Public Information Notice No. 03/133

Public Information Notice: IMF Concludes 2003 Article IV Consultation with Georgia

November 7, 2003

On October 17, 2003, the Executive Board of the International Monetary Fund (IMF) concluded the Article IV consultation with Georgia.¹

Background

Georgia has faced daunting challenges since independence given an environment rife with political tension, declining living standards, and severe economic dislocations, including dwindling tax revenue and loss of Soviet-era energy subsidies and market access. Weakened by civil war and de facto secession of two provinces, Georgia nonetheless has had to build basic national institutions and embark on fiscal consolidation and first-generation reforms, including privatization, land reform, and energy sector rehabilitation. Heavy energy-related foreign borrowing in the first years of independence saddled the country with debt, and the financial crises in Russia and Turkey-Georgia's two main trading partners-have further complicated economic management.

Against this backdrop, and with much left to be done, the authorities can point to several achievements. During the broader transition period, these include strides in structural reform and fiscal retrenchment during 1994-97; price and exchange rate stability after a hyper-inflation episode; accession to the World Trade Organization in 2000; and gradual harmonization of economic legislation with international best practice.

Since the last Article IV consultation in 2001, sustained activity in Russia and the onset of oil and gas pipeline construction have buoyed Georgia's output growth and inflation has remained subdued at around 5 percent and the exchange rate has been stable. The general government deficit remained below 2 percent in 2002 (reflecting reduced expenditure commitments and further improvement in tax revenues) allowing the authorities to reduce domestic arrears somewhat during the year. In the area of structural reforms, progress on banking sector reform has been substantial. Fiscal and energy sector reforms have also advanced, albeit with delays.

Developments in the first half of 2003 have been less favorable, particularly with respect to fiscal performance. Optimistic budget assumptions on external and privatization receipts, which did not materialize, and a slackening of the tax effort early in the year; led to non-observance of the March and June indicative arrears targets. Excise collections have been disappointing, as quarterly indicative targets for 2002-03 set as guideposts to curb evasion were missed. In addition, corruption has remained resilient, diverting scarce public resources, exacerbating income inequalities, adding to the cost of doing business, and weakening confidence.

Executive Board Assessment

Directors noted Georgia's impressive economic strides since independence, including laying the foundations for an open, market-based economy, achieving price and exchange rate stability, and embarking on major first-generation reforms. Directors expressed concern, however, that pervasive corruption and tax evasion remain the most serious obstacles to fiscal sustainability and private sector development. In view of indications that corruption has increased in 2003, and the grave economic and socio-political costs associated with such practices, they emphasized the need to place anti-corruption efforts at the center of the authorities' strategy to strengthen the macroeconomic situation and fulfill the objectives outlined in the Economic Development and Poverty Reduction Program (EDPRP). Directors hoped the recent alliance forged between the Anti-Corruption Bureau and resident Non-Governmental Organizations would add momentum to the ongoing efforts to fight corruption.

Directors welcomed the recent steps taken to strengthen fiscal performance-including passage of a budget systems law, a tax reform, and enhanced investigative and tax-enforcement powers of the Ministry of Finance. However, they considered that further efforts were required to rein in persistent tax evasion and improve budget planning. They saw action in these areas as essential in order to prevent the further buildup in domestic arrears and secure the resources for core spending required for sustained long-term growth and poverty reduction. Looking ahead, Directors urged the authorities to introduce supporting improvements in budgetary design and implementation, including making the single treasury account and commitment controls fully operational, and aligning cash management and accounting procedures with best practice. On the revenue side, Directors stressed the need for improved tax and customs administration, including through a strengthening of enforcement procedures, and the phasing out of tax exemptions.

In light of the findings of the latest debt sustainability analysis, Directors observed that any new external borrowing by the authorities will have to be restrained and on appropriately concessional terms, and many Directors underlined that concessional treatment of bilateral debt obligations would help to achieve longer term debt sustainability. Continued fiscal efforts, complemented by progress on reforms, would also substantially enhance sustainability prospects.

Directors noted that the unresolved fiscal problems in 2003 had forestalled conclusion of the third review under the Poverty Reduction and Growth Facility arrangement. They encouraged the authorities to strengthen program ownership and adhere closely to the quarterly quantitative guideposts for the rest of 2003, as well as to formulate and secure timely approval of a 2004 budget based on plausible assumptions to avert the need for ad hoc sequestrations. In that regard, Directors found it disappointing that preliminary data on tax revenues through end-September 2003 point to a shortfall from the indicative target.

Directors commended the authorities for the prudent stance of monetary policy, which has played a crucial role in anchoring price stability. They encouraged the development of new operational tools for conducting monetary policy. Directors observed that new deposit reserve requirements, differentiated by currency denomination, could play a role in mitigating dollarization, but that long-term reversal of this phenomenon will hinge on sound economic fundamentals, good governance, and political stability. Directors also agreed that a further deepening of the treasury bill market will be helpful to enhance monetary policy implementation. Directors considered that the managed float of the lari had served the National Bank of Georgia (NBG) well, given the low level of foreign reserves and the economy's vulnerability to external shocks, but they advised the NBG to stand ready to allow the currency to float more freely if it came under pressure.

Directors welcomed the refinements introduced in financial sector regulation and supervision, including passage of new anti-money laundering legislation. They noted that these measures had contributed to an improvement in financial sector stability indicators since the 2001 financial system stability assessment was conducted. Directors encouraged the authorities to secure passage of enabling amendments to bring the anti-money laundering law into full compliance with international best practices, and to put in place an effective supervisory framework for microfinance institutions.

Directors stressed the importance of sustained progress in reforming the energy sector, so as to stem fiscal pressures and stabilize power supplies. They welcomed the reinstatement of the autonomy of the sector's regulatory body and the return to cost-recovery tariffs anticipated in December 2003, along with the improvement in collection rates from certain groups of customers achieved thus far. Looking ahead, Directors stressed the need to intensify these efforts, especially by disconnecting non-paying customers, and urged the government at all levels to support the disconnection program and the government's own strategy of transferring management of state-owned distribution, transmission, and dispatch to private companies. Directors also highlighted the importance of setting up a suitable institutional framework for verification and settlement of legacy domestic debts of the energy sector in a timely and orderly manner.

Directors noted the important initiatives now underway to improve public sector operations, including institutional changes in the oversight and divestiture of state property and audits of problematic state enterprises. They urged the authorities to follow up diligently on the recommendations from the audits, as well as to finalize promptly the strategy and costing of the envisaged civil service reform.

Directors observed that full exploitation of Georgia's development potential will require perseverance with the adjustment and reform effort, along with a substantial improvement in the business environment. In this vein, they emphasized the need for more effective and faster implementation of measures to combat corruption and powerful vested interests. These measures should aim to ensure a level playing field, and the uniform application of regulations. It was also suggested that these measures be complemented by stronger efforts to promote greater media attention, public debate, and educational programs targeted against corruption. Directors supported further liberalization of the trade regime to help foster rapid and outward-looking economic growth. In this regard, they welcomed the authorities' plans to study the feasibility of moving toward a low uniform tariff, supported by technical assistance from donors.

Directors considered that the finalization of Georgia's poverty reduction strategy paper is a significant achievement, both in its content and in the broad participation in its formulation, which provides a basis for addressing the main economic and social challenges facing Georgia. However, concern was expressed about some of the measures contemplated in the EDPRP, including the lack of project prioritization, and provision of subsidies and other support to certain industries and sectors. Directors emphasized that in the implementation stage, the authorities will need to articulate more fully the linkages between planned expenditures and the EDPRP, show leadership in improving governance and reducing corruption, and refine the specific targets to be used in assessing outcomes.

Directors noted that the provision of data by the authorities is adequate for surveillance and program monitoring purposes, but encouraged the authorities to undertake, with technical assistance from the Fund, further improvements in the statistical database, particularly in the compilation of national accounts, balance of payments, and fiscal statistics.