Public Information Notice No. 98/69

Public Information Notice: IMF Concludes Article IV Consultation with Georgia and Approves Third Annual ESAF Arrangement

September 11, 1998

On July 27, 1998, the Executive Board concluded the Article IV consultation with Georgia¹ and approved the third annual loan under the Enhanced Structural Adjustment Facility (ESAF)².

Background

During 1997 the Georgian economy grew by 11 percent, sustained by a rapid increase in agriculture and the services sector, while the average annual inflation rate continued its downwards path initiated in 1995 and reached single-digit levels of about 7 percent. The fiscal deficit (on a commitment basis) declined from 4.5 percent in 1996 to 4.1 percent in 1997, and the ratio of general government tax revenue to current expenditure increased from 56 percent to 66 percent, as tax administration measures, together with the introduction of a new tax code, boosted tax revenue. The current account deficit widened from 9 percent of GDP in 1996 to 10 percent in 1997, mainly reflecting a rapid growth in imports associated with the construction and refurbishment of the "early oil" pipeline connecting Azerbaijan to the Black Sea.

The conduct of monetary policy remained prudent in 1997, with the exchange rate remaining at about lari 1.3 per U.S. dollar and gross reserves of the National Bank of Georgia (NBG) increasing to US$173 million. Compliance with banking sector prudential regulation continued to improve in 1997, although at times, several small-and medium-size commercial banks had difficulties in meeting the reserve requirements and liquidity ratios in a timely manner. The authorities have recently strengthened the banking sector prudential regulations, and are taking a tough stance on the issue of problem banks. To that end the NBG has put forward a system of leading indicators to monitor such banks and trigger necessary action by the monetary authority, if deemed appropriate.

The implementation of the government’s structural reform program moved forward in 1997. Privatization of medium- and large-scale enterprises accelerated in the second half of the year. Energy sector reform also advanced as the authorities enacted the Electricity Law, which set new parameters for government’s involvement in the sector and the establishment of a competitive market for electricity distribution and generation over the coming years. Agricultural land privatization made further progress with the distribution of about 60 percent of cultivated land to private farmers by end-1997. Public expenditure control improved with the treasury system expanding to cover almost all central government spending units and the Pension Fund.

Following extensive discussions with IMF staff, the Georgian authorities enacted a number of prior actions for a program that could be supported by a third annual ESAF arrangement covering the period May 1998/April 1999. The prior actions under the program included, inter alia, eliminating the remaining export restrictions on logs and scrap metal; dealing with problem banks; and electing the Board of Directors of the NBG.

The 1998 program embraces an important fiscal effort (equivalent to 2.5 percent of GDP on an annual basis) consisting of various revenue raising measures and cuts in expenditure appropriations included in the 1998 budget. As in the last two years, the program aims at increasing tax collections. The program also targets the elimination of all outstanding government expenditure arrears by end-1998 and a reduction in tax arrears from an equivalent of 30 percent of general government tax revenue at end-1997 to 15 percent by end-1998. Monetary policy will remain tight, with central bank financing of the budget declining sharply with respect to 1997. Gross international reserves are targeted at US$210 million by end-1998.

Structural reform will move forward in 1998, mainly in the areas of privatization of urban and industrial land and large-scale enterprises, financial sector reform, energy sector restructuring, and civil service reform.

Executive Board Assessment

Directors observed that the Georgian authorities have made major efforts to stabilize the economy and implement structural reform during the past three years. Key ingredients in the authorities’ economic program have been efforts to increase tax collection and reduce the overall fiscal deficit, complemented by a prudent monetary policy. Systemic reform has also been critical for the success of the program. In particular, privatization of agricultural land andenterprises, coupled with banking, energy, and legal sector reform, has underpinned the authorities’ effort to establish a market economy in Georgia.

Executive Directors noted that, despite the important strides made thus far, Georgia still faces daunting economic challenges that need attention in the short and long run. Directors stressed that fiscal adjustment needed to be strengthened, and noted the urgent need to mobilize additional tax revenue in order to cover general government current expenditures and finance basic public investment projects. Directors were reassured by the authorities’ intention to continue to work toward broadening the tax base to cover sectors with large revenue potential to the budget; removing remaining tax exemptions; and establishing a fairer tax system in which domestic and foreign goods and services are taxed at the same rates. In this regard, Directors noted the potential to collect greater revenue from, inter alia, cigarette excise duties, and expressed regret that the agricultural sector remained exempt from taxation in 1998.

Directors welcomed the authorities’ intention to eliminate all outstanding government expenditure arrears and avoid the accumulation of any new arrears during the program period. They were also encouraged by the authorities’ decision to tackle the issue of tax arrears, improve the targeting of the social safety net, increase budgetary allocations for health and education, and further develop the treasury system of the Ministry of Finance, as all of these measures were critical components of a comprehensive approach to fiscal consolidation. Directors urged the authorities to strive for greater fiscal transparency.

Directors recommended the continuation of a prudent monetary policy for the program period, as this policy will be critical in supporting the stability of the exchange rate and achieving the program’s international reserves objectives. Regarding exchange rate policy, Executive Directors agreed that the stability of the nominal exchange rate had been fundamental in anchoring inflationary expectations, and thus in reducing inflation from hyperinflation levels in 1994 to single-digit levels in 1997–98. Nonetheless, they urged the authorities to keep the current exchange rate policy under constant review in view of the central bank’s still vulnerable external reserve position.

Executive Directors supported Georgia’s efforts to reform the domestic banking system and welcomed the steps taken to tighten banking sector prudential regulations and strengthen banking supervision. Resolute action by the supervisory authorities will be required to build a sound banking system, including the requirement that commercial banks’ reporting meet international accounting standards. As important first steps, Executive Directors welcomed the decisions to introduce le`ading indicators to monitor problem banks and raise banks’ capital requirements.

Directors stressed the importance of pressing ahead with the authorities’ structural reform program. The privatization of urban and industrial land, together with the planned consolidation of the government’s divestment strategy from the energy and other industrial sectors, were steps in the right direction. Judicial reform would also be fundamental for establishing a solid system of property rights in Georgia. Directors welcomed the elimination of the export ban on scrap metal and the prohibitive export license fee on logs, noting that establishment of a liberaltrade regime was paramount in ensuring an efficient allocation of resources and bringing about sustained economic growth.

Executive Directors commended the authorities for their efforts to improve the compilation of monetary and price statistics. However, they urged the authorities to improve the compilation of balance of payments and national accounts statistics.

Noting Georgia’s weak external position, Directors welcomed Georgia’s completion of debt rescheduling agreements on pre-1995 bilateral debt with all creditors. Directors took note of the recent contacts between Georgia and Turkmenistan regarding the rescheduling of principal payments falling due during 1998–99, and regretted that an agreement had not yet been reached. They urged the authorities to continue their efforts to reach an appropriate rescheduling agreement with Turkmenistan as soon as possible. In the exceptional circumstances of Georgia, the Executive Board was prepared to approve Georgia’s request for a third annual ESAF arrangement, notwithstanding the accumulation of external arrears to an official creditor during the program period. This approval reflected a judgment that strong efforts were being made to reach a rescheduling agreement, and that prompt support from the Fund was important to maintain the momentum of economic reform in Georgia and to strengthen the country’s debt-service capacity over the medium term. In making progress toward external viability, Directors discouraged Georgia from borrowing in the international capital market, given the existing onerous external debt burden, and noted the need to increase domestic saving. In this regard, Directors underscored the importance of fully implementing the policy measures the authorities have committed to under the ESAF.