Georgia
Recent Economic Developments and Selected Issues
Author: International Monetary Fund
Publication Date:
26 Nov 2001
eISBN:
9781451814507
ISBN:
9781451814507
Language:
English
Keywords:
ISCR; CR; foreign currency; exchange rate; banking sector; treasury bill; banking system; distribution company; tax code; monetary policy; State capture; private sector; reform program; foreign direct investment
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Real GDP growth in Georgia has been slow since the Russian crisis, but there are signs of more vigorous growth, despite weak external demand. The paper discusses administrative corruption, state capture, influence, and tax policy formulation. The trends of total social expenditure in relation to fiscal adjustment have been analyzed and discussed in the context of Georgia's poverty reduction strategy. Banking sector reforms and financial development, dollarization, the energy sector, and statistical data of economic indices of Georgia are also presented.

Abstract

Real GDP growth in Georgia has been slow since the Russian crisis, but there are signs of more vigorous growth, despite weak external demand. The paper discusses administrative corruption, state capture, influence, and tax policy formulation. The trends of total social expenditure in relation to fiscal adjustment have been analyzed and discussed in the context of Georgia's poverty reduction strategy. Banking sector reforms and financial development, dollarization, the energy sector, and statistical data of economic indices of Georgia are also presented.

I. Recent Economic Developments

A. Real Sector

Output

1. Real GDP growth in Georgia has been slow since the Russian crisis, but there are signs of more vigorous growth in the first half of 2001, despite weak external demand. After several years of double-digit output growth in the mid-90s, growth slowed to about 3 percent in 1998 and 1999 and less than 2 percent in 2000. This reflected the Russian crisis of 1998, droughts in 1998 and 2000, increasingly severe energy supply problems, and underlying structural problems, particularly in the fiscal and governance areas. However, growth in the first half of 2001 was over 5 percent, reflecting a rebound in agriculture and strong growth in some services, particularly communications, hotels and restaurants (Figure I-1 and Table A-1).

Figure I-1.
Figure I-1.

Georgia: Macroeconomic Indicators, 1997-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Sources: Georgian authorities; and Fund staff estimates.1/ Commitment basis.2/ Excluding official transfers.

Revised GDP Estimates

In early 2001, the authorities published revised GDP estimates for the period 1996 to 2000. The changes consisted of an upward revision of spending on education and health and a downward revision of spending on financial intermediation. A technical assistance mission by the IMF’s Statistics Department found the data methodology to be basically sound, although some refinements were recommended. The largest change that was made in the context of this revision was a 3.6 percent upward adjustment to 1998 GDP. This is a much smaller change than the 34 percent downward revision of GDP undertaken in early 2000, and may suggest an increasing reliability of the GDP figures produced by the Georgian State Department of Statistics. However, many problems persist, including with measuring financial intermediation.

2. Agriculture was hit by droughts in 1998 and 2000, but is expected to grow strongly in 2001. The expectation of recovery in 2001 is based on very favorable weather conditions through end-July and on the availability of high quality seeds brought into the country through international aid following last year’s drought. However, a lack of irrigation systems, poor infrastructure in rural areas, the lack of a well-developed land market, and limited access to credit continue to constrain the sector. The share of agriculture in GDP has fallen from about a third of GDP in the mid-90s to under a quarter today (Table A-1).

3. After a drop of industrial output in 1998, industry grew by nearly 3½ percent in 1999 and by 3¼ percent in 2000. More recently, energy supply interruptions were the main factor behind a sharp decline of industrial output in the first quarter of 2001, but there was a rebound in the second quarter as continuous energy supply resumed.1 Nonetheless, industrial output fell by ½ percent in the first half 2001 compared to a year earlier. In recent years, industry’s share of GDP has been stable at 13-14 percent, but performance has been uneven across industries, with mining and food-processing performing better than the industrial average. In large parts of heavy industry, privatization and restructuring have been slow, leading to relatively weak performance (Tables A-1 and A-2).

4. Construction output has been volatile in recent years, partly reflecting the influence of pipeline construction. The Baku-Supsa pipline project boosted construction in 1997 and 1998. After the pipeline had been completed in 1998, a decline in construction followed in 1999. The sector grew moderately during 2000, but slowed in the first half of 2001. Construction accounts for about 4 percent of GDP.

5. Privately-supplied services have shown above-average growth in recent years. The combined share in GDP of services delivered in the areas trade, hotels and restaurants, transport, communications and financial intermediation has steadily increased from 21 percent in 1996 to 30 percent in the first half of 2001. Transport and communications have been the strongest sectors, both more than doubling their shares of GDP since 1996. By contrast, trade has shown only a small gain in share of GDP.

Labor market developments

6. Total employment grew by only 1 percent between 1998 and 2000, but private sector employment is recovering strongly, while state sector employment has declined steadily (Table A-4). The unemployment rate on the ILO definition increased from 7¾ percent in 1997 to a peak of 12¾ percent in 1999 and then fell back to 10½ percent in 2000 (Table A-5). After registering substantial gains in 1997 and 1998, real wage growth slowed to 2 percent in 1999 in the aftermath of the Russian crisis but recovered to 12 percent in 2000 (Table A-6 and Figure I-2).2

Figure I-2.
Figure I-2.

Georgia: Average Monthly Wages for the Whole Economy, 1997-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Sources: Georgian authorities; and Fund staff estimates.

Prices

7. After an inflationary spike due to the Russian crisis, inflation continued its downward trend and has been stable at around 5 percent since mid-2000 (Table A-8). The decline in inflation that started in 1995 was interrupted in late 1998 by the depreciation of the lari in the wake of the Russian crisis, and the annual inflation rate rose to over 20 percent during much of 1999. However, inflation dropped back to 4½ percent by end-2000, reflecting firm monetary policy, a more stable exchange rate, and the absence of demand side pressures. It remained at about that level in the 12 months to August 2001.

B. Fiscal Sector

8. Fiscal performance improved significantly in 2000. While total revenues and grants remained stable compared to 1999 as a percentage of GDP, tax revenues increased by ½ percent of GDP (Table A-9 and Figure I-3).3 This was offset by a sharp decline in grants. Total expenditure and net lending fell by 3 percent of GDP to the lowest level since 1995. This was accounted for by cuts in both primary current expenditure and capital expenditure (partly reflecting lower external project financing), while interest payments increased slightly. The deficit on a commitment basis declined by 2½ percent of GDP, to 4 percent. The accumulation of expenditure arrears, mainly in the first half of the year, remained high and contributed to limiting the deficit on a cash basis to 2½ percent of GDP, half the level of 1999. The improvement in the fiscal stance occurred in the second half of the year and, in particular, in the fourth quarter. It reflected both a strengthening of the tax and customs administrations, and a revised budget in mid-year, following the presidential election, which sharply reduced expenditure commitments.

Figure I-3.
Figure I-3.

Georgia: Public Finances, 1998-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Sources: Georgian authorities; and Fund staff estimates.1/ Commitment basis.

9. In 2001, the fiscal situation deteriorated during January-April but has since recovered. The budget for 2001 envisaged a further increase in tax revenues of about ½ percent of GDP, further reductions in current expenditure commitments, a commitments deficit of 2 percent of GDP, and repayment of expenditure arrears of just over 1 percent of GDP. In the early months of the year, tax collections fell short of the budget target. Possible reasons include weaker than expected economic activity during the winter; the introduction of a visa regime by Russia that reduced migrant workers’ remittances; reductions of excise rates on domestic tobacco products and car property fees, approved by parliament in December 2000; and increased smuggling of cigarettes and oil and petroleum products.4 Domestic financing also turned out lower than assumed, partly because of difficulties in selling Treasury bills. The resulting shortfalls led to expenditure arrears accumulation. However, from May to August tax collection recovered, helped by stronger economic activity, allowing the clearance of the arrears that had been accumulated in the first quarter.

10. The reform of fiscal institutions continued in 2000 and 2001. The Ministry of Revenue’s Large Taxpayers’ Inspectorate (LTI) closed its “Social Fund Department” in order to strengthen tax administration. The department’s duties were attributed to the functional areas of the Inspectorate. In the area of expenditure control and management, the Ministry of Finance assumed the sub-treasury accounts that were previously controlled by the Ministries of Defense and the Interior; introduced a system of recording contracts that exceed a defined threshold; audited the pre-2001 stock of expenditure arrears; revised the regulations on customs exemptions; and introduced an administrative unit to strengthen controls on exempted imports. The collection capacity of the tax and customs administration was, however, adversely affected by high turnover of senior staff of the State Customs Department and by a Ministry of Revenue decree of April 2001 that, inconsistently with the identification criteria, removed some large taxpayers from the Large Taxpayers’ Inspectorate.

Fiscal Institutional Setting

In 2000-01, there were no major changes to the institutional structure of the general government, which comprises central and local government and extrabudgetary funds. The local government accounts include the autonomous republic of Adjara, but South Ossetia and Abkazia do not have fiscal relations with the central budget. There are 10 administrative regions and 53 administrative districts. There are three extrabudgetary funds, the Social Security Fund, the Road Fund, and the Employment Fund (for details see Chapter III). The central government, together with these funds, is referred to as the state government.

Local government budgets, unlike the state budget, are not subject to parliamentary approval but are heavily influenced by the state government. Local governments do not have the legal authority to levy their own taxes. Instead, they receive a portion of revenues from the various state taxes, with the share varying according to the region and type of taxes. In 2000, local government budgets received 31.2 percent of the total tax revenues (about 1 percentage point more than in 1999).

C. Monetary Policy and Financial Markets

11. The Russian crisis and a weak fiscal position have been important challenges for the financial sector. Concerns about the unsustainable fiscal situation and the onset of the Russia crisis in the latter part of 1998 brought about a sharp contraction of lari money demand. The treasury bill market was curtailed, the banking system came under significant pressure, and there was a loss of confidence in the lari, culminating in a sharp depreciation in December 1998.

12. Since the crisis, money demand has increased substantially and financial intermediation has resumed, but confidence in the lari seems to remain weak. Broad money (including foreign exchange deposits) increased by 43 percent from end 1999 to June 2001. This reflected a sharp increase in commercial banks’ deposit liabilities of 67 percent. Over the same period, the money multiplier rose from 1.44 to 1.66, and M3-velocity fell from 13.7 to 9.6. However, dollarization increased significantly in the wake of the Russia crisis, rising from 69 percent at end-1998 to 79 percent at end-1999.5 Since then, dollarization has failed to decline in spite of more favorable macroeconomic developments, suggesting that confidence in the lari remains low. (Figures I-4 and I-5 and Tables A-15 to A-24).

Figure I-4.
Figure I-4.

Georgia: Monetary Indicators, 1997-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: National Bank of Georgia.1/ Difference between amount sold and amount purchased.
Figure I-5.
Figure I-5.

Georgia: Foreign Exchange Market and International Reserves, 1997-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: National Bank of Georgia.1/ No interventions occurred in January nor February 1999.

13. Prudent monetary policy has contributed to low inflation and a stable exchange rate within a floating exchange rate regime.6 Following a tight monetary stance in the wake of the events in 1998, fiscal pressures exerted considerable strains on monetary policy in the late 1999 and the first half of 2000. This led to a sizeable expansion of net credit to government that contributed to pressures in the foreign exchange market, leading to a significant deterioration in net international reserves. During the second half of 2000, the fiscal situation improved and the NBG was able to rein in credit to the government. It was also able to ease reserve requirements by two percentage points in June 2000.7 At the same time, the NBG began to step up its purchases of foreign exchange in order to bolster reserves. During 2000, due to favorable balance of payments developments, purchases amounted to US$75 million. Since most of these purchases occurred toward the end of 2000, reserve money growth began to accelerate sharply at the end of the year. However, this did not have a significant impact on inflation in 2001, as the central bank maintained a tight rein on government credit, and reserve money fell back during the first half of 2001.

14. In the banking sector, prudential regulations have been strengthened, but confidence remains low. The Russian crisis and the loss of confidence in financial markets put a significant strain on the banking system, but a full-scale crisis was averted, in part because the NBG extended liquidity support to some larger banks. The strengthening of prudential requirements and improved supervision have revealed weaknesses in the sector. In the past two years, additional prudential requirements were put in place, including higher minimum capital requirements, revised asset classification and provisioning requirements, and international accounting standards (Table A-24). In addition, technical assistance has improved the NBG’s supervisory ability.8

15. The treasury bill market remains very thin, thereby limiting the development of indirect monetary instruments. In December 1998, the entire stock of treasury bills was retired, after a peak stock of outstanding bills of lari 23 million had been reached in mid-1998. Auctions resumed in August 1999, but continued lack of confidence in fiscal policy limited sales. In addition, the government resorted to direct borrowing from the banking system, thereby undermining the treasury bill market. Conditions improved somewhat in the latter part of 2000, as the fiscal situation improved and the practice of direct borrowing was stopped, although the stock of treasury bills at end-2000 was only lari 3 million. During 2001, some further progress was made, and the stock reached 6 million by June 2001. A secondary market for treasury bills exists but the small size of the primary market limits its development.

16. Nominal interest rates have generally declined since 1999, reflecting in part the decline of inflation, although the Turkish crisis adversely affected rates at the beginning of 2001. The interest rate for 30-day maturity loans in the interbank credit auction fell from 29 percent at end-1999 to 14 percent as of end-June 2001 (Table A-22), Treasury bill yields edged downward from 12 percent at end-1999 to 7 percent in November 2000.9 They rose again in early 2001, possibly influenced by concerns surrounding events in Turkey as well as a weakening of the fiscal situation. However, since May 2001 they have eased downward again.

D. External Sector

17. The external current account strengthened in 2000 but was adversely affected by the Turkish crisis in the first half of 2001. The current account deficit declined from 8½ percent of GDP in 1999 to 5½ percent of GDP in 2000 (Table A-25).10 Customs data, covering only recorded trade, point to a strong increase of exports by 39 percent and a moderate increase of imports by 8 percent in 2000. However, the current account improvement has been reversed in the early months of 2001. Exports declined sharply, reflecting the lower industrial production in early 2001 and the Turkish crisis, while imports increased moderately.

18. Turkey became the largest importer of Georgian goods in 2000, but exports to Russia were also strong. Russia’s share of Georgia’s exports dropped sharply in the wake of the Russian crisis. Although exports to Russia grew strongly in 2000, reflecting a real depreciation of the lari against the ruble and the strong growth of the Russian economy, Turkey became Georgia’s largest export market in 2000 (Table A-26). In part, this reflected a strong increase of exports of scrap metal, following the elimination of an export tax on scrap metal in 1999 (Table A-27).

19. The nominal exchange rate was stable during 2000 but depreciated moderately in early 2001, following the crisis in Turkey. Since then, the nominal rate has been stable. The real effective exchange rate showed little overall change in 2000, in spite of a real depreciation against the ruble. In the first half of 2001, however, it appreciated, mainly because of the sharp depreciation of the Turkish lira (Figure I-6 and Table A-31).

Figure I-6.
Figure I-6.

Georgia: Bilateral and Real Effective Exchange Rates, 1997–2001 1/

(1995=100)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: IMF, Information Notice System; and Fund staff estimates.1/ Increase indicates appreciation.

20. The external capital account remained weak in 2000, with lower concessional loan disbursements offsetting larger foreign direct investment. Disbursements of medium- and long-term loans decreased to US$35 million, as World Bank structural adjustment lending was delayed. Principal falling due rose to US$110 million. However, foreign direct investment increased to US$153 million, mainly due to the investment by the US-based electricity utility AES in rehabilitation and upgrading of their Georgian assets.

21. Despite strong current account developments, low loan disbursements and high debt service obligations led to a fall in official reserves and accumulation of external arrears. Gross international reserves fell by US$23 million to US$109 million (0.9 months of import cover) at end-2000. Exceptional financing in 2000 included arrears on debt service of US$68 million, partly offset by net repurchases to the IMF of US$27 million. Georgia paid US$12 million to Turkmenistan (of the US$79 million due in principal) through an in-kind transaction. Georgia received no loans from the IMF during 2000. However, in January 2001, the IMF approved a three-year arrangement under the PRGF amounting to SDR108 million (72 percent of quota), and SDR18 million were drawn in the first quarter of 2001. The gross reserves rose to US$128 million by end-August 2001.

22. Georgia’s external debts remain very high. At end-2000, external debt stood at US$1.6 billion (53 percent of GDP), of which about 50 percent was debt to bilateral creditors (Table A-29). Of the bilateral debt, about 90 percent was incurred prior to December 1994 and had been rescheduled previously.11 In 2000, Georgia started to make principal repayments to Russia, China, and Ukraine, as agreed during previous bilateral rescheduling. Principal repayment to Turkmenistan started in 1998, but Georgia, while remaining current on interest payments, has had continuing difficulties in making these principal payments. By end-2000, arrears to Turkmentistan amounted to US$179 million.

23. Georgia successfully concluded a rescheduling of bilateral debt with Paris Club creditors in March 2001. The agreement involves a rescheduling of principal payments falling due during 2001 and 2002 on medium- and long-term government debt contracted before November 1, 1999. Under this agreement, all of the previously rescheduled debt is subject to new rescheduling. Payments will be rescheduled over 20 years, with a 3-year grace period and a graduated repayment schedule. Creditors agreed to apply an interest rate no higher than that already applied to previously rescheduled debt (4 percent). The agreement includes a good will clause in which creditors agreed in principle and in case of a financing need to consider an extension of the consolidation period through end-2003.

24. Georgia maintains an open and liberal trade regime and acceded to the WTO in June 2000. The IMF’s trade restrictiveness index for Georgia is currently 2 on a scale of 1 to 10. In line with commitments to the WTO, the authorities intend to change the import tariff schedule from 0, 5, and 12 percent to 0, 4, 9, and 12 percent. The simple average tariff rate, which currently stands at 10.9 percent, can be expected to decline further. However, the parliament passed a resolution in July 2001 to introduce a temporary ban on the export of timber through end-December 2001.

E. Structural Reform

25. After significant strides since 1995, the pace of structural reform has slowed. Progress has been made in privatization, regulatory reform, banking sector restructuring, trade liberalization, judicial reforms, and health sector reforms. However, recently the pace of reform has been affected by uneven commitment in implementation, weak institutional capacity, and poor governance, and much still needs to be done to complete the market reform agenda. Priorities include the completion of initiated reforms, particularly in the areas of governance, privatization, and energy sector reform;12 a substantial improvement in the environment for business; and investments in public infrastructure and services.

26. The government has intensified its privatization efforts, but no significant sales have been completed in the past two years. Under the government’s plan, infrastructure is to be offered to strategic investors via a competitive tender process, either through outright sales to strategic investors of a controlling majority of shares (e.g. telecom and energy generation/distribution), or through long-term concessions for commercial activities (e.g. water and port concessioning). The highlight so far has been the privatization of Tbilisi’s Telasi Power Company at end-1998, when 75 percent of the shares were sold to a U.S. investor, AES. Georgia has also sold productive assets at the thermal power plant Tbilsresi, and concessioned two major hydropower plants to the same investor. The government is currently working with IFC to privatize the remaining distribution and generation companies, and under the IDA-supported Electricity Market Support Project, the government is hiring a private international management contractor to manage the electricity transmission and dispatch companies and the wholesale electricity market. The government has also requested World Bank assistance to lease Tbilisi’s water utility, and plans to replicate this approach in other urban areas. The government has designed a development strategy and regulatory framework for Poti Port that entails the creation of a new Port Authority, and granting of concessions to private operators; bidding documents to concession one berth have already been completed. In 2001, a tender for privatization of the telecommunications sector was issued. Lack of investor interest, powerful vested interests and corruption in the energy sector have impeded progress in privatization of infrastructure to strategic investors.

27. Progress has been made in agricultural land privatization. The agricultural land privatization program started in 1992 and involved the distribution of individual land plots (850,000 hectares) to private farmers. In 1996, the Government instituted a land lease program involving about 750,000 hectares. To date, nearly 900 land parcels have been privatized. The government’s reform program envisages the creation of a land registration system that would be the basis for the development of a land market by allowing land to serve as bank collateral.

28. Corruption remains a major constraint on economic growth, development, and poverty alleviation efforts. In mid-2000, President Shevardnadze established an anti-corruption advisory body, including representatives from the three branches of the government and from civil society, to develop a strategy for combating corruption. The commission prepared a paper that was endorsed by the President and published in November 2000. It lays out a broad strategy to combat corruption, including measures in six main areas: liberalization of the business environment; improving the effectiveness of the state management system; strengthening law enforcement bodies and judiciary; development of representative democracy; and reform in education. However, implementation is proceeding slowly. In March 2001, presidential decree No. 95 identified specific short-term measures to be implemented, including measures to broaden financial disclosure, clarify the role of regulatory agencies, introduce audits in government agencies and require publication of their expenditures. An anti-corruption council was established comprising representatives from government and civil society in order to monitor progress. A recent report issued by the council, following up on the implementation of decree No. 95, was critical of progress made, indicating that a number of measures were not fully implemented. In July, another presidential decree was issued (No. 758) that aims at increasing fiscal transparency, including through proposals for a draft budget code, monitoring of state debt, the establishment of a code of ethics for civil officials, and elimination of revenue transit accounts.

29. The government has also embarked on initiatives aimed at reducing administrative interference via public procurement and licensing reforms. The public procurement law was amended in April 2001 to address problems with the 1998 law, on the basis of a review carried out in collaboration with the World Bank. The law on licensing was enacted in 1999 and regulations were issued by the various licensing agencies. In April 2001, the Government decided to substantially amend the current law. The revised law will provide the legal instrument to repeal the various licenses (and permits) that have proliferated at the central and local levels, include general principles for issuing licenses, and provide for the establishment of a monitoring unit within the Ministry of Justice to ensure the proper implementation of the licensing reforms.

II. Administrative Corruption, State Capture, Influence and Tax POLICY FORMULATION13

A. Summary and Introduction

  • Several surveys indicate that domestic enterprises and the public believe that Georgia has high levels of administrative corruption both in terms of the spread of institutions affected and relative to perceptions of administrative corruption in a majority of other CIS countries. A significant proportion of firms perceive that the policy process in Georgia is captured by narrow interests.

  • An analysis of changes to the Georgian tax code since its passage into law in 1997 indicates that some sectors, particularly excisable goods, have had frequent changes of tax legislation that have served to narrow the tax base, reduce effective rates and complicate the administration of tax policy. A detailed case study of tobacco excises is presented.

  • Tentative conclusions are that corporate interests substantially influenced the policies for taxation of excisable goods, particularly tobacco products, and that firms clearly influenced VAT policy by lobbying for tax preferences in the areas of energy exploration, agriculture and utilities, although there is no evidence of direct payments to purchase policy change in any of these cases.

  • The central policy lessons are: proposals to change tax policy legislation should include a clear indication of the likely revenue impact, preferably by an independent authority, so that policymakers can have access to information that will enable them to make an accurate assessment of the claims of sectoral interests; and, in the interests of fiscal and legislative stability, that tax policy amendments only be made in conjunction with presentation of the budget or amendments to the budget, to avoid inconsistencies between tax legislation and budget revenue estimates.

30. Studies of corruption in transition economies identify several types of interaction between firms and the state: administrative corruption where illegal or informal payments are made to public officials to obtain a particular administrative or regulatory outcome; state capture where payments are made to “purchase” laws and regulations and alter the rules for commercial activity; and finally, cases where firms influence policy making without recourse to illicit payments to officials. This chapter considers the extent of administrative corruption and state capture in Georgia and the extent to which the latter might affect the formulation of tax policy in the areas of VAT and excises.

B. Administrative Corruption and State Capture in Georgia

31. The analysis of economic performance in transition economies has increasingly focused on the impact of pervasive corruption in inhibiting investment, deterring competition, reducing fiscal revenues and more broadly in restraining economic growth and poverty reduction.14 As indicated by Kaminski and Kaminski: “Corruption belongs to the broad category of phenomena when formal institutional rules become inactive and people’s activities become guided by concerns external to the organizational mission.”15

32. Surveys in Georgia, and in most transition economies, indicate that administrative corruption involving side payments is widespread and that the public and enterprises view state institutions as having a high level of dishonesty. Cross-country surveys place Georgia in a group of “high corruption” countries within the post-Soviet space, particularly in terms of administrative corruption.

33. An empirical enterprise perception survey (EBRD/WB Business Environment and Enterprise Performance Survey—BEEPS; EBRD, 1999) attempts to distinguish between small scale administrative corruption and high level grand corruption. The BEEPS survey draws a distinction between administrative corruption where firms pay bribes to circumvent bureaucratic and regulatory procedures, including kickbacks on public procurement contracts, and “state capture” where firms extract rents from the state by “purchasing” laws, rules and regulations from state actors.

34. The Georgian sample of 129 enterprises in the 1999 BEEPs survey indicated above average severity of both administrative corruption and state and judicial capture (Figure II-1).

Figure II-1.
Figure II-1.

Georgia; State Capture and Administrative Corruption: Georgia and Regional Averages

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Hellman, J., G. Jones and D. Kaufmann, 2000, “Seize the State, Seize the Day: State Capture, Corruption, and Influence in Transition,” “World Bank Policy Research Working Paper 2444 (http://www.worldbank.org/wbi/governance/).Note: The thick line represents the estimated performance of the country you chose on each of the four dimensions. Distance from the origin indicates worsening of the degree of capture and corruption respectively. The dashed line represents the average performance of by the countries in the Former Soviet Union. The dotted line indicates the average performance of the countries in Eastern Europe (outside the Former Soviet Union).

35. As regards administrative corruption proxied by average bribe payments as a share of firm revenues, Georgia is above both CIS and CEE averages with over 4 percent of revenue paid as bribes to public officials (Figure II-2). Enterprise managers were asked “what percentage of revenues do firms like yours pay per annum in unofficial payments to public officials?”

Figure II-2.
Figure II-2.

Georgia: Administrative Corruption: Bribery Payments as a Share of Gross Firm Revenues

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Hellman, J., G. Jones and D. Kaufmann, 2000, “Seize the State, Seize the Day: State Capture, Corruption, and Influence in Transition,” World Bank Policy Research Working Paper 2444 (http://www.worldbank.org/wbi/governance/).

36. Another survey undertaken with the agreement of the Government of Georgia assessed perceptions of corruption by 1,350 businesses, households and public employees (World Bank and USAID, 1998, unpublished). All three groups of respondents ranked police and traffic police, tax and customs authorities and energy sector companies as the most dishonest institutions from a list of 22 public and civil society structures. This survey quantified the degree of administrative corruption in terms of bribes paid by those admitting the need to pay bribes. Businesses reported the highest average bribes paid for tax inspections, building permits, import permits or licenses, and customs clearance.

37. As revenue collection agencies are widely associated with administrative corruption in transition countries, it is not surprising that there is a negative correlation between an index of the level of perceived corruption and the level of tax collections as a share of GDP. This correlation is shown in Figure II-3 and is statistically significant from zero at the 95 percent confidence level.

Figure II-3.
Figure II-3.

Georgia: Administrative Corruption Index and Revenue/GDP

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Source: Hellman, J., G. Jones and D. Kaufmann, 2000, “Seize the State, Seize the Day: State Capture, Corruption, and Influence in Transition,” World Bank Policy Research Working Paper 2444 (http://www.worldbank.org/wbi/governance/) and IMF staff estimates.Notes: Revenue/GDP ratio defined as average of latest available three calendar years to 1999. Country selection and definition of Administrative Corruption Index see Figure 2.

38. State capture is analogous to the existence of vested interests which influence public policy in order to further private, group or clan interests without reference to stated public policy goals. In practice, the distinction between the articulation of vested interests seeking to capture the state and the legitimate operation of pressure and lobby groups in a democratic system is often hard to determine. One criterion to distinguish between state capture and more democratic bargains is based on whether or not financial transfers are used as a tool to achieve policy change, although this is rarely documented. A second, weaker, criterion is the specificity of policy change—whether it channels benefits to a single or small group of economic interests, with costs—such as loss of tax revenue—spread more widely.

39. Aside from the practical problem of distinguishing state capture from legitimate democratic processes, the perception of its impact may be very difficult to assess as the benefits or rents accrue to relatively few interests while the costs may be very widely spread.

40. A significant proportion of surveyed firms in Georgia reported that they were affected by decrees, laws, criminal and commercial court actions that they classed as reflecting state capture. A composite index of state capture reflecting the proportion of firms affected by different types of state capture placed Georgia in the second worst quintile of 22 CEE and CIS countries, with greater impact of state capture reported in Azerbaijan, Bulgaria, Croatia, Kyrgyzstan, Latvia, Moldova, Russia and Ukraine (Table II-1). State capture in Georgia was most widely perceived to have affected Parliamentary legislation, presidential decrees and central bank actions.

Table II-1.

Direct Impact of State Capture on Firms

(Percent of firms reporting a significant or very significant impact of state capture, unless otherwise indicated)

article image

Calculated as the unweighted average of the six component indices.

Source: “Seize the State, Seize the Day: State Capture, Corruption, and Influence in Transition,” p. 9 (World Bank PRWP 2444, http://www.worldbank.org/wbi/governance/).

41. More broadly, the relationship between the impact of state capture in the EBRD/WB survey and economic or fiscal variables is less clear than for administrative corruption. For example, the relationship between revenue yield and state capture is statistically weak. This is not surprising as the index of state capture includes many variables that are not directly related to tax collection, such as procedures in civil and criminal courts and party political finance (Figure II-4).

Figure II-4.
Figure II-4.

Georgia: State Capture and its Subcomponents: Research Results

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Hellman, J., G. Jones and D. Kaufmann, 2000, “Seize the State, Seize the Day: State Capture, Corruption, and Influence in Transition,” World Bank Policy Research Working Paper 2444 (http://www.worldbank.org/wbi/governance/).Note: The dotted bars represent estimates of the percentage of countries which rate worse on each governance dimension than the country you chose. Thus, longer bars mean better performance. The error bars indicate the percentage of countries which rate worse (better, respectively) after taking into account the standard error of the estimates.

C. State Capture, Influence and the Tax Policy Process in Georgia

42. Although survey evidence in transition economies indicates that a significant proportion of firms perceive that the policy process is captured by narrow interests and also perceive a direct impact effect from this capture, less attention has been focused on how state capture works in practice or the type of interests that influence the policy process. Cross-country analysis has focused on the links between indicators of perceived corruption and underlying weaknesses in public policies and institutions with various proxy indicators of political development and the depth of structural reforms.

43. To illustrate and analyze state capture in Georgia, we consider the tax policy process since the passage of a comprehensive Tax Code. The approval of the Tax Code of Georgia in June 1997 served to rationalize the tax system by bringing all tax legislation together into a single legislative document from 29 separate legal acts—the Georgian authorities worked closely with Fund staff legal experts in drafting the Code. The Code came into force progressively and by January 1998 was fully in force. The Code also broadened the tax base by eliminating some exemptions (although many remained, particularly under the VAT), defined taxpayer rights and obligations clearly, and reduced various excessive tax penalties introduced during an earlier period of high inflation.

44. The main taxes and rate structure of the Code are summarized in Box II-1.

Main Taxes and Tax Rates of 1997 Georgian Tax Code

  • Single rate of VAT at 20 percent with a low registration threshold (US$2,300 at 1997 exchange rates). Exports zero-rated.

  • Single rate of corporate income tax at 20 percent with allowable deductions broadly in line with international practice.

  • A personal income tax with bands at 12, 15, 17 and 20 percent, with very modest progressivity as most incomes are taxed at the top marginal rate.

  • Social tax on payroll of 28 percent (Tax Code does not govern payroll taxes payable to the medical insurance or employment funds).

  • Withholding tax of 10 percent on interest and dividends.

  • A limited number of ad valorem excises (alcoholic beverages, tobacco products, gasoline and a few minor excises).

  • Taxes on property and land, vehicle ownership and inheritance tax.

  • A wide range of natural resource taxes.

  • Seven local taxes including a turnover tax of 1-2 percent depending on region.

Source: Tax Code of Georgia, 1997.

D. Tax Code Revisions

45. The tax code quickly became a focus for repeated legislative amendments.16 Between mid-1997 and mid-2001, 27 individual packages of amendments were approved, comprising hundreds of specific amendments. A Fund staff paper prepared for the Georgian authorities (Georgia: Tax Policy Review, October 2000, unpublished) noted that:

“These [legislative] changes have been wide-ranging. Some amendments have been introduced by the authorities in an attempt to improve tax administration and collections, and others have been driven by the need to comply with conditionality under Fund programs or WTO obligations (e.g. increases in excise rates, harmonization of tariff classification, and removal of some exemptions). However, many new exemptions have been introduced to benefit special sectors or interest groups in the economy (e.g., natural gas companies, the agricultural sector, and energy enterprises) while some have been introduced to reduce the tax burden on poorer segments of society (e.g., in mountainous regions). … The overall impact has been to narrow the tax base and complicate the tax legislation considerably.” (p. 3)

46. During the period July 1997 to April 2001, 113 specific code amendments were passed relating to tax policy, i.e. rate changes, tax base narrowing or broadening, and temporary provisions relating to tax rates or bases (summarized in Figure II-5). This listing excludes all amendments which are primarily administrative in nature, and amendments to clarify the intent of Code. While many tax policy amendments were relatively minor, a good number had a significant revenue impact, particularly frequent and large adjustments to excise rates and the introduction of VAT exemptions.

Figure II-5.
Figure II-5.

Georgia: Tax Code Amendments 1997–2001, by type of tax

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Parliament of Georgia.

47. Policy makers have focused their attention on amending the provisions of the two main indirect taxes which account for 78 percent of central government revenue. Value added tax (VAT) and excises account for 58 percent of the number of tax policy amendments to the Code. The two main direct taxes, corporate and personal income taxes account for 9 percent of the total amendments, and taxes on property and land account for a further 11 percent of total amendments, with the remainder accounted for by local taxes, resource taxes and minor taxes.

48. The following sections look in more detail at the nature of the amendments and the motivation behind policy changes for the VAT and excises.

E. Legislative Amendments to the VAT

49. The thrust of the 38 specific legislative amendments to the VAT rates and definition of taxable base was to introduce a significant number of exemptions and to narrow the tax base (Table II-2). The bulk of the exemptions were introduced or extended during 1998-1999, notably for primary agricultural production, wheat, imported fuel oil, natural gas and electricity, inputs for the oil and gas sector, imported cigarettes, newspapers and magazines. Only two exemptions were removed during the entire period (automobiles and primary agricultural production before processing, both in the context of IMF program conditionality). Three products were zero-rated, wheat (subsequently reversed as part of Fund program conditionality), domestically-produced cigarettes (also reversed) and electricity other than that supplied to the final consumer. One amendment reduced the VAT rate from 20 to 7 percent for bread, pasta and domestic production of flour. This was subsequently reversed, again as part of policy actions required for IMF financial support. A number of amendments narrowed the tax base, including an increase in the turnover threshold from very low levels (although mainly to simplify administration), and a variety of schemes to reduce VAT liabilities in respect of energy, water and sewerage services by levying VAT on cash receipts or a fixed proportion of supplied services rather than invoiced sales.

Table II-2.

Georgia: Amendments to the Value Added Tax, 1997-2001

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Source: Tax Code of Georgia and subsequent amendments.

50. Although sector lobby groups promoted VAT exemptions, particularly in the case of agriculture, utilities, oil and gas, it is inherently difficult to find clear evidence of “state capture” in the form of transactions related to the purchase of legislative reform, even though sectoral ministries strongly articulated the case for exemptions on behalf of their constituencies.

51. In the case of utilities (water, sewage and electricity) much of the pressure for exemptions or cash treatment resulted from a deficiency in the Code, which did not provide for tax relief on bad debts. The utility companies had extremely poor collection rates, as well as below cost recovery tariffs, and VAT liabilities on services supplied were very high relative to cash payments, which compounded their severe financial problems. The authorities preferred to provide exemptions to introducing a bad debt provision, as they were not confident that the VAT administration could effectively audit fraudulent claims of nonpayment.

52. Primary agriculture was granted a transitional and temporary VAT exemption when the Tax Code was introduced, for primary production from small firms. In 1998, the exemption was prolonged (until April 1999) and extended to all firms, regardless of size. In June 1999, the VAT threshold for primary agricultural producers was raised to nearly double the threshold for all other sectors. After extensive discussions with the Fund staff, the VAT exemption for primary agriculture was removed, effective January 1999. Although primary agriculture is in mid-2001 not VAT exempt, the 2002 budget is likely to remove a large group of small farmers from the tax net, primarily for reasons of administrative simplicity.

53. In primary agriculture, the case for exemptions was articulated mainly on the grounds of tax or subsidy competition from neighboring countries, especially Azerbaijan and Turkey, and tariff free trade with neighboring CIS countries. This was compounded by the inability of customs authorities to levy VAT on imported foodstuffs due to porous borders, tax privileges granted in 1995 to a small number of firms, and administrative corruption involving importers, tax and enforcement agencies.

54. As most farmers in Georgia are small scale and not organized as a political or commercial grouping, it is difficult to see how state capture could have been coordinated. Nonetheless the introduction of agricultural exemptions is and remains politically popular, as 40 percent of the labor force works in agriculture. This strongly suggests that, as in many other countries, exemptions were passed for reasons of political expediency rather than the result of direct pressure from vested interests.

55. The oil and gas sector has very broad VAT exemptions introduced in parallel with the 1999 Oil and Gas Law (which also provided a wide range of exemptions across most taxes). Industry concentration is much higher than in the agriculture sector (five oil and gas exploration firms), so collusive state capture is theoretically easier to coordinate and the potential benefits of state capture are similarly fairly concentrated. However, there is no evidence available to suggest that exemptions for the oil and gas sector were in any sense “purchased.” Nonetheless, tax policy was clearly influenced by a combination of the sector interest lobby groups, with reference to oil and gas exemptions in other jurisdictions. The oil and gas sector influenced tax policy by effectively trading VAT and other exemptions for particular terms in production-sharing agreements where the State of Georgia was a negotiating partner. In the absence of tax concessions the terms of production sharing agreements would likely have been less beneficial to Georgia. However, this policy choice back-loaded the possible fiscal benefit from oil and gas extraction activities at a time when the budget was rapidly accumulating domestic and external payment arrears.

56. Nonetheless in all three cases (utilities, agriculture, and oil and gas) sector specific amendments to the tax code were introduced. While there is no direct evidence of state capture, it seems likely that firms had a significant influence on the direction of policy to provide tax exemptions or special provisions, particularly in the oil and gas sector.

F. Legislative Amendments to Excise Legislation

57. The excise legislation in the 1997 Tax Code provided for ad valorem excises on a limited range of goods and applied equally to domestic and imported goods. Numerous amendments (detailed in Table II-3) have shifted excises for tobacco, alcohol, fuel products and cars to a specific basis and resulted in an effective reduction of the overall excise as a share of the pre-excise price. Also, in the case of tobacco products, a differential specific excise regime has been introduced favoring domestic production since the start of 2001. Nonetheless excises remain an important revenue source, accounting for just over one tenth of total tax revenues in 2000.

Table II-3.

Georgia: Amendments to Excise Taxation, 1997-2001

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Source: Tax Code of Georgia and subsequent amendments.

58. There has been significant public debate over the most appropriate excise regime for Georgia in recent years, involving excisable goods producers, importers, trade associations, and public officials. The staff of the Fund provided advice and technical assistance on the design and implementation of excises. While the main excisable goods are potentially large revenue sources, especially fuel and tobacco products, revenues have been significantly below potential because of significant sources of untaxed supply.

59. The main focus of debate has been whether low specific excises—marked on paid products with excise banderoles—would raise more revenue than moderate to high ad valorem excises. The argument for low specific rates is to provide incentives to importers and domestic producers to operate in the legal taxed market and to eliminate or reduce valuation problems. This view has mostly been articulated by the traders and producers in the excisable goods sector. In view of the widespread and severe valuation problems—which led to the valuation function of customs being contracted out in 1999—the Tax Code was amended during 1998 and 1999 to replace ad valorem with specific excises. The focus of policy debate then shifted to the level of specific excises with amendments introduced in 2000 and 2001 to reduce the main specific excises. The Fund staff has consistently argued that the focus of policy attention should be on tax administration (audit, transit procedures, anti-smuggling measures) to improve enforcement of existing excise legislation, as well as periodic increases of specific excises.

60. It appears that over the four years since passage of the Code, sector interests have prevailed and Georgia has opted for a policy of specific excises replacing the ad valorem excises in the original tax code. In absolute terms, on a mid-market product, the specific excises introduced in Georgia are significantly lower than the original ad valorem excise in the 1997 Tax Code. They are also low by international standards, although not lower than in neighboring markets (Russia, Armenia and Azerbaijan) where similar arguments have prevailed. Aside from the issue of foregone revenue resulting from low excises, specific excises result in a relatively high ratio of excise to price for low cost local production, which leads to pressure to differentiate excises in favor of local production.17

61. While it is difficult to indicate that excise policy is subject to state capture in Georgia, certainly sector interests have an important say in the direction of policy. The following section considers tobacco excises in more detail as an illustration of the tax policy process.

G. Tobacco Excise Policy in Georgia

62. Tobacco consumption in Georgia is high by international standards—estimated consumption of 350 million cigarette packs per year is equivalent to expenditure of about 5 percent of GDP. The market is divided into two main segments, very low priced unfiltered cigarettes produced in Georgia and imported from Russia, and the filter market—about 80 percent of total consumption—which until early 2001 was almost entirely imported. The filtered cigarette market accounts for the vast majority of total expenditure on tobacco goods in Georgia. The tobacco sector is highly concentrated. In 1999, three quarters of all import excise stamps were purchased by two firms and 97 percent by just four firms, while only one or two domestic producers have been in operation. As discussed in Box II-2, excises on cigarettes and other tobacco products were frequently amended during the period 1997-2001, with a significant reduction in the effective excise rate over time.

63. Tobacco sector interests in Georgia were actively trying to influence tax policy. First, the limited number of importers managed in 1996 to completely evade the 100 percent ad valorem excise, but then complied with the tax legislation when the excise was reduced to minimal levels of US$0.04 per pack. Second, the authorities’ attempt to reintroduce the 100 percent ad valorem excise in July 1997 with the new tax code was quickly overturned by a code amendment in September 1997 introducing a low fixed excise (and removal of VAT at the same time). Third, the experience of excise stamp sales indicates that importers made significant advance payments for excise stamps during 1999 (peaking at lari 27 million or ½ percent of GDP), although it is not entirely clear whether these advance payments were made in order to influence future tax policy or as a covert means of pre-election budget financing.18 Fourth, the reduction of the domestic excise in 2001 by half, contrary to Georgia’s obligations under the WTO, was a policy clearly and publicly articulated by a joint venture investor in a cigarette factory during late 2000 that was subsequently adopted by the parliament.

The Reduction of Effective Cigarette Excise Rates, 1997-2001

The effective rate of excise relative to a theoretical mid-market cigarette brand before tax (US$0.40 pack of 20 filter cigarettes) is shown in Figure II-6 for the period 1997–2001. An ad valorem regime for tobacco imports was in force before October 1996, with excise at 100 percent and VAT of 20 percent in addition. Owing to widespread falsification of declared import value there were virtually no revenues recorded from excises. A transitional regime of a fixed tax of lari 0.06 (about 4 U.S. cents) per pack of twenty was then introduced, resulting in a significant pick up in revenues. The Tax Code reintroduced ad valorem excise at 100 percent in July 1997. Then, shortly after, the Code was amended to introduce a fixed tax of lari 0.25 (US$0.18) on imported filter cigarettes in lieu of excise and VAT, which implied a significant reduction in average excise rates. At end-1998, a similar fixed tax was introduced for domestic produced cigarettes at a rate of lari 0.15 on filter cigarettes and in April 1999, a system of excise stamps was introduced. At end-1999, the discriminatory taxation in favor of domestic production was removed in accordance with WTO requirements and the excise rate increased to lari 0.40 (US$0.20) per pack on recommendations of IMF staff. In 2001, the excise on local production was cut in half to lari 0.20, and the effective rate of tax brought down to just over 20 percent of pretax price in respect of excise, while cigarettes remained exempt from VAT. Thus domestic production faced more or less the same indirect tax burden in the form of excise as other goods liable for VAT at the standard rate.

Figure II-6.
Figure II-6.

Georgia: Excise Taxation of Mid-Price Filter Cigarettes, 1997–2001

(Assumes pre-tax price US$0.40)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Parliament of Georgia, Ministry of Revenue; and Fund staff estimates.

64. Almost all of the legislative amendments regarding tobacco excises were added to the Tax Code as transitional provisions which lapse between a few months and up to two years after passage into law. This indicates that sector interests are often able to lobby for temporary gains but that they require periodic renewal, and renewed lobbying efforts. Many of the amendments to tobacco excises were introduced without consideration of the budgetary impact and outside the normal budget approval or amendment process. For example, the reduction of domestic excises from January 2001 was approved after the 2001 Budget, and revenues subsequently fell well short of budgetary estimates based on higher excise rates through mid-2001.

H. Conclusions and Policy Lessons

65. Survey data from businesses in Georgia show a widespread perception that policy change is the result of “state capture.” An analysis of Tax Code amendments since 1997 indicates that sectoral lobbies can be very effective in influencing tax policy in Georgia, particularly in case-studies presented on VAT exemptions in the oil and gas sector and excise rate reductions in the tobacco sector. However, the precise means of attaining such influence—whether through the legitimate persuasive power of argument or through illicit side payments—is not clearly determined. The influence of vested interests on policy appears strongest when the sectors are highly concentrated. While there is no evidence of direct payments to policymakers there is some correlation between the introduction of tax concessions and either advance payment of tax or a parallel agreement on profit-sharing terms.

66. Overall, Tax Code amendments in Georgia, whether or not a result of state capture or pressure from vested interests, appear since 1997 to have narrowed the tax base and reduced potential revenues. In addition, the frequent recourse to transitional provisions and repeated amendment of the Tax Code has created uncertainty over the legislative environment. Other consequences of tax code amendments, not discussed above, are the occurrence of frequent tax disputes arising from implementation of hastily drafted amendments and inconsistencies between budget revenue estimates and tax policy legislation.

67. Finally, it might be noted that vested interests seeking to reduce tax liabilities often conflict with the advice of international financial organizations which seek to broaden and strengthen the tax base. As in the case of cigarettes in Georgia, this results in tax policy conditionality which is implemented but not sustained over a significant period of time.

68. Two central policy messages result from the above analysis:

  • First, that proposals to change tax policy legislation should include a clear indication of the likely revenue impact, preferably with an independent impact assessment, so that policymakers can have access to information which will enable them to make an accurate assessment of the claims of sectoral interests.

  • Second, in the interests of fiscal and legislative stability, that tax policy amendments should only be made in conjunction with presentation of the budget or amendments to the budget to avoid inconsistencies between tax legislation and budget revenue estimates.

III. Selected Social Expenditure Issues19

A. Summary and Introduction

  • From 1997 to 2000 public sector social expenditures declined, on a cash basis, from 8¾ percent to 7½ percent of GDP. The decline affected primarily the education system, health care services, and welfare programs.

  • The decline occurred during a period of large fiscal adjustment. The general government deficit, on a cash basis, fell from over 6 percent of GDP in 1997 to 2½ percent of GDP in 2000. The adjustment was accounted for mainly by cuts in primary expenditure. Tax revenues rose, but this was partly offset by a fall in grants, while interest payments increased.

  • Social areas were not protected from cuts in cash primary spending, largely because of the accumulation of arrears on pensions, health and welfare spending. The actual allocation of social expenditure was inefficient and ineffective in limiting the increase in the number of poor households.

  • The establishment of a sustainable fiscal situation, consistent with the government’s poverty reduction strategy, requires a substantial increase in tax revenues. In addition, greater efforts are needed to protect the share of social spending within the total, especially by avoiding arrears, and to improve targeting on the poor.

69. This chapter considers developments in public sector social expenditure in five areas: education, health care, pensions, unemployment benefits, and welfare programs.20 The analysis covers a four-year period beginning in 1997. The next section analyzes the trends of total social expenditure in relation to fiscal adjustment. The following sections deal with the five individual components of social expenditure. Finally, the observed trends are discussed in the context of Georgia’s poverty reduction strategy.

B. Social Expenditure Trends

70. During 1997-2000, the total amount of public expenditure classified as “social” declined, on a cash basis, from 8¾ percent to 7½ percent of GDP (Table III-1 and Figure III-1). In particular, the resources dedicated to the education sector, health care services and welfare programs dropped significantly while the expenditure on pensions and unemployment benefits remained stable, in relation to GDP.

Table III-1.

Public Sector Social Expenditure, 1997–2000 1/

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Sources: Georgian authorities; and Fund staff estimates.

On a cash basis. Includes General Government and State Medical Insurance Company.

Does not include the expenditure for poverty benefits.

Welfare programs include poverty benefits, refugee allowances and food programs.

Figure III-1.
Figure III-1.

Georgia: Social Expenditure, 1997-2000

(In percent of GDP)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

71. The downtrend in social expenditure is fully accounted for by the central government and the state agencies: total social expenditure managed by the central administration fell by 1½ percentage points to 5 percent of GDP (Table II-2). Specifically, as a share of GDP, expenditure in the education sector was cut by half and the amount spent in the health care sector was also reduced drastically. Social spending by local government remained roughly constant, as a share of GDP.

Table III-2.

Central Government Social Expenditure, 1997–2000 1/

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Sources: Georgian authorities; and Fund staff estimates.

On a cash basis. The Central Government expenditure includes the central budget expenditure for education, health programs and welfare programs; the tranfers to SMIC; the Social Security Fund expenditure; and the Employment Fund expenditure.

Does not include the expenditure for poverty benefits.

Welfare programs include poverty benefits, refugee allowances and food programs.

72. The decline of public resources dedicated to social spending occurred during a period of large adjustments. The general government deficit, on a cash basis, fell from 6 percent of GDP in 1997 to 2½ percent of GDP in 2000 (Table III-3). The improvement was due to both increases in total revenues and grants (by 1 percent of GDP) and reductions of expenditure on a cash basis (by 2½ percent of GDP). The reduction of expenditure was split equally between cuts in current and capital expenditure (Table II-3 and Figure III-2).

Table III-3.

General Government Fiscal Operations, 1997–2000

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Sources: Georgian authorities; and Fund staff estimates.

The data do not include the SMIC expenditure financed by payroll.

Figure III-2.
Figure III-2.

Georgia: Composition of the Fiscal Adjustment, 1997-2000

(In percentage of the adjustment)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

73. Primary current expenditure experienced a large decrease on a cash basis (by 2½ percent of GDP) while the resources spent in interest payments grew by 1¼ percent of GDP. From 1997 to 1999, cuts in primary current expenditure were larger on social items than on non-social items, although the share of social items recovered in 2000. (Table III-4 and Figure III-3). Overall, the trends in the composition of primary current expenditure in recent years show that social items received no particular protection from cuts necessitated by the execution of fiscal adjustments.

Table III-4.

General Government Social Expenditure 1997–2000 1/

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Sources: Georgian authorities; and Fund staff estimates.

On a cash basis. The data do not include the SMIC expenditure financed by payroll.

Does not include the expenditure for poverty benefits.

Welfare programs include poverty benefits, refugee allowances and food compensation.

Figure III-3.
Figure III-3.

Georgia: Social Expenditure, 1997-2000

(In percentage of primary current expenditure; on a cash basis)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

74. An analysis of Georgia’s fiscal operation on a commitment basis delivers a different picture. From 1997 to 2000 the budget plans allocated a relatively stable amount of resources for social items, as a percentage of GDP, relying on additional tax revenues and grants to shrink the deficit. Continuing under-performances on the revenue side resulted in the incomplete execution of the budgets and accumulation of a large amount of arrears on social expenditure to meet the overall fiscal targets. From 1997 to 2000, the stock of arrears accumulated on pensions was 1.1 percent of GDP while arrears on health and welfare programs reached 1.4 percent of GDP (Table III-5).21 If the 2000 budget had been fully implemented, the decline in social expenditure since 1997 would have been less than half the actual amount (0.6 percent of GDP instead of 1.3 percent of GDP).

Table III-5.

Net Change of Expenditure Arrears 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

Includes the expenditure arrears for food programs and health programs.

Includes the expenditure arrears for poverty benefits and refugee allowances.

75. The shortfall in executing the budgets and cuts in social expenditure undermined the effectiveness of the programs that were targeted to reduce poverty and inequality. During 1997-2000, the share of the Georgian population living below the “recommended poverty line” (US$25 per month per equivalent adult) rose from 13½ percent to 23 percent.22 Poverty depth23 also increased. Finally inequality, measured by the Gini percent on consumption, reached 0.40 in 2000 (from 0.36 in 1997), one of the highest levels among the transition economies.

C. Social Expenditure in Georgia and in Other Transition Economies

76. In terms of public resources allocated to social expenditure, Georgia performed well below the average of the transition economies and the levels of similar transition countries.24 All those economies experienced a decline in social expenditure and a downsizing of government fiscal operations after the collapse of the Soviet Union but, as a 1996 World Bank review highlighted, Georgia’s case is among the most dramatic.25

77. In 1998, the most recent year with comparable data, public resources spent on education by 24 transition economies averaged 4.3 percent of GDP while in Georgia the education sector received 2.3 percent of GDP.26 In the health sector the average expenditure for the same group of transition economies was 3.5 percent of GDP, more than three times the level in Georgia. In comparison with Azerbaijan and Moldova, countries with similar per capita GDP (around US$550 in 1998), Georgia’s total social expenditure is less than half (Figure III-4) in terms of GDP.

Figure III-4.
Figure III-4.

Georgia: Social Expenditure in Selected Transition Economies, 1998

(In percent of GDP) 1/

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

1/ In 1998, Azerbaijani Georgia, and Moldova had very close GDP per capita (respectively, US$576, US$510, and US$525). The GDP per capita in Tajikistan in the same year was US$215.

78. The low level of social expenditure is a direct result of Georgia’s low fiscal revenues: in 1998, general government tax revenues were 12¾ percent of GDP in Georgia, compared to an average of 30 percent of GDP for the transition economies.27

D. The Education Sector

79. The education sector in Georgia consists of four levels: kindergarten, compulsory general education (grades 1-9), upper secondary (grades 10 and 11), and higher education. The administration is run jointly at the central and local level. The central budget is responsible for a small part of the school facilities and for higher education. Local budgets are responsible for most of the facilities and for employees compensation, although the local budgets receive transfers from the central budget to pay teachers’ salaries.

80. General government expenditure dedicated to education dropped dramatically during the 1990s in real terms.28 A steep fall at the beginning of the decade was followed by a slower but continuing downtrend. The resources allocated to schools and universities were only 2½ percent of GDP in 2000 (Table III-6).

Table III-6.

General Government Expenditure in Education, 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

81. The consequences of the financial collapse have been reflected in the very low level of teachers’ salaries, the degradation of the facilities, the cut off in financial support for welfare services to students, and increases in the costs paid by parents. The enrollment rates in public sector institutions, historically very high (about 100 percent for the compulsory general education and 75 percent for upper secondary schools), have dropped by 23 percent on average, partially offset by an increase in private school attendance.

82. The allocation of expenditure within the sector has shifted toward local governments, i.e., the administrations responsible for pre-school and mandatory school institutions. The shift, broadly consistent with the recommendations of the World Bank, assigned to local budgets 85 percent of the resources dedicated to the education sector in 2000, 13 percentage points more than in 1997.29

E. The Health Sector

83. The public health care system is financed by the Ministry of Health; the State Medical Insurance Company (SMIC, a semi-independent agency); and municipalities.30 The Ministry of Health and the municipalities directly manage some programs while the SMIC refunds the cost of the state-supported programs managed by private providers. The SMIC is funded by transfers from the central budget and by a 4 percent payroll tax on wages and salaries (3 percent paid by employers and 1 percent paid by employees).

84. A World Bank supported reform, implemented from 1997, concentrated the responsibilities of the public sector on the basic needs of the population and gave the SMIC a central role in the financial management of the programs. The system provides a basic package and essential clinical services. Some services outside the basic package are provided on a fee-for-service basis, with exemptions made for selected vulnerable groups.

85. The resources for the health care system fell dramatically in the years immediately after the collapse of the Soviet Union and continued to fall in the second half of the nineties, following the pattern of the education sector.31 In 2000, public resources available for the health sector amounted to 1.1 percent of GDP (Table III-7) or 6.9 percent of primary current expenditure. Consistent with the reform, the SMIC has managed a larger share of health expenditure than in the past (from 28 percent in 1997 to 55 percent in 2000) and, consequently, the relevance of the Ministry of Health in the direct management of health programs has faded.

Table III-7.

General Government Expenditure in Health Care, 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

Does not include the transfers to SMIC.

F. The Pension System

86. The pension system, reformed in 1994-96 but still based on the Soviet-period legal framework, is a “pay-as-you-go” scheme.32 The scheme, managed by a semi-independent agency, the United Social Security Fund (SSF), is financed by a 28 percent payroll tax (27 percent paid by the employers and 1 percent paid by the employees) and by transfers from the central budget. Under the 1996 reform, the mandatory minimum age requirement for retiring was raised at once by 5 years to 60 and 65 years respectively for women and men.33 The reform also introduced flat rate, old-age pensions.

87. The number of pensioners fell from 977,000 in 1997 to 902,000 in 2000, mainly because of the increase in the minimum retirement age. In 2000, the old-age pensions (“labor pensions”) and the social pensions (“welfare pensions”) made up 90 percent of the all benefits paid by the SSF.34 The remaining 10 percent represented so called “privileged pensions,” i.e. benefits paid to selected categories of citizens (i.e. military staff and war participants). Since 1997, the labor pension and the social pensions have been frozen at 14 lari or US$7 per month (slightly more than ¼ of the “recommended poverty line,” in 2000) while the privileged pensions have remained around 40 lari per month (about 80 percent of the “recommended poverty line” in 2000).

88. Despite the decline of the average pension in real terms and the decline in the number of beneficiaries, the total amount actually spent on the public pension system was stable at about 2.7 percent of GDP in the period examined (Table III-8). The result is explained by the declining trend in the accumulation of expenditure arrears. In particular, the annual accrual of arrears on pensions declined from 0.7 percent of GDP in 1998 to 0.4 percent of GDP in 2000.

Table III-8.

Social Security Fund Operations, 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

89. During the period analyzed, the central government significantly reduced its support to the pension system: on a cash basis, the central budget covered 21 percent of the total expenditure on pensions in 1997 while the share fell to 13 percent in 2000.

G. The Employment Fund

90. The Employment Fund is meant to provide unemployment benefits, job search assistance and job training. The fund is financed by a 1 percent payroll contribution paid by the employers on wages and salaries. The level of the benefits it is expected to provide is around 13 lari per month or a quarter of the 2000 “recommended poverty line.” The average annual expenditure was 0.1 percent of GDP during 1997-2000 period (Table III-9). Given its very small budget and the low level of benefits, the agency is ineffective.

Table III-9.

Employment Fund Operations, 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

H. The Welfare Programs

91. The welfare programs include the social pensions (see above), poverty benefits, refugee allowances and food programs.35 These programs are financed by the central budget. The poverty benefits were originally called “family allowances” and were paid to poor households with two or more children under 18 years. In 1999, in the context of the energy sector reform and constrained budget, the government reduced the number of beneficiaries and targeted the family allowances on poor single pensioners.36 The refugee allowances are targeted to the refugees from civil conflicts in Abkazia and other regions of Georgia. The food programs provide food for boarding schools and orphanages, hospitals, and law enforcement ministries.

92. Expenditures on family allowances/poverty benefits and food programs have been stable at 0.1 and 0.2 percent of GDP respectively. The amount spent on refugee allowances fell from 1.1 percent in 1997 to 0.7 percent of GDP in 2000 (Table III-10) because benefits shrank in real terms and the number of beneficiaries declined.

Table III-10.

General Government Expenditure in Welfare Programs, 1997-2000

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Sources: Georgian authorities; and Fund staff estimates.

The data for 1997 is estimated.

I. Social Expenditure and the Poverty Reduction Strategy

93. Fiscal adjustment in Georgia has primarily relied on expenditure cuts. Although tax collection improved (by 1½ percent of GDP) during 1997-2000, grants and non-tax revenues were continually lower than assumed in the budget plans, while debt service absorbed an increasing share of budget resources. In this context, social expenditures, despite their very low level, were used to limit the overall deficit on a cash basis, notably via accumulation of expenditure arrears.

94. During the period examined, the government slightly improved the “efficiency” (from 3.8 percent in 1998 to 7.8 percent in 2000) and the “effectiveness” (from 0.6 percent in 1998 to 1.5 percent in 2000) of transfers to household and improved the allocation of resources within the health care and the education systems (see above).37 These tiny improvements were more than offset by the decline of total social expenditure. To be effective, policies to combat poverty and inequality need not only to be efficient but also to provide for an adequate amount of resources for funding primary education, basic health care services, targeted social pensions and welfare benefits.

95. The need for additional resources to fund social spending has emerged very clearly during the preparation of the PRSP. For example, the reforms in the health sector and in the pension system described in the interim-PRSP are expected to increase public expenditure by 7 percent of GDP by 2010. In developing its analysis to cost and prioritize the reform measures the authorities should consider a notable increase in tax revenues as the key component of an effective poverty-reduction strategy.

96. The following policies are recommended to establish a sustainable fiscal framework consistent with the poverty reduction strategy defined in the authorities’ Interim-PRSP:

  • a stable increase in tax revenues to enlarge or at least to preserve the room for primary expenditure in a period characterized by rising external debt service;

  • for a given level of overall primary expenditure, strengthening the protection of social expenditure—both by avoiding arrears and ensuring adequate budgetary provision for pro-poor expenditure;

  • given the fiscal constraints, costing and prioritizing the social and non-social measures included in the PRSP;

  • considering the minimal level of efficiency and effectiveness of social expenditure, better targeting of social expenditure on the poor. In particular, in the health care sector providing additional resources for a basic package of clinical services; in the education sector concentrating resources in primary, elementary, and middle schools.

IV. Banking Sector Reforms and Financial Development38

A. Summary and Introduction

  • Georgia has advanced in developing its financial system—introducing a two-tier banking system, divesting its state-owned banks, and developing the legal framework for bank regulation. However, the sector suffers from low levels of financial intermediation and weak corporate governance, and its role in facilitating investment and growth is severely constrained.

  • This chapter examines recent developments in the banking sector in Georgia, including its structure, operations, indicators of soundness and vulnerability, the regulatory and prudential framework, and financial development and reform.39

  • The banking sector is small by international standards, and in comparison with banking sectors in other CIS countries. Integration with the rest of the world and foreign investment in the banking sector are limited. While there has been substantial consolidation, there are still too many banks. The level of dollarization is high, with the ratio of dollar deposits to total deposits at over 80 percent.

  • At first glance a number of prudential indicators suggest a healthy banking system. However, weaknesses in the data mask underlying problems. Recent onsite inspections have revealed substantial weaknesses in banks’ portfolios. Stress tests conducted by recent FSAP missions suggest that the sector is vulnerable to credit risk and the secondary effects of exchange rate shocks.

  • The legal framework of the banking sector, while advancing in recent years, needs further improvement. Amendments to the central bank and commercial bank laws, currently under discussion in parliament, are intended to strengthen the independence of the central bank, its ability to administer and close banks, and prevent criminal elements from gaining control of a bank. Measures are also needed to prevent money laundering.

  • To encourage financial development, it will be necessary to continue with efforts to strengthen bank regulation and supervision, in order to improve confidence in the sector, attract strategic foreign investors, and develop capital markets. Broader structural reforms will also be needed, including improved collateral and bankruptcy laws, licensing reform, privatization, and other measures to improve the business climate.

B. Structure of the Banking System

97. The financial sector is small by international standards as well as in comparison to other CIS countries. Commercial banks are the main component of the financial sector, with assets accounting for about 13 percent of total GDP in 2000. The insurance sector is rudimentary and there is a small treasury bill market and nascent stock exchange. There are also about 200 small rural credit unions which have total deposits of only about lari 2 million. Using broad money to GDP as a measure of the size of the financial sector, Georgia’s ratio is just 10½ percent, compared to 60 percent in the U.S. (excluding money market instruments and bonds), 40 percent in Estonia, and about 15 percent in Armenia.

98. The banking system comprises resident regional small and medium-sized banks, a handful of large banking institutions with branch networks, and two foreign banks. Like other BRO countries, Georgia created a two-tiered banking system in the early 1990s—a central bank was created, the National Bank of Georgia (NBG), based on the Western model; and a large number of commercial banks emerged, the largest of which originated in the old Soviet-style monobanking system.

99. The banking sector has undergone a substantial consolidation since 1994, but there are still too many banks relative to Georgia’s population and the size of its economy. The introduction of bank prudential standards, generally in line with the Basle guidelines, together with vigorous enforcement of the regulatory framework by the NBG, led to a sharp reduction in the number of banks, from a peak of 229 in early 1994 to 29 by end-June 2001.40

100. There is a high degree of concentration of assets in the banking sector. The 10 largest banks control about 80 percent of total assets and deposits. Of these, the three largest banks control about one-half of the assets. This suggests a competitive structure unlikely to heighten market discipline in the financial sector.

101. Two of the largest banks are former state-owned banks, whose experience lies with the Soviet-style system41 and which are predominately locally owned. The share of the former state banks (FSBs) in financial intermediation has continued to shrink—from 39 percent of total assets at end-1996 to about 32 percent as of end-June 2001—mainly as private banks established since independence have been able to successfully attract domestic deposits and benefit from foreign credit lines, and to a lesser extent due to the write-off of bad loans by the FSBs. Consequently, the FSBs are no longer the single players in any particular sector. Following an international audit, two of the three FSBs underwent a fundamental restructuring, including laying off a substantial number of workers and closing unprofitable branches, thus improving their net worth. One of the remaining former state banks, Agrobank, continues to have significant financial difficulties.

102. Foreign investors have majority ownership of seven of the banks in Georgia, which comprise about 11 percent of the total assets of the banking sector.42 This share is substantially lower than in a number of the more advanced transition economies, such as Hungary and Poland, where over half of the assets are foreign owned. The two wholly foreign-owned banks (one Turkish, one Azeri) are very small. Consequently, the beneficial effects of strategic foreign investment—a decisive factor in the rapid modernization of commercial banking systems in Hungary and other East European countries—is minimal.

103. Integration of Georgian banks with the international economy is limited, although some banks have obtained external credit lines from IFIs. Total outstanding credit to banks from IFIs amounted to some US$46 million at end-June 2001, of which about one-third is covered by state guarantees. Most of the borrowing occurred in 1997 and is distributed among a number of the medium to large-sized banks, including two FSBs.

C. Banking System Operations and Recent Developments

104. The level of banking system financial intermediation remains low due to a number of factors:

  • lack of confidence in banks: hyperinflation in the early 1990s eroded the stock of savings and there is a general distrust of banks as savings mechanisms.

  • a large informal sector which operates outside the banking system;

  • tax administration, which places pressure on the banking system in the final days of the month as efforts are made to achieve performance targets, resulting in sizeable liquidity pressure;

  • harassment by tax authorities of businesses that have deposits in banks, often blocking and/or sequestering the banks’ deposits without a clear motive;

  • high commercial lending rates, despite sharp reductions in inflation in the late 1990s, reflecting risk premiums and scarcity of credit;

  • a large agricultural sector, which is typically less monetized;

  • low per capita income, which constrains savings;

  • lack of familiarity among bank managers with collateral-based lending and other Western banking methods, which are vital for enterprise lending to take hold.

105. The level of bank intermediation is recovering, following the significant setback in 1998 in the wake of the Russian crisis. Deposits in the banking system have increased by over 150 percent since 1997, before the onset of the Russia crisis.43 However, the level of deposits remains disappointingly low at only about 5 percent of GDP. The majority of these deposits are short-term time deposits of the business sector. Household deposits remain small—at less than 2 percent of GDP—and have remained about one-third of total deposits since 1997.

106. As deposits have increased, assets have grown significantly, with the maturity of loans gradually lengthening, reflecting lower inflation and access to foreign credit lines. The share of non-government loans in total assets amounts to 58 percent as of end-June 2001, compared to 60 percent in the U.S., 40 percent in Lithuania, and 45 percent in Poland. The share of long-term lending in total credit increased from 2½ percent at end-1997 to 29 percent by May 2001.

107, At the same time, there has been a significant increase in foreign exchange lending in banks’ portfolios, reflecting increased dollarization and banks’ desire to pass foreign exchange risk on to their clients. Dollarization increased significantly in the wake of the lari devaluation in late-1998, and has failed to decline subsequently, despite exchange rate stability and low inflation. The share of foreign exchange denominated deposits in total deposits increased from 58 percent in 1997 to 82 percent of total deposits as of end-June 2001. Loans in foreign currency rose from 44½ percent of total lending at end-1997 to 77½ percent in end-June 2001.44

108. Loans to the non-government sector amounted to only 6½ percent of GDP in 2001, as compared to 26 percent in Estonia and 30 percent in Poland, and are mainly concentrated in the trade sector. The limited lending reflects the low level of deposits and limited access to foreign capital in the sector, but also limited lending opportunities. Most of bank financing is concentrated in the trade sector (Table A-20), although there has been some increase in the share of financing to industry. Consumer lending is not developed, reflecting deficiencies in risk assessment, collateral, and credit resources.

109. The assets of commercial banks include a sizeable share of cash and reserves, accounting for over a quarter of total assets (compared to 5 percent in the U.S. and 3½ percent in Poland). This reflects the high liquidity ratio requirement, limited access to alternative sources of liquidity, and an inefficient payments system. Access to the interbank market is limited, and lender of last resort has not been used often and is expensive. The payment system does not provide intraday credit and there is no check clearing system. The share of securities in total assets is only about 1 percent, as the treasury bill market is very small and secondary market virtually nonexistent (in the U.S., securities amount to about 15 percent of total assets of banks and in Poland, about 20 percent). This may also be a factor in the large share of fixed assets, including real estate, which accounted for about 10 percent of total assets. Such investments may prove to be risky, and until recently these assets did not need to be provisioned for, which may also have provided an incentive.

110. Interest income is the primary source of income for banks, accounting for about two-thirds of total income. Fees, commissions and foreign exchange conversion operations make up most of the rest of banks’ income. Expenses are mainly for interest on deposits, personnel and provisions. Interest income, mainly from interest on loans, exceed interest expenses (mainly time deposits) by a factor of 3, reflecting a sizeable interest rate spread of about 21 percent (Figure IV-1).

Figure IV-1.
Figure IV-1.

Georgia: Commercial Interest Rates, 1997-2001

(In percent)

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Georgian authorities.1/ Difference between 3-month lending and deposit rates.

111. The high interest rate spreads may reflect several factors:

  • a lack of competition, which inhibits efficiency, reflecting the dominance of a few large banks in the sector and the lack of strategic foreign investors;

  • high credit risks, compounded by difficulties of liquidating collateral of delinquent borrowers, which in turn are a reflection of insufficient progress in enterprise and legal reforms;

  • a high reserve requirement (14 percent as of September 2001), which is costly to banks, although mitigated somewhat by a remuneration of 8 percent; and

  • the existence of too many banks, which may lead to high overhead costs of the banking system on account of the small scale of their operations.

D. Banking System Soundness and Vulnerability

112. While the financial sector is small and there is limited international integration, the failure of a large bank could pose a risk to economic stability, through some combination of higher interest rates, a contraction in credit to the private sector, an increase in inflation and/or a weakening of the currency and disruption of the payment system. Indicators of bank soundness and stress tests suggest that the sector is vulnerable to credit risk and the secondary effects of exchange rate shocks.

Banking system soundness

113. Macroprudential indicators (MPIs) are a useful tool in monitoring the health of the financial system as a whole.45 These indicators consist of quantitative variables which comprise both aggregated microprudential indicators of the health of individual institutions, such as capital adequacy ratios, nonperforming loans, loans to deposit ratios; and macroeconomic variables, such as inflation, growth, the current account deficit, which are associated with financial system soundness. The macroeconomic variables may be used for stress tests to evaluate quantitatively the impact of large changes on the portfolio of financial institutions and on aggregate solvency of the financial system. Financial crises usually occur when both types of indicators point to vulnerabilities, i.e., when financial institutions are weak and face macroeconomic shocks. Table A-23 presents selected prudential indicators for Georgia’s banks and the basic data table shows key macroeconomic variables.

114. At first glance a number of the macroprudential indicators appear favorable, but they mask vulnerabilities hidden by inadequate regulations and reporting standards. Capital adequacy and bank liquidity indicators are well above the minimum standards and even remained relatively stable through the 1998 Russian crisis, suggesting a healthy banking system. Similarly, non-performing loans have historically been surprisingly low and the system as a whole was profitable in 2000. However, recent on-site inspections have revealed significant understatement of distressed assets (and as a result an overstatement of capital and profitability), and understatement of nonperforming loans, reflecting deficiencies in reporting and weak classification and provisioning requirements.46 In addition, capital adequacy does not provide a picture of the quality of the capital, which may be undermined by insider borrowing for new capital and issuance of stock for non-cash assets.47 These high ratios may also reflect structural factors—for instance, banks with a small amount of deposits tend to maintain higher than average CARs. At the same time, high ratios may reduce banks’ profitability as they are unable to use these funds for commercial purposes.

115. The macroeconomic indicators reveal a mixed picture. Inflation is low and the exchange rate is broadly stable. However growth remains slower than in the pre-1998 period, real interest rates remain high; foreign exchange reserves are low, and the fiscal situation remains fragile with a high level of domestic expenditure arrears. Low inflation and a stable exchange rate are important for bank soundness, particularly in view of the high level of dollarization. However, a low growth rate can point to weakening of borrower’s capacity to repay, and a slump in a sector where loans are concentrated could have an immediate impact on bank soundness. A weak fiscal situation suggests that there are potential risks to macroeconomic stability which can negatively affect banks solvency and liquidity.

116. While commercial banks registered a profit in 2000, new provisioning requirements have contributed to losses in the first half of 2001, as banks have had to increase provisions due to low credit quality. Low profitability and/or losses weaken bank’s ability to withstand shocks.

Banking system risks

117. The MPIs point to vulnerabilities in the sector reflected in poor asset quality, profit losses, and fragilities in the macroeconomy that could adversely affect bank soundness. In addition, stress tests prepared by the FSAP mission suggest that the banking system is vulnerable to several important financial risks, in particular credit and foreign exchange risks, which suggest a need for increased provisioning.

118. The main risk to the banking sector is credit risk, mainly due to inadequate risk identification and insufficiently rigorous monitoring and management practices. As noted above, indicators such as capital adequacy and nonperforming loans mask underlying vulnerabilities due to weak reporting and supervisory practices. Recent measures to strengthen the banking regulation, including new asset classification and provisioning requirements, should help to reduce this vulnerability (see Section E below). In addition, fragilities in the economy, as noted in the above macroprudential indicators, and the vulnerability of the economy to external shocks, can undermine banks’ portfolios by limiting the ability of borrowers to service their debts.48

119. In addition, banks are exposed to foreign exchange risk, reflecting the high level of dollarization of deposits and loans. The net foreign exchange open positions of banks are regulated, but at the same time about 80 percent of the system’s loans are in foreign exchange. Consequently in a small open economy, banks’ vulnerability to foreign exchange risk is linked to the vulnerability of borrowers’ net foreign currency earnings. While it is difficult to ascertain the vulnerability of borrowers, i.e., to obtain data on corporate foreign exchange exposure, the underdeveloped financial market would suggest that there is virtually no hedging of foreign exchange risk by borrowers.

120. Banks are also vulnerable to liquidity pressures. For instance, there is often pressure on banks in the last days of the month due to tax mobilization and there is the possibility of sudden withdrawal by a large depositor—the latter posed some liquidity difficulties for one large bank recently. In the case of lari denominated assets there does not appear to be a problem, as there are sizeable liquid assets in lari and all reserve requirements are denominated in lari. However, there may be more of a problem with foreign exchange liquidity, as short term liabilities (less than one month) outweigh short term foreign exchange assets.

121. Interest rate risk is relatively small, reflecting a small maturity gap between assets and liabilities,49 a predominance of short term assets and liabilities, as well as large interest rate spreads, and a high ratio of equity to liabilities.

Macroeconomic effects of banking system fragility

122. The small size and fragility of the banking have several important macroeconomic impacts:

  • the effectiveness of monetary policy is severely limited;

  • credit is limited and not channeled in a way that maximizes benefits to the real economy, i.e., the high cost of intermediation penalizes new and good borrowers and distorts the allocation of credit;

  • reliance on external credit lines poses risks to financial stability.

123. The role of monetary policy instruments is limited, because the normal monetary policy transmission mechanism via interest rates is ineffective. In addition, the development of indirect instruments, such as open market operations, is severely constrained in the absence of significant securities market.

124. The small size of the financial sector implies that there is very little available credit. High real interest rates (above 10 percent) limit most credit to areas with high rates of return, particularly in the trade sector, while most other economic activities have almost no access to credit. In addition, banks’ losses, despite continued high spreads between borrowing and lending rates (net interest income), suggest that loan performance is poor, implying an interest subsidy to nonperforming borrowers (e.g., state-owned enterprises). In addition, the low level of financial intermediation restricts use of the credit instrument to discipline company managers and strengthen governance in the corporate sector.

125. External credit lines from IFIs, which account for about 20 percent of banking system liabilities, and for which there are generally state guarantees, could pose risks to financial stability. The total amount of guaranteed lending from IFIs amounts to US$46 million and is concentrated among 5 medium to large-sized banks. Most of these loans are long-term (over 1 year), so they improve the maturity of banks’ liabilities. However, since credit lines are used to provide credit to SMEs, many of which do not have foreign exchange income, the structure increases the foreign exchange/credit risk of the banking system. The calling of loans with government guarantees also poses additional costs to the budget.

E. Regulatory and Prudential Framework

126. Regulation plays a significant role in financial development. “The development of deeper financial systems depends significantly on the effectiveness of regulatory and institutional reform, as can be seen from the significant positive correlation between a measure of the extent of banking intermediation and the EBRD’s transition indictors for banking reform (EBRD 1998).” In addition, strong enforcement of prudential regulations can contribute to a strengthening of financial discipline, which reduces vulnerability to adverse shocks and can help to reduce macroeconomic risks.

127. Many of the vulnerabilities of the Georgian banking system are a consequence of its stage in the transition process: the banking supervision capacity is developing, the legal and credit culture is weak, and intermediation costs are high. According to EBRD indicators, Georgia achieved a rank of 2.3 in 1999 on a scale of 1-4,50 similar to that of other CIS countries (e.g., Armenia, Moldova, Kazakhstan), but still below the Baltic countries and Central European transition countries (rankings 3 and 4).

128. The law governing the central bank was enacted in September 1995. Legislation controlling the creation, supervision, and resolution of commercial banks and other credit institutions was passed in February 1996. According to the law, the NBG has the power to issue banking licenses, publish prudential regulations, and supervise banks both off and on-site. In addition, the NBG has the power to take the necessary measures and/or sanctions when problems arise and close cooperation with foreign supervisory authorities is clearly noted.

129. A recent FSAP review found that the legal framework governing the financial sector has shown substantial advances, but there are many areas in need of improvement. Transparency of monetary and financial policies is generally quite sound except in the area of payments system oversight. Compliance with the Basle core principles has shown significant advances. However, there is a need to strengthen regulations pertaining to foreign exchange, country and market risks; improve the NBG’s ability to administer and close distressed banks; and allow the central bank to bar persons with past criminal activity from obtaining controlling interest in a bank (see Table A-24 for the current prudential requirements).

130. Recent measures to strengthen the system include new minimum capital requirements; new asset regulations and provisioning requirements; conflict of interest regulations and the introduction of international accounting standards (IAS). New regulations that expanded the assets for provisioning came into effect on April 10 2001; banks’ compliance is being reviewed as part of the inspection process, along with implementation of international accounting practices, which will help reduce vulnerability to credit risk. Conflict of interest regulations are aimed at dealing with insider lending, which is important for helping the sector combat fraud. A number of the bank closings, including of several medium-sized banks, have been due to governance-related problems.

131. There is a need for an improvement in the NBG’s ability to administer banks in distress and to close failed banks. While prompt action on the part of the NBG averted a crisis after the Russian crisis precipitated a significant drop in the demand for lari, banks which have had their licenses revoked have often contested in court the NBG’s authority to close them. Presently there are three such cases with the courts. While, the NBG has typically prevailed in these cases, a strengthening of the law is needed to uphold the NBG’s authority to effectively deal with problem banks and avoid an unnecessarily drawn out process in the courts. Amendments to the central bank and commercial bank law in order to establish its primacy in dealing with bank-related issues are now with parliament.

F. Financial Development and Reform

132. The financial sector’s role in facilitating growth is severely constrained by its small size, as is its role in improving corporate governance through the use of credit. To encourage financial development, broad based reforms are needed in order to strengthen the banking sector and develop an environment conducive to business:

  • Continue with strengthening bank regulation and supervision, to impose financial discipline and increase confidence in banking sector. This involves strengthening the legal structure to improve the NBG’s enforcement powers; effective implementation of IAS and loan classification and provisioning requirements; measures to reduce bank fraud and money laundering.

  • Strengthen the process for entry and exit of banks to improve competition. An important step would be to strengthening the NBG’s ability to resolve failed banks, including through temporary administration and bank liquidation procedures. A credible threat of exit is fundamental to the process of competition. Once a credible exit strategy is in place, the banking system can be opened to competitive entry, and transparent application of licensing requirements would help ensure than new banks are prudent and capable.

  • Pursue bank consolidation, to increase efficiency and exploit economies of scale. Consolidation can also facilitate supervision by reducing the number of banks subject to inspection. Measures in this area would include measures to encourage mergers and acquisitions of smaller banks.

  • Attract strategic foreign investment into the sector to spur reform by bringing in advanced technology and banking skills. This would also reduce the scope for connected lending. Such investment could be in the form of either establishing new banks or in buying shares of existing banks, although Georgia’s small size limits foreign banks incentive for setting up new retail operations. Entry of foreign banks would help to avoid the problems of one bank becoming ‘too big to fail’ and help to curb monopolistic practices.

  • Continue with development of capital markets, including the treasury bill market and stock exchange, and modernize the payments system. Further development of the treasury bill market will require continued fiscal measures to strengthen the budget. To develop the corporate securities market, efforts need to be made to improve corporate governance, including auditing and accounting practices of enterprises to provide timely and reliable information to investors, and enforcement of company law. Procedures need to be developed to facilitate alternative non-cash transactions, such as checks and debit/credit cards.

  • Strengthen the legal framework and move forward on the economic reform agenda to improve the business environment. To encourage confidence in the sector and reduce the cost of borrowing, an effectively functioning legal system needs to be in place in order to enforce property rights and contracts, as well as creditor and shareholder rights. Measures in this area include the implementation of effective collateral and bankruptcy laws. Efforts need to continue with land reform to enable land to be used as collateral, licensing reform, privatization, and fiscal reform measures, including strengthening tax administration.

V. Dl Georgia: EMpirical Evidence and Policy Implications51

A. Summary and Introduction

  • As inflation declined and exchange rate stability was restored following the Russian crisis, broad money grew rapidly, driven by a rebound in the demand for money. Despite these favorable developments, dollarization, which rose sharply at the time of the crisis, has remained high.

  • The presence of hysterisis would help to explain why the demand for foreign currency increases when the economic situation deteriorates, but decreases by less when the economic situation improves. Households and enterprises adapt their money management techniques to include foreign currency deposits as an inflation hedge. Once the fixed costs of developing and applying these techniques are overcome, there may be little incentive to switch back even after a period of economic stability and low inflation. Regulatory and institutional factors as well as concerns over policy management of the authorities can also play a role in reinforcing the ratchet effect.

  • A simple econometric model of currency substitution is estimated, which includes the interest rate differential, depreciation, an indicator of structural change measured by openness or monetization, and a ratchet variable to take into account the limited reversibility of the dollarization process. The empirical evidence suggests that depreciation of the exchange rate and the ratchet effect are significant determinants of the dollarization process in Georgia, and that institutional factors, such as monetization or the opening up of trade, are also relevant.

  • The policy implications of a persistently high level of dollarization are that the government must pursue sound macroeconomic policy for a sustained period in order to enhance confidence in the currency. In addition, measures should be taken to reduce demand for foreign currency, including through development of alternative liquid financial instruments. Direct measures are not advisable since they typically lead to capital flight and undermine confidence in the local currency. While a fixed exchange rate regime could help to protect against exchange rate risks, a floating exchange rate regime is appropriate for Georgia, given the low level of reserves and its vulnerability to external shocks.

B. Dollarization: What is it and How is it Measured?

133. The process by which foreign currency replaces the local currency as a store of value, unit of account, and medium of exchange within the domestic economy is referred to as dollarization. Currency substitution refers to the substitution of foreign for domestic currency as a medium of exchange, which is often described as the last stage of the dollarization process.

134. In this chapter, dollarization is defined as the ratio of foreign currency deposits to total deposits in the banking system. In principle, the ideal measure of dollarization would be to take into account all foreign currency balances, including notes and coins and foreign currency deposits within the domestic banking system and abroad. As is the case in most countries, it is difficult to obtain reliable time series estimates of dollars in circulation, although the NBG has estimated that the volume of foreign currency physically circulating in Georgia could, under not unreasonable assumptions, be as high as US$120-150 million (50 to 60 percent of broad money).52 Since reliable time series estimates are not typically available, they are excluded in most empirical work.

C. Factors Influencing the Dollarization Process

135. Risk and return considerations, as well as institutional and structural factors, are important determinants of the extent of dollarization.

  • Risk and return considerations are of central importance in that they provide the basis for the allocation of financial savings between foreign and domestic currency deposits. Foreign currency deposits can become an attractive form of saving for domestic investors, assuming confiscation risks are minimal, in order to avoid losses in the value of their portfolio due to a deterioration in the macroeconomic environment. Actual or expected reductions in the value of domestic currency holdings are typically induced by either high inflation, expectations of exchange rate depreciation or low interest rates on domestic currency holdings.

  • Institutional factors play an important role in that they define the rules of the game, e.g., whether individuals are allowed to hold their savings in foreign exchange deposits, the absence of total surrender requirements, how foreign currency deposits are treated in reserve requirements, and transaction costs in moving among alternative assets. External and internal convertibility also plays a role in entry-exit barriers to holding foreign currency deposits. Moreover an economy’s financial development is a factor, as economies with limited financial development offer little in the way of alternatives to holding foreign currency instruments and assets as an inflation hedge. Consequently, other factors being equal, dollarization is likely to be higher in countries with limited financial markets.

  • Structural factors, such as the opening up of trade, reduction of tariffs, and the removal of current and capital account restrictions, are usually associated with the increased use of foreign currency denominated assets as they are part of integration with international markets, and hence facilitate access to foreign currency assets by domestic investors. This process can be assisted by financial liberalization, including market-determined interest rates and the general process of monetization and financial deepening.

D. Stylized Facts about Dollarization in Georgia

136. The dollarization ratio in Georgia, as defined by foreign currency deposits relative to total deposits, is among the highest among the BRO countries, with foreign currency deposits reaching over 80 percent in 2001 (Figure V-1). From 1997 to mid-1998, the ratio increased from 58 percent to 63 percent, although inflation declined and the lari was relatively stable. Subsequently, with the onset of the Russian crisis in August 1998 and the devaluation of the lari, there was a sharp rise in the dollarization ratio, to about 77 percent by mid-1999. However, even after inflation began to fall and the lari stabilized, the ratio continued to edge upward, reaching about 82 percent by the first quarter of 2001, which suggests a certain amount of inertia or hysterisis.

Figure V-1.
Figure V-1.

Georgia: Dollarization Ratios, 1997-2000

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: EU2, Centralized Database; and Fund staff estimates.

137. Risk and return considerations are an important factor in explaining the high level of dollarization. The difference between the interest rate on foreign currency and domestic currency deposits has typically been small, reflecting in part the very underdeveloped financial system. Consequently, the yield on dollar assets relative to the lari is largely determined by the expected depreciation of the lari vis-à-vis the U.S. dollar. When the lari came under pressure in 1998, even before the onset of the Russian crisis, due to the weak fiscal position, dollar deposits became more attractive. Subsequently, during 1999, when lari deposits became more attractive after the exchange rate rebounded and then stabilized, there was no decline in the dollarization ratio.53

138. The tendency of dollarization to remain persistently high despite more favorable exchange rate and inflation developments may suggest that hysterisis is a factor in the dollarization process. If so, it is likely that there will need to be a long period of low inflation and exchange rate stability before the level of dollarization will come down. The hysterisis may reflect factors such as political instability, the lingering effects of the hyperinflation of the past, and the lack of confidence in the policy handling capability of the government.

139. Institutional and structural factors appear to also have played a role in the high level of dollarization in Georgia. For instance, Georgia maintains a relatively liberal exchange rate regime (accepting Article VIII as of December 20 1996), foreign currency deposits can be held by resident individuals and enterprises, and it enjoys one of the most open trade regimes among the CIS countries, with low tariffs. In addition, there has been a steady increase in monetization, measured by money supply relative to GDP, although the process was temporarily set back by the Russian crisis. Figure V-2 shows the trend increase in openness and monetization over the period 1997 to 2001, which coincides with the upward trend in the dollarization ratio. Furthermore, the high level of dollarization in Georgia reflects to a significant extent the limited financial markets and hence the lack of alternative, high yield domestic currency instruments which can serve as an inflation hedge. In addition, a sizeable informal economy, as exists in Georgia, is often associated with a significant amount of dollar-based transactions. The size of these transactions would be expected to decline with structural reform as enterprises in the informal sector move into the formal economy.

Figure V-2.
Figure V-2.

Georgia: Analysis of Dollarization, 1997-2001

Citation: IMF Staff Country Reports 2001, 211; 10.5089/9781451814507.002.A001

Source: Georgian authorities; and Fund staff estimates.

E. A Simple Econometric Analysis of Dollarization

140. Most models of dollarization are based on a simple money demand equation that includes a variable to explain currency substitution, such as inflationary or exchange rate expectations and/or interest rate differentials. The underlying assumption is that the demand for foreign currency is driven by the uncovered interest parity condition, i.e., the difference between the real rates of return on domestic and foreign currency.54 In addition, a ratchet variable can be used to capture the limited reversibility of the dollarization process.55

141. In this section, empirical analysis is performed to see if there is a long run relationship between the dollarization ratio, the interest rate differential, depreciation of the exchange rate, and a ratchet variable, defined as the highest previously achieved dollarization ratio, and the degree of openness of the economy or monetization. The latter are included to capture the structural change in the economy as it becomes more integrated with the international economy. Subsequently, an error correction model is estimated to discern the short-run dynamics. The model is defined as follows:

Mt=a0+a2⁢It+a3⁢Et+a4⁢Rt+a5⁢St+ut

Where:

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142. As depicted in Figure V-1, the dollarization process in Georgia exhibits an upward trend. The time series properties of data may affect traditional measures of statistical inference, so that if a time series has a persistent upward or downward trend (i.e., it is nonstationary), spurious results may be obtained from standard regression techniques such as OLS. In light of this, unit root tests were first carried out for the period 1997-2001 on the series to test whether the variables were stationary. The tests revealed that the existence of unit root could not be rejected for all variables except the openness series (Table V-1).59

Table V-1.

Estimates of Dollarization Determinants, Long-Run Estimates

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Estimation results using monetization to proxy structural change.

Estimation using openness to proxy structural change.

Indicates significance at the 10 percent confidence interval; for the unit root and cointegration tests significance indicates that the null hypothesis of unit root can be rejected.

143. Granger (1981) and others have shown that linear combinations of one or more time series may turn out to be stationary, i.e., nonstationary variables are cointegrated, thereby producing stationary residuals. The presence of a cointegrated long-run relationship between the variables allows the dynamic relationship to be represented in the form of an error correction model (ECM).

144. The results of the cointegration test using the above model indicate that there is a long run relationship between dollarization and the depreciation of the exchange rate (E), the ratchet variable (R) and monetization (S1) or openness (S2) (Table V-1). The long run coefficients indicate that the dollarization ratio is positively related to these determinants.60 It was found that the interest rate differential (I) had the incorrect sign, so it was not included.

145. An error correction model was then estimated to determine the short run dynamics.61 The results suggest that the short-run dynamics are influenced by the depreciation rate, and the ratchet variable. In the case where monetization is used, it also affects the short-run dynamics. The significance of the error correction term (ECM) supports the significance of the long run relationship in the model. The R2 is low, suggesting the explanatory power of the models are low. On the other hand the high F-statistic provides validity to the models, ruling out the hypothesis that the coefficients of the model are all zero. Figure V-2 shows the estimated values plotted against the actuals after being normalized.

Table V-2.

Estimates of Dollarization Determinants, Short-Run Dynamics

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Estimation results based on using monetization to proxy structural change.

Estimation using based on using openness to proxy structural change.

Significance at the 5 percent confidence interval.

Significance at the 10 percent level.

F. Pros and Cons of Dollarization

146. Should dollarization be discouraged? The answer in part depends on what is causing it. For instance, if the process is the result of financial and trade liberalization, and the desire of residents to hold part of their asset portfolio in foreign currency, then this is a normal outcome of international integration. On the other hand if increased dollarization is coming from economic and political instability and lack of confidence in the local currency then it may be problematic.

147. On the positive side, in countries, where inflationary experience has destroyed confidence in the local currency, dollarization can sometimes help to remonetize the economy, restore local intermediation, and reverse capital flight. Dollarization can mean closer integration with international markets and exposure to competition with those markets and a more diverse range of assets for domestic investors.

148. On the negative side, dollarization can complicate monetary policy by introducing an endogenous foreign currency component into the money supply, and it contributes to a loss of seignorage. There is also a potential for greater fragility of the banking system in highly dollarized economies. Such fragilities can limit the policy options available to the authorities and put an additional burden on the central bank as lender of last resort.

149. In the case of Georgia, the above empirical analysis suggests that dollarization is influenced by beneficial as well as detrimental factors. The existence of foreign currency deposits has certainly facilitated the development of the financial system and has coincided with the liberalization of the trade and capital account and monetization, as indicated by their significance in the currency substitution equation. On the other hand, currency substitution is sensitive to the depreciation rate and has a tendency to persist as indicated by the significance of the ratchet variable. Consequently, financial weakness combined with a large external shock can induce a significant shift from local currency to dollar assets, placing pressure on the exchange rate and on the banking system, as was the case in 1998.

150. Direct measures to limit dollarization may be unwise, given that it appears that there are beneficial aspects to it, such as encouraging financial intermediation. On the other hand, the persistent and high level of dollarization in Georgia suggests that the authorities need to take measures to encourage confidence in the local currency.

G. Policy Implications and Conclusions

151. The most effective way to prevent excessive dollarization is by pursuing sound macroeconomic policy. In addition, institutional arrangements that bolster confidence in the maintenance of price stability, such as an independent central bank, with a clear price stability mandate, can enhance confidence in the domestic currency and thereby reduce the degree of dollarization. The significance of the ratchet effect in explaining the dollarization process in Georgia suggests that a long period of stability is needed before dollarization will decline. Other measures which can reduce the demand for foreign currency include the promotion of alternative financial instruments, such as stocks, mutual funds, corporate bonds and asset backed securities and derivatives that can substitute for foreign currency deposits in resident’s asset portfolios. Encouraging the development of financial markets and competition within the banking system, for instance through entry of strategic banks or investors, would help to ensure market-determined interest rates and development of alternative financial instruments. In addition, the use of the domestic currency can be assisted by providing a competitive domestic currency payments system. More direct measures to reverse dollarization can be problematic. Regulatory limits on foreign currency deposits or punitive reserve requirements on dollar deposits may simply drive dollars offshore, and forced conversions will undermine confidence and may result in capital flight.

152. Since foreign currency deposits are part of the money supply and are endogenously determined, dollarization complicates the choice of intermediate target for monetary policy. Fundamentally, the choice of target is an empirical issue and depends on which monetary aggregate is most strongly linked to output and prices. At any rate, dollar-denominated assets should be among the relevant indicators for monetary policy in a highly dollarized economy. With regard to exchange rate policy, the prevalence of currency substitution would tend to strengthen the case for a fixed-rate system in order to protect against exchange rate movements. In the case where there is only asset substitution, a flexible exchange rate may give the central bank greater monetary autonomy, since the links between international and domestic interest rates may be increased, although vulnerability to exchange rate risk, as in Georgia’s case, would argue in favor of a fixed rate. Nonetheless, in Georgia’s case, a floating exchange rate regime is appropriate under the present circumstances given the low level of reserves and vulnerability of the macroeconomy to external shocks.62

VI. The Energy Sector63

A. Summary and Introduction

  • The energy sector in Georgia has faced several challenges: (i) the inheritance of a distorted and low energy price system following the breakup of the Soviet Union; (ii) the collapse of the economy following the breakup; and (iii) a civil war that disrupted the fuel and energy network.

  • This section provides an overview of developments in Georgia’s electricity, natural gas and oil sectors, as well as oil and gas transit pipelines. In particular, it emphasizes the recent efforts to reform the electricity sector.

  • In spite of some reform having been carried out during the second half of the nineties, serious problems continue to plague the electricity sector. The regulatory framework has been strengthened and a privatization program has attracted some private capital, but privatization has come to a standstill in 2000. Also, the state-owned elements of the power sector remain unable to achieve cost-recovery and have accumulated a large amount of debt. Frequent power outages continue to hamper economic growth. The conditions necessary for returning the state-owned sector to financial health and establishing a more reliable electricity supply have yet to be implemented.

  • The authorities have recently committed to an ambitious reform program, supported by a World Bank credit and focused on private sector involvement. Implementation of this new reform has been uneven. While some efforts have been made to revive privatization, there continues to be little progress in resolving the problems of the electricity sector debts.

  • The natural gas sector exhibits problems similar to those of the electricity sector. While the regulatory framework has been strengthened, the state-owned parts of the sector fail to achieve cost recovery and have accumulated considerable debts. Supply to households and commercial customers in the cities has been reduced to low levels. Privatization has been very slow. A comprehensive reform strategy for the gas sector and a plan for the resolution of its debt have yet to be developed.

  • Notwithstanding today’s difficulties, the energy sector could become an important source of foreign currency revenues to the budget. Given its geographic location, Georgia could be an important player in the transit trade offered by the Caspian Sea region’s reserves of hydrocarbons. There also seems to be potential for electricity transit from Russia to Turkey. However, the transit fees that Georgia has been able to secure for the oil pipelines are low by international standards.

B. The Power Sector

Structure of the sector and pre-reform problems

153. Georgia’s electric power system serves 1.1 million customers in a country of 5.4 million people, with a coverage of nearly 100 percent. Power generation is hydroelectric and thermal, with hydroelectric generation accounting for about 80 percent of the total. The thermal plants mostly burn natural