The FINANCIAL — OVERVIEW AND OUTLOOK
The credit profile of Georgia (Ba2 stable) reflects high average growth rates, strong and improving institutions, and a moderate debt burden, weighed against low income levels, a small economy, external vulnerability from the economy’s reliance on foreign-currency denominated funding, and latent geopolitical risks.
Georgia’s strong and improving institutional framework is anchored by close engagement with the European Union (EU, Aaa stable) and IMF. In addition, Georgia has growing access to a diverse set of markets through various trade agreements, which will allow FDI inflows to remain close to 10% of GDP and will likely raise exports and economic growth in the medium term.
By contrast, credit challenges stem from low domestic savings that imply that a large share of investment is financed by external debt, making the economy and sovereign vulnerable to a tightening in external financing conditions. The economy’s small scale and preponderance of very small companies is also a constraint to growth potential.
Upward pressure on Georgia’s rating could develop as a result of continued institutional and economic reforms leading to higher domestic savings, reduction in external vulnerability, greater diversification, and robust productivity growth. Measures to bolster the resilience of the banking system would also reduce credit risk.
Downward pressure on the rating could develop from an increase in external vulnerability risks or heightening of geopolitical tensions. A deterioration in fiscal metrics could also put downward pressure on the rating.
This credit analysis elaborates on Georgia’s credit profile in terms of economic strength, institutional strength, fiscal strength and susceptibility to event risk, which are the four main analytic factors in our Sovereign Bond Rating methodology.
Georgia’s “Low (+)” economic strength score balances the economy’s small size, moderate concentration, high growth volatility, excess credit growth, and low wealth levels, against its significant growth potential, favorable business climate, and increasing integration into the global economy. Georgia shares this assessment with Armenia (B1 positive), Swaziland (B2 negative), Nicaragua (B2 positive), Uganda (B2 stable), Ecuador (B3 stable), and Serbia (Ba3 stable). Georgia’s economic strength score is set above the indicative score of “Low (-)” to reflect the greater economic diversification of the economy than its size suggests.
Georgia’s economy does not exhibit anomalous concentration despite its small size
“With a nominal GDP of only $14.3 billion in 2016, Georgia lies in the bottom quartile of the sovereigns we rate in terms of scale. A smaller economy tends to be more exposed to sector-specific shocks since there is less scope for other sectors to offset them. However, other diversification indicators suggest only a moderate degree of economic concentration in Georgia’s case.,” according to Moody’s.
In its domestic production and external trade, Georgia has seen its service economy gradually outgrow primary and secondary industries. Trade and tourism have come to represent the largest segments of the country’s domestic production and foreign trade, respectively.
Low wealth levels provide minimal shock absorption capacity
Albeit rising and comparable to regional peers, wealth levels in Georgia remain low in the global context. Low incomes constrain households’ capacity to absorb economic shocks.
Real GDP growth averaged 3.6% in Georgia over 2008-17, broadly in line with the Ba median and 0.4 percentage points above the CIS average over the same period. In terms of gross value added, the country’s output expanded by around 39% between 2008 and 2017 (or the four quarters to Q3 in each year), led by robust growth in trade, construction, and manufacturing activity.
In recent years, economic growth has been driven in large part by sizable FDI inflows and rapid credit growth. These factors allowed Georgia to largely escape the slowdown that gripped the CIS region in 2014-15 in the wake of the global commodity market correction and the international sanctions on Russia (see Exhibit 7). However, rising credit intensity poses risks to the sustainability of growth. A potential deceleration in FDI inflows that may follow the completion of the FDI-funded TANAP natural gas pipeline could also weigh on growth.
“Considering the current economic momentum, favorable global conditions, and progress on institutional reforms, we expect growth to average around 4.3% over 2018-2019 and accelerate to Georgia’s potential growth rate of around 5.0% in 2020-2021, outperforming its regional peers,” Moody’s reported.
At only 20% of GDP, Georgia’s exports of goods account for a relatively small share of its total economic activity. This low level of reliance on exports compares to an average of 27% for other rated CIS sovereigns.
After adopting the Association Agreement (AA) and the Deep and Comprehensive Free Trade Agreement (DCFTA) with the EU, as well as free trade agreements with China (A1 stable) and the European Free Trade Association (Switzerland (Aaa stable), Norway (Aaa stable), Liechtenstein, Iceland (A3 stable)), in addition to long-established agreements with Turkey (Ba2 stable), the United States (Aaa stable), Japan (A1 stable), and Canada (Aaa stable), Georgia now faces relatively low hurdles to expanding its footprint in international trade. Furthermore, its access to maritime trading routes via the Black Sea sets it apart from peers in the Caucasus and Central Asia in terms of physical access to global markets and related transportation costs. Combined with the country’s conducive business environment and low labor costs, these factors bode well for investment in export-oriented industries and, ultimately, for export-driven growth over the medium term.
These favorable factors will take some time to bear appreciable fruit. While exports increased substantially in 2017 (by 29% to $2.7 billion), they were still down from 2013-14 peaks. Exports to the CIS rebounded the strongest, with exports to Russia (Ba1 positive) growing by 91% (or by $188 million, to $395 million), far exceeding the 13% growth in exports to the EU (by $74 million, to $646 million) and the 12% growth to non-EU non-CIS markets (by 98 million, to $901 million) combined. This suggests that entrenched trade patterns will continue to dominate as legacy export industries (cooper ore, ferroalloys, viticulture) take some time to fully capitalize on improved access to new global markets. Considering currently low levels of domestic savings, substantial FDI inflows into established or new export industries are likely to be required to fully unlock the opportunities presented by Georgia’s competitive advantages.
“Our “High (-)” assessment of Georgia’s institutional strength reflects its significant progress in establishing and sustaining transparent, predictable, and effective institutions over the last 15 years. This assessment is further corroborated by the central bank’s track record of maintaining low inflation. Georgia shares this score with mostly high-income sovereigns, including Cyprus (Ba3 positive), Hungary (Baa3 stable), and Uruguay (Baa2 stable), ranking well above regional peers (see Exhibit 9). We have adjusted the country’s institutional strength score down to “High (-)” from the indicative “High” due to our view that Georgia’s institutional capacity still lags those of its “High” institutional strength peers,” Moody’s said.
A 15-year track-record attests to reform durability
After embarking on a fundamental institutional reform program in the wake of the 2003 Rose Revolution, Georgia’s governance indicators improved rapidly, surpassing all regional peers and many global peers. With a focus on market liberalization, the reforms removed hurdles to economic activity, cementing property rights, greatly reducing corruption, streamlining and localizing government services, and deregulating business and labor markets.
Notably, these gains in institutional development have been sustained and extended after the government brought in by the Rose Revolution was succeeded by the opposition in 2012. Initially catalyzed by foreign donor support, mainly in the form of official foreign aid and charitable contributions, Georgia’s institutional framework has proven to be self-sustaining in the long run. Minor loss of domestic approval of government institutions in recent years is likely mostly related to somewhat more challenging macroeconomic conditions, in particular the depreciation of the currency.
Agreement with the EU and IMF supports further institutional transformation
Georgia’s main economic ministries and the central bank already demonstrate relatively effective policy management.
The central bank is independent and its conduct of monetary policy is moderately effective at managing inflation. Georgia was among the first countries in the CIS region to adopt a flexible exchange rate, which helps it maintain price competitiveness and preserve foreign exchange reserves. Its commitment to capital account openness has supported Georgia’s efforts to attract and retain capital.
Moreover, Georgia’s data are of high quality and readily available, which contributes to transparent and predictable policymaking. It subscribes to the IMF’s Special Data Dissemination Standard (SDDS) and provides considerable data beyond that of many of its comparators, such as a forward-looking debt service payment schedule.
As part of the AA and DCFTA, the EU provides Georgia with technical and financial support to further develop its institutions. The two agreements aim to further deepen political and economic relations by bringing Georgia’s institutional framework closer to EU norms. Georgia has thus committed to implementing further reforms in many institutional domains, including justice, anti-corruption, personal privacy protection, border control and conflict resolution in its disputed territories.
In April 2017, the IMF approved an Extended Fund Facility program for Georgia, granting it access to SDR210.4 million. While the government is not facing liquidity stress, the program can still benefit the sovereign’s credit profile by supporting policy credibility and catalyzing additional structural reforms, mainly in the financial sector, pension system, public-private partnership, and education. Based on the IMF’s November 2017 review, Georgia was meeting or exceeding all of its performance criteria under the program.
Conduct of monetary policy shows moderate policy effectiveness
Georgia has been moderately successful at maintaining price stability in the face of external pressures. Although Georgia is a small open economy, exposed to considerable external pressures, the authorities have managed within a floating exchange rate regime.
As such, even though Georgia has had to contend with a 30% depreciation of the lari against the US dollar between late 2014 and early 2016, inflation peaked at only 7.1% in June 2017 and has averaged 4.0% since September 2014. This was partially the result of decisive action taken by the National Bank of Georgia (NBG, central bank) in 2015, raising its policy rate seven times by a total of 400 basis points, to 8%.
This experience compares favorably to other CIS sovereigns, such as Azerbaijan (Ba2 stable) and Kazakhstan (Baa3 stable), where inflation rates increased to highs of 17% and 18% respectively, following large depreciations in their currencies – although the depreciation in Azerbaijan and Kazakhstan to the US dollar was also larger than in Georgia, at around 50%.
“Going forward, we expect end-year inflation to be 3.4% in 2018, due to moderating growth in economic activity and a somewhat stronger lari, and slightly lower at 3.0% in 2019.
Georgia’s fiscal strength, which we assess at “Moderate”, compares favorably to global rating peers, despite a relative high share of foreign currency debt. Regionally, Georgia’s fiscal strength is similar to those of Belarus (B3 stable), Moldova (B3 stable), and Tajikistan (B3 stable), with all four funding themselves mainly in foreign currency. In a global context, Georgia’s fiscal profile is most similar to that of Fiji (Ba3 stable), with its comparable debt burden but somewhat lower debt affordability and lower share of foreign currency debt.
We assess Georgia’s fiscal strength as “Moderate,” supported by the government’s moderate debt burden and very high debt affordability. While deficits have historically remained low, we estimate that the deficit narrowed to 0.5% of GDP in 2017 as a result of stronger growth and forecast that it will rise modestly to 1.9% of GDP in 2018 as the government continues its program of improving infrastructure. Notwithstanding the government’s commitment to restraining current expenditures and borrowing only for its infrastructure program (expected to be completed in 2021), the high percentage of foreign currency debt weighs on fiscal strength.
We estimate that Georgia’s government debt amounted to 41.3% of GDP at year-end 2017 or 142% of government revenue, both relatively low levels. In addition, interest payments relative to revenue were also low at 4.4% in 2017, reflecting the prevalence of loans granted by international institutions on concessional terms. These metrics compare well with those of Ba-rated peers,” Moody’s said.
Georgia is continuing to refine its fiscal rules
The Economic Liberty Act that has been in force since 2014 stipulates that debt-to-GDP must not exceed 60%, expenditures must not surpass 30% of GDP, and budget deficits must not exceed 3% of GDP. The act also allows the government a degree of “tactical short- term flexibility.”
Within these rules, the government cannot easily increase spending since the implementation of new taxes (except excise taxes) and any increases in the upper rate of existing taxes must be approved by referendum. The Georgian authorities are continuing to develop more flexible fiscal rules with greater capacity to reflect countercyclical requirements, with technical assistance from the IMF.
Georgia also benefits from diversified revenue sources. In 2017, 90% of revenue came from taxes, with only 3% of revenue came from grants. Taxes come from several sources, with value added tax accounting for 38% of revenue in 2017, income tax for 27%, corporate profit tax for 7%, and excise tax for 13%.
“Georgia’s debt-to-GDP and debt-to-revenue increased significantly in 2015 due to the depreciation of the lari against the USD, because over 75% of Georgia’s government debt is denominated in foreign currency. Although we estimate that debt-to-GDP declined to 41.3% in 2017, a further depreciation of the currency could increase the debt burden. The immediate risk related to the high share of foreign-currency debt is partially mitigated by the long duration of the country’s external debt. That means that although the debt burden rises when the currency depreciates, debt affordability changes more slowly.
Over the next two years, we expect robust nominal GDP growth, moderate deficits, and a broadly stable lari to allow the debt burden to remain stable relative to GDP, in the 40-45% range,” according to Moody’s.
Contingent liability risks from the largest state-owned enterprises are contained
With about GEL2.8 billion in debt (7.5% of GDP in 2016), the three largest Georgian state-owned enterprises represent a limited risk of contingent liabilities for the government, particularly given the relatively robust financial position of the largest one, Georgian Railway.
Moreover, to limit risks to public finances, the government uses its Partnership Fund (PF) to support its economic policy objectives. The PF is a joint stock company, fully owned by the government, which fosters private investments in key sectors (energy, agriculture, manufacturing, and real estate) principally via minority equity participation, but also through loans and guarantees. The PF was capitalized via transfers, including 100% of the shares of Georgian Railway and Georgian Oil and Gas Corporation. PF’s business model carries little risk of contingent liabilities because it is not indebted and finances its operations via dividends from the shares it owns.
“We assess Georgia’s susceptibility to event risk as “Moderate,” driven mainly by banking sector risk. While not to the same degree, political risk related to the dispute with Russia over breakaway regions and external vulnerability risk stemming from a wide current account deficits remain significant for the rating.l,” Moody’s reported.
One of the main drivers of our “Moderate (-)” assessment of political risk is Georgia’s strained relationship with Russia, dating back to Russia’s backing of separatist forces in the Abkhazian war (1992-93) and reinforced by the Russian-Georgian war over South Ossetia (2008). As a result of Russian interventions, Georgia effectively lost control over the two regions, which make up 20% of its sovereign territory. Russia recognized the disputed regions as independent states and continues to support them, signing mutual defense treaties with both regions in late 2014 and early 2015. In March 2017, Russia approved a plan to integrate the South Ossetian army into the Russian army, in what Georgia argues is a continued attempt to absorb the separatist areas. Georgian authorities have also criticized recent political moves in both territories as illegal, including elections in Abkhazia and the renaming of South Ossetia.
In the aftermath of the 2008 war, the Russian government imposed barriers on trade with Georgia, largely shutting down non-energy trade between the two nations. However, as mentioned above, economic relations between the two countries have been improving since 2012. While overwhelmingly seeing Russia as a threat, polls indicate that the Georgian electorate supports further diplomatic dialogue with Russia and approves the government’s constructive and pragmatic handling of the relationship.
“Our baseline assumption is for the status quo to be maintained on political issues dividing Russia and Georgia, but for limited and gradual progress on economic and trade issues over the medium term. However, as reflected in our “Moderate (-)” score, we cannot rule out an escalation of tensions, first and foremost in the economic arena but also potentially in renewed fighting around the breakaway regions. These risks represent moderate-probability moderate-to-high impact events.
We assess event risk due to domestic political risk as low. The vast majority of Georgian society and the political elite are united around the goal of further association with, and ultimately membership in, the EU – despite frequent political confrontations between members of the Georgian Dream coalition and the opposition. The October 2016 parliamentary elections, won by the incumbent Georgian Dream, were preceded by a boisterous campaign season, and were judged by international monitors to have had a number of issues albeit with no significant influence on the overall outcome. Following the elections, the opposition UNM split over differences regarding Mr. Saakashvili’s role in determining the party’s position. The majority of MPs left the UNM to form a new party,” Moody’s reported.
The elections provided the Georgian Dream a constitutional majority in parliament, which it leveraged to initiate a constitutional reform. The constitutional reform approved in 2017 will limit presidential powers while transforming the electoral process for both the president and the parliament. Under the amended constitution, Georgia will gradually transition from a mixed majoritarian- proportional electoral system to fully proportional parliamentary elections by year 2024. At the same time, direct popular presidential elections will be replaced with an indirect procedure led by the parliament. Established parties, especially the ruling party, are viewed as the main beneficiaries of the changes. While the amendment presents risks to government accountability and political competition, it may serve to catalyze consolidation within the opposition, potentially resulting in a less fractured and more balanced political landscape.
“While the proportion of foreign currency debt in total government debt is high (78% as of Q3 2017), most of Georgia’s debt is on concessional terms with long maturities and at low interest rates. Hence, its debt service payments are moderate, with one Eurobond due in 2021. We estimate annual gross borrowing requirement for 2018 at 7.7% of GDP, down modestly from 7.9% in 2017.
Our assessment of “Moderate” banking sector risk reflects the moderate size of Georgia’s banking system, with assets accounting for around 89% of GDP in 2016, and the intrinsic financial strength of banks (with a weighted average baseline credit assessment of Ba3), weighted against some reliance on wholesale funding,” Moody’s said.
Capitalization levels and liquidity buffers were adequate as of end-2017, with a regulatory Tier 1 capital to risk-weighted assets ratio under Basel III of 14.0%, well above the 8.5% regulatory minimum, and a liquid assets to total assets ratio of 21.3%. The system’s strong core profitability is supported by very high margins, and the system’s net interest margin of 6.6% in the second half of 2017 compares favorably to the 4% median for Moody’s-rated banks in other developing markets.
Dollarization has continued to ease over time resuming a downwards drift in mid-2016, with deposit dollarization reaching 64% by December 2017 (see Exhibit 23). If the lari were to begin to weaken again, as it did from December 2015 it could negatively impact bank asset quality and profitability, as borrowers with incomes in lari would find it harder to repay their foreign currency loans.
Partly mitigating this issue, however, is the requirement by the central bank under Basel II/III that banks employ an additional 75% risk weight for loans to unhedged borrowers.
Other concerns have also eased including the nonperforming loan (NPL) ratio of 5.9% of total loans as estimated by the NBG in Q4 2017, which has fallen from its most recent peak of 8.6% in Q1 2016. According to the less stringent IMF methodology, NPLs stood at 2.8% in Q4 2017.
In part reflecting its success in attracting foreign capital, Georgia has consistently registered a domestic savings shortfall. FDI flows in particular have been instrumental in bridging the saving-investment gap. Georgia’s limited capacity to produce capital and intermediate goods domestically has led foreign and domestic investors to rely on imported materials, industrial supplies, and equipment, directly adding to the current account deficit.
Georgia’s success at attracting FDI, combined with the potential for pension reform to boost domestic savings significantly – the rundown of its substantial infrastructure investment pipeline by 2021 and potential for exports growth – support a final score of ”Moderate(-)” compared to the indicative score of “Moderate.”
While the bulk of foreign direct investment accumulated in the economy arrived in form of equity, Georgia has also amassed substantial external debt obligations, mainly in loans from International Financial Institutions (IFIs). The total external debt stock stood at 101.8% as of the third quarter of 2017, with just over a quarter of this amount accounted for by loans to the government.
Most of those loans are extended on concessional terms and with long tenors, reducing refinancing risks. As of 2016, average interest rate on new external debt stood at only 1.8% and the average term to maturity was 21 years. Moreover, the IFIs’ lower sensitivity to market conditions makes them a more stable funding source at times of heightened economic volatility.
Nevertheless, the market component of external debt still presents risks to the sovereign as a sudden stop in capital flows could put significant strain on the central bank’s foreign exchange reserves and/or the exchange rate. As of the third quarter of 2017, principal payments on external debt due within 12 months exceeded NBG’s foreign exchange reserves by over 50%, consistent with an external vulnerability indicators (EVI) above 150%. Excluding intercompany lending and loans to the government, both of which may face lower refinancing risks than other types of debt, does not fundamentally change this picture (see Exhibit 27). Combined with a current account deficit that is largely covered by FDI inflows, Georgia’s external vulnerability is comparable to other sovereigns in the “Moderate (-)” category.
Apart from reflecting FDI inflows, Georgia’s current account dynamics have mirrored the evolution of the country’s economic model. Over the past five years, tourism emerged as one of the key sources of foreign currency revenue for the country. This high degree of specialization in foreign trade presents an external vulnerability risk as tourist flows may decline substantially should the political risks crystalize. The second largest component of net inflows is secondary income, made up primarily of remittances and foreign aid, which we view as a relatively resilient source of foreign exchange inflows.
Combining the scores for individual factors provides an indicative rating range. While the information used to determine the grid mapping is mainly historical, our ratings incorporate expectations around future metrics and risk developments that may differ from the ones implied by the rating range. Thus, the rating process is deliberative and not mechanical, meaning that it depends on peer comparisons and should leave room for exceptional risk factors to be taken into account that may result in an assigned rating outside the indicative rating range.
This section compares credit relevant information regarding Georgia with other sovereigns that we rate. It focuses on a comparison with sovereigns within the same rating range and shows the relevant credit metrics and factor scores.
Georgia’s “High (-)” institutional strength sets it apart in its peer group, exceeding the Ba2 median of “Moderate (-)” and ranking above all immediate peers, except Croatia. This strength compensates for Georgia’s somewhat elevated susceptibility to event risk, assessed at “Moderate,” which stems primarily from banking system vulnerabilities. Taking into account the high degree of diversification for its size, Georgia’s economic strength is comparable to peers. Lastly, owing to a lower debt burden and concessional terms of financing, fiscal strength is somewhat stronger in Georgia than in its closest peers.