## 1. Scaling Up Social Expenditures

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### Context and recent macro developments
- Political context:
  - First peaceful and democratic transfer of power in Georgia’s recent history occurred last October.
  - Increased political tensions between incoming Prime Minister Ivanishvili and President Saakashvili (who will leave office in October); some former government members charged with offences.
- Growth and structural drivers:
  - Economic growth averaged 6 percent from 2005-12.
  - Growth driven by private investment and domestic consumption; supply-side support from strong physical capital accumulation and total factor productivity (TFP) gains.
  - Broad-based growth in manufacturing, construction, transport, and financial services; agricultural output continued to decline.
- Labor, poverty, and social indicators:
  - Employment fell by 5 percent from 2003 to 2012; unemployment about 15 percent.
  - Half the labor force in small-scale agriculture, mostly underemployed.
  - Poverty: more than 30 percent of the population living below the US$2 poverty line in 2011; poverty increased slightly in recent years.
  - Inequality: Gini coefficient above 0.4 (2010).
- External and financial vulnerabilities:
  - Tourism receipts increased to 9 percent of GDP; remittances to 4½ percent of GDP.
  - Current account deficit around 11.5 percent of GDP from 2010 to 2012; trade deficit rose above 25 percent of GDP.
  - Financing shifted from mainly FDI to less stable sources including Eurobond issuance and increases in nonresident deposits (now 15 percent of total deposits).
  - Net external liabilities rose to close to 100 percent of GDP.
- Recent developments (growth, inflation, monetary, fiscal):
  - Growth slowdown: after ~7 percent growth from 2010 to H1 2012, growth levelled in Q3 2012; fell to 2.7 percent y/y (-2 percent q/q seas. adj.) in Q4 2012 and to 2.4 percent y/y (+0.2 percent q/q seas. adj.) in Q1 2013.
  - Inflation: rose to almost 15 percent in May 2011, then fell to minus 1.7 percent in April 2013; headline inflation below NBG’s 6 percent target.
  - Exchange rate: nominal effective exchange rate appreciated by 10 percent from end-2010 to end-2012; lari-dollar rate stable within ±1 percent band between July 2012 and mid-May 2013.
  - NBG policy rate cuts: from 8 percent in mid 2011 to 4.25 percent in May 2013 (text also notes 4 percent in June 2013).
  - Private credit growth declined from around 20 percent to 12–15 percent since October 2012.
  - NBG foreign currency purchases: US$335 million bought so far this year (text); purchases since July 2012 total USD 340 million and sales USD 65 million through April 2013 (Annex).
  - Fiscal: first-quarter revenues lower than projected by about GEL 100 million (0.4 percent of GDP), but government ran a GEL 200 million surplus; unexpected fiscal tightening contributed to slowdown.

### Government policy agenda and social expenditure reorientation
- Policy priorities:
  - Share growth benefits more widely through social protection, job creation, and agriculture.
  - Labor Code revisions passed in June expected to enhance workers’ rights, including job security.
  - Increased allocations in the 2013 budget for agriculture; establishment of an Agriculture Fund and plans to reorganize the Partnership Fund and create a private-equity Fund.
- Reorientation of spending:
  - Redirecting spending away from capital spending toward social expenditures.
  - Public investment averaged 8 percent of GDP over the past 5 years; total social expenditure historically low at 11 percent of GDP.
  - Government spending an additional GEL 800 million (3 percent of GDP) on an annualized basis to address private health care costs, low educational quality, and high poverty and inequality.
- Planned social reforms (high level):
  - Introduce a universal healthcare system.
  - Raise pensions.
  - Double TSA allowances.
  - Expand school vouchers.

### Box 1 — Detailed social reforms and fiscal impacts
- Healthcare reform:
  - Universal healthcare will cover around 2.5 million previously uninsured individuals and costs about 1 percent of GDP.
  - Since March 2013, emergency health care free for in-patient and out-patient services.
  - From July, previously uncovered individuals (about half Georgia’s population) will benefit from non-emergency services without contributions.
  - Social Service Agency to negotiate rates/procedures and reimburse providers; most medical services will have a substantial co-pay (to be decided); most drugs not covered under basic scheme.
  - From May 2014, Social Service Agency will cover individuals previously covered by state programs whose insurance was operated by private companies.
  - Reform plans estimated to add 1 percent of GDP per year to existing health costs, making health the largest reform area.
- Pensions:
  - Old-age pensions increased in two stages: to GEL 125 in April and to GEL 150 from September.
  - Cost of old-age pension increases around 0.8 percent of GDP.
  - Disability pensions rise to GEL 150 and GEL 100 depending on severity.
  - Pensions for victims of political repression rise to GEL 100.
  - Disability pensions and pensions for work related injuries introduced (0.2 percent of GDP).
  - Authorities working on a mandatory second pillar contribution scheme.
- Targeted Social Assistance (TSA):
  - TSA covers around 10 percent of the population by proxy means-testing.
  - Monthly allowances double: from July, first household member receives GEL 60 (US$37) and GEL 48 (US$29) for each additional member.
  - Cost of doubling TSA: 0.5 percent of annual GDP.
- Education:
  - Education spending increased slightly (0.2 percent of GDP) for vouchers and school renovation; teacher salaries increased in early 2013.
- Social expenditures, 2010–13 (In percent of GDP):
  - Education: 2010: 2.9; 2011: 2.7; 2012: 2.9; 2013 proj.: 2.9
  - Health: 2010: 2.2; 2011: 1.6; 2012: 1.6; 2013 proj.: 2.7
  - Social Protection: 2010: 6.9; 2011: 6.4; 2012: 6.6; 2013 proj.: 7.2
  - Pension (economic definition): 2010: 4.1; 2011: 4.0; 2012: 4.1; 2013 proj.: 4.2
  - Social assistance (economic definition): 2010: 1.2; 2011: 0.9; 2012: 1.0; 2013 proj.: 1.8
  - Total: 2010: 12.0; 2011: 10.7; 2012: 11.1; 2013 proj.: 12.8
- Aggregate fiscal impacts highlighted:
  - Health reforms add 1 percent of GDP per year.
  - Pension increases cost around 0.8 percent of GDP; disability/work-injury pensions add 0.2 percent of GDP.
  - Doubling TSA costs 0.5 percent of GDP.
  - Education increases by 0.2 percent of GDP.
  - Combined measures projected to raise total social expenditures to 12.8 percent of GDP in 2013.

### Structural reforms, energy, and investment funds
- Structural reform priorities for sustained growth:
  - Growth will need capital accumulation and TFP gains around 3–4 percent annually.
  - Key reforms: vocational training, reallocation from subsistence agriculture, enlarge market size and competitiveness, develop local capital markets and contributory pensions, strengthen property rights and independent judiciary, create competition agency.
- Energy sector and hydropower:
  - Hydro stations generate about 75 percent of annual output; summer surpluses exported, winter shortfalls met by gas-based thermal stations and imports.
  - Georgia became a net electricity importer in 2012 for first time in almost a decade.
  - Turkish wholesale prices more than 30 percent higher than in Georgia; Turkey’s market expected to grow about 7 percent annually.
  - Enguri plant supplies at less than 1 US$ cent per kWh; new hydro stations cost approximately 6 US$ cents per kWh.
  - Three proposed large hydropower projects estimated cost around 15 percent of GDP.
  - Tariffs cut for low-end consumers in January and again in April by about 25 percent; distributors allowed to purchase more of Enguri’s cheap electricity.
  - Policy recommendation: design government-backed power purchase agreements to ensure sufficient risk transfer to private sector; strengthen regulatory framework, transparent price-setting, and transmission access rules.
- Investment funds and agriculture:
  - Clarify objectives and align governance of investment funds with international best practice.
  - Partnership Fund to retain minority-financing mandate; independent adviser hired.
  - Agricultural Development Fund expected to disburse around 0.8 percent of GDP in 2013; Private Equity Fund planned size US$3 billion or 20 percent of GDP (mission noted lack of clarity on market failures being addressed).
  - Agriculture Fund distributed vouchers; reported doubling in area under cultivation; misuse of some vouchers and allegations of misspending noted.

### Monetary, financial sector, and supervision
- Monetary policy and transmission:
  - NBG improving monetary operations and inflation targeting framework; interbank, NBG CD, and Treasury rates more aligned with policy rate.
  - Support for measures to strengthen monetary transmission and de-dollarization, including floating-rate lari loans and development of corporate bond and stock markets.
  - Despite deflation, little benefit seen to lowering inflation target; relatively high headline target may be retained due to Balassa-Samuelson effects and transmission weaknesses.
  - NBG reiterated commitment to floating exchange rate; FX purchases help build reserves and resist overvaluation.
- Financial sector metrics and risks:
  - Capital adequacy ratio (NBG measure) as of April: 18 percent; liquidity ratio 41 percent (minimums 12 and 30 percent).
  - NPLs increased at end-2012; banking sector profitability stable so far in 2013 due to provisioning.
  - Dollarization around two-thirds of loans and deposits remains a main risk.
  - Nonresident deposits a significant funding source; increasing fraction withdrawable only at maturity.
- Supervisory measures and reforms:
  - New liquidity requirement for nonresident deposits from end-June 2013; adoption of liquidity coverage ratio by end-2013 with higher outflow rates for FX deposits; capital add-ons for FX lending risks in 2013 stress tests.
  - NBG completed self-assessment of banking supervision and transitioning to risk-based supervision; fine-tuning ICAAP process.
  - Concern over removal of insurance supervision from NBG and delays establishing new insurance supervisory body.
  - Staff supported developing local corporate bond and stock markets; pension reform noted as helpful for private savings.
  - Authorities requested an FSAP; staff hoped it could start in the coming year.

### Staff appraisal, short-term policy recommendations, and governance
- Recent performance summary:
  - Real GDP growth averaged 6½ percent in 2011–12.
  - Unemployment fell slightly from more than 16 percent in 2010 to 15 percent in 2012.
- Short-term policy stance recommended:
  - More expansionary fiscal and monetary policies recommended to support recovery.
  - Address causes of budget under-spending to ensure spending recovers later in the year; allow a higher budget deficit in near term if revenues are lower due to slowdown.
  - Further monetary loosening warranted, with measures to strengthen transmission: issue treasury bills and deposit proceeds long-term with commercial banks to encourage longer-term lari lending; ease collateral standards to support floating-rate lending.
- Governance and communication:
  - Greater clarity and improved communication of economic policies to reduce business uncertainty.
  - Clarify role and improve governance of investment funds and barriers they aim to overcome.
  - Adoption of Labor Code revisions expected to reduce investor uncertainty and help balance employer/employee interests.

### External sustainability and medium-term macro objectives
- Medium-term external targets and recommendations:
  - Aim to gradually lower current account deficit to around 6 percent of GDP in the medium term through continued fiscal consolidation, higher private saving (pension reform, deepening local financial markets), exchange rate adjustment, and structural reforms.
  - Continue reserve accumulation given exchange rate overvaluation and continue measures to reduce dollarization.
- Key risks:
  - Heightened domestic uncertainty, government underspending, difficult external environment, and high external indebtedness (net external liabilities close to 100 percent of GDP).

### Executive summary projections, key fiscal and macro figures
- Real GDP growth (percent): 2010: 6.3; 2011: 7.2; 2012: 6.1; 2013: 4.0; 2014: 6.6.
- Inflation, period average (percent): 2010: 7.1; 2011: 8.5; 2012: -0.9; 2013: -0.8; 2014: 4.5.
- Overall consolidated government balance (percent of GDP): 2010: -6.6; 2011: -3.6; 2012: -3.0; 2013 proj.: -2.8.
- Public debt (percent of GDP): 2010: 39.2; 2011: 33.8; 2012: 32.3; 2013: 31.8.
- Current account balance (percent of GDP): 2010: -10.2; 2011: -12.7; 2012: -11.5; 2013: -10.0; 2014: -9.1.
- Gross external debt (percent of GDP): 2010: 84.1; 2011: 77.8; 2012: 81.4; 2013: 77.8.
- Gross international reserves (US$ billions): 2010: 2.3; 2011: 2.8; 2012: 2.9; 2013: 2.6.
- Selected financial indicators:
  - Deposit dollarization (percent): 2010: 68.6; 2011: 63.3; 2012: 66.0; 2013: 64.8.
  - Private credit annual growth: 2010: 18.8; 2011: 24.3; 2012: 12.8; 2013 (end-of-period): 14.3.
  - Capital adequacy ratio (Basel I): 2012 Dec: 17.4; 2013 Mar: 17.7 (authorities report further increase to 26.4 percent).
  - Nonperforming loans (90-day overdue) rose from 3.7 percent to 4.5 percent (authorities’ statement).

*Source: _cr13264 - IMF staff report (June 24, 2013).*

### 1. Scaling Up Social Expenditures ________________________________________________________________ 14

### 1. Scaling Up Social Expenditures

### Context
- Last October’s elections saw the first peaceful and democratic transfer of power in Georgia’s recent history.
- The new government is committed to sustaining Georgia’s rapid growth and to strengthening the rule of law, transparency and social inclusion; substantial differences between incoming Prime Minister Ivanishvili and President Saakashvili (who will leave office in October) have increased political tensions, with some members of the former government charged with offences.
- Over the last ten years, Georgia’s economy has grown rapidly:
  - Economic growth averaged 6 percent from 2005-12.
  - Growth was driven by private investment and domestic consumption; supply-side support came from strong physical capital accumulation and total factor productivity (TFP) gains.
  - Growth was broad based, particularly strong in manufacturing, construction, transport, and financial services; agricultural output continued to decline.
- Policy evolution and government intervention:
  - Initial reforms (post-2004) emphasized libertarian/free market approaches: business environment improvements, corruption reduction, police reform, energy restoration, tax system overhaul.
  - Some features—very liberal labor code and limited safety net—left much of the population economically vulnerable.
  - Private investment collapsed following the financial crisis and the 2008 conflict with Russia; the government increased public infrastructure investment and in 2011 created a Partnership Fund to catalyze private investment through minority public co-financing.
- Distributional outcomes and social indicators:
  - From 2003 to 2012, employment fell by 5 percent; unemployment remains high at 15 percent.
  - Half the labor force is in small-scale agriculture, mostly underemployed.
  - Existing social safety net components: (i) public health insurance for means-tested eligible households, old-age pensioners, and infants; (ii) flat public pensions for all retirees; and (iii) targeted social assistance (TSA).
  - Persistent shortcomings: pensions remain below subsistence, half the population lacks health insurance, and there are no unemployment benefits.
  - Poverty: more than 30 percent of the population living below the US$2 poverty line in 2011; poverty increased slightly in recent years.
  - Inequality: Gini coefficient above 0.4 (2010).
  - Health and education outcomes are mixed; educational quality is relatively low compared with comparators.
- External and macro balance issues:
  - Despite tourism receipts increasing to 9 percent of GDP and remittances to 4½ percent of GDP, the current account deficit persisted at around 11.5 percent of GDP from 2010 to 2012.
  - Trade deficit rose above 25 percent of GDP.
  - Financing composition shifted from mainly FDI to less stable sources including Eurobond issuance and increases in nonresident deposits (now 15 percent of total deposits).
  - Net external liabilities have risen to close to 100 percent of GDP.
- Implementation of prior recommendations:
  - Most 2011 Article IV consultation recommendations were implemented: fiscal consolidation continued; public investment streamlined to create fiscal space for social expenditures; 2011 Economic Liberty Act diluted constitutional referendum requirement for new taxes; the NBG improved inflation forecasting/modeling and adopted measures to contain nonresident deposits; NBG purchased foreign currency to respond to capital inflows.

### Recent Developments
- Growth slowdown:
  - After ~7 percent growth from 2010 to H1 2012, growth levelled in Q3 2012.
  - Growth fell to 2.7 percent y/y (-2 percent q/q seas. adj.) in Q4 2012 and to 2.4 percent y/y (+0.2 percent q/q seas. adj.) in Q1 2013.
  - Demand-side causes: weaker private investment (likely due to increased business uncertainty) and lower government spending.
- Inflation and exchange rate dynamics:
  - Headline inflation has fallen well below the NBG’s 6 percent medium-term target; inflation volatility remains high.
  - Inflation rose to almost 15 percent in May 2011 (higher food prices), then fell to minus 1.7 percent in April 2013.
  - Nominal effective exchange rate appreciated by 10 percent from end-2010 to end-2012; lari-dollar rate increasingly stable since March 2011, remaining within a ±1 percent band between July 2012 and mid-May 2013.
  - Drivers of the sharp decrease in inflation since May 2011: lower food prices, lagged effects of exchange rate appreciation, cuts in administered energy prices, and subdued domestic demand.
- Monetary policy and credit:
  - NBG policy rate cuts: from 8 percent in mid 2011 to 4.25 percent in May 2013.
  - Commercial bank lari deposit rates fell broadly in line, except end-2012 when some small banks increased rates.
  - Lending rates have barely dropped; private credit growth declined from around 20 percent to 12–15 percent since October 2012.
  - Weak monetary transmission and lower credit demand; banks cautious in lending due to slowdown.
  - NBG foreign currency purchases: US$335 million bought so far this year, helping resist appreciation pressures and lowering deflation risk.
- Fiscal developments:
  - Unexpected fiscal tightening contributed to the slowdown.
  - First-quarter revenues were lower than projected by about GEL 100 million (0.4 percent of GDP), but the government ran a GEL 200 million surplus.
  - Authorities characterized tightening as unintentional, reflecting procedural delays from stricter procurement, financial difficulties in construction businesses, and savings from centralized purchases.

### Policy Agenda and Social Expenditure Scaling
- Government priorities: share growth benefits more widely, focusing on social protection, job creation, and agriculture.
- Labor and agriculture measures:
  - Labor Code revisions passed in June expected to enhance workers’ rights, including job security.
  - Increased allocations in the 2013 budget for agriculture and establishment of an Agriculture Fund (privately funded, from a foundation owned by the Prime Minister).
  - Plans to reorganize the Partnership Fund and create a private-equity Fund to stimulate private investment.
- Reorientation of spending:
  - The government is redirecting spending away from capital spending toward social expenditures.
  - Historical context: public investment averaged 8 percent of GDP over the past 5 years (one of the highest in the region); total social expenditure (pensions, health, and education) has been among the lowest at 11 percent of GDP.
  - The government is spending an additional GEL 800 million (3 percent of GDP) on an annualized basis to address high private health care costs, low educational quality, and high rates of poverty and inequality.
- Planned social reforms:
  - Introduce a universal healthcare system.
  - Raise pensions.
  - Double TSA allowances.
  - Expand school vouchers (Box 1 referenced).
- Fiscal consolidation commitment:
  - Authorities remain committed to fiscal consolidation and to meeting the 30 percent limit on spending introduced by the Economic Liberty Act from 2014 onward.
  - Capital spending was reduced to meet these objectives but would remain above 6 percent of GDP, broadly in line with comparator countries.

*Source: _cr13264 - 1. Scaling Up Social Expenditures (IMF country report content).*

### Box 1. Georgia: Scaling Up Social Expenditures

### Box 1. Georgia: Scaling Up Social Expenditures

### Healthcare reform: universal coverage and cost implications
- The newly established universal healthcare system will cover around 2.5 million previously uninsured individuals and costs about 1 percent of GDP.
- Since March 2013, emergency health care has been made free of charge for in-patient and out-patient services.
- From July onwards, individuals previously not covered by state insurance programs (about half Georgia’s population, including children above the age of 6 and adults) will benefit from non-emergency services without having to contribute to the scheme.
- A newly created Social Service Agency will negotiate rates and procedures and reimburse medical providers, which patients can choose freely.
- Most medical services will have a substantial co-pay (still to be decided), which could leave a market for existing private insurance companies.
- Under the basic scheme, most drugs will not be covered, but could be added in the future, together with additional medical procedures.
- From May 2014 onwards, the Social Service Agency will cover individuals previously covered by state programs (socially vulnerable, pensioners, children below 6) whose insurance was operated by private companies.
- While substantial savings are expected from centralized purchases and negotiations, the reform plans are estimated to add 1 percent of GDP per year to existing health costs, making health the largest reform area.

### Pensions: increases and new benefits
- Old-age pensions (a flat basic allowance that includes a GEL 15 health insurance premium) are being increased in two stages: to GEL 125 in April and then to GEL 150 from September.
- The cost of the old-age pension increases is around 0.8 percent of GDP.
- Disability pensions rise to GEL 150 and GEL 100 depending on the severity of the disability.
- Pensions for victims of political repression rise to GEL 100.
- Disability pensions and pensions for work related injuries are introduced (0.2 percent of GDP).
- The authorities are working on a mandatory second pillar contribution scheme.

### Targeted social assistance (TSA)
- Georgia’s TSA currently covers around 10 percent of the population, identified by proxy means-testing.
- Monthly allowances will double: starting in July, the first household member will receive GEL 60 (US$37) and GEL 48 (US$29) for each additional household member.
- This will cost 0.5 percent of annual GDP.

### Education spending
- Education spending is being increased slightly (0.2 percent of GDP), mainly for vouchers used by public schools to finance their expenses, and for renovation of public school buildings scheduled for July/August.
- In addition, teacher salaries were increased in early 2013.

### Social expenditures, 2010–13 (In percent of GDP)
- Education: 2010: 2.9; 2011: 2.7; 2012: 2.9; 2013 proj.: 2.9
- Health: 2010: 2.2; 2011: 1.6; 2012: 1.6; 2013 proj.: 2.7
- Social Protection: 2010: 6.9; 2011: 6.4; 2012: 6.6; 2013 proj.: 7.2
- Pension (economic definition): 2010: 4.1; 2011: 4.0; 2012: 4.1; 2013 proj.: 4.2
- Social assistance (economic definition): 2010: 1.2; 2011: 0.9; 2012: 1.0; 2013 proj.: 1.8
- Total: 2010: 12.0; 2011: 10.7; 2012: 11.1; 2013 proj.: 12.8

### Key policy considerations and projected fiscal impacts
- Health reforms are the largest single reform area and are estimated to add 1 percent of GDP per year to existing health costs.
- Pension increases cost around 0.8 percent of GDP; disability and work-related injury pensions add 0.2 percent of GDP.
- Doubling TSA allowances will cost 0.5 percent of annual GDP.
- Education spending increases by 0.2 percent of GDP.
- The combined measures contribute to rising social expenditures, with the total projected to reach 12.8 percent of GDP in 2013.

*Source: IMF staff summary of Box 1. Georgia: Scaling Up Social Expenditures.*

### 25.      The authorities agreed on the importance of structural reforms if Georgia is to sustain

### _cr13264 - 25.      The authorities agreed on the importance of structural reforms if Georgia is to sustain

### Structural reforms to sustain growth
- Growth will need to rely on capital accumulation and especially TFP gains (around 3–4 percent annually).
- Key structural reforms identified:
  - Vocational training to reduce skill mismatches; reallocation from subsistence agriculture to higher productivity sectors and increased agricultural productivity could generate large TFP increases.
  - Enlarging market size by increasing competitiveness of Georgian products and improving access to foreign markets, including through free trade agreements.
  - Encouraging private savings by developing local capital markets, creating contributory pension systems and ensuring macro-economic stability.
  - Strengthening property rights through an independent judiciary that fairly enforces the rule of law, and creation of a competition agency to combat domestic monopolies.

### Energy sector and hydropower (Box 3)
- Strategic objectives and concerns:
  - Establish transparent and fair “rules of the game” for the energy sector to attract investment and harness hydropower potential.
  - Questioned recent electricity tariff reductions (negotiated directly with distributors) as they could lower distribution company profitability and undermine future investment unless side-benefits exist.
  - Encouraged publishing contracts to assuage concerns, subject to companies’ consent.
  - Encouraged economics ministries (with World Bank) to develop an energy policy strategy to strengthen the regulatory framework, price-setting, and transmission line access rules.
- Hydropower importance and dynamics:
  - Hydro stations generate about 75 percent of annual output; summer surpluses are exported to Russia or Turkey while winter shortfalls are covered by gas-based thermal stations and imports.
  - Georgia became a net electricity importer in 2012 for the first time in almost a decade due to rising domestic consumption and falling hydro generation.
  - Higher-cost gas-based generation increased while hydro generation fell, contributing to a worsening current account deficit.
- Export opportunities and costs:
  - Turkish wholesale prices are more than 30 percent higher than in Georgia and Turkey’s market is expected to grow about 7 percent annually.
  - A soon-to-be-launched high-capacity transmission line to Turkey could boost exports.
  - Average generation costs: Enguri plant supplies at less than 1 US$ cent per kWh; new hydro stations would cost approximately 6 US$ cents per kWh.
  - Three proposed large hydropower projects have an estimated cost of around 15 percent of GDP.
- Tariff changes and investor implications:
  - Tariffs were cut for low-end consumers in January and again in April, by about 25 percent.
  - To help distributors offset costs they were allowed to purchase more of Enguri’s cheap electricity.
  - The tariff cuts went against the inevitable upward trend in average generation cost and could undermine trust in the regulatory framework and discourage investment.
- Policy recommendation:
  - Design government-backed power purchase agreements to ensure sufficient risk transfer to the private sector and contain public sector risks; strengthen regulatory framework and transparent price-setting and transmission access rules to encourage hydropower investment and limit the need for government guarantees.

### Investment funds and agriculture
- Investment funds governance and objectives:
  - Urged government to clarify objectives of various investment funds and align governance with international best practice.
  - Partnership Fund will retain mandate of using minority financing to catalyze commercially viable projects; an independent adviser has been hired to improve governance.
  - Agricultural Development Fund expected to disburse around 0.8 percent of GDP in 2013; Private Equity Fund planned size US$3 billion or 20 percent of GDP. Mission noted lack of clarity on market imperfections being addressed.
  - Encouraged careful governance design to avoid preferential treatment and appearances of conflicts of interest.
- Agriculture policies and outcomes:
  - Government improving irrigation infrastructure and completing land registry; Agriculture Fund distributed vouchers for seed and fertilizer purchases.
  - Result reported: doubling in the area of land under cultivation.
  - Agriculture Fund, with commercial banks, developed interest-subsidy lending schemes for farmers and agro-processing investment.
  - Noted misuse of some vouchers and allegations of misspending that led to the Agriculture Minister’s resignation.

### Social policies and inclusiveness
- Fiscal cost and priorities:
  - New government plans on social reforms are a large part of the 2013 budget: an extra 3 percent of GDP.
  - Universal healthcare system planned: extra 1 percent of GDP cost in the 2013 budget.
- Healthcare reform observations:
  - Government health spending as a share of GDP is low, but total health spending is quite high.
  - Reform could reduce very high private health costs and improve outcomes, but would still leave sizeable co-payments for drugs and an unclear role for private insurers.
  - Authorities expect Social Service Agency to achieve major cost savings through centralized procedures and better control of medical services.
- Education and vocational training:
  - Plans to improve educational quality and vocational training to address skills mismatches, promote tertiary education in mathematics and finance new science faculties.
  - Pre-school made free, but enrollment poor due to low quality and bad infrastructure.
  - Teacher salary increases: GEL 60–205 per month (depending on performance) to an average of GEL 413 (US$250) per month, according to the World Bank.
- Distributional concerns and recommendations:
  - 80 percent of the new spending is on universal transfers and may have limited effects on inequality.
  - New health insurance likely to benefit the (lower) middle classes most, as socially vulnerable households are already covered.
  - Pension increases are completely universal given the flat benefit and no contribution scheme.
  - Mission and World Bank would have recommended broadening coverage rather than doubling the monthly TSA allowance; 30 percent of the population still lives below the US$2 poverty line.
  - To lower inequality, mission suggested complementing measures with revenue reforms—e.g., making personal income tax more progressive.

### Monetary and financial sector reform
- Monetary policy framework and NBG initiatives:
  - NBG improving monetary operations and inflation targeting framework; interbank, NBG CD, and Treasury rates more closely aligned with policy rate over last two years.
  - NBG improving forecasting, upgrading inflation report and press conferences; mission recommended events follow a pre-announced schedule and emphasized preserving NBG independence.
- Refinements discussed:
  - Support for initiatives to strengthen monetary policy transmission and encourage de-dollarization, including introduction of floating-rate lari loans and goals to develop corporate bond and stock markets.
  - Despite price deflation, both sides agreed little benefit to lowering the inflation target; a relatively high headline inflation target may need to be retained due to Balassa-Samuelson effects and transmission weaknesses.
  - NBG reiterated commitment to a floating exchange rate; recent FX purchases help build reserves, resist overvaluation pressures, and avoid further deflation.
- Financial sector metrics and risks:
  - As of April, capital adequacy ratio (NBG measure) was 18 percent and liquidity ratio 41 percent, above minimum requirements of 12 and 30 percent respectively.
  - NPLs increased at end-2012; banking sector profitability stable so far in 2013 due to provisioning.
  - Dollarization at around two-thirds of loans and deposits remains a main risk.
  - Nonresident deposits are a significant funding source; increasing fraction withdrawable only at maturity.
  - New supervisory measures: end-June 2013 new liquidity requirement for nonresident deposits; adoption of liquidity coverage ratio by end-2013 with assumed higher outflow rates for FX deposits; capital add-ons for FX lending risks in 2013 stress tests.
  - Staff supported developing local corporate bond and stock markets and noted pension reform would be helpful to encourage private savings.
- Supervision and institutional issues:
  - NBG completed a self-assessment of banking supervision framework and is transitioning to risk-based supervision; fine tuning ICAAP submission and review process.
  - Mission expressed concern over removal of insurance supervision from NBG and delays in establishing a new insurance supervisory body.
  - Emphasized importance of maintaining competitive salaries to preserve quality of NBG supervision.
  - Authorities requested an FSAP; staff hoped it could start in the coming year.

### Staff appraisal and policy recommendations
- Recent performance and challenges:
  - Real GDP growth averaged 6½ percent in 2011–12.
  - Unemployment fell slightly from more than 16 percent in 2010 to 15 percent in 2012.
  - Inflation has fallen steadily; exchange rate kept stable against US dollar; Georgia experienced a marked slowdown due to political and policy uncertainty, government under-spending after elections, and weak global conditions.
- Risks from delayed recognition and policy response:
  - Reluctance to recognize that growth in 2013 may be lower than expected delayed appropriate policy response; earlier acknowledgement and policy action would enhance credibility and support growth.
- Short-term policy stance:
  - More expansionary fiscal and monetary policies recommended to support recovery.
  - Government should address causes of budget under-spending to ensure spending recovers later in the year.
  - Given fall in inflation and current account deficit, scope for allowing a higher budget deficit in near term if revenues are lower due to slowdown.
  - Further monetary loosening warranted, accompanied by measures to strengthen transmission mechanism, including issuing treasury bills and depositing proceeds long-term with commercial banks to encourage longer-term lari lending.
- Governance and communication:
  - Greater clarity and improved communication of economic policies can reduce business uncertainty.
  - Government should clarify role and improve governance of different investment funds and the barriers to investment they are designed to overcome.
  - Adoption of Labor Code revisions removes a key source of investor uncertainty and should help strike balance between employer and employee interests to improve welfare and productivity.

*International Monetary Fund staff report content.*

### 44.      Greater cooperation between the government and the central bank is also essential for

### Greater cooperation between the government and the central bank is also essential for recovery

### Central bank–government cooperation and transparency
- The NBG’s moves towards greater transparency are welcome, specifically:
  - improving the inflation report; and
  - launching regular meetings to explain inflation developments and reasons behind interest rate decisions.
- Further cooperation between the NBG and the Ministry of Finance is recommended, provided central bank independence is preserved, to:
  - make it easier to discuss the slowdown; and
  - devise a coordinated monetary and fiscal policy response for recovery.

### External sustainability and macroeconomic challenges
- Over the medium term, Georgia’s main macroeconomic challenge is to gradually reduce its current account deficit and foreign indebtedness.
- The recent decline in the current account appears largely cyclical.
- Policy recommendations to ensure external sustainability and strengthen resilience to external shocks:
  - aim to gradually lower the current account deficit to around 6 percent of GDP in the medium term through:
    - continued fiscal consolidation;
    - higher private saving (through pension reform and deepening of local financial markets);
    - exchange rate adjustment; and
    - structural reforms to improve competitiveness;
  - continue reserve accumulation given the exchange rate overvaluation; and
  - continue measures to reduce dollarization through regulatory measures and, more permanently, by improving Georgia’s economic and political fundamentals.

### Social spending, inclusiveness, and health policy
- The government’s agenda of more inclusive growth is welcome, but increased social expenditures might have been better targeted.
- Substantial increases in social and agricultural spending should help address relatively high poverty, inequality, and unemployment.
- Concerns and recommendations:
  - rapid introduction of a universal healthcare system may run into implementation delays and does not seem to address high drug costs, a main cause of risk and impoverishment;
  - in line with World Bank recommendations, coverage of targeted social assistance might have been broadened.

### Structural reforms and the energy sector
- The authorities’ commitment to tackle structural impediments to growth is welcome.
- Areas for policy focus:
  - address skill mismatches;
  - open up foreign markets to Georgian products and improve their competitiveness;
  - strengthen property rights and the rule of law; and
  - promote competition, building on past improvements in the business environment and fighting low-level corruption.
- In the energy sector, the government should aim to establish transparent and fair rules monitored by an independent regulator to lessen the need to provide investors with guarantees.

*Source: IMF staff report content unit paragraphs 44–47.*

### 48.       The staff recommends that the next Article IV consultation be held in accordance with the

### _cr13264 - 48.       The staff recommends that the next Article IV consultation be held in accordance with the

### Executive summary and macro outlook
- Staff projects real GDP growth: 2013: 4.0; 2014: 6.6 (from Table 1 and summary text).
- Inflation projections (period average): 2013: -0.8; 2014: 4.5.
- Growth outlook in text: growth could reach 4 percent in 2013, rising to around 6 percent in 2014 and beyond, conditional on strong policy action.
- Key risks: heightened domestic uncertainty, government underspending, difficult external environment, and high external indebtedness (net external liabilities close to 100 percent of GDP).

### Fiscal policy: findings and recommendations
- Recent performance:
  - Overall consolidated government balance: 2010: -6.6; 2011: -3.6; 2012: -3.0 (percent of GDP).
  - 2013 budget aims: deficit of -2.8 percent of GDP (Table 1 / summary).
  - Public debt: 2012: 32.3; 2013: 31.8 (percent of GDP). Foreign-currency denominated: 2012: 27.6; 2013: 26.8 (percent of GDP).
- Policy recommendations (text):
  - Allow a higher budget deficit if revenues are undercut by slowdown; address causes of recent budget underspending.
  - Continue fiscal consolidation to bolster external stability and reduce the current account deficit in relation to GDP.
  - Reprioritize spending toward social programs while maintaining critical capital spending; authorities commit to reducing fiscal deficit to 1.5 percent of GDP by 2017.
  - Specific measures in authorities’ program: introduce Universal Health Care, double targeted social assistance allowances, increase education investment, maintain capital spending above 6 percent of GDP.

### Monetary and exchange rate policy
- Recent policy actions:
  - NBG policy rate cuts: from 8 percent in mid-2011 to 4 percent in June 2013 (text). Table 1 shows policy rate end-of-period 2010: 7.5; 2011: 6.8; 2012: 5.3.
  - NBG foreign exchange interventions: purchases of USD 335 million so far this year (text); purchase auctions since July 2012 total purchases of USD 340 million and sales of USD 65 million through April 2013 (Annex text).
  - As of end-April 2013 de facto exchange rate arrangement reclassified to a stabilized arrangement against the U.S. dollar (effective July 1, 2012).
- Recommendations (text):
  - Further monetary easing is generally appropriate in the near term.
  - Strengthen monetary policy transmission (room to lower lending rates and encourage longer-term and floating-rate lari lending).
  - Measures to strengthen transmission: consider depositing long-term proceeds from new treasury bills with commercial banks; ease collateral standards to support floating-rate lending.
  - Continue FX purchases to rebuild reserves and resist appreciation pressures while preserving central bank independence.

### External sector and external vulnerabilities
- Key levels and projections:
  - Current account balance (in billions of US$): 2010: -1.2; 2011: -1.8; 2012: -1.8; 2013: -1.5; 2014: -1.3 (Table 2).
  - Current account balance (percent of GDP): 2010: -10.2; 2011: -12.7; 2012: -11.5; 2013: -10.0; 2014: -9.1; 2015: -7.7 (Table 2 and concluded).
  - Trade balance (percent of GDP): 2012: -26.6; 2013: -24.7; 2014: -24.8; 2018 projection: -20.5 (Table 2).
  - Gross external debt (percent of GDP): 2012: 81.4; 2013: 77.8; 2014: 81.4; 2018 projection: 67.8 (Table 2 & Table 8).
  - Gross international reserves (in billions of US$): 2010: 2.3; 2011: 2.8; 2012: 2.9; 2013: 2.6; 2014: 2.8; 2015: 2.7 (Table 1 / Table 2).
- Findings:
  - Current account deficits persist around double-digit percent of GDP, reflecting low national saving relative to investment needs.
  - Financing shifted from FDI toward less stable sources (Eurobond issuance, increases in nonresident deposits—now 15 percent of total deposits).
  - Net external liabilities near 100 percent of GDP (text).
- Policy recommendations:
  - Bolster external stability by reducing current account deficit through continued fiscal consolidation, higher private saving, exchange rate adjustment, and structural reforms to improve competitiveness.

### Financial sector: soundness and policy measures
- Indicators and findings:
  - Deposit dollarization: 2010: 68.6; 2011: 63.3; 2012: 66.0; 2013: 64.8 (percent, Table 1 and Table 6).
  - Private credit annual growth: 2010: 18.8; 2011: 24.3; 2012: 12.8; 2013 (end-of-period): 14.3 (Table 1 / Monetary Survey).
  - Capital adequacy ratio (Basel I): 2012 Dec: 17.4; 2013 Mar: 17.7 (Table 6). Authorities report capital adequacy ratio further increased to 26.4 percent (authorities’ statement).
  - Nonperforming loans (90-day overdue) rose from 3.7 percent to 4.5 percent (authorities’ statement).
- Recommendations and measures:
  - Discourage foreign-currency lending and nonresident FX deposits through tightened prudential measures.
  - New supervisory measures: tightened liquidity requirement for nonresident deposits; higher outflow rates for FX deposits in liquidity coverage; capital add-ons for FX lending risks.
  - Develop long-term lari lending and floating-rate lari lending to improve transmission and de-dollarization (NBG measures and joint steps with Ministry of Finance).
  - Authorities requested an FSAP participation.

### Structural reforms and growth-enhancing measures
- Policy priorities (authorities and Directors):
  - Improve external competitiveness via structural reforms: labor market, education and vocational training, property rights, rule of law, and trade (including deep and comprehensive free trade agreement with the EU).
  - Promote inclusive growth: strengthen social programs, Universal Health Care implementation, increased social assistance, and agricultural modernization via an Agriculture Fund.
  - Develop local currency capital markets and reduce dollarization (support from IFIs and EBRD measures).
  - Energy sector: upgrade regulatory framework to attract investment in hydropower and regional trading; support renewable energy and energy efficiency.
  - Improve business environment: legal transition assistance on secured transactions, insolvency, concession laws, corporate governance, judiciary reforms.

### Key statistics and projections (selected, as presented)
- Real GDP growth (percent): 2010: 6.3; 2011: 7.2; 2012: 6.1; 2013: 4.0; 2014: 6.6.
- Nominal GDP (billion U.S. dollars): 2010: 11.6; 2011: 14.4; 2012: 15.8; 2013: 17.0; 2014: 16.3; 2014 projection elsewhere: 17.3 (Table 1 and summary table).
- Inflation, period average (percent): 2010: 7.1; 2011: 8.5; 2012: -0.9; 2013: -0.8; 2014: 4.5.
- Overall consolidated government balance (percent of GDP): 2010: -6.6; 2011: -3.6; 2012: -3.0; 2013 (projection): -2.8.
- Public debt (percent of GDP): 2010: 39.2; 2011: 33.8; 2012: 32.3; 2013: 31.8.
- Current account balance (percent of GDP): 2010: -10.2; 2011: -12.7; 2012: -11.5; 2013: -10.0; 2014: -9.1.
- Gross external debt (percent of GDP): 2010: 84.1; 2011: 77.8; 2012: 81.4; 2013: 77.8.
- Gross international reserves (US$ billions): 2010: 2.3; 2011: 2.8; 2012: 2.9; 2013: 2.6.

*Prepared by Middle East and Central Asia Department (June 24, 2013).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2013/_cr13264.pdf_