Over the last years Georgia’s relations with the International Monetary Fund (IMF) have been excellent. The three-year PRGF arrangement, which was completed successfully in September 2007, supported a wide range of economic reforms and thus laid the foundation for Georgia’s recent strong macro-economic performance. This strong performance has been very dependent on foreign inflows, mainly in the form of FDI.
As a result of the recent armed conflict, economic activity has been disrupted and investor confidence has been eroded. The Georgian authorities have requested the support from the IMF because they believe that such support can counter the erosion of investor confidence. The authorities are confident that the economy will recover from the conflict as a package of decisive measures, supported by a Stand-By Arrangement with the Fund, will succeed in reassuring the domestic and foreign business community as soon as possible.
The authorities strongly believe that their sound record of growth and stability can be continued in the future as stable macroeconomic conditions will continue to prevail and investors will be reassured that Georgia remains an attractive place for business.
The authorities are grateful for the swift and decisive response of management to their request for assistance and they are particularly grateful for the excellent and dedicated work of staff, who had to work under time pressure in a difficult and uncertain environment.
Since 2004, Georgia has implemented a policy of comprehensive economic reform, based on the firm conviction that economic growth and competitiveness are best fostered through private investment. To this end, barriers to private sector activity were eliminated through a comprehensive program of structural reform, deregulation and privatization. Georgia ranks as one of the top performers in the Doing Business survey, moving up to rank 15 on the ease of doing business in the 2009 survey which was published this week by the World Bank.
Economic growth over the past years has been at double digits. At the same time, inflationary pressures were inevitable, but intensified efforts to reduce inflation to single-digits have been successful, despite the complicated global environment of high energy and food prices.
Georgia’s extraordinary growth performance has been driven by private capital inflows. By 2007, private capital inflows had increased to $2.2 billion (22 per cent of GDP) and they continued unabated in the first half of 2008. At the same time the current account deficit has increased substantially (to 26 per cent of GDP in the first half of 2008) and this has made the economy vulnerable to sudden reversals in investor confidence.
Exports have grown exponentially (average annual growth of 26 per cent over 2003–07) and have been significantly diversified. Georgia is actively pursuing free-trade agreements with Turkey and the United States, and it benefits from good trade relations with the European Union.
Greatly improved revenue performance has allowed Georgia to modernize its state and civil service, enhance the social safety net and invest in infrastructure. This achievement was the result of improved tax administration, simplified procedures, better taxpayer services, and, most important, fewer taxes and lower rates. During the first half of 2008, revenue collection and privatization proceeds exceeded the forecasts. The major part of the proceeds of a Eurobond, which was issued successfully in April 2008, were transferred to newly created sovereign wealth funds.
Recently the institutional set-up for the conduct of monetary policy and supervision has been modernized. Amendments to the central bank law now make price stability the primary objective of the National Bank of Georgia (NBG), requiring the NBG to target single-digit inflation. At the same time a new Financial Supervision Agency (FSA) was created as a fully independent agency with its own supervisory board. The FSA will be responsible for the consolidated supervision of banks, insurance companies and securities firms.
As a result of tight monetary policy both reserve money growth and the growth of bank credit have slowed significantly in the first half of this year. At the same time, the NBG has allowed much greater flexibility in exchange rates and the lari has appreciated by nearly 13 percent vis-à-vis the US dollar in the course of this year, thereby contributing to reducing inflation.
As a result of the armed conflict, the macroeconomic outlook has deteriorated as private inflows are expected to slow down sharply. This sharp downward revision of economic prospects has brought the vulnerability of the external sector to the fore. In the absence of international support, including from the IMF, Georgia’s international reserves would decline sharply over the remainder of this year and next, to a level that would cover just a few weeks of imports. This would further increase vulnerabilities and substantially weaken Georgia’s external position. Strong and rapid international support will therefore be essential to allow the maintenance of an adequate level of reserves.
The staff projection of a financing gap of about $1.2 billion over 2008-09 is expected to be only partially covered by the IMF as there is a strong expectation on the part of the authorities that grants and concessional financing provided by other IFIs and bilateral donors and creditors will be forthcoming. The authorities intend to make a first drawing under the SBA to shore up reserves to close to the targeted level over the program period. This would provide the program with a strong starting position and assist in a rebound of confidence among investors. Such initial drawing would also be helpful as long as there are no concrete indications regarding the size and the timing of donor assistance.
There is a clear understanding that Fund credit would solely be used to bolster central bank reserves and would not be used to finance the fiscal deficit. The authorities are hopeful that, with international assistance from other sources forthcoming, the remainder of the financial support under the program can be regarded as precautionary as inflows resume.
The authorities are fully committed to a flexible exchange rate policy. It was necessary to defend the lari during the crisis period in order to prevent further uneasiness in the market. Under the program, priority will be given to maintaining the targeted level of international reserves, and the exchange rate will be allowed to adjust to a shortfall in foreign inflows.
The program supported by the Stand-By Arrangement with the IMF is expected to restore investor confidence. Private inflows are anticipated to pick up modestly in 2009 and sustain higher investment, while export growth is expected to increase gradually. As a result, real GDP growth is projected to recover to mid single digits, while inflation (which would remain in single digits) would decline gradually. The current account deficit, while still large, is expected to decrease over time to around 16 per cent of GDP in 2010.
As spelled out in greater detail in the Letter of Intent, the authorities have taken a number of comprehensive measures to ensure that the fiscal deficit will remain within the agreed targets of 6 per cent in 2008 and 3¾ per cent in 2009. These targets will be subject to an upward adjustor in case concessional donor financing exceeds pre-conflict commitments. To increase transparency, the Ministry of Finance will produce annual reports on consolidated public expenditures and public arrears and debt.
The reconstruction costs, provisionally estimated at around $ 1 billion, including the resettlement costs for displaced persons, will require an increase in spending, and therefore some temporary increase in the fiscal deficit is inevitable. Since much of this spending is likely to be financed by donor grants, the maintenance of a sound macroeconomic fiscal framework in the medium term is feasible. The Georgian authorities remain committed to structurally minimize the size of the fiscal footprint on the economy.
Monetary policy will remain strongly committed to maintaining single-digit inflation and reducing it gradually in the medium term. To this end the authorities plan to adopt an inflation-targeting regime in the course of 2009. In the immediate future, monetary policy will be guided by quarterly targets for the net international reserves and net domestic assets of the NBG, as set out in the program.
The loss of confidence has had a serious impact on bank liquidity. This has made it necessary for the NBG to waive the reserve requirements on a temporary basis, and activate an uncollateralized lending facility. In the coming months a liquidity management framework will be developed in order to preserve financial stability and ensure a smooth functioning of the payments system. The NBG will also revise its lender of last resort facility to ensure that this would not encourage excessive risk-taking by financial institutions. Close collaboration with the FSA will be needed.
The financial sector has shown considerable overall stability and resilience during the recent conflict. The NBG and FSA have worked well together to ensure the smooth operation of the payments system, as well as to maintain public confidence in the lari and the banks. Nevertheless, the authorities are fully aware that substantial risks for financial stability remain. The FSA has started to assess any potential vulnerabilities in the banking sector by conducting on-site inspections. Next, the FSA will make sure that the banks have contingency plans readily available to mitigate potential liquidity and capital pressures in the near future.
Cooperation between the FSA and the NBG needs to be further strengthened, including arrangements for information exchange on individual institutions’ positions and for sharing possible irregularities in the financial system. The authorities would welcome a streamlined and focused Financial Sector Assessment Program (FSAP) update mission in the second half of 2009 to assess developments in the financial sector and review the new regulatory set-up.
The Georgian authorities are grateful for management, staff and the Board to agree on a program under the Stand-By Arrangement under the exceptional access procedures. They fully understand that the support of the IMF builds on the excellent relationship with the IMF over the past years and the good track record built up under previous programs. They are fully committed to bring the program to a successful ending and they are confident that the IMF’s support will be helpful in getting the economy back on track. They stand ready to take additional measures if this were to be necessary. Georgia will maintain the usual close policy dialogue with the Fund. Such dialogue can be assisted by the continued presence of a resident representative, should the IMF decide to maintain the post open.