Report No. 22854-AM Armenia Growth Challenges and Government Policies (In Two Volumes) Volume I: Main Conclusions and Recommendations November 2001 Poverty Reduction and Economic Management Unit Europe and Central Asia Region Document of the World Bank CURRENCY AND EQUIVALENT UNITS (Exchange Rate Effective June 30, 2001) Currency Unit = Dram Dram = USS0.001l US51.0 = 554 Dram WVEIGHTS AND MEASURES Metric System. ABBREVIATIONS AND ACRONYMIS ADA Armenian Development Agency AMD Armenian Dram ARIA Moldovian Agency for Enterprise Restructuring ASYCUDA Automated System for Customs Data BOP Balance of Payment CCC Council of Court Chairmen CEDECE State Commission for Economic Development and Extemal Commerce CEE Central and Eastem Europe CIS Commonwealth of Independent States CPIA Country Policy and Institutional Assessment CPI Consumer Price Index EBRD European Bank for Reconstruction and Development EPZ Export Processing Zone EU European Union FDI Foreign Direct Investment FIAS Foreign Investor Advisory Service FSU Former Soviet Union GOA Govemment of Armenia GDP Gross Domestic Product IAC Information and Advisory Center IBRD Intemational Bank for Reconstruction and Development ICRG Intemational Country Risk Guide IFS Intemational Financial Statistics ILO Intemational Labor Organization IhIF Intemational Monetary Fund IP Industrial Park IT Information and Telecommunication JSCL Joint Stock Company Law MBRC Macedonian Business Resource Center MOFE Ministry of Finance and Economy MOTC Nlinistry of Transport and Communication NAFTA North America Free Trade Agreement NGO Non-Govemment Organization NIE Newly Industrialized Economies NK Nagomo - Korabakh NSS National Statistical Service OECD Organization of Economic Cooperation and Development OTE Hellenic Telecommunication Organization PIAL Privatization Implementation Assistance Loan PIU Project Implementation Unit PPP Purchasing Power Parity PSD Private Sector Development RA Restructuring Agency R&D Research and Development ROA Republic of Armenia RPC Russian Privatization Center SME Small and Medium Enterprises SOE State-Owned Enterprise TB Treasury Bill TI Texas Instrument TRACECA Transport Corridor Europe Caucuses TVE Township-Village Enterprise USAID United States Agency for Intemational Development USSR Union of Soviet Socialist Republic VAT Value Added Tax WSJ Wall Street Joumal WTO World Trade Organization FISCAL YEAR January I to December 31 Vice President: Johannes F. Linn Country Director: Judy M. O'Connor Sector Director: Pradeep K. Mitra Sector Manager: Samuel K. Otoo Task Team Leader Lev NI. Freinkman ACKNOWLEDGMENTS The report was prepared by a core team that includes Lev Freinkman (team leader), Karen Grigorian, Gohar Gyulumyan, Yevgeny Kuznetsov, and Zakia Nekaien- Nowrouz. Usha Rani Khanna edited the report. Background papers for the report were prepared by Luis Alvaro-Sanchez, Vahram Avanessyan, Geeta Batra and Andrew Stone, David Grigorian, Artsvi Kahchtryan, Une Lee, Alexander Poghossian and Vahram Stepanyan, Evgeny Polyakov, and Ruslan Yemtsov and Armine Petrossian. The team also greatly benefited from broad support and cooperation with Armenian authorities, especially the Ministry of Finance and Economy, the Central Bank, and National Statistical Service. In addition, a large group of individuals contributed their input and comments, including Gohar Abajan, Ataman Aksoy, Arusyak Alaverdyan, Konstantin Atanesyan, Yuri Boutayev, Peter Fallon, Lars Jeurling, Vladimir Kreacic, Mark Lundell, Robert Nooter, Christian Petersen, Gevorg Sargsyan, David Shahzadeyan, Jonathan Walters, and Salman Zaheer. Samuel Otoo is the Sector manager, and Pradeep Mitra is the Department Director. Judy M. O'Connor is the Country Director for Armenia. TABLE OF CONTENTS Introduction ................................................................1 Armenia's Economy Has Been Growing Since Mid-90s but it Currently Faces the Risk of Slowdown ..........................................................1 To Make Growth Broad-Based, Armenia's Government Must Create an Environment for Accelerated Development of the Private Sector .................. 13 International Aid Donors Can Advance the Growth Strategy by Supporting the Creation of "Restructuring Agencies" ..................................... 17 Success in Nascent Export-oriented Clusters will help Attract Foreign Direct Investment to These and Other Sectors ....................................... 20 The Software Industry is a Logical Place for Private Investment to Begin ......................................................... 21 List of Tables Table I New Private Sector Activity as Share of GDP (percent) .3 Table 2 Three Spheres of Economic Activity in Armenia .4 Table 3 Firms Reporting Frequent Solicitations of Informal Payments from Government Employees .9 Table 4 Summary of the Proposed Growth Strategy .14 List of Boxes Box 1 Moldova's Enterprise Restructuring Agency .20 INTRODUCTION 1. Since the mid-90s, the Armenian Government has been among the most advanced reforrnists in the forner USSR, and Armenia has been among the highest growing economies in the region. Nevertheless, Armenia still is a resource-poor, landlocked economy with underdeveloped institutions, low income levels (which is about two-thirds of the average for the CIS), and a high, although rapidly diminishing, stock of human capital. The country's future depends on the government's ability to expand investment in and export opportunities for Armenian firms by helping them to restructure and by facilitating their linkages with global markets. 2. This report reviews growth trends in Armenia for the period 1994-2000, outlines major weaknesses of existing development patterns, and suggests a package of policy recommendations designed to accelerate enterprise restructuring, attract investment, and encourage the creation of new businesses in the medium term (three to five years). Such steps are needed to sustain (and preferably to increase) the current growth rates, to stop emigration among the young and skilled, and to reduce poverty. 3. The government needs to focus much more clearly on generating the environment for private sector led growth by removing bottlenecks in policies, infrastructure and institutions that prevent new private businesses from flourishing. International aid donors can help by supporting the removal of administrative barriers for investments, the rehabilitation of infrastructure, and the creation of "restructuring agencies" that will enable firms in key sectors to overcome or avoid common constraints to business growth in Armenia. Successful restructuring by such firms should have a demonstration effect on the country's economy and help consolidate public support for moving forward the programn of reform begun a decade ago. Armenia's Economy Has Been Growing Since Mid-90s but it Currently Faces the Risk of Slowdown 4. Over the last several years, Armenia has made impressive progress in establishing a suitable framework for structural reforms. Despite external shocks, macroeconomic conditions have remained quite stable, with low inflation, a relatively stable exchange rate, a sufficient level of international reserves, and considerably reduced budget and quasi-budget deficits. 5. Armenia's growth performance has been strong compared to the rest of the Commonwealth of Independent States (CIS). After an estimated 60 percent decline between 1991 and 1993, real GDP grew 5.4 percent in 1994. Since then, annual growth has averaged about 5 percent-a remarkably resilient performance in the face of the Russian financial crisis of 1998 and political assassinations in October 1999. In the second half of 2000, the economy has shown an additional improvement in performance, supported by export expansion. I 6. The country's economic expansion in 1995-2000 was fueled by a recovery from the severe contraction of the early 1990s. Factors that contributed to growth included recovery in electricity supply, expansion of external private transfers that pushed domestic demand, and a major program of international assistance that made Armenia a leading regional recipient of donor funding in per capita terms. On average in 1995-99, donors provided about 7 percent of Armenia's GDP in annual budget support mostly through a combination of grants and low-interest credits. 7. Economic growth was also supported by a relatively strong recovery in agriculture backed by a privatization of rural land very early in transition and considerable import substitution in food consumption. 8. These factors are not long-term engines of economy-wide growth, however, and current growth rates will not be sustained unless major constraints are removed. Patterns of Growth 9. Forty-three percent of the increase in real GDP in 1994-99 came from expansion in the service sector. Agriculture contributed an additional 30 percent. The contribution of the industrial sector, where Armenia's skilled labor represents a strong potential comparative advantage, was just 13 percent. 10. The output of the country's traditional industrial companies grew more slowly than did the economy as a whole, and their productivity and rates of capacity use slipped. The largest enterprises seriously underperformed the rest of the industrial sector. The share of the country's total industrial output produced by the 100 largest enterprises dropped from 28 percent in 1997 to below 20 percent in 1999, while the share of registered firms reporting profits declined from 64 percent in 1997 to 33 percent in 1999. 11. The largest Armenian enterprises are much less productive than their counterparts in Lithuania and Kazakhstan. Lithuania's enterprises were about eight times more productive than Armenia's in 1997, in terms of sales per employee, and the gap appears to have widened in 1998-99. 12. Cross-country analysis of large enterprises also suggests a rather low level of capacity utilization in Armenian firms. Improving capacity utilization for Armenian industry is becoming increasingly difficult, however, as old markets in Central and Eastern Europe continue to shrink. Unless and until new product markets are discovered (or old markets recovered), the financial viability of most of Armenia's large companies is highly questionable. Moreover, in a number of cases traditional markets and value chains for these companies entirely disappeared. And, even in more favorable cases capturing new markets will take time, and serious investment in technology and training and major policy efforts will be needed. 13. The birth rate of new companies remains depressed, as does their rate of survival. One of the broad lessons of transition in Central and Eastern Europe is that large firms 2 formerly owned by the state support growth largely to the extent that they provide assets and human capital for new entries driven by dynamic local and foreign managers. The same experience suggests that so-called first movers, firms that have been making successful but risky investments in developing new products, approaching new markets, and building new partnerships, are more likely to be new entries than traditional firms. In the transition economies of Central and Eastern Europe, as in other parts of the world (notably Latin America), successful restructuring at the micro level has hinged on management turnovers and changes in management culture. 14. Company registration data show that the number of small new firms in Armenia is low by international standards. By late 2000, as estimated, Armenia had about more than 30,000 operational businesses, which amounts to less than 10 entities per 1,000 inhabitants. Modern market economies have much higher incidence of SMEs, e.g. Germany has 37 registered SMEs per 1,000 inhabitants, Slovenia 45, and the United States 74. Moreover, there is concern that the growth in the number of firms in Armenia has been rather slow recently, which reflects high costs of entry. 15. About 60 percent of Armenia's GDP is produced not by traditional enterprises that were established in the Soviet times, but by the new private sector (Table 1), a high level that is similar to many leading economies in transition. However, the structure of the new private sector in Armenia differs from that found in more successful economies. Registered companies account for less than a quarter of the business activity of the de novo sector. The rest derives from predominantly low-productivity informal activities in agriculture, commerce, and urban services. Table 1: New Private Sector Activity as Share of GDP (percent) Type of activity Share of GDP GDP produced by new private sector 60 New firms in industry4 New firms in other sectors9 Individual entrepreneurs6 Informnal (non-registered) business activiyof households 1 Family farms 25 Other (including traditional companies) 40 Total 100 Source: World Bank estimates based on data from Armenian National Statistical service. 16. The private sector in Armenia can be visualized as a pyramid consisting of three types of economic activities (Table 2). At the base of the pyramid are the formal subsistence-type activities in which virtually the entire economically active population is engaged. Productivity is very low and self-employment high. The subsistence economy has absorbed the shocks produced by contraction of the inherited economy of state- owned and privatized organizations that constitute the second layer of the pyramnid. The third layer--uite small in termns of employment and output but high in productivity- consists of new SMEs. With approximately 7,000 employees, new industrial SMEs 3 produce about US$230 million in output. In the inherited economy, by contrast, 80,000 employees produce US$340 million in industrial output. The seven-fold gap in labor productivity between start-up firms and inherited enterprises shows the great growth potential of breaking up inherited assets into spin-offs and transforming informal economic activity of population into more traditional SMEs. Table 2: Three Spheres of Economic Activity in Armenia Segment of the economy Employment and output Objectives for public interventions kntrepreneurial/SME 7,000 employees Facilitating entry and expansion Start-ups and spin-offs with 5-50 US$230 million based on productivity growth ernployees nherited 80,000 employees iquidation, bankruptcy, arge privatized and state-owned US$340 million mprovement of corporate firms and R&D organizations govemance Recombination of assets, _________________________ ____________________ estructuring through spin-offs Self-employed/informal Nearly the entire Increasing productivity of family Family production and informal population economy through microcredit and urban microenterprise, including US$21 million (industry business development services activities for home consumption only) nd informal operations 1.1 percent of GDP) A'ote: Industrial sector includes manufacturing, energy, and mining. Source: Armenian National Statistical Service, based on household surveys (for self-employment), enterprise surveys, and other data. Areas of Concern 17. The incidence of poverty in Armenia between 1996 and 1999 (using the comparable poverty line based on the minimum food basket and allowances for essential nonfood spending) has remained at around 55 percent of the population. One in three workers is either unemployed or has been on prolonged administrative leave, according to the government's 1999 labor survey, and many have dropped out of the labor force. Almost half of the country's adults of prime working age (25-49 years old) lack gainful employment. At least 20 percent of the population has left the country since the late 1980s. 18. Growth has not yet made up for jobs lost to downsizing, and the sector and enterprise bases of growth have been narrow-a fact that explains the "mystery of growth without poverty reduction." Traditional enterprises had a stronger impact on employment and income levels than did new companies characterized by relatively high productivity but low demand for labor. Soviet-era firms have continued to shed their labor, forced by further compression of traditional markets in the former Soviet Union and by tighter budget constraints, while entry of new, labor-intensive SMEs has been insufficient to soak up surplus labor. Potential income gains from growth in the agriculture and budget sectors were largely wiped out by unfavorable changes in relative prices and wage arrears. 4 19. Overall, despite a relatively strong recent performance, economic growth in Armenia has not been supported by strong enterprise restructuring or by massive entry of new private business. As a result, the country faces a noticeable imbalance between its relatively strong macroeconomic fundamentals (and substantial structural reforms), and a weak supply and investment response. Unless this issue is addressed, the growth rates of the last 5-6 years will be unsustainable. That is, while Armenia needs and has a potential to generate a high growth episode over the next decade, without additional reforms at the microeconomic level, the economy is likely to slow down relative to the current growth rates. 20. The winners from economic growth in Armenia are excessively concentrated. About a thousand employees in the country's diamond industry were responsible for $70 million in exports in 1999-30 percent of the country's manufacturing exports. Another thousand employees produce $15-20 million in exported software. While the economic impact of these sectors on national living standards is rather modest at the moment, they could form the nucleus for faster and more broad-based economic growth if they can be consolidated into export-oriented clusters offering high value added-and if their performance can be replicated elsewhere in the economy. 21. Privatization in Armenia has generally led to a consolidation of control by incumbent managers. Mass privatization in the CIS generally has not yet brought significant improvements in enterprise performance. However, statistical analysis has shown that performance varies considerably with ownership structure. Foreigners, banks, small groups of individual owners, and managers (to a smaller extent) tend to be the most effective owners, while diffused ownership (either by workers or by large numbers of citizens) and ownership by insiders are associated with poorer performance. 22. Two of the most effective ownership classes (banks and foreign investors) have played a very limited role in Armenia, which may partially explain the relative weakness of enterprise restructuring in the country. At the same time, the cross-country comparison presents a puzzle with respect to ownership by management. On average in the CIS, management ownership tends to support restructuring, but not in Armenia-at least not yet. In a surprising number of cases, the strategy of incumbent managers who became owners appears to have been focused on asset stripping. 23. In 2000, merchandise exports were only 14 percent higher than they were in 1995, amounting to just 16 percent of GDP. Low export levels currently represent a major source of macroeconomic risks in Armenia. As in other small economies, Armenia's longer-term growth prospects to a large extent depend upon developing much stronger export capabilities. 24. Armenia still exports quite a limited number of products-a weakness in the country's export structure. Only about 60 types of products (according to the four-digit commodity classification) were regularly exported in 1995-99. Fourteen top products accounted for 87 percent of total merchandise exports in 1999 (compared to about 80 5 percent in 1995). Except for diamonds and gems, Armenia's leading exports are concentrated in sectors (energy, metallurgy, and mining), where the country does not have strong comparative advantages in the long termn. Metal scrap remains a significant part of overall exports, and the market share of agricultural and food products has increased as well. At the same time, except for software, no significant new export sector has emerged. 25. Countries outside the FSU accounted for 75 percent of Armenia's new export markets in 1999, up from 37 percent in 1995. When diamond exports are measured on a net basis, however, the overall share of non-CIS countries is considerably lower and does not exceed 40 percent. Therefore, while some diversification of exports has taken place, it is still less advanced than the data on gross exports suggest. Overall, a considerable share of traditional Armenian exports (food, footwear, equipment), especially from SMEs, continues to go to CIS countries. Many enterprises, especially those with no foreign ownership, are unable to find strategic partners and new markets outside the former Soviet Union (FSU). 26. Investment in Armenia is low. Based on an alternative interpretation of the data, the report estimates that the current level is about 15 percent of GDP, 4-5 percentage points below the level reported in official datal and well below the investment needs of the country. By contrast, gross domestic investment in the leading transition economies of Central Europe and the Baltics was more than 20 percent of GDP in the latter half of the 1990s. 27. The development impact of current investment is even lower than investment volumes would suggest. Investments are heavily concentrated in the public and household sectors (including housing, utilities, and infrastructure), and much less so in sectors that reflect and contribute to enterprise restructuring and productivity growth. Such an imbalanced investment structure derives from both supply (availability of donor financing) and demand (weakness of the private sector, needs of the earthquake zone) sides. 28. Armenia's public external debt stood at $862 million (45 percent of GDP) at the end of 2000. The large share of concessional credits and the small share of commercial debt protect the country reasonably well against hikes in international interest rates and significant shifts in value of the major international currencies. Still, in terms of net present value, external debt at end-1999 was about 153 percent of exports of goods and services and 167 percent of fiscal revenues, so although the current overall debt burden is moderate in terms of the size of the economy, it is high relative to expected earnings. The debt ratios improved somewhat in 2000, after a 15 percent expansion in exports in the second part of the year. However, given the debt burden relative to current export and fiscal revenue levels, it is important that foreign financing in the next several years be provided as grants or on a highly concessional basis. The main report provides an explanation of this discrepancy in estimates for investment rate. 6 29. Stubborn Problems Constrain Armenia's Ability to Restructure its Economy and Achieve Sustainable Growth 30. Three factors represent critical constraints on sustainable economic growth-a poor business and investment environment, weak managerial skills, and uncertainty about the country's economic and political prospects in an unstable region. Government has not yet Provided for Sufficient Improvements in the Country's "Challenging" Business Environment 31. Despite considerable progress with structural and institutional reforms, including in such important sectors as power generation and distribution, banking supervision, social protection, and land reform, Armenia's basic institutions in support of the market environment remain weak. This is not surprising given the scale of the task and the severe resource limitations the country faces. However, Armenia has tried to build too many new institutions simultaneously without proper prioritization and sequencing, for instance in the area of capital markets development. This excessively broad institutional agenda, which is at least partly donor-driven, has weakened several core functions of economic management and created problems of inter-agency coordination. 32. Presently the state lacks the capability and in some cases incentives to create an effective business environment by enforcing the country's favorable legal framework. In the early 1990s, the Armenian government was very decisive in advancing its broad liberalization agenda, removing various restrictions on trade, prices, exchange rates, and interest rates. Since 1996, the country's macroeconomic environment has contained few distortions related to formal government regulations, the nominal tax regime, and budget subsidies. The notional business environment reflected in laws and regulations is relatively good. 33. At the microeconomic level, however, the situation is different. The state was not capable yet of enforcing the favorable legal framework so as to create an effective business environment. Liberalization and deregulation bring tangible benefits only if they are supported by sufficient government capacity to protect the liberal economic regime. If this capacity is lacking, as Armenia's experience confirms, one may expect that central regulations have a tendency to be replaced by decentralized regulations imposed by local governments, special interest groups, and sectoral agencies- unpredictable practices that are profoundly discouraging to business and investment. In the absence of a well-established government policy in this area and given Armenia's frequent changes in government, numerous controlling agencies, and weak central oversight, a "decentralized model" of excessive and unpredictable regulation has emerged. 34. The Armenian government is large and exerts substantial pressure on the relatively weak and small private sector. According to World Bank estimates, Armenia's budgetary sector in 1998-99 employed almost 10 percent of the country's population. In the OECD states, by contrast, the average share is 7.7 percent and in the FSU states about 7 8 percent. The regulatory functions of government are fragmented, and individual agencies receive little central oversight. A 1994 presidential decree granted 17 separate state agencies the right to conduct business inspections. In summer 2000, a new law on inspections somewhat reduced the number of inspecting agencies and introduced a more transparent framework for state inspections of businesses. 35. Business surveys conducted in Armenia in 1996-2000 identify taxation, policy instability, and lack of financing as leading constraints to effective operation and expansion of firms. A 1999 enterprise survey conducted in 22 economies in transition umder supervision of the World Bank and the European Bank for Reconstruction and Development produced similar findings: * As in other countries in Central and Eastern Europe, tax rates and regulations are the leading regulatory problem for Armenian businesses. Tax administration problems derive not only from government policies, but also from the accounting practices and financial capacity of firms. * Political and policy uncertainty arise not only from recent events and decisions but also from the fact that businessmen find it difficult to get timely information on changes in laws, regulations, and policies affecting them, and the government rarely consults affected businesses before making critical decisions. * High interest rates are perceived as a serious financial constraint on Armenian businesses. Firms, especially small firms, rely heavily on family and friends for finance. * Roads are the leading infrastructure constraint. Customs processing in Armenia delays imports more than in other countries of the region. * Businesses give the Armenian government poor ratings for helpfulness, efficiency, and the quality and integrity of public services. 36. Even when compared to other CIS economies, Armenia's business environment must be considered very challenging. Armenian firms report being solicited for bribes more often than in most economies in transition, especially in dealings related to taxes, licenses, and courts. Armenian firms also face much less predictability in the unofficial payments they have to make (Table 3). ! Tax rates were considerably reduced, while the tax structure was simplified, by the decisions adopted in the second part of 2000 and in 2001. 8 Table 3: Firms Reporting Frequent Solicitations of Informal Payments from Government Employees (Percent of firms that gave answers 1 (always), 2 (mostly) or 3 (frequently) to questions on informal payments; respondents have six options to select from.) Irregular Advance Service If payment is made If official breaks rules, payments knowledge of delivered as to one official, business can appeal to made to amount of agreed once another will request superior and receive government payment payment is payment for the correct treatment made same service without recourse to .____________________ irregular payment OECD 0.12 0.26 0.62 0.17 0.45 CIS 0.29 0.46 0.75 0.35 0.38 CEE 0.33 0.48 0.73 0.28 0.36 Armenia 0.40 0.51 0.73 0.36 0.37 Note: OECD=Organization for Economic Co-operation and Development, CIS=Commonwealti of Independent States, CEE=Central and Eastem Europe. Source: 1999 enterprise survey undertaken for the World Bank and European Bank for Reconstruction and Development. Insufficient Demandfor Change Raises the Risk of a Stagnation Trap 37. The report identifies simultaneous market and government failures that together set a stage for a potential stagnation trap. These include: - Slow pace of deregulation reform and insufficient support an investment- friendly business environment. - Mismatches in resource allocation: new entrepreneurs have restricted access to available assets, including equipment, industrial space, and land, which remain largely underutilized. * Insufficient supply of new managerial skills. Business training programs have been established, but they remain largely isolated from the business needs of existing managers and business owners. 38. Coordination Problem and First Movers. The profitability of an individual investment is dependent on what happens elsewhere in the economy. But, if all investors wait for an auspicious environment and nobody moves first, nothing happens. The resulting "coordination problem" is a reflection of economic and political uncertainty that depresses demand for assets and business expectations. This is why "first movers" are critical for changing economic perceptions about the quality of the investment climate and triggering a supply response. 39. Notional and Effective Incentives. Even if the business environment is reasonably friendly, firms must have minimum skills to benefit from it. Enterprise restructuring is a challenge for a post-socialist manager who needs new skills to deal with new markets, partners, and ways of doing business. Knowledge- and skill-based 9 constraints are especially severe in small, isolated economies such as Armenia, which have thin internal markets for information, weak traditions of interfirm cooperation and external partnership, and, therefore, generally high costs of entering new export markets. 40. Under such circumstances, even the right incentives for restructuring might not be sufficient to start the restructuring process. Capabilities and opportunities for restructunng are at least as important. A firm that has correct incentives but no capacity to act on them has no effective incentive at all. 41. Stagnation Trap. The unfriendly business environment, the coordination problem, and skilled-based constraints for restructuring combined pose a risk of the stagnation trap, which sets in when low levels of investment and entrepreneurial activity support pessimistic investment expectation and vice versa. The poor business environment discourages first movers, which in turn aggravates the coordination problem, resulting in even lower investments and even fewer new entries. In addition, low entrepreneurship in such an economy produces too little pressure to reform the business environment andl therefore further supports stagnation. 42. Thus, Arrmenia faces a serious risk of being caught in the stagnation trap, which, if it happens, has the potential to become quite stable because existing demand for change is neutralized by powerful factors. * The country's relatively strong but unsustainable economic recovery allows for complacent delays of unpopular reforms. * The most able and vocal proponents of reform tend to emigrate. • Aid provided by international donors acts as a balance-of-payment shock absorber. Because nominal growth rates are high and the Armenian government has a record of reform, donors have been less insistent about the need for improvements in the investment climate. * Powerful interest groups represent those who benefit from the status quo. * Because of its small internal market, Armenia attracts little external investment interest, while members of the Armenian Diaspora tend to limit their criticism out of concern for the government's reputation. Other Constraints to Growth are Serious but Surmountable 43. Other constraints are important but need not prevent further restructuring and growth. 44. The blockade resulting from the unresolved Nagorno-Karabakh conflict has raised transportation costs, closed export markets in Turkey and Azerbaijan, provoked excessive defense spending, and raised investment risks. However, its direct costs declined 10 significantly after 1995 for private operators who found ways to handle the transportation obstacles. Expansion of Armenia's exports is possible with improved marketing capabilities and expanded international partnerships. The blockade also has its "positive" side, at least short term: it has been serving as an effective protection against import competition in two major sectors of the economy-agriculture and food processing. 45. Short-term gains from lifting the blockade could be significant, although they would not alone solve the country's development problems. It is estimated that without the blockade annual merchandise exports could quickly increase by $300 million, compared to the level of late the 90s. 46. The high cost of borrowing is a drag on private sector development. The Armenian economy remains highly undermonetized, and the banking sector is small and segmented, making the costs of bank credit prohibitively high. But expensive borrowing is to a large degree a result, not a source, of more fundamental economic weaknesses. The unfriendly business environment creates strong incentives for firms to remain in the informal economy and to operate outside the banking system, keeping monetary depth low while greatly increasing the risks and costs of bank lending. In addition, the existence of numerous under-utilized donor-sponsored credit lines in Armenia provides ample evidence that further expansion in private credit is constrained by the lack of bankable projects, not by insufficient funding. Experience from other developing economies suggests that the early stages of enterprise restructuring are often financed not by banks but by other sources, such as commercial credit from suppliers and other partners. 47. The possibility that a low equilibrium trap may form in the financial sector cannot be dismissed, however. In such a trap, adverse factors exert a mutually reinforcing negative impact on longer-term development prospects: * Demand constraints-quality of business plans, low transparency of borrowers, improperly registered property rights-mean that much more funding is potentially available (from credit lines) than is actually used. * The funds that are used are too expensive because the costs of intermediation have been raised by the small size of banks, weak judicial protection of lenders' rights, and unresolved property rights issues (e.g., for urban land) that limit the value of potential collateral. * Too low a share of the funds that banks channel to the real sector return as private sector deposits. The low rate of "recycling" can be traced to informality and the confidence crisis. 48. Budget constraints on Armenian enterprises are not firm, and subsidies are still too high. Experience with transition elsewhere since 1990 suggests that hard budget constraints are not just a critical element of macroeconomic stabilization; they are also needed for enterprise restructuring and the credibility of reforms. When compared to 11 several of the largest CIS economies, budget constraints in most of Armenia's enterprise sector in the late 1990s appear relatively firm.3 Still, total annual subsidies-including accumulated debts to utilities and tax arrears-are estimated to have been 6-7.5 percent of GDP in 1996-99. At least two-thirds of these subsidies in all years except 1999 were provided through quasi-fiscal channels such as non-paid services of utility providers, mostly in power, gas, and heating. 49. The largest recipients of subsidies were households, which had been subsidized indirectly through infrastructure services such as energy, water, and irrigation. Commercial enterprises received a smaller share of total subsidies, and such subsidies have been heavily concentrated in a few of the largest companies-both state-owned and recently privatized. The liquidation or forced restructuring of these firms would have a beneficial impact on the entire enterprise sector, but there is no evidence that the soft budget constraints for a few large companies has slowed down the overall enterprise restructuring process. Arrears and implicit subsidies in Armenia are a fiscal problem rather than one of restructuring. Implicit subsidies also consume scarce public resources, which alternatively could be used more efficiently by providing a targeted social assistance for the most needy. 50. Despite considerablefiscal adjustment since the mid-1990s, the sustainability of fiscal performance remains a major concern. On the spending side, an additional reallocation of funds will be required to concentrate limited resources in the most critical areas, especially those related to support of primary social services and basic infrastructure. Without such a shift, the country's human capital base will continue to erode, raising the price of future broad-based growth. Revenue collection, although improved since 1996-97, is still far below expectations due in part to the size of the informal economy and persistent weaknesses in tax and customs administration. 51. The dram had appreciated considerably in 1998-99 against the currency of many of Armenia's regional trade partners, making the country's exports more costly. In contrast to most CIS countries, Armenia managed to avoid major macroeconomic disruptions from the 1998 Russia crisis, such as significant devaluation of the national currency and an inflation hike. A combination of tight monetary policy, relatively high hard currency reserves, and low levels of short-term debt accounts for the stability of the dram in 1998-99. In general, such stability is quite positive for economic management and for the credibility of the local currency. However, it came at the price of considerable appreciation against the currencies of many of Armenia's regional trading partners. 3In Russia heavy hidden and. untargeted subsidies, provided through systematic nonpayment of taxes and energy costs, amounted to 7-10 percent of GDP annually in 1995-97. Adding explicit budgetary subsidies brings the total to more than 15 percent of GDP. Such soft budget constraints have stifled enterprise restructuring and growth and contributed significantly to the 1998 crisis through accumulation of public debts. See Brian Pinto, Vladimir Drebentsov, and Alexander Morozov, "Give Macroeconomic Stability and Growth in Russia a Chance." Policy Research Working Paper 2324, World Bank, Washington, D.C. 12 52. The real value of the dram in early 2001 was close to its level in January 1997. That value was a product of two opposing trends: appreciation against CIS currencies and depreciation against the currencies of the rest of the world. In early 2001, after the ruble had recovered somewhat, the dram was still 60 percent more expensive than the Russian currency and almost 50 percent higher than the Georgian lari. 53. Because many of Armenia's exporters do not yet have sufficient skills to penetrate new markets outside the FSU, they are unable to switch their exports quickly in response to exchange rate developments. Thus, the appreciation of the dram in the aftermath of the Russia crisis significantly affected the competitiveness of traditional exporters whose main markets are in the FSU. The appreciation exacerbated the impact of lower demand from Russia and other CIS states, both of which contributed to the deterioration of Armenian exports and industrial performance in 1998-99. 54. The dram's appreciation may have been excessive. Arguably, the government's policy response to the Russian crisis in late 1998 and early 1999 could have been less restrictive, allowing for more depreciation of the dram relative to the U.S. dollar. Now, however, the government's power to restore the pre-crisis exchange rate proportions is limited, and the overvalued dram may continue to affect the competitiveness of a specific segment of Armenian exporters. This finding reinforces the importance of correcting the fundamental weaknesses identified above-management capacity and distortions in the business environment that depress competitiveness. 55. The crisis in Russia, and more recently economic developments in Turkey, underline intrinsic macroeconomic vulnerabilities of the Armenian economy. Macroeconomic management in a small, open economy could become very challenging when its much larger neighbors and main partners have volatile exchange rates. To Make Growth Broad-Based, Armenia's Government Must Create an Environment for Accelerated Development of the Private Sector 56. By establishing a stable macroeconomic environment and liberal trade regime, the government introduced a critical precondition for future export-driven growth. The binding constraint now relates to structural and micro-level fundamentals. While preserving its macroeconomic gains, the government must focus its medium-term strategy on improving the business environment, promoting deregulation, removing administrative barriers to investment, and setting up mechanisms for public-private dialogue-a "top-down" agenda that is traditional for economies in transition. Complementing that agenda must be a set of selective, bottom-up interventions to promote new business entry, especially in skill-based and export-oriented sectors (Table 4). Without additional effort to support private sector development and improve the business environment, it is likely that Armenia's overall growth rate would slow down in the coming years as the momentum provided by the recovery from the initial collapse dissipates. 13 Table 4: Summary of the Proposed Growth Strategy Main pillars Core polices Immediate priorities Maintaining a Strengthening the quality of Reducing fiscal and quasi-fiscal risks sustainable macroeconomic management Improving Armenia's debt profile macroeconomic Joining the World Trade Organization framework and liberal trade regime Irnproving the Advancing the deregulation Reforming tax administration and customs to quality of the agenda lower the costs of compliance and provide equal business Setting efficient mechanisms treatment of taxpayers environment for public-private consultation Reforming tax policy to promote simplification Supporting financial and equal treatment deepening Further consolidating, downsizing, and rationalizing government inspections Liberalizing registration and licensing procedures Establishing a modern framework of company law Removing outdated laws and regulations from the _____________________ _ regulatory framework Facilitating Strengthening core Establishing core restructuring agencies to economic government functions related facilitate expansion of new entry and support first restructuring and to economic development and movers in the private sector. Agencies include: new private entry private sector growth * An investment promotion agency to support Expanding opportunities for business linkages and inflows of foreign management and business direct investment training for existing managers * An enterprise restructuring agency to and business owners restructure on a case by case basis large enterprises into start-ups and spin-offs * A business advisory center to provide business development and advisory services for new entry * An information technology business incubator to pilot new policies of public L I support for new entry in the skill-based sector Effective Deregulation will improve the Business Environment 57. The Government increasingly recognizes the need for more focused efforts to improve the business environment. Beginning in 2000, a program of measures has been adopted to this end, which is being supported by the Fourth Structural Adjustment Credit (SAC IV) from the World Bank. Key elements of the program include: * Reforming tax administration to reduce compliance costs for taxpayers while raising collections. * Developing a customs system that facilitates trade, generates revenues, and prevents the flow of illegal goods. * Improving taxpayer services to build confidence, and establishing a forum for public-private dialogue in this major area of the reform program. 14 * Simplifying the tax system and making it more equitable. * Further consolidating, downsizing, and rationalizing government inspections to reduce the number of agencies and agents with inspection powers. * Liberalizing registration and licensing procedures with the objective of reducing the costs of interaction between the public and private sectors. * Establishing a modem framework of company law and making other improvements to the legal framework. * Repealing or rescinding outdated (mostly Soviet-era) laws and regulations that clash with market economy principles. * Strengthening mechanisms of public-private consultation to improve the government's capacity to address problems faced by the private sector. 58. Other priorities of the strategy to improve the business environment include: X Deepening the financial system through policies to reduce lending risks and the costs of borrowing, encourage consolidation in the banking system, and force banks to increase their capitalization. a Accelerating development of land markets. * Improving the quality of infrastructure services, such as telecommunications, transportation, and urban water supply. * Strengthening regulatory capacity to support privately owned operators in energy and infrastructure. * Improving the transparency and technical quality of privatization processes so as to attract strategic investors into the largest state-owned companies. 59. These initiatives are very timely and it is important that the Government carry through expeditiously with implementation. Selective Interventions are needed in the Short Term to Promote New Entry and Restructuring, Especially in Skill-based and Export-oriented Sectors 60. The traditional top-down approach to restructuring has limitations in Armenia's circumstances. Outright liquidation of loss-making companies, for example, is not an attractive option, because pervasive uncertainty depresses demand even for viable assets. Establishing an efficient national system for bankruptcy and liquidation, another common top-down strategy, may be too institutionally demanding for immediate imposition in 15 Armenia. Such a system will be achieved only gradually, as the capacity of various institutions is raised. 61. Because Armenia has neither the time, nor the capability, nor the budgetary resources for full-scale institutional reform, credible reforms that create incentives and opportunities for restructuring are critical. Institutional short-cuts-in the form of restructuring agencies-can help Armenia economize on institution-building by ensuring a functional fit between country conditions and the demands of restructuring. 62. Short-cuts are also required because improvements in the business environment do not always bring an immediate investment response. The massive brain drain that Armenia is experiencing indicates that the window of opportunity for embarking on a high-growth trajectory may not remain open much longer. If the country's stock of skilled personnel drops below some critical threshold level (widely recognized though difficult to quantify), skill-based industries will be much slower to develop. Hence, the need for "bottom-up" changes in industrial policy that will build on positive (but slow) changes in firms' behavior and thus generate momentum for broader improvements. 63. Active government policies to support private sector development should aim to ensure that private sector agents will be able to capitalize on gains associated with an improving investment climate. Although public interventions can rarely jump-start positive trends in the private sector, they can accelerate and mainstream positive trends already underway. The same principle applies to restructuring and institutional change. 64. The strategy of private-sector-led growth includes policies to facilitate: - Increasing private sector employment in SMEs by reducing the costs of new entry and, even more important in the Armenia context, of staying in business and growing. * Restructuring the assets of large enterprises that were parts of value chains that no longer exist. * Selecting, as a pilot for new policy initiatives, one or two skilled-based sectors in which to develop and exploit core competencies as engines for economy- wide growth. * Designing mechanisms to ensure that the benefits of those engines spill over into the rest of the economy. * Expanding business development services to support the expansion of companies that survive the transition and contribute to local value chains. * Upgrading sectoral policies to maintain local competencies to produce needed services efficiently in sectors such as agriculture, housing, utilities, and transportation. 16 65. Nascent export-oriented clusters such as software and diamond-polishing are likely to benefit most quickly from the proposed selective interventions, creating the conditions for a broader export push that will leverage Armenian skills and assets in other sectors that have been doing relatively well over the last 4-5 years-mining, tobacco, wines, food processing, and some apparel-related activities. 66. The core of the proposed strategy of selective restructuring is support for first movers and the development clusters that emerge around them. The Armenian economy has its first movers-companies that actually take a lead in the restructuring process. Their number is small, and as a rule they remain unsophisticated, with limited potential for expansion, especially into non-CIS markets. Their very existence, however, especially in high-skill industries such as software, provides a window of economic opportunity. The government's major objective should be to design policy interventions and supporting institutions to help existing first movers to expand-and new ones to emerge-and to create linkages between first movers and the rest of the economy. 67. Sectoral studies prepared by the World Bank staff in 1999-2000 and summarized in the main report recommend specific policy reforms for individual sectors-such as energy, agriculture, telecommunication, transport, and housing-that complement the strategy presented above. The recommended sectoral interventions would support expanding opportunities for business linkages (in transport and telecommunications), reduce critical constraints for skill-based development (in telecommunications), support new labor-intensive entry (in food distribution and housing), and have a significant impact on macroeconomic and fiscal sustainability (reduced energy losses). International Aid Donors Can Advance the Growth Strategy by Supporting the Creation of "Restructuring Agencies" 68. Donors could help accelerate the restructuring process by supporting the establishment of critical restructuring organizations and encouraging government ownership of restructuring activities. Current volumes of assistance available for Armenia, appropriately reallocated, are adequate for the task. 69. With donor assistance, the government should establish several public-private organizations ("restructuring agencies") to provide public assistance to the private sector related to restructuring, export promotion, acquisition of new skills, and international networking. As a first step, three such organizations should be created: * An enterprise restructuring agency to address the restructuring problems of the largest existing companies. A similar agency in Moldova is described below. * An advisory center to provide basic technical assistance, including export promotion and training, to start-ups and to support development of local business associations and other business organizations. 17 * An investment promotion agency to represent Armenia to international investors and support expansion of emerging clusters that have proved their international competitiveness. Such an agency already has been established in Armenia, but it is still at an early stage of development. 70. The major advantage of restructuring agencies lies in the consolidation of institutional support and various public services under one roof, reducing the cost to business of institutional segmentation. Given the weaknesses of traditional market institutions in Armenia, restructuring agencies help fill the gap by packaging assistance and protecting clients from the unfriendly business environment. 71. In what appears to be a global trend, various countries have piloted hybrid organizations that specialize in supporting private sector development. The new hybrids combine to various degrees the functions of traditional consulting companies, investment promotion agencies, nongovernmental organizations, and investment banks. They may take the form of a foundation (Chile), equity seed fund (Denmark and other countries in Western Europe), business advisory center (Macedonia), or restructuring agency (Moldova). Services include traditional restructuring instruments such as management training, business incubators, seed financing, advisory and information services, matching grant schemes, and facilitation of private-to-private collaboration through business associations. Packaging such services in response to specific local needs appears to generate considerable value added. The main performance indicator for these agencies has to be linked to the number and performance of first movers in the economy. 72. By protecting first movers, these agencies may be able to trigger a more intensive restructuring process. Successfully restructured first movers become role models for the rest of the enterprise sector, and they often work with other enterprises to help mainstream their initial successes. 73. International experience shows that the activity of restructuring agencies can strengthen reform coalitions in a difficult political environment. Agencies develop new, influential networks of managers and consultants who have been involved in their programs and have a stake in reform. They raise demand for restructuring by creating a shared understanding among managers and government officials of the needs for restructuring and the value of intensive use of external consultants. 74. The experience of Moldova's Enterprise Restructuring Agency (ARIA) may be especially relevant for Armenia (Box 1). ARIA has successfully promoted enterprise restructuring by liquidating large, traditional industrial enterprises and creating a new institutional structure-the industrial park-that has stimulated spin-offs and start-ups using existing assets. The industrial park assists new entrants by providing a package of three critical services: 18 * Access to productive assets. * Advice on using the assets to take advantage of market opportunities and managerial capabilities. * Protection from administrative harassment. 75. The main report provides further recommendations for institutional design of restructuring agencies, including: * Criteria for selection of assets for restructuring. Low rents from the assets are a major criterion. * Performance-based incentives for agency staff. Compensation of project teams should be linked to restructuring outcomes and not to production of reports. * Continuous learning. Young and energetic staff are motivated by more than pay; opportunities to learn new skills and master new challenges are just as important. * Multisectoral mandate. Cross-cutting functions help an autonomous agency maximize its interaction with the rest of the government. A good example is investment promotion. Efficient investment promotion agencies deal daily with issues that overlap with the responsibilities of many other agencies, which must be convinced to change their policies and be broadly cooperative. Investment promotion agencies have two clients: potential private investors and the government at large. 76. Other steps could increase the efficiency of donor assistance for restructuring: * Consolidate and package delivery of technical assistance. Although Armenia has recently become one of the leading recipients of donor-funded technical assistance in the region, the results of numerous programs dedicated to private sector development have been much less visible than one might expect. * Introduce high-intensity assistance programs and focus them on a limited number of potential leaders (first movers) with established track records. Such programs should provide a broad package of longer-term assistance. * Widen the participation of local counterparts and strengthen incentives to support transfers of knowledge and skills to recipients. 19 * Expand support for development of local private business organizations as instruments of collective learning and private cooperation, and as major proponents of further reforms. Box 1: Moldova's Enterprise Restructuring Agency Moldova's Agency for Restructuring and Enterprise Assistance (ARIA) was created in 1995 to accelerate the adjustment of newly privatized enterprises to market conditions. It was supported by two private sector development loans from the World Bank. ARIA supports the private sector through training, policy advocacy, business support, and other services. ARIA has created industrial parks on the premises of large, nonviable, state-owned enterprises. The physical plant of the original enterprises has been reconfigured into premises that provide security, physical infrastructure, and business services for small and medium-size enterprises and other businesses emerging from the liquidation of the original enterprise. ARIA has succeeded by working with existing capital and human resources in developing an efficient solution to politically-charged issues of liquidation and restructuring. It has empowered managers, but if they did not cooperate, it has replaced them. Another important feature of the ARIA model is intensive use of domestic consultants, a practice that not only saves money but also promotes growth of the local consulting industry, which then replicates the project strategy with other enterprises. Foreign consultants are used for training and only where absolutely necessary. Data collected from firms indicate that ARIA's projects have had a substantial impact on restructuring. In 1995, the firms that later found their way to ARIA were on average worse off than other firms, both in terms of productivity and profitability. By the end of 1999, despite worsening economic conditions in Moldova, ARIA-assisted firms were more productive than their unassisted counterparts. They exported more and paid more in taxes per worker. ARIA's assistance is positively, significantly, and consistently correlated with growth in sales, exports, and productivity. Success in Nascent Export-oriented Clusters will help Attract Foreign Direct Investment to These and Other Sectors 77. Sustainable levels of job creation and economic growth in Armenia- prerequisites for social and political stability in the country-will depend to a large extent on foreign direct investment. Most of Armenia's industrial assets were created as a part of technological chains that by now have largely disappeared. The country faces a challenge of reindustrialization: Existing assets (both capital and labor) need to be restructured and upgraded so as to fit into new global and regional value chains. The necessary changes will require considerable investments, far beyond those possible from Armenia's domestic savings. Foreign investment is also a major source of new management culture, market knowledge, and technology transfer, and so can contribute to meeting Armenia's need for managerial skills. The Armenian Diaspora could partially be more important as a source of managerial expertise and an entry point to the outside world rather than a source of investment financing. 78. Annenian institutions responsible for investment promotion and investment support are still weak, even compared to other FSU states. Little effort has been made to 20 build the infrastructure needed to attract investments and support investors in the early stages of their ventures. In particular, the government has not been able to tap into the investment potential of the Armenian Diaspora and to channel the ongoing flow of Diaspora-funded humanitarian assistance into real sector investments. 79. It would be unrealistic to expect a surge in conventional foreign direct investment in the short term. With respect to investment promotion, Armenia must pass through a "preinvestment stage" of investment promotion, during which the government needs to make progress in improving the business environment and training more managers, which together would make local assets more attractive to foreign investment. Management training is critical because it would set the scene for successful cooperation between local and foreign managers-a prerequisite for conventional foreign direct investment. To be successful, management training should be closely linked with implementation of specific restructuring projects and with promotion of business linkages between local firms and the outside world. The Software Industry is a Logical Place for Private Investment to Begin 80. The strong expansion of the software sector in 1997-2000 represents one of the brightest spots in Armenia's recent industrial development. Output and exports of the country's software companies doubled each year from 1997 to 1999, to reach $15-20 million. Under favorable circumstances, the sector could produce a major spillover effect on the rest of the economy in terms of productivity and global linkages. Western companies-often owned or managed by overseas Armenians-have shown strong interest in the sector as a response to the global shortage of programmers. 81. At the moment the software sector remains small-its 1,000 employees produce about 7-8 percent of the country's merchandise exports (as officially reported). Its current pace of expansion could be undermined by inadequate telecommunication services, shortages of management skills and business development services, insufficient protection of property rights in software products, outdated software training in local universities, and the limited pool of available programmers, in addition to the general constraints that hamper private sector expansion. 82. Given the successful growth of the sector-an entirely spontaneous, market- driven process-it is logical for the government to explore ways of supporting and accelerating that expansion. The sector's potential, as well as its current constraints, make it an ideal pilot case for a strategy of private sector driven, skill-based growth aided by government interventions that are relatively short-term, nondistortionary, and replicable to other sectors of the economy. The need for a tangible demonstration effect is particularly acute in Armenia, where the most talented individuals leave the country because they have lost faith in the ability of the economy to turn around. 21 83. Key elements of the government's strategy in the software sector might include: * Implementing the policy reforms called for by the recently adopted sector master plan. * Setting up institutions such as incubators or other forms of managed industrial space for new software and e-business firms. * Improving the communications infrastructure and reducing the cost of internet communications. * Strengthening key supporting institutions and systems, including those that protect intellectual property rights and ensure contract enforcement. * Promoting spillovers from software development and demand for software products in related sectors such as publishing, engineering, and other skill- and knowledge-based services. * Facilitating intrasectoral links and private cooperation in the sector to accelerate business learning, reduce risks and costs of external expansion, and support stronger international linkages. 84. A new incubator for information technology businesses-a joint project of the government and the World Bank-will address some of the foregoing objectives using new forms of cooperation among the government, donors, the Armenian Diaspora, and the local private sector. Its main objective is to produce a demonstration of business success powerful enough to act as a catalyst and help break the vicious cycle of low expectations, low demand for institutional change, and low investment and outcomes. If successful, the main features of the project could be scaled up and replicated in other sectors. 85. The project is expected to have the following components: * Managed work space (with satellite dish) for small and medium-size companies will provide a productive business environment and infrastructure. * A business development facility will provide marketing, managerial, and other business linkages to connect Armenian firms with the Western demand for software. * A skill development fund will create programs to enhance joint industry- university skill and a continuing education process, beginning with student apprenticeships in local export-driven companies. 22