ARMENIA ECONOMIC POLICY ISSUES AS A TRANSITION COUNTRY

Armenian News Network / Groong
September 19, 2000

By Vartan Marashlian


Armenia has had very low inflation (decreasing year after year) for
almost 4 years, stable domestic currency, average level of budget
deficit and GDP growth. This is considered proof that reforms are
going in the right direction and financial stability has been
achieved, an efficient market economy has been created and all
preconditions for strong economic growth and investment flow to
Armenia have been established. But what we see now in reality is
strong economic stagnation, very low levels of investment activity,
acute social problems and problems of poverty, which go contrary to
what one of the major official macroeconomic indicators show -
permanent GDP growth from year to year. (See Table 1.)

What are the reasons and how can the real economic situations be
explained?

Armenia seems to implement reforms step-by-step as recommended by
leading international financial institutions, but all it has in the
plus, at this stage, is a number of macroeconomic indicators. What
still remains unsettled (regarding only economic issues) are problems
of mass unemployment, very low standards of living and purchasing
power, huge foreign trade deficit, fast growing external debt, low
foreign direct and portfolio investments, low investment activity,
corruption, and many other issues. Actually, many economic problems in
Armenia often have non-economic roots but in this article we will
concentrate only on the economic causes.

To determine the reasons why reforms didn't bring the expected
results, we need to understand what Armenia is nowadays, and to
classify the root causes of the economic issues:

1) Armenia is a country in transition. This makes Armenia a subject of
comparative analysis with other transition countries, post-socialist
countries and republics of the former Soviet Union. Countries in this
group have many similar socio-economic issues and many of them have
implemented reforms based on recommendations by international
financial institutions.

2) Unsettled historical and social issues for Armenians. Human,
societal and state development as well as historical issues have a big
impact on economic processes, and exist in contemporary Armenian
society in the form of numerous stable and self-developing complexes,
inefficient norms of behaviour and understanding both in Armenia, the
Diaspora and between them.

The focus of this article is on the first aspect, which makes Armenia
a part of a world in transition. However, the second aspect correlates
strongly with the first, and is perhaps not less important in terms of
understanding the reasons of negative political, social, economic and
societal processes that take place in Armenia.

Economic reforms in transition countries can be divided into
achievement of 5 major economic tasks:

- financial stabilization (low inflation and budget deficit, stable
  prices and exchange rate);
- liberalization of economy (prices, economic links, foreign trade);
- privatization;
- structural adjustment of the economy;
- acceptance of the reforms, new institutions by the society, and
  creation of new stable norms of behaviour.

These are all economic tasks, of which the first three can be reached
in a short-term perspective while the last two points require a longer
time frame and a much more detailed approach, because they deal with
evolutional issues and changing of the mentality of people and their
norms of behaviour - the last point is a very difficult process which
can't be reached only by economic measures. It deals with political
and social, as well as historical and cultural issues. The first three
stages can be done based on some technical approach, while the last
two deal with an adaptive approach towards problems.

The reforms in transition countries were implemented based on
Washington Consensus principles (financial stabilization,
liberalization and privatization), that was established by the IMF and
USA economic elite in 1970s for Latin American countries that
traditionally suffered from hyperinflation and huge budget deficits.
It was concerned with the maximum deregulation of the economy and
decreasing the role of the state to monetary and fiscal policies,
their integration in world economic processes such as globalization
and international organizations. Later on, those principles were
accepted as a "guidebook for reformers" in many transition countries
and implemented at different speeds and intensity.

The practice of the recent 3 years as well as financial crisis of the
developing and transition economies in 1997-1999 has shown that this
scheme does not cover the whole basket of economic problems and brings
too many negative processes, disproportions in the economic development
of these countries. It has clearly proved that many social-economic
processes in transition countries are new and unique and not covered
by existing economic theories and approaches.

In fact, the whole concept of reforms in transition countries was
brought to a simplified scheme in which the first three stages should
be achieved within a very short-term (shock-therapy) and after
reaching financial stabilization, the second stage - stable economic
growth would be automatically reached by the self-creation of
efficient markets and institutions, and socially accepted norms of
behaviour. The monetarists' hypotheses that efficient institutions
must arise because of natural selection and that all institutions and
society will be rational in their actions have not proven to be true.

The practice showed that inefficient development can be self-supporting,
self-developing and stable, especially in those countries which stayed
under communist regime for a longer time. The consequences of the
economic reforms in these countries were unexpected by many experts,
whatever guideline direction of the reform process you would look at,
mostly because of a mixture of aims with instruments, and neglecting
the transformation costs and institutional traps effect on the
reforms. Let's numerate the most important of these:

The rush to bring the prices under control produced a system of mutual
arrears and provoked a shift towards barter trading, which actually
meant that a non-monetary economy took shape on a new basis. Attempts
to change the tax-collecting system gave a boost to shadow economy
development. The slackening of state control over cash flows - a
measure expected to create a competitive economic environment - fueled
corruption. Lowering inflation and stabilizing prices didn't bring the
cost of capital down and more available to the real sector of economy.
Decrease and tight control of the budget deficit didn't result in a
growth-oriented structure of expenditures and stability in budget
incomes, but to a simultaneous decrease in both of them. Creation of
the most developed financial sector in transition countries only in
some cases caused an essential effect on the real economy and lending
to small and medium size enterprises in other cases was one of the
primary reasons for financial crises and disproportions in economic
development. Stability of domestic exchange rate doesn't bring about
growth of domestic production and export, but rather to stagnation of
the economy and an increase in the foreign trade deficit thus making
foreign exchange rate a long-term hostage of stability of prices and
low inflation targets. The "shock privatization" campaign, instead of
producing efficient private property holders, gave birth to a great
number of inefficient organizations, a decrease of activity and in
many cases to plundering and selling of the assets of privatized
objects. All these changes were accompanied by an unforeseen and
uncommonly sharp production decline, dramatic increase in unemployment
and sharp polarization of the income structure within society.

Many of these unexpected phenomena are known as institutional traps.
They are responsible for the misfortune of the economic reforms in
many transition countries, including Armenia.

The analysis shows that the formation of transformation costs and
institutional traps are major risks in any reform process, and
avoidance of these traps is an urgent task during transition. Major
institutional traps are barter, mutual arrears, tax evasion, and
corruption. Transformation costs are increased through the linkage
effect and can support an originally inefficient norm even when the
coordination effect stops working. Once fallen into an institutional
trap, the system chooses a non-efficient path of development, and with
time, returning to efficient development may not make sense any
longer. Moreover, a system with a prevalent efficient norm, if
strongly disturbed (with the set of equilibria, however, remaining
structurally unchanged), may fall into an institutional trap in which
it will remain even after the disturbing factor is removed. This is
the so-called "hysteresis effect", which is typical to all
norm-forming processes, including those involving institutional traps.

Each institutional transformation should be preceded by efforts to
forecast and forestall possible institutional traps. Such efforts
should became part and parcel of preparations for any kind of reform.
Transformation costs should be taken into account. The right choice of
the rate and sequence of reforms, and wise industrial policy are
prerequisites of institutional trap avoidance.

But if a trap is formed, the task of breaking out of it turns out to
be very difficult. Related theory hasto be developed yet. Standard
temptation is the imposition of much harsher sanctions for deviation
from socially efficient norms. Such strategy may imply considerable
expenditures and is capable of generating even worse institutional
traps. However it is quite possible that new reforms have to be
conducted to get out of institutional traps.  The measures should be
directed to weaken coordination, linkage, and inertia effects
supporting the traps, to increase their transaction costs, and to
decrease transformation costs and transaction costs of efficient
norms.

Experience with large-scale transformations reveal an important and
specific aspect of macroeconomic policy in economies in transition. If
market mechanism is well developed, macroeconomic policy influences
mostly macroeconomic indicators such as exchange rate, inflation, or
GDP. For a country with unstable institutional structures,
macroeconomic impact is capable of altering that structure. In
Armenia, the standard receipt for fighting inflation-tough monetary
policy promoted the formation of institutional traps.


			       Table 1
 =======================================================================
 Macroeconomic Indicators           1995    1996    1997    1998    1999

 GDP at constant prices (% change)   6.9     5.9     3.3     7.2     3.3
 Consumer prices                   176.7    18.8    13.8     8.7     0.6
 Trade balance (US$ millions)     -403.4  -565.5  -660.8  -681.9  -611.1
 Current account (% of GDP)        -37.5   -29.7   -27.8   -27.1   -20.4
 Foreign Debt (% of GDP)            29.0    32.5    39.1    38.9    45.4
 Foreign Reserves                    1.8     2.3     3.0     3.6     4.2
 (months of imports)
 Exchange Rate dram/USD            405.9   413.4   490.0   504.9   535.1
 (period average)

 Interest Rates (%, annual rate)
 (*) 91-days Treasury Bill          37.9    45.1    52.9    44.6    53.8
 (*) 3 months Banks Loans (Drams)           69.6    57.1    49.1    39.3

 State Budget (% of GDP)
 (*) Deficit                        11.0     9.3     4.7     3.7     5.2
 (*) Revenues                       17.8    15.1    16.4    18.5    20.2
 (*) Expenditures                   28.8    24.4    21.1    22.1    25.4
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Vartan Marashlian is a PhD candidate in economics at Moscow State
University. He has experience working in the russian banking sector,
as well as the Government of Armenia where he was assistant to the
Prime-Minister and Minsiter of Economy, Armen Darbinian. He is
currently working with the International Center for Human Development
(http://www.ichd.org/), an independent think-tank in Yerevan
established by Armen Darbinian.