In this paper we offer for discussion some Georgian economy related, technical issues/problems for the improvement of its competitiveness. Transparency International’s Corruption Perceptions Index 2010 (a measure of domestic, public sector corruption) released on October 26, 2010 ranks Georgia 68th (66th in 2009) out of 178 countries.
According to the report areas of concern in Georgia remain the urgent need for judicial reform, protection of property rights, a lack of transparency in public spending (including the Reserve Funds for the President, the Mayor of Tbilisi and the Government), grand corruption among top-level officials, opaque media ownership and financing, as well as a general low level of civil society involvement in the planning and execution of public policy. We think that to these issues monopolization of various sectors of the economy and import of certain goods (based on anecdotal examples) to the country by few entities should be added.
1. Agriculture
1.1. Georgia vs. Brazil.
1.1.1. Georgia. The Nominal GDP from the agriculture sector increased from 1,396.1 million GEL (673.7 million USD) in 2001 up to 1,488.4 million GEL (891.0 million USD) in 2009, i.e. 92.3 million GEL or a 6.6% increase in eight years (while Georgia’s nominal GDP increased by 170.0% from 6,648 to 17,949 million GEL for the same period). But we think that if we take into account GDP deflators for the sector (unfortunately, GDP deflators are available only for the whole economy and not for the agriculture sector) during these years, the real GDP from the agriculture sector actually declined from 2001 to 2009 (if we use the GDP deflator for the whole economy in these calculations, we will see that the real GDP from the agricultural sector declined by 35% from 2001 to 2009).
At the same time the percentage of people employed in the agriculture sector has remained almost constant during these years and made up 53.4% of all the working force in 2008. Taking everything above into account we can say that the level of life of these people has not improved at all.
The number of registered companies from the agriculture sector was 1.6% of all registered companies in Georgia and these registered companies from the agriculture sector were receiving the same 1.6% loans (worth 49.6 million GEL) of all loans disbursed to all legal entities (3,034 million GEL) by commercial banks as of May 1, 2009 (Bulletin of Monetary and Banking Statistics, April, 2009, table 3.10). From this we can conclude that a great majority of the 53.4% (of the working force) of people (who are not owners of or are not employed by these companies) employed in the agriculture sector, for example micro and subsistence farmers who usually are not registered as legal entities (and do not pay any tax except tax on land), are not receiving any loans from the banking sector.
1.1.2. Brazil. In less than 30 years Brazil has turned itself from a food importer into one of the world’s great breadbaskets (the first country to have caught up with America, Canada, Australia, Argentina and the EU, the traditional “big five” grain exporters). Between 1996 and 2006 the total value of the country’s crops rose from 23 billion BRL (23 billion USD) to 108 billion BRL, or 365%. Brazil increased its beef exports tenfold in a decade. It is also the world’s largest exporter of poultry, sugar cane, orange juice, tobacco and ethanol. Since 1990 its soya bean output has raised from barely 15m tones to over 60m and Brazil accounts now for about a third of world soya bean exports, second only to America.
Several years ago, driven partly by fear that it would not be able to import enough food, Brazil decided to expand domestic production through scientific research (several years ago Brazil sent 1,200 young Brazilian graduates abroad to obtain further qualifications. When they came back, they adapted plant and animal varieties so that they could thrive in the tropics and especially in the acid soil of the cerrado, the vast, largely flat savannah of the interior. This green revolution hugely increased productivity: over the past 30 years only 20% more land has come into agricultural use but production has risen by 150%), not subsidies. Instead of trying to protect farmers from international competition-as much of the world still does-it opened up to trade and let inefficient farms go to the wall (at that time most of the country was regarded as unfit for agricultural production).
Brazil’s progress has been underpinned by Embrapa, the state agricultural-research company (e.g. running the world’s only laboratory deploying nanotechnology for agriculture and breeding new cattle and seeds, creating plant varieties that absorb fertilizer more efficiently), and pushed forward by GM crops; capital-intensive large farms; openness to trade and new farming techniques. Brazil represents a clear alternative to the growing belief that, in farming, small and organic are beautiful.
1.2. Issues/Questions.
1.2.1. Can the Brazil model be used for Georgia’s agriculture sector development? For example, will GM foods’ development not create serious problems here?
1.2.2. Leasing. Farmers and rural enterprises are particularly constrained by a lack of assets that can be used as collateral for loans from commercial banks. Leasing overcomes this constraint because it requires no collateral or less collateral than typically required by banks for loans. Because leases also often require lower down payments than the equity required for loans, they are more affordable for rural enterprises that have limited funds and little access to borrowed funds.
Can leasing substantially improve access to finance for rural areas? What hinders the development of leasing in Georgia? (as we were told the total assets of the three existing leasing companies here is about 30 million GEL or 0.3% of the total assets of the banking sector). For example, some problems faced by leasing companies are: their bad leases cannot be written down (i.e. tax deductibility) as easily (long court processes with substantial expenses are required) as bad loans of commercial banks (but microfinance institutions face the same problems and despite this they are developing much better than leasing companies); As opposed to commercial banks and microfinance institutions, which are regulated by the National bank of Georgia (prudential and non-prudential regulation, respectively), leasing companies are not regulated by any institution. Does this difference create a trust and credibility problem for potential investors in leasing companies, especially, for foreign ones?
1.2.3. Insurance. Index-based insurance schemes have been implemented on a pilot basis in several countries. Such schemes use an easily observable index (of a natural event known to cause losses, such as excess rain, high river levels or extreme sea surface temperatures) that is not subject to tempering. The index is correlated with the underlying risk and used to make decisions on insurance payouts, thus eliminating the cost of verification as well as incentives to misrepresent losses. For example, a) an ongoing pilot project in Peru insures firms (such as microfinance institutions or firms in the value chain) serving smallholder households. The insurance pays out based on extreme El Nino events that create catastrophic flooding resulting in significant consequential losses and extra costs for a wide range of stakeholders in northern Peru (Overview, Innovations in Rural and Agriculture Finance, Renate Kloeppinger-Todd and Manohar Sharma, July, 2010); b) a pilot project in India, set up by the microfinance institution BASIX and a commercial insurer with the help of the World Bank, has been providing weather insurance for small farmers to improve their access to credit. The microinsurance scheme is based on a rainfall index. Payments are based not on individual loss adjustments-a costly undertaking not feasible in microinsurance-but rather on whether rainfall measured at a local weather station reaches a certain threshold. The insurance contracts are linked to credit because the insurance secures repayment of the loans (Microinsurance Innovations in Rural Finance, Innovations in Rural and Agriculture Finance, Martina Wiedmaier-Pfister and Brigite Klein, July, 2010).
Can such an instrument be developed here? For example, against hail in Kakheti? We would like to note here that as we learned just a few days ago (www.commersant.ge, October 27, 2010) insurance company Ardi Group created a product for wheat crop insurance.
1.2.4. Forward Contracts. Can use of forward contract for sales of agricultural products not be developed here? (over the counter derivatives in the form of forward sales of agricultural goods date back to the 15th century, and perhaps earlier, as the first options trade is attributed to the Greek philosopher Thales circa 600 B.C.) What are problems? Contracts’ enforcement? What else?
1.2.5. Market Access. In Bangladesh CellBazaar provides to the 20m subscribers to Bangladesh’s GrameenPhone with a virtual marketplace where they can sell things as humble as sacks of potatoes (Emerging Markets are Teaming with Young Entrepreneurs, the Economist, October 7, 2010).
1.2.6. The following is an extract about the American economy from the Economist (Traditional Listed Companies are Facing Competition, August 19, 2010): “Private partnerships … also escape from the double taxation that plagues the corporate sector: corporations have to pay corporate taxes and then their shareholders have to pay taxes on their dividends.”
Does Georgia’s company law (i.e. Law on Entrepreneurs) allow such legal status? If not, should it not be promoted (to be introduced) for companies involved in primary agriculture?
1.2.7. According to a draft Tax Code:
a) Article 83.1.k. Up to January 1, 2012 from income tax are exempted income of a physical person from primary agriculture activities, also remuneration of persons hired by him if annual consolidated income of this person does not exceed 100,000 GEL.
b) Article 100.f. Up to January 1, 2012 from profit tax is exempted the part of the profit, received from agriculture sector activities, invested in the same sector.
Based on the above provided problems in the agriculture sector and on the consideration that taxation has to be used as a lever to promote job creation in the agriculture sector (e.g. FDI in the agriculture sector is 0.7 of the total FDI during 2007-2009) we think that the exemption date in the above two articles (i.e. for primary agriculture) should be extended for several additional years (at least to the date when the sector starts growing).
2. High Energy and electricity intensity
According to Nodar Khaduri (Competitiveness of Georgia: Analysis and Perspectives, PMCG Group, July 8, 2010) Georgia’s energy intensity rate (the share of energy resources in the cost of production) exceeds that of Armenia, Lithuania, Latvia, Turkey. It is 2 times more than the world average indicator, about 1.6 times more than the Europe average indicator, 4 times more than Germany, 6 times more than Japan, 2 times more than the USA average indicator. As for Georgia’s electricity intensity, it is 3 times more than Turkey’s. 3.5 times more than the USA’s, 5 times more than the UK’s and 3 times more than the world average indicator. (Source: International Energy Agency (IEA) (Statistics, 2008).
According to www.commersant.ge (October 15, 2010) the price for 1 cubic meter of natural gas is the equivalent of 4,25 and 0.33 GEL in Russia, Azerbaijan and Armenia, respectively while Georgians pay 0.55 GEL.
Issues/Questions. We think that the Georgian Government and/or donors should investigate this issue and if data provided in the report is correct devise ways how to reduce these costs to the world average numbers and as a result to improve the competitiveness of Georgian companies.
3. Research and Development (R&D)
The above provided impressive record of Brazil’s agriculture innovation is based on substantial investment in R&D. “Unfortunately there is little of this kind of innovation in other parts of Latin America’s economies. Latin American firms invest only 0.5% of gross revenues in research and development, compared with the 2% spent by companies in the rich world” (A special report on Latin America. Commodities alone are not enough to sustain flourishing economies, the Economist, September 9, 2010).
In September, 2010 Mr Obama unveiled a trio of economic proposals (see: Barack Obama’s economic proposals, the Economist, September 9, 2010). One of these proposals would make a tax credit for research and development permanent (the credit expired last year). Mr Obama now also proposes to make it slightly more generous, raising it from 14 cents to 17 cents per USD of qualifying R&D.
Issues/Questions. I do not think that Georgia has any data on R&D spending. Should a similar to USA legislation be introduced (I think that we do not have it) to promote innovation?
4. Investment
Mr. Obama’s other proposal would let businesses deduct the full cost of investment against their taxes next year instead of over three or more years. This would encourage them to bring forward their investment plans to 2011. In USA the impact of this proposal is debatable because of low interest rates (which diminish the value of an early tax refund) and the fact that businesses are much more worried about weak demand than their cost of capital. Still, Kevin Hassett, an economist at the conservative American Enterprise Institute, thinks this could boost investment by 5% to 10% (Barack Obama’s economic proposals, the Economist, September 9, 2010).
Issues/Questions. Should such a proposal be considered for Georgia taking into account, for example, that interest rates in Georgia are very high, much higher than in the USA and therefore it is going to be more attractive for Georgian companies (than USA ones) and can bring forward their investment plans? Can increase FDI?
5. Debt Market and Institutional Investors
5.1. Government Securities. Georgia’s 2010 fiscal deficit target is reduced from 7.4% of GDP to 6.3% (the fiscal deficit was 9.2% in 2009). The bulk of this year’s deficit financing will come from external sources (e.g. IMF, the World Bank And Asian Development Bank). From the internal financing, treasury bills are the main source, though net borrowings will be cut to 100 million GEL in 2010 from 260 million GEL in 2009 to prevent crowding our private investments (but for October 20, 2010 government gross 2010 borrowing, through treasury bills and notes, with maximum two year maturities, made 502 million GEL (the National Bank of Georgia (http://www.nbg.gov.ge/index.php?m=306, Treasury Bills and Treasury Notes Auctions). It results in much more than 100 million GEL net borrowing in 2010). Privatization revenues no longer play a significant role in deficit financing as the country’s privatization programme has nearly been completed (BG Capital, Georgian Economy Bridging the Gap, September 16, 2010).
Since government securities are the main internal instrument for financing fiscal deficits, the Government should gradually lengthen their maturities and increase net yearly borrowings (as donors’ support will be reduced in the following years). We think that to succeed here it is necessary for the Georgian Government to take care of the development needs of such institutional investors which are an important source for long-term finance, e.g. pension funds, insurance companies and investment funds, and which cannot today play any significant related role in Georgia. Without development of these institutions, we are afraid that increasing net borrowings and lengthening maturities will substantially increase the Government’s borrowing costs which are very high even now. For example, at the October 6, 2010 auction, to borrow 10 million GEL for 336 days through treasury bills, the weighted average discount rate reached 14.23% (and according to the auction held on October 8, 2010, the Georgian Government will pay 15.6% for borrowing 20 million GEL for 731 days through treasury notes).
A good, related, example is provided by developing countries in Latin America and Asia (Emerging-market debt, the Economist, August 26, 2010) which can borrow in local currency at much better terms (e.g. earlier this year Peru was able to issue 300 million PEN (105.2 million USD) of 32-year local-currency bonds with yields of just 6.9%).
5.2. Corporate Debt Market. Corporate fixed-income securities markets have become an increasingly important source of financing for the private sector in recent years in many countries, especially for some emerging market countries. Previously, corporate borrowing had centred around the banking sector in many countries. However, the advent of several banking crises (e.g. the Asian financial crisis) in some of these countries has led to the realization that the sources of corporate borrowing need to be diversified. Unfortunately, to date, the corporate fixed-income securities market in Georgia remains largely underdeveloped, with a limited supply of quality issues and inadequate market infrastructure (in the history of Georgia there were only few cases of bonds issuance by Procredit Bank; Bank of Georgia; Arsi (guaranteed by Bank of Georgia), a construction company; Georgian Credit, an MFI, and Elit Electronics to the total amount of about 20 million GEL).
For example, the development of the mortgage securities market will allow Georgian banks to leverage their existing or incoming resources (according to BG Capital (Georgian Economy Bridging the Gap, September 16, 2010) Georgia’s banking sector has one of the lowest penetration ratios among CEE countries (assets-to-GDP and loans-to-GDP ratios of 44% and 28%, respectively, in 2009) and will ease access to mortgage loans for many Georgians. But for the development of mortgage securities’ market the issues which created problems in developed countries should be taken into account. In this regard an interesting example is Denmark with its two specific characteristics (Denmark’s mortgage banks are continuing to sell bonds and issue mortgages at a pace similar to that before the credit crisis (A Slice of Danish, the Economist, December 30, 2008). The first is that a financial institution issuing mortgage bonds remains responsible for making payments on them. This avoids encouraging lax lending (a flaw of America’s market), a result of a broken link between those who sell mortgages and those who bear the risk of default. The second characteristic of Denmark’s market is that mortgage holders can buy the bonds and use them to redeem their mortgages. This is useful when interest rate increase (or house prices fall) results in trading of mortgage-backed bonds at a discount (in the USA there is no mechanism to do so).
5.3. Institutional Investors. A growing proportion of savings in the industrialized countries are being channelled through institutions such as investment banks, life insurance companies, pension funds and mutual funds, rather than being invested independently by small savers. The existence of properly functioning non-bank financial institutions will improve the allocation of financial resources, improve the terms of resources provided and increase the volume of domestic resources mobilized.
We think that the weakness of local institutional investors in Georgia is considerably the result of existing legislation. For example, the pension reforms in Poland (a less stringent variation of Chile’s successfully implemented pension system) allowed workers to divert 9% social security taxes to personal retirement accounts, by the worker’s choice of private investment managers (Chile instituted a system of mandatory, private retirement savings. Workers pay 10% of their monthly wages to an individual investment account and they no longer pay social security taxes to the government).
Thus, in Chile social security taxes were replaced by mandatory private retirement savings, while in Poland it was allowed to replace a part of social security taxes with private retirement savings.
In Georgia social security payments were abolished, but this step was not linked with private retirement contributions, i.e. if now workers want to contribute to the private retirement saving schemes they must do it from their net salaries.
5.4. Issues/Questions.
5.4.1. According to the new Tax Code the income tax is going to be reduced gradually from 20% to 15% during the next few years, starting from 2013. We think that it would be much better for the country’s future development if the reduction of income tax on salaries would have been linked with private retirement accounts, i.e. the amount by which income tax is reduced would have been transferred to the private retirement accounts.
Can tax credit for enterprises contributing to their employees’ retirement accounts be considered an option here?
5.4.2. There is no proper legislation on collective investment schemes/investment funds in Georgia.
5.4.3. There are many questions related to the activities of non-bank financial institutions (e.g. should regulation of insurance companies not be improved substantially?). Therefore we think that an assessment of the non bank financial sector is needed.
6. VAT Fraud
Georgian tax authorities withheld VAT repayments to many businesses (for example, according to Georgia Sector Competitiveness Overview, IFC, June, 2009, p. 19: “there is a widespread perception that the tax authorities are overly aggressive in levying taxes and penalties on those companies that are doing their best to comply; and they are overly slow in processing appeals or reimbursing VAT) and we think that such actions hinder the development of many of them.
Are tax authorities withholding VAT repayments to avoid many different forms of VAT fraud? Including “missing trader” (i.e. an entity which charges VAT on the sale of goods, and then instead of paying this to the Government it disappears together the VAT amount) and “carousel” (it works especially well in countries where it is quick and easy to set up new companies) frauds? For example, according to the: a) British Institute for Fiscal Studies (EU VAT fraud part 3, Richard Baldwin, VOX, June 17, 2007) reports that VAT fraud cost the Exchequer 12.4 billion GBP in the 2005-2006 fiscal year (14.5% of the potential VAT take) and b) BBC, “So-called missing trader or carousel fraud is estimated to cost European taxpayers up to 170 billion GBP a year – twice the European Union’s annual budget” (Wikipedia, Missing trader fraud).
Issues/Questions. Are VAT related frauds serious problem for Georgia? Or are these frauds not causing serious problems in small countries like Georgia (where people know each other well)? Should not the issue of withholding VAT repayments be addressed, especially if we take into account how expensive it is to borrow in Georgia?
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