Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. P-7430-AM

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE

EXECUTIVE DIRECTORS

ONA

PROPOSED FOURTH STRUCTURAL ADJUSTMENT CREDIT

IN THE AMOUNT OF SDR 38.4 MILLION

(US$50.0 MILLION EQUIVALENT)

TO THE

REPUBLIC OF ARMENIA

April 26, 2001

This document has a restricted distribution and may be used by recipients only in the performance oftheir official duties. Its contents may not otherwise be disclosed without World Bank authorization

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CURRENCY EOUIVALENTS(Exchange Rate Effective December 31, 2000)

Currency Unit = DramDram = US$0.0018

US$1.0 = 552.18 Dram

GOVERNMENT FISCAL YEARJanuary 1 to December 31

WEIGHTS AND MEASURESMetric System

ABBREVIATIONS AND ACRONYMS

ADA Armenian Development AgencyCAS Country Assistance StrategyCBA Central Bank of ArmeniaCIS Commonwealth of Independent StatesDFID Department for International Development, U.K.EBRD European Bank for Reconstruction and DevelopmentESAF Enhanced Structural Adjustment FacilityEU European UnionEQZ Earthquake ZoneFDI Foreign Direct InvestmentFFPMC Foreign Financing Projects Management CenterFSAP Financial Sector Assessment ProgramFSU Former Soviet UnionGOA Government of ArmeniaGDP Gross Domestic ProductIAS Intemational Accounting StandardsIDA International Development AssociationIMF International Monetary FundMSS Ministry of Social SecurityMTEF Medium Term Expenditure FrameworkPRGF Poverty Reduction and Growth FacilityPRSP Poverty Reduction Strategy PaperSAC Structural Adjustment CreditSATAC Structural Adjustment Technical Assistance CreditSME Small and Medium EnterprisesSOE State-Owned EnterpriseTACIS Technical Assistance to the CIS, EU programUSAID United States Agency for International DevelopmentWTO World Trade Organization

Vice President: Johannes F. LinnCountry Director: Judy M. O'ConnorSector Director: Pradeep K. MitraTeam Leader: Lev M. Freinkman

REPUBLIC OF ARMENIA FOR OFFICIAL USE ONLY

FOURTH STRUCTURAL ADJUSTMENT CREDIT

Credit Summary

Borrower: Republic of Armenia

Amount: US$50.0 million equivalent

Terms: Standard IDA terms with a 40 year maturity, and a grace periodof 10 years

Commitment Fee: A rate of 0.75% of the undisbursed credit balance

Objectives and Description: The proposed SAC IV credit would support the Government'sefforts to facilitate private sector development and job creation,including strengthening those public institutions capable ofsustaining an investment-friendly business environment. SAC IVwould also support further deepening and consolidation ofseveral reforms in social protection, health, and education whichwere originally outlined under SAC III. As a quick-disbursingoperation, it would support the country's balance of paymentsand budgetary requirements. The proposed credit would build onthe technical assistance support provided under the Association'sSecond Structural Adjustment Technical Assistance Credit(SATAC II). The success of the proposed credit hinges uponmaintaining peace in the country and having a stable macro-economic frarnework, in agreement with the 1MF.

Benefits: The Credit would provide an opportunity to help the Governmentsustain macroeconomic stability without drastic cuts in budgetexpenditures, i.e. at much lower social costs. Longer-termnbenefits relate to acceleration of the reforn implementationprocess in key structural areas. In addition, the Bank Group'ssupport for the Government program would be an importantsignal for market participants regarding Armenia country risks.

Risks: A drastic deterioration in the macro and political environment ispossible, and may be caused by a weakening of authorities'willingness to reform in the face of popular political pressure.Among the major challenges will be improving revenueperfornance, strengthening public sector institutions, facilitatingenterprise restructuring in core manufacturing, and sustainingenergy sector reforms.

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not be otherwise disclosed withoutWorld Bank authorization.

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Schedule of Disbursements: SAC IV is proposed to be a three-tranche operation in a totalamount of US$50.0 million equivalent: two equal regulartranches of US$15.0 million each and one floating tranche Inkedto the completion of privatization of power distributioncompanies. It is expected the credit will be fully disbursedbefore the end of 2001.

Poverty Category: The proposed credit would have a social mitigation impact, as itwould support improvements in the targeting of social benetits tothe poorest groups. hi addition, the credit would supportmeasures to expand the public provision of basic health,education and housing services, improve their quality and eiisureequitable access to those services, especially by the poor.

Environment category: The project will have no direct impact on the environment.

Rate of Return: N/A

Project ID Number: AM-PE-65189

The SAC IV core preparation team comprised Lev Freinkman (ECSPE), task team leader, YuiriBoutaev (ECCAR), Marit Granheim (ECSHD), Karen Grigorian (ECCAR), Dominic Haazen(ECSHD), Susanna Hayrapetyan (ECCAR), Peter Nicholas (ECC03), Aleksandra Posarac(ECSHD), David Shahzadeyan (ECCAR), Martin Slough (ECSPF), Salman Zaheer (ECSEG).

Peer Reviewers: Kristin Hallberg (ECSPE), Xiaoqing Yu (ECSHD).

Table of Contents

I. THE ECONOMY .................................. 1

II. THE COUNTRY'S ADJUSTMENT PROGRAM ................................. 6A. Core Issues .............. 6B. Improve Business Climate, Facilitate Enterprise Restructuring and

Strategic Privatization. 8C. Reforms in Social Sectors: Inprove Efficiency in Service Delivery

and Strengthen Equity of Access ............................ 16

III. THE PROPOSED CREDIT ............................ 22A. Rationale and Objectives for Association Involvement ................... 22B. Lessons Learned ....................................... 23C. Benefits and Risks ...................................... 23D. Coordination with the IMEF ....................................... 24E. Board Conditions ....................................... 25F. Implementation ....................................... 28G. Financial Arrangements ............. ......................... 28H. Poverty hnplications ....................................... 291. Enviromnental Impact ...................................... 30

IV. RECOMMENDATION ................ 30

Annexes:

Annex 1 Main Economic Indicators

Annex 2 Letter of Development Policy

Annex 3 Policy Reforms Program Matrix

Annex 4 Timetable of Key Processing Events

Annex 5 Status of Bank Group Operations and Status of IFC Operations

Annex 6 Country at a Glance

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL DEVELOPMENT ASSOCIATION

TO THE EXECUTIVE DIRECTORSON A PROPOSED FOURTH STRUCTURAL ADJUSTMENT CREDIT

TO THE REPUBLIC OF ARMENIA

1. I submit for your approval the following Report and Recommendation on a proposedFourth Structural Adjustment Credit to the Republic of Annenia for SDR 38.4 million (US$50.0million equivalent) to support the Government's structural reform program. The credit will beon standard IDA terms, with a 40 year maturity and a grace period of 10 years.

I. THE ECONOMY

1.1 Background. Armenia's economic performance for the last several years has been mixed.In the mid 1990s, the Government was rather successful in implementing its liberalization andstabilization programs and creating strong macroeconomic prerequisites for growth. Thestabilization program, sustained since spring 1994, also helped to establish a suitable policyframework for structural reforms. The economy has been growing for the last six years at theaverage growth rate of approximately 5% of GDP. Despite considerable macroeconomicpressures in the course of 1999-2000, associated with the 1998 Russia crisis and internal politicaltensions, the Government managed to keep these macroeconomic gains mostly intact: inflationremains low (average annual rate of about 1% for 1998-2000), the exchange rate has been stableand the level of foreign reserves is quite comfortable.

1.2 Nevertheless, the Armenian public views the current outcomes of economic performancequite negatively. The population does not feel that it has gained much from economic growth,people are largely pessimistic about future economic prospects, and emigration remains high.2000 GDP still did not exceed 60% of its pre-crisis level. Poverty, unemployment, and incomeinequality remain extremely high. Recently, social pressures have been a major source of bothincreased political instability and resistance to further reforrns. Overall, it seems problematic thatthe current growth rates could be sustained both politically and economically without majorchanges in the structure of growth, which in turn would require major adjustments in economicpolicy. The primary indicators of weaknesses in the existing growth pattern are inter-related andinclude: (a) low investment rate and thus weak capacity to create new jobs; (b) low level of FDI;(c) low exports; (d) slow rates of both new entry and enterprise restructuring in coremanufacturing; (e) underdeveloped financial system; and (f) high income inequality.

1.3 Armenia's growth has to show a stronger ability for job generation. This is critical to re-establish public trust in the Government's economic strategy, regain public confidence, and stopemigration. To achieve these objectives, the Government will need to undertake a majoradditional reform effort, specifically to ensure major improvements in the business andinvestment climate. Armenia needs some refocusing of its new reform program, with moreemphasis on microeconomic issues and on institution building in several core areas. Variousreforms in social sectors, initiated in the late 1990s, also have to be continued and mainstreamed.

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At the same time, the Government has to build additional safeguards against possible backsli dingin the area of macroeconomic stabilization and ensure full recovery of its revenue performance.

1.4 With respect to its reform path, Armenia is under the Base Case Scenario outlined in theCAS presented along with this Report. Overall, considerable progress was made across theboard with demonstrated serious improvements in fiscal management, energy sector reform,social protection, primary education and development of basic legislation supportive of marketreforms. However, these and other reform benchmarks have not been achieved easily. Thereform process in 1997-2000 went through its ups and downs, was affected by politicalresistance, insufficient government capacity in several areas, and external shocks. There havybeen considerable delays in agreeing on a PRGF program to follow on from the ESAFarrangements as well as in disbursement of tranches of SAC III (IDA/R98-176 dated December1, 1998), caused by slower than agreed reform progress in a number of core sectors.

1.5 This happened due to, first, an apparent weakening of political support for reforms, %& hichat least in part relates to the fact that so far reforms have brought too few benefits to thepopulation, including the most active and educated groups of urban voters. A change in attit idetowards energy reforms and privatization was the most noticeable. Second, the government' administrative capacity to maintain the speed of the reform process was seriously affected bypolitical changes. Presidential elections in early 1998 and associated personnel changes in th eadministration caused substantial delays in implementation of the reform program and raised therisk that the reform program would slow significantly. In 1999 and early 2000, Armenia wentthrough three more changes of the Prime Minister and associated changes in various ministriz-s,which also affected the speed of reform implementation. Also, implementation of some poli ,ieswas delayed because of the insufficient technical capacity of several line ministries.

1.6 The Interim PRSP, and the recent agreements with the Government on the PRGF suggestthat the authorities are ready to re-energize their reform efforts. The Government recognizes thehigh vulnerability of the Armenian economic situation as well as a need to facilitate privateinvestment and growth as a core policy response to current economic and political weaknesses.The Government made a commitment to introduce additional necessary adjustments in itspolicies to eliminate major distortions in the business climate and strengthen its capacity forinvestment promotion. In December of 2000, the authorities set up a High Level BusinessCouncil to support such reforms through a consultative process with the investor community.The Government has also been preparing an international investment conference, supported bythe IFC, the US Trade and Development Agency, and the World Bank.

1.7 Despite a recent period of increased internal political tensions, Armenia has preserved astrong consensus among the major political factions on longer-term economic reform objecti ves.At the same time, Armenia's political elite remains less cohesive on a number of importanttactical issues (such as the timetable for privatization). Recent progress in negotiations on thestatus of Nagorno-Karabakh also provides some hope for a forthcoming final resolution of thisconflict, which would further support political stability in Armenia and the whole region.Normalization of economic relations with neighbors would bring major benefits to Armenia

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through lower investment risks, lower transportation costs, and stronger opportunities for tradeand regional cooperation.

1.8 Developments in 1998-2000. Although weakened by the Russia crisis, Armenia's overalleconomic performance was satisfactory in 1998, recording a high level of real GDP growth andlow inflation. GDP grew by 7.2% -- the highest rate since the reform program began. Theaverage inflation rate for 1998 was 8.7% -- below the level envisaged in the ESAF-supportedprogram. The 1998 budget deficit was lowered to 4.7% of GDP as a result of both improved taxcollection and a reduction in current expenditures. Major improvements occurred in the taxcollection of both imported and excisable goods. The exchange rate remained relatively stableand was backed by a sufficient level of international reserves.

1.9 However, since the summer of 1998, Armenia's performance has been affected by theRussia crisis. In contrast to several other countries in the region, the impact of the crisis hasdeveloped rather gradually. As a result, Armenia has been able to avoid both an exchange ratecrisis and acceleration in inflation rates. The spillover effects of the Russia crisis started to befelt more heavily in early 1999. The GDP growth continued but it slowed to about 4.9% for thefirst six months of 1999. Lower volumes of private transfers from Armenians living in Russialed to lower domestic demand and lower imports, which in turn caused a weakening in revenueperformance. The exchange rate depreciated by almost 7% in January 1999 despite heavyCentral Bank intervention. Interest rates for Treasury bills continued to grow and exceeded 60%in April 1999. The higher costs of deficit financing and lower tax collections were accompaniedby shortfalls in external financing. The accumulation of budget arrears and the deterioration offiscal prospects led to delays in reaching the targets agreed under the IMF ESAF program.

1.10 In consultation with the IMF in July 1999, the Government developed a fiscal package toclose the emerging fiscal gap for the rest of the year. The authorities also instituted a newarrangement for policy coordination between the Ministry of Finance and the Central Bank inorder to enhance the efficiency of government domestic borrowing. Beginning August 1999, theCentral Bank further limited its interventions in the foreign exchange market.

1.11 Throughout 1999, Armenia's reform process was seriously affected by difficult politicaldevelopments. On May 30, 1999, Armenia held its second Parliamentary elections sinceindependence. The elections saw the success of the Unity block and led to major changes in thecomposition of both the Government and Parliament's leadership. While the new Governmentreaffirmed the continuation of the previously developed reform program, personnel changes inthe administration, however, caused a temporary slow-down in the program's implementation.

1.12 By October 1999, the new Government re-established control over economicdevelopments. The reform targets agreed as a conditionality of the second tranche of SAC IIIwere fully achieved in mid September and the tranche was disbursed on September 20, 1999.The ESAF program was also fully back on track by that time. Unfortunately, almost immediatelyafter this, the country's political process was interrupted by the assassination of several leadingArmenian politicians, including the Prime Minister, Mr. Sargisyan and the speaker of Parliament,Mr. Demirchian.

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1.13 This tragic event was followed by more than six months of internal tensions betweenleading political fractions. The Government's ability to implement reforms during this periodwas severely limited. The political crisis seems to have ended in May 2000, when PresidentKacharyan appointed a new Government, led by Prime Minister Andranik Margaryan, who madea pledge for full cooperation between different branches of power. A number of key ministersfrom the previous cabinets retained their positions. The current political environment is viewedas rather supportive of the acceleration of reform.

1.14 The political uncertainties of late 1999 and early 2000 had a strong negative impact o imacroeconomic and fiscal performance. Economic growth slowed dramatically in the lastquarter of 1999. As a result, annual GDP growth in 1999 amounted to only 3.3% rather than theprojected 5.5%. Political uncertainty and related crisis of confidence affected the economythrough two main channels: drastic reduction of investment activity, including delays withfinalization of several large investment projects, and serious deterioration in both taxperformance and revenue collection of public utilities.

1.15 Growth continued to be quite weak in early 2000, but then it has accelerated since a verydepressed first quarter. For the year 2000 as a whole, the GDP growth reached 6%, despite asevere drought. Still, tax collection was 10% lower than a year ago, which was the strongestmanifestation of noticeable erosion in reform momentum. The latter resulted in a significantexpenditure squeeze and further accumulation of budget arrears. Total budget and pensionarrears increased from less than 1% of GDP in September 1999 to about 5% of GDP at the end of2000.

1.16 At the same time, political uncertainty and fiscal pressures did not result in any seriot..spressure on the currency market. The monetary policy remains under control, which helps tokeep inflation lower than projected and the exchange rate to remain comfortably stable. Thedemand for money increased, and expansion in dram broad money amounted to about 35% in1999-2000. Average yields on Treasury bills declined gradually from 58 percent in June 1999 to24% in December 2000. Still, real interest rates remain high in Armenia.

1.17 Privatization continued in 1999-2000 but at a slower pace than in previous years. Th,.Government did not finalize any major strategic privatization, which would result in bringing in aconsiderable amount of foreign investment. Still, several medium-size privatizations werecompleted successfully n 2000, including those in chemicals, electronics and diamond-polistingsectors.

1.18 Overall, despite considerable external pressures, the macroeconomic situation remainedrather stable if compared to other low-income countries in the FSU. The Government has astrong macroeconomic management team with strict monetary discipline and strong cooperal ionbetween monetary and fiscal authorities. The Government has been quite successful instrengthening expenditure management, consolidation of quasi-fiscal operations and building thecapacity of the Treasury.

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1.19 Economic Prospects. Annual GDP growth of 5% is projected for the coming decade, ifthe reform program deepens and initiatives to expand regional cooperation develop. In the earlyyears, these high levels of GDP growth are expected to result primarily from higher capacityutilization. Over the medium term, as the potential for increased capacity utilization is graduallyexhausted, investment in new capacity will play an increasing role in generating growth. Thiswill occur as private sector confidence, both domestic and foreign, responds to the improvedinvestment climate, and as the financial sector plays a more effective role in channeling savingsinto investment. Thus, the gross investment rate, estimated at 17% in 1998, is targeted to rise toabout 18.3% by 2003.

1.20 Growth is expected to be led by export demand from both traditional markets, as thoseeconomies recover, and increasingly from non-traditional markets, such as the Middle East andWestern Europe. So far, export trends have been quite volatile reflecting both the specific natureof some of Armenia's main export products (e.g. jewelry and processed diamonds), weakcapabilities of the local private sector, as well as the instability of several of Armenia's majorexport markets. Export growth of about 10% a year (in volume terms) is projected throughoutthe 2000-05 period, assuming continued improvements in both the business environment andrelations with Armenia's neighbors. Infrastructure investments designed to rehabilitateArmenia's transport and communications with neighboring countries will significantly facilitategrowth in external trade and the development of the country's transit potential. Furthermore,Armenia's highly-educated and entrepreneurial labor force is a source of its comparativeadvantage if their skills can me matched to adequate investments.

1.21 External Financing Needs and Debt-Servicing Capacity. Currently, trends in merchandiseexport represent the weakest element of Annenia's macroeconomic performance and a majorsource of macroeconomic vulnerability. The level of merchandise export declined by about 10%between 1995 and 1999, reflecting gradual erosion of traditional markets in the FSU, andcurrently it amounts to just 13% of GDP. As a result, Arnenia's trade deficit is large andamounted to 29% of GDP in 1999. While Armenia continues to benefit from the considerableinflow of remittances and private transfers (7-8% of GDP a year) and official transfers (onaverage 6% of GDP a year in 1998-2000), it still has considerable residual requirements forexternal financing. The current account deficit after official transfers is projected to average 12%of GDP over the next three years. A residual financing gap of about US$210 million is estimatedfor 2001-03. Armenia is a high recipient of external assistance: in 2001, it expects to receiveabout US$240 million (11 % of GDP) in total through a combination of official transfers andconcessional loans or about US$75 per capita (based on population estimate of 3.1 million).

1.22 External Debt. Armenia's public external debt stood at US$862 million or 45% of GDPby the end of 2000. The debt's relatively large grant element (36%) reflects the large share ofhighly concessional IDA credits and the small share of non-concessional commercial debt. Lessthan one-fourth of total nominal debts carries variable interest rates. This composition of debtprotects Armenia reasonably well against higher international interest rates or significant shifts invalue of the major international currencies. There is a moratorium on non-concessionalborrowing. Armenia has a good record of servicing its external debt. In addition, the authoritieshave been negotiating a restructuring of its largest non-concessional debts with several creditors

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(Russia, Turkmenistan, and EU), which is likely to result in further improvement of Armenia sdebt profile.

1.23 Still, in terms of net present value, external debt was estimated at end-1999 at 153% cfexport of goods and services and at 167% of fiscal revenues, meaning that while the currentoverall debt burden is modest in termns of the size of the economy, it is high relative to expecl "dexport earnings. The high debt-to-export ratio represents a constraint for improvements inArmenia's creditworthiness. The debt ratios improved somewhat in 2000, after a 15% expaniionin exports in the course of the second part of the year. The medium-tern forecast suggestsfurther gradual improvements in the debt profile over the next several years. Overall Arrneni l'sdebt should remain manageable as export performance continues to improve, but the Bank dc esnot envisage that Annenia will become creditworthy for IBRD lending during next three years.

1.24 Downside Risk Scenario. The baseline macroeconomic scenario builds on theexpectation that the maintenance of prudent macroeconomic policies within the framework o "amore market-friendly policy setting will elicit a strong private sector response on the basis ofwhich the economy can steadily expand. The alternative scenario evaluates the macroeconomicconsequences of a less favorable external environment and/or weaker response of foreigninvestors and the domestic private sector to the government's economic policies than what isprojected in the baseline scenario. In particular, export growth is assumed to be about 1/3 lowverand GDP growth is 2.4 percentage points lower. FDI and import are also somewhat lower thanin the baseline scenario. Under these assumptions, both the current account deficit and financinggaps are much higher which lead to a more rapid build-up of extemal debt. The debt profiledeteriorates considerably and core debt ratios exceed conventional thresholds of sustainability inabout 2007. The net present value of debt to exports increases throughout the projection peribd,reaching about 190 percent by 2010 and the NPV of debt-to-revenues ratio would increase to 240percent. This underlines existing problems with debt sustainability, especially its vulnerabilil y tolower non-debt financing flows, such as FDI and grant support.

II. THE COUNTRY'S ADJUSTMENT PROGRAM

A. CORE ISSUES

2.1 Both the quality and sustainability of the recent economic growth in Armenia are ofserious concern. The economic recovery so far has had quite a narrow sectoral base, was notsupported by a sufficient investment response and enterprise restructuring, and therefore did niotbring about any noticeable job creation and poverty reduction.

2.2 The Government has made adjustments in its reform strategy to ensure both moresustainable economic performance and broader distribution of gains associated with such growth.This requires a three-pronged strategy focused on: (a) enhancement of a business climate forbroad-based economic growth and employment creation; (b) continued reforms of Armenia's stillinefficient social sectors to provide equitable access to basic education and health services aswell as increase efficiency of social protection; and (c) further advancement of core structural

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reforms to consolidate recent reform gains in infrastructure, financial sector, legal framework,and several other areas.

2.3 The main challenge for the Government's strategy relates to the scale of problems to beaddressed in the area of business environment for domestic and foreign private investment. Thisrequires actions to reduce corruption and red tape, build confidence through transparentprivatization of strategic state enterprises, reduce distortions in the tax policy, reform the taxadministration to make it more transparent and less expensive for taxpayers, minimizeinterventions that provide explicit and implicit support to well-established enterprises againstnew private entry, and facilitate a more efficient system of credit mobilization and allocation. Animmediate priority is to set up a consultative mechanism between the Government and thebusiness community, which would accelerate changes in the expectations of the private sectorand facilitate reform implementation.

2.4 A more dynamic private sector will create desperately needed new jobs, and will helpprovide the tax revenues to fund vital social services and transfers, which are now often eitherunavailable or only partially available to the poor. Human capital is being steadily eroded inArmenia, and the costs of this erosion for future growth and employment generation arepotentially high. In the short term, the Government is expected to advance further reforms in thefinancing and delivery of social services to ensure more efficient use of limited public funds.According to the population survey, three of the most important issues for Armenia's problemsrelate to unemployment, social protection and preventive health-care. These public preferencesare remarkably consistent across different social groups, locations, and respondentcharacteristics.

2.5 Armenia's ranking on structural reforms is quite high for the FSU states. Over the lastseveral years, authorities have made considerable progress in strengthening supervision ofcommercial banks, pursuing financial rehabilitation of the energy sector, strengthening tax andcustoms administration, as well as the treasury system, reforming the legal and regulatoryframework for a market economy, and initiating comprehensive judicial and accounting reforms.During the next stage of reforms, the agenda has to be expanded to cover new areas such as civilservice reform and district heating, as well as to foster a new momentum in areas where recentprogress was not sufficient. More specifically, in the area of privatization and enterpriserestructuring, more attention has to be paid to the quality of privatization, with the objective ofattracting strategic investors into the largest state-owned companies. In infrastructure, financialrehabilitation in water and irrigation will be a priority. In energy and telecommunications, thefocus will be shifted to strengthening the regulatory capacity of respective govermment agenciesand establishment of the environment supportive of privately-owned operators. In the financialsector, the government's strategy will aim at financial deepening of the economy by boostingcredibility of banks and other financial institutions and reduce the scope of the informaleconomy. The detailed reform program, including timetables for the implementation of specificmeasures, is described in the attached Letter of Development Policy (Annex 2).

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B. IMPROVE BUSINESS CLIMATE, FACILITATE ENTERPRISE RESTRUCTURING AND

STRATEGIC PRIVATIZATION

2.6 The evidence from various enterprise surveys seems to be quite clear: Armenianenterprises face substantial institutional barriers for investments, restructuring, and growth.These barriers cover the entire list of traditional problems for the FSU: discretion in tax andcustom administration, corruption, administrative harassment and red tape, difficulties for newientry, weak contract enforcement, unavailability of market information and other supportingservices, etc. In addition, there are some major problems in the incentive structure at theenterprise level, where most of the recently-privatized state enterprises (SOEs), especially tho ,ein manufacturing, have been demonstrating quite a weak restructuring effort.' These formerSOEs, as in many other FSU states, have been fully controlled by incumbent managers, whosostrategy in a surprising number of cases is based on exporting the existing equipment andkeeping companies idle most of the time.

2.7 Also, the economy remains heavily undermonetized and largely operates in the informalsector. As a result, private credit is still too expensive, which constitutes an additional barrier forprivate sector expansion. Due to the regional conflict, Armenia's primary borders remain closed.This exuberates investment risks and increases transportation and communications costs.

2.8 The relative importance of the above-mentioned problems varies across sectors, but theiraccumulated impact is fully observed: it prevents businessmen from retuming from the informalto formal economy, from expanding their activity from trade and services to manufacturing ar.dexport, from more active restructuring of privatized assets, and in the case of overseas investcrs,including those from the Diaspora, from complementing humanitarian assistance by directinvestment. The basic problem could be summarized as follows: distortionary micro regulationsand administrative practices do not allow entrepreneurs to utilize potential gains associated w iththe strong macro performance and good basic legislation. Gains from macro reforms could notbe shared by micro economic agents.

2.9 Many existing weaknesses derive from the insufficient capacity of public sectorinstitutions that are responsible for improvements in investment and the business climate. Thegovernment's position with respect to its role in industrial development remains undefined.Critical government functions in this area are badly underdeveloped. These include selective andcompetitive support to enterprise restructuring through facilitating export and internationalcooperation opportunities, strengthening informational support, expanding management train: ng,and especially more active FDI promotion. Specifically, the international experience related loeffective use of FDI (including investments and expertise provided by Diaspora investors) as anengine for growth remains underutilized.

1 At the same time, the Government made much more progress with respect to strengthening budget constraintswithin the enterprise sector. Most conventional budget subsides were eliminated. Subsidization has remained onlyin implicit forms (tax and energy arrears) and by regional standards is kept at relatively low levels. For instance. thestock of tax arrears (including fines) increased from 2.4% of GDP in 1997 to 4.9% in late 1999.

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2.10 There is also ineffective communication between business and the Government. TheGovernment does not have the capacity to monitor problems faced by the private sector andaddress them without considerable delays.

2.11 Weak Government capacity is also, at least in part, responsible for the high incidence ofcorruption and red tape. According to a recent EBRD/IBRD survey, 40% of firms in Armeniaadmitted to bribing public officials frequently. They pay in bribes almost 7% of their revenues,compared to the average of 4% for 20 economies in transition. One reason why liberalizationand de-regulation did not bring expected benefits is because they have not been supported bysufficient government capacity to protect a liberal economic regime. Without such centralgovernment protection, central regulations were replaced by decentralized regulations andharassment, which could be more costly than the original ones.

2.12 The Government reform program suggests a comprehensive policy package to supportprivate sector investment and growth.

Legal and Regulatory Framework

2.13 Over the past several years, Armenia has adopted a number of laws and regulationsbuilding the infrastnrcture for a market economy, including company laws, banking laws,bankruptcy law, land law, etc. The key accomplishment was the passage of the new Civil Codewhich became effective in early 1999. The Government also adopted a Law on IntellectualProperty in 1999 and joined several international conventions on intellectual property rightsprotection. What must follow in the area of legal framework is the adoption/amendment ofseveral core commercial laws which are complementary to the Civil Code, as well as institutionalstrengthening of the regulatory authorities responsible for administration and enforcement ofthose laws. The Government priorities in the area of legal drafting include:

* appropriate amendments to the Law on Joint Stock Companies;

* a new Law on Limited Liability Companies, which would govern operations ofsmaller companies that are not able to meet requirements of the Joint Stock CompanyLaw;

* a new Concession Law and Product Sharing Law to support an inflow of foreigndirect investment (FDI), especially into the mining industry;

* a new Law on Inspections,2 which would greatly limit discretionary audits of privatebusinesses and arbitrary interventions by various Government entities. Such a newlaw would also increase the accountability of auditors;

2 Adopted on by Parliament on May 17, 2000.

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* amendments to the Law on Registration of Legal Entities to liberalize and simplifymarket entry; this should be accompanied by streamlining licensing procedures aridother actions to facilitate new entry;

* a new Administrative Code, which would set up a broad regulatory frameworkregarding the relationship between Government agencies and private business,including a transparent framework for administering penalties and fines;

* a new Procurement Law3 to support transparent system of public procurement and faircompetition; set up a Public Procurement Agency under the Ministry of Finance;

* a new Land Code to enable: (a) State-Owned Enterprises (SOEs) and privatizedcompanies to gain ownership of the land they occupy (not just permanent use rig} ts),(b) development of land markets in urban areas;

* amendments to the Law on State Property Privatization (see below);

* amendments to the Energy Law (see below);

* a new Law on Auditing Activities.

2.14 This legal drafting will be conducted in close collaboration with the donor community.According to the Government's plans, the adoption of new laws will be accompanied by steps tostrengthen the institutional capacity of various implementing agencies, including the Ministriesof Finance and Economy, Revenues, State Property Management, and Industry and Trade, th eArmenian Development Agency (ADA), and the Energy and Securities Commissions. Reformactions that would support this capacity building are described in other sections below. TheGovernment also plans to conduct a comprehensive review of business regulations with theobjective of cleaning up the regulatory framework from obsolete instructions that are notconsistent with market principles.

Institutional Capacity and Public Administration

2.15 The Government has prepared a number of steps to strengthen its capacity to supporiinvestors and exporters, especially by establishing a High Level Business Council, a primaryvenue for ongoing consultations with the business community. The GOA also intends tostrengthen the performance of the ADA with respect to its investment promotion and foreigninvestment support functions. It will also clarify functions and responsibilities of the Ministry ofIndustry and Trade and the ADA to avoid overlap and competition. In compliance with WT0requirements, the GOA plans to set up and make fully operational the National NotificationCenter.

3 Adopted on by Parliament on June 5, 2000.

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2.16 The Government intends to implement other relevant measures in the area of publicadministration with the objective of reducing the costs of interaction between the public andprivate sectors. The Government's approach suggests that at this stage, it should concentratereform efforts in a number of core areas that, from a business perspective, represent the majorobstacles (worst offenders) to investors. These include:

* Rationalization of the system of business inspections with possible downsizingand streamlining functions of various controlling Government agencies;

* Streamlining the systems of business registration and licensing;

* Reforming the system of public procurement to ensure equal opportunities to theprivate sector, including SMEs and new entry;

* Accelerating reforms in the tax and customs administration as described below;

3 Expanding the capacity for enforcing bankruptcy legislation through providingtraining to judges and fostering development of a professional cadre ofindependent bankruptcy managers;

- Strengthening capacity to provide information and advisory services to the privatesector.

2.17 The Government intends to establish a special monitoring mechanism to track actualprogress in the area of business environment based on outcome-oriented quantitative indicators.A system of regular business surveys will be introduced as the core of such a monitoringmechanism. Based on the results of a pilot survey which was undertaken in late 2000, theGovernment will develop specific quantitative targets for the reduction of Governmentinterference in business activity, which will be core monitoring indicators for the SAC IVprogram. The Government will ensure broad public access to survey outcomes.

2.18 The Government has also developed a comprehensive program for reforming itsjudiciary, with particular focus on strengthening judicial governance, re-designing courtadministration and the case management system, rehabilitating court infrastructure, improvingjudicial training and enforcement of court decisions. The Judicial Reform Project (FY01) of theIDA is the main instrument in assisting the Government to implement this program. In addition,to strengthen the effectiveness of the judiciary, the GOA, supported by bilateral and multilateraldonors, initiated certain legislative and institutional measures to reform the legal educationsystem, develop the legal profession, reform the prosecutor office, and establish alternativedispute resolution mechanisms.

2.19 This current Government program includes initial critical steps to strengthening publicinstitutions that are capable of sustaining an investment-friendly business environment.However, reforms in the above mentioned areas will take more time to complete than the

12

proposed lifespan of SAC IV. It is expected that the expansion of these reforms may besupported later under follow-up operations.

Enterprise Privatization and Restructuring

2.20 In the first part of 2001, the GOA will develop and submit to Parliament a number ofamendments to the Law on State Property Privatization, covering issues that cannot be resolv .dby Government Decrees alone. These include inter alia: (i) simplifying the conditions for theliquidation of non-viable companies and/or transfer of their assets to municipalities; (ii)establishing provisions for simplifying the resolution of tax debt issues during privatization aadliquidation; (iii) requiring the right to vote the state share to be transferred to the Ministry ofState Property Management for all enterprises, for which Government decision on privatizationhas been issued; and (iv) permitting the transfer of ownership to local communities as a meth.dof privatization, under clear procedures for transfer, and guidelines for resale of property thustransferred. Furthermore, the GOA will issue additional regulations on: (a) establishingtransparent and straightforward procedures for auctions under which all bidders must observe thesame rules and conditions; and (b) allowing uncompleted construction sites to be offered for saleunder a simple, expedited procedure.

2.21 Armenia entered the transition period with about 2,100 medium and large SOEs, of vnhichmore than 1,500 (70%) have been privatized. However, privatization of a number of largestSOEs has been delayed. In December 2000, the Government adopted a new PrivatizationProgram for the period 2001-2003. The new program provides for privatization all thoseenterprises from the previous 1998-2000 program not yet privatized. As part of the program. theGovernment established a timetable to prepare and offer before the end of 2001 for competitivesale 12 large SOEs from the list of about 75 strategic SOEs, listed in the Government Decree No.747. In addition, the Government decided to advance privatization of the national airline andinvite a private company to manage Yerevan Airport.

2.22 In April 2001, the Government concluded the international tender for privatization ofelectricity distribution companies (EDCs), which did not bring any bid. This happened largelybecause the pre-qualified bidders had been intensively engaged in bidding for power sector assetsin other countries in the region, but also due to the inability of the Government to actively at!ractbidders to Armenia earlier this year, especially given the delays during 2000 due to politicalobstacles to the privatization. The Government has re-confirmed its intention to privatize theEDCs in 2001 and will set up a new steering committee, led by the Prime Minister, to lead thepreparation of the new tender. The Government agreed to fully incorporate lessons from theearlier tender that would include making adjustments to the legal framework and ensuring thatthe corporate, financial and asset ownership issues are resolved before the next round oftendering is conducted. The completion of the sale of EDCs through a transparent andcompetitive process will be a condition of disbursement for the floating tranche of SAC IV.

2.23 In addition, by mid-2001 the Government intends to have adopted a strategy for attractingprivate investments in electricity generation, including identifying which enterprises would beoffered for sale during the 2001-03 period and the method of privatization to be followed. The

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privatization strategy will be aimed to maximize private investment to ensure that medium-termelectricity demand can be met in a reliable, efficient and least-cost manner, while also ensuringArmenia's energy security and other strategic interests.

2.24 The Government has modernized procedures for issuing land and real estate titles to bothprivatized enterprises and SOEs. This will help to reduce costs and delays in the privatizationprocess. At least 150 companies (both SOEs and privatized firms) will receive their land titlesby the end of 2001. The Government has already made considerable progress in the area of realestate registration over the last year, by strengthening the Cadastre Committee's capacity,accelerating the pace of actual registration, and removing several specific barriers to registration.In particular, the registration fee is fully waived for the registration of assets belonging to SOEsthat are in the privatization process. The Government will take additional steps to accelerateliquidation of companies that failed to be privatized (as provided by Government Decree No.752). To strengthen institutional capacity for liquidation, new procedures will be adopted forcompetitive selection of bankruptcy managers, contracting them, and providing them withcompetitive pay.

2.25 In July 2000, the GOA also developed the concept for managing the sale and lease ofpublicly-owned real estate to private entities and individuals with the objective of liberalizingaccess of the private sector to such real estate on a competitive and transparent basis.

2.26 The GOA will further support enterprise development and restructuring by undertakingsteps to improve the efficiency of labor markets. Specifically, in the course of 2001 theGovernment plans to conduct a comprehensive review and evaluation of labor regulations, andpropose changes in labor market regulations, including in the Labor Code, which would facilitatederegulation and efficiency improvements of the labor markets.

Tax and Customs Administration

2.27 The Government has developed a new tax reform concept, several key elements of whichwere already adopted by Parliament in December 2000. The concept aims at further reduction indistortions in the tax regime, streamlining tax administration, and reduction in costs of taxcompliance for private businesses. In summer 2000, the GOA completed reorganization andconsolidation of regional tax departments. The Government is also committed to upgrading boththe regulatory framework and administrative procedures that govern customs operation. TheGOA developed a new Customs Code which is fully consistent with WTO requirements. TheCode was adopted by Parliament on July 6, 2000. On March 22, 2001, the Governmentapproved a comprehensive program for customs administration reform to provide a redesign ofimport and export procedures based on increased transparency, automation, and consolidation ofrequired documentation. Other core actions of the Govermnent program include:

* Simplification of taxation of small businesses by increasing the minimum turnoverthreshold that are subject to VAT to 10 million drains annually, and by introducing asimplified sales tax for small businesses.

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* Simplification of the tax structure by: (a) eliminating most remaining tax exemptionson VAT; and (b) eliminating excise on goods with insignificant revenue yields.

* Streamlining the enforcement and administration of business taxation with a view toreduce current disincentives for enterprises to stay in the informal economy. This willentail developing a medium-term strategy for reforming tax administration focusedon: (a) functional reorganization of tax administration; (b) increased effectiveness ofinternal control; (c) improved and streamlined audit and appeals procedures; (d)strengthened performance and accountability of personnel in the Ministry of StateRevenue; and (e) improved system for off-site surveillance of tax returns, therebyreducing the incidence of arbitrary on-site inspections.

* Introduction of procedures which ensure full and timely tax refunds, including VATrefunds to exporters.

* Launch of a tax awareness campaign to "educate" owners/managers of small andmedium enterprises on tax laws, current tax structure/rates, and methods ofcalculation. Design and implement training programs on financial accounting andbookkeeping for owners/managers of SMEs.

Financial Sector and Capital Markets

2.28 The Government will continue its policy of consolidating the banking system by requiringbanks to increase their capitalization over the next few years, especially the smaller banks whoseefficiency and cost/income ratios are compromised by their small scale. Specific measuresshould include stricter definitions of what sources of capital will be accepted by the Central B.nkof Annenia (CBA) as meeting the minimum capital requirements, emphasizing cash injectionsand the retention of earnings, rather than simply the revaluation of fixed assets. The present loanclassification system used by banks and the CBA will be revised to introduce more reliance or aborrower's ability to service a loan. Valuation methodologies with respect to loans and collateralwill be strengthened and new provisioning rules will be introduced that are consistent withinternational best practices.

2.29 The Government in consultation with the CBA adopted a decision on privatization of theArmenian Savings Bank and is committed to its implementation during the first half of 2001.

2.30 In a way similar to the policy with respect to minimum capital of commercial banks, theGOA introduced a timetable for phased increases in the minimum capital requirement forArmenian insurance companies from US$100,000 to US$500,000 for insurance companies.

2.31 The GOA will implement additional steps to strengthen capital market institutions,including: (a) introduction of appropriate regulations and procedures to implement the Securiti esMarket Regulation Law; (b) boosting enforcement of regulatory standards on professional marketparticipants; and (c) consolidation of shareholder registers in the Central Depository. TheGovernment will also encourage the consolidation of the existing stock exchanges and ensure

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that a new exchange has a sound ownership and governance structure, trading rules, and code ofprofessional conducts.

Strengthening the Regulatory Framework in Energy and Infrastructure

2.32 In the energy sector, the Government introduced amendments to the legal and regulatoryframework to better support privately-owned companies. This includes modifications to theEnergy Law that provide for strengthening the financial independence of the Energy RegulatoryCommission (ERC) and eliminating inconsistencies in regulatory mandates between the ERCand the Ministry of Energy. The GOA also: (i) eliminated the Government's right to allocaterevenues during periods of less-than-full collections (elimination of Article 46 of the currentLaw); (ii) incorporated the institutional and contractual arrangements to support the functioningof the electricity market; and (iii) provided the ERC with the responsibility to regulate theelectricity market through its licensing, tariff setting, contract approval, market rules approval,and customer protection functions. The GOA is also supporting the establishment of anappropriate power market structure that would support the transition to a competitive electricitymarket.

2.33 In the telecommunications sector, a new legal regulatory framework for the establishmentand operation of an independent Regulator will be developed, which would provide for, interalia, the introduction of non-discriminatory interconnection regime, equitable universal accesspolicy, tariff re-balancing and regulation, as well as modem procedures for allocation offrequencies, numbering and rights of way.

2.34 In the water sector, a new draft Water Supply and Wastewater Law will be finalized toclarify rights and obligations of stakeholders in the sector and set up a clear and predictableregulatory framework, including for private sector providers.

Land Markets

2.35 The GOA is accelerating its land registration program by streamlining the procedures forissuing land titles to farmers and complete issuing at least 200,000 certificates of land ownership.The GOA will also facilitate development of rural land markets by: (a) modifying the valuationmethod for land plots to reduce tax obligations of land sellers; and (b) strengthening marketinfrastructure at the mars level to ensure full and timely registration of all land transactions.

2.36 A separate program for granting titles of land ownership to privatized and state-ownedenterprises will be initiated (as mentioned above).

Accounting Reforms

2.37 The Government will continue its efforts to support conversion by enterprises to theaccounting standards, which are fully consistent with the International Accounting Standards(IAS), including: (a) ultimate conversion to IAS of open joint stock companies by July 1, 2001;(b) more active conversion to IAS of SOEs, with priority given to those that are on the

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privatization list; and (c) expand accounting and reporting reforms in core public sectororganizations, including those in education (schools) and health (hospitals).

2.38 In late 2000 the Government adopted the remaining set of fully LAS-consistent accoun ingstandards and made necessary amendments to the existing standards to ensure their consistencywith the IAS. The Government will also develop and start implementation of a new nationalprogram for accounting training.

C. REFORMS IN SOCIAL SECTORS: IMPROVE EFFICIENCY IN SERVICE DELIVERY AND

STRENGTHEN EQUITY OF ACCESS

Social assistance and poverty monitoring

2.39 Poverty in Armenia is widespread. 55% of the population were classified as poor or vcrypoor based on 1998/99 household survey data In the short term, given Armenia's limited fiscalresources, efforts to strengthen the social safety net must focus primarily on making moreefficient use of available scarce funds. This requires further measures to improve targeting olpoverty benefits along with the elimination of implicit subsidies in public service provision to theprivileged (but not necessarily needy) groups. Resources released through these two measure,;could then be allocated to increase the real level of benefits delivered to more vulnerablerecipients.

2.40 The Government adopted several major reforms in social assistance in 1999. Aftersubstantial investments in preparatory work, the Government completed a major adjustment iti itssocial safety net by introducing a single vulnerability benefit targeted to needy families.Simultaneously, the level of benefits was increased. Overall budget spending on poverty benc- fitsincreased by almost 50% in 1999. However, the experience of the first two years ofimplementing the new poverty benefit and the proxy means-testing targeting mechanism reveiledseveral important problems which have to be addressed. First of all, the current coverage ofrecipients (about 30% of families) is too wide and is not fiscally sustainable on a long-term basis.Also, further improvement in targeting efficiency and effectiveness is necessary.

2.41 The Government also approved a draft Law on Social Benefits and submitted it toParliament. The draft is based on proxy means-testing as a main instrument to identify benefi 2s

recipients. The draft provides for strengthening the role of local communities in monitoringbenefits administration and introduces a developed system of checks and balances, includingprocedures for the verification of recipients' eligibility, as well as appeals procedures. Severa Ipieces of regulations were adopted to strengthen the administrative capacity for benefitsadministration, local participation, monitoring and evaluation.

2.42 The reforms in social protection in 2001 focus on further consolidating recent gains in thesystem. Priorities for the program to be supported under SAC IV include:

* Improvements in the targeting of poverty benefits and gradual reduction in thenumber of its recipients based on: (a) re-registration of all recipients of poverty

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benefits; (b) introduction of the new formula for eligibility assessment, based on theinformation received during the reapplication process and from the poverty update tobe prepared jointly by the Government and the World Bank; (c) carrying out ofbeneficiary assessment of the poverty benefit program; and (d) reduction in the budgetallocation for poverty benefits in 2001.

* Strengthening the capacity of the Ministry of Social Security (MSS) to administerpoverty benefits and monitor its impact on the poor by: (a) improving procedures forpoverty benefits administration and monitoring; (b) improving organization of theterritorial centers for social assistance; (c) establishing information managementsystems within the MSS which would include the operational database on allapplicants and recipients of poverty benefits; and (d) setting up arrangements forrolling over a 3-year budget for social protection and insurance.

* Transfer the financing of social pensions to the regular state budget.

* Prepare and carry out in the first half of 2001 the new round of household expendituresurveys. Introduce the survey into the regular statistical work program of the StateStatistical Service.

Social Insurance

2.43 In 1999, as part of the program supported by SAC III, the Government adopted severalimportant steps to reformn the social insurance system. The Government adopted thecomprehensive Pension Reform Strategy (Decree No. 734 of December 2, 1999), which wasdeveloped in consultation with the Bank. The Strategy defines tightening eligibility criteria,including the elimination/major squeeze of early retirement provisions as a priority for the firststage of pension reform implementation. The strategy also provides a plan for the introduction ofprivate, voluntary pension insurance in the medium term.

2.44 In addition, the Government implemented several specific steps to strengthen thesustainability of the existing pension system, including: (a) strengthening enforcementmechanisms for the collection of pension contributions; and (b) rationalization of paymentmechanisms for pensions. In particular, through its Decree No. 733 of December 2, 1999, theGovernment adopted the concept and timetable for implementation of personal identificationnumbers (PINs) in the social insurance system, which will be coordinated with the introductionof similar PINs for taxpayers. Strengthening enforcement was undertaken through improvementsin company registration, as well as better collection of contributions from the self-employed andfanners. Further actions were taken to rationalize the disbursement of pension benefits, includingtightening the Fund for Social Insurance's control over the payment process, computerizing thepensioner database, and carrying out more frequent, random checks of beneficiaries.

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2.45 Further reform actions in 2001 include:

* Completion of the first phase of pension reform, notably: (a) submission toParliament a new Law on State Pensions, which will inter alia eliminate earlyretirement provisions and other privileged pensions; (b) introduction of mechanisnsfor the unified and consistent implementation of regulations in the area of socialinsurance; and (c) defining the legal status of the Social Insurance Fund as a policy-implementing government agency.

* Review and cost out current special pension benefits, including those given to militarypersonnel and the judiciary; curtail new preferential pension arrangements forgovernment employees.

* Submission to Parliament the Law on Social Security Numbers to ensure inter ali 2that a unified identification code will be used by both the social securityadministration and the tax inspectorate. Launch implementation of the socialinsurance numbering system in full compliance with the law.

Education

2.46 Over the last 10 years, the Armenian education system (as well as public health) has beenbadly affected by underfinancing. Public expenditure on education is currently just over 2% ofGDP. For a country of its income level, Armenia's spending on education constitutes anextraordinarily small share of the budget (8.2% in 1999), despite some expansion over the lasttwo years. No country in the world has been able to finance free and universal/compulsorygeneral education at this level of funding. Gradual expansion of the education budget inArmenia is a priority. Another priority is to reduce excess capacity, overcome entrenchedinefficiencies in the inherited system, including massive overstaffing, and maintain equity,standards, and universal access to general education.

2.47 The Government has been quite active in promoting rationalization and reforms inprimary and secondary education. The new Law on Education was adopted by Parliament inApril 1999. The Government prepared and started a school restructuring pilot to test newmanagerial and financial arrangements in 157 schools (10% of the country's total). Allparticipating schools have: (a) school council membership selected, confirmed and registered; (b)their own bank accounts opened and operational; and (c) received specialized training and othersupport for school accountants and principals. Specific formulas for per-student school fundingwere developed and approved. The budget laws for 2000 and 2001 separate funding of pilotschools from the rest of the school system and provide sufficient allocations in support of therationalization process.

2.48 The Government's first Medium Term Expenditure Framework (MTEF), approved ir late1999, identified an increase in the education budget among the top fiscal priorities for the ne:ktthree years. The MTEF also suggests a major effort to reduce overstaffing in schools with asimultaneous increase in teachers' salaries. The Government additionally spent approximately

19

US$8 million in 2000 from privatization proceeds for emergency rehabilitation of schools. Also,a number of new schools are to be built in the Earthquake Zone (EQZ).

2.49 The policy priorities supported under SAC IV include:

* Expanding the education budget for 2001-02 based on the benchmarks set up in theMTEF. The adopted 2001 Budget Law provides for a real increase in the per studentbudget for general schools of about 9 percent. The Government will finalize a newMTEF in late 2001 to establish further targets for an expansion in education spending.

* Considerably expanding the school finance and management reform pilot programduring the school years 2000-01 and 2001-02, based on the evaluation of the programcompleted in 2000. 50 additional schools in two more education zones joined thepilot program in September 2000.

* Launching school rationalization plans in three educational zones through theconsolidation of classes and schools, the introduction of multi-grade classes, and themulti-subject specialization of teachers to ensure a significant increase in thestudent/teacher ratio over three years.

* Strengthening accountability and reporting requirements within the public schoolsystem based on the introduction of a new management information and assessmentsystem for schools, accounting standards and additional training of school principalsand accountants, school board members, and respective representatives of localgovernments.

* Forging an agreement on the concept and implementation of reforms in highereducation with special emphasis on reforms in financing which would includetargeting of higher education subsidies and the introduction of alternative fundingmechanisms for higher and technical education.

Health

2.50 The provision of health care deteriorated markedly in the last decade. Sharp reductions inbudget allocation resulted in decreased attendance by the poor at health clinics and, consequently,a fall in health standards. Additionally, health financing reforms did not bring the expected gainsin transparency and cost control. At the same time, the system suffered from major inefficienciesand over-capacity. The health sector has also accumulated a considerable sum of budgetaryarrears (more than 1. 1% of GDP in late 2000).

2.51 The Government is committed to reversing this trend, and especially to acceleraterestructuring of the existing facilities. As a first step in this direction, in June 1999, theGovernment approved its strategy for hospital restructuring. It provides for a 25% reduction incapacity over the next five years. The first group of small hospitals was closed in summer 2000

20

by Prime Minister's decision No. 532 of August 15, 2000. It resulted in an approximate 4%reduction in the total number of hospital beds.

2.52 Key elements of the sectoral reform program, which has been implemented since 200),are targeted to improving accessibility of health care for the poor, increased transparency, aniJreducing the burden of informal payments. They include:

* A new Charter of the State Health Agency which was approved on August 9, 2000and provides for higher management efficiency and budget savings.

* Further rationalization and consolidation of the hospital system will be undertakeni toprovide a proper balance between primary and hospital service. In February 2001, theGOA approved two first regional health rationalization plans. In the medium term,one-third of the hospital system has to be privatized to reduce the fiscal burden of thesystem and increase its efficiency.

* Actions will be taken to strengthen financial planning, budgeting, and accountabilityin the sector, based on the MTEF. The Government made further adjustments in iheBasic Benefit Package to make it consistent with available public financing for 2(. 01.The Government is committed to avoid running budget arrears in the sector throug.h acombination of better budget planning, stricter control and increased spending.

* The structure of the health budget will be modified to ensure an increase in the sh areof primary health care expenditures from 34% to 40% of the total in the medium term.

* New mechanism of public hospital contracting and financing will be agreed andpiloted.

Housing and Utilities

2.53 Relative to its income and urbanization level, Armenia's housing stock appearssufficiently large. However, due to major incentive problems, there are sizeable interregionawand quality mismatches between demand and supply, leading to a common perception ofcontinued housing shortages, especially in the EQZ. Currently, about 100,000 families are oll thewaiting list to be reallocated better public housing. At the same time, it is believed an evenlarger number of both privately- and publicly-owned units remain vacant. It is estimated theexisting housing stock provides an average of about 13 square meters per capita, more than 5 0%above the average of countries with a comparable GDP level.

2.54 Another immediate constraint on development of the housing sector in Armenia relatos topoor maintenance of the existing stock and its inefficient use. Deterioration of the housing siockcontinues due to lack of significant incentives to adequately maintain this asset. The lack offinancing for both repair and maintenance, the proximate cause of deterioration, is primarily :heresult of weak incentives for current homeowners. Though community and maintenance chargesare nominal, the rate of non-payment is over 80%. Some 30% of households do not pay their

21

condominium fees. A recent study estimates that the overall budget and quasi-budget subsidiesfor housing-related utility services (primarily water and district heat) account for about 1% ofGDP. Continued neglect of basic maintenance could result in destruction of some segments ofthe existing stock, and affect future claims on public funds to support emergency assistance andresettlement.

2.55 Water supply has deteriorated in most parts of Armenia, both in terms of water qualityand reliability of supply, and constitutes a major public health risk. In the heating sub-sector,less than 10% of all families continue to have access to heavily-subsidized district heat networks.These subsidies, which amount to approximately 0.5% of GDP per year, are mainly received byrelatively better-off urban households and represent the most regressive subsidy remaining in theArmenia fiscal system.

2.56 Reforms in housing and utilities have to improve the efficiency of housing assistance tothe poor and ensure sustainable financing of the available stock of housing. To ensureimprovements in this sector, the Government is currently implementing a program to:

* Modify housing assistance programs to the poor, making them less distortionary ofthe market, more affordable for the budget, and better targeted. The Governmentinitiated the housing certificate pilot in 2000, and, based on its evaluation, decided onits expansion in 2001.

* Abandon the quantitative targets for new housing construction in the EQZ with theintroduction of the housing certificate program. Restructure budget expenditure onthe housing program by switching from new construction to reinforcement of existingstructures, housing certificates, etc.

* Establish a market for housing maintenance services through the introduction of aprogram of competitive tenders, introduction of contractual regulations betweenproviders and condominiums, support for new private entry, and liberalization ofmaintenance fees. It will conduct the first tenders before the end of 2001.

2.57 In water and sewerage, the Government will continue to improve the water supply bystrengthening regulation, accounting and reporting, promoting increased investments and moreefficient management to reduce health risks and ensure the sustainability of the water companies'operations. The Government is committed to accelerating the implementation of severalrehabilitation projects, partially supported by multilateral and bilateral donors, which wouldensure reductions in both water losses and operating costs. Specifically, the Governmentsupports:

* Establishment of autonomous and self-reliant municipal/regional water andwastewater utilities.

* Gradual phase-in of full cost recovery and strengthening payment discipline in thesector.

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* Enforcement of the private management contract of the Yerevan Water Company,which became effective in June of 2000.

2.58 In district heat, the Government approved a reform action plan in mid 1999, whichsuggested a drastic reduction in subsidies and commercialization of operating companies in tlhesector. However, implementation of the plan during the two previous winter seasons was slo w,which resulted in further accumulation of arrears to gas and power providers. The Governmenthas to finalize its strategic options for longer-term development of the sector and make its choice.In the short run, additional efforts are needed to phase out Government involvement in theprovision of heat and impose a hard budget constraint on heat providers. The GOA will haveadopted a Comprehensive Heating Strategy and Action Plan, covering legal, regulatory, mart etstructure and financing issues by mid-2001.

III. THE PROPOSED CREDIT

A. RATIONALE AND OBJECTIVES FOR ASSOCIATION INVOLVEMENT

3.1 The CAS being presented to the Board alongside this Report aims at broadening grow, ththrough assisting the development of the private sector, better governance and a reversal of thedecline in human capital. The proposed SAC IV operation supports continuation of structuralreforrns initiated under SAC II and SAC Im and is a key pillar of this strategy. It will support theGovernment's efforts to facilitate private sector development and job creation, includingstrengthening of public institutions that are capable of sustaining an investment-friendly busi iessenvironment. Measures to be supported under the Credit are also essential to enhance the socialsustainability of reforms, and necessary to strengthen macroeconomic stability andcreditworthiness.

3.2 The proposed SAC IV will be the fifth Bank Group adjustment operation in Armenia Itis important for the country, which, despite major recent policy adjustments, still has limitedaccess to private capital markets and a negative savings rate. As is envisioned in the CAS,Armenia continues to require substantial support for balance of payments and for budgetaryfinancing. By providing support through a quick-disbursing operation, the Bank will help toreduce the social costs of market reforms.

3.3 The structure of the proposed Credit assumes that recent slippages in reformimplementation will be eliminated and lending under the High Case Scenario, as described iiI theCAS, would remain fully justified. SAC IV has been prepared in parallel with the preparation ofthe interim Poverty Reduction Strategy Paper (PRSP) and with the preparation of the PRGF bythe IMF.

3.4 Links Between SAC El and SAC IV Supported Programs. The distinctive feature of theprogram to be supported by SAC IV relates to its focus on improvements in the businessenvironment and general support for private sector development. In this respect, SAC IV differssignificantly from earlier programs, supported by SAC H and SAC IIl, which had much broadersectoral coverage. Re-focusing the new program seems justifiable, given the major need to

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address distortions in the PSD area, and the fact that reform progress in other areas wassubstantial.

3.5 At the same time, it is suggested to keep in the SAC IV supported program social sectorscovered in SAC II and SAC III, which are critical to the Govemment's poverty reduction strategyoutlined in the Interim PRSP. In social sectors (especially in education and social protection),reforms have been seriously advanced over the last two years at the legislative, regulatory, andpilot levels. The SAC IV supported program suggests additional emphasis on implementationand mainstreaming of the earlier initiated reforms.

B. LESSONS LEARNED

3.6 Three main lessons from earlier adjustment operations in Armenia seem to be relevant forthe preparation of SAC IV:

* The Govemment capacity for policy development and reform implementation remainsquite limited. Therefore, to be successful, the reform program should remain focusedon critical issues - e.g., worst offenders and sectors with a large potential spillover.

* Strong coordination of the program with the IMF is of critical importance regardingboth timing and substance of the operation.

* Annenia is currently at the second more advanced and more complicated stage ofreforms, where further progress requires a considerable amount of technicalassistance. Therefore, mobilization of technical assistance, funded by bilateral andmultilateral donors, is necessary to provide a critical mass of high-quality advice.

C. BENEFITS AND RISKS

3.7 Like many adjustment operations in the FSU, SAC IV is a high-risk, high-return type ofproject. As the recent experience of SAC IH suggests, the intemal political environment inArmenia remains rather unstable with relatively high risks of delays with implementation of corestructural reforms. There is a possibility of a weakening of the authorities' willingness to reform,which would derive either from internal political tensions or from populist pressures. The risksminimizing measures include: (a) a strong up-front policy conditionality; (b) the fact thatpreparation of the credit was preceded by sector work and policy dialogue, which became majortools to broaden consensus regarding a policy package and reduce risks of the operation; and (c)establishment of explicit coordination arrangements with various ongoing programs of technicalassistance, which are funded by bilateral donors and which could support capacity-building incore sectors and thus mitigate the risks.

3.8 Armenia is also a country within an unstable region. While both the conflict overNagorno-Karabakh and the internal conflicts in Georgia have eased, there is still the risk of theresumption of hostilities, which is an important issue for potential investors. Moreover, progress

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towards a final conflict resolution may remain to be slow, and Armenia will continue to pay iwrthis through inter alia higher country risks indices and higher transportation costs. Also, due toits economic structure, Armenia is still highly dependent on trade with the rest of the FSU andthus is vulnerable to external shocks.

3.9 The main benefit from the operation derives from its considerable leverage on both tk ccomposition and pace of the implementation of the reform program. SAC IV will provide amajor share of budget deficit financing and the Government remains highly sensitive to theBank's recommendations on possible modifications of reform priorities. Therefore, the credi tprovides a major opportunity to channel the GOA's reform effort into the most critical area -improvements in the business and investment climate - and ultimately to facilitate changes irinvestors' expectations and sentiments with respect to the Armenian market. In addition, theBank Group's support for the Government program would be an important signal for privateinvestors regarding Armenian country risks.

3.10 The Credit also provides an opportunity to help the government sustain macroeconon- icstability without drastic cuts in budget expenditures, i.e. at much lower social costs.

D. COORDINATION WITH TtlE IMF

3.11 A three-year Enhanced Structural Adjustment Facility (ESAF) was approved by the PAF'sBoard in February 1996. Second and third annual arrangements under the ESAF were approv edin April 1997 and December 1998, respectively. The ESAF mid-term program review, originallyscheduled for spring 1999, was not completed in time. Corrective actions were agreed with theGovernment in May 1999 and included halting interventions in foreign exchange markets, partialrepayment of a Central Bank credit to the budget, and improvement in revenue performance. TheGovern-ment also implemented a package of fiscal adjustment measures to ensure that both tl.e1999 budget and quasi-budget deficits would stay within the limits of the program. The midterm review of the ESAF program was finally completed on October 8, 1999.

3.12 An IMF mission in March 2000 began discussions with the authorities on a successorarrangement to the ESAF within the PRSP framework. The preparation of the PRGF to the IXMFBoard of Executive Directors was somewhat delayed in the course of 2000, mainly due todeteriorated tax performance and accumulation of considerable budget arrears, including thosefor salaries and pensions. However, the agreements reached between the authorities and the [MFmission in January 2001 cleared the way for a presentation of the PRGF to the Board in April of2001.

3.13 Establishing an appropriate macro-economic program and concluding an agreement (:nthe PRGF is a core condition for SAC IV Board presentation. The proposed policies under S ACIV are consistent with the package proposed under the PRGF, and complement the authorities'efforts to sustain macro stability, reduce poverty and improve quality of growth. It is alsoexpected that the new IMF-supported program would provide additional measures in the areas oftax policy, tax administration, financial sector development and fiscal management, which vwouldcomplement policies, supported by SAC IV, to establish a better business climate.

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E. BOARD CONDITIONS

3.14 Annex 3 presents the matrix of specific policy measures that the Government would haveto implement prior to release of the first, second, and floating tranches of SAC IV.

Conditions for First Tranche Release

1. The GOA announced the results of the privatization tender for power distributioncompanies.

2. The GOA submitted to Parliament amendments to the Civil Code and/or to the CivilProcedures Code, being satisfactory to the Bank, to remove inconsistencies with theBankruptcy Law. The amendments were passed by Parliament in the first reading.

3. The authorities have legally established a new high level council (the "BusinessCouncil") to promote improvements in the business and investment climate withbroad participation of local and foreign companies. The Business Council adopted anAction Plan, satisfactory to the Bank, to address the most serious administrativeconstraints to investments in Armenia, which is consistent with the recommendationsof the FIAS Report on Administrative Barriers.

4. The GOA completed agreed actions to liberalize the business environment (as part ofthe Action Plan described above), including: (a) submission to Parliament of a newdraft Law on Licensing, which provides for a simplified and more transparent systemof license administration (the Law was passed by Parliament in the first reading); (b)consolidating and downsizing controlling/auditing agencies; and (c) amending thelegal and regulatory framework that defines procedures for inspections of businessactivity.

5. The GOA adopted (by Decree No. 167 of March 9, 2001) a medium-term Action Planfor reforming tax and customs administration. This strategy is focused on improvingefficiency and reducing costs of compliance for taxpayers through: (a) functionalreorganization and computerization of district tax administration offices; (b) redesignof the customs import and export procedures to facilitate the movement of goods; (c)improving and streamlining audit and appeals procedures; (d) improving taxpayersservices; and other actions.

6. The GOA developed and submitted to Parliament a new draft Land Code, satisfactoryto the Bank, which permits the transfer of land titles to enterprises (both SOEs andprivatized companies) in order for them to become the owners of the land theyoccupy. The Code was passed by Parliament in the first reading.

26

7. The GOA strengthened the legal and regulatory framework to better support privately-owned companies in the energy sector, including through having obtained necessawyamendments to the Energy Law and Civil Code.

8. The GOA adopted a specific decision to privatize the Armenian Saving Bank, basedon the recommendations of the Diagnostic Study and Audit.

9. The GOA completed an evaluation of the first stage of the school finance andmanagement reform pilot and decided on its extension for the school year 2000-01.

10. The GOA made steps toward improving governance and budget management in thehealth sector, including: (a) adopting the new Charter for the State Health Agency; (b)introducing the new contracting system, placing a global budget on amount ofservices provided; (c) substantially reducing the list of services covered by budgetfinancing and made it consistent with the approved 2001 budget; (d) developing alndannouncing criteria on which selective contracting will be piloted in 2001.

11. The GOA initiated the following steps to ensure improvements in the targeting ofpoverty benefits and gradual reduction of the number of its recipients: (a) re-registering all recipients of poverty benefits; (b) carrying out beneficiary assessmeltof the poverty benefits program; (c) establishment a data base on poverty benefitapplicants and recipients; and (d) refraining from introducing new social benefitswhich could be fiscally unsustainable.

12. The GOA ensured an increase in public funding of education and health in 2001,including: (a) increasing the real budget for primary education; and (b) adopting atimetable for the repayment of budget debts to health providers.

13. Maintenance of an appropriate macro-economic program.

Conditionsfor Second Tranche Release

1. The GOA will have in place core pieces of legislation to improve company law ardmake it fully consistent with the Civil Code, including: a) an amended Law on JointStock Companies; b) a new Law on Limited Liability Companies; and c) improvedlegal framework for bankruptcy procedures.

2. The GOA will have demonstrated satisfactory progress with the implementation c fthe medium term Action Plan for improving the business environment and remov ngadministrative barriers for investments, which was adopted by the GovernmentDecision No. 58 of December 28, 2000.

3. The GOA will have demonstrated satisfactory progress with the implementation c fthe medium-term Action Plan for reforming tax and customs administration, whichwas adopted by the Government Decree No. 167 of March 9, 2001.

27

4. Privatization of the Armenian Saving Bank will have been completed.

5. The GOA will have adopted a strategy, satisfactory to the Bank, for the improvementof efficiency of the non-privatized sections of the power sector, includingidentification of enterprises to be offered for privatization during the calendar years2001-2003.

6. The GOA will have adopted a Comprehensive Heating Strategy and Action Plan,being satisfactory to the Bank, that cover legal, regulatory, market structure andfinancing issues.

7. The GOA will have prepared and started implementation of school rationalizationplans in three education zones through the consolidation of classes and schools,introduction of multi-grade classes, and the multi-subject specialization of teachers.

8. The GOA will have introduced further reforms in health financing, including: (a)approval of rationalization plans for hospital networks for at least two marzes; (b) noaccumulation of arrears in payments by the SHA to providers for new 2001 contracts;and (c) satisfactory progress with repayment of budget debts accumulated in calendaryears 1998-2000.

9. The GOA will have completed (a) re-registration of the poverty benefit recipients,beneficiary assessment of the assessment of the benefit, and establishment of the database on recipients, and (b) it will have introduced, starting as of July 1, 2001, the newformula for eligibility assessment, based on the information received during the re-application process.

1O. The GOA will have completed the first phase of the pension reform, to include: (a)submission to Parliament of a new Law on State Pensions, (b) introduction ofmechanisms for the unified and consistent implementation of regulations in the areaof social insurance; (c) defining the legal status of the Social Insurance Fund as apolicy-implementing government agency; and (d) submission to Parliament of a DraftLaw on the Social Security Codification System.

11. Maintenance of an appropriate macro-economic program.

Condition for Floating Tranche Release

1. The GOA will complete the sale of power distribution companies, including signing ashare transfer agreement with a winner of the privatization tender.

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F. IMPLEMENTATION

3.15 The proposed SAC IV credit would support implementation of the Government'sAdjustment Program described above. The Credit of US$50.0 million equivalent would be madeto the Republic of Armenia, as represented by the Ministry of Finance and Economy. The cre ditwould be on standard IDA terms, including a 40 year maturity and a 10 year grace period.

3.16 The credit will be released in three installments: the first on effectiveness, the second onfulfillment of the specific tranche release conditions outlined above and if general progress OIiimplementation of the LDP (including attainment of its macroeconomic stability objectives) isalso satisfactory. The floating tranche will be released after the completion of the privatization ofpower distribution companies, assuming overall progress on implementation of LDP as well is amacro framework remain satisfactory. The first tranche (US$15.0 million equivalent) will bedisbursed upon effectiveness and will be triggered by implementation of the core conditionslisted above. The second tranche (US$15.0 million equivalent) is expected to be disbursed il thethird quarter of 2001. The floating tranche (US$20.0 million equivalent) is likely to be disbu ̂ sedby the end of 2001.

3.17 Primary responsibility for coordination of the Government's actions in the preparatior.and implementation of the credit has been given to the Government Commission chaired by t'leMinister of Finance and Economy. Implementation of the SAC IV supported program will beclosely coordinated with ongoing work on preparation of the PRSP.

3.18 The program will involve several supervision missions. A set of performance indicators,agreed during negotiations, will guide the supervision and impact assessment of this operatioin.

3.19 Implementation of SAC IV supported program will be undertaken in close cooperationwith other donors, including the DFID, EBRD, TACIS, and USAID, which will provide criticaltechnical assistance necessary for the preparation and implementation of the agreed sectoralreforms. The Government's capacity for reform implementation will be further strengthened oytechnical assistance funded under the ongoing SATAC2, which focuses on measures to supportprivate sector development, as well as to reform social protection and education.

3.20 Based on the experience of SAC III, additional assistance from bilateral European donDrsto co-finance SAC IV may materialize later in 2001.

G. FINANCIAL ARRANGEMENTS

3.21 Disbursements. Disbursements under the proposed SAC IV will be to the Central Bankof Armenia (CBA), and an account of the Ministry of Finance and Economy will be establish( dat the CBA ("Deposit Account"). Upon notification by the Association of the release of eachtranche, the proceeds of the credit will be deposited by the Association in this account at therequest of the Borrower. The credit will be disbursed according to the Bank's simplifieddisbursement procedures for adjustment operations. The disbursement will not be linked tospecific purchases and there will be no procurement requirements. If after deposit in this

29

account, the proceeds of the credit are used for ineligible purposes (i.e., to finance items importedfrom non-member countries, or goods or services in the standard negative list), the Associationwill require the Borrower to either: (a) return that amount to the account for use for eligiblepurposes; or (b) refund the amount directly to the Association, in which case the Association willcancel an equivalent sum of the undisbursed amount of the credit.

3.22 The Ministry of Finance and Economy account will be credited with the dram equivalentat the official exchange rate on that day. The official exchange rate to be applied will bedetermined by the inter-bank foreign currency auction market. The Government will therebyreceive non-inflationary budgetary support. The Government intends to use the credit proceedstowards meeting its general budget expenditures, including debt service payments. The foreignexchange proceeds of the proposed SAC IV will be sold by the CBA or held in reserves, inaccordance with the objectives of monetary policy. The Ministry of Finance and Economy andthe Central Bank have in place the basic financial management systems in terms of accounting,reporting, auditing, and internal controls. The procedures used by the CBA for sales of itsforeign exchange are viewed as transparent. The CBA adopted IAS in 1996 and is audited byinternationally-recognized auditing firms. The Bank will receive an audit report from anindependent auditor after each tranche has been disbursed, certifying that the foreign exchangeproceeds were used by the CBA according to the objectives of the adopted monetary program.As the IMF intensifies its safeguards assessments, there will be consultations with the IMF, anddisbursements under the credit will be dependent upon continuing favorable assessment by theIMF.

3.23 To date, the country strategy and program have supported improvement of financialmanagement capacity, including through support to both the CBA and the Treasury underSATAC and SATAC2. The recent Armenia Institutional and Governance Review identified anumber of priorities for further strengthening budget management in the country, as well asbroader priorities for reforms in governance. The Bank is cooperating closely with the IMF toaccelerate improvements in budget expenditure control and reporting. In addition, the recentjoint FSAP mission developed a new set of recommendations to strengthen financialsustainability and transparency. The Bank also has been working with other donors (the USTreasury, DFID) which have provided additional support to the authorities to upgrade budgetmanagement and budget controls.

3.24 Accounts, Auditing, and Closing Date. The Bank will audit the Deposit Account inaccordance with Section 3.02 of the Development Credit Agreement by independent auditorsacceptable to the Bank. Audit reports should be furnished to the Bank four months after therelease of each tranche. Terms of reference for the independent auditors and financial reportswill be submitted to the Bank and discussed with the Borrower. The final tranche of the credit isexpected to be released in late 2001. The proposed closing date is March 31, 2002.

H. POVERTY IMPLICATIONS

3.25 The proposed credit would have a social mitigation impact, as it would supportimprovements in the targeting of social benefits to the poorest groups. In addition, the credit

30

would support measures to expand the public provision of basic health, education and housing'services, improve their quality and ensure equitable access to those services, especially by thepoor.

1. ENVIRONMENTAL IMPACT

3.26 The project will have no direct impact on the environment. For the purposes ofOperational Directive 4.01, it has been rated Category C, and therefore does not require anenvironmental assessment.

IV. RECOMMENDATION

4.1 I am satisfied that the proposed credit complies with the Articles of Agreement of theAssociation and I recommend that the Executive Directors approve the credit.

James D. WolfensohnPresident

By Sven Sandstr6m

Washington D.C.April 26, 2001

Annex IPage I of 2

Armenia - Key Economic Indicators

Actual Estimate ProjectedIndicator 1996 1997 1998 1999 2000 2001 2002 2003 2004

National accounts (as % of GDP)Gross domestic producta 100 100 100 100 100 100 100 100 100

Agriculture 37 32 34 29 29 28 27 26

Industry 33 33 31 33 35 36 38 39

Services 31 35 35 39 35 36 35 35

Total Consumption 112.7 118.9 114.7 109.3 110.6 108.0 103.7 100.2Gross investment 17.9 16.9 16.9 17.3 16.8 17.2 17.8 18.3

Government investment .. .. .. .. 4.1 3.8 4.0 4.0Private investment .. .. .. .. 12.7 13.4 13.8 14.3

Exports (GNFS)b 23.2 20.3 19.0 20.7 23.0 25.0 25.1 25.3 25.7Imports (GNFS) 56.0 58.3 52.8 49.8 49.9 50.6 47.9 45.8 45.4

Gross domestic savings -13 -19 -14.7 -9.3 -13 -10 -6 -2Gross national savingsC -4 -9 -5.9 .. 1 4 6 8

Memorandum itemsGross domestic product 1597 1639 1899 1847 1915 2089 2280 2489 2693(US$ million at current prices)GNP per capita (US$, Atlas method) 620 520 480 490 529 543 569 613 686

Real annual growth rates (%, calculated from 1994 prices)Gross domestic product at market prices 5.9 3.3 7.2 3.3 6.0 6.5 6.0 6.0 5.0Gross National Income 5.9 3.4 7.0 2.9 6.0 5.7 5.1 5.3 4.4

Real annual per capita growth rates (%, calculated from 1994 prices)Gross domestic product at market prices 5.5 3.0 6.9 2.9 5.7 6.2 5.7 5.7 4.7Total consumption 2.2 7.9 3.5 -0.1 6.9 3.7 1.5 2.1Private consumption 2.7 8.9 4.0 0.0 6.9 4.0 1.9 2.3

Balance of Payments (US$ millions)Exports (GNFS)b 368 330 360 383 441 522 573 630 691

Merchandise FOB 290 234 229 247 307 356 392 432 475Imports (GNFS)b 888 952 1000 919 955 1058 1092 1139 1222

Merchandise CIF 760 793 806 721 774 848 870 908 944Resource balance -520 -622 -640 -536 -514 -536 -519 -509 -531Netcurrenttransfers 185 217 177 174 187 189 197 206 216Current account balance -291 -307 -403 -307 -276 -294 -275 -261 -281

Net private foreign direct investment 18 52 221 122 122 140 140 140 150Long-term loans (net) 173 184 34 85 69 112 75 60 94Official 113 101 34 85 69 112 75 60 94Private 60 84 0 0 0 0 0 0 0

Other capital (net, incl. eors & omissions) 100 71 152 104 119 48 60 61 77Change in reservesd 0 0 -4 -5 -34 -6 0 0 -40

Memorandum itemsResource balance (% of GDP) -32.6 -38.0 -33.7 -29.0 -26.8 -25.7 -22.8 -20.4 -19.7Real annual growth rates ( YR94 prices)

Merchandise exports (FOB) .. .. .. .. .. .. ..

PrimaryManufactures .. .. .. .. .. .. ..

Merchandise imports (CIF)

(Continued)

Annex IPage 2 of 2

Armenia - Key Economic Indicators

(Continued)

Actual Estimate ProjectedIndicator 1996 1997 1998 1999 2000 2001 2002 2003 2004

Public finance (as % of GDP at market prices)eRevenues 17.6 19.7 17.1 19.3 16.3 17.2 17.6 1 ,.0 18.5Expenditures 26.3 25.7 21.9 26.5 23.4 21.2 20.2 2 .0 21.0Fiscal balance, accrual basis, deficit (-) -8.7 -6.0 -4.8 -7.2 -7.1 -4.0 -2.6 - .0 -2.5Fiscal balance, cash basis, deficit (-) -9.3 -5.9 -4.3 -5.2 -4.2 -4.6 -3.8 -1.0 -2.5Foreign financing 6.5 6.3 2.6 4.7 1.5 4.3 3.3 '.4 2.0

Monetary indicatorsM2/GDP 8.3 8.7 10.0 11.0 14.6 14.7Growth of M2 (%) 35.6 28.7 36.0 13.6 38.7 12.0Private sector credit growth -2.9 25.5 60.7 5.8 24.2 8.6Total credit growth (%) 37 -12 51 -0.8 9.0 9.5

Price indices (YR94 =100)Merchandise export price index .. .. .. .. .. ..

Merchandise import price index .. .. .. .. .. ..

Merchandise terms of trade index .. .. .. .. .. ..

Real exchange ratef 180.0 169.2 176.0 163.6 157.2 157.2 157.2 157.2 157.2

Real interest rates t 22.2 35.1 33.4 52.9 23.6 ..

Consumer price index (% change) 18.7 14.0 8.7 0.7 -0.8 4.5 3.0 3.0 3.0GDP deflator (% change) 19.6 17.7 11.2 0.1 -1.4 4.5 3.0 b.0 3.0

a. GDP at factor costb. "GNFS" denotes "goods and nonfactor services."c. Includes net unrequited transfers excluding official capital grants.d. Includes use of IMF resources.e. State budgetf An increase denotes appreciation.g. For 1996-1999: 91-day T-bill yield. For 2000 average yield of T-bills with 182-day maturity.

ID#165,From: 202-473-8787, To: World Bank, 05MRR01, 09:22, Page003of003

MIRR 05 '01 05:57PN WORLD BANK RRMENIA P.2/2

PRIME MINISTER

Dear Ms. O'Connor,

The atKached Letter of Development Policy outlines the program to strengthenprospects for sustained economic growth and poverty reduction over themedium term in the Republic of Armnenia. We request the World Bank tosupport this program with Forth Structural Adjustment Credit of US $50million.

The program of measures in the Letter is intended to accelerate economicgrowth maintaining prudent macroeconomic policy stance while continuing todeepen the comprehensive structural reforms.

Yours sincerely,

,/,G>• .of Andranik Margaryan

Ms. Judy M. O'ConnorCountry Director for ArmeniaThe World Bank

MAR 0 5 2001, - f1

Yerevan. Republic of Armenia

Annex 2 Page I of 13

Republic of Armenia

LETTER OF DEVELOPMENT POLICY

1. The main objective of the Government's economic reform program is to strengthenprospects for sustained economic growth and poverty reduction over the medium term.To this effect, the Government is committed to maintaining its prudent macroeconomicpolicy stance, while continuing to deepen the comprehensive systemic reforms alreadyunderway. The Government recognizes that strengthened public sector management,improvements in the business environment, strengthening legal framework, advancingprivatization, and improved financial discipline in public infrastructure are needed tosustain economic growth and social development. At the same time, the Government isfirmly committed to ensuring that the continued costs of transition are sociallysustainable, as well as to preserving and further developing Armenia's highly educatedand skilled workforce.

Poverty Reduction Strategy

2. The Government has embarked on a Poverty Reduction Strategy. The Strategy hasbeen developed in close consultation with civil society, all branches of the Government,donors, private sector and the media. To date a draft Interim Poverty Reduction Strategyhas been prepared, and is currently being discussed both inside and outside theGovernment. The draft has benefited from discussions at the PRSP Workshop inMoscow in October 2000, which was attended not only by central Government officialsbut also by representatives of the Armenian National Assembly, NGOs, academia, theprivate sector and the media. This Letter of Development Policy should be read againstthe background of the evolving Poverty Reduction Strategy, which provides a broaderperspective on the Government's overall strategy to reduce poverty.

Macroeconomic Stability

3. The Government's macroeconomic and structural policies aim to accelerate economicrecovery and attain average real GDP growth of at least 6 percent for 2001-03. Thegrowth is expected to be export driven, with a total export growth of more than 40percent in three years. The Government program also provides for maintaining annualinflation (on an end-period basis) below 3.5 percent, reducing current account deficit(excluding official grants) from 14.6 percent of GDP in 2000 to 10.6 percent in 2003, andkeeping the Central Bank's gross external reserves to an equivalent of 3.5 months ofimports of goods and non-factor services. These objectives will be achieved throughcontinued tight monetary policies, a significant fiscal adjustment, restrained externalborrowing, and maintaining the flexible exchange rate regime. The fiscal deficit (on anaccrual basis) is targeted to decline from more than 7 percent in 1999-2000 to 4.6 percentin 2001 and about 3 percent in 2002-03. The fiscal adjustment will be achieved through acombination of improved revenue performance (by two percentage points of GDP) andsome expenditure rationalization. The Government program also aims at furtherimprovements in Armenia's debt profile and creditworthiness: net present value of public

Annex 2 Page 2 of 13

debt is expected to decline from 153% in 1999 of exports to below 120% in 2003. TheGovernment will continue to abstain from borrowing on commercial terms.

Improvements in the Business Environment

4. Attraction of new investments, both foreign and domestic, is considered by theGovernment as a key to addressing the main growth challenges of Armenia - jobcreation, productivity growth, and export expansion. Therefore, the Governmentconsiders the removal of administrative barriers for business and investments a coreelement of its growth strategy. On December 31, 2001, the President of Armeniaestablished a new high level council (the "Business Council") to promote improvementsin the business and investment climate, with broad participation of local and foreigncompanies. The Government has also adopted a medium-term Action Plan to address themost serious administrative constraints to investments in Armenia. The Business Counci Iwill take a lead in monitoring the implementation of the Action Plan, based on anestablished set of quantitative benchmarks and through regularly undertaken enterprisesurveys of regulatory costs. The immediate priorities of the Action Plan include: (i)simplification of registration procedures; (ii) streamlining licensing procedures andreducing the scope of licensing requirements; (iii) simplification of procedures forissuing construction and site development permits, (iv) preparing a comprehensivedescription of company registration and licensing process and making them available tothe public; and (v) streamlining rules for issuing and renewal of visas and residentialpermits.

5. Based on the Law on Business Inspections, which was adopted in summer 2000,the Government plans to introduce further amendments to charters and the regulatoryframework that defines procedures for inspections of business activity. The Governmentwill develop a new legal act to make it illegal for officials from the traditionally powerfu Igovernment agencies to enter business premises without proper justification for initiatingcriminal investigation. It also plans to downsize several controlling and auditing agenciessuch as sanitary and trade inspections. In addition, the Ministry of Justice will undertakea comprehensive review of business regulations with the objective of cleaning up theregulatory framework from obsolete instructions that are not consistent with marketprinciples.

6. Another avenue to improve the business environment relates to reforms in publicadministration. The Government's focus will be on restructuring, downsizing andmodernizing the civil service, improving public expenditure management andprocurement procedures, and strengthening internal and external audits. The Governmenlwill finalize its anti-corruption strategy by the end of 2001. To support fair competition,the Government will made further progress toward a transparent system of publicprocurement. The Law on Public Procurement, adopted on June 5, 2000, will becomefully effective in the course of 2001.

7. The Government will implement actions to improve the efficiency of lawenforcement and court administration. This will be achieved through additionalinvestments in court automation and statistical systems, training of judges and court

Annex 2 Page 3 of l3

personnel, improved case management and court financing systems, and strengthening ofthe Council of Court Chairmen.

8. The Government envisions a number of steps to expand capabilities of variousGovernment agencies that are critical for market development and investment facilitation.The priority will be given to capacity building in the Armenian Development Agency(ADA), which will provide a full range of investment services and perform other coreinvestment promotion functions. With close involvement of the ADA and other relevantagencies, the Government is working on preparation of the international investmentconference that will be held in New York in May of 2001. The Conference will help tostrengthen investment image of Armenia as well as advance several specific investmentprojects.

9. The ADA will also operate as a working secretariat to the Business Council andensure wide dissemination of its decisions and implementation outcomes. In addition, theGovernment will support strengthening of the regulatory functions of the Energy andSecurities Commissions, as well as of the newly established State Competition ProtectionCommission. The Govermment will set up the Notification Center in the Ministry ofIndustry and Trade in compliance with the WTO requirements.

Reforms in Tax and Customs

10. The Government has adopted several decisions to advance its reforms of tax policy,as well as of tax and customs administration. On the policy side, a new tax reformpackage was adopted in December 2000 and it constitutes a part of this year's budget.The package provides for a considerable reduction in the nominal tax burden on theprivate sector, as well as for elimination of several remaining distortions in the taxregime. In particular, it includes: (i) simplification of taxation of small businesses; (ii)simplification and reduction in overall taxation of salaries and wages; (iii) streamliningprovisions for carryover of losses; (iv) reduction in penalty rates for tax arrears; and (v)elimination of various exemptions for value-added, profit, and income taxes. It alsoprovides for an increase in the threshold for VAT registration and payment. The previousthreshold of 3 million drams in annual sales was too low and cumbersome for the revenueadministration and the taxpayers, and it was increased to 10 million drams. In addition,collection of VAT on most imported goods will be moved to the border, which simplifiesenforcement of equal tax treatment of importers. The package also introducedconsolidated taxation of 'related parties' aimed at the limitation of opportunities for taxevasion.

11. With respect to tax administration, Government's strategy for 2001-02 assumes (i)completion of functional reorganization and computerization of district tax administrationoffices; (ii) introduction of new streamlined audit procedures; (iii) increased effectivenessof internal control in the Ministry of State Revenues; and (iv) improved administration oftax refunds, with a priority given to reshaping VAT refund procedures for exporters. Bysummer 2001, the Government will initiate a pilot that will shift responsibility forcollections of mandatory social insurance contributions to the Ministry of StateRevenues. The Government will also introduce new mechanisms to expand availability oftaxpayer services and broaden opportunities for taxpayer participation in the design,

Annex 2 Page 4 of 13

implementation of the tax administration modernization plan, and expand provision ofinformation for taxpayers.

12. On July 6, 2000, the Parliament adopted a new Customs Code that has beendeveloped in accordance with WTO requirements. As follows from Armenia'scommitment to complete the WTO admission process in 2001, the Government plans tocomplete a comprehensive modernization of the existing customs regulations by the endof 2001 and make them consistent with the requirements of the Customs Code. By March2001, the Government will adopt a new Action Plan for modernization of customsadministration, which would be aimed at completion of the adjustment of customspractices to WTO standards with special attention to the valuation and classificationprocedures, and to intellectual property right issues. This will include redesign andsimplification of existing customs import and export procedures to facilitate movementsof goods, based on increased transparency, automation, consolidation of requireddocumentation, and a switch to the selectivity technique of cargo examination. TheGovernment will also strengthen integration of the Tax and Customs branches of theMinistry of State Revenues.

Improvements in the Legal Framework

13. The Government program provides for a major modernization aimed to advance thebasic legal framework for private sector development. Drafts of several core pieces oflegislation were either completed and submitted to Parliament in late 2000 or will befinalized in the first quarter of 2001. These include:

* Law on the Registration of Legal Entities, which would simplify theregistration process and make it more transparent for investors,

* Law on Licensing, which would provide for a simplified and more transparenisystem of license administration, reduce the number of activities subject tolicensing, and establish a much stronger protection mechanism againstdiscretional revoking of licenses by the executive authorities.

14. The Government will also submit to Parliament new draft legislation to improvecompany law (Laws on Joint Stock Companies and Limited Liability Companies) andmake them fully consistent with both the Civil Code and the Securities Law. The newJoint Stock Company (JSC) Law would simplify and make more transparent proceduresfor company reorganization and thus make Armenian corporations more attractive forinvestments. At the same time, it would upgrade mechanisms for shareholder protectionin line with the international experience. The Limited Liability Companies Law would selup a simplified legal framework for smaller companies that are not covered by the JSCLaw.

15. The Government has submitted to Parliament amendments to the Civil Code toremove its current inconsistencies with the Bankruptcy Law, and expects theseamendments to become effective before April 1, 2001. At the same time, a new set ofamendments to the Bankruptcy Law will be submitted, which would streamline

Annex 2 Page 5 of l3

bankruptcy procedures and thus increase enforceability of this law. In the course of 2001,the Government will develop a new Concession Law, which will facilitate newinvestments in the mining sector, including those through product sharing arrangements.

16. By the end of 2001, based on a comprehensive review and evaluation of theexisting labor regulations, the Government will complete drafting a new Labor Code,which would facilitate deregulation and efficiency improvements of labor markets byinter alia expanding flexibility of labor contracts.

Further Advancement of Privatization

17. The Government will continue to make progress on privatization. In the first part of2001, the Government will approve and submit to Parliament a new PrivatizationProgram for the period 2001-2003. The new Program would include for privatization orliquidation all the enterprises from the previous 1998-2000 Program not yet privatizedand expand the list for privatization to include all remaining enterprises appropriate fortransfer to private ownership. Additionally, the Program would emphasize improvementin the quality of privatization with the objective of facilitating inflow of strategicinvestors in privatized companies and would remove requirements placed in priorprograms specifying sales methods for specific enterprises.

18. The Government expects to complete privatization of at least 100 large andmedium enterprises each year in 2001-2003. Most privatizations will take place throughpublic auctions and competitive tenders on a cash basis. The Government intends to sellsome strategic enterprises in mining, energy, machinery, and other sectors. By summer2001, it plans to announce an international tender for privatization of the ArmenianAirlines, while a management contract for the Yerevan airport will be offered to anexperienced international operator. The draft new privatization program also provides forcompletion of privatization of trucking companies, as well as for conclusion of "small"privatization.

19. As it determined by the Government Medium-Term Expenditure Program, theGovernment will use its privatization proceeds for financing priority projects from thepublic investment program and for improvement in the external debt servicing profile.

20. To improve the attractiveness of state companies designated for privatization andaccelerate the privatization process, the Government proposes to develop a number ofamendments to the Law on State Property Privatization and to other related laws. Theseprovide for: (i) a simplified resolution of debt issues during privatization; (ii) permitting atransfer of ownership to local communities as a method of privatization, under clearprocedures for transfer, and guidelines for resale of property thus transferred; (iii) asimplification of procedures for liquidation of non-viable companies and transfer (whenappropriate) of their assets to communities; and (iv) a transfer of the right to vote the stateshare to the Ministry of State Property Management (MSPM) for all enterprises for whichthe GOA decision on privatization has been issued.

21. With respect to land privatization, the Government will make steps to advanceprivatization of urban land and development of land markets. For this purpose, in

Annex 2 Page 6 of l3

December 2000, the Government developed and submitted to Parliament a new draftLand Code, which contains a full set of provisions that would allow a smooth transfer ofland titles to enterprises (both state-owned and privatized companies) in order for them tobecome the owners of the land they occupy. The Government expects the Code tobecome fully effective in the second quarter of 2001. As soon as the Code is adopted an.c'necessary amendments in other legislation (such as Privatization Law) are introduced, thGovernment will initiate the process of actual land transfer; it plans for at least 50 state-owned enterprises and 100 privatized companies (not counting for small firms) to receivttheir titles of land ownership before the end of 2001.

22. The Government has made a major advancement in the development of land marketinfrastructure by strengthening the capacity of the Land Cadastre Agency to support landtitling and registration of transactions with land and other real estate. The Law on TitleRegistration, adopted in April, 1999, defines the procedures and standards that govern th ̂registration system, guarantees ease of access to the database of information on propertyrights embodied in the registry, and specifies the responsibility of the state to maintainthe accuracy of the information in the registry. In early 2000, the Government introducecstreamlined procedures for issuing land titles and reduced land registration fees. Theregistration process has accelerated considerably since spring 2000. Between November2000 and May 2001, the Cadastre Agency plans to issue to individual farmers and otherowners at least 200,000 additional certificates of land ownership. Also in March 2000,the Government adopted a medium-term program of sale of publicly owned agriculturalland, which would help to improve utilization of land and facilitate development of large,commercially viable farms as well as facilitate individual housing construction anddevelopment of land markets. The Government will privatize at least 4,000 hectares ofagricultural land during 2001.

Privatization in the Energy Sector

23. In the energy sector, the Government has been making progress in implementationof the broad sector privatization strategy, adopted in December 1997. The sale ofcontrolling interest in the four power distribution companies was under intensivepreparation in the course of 2000. This privatization is governed by the speciallydeveloped Privatization Law, which was passed by Parliament in July 2000. To improvequality of privatization, the Government also: (i) contracted a reputable law firm to drafttender documents in line with international standards, and to represent the Government irnegotiations with the bidders; (ii) excluded from the list of pre-qualified bidders thecompanies that did not meet the financial and operational threshold; and (iii) adopted anew set of tender draft documents and sent them to the pre-qualified bidders. In an effortto enhance investor comfort, in November 2000, the Government and the EBRD alsoconcluded a Direct Sales Agreement under which EBRD would purchase up to 20percent of the shares in each electricity distribution company at the time of itsprivatization. According to the approved timetable, in March 2001 the Government willbe in a position to announce the winners of the privatization tender and issue an invitationto negotiate to the winning bidder. The privatization of four companies (sold in twoseparate packages) will be fully completed in April 2001, when the Government plans tosign a share transferring agreement with the winning bidder or bidders.

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24. By mid-2001, based on its experience with privatization of power distributioncompanies, the Government will develop and adopt a strategy for the non-privatized partsof the power sector, which identify enterprises to be offered for sale during the 2001-03period and the method of their privatization. The strategy would seek to attract privateinvestment while encouraging the development of a competitive electricity market inArmenia.

25. In spring of 2001, the Government and the Energy Regulation Commission (ERC)will support the establishment of an appropriate power market structure that wouldfacilitate the transition to a competitive electricity market. This will require: (i) setting uptwo new separate (from accounting and administrative viewpoint) functions within theArmenergo - Wholesale Contractor and Financial Settlements - in addition to thecompany's national dispatch functions; and (ii) designing rules for the Settlement Centerto collect and process information, calculate payment amounts and issue instructionsunder which payments would be made to members of the electricity market and theirrespective suppliers and creditors. No later than 6 months after the successfulprivatization of distribution companies, the Government and ERC will:

* appoint, through a competitive selection, a financially strong commercial bankto be the Market Funds Administrator and give it the sole authority to carryout the payment instructions issued by the Settlement Center;

• adopt new market-based dispatch rules;

* prepare a detailed schedule for developing a competitive electricity market,specifically for allowing direct contracts between large consumers anddistributors and generators/importers.

Regulatory Framework in Infrastructure

26. In the energy sector, the Government plans to further strengthen the legal andregulatory framework to better support privately owned companies, including through theintroduction of necessary amendments to the Energy Law. On December 29, 2000, theERC issued a decision, which requires Armenergo to begin contracting power from thegeneration companies in 2001 on the basis o.provisional ("pro-forma") two-part tariffs,including a fixed charge for the amount of generating capacity contracted and a variableenergy charge for actual energy purchased. Based on the 2001 experience, Armenergowill enter into legally-binding two part contracts which will come into effect by January1, 2002.

27. Additional efforts to strengthen the legal and regulatory framework in the powersector in 2001 will be focused on: (i) strengthening the financial independence of theEnergy Regulatory Commission from the budget and making its salary structure andoperating budget suitable to attract high quality staff and services; (ii) eliminating theGovernment's right to allocate revenues during periods of less-than-full collections; (iii)providing the ERC with the responsibility to regulate the electricity market through its

Annex 2 Page 8 of 13

licensing, tariff setting, contract approval, market rules approval, and customer protectionfunctions, and (iv) resolving legal issues related to rights of servitude of private andprivatized energy and other infrastructure companies.

28. Together with the ERC, the Government will prepare an action plan to bring keysafety, technical, environmental, and economic efficiency regulations, enforcementmechanisms, and institutional arrangements in the energy sector in line with appropriateinternational practices to support developments of the predominately privately-ownedpower sector.

29. In the course of 2001-02, the GOA and ERC will take all necessary measures toensure satisfactory functioning of the power sector in accordance with electricity marketrules and the revised Energy Law. In particular, the GOA will ensure timely payments t 3the electricity distribution companies from all budget organizations and budget-dependent electricity customers.

30. In the telecommunications sector, a new legal regulatory framework for theestablishment and operation of an independent regulator will be developed, which woulIprovide inter alia for the introduction of a non-discriminatory interconnection regime,tariff re-balancing and regulation, as well as modem procedures for allocation offrequencies, numbering and rights of way.

31. In the water sector, the Government signed a private management contract with th einternational operator in 2000 on managing the Yerevan Water and Sewage Company.Based on the experience with this contract, in 2001 the Government will finalize its planson switching to private management in other sector companies. In the course of 2001, tt eGovernment will also develop and submit to Parliament a new Water Sector Law, whichwould clarify rights and obligations of all stakeholders.

Enterprise Reorganization and Restructuring

32. The Government is aware that not all enterprises could be successfullyprivatized and that it is essential to ensure quick and orderly exit procedures for those thatfail to be sold. The Privatization Law specifies that if an enterprise fails to sell after threeattempts at privatization, it must be liquidated. In December 1999, the Governmentadopted Decree No. 752, which introduced a timetable for the liquidation of companiesthat had failed to be privatized previously despite being offered for sale. In the course oi2000, 18 such companies were liquidated. In the first half of 2001, the Government plansto liquidate (or complete bankruptcy procedures) of at least 20 additional companies anc.sale of as many assets as possible of such companies through transparent liquidation anctbankruptcy auctions.

33. The Government will take actions to strengthen capacity of the judicial system toresolve bankruptcy cases through (i) strengthening the relevant Department in theMinistry of Justice; (ii) systematic training of judges and bankruptcy managers; and (iii)providing necessary amendments to regulations on bankruptcy resolution. In the firsthalf of 2001, hearing of at least 20 bankruptcy cases will be fully completed and

Annex 2 Page 9 of 13

accompanied by sales of assets of bankrupt companies through transparent liquidationand bankruptcy auctions.

34. To facilitate enterprise restructuring and new private entry, the Government willtake steps to ease access of private sector entities to real estate on a competitive andtransparent basis. For this purpose, the Government will adopt a Concept for real estatemanagement and request the MSPM to issue specific instructions that define a new set ofrules for sale and leasing of publicly owned real estate. By mid-2001, the Governmentplans to make significant progress with implementation of the Concept, including (i)establishment of a comprehensive database of available real estate, and (ii) undertakingof at least 15 auctions for leasing office space in Yerevan.

35. Armenia has a rather developed legal framework for commercial lending, which isgovemed by set of banking laws and the Civil Code. However, there are still severalregulatory and institutional constraints that undermine enforcement of collateral in casesof borrower's default (foreclosure). This raises uncertainty for creditors and increasesoverall costs of borrowing. To remove these barriers, the Government will enactamendments to the regulatory framework, which would introduce new streamlinedforeclosure procedures and provide for reduced timing of foreclosure resolution.

Financial Sector and Capital Markets

36. In the course of 2000, the Government advanced the formation of the main legaland regulatory pillars for capital market development. The Law on Securities MarketRegulation (the "Securities Law") was adopted on July 6, 2000. As required by the Law,members of the Securities and Exchange Commission were appointed by the PresidentialDecree of August 10, 2000. The Government also set up a Central Depository forsecurities and approved the plan for its development. The Government has committed totransfer the shares of the Central Depository to a dully created and registered self-regulated organization of market participants by July 1, 2001. In 2001, the Governmentplans to implement further steps to strengthen capital market regulation, including: (i)introduction of appropriate regulations and procedures by the Securities Commission toimplement the Securities Law; (ii) boosting enforcement of regulatory standards on theprofessional market participants; and (iii) advance consolidation of shareholder registersin the Central Depository. While members of the existing four stock exchanges ofArmenia have decided to create a consolidated market, the Securities Commission willensure that a newly formed exchange has a sound ownership and governance structure,trading riles, and code of professional conducts.

37. Adoption of internationally accepted accounting standards (IAS) represents one ofthe key elements of the Govermment's strategy to promote accountability andtransparency in the private sector, improve corporate Governance and shareholderprotection. To that effect, in 1998-2000 the Government developed and adopted all 33IAS-consistent accounting standards and initiated conversion of the enterprise sector toIAS-consistent accounting. The Government will continue these efforts in 2001-02through: (i) ultimate conversion to the IAS-consistent standards of all open joint stockcompanies by the end of 2001; and (ii) more active conversion to IAS-based accounting

Annex2 Page 10of 13

of state-owned and commercial enterprises with priority given to the SOEs that are on theprivatization list.

38. The Government will also expand accounting and reporting reforms in core publicsector organizations, including those in education (schools), health (hospitals), and sock.1insurance (Social Insurance Fund). It will advance a comprehensive training program tofacilitate the implementation of the new accounting standards.

39. On September 13, 2000 the Government adopted a Decree No. 550, which stipulates atender privatization of the controlling interest in the Armenian Saving Bank to the strategicinvestor, based on the results of bank audit and the Diagnostic Study. Based on the adoptedtimetable, privatization of the Saving Bank, which is the only remaining state-owned bank inArmenia, will be completed by September 2001.

40. The Government program also provides for further strengthening as well as forbetter regulation and supervision of Armenian insurance companies. On November 2,2000, the Government approved a concept for development of the insurance sector andinsurance market in Armenia. The minimum size of charter capital of insurancecompanies was doubled as of January 1, 2001. The Government will establish a timetablefor additional phased increases in the minimum capital requirement for insurancecompanies, and it will ensure its implementation in 2001-03.

Strengthening Social Assistance and Insurance

41. The Government of Armenia has been paying particular attention to providingassistance to the poorest groups of the population. It is committed to the principle ofsocial equity in the distribution of social benefits, meaning that only the needy shouldreceive cash and in-kind benefits financed by the state budget. At the beginning of 1999.the Government has abandoned the categorical approach to determine eligibility forsocial protection and introduced a single proxy means-tested family benefit to protectvulnerable groups in society. Government's restructuring of the social assistance systemalso provides for a greater role for local governments, communities and NGOs in theidentification and registration of the beneficiaries, as well as in the monitoring ofprogram implementation.

42. The next stage of reforms in social protection will be focused on improvements intargeting of the poverty benefit and gradual reduction of the number of its recipients. Inthis regard, the following steps will be implemented in 2001: (i) re-registration of allrecipients of the poverty benefit by April 1, 2001; (ii) undertaking a beneficiaryassessment of the poverty benefit program; (iii) introduction as of July 1, 2001 of the newformula for eligibility assessment, based on the information received during thereapplication process; and (iv) establishing a data base on poverty benefit applicants andrecipients in the Ministry of Social Security. While the Government is committed toabstaining from the introduction of new social benefits that could be fiscallyunsustainable and providing no increase in the budget allocation for poverty benefit in2001, it will also make sure that 2001 budget allocated for family benefits is fullydisbursed.

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43. In December 1999, the Government adopted a pension reform strategy. Thestrategy provides a broader vision for the overall pension system developments, includesan assessment of the financial sustainability of the current public system, and spells outshort- and medium-term priorities of the Government. As envisioned by the Strategy, in2001 the Government will complete the first phase of the pension reform, which wouldinclude: (i) submission to Parliament of a new Law on State Pensions, which inter aliawill define the legal status of the Social Insurance Fund, eliminate early retirementprovisions and other privileged pensions, provide for unified regulation of publicpensions (no public pension entitlements could be granted by other laws), and introducemechanisms for unified and consistent implementation of regulations in the area of socialinsurance; (ii) submission to Parliament of a Draft Law on the Social SecurityCodification System (PINs -- Personal Identification Numbers); and (iii) implementingthe first phase of establishing the Information Management Center for PINs. TheGovernment will develop and submit amendments to the Charter and other regulations onthe Social Insurance Fund to make its budget a subject of approval by Parliament.

Restructuring in Primary and Secondary Education

44. The Government recognizes that preserving Armenia's highly educated labor forceis a key to the country's future economic growth. To this end, over the last several years,the Govermment initiated a process of increasing the proportion of financing for generaleducation within the state budget, developed a new textbook strategy to improveproduction and distribution of textbooks and reduce costs to parents, and upgradedmanagement systems in the Ministry of Education and Science. The Governmentprovided for another increase in public funding of general education in 2001: the Law on2001 Budget includes a real increase in the per student budget for general schools ofmore than 9 percent.

45. The Government is aware that revising the financing mechanism for education iscrucial to improving incentives and increasing the overall quality and efficiency of thesystem. In September 1999, the Government initiated a phased transition to the newfinancing mechanism by launching a school finance and management reform pilot thatcovers 154 schools (about 10 percent of Armenia's schools) in three educational zones. Itprovides for piloting of decentralization in school management, new school status, andfunding mechanism that is based on the per pupil financing formula. In June 2000 theMinistry of Education and Science completed an evaluation of the first stage of theschool pilot and decided on its extension for the school year 2000/01. About 50additional schools in two more education zones joined the pilot in September 2000.

46. The next step in rationalization of the school system will provide for consolidationand rationalization of schools in line with the current demographic and economic trends.The Government prepared and will start implementation of school rationalization plans in2 education zones to facilitate consolidation of classes and/or schools, introduction ofmulti-grade classes, and multi-subject specialization of teachers. The plans would haveenvisioned a substantial increase in the current student/teacher ratio, which is fiscallynon-sustainable.

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47. The Government will also approve a national system for pupil assessment andmonitoring of standards in general education.

Restructuring in the Health Sector

48. The Government is committed to improving access to and quality of health carewithin the framework of the overall economic reform program. In 1999 and 2000, theGovernment has taken significant steps towards this goal. In particular, the Governmentadopted a new Charter for the State Health Agency (SHA) to facilitate improvements ingovernance and accountability of the SHA. Significant progress was made instrengthening capacity of the SHA and in developing its operating procedures. In June of2000, a new contracting system for hospitals was introduced that places a global budgeton amount of services provided. Also about 50 small rural hospitals were closed in 2000to initiate a decline in total hospital bed capacity as part of the sectoral rationalizationstrategy.

49. In 2001, the Government will reduce a number of hospitals that receive budgetfunding under the contracts with the SHA. In the first quarter of 2001,the Ministry ofHealth will develop and announce criteria on which such selective contracting will bepiloted for a limited number of hospitals and/or services.

50. Since 1997, the budget for health care follows a program budgeting approach basedon a minimum basic benefit package of services (BBP) entirely financed by the state.The BBP was revised for 1999 by changing the structure of the package to ensure itsconsistency with available funding and better reflect actual costs of service provision.The content of the BBP has been improved to address the main burden of disease, as wellas health conditions, which have a strong social impact. As a part of the 2001 budgetpreparation, the Government has approved a further reduction in the list of servicescovered by the BBP to make it consistent with the available sectoral budget.

51. In 2001, the Government will further advance reforms in health financing,governance and budget management. It will prepare, approve and start implementation ofrationalization plans for hospital networks for at least 2 marzes.

52. In May 2001, the Government will conclude verification of budget debts to healthproviders, accumulated in 1998-2000, and establish a transparent framework for theirgradual clearance. The Government will start repaying these debts according to thisschedule and is committed to accumulation of no arrears in payments to health providersfor new 2001 contracts.

Housing and Utilities

53. The Government considers sustainable developments in the housing and utilitysector may provide a major contribution to national savings, investments and growth.Improvements in housing conditions, especially in the Earthquake Zone, will also becritical for recovery of public trust in Government policies as well as have importanthealth and environmental spillover effects.

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54. In summer 2000, the Government launched a housing certificate pilot, whichsuccessfully tested an alternative approach for housing assistance to victims of the 1988earthquake. Based on this experience, the Government has decided on undertaking in2001-02 a larger housing certificate program that will allow accelerate a resolution ofhousing shortages, based on the better use of the existing housing stock and withoutcreating excessive budget pressures. Based on its experience with the pilot, theGovernment will also modify public programs of housing assistance to the poor bymaking these programs less market distortionary, more affordable for the budget, andbetter targeted.

55. The Government is committed to developing and adopting a ComprehensiveHeating Strategy and Action Plan by October 31, 2001. The strategy will cover issuesrelated to sectoral development, including its legal, regulatory, market structure, andfinancing aspects, as well as mechanisms for providing budget support to vulnerablehouseholds. It will also define the roles of Republican and municipal governments as theyrelate to financing, ownership, and regulation of the sector. The Government plans tophase out its involvement in the provision of heat and impose a hard budget constraint onpublicly owned heat providers. It will further reduce budget subsidies to heatingcompanies in the 2000-01 winter.

Annex 3Armenia SAC4: Policy Reforms Program Matrix

Tranche release conditions are in BOLD.

Sectoral areas Board Presentation - Spring 2001 2d tranche - 3r quarter of 20011. Maintenance of Satisfactory macroeconomic performance. Satisfactory macroeconomic performance.sustainablemacroeconomicframework2. Power Sector Announcement of the results of the privatization tender for Condition of the floating tranche: Completion of the sale of powerPrivatization power distribution companies. distribution companies: signing of a share transferring agreement

with a strategic investor or investors.

3. Business 1. The GOA will have submitted to Parliament several core 1. The GOA will have in place legislation to improve company lawclimate: pieces of business legislation, which would take into account and make it fully consistent with the Civil Code, including:Improvements in the recommendations of the IBRD/IFC and other donors. These a) an amended Law on Joint Stock Companies;the legal would include: b) a new Law on Limited Liability Companies; andframework a) Procurement Law; c) improved legal framework for bankruptcy procedures.

b) amendments to the Law on Trademarks; andc) Law on the Registration of Legal Entities. 2. The GOA will have enacted amendments to the regulatory

framework to remove existing barriers for enforcement of the existing2. The GOA will have submitted to Parliament amendments legislation on collateral (foreclosure), including (i) a submission of theto the Civil Code and/or to the Civil Procedures Code to Law on Public Auctions, (ii) amendments to the laws related to theremove inconsistencies with the Bankruptcy Law. enforcement of court decisions, and (iii) provisions that accelerate

resolution of collateral disputes by courts.

3. The GOA will have implemented actions to improve the efficiency ofcourt administration with respect to managing civil cases bystrengthening of the Court Administrative Office, improving casemanagement and court financing systems, additional investments incourt automation and statistical systems, training of judges and courtpersonnel.

4. Business The GOA will have completed agreed actions to liberalize 1. The GOA will have implemented Further actions on businessclimate: the business environment (as part of the Action Plan liberalization per the approved Action Plan, including but notliberalization described below), including but not limited to: limited to:

a) submission to Parliament of a new draft Law on Licensing, a) Introducing amendments to a charter and streamline the regulatorywhich would provide for a simplified and more transparent framework of Sanitary and Fire state inspections to limit theirsystem of license administration. opportunities for discretionary interventions into business activities; b)b) downsizing controlling/auditing agencies; and Redesign procedures for obtaining construction and site developmentc) amending the legal and regulatory framework that defines permits; c) Developing suggestions on further downsizing of variousprocedures for inspections of business activity. state inspections; d) Introduce steps to support public access to the

2regulatory information; and e) Simplify the process and introduce moretransparent regulations for issuing visas and residential permits forforeigners.

2. To support fair competition, the GOA would have made furtherprogress toward a transparent system of public procurement.

3. The Ministry of Justice will have completed a comprehensive reviewof business regulations, adopted before 1/1/96, with the objective toclean up the regulatory framework from obsolete instructions that arenot consistent with market principles.

5. Business 1. The authorities will have established a new high level The ADA, on behalf of the Business Council, will produce periodicclimate: building council (the "Business Council") to promote improvements Evaluation Reports to monitor progress in removing administrativepublic-private in the business and investment climate with broad barriers to business and reducing regulatory costs against the establishedpartnership and participation of local and foreign companies. The Business benchmarks.monitoring Council will have adopted an Action Plan to address themechanisms most serious administrative constraints to investments in

Armenia, which would be consistent with therecommendations of the FIAS Report on AdministrativeBarriers.

2. The Council would establish a set of quantitative benchmarksfor further reforms based on a specially undertaken enterprisesurvey of regulatory costs.

3. The Armenian Development Agency (ADA) will operate as aworking secretariat to the Business Council. The ADA willdevelop operational procedures for the Council and ensure widedissemination of its deliberations as well as of progress made toremove the constraints.

6. Tax and 1. The GOA will have adopted a medium term Action Plan, The GOA will have demonstrated satisfactory progress with thecustoms satisfactory to the Bank, for reforming tax and custom implementation of the medium term Action Plan for reforming taxadministration administration, based on the recommendations from the and custom administration to ensure:

IMF/IBRD and other donors, with clearly defined a) improvements in quality of taxpayer services and simplification ofresponsibilities for its implementation. This strategy would be tax/custom procedures and documentation;focused on: b) stronger integration of the Tax and Customs branches of the Ministry") .Ionai i-ui-IIaiizatic i.IdtI a v

administration offices; c) completion of the functional organization/informatization of allb) redesign of the Custom import and export procedures to district tax offices;

3 _____facilitate movements of goods based on increased transparency, d) initiating of the pilot, which would shift responsibility for payroll taxautomation, consolidation of required documentation, switch to collections to the Ministry of Revenues;selectivity technique in cargo examination, etc.; e) efficiency of a consultative mechanism between the Revenuec) improving and streamlining audit and appeal procedures; Ministry and taxpayers regarding both current administrative practicesd) improving taxpayers services; and modernization plans;e) developing mechanisms of taxpayers participation in the f) successful adjustment of customs practices to WTO standards,design and implementation of the modernization plans; and with special attention to the valuation and classification procedures, andf) simplifying taxation of small businesses. to intellectual property right issues.

2. By the time of the Board the GOA would provide:a) effective piloting of the second phase of the informationmanagement strategy;b) creation of a credible mechanism to exchange views betweentaxpayers and the Revenue Ministry;c) expanded provision of information to taxpayers; andd) improved administration of VAT refund; give a priority to aresolution of problems with VAT refund for exporters.

7. Legal and 1. The GOA will have approved and submitted to Parliament a 1. The GOA will demonstrate satisfactory progress with theregulatory new Privatization Program for the period 2001-2003. The new implementation of the new Privatization Program against the agreedframework for Program would include for privatization or liquidation all those benchmarks, including completion of privatization of at least 100 largeprivatization enterprises from the previous 1998-2000 Program not yet and medium enterprises each year in 2001-2003.

privatized and expand the list for privatization to include allremaining enterprises appropriate for transfer to private 2. The GOA will have developed and submitted to Parliament aownership. The Program also would make an emphasis on Concession Law to include a chapter relating to product sharing.improvement in quality of privatization with the objective offacilitating inflow of strategic investors in privatized companies 3. The GOA will have developed and submitted to Parliament a Law onand would remove requirements placed in prior programs Privatization of Municipal Property.specifying sales methods for specific enterprises.

2. The GOA will have developed and submnitted to Parliament anumber of amendments to the Law on State PropertyPrivatization and to the related laws, covering a number of itemswhich cannot be resolved by Government Decrees alone. Theseinclude: (i) simplifying the procedures for liquidation of non-viable companies and/or transfer to communities of assets ofsuch companies; (ii) providing for simplifying the resolution ofdebt issues during privatization; (iii) requiring the right to votethe state share to be transferred to the MSPM for all enterprises,for which the GOA decision on privatization has been issued(per Decree No. 747); and (iv) permitting transfer of ownership

4

to local communities as a method of privatization, under clearprocedures for transfer, and guidelines for resale of propertythus transferred.

8. Enterprise The GOA will have made satisfactory progress with the The Government will have established a sufficient capacity to resolverestructuring and implementation of Government Decree No. 752 and PM Order bankruptcy cases through strengthening a respective department in theliquidations No. 756, which introduced a timetable for the liquidation of Ministry of Justice; systematic training of judges and bankruptcy

companies that had failed to be privatized previously despite managers; and providing amendments to regulations on bankruptcybeing offered for sale. Such progress will include the resolution. Al least 25 bankruptcy cases will have fully completed andliquidation (or completion of bankruptcy procedures) of at least accompanied by sales of assets of such companies through transparent20 companies that failed to be privatized and actual sales of as liquidation and bankruptcy auctions.many assets as possible of such companies through transparentliquidation and bankruptcy auctions.

9. Real estate The GOA will have developed and approved a concept for Satisfactory progress with the implementation of the concept will havemanaging the sale and leasing of publicly-owned real estate to achieved:private entities and individuals with the objective of liberalizing a) a comprehensive database of available real estate will have beenaccess of the private sector to such real estate on a competitive established and it will have transparent rules for public access;and transparent basis. b) at least 15 auctions for leasing office space in Yerevan would be

conducted; andc) budget revenues from such leases would increase and transparentsystem of reporting on such revenues would be put in place.

10. Land 1. The GOA will have developed and submitted to 1. The GOA will have ensured effectiveness of a new legislation,privatization and Parliament a new Land Code that would allow transferring which governs transfer of the urban land to enterprises than occupy thisland markets land titles to enterprises (both SOEs and privatized land.

companies) in order for them to become the owners of theland they occupy. 2. The GOA will have ensured that at least 50 SOEs and 100 privatized

companies (not counting for small firms) have received their titles of2. The GOA will have introduced streamlined procedures for land ownership.issuing land titles to farmers and other landholders and issued atleast 200,000 certificates of land ownership. 3. The GOA will reduce requirements to minimum land prices to bust

demand for land to be sold out through public auctions. It will allow adiscount up to 75% of current cadastre valuation compared to theexisting maximum discount of 30%.

11. Regulatory 1. The GOA will have strengthened the legal and regulatory 1. The GOA will have adopted a strategy for the improvement inframework in framework to better support privately owned companies in efficiency of the non-privatized sections of the power sector,infrastructure the energy sector by having secured their rights of servitude, including identification of enterprises be offered for sale during the

and by having obtained necessary amendments to the 2001-03 period and the method of privatization to be followed. TheEnergy Law. Amongst other provisions, the Energy Law strategy would be aimed to maximize private investment to ensureand the GOA would have: (i) increased the financial that medium-term electricity demand can be met in a reliable,

5

independence of the Energy Regulatory Commission (ERC) efficient and least-cost manner, while also ensuring Armenia'sand made its salary structure and operating budget suitable energy security and other strategic interests.to attract high quality staff and services; (ii) eliminated theGovernment's right to allocate revenues during the periods 2. Together w-ith the ERC, the GOA wiil havc prepared an action plan toof less-than-full collections (elimination of article 46 of the bring key safety, technical, and environmental standards andcurrent Law); (iii) empowered the ERC to approve market regulations, and their enforcement and institutional arrangements, in linerules and institutional and contractual arrangements to with appropriate intemational practices to support a predominantlysupport the functioning of the electricity market; and (iv) privately-owned and operated energy sector.provided the ERC with the responsibility to regulate theelectricity market. 3. The GOA and ERC will support the establishment of an appropriate

2. The GOA will have developed and submit amendments power market structure that would facilitate the transition to ato the Civil Code to resolve the issues related to rights of competitive electricity market. This will require: (i) adopting rules forservitude of privatized enterprises in the energy and other the Financial Settlement Center to collect and process inforrnation,infrastructure sectors. calculate payment amounts and issue instructions under which payments

would be made to members of the electricity market and their respective

3. In support of establishing of an appropriate power market, the suppliers and creditors; (ii) Annenergo to have contracted powerGOA will have approved the restructuring of Armenergo to generation capacity and energy for 2001 on the basis of provisionalcreate three distinct functions: contracting, financial settlement, ("pro-forma") two-part tariffs, and based on its capacity/energy demandand national dispatch. forecast for 2001 and on principles of least-cost dispatch. The two-part

tariffs would be used by Armenergo to enter into legally bindingcontracts for 2002.

4. The GOA and ERC would have made satisfactory progress to:(i) appoint, through a competitive selection, a financially strongcommercial bank to be the Market Funds Administrator and give it thesole authority to carry out the payment instructions issued by theSettlement Center; (ii) adopt market-based dispatch rules; and(iii) prepare a detailed schedule for developing a competitive electricitymarket, specifically for allowing direct contracts between largeconsumers and distributors and generators/importers.

5. The GOA would have ensured timely payments to the electricitydistribution companies from all budget organizations and budget-dependent electricity customers.

6. In the telecommunications sector, a new legal regulatory frameworkfor establishment and operation of an independent Regulator would bedeveloped, which would provide for, inter alia, the introduction of non-discriminatory interconnection regime, equitable universal access

___________________________________________ policy, tariff re-balancing and regulation, as well as modem procedures

6for allocation of frequencies, numbering and rights of way.

7. The GOA will have deveioped and submit to Parliament a new WaterSector Law, which would clarify rights and obligations of allstakeholders.

12. Financial 1. The GOA will have adopted a Decree to privatize the 1. Privatization Tender for the Armenian Saving Bank will haveSector and Capital Armenian Saving Bank, based on the recommendations of been completed and a winner will be announced.Markets the Diagnostic Study and Audit.

2. The GOA would implement steps to strengthen capital market2. The GOA would have introduced a timetable for phased institutions and regulations, including: (i) introduction of appropriateincreases in the minimum capital requirement for Armenian regulations and procedures to implement the Securities Marketinsurance companies. Regulation Law; (ii) boosting enforcement of regulatory standards on

the professional market participants; and (iii) consolidation ofshareholder registers in the Central Depository. The Government willalso encourage the consolidation of the existing stock exchanges andensure that a new exchange has a sound ownership and governancestructure, trading rules, and code of professional conducts.

13. Accounting The GOA will have completed development and adoption of The Government would continue its efforts to support conversion byremaining accounting IAS-consistent standards. enterprises to the accounting standards, which are fully consistent with

the International Accounting Standards (LAS), including: (a) ultimateconversion to IAS of all open joint stock companies by in the year 2001;(b) more active conversion to IAS of SOEs, with priority given to thosethat are on the privatization list; initiate conversion to IAS for at least100 SOEs; and (c) expand accounting and reporting reforms in corepublic sector organizations, including those in education (schools),health (hospitals), and social insurance (Fund for Social Insurance).

14. WTO The GOA will have:accession a) developed and submitted to Parliament a draft Customs Code

to make it fully consistent with WTO requirements; andb) adopted other regulations, which are necessary forcompletion of the WTO admission process, as required by thePrime Minister's Resolution No. 606 of September 23, 1999.

15. Housing and 1. The Government will have launched the housing certificate 1. Based on the evaluation of the pilot, the GOA will have modifiedutilities pilot in 2000, which would be closely monitored and expanded public programs of housing assistance to the poor by making these

as warranted. programs less market distortionary, more affordable for the budget, andbetter targeted.

2. The Government will have resolved administrative problems,which delay preparation ot the Heating Strategy, including: a) 2. The Government will have make progress in reforming theappointing a project manager; b) opening a special account; and district heating sector to ensure phasing out Governmentc) adopting an action plan for preparation of the Strategy. involvement in the provision of heat and impose a hard budget

constraint on heat providers. The GOA will have adopted aComprehensive Heating Strategy and Action Plan, covering legal,

________________ ______________________________________________________ regulatory, market structure and financing issues.16. Restructuring 1. The GOA will have completed an evaluation of the first 1. The GOA will have prepared and started implementation ofin primary and stage of the school finance and management reform pilot school rationalization plans, satisfactory to the Bank, in 3 educationsecondary and decide on its extension for the school years 2000/01. zones through consolidation of classes and/or schools, introductioneducation of multi-grade classes, and multi-subject specialization of teachers.

2. At least 50 additional schools in two more education zones The plans will have envisioned a substantial increase inwill join the pilot in September 2000. student/teacher ratio.

3. The Government will have ensured an increase in public 2. The GOA will have provided a further expansion of the schoolfunding of education in 2001, including an increase in the finance and management reform pilot for the school year 2001/02.real budget for primary education.

17. Restructuring The GOA will have made steps to improve governance and The GOA will have introduced further reforms in health financingin the health budget management in the health sector, including: that would include:sector a) adoption of the new Charter for the State Health Agency; a) piloting of selective contracting with health providers for a

b) introduction of the new contracting system that places a limited number of hospitals;global budget on amount of services provided; b) rationalization plans for the hospital networks for at least 2c) substantial reduction in the list of services covered by the marzes are prepared and approved;budget financing and make it consistent with the approved c) accumulation of no arrears in payments by the SHA to providerssectoral budget; for new 2001 contracts; andd) developing and announcing criteria, on which selective d) conclusion of verification of budget debts to health providers,contracting will be piloted in 2001; accumulated in 1998-2000; the Government will start repayinge) adopting a transparent framework for gradual these debts according to this schedule.repayment of budget debts to health providers; andf) Closure of 30 small rural hospitals to ensure a decline in totalhospital bed capacity by at least 5%.

18. Strengthening The GOA will undertake the following steps that would 1. The GOA will have completed re-registration of the povertySocial Assistance ensure improvements in targeting of the poverty family benefit recipients, beneficiary assessment of the assessment of theand Insurance benefit and gradual reduction of the number of its benefit, and establishment of the data base, and it will have

recipients: introduced, starting as of July 1, 2001, the new formula fora) Start re-registration of all recipients of the poverty eligibility assessment, based on the information received during thebenefit; re-application process.b) Initiate beneficiary assessment of the poverty benefitprogram; 2. The GOA will have completed the first phase of the pensionc) Launch establishment of a data base on poverty benefit reform, which would include: (i) submission to Parliament of a newapplicants and recipients in the MOSS; and Law on State Pensions, which will inter alia eliminate earlyd) restrain from the introduction of new social benefits that retirement provisions and other privileged pensions and provide forcould be fiscally unsustainable and provide for no increase unified regulation of public pensions (no public pensionin the budget allocation for poverty benefit in 2001. entitlements could be granted by other laws); (ii) introduction of

8mechanisms for unified and consistent implementation ofregulations in the area of social insurance; (iii) defining, in a waysatisfactory to the Bank, the legal status of the Social InsuranceFund as a policy implementation government agency; (iv)submission to Parliament of Draft Law regulating the SocialSecurity Codification System ( PINs -- Personal IdentificationNumbers); and (v) implementing the first phase of establishing theInformation Management Center for PINs.

19. Strengthening The GOA will have undertaken steps to improve labor marketEfficiency of functioning by:Labor Markets a) conducting a comprehensive review and evaluation of labor

regulations, andb) proposing changes in labor market regulations, which would facilitate

____________________________________________________________ deregulation and efficiency improvements of labor markets.

Annex 4Page 1 of 1

Timetable of Key Processing Events

1. Time taken to prepare: 10 months

2. Prepared by: Government of Armenia with theassistance of IBRD/IDA staff

3. Preparation missions: January 25, 2000, April 11, 2000August 5, 2000

4. Pre-appraisal mission: October 15, 2000

5. Negotiatiors: January 30, 2001

6. Planned Board presentation: May 22, 2001

7. Planned date of effectiveness: May 31, 2001

8. Expected program completion: March 31, 2002

Annex 5Page 1 of 1

Status of Bank Group Operations and IFC Operations(as of December 31, 2000)

1. The Republic of Armenia joined the International Bank for Reconstruction andDevelopment (IBRD) in September 1992. The first project, and only IBRD loan to date, was anInstitution Building Loan (US$12.0 million approved in March 1993), to support implementationof the government's reform program in the areas of financial sector reform, enterprise reform andprivatization, mobilization of fiscal revenue, and social and employment services.

2. The first IDA credit was granted to Armenia in February 1994 (an EarthquakeRehabilitation Credit for US$28.0 million). To date, a total of 21 IDA credits have beenapproved across a number of sectors. Also in 1994, a Power Maintenance Credit (US$13.7million, now closed), and an Irrigation Rehabilitation Credit (US$43.0 million) were approved.Other investment credits approved to date include a Highway Rehabilitation Credit (US$31.0million), an Enterprise Development project (US$16.7 million), a Social Investment Fund(US$12.0 million), a Health Credit (US$10.0 million), an Education Credit (US$15.0 million),an Agriculture Reform Credit (US$14.5 million), a Title Registration project (US$8.0million), and a Municipal Development Project (US$30.0 million). Most recently, in 1999-2000an Electricity Transmission and Distribution Adaptable Program Loan (US$21.0 million), anIrrigation Dam Safety Credit (US$26.6 million), Transport Credit (US$40.0 million), SecondSocial Investment Fund Credi (US$20.0 million), and Judicial Reform Credit (US$11.4million) were approved.

3. As of December 31, 2000, disbursements against these investment credits total roughlyUS$169.2 million, against commitments of US$340.9 million approved.

4. Adjustment lending began in February 1995 with the approval of the US$60.0 millionEconomic Rehabilitation Credit. In February 1996 this was followed by the first StructuralAdjustment Credit (SAC) of US$60.0 million and an accompanying Technical AssistanceCredit (SATAC) of US$3.8 million. SAC II (US$60.0 million) and SATAC II (US$5.0 million)were approved on August 26, 1997. The adjustment loans above were all fully disbursed onsatisfactory completion of the reform programs they supported. Disbursements to date under thetechnical assistance credits stand at US$2.6 million for SATAC I, and US$2.4 million forSATAC II. On December 1998 a SAC III for US$65.0 million was approved, the last tranche ofwhich was released on December 20, 2000.

5. Total adjustment lending to date totals US$245.0 million, and technical assistancefinancing (including the Institution Building Loan) provided totals US$20.8 million.

6. World Bank lending to Armenia, as of December 31, 2000, totals US$606.7 million, ofwhich US$429.8 million has been disbursed to date. Of the 22 IDA credits and one IBRD loanapproved, 15 remain under implementation, and eight have closed.

7. The International Finance Corporation (IFC) has been active in Armenia since 1998,actively seeking private investment opportunities. It has supported work on legal and regulatoryframeworks, housing finance, corporate govemance, and has promoted several business ventures,including a hotel in Yerevan, a leasing company and a venture capital fund. Nevertheless,financing for small- and medium-scale businesses through credit lines remains difficult,principally due to the weakness and under capitalization of Armenian banks. Presently, the IFC ispromoting a major international investor conference planned for New York in May 2001.

Annex 6

Armenia at a glance 4/4/2001

Europe &POVERtY and SOCIAL Cental Low-

Arnnena Asua Inconm Developmentdiamond-1999Population, mid-year (millions) 3.8 475 2,417 Life expectancyGNP per capta (Atlas method, US$) 490 2.150 410GNP (AtlasmnSod, US$billions) 1.9 1,022 988

Average annual growth, 1993-99

Pooulation (%) n.a. 0.1 1.9Laborforce (Y.) -1.5 0.6 2.3 GNP Gross

per __lprmaryMost recet estL (ateyearavIlable 1993-99) capita enrollment

Poverty (% of populabon below national poverty line) 55Urban population (% of total population) 67 67 31Life expectancy at birth (Years) 73 69 60Infant mortaliy (per 1, 000 live births) 15 22 77Child malnutriion (% of chiktren under 5) 3 8 43 Access to safe waterAccess to improved water source (% of population) 85 .. 64Illiteracy (% of popuation age 15+) 1 3 39Grossprimarvenrollment (%ofschoor-agepopulation) 90 100 96 Armenia

Male 88 101 102 Low-income grcupremale 93 99 86

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1979 1989 1998 1999Economic rattsr

GDP (USS billions) .. 1.9 1.8Gross irvestment/GDP 16.9 17.3 TradeExports of goods and serviceslGDP 19.0 20.7Gross domestic savinas/GDP -14.7 -9.3Gross national savinas/GDP -5.9

Currert account balance/GDP .. 21.2 -16.6 Domestic lamfInterest payments/GDP . 1.0 1.0 Sangs InvemertTotal debtlGDP 41.4 46.3Total debt seMcelexports 19.0 14.3Present value of debtVGDP 26.7 29.7Present value of debttexports . .. 143.8 153.6

Indebtedness1979.89 1989.99 1998 1999 199943

(average annual growth)GDP . -3.2 7.2 3.3 6.1 - ArmeniaGNP per caita . -3.0 6.3 3.0 Low-income groupExports o goods and services -18.2 8.9 6.5 13.3

STRUCTURE of the ECONOMY1979 1989 1998 1999 Growth of Investment and GOP %)

(%6 of GDeAgriculture 34.0 28.7 10Industrv 30.8 32.6 or

Manufacturnn 21.9 23.0 97 9s rServices 35.3 38.7 -104

Prvate consumption 103.6 98.5 -20General aovemment consumption .. 11.1 10.7 rW 0---DPImports ofoodsand services . 52.8 49.7

197949 198949 1998 19m G9row of exports and Imports (%)(average annual growth)Agriculture 12.6 1.3 Industry 10 59

Manufactunn - -2.7 5.2Services . 5.6 3.0

Private consumption 4.3 0.4 *7General govemment consumption -2.4 -0.7 4Gross domestic investment 5.0 1.1 soImports o goods and services -4.4 0.1 Eiq,Eorts _lmpotsGross national product .. .. 6.5 2.7

Note 1999 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. It data are missina, the diamond willbe incomplete.

Armeniw

PRICES and GOVERNMENT FINANCE1979 1989 1998 199f Inflation (

f% change) s,oo Consumer prices 8.7 0.7 4,00 oImplicit GDP deflator 10.8 01 3.1

Goverment finance 1,01)(1(% of GDP, includes current grants) oCurrent revenue 17.1 193 54 55 5e 97 DeCurrent budget balance 1.2 0.1 -GOG deflator 0CPIOverall surplus/deficit -43 -5.2

TRADES1979 1989 1998 1999 Exportand import levels (USS mill.)

(US$ milliions)Total merchandize exports (fob) 229 247 50

Copper mineral, concentrate 9Molybdenum mineral, concentrate 8 .Manufactures 102

Total merchandize imports (cif) 806 721 40Food 201 129 200Fuel and enermy 203Capital goods 113 o0

53 54 55 55 57 55 goExport price index (1995=100)Import price index (1995=f100) . ExportS a ImpolsTerms of trade (1995=100) -

BALANCE of PAYMENTS1979 1989 1998 1999 Current account balance to GDP(%)

(US$ millions)Exports of tgoods and seroes 360 383 oImports of goods and services 1,000 919Resource balance -640 -536 5 .l

Net income 60 55 -10Net current transfers 177 174 I 'llCurrent account balance -403 -307 20

Financing items (net) 406 311 20Changes in net reserves -4 -4 25

Abmo:Reserves including gold (fS$ millons) 298 305Conversion rate (DEC, local/USS) 505 535

EXTERNAL DEBT and RESOURCE FLOWS1979 198 1998 1999

(fSS millions) Com position of 1998 debt (USS m ill.)Total debt outstanding and disbursed 787 855

IBRD 1 0 9 46 10IDA 293 352

Total debt serce 68 55 133IBRD I 2 29 3IDA 2 2

Compositon of net resource flowsOfficial grants 113 94 129Official creditors 148 84Private creditors 0 0Foreign direct investment 221 122Portfolio equty -16 2 190

World Bank programCommitments 125 48 A-IBRO E-BilateralDisbursements 43 66 B - IDA D - Other multlateral F - PnvatePrincipal repayments 0 0 C -IMF G -Short-termNet flows 43 66Interest payments 2 3Net transfers 40 63

MAP SECTION

IBRD 29596

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