## _cr06170

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---

### A. Introduction and recent macro-financial context
- Georgia’s output contracted sharply during early transition; rebound in mid-1990s; setback in 1998; since 2001 growth near 7 percent per year with modest inflation.
- Real GDP in 2005 amounts to about half of the 1989 level.
- Post–Rose Revolution (late 2003) reforms focused on strengthening the fiscal position, addressing infrastructure constraints, and improving the business climate.
- Recent expansion has not been accompanied by significant financial sector deepening; monetization remains below 20 percent of GDP in Georgia and the Caucasus.

### B. Why financial development matters
- Empirical link: better functioning banks and markets → faster growth (Levine, Loayza, and Beck, 2000).
- Mechanisms by which an efficient financial system promotes development:
  - Mobilizing and pooling savings, including attracting resources from abroad.
  - Channeling investment toward higher return activities by reducing information costs and reflecting risk in interest rates.
  - Exerting corporate governance through monitoring borrowers.
  - Facilitating risk management and diversification.

### C. Financial sector structure and recent trends — key indicators
- Banking system credit to economy (percent of GDP, Georgia): 1996: 3.3; 1998: 4.7; 2000: 7.3; 2002: 8.3; 2004: 9.5; 2005 Est.: 15.0.
- Monetization (M3 where available, M2 otherwise) (percent of GDP, Georgia): 1996: 6.7; 1998: 7.3; 2000: 10.3; 2002: 11.6; 2004: 15.2; 2005 Est.: 16.5.
- Peer examples (percent of GDP): Kazakhstan banking credit to economy: 1996: 5.1; 1998: 5.9; 2000: 11.1; 2002: 18.5; 2004: 28.2; 2005 Est.: 38.6.
- Baltics monetization (percent of GDP): 1996: 21.6; 1998: 23.6; 2000: 28.9; 2002: 33.6; 2004: 38.7; 2005 Est.: 47.6.
- Liquid liabilities in Georgia rose from 10 percent of GDP at end-2000 to 16 percent at end-2005; private sector credit remained below 10 percent of GDP until end-2004, when rapid credit growth began.

### D. Banking system structure, concentration, and nonbank institutions
- Number and ownership:
  - Currently 18 banks: 16 private Georgian banks; remaining are branches of Turkish and Azeri banks.
  - Peak number of banks was 229 in 1994.
  - New minimum capital requirement: paid-in capital to about US$6.5 million by 2008.
- Market concentration (end-2005):
  - Six largest banks held about 87 percent of total assets, 90 percent of total loans, and about 89 percent of deposits.
  - Herfindahl-Hirschman Index (based on loan share): 1495 at end-2005; 718 at end-1998.
  - U.S. standard: HHI of 1495 = moderately concentrated market.
- Nonbank institutions and markets:
  - 42 credit unions with total assets of GEL 1.8 million (less than 0.02 percent of GDP).
  - Insurance sector (2004): total premia GEL 45 million, or 0.5 percent of GDP.
  - Stock market small; 2005 total annual turnover: GEL 62 million (about 0.5 percent of GDP).
  - Two commercial bank bond issuances in late 2005 totaling about US$4 million.

### E. Dollarization, monetary policy constraints, and de-dollarization progress
- Banking system highly dollarized; constrains central bank monetary policy and poses currency-mismatch risks.
- NBG measures: differentiated reserve requirements for domestic and foreign currencies.
- Deposit dollarization: declined from about 86 percent at end-2003 to 72 percent in December 2005.
- Loan dollarization: declined from 88 percent to 76 percent (period implied by context).
- Caucasus unweighted average deposit dollarization: 83 percent in 2001 → 73 percent in 2005.
- Baltic economies deposit dollarization: 43 percent in 1999 → 36 percent by mid-2003.
- Mitigation: dollar-denominated loans risk-weighted at twice the international standard unless borrower has demonstrated foreign-currency earnings.

### F. Financial soundness, profitability, and risks — selected indicators (exact values)
- Interest rate spread between deposit and lending rates: 10 percent as of end-2005.
- Nonperforming loan ratio: 3.8 percent of total loans at end-2005 (down from 6.2 percent at end-2004).
- Capital adequacy ratio (CAR): 17.5 percent at end-2005.
- Liquid assets: about 76 percent of total assets (end-2005).
- Tier I capital ratio: 12.2 percent (end-2005).
- Sector-wide return on equity: almost 15 percent in 2005 (a 50 percent improvement over 2004).
- Positive earnings for all but three banks in 2005.

Selected Financial Soundness Indicators, 2000–2005 (percent unless otherwise indicated)
- Capital to assets: 2000: 33.6; 2001: 30.5; 2002: 28.3; 2003: 26.2; 2004: 21.9; 2005: 18.8.
- Regulatory capital to risk-weighted assets: 2000: 36.7; 2001: 33.1; 2002: 21.9; 2003: 20.3; 2004: 18.8; 2005: 17.5.
- Nonperforming loans to total gross loans: 2000: 7.1; 2001: 11.6; 2002: 7.9; 2003: 7.5; 2004: 6.2; 2005: 3.8.
- Loans collateralized by real estate (selected years): 2001: 30.2; 2002: 33.3; 2003: 31.9; 2004: 33.5; 2005: 30.8.
- Return on assets: 2000: 0.5; 2001: 1.6; 2002: 4.2; 2003: 4.0; 2004: 2.4; 2005: 3.1.
- Return on equity: 2000: 1.5; 2001: 5.0; 2002: 14.9; 2003: 15.0; 2004: 10.0; 2005: 14.9.
- Net interest income to gross income: 2000: 56.4; 2001: 63.3; 2002: 62.9; 2003: 66.0; 2004: 61.2; 2005: 61.4.
- Noninterest expenses to gross income: 2000: 62.9; 2001: 53.2; 2002: 56.1; 2003: 54.9; 2004: 61.6; 2005: 57.2.
- Spread between reference lending and deposit rates in domestic currency: 2000: 15.0; 2001: 22.0; 2002: 19.0; 2003: 22.6; 2004: 13.3; 2005: 9.2.
- Spread in foreign currency: 2000: 23.0; 2001: 22.0; 2002: 14.4; 2003: 18.5; 2004: 19.4; 2005: 17.0.
- Liquid assets to short-term liabilities: 2002: 28.1; 2003: 32.5; 2004: 30.7; 2005: 34.7; 2005 (alternative row): 33.3.
- Liquid assets to total assets: 2002: 80.4; 2003: 92.6; 2004: 92.1; 2005: 104.2; 2005 (alternative row): 76.5.
- Net open position in foreign exchange to capital: 2000: 15.7; 2001: 6.9; 2002: 9.3; 2003: 8.5; 2004: 7.4; 2005: 7.5.
- Foreign currency-denominated loans to total loans: 2000: 81.4; 2001: 81.4; 2002: 83.8; 2003: 87.7; 2004: 86.7; 2005: 76.2.
- Foreign currency-denominated deposits to total deposits: 2000: 77.9; 2001: 85.7; 2002: 84.9; 2003: 86.1; 2004: 74.3; 2005: 71.6.

### G. The 2005 credit boom: scope, composition, and financing
- Credit expansion began early 2005; private sector credit rose to 15 percent of estimated 2005 GDP from about 10 percent in 2004.
- Number of outstanding loans grew by 34 percent in 2005; loan value grew about 83 percent in 2005.
- Average loan size increased by GEL 1,500 to GEL 5,900 in 2005.
- Share of large loans (over GEL 100,000) by amount remained almost 70 percent of total loans.
- Ratio of loans with maturity longer than 12 months over short-term loans (up to 12 months) increased from 1.6 to 1.9 during 2005.
- Stock of long-maturity loans grew by GEL 540 million in 2005, or 4.7 percent of GDP.
- Lending interest rates moved into the 10–20 percent interest range (concentration increasing).
- Almost one-fourth of outstanding loans were denominated in domestic currency in 2005, up from 15 percent 12 months earlier.
- Total domestic private sector credit grew by 83 percent in 2005; lari-denominated lending tripled.
- Banks financed increased lending mainly by attracting deposits (deposits grew by 31 percent in 2005) and a build-up of foreign liabilities of GEL 230 million (2 percent of GDP).
- Lari deposits increased by 45 percent in 2005; foreign-currency denominated deposits grew by 23 percent.
- Concentration: six biggest banks accounted for 94 percent of the additional loan portfolio in 2005.

### H. Drivers of the credit boom and bank behavior
- Contributing factors cited by banks:
  - Per-capita income threshold for demand for financial intermediation.
  - Strong deposit growth enabled lending expansion.
  - Credit information bureau establishment expected to help, though benefits limited so far.
  - Ability to attract experienced bankers through competitive salaries improved bank management.
- Bank practices during boom:
  - Simplified loan application processes for small loans; reduced or eliminated collateral for small amounts (example: one bank eliminated collateral for loans smaller than GEL 6,000, previously GEL 1,000).
  - Increase in very short-term loans (up to one month) alongside a shift toward longer maturities.
- Banks did not attribute the boom primarily to recent tax system changes or significant improvements in the court system.

### I. Factors explaining historically low financial development and remaining constraints
- Identified impediments:
  - Macroeconomic instability legacy (hyperinflation early 1990s; depreciation after Russian crisis 1998/99).
  - High cash holdings outside banking and reserve requirements limit loanable funds.
  - Historically low demand for credit due to low income and unfavorable business environment.
  - Weak institutions: limited firm information, weak creditor rights, inefficient judicial enforcement.
  - Perceived restrictive financial regulations.
  - Market structure: over-banking with many small, financially weak banks.
- Monetary/monetization specifics:
  - Broad money (including foreign currency deposits) accounts for only 16 percent of annual GDP.
  - End-December 2005: domestic currency held by the public = 69 percent of broad money excluding foreign currency deposits, and 39 percent of broad money including foreign currency deposits.
  - Weighted average reserve requirement ~10 percent; current reserve requirements: 13 percent for foreign currency deposits and 2 percent for lari deposits.
- Operational constraints:
  - Banks cited enforcement delays: sale of collateral could take up to two years in practice.
  - Excess reserves declined after the credit boom; uncertainty whether lending expansion reflects improved legal environment or weakened prudence.

### J. Regulatory and structural constraints
- Regulatory constraints perceived by banks:
  - Ceiling of 25 percent on equity stakes in domestic banks by non-industry investors (complicates attraction of strategic international partners).
  - 200 percent risk weighting for some foreign currency loans considered too restrictive by some banks.
  - Capital adequacy requirement: 12 percent overall; Tier I at least 8 percent of risk-weighted assets.
- Market structure and small-bank problems:
  - Number of banks reduced to 18 but still large relative to economy.
  - Many small banks with high overheads, low profitability; most small banks have ROE < 10 percent; all three banks with negative ROE were small banks.
  - Weak banks can undermine public confidence and risk disintermediation.

### K. Readiness for financial deepening and policy implications — recommended actions
- Preconditions for sustained financial deepening:
  - Further monetization is indispensable.
  - Continued prudent macroeconomic policies and deregulation to promote monetization and intermediation.
  - Improve enforcement of creditor rights and judicial efficiency.
  - Refine regulatory rules that impede foreign strategic investment (e.g., ownership restrictions).
  - Consider impacts of reserve and capital requirements on lending capacity.
  - Strengthen institutional capacity: credit information, risk evaluation, professional banking skills.
- Risks from rapid expansion and supervisory responses:
  - Numerical example: an increase in the ratio of credit to GDP from 10 percent to 40 percent in eight years would imply credit growth of 30 percent per year on average (assuming nominal GDP will grow by 9 percent each year).
  - Recommended supervisory measures if boom accelerates:
    - Tighten fiscal and/or monetary policy when necessary.
    - Strengthen supervisory capacity and risk-management systems.
    - If warranted, tighten prudential requirements: loan concentration ratios, asset classification rules, reduce loan-to-value ratios for mortgage lending.
    - Enforce more stringent disclosure requirements and enhance consolidated reporting and inter-supervisor cooperation.

### L. Foreign participation in the banking sector
- No legal or regulatory barriers in principle to foreign investment in Georgian banking, but foreign competition limited.
- Two wholly foreign-owned banks operate in Georgia: combined 1 percent of total banking assets.
- Foreign investors hold shares in 12 resident banks and account for about half of the authorized capital of commercial banks, including IFI investments (EBRD, IFC, KfW, DEG).
- No substantial engagement by a leading international commercial bank.
- One regulatory restriction: 25 percent ownership limit in a Georgian bank for nonbank (non-industry) investors (applies only to nonbank investors).

### M. Measures already under way and recommended institutional reforms
- Measures underway:
  - Credit information bureau recently set up.
  - Sovereign ratings: Standard & Poor’s assigned “B+” long-term and “B” short-term ratings in December 2005 with positive outlook.
  - NBG plans deposit insurance scheme—possibly in 2007; preconditions and careful design emphasized.
  - NBG introduced legislation to allow 100 percent ownership of a commercial bank by any individual or legal entity.
  - NBG proposed revised fit-and-proper criteria for bank owners and managers.
  - New capital requirements expected to further reduce number of small banks.
- Recommended institutional and market reforms:
  - Improve protection of creditor rights and expedite court procedures.
  - Promote accounting and auditing standards and disclosure consistent with international best practices.
  - Close or merge small weak banks; enforce prudential regulations and timely, transparent closure of weak banks.
  - Encourage entry of established foreign banks by strengthening political/economic stability and property rights.
  - Strike balance between safeguarding financial integrity and avoiding over-regulation; consider lowering capital adequacy ratio in the longer run if public confidence improves and definitions are not diluted.

### N. Shadow economy — measurement, findings, and implications
- Objective: evaluate impact of anti-corruption strategy on size of shadow economy using demand-for-cash approach; corroborate with SDS survey-based estimates.
- SDS survey-based estimates (aggregate share of shadow activity):
  - Average in 2003: 33.6 percent.
  - 2004: 29.2 percent (noticeable drop).
- Demand-for-cash empirical findings:
  - Statistically significant structural break in demand for cash coincides with first quarter of 2004.
  - Six quarters after the breakpoint (by mid-2005) hypothetical excess of cash amounts to 9.8 percent of M2.
  - Interpreting as reduction in underground activity implies:
    - 18 months into the anti-corruption effort, almost 10 percent of total economic activity moved from underground to open.
    - If velocity of cash in shadow sector is 15 percent higher than in open economy, share of legalized GDP after 1½ years amounts to 11½ percent.
  - Demand-for-cash estimates suggest degree of legalization may have been twice as high as SDS indicates.
- Caveats and alternative explanations:
  - Shift from foreign-currency deposits to lari deposits could partially explain cash/deposit ratio break; visual inspection indicates U.S. dollar deposits remained broadly stable while lari deposits accelerated.
  - Short sample size, possible omitted-variable bias, and velocity assumptions limit precision.
- Policy implications:
  - Underestimating legalization biases assessments of actual and potential growth: SDS-based decrease of about 4½ percentage points could imply true 2004 growth only about 2 percent; demand-for-cash results could imply negative real growth in 2004.
  - Sustaining legalization may require stepping up enforcement or intensifying governance and business-climate reforms (civil service reform, reduction of red tape, privatization).

### O. LEPL reform — objectives, risks, and recommended fiscal safeguards
- Objectives: grant operational autonomy to management teams of budgetary organizations turned LEPLs to set goals and implement swiftly.
- Major risks identified:
  - No comprehensive database of LEPLs and charters (database creation underway; scheduled completion by end-March 2006).
  - Weak monitoring and reporting: LEPLs may not report revenues/expenditures to ministry of finance; transfers recorded as lump sums; expenditures not recorded.
  - Cash and macro-fiscal management risks: multiple LEPL bank accounts hinder treasury visibility and cash management.
  - Quality of spending and arrears risk: lack of reporting and audit capacity; potential accumulation of arrears.
  - LEPL debt and borrowing risk: legal requirement for ministry authorization often not observed in practice; commercial banks may lend assuming central government guarantee.
  - Potential loss of revenue and vertical imbalance: revenue performance at local level deteriorated in 2005; reliance on central transfers increased between 2003 and 2005.
- Recommended next steps:
  - Build on treasury reform and move toward a Treasury Single Account to increase fiscal transparency and cash management.
  - Complete comprehensive database of registered LEPLs (database creation underway; completion by end-March 2006).
  - Issue guidelines defining control mechanisms, audit scope, reporting requirements, and conflict-of-interest rules.
  - Operationalize monitoring framework:
    - First-best: adapted treasury regime integrating nonmarket LEPLs while allowing autonomy (detailed sequence of actions (i)–(vii) as provided).
    - Second-best: retain LEPL access to commercial bank accounts but require reporting of financial information and bank statements to line ministries and ministry of finance; cooperation with the central bank required to compile accurate financing information.

### P. Governance, business environment, and competitiveness — selected findings and exact measures
- Doing Business 2005: Ease of Doing Business rank: Georgia 100 out of 155 countries.
  - Starting a Business — Procedures (number): 8.0; Duration (days): 21.0.
  - Dealing with Licenses — Procedures (number): 29.0; Time (days): 282.0.
  - Registering Property — Procedures (number): 6.0; Time (days): 9.0; Cost (% of property value): 0.6.
  - Enforcing Contracts — Procedures (number): 18.0; Time (days): 375.0; Cost (% of debt): 31.7.
- Trading Across Borders (Georgia vs peers — exact reported values):
  - Georgia: Documents for export (number): 9.0; Signatures for export (number): 35.0; Time for export (days): 54.0.
  - Georgia: Documents for import (number): 15.0; Signatures for import (number): 42.0; Time for import (days): 52.0.
  - By comparison, Armenia export time 34.0 days; Azerbaijan export time 69.0 days; Baltics export time 12.0 days.
- Global Competitiveness Index (GCI, 2005):
  - Georgia 2005 Rank: 86th out of 117 countries; 2005 Score: 3.39; up eight spots from 2004.
- Corruption Perception (Transparency International CPI):
  - Georgia 2004 score: 2.0; 2005 score: 2.3; 2005 Rank: 130; Regional Rank: 16; Confidence range: 2.0-2.6; Surveys used: 4.
- Press freedom (Reporters Without Borders, 2005):
  - Georgia ranked 99 out of 167 countries.
- Firms’ perceptions (BEEPS 2005 in Georgia):
  - Percent of firms citing tax administration as a problem: 84 percent in 2002 → 23 percent in 2005.
  - Percent of firms reporting corruption as a problem: 66 percent in 2002 → 39 percent in 2005.
  - Judiciary showed lack of improvement; increase in contract violations faced by firms.
- Tax revenue outcomes:
  - Tax to GDP ratios increased by 25 percent in 2004, and 9 percent in 2005.

### Q. Competitiveness, exchange rate, and policy recommendations
- Real effective exchange rate (REER):
  - REER appreciated by 17 percent between January 2004 and April 2005.
  - RER believed to have been significantly undervalued historically; estimate: undervalued by about 35 percent based on international price-level comparison.
- External inflows and balance of payments (selected exact figures and indicators):
  - Georgia will receive about $300 million from the Millennium Challenge Corporation in 2006–09.
  - FDI projected to exceed 10 percent of GDP over the next four years.
  - Official disbursements could almost double given international support.
  - Large privatization receipts financed a widening fiscal deficit that reached 2½ percent of GDP in 2005, compared to less than half a percentage point of GDP in 2004.
- Export composition (2004, as reported):
  - Scrap Metals: 13%; Aircrafts, other: 8%; Wine: 7%; Ferrous Metals: 5%; Sugar: 5%; Copper Ores and Concentrates: 4%; Fertilizers: 43%; Other: 15%.
- Transportation and trade costs:
  - Sea shipment of a 40-foot container from Norfolk, U.S., to Tbilisi is almost 50 percent more expensive than to the Baltic capitals and 10 percent more expensive than to Yerevan.
- Policy recommendations (exact guidance preserved):
  - Allow the nominal exchange rate to adjust freely to external inflows.
  - Monetary policy should target low single-digit inflation.
  - Implement prudent fiscal policy to contain domestic demand and limit real appreciation.
  - Design fiscal programs targeted on improving productivity (e.g., infrastructure).
  - Ensure productivity continues to improve through market-based reforms that reduce paperwork and red tape.
  - Pursue transparency reforms to reduce cost of corruption.
  - Simplify administration of international trade; reduce administrative burdens (example: entrepreneur must submit 9 (15) documents and obtain 35 (42) signatures to export (import) goods; export shipment takes 54 days on average in Georgia vs. 31 days in the region and 12 days in OECD countries).
  - Abolish import tariffs completely within two years (government proposal: gradual elimination of all tariffs by 2008).

*Excerpt from IMF staff report content unit _cr06170 (excerpts provided).*

### References..............................................................................................................

### I. Financing Economic Development in Georgia

### A. Introduction and recent macro-financial context
- Georgia’s output contracted sharply during early transition; rebound in mid-1990s; setback in 1998; since 2001 growth near 7 percent per year with modest inflation.
- Available data show that real GDP in 2005 amounts to about half of the 1989 level.
- Since the Rose Revolution in late 2003, reforms focused on strengthening the fiscal position, addressing infrastructure constraints, and improving the business climate.
- Recent economic expansion has not been accompanied by significant financial sector deepening; monetization remains below 20 percent of GDP in Georgia and the Caucasus.

### B. Why financial development matters (Box I.1)
- Empirical evidence links better functioning banks and markets to faster growth (Levine, Loayza, and Beck, 2000).
- Mechanisms by which an efficient financial system promotes development:
  - Mobilizing and pooling savings, including attracting resources from abroad.
  - Channeling investment toward higher return activities by reducing information costs and reflecting risk in interest rates.
  - Exerting corporate governance through monitoring borrowers, inducing managers to maximize firm value.
  - Facilitating risk management and diversification, encouraging innovative and riskier projects with higher expected returns.

### C. Financial sector structure and recent trends
- Banking system and monetization indicators for Georgia (selected years from Table I.1):
  - Banking system credit to economy (Georgia): 1996: 3.3; 1998: 4.7; 2000: 7.3; 2002: 8.3; 2004: 9.5; 2005 Est.: 15.0 (all values in percent of GDP).
  - Monetization (M3 where available, M2 otherwise) (Georgia): 1996: 6.7; 1998: 7.3; 2000: 10.3; 2002: 11.6; 2004: 15.2; 2005 Est.: 16.5 (percent of GDP).
- Comparison points in Table I.1 (selected peers, percent of GDP):
  - Kazakhstan banking credit to economy: 1996: 5.1; 1998: 5.9; 2000: 11.1; 2002: 18.5; 2004: 28.2; 2005 Est.: 38.6.
  - Baltics monetization: 1996: 21.6; 1998: 23.6; 2000: 28.9; 2002: 33.6; 2004: 38.7; 2005 Est.: 47.6.
- Liquid liabilities in Georgia rose from 10 percent of GDP at end-2000 to 16 percent at end-2005; private sector credit remained below 10 percent of GDP until end-2004, when rapid credit growth began.

### D. Banking system structure, concentration, and nonbank institutions
- Number and ownership:
  - After a recent takeover, there are currently 18 banks, of which 16 are private Georgian banks, and the others are branches of Turkish and Azeri banks.
  - Peak number of banks was 229 in 1994.
  - New minimum capital requirement obliges existing banks to increase paid-in capital to about US$6.5 million by 2008.
- Market concentration and consolidation:
  - At end-2005, the six largest banks held about 87 percent of the system’s total assets, 90 percent of total loans, and about 89 percent of deposits.
  - In 1998 the top six banks held 56 percent of assets and 58 percent of deposits.
  - Herfindahl-Hirschman Index for Georgia’s banking system (based on each bank’s share in total loans): 1495 at end-2005; 718 at end-1998.
  - By U.S. standards, an HHI of 1495 indicates a moderately concentrated market.
- Other financial institutions:
  - 42 credit unions with total assets of GEL 1.8 million (less than 0.02 percent of GDP), serving mainly rural areas.
  - A number of microfinance companies assist very small entrepreneurs.
  - Insurance sector (2004): total premia collected amounted to GEL 45 million, or 0.5 percent of GDP.
- Capital market development:
  - Georgia’s stock market is small and active trading limited to shares of a few companies (2005 total annual turnover: GEL 62 million, about 0.5 percent of GDP).
  - About 44 percent of total turnover stems from trading of the only continuously listed company; shares of 279 other companies are admitted for trade but not continuously listed.
  - No corporate bond issuance until late 2005, when two commercial banks issued bonds totaling about US$4 million.
  - Importance of active government securities market for fostering debt market development is noted.

### E. Drivers, constraints, and transitional dynamics
- Current financing sources and transitional considerations:
  - Resource allocation has relied more on privatization-related investment, retained earnings, and unofficial financing.
  - Foreign direct investment (FDI), external aid, and remittances have been important recent financing sources.
  - Surveys indicate more than 70 percent of SMEs and about 60 percent of large enterprises have never approached banks for credit; almost 80 percent of capital investments in SMEs financed by retained earnings and owners’ private savings (IFC, 2004).
- Policy-relevant observations:
  - As privatization progresses, legalization of the economy reduces the informal sector and firms expand; traditional modalities of corporate finance will need to be replaced by more efficient funding through the financial system.
  - Major FDI-financed projects (oil and gas pipelines) largely completed; foreign aid could decline over time; the financial system will need to play a larger role going forward.

### F. Agenda and chapter outline (as presented)
- The chapter:
  - Reviews financial sector development in Georgia and compares it with neighboring countries, the CIS-7, the Baltics, and the CEE (Section B).
  - Analyzes possible factors constraining financial intermediation in Georgia and some CIS countries more generally (Section C).
  - Outlines ways to bolster healthy financial sector development (Section D).
  - Presents conclusions (Section E).

*Prepared by Andreas Billmeier and Shuang Ding.*

### 9.      There are, in principle, no legal or regulatory barriers impeding foreign

### _cr06170 - 9.      There are, in principle, no legal or regulatory barriers impeding foreign

### Foreign participation in the banking sector
- No legal or regulatory barriers in principle to foreign investment in the Georgian banking system, but foreign competition is not significant at present.
- Only two wholly foreign-owned banks operate on Georgian territory, for a combined 1 percent of total banking assets.
- Foreign investors hold shares in 12 resident banks and account for about half of the authorized capital of commercial banks, including investments by IFIs such as the EBRD, the IFC, and KfW and DEG.
- No substantial engagement by a leading international commercial bank.
- One regulatory restriction: a 25 percent ownership limit in a Georgian bank for nonbank (non-industry) investors (applies only to nonbank investors; see paragraph 20 in source).

### Dollarization, monetary policy constraints, and de-dollarization progress
- Banking system balance sheets are highly dollarized, constraining the central bank’s capability to conduct effective monetary policy and posing risks to commercial bank operations.
- NBG measures to stimulate lari demand include differentiated reserve requirements for domestic and foreign currencies.
- Deposit dollarization declined from about 86 percent at end-2003 to 72 percent in December 2005.
- Loan dollarization declined from 88 percent to 76 percent (period implied by context).
- Further reduction in dollarization would require a solid track record of prudent fiscal and monetary policies.
- Caucasus unweighted average deposit dollarization declined from 83 percent in 2001 to 73 percent in 2005.
- Baltic economies: deposit dollarization decreased from an unweighted average of 43 percent in 1999 to 36 percent by mid-2003.
- Mitigation of currency mismatch: all dollar-denominated loans are risk-weighted at twice the international standard unless borrowers have a demonstrated source of foreign currency earnings.

### Financial soundness, profitability, and risks (selected indicators and levels)
- Interest rate spread between deposit and lending rates: 10 percent as of end-2005.
- Nonperforming loan ratio: 3.8 percent of total loans at end-2005, down from 6.2 percent at end-2004.
- Capital adequacy ratio (CAR): 17.5 percent at end-2005.
- Liquid assets: about 76 percent of total assets (end-2005).
- Tier I capital ratio: 12.2 percent (end-2005).
- Sector-wide return on equity: almost 15 percent in 2005 (a 50 percent improvement over 2004).
- Positive earnings for all but three banks in 2005.

Selected Financial Soundness Indicators, 2000–2005 (In percent, unless otherwise indicated)
- Capital to assets: 2000: 33.6; 2001: 30.5; 2002: 28.3; 2003: 26.2; 2004: 21.9; 2005: 18.8
- Regulatory capital to risk-weighted assets: 2000: 36.7; 2001: 33.1; 2002: 21.9; 2003: 20.3; 2004: 18.8; 2005: 17.5
- Nonperforming loans to total gross loans: 2000: 7.1; 2001: 11.6; 2002: 7.9; 2003: 7.5; 2004: 6.2; 2005: 3.8
- Loans collateralized by real estate (selected years): 2001: 30.2; 2002: 33.3; 2003: 31.9; 2004: 33.5; 2005: 30.8
- Return on assets: 2000: 0.5; 2001: 1.6; 2002: 4.2; 2003: 4.0; 2004: 2.4; 2005: 3.1
- Return on equity: 2000: 1.5; 2001: 5.0; 2002: 14.9; 2003: 15.0; 2004: 10.0; 2005: 14.9
- Net interest income to gross income: 2000: 56.4; 2001: 63.3; 2002: 62.9; 2003: 66.0; 2004: 61.2; 2005: 61.4
- Noninterest expenses to gross income: 2000: 62.9; 2001: 53.2; 2002: 56.1; 2003: 54.9; 2004: 61.6; 2005: 57.2
- Spread between reference lending and deposit rates in domestic currency: 2000: 15.0; 2001: 22.0; 2002: 19.0; 2003: 22.6; 2004: 13.3; 2005: 9.2
- Spread in foreign currency: 2000: 23.0; 2001: 22.0; 2002: 14.4; 2003: 18.5; 2004: 19.4; 2005: 17.0
- Liquid assets to short-term liabilities (selected years): 2002: 28.1; 2003: 32.5; 2004: 30.7; 2005: 34.7; 2005 (alternative row): 33.3
- Liquid assets to total assets (selected years): 2002: 80.4; 2003: 92.6; 2004: 92.1; 2005: 104.2; 2005 (alternative row): 76.5
- Net open position in foreign exchange to capital: 2000: 15.7; 2001: 6.9; 2002: 9.3; 2003: 8.5; 2004: 7.4; 2005: 7.5
- Foreign currency-denominated loans to total loans: 2000: 81.4; 2001: 81.4; 2002: 83.8; 2003: 87.7; 2004: 86.7; 2005: 76.2
- Foreign currency-denominated deposits to total deposits: 2000: 77.9; 2001: 85.7; 2002: 84.9; 2003: 86.1; 2004: 74.3; 2005: 71.6

### The 2005 credit boom: scope, composition, and financing
- Credit expansion began early 2005; private sector credit rose to 15 percent of estimated 2005 GDP from about 10 percent in 2004.
- Number of outstanding loans grew by 34 percent in 2005; loan value grew about 83 percent in 2005.
- Average loan size increased by GEL 1,500 to GEL 5,900 in 2005.
- Share of large loans (over GEL 100,000) by amount remained almost 70 percent of total loans.
- Ratio of loans with maturity longer than 12 months over short-term loans (up to 12 months) increased from 1.6 to 1.9 during 2005.
- Stock of long-maturity loans grew by GEL 540 million in 2005, or 4.7 percent of GDP.
- Lending interest rates moved into the 10–20 percent interest range (concentration increasing).
- Almost one-fourth of outstanding loans were denominated in domestic currency in 2005, up from 15 percent 12 months earlier.
- Total domestic private sector credit grew by 83 percent in 2005; lari-denominated lending tripled.
- Banks financed increased lending mainly by attracting deposits, which grew by 31 percent in 2005, and by a build-up of foreign liabilities of GEL 230 million (2 percent of GDP).
- Lari deposits increased by 45 percent in 2005; foreign-currency denominated deposits grew by 23 percent.

### Bank behavior and market concentration during the boom
- The credit boom was concentrated in the six biggest banks; they accounted for 94 percent of the additional loan portfolio in 2005.
- Loan application processes simplified for small loans; collateral requirements decreased substantially or were eliminated for small amounts (example: one bank eliminated collateral for loans smaller than GEL 6,000, previously GEL 1,000).
- Increase in very short-term loans (up to one month) occurred alongside a shift toward longer maturities.

### Drivers of the credit boom (survey insights and macro context)
- Timing: credit boom occurred four years after strong growth began in Georgia, and one year after the Rose Revolution.
- Contributing factors cited by banks:
  - Per-capita income needed to exceed a threshold to create sufficient demand for financial intermediation.
  - Strong deposit growth enabled lending expansion; causes could include increased confidence in banks or legalization of the economy.
  - Establishment of a credit information bureau expected to improve information asymmetries, though benefits so far limited.
  - Ability to attract experienced bankers (domestic and foreign) through competitive salaries improved bank management.
- Banks did not attribute the boom primarily to recent tax system changes or significant improvements in the court system.

### Factors explaining historically low financial development and remaining constraints
- Identified impediments to financial intermediation:
  - Delays in establishing macroeconomic stability (hyperinflation in early 1990s; depreciation after Russian crisis 1998/99).
  - Lack of loanable funds due to high cash holdings outside banking and reserve requirements.
  - Low demand for credit historically due to low income and an unfavorable business environment.
  - Weak institutions: limited information on firms, lack of expertise in credit evaluation, weak creditor rights, inefficient judicial enforcement.
  - Certain financial regulations perceived as restrictive.
  - Market structure: over-banking with many small, financially weak banks.
- Specific details:
  - Broad money (including foreign currency deposits) still accounts for only 16 percent of Georgia’s annual GDP (Table 1 reference).
  - As of end-December 2005, domestic currency held by the public accounted for 69 percent of broad money excluding foreign currency deposits, and 39 percent of broad money including foreign currency deposits.
  - Weighted average reserve requirement ~10 percent; current reserve requirements: 13 percent for foreign currency deposits and 2 percent for lari deposits.
  - Banks cited long times (sale of collateral could take up to two years) for enforcing collateral in practice.
  - Excess reserves of commercial banks declined after the credit boom, but uncertainty remains whether lending reflects improved legal environment or weakened prudence.

### Regulatory and structural issues that have constrained expansion
- Regulatory constraints perceived by banks:
  - Ceiling of 25 percent on equity stakes in domestic banks by non-industry investors, complicating attraction of strategic international partners.
  - 200 percent risk weighting for some foreign currency loans considered by some banks to be too restrictive.
  - Current capital adequacy requirements could tie up resources that might otherwise be available for lending (capital adequacy ratio requirement: 12 percent overall; Tier I at least 8 percent of risk-weighted assets).
- Market structure:
  - Number of banks reduced to 18, but still large relative to the economy; many small banks perceived as financially weak.
  - Small banks face high overheads and low profitability; most small banks have ROE < 10 percent, and all three banks with negative ROE were small banks.
  - Existence of weak banks can undermine public confidence and risk disintermediation.

### Readiness for financial deepening and policy implications
- The recent expansion could reverse financial repression and begin sustained financial deepening, as seen in the Baltic and many CEE economies after macroeconomic stabilization.
- Essential prerequisites and policy implications highlighted:
  - Further monetization of the economy is indispensable.
  - Continued prudent macroeconomic policies and deregulation to promote monetization and intermediation.
  - Address remaining constraints: improve enforcement of creditor rights and judicial efficiency; refine regulatory rules that impede foreign strategic investment; consider the impact of reserve and capital requirements on lending capacity.
  - Strengthen institutional capacity (credit information, risk evaluation, professional banking skills) to sustain the credit expansion in a prudent manner.

*Source: Excerpt from IMF staff report (_cr06170), pages 9–15, tables and box material as provided in the source content.*

### 23.      The authorities have already set in motion some of the processes that are

### The authorities have already set in motion some of the processes that are anticipated to promote financial intermediation over time

### Measures already under way
- Credit information bureau recently set up; will collect and share information about borrowers from participating commercial banks to reduce counterpart risk and facilitate commercial lending.
- Government sought sovereign credit ratings; in December 2005, Standard & Poor’s assigned its “B+” long-term and “B” short-term sovereign credit ratings to the government of Georgia, with positive outlook — first ratings since independence; expected to help local banks borrow from abroad at more favorable terms.
- NBG plans to introduce a deposit insurance scheme—possibly in 2007—to increase public trust in the banking sector. Important design and preconditions noted to avoid moral hazard, adverse selection, and agency problems.
  - Weak banks need to be closed or merged before introduction to minimize risk of immediate depletion of the deposit insurance fund.
  - The scheme should encompass appropriate coverage limits, scope of coverage, coinsurance, funding, premia structure, management, and membership requirements. Preconditions include a strong banking system, good bank supervision, clear rules for financial reporting and accounting, and a strong and fair judiciary that supports collateral and creditor rights.
- NBG has introduced legislation to parliament to eliminate restrictions on bank ownership, allowing any individual or legal entity to own 100 percent of a commercial bank to facilitate ownership restructuring and mergers and acquisitions.
- NBG proposed adoption of revised fit-and-proper criteria for bank owners and managers to minimize substandard corporate governance risk.
- New capital requirements expected to further reduce number of small banks, which on average display weaker CAMEL ratings.

### Recommended institutional and market reforms
- Strengthening institutions and infrastructure
  - Improve protection of creditor rights and expedite court procedures.
  - Promote accounting and auditing standards and disclosure requirements that comply with international best practices.
- Further consolidating the banking sector
  - Close or merge small weak banks to achieve economies of scale and scope without compromising competitiveness.
  - Enforcement of prudential regulations and timely, transparent closure of weak banks recommended.
  - Cited evidence: a recent study found no evidence that competitiveness is negatively related to banking system concentration and confirmed contestability determines effective competition.
- Encouraging foreign entry
  - Entry of established foreign banks can bring capital, know-how, sound corporate governance, and competition; can increase confidence and reduce bailout risk.
  - Barriers noted: small market size and perceived country risk; recommendations include strengthening political and economic stability, property rights, business climate, and regional cooperation to attract foreign banks.
- Streamlining regulations
  - Strike balance between safeguarding financial integrity and avoiding over-regulation.
  - As public confidence improves and provided definitions of capital and risk assets are not diluted, lowering capital adequacy ratio could be considered in the longer run to reduce cost of financial intermediation.

### Risks from rapid financial expansion and supervisory responses
- Rapid expansion without quality control can give rise to financial fragility and increase cost of intermediation.
- Numerical example preserved from source:
  - An increase in the ratio of credit to GDP from 10 percent to 40 percent in eight years would imply credit growth of 30 percent per year on average (assuming nominal GDP will grow by 9 percent each year).
- Recent credit booms in other transition economies highlighted risks:
  - Bulgaria and Romania: credit booms contributed to widening macroeconomic imbalances and heightened external vulnerability; addressed through tight fiscal policy.
  - Ukraine: credit expansion raised concerns over loan quality and banking sector stability.
- Recommended supervisory and policy measures if credit boom accelerates:
  - Tighten fiscal and/or monetary policy when necessary to reduce demand pressures.
  - Strengthen supervisory capacity to handle larger and more complex loan portfolios.
  - Ensure commercial banks implement comprehensive risk management strategies, policies, systems, and have qualified staff.
  - If warranted, strengthen prudential requirements: tighten loan concentration ratios, asset classification rules for property and consumer loans, and reduce loan-to-value ratios for mortgage lending.
  - Enforce more stringent disclosure requirements to encourage private monitoring of banks.
  - Respond to universal banking trends by encouraging information exchange and cooperation between industry supervisors and by enhancing consolidated reporting.

### Key findings, indicators, and recent outcomes
- Financial deepening has lagged behind economic development in Georgia; monetization and private sector credit remain low by international standards.
- Factors hindering financial development: lack of confidence in financial sector and economy, cash-based transactions, sizable informal economy, limited investment opportunities, weak institutions and infrastructure, unhealthy competition, regulatory restrictions.
- Recent credit expansion:
  - In 2005, banks started to massively expand loan portfolios, resulting in an 83-percent increase of credit to the private sector.
  - Such expansion could signal the start of sustained financial deepening or the onset of an explosive credit boom; close supervision required.
- Institutional improvements and macro stability needed to foster financial development while managing risks.
- BEEPS 2005 survey results for Georgia:
  - Percent of firms citing tax administration as a problem: 84 percent in 2002 → 23 percent in 2005.
  - Percent of firms reporting corruption as a problem: 66 percent in 2002 → 39 percent in 2005.
  - Judiciary showed lack of improvement; increase in contract violations faced by firms.
  - Infrastructure (transportation, energy, telecommunications) remains an obstacle to business.
- Doing Business 2005 rankings and selected indicators:
  - Ease of Doing Business rank: Georgia 100 out of 155 countries.
  - Selected country ranks: Armenia 46; Azerbaijan 98; Estonia 16; Latvia 26; Lithuania 15; Ukraine 124.
  - Georgia: Starting a Business — Procedures (number) 8.0; Duration (days) 21.0.
  - Georgia: Dealing with Licenses — Procedures (number) 29.0; Time (days) 282.0.
  - Georgia: Registering Property — Procedures (number) 6.0; Time (days) 9.0; Cost (% of property value) 0.6.
  - Georgia: Enforcing Contracts — Procedures (number) 18.0; Time (days) 375.0; Cost (% of debt) 31.7.
- Tax revenue outcomes after government changes:
  - Tax to GDP ratios increased by 25 percent in 2004, and 9 percent in 2005, enabling public programs while maintaining fiscal stability.

*Source: IMF staff report chapter content (excerpts provided).*

### 41.      Somewhat surprising are the procedural requirements for exporting and

### _cr06170 - 41.      Somewhat surprising are the procedural requirements for exporting and

### Trading Across Borders
- An official procedure is counted from the time an agreement is made between the two relevant parties to the delivery of the cargo.
- Comparative procedural burdens (Table II.3):
  - Armenia
    - Documents for export (number): 7.0
    - Signatures for export (number): 12.0
    - Time for export (days): 34.0
    - Documents for import (number): 6.0
    - Signatures for import (number): 15.0
    - Time for import (days): 37.0
  - Azerbaijan
    - Documents for export (number): 7.0
    - Signatures for export (number): 40.0
    - Time for export (days): 69.0
    - Documents for import (number): 18.0
    - Signatures for import (number): 55.0
    - Time for import (days): 79.0
  - Georgia
    - Documents for export (number): 9.0
    - Signatures for export (number): 35.0
    - Time for export (days): 54.0
    - Documents for import (number): 15.0
    - Signatures for import (number): 42.0
    - Time for import (days): 52.0
  - Baltics
    - Documents for export (number): 6.3
    - Signatures for export (number): 4.3
    - Time for export (days): 12.0
    - Documents for import (number): 10.0
    - Signatures for import (number): 5.3
    - Time for import (days): 17.3
- Key observations:
  - It takes 20 days longer to export, and 15 days longer to import goods, in Georgia than in Armenia.
  - Companies importing raw materials/intermediate goods for subsequent export must collect 24 documents and 77 signatures, and paperwork would take 106 days.
- Policy context:
  - The trade liberalization strategy and the customs code being discussed in parliament envisage a complete elimination of tariffs by 2008 and streamlining of customs regulations, seen as steps toward more open trade.
- Source noted: World Bank Doing Business database.

### Global Competitiveness (Growth Competitiveness Index, GCI)
- GCI: weighted average of technology (0.5), public institutions (0.25), and macroeconomic environment (0.25).
- Georgia’s 2005 performance:
  - 2005 Rank: 86th out of 117 countries
  - Change: up eight spots from 2004 (the seventh largest upward move)
  - 2005 Score: 3.39
  - Main areas of improvement cited: macroeconomic stability and quality of public institutions.
  - Survey notes: perceived improved fiscal setting, easier access to credit, more objective government criteria for policies and contracts; organized crime somewhat less problematic; corruption remains a serious problem.
- Table II.4 excerpts:
  - Armenia: 2005 Rank 79, 2005 Score 3.4
  - Azerbaijan: 2005 Rank 69, 2005 Score 3.6
  - Baltics (aggregate note): GCI 2005 ranking for Estonia is 20, for Latvia 44, and for Lithuania 43.
- Source: World Economic Forum.

### Nations in Transit (Freedom House democracy scores)
- Freedom House ratings based on electoral process (EP), civil society involvement (CS), independent media (IM), judiciary (JFI), and corruption (CO). Scale: 1 (most democratic) to 7 (least democratic).
- Selected 2005 scores (Table II.5):
  - Armenia: EP 5.75, CS 3.50, IM 5.50, JFI 5.25, CO 5.75, Democracy Score 5.18
  - Azerbaijan: EP 6.25, CS 4.75, IM 6.00, JFI 5.75, CO 6.25, Democracy Score 5.86
  - Georgia: EP 4.75, CS 3.50, IM 4.25, JFI 5.00, CO 5.75, Democracy Score 4.96
- Note: Georgia’s democracy score went from 4.83 in 2003 to 4.96 in 2005, losing ground in media independence and judicial framework/independence.
- Source: Freedom House.

### Economic Freedom (Heritage Foundation)
- Index of Economic Freedom: 50 variables into 10 equally weighted categories.
- Georgia’s move:
  - 2005 Ranking: 100th, Score 3.34 (“mostly unfree” in 2005)
  - 2006 Ranking: 68th, Score 2.98 (“mostly free” in 2006)
  - Areas of improvement: monetary policy, the financial sector, and foreign investment.
  - Persisting weaknesses: property rights, regulation, and the informal market.
- Table II.6 excerpts (Score / Ranking):
  - Armenia: 2005 Score 2.58 Ranking 42; 2006 Score 2.26 Ranking 27
  - Azerbaijan: 2005 Score 3.38 Ranking 103; 2006 Score 3.51 Ranking 123
  - Georgia: 2005 Score 3.34 Ranking 100; 2006 Score 2.98 Ranking 68
- Source: Index of Economic Freedom, Heritage organization.

### Corruption Perception (Transparency International)
- CPI summarizes perceptions of public-sector corruption; higher score = improvement.
- Georgia CPI:
  - 2004 score: 2.0
  - 2005 score: 2.3
  - 2005 Rank: 130
  - Regional Rank: 16
  - Confidence range: 2.0-2.6
  - Surveys used: 4
  - Georgia remains in the lowest quintile of countries despite modest improvement.
- Table II.7 excerpts:
  - Armenia: Rank 88, Regional Rank 5, 2005 CPI Score 2.9, Confidence range 2.5-3.2, Surveys used 4
  - Azerbaijan: Rank 137, Regional Rank 18, 2005 CPI Score 2.2, Confidence range 1.9-2.5, Surveys used 6
  - Baltics: 2005 CPI Score 5.1 (note only shown as “Baltics......5.1......”)
- Global Corruption Barometer (public-opinion based) insights for Georgia:
  - Judiciary scored worst at 3.9; police scored 2.9 (reflecting massive restructuring of police in 2004).
  - Public perception of change over past 3 years: 46 percent thought corruption had decreased at least a little; 20 percent thought it had increased at least a little.
  - Expectations for next 3 years: 38 percent expected corruption to decrease; 8 percent expected it to increase.

### Reporters Without Borders — Press Freedom
- 2005 ranking out of 167 countries:
  - Georgia ranked 99
  - Armenia ranked 102
  - Azerbaijan ranked 141
- Note: Georgia’s press freedom levels appear comparable to Armenia but show some deterioration over the last two years illustrated in Figure II.3.

### Conclusion (Governance and Reform Impact)
- Main administration mission: reduce corruption to build a broader tax base and improve the business environment.
- Strategy emphasized narrowing the scope of government to reduce rent-seeking opportunities.
- Reforms under discussion reflecting streamlining and liberal approaches: trade liberalization, customs code, banking sector strategy.
- Assessment:
  - Much progress made in a short time; surveys reflect improvement.
  - Survey data are from late 2004–early 2005, a short time after government change; future surveys likely to show greater gains.
  - Areas needing greater attention: strengthening legal institutions for property rights and contract enforcement; ensuring a free press; development of political branches to create effective checks and balances.

### Measuring the Shadow Economy: Introduction and Background
- Purpose of chapter: evaluate impact of Georgian anti-corruption strategy on size of shadow economy using the demand-for-cash approach.
- Rationale for measuring shadow economy:
  - Shadow sector undermines tax revenue.
  - Large shadow economy reduces reliability of official statistics.
  - Shadow-economy trends inform perceptions of tax/administrative burden and governance quality.
- Definition: “Shadow” or “informal” economy comprises all economic activity that contributes to GDP but is currently unregistered (Schneider and Enste, 2000).
- Context:
  - President Saakashvili won in January 2004 on an anti-corruption/legalization platform; 2005 tax reform aligned with that strategy.
  - SDS official estimates and anecdotal evidence suggest 2004 reported growth driven substantially by activities moving from underground to official sector.
- Methodological choice:
  - Demand-for-cash approach selected due to ready availability of monetary data.
  - Alternative approaches (surveys, electricity consumption) not feasible or reliable in Georgia because of limited data and frequent, supply-driven electricity blackouts.
- High-level finding preview:
  - SDS estimates and demand-for-cash results are qualitatively consistent: share of shadow economy dropped following political changes at end-2003 and the anti-corruption campaign in 2004; more recently shadow activity began to rise again in some sectors.
- Background on reforms to reduce corruption:
  - Post-1991 Georgian decline and governance failures culminated in Rose Revolution in November 2003.
  - New leadership prosecuted many corrupt officials and appointed new policymakers in vulnerable positions (tax, customs, law enforcement).
  - Public-sector reforms included reducing the number of civil servants, reducing ministries from 18 to 14, abolishing redundant entities, increasing remuneration of remaining staff.
  - Regaining control over Ajara in mid-2004 reduced smuggling through Batumi.
- Survey evidence:
  - BEEPS shows government success in reducing corruption and legalizing economic activity.
  - Sales reported for tax purposes in Georgia rose from 65 percent to about 90 percent between 2002 and 2005.
  - This surge in transactions reported for tax purposes is consistent with a considerable reduction in the shadow economy in 2004.

### Shadow Economy — SDS Survey-Based Estimates (Summary)
- SDS methodology:
  - Estimates based on enterprise and household surveys.
  - Informal employment proxied by the difference between employment reported by firms and labor force survey figures.
  - Shadow output assumed proportional to employment with uniform employment-output relation across industries.
- SDS findings (Figure III.2 summary):
  - Aggregate share of shadow activity:
    - Average in 2003: 33.6 percent
    - 2004: 29.2 percent (noticeable drop)
  - Sector decomposition: largest contributions to the decrease between Q1 2003 and Q1 2004 were from:
    - Electricity, gas, and water supply
    - Construction
    - Trade and repair services
    - Health care and social services
    - Mining and quarrying

*Italic: Source — IMF content unit _cr06170 (excerpts provided).*

### 63.      Although the size of the shadow economy shrunk through the fourth quarter of

### D. Shadow Economy: The Demand for Cash

### SDS survey findings and caveats
- SDS survey-based estimates indicate the size of the shadow economy shrunk through the fourth quarter of 2004, with some sectors showing signs of a rebound (notably construction; mining and quarrying to a lesser extent; and the utility sector).
- Methodological caveats of the SDS approach:
  - Assumes respondents’ answers were not affected by the political regime change rather than by a change in economic behavior; willingness to disclose employment in shadow activities could have shifted with the political environment.
  - Assumes sectoral output is proportional to number of employees and does not distinguish capital-intensive from labor-intensive sectors, biasing results toward labor-intensive sector changes.
  - Uses some ad-hoc information and judgmental adjustments that are difficult to control.
- Recommendation from the chapter: corroborate SDS results with an alternative approach, such as the demand-for-cash method.

### Demand-for-cash method and empirical specification
- Demand for cash proxied by the ratio of cash in circulation to deposits and modeled as a function of the real interest rate on deposits in a cointegrated model.
- The test for a structural break is applied for the first quarter of 2004, supported by statistical testing and evidence in Figure III.2.
- The specification uses seasonal dummies and the real interest rate (inflation is an implicit regressor). The approach follows Cagan (1958) and Gutmann (1977) rather than Tanzi (1980, 1983).

### Empirical results and quantitative inferences
- A statistically significant structural break in demand for cash coincides with the new government’s crackdown on corruption and results in a sharp decrease in demand for cash in the first quarter of 2004.
- The drop reflects a faster accumulation of lari deposits relative to the amount of cash in circulation.
- Six quarters after the assumed breakpoint (by mid-2005) the hypothetical excess of cash (unused for shadow transactions) amounts to 9.8 percent of M2.
- Interpreting this discrepancy as a reduction in underground activity implies:
  - 18 months into the government’s anti-corruption effort, almost 10 percent of total economic activity had been moved from the underground to the open.
  - If the velocity of cash in the shadow sector is 15 percent higher than in the open economy, the share of legalized GDP after 1½ years amounts to 11½ percent.
- Comparison with SDS:
  - Demand-for-cash estimates suggest the degree of legalization may have been twice as high as recorded by the SDS survey-based estimates.
  - Both methods agree qualitatively: the legalization process proceeded rapidly through the first three quarters of 2004 and stalled in late 2004–early 2005.
  - SDS indicates a somewhat slower initial decline in the shadow economy.

### Caveats, alternative explanations, and limitations
- Possible alternative explanations for the break in the cash-to-deposit ratio:
  - Shift in preferences from foreign-currency deposits (U.S. dollars) to lari deposits as the lari started to appreciate against the U.S. dollar around the time of the break. Visual inspection indicates the break is in demand for cash rather than composition of savings because U.S. dollar-nominated deposits remained broadly stable while lari deposits accelerated sharply in 2004.
  - Increased trust in the banking system could have raised deposits and overstated the break; counterargument: lari deposits increased much more than U.S. dollar deposits, which is inconsistent with generic trust-driven deposit growth unless depositors expected lari appreciation.
  - Omitted-variable bias: omitted regressors could include exchange rate, degree of dollarization, and financial development; dollarization not included due to possible endogeneity.
  - Short sample size may yield an imprecise estimate of the hypothetical path of cash in circulation.
  - The demand-for-cash approach hinges on the assumption that the velocity of cash in the shadow sector equals the velocity of M2 in the overall economy; relaxing this assumption alters levels but not the broad path.

### Conclusions and policy implications
- The demand-for-cash approach confirms evidence of a contraction in the shadow economy in Georgia following the late-2003 political changes.
- Quantitatively, the demand-for-cash method implies a larger legalization effect than the SDS: the degree of legalization may have been twice as high as the SDS indicates.
- Implication for growth measurement:
  - Underestimating the degree of legalization biases assessments of actual and potential economic growth.
  - A rough calculation: true 2004 economic growth might be only about 2 percent if the SDS estimate of a decrease in the shadow economy share by about 4½ percentage points from end-2003 to end-2004 is correct.
  - If the degree of legalization followed demand-for-cash results, true real growth in 2004 could have been negative.
  - For 2005, real and reported GDP growth are likely to be more similar because both approaches indicate a slowdown in the legalization process.
- Policy implications for sustaining further progress:
  - Further progress may require either stepping up enforcement measures to their high post-revolution levels or intensifying efforts to improve governance and the business climate, including:
    - further civil service reforms;
    - a reduction of red tape and further streamlining of regulations and procedures (without putting the regulatory framework at risk);
    - privatization of the remaining state-owned enterprises.
- Institutional context: the quick and substantial success in legalizing parts of the economy is state-contingent and reflected a very high initial degree of perceived corruption, the timing of the regime change, and a substantial turnover in government officials.

*Sources: State Department for Statistics of Georgia (SDS); National Bank of Georgia (NBG); Fund staff estimates and calculations.*

### 82.      The objectives of the Georgian LEPL reform are similar to the objectives of

### _cr06170 - 82.      The objectives of the Georgian LEPL reform are similar to the objectives of

### Objectives and rationale
- The LEPL reform in Georgia is premised on granting operational autonomy to management teams of budgetary organizations turned LEPLs so each organization can set its own goals and priorities and implement them swiftly.
- The logic underpinning most fiscal decentralizations is to increase the independence of local governments with regard to certain fiscal institutions and public services, while ensuring greater accountability through direct local elections.
- Unlike representative local government, LEPL management teams are not directly subject to electoral scrutiny; therefore the LEPL strategy may reduce accountability to recipients of government services unless additional safeguards are introduced.

### Key fiscal issues and risks identified
- Lack of comprehensive database:
  - No comprehensive database of all LEPLs and their charter information exists; authorities are preparing such a database.
  - Policymakers cannot assess the size or sectoral composition of LEPLs or access reliable and timely basic information without it.
- Monitoring and reporting weaknesses:
  - Once LEPLs open commercial bank accounts, they do not present information to the ministry of finance about their revenues or expenditures.
  - Even when an LEPL has received a subsidy or transfer from the state budget, it is not required to report if or how those funds are spent.
  - Increasingly large portions of general government revenues and expenditures will no longer be reflected in the fiscal accounts as LEPLs grow.
- Deterioration of budget classification and transparency:
  - State budget transfers to LEPLs are recorded as lump sums and corresponding expenditures are not recorded, changing the reported composition of central government expenditures over time.
  - Wage and salary payments previously recorded by central government on behalf of budgetary organizations may now be reported as subsidies and transfers or expenditure on goods and services.
  - LEPLs that do not require transfers may have revenues and expenditures not recorded at all.
- Cash and macro-fiscal management risks:
  - The government may be unable to manage cash balances of LEPLs during macroeconomic shocks (examples: pandemic, surge in energy prices).
  - Cash balances could be held in several thousand commercial bank accounts, hindering the ministry of finance’s ability to assess net credit to government.
  - A change in fiscal stance could require cooperation from thousands of LEPLs and their financial managers.
- Quality of spending and arrears risk:
  - LEPL revenues and expenditures are not reported to the ministry of finance, resulting in little or no control over spending quality.
  - Line ministries may lack public financial management expertise to assess and audit LEPL information.
  - No consistent guidelines ensure timely, comprehensive, and consistent financial reporting across line ministries, increasing the risk of mismanagement and accumulation of arrears.
- LEPL debt and borrowing risk:
  - Georgia’s LEPL law requires ministry of finance authorization before LEPLs incur debt.
  - In practice, LEPLs and commercial banks can enter debt contracts without explicit authorization; commercial banks may view LEPLs as part of general government and lend assuming central government guarantee.
  - Guidelines should include explicit provisions on bank arrangements, including a prohibition on any commercial bank borrowing by LEPLs and clear reporting requirements to prevent arrears.
- Potential loss of revenue and vertical imbalance:
  - Revenue performance at the local government level deteriorated in 2005 and reliance on central government transfers increased between 2003 and 2005.
  - Granting LEPLs revenue-raising responsibility over non-tax revenues could incentivize better expenditure management, but lack of technical capacity could cause a significant drop in revenues collected and increase the vertical fiscal imbalance.
  - Figures referenced: Figure IV.2 (Georgia: Sources of local government revenue, 2003-05; In millions of lari) and Figure IV.3 (Georgia: Vertical fiscal imbalance, 2003-05; In percent of local government revenues).

### International experiences and lessons
- Armenia:
  - Conversion of thousands of public entities to noncommercial organizations (NCOs) without adequate monitoring/reporting provisions resulted in loss of ability to produce consolidated government accounts and undermined budget transparency.
- Bolivia and Argentina:
  - Weak fiscal monitoring and reporting and lack of incentives for local governments impaired macroeconomic coordination and control over subnational borrowing.
- Canada:
  - Market discipline alone was insufficient to mitigate provincial borrowing risks: provincial debt rose from 4.9 percent of GDP in 1980 to 22.7 percent of GDP in 1994.
- Colombia:
  - Sequencing of fiscal reforms and fiscal responsibility laws improved transparency and service delivery; fiscal rules reduced local debt and improved sustainability, though further coordination across levels remained needed.
- Russia and Czech Republic:
  - Devolution of revenue-raising responsibility in the mid-1990s led to significant growth in vertical fiscal imbalance.
- China:
  - Recentralization of most revenue in mid-1990s accompanied by transfer of expenditure mandates without commensurate funding led to reliance on extrabudgetary revenues, anecdotal evidence of arrears, and indirect borrowing at local level.

### Recommended next steps and policy measures
- Build on past public financial management progress, including treasury reform and the move toward a Treasury Single Account to increase fiscal transparency and enable proper cash management procedures.
- Create a comprehensive database of all registered legal entities of public law:
  - The database creation is underway and should be completed by end-March 2006.
  - Database should identify all organizations operating as LEPLs and verify legal requirements at establishment; include: name, legal status, governance framework, provisions for financial reporting, and procedures for accountability and internal control.
- Issue guidelines defining mechanisms of control for LEPLs:
  - Address conflicts of interest where state agencies both oversee and are represented on supervisory boards.
  - Define scope and implementation of audit by the chamber of control and assess chamber’s technical capacity.
  - Define required reporting information and recipients, targeted initially at nonmarket LEPLs classified in the database.
- Operationalize an effective monitoring framework:
  - First-best option: an adapted treasury regime integrating all central government nonmarket LEPLs while allowing financial autonomy without sacrificing fiscal transparency. Required actions include:
    - (i) forgo commitment controls on LEPL accounts with the treasury;
    - (ii) ensure decentralized control systems in the guidelines compensate for lack of commitment controls;
    - (iii) establish a treasury ledger account in lieu of a commercial bank account for each central government LEPL that is a nonmarket and nonprofit institution;
    - (iv) implement a zero ceiling on borrowing by LEPLs;
    - (v) provide regular planning and execution reports on financial performance of nonmarket nonprofit LEPLs within general government fiscal reporting;
    - (vi) ensure verification of consolidated execution reports of central government LEPLs by the treasury;
    - (vii) further enhance technical capacity at the treasury.
  - Second-best option (where treasury reforms are less successful): retain LEPL access to commercial bank accounts and require reporting of financial information and bank statements to line ministries, which relay to the ministry of finance — noting drawbacks:
    - Requires close, continuous cooperation between ministry of finance and other institutions.
    - Line ministries may have limited technical capacity to process information from hundreds or thousands of LEPLs.
    - Cooperation with the central bank is required to compile accurate information on government financing and to disaggregate commercial bank holdings of LEPLs in the monetary survey.

*Italicized source attribution: Excerpt from IMF staff report chapter on Georgian LEPL reform.*

### 105.     Careful thought should be given to the devolution of revenue raising

### Careful thought should be given to the devolution of revenue raising responsibility

### LEPL reform and revenue devolution
- Careful thought should be given to the devolution of revenue raising responsibility, given the fiscal risks outlined above.
- The authorities should carry out a realistic assessment of revenue raising capacity at the LEPL level, and devolve responsibility only for those revenue sources that can be more efficiently collected at the LEPL level.
- Other revenues should continue to be collected at the local and central government level.
- This paper highlights the Georgian strategy of LEPL reform and its strengths, as well as its fiscal implications and risks. The proposals presented focus on ways to mitigate the fiscal risks in a way that furthers the original objective and goals of the LEPL reform.

*Key fiscal observation*
- A realistic assessment of revenue-raising capacity at subnational (LEPL) level is required before devolving tax responsibilities.

*Immediate implication*
- Devolve only revenue sources that are more efficiently collected at the LEPL level; retain other revenues at local and central levels.

*Fiscal risk mitigation focus*
- Mitigate fiscal risks while preserving LEPL reform objectives and goals.

*Italic line for pagination context in original document*
- - 50 -

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### Is Georgia Competitive? (Chapter summary)

### Overview and main finding
- Georgia’s real exchange rate (RER) started to appreciate in early-2004, following years of steady weakening.
- Between January 2004 and April 2005, the real effective exchange rate (REER) appreciated by 17 percent.
- The RER was most likely undervalued in the past and has to move closer to equilibrium.
- Two recent competitiveness studies suggest that the productivity of Georgia’s economy has improved in 2004–05, cushioning the negative impact of the real appreciation on external competitiveness.
- U.S. dollar wages remain the lowest in the region.

### Drivers of appreciation and external pressures
- Foreign exchange inflows related to foreign direct investment and a repatriation of savings have contributed to financing a widening current account deficit.
- Foreign capital inflows are identified as the main source of the recent appreciation episode, and pressures on the RER are likely to persist for the foreseeable future.
- The outlook for external financial support of the reform process (both official and private in the form of transfers and direct investment) remains positive.
- Domestic spending pressures will not ease soon, and Georgian exports have started to lose ground in main trading partners’ import markets.

### Real exchange rate and competitiveness dynamics
- Bilateral real exchange rates (BRERs) with the U.S. dollar and with the Russian ruble have moved in opposite directions: the U.S. dollar BRER shows a clear appreciation since 2001, while the ruble BRER depreciated steadily between 1999–2003 before stabilizing in 2004.
- Despite the 2004–05 appreciation episode, Georgia’s REER has remained below its 2001 level.
- In the past decade, Georgia is the only CIS country in the region (except Russia) for which the REER has tended to appreciate—together with Bulgaria, Romania, and Turkey—after adjusting for actual trade weights.
- CPI-based REER movements may not fully reflect external competitiveness; additional cost-based indicators are useful.

### Selected cost-based indicators and wages (exact reported values)
- While remaining lowest, the average monthly U.S. dollar wage in Georgia rose relative to the wages in every country in the sample in 2004, after four years of falling.

Table V.1 excerpts (as reported in source)
- Georgia38 42444749  71
- Armenia35 39424658  80
- Azerbaijan 1/455056657991
- Bulgaria108105114124160186
- Romania95100105117147184
- Russia6480113141179237
- Ukraine43 42587187111

Wages in Georgia relative to wages in: (In percent) (as reported)
- Armenia1101071041038589
- Azerbaijan858579736278
- Bulgaria354039383138
- Romania40 42424033  39
- Russia59 52393327  30
- Ukraine88 99766756  64

- Sources: Georgian authorities; and Fund staff estimates.
- 1/ January-June for 2004.

### Transportation and trade costs
- 2005 transportation cost data indicate Georgia has a competitive disadvantage even compared to neighboring landlocked Armenia.
- Sea shipment today of a 40-foot container from Norfolk, U.S., to Tbilisi is almost 50 percent more expensive than to the Baltic capitals and, more surprisingly, 10 percent more expensive than to Yerevan. Both shipments to Tbilisi and Yerevan arrive at the same Georgian port (Poti).

### Export market shares and composition
- Georgia’s share in its main trading partners’ markets for imported goods has been falling in 2004–05.
- Export growth in non-oil producing neighboring countries (Armenia, Bulgaria, Romania, and Turkey) averaged 21 percent per year in 1999–2004.
- Excluding a one-time adjustment of export data in 2004, Georgia’s annual export growth averaged about 5 percentage points lower per year during the same period.
- Composition of exports, 2004 (as reported in source):
  - Scrap Metals: 13%
  - Aircrafts, other: 8%
  - Wine: 7%
  - Ferrous Metals: 5%
  - Sugar: 5%
  - Copper Ores and Concentrates: 4%
  - Fertilizers: 43%
  - Other: 15%
- One-third of total exports in 2004—scrap metal and aircraft repair services—cannot be sustained: scrap metal supply is limited; aircraft repair services (Turkmenistan client) are paid in kind for old energy-related debt expected to be paid off by 2008.

### Balance of payments and monetary indicators (Table V.2 — exact text reproduction)
- Table V.2. Georgia: Selected Balance of Payments and Monetary Indicators, 2002–05 (In millions of U.S. dollars, unless otherwise indicated)
- 2002200320042005
- Proj.
- Export growth (in percent) 1/17327410
- Terms of Trade (Index)96777275
- Transfers190269372425
- Official6656101148
- Private124213271277
- FDI122335503415
- Gross official reserves198191367474
- Foreign exchange/total deposits (in percent)...867472
- Source: Georgian authorities; and Fund staff estimates.
- 1/ Including a one time adjustment for extended data coverage in 2004.

### Medium-term inflows and fiscal stance
- These inflows are likely to continue in the medium term.
- Georgia will receive about $300 million from the Millennium Challenge Corporation in 2006–09.
- FDI is projected to exceed 10 percent of GDP over the next four years.
- Official disbursements could almost double given the strong international support for the authorities’ reform policies.
- Somewhat more expansionary fiscal policy contributed to higher domestic demand. Large privatization receipts financed a widening fiscal deficit that reached 2½ percent of GDP in 2005, compared to less than half a percentage point of GDP in 2004.

### Misalignment and productivity
- The RER in Georgia is believed to be significantly undervalued. Based on an international comparison of price levels, we estimate the RER in Georgia to be undervalued by about 35 percent, close to the size of the misalignment that prevailed in the mid-1990s.
- There is some evidence that the appreciation is partly driven by a fundamental improvement in productivity (the Balassa-Samuelson effect).
- According to the World Bank Doing Business in 2006 Report, Georgia was the top reformer in the CIS region in 2005 and the number 2 reformer globally.
- In particular, the authorities (i) made it easier to start a business, cutting the number of activities that require licensing from 909 to 159; (ii) made it less costly to fire redundant workers; (iii) cut the time and cost to register property; and (iv) introduced a new tax law with fewer and simplified taxes.
- The source notes Georgia ranks at 100 in the Doing Business Report.
- Georgia also scores lowest among the countries in the region in the Global Competitiveness Report 2005-2006 by the World Economic Forum (WEF).
- WEF regional rankings (as reported): Bulgaria (58), Kazakhstan (61), Turkey (66), Romania (67), Azerbaijan (69), Russia (75), Armenia (79), Ukraine (84), and Georgia (86).

### Policy recommendations (exact policy guidance and rationales)
- Allow the nominal exchange rate to adjust freely to external inflows.
  - It would be unwise to resist the nominal exchange rate appreciation associated with pressure on the RER from short-term sources.
  - If the nominal exchange rate is not allowed to appreciate, the real appreciation will occur in the form of higher inflation, which is more costly in the long term.
- Monetary policy should target low single-digit inflation.
  - Monetary policy should target low single-digit inflation; costs of inflation are higher and real appreciation cannot be avoided through exchange rate management.
- Implement prudent fiscal policy to contain domestic demand and limit the real appreciation of the exchange rate.
  - Appreciation of the RER can only be avoided through implementing prudent fiscal policy to contain domestic demand.
  - Earlier in 2005, inflation in Georgia rose gradually as a result of large fiscal spending and unsterilized intervention, exceeding 10 percent in May.
  - Government-targeted annual fiscal deficit of more than 3 percent of GDP and monetary policy mainly guided by efforts to stem upward pressures on the nominal exchange rate resulted in accelerated real appreciation.
- Design fiscal programs that are well-targeted on improving productivity (e.g., through infrastructure investments) to increase room for spending.
- Ensure productivity continues to improve through market-based reforms that reduce paperwork and red tape.
- Pursue transparency reforms to reduce the high cost of corruption.
- Simplify the administration of international trade; reduce administrative burdens of trading.
  - In Georgia, an entrepreneur has to submit 9 (15) documents and obtain 35 (42) signatures to export (import) goods.
  - It takes the same company 54 days on average before an export shipment can leave the country, compared to 31 days in the region and 12 days in OECD countries.
  - Customs paperwork and other red tape cause most delays for exporting and importing firms; less than a quarter of the delays are caused by poor ports or roads.
  - The new Customs Code is a welcome step to modernize customs administration.
- Continue anti-corruption efforts and transparency reforms.
  - Georgia ranks in the bottom quartile in the World Bank’s governance database for most governance indicators, including the control of corruption, the rule of law, the regulatory quality, and government effectiveness.
  - Georgia stands low in Transparency International’s 2005 Corruption Perceptions Index (at 130 out of 160 countries).
- Abolish import tariffs completely within two years to remove key obstacles to growth and reduce rent-seeking in customs administration.
  - The gradual government-proposed elimination of all tariffs by 2008 will reduce pressure on domestic prices and strengthen enterprise profitability.

*Italic source attribution line*  
*Source: Excerpted content from IMF document _cr06170 - 105. Careful thought should be given to the devolution of revenue raising responsibility_.*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2006/_cr06170.pdf_