Preface

Armenia is a small mountainous country situated in the southern part of the Caucasus and covering approximately 30,000 square kilometres. The neighbouring countries are: Turkey to the west, Georgia to the north, Azerbaijan to the east and southwest, and the Islamic Republic of Iran to the southeast. On September 21, 1991, Armenians almost unanimously voted for independence from the Soviet Union. Since then Armenia has faced several political and economic challenges, but its 3.7 million people have successfully overcome the political and economic hurdles to make Armenia one of the few countries among the countries of the former USSR to report economic growth in 1994. This trend has continued in 1995 and 1996.

Recent economic developments

Armenia has suffered the sharpest fall in output of any former Soviet republic. GDP declined by 15 per cent in 1993, following a 52 per cent fall in 1992. Average monthly inflation rose from over 35 per cent in 1993 (reaching over 150 per cent in the final quarter of 1993) to over 50 per cent in the first five months of 1994.

Starting from 1994, Armenia has successfully stabilised its economy. Real GDP registered an increase of 6.9 per cent in 1995 following 5.4 per cent growth in the previous year, while annual inflation was brought down to 32 per cent in 1995 from four-digit levels in 1994.

Real GDP growth during the 1996 was 5.8 per cent compared with the corresponding period of the previous year, driven primarily by expansion in the trade sector. Cumulative inflation during 1996 was 5.6 per cent, against the projected figure of 14 per cent.

Until mid-1994, the Central Bank of Armenia (CBA) has evolved against a background of turbulent events over which it has had little or no control. An earthquake in 1988 severely damaged the country's infrastructure and caused a major refugee problem. In addition, Armenia has suffered massive losses due to the breakdown of trade arrangements with the former Soviet Union (FSU) countries and an economic blockade. These early challenges were formidable. There was a need for the old National Bank to adapt its operations to many new factors: Armenia's independence; the country's incipient transformation into a market economy; the establishment of new relationships with other central banks; the introduction of a national currency, the Armenian Dram (AMD) in November 1993; and stabilisation of the economy.

Treasury bill market

Armenian financial market is in a stage of formation. The Treasury bill (T-bills) market was launched on September 14, 1995, to serve the dual purpose of providing a means of raising non-inflationary financing for the budget while also constituting an additional instrument for conducting open market operations by the CBA. Currently auctions are usually held twice a week, alternating between 28-day, 91-day, 182-day (from May 21, 1996), 273-day (from November 14, 1996) and 364-day (from November 14, 1996) T-bills. The central T-bill depository account maintained by the CBA keeps track of T-bills purchased and outstanding, as well as T-bills pledged as collateral for CBA credits to the auction or in inter-bank lending. At the end of February, 1997, the total face value of the outstanding stock of T-bills was Dram 10.2 billion, of which 98 per cent was held by banks. Of the total, 91-day T-bills accounted for 42 per cent, 182-day T-bills for 45 per cent, and 273 and 364-day for 10 per cent; the remainder were 28-day T-bills.

The end-of-period yield on the 28-day T-bills fluctuated around 37 per cent during the last quarter of 1995 and 38, 36, 23 and 40 per cent during the four quarters respectively of 1996. The end of-period yield on the 91-day T-bills fluctuated around 38, 37, 25 and 65 per cent during the four quarters respectively of 1996. The end-of-period yield on the 182-day T-bills fluctuated around 39, 28 and 65 per cent during the three quarters respectively of 1996.

While there now exists a functioning primary market for T-bills in Armenia, there is no substantive secondary market. Its development is hindered by limited supply. The CBA, which does not participate in the primary market as a buyer, maintains a standing offer to redeem T-bills before expiration at a break-even price depending on the average price at the auction and the time remaining to maturity. As the T-bills market deepens, there may be potential for drawing in significant funds from outside the banking system and for inducing investors to diversify away from foreign currency denominated deposits.

Interest rates

The refinance rate is used to calculate interest charges on the net credit to the government from the CBA and serves as the basis for calculating charges for bank overdrafts, as well as the penalties for banks that have breached the reserve requirement over a given two-week reporting period. Following a steady decline in inflation during 1995, the refinance rate fell from a high 210 per cent in January to 52 per cent in October, a level around which it has subsequently remained. As of March 1997 it was determined at the level of 58 per cent.

Banks' interest rates on one-month deposits and loans have exhibited a downward trend since September 1995, and fluctuated around 40 and 70 per cent respectively during 1996. However, the margin between the lending and deposit rates has remained substantial, reflecting primarily the lack of competition and also the fragile state of the banking system. In addition it may also reflect an adverse selection of applicants for credit at high real rates of interest on banking lending.

Taxes

From the list of taxes the following ones concern enterprises and households:

Personal income tax applies to physical persons with permanent residence in Armenia and those without permanent residence who earn income in Armenia. Income subject to tax includes that from labour, leasing of property, business activities, share capital participations, securities and interest income and others.

Exempt incomes include state social security, social insurance, payments by certified non-profit organisations, gains from state bonds and bills, and agricultural income. Non-residents are not subject to income taxation.

Enterprise profits tax is a tax on the profits of legal persons operating in Armenia, including foreign legal entities. The taxable profit is determined based on the book profit, which is the sum of profit from the sales of products, services, intangibles, fixed assets and other material valuables, together with non-operational income such as revenues from leased property, sales of inventories, shares and other securities, and others.

Exemptions from profits tax include amounts that companies devote to reserve funds (up to 25 per cent of actually formed capital) and profits from state securities to value of the difference between the value of acquisition and the face value of privatisation certificates (vouchers). Joint ventures and enterprises with foreign participation receive varying levels of tax credits (up to 3-10 years after being officially registered), depending on the proportion of foreign capital. This level is 50 per cent when the foreign capital participation is above 50 per cent and the minimum investment is a sum equal to US$100,000, and 30 per cent if it is between 30 and 50 per cent and the minimum investment is a sum between $40,000 to $100,000. Banks are imposed with 30 per cent tax as a percentage of net income (profit).

Foreign investment policy

Armenia is one of the CIS countries which eliminated all restrictions and defined a liberal policy aimed at attracting foreign investment. The policy is based on the 'Law on Foreign Investments', which provides a guarantee against nationalisation and confiscation, excepting external circumstances upon a judicial decision. In case of unlikely events followed by confiscation, full compensation will be applied. Foreign investors are indemnified against damages resulting from different illegal actions of the Government and citizens of the republic. The law also guarantees the full repatriation of profits and assets without any hindrance. By the same law and resolution there are no restrictions connected either with amount or time on the remittance of foreign currency deposits.

The Central Bank of Armenia has adopted resolutions based on the 'Law on Foreign Investments'. According to these resolutions all restrictions on capital flows both inwards and outwards for non-residents are eliminated. Residents should repatriate balances from their accounts during the 30 days after receipt of the proceeds. Restrictions on payment systems as well as the discriminatory treatment of operations carried out by residents and non-residents of the Republic of Armenia were abolished. Restrictions on the inflow of foreign currency and import of securities reflected in foreign currency to Armenia were also abolished. According to the resolution resident legal and physical entities may carry out operations on current and capital transfers from accounts with banks without any restrictions.

Foreign exchange regulation

According to the resolution N 141 'On Foreign Exchange Regulation and Administration of Control', there is no longer any restriction on current account operations. The CBA has approved licensing regulations for additional foreign exchange dealers. Acting foreign exchange bureaux will be given new status. According to the above mentioned resolution, physical and legal entities will be allowed to act as foreign exchange dealers after being licensed by the CBA. The CBA has established a favourable regime for determination of foreign exchange rates. It will establish a daily exchange rate as the midpoint of the previous day's buying and selling operations in the financial markets. Foreign exchange dealers and banks are free to establish exchange rate for their own transactions. This resolution comes into effect from November 1, 1997 onwards.

An important step towards liberalisation of payments and transfers on current international operations was the repeal of the resolution on 'Surrender Requirements for Republic of Armenia Enterprises'.

Foreign banks are authorised to participate in the domestic foreign exchange market without restrictions as well as resident banks. Legal and physical entities can open their accounts with foreign banks without any restrictions.

Residents and non-residents of Armenia can make all types of transactions commonly used in international banking practice, although residents should repatriate balances from their accounts during the 30 days after receipt of proceeds. Though the dram is the legal tender of the Republic of Armenia, non-residents can implement any type of operations payable in foreign currency for goods and services without any restriction (residents can implement such operations only with non-residents).

As of end of 1996, there were three foreign exchange auction markets operating in Armenia, the Yerevan Stock Exchange, the Gumry Stock Exchange and the Adamand Stock Exchange. Since July 1995, however, banks have also been able to trade foreign exchange outside these markets. Access through banks to these auctions for private sector and public entities is unrestricted.

The weighted monthly average dram exchange rate remained stable during 1995, moving within a narrow margin of Dram 400-410 per US dollar. Since August 1995, the spread between the cash and noncash exchange rates has come down to negligible levels. However, the weighted monthly average dram exchange rate during 1996 fluctuated within a wider margin of 402-437 per US dollar. The real effective exchange rate appreciated by 7 per cent during 1995; it depreciated by 5 per cent during the first half of 1996, reflecting a depreciation against currencies of countries of the former USSR of 8 per cent, and no change against other currencies.

Trade policy

Armenia has pursued a liberal trade policy consisting of a simple and relatively open tariff based import regime with a low uniform tariff; avoidance of quantitative restrictions on imports or exports; and the dismantling of clearing trade with countries of the former USSR Armenia is currently applying for membership in the World Trade Organisation.

The current tariff structure consists of a regime with two bands at 0 and 10 per cent respectively. The zero rated products are limited to staple foods, agricultural products, fuel, essential pharmaceutical products, basic clothing, and raw materials used intensively in the production of exports.

Tariff exemptions are currently extended to all goods that originate from countries of the former USSR. Goods associated with humanitarian aid, medical equipment, meat, agricultural and dairy products, sugar, crude oil derivatives and selected industrial raw materials are also exempt from import tariffs.

Non-tariff restrictions remain in place against the importation of weapons, nuclear materials, illegal drugs and other goods that pose health, security, and environmental hazards. Import licensing requirements are limited to medicines, which are subject to approval by the Ministry of Health, and agricultural chemicals, which are administered by the Ministry of Agriculture.

Armenia maintains a 10 per cent export tax on specific products payable by unregistered traders only, and customs fees of 0.3 per cent on the declared value of exports and imports. However, there are no quantitative restrictions on exports except on certain artwork and jewellery; these are expected to be eliminated in order to comply with WTO regulations. Export licenses are required for textiles destined for the EU (in accordance with an agreement with the EU), and also for medicines, selected live animals and plants for reasons of public health.

Banking system developments

The banking system in Armenia consists of the CBA, four major commercial banks which comprise about 70 per cent of the assets and 37 per cent of the statutory capital in the banking sector overall, 30 smaller commercial banks, and the Midland Bank of Armenia which began operations in March 1996 with statutory capital of $4 million, or 33 per cent of the total statutory capital of the commercial banks. In spite of high real deposit rates, the public appears to perceive bank deposits as risky assets. This is reflected by the high level of disintermediation, with the ratio of bank deposits to broad money falling from 58 per cent in the first quarter of 1995 to 41 per cent in February 1997.

On the positive side, some smaller private banks have been making good progress in developing new banking services and generating profitable banking business. Moreover, the total capital in the banking system has increased since October 1995 by two-thirds, although much of this increase is due to the beginning of operations of Midland Bank.

Based on a much-improved licensing system, the CBA imposed some criteria for newly established banks under the resolution N 5 'On Bank Licensing' of September 5, 1996.

Prudential economic standards

The Central Bank of the Republic of Armenia defines the following prudential economic standards for banking:

1. the minimum statutory fund and the minimum total capital of the bank;
2. the normatives for the total capital adequacy of the bank:
   • the marginal ratio between total capital and risk weighted assets;
   • the marginal ratio between fixed capital and risk weighted assets;
3. the normative for the liquidity of the bank:
   • the marginal ratio between high liquid assets and total assets (total liquidity);
   • the marginal ratio between high liquid assets and demand liabilities (current liquidity);
4. the maximum exposure to a single borrower;
5. the maximum exposure to persons associated with the bank, including the maximum exposure to individuals associated with the bank;
6. the minimum reserve requirement allocated with the Central Bank;
7. the normative for foreign currency positions.

A normative for the maximum risk on the bank's lenders is not defined.

When the regime of prudential economic standards is tightened by the Central Bank, the prudential economic standards take effect six months after adoption, while in case of the loosening of such a regime, the prudential economic standards take effect upon their adoption by the Central Bank of Armenia.

To provide a stable banking system, the Central Bank may, in unusual circumstances, define special prudential standards with up to six months' duration.

The Central Bank of the Republic of Armenia determines the following limits of prudential economic standards:

The minimum statutory fund and total capital of the bank.

The bank's statutory fund is denominated in cash (both in Armenian drams and foreign currency). Foreign currency investments in the statutory fund are accounted for in Armenian drams and foreign currency based on a double evaluation, according to the exchange rate determined by the Central Bank of Armenia as of the investment day. The part of statutory fund completed in foreign currency is not subject to any revaluation. The minimum statutory fund of the bank shall be Dram 50 million.

Effective from January l, 1997 no additional requirement for statutory funds is provided for subsidiaries of banks operating in the Republic of Armenia.

The total capital of the bank is the grand total of its fixed (primary) and additional (secondary) capital. The fixed (primary) capital includes actually paid-in statutory capital, undistributed profit, profit-generated funds, and excess amounts of shares (stock). The additional (secondary) capital includes fixed assets, foreign currency, and precious metals revaluation reserves. The premium of shares (stocks) is the amount of the difference between the sale and par values of shares (stocks) issued by the bank.

For banks with statutory capital exceeding $3 million, long term subordinated borrowings are included in the calculation of additional (secondary) capital.

Long term subordinated liabilities are funds attracted for five (not less) years. This being the case, an early maturity of such liabilities is not envisaged. In the case of the bankruptcy of the bank, the maturity would be carried out after meeting the liabilities of other lenders while preceding implementation of liabilities of shareholders. Those liabilities, beginning from the fifth year prior to the full maturity, are included in the calculation of additional capital with a 20 per cent reduction for each year outstanding.

The minimum total capital of the bank is defined as:

• $350,000 or equivalent in Armenian drams by January 1, 1997
• $600,000 or equivalent in Armenian drams by January 1, 1998
• $800,000 or equivalent in Armenian drams by January 1, 1999
• $1,000,000 or equivalent in Armenian drams by January 1, 2000

Banks that are established, restructured or merged in a given year are obliged at the time of registration to provide, according to the schedule above, the minimum total capital defined for the next year.

Normatives for total capital adequacy of the bank.

The minimum ratio between total capital and risk weighted assets, is defined as:

• 5 per cent from January 1, 1997 to November 1, 1997
• 8 per cent from November 1, 1997 to October 1, 1998
• 10 per cent from October 1, 1998.

The minimum ratio between fixed capital and risk weighted assets is defined as:

• 3.25 per cent from January 1, 1997 to November 1, 1997
• 6 per cent from November 1, 1997 to October 1, 1998
• 7.5 per cent from October 1, 1998.

Liquidity normatives for the bank.

The minimum ratio between high liquid assets and total assets is defined as 25 per cent.

The minimum ratio between high liquid assets and demand liabilities is defined as:

• 30 per cent effective January 1, 1997
• 40 per cent effective January 1, 1998
• 60 per cent effective January 1, 1999

The maximum exposure to a single borrower.

The maximum exposure to a single borrower is the maximum ratio between bank's loans to a single borrower and related persons, the amounts of guarantees against his/her liabilities and the total capital of the bank.

The maximum risk on a single borrower is defined as:

• 30 per cent effective January 1, 1997
• 25 per cent effective July 1, 1997
• 20 per cent effective January 1, 1998

The maximum exposure to bank related persons.

The bank related persons are:

1. bank managers;
2. persons with significant participation in the capital of the bank;
3. persons related to and co-operating with those mentioned in points a) and b);
4. persons related to the bank.

The maximum risk on bank related persons is defined as the maximum ratio between the total capital and the amount of insider loans, other borrowings and guarantees issued against liabilities of such insiders.

The maximum risk on all persons related to the bank is defined as:

• 100 per cent before January 1, 1998
• 80 per cent effective January 1,1998
• 60 per cent effective January 1,1999

This being the case, the maximum risk on one person related to the bank shall not exceed the total capital by:

• 10 per cent before January 1, 1999
• 5 per cent effective January l, 1999

The minimum reserve requirement allocated with the Central Bank.

With effect from August 1, 1997, the minimum reserve requirement allocated with the CBA against funds attracted by banks and subsidiaries of foreign banks operating in the Republic of Armenia, shall be defined at the level of eight per cent.

Foreign currency position normative.

The 'long' foreign currency position in banks (the positive difference between foreign currency assets and liabilities) shall not exceed 40 per cent of the total capital of the bank.

Payments system

Payments in Armenia have been realised primarily through payment orders so far. Inter-bank clearing and settlement is performed by the CBA. An inter-bank clearing system has been functioning in Yerevan since May 1994. However, in order to reduce transaction costs and delays, an electronic payment system based on the SWIFT format has been developed at the CBA (CBANET); this has been fully functional in Yerevan since September 1996 and covered the entire country from February 1997.

The increasing business activity observed in the Armenian economy during recent years highlights the importance of development of the payment system. The figures on inter-bank payments' volumes stress the up trend in the volumes of non-cash payments. Continuing inefficiencies in physical paper delivery by post or by courier, the physical inaccessibility of some regions especially in winter, the need for reliable and rapid final customer payments to increase the monetary efficiency of the economy and the need to reduce the risks and costs associated with the build up of a float in the payment system made the existing system inefficient and caused the necessity of reforms in the sphere of inter-bank payments.

Given this situation on one hand, and the desire to meet both the challenges of the internal market and the internationally accepted standards for inter-bank payment mechanisms on the other, the Central Bank of Armenia recognised the implementation of an Electronic Payment System (EPS) to be the most suitable direction of development for the inter-bank payment system of Armenia.

It is worth mentioning that the Central Bank of Armenia has already done considerable work toward the development of inter-bank payment mechanisms. Currently, settlement in the Central Bank of Armenia is routinely accomplished with an automated real time double entry settlement application, against credit balances only. The Central Bank of Armenia performs inter-bank clearing which is organised around two automated settlement sessions. Anticipated shortfalls in credit can be covered by loans from the Central Bank of Armenia against Treasury Bills.

Taking into consideration the limited technical competence and financial capacity of the commercial banks in terms of installing their own dedicated Wide Area Network (WAN) and expecting that WANs will provide a platform to support a range of important customer financial services as well as develop the capital market overall, the Central Bank of Armenia bore the role of the operator of the proposed system. Since direct bilateral settlement is officially permitted but is not used at this time in Armenia and in fact virtually all inter-bank settlements are performed in 'Central Bank Money', it is obviously advantageous for the Central Bank of Armenia to operate the system.

The participants of the EPS will be:

• at the first stage - the Central Bank of Armenia, the Commercial banks and their branches;
• at the second stage - other financial institutions;
• at the third stage - the customers of the banks.

Banks can become a member of the EPS by signing a mutual agreement with Central Bank of Armenia, the service provider. The effect of EPS implementation will no doubt be positive, as the banks may be expected to take the opportunity to upgrade their services. The efficiency gains and reduction of risks will also be extremely positive. Positive changes in the velocity of money circulation may also be anticipated. The process of implementation of EPS may give rise to some problems caused by lack of experience. This is however expected to be balanced by the programs of training prepared by Central Bank of Armenia for the introduction of new technology.

The pre-implementation stage of the EPS started in September, 1994 when the Central Bank of Armenia signed an agreement with the Ministry of Communications, elaborated the project and financial requirements for the system together with Infocon JSC (privately owned company) and fulfilled negotiations with USAID on providing the necessary funding for the project.

Legal reforms

Armenia has taken an important step in reforming the legal environment, especially with respect to banking, with the passage on June 30, 1996, of the Central Bank Law, the Law on Banks and Banking, and the Law on Bank Insolvency. The Law on Banking Secrecy was passed in mid-October. The Central Bank Law established firmly the independence of the CBA in setting monetary policy, while leaving some room for ex-post parliamentary oversight of the implementation of its budget. The other two laws define the legal environment in which commercial banks operate and the procedures for dealing with insolvent banks. With the passage of all these laws, it is expected that Armenian enterprises and banks will operate in a well-defined, transparent legal environment in 1997.