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Georgian Economic

Trends Quarterly Review 2004 No. 4

The European Union, GEPLAC and Georgian Economic Trends

The relations of the European Union (EU) with the countries of Eastern Europe and Central Asia were underpinned in 1991 through a programme of technical assistance called Tacis. Since then these relations have deepened through political dialogue into a partnership resulting in greater cooperation towards common goals. In the case of Georgia, such cooperation is the subject of a Partnership and Cooperation Agreement with the EU which entered into force in July 1999. The Georgian – European Policy and Legal Advice Centre (GEPLAC) was first established in 1998 as a project under the Tacis programme. The current phase of the project is being implemented by Deutsche Gesellschaft fur Technische Zusammenarbeit (GTZ) GmbH. In addition to Georgian Economic Trends (GET) and the Georgian Law Review, GEPLAC is involved in the provision of economic policy and legal advice to the government of Georgia on both a programmed and ad hoc basis. While GET is produced with the financial assistance of the EU, the content is the sole responsibility of the authors and can in no way be taken to reflect the views of the EU.

GEORGIAN ECONOMIC TRENDS

GEORGIAN ECONOMIC TRENDS – 2004 No.4

Georgian Economic Trends (GET), a quarterly publication, aims to provide all those interested in the progress of economic reform in Georgia with a review of developments and transition. GET was established in 1995 and is published in Georgian and English. This and previous editions of GET are available on the internet at:

www.geplac.org The following people worked on this edition (in alphabetical order): George Eradze, David Gvenetadze, Mark Hudson, Natalia Kakabadze, Shota Keldishvili, Dimitri Kemoklidze, Gocha Kereselidze, Sophie Khmaladze Erekle Natadze, Veronica Schneider, Simon Stone, Irakli Tsereteli GET draws on information from a wide range of government and non-government sources including in particular the State Department for Statistics, the National Bank of Georgia, the United State Social Insurance Fund, the Ministry of Finance, the Ministry of Foreign Affairs, the Ministry of Economy, Industry and Trade, Department of Privatisation, the Ministry of Labour, Healthcare and Social Affairs as well as other Government ministries and departments. Wherever possible every care is taken to ensure that data sources are fully acknowledged since without the full co-operation and support of information providers, including regular consultation, it would not be possible to produce this review. The purpose of GET is to offer an independent analytical account of economic trends drawing on information made publicly available. As part of this work, commentary and advice are offered on policy and on the collection and dissemination of economic and other information. These are always intended to support the process of economic reform in Georgia, and also to relate this to the Partnership and Cooperation Agreement between Georgia and the European Union. However, they represent the view of the authors and editors only and do not represent any official view of the European Commission, the Georgian-European Policy and Legal Advice Centre or the Government of Georgia.

GET also publishes feature articles by outside contributors: academicians, government officials, members of parliament, independent scholars and researchers, etc. on economic issues of contemporary relevance in Georgia. Before being accepted for publication, all articles will be reviewed by members of GET Editorial Board that may also seek permission to edit such articles. Articles will be published only if they are deemed to be consistent with GET editorial policy. Contributors are requested to submit their papers either in English or in Georgian by e-mail as an attached Word file (Font: Arial, size 10 for English and AcadNusx, size 10 for Georgian) to Veronica Schneider, editor-in-chief at [email protected] or to deliver them as a Word file on a diskette to the address below. The ideas, opinions, findings, interpretations and conclusions contained in the feature articles are those of the author(s) only and do not necessarily coincide with those of GET Editorial Board, neither do they represent any official view of the European Commission, the Georgian-European Policy and Legal Advice Centre or the Government of Georgia. Readers may quote any information used provided it is properly acknowledged. For further information or comments please contact: Veronica Schneider Editor-in-Chief Georgian Economic Trends Georgian-European Policy and Legal Advice Centre (GEPLAC) 42, Kazbegi Ave, Tbilisi 380077 Tel: (995 32) 53 71 40 / 53 71 42 / 53 71 43 53 71 45 / 53 71 46 Fax: (995 32) 53 71 38 E-mail: [email protected] To subscribe to GET, please, send an e-mail or fax stating your contact details and language of the edition to the e-mail address/fax numbers above.

GEORGIAN ECONOMIC TRENDS

GEORGIAN ECONOMIC TRENDS – 2004 No.4 1

Contents

Foreword 3

Part I. Economic Trends 1. Summary 6

2. National Accounts and Main Trends 9

3. Government Finance 16

4. Money and Finance 22

5. International Trade and Foreign Economic Relations 32

6. Privatisation 40

7. Labour Market, Incomes and the Social Safety Net 46

8. The EU-Georgian Relations 56

Calendar of Events 65

Part II. Appendix: Feature Articles I. The Economic Growth Competitiveness and the Countries of Commonwealth

of Independent States 84 By Tengiz Lomitashvili, Student, Tbilisi State University, Economic Department

II. Comparative Analysis of Railway in Transition Economies, By Their Technical

Characteristics 96 By P. Tsagareishvili, Candidate of Technical Sciences,

G. Gvenetadze, Student, Tbilisi State University (Georgian Railway Marketing Service)

III. EU PCA and ENP Policies for Georgia: How Economic Integration with the

European Union May Ease the Reform Process and Economic Development

in Georgia 101 By Ivan Samson and Olena Vasylchenko

Part III. Statistical Appendix Statistical Appendix 117

Abbreviations 128

FOREWORD


Dear Reader Welcome to GET 2004/4, in which, as usual, GEPLAC is providing its own assessment of the current economic developments and main trends in Georgia. On the anniversary of the “Rose Revolution”, it is appropriate to examine briefly the progress made in the last year. We would say that a number of positive changes have taken place in Georgia, but much more can be achieved in future, if the right policies are implemented. The new Georgian authorities embarked on a very ambitious reform programme that includes the fiscal sphere, strengthening governance, addressing corruption and smuggling, and fostering economic growth and reduction of poverty, together with restoration of general public confidence. Improvement of revenue collection is the key achievement of the new Government. According to the Q1-Q3 performance data, the total tax revenues are 51 per cent higher compared to last year and even 5 per cent higher compared to the target for 2004. The increase of the tax revenues is preconditioned by changes in the financial policy, improvement of tax and customs administration and reforms in governance and anti-corruption measures. The Government of Georgia, with the help of the international donor community, has begun a major programme to streamline customs processes and eradicate the inefficiencies and malpractice that have so plagued this area. The major part of the reform of financial policy is the introduction of the new Tax Code which has been approved by the Parliament on December 22, 2004.. The new Tax Code is expected to become effective on 1 January 2005. In our discussions with other economists, policymakers in various fields, and a broad audience of interested parties, reform of the taxation system is seen as fundamental to the encouragement of business activity in Georgia. In the short term, as we have seen, the efforts to boost tax collection have created difficulties for the private sector. They have also contributed to the rise of the Lari, which was particularly sharp at certain points during the year, and a source of some difficulties in an economy which is still heavily dollarised. It is hoped that, in the longer term, a far reaching reform will not only ensure continued high levels of collection, but also create incentives for a strengthened culture of voluntary compliance with the law. Related to this, we should also mention (and this is also referenced in one of our later Chapters), the positive effects of re-establishment of central Government control over the region of Adjara. The Government’s prioritisation of this issue was, in our view always correct as both a political and economic consideration. At the same time, however, the problems of Georgia’s regions (not only Abkhazia and South Ossetia) remain, and it is here that a great deal needs to be done to alleviate poverty and the welfare consequences of this. In the

FOREWORD

4 GEORGIAN ECONOMIC TRENDS – 2004 No.4

absence of a universal social safety net, the actions of donors, with targeted initiatives, will be particularly important. Against this background, we come back once more to the question of how to regenerate economic life in Georgia, in a more direct way, which in turn leads us to consider issues of competitiveness. Our first external article in this edition is by Tengiz Lomitashvili, student, Tbilisi State University, Economic Department, and looks at a comparison of competitiveness among countries of the former Soviet Union. Such analysis is a kind of first step to a more focussed analysis of sectors which are the most likely to contribute to growth in the future. The approach of this article is close to one which GEPLAC is applying in its current Benchmarking activity. This is related to an aim of assessing Georgia’s progress under the Partnership and Cooperation Agreement with the EU (PCA) by means of quantitative measures and comparisons with other reforming countries. Such an exercise is a precursor to more specific policy advice activity that will be launched in the New Year. In talking, as we often do, about economic sectors, and an approach to industrial policy, GEPLAC is keen to avoid the suggestion that this is only the old process of “picking winners”. We prefer to call it “identifying winners” and this should be the approach of Government and donors alike. It means recognising real potential in both public and private enterprises, especially those which have a strong notion of what they want to do, rather than forcing development that may not have a true economic justification. Our second article examines the situation of Georgian Railways, which must be a key sector for a country seeking to develop its transit potential. This is written by Paata Tsagareishvili, Candidate of Technical Sciences, and Gogita Gvenetadze, student, Tbilisi State University. The transit theme is indeed important for Georgia, since its geographic location is one feature that definitely will not change – the issue is how to gain from this. The BTC pipeline, which will come on stream in the 2nd quarter 2005, is an obvious example of such benefit, with income to Georgia of approximately USD 50 million per year and substantial ongoing operational expenditure. Technical assistance (TA) is one of the components of PCA, being the source and consequence of modernisation of the Georgian economy, as well as political and social structures. For all donors, however, there are important issues to consider regarding the role of TA in an industrial policy. Clearly, when the economic base of Georgia is to be rebuilt, there should be a targeting of sectors and a relation to local welfare needs. However, we believe that the conditions should be created for specific sectors and enterprises to commence asking for TA themselves, based on the needs that they assess. The same applies at the national level, of course, and this is in the essence of the EU’s European Neighbourhood Policy (ENP), to which Georgia was admitted, along with Armenia and Azerbaijan, in June of this year. ENP encourages countries to commence identifying priorities for future TA and also relates these to political goals. The ENP, its importance and major goals are discussed in more detail in our third article by Ivan Samson and Olena

FOREWORD


Vasylchenko, economic researchers in the PEPSE laboratory at Grenoble UPMF University, France. Prof. Samson is also senior economist in the EU-Tacis project "Support to the PCA Implementation Process – SIPCA”, in Georgia. The article also contains an analysis of the general investment environment in Georgia, which is of course an important condition for the regeneration of the economy.

_______________

As ever, we hope you will find our journal of interest. At this particular time, we wish all our readers a Happy New Year and look forward to continuing progress in Georgia in 2005.

CHAPTER ONE: SUMMARY


NATIONAL ACCOUNTS AND MAIN TRENDS According to preliminary estimates of the State Department for Statistics (SDS), Georgia’s GDP in Q1-Q3 2004 was GEL 7,010.4 million (USD 3,609.6 million, i.e., USD 795.7 per capita). GDP growth rate in Q1-Q3 2004 was 8.4 per cent, compared with 8.6 per cent in the corresponding period of 2003. It is a very positive development in the Georgian economy that the high growth rate is continuing. The highest growth rates, as in previous quarters, were observed in the industry, construction, transport and telecommunication sectors. At the same time, not every sector of the Georgian economy grew in Q1-Q3 2004, particularly negative growth was observed in agriculture and domestic processing of products. The acceleration of economic growth resulted from expansion in industry, construction and services. Domestic demand together with the increased exports is still the main driving force of economic growth in Georgia. FOREIGN DEBT As of 30 September 2004, Georgia’s outstanding foreign debt, including state guaranteed debt, amounted to USD 1,801.8 million (GEL 3,315.2 million), that is 45.6 per cent of GDP in 2003. Compared with the previous quarter, the outstanding debt decreased by USD 19.8 million. On 21 July 2004, the creditors of the Paris Club and the Government of Georgia agreed on the rescheduling of foreign debt of Georgia. This agreement became possible only after the IMF approved a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) for Georgia that is designed to support ambitious plans of reforms in the country. BALANCE OF PAYMENTS Figures for the balance of payment for Q3 2004 were not available at the time when the current issue of GET was being written; Thus, in this issue of GET we will analyse the trends of H1 2004. The improvement of balance of payments is related to the increased balance of current account and to the increased balance of capital accounts. Though the balance of financial accounts has deteriorated, the overall balance of payments improved in H1 2004 compared with H1 2003. GOVERNMENT FINANCE According to the 2004 State Budget, total revenues at the end of Q3 were expected to reach GEL 1,076 million, that is 65 per cent of revenue expectations for the whole year. Actual state budget revenues were GEL 1,144 million, GEL 68 million higher than planned. Higher than expected tax revenues explains the main portion of the surplus. External grants and non-tax revenues also were received in excess of expected amounts. Overall tax collection has improved drastically by 51 per cent over the year. Almost all taxes were collected at the levels substantially higher that of 2003. Actual State Budget expenditures of GEL 1210 million were 46 per cent higher compared to the previous year. The main spending was on social security, debt servicing and general government. State budget deficit financing was GEL 66 million. The total amount received by state for financing State Budget deficit was higher and GEL 40 million was retained on treasury accounts. MONEY AND FINANCE The deposit liabilities of commercial banks denominated in the Lari grew by 102 per cent and in foreign currencies by 29 per cent. As the result of that M2 grew by 35.4 per cent and M3 grew by 24.8 per cent. M3 money multiplier fell from 1.83 per cent to 1.77 per cent, while M2 grew from 0.91 per cent to 0.95 per cent.

SUMMARY


The Lari appreciated in nominal terms by 19.1 per cent during January - September 2004 that was reflected in a fall of the US dollar from USD/GEL 2.10 to USD/GEL 1.70 (official rate). The market rate was USD/GEL 1.68. During the first 9 months of 2004 the CPI grew by 0.9 per cent. As of the end of September the annual inflation was 6 per cent that was within the targets. INTERNATIONAL TRADE AND FOREIGN ECONOMIC RELATIONS During the first nine months of 2004 recorded external trade turnover was USD 1,715.2 million, of which exports were USD 446 million and imports USD 1,259.3 million. Exports increased by 40 per cent, while imports increased by 56 per cent. Despite these changes, the export coverage of import ratio decreased in the recording period in comparison with the same period of the previous year, from 40 to 36 per cent. Recently, in July 2004 the European Commission proposed guidelines for the GSP for the period 2006-2015, based on the experience gained from past schemes, in a number of areas: simplification (cutting back the five separate arrangements which exist at present); focusing the benefits on those developing countries most in need, fostering regional cooperation and strengthening the focus for additional GSP benefits on sustainable development. In October 2004, the European Commission adopted a proposal setting out the details of the EU system of trade preferences (GSP) for the period 2006-2008 based in the guidelines issued in July (http://trade-info.cec.eu.int/doclib/html/117929.htm). The text will now be sent to the Member States, the European Parliament and Economic and Social Committee so that it can be adopted in time for entry into force on 1 July 2005. PRIVATISATION The Government has launched a new phase of reforms in Georgia and privatisation is a crucial component of this process. It will play a distinctive role in the economic development of the country. More than 15,000 enterprises have been privatised since the beginning of the privatisation process in Georgia in 1992. The number of the remaining state owned enterprises is quite substantial - there are approximately 1,800 small, medium and strategically important enterprises with state participation, with over 180,000 persons employed. Major trends of the current privatisation policy are a quick transfer of the remaining enterprises into private ownership and a radical deregulation of the economy to mobilise private investments. It is obvious that in terms of privatisation of the MLEs some serious steps and measures need to be taken. In such sectors as energy, telecommunications, manufacturing and transport many assets have become a heavy burden for the economy and urgently need restructuring, rehabilitation, or liquidation. In the Q3 2004, there were some privatisation cases of state owned MLEs as well as municipal enterprises. Four state owned MLEs were privatised in this period, among them the largest was the hotel “Inturist” in Achara. As far as the municipal enterprises are concerned, complete data about their privatisation process is not available in the corresponding state institutions. In the Q1-Q3 2004, privatisation of small enterprises still is continuing. Due to reorganisation of the privatisation offices in the regions, the information is not complete. The process of the data supply is aggravated also by the fact that the most of the small enterprises are under municipal ownership and it takes extra effort to collect and to combine these data in the centralised data processing system.

SUMMARY


EMPLOYMENT, INCOMES AND THE SOCIAL SAFETY NET LABOUR MARKET Although economic situation in Georgia is undergoing a certain revival and there is anecdotal evidence of businesses emerging that should bring about at least some new jobs, the labour market situation still remains largely unfavourable and unstable. Whilst unemployment rate figures are generally in line with those for transition economies and, if taken alone, may even suggest optimistic conclusions for labour market trends, the overall picture is flawed by persistent underemployment, widespread hidden and disguised unemployment and majority of salaries falling way below the minimum subsistence level. Most of the working age population is either underemployed or non-employed. New stable jobs are rarely created and very few of them are relatively stable. The labour market is dominated by agricultural subsistence self-employment. A large portion of the employed are engaged in unofficial and unregistered low-paying largely self-employment activities. Just around 20 per cent of the working age population have waged or salaried jobs and the vast majority of those employed are hardly earning a living. All the above-mentioned long-term labour market problems adversely effect the poverty situation that is continuously reflected in painful declines in living standards experienced by large numbers of households. SOCIAL POLICY AND THE SOCIAL SAFETY NET Since a large share of the Georgian economy is accounted for by informal activities, the vast majority of the population, including informal sector employees, the self-employed and the non-employed, as well as their family members, have no social protection whatsoever, and the assistance for those covered by the social safety net is symbolic. Fundamental steps are to be taken on the way to restructuring the state social protection system to create an economically viable, affordable and equitable social safety net that would be fit to alleviate poverty effectively, especially for the most vulnerable. In conditions of inadequate pension assistance, alleviating poverty in old age is of vital importance. Social policy and reforms are among the top government priorities and certain steps have already been made. According to the current pay-as-you-go public pension system, a flat-rate old age pension payable to the majority of pensioners countrywide grew from GEL 14 to GEL 18 in May 2004, in accordance with a presidential decree, of which GEL 14 is the main flat-rate pension allowance and another GEL 4 is paid to cover previously accumulated pension arrears. The President and the Government undertook to raise the pension rate to GEL 28 beginning from the new year. EU-GEORGIAN RELATIONS According to the State Department for Statistics, in the period January-September 2004 Georgia’s trade relations with the Member States (25) of the European Union amounted to USD 510.9 million, which is about 33.1 per cent more than in the same period of previous year. During this period Georgian exports to the EU market were USD 75.8 million (136.9 per cent compared with previous year). EU Member States’ exports to Georgia amounted to USD 435.1 million (132.5 per cent compared with previous year). For the period, 29.8 per cent of Georgia’s total foreign trade was with EU Member States, 16.6 per cent of exports and 34.5 per cent of imports. The most important event that took place recently in EU-Georgian relations was inclusion of Georgia into the ENP. In its conclusions of June 14, 2004 the EU Council noted the recommendations of the European Parliament, the Commission, SG/HR and the EU Special Representative for the Southern Caucasus and decided to include Armenia, Azerbaijan and Georgia in the ENP. Georgia understands that the ENP is not directly related to the enlargement in terms that it does not foresee membership opportunity for its new neighbors; nevertheless, Georgia views the European Neighborhood Policy as a powerful mechanism facilitating the ongoing integration processes in Europe. Georgia believes, that it will not only promote the economic and political development of Georgia and bring it closer to the EU, but it will also help to develop closer links between the South Caucasus countries integrating the region. According to Georgia the cooperation between the EU and Georgia should not only concentrate on the

SUMMARY


areas defined in the PCA, but should also try to address issues that are not touched by the existing agreement, such as fight against terrorism.

CHAPTER TWO: NATIONAL ACCOUNTS AND MAIN TRENDS


GDP AND MAIN TRENDS According to preliminary estimates of the State Department for Statistics (SDS), Georgia’s GDP in Q1-Q3 2004 was GEL 7,010.4 million (USD 3,609.6 million, i.e., USD 795.7 per capita). GDP growth rate in Q1-Q3 2004 was 8.4 per cent, compared with 8.6 per cent in the corresponding period of 2003. It is a very positive development in the Georgian economy that the high growth rate is continuing. The highest growth rates, as in previous quarters, were observed in the industry, construction, transport and telecommunication sectors. At the same time, not every sector of the Georgian economy grew in Q1-Q3 2004, particularly negative growth was observed in agriculture and domestic processing of products. The acceleration of economic growth resulted from expansion in industry, construction and services. But the main driver of such a high rate of growth was the continuing construction of the Baku-Tbilisi-Ceyhan pipeline. The launch of the project positively affected the construction and services sectors. It is also worth mentioning that the project employed a substantial number of the labour force, which increased the income of population and correspondingly boosted domestic demand. Domestic demand together with the increased exports (see Chapter Five) is still the main driving force of economic growth in Georgia. Table 2.1 shows the structure of GDP and its growth rates. Table 2.1: Structure and growth rate of GDP, Q1-Q3 2004 (GEL million)

Q1-Q3 2004 Share in GDP Q1-Q3 2004 (per cent)

Q1-Q3 2004 vs. Q1-Q3 2003 (per cent)

Agriculture, forestry and fishing 1,185.8 16.9 -9.6

Industry 894.1 12.8 12.1

Domestic processing of products 259.1 3.7 -2.8 Construction 409.4 5.8 15.8

Hotel and restaurant 193.5 2.8 13.0

Transport 732.3 10.4 5.6

Telecommunication 283.7 4.0 28.5

Financial intermediation 98.2 1.4 9.1

Operation with real estate, commercial activities

410.5 5.9 13.3

State management, defence 327.9 4.7 4.5

Education 259.5 3.7 -0.2

Health care and social services 257.6 3.7 3.6

Other services 270.6 3.9 23.0

Adjustments for financial intermediation services

-52.9 -0.8 -10.9

Net taxes 570.9 8.1 33.0

GDP 7,010.4 100.0 8.4 Source: State Department for Statistics

NATIONAL ACCOUNTS AND MAIN TRENDS


Figure 2.1: Structure of GDP, Q1-Q3 2004

Health care and social services, 3.7

Other services, 3.9

Education, 3.7

State management, Defence, 4.7

Operation w ith real estate, commercial

activities, 5.9

Telecommunication, 4

Financial intermediation, 1.4 Transport, 10.4

Hotel and restaurant, 2.8

Construction, 5.8

Domestic processing of products, 3.7

Industry , 12.8

Agriculture, forestry and f ishing, 16.9

Net taxes, 8.1

Amendments by f inancial

intermediation services, -0.8

Source: State Department for Statistics Non-recorded operations and the informal economy still remain a major problem for economic reform and policy, although there was a slight improvement of the situation in Q1-Q3 2004. The new political environment after the ‘Rose Revolution’ and the determination to crack down on corruption is the crucial factor that induced this positive development. From figure 2.2 we can observe that in Q1-Q3 2004 the share of the non-recorded economy in the total output is reduced compared with H1 2004. It is anticipated that after adoption of a new tax code that is more liberal compared with the current code, the positive trend of the legalisation will continue. Figure 2.2: Share of Non-recorded Economy in Total Output, 2002-Q1-Q3 2004

33.6 32.6 31.8 29.6 27.2

66.4 67.4 68.2 70.4 72.8

0

20

40

60

80

100

120

2002 H1 2003 2003 H1 2004 Q1-Q3 2004

Recorded

Non-recorded

Source: State Department for Statistics



SECTORS OF ECONOMY Agriculture According to the preliminary data of SDS in 2004 the harvest was not so rich as in the previous year and this fact was reflected in the decreased growth rate of the agricultural sector. The structural reforms being implemented in the sector can be considered as a very positive development that in the future should be reflected in the sector’s output. As a result of land reform, currently about 25 per cent of the country’s total arable land has been privatised and about 30 per cent has been leased. A new draft law on the additional privatisation of the arable land has been prepared that will soon be reviewed by Parliament and its adoption is anticipated before the end of the year. Adoption of the law would give a new impetus to the development of agribusiness in Georgia. The growth evidenced in the sector is important due to its strategic importance: about 50 per cent of the total labour force is employed in agriculture. Despite some positive developments in the sector, there is still evidence of some acute problems. Labour productivity is much lower (about 4 times) than in other sectors of economy. Most households are too small and rely on manual work; banking credits are not accessible for the sector; insurance services are not widely used in the sector; agricultural techniques are commonly obsolete; the fertility of soil is declining; and the irrigation and drainage systems need restoration. Solutions to these problems is related to the creation of favourable conditions for investment in agriculture. Partially, the solution of these problems can be found in the development of the land market, that correspondingly can attract lenders in the sector. Together with the above-mentioned problems, protecting the domestic market from smuggling and counterfeit goods also should be on the top policy agenda of the Government. Industry Registered output of industrial enterprises in Q1-Q3 2004 increased by 5.6 per cent compared with the corresponding period in previous year. According to the SDS, output amounted to GEL 1,218.2 1 million and was distributed by main fields of activity as follows: processing industry 64.0 per cent; energy and water supply 28.0 per cent; and mining industry 8.0 per cent. Figure 2.3: Distribution of the industrial output by sectors

64

28

8

Proccessing industry

Energy and w ater suppy

Muning industry

Source: State Department for Statistics 11 The figures expressing the sums of sectoral outputs differ from those in Table 2.1. This differences are conditioned by the fact that GDP’s table includes only sums value added produced in the sectors.



Table 2.2: The data on enterprises by sectors

Number of enterprises

Mining 92 Coal and lignite extraction, peat processing 5 Extraction of crude oil and gas 2 Extraction of metallic ore 22 Other 63 Processing 2,920 Processing of food products and production of alcoholic drinks 1,685 Tobacco production 13 Textile products 17 Garment industry, fur processing 39 Leather processing and footwear production 43 Timber processing excluding furniture production 265 Cellulose, paper and paper products production 26 Publishing and polygraph industry 230 Production of coke, oil distilling products and nuclear fuel 8 Production of chemicals 72 Production of rubber and plastic products 49 Production of non-metal and other mineral recourses 172 Main metal production 20 Production of finished metal products except machinery and tools 68 Production of machinery and equipment 41 Stationary and calculating machines production 1 Electric machinery and other equipment production 31 Radio, TV and communication equipment production 6 Medical and optic equipment and clock production 14 Production of vehicles and trailers 14 Other transport equipment production 22 Production of furniture and other finished goods 81 Recycling production 3 Electricity, gas and water supply 198 Electricity, gas, steam and hot water supply 95 Water reserving, distilling and distribution 74

Source: State Department for Statistics The general situation in the industrial sector still depends heavily on the activity of a small number of enterprises. 50 enterprises account for a little over three quarters of industrial output. The development of small and medium enterprises is hindered by unfavourable legislation and widespread corruption. In previous years, the practice of “state capture” and unfair competition was still in place. As a result, the most economically viable are those enterprises that lobby by illicit means. In such a business environment, small and medium enterprises have little chance for survival and further development. It is worth mentioning that in the small and medium industrial enterprises only 16.7 per cent of general industrial output was produced, while in the most developed countries the share of such firms is 50-60 per cent. In this regard, the elaboration of the new draft of the Tax Code that is more liberal and favours small and medium enterprises can be considered as a very positive institutional change conducive to the development of the industry. Construction The boom in demand for private apartments facilitated the development of the construction sector in Georgia. The growth rate of the sector in Q1-Q3 2004 reached 15.8 per cent. The total output of the



sector was GEL 476.1 million. It is worth mentioning that a considerable part of the output arose from the construction of Baku-Tbilisi-Ceyhan oil and Shah-Deniz gas pipelines. The share of these projects in the overall construction output was 61.0 per cent in Q1-Q3 2004. In Q1-Q3 2004, 529 construction firms were functioning out of which 79 were state owned and 450 were privately owned. Private sector activity accounted for 96 per cent of total output. Transport and Telecommunications The output of the transport sector increased by 5.6 per cent in Q1-Q3 2004. It is important to mention that there is evidence of increased activity in all types of transport services (railways, motorways and airlines as well as sea ports and city transport). Increases in international transportation of cargo contributed to the growth of turnover of Georgian transport services. The volume of transported cargo increased by 0.9 per cent and the turnover of cargo increased by 9.7 per cent. In cargo transportation the lion’s share was carried by motorway (61.6 per cent), and in terms of turnover railway cargo transport accounted for about 88.7 per cent of total turnover. The number of passengers carried by Georgian air companies in Q1-Q3 2004 increased by 40.6 per cent compared with the corresponding period of the previous year. In Q1-Q3 2004, Batumi and Poti sea ports processed 9.9 million tonnes of cargo, that was 10.3 per cent more than in Q1-Q3 2003. The further development of the TRACECA project is likely to increase the output of the Georgian transport system. The possibility of transportation of humanitarian shipments to Afghanistan and Iraq through the territory of Georgia also creates an additional opportunity of raising transit volumes in the near future. There was an overall extension of telephone communication networks in Q1-Q3 2004. The number of ordinary phone customers was 596. thousand (an increase of 2.1 per cent). A substantial increase was observed in the numbers of mobile telecommunication subscribers. There are now 673.3 thousand which is 31.2 per cent more compared with the corresponding period in 2003. Tourism According to data of SDS in Q1-Q3 2004 Georgia was visited by 280.4 thousand visitors: 162.7 thousand from the CIS countries and 117.7 thousand from other countries. The number of tourists in Q1-Q3 2004 increased by 16.7 per cent compared with the corresponding period in 2003. According to the common assessment of SDS and State Department of Tourism in Q1-Q3 2004 the economy of Georgia received revenues equivalent to GEL 587.3 million that is about 8.4 per cent of overall GDP. FOREIGN DEBT As of 30 September 2004, Georgia’s outstanding foreign debt, including state guaranteed debt, amounted to USD 1,801.8 million (GEL 3,315.2 million), that is 45.6 per cent of GDP in 2003. Compared with the previous quarter, the outstanding debt decreased by USD 19.8 million.



It is a very positive development that foreign debt is decreasing. This tendency was resulted by the repayment of the debt to bilateral creditors, particularly to Turkey, Uzbekistan and Ukraine. In addition to the debt repayment, the changing of USD’s exchange rate against SDR, EUR, JPY, CHF and KWD, in which more than half of Georgia’s foreign debt is denominated, induced a change in total debt in USD terms in Q1-Q3 2004. In this period, Georgia paid USD 155.4 million for debt servicing, including USD 131.4 million in principal and the rest for interest, commitments and penalties. The debt to GDP ratio is a key statistic in any assessment of debt sustainability. It is important to mention that this figure in Q1-Q3 2004 decreased very slightly compared with the same ratio in H1 2004 from 46.1 per cent to 45.6 per cent.

Table 2.3: Foreign Debt, Q1-Q3 2004 (USD Million)

Q1 2004 Q1-Q3 2004 Total Debt 1,821.6 1,801.8 Debt service of which:

90.4 155.4

Principal Repayments

69.5 131.4

Interest Payments 20.9 24.0 Ratios, %

Debt to GDP Ratio 46.1 45.6 Source: Ministry of Finance On 21 July 2004, the creditors of the Paris Club and the Government of Georgia agreed on the rescheduling of foreign debt of Georgia. This agreement became possible only after the IMF approved a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) for Georgia that is designed to support ambitious plans of reforms in the country. On 4 June 2004, the Executive Board of the IMF approved a three-year arrangement under the Poverty Reduction and Growth Facility (PRGF) in an amount equivalent to SDR 98 million (about USD 144 million) to support the government’s economic programme into June, 2007. A concessional restructuring of Georgia’s foreign debt will enhance its sustainability prospects. Although the support of the IMF is crucial in the process of debt rescheduling a sustainable path would also require that Georgia (a) abstains from borrowing on commercial terms and continues to shift its financing mix towards more concessional sources (including grants); (b) considerably increases tax revenue collections; and (c) implements the reforms required to achieve and maintain solid export and GDP growth. BALANCE OF PAYMENTS Figures for the balance of payment for Q3 2004 were not available at the time when the current issue of GET was being written; only figures for H1 2004 are available. Thus, in this issue of GET we will analyse the trends of H1 2004 of BOP and in the Chapter Five will be analysed the export/import trends for Q1-Q3 2004 (as a rule the export/import data are available earlier than complete data for BOP). The improvement of balance of payments is mainly related to the increased balance of current account and to the increased balance of capital accounts. Though the balance of financial accounts has deteriorated, the overall balance of payments improved in H1 2004 compared with H1 2003.



Table 2.4: Balance of Payments Q1 2003- Q1 2004 (USD million)

Q1 2003 Q2 2003 Q1 2004 Q2 2004 H1 2003 H2 2004

A. Current Account -113,1 -104,7 -119,7 -77,1 -217,8 -196,8 Goods : exports (FOB) 104,7 171,8 165,5 314,5 276,5 480 Goods : imports (FOB) -235,7 -333,1 -365,1 -476,4 -568,8 -841,5 Balance on Goods -130,9 -161,2 -199,6 -161,9 -292,1 -361,5 Services : Credit 87,6 107,6 114,4 117,2 195,2 231,6 Services : Debit -94,9 -93,8 -99,9 -120,7 -188,7 -220,6 Balance on Goods and Services -138,2 -147,5 -185,1 -165,4 -285,7 -350,5 Income : credit 31,4 50,7 46,6 15,4 82,1 62 Income : debit -34,5 -37,6 -40,3 54,6 -72,1 14,3 Balance on Goods, Services, and Income

-141,3 -134,5 -178,8 -95,4 -275,8 -274,2

Current transfers : credit 35,5 40,9 70,5 85,3 76,4 155,8 Current transfers : debit -7,3 -11,1 -11,4 -12,5 -18,4 -23,9 B. Capital Account 4,9 4,7 5,9 7,2 9,6 13,1 Capital account : credit 6,9 7,2 6,9 8,2 14,1 15,1 Capital account : debit -2,0 -2,6 -1,0 -0,9 -4,6 -1,9 Total, Groups A plus B -108,1 -100,0 -113,8 -78,0 -208,1 -191,8 C. Financial Accounts 89,7 109,2 99,8 61,8 198,9 161,6 Direct investment 59,9 72,8 118,2 118,3 132,7 236,5 Direct investment abroad -1,0 -9,2 -1,0 -1,1 -10,2 -2,1 Direct investment in Georgia 60,9 81,9 119,2 119,4 142,8 238,6 Portfolio Investment -500 0 0 0 -500 0 Assets -500 0 0 0 -500 0 Liabilities 0 0 0 0 0 0 Other Investment 30,3 26,9 1,7 6,7 57,2 8,4 Assets 6,4 5,9 -18,2 8,6 12,3 -9,6 Liabilities 23,9 21,1 19,9 -1,9 45 18 Total, Groups A Through C -18,5 9,2 -4,0 -16,5 -9,3 -20,5 D. Net Errors And Omissions 9,4 -9,2 3,9 8,1 0,2 22 Overall Balance (Total, Groups A Through D)

-9,1

1,2 9,9

-8,4 -7,9 1,5

E. Reserve Assets 9,1 -1,2 -9,9 8,4 7,9 -1,5 Source: State Department for Statistics The improvement of the balance of current account is resulted of the increased transfers to government and remittances of long-term workers from abroad. It is worth mentioning that the deterioration of the balance of financial accounts is not related to the decrease of direct investments in Georgia. The direct foreign investments in Georgia in H1 2004 were two times higher than in H1 2003. The continuation of the construction of oil pipeline Baku-Tbilisi-Ceyhan and institutional reforms in the country, are likely to support this trend in the following years.

CHAPTER THREE: GOVERNMENT FINANCE


According to the 2004 State Budget, total revenues at the end of Q3 were expected to reach GEL 1,076 million, that is 65 per cent of revenue expectations for the whole year. Actual state budget revenues were GEL 1,144 million, GEL 68 million higher than planned. Higher than expected tax revenues explains the main portion of the surplus. External grants and non-tax revenues also were received in excess of expected amounts. Overall tax collection has improved drastically by 51 per cent over the year. Almost all taxes were collected at the levels substantially higher that of 2003. Actual State Budget expenditures of GEL 1210 million were 46 per cent higher compared to the previous year. The main spending was on social security, debt servicing and general government. State budget deficit financing was GEL 66 million. The total amount received by state for financing State Budget deficit was higher and GEL 40 million was retained on treasury accounts. STATE BUDGET REVENUES Initial revenue projections for the state budget 2004 envisaged collections of GEL 1,424.4 million, by the end of the year. However during the year it proved that budget revenues would be higher than expected. The Government revised the budget revenue target and a new target was set at GEL 1,655 million, 16 per cent higher than the initial target. By the end of Q3 2004, the budget was expected to receive GEL 1,076 million. Actual revenues were GEL 1,144 million, 6 per cent higher than the revised target. Two thirds of the GEL 68 million surplus is explained by higher than expected tax revenues while external grants and non-tax revenues also were received in excess of target. The tax revenue target of the state budget was set at GEL 881 million 7 per cent higher than the initial target. Actual tax revenue receipts of GEL 927.4 million were 5 per cent higher than target. However, it is more important that actual tax collection was improved over the year by 51 per cent. A comparison of 2004 State Revenues with planned and previous year figures is provided in Table 3.1. Table 3.1: State Budget Revenues, 9 months 2004 (GEL million)

Year target

9 month target

9 month actual

revenues

Diffe-rence

Actual revenues

as per cent of target

Growth over the

year %

Per cent in

total

9 month revenues as per cent of Year target

Total revenues and grants 1,655 1,076 1,144 68 106 166 100 69

Tax revenues 1,198 881 927 46 105 151 81 77 Non-tax revenues 257 167 182 14 109 357 16 71

Capital Revenues 81 5 3 -2 58 0 4

Revenues of Special state funds

398 295 312

17 106 173 27 79

Grants 119 23 33 10 144 147 3 28 Source: Ministry of Finance, GEPLAC calculations Nominal growth of overall budget revenues over the year was 66 per cent. This indicates a real improvement in the management of public finance in Georgia and shows the results of efforts of the new administration. Of GEL 1,144 million in total State Budget revenues, 81 per cent comes from

GOVERNMENT FINANCE


tax revenues. The target for tax revenues was 105 per cent achieved. Non-tax revenues of GEL 182 million made up 16 per cent of the total figure, while grants of GEL 23 million were 3 per cent of state revenues. Non-tax revenues were 9 per cent higher than projected amount and made up 357 per cent of corresponding figure of 2003. The revenue response to administrative measures of the Government was fastest in this area. Non tax revenues cover profits of the National Bank, repayment of state credit, revenues from ownership and economic activities, administrative fees and various penalties. It should be mentioned that due to unexpectedly high receipts, the year’s target for non tax revenues was revised 96 per cent upwards. Revenues of Special State Funds (basically included in tax revenues above) formed 27 per cent of total state receipts. The target here was 106 per cent achieved. A detailed breakdown of central budget tax revenues is provided in Table 3.2. Table 3.2: Central Budget Tax Revenues, H1 2004 (GEL million)

Year target

9 month target

9 month actual

revenues

Diffe-rence

Actual revenues

as per cent of target

Growth over

the year

%

Per cent in total

9 month revenues

as per cent of

Year target

Central budget tax revenues 811 593 624 31 105 144 100 77

Income tax 16 16 16 0 100 115 3 100 Profit tax 11 11 11 0 100 125 2 100 VAT 544 388 410 22 106 134 66 75 on domestic products 245 177 185 8 105 106 30 76

on imports 299 211 225 14 106 171 36 75 Excise 143 107 111 4 104 193 18 77 on domestic products 46 36 38 2 104 245 6 82

on imports 97 71 73 2 103 174 12 75 Customs duty 81 57 58 1 103 140 9 72 Other taxes 15 13 16 3 126 280 3 109

Source: Ministry of Finance, GEPLAC calculations Tax revenues of central budget exceeded the target by 5 per cent however comparison with previous year shows an impressive (44 per cent) improvement. As seen from the table, direct taxes were collected exactly as set by target. The reason for this is that income and profit tax receipts starting from Q 3 2004 are directed to local budgets. Consequently they are no longer included in target and revenue figures of central budget. Annual targets were set according to actual collection in first half of the year. In previous years and in first half of 2004, 40 per cent of receipts from these taxes were included in central budget revenues. There was a sharp rise in revenues from these taxes in 2004. The figures show that actual collection of direct taxes which is the same as at the end of the second quarter is considerably higher than actual performance of first three quarters of 2003. Continuous rise in profit tax receipts is observed from 2002 while for personal income tax this is the first significant improvement over the period. This is connected with global trend of legalisation of business activities as well as personal incomes. The situation with indirect taxes has also improved considerably. Collection of VAT has improved significantly compared to the previous year by 34 per cent, while collection of excise duty improved by

GOVERNMENT FINANCE


93 per cent. Improvement in VAT collection is dominated by a 52 per cent improvement of VAT collection on imported goods while collection for domestic products has improved only by 6 per cent. Total amount collected under VAT heading was GEL 410 million and made up 106 per cent of government expectations. The situation is even better with excise duty. GEL 111 million was collected under this heading and target was met at 104 per cent. For both imported and domestically produced excise goods collection has improved considerably by 74 and 145 per cent respectively. Collection of customs duty exceeded target by 3 per cent and has improved over the year by 40 per cent. Other taxes were collected at 126 per cent of target. However comparison with the 2003 figure show that collection has improved by 180 per cent. The overall picture of tax collection is similar to that of the end of the previous quarter. Almost all taxes were collected at levels substantially higher than those of 2003. Despite the fact that collected amounts from indirect taxes in Q3 are not included in central budget revenues, receipts are substantially higher compared to the previous year. This is in line with a general trend towards legalization of businesses and personal incomes. Improvement of collection of taxes on imports and excise is a result of administrative reform and reduced corruption in tax and customs structures. Domestic VAT has improved only by 6 per cent. It can be suggested that administration of a large number of domestic firms is a more complex task compared to administration of a relatively small number of import businesses and producers of excise goods. Government is planning to introduce tax and financial amnesty. Box 3.1: PRACTICES

Why are amnesties so widespread?

• Inability to commit to a long-term enforcement policy The optimal tax enforcement literature recognizes that governments may have a short term incentive to scale back enforcement levels to reduce monitoring costs: If evasion has been satisfactorily deterred by the announced policy, few tax offenders will be detected and tax audits will yield an ex post revenue loss. Similarly once an audit or prosecution is in progress, the ex post revenue effects of pursuing them to their end may not be judged worthwhile: Citizens currently under investigation may be induced to `settle' their dues voluntarily via an amnesty program. A third example of inability to commit is when a government lowers the tax rate through lenient taxation in an amnesty. Such amnesties, if resorted to repeatedly, causes them to be rationally anticipated by citizens adversely affecting ex ante deterrence. In the long run it is desirable for the government to commit to a given enforcement policy, and forego the use of such amnesties. Stella (1991) examines the signaling role of such amnesties in a context where citizens try to guess the true cost incurred by the government in auditing. A `weak' government would try to convince citizens that it was actually `strong' by mimicking the audit behaviour optimal for a `strong' government, but citizens would rationally be aware of this penchant. The equilibrium would involve the use of a mixed strategy by the government, where the probabilities of high and low audit rates balances the government's interest in a strong reputation and short?term revenue. The probability of the low audit rate can be interpreted as an intermittent offer of an investigation amnesty.

GOVERNMENT FINANCE


• Flexibility Inability of the government to commit suggests the need for a constitutional ban on amnesties. This however raises the question: can amnesties conceivably form part of a long term enforcement policy to which the government commits? A possible reason for this not being the case is that amnesties permit greater flexibility in enforcing tax compliance than is otherwise the case. First, optimal audit policies generally requires that high income disclosures be investigated less frequently than low disclosures. The tax administration may, however, be constrained (for example, legislatively) to over?auditing citizens who make high income disclosures. Consequently it may be revenue and welfare enhancing if such citizens are offered an investigation amnesty. This is part of the justification by Franzoni (1994) of a permanent investigation amnesty or equivalently, a presumptive tax. However, instead of an amnesty, direct reform of investigation policy could also remove these restrictions. Second, limited information possessed by a tax administration about heterogeneity of citizens with respect to risk?aversion or to the cost of hiding income since citizens may make it revenue and welfare enhancing for the government to offer a menu of enforcement policies between which citizens self?select. An amnesty may be a part of such a menu, resembling "sales" by price discriminating firms (Cassone and Marchese, 1995). • Insurance Andreoni (1991) and Franzoni (1994, 1996) also points to the insurance value to risk?averse citizens of an amnesty for past tax evasion, combined with saving in audit costs to the government. In fact Andreoni (1991) argues that amnesties tend to be revenue neutral since the revenue loss from earlier cheating is offset by amnesty receipts. Related arguments are offered by Cassone and Marchese (1994), Kaplow and Shavell (1994), and Malik and Schwab (1991). • Equity A justification sometimes offered by governments is that an amnesty is an equitable transition measure to a period of stepped up enforcement. This argument appears far from clear: an amnesty inequitably allows lenient treatment of amnesty participants, contrasted to offenders convicted either before or after the amnesty. • Avoiding costly prosecution Amnesties may allow the tax administration to economize on prosecution costs. This has an obvious resemblance to the rationale for out?of?court settlements and plea bargaining, and has special importance in countries where the court system is overburdened. Ex ante incentive effects have been discussed by Chu (1990), Kaplow and Shavell (1994), and Franzoni (1994b). • Asset laundering As discussed, inducing taxpayers to declare hidden assets, have been important in, for example, India. Declaration of assets can enhance taxpayer compliance subsequent to an amnesty since their asset are now known to tax authorities. On the other hand, if such an amnesty is anticipated, taxpayers may strategically evade taxes prior to the amnesty, owing to the projected dilution of penalties for tax evasion which could, as discussed in the context of anticipated amnesties, actually increase revenue prior to the amnesty. However the long run revenue effects of such amnesties are likely to be negative (Das-Gupta and Mookherjee, 1996, 1998). This may not be the case, however, in the presence of economic reforms leading to greater investment opportunities. In such a case, former tax evaders may wish to disclose assets in order to take advantage of higher "white economy" rates of return. An amnesty may help accelerate the process of asset laundering and raise the growth rate of the economy. Source http://www1.worldbank.org/publicsector/tax/amnesties.htm

SPECIAL STATE FUNDS Total revenues of the Social Security Fund in the first 9 months of 2004 were GEL 332 million, including amounts retained from the previous year. Of this amount, GEL 276 million came from social taxes and GEL 42 million was transferred from the central budget. GEL 8 million was transferred from local budgets for an urgent ambulance assistance programme. State pensions and various

GOVERNMENT FINANCE


social benefits were financed at GEL 235 million. GEL 62 million was spent for healthcare state programmes. Administrative expenses of the fund were GEL 6 million. By the end of Q3 2004, own revenues of the Roads Fund (which comes from excise on oil products and other taxes) were GEL 58 million (105 per cent of target). The main spending of the fund was on roads maintenance, payments for works performed in previous periods; co-financing of projects financed by foreign credits; repayment and servicing of credits, and administration. STATE BUDGET DEFICIT State budget deficit was GEL 66 million in the first the first 9 months of 2004. However amounts received by the government for financing the state budget deficit were higher. GEL 97 million came from foreign investment credits. Another GEL 10 million were received by means of T-Bills. An excess of GEL 40 million was retained on treasury accounts. STATE BUDGET EXPENDITURES State budget expenditures in Q1-Q3 2004 amounted to GEL 1210 million. The figure shows a 46 per cent increase over government spending of the corresponding period of 2003. A breakdown of State Budget expenditures by function is provided in the table below: Table 3.4: State Budget Expenditures by Function, 9 months 2004 (GEL million)

9 months 2004 Per cent in total 9.months 2003

Per cent in total

Growth over the year

General Government 217.6 18.0 159.4 19.2 136.5 Defence 73.4 6.1 42.3 5.1 173.6 Law and order 142.9 11.8 62.8 7.6 227.7 Education 40.8 3.4 29.3 3.5 139.3 Health care 20.7 1.7 5.4 0.7 381.8 Social Security 316.1 26.1 213.3 25.7 148.2 Housing 2.7 0.2 2.7 0.3 101.6 Culture sports religion 25.8 2.1 19.3 2.3 133.9 Energy 37.3 3.1 34.2 4.1 109.2 Agriculture 19.0 1.6 8.8 1.1 215.4 Construction and mining 0.7 0.1 0.4 0.0 180.9 Transport and communications 41.8 3.5 35.2 4.2 118.6 Other economic activities 2.5 0.2 1.8 0.2 142.1 Other 269.2 22.2 216.3 26.0 124.4 Total 1210.5 100.0 831.1 100.0 145.7

Source: Ministry of Finance; GET calculations The largest expenditure item was social security. Growth here was 48 per cent. Both main components of social security spending had a positive growth rate. Goods and services purchased of GEL 146 million were 64 per cent higher compared to the previous year, while subsidies and current transfers increased by 13 per cent and amounted to GEL 67million. The second largest item of government spending is under the category Other, which makes up 22 per cent of state budget expenditures. GEL 269 million was spent under this heading; a 24 per cent growth over the year (lower than average). The amount is mainly comprised of interest payments on state debt of GEL 109 million (9 per cent of budget expenses), subsidies and current transfers to lower level budgets of GEL 101 million and principal payments of foreign debt of GEL 55 million.

GOVERNMENT FINANCE


Spending on general government made up 18 per cent of total state budget expenditures. This heading incorporates current expenses of government agencies (mainly salaries and goods purchased), as well as expenses of programmes financed by international financial organizations. Growth over the year was 36 per cent here; GEL 217 million in 9 months 2004 against GEL 159 million in 9 months of 2003. Expenditures on law and order increased to 12 per cent of total budget expenses from 8 per cent in 2003. This is connected with reform processes in law enforcement structures and also with purchase of new equipment for the police. GEL 142 million spent for law and order was 227 per cent of corresponding 2003 spending. Other functional categories were each less than 10 per cent of total expenditures. The higher than average growth was in financing of health care, agriculture construction and defence;. Expenditure figures for the rest of the year will provide a more definite picture of government priorities. Breakdown of state budget expenditures by economic category is provided in the table below. Table 3.5: State Budget Expenditures by Economic Category, 9 months 2004 (GEL million)

9 months 2004

Per cent in total

9 months 2003

Per cent in total

Growth over the year

Total 1210.5 100 831.1 100 146 Salaries 124.8 10 83.4 10 150 Social contributions 19.9 2 18.3 2 108 Business trips 6.5 1 4.0 0 163 Other goods and services 397.1 33 216.4 26 183 Interest payments 109.1 9 118.8 14 92 Subsidies and current transfers 369.5 31 198.2 24 186 Capital Expenditures 71.7 6 36.0 4 199 Net lending 112.091 9 156.023 19 72

Source: Ministry of Finance; GET calculations Other goods and services were purchased for GEL 397 million compared to GEL 216 million spent in 2003. Two thirds of the amount was spent for social security needs. Growth of 83 per cent under this category was considerably higher, compared to overall growth of budget expenditures. 31 per cent of state budget expenditures were subsidies and current transfers. A total of GEL 369 million spent under this category was 86 per cent higher compared to the corresponding period of the previous year. Transfers ware mainly of a social nature (transfers to local budgets and social security fund), however substantial amounts were spent under this heading for general government, education, law and order needs. GEL 36 million was a subsidy to the energy sector. 9 per cent of state budget expenditures comes in the Net Lending category. The GEL 112 million spent was only 28 per cent lower compared to 2003. From this amount, GEL 57 million were programmes financed by international financial institutions, while GEL 55 million was spent on repayment of state debt. Interest payments were GEL 109 million and made up 9 per cent of total State Budget expenditures against 14 per cent a year ago. The amount was 8 per cent lower compared to interest paid in H1 2003. Appreciation of Georgian currency contributed to lower interest payments. Salaries of state employees were paid at GEL 124 million, 46 per cent higher compared to the previous year. The growth rate of social contributions paid by the state as an employer was 50 per cent.

CHAPTER FOUR: MONEY AND FINANCE


MONEY SUPPLY Successful anti-corruption measures, improvement of tax discipline and a declining shadow economy were the main achievements of the Government in 2004. As a result a certain amount of money was paid by taxpayers mainly as tax revenues. That money was accumulated on the Government accounts and correspondent accounts of commercial banks. Georgia received GEL 58.6 million in a Structure Adjustment Credit (GEL 13.8 million in March and GEL 44.8 million in August). All those amounts required conversion into the legal tender. The market reacted to that by increased demand and creation of a shortage for the Lari, resulting in its appreciation in nominal terms1. Commercial banks supplied foreign currency on the Tbilisi Interbank Currency Exchange to buy the Lari. Within those conditions the NBG had to purchase foreign currency, but there was a potential of putting more into circulation than the market was able to absorb. Had that been the case, the resulting inflation effect of oversupply of the Lari would have become inevitable. It became a challenge for the National Bank. In July the NBG responded by decreasing reserve requirements for the Lari deposits from 13 to 2 per cent in July 2004 (while for foreign deposits it remained 13 per cent). The reason was to transfer money from reserve accounts into circulation. At the same time, since the beginning of 2004 the NBG had been using available market instruments to maintain the money supply. The interbank credit auctions were widely used to manage liquidity by the NBG. The NBG issued money into circulation through extending credits. When commercial banks paid back the money was withdrawn from the circulation. The NBG also introduced deposit auctions for the purpose of managing liquidity. Banks put money with the NBG withdrawing it from the circulation and received interest for that. Initially there were overnight deposits with 2 per cent annual weighted interest but later the NBG started to offer deposits with longer maturity. During January-September 2004 the NBG delivered GEL 306 million through TICEX satisfying the high demand for the legal tender. Also during the same period Georgia, received GEL 59 million from the World Bank’s Structural Adjustment Credit. Simultaneously the NBG provided measures to absorb and manage the liquidity in circulation and it resulted in increasing money into circulation only by GEL 127 million (or by 23.4 per cent) since the beginning of the year. The dramatic inflation effect of the oversupplied Lari has been avoided.

1 From December 31 to September 7th the Lari appreciated in nominal terms by 23.5 per cent. (The NBG’s data).

MONEY AND FINANCE


Figure 4.1: Money Supply, December 2001 – September 2004

0

200,000

400,000

600,000

800,000

1,000,000

1,200,000

1,400,000

Dec-01

Feb Apr Jun Aug Oct Dec-02

Feb Apr Jun Aug Oct Dec-03

Feb Apr Jun Aug

GEL

thou

sand

Deposits in foreign currencies

GEL deposits

Currency outside commercial banks

M3

M2

M0

Source: GEPLAC calculations based on data provided by the National Bank of Georgia The other consequence of legalisation of the shadow economy was the moving of money from outside into the banks. (The table below shows that ratio between M0 and GEL deposits liabilities fell, reflecting the process but in Lari terms). It resulted in accumulation of the deposits in commercial banks and reflected in growth of both Government and private deposits. It should be noted that deposits in the national currency grew faster than in foreign currencies something that has not been the case during previous years. The deposit liabilities of commercial banks denominated in the Lari grew by 102 per cent and in foreign currencies by 29 per cent. As a result, M2 grew by 35.4 per cent and M3 grew by 24.8 per cent. The M3 money multiplier fell from 1.83 per cent to 1.77 per cent, while the M2 multiplier grew from 0.91 per cent to 0.95 per cent. Table 4.1: Monetary Ratios

Dec Jan Feb Mar Apr May Jun Jul Aug SepDollarisation Ratio % 86.13 85.52 81.82 83.17 83.61 83.55 82.27 81.21 78.27 77.89Money Multiplier (M2) 0.91 0.92 0.94 0.92 0.95 0.92 0.91 0.96 0.94 0.95Money Multiplier (M3) 1.83 1.94 1.89 1.88 1.92 1.91 1.81 1.93 1.77 1.77MO/ GEL Deposits 5.14 4.31 3.50 3.73 3.97 3.72 3.68 3.26 3.06 3.10

2003 2004

Source: GEPLAC calculations based on data provided by the National Bank of Georgia MONETARY INSTRUMENTS2 Interbank Credit Auctions. Within the growing demand for the Lari and issuing of the legal tender into circulation from one side and existing danger of over-supply of the money onto the market, the NBG widely used the interbank credit auctions to regulate the level of the money supply. The credit auctions played an important role

2 The National Bank of Georgia implements monetary policy in accordance with the annual programme-the subject of approvement of the Parliament. The main goal of the monetary policy is keeping the stable exchange rate of the national currency (Lari) and maintaining the price level within the annual inflation of 5-6 per cent. The monetary policy is based on the strict control over money supply. The policy foresees that within free float foreign exchange rate the NBG should not issue foreign currency in circulation even in the case of high demand for that. Meanwhile, the NBG shall purchase foreign currency on Tbilisi Interbank Currency Exchange to maintain the certain level of international reserves.

MONEY AND FINANCE


as a source of credit recourses for commercial banks and at the same time through this mechanism a surplus of money is absorbed when necessary. During the first nine months of 2004, the total turnover of credit auctions was GEL 120.4 million – twice more than 2003 total turnover. The role of the NBG as a purchaser was significant since its share in the total turnover was 78.7 per cent. As a result of decreasing reserve requirements in July, the level of liquidity in commercial banks increased. Banks were no longer obliged to freeze 13 per cent of attracted deposits but just 2 per cent on the NBG account. As a result, the demand for credit recourses fell and there were no credit auctions in July and August. In September the credit auctions renewed and the share of them in the total nine months auctions’ turnover was 53.7 per cent. In September, the NBG absorbed almost all supplied amounts of GEL 64.5 million. During the first nine months of 2004 the average weighted interest rate for credit auctions was 10.8 per cent that was 6.7 per cent less than it had been in September 2003. T-Bills During the first nine months of 2004 the annual weighted interest rate for T-Bills fell gradually. The highest interest rates were fixed in January (36.1 per cent annual), however in February they fell to 22 per cent and this ceiling did not change until July. It is likely that the increasing of tax revenues and a nominal appreciation of the Lari increased the creditability of the Government securities. In July-September this trend continued and weighted annual interest rates fluctuated within 13.4-14.4 per cent. It should be noted that in July, banks received more free liquidity because of cutting reserve requirements from 13 to 2 per cent. During that period the demand for liquidity fell One could assume that there was excess liquidity during that period which was placed by banks into T-Bills. That was why the annual interest rate continued to fall. It is well known that during the last several years the NBG and the Ministry of Finance made deliberate policy toward the total substitution of direct crediting by Government Treasury Bills. So that the improvement of economic situation was taken as a signal to increase the maturity of T-Bills. The maximum maturity of T-Bills issued by Ministry of Finance during the first 9 months of 2004 was 364 days. During the first three quarters of 2004, commercial banks constituted the biggest share of T-Bills holders both on primary and secondary markets (58 per cent and 82 per cent respectively), companies – (34 per cent and 13 per cent), individuals – (8 per cent and 5 per cent). However, one can assume that within the tendency of falling of interest rates the involvement of commercial banks on the market could reduce and be substituted by non-bank investors.

MONEY AND FINANCE


DOMESTIC INFLATION Table 4.3: Monthly Consumer Price Index and Inflation, 2003- 2004 Q3 (December 2002 = 100)

Price Index Inflation from previous month

2003 Jan 102.10 2.1 Feb 101.59 -0.5 Mar 101.59 0.0 Apr 102.10 0.5 May 102.30 0.2 June 102.40 0.1 July 101.48 -0.9 Aug 101.38 -0.1 Sep 101.89 0.5 Oct 101.89 0.0 Nov 106.78 4.8 Dec 106.99 0.2

2004 Jan 107.42 0.4 Feb 107.85 0.4 Mar 107.96 0.1 Apr 107.74 -0.2 May 107.78 0.04 June 106.06 -1.6 July 106.91 0.8 Aug 106.27 -0.6 Sep 107.86 1.5

Source: State Department for Statistics and GEPLAC calculations. During the first 9 months of 2004 the CPI grew by 0.9 per cent. Due to bad weather conditions prices of fruits increased by 22 per cent. Also because of improved tax administration the alcoholic drinks and tobacco (the excisable goods) became more expensive by 15 per cent. Along with the improvement of tax administration, indirect taxes paid by importers should have been reflected in commodity prices. However, the lari’s appreciation offset the price growth for imported goods. As of the end of September the annual inflation was 6 per cent that was within the targets. DOMESTIC FOREIGN EXCHANGE MARKET During the first nine months of 2004 there was stable demand for the national currency reflected in a total supply of USD 210.3 million of foreign currency on the Tbilisi Interbank Currency Exchange (TICEX). The supply exceeded demand for foreign currency by more that three times (USD 79.1 million). During January-September 2004 the total supply of foreign currency on TICEX was almost twice that during the whole of 2004.The Lari appreciated in nominal terms by 19.1 per cent during January - September 2004 that was reflected in a fall of the US dollar from USD/GEL 2.10 to USD/GEL 1.70 (official rate). The market rate was USD/GEL 1.68. Within these circumstances the NBG made a decision to start supplying the market with US dollars selling them on TICEX from September 15th to hamper the further appreciation of the Lari. It should be noted that the NBG had not intervened in the foreign currency since December 1998 following the policy that did not foresee foreign currency interventions. The main idea of the US dollar intervention was to show the market players that the NBG is ready to change its policy to keep the stability of the exchange rate of the national currency. The NBG issued USD 3.4 million through TICEX. After that measure the nominal

MONEY AND FINANCE


exchange rate of the Lari depreciated gradually and has been fluctuating within USD/GEL 1.825-1.875 During the first nine months of 2004, the NBG’s net interventions were USD 162.6 million.

BANKING The experience of recent years experience has shown substantial progress in the banking sector of Georgia. The reform in the banking system has been implemented by the National Bank of Georgia. As a result of the reforms the number of banks decreased from 228 by the end of 1994 to 23 by the end of September 2004, mostly at the expense of insolvent banks and those that could not meet the NBG’s special requirements. 13 of existing banks have foreign shareholders among which are EBRD, IFC and other international financial organisations. There are two branches of foreign banks - Azeri and Turkish - however these do not provide lending and depositing business in Georgia. The process of bank has enlargement continued. At the beginning of 2003, 80 per cent of banks’ assets and 85-90 per cent of banks’ deposits were accumulated by 8 commercial banks. As of October 1st 2004, six commercial banks accumulate 81 per cent of assets, 85 per cent of liabilities and 84 per cent of deposits. Each of them owns more than 5 per cent of assets of the whole banking system. They improve client services based on new banking technologies (internet banking, etc.), provide internal settlement in real time and have diversified loan portfolios. The commercial banks’ system has shown stable growth during recent years. In 2003, the share in GDP of total assets increased by 20 per cent, net loans - by 24 per cent, total deposits - by 25 per cent and capital - by 10 per cent (similar to previous years3). Sufficient progress was achieved in diversification of banks’ risks. The problem of risk diversification was very topical even 3 years ago because of Georgian banks received the biggest share of their income from loans. In 2001, 92 per cent of interest income of commercial banks was from loans. By the end of H1 2004, this indicator fell to 52 per cent while the share of non-interest income became 41 per cent. These figures indicate that banks have developed other services and that made them less vulnerable. Even four years ago the largest share of loans of commercial banks were extended to finance trade (mainly imports), while other sectors’ possibilities to obtain loans from bank remained limited. According to the National Bank’s data, in March 2001, 70 per cent of total loans were allocated to trade, while by March 2002 that indicator reached 77 per cent. The recent figures indicate that the structure of loans’ portfolio of commercial banks has been changed. The main segment of it is occupied by individuals’ loans. As of July 1st 2004, 32 per cent of loans were issued to physical persons, 34 per cent to trade and services, 15 per cent to the mining industry and 5 per cent to other sectors. The structure of the loans according to maturity also has been gradually changing toward the increasing of long-term loans. As of the end of 2002, the share of loans with a maturity of more than one year was 38 per cent, while as of June 30th 2004, it was - 54 per cent. Commercial banks are working towards improving the level of collateral and credibility assessment. As a result of that, the measures of the share of good loans in their loan portfolios has been gradually

3 In the process of harmonisation of the Georgian banking legislation with that of the EU and further development of the commercial banking system, the NBG increased the minimum paid-up capital to GEL 12 million. The EU standard for paid-up capital for banks is EUR 5 million. According to the NBG’s Order of January 13, 2004, all newly established banks including branches of foreign banks, are required to possess paid-up capital of GEL 12 million. For already established banks this requirement should be fulfilled by December 31, 2008 according to a special schedule

MONEY AND FINANCE


increasing. As of the end of 2003 it was 84 per cent and as of September 1st that figure increased to 88 per cent. The deposits of commercial banks indicate two main factors: the first that the Lari still plays a weak role as a mean of savings and the credibility of banks within the population has been improving. The share of foreign currencies deposits in the total deposit portfolio remains high, however dollarisation ratio of deposits fell from 86 to 76 per cent during January-August 2004. The share of individuals’ deposits increased by 15 per cent during January-August 2004 and comprised 52 per cent of total deposits. The average spreads between loans and the interest rates for time deposits are 18 per cent in the national currency and 10 per cent in foreign currencies. On average, commercial banks pay more interest for the long-term Lari deposits expecting some depreciation of the Lari in the long-term perspective. Simultaneously, loans in the national currency became more expensive, especially in 2004. This can be explained by the nominal appreciation of the Lari because banks had to avoid income loss in dollar terms. However, the share of loans in the national currency is relatively small (12 per cent) in the total loan portfolio of commercial banks and does not explain the total interest rate development. One of the important functions of banks is an intermediation between taxpayers and the budget. Commercial banks are large taxpayers themselves. The central bank plays the intermediate’s role between the budget and commercial banks. The tax policy is reflected in a Tax Code. So that the issue of a new tax code is very topical for commercial banks. The new tax code was approved by the Parliament of Georgia. It foresees tightened inspection and sanctions against delinquent taxpayers for the purpose of improvement of tax discipline but such approach caused some concern within the commercial banks. These are some patterns mentioned by banks of how the stricter tax rules could hamper their activity. The new Tax Code requires banks, in the case of necessity, to provide tax authorities with information about amount of taxpayers’ bank accounts and operations with those accounts. If an individual who does not operate any business opens a bank account the bank has to inform the tax authorities during 3 days about that. According to the banks all above measures are in contradiction with the principle of banking confidentiality. Under the new Tax Code the tax authorities are able to draw the amount payable from a taxpayer from its term deposit’s account. However term deposits are one of the main source of commercial banks loans so that this might create a misbalance of liquidity of a commercial bank that might negatively reflect on the bank’s sustainability. That is why from commercial banks’ point of view term deposits should not be used for tax settlements. The new tax code obliges to pay 5 per cent from declared amount payable for each overdue month as a penalty, but not less than GEL 200. In the case of long-term indebtedness the cutting off penalties will create an imbalance in the bank’s liquidity that will also negatively affect the bank’s financial position. The current Tax Code frames the penalty as 25 per cent of declared amount regardless the timing that creates the process of liquidity management more predictable. That is why banks suggest to set up an absolute amount or a ceiling for penalties. The Tax Code is likely to negatively affect commercial banks incomes since it instructs banks to provide payments with the Budget without commission fees. However, the NBG that provides the similar operations for commercial banks charge such commissions. It puts commercial banks into disadvantaged position. The share of those fees is small in banks’ income, however, the new Tax Code is likely to affect price setting in the banking system.

MONEY AND FINANCE


Along with the BANKING subchapter in this issue we started to observe Georgian commercial banks. It was motivated by high interest of wide spectrum of readers to this sector. At the same time it includes a component of observation of the Georgian business sector. In the further issues of GET the list of the banks will be continued and readers will be able to learn not only data reflecting banks’ activity but particular cases. Hereby we started with JSC TBC Bank the only Georgian bank that was nominated (three times) by Financial Times Group as one of the successful banks in the world4. JOINT-STOCK COMPANY TBC BANK. General Overview. TBC Bank was founded in December 1992. The first half of 90-s was characterised by insolvency of commercial banks in Georgia. At the same time the reform toward recovery of the banking and of the monetary system in the country was started. Within that reform, banks were obliged to fulfil special requirements directed to strengthening their management, financial positions and credibility. A lot of Georgian banks could not meet the requirements and closed down. However, this was not the case for TBC bank. This bank, together with a number of other banks, became one of the successful experiences of the Georgian banking system and during last 10 years enlarged their capital, assets, deposits, loan portfolio and scope of activity. Nowadays TBC bank has a network of 4 branches in Tbilisi and 6 in regions. The bank has about 500 employees that is a very high number of jobs created in the Georgian official sector. TBC Bank is the largest according to assets, deposits and loan portfolio. With GEL 55 million in capital the bank is the second largess commercial bank by capital. The trust relationship that TBC Bank has managed to establish with the international financial organisations played very important role in the successful development of its business. Initially credit lines were allocated by international financial organisations for projects aimed at development agriculture, processing industry and small and medium enterprises. Through those credit lines, the bank received financial resources that helped it to improve and enlarge its lending activity. The bank adequately managed its lending portfolio that became a precondition for further development of bank’s activity with the donors. TACIS allocated credit line for the agriculture sector, particularly for wheat production in 1996. In 1997, EBRD allocated a credit line to fund working capital, leasing and investment in fixed assets for SME’s development. Later on EBRD supported TBC Bank payment obligations to correspondent banks under a trade facilitation agreement. EBRD guarantees letters of credit issued by TBC Bank. TBC bank has been implementing an Agriculture Development Project and a Credit Union Development Project with the World Bank. The aim of those projects is development of private sector farming and agro-processing and establishment of rural credit unions in Georgia. In 1998, TBC Bank signed two agreements with the International Finance Corporation (IFC) on providing a long-term credit line and the purchasing of an option agreement for participation of IFC in the equity of TBC Bank. In 2001, the bank signed a new loan agreement with IFC to finance SME projects and a long-term mortgage loan program

4 Since its inception in 1926, The Banker magazine, a member of the Financial Times Group has been a trusted source of global financial intelligence and given The Banker’s exclusive bank ratings and banking coverage, it is uniquely placed to bring its worldwide perspective to the awards. The Banker, distributed to financial groups throughout the world, is of great prestige. The Financial Times Group rating is not a simple classification, as the organization selects all participant banks itself based on their financial performance.

MONEY AND FINANCE


In 1998, TBC Bank signed a 7 year Credit Line Agreement with German Investment and Development Company (DEG)5. Initially DEG provided TBC Bank with credit to finance small and medium size business in Georgia. In 2000, two other Credit Line Agreements were signed. From 1996 to December 2003 the bank signed agreements on USD 21 million and EUR 7 million. Foreign financial organisations developed their partnership by participation in the capital of the bank. In May 2000, IFC and DEG became the owners of 20 per cent (10 per cent each) of TBC bank’s capital. Three years later, in May 2003, Soros Investment Capital (SIC)6 purchased 25 per cent of shares of the bank (the maximum portion allowed by Georgian legislation for one or a group of shareholders)7. The combined shar

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