Chris Weafer of Macro-Advisory -
This year Georgia’s economy is expected to grow at less than half the pace of last year. The immediate reason is because of the impact of the Russian recession and the contagion from ruble weakness across the Commonwealth of Independent States (CIS) and wider Eurasian region. But the underlying reason why the fallout from Russia has hit Georgia hard is because the country has been moving far too slowly to create a stronger, more diversified domestic economic base. A decade of tough anti-Russian political rhetoric, and success in administrative and legislative reforms has not been matched with any success in attracting investment.
Georgia’s GDP expanded by 4.8% in 2014, but is expected to grow by no more than 2.0% this year as consumers rein back spending and the country’s principal exports struggle. The main areas of concern are the lower volume of remittances, a reduction in trade with other CIS states and the impact on domestic activity of rising inflation, high interest rates and the currency devaluation. Retail sales, which had been growing at a strong double-digit pace for several years, will be lucky to grow at 10% this year as wage growth slows and unemployment rises to near 15%, up from an average of 12% last year.
The country’s balance sheet is in relatively good shape, but with little room to boost spending or investment. The forecast budget deficit is 3.5% of GDP while total external debt to GDP is at 80%, of which half is sovereign debt.
The economy is also now suffering from the excessive dollarization in the banking system that has emerged over the past six years. This seemed like a good idea at the time given the political emphasis on Western integration. But instead of paving the way to the West, the currency imbalance has added to the economy’s vulnerability to the currency weakness across the CIS/Eurasia region. The National Bank of Georgia (NBG), one of the most effective state institutions, has been finally forced to tackle that issue and, in late February the NBG, in collaboration with the country’s main banks, started the process of restructuring dollar loans issued to individuals with income in lari. According to a NBG statement, they have “enough reserves to secure financial stability” during this process.
The National Bank of Georgia raised its benchmark rate in early May to 5%. It also made clear that the rate could go higher if inflation accelerates and/or if it needs to calm volatility in the currency market. Here also that will depend a great deal on where the ruble trades. We expect ruble weakness in the fourth quarter and therefore expect to see further weakness in the lari and a further rise in the benchmark interest rate in the second half of this year. The lari, which started 2014 with an exchange rate of GEL1.70 versus the dollar, is now at GEL2.25 and is forecast to end 2015 at GEL2.50.
Bread and water
Apart from now having to deal with the dollarization threat, the impact of the Russian and regional slowdown is that there is now a greater sense of urgency to match the success in the institutional and legislative reforms with real progress to create a stronger and more diverse economic base. For example, the government is now much more focused on trying to rebuild the output and competitiveness from the agriculture sector. This sector of the economy now only accounts for 9% of GDP while, at the end of the Soviet era, it was 30% of GDP. After two decades of neglect the sector is far too fragmented and under-invested.
The one product where Georgia has been able to significantly boost exports to the EU is wine. Exports to Asia have also been growing strongly. But the gains in the wine trade are more than offset with the decline in the trade in second-hand cars. This import-export business is the largest segment of Georgia’s external trade and is now under threat due to regulatory changes in the country’s biggest customer country, Azerbaijan. Hydroelectricity is another sector that has attracted a lot of inward investment and is expected to receive more. Georgia has the highest per-capita hydropower generation in the world and plans to link its grid into the so-called Caucasus Power Grid.
Amongst all of the CIS states, Georgia has been the most proactive and effective in improving its business and investment climate. It routinely ranks at the top of the regional rankings in terms of business conditions, economic freedoms and corruption perception. Despite that, inward investment has remained modest, and has mostly been directed at oil and gas pipelines transiting the country from Azerbaijan to Turkey or the Black Sea.
Since the Rose Revolution in 2003, the government has been pushing for greater integration with the EU, especially after the 2008 conflict with Russia effectively closed off that market. The EU and Georgia finally signed a free trade and association agreement in June of last year, and this offers hope that Georgian exports will be more easily able to access that market. This is, of course, a two-way route: EU goods will also be able to more easily access the Georgian market.
But the EU continues to stall on an easier visa regime and this is one factor blocking greater inward investment from the EU to the country. This over-confidence and over-reliance on improving trade with the EU, as well as disruptive domestic politics, certainly played a key part in distracting from more serious efforts to broaden out the economic base.
Where's the money?
Having been disappointed with the slow response from the EU, Georgia is now starting to focus more on its own neighbourhood and to China. The country could benefit if a spur line in China’s $100bn, 21st century Maritime Silk Road project is built up to the Black Sea. It could also benefit if a post-sanctions Iran looks to use the Black Sea as a trade corridor with the EU.
Opinion polls show that while a majority of people still favour closer engagement with the EU, including Nato membership, there is a growing sense of frustration that the expected economic benefits are either not coming or far too slowly. Polls over the past year showed a steady increase in the percentage of people in favour or Georgia considering joining the Eurasia Economic Union (EEU), albeit that percentage is still less than 33%. The issue may become more contentious if the EU continues to drag its heels on the visa issue and inward investment and if, for example, Georgia’s neighbour Armenia starts to report benefits from its EEU membership.
Strikes for better pay, mostly as a result of the currency devaluation, are also coming more frequently. A poll by NDI in May shows that job security (67% of respondents), inflation (43%) and continuing high levels of poverty (37%) are by far the public’s main concerns. Only 3% of people said that their situation was improving, while 34% said that their position continues to worsen. Territorial integrity (27%) was the top issue pre-economic downturn.
Domestic political concerns are also a factor for investors. While there is no sense of any immediate potential unrest, there are plenty of distractions that deflect from the economic priorities. The ruling coalition had to defend a vote of no confidence in parliament in May, which was caused after one-third of cabinet ministers had resigned or been fired since the last election. An opinion poll carried out in early May showed that public support for the Georgian Dream government has dropped sharply since the last election. This, however, can be considered normal for incumbent governments during periods of economic weakness and uncertainty. It is, however, another reason for the government to start addressing economic concerns well ahead of the next election in late 2016.
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