Financial Times Ltd 2023. 27 56. The top sectors for greenfield FDI projects have been shifting toward tradable services, but the bulk of FDI inflows involve resource-seeking FDI in extractive industries and energy. Most FDI projects coming to Armenia in 2003– 12 were in sectors that attract resource- or market-seeking FDI, such as financial services, communication, or metals. Many FDI projects in 2013–22 were also in tradable services, such as software and IT and business services, which have emerged globally as the top sectors for FDI (Figure 39). However, overall FDI inflows recorded by the Central Bank of Armenia (CBA) shows that the average project capital expenditure (capex) was much higher in sectors such as metals (mining/extraction, with average project capex of US$78 million) than in service-oriented sectors such as software and IT (average project capex of US$18 million, median capex of US$6.7 million). The top-performing sectors in FDI inflows in 2014–21 were electricity and gas, mining, quarrying and other mining support services, and real estate activities (Figure 40). Figure 39. Top Sectors for Greenfield FDI, Number of Figure 40. Top Three Sectors by FDI Inflows, 2014–21 Projects Source: FDI Markets database from the Financial Times Ltd 2023. Source: Statistical Office of Armenia: Inflows of foreign and direct investments by type of activity, 2014–21 (balance of payment and international investment position, sixth version – BPM6). 4.2. Drivers of Poverty Reduction Evolving Drivers of Poverty Reduction 57. Drivers of poverty reduction are tied to the dynamics of the ongoing structural transformation. Growth analysis revealed that Armenia is going through a structural transformation in which the agricultural sector, characterized by low productivity, is shrinking in terms of employment and value-added share while the service and industrial sectors are becoming more prominent. These shifts help explain the results of the income growth decomposition analysis, in which households’ income generation structure is linked to poverty reduction (Figure 41). The analysis compares two periods, 2010-16 and 2016-21, as 2016 was the year of a structural break in the growth trajectory as discussed in Section 3. It coincides with the latest data used for the poverty analysis in SCD1, allowing the analysis to compare before and after SCD1. 28 Figure 41. Decomposition of Income Poverty Reduction Source: World Bank staff calculations based on ILCS. Note: Negative values indicate contribution to reductions in poverty, while positive values indicate contribution to increases in poverty. Details of each component are as follows: Dependency Ratio: share of adults in the household; Employment: share of employed adults in the household; Wages: average wage income per employed adult in the household (from manufacturing and services sector); Agriculture: average agricultural income per employed adult in the household; Social Protection: average social protection benefits per adult in the household; Remittances: average remittances per adult in the household; Other: average income from other sources per adult in the household (includes income from stocks or financial actions, sales of real estate, and income from property). 58. Having jobs has become an increasingly important driver of poverty reduction in recent years. The results from the decomposition analysis show that poverty decreased in both periods as total income per capita rose by 45 and 13 percent, respectively. 43 According to the ILCS, employment measured by the share of employed among working-age household members (ages 15–75) rose in 2016–21 by 12.2 percentage points (from 32.0 to 44.2 percent), compared with a 4 percentage point increase in 2010–16 (from 28 to 32 percent). The dramatic rise in employment contributed significantly to poverty reduction in 2016–21. 59. Growth analysis shows that the expansion of the industrial and services sectors did not necessarily result in an increase in employment. Coupled with the demographic shift, employment remains a critical factor for poverty reduction. However, during 2010–16, there was a net reduction in employment. Yet at the same time, Armenia’s shrinking population, accompanied by a decline in the number of working-age adults, resulted in a rise in the share of employed among adults within the household. This demographic shift led to an increase in income per capita which resulted in poverty reduction. The larger impact of employment in the second period is thanks to the larger increase in the share of employed among working-aged adults within the household. 60. The increase in wages from the growing industry and services sectors was also an important contributor to poverty reduction, especially in 2010–16. Wages—measured by the wage income from the industry and services sectors per adult in the household—increased, reflecting the improvement in productivity in these two sectors driving the structural transformation. However, due partially to a larger shift of labor into the industrial sector during 2016– 21, the productivity in this sector did not grow as much in the second period compared to the first. This resulted in a smaller contribution of wages to poverty reduction in the second period. 43The income growth decomposition uses income per capita as the variable of interest instead of per adult equivalent consumption aggregate. As such, the national poverty lines for the respective years are adjusted by the marginal propensity to consume. 29 61. While labor income continues to play an important role in reducing poverty, the contribution of wages has fallen in recent years, which may be explained by the drop in returns to education. Unlike the pre-2016 period, the contribution of wages to poverty reduction fell in 2016–21. One possible explanation for the observed changes in wage income is the significant and persistent decline in returns to education. Analysis using the Mincer equation (in which wage earnings are regressed as a function of schooling and labor market experience) highlights that the rate of returns to schooling fell from 6 percent in 2010 to 4 percent in 2016 and 2 percent in 2021 (Figure 42). 44 This is an exceptionally large decline: the literature shows that, on average, returns to schooling declined by 3.5 percentage points worldwide since 1980, associated with an increase in the supply of schooling by almost 50 percent (Patrinos 2016). In the case of Armenia, returns dropped by 4 percentage points in a decade without a change in the supply of schooling (Table 1). Figure 42. Returns to Schooling Table 1. Years of Schooling Population Year group 2010 2016 2021 Total 13.2 12.5 13.3 Men 13.2 12.4 12.7 Women 13.3 12.7 13.7 Source: ILCS 2010, 2016, 2021. Source: ILCS 2010, 2016, 2021. 62. The improvement in the contribution of agricultural income to poverty reduction reflects an increase in agricultural income for those who remained in the agricultural sector. The impact of agricultural income in 2016–21 was neutral for poverty reduction—an improvement from 2010–16, when the impact on poverty reduction was negative. The improvement in 2016–21 was thanks to a decline in the size of the workforce remaining in the agricultural sector with the ongoing structural transformation, which raised productivity and increased income for those remaining in the agricultural sector. 63. Yet as shown in the growth analysis, productivity of the Figure 43. Sector of Employment by Poverty Status, agricultural sector is substantially lower and has a long way to 2021 converge with that of the industrial and services sectors. Given the significant share of the poor employed in the agricultural sector (Figure 43), improvement in agriculture productivity is expected to lead to higher incomes for the poor employed in the agricultural sector if supported by the right policies. Policies need to address the lack of scale, lack of skills and knowledge that is holding back many farmers from investing in new agricultural technology, inefficient land markets, and vulnerability to risks from climate change including weak irrigation systems. 64. Although social protection has contributed to poverty Source: World Bank staff calculations based on ILCS 2021. reduction, the impact on poverty reduction was relatively small compared to other factors. Pensions are the biggest component of social transfers, benefiting not only the poor but the whole population so the impact is not progressive. The Family Benefit Program is the largest monetary and targeted social assistance program in Armenia, both in terms of population coverage and fund allocation from the State Budget. The program is well-targeted in allocating 80 percent of the benefits to the bottom 40 percent. 45 However, coverage is low, benefiting only about one-fourth (26.3 percent) of the poor as measured by the national poverty line in 2021 44 Specifically, the estimates are the result of regressing the logarithm of wage on years of schooling, experience, and experience squared. 45 In 2021, around two-thirds of the bottom 40 percent was identified as poor. 30 (ArmStat 2022a), so it has had a relatively small impact on poverty reduction among the factors considered in the analysis. 46 65. The declining rate of growth in remittances among poor households has counteracted the progress in poverty reduction. On average, per capita remittances per month increased by 10 percent during 2010–16 and accelerated to a 16 percent increase during 2016–21. However, the share of remittances in household total income is consistently larger among better-off households: 9 percent among the non-poor versus 6 percent among the poor in 2010, 9 percent (non-poor) versus 5 percent (poor) in 2016, and 6 percent (non-poor) versus 4 percent (poor) in 2021. The rate of increase in absolute terms between the two periods, 2010-16 and 2016-21, was also larger among the non- poor (9.4 percent) compared to the poor (6.7 percent). 47 Spatial Dimensions of Poverty and Vulnerability 66. Disparities in welfare persist across geographic areas, and spatial variation is pronounced at the community level. The poverty rate fluctuates widely across regions each year, with the highest rates observed in Gegharkunik followed by Shirak in 2021 (Figure 44). However, the regional average masks the variation of wealth at the community level. Yerevan and the surrounding communities in the central and northwestern areas are associated with relatively higher levels of wealth. Figure 44. Regional Poverty Rates Figure 45. Distribution of the Poor, by location Source: World Bank staff calculations based on ILCS 2020 and Source: ArmStat Social Snapshot, 2011–22. 2021. 67. The poor are concentrated in rural areas, followed by secondary cities (Figure 45). The concentration of the poor in rural areas has intensified since 2020, while the share of the poor was equally large or even higher in secondary cities during 2011–18. 48 In 2021, 52 percent of the poor lived in rural areas, while the share was 16.7 percent in Yerevan and 31 percent in other urban areas. Disparities in living standards were substantial in 2021, with the average monthly consumption per adult equivalent in Yerevan being almost 30 percent higher than in rural areas in real terms. 49 46 There was also a reduction in the number of beneficiaries among the bottom 40 percent and a smaller increase in the benefits received during the 2016–21 period, which led to a drop in its contribution to poverty reduction. 47 The trend in remittances varies by the definition of households’ welfare status—whether they are based on income or consumption, and whether to use the value excluding or including remittances. It would also depend on how the averages are calculated—whether the estimates are averaged across all households or only among beneficiary households. 48 Historically, the poverty rate has been higher in other urban areas than in rural areas, but the trend reversed in 2019. This may be due at least partially to the changes in the design of the questionnaire of the ILCS and the computation of the consumption aggregates. 49 The average monthly consumption aggregate per adult equivalent in 2021 was 77,957 AMD in Yerevan, 65,746 AMD in other urban areas, and 61,266 AMD in rural areas (ILCS 2021). 31 68. The spatial gap in welfare is correlated with a gap Figure 46. Rural-Urban Divide, Accessibility and Human in connectivity and access to basic services. Economic Capital Outcomes activities are concentrated in Yerevan and surrounding cities and communities in the central-west areas. 50 Less well-off communities tend to be located far from the main road network and poorly connected to markets. The rural- urban divide is also notable in terms of access to basic services such as roads, schools, water, and health facilities, which also affects outcomes in human capital accumulation (Figure 46). 51 Although progress has been made in poverty reduction in recent years, secondary cities still face a lack of opportunities in the labor market. Source: World Bank staff calculations based on ILCS 2021. Characteristics of the Poor: Lack of Human Capital and Limited Access to Services and Opportunities 69. The poor lack human capital in terms of education and health, which undermines the growth of household income over their lifecycle. Educational attainment is lower among the poor, as shown by the gap in harmonized test scores between the poor and non-poor (Figure 47). The gap of 66 points—on a scale that ranges from 300 (minimal attainment) to 625 (high attainment)—is larger than the typical gap of 55 points across the 50 countries for which data are available (World Bank 2020f). The poor are also deprived in terms of health, with a larger share of the population having to terminate usual activities due to illness, injury, or bad health (Figure 48). According to the Human Capital Index (HCI), an Armenian child born today will be only 58 percent as productive during their lives as they could have been if they had received the full set of health and education services available, and this rate has remained stagnant in recent years (2012–20). Figure 47. Educational Outcome: Harmonized Test Scores, Figure 48. Health Outcome: Termination of Usual Activities, by by Poverty Status Poverty Status 600 500 483 417 400 Score 300 200 100 0 Poverty Status Poor Non-Poor Source: World Bank 2020f. Source: World Bank staff calculations based on ILCS 2021. 70. The disparity in human capital outcomes is associated with inequalities in access to services. Compared to the non-poor, the poor face difficulties accessing basic services such as education, health, sanitation services, and digital connectivity (Figure 49). 50Economic activities are measured by night-time lights as the proxy for GDP in the area. 51According to the source, close to 600 rural settlements lack access to regular water supply, many of them located near the border with Azerbaijan. 32 Figure 49. Deprivation in Access to Services (%) Figure 50. Opportunities in Labor Market, by Poverty Status (%) Source: World Bank staff calculations based on ILCS 2021. Note: For education, figures show percentage of those between Source: World Bank staff calculations based on ILCS 2021. ages 15–75. 71. The poor also lack access to opportunities as measured by access to good-quality jobs. While 65 percent of the working-age population (ages 15–75) are employed, the rate among the poor was 59 percent in 2021. Among the employed, a disproportionately larger share of the poor is employed in the low-productivity agricultural sector and a smaller share in the higher-productivity service sector. This is reflected in difficulties accessing good-quality jobs. Good- quality jobs are not widely available, and they are unequally distributed across socioeconomic groups with almost half of the poor (47.5 percent) not having access to decent jobs, compared to 37 percent of the non-poor (Figure 50). 72. Labor mobility across sectors was low and did not contribute to poverty reduction, indicating that improving labor productivity in agriculture is key to reducing poverty. Analysis by the World Bank shows that almost none of the poverty reduction came from a transition of workers from one sector to another, revealing low worker mobility and weak labor market dynamism (World Bank 2020b). Therefore, continued efforts are needed to decrease poverty among agricultural workers by improving labor productivity in the agricultural sector (World Bank 2020b). Vulnerability to Environmental Risks 73. Armenia’s climate risk is high relative to other countries, with above-average projected temperature rises and climate volatility (IMF 2022a), and exposure to risks varies significantly across geographic areas. Temperature rise causes shifts in evaporation from the land, changes in the magnitude and frequency of heavy precipitation, and flooding. Notably, the climate-related risks are not equally distributed across geographic areas of Armenia. For example, regions in the north are exposed to higher risk of floods, while temperature variation is higher in the central- western and south-eastern areas of Armenia. These gaps in exposure to risks will have unequally distributed impacts on livelihoods across space, which can exacerbate disparities in welfare across regions and communities. 74. Climate-related risks and natural disasters are also expected to have distributional impacts across socioeconomic groups. The poor may be more vulnerable to climate change due to both higher exposure and low adaptive capacity. Climate change is expected to heavily affect agricultural activities in Armenia through degradation of land and increased flooding risk, which negatively affect productivity. 52 As agriculture is the dominant source of livelihoods for the poor in Armenia, this is likely to hurt the poor. To mitigate the potential damage from climate 52 For example, an analysis in India showed that a moderate level of warming over the next three decades could result in a 17 percent reduction in agricultural productivity and a 3-4 percentage point increase in the national poverty rate (Jacoby et al. 2011). 33 change, their adaptation capacity should be increased, for example by changing inputs and technology in agriculture and enhancing employability in the non-farm sector through accumulation of human capital. 5. Key Challenges to Resilient, Sustainable, and Inclusive Growth 75. This section examines empirical evidence to identify the main challenges to attaining the twin goals in Armenia in a sustainable way. The section identifies the most salient challenges since SCD1 by exploring both macroeconomic and microeconomic constraints informed by the growth and poverty analyses in Sections 3 and 4, those identified in SCD1, and those that seem most relevant going forward. Figure 51 maps the most important barriers to more sustainable growth, stronger poverty reduction, and shared prosperity as identified by the analysis of Sections 3 and 4. The intersection of the results from the two analyses informs the key challenges for Armenia to address. While “governance, institutions, and data” does not explicitly emerge from the analysis in Sections 3 and 4, it is identified as a constraint that cuts across sectors in Armenia and underpins all of the challenges identified. Appendix C includes a summary of the key findings of SCD1, and Appendix E describes the methodological steps for identifying comparison countries to benchmark progress and challenges in Armenia. Figure 51. Barriers to Growth and Poverty Reduction 76. SCD2 identifies five major challenges to achieving sustainable, inclusive, and resilient growth in Armenia. While most were identified in SCD1, there is a shift in focus given the changing economic and geopolitical circumstances as discussed earlier. Although many of the same constraints are still hindering faster progress in achieving the twin goals, Armenia has experienced rapid changes in external and internal conditions since SCD1, and building resilience to fragility and conflict has become a new challenge in light of the vulnerability revealed by heightened geopolitical tensions in the region. At the same time, some of the challenges identified in SCD1—for example, macroeconomic management—have become less pressing thanks to successful implementation of certain policy reforms since SCD1. Nonetheless, continued efforts are recommended to cope with the highly unpredictable economic challenges facing Armenia. Since effective governance and institutions are essential for creating an enabling environment for sustainable and inclusive growth, governance and institutions have been added as a cross-cutting area given the reduction in government effectiveness and the salient need to enhance institutional capacity. Figure 52 summarizes the evolution of the major challenges. 34 Figure 52. Evolution of Key Challenges for Inclusive and Sustainable Growth from SCD1 to SCD2 Challenges in SCD1 Challenges in SCD2 C4: Resilience and sustainability 1.1 Vulnerability to risks of fragility, conflict, and  Macroeconomic management violence (NEW in SCD2)  Demographic changes and impact on health and pension needs  Large share of vulnerable households, instruments 1.2. Vulnerability to economic shocks available to cope with shocks  Climate change, environmental disaster risks 1.3. Vulnerability to risks from climate change, C1: External sector performance environment, and natural disasters  High trade costs  Global connectivity infrastructure (hard and soft) 2. Accessibility to markets and better integration C3: Labor productivity for trade  Labor market relevance of the education system  Skill match 3. Quality of human capital  Care responsibilities C2: Private sector productivity 4. Private sector development  Investment climate  Market contestability Cross-cutting challenge: governance and  Financial deepening and access to finance institutions, data (NEW in SCD2) 5.1. Vulnerability to Shocks and Environmental Risks 77. To achieve sustainable and inclusive economic growth, Armenia will need to strengthen its capacity to manage shocks and environmental risks. At the macroeconomic level, fragility and vulnerability to conflict as well as rising inflation underscore the need to improve resiliency, particularly given Armenia’s historical external dependence on Russia. The huge disruptions in economic growth during the 2007–09 global financial crisis, the end of the commodities super cycle in 2015–16, and the twin shocks in 2020 are evidence of the country’s fragility to economic shocks. At the microeconomic level, households remain vulnerable, while the social protection system could be strengthened. In terms of the environment, increasingly frequent destructive events associated with climate change and natural hazards require adequate preparedness for environmental and climate shocks. This section discusses three key vulnerabilities for Armenia then highlights vulnerable groups who are particularly at risk and some resilience factors. 5.1.1. Fragility and the Risks of Conflict 78. A deep and widespread sense of insecurity resulted from the outcome of the 2020 military conflict in Nagorno- Karabakh, amid broader geopolitical shifts. The results of the aforementioned event have brought a paradigm shift in Armenian polity and society, as public opinion priorities have shifted away from economic and governance issues to security issues. The 2020 military conflict and the 2021 and 2022 fighting in the border area, including in Armenia’s territory, have created considerable social scars and grievances and many Armenians (particularly those in border areas) continue to experience disruptions to their livelihoods. Armenia’s sense of insecurity is the product of the interplay of various factors of fragility moderated by dimensions of resilience (Box 3). 35 Box 3. Structural Factors of Fragility, Risk, and Resilience Factors of fragility and risk  Armenia’s fragile state of relations with two immediate neighbors is rooted in deep historical grievances that are difficult to resolve, continue the possibility of renewed conflict, and significantly constrain the prospects for development.  Armenia’s relatively small size and landlocked position, the overall geopolitically complex setting, and the country’s dependence on energy imports create significant dependency on Russia and vulnerability to regional and global power politics.  Domestically, Armenia is ethnically homogeneous but has considerable demographic and regional disparities in outcomes and a high level of social vulnerability that, in a context of exclusion grievances, create space for the erosion of trust in institutions.  Armenia’s economy is vulnerable to externally induced shocks that, considering the share of the vulnerable population, have the potential to disrupt social stability and amplify other drivers of conflict. Factors of resilience  Armenia is a fragile but relatively developed democracy with a homogenous society, strong sense of identity, and high degree of state legitimacy.  Armenia continues to have other sources of remittances outside of Russia, and its diaspora still has considerable untapped human capital potential.  Armenia can rely on a range of external multilateral memberships and bilateral partnerships, as well as on the role of its diaspora to muster political support.  Armenia’s youth and its women, particularly in urban centers, have an increasing sense of agency in the public sphere and are among the most affected by conflict and violence. As such, they can be key drivers in addressing some of the social and political elements of fragility. Potential risks going forward  The potential broadening of geopolitical uncertainty in the region may increase volatility in Armenia’s relations with its neighbors.  The Armenian economy’s dependence on developments in Russia leaves it exposed to short-term economic volatility and shocks, as well as to medium-term structural economic changes as markets adjust to the new conflict situation.  Environmental risks and shocks that increase social vulnerability are also possible, either as a side effect of war or due to continuous degradation by economic activity and climate change.  The government’s ability to build resilience to the drivers of fragility or risks faces the obstacle of limited fiscal space. The materialization of risks would require difficult expenditure trade-offs that may raise issues of debt sustainability or fuel political instability. Source: World Bank 2023c. 79. The ongoing conflict and unresolved peace process have ramifications for Armenia’s development path. Persistent political uncertainty could inevitably have negative impacts on investor sentiment, FDI, and economic outcomes. For example, the September 2022 fighting disrupted the key tourist town of Jermuk, close to where recent violence occurred, and has affected a nearby gold mining project’s efforts to raise investment. This has also presented several problems related with non-irrigated and unused lands and water resources and resulting environmental impact.“ 80. The increased erosion of trust in institutions stems from growing political and social polarization and economic and environmental stressors that deepen exclusion. The security concerns sparked by the 2020 military conflict have derailed the broader consensus on governance reform inspired by the 2018 revolution by handing the former political establishment a political cause. While Armenia has put in place a robust anticorruption legislative and regulatory framework, public servants express limited confidence regarding the effectiveness of different actors in the fight 36 against corruption. 53 Two-thirds of Armenians continue to believe that the country is run in the narrow interests of elites and not the majority (IRI 2022a). 5.1.2. Vulnerability to Economic Shocks 81. The lack of diversification makes Armenia vulnerable to economic shocks. As discussed earlier, exports are concentrated among a few trading partners and products. The country’s economic growth history is somewhat akin to that of an oil exporter. First, about one-third of Armenia’s exports are minerals and are thus exposed to commodity price shocks. Second, the strong links to Russia have exposed Armenia’s economy to volatility including from oil price shocks and the 2015-16 sanctions on Russia (Figure 53) (Garrote-Sánchez et al. 2022). Russia is Armenia’s leading trade partner (accounting for one-third of all bilateral trade over 2018–21) and its primary source of FDI (41 percent of net FDI stock in 2021) and remittances (5 percent of GDP in 2021). Russia’s invasion of Ukraine has exposed Armenia to trade disruptions, and closures among terrestrial and air transportation centers in the region are disrupting trade routes into and out of the country. In 2022, Armenia became a transit hub for re-exportation to Russia, particularly for electronics, transportation equipment, and machinery. It is unclear how potential sanctions on Russia might affect trading partners in the future. Figure 53. GDP Growth in Armenia and Russia and Oil Price Figure 54. Major Imported Agrifood Commodities and Armenia’s Dependency on Supplies from Russia and Ukraine in 2021 Sources: GDP World Bank WDI Source: FAO and World Bank (forthcoming). https://data.worldbank.org/indicator/NY.GDP.MKTP.KD.ZG, for 2022 World Bank Macro Poverty Outlook; World Bank Commodity Markets. 82. Armenia’s high dependence on certain food items could pose a risk to food security. Armenia’s reliance on import dietary energy is substantial, with an import dependency ratio of 0.43 (FAO and World Bank 2023). 54 Certain key commodities for Armenia have high import dependency. For example, Russia accounted for 98 percent of Armenia’s imports of wheat, wheat flour, sunflower seed oil, and other cereals; almost 35 percent of all agrifood imports; and 39 percent of poultry in 2021 (Figure 54). Russia also accounts for more than 50 percent of imports of bread, pasta, bulgur, and pastries (in value terms). In addition, Russia is Armenia’s primary source of fertilizers (38 percent in 2021), an input for domestic food production. Thus, ad hoc policy changes and supply disruptions from Russia can pose significant threats to Armenia’s food security. 83. Armenia’s high share of commodity exports exposes it to several risks. Armenia’s economy is vulnerable to exogenous commodity price shocks. Furthermore, any growth in mineral exports, while important for hard currency 53Armenia Public Sector Accountability Survey. World Bank (May 2023). 54The import dependency ratio reflects the extent to which a country’s supply of a commodity comes from imports. The higher the ratio, the more dependent a country is on importation. World Bank. Forthcoming. Reconfiguring Trade to Overcome Geographical Limitations: A Trade and Competitiveness Diagnostic for Armenia. Washington, DC: World Bank. 37 generation, could present macro-fiscal and long-term structural risks. To some extent, diversifying the mineral basket (through discovery and development of high-value minerals other than copper and gold) and moving downstream to domestic processing of minerals can reduce the degree of risk. Heavy reliance on primary commodity exports to generate hard currency can lead to an over-valued currency, placing other export sectors at a competitive disadvantage. The lessons learned among resource-rich countries over past decades call for macro-fiscal measures to dampen shocks and avert an over-valued currency. 84. To reduce its vulnerability from concentrated trade products and partners, Armenia could seek to expand its export offerings based on comparative advantage, diversify its partners, and identify potential alternate markets for goods that are vulnerable. Armenia would benefit from an export strategy to identify these avenues. Armenia’s manufacturing sector has a comparative advantage in metal products, textiles and apparels, food and beverages, and other manufacturing. 55 In particular, estimates from a gravity model using 2021 data suggest that Armenia’s strongest comparative advantage in the manufacturing sector relative to agriculture is in metal products (Appendix L). Armenia could also enhance trade with a wider group of trade partners. For example, Armenia can better capitalize on market access to members of the Eurasian Economic Union of which it is part and related free trade agreements (FTAs). Armenia could also explore boosting trade with countries where there is significant export potential, such as the United States, France, and the United Kingdom (Figure 55). Figure 55: Armenia’s Estimated Missing Exports 450 Average missing exports in US$ million 400 350 300 (2013-2019) 250 200 150 100 50 0 France Ukraine Brazil Egypt, Arab Rep. United States China Poland Finland Kuwait Lithuania Hungary Italy India Korea, Rep. Czech Republic Belarus Indonesia Lebanon Austria South Africa Norway Ireland United Arab Emirates Iran, Islamic Rep. Uzbekistan Pakistan Qatar Argentina Türkiye Spain New Zealand Sweden Saudi Arabia Israel Australia Greece Denmark Singapore Mexico Malaysia Thailand Portugal Slovak Republic Nigeria Colombia United Kingdom Japan Germany Kazakhstan Source: World Bank staff calculations based on gravity model using BACI. Note: This analysis was done using data before the onset of the COVID-19 pandemic. Trade patterns between Armenia and Russia changed significantly after the imposition of sanctions on Russia in 2022. 85. Estimates based on past crises project that Russia’s invasion of Ukraine could reduce the stock of migrants and increase the labor supply in Armenia (Garrote-Sánchez et al. 2022). Economic developments in Russia could have a strong impact on migration flows in Armenia. In 2020, the stock of migrants dropped from 5.1 percent to 2.9 percent of the working-age population in Armenia (43 percent of the stock in 2019). Remittances dropped significantly during the first months of the pandemic but then rebounded, with a final annual drop of 12 percent, lower than previously projected. Shocks to the Russian economy due to international sanctions and the war could lead to contractions in the stock of Armenian emigrants: simulation exercises based on household microdata suggest that the shocks could affect 55Countries are said to enjoy a comparative advantage in a certain good when they can produce it more efficiently (at a lesser cost) than other countries. Textiles and wearing apparel, food and beverages, and other manufacturing have a comparative advantage of greater than 0.8 relative to agriculture. 38 20,000 to 50,000 returning migrants, or 1-2 percent of the working-age population (Garrote-Sánchez et al. 2022). The net impacts of the return of migrants to Armenia remain uncertain—the benefits include the supply of skilled workers, while the risks include pressures on labor markets and other disruptions. 86. Economic and other shocks could trigger the realization of important liabilities. Armenia’s debt to GDP ratio fell from 63.5 percent in 2020 to 47 percent as of end-2022 thanks to the dram’s appreciation and strong GDP performance. While the public debt is sustainable, a debt sustainability analysis reveals high sensitivity of Armenia’s public and external debt to a variety of shocks, with shocks to growth and the exchange rate having the most pronounced impact (IMF 2022b). Climate change risks and contingent liabilities arising from state-owned enterprises (SOEs) such as the Armenian National Interest Fund as well as public-private partnerships are other important sources of fiscal risk that need to be carefully monitored and managed. Such risks could be triggered by economic and financial shocks. 87. Given increasing global uncertainty and monetary policy normalization, Armenia also faces risks from inflation, especially in the case of dram depreciation. In an uncertain global environment with monetary policy normalization coupled with the risk of commodity and food price shocks and given Armenia’s energy dependence, inflation poses a risk to households and firms. Headline and core inflation stood at 8.3 percent and 8.8 percent, respectively, in December 2022 year on year, and the CBA raised the policy rate to a historically high 10.75 percent by end-2022 in response (Figure 56Figure 55). Domestic prices respond differently to currency appreciations and depreciations in the short and long run. Exchange rate pass-through analysis on Armenia indicates that, in the long run, currency appreciation has no statistically significant effect on domestic consumer prices, while the exchange rate pass-through associated with currency depreciation is large and highly significant (Khachatryan and Grigoryan, forthcoming). Figure 56. Inflation and CBA Policy Rate Figure 57: Comparison of Growth and Balance Correlations: Correlation Coefficient between Growth and Actual/Structural Balance 12.0 10.0 8.0 6.0 Percent 4.0 Inflation target 2.0 0.0 Apr Apr Apr Apr Jan Jan Jul Oct Jan Oct Jan Jul Jul Oct Jul Oct -2.0 2020 2021 2022 2023 CPI inflation, 12-month Policy rate Source: CBA database. Source: World Bank 2023b. Note: The correlation chart shows the correlation coefficient between real GDP growth and the change in actual and structural balances of the selected countries. 88. Armenia has a reasonable track record of countercyclical fiscal policy which has dampened output volatility but can be improved. In the face of multiple crises including natural disasters and conflict, Armenia’s reasonably good countercyclical fiscal policy over the last couple of decades—supported by a fiscal rule 56—has led to less volatile 56 Armenia was able to maintain fiscal discipline over the last decade, showing a strong commitment to fiscal rules. However, in response to various shocks, government debt rose significantly from 15 percent of GDP in 2008 to close to 54 percent of GDP in 2017. Fiscal rules were upgraded in 2017 through the establishment of a statutory threshold of 60 percent of GDP. The government demonstrated a strong commitment to these rules by reducing public debt to 50 percent of GDP by the end of 2019. In 2020, as in many other countries, there was a sharp jump in debt to GDP due to high COVID-19-related spending, a sharp fall in revenues, and decline in GDP. Debt rose above the statutory threshold, and the government triggered the escape clause in the fiscal rules to allow for the temporary increase in response to the emergency. 39 growth compared to many of its peers (World Bank 2023b). However, the correlation in Armenia between real GDP growth and the fiscal balance—a signal of countercyclicality—is less strong than in Estonia, for example (Figure 57). 57 The degree of countercyclicality in Armenia can be improved. 89. Armenia can build more buffers to support fiscal countercyclical policy. Budget rigidity refers to the constraints on changing the size and composition of public spending. An increasingly high degree of budget rigidity may constrain Armenia’s ability to adjust to crises and enhance countercyclical fiscal policy. In recent years, Armenia has had persistently high budget rigidity (Figure 58). On average, 77 percent of the budget was on spending areas that are assessed as “high” rigidity, higher than all peers during 2016–21 (Figure 59). High-rigidity expenditure areas typically include the wage bill, public debt servicing costs, pensions, subnational transfers, and spending on defense and courts. Figure 58. Evolution of Rigidity in Armenia, 2016-2021 Figure 59. Evolution of High Rigidity Sources: Ministries of Finance, World Bank BOOST Database; World Bank Force and Momentum Model, World Bank 2023b. 90. Given the spending pressures related to policy commitments, Armenia will require a combination of budget cuts, domestic revenue mobilization, and improvements in spending efficiency to fulfill policy commitments in the event of an economic shock (World Bank 2023b). Reforms have led to impressive results, including increased revenue collection and well-managed spending levels, contributing to macroeconomic stability and debt sustainability. Relying on additional debt financing may not be viable as it would result in non-compliance with the established fiscal rule and further increase borrowing costs. Revenue mobilization can be boosted further by building on Armenia’s existing strengths in tax policy and administration to enhance the quality of revenue collection and revise the tax policy roadmap. Expenditure cuts in other areas would be necessary, although high budget rigidity limits the scope of adjustments. Thus, improving spending efficiency is crucial for addressing difficult spending choices and thus providing additional cushion in preparing for economic shocks. 5.1.3. Climate Change, Environmental Risks, and Natural Hazards 91. Environmental risks, including climate change and natural hazards, pose high economic and social risks for Armenia. Armenia is a climate-vulnerable country 58 and highly dependent on natural resources for exports, government revenue, and as a source of livelihood. With the average temperature rising faster than the global average (2.5°C versus 1.3°C in 2020, respectively) (Berkeley Earth, n.d.), Armenia is exposed to multiple environmental challenges, including heat waves, floods, drought, and air pollution. Armenia is also exposed to a high risk of 57 This is measured by both the actual balance, which refers to the difference between actual revenue collection and executed spending, and by the structural balance, which is the difference between government revenues and expenditures, corrected by the effect that could be attributed to the economic cycle and one-off events. This indicator aims to capture structural trends to assess whether fiscal policy is expansionary, neutral, or contractionary for a given period. 58 In recent decades, climate change has significantly increased the frequency and intensity of hazardous hydrometeorological phenomena in Armenia (World Bank and ADB 2021). 40 earthquakes, as the country lies in a region of high seismicity. 59 These events may have huge distributional economic and health impacts, for example through damages to the agriculture, water, and energy sector. 60 According to the estimates, 0.7 percent of GDP is at risk from natural disasters such as landslides, floods, and severe droughts, which are projected to increase. 61 The potential impacts on the well-being of the population are also high in Armenia—which ranks 35th globally in terms of vulnerability to natural disasters—compared to other countries (Hallegatte et al. 2017; World Bank 2022f). 62 Adapting to Climate Change and Natural Disasters 92. Adaptation policies focused on resilient infrastructure and climate-smart agriculture will help reduce Armenia’s vulnerability to chronic and acute climate risks. Armenia has a large adaptation deficit to manage, including insufficient irrigation and high vulnerability to natural hazards such as droughts, floods, frosts, severe storms, and acute disasters such as earthquakes. Tailored policies to increase resilience with a focus on the most vulnerable populations can immediately reduce climate risk to assets from 0.73 percent to 0.70 percent of GDP and risk to well- being (calculated from consumption loss) from 1.03 percent to 0.86 percent of GDP, equivalent to US$34 million in potential annual gains (Hallegatte et al. 2017). Investing in climate-smart agriculture, supported by innovations by larger farms and agribusiness, is expected to increase productivity and enhance resilience while also reducing GHG emissions. 63 I Awareness about climate change risks and adaptation needs also carries opportunities beyond agriculture to unlock new growth engines for greener growth with the right policies in place. 93. Despite some progress and efforts by the government of Armenia, policies for resilience and emergency preparedness still need improvement and should be a priority for achieving sustainable and inclusive growth. Following the 6.5 magnitude earthquake that hit the city of Spitak in 1988, the government increased its commitments in disaster risk reduction and emergency preparedness to safeguard its country from any renewed shocks (Appendix J). However, given the relatively high risk of natural disasters, the government could improve the disaster risk management system by preparing risk-alert mechanisms, real-time assessment of asset condition post-disaster by enhancing digital technologies both at the central and local levels, 64 strengthening the social protection system to enhance the efficiency and timeliness of emergency support, and developing a disaster risk financing and insurance strategy to make the financial management of disasters more effective (UNICEF 2021; World Bank 2017d). 94. Armenia produced its first National Adaptation Plan in 2021, but this plan remains limited in scope, providing only an overview of institutional actions to build resilience to climate change across the country. The National Adaptation Plan lists 26 measures to (1) introduce and enhance the National Adaptation Plan process in Armenia and (2) enhance institutional and technical capacity for the National Adaptation Plan process, with an assessed cost of AMD 560 million. However, the plan does not contain any specific actions to build resilience and adapt to climate change. Instead, the plan focuses on the early processes of establishing the technical capacity to assess risks and needs. The few policy actions related to fiscal risk management specified in the National Adaptation Plan are delayed 65 and are not expected to be completed until 2023 (IMF 2022a). 66 Acknowledging the urgent need to mitigate and adapt to 59 Analysis indicates that an earthquake with a magnitude of 7.0 or greater would destroy most of the buildings in Yerevan, potentially killing 300,000 people (ADB 2019b). 60 Vulnerability assessment by the University of Notre Dame https://gain.nd.edu/our-work/country-index/ . 61 Hallegatte et al. 2017. 62 According to the analysis, the risk to well-being is estimated to cost 1.03 percent of GDP (Hallegatte et al. 2017). 63 World Bank Climate-Smart Agriculture https://www.worldbank.org/en/topic/climate-smart-agriculture. Areas for innovation include: circular models and the use of renewable energy (such as biogas production and aquaponics), financing of equipment, and technical advisory services to enhance aggregation capacity and processing capacity as well as product quality, with an emphasis on climate-friendly innovations along the value chain. 64 Government officials are committed to enhancing the potential of digital technologies to enhance climate resilience. See https://www.unescap.org/events/2022/armenia-national-workshop-digital-technologies-disaster-risk-management . 65 These include (1) Action 2.1 on the development of a guideline on the integration of climate-related risk management into sectoral and regional development strategies and (2) Action 2.4 on the mapping and development of a database on risks related to climate change. 66 Republic of Armenia National Adaptation Plan, 2021. https://unfccc.int/sites/default/files/resource/NAP_Armenia.pdf 41 climate change and be prepared for a strong recovery from natural disasters, in 2021, the government also renewed its commitment to green recovery and growth by introducing green economy and sustainable development policy priorities in its new five-year (2021–26) program. 67 Reducing Pressures on Natural Capital for Improved Resilience 95. Human pressures on the natural capital stock further increase vulnerability to environmental risks. For example, the mining sector is causing serious direct and indirect impacts on water quality, forests, and biodiversity. The emission intensity of mining of mineral products is significantly higher than in all neighboring countries and ten times higher than in the EU. 68 At mining sites, land preparation and expansion and waste management are destructive processes, changing abiotic and biotic conditions and in some cases transforming natural forests and threatening species and ecosystems. About 8,000 hectares of land have been degraded by mining activities, with an additional 1,500 hectares used to store tailings dumps. Pollutants are commonly leached out, affecting waterways and local biodiversity (World Bank 2016). Due to mining activities, 16 rivers in Armenia have been identified as exhibiting the highest degree of pollution. 69 Other problems in the mining sector are related to the lack of rehabilitation efforts and management of mining sites that negatively affect valuable water resources and threaten the health of people and ecosystems. While many of these problems stem from abandoned mine sites and past waste disposal, some mining operations have generated controversy due to pollution and other impacts on the local ecology. 70 96. Armenia’s air quality ranks among the worst in Europe, and untreated waste and wastewater continue to pollute the environment. Welfare costs associated with air pollution by fine particles (PM2.5) represent about 11 percent of GDP equivalent, compared to 4 percent on average in the ECA region (World Bank 2022e). An estimated 74 percent of the rural population depends on fuel wood for cooking and heating, which contributes to mean population exposure to PM2.5 that is three times the WHO guidelines (World Bank 2022h). In addition to fuel wood use, air pollution in Armenia is caused by fossil fuel combustion in energy, industry, agriculture, transport, and buildings as well as by fires, windblown dust, and other dust which account for approximately 50 percent of PM2.5 pollution, signaling the importance of landscape restoration and improved land management practices (McDuffie 2021). Also, in Armenia, only 9 percent of the wastewater is treated, and waste management capacity is very low. 71 Outdated water infrastructure (over 78 percent) and rising water demand increase the risk of water shortages. 72 In 2020, Armenia used 44 percent of its internal freshwater resources, up from 25 percent in 2002 and significantly more than the global average of 9 percent. 73 97. Agriculture is not only one of the sectors most vulnerable to climate change but also the second-largest producer of GHG emissions in Armenia and a source of other land pollution. Extreme weather events such as storms, droughts, hot dry winds, hail, and spring frost have been more frequent and have lasted longer, already inflicting great damage on agriculture. At the same time, crop and livestock production is still carried out using traditional means, which are inefficient and harmful to natural resources. Land degradation due to chemical pollution from mineral substances used in agriculture and chemicals in urban areas, salinization partly due to poor irrigation and drainage 67 The government has also launched the “Growth and Recovery for the Strengthening, Upgrading and Prosperity of Armenia” platform with the goal of combining and optimizing policies and investment initiatives to support Armenia’s transition to a green economy. 68 Global Trade Analysis Project 10 via EITE tool. 69 2018 data of the Hydrometeorology and Monitoring Center and the Ministry of Energy Infrastructures and Natural Resources. 70 The construction of the new Amulsar open pit gold mine was suspended in 2018 after protests linked to the environmental impact related to subsoil use rights. NGOs tracking the mining sector regularly highlight issues raised at a local level over a range of environmental threats posed by mines. After extensive due diligence and dialogue, construction is set to restart in 2024. 71 Yale Environmental Performance Index. https://epi.yale.edu/ 72 European Environment Agency (EEA) and ENI SEIS II East Project https://aarhusclearinghouse.unece.org/resources/eea-seis-ii-east-project- outputs-access-environmental-information 73 FAO Global Information System on Water and Agriculture. https://www.fao.org/aquastat/en/ 42 practices, as well as deforestation due to overcutting, overgrazing, mining, and forest fires are all affecting agricultural productivity and reduce valuable ecosystem services erosion control. 74 98. One of the biggest challenges for agricultural reform is the management of water. Nearly 70 percent of water withdrawals in Armenia are for agriculture. While Armenia is not water-scarce, water resources are declining in quantity and quality, and the availability of water resources and river flows has become uncertain. The vulnerability will vary by basin and watershed, but according to an estimate, the average river flow could decrease by 39 percent by the end of the century, affecting multiple sectors including agriculture and hydropower infrastructure (World Bank and ADB 2021). Improving water storage capacity in Armenia by constructing reservoirs will also be critical to ensuring more resilient water services to the agricultural sector, as highlighted in the Armenia 2021–26 program. 75 5.1.4. Risk Differentiation 99. The vulnerabilities Armenia is exposed to in terms of shocks vary in cause and solution. Fragility and conflict- related risks include those from inter-state conflict and those from risks of internal tensions, arising from eroding trust in institutions and government effectiveness. While the two are closely linked, as trust in institutions is highly responsive to the government’s handling of the border issue, additional mitigating factors can be planned . While risks from inter-state conflict are outside the scope of development interventions, government can mitigate their impacts through social protection systems, for example. Risks from international tensions could also be partly addressed through development interventions, for instance by strengthening government effectiveness, service delivery, and fostering a more inclusive society and accountable government. However, other risks such as vulnerability to economic and climate shocks require a different approach. Development interventions and government policy can shift the economy towards a more diversified one in terms of dynamic sectors, export partners, products, and sources of FDI. Although Armenia is mostly affected by the impacts of climate change, the government can take measures to support the country's adaptation to climate change effects. 5.1.5. Vulnerable Populations and Building Resilience This section highlights populations who are particularly vulnerable to the three shocks discussed above due to lack of access to services and opportunities or low accumulation of capital—namely, women and girls, the displaced population, and international migrants. Women and Girls 100. Despite considerable progress, gender gaps persist and hinder Armenia in reaching its development potential. Improving gender equality is a government priority anchored in the national gender strategy for 2019–23, Armenia 2021–26, and Strategy 2050. Evidence points to significant progress: for example, the sex ratio at birth—a common indicator of gender disparities and social preference for sons over daughters—improved from 1.17 boys per girl in 2001 to 1.11 in 2016–18 (ArmStat 2019). 76 Women’s representation in public and political life has also improved. For example, female members of parliament now constitute 35 percent of all lawmakers of the National Assembly, up from 18 percent in 2017, 77 and the share of women judges increased from 27 percent in 2019–20 to 33 percent in 2023. 78 Nonetheless, many Armenian women continue to be outside the labor market or are employed in poor-quality 74 The annual economic costs of deforestation and forest degradation in Armenia are estimated to be US$99.5 million (World Bank 2022h). 75 Improvements in the water sector have huge externalities. For example, increasing water storage will not only affect the sustainability of agriculture but also the reliability of hydropower generation. According to an estimate, climate change could cause a reduction of hydropower- based electricity generation by 15 percent by 2100, compared to the 2020 level (IMF 2022a). 76 The ratio increases from 1.04 for the firstborn child to 1.40 for the third child (ArmStat 2019). Interpreting the skewed sex ratio at birth as missing girls points to a loss of girl births due to a preference for sons and thus recourse to sex-selective abortion (Sinha and Kumar, 2019). Gegharkunik marz at the border has the lowest female sex ratio at birth, reflecting a cultural preference for males that is rooted also in military traditions. 77 National Assembly of the Republic of Armenia. http://parliament.am/?lang=eng . 78 Judicial Power of the Republic of Armenia. https://court.am/. “Gender equality in the judiciary of Armenia: challenges and opportunities,” Partnership for good governance 2019-2021, Council of Europe; and World Bank calculations as of March 2023. 43 jobs, despite their high level of human capital. Reducing gender gaps is not only important from the standpoint of equity and fairness but should also be a major priority in any effort to boost inclusive growth and realize a country’s full potential. Enhancing women’s participation in the labor market is critical, especially in the context of an aging population and declining productivity growth. 101. The sources of gender disparities are multidimensional and often difficult to quantify. Economic, social, and institutional factors contribute to this pattern of exclusion of girls and women from economic opportunities. Women experience time poverty linked to unpaid domestic tasks and the narrow use of childcare services. Most households rely on women as primary care providers in child rearing and development, while fathers contribute to a lesser extent. 79 This is reinforced by the low access to high-quality childcare, early education, and flexible care for elders. Data from the Time Use and Gender Survey 2022 indicates that one-third of households with children under age five do not have access to regular childcare services. 102. Social stereotypes and gaps in legal protection contribute to gender disparities. Gender stereotypes persist, leading to gender disparities in labor participation, employment type and sector, and fields of study. For example, women students are not traditionally encouraged to pursue technical specialties. In addition, Armenia has no criminal penalties or civil remedies for sexual harassment experienced in the workplace, although the evidence suggests that sexual harassment of women in the workplace and the political arena is widespread (US State Department 2022). Displaced Population 103. The displaced population faces barriers to economic and social opportunities. There are tens of thousands of displaced persons in Armenia since 2020 from Nagorno-Karabakh as a result of the military conflict with Azerbaijan, including those who have been displaced from Gegharkunik, Syunik, and Vayotz Dzor marzes due to the September 2022 fighting in the border districts, according to authorities. Many face high rents in Yerevan and challenges accessing land in rural areas. The displaced population lacks opportunities to accumulate and use their human capital or gain access to basic services—such as health care and psychosocial assistance—and good-quality housing. Armenia faces the challenge of ensuring sustainable housing and livelihoods for the displaced population that is still largely dependent on social transfers. To do so, it is important to have an accurate snapshot of the living conditions of displaced persons and to identify the barriers they face in access to education, health care, and other services (World Bank 2023c). International Migrants 104. Remittances from international migration provide an essential income source for Armenian households. The size of the Armenian diaspora is currently estimated at 7 million people, living in more than 100 countries. 80 In 2021, around 14 percent of households reported receiving remittances (2021 ILCS). Households with migrants abroad that are receiving remittances tend to be better off and less likely to live in poverty (Garrote-Sánchez et al. 2022). Moreover, during times of crisis, remittances can serve as an automatic stabilizer for households whose members can continue to work abroad. 81 105. However, international migrants remain highly vulnerable to external shocks due to their geographic and occupational concentrations. Migration from Armenia—as for other countries in the Caucasus and Central Asia—is highly concentrated on one single country. Among households with members who had migrated during 2019–21 and had not returned as of 2021, the majority went to Russia (65.5 percent), followed by internal migration to other communities in Armenia (24.8 percent). Thus, a large proportion of migrants and their families are exposed to risks of 79 Based on the Armenia Time Use and Gender Survey collected by the World Bank in May–June 2022 via telephone interviews. 80 High Commissioner for Diaspora Affairs. http://diaspora.gov.am/en/diasporas. It has also been estimated that close to 960,000 emigrants with Armenian citizenship live abroad (UNDESA 2020). However, this estimate does not necessarily account for ethnic Armenians who may hold other citizenships but maintain strong linkages and affinities to the country (IOM 2022). There is heterogeneity among the diaspora communities. Often, they are distinguished into “old” and “new” based on the timing of the emigration—whether before or after the independence. Evidence shows that the first group has fewer ties with Armenia, while the latter is more willing to take risks and has higher stakes in contributing to the country (IOM 2020). 81 For example, these households observed a rise in the value of remittances and a reduction in poverty in 2020 (Garrote-Sánchez et al. 2022). 44 economic fluctuation in the Russian economy. Migrants also lack diversification in their sectors of occupation: in 2019, 77 percent of Armenian migrants were working in the construction sector, which is considered to be a cyclical industry prone to being negatively affected by economic downturns. Only 6 percent were working in manufacturing, services, or transportation (Garrote-Sánchez et al. 2022). Estimates also show that households with returned migrants in 2020 suffered large income losses, leading to an increased poverty rate among this group (Ibid). Social Protection to Build Resilience 106. Social protection can be critical for building resilience to different types of shocks, and the social protection system in Armenia has been important in preventing Armenians from falling into poverty. While the social protection system requires additional adjustments to ensure it is fiscally sustainable and socially adequate, it has undergone significant reform in the last decade, including the introduction of a mandatory funded pension pillar. Armenia has a relatively well-developed social protection system underpinned by legislation and comprising three pillars that are common around the world: social insurance, social assistance, and labor market policies and programs. The analysis shows that in the absence of any social protection benefits, and if households were unable to compensate with other sources of income, half of Armenians would live in poverty, and inequality would increase by 40 percent. However, the social protection system does require adjustments to address gaps, ensure it is fiscally sustainable and socially adequate, and be better prepared to expand outreach in response to shocks. Refer to Appendix K for more information on the social protection system and areas for improvement. 5.1.6. Governance and Institutional Bottlenecks – A Related Example in the Water Sector 107. Challenges in managing shocks and environmental risks include poor governance arrangements and weak institutional capacity to govern, maintain, finance, operate, and regulate resources in the water sector. The water sector is critical to building resilience to shocks, especially for poor and vulnerable households relying on agriculture for their livelihoods. 82 However, the sector faces multiple challenges associated with weak governance and institutions. First, the sector is fragmented as multiple agencies are involved in the management and regulation of water resources, with no coordination at higher levels of government among the various agencies that supply, regulate, and monitor water management in Armenia. Second, Armenia does not have an overarching water strategy that provides an overall vision and sets targets for water management. In addition, there are no standalone strategies for the irrigation sector or the drinking water and sanitation sector, resulting in weak planning and implementation of infrastructure investment. Third, accountability measures are weak. Checks and balances need to be strengthened to improve the cost efficiency of the sector. 83 Fourth, the sector lacks a modern information system, which affects data transparency, quality, and timeliness in responding to shocks to water availability in the context of growing demand for water. Fifth, although irrigation operation and management at the secondary and tertiary levels is decentralized, thus allowing local farmers to participate in irrigation scheme management, the mechanism is not functioning effectively due to dilapidated infrastructure, poor administrative planning, weak accountability, and financial management issues among farmer organizations. 84 5.1.7. Binding Constraints The table below summarizes the binding constraints discussed in this section. 82 There is also a health risk from the low quality of water, as Armenia lacks irrigation water quality control. 83 For example, the Water Supply Agency that is responsible for the main irrigation systems through large canals faces a huge funding gap of around 55 percent (i.e. the difference between the costs incurred for the provision of services and tariff charged for the services), but the tariff structure has remained unchanged since 2010. In addition, the accounts of the water user associations, which are responsible for management, operation, and maintenance, are not independently audited. 84 Some service areas are too large to ensure local farmers’ participation in governance. 45 Table 2. Binding Constraints for Vulnerability to Shocks and Environmental Risks Key Challenges Binding Constraints Weak emergency preparedness and service delivery for border areas 1.1: Risks of fragility, conflict, and violence Lack of adaptive social protection systems Weakened trust in political and social institutions Concentrated trade products and trade partners High dependency on raw materials for export Heavy dependence on natural gas imports from Russia 1.2: Vulnerability to economic shocks Low coverage, quality, and efficiency of public services Lack of equal access to services and opportunities Lack of adaptive and efficient social protection system Insufficient investments to address energy efficiency and energy security Lack of financial incentives to promote the green transition 1.3: Exposure to climate change and environmental risks Limited investments in climate-smart infrastructure to reduce GHG emission Lack of adaptive and efficient social protection system Limited protection and management of natural resources (including air pollution) 5.2. Accessing Markets and Trade Integration 108. Connectivity obstacles within and outside Armenia are one of the most salient development challenges and are a defining characteristic of everyday life for Armenian people and businesses. As, discussed earlier, Armenia is a landlocked country located in a region of difficult topography and geopolitical tensions. Of its four borders, two borders (Azerbaijan and Türkiye) have been closed for years, limiting access to regional and international trade and integration. Similarly, poor infrastructure within the country constrains access to goods, services, and labor markets. It hinders the delivery of basic public services—inputs for the productive activities of firms and for the household accumulation of human capital—and contributes to spatial disparities. This section analyzes the evidence on physical connectivity, trade logistics, and digital connectivity as development constraints and the role of the diaspora in enhancing connectivity. 5.2.1. Trade Integration and Global Value Chains 109. According to a global value chain taxonomy, Armenia’s global value chain links were mostly related to limited manufacturing in 2015 (World Bank 2020a). Armenia specializes in upstream global value chain tasks, selling primary goods of limited complexity that other countries use to produce exports. Its position is reflected in the small manufacturing share in the export basket (an average 20 percent in 2014–19); the low intensity of global backward links, proxied by the share of value added in gross exports (25.5 percent in 2021); and the larger share of forward participation, proxied by the share in gross exports of the exported domestic value added used by Armenia’s direct trading partners to produce their own exports (25.6 percent in 2015). Armenia has not upgraded to the upper tiers of the taxonomy, such as advanced manufacturing and services or innovative activities, which are typically associated with higher value added in global value chain engagement. Structural peers also tend to have low and limited engagement in global value chains. In contrast, Estonia, an aspirational peer, is in the group of advanced manufacturing and service economies. 110. A gravity model estimates that Armenia’s exports are only at 35.7 percent of their potential. 85 While full potential may not be able to be realized due to certain barriers, closing the gap between actual and potential exports 85 For 2013–2019 based on observable characteristics such as economic size and geography and current policies. The methodology is available in Annex L. World Bank, Reconfiguring Trade to Overcome Geographical Limitations: A Trade and Competitiveness Diagnostic for Armenia (forthcoming). Armenia’s peers have the following exports-to-potential ratio: 26 percent Albania, 40 percent Bosnia and Herzegovina, 42 percent Georgia, 52 percent Moldova, and 64 percent Estonia. 46 in Armenia requires improving access to markets by expanding the scope of export destinations, diversifying the export basket, raising the competitiveness of exported products, and developing value chains. Progress along these lines is contingent on identifying and addressing connectivity and logistics bottlenecks, removing excessive trade barriers, identifying opportunities for the diversification of exports (including through opportunities in regional markets), and encouraging Armenia’s upgrading in global value chains. Raising competitiveness will also entail improving resource efficiency to match peers and, going forward, lowering the emissions intensity of industrial production that is expected to become subject to border carbon adjustments, for example under the EU’s proposed mechanism from 2026. 86 111. Armenia stands to gain from the effective implementation of the WTO Trade Facilitation Agreement (TFA) and needs to mitigate the implications of the loss of preferences under the EU’s Generalized Scheme of Preferences.87 Implementation lags are primarily in three areas: involvement of the trade community, internal border agency cooperation, and external border agency cooperation. 88 A general equilibrium model of world trade has been used to analyze counterfactual simulations of two scenarios using a 2021 baseline. The first is Armenia’s full implementation of the WTO TFA, which would generate large increases in both imports and exports (by over 10 percent for the former and close to 15 percent for the latter, relative to the baseline scenario), which translate into a substantial decrease in the price level as well as a higher real GDP (of about 2.5 percent). The second is the loss of preferences under the EU's Generalized Scheme of Preferences+ scheme, which would produce small losses in exports, imports, and GDP in an aggregate sense but large losses (by over 20 percent) in exports to the EU in sectors such as metal products, textiles and apparel, agriculture, and food and beverage. 89 112. While Armenia has been part of the Eurasian Economic Union (EAEU) since 2015 and has several FTAs in force, it could benefit from expanding and deepening integration. Prior to 2015, Armenia had signed eight FTAs with former members of the former Soviet Union. 90 Since 2015, Armenia has been in a customs union with Belarus, Kazakhstan, the Kyrgyz Republic, and Russia under the umbrella of the EAEU. As a member of the EAEU, Armenia implements the common external tariff applicable to all other members but is allowed to apply also the tariffs negotiated as part of the FTAs signed before 2015. Furthermore, as a member of the EAEU, Armenia has had an FTA with Vietnam since 2016, with China since 2019, and a recently concluded one with Iran. In addition, Armenia signed the Comprehensive and Enhanced Partnership Agreement with the EU in 2017. Armenia’s exports to the countries in the trade agreements have picked up following implementation of the agreements, but as suggested by the gravity model estimates, there is scope for further integration—for example, by having the EAEU sign agreements with more trading partners. 113. A key aspect of facilitating trade in Armenia relates to export promotion. Armenia does not have an up-to- date export policy, and there is no public body responsible for supporting the export business. Challenges faced by the trade community include limited information on trade reforms, regulations, and requirements; new market access opportunities; implications of international agreements; and market developments. Many SMEs lack the skills to find reliable international partners, negotiate terms and conditions, and market products internationally (ERDSC, forthcoming). As of 2019, the Business Armenia Foundation is no longer responsible for implementing trade promotion activities. Enterprise Armenia focuses on investment promotion, and the Export Insurance Agency of Armenia only focuses on export insurance. Armenia could benefit from a foreign trade strategy and an export promotion agency to 86 Around 2.5 percent of Armenia’s exports are aluminum and iron and steel exports to the EU and would therefore be covered by the carbon adjustment mechanism as put forward by the European Commission’s latest proposal from December 2022. 87 An important aspect to consider is that the provisions of the TFA can be implemented at different maturity levels, leading to varying differences in trade facilitation, speed of trade flows, and related costs. For example, a country may implement risk management in Customs, being aligned with WTO TFA-related provisions, but still physically inspect more than 20 percent of the cargo, while more mature administrations inspect only less than 5 percent of all cargo as their risk management systems are more effective and usually supported by post-clearance audits. Similarly, many countries already assess that they have implemented single window solutions while some processes and procedures are still paper based. It is therefore important to consider the TFA Gap Assessment methodology, which analyzes the situation of the country considering full and effective implementation of provisions, not necessarily the minimum requirement to comply with the agreement. 88 OECD Trade Facilitation Indicators, 2022 http://compareyourcountry.org/trade-facilitation/en/1/ARM/ARM/default 89 Gain and loss estimates are preliminary and subject to revision. 90 Georgia, Tajikistan, Belarus, Kazakhstan, Kyrgyz Republic, Moldova, Turkmenistan, and Ukraine. 47 offer services related to image building, export support services, marketing and market research, and publications (ERDSC, forthcoming). 114. Armenia can potentially reap more value-added Figure 60. Global Value Chain Upgrading: Per Capita Exported benefits from global value chain engagement (Figure 60). Domestic Value Added, by Country, 2015 With its current specialization in commodities and limited manufacturing tasks, Armenia lags many peers in per capita exported domestic value added. Participating in global value chains as a seller of primary products is beneficial in years when commodity prices increase, but it can quickly become a source of vulnerability during times of slowing global prices. At the same time, specializing in light manufacturing typically helps boost employment but brings modest value-added benefits. Scaling up value added benefits to boost GDP is more closely associated with participation in global value Source: World Bank staff calculations using data from the EORA chains as advanced manufacturing and services and Global Supply Chain Database and World Development Indicators database. innovative activities. Strategies that could help with this goal include encouraging vertical FDI, which is known to go hand in hand with global value chain participation;91 finding opportunities to specialize in more complex manufacturing tasks; and thinking of ways to use services to boost the sophistication of manufacturing products (servicification), including by building on the comparative advantage that Armenia has developed in IT services. 5.2.2. Infrastructure and Border Management 115. While Armenia has improved key aspects of trade facilitation measures since 2018, its connectivity infrastructure lags its peers. According to the Logistics Performance Index (LPI), 92 the largest improvements have been observed in infrastructure, logistics service quality, and customs (Figure 61). Compared to other landlocked countries, Armenia has done well in terms of the time containers stay in one place. 93 Armenia’s performance worsened over time in terms of timeliness of a shipment arriving within the scheduled or expected delivery time and competitively priced international shipments. Armenia also lags behind peers especially in the quality of trade- and transport-related infrastructure (such as roads, IT), competence and quality of logistics services (such as transport operators and custom brokers), ability to track and trace consignments, and ease of arranging competitively priced shipments (Figure 62) 91 Vertical FDI is a type of investment in which a foreign company invests in different stages of the production process in different countries. By fostering countries’ specialization in tasks, vertical FDI promotes global value chain links and trade related to global value chains. For example, the investment of Samsung in Vietnam is a type of vertical investment that has brought benefits to the recipient country. 92 LPI measures a country’s performance on trade logistics based on a worldwide survey of 160 countries. The aggregated LPI provides an average of the 2012–18 LPI scores with higher weights for more recent years and smooths out oscillation occurring from one edition to the other, especially as the LPI is a perception-based indicator. 93 Specifically, dwell time measures: port dwell time, reference dwell time for transit countries, and inland and destination dwell time. Based on the World Bank Logistics Performance Index. 48 Figure 61. Logistics Performance Index, Armenia Figure 62. Logistics Performance Index 2023, Armenia versus Peers Source: World Bank Logistics Performance Index. Source: World Bank Logistics Performance Index. Note: 2012–18 refers to aggregated ranking. 116. Weak connectivity infrastructure (along with high trade costs) was one of the factors responsible for Armenia’s poor external outcomes. The time to pass through Armenia’s open borders is long compared to the ECA average and average of all countries where data are available (Figure 63), due to capacity constraints, customs procedures, and cross-border administrative integration. As a result of poor maintenance and underinvestment, the country must also deal with old and obsolete transport infrastructure (World Bank 2021e). This is especially important for the border crossing point at Upper Lars on the Russian-Georgian border, as this is the main transport corridor and the only surface transport route connecting Russia to Armenia. 94 However, the Government plans to have the railway modernized through the concessionaire South Caucasus Railways, a subsidiary of Russian Railways. Figure 63. Delays in Clearing Trade Goods through Customs a. Days to clear direct exports b. Days to clear imports Sources: World Bank 2020h; Enterprise Surveys (dashboard), World Bank, https://www.enterprisesurveys.org/en/enterprisesurveys. 117. High transport costs hinder Armenia’s export performance. During the COVID-19 pandemic, preexisting difficulties hindered cross-border trade and inflated transport costs. Transport by road, weather permitting, became prohibitively expensive and involved significant delays which exceeded one month for inbound cargo from distant markets such as China. Switching to air transport was not feasible, with air cargo rates increasing by 30-35 percent from the pre-pandemic period. These shocks have highlighted and worsened connectivity issues in Armenia, and its isolation from international transport routes inflates trade costs and disrupts supply chain operations. Logistics and transport services must be modernized. Improved efficiency in logistics could boost competitiveness and stimulate economic growth. 95 At the same time, Armenia could explore other opportunities to improve its connectivity to 9490 percent of all freight flows move via Georgia and 10 percent via Iran (World Bank 2021e). 95There is a correlation between logistics performance and higher incomes (IFC 2021). The cost of logistics can be up to 25 percent of GDP in some developing economies, compared with 6–8 percent in Organisation for Economic Co-operation and Development (OECD) countries. 49 international markets, including negotiations for reopening international borders and investments to grasp indirect benefits from the Belt and Road Initiative (BRI). 96 118. The lack of direct connectivity to Armenia's main trading partner, Russia, increases transport costs and hinders export competitiveness. The road network is strategically important, as it is the only surface transport mode that connects directly with Russia, and the Border Crossing Point at Upper Lars, Georgia is the only viable connection for Armenia to access Russia by road. Lars is congested due to limited throughput capacity, difficult topography, and seasonal conditions such as avalanches and mudslides. This situation increases the waiting time of trucks and transportation costs. 119. Despite an extensive road network, poor road quality is an obstacle to connectivity. Road condition data collected through a road survey suggest that Armenia has a relatively well-developed road network, serving all parts of the country. The share of paved roads, at 84 percent, is high compared with other developing countries and in line with most European countries (World Bank 2017b). However, road quality is a concern: close to 41 percent of roads are in good or very good condition; 19 percent are in fair condition; and 40 percent are in poor or very poor condition. Disparities are even more acute between the primary road network and feeder roads (World Bank 2017b). Map 1 shows the international roughness index for roads in Armenia. Most show values greater than 2.5, indicating poor to bad road conditions. Map 1. International Roughness Index, Armenia 2019 Map 2. Accessibility to Yerevan Yerevan Source: World Bank 2021e. Source: World Bank 2021e. 120. Rural connectivity is a challenge for Armenia’s road network. A road survey showed that the network in Armenia still has significant deficiencies, 97 including: (1) intervillage connectivity is cumbersome in some marzes and (2) last-mile connectivity challenges still exist for a small share of the population (5 percent by World Bank estimates) who live more than an hour from a high-density population center. The survey also showed that significant investment is needed in transport road infrastructure to bring Armenia closer to the rural accessibility level of higher-income countries in Europe. 98 Map 2 illustrates the poor accessibility by road from Yerevan: it takes four hours to reach the Georgian border 200 kilometers away and eight hours to reach the Iranian border 370 kilometers away. 121. Rehabilitation efforts to address Armenia’s connectivity challenges are underway. Over the past few years, the government has been engaged in various initiatives aimed at developing the road network and developing asset 96 Although no corridor of the BRI passes through Armenia, indirect benefits from the BRI could be enhanced by implementing complementary policies and infrastructure improvements. 97 This was the first countrywide survey of national, republican, and lifeline roads done in Armenia and was used in World Bank 2017b. 98 Over 30 percent of Armenia’s rural population did not have access to an all-weather road in 2017 (World Bank 2017b). 50 management processes and practices. Major projects include the 556-kilometer North-South corridor project and the 190-kilometer Yerevan-Northeast section to Georgia. 122. Rail infrastructure is another bottleneck in the Armenian logistics sector. The Armenian rail system comprises a network of 780 kilometers of railways. The Railway system in Armenia is currently owned, managed and operated by South Caucasus Railway, a joint stock company created by "Russian Table 3. Proportion of Freight Carried by Rail Railways” under a 30-year Concession Agreement valid until 2038. This agreement requires the South Caucasus Railway to carry out Country % by rail or inland waterway necessary improvements and repairs to the railway assets including Armenia 5% the maintenance of speeds at 30 km/h. The South Caucasus Railway Belarus 65% is capable of transporting up to 8.0 million tons of cargo annually. Taking into account investments from the concession date, the local Georgia 24% speed is currently about 40 km/h. This speed is due to the complex Moldova 19% profile and single-track sections. Armenia lacks a direct railway connection to Russia. 99 The transport of bulk freight to and from Ukraine 52% Russia (i.e. wheat) is currently being carried out by truck, which is Source: Integrated Transport Planning Ltd. 2021. inefficient and expensive. Transportation of products using rail transport is only possible using sea transport through the ports of Georgia, which in turn increases the delivery time and cost of transportation. The rail infrastructure consists of mostly single tracks with old equipment and rolling stock that requires modernization and the use of technology. As a result, the volume of freight carried by rail in Armenia is significantly lower than the volume in other countries in the South Caucasus and the region (Table 3). 123. To improve connectivity, Armenia needs to improve its rail system and its operational efficiency and develop a system for information sharing. In addition to lack of investment, Armenian Railways lacks intermodal services, which impedes the efficiency of container shipments to and from Georgian ports. Armenia needs to establish regular block train services to the Georgian Black Sea ports to attract more containers on the rail and optimize container supply chain operations. In addition, the lack of information sharing between operators and customs authorities remains a barrier and affects transit time. The performance of the Trans Caucasus Transit corridor can be improved by strengthening information flows among operators and making transport data available to all users through a Corridor Management Information System. 124. As a landlocked country, another priority for Armenia is to improve air connectivity. Air transport flow has been growing rapidly since 2013, reaching a record 3.7 million passengers in 2022, coinciding with an upsurge in tourism during the same period. The adoption of an “Open Skies” policy played a big role in this growth, as it allowed foreign airlines to increase capacity. The opening of the air cargo route between Türkiye and Armenia is also expected to have a huge impact, as demonstrated by the recent increase in air cargo between Russia and Armenia. The recently signed Common Aviation Area agreement between Armenia and the EU, the upgraded cargo terminal at the main international airport, and the needs assessment of the logistics sector by the government should all help accelerate trade by air. However, improving the conditions of local roads that connect airports with markets will be a critical prerequisite for boosting cargo transportation by air. 125. An opening up of the borders with Armenia’s two neighbors could bring about diversions in current transport flows as well as induce demand. A road connection between Yerevan and Nakhichevan opens a north-south road transit route that connects Russia through Georgia to Iran (through Yerevan and Nakhichevan) and the Middle East, placing Armenia in the center of the transport route, a very advantageous position for trade and transport as opposed to its current position of poor accessibility and connectivity. 100 A potential opening up of a route connecting Yerevan 99The rail connection via Abkhazia is closed, and the rail ferry service from Poti to Port Kavkaz (in Russia) has been discontinued. 100The Nakhichevan-Yerevan connection creates a north-south route that then connects to the east-west/middle corridor that runs across Georgia and Azerbaijan (Armenia is not physically on the east-west route and needs to connect through the north-south to get to the east- 51 to the west of Azerbaijan—as has been discussed in recent years in the context of the peace negotiations—could present opportunities for the development of rail connecting to the East-West Trans Caucasus transit rail corridor, encouraging a modal shift from road to rail. In addition, opening the border between Armenia and Türkiye through Gyumri could increase the freight flows and accessibility of Armenia significantly more than opening the border with Azerbaijan alone. The opening of these borders would allow Armenia to improve its trade with current trading partners and diversify trade toward Europe and China, although such openings are sensitive and subject to geopolitical risks. 126. Connectivity challenges are also present for the power sector, as Armenia faces major supply security challenges in the decades ahead, which makes closer regional integration of its power network an urgent priority. About two-fifths of Armenia’s power supply comes from the aging Armenia Nuclear Power Plant, currently scheduled to close in 2036, and about half of the remaining share comes from natural gas imported from Russia, which is not compatible with the country’s long-term climate and energy security ambitions. 101 Domestic renewable energy—in particular, wind and solar power—represents a substantial alternative source. However, these resources are intermittent and vary seasonally. Closer integration with regional power grids would help improve energy security by reducing the need for back-up capacity in times of lower renewable energy availability and by providing export markets in periods of abundance. Currently, Armenia’s electricity network only has two high-voltage linkages (220 kV +) with neighboring Georgia and Iran. Electricity trading with Georgia is currently limited, as Georgia and Armenia have asynchronous systems and the market in Armenia is mostly closed, and interconnections with Azerbaijan and Türkiye exist but are not active. The development of high-voltage interconnections with Georgia (5400 kV) and Iran (400 kV) are underway but are substantially delayed compared to the original schedules. In the long term, Armenia has the opportunity to interconnect with the EU market through the Black Sea undersea cable currently being prepared between Georgia and Romania (European Commission 2022). 127. The recent energy sector reform includes liberalization of the electricity market, but reform of the gas sector is falling behind. In 2022, Armenia launched the first phase of a five-year process for liberalization of the electricity market to unlock new sources of commercial finance and to modernize the power sector, supported by legal amendments to the Energy Code, the Transmission and Distribution Network Codes, and the Rule and Regulations by Market Regulator. The first phase kicked off in February 2022 by (1) enabling some power plants to avoid selling electricity at prices set by the Public Services Regulatory Commission and to sell at prices determined according to market supply and demand and (2) shifting from monthly to hourly trading of electricity. In comparison, reforms in the gas sector are falling behind. Natural gas provides about two-thirds of the overall energy consumption of Armenia, which has mainly been imported from Russia (85 percent) as discussed earlier. The price of gas imports is fixed but is subject to frequent (unilateral) price adjustments, making Armenia vulnerable to sudden price shocks. 128. Domestically, Armenia will have to continue investing in the electricity transmission and distribution networks. Over the past years, High Voltage Electric Networks has rehabilitated or started rehabilitating most of its 15 substations. In recent years, it has also rehabilitated two critical transmission lines that are essential to improving the country-wide reliability of electricity supply. However, rehabilitation works on four substations remain to be designed and financed. Implementation of this program will have to continue throughout this decade to complete the rehabilitation of major network assets. At the distribution level, since 2017, a revised tariff framework has allowed the privately owned distribution company Electrical Networks of Armenia to increase annual investment in the distribution grid from US$12 million in 2015 to US$70 million in 2020. Investments will have to increase further over the coming years to meet the distribution grid rehabilitation requirements, estimated at US$750 million between 2021–28 (World Bank 2021d). west route). This provides Armenia the opportunity to become a transit country for both the north-south and east-west routes for freight flows. 101 A new nuclear power plant is proposed, but a final investment decision has not yet been taken, and design and construction will take a long time. 52 129. The policy framework to improve energy efficiency and scale up renewable energy needs further improvement. Apart from several large hydroelectric plants, the contribution of renewables to the overall energy mix is still modest (International Energy Agency 2022a), despite an impressive recent ramp-up of distributed solar photovoltaics (PV). The National Program on Energy for 2022-30 aims to increase the share of electricity generation from solar to at least 15 percent (from less than 3 percent in 2020) and to reduce total final energy consumption by 20 percent by 2030. With the amendments made to the Energy Sector Development Strategy till 2040 and its implementation plan, it is foreseen to increase the capacity of solar power plants to 1,500 MW and wind power stations to 500 MW by 2040. This is expected to raise the share of electricity produced from renewable energy sources in gross final electricity, including large hydropower plants, to about 60 percent in 2040. Elements of the policy and regulatory frameworks exist, including through a suitable power sector market framework, the experience with numerous pilot programs and projects such as the competitive auction for solar PV for the Masrik-1 plant, and a dedicated financing entity for renewable energy and energy efficiency promotion (the Renewable Resources and Energy Efficiency Fund). However, Armenia will need to put in place the incentives and conditions to integrate growing shares of renewable energy into the power grid and to rapidly scale up energy efficiency throughout the economy to achieve its targets in an economically efficient way. 5.2.3. Digital Access 130. Access to digital connectivity in Armenia is high but uneven across subnational areas. Nearly 100 percent of the population is covered by mobile internet services (3G or 4G). However, this has not translated into a high uptake of connectivity, particularly in rural areas. Approximately 60 percent of households subscribe to fixed broadband services (compared to nearly 80 percent in Georgia) (Telegeography GlobalComms Database 2022), and approximately 65 percent of the population subscribes to mobile internet services (compared to around 50 percent in Georgia) (GSM Association 2022). However, nearly 80 percent of the population reports that they use the internet, indicating that a share of internet users is likely only accessing the internet via mobile services (International Telecommunications Union 2021), which in turn may limit the scale and nature of digital services that can be adopted by that population. The unconnected tend to be more concentrated in rural areas, where fixed broadband household penetration is 15 percent lower than in urban areas (World Bank 2019b). While the COVID-19 pandemic accelerated digital adoption globally, including in Armenia, it has also highlighted key underlying challenges in developing broadband markets, with rural areas at increasing risk of exclusion due to lower access to, and use of, digital connectivity. 131. Barriers in affordability, service quality, and access to digital devices affect digital adoption in rural areas. While entry-level broadband packages are affordable and cost less than the affordability threshold of 2 percent of per capita gross national income, 102 fixed broadband tends to cost over 4 percent of per capita gross national income, and the cost of high-speed packages (above 50 Mbps) is even greater (International Telecommunications Union 2022). Even entry-level broadband services can be unaffordable for the bottom 40 percent. The quality of services delivered tends to be lower in rural areas than in urban centers, as urban centers have concentrated on the development of broadband markets and the deployment of modern technologies. World Bank analysis of 18 months (January 2021–June 2022) of voluntary speed tests data from Ookla reveals that over 55 percent of speed tests conducted during that period were below 30 Mbps and concentrated outside the main urban centers. 103 Rural areas face high costs in deploying wired networks, lag in investment in modern technologies by internet service providers due to lower expectations of financial returns, and tend to be connected by technologically inferior solutions. The cost of digital access devices (laptops, tablets, smartphones, and so on) is another barrier to digital adoption among rural and economically vulnerable populations. 132. The lack of digital skills and awareness of digital services poses another barrier to digital adoption in rural Armenia. The perceived lack of demand among rural populations acts as a barrier to investment by telecommunication 102 The United National Broadband Commission for Sustainable Development has established 2 percent of GNI per capita as the affordability threshold for entry-level broadband plans. 103 Ookla data was accessed through the Data Development Partnership. 53 and internet providers, who see limited returns for their investments in these areas. This creates a negative cycle in which the perception of low demand hinders investment in higher-quality connectivity, which then disincentivizes the adoption of these services by individuals due to the price-quality mismatch. 104 133. Unlocking constraints in access to digital connectivity is fundamental for boosting inclusive growth in Armenia. According to the International Telecommunications Union, a 10-percent increase in broadband penetration raises GDP growth by 1.4 to 1.8 percent in ECA countries. A more coordinated approach could be adopted in Armenia to accelerate the penetration. This requires key legal and regulatory reforms aimed at promoting competition in services, reducing the cost of infrastructure deployment including through cross-sectoral infrastructure sharing, as well as strategic investments from the public and private sectors to close access and skill gaps in areas that are at higher risk of exclusion. The domestic IT industry in Armenia has strong foundations and existing interlinkages with global digital markets that can be leveraged to drive digitization and the establishment of an export-oriented digital services industry. In addition, digitization of the government would support enhanced public service delivery and inclusion. Nearly all citizen-facing public services are available digitally in advanced economies—for example, 99 percent of all public services in Estonia are digitally available. The expertise and global experience of the domestic IT industry can also be better leveraged to implement public sector digitalization activities, both as suppliers of IT services as well as through public-private-partnerships on key infrastructure and services such as cloud infrastructure, authentication and trust frameworks among others. 5.2.4. Diasporas as a Catalyst for Enhancing Connectivity 134. Diasporas can enhance connectivity by promoting trade and FDI, creating businesses and spurring entrepreneurship and innovation, and transferring new knowledge and skills (Newland and Plaza 2013). 105 The largest Armenian population exists in Russia (around 3 million) followed by the United States (around 1.6 million), France (around 650,000), Georgia (200,000–400,000), Iran (60,000–80,000), and Germany (around 60,000). 106 There is increasing recognition that beyond providing economic support through remittances, diasporas can be important sources of knowledge, skills, investment, and business connections. For example, they can have a positive impact on trade by creating connections between producers in destination countries and consumers in Armenia and vice versa; enhancing investment by boosting investor confidence in the Armenian market; and transferring valuable skills, experiences, and contacts from abroad back to Armenia that can promote entrepreneurship and create new businesses. 135. The ICT services sector has a proven track record of building and enhancing business opportunities through diaspora links. In the early 2000s, diaspora connections and prominent Armenians in various ICT hubs around the world (largely in Silicon Valley) played a pivotal role in the accelerated development of the ICT sector. Since then, they have been critical in bringing technological multinational companies to Armenia, setting up local research and development centers, investing in IT educational and infrastructure programs, generating leads for local IT companies, and linking with knowledge and funding sources. There is also a vast untapped potential in the value the diaspora can bring to the science and research ecosystem in Armenia. The realization of this potential is possible by engaging high-performing diaspora scientists at renowned international institutions in research collaborations and joint work with local scientific teams. The scientific community of the diaspora is nearly the same size as the local science community but excels significantly in quality and performance. Ways of engaging diaspora Armenians in higher value-added activities include stocktaking of strategic connections in prioritized sectors and building mechanisms for joint projects. 136. While Armenia has an engaged and connected diaspora, and the government recognizes its important role including as investors, diaspora investments still seem to be limited. Established in June 2019 by the Prime Minister, the Office of the High Commissioner for Diaspora Affairs and Enterprise Armenia assist diaspora Armenian investors 104 Results from consultations, analysis, and survey conducted by the Digital Global Practice at the World Bank during 2019–22. 105 The potential role of the diaspora in accelerating Armenia’s development process has been emphasized in the SCD2 consultation and discussed, for example, in IOM 2023. 106 Office of the High Commissioner for Diaspora Affairs; http://diaspora.gov.am/en 54 by addressing their concerns for investing and providing comprehensive support for the implementation of investments. According to a survey conducted by the Ministry of Economy, 74 percent of the 2,000 Diaspora- Armenians included in the survey were willing to make investments in Armenia. 107 However, little information is available to assess the magnitude, effectiveness, and full potential of this diaspora. 108 Drawing from the success of other countries, the first step for the government is to devise a roadmap or strategy that identifies the sectors and areas that require diaspora input. 109 As acknowledged by the Office of the High Commissioner, it is also critical to gain a better understanding of who and where the diaspora populations are. This involves comprehensive data collection, including mapping of the location, skills, and experiences of the diaspora. 110 Given the diversity of diaspora agendas, interests, and strategies, building a system of communication to find areas of mutual interest for practical collaboration is also critical. 5.2.5. Governance and Institutional Bottlenecks – A Related Example in the Digital Sector 137. A more holistic and coordinated approach to digital development is needed to enhance digital connectivity for a digitally enabled society. Public service digitization, especially in rural areas, can be an important driver of digital demand, which can create incentives for the expansion of privately financed digital networks. While the government is committed to the digitization of government services, progress has been hampered because public service digitization has been siloed in Armenia, with individual ministries and agencies adopting digital technologies at varying rates. There is also a lack of unified standards, protocols, and shared infrastructure which are essential prerequisites for interoperability and integration of databases, registries, and services. The government recently established the Information Systems Management Board to address these challenges, which is a critical step toward a more digitally enabled and integrated public sector (Box 4). Box 4. Governance for Digital Transformation The IT industry in Armenia has historically been the most established among the South Caucasus countries, with strong links to international markets. The dynamism of the private sector extends from the digital infrastructure and connectivity markets to digital service delivery and cross-cutting issues such as cybersecurity and digital authentication. The industry has also evolved from IT to advanced digital services (including artificial intelligence products), with two companies, PicsArt and ServiceTitan, attracting international investment at valuations above US$1 billion and achieving unicorn status.a There are also several private sector coding academies that complement the formal education system, in turn bridging gaps between industry and the formal education sector curricula as well as attracting individuals to invest in digital skills. The TUMO Center for Creative Technologies is a successful example, educating over 20,000 teenagers on technology and design free of charge. It has also become a successful Armenian export, with seven TUMO franchises opened in six other countries. However, the level of digitization of the private sector, including core industries like banking, is not reflected at the same level in the public sector. The gap in digitization between the public and private sectors (including in data infrastructure and cybersecurity) reflects the need for a more coordinated approach to digital transformation, while it also provides an opportunity to leverage the domestic private sector to a greater extent to help achieve Armenia’s digital ambitions. The government has expressed a strong commitment to digital development and seeks to transform the country through digitalization. The Digitization Strategy envisages the digital transformation of the government, economy, and society through the introduction and development of innovative technologies, cybersecurity, data policy and e-services and e-government systems, coordination of digitalization processes, creation of common standards and digital environment, as well as initiatives promoting the use of digital technologies in the private sector and the development and implementation of programs promoting the use of electronic tools by the public.b 107 https://www.1lurer.am/en/2022/05/26/Investment-environment-really-promising-Vahan-Kerobyan/729653 . 108 The need for a more systematic approach to diaspora relations was confirmed in the SCD consultations (Appendix I). 109 For example, the past success of governments such as the Republic of Korea and Taiwan, China in bringing diaspora talent and treasure to the table was in large part possible because both governments had sound development strategies in place to invest in education, promote science and technology, build infrastructure, and foster entrepreneurship (IOM 2012). 110 In India, the government tasked a High-Level Committee to analyze the location, situation, and potential development role of the estimated 20 million non-resident Indians and persons of Indian origin. The information resulting from this two-year exercise led to a new direction in diaspora policy, including the creation of a Ministry of Overseas Indian Affairs in 2004 (IOM 2012). 55 The government has established several institutions to support the digitization agenda. The government has reformed and created institutions including the Information Systems Management Board (ISMB), Chief Information Officer (CIO), Ministry of High-Tech Industry (previously Communications and Transport Ministry), and public-private engagement forums on digitization, which are fundamental for building the overall digital ecosystem. In particular, the ISMB, led by the Central Bank of Armenia, comprises key line ministries including the Ministry of High-Tech Industry (MHTI) which reports to the Deputy Prime Minister (who is also the country’s CIO). To implement the digital transformation vision set by the ISMB, the Information System Agency of Armenia was recently established under the auspices of the Central Bank. The Agency is also expected to house the Civilian Cybersecurity Operating Center and Cybersecurity Emergency Response Team. The agency is meant to become a full-fledged regulatory and supervisory body of digital infrastructure (which may affect the roles and responsibilities of the current telecommunication regulator, the Public Services Regulatory Commission). A strong and coordinated institutional and legislative set-up will be required to effectively implement the national Digitization Strategy, given its cross-sectoral nature. The substantial evolution in institutional arrangements follows a few years of absence of clear ownership and of the agenda within the government, including lack of clarity on the role of the CIO and MHTI. The Agency is only starting to recruit staff and will likely suffer from limited capacity and resources for some time, given its considerable scope of interventions. In parallel, the MHTI underwent multiple management changes and has continued to lack adequate technical staff. The Public Services Regulatory Commission relies also on a very limited number of staff to carry out its duties and has followed a laissez-faire approach on many issues, with relatively successful outcomes in terms of market development thanks largely to a competitive market led by dynamic private operators. However, even if basic legislation for digital development exists, most of the laws appear to be outdated, and important areas such as infrastructure sharing, advanced market analysis for competition, cybersecurity, data governance, and technology standards also lack adequate regulations and development policies. a Tosunyan 2021. b World Bank 2022h. 5.2.6. Binding Constraints The table below summarizes the binding constraints discussed in this section. Table 4. Binding Constraints for Accessing Markets and Trade Integration Key Challenges Binding Constraints Inadequate transport infrastructure Insufficient public investment and need for continuous prudent macroeconomic management Inadequate investment to build capital stock 2: Accessibility to markets and better integration to Need to enhance digital connectivity trade Insufficient legal and regulatory framework to enhance trade Weak logistic services Closed borders with neighboring countries Weak institutions to promote export and diversification Need to ensure a reliable energy supply 5.3. Quality of Human Capital 138. The low productivity of the labor force continues to be a major development challenge for Armenia. Under SCD1, an aging population with a large share of young people unprepared for the labor market and lacking required skills were identified as major reasons for low productivity. This constraint still poses a challenge today, with labor productivity stagnating since 2019, associated with stagnation in the improvement in human capital in terms of both education and health. While the years of schooling are relatively high by international standards, the level of learning outcomes can be improved. High prevalence of noncommunicable diseases (NCDs), limitations in the financial coverage of health services, and the high share of out-of-pocket expenditures hinder improvement in health outcomes. Investment in human capital through expenditures on education and health enhances the productivity of labor as people become physically fit and skilled at their jobs. This section further analyzes human capital in terms of education and health, and active labor market measures to boost returns to human capital. 56 5.3.1. Access to Learning and Relevant Skills 139. The stock of human capital is as expected at Armenia’s stage of development, but the country is behind some comparator countries. As mentioned earlier, the HCI of Armenia measured in 2020 indicates that children born in Armenia today will be only 58 percent as productive during their lives as they could have been if they had received the full set of health and education services available, and this indicator has not improved since 2012 (Table 5). Armenia’s overall HCI level is comparable to several peers, but Armenia could further improve its HCI to the level of aspirational peers such as Estonia (Figure 64). In terms of learning, in 2020, Armenian children were expected to complete 11.3 years of schooling on average, which is only slightly lower than the average for upper-middle-income countries (UMICs) (12.2 years) and ECA (13 years). However, the years of schooling declines to 8.0 years if the quality of education is considered, which is lower than many peers (Figure 65). 111 Human capital improvements in Armenia also seem to be stagnating—for example, after improvements in stunting outcomes between 2012–20, progress is now slowing, and the prevalence of stunting remains high compared to peer countries (Figure 66). Table 5. Human Capital Index, Armenia, 2012, 2017, and 2020 2012 2017 2020 Indicator Men Women Overall Men Women Overall Men Women Overall Overall Human Capital Index 0.56 0.61 0.58 0.55 0.59 0.57 0.56 0.6 0.58 Survival to age five 0.98 0.99 0.98 0.99 0.99 0.99 0.99 0.99 0.99 Expected years of schooling 11.5 12.2 11.8 10.9 11.3 11.1 11.1 11.5 11.3 Harmonized test scores n/a n/a n/a 439 448 443 439 448 443 Learning-adjusted years of n/a n/a n/a n/a n/a n/a 7.8 8.3 8.0 schooling Adult survival rate 0.82 0.92 0.87 0.83 0.93 0.88 0.83 0.94 0.89 Not stunted rate 0.78 0.8 0.79 0.89 0.92 0.9 0.89 0.92 0.91 Source: World Bank 2020e. Figure 64. Human Capital Index, Figure 65. Learning-Adjusted Years of Figure 66. Prevalence of Stunting, Height Armenia and Peers, 2020 Schooling, Armenia and Peers, 2019 for Age Source: World Bank Human Capital Sources: World Bank staff calculations; methodology Source: UNICEF, WHO, World Bank: Joint Project 2020. of Filmer et al. 2018; TIMSS (Trends in International child malnutrition estimates (JME). Note: Scale 0 to 1. Mathematics and Science Study) (data repository), International Association for the Evaluation of Educational Achievement, https://www.iea.nl/data- tools/repository/timss 140. Progress in education has been stagnating, and learning outcomes indicate disparities and quality issues. During the last decade, it appears that achievements in education have been reversing. While expected years of schooling have increased since the 1990s, they have remained virtually constant since 2010. Overall enrollment rates have declined across most levels of schooling, with geographic and socioeconomic disparities. At earlier stages of life, There was an improvement in 2019 TIMSS scores for Armenia which may increase the overall HCI score, which will be announced later in 111 2023. 57 access and enrollment in preprimary education are lower in rural areas. Moreover, despite some progress in learning outcomes, students in upper secondary school are absorbing only two-thirds of the knowledge imparted, as demonstrated by their low test scores. The scores also show regional disparities (urban versus rural) and socioeconomic disparities (World Bank 2023a). The fact that higher enrollment was not coupled with higher test scores signals the low quality of education. Later in life, only 50–60 percent of graduates from institutions of higher education and from vocational education and training find work after completing their studies (World Bank 2023a). 141. Low returns confirm the perceived low quality of education. The labor market relevance of the education system was an issue raised in SCD1. The low rate of returns to one extra year of education confirms that Armenian education is suffering from a severe problem in quality. Employers in Armenia have continuously noted the lack of practical skills of new graduates and the fact that they are not work-ready. Education is overly broad and general, with a lack of focus on specialization and a lack of well-functioning internship/practicum programs to equip students with skills. Thus, students have traditionally remained in student mode until the very end of their courses (Anush Shahverdyan 2008). 142. Strengthening higher education—especially in Figure 67. Employment by Educational Attainment (1,000s) specialized secondary and tertiary education—to build the professional expertise necessary for innovation and technology adoption is instrumental for resilient and sustainable economic growth. Economic research unequivocally shows high rates of private and social return on investments in tertiary education (Murthi et al. 2021) and the significance of specialized skills for innovation and technology adoption (World Bank 2022g). In Armenia, employment among the tertiary-educated population and those with specialized secondary education has been rising since 2018 (Figure 67), and the economic returns for tertiary education graduates are the highest. 112 However, Source: ArmStat efforts are needed to enhance accessibility and https://statbank.armstat.am/pxweb/en/ArmStatBank/ArmStatBank __2%20Population%20and%20social%20processes effectiveness. In Armenia, tertiary education remains out of __23%20Employment%20and%20unemployment/PS-eu-13- reach for many of the poor: among the working-age 2021.px/?rxid=9ba7b0d1-2ff8-40fa-a309-fae01ea885bb. population, the share of those with tertiary education was 30 percent among the poor, while the rate was 48 percent among the non-poor in 2021. 143. Even at a young age, children in Armenia face inequalities in accumulating high-quality human capital, excluding them from future economic opportunities and mobility. One-fifth of Armenian children are growing up in multidimensional poverty and may also lack the means to overcome intergenerational poverty in the future. A large share of children lacks basic inputs to accumulate high-quality human capital, driving high inequality of opportunity and low economic and social mobility (Tiwari et al. 2018). Children living in poor households are 6 percentage points more likely to be stunted than children in more well-off households, and they perform worse in terms of harmonized test scores. At the macro level, the exclusion of these children from economic opportunities weighs down labor markets and inclusive growth (World Bank 2020e). 144. One gap for vulnerable children is in access to and utilization of early childhood development services, despite the availability of high-quality facilities. The quality of kindergarten services is comparable with regional peers—the curriculum is a strong point, although human resourcing needs improvement. A World Bank facility survey of early childhood development service providers in four marzes also found well-established public early childhood development services across health and education (World Bank 2017c). Nonetheless, there is a gap in the promotion Analysis undertaken for this SCD2 based on the 2021 ILCS show that the returns to tertiary education (in terms of the logarithm of wages) 112 were 1.3 percent for tertiary, compared to 0.4 percent for general secondary and 0.2 percent for specialized secondary. 58 of cognitive and social development for children under age three, which is especially problematic given that global evidence suggests that the returns to investment are likely to be highest among the youngest children (Ayliffe, Honorati, and Zumaeta 2019; Richter et al. 2016). 145. Access to preschool and childcare services also has important implications for women in Armenia. In Armenia, the time allocation to childcare as a share of total activity is three times higher for women than men and consistent across all locations (Figure 68). Increased access to and usage of childcare services is thus expected to have huge impacts in improving female labor force participation. Similarly, given that women are predominantly responsible for unpaid domestic care work (Icaza and Tarlovsky 2023), increased access to and utilization of preschools would increase women’s opportunities to join the labor market and retain their jobs. Figure 68. Average Share of Time Allocated to Labor and Domestic Work, Weekday Source: Icaza and Tarlovsky 2023. Note: Includes adult respondents. Shares are calculated based on the total hours of activity reported by each respondent of the survey and averaged across gender and location, applying population weights. Activities not shown are studying, leisure, sleeping, self-care, transport, and others. 146. In terms of education spending, higher levels of spending and reforms to improve the efficiency of spending will be critical to increasing Armenia’s human capital. Aggregate country data suggest there is a close correlation in the ECA region between education spending as a share of GDP and performance on standardized assessments as captured by the Trends in International Mathematics and Science Study. 113 Armenia’s spending on education as a share of GDP is among the lowest in ECA, fluctuating between 2–3 percent of GDP over 2011–17 compared to the ECA average of 4 percent. Moreover, the education sector’s fragmented governance and lack of autonomy at the local level reduce the effectiveness of the sector and negatively affect resource efficiency. Recent reform in the education sector aims to establish effective, open, performance- and outcome-based governance and financing systems, but it needs to be accompanied by appropriate financing, capacity development support, and monitoring (World Bank 2023a). 5.3.2. Access to Health Services 147. Challenges in accessing high-quality health services result in poor health outcomes. Evidence points to gaps in access to high-quality health care services—for example, Armenia is rated 70.7 out of 100 in the healthcare access and quality index developed by the Institute for Health Metrics and Evaluation (GBD 2017 DALYs and HALE Collaborators 2018). Healthy life expectancy—an indicator that excludes from longevity any years of less than full health due to disease or injury—was 67.1 years in 2019, below the peer countries, such as Georgia (73.3 years) and Estonia (78.9) Kruk et al. (2018) estimated that the percentage of amenable deaths—premature deaths (deaths under age 75) that could potentially be avoided, given effective and timely healthcare—due to poor quality service exceeded 50 percent in Armenia. Although this rate is lower than the average rate of 79 percent among the central European countries considered for the analysis, there is scope for improvement. The main contributing factors to the gaps in access include challenges in health financing, delivery, and governance (Chukwuma et al. 2020). Trends in International Mathematics and Science Study (TIMSS) (data repository), International Association for the Evaluation of Educational 113 Achievement, Amsterdam, https://www.iea.nl/data-tools/repository/timss. 59 148. The health system has traditionally focused on curative rather than preventive services, 114 leading to major shortcomings in addressing the growing burden of NCDs (WHO 2022). In addition to the costs of preventable premature deaths and years of disability, the estimated economic burden of NCDs is significant. The WHO estimates that the most common NCDs account for 63 percent of total public health spending. The burden of NCDs partly reflects the underutilization of high-quality care and exposure to behavioral risk factors, including the high prevalence of smoking and obesity. 115 The coverage of care for NCDs is low in Armenia, and the utilization of primary health care services is also low with only 32 percent of the general population visiting the facilities according to the last assessment in 2020–21 (National Institute of Health 2022). The health care model in Armenia is centered on curative care which accounted for 59 percent of health care expenditures in 2018, above the average for Europe. 116 149. Low government funding and spending Figure 69. Out-of-Pocket Expenditure (as % of current health inefficiencies contribute to a large share of out-of- expenditure) pocket expenditures and result in inequities in access to health care services. Government spending on health in Armenia is one of the lowest in the ECA region, contributing to financial gaps in access and limiting the capacity to improve health care quality. Moreover, there are large inefficiencies in public spending: total health expenditure in Armenia was 11.3 percent of GDP in 2019—higher than the 2019 averages in UMICs (5.9 percent) and the world (9.8 percent)—but the share of public financing in total health spending is among the lowest in the world and is below the average in UMICs (57 percent). The share of out-of-pocket spending is also high at 78 percent, one of the highest shares in the world (Figure 69). 117 Next to quality issues, financial barriers are the second-most important cause of the Source: World Health Organization, The Global Health Observatory database as of January 2021. underutilization of primary health care services. A key driver of out-of-pocket spending is the lack of coverage among up to 70 percent of the population for outpatient medicines, diagnostics, and hospital care. Given the limited financial resources, a greater focus is needed on the effective allocation and governance of resources for health spending to provide households—especially poorer households—with financial protection and to minimize the probability of catastrophic health expenditures (Chukwuma et al. 2020). 5.3.3. Access to High-Quality Jobs 150. The persistence of substantial unemployment over the past decade suggests that there are structural, long- term barriers and potential mismatches to finding employment. Unemployment in Armenia has been high compared to some of its peers (Figure 70). The main reported obstacle to finding jobs among jobseekers is a lack of jobs—55 percent of jobseekers reported it to be a main constraint. This response was more prevalent among men (61 percent), individuals with relatively low educational attainment (lower-secondary education or less, 78 percent), and residents of rural areas and secondary cities (over 60 percent). Around 10 percent of jobseekers attribute unemployment to the lack of jobs corresponding to their profession or skills; this share is 20 percent among jobseekers with tertiary 114 Existing programs implemented by the Ministry of Health with the aim of prevention, early detection, effective and timely treatment of non-communicable diseases include screening and free medical treatment for acute medical condition (Ministry of Health). 115 Over 50 percent of Armenian men ages 15 and above are smokers, and 55 percent of the population ages 15 and above are obese (National Institute of Health 2022). 116 Armenians have a 20 percent probability of death before age 70 associated with the main NCDs, which is above the average for countries in the Europe region (16 percent) and the global average (18 percent) (World Health Organization Global Health Observatory Data Repository). 117 Private health expenditures in Armenia are mainly out of pocket. 60 education (ADB 2019a). Among individuals registered as unemployed with the public employment services, around 75 percent suffer long-term unemployment, and over 90 percent are considered uncompetitive in the labor market (Honorati et al. 2019). Some subsectors are growing in terms of employment—such as information and communication, financial and insurance activities, and professional activities, which tend to require relatively high skills—but these sectors are still small in absolute size of employment. Moreover, good-quality jobs are not available to many in Armenia (Figure 71). Figure 70. Unemployment Rate (% of Total Labor Force)) Figure 71. Share of the Labor Force Working 20 or More Hours a Week with a Contract 80 70 40 60 35 Percentage of total labor force 50 30 40 25 20 19 30 15 20 13 10 10 5 0 Lithuania Slovak Rep Russia Hungary Slovenia Italy FYR Macedonia Mongolia Greece Armenia Kazakhstan Montenegro Tajikistan Belarus Czech Rep Latvia Estonia Bulgaria Romania Croatia Ukraine Moldova Cyprus Uzbekistan Germany Poland Serbia Bosnia Herzegovina Albania Georgia Kyrgyz Rep Kosovo Turkey Azerbaijan 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Albania Armenia Bosnia and Herzegovina Estonia Georgia Kosovo Moldova Tunisia Source: ArmStat Labor Force Survey data for Armenia and ILOSTAT Source: Tiwari et al. 2019. Work Statistics –19th ICLS (WORK database) as of July 2023 for other countries. 151. Women face high unemployment, potential underemployment, and barriers to accessing high-quality jobs. Armenian women achieve high levels of human capital and skills, although their work and talents are often underutilized. Unemployment is high among young women ages 15–24 at 33.6 percent, compared to 28.3 percent of men in the same age group. 118 Women are also more likely (22 percent) than men (11 percent) to work part-time. 119 Analyses of the equality of opportunity based on a human opportunity index highlight the incidence of gender as an unfair determinant of access to high-quality jobs. 120 Women’s access to high-paying jobs is affected by occupational segregation—for example, women are underrepresented in science, technology, engineering, and mathematics, accounting for only 38 percent of graduates in these fields. 121 152. Women also earn less than men, with a large unexplained gender wage gap. Women employees earn only 74 percent of the net wages of men. 122 Men earn higher average wages relative to women, regardless of age and educational attainment—even women employees with tertiary educational attainment earn only 71 percent of the wage earnings of men at the corresponding level of education. 123 Women’s underrepresentation in occupations associated with higher wages may partially explain the lower earnings of women. Rodríguez-Chamussy, Sinha, and Atencio (2018) estimate that women face an average earnings gap of 33 percent (unadjusted), and while econometric adjustments for differences in education, age, experience, and other observable characteristics reduce the wage gap, the adjusted wage gap is still high at 20 percent. This gap points to unexplainable factors that may reflect gender discrimination. 153. Another challenge for Armenia is the large share of youth not in education, employment, or training (NEET). The rate of youth NEETs in Armenia is among the highest in the region despite some progress (Honorati et al. 2019) (Figure 72). According to estimates, 37.3 percent of women and 19.2 percent of men ages 15–29 were NEETs in 118 Statistics are for 2021 from ILOSTAT Work Statistics –19th ICLS (WORK database) as of July 2023 for other countries. 119 Statistics are for 2021 from ArmStat Labor Force Survey Data. 120 Statistical Data (dashboard), Statistical Committee of Armenia, https://armstat.am/en/. 121 2018 data of Gender Data Portal (dashboard), World Bank, https://genderdata.worldbank.org/. 122 World Bank staff calculation based on 2021 ECPOV harmonized database. 123 World Bank staff calculation based on 2021 ECPOV harmonized database. 61 2021. 124 Regardless of the exact age cohort, young women are always more likely than young men to become NEETs. The share of women NEETs increases sharply for the 25–29 age group, most likely related to motherhood and family responsibilities. Among men, circular and seasonal migration is the most common reason for inactivity. People with low educational attainment report that seasonal migration and discouragement—that is, failure in finding job—are common reasons for their inactivity. Based on regression analysis, the individual characteristics (aside from sex) that correlate strongly and positively with the probability of NEET status include age, membership in a vulnerable minority (such as displaced population or persons with disabilities), and an immigration background. Household composition (especially the presence of young children) and marital status stand out as important correlates of NEET status among women but not men. Socioeconomic status is also an important correlate, with most NEETs living in lower-income households (Buitrago-Hernandez, Fuchs, and Cancho 2019). 154. Although Armenian Public Employment Services offer a broad portfolio of services, the support might not be targeted effectively, and most programs reach only a small Figure 72. Share of Youth Not in Education, Employment, number of beneficiaries. Public Employment Services has or Training (% of population ages 15 – 29) established 15 active labor market measures (ALMMs), but many of these programs remain small. Overall, the largest 40 38 share of funding for ALMMs goes to rural self-employment Percentage of youth population support. However, the targeting of such measures is not fully 30 28 aligned with the profile of the registered unemployed. 20 Whereas the majority (54 percent) of the beneficiaries are rural residents, this group only makes up 41 percent of the 10 registered unemployed (World Bank 2022). Due to a lack of 0 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 resources and limitations in engaging people with weak labor market attachment, public employment services only Albania Bosnia and Herzegovina Armenia Estonia reach and serve a small share of all the unemployed. Among Georgia Moldova Kosovo Tunisia the unemployed, only 26 percent are registered with public Europe and Central Asia World: high income employment services. The limited outreach is a result of the Source: ArmStat Labor Force Survey for Armenia. Other countries narrowness of the financing and limited human resource are from ILOSTAT Work Statistics –19 ICLS (WORK database) as th of July 2023. https://ilostat.ilo.org/data/ capacity at the recently established local centers of the Note: For countries other than Armenia, age range is 15-24. unified system of integrated social services, which provide counseling to jobseekers and employers (World Bank 2022). 5.3.4. Governance and Institutional Bottlenecks – A Related Example in the Health Sector 155. Governance and institutional bottlenecks in addressing the low human capital include inefficiencies and limited accountability of the responsible government agents, lack of transparency in decision-making, capacity constraints to implementing the reforms, and slow progress in reaching the underserved populations in the health sector. In 1998, the State Health Agency in the Ministry of Health was established as the single public payer responsible for purchasing services in the Basic Benefit Package on behalf of the government. However, its role has been eroded as multiple private purchasers are being approved by the Ministry of Health non-selectively, leading to fragmentation and inefficiency in the health system. Furthermore, while Armenia shifted to program-based budgeting in 2019, there are no program managers accountable with a clear objective of the program areas. In addition, no institution has a clear mandate to monitor the quality of services in primary healthcare facilities, and health information systems are not fully functioning due to limited digital capacity at the local primary healthcare facilities. 156. Decentralized procurement and insufficient regulation and monitoring of wholesalers, retailers, and health service providers contribute to high prices of medicines and high out-of-pocket expenditures. About 30 percent of 124 ArmStat staff calculation based on Labor Force Survey. 62 total health spending in Armenia is on medicines and medical supplies, which is high for a UMIC. 125 This can be attributed to relatively high retail prices and markups due to high manufacturer charges, distribution costs, and the value-added tax, which is the highest in the region at 20 percent. The differences between wholesale and already-high retail prices across molecules range from 2 to 125 percent, and at an average of 29 percent, it exceeds the markups in comparator countries. 126 5.3.5. Binding Constraints Table 6 summarizes the binding constraints discussed in this section. Table 6. Binding Constraints to Addressing the Low Quality of Human Capital Key Challenges Binding Constraints 3: Human capital Low quality and relevance of the education system Unaffordability of health services Need to improve efficiency and effectiveness of public spending Lack of coordination between education sector and labor market Weak active labor market programs, including addressing gender gaps in labor market 5.4. Private Sector Development 157. Insufficient private sector productivity was one of the four challenges identified in SCD1. The productivity of firms and workers is affected by numerous factors, including: the availability of high-skilled, healthy workers in the labor market; efficient connectivity and logistics to reach markets; and resilience and mechanisms to cope with shocks. Low and heterogenous productivity can be a consequence of challenges with those factors, as well as a contributing factor perpetuating other development challenges. 127 SCD1 found that “insufficient private sector productivity stands in the way of both higher growth and job creation. Firms, as the productive engines of the economy, appear constrained in their ability to lift productivity” (World Bank 2017b). This section evaluates progress over the past years on firms’ inputs and the enabling environment for the private sector, and it identifies the emerging challenges for boosting productivity in Armenia. It first discusses productivity at the sector level then summarizes the main obstacles to improving output and productivity beyond those discussed in Section 5, with which productivity gaps in Armenia are highly interlinked. 5.4.1. Sectoral Productivity 158. By measures of labor productivity—measured here as total output per worker—private sector productivity in Armenia is low, stagnant, and varies across economic sectors. Labor productivity measured by value added per worker has been growing over the last two decades across the main sectors. This appears in line with the results from the TFP analysis discussed in Section 4. 128 However, the average level of labor productivity by sector is among the lowest 125 This is the share of drugs and medical products in total health spending (public and private spending combined) in 2021 from National Health Accounts (2022). 126 Market Performance Group 2021. Pharmaceutical Market Assessment for Armenia cited in World Bank 2023b. Data were collected on 50 commonly used molecules from 20 hospitals and 20 PHC centers from Yerevan and selected administrative areas. 127 The problem can also be analyzed as a “coordination failure.” For example, in a country with low productivity and lack of innovation in the IT sector, workers would not have incentives to accumulate human capital in specialized areas of STEM, and universities may not even invest in providing those skills. The lack of high-skilled STEM workers would simultaneously contribute to a low-productivity equilibrium and underdevelopment of the IT sector. Breaking this coordination problem is hence an important policy challenge. 128 This would need to be confirmed through an analysis of firm-level productivity data. Otherwise, it could seem that there is a paradox between Armenia’s seemingly high TFP rates and low labor productivity. Low labor productivity can in principle coexist with high TFP if capital intensity is low, although this would require technical progress that is not at all embedded in new physical capital investment. Furthermore, the labor productivity measured used here (i.e. value-added per worker) may not be as accurate as the marginal labor productivity measure which is unavailable. 63 relative to Armenia’s peers. Notably, average productivity in services is twice as high as in agriculture, and productivity in industrial activities is three times higher than the average in agriculture (Figure 73). These productivity gaps across sectors suggest a misallocation of resources. Although average productivity can mask heterogeneity within sectors, the low estimated productivity in agriculture is related to the small average size of plots and the related disincentives for large investments and technological upgrades. Armenia’s levels of manufacturing productivity are in line with peer countries, but productivity in agriculture and services is lower than among peers. Figure 73. Labor Productivity: Output per Worker a. All Sectors b. Agriculture c. Services d. Manufacturing Source: World Bank staff calculations based on World Development Indicators (dashboard), https://datatopics.worldbank.org/world- development-indicators/. 159. Despite evidence of low productivity and recent declines in output, agriculture continues to be a strategic sector of the Armenian economy. Today, agriculture is dominated by semi-subsistence, part-time smallholder farmers with farms of 1.5 hectares on average (Agricultural Census 2014). Agricultural productivity is low, as measured by productivity per hectare, per worker, and per unit of water use (FAO 2020c), and the sector is highly vulnerable to adverse climate events. Moreover, some evidence indicates declining agricultural output in recent years: according to data collected by ArmStat, the sector experienced a decline for five consecutive years, by -0.7 percent of GDP in 2021 and by -1.8 percent in 2022. However, there are reasons for concern about the accuracy of official statistics on agriculture (including the classification of land and property for agricultural production), and there is also evidence of considerable heterogeneity and success cases within the sector. 129 160. Irrigation is important to agricultural productivity in Armenia, with more than 80 percent of the gross crop output produced on irrigated lands. Agriculture in Armenia is heavily dependent on irrigation, and returns are higher on irrigated lands. However, irrigation systems in Armenia have suffered from decades of lack of investment and 129Anecdotal evidence collected during the identification mission to Yerevan (June 2022) and to be researched further. Export data shows increasing volumes and values of agricultural exports. 64 modernization. Water losses are high, and energy usage (to pump water) is expensive. Because tariffs remain low, subsidies are often needed to maintain a basic level of irrigation service for farmers. 161. Access to inputs and capital for agricultural production has improved in recent years. Government subsidy programs have supported improvements in access to fertilizer and seeds, and public investment has focused on enhancing access to irrigation, farmer cooperatives, and producer associations. These measures could improve grassroots irrigation management and promote economies of scale and profitability in agricultural markets. However, implementation is far from complete; the Ministry of Agriculture was subsumed into the Ministry of Economy several years ago, and the farmer extension service was abolished. Given the importance of knowledge as a basis for technology adoption among farmers (including technologies and practices that enhance climate resilience), public support is needed for knowledge transfer around new technologies and farming practices that would enhance climate resilience among farmers. More support is also needed to improve the performance of irrigation sector institutions. At the same time, access to capital has advanced significantly through subsidized commercial bank lending programs in agriculture, as well as FDI and funding by international financial institutions. A large share of the fiscal stimulus implemented since 2020 was channeled to investments in agriculture, raising the possibility for sectoral improvements in the medium to long term, provided the targeting and delivery mechanisms of support programs are improved. 162. Despite this recent progress, some key challenges to agricultural productivity seem deeply rooted. Three main constraints are preventing the transformation of agriculture into a modern dynamic sector. First, Armenia has limited areas of arable land, and land ownership is fragmented and dominated by small-scale, semi-subsistence farms. Second, low adoption rates of advanced technologies and farm management practices have prevented the sector from becoming more productive, market-oriented, and diversified. Third, producers are poorly integrated into agriculture value chains, and agribusinesses lack the capacity to include more small-scale farmers in their supply chains (Agricultural Census 2014). A lack of reliable agricultural data makes the design of appropriate support measures for the sector difficult. 163. Within manufacturing, the productivity of mining has improved, and the sector has potential for expansion but is constrained by investment and a need to green the sector. Given Armenia’s favorable mineral geology, the mining sector has potential for further expansion considering rising global demand and mining investment. The global mining industry is scouring the globe to find the next generation of deposits, especially those of climate critical minerals which are in strong demand as the world moves to decarbonize. Armenia has proven reserves of copper and molybdenum and a significant potential for gold and a range of other minerals that could be further valued through geological research and exploration. In the medium run, the demand for minerals needed for the energy transition could also create opportunities for mining, if Armenia is able to attract investment oriented toward a green growth model. Armenia would need to attract investment on a far larger scale than at present, primarily from foreign sources, for its growth ambitions to be realized. Even maintaining the sector at its present scale will require an increase in capital investment to avoid depletion due to the exhaustion of available reserves. The sector could be expanded both by increasing the volume of minerals mined and adding value by processing minerals before export. While this would not contribute to increased economic complexity of Armenia’s exports, it could be an important source of growth and fiscal revenues in the decade ahead. Mining already accounts for two of the country’s top five taxpaying enterprises and accounted for around 10 percent of direct tax receipts in 2021. 164. However, environmental, social, and governance practices in the mining sector remain challenging. The mining sector in Armenia has a legacy of irresponsible mining practices in past decades, which has resulted in low acceptance toward mining in host communities. Environmental, social, and governance (ESG) standards, which increasingly set a benchmark for responsible mining internationally, need to be enhanced. Commensurate with this is a need to improve the capacity of regulatory institutions to set and enforce higher standards. The strategy for the development of the mining sector, adopted in May 2023, aims to rebuild confidence and restore trust by promoting investment in responsible mining founded on sustainability principles and higher ESG performance. 65 165. In the services sector, certain sub-sectors such as tourism show promise for boosting productivity, particularly if measures are taken to help realize their full potential. International tourism arrivals more than doubled in the last decade to reach a peak of 1.9 million tourists in 2019, and the sector accounted for 12.5 percent of total employment that year (World Bank 2021a). After a decline in 2020 due to the twin shocks, tourism has shown dynamic growth, reaching 1.7 million in 2022 (Figure 74). This was supported by tourism from Russia, with Russian visitors increasing more than two-fold in 2022 year on year. 166. More can be done to help realize the full economic potential of tourism. The country ranked 61st among 117 countries on the World Economic Forum (WEF) 2021 travel and tourism competitiveness index, with low rankings in infrastructure (WEF 2022). In addition to addressing infrastructure gaps, medium-term interventions to improve competitiveness could target digital nomads, free independent travelers, and nature and wellness tourists, including measures such as enhanced digital infrastructure, market-relevant product offerings, coordinated promotion at the firm level, and awareness raising (domestically and abroad) on Armenia’s tourism offerings (World Bank 2021a). Figure 74. Tourist Arrivals and Revenues 2010-2022 Figure 75. ICT Service Exports (BoP) 2,000 3,000 2,513 1,600 2,400 Number of persons (000) 1,200 1,553 1,800 mln. USD 875 800 1,200 813 694 1,464 888 1,305 524 1,191 400 715 929 986 790 600 559 631 687 223 430 352 315 273 303 347 210 263 125 127 156 138 0 0 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 2022 Russia Other countries Tourism revenues, mln USD (RHS) Source: ArmStat Socio-Economic Situation of the Republic of Source: World Development Indicators database. Armenia; CBA, Balance of Payments BPM6. 167. Similarly, the ICT sector has been dynamic, but Armenia can do more to better position itself to leverage global digital trends. Armenia aspires to be an ICT hub and has a recent track record of providing outsourcing services to global firms. ICT services dominate Armenia’s high-tech exports—mostly in software programming—and ICT service exports nearly tripled from US$127 million in 2010 to US$382 million in 2021 (Figure 75). Among its comparator countries, Armenia is second only to Estonia in ICT service exports, and on a per capita basis (US$137) in 2021, it outperformed even China (US$36) and India (US$85). However, Armenia could do more, as exports of global leaders exceeded US$1,000 per capita in 2017 (World Bank 2019a). Armenian firms may struggle to stay competitive in high- tech global value chains if they continue to target software and hardware solutions for vertical applications. The government can strategically support Armenia’s migration toward activities that are catalyzed by emerging technologies, for example in the areas of biotech and digital health, cleantech, and earthquake engineering (World Bank 2019a). The recent relocation of IT firms and talent from Russia offers an additional opportunity for Armenia to seize: over 50,000 IT specialists from Russia are estimated to have arrived in Armenia after several companies relocated in 2022 and registered in Armenia. 130 130 Estimate from Minister of Economy, September 2022. Interview with RTVI. 66 168. The increasingly poor reliability of electricity Figure 76. Firms Experiencing Electrical Outages service affects private sector productivity, especially for those industries that rely on uninterrupted processes or digital services. After a period of improvement in the 2000s, lack of investment in the power network is leading to increasingly poor reliability of electricity service which harms the general business environment and could result in increased costs, disruption of production, and equipment damage. The system- average frequency of interruptions increased from 5.3 yearly interruptions per customer in 2013 to 9.1 in 2021, indicating that the average customer experienced almost twice as many outages in 2021 than in 2013. The Source: World Bank 2020h, Enterprise Surveys. average interruption frequency per line for 110 and 220 kV overhead transmission lines is 2.5 times higher than for comparator well-performing utilities. The World Bank enterprise surveys indicate a similar trend of deteriorating reliability between 2013 and 2020 (Figure 76). 131 5.4.2. Access to Finance and Financial Inclusion 169. Armenian manufacturing and services firms report obstacles to growth related to finance, the business environment, and human capital. 132 These obstacles include access to finance, informal practices of competing firms, political instability, an inadequately educated workforce, and tax regulations (Figure 77). The intensity of these obstacles varies by size of firm (Figure 78). For instance, access to finance is an obstacle that is reduced with size, whereas informality and political instability are bigger concerns for larger firms. Midsize firms are the most affected by the inadequately educated workforce and tax rates. Figure 77. Main Obstacles to Doing Business Figure 78. Obstacles to Doing Business, by Firm Size Source: 2020 data of Enterprise Surveys (dashboard), World Bank, https://www.enterprisesurveys.org/en/enterprisesurveys. “Percent of firms choosing access to finance as their biggest obstacle.” 170. Armenian banks are adequately capitalized, liquid, and operating in a broadly supportive macroeconomic context. They experienced record profits in 2022, supported by the huge increase in nonresident deposits, foreign exchange gains, and low provisioning. As of May 2023, capitalization stood at over 20 percent, nonperforming loans 131 The share of firms experiencing electrical outages fell from 41 percent in 2009 to 34 percent in 2013 but then increased to 63 percent in 2020, twice as high as the regional average (31 percent). Similar trends can be seen in the number of outages per month (0.9 in 2009, 0.4 in 2013, and 2.5 in 2020, compared to the ECA average of 0.8) and their typical duration (3.7 hours in 2009, 1.9 hours in 2013, and 2.9 hours in 2020). 132 Firms surveyed through the Enterprise Surveys (dashboard), World Bank, https://www.enterprisesurveys.org/en/enterprisesurveys. The sample in Armenia included firms in manufacturing (all subsectors), construction, motor vehicles sales and repair, wholesale, retail, hotel and restaurants, storage, transportation, and ICT. Firm size included more than five employees. Status: formal firms with more than 1 percent private ownership. Excluded sectors: agriculture, fishing, mining, public utilities, financial intermediation, public administration, education, health care, and social work. Size of excluded firms: less than five employees, informal firms, and 100 percent state-owned enterprises. 67 at 2.6 percent of total loans, return on equity at 17.9 percent, and liquid assets to total assets at above 36 percent. Credit grew by over 6 percent as of May 2023, driven mostly by lending to households. Despite adequate fundamentals, risks mainly relate to the high level of dollarization, rising real estate prices, tighter global financial conditions, a slowdown in major trading partners, and geopolitical risks from the persistent tensions with Azerbaijan. 171. The banking sector is well regulated and supervised. In the last few years, the CBA has undertaken significant efforts to modernize its regulatory and supervisory framework for the banking sector and financial safety net to ensure that it is in line with international standards and best practices. Key reforms include: (1) bringing the definition of non- performing loans in line with international standards; (2) amending the capital requirements regime; (3) enhancing macroprudential tools and tackling imbalances, as shown by restricting the provision of mortgage loans in foreign currency; (4) upgrading its supervisory toolkit, including implementing bottom-up micro-prudential stress testing, recovery planning requirements, and others; (5) preparing a draft Bank Resolution Law that will confer the CBA with new, ample powers to manage bank failures, (6) establishing a bank resolution unit, and (7) working to increase capacity to assess banks’ recovery plans and develop resolution plans for systemically important banks. 172. Overall, domestic credit to the private sector accelerated in recent years, reaching seemingly appropriate levels. Armenia’s financial depth—measured as the proportion of domestic credit to the private sector in relation to GDP—increased by 20 percentage points and is now at a level that is expected for the country’s income level and one of the highest levels among peers (Figure 79a). However, the credit must be flowing to large firms, as reflected by the percentage of small firms that find access to credit to be the biggest obstacle (34 percent), half the share among big firms (17 percent). At the same time, the cost of credit declined by almost 3 percentage points. The cost of domestic credit is at a level expected given the financial depth of the country, although it is the highest among peers (Figure 79b). The lower cost among peers probably comes from constraints among firms, including lack of awareness, low financial literacy, and widespread informality. Figure 79. Credit to the Private Sector a. Financial depth versus income level, 2019 b. Domestic credit to private sector Source: World Bank staff calculations based on World Development Indicators (dashboard), https://datatopics.worldbank.org/world-development-indicators/ 173. While access to finance is improving, it remains a significant constraint to growth and private sector development. Access to finance was identified as a major constraint by 31.6 percent of firms, compared to 14.5 percent in ECA and 23.4 percent for all countries (World Bank 2020h). Armenia’s financial markets are bank- and credit- dominated, with lower participation by non-banks and capital market institutions. Alternative instruments such as leasing, factoring, trade finance, early-stage financing, and equity financing are underdeveloped. In addition, collateral requirements are high in Armenia. The prevalence of cash and informality makes it more difficult for banks to evaluate the repayment capacity of borrowers, which combined with difficulties in collateral execution, results in higher collateral requirements, especially for SMEs. Loans are collateralized at over 207 percent of the loan amount, compared to the ECA average of 164 percent (World Bank 2020h). One symptom of binding finance is the sensitivity 68 of investment to changes in the cost of credit. Between 1999 and 2008, reductions in lending interest rates were associated with increases in the investment rate (Figure 80a). This suggests that the cost of credit was preventing firms from investing. However, after 2008, reductions in the cost of credit did not mirror investment growth (Figure 80b). The cost of credit is high compared to peers (Figure 81). Figure 80. Sensitivity of Investment to the Cost of Credit a. 2000s b. 2010s Source: World Bank staff calculations based on data of the Economist Intelligence Unit and International Monetary Fund. Figure 81. Interest Rates on Lending a. Expected rate by level of credit penetration, 2019 b. Rate comparison Source: World Bank staff calculations based on World Development Indicators (dashboard), https://datatopics.worldbank.org/world- development-indicators/ 174. Furthermore, domestic capital markets are growing from a low base but remain shallow. The government securities market is moderately developed and provides the basis of the local securities market. The total market value at the end of 2021 was AMD 1,867 billion, of which AMD 1,204 billion (64 percent) corresponded to the government bond market, AMD 489 billion (26 percent) to the corporate bond market, and AMD 174 billion (9 percent) to the equity market. 133 The stock market is shallow and has low liquidity, with a market cap of AMD 277 billion (with 10 issuers and 205 trades) as of June 2023. The development of the capital market is a priority for authorities, as per the capital market development strategy approved in 2020. An action plan with specific milestones and timelines covering reforms to the money market, foreign exchange market, sovereign market, as well as derivative markets is currently under implementation. The CBA is facilitating the introduction of an over-the counter commercial trading platform for the overnight repo market. It is also undertaking a major review of the payment system to align the operation and oversight of the financial market infrastructure with the Objectives and Principles of Securities Regulation Principles. 175. In addition, aspects of Armenia’s corporate law are poorly suited to early-stage financing and investment. Armenian law only allows joint-stock companies to issue preferential stock, and these must be nonvoting shares. Armenia has no legal structure that permits different classes of voting shares, which entail differing entitlements to dividends and various levels of voting power. When seed funding is received as a debt, converting that investment into equity during subsequent funding rounds is not possible. These constraints impede venture capital and angel investors 133 Armenia Securities Exchange (AMX) Annual Report 2021. 69 in acquiring preferred stock with liquidation or dividend preference (as is typical). Similarly, early-stage investors are not able to request voting power—even if subordinate—which makes Armenian start-ups less attractive. 176. Due to these limitations and an outdated FDI law, Armenian firms often incorporate abroad to attract investment, limiting local spillover. The lack of early-stage financing has driven some Armenian tech firms to seek investment abroad. In most cases, investors request that investees incorporate under laws with which the investors are familiar—this is especially true of US investors. Given that many Armenian firms have grown through US investment (thanks largely to diaspora links), most Armenian tech start-ups are incorporated in the United States, even if the US headquarters are virtual or nominally staffed. This firm structure reduces the entity to subsidiary status, meaning that any investment remains in the US account, and dollar transfers are limited to operational costs, salaries, and overhead. 177. Other barriers inhibit FDI in Armenia, particularly lack of predictability and a missing government strategic vision for FDI. Over one-fifth of investors surveyed by the International Financial Corporation in 2023 cite lack of predictability in decision-making based on laws and regulations of government bodies (IFC forthcoming). Decisions are often slow and do not always meet deadlines outlined in laws and regulations. This affects the predictability of project timelines and implementation. Regulations also often change: for example, in 2022 alone, there were 30 amendments to the Tax Code. Among investors, 18 percent cited the lack of a strategic vision of the country’s development path as a barrier to investment, along with insufficient targeting and outreach to investors. Other challenges highlighted by investors included few exit routes and exit strategies due to the underdeveloped stock market, as well as project scalability and bankability given limitations in physical infrastructure and the size of the local market. An FDI strategy that identifies measures to improve the business climate, develop supporting infrastructure, enhance skills and knowledge transfer, and identifies viable sectors for investment would support further FDI attraction and diversification of investments in terms of sectors and destination of flows. 178. Private capital mobilization will be crucial to bridge investment gaps in infrastructure, regional connectivity, and access to finance. As such, further improvements in the investment climate and active FDI attraction are needed. While more information is needed on private capital mobilization values across sectors, indicators suggest substantial volumes in infrastructure alone. For example, in the energy sector, the transmission grid investment needs—excluding the regional interconnections for Georgia-Armenia and Armenia-Iran—are estimated at US$230 million for 2021-35, and distribution grid investment needs are estimated at US$445 million for 2021–27. 134 179. In terms of financial inclusion, despite improvements in recent years, Armenia continues to lag the region on key metrics and could do more to advance digital payments. Account ownership is low relative to the regional average. According to the 2021 Findex database, only 55 percent of adults have an account, and the gap is more pronounced for young adults, women, those in rural areas, and the poorest 40 percent of the population. Following the adoption of the Law on Noncash Transactions in 2022, which required all payments exceeding AMD 300,000 to be non-cash for individuals, entrepreneurs, and firms, Armenia witnessed a notable enhancement in its non-cash payment infrastructure and a significant upsurge in the proportion of non-cash transactions. 135 However, cash is still quite dominant, especially in rural and remote regions (Global Findex 2021). Only 16 percent of adults made a digital merchant payment, compared to 54 percent in ECA (excluding high-income economies). Banks are the main providers of payment services on both the issuing and acquiring side, and there is little evidence of existing players or new players leveraging new technologies and business models to provide innovative products. The CBA is pursuing digitalization in the financial sector, including a particular emphasis on an updated national payment system strategy. Significant opportunities exist for further advancing digital payments by addressing constraints posed by the identification (ID) infrastructure and regulatory environment to develop non-bank payment services. These efforts will support implementation of Armenia’s digital transformation strategy. World Bank staff calculations. 134 As of early 2020, there were only 11,613 POS terminals and 1,735 virtual POS terminals within the country. As of the second quarter of 135 2023, these figures had surged to 75,469 and 4,234, respectively (Central Bank of Armenia). 70 180. Building the architecture for green finance and strengthening the innovation ecosystem will unlock green technology uptake, increase the competitiveness of the private sector, and help connect the private sector to global value chains. Greening the financial system will increase financing flows into activities that contribute to climate and environmental objectives. The estimated need for green investments (climate mitigation and adaptation in line with the NDC) is estimated at US$5.7 billion during 2020 and 2030 (Kato and Neuweg 2021) and far exceeds public sector capacity. Removal of barriers to green finance for the private sector is key to addressing climate and transition risks and sustainability challenges. There is an urgent need to introduce a green taxonomy in Armenia as a consistent guideline to define green economic activities and appropriate financial instruments to enhance market transparency and facilitate the alignment of capital flows with environmentally sustainable and green economic activities. Green bonds and carbon pricing could have an important role to play in mobilizing private sector resources. 5.4.3. Competition and Contestability 181. While perceptions of Armenia’s competition policy and organization of the market have improved, more can be done to boost competition. Since 2018, there has been a notable improvement in perception of competition policy (Figure 82). The new government pledged to open industries that had previously been closely connected to the state to competition. The focus of these efforts has been on anticorruption actions rather than economic reforms. Recent reforms to curb state aid to limit the anticompetitive effects of state subsidies in a manner consistent with good international practices are under implementation. However, despite the improvements in the competition policy indicator, competition policy is the area in which Armenia most lags peers, followed by liberalization of foreign trade (Figure 83). A holistic competition policy is needed, encompassing three pillars: opening markets through pro- competition sectoral regulation, promoting a level playing field, and ensuring effective enforcement of the competition law. While perception-based indicators such as these reflect an improvement in competition in Armenia, more information is needed to determine the extent to which competition and contestability challenges have continued since the Velvet Revolution. Figure 82. Organization of the Market and Competition, Armenia, Figure 83. Organization of the Market and Competition, 2016–22 Armenia versus Peers, 2022 Source: Bertelsmann Transformation Index2022. Source: Bertelsmann Transformation Index2022. 182. Armenia’s manufacturing sector has a relatively moderate level of market concentration compared to some peers, and while the reported level of concentration declined markedly over 2013-20, it remains high. In industries that are typically characterized by low levels of market concentration such as in the manufacturing sector, the latest 2019–20 firm-level survey data from the World Bank’s Enterprise Survey suggest a significant presence of oligopolistic structures (that is, monopoly, duopoly, and oligopoly markets) or concentrated markets in 2020. The data show that the proportion of firms in Armenia’s manufacturing sector that considered that they were operating in concentrated markets or oligopolistic structures was relatively high (39 percent) in 2020 compared to those in peer countries such as Tunisia (18 percent) and Kosovo (21 percent) (Figure 84). This share was, however, better than in other peer 71 countries such as Estonia (45 percent) and Georgia (47 percent). The share of respondents operating in concentrated markets in Armenia’s manufacturing sector declined from about 84 percent in 2013 to about 39 percent in 2020—a decrease of 54 percentage points (Figure 85). Relative to peer countries, this decline was the largest reduction in oligopolistic structures during that period. Several factors may have contributed to this decline, including government regulations and interventions that ease entry or level the playing field. The level of market concentration at a given point in time in any economy could also be the consequence of natural barriers, small market size, or firms operating more efficiently because of scale economies. Figure 84: Manufacturing Market Structures Figure 85: Proportion of Oligopolistic Market Structures in Armenia’s Manufacturing Sector Source: World Bank staff elaboration based on World Bank Enterprise Survey for the years indicated in the figures. Note: The shares reflect the percent of responding establishments that answered “None,” “One,” “2-5,” or “More than 5” or whose responses were classified as such to the question “For fiscal year [indicated in parenthesis], for the main market in which this establishment sold its main product, how many competitors did this establishment’s main product/product line face?”. For example, “None” or “0” was coded as “Monopoly,” and “One” or “1” as “Duopoly.” Establishments with no or missing answers to the question and establishments whose main market for their main product line was international are excluded. The exclusion of the latter was because these establishments tend to have missing answers to the question. 183. The impact of SOEs on the competitive landscape is not expected to be significant, as SOEs are much less prevalent than in other post-Soviet countries following a major privatization effort in the 1990s and early 2000s. Armenia has 215 state and community owned companies, of which 168 have central government ownership and 47 have Yerevan Municipality ownership. 136 SOEs that have central government participation account for 11 percent of GDP in assets. While the data may not be strictly comparable, the number of SOEs in Armenia, their share of total employment and size of assets compared to GDP for those SOEs with 90 percent or more ownership is less pronounced compared to peer countries such as Georgia (Gigineishvili et al. 2023). 137 SOEs in Armenia are mainly in energy, health, water, telecommunications and transport, The key risk from SOEs is as a source of fiscal risk, as 22 percent of SOEs in Armenia operation at a loss. Energy sector SOEs, for example, have public or publicly guaranteed debt for electricity sector investment. Further, the energy sector comprises 82 percent of liabilities of central government SOEs. Similarly, transport SOEs could be a source of fiscal risk, as airports and the railway network are under concessions. Energy SOEs are not expected to have a major impact on competition, firm dynamism, labor markets, and innovation and technology adoption. However, more information is needed to assess the impacts of all SOEs in these areas. 5.4.4. Governance and Institutional Bottlenecks – A Related Example in Public Procurement 184. Limited private sector competition in public procurement lowers the efficiency of public spending and quality of public services and increases corruption risks. Low competition and non-competitive tendering practices are prevalent in Armenia, and the use of non-competitive tendering procedures and the resulting single source procedure rates are higher than in comparable European countries. 138 According to the 2022 Ministry of Finance annual report, 136 Ministry of Finance. Fiscal Risks Statement based on 2021 data. 2024-26 Medium-Term Expenditure Framework. 137 Based on 2019 or latest data available. 138 Single bidding means all those tenders in which only one bid was received, irrespective of procurement method. 72 the share of direct contracting (single sourcing or non-competitive bidding) has been 37.8 percent by value and 45.98 percent by number. 139 Using public procurement open data between 2017 and early June 2020, World Bank analysis shows that 41 percent of expenditures were single-bidder contracts (excluding framework agreements and request of quotations). Contracts larger than AMD 10 million (around US$25,000) had a slightly higher proportion of single-bidder contracts at 44 percent. These high-value single-bidder contracts are estimated to cover 39 percent of total procurement spending. A significant share of non-competitive contracts are single source and urgent single source contracts that account for roughly 14 percent of total expenditure (including spending through framework agreements and request for quotation). 140 Average participation in tenders remained low at 1.7 per activity from 2019 to 2021, increasing to 1.9 in 2022. Non-competitive tendering practices lower efficiency and increase corruption risk. 5.4.5. Binding Constraints Table 7 summarizes the possible polity priority areas and binding constraints discussed in this section. Table 7. Binding Constraints for Enhancing Private Sector Development Key Challenges Binding Constraints Insufficient access to finance and lack of financial deepening Need to promote startups and firm entry and exit by strengthening business regulations and practices Need to enhance investment climate and business regulations 4. Private sector development Need to enhance access to finance especially for SMEs from domestic investment, FDI, and diaspora investment Sparse opportunities and incentives to invest to enhance productivity and accelerate growth 5.5. Cross-Cutting Theme: Governance, Institutions, and Data 5.5.1. Quality of Institutions 185. Institutional quality and governance bottlenecks underlie all of Armenia’s development challenges and are thus identified as a cross-cutting constraint. As mentioned earlier, this constraint is newly highlighted for SCD2. It covers institutional quality and the government’s ability to strategically manage prioritization, design, and implementation of government policies. 186. Armenia has made progress in strengthening the quality of its institutions since 2016, especially in the areas of anticorruption and transparency in the public sector. Strengthening the rule of law, accelerating the fight against corruption, and ensuring an accessible, equitable, accountable, and better-performing justice system have been core elements of the government program (Box 5). An anticorruption strategy (2019–22) was approved, and a new anticorruption institutional architecture has been established. A comprehensive Strategy for Judicial and Legal Reforms (2019–23) was adopted which was followed by the 2022-26 Strategy for Judicial and Legal Reforms. The government remains committed to establishing an accountable and efficient governance framework and improving public sector effectiveness and trust in government. Priorities include advancing a comprehensive public administration reform; strengthening strategic planning and policy implementation, public financial management, and public investment management frameworks; 141 improving domestic revenue mobilization; and putting forward ambitious modernization and digitalization reforms including in public service delivery. Progress was reflected in higher levels of trust in government—trust in the Prime Minister and Ministers increased from 20 percent in 2017 to 71 percent in 2019—and 139 10 percent of all single source contracts correspond to natural monopoly services. 140 While Armenia stopped using framework agreements starting 2017, the analysis considers the use of framework agreements where those cases occurred. 141 Progress includes strengthening Public Investment Management regulations and establishing a new Investment Committee. 73 a reduced perception of corruption as measured by Gallup World Poll’s Corruption Index in Government (decreased from 73 percent in 2017 to 33 percent in 2019). 142 Box 5. Justice Sector Reforms Following the Velvet Revolution, Armenia set ambitious goals for reforming the justice sector. A strong political will for change toward a citizen- and business-centric approach in delivering justice sector services, with an emphasis on quality and integrity, is reflected in the comprehensive Strategy for Judicial and Legal Reforms 2019–23 and its successor the Strategy for Judicial and Legal Reforms 2022–26. However, implementing the ambitious reform agenda and delivering tangible results on the ground have proven to be challenging due to lack of relevant data for informed decision-making; a stretched-thin workforce frequently lacking specialized skills (for example, in ICT); and scarce financial resources that leave little to no resources for reform once salaries are paid. These factors—coupled with gaps in robust policies and guidelines—hinder long-term planning, leading to faster-than-usual deterioration of investments in hard infrastructure and ICT. Aware of the challenges and the spotlight they are under, the justice sector leadership is taking steps in the right direction. For example, for the rendering of court decisions, Armenia’s courts currently rely on a piecemeal approach in which several Case Management Systems are running in parallel—at times even in the same court—making it impossible to manage caseloads and workloads and to ensure quality and timely delivery of services. To overcome and apply a whole-of-sector approach, an E-Court platform has been mapped out that foresees leveraging of existing e-government structures for equal standards in public service delivery across Armenia and cost savings for the justice sector in the long run. Improvements can also be seen in improving collaboration and institutionalizing feedback loops. Previously applied top-down approaches in decision-making are slowly being removed, both for internal as well as external users of the systems. For example, judges are informed and consulted with on a regular basis to ensure institutional buy-in and to translate policy changes into front-line service delivery improvements. Progress is also being made in identifying gaps in the legal, regulatory, and procedural frameworks. For example, although an electronic system was introduced for fast tracking uncontested claims, it is not used due to system gaps, such as absence of a bulk payment option. Allowing for feedback loops and addressing concerns raised by users such as businesses and corporate lawyers has been a significant step forward that facilitates meaningful improvements. Source: World Bank, 2023. Supporting Judicial Reforms in Armenia: A Forward Look. 187. Institutions in Armenia remain fragile and vulnerable to shocks. After improving significantly following the Velvet Revolution, Armenia’s institutional development then stalled due to the pandemic and the conflict with Azerbaijan. 143 Even top government priorities such as judicial reform are not advancing according to public expectations, and anticorruption efforts are perceived to have stalled after the initial momentum that followed the Velvet Revolution. 144 While significant achievements have been made in domestic revenue mobilization, progress in public financial management reforms has been slower, including in financial reporting and implementation of an Integrated Financial Management Information System, and there have even been backward steps in internal control and internal audit reforms. 188. The institutional framework for planning, monitoring, and evaluation is neither clear nor comprehensive. The existing regulatory and institutional framework in Armenia for strategic planning has limited connection between strategic documents; weak linkages to budget planning; and insufficient evaluation, monitoring, and performance management. These challenges were identified by a Baseline Measurement Report on the Principles of the Public Administration (OECD and SIGMA 2019), which rated the “Quality of the strategic framework of public administration reform, effectiveness of implementation and comprehensiveness of the monitoring system” with its lowest score of 1 out of 5. 142 https://caucasusbarometer.org; Gallup World Poll’s Corruption Index measures perceptions in a community about the level of corruption in government. Higher scores on the Corruption Index indicate that more residents perceive corruption to be widespread. 143 The State Fragility Index fell dramatically in 2017 (score of 71) but reversed with the pandemic and the war (score of 64.2 in 2020). Other indicators such as the Bertelsmann Transformation Index show a similar trend. 144 Citizens’ perception of corruption increased from 33 percent in 2019 to 52 percent in 2022, according to Gallup’s World Poll. 74 5.5.2. Government Effectiveness 189. Institutional changes have not translated into improved services, reflecting limited government effectiveness. The reform process has generally been ambitious in design but piecemeal in implementation. This can be attributed to low institutional capacity, lack of long-term planning, and lack of evidence-based decision-making, leading to duplication of efforts, deterioration in investments, and low-quality service provision. According to a recent World Bank survey, there are limited career or compensation incentives to motivate public servants to perform well. While recruitment practices are generally perceived as fair and transparent by public servants, use of performance evaluations is more limited than in other countries for which comparable data is available, and public servants have concerns on how they are conducted and on their impact. Only 27 percent of public servants report being satisfied with their salary, a lower share than for the majority of countries with comparable data available. 145 Armenia ranks low in government effectiveness relative to several structural peers and all aspirational peers (Figure 86) (Quality of Government 2022). 146 147 Figure 86. Government Effectiveness, Armenia and Peers Figure 87. Rankings of Main Areas of Governance, Armenia, 2016– 20 Source: World Governance Indicators 2022, World Bank. Source: World Governance Indicators 2022, World Bank. 190. The administrative consolidation of communities may also have major implications for local development, service delivery, and spatial disparities. Governance is problematic in small rural communities. Prior to the administrative consolidation process, Armenia had 915 local self-government entities (of which 866 were rural), which impeded the delivery of high-quality services, the raising of sufficient revenue, and the maintenance of public infrastructure. 148 In 2011, the government launched a reform process that merged and enlarged administrative units, aiming to make budgeting and local self-government more efficient. The first phase of consolidation of the communities kicked off in 2015 and was completed in September 2022, resulting in the consolidation of 915 communities into 71 (including Yerevan), of which 64 contain many settlements. The consolidation process offers 145 Armenia Public Sector Accountability Survey. World Bank (May 2023). 146 Peer countries selected in the institutional analysis differ from comparator countries used otherwise in the SCD, as the analysis considers factors such as a country’s history, political structure, and other indicators that are not captured in the core comparator countries. 147 Government effectiveness under the WGI captures perceptions of the quality of public services, quality of the civil service and the degree of its independence from political pressures, quality of policy formulation and implementation, and credibility of the government's commitment to such policies. 148 https://documents1.worldbank.org/curated/en/205871585015279882/pdf/Armenia-Social-Investment-and-Local-Development-Project- Additional-Financing.pdf 75 opportunities for building local government capacity and promoting inclusive local development, but it requires managing risks and providing targeted support to the most vulnerable communities and administrative units. 191. Weak government effectiveness is a critical bottleneck to inclusive service delivery and growth, and more information is needed to understand and address the causes. Cross-country indicators such as the Bertelsmann Transformation Index and Worldwide Governance Indicators suggest that the government institutional setup, the quality of design, and the capacity and commitment to implementation affect the successful realization of policies and reforms. More disaggregated data are needed to unbundle the drivers of government effectiveness in Armenia. For instance, it would be useful to have access to data on service delivery, labor institutions, regulatory quality, and service delivery at the local, sectoral, and national levels to better identify constraints in government effectiveness. 5.5.3. Investment in Data 192. Investment in data is another critical cross-cutting area that serves as a basis for evidence-based policymaking and policy implementation. Data are a prerequisite for the design, execution, monitoring, and evaluation of public programs and policies. Data can also help accelerate the pace of many reforms executed by the government and contribute to inclusive and sustainable growth by holding the government accountable and prioritizing scarce resources. In Armenia, the lack of data and modern information systems was identified as a bottleneck by many sectors, including the water, health, digital, and agricultural sectors. 149 Improving data and public sector modernization are also critical for better quality and access to services. A World Bank ICT survey found that only five percent of Armenian citizens and businesses currently use online government services. 150 The government of Armenia has prioritized the digital economy as a key pillar of economic growth and public sector modernization, but a whole-of- government approach to digitalization is needed to maximize the use of government data for improving government and citizen services and enabling high-impact reforms. Satellite imagery and remote sensing data that are publicly available can also inform policymaking. This would be possible, however, only if Armenia prioritized investments not only in the collection of quality data but also in the technological and human capital necessary for frontier applications on data. 5.5.4. Binding Constraints Table 8 summarizes the binding constraints discussed in this section. Table 8. Binding Constraints for Addressing Institutional Quality and Governance Bottlenecks Key Challenges Binding Constraints Cross-cutting challenge: strengthen governance and institutions Inadequate government effectiveness and service delivery due to and invest in data insufficient planning, monitoring and evaluation, and prioritization Need to strengthen the social contract through accountable and inclusive institutions Need to prioritize investments in quality data for evidence-based policy making 149 For example, to monitor progress toward increased productivity in agriculture, Armenia needs accurate, crop-specific measures of the area under cultivation and the production of yields, not only at the national level but also at a more granular level to allow better targeting of policies and designing of programs that promote agricultural and rural development and resilience against disasters and extreme weather events. 150 World Bank, Press Release, March 2022, Armenia to Improve Public Sector Performance through Digital Solutions, with World Bank Support, www.worldbank.org/en/news/press-release/2022/03/03/armenia-to-improve-public-sector-performance-through-digital-solutions-with- world-bank-support. 76 6. Policy Priorities and High-Level Outcomes 6.1. Approach to Prioritization and Results 193. Grounded in the diagnostic conducted in the preceding sections, SCD2 identified Armenia’s policy priority areas to address the key challenges. Corresponding to the binding constraints discussed in Section 5, SCD2 identified 11 possible policy priority areas for government action. Among all possible priority areas, a prioritization was conducted to narrow down the priorities that are likely to have the greatest bearing on gaining resilience and generating sustainable and inclusive growth. The prioritization process involved a quantitative international benchmarking exercise and an assessment using additional filters based on the deliberation of World Bank experts and a series of consultations with major stakeholders In Armenia (Figure 88). Figure 88. SCD Prioritization Approach Policy Priority Areas 194. The prioritization process relied on international benchmarking. International benchmarking was done by comparing Armenia’s performance against the rest of the world and comparator countries based on numerous development indicators. Among more than 200 indicators for benchmarking Armenia’s performance in the possible priority policy areas, 130 indicators were selected based on their relevance as assessed by World Bank experts. Each indicator was compared against the median value of the countries in eight different reference groups: (1) World, (2) EU, (3) New EU, (4) ECA without high-income, (5) ECA all, (6) UMIC, (7) regional peers, and (8) OECD countries (see Appendix E and H for details). For each indicator, a measure of distance to the median value within the reference group was computed for every country in the reference group. The countries were then ranked according to the distance to the median value. The ranking helped indicate areas in which Armenia is far from the median and thus areas that require higher priority. Details on the methodology and results are presented in Appendix H. 195. These results were further validated by applying additional filters of urgency and technical feasibility. To provide a realistic sense of what could be achieved, a technical feasibility filter was applied to assess the likelihood that the proposed policy reforms in each area could be implemented in the next few years considering the technical complexity. The urgency of implementing the policies was also considered to assess whether any delay in easing a particular priority area led to adverse consequences that would be costly or difficult to reverse. The level of priority was assessed by the World Bank experts by assigning a criticality rating of “high,” “medium,” or “low.” All priority areas identified by the international benchmarking are associated with an average score of “high” or “medium” in terms of urgency and technical feasibility. 196. In addition, public engagements with diverse stakeholder groups were organized in May 2023 in Yerevan to seek views on Armenia’s development challenges and priorities. Four meetings were held in total, with close to 100 participants. The meetings included representatives from the central government, Parliament, development partners, civil society organizations (CSOs), academia, and national and international firms in the private sector. Appendix G provides a summary of the discussions and opinions expressed by participants in the meetings. 197. The prioritization process identified 11 priority areas, including governance, institutions, and data as the cross- cutting area that affects all priorities. Table 9 shows how the priority areas evolved between SCD1 and SCD2. 77 Table 9. Evolution of Policy Priority Areas SCD1 Priorities SCD2 Priorities Overlapping Priorities 1.Adapt to climate change by building resilience to climate-related shocks i. Strengthen environmental management and adaptation to and natural disasters by scaling up risk prevention systems and updating climate change technologies and infrastructure 2. Reduce pressures on natural capital for improved resilience and mitigation by improving energy efficiency and security and promote the green economy 3. Diversify trade partners and export products and enhance the ii. Leverage exports enablers and multi-connectivity links economic complexity of exports 4. Improve integration for trade by strengthening institutions and continue efforts to facilitate trade 5. Boost public and private investment in physical and digital access to close domestic and international connectivity gaps iii. Ensure on-the-ground market contestability and competition 6. Foster a competitive private sector in the services and manufacturing sectors by developing a coherent strategy to attract investments (domestic, FDI, diaspora) iv. Fill other investment climate gaps v. Strengthen macro management supportive of stability and growth vi. Ensure the education and workforce development system 7. Advance human capital accumulation by improving the quality and provides skills relevant to the market relevance of education, increasing the affordability of health services, vii. Strengthen micro-resilience through access to finance and and allocating resources effectively address the health implications of population aging viii. Support matching of workers to jobs 8. Promote access to and generate good-quality jobs by strengthening ix. Facilitate women’s labor market participation coordination between the education sector and labor market New Priorities in SCD2 9. Increase resilience to fragility and conflict by developing an adaptive social protection system and improving trust in political and social institutions 10. Improve productivity, cultivate climate-smart agriculture, and further develop value chains 11. Cross-Cutting Theme: strengthen governance and institutions by improving government effectiveness, accountability, and inclusiveness of institutions and investing in data for evidence-based policy making Priorities Dropped in SCD2 Strengthen social protection and tackle pensions Enhance prudent macroeconomic management Build an equitable society Address connectivity challenges in the energy sector 198. The new set of priorities in SCD2 reflect a greater emphasis on reforms to improve resilience to fragility and conflict. With growing uncertainties triggered by increased regional tensions, the country stands at a critical juncture for addressing its intrinsic vulnerability to risks from fragility and conflict. In addition to continuing the peace negotiation efforts, it will be important to strengthen the system to improve service delivery and promote inclusion and resilience of the communities affected by conflict to help them cope with diverse types of shocks. 199. Some priority areas were dropped in SCD2 in light of progress made since SCD1. Prudent macroeconomic management, an area in which the government action has proven to be effective, is no longer identified as a policy priority area in SCD2. Together with the improvement in social protection programs, especially through pensions reform, these government efforts probably helped cushion the impacts of the crises in 2020 and 2022. Despite the country’s exposure to the twin shocks in 2020, expanded clashes in 2022 with Azerbaijan, and Russia’s invasion of Ukraine, Armenia maintained macroeconomic stability with improved macroeconomic management, fiscal discipline, a sound financial sector, and support through the social protection system. Despite remaining challenges, due to 78 relatively low inequality and low losses from electrical outages compared to other countries, equitable society and connectivity issues in energy that were identified as priorities in SCD1 have been dropped from the priorities in SCD2. 200. Governance, institutions, and data—treated as a cross-cutting theme in SCD2—have become a more pressing concern since SCD1 and have been identified as a new priority area. Despite some progress made in policy priority areas identified in SCD1, SCD2 confirms that 15 out of 16 policy priority areas are still valid. This indicates a need for stronger governance and institutions that enable the state to commit to and implement the policies for positive development outcomes. SCD1 focused on governance as a prerequisite for ensuring market contestability and competition, but SCD2 treats the challenge as a cross-cutting theme that affects multiple dimensions of policy areas to address the major binding constraints. Recommended policy actions include strengthening institutions by enhancing strategic planning capacity and improving the link between planning and budgeting; improving the capacity of institutions and enhancing inclusiveness in planning at all legislative levels (national, marz, municipality) for better service delivery; and advancing public financial management reforms. Deeper analysis is needed based on a better understanding of the decision-making process and bottlenecks to implementing individual reforms. 201. Given Armenia’s exposure to fragility and conflict, several scenarios could affect the policy priorities. The geopolitical uncertainty in the region may complicate the conflictual relations between Armenia and Azerbaijan in a range of scenarios. Possible medium-term scenarios range from a negotiated peace settlement to volatility and episodic fighting in the border areas to a larger-scale war (World Bank 2022d). Three scenarios are considered: a peace scenario, a protracted volatility scenario, and the extreme case of a large-scale war scenario. The 2020–25 World Bank Fragility Conflict and Violence Strategy provides a guiding framework on how policy priority areas could shift (World Bank 2020i). The peace settlement scenario would involve an opportunity to strengthen resilience and institutions by supporting investments in connectivity and infrastructure, access to livelihoods among displaced populations, inclusion, and recovery and resilience in districts affected by conflict. At a regional level, such a development would better position both Armenia and the South Caucuses to work on joint regional projects to enhance their standing in the region, such as in energy, transport, water, tourism, and environment. The protracted volatility scenario would involve a shift toward preventing grievances and tensions by strengthening processes and institutions that foster resilience. Development gains and the capacity of the private sector would be protected during crises and the transition toward stability. In the large-scale war scenario, policy would shift to addressing humanitarian and emergency situations, working toward peacebuilding, and considering medium- to long-term development challenges arising from displacement. 6.2. High-Level Outcomes 202. High-level outcome (HLO) is a concept associated with a sustained improvement in well-being aimed at facilitating the achievement of the twin goals. HLOs are goals to be achieved in the long run that directly capture the desired improvements in the population’s welfare. 151 Achieving HLOs requires contributions from the public and private sectors, but development in these sectors itself will not be considered as HLOs as they do not directly reflect the well-being of the population. These HLOs provide options to be adopted in the CPF which determines the World Bank’s engagement with the government over the next four to six years. 203. Four HLOs were identified, guided by the expected long-term outcomes from the priority areas, and they are in alignment with Armenia’s own development strategy and the long-term goals specified in the Armenia Transformation Strategy 2050. 152 When all priority areas identified in the SCD2 are addressed, the people in Armenia are expected to achieve the following: (1) better education outcomes to ensure inclusive, sustainable, and resilient growth; (2) better health outcomes by having equal access to quality care; (3) a dynamic and innovative private sector 151 HLOs reflect, for example, progress in the accumulation of human capital including education and health, access to opportunity, improvement in security, enhanced mobility, or improvement in the standard of living. 152 For example, see https://www.primeminister.am/en/press-release/item/2020/09/21/Nikol-Pashinyan-meeting-Sept-21/. Development objectives in Transformation Strategy 2050 include educated citizens, healthy and safe people, effective and accountable government, and green and resilient growth. 79 to create more and better quality jobs; and (4) increased household resilience to shocks. The 11 priority areas identified in SCD2 are mapped to the four HLOs, formulated to capture desired improvements in the population’s well-being (Table 10). HLO1: Better education outcomes Investing in education to create a knowledge-based, innovative economy that prioritizes market-oriented education reform is a focus area in Strategy 2050 and a key development challenge in SCD2. Policies that equip citizens with the knowledge and skills required in the rapidly changing business environment will not only improve productivity and support private sector growth but also enable Armenia to compete in the global economy. Modernizing education would also allow citizens to prepare to work in green jobs, thereby facilitating sustainable and resilient growth. To ensure inclusive growth, it is critical to improve access to quality education for all, including the poor and vulnerable in remote areas. Progress in HLO1 will also contribute to improving the labor outcomes indicated in HLO3. HLO2: Better health outcomes and lower incidence of NCDs The development of the health sector is a main priority in Armenia 2021–26 and Strategy 2050. Better health outcomes are also a critical component of human capital which has been identified as a priority in SCD2. Equitable access to quality health services that are affordable for all is vital to ensuring healthy and productive workers and is also linked to HLO3. HLO3: More and better-quality jobs Armenia is committed to tackling poverty reduction through job creation and raising real wages for the working poor as advocated in Strategy 2050. A dynamic and innovative private sector and improved connective infrastructure, including digital connectivity, are crucial to job creation. A well-functioning labor market, improved education, and better health outcomes through equitable access to services (HLO1 and HLO2) are crucial to enabling access to good jobs. HLO4: Increased household resilience to climate-related shocks and natural disasters As the livelihoods of the poor rely heavily on natural resources and agriculture, improving the management of natural resources to ensure that they are used in a sustainable manner remains critical. As the agriculture sector continues to be an important sector for inclusive growth, improving agricultural productivity and resilience is a priority. This requires investing in the irrigation system; incentivizing the adoption of climate-smart agricultural practices among farmers; including rural economies in agricultural value chains; and developing a disaster risk management system to safeguard and insure people against shocks from climate, weather, and other natural-related disasters. 80 Table 10. High-Level Outcomes # Policy Priority Areas HLOs Better Better health More and Increased education outcomes and better- household outcomes lower quality jobs resilience to incidence of climate-related NCDs shocks and natural disasters 1 Increase resilience to fragility and conflict by developing an x adaptive social protection system and improving trust in political and social institutions 2 Diversify trade partners and export products and enhance the x economic complexity of exports 3 Adapt to climate change by building resilience to climate- x related shocks and natural disasters by scaling up risk prevention systems and updating technologies and infrastructure 4 Reduce pressures on natural capital for improved resilience and x mitigation by improving energy efficiency and security and promote the green economy 5 Boost public and private investment in physical and digital x access to close domestic and international connectivity gaps 6 Improve integration for trade by strengthening institutions and x continue efforts to facilitate trade 7 Advance human capital accumulation by improving the quality x x and relevance of education, increasing the affordability of health services, and allocating resources effectively 8 Promote access to and generate good-quality jobs by x x strengthening coordination between education and the labor market 9 Foster a competitive and innovative private sector in the x services and manufacturing sectors by promoting investments (domestic, FDI, diaspora) and innovation 10 Improve productivity, cultivate climate-smart agriculture, and x x further develop value chains 11 Cross-Cutting Challenge: strengthen governance and x x x x institutions by improving government effectiveness, accountability, and inclusiveness of institutions and investing in data for evidence-based policy making 81 7. 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Selected Actions and Policy Reforms since 2017 This Appendix summarizes key actions and policy reforms implemented since 2017 as per the government’s assessment (that is, the World Bank does not necessarily endorse each of these actions as a reform). The effectiveness of these actions and reforms is not evaluated, given the limited time since implementation and the exceptional circumstances in 2020. Governance  Anticorruption agenda. Anticorruption was a key pillar of the Velvet Revolution, and the government of Armenia has implemented a strong agenda. Along with legislative changes, policy reforms have included the establishment of the Corruption Prevention Commission in 2019 and the adoption of Armenia’s Anticorruption Strategy and Action Plan for 2019–22 (Government Decree N1332-N). In March 2021, the Parliament adopted a law creating a new anticorruption body with stronger investigative and enforcement functions, merging several existing agencies with anticorruption powers. It also adopted legislation establishing a specialist anticorruption court to handle all corruption-related cases. In 2020, the Law on civil forfeiture of illicit assets was adopted, and a relevant department was established in the General Prosecutor’s Office. The CPC’s role includes regulating and controlling the process of gift registration and implementing control over the current financial activities of political parties in cases prescribed by the Constitutional Law 'On Political Parties' and other related regulations outlined in the 'Law on Corruption Prevention Commission' and the 'Law on Public Service.’  Over time, the mandate of CPC was strengthened together with improvement of the the legislative framework for asset declarations, gifts, conflict of interests. A new electronic asset declaration system was developed and launched in February, 2023, allowing pre-filling of data due to interoperability with other state databases. An integrity checking system was established for candidates for judges, investigators, and prosecutors. The beneficial ownership institute was introduced.  E-government. The government has prioritized the digital economy as a key pillar of economic growth and public sector modernization. Among other actions, it adopted the Digitalization Strategy for 2021–25 and established the Ministry of High- Tech Industry in 2019. It has established the e-petition system and the e-request platform. Through these platforms, citizens can file requests and complaints digitally as well as submit various license applications online.  Procurement. To foster spending efficiency, new budget allocation rules have been introduced. These rules are expected to incentivize competitive procurement through the new e-procurement system. Justice and Rule of Law  Judicial reform. The government’s ambitious reform agenda aims to ensure a strong and independent judiciary, as reflected in the adoption of the 2022–26 Judicial and Legal Reform Strategy in 2022 (Government Decree N1133-L). Reforms planned under this strategy include the launch of a network of anticorruption courts, digitization of judicial processes, and introduction of an e-court system. Introduction of an e-criminal case platform for preliminary investigation bodies will play a pivotal role in modernizing this system.  Human rights. The law on the rights of people with disabilities was amended in May 2021. The change aims to end discriminatory practices and improve the assessment of disability. The assessment is transitioning to a method based on the extent of limited functionality and personal needs, rather than the degree of disability only. New Criminal Codes and Criminal Procedure Codes were adopted in 2021, with the aim of bringing criminal procedures in line with international standards.  Money laundering. In June 2021, a centralized registry of bank accounts of individuals was created to align with global standards for combating money laundering and terrorism financing. This registry meets one of the obligations in the EU-Armenia Partnership Agreement.  Police reform. The Police Reforms Strategy and Action Plan for 2020–2022 (Government Decree N638-L) was adopted in April 2020 and implemented. In line with the strategy, the Ministry of Internal Affairs was established in December 2022 and has been fully operational since January 2023. The Ministry is responsible for policy development and implementation in the following areas: police, rescue, migration and citizenship service. One of the key reforms was the establishment of the Patrol Police in all marzes of Armenia (from 2020-23) as a new, modern external police service. The Water Patrol Police will be launched by end-2023, and the establishment of a Police Guard, and redesign of the Criminal Policy are planned. 88 Business Environment  Investment. The Investment Support Office at the Ministry of Economy was created in 2019 to promote domestic and foreign investments. The office is a one-stop shop for investors, providing information on investment opportunities and the business environment and supporting investors in accessing public services and communicating with the authorities.  State-owned enterprises. In January 2020, stricter mandatory criteria were introduced for the audit and publication of financial reports of state-owned enterprises.  Customs. The government has introduced digital solutions for exporters, who can submit all relevant documents via a single online portal and receive certificates of origin within one working day (one-stop shop portal). The system has cut the border crossing customs clearance time from 20–70 hours to 2–3 hours on average, and in 2022, over 2,300 preliminary declarations were registered (ARMENPTRESS, February 14, 2023).  Insolvency and bankruptcy framework. The Supreme Judicial Council approved the composition of a new specialized Insolvency Court and selected 12 acting bankruptcy judges, effective in August 2018. The Law on Bankruptcy was amended on December 26, 2019 and introduced major changes and improvements to the regulatory system for insolvency practitioners.  Technology start-ups. The government has granted tax privileges to start-ups in the technology sector and amended the Law on State Support for the Information Technologies Sector (effective May 2019). This amendment includes a 0 percent profit tax and 10 percent income tax on eligible technology start-ups with 30 or fewer employees. The vision behind these measures is to draw the Armenian diaspora back to the country.  Capital markets. In July 2020, a new capital market development program was adopted with the objective of helping to utilize domestic savings more effectively, increase transparency in the corporate sector, and enhance monetary transmission. Fiscal Policy and Revenue Mobilization  Fiscal rule. In January 2018, a new fiscal rule was introduced. The rule aims to curb current spending, while allowing more flexibility for investment projects based on public debt thresholds. When the government debt-to-GDP ratio exceeds 40 percent, the government will be allowed to run a fiscal deficit exclusively to finance capital expenditures. In those cases where the ratio rises above 50 percent, the government will also be required to cap current spending and develop a medium-term plan to lower the debt burden. When government debt surpasses 60 percent of GDP, the government will be obliged to link current expenditures to tax revenues and submit a remedial action plan to Parliament. Escape clauses were introduced for extreme cases such as natural disasters, armed conflicts, and economic shocks.  Personal income tax regime. The income tax rate was previously structured into three progressive brackets at 24.4 percent, 26.0 percent, and 36.0 percent. A major reform introduced a flat tax rate of 23 percent beginning in January 2020. The rate is to be reduced by 1 percentage point annually until it reaches 20 percent in 2023.  Tax administration. The Ministry of Finance implemented the automatic value added tax refund system. The budget execution of the government and tax collection have improved in recent years. Armenia has maintained a trend of increasing tax revenues, despite declines during periods of crisis. In 2019, the tax-to-GDP ratio stood at 22.5 percent. Armenia has also had significant changes in its tax structure. The contribution of income and trade taxes to total taxes has increased since 2010.  Pensions. All workers are now under a mandatory funded pension system. The new system has been in place for private sector workers since July 2018, after becoming compulsory for public sector employees in 2014. Retirement savings are administered by an asset management provider and are invested into local and foreign financial assets (see Appendix G). Labor and Social Protection System  Employment and minimum wage. An employment strategy (“Work, Armenia”) was adopted in December 2019. It proposes a set of active labor market policies to address labor market shortcomings and create sustainable and inclusive employment. In January 2020, the government approved a 23 percent increase in the minimum wage.  Social assistance. A unified system of integrated social services was created to rationalize the delivery of social assistance and employment services.  Paternity leave. Armenia approved paid paternity leave in 2021. The approved paid leave for working fathers is five days. 89 Energy  Electricity market liberalization. Armenia launched a five-year process for the liberalization of the electricity market in 2022, supported by legal amendments to the Energy Code, Transmission and Distribution Network Codes, and Rules and Regulations by Market Regulator. The first phase kicked off in February 2022 by (1) enabling some power plants to avoid selling electricity at prices set by the Public Services Regulatory Commission and to sell at prices determined according to market supply and demand and (2) shifting from monthly to hourly trading of electricity. The Yerevan Thermal Power Center provides the balancing service settled by the Universal Supplier. The electricity market in the transition stage proves that supply is more than adequate to meet the load. The market already has ten wholesale electricity traders and ten retailed suppliers (four of them are the same companies holding both licenses).  Renewable energy. The Energy Sector Development Strategy till 2040 and its Action Plan were adopted in 2021. The National Program on Energy Saving and Renewable Energy for 2022–2030 was adopted in 2022 and aims to increase the share of electricity generation from solar to at least 15 percent (from less than 3 percent in 2020) and to reduce total final energy consumption by 20 percent by 2030. Result targets are mainly expected to be reached by end-2023 and 2024. Several actions have commenced, including studies for wind energy and battery storage potential, agreements for energy efficiency, energy- saving improvements in public facilities, and heating studies to find sustainable ways to replace fossil fuel energy. With the amendments made to the Energy Sector Development Strategy and Action Plan to 2040, the construction of solar power plants with a capacity of 1,500 MW, connected to storage stations upon necessity is envisaged along with wind power stations with a total capacity of 500 MW for the period 2030-2040. Climate and Environment  Climate change. Actions include the April 2021 update of the Nationally Determined Contribution, set under the United Nations Framework Convention on Climate Change (Governmental Decree No. 610-L). Armenia’s updated contribution is aligned with a 2030 mitigation target of a 40 percent reduction in greenhouse gas emissions (relative to the level in 1990). Pretax subsidies on fossil fuels as a percentage of GDP were cut. The National Action Program of Adaptation to Climate Change and the List of Measures for 2021–2025 were approved in May 2021. Amendments to the Water Code, Forest Code, and Law on Atmospheric Air Protection were also adopted. The Hydrometeorological Agency moved to the Ministry of Environment and merged with the Environmental Monitoring Agency, increasing the capacity of the joint agency. Some Aichi biodiversity targets were achieved (Armenia’s 6th National Report to the Convention of Biological Diversity). 90 Appendix B. Government 2021–26 Program (Armenia 2021–26) Table A.1. Pillars and Goals Captured in Armenia 2021–26 Main Goals Economy Pillar • GDP: reach a minimum average annual growth rate of 7 percent (and in case of favorable external economic conditions, 9 percent) • Unemployment: reach a level of unemployment lower than 10 percent • Incomes: target fund for salaries in the non-governmental sector of the formal employment equal to 25 percent of GDP • Productivity: achieve at least 5 percent annual growth of gross factorial productivity • Investment: attain investment as a share of GDP higher than 25 percent, with FDI to GDP being higher than 6 percent • SMEs: reach 55 percent in the share of SME participation in GDP over five years • Infrastructure support: provide at least AMD 50 billion over five years • Manufacturing industry: provide support of at least AMD 80 billion over the coming five years and establish three industrial zones, increase participation to at least 15 percent of GDP, increase economic complexity from -0.39 to 0.1 points over the medium term, and create grounds for being classified among countries with high economic complexity over 10 years • High technologies: reach a level of employment of 35,000 people (16,000 new jobs) and a level of turnover of AMD 500 billion (6–7 percent of GDP) • Military: promote the development of a military-industrial complex • Digitalization and telecommunication: provide municipal and rural settlements with at least 80 percent broadband (optic fiber), provide round-the-clock control over radio airtime in the whole territory of the Republic of Armenia, and ensure up to 100 percent clean airtime • Agriculture: implement several measures to intensify agriculture, increase productivity, target use of land resources, ensure the effective and economical use of water resources, and so on • Tourism: increase the number of international visitors to 2.5 million by the year 2026 and have flights to at least 25 new destinations by 2025 • Green economy: minimize the role of natural gas in the structure of electricity production by replacing it with sources of renewable and alternative electric energy, prepare the electric power transmission infrastructure for change in terms of growth of demand and structure, prepare the transition of infrastructure to facilitate alternative transportation and to help the population obtain electric systems for food preparation and heating Infrastructure Development Pillar • Transport: (1) automobiles: introduce a unified railway network, ticket system, interactive map, electronic systems, and so on; (2) air: raise the level of flight and aviation safety and increase the effectiveness of civil aviation management; (3) railways: obtain a new passenger and freight rolling stock and raise the level of traffic; (4) water: adopt a new law on commercial navigation • Road construction: renovate nearly 500 kilometers of roads annually, implement the North-South Road Corridor Investment Program (reconstruction of Tranche 2 and Tranche 3), launch activities for construction of the new 60- kilometer Sisian-Kajaran road, plan and launch monetary implementation of the 175-kilometer Artashat-Sisian section of the North-South Road Corridor, reconstruct 52 kilometers of M-6 • Water economy: renovate capital of certain accident-prone sections of the Arpa-Sevan tunnel; make inventory and assessment of irrigation systems; save 7.3 million kWh electricity every year and increase irrigated lands by 1,373 hectares; carry out ten primary antiflood action plans; and work for urgent restoration of the sections of water supply and water disposal systems in 11 cities and 41 rural settlements in 6 marzes and restoration of distribution networks by 2023 • Energy: gradually liberalize the electricity market; build solar power stations, including automatic solar power stations with a capacity of up to 1,000 MW to make the share of production of solar power reach at least 15 percent by the year 2030; carry out preparatory works to build wind power stations with a capacity of nearly 500 MW; complete modernization to ensure safe operation of the Armenian Nuclear Power Plant by 2036; raise the electricity system to a fully new level through modernization and expansion of the high-voltage transmission network; launch the Armenia-Iran and Armenia- Georgia 400 kW power transmission lines and rehabilitate the old substation; finalize activities related to the four-party (Armenia-Iran-Georgia-Russia) North-South Power Transmission Corridor initiative; gradually implement the EU energy- related directives on energy policy, energy security, diversity of energy sources, diversification of transmission path, 91 competitive electricity markets, use of renewable energy sources, promotion of energy efficiency and energy saving, regional energy cooperation, technological and scientific-technical cooperation, and so on; improve SOE governance and match the ISO basic certificates for all SOEs in the energy sector; promote sustainable heating policy to reduce natural gas and firewood consumption Law and Justice Pillar • Implement the judicial-legal reforms agenda, ease the workload of courts, and reduce the time limits for examining cases in courts; modernize procedural law; and reform the police by introducing patrol service in the whole territory of the Republic of Armenia by the end of 2023 and by comprehensively reviewing the remuneration of police officers Institutional Development Pillar • Public administration reform: introduce policy on unified data, a unified electronic platform, and a modern model of unified offices system of decent remuneration in the state service system; modernize the system of performance evaluation; review the existing system of education, training, and retraining of state servants; create a unified national spatial data infrastructure and a database of sector-specific cadasters; launch a national geoportal • Fiscal policy: foster stability of public finance; ensure larger financing of the deficit of the State Budget at the expense of loans in the dram to minimize the sensitivity of debt with regard to currency fluctuations; improve the tax-to-GDP ratio by at least 2.6 percentage points, making it reach at least 25 percent in 2026; and reduce the debt-to-GDP ratio, reaching a target of less than 60 percent • Tax and customs administration: gradually lift the value added tax on imported goods, review the tax regulations in the capital market, expand international cooperation in the Tax and Customs sectors, apply regulations for pricing of transfers and the systems of information exchange for taxation, simplify customs administration and introduce the one-stop shop system, and establish a bank for the Public Investment Program Development of Human Capital Pillar • Demography: ensure a sustainable increase in births in the upcoming years, expand beneficiaries receiving benefits for care of a child under age 2, and grant monthly financial assistance of AMD 50,000 to families for the third child and subsequent children under age 6. • Education: build and renovate at least 300 schools by 2026; create modern natural science and engineering laboratories in all 1,400 schools; change and introduce new textbooks and educational materials; introduce a differentiated policy on the professional development of teachers; create effective, open management and financing systems; enhance electronic learning tools; build and renovate at least 500 kindergartens and preschool institutions by the year 2026; increase the percentage of children ages 3-5 enrolled in preschool institutions to at least 85 percent by 2026; introduce and expand dual training based on employment in at least two educational institutions on an annual basis; improve the building conditions of educational institutions and ensure training and production bases (laboratories) in at least two institutions a year; and introduce Master's degree programs for professions following new demands in the labor market • Science: develop infrastructures that are favorable for competitive scientific activities; enhance qualifications of workers in the field of science and engage young specialists (implement grant programs to support PhD students, postdoctoral research, vocational training, and qualification of employees); increase the efficiency of state financing in the field of science; and reform legislation regulating the field of science • Health care: ensure the availability and affordability of health care services for citizens, reduce the ratio of private expenditures to general health care expenditures by 40 percent, introduce an integrated electronic health care system, and upgrade 50 health care institutions • Labor and social protection: equalize the minimum pension amount and average pension amount to the costs of the food and consumer baskets and set AMD 85,000 as the amount of minimum salary Source: Government of Armenia 2021a. Note: The pillar on security and foreign policy is not included. 92 Appendix C. Findings of SCD1 SCD1 identified four challenges facing Armenia in boosting equitable growth and shared prosperity as of 2017: • External sector performance: Armenia imposed high trade and transport costs on economic activity, and the country suffered from limited global connectivity infrastructure (hard and soft). • Private sector productivity: Insufficient productivity was linked to three factors: unfinished investment climate reforms, low degree of competition, and low level of financial development and access to finance. • Labor productivity: Challenges included shrinking labor resources, low labor market participation (particularly among women), low employment, high unemployment, falling worker productivity, and learning outcomes that lagged demand (by level and type of skills). • Resilience and sustainability: Armenia faced vulnerabilities at the macro, environmental, and micro levels, including an aging population which had implications for fiscal sustainability (through health spending and the pension system) and for poverty. Managing natural assets and adapting to climate change had implications for the long-term macroeconomic sustainability of resource-dependent sectors and society as a whole. The priorities identified for SCD1 included expanding labor markets, enhancing private sector development, and raising labor productivity to create jobs, rebalance growth drivers, transform structurally, and support inclusive spatial development. The challenges and priorities identified in SCD1 are summarized in Figure C.1.. Figure C.1. Challenges and Priorities Identified in SCD1 Source: World Bank 2017a. 93 Appendix D. Characteristics of the Poor Certain individual and household characteristics are associated with higher probability of poverty. Larger households, female-headed households with children, and those without tertiary educational attainment tend to be poor (Table D.1). In addition, the poor tend to live in poor housing conditions with dilapidated walls and floors, broken frames and doors, insufficient living space, as well as poor heating, dampness, leaking roofs, poor lighting, and lack of green zones (Armstat 2022b). A large urban-rural divide can be seen in access to a centralized sewerage system, 24-hour access to drinkable water, and access to centralized garbage disposal services, such as a garbage collection system and disposal by truck. For example, more than 10 percent of households in rural areas rely on burning garbage for disposal compared to 0.1 percent of households relying on the same practice in urban areas (Armstat 2022b). A huge gap also exists in heating sources, with a significantly larger share of rural households relying on wood and less using electricity and natural gas. Table D.1. Profile of the Poor and Rural Households Poor Non-poor Average household size* 5.2 4.1 Tertiary education attainment (complete or incomplete)** 38% 54% Female-headed household with Male-headed children under age 6 household Poverty rate 39.1% 27.4% Rural Urban Centralized sewerage system 47.5% 99.2% 24-hour access to drinkable water 70.6% 91.6% Centralized garbage disposal services 89.5% 99.8% Heating sources - wood 61.4% 6.2% - electricity 5.0% 36.8% - natural gas 40.5% 74.0% Sources: ILCS 2021; ArmStat 2022b. Note: * Population weighted and calculated by the World Bank. ** Estimates among individuals 15 years and older. Other estimates are taken from ArmStat 2022a. In rural areas, poverty reduction achieved through redistribution during 2016-21 was offset by the negative impact of growth on poverty reduction, leading to an increase in poverty (Figure D.1). Poverty reduction in 2016–21 was driven by redistribution (or improvement in inequality), and growth (or increase in mean consumption) did not contribute to poverty reduction (unlike during 2010–16). This applies in all areas: Yerevan, other urban, and rural areas. Although all areas contributed to the reduction in the national poverty rate in 2010–16, the slowdown in poverty reduction in 2016–21 was due to the slowdown in poverty reduction in other urban areas and the poverty increase in rural areas. Rural poverty rates in border regions such as Shirak, Gegharkunik, Tavush, Vayots Dzor, Armavir, and Ararat are higher than the national poverty rate of 26.5 percent in 2021 (Figure D.2). Urban poverty is also high—even higher than rural areas in Gegharkunik, followed by Armavir, Tavush, and Shirak. Analysis is needed to understand the sources of anti- poor growth in these border regions. 94 Figure D.1. Growth and Redistribution Figure D.2. Poverty Rates, by Region and Location (%) Source: World Bank staff calculations based on ILCS 2010, 2016, and Source: World Bank staff calculations based on ILCS 2021. 2021. 95 Appendix E. Selection of Peer Countries Armenia’s performance was benchmarked relative to peer countries, including structural, regional, and aspirational peers. The identification of peers was conducted using the CEM 2.0 Data Generator tool developed by the Macroeconomics, Trade, and Investment Team at the World Bank. The group of structural peers comprises six countries that are considered most similar to Armenia in terms of structural economic indicators, such as GDP per capita, human capital, age dependency ratio, inflows of FDI, value added of the services sector, and international tourism. Using the same tool, the aspirational peers were selected from a shortlist using GDP per capita, poverty headcount, and Gini index as aspirational variables. The final selection was made during an internal consultation with the country team and Country Management Unit. Structural peers. The structural peer group consisted of several countries considered similar to Armenia in terms of selected indicators. The similarity was measured by distance—that is, how close the country was to all other countries based on each country’s relative global ranking on a selected indicator. The period considered for the values of the indicators was 2017–19. Six indicators were used to identify regional and global structural peers: • GDP per capita, PPP (constant 2011 international US dollars) • Age dependency ratio (percent of the working population) • Services, value added (percent) • FDI, net inflows (percent of GDP) • Human capital index • International tourism, receipts (percent of total exports) Ex post checks verified two variables absent from the tool: landlocked and remittances inflows (percent of GDP). Regional peers: Most of the structural peers happened to be countries in the region. Georgia is the only country in the region with distinct structural features. Therefore, the neighboring country was added to the list. Aspirational peers. After selecting the structural indicators, the tool allowed for the selection of aspirational peers based on one outcome variable of interest (and not the intersection of more than one as was done with the structural peers). Four indicators benchmarked the aspirations of Armenia to improve its performance: • GDP per capita, PPP (constant 2011 international US dollars) • GDP per capita (constant 2010 US dollars) • Poverty headcount ratio at US$1.90 a day PPP (constant 2011 international US dollars) • Gini index (World Bank estimate) The countries that appeared consistently in these four rankings were: Indonesia, Thailand, and Tunisia. Anecdotal evidence suggests that the Baltic countries represent an aspiration in the region. Specifically, Armenia observes Estonia with considerable attention. The final list of peer countries was Albania, Bosnia and Herzegovina, Estonia, Georgia, Kosovo, Moldova, and Tunisia. Figure E.2 presents features shared by the selected set of countries, based on the six indicators from the CEM tool (to identify structural peers), in addition to information on governance and remittances. Figure E.3 presents the outcome variables of interest (such as GDP, poverty, and inequality) that were used to assess potential aspirational peers. 96 Figure E.2. Select Indicators, Structural Peer Countries Age dependency ratio Services, value added Foreign direct investment, net flows Human Capital Index Remittances Rule of law Government effectiveness Control of corruption Voice and accountability Figure E.3. Selected Indicators, Aspirational Peer Countries GDP per capita Poverty headcount ratio at US$5.50 (2011 PPP) Inequality 97 Appendix F. Main Sources of Information and Empirical Data Table H1. Data Sources Source Indicators / Themes World Development Indicatorsa Indicators on macroeconomics; employment and labor markets Basic macroeconomic and price indicators; national accounts; statistics from ArmStatBank (ArmStat)b household surveys, firm-level microdata, and so on Integrated Living Conditions Survey Poverty; household welfare and consumption; dwelling and living conditions; (ILCS) household income sources Labor Force Survey Labor force and employment indicators Time Use and Gender Survey Time use; gender roles and preferences; intrahousehold dynamics Impacts of COVID-19, inflation, food insecurity, and other shocks on employment and Armenia High-Frequency Surveys household welfare Official poverty and inequality estimates; trends in social protection and social Social Snapshot of Armenia assistance; living conditions; demographic trends Labor Markets in Armenia Labor force and employment indicators; NEETs Statistical Yearbook (ArmStat 2022b) Demographic trends; agglomeration Findex database Financial inclusion indicators Obstacles to doing business; access to productive inputs; access to adequate human Enterprise Surveysc capital; impacts of COVID-19 on firms; and so on Poverty and Inequality Platformd Poverty and inequality estimates World Bank Gender Data Portale Gender statistics Budget and expenditure data; public spending on social protection, social assistance, Ministry of Finance and human development Ministry of Energy infrastructures National statistics and administrative data on mining and energy sectors and Natural Resources Macro Poverty Outlook Macroeconomic trends and projections; international poverty projections Harvard Growth Lab Economic complexity index International Monetary Fund Fiscal policies; debt sustainability; financial and macroeconomic indicators PWT10 Total factor productivity and labor share data a. World Development Indicators (dashboard), World Bank, https://datatopics.worldbank.org/world-development-indicators/. b. See ArmStatBank (statistical tables), Statistical Committee of Armenia, https://statbank.armstat.am/pxweb/en/ArmStatBank/?rxid=9ba7b0d1-2ff8-40fa-a309-fae01ea885bb. c. Enterprise Surveys (dashboard), World Bank, https://www.enterprisesurveys.org/en/enterprisesurveys. d. Poverty and Inequality Platform (dashboard), World Bank, https://pip.worldbank.org/home. e. Gender Data Portal (dashboard), World Bank, https://genderdata.worldbank.org/. 98 Appendix G. Findings and Results from the Stakeholder Consultations The World Bank SCD team conducted two external stakeholder consultations for the preparation of SCD2. The first was an identification mission to Yerevan, Armenia during June 6–10, 2022. The mission’s main objective was to hold in-country stakeholder consultations on the preliminary hypotheses of the upcoming SCD. The mission met with relevant government counterparts, representatives of the private sector, experts in private interdisciplinary research groups, academia, civil society, and development partners. The team is grateful for the comments received and support provided from the participants at the consultation meetings. The team requested feedback on two main questions: (1) “Are the identified challenges in line with perceived constraints to development in Armenia?” and (2) “Are there additional areas that are not considered?”. Participants stressed the need for a deeper understanding of (1) drivers of low productivity in agriculture; (2) constraints on private sector growth, including access to low-cost financing; (3) human capital constraints, including inadequate skills in the labor force and mismatches between the labor force and industry needs; (4) government effectiveness; (5) social norms and other drivers of low economic participation by women; (6) the need for greater connectivity and market diversification; (7) demographic challenges and outmigration; (8) exposure to climate risks; (9) regional disparities and lack of opportunities outside Yerevan and other large cities; and (10) risks and opportunities given the situation in Ukraine and the influx of foreigners to Armenia. These results were reflected in the draft to the extent possible. The second external stakeholder consultation took place May 10–12, 2023 in Yerevan. Views were sought on the narrative of the SCD2, key development challenges, and policy priority areas that the team had identified. Four meetings were held in total with close to 100 stakeholders from (1) civil society organizations, think tanks, and academic institutions; (2) private sector; (3) international organizations and development partners; and (4) government and government bodies. All meetings were held in hybrid mode with translation, and most stakeholders participated in person. Each meeting was allocated 1.5 hours of presentation from the SCD team and the discussions that followed. Polls were taken twice during the meetings to keep the consultations interactive. Questions asked in each poll were the following: (1) First Poll: “What are the top five most important policy priority areas in Armenia today?” The participants were asked to choose the top 5 priorities among the 15 possible areas provided by the SCD team. The first poll was held before the SCD presentation. (2) Second Poll: Two questions were asked in the second poll. (Q.2.1) “What are the top five most important policy priority areas in Armenia today, after hearing the presentation today?” (Q2.2) “Is there an important policy priority the SCD is missing? What is it?” Figure G.1 summarizes the results from polls 1 and 2, aggregated across all the meetings. A clear list of priorities emerged from the consultations with little variation across the different stakeholders. 99 Figure G.1. Results from the Polls Source: Results obtained from the polls during the consultation meetings. Note: A technical glitch prevented the first question from poll 2 in the meeting with CSOs. In the aggregated responses for poll 2 above, this includes the CSO meeting poll 1 results to capture the preferences of this group. The sample size was 94 for poll 1 and 77 for poll 2 (assuming that the responses from the CSOs did not change after the presentation). Results from the Polls The results show that the ranking of priority areas was similar across the two polls, but the emphasis shifted substantially toward specific areas. Specifically, greater preeminence was given to fragility and conflict, human capital accumulation, governance and institutions and data needs, diversification, and trade integration in poll 2 after the presentation. These are all consistent with the priority areas identified in SCD2. In all meetings except for the one with the private sector, increasing resilience to fragility and conflict was the most important policy area both in the first and second polls. 153 Interestingly, the private sector was the only group that ranked human capital consistently as the most important policy priority in the two polls (73 percent and 82 percent, respectively), ahead of fragility and conflict (ranked 2nd in both polls). 154 This result resonates with the priority identified in the SCD2: that investing in human capital, especially in skills and knowledge that are relevant for the changing demand in the labor market, is critical to further develop the private sector and increase the productivity of firms and labor. 153 The second poll in the meeting with the CSOs which was done orally due to technical issue confirmed that the results did not change between the two polls. 154 In the second poll for the private sector, fragility and conflict and “strengthening governance and institutions and investing in data” were both in second place. 100 The majority also supported the importance of strengthening governance and institutions and investing in data (ranked 2nd in poll 2 across all meetings). Some participants also stressed the low capacity of local government, low public participation, and civic education. This priority area is discussed in the SCD2 as one of the critical factors for effective service delivery. The only gap between the results from the polls and the 11 priorities identified in the SCD2 is that more emphasis was given to building equitable society (ranked 9th in poll 2, but dropped from the priority list in SCD2) and less emphasis was given to the migration of GHG emissions (ranked 14th in the poll, but identified as a priority in SCD2). The greater emphasis on building equality seemed to stem from perceptions that differ from the reality in Armenia. In Armenia, the level of inequality is relatively low compared to other peer countries. The issue was not presented in the meetings, but the team clarified the trend during the discussion that followed poll 2. The low ranking of mitigation of GHG emissions provided useful insights to the team in reframing the main challenge related to the risks from climate change. After the consultation, instead of highlighting the need to reduce GHG emissions, the team emphasized the need to reduce pressures on natural capital to improve resilience to climate- related shocks in the diagnostic. Featured Topics in the Discussions A few topics were raised several times during the consultations, including the diaspora. The consultations highlighted the importance of the diaspora, not only as a source of income but also as a source of knowledge and innovations. The team agrees that leveraging the connection to diasporas provides vast opportunities for Armenia, as discussed in the report. Among the many existing challenges, the high international poverty rate compared to other countries with equivalent levels of income per capita was brought up and discussed as a pressing issue in multiple sessions. The team emphasized that despite low rates of extreme poverty, poverty reduction remains an important national goal. The team clarified that the objective of the SCD is to address the bottlenecks to achieve further poverty reduction. Related to poverty, some participants highlighted the importance of discussing multidimensional poverty and related food insecurity issues in the report. Reference to vulnerable groups such as women and children and discussion on gender gaps were also suggested to ensure inclusive growth. Although these topics were not highlighted during the presentation, the team recognizes their importance, and the topics (including non-monetary aspects of poverty, vulnerable people, and gender gaps) are discussed in SCD2. Concerns were expressed over the data used for the analysis, the need to acknowledge the most recent progress made in Armenia, and the lack of forward-looking nature in the analysis. Given that the SCD is an evidence-based report based on the latest data available, the team emphasized that the objective of the SCD is to identify priority areas based on a diagnostic of the past, and it stressed the need for data to enable empirically rigorous analysis. The team also explained that there are other corporate products to present the forward-looking analysis, such as the upcoming County Economic Memorandum. The importance of security issues was emphasized in the open-ended responses. Topics related to social norms as well as the need to strengthen the social contract and foster a dynamic relationship between the community and government were discussed. Related to government effectiveness, the community consolidation process and decentralization agenda were highlighted as important areas in which government effectiveness could be improved at the central and local levels. Digitalization of government services such as for taxes was discussed as an example of ongoing reform that could support government effectiveness. As for private sector challenges, the consultations revealed that lack of financial literacy is a bottleneck for the use of finance for establishing and building a business. The discussion also highlighted the challenges to greening businesses and the need to plan for a green growth model. The need to develop capital markets was also featured in the open- 101 ended poll answers. The strong appreciation of the dram in 2022 was highlighted as hurting competitiveness, especially for the agricultural sector. Four sets of written comments were also received as a follow-up to the discussion during the consultations. Many expressed their support and endorsed the overall storyline and priority areas presented. Some additional information provided included the need to consider political settlement and the power structure of the country; construction sites and traffic as additional causes of environmental risks; and the sectors in which the diaspora communities have advantages in Armenia’s development process. The information received was referred to in SCD2 where relevant and useful in supporting the storyline. The feedback was helpful in strengthening the narrative and validating the prioritization results which have been incorporated into the SCD. This included the suggestion for the team to further elaborate on the changing nature of the persistent challenges and priorities discussed in SCD1 and SCD2. Although many topics discussed in SCD1 are indeed still valid in SCD2, the team recognizes the shifts in focus due to recent events, and this was reflected in SCD2. 102 Appendix H. International Benchmarking for Prioritization The prioritization followed a two-step procedure: STEP 1: The first step was the international benchmarking exercise. The team collected a wide range of indicators to assess Armenia’s performance in each possible policy priority area. Around 180 indicators were used across 17 possible policy priority areas. Each indicator was compared against the median value of the countries in eight different reference groups: (1) World, (2) EU, (3) New EU, (4) ECA (without high income), (5) ECA All, (6) UMIC, (7) regional peers, and (8) OECD countries. Countries included in different groups are listed at the end of this section. The determination of priority level (color coded as green for low, yellow for medium, and red for high) was conducted as follows: 1. For each indicator, the magnitude of the difference between Armenia and the median value of the reference − group was normalized using the formula = 100 × , where is the value of Armenia for indicator and is the median value of indicator across countries in the reference group . This was done for all the countries in the reference groups. 2. Indicators were re-ranked so that the lower the value of the normalized gap, the more the country was underachieving with respect to the median of the reference group. 3. Thresholds were set to define the level of priority by taking the 33rd and 66th percentiles of the distribution of the normalized gap for each reference group. If the indicator for Armenia was below the 33rd percentile, the indicator was given a high priority. Level of Priority Normalized Gap ( ) 1 ≤ 33 High 33 < ≤ 66 2 Medium > 66 3 Low 4. The set of rules to identify priorities from the international benchmarking were: Rule 1: If any indicator was dominated by a “high” level of priority (that is, red cells), then the policy area was identified as a "high" priority in this first step of the prioritization. Rule 2: If there was no indicator with high priority (that is, no red cells), then the result was determined by the dominant level of priority within the possible policy priority area. The results from the international benchmarking exercise are shown in Table H.1. STEP 2: The urgency and feasibility filters were used to validate the results from the international benchmarking. The level of priority of each policy area was assessed by the World Bank experts by assigning a rating of “high,” “medium,” or “low.” All policy priority areas were confirmed to have an average ranking between medium and high. 103 • Urgency filter: This filter assessed the urgency to act given the complex geopolitical situation faced by Armenia and the country’s vulnerabilities to shocks (fragility, conflict, and violence (FCV); economic shocks; and environmental risks). • Feasibility filter: This filter assessed the likelihood that the proposed policy actions could be implemented in the next 4–6 years, taking into account the technical feasibility of the government’s implementation of the reform. Countries included in the reference groups: 1. Regional peers (7 countries): Albania, Bosnia and Herzegovina, Estonia, Georgia, Moldova, Tunisia, Kosovo. 2. EU (27 countries): Austria, Belgium, Bulgaria, Croatia, Cyprus, the Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Lithuania, Luxembourg, Malta, the Netherlands, Poland, Portugal, Romania, Slovakia, Slovenia, Spain, Sweden. 3. New EU (countries that joined the EU after 2003): Bulgaria, Croatia, Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Romania, Slovakia, Slovenia. 4. ECA (18 countries): Albania, Armenia, Azerbaijan, Bulgaria, Bosnia and Herzegovina, Georgia, Kazakhstan, Kyrgyz Republic, Moldova, North Macedonia, Montenegro, Serbia, Tajikistan, Turkmenistan, Türkiye, Ukraine, Uzbekistan, Kosovo. Table H.1. Indicator-Level Results of Benchmarking Binding Constraint 1.1: Risks of fragility, conflict, and violence Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level Military expenditure per capita (constant 2019 US$) (If high, then low priority) low medium medium low low low low medium Refugee population (If high, then high priority) high high high high high high high high Political stability and absence of violence/terrorism: estimate high high high low low low low high 1.1.1 Increase resilience to Government effectiveness: estimate low high high low low low low high fragility and conflict by Control of corruption: estimate high high high high high high high high developing adaptive social Regulatory quality: estimate high high high high medium high low high High protection system and improving Rule of law: estimate medium high high high low high high high trust in political and social Voice and accountability: estimate high high high high medium high low high institutions WGI government efficacy, index (-2.5 to 2.5) low high high low high low low high Rule of law: estimate medium high high high low high high high Voice and accountability: estimate high high high high medium high low high 2018 Corruption perception index (0-100, 0 = country perceived as highly corrupt) (Transparency International) medium medium medium medium medium medium medium medium 104 Binding Constraint 1.2: Vulnerability to economic shocks Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level Economic complexity high low low high high high high high 1.2.1 Diversify trade partners and Global merchandise exports as a share of GDP (Fouquin and export products, and enhance Hugot; CEPII 2016; National data) high medium high high high high high medium High economic complexity of exports Market concentration index (Hirschman-Herfindahl index of exports value destination) high high high high high high high high Taxes on goods and services incl. sales taxes, VAT, and excise duties (% of GDP) medium medium medium medium medium low medium low Taxes on incomes, profits, and capital gains (% of GDP) low medium low low low low low medium Total tax revenue from social contributions, direct and indirect taxes (% of GDP) medium medium medium medium medium medium medium medium 1.2.2 Enhance prudent Current account balance (% of GDP) low high low medium medium low high high Medium macroeconomic management GDP per capita growth (annual %) low low medium high medium low high low GDP per capita, PPP (constant 2017 international $) medium medium high medium high medium medium high Inflation, consumer prices (annual %) high high high high high high high high Total reserves (% of total external debt) high high high high high high high medium Central government debt, total (% of GDP) medium low medium high medium high high low Tax revenue (% of GDP) low low low low low low low low Discriminatory norms toward women*** medium high high medium high high high high Gender pay gap as difference in monthly earnings high high high high high medium high high Labor force participation rate, female (% of female population ages 15+) (modeled ILO estimate) medium medium medium medium medium medium medium medium Labor force participation rate, male (% of male population ages 15+) (modeled ILO estimate) medium medium medium medium medium medium medium medium Labor force, female (% of total labor force) medium low low medium low medium medium medium 1.2.3 Build an equitable society Male to female ratio at birth medium medium medium medium medium medium medium medium by providing equal access to services and opportunities and Proportion of seats held by women in national Parliaments (%) medium medium medium medium medium medium medium medium Medium develop adaptive and efficient Women's Parliamentary representation medium medium medium medium medium medium medium medium social protection system Account ownership at a financial institution or with a mobile money service provider, female (% of population ages 15+) high medium medium high high high medium medium Account ownership at a financial institution or with a mobile money service provider (% of population ages 15+) medium medium medium medium medium high medium medium Social contributions (% of revenue) (If low, then high priority) high high high high high high high high Social assistance adequacy low . . low low low medium low Social assistance coverage medium . . medium medium high high low Social insurance adequacy medium . . medium medium medium high medium 105 Binding Constraint 1.3: Vulnerability to environmental risks and natural hazards Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level People using at least basic drinking water services, rural (% of rural population) medium low low medium low medium low low People using at least basic drinking water services, urban (% of urban population) medium low medium medium medium medium medium low People using at least basic sanitation services, rural (% of rural population) medium medium medium medium medium medium medium medium People using safely managed drinking water services (% of population) medium medium medium low medium medium low medium 1.3.1 Adapt to climate change by People using safely managed sanitation services (% of buidling reselince to climate- population) medium medium medium low medium low low medium related shocks and natural Waste collection coverage, rural (% of rural population) high high high high high high high high disasters by scaling up risk Waste collection coverage, urban (% of urban population) low medium medium medium medium medium medium medium High prevention systems, and updating technologies and Waste treatment open dumping (%) (If high, then high priority) high . . high high high high high infrastructure SDG 6.4.1. Water Use Efficiency high high high high high high high high SDG 6.4.2. Water Stress high high high high high high high high Energy Intensity of GDP (TOE per thousand 2015 USD PPP) medium low low medium low medium medium low Total freshwater withdrawal high low high low high medium high low Treated municipal wastewater high high medium high medium high low high Water productivity, total (constant 2015 US$ GDP per cubic meter of total freshwater withdrawal) high high high high high high high high Number of deaths, missing persons and directly affected persons attributed to disasters, per 100,000 population high high high high high high high high Air pollution deaths from fossil fuels high low low low low medium low low Annual C02 emissions from fossil fuels and industry high low low low low low low low 1.3.2 Reducing pressures on Forest area (sq. km) (If low, then high priority) high high high high high high high high natural capital for improved CO2 emissions (kg per 2017 PPP $ of GDP) medium medium low low low low low medium resilience and mitigation by Coal subsidies as % of GDP, real 2021 USD low low low low low low low low High improving energy efficiency and Natural gas subsidies as % of GDP, real 2021 USD high high high high high high high high security, and promote green Oil subsidies as % of GDP, real 2021 USD medium high high high high high high high economy Renewable energy consumption (% of total final energy consumption) (If low, then high priority) high medium medium high high high high medium Binding Constraint 2: Accessibility to markets and better integration to trade Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level Rail lines (total route-km) high high high high high high high high 2.1 Boost public and private investment in physical and Railways, goods transported (million ton-km) high high high high high high high high digital access to close domestic High Road connectivity index high medium medium medium medium high medium medium and international connectivity gaps Account ownership at a financial institution or with a mobile money service provider, poorest 40% (% of population ages 15+) high medium high high high high medium high Logistics performance index: overall (1=low to 5=high) medium medium medium medium medium medium medium medium 2.2 Improve integration for trade by strengthening institution and International tourism, number of arrivals (If low, high priority) high high high high high high high high High continue efforts to open borders with neighboring countries Time to export: border compliance (hours) low high high high low high high Time to import: border compliance (hours) low low low low low high If there were outages, average losses due to electrical outages 2.3 Address connectivity (% of annual sales) low high medium low low low medium high Medium challenges in the energy sector Percent of firms experiencing electrical outages medium high high high high high high high 106 Binding Constraint 3: Human Capital Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level Government expenditure per student, tertiary (% of GDP per capita) high . . high high high high medium Government expenditure on education, total (% of GDP) high medium medium high high high high medium Government expenditure per student, tertiary (% of GDP per capita) high . . high high high high medium 3.1 Advance human capital School enrollment, preprimary (% gross) high medium medium medium high high high medium accumulation by improving Cause of death, by non-communicable diseases (% of total) medium low low medium low medium medium low quality and relevance of Probability (%) of dying between age 30 and exact age 70 from education, increasing High any of cardiovascular disease, cancer, diabetes, or chronic affordability of health services, respiratory disease, both sexes medium high medium low low medium medium high and allocating resources Probability (%) of dying between age 30 and exact age 70 from effectively any of cardiovascular disease, cancer, diabetes, or chronic respiratory disease, female low medium medium low low medium medium high Probability (%) of dying between age 30 and exact age 70 from any of cardiovascular disease, cancer, diabetes, or chronic respiratory disease, male high high medium low low high medium high Labor force participation rate for ages 15-24, total (%) (modeled ILO estimate) medium low low low low medium medium medium Labor force participation rate, total (% of total population ages 3.2 Promote access to and 15+) (modeled ILO estimate) medium medium medium medium medium medium medium medium generate good-quality jobs by Unemployment, total (% of total labor force) (modeled ILO strengthening coordination estimate) high high high high high high high high High between education and labor Unemployment, youth total (% of total labor force ages 15-24) market (modeled ILO estimate) high high high high high high medium high Average wage (2017 PPP $) (If low, then high priority) high high high high high high high high Average wage female (If low, then high priority) high high high high high high high high Average wage male (If low, then high priority) high high high medium high high high high 107 Binding Constraint 4: Investment and Private Sector Inputs Reference Groups Priority Possible Policy Priority Area Indicators World EU New EU ECA ECA All UMIC Regional OECD Level Account ownership at a financial institution or with a mobile money service provider (% of population ages 15+) medium medium medium medium medium high medium medium 4.1 Reduce the costs of firm Commercial bank branches (per 100,000 adults) low low low low low low low low establishment and operation by Domestic credit to private sector (% of GDP) low medium low low low low low medium Medium enhancing financial deepening Foreign direct investment, net inflows (% of GDP) high high high high high high high high and modernizing corporate law Global competitiveness index 4.0: financing of SMEs ** medium medium low low low medium low medium Gross capital formation (% of GDP) (If low, then high priority) medium medium medium high medium medium medium medium Research and development expenditure (% of GDP) high high high medium high high medium high International tourism, number of arrivals (If low, high priority) high high high high high high high high International tourism, receipts (% of total exports) (If low, high priority) low low low low low low medium low Market organization: To what level have the fundamentals of market-based competition developed? low medium medium medium medium medium medium medium Competition policy: To what extent do safeguards exist to 4.2 Foster a competitive private protect competition, and to what extent are they enforced? low medium medium medium medium medium medium medium sector in services and Manufactures exports (% of merchandise exports) high high high high high high high high manufacturing sectors by Medium- and high-tech manufacturing value added (% High developing a coherent strategy manufacturing value added) high high high high high high high high to attract investments (domestic, If there were outages, average losses due to electrical outages FDI, diaspora) (% of annual sales) low high medium low low low medium high Number of electrical outages in a typical month high high high high high high high high Percent of firms experiencing electrical outages medium high high high high high high high 2017 percentage of survey respondents who reported having paid a bribe in the last year to access public services such as education; judiciary; medical and health; police; registry and permit services; utilities; tax revenue and customs; and land service low low low low low low low low Agricultural raw materials exports (% of merchandise exports) high high high high high high high high Agriculture, forestry, and fishing, value added per worker (constant 2015 US$) medium high high medium medium medium low high Arable land share (% of land area) low medium medium medium medium low medium medium Cereal crop yield (If low, then high priority) medium medium high high high medium medium medium Cereal crop yield, attainable (If low, then high priority) low low low medium medium low low low 4.3 Improve productivity and Maize crop yield gap high high high high high high medium . cultivate climate-smart Potato crop yield gap high high high low low high low high High agriculture and further develop Wheat crop yield gap low low low low low low low low value chain SDG 6.4.1. Water use efficiency (if low, then high priority) high high high high high high high high SDG 6.4.2. Water stress high high high high high high high high Total freshwater withdrawal high low high low high medium high low Treated municipal wastewater high high medium high medium high low high Water productivity, total (constant 2015 US$ GDP per cubic meter of total freshwater withdrawal) high high high high high high high high 108 Appendix I. Call for Papers: Sustainable Economic Growth and Poverty Reduction in Armenia As part of the consultation process, the team announced a call for research proposals to understand the current challenges facing Armenia from the local perspective. Responding to the call, a total of 28 proposals were submitted from academia, research institutions, civil society, and other development and policy practitioners. Among the 28 proposals, 5 were selected based on analytical rigor and relevance of analysis in relation to the overarching theme of sustainable and inclusive growth (Table K.1). The research papers were revised based on the virtual quality enhancement review meeting that took place in January 2023 and served as critical inputs to support the storyline in the SCD. Table I.1. Selected Papers and Authors Title Author Research Description Asymmetry in Exchange Rate Pass- Gor A. Khachatryan (Yerevan State University) By using the nonlinear autoregressive distributed Through into Consumer Prices: Evidence and Aleksandr Grigoryan (American University of lag framework, the paper shows empirically how from Armenia Armenia) the exchange rate passes through to consumer prices in Armenia. The study finds that domestic prices respond differently to currency appreciations and depreciations. Policy Changes and Labor Market Vardan Baghdasaryan and Gayane Barseghyan The study estimates the causal impact of the Outcomes: Effects of Contributory (American University of Armenia) contributory pension and minimum wage on (Funded) Pension Scheme and Minimum informality and unemployment in Armenia based Wage Policies on discontinuity models and shows that there are no significant impacts. Migration Intentions and Labor Market Aleksandr Grigoryan (American University of The research explores the relationship between Conditions: Evidence from the Armenian Armenia) the intention to migrate for labor and the Labor Force Survey for the Period 2018 - deprivations in the labor market. The analysis 2020 finds that the deprived workers in the labor market are more willing to migrate, but willingness is also affected by the options available to the workers. Improving the Quality of School Ruzanna Tadevosyan (Armenian State University By collecting the original survey, the study Education in the Republic of Armenia of Economics) confirms that factors such as low financing, lack of teacher motivation, and inadequate teachings importantly affect the educational outcomes in Armenia. Facilitating International Trade through Margaret Baburyan (Economic Research and The paper analyzes the export promotion Development of Relevant Infrastructure Development Support Center) institutional model in Armenia and compares it with international benchmarking countries. Supplemented by the original data collected from local stakeholders, the paper suggests a model that best fits Armenia to enhance exports. 109 Appendix J. Disaster Risk Management Measures Taken after the 1988 Earthquake Table K.1. Examples of Government Efforts in Disaster Risk Management and Adaptation Year Policy Actions 1991 Established a new Disaster Risk Reduction system 1994 Adopted the first Armenia Seismic Code 1997 Established the Cabinet Contingency Fund 2008 Established the Ministry of Emergency Situations 2010 Established the National Platform for Disaster Risk Reduction to support multi-sectoral coordination for disaster risk reduction 2011 Introduced the legal framework for damage and loss assessment 2015 Signed the 2015-2030 Sendai Framework to improve the country’s resilience to disasters Adopted the Disaster Risk Management National Strategy Became a member of the UN International Search and Rescue Advisory Group (INSARAG) 2017 Enacted the Disaster Risk Management National Strategy and the Action Plan 2018 Carried out the Earthquake Response Exercise (ERE) to improve awareness and best practices of national and local authorities Adopted the Inter-Agency Needs Assessment (ARIANA) to increase the country’s preparedness Conducted national implementation of the Multi-Cluster Initial Rapid Assessment (MIRA) 2019 Adopted a new seismic hazard map adopted and initiated an update of Armenia’s seismic codes 2020 Hydrometeorology and Monitoring Center was established under the Ministry of Environment to support development of a united environmental monitoring system and to improve data exchange. 2021 Enacted the decree on National Adaptation Plan (National Action Program of Adaptation to Climate Change and the List of Measures for 2021-2025) 2022 Approved the Program on Energy Saving and Renewable Energy for 2022–30 Submitted amendment to the Law on Atmospheric Air Protection Submitted amendment to the Law on Environmental Impact Assessment and Expert Appraisal 2022-23 Developed a unified early warning data system and mobile phone application . Weather satellite system acquired to strengthen forecasting and early warning systems. 110 Appendix K. Social Protection System to Build Resilience Social protection can be critical for building resilience to different types of shocks, and the social protection system in Armenia has been important in protecting Armenians from falling into poverty. The social protection system in Armenia has undergone significant reform in the last decade, including the introduction of a mandatory funded pension pillar. Armenia has a relatively well-developed social protection system, underpinned by legislation and comprising three pillars that are common around the world: social insurance, social assistance, and labor market policies and programs. The analysis shows that in the absence of any social protection benefits, and if households were unable to compensate from other sources of income, half of Armenians would live in poverty, and inequality would increase by 40 percent. 155 However, gaps remain, and the social protection system requires additional adjustments to ensure that it is fiscally sustainable and socially adequate. Even after the delivery of social protection transfers, one in four Armenians remains poor, and more than half (57 percent) of those who remain in poverty are not reached by any social assistance benefit. 156 At the same time, many non-poor households receive the benefits, suggesting that there is room for improvement in the targeting of the programs. Moreover, Armenia’s social protection system does not seem well prepared to expand outreach in response to shocks. During the COVID-19 pandemic, the government protected the financing of regular programs and increased the social protection budget to make room for additional spending. The share of social assistance benefits in the consumption of the poor almost doubled (from 32 percent in 2019 to 56 percent in 2020), associated with the increase in government spending (vertical scale-up). 157 However, the rise in spending was accompanied by an increase of only 15 percent in the number of social assistance beneficiaries (horizontal scale-up), thus leaving many of the poor and vulnerable (particularly those in the informal sector) without support during the pandemic. This raises questions about the ability of the system to be shock-responsive—its capacity to identify and reach out to the most vulnerable families and individuals who are not already enrolled in the system and who need immediate assistance when affected by large-scale shocks. Focusing on vertical scale-up might reinforce the bias toward existing groups that are already served by social protection systems, which may not include all the vulnerable or those most affected by the shock. 158 To build adaptive social protection to enhance poor and vulnerable households’ resilience to shocks, it is critical to systematically include protection against unemployment and employment injury in the social protection system. Unemployment insurance was removed from the social protection system in 2013 and was replaced with a cash support system providing support to unemployed job seekers on a case-by-case basis. Therefore, little support is available to protect workers from income loss, although the government plans to reintroduce unemployment insurance. Similarly, it is also important to extend social insurance schemes to self-employed and informally employed so that individuals are protected against shocks at different stages of their lives and in particular at old age or in case of a health shock. The social protection system can be more efficient and effective by addressing the fragmentation of the social assistance and labor market programs and services. In 2021, a total of 35 schemes (almost half of the overall number of social protection programs) were being implemented for disability benefits and services, housing, and labor market measures, with overall financing amounting to less than 3 percent of the social protection budget (or 0.24 percent of 155 Unless otherwise specified, the welfare indicator used in all analyses in this Appendix is based on household consumption per adult equivalent. See ArmStat 2022 a. 156 Estimates using ILCS 2021, taken from World Bank 2023b. 157 Some social assistance benefits increased more than others. For example, the temporary increase in the Family Benefit was more than threefold. 158 Survey data suggest that the response to the COVID-19 shock was effective but not particularly efficient. While the poverty rate and poverty gap did not increase, the benefit-cost ratio of social assistance benefits dropped. The benefit-cost ratio is measured as the poverty gap reduction, in local currency units, for each 1 unit spent on the social program . However, it is important to note that the efficiency lens needs to be applied to shock-response measures with caution. In most cases, a “no regrets” approach (anticipatory action) is more suitable to shock-response interventions. 111 GDP). Many of these schemes were affected not only by the low financing but also by limited coverage and uneven spatial distribution. Consolidation of delivery mechanisms and using alternative public-private models, coordination across different programs, and institutional information sharing may increase cost-effectiveness and coverage of the social protection system. 112 Appendix L. The Gravity Model to Estimate Export Potential The analysis of Armenia’s export potential and missing exports is based on a gravity model. 159 This analysis follows earlier work done by Mulabdic and Yasar (2021) by estimating a gravity equation 160 using data for 160 countries over the 2013–2019 period. 161 Bilateral exports are modeled as a function of exporters’ and importers’ nominal gross domestic products (GDPs), economic development (GDP per capita), and remoteness indexes. Trade costs are proxied by policy variables such as the level of weighted applied tariff duties and presence of trade agreements in addition to distance and controls for sharing a common border, language, or colonial ties. Methodology and Data Bilateral trade data at the HS 6-digit (HS 2002) are from the CEPII’s BACI database. The data cover 160 countries across all geographic regions for the 2013–19 period. The sample is restricted to countries with populations greater than 1 million. Population data are from the World Development Indicators (WDI) database. To empirically assess if Armenia is under-exporting, a Poisson Pseudo Maximum Likelihood (PPML) estimator was used to estimate the following gravity equation: = �1 ln�1 + � + 2 + 3 ln� � + 4 where + 5 + 6 + 7 ln( ) + 8 ln� � + 9 ℎ + 10 ℎ + 11 ln( ) (1) + 12 ln� � + 13 ln � � + 14 ln � � + 15 ln( ) + 16 ln� �� + is the bilateral trade flow from country to country in a specific industry, are bilateral applied tariff duties, comes from Mario Larch’s Regional Trade Agreements Database from Egger and Larch (2008) and is an indicator variable that takes value of 1 if and have a trade agreement in year , is the geographical distance between and , is a variable that takes value of 1 for country-pairs that share a border, is a binary variable equal to 1 if and share the same language, and captures the presence of any colonial ties. Bilateral tariff duties are from the Market Access Map (MAcMap) database, while all the other variables come from CEPII’s gravity database. Other control variables such as exporters’ and importers’ GDPs as well as per capita GDPs are from the World Bank’s WDI database. Finally, the analysis controls for a dummy of mineral resources, which is equal to 1 if minerals exceed 10 percent of GDP for the 2013–19 period, and capital per worker (Chor 2010; Romalis 2004). Variables were constructed for capital stock per worker based on data from the Penn World Tables 9.1 following work by Levchenko and Zhang (2014). To control for the unobservable multilateral resistance terms, “remoteness indexes” (Baier and Bergstrand, 2007; Wei, 1996) were constructed instead of using exporter-year and importer-year fixed effects. 162 Based on Mulabdic and Yasar (2021) and World Bank (2022) 159 These estimates are slightly different from Mulabdic and Yasar (2021), as this sample is restricted to the pre-COVID period. In addition, 160 Mulabdic and Yasar (2021) used simple average tariffs in their estimation, while this model uses weighted average tariffs at the exporter- importer level. 161 �, −∑ , ∑ See Mulabdic and Yasar (2021). The index is defined as , = �∑ �, +∑ , � ∗ 100, where are observed � are the predicted flows based on a gravity model. exports from country to , while 162See Mulabdic and Yasar (2021) for details. 113 Appendix M. Justice Sector and the Private Sector Jurisdictions around the globe recognize accessible, effective, and efficient justice to be indispensable to the protection of citizens’ rights and freedoms and critical for supporting private sector development and economic growth. Accountable and effective justice institutions and efficient procedures create the enabling environment and level playing field for increased private sector investment, and they allow citizens and businesses to unlock their economic potential by protecting private property rights, enforcing contracts, and fostering growth in compliance with legal and regulatory frameworks. 163 In contrast, poorly performing courts delay business activity, undermine predictability, and increase risks, thereby constraining private sector growth. While courts are not immediately considered to be a major constraint to doing business in Armenia today, broader areas related to the justice sector are. According to the Enterprise Surveys 2020, only 1.2 percent of firms in Armenia list courts as a constraint (see also Figure 77). However, other areas in which courts and the justice sector play an indirect role are listed as areas of concern. Informal practices, which go contrary to growth in compliance with the legal and regulatory frameworks that courts and the justice sector are supposed to safeguard, are ranked as a main obstacle (12.9 percent), second only to access to finance. Corruption (3.8 percent) and access to land (3.3 percent) are also among the top 10 obstacles to doing business and within the scope of work of courts and the justice sector to create a level playing field and protect property rights. Generally, weak justice systems disproportionately hamper micro, small, and medium-sized enterprises because they have less buffers to absorb these challenges, which can become make-or-break for their businesses. Moving forward, and as Armenia seeks to propel its economic growth through private sector development, court performance may become more of an issue as firms intend to grow and expand and would rely on courts to solve (economic) disputes. Given the lack of disaggregated data available for judicial performance, it is difficult to assess how efficiently commercial cases are processed. While small in share (with less than 1 percent of the total court caseload in Armenia), the demand for court-supported insolvency procedures increased by 8 percent during 2017–21 (World Bank 2023e). In 2021, just below one in five cases (19 percent) were brought forward by companies. In light of this growing demand, additional judges were added, helping to sustain desirable clearance rates. However, the Bankruptcy Court has seen an increasing backlog, high congestion, and the highest disposition time among all courts in Armenia with 1,158 days per case (2021). 164 Issues around contract enforcement—or perception thereof— constitutes a constraint on economic development as it discourages doing business with strangers. The business community seems to be torn regarding the efficiency of bailiff services: according to a multi-stakeholder justice sector survey (World Bank 2021c), 33 percent of business representatives believe bailiffs are efficient, while 19 percent believe the opposite, and the vast majority did not provide an answer. Furthermore, non-awareness regarding the availability of other dispute settlement mechanisms in Armenia were expressed, with only 1 in 10 and 2 in 10 of businesses being aware of the availability of arbitration and mediation procedures, respectively. 163 https://www.worldbank.org/en/topic/governance/brief/justice-and-rule-of-law 164 As Armenian court statistics do not provide data on actual disposition times, a proxy indicator developed by the Commission for the Efficiency of Justice at the Council of Europe was applied. 114 Appendix N. Knowledge Gaps SCD2 identified a few knowledge gaps that have remained since the publication of SCD1 as well as new knowledge gaps that have emerged. Table N.11 lists the gaps addressed and the newly identified gaps to be addressed in future studies. Table N.11: Knowledge Gaps, SCD1 and SCD2 Knowledge gaps identified in SCD1 that were addressed Trade and transport facilitation assessment Assessment on the challenges and policy actions in the ICT sector Short-term migration flows and educational attainment of emigrants Population trends and urban share of population Trade and competitiveness diagnostic Selected new and remaining knowledge gaps Reasons for high contribution of total factor productivity on growth Quality firm-level data for analysis of productivity at the sectoral level Wage employment trends within sectors, employment by education per sector to understand into which jobs human capital is going, and spatial analysis to analyze mobility issues Main constraints on labor mobility within and across sectors Agricultural sector data, including data on the classification of land and property for agricultural production Profile of the diaspora, including mapping of the location, skills, experiences, and investments made in Armenia Political economy underlying the weak governance and institutions Natural capital accounting exercise and distributional impact of climate change and natural disasters Comprehensive analysis of the factors underlying the high international poverty rates Identification of critical bottlenecks hindering the functioning of Armenia’s markets and the extent to which competition and contestability challenges have continued since the Velvet Revolution Review of the development of insurance mechanisms, considering the country’s fragility and anticipated physical risks from adaptation Estimate of the private capital mobilization values needed for infrastructure across sectors Key constraints to boosting domestic investment Review of the country’s current FDI policies and programs based on solid analytics and evidence to identify key reform areas for FDI attraction Effect of remaining state-owned enterprises on competition, firm dynamism, labor markets, innovation, and fiscal implications 115