Economic Slowdown
Pre-War Situation
In the last three years (2005-2007), the Georgian economy has experienced a dynamic development with an average real GDP growth rate exceeding 10 percent. The projection for 2008 was some 9 percent. The strong economic growth was mainly driven by private capital inflows from abroad (direct foreign investments plus bank credits). Official data, which is confirmed by the IMF, indicates that these inflows increased by 4.6 times in 2004-2007 to USD 2.3 billion (or 22.5 percent of the GDP).
A Risk of Deep Recession
As a result of the military actions and the Russian occupation, significant damage was caused to almost all sectors of the Georgian economy with agriculture, transport, tourism, trade, construction and financial intermediation being particularly hard hit. Actual losses in these sectors were topped up by an abrupt worsening of the investment climate which resulted in a cutback of foreign capital inflows. According to official estimates (also confirmed by the IMF), the volume of these inflows experienced a shrinkage from USD 1.5 billion in the first half of 2008 to USD 0.5 billion in the second half of the year which suggested a slowdown in the GDP growth rate from the estimated 9 percent to 3.5 percent this year. With the restoration of the investment inflow in 2009-2010, the Government and the IMF predict an acceleration of the economic growth rate by 4 percent and 6 percent, respectively. Under the considerable international financial assistance framework, more optimistic estimates suggest an actual GDP growth rate of approximately 5 percent this year and correspondingly increasing to 6-7 percent in the years to come.
What to Do?
To have a less painful recession scenario materialised, the incoming international financial assistance and, particularly, its grant component which goes directly to the budget, should be used as much as possible to stimulate domestic demand. Received funds should be strictly targeted not only towards the restoration of destroyed public infrastructure and the resettlement of IDPs but also to the rehabilitation of the agricultural, transport, energy, tourism and utilities sectors. It is crucial that the spending of these funds has a high multiplier effect. At the same time, a mass monetisation of the aid to victims (IDPs) should be avoided as it may trigger inflation pressure.
To regain pre-war economic growth rates, intense FDI inflows should resume in the shortest possible time. Since it is not easy to revive the confidence of investors, especially under the global financial crisis, the country should apply the existent political risk insurance mechanisms. It seems expedient to use the insurance capacities of governmental agencies of particular countries supporting overseas private investments (the OPIC in the US, for example). This aspect, however, is not adequately considered in the current scheme of international financial assistance even though similar agencies operate in almost every key donor country.
Against the background of a global flight from risky assets, we deem it necessary to apply extraordinary methods for the attraction of new investors. In this regard it seems reasonable to grant them some of those privileges, including tax breaks which can be enjoyed only by the investors operating under effective legislation in the free industrial zone, for a certain period and throughout the country. Moreover, special benefits should be offered to those investors who would invest their capital into export-oriented industries and create new jobs.
To support economic activity, the credit operations of commercial banks should be urgently restored by an optimal combination of efforts of the National Bank, on the one hand, and international financial institutions (EBRD, IFC and etc.), on the other. In particular, the NBG should use its refinancing instruments to shore up a short-term (up to one year) liquidity of commercial banks whereas credit resources of the international financial institutions should serve the financing of long-term loans of the banks and thus help stabilise their interest rates and increase crediting.
To provide more effective support to the agricultural sector and the food processing industry as well as local tourist infrastructure, it is expedient to replace a “cheap credit” programme with the interest rate subsidy programme under which commercial banks themselves will evaluate the commercial viability of submitted projects upon the basis of clearly defined priorities. Moreover, given the new realities, the financing of the interest rate subsidy fund should be much larger than that of the “cheap credit” programme.
To somewhat neutralise the serious financial problems having emerged in the construction sector, the capacities of larger construction companies should be extensively used in the restoration of destroyed infrastructure and the resettlement of IDPs whilst the work performed by them be instantly financed and thus enable these companies to timely service or restructure their debts to banks.
Current Account Deficit and Devaluation of GEL
Pre-War Situation
Over the past three years (2005-2007), the current account deficit of Georgia has increased by 2.8 times and exceeded USD 2 billion (19.7 percent of GDP). This development was largely attributed to a sharp increase in imports which have more than doubled over the same period. The rapid growth of imports was the result of a consumption boom which was mainly financed from cheaper and long-term credit resources attracted by banks from abroad. The current account deficit was covered through private capital inflows, primarily FDIs. A pre-war balance of payments, therefore, revealed no gap and the exchange rate remained stable.
Balance of Payments Gap
Neither the Government of Georgia nor the IMF expects any serious deterioration of the current account balance following the August events. On the contrary, they predict a rather significant improvement in 2009-2010 [2, p. 54]. Following an unprecedented high level of the current account deficit in the first half of 2008, it will indeed notably decrease owing to an essential drop in imports financed from foreign investments and bank credits.
The current account balance, however, is not likely to improve significantly in the medium-term perspective. First, the economy cannot be rehabilitated and effectively reconstructed without wide-scale imports. Second, given the existing situation (shortage of investments and credits) and the global economic slowdown, the prospects of Georgian exports look rather vague. Third, Russia may possibly block remittances to Georgia which have already notably decreased since August. Under the global financial crisis, one cannot rule out the drop in remittances from other countries as well. Given the above, we may assume that the current account balance in the medium-term (until the end of 2010) will remain broadly at the 2007 level.
On the other hand, there is an apparent deterioration in Georgia’s investment climate which is already causing the suspension of some ongoing investment projects and the postponement of new ones for an indefinite period. This means that the source of financing of the current account deficit will significantly deplete. Even though the foreign financial assistance is expected to largely compensate this loss, it may still be insufficient to avoid a financial gap in the balance of payments. Such a perspective is also suggested by the IMF, especially for the period 2009-2010.
Abrupt Depreciation of the Lari
Against the background of a global financial crisis, donor assistance was not received in due time to meet the needs of a balance of payments which resulted in a strong outflow of foreign currency from the country. At first, the National Bank held back the exchange rate artificially but then allowed it to fall all at once on Friday, 7 November 2008. Moreover, the sudden devaluation of the national currency continued through that weekend when banks and the Interbank Currency Exchange were closed and thus left the market to Exchange Bureaus which easily adapted to stock-jobbing. Eventually, the national currency depreciated by almost 15 percent which was a shock that Georgian economic agents and households had not experienced for a long period of time. It is no wonder that the credibility which the national currency had gained over the years was strongly shaken and which will most likely result in extremely negative long-term effects.
Future Objectives
To prevent a balance of payment gap and further devaluation of the lari, a necessary first step is to work with donors in order to develop a mechanism of co-ordination of the incoming international financial assistance in the period 2008-2010 which would allow the Government of Georgia the opportunity to better adjust the financial inflows to cover the current account deficit.
With the exhaustion of international financial assistance, a longer-term sustainability of the balance of payments should be ensured with a substantial decrease in the current account deficit. To this end, the recovery of FDI inflows should be entirely connected with the faster development of the export sector of the Georgian economy. In the near future, foreign investors can be attracted, amongst other means, by the possibility of preferential trade with the US and the EU. Following the agreement on the enhancement of preferences reached with the US, it is crucial to extend the right to use the GSP+ with the EU which requires a timely fulfilment of obligations assumed by Georgia.
Real prospects for free trade agreements with the US and the EU may be of special interest for potential investors. The Government of Georgia should spare no efforts in finalising negotiations on the free trade with both parties by 2010. This will not be an easy task although agreements can be reached provided that Georgia’s trade-related legislation and regulatory practice are brought in line with those of the EU and the US. The Georgian side will probably find it difficult to share EU requirements as the regulatory framework of Georgia is based upon an ultraliberal version of the Anglo-Saxon economic pattern which significantly differs from the European system. Nevertheless, it is essential to post good progress in respective sectors (sanitary and phitosanitary controls, standards and technical regulations, customs procedures, public procurement and prudential regulation, etc.) which will inevitably fall under the future free trade agreements, already in 2009.
An optimal harmonisation of the use of granted trade preferences and foreign investments in the near future could be implemented through a so-called processing trade scheme where enterprises set up with foreign investments process raw material and semi-finished goods imported by the investors themselves for further export.
A full-scale application of preferential trade regimes is directly linked with overcoming non-tariff barriers which, in turn, depends upon the rapid development of a national quality infrastructure; namely, the recognition of European standards in agriculture and food processing, first of all, and the introduction of a civilised practice of export product certification.
The setting up of an exports financing fund will be an indispensible means of export promotion. It would provide financial support of guarantee and insurance service to Georgian exporters during the use of trade preferences. This could be accomplished with the support of international financing and donor institutes (EBRD, KfW, for example) and with minimal administrative costs.
In their country strategies for Georgia, international financial institutions and other donors (EBRD, IFC, ADB, etc.) should focus upon financing projects (including via Georgian banks) which will promote an export oriented production. At the same time, priority should be given to technological imports and the development of leasing rather than imports of long-term consumer goods.
Weakening of Stability of the Banking Sector
Pre-War Situation
The banking sector has been one of the most burgeoning sectors of the Georgian economy in the past three years (2005-2007) with its assets growing over this period by 60 percent and deposits by 55 percent on annual average. The total assets of the banking sector made up 43 percent of GDP in 2007 whereas it stood at 22 percent in 2005 and at a mere 15 percent in 2004. The above indicators clearly reflect the fact that Georgia has experienced a real credit boom in recent years which was marked with a higher growth of long-term loans as compared to that of short-term ones. Much of the long-term credits were put into three sectors: trade, industry and construction with the loans to trade notably exceeding the total amount of credits to the other two sectors. The credit boom and, in particular, long-term crediting, therefore, has served the financing of the imports rather than the development of real production.
The credit boom has been accompanied by increasing banking risks. A mass financing of an apparent mismatch between the maturity of deposits and credits with cheaper and long-term credit resources from abroad enhanced the liquidity risk. As the global financial crisis widened, Georgian banks failed to mobilise needed credit resources which, in the end, caused a sharp increase in credit rates. This was also conditioned by the inflation which was met by a significant increase in the base interest rate by the NBG. The rise of the interest rates was followed by the decline of the quality of the credit portfolio of banks. Construction and trade companies, for instance, experienced a notable drop in sales and, therefore, encountered serious financial problems. All of these factors have led to a notable break in the credit boom in Georgia.
Danger of Banking Crisis
Russia’s invasion complicated the existing situation in the banking sector straight away. Depositors rushed to banks to withdraw their money with more than 17 percent of domestic deposits having been taken out of the system. At the same time, banks’ credit portfolios worsened which was associated with the destruction of the civil infrastructure and the halt in economic activity in several regions of the country due to the military actions. Afterwards, the financial state of the construction and trade sectors deteriorated, translating into a significant increase of overdue loans to banks. As a result, a sharp liquidity deficit became apparent which came to be somewhat neutralised by refinancing operations and an essential downsizing by the NBG of the minimum reserve requirement to commercial banks. A significant decrease of the liquid assets ratio established for commercial banks also helped to temporarily defuse the situation.
Some alleviation in the liquidity deficit by the end of September, however, does not mean that the problem has been solved. It is true that banks have somehow managed to cope with their current liabilities but this situation is rather unlikely to be sustained as the banks still maintain very high credit rates and have minimised credit operations. To avoid a banking crisis, international financial institutions and donor countries have pledged almost USD 1 billion for the rehabilitation of the banking sector within the framework of a rescue package for Georgia. This assistance will be received by Georgian banks in the form of credit lines and guarantees as well as equity participation.
Urgent Measures
Given the special role of the banking sector in the reconstruction of the Georgian economy and the recovery of a high growth rate after the Russian invasion, it is an urgent task for the Government of Georgia, the NBG and the Financial Supervision Agency to draw up a detailed medium-term action plan for the rehabilitation of the banking sector in co-ordination with international financial institutions and other donors. To this end, the Financial Supervision Agency should perform an objective assessment of the quality of credit portfolio and liability structure of operational commercial banks in the shortest possible time together with an appropriate positioning of the banks which should be used as a basis for determining the expedience and size of the financial assistance to be given to each banking institution.
The feasibility of the action plan will much depend upon the development of relatively short-term (up to one year) refinancing instruments of commercial banks by the NBG and the introduction of such a rule for setting an interest rate on these instruments which would rely upon money market conditions. The refinancing should be provided to those banks which face only a current liquidity problem and will be able to continue a stable growth with the assistance of international financial institutions. At the same time, banks facing financial difficulties which cannot be overcome should be subject to strict requirements of recapitalisation implying either the attraction of additional investments or the merger with more stable banks.
Bearing in mind that the safety of the banking sector is primarily conditioned by macroeconomic determinants whilst a systemic management of bank liquidity is carried out by national (central) banks as the global financial crisis has shown, it is necessary to strengthen the institutional power of the NBG in the regulation of the banking and, in general, financial sector. In this regard, the signing of a memorandum of understanding between the NBG and the Financial Supervision Agency will not be enough. In addition, the Vice President of the NBG should also be represented ex-officio in the Agency’s Council along with the President of the NBG whilst at the same time the representatives of the Government should be legally excluded from the membership of the Council.
In order to prevent the resources of banking institutions from fragmentation and banks from sharing non-banking risks, the legislation should be amended to strip the banks of the right to participate, directly or indirectly, in the capital of (i) insurance companies, thus facilitating the development and further diversification of insurance business independently from banking and (ii) companies of non-financial sectors (trade, real estate, tourism, etc.).
To minimise the possible adverse effect of the deteriorating real estate market on banking institutions, it is expedient to start negotiations between banks and major construction companies on a reasonable restructuring of the companies’ debts to the banks and the resumption of financing of relatively promising projects through credit resources of international financial institutions. These negotiations should be held under the aegis of the Financial Supervision Agency.
To restore confidence to the banking sector, a deposit insurance system needs to be set up in the country in the near future which would ensure some protection of depositors’ interests in the case of banking institutions going bankrupt. A draft law on the insurance of deposits, which was drawn up by the NBG with the assistance of German experts, was at that time neglected. This draft law can be resubmitted to the Parliament for consideration after making some amendments therein.
Merab Kakulia,
\”Crisis in Georgia, 2008. Preconditions, Reality, Perspectives\”,
Independent Experts\’ Club
