Ben Aris in Yerevan -

Armenia has been hit by the crisis, but the blow was not to the nose, rather it came under the belt: all the problems the banking sector is suffering have been passed on to them by a slowdown in the real economy.

"We were lucky not to be as integrated into the international capital markets as Russia or Kazakhstan," says Tigran Davtyan, deputy executive director of ConverseBank, who adds wryly that Armenia had been trying to develop the local capital markets beyond the government securities one and some corporate bonds, but "luckily, we failed."

The government was fairly optimistic the crisis would pass by Armenia at the start of the year, predicting a relatively mild contraction in GDP of 7-8%. So when the Central Bank of Armenia (CBA) was forced to devalue the dram by 22% at the start of March, followed by a 15% fall in GDP at the end of the first quarter, the state went into emergency mode.

The CBA slashed rates and pumped liquidity into the banking system in the hopes of buoying economic activity. Interest rates have been cut several times and the repurchase agreement (repo) deal on government securities has been extended from one week to up to several months. Now businessmen are a lot more pessimistic about the prospects for a fast recovery. "Growth was fast in the last few years and we were growing 10-15% every year for about eight years, but the growth was already starting to fall in 2008 before the worst of the crisis hit," says Robert Petrosyan, head of strategy at Armeconombank (AEB). "Now we are only expecting the strong growth to resume in 2011," expressing an opinion shared by almost all the businessmen interviewed for this article.

Still, the worst seems to have past. Economists are predicting that the economy will only contract by 2% in the third quarter and may be back in the black by the last quarter in quarter-on-quarter terms. "We can already see the beneficial effects of these changes in the real economy," says Davtyan. "The dram is already appreciating."

Sheltered from the storm

Thanks to the very conservative policies of Armenia's central bank, coupled with the sector's relative isolation from the international capital markets, the Armenian banking sector was sheltered from the worst of the international financial storm.

Today, the level of non-performing loans is relatively low at 6.5% of total loans, while the average capitalisation of banks is a very high 25-30% of total assets. "Most of the NPLs are in the real estate and construction sector, but it has also hit the small and medium-sized enterprises. In June, the NPLs were 10-11% of the total loan portfolio, but against this we have a very high [Capital Adequacy Ratio], which provides a cushion," says ConverseBank. "NPLs could go as high as 20% before we start to have any real problems in the bank sector."

The upshot is that the sector could bear very high bad debt levels before any bank would run into a shortage of capital. At the same time, the CBA reserves of $25bn-30bn is enough to bail out any bank that gets into problems. "The [International Monetary Fund] and Russia between them have given Armenia loans of over $1bn, which is a very large sum for us, and so we are not anticipating any macroeconomic problems either," says Petrosyan.

The growth of banks like AEB has slowed considerably, but they are still in profit and see 2009 as a hiccup rather than a disaster. Armenian banks find themselves in a frustrating position now: they have the liquidity to make loans, but they can't find anyone to lend to. "This year is a write-off, but there is some optimism that the economy will start growing next year. Still, there could be a 'W' style crisis this autumn, but if that happens, it will be mild. By 2011, everyone is pretty sure we will return to strong growth as we saw before 2007, with some differences as the system has changed," says Petrosyan

Amongst the most painful changes was the popping of a bubble on the real estate market and prices aren't expected to return to their previous levels any time soon. However, the damage was limited by the CBA's tight regulation and the almost complete lack of exposure of the bank sector to the international capital markets. "We are not afraid of capital flight, as the Armenian banking sector is a closed system so there were no speculative capital inflows to leave again. Foreign investment is not big here and what there is tends to be direct investment," says Dr Konstantin Saroyan, member of the board responsible for development at ArmSwissbank.

What capital flight there has been was internal, as residents switched their deposits from dram-denominated to dollar- or euro-dominated ones, which led to the devaluation. However, the switch of currencies has put the banks in a difficult position as they rely heavily on deposits to fund credits; with the volume of drams draining out of their coffers, the banks were squeezed and so credit volumes fell, but not catastrophically. "The volumes of credits were reduced but the banks still have liquidity and they want to lend," says Agricol bank. "NPLs are up a little in the sector, but not at our bank. The problems are not really in the bank sector, but in the real economy. This is a psychological crisis in Armenia more than anything else."

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