Georgia: 2013 Article IV Discussions Concluding Statement of the IMF Mission
June 10, 2013
Describes the preliminary findings of IMF staff at the conclusion of certain missions (official staff visits, in most cases to member countries). Missions are undertaken as part of regular (usually annual) consultations under Article IV of the IMF's Articles of Agreement, in the context of a request to use IMF resources (borrow from the IMF), as part of discussions of staff monitored programs, and as part of other staff reviews of economic developments.
1. Georgia has tremendous opportunities to implement further reforms and achieve a more prosperous society. If the government can, as it plans, build on Georgia’s achievements over the past years by strengthening judicial independence and the rule of law, by improving the transparency of tax enforcement, by promoting basic freedoms, by fighting poverty and inequality, and by reaching trade agreements with major partners and an Association Agreement and DCFTA with the EU, then the potential medium-term benefits are huge. But to get there, there are many challenges along the way.
2. Following three years of rapid growth, Georgia’s economy experienced a political transition-related slowdown. After growing at an average rate of 7 percent from 2010 through the first half of 2012, the economy started to slow in the third quarter of 2012. Inflation has fallen sharply, from 15 percent in May 2011 to -1.7 percent in April 2013, reflecting the lagged effects of exchange rate appreciation, lower food and energy prices (the latter negotiated by the government), but also the slowdown in domestic demand.
3. While possibly already underway before the elections last year, the slowdown also reflects political uncertainty and delays in policy implementation. The slowdown in neighboring economies has not helped, but investors already became cautious ahead of last October’s general elections. Since the elections, this caution appears to have been reinforced by slower disbursement of government spending, higher than anticipated real interest rates, and political tensions. Businesses have explained that announcement of major reforms (though in many cases welcome), before providing details about their content and implementation (for example, healthcare reform, labor code, Partnership Fund, and the establishment of new private equity funds), has added to uncertainty over government policy.
4. Provided that the political situation remains stable, business uncertainty subsides and supportive economic policies are in place, the economy should grow rapidly in the second half of this year. Though projections at this time are subject to greater than usual uncertainty, our baseline forecast has the economy growing rapidly for the remainder of the year (an annualized rate of around 8 percent, seasonally adjusted). Because of the slowdown observed through the first quarter, this should result in GDP growth of 4 percent in 2013, rising back to around 6 percent from 2014 onwards. Inflation would then increase to 1½ percent at end-year and to about 5 percent by end-2014. There are upside and downside risks to the projection: on the upside, opening of the Russian market plus higher investment; on the downside, slower growth in partner countries and delays implementing the policies set out below. Provided that the authorities take the monetary and fiscal policies actions described below, plus improve clarity over their economic policies, the slowdown should prove temporary.
5. The mission supports the new government’s agenda of more inclusive growth. The rapid growth of the last decade resulted in barely any increase in employment. Much of Georgia’s population is either unemployed or underemployed in agriculture. Relative to comparable countries, Georgia performs worse in terms of poverty, and much worse in terms of inequality. Substantial increases in social expenditures and agricultural support already being implemented by the new government should help address these concerns. However, since sustained strong growth is also essential for job creation, the government should accompany its emphasis social issues with more active fiscal and monetary policies, and should boost business confidence and investment by reducing policy uncertainty.
Macroeconomic Policies for Economic Recovery
6. Fiscal policy needs to support economic recovery. Government capital spending fell short in 2012Q4 and 2013Q1 because of the application of stricter procurement procedures and financial difficulties in some construction businesses. Public consumption also fell in 2013Q1, in part because of the new procurement rules, but also because of centralized purchases (which generated substantial savings). The resulting fall in government spending added to the slowdown. This now needs to be reversed in the remainder of the year. Lower growth and inflation will likely reduce revenues by around 290 million GEL (1 percent of GDP) in 2013. With inflation subdued and the current account deficit falling, there is a case for letting the automatic fiscal stabilizers operate. Lower revenues should only be partly matched by lower government spending (which should be feasible given that prices are lower than projected), and the deficit target might need to be increased from 2.8 to around 3.3 percent of GDP.
7. With inflation well below target, further easing of monetary policy also seems warranted. The NBG has already reduced its policy rate from 8 percent in mid-2011 to 4.25 percent. Despite this, the level of credit has remained flat so that credit growth has fallen from 30 percent at end-2011 to 12 percent at end-March 2013, and inflation remains well below the NBG’s 6 percent medium-term target. On balance the mission would recommend some further policy rate reductions. However, more important would be to ensure that existing cuts lead to lower bank deposit and lending rates, especially at longer maturities (where interest rates are considerably higher). To do this, the mission supports the NBG’s initiative to have the government issue treasury bills and deposit the proceeds long-term with commercial banks, to encourage long term lari lending by banks. Other options include making it easier for banks to access NBG lari funding, further encouraging the adoption of flexible rate lari lending by banks, using prudential measures to encourage de-dollarization, and deepening the financial system (development of pension funds).
8. Central bank independence is essential, and cooperation is needed so that monetary and fiscal policy can work together to help end the current slowdown. The mission welcomes the NBG’s moves towards greater transparency, by improving the inflation report, and launching regular meetings to explain inflation developments and the reasons behind MPC interest rate decisions. However, greater cooperation between the NBG and the Ministry of Finance, in a way that preserves central bank independence, would make it easier to measure and diagnose the causes of the recent slowdown, and to devise a coordinated monetary and fiscal policy response that will promote recovery.
9. The government should strengthen communication of its policy initiatives. While broadly supporting the government’s reform efforts, premature announcement of some policy initiatives before details are known, and, in the case of the newly adopted Labor Code, difficult and drawn-out consultations with key stakeholders, could have contributed to policy uncertainty. Providing detailed information about the objectives, implementation, and the timeline of new policy initiatives before announcing them to the public is needed to help restore business confidence.
10. Georgia’s current account deficit and foreign indebtedness need to be reduced over the medium term. Despite declining recently because of the slowdown, the current account deficit has remained persistently high, averaging 11.5 percent of GDP from 2010 to 2012, one of the highest in the region, while gross external debt has reached 80 percent of GDP. In part the current account deficit reflected large capital inflows which, despite the NBG’s foreign currency purchases, have prevented necessary real exchange rate adjustment. To make sure Georgia’s external indebtedness is sustainable, and to protect from exchange rate shocks or the risk of a sudden stop in capital inflows, the government should gradually lower the current account deficit to a more sustainable level of around 6.5 percent of GDP in the medium-term, through continued fiscal consolidation, higher private saving, exchange rate adjustment, and structural reforms to improve competitiveness.
Improving Competitiveness and Growth
11. The government should focus its involvement in the energy sector on establishing transparent and fair “rules of the game” overseen by an independent energy regulator:
- The recent reduction in tariffs has lowered the profitability of electricity distribution companies and risks hindering investment. In the interests of transparency, we encourage the government to publish the terms of the agreements reached with the electricity distribution companies, so that the reasons behind the tariff cuts can be understood.
- To attract the investment necessary to realize Georgia’s vast potential, the government should work with its development partners to improve the sector’s regulatory framework. We encourage the government to re-commit to the rules-based mechanism for setting energy prices, and to quickly develop an energy policy strategy.
- The above steps should alleviate investors’ concerns that the government might intervene in price-setting and transmission line access in the future. This should encourage new investment. They might also reduce the need for issuing PPA guarantees, which would expose the government to substantial contingent liabilities, and which should only be adopted as a last resort, once all other options identified by the energy policy strategy have been considered.
- The mission encourages the government to make sure that natural gas pricing is being implemented in a way that makes most use of the potentially significant economic rents created by the low price of natural gas imports.
12. The government should clarify the role and improve the governance of the different investment funds:
- The mission welcomes the increased openness and governance improvements that have already taken place in the new Sovereign Fund (which consolidates the existing Partnership Fund) and strongly supports its commitment to improve governance further, in line with international standards. These governance improvements will make the Sovereign Fund a more valued investment partner.
- The objectives and the governance structure of the new investment funds (Agricultural Development Fund, Private Equity Fund), as well as the size of the financing they can realistically attract, should be clarified as soon as possible. While the intention seems good, the potential size of these funds, uncertainty over their scope, and possible preferential treatment could, inadvertently, discourage investment by others. There should also be no perception of any potential conflict of interest in the funds.
- Finally, clearer diagnosis of the reasons why private investment is so low in Georgia might make these new funds more effective, or suggest other policies that would better stimulate investment.
Encouraging Inclusive Growth
13. If carried out in a balanced way, reform of the Labor Code should promote more inclusive growth. The existing Labor Code meant workers could be fired at will without any system of unemployment benefits to fall back on, and made to work unpaid overtime. Workers faced substantial uncertainty, discouraging investment in skills and human capital, and employment barely increased. A more balanced labor code, where employers need to give clearer reasons for dismissal, and with some increased severance pay, could increase job motivation and productivity, and should bring Georgia in line with ILO and EU commitments.
14. Increases in social expenditure should improve social outcomes, but could be better targeted to reduce inequality:
- 80 percent of the government’s social spending increase will be on universal transfers (untargeted), only 20 percent for targeted social assistance. While the social assistance allowance (currently received by 10 percent of the population) was doubled, broadening access to reach the remaining population (around 30 percent) below the poverty line might also have been considered.
- Introduction of universal health insurance should improve health outcomes and reduce high costs in the health sector (around 10 percent of GDP), provided public sector capacity is sufficient. The takeover of key services from existing private health insurers by a public entity, the Social Service Agency, will reduce the market for private insurance significantly. The mission recommends that private health provision should remain, while protocols and procedures should be strengthened. However, the reforms do not seem to address the problem of high drug co-payments (a major source of impoverishment) and do little to save costs by promoting generics.
- The mission welcomes the government’s plans to improve education, including through greater access to pre-school and financing of textbooks for schoolchildren, and higher teacher salaries.
- Finally, on pensions, the mission would recommend that future increases be linked systematically to inflation; for higher pensions in the medium-term, a contribution scheme may be needed.
15. The IMF team is grateful to the authorities for open and constructive discussions during the mission, and also to the many social partners and non-government representatives who made time to meet with us and who helped improve our understanding of recent developments in Georgia.