Clare Nuttall in Yerevan -

The Armenian government talks a lot about cleaning up corruption and bringing the country's shadow economy out into the open. But vested interests and a lack of political will at the top mean the steps taken so far have been small and only mildly effective.

This is a sharp contrast to Georgia, Armenia's neighbour and its main gateway to the outside world. The paths of the two small post-Soviet nations suddenly diverged after the 2003 "Rose Revolution" in Georgia, when the new president, Mikheil Saakashvili, launched a far-reaching anti-corruption programme, purging the police force, civil service and education system. This yielded dramatic results in just a few years, with Georgia shooting 50 points up Transparency International's "Corruption Perceptions Index".

Georgia's experience is starting to have an impact in Armenia, where people are increasingly aware of how much easier life is across the border and are starting to put pressure on their own government to change. Many Armenians, for example, buy their cars at the Rustavi bazaar near Tbilisi, where they see that they can register a new car in just 15 minutes compared to several hours in Armenia. This, together with the lack of bribe-hungry traffic police, has made Armenians question the system back home.

Armenian businesspeople have a similar epiphany when they start investing in Georgia. "When people get home, they complain and start to put pressure on agencies here, which has already had some results," says Konstantin Saroyan, CEO of Yerevan's stock exchange OMX Nasdaq Armenia. "Effecting change in the business environment takes longer, not least because fewer people are involved, but I hope that in time it will go in that direction."

There has been some progress already. Albeit to a lesser extent than Georgia, Armenia has nonetheless advanced up the World Bank's "Doing Business" ranking, rising six points to 55th place in 2011, the second highest score for any country in the former Soviet Union. However, Armenia also has one of the world's largest shadow economies compared to the size of its GDP - it is estimated at between 50% and 60% of total GDP. An International Monetary Fund report found that in 2010 taxes amounted to just 16.9% of GDP, giving Armenia the lowest tax collection rate of any former Soviet state except Tajikistan. In the latest "Corruption Perceptions Index", released in December, Armenia was in 129th place, while Georgia was in 64th.

Taxing times

Changes made by Serzh Sargysyan's government include reforms to the tax collection agency. Some of the highway and traffic police reforms successfully implemented in Georgia have been cut and pasted in Armenia. As early as 2008, the government launched a lottery using retail till receipts, in a bid to encourage shops to issue receipts and stop retailers from evading tax. But after the initial excitement about the lottery, the novelty has worn off; formal retail outlets still account for only around 12% of retail trade in Armenia, with the rest taking place in open air bazaars, stalls and kiosks.

Armenia's first retail chain Star Supermarkets initially struggled because the founders were determined to play by the rules, says the company's CEO Vahan Kerobyan. "Getting the formal sector up to 10-15% is the most difficult stage, because the industry is not fully transparent. We suffered in the beginning, as we are a transparent company that is competing with street vendors who are not transparent at all," Kerobyan tells bne.

Armenia is also seeing a growing divide between rich and poor, but the emergence of a middle class at least in Yerevan. "Armenia is seeing a widening of the wealth gap, which is increasing pressure for change," says Richard Giragosian, director of the Regional Studies Center in Yerevan. Many people are still migrating abroad for work; according to official statistics; one-third of the population is living in poverty.

Reducing inequality and tackling corruption would bring considerable benefits for businesses in Armenia. "Armenia's macroeconomic indicators are strong, but the country would benefit from more reforms like those implemented in Georgia. A lot of words are said, but the government needs to be more aggressive in making changes," says Aram Kayfajyan, director of Yerevan-based investment firm Armenbrok.

Saroyan agrees that while many businesses currently prefer to stick to the old ways, in the longer term they will be forced to become more transparent. "The government already has incentives to encourage companies to go public, but some businesses prefer to work as they are, with shadow transactions. We try to explain to companies that for now they can thrive with this policy, but Armenia is steadily reducing the shadow economy," he says. "Companies that understand this evolution today will be better off in the future."

Investment blues

Cleaning up Armenia's image should help to boost investment. Despite Armenia's 8m strong diaspora, foreign direct investment has only inched up over the years. In the 1990s, many diaspora investors got burned and abandoned their attempts, while those that have flourished in Armenia tend to be the ones who adapted to local practices. Today, around 70% of the flow of money from the diaspora into Armenia is aid, with much of the rest used for buying real estate.

Giragosian points out that the disapora tends to "build churches not factories", and that aid channelled into the country has no conditionality on democracy or greater transparency. "Demands for democracy or economic development, or any criticism of the government are seen as airing dirty laundry in public and giving ammunition to Armenia's enemies," he says.

As a result, the pressure for change is coming from within Armenia. The biggest problem for Sargysyan is that while he may be able to fight lower level corruption, some of the most lucrative segments of the economy are still dominated by a handful of oligarchs who control the imports of key commodities, including sugar, gasoline and kerosene. So far, there have been few signs that Sargysyan has the stomach to take on these oligarchs.

The government has started to act, but unlike in Georgia it is treading carefully - not least because 2012 is a parliamentary election year, with the next presidential elections due to follow in February 2013. The continuing high level of poverty in the country means that hitting anyone's livelihood or enforcing higher tax payments is going to be unpopular. But without strong will from the top, the process of reducing Armenia's shadow economy, while inevitable, will be slow and bumpy.