Georgia— 2011 Article IV Consultation Mission Concluding Statement
1. Backed by the steady implementation of the economic program supported by the Stand-By Arrangement with the International Monetary Fund (IMF), real GDP grew by over 6 percent in 2010. Encouragingly, growth was broad based across all economic sectors driven by a rebound of credit to the private sector and strong export demand. The recovery of private sector growth enabled the government to withdraw some of the fiscal stimulus of 2009 and improve its financial position, notably by tightening current spending. As a result, the government deficit narrowed to 6.6 percent of GDP in 2010 from 9.2 percent in 2009. The external position has also improved since mid-2010, as evidenced by the absence of exchange rate pressures, which allowed the central bank to strengthen its net international reserve position. While FDI inflows are well below the initial forecast, their level (estimated at under USD 600 million, or 5 percent of GDP, in 2010) remains quite respectable by international standards.
2. As in most other countries, consumer price inflation has risen unexpectedly since mid-2010, reaching 12 percent in January 2011. Nearly all of this inflation originates from hikes in the international prices of food and energy: since mid 2010, the price of primary food commodities has risen by about 20 percent (wheat prices by nearly 60 percent) and the price of oil by 30 percent. The erosion in living standards from these price shocks is of concern, particularly for the most vulnerable sections of society, and should be addressed by maintaining adequate social safety nets. In the absence of additional external shocks, we expect prices to stabilize in the second half of 2011 and, on that basis, inflation should decline gradually back to single digits by the end of the year.
3. The policy response to the twin crisis of 2008-09 succeeded in averting a much deeper economic contraction, but vulnerabilities remain. The countercyclical fiscal response led to a significant increase in public debt (from 22 percent of GDP in 2007 to 39 percent in 2010). Private sector balance sheets have also been weakened by the crisis, as evidenced by higher dollarization and indebtedness and, for the banks, a deteriorated loan portfolio, although the increase in non-performing loans (NPLs) also reflects vulnerabilities built-up prior to the crisis. Meanwhile, the external environment is likely to remain volatile and the expected strong rebound of FDI appears increasingly uncertain.
4. Against this background, the main economic policy challenges over the next few years are to create the conditions for solid economic growth even in the absence of a strong rebound of FDI, strengthen public balance sheets, maintain price and external stability, and prevent the emergence of new imbalances and systemic risks in the private sector as credit and external borrowing resume.
Sustaining economic growth and maintaining a viable external position
5. The mission has revised upward its real GDP growth projection for 2011 to 5½ percent. Public investment has been crucial to sustaining growth during the crisis and enhancing the economy’s productivity through infrastructure improvements. The mission shares the government’s view that private sector investment should replace government investment as the motor of growth going forward, and also agrees with the authorities that sole reliance on FDI may not be sufficient to unlock the economy’s growth potential in the post crisis environment. It supports the authorities’ intention to adopt a more proactive approach to promote productivity growth and attract private investment in high potential sectors such as agriculture and energy. Sector development programs could include structural reforms and targeted public investment, which however would need to be consistent with a compression of the overall capital budget. While public private partnerships and state enterprise investment may also be effective instruments of development, such ventures should be considered with caution in view of the large direct and contingent fiscal costs which they may generate.
6. Preserving external competitiveness is also fundamental to sustained growth and, in this regard, the crisis-related real exchange rate depreciation has moved the lari exchange rate much closer to equilibrium. However, the current account deficit (10 percent of GDP in 2010) remains large by most measures, including by comparison with other emerging market economies in the region. In line with a more conservative view of FDI inflows, the mission considers that policies should aim at reducing the current account deficit to 5-6 percent of GDP over the medium term. This adjustment would come in part from the expected growth recovery of trading partners and domestic productivity gains complemented by exchange rate adjustment as needed. Accordingly, exchange rate flexibility should remain a fundamental pillar of the growth and adjustment strategy going forward.
7. The government and the central bank face large external debt service obligations in 2012-14 (including to the IMF), peaking at just over USD 1 billion in 2013 (equivalent to 8 percent of GDP). Georgia’s sound policy performance and overall macroeconomic conditions and prospects place it in a good position to tap international financial markets to cover a good part of these obligations—the rest being repaid out of the accumulation of international reserves and T-bill issuance. However, international financial markets remain very volatile and an alternative refinancing strategy could involve greater issuance of T-bills, accompanied by faster external adjustment. As in the past, the IMF stands ready to provide support in the case of continued global market instability. The mission discussed these options with the authorities and recommended that T-bill issuance be raised gradually to cover this possibility.
Restoring a sound fiscal position
8. Fiscal policy over the next few years should be anchored on the need to reduce the debt-to-GDP ratio over the medium term. Debt sustainability analysis suggests that the government deficit should converge to around 1½ percent of GDP over the medium term to achieve this objective, i.e. a cumulative adjustment of about 5 percentage points of GDP relative to 2010.
9. The strong cyclical rebound of the economy and the possibility that expenditure pressures will reemerge around the 2012 and 2013 elections argue in favor of front loading fiscal adjustment as much as possible in 2011. The mission therefore welcomes the authorities’ intention of reducing the deficit to below 4 percent of GDP in 2011. Such an outcome would imply that half of the adjustment targeted from 2010 to 2016 would take place in 2011. In the event of an even stronger cyclical recovery, the mission would urge the authorities to save the revenue over-performance toward faster deficit reduction.
10. Over the medium term, the expenditure-based adjustment strategy chosen by the authorities will require tough decisions, especially in view of the need to strengthen social safety nets against recent losses in purchasing power, and to rationalize public capital spending around fewer projects. The strategy is likely to leave limited room for contingency expenditure measures in the event of adverse shocks. Accordingly, the mission considers it important to preserve sufficient flexibility on the revenue front. Having now adopted the constitutional amendment subjecting tax increases to a referendum, it is important that the envisaged escape clause cover a sufficiently wide range of contingencies.
Preserving price stability
11. There is little that monetary policy can or could have done to prevent the surge in the price of food and energy. The main challenge ahead for monetary policy is to avoid the emergence of second round effects that would entrench inflation at this higher level, undermining confidence in the lari. In this respect, the mission considers that the stance of monetary policy is currently appropriate, but also welcomes the readiness of the National Bank of Georgia to tighten monetary policy conditions further should there be signs that inflation is becoming more generalized or that credit growth is accelerating too fast.
12. The planned transition to an inflation-targeting framework should eventually anchor expectations around the inflation target rather than the exchange rate, thus allowing the exchange rate to move more flexibly. One of the preconditions to effective inflation targeting is the ability to affect market interest rates and, through that, credit aggregates and expectations. In this regard, the reforms undertaken by the National Bank since 2009 to improve monetary policy effectiveness have begun to bear fruit, and policy interest rate signals are now more effectively transmitted to market interest rates. The authorities are encouraged to continue down the path toward inflation targeting by building up their inflation forecasting and modeling capacity with technical assistance from the IMF.
Preventing the emergence of new private sector imbalances
13. Given the relatively low level of financial intermediation, the authorities will continue to face challenges in balancing financial development considerations against prudential ones, so as to limit systemic risks. On developmental grounds, there should be scope for credit to grow faster than GDP. However, with such growth come higher risks, which would be mitigated if debt service burdens were lower (longer maturities and lower interest rates) and loan penetration higher.
14. With the stabilization of financial conditions, the supervisory authority has moved in a timely and appropriate way to restore liquidity and capital requirements back toward pre-crisis levels. At the same time, large liquidity and capital buffers carry costs which contribute to high intermediation margins. The mission welcomes therefore the efforts under way to move to risk-based supervision which should increase the efficiency of supervision. The substantial decline of NPLs (from 8.6 percent of the loan portfolio in mid-2009 to 5.4 percent at end-2010) and adequate provisioning reduce concerns about their impact on financial stability. Increases in foreign exchange reserve requirements should help counter the recent pick up in loan dollarization. Significant progress on this front will depend on the banks’ ability to increase their lari deposit base.
15. On the funding side, the Georgian banking sector has succeeded in reducing considerably its exposure to foreign borrowing which proved to be a major systemic vulnerability during the financing crisis. Since then, a new source of funding has emerged in the form of non-resident deposits, which have grown quite sizably (by roughly 1½ percent of GDP from mid-2008 to end-2010), because of the attractive yields. The risk of overheating from these inflows appears negligible at present, and in fact non-resident deposits may prove useful given uncertain prospects for more traditional types of external financing. Nonetheless, reliance on such potentially volatile inflows can create risks for the financial system, and the authorities are moving to limit reliance on non-resident deposits as a funding base for domestic operations. The mission welcomes the proactive stance of the supervisory authority in regard to new risks, but would caution against using too blunt an instrument against such inflows.