Georgia - Country economic memorandum : from crisis to recovery : a blueprint for reforms (Vol. 2 of 2) : Statistical appendix

Report No. 11 275-GZ Georgia Country Economic Memorandum From Crisis to Recovery: A Blueprint for Reforms Volume 1: Main Report May 18, 1993 Country Operations Division 2 Country Department IV Europe and Central Asia Region FOR OFFICIAL USE ONLY i,.1~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~7 only in dw peformance of thir ofrcWdite. .4, co Wt', . b dkcdosd withoutorld Bank audizatlon' .- -; .;,= -F : . - HX ' -e .- g  CURRENCY EOUIVALENTS Currency Unit - Ruble (Rbl) EXCHANGE RATE: RUBLES PER S 750 (February, 1993) WEIGHTS AND MEASURES Metric System ABBREVIATIONS CBR - Central Bank of Russia CIS - Commonwealth of Independent States CMEA - Council for Mutual Economic Assistance EPU - European Payments Union FSU - Former Soviet Union GDP - Gross Domestic Product GOSKOMSTAT - State Committee on Statistics IMF - International Monetary Fund NBG - National Bank of Georgia NIP - National Income Produced NMP - Net Material Product PPP - Purchasing Power Parity SPM - State Property Management Committee VAT - Value Added Tax FISCAL YEAR January I - December 31  FOR OFFICLAL USE ONLY Note This report is based on the work of a mission which visited Thilisi, Georgia, between June 26 - July 10, 1992. The draft report was discussed with the Georgian authorities in March 1993. The contributors include Messrs/Mdmes. Pant (mission leader), Chazelas (financial sector), Conway (macro), Cordet-Dupouy (industry/privatization), Milanovic (social safety net), Panagariya (trade), Pepper (energy) and Shirley (privatization). Mr. Saghir contributed to the discussion on privatization and Mr. Zheng assisted in the chapter on medium term prospects. Ms. Banerji updated the report and the Statistical Appendix. Ms. Rosenthal was responsible for production of the report. This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  I  GEORGIA COUNTRY ECONOMIC MEMORANDUM FROM CRISIS TO RECOVERY: A BLUEPRINT FOR REFORMS Table of Contents Executive Summary ............ i PART I: - THE IMPERATIVE OF MACROECONOMIC STABIUZATION ... 1 Chapter 1 - THE ORIGINS OF THE CRISIS. 2 Chapter 2 - MEDIUM TERM PROSPECTS. . 1 Chapter 3 - POLICIES FOR MACROECONOMIC STABILIZATION AND GROWTH .................................... 21 PART II: - THE AGENDA FOR STRUCTURAL REFORMS .26 Chapter 4 - REFORMS TO ENLARGE ROLE OF MARKS AND INTENSIFY COMPETTON .2 Chapter 5 - ENTERPRISE AND FINANCIAL SECTOR REFORM .33 Chapter 6 - REFORM OF THE SOCLAL SAFETY NET .52 Annex 1 - The Industrial Sector Annex 2 - The Energy Sector Bibliography  GEORGIA Country Ecoonoic Manorandum FROM CRISIS TO RECOVERY: A BLUEPRIT FOR REFORMS Volume I Text Tables, Figures and Boxes Text Tables Table 2.1 Trends in Macroeconomic Variables 1992-2003 Table 2.2 GDP Growth in Central and Eastern European Countries, 1989-92 Table 2.3 Sources and Uses of Foreign Exchange 1992-95 Table 6.1 Pensioners and Pensions in Selected Countries Table 6.2 Number of Pensioners and Monthly Amounts of Pensions Table 6.3 Unemployment Benefits Table 6.4 Financing of Unemployment Benefits Table 6.5 Estimated Financial Effects of Recommendations Box 1.1 Is There An Expanding Underground Economy? Box 1.2 The Cash Shortage Phenomenon Box 3.1 Summary of Recommendations on Tax Policy Box 4.1 Reasons for Export Licensing? Box 5.1 The Legal Framework for Privatization Box 5.2 Privatization of Housing Box 5.3 Privatization of Land Box 5.4 The Financial System in Georgia Box 6.1 Income Distribution in Georgia Figures Fig 1.1 GDP Growth in Russia and Georgia Fig 1.2 Monthly Inflation in 1992 Fig 2.1 Trends in Consumption, Investment and GDP 1992-2003 Fig 2.2 Trends in Exports and Imports 1992-2003  EXECUTIVE SUMMARY 1. Georgia was among the first of the republics of the former Soviet Union (FSU) to declare independence on April 9, 1991. It is a relatively small country with a populationof 5.4 million situated in the southern part of the Caucasus region. Until recently, living standards in the republic were quite good. Life expectancy at birth is among the highest in the republics of the FSU, and infant mortality is below the Soviet average, as is the crude death rate. Georgia is Inown for its large and growing under- ground economy. This, combined with a strong agricultural economy and a long tradition of close family ties contributes to a picture of a relatively well-off republic. Yet according to official statistics, Georgia ranks near the bottom of the FSU in terms of per-capita income - with an estimated US$1634 in 1991 Georgia ranked higher than only Kyrgyzstan, Uzbekistan and Tadjikistan among the fifteen FSU republics. In 1992, Georgia remains among the poorest of the FSU republics. Recent Economic Developments 2. Living standards are being rapidly undermined by the economic crisis that Georgia has been experiencing for the last 18 months. To a large extent this reflects economic developments in other parts of the FSU. The contraction in economic activity and the acceleration in inflation was more a reflection of the progressive break-down of the existing economic system rather than the result of systemic refonns. The restructuring of the economy along lines of comparative advantage is yet to occur. 3. Net material product (NMP) declined by a cumulative total of 40 percentage points during 1990-91, and fell by an additional 46 percent during 1992. Prices that were more or less stable until 1990 have risen steeply since, increasing by more than 1500 percent on an end-year basis in 1992. Living standards are being further eroded because the shortfall in budgetary revenues has forced the government to cut public expenditures on social programs. More than 116,000 persons (5.4 percent of labor force) are unemployed. 4. Georgia is particularly vulnerable to developments in Russia since their economies are closely inter-related. More than 67 percent of Georgia's exports went to Russia in 1991, and 60 percent of its imports came from Russia. Georgia depends heavily on imports from Russia for its energy needs: until this year, virtually all crude oil and natural gas consumption was imported from Russia. Not surprisingly, as the Russian economy contracted, so did Georgia's. The disruption of inter-regional trade in 1991-92, and the continuing political turmoil and civil strife in some parts of the country aggravated these negative trends. 5. Inflation in Georgia also followed trends elsewhere in the region. In 1991 it reflected the excess demand fueled by the monetary overhang that characterized the Soviet economy prior to its dissolution. Thereafter, the increase in prices reflected both a one-shot increase due to the liberalization of most prices in February 1992, and the continuing pressure on demand due to the widening budget deficit and rapid credit expansion, especially in the second half of 1992. The lack of confidence in the ruble added to demand pressures as enterprises and households preferred to spend their money on goods rather than hold it.  ii Medium Term Prospects 6. In the next two years, Georgia can only moderate the decline in economic activity. Thereafter, with the right policies and with adequate financial and technical support from the international financial community, the prospects for growth are favorable. 7. In the near term, the prospects for the Georgian economy are tied closely to Russia's: the linhges in production and demand are simply too strong to be severed quickly without serious damage to the Georgian economy. Since economic activity in Russia is expected to contract further at least until 1994, for this reason alone it is difficult to immediately reverse the decline in economic activity in Georgia. Moreover, as noted earlier, ecowmic restructuring has yet to begin. Experience elsewhere has shown that initially restructuring inevitably results in a contraction in total output: the downsizing of the predominant state sector is not immediately compensated by the growth of the private sector. Thus it is only in 1995 that positive growth may be achieved. 8. Thereafter, the outlook for the economy is favorable if systemic market oriented reforms are implemented. Georgia has a tradition of entrepreneurship which should serve it well as the economy is unshackled from government controls. It has a potentially strong agriculture where privatization has already had a significant impact on productivity. The service sector can also be expected to respond strongly to the liberalization of the economy. A leaner industrial sector, restructured along lines of comparative advantage and increasingly under private ownership will also contribute to growth in the medium term. With the right policies and adequate financial and technical assistance from the international financial community, Georgia can register growth in the order of 5-6 percent per year during 1995-2003. The Macroeconomic Poilcy Framework 9. Macroeconomic stability is essential for sustained economic recovery. Without it, investor confidence will be lacking. And unless the steady decline in the rate of investment of recent years is reversed, prospects of growth will be limited. Financing the higher rate of investment will require policies to increase the rate of public and private savings. Implementation of a stabilization program, including tight fiscal and credit policies, and complemented by an incomes policy to restrain the growth of wages in the state sector will be essential. These policies, together with adequate external financing will provide the resources necessary for efficient investment. 10. However, stabilization cannot be sustained unless domestic demand management policies are complemented by systemic reforms that increase the efficiency of resource allocation and minimize the contractionary effects on output of demand management policies. Policies that facilitate and promote inter-regional and international trade are particularly important. Reforms that increase competitiveness and productivity are also necessary if Georgia is to promote its exports, which must provide the main impetus to growth for a small economy such as Georgia. (I) Stabilization Polcies 11. In view of the continuing instability of the ruble, and the shortages of ruble bank notes that made timely payment of wages and salaries difficult, the government has taken the decision to  iii introduce its own currency (called the Lari). As an interim measure, till adequate preparations are completed to introduce the new currency, coupons were introduced on April 5, 1993. 12. With the imminent introduction of a new currency, inflation in Georgia will no longer be hostage to imprudent macroeconomic policies in Russia or elsewhere in the ruble zone. However, a new currency per se will not be sufficient to combat inflation. What is important is that adequate policy instruments and institutions to implement prudent macroeconomic policies be in place when the new currency is put in circulation. 13. In order to reduce inflation, a substantial reduction in the budget deficit will be required. In 1992, the primary budget deficit increased to almost 35 percent of GDP, and economic restructuring will only increase the pressure on the budget to finance new needs (for example, additional unemployment, re-capitalization of banks). As experience in other countries has shown, a significant reduction in fiscal imbalances is a necessary element in any successful stabilization episode. The government should aim at balancing the budget in the medium term, starting with a significant initial reduction in the deficit in 1993. This will require policies to increase revenues, but it will also entail cutting all but the most essential public expenditures. 14. A number of recommendations have been made to mobilize tax revenues. Essentially, these aim at widening the tax base, limiting exemptions and tax holidays, increasing certain tax rates and introducing some new taxes and excises. In addition, measures will be required to strengthen the tax collection and customs administration, especially to cover private business activity and trade that are likely to be the main source of growth in the near future. The progressive liberalization of the economy will also encourage the hitherto under-ground economy to surface, thus increasing the tax base. With respect to expenditures, these were cut sharply in the first half of 1992. However, there is scope for further reductions. Consumer subsidies on food, energy and passenger transport, and rents should be progressively eliminated. Expenditures on various social programs such as pensions, family allowances, unemployment compensation, poverty alleviation can be reduced through better targeting and by reducing the level of some of the benefits. Public investments in the productive branches have also been cut back, although there may be scope for further rationalization. 15. Even with the best expenditure reduction efforts, the fiscal deficit will remain for the next few years. Increased efforts should be made to finance the deficit by borrowing from the public, say by offering bonds carrying remunerative interest rates. Financing the deficit by credit creation would only increase the pressure on prices and slow down economic recovery. 16. An incomes policy to restrain the growth of wages in the transition period may also be necessary. In the absence of clear ownership rights and 'real' owners, there is no countervailing influence to discipline the wage demands of workers in state enterprises. The growth in wages could outstrip the growth in labor productivity, once again weakening competitiveness. An explicit incomes policy which discourages the excessive growth of wages may be required in the transition until financial discipline is established through privatization and commercialization of state enterprises. (II) Systemic Reforms 17. Important systemic reforms to increase productivity and to lay the foundations of a market based economy must be implemented as part of a comprehensive package. Implementing some and not  iv others will not be effective. The government's 'Medium Term Program of Macroeconomic Stabilization and Systemic Change in the Republic of Georgia' presents some of the important reforms the government intends to implement in the next 18 months. These reforms include first, measures to progressively liberalize markets for goods and factors of production and thereby reduce government interventions in resource allocation. Continued government intervention in setting prices or limiting profit margins, controlling imports, and directing credits will only perpeuate mis-allocation of resources. Second, systemic reforms are required to encourage and enable enterprises, banks and households to respond flexibly and efficiently to market signals and opportunities. Changes in the ownership and management structure in enterprises and banks is a key aspect of these reforms. In their absence, there is no assurance that agents will not react perversely to market signals. And finally, reforms are necessary to provide an affordable social safety net for those that are poor and for those hurt by the transition. For if this is not in place, the sustainability of reforms could be jeopardized. These three broad areas constitute the agenda for reform. The report addresses the main policy issues in each of these areas and identifies concrete measures that could be implemented in the short and medium term. 18. As will be seen, the task is enormous. Yet, as in the other countries of the FSU, the capacity to design and implement reforms is limited. Even with the best of technical assistance and training, the pace and breadth of reforms will be constrained by the absorptive capacity of implementing agencies. Thus it is important to define priorities clearly, and to design reforms so that they are relatively easy to implement. At this stage, simplicity in design should take precedence over complicated and sophisticated approaches. For this reason as well, reforms that call for the withdrawal of the state from economic activity must have priority. 19. A second criteria for choosing priorities, and sequencing, must be whether or not (and how seriously) the proposed reform strengthens or weakens the fiscal balance. As argued earlier, achieving macroeconomic stability is critical and the reduction of fiscal imbalances is a key to achieving this objective. Reforms that increase tax revenues, or reduce claims on government resources, should have priority, at least in the short term. 20. A third criteria should be whether or not the reforms seek to harness the latent entrepreneurial talent of the Georgian people. There is some evidence suggesting the likelihood of considerable, and thriving, unreported economic activity. Bringing this sector into the mainstream of economic activity, and fostering its growth, is likely to have a strong ripple effect throughout the economy. Policies that promote this end, including in particular measures that reduce government intervention in economic activity, should be accorded priority. Policies to Intensify Competition 21. The government has already taken the first major step towards liberalizing the economy by freeing most retail prices. It should move quickly to eliminate price controls on some of the other commodities. Forces of competition should be strengthened by eliminating barriers to trade, domestic and foreign, and by facilitating entry of new enterprises. Measures to facilitate inter-regional trade, such as a clearing union, could be useful during the transition period. 22. Prices of only a few basic foods, public utilities and rent are controlled by the government. Rightly, the government has also moved to remove barriers to trade in commodity markets, including limits on profit margins in trade. However, competition is still limited and additional measures  v will be required. These include eliminating barriers to competition from imports, and deregulation policies to encourage entry of new enterprises. A state-supervised policy of soliciting competitive bids for the distribution of commodities to the market may also be desirable to promote competition in the transition. 23. Prices that remain administered have been raised several fold since January 1992. However, at the current exchange rate, they still remain below world prices. Of special importance are energy prices. Some energy prices have been liberalized (gasoline, diesel oil, and crude oil). However, others remain administered. The bulk of energy consumed in Georgia is imported, and even with the recent increases in domestic energy prices, they sell at substantially below the import costs. Notwithstanding adjustments in the exchange rate, further increases in energy prices are likely to be required not only to economize on the use of energy (energy intensity is high in Georgia), but also to ease the pressure on the budget. With some import prices still below world prices, further increases in domestic energy prices cannot be avoided. 24. For a small economy like Georgia, intenational trade provides a potent stimulus for competition. While the import regime is already quite free, exports are restricted through a pervasive licensing system. This should be substantially eliminated. 25. An even bigger problem in the short to medium term is to prevent a further collapse of inter-regional trade. The continuing uncertainty about the currency regime in Georgia and elsewhere in the region, together with the uncertainty about the value of the ruble, is forcing countries to shift increasingly to barter trade, or to balance trade bilaterally. This will only further shrink the volume of trade, with adverse impact on production and welfare throughout the region. In these circumstances, a clearing union providing short-term credit and having relatively short settlement periods may help preserve inter-regional trade. Enterprise Reform 26. Reforms that expose the economy to competition and market forces are important but are not sufficient to improve the efficiency in resource allocation. Liberalization does not, by itself, provide the structures that are part and parcel of the checks and balances inherent to a well-functioning market economy (e.g., atomistic markets, property rights, binding contracts, public regulations etc). Without these structures, incentives may operate in perverse ways - to the detriment of efficiency. Creating the legal and institutional structures that go with a market economy must be on top of the government's priorities. 27. One of the most fundamental issue to be resolved is the question of property rights. While it is probably possible to run a clear cut state enterprise or a private firm efficiently, it is not possible to get anything like efficiency from an enterprise whose current and future ownership status are in limbo. Thus it is important, first, to identify as quickly as possible those activities and enterprises that are to be privatized, and those that will remain under state ownership even in the long term. Second, it is important to identify the 'real" owner right away, and eliminate any ambiguity about who the owner is. Without clearly defined ownership rights, and legally recognized owners with an interest in the long term preservation and appreciation of the enterprises' capital, there is no discipline on enterprise managers, and little incentive for them to improve productivity. Privatization of state enterprises, whereby ownership of assets is transferred to clearly identified owners, is therefore of critical importance.  vi How to accelerate privatization while maintaining transparency of the process becomes an immediate policy issue. 28. In contrast to many other countries of the FSU, Georgia has already successfully privatized most of public housing. It has also privatized more than 50 percent of agricultural land. In mid-August 1992 the government adopted the first State Program of Privatization of State and Municipality Owned Enterprises for 1992-93. It defines the government's strategy for privatization, the scope of privatization, and institutional arrangements to implement the program. Except for water and forestry resources and certain public utilities (such as large power plants, pipelines, and the metro), virtually everything else is to be privatized over time. The government also approved the first list of 752 enterprises and assets that are to be sold by mid-1993. These include enterprises of different sizes. However little progress has been achieved to date in the privatization of small or large enterprises. The first small scale auction was held in Tbilisi in early March but this involved only the sale of cars and trucks. Auctions of small shops, catering services and unfinished construction projects in Tbilisi are to begin in the first half of 1993. 29. Rightly, the government intends to adopt a flexible and pragmatic strategy, combining a top-down and a bottom-up approach. Simple, pragmatic and flexible approaches should be preferred to sophisticated first best solutions. Speed is important. The decentralized, bottom-up approach, where privatization is initiated by the workers, managers, or a potential buyer, is especially appropriate given the limited implementation capacity of the official agencies. However, it is important that there be transparent rules and regulations governing the process. Otherwise, as experience elsewhere has shown, there is a danger that accelerated privatization schemes result in abuse and asset stripping (as happened in Poland and Hungary in the early stages of spontaneous privatization). 30. The government is considering a voucher scheme to accelerate the privatization of medium and large state enterprises and to ensure widespread ownership. The goal is to distribute the first tranche of vouchers in 1993. Initially, enterprises with an estimated book value greater than Rbl 20 million will be transformed into joint stock companies and partially privatized through the distribution of vouchers. 31. Preparatory work and important policy decisions with regard to the implementation of the voucher scheme are yet to be fmalized. Any scheme should take account of the following considerations. First, the scheme should be simple. Complex share distribution schemes should be avoided in favor of distributing the vouchers free to the population. Second, the objective of achieving widespread ownership should be balanced with the need to provide effective ownership control. Only a limited portion (say 30 percent) of the total assets should be distributed through the voucher scheme. For the same reason, not more than say 20 percent of assets should be distributed to employees. Further, the voucher scheme should be designed to allow sales to controlling shareholders. In particular, it would be desirable that vouchers be tradable, thus permitting consolidation of ownership. In order to reduce the inflationary impact of tradable vouchers, these may be issued in tranches that are tradable for a limited duration only. 32. As experience in Poland, Hungary and Czechoslovakia has shown, even the best of privatization takes time, and there are certain activities that are unlikely to be privatized even in the long term (for example, public utilities). For these activities, alternative governance structures must be created that work within the existing state ownership but make management and workers sensitive to long-term profitability considerations. One solution which is being increasingly adopted in other countries is  vii commercialization of enterprises. The government's strategy recognizes the importance of corporatization, but the process of corporatization is not well defined nor is it indicated which companies will be transformed and the criteria for transformation. In order to accelerate corporatization, it is desirable that the government adopt a decree on the immediate transformation of all enterprises employing, for example, more than 150-200 people into joint stock companies. The state would exercise its ownership rights in the transformed joint stock companies through company boards. For this to work, however, there ought to be significant incentive for managers and directors to manage the enterprise well. 33. Financial discipline will have to be tightened if enterprise managers and workers are to be sensitive to market signals. Subsidies to loss-making activities, financed through the budget or through the financial system, will have to be progressively reduced. To the extent subsidies are provided during a transition period, these should be done through the budget, which is transparent, rather than through the financial system. These subsidies should be eliminated over time, as part of an overall restructuring plan for these enterprises. The closure of a few obviously loss-making activities may be necessary. 34. While the state enterprises will continue to dominate the productive branches in the short to medium term, the main source of growth during this period will be the small but dynamic private sector. The enactment of new legislation on the creation and transfer of property rights and on contract law, as well as their enforcement, is essential to the development of the private sector. Other measures may also be required. Macroeconomic stabilization, the liberalization of prices and trade, the reform of the financial sector, and the elimination of support to the state enterprise sector will also facilitate the growth of the private sector. Financial Sector Reforms 35. An efficient financial system is necessary to mobilize financial saving of the population and channel it to efficient investors. Currently, the banking system is not performing either of these functions adequately. Financial institutions offer little incentive to saving. And a large part of financial savings of the population is being directed to particular activities by the state without regard to the profitability of the investments. 36. Savings deposits in banks are shrinking in nominal and real terms. This is not surprising: interest rates on savings deposits are too low. There is little incentive for banks to raise these rates as long as they have access to low cost refinancing credits from the NBG. Thus, interest rates on refinancing credits from the NBG should be raised to at least the maximum deposit interest rate. Interest rates on household deposits with the savings bank should also be increased. But raising interest rates may not be sufficient to promote savings in banks. To increase public confidence in the banking system it may be necessary to eliminate the limits on withdrawal of savings deposits. 37. Most of the credit expansion in 1992 by the major banks was based on refinance credits from the NBG. These were used to finance priority projects chosen by the NBG based on recommendations of the government. Directed credits are not consistent with a decentralized, market based financial system. Their use should be phased out, and banks should be encouraged to obtain resources from the inter-bank market. Access to refinance credits should be based on clear criteria (such as the capital of the bank). It should not distinguish between different activities.  viii 38. Banks are burdened by a large portfolio of non-performing loans. This is partly due to the loss of certain assets resulting from the break-up of the FSU. Partly it is caused by the policy of the government which directed the banks to lend to clients that were not creditworthy. The burden of non- performing loans is only likely to worsen as interest rates rise and enterprise restructuring gets underway. Non-performing loans skew the lending decisions of banks towards high risk (but high return) investments. Unless prudential regulations are strong, there is a risk of financial instability. This risk is even greater given the incestuous relationship between banks and enterprises. Banks are largely owned by enterprises that are also its major clients, which makes objective portfolio decision-making difficult. 39. Prudential regulations, and the capacity to supervise banks effectively, need to be strengthened urgently. To reduce risks, it would be desirable to lower the maximum amount of credit any one client can get from 50 percent of the paid in capital to 15-20 percent. Currently, prudential regulations do not apply to state banks which dominate the financial system. An action plan to force state banks to comply with prudential regulations should be adopted. The licensing requirements for new banks should be tightened by increasing the minimum capital requirement, by lowering the maximum individual shareholding limit, and by raising financial and managerial standards for founders. In the short term, problem banks should be downsized. Over the medium term, the problem of non-performing loans would need to be addressed through recapitalization, in the context of the restructuring and privatization of banks. Reform of the Social Safety Net 40. The restructuring of the economy will cause hardship for the population during the transition. Unemployment will rise significantly, real wages are bound to fall, and the cuts in consumer subsidies will increase the cost of living. Unless these adverse consequences are managed carefully, social support for the reform process will be jeopardized. However, resources are scarce. Tax rates are already quite high and increasing these further can only hurt Georgian competitiveness at a time when export competitiveness is essential. Increasing taxes will also prevent the underground economy from surfacing, which should be an important objective of reforms. Moreover, increasing the rates may not mean much anyway if tax collection does not improve. On the other hand, the scope for deficit financing is also limited given the necessity of stabilizing inflation. Thus there is no option but to economize on social spending by targeting these to the most needy, and by reducing the level of some of the existing benefits. The report recommends concrete ways in which savings can be achieved in each of the main social programs: pensions and family allowances, sick pay, and unemployment compensation. Roughly, total spending on these programs was equivalent to 12-13 percent of GDP. 41. Expenditures on pensions can be reduced by reducing payments to working pensioners and by tightening the eligibility criteria for obtaining disability pensions. These two categories of pensioners are very large in Georgia compared to other countries. A gradual increase in the retirement age of men (from 60 to 62 years) and for women (from 55 to 62 years) may also be desirable. Sick leave benefits are also generous: 100 percent of the wage for up to 5 months of leave for all those with 8 years seniority. The level of the benefit should be reduced to say 80 percent of the wage and the number of days reduced (the average number of days of sick leave in most economies is 15-20 per year). Also, to reduce the scope for abuse, enterprises should bear the cost of at least the first week of sick leave. 42. By end 1992, about 116,000 persons (5.4 percent of labor force) were unemployed, though only 10.5 percent of the unemployed workers received unemployment benefits. Entitlements are  ix relatively generous: they imply an average replacement rate (benefits as a share of previous wage) of 65 percent which is in the upper ranges of the ratio in eastern and western Europe. If restructuring occurs at about the pace at which it did in some of the East European economies during 1990-91 (for example Poland, Czechoslovakia), the rate of unemployment (and those eligible for benefits) could rise very quickly to at least 8 percent (12-13 percent in Slovakia). If this happens, the existing payroll tax of 3 percent will be insufficient to finance the existing level of unemployment compensation. Either the payroll tax would have to be increased, or present entitlements reduced substantially. A combination of reduction in present levels of unemployment entitlements (so as to reduce the replacement rate to about 50 percent), plus the savings generated from reforms in pensions, sick pay etc. would permit financing of unemployment benefits without raising the payroll tax. One way to reduce present entitlements would be to lower the benefits during the first three months of unemployment from the present level of 100 percent of the previous wage to, for example, 70 percent. Unemployment benefits for people released from jails, the Army, and new job entrants should also be eliminated. 43. While these proposals are likely to be sufficient to ensure that the increased claims for unemployment compensation can be met without raising taxes, they will not be adequate to provide funds for any kind of universal welfare scheme. The poverty gap is likely to be too large. The best that can be expected in the short term is continued recourse to foreign funding and some ad-hoc help to the most destitute along the lines of what already exists (help for refugees, food aid). In order to deliver such help more effectively, a denser network of local (community-based) institutions should be developed. However, if a more universal welfare system is desired, the only alternative is a substantial increase in the already-high taxation. External Financing Requirements 44. Economic recovery will depend on the implementation of the stabilization policies and structural reforms outlined above. However, it will also require external financial and technical assistance. Without such support, as mentioned above, the drop in living standards is likely to be too steep, which could jeopardize social support for the reform program. External financial assistance will also be needed to finance critical imports for production as well as technical assistance in designing and implementing the transition to a market economy. 45. Conservatively, it is estimated Georgia will require about $250-350 million per year during 1993-95. This assumes Georgia will not have to service any of its share of FSU debt during the period. Almost all of this foreign assistance must most likely come from official bilateral and multilateral sources. Over time, as macroeconomic stability is ensured and structural reforms take hold, it may be expected that commercial sources of financing will increase their exposure. Given the uncertainties underlying the medium term, creditworthiness assessments are fraught with pitfalls. What is clear, however, is that Georgia presently faces a serious economic crisis. To weather this successfully, external technical and financial assistance in the short term must contain a substantial grant element. 46. To facilitate the flow of foreign aid, and to use it effectively, the government will need to develop adequate institutional capacity. This will involve establishing a capacity to define priorities for external financial and technical assistance; identifying alternative sources for assistance; coordinating the activities of different donors; managing external debt; and maintaining a close link between economic policy management and external financing needs.  I  PART I THE IMPERATIVE OF MACROECONOMIC STABILIZATION The collapse of the Soviet Union in late 1991 and the attendant disruption in institutions that managed the economy till then has forced the Georgian economy into a tailspin. Output contracted by a cumulative 40 percent during 1990 and 1991 and NMP declined by another 45-46 percent in 1992. Inflation accelerated to more than 1500 percent by end-1992. It is in these difficult conditions that Georgia is attempting to establish the foundations of a market economy. The task is especially daunting because Georgia starts the transformation virtually from scratch: existing institutions are ill-suited to a market based economy, and there is a dearth of people who know and understand how the transition to a market economy is to be managed. Yet, unlike many of the other countries of the FSU, Georgia has a long tradition of entrepreneurship which should serve it well during the transition (Chapter 1). As described in Chapter 2, the medium term prospects for the economy are good, based on robust growth in exports. There is a solid potential in agriculture, and services (including tourism) are likely to develop strongly. With appropriate macroeconomic stabilization policies and structural reforms, this potential can be achieved. However, in the short term the decline in output can only be moderated, not reversed. And macroeconomic stabilization policies will be essential to decelerate the rate of inflation. This will require maintaining tight fiscal, credit and incomes policies (Chapter 3). Georgia will require considerable external financial assistance, with a substantial degree of concessionality, at least initially, if it is to successfully manage the transition. This is needed to help cushion the decline in private consumption and to raise the rate of investment. Already, living standards have fallen steeply making Georgia one of the poorer countries of the FSU. And the future growth of the economy is being jeopardized by the continuing cuts in public and private investment. Concessional external assistance can help reverse these trends and thus sustain the transition during a difficult period.  I  GEORGIA CHAPTER 1 THE ORIGINS OF THE CRISIS Background 1. Georgia is a relatively small country with a population of 5.4 million. Covering an area of 70,000 square kilometers, it is situated in the southern part of the Caucasus region, bordered by Turkey and Armenia to the southwest, Azerbaijan to the southeast, and Russia on the north. The Black sea borders Georgia on the west.' 2. Georgia's per capita income is estimated at $1634 in 1991, which places it among the poorer republics of the former Soviet Union (FSU).2 However, other indicators of living standards belie this assessment: life expectancy at birth is the highest among the republics, and infant mortality is below the FSU average, as is the crude death rate. Despite a high population density, Georgia has a stock of housing per capita that is unrivaled outside the Baltic states (see Table 1.1. Volume 2!. One explanation for this puzzle may be the existence of a thriving underground economy. Georgia has a long history of non-official market transactions and the existence of a relatively prosperous under-ground economy, not captured by official statistics, is consistent with the observed standard of living. 3 . Agriculture is relatively more important in the Georgian economy than in other economies of the FSU. It accounted for about 29 percent of Net Material Product (NMP) in 1992, while industry contributed another 34 percent.? The rest of NMP was divided between transport and communication (21 percent), construction (8 percent), trade and catering (2 percent) and others. Georgia produced almost the entire citrus fruits and tea crops of the FSU, and a disproportionately large share of grapes. While industry has a substantial agro-industrial base, Georgia was also a relatively large producer of steel pipes, AC electric motors, synthetic fibers, roofing material, textiles and shoes. There is significant private sector activity in agriculture and already more than 50 percent of agricultural land is privately owned. Industry is almost entirely state-owned. 4. External trade, largely with the republics of the FSU, plays a big role in the economy. Total external trade (the average of imports and exports) amounted to almost 43 percent of GDP in 1988- 90, of which inter-republican trade was as much as 37 percent of GDP.4 Georgia relies heavily on imports of energy from other republics, notably Russia (for electricity, crude oil) and Turkmenistan (natural gas). Imported energy amounted to about 80 percent of total energy supply in 1990. Wheat, sugar and some heavy machinery are the other major imports. Georgia's main exports include citrus, tea, tobacco, wine and mineral water. By far the biggest trading partner is Russia. Georgia was a net beneficiary in trade with the rest of the FSU primarily due to the subsidization of energy imports. 5. Traditionally, Georgia has recorded a trade surplus with the republics and a deficit with the rest of the world. However, because energy imports from Russia were under-priced, trade with the republics would also very likely have been in deficit if it were valued at international prices.5 Recent Economic Developments 6. Recent macroeconomic developments reflect both trends that are common to the other republics of the FSU (especially Russia) as well as the peculiarities of the Georgian experience. All the  -3- countries of the FSU experienced a sharp contraction in output during 1990-92 as well as accelerating inflation. So has Georgia. The shrinking of inter-regional trade has affected not only Georgia but every other republic of the FSU. And Georgia suffers from the same shortage of ruble banknotes as do the other countries in the region. 7. On the other hand, recent developments were influenced by factors specific to Georgia. First, there is probably more of an underground economy in Georgia than in other republics (Box 1.1). The existence of the underground economy, and its apparent growth in recent years, may have helped cushion the impact of the collapse of the official economy. And the traditional entrepreneurial skills provide Georgia a distinct advantage over many of the other countries in the region in their transition to a market economy. Second, Georgia suffered more than other republics because it was the first to break away from the Soviet Union, which led to harsh retaliation in the form of limitations on trade of critical imports. Third, given Georgia's relatively small size, and its greater dependence on trade, the breakdown of trade that occurred in 1991-92 affected Georgia relatively more strongly. Trends in Russia are likely to be magnified in Georgia: just as economic contraction will be more severe than in Russia, economic recovery will be quicker as well. And finally, unlike most of the other republics Georgia suffered from natural disasters and civil disturbances in 1991-92. Output 8. Afteralongperiodof GDP GROWTH In Russia and Georgia sustained growth during the seventies | and until the mid-eighties, production in Georgia has been steadily declining since 1989. NMP fell in 1990 and 1991 by a cumulative total of almost 40 percent. The decline in economic * -4 7 activity accelerated in 1992, when - NM,P fell by 46 percent. Industrial k production is estimated to have fallen by more than 46 percent in 1992 and agricultural production by more than 30 percent. The decline in . . production was pretty much across . . . im . _ . the board. (see Table 7.1. Volume a F. 4 el. Fgwure 1.1 9. This decline was caused by several factors. First, to a large extent the decline in Georgia mirrors the decline in economic activity in Russia (Figure 1.1). After stagnating in 1990, GDP in Russia fell by 9 percent in 1991 and by a further 15 percent during 1992. Georgia depends on Russia for supplies of critical inputs in production (such as energy) as well as a source of demand for its products.' Second, there was a precipitous decline of inter-regional trade, caused partly by the general disarray in the Soviet Union during 1990-91, but also by the blockage of Georgia after independence in 1991 and continuing strained relations with Russia. Imports of critical imports, especially oil and natural gas from Russia were cut sharply, affecting majority of industry, agriculture and transport.7 Third, Georgia experienced a deterioration in its terms of trade as prices of critical inputs (energy, fertilization, ores) that Georgia imported from Russia increased sharply.'  -4 - 10. The collapse of output was also caused by factors specific to Georgia. First, the earthquake in April 1991 caused extensive damage to infrastructure and had an adverse impact on production (particularly agriculture). Second, severe shortages of energy developed towards the end of 1991 because of the harsh winter (which increased demand and reduced hydroelectric production), disruption of some imports (because of the conflict between Armenia and Azerbaijan), and the difficulties of concluding inter-state agreements on energy imports because of sharply increased prices. Finally, the political tensions and civil strife in parts of Georgia contributed to the loss in production.9 Inflation 11. As in the other parts of the FSU, in Georgia too price stability was maintained until 1990. But with the collapse of the system in 1991, inflation accelerated sharply. The retail sales deflator rose by 78.5 percent during 1991 (up from 4.8 percent during 1990). Indeed, comparing the fourth quarter of 1991 with the same period of 1990, the index rose by 128 percent. Inflation continued to accelerate in 1992, especially during the second half. While the average yearly increase in the retail price index was about 913 percent, prices rose 36 percent in December alone. 12. The acceleration of inflation can be attributed to the continuing contraction in supply on the one hand and the release of pent up demand pressures on the other. On the supply side, there was not only a sharp contraction in real output in 1991 (NMP fell by 28 percent), but also a significant reduction in net imports (from Rbl 864 million in 1990 to only Rbl 36 million in 1991, in current prices). These combined to reduce domestic availability of goods.'