Program Note

Georgia

Last Updated: August 17, 2009

Background

Until mid-2008, the Georgian economy continued to grow rapidly, having notched up several years of double-digit growth rates driven by external inflows—mainly foreign direct investment—and strong credit growth. Inflation was rising and the domestic currency (the lari) was appreciating. But the shock of the August 2008 armed conflict with Russia and the global economic downturn exposed the economy’s vulnerability to its structurally high current account deficit and rapid credit growth. Increased security concerns eroded confidence and resulted in temporary deposit withdrawals from banks, depreciation pressures, and a slowdown in bank lending. The global economic downturn led to a further slowdown in foreign direct investment and a drying up of private international borrowing, which continued through the first half of 2009.

Role of the IMF

Georgia’s current SBA-supported program aims to build the country’s international reserves, help restore investor confidence, and protect the poor during this economic downturn. It was originally designed to deal with the temporary shock of the conflict and was supported by a donor-financed fiscal stimulus to limit the economic slowdown. But, in light of the deteriorating global environment, the program had to be adjusted to preserve Georgia’s external stability. This goal was achieved by:

• supporting an adjustment of the exchange rate through a devaluation of 17 percent in November and the introduction of foreign exchange auctions to allow for more flexibility;
• adjusting fiscal policy to the worsened economic outlook by allowing a marked increase in infrastructure and social spending;
• define an exit strategy aimed at returning to viable fiscal and external positions in the medium term;
• boosting official reserves with the use of IMF resources; and
• restoring confidence in the financial system in the aftermath of the conflict.

The Fund’s program engagement was supported through the provision of timely technical assistance to improve the lender-of-last resort facility, enhance monetary and financial sector statistics, strengthen financial supervisors’ stress testing capacity, and develop a foreign exchange swap instrument for commercial banks.

Progress to Date

Reflecting the conflict and the global crisis, economic growth turned negative during the second half of 2008 and the first quarter of 2009. Year-on-year GDP growth slowed to -5.9 percent in 2009Q1, down from over 12.3 percent in 2007. Inflation peaked at 12½ percent during the conflict due to temporary transportation and supply disruptions, but slowed to 0.1 percent by July 2009 as global food and energy prices receded and demand weakened. The current account deficit fell substantially through the first quarter of 2009 and will continue to narrow due to the slowdown in domestic demand. The fiscal deficit widened in 2008, in part as a result of the conflict and the need to sustain demand through countercyclical policies. The loss of bank deposits resulting from the conflict was recovered by year-end, but credit growth slowed down. The banking sector has shown resilience to the crisis: bank soundness indicators have deteriorated, but capitalization and liquidity ratios remain adequate, and roll-over risks from short-term external obligations have been largely contained.

Economic activity continued to contract through the first half of 2009, led by falling exports and remittances, and a contraction in bank lending. The external current account deficit is narrowing faster than expected, led by declining imports. Declining import demand and improved confidence have reduced pressures on the exchange rate, and the foreign exchange market has stabilized since mid-March.

The Challenges Ahead

Further declines in private capital inflows, exports, and remittances, as well as delays in official assistance, or prolonged domestic and regional political tensions could result in a deeper contraction than currently forecast. The banking system, which is exposed to dollarized balance sheets of unhedged borrowers, remains vulnerable to the possibility of a longer and deeper recession and the re-emergence of foreign exchange market pressures.

The authorities are determined to deal with these difficulties by letting the market play an active role in the determination of the exchange rate and interest rates; transitioning from an expansionary fiscal stance in 2009 to a path of steady fiscal consolidation starting in 2010; monitoring financial sector developments closely and maintaining an adequate framework to ensure financial stability. The adaptability of policies and the improved planning capacity demonstrated in recent months, as well as the solid track record of structural and market reforms, give assurances that the authorities will be able to maintain economic stability.

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