Georgia
First Review Under the Stand-By Arrangement-Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Georgia
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International Monetary Fund
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Publication Date:
06 Jan 2009
eISBN:
9781451814682
Language:
English
Keywords:
ISCR; CR; market uneasiness; Stand-By Arrangement; Georgia's Stand-By Arrangement; policy; authority; financial crisis; broad money; private sector; balance of payments pressure; debt service; International reserves; Exchange rates; Global
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The staff report for the First Review Under the Stand-By Arrangement with the officials of Georgia highlights economic developments and policies. Sustaining economic growth and maintaining confidence in the currency and the financial system within the constraints of available external financing are the main program priorities. IMF staff recommended a more active role for monetary policy in encouraging market interest rate adjustments. With global markets in distress, the authorities should work on contingency planning to keep the financial sector strong.

Abstract

The staff report for the First Review Under the Stand-By Arrangement with the officials of Georgia highlights economic developments and policies. Sustaining economic growth and maintaining confidence in the currency and the financial system within the constraints of available external financing are the main program priorities. IMF staff recommended a more active role for monetary policy in encouraging market interest rate adjustments. With global markets in distress, the authorities should work on contingency planning to keep the financial sector strong.

I. Recent Political and Economic Developments

A. Political Developments

1. Geopolitical tensions remain high in the aftermath of the August armed conflict with Russia. While Russian troops have pulled back from undisputed Georgian territory following the deployment of international observers, the prospects of a withdrawal from the disputed areas seem remote, and conditions in the two breakaway regions remain tense. Georgia’s prospects for NATO membership are still uncertain.

2. President Saakashvili maintains political and popular support. Solidarity with the President has strengthened his party, which has a two-thirds majority in parliament. A new Prime Minister, Mr. Mgaloblishvili, was appointed on November 1, 2008. The opposition has been rallying support for challenging the decisions leading up to the conflict and calling for early elections in the spring, but recent demonstrations did not gather much momentum.

B. Economic Developments

3. The stabilization actions following the conflict proved effective, but financial conditions began deteriorating in late September, leading to market uneasiness. The temporary peg of the lari to the U.S. dollar served as an effective anchor to preserve confidence in the short term. At the same time, the easing of liquidity conditions helped protect the integrity of the payments and financial systems. However, financial indicators, which showed some improvement in September, have again come under pressure partly as Georgia began to feel the effects of the global financial crisis (see Box).

Georgia—Recent Evolution of Key Financial Indicators

  • Gross international reserves increased to $1.37 billion by end-September, aided by the SBA purchase ($250 million) and a first transfer of $50 million from the foreign assets of the sovereign wealth funds (SWFs) to the government’s accounts.1 In October, however, reserves declined to $1.27 billion mainly due to interventions, notwithstanding additional transfers of about $150 million from the SWFs.

  • Interventions in the foreign exchange market by the National Bank of Georgia (NBG) to defend the temporary peg amounted to one-third of gross reserves during August 7–November 7. In August only, sales amounted to $190 million. During most of September the situation stabilized faster than expected under the program, with the NBG purchasing foreign exchange. However, pressures resumed, and the NBG sold $320 million from September 28 to November 7, when the lari began to depreciate.

  • Bank deposits dropped by 13 percent in August, creating strong pressures on bank liquidity. During September they recovered by 5 percent, but in October and early November they declined again. The share of foreign currency deposits increased somewhat, and the decline in currency in circulation is likely to reflect an increase in dollar cash holdings.

  • The spread on Georgia’s sovereign bonds over comparable U.S. Treasury bills increased from 550 to nearly 800 basis points during the conflict, declined to 700 basis points after the cease-fire, but rose to over 1100 basis points in the wake of the global financial crisis.

1/The government decided to repatriate most of the SWFs resources ($370 million) in September-December 2008, even though it still intends to use them in 2009.
Figure 1.
Figure 1.

Georgia: Key Financial Indicators

Citation: IMF Staff Country Reports 2009, 001; 10.5089/9781451814682.002.A001

1/ Real exchange rate appreciation during the first 8 months of 2008 was driven by nominal appreciation and inflation pressures. Recent events (particularly, nominal depreciation in early November) have not been reflected in the actual data.2/ Based on INS exchange rates and CPI. An increase indicates an appreciation.

4. The conflict had only a temporary impact on domestic prices but, in combination with the global slowdown, it impaired economic activity.

Figure 2.
Figure 2.

Georgia: 12-Month CPI Inflation

(In percent)

Citation: IMF Staff Country Reports 2009, 001; 10.5089/9781451814682.002.A001

Source: Department of Statistics of Georgia.1/ Utility includes transportation, housing, and electricity.

  • Annual inflation rose sharply to 12¾ percent in August due to major transportation and supply disruptions, but fell to 7 percent in October. Taking into account the expected economic slowdown and the recent lari depreciation, end-year inflation is projected to be about 10 percent.

  • Real GDP growth, which had been impressive and broad based until June 2008, is projected to become negative in the second half of 2008, following a sharp decline in private demand driven by lower inflows and the shock to confidence. Growth in 2008 is projected at 3½ percent.

Figure 3.
Figure 3.

Georgia: Real GDP Growth

(In percent, relative to same quarter of previous year)

Citation: IMF Staff Country Reports 2009, 001; 10.5089/9781451814682.002.A001

Source: Department of Statistics of Georgia.

5. The central bank provided ample bank liquidity during and after the conflict. It waived the 13 percent reserve requirement for seven weeks and reintroduced it at a 5 percent rate. It also granted to banks uncollateralized 180-day loans for 140 million lari (5 percent of deposits) at lower-than-market interest rates. Liquidity concerns, which dominated the immediate post-conflict situation, have been mitigated and the payments system is functioning well. Banks’ demand for liquid assets now appears to be essentially precautionary and motivated by heightened uncertainties about stability of the depositor base and the availability of funding to meet external obligations.

6. Reflecting the ongoing uncertainty, growth in monetary aggregates and in credit to the private sector has continued to shrink. Banks’ cautious approach to lending does not appear to be related to liquidity conditions or interest rates, but rather to their concern about underlying economic conditions, the future evolution of the cost of funding, the need for provisioning, and the health of the real estate loan portfolio. Deposit and lending rates have not fluctuated much and have not reacted to central bank signaling.

Text Table 1.

Georgia: Bank Deposit and Lending Rates 1/

(In percent)

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Source: National Bank of Georgia.

Weighted average rate offered by commercial banks on 6-12 months deposits

Figure 4.
Figure 4.

Georgia: Financial Sector Indicators

(In millions of lari)

Citation: IMF Staff Country Reports 2009, 001; 10.5089/9781451814682.002.A001

Sources: Georgian authorities; and Fund staff estimates.

7. Fiscal performance in the third quarter was broadly in line with the program. August tax revenues were significantly lower than the monthly average so far in 2008, but they recovered by September and October. Spending increased reflecting the repair of conflict-related damage and rising social needs. The 2008 deficit contained in the budget supplement approved by parliament in October slightly exceeds the program deficit, but the authorities are confident the target will be met.

Text Table 2:

Georgia: Fiscal Developments, 2008

(In millions of lari)

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Source: Ministry of Finance.

8. With total pledges of $4.5 billion over three years, the October donor conference in Brussels was a success. Although the disbursement schedule is uncertain, some $1.3 billion are expected in 2008–09 to support budgetary needs and capital projects, and about $500 million for lending and equity injections in commercial banks—to help them meet the external obligations coming due in 2009. The package to the public sector is highly concessional, and while adding to the debt stock, is not expected to compromise Georgia’s debt outlook as illustrated in the September 2008 DSA (Country Report No. 08/328).

Text Table 3.

Georgia: External Financing Assumptions, 2008–10 1/

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Sources: Ministry of Finance; and Fund staff estimates.

Authorities’ and Fund staff projections based on the pledges made during the donor conference.

Including pre-conflict commitments and roughly $1.3 billion of new commitments for the last quarter of 2008 and 2009.

Lending and equity injections.

II. Performance Under the Program

9. All conditionality for the first review was observed. The end-September quantitative targets were met with ample margins and the end-October structural benchmark on signing and implementing a Memorandum of Understanding (MoU) between the NBG and the Financial Supervisory Agency (FSA) was also observed (see Tables 1 and 2 of the LOI). The quantitative targets for end-2008 and for 2009 were adjusted to reflect the earlier-than-anticipated transfer from the sovereign wealth funds to reserves and the impact of donor financing.

Table 1.

Georgia: Selected Macroeconomic Indicators, 2006–09

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Sources: Georgian authorities; and Fund staff estimates.
Table 2.

Georgia: Annual Consolidated Government Operations 1/

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Sources: Ministry of Finance; and Fund staff estimates.

Consolidated government includes central and local governments and the Sovereign Wealth Funds.

The 2008 deficit PC remains unchanged except for Lari 24 million which was added to reflect the fact that a grant financed prepayment of debt to the EU was postponed.

The adjustor is derived from additional $40 million financing from the World Bank which was partly offset by lower than programmed spending for capital projects. In addition, the borrowing projections include $70 million from the AsDB which are not assumed to be spent in the 2008 budget.

10. The initial market reaction to the program was favorable. The timely announcement of the SBA boosted reserves and contributed to easing pressures in the market. It also helped mobilize significant donor support. If all SBA purchases were drawn, Fund support would amount to 30 percent of total incremental donor support in 2008–09. The potential catalytic impact of the Fund program on private sector inflows was hindered by the additional shock to confidence stemming from the global financial crisis.

III. Outlook and Risks Linked to the Global Financial Crisis

11. The global financial crisis has created new risks for the outlook. The uncertainty about the post-conflict security situation has dampened the business environment. Moreover, the unfolding international financial crisis and the economic downturn in neighboring countries has further buffeted the Georgian economy. If these uncertainties do not recede, the economy would be subject to (i) balance of payments pressures; (ii) higher risk of financial stress from a weakening bank loan portfolio; and (iii) downward risks to economic growth.

Balance of payments pressures

12. There are indications that foreign inflows, trade activity, and remittances could be affected by the global economic slowdown. Most investors remain in a wait-and-see mode, with only ongoing projects being brought to completion. Revisions to the balance of payments outlook point to lower-than-anticipated private direct investment and other capital flows in 2009, even though the highly diversified sourcing of FDI should help limit the risks of an outright freeze. Moreover, the economic slowdown in Russia could weaken remittances, and trade activity would be hurt by weaker global demand and disruption to trade credits. The envisaged donor support—if not imperiled by the global financial difficulties—is expected to help counteract this impact. Overall, the shift in the composition of financial inflow providers (from international investors to multilateral and bilateral creditors and donors) and inflow recipients (from private companies, banks, and individuals to the government) creates a new challenge for the authorities, placing the government in the key role of intermediating foreign inflows.

Text Table 4.

Georgia: Summary Balance of Payments, 2008–09

(In millions of U.S. dollars)

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Sources: National Bank of Georgia; and Fund staff estimates.

Banking sector vulnerabilities

13. While official inflows should help cover banks’ repayment obligations, and the confidence shock on depositors has so far been contained, banks remain vulnerable. The banking sector is relatively small, and direct links with international financial markets are weak. Nonetheless, the system is still vulnerable to spillover confidence effects on depositors and a deterioration in the quality of the loan portfolio, in particular if global financial pressures continue, investor interest in infrastructure and real estate projects diminish, and funding costs rise further. Although bank soundness indicators are broadly adequate, the recent sharp increase in nonperforming loans and the decline in profitability are matters of concern.

Text Table 5.

Georgia: Prudential Indicators of Commercial Banks, 2004–08

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Source: National Bank of Georgia.

Percent of total regulatory capital.

Economic growth

14. The authorities expect a real GDP growth of 4 percent in 2009 with higher public spending offsetting lower private investment. Such a growth projection represents a sharp improvement relative to the second half of 2008, but is only one-third of last year’s growth. GDP growth is subject to downward risks as it would largely rely on the absorptive and implementation capacity of public spending and the timeliness of donor funding. With subdued private investment, public investment would be the main contributor to growth in 2009. Exports will benefit from the recent exchange rate depreciation, but its contribution to growth will be hurt by the expected decline in metal prices (a key export item). Nonetheless, lower imports reflecting the slowdown in capital inflows and growth, as well as the depreciation, should help narrow the external current account deficit to 18½ percent of GDP from 21¼ percent in 2008.

Text Table 6.

Georgia: Savings and Investment Balance, 2006–09

(In percent of GDP)

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Sources: Georgian authorities; and Fund staff estimates.

15. If downside risks materialize, policy adjustments would be needed. Should pressures in the balance of payments be stronger than envisaged (e.g. lower-than-projected private inflows), the exchange rate should be allowed to find its new equilibrium. On the fiscal front, the government would need to limit its use of the SWFs resources to help protect international reserves, and should carefully scrutinize donor-financed spending to avoid additional pressures in the current account. Financial sector policies should aim at safeguarding bank soundness in the face of a likely further deterioration in bank asset quality.

IV. Policy Discussions

A. Exchange Rate and Monetary Management

16. Following the pressures in the foreign exchange market and the fragile balance of payments outlook, the authorities allowed the lari to depreciate. Aware of the disruptive effects of a delayed forced exit, the NBG took corrective action coordinated at the political and technical level. It allowed the exchange rate to depreciate by 16 percent in the first ten days of November (culminating in a one-off adjustment of 11 percent on November 10). Following this adjustment, the NBG intervened in the market for two days to stabilize the rate at its new level and restore confidence. Thereafter, the NBG started to purchase/sell smaller daily amounts of foreign exchange at the new rate as it considers that the exchange rate will find its equilibrium at about that level. NBG has reconfirmed its commitment to allow for exchange rate flexibility. The end-December NIR target provides a small margin for intervention, but the target is relatively tight. While the recent depreciation will imply an upward adjustment in consumer prices and will raise costs for economic agents with foreign exchange exposures, it will help address the balance of payments pressures, preserve international reserves, improve competitiveness, and support economic growth.

17. Exchange rate flexibility should be accompanied by supportive monetary policies. Staff recommended a more active role for monetary policy in encouraging market interest rate adjustments, and stressed that lowering liquidity surpluses once confidence returns—including by increasing policy rates, which were significantly reduced after the conflict—would be a necessary step. The effectiveness of monetary operations in signaling interest rates to the market could be enhanced by improving liquidity forecasting—in particular regarding fiscal liquidity needs, further securitizing government debt, and developing government bond markets.

18. Improving the NBG’s lender of last resort facility (LoLR) is of crucial importance. Staff and the authorities agreed that this facility (structural performance criterion for end-December 2008) should not encourage excessive risk-taking by banks. The framework should place limits on lending to individual banks in relation to their capital and clarify the role of the FSA in certifying that participating institutions are solvent and in monitoring the use of resources. A Fund MCM technical assistance mission will discuss the details with the authorities.

B. Addressing Bank Vulnerabilities

19. Strong supervisory vigilance over the banking system remains crucial. Over the past years the FSA has tightened prudential regulations significantly, but following the conflict it lowered the liquidity ratio from 30 to 20 percent, and brought down from 200 to 175 percent the risk weights for foreign currency loans. Staff pointed out that while the strong standards have enhanced banks’ ability to weather the more difficult environment, the recent relaxation should be temporary and needs to be accompanied by efforts to ensure banks’ compliance and by measures to strengthen the FSA’s institutional capacity. The authorities explained that they are working with banks on the implementation of action plans based on individual vulnerabilities.

20. On liquidity, the main concerns are banks’ maturing external liabilities and the impact of market uneasiness on deposits. The authorities explained that the expected lending and equity injections of about $500 million by IFIs (notably the EBRD and the IFC) and some credit from parents of foreign owned banks should help meet maturing large external obligations in 2009, which amount to around $700 million (14 percent of liabilities). The recovery of domestic deposits will depend critically on the resurgence of confidence.

21. The general economic slowdown and the currency depreciation could weaken the quality of bank assets. The expected decline in asset prices (mainly in real estate) could weaken banks’ balance sheets. While their foreign exchange position is roughly balanced, banks will have to absorb any deterioration in the loan portfolio from lending in foreign currency to unhedged borrowers. Estimates by the FSA suggest that the banking sector would be able to absorb such deterioration, but close monitoring to detect the emergence of any solvency issues will become critical.

22. With global markets in distress, the authorities should work on contingency planning to keep the financial sector strong. The authorities believe they are prepared to manage potential bank difficulties—in case they arise—in an effective and coordinated manner. Staff emphasized however the need to complete as soon as possible a contingency plan to deal with depositors, borrowers, and bank recapitalization.

C. Calibrating the Fiscal Stimulus

23. The expected donor support should help finance a deficit of about 6¾ percent of GDP in 2009.1 The decline in the tax-to-GDP ratio reflects the ongoing reduction of the income and dividend tax rate to 15 percent (a reduction of 5 percentage points in January 2009). Staff expressed concern about this decision given that the recent revenue overperformance may prove temporary, but the government felt it was critical to stimulate private sector activity. On the expenditure front, capital spending is projected to increase significantly (by about 4 percent of GDP), while current spending (mainly on defense) is anticipated to fall sharply despite the expected pick up of social outlays. As a result, the fiscal stimulus (measured as the change in primary balance excluding grants) will be about 2 percent of GDP in 2009, and the operational surplus of the government is projected to improve significantly.

24. The envisaged countercyclical fiscal stance is not expected to add pressures to the balance of payments. The authorities are aware that given the high import component of spending, the magnitude and pacing of expenditure—particularly of the domestically financed outlays—should be consistent with the balance of payments objectives. Given the uncertainty of the timing of donor disbursements, the government plans to manage the budget carefully through supplements that gradually incorporate financing that actually materializes, which is a reasonable approach although not optimal in terms of medium-term planning. Staff stressed the need to prioritize spending in favor of the most pressing reconstruction and social needs.

25. Progress has been made in structural fiscal reforms. Coverage of the budget has been improved by reporting legal entities’ operations in the draft 2009 budget. A pilot program was initiated to allow ministries to incorporate their budgets into the medium-term expenditure framework, and a dispute resolution office at the ministry of finance was established.

V. Other Issues

26. Safeguards Assessment of the NBG. The update assessment of the NBG’s governance framework confirmed relatively strong safeguards, but also found that it faces emerging risks as it modernizes its audit, accounting, and control systems, and responds to the impact of the conflict and the global financial crisis. To address these risks, the NBG needs to reconstitute its audit committee with only non-executive members, and appoint external auditors for a multi-year term to improve audit efficiency and effectiveness.

27. Statistical Issues. While data quality has strengthened, economic analysis would benefit from an improvement in real sector information (early indicators of economic activity) and BOP data (timely data on capital and portfolio inflows).

28. Drawing of the Second Purchase. The authorities have indicated that, given expected donor financing and the availability of resources transferred from the SWFs, they do not currently intend to draw the SBA tranche (SDR 63.1 million) that will be available following completion of the first review.

VI. Staff Appraisal

29. The authorities dealt effectively with the immediate consequences of the conflict and took commendable action to allow the exchange rate to depreciate. While the exchange rate adjustment could involve costs for the banking and corporate sectors, it avoided the risks of a disorderly exit later on, and should help preserve international reserves, improve competitiveness, and support economic growth. The NBG’s decision to intervene temporarily in the market to avoid excessive fluctuations in the exchange rate following the step depreciation was appropriate, but it is important that this is short-lived so as to avoid the reestablishment of a de-facto peg. The authorities’ commitment to exchange rate flexibility will help protect international reserves, which are essential given the uncertain outlook for private capital inflows.

30. The replacement of large private inflows with sizable, but temporary, official inflows creates new macroeconomic management challenges. Until access to international markets is restored and consumers and investors regain confidence, the main challenges are to sustain growth and maintain confidence in the currency and the financial system within the constraints of available external financing. This creates difficult policy tensions for exchange rate management (between calming the markets and facilitating the needed adjustment) and fiscal policy (between sustaining demand and containing balance of payments pressures). The authorities’ decision to allow an orderly depreciation, while expanding fiscal policy in line with available financing, strikes the right balance between these competing demands.

31. The anticipated financial support from development partners is expected to create space for the needed countercyclical fiscal policy. The generous support by donors, which will not compromise the debt sustainability outlook, is expected to fill the 2009 balance of payments gap while financing important government outlays. The envisaged fiscal stimulus will focus on addressing reconstruction and social needs, while minimizing unproductive spending. Timely disbursements by donors will be critical to the success of the program.

32. There is room for a more vigorous role for interest rate adjustments now that the post-conflict liquidity concerns have been addressed. Although uncertainty may limit the response of deposits to higher returns, better interest rate signaling by the NBG and enhanced use of the policy instruments should help avoid liquidity surpluses in the market and ease any further pressures in the foreign exchange market. The improved LoLR facility will also help the NBG deal with this crucial central bank function both in normal and in extraordinary times.

33. Strong supervisory vigilance over the banking system remains crucial. Liquidity could suffer from market nervousness and a further decline in asset quality, notably from a reversal of real estate prices, would lower capital adequacy ratios. Strong efforts are therefore needed to ensure that banks comply with loan classification and provisioning requirements, supported by continued on-site inspections to detect the emergence of any solvency issues. The recently signed MoU between the NBG and the FSA provides a critical instrument for enhancing policy coordination. Nonetheless, there is a need to prepare a plan to reinforce the framework for managing potential banking sector difficulties.

34. Risks to the program have increased as the Georgian economy has begun to feel the effects of the global financial crisis. The main challenges are the balance of payments imbalances that could be created by a larger-than-anticipated decline in private inflows, slower-than-envisaged donor disbursements, financial sector vulnerabilities stemming from a possible weakening of bank asset quality, a weakening of trade activity, and a sharper slowdown in economic growth. Given its good debt servicing record and strong commitment to macroeconomic discipline, Georgia is not expected to experience difficulties in repaying the Fund despite the challenging environment.

35. Over the medium term, adjustment policies could be needed to address a very large external current account deficit. The sudden decline in private capital inflows has exposed this key vulnerability, and the future evolution of these inflows will determine the need for adjustment. In this regard, renewed exchange rate flexibility will provide the authorities with a key policy tool.

36. The authorities do not currently intend to draw the SBA purchase that will be available at the completion of the first review.

Table 3.

Georgia: Quarterly Consolidated Government Operations 1/

(In millions of lari)

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Sources: Ministry of Finance; and Fund staff estimates.

Consolidated government includes central and local governments and the Sovereign Wealth Funds.

Table 4.

Georgia: Summary Balance of Payments, 2006–12

(In millions of U.S. dollars)

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For private debt starting 2008, estimates are based on the survey conducted by the National Bank of Georgia and Fund staff assumptions.

Table 5.

Georgia: Accounts of the National Bank of Georgia, 2006–09

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Sources: National Bank of Georgia; and Fund staff estimates.

New classification of gross international reserves reported since the beginning of 2007.

The required reserve regime was modified in May 2007. Under the new regime, tha lari reserves are deposited at banks’ corresponding accounts, the foreign-currency reserves have been gradually converted into the required currency (US$) and included in the NFA as both asset and liability.

Including the lari required reserves and overnight deposits from banks.

Projections are based on projected exchange rates.

Table 6.

Georgia: Monetary Survey, 2006–09

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Sources: National Bank of Georgia; and Fund staff estimates.

New classification of gross international reserve reported since the beginning of 2007.

M2 divided by reserve money.

M3 divided by reserve money.

Table 7.

Georgia: External Vulnerability Indicators, 2006–12

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Sources: IMF Finance Department; and Fund staff estimates and projections.

Excluding currency and deposit liabilities of banks.

Table 8.

Georgia: Indicators of Fund Credit, 2006–17

(In millions of SDR)

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Sources: IMF Finance Department; and Fund staff estimates and projections.

End of period.

Repayment schedule based on repurchase obligations.

Table 9.

Georgia: External Financing Requirements and Sources, 2006–12

(In millions of U.S. dollars)

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Sources: Statistics Department of Georgia, National Bank of Georgia; and Fund staff estimates.

Including the receipts from bond issuance.

Including errors and omissions.

PRGF disbursements in 2006 and 2007, SBA purchases from 2008.

Assumes rescheduling of 2003 arrears in 2004 and of principal maturities falling due during 2004–06. Includes comparable treatment by non-Paris Club bilateral creditors.

Attachment I. Georgia: Letter of Intent

November 28, 2008

Mr. Dominique Strauss-Kahn

Managing Director

International Monetary Fund

Washington, D.C.

Dear Mr. Strauss-Kahn:

1. In September 2008, the International Monetary Fund (IMF) approved a Stand-By Arrangement for Georgia to assist with recovering from the economic dislocation caused by the conflict with Russia. This support proved invaluable in the months immediately following the conflict and we are grateful to the IMF for the support and especially the expeditious manner in which the program was approved.

2. This letter of intent describes our economic strategy and the range of economic policies that we plan to implement during the remainder of 2008 and in 2009. We are, of course, committed to fulfilling the commitments made in the Letter of Intent dated September 9, 2008. Further, we affirm our commitment to implementing policies that will ensure macroeconomic stability characterized by private sector led growth in an environment of low inflation. This will facilitate restoration of investor confidence and renewed access to capital markets. We believe that achieving sustainable economic growth is the best means of improving the living standards of Georgians and reducing poverty in a united country.

Recent Economic Developments

3. Economic performance during the first half of 2008 was robust. Real GDP grew by 8.5 percent in the 12 months to end-June 2008. As in past years, this strong performance was due mainly to large private capital inflows. In the first six months of 2008, private capital inflows totaled USD 1.6 billion, which is the largest amount recorded in any six-month period. Despite strong growth, disciplined monetary and fiscal policies kept inflation at 9.8 percent for the 12 months ending in July.

4. During the first half of 2008, the NBG tightened monetary policy in response to inflationary pressures. Reserve money growth was 19 percent in the 12 months to mid-August 2008, while broad money growth was 28 percent over the same period. Greater flexibility in exchange rates was allowed with the result that the lari appreciated by 12 percent in nominal terms against the dollar in the first seven months of this year.

5. Tax performance was also strong during the first half of 2008 with revenue collection increasing by 31.3 percent compared with the same period last year. At the same time, expenditures were higher.

6. The conflict with Russia in early August had serious economic, social and political consequences. The immediate economic consequence was the disruption of our transport infrastructure, which severely hindered economic activity, and a slowdown in foreign inflows. As a result, we estimate that growth in the third quarter was barely positive. Because of these dislocations, 12-month inflation spiked in August—12.8 percent—but has since subsided to 7 percent for the 12 months ending in October.

7. The current account deficit was about USD 1.7 billion in the first half of 2008. This reflects mainly the financing requirements associated with FDI-related imports. With the slowing of FDI in the second half of this year, we expect that FDI-related imports will also decline in the coming months, but there will be higher imports related to urgent humanitarian and reconstruction needs. Overall, the current account deficit is set to narrow considerably in the second half of the year.

8. The financial sector expansion was slowing prior to August as part of a policy to slow the growth of monetary aggregates and inflationary pressures. The immediate consequence of the conflict was an outflow of deposits and increased dollarization. Reflecting the underlying strength of the sector and public confidence, by the end-October the banking system recovered a considerable share of the lost deposits.

9. On balance, our record of growth and stability performance was indeed impressive before the conflict with Russia, and we believe that it will resume in the near future. In order to overcome the dire consequences of the conflict with Russia and the global economic crisis, we plan to redouble our efforts to improve macroeconomic conditions and reassure investors that Georgia will continue to be an attractive place for business.

Macroeconomic Policies for 2009

10. Without question, the major macroeconomic challenge facing Georgia is restoring investor and consumer confidence and, in turn, private capital inflows. We recognize this will be a daunting task especially in the context of the global economic crisis. Nonetheless, we are committed to maintaining macroeconomic stability and to intensifying our economic reform process as the main vehicle of resuming strong growth. We anticipate—on the basis of the generous pledges made at the recent donor meeting in Brussels—that significant financial support will be available to Georgia very soon, notably budget support from the U.S. These resources will support a wide range of mainly capital expenditures necessitated by the conflict and needed for establishing a foundation for sustained economic growth. They will also help close the balance of payments gap stemming from the expected decline in private inflows. The expansionary fiscal effects will also allow us to offset the contractionary consequences of the conflict and the global economic environment, establishing a foundation for sustained economic growth.

11. For 2008, we project an overall fiscal deficit of GEL 1,158 million (performance criterion for end-December) or about 6.0 percent of GDP. The main emphasis of budget expenditures in the remainder of 2008 and next year will be increased and improved social spending and reconstruction of damaged infrastructure. For 2009, we expect a fiscal deficit of GEL 1,470 or about 6.8 percent of GDP which can be accommodated within the SBA’s indicative target. This ceiling would be reviewed in the context of subsequent program reviews. The Government of Georgia is fully committed to manage the financial assistance from the donor community in an efficient and transparent manner.

12. The combination of a tight monetary stance in the first half of 2008 and the current economic slowdown have significantly eased inflationary pressures. For 2009 we project growth in reserve money of 12 percent and we are targeting growth of the broader monetary aggregates of 17 percent for M2 and 15 percent for M3.

13. In order to maintain macroeconomic stability and confidence, we decided to defend the domestic currency in the midst and aftermath of the conflict with Russia. The exchange rate stabilized without intervention by the central bank during most of September, but due to the global erosion of confidence we again had to intervene to maintain stability in the foreign exchange market. Nonetheless, the exchange rate depreciated by 16 percent in early November and we remain committed to a more flexible exchange rate regime. Priority will be given to maintaining the targeted level of net international reserves under the program. Our monetary policy will be managed accordingly to meet our inflation target.

14. The financial sector once again demonstrated its robustness and resilience to the two shocks that developed from the beginning of August. That has been possible due to the health of the banking sector, i.e. high liquidity position and capitalization of banks. Since the conflict erupted, banks responded by shrinking their balance sheets and taking a more cautious approach to lending due to changed perception of risks. At the same time the liquidity situation of banks strengthened because of the conservative lending policies and the liquidity injections of the central bank. Thus, we believe that as banks ultimately secure long-term funding from the international financial institutions they will resume private sector lending.

15. Under the terms of the memorandum of understanding between the NBG and the FSA that was signed in October (structural benchmark for end-October), we have established a Joint Financial Sector Committee (JFSC). It is envisioned that the JFSC will be the main vehicle for discussing and analyzing issues related to the financial sector.

16. We commit to implementing the recommendations of the recent update safeguards assessment report within the agreed deadlines. In particular, we will reconstitute the NBG’s Audit Committee with only non-executive members, and require the internal audit department to audit the monetary data reported to the Fund at each test date and at the financial year-end.

Program Monitoring

17. All performance criteria for the First Review under the Stand-By Arrangement were met. We request the completion of the First Review and express our intention not to draw the SBA purchase that will be available at the completion of the first review. We will maintain the usual close policy dialogue with the Fund and stand ready to take additional measures as appropriate to ensure the achievement of the program objectives. The third and fourth reviews are scheduled for end-May 2009 and end-August 2009. We request the modification of the performance criteria for end-December 2008, on which the next quarterly review will be based (attached Tables 1 and 2).

Table 1.

Georgia: Quantitative Performance Criteria and Indicative Targets, 2008–09

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Source: Georgian authorities; and Fund staff estimates.

Actual figures for September 2008 and quantitative targets are based on program exchange rates.

The continuous performance criterion for external arrears is defined in paragraph 14 of the TMU.

The 2008 deficit PC remains unchanged except for Lari 24 million which was added to reflect the fact that a grant financed pre-payment of debt to the EU was postponed.

Table 2.

Georgia: Structural Benchmarks and Performance Criteria

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18. We authorize the IMF to publish the Letter of Intent and its attachments as well as the related staff report.

Sincerely yours,

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Attachment II. Georgia: Revised Technical Memorandum of Understanding

November 28, 2008

1. This memorandum sets out the understandings between the Georgian authorities and the IMF staff regarding the definitions of quantitative and structural performance criteria and indicative targets, as well as respective reporting requirements for the Stand-By Arrangement (SBA). These performance criteria and indicative targets are reported in Tables 1 and 2 of the Memorandum of Economic and Financial Policies (MEFP), attached to the letter dated September 9, 2008 and Table 1 attached to the letter of intent dated November 28, 2008.

Table 1.

Program Exchange Rates

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Table 2.

Projected Foreign Borrowing of the Consolidated Government 1/

In millions of U.S. Dollars)

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For 2008, cumulative starting from June 30, 2008. For 2009, cumulative from the beginning of the calendar year.

In line with the borrowing assumption in the original program.

2. The exchange rate for the purposes of the program of the Georgian lari to the U.S. dollar is set at GEL 1.41 = $1. The corresponding cross exchange rates are provided in Table 1.

Consolidated Government and the Public Sector

3. Definition: The consolidated government is defined as the central government, local governments, extrabudgetary funds, public services providing general government system LEPLs, and the Sovereign Wealth Funds (Future Generations and Stable Development Funds). In case the government establishes extrabudgetary funds, they will be consolidated within the consolidated government. The public sector consists of the consolidated government and the National Bank of Georgia (NBG).

4. Supporting material: The Treasury Department of the Ministry of Finance (MOF) will provide to the IMF detailed information on monthly revenues, expenditures, and arrears of the consolidated government. In addition, data will be provided on the cash balances in the accounts of the Ministry of Finance.

Quantitative Performance Criteria, Indicative Targets, and Continuous Performance Criteria: Definitions and Reporting Standards

A. Ceiling on the Cash Deficit of the Consolidated Government

5. Definition: The cash deficit of the consolidated government will be measured from the financing side at current exchange rates, and will be defined as equal to the total financing. Total financing will be defined as the sum of (i) net domestic financing from banks and nonbanks, (ii) net external financing, and (iii) privatization receipts.

  • Net domestic financing consists of bank and nonbank financing to the consolidated government which will be defined as follows:

    • (i) Loans provided by commercial banks to the consolidated government minus accounts held by the consolidated government at commercial banks. These accounts and loans will be monitored based on the NBG’s monetary survey. Any other securities issued by the consolidated government (for example, promissory notes) are also included in domestic financing.

    • (ii) Loans provided by the NBG to the consolidated government minus accounts of the consolidated government held at the NBG in lari and foreign currency. Accounts that are outside of the MOF’s control are excluded from domestic financing. These accounts include VAT refund account; earmarked grants account; account for state agencies deposits; account for local government revenues for the day to be transferred to their account; national disaster fund account; and investment grant and credit account. As of June 30, 2008, cash balances in these accounts were lari 160.5 million. These accounts will be monitored based on the changes in cash balances as recorded by the Treasury Department.

    • (iii) Treasury bills that have been securitized and sold by the NBG, including the bills that have been purchased by nonbanks.

  • Net external financing is defined as the total of loans disbursed to the consolidated government for balance-of-payments support and project financing (capital expenditure and net lending), net change in external arrears, change in the accounts of the consolidated government abroad, including the accounts of the Sovereign Wealth Fund, minus amortization. Amortization includes all external debt-related payments of principal by the consolidated government. Amortization to external creditors via third parties is accounted for at the time and in the amount of payment by the budget to the third party, rather than at the time of recognition of amortization by the external creditor.

  • Privatization receipts consist of all transfers of monies received by the central and local governments in connection with the sale of central or local government assets, including privatization proceeds which were transferred to the Sovereign Wealth Funds. This includes receipts from the sales of shares, the sale of assets as well as leases and the sale of licenses with duration of 10 years and longer.

6. Adjustor:

  • For 2008, the fiscal deficit target will be adjusted upward for any excess in foreign borrowing by the consolidated government relative to the projected amounts presented in Table 2. The upward adjustor shall not exceed 387 million Georgian lari.

  • For 2009, the fiscal deficit target will be adjusted downward for any shortfall in foreign borrowing by the consolidated government relative to the projected amounts (Table 2). In addition, the fiscal targets for each quarter of 2009 will be adjusted upward by the overperformance of the fiscal deficit relative to the target for end-December 2008, up to a ceiling of lari 479 million.

7. Supporting material:

  • Data on domestic bank and nonbank financing will be provided to the IMF by the NBG and the Treasury Department of the MOF within four weeks after the end of the month.

  • Data on external project financing as well as other external borrowing will be provided to the IMF monthly by the Debt Unit at the MOF (specifying projects by creditor) within two weeks of the end of each month.

  • Data will be provided at the actual exchange rates.

  • Data on the accounts of the Sovereign Wealth Funds will be provided by the NBG.

  • Data on privatization receipts will be provided by the Treasury Department of the MOF to the IMF on a monthly basis within two weeks of the end of each month. The data will be consistent with the revenue account(s) in the NBG.

  • Data on treasury bills that have been securitized and sold by the NBG, including the bills that have been purchased by nonbanks, will be reported by the NBG on a monthly basis within two weeks of the end of each month.

B. Floor on the Net International Reserves of the NBG

8. Definition: Net international reserves (NIR) of the NBG in U.S. dollars are defined as foreign assets minus foreign liabilities of the NBG. Foreign assets of the NBG include gold, gross foreign exchange reserves, SDR holdings, and the reserve position in the IMF. Gross foreign exchange reserves of the NBG are defined as liquid, convertible currency claims of the NBG on nonresidents that are readily available. Pledged or otherwise encumbered assets, including (but not limited to) assets used as collateral (or guarantee for third party external liabilities) are excluded from foreign assets. Foreign liabilities shall be defined as outstanding liabilities to the IMF and any other liabilities of the NBG. This defined, the definition of NIR excludes foreign assets stemming from foreign currency deposits of financial institutions at the NBG. For program monitoring purposes, the stock of foreign assets and foreign liabilities of the NBG shall be valued at program exchange rates as described on paragraph 2 above. The stock of NIR amounted to $1,060 million as of end-June 2008 (at the program exchange rate).

9. Supporting material: Data on net international reserves (both at actual and program exchange rates) and on net foreign financing (balance of payments support loans; cash grants to the consolidated government; amortization (excluding repayments to the IMF); interest payments on external debt by the MOF and the NBG) will be provided to the IMF in a table on the NBG’s foreign exchange flows (which include details of inflows, outflows, and net international reserves) on a monthly basis within two weeks following the end of the month.

C. Ceiling on Net Domestic Assets of the NBG

10. Definition: Net domestic assets of the NBG are defined as the difference between its net foreign assets and reserve money. Thus defined, the net domestic assets are the sum of net claims on the government (the sum of loans and treasury bills purchased by the NBG, less deposits of the government with the NBG), claims on banks, claims on the rest of the economy, and other items net (comprising the NBG capital accounts, net unclassified assets, counterpart funds and exchange rate revaluation). Performance against the NDA target will be measured at program exchange rates.

11. Supporting material: The NBG will provide to the IMF its balance sheet, which includes data on its net domestic assets, on a monthly basis within two weeks of the end of each month. Data will be provided using both actual and program exchange rates.

D. Ceiling on Contracting or Guaranteeing of New Nonconcessional External Debt by the Public Sector

12. Definition: Nonconcessional external loans are defined as loans from lenders other than the IMF with a grant element of less than 35 percent of the value of the loan. The grant element is to be calculated by using currency-specific discount rates reported by the OECD (CIRRs).2 For maturities of less than 15 years, the grant element will be calculated based on six-month averages of commercial interest rates. For maturities longer than 15 years, the grant element will be calculated based on 10-year averages. This performance criterion applies not only to debt as defined in point No. 9 of the IMF’s Guidelines on Performance Criteria with Respect to External Debt (Decision No. 12274-(00/85) August 24, 2000) but also to commitments contracted or guaranteed for which value has not been received.3 Previously contracted nonconcessional external debt that has been rescheduled will be excluded from the definition of “new debt” for the purposes of this performance criterion.

13. Supporting material: Details of all new commitments and government guarantees for external borrowing, with detailed explanations, will be provided by the MOF to the IMF on a monthly basis within two weeks of the end of each month. Data will be provided using actual exchange rates.

E. Continuous Performance Criteria on Nonaccumulation of External Arrears

14. Definition: During the period of the arrangement, the consolidated government and the NBG will not accumulate any new external payment arrears on debt service obligations to official creditors. Official external payment arrears are defined as unpaid debt service by the consolidated government and the NBG beyond 30 days after the due date. The performance criterion on nonaccumulation of external debt is continuous.

15. Supporting material: Details of official arrears accumulated on interest and principal payments to creditors will be reported to the IMF within one week from the date of the missed payment. Data will be provided using actual exchange rates.
1

This target assumes full use of the 3 percent of GDP adjustor envisaged in the program to accommodate concessional donor financing. It would be adjusted upward in the event that the 2008 fiscal target is overperformed.

2

An electronic spreadsheet file that shows the relevant discount rates reported by the OECD (CIRRs) will be provided on a periodic basis by IMF staff. A web-based grant element calculator is available at http://www.imf.org/concessionality.

3

Point No. 9 of the IMF’s guidelines reads as follows: “(a) For the purpose of this guideline, the term “debt” will be understood to mean a current, i.e., not contingent, liability, created under a contractual arrangement through the provision of value in the form of assets (including currency) or services, and which requires the obligor to make one or more payments in the form of assets (including currency) or services, at some future point(s) in time; these payments will discharge the principal and/or interest liabilities incurred under the contract. Debts can take a number of forms, the primary ones being as follows: (i) loans, i.e., advances of money to obligor by the lender made on the basis of an undertaking that the obligor will repay the funds in the future (including deposits, bonds, debentures, commercial loans and buyers’ credits) and temporary exchanges of assets that are equivalent to fully collateralized loans under which the obligor is required to repay the funds, and usually pay interest, by repurchasing the collateral from the buyer in the future (such as repurchase agreements and official swap arrangements); (ii) suppliers’ credits, i.e., contracts where the supplier permits the obligor to defer payments until some time after the date on which the goods are delivered or services are provided; and (iii) leases, i.e., arrangements under which property is provided which the lessee has the right to use for one or more specified period(s) of time that are usually shorter than the total expected service life of the property, while the leaser retains the title to the property. For the purpose of the Guideline, the debt is the present value (at the inception of the lease) of all lease payments expected to be made during the period of the agreement excluding those payments that cover the operation, repair, or maintenance of the property. (b) Under the definition of debt set out in point 9(a) above, arrears, penalties, and judicially awarded damages arising from the failure to make payment under a contractual obligation that constitutes debt are debt. Failure to make payment on an obligation that is not considered debt under this definition (e.g., payment on delivery) will not give rise to debt.”

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Cover IMF Staff Country Reports
Georgia: First Review Under the Stand-By Arrangement-Staff Report; Press Release on the Executive Board Discussion; and Statement by the Executive Director for Georgia
Author:
International Monetary Fund
Volume/Issue:
Volume 2009: Issue 001
Publisher:
International Monetary Fund
ISBN:
9781451814682
ISSN:
1934-7685
Pages:
66
DOI:
https://doi.org/10.5089/9781451814682.002
Figure 1.

Georgia: Key Financial Indicators
Figure 2.

Georgia: 12-Month CPI Inflation

(In percent)
Figure 3.

Georgia: Real GDP Growth

(In percent, relative to same quarter of previous year)
Figure 4.

Georgia: Financial Sector Indicators

(In millions of lari)