The FINANCIAL — The International Monetary Fund will cut its forecast of 5% GDP growth in Georgia for 2015. The IMF supports the Georgian authorities’ decision to allow the Lari to float freely as it helps facilitate adjustment to external shocks and preserve Georgia’s external price competitiveness.
The IMF recommends the Government to accelerate the pace of structural reforms, while consulting—more broadly and on a timely basis—the civil society and the business community on key reform initiatives. Adjusting to external shocks and attracting investment and technologies to modernize the economy to take full advantage of the Association Agreement with the EU are the key challenges for Georgia in the coming period.
In his exclusive interview with The FINANCIAL, Azim Sadikov, IMF Resident Representative in Georgia, spoke about recent economic developments, external shocks affecting the Georgian economy, and causes and implications of the recent depreciation of the Lari.
Q. Depreciation of the national currency is currently the top issue in Georgia. We have heard a lot of criticism and accusations made against the Government’s policy and central bank. What is your position, was it possible to avoid such a dramatic devaluation of the GEL and if so, then how?
A. Let’s first look at the global and regional environment in which the Georgian economy is operating currently. It has been affected by two large external shocks: the sharp fall in oil prices, and the crisis in Russia and its impact on the region. As a fuel importer, Georgia is benefiting directly from lower oil prices as they reduce the country’s import bill. However, these gains are more than offset by losses from the deepening recession and sharp currency depreciation in Russia and its ripple effect through the region. Fortunes of Georgia’s many key trading partners, for example Armenia, are closely tied to Russia. The sharp decline in oil prices since last summer intensified the crisis in Russia and is also weighing down on other oil-dependent economies of the region such as Azerbaijan and Kazakhstan. These developments led to shortfalls in external inflows in Georgia, with exports and remittances dropping by 20-25 percent y-o-y in November and December.
The shortfalls in foreign exchange earnings led to pressures on the Lari. Because the external shocks are large and generally seen as persistent, depreciation of the Lari was unavoidable. It was justified as well because resisting depreciation under the current sustained external pressures would have been counterproductive. It might have worked only for a time being and would have cost Georgia its hard-earned foreign reserves. So, it was appropriate—and we are pleased—that the authorities allowed the Lari to float in line with the market realities.
There are ways other than intervention to limit depreciation. Pressures on the GEL could be reduced by sharply tightening monetary and fiscal policies. However, this can have serious ramifications for the real economy as tighter policies will likely cause severe slowdown or even a recession.
Q. What will be the impact of the depreciation of the GEL on the economy?
A. One observation to keep in mind when we discuss the exchange rate is that the Lari depreciated mainly to the US$. Over the last twelve months, the Lari has appreciated strongly to the Russian Ruble and the Ukrainian Hryvnia, has strengthened a bit to the Euro, and has been stable to the Turkish Lira and the Armenian Drahm. In fact, the Lari has strengthened over the last year against the currency basket comprising Georgia’s main trading partners.
Had the Lari not depreciated to the US$, it would have appreciated strongly against other currencies. This would hurt Georgian producers because Georgian goods and services would become expensive for foreigners while imports from neighbours would be cheap. So, the depreciation was desirable for the real economy under the current circumstances as it helped preserve the competitiveness of domestic producers. It also helped Georgia remain attractive for investors.
Inflation would be the immediate concern following depreciation because it raises import prices expressed in local currency. There are a number of factors to believe that a sharp and sustained rise in inflation is not a risk now in Georgia. First, as I already mentioned, the Lari did not depreciate against the currencies of countries where Georgian imports come from, like the EU, Turkey, and Russia. Second, oil and other global commodity prices have declined recently, helping keep inflationary pressures down. Third, inflation is currently at 1.4 percent y-o-y and, while it will likely pick up in coming months, the NBG’s inflation target for this year is 5 percent. That said, there are early signs that retailers, especially those with US$ loans and now facing higher debt service burden, are trying to raise their prices, and the natural gas provider announced plans to increase the gas price for legal entities.
The most painful impact so far has been on companies and households who earn income in Lari but borrowed in US$. Like many emerging economies, Georgia is highly dollarized. About 60 percent of all bank loans are in US$. Many companies have US$ loans, while, in the retail sector, more than 80 percent of the mortgages are in US$. These borrowers are now facing about 15-20 percent higher debt service burden in Lari than a year ago.
Q. It doesn’t seem fair to solely blame the customers and their lack of financial literacy, as don’t the commercial banks themselves not issue mortgage loans in the national currency?
A. There is no point of blaming anyone. Obviously, potential borrowers should be fully aware that, while foreign currency loans may carry lower interest rates, they expose borrowers to exchange rate risks. Banks should play an active role educating their clients about such risks: it is their social responsibility and ultimately in their commercial interest.
It is true that banks do not always offer mortgages in Lari. To a large extent, this stems from the lack of long-term Lari funds. The main reason for this is a low saving rate in Georgia, which leaves a very high current account deficit financed by foreigners who bring foreign currency funds. This is one of the reasons the authorities’ economic program supported by the IMF’s Stand-By Arrangement aims to reduce the current account deficit and to stimulate savings by supporting pension system reforms, developing capital markets, and introducing a deposit insurance scheme. These reforms will yield results gradually though. In the meantime, the NBG and the government together have implemented schemes to provide banks limited long-term Lari funding.
Q. Recently the President of the central bank stated that he will restrict the monetary policy. What will be the results of this “artificial respiration” for the national currency? (Some experts consider it pointless, stating that it will strengthen the GEL just for a short time and actually increase the level of unemployment)
A. We already spoke about the factors affecting inflation. I believe that if there are clear signs pointing to higher inflation in the near future (backed by rising inflation expectations), the authorities should consider tightening the monetary policy by raising the policy interest rate. However, given the balance of risks described earlier, such a move will need to be assessed carefully so that the tightening does not start prematurely.
Q. Reducing the country’s predicted 5% economic growth was another initiative of the President of NBG. Meanwhile the IMF predicted the economic growth of Georgia for 2014-15 to reach 5%. How reasonable is this initiative and will the IMF also revise its prediction?
A. We continuously monitor the Georgian economy and revise, when needed, our growth estimates. Projecting growth is difficult, especially under the current unpredictable external environment. That said, growth projections across the whole region have been slashed down considerably, in some countries by more than 3 percentage points. The Georgian economy does not operate in a vacuum and its performance will be adversely affected by what is happening elsewhere. What this means is that we will soon cut our growth forecast for Georgia too. We are waiting for data releases in coming weeks and will work together with the government and the NBG to arrive at a more realistic figure.
Q. What are your expectations of how far the GEL will depreciate?
A. The Lari is a floating currency. It can appreciate or depreciate reflecting market developments which in turn depends on so many factors. Where will the oil price settle this year? How soon can the tragic conflict in Ukraine be resolved? How will the recession in Russia develop? How will it affect the region? All of this is highly uncertain. As I explained earlier, the appropriate response is to let the Lari float and focus efforts on boosting exports, attracting tourists and foreign investment, and launching new projects.
This will be a challenging year for the whole region, but Georgia is arguably better positioned than many other countries.
Q. The IMF typically assists countries by providing financial assistance, advice and technical assistance. What is your main advice for the Georgian Government currently?
A. In terms of macro policy and this is where our expertise lies, we are pleased that the Lari is floating. As experience of other emerging countries shows, it is not easy to overcome the fear of floating. We therefore appreciate the resolve of the Georgian authorities, especially the NBG. A floating Lari is an achievement and shows the maturity of the central bank. Monetary policy is currently broadly appropriate, but of course the NBG should continue monitoring inflation developments and financial stability. If consumer loans continue growing very strongly this year as they did in 2014, thus raising concerns about their quality, there could be an argument for policies to curb their fast growth.
Georgia needs FDI to modernize its economy, to bring new technologies, capital, and know-how. Therefore, equally important to macro policies aimed at ensuring macro stability is to redouble efforts to attract investments and reform the economy. Reforms should aim at making Georgia a better place for doing business by strengthening property rights and improving the predictability of the regulatory environment. New initiatives need to be assessed based, among other things, on whether they help or hurt Georgia’s attractiveness to business and investment. Finally, Georgia’s long-term fortunes will be determined by the skills and the education of its youth. It is critical to invest in education and reform the sector so that Georgian kids receive high-quality education that they deserve.
Q. During previous years Georgia has been acquiring the image of a business-friendly country, attracting foreign investors. Some steps implemented by the new government (labour law, visa and migration policy, banning agro land acquisition) were negatively received by foreigners. What are the remaining competitive advantages that Georgia has for attracting foreign investors?
A. Georgia remains arguably the best place for doing business in the region. First, despite some shortcomings, it still has one of the most business-friendly regulatory frameworks. Of course, there is room to enhance it further. Georgia has an overall competitive tax regime, with few taxes with generally low rates. Second, Georgia has a strategic location as the only country in the Caucasus and the Central Asia with the access to the sea and thus global markets. The third advantage is the AA (and its DCFTA part) with the EU. Finally, the successful democratic peaceful transition that took place in 2012 is a plus for Georgia.
Q. Which countries should be targeted as sources of potential investors?
A. I do not think that there is a need to focus on any specific country. The key is to think how to put and keep Georgia on the map so that every potential investor knows that Georgia is a place that welcomes businesses and investment. This requires a concerted joint effort of the government and the Georgian business, but also continuous reforms to strengthen the business environment, improve infrastructure, and upgrade Georgia’s human capital.
If these efforts are successful, investments will surely come, even in periods of regional instability. Investors make their decisions based on long-term strategic planning and will not be deterred by a temporary turmoil if they see good long-term prospects for their investment.
Q. The U.S. has always supported Georgia with financial aid. Meanwhile the volume of FDI from the U.S. has always been small. What is the reason for that?
A. Indeed, the U.S. has been one of the biggest supporters of Georgia, providing large financial and technical assistance in many areas. Even then, FDI from the United States and also trade between the two countries have been relatively modest. The main reason for this is the long distance between the countries. The well-known, at least among economists, gravity model of trade and FDI shows that distance is one of the most important determinants of trade and FDI between two countries. However, I believe that this will gradually change as Georgia modernizes its economy, the region becomes more closely integrated, and the U.S. businesses find out more about Georgia and the region. The potential for more trade and investment between Georgia and the Unites States is huge.
Q. What kind of regulations does Georgia require to improve its economic environment?
A. In the short term, it is important to consult with the business community and the civil society before introducing regulations that could affect their operating environment. This is important for two reasons. First, businesses and the civil society may flag some unintended consequences of proposed initiatives which may not be obvious otherwise. Second, these consultations help build trust between the government and the private sector.
For the medium term, Georgia needs to continue working on the second generation economy-wide reforms, such as pension reforms, capital markets development, and a deposit insurance scheme. Sector reforms should aim at modernizing agriculture, the energy sector, and education to strengthen productivity and make Georgia more competitive.
Q. The country’s budget under the new government has been mostly focused on meeting social responsibilities. Do you think that under the current economic conditions it was a little bit early to carry such responsibilities?
A. I would argue the opposite. Georgia cannot afford to have high poverty and have most of its population without even basic health insurance. Thanks to impressive reforms in 2000s, the economy grew strongly over the last decade, but poverty remained high as dividends of this impressive growth were not shared more inclusively. Therefore, we supported the government’s objective to fight poverty, including by increasing social spending. We have advocated for more targeted increases in social programs, aimed at the most vulnerable, not given across the board to everyone.
The government increased social spending without raising the fiscal deficit. This was done largely by shifting resources from capital projects. While I see sometimes criticism of this strategy, we should keep in mind that not all capital spending is always productive and good.
Q. The growth of profit of Georgian commercial banks exceeds the growth of the economy. Do you agree that such a rapid expansion of commercial banks could be hampering the development of the economy?
A. On the contrary, the healthier the banking sector, the better it can serve the needs of the economy and help it grow. Compared to its peers, Georgia has more scope for further financial deepening which means that over the medium term banks here would be expected to grow faster than the economy. Many segments of the economy (especially SMEs and households) remain underbanked. As they start using banking services more fully, Georgian banks will keep growing, supporting along the way economic growth.
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