PROGRAM INFORMATION DOCUMENT (PID) APPRAISAL STAGE April 8, 2014 Report No.: AB7536 Operation Name Georgia Third Competitiveness and Growth Development Policy Operation (DPO3) Region Europe and Central Asia Country Georgia Sector Other domestic and international trade (10%);General public administration sector (30%);General education sector (30%);Other social services (20%);General energy sector (10%) Operation ID P146890 Lending Instrument Development Policy Lending Borrower Ministry of Finance, Georgia Implementing Agency Ministry of Finance Date PID Prepared April 4, 2014 Estimated Date of Appraisal April 28, 2014 Estimated Date of Board June 26, 2014 Approval Corporate Review Decision Following the corporate review, the decision was taken to proceed with the appraisal. Country and Sector Background 1. Georgia is a small open economy which undertook several reforms and saw rapid growth over the past decade. The economy grew by an average rate of 6 percent a year during 2004-13, largely powered by services, construction and non-tradables in general. Despite strong growth performance, unemployment in the country has remained high, because of low net job creation. With economic transformation in Georgia, some of the older industries died, shedding their labor force. New industries grew during the same period but have not been able to absorb the workforce as effectively. Despite significant improvements in the business environment, progress in improving the ease of closing a business, getting electricity and access to finance remains limited. In addition, businesses complain that job seekers do not have adequate skills, in large part because the existing educational curriculum is not in line with the demands of the private sector. The lack of required skills forces highly educated workers to take up less skilled jobs or remain unemployed. In line with these developments, although Georgia experienced a period of high economic growth during 2004-08, unemployment persisted at 13 percent. Unemployment rose during the 2008-09 global economic and financial crisis and reached 17 percent in 2010 before falling to 15 percent in 2012, after two years of recovery. Unemployment among higher education graduates, particularly women, is extremely high reflecting the inadequacies of the current education system. Nearly 44 percent of unemployed women and 35 percent of unemployed men in Georgia are higher education graduates. Tackling this unemployment problem will need reforms both in the business environment and in the quality and relevance of the education system. 2. The sources of productivity growth which aided economic expansion during the last decade appear to have run their course and future productivity improvements will need to come from other areas. These include improvements in market access, the logistics infrastructure, and skills, as well as growth in firm-level productivity supported by specific reforms in the business environment. A supportive macro-fiscal environment will remain a necessary condition. This Development Policy Operation (DPO) supports government reforms in some of these areas. Operation Objectives 3. The program development objectives are to: (i) Strengthen legislation to promote market access to the EU and improve customs efficiency, power sector reliability and the quality of general education, (ii) Improve the coverage and transparency of the budget, and (iii) Improve the accessibility to and quality of healthcare services and efficiency of targeted social programs. 4. The three DPO pillars map to three of the four priority areas outlined in the government’s development strategy which includes macroeconomic stability, increased competitiveness of the private sector and human capital development. The policy actions supported by this DPO targets the government’s most urgent development challenges. Export promotion and an increase in FDI are essential for productivity growth and are being targeted through the Deep and Comprehensive Free Trade Area (DCFTA) with the EU. An efficient and reliable supply of energy to domestic businesses and consumers is necessary to improve the business environment. A sound education system and increased access to health care will help develop human capital. Improved public financial management will promote better policy making and fiscal discipline and will contribute to macroeconomic stability. Finally, improved effectiveness of social spending will help increase assistance to the poor. 5. The prior actions for this operation and the expected results are mentioned below. Pillar I (a) Prior Action 1: The Government of Georgia has issued Decree no. [] for setting up the competition agency for the implementation of the law on competition. The Government of Georgia has issued: (i) Decree no. 120 dated May 17, 2013 mandating indication of country of origin and date of production for eggs, (ii) Decree no. 198 dated July 30, 2013 defining the rules of bio-production, (iii) Decree no. 1915 dated December 27, 2013 making the violation of food labeling a criminal offense, and made budget provisions for an additional 180 staff in the National Food Agency in the 2014 budget for the implementation of the law on food safety. The expected result of these policy actions is to increase the number of European and international standards registered/adopted as Georgian standards by 20 percent by the end of 2014. In addition, the number of animals vaccinated by the National Food Agency is to increase from 1.2 million in 2012 to 4.5 million in 2014. (b) Prior Action 2: The Revenue Service under the Ministry of Finance has adopted the Trade Facilitation System to integrate customs processes and simplify transactions for handling containers in sea ports. The expected result of these policy actions is to increase monthly customs detections by 100 percent by December 2014, a reform supported by the second operation in this DPO series. (c) Prior Action 3: The Electricity Regulatory Authority has issued Resolution no. [ ] adopting the new transmission grid code. The law on electricity was amended through Parliament Resolution no. N1902-RS dated December 27, 2013 and the Ministry of Energy has amended the Market Rules through Order no. N6 dated January 31, 2014 to enable the adoption of the grid code by the Regulatory Authority. (d) Prior Action 4: The Ministry of Education and Science has issued Decree no. 180 dated May 2, 2013, Decree no. 960 dated December 3, 2013 and Decree no. 220 dated March 4, 2014 for establishing a monitoring framework for the assessment of the implementation of the new national curriculum for primary, basic and secondary education. (e) Prior Action 5: The Ministry of Education and Science has issued Decree no. 39/N dated March 28, 2014 adopting professional standards for teachers which gives professional characteristics, knowledge and skill requirements pertaining to the teaching environment, teaching/learning process, and professional development for each category of teachers. (f) Prior Action 6: The Ministry of Education and Science has issued Decree nos. 162, 163, and 164 dated February 6, 2014 for the implementation of the new quality assessment system for the evaluation of school principals which certified 981 candidates. The expected result of these policy actions in the education sector is to improve the correct response rate in Georgian Language and Literature and Mathematics in the Grade XII school-leaving examinations by at least 5 percent. Pillar II (g) Prior Action 7: The Ministry of Finance of Georgia has prepared financial reports of all central government budgetary organizations in accordance with the modified cash-basis International Public Sector Accounting Standards. (h) Prior Action 8: The 2013 budget performance of all central government LEPLs is available through the e-budget and the Minister of Finance of Georgia issued Order no. 77 dated March 14, 2014 and Order no. 442 dated December 31, 2013 requiring all central government LEPLs to submit budget performance numbers for 2014 either through the e-budget or through hard copies and only through the e-budget from 2015 onwards. The expected result of these policy actions is to improve Georgia’s score on the Public Expenditure and Financial Accountability (PEFA) indicator (PI-25) to C+ by 2014. This indicator measures the quality and timeliness of annual financial statements. Georgia has achieved its end of the program target in the 2012 PEFA assessment. The improved score reflects the annual preparation of a consolidated government statement, external audit of the financial statements within 15 months of the end of the fiscal year and presentation of the statements in a consistent format with some disclosure of accounting standards. Pillar III (i) Prior Action 9: The Ministry of Labor, Health and Social Affairs issued Decree no. 01-25/n dated June 19, 2013 for implementation of upgraded standards for facilities providing primary health care. The expected result of these policy actions is to increase the percentage of hospitals, outpatient facilities and laboratories submitting detailed reports on compliance with upgraded standards to 65 percent by the end of 2014. (j) Prior Action 10: The Ministry of Labor, Health and Social Affairs has adopted the pension module of the Social Information Management System throughout the country. The expected result of these policy actions is to reduce the time taken to issue benefits after assessing eligibility to 3 days for state pensions. Rationale for Bank Involvement 6. The government has made significant progress on all the prior actions supported by this operation. It has already fulfilled 8 of them and will complete the remaining 2 (on the competition agency and the electricity transmission grid code) latest by April 21, 2014. It has an up and running trade facilitation system which integrates customs, shipping lines and ports and facilitates easy exchange of documents and tracking of goods. The Ministry of education has adopted new professional standards for teachers, established a monitoring framework for the assessment of the implementation of the new national curriculum, and implemented the new quality assessment system for the evaluation of school principals. These efforts will go a long way in improving the quality of general education. The 2013 budget performance of all LEPLs is available on the e-budget and the government has put in place the required institutional framework to ensure that this process continues in subsequent years. The Ministry of Finance also prepared the financial reports of all central government budgetary institutions in accordance with IPSAS2. In addition, the government has implemented upgraded standards for facilities providing primary health care and has implemented the pension module in the Social Information Management System. These measures will increase the quality healthcare services and the efficiency of social assistance programs. 7. Georgia’s overall macroeconomic policy framework is adequate for this operation. With greater political stability, overall business confidence is expected to improve and will help strengthen growth prospects. The government remains committed to fiscal consolidation which will have a beneficial impact on the fiscal deficit and on public debt levels. In addition, the National Bank of Georgia’s reserves position remains comfortable. There has also been a significant progress in poverty reduction and shared prosperity in recent years. The poverty rate, according to the national poverty line, reduced from 21 percent in 2010 to 14.8 percent in 2012. This was mainly attributable to government transfers, food disinflation and increased earnings. In addition, consumption growth among the bottom 40 percent was 5.4 percent during 2010-12 compared with 3.6 percent for the population as a whole. The government remains committed to overall macroeconomic stability which is a cornerstone of the government’s socioeconomic development strategy. 8. The IMF Stand-By Arrangement (SBA) and the Stand-By Credit Facility (SCF) will end in April 2014 and a new arrangement could be under discussion. IMF’s program also emphasized fiscal consolidation and sound macroeconomic policy, with a focus on growth- enhancing structural reforms. Tentative financing Source: ($m.) International Bank for Reconstruction and Development 70.0 International Development Association (IDA) 20.8 Total 90.8 Institutional and Implementation Arrangements 9. The Ministry of Finance leads the effort in coordinating the overall implementation of the DPO program. The deputy minister of finance is the main counterpart for this operation and he coordinates with all the line ministries which are involved in the DPO series. The line ministries submit progress reports on the prior actions and result indicators to the Ministry of Finance as and when requested. Given the long history of budget lending operations in Georgia, some institutional capacity and memory has been built up on data requirements for monitoring. While there are some variations between line ministries, in general, they have the capacity to provide good and timely data when needed. 10. Regular reviews are carried out by the Bank team to monitor progress on the reforms during supervision missions. Data for monitoring is generally available through special requests made to the respective ministries and is reliable. Bank staff will continue monitoring progress towards the expected results of the program. Macroeconomic data is available through the statistical agency. Georgia subscribed to the IMF’s Special Data Dissemination Standards (SDSS) in 2010 and is a compliant country. As a result, timely and good quality data is readily available through the National Bank of Georgia, Ministry of Finance and the National Statistics Office Risks and Risk Mitigation 11. The main risks to the operation and mitigating measures are summarized below. (a) Political and governance risks  The risk exists that policy uncertainty that characterized much of 2013 returns and weakens program sustainability. This risk is mitigated by the stabilization in the political context since the Presidential elections in October 2013 and the new government has demonstrated commitment to the reforms under the ongoing DPO series. Despite changes in key political posts, comfort is derived from the fact that the ruling coalition has strengthened its position both in the Parliament and at the local self-government level. The Bank team is in constant dialog with the authorities to ensure that the reform measures supported by this operation are sustained.  Relations with Russia have improved but tensions continue, especially on South Ossetia. The administrative border with occupied South Ossetia was changed to include some of the neighboring villages inhabited by Georgians, thereby adding to tensions between the two countries. However, the trade embargo by Russia was lifted when Russia joined the WTO and the number of Russian tourist arrivals into Georgia increased significantly in 2013. (b) Macroeconomic risks  High unemployment, fiscal pressures and external vulnerability are the main risks to the economy. Low net job creation even during high-growth periods led to high and sustained unemployment levels in the country which in turn have a negative impact on poverty and shared prosperity. Fiscal risks could emanate from ineffective use of the increased budget allocation to social benefits. Mitigating factors include continuous dialog with and technical assistance from the World Bank in the health and social assistance sector. The government’s commitment to efficient public financial management and fiscal consolidation over the medium-term while maintaining capital expenditures, and adherence to Georgia 2020, which focuses on increasing competitiveness, human capital development and access to finance, will help address medium- to long-term growth and employment concerns. On the external front, the country continues to be vulnerable given its high current account deficit and large external debt, heightening foreign exchange risks. In addition, disturbances in some of its key export markets could affect external performance. Manifestations of external disturbances could take the form of lower FDI, exports, remittances and other capital inflows. Mitigating factors include a flexible exchange rate policy, comfortable foreign exchange reserves, market access and good relationships with donors who could ramp up their programs if needed. (c) Operational design, implementation and sustainability  Weak implementation capacity, especially in the line ministries, could undermine the benefits of the reforms. Implementation of this DPO series spans several ministries and capacity is limited in some of them. This has been mitigated through technical assistance provided by the World Bank and other development partners. Donor supported programs are providing assistance in key policy areas covered by this DPO series like the power sector (World Bank, USAID, and EBRD), social protection (World Bank), education (World Bank) and trade facilitation (EU). Poverty and Social Impacts and Environment Aspects Poverty and Social Impacts 12. The overall poverty, social, and gender impacts of the policy measures supported by the DPO are expected to be positive. The supported policy measures under Pillar I are expected to have positive distributional impacts. In the case of the first prior action (related to implementation of DCFTA), simulations suggest that in the medium-term, improvements in the living standards of the population will occur for everyone with relatively larger impact at the upper end of the distribution. Improved coverage and targeting of social programs in general, and actions under Pillar III specifically, will be needed to efficiently respond to any adverse social and distributional impacts of reforms. In addition, the rollout of the pension pillar under SIMS can enhance poverty reduction since pensions cover a large share of the population and have a strong poverty reducing impact. While some measures have no direct gender impacts, reforms to the teacher performance appraisal system will positively affect women given that more than 80 percent of teachers are female. Enhanced standards of health services delivery also have the potential to benefit women via improved reproductive care services. In addition to gender equality, education reforms are expected to be beneficial from the point of view of shared prosperity. In 2012, 85 percent of those in the bottom 40 had secondary education or less. This same group also faces higher unemployment rates and greater rates of rural self-employment. Good quality education in public schools can therefore potentially have a large impact on shared prosperity. The prior actions in Pillar II improve the overall functioning of the public sector and are expected to be distributionally neutral. Environment Aspects 13. Most of the policy reforms under this operation are neutral to the environment with the exception of two prior actions, one on DCFTA and the other on the electricity transmission grid. Operationalizing the legislative components of the DCFTA would entail adoption of the food safety law and enhancement of sanitary and phytosanitary standards in the field of agro- production. This is likely to lead to the application of cleaner and more responsible technologies of primary production and food processing. Export orientation would mean higher quality standards of produce, which is attainable through better pesticide management, well controlled application of agrochemicals and careful selection of animal feed. Environmental impacts of such improvements are likely to be positive as they are expected to lead to decrease in environmental pollution from poor quality and/or extensively used inputs. However, more stringent requirements in the quality of post-harvest treatment, storage of agricultural products, safety of sawing material, and health and sanitary conditions in animal farms may lead to increased application of disinfectants and antibiotics that may be potentially harmful for the environment. Therefore, the by-laws and regulations supporting the food safety law should carry provisions for mitigating the above-mentioned risk. 14. Environmental impacts could be negative in the power sector as well. The government is undertaking legal and regulatory reforms to stimulate the development of new hydropower generation plants and electricity transmission lines. Expansion of infrastructure may lead to negative environmental impacts, including cumulative impacts of construction and operation of power plants. The construction of several new hydropower plants may cause transformation and loss of some natural and/or critical habitats, disrupt aquatic life in the affected water bodies, influence micro climatic conditions, and cause resettlement of communities and/or restrict their access to traditionally used natural resources and routes of communication. Risk mitigation in this area includes Bank support to the government in carrying out a strategic environmental and social assessment of the power sector development strategy which will be financed from the Transmission Grid Strengthening Project currently under preparation. USAID is providing technical assistance to the Government of Georgia in making strategic choices between several scenarios considered for power sector development in the country. Diversification of generation sources by exploring the potential for other renewables may also help decrease cumulative risks of constructing new hydropower plants. The EU support to the Government of Georgia in drafting the law on renewables is aimed at removing barriers for developing alternative sources of renewable energy Contact point: World Bank Contact: Mona Prasad Title: Sr Country Economist Tel: (202) 458-8757 Fax: (202) 522-2753 Email: mprasad@worldbank.org Borrower Contact: Mr. David Lezhava Title: Dy Minister of Finance Tel: (995 32) 2261455 Email: d.lezhava@mof.ge For more information contact The InfoShop The World Bank 1818 H Street, NW Washington, D.C. 20433 Telephone: (202) 458-4500 Fax: (202) 522-1500 Web: http://www.worldbank.org/infoshop