Ben Aris in Berlin -

Is Armenia going to be the next big thing?

In the last year or so, Ukraine and Kazakhstan have caught fire and some investors are now searching the backwaters of the region in the belief the stock markets there will put in the same heady triple-digit gains that those two countries have returned since 2006.

Aside from several investment banks recently issuing reports on Armenia, what has really piqued the curiosity of investors is the decision by Russia's state-owned VTB Bank to take full control of Armsberbank in the last week of July, after buying a stake of 70% plus one share in the Armenian bank last year. The Russian bank, which has recently opened subsidiaries across the region, now plans to double Armsberbank's charter capital from the current $21.9m.

Tucked in between the Caspian and Black Seas under mount Ararat - where legend has it Noah landed after the Biblical floods receded - Armenia has been a quiet success story in the last six years.

The economy is booming. It sports one of the best legislative bases in the Commonwealth of Independent States (CIS). And it enjoys a regular stream of money sent home by the 10m strong army of Armenians working abroad. Indeed the remittances from ZmigrZ workers are so great that Armenia's biggest problem is currency appreciation of the dram, despite 45% of the population still working in agriculture.

In the long term, though, the country's development is going to be constrained by the slow-burning dispute with neighbour Azerbaijan over the Nagorno Karabakh region. For example, the government can't risk investing huge amounts into the country's significant petrochemical industry until the dispute is resolved just in case war breaks out. At the same time, the country's good relations with neighbouring Iran, which recently built an oil pipeline between the two countries, has unsettled Washington, which is otherwise well disposed to Yerevan.

Internal reform

While Armenia is probably in the trickiest geopolitical position of all the Caucasian republics, it has shined when it comes to internal reform. The charismatic President Robert Kocharian was elected in 1998 and has since pushed through some of the most comprehensive reforms in the CIS. The Central Bank of Armenia has been amongst the most progressive of the state organs and reform of the bank sector is running well ahead of the rest of the economy, although it remains small and underdeveloped.

There are 21 banks in Armenia, all privately owned, that accounted for 94% of total financial assets in the country at the end of 2006, according to Fitch Ratings. Total banking sector assets are 20% of GDP, low even by CIS standards, and four banks dominate the sector, accounting for just under half of all the assets at the end of 2006. The local branch of HSBC alone has 15% of total assets and 22% of deposits.

Robert Kocharian

Thanks to the reforms, the banking system is growing strongly, albeit from a very low base. Bank credit to the private sector grew 33% in 2006, the same pace as in 2005. However, the stock of private-sector bank credit to GDP was just 8.7% at end-2006, up from 7.8% the year before, giving Armenia the lowest private-sector credit/GDP ratio of any country in Eastern Europe.

The problem is that although the banking sector is well regulated, owners have become lazy thanks to the lack of competition; Armenia's banks may be small, but as the spreads between deposits and credits are large, they are very profitable, returning an average 15.9% on equity in 2006. As a result, all the banks are in pretty robust health - well capitalized and with a high capital adequacy ratio of 35% as of the end of 2006, which is some three-times the CIS norm. And as the credit frenzy that has gripped many of the other countries of Eastern Europe has yet to arrive in the capital Yerevan, the non-performing loan ratio is low at 2.5% of total loans.

Most of the credit for the good health of the bank system can be laid at the door of the central bank. It has traditionally been tough on banks. But now the sector is starting to grow as the central bank eases its stance and switches its energies to promoting the broadening of the sector and the development of insurance and investment businesses, says Emmanuil Mkrtchyan, chairman of AmRatings, the local bank rating agency and part of Global Ratings, the leading bank rating agency in the CIS.

"Armenia's banking system functions far more smoothly than the economy as a whole, which makes banks unusually attractive partners for foreign investors," says Mkrtchyan. "Most current investors in the market for banking services are members of the Armenian diaspora - both pre- and post-Soviet waves - and carry little weight in political circles."

The central bank has been an engine for change and introduced new corporate governance regulations for banks in mid-2006. The new rules were targeted at clarifying ownership structures and preventing excessive lending to connected entities. Minimum capital requirements were also raised in March: banks had to have a minimum of AMD5bn in capital by the start of 2009 and maintain a minimum of AMD2.4bn in the meantime. Any new banks that open between now and 2009 must use the higher number.

"The government and especially the central bank get very high marks for their commitment and consistency when it comes to reform. It has only been in the last few years that the benefits are starting to come through in terms of investment," says David Heslam, in charge of sovereign ratings for emerging Europe at Fitch.

The players

Armenia is unusual in that foreign banks are well represented in the local market, largely due to the government's policy of encouraging its banks to compete. The local branch of HSBC dominates the sector. "There was a concerted effort by the government to attract foreign banks into the system as competition was lacking. The idea was to give the local banks a boot as they are very profitable thanks to the relatively big spread between deposit and credit interest rates," says Heslam.

HSBC has a big advantage over its local competition thanks to its access to cheap funding from its parent bank and because it holds the most local deposits. Just behind HSBC, a battle is brewing between the foreign-owned Raiffeisenbank Armenia and the micro-credit specialist ProCredit. ProCredit operates in 19 countries and specialises in providing small business and agricultural loans especially in Eastern Europe. Raiffeisenbank has been aggressively snapping up local banks in each of the Eastern European markets and bought AreximBank from companies controlled by the Russian oligarch Boris Ivanishvili, who is an ethnic Georgian. Ivanishvili had already sold his Russian retail bank Impexbank to Raiffeisen in 2006 for $550m, which also held his shares in AreximBank. AreximBank has solid market positions in both Armenia's corporate and retail banking sectors, as well being the leader in auto loans. Raiffeisen will merger its local operations with its new acquisition as it did in Russia with Impexbank, and is preparing to go head-to-head with the domestic market leaders ArdshininvestBank, Armekonombank and HSBC Bank Armenia.

However, the market is already being shaken up with the arrival of new players. VTB was an early entrant and will be followed by the banking arm of the state-owned Russian gas monopolist Gazprom, which says it plans to set up an Armenian subsidiary sometime this year. Both these banks are huge by local standards and will make the locals work hard to maintain their market shares.

Further down the food chain some smaller deals will introducea degree of specialisation. Leading Russia investment bank Troika Dialog, controlled by Ruben Vardanyan, an ethnic Armenian, is in talks to take over ArmimpexBank, one of Armenia's largest banks, to create the country's first proper investment bank. ArmimpexBank is currently owned by British citizen Vache Manukian, but has been doing little more than tread water for most of the last five years.

ArmimpexBank is second choice for Vardanyan, who had been eyeing ConversBank. But this was eventually sold for around $45-50m to Eduard Eurnekian, an Argentine businessman who operates the Yerevan airport. Troika is anticipating the central bank's recent policy initiative to diversify the banking sector and build up other financial services. Currently the only bank offering anything like investment bank services is Armsvisbank.

And Lebanon's Biblios Bank is already in talks with ITB, a smaller local bank, about an acquisition worth an estimated $11m. ITB's issued capital was about $8.4m as of March, making it the smallest-but-one bank in the country.

A group of Dutch investors who manage Armenia's post office had been interested in ITB, but were outbid by Biblios Bank, according to Global Rating. The Dutch investors were hoping to use ITB as their basis for developing an Armenian version of the Dutch PostBank, which is still on the cards. Analysts say that Armenia's Prometei Bank is the most likely acquisition target still available.

All this interest is being fuelled by the potential upside in the valuations of Armenia's banks. The success of Bank of Georgia in the next-door republic has whetted people's appetite for small banks in small countries. The population and macroeconomics of Georgia and Armenia are very similar, but the divide between the valuations of their respective banks is huge. The sale of ConversBank was the biggest deal to date and netted about $50m, whereas Bank of Georgia floated on the London Stock Exchange at the start of 2006 and its market capitalisation passed the $1bn mark in June. The question is when, rather than if, the valuations of Armenian banks will start to catch up?

"Armenia will probably take a bit longer as, despite all the progress, it remains at a low stage of development. There is not much in the way of a capital market. The government bond market is not very liquid. The banking sector is small and mostly self reliant and remains small and fragmented," says Fitch's Heslam.

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