CENTRAL BANK OF ARMENIA

CENTRAL BANK OF ARMENIA Approved under the Central Bank Board Resolution No. 114 A, 02.05.2011 The Monetary Policy Program of the Republic of Armenia Quarter 2, 2011

Table of Contents Monetary Policy Guidelines of the Central Bank of Armenia under Inflation Targeting Strategy... 4 Q1 2011 Actual Indicators and Developments... 6 Upcoming 12-Month Period Forecasts... 12 External environment... 12 Aggregate Supply... 14 Labor Market... 15 Aggregate Demand... 16 Consolidated Budget... 17 Inflation Forecasts and Monetary Policy Directions in the Projected 12-Month Period... 18 2

The consequences of the financial and economic crises showed up in the Armenian economy at the end of 2008. Starting 2009, the Armenian authorities took up anti-crisis measures. In consideration of the characteristic features of the domestic economy as well as following the action taken by inflation targeting central banks, the Central Bank of Armenia implemented quantitative easing under the inflation targeting strategy regime. The policy was aimed at an affective combination of the objectives for maintaining price stability and economic growth in the time of economic decline. At present, the monetary policy of the Central Bank gradually returns to the framework of the inflation targeting. To this effect as well as by virtue of the principle of transparency, the Central Bank finds it reasonable to publish, in a re-edited version and with certain clarification, the paper Monetary Policy Guidelines of the Central Bank of Armenia under Inflation Targeting Strategy. 3

MONETARY POLICY GUIDELINES OF THE CENTRAL BANK OF ARMENIA UNDER INFLATION TARGETING STRATEGY Article 4 of the Republic of Armenia Law on the Central Bank establishes that primary objective of the Central Bank is maintaining price stability. This gives the Central Bank authority to have its contribution to the implementation of economic policy for achieving a sustainable and high economic growth in the long-run. The price stability implies such a change in the price level that does not affect savings and investments by economic agents as well as other decision-making, nor does it create inflation expectations (both upside and downside). The price stability is generally defined through a low and stable level of inflation, which now is 4 percent, within the band of +1.5 pp, for the Armenian economy. This is the target inflation indicator in the medium-run as well. To maintain price stability, the Central Bank of Armenia has adopted an inflation targeting strategy as established by the monetary policy program provisions of the Central Bank for 2006 (approved by the Board of the Central Bank Resolution No. 563 A, dated 19/12/2005), since 2006 the Central Bank has moved to the fullyfledged inflation targeting strategy from the monetary targeting regime. To fulfill its ultimate goal, the Central Bank formulates, approves and implements quarterly monetary policy program for the upcoming 12-month period. The program presents inflation forecasts (for a quarterly basis) for the upcoming 12- month period; provides the monetary policy strategy and directions 1 in attaining the target inflation indicator, using forward looking approach. The level of inflation is forecast, using the CPI disaggregation model based on the unchanged market interest rates assumption. The conditional forecast for inflation is publicly disclosed in the monetary policy program. Possible deviations from the inflation indicator illustrated through the Fan chart provided in the program. At the same time, basing on data on current macroeconomic developments (GDP, exchange rate, interest rate, etc.), the Quarterly Projection Model (QPM) is used to forecast the unconditional inflation, i.e. inflation created in response to the Central Bank action (the deviation between the latter and target inflation indicator is minimized when the Central Bank responds to). The CBA does not communicate unconditional forecast. In implementing an inflation targeting strategy, the Central Bank is guided by the following principles: 1. The primary and ultimate objective of the Central Bank is maintaining price stability, which is set within the band of 4 percent (+1.5 pp) inflation. 2. The inflation indicator is the growth of consumer price index which denotes the growth of index for 470 items of consumer goods prices and service tariffs. 3. The forecast level of inflation serves as nominal anchor. 4. The Central Bank repo or refinancing rate serves as an operational target; the repo or refinancing rate is set by the Board of the Central Bank pursuant to a preannounced yearly schedule, for any particular period for reserve requirement. The monetary policy conveys impulses to the economy not only through a change in interest rate but also by leaving its level unchanged for any particular period of time. 1 See sub-section Strategy of Section Monetary Policy of the Central Bank website. 4

5. Each quarter, the Board of the Central Bank decides on the directions of the monetary policy for the upcoming quarter within 30 days after the first decision during that quarter on monetary policy instruments has been made, based on inflation forecasts as well as risks deriving from individual sectors of the economy. 6. The target horizon is 12-month. This means that, each quarter, inflation of the next 12-month period is to be forecast on a quarterly basis, and monetary policy implementation has to abolish the gap between the target and forecast inflation indicators. At the same time, apart from quarterly inflation, the Central Bank keeps watch over monthly dynamic of indicators yet makes review of actual inflation on a quarterly basis. 7. For accountability and transparency purpose, a press release is issued when the Board of the Central Bank takes a decision on interest rates of monetary policy instruments, while the Minutes of the Board meeting on Interest Rate follow within 10 days thereafter. Each quarter, the Monetary Policy Program is published within 30 days after the fist decision during that quarter on monetary policy instruments has been made, and Inflation Report for the previous quarter is published within two months following the end of the quarter. 8. Exclusive events which are widely recognized as non-monetary factors that objectively affect inflation (supply shocks) are analyzed and commented more comprehensively, as follows: soaring international prices; Significant fluctuation of the dram exchange rate caused by external shocks, which does not reflect the economic fundamentals and the course of monetary policy; Significant changes in agriculture, which influence the price of goods; and Force majeure events. These can create mainly supply shocks which are one-off events, and neutralizing their influence through the monetary policy would hamper the growth of economic activity. In countries with short history of low inflation, such supply shocks create inflation expectations and leave second round effects. This is why the Central Bank finds it appropriate to comment on the impact of such factors on inflation and on what its attitude toward it is. 9. The Central Bank watches over the dynamics of demand for Dram, especially the ups and downs in the dollarization, steered by the number-one priority of maintaining price stability. 10. In implementing an inflation targeting strategy, the Central Bank does not publish exchange rate forecasts but rather is guided by the principles of floating exchange rate regime (unless there is strong need to curb sharp fluctuations). Nor does the Central Bank publish interest rate forecasts. 5

Q1 2011 ACTUAL INDICATORS AND DEVELOPMENTS Persisting high inflationary environment was forecast for the first quarter of 2011 due to transmitted high inflation on prices of agricultural products, food products and raw materials in world markets in 2010 as well as second round effects and high inflation expectations fuelled by the these factors for months. Moreover, there were uncertainties outlined in the first quarter monetary policy program that contained risks of deviation of inflation from its central value. During the quarter, main inflation risks materialized in the previous program showed up, and the inflationary environment expanded further. This was largely a consequence of intensified inflationary pressures in world markets of raw materials and food products in the first months of 2011. As a result, in March the 12-month inflation reached 11.5 percent. The contribution of price increases of food products made to headline inflation was 8.3 pp, of which price increases of agricultural products made 5.4 pp contribution and imported food products, about 2.7 pp contribution. The contribution from price increases of non-food products and service tariffs came at 0.6 pp and 2.5 pp, respectively, to the 12-month inflation. Inflation in the first quarter reached 5.2 percent, with 4.2 pp contribution coming from prices of food products, 3.1 pp of which alone was due to growth in fruit and vegetable prices and 0.5 pp due to growth in bread prices. Prices of nonfood products rose, with healthcare service and transport fare increases making up, respectively, 0.1 pp and 0.8 pp contribution. In March, the 12-month core inflation reached 6.18 percent as a result of the 1.93 percent growth of core CPI during the Quarter. 114 112 110 108 106 104 102 100 12-month dynamics of core inflation and headline inflation % 2010/01 2010/02 2010/03 2010/04 2010/05 2010/06 2010/07 2010/8 2010/9 2010/10 2010/11 2010/12 2011/1 2011/2 2011/3 Core inflation (12-month) Inflation (12-month) In view of the assessment of existing risks affecting the inflationary environment, and seeking to absorb second round effects and have inflation expectations anchored, the Central Bank embarked on tightening of monetary conditions that was intended back in the end of the previous year. Starting from February, the Board of the Central Bank has two times raised the refinancing rate, by 0.5 pp each time, to set it at the level of 8.25 percent. The Board had consensus that although the inflationary environment is further fuelled mostly by supply-side factors while recovery of aggregate demand and developments in labor market would create moderate inflationary pressures in the future, increasing the refinancing rate is necessary in order to mitigate the second round impacts of the recorded high inflation and to have the expectations anchored. 6

External environment According to the IMF estimates of April 2011, in 2010 the global output growth reached 5.0 percent compared with 0.5 percent decline recorded in the previous year 2. It reached 7.3 percent in emerging economies and merely 3 percent in developed countries. In 2010 inflation accelerated in both developed and emerging countries and amounted to 1.6 percent and 6.2 percent (0.1 percent and 5.2 percent in the previous year), respectively. Average inflation indicator in CIS and Georgia in 2010 was 9.8 percent. In the first quarter of 2011, international markets of primary goods recorded substantial price fluctuations due to uncertainties triggered by geopolitical developments in the principal oil exporting countries and the Japan disaster. This drove prices of almost all raw materials and food products to record new peaks in the first half of the quarter, albeit some downside adjustments were seen at the end of the quarter. In the first quarter, oil prices reported 20.9 percent growth q-o-q, with a price of Brent crude having exceeded the mark of USD 117 a barrel during the quarter and amounting to USD 104.9 a barrel on average (y-o-y growth - 36.8 percent). Though in the oil market demand has been growing faster than supply since the end of the previous year, international oil prices soared however due to political developments in the Middle East and North Africa in early 2011. Political pressures in Libya, a country that provides about 2 percent of world oil extraction have escalated the inflationary trends. The first quarter posted new price peaks for both base metals and precious metals. At the London Metal Exchange, the copper price rose by 11.6 percent q-o-q and amounted to USD 9635 per ton on average (y-o-y growth - 33.2 percent). Also, attributable to optimistic expectations about economic recovery in developed countries, in mid-quarter the copper price even topped the mark of USD 10000. International copper prices however adjusted somewhat downside in the face of expectations about reduction of the demand from China as well as the consequences of the Japan disaster. International molybdenum prices have increased by about 1.0 percent q-o-q, exceeding the average indicator of the same period of previous year by merely 4.7 percent. International gold prices have risen by 1.4 percent and amounted to USD 1386 per Troy oz (y-o-y growth - 25.0 percent). In the first quarter, food prices continued growing: they even demonstrated a rapid growth behavior at the beginning of the year, Average quarterly wheat price at the Chicago Commodity Exchange made up around USD 9.0 a bushel, which is a 16.6 percent increase in relation to the previous quarterís average, and a 69.1 percent increase compared with the first quarter of 2010. Despite some downward trends observed at the end of the quarter, the tightness deriving from the fundamentals in this market remained to be decisive in pricing. In the first quarter, international rice prices rose by 4.2 percent q-o-q and reached USD 14.7 US hundredweight (45.4 kg), which exceeded the respective indicator of the previous period by 7.1 percent. According to the New York Board of Trade release of international sugar prices index, in the first quarter of 2010 the sugar price dropped by 2.6 percent q-o-q, resulting in average quarterly sugar price of US cents 34.7 a pound (y-o-y growth - 35.6 percent). Notwithstanding the tightness in this market, the sugar prices trended mainly downward, making up roughly US cents 31 a pound at the end of the quarter, as information that the production would surpass the demand to some extent came in. Rising prices of raw materials and food products brought about inflationary expectations in the USA and other developed countries. This, combined with the geopolitical tension in the Middle East and North Africa, drove the US dollar to depreciate vis- -vis Euro by around 0.6 percent q-o-q, to reach USD 1.36 per one Euro (the US dollarís y-o-y appreciation was 1.3 percent). 2 ìworld Economic Outlook Updateî, IMF, April 11 2011. 7

Considerably accelerated inflation trends in emerging countries amid rising international food prices were reflected in the decisions about tightening monetary conditions and raising interest rates. This has often been concurrent with other quantitative and macro-prudential measures, the most important among which was the increase of the reserve requirement ratio [in Russia, China], and etc. The food price surge globally triggers inflationary pressures and concerns even in developed countries, in the EU and Great Britain, among others. So, the European Central Bank raised, on April 7 2011, the policy rates by 0.25 pp, setting at the level of 1.25 percent. Whereas the US Federal Reserve System preferred to maintain a moderate monetary environment by further implementing the QE2 policy. During the quarter the three-month LIBOR increased slightly, making up 0.31 percent. In early 2011 world markets of primary goods and food products further saw considerable inflation developments which somewhat exceeded expectations. As a result, high inflationary pressures coming from the external sector persisted in the domestic economy. Aggregate supply 3 The Central Bankís Q1 2011 GDP growth rate estimates were revised downside, taking into account the is quarter dynamics of the Economic Activity Indicator 4, published by the National Statistics Service of Armenia early in the year. According to EAI, the GDP growth rate was estimated 2.7 percent, which is determined by an estimated growth of value added in industry and services. In Industry the value added has increased by 5.9 percent mainly due to the increased volumes in metal ore mining, food production, beverage production, metallurgy and items of finished metal manufactures, which is a result of consistent improvement in external demand as domestic and world economies recover. Increased electricity and gas production volumes further contributed to the growth of value added. In Construction the value added has reduced by 5.5 percent. The reduction in construction volumes financed by state budget, local budgets and international loans was somehow offset by the increase of the construction volumes financed by organizations and humanitarian aid. In Services the growth of value added was estimated 2.9 percent primarily as a result of increased retail trade turnover under an unchanged level of wholesale trade turnover. At the same time, the growth in financial and insurance and transport services largely contributed to the growth of value added in Services. In Agriculture the value added declined by 1 percent due to decreased egg production volumes under an unchanged level of outputs in animal growing and plant growing sub-branches. Labor Market 5 In the first quarter of 2011 the growth of average nominal wages was estimated around 6 percent, reflecting wage increase in private sector as well as moderate 3 The growth rates of GDP and sub-branches of the economy for the first quarter of 2011 are the Central Bank estimates based on EAI for January, February and Mach. 4 EAI, unlike the GDP indicator, is calculated based on the volumes of outputs of different economic activity segments rather than the volumes of value added, and it does not include net taxes on manufacture and services of financial intermediation that are measured indirectly. More information on this indicator can be found in the press release on ìmoving to the Discrete (Net Monthly) Method from the Cumulative Method for Compilation, Survey and Publication of Current Macroeconomic Indicators for a Yearî, which the National Statistics Service of the Republic of Armenia published in 2011. 5 The labor market data for the first quarter of 2011 are the Central Bank estimates which are based on actual January and February 2011 figures and March 2011 estimations. The growth indicators represented in this sub-section are relative to the same quarter of the previous year, unless otherwise specified. 8

increase of wages in some budget-supported organizations. Note, that increased productivity in industry and services, growing demand for labor as well as inflation recorded in the previous year had a significant impact on the growth of nominal wages in the private sector. Increased nominal wages in healthcare, reflecting the introduction of a single payment window in the healthcare system, also contributed to the overall growth of nominal wages during the first quarter. In the first quarter of 2011, demand for labor continued increasing mostly due to a reported increase of output in industry and services. As a result, the average quarterly unemployment rate fell against the same period of the previous year by 0.7 pp and reached 6.6 percent. In the first quarter, concomitant with economic growth, labor productivity grew by around 2 percent. As a result of these developments, unit labor costs have increased by around 4 percent, creating minor inflationary pressures in the economy, which amounted to about 0.3 pp. Aggregate Demand 6 In the first quarter of 2011 private spending in real terms grew by around 6 percent, determined by both real growth in private investments and consumer expenditures. Relative to the previous year, public expenditures in real terms have decreased by nearly 8 percent. With the developments mentioned above, the domestic demand has grown by about 2 percent. The growth of private investments was estimated at around 4 percent, owing to increased profitability in a number of sectors of the economy as a result of a slowly but steadily growing domestic and external demand. Growing private investments were financed mainly through loanable funds provided to the private sector and, in part, by own funds generated as a result of domestic economic growth. In the first quarter however, the developments in construction 7 negatively affected the growth rate of investments made by the private sector. Private consumption in real terms has increased by around 4 percent due to the growth of private sector disposable income as a result of increased private remittances and reported domestic economic growth 8. Expanded volumes of lending to the economy somewhat contributed to the growth of private consumption. In the first quarter of 2011, continued growth of private spending resulted in neutralization of the gap between private spending and their potential level, which was caused by the crisis in 2009. As a result of the aforementioned developments, private spending had no impact on inflation. In view of the developments in world and domestic economies during the first quarter of 2011, current account was adjusted upside (improvement) relative to the same quarter of the previous year. The real volumes of export of goods 9 and services have grown by 6.2 percent y-o-y, which exceeded expectations. The growth of export of goods and service by value topped expectations as estimations show 20.2 percent y-o-y growth. The growth of export was conditioned mainly by positive developments maintained in industry as well as y-o-y increase of metals prices in international markets. The developments of domestic economy were more remarkable in import indicators: in the first quarter the import of goods 10 and services in real terms 6 The data on real growth of private sector consumption and investments for Q1, 2011 are the Central Bank estimates. Actual figures of these indicators are as of the third quarter of 2010. The growth indicators represented in this sub-section are relative to the same quarter of the previous year, unless otherwise specified. 7 See sub-section Aggregate supply. 8 See sub-section Aggregate supply. 9 In January-Mach of 2011, the growth of export of goods (FOB) has been 25.2 percent. The quarterly indicator of export of services is a forecast. 10 In January-March of 2011, the growth of import of goods (FOB) has been 6.4 percent. The quarterly indicator of import of services is a forecast. 9

shrank by 15.5 percent y-o-y, which was explained by accelerated growth rates of import prices in light of budget constraints with economic agents. Based on the first quarter results, the value of import of goods and services has grown by 5.1 percent y-o-y under high y-o-y increase of import prices. In the first quarter of 2011, the y-o-y growth of net inflow of non-commercial remittances of individuals reached 25.7 percent, exceeding the forecast. This behavior is mainly explained by the developments in Russian economy. Consolidated budget 11 In the first quarter of 2011, the fiscal policyís impact on aggregate demand, hence prices can be characterized as a policy to curb inflation. This showed up in the form of over-performed revenues and some savings on expenditures 12. Budget revenues were over-performed against the quarterís forecast to the amount of nearly AMD 2.0 billion, thanks to increased tax revenues and social allowances. Relative to the first quarter of the previous year, the increase of revenues was 9.5 percent. There were notable savings on public expenditures against quarterly proportions of the Government mostly because of non-disbursement of expenditures due to the shortfalls in foreign grant programs and some savings on expenditures that were planned to be made from domestic sources. As a result of such savings, actual expenditures of the first quarter were around 1 percent less compared with the same quarter of the previous year, and the expenditures impulse made up 1.6 pp restrictive instead of the projected estimation of neutral. The budget deficit, too, was below the program level in the light of the aforementioned setting of savings on revenues and expenditures. In the outcome, in the first quarter of 2011 the fiscal impulse had 2.1 pp restrictive impact instead of the projected neutral. It is estimated that the latter has neutralized the lagged impact of the expansionary policy of the fourth quarter of 2010. To sum up, the lagged impact of the expansionary policy of the fourth quarter of 2010 has been neutralized by the restrictive impact of the Q1 2011 fiscal policy. Also, taking into account weak inflationary pressures in the labor market and neutral impact of private spending, one may conclude that net impact of domestic demand and labor market in the first quarter has been slight inflationary and estimated in the range of 0.5 pp. Money and credit With the tightening of monetary conditions and further de-dollarization measures, the Central Bank raised the refinancing rate by a total 1.0 pp to set it at 8.25 percent level and introduced a change to the reserve requirements mechanism (whereby 75 percent of foreign currency funds reserved must be kept in dram instead of the former requirement of 50 percent) during the first quarter. After the monetary conditions were tightened, the picture in the first quarter changed as follows: in interbank and intrabank repo markets the average interest rate rose, respectively, by 0.54 pp and 0.77 pp, in relation to the previous quarter. Nevertheless, given existing liquidity levels as well as reduced volumes offered by the Government, in the primary market interest rates of treasury bills tended to fall in relation to the previous quarter. In particular, the average interest rate of up to 11 The fiscal sector analysis was made using preliminary actual indicators of the first quarter of 2011, including expenditures financed by PIU funds. The fiscal impulse was estimated against 2010 consolidated budget indicators. The impact of revenues was calculated against the actual nominal GDP indicator, and the impact of expenditures, against estimated potential GDP indicator. 12 Comparison of budget revenues, expenditures and deficit indicators was made by weighing their projected levels against quarterly proportions set by the Government (including PIUs) and the Central Bank quarterly forecasts of the state budget. 10

1-year bonds dropped by 1.21 pp and average interest rate of mid-term notes fell by 0.68 pp. In the foreign exchange market in the first quarter, relative to the previous quarter, the exchange rate developments were as follows: AMD versus USD depreciated by 1.48 percent, AMD versus EUR depreciated by 2.10 percent, and AMD versus RUR depreciated by 6.25 percent. Notwithstanding gradual increases of the refinancing rate, growth of lending to the economy was maintained during the first quarter, making up more than 29.3 percent y-o-y at the end of March. Foreign currency loans prevailed in total lending during the quarter as AMD 61.9 billion-worth of loans alone, out of AMD 79.5 billion in total, were provided in foreign currency, which entirely went to finance SME business plans. Over the quarter foreign currency loans to households have decreased by AMD 8.4 billion and dram loans have increased by AMD 17.6 billion entirely due to consumer loans. Under tightened monetary conditions and credit market developments mentioned above, during the first quarter dram deposits and foreign currency deposits have increased, by 5.8 percent and 7.2 percent, respectively. Broad money grew by 1.6 percent but dram broad money reduced by 2.6 percent. Based on the 12-month figures however, dram deposits have grown faster over foreign currency deposits, making up 49.8 percent and 1.5 percent, respectively. This led dram broad money to post faster growth over broad money, amounting to 26.8 percent and 14.0 percent, respectively. 11

UPCOMING 12-MONTH PERIOD FORECASTS External environment 13 In an April, 2011 World Economic Outlook, the IMF predicts that in 2011 the world output growth rate will be kept within the levels forecast in January, making up 4.4 percent. World inflation forecasts for 2011 were adjusted upside, relative to the January forecasts. Inflation rates will speed up in developed and emerging countries and will reach 2.2 percent and 6.9 percent, respectively. Economic growth rate in Euro-area is expected to be 1.6 percent instead of an estimated 1.7 percent for 2010. In 2011, economic growth rate in the USA will remain at the level of 2.8 percent as was recorded in 2010. Economic growth rate in Russia is expected to exceed the previous yearís estimated 4.0 percent level to amount to 4.8 percent in 2011, whereas inflation is expected to reach 8.5 percent. It should be noted that average inflation in CIS and Georgia will be around 10 percent in 2011, according to the IMF estimations. In commodities markets in 2011 prices will behave in the context of stabilizing rates of economic recovery in developed countries, absence of additional stimulatory monetary policy measures from US Federal Reserve System, some slowdown of the demand in emerging countries amid tightened economic policies, recovering supply of agricultural products and geopolitical developments.. This may point to the relatively balanced supply and demand developments in the forecast period of time. Over 2011 and in early 2012 international oil prices are predicted to remain high, in the range of USD 120 a barrel. According to estimations by International Energy Agency, in 2011 the world demand for oil will grow by about 1.6 percent, which will make up roughly 89.5 mb/d. Notwithstanding an expected growth of extraction volumes by non-opec countries, the decision-making on extraction of oil by OPEC will be critical in order to meet the demand in full. Given this, OPECís effective spare capacities will rest, for the first time after 2008, at a level lower than 5 mb/d, i.e. making up 4.1 mb/d. In the projection period, prices of base metals are expected to stabilize at current high levels and prices of precious metals mainly to show upward trends. In particular, despite some expectations about downward trends, the copper market is in the phase of fundamental tightness in terms of supply and demand, which presumes more uncertainties over pricing, determined by contractionary policy of China, on the one hand, and rapid recovery considerations in the aftermath of the Japan disaster, on the other. As a result, the copper price is expected to be around USD 9500 per ton. As for the gold price, it will rise to some extent, resting in the range of USD 1500-1550 per troy oz, reflecting geopolitical developments and expectation for inflation acceleration and US dollar exchange rate depreciation. Tightness deriving from fundamental factors persisted in the wheat market. According to April estimations of the US Department of Agriculture, some 647 million tons of wheat production is expected for the marketing year 2010/2011 against around 683 million tons recorded in the previous period 2009/2010. Because consumption is estimated to be around 662 million tons, the world wheat stock is predicted to decrease to make up 183 million tons. International Grain Council estimates that under the current low levels of world wheat stocks, tension in the market will only be somehow mitigated if production in the period 2011/2012 grows significantly. This however is not envisaged for the forecast 13 The forecasts of external sector have been based on the information provided from the IMF, World Bank, The Economist, Global Insight, Financial Times, US Department of Agriculture, ÓÒ ËÁÌÂÒ ÓÌÒ ÎÚËÌ and other sources. 12

period of time since an estimated 4 percent growth of production (673 million tons) will make it possible just to meet growing consumer demand and the global supply and demand will be mainly in balance. From the point of view of pricing this means that the decline of stock-to-consumption ratio could cause new inflationary pressures in the market, on the one hand, and the high levels of stock in main wheat exporting countries (some 55% higher relative to the levels of food crisis years of 2007/2008) may result in some downward adjustment in prices, on the other. Thus, in case of normal weather conditions the tightness in the market will wane only in mid-2012. And in 2011 prices will be kept at elevated levels, demonstrating mainly upward trends. There is some loosening of the tightness observed in the world sugar market. Although International Sugar Organization predicted reduction in the sugar output volumes for the marketing year 2010/2011 down to 167.8 million tons, excess production of sugar expected in the main exporting countries is forecast to meet the required extra demand. The latter will determine some decrease of sugar prices in the projection horizon, which will be around 28 cents/pound. Certain risks are nevertheless maintained toward an upside direction since the stock/consumption ratio, an important factor that determines the sugar pricing, will fall to a 20-year minimum. As for the rice, prices will be mostly around 14.5 cents/pound. The stabilizing of prices will depend largely on expected record output volumes in spite of the demand grown notably higher. In an April forecast, the US Department of Agriculture estimated some 451.5 million tons of rice crops for the marketing year 2010/2011, which will lead to the highest indicator of global stock levels of the last 8 years, amounting to about 99 million tons. World economic developments entered the phase of sustainable development, and the IMF assessments suggest that potential risks have reduced notably, but remained mainly downside. Public balance problems across developed countries, signs of overheating of economies and destabilizing pressures on exchange rate and prices in emerging countries amidst large capital inflows, as well as inflationary environment transmitting from world commodity markets remain the main factors that hamper world economic growth in the forecast time horizon. The probable rapid increase of oil prices has come as the new significant factor that may add to the impediment to the world economic growth and thus reduce growth opportunities in both developing and developed countries. Under such conditions, priorities in the context of economic policies for 2011 will be, among others, shaping adequate economic stimuli in line with fiscal consolidation, further strengthening of the financial systems in developed countries, and managing tremendous capital flows and combating inflationary environments in emerging countries. In this regard, emerging countries will continue tightening monetary policy conditions by using macroprudential tools of any variety, among other. Inflationary pressures are becoming discernible in developed countries, too. This prompted the ECB, already in April, to raise interest rates. The monetary policy in developed countries will remain mainly at relatively a moderate stance, while inflationary pressures in emerging countries will be a reason for tightening monetary conditions. According to the US Federal Reserve Systemís Q1 2011 reviews, the US will continue implementing an expansionary policy (abandoning quantitative easing since the mid of the year) amid anchored long-term inflation expectations and high unemployment, while believing that the global inflationary pressures on its economy are temporary. Main risks in world commodity market developments are associated with the possibility of US Fed injecting extra monetary stimuli in the middle of the year. This would escalate the problems with the management of capital inflows and create additional inflationary pressures in emerging economies. As well as this would drive to the dollar exchange rate depreciation and further upside pressure of dollar prices in the commodities markets. 13

To sum up, amid sustainable development of world economic growth and developments in world commodities markets in the projection period, inflationary pressures spilling over to the domestic economy will weaken in general, although their impact will persist to some extent. However, existing risks are mainly towards price increases. Aggregate Supply With indicators below the Q1 2011 forecasts of economic growth, the forecasts made for the period April-December were revised downside. As a result, economic growth is expected within 3.7-4.8 percent 14 for 2011 and within 2.8-4.2 percent for the period January-March of 2012. For Industry, forecasts show about 4.1-6.1 percent growth of value added due to expected growth in ore mining and metallurgy as prices of base metals in international markets persist at high levels; expected increase of volumes in production of food and beverage driven by continued recovery of world and domestic economies; effective technologies introduced to heat stations during the previous year; as well as expected increases in electricity generation owing to investment in projects, both former and new ones, in renewable energy. For Construction, some acceleration in growth rates is anticipated yet the value added remains relatively small, in the range of 0.6-2.6 percent, mostly owing to increased construction volumes in energy, agriculture, transport and communications. No significant changes are expected in construction volumes financed by households. For Services, the forecast of value added is in the range of 2.8-4.8 percent, primarily due to expected growth in private spending and public expenditures, which will be reflecting both the volumes of trade turnover and other services rendered. For Agriculture, the forecast of value added is in the range of 6.2-8.2 percent, which will be driven by expected growth in plant growing and animal breeding. Because of the lack of high-value investments, productivity in agriculture remains almost unchanged, and under such conditions output in plant growing depends primarily on the weather 15. Therefore, the least risky scenario was accepted forecasting the growth in agriculture. Risks to economic growth are dual-sided and associated with exogenous and indogenous factors. As such, risks are tantamount. The risks are associated with accelerated recovery rates of global economy and higher-than expected growth of domestic demand. There is likelihood of both upside and downside risks to forecast with regard to all sectors of the economy. In particular, upside risks may prevail in industry determined by quicker recovery in the world economy as well as efficiency of the measures taken by the Government and investment projects in sectors of the economy. Downside risks are mostly associated with the postponement of investment projects in the private sector due to possible slowing of the world economic growth, the slowdown in the pace of measures carried out by the Government as well as pessimistic developments in agriculture de to unfavorable weather conditions. 14 See the 30 percent interval in the real GDP growth (cumulative) projection probability distribution chart in this paper. 15 Because the planned measures in agriculture are developed in the light of medium-term perspective, their impact on the productivity of this branch will not be significant yet. 14

Real GDP Growth (Cumulative) Projection Probability Distribution 9 8 7 6 5 4 3 2 1 0-1 5.4 6.2 1.9 January 2011 projection 2.1 April 2011 projection I/10 II III IV I/11 II III IV I/12 90% 70% 50% 30% Economic Growth Projection Probability Distribution Economic growth interval Probability of economic growth interval Q2, 2011 Q4, 2011 < 1% 1.02% 4.29% 1-3% 53.67% 24.76% 3-7% 45.62% 70.35% 7-9% 0.00% 0.59% 9% < 0.00% 0.00% Real GDP Growth Forecast Probability Distribution 90 percent probability interval 30 percent probability interval Period min max min max January-June 2011 to January-June 2010 2.5 3.9 3.1 3.5 January-September 2011 to January-September 2010 2.4 5.3 3.7 4.3 January-December 2011 to January-December 2010 1.7 6.3 3.7 4.8 January-March 2012 to January-March 2011 0.3 6.1 2.8 4.2 Labor Market 16 Forecasts of demand for labor for the period April-December 2011 have been revised. In the forecast period average nominal wages are expected to grow by around 7 percent, determined by the growth of nominal wages in the private sector 16 The labor market data for 2011-2012 are the Central Bank estimates which are based on actual figures of the fourth quarter of 2010 and actual January and February figures. The growth indicators represented in this sub-section are relative to the same quarter of the previous year, unless otherwise specified. 15

as a result of economic revival, and by a moderate growth in some budgetsupported organizations. Inflation recorded during the previous year will somewhat contribute to the growth of nominal wages throughout the year. In the first quarter of 2012 the dynamics of growth rate of average nominal wages will be maintained. In 2011 the demand for labor will keep on growing mostly due to the output growth in industry and service sectors. This will push the number of the unemployed down, and the average level of the officially unemployed in the economy will reduce by 0.5 pp and reach 6.6 percent in 2011. In the first quarter of 2012, the number of the unemployed will continue decreasing to make up 6.4 percent, getting closer to the pre-crisis level. In the period April-December 2011, the developments in the labor market will create weak inflationary pressures in the consumer market (by about 0.2 pp), since some 3 percent increase in unit labor costs in the private sector will be observed. Yet such inflationary pressures in the labor market are expected to be somewhat weaker relative to the second half of 2010. These pressures will further mitigate in the first quarter of 2012 because of a slower growth pace of unit labor costs compared with the respective indicator of the 2011. Aggregate Demand 17 Private Sector Spending Estimations of private sector spending for the period April-December 2011 have been forecast slightly downside, on a basis of expected slower economic growth rate and somewhat s sluggish economic activity. According to revised estimations, in the period April-December 2011 private expenditures are expected to grow by about 6 percent, which is determined by both increased private consumption and private investments. The domestic demand will increase by 4 percent in the event private spending grows and public expenditures grow a little. In the first quarter of 2012, private spending and domestic demand are expected to grow, by 5.5 percent and 4.8 percent, respectively. In the period April-December 2011, private investments will grow by nearly 8 percent, and in the first quarter of 2012, by around 12.4 percent, reflecting boosted profitability in industry and services as a result of slowly but steadily recovering external and domestic demand. Own funds and loans made available to private sector will remain the main source of financing for private investment. Note, however, that low activity in construction will negatively affect the total growth rate of investments in spite of expected high growth rates in construction financed by organizations. The negative impact of low-than-forecast economic activity on household incomes will mitigate considerably thanks to expected higher growth of remittances from abroad, which will drive private consumption to grow by 4.8 percent in the forecast time horizon and by 5 percent in the first quarter of 2012. In the period April-December 2011, continued growth of private spending will lead to neutralization of the gap between private spending and their potential level [which was caused by the crisis in 2009]. In the first quarter of 2012 the private spending gap will be close to zero, i.e. positive. As a result of the aforementioned developments, over 2011 private spending will be rather close to the potential level and will have a neutral impact on inflation but are expected to create minor inflationary pressures in the consumer market during the first quarter of 2012. 17 The data of real growth of private consumption and investments for 2011-2012 are the Central Bank estimates. Actual figures of these data are as of the fourth quarter of 2010 and published by the National Statistics Service of Armenia. The real growth indicators represented in this sub-section are relative to the same quarter of the previous year, unless otherwise specified. 16

Current Account Forecasts of current account components of Balance of Payments for 2011 have been revised in the face of new developments in global and domestic economies. Given persistently high prices of base metals in world markets (in the first quarter of 2011, the price-rise on metals exceeded expectations), growth rates in world economy and expected development of the domestic industry, the 2011 forecast of export by value was revised mostly upside. New forecasts suggest that in 2011 the growth of export of goods and services by value will be in the range of 15-17 percent and the growth of real volumes will be within 6-8 percent. Risks to export both upside and downside still exist, which will depend on the developments in world economy, international metals prices and further developments in domestic industry. It is expected that the 2011 developments with export of goods and services will persist over the first quarter of 2012 (8-10 percent growth). In view of the little growth of value of import of goods and services, high rates of real decline and further developments in world and domestic economies, the revised indicator of real volumes of import changed notably. For 2011, the increase of the value of import of goods and services is expected in the range of 7-9 percent but real volumes are expected to reduce by 6-8 percent. The latter will incur the impact of expected developments in growth rates of import prices in the face of limited growth of income of economic agents. Potential risks to import are also dual-sided and depend on price behavior in world markets and domestic economy. For the first quarter of 2012, small growth of import in the range of 2-4 percent is anticipated. Forecasts for non-commercial remittances by individuals were revised upside. Taking into account high inflation recorded in the first quarter of 2011 (it surpassed expectations) as well as improved expectations of the IMF for Russian economic growth (4.8 percent instead of the previous forecast of 4.5 percent), the growth of non-commercial remittances by individuals in 2011 will be within 16-19 percent. The growth of non-commercial remittances in the first quarter of 2012 is expected in the range of 10-14 percent. All aforementioned developments suggest that over 2011 the current account / GDP ratio will improve fairly and will be in the range of 10.0-12.0 percent. Consolidated Budget 18 The fiscal policy implemented in 2011 can be characterized as policy that shifted from the one designed to take anti-crisis measures to the balanced policy while trying not to contribute to the creation of additional inflationary pressures and not to impede to the recovery of economic growth. It should be noted that the 0.3 pp growth mark of tax revenues in GDP against the previous year as well as making public expenditures in compliance with established proportions is the main item in the to-do-list of public spending. Actual developments in the first quarter (minor over-performance on revenues and savings on expenditures) prompted some adjustments with the influences anticipated to show up over the next quarters. In particular, a slightly expansionary impact is expected in the third quarter which will, however, be offset on an annual basis. So, the impact of the fiscal policy on aggregate demand will be neutral, which is a consequence of little expansionary expenditures and slightly restrictive revenues impacts. 18 The fiscal sectorís impact has been estimated using consolidated budget indicators based on the proportions laid down in the Republic of Armenia Law on State Budget 2011. The fiscal impulse has been estimated against consolidated budget indicators of 2010 as a base year, which was determined by positive trends for economic recovery and the return move to a more balanced fiscal policy from an expansionary one. It should be noted that the revenues impulse has been calculated against an estimated nominal GDP indicator and the expenditures impulse has been calculated against an estimated potential GDP. 17

In the first quarter of 2012 the fiscal policy will have somewhat a restrictive impact, according to the Central Bank estimations based on the ìgovernment Medium-Term Expenditures Program 2012-2014î indicators. To sum-up, in the period April-December of 2011 the state budget will have somewhat a restrictive impact on demand. This, coupled with minor inflationary pressures coming from the labor market and neutral impact of private spending, may bring into a conclusion that in the period April-December of 2011 and in the first quarter of 2012 net impact of the labor market and domestic demand on inflation will be neutral. 18

INFLATION FORECASTS AND MONETARY POLICY DIRECTIONS IN THE PROJECTED 12-MONTH PERIOD In view of actual and projected macroeconomic conditions, inflation forecasts were made and monetary policy directions for the forecast 12-month horizon projected through inflation model by selected commodity groups and the Quarterly Projection Model. The results of the inflation model by commodity groups were based on an assumption of constant market rates during the forecast horizon, which means that likely inflation developments were estimated under the condition of interest rates as a result of tightened before monetary conditions and changed reserve requirement mechanism. According to conditional forecasts built on such an assumption, high level of the 12-month inflation will persist during the second quarter of 2011, with its central projection of 9.2 percent, which will be attributable to unprecedented high inflation, transmitted from 2010, price increases on food products and raw materials in world markets, second round effects and high inflation expectations. Then, starting from the third quarter, inflation is expected to subdue as the above mentioned factors run out partly. At the end of the year inflation will come back to the 4±1.5 percent band target: the central projection makes up 5.3 percent. At the end of the first quarter of 2012, the central projection amounts to 4.2 percent in the 12-month horizon. While high inflation risks prevailed in previous forecasts, these are currently observed to have gradually become balanced: the risks associated with agriculture, external sector and recovery of domestic demand are balanced. There is more than 86 percent probability that at the end of the year the 12-month inflation will be in the range of 4-7.5 percent, of which 41 percent probability is for the inflation in the range of 4-5.5 percent. Inflation Projection Probability Distribution Chart (12-month) January 2011 projection 9.2 7.5 April 2011 projection 5.3 4.2 12 11 10 9 8 7 6 5 4 3 2 1 0 2009/03 2009/04 2010/01 2010/02 2010/03 2010/04 2011/01 2011/02 2011/03 2011/04 2012/01 Inflation Projection Probability Distribution Inflation interval Probability of inflation interval Q4, 2011 Q1, 2012 < 3.0% 0.73% 13.55% 3.0-4.0% 6.72% 22.77% 4.0-5.5% 40.75% 37.68% 5.5-7.5% 45.43% 22.88% 7.5-9.5% 6.24% 3.01% 9.5% < 0.13% 0.11% 19