EXECUTIVE SUMMARY

Armenia is a small, strategically located country (land area of 29,800 square kilometers, slightly larger than Maryland) with a literate population of about 3 million. Located in the heart of the Caucasus, Armenia is bordered by Turkey to the west, Georgia to the north, Iran to the south, and Azerbaijan to the east and southwest. The Armenians have a strong tradition of education and enterpreneurship which, combined with their close ties to the U.S. through the American-Armenian Diaspora, provides attractive prospects for joint venture partners and other business linkages with U.S. companies.

Over the past few years, Armenia has successfully managed to implement a comprehensive stabilization and structural reform program. Some of the main achievements include: price liberalization;

privatization of small-scale enterprises (over 7,000) and medium/large enterprises (1,800 for sale as of early 1998); and significant progress towards joining the WTO (experts believe that Armenia will become a member this year). In addition, Armenia has strengthened its banking sector by putting in place modern regulatory and supervisory frameworks.

Economic progress will depend on the continuation of the reform program, as well as positive political developments. Armenia’s major impediment to development is the trade embargo imposed by two of its four neighbors – Turkey and Azerbaijan. This embargo will remain in place so long as there is no peace agreement with Azerbaijan

that resolves the status of the Nagorno-Karabakh enclave. There has been a five-year cease-fire in the eight-year Nagorno-Karabakh conflict, but the potential for renewed conflict still exists and still dampens expectations.

Armenia is politically stable and committed to market reforms. Armenia has good potential in high-tech, light industries, high-value agricultural products, and in the medium term, tourism. These opportunities, coupled with its large pool of underemployed but highly literate labor force, low labor costs, and entrepreneurial spirit, offer some of the most promising advantages in the NIS region for U.S. companies. Some of the most attractive sectors for future business will most likely be in power generation, transportation/highways (establishing an east-west transportation corridor), water and wastewater treatment, agribusiness/food processing, and tourism/hotel development.

ECONOMIC OUTLOOK

Since 1994 Armenia has enjoyed positive growth rates in GDP output. In 1994 and 1995, GDP grew by 5.4% and 6.9% respectively. Growth slowed somewhat in 1996 and 1997, but reached 6.7% in 1998. By late 1996, annual inflation had fallen to under 6% - the lowest in the FSU - as compared to 46% per month in the first quarter of 1994. Now, inflation is less than 1% annually.

The economic progress has earned Armenia increasing support from international institutions. The IMF, World Bank, EBRD, as well as other financial institutions and foreign countries, are extending considerable grants and loans. Total loans extended to Armenia in 1993-1998 likely exceeded $800 million. These loans are targeted at: reducing the budget deficit; stabilizing the local currency; developing private businesses; energy; agriculture; food processing; land and air transportation; health and education; as well as ongoing rehabilitation work in the region damaged by the 1988 earthquake.

Armenia’s output is expected to grow at 6% to 7% per year as the reform program continues to transform the economy and as regional tensions ease. Improvements in both the reform program and regional tensions would remove constraints on external trade, sharply decreasing transport and energy costs, and enhancing access to external financing. Over the next few years, GDP growth is expected to result primarily from rapid private sector development and a rise in capacity utilization. Growth is expected to be led by export demand in the FSU markets as those economies recover, and by increasing penetration of nontraditional markets, such as Middle Eastern and European markets.

BUSINESS AND INVESTMENT CLIMATE

Over the past few years, the business and investment climate in Armenia has consistently improved. Early on in its transition, Armenia passed a law and signed a treaty which protect foreign investors: 1) Bilateral Investment Treaty signed by the U.S. and Armenia in September, 1992; and 2) Law on Foreign Investment adopted by Armenia in July 1994. These protective mechanisms allow any foreign investor – defined as a foreign company, citizen of a foreign country, person without citizenship residing in a foreign country, Armenian citizen permanently residing outside Armenia, or international organization – to invest in Armenia. Foreign investors can invest in a number of different areas (e.g., joint-stock companies, joint-venture businesses, securities, and paid services), with the exception of natural resources, which is permitted only through concession agreements. The law protects investors’ intellectual property rights. According to the Law on Foreign Investment, foreign investments cannot be nationalized or confiscated without due process and just compensation.

Besides basic foreign investment laws, the Government is committed to privatization and has progressively diminished its control over industry. The National Assembly (Parliament) is steadily developing and passing laws which create the framework for a market oriented economy. This commitment to privatization was made clear when the Government sold 75% - 90% of its interests in the following to international firms for cash: the premier hotel in the country; the telephone monopoly; and the nation’s most treasured business, the Armenian brandy factory.

The Government is aware that corruption and transparency issues are still serious barriers to business. While the environment is better in Armenia than some of the other countries of the former Soviet Union, problems remain despite Government reform efforts. For example, individuals in Government positions are still engaged in private businesses and frequently use their influence to expand and protect their enterprises, often in a way contrary to established international business practices. One serious constraint is the lack of a transparent business, regulatory, and tax environment in part caused by a lack of accurate information (particularly in English). The new Civil Code, however, has been translated into English and is available at the U.S. Embassy, USAID, the library at the American University of Armenia, and other local libraries. Still, many of the business laws have numerous sub-regulations and norms that often change and are difficult to trace. Bureaucratic procedures may sometimes appear complex and confusing. Low-paid personnel of state agencies dealing with various business-related issues are often tempted to use the newcomer's limited knowledge of the local environment to ask for a fee to "speed up" even the simplest procedures. Cash "awards" for granting contracts, bank credits, well-paid jobs, and other forms of bribery are widespread.

To avoid these and other complications, the U.S. Embassy recommends that U.S. firms consult thoroughly with local lawyers on every aspect of their future activities in Armenia, including registration, licenses, taxes, particular tax incentives, local accounting principles, import/export procedures, certification requirements, contracts, etc. This is especially recommended for firms entering Armenia for the first time, and for those that have no Armenian partner. Firms are urged to carefully select an Armenian partner, and to adopt a long time horizon regarding expected returns.

POLITICAL CLIMATE

Armenia is a republic in which a President is elected every five years. There were special elections for President held in 1998, after Levon Ter Petrossian resigned. These were carried out on a more peaceful note than the 1996 presidential elections, improving the image of the country significantly. That image had been hampered by the 1996 elections, when a number of incidents took place where both the opposition, which disagreed with the election results, and the Government, resorted to violence. Tensions have since receded and a reconciliation process is under way. Armenia enjoys a particularly close relationship with the U.S. On a per capita basis, Armenia is the third largest recipient of U.S. aid. The United States Embassy was the first embassy to open in Yerevan in February 1992. The Armenian Embassy opened in Washington in the same year. U.S. aid to Armenia emphasizes: humanitarian assistance (food and fuel); building democracy and good governance; modernizing the banking system; fiscal reform; restructuring the energy sector; agricultural marketing; and creating a regulatory and a financial framework for private sector development. The U.S. is active in efforts to negotiate an end to the Karabakh conflict. Armenian and U.S. Government officials maintain very close working relations. In the future, there are two primary political issues that will need to be resolved in order for Armenia to enjoy the benefits of an open, growing regional and global economy. First is the conflict surrounding Nagorno-Karabakh, an Armenian-populated autonomous enclave in neighboring Azerbaijan, which has lowered the attractiveness of investment in the region. A cease-fire has been observed by both sides for more than five years. There is, however, no indication that the embargoes will be lifted in the near future. There has been no substantial progress toward a settlement, though international efforts are ongoing. The second issue, related to the Nagorno-Karabakh territorial dispute, is the role of Turkey. Turkey has sided with Azerbaijan in this conflict and has established a blockade of Armenia, paralleling that of Azerbaijan. The embargoes have lost a small amount of their economic influence because many Turkish goods and Azeri oil products find their way to Armenia anyway, albeit at much higher prices. Also, since 1995, Turkey has allowed a limited number of passenger charter flights between the two countries as well as Armenian transit flights over Turkish territory. The embargo remains one of the key factors hindering economic development of Armenia. The embargo also ties the hands of many U.S. businesses whose regional headquarters (which usually cover the Caucasus) are in Turkey.

SOURCES OF FINANCING

Armenia's banking sector has two large state-controlled banks (Savings Bank and Ardshinbank) and more than 20 private commercial banks with over 220 branches. Foreign banks are represented by Midland Armenia Bank (member of HSBC group), Rossiyski Kredit Armenia (Russia), and Mellat Bank (Iran). The number of private banks has been slowly declining because the Central Bank has pursued a policy of tightening bank capitalization requirements to push the weak banks into closing or into mergers with stronger banks. The increased requirements and competition force the banks to begin to meet international standards. Consequently, remaining banks are considerably stronger and are subject to close supervision. were carried out on a more peaceful note than the 1996 presidential elections, improving the image of the country significantly. That image had been hampered by the 1996 elections, when a number of incidents took place where both the opposition, which disagreed with the election results, and the Government, resorted to violence. Tensions have since receded and a reconciliation process is under way.

Armenia enjoys a particularly close relationship with the U.S. On a per capita basis, Armenia is the third largest recipient of U.S. aid. The United States Embassy was the first embassy to open in Yerevan in February 1992. The Armenian Embassy opened in Washington in the same year. U.S. aid to Armenia emphasizes: humanitarian assistance (food and fuel); building democracy and good governance; modernizing the banking system; fiscal reform; restructuring the energy sector; agricultural marketing; and creating a regulatory and a financial framework for private sector development. The U.S. is active in efforts to negotiate an end to the Karabakh conflict. Armenian and U.S. Government officials maintain very close working relations.

In the future, there are two primary political issues that will need to be resolved in order for Armenia to enjoy the benefits of an open, growing regional and global economy. First is the conflict surrounding Nagorno-Karabakh, an Armenian-populated autonomous enclave in neighboring Azerbaijan, which has lowered the attractiveness of investment in the region. A cease-fire has been observed by both sides for more than five years. There is, however, no indication that the embargoes will be lifted in the near future. There has been no substantial progress toward a settlement, though international efforts are ongoing.

The second issue, related to the Nagorno-Karabakh territorial dispute, is the role of Turkey. Turkey has sided with Azerbaijan in this conflict and has established a blockade of Armenia, paralleling that of Azerbaijan. The embargoes have lost a small amount of their economic influence because many Turkish goods and Azeri oil products find their way to Armenia anyway, albeit at much higher prices. Also, since 1995, Turkey has allowed a limited number of passenger charter flights between the two countries as well as Armenian transit flights over Turkish territory. The embargo remains one of the key factors hindering economic development of Armenia. The embargo also ties the hands of many U.S. businesses whose regional headquarters (which usually cover the Caucasus) are in Turkey.

The Government has created the legislative environment to encourage the growth of the private insurance market. Marine Midland has opened a commercial insurance subsidiary that is now doing business in the country.

Lending from most private banking institutions is limited by their low capacity (very few banks can provide loans exceeding $20,000). At present, many private banks limit their lending operations to short-term loans in local or hard currency at a very high rate of interest (up to 6-9 percent/month, or 50-70 percent per annum). These banks usually demand collateral of adequate or higher market value (homes, cars, gold, etc.). By December 1, 1997, total chartered capital of all 30 commercial banks was 16.8 billion dram or $33.7 million.

The banking situation, however, is beginning to change. Marine Midland, for example, is now lending on one to two year terms to about 40 enterprises at more affordable interest rates. It is unclear, however, how fast this financial deepening of the economy will proceed, especially in light of the economic problems now being experienced by Russia, Armenia’s main export market.

Project financing is still limited and is primarily implemented through subsidized loan programs funded by foreign Governments and multilateral financial institutions. The programs are aimed at private business development for specific categories of enterprises. They are serviced by a few local banks and offer loans ranging from $500 to $500,000 with, on average, 15-20 percent annual interest. The loans are normally supported by a business plan and are secured by adequate collateral.

The best sources of export and insurance financing are from the U.S. Export-Import Bank and Overseas Private Investment Corporation (OPIC). In July 1997, the Ex-Im Bank signed a General Project Incentive Agreement with Armenia which provides a framework for financing the purchase of U.S. exports, with the loans to be repaid with revenues generated by production from the enterprises buying U.S. goods or services. To insure their risks in dealing with Armenian partners, U.S. businessmen are encouraged to contact OPIC in Washington D.C. OPIC is a Government-affiliated agency which, upon agreement with Armenia, provides insurance (and reinsurance) coverage against three types of political risks: currency inconvertibility; expropriation; and political violence.

At present, financing for projects in Armenia is provided mainly by the World Bank, EBRD, USAID, OPIC, and TDA (feasibility studies). Most projects financed by international institutions, such as the World Bank or EBRD, are contracted on an international tender basis.

SECTORAL OVERVIEW

Based on discussions with the U.S. Embassy and Armenian officials, some of the best business opportunities in the future are: power generation; transportation/highways (establishment of an East-West transportation corridor); water and wastewater treatment; agribusiness/food processing; and tourism/hotel development. During the first half of 1998, total investment in Armenia reached $188 million, with foreign investment totaling $140 million. In 1997-1998, there were a number of large investments recorded: more than $25 million was invested in oil and gas exploration; at least a $15 million investment was made in gold processing; and $30 million was invested into the purchase of the Yerevan Cognac Factory. Moreover, $150 million went into the privatization and purchase of the Armenia Telephone Company. The sectors that showed solid growth (5 percent on average) included energy generation, chemicals, telecommunications, agriculture, construction and construction materials. Significant growth in the overall number of businesses was observed in wholesale and retail trade (31 percent, mainly food), restaurants (38 percent), passenger and cargo transportation (12 percent), real estate brokerage (29 percent), education (39 percent), and health care and social services (39 percent).

ENERGY

Armenia's energy sector is undergoing changes that are resulting in procurement opportunities for foreign suppliers. While the country's economy is not generating enough funds to independently finance the energy sector projects, procurement is mainly financed by international financial institutions, such as the World Bank and EBRD, or bilateral or foreign aid institutions such as U.S. Agency for International Development. Creative financing is welcome.

The Government recognizes the importance of promoting foreign private investment. World Bank estimates are that about $1.7 billion in new investment will be needed to reverse the deteriorating situation in the power sector. As such, it is working with donors to establish long-lasting energy sector reforms. Key elements of the Government’s energy sector reform program include:

1) strengthening the regulatory capacity of the Energy Commission;

2) introducing IAS-based accounting for sector enterprises;

3) adopting a Financial Rehabilitation Plan for the power sector to restructure the stock of receivables and payables and to prevent the growth of new arrears; and

4) implementing, with donor assistance, a privatization program. Some of the more promising business opportunities related to this program include:

· Power Delivery. The World Bank is moving ahead with a $33 million credit for an Electricity Transmission and Distribution program. The project seeks to rehabilitate/modernize transmission and distribution networks. Opportunities exist for procurement of dispatch systems, cables, transformers, electric metering systems, and other related equipment.

· Thermal Power. The Ministry of Energy is hoping to find investors to buy into the construction of a 300 MW gas-fired power station. The EBRD plans to assist the Government to find an investor to complete construction of a 300 MW generation unit at Hrazdan TPP. Investors are also sought to privatize the entire Hrazdan TPP complex.

· Hydro-Power. More than thirty small hydro-power plants are undergoing privatization. The plants are in various stages of readiness, starting with almost Greenfield and ending with operating facilities. Thirteen of those plants were already privatized in the beginning of 1997. Owners of most of the plants need to renovate/upgrade the facilities. Opportunities may exist for procurement of small hydro-turbines, and related equipment.

TRANSPORTATION

Armenia’s highways received little or no maintenance from the mid-1980s to 1996. In 1996, World Bank-financed road rehabilitation projects began to restore key arterial links. Armenia has the potential to be the transportation corridor between Georgia and Central Asia and Turkey and Europe. Assuming the Turkish blockade will be lifted, the U.S. has studied two road and two rail links that would facilitate trade between Georgia and Turkey that transit Armenia. For the roads, the link from Sadachlo on the Georgian border to Kars, Turkey via Gyumri would require about $92 million to upgrade the road in Armenia. The link from Sadachlo to Igdir, Turkey via Echmiadzin would cost a minimum of $19 million to upgrade the road in Armenia. The World Bank’s ongoing and upcoming transportation loans may cover $60 million of the total cost of restoring the Gyumri link and $8.5 million of the cost of restoring the Echmiadzin link.

The rail link parallels the road route via Gyumri from Georgia to Kars, Turkey. The World Bank’s ongoing loan program is assisting the Armenian Railways Corporation upgrade its Armenia-Georgia service. Moreover, the World Bank’s pending third transportation loan to Armenia would devote adequate funding to this track given current traffic. Should traffic increase, about $700,000 to $800,000 should be invested to upgrade the track near the border with Georgia. These, however, may be underestimates.

TOURISM

The Republic of Armenia offers some good opportunities to open new guest lodging which serve several different niches in the hospitality industry. The country has both good scenic destinations and cultural sites. Armenia is a small, rocky country with splendid mountains and canyons, beautiful forest regions in the North, and the magnificent Lake Sevan located at more than 2,000 meters above sea level. In the southwest of Yerevan, the rocky terrain gives way to the Ararat Valley, full of fruit plantations and vineyards. From here one can observe a splendid view of the biblical Mount Ararat, with its two snowy summits towering high over the horizon. Armenia is the source of several unique cultivars and species of birds and wildlife. This provides for some good ecotourism opportunities.

Armenia is also rich with ancient monuments - Christian churches and monasteries, some of which date back nearly to the birth of Christianity. Some of them are concentrated in the holy city of Echmiadzin, the residence of the head of the Armenian church, the Catholicos of All Armenians. Armenia also has a good skiing base in Tsakhkadzor.

The country’s tourism infrastructure is in an early stage of development. The years of conflict in neighboring Azerbaijan have diverted tourists from this formerly popular region. The Government has negotiated the sales of its three major hotels in Yerevan to foreign investors. In 1996, tourist traffic resumed and started to grow. In the next few years there will be opportunities in the following: Rehabilitation of the Hotel Armenia. This rehabilitation job will be supervised by Marriott International and will cost about $22 million. · Development of small hotels and guesthouses. There are good opportunities to open small hotels and guesthouses (2-3 star level) to help develop the ecotourism and religion-based tourism opportunities.

AGRICULTURE

Food products constituted 30.8 percent of total Armenian imports in 1997. Seventy percent of all consumed food was imported. In general, food imports have been growing, while local production has been declining due to high production costs. Imported foodstuffs are mainly of Iranian, Turkish, Russian, UAE, European, and U.S. origin. U.S. imports are primarily meat and poultry products, eggs, grocery items, beer and alcoholic beverages. U.S. food exports to Armenia grew sharply in 1996-1998 with the establishment of U.S. and European food distributors in Yerevan. Though no statistics are available, U.S. commercial exports are expected to increase in 1999 and may even dominate the market in some sectors, such as meat and poultry. Meat and poultry products, eggs, sugar, flour, soft drinks and alcoholic beverages represent the best export niches in the market.

Armenia is famous for its fruits and vegetables, which due to soil and climatic conditions, high altitude, and limited use of chemical fertilizers, are rich and flavorful. With modern processing and packaging technologies, Armenian fruit and vegetable products can successfully enter international markets. Most food processing plants and canneries in the country, however, have outdated equipment, cannot provide export-quality products, and are looking for foreign partners. This sector is already beginning to attract U.S. investors, who are considering several projects in tomato paste and fruit juice production and packaging for local markets, as well as for export. From 1996, the U.S. Department of Agriculture began an ambitious project aimed at assisting Armenia in processing, packaging, and exporting its fruits and vegetables. Cheese factories are just beginning in Armenia on a commercial scale and may represent opportunities in the future for U.S. investors. The USDA Marketing Service in Armenia is looking for U.S. suppliers of irrigation equipment for farms of about 300 acres. There are also opportunities in feed mixing and distribution as well as fertilizer production and distribution.

The Armenian Development Agency, through the Prime Minister’s office, has opportunities for U.S. investors in several cannery factories, a juice factory and the development of the electronics sector.

TDA Caspian Region Briefing Book