How To Understand Current Account Balance In Armenia

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1 CURRENT ACCOUNT: THE REGIONAL DEVELOPMENTS AND TRENDS Prepared by Armenuhi Burnazyan and Arevik Aleksanyan In our project we tried to analyze Current Account (CA) balance trends for Armenia, Georgia and Azerbaijan. Key determinants of CA balance and its financing part are presented. This paper also includes regression analysis in conjunction with factor analysis. The observation period covers the period starting from 1997 to 2006 for which time series are available. For cross-country comparison the indicators are taken as a percent of GDP. Armenia Existing situation and economic challenges Throughout recent years, Armenia s industrial infrastructures transport, energy, water and irrigation, and telecom registered certain positive developments. However, Armenia still needs improvement in terms of structural and management reforms required for proper operation of infrastructures in a free market. The obsolete infrastructure assets continue to remain a major challenge for sustainable development and poverty elimination. The worsening international environment and growing domestic imbalances represent significant challenges in this outlook. Armenia s external current account deficit, which is already high, is likely to experience more pressure as huge decrease in remittances is expected. Situation with trade Currently Armenia is trading with 108 countries. Main export commodities are pig iron, unwrought copper, nonferrous metals, diamonds, mineral products, foodstuffs and energy. Import commodities are natural gas, petroleum, tobacco products, foodstuffs and diamonds. Main exporting destinations are Russia 17.5%, Germany 14.7%, Netherlands 13.5%, Belgium 8.7%, Georgia 7.6%, US 6.6%, Switzerland 4.3%, Bulgaria 4.1%, Ukraine 4% (2007). Import partners are Russia 15.1%, Ukraine 7.7%, Kazakhstan 7.4%, Germany 6.8%, China 6%, France 4.6%, US 4.5%, Iraq 4.3% (2007) 1. The Graph 1 shows that the main determinants of the current account balance in Armenia are the trade balance and net current transfers. While the trade balance has always been negative due to higher imports versus exports, the net current transfers have been always positive (due to huge private remittances). Thus, the current account deficit has been partially offset by current transfer receipts. 1 Based on data. 1

2 During CA deficit had a decreasing trend, which was mainly conditioned by three factors: growth in exports, reduction in imports (from import substitution by domestic production) and increasing trends in private transfers (See Graph 1). Graph 1. Components of Current Account Balance (% of GDP) The observations of sources of financing show that the CA deficit was mainly financed by foreign investments. Armenian Financial and Capital account balance has a decreasing trend during , which was consistent with current account balance trends. During were received significant financial recourses related with Linsy Foundation. In 2004 Current Account was financed mainly by FDI, which was directed to communication sphere of the economy and to food and beverage production sphere. The geographical structure of FDI was as the following: Greece 31%, Argentina 14%, France 23%, USA 8%, and Russia 5%. Azerbaijan Existing situation and economic challenges For the fourth consecutive year, Azerbaijan s economy was among the fastest-growing economies in the world in 2008; however, growth declined to 10.8% from 25.4% in 2007, and 33.4% in The contribution of net exports, fueled by expansion of hydrocarbon exports, was the major driver of growth. Rapid economic growth is placing significant stress on inadequate physical and social infrastructure. At the same time, the large inflow of foreign revenue from oil exports is fueling inflation and pushing up the exchange rate. Recognizing these development challenges, the Government of Azerbaijan has implemented a number of programs to promote sustainable economic development in the non-oil sector to rehabilitate deteriorating physical infrastructure and to reduce disparities between the country s regions. 2

3 The key challenges facing Azerbaijan are promoting sustainable economic development in the non-oil sector, improving infrastructure, making social development more inclusive by reducing economic disparities among regions, promoting good governance, and improving the climate for private-sector growth. Situation with trade Azerbaijan trades with 118 countries. The main export commodities are oil and gas (90%), machinery, cotton and foodstuffs. Import items are machinery and equipment, oil products, foodstuffs, metals and chemicals. The export main partners are Turkey 17.4%, Italy 15.5%, Russia 8.7%, Iran 7.2%, Indonesia 6.4%, Israel 6.1%, Georgia 5.7%, US 4.8%, France 4.3%. Import partners are Russia 17.6%, Turkey 10.9%, Germany 8.2%, Ukraine 8.2%, UK 7.2%, Japan 5.2%, China 4.9%, US 4.7%. From Graph 2 illustrates that the main determinants of the CA balance in Azerbaijan are trade balance and balance on services. In contrast to Armenia, trade balance was mainly positive, except the periods of and This surplus was mainly conditioned by high prices and exports volumes of oil. Besides, balance on services, which was negative for the whole period, had a big proportion in current account balance. From the deficit had an increasing trend, which was conditioned by significant increases in imports of goods and services for huge investments in oil production and treatment sectors. Afterward there was a CA surplus, conditioned by rapidly declining trends in imports. Azerbaijan Financial and Capital account, except for 2001, always have significant net inflow, where the biggest portion has FDI (mainly sale of big oil companies). In 2004 big portion of capital inflows were redirected to import goods and services related with fossil fuel sector (1.8 billion USD). Graph 2. Components of Current Account Balance (% of GDP) 3

4 Georgia Over the course of the last 5 years, Georgia s new government has implemented radical and far-reaching economic reforms. Widely acknowledged improvements have been made in such areas as fiscal management, anticorruption, business regulation, and social assistance. Some of the impressive results of these reforms include Gross domestic product (GDP) growth of 10.5% on average over the last 3 years, The doubling of foreign investment from 8.4% to 16% of GDP in , Increase in tax revenue collection from 14.1% to 25.8% of GDP, The implementation of the first targeted social assistance program for 600,000 beneficiaries, 24-hour electricity supply as compared to an average of 7 hours per day before the reforms, and The country s global ranking on the World Bank s Ease of Doing Business Index as number 18. The ambitious poverty reduction targets spelled out in the 5-year plan have been seriously undermined by the brief conflict between Georgia and the Russian Federation in August Previously strong investor and customer confidence suffered, while public finances came under significant pressure. The country risk, expressed by the spread on government-issued international bonds, increased from 465 basis points in the prewar period to about 719 basis points in September. As a result of sharp revenue shortfall and rise in expenditure, the Government of Georgia had to seek $480million budget support for deficit financing. The banking sector came under serious pressure as a result of the combined effect of hostilities and the world credit crunch. Deposit withdrawal from banks peaked at 16% of total deposits during August, and access to international capital markets largely closed, both as a result of the conflict and the top banks beginning to reduce their loan books. Although some of the withdrawn capital has been flowing back after the conflict, the decrease in lending, along with weakened consumer demand, significantly affected economic activity in the country, putting pressure on businesses and further increasing the risks for the banking sector. To avert a more protracted economic downturn, the Government has adopted a countercyclical fiscal and monetary response to the crises. Net expenditure cuts have been kept to a minimum thanks to the mentioned donor support. The National Bank of Georgia released 24% of its international reserves to satisfy demand for dollars and also signed a $750 million standby arrangement with the International Monetary Fund (IMF) in order to boost the depositor confidence in lari. Situation with trade Georgia exports mainly scrap metal, wine, mineral water, ores, vehicles, fruits and nuts and imports fuels, vehicles, machinery and parts, grain and other foods and pharmaceuticals. The main export partners are Turkey 13%, US 11.2%, Azerbaijan 6.3%, UK 5.4%, Bulgaria 5.1%, Ukraine 5%, Armenia 4.8%, Turkmenistan 4.5%, Canada 4.2%. Import partners are 4

5 Turkey 14%, Russia 12.3%, Ukraine 8.5%, Azerbaijan 7.3%, Germany 6.8%, US 5%, Bulgaria 4.6%. The composition of CA of Georgia is much similar to Armenia. The biggest portion of CA is trade balance, which drives negative trend of CA (Graph 3). During the observed period Trade balance constitutes on average -18.7% in GDP (Armenia -20.4%). Like in Armenia, current transfers (private remittances) also have an important role in Georgia s economy, generating on average 5.7% of GDP (Armenia 9.8%). Graph 3. Components of Current Account Balance (% of GDP) FDI inflows are increasing year to year. In Georgia the biggest foreign investor is the USA which every year invests 20-30% of FDI volume. In 2004 December 31 st international reserves of Georgia were million. At the end of 2004 external debt of Georgia, without government guarantees was million USD, which is 34.2% of GDP compared with previous year 43.5%. Debt/ export ratio was 113.7% compared with previous year 137.8%. External debt is fully long term. The trends of CA balance in all three countries are summarized in Graph 4. Graph 4. Current Account as share of GDP 5

6 Being an oil exporting country, Azerbaijan has more volatile economy, due to oil price fluctuations in international commodity markets. Model and Methodology Based on empirical literature we constructed a model for describing factors that have impact on current account balance. For our regression analysis we take the following variables/indicators: age dependency ratio (dependents to working-age population), population growth (annual %), fuel balance, GDP per capita growth (annual %) and net foreign assets/gdp. These variables have much impact on CA. For example, higher age dependency ratio and higher population growth rates reduce savings and thus have negative impact on CA (the life-cycle theory of consumption and saving predicts that young households borrow, middle-age households save for retirement, and households in retirement dissave. Therefore relatively young and relatively old countries are both more likely to run current account deficits.). Country s net foreign asset (NFA) position directly affects its net investment income, and therefore its current account balance. Here are the results of our regression analysis (T-statistics are in parentheses): Armenia Y = *X *X *X *X *X 5 (0.09) (0.88) (-0.95) (-0.08) (0.6) where, Y Current Account/GDP X 1 Age dependency ratio X 2 Population growth X 3 Fuel balance 6

7 X 4 GDP per capita growth X 5 Net foreign assets (NFA)/GDP Adj.R 2 =0.8532, which means that the independent variables are explaining the variation in the dependent variable by 85.32%. F-test =0.0417, so our independent variables jointly have affect on dependent variable (CA/GDP). There is a positive relationship between Armenia s CA and age dependency ratio, population growth and net foreign assets/gdp variables. As these variables increase, CA increases too. There is a negative relationship between CA and fuel balance, GDP per capita growth. Azerbaijan Y = *X * X *X 3-3.1*X *X 5 (3.29) (-1.05) (-0.37) (-3.85) (2.82) where, Y Current Account/GDP X 1 Age dependency ratio X 2 Population growth X 3 Fuel balance X 4 GDP per capita growth X 5 Net foreign assets (NFA)/GDP There is a positive relationship between Azerbaijan s CA and age dependency ratio and net foreign assets/gdp variables. As these variables increase, CA increases too. There is a negative relationship between CA and population growth, fuel balance, GDP per capita growth. In contrast of Armenia and Georgia here T-statistics have some significance (except X 3 ). Georgia Y = * X * X * X * X *X 5 (-0.05) (-0.22) (-1.09) (-0.99) (-0.75) where, Y Current Account/GDP X 1 Age dependency ratio X 2 Population growth 7

8 X 3 Fuel balance X 4 GDP per capita growth X 5 Net foreign assets (NFA)/GDP With a sharp decrease in private capital inflows following the conflict, the current account deficit, which has been increasing since 2003, and hence it now exclusively financed by donor aid, thus all the indicators have a negative relationship. 8

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