Worker helps renovate old car factory: foreign direct investment in Georgia has picked up in the course of 2009 (photo: AFP Photo/Vano Shlamov)
GLOBAL ECONOMIC CRISIS
Until mid-2008, the Georgian economy was growing rapidly, fueled by high levels of foreign direct investment and strong credit growth. But in August of that year, the armed conflict with Russia over the disputed region of South Ossetia proved a devastating setback for Georgia’s economy, prompting the authorities to request a $750 million Stand-By Arrangement (SBA) from the IMF and to secure emergency financing from donors.
In the months that followed, Georgia’s difficulties were compounded by the impact of the global economic crisis. In August 2009, nearly a year after the original IMF-supported program was agreed, Georgia received a $420 million increase in IMF financing and an extension of the program to June 2011.
In an interview on the occasion of the program’s fourth review, Gardner discusses Georgia’s progress to date.
IMF Survey online: Could you describe Georgia’s economy today?
Gardner: The economy is slowly turning the corner. The immediate objectives of the IMF-supported program were to restore confidence and stabilize the financial situation, and I think these objectives have been met. We see that in the steady growth of deposits since mid-2009—deposits that had shrunk quite sizably right after the war and then again in early 2009. And we see it in the narrowing of Eurobond spreads, which have come down by about 1500 basis points since the end of 2008 and are now back to the level they were at the time of issue in April 2008. We also see that foreign direct investment is still coming in—about $500 million in the first three quarters of 2009—and this is a particularly encouraging sign.
Are these signs of improvement in confidence translating into higher economic activity? We have some indications that the economy started recovering around mid-2009, such as renewed growth in imports, stabilization of exports, and growth in the turnover of enterprises, as measured by value-added tax declarations.
IMF Survey online: Since the slowdown started much earlier in Georgia than in the rest of the region, can it be expected to emerge from the crisis earlier?
Gardner: If the war alone had been the cause for the slowdown, I would probably say yes. But the global financial crisis dealt Georgia a second blow. As a result, Georgia is now at a similar point in the cycle as other emerging market countries in the region. Its economy is being weighed down by a common set of factors—the drying up of private capital inflows, lower remittances, and slow growth in export markets. Export markets contracted by 15 percent in 2009, and are projected to grow by just over 3 percent in 2010. On the positive side, the policies adopted by the authorities have put the country in a good position to take advantage of the world recovery when it does take place.
IMF Survey online: Are there vulnerabilities in Georgia’s banking system that could pose a risk?
Gardner: The banking sector is emerging from the crisis in a relatively solid position. It was buffeted by a sudden confidence shock as a result of the war, and again in early 2009, as a result of domestic political instability. Cumulatively, from peak to trough, deposits fell by nearly 30 percent (adjusting for valuation effects due to the devaluation of the local currency in November 2008).
Fortunately, the banking sector entered this rough period with very large capital buffers. That advantage—plus large injections of capital and liquidity by the International Finance Corporation and the European Bank for Reconstruction and Development as well as emergency liquidity provided by the central bank after the conflict—enabled the banking sector to weather both the liquidity shock and the large deterioration in the quality of the loan portfolio. Right now, the balance sheets are improving steadily. We see liquidity ratios back to much more comfortable levels, capitalization ratios are still high, and provisioning against bad loans has increased sizably.
That said, there are risks. The most significant one for Georgian banks remains their indirect foreign currency exposure. Most loans are denominated in dollars, but most borrowers, whether households or enterprises, have incomes in local currency. If the exchange rate were to depreciate substantially, this imbalance would create considerable financial stress for these borrowers.
IMF Survey online: What are the elements of Georgia’s fiscal stimulus?
Gardner: Part of the response to the crisis was to make up for plummeting private demand by increasing public spending—a key element in putting a floor on the contraction of economic activity in Georgia. This was made possible by allowing the public deficit to increase quite sizably, from about 4½ to 9½ percent of GDP between 2007 and 2009. Much of this increase is attributable to lost tax revenues but also to a reduction in the income tax rate in 2009 and higher spending, which increased by about 20 percent.
But equally important, the structure of spending also changed radically, with a large reallocation of government spending to areas that had a bigger impact on economic activity. For instance, defense spending, much of it falling on imports, was reduced by 3½ percentage points of GDP, freeing resources for an equivalent increase in social spending. When we estimated the fiscal impulse that derived from the combined effects of the larger deficits and the changed structure of spending, by excluding for instance government spending falling on imports, we found that the fiscal stimulus amounted to about 5½ percentage points of GDP in 2008, and an additional 3½ percentage points in 2009. Cumulatively, this is almost twice the size of the increase in the deficit.
IMF Survey online: So the fiscal stimulus has worked?
Gardner: Yes—but as always, there are two sides to the coin. Increased spending and lower taxes have an immediate demand impact. But this could be undermined if the resulting deficits create a perception among potential investors that public debt is rising to unsustainable levels. The good news, in the case of Georgia, is that the government started out with very low levels of debt, which meant that it could afford to use fiscal policy very actively as a countercyclical policy tool. Having done so, however, the authorities now consider that they have pretty much used up all the room available to them in terms of fiscal policy loosening. For these reasons, the program going forward targets a considerable and steady fiscal consolidation starting with a deficit reduction of 2 ½ percent of GDP in 2010. Is this withdrawal of fiscal stimulus premature? We think not, in view of the risks posed by further debt accumulation and the credibility cost of delaying adjustment.
IMF Survey online: Georgia was one of the region’s strongest performers from 2004-2008, registering growth as high as 12 percent in 2007. What will it take to get back to that level?
Gardner: The 12 percent growth rate of 2007 is probably not the right target to be thinking about. The economy was overheating in 2007, and this high growth was made possible, in part, by a 70 percent increase in bank credit, which was obviously not sustainable. Looking ahead, the conditions are in place for the economy to return to high and steady growth over the medium term—presently we are banking on a steady state growth rate of around 5 percent, but there is clearly an upward potential to that rate. Along the way, the economy may even rebound at a faster pace, but global conditions are such today that this is unlikely to be the case in 2010.
IMF Survey online: Georgia is a highly dollarized economy. What complications does this present for the country’s recovery?
Gardner: Georgia is not alone in this situation. The main complication has been that the authorities were pretty much powerless to deal with the dollar liquidity shock they faced. As deposits were being drawn down, including those in dollars, the central bank was not in a position to act as a lender of last resort in foreign currency. That, in turn, forced the banks to try to retain the deposits by keeping interest rates high in dollar terms. Interest rates on dollar deposits were until very recently in the neighborhood of 10 percent, and lending rates are easily 15-20 percent. Given the decline in inflation, the implied real interest rates are very high and have undoubtedly played a role in the depressed state of private sector demand. The encouraging sign is that banks have begun to lower interest rates and should continue to do so, prompted by the improvement in liquidity conditions.
IMF Survey online: The authorities have committed to a more flexible exchange rate regime. How do you see the exchange rate evolving?
Gardner: A basic premise of the program is that the exchange rate should respond flexibly to market signals. We don’t have a preconceived path for the exchange rate, but because of all the uncertainties relating to the speed at which exports, remittances, and private capital will recover, it is important to protect international reserves and the stability of the economy by letting the exchange rate adjust as needed. At the same time, it is understood that the authorities should try to avoid excessive volatility in the exchange rate and, in particular, should intervene in the foreign exchange market to avoid overshooting of the exchange rate due to temporary factors.
IMF Survey online: How would you characterize the business climate in Georgia?
Gardner: The business climate was hurt by the political uncertainty that followed the conflict with Russia and the domestic unrest that followed. That unrest has now subsided, and the fact that foreign direct investment has been growing in the course of 2009 attests to that improvement. When it comes to the legal and institutional business environment, Georgia is very well placed. The country has made remarkable strides over the last few years—the World Bank’s Doing Business Index ranks Georgia first in Eastern Europe and Central Asia and first among lower middle-income countries. Georgia has also moved up quickly through the ranks of Transparency International’s Corruption Perception Index, and there’s a general perception that interactions between the public and the government are now free of corruption. The authorities’ structural reform program is now focusing on improving government efficiency and transparency, while continuing the privatization of public sector assets.
IMF Survey online: How soon do you think Georgia will recover?
Gardner: That depends a lot on the international environment. We expect the recovery to continue through next year, but to remain moderate because the world economy is recovering only very slowly. The main risk factors remain the speed at which credit and foreign direct investment pick up and private sector investment resumes. The program has already succeeded in restoring confidence and stabilizing financial conditions, and is now focusing on ensuring continued macroeconomic stability and an orderly exit from Georgia’s reliance on external financial support.
