Report financed by the international funds say global financial crisis contains more than enough risks for Georgia to experience serious problems with respect to maintaining economic well-being.
The FINANCIAL (via finchannel.com) -- Report prepared by the experts of Open Society - Georgia Foundation and the Economic Policy Research Center criticizes economical policy of Georgian Government and its Strategy for Protection from Global Economic Crisis. Report says “it does not address necessary requirements of a strategic document”. Authors of the report say the global financial crisis contains more than enough risks for Georgia to experience serious problems with respect to maintaining economic well-being.

As a result of global financial crisis Georgia may lose one of the chief sources of capital formation and maintenance of stability of balance of payment experts say. Threat of reducing the volume of transfers, risks in the banking sector and dependent on foreign factors, risks associated with increasing foreign debt are key points of the report.

In the aftermath of military operations in August 2008, donor states and organizations pledged at the donors' conference held in Brussels in October to allocate to Georgia in 2008-2010 aid worth 4,5 billion USD. But experts say future actions of the Government of Georgia may not be limited to eradicating post-war consequences only, as the global financial and economic crisis poses even further threat to the prospects of country's economic development.

Key Findings of the Project

“Threat of slowing down the growth of Georgia's economy - in recent years Georgia achieved a high speed of economic growth. In last five years increase in average nominal GDP exceeded 20%, provoked mainly by the consumption boom. Against the background of global economic crisis, the in-flow of direct and portfolio investments as well as single transfers, which provided Georgian market with abundant liquidity, will decrease in a nearest future. If the consumption speed is not restrained, the country will have to either take private debts with higher interest rates, or to take the state credits, which will substantially aggravate country's economic state.

A permanent change of the country's export-import structure in favor of import demonstrates that the terms of Georgia's trade are permanently deteriorating also: prices on Georgia's chief export goods are reduced, and a majority of enterprises producing them is either closed down or operates in a slow mode.

In recent years, structure of Georgia's export witnessed an increase not in the type of exported production, but in the portion of specific good category, thus making the country's export potential highly dependable on several goods only (nonferrous metals, scrap metal, copper mines, fertilizers, hazel nut).

Potential unpredictable development of both foreign and domestic conjuncture, or hypothetic delay in the donors' aid may create gravest problems to the economic system of Georgia, a number of sectors of which is significantly dependant on the availability of cheap liquid funds and a positive dynamics of consumers' income (trade, services, construction).

Threat of termination or reduction of investment flows - "cheap money" policy pursued in leading world economies provided an opportunity to global investors to invest capital in high-risk states, which could have been much more difficult in case of strict monetary policies in the developed states. Apart from this, financial institutes of leading states created an opportunity of investing intense liquidity profitably themselves, by investing in the high-risk assets of developing states.

In conjunction with these two factors it is remarkable that in recent years a volume of foreign, and particularly direct investments increased in Georgia. Although a part of investments was provoked by liberalization of economy and successful measures taken with respect to pursuing strict budgetary policy, rapid growth of foreign investments was still provoked more by the above-mentioned factors. This opinion is further upheld by the fact that an increase in foreign investments higher than in Georgia was established in relatively less developed countries of Asia and Africa.

Global financial crisis has already led to restriction of international capital flows. On a massive scale, funds are transferred from securities and assets to cash, and in most cases capital abandons risk markets. For investors, developing countries in general including Georgia still do not represent a portfolio of high-class capital investments. Therefore, against the background of more expensive capital and stricter regulations in the near future, maintenance of existing level of in-flow of foreign resources in our country should not be expected longer in nearest several years.

As a result of global financial crisis Georgia may lose one of the chief sources of capital formation and maintenance of stability of balance of payment.

This is even further alarming as foreign savings play a key role in the formation of country's gross capital. As a result of their reduction, Georgia will become much more vulnerable to foreign shocks and its undesirable condition as it is will worsen in respect to international financial position.

Risks in the banking sector and dependent on foreign factors - Georgian banks have already felt negative impact of the August war and a global financial crisis: interest rates increased sharply, loan terms were made significantly harsher, and a volume of "bad loans" increased, which was reflected in a growing number of written-off loans. Due to the mentioned, entire banking system saw the first significant loss in last 10 years - worth 215 million GEL.

Problem of lack of savings within the country will become especially acute when a global economic crisis reaches its peak. Unfortunately, Georgian financial system is quite vulnerable to it, as it is undesirably dependent on the dynamics of international capital markets.

Negative balance between the deposits and loans of the banking system by the end of 2008 constituted approximately 13% of GDP. In such conditions, banks will hardly maintain balance if the capital starts flowing out of the country. Moreover, serious problems will arise even if the in-flow of international capital in the country is suspended, which seems to be a rather realistic scenario in light of hardest ongoing worldwide crisis.

Big inconsistency between the average volume of deposits and loans is especially dangerous. Average loan exceeds an average deposit by almost three times. In such instance banks will have to announce banking holidays or restrict withdrawal of deposits.

Threat of reducing the volume of transfers - in 2009 it is expected that a volume of money remittances that constantly grew until recently will reduce. Global crisis already had its impact on all states, which secured largest monetary in-flows in Georgia by transfers.

Increasing migration from the country and rather rapid development of economies in the countries of the migrants' settlement might have been a chief pre-requisite for growing volume of transfers. This is particularly applicable to Russia, where in parallel with speedily growing global prices on oil and raw materials, the incomes of both local population as well as economic migrants increased. Global economic crisis has already exerted negative impact on Russia's economy, which is a primary source of transfers made to Georgia. Unfavorable environment is in other states of settlement of Georgian migrants also (EU, USA). In view of this, volume of pure transfers is expected to decrease in 2009, thus creating a quite heavy pressure on national currency, as well as population and the banking sector.

Further, described source of income may significantly decrease not only due to a global crisis only, but owing to activation of non-economic factors also (for instance, more strenuous political relations with Russia), which will be directly reflected in the scale of economic activities in the country.

Risks associated with increasing foreign debt - due to structural and other type of problems existing in the economy, Georgia might be obliged to take loans under much more severe terms, which will further deteriorate country's foreign economic state, especially as tendency of accelerating foreign debt is recurring since 2008.

Assuming that moneys transferred to Georgia by donors are spent in entirety for its development and approximately 2 billion USD from these funds are loans, the rate of country's debt increase will considerably exceed the rate of GDP growth. The ratio of foreign debt to GDP by the end of 2009 will reach approximately 30%. Yet, this does not necessarily imply that Georgia's foreign debt will definitely become a serious macroeconomic problem. On the other hand, it is obvious also that the dynamics of international conjuncture and our country's foreign debt already include tangible signs of such threat.

Based on the mentioned, the Government has to clearly apprehend existing environment and above-described real or expected risks, so that necessary steps for changing the environment are made effectively to a maximum extent and a set of preventive measures is applied to alleviate shocks caused by a recession.

Conclusions / Recommendations

Without immediate implementation of sectors and activities highlighted in the Conclusions / Recommendations section, it is hardly imaginable to pull country out of the existing crisis.

Banking Sector

To mitigate the problems of a banking sector it is necessary to carry out urgent measures in order to avoid a bank panic, which may inflict a huge damage on still developing Georgian banking system by creating a systemic crisis, especially when Georgian banks already experience solvency problems.

Currently, the country has an extremely weak mechanism of long-term savings and their transformation into loans.

The society still does not trust the banking system, and therefore the latter has to rely on foreign sources to fund the assets. Big share of the banks’ liabilities falls on short-term deposits, whereas in recent period long-term crediting (mortgage and consumption boom) has rapidly grown mainly at the expense of international capital.

According to the data of the National Bank of Georgia , a negative balance between the deposits and loans of the banking system by the end of 2008 constituted approximately 13% of GDP. In such conditions, banks will hardly maintain balance if the capital starts flowing out of the country. Moreover, serious problems will arise even if the in-flow of international capital in the country is suspended.

This seems to be a rather realistic scenario in light of hardest ongoing worldwide crisis, which was called by the former Chairman of the US Federal Reserve System Alan Greenspan as “the crisis, which occurs once in 50 years, or possibly, once in a century”.

Banking system, in which there is a significant imbalance between terms of deposits and loans, is especially inclined towards a banking panic described by the so-called Diamond-Dibvig model. Unfortunately, this is a very evident disadvantage of Georgian banking system (refer to table).





Source: National Bank

In view of fact that by the end of last year approximately 2 million 170 thousand deposits of natural persons and legal entities were registered in Georgia, out of which a number of deposits up to one month constituted 99% of a gross number, it is easy to guess that a long-term savings mechanism does not practically operate in the country. Total number of loans is approximately the same and exceeds 1 million 260 thousand. Although a volume of deposits up to one year in a gross volume of deposits is only 54%, in case of a banking panic the system will be practically left without attracted funds.

Big inconsistency between the average volume of deposits and loans is especially dangerous. Average loan exceeds an average deposit by almost three times.

Pursuant to the Diamond-Dibvig model, in such case the banks will have to announce banking holidays or restrict withdrawal of deposits. Overall, under the model, such action will inflict further damage on the banking system and may well become a reason for apparent banking crisis. Introduction of institute of deposit insurance, which exists in many countries worldwide, is a way to avoid crisis development of events.

Apart from a fact that such a scheme is a rather effective means of protection from the banking panic, empirical studies confirm that countries having schemes for insuring deposits enjoy relatively more direct foreign investments.

As pursuant to the Government’s calculations a volume of aid to be provided to a banking sector exceeds 1,1 billion Dollars, we find it reasonable to start working on the scheme for insuring deposits. Such a scheme should insure at least a portion of the most short-term deposits by the terms. Having into consideration that an average volume of such deposits does not exceed 1,000 GEL, it is obvious that these funds are necessary consumption means for the average and poor classes of population. Moreover, it is necessary to design such a scheme for insuring deposits, which stimulate bank’s clients to make long-term savings. The following mechanism may be developed for this: depositors, which request immediate withdrawal of monies from the bank, will have their deposits insured less portion-wise compared to those who trust the banks more.

It is apparent that last year the banks incurred serious losses and a portion of the state assistance should be spent on their recapitalization. Large amounts are needed also for paying off pending liabilities accumulated on on-landing means, but the strategic document of country’s development should definitely talk about the scheme for insuring deposits, especially when international financial institutions have provided Georgia with numerous recommendations about this issue.

With respect to assisting the banking sector itself it is notable that unfortunately nothing is said about the purpose and the types of mechanisms of allocating funds to the banks. Non-clarification of these two components transparently and clearly will provoke further uncertainty, damaging the as it is vulnerable financial system even more.

Pension Reform

Unfortunately, the Strategy for Protection from Global Economic Crisis of the Government of Georgia does not mention such a crucial instrument of operation of financial field, as a pension reform.

Population of Georgia, just like the population of majority of developed part of the world, grows old. Although a ratio of capable and incapable part of population is still stable and according to the data of the Department for Statistics this figure in 2003-2008 falls approximately within the 1.4-1.5 range, a process of speedy growth of pension-age population is already evident. For instance, ratio of number of capable population with a number of pension-age population reduced from 4.37 in 2003 to 4.08 in 2008. In light of birth-rate stagnation, this process will aggravate further especially in the rural areas.

Foundation should be immediately laid for the pension sector reform through private-state partnership, which should start with identification of exact number of pensioners and relevant modification of taxation system. Otherwise the country will soon end up in a gravest situation in respect of fulfillment of social protection obligations. Obviously, pension reform is a time-consuming process, but funds allocated by the international community should be utilized in this area right now, as in the future it will be extremely difficult to attract cheap funds for funding the social protection mechanisms.

We recommend the Government to accumulate allocated funds for launching the transition period and gradually transferring from existing ineffective scheme (when high-income employees pay large taxes to receive much less pension in the future) to a more effective system based on personal savings. Clearly, transition period will be associated with losses of certain social groups, but their compensation will be possible from the funds allocated by the donors. It has to be taken into account that the crisis events make it easier to carry out unpopular, but needed reforms. Postponement of this reform will hinder its implementation in the future.

Investments in Transport Infrastructure

Decision of the Government to invest in transport infrastructure as such may be assessed positively. This is particularly applicable to rehabilitation of rural roads. To this end, the authorities plan to receive from the donor aid only in 2009 approximately 136 million GEL. Rehabilitation of rural roads and ensuring connection of isolated regions with the center is crucial for normal operation of Georgia’s economy and social area. Nevertheless, it has to be taken into account that capital invested in the roads generally in a short-term period fosters even speedier growth of import rather than export. This sentiment is confirmed as theoretically, as well as by numerous empirical studies.

Rehabilitation of transport infrastructure in Georgia is a rather import-loaded field, as a major portion of required capital for this and the current assets are not produced locally. Besides, it is suspected that the income of the employed in road-construction sector will be still spent on import. In the first place, only 9% of GDP is generated in this field and a portion of the employed in this sector is small compared to gross employment rate. Secondly, roads and major transport infrastructure belong in general to the state and a private sector may have only indirect motivation to invest in this field.

It is meant here that private sector in itself will not invest money in the roads unless the state authorities intend to modernize the roads and hire the private sector to fulfill this task. Unlike other types of infrastructure (energy infrastructure, irrigation, where the systems may be privatized in near future), involvement of private sector in road construction, at least in Georgia’s current reality, will not be of full value as representatives of private sector are not appropriately stimulated.

Contrary to the above-mentioned, we believe that the energy or irrigation sectors rehabilitated by the state might be much more attractive for private capital in general, as it is quite possible to privatize these areas.

Thirdly, if we assume that according to Georgian Government’s calculations the country albeit slow speed will still grow economically, then the consumption of our population, including import, will only increase at the expense of improving infrastructure. It is widely known that consumption, and including import, is directly proportionate to incomes – if the income grows, consumption will grow, including the consumption of imported goods.

Damaged roads and bad infrastructure generally hamper the functioning of sales, including imported goods sales market. Therefore, development of road infrastructure fosters import in a short-term period. As for the export growth, it should be viewed as a directly proportionate result of growth of revenues of Georgia’s trading partner countries. Hence, improvement of Georgian infrastructure cannot affect them, especially when incomes and consumption are reduced worldwide in light of the global crisis.

Improvement of transport infrastructure will facilitate export in case the country will pursue policy seriously fostering supply stimulation, which will yield the results gradually. We do not have anything against rehabilitation of the transport system, but find that without serious steps facilitating national production, maximum utilization of road rehabilitation is quite low.

Agricultural Sector

Measures stimulating supply may include investing funds in rehabilitation of irrigation and drainage systems. In recent years only the production of Georgian food and agricultural products has demonstrated its real export potential along with several other products (processing of nonferrous metals, fertilizers, other). In addition, a potential to replace import in agricultural and food sectors is high as well. As in initial production entirely, as well as in food processing approximately 15% of the country’s GDP is generated, whereas a number of the employed in rural areas is more than half of total number of the employed. In case of correct organization of agricultural production, the country will save large volumes of currency reserves that are spent today on import.

In 2008, Georgia’s import of food and agricultural goods constituted 942 million 65 thousand USD, while export equaled only 250 million 508 thousand USD. Recently a number of crucial food products produced per capita has drastically reduced. For example, wheat production per capita reduced from 44 to 17 kilograms from 2005 to 2007, corn – from 98 to 68, vegetables – from 102 to 43, potato – from 101 to 52. From 1990 to 2007 area of sowed land plots reduced from 700 thousand to 297 thousand. Two-fold reductions were marked in the areas sowed with grain, sunflower, and melon crops.

One of the reasons of this unfavorable tendency, among others, is a failure of the irrigation and drainage system. Rehabilitation of system would give the country two types of direct income: 1) would return non-irrigated land into production, and 2) would increase income several times (2-3 times) by watering the irrigated land parcels. According to calculations of program AgVantage prepared in 2007, rehabilitation of irrigation and drainage systems would increase country’s revenues by 500 million GEL annually. Pursuant to calculations of the same organization, approximately 55 million USD are required annually (this includes capital expenses and operation costs) for covering up to 250 thousand hectares of irrigation system. Approximately half of these funds should be allocated by farmers if the Government manages to develop optimum scheme for private-state partnership in this sector. Positive output of these measures is more than obvious. Moreover, IRR of such projects exceeds 30% annually even if calculated with respect to long-term period.

Unfortunately, Government’s document mentions in relation to this crucial sector only that 21.2 million GEL are to be allocated in this area. It is not indicated whether this will be allocated directly from the state budget or from any of the donors. We believe that irrigation and drainage systems require much more attention and should represent a key element of the Government’s strategic vision, since its rehabilitation is significantly beneficial for the country.

Apart from this, this matter bears huge political importance as well, as rehabilitation of such systems will assist the population in depressive peripheral zones to stay there and will raise their well-being, which itself will reduce budgetary liabilities in terms of social obligations. We believe that it is possible to engage local authorities more actively in development and implementation of infrastructural projects, provided they are given more opportunities to collect land and real estate taxes on spot (i.e. by activating real leverages of financial decentralization).

Foreign Trade

Government’s document talks a lot about cancellation of double taxation and establishment of free trade regimes with individual countries. It is believed that by executing these treaties only Georgia will be provided an opportunity to penetrate markets of leading states. Unfortunately the reality is much more complex. Georgia enjoys free trade regime with the CIS states for a long time now, but the goods produced in Georgia do not play a decisive role even on the CIS markets.

Bringing Georgia’s relevant legislation in compliance with the European standards is necessary for full utilization of preferences offered by the European Union. In particular, at the moment the effect of the Law on Food Safety and Quality is suspended in Georgia. Without this Law, it is impossible to export in large volumes the food and beverages produced in Georgia to the European market. Unfortunately, Government’s document doe not mention this at all.

Increasing the Role of National Bank

Government’s strategy did not pay due attention to the role of National Bank in stabilization of the country’s economy. Pursuing expansionist policy declared by the Government is impossible without respective synchronization with the National Bank.

Implementation of several macroeconomic activities indicated in the Government’s document only by means of fiscal instruments is impossible even theoretically. Clear examples of this are the initiatives of the Financial Center and Free Industrial Zones mentioned in the presentation, which, in our opinion, are totally unreasonable, unprepared, and out of place in Georgia’s current context, especially in light of ongoing global crisis. Measures proposed by the Government imply in itself securing the stability of national currency and prices, which is a straightforward prerogative of the National Bank.

If the Government plans expansionist policy, it is unclear how should the stable inflation rate be maintained if the National Bank has nothing to do in the presentation?

Back in the middle of the 20th Century, Dutch economist and Nobel Prize Laureate Jan Tinbergen  demonstrated that fulfilling two or more macroeconomic policy tasks is impossible without at least two macroeconomic instruments. We find it extremely important that the Government's strategy for overcoming the crisis should have paid due attention to ways of maintaining national currency rate, as in case of devaluation of Georgian Lari it will be difficult not only to pursue expansionist policy, but to maintain the country's solvent capacity.

"Expansionist Policy - 2009" of the Government

Interestingly, the Government of Georgia, which is a consistent advocate of free market economy, still intends to continue the cheap loan program and to distribute fertilizers and agricultural equipment to the farmers, when no one has yet assessed the efficiency of already completed similar programs. In these circumstances one has to ask why has not the Government opted for the policy of subsidizing individual fields of economy, especially when leading western states also do it in the crisis conditions? If the expansionist policy is talked about, why is not a more serious subsidizing of economy discussed? Besides, unreasonable use of the term 'expansionist policy' by the Government is unclear.

Overview of the expenditure section of the 2009 budget leaves impression that the country's authorities have substantially reduced only the costs of power structures and the defense (funding of the Ministry of Internal Affairs constituted 742 million GEL in 2008, and was reduced to 568 million in 2009; defense budget was reduced from 1 billion 547 million in 2008 to 942 million in 2009), while the established growth in other areas is less than nominal growth speed of economy in general. This is applicable to assignments in the health care (1,3 billion GEL in 2008, 1,494 billion - in 2009) and education (465 million in 2008, 538 million - in 2009) sectors.

Expansionist fiscal policy implies substantial growth of economic role of the Government, which often entails large budgetary deficit that the state sector in most cases covers with money borrowed from private and foreign sectors. In case of Georgia the expansionist policy, as the Government calls it, was not a choice for our country. Government of Georgia did not on its own intend to pursue such a policy. Fortunately for Georgia, following the August events and at the outset of a global crisis Georgia's friend states expressed free will and happened to have funds to render vast financial aid to the country. We believe that the Government's document has to emphasize real significance of aid received from western partners and a fact that most crucial areas of budgetary expenditures would have been left almost non-funded without their aid.

Finally, it could be mentioned that the Strategy for Protection from Global Economic Crisis presented by the Government does not address necessary requirements of a strategic document. It does not clearly establish the authorities' real plans in terms of avoiding potential threats of a global crisis (our report examines most apparent threats that are characteristic not only to Georgia but states that are much more financially sustainable than Georgia). Unfortunately, Government's strategic document does not mention real threats, overcoming of which would preserve dynamism to Georgia's economy.

The draft 2009 state budget of Georgia is not sufficiently modified to take into account the crisis-driven reality. It mostly presents a reaction to the aid allocated by international donors, without good will of which country's authorities would not practically have its own plan and resources to withstand a global crisis”.


Report was prepared by the experts of Open Society - Georgia Foundation and the Economic Policy Research Center. The project was implemented from November 2008 until February 2009 and was carried out within the framework of Transparent Financial Aid to Georgia Coalition. OSGF says the Coalition aims at promoting the efficiency and transparency of financial aid pledged by donor states and organizations to Georgia.

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