Quasi-Fiscal Activities, Hidden Government Subsidies, and Fiscal Adjustment in Armenia Lev Freinkman Gohar Gyulumyan Artak Kyurumyan The World Bank 1659-00 FM & Intro 9/2/03 15:28 Page i W O R L D B A N K W O R K I N G P A P E R N O . 1 6 Quasi-Fiscal Activities, Hidden Government Subsidies, and Fiscal Adjustment in Armenia Lev Freinkman Gohar Gyulumyan Artak Kyurumyan THE WORLD BANK Washington, D.C. 1659-00 FM & Intro 9/2/03 15:28 Page ii Copyright © 2003 The International Bank for Reconstruction and Development / The World Bank 1818 H Street, N.W. Washington, D.C. 20433, U.S.A. All rights reserved Manufactured in the United States of America First printing: September 2003 1 2 3 4 05 04 03 World Bank Working Papers are published to communicate the results of the Bank's work to the development community with the least possible delay. 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Permission to photocopy items for internal or personal use, for the internal or personal use of specific clients, or for educational classroom use, is granted by the World Bank, provided that the appropriate fee is paid. Please contact the Copyright Clearance Center before photocopying items. Copyright Clearance Center, Inc. 222 Rosewood Drive Danvers, MA 01923, U.S.A. Tel: 978-750-8400 • Fax: 978-750-4470. For permission to reprint individual articles or chapters, please fax your request with complete information to the Republication Department, Copyright Clearance Center, fax 978-750-4470. All other queries on rights and licenses should be addressed to the World Bank at the address above, or faxed to 202-522-2422. ISBN: 0-8213-5604-6 eISBN: 0-8213-5605-4 ISSN: 1726-5878 Lev Freinkman is Senior Economist in the Poverty Reduction and Economic Management Depart- ment of the Europe and Central Asia Region at the World Bank. Gohar Gyulumyan is Economist in the same department at the World Bank. Artak Kyurumyan is Consultant to the the World Bank. Library of Congress Cataloging-in-Publication Data Freinkman, Lev M. Quasi-fiscal activities, hidden government subsidies, and fiscal adjustment in Armenia/ Lev Freinkman, Gohar Gyulumyan, Artak Kyurumyan. p. cm.-- (World Bank working paper; no. 16) Includes bibliographical references. ISBN 0-8213-5604-6 1. Finance, Public--Armenia (Republic) 2. Fiscal policy--Armenia (Republic) 3. Budget deficits--Armenia (Republic) I. Gyulumyan, Gohar. II. Kyurumyan, Artak. III. Title. IV. Series. HJ1302.2.F74 2003 339.5’2’094756-dc22 2003057674 1659-00 FM & Intro 9/2/03 15:28 Page iii T C ABLE OF ONTENTS Abstract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .v Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .vii Acronyms and Abbreviations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .ix Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .1 Chapter 1. Traditional and Alternative Approaches to the Evaluation of Fiscal Adjustment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .3 Chapter 2. Quasi-Fiscal Activities in the FSU Countries . . . . . . . . . . . . . . . . . . . . . . . . . . .7 Chapter 3. Armenia: Public Sector Balance and Hidden Deficit . . . . . . . . . . . . . . . . . . . .11 Chapter 4. Hidden Budget Subsidies, Quasi-Fiscal Subsidies and Contingent Liabilities in Armenia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .19 Chapter 5. Financing of Hidden Deficit and Ultimate Recipients of Quasi-Fiscal Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .29 Chapter 6. Main Policy Conclusions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .37 ANNEXES Annex A. External borrowing by Government to support of operations of the energy and utility sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .39 Annex B. Main Annual Subsidy Flows in the Economy, 1996–2001, million Dram . . . . . . . .41 References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .49 TABLES Table 1. Armenia: Pre-Transition Price Distortions and Price Adjustment in the Early Transition . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .9 Table 2. Net Present Value of External Debt, in Percent, 2000 and 2002 . . . . . . . . . . . . .12 Table 3. General Government’s Budget Deficits in the Ex-USSR States, Cash . . . . . . . . . .14 Table 4. Armenia: Actuarial, Conventional, and Hidden Deficit, 1995–2001 . . . . . . . . . .15 Table 5. Budget Subsidies and Direct Budget Credits to Large SOEs . . . . . . . . . . . . . . . .21 Table 6. Tax Arrears, Stocks by the Year End . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .21 Table 7. Subsidization Through the Gas-for-Equity Privatization . . . . . . . . . . . . . . . . . . .22 Table 8. Government External Borrowing to Support Operations of the Energy and Utility Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Table 9. Total Hidden Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Table 10. Total Subsidies . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .23 Table 11. Electricity Tariffs in Selected Economies in Transition in 2000, Without VAT . . .25 Table 12. Customers’ Non-payments to Main Utilities . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Table 13. Government Guarantees Issued for Banking Credits Granted to Commercial Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .26 Table 14. Outstanding Banking Credits to the E&U Sector in 1998–2001 . . . . . . . . . . . . .27 Table 15. The Annual Average Under-financing in the Energy and Infrastructure in the Late 90s . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .27 iii 1659-00 FM & Intro 9/2/03 15:28 Page iv IV CONTENTS Table 16. Armenia. Inter-sectoral Flows of Subsidies, 1999 . . . . . . . . . . . . . . . . . . . . . . . . .30 Table 17. Recipients and Donors of Quasi-Fiscal Subsidies in Armenia . . . . . . . . . . . . . . . .32 Table 18. Recipients of (Total) Subsidies in Armenia . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Table 19. Financing of Subsidies Provided by the Energy Sector . . . . . . . . . . . . . . . . . . . . .35 Annex A. External Borrowing by the Government to Support Operations of the Energy and Utility Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .40 Annex B. Main Annual Subsidy Flows in the Economy, 1996-2001 . . . . . . . . . . . . . . . . . .42 FIGURES Figure 1. Real Exchange Rate Developments in Selected CIS Countries . . . . . . . . . . . . . .12 Figure 2. Average GDP Growth in Selected CIS Countries, 1997–2001 . . . . . . . . . . . . . .12 Figure 3. Average Annual Inflation in Selected CIS Countries, 1997–2001 . . . . . . . . . . . .13 Figure 4. Armenia: Hidden Deficit as Percent of GDP, 1995–2001 . . . . . . . . . . . . . . . . . .16 Figure 5. Armenia: Composition of Actuarial Deficit . . . . . . . . . . . . . . . . . . . . . . . . . . . . .16 Figure 6. Armenia: Accrual and Actuarial Deficits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Figure 7. Gross International Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .17 Figure 8. Moldova: Fiscal Adjustment, 1995–2000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .18 Figure 9. Budgeted Subsidies, Hidden Subsidies, and Quasi-Fiscal Subsidies . . . . . . . . . .24 Figure 10. Fiscal and Quasi-Fiscal Financing of Quasi-Fiscal Subsidies in the Energy Sector . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .24 Figure 11. Main Subsidization Flows through Non-payments . . . . . . . . . . . . . . . . . . . . . . .31 Figure 12. Quasi-Fiscal Subsidies by Recipient . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .32 Figure 13. Quasi-Fiscal Subsidies by Source of Financing . . . . . . . . . . . . . . . . . . . . . . . . . .33 Figure 14. Quasi-Fiscal Subsidies to Population as a Share of Total QFS . . . . . . . . . . . . . . .33 Figure 15. Quasi-Fiscal Subsidies to Population and Budget Expenditures on Social Protection/Insurance, 1996–01 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .34 Figure 16. Budgeted, Hidden, and Quasi-Fiscal Subsidies to the Enterprise Sector . . . . . . .34 1659-00 FM & Intro 9/2/03 15:28 Page v A BSTRACT This paper aims to develop a detailed analysis of quasi-fiscal deficits and subsidies, and their impact on Armenia’s fiscal performance in the second part of the 1990s. Based on the flow-of- funds approach, we estimate the magnitude of the quasi-fiscal deficits and the incidence of quasi- fiscal subsidies in Armenia, as well as identify main recipients and sources of quasi-fiscal financing. The principal finding of the paper is that while quasi-fiscal deficits in Armenia remain considerable, their recent decline has been a major contributing factor to Armenia’s fiscal adjustment. The paper also shows that households remain a major ultimate recipient of quasi-fiscal subsidies. Thus, the main distortive impact of quasi-fiscal subsidies is on social policy and equity, rather than on enter- prise restructuring and private sector performance. Still, the current level of public sector deficit in Armenia remains too high, which requires an additional adjustment effort. The paper suggests that to make fiscal adjustment sustainable a further strengthening of financial control, accounting and reporting in the public sector is needed, including through better Government monitoring of debts and other liabilities accumulated by the large state enterprises and phasing out the phenome- non of implicit (hidden subsidies), such as debt-for-equity swaps. The proposed approach to the analysis of quasi-fiscal deficits and subsidies, based on estimates of accumulated debts in the public sector and its main parts, seems to be fully applicable to other economies in transition, especially to those low-income CIS countries, which are heavily dependent on energy imports. v 1659-00 FM & Intro 9/2/03 15:28 Page vi 1659-00 FM & Intro 9/2/03 15:28 Page vii A CKNOWLEDGMENTS An earlier draft of this paper was prepared for the Conference “Armenia: Recent Economic Trends and Growth Prospects,” organized by the Armenian International Policy Research Group on January 25, 2003 in Washington, D.C. The views in the paper are those of the authors, and should not be attributed to the World Bank. The authors are grateful to Azamat Abdymomunov, Ani Balabanyan, Vladimir Drebentsov, Artsvi Khachatryan, Rendall Maringer, Gayane Minasyan, Alexander Morozov, Brian Pinto, Carolina Revenco, Gevorg Sargsyan, Brian Steven Smith, Eka Vashakmadze and Ann-Margret Westin for comments and help with data. vii 1659-00 FM & Intro 9/2/03 15:28 Page viii 1659-00 FM & Intro 9/2/03 15:28 Page ix A A CRONYMS AND BBREVIATIONS CBA Central Bank of Armenia CEE Central and Eastern European CIS Centrally-planned Independent States CL Contingent Liabilities E&U Energy and Utility (sector) EBF Extra-Budgetary Funds FSU Former Soviet Union IMF International Monetary Fund PSB Public Sector Balance QF Quasi-Fiscal QFS Quasi-Fiscal Subsidies SOE State-Owned Enterprises ix