The FINANCIAL — The economic downturn in Georgia has turned out to be deeper than expected, International Monetary Fund said in its latest report prepared by the Middle East and Central Asia Department. “The reduction of policy interest rates and ample liquidity injections have not led to a resumption of bank lending, owing to balance sheet weaknesses and higher credit risk.
The financial sector has been resilient so far, but remains vulnerable to a deterioration in asset quality and continued uncertainty about the deposit base”, IMF suggests.
The fall in FDI, remittances, and exports has continued through the first half of 2009, leading to a significant reduction of employment and incomes. Real GDP growth projections for the year as a whole have been revised down to -4 percent. Reflecting the slowdown, inflation has fallen and the external current account deficit narrowed. Foreign exchange pressures have eased due to a decline in imports, limiting the need for central bank intervention in the market. The political situation remains uncertain, but internal tensions have abated.
IMF says reduction of policy interest rates and ample liquidity injections have not led to a resumption of bank lending, owing to balance sheet weaknesses and higher credit risk.
“The authorities have thus decided to accommodate tax revenue losses in a higher deficit in 2009. Significant fiscal adjustment will begin in 2010 to help preserve investor confidence and restore access to international capital markets ahead of the large repayment obligations coming due in 2013”,IMF believes.
IMF said external current account deficit has narrowed faster than expected, led by declining imports; but capital inflows have also fallen short of earlier projections.
“FDI––the main driver of economic activity in previous years––fell by about 70 percent in the first half of the year relative to the same period of 2008, while there was a net outflow in non-FDI private capital despite large injections from IFIs to commercial banks. The stabilization of the foreign exchange market, which coincided with the replacing of the daily fixing session with auctions, allowed the National Bank of Georgia (NBG) to acquire foreign exchange from the market in March and April and to limit its foreign exchange sales in May-June to $34 million compared with $130 million in January-February.
“Sales of foreign exchange in May-June were motivated in part by the desire to establish the credibility of the auctions with the market, even in the face of limited demand for foreign exchange. Since then, the amounts sold atauction have fallen to very low levels. Replenished by the $190 million SBA purchase of late March, gross official reserves stood at $1.5 billion (about 3 months of next year’s projected imports) as of mid-July. The competitiveness gain achieved by the lari devaluation of November 2008 has been partly eroded by devaluations in partner countries.
“Despite strict public expenditure control, spending reductions in the first half of 2009 were outpaced by the decline in tax revenues by a wide margin. Adjusted for oneoff effects, expenditure in the first two quarters was 11 percent lower (in nominal terms) than over the same period of 2008 owing to cuts in defense spending”, IMF reports.
“Notwithstanding policy loosening, monetary conditions remain very tight, with monetary and credit aggregates contracting through the first half of the year and real deposit interest rates rising to 8½ percent”.
“Despite stabilization in deposits and deposit dollarization since mid-May, banks have continued to curtail credit to preserve adequate liquidity buffers in the face of ongoing uncertainty and heightened credit risk. With increased credit risk, intermediation margins widened steadily through February 2009, but have since come down. The central bank’s refinancing rate has been lowered repeatedly, but with limited eligible collateral available for accessing this window, this has only led to a widening disconnect between market rates and the policy rate.
“With the help of external financial support, the financial sector has been able to weather pressures, but remains vulnerable to a deterioration in asset quality and continued uncertainty about the deposit base.
Capital and liquidity injections into the two largest banks allowed them to meet external payment obligations and improved solvency and liquidity indicators, but the share of nonperforming loans in total loans has risen by 15 percentage points since June 2008. So far, domestic currency loans have been disproportionately affected, but stress testing points to the vulnerability of the loan portfolio to further exchange rate depreciation. Faced with deposit outflows and little prospect for additional recapitalization in the short term, banks have continued to build up precautionary balances. Banks’ cautious attitude to lending has prudential benefits given very high loan-todeposit ratios, but is placing additional strains on the economy”, says IMF report.
“External and fiscal adjustment is not expected to be constrained by structural impediments. The return to viable fiscal and external positions over the medium term is driven by the expected gradual recovery of economic growth and private capital inflows, backed by fiscal adjustment measures. Georgia’s strong record of structural reforms should enable the economy to respond flexibly and favorably to renewed opportunities for growth. Accordingly, structural conditionality in the program is limited to fiscal and financial measures.
Based on a moderate recovery of activity, real GDP growth is projected at 2 percent in 2010. After a sizable expansion of government spending in the second half of 2009, the withdrawal of fiscal stimulus in 2010 is expected to dampen the impact of the gradual pickup of FDI and of resumed bank lending. Inflation is projected to edge up as growth resumes.
IMF says authorities expect real GDP growth to rise gradually over the medium term to 6-7 percent, but the staff’s medium-term scenario takes a more conservative view with growth trending at 5 percent over the medium term.
“The Georgian economy should be able to capitalize on a recovery of world growth, given its geographic location as a natural transit point of world trade in goods and energy, a very favorable business environment, flexible economic institutions, and a demonstrated capacity for timely policy action. The
difference in growth rate assumptions between the authorities and staff reflects simply different appreciations of this potential and the strength of the external environment. The staff’s scenario assumes some pickup of inflation, which at 5 percent would remain well below pre-crisis levels.”
“The deterioration in the external outlook and the need to maintain a larger reserve buffer give rise to an external financing gap in 2010-11. Much of the gap is closed by policy adjustment, notably a reduction of the fiscal deficit (excluding grants) of 2½ percentage points of GDP in 2010. The remaining gap (about $300 million in 2010, and $100 million in 2011) would be financed by the proposed augmentation of access under the SBA. As shown in the table and figures below, the financing gap stems from the downward revision of private and official capital inflows, and the need for a faster increase of gross international reserves. A higher reserve buffer is called for in the face of highly uncertain private financial flows and unclear prospects about regaining market access in the near future. These factors outweigh the impact of a downward revision in the current account deficit projections for 2010 and 2011.
“The balance of risks remains on the downside, particularly as regards the size of the GDP contraction in 2009, the timing and pace of the economic recovery, and the resumption of private capital inflows. Further declines in private capital inflows, exports, and remittances, as well as delays or shortfalls in official assistance, or prolonged domestic and regional political tensions could result in a deeper contraction than currently forecast. While foreign exchange pressures have eased recently, they could reemerge in the event of financing shortfalls, and the combined effect of output contraction and lari depreciation would have repercussions on the banking sector, which is exposed to highly-dollarized balance sheets of unhedged borrowers. Deteriorating bank asset quality could, in turn, damage depositor confidence, putting downward pressure on international reserves, and leading to more serious balance of payments and financial sector difficulties.
“The fiscal deficit is projected to increase from 5.6 percent of GDP (Second Review) to 9.4 percent, owing mainly to the downward revision in GDP growth.4 Spending is expected to remain unchanged compared with the second review projections despite the adoption in July of a supplementary budget, which increases spending authorization by 1½ percent of GDP (mostly in the areas of capital and social expenditures).
This is explained by anticipated underexecution of spending relative to the revised budget appropriations, and by the fact that spending was projected to be higher than that of the budget at the time of the second review.5 The authorities plan to contain overall spending by reallocating resources to social and capital spending from other less urgent needs. Thus, defense spending is expected to decline by 3½ percentage points of GDP relative to 2008, while social spending is projected to increase by 1 percentage point.6 Revenue targets would come under stress in the event of a larger GDP contraction this year, but the authorities could exercise even stronger expenditure restraint to meet the deficit target.
“The authorities’ medium-term fiscal adjustment strategy is heavily front loaded, and the 2010 budget now under preparation envisages sizeable expenditure cuts. With grants expected to fall by half, revenues are projected to decline by 2.8 percentage points of GDP in 2010.7 The fiscal deficit will however improve by
2 percentage points of GDP. As illustrated in the table below, non-interest expenditures (adjusted for one-off effects) are projected to decline by nearly 10 percent in real terms (and 4.3 percent in terms of GDP). Policy options include substantial real reductions in administrative costs across the board, with the exception of the ministries of health education and agriculture, cuts in subsidies to semi-public institutions, capping the wage bill in real terms, reduction in cofinancing of investment projects, and cuts to the investment budget connected to the winding down of large infrastructure projects now under way (mainly roadsand public buildings).
“Fiscal deficits in the second semester of 2009 and in 2010 will be financed by a mix of T-bill issuance,
privatization receipts, and external budget support. Part of the balance of payments support provided by the IMF in 2009 ($100 million) will be channeled to the budget, including the 2009 financing that was treated as precautionary in the second review. In 2010, all of the IMF financing is provisionally channeled to the budget pending confirmation of the amount of budget support that is in the pipeline from other IFIs.
Beyond 2010, the adjustment strategy will continue to rely on expenditure containment. If needed, the authorities would be ready to contemplate revenue measures to reach their medium-term deficit targets, but their priority remains on broadening the tax base while further reducing income tax rates once conditions permit. Under the authorities’ scenario, current expenditures would decline by 3 percent in real terms from 2010 to 2013, and capital spending by 12 percent, reflecting the winding down of externally financed large
scale projects initiated in the wake of the 2008 conflict, the impact of the economic recovery on the cost of social assistance, and potential cuts in military, administrative, and nonessential capital outlays. The fiscal deficit would decline steadily to 4 percent of GDP in 2012 and just under 3 percent in 2013. As a way of signaling their commitment, the authorities will include these medium-term fiscal targets in the 2010 budget document (October 1, 2009, structural benchmark). The strategy will be described in greater detail in the medium-term expenditure framework document, which the authorities plan to finalize by mid-2010.
The increase in public debt associated with the fiscal response to the 2008 armed conflict and subsequent economic crisis is sizable, but the authorities’ adjustment strategy helps allay debt sustainability concerns.
While economic recovery and an ambitious fiscal consolidation are expected to moderate solvency ratios in the medium-term, debt service obligations are very high in 2013-14. These reflect a $500 million Eurobond
maturing in 2013 and repurchase obligations to the Fund, which peak in 2013. Debt sustainability issues would become more pressing in the event of a deeper and more prolonged economic downturn, if government support of the financial sector became necessary, or if normal access to international capital markets could not be restored by 2012.
Debt Analysis
While the economic crisis and the government’s fiscal response is leading to a sharp deterioration in public sector’s indebtedness, solvency ratios do not raise immediate concerns. However, large risks stem from the bunching of external repayments in 2013-14, with public external debt service amounting to 25½ percent of exports in 2013. Staff assesses the risk of debt distress as moderate.
From 2004 through mid-2008, Georgia’s private external debt increased rapidly, while public debt fell to low levels. This reflected a sharp increase in capital inflows, including loans and deposits from abroad, and a shift away from official to private forms of external financing. By mid-2008, private and public external debt both amounted to 20 percent of GDP.
The August conflict and the global financial crisis changed radically the debt dynamics. Private inflows dried up as banks lost access to capital markets, but large fiscal and balance of payments needs, including banks’ repayment obligations, were addressed by loans and grants from donors, who committed $4.5 billion of external assistance over 2008–10 at the October 2008 Brussels conference. At end-June 2009, the stock of public external debt was slightly less than $3 billion, more than $500 million above the end-June 2008 level. Going forward, the fiscal impact of the crisis and the related policy response imply a further increase in public debt in the next two years. To allay debt sustainability concerns, the authorities intend to undertake strong fiscal adjustment during the program and in the medium term. The authorities’ medium-term framework envisages a reduction in fiscal deficit from 9.4 percent of GDP in 2009 to under 3 percent in 2013. As a result, after peaking at 47 percent of GDP in 2011, the public debt-to-GDP ratio is expected to decline gradually to 41 percent by the end of the projections. Key risks to the debt outlook arise from the bunching of debt service obligations in 2013–14.
Repurchases to the Fund are at their maximum in 2013, when the outstanding $500 Eurobond also matures. As a result, the external public debt service-to-exports ratio in 2013 is projected to exceed 25 percent, while external debt service obligations would amount to 46½ percent of exports, or about 100 percent of the projected end-2012 gross international reserves.
In an effort to encourage domestic currency lending, the NBG has introduced foreign exchange swaps. Commercial banks rely heavily on foreign currency funding. Swaps with the NBG are intended to allow banks that have access to foreign exchange liquidity to finance lari loans to borrowers whose unhedged position makes them unsuitable for dollar borrowing. The central bank has so far issued only a limited amount of swaps and intends to cap the total amount outstanding at GEL 60 million (roughly 3.5 percent of reserve money) to limit NBG’s contingent dollar liabilities and the risk that foreign exchange swaps will invite abuse and speculation.
Financial system vulnerabilities are being addressed by strengthening supervision. The authorities are acting on different fronts to improve supervision. The FSA and the NBG will be merged, creating a single supervisor for the whole financial system.
IMF says Georgian authorities are making good progress in the preparation of a contingency plan to safeguard the financial sector.
Capacity to Repay
With the requested augmentation of 180 percent of quota, at its peak, Georgia’s outstanding credit to the Fund would amount to 33 percent of exports or 58 percent of gross reserves. The risks are high in 2013, when both the peak repurchases to the Fund of about $425 million (9½ percent of exports) and the $500 million Eurobond-2013 (equivalent to 11 percent of exports) would come due. In that year, total external debt service and public external debt service are expected to exceed 45 percent and 25 percent of exports, respectively. To rollover the Eurobond, the government will need to regain the access to capital markets, which will rest critically on achieving a sustainable fiscal position by 2012.
On July 30, 2009 Georgian government sent letter to Mr. Dominique Strauss-Kahn, Managing Director, IMF describing the economic policies that Georgian government plans to implement during the rest of 2009 and in 2010. Letter of Intent was signed by Nika Gilauri, Prime Minister of Georgia, Kakha Baindurashvili, Minister of Finance and Giorgi Kadagidze, President of the National Bank of Georgia.
Authors wrote that lower commodity prices, a decline in the demand for the Georgian exports and a significant decline in private capital inflows were the main transmission channels through which the global crisis affected the Georgian economy.
“Growth in 2008 was a modest 2.1 percent, which reflects the consequences of Russia’s invasion of Georgia and the global economic crisis. In the first quarter of this year, the economy contracted by 5.9 percent. While the contraction affected most sectors of the economy, retail trade, manufacturing and construction contributed most to the decline.
“End-period inflation was 5.5 percent for 2008 and twelve-month inflation was only 2.3 percent as of end-June 2009. Year-on-year growth of reserve money and broad money aggregates has been negative since
November 2008.
“Fiscal performance has been adversely affected by the ongoing economic decline.
Tax collection in the first half of 2009 declined by 16.5 percent in nominal terms compared with the same period of last year (excluding one-off effects). Expenditure was contained at GEL 2,921million, or 11percent lower than the same period of last year 50 (excluding one-off effects). In all, the fiscal deficit reached 4.1 percent of projected annual GDP in the first half of the year, in line with program projections.
“Balance of payments data for the first quarter of 2009 show that exports and imports of goods and services declined by 23 percent and 29 percent, respectively, which reflects both a drop in commodity prices and lower domestic demand. Worker remittances dropped by 26 percent with the majority of decline accounted for by those from Russia. While narrowing, the current account deficit remains high at 17.6 percent of GDP for the first quarter of 2009. FDI inflows, one of the main sources of financing for the current account
deficit and a principal driver of economic growth, decline by more than 75 percent compared with the same period in 2008. Other capital inflows—mainly donor assistance–increased by 28 percent thereby partially offsetting the drop in private capital.
Macroeconomic Policies for 2009 and 2010
Georgian government assured that the major macroeconomic challenge continues to be the restoration of economic growth.
“This will, of course, require the resumption of private capital inflows and domestic lending in support of investment projects. At the same time, we recognize that many of the extraordinary actions undertaken in response to the economic crisis are not sustainable in the medium term. Hence, our efforts to enhance macroeconomic stability will concentrate on intensifying economic reforms, refining policy instruments and achieving a sustainable fiscal and external balance as quickly as possible”, wrote the head the government.
Gilauri notes that economic situation has been exacerbated by domestic political tensions with the result
that there was likely a further contraction of economic activity in the second quarter of this year.
“We continue to expect a modest recovery in the second half of the year, but it is difficult to assess the magnitude of any such recovery. So, while we envision a scenario whereby the contraction for the year as a whole could be only 1.5 percent, we are prepared for a larger contraction. Our projections and planning—and hence program targets—assume a contraction in real GDP of 4 percent this year”, he wrote.
“Beginning in 2010, we anticipate that economic recovery will strengthen and that our economy will again grow. An important source of this growth is expected to be a recovery in exports. Further, we anticipate a strong recovery in FDI beginning in 2010. As result, we project real GDP will increase by 2 percent next year, inflation is projected at around 3 percent and nominal GDP at GEL 19,042 million in 2010.
“The current account deficit for this year is expected to moderate to around 16 percent of GDP from a record high level of nearly 23 percent in 2008. Exports and imports of goods and services are projected to decline by 20 percent and 27 percent, respectively.
“Worker remittances are expected to drop by around 18 percent for the year. We project FDI inflows
in the amount of around US$ 900 million for 2009, which is 40 percent lower than in 2008 and deprives the economy of an important source of growth. Overall, we expect an accumulation of gross reserves in the amount of over US$230 million, assuming that all available purchases under the SBA are made.
“Our fiscal stance for the remainder of 2009 will continue to sustain demand through donor financed spending. While overall spending will be roughly in line with previous plans, the shortfall in revenue linked to the deterioration in economic activity will widen the fiscal deficit to 9.4 percent of GDP for the year”.
Government promised to continue to implementation of public finance reform program that includes
developing liquidity management guidelines, preparing the functional and technical specification for the PFMS, developing new format of the mediumterm framework (Basic Data and Directions) document, improving the format of local budgets, ensuring functionality of the risk assessment tax audit system, further streamlining tax and customs codes and developing necessary sub-legislation, establishing electronic information exchange system between banks and the Revenues Service, improving capital budget forms, establishing customs audit and progressing towards risk-based customs control, fostering full functionality of the electronic treasury system and inclusion of all taxes into the e-filing system.
“We envision that monetary policy will remain strongly expansionary in 2009 The early experience with foreign currency swaps suggests that they have eased credit conditions without adversely affecting the foreign exchange market, but we will limit the use of this instrument to limit liquidity injections. Most of the liquidity injections this year will come from external financing of the budget. Using a combination of swaps, sales of certificates of
“We are confident that the NBG has the necessary tools to adjust monetary conditions without rekindling inflationary pressures. We continue to project endperiod inflation to be 3.5 percent.
These projections are, of course, sensitive to assumptions regarding the money multiplier and, in turn, commercial bank lending to the private sector. We are confident, however, that should price pressure begin to develop late this year or early next year, that the NBG has the necessary tools to respond appropriately.
The outlook
In his statement Mr. Bakker says that export growth is expected to retrench somewhat further this year and import growth is likely to show a much steeper drop than earlier anticipated, mainly due to reduced domestic demand. As a result of these developments, the current account deficit is expected to decline this year by more than 6.5 percent.
“The ongoing global crisis, recent domestic political unrest, and the banks’ credit freeze are
weighing on economic activity”, says Bakker.
“Real GDP growth projections for 2009 have been revised downward by the authorities to -4 percent. While acknowledging that uncertainties are particularly large in these times, the authorities expect that a modest recovery will begin in the second half of this year, but that growth, at 2 percent, will remain subdued in 2010. Apart from a low base in the second half of 2008, this expectation reflects a normalization in the political situation, and the impact of the authorities’ countercyclical policies. Due to the wide output gap, CPI inflation is projected to remain low over the next year, in the range of 3-3.5 percent.
“The authorities’ main challenge remains the restoration of growth, while ensuring mediumterm
macroeconomic and external stability”.
“Low inflation and inflation expectations have provided room to the central bank for considerable monetary relaxation. However, as in many other countries, the effectiveness of the interest rate channel has been hampered by banks’ risk aversion and need to deleverage their balance sheets. To stimulate banks to lend in domestic currency, the authorities have recently introduced foreign currency swaps, which may entice banks that rely on foreign currency funding to provide loans to borrowers in domestic currency.
The fiscal deficits over 2009 and 2010 will be financed through a combination of external budget support, privatization receipts and the issuance of treasury bills.
For this year, the bulk of external support is coming from donors and IFIs on relatively favorable terms. The Fund is expected to cover about 9 percent of the financing in 2009. For next year, the Fund’s share is projected to be higher. However, the authorities expect additional budget support from the World Bank and ADB will be forthcoming in 2010. They agreed that once this financing has been formally secured, Fund support to the budget can be reduced accordingly.
Taking into account the stress tests results and the assurances from foreign shareholders, the authorities will submit a status report to staff by September on the required actions in case of problems at individual banks, Age Bakker reported.
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