Developments since the SBA approval

1. After years of strong growth, supported by a wide range of reforms, economic activity slumped as a result of the armed conflict in early August. Infrastructure was damaged, private capital inflows slowed sharply and domestic confidence dropped. The immediate consequence of this pervasive uncertainty was an outflow of deposits and a flight into dollar-denominated assets.

2. In the aftermath of the conflict, the authorities managed to stabilize the situation by temporarily pegging the currency against the dollar, helping to anchor short-term expectations. By easing liquidity conditions significantly, the central bank ensured a smooth functioning of the payments system. Financial market turbulence was further eased thanks to the timely announcement of IMF support. The IMF program supported the government in its stabilization policies and helped to catalyze other financial support. The donor conference that took place in Brussels in October 2008 proved to be a huge success, resulting in pledges of about USD 4.5 bln over the years 2008–10. Georgia’s authorities are grateful to the IMF for its support and for the speedy manner the program was approved by the Board.

3. Reflecting the authorities’ strong commitment to the IMF program, all conditions for the first review were fulfilled. Quantitative targets were met by a wide margin. The structural benchmark was also observed on signing and implementing the Memorandum of Understanding between the National Bank of Georgia and the Financial Sector Authority (FSA) in order to improve cooperation between these institutions. In the meantime, a new prime minister has been appointed, who recently nominated 4 new ministers, including one for economic development. The authorities would like to reassure that these government appointments will have no impact on the cooperative relation between the government and the IMF. The authorities remain fully committed to achieving the program’s objectives.

4. Despite the swift response by the authorities and the Fund, financial conditions began to deteriorate again since late September. A rapidly deteriorating external environment, associated with the ongoing crisis in global financial markets, confronted Georgia with a second shock in less than two months time. The spread on Georgia’s sovereign bond spreads rose, bank deposits declined again and credit growth dropped. In order to stabilize the foreign exchange market, the authorities initially intervened, but as pressures on the exchange rate persisted they allowed the lari to depreciate by 16 percent in the first ten days of November. After this bold step, volatility in the foreign exchange market returned to more normal levels.

The outlook

5. While the challenges were already large in the wake of the conflict, the global financial crisis is making the authorities’ tasks even more daunting. Restoring private capital inflows and business and consumer confidence may take more time, potentially producing a more protracted slowdown in economic activity and adding to the existing pressures in the balance of payments and in the banking sector. In these circumstances, the expected support from donors will be essential in restoring stability. For 2008 and 2009, the authorities anticipate donor support of USD 1.8 bln flowing into the country, with frontloaded disbursement of grants.

6. In view of this bleak environment, economic activity is set to contract in the second half of 2008. Owing to a strong first half, annual growth is still expected to reach 3.5 percent. For 2009, the authorities project GDP growth to reach 4 percent, mirroring a strong acceleration in public investment, which will compensate for the expected slump in private investment and consumption. Although exports are benefiting from the lari depreciation, the contribution of exports to GDP growth is hampered by a fall in metal prices. As imports are dropping too, the current account deficit is set to narrow from more than 21 percent of GDP in 2008 to slightly more than 18 percent of GDP in 2009. While this deficit remains substantial, it is expected to be fully funded by foreign direct investment and donor inflows.

7. Following the two large shocks, the banking sector is also facing pressures at the liability and asset side of the balance sheet. Deposit outflows increased banks’ liquidity needs; whereas the economic downturn coupled with lari depreciation is leading to a rise in non-performing loans. Thanks to strong capital and liquidity buffers, the banking sector has managed to accommodate these shocks without major problems. As a sign of confidence in its resilience, the banking sector recovered a considerable share of lost deposits by the end of October. Deposits have remained relatively firm since then.

The policies

8. With donor money flowing into the country, the authorities have the room to expand fiscal policies further to counteract the adverse impact from the shocks on economic activity. In line with the program, the 2009 fiscal deficit is expected to increase to 6.8 percent of GDP, up from 6 percent of GDP in 2008. Taxes on income and dividends will be further lowered by 5 percentage points to stimulate private sector activity. At the same time, expenditures will be increased and targeted at social outlays and the reconstruction of damaged infrastructure. In order to avoid any unproductive spending, the authorities have also committed to allocate donor assistance in a fully transparent and efficient manner.

9. The authorities have moved towards a more accommodative monetary policy stance following the conflict. Despite the recent depreciation of the lari, inflationary pressures are expected to ease to 7-8 percent by the end of next year on the back of the economic downturn. The authorities are firmly committed to monetary policy consistent with the inflation target. They also reaffirmed their commitment to a more flexible exchange rate and to maintaining the targeted level of net international reserves.

10. Given banks’ strong capital and liquidity standards due to years of tight prudential regulations, the FSA relaxed its prudential regulations to cope with the uncertain financial environment. The required liquidity ratio was cut and the risk weight for foreign currency loans was lowered. These measures are expected to be reversed in case credit growth accelerates quickly. Banks’ liquidity has recently strengthened due to more cautious lending practices and liquidity injections by the central bank. As a result, the actual liquidity ratio of the banking system is several percentage points above the required level. Stronger liquidity, combined with the prospect of USD 500 mln lending and equity injections by IFIs, will help banks to largely cover their external debt obligations for 2009.

11. The authorities noted the deterioration in banks’ loan quality, but are confident that banks could withstand losses arising from the recent depreciation of the lari, and even possible stagnation of GDP growth and a decline in real estate prices in 2009. The system as a whole would be able to absorb more severe shocks thanks to very conservative capital adequacy requirements. To further strengthen the banking sector, the authorities are currently working on improving the central bank’s lender of last resort facility. In order to review recent developments in the financial system and the new regulatory framework, the authorities requested a streamlined Financial Sector Assessment Program for the second half of 2009.

12. The authorities recognized the downward risks to the outlook and stressed they remain vigilant. In case the risk of a stronger drop in private capital materializes, the authorities are confident this risk can be addressed effectively with the support of their strong macroeconomic framework, including a more flexible exchange rate regime, and the robustness of their financial system. Additional policy adjustments will be taken, if these were to be required.

13. Against this background, the authorities request the completion of the first review. They intend not to draw the SBA purchase that will be available at the completion of the first review given the expected donor financing and the availability of resources transferred from the sovereign wealth funds.