US embassy cable - 05YEREVAN139

C O N F I D E N T I A L SECTION 01 OF 03 YEREVAN 000139 
 
SIPDIS 
 
DEPT FOR EUR/CACEN, EUR/ACE 
 
E.O. 12958: DECL: 01/20/2015 
TAGS: ECON, EAID, EFIN, AM 
SUBJECT: ARMENIA'S 2005 BUDGET:  MORE BUTTER, STILL PLENTY 
OF GUNS 
 
REF: A) 04 YEREVAN 2510 B) 04 YEREVAN 2579 C) YEREVAN 
 
     52 D) YEREVAN 83 
 
Classified By: DCM A.F. Godfrey for reasons 1.4 (b/d). 
 
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SUMMARY 
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1. (C) The GOAM has billed the 2005 budget as having a social 
focus.  Both tax receipts and social spending are set to rise 
ambitiously in line with the GOAM's Poverty Reduction 
Strategy.  After much debate, official defense spending is 
set to rise too, although spending on education will exceed 
official defense expenditures for the first time.  The 
international donor community, especially the IMF, is 
skeptical, noting that the GOAM has moved significant 
revenues (and thus, presumably, expenditures) off-budget. 
Substantial non-tax revenues from the well-known Kajaran mine 
privatization are conspicuously absent from the budget.  We 
believe that the budget does not represent the full extent of 
official expenditures.  The government of Armenia appears to 
be moving important revenues off-budget, presumably in order 
to finance defense expenditures in Nagorno-Karabakh (ref B). 
End Summary. 
 
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BUDGET IN NUMBERS 
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2. (U) The Armenian state budget is small, even compared to 
Armenia's small GDP (forecast to be 2,058 billion dram or USD 
4.12 billion in 2005).  The 2005 budget predicts state 
revenues of 345 billion dram (USD 690.7 million) and state 
expenditures of 394 billion dram (USD 789.2 million), 16.7 
and 19 percent of GDP, respectively.  The GOAM relies on 
concessionary loans from International Financial Institutions 
(IFIs) to finance 34 billion drams (USD 69.3 million) of the 
budget deficit.  The government will issue bonds -- sold 
domestically -- to meet the remaining deficit of 14.6 billion 
dram (USD 29.2 million).  The lion's share of Armenia's 
outstanding debt is to International Financial Institutions, 
who agree that Armenia's debt is prudent and serviceable. 
The 2005 budget relies on a reasonable assumption of 8 
percent growth in nominal GDP during 2005.  (Note:  All 
amounts are noticeably greater this year than last in dollar 
terms, as the Dram appreciated 16 percent on the dollar in 
2004.  End Note.) 
 
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SOCIAL SPENDING IN LINE WITH POVERTY REDUCTION STRATEGY 
--------------------------------------------- ---------- 
 
3. (U) During parliamentary budget debates, MP's and Ministry 
of Finance officials repeatedly stressed the social focus of 
the 2005 budget.  The government is changing the budget in 
line with the guidelines set out last year by the Poverty 
Reduction Strategy Paper, reducing expenditures on subsidies 
and domestic interest payments, and increasing expenditures 
on health, education, social security. Spending on public 
health, education and social sector accounts for 35.6 percent 
of budget expenditures.  The 2005 budget allocates 61.6 
billion drams (USD 123.3 million) to education and science, 
up from 54.4 billion drams (USD 108.8 million) in 2004. 
Social security spending will be 46.5 billion drams (USD 93.1 
million), 5 percent higher than in 2004, to meet programmed 
pension increases.  The average social pension will increase 
by 1000 drams (USD 2) to 4000 drams (USD 8).  These increases 
are broadly in line with the Poverty Reduction Strategy, 
which calls for increasing spending on health, education and 
social security by 1 percent of GDP in 2005.  Paying for 
these increases depends on meeting the programmed increases 
in tax revenues, or cutting back other expenditures (which is 
how the government financed increased social payments last 
year). 
 
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MISSING REVENUES - PART ONE 
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4. (SBU) The GOAM's inability to adequately collect revenues 
continues to thwart full implementation of the Poverty 
Reduction Strategy.  President Kocharian has declared 2005 
the year of tax and customs reform.  The President and his 
Chief Economic Advisor have publicly called for improvement 
of the tax administration both to increase revenue collection 
and to create a better tax environment for businesses (refs C 
and D).  The 2005 budget reflects this, calling for an 
increase in tax receipts of nearly 20 percent to 292 billion 
dram (USD 585 million).  This would bring tax revenues to 
14.1 percent of projected GDP, still shy of the 18.8 percent 
goal set out in the GOAM's Poverty Reduction Strategy Paper. 
 
5. (SBU) The programmed increase in tax collections seems 
optimistic when compared to past outcomes.  Last year's 
budget called for a 16 percent increase (on top of growth) in 
tax collection, but in fact tax revenue fell as a percentage 
of GDP in 2004.  According to the  budget, the programmed 
higher tax revenues are based solely on "expected 
improvements in (tax) administration" and the introduction of 
the minimum tax to catch businesses who evade taxation. 
Comment:  If the government is successful in genuinely 
reforming the tax administration, there is enough slack in 
the current tax system to increase revenues considerably. 
But such reform would require political will that has proven 
elusive in the past (ref C).  End Comment. 
 
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MISSING REVENUES - PART TWO 
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6. (C) Another cause of Armenia's anemic on-budget cash flow 
is that the GOAM moves some revenue streams off the official 
budget (refs A and B).  (Comment: While Armenia claims it 
does not provide for the defense of the ostensibly 
independant Nagorno-Karabakh, in fact it is common knowledge 
that it does.  Keeping expenditures for the defense of 
Nagorno-Karabakh out of public documents is almost certainly 
the primary reason the GOAM keeps revenues and expenses off 
the official budget.  End Comment.)  In a December 7, 2004 
meeting with the Ambassador, the IMF Resident Representative 
James McHugh said that he suspected that the Government of 
Armenia has been increasing the amount of expenditures and 
revenues that it kept off-budget in 2004. 
 
7. (C) The recent sale of the Kajaran Copper Molybdenum plant 
for USD 132 million (18 percent of officially projected 2005 
tax revenues) was conspicuously absent from the government's 
non-tax revenue report.  (The 2004 operational profits from 
the Kajaran mine, more than USD 20 million, were also 
diverted off-budget to a Fund under the control of the 
Ministry of Defense (ref A).)  From a final sale price of USD 
132 million, only 17.5 billion dram (USD 35 million) appears 
in the state budget. According to a December 2004 government 
signed by the Government's Chief of Staff, the rest of the 
money is to be directed to various off-budget 
state-controlled funds.  Some of this redirection is for the 
type of spending that is traditionally on-budget in other 
countries.  For example,  the City of Kajaran (where the mine 
is located) is to receive 32.1 million dollars.  An appendix 
to the decree cites a decision by the City of Kajaran to then 
give USD 5 million to the Ministry of Defense and another USD 
27 million to Armgasard, a defunct state-owned energy company 
whose debts are administered by the Ministry of Energy.  The 
municipality will in fact keep only USD 100,000 to refurbish 
a kindergarten and a municipal building. 
 
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ON-BUDGET DEFENSE EXPENDITURES ARE UP 
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8. (C) After an initial official press announcement that 
defense spending would not rise, and then a heated cabinet 
debate, the official defense allocation is up 22.4 percent 
from the 2004 budget to 61 billion drams (USD 122 million). 
Official defense expenditures account for 3.6 percent of 
estimated GDP, the second highest ratio in the former Soviet 
Union.  The President's economic advisor, Vahram 
Nercissiantz, told us that the Minister of Finance wanted to 
keep the increase in defense spending entirely off-budget 
because he (incorrectly) thought that an IMF rule prohibited 
defense spending above a certain level.  Nercissiantz said 
that, in a heated cabinent debate, he and others urged the 
Minister to move a large portion of the increase on budget, 
in part to improve transparency and in part to make a show of 
the increased defense spending. 
 
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COMMENT:  STILL A DEFENSE BUDGET 
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9. (C) The characterization of Armenia's 2005 budget as a 
social budget is slightly disingenuous.  The government has 
programmed significant increases in social spending, but the 
official budget represents only part of government spending. 
While increasing tax revenues still remains an important part 
of the government's poverty reduction strategy, a large part 
of the missing revenues are intentionally moved off budget. 
(Armenia has the lowest revenue-to-GDP ratio in the CIS.) 
There is no public debate in Armenia about the propriety of 
financing the defense of Nagorno-Karabakh.  Published 
government decrees show that the Ministry of Defense receives 
more money than is accounted for by its line in the budget, 
and that important revenue streams are diverted to funds 
controlled by the Ministry of Defense with no accountability 
to the National Assembly or Ministry of Finance auditors. 
Were these expenditures to be counted, the 2005 "social" 
budget would look more like the defense budget that it does. 
EVANS