Business Monitor Online
October 29, 2014 Wednesday

BMI View: Armenia's economic growth model will become increasingly
interlinked with Russia over the coming years on account of the
former's accession to the Eurasian Economic Union in 2015 . Although
this will provide a modest short-term boost in trade and structural
funding, Armenian integration with Russia will ultimately prove an
impediment to growth.

Macro Backdrop

We believe that the Armenian economy will continue along a slower
growth trajectory over the coming years due to its increasing
ties with Russia, for which we hold a similary downbeat macro
view. Russia will continue to be Armenia's largest export partner
for the foreseeable future, having accounted for 22.6% of Armenian
exports in 2013. Furthermore, as of August 2014, Russia accounted for
74% of remittance inflows into Armenia, representing almost 17% of GDP.

Given our sluggish 2015 and 2016 real GDP growth forecasts for Russia
of 1.2% and 2.6% respectively, we fail to see any significant growth
drivers of the Armenian economy. The country's industrial base remains
both relatively small and run in much the same way as it was in the
Soviet era with declining cost competitiveness, outmoded technology
and a lack of innovation. Moreover, fixed investment stood at almost
half its pre-crisis peak in real terms at year-end 2013, and two of
the country's four land borders are closed to trade.

That said, we do expect a modest short-term uptick in exports and
inward investment on account of Armenia's impending induction into
the Eurasian Economic Union (EEU). The EEU is a political and economic
bloc that already comprises Russia, Belarus and Kazakhstan, and will
almost certainly include Kyrgyzstan in the near future. Against this
backdrop, we are forecasting headline real GDP growth of 3.1% and 3.0%
in 2015 and 2016 respectively.

Slower Trend Growth Ahead Armenia - Real GDP Growth (% chg y-o-y)

Private Consumption: Private consumption will remain the principal
driver of economic growth in Armenia over the coming quarters,
contributing 3.2 and 3.6 percentage points (pp) to growth in 2015 and
2016 respectively. Consumer spending has represented around 85% of GDP
over the past five years and we see little to suggest this will change,
though stagnating remittance flows from Russia will prevent significant
private consumption growth. Indeed, we are already beginning to see
this trend play out, with private consumption contracting by 2.3%
and 3.4% in year-on-year terms in Q114 and Q214 respectively, in
tandem with waning remittance flows from Russia.

Retreating Russian Remittances Armenia - Remittance Flows From Russia

In addition, the majority of remittances from Russia are transferred
in US dollars rather than roubles (RUB). This means that although we
are forecasting the Armenian dram to continue strengthening against
the rouble, the recent rouble sell-off has sent the USD/RUB exchange
rate to all time highs, which will decrease the local currency value
of Russia-Armenia money transfers.

Another way in which Russia's economic malaise will hurt Armenian
households is via bank lending. Western sanctions on Russian banks
will continue to push subsidiaries in Armenia repatriate capital to
parent banks in Russia. This will tighten credit conditions and weigh
further on private consumption over the coming quarters.

Government Consumption: Public spending in Armenia will remain
relatively low by regional standards as a percentage of GDP over the
next few years, and as such will have little bearing on the country's
growth trajectory. Armenia has traditionally run small fiscal deficits
- apart from blips in 2009 and 2010 caused largely by external shocks
- and we believe this trend will continue on account of the country's
narrow tax base, which is exacerbated by the large informal sector.

Moreover, Armenia has shifted from multilateral credit and aid lines to
international financial markets as a means of government financing over
the past few years. This will mean that the government will continue
to keep spending in check to avoid damaging investor confidence,
which would lead to a spike in borrowing costs.

Consequently we forecast government consumption to contribute just
0.4 pp to headline growth in both 2015 and 2016.

Gross Fixed Capital Formation: Fixed investment in Armenia has
declined over 45% in real terms since its pre-crisis peak in 2008,
and while we expect the sector to return to growth in 2015 following
six consecutive years of contraction, this will by no means signal
an investment boom. Indeed, we are forecasting GFCF to contribute
an average of just 0.3 pp to growth between 2015 and 2017. The most
significant factor driving an uptick in investment will be Armenia's
accession to the EEU, which will likely result in the country receiving
more structural funding from Russia.

Barren Fixed Investment Outlook Armenia - Fixed Capital Formation

Net Exports: Another benefit of Armenia's accession to the EEU will
be a short-lived increase in exports. We forecast exports increase
by 7.0% and 5.0% in 2015 and 2016 respectively as Armenian exporters
gain tariff-free access to the markets of Russia, Kazakhstan, Belarus
and eventually Kyrgyzstan. However, we still forecast net exports to
remain a drag on growth over the coming years for two main reasons.

Firstly, the EEU single market will make imports from other member
states more competitive in Armenia, which will negate an improving
export picture in terms of headline real GDP growth, though will
nevertheless boost GDP per capita. Secondly, the continued weakness
in the rouble will improve the purchasing power of Armenians importing
goods from Russia, which will further drive up Armenia's import bill.

Consequently, we forecast net exports to subtract 0.9 and 1.1 pp from
growth in 2015 and 2016 respectively.

Against this backdrop, we believe that Armenia's present current
account dynamics will remain in place over the next few years. The
country will continue to run a massive goods and services deficit
of around 22% of GDP that will be counterbalanced to some extent by
large surpluses in the income and current transfers accounts. Armenia
will nonetheless continue to run current account deficits in excess
of 7.0% of GDP, which, combined with a capital and financial account
deficit that has typically tracked the current account, could leave
Armenia exposed to external shocks. However, we do not believe that
Russia will allow a new member of the EEU to succumb to a balance
of payments crisis. As such, we expect Armenia's external position
to remain precarious, but Russian support will stave off any crisis
that could threaten Armenia's fragile growth trajectory.

Risks To Outlook

Although Armenia and Azerbaijan have agreed to pursue talks over
the disputed Nagorno-Karabakh region, the potential for a military
escalation in the territory remains the key risk to Armenia's
economic stability after the tensions reached their highest point
since a cease-fire was signed in 1994 in mid-2014. Any direct military
involvement by Armenia in the region would severely limit the country's
growth prospects for several years.

From: A. Papazian