Country Economic Update February 2018 Macroeconomics, Trade and Investment Global Prac�ce GEORGIA: Making the Recovery Sustainable Country Economic Update February 2018 Government Fiscal Year January 1 – December 31 Currency Equivalents Exchange Rate Effective as of February 5, 2018 Currency Unit Georgian Lari (GEL) US$1 GEL2.4638 Weights and Measures Metric System Abbreviations and Acronyms GEUAA Georgia EU Association Agreement IFC International Finance Corporation ADB Asian Development Bank IFI International Financial Institution BP British Petroleum IMF International Monetary Fund CAD Current Account Deficit MoF Ministry of Finance CAR Capital Adequacy Ratio MLT Medium and Long Term CEU Country Economic Update MOLHSA Ministry of Labor, Health and Social Affairs CIT Corporate Income Tax MPs Members of the Parliament CPI Consumer Price Index NBG National Bank of Georgia DCFTA Deep and Comprehensive Free Trade Area NDI National Democratic Institute DIS Deposit Insurance System NPL Non-Performing Loans EBRD European Bank for Reconstruction and PIM Public Investment Management Development PER Public Expenditure Review ECA Europe and Central Asia PIT Personal Income Tax ECOPA European Consensus-Platform for PPAs Power Purchasing Agreements Alternatives PPP Public Private Partnership EU European Union PPT Percentage Point FDI Foreign Direct Investment ROA Return on Assets FIZ Free Industrial Zone ROE Return on Equity FSI SOEs State Owned Enterprises FSAP Financial Sector Assessment Program SMEs Small and medium enterprises FX Foreign Exchange UHC Universal Healthcare GDDG Georgian Dream Democratic Georgia USAID United States Agency for International GDP Gross Domestic Product Development GEL Georgian Lari VAT Value Added Tax Geostat State Department of Statistics of Georgia UNM United National Movement GR Georgian Railway WB World Bank GOGC Georgian Oil and Gas Corporation WDI World Development Report HH Household ii Table of Contents Overview.......... . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............................................................................. ...... 1 A. Recent Socio-Economic Developments. . . . . . . . . .............................................................................. ...... 3 Recent Political Events. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 3 Growth and Inflation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 4 External sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 7 Financial sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 9 Social sector. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 11 B. Macroeconomic Policies and Structural Reforms............................................................................... 13 Assessment of fiscal and debt policies. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 13 Assessment of monetary and exchange rate policies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 15 Ongoing structural reforms. . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 16 C. Economic Outlook and Risks. . . . . . . . . . . . . . . . . . . . . . .............................................. . . . . . . .............................. 18 Baseline scenario. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 18 Risks and Mitigation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 22 D. Focus Note: FDI and Economic Performance in Georgia................................................................... .... 23 Overview......................................................................................................................................... 23 1. Introduction and Literature Review. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 24 2. Dynamics of FDI. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 25 3. Drivers and Constraints for FDI. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 27 3.1 Human Capital and Inadequately Educated Workforce. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 28 3.2 Infrastructure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 29 3.3 Global factors. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 30 3.4 Legal framework and government policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 31 3.5 Taxation. . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 31 3.6 Macroeconomic stability. . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 32 4. FDI and Economic growth - Theory. . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 33 4.1 FDI and Economic growth – Empirical Literature. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 33 4.2 FDI, Gross Capital Formation and GDP growth. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 33 4.3 FDI and the Current Account Deficit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 34 4.4 FDI and Trade. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 35 4.5 FDI and Productivity. . . . . . . . . . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ..... 37 4.6 FDI and employment. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ...... 38 References........ . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .............................................................................. .... 40 Figures Figure 1. Georgia GDP Growth and Per Capita GDP bottomed up in 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 5 Figure 2. Georgia performed better than many ECA countries, 2016-2017e. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 5 Figure 3. Consumption has moderated. . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 6 Figure 4. Growth concentrated in services. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 6 Figure 5. Current Account Deficit further improved along with trade balance in 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 7 Figure 6. Public, Private Debt slightly increased. . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 7 iii Figure 7: Tourism is the fastest growing sector. . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 8 Figure 8: Composition of external debt reveal vulnerabilities, end-September 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ......... 9 Figure 9. Credit growth recovered in 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 10 Figure 10. Dollarization of loans declined in 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 10 Figure 11. Poverty Indicators improved (2003-2019). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 11 Figure 12. Labor force participation rate (2016). .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 11 Figure 13. A Fiscal Consolidation has started . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 14 Figure 14. Social spending is the largest component, 2017. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 14 Figure 15: NBG tightened monetary policy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 16 Figure 16: Nominal exchange rate remains volatile (GEL/$). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 16 Figure 17. Public Debt Sustainability. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 21 Figure 18. External Debt Sustainability. . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 21 Figure 19: Global FDI flows increased (1990-2016) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 24 Figure 20: Overall dynamics of FDI in Georgia is positive (million$, % of GDP). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 26 Figure 21: Georgia’s FDI performed better than many ECA countries,. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 26 Figure 22: FDI by economic sectors, share in total, 2007-2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 29 Figure 23: Top 5 problematic factors for doing business in Georgia. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 29 Figure 24: Decomposition of real growth. . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 34 Figure 25: FDI and Gross fixed capital formation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 34 Figure 26: Saving-Investment Balance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 34 Figure 27: Current Account Deficit. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 34 Figure 28: Trade and consumption of electricity. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 37 Figure 29: Productivity-real value added per employed person, 2016 (GELm). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .... 37 Tables Table 1. Selected Macroeconomic and Social Indicators, 2013-2020. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 18 Table 2. Fiscal accounts, 2013-2020 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 19 Table 3. External Financing Requirements and Sources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 20 Table 4: The structure of FDI by country. . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 27 Table 5: Linkages with partners in 2016, percentage of total. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 30 Table 6: Correlation coefficients of FDI to trade indicators (2007-2016). . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 35 Table 7: correlation coefficients of employment to FDI and Investment in Fixed Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 39 Table 8: Correlation coefficients of FDI to Investment in Fixed Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 39 Box Box 1. Key Constitutional Amendments. . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ........ 3 Box 2. The tax reform in Estonia. . . . . . . . . . . . . . . . . . . . .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . ....... 32 iv Foreword This edition of Georgia’s Country Economic Update (CEU) is part of a semi-annual series designed to monitor socio-economic developments in Georgia. It presents a concise analysis of political, economic and social de- velopments, as well as the progress achieved with the implementation process of structural reforms during 2016. It also includes a focus note on Georgia’s foreign direct investment (FDI). This edition of the Georgia Economic Report was prepared by the World Bank economic team working on Georgia—Mariam Dolidze (Senior Economist), with input from David Keshelava (Consultant), Natalia Tsivadze (Financial Sector Spe- cialist) Inga Paichadze (Senior Communications Officer), under the guidance and supervision of Genevieve Boyreau (EFI Program Leader) and Maria Gonzalez-Miranda (Practice Manager), and Tamuna Namicheishvili (Program Assistant) provided administrative support. Photo on the cover page is a courtesy of Mr. Vakhtang Kuntsev-Gabashvili. Maria Gonzalez-Miranda Practice Manager Macroeconomics, Trade and Investment Global Practice v Overview A pickup in global growth The country benefited from the improved external demand in 2017. coupled with strengthening Global growth is estimated to have picked up in 2017 to 3.0 percent business and consumer from 2.4 percent in 2016, reflecting gradual recovery in the euro confidence have supported a area, China, emerging Europe, and Russia as commodity prices and notable recovery in Georgia. financial markets continued to stabilize. With growth outcomes in 2017 generally stronger than expected, Georgia’s annual growth estimate was revised to 4.2 percent, compared to an earlier projection of 3.5 percent. Higher growth is likely to have improved population incomes, following adverse social outcomes in 2016 (figure 1). In 2016, poverty indicators deteriorated to 25.6 percent from 25.3 percent in 2015 (at US$3.2 a day in 2011 PPP terms). The growth drivers shifted The recovery in the first three quarters of 2017 was driven by a from public spending in 2016 sharp increase in net exports, and—to a smaller extent—by private to net exports in 2017. consumption; on the flipside, this was accompanied by a slight decline in overall gross investment (largely due to weakened inventories) and a considerable drop in public consumption. The benefits of a well- managed monetary policy and adequate exchange rate flexibility on Georgia’s competitiveness were further supported by a firm economic recovery in its main trading partners, helping the current account deficit narrow significantly; a reduction to 9 percent of GDP is estimated as of end-2017. The government accelerated Fiscal consolidation measures implemented under the 2017 budget the implementation of and stronger than expected growth ensured a considerably improved structural reform along with fiscal stance, with the fiscal deficit at 3.4 percent of GDP by end-year. the improved macro-fiscal Key structural measures have been taken: (i) a new remuneration law stance in 2017. for the civil service was approved by the Parliament as envisaged by the recently enacted Civil Service Law—it sets the salary ceilings and provisions to ensure that the public wage bill is consistent with the medium-term projections under the government’s fiscal framework; (ii) a new PPP law that is integrated with the overall investment plan and budget cycle was prepared and submitted to the parliament; also, a PPP unit has been established at the Prime Minister office; (iii) a Public Investment Management (PIM) framework was established in order to strengthen the monitoring of public investment; a dedicated Public Investment Unit was established at the Ministry of Finance (MoF); (iv) in the 2018 Budget, the fiscal risk annex includes a quantitative reporting of quasi-fiscal relationships, and expands the analysis of contingent liabilities associated to SOEs. 1 The gradual recovery is GDP growth is expected to rebound to 5 percent by 2020. The external expected to continue sector will recover through a robust increase in net exports, with the on the back of prudent main growth driver shifting to the external demand. The government macroeconomic and fiscal has committed to contain its administrative expenses based on the policies and structural reform. package of fiscal consolidation measures, and expand the capital budget instead, helping address the remaining infrastructure bottlenecks. As a result, a gradual reduction in the fiscal deficit is expected to come from the robust GDP growth and a careful management in public spending. In addition, reforms in the non-banking financial sector, capital markets and pension system will be major steps towards strengthening the financial system and positioning it to support the recovery. Upside risks stem from a stronger-than-expected domestic demand and/or a sustained improvement in the external environment. Downside risks include inward-looking policies in advanced countries and weaker- than-expected growth in both advanced and emerging economies, as a possible tightening in global financial conditions could threaten the growth momentum. However, an improved macro-fiscal stance, a flexible exchange rate, and well-capitalized, liquid banking system are in place in Georgia to help the country cope with negative shocks. 2 A. Recent Socio-Economic Developments Recent Political Events Following the 2016 October The Parliament of Geor- Box 1. Key Constitutional Amendments parliamentary elections, gia approved the draft Under the new Constitution, direct the ruling party initiated a Constitution on Septem- presidential elections are to be abolished in process of much-debated and ber 26, owing to a ma- 2024, and the country will transfer to fully wide-ranging constitutional jority vote by the ruling proportional parliamentary representation; amendments. party. The draft did not electoral blocs will no longer be allowed and obtain the support of the the 5 percent threshold will remain intact. opposition parties, the  Georgia will switch to fully proportional President, nor civil soci- elections in 2024. ety representatives, be-  The 2020 parliamentary elections will be cause of the lack of con- held using the current mixed electoral system, where voters elect 73 MPs in sensus on critical issues majoritarian, single-seat constituencies, such as the electoral sys- while the remaining 77 seats are tem and the presidential distributed proportionally in the closed elections. The Georgian party-list contest; The threshold for Dream recently initiated entering the Parliament will be reduced a new round of the con- to 3 percent and parties will be allowed stitutional amendment to form electoral blocs. process to incorporate  The President will no longer be elected the Venice Commission through direct ballot, transferring the recommendations in the mandate to the college of electors newly-adopted Consti- composed of 300 members, including tution. According to the MPs, local and regional government representatives. The 2018 presidential amendments, parties election, however, will still be held will be allowed to form directly; election blocs for the  Selling agricultural lands to foreign next parliamentary elec- nationals will be prohibited. tion in 2020. Also, the  The opposition rights in parliament will so-called bonus system, be boosted, including by permitting them which entails transfer of to create investigative commissions. votes of the parties that fail to cross the parliamentary threshold entirely to the winner, will be scrapped. Amendments will also be introduced to the provisions re- lated to the Constitutional Court. The constitutional bill includes other changes as well, which have not been agreed with the Venice Commis- sion1, including to Article 5 of the new constitution, which defines the principles of a social state. The new constitution will enter into force following the next presidential election in fall of 20182. 1 The Venice Commission is the Council of Europe’s advisory body on constitutional matters. Its role is to provide legal advice to its member states and, in particular, to help states wishing to bring their legal and institutional structures into line with European standards and international experience in the fields of democracy, human rights and the rule of law. 2 Exact date will be defined later. 3 On October 21, 2017, Georgian Tbilisi, the country’s capital and home to one third of its voters, elect- citizens headed to polls to ed the Mayor and its 50-member Sakrebulo. While the ruling Georgian elect 2058 members of 64 city Dream – Democratic Georgia won in all 73 electoral districts in the par- councils (Sakrebulo) and 64 ty list contest, the runner-ups offered a less homogenous picture. Ac- municipal mayors. cording to the national democratic institute (NDI), the legislative and electoral framework largely meets mostly international standards and is conducive to the conduct of democratic elections. NDI also noted that with the further consolidation of power in one party, prospects for a vibrant and pluralistic democracy are at risk and the responsibility lies with the country’s leadership to create an environment that promotes a genuinely inclusive governing process and strengthens democratic checks and balances. Growth and Inflation The Georgian economy The external environment improved in 2017, as the recovery of the Rus- performed well in 2017, sian economy and better prospects for the EU generated strong exter- and GDP growth improved nal demand for Georgia’s exports. GDP growth in the Europe and Cen- markedly, led by a stronger tral Asia region is expected to reach 2.2 percent in 2017, its strongest external environment, higher growth in six years (figure 2). In Georgia, driven by the solid recovery in private consumption and exports (which rose by 21.3 percent in real terms), the economy grew supported by the macro-fiscal by 4.8 percent in the first three quarters of 20173. Exports of goods policy framework. and export of services both picked-up strongly. Tourism proceeds re- mained especially robust with a strong positive contribution to export of services. Import increased as well, but at much lesser pace, with the trade balance improving considerably and net exports contributing up to 4.7 ppt to overall growth during the first three quarters of 2017. The fiscal consolidation reforms and flexible exchange rate policy supported smooth external adjustment. The contribution of investment The share of gross investments declined to 29.5 percent of GDP or 1.2 to growth moderated in the ppt lower than in the first 9 months of 2016. Total investment growth first three quarters of the year. decelerated to 0.7 percent in the real terms because of a weaker accu- mulation of inventories. This might be associated with the postpone- ment of investor decisions to build the stock in the pre-election period. Meanwhile, total fixed investments grew by 2.2 percent year-on-year in the first 9 months of 2017 (compared to 4 percent in the same period in 2016). Based on the FDI composition in the same period, investments predominantly were directed to the transport, construction, and real estate sectors. Public investment has been strong throughout the year and it is estimated to have accelerated in the last quarter of 2017. This was driven by the government decision to increase capital budget al- 3 Geostat’s flash growth estimates 2017 is 4.8 percent. 4 location through the end-year state budget amendment for 2017. It is expected that annual growth outcomes will demonstrate a strong con- tribution from total investment, given the greater certainty following the-local election and the accelerated pace of the public investments in the last part of the year. Meanwhile, total consumption Total consumption in real terms almost stagnated with limited contri- slightly undermined the bution to growth in the first three quarters of the year (figure 3). In con- growth recovery in the first 9 trast, the private consumption grew at almost 2 percent year-on-year months of 2017. driven by a credit growth and recovery in remittances. Domestic credit growth exceeded 18 percent on average in 9 months over the same period of 2016; in particular, loans to the households expanded by 23 percent year-on-year. In addition, a continued recovery in remittances also stimulated private consumption. However, public consumption in real terms declined by 6 percent in the same period in-line with the im- plementation of envisaged fiscal consolidation measures, such as an in- troduction of wage- and hiring-related constraints for civil servants and stricter approach for purchase of goods and services in public sector. Figure 1. Georgia GDP Growth and Per Capita GDP Figure 2. Georgia performed better than many ECA bottomed up in 2017 countries, 2016-2017e (Percent)` (%, $US) Source: Estimates based on Geostat statistics. Source: WDI, Bank staff calculations. 5 Figure 3. Consumption has moderated Figure 4. Growth concentrated in services (Contributions, growth %) (Contributions, growth %) 12.0% 8.0% 7.2% 10.0% 7.0% 7.2% 5.6% 8.0% 6.0% 5.3% 4.9% 4.9% 5.6% 5.3% 4.4% 6.0% 4.9% 4.9% 5.0% 4.4% 3.2% 4.0% 3.2% 3.0% 3.1% 4.0% 2.9% 3.0% 2.9% 3.1% 2.6% 2.8% 2.9% 2.9% 2.6%2.8% 2.5% 2.5% 1.7% 3.0% 2.0% 1.7% 2.0% 0.0% 1.0% -2.0% 0.0% -4.0% -1.0% -2.0% -6.0% I 14 II 14 III 14 IV 14 I 15 II 15 III 15 IV 15 I 16 II 16 III 16 IV 16 I 17* II 17* III I 14 II 14 III 14 IV 14 I 15 II 15 III 15 IV 15 I 16* II 16* III IV I 17* II 17* III 17* 16* 16* 17* Agriculture Manufacturing net exports Change in Inventories Gross Fixed Capital Forma�on Public Consump�on Construc�on Services Private Consump�on GDP Net Taxes GDP Source: Geostat and WB staff estimates. Construction and trade were The stronger performance in the construction sector is well aligned the top two sectors driving with the trends observed in FDI, (which generally dominated construc- growth in the first three tion) as well as with the public investments in roads and municipal quarters of 2017. infrastructure. Trade benefited strongly from the enhanced external transactions, especially export of wine, mineral waters and beverages and contributed 0.9 ppt to 4.8 percent growth. Other service-related sectors, such as transport, communication, restaurants grew strongly as well by the rate above GDP growth (figure 4). These sectors highly benefit from the growing number of tourists traveling to Georgia. Al- though tourism generates demand for agricultural products too, the sector still contracted by 2.7 percent annually, affected by a series of one-off shocks, including the unfavorable weather conditions and in- sect epidemy that severely hit the harvest of walnuts – one of the key export products. The share of agriculture sector in GDP dropped to 6.9 percent in the first 9 months of 2017 from 8 percent in the same period of 2016. This production shock adds to the striking trend of productivity decline in the agriculture sector, in a context in which the agri-sector holds about 50 percent of total employment. Annual inflation was at 6.7 Apart from one-time factors, such as the sharp increase in excise taxes percent in 2017, exceeding on fuel and tobacco early in the year, the rising global oil prices, espe- NBG’s target. cially in the second half of the year were passed through to the econ- omy. As a result, headline inflation stood significantly above the NBG’s target of 4 percent. Inflation as expected decreased considerably in the beginning of 2018 once the impact of one-time factors is fading out. In- flation expectations also increased in the last months of 2017, partially driven by the depreciation of Lari in the last quarter of the year as trade 6 balance slightly deteriorated due to higher import of goods. In addition, the demand-driven inflation pressure emerged because of the better than expected economic performance. Annual inflation of 6.7 percent was much higher than 1.8 percent in December 2016, in response to which the NBG raised its policy rate by 0.75 ppt to 7.25 percent. The NBG increased its policy rate three times (on 25 January, 2 May and 13 December) by 0.25 ppt every time during 2017 (figure 15). External sector Georgia’s external position An improvement in the trade balance arising from higher exports and strengthened considerably, muted imports resulted in the current account deficit falling to 7.1 per- with the current account cent of GDP in the first three quarters of 2017 from 11.2 percent in deficit narrowing. the same period of 2016 (figure 5). Exports of goods expanded by 22 percent on the back of strong external demand from Russia, Azerbaijan, Ukraine, China, and the US. Tourism proceeds rose by 29 percent as the number of foreign visitors in 2017 reached 7 more than 2 visitors per capita. The recovery in external demand boosted worker’s remittances by 17 percent year-on-year in the first three quarters of 2017. By con- trast, the factor income balance weakened further due to the increased income profit repatriation by FDI shareholders, while a considerable part of it was reinvested, counting as an inflow in the capital and fi- nancial account. Net FDI inflows increased in the first three quarters of 2017 to 10.6 percent of GDP year-on-year (compared to 9.1 percent of GDP a year earlier), which exceeded the current account deficit and along with other financial and capital inflows strengthened the interna- tional reserve position of the country. Figure 5. Current Account Deficit further improved Figure 6. Public, Private Debt slightly increased along with trade balance in 2017 (% of GDP) (% of GDP) Source: National Bank of Georgia. 7 External proceeds from tourism The number of all Figure 7: Tourism is the fastest growing sector and workers’ remittances types of visitors (# of persons, m GEL) continued to improve through in 2017 increased 2017. by 18.8 percent year-on-year and reached 7.6 mil- lion people, out of which 46 percent were classified as tourists (figure 7), with their num- ber increased by 28 percent. Top countries of ori- gin were Armenia, Azerbaijan, Russia, Turkey and Iran. Money transfers Source: Ministry of Economy of Georgia and Staff calculations. registered through the banking system rose by 20 percent in 2017 driven by remittances from Israel and EU countries, such as Italy, Greece, Germany. Russia tra- ditionally is the top country of origin for such transfers and inflows from this country increased by 15.5 percent reaching 33 percent of total. External financing requirements Net FDI inflows increased in the first three quarters of 2017 to 10.6 fell in-line with the positive percent of GDP year-on-year (compared to 9.1 percent of GDP a year developments of the current earlier), which exceeded the current account deficit and added to the account. international reserves. Net inflows of FDI largely originated from Azer- baijan, Turkey, and the UK (see the Focus Note). FDI inflows were di- rected into the transport, construction and real estate sectors. In ad- dition to FDI, new borrowings were disbursed from the IFIs and other development partners to the public sector. Donor concessional funding exceeded 3.3 percent of GDP. At the same time, debt repayments of the private sector exceeded the new external borrowings in the first three quarters of 2017; as a result, net borrowing was negative. During this 9-month period, the NBG accumulated gross international reserves of about $269m or 2.2 percent of GDP, comfortably meeting the target established under the new IMF program4. 4 The IMF Executive Board Approved US$285.3 million Extended Arrangement under the Extended Fund Facility for Georgia on April 12, 2017. 8 Georgia is highly dependent on Total external debt Figure 8: Composition of external debt reveal external financing, which has reached $16.7 bil- vulnerabilities, end-September 2017 resulted in the accumulation lion as of end-Sep- (% of total) of a large stock of external tember 2017, and debt. 112.3 Percent of GDP (was 109.6 12% Banks percent of GDP 21% Other Non-Financial by end-Septem- Corporations ber 2016) (figure Intercompany Loans 6). During the first State Budget three quarters 31% NBG & SOE of 2017 the debt 21% stock increased by $932m, out of 15% which $518m rep- resented newly contracted debt. Source: Ministry of Economy of Georgia and Staff calculations. The central govern- ment external debt reached 34.6 percent of GDP by the end of September, while public sector debt (including the NBG and public enterprises, in addition to the general government) held 48 percent of GDP, equivalent to 43 per- cent of total debt (Figure 8). Debt of public corporations includes the Georgian Oil and Gas Corporation (Eurobond of US$250 million), the Georgian Railways (Eurobond of $670 million), Marabda-Kartsakhi Rail- way (US$560 million). The short-term debt, which amounted to about 22 percent of total debt by the end of September 2017, mostly con- sists of trade credits, owned by non-financial corporations, deposits of non-residents in the banking sector of Georgia, and short-term inter- company loans by foreign direct investors. Financial sector The banking sector is well The credit issued by commercial banks to the national economy ex- capitalized, profitable and the panded by 18 percent, and total banking sector assets increased by 22 level of NPLs is not concerning, percent in 2017(figure 9). The capital adequacy of the banking sector but structural vulnerabilities (CAR) stood at 19.1 percent in December 2017, exceeding the NBG reg- remain high. ulatory required ratio of 10.5 percent. The liquid-to-total assets ratio was at 21.3 percent. Profitability remains high, with a return on equity (ROE) and return on assets (ROA) at 20.7 percent and 2.8 percent, re- spectively. Nonperforming loans (NPLs) are lower than in neighboring countries, and on a declining trend—falling to 6.0 percent in Decem- ber 2017, compared with 7.3 percent in 2016. NPLs under the IMF FSI methodology were reported at about 3.5 percent. Strict banking super- vision, reasonable underwriting standards of the banks and continued credit growth have added to solid performance of the sector. At the same time, systemic financial sector vulnerabilities are high - the mar- ket share of the top 2 banks, retail loan growth, and, high dollarization – against the backdrop of weak financial safety nets and a deficient crisis preparedness framework. 9 High dollarization is a crucial About 65 percent of the banking deposits were in foreign currency in challenge for Georgia’s the end of 2017, including 77 percent dollarization for individual depos- economy as it weakens itors. The banking sector’s long-term and short-term external debt is effectiveness of the monetary about 24 percent of GDP. On the asset side of the balance sheet, about policy transmission under the 57 percent of banks’ loans are foreign currency denominated (down inflation targeting regime. from 65 percent in December 2016), including 69 percent of corporate loans and 46 percent of household loans (figure 10). High dollarization increases foreign exchange risk for borrowers, especially for non-ex- porting, small and medium enterprises (SMEs) and households that rely on income in local currency and are unhedged against the depre- ciation of the Lari. The top banks in Georgia The combined assets of the two largest banks in Georgia were equiva- became both larger as a lent to 65 percent of GDP as of 2017, rising from 29.3 percent in 2010; proportion of GDP and more and their share over the same period increased to 71 percent of total concentrated in terms of banking sector assets from 58 percent. The top two banks5 also repre- market share. sent large financial-industrial groups. Their size brings scale benefits, greater risk diversification that helps sustain profitability, and access to international financing at an advantageous funding cost; but, if one of these banks were to fail, the impact on the financial system would be potentially substantial. The FSAP 2014 Update recommended the enhancement of the bank resolution framework and the introduction of an explicit deposit insurance system to strengthen existing financial stability and safety net framework. Law on Deposit Insurance was ad- opted in June 2017. Deposit insurance coverage for household deposits came into effect on January 1, 2018. Figure 9. Credit growth recovered in 2017 Figure 10. Dollarization of loans declined in 2017 (percent) (percent) 50% 80% 40% 70% 30% 20% 60% 10% 50% 0% 40% -10% Jan-12 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Sep-12 Sep-13 Sep-14 Sep-17 Sep-15 Sep-16 May-12 May-13 May-14 May-15 May-16 May-17 Oct-17 Jan-16 Jan-17 Jan-12 Jan-15 Jan-13 Jan-14 Sep-16 Sep-17 Sep-12 Sep-13 Sep-14 Sep-15 May-16 May-17 May-15 May-12 May-13 May-14 Oct-17 FX loans, % of total loans Corporate Household Total FX deposits, % of total deposits Source: National Bank of Georgia. 5 Both of these commercial banks are domestic (owned by local investors). 10 Social sector Net job creation stagnated in According to the household survey data that covers both formal and in- 2016 and important challenges formal sectors, the overall unemployment rate declined to 11.8 percent remain. in 2016 from 14.6 percent in 2013. Nevertheless, this level is one of the highest in the Europe and Central Asia (ECA) region. The government’s success in attracting foreign investors through significant improvements in the business environment was not sufficient to improve employment outcomes in the country. New growth sectors, especially tourism and other services, have not been able to generate sufficient employment vis-a-vis those sectors that shed jobs. In addition, the existing educa- tional system is not in line with the demands of the private sector, and student performance ranks low, generating a skills gap. Low net job creation (even during high-growth periods) led to high and sustained unemployment levels in the country which, in turn, have had a negative impact on poverty and shared prosperity. The currently unemployed and inactive population is close to 45 percent of the poor “bottom 40” population.6 In addition, the problem of low female participation at 57 percent currently (77 percent for male) remains yet to be addressed. Figure 11. Poverty Indicators improved (2003-2019) Figure 12. Labor force participation rate (2016) Source: WB staff estimates based on Geostat HIS data. Source: World Bank database. 6 This refers to the 40 percent of population with the lowest income. 11 The slowdown in employment The stagnation in poverty reduction breaks a declining trend that start- creation had an adverse ed in 2010, which was propelled mainly by employment opportunities impact on poverty reduction and social assistance. The slight reduction in employment observed which stalled in 2016. in urban areas translated into an increase in poverty in urban areas, though extreme poverty remained at the same level. Poverty at $3.2/ day (2011 PPP) was estimated at 18.7 percent in 2016, almost one per- centage point higher than in 2015. The positive outcomes from labor markets in 2017, especially among the less-skilled, suggest poverty will start again to decline, but also highlights the vulnerability of the popu- lation just above the poverty line to labor market fluctuations. Inequal- ity, as measured by the Gini coefficient, has fallen from a peak of 42 points in 2010 to close to 39 in 2016 (using the consumption aggregate used for international poverty comparison). Nonetheless, inequality is still among the highest in the ECA region and is evident along geo- graphic dimension. For instance, regions located in the eastern parts of the country surrounding Tbilisi have poverty rates considerably higher than in the western regions or in Tbilisi. Similarly, along the urban-ru- ral divide, the gap between rural and urban poverty rates has broadly been stable over the past decade, at an average of around 8 percent- age points. While some differences in welfare across space are to be expected in any country, persistent gaps potentially signal chronic lack of economic opportunities in lagging regions. 12 B. Macroeconomic Policies and Structural Reforms Assessment of fiscal and debt policies Fiscal pressures from the The fiscal deficit in 2017 narrowed from 4.1 observed in 2016 to the expenditure side remained estimated 3.4 percent of GDP (figure 13). The composition of expen- elevated in 2017, while diture was considerably rationalized to enhance fiscal sustainability. the risks to sustainability In order to prioritize social and infrastructure funding the authorities diminished with a solid introduced ceilings on the wage bill and on the purchase of goods revenue performance and and services in the 2017 budget law. Savings for about 0.8 percentage expenditure reshuffle. points of GDP were generated in 2017 from reduced administrative costs. This helped—on one hand—to ease the fiscal pressure on social spending (which increased in nominal terms but declined by 0.5 per- centage points as a ratio to GDP); and on the other hand, allowed the government to stimulate capital expenditures by 1.9 percentage points of GDP (figure 14). With the overall deficit at 3.4 percent of GDP the government freed-up more fiscal space than initially envisaged accord- ing to the annual fiscal target (4.1 percent of GDP). The government took an advantage of the revenue windfall to advance payments for infrastructure projects in 2018. Both tax and non-tax Despite earlier concerns over the possible losses from the PIT reform revenues of the general (applying the Estonian model starting in early 2017), collections from government had solid the corporate tax were strong. The profit tax exemption retained by outcomes. the private sector as a result of the reform is estimated at GEL368m (1.3 percent of nominal GDP) in the first 9 months of 2017, which was slightly lower than budgeted (by about GEL46m), reducing the public revenue loss from the reform. Overperformance against the planned collections was particularly strong for the value-added tax (an addition- al GEL300m or 11 percent higher) although this is partially explained by the inaccurate information about the actual VAT collections in 2016.7 Excise collections suffered despite the sharp increases in their rates. This was mainly attributable to the 3-month payment delay introduced for car importers and accumulation of inventories by the tobacco im- porters at the end-of-year in anticipation of spike in excise rates for tobacco from January 1, 2017. 7 Around GEL300m in VAT collected in 2016 remained unidentified as a particular type of tax and considered as overpayment due to temporary technical issues following the introduction of treasury single taxpayers’ account. As a result of the inaccurate baseline of 2016, VAT collections were underestimated in the 2017 budget. 13 Figure 13. A Fiscal Consolidation has started Figure 14. Social spending is the largest component, 2017 (% of GDP) (expenditure composition, % of GDP) Source: MOF and bank staff estimates. Georgia’s public debt remained A sharp increase in public debt in 2015 and 2016 was primarily driven by sustainable at 45 percent of the depreciation of the Lari against the USD, while the increase in 2017 is GDP8 as of end 2017. attributable to operational borrowings and further (but more moderate) currency depreciation. About 79 percent of public debt in 2017 was ex- ternal and dominated by long-term multilateral and bilateral debt. Given the concessional nature of public debt, interest payments are low and av- erage at around one percent of GDP a year. Nearly 75 percent of external public debt is at fixed interest rates, thereby reducing interest rate risk. In addition, less than 5 percent of public debt is short-term, helping main- tain rollover risks well contained. Georgia’s public debt is likely to decline to about 40 percent of GDP over the medium-term by 2022, supported by a gradual reduction in the fiscal deficit. Alternative scenarios confirm the need to reduce the fiscal deficit to stabilize the debt to GDP ratio in case of additional shocks, like further exchange rate depreciation9. Georgia’s quasi-fiscal According to the Fiscal Risks Annex to the 2018 Budget Law prepared by risks emanating from the the MOF, liabilities of the 43 high-risk SOEs reached 12.8 percent of GDP contingent liabilities of the by the end of 2016, 87 percent of which were concentrated in 3 compa- State-Owned Enterprises nies: Marabda-Kartsakhi Railway Company (44 percent of total), Georgian (SOEs) are estimated to be State Electrosystem (27 percent) and Georgian United Water Company substantial. (16 percent). The liabilities of the 33 medium-risk SOEs were about 7.4 percent of GDP concentrated in companies such as Georgian Railway (GR), Georgian Oil and Gas Corporation (GOGC), Commercial Operator of Elecro-power System. The government is committed to monitor and manage quasi-fiscal liabilities and operations under the IMF program. In 8 Includes external and domestic debt plus soviet times historical non-interest debt of about 1.9 percent of GDP. 9 Debt Sustainability Analysis, WB and IMF estimates. 14 addition, the government (together with the IMF and the WB) closely monitors contingent liabilities generated by the government’s Power Purchasing Agreements (PPAs). Under these PPAs the state issues guar- antee to purchase excess electricity from the operators on a seasonal basis. As of end 2017 there were 72 signed PPAs, of which 18 are linked to power plants that are already operational, 16 are under construc- tion, 19 are awaiting the licenses and another 19 are at the assessment stage. While the fiscal risks of PPAs are high, the needs for additional power capacity are also evident from the consumption growth trend. Therefore, the Government is committed to review carefully its deci- sions going forward and ensure compliance of the new PPAs with the recently adopted Law on Public Private Partnerships. The latter will be enacted on March 31, 2018. Assessment of monetary and exchange rate policies Georgia’s floating exchange This regime allowed the NBG to conduct of an independent monetary rate policy is consistent with policy, facilitated the economy’s adjustment to the shock, and prevent- its inflation targeting regime. ed exchange rate misalignments. Under the floating exchange rate re- gime, in 2017 the NBG opted to buy foreign exchange to improve its international reserves position. Gross international reserves reached US$3.0 billion as of end 2017 (which is about 4 months of import of goods and services), the first time since 2013. In Georgia, the Lari-dol- lar exchange rate fluctuated between GEL2.77 per dollar in January 2017 to GEL2.38 in April, ending the year at around GEL2.55 per dollar and triggering higher inflation expectations (figure 16). In real terms, the exchange rate was volatile as well. It appreciated by 10 percent through January-April. The real effective exchange rate depreciated by 11 percent during May-November, impacting positively on export competitiveness. The NBG believes that a higher volume in the foreign exchange forward market could help smooth exchange rate seasonality. Monetary policy is geared The NBG’s inflation target is 4 percent in 2017 and 3 percent for the towards maintaining price medium-term. As the annual inflation spiked to 6.7 percent in 2017, stability within the inflation the NBG increased the policy rate from 6.50 in January to 7.25 percent targeting framework. in December (figure 15) in response to the emerging inflation expec- tations caused by the significant increase in excise taxes on tobacco and fuel in 2017. The NBG appropriately considers it as a one-off spike which will expire in early 2018 and further monetary policy tightening will likely not be necessary. Inflation expectations also increased in the recent months driven by the depreciation of Lari in the last quarter of the year. In December 2016, the NBG introduced a new monetary pol- icy instrument—a one-month open market refinancing loan. Through this policy instrument, the NBG supplies short-term liquidity to the banking system when needed. 15 Figure 15: NBG tightened monetary policy Figure 16: Nominal exchange rate remains volatile (percent) (GEL/$) 10 8 6 4 2 0 -2 -4 Apr-13 Apr-14 Apr-15 Apr-16 Apr-17 Oct-13 Oct-14 Oct-15 Oct-16 Oct-17 Jan-13 Jan-14 Jan-15 Jan-16 Jan-17 Jul-13 Jul-14 Jul-15 Jul-16 Jul-17 Infla�on Policy Rate Source: Geostat, NBG. Source: NBG. Ongoing structural reforms The government that took This assumes that structural reforms will support rapid growth in in- office in late 2016 outlined a vestment, employment, and firm productivity, while also ensuring the Four-Point-Program consistent realization of potential benefits associated with the DCFTA in terms of with the main objective of the higher exports and FDI. The following top priority reforms were initiat- Socioeconomic Development ed or launched in recent years. Strategy of Georgia, “Georgia 2020”. • A new remuneration law for the civil service was approved by the Parliament as envisaged by the recently enacted Civil Service Law. The salary ceilings and provisions set by the remuneration law will ensure that public wage bill is consistent with the medium-term wage bill projections under the IMF program; • A Public Investment Management (PIM) framework was set up to strengthen the monitoring of public investment; a dedicated public investment unit was established at the MoF; and the Tbilisi Munic- ipality has begun using the PIM Guidelines as part of a pilot involv- ing 5 other municipalities. Following training of municipality staff, a project concept note was prepared in the appropriate. A new PPP law that is integrated with the overall investment plan and budget cycle was prepared and endorsed by the government, and a PPP Unit has been created at the Prime Minister Office; 16 • In the 2018 Budget Law, the Fiscal Risk Annex includes a quantita- tive reporting of quasi-fiscal relationships, and expands the analy- sis of contingent liabilities associated to SOEs; • Pension reform has been moving forward supported by the WB, ADB and other development partners. A roadmap was completed and published as part of the pension reform strategy published in March 2016. The draft law was approved by the Cabinet for public consultation in March 2017 and was presented to Parliament for discussion in December 2017. It is expected to be approved during 2018 spring session to start implementation from July 2018; • Deposit insurance system (DIS): To foster savings in the economy and enhance the financial and social safety net, the authorities committed to develop a. The government approved the Strategy and Action Plan on Introduction of DIS in Georgia on March 2, 2017 and the Parliament adopted the Law on DIS on May 17, 2017. This key recommendation of the 2014 FSAP will help Georgia to meet the related EU AA commitments on the DIS. 17 C. Economic Outlook and Risks Baseline scenario Positive external Georgia’s growth of 4.8 percent in the three quarters of 2017 was high- developments have helped er than expected in the beginning of the year and the annual estimates to accelerate growth in were upgraded to 4.2 percent for 2017 driven by a strong recovery in Georgia, benefiting from exports and growth in private consumption. Steady implementation of the resilience demonstrated the reform program will result in a gradual acceleration of growth over during the recent crisis. the medium-term to 5 percent by 2020. The annual CPI inflation is ex- pected to converge to the NBG’s target of 3 percent by year-end 2018, and the current account deficit will narrow to 9 percent of GDP by 2020. Table 1. Selected Macroeconomic and Social Indicators, 2013-2020p 2013 2014 2015 2016 2017e 2018p 2019p 2020p Actuals Projections (Percent change, unless otherwise indicated) National Accounts               Real GDP (percent change) 3.4 4.6 2.9 2.7 4.2 4.3 4.6 5.0 GDP nominal (in billions of U.S. dollar) 16,140 16,508 13,988 14,333 15,150 16,350 16,350 18,960 GDP per capita (in U.S. dollars) 3,600 3,676 3,767 3,853 4,120 4,373 4,671 4,980 Consumer price index -0.5 3.1 4.0 2.1 6.7 3.1 3.0 3.0 (In percent of GDP, unless otherwise indicated) Investment and saving Gross investment (in percent of GDP) 24.8 29.8 31.5 32.4 31.5 33.1 33.5 33.7 Public 5.9 5.6 5.6 5.1 6.2 6.5 7.2 8.0 Private 18.9 24.2 25.9 27.3 25.3 26.6 26.3 25.7 National Savings 19.1 19.2 19.6 19.5 22.0 23.7 24.2 24.7 General Government Operations         Revenues and grants 27.5 28.0 28.1 28.4 29.4 29.0 28.7 28.5   Of which: Tax revenues 24.8 25.1 25.1 25.8 26.5 26.0 26.0 25.9 Grants 1.0 1.0 1.0 0.8 0.9 1.0 0.9 1.0 Expenditure and net lending 30.1 31.0 31.9 32.5 32.8 32.4 32.0 31.5 Current expenditure 24.3 25.4 24.9 26.1 24.5 24.0 23.3 22.4 Of which: interest payments 0.9 0.9 1.0 1.2 1.3 1.4 1.2 1.5 Capital expenditure and net lending 5.9 5.6 7.0 6.4 8.3 8.5 8.7 9.1 Primary balance -1.7 -2.1 -2.8 -2.9 -2.1 -2.1 -2.1 -1.6 Overall fiscal balance -2.6 -2.9 -3.8 -4.1 -3.4 -3.4 -3.3 -3.0 (In percent of GDP, unless otherwise indicated) External Sector               Current account balance -5.8 -10.6 -11.9 -12.8 -9.5 -9.4 -9.3 -9.0   Exports of goods and services 44.5 42.6 44.6 43.8 50.0 50.6 50.2 49.8   Imports of goods and services 57.4 60.6 62.3 59.5 61.8 62.6 62.1 61.7 Remittances 4.7 4.6 4.2 4.3 4.8 4.7 4.8 5.0 FDI (net) 5.1 8.1 9.0 9.3 9.2 9.0 9.1 9.2 Gross International Reserves (in months of total imports) 3.4 3.4 3.3 3.6 4.0 3.9 3.9 4.0 (in billions of dollars) 2.8 2.7 2.5 2.8 3.0 3.4 3.7 4.2 Source: Georgian authorities; and Bank staff estimates and projections. 18 Fiscal operations will continue Considerable consolidation of administrative spending, streamlining of to gradually shift from current the subsidies and a more efficient social safety net will help to achieve to capital spending in the medium-term fiscal consolidation while providing space for capital medium-term. spending. The fiscal deficit of the general government will be gradually reduced to 3 percent of GDP by 2020, helping stabilize public debt at around 40 percent of GDP. Increasing public investment to reduce infra- structure bottlenecks will be made possible by reducing current spending from 24.5 percent of GDP in 2017 to 22.4 percent in 2020. This will be achieved primarily by improving the efficiency of public spending: con- taining the wage bill and administrative expenses which were increasing steadily and steeply for at least last 4-5 years, better targeting subsidies and social assistance programs. The 2018 approved Budget The 2018 State Budget Law outlines continued consolidation path to is consistent with the maintain the deficit at 3.4 percent of GDP. Such outcome will not be au- government medium-term tomatic – it will require continued rationalization of current spending, plan to enhance revenue including (i) further containing the wage bill and administrative expenses measures and contain current consistent with the new civil service law; (ii) improving the targeting of spending. subsidies and of social assistance programs, (iii) reducing transfers and privatizing loss-making state-owned enterprises (SOEs); and (iv) improv- ing performance-based budgeting. Table 2. Fiscal accounts, 2013-2020 (In percent of GDP) 2013 2014 2015 2016 2017e 2018p 2019p 2020p Actuals Projections Overall fiscal balance -2.6 -2.9 -3.8 -4.1 -3.4 -3.4 -3.3 -3.0 Primary Balance -1.7 -2.1 -2.8 -2.9 -2.1 -2.1 -2.1 -1.6 Revenues and grants 27.5 28.0 28.1 28.4 29.4 29.0 28.7 28.5 Taxes 24.8 25.1 25.1 25.8 26.5 26.0 26.0 25.9 Non-tax revenues 2.7 2.9 3.0 2.6 2.9 3.0 2.6 2.6 Total expenditure and net lending 30.1 31.0 31.9 32.5 32.8 32.4 32.0 31.5 Current expenditure 24.3 25.4 24.9 26.1 24.5 24.0 23.3 22.4 Wages and salaries 5.3 5.2 5.0 5.2 4.4 4.4 4.2 4.0 Goods and services 3.8 3.9 3.8 4.1 4.1 3.8 3.4 3.2 Interest payments 0.9 0.9 1.0 1.2 1.3 1.3 1.3 1.4 Subsidies and grants 2.1 2.2 2.4 2.3 2.3 2.2 2.1 2.0 Social expenses 8.5 9.6 9.6 10.1 9.6 9.5 9.4 9.3 Other expenses 3.7 3.6 3.1 3.2 2.8 3.0 2.9 2.5 Capital expenditure and net lending 5.9 5.6 7.0 6.4 8.3 8.5 8.7 9.1 Government Financing External 0.6 1.7 2.1 2.2 1.8 2.5 2.6 2.2 Domestic 1.5 0.8 0.6 0.8 0.9 0.5 0.5 0.6 Privatization 0.5 0.4 1.1 1.1 0.7 0.4 0.2 0.2 Source: Georgian authorities; and Bank and Fund staff estimates and projections. 19 Monetary policy will NBG targets inflation at 3 percent from 2018 onwards. Inflation is continue to operate within forecasted to remain above 4 percent target in 2017, mainly a result the framework of inflation of a hike in excises. With the effects of temporary factors expiring in targeting with exchange rate 2018, inflation will converge towards target by the year-end. Foreign flexibility. exchange interventions will be limited to smoothing excessive volatility of the exchange rate. The level of gross international reserves, currently below the level recommended by the IMF’s Assessing Reserve Adequa- cy (ARA) metric, will be raised throughout the program. The monetary policy transmission mechanism will be strengthened by promoting lar- ization of loans and deposits. The current account deficit The deficit will continue to be financed by the FDI, as new projects de- is projected to fall below 10 velop and BP pipeline project financing fades out (Table 3). Meanwhile, percent of GDP in 2018 and the Government program is expected to improve external competitive- 2019, supported by export ness. Ambitious structural reforms, together with the continued im- growth and tourism. plementation of the EU-Georgia Association Agreement and free trade agreements with China and other countries, will support access to new markets and economic diversification. Improving further the business environment will help mobilize FDI in tradable sectors, improve com- petitiveness and reduce external vulnerabilities. Table 3. External Financing Requirements and Sources (percent of GDP) Outturn Projections 2017 2018 2019 2020 2021 2022 Overall fiscal balance 17.3 17.8 17.0 16.7 16.8 17.1 Requirements 9.5 9.5 9.3 9.0 9.0 8.7 Current Account Deficit 6.4 6.8 6.9 7.2 7.2 7.8 Medium and long-term debt 5.4 5.5 5.3 5.4 5.3 5.7 Private 1.8 2.0 1.7 1.7 1.5 1.7 Banks 3.6 3.5 3.6 3.7 3.8 4.0 Corporates 1.1 1.3 1.6 1.8 1.9 2.1 Public 1.2 1.5 0.8 0.5 0.6 0.6 Others (net) 18.0 17.9 17.8 18.0 18.2 17.7 Sources 9.2 9.0 9.1 9.2 9.2 9.1 Foreign Investment (net) 0.6 0.4 0.3 0.3 0.3 0.2 Portfolio Investment (net) 8.0 8.3 8.2 8.3 8.5 8.2 MLT Disbursements 5.5 5.5 5.0 5.0 5.0 4.7 Private 2.5 2.4 2.0 2.0 2.0 2.0 Banks 3.0 3.1 3.0 3.0 3.0 2.7 Corporates 2.5 2.8 3.2 3.3 3.5 3.5 Public (only project loans) 0.2 0.2 0.2 0.2 0.2 0.2 Short-term & other capital (net) 0.5 0.4 1.1 1.1 0.7 0.4 Source: DSA, IMF and WB staff estimates. 20 Georgia’s public debt is The downside risks to the baseline scenario are associated with (i) fur- projected to decline to 40 ther tightening of US monetary policy and Lari depreciation; (ii) deteri- percent of GDP by 2022. oration in the external environment including a weaker EU outlook and regional geopolitical tensions; and (iii) potential delays in implemen- tation of consolidation measures, or accumulation of new liabilities or materialization of contingent liabilities. Given the large part of the debt is denominated in US dollars, a 37 percent10 Lari depreciation would push public debt to 46 percent of GDP by 2022, while with higher real interest rates11, public debt would grow to close to 43 percent of GDP. Under a lower GDP growth scenario public debt would rise above 48 percent by 2022, while combined risks would push public debt to 63 percent of GDP by 2022. Total external debt However, projections remain highly sensitive to changes in macroeco- excluding intercompany nomic assumptions. Deterioration of non-interest current account gap loans, is projected to decline and lower growth shock would push external debt to 103 percent and to about 90 percent of GDP 100 percent of GDP, respectively. Yet, external debt is most sensitive to in the medium term. the 30 percent exchange rate depreciation shock which would push the debt to 134 percent of GDP by 2022. Figure 17. Public Debt Sustainability Figure 18. External Debt Sustainability (in percent of GDP) Real deprecia�on shock/ 140 134 120 30 % deprecia�on 100 80 91 Baseline 60 40 20 2012 2014 2016 2018 2020 2022 Source: IMF DSA framework and WB staff calculations. 10 Estimate of overvaluation or maximum historical movement of the exchange rate. 11 Higher by 25 basis points. 21 Risks and Mitigation Fragile growth, continued Georgia remains vulnerable to regional developments given its high • fiscal pressures, a large current current account deficit, and the risks of low export demand and re- account deficit, and high mittances. More inward-oriented policies and weaker economic external debt are the main growth in key advanced and emerging economies could undermine risks to the economy. efforts to promote trade. Spillover effects from geopolitical uncer- tainties and potentially slower-than-expected recovery in the EU, could potentially dampen investment inflows to Georgia and in- crease external imbalances. At 95 percent of GDP in 2017 (or 112 percent including intercompany loans), external debt is very high and tighter global financial conditions and a stronger U.S. dollar could deteriorate debt dynamics further. Loan dollarization at 65 percent in 2017 increases the vulnerability of the financial sector to exchange rate risks as well. Mitigating factors include a flexible exchange rate policy, the new program with the IMF, and market access; With growth prospects improving in the economies of key trading • partners, the output expansion in Georgia is likely to be improved as well. However, the banking sector remains fragile in many countries, and exposures have grown in countries that depend on commodity exports. This risk is mitigated, to an extent, by the structural reforms being undertaken by the government to improve competitiveness and the investment climate in the country. Relative price changes have opened up the opportunity for increased exports, but in most cases structural reform is needed to realize these opportunities; Fiscal risks largely emanate from pressures to further increase so- • cial spending on pensions, social protection and health programs, as well as PPPs and PPAs. Fiscal space from efficiency improvements in social areas should play a crucial mitigating role in overall fiscal man- agement and prudence deficit over the medium-term. In addition, public contingent liabilities also pose a risk, especially, those arising from power purchase agreements (PPAs) signed by the government and from quasi-fiscal activities by state-owned enterprises. These contingent liabilities need to be monitored and managed steadfast- ly to avoid the devolvement of additional liabilities on the budget. Mitigating factors include the SOE and public investment manage- ment reforms, government’s commitment to fiscal consolidation as evidenced by the 2018 Budget. 22 D. Focus Note: FDI and Economic Performance in Georgia Overview Georgia has embedded The government implemented number of important institutional re- remarkable improvements in forms to this end, including a simplified and streamlined taxation sys- its business climate over the tem, a transparent and open governance structure, better legal system, last decade. enhanced property rights and sound prudential regulation and super- vision of the banking system. Georgia improved its ratings in Doing Business survey to top ten. Other cross-country surveys suggest that impressive progress has been achieved in economic freedom (#13 out of 180 countries), trade openness (#41 out of 160 countries), and fight- ing corruption (#44 out of 176 countries). At the same time inflows Gross FDI inflows reached its peak in 2007 at about 18 percent of GDP of FDI have increased and remained relatively high (in a range of 6-10 percent of GDP) since considerably since 2004. then, despite of several external and domestic shocks. It is important to understand whether these FDI inflows contribute to growth and meet expectations of policy makers, which relate to FDI fulfilling insufficient capital inflows, encouraging export growth, decreasing unemployment, intensifying the economic development, raising the main macroeco- nomic parameters (GDP and GDP per capita) and the country’s interna- tional economic competitiveness. This chapter aims to assess the factors that define FDI structure and composition in the country and its impact on the Georgian economy. It reviews country and sector composition of FDI and identifies drivers and constraints associated with the FDI inflows. Based on the findings of this analysis possible solutions and recommendations are suggested. Key findings: • There is a significant concentration of FDI in the large transport-re- lated projects in Georgia. Further analysis will be critical to under- - There is a significant stand why this sector has become particularly attractive, and how its concentration of FDI in positive impact can be maximized into the domestic economy; the large transport-related • A skills mismatch, inadequate infrastructure and limited access to projects in Georgia; finance constrains local as well as foreign firms despite favorable business climate and relatively resilient macroeconomic environ- - A skills mismatch, inadequate ment; infrastructure and limited • While theoretically FDI has a positive effect on employment, in the access to finance constrains case of Georgia the empirical relationship between employment foreign firms; and FDI seems tenuous at best; at the same time, there is a strong positive correlation between employment in different sectors and - The empirical relationship investments in fixed assets almost for all the sectors. Further de- between employment and FDI tailed analysis is needed to understand how different investment seems tenuous at best; projects have been linked to direct impacts on employment, and whether there have been any spillovers or second-round effects; 23 - FDI may generate large • FDI has largely financed the current account gap in recent years; outflows or repatriation of however, it may generate large outflows or repatriation of profits in profits in the medium to long- the medium to long-run if productivity of firms is not improved over run. time and does not generate exports; • Improve FDI statistics to allow policy makers better to identify FDI inflows that are related to the mergers/acquisitions and greenfield investment, as well as their direct and indirect impact on output and employment in different sectors and at the macro level; Way forward for the FDI • Improve the legal framework, identify existing deterrents to FDI still attraction requires improved present in the economy, and implement public policies to encour- legal framework, educated and age investments in a diverse set of sectors (such as agriculture, min- skilled work force, transparent ing, light manufacturing, ect.), and attract responsible investors; and simple tax system and • Ensure that the level of educational attainment, provision of infra- comprehensive statistical structure services, local technological capabilities and development information. of domestic financial markets capture full benefits associated with the FDI; • Maintain a level playing field and a stable, certain, simple and trans- parent tax system. 1. Introduction and Literature Review With FDI rising worldwide over Figure 19: Global FDI flows increased (1990-2016)12 the last decade (Figure 19), (billion$) there are ongoing discussions related to the impact it has on the economy of the host country. Source: International Monetary Fund, Balance of Payments database. 12 Horizontal lines on the graph represents average FDI per decade. 24 In neoclassical growth models, FDI promotes the accumulation of capi- tal stock that eventually contributes to economic growth. These models are based on the assumption that the efficiency of domestic capital is the same as that of foreign capital. Therefore, FDI inflow has no spill- over effect on the host economy through technological transfer, but only through the increase in an input of production. In practice, FDI has added FDI is typically carried out by multinational corporations that invest a benefits, as the efficiency of large amount of money in R&D to improve their technological capa- foreign capital tends to be bilities. Indeed, Yu et al. (2011) claim that FDI is one of the most im- significantly higher than that portant channels for technological dissemination. As a result, FDI not domestic capital. only increases the amount of capital goods in the host country, but also improves the quality and variety of production technologies (Melnyk et al., 2014). In addition, the transfer of advanced technologies leads to “technological diffusion” – the presence of technologically advanced foreign companies makes it easier for domestic producers to adopt new technologies and improve the efficiency of their business activities (Neuhaus, 2006). In sum, FDI also has a (1) increased competition in the host economy and improved quality number indirect spillovers, of domestic firms; (2) the sharing of technologies and experience to including: domestic suppliers and building more efficient sales networks; and (3) transferred knowledge by sharing technical and managerial know-how to local employees through labor force training (Blomstrom & Kokko, 1997). Nevertheless, in some cases, According to Schoors at al. (2002), when the host country is in the early FDI might pose risks for the stage of development, FDI might weaken the market position of local domestic economy. producers (even productive ones) and cause structural unemployment. Moreover, profit repatriation and increased dependence on foreign in- vestors are considered as other channels for a negative contribution. 2. Dynamics of FDI FDI is an important Often officially available data on Foreign Direct Investment (FDI) fails macroeconomic indicator to consistently reflect a country’s business environment and attrac- for policymakers in Georgia tiveness for foreign investors. Thus, using FDI numbers for economic despite problems with its analysis could lead to misleading results due to a lack of background reliability. information on the nature of a particular investment and its calculation methodology, (Mosiashvili & Pkhakadze, 2015). The dynamics of FDI in Georgia Until 2003, both foreign and domestic investments in the country were reflect three distinct phases limited by an absence of sustainable economic and political institutions, in the country’s economic and the lack of regulatory frameworks and a high level of corruption. From political development. 1997 to 2002, FDI in Georgia amounted to US$166 million per year on average, which constituted 5 percent of GDP. From 2003, as a result of 25 successful structural reforms implemented by the new political regime, FDI started to pick up. This period also coincided with the accelerat- ed growth of the global economy, but it ended in 2008 as a result of the global financial crisis and the Russian military invasion of Georgia. During the period 2003-2008, net FDI inflow to Georgia reached record levels – amounting to US$1 billion per year on average, which consti- tuted 12.1 percent of GDP. In the post-war and post-crisis period, FDI to Georgia and its share in GDP fell sharply; however, in 2014, as a result of the large infrastructure projects launched by BP and Azerbaijan, net FDI inflows increased once more amounting to an average of US$1.2 billion per year (8.1 percent of GDP). Figure 20: Overall dynamics of FDI in Georgia Figure 21: Georgia’s FDI performed better than is positive many ECA countries (million$, % of GDP) (1997-2016 average, % of GDP) high income) Source: Geostat, World Bank. Source: World Bank. The structure of top source This low diversification can be explained by the large investments made countries by share of total FDI in the construction of oil and gas pipelines connecting Azerbaijan and has remained relatively stable Turkey (and later Europe), by BP, the State Oil Company of Azerbaijan over the last two decades. (SOCAR), Chevron, etc. The share of net FDI inflows from the top ten countries always exceeded 70 percent of the total during the three phases distinguished in Table 1. Azerbaijan, the United States, the Unit- ed Kingdom and Turkey are countries which have regularly invested in Georgia 26 Table 4: The structure of FDI by country Share, % 1997-2002 2003-2008 2009-2016 Country Share (%) Country Share (%) Country Share (%) 1 United States 40.5 United Kingdom 12.2 Azerbaijan 19.5 2 United Kingdom 8.7 United States 10.0 Netherlands 12.5 3 Turkey 8.6 Turkey 7.6 United Kingdom 10.2 4 Russia 6.2 Netherlands 7.5 Turkey 7.8 5 Australia 5.7 United Arab Emirates 7.2 Luxembourg 5.9 6 Austria 3.8 Virgin Islands, British 7.0 United States 5.3 7 Germany 2.7 Azerbaijan 5.1 China 4.9 8 Azerbaijan 2.6 Kazakhstan 5.1 United Arab Emirates 4.3 9 Cyprus 2.5 Cyprus 4.7 Czech Republic 3.2 10 Norway 2.5 Czech Republic 4.6 Russia 3.1 Source: Geostat. The sectoral distribution of FDI The transport and communications sector was dominated by large in Georgia is similarly highly investment projects: in particular, the construction of the Baku-Tbili- concentrated. si-Ceyhan (BTC) Pipeline, the South Caucasus Pipeline and its further expansion, and the Baku-Tbilisi-Kars railway, attracted nearly 25 per- cent of total foreign investment in 2007-2016. The energy and manu- facturing sectors received 13.4 percent and 12.3 percent of total FDI in that period, respectively. Agriculture and fishing – a sector that, accord- ing to Geostat, employed about 870,000 people (about 50 percent of the labor force) in 2016 – has not been popular with foreign investors. Only 1.2 percent of net FDI inflows ended up in this sector during 2007- 2016. Statistical analysis of FDI In 2015, around 70 percent of entire FDI to Georgia could be attribut- data by country and by ed to six large-scale projects, which were dominated by infrastructure sector shows that Georgia is investments (Movchan & Saha, 2016). The largest single investor com- highly dependent on large pany was BP, and its interests in the region brought a significant part multinational companies and of FDI to Georgia. According to Geostat data, BP was the biggest FDI their investment interests. source for Georgia in four consecutive years (2013-2016), with more than $2 billion invested in country during 2014-2017 in the South Cau- casus Pipeline Expansion (SCPX) project alone. Another example of the importance of large foreign investors is the Hualing Group, which brought more than $500 million into Georgia since 2007, most which was invested in 2013-2015 (Larsen, 2017). 3. Drivers and Constraints for FDI According to the empirical Market size, a stable economic and political situation, together with literature, several factors favorable investment environment and efficient domestic markets determine the investment create good starting point for foreign investors to think about making 27 climate in a country and define large investments in a developing country. Therefore, development of the level of competitiveness of human capital, quality of infrastructure, access to financing, stable tax the domestic economy. system, legal framework and government policy, macroeconomic sta- bility and economic conditions of the main partner countries are main determinants of the country’s attractiveness for foreign investors. However, the interaction Research has identified four types of foreign direct investment in terms between host countries’ of investors’ motivation: natural-resource-seeking FDI, market-seek- characteristics and FDI might ing FDI, efficiency-seeking FDI and strategic-asset-seeking FDI (USAID, vary across countries’ level 2005). Each type of FDI needs a different treatment from domestic pol- of development and resource icymakers. Georgia has a potential to attract efficiency-seeking FDI and abundance. use its favorable geographic location and exploit investment potential in the transit sector. Investments in this sector (for example, the large BP investment) require political stability; in addition, efficiency-seeking FDI needs competitively-priced inputs and labor, and fast technological development. Sectorial and country diversification achieved by focus- ing on the different type of investments will make FDI inflows more sustainable and will further contribute to the sustainable development. 3.1 Human Capital and Inadequately Educated Workforce Literature shows that the level Therefore, it is important for the domestic government to implement of human capital is important effective education policies that directly enhance the domestic skill determinant of attracting base and serve other two important functions: i) attracting FDI, as for- FDI, especially in the capital- eign investors are mainly seeking a new location with pre-existing hu- intensive sectors that are the man capital (Noorbakhsh et al., 2001); and ii) ensuring that the local most FDI intensive sectors for workforce has enough capacity to absorb skill spillovers from the activ- Georgian reality. ities of the transnational corporation is the host country (Blomström et al., 2003). According to the Global Given Georgia’s economic structure relatively few jobs require tertiary Competitiveness Report (2017- education. The majority of the population is working in the relatively 18), an inadequately educated low-productivity agricultural and trade sectors, where demand on the workforce is the most college graduates is quite limited. Therefore, the supply of the educat- problematic factor for doing ed workforce exceeds its demand. Moreover, some workers with tertia- business (see Figure 23). ry education may have knowledge that is far from that required when high-skills jobs are created. This phenomenon in the economic litera- ture is known as “skills mismatching”. According to the World Bank’s article: “Georgia: Skills Mismatch and Unemployment, Labor Market Challenges”, if all of the unemployed in Georgia were employed and new jobs require the same education profile as the existing ones, 22 percent of people with a tertiary education would not be able to find a job and 31 percent of the jobs requiring vocational skills would not be filled by workers with vocational education. Nowadays, many people with tertiary education are working on positions that require vocational 28 skills. At the same time, employers have difficulties to find people with specific professional education, such as IT technicians, production line workers, tractor operators, and hotel management personnel (Livny and Biermann, 2016). In addition, Georgia is ranked 107th country in the world by the quality of its education system with a relatively low score of 3 out of 7 (Global Competitiveness Report (2017-18)). There- fore, despite high literacy rate and high demand on higher education, the quality of education (evaluated by international scores e.g. Pisa Score or TIMMS Score) still remains an important constrain. Figure 22: FDI by economic sectors, 2007-2016 Figure 23: Top 5 problematic factors for doing (share in total, %) business in Georgia (%) Source: Geostat. Source: The Global Competiiveness Report 2017-18. 3.2 Infrastructure The quality and availability Furthermore, a contribution of the transport sector to gross domestic of internal and international product (GDP) substantially increased from $285 million in 1996 to $2.1 transport services in Georgia billion in 2011, reaching 14 percent of GDP. However, authors identify have improved significantly, bottlenecks in sector development: rural transport services that does according to the “Georgian not meet demand of economy, almost road-based passenger transport, Transport Sector Assessment, inefficient distribution of tariffs and etc Strategy, and Road Map” (2014) according to the Asian Development Bank (ADB). Georgia is characterized In addition, according to the OECD statistics, Georgia spent more than by an increasing trend of 15 mln Euro on road maintenance in 2014. However, ADB concluded infrastructure investment in that annual expenditure on maintenance is not sufficient to keep entire 29 road transport – from 124 mln road system in good condition. In addition to the poor maintenance, Euro in 2008 (1.5 percent of overburdened foreign trucks further aggravates this problem (ADB, GDP) to more than 224 mln 2009). This finding is confirmed by the Global Competitiveness Report Euro in 2014 (about 2 percent (2016-17), as Georgia occupies 75Th and 78th positions in the global of GDP). ranking in terms of quality of infrastructure and quality of roads re- spectively 3.3 Global factors As a country with open Table 2 offers a perspective on the linkages and dependencies of Geor- economy with the high share gia on other countries with respect to external factors in 2016. Dark- of FDI, remittances and export er colors correspond to stronger linkages and, consequently, stronger of services and FDI, the spillover effects. For example, Russia, Azerbaijan, Armenia, Turkey each Georgian economy is sensitive absorbed between 7-10 percent of Georgian exports. Thus, the pro- to episodes of economic crisis jected economic recovery in Russia and Azerbaijan after slowdown and recovery in the region. of economic growth in 2014-2016 will have positive influence on the Georgian economic parameters. While the country has pursued im- portant Euro-Atlantic integration goals, AA and DCFTA with EU, Geor- gia’s economic ties with neighboring countries and member of CIS were stronger than with EU in 2016. However, recent association and trade agreements and the Visa-free regime imposed in 2017 are expected to decrease dependence of Georgia on volatile CIS countries towards more stable EU and faster growing China. Table 5: Linkages with partners in 2016, percentage of total (%) Source: Geostat, Georgian National Tourism Administration (GNTA). 30 30| 3.4 Legal framework and government policy Georgia has a liberal and According to Doing Business 2018, Georgia ranked 9th among 190 business-friendly legislative countries and highest in Europe and Central Asia Region. The result framework however the gaps was achieved by implementing 47 reforms during last 15 years, which on judicial independence is the highest number among countries in the ECA region. In addition, undermines its attractiveness the Georgian legal framework can be further improved by structural for foreign investors. reforms in trading across borders and resolving insolvency. It is worth noting that according to the Global Competitiveness index (2017-2018) of the World Economic Forum, the legal framework in Georgia is behind best international practice with regard to (1) the efficiency in settling disputes and efficiency in challenging regulations; (2) the presence of favoritism in decisions of government officials and (3) the gaps on judi- cial independence that reduced the attractiveness of the Georgian legal framework for foreign investors. 3.5 Taxation Georgia’s tax system is based Georgia has a flat tax system considered to be rather efficient by re- on sound foundations and by gional standards. After a series of reforms in 2003-07 to simplify the tax and large, the system follows system, eradicate border smuggling and enhance tax administration, international best practices. Georgia’s tax collections improved dramatically and reached 25 percent of GDP by 2007. Tax revenues have been a stable source of revenue at 24-26 percent of GDP since 2007 despite periods of high growth vola- tility in 2009, 2013 and 2015. Income tax in Georgia is collected at a flat rate of 20 percent, while the value-added tax (VAT) and corporate tax are levied at a flat rate of 18 percent and 15 percent respectively. As of 2017, the VAT constituted the largest single source of revenues at 40 percent of the total; income tax contributed 25 percent, profit tax 12 percent and excises 10 percent. Electronic filing is the norm and the tax administration is well-geared on modern lines with additional reforms under discussion. To preempt any reversal of the tax reforms and pro- vide certainty, a Liberty Act was enacted in 2014 to ban new state tax or rate increase without a referendum for most taxes, which has limited potential tax revenue increases. Excise taxes are an exception to this rule and therefore has been raised frequently, with the last increase in January 2017 In 2017, the Georgian Reinvested or retained profits are no more subject to income tax; only government implemented distributed profits will be taxed by 15 percent. This tax incentive is ex- an important initiative and pected to boost reinvestment and overall investment level; the prelimi- introduced a new taxation nary statistics suggest that the reform already had effect on investment scheme of corporate income decisions – the reinvestment component of FDI made in the first half (the “Estonian model”) of 2017, showed a record annual increase of 263 percent from $97.8 million in previous year. 31 Box 2. The tax reform in Estonia With the tax reform, Estonia became the most competitive country among OECD members and one the largest stocks of FDI per capita among EU accession candidates in 2002. The reinvested corporate profits were no longer subject to income tax. Its income tax system, 20 percent flat income tax rate, at that time was considered as one of the simplest tax systems in the world. This simple and clear tax system contributed to confidence among business- es and helped promote capital investment. The competitive tax environment was vital in attracting foreign direct investments to Estonia. The Estonian corporate tax system has been conducive to economic growth. In fact, after Estonia enacted its cash-flow corporate tax in 2000, investment surged relative to its neighbors. Between 2000 and 2004, investment growth in Estonia was 39 percentage points faster than neighboring Latvia and Lithuania. The increase in FDI coincided with the exemption of reinvested earnings from corporate income tax since 2000, the model that Georgia adopted in 2017. In addition, Georgia exempts One of the important exemptions is for foreign source income. This is incomes from certain sources, likely to be availed by individuals who are high income as low income as it aims to encourage individuals are not likely to derive their income from foreign sources. investment from these sources. Similarly, capital gains accrue on capital ownership over a period of time. High income individuals would hold assets that accumulate cap- ital gains over time. In the case of the exemptions for foreign source income and long-term capital gains, the beneficiaries are likely to be high-income taxpayers. The high-income taxpayers can be domestic or foreign depending upon the ownership structure of the industry in Georgia. These tax exemptions appear to be aimed at promoting pri- vate investment. 3.6 Macroeconomic stability Achieving macroeconomic It is widely recognized that the stable macroeconomic environment fur- stability remains a ther reduces risk for FDI, allows better planning, ensures a robust do- necessary, but not sufficient, mestic demand, and a good platform for exports. As mentioned before, condition for attracting the fall of commodity prices on world markets, global appreciation of investments. dollar and weakened regional demand in 2014-2016 year put pressure on macroeconomic stability in Georgia. Taken together, these factors were the main contributors to the sluggish economic growth in 2015 and created further obstacles to attract foreign investments. The macro environment has generally been supportive to FDI during 2017 – with important efforts to contain inflation, maintain a floating, stable, fully convertible and transparent exchange rate regime. In addition, fiscal policy and the external sector have been supportive to growth but they do represent some important risks (increased debt burden on borrow- ers, for both private sector and the government; contingent liabilities) that the government is mindfully addressing. Overall, the macro envi- ronment does not seem to have acted as a deterrent for FDI, though the volatility in regional conditions and prospects inevitably plays a role. 32 4. FDI and Economic growth - Theory 4.1 FDI and Economic growth – Empirical Literature There is no consensus in the According to the literature, there are four common outcomes of causality empirical literature about analysis: (1) the positive contribution of FDI in economic growth is clear the direction of the causal and does not depend on any additional conditions/factors (e.g. Campos relationship between FDI and et al. (2002); Melnyk et al. (2014)); (2) FDI has a positive impact on real economic growth. GDP growth, but only for countries that have a sufficient level of human capital, an appropriate trade policy, enough absorptive capability and/or a friendly business climate (e.g. Alfaro et al. (2008)); (3) FDI does not have any significant influence on economic growth (e.g. Lyroudi et al. (2004); Carkovic & Levine (2002); Herzer et al. (2007)); and (4) FDI has a negative impact on economic performance (e.g. Mencinger et al. (2003)) Although much of the Guersoy and Kalyoncu (2012) studied the connection between FDI and literature tests the causal GDP growth in Georgia over the period 1997-2010. The authors conduced relationship between FDI and Engel-Granger cointegration and Granger causality tests and found that economic growth for a country these two variables are cointegrated and there is unilateral causality be- group, very few studies tween them – it is only FDI that causes GDP growth and not vice-versa. investigate this issue on the national level (and only one study does this for Georgia). 4.2 FDI, Gross Capital Formation and GDP growth According to the theoretical In recent years, investments have been the main source of economic foundations, one of the growth for Georgia (see Figure 25). Especially after the regional crisis in most important channel FDI 2014, growth in Gross Capital Formation (that measures total investment) contributes to economic was the main source of real GDP growth in Georgia, neutralizing the high growth is through the negative contribution of the significantly deteriorated trade balance. Gross acquisition of capital stock Capital Formation contains two components: Gross Fixed Capital Forma- (real investment). tion (GFCF) and change in inventories. The first measure can be used to evaluate fixed capital formation in the economy, which, according to the theoretical foundations, determines the short-run growth of the country. However, it is hard to determine the role of FDI in acquiring fixed capital. FDI can be used to finance fixed capital formation, but it can also be used to finance the deficit of a company and/or to pay off a loan. Therefore, the share of FDI in GFCF can only be approximated based on the part of the fixed capital that was acquired using FDI. The evolution of FDI as a share of GFCF has followed a similar pattern to the evolution of FDI. During the ear- ly years of transition, the share was relatively low, but after 2005 (during the global economic boom) it started to accelerate rapidly and reached a peak value of 77 percent. Following the 2008 financial crisis, the share fell rapidly to a low of 23 percent, and it now stands at 36 percent. 33 Figure 24: Decomposition of real growth Figure 25: FDI and Gross fixed capital formation (%, contributions) (million$, %) FDI as a Share of Gross Fixed Capital Formation Source: Geostat and staff calculations. Source: Geostat, NBG and staff calculations. 4.3 FDI and the Current Account Deficit Georgia is a country with This leads to a large (yet sustainable) Current Account (CA) deficit (see a low domestic savings rate. Figure 27). The imbalance in the CA usually exceeds 10 percent of GDP As a result, savings as a share and has been characterized by an increasing trend over the last three of GDP are much lower than years that is just starting to reverse in 2017. In Georgia, FDI remains investment. the main source of financing the CA deficit. For example, 75 percent of the deficit was financed by FDI in 2016 and this number was close to 70 percent for both 2014 and 2015 as well. Therefore, it is important to make productive investments that can be directed to closing the gap in the current account. Figure 26: Saving-Investment Balance Figure 27: Current Account Deficit (% of GDP) (% of GDP) CAB=S-I Current account deficit financed by debt instrument (%) Source: NBG, Geostat. Source: NBG. 34 4.4 FDI and Trade FDI affects economic growth FDI promotes exports by making country more competitive in price and through different transmission quality, increasing productivity through capital accumulation, improv- channels, of which the trade ing transport infrastructure and production facilities, attracting new channel is one of the most technologies and know-how. In case of Georgia the effect should be important, especially for even stronger – developing country with tiny domestic market and lib- countries like Georgia. eral trade regime with rest of the world should attract export oriented FDIs. However, FDI affects not only At the initial stage of investment phase, FDI negatively affects trade exports, but also imports. balance through increasing imports of machineries, equipment, oth- er capital goods and services of foreign experts. In the later phases of the investment the effect on imports is dependent on input nature and output type of production. If FDI uses domestic raw materials and in- termediary goods in production process, it will not have adverse effect on imports. If FDI is concentrated in industries which produces goods that are complementary to the imported products, it may encourage imports. However, if investments are made in sector which consists of import substituting industries, it would shrink import values. Table 6: Correlation coefficients of FDI to trade indicators (2007-2016) FDI stock in Net FDI FDI in transports Net FDI transports and and communications (flow) communications (stock) (flow) (stock) Exports of goods 0.00 0.68 0.00 0.88 Imports of goods 0.19 0.69 0.15 0.55 Imports of Capital goods (except transport equipment) 0.32 0.74 0.34 0.66 Imports Transport equipment and parts 0.15 0.39 0.00 0.25 Exports of services 0.10 0.96 0.36 0.88 Exports of transport services -0.03 0.90 0.19 0.79 Exports through pipeline transport and electricity -0.27 0.79 0.17 0.75 transmission Source: Geostat. Nearly 25 percent of FDI in For this reason, our analysis observes correlations between FDI in these Georgia during last ten years sectors and trade indicators in 2007-2016. The results shown in table 5 went into transport and suggest that: communications. 35 • Accumulated stocks of FDI have a stronger correlation with trade in- dicators than its flows. It could be explained by the fact that invest- ment needs time to affect production and exports. • Correlation between imports of capital goods and FDI indicators are positive, suggesting that FDI in Georgia is associated with increasing imports at the initial stage. • Generally, there is no strong linkage between net FDI flows and trade indicators. Georgian exports are dependent on various variables like regional demand, geopolitical situation in the region and trade rela- tionship with neighbors. More generally, FDI in The increased import of raw materials and intermediary goods in the transport and initial stage production process will gradually be outweighed by ben- communication (mainly efits from transit of oil and gas through pipelines in the future. Fur- made by BP) are expected to thermore, Georgia benefits from these projects in different ways. For have a net positive impact example, two major regional oil pipelines – Baku-Tbilisi-Ceyhan (BTC) on trade for the country in and South Caucasus pipeline Baku-Tbilisi-Erzurum (Shah-Deniz) signifi- the long run. cantly increase Georgia’s export potential. According to the agreement made between Georgia and Azerbaijan around BTC pipeline13, Geor- gia will receive around US$ 2.1 billion (as a transit fee) during the 40 years contract functioning time, which corresponds to the 62.5 million dollars per year. Also, per the agreement around South Caucasus pipe- line Georgia is not only transit country but also a natural gas consumer country. Therefore, Georgia has an option to purchase 5% of gas ex- ported from Azerbaijan to Turkey for a favorable price and get addition- al half a million cubic meter gas from the project investors at a special price (Georgian Oil and Gas Corporation). To analyze the impact on Georgia is a net importer of electricity, and domestic generation is usu- trade of FDI in its second ally less than domestic demand. Currently, FDI is ongoing in the ener- largest recipient sector of gy sector, particularly to develop new HPPs and promising aspects of energy (with 13 percent these investments include: First, increased domestic generation that share in total FDI) one could will save significant part of electricity imports. The demand on electric- look at the exports and ity in the country rose significantly from 7,800 million kW/h in 2007 to imports of electricity. 11,026 million kW/h in 2017, constituting a 41% increase. Therefore, investments in electricity generation saved for the country about 483.6 million USD on electricity imports during the last ten years compared to the scenario where generation powers freeze on 2007 level.14 Second, investments in the electricity sector further increase the electricity ex- port potential of the country especially in the summer time. Beyond this significant direct impact on trade, there is indirect positive effect on the whole economy through lower electricity prices. 13 The contact came into force in 2000. 14 The total amount is calculated based on average import price of 2016 and the total amount of electricity country would have to import in case of no increase in domestic generation. 36 Figure 28: Trade and consumption of electricity Figure 29: Productivity-real value added per employed person, 2016 (GELm) Produc�vity Total Produc�vity 0.035 Produc�vity Gain from 2006-2016 0.03 0.025 0.02 0.015 0.01 0.005 0 Real estate Agriculture and Industry Wholesale and retail trade Community, social fishing affaits Construc�on Hotels and restaurants Transport and communica�on Educa�on Health and social work Total Source: GeoStat, ESCO. Source: Geostat. 4.5 FDI and Productivity FDI affects economic growth While all of these benefits are considered as crucial ones for country’s through different spillover development, particular emphasis is placed on the contribution of FDI channels, including by bringing to the productivities of the domestic industries. According to the theo- capital, new technologies, retical foundations, the transfer of technologies and knowledge result- know-how marketing and ing from FDI inflows goes beyond actual projects of foreign investors management skills. and benefits domestic firms. However, there is no empirical evidence that this positive spillover actually exists. The firm-level panel data and case study analysis show that the importance of these theoretical spillover channel is commonly exaggerated for developing countries15. There are more optimistic findings based on the industry-level stud- ies that rely on cross-sectorial data, but the main disadvantage of this methodology is the difficulty in establishing the direction of causality (Javorcik, 2003). While there is no empirical Sectors that were the most attractive for foreign investors stand as the literature that studies the most productive sectors in the country. For example, top 3 the most impact of the FDI inflows productive sector16: transport and communication sector, construction 15 Haddad and Harrison (1993) on Morocco, Aitken and Harrison (1999) on Venezuela, and Djankov and Hoekman (2000) on the Czech Republic doubt that there is any spillover effect of FDI on the productivity of industries. However, it worth noting that Haskel, Pereira, and Slaughter (2002) and Keller and Yeaple (2003) identified positive spillover in the United Kingdom and United States, respectively. 16 Community, social and personal service activities could be considered as a high productive sector, but we should take into consideration the fact that small share of this sector in number of employed people and added value. 37 on sectoral productivity in sector, and industry, where real17 value added per employed person Georgia, data suggests that even reaches 315, 253 and 233 thousand lari respectively18, have been the sectors that were the most the most attractive sectors for foreign investors in the recent decade. attractive for foreign investors Furthermore, these sectors were characterized by large amount of in- experienced the highest vestments in fixed assets. The least productive sectors, like agriculture productivity gain in the recent and fishing and education sectors were the least attractive sectors for decade. foreign investments as well (see the Figure 29). These findings are not surprising, as FDI is mainly made in capital intensive sectors that are distinguished by high productivity. In addition, it is worth noting For example, top 3 fastest improving sectors in terms of productivity: that the sectors which are the construction, industry and real estate, where value added per employed most attractive for foreign person improved by 153, 109 and 97 thousand lari respectively, again investors experienced the has been the most active destinations for foreign direct investment. largest productivity gains in However, despite the fact that there is a strong correlation between FDI the last 10 years. and sectorial productivity (and productivity gain), it is hard to conclude that there is causal relationship between these variables and what is the direction of causality. 4.6 FDI and employment While theoretically FDI A high share of self-employed people in total employment in the coun- have the positive effect on try complicates this analysis even further. Theoretically, high FDI inflow employment, in the case causes moving self-employed people to formal employment in the cor- of Georgia the relationship responding sectors and this finding is confirmed by data. The share of between them is ambiguous. self-employment in total employment varied between 66.2 percent (2004) to the 54.2 percent (1999), starting a gradual decline in the re- cent years to 57.3 percent in 2016. Yet, there are other objective factors that also incentivize people to involve into to the formal employment – domestic investment, decreasing tax burden, tax system simplifica- tion, and negative net migration that puts this theoretical foundation into question. A simple correlation test between employment and FDI, which includes only officially hired people showed that the linkage be- tween these two variables is statistically not significant and even neg- ative in some economic sectors. However, there is a strong positive correlation between employment in different sectors and investments in fixed assets almost for the all of sectors. In addition, there is a weak positive correlation between investment in fixed assets and FDI, and construction sector remains the only sector where these two variables are closely linked to each other (see the table 8). From this very simplis- tic comparison, one can conclude that without knowing details about every specific FDI inflow or outflow, FDI (as represented by BOP statis- tics) might lead to the misleading interpretations. 17 Real value added is computed based on the sectorial GDP deflator. 18 The source of this statistical data is business statistics, provided by Geostat and do not contain information about self-employed people and their contribution to the national economy. However, sectors that are dominated by self-employed workers (for example agriculture) are still the least productive sectors after taking into consideration of them (“Structural Transformation in Georgia – In the Right Direction at a Turtle’s Pace” (2016), Davit Keshelava). 38 Table 7: correlation coefficients of employment to FDI and Investment in Fixed Assets Investments in Economic Sector FDI fixed assets Total 0.89 0.13 Agriculture, hunting and forestry 0.78 -0.22 Fishing 0.55 - Industry 0.50 - Construction 0.72 0.29 Wholesale and retail trade; repair of motor vehicles 0.66 - and personal and household goods Hotels and restaurants 0.62 -0.38 Transport and communication 0.33 0.52 Real estate, renting and business activities 0.95 -0.21 Education 0.33 - Health and social work 0.68 0.39 Community, social and personal service activities 0.24 - Source: Geostat and staff calculations. 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