Georgia - Rehabilitation Credit Project

Document of The World Bank FOR OmCI USIE ONLY Repoct Ne. P-6538-GE REPORT AND RECONMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT IN AN AMIOUNT OF SDR 51.0 MILLION TO THE REPUBLIC OF GEORGIA MARCH 7, 1995 FILE COPY 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.  GEORGIA - REHABILITATION CREDIT Currency Equivalents Currency unit = Coupons US$1.00 = 1,300,000 Coupons (February 14, 1995) Weights and Measures Metric System Abbreviations and Acronyms cIS Commonwealth of Independent States EU European Union ESW Economic and Sector Work FSU Former Soviet Union GDP Gross Domestic Product GNP Gross National Product IBC Institutional Building Credit IBRD International Bank for Reconstruction and Development ICB International Competitive Bidding IDA International Development Association IFC International Finance Corporation IMF International Monetary Fund MIGA Multilateral Investment Guarantee Agency MOF Ministry of Finance MPP Mass Privatization Program NBG National Bank of Georgia NMP Net Material Product PIU Project Implementation Unit SDR Special Drawing Rights SOE Statement of Expenditures SPM Ministry of State Property Management STF Systemic Transformation Facility TICEX Tbilisi Interbank Currency Exchange Government Fiscal Year January 1 - December 31  FOR OFFICIAL USE ONLY REPUBLIC OF GEORGIA - REHABILITATION CREDIT CREDIT AND PROGRANI SUlMlMARY Borrower: Republic of Georgia Amount: SDR 51 million (US$75 million equivalent) Terms: Standard IDA terms (thirty-five years to maturity, including ten years grace period) Objectives and Description: The main objective of the proposed credit is to support the Government's economic reform program aimed at restoring macroeconomic stability and at promoting the resumption of growth and improvement in living standards. The reform program comprises three sets of policies: (a) those aimed at reducing and redefining the role of the public sector in the economy; (b) those that foster the development and increased efficiency of markets; and (c) those that maintain a minimum social safety net through improved targeting of benefits. Among the key reforms are price and trade liberalization; phasing out of the state order system; restructuring of the Government sector; privatization and private sector development; and improved targeting of social benefits. The other objectives of the credit are to: (i) provide budgetary support to maintain the level of basic public expenditures, in particular for wages and the social safety net; (ii) provide foreign exchange for the purchase of critical imports; (iii) improve the functioning of the foreign exchange market; and (iv) provide a framework for financial assistance from other donor agencies. Poverty Category: Poverty focused. The proposed credit would support: (i) public sector reforms that reallocate public expenditures to ensure access to basic health and education services by the poor; and (ii) increases in cash transfers to the poorest groups (pensioners, children, unemployed, refugees and low-paid government sector employees) by redirecting resources saved through the elimination of generalized subsidies and improved targeting. Further reforms aim at further targeting of benefits and restructuring of the pension system to generate additional resources for protecting the poorest. Allowances have been made in the fiscal program to strengthen the social protection system. Benefits: Implementation of the proposed reforms will help to restore macroeconomic stability and to reverse the decline in economic activity, thus promoting employment in the private sector and improved living standards. This objective will also be served through the increased availability of foreign exchange for obtaining critical imports. Risks: The proposed credit faces four main risks. The first risk relates to possible slippage in implementation of reforms resulting from lack of continuous political support or from social tensions due to difficult living conditions This document has a restricted distribution and may be used by recipients only in the performance of their ofricial duties. Its contents may not otherwise be disclosed without World Bank authorization.  ii following the sharp price realignment. The lack of adequate and timely external assistance of the magnitude required could also lead to growing social tensions, by forcing a stronger domestic adjustment that would be socially hard to sustain. This risk will be mitigated by the Bank's financial support and by its efforts to mobilize external donor support and humanitarian aid. The second risk is that Georgia may be unable to reach agreements with its main creditors, Russia and Turkmenistan, leading to further disruption in energy supplies. This risk is being addressed by policies aimed at achieving full cost recovery in the energy sector, by the Government's commitment to avoid accumulating new arrears, and by bilateral negotiations underway to regularize previous arrears. Weak implementation capacity could also delay implementation and output recovery; this risk would be addressed through continuous technical support, in particular through the Institutional Building Credit. Finally, there is the risk that civil conflicts could resurface. However, it is expected that negotiations underway will lead to a lasting resolution of these conflicts, as well as to the return of refugees to Abkhazia. Rate of Return: Not applicable Appraisal Report: Not applicable Estimated Disbursement: The proceeds of the proposed credit would be disbursed in one tranche upon effectiveness. US$15 million (20 percent of the credit) could provide retroactive financing for eligible imports procured in the four months preceding the date of loan signing. Map: IBRD No. 25287. This report is based on a main mission which visited Georgia in October 1995, comprising Michelle Riboud (senior country economist and mission leader), Prabhat Garg (EC4C2), Judy O'Connor (EC4DR), Stuart Bell (PSD), Heidi Mattila (CFS), John Nash (IECIT), Marcelo Bueno (EC4PE), Michael Fuchs (EMTPS), Gary Burtless and Andre-Paul Weber (consultants). Basil Kavalsky is the Country Department Director and Wafik Grais is the Division Chief responsible for Georgia in the Europe and Central Asia Region. Documents were reviewed by Carlos Silva and Alberto Valdes. Nadia Pushkina, Rosario Hablero and Una Raymond provided secretarial support.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT TO THE REPUBLIC OF GEORGIA TABLE OF CONTENTS PART I. COUNTRY POLICIES AND WORLD BANK ASSISTANCE STRATEGY ... ..... 1 I. Recent Economic Developments .1 A. Background .1 B. Recent Economic Trends. 2 C. Status of Structural Reforms. 5 II. The Government's Economic Reform Program.. 6 A. Overview. 6 B. The Stabilization Program. 7 (i) Fiscal Policy 7. 7 (ii) Monetary Policy. 8 (iii) Public Sector Wages and Social Security Payments. 8 C. The Structural Reform Program. 8 (i) Reducing and Redefining the Role of the Public Sector. 9 (ii) Promoting the Development of Markets and Increasing their Efficiency .14 (iii) Ensuring a Minimum Level of Social Protection .19 III. Macroeconomic Prospects and External Financing Requirements . .22 A. Inflation and Output .22 B. The Fiscal Outlook .23 C. External Sector .24 D. External Debt and Financing Requirements .24 PART II. THE BANK GROUP'S ASSISTANCE STRATEGY ......... ............ 27 I. Background and Objectives .................................. 27 II. A Period of Conflict and Nation-Building ......................... 27 III. A New Relationship .......... ............................ 28 IV. The Lending Program ......... ............................ 29 V. Implications for World Bank Exposure ........................... 31 IV. Economic and Sector Work Program ............................ 32 VII. MIGA and IFC Activities ................................... 33 PART III. THE PROPOSED CREDIT ................. ................... 33 I. Background and Rationale for World Bank Involvement ................ 33 II. Program to be Supported ................................... 33 Ill. Project Implementation .................................... 35 IV. Procurement . .......................................... 36 V. Disbursement . .......................................... 37 VI. Reporting, Accounting, and Auditing ............................ 38 VI. Environmental Safety .......... ........................... 38 VIII. Agreements Reached .......... ............................ 38 IX. Benefits and Risks ........... ............................ 38  2 PART IV. RECOMMENDATION .................................... 39 ANNEX 1 Key Economic Indicators ANNEX 2 Rehabilitation Credit - Timetable of Key Events ANNEX 3 Letter of Development Policy ANNEX 4 Policy Matrix MAP  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED REHABILITATION CREDIT TO THE REPUBLIC OF GEORGIA 1. I submit for your approval the following report and recommendation on a proposed credit to the Republic of Georgia for SDR 51 million (the equivalent of US$75 million) to provide support for the Govermnent's economic reform program. The credit would be on standard IDA terms with a maturity of 35 years including a grace period of 10 years. 2. Georgia joined the IBRD in August 1992, MIGA in December 1992, and IDA in August 1993. It has not yet completed the membership process with IFC. The first Country Economic Memorandum entitled "Georgia, from Crisis to Recovery: A Blueprint for Reforms" (Report No. 11275-GE) was distributed to the Board in May 1993. An updated version of that report was made available to the general public in October 1993. PART I. COUNTRY POLICIES AND WORLD BANK ASSISTANCE STRATEGY I. Recent Economic Developments A. Background 3. Georgia was among the first Republics of the former Soviet Union (FSU) to declare independence, which occurred on April 9, 1991. It has a population of 5.4 million people in a geographical area of 70,000 square kilometers, bounded by the Black Sea, Russia, Azerbaijan, Armenia, and Turkey. At the time of its independence, Georgia appeared to be a relatively well-off republic with fairly good growth potential. Its sources of strength were its educated labor force', its long tradition of entrepreneurship, the existence of a significant underground economy, and non-negligible private sector activity in agriculture. Furthermore, the country's location made it a primary transit conduit for goods shipped elsewhere in the Caucasus. Industry accounted for 37 percent of the net material product (NMP), on average during 1989-91, and agriculture 33 percent. Agriculture was relatively more important in Georgia than in other FSU economies. In 1990, 96 percent of the country's exports were to other FSU republics, and imports from that region constituted 72 percent of its imports. 1/ The proportion of the Georgian population (aged 15 or more) with higher education was 17.5% in 1989, the highest proportion among FSU countries. This compares with 13.0% in Russia, 13.5% in the Baltics, and 12.5% for the Soviet Union overall.  2 4. Since independence, Georgia has suffered from intense civil conflict. Throughout 1992 and 1993, Government forces fought against supporters of former President Gamsakhurdia. During the same period, fighting over Abkhazia also continued. The conflict has resulted in a large influx of refugees (about 270,000) from Abkhazia to other parts of Georgia, worsening the economic plight of the country. Toward the end of 1993, the intensity of armed conflict abated and the Government achieved greater political control. A cease-fire is now in effect, and an agreement involving Russia and the United Nations has been signed to work out a peaceful resolution of the conflict. Georgia joined the Commonwealth of Independent States (CIS) and Russian peacekeeping forces are now in Abkhazia to work out the return of refugees to the province and to reopen the route to Russia. B. Recent Economic Trends 5. In recent years, the Georgian economy has been greatly affected by the disruption in payments and trade within the FSU, by large terms of trade shocks, and by output declines in Russia and elsewhere in the region. A self-imposed trade embargo following the declaration of independence, an earthquake in 1991 and most important of all, two years of civil conflicts, have imposed substantial additional economic and social costs. These factors, aggravated by the effects of increasingly loose financial policies, have resulted in the sharp economic decline and worsening of living conditions currently observed in Georgia. 6. Production has been declining since 1989; the contraction has, however, been particularly sharp since 1991. It is estimated that between 1989 and 1991, net material output (NMP) fell by a cumulative total of 30 percent. Further annual declines of over 40 percent and 32 percent are estimated for 1992 and 1993, respectively. For the whole period, the cumulative decline is about 75 percent, one of the sharpest declines observed among FSU countries. Available data for the first months of 1994 indicate further output contraction, although probably of lesser magnitude. As a result, GNP per capita, estimated at US$563 for 1993, is one of the lowest among FSU countries. 7. The contraction of output since 1991 has affected all sectors. Except for construction where the contraction was strongest, the industrial, agricultural and service sectors declined each by about 65 percent between 1991 and 1993. In 1993, economic activity in construction practically came to a stop while agricultural production fell by 42 percent, and industrial production by 21 percent. Only in the service sector was the decline relatively small in 1993, indicating that structural changes were already taking place in the economy. Official data do not, however, provide a complete picture of the economic situation. The informal economy - a long-standing feature of the Georgian economy - seems to have developed considerably, especially in the trade sector, but its activities remain largely unmccorded in the national accounts. The magnitude of economic decline may thus be overestimated. Still, indirect indicators such as energy consumption suggest that, even if the informal sector has developed rapidly, the overall decline in the economy has been substantial and most likely exceeds 50 percent for the whole period 1990-1993. 8. As a result of the sharp decline in output, the total number of people employed (about 2.7 million in 1990) has declined by almost 30 percent since 1990. Although private sector employment grew by 58 percent (and now represents 20 percent of total employment), its increase was not large enough to  3 compensate for the decline in the state sector2. Open unemployment, estimated at about 0.1 percent of the labor force at the beginning of 1992, rose to 8.4 percent by December 1993. In addition, hidden unemployment is significant: in 1993, one-fourth of state enterprises reported production stoppages. 9. External trade, largely with the states of the FSU, used to play a big role in the Georgian economy. Total external trade (average of imports and exports) amounted to almost 43 percent of GDP in 1988-90, with inter-republican trade accounting for as much as 37 percent. Georgia relied heavily on imports of energy from other republics, notably Russia (for electricity and 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 were the other major imports. Exports included citrus, tea, tobacco, wine, and mineral water. By far the biggest trading partner was Russia. 10. In 1991 and 1992, trade with the other FSU republics and the rest of the world collapsed. This was due to several factors, which include the self-imposed embargo on trade with other republics following the declaration of independence, the general breakdown of trade channels in the FSU, the disruption of transport routes due to the fighting in Abkhazia and Ossetia, the disruption of production from input shortages, and the disintegration of the state order system. Available evidence suggests that the volume of imports may have fallen by more than half from 1991 to 1992. Although the importance of oil and gas increased greatly to over 44 percent of total imports, energy shortages became acute, sharply affecting industry, agriculture and transportation. 11. There are indications3 that trade recovered somewhat in 1993 and 1994, with some re-orientation towards non-FSU countries and increased private sector participation. However, the -olume of net energy imports was further reduced as Georgia had to face an increase of more than 148 oercent in the unit cost of natural gas. Foreign exchange shortages, difficulties regarding payments arrangements and uncertainties about currency values have led to increasing reliance on bilateral agreements and barter trade. Approximately half of Georgia's trade is organized around these bilateral treaties. The trade balance, which registered a small deficit in 1991, deteriorated thereafter. This reflected both the collapse of exports and the deterioration in the terms of trade. The deficit amounted to about US$243 million in 1993, and an estimated US$334 in 1994. Increasingly, Georgia has accumulated arrears related to its energy imports. The total stock of arrears is estimated to have reached about US$370 million by the end of 1994. Most of these arrears are owed to Turkmenistan and Russia. 12. Until 1991, inflation was low in Georgia. Since then, however, inflation has surged. Prices rose, on average, by 80 percent in 1991 and by more than 900 percent in 1992. During the second half of 1993, the inflationary process accelerated sharply following the introduction of the new currency. By the end of 1993, the annual rate of inflation had reached 8,400 percent and was ten-times that of Russia. Inflation during the first months of 1994, with a monthly rate of about 60 percent, showed no sign of deceleration. While, in the early period, the surge in prices largely reflected price liberalization, the 2/ Private sector employment (like production) is most likely underestimated. The discrepancies observed between figures on job losses in the state sector (over 700,000 jobs since 1990) and on unemployment (about 180,000 at the end of 1993) suggest that employment may be growing rapidly in the underground economy. Some out-migration and reduction in the labor force may also have taken place. 3/ Statistical deficiencies prevent an accurate estimate of the increase.  4 recent acceleration can be directly associated with deterioration in the fiscal position of the government and domestic credit expansion. 13. Georgia's fiscal performance weakened considerably after 1992. The primary budget deficit rose from 3.7 percent of GDP in 1991 to about 31 percent in 1992 and 26 percent in 19934. While the whole deficit was financed through money creation in 1992, 80 percent of the 1993 deficit was financed through external loans and grants (e.g., loans from Turkmenistan for energy imports, loans from the EU and grants from the US for food). This change reflects the Government's growing difficulties in collecting revenues through inflationary finance, and its increased reliance on humanitarian aid for food, medicines, and support to refugees, as well as on external financing. 14. The deterioration of the fiscal stance resulted largely from shortfalls in revenues aused by the steep drop in production, the impact of inflation, and worsening tax collection. Reverue collection (excluding grants), which was around 30 percent of GDP in 1991, fell to 11 percent in 1992 and collapsed to about 3 percent in 1993. Available data for 1994 indicate a further drop in tax collection and an estimated deficit of about 32 percent of GDP for the first half of the year. On the expenditure side, the composition of government expenditures changed significantly: wages, expenditures on social programs, and capital expenditures have been drastically reduced. Subsidies (explicit and implicit) - the most significant being for electricity, gas, and bread - accounted for 70 percent of government spending during the first half of 1994. 15. In common with other countries belonging to the ruble zone, Georgia has experienced severe shortages of ruble banknotes. The Georgian coupon was introduced in April 1993 (at a conversion rate of 1 coupon per ruble) and it was proclaimed the sole legal tender in August 1993. As a result of an expansionary monetary policy and of the rapid inflation that followed, the exchange rate of the coupon depreciated steadily vis-a-vis the Russian ruble from 5.5:1 in August 1993 to 1,030:1 by August 1994; and vis-a-vis the US dollar from 5,600:1 to 2,400,000:1. Implementation of the first stabilization measures in September 1994 halted the depreciation of the coupon and reversed trends: as of February, the exchange rate was 1,300,000 coupons per US dollar. Price developments during the second half of 1993 have also led to substantial currency substitution. Both rubles and dollars are extensively used as units of account, payment for transactions, and stores of value. This has reduced the demand for domestic currency to a bare minimum, making the inflationary effects of deficit financing via money creation even greater. 16. With the continuous deterioration of the economic situation over the last five years, the living standards of the majority of the population have declined sharply, especially since the end of 1991. Unemployment, almost negligible at the beginning of 1992, reached 8.4 percent of the labor force by December 1993 (see para. 8). The drop in early 1994 in the number of persons registered "with the status of unemployed" was mainly due to the rapid decline in the value of unemployment benefits rather than to an improvement in the employment situation. Real wages, which remained practically constant in 1991, declined by about 90 percent over the course of the last two years. Families now spend on average about 80 percent of their reported income on food and must rely to a large extent on informal sector activities, sales of personal effects and assets, or remittances from abroad to cover their basic 4/ The 1993 deficit is estimated taking into account grants and implicit subsidies financed by external loans.  5 expenditures. In addition, rationing of electricity, lack of heating during the winter, and cuts in public transportation are imposing considerable hardship on the population. 17. The Government's capacity to finance social programs and guarantee an adequate safety net has also declined sharply. Expenditures on health and education declined from 11 percent of GDP to 2 percent in 1993, and there is already evidence that both maternal and infant mortality are increasing. Expenditures on pensions and family allowances do not exceed 1 percent of GDP, although pensioners represent one-fifth of the population. The number of persons receiving unemployment benefits is small and declining, although unemployment is rising. Cash and in-kind assistance is provided to the 270,000 refugees from Abkhazia, and is mostly financed with humanitarian aid provided by foreign donors. C. Status of Structural Reforms 18. In spite of the many difficulties, Georgia has already made progress over the past few years in implementing structural reforms aimed at reducing the role of the Government in the economy and at creating a market environment. In contrast with many other FSU countries which chose the opposite path, Georgia made progress on structural reforms but lagged behind on macroeconomic stabilization. The areas in which progress has been achieved include domestic pricing, international trade, exchange rate policy, and private sector development. 19. Domestic Pricing. Until the beginning of 1992, all prices were regulated although there were parallel or bazaar markets for many goods. As a first step, prices for a large number of commodities were liberalized in February 1992. A second round of liberalization was implemented in July 1992. Barriers to participation in commodity markets and restrictions on trade among citizens were removed during the same year. Consequently, prices that remained under government control as of mid- 1 994 were those of bread, medicines, municipal services, energy products (coal, gas and electricity), public transportation, and communications. 20. International Trade and Foreign Exchange Regime. Although significant export restrictions and an export tax of 8 percent (scheduled to be eliminated) still prevail, Georgia has adopted an open import regime since 1992. There are no restrictions on imports from any part of the world. Only a 2 percent uniform customs duty applies to imports from outside the CIS. This duty is scheduled to be raised to 12 percent under the stabilization program (see para. 30). Regarding the foreign exchange regime, the Georgian authorities have been committed since 1992 to a unified, market-determined exchange rate, which is set in weekly foreign exchange auctions run by the National Bank of Georgia (NBG). 21. Privatization. Before the breakup of the Soviet Union, Georgia was ahead of other FSU republics in the area of privatization. Ninety-five percent of rural housing was already private and, as early as 1987, privatization of small residential houses was made possible. In the agriculture sector, although only 6.5 percent of cultivated land was private, almost one-third of labor (about 8 percent of total employment in the country) was working on private plots. In addition, the informal economy already provided opportunities for private sector activities (see para. 3). 22. Since the country's independence, a basic legal and institutional framework for privatization has been developed. A first and main law on privatization of state-owned enterprises was passed in August 1991. It established the overall institutional framework and the basic principles of privatization, including the assets that could be privatized as well as methods and procedures. It also defined the eligible buyers  6 and certain rights and privileges for employees. This law anticipated the preparation of a privatization program adopted in 1992, which contained a list of state enterprises that would be either subject to or excluded from privatization. As the main law on privatization is generally empowering, it was followed by other secondary laws, decrees, and regulations, covering auctions and competitive sale, valuation of assets for privatization, and the transformation of enterprises into joint-stock companies. In 1993, laws and decrees regarding a voucher program and investment funds were enacted. 23. To enhance administrative efficiency and simplicity, the tripartite institutional structure envisaged in the 1991 law (comprising the Ministry of State Property Management (SPM), State Property Funds and a Privatization Commission) was modified by an August 1992 decree. The Ministry of SPM now assumes overall responsibility for managing state-owned property in Georgia, developing privatization strategies, reviewing enterprise privatization plans, and carrying out privatization through its 66 regional offices5. 24. Up to now, privatization of small-scale enterprises has progressed fairly rapidly: by October 1994, 1,657 small-scale enterprises (out of 6,481 identified for sale) were privatized, including trading outlets, gas stations, food processing plants, construction sites, printing shops and tourist agencies. In addition, 270 previously leased enterprises have been privatized. Privatization of medium and large enterprises has been slower: only 8 have been privatized to date. However, over recent months, there is evidence that the corporatization of medium and large-scale enterprises, an intermediate step in the privatization process, is making rapid progress (see paras. 38-41). 25. After a period of interruption, privatization of housing was renewed in 1992 and is now nearly complete. Transfer of housing to present tenants, has been made practically free of charge, save for a titling fee and the equivalent of a two years' lease. Once the titles are transferred, owners are free to sell or otherwise further transfer the housing. Land reform started in early 1992, with privatization of about 740,000 ha (about 25 percent of cultivated land) as the original target. About 650,000 ha have already been allocated to private farmers, and rural and urban households. Official statistics also indicate that about 50 percent of the labor force in the agriculture sector works on private plots, up from 30 percent in 1989. Over 75 percent of vegetables, fruit and meat is now provided by the private sector. II. The Governmnent's Economic Reform Program A. Overview 26. Throughout 1992 and 1993, the civil conflicts and the breakdown of law and order have delayed the consolidation of the Georgian nation, led to deep macro-economic imbalances and interfered with the implementation of structural reforms. With progress achieved toward political stability and restoration of law and order, the Government has, since the beginning of 1994, focused its attention on rebuilding its economy and expressed its commitment to restore macroeconomic stability and foster the resumption of growth. To that end, a comprehensive program of macroeconomic stabilization and structural reforms was designed with the assistance of the IMF and the World Bank. To demonstrate its commitment to reversing recent economic trends and to accelerating the transition toward a market economy, the 5/ SPM has responsibility over the whole country except in Tbilisi, Kutaisi, and Batumi where municipalities implement the privatization program.  7 Government has over the last few months, taken a series of decisive and courageous measures. These include a sharp reduction in subsidies for bread and transportation, the adjustment of energy prices to cost recovery levels, the tightening of monetary and credit policies, and several decrees to speed up privatization. On December 15, 1994, the Board of Directors of the IMF approved a first purchase of SDR 27.75 million (approximately US$39 million) under the System Transformation Facility (STF). 27. The Government's economic reform prograrn aims at restoring stable macroeconomic conditions and at promoting output recovery. It focuses on four interconnected and mutually reinforcing elements. First, macroeconomic stabilization will be achieved through a drastic fiscal adjustment and tight monetary policies. Second, reforms of the public sector will be undertaken to reduce and redefine the role of the Government in the economy. The aim is to ensure the sustainability of the stabilization program, the strengthening of the institutions of public management, and a growing reliance on private sector activity through an acceleration of the privatization process. It is also to reallocate scarce public resources toward basic social services. Third, the development and a more efflcient functioning of markets will be fostered by finalizing the liberalization of domestic prices as well as of the foreign exchange and trade regimes; by promoting competition and creating a favorable environment for private sector development; and by strengthening the financial sector. Finally, a minimum social safety net, compatible with the limited available resources, will be maintained by ensuring a minimum level of cash transfers to the poorest groups of the population. B. The Stabilization Program 28. The Governrnent has recognized that the monetary and fiscal policies implemented in recent years, which relied on inflationary finance, domestic dissaving, foreign aid, and external borrowing are unsustainable, and that a stable macroeconomic environment is essential to restore favorable prospects for economic growth. To bring about rapid stabilization, leading to a reduction of the monthly inflation rate from about 60 percent during the first half of 1994 to low single-digit levels by the end of 1995, the Government is committed to undertaking a drastic fiscal adjustment, and to maintaining tight fiscal and monetary policies thereafter. (i) Fiscal Policy 29. The overall fiscal deficit of the general government is targeted to decline from 26 percent of GDP in 1993 to about 9 percent in 1994, and to be limited to no more than 6-7 percent in 1995. For 1994 and 1995, the main elements of the fiscal adjustment are the complete elimination of remaining generalized subsidies and an increase in budgetary revenues from the sale of donated imports of flour and wheat at the coupon equivalent of world market prices. As of September 1, 1994, domestic prices for gas and electricity were increased to cover costs (import or production and distribution costs), and will thereafter be readjusted every month (see para. 54). Subsidies for bread and transportation were substantially reduced and will be phased out by mid-1995. Provision of all subsidies and transfers to enterprises, including interest subsidies, were eliminated. 30. To facilitate tight control of expenditures and further strengthen the fiscal position of the Govermnent, the stabilization program, in addition to quarterly targets for Central Bank borrowing by  8 the General Government6 includes: (i) centralization of all budget accounts of the Republican Governmnent at the National Bank of Georgia (NBG); (ii) prohibition of bank borrowing by local governments; (iii) preparation for the introduction of a Treasury; and (iv) adoption of revenue-enhancing measures: increases from 14 to 20 percent in the VAT rate, from 2 to 12 percent for import custom duties; from 10 to 15 percent for the gasoline excise tax. In addition, there will be increases in the presumptive tax on kiosks, introduction of a 10 percent VAT on flour and bread products; reduced VAT exemptions; readjustment of income tax brackets; and increases in penalties for non-compliance with tax obligations. The latter measures have been approved by Parliament in November and declared effective as of December 1, 1994. In addition, the Government will, with the assistance of the World Bank (under the Institutional Building Credit, IBC) and the IMF, strengthen customs and tax administration to enforce compliance and timely tax collection. (ii) Monetary Policy 31. In the area of monetary and credit policies, the reform program relies on the control of domestic credit expansion and more efficient allocation of credit. Changes in bank credit to general government and in net domestic assets of the NBG will be guided by inflation and international reserves targets. To sterilize part of the massive monetization of the fiscal deficit in the third quarter of 1994, the NBG tightened enforcement of reserve requirements, including imposing penalties for non-compliance. In addition, reserve requirements on foreign currency deposits were raised to the same level as domestic currency deposits (20 percent). Directed credits to selected sectors at highly subsidized rates and automatic access by state commercial banks to NBG overdraft facilities have been eliminated. To prevent the clogging up of the payments system, they will be replaced by a short-term credit facility to be developed with the assistance of the IMF. The Government also removed restrictions imposed on the convertibility of coupon deposits into cash that had led to the emergence of a separate market for noncash coupons and impaired the functioning of the banking system. When policies are in place to ensure sustained price stability, a national currency, the lari, will be introduced. (iii) Public Sector Wages and Social Security Payments 32. To compensate partially for the increase in prices, in September 1994 the Government increased the wages of employees in the budgetary sector, tilting the wage structure in favor of the lowest paid. It also provided additional cash payments for pensioners and other beneficiaries of the social security system. Because of the fragile fiscal situation, further increases in public sector wages and social benefits will be limited to rates equivalent to the target inflation rate during the first two quarters of 1995; possible increases in real wages as well as readjustments of the wage scale and of the social benefit structure, will only be considered during the second half of 1995. No limit on wage growth will be imposed in enterprises and non-budgetary organizations. C. The Structural Reform Program 33. The structural reform program of the Government has three main components. The first component aims at reducing and redefining the role of the public sector through an acceleration of the privatization process, the imposition of hard-budget constraints on e. terprises and the restructuring of the 6/ The General Government includes republican (central) and local budgets, as well as extrabudgetary funds  9 government sector, including a focus on basic social services. The second component comprises policies governing price regulation, competition, trade and finance, that will foster the development of markets and their increased efficiency. The third component aims at maintaining a minimum safety net through increased targeting of benefits, thus ensuring a minimum level of cash transfers to the poor. The Government believes that this overall set of policies is necessary to ensure the sustainability of the stabilization program, facilitate a rapid transformation of the Georgian economy and create a favorable environment for resumption of growth, without which sustained poverty reduction cannot be achieved. (i) Reducing and Redefrning the Role of the Public Sector 34. The urgent need to create an environment that facilitates a quick output recovery and to restore macroeconomic stability requires strengthening the institutions of public management while reducing and redefining the role of the Government in the economy. Tax reform, strengthening customs and tax administration, and enforcing compliance are ways to increase the capacity of the Government to collect revenues and administer resources. The Government introduced new tax laws in 1992 and at the beginning of 1994, and is currently receiving technical assistance to strengthen both its tax and custorns administration (see para. 30). These measures, in addition to the reforms adopted in November 1994 (see para. 30), should help to reverse current trends in tax collection. Stabilization itself should also contribute to that objective by reducing the negative effect of inflation on real tax revenues. 35. Even with substantial progress in raising revenues, the current level of government resources is so low that public-sector institutions must be thoroughly reorganized in order to narrow the budget deficit and ensure the sustainability of macroeconomic stability. Moreover, the restructuring of many Government activities and the divestiture of state assets is desirable, even in an environment where the public deficit would remain moderate, in order to foster the development of private sector activity. Many Government activities can be more efficiently performed by the private sector under a proper regulatory framework. 36. To address these issues and reduce the scope for public interventions in the economy, the Government is committed to a deep reform of the public sector consisting of: - the rapid transfer of ownership rights to the private sector. - the imposition of hard budget constraints on remaining state-owned enterprises. - the radical restructuring of the Government sector. 37. Transfer of Ownership Rights to the Private Sector. Although Georgia has made substantial progress in transferring small-scale enterprises to private owners, the need for the Government to reduce further the range of its interventions, maintaining only a regulatory role for the remaining ones, and to impose hard-budget constraints on enterprises calls for acceleration of the privatization program. 38. Privatization of State-Owned Enterprises. Until the spring of 1994, small-scale enterprises (defined as enterprises with book value less than Rbl 30 million7 as of January 1993) were privatized through auctions and tenders, while medium and large-scale enterprises (those with book value over Rbl 30 million) were subject to mass privatization, or to tenders for selected cases (case-by-case privatization). As an intermediate step towards privatization, all medium- and large-scale enterprises are being 7/ About US$50,000.  10 transformed into joint-stock companies. Once corporatized, enterprises are governed by a transitory body, the privatization board, and are no longer under the control of line ministries. 39. Since May 1994, in an effort to accelerate the pace of the program, and in particular to break the resistance of collectives, a new feature was introduced through a decree of the Head of State (decree 178 dated May 1994), which gives employees the right to purchase 100 percent of the shares of small-scale enterprises and 51 percent of the shares in medium- and large-scale enterprises identified for sale. These direct sales ("insider" privatization) are similar to those adopted in Russia, and are now a hallmark of the Government's program. Under this scheme, 100 percent of the shares of small-scale enterprises are first offered to "companionships" (partnerships), formed by at least 50 percent of enterprise employees. The partnership must submit an application to the SPM. Employees receive 5 percent of shares for free; payment for the remaining 95 percent can be in vouchers (35-50 percent) and local currency (45-60 percent). If the employees do not purchase the enterprise, it is sold at auction or through competitive tender. For medium and large-scale enterprises which have been transformed into joint-stock companies, employees are eligible to purchase up to 51 percent of enterprise equity: 30 percent can be paid for by vouchers, and the remainder is available at a discount8. In addition, employees receive 5 percent of shares for free bringing their shareholding to 56 percent. There are no restrictions on the subsequent resale of shares by employees. The decree does not apply to enterprises in the mining and military sectors which will remain under state ownership in the near term and to enterprises subject to case-by- case privatization for which the proportion of shares available to employees will be below 51 percent. Valuations for all enterprises are based upon book value. However, given the payment arrangements discussed above, insiders enjoy substantial discounts. 40. As of October 1994, small-scale privatization was fairly advanced (see para. 24): 1,657 small- scale enterprises had been privatized (25 percent of the 6,481 small enterprises so far identified for sale). Of these, approximately 46 percent has been privatized through competitive tenders, 43 percent through auctions and 11 percent through direct sales. Privatization of small enterprises is pursued according to fixed targets: between mid-October 1994 and February 1, 1995, 847 additional enterprises have been privatized, thus reaching 40 percent of the target (6,481 enterprises). The Government intends to complete privatization of these enterprises by the end of 1995. To reach that objective, an October decree streamlined the administrative process and imposed a two month deadline for completing privatization through direct sales following notification by SPM. To further accelerate the process, the Government adopted additional measures. First, minimum bid prices were eliminated at the second round of auctions for enterprises not sold at the first auction attempt. Second, enterprises not sold at a second auction will be liquidated and their assets auctioned piecemeal with no minimum bid prices. Third, to provide incentives to local authorities to meet privatization targets, a policy is implemented allowing those municipalities that have achieved the SPM-imposed targets for small-scale privatization to retain a percentage of privatization proceeds derived from the sale of enterprises within each municipality. Fourth, the Government eliminated pre-conditions on post-privatization activities for all small enterprises. 41. Privatization of medium and large-scale enterprises had proceeded more slowly. As of October 1994, out of the 1,007 medium and large enterprises designated for privatization (which covers virtually all enterprises but a small number in the mining and military sectors), 335 had been transformed into joint-stock companies and only 8 privatized. The process was hampered by the relatively weak position of the Ministry of SPM vis-a-vis the line ministries, cumbersome and lengthy procedures for 8/ 'Part of the remainder can be paid in coupons on terms and part can be obtained without charge.  I1 enterprise corporatization, and by lack of support for the program, especially from enterprise managers and collectives. The Government has recognized that these factors have delayed the privatization process and has taken corrective measures. The May decree extending the rights of employees to acquire 51 percent of shares through a direct, non-competitive sale has addressed the latter problem (see para. 39). The other constraints have been addressed by strengthening the SPM's position, requiring line ministry cooperation, and streamlining the corporatization process. In consequence, the corporatization process has accelerated over recent months. Between July and October 1994, 247 enterprises were transformed into joint-stock companies, and since October, 407 additional ones were corporatized. Thus, as of February 1, 1995, about 73 percent of medium and large-scale enterprises have been transformed into joint-stock companies. The government intends to complete the corporatization of all remaining medium- and large-scale enterprises by July 1, 1995. 42. Thirty-five percent of the shares of medium- and large-scale enterprises which have been transformed into joint-stock companies are currently reserved for voucher auctions (mass privatization program) which the Government intends to implement in several waves over 1995, and to complete by mid-1996. The voucher-based mass privatization program (MPP) is being supported by technical assistance under the World Bank Institutional Building Credit (IBC). Three pilot auctions are expected to take place in May and June 1995. Several necessary preparatory tasks have already been completed at the beginning of 1995. The list of eligible recipients of privatization vouchers has been completed; guidelines have been issued to complete the legal framework for the MPP, including the rules for distribution of vouchers, auctions and bidding procedures; and the large enterprises to be sold at the first two regional and at the first national voucher auctions have been identified. The Government intends to distribute by May 1995, the preparation packages for the enterprises to be included in the first three MPP voucher auctions. The MPP will be supported by a comprehensive public relations campaign, publicizing the program objectives, procedures for participants to obtain vouchers, as well as procedures for the conversion of vouchers to shares in enterprises and investment funds. 43. The Government is aware that management/employee buy-outs will leave many large enterprises lacking in the capital and skills required to restructure and tum around potentially viable enterprises. Because such enterprises are expected to be a primary source of supply response to the adjustment program, the Government has adopted a case-by-case track for privatizing a select group of such firms. In this case, employees will be eligible to purchase a minority stake in these enterprises, but the majority will be reserved for core investors. To that end, the Government has developed and adopted criteria for selecting enterprises to be privatized through international tenders. It has also identified 15 large enterprises for this program and intends to complete privatization of these enterprises by mid-1996. 44. Privatization of Land. Land reform started in early 1992; at that time, almost 200,000 ha (6.5 percent of cultivated land) were in the hands of private farmers; by mid-1994, another 450,000 ha had been allocated to farmers, and to rural and urban households with the maximum size of land holdings for arable areas and perennial crops set at 1.25 ha. Private land now represents about 38 percent of arable land, 51 percent of land for tree-crops, 20 percent of hay fields, and 5 percent of pasture; in total, about 20 percent of cultivated land. Distribution of land has taken place in all regions, although somewhat more extensively in the west than in the east.  12 45. Although the privatization of land has already had positive effects on the economy in terms of output and farmers' incomes9, the lack of official documentation supporting land holdings and the lack of legislation specifying disposition rights, has prevented private farmers from selling or buying land to take advantage of increased profitability associated with larger farm size. These problems have also prevented farmers from renting out land as they fear being unable to take the land back after the prescribed time. The Government is aware of these shortcomings, and has initiated with assistance of the World Bank the preparation of a land law defining the legal framework for transactions related to land including sale, lease and inheritance, and giving landowners unrestricted rights to enter into such transactions. It intends to submit the draft law to Parliament for discussion no later than July 1995. The Government has also set a target of distributing a further 130,000 ha. (excluding Abkhazia) and privatizing the remaining state and collective farms. By mid-1995, the Government will define the principles according to which the distribution of remaining agricultural land will be completed. It will also define targets for privatization of state and collective farms. Implementation of the land privatization program will be completed by February 1996. 46. Privatization of Housing. Most housing units in rural areas and some urban dwellings were already privately owned before the country's independence (see para. 25). Legislation on privatization of dwellings was approved in 1991 and by now, privatization of apartments in urban areas is nearly complete. Owners are free to sell or rent their housing. What is still lacking is the definition of ownership rights for communal spaces and facilities and a legal framework allowing for the privatization of buildings. The Government intends to enact the necessary legislation by mid-1995. 47. Imposition of Hard Budget Constraints on State-Owned Enterprises. Since the process of privatizing state-owned enterprises will take time, and some activities will remain under state ownership in the medium term, imposing a hard budget constraint on state enterprises and improving their autonomy and accountability is crucial for their adjustment as well as for stabilization. These policies will also foster private sector development by preventing unfair competition by state enterprises facing softer constraints, and by revealing profitability to prospective investors. In addition to the imposition of financial discipline through the elimination of subsidies and a market-based system of credit allocation, the Government will also take measures to signal that the state will not bail out non-viable activities. As a first step in that direction, the Government is preparing, with technical assistance from Germany, a draft law on bankruptcy which will be submitted to Parliament by April 1, 1995. Thereafter, the enterprise sector will be exposed to the provisions of the law. The Government has also identified and made public the list of the 25 largest loss-making state-owned industrial and agricultural enterprises and, through a resolution of the Cabinet of Ministers, has ordered the preparation of detailed action plans for these enterprises, including partial and complete privatization, partial or complete declaration of bankruptcy, breaking up of monopolies, and divestment of social assets. Preparation of these action plans will be undertaken with technical assistance financed under a Japanese grant and completed by September 1995. During preparation and implementation of these action plans thereafter, these enterprises will not benefit from loans from the NBG or from any of the state banks, nor will they benefit from any publicly guaranteed loan from the private banking sector. 48. In addition to the hard budget constraints imposed through fiscal discipline, the Government intends to promote increased efficiency of operations in state-owned enterprises through the introduction 9/ More than 75 % of the production of vegetables, fruit and meat is already provided by the private sector.  13 of management contracts. These contracts, which include hiring of senior management on a contractual basis, incentive schemes, explicit profit or loss reduction targets. and other performance targets, will be introduced on a pilot basis by the end of 1995 in three enterprises in the mining and military sectors which are not subject to privatization in the medium-term. Based on an evaluation of this pilot project, the Government expects to extend the experiment and to institute mechanisms to enhance incentives and managerial accountability in other enterprises in the sector. 49. Restructuring the Government Sector. The Government is aware that the fiscal adjustment will in the short run have a major impact on living standards and, in particular, on the real wages of public employees who already have to rely on additional jobs or other sources of income to cover their basic needs'". Although the budgetary savings resulting from the subsidy cuts made possible some wage adjustment in September, the low level of revenues will not allow major wage increases in the near future unless the number of employees in the budgetary sector is sharply reduced. At the same time, it is essential that the Government strengthen its capacity to provide basic public services. To that end, the Government intends to define a set of critical public functions and to identify the civil servants and public-sector employees needed to perform these functions efficiently. Functions that can be performed by the private sector will be privatized; functions that no longer correspond to the role of a Government in a market economy will be eliminated. The urgent need for such reforms is made evident by the numerous practices - though illegal - which have already led to the implicit privatization of many Government activities. Public bus drivers collect and keep fares from passengers; school administrators collect tuition from some of their students; and nurses and doctors in hospitals and polyclinics provide medical services for fees. De facto user fees have already been introduced for a large number of public services. Regularizing and rationalizing them can greatly improve efficiency. 50. Time will be needed before these reforms can be implemented and the public sector restructured. However, the Government recognizes that the fragility of the fiscal stance requires their implementation as soon as possible. To carry out the first stage of this reform program, the State Commission on the Structure of State Organizations has been established under the chairmanship of the Prime Minister. Its task was to prepare a plan to restructure the Government's ministries and departments to better reflect their role in a market economy and to oversee a reduction of at least 25 percent in the number of staff employed by the budgetary sector, currently estimated at about 630,000. The reorganization plan will not be accomplished with across-the board downsizing, but will instead follow a detailed examination of the new responsibilities of each office. Some offices may be expanded; many will be reduced in size; and some will be eliminated altogether because their roles are duplicated or are no longer consistent with the reduced Government's role in the economy. Two alterniative plans have been submitted to Parliament in December 1994 and will be discussed in early 1995. The reduction in staff requirements will be implemented by the end of the first quarter of 1995. 51. In addition to reform of the top levels of public administration, the Government is also committed to introducing reforms to restructure social services, such as health and education, which have suffered from drastic cuts in public expenditures. Because the Ministries of Education and Health have historically been two of the largest civil service employers, and because both provide essential public services, their reform is particularly important from the point of view of reducing obligations on the state budget and 10/ Wages of public employees are substantially below those of other workers. The average monthly salary of an employee in the budgetary sector was equal to 3.5 million coupons in September 1994. This is equivalent to about twice the monthly bread ration.  14 improving efficiency in resource allocation. The objective of the reforms is, in particular, to concentrate the limited available public resources on a basic set of services and to ensure access to these services by the poorest segments of the population. 52. The Ministry of Health has already developed a comprehensive reform plan. A proposal defining the basic policy lines has been approved by the Cabinet of Ministers, and a decree by the Head of State was issued in December 1994 to enact these reforms. The reform guarantees free access to health care in hospitals and polyclinics for a core set of medical services. All other services will be provided on a fee-for-service basis. In this way, hospitals and polyclinics will receive income to pay salaries, defray capital depreciationi, and purchase new equipment and facilities. Some hospitals and polyclinics will be privatized; all will become self-managing and independent of day-to-day direction from the Ministry of Health. Hospital and polyclinic fees will finance the salaries of the health care providers who will be removed from budgetary sector payrolls. The reform will be implemented, starting in January 1995, over a period of two years. The reform plan will also include regulations and a financing mechanism to ensure provision of basic health services to all Georgians and especially to those who do not have enough income or assets to pay for these services without help. The Ministrv of Health will retain an important role in accrediting hospitals and licensing doctors and senior health professionals. A plan for accreditation will be adopted by mid-1995. 53. Preparation of reform in the education sector is less advanced than in the health sector. The Ministry of Education, however, is developing a comprehensive program to reforn the organization and financing of Georgian kindergartens, primary and secondary schools, and post-secondary educational institutions. Under the reform program, basic education during the 9 years of compulsory schooling (from age 7 to 15) will continue to be financed out of the state budget to ensure access by low-icome households. Enriched education in grades 1 through 9 as well as schooling in kindergartens and post- secondary institutions will be funded out of fees paid by students or their parents. Some secondary and post-secondary students will qualify for state scholarships, which will be allocated depending on scholastic performance or the results of competitive examinations. This scheme is being introduced during this academic year, on an experimental basis in two moderate-sized cities. Based on an evaluation, a proposal for reform at a national level will be prepared and discussed by the Georgian Government by the end of 1995. (ii) Promoting the Development of Markets and Increasing their Efficiency 54. Promoting Competition and Private Sector development. Government intervention in the area of pricing was already substantially reduced in 1992. Most retail and wholesale prices were liberalized at that time. Currently, medicines are subject to a 25 percent markup over production or import cost, and the prices of rationed bread, municipal services, energy products (gas and electricity), public transportation and communications are still fixed by the Government (see para. 19). Maintaining these prices at constant nominal levels at times of accelerating inflation and relying heavily on imports for some of them (energy and wheat), led to increasingly significant subsidies and huge distortions in resource allocation. In an effort to remove these distortions and strengthen the budget, the Government decided to readjust all prices to achieve full cost recovery. As of September 1, 1995, domestic prices for gas and electricity were increased to reflect full import and distribution costs and will be readjusted each month to maintain full cost recovery. Price adjustments have been huge, especially for consumers: the price of electricity rose 600 times, that of gas for cooking, 13,000 times, and that of gas for heating about 5 times. For enterprises, the price of gas was raised about 5-fold, and that of electricity more than 10 times. On September 17, the price of bread was increased from 700 to 200,000 coupons per kilogram;  15 a further increase to 280,000 coupons took place on December 25. Subsidies for transportation were reduced in September through a 50-fold increase in subway fares, and will be eliminated by mid-1995. Bread price will be fully liberalized by mid-1995 (see para. 56). Regulated prices therefore will only remain for public transportation, energy and municipal services while restructuring of the sectors takes place (see para. 55). For all of them, the Government is committed to achieving and maintaining full cost recovery. 55. Although the recently adopted price realignment for electricity eliminates cross-subsidization between types of energy and will have a favorable fiscal impact (provided efforts are intensified toward collection of bills"), it is only based on average cost. The structure of electricity prices needs to be based on long-run marginal cost to increase the efficiency and reliability of energy supply, provide proper signals for energy demand, and generate the sources of funds necessary for investment in the sector. The Government is currently preparing a restructuring plan of the power industry, and intends to start its implementation by end-1995, corporatizing the generating and distribution companies, and introducing an efficient price structure. In addition, the Government is committed to opening the power generation sub-sector to private investment in order to address supply constraints and to promote competition in the supply and pricing of energy. Concurrent with these measures, the Government will develop a comprehensive regulatory framework for power generation and distribution. 56. The elimination of the bread subsidy needs to be accompanied by a reorganization and a break-up of the Bread Corporation which has a monopoly over wheat procurement and a quasi-monopoly over bread production. To introduce competition in the market for bread products, the Government intends, in parallel with the liberalization of bread prices and the elimination of rationing, to adopt by mid-1995 a restructuring/privatization plan leading to the break-up of the Bread Corporation into independent milling, baking, and retail units and their subsequent privatization. The Government will complete privatization of the Bread Corporation according to this plan by the end of 1995. It is expected that these measures will have a positive impact on the domestic production of wheat, and will contribute in the medium term to a reduction in the need for wheat imports. 57. The Government recognizes that the private sector will be the primary source of job creation and growth in the economy, and is an important source of competition for remaining state-owned enterprises. Through rapid stabilization, the acceleration of the privatization program, and completion of price liberalization, the Government is going a long way toward creating a favorable environment for private sector activity. The Government's strategy also includes the reduction of barriers to entry for new businesses and the completion of the legal and institutional framework necessary for private sector activity and competition. To that end, the Government has adopted fairly simple registration procedures for new business, and local authorities clear new applications over a relatively short period of time. Constraints on private sector access to commercial real estate have been addressed through long-term leasing arrangements. A law on entrepreneurship completing the legal framework for private business was approved by the Parliament in November 1994. In addition, a law on investment, granting equal treatment to foreign and domestic investors was submitted to Parliament in September and is under discussion. Foreign investors will also be specifically targeted in the marketing of large, strategic enterprises to be sold through international tenders. Finally, an anti-monopoly law designed to facilitate the break-up of monopolies and to control the abuse of dominant market positions and restrictive trade 11/ Improved collection will be critical to meet the fiscal objectives. As part of the fiscal program agreed with the IMF, the Government has agreed on targets for collection of bills.  16 practices, is under preparation and will be submitted to Parliament by mid-1995. Upon Parliamentary approval, an anti-monopoly commission will be created. 58. Also consistent with the Government's policy of liberalization, most restrictions on domestic trade have been eliminated. All fixed margins on wholesale and retail trade were abolished in 1992 except for those on medicines (see para. 54). Trade-related infrastructure - such as wholesale storage bases and trucking enterprises - is either privatized or in the process of privatization. The main remaining factor hindering the development of markets is the obligation imposed on many enterprises to deliver part of their production domestically under the state order system. These quotas are used for various purposes, including compensation for input suppliers, direct distribution by municipalities, and building of state emergency reserves. Although the amount of goods purchased under state orders has declined significantly over the last few years, and has been increasingly directed towards meeting the needs of international trade (see para. 65), the system still represents an important source of taxation on domestic producers. As part of the program to dismantle the state order system, the Government has taken a first step by eliminating in February 1995, the quotas directed toward domestic uses and intends to develop a market-based system of procurement using bids and tenders. 59. Liberalization of factor markets is also essential for promoting rapid increases in productivity. The Georgian labor market appears to be characterized by a high degree of labor mobility. Since 1990, employment in the state sector has decreased by 30 percent and private sector employment is reported to have increased by 58 percent. Taking into account the largely unrecorded expansion of the informal sector, labor flows toward the private sector must even be larger. It is essential to accompany the on- going reallocation of labor with an appropriate wage policy. To that end, the Government will not impose wage regulations that would create the wrong set of incentives. No wage controls will be imposed on the private sector. Wages and other forms of compensation will also be freely negotiated"2 between employers and employees in state-owned enterprises as part of the strategy to impose similar market conditions on enterprises that remain under state ownership. 60. Fostering Export Growth. For an economy like Georgia's, with a small domestic market and few energy resources, international trade will be a key factor for economic recovery. Developing a smoothly functioning foreign exchange market and eliminating implicit and explicit taxes on exports are thus two critical elements in the Government's economic program. 61. Foreign Exchange Regime. Although the Government took significant steps toward developing a market for foreign exchange characterized by a unified rate determined in an interbank market, the system still had until recently a number of limitations which constrained its effectiveness. One problem was the requirement that exporters surrender 32 percent of their foreign exchange receipts in return for coupons. Until very recently, most of this was used to fund the foreign exchange needs of the government through a mechanism that resulted in a large implicit tax on exports. Although, in principle, exporters were supposed to be reimbursed at the market rate, an implicit tax arose for several reasons: (i) payment to exporters was made in non-cash coupons, but at the exchange rate set in the auctions for cash coupons, while the exchange rate for non-cash in the unofficial market was twice as high; (ii) only ten percentage points of the 32 percent went to the NBG and then directly to the auction, while reimbursement of the remaining funds allocated to the Ministry of Finance and local governments was 12/ Only a minimum wage regulation applies; however, the level of the minimum wage is so low that practically no worker in the formal economy, is reported to be paid at that level.  17 generally delayed for periods ranging from several weeks to two months; thus, when inflation and the opportunity cost of funds were high, the funds lost considerable value; and (iii) restrictions on the convertibility of non-cash coupons limited their value to exporters. 62. An additional problem was that the practice of allocating only a small fraction of the foreign exchange to the NBG limited the development of a free exchange market, as the rest of the foreign exchange was essentially used the same way as under central planning. A final problem was that regulations limiting participation in the auction and imposing restrictions on bidding obstructed the development of a smoothly functioning market. 63. To address these issues, the Governrment began at the end of September 1994 to channel the totality of the surrendered foreign exchange to the NBG (instead of direct allocation to the state and local currency funds), thus ensuring that exporters are reimbursed rapidly at the auction rate. This, along with the abolition at the same time of the distinction between cash and noncash coupons (see para. 72), has gone a long way toward minimizing the adverse effect of the surrender requirement. The NBG has also increased the frequency of foreign exchange auctions, which now take place twice a week. 64. These important advances notwithstanding, several legal obstacles still obstruct the development of a fluid market in foreign exchange and create difficulties for exporters. These include the remaining distinction between cash and noncash in foreign currencies; restrictions on the purposes for which exporters can withdraw foreign exchange from their accounts; and the exclusion of all bidders except banks from bidding in the auction. At the end of 1994, the NBG removed remaining restrictions on the exchange of foreign currency cash and non-cash balances. It also intends in the near future to expand participation in the auction to foreign exchange bureaus. Exporters to the ruble area are no longer subject to the surrender requirement. By the end of 1995, the surrender requirement will be eliminated. 65. International Trade. In contrast to the import regime, which is relatively free (uniform customs duty, and virtually no non-tariff barriers), quantitative restrictions on exports are still pervasive and constitute significant impediments to trade. They take the form of export prohibitions and licenses, and are mostly linked to Georgia's bilateral trade agreements and to the state order system. The export controls are used to ensure that the state is able to secure supplies of certain goods at low real prices under the state order system. These goods are used to meet the obligations of the trade agreements. Until very recently, they were also used for domestic distribution for various purposes (see para. 58). At the end of 1994, 27 categories of goods were still subject to export licenses and 12, to export prohibitions. These restrictions tax producers, especially exporters, and obstruct the development of export channels by the enterprises themselves. In addition, exports to non-FSU countries have been subject to an 8 percent tax on foreign exchange earnings. 66. Because of the interlinkages among sectors, the state order system has created a tremendous burden of inter-enterprise debt, which has strongly contributed to the breakdown of production in Georgia. Because of this breakdown and the resistance of producers, only a small fraction of the deliveries required under the state order system are actually being made. Elimination of the system would improve producers' incentives and lead to greater capacity utilization. 67. The government is aware of the shortcomings of the present system and is committed to its dismantling. It is, however, keenly aware of how serious would be the consequences of any disruption in energy supplies, most of which are imported under barter agreements. Thus, it has adopted a phased approach. As of December 1, 1994, the 8 percent tax on foreign exchange earnings was abolished. In  18 February 1995, the Government eliminated all quotas under the state order system that are not necessary to ensure deliveries of the specific goods required for export in the barter agreements for energy supplies, thus reducing the number of products under quotas from 27 to 7. For the seven products that remain under the state order system, the Government will minimize the adverse effects on producers by ensuring that the prices paid will be equivalent to border prices, converted to local currency at the rate of exchange prevailing on the date of payment. The Government also intends to phase out completely the quota system over a period of about one year. 68. The Government has also started reducing the number of goods under export licensing (from 27 to 19) and intends to eliminate gradually remaining requirements and prohibitions, except for those required by agreements giving limited preferential market access to Georgian exports (e.g. the Multi- Fiber Agreement), or those used for reasons of environmental protection, health or arms trade control. This gradual elimination will take place over a period of about one year. During that period of time, export controls will affect mainly the goods used in barter agreements and a few basic food items. To indicate its commitment toward full trade liberalization, the Government issued in February 1995, a decree specifying the precise timetable for the complete phase out of the remaining state orders and the gradual elimination of export licensing requirements and prohibitions. 69. Strengthening the financial sector. The Government recognizes that financial sector reforms are critical for increasing domestic financial savings and for ensuring that credit is allocated to the most efficient users. Until very recently, credit allocation continued to be directed by the state. Almost all of the credit expansion came through the main specialized state banks (the Agro Bank, the Industrial Bank, and the Housing Bank), either through directed credits to particular sectors at highly subsidized rates or through access to overdraft facilities at zero nominal interest rates. The rest of the banking sector was largely reduced to financing inventory purchases for short-term trading at very high interest rates. The recent decision to eliminate directed credits to state enterprises and the automatic access of state banks to overdraft facilities, as well as the commitment not to interfere with the credit decisions of banks, are important steps toward promoting a more efficient allocation of credit and greater financial savings. 70. In addition to these measures, a wide range of structural and institution-building reforms in the financial sector are also essential for the effective operation of a market economy. 71. The Government recognizes that establishing the legal framework for the banking sector is a necessary condition for an efficient and competitive financial sector. While the current banking law contains the basic provision for central banking, bank supervision, and regulatory enforcement, it still includes a number of provisions that limit the independence of the NBG, and at the same time lacks other provisions necessary for effective monetary policy and credit management. To that end, a new draft NBG law has been prepared with the technical assistance of the IMF, and submitted to Parliament in December 1994. The proposed new legislation will substantially strengthen the autonomy of the NBG to carry out monetary policy, limit the financing of the Government, promote and maintain price stability, and foster the liquidity, solvency, and proper functioning of the financial system. 72. Although the process of financial intermediation has been improved by the decision to permit deposits in foreign currency and to let banks freely set interest rates on deposits, the functioning of the financial sector was seriously impaired by the legal dichotomy between "cash" and "non-cash" circuits. The separation between these circuits, although not complete, was accomplished via restrictions on the use of accounts, in both domestic and foreign currency. Cash withdrawals were permitted only for limited purposes and involved significant transaction costs. The transfer of funds to other accounts was  19 also restricted. These restrictions discouraged households and enterprises from holding deposits in the banking system, and strongly limited the capacity of the financial sector to mobilize financial resources. Another result was that the market-determined exchange rate for non-cash coupons was twice as high as that for cash coupons (see para. 61). The Government has recognized that these restrictions which were designed to limit the demand for foreign currency were counterproductive and accelerated financial disintermediation. The Government eliminated the cash-noncash distinction for coupons, in September 1994, and for foreign currencies, in December. By mid-1995, it also intends to develop appropriate legislation for facilitating the use of checks as means of payments. 73. The Government recognizes that the main financial institutions in Georgia are in perilous financial condition and are poorly equipped to attend the needs of an emerging private sector. It also recognizes that, as hard budget constraints are imposed on state-owned enterprises, the state banks will have to face an increasing number of unpaid loans. Thus, in addition to the corporatization of the five state banks which has already started, a major restructuring program may be required. To that end, the Government is undertaking a major diagnostic review of these banks in order to develop a comprehensive understanding of the operational, management, and financial problems besetting them. The review should provide a basis for developing strategies for institutional strengthening consistent with the Government's plan for privatizing and downsizing the state banks, and is being undertaken with technical assistance financed under the IBC. Based on the results of the diagnostic studies, which are expected to be completed by mid-1995, a privatization action plan will be developed and implemented. 74. As regards the situation of the 220 private banks which have been created in recent years, the NBG has identified about one-quarter that warrants closing. On-site bank examination and supervision is totally lacking, and off-site surveillance is almost non-existent. To halt the proliferation of new banks in the sector, a moratorium on the licensing of new banks was imposed in May 1994 and the minimum level of capital was raised from 200 million to 500 million coupons. In October, licenses were withdrawn from 42 commercial banks; foreign exchange licenses were also withdrawn from 28 banks. The Government is aware that these measures are still insufficient. With technical assistance from the IMF and the Central Bank of the Netherlands (under the IBC), the NBG intends to strengthen its supervision function. As part of this strategy, the NBG has revised prudential supervisory standards and issued new regulations in February 1995. (iii) Ensuring a Minimum Level of Social Protection 75. Georgia's system of social protection is still, to a large extent, identical to the system that prevailed in the Soviet Union. The only recent changes have been the introduction of an unemployment benefit scheme and the implementation of special assistance programs for about 90,000 families, considered to be particularly vulnerable, and for about 270,000 refugees from Abkhazia. In recent years, and in parallel with the sharp decline in living standards of the population, the system has faced increasing difficulties. The reduction in employment, the decline in real wages, and the Government's inability to collect social security contributions from the informal economy have together produced a collapse in the revenues of the social security and unemployment funds. Maintaining expenditures of the funds in line with revenues has led to benefit levels that are far too low to sustain a minimal standard of living. At the beginning of 1994, monthly pensions and unemployment benefits could only be used to purchase a small number of subsidized items; virtually no products offered for sale in private markets were accessible to those without other sources of income. The main form of social protection thus consisted of generalized subsidies for bread, energy, and municipal services. A similar situation applied to the approximately 630,000 workers paid out of the state budget, whose wages were not much higher  20 than pensions. Additional jobs, other sources of income, and strong family ties became in Georgia the main source of social safety net. 76. The Government is thus facing several pressing problems in the short run. First, the current system of social protection provides inadequate cash aid to vulnerable groups but has no capacity to raise significant revenues to increase benefits. Second, the removal of subsidies for bread, energy, and transportation eliminates the most important remaining form of social protection and imposes a sharp reduction in the real incomes of the population, hurting most those who cannot protect themselves. Third, the expected reduction in public employment may lead to a further increase in unemployment. 77. The Government is aware of these issues as well as of the impossibility, given existing financial constraints, of offering an adequate assistance program. It is, however, highly concerned about the hardship already imposed on the population, and convinced that attempting to maintain a minimum level of social protection is crucial for the success of its economic reform program. Hence it is determined to use the limited resources available as efficiently as possible. The overall strategy is to use some of the resources saved by eliminating generalized subsidies to strengthen the current system of social protection, and to target benefits more effectively. 78. Pension System Reform. By the spring of 1994, increasing financial constraints and periodic adjustments in pensions in response to inflation had largely eliminated differences in monthly pensions between highly paid and poorly paid pensioners. Almost all linkages between past social security contributions and current benefits had vanished, transforming pension contributions into a pure tax on labor. However, the staff of the social security offices were obliged to manually perform burdensome and time-intensive calculations of individual pensions, even though the resulting differences in pensions had no significance on standards of living. In September 1994, in order to reduce the administrative burden and the need for staff, the Government transformed the pension system into a simple social assistance program providing a flat-rate benefit to all pensioners. At the same time, it eliminated entitlement to special pension supplements. The system could not afford to grant favorable treatment to important groups of pensioners, and, moreover, there was no economic reason to impose the costs of these extra benefits on enterprises and workers in the less favored sectors. 79. Also in September, to provide partial compensation for the elimination of subsidies, pensions were raised to 2.5 million coupons per month, about 18 times their nominal level in July 1994. Child allowances and unemployment benefits were also increased. Fiscal constraints prevented the Government from raising benefits as much as it raised bread, electricity, and natural gas prices. At the same time, the Government eliminated benefits to pensioners who continued to work -- roughly 16 percent of the 1.14 million people who collected pensions in January 1994. It also eliminated childbirth and death benefits. In the very short-run, this only saved a modest amount of resources since real benefits remained very low. However, by limiting the number of people eligible to collect benefits the Government was able to provide a somewhat larger adjustment for those who remained eligible. 80. Targeted Social Assistance. The Government already has considerable experience in granting assistance to the neediest groups in the population. In addition to refugees from Abkhazia, several vulnerable groups (about 90,000 families) have been identified, including pensioners who live alone, single mothers, and families with many children. Except for groups that are easy to identify, such as pensioners living alone, the system relies mainly on self-targeting as a way of identifying individuals and families who need assistance. Refugees are provided with two kinds of help, cash and in-kind assistance. In-kind assistance is offered in the form of housing to roughly a third of the 270,000 refugees. It is  21 provided as food and medicine to selected refugees as well as to lone pensioners, single mothiers, and needy families with many children. Cash allowances are provided to all refugees who do not hold a formal sector job or receive a pension. In September 1994, as subsidies were eliminated, cash allowances were increased to 833,000 coupons per month for refugees living in government-provided lodgings, and to 2.5 million coupons per month for refugees living outside of special refugee lodgings. When resources are too limited to meet the demand for in-kind aid, targeted families are rotated on and off the list of those actually receiving assistance, reducing the frequency with which the aid is granted. 81. Medium-Term Reforms. The measures listed above, adopted in September 1994, represent significant steps toward strengthening the social safety net. The level of benefits is, however, still extremely low and remains inadequate for people without other sources of support. In the very short run, given the very limited financial resources, increasing the level of benefits to a more significant level could only be achieved by sharply reducing still further the number of beneficiaries. Given the difficulties of obtaining reliable information on household incomes, and thus of identifying the most needy, the Government considers that further targeting could leave some fraction of the population totally unprotected, and would create unsustainable social costs in the context of the current difficult economic situation. It also considers that further reforms of the social protection system could not be implemented without a parallel readjustment of public sector wages which are currently hardly higher than the level of pensions. The Government is, however, aware that the present set of reforms fails to address medium- term issues and that a comprehensive reform of the social protection system is needed. 82. Over the medium term, there is still room for improved targeting. The most costly form of cash transfers (besides pensions) is the child allowance program, part of which is financed out of the contributory pension system. Children age 16 and younger receive monthly cash allowances equal to 45 percent of the official minimum wage -- or 450,000 coupons per month in October 1994 -- if they reside in urban areas. The child allowance in rural areas is 30 percent of the minimum wage, or 300,000 coupons a month. The Government is aware that child allowances are not targeted to the needy and intends to improve methods to identify those families with children that need more support. 83. As economic recovery proceeds, the contribution rate to the public pension system (37 percent of payroll for state and private enterprises and 26 percent of payroll for budgetary organizations) will need to be gradually reduced to maintain the public pension at a low level while allowing for the introduction of a second-tier system linking contributions to benefits. In the very short run, the establishment of privately-funded pension schemes is premature, because these would require macroeconomic stability and a secure financial sector. The Government is, however, aware that the recent collapse in the value of public pension benefits has damaged the credibility of public social security as a source of dependable retirement income. It is also aware that the system is unsustainable. As of January 1994, only 1.9 million Georgians were officially employed in the civil service, in state enterprises, in cooperatives, and in registered private-sector enterprises (and many of these workers were on short hours). In that month, 1.14 million Georgians collected pensions -- roughly 3 pensioners for every 5 active workers. The ratio of pensioners to social security contributors is probably even higher than those figures suggest. By October 1994 the number of pensioners had dropped 16 percent, to approximately 0.96 million, after pensions to working pensioners were eliminated. But the number of Georgians contributing to the pension system was estimated to be just 1.2 million active workers, suggesting that there were 4 people collecting pensions for every 5 workers contributing to the pension system. As a first step towards increased sustainability, the Government will need to consider raising the retirement age. However, most workers employed in the informal economy do not contribute to the pension system, and many workers in the formal sector who receive wage supplements paid in rubles,  22 dollars, or in-kind benefits do not pay contributions on their non-coupon compensation. Hence, the introduction of a private, defined-contribution pension scheme in the medium term may well be the only credible retirement savings vehicle. If prudently regulated and supervised, such a system would mobilize long-term savings and provide improved income security to retirees. It would also contribute to the development of a modern and efficient long-term capital market. To prepare the way for these medium- term changes, the Government intends to start developing a regulatory framework to encourage workers, enterprises, and financial institutions to establish privately-funded pension schemes. 84. These reforms go beyond the horizon of the present Rehabilitation Credit. Initiating their preparation is however urgent. While there is little room for choice now, by mid-1995, when the fiscal situation is expected to improve, decisions will have to be taken regarding both the level of wages in the public sector and the level of benefits. To that end, in February 1995, a commission headed by the Minister of Labor and Social Security has been appointed to initiate preparation of a reform plan to be completed by mid-1995. The reform plan will: (i) address the sustainability of the pension system; (ii) examine possibilities for further targeting of benefits, in particular the identification of vulnerable groups; and (iii) evaluate the budgetary implications of a recomnnended set of actions. This program of actions would be implemented thereafter. .II. Macroeconomic Prospects and External Financing Requirements 85. Implementation of the reform program described in Section II should stem the decline of production and set the stage for the resumption of growth. This section describes the macroeconomic outcome of this program in the short and medium term. Caution is warranted however, given the high degree of uncertainty and the poor quality of available data. Nonetheless, some basic elements of an indicative scenario for the period 1995-2003 can be identified. Monthly inflation is expected to fall to low single-digits by the end of 1995. Real GDP would still register a small decline in 1995, but real growth would resume in 1996. Improvement in living standards would occur only gradually, and only after the end of the decade would the level of private consumption recover to that of 1993. Even this modest recovery requires substantial extemal financing in the coming years. A. Inflation and Output 86. After a price surge at the start of the program, following the elimination, or sharp reduction of subsidies for bread, gas, electricity and transportation, it is expected that the stabilization process will be rapid and that the monthly rate of inflation will drop to low single-digits by the end of 1995. Over subsequent years, provided that fiscal discipline is maintained, the Georgian and world monthly rates of inflation could converge. 87. There is little scope for growth of output and consumption in the very short run. Real GDP is estimated to have fallen by about 29 percent in 1994, reflecting the decline that has already occurred in the first half of the year and the continuation of inappropriate policies until September. In 1995, even with satisfactory implementation of the program, a further contraction in economic activity - although of much lesser magnitude - can be expected. Even though Georgia is well endowed with human capital, the necessary reallocation of resources to more valuable uses, both within and between sectors will be a gradual process, in particular in industry. In addition, the stabilization program entails a reduction of public expenditures and in the number of public employees, the elimination of subsidies, and an increase in taxes, as well as the elimination of directed credits to enterprises. All these factors will also reduce  23 private consumption in 1995. Positive real growth is expected to resume in 1996 at an annual rate of about 3 percent, led by the agricultural and service sectors and fostered by improved external conditions, in particular those related to Russia (which remains the main trading partner of Georgia) and other FSU countries. Later, as Georgia begins to trade with the rest of the world, investment and export growth would support a 6-7 per cent growth rate. 88. A number of factors can play a key role in the resumption of growth. The Georgian economy has already shown its capacity to develop entrepreneurial skills and private sector activities. The growing informal sector and the emerging private agricultural sector have been the main source of support for the population during the past four years. The service sector has already started developing, and the agricultural sector is showing some signs of recovery in grain producing areas and regarding livestock population. It is expected that further progress in land reform, price and trade liberalization, and increased competition will contribute to rapid growth of agricultural production. In addition, both the service and the agricultural sectors have less need for additional capital inputs than does industry. They could thus rapidly become the fastest growing sectors in the economy. The fairly high labor mobility that characterizes the Georgian labor market is expected to facilitate the necessary changes in the structure of production and productivity increases. The expected reduction in the size of the government sector will also induce the reallocation of labor needed to respond to new growth opportunities. In the industrial sector, although the imposition of hard-budget constraints and the rapid pace of privatization will facilitate enterprise restructuring, the need to adjust to sharp increases in energy prices will somewhat delay output recovery, except in the agro-processing sector which should benefit from trade expansion. 89. Recent years have witnessed a very substantial reduction in the rate of investment in the economy. Private sector investment is just incipient and has been discouraged by macroeconomic instability and political events. The public sector has practically stopped investment expenditures because of shortfalls in revenues and rising deficits. As the economy stabilizes and new opportunities for growth emerge, an upward trend is expected. Investment should rise to 9.5 percent of GDP in 1997, thereafter reaching almost 15 percent in 2000. Public investment will be mostly directed at rebuilding and expanding the physical infrastructure needed to support private sector development. Significant private investment would only arise as of 1997, after a stable political and economic environment is in place. 90. Financing the growth of investment will require substantial external flows even with resolute implementation of reforms. Gross domestic savings are only projected to be positive as of 1998, and will remain in the short and medium term insufficient to support economic recovery. In the short term, external resources will be necessary not only to help rebuild infrastructure and finance other investments necessary for growth, but also to complement the limited supply of consumption goods. B. The Fiscal Outlook 91. Fiscal policy will be central to reestablishing macroeconomic stability and ensuring sustainability of the stabilization process. The bulk of the fiscal adjustment is expected to take place during the last quarter of 1994 and in 1995. The fall in expenditures, along with increases in tax revenues will help to reduce the deficit from about 32 percent during the first half of 1994 to about 5 percent of GDP in 1995. However, improving the fiscal stance in the medium term still requires strengthening revenue efforts and considerable adjustment in the level and composition of expenditures. 92. On the revenue side, it is expected that rapid stabilization by eliminating the negative effect of inflation, will bring about a quick reversal in real tax revenue trends. The strengthening of tax  24 administration will lead to improved compliance and to a gradual increase in revenues. Additional revenues would be obtained from the privatization proceeds in early years and from tax reforms and grants. On the basis of these assumptions, government revenues in terms of GDP would almost double and tax revenues quadruple by 1998 relative to their 1994 level; however, given the very low level of current tax revenues, they would only reach 13.5 percent of GDP by 2003. By that time, the relative importance of grants would have decreased substantially. 93. On the expenditure side, projections reflect the removal of subsidies as of September 1994 and a substantial reduction in the consumption of gas and electricity by budgetary organizations. Another factor reducing expenditures is the expected decrease in the number of public employees from 630,000 in 1994 to about 500,000 by the end of 1995. However, to strengthen the social protection system, allowances are made for increases in expenditures for the social safety net, wages and higher investment outlays needed to rebuild physical infrastructure and to maintain an adequate level of human capital investment. Thereafter, wages and expenditures for the social safety net are expected to grow at a rate slightly superior to GDP growth. Capital expenditures are projected to increase steadily from 1995 on, to rebuild infrastructure. By 2003, capital expenditures would represent about 25 percent of total public expenditures. A primary fiscal surplus from 1999 on could be used to service interest on debt. C. External Sector 94. The financial constraints expected to prevail in 1995, the sharp relative price adjustment, and the commitment not to accumulate further arrears are expected to prevent any increase in imports during that year. Imports would only recover later, responding to the needs for raw materials, equipment, and capital goods that have been severely lacking in recent years. From 1996 on, imports would grow at an annual rate of about 6 percent, lower than that of exports, contributing to a gradual narrowing of the trade balance. 95. The sharp increase in energy prices should induce adjustment in energy use. In the very short run, one can expect a reduction in residential consumption and in energy-intensive industries. Later, the new energy prices should promote energy substitution and provide incentives for developing domestic energy sources. These elements would reduce the demand for energy imports and the currently high share of energy products in total imports. 96. The recovery of exports is likely to be a key contributor to the resumption of economic growth in Georgia. Exports are expected to be fostered by the removal of restrictions which constitute major impediments to their development: export prohibitions and licenses, state order system, explicit export taxes, and foreign exchange requirements. As these restrictions are lifted, exports are expected to grow in 1996 and 1997 at an annual rate of about 10-11 percent, recovering from their currently depressed level, and thereafter, at an average annual rate of about 9 percent. The agricultural sector and the food processing industry are likely to be the main short run beneficiaries from the changes in trade policies, in particular following the expected revival of agricultural output. 97. As a result of the expected fiscal adjustment, the current account deficit is expected to decrease from US$492 million in 1994 to about US$422 million in 1995. Higher rates of growth for exports than for imports during the whole period will contribute slowly to a steady reduction in the current account deficit in terms of GDP, projected at 24 percent in 1995. By 2003, the current account deficit would be equal to about 4.4 percent of GDP.  25 D. External Debt and Financing Requirements 98. Although Georgia agreed to the zero option with the Russian Federation and has no responsibility for the external debt of the FSU, it has accumulated significant external obligations over the past few years, mostly on commercial terms and with short maturities. Excluding arrears, the total stock of debt amounts to US$595 million at the end of 1994. Forty-five percent of this amount is bilateral debt due mostly to Russia and Turkmenistan, and 22 percent is due to the European Union. Including arrears, mostly for gas imports, the total stock of external debt is estimated at about US$975 million at the end of 1994. 99. In 1995, Georgia will need substantial external financial resources to finance a current account deficit of US$422 million, US$261 million of amortization payments on existing debt, and US$18 million for building up foreign exchange reserves to cover three and a half weeks of imports. In addition, the stock of external arrears will have reached about US$367 million at the beginning of the year. This entails a gross financing requirement of about US$1 billion. Based on current information on the lending program of multilateral institutions, and other identified commnitments including grants, the residual financing would amount to about US$728 million. The greater part of this requirement is expected to be filled by either debt relief or restructuring, and refinancing of arrears, which would reduce residual financing needs to about US$100 million. 100. During the period 1996-2003, total gross financing requirements are projected at about US$446 million annually on average. This amount would be necessary to finance an average annual current account deficit of US$277 million; a modest built-up of reserves of US$36 million, with the reserve cover increasing from three and a half weeks of imports in 1995 to about 2.3 months on average from 1996 on; and US$133 million of amortization payments due. During these years, the bulk of external resources would have to come from official sources, initially on concessional terms. A good portion of multilateral assistance would take the form of balance of payments support aimed at financing critical imports and mitigating the decline in living standards. As Georgia gains commercial creditworthiness, financing from private creditors and foreign private investors is expected to become important. 101. Georgia's debt burden is projected to peak in 1998, decreasing thereafter. Total debt in terms of exports is expected to reach 289 percent of exports in 1997, decreasing thereafter to 199 percent in 2003. Total debt service burden in terms of exports would decrease from 63 percent in 1995 to about 36 percent in 2003. These indicators are significantly higher than those of countries with similar levels of income. The magnitude of external obligations and financing requirements for the coming years strongly indicates that, in the short run, debt service relief, together with a significant amount of grants and lending on concessional terms will be crucial in assisting Georgia during the transition.  26 Key Macroeconomic Indicators (in Percentage) 1993 1994 1995 1996 1997-98 99-2003 Actual Est. - --- ---------------Projected------------------------ Real Growth Rates GDP at Factor Cost -32.1 -28.7 -3.8 3.1 5.5 6.9 Exports of G&NFS' -10.6 0.9 11.4 9.7 8.7 Imports of G&NFS' 4.2 -0.2 6.6 5.9 6.0 Private Consumption -23.2 -15.0 -3.9 0.1 2.2 4.6 (index: 1994=100) 117.1 100.0 96.1 96.2 99.5 114.9 As percent of GDP Domestic Savings -18.9 -35.1 -19.8 -10.2 -0.1 9.4 Gross Domestic Investment 6.0 3.5 3.5 6.7 11.3 15.2 Resource Balance -24.9 -38.6 -23.3 -16.9 -11.4 -5.8 Primary Deficit -26.2 -10.9 4.5 -3.2 -0.5 0.3 Fiscal Deficit -26.3 -10.9 4.8 -4.0 -1.4 -0.4 Total Debt Outstanding 53.2 92.2 85.1 93.0 98.9 90.1 Total DOD (millions of US$) 648.0 974.9 1380.3 1744.1 2113.0 2670.5 Inflation (Annual Avg) 4085.6 12,620.4 118.6 15.7 6.0 6.0 Sources: Georgian authorities and staff estimnates. ' Trade data for 1993 have been revised and are not compatible with 1992. Exports and imports for 1994 are based on preliminary data from the IMF. External Financing (in millions of US Dollars) 1993 1994 1995 1996 Actual Estimated ----------Projected--------- Gross Financing Needs 309.5 647.0 700.9 522.9 Current Account Deficit 306.2 491.8 422.1 368.2 Amortization 3.3 119.2 260.8 119.3 Changes in Reserves (+= Increase) 0.0 36.0 18.0 35.4 Assumed Identified Financing 640.6 291.1 300.8 107.2 Official Transfers' 131.2 162.0 169.8 34.7 Foreign Direct Investment 5.5 0.0 0.0 5.0 Medium/Long-term Disbursement2 503.9 129.1 131.0 67.5 Short-term Capital Inflows 0.0 0.0 0.0 0.0 Financing Gap -331.1 355.9 400.1 415.7 Covered by Net IMF Purchases 0.0 38.9 38.9 0.0 Changes in Arrears 62.0 305.0 -367.0 0.0 Gap-fill Financing3 -393.1 12.0 728.2 415.7 Sources: Georgian authorities and staff estimates. Estimates for 1995 are based on the results of the Consultative Group (CG) meeting held in Paris in November 1994. Estimates for 1995 include disbursement from an EBRD loan and a Turkish loan announced at the November CG meeting. Includes new money and debt rescheduling.  27 PART II. THE BANK GROUP'S ASSISTANCE STRATEGY I. Background and Objectives 102. The objectives of the World Bank's country assistance strategy are to help reverse the economic decline of the past few years, to assist the transition to a market economy and alleviate the poverty which has emerged in Georgia in recent years. With a particular focus on promoting private sector development and redefining the role and improving the efficiency of the public sector, the World Bank will support Georgia's structural reform programs through lending, economic and sector work (ESW), policy dialogue and an active role in resource mobilization and aid coordination. Through its lending program, the Bank will support economy-wide and sector-specific reforms that promote economic growth as well as investments to rehabilitate and build new capacity in critical infrastructure sectors. The Bank will also assist in strengthening public management, developing human resource and institutional capacities and strengthening the social safety net. The following preliminary country assistance strategy has been discussed with the Georgian authorities in general terms. lI. A Period of Conflict and Nation-Building 103. The assistance strategy reflects the constraints that have hindered a more active role for the Bank until recent months. While some constraints have eased, others continue to affect the Bank's ability to develop and implement lending operations and the composition of the program. The Bank must also proceed with the understanding that many of the causes of Georgia's recent problems have not yet been fully resolved. 104. The primary constraint hindering development of a full assistance program with Georgia was the civil conflict. When Georgia joined the World Bank in mid-1992, clashes were continuing between supporters of the current government and those of the previous president who had been deposed in early 1992. In addition, secessionists in Ossetia and in Abkhazia during mid-to-late 1993 fought against government forces to achieve independence. With the settlement in Ossetia and the defeat of government forces in Abkhazia, the civil conflicts are now quiet, and negotiations to find a lasting resolution in Abkhazia are taking place. While the possibility remains that conflict could resurface, government officials are now able to refocus their attention on economic matters. 105. A second important constraint had been a lack of commitment to reform on the part of government officials responsible for economic policies. This constraint has been relieved over time by the appointment of an increasing number of higher-level government officials committed to working with the IMF and the World Bank on the design and implementation of stabilization and structural reform programs and their ability to achieve agreement on change within the government. A further issue has been the weak institutional and technical capacities within the government, which impinge on program development and will continue to constrain project implementation as more projects are initiated. Technical assistance and training, through the Institution Building Credit and other donor programs, are helping to improve this situation, though substantial institutional development and capacity building are still needed. 106. These constraints prevented the Bank from instituting a comprehensive assistance program during the first two years of Georgia's membership in the Bank. Given the security situation through early  28 1994, lending in particular was not feasible, nor was the Bank able to devote many resources to identifying or preparing eventual investment operations. In this situation, the Bank instead focused on building macroeconomic and sector knowledge and providing limited technical assistance through Bank missions. A Country Economic Memorandum was prepared and introductory missions on transport, agriculture, and the environment took place. III. A New Relationship 107. After the halt of the civil conflict, during early 1994 the Bank was able to initiate a broader program of lending preparation. The Institution Building Credit which had been negotiated in June 1993 was finalized and approved by the Board in July 1994. This credit provides support to the country's privatization efforts, financial sector reform, tax and customs administration strengthening, and economic policy development. Project implementation in these areas has begun. During the summer of 1994, the Bank prepared a Municipal Infrastructure Rehabilitation Credit which addresses the severe deterioration of municipal infrastructure in Tbilisi and other larger cities. It includes assistance with immediate heating needs and energy efficiency improvements in schools and hospitals. This project was approved by the Board in November 1994 and is already having an impact this winter. In addition to these activities, Georgia is benefiting from the GEF-funded Black Sea Environmental Program which is being jointly executed by the Bank, UNDP, and UNEP. With the aim of addressing environmental problems along the Georgian Black Sea coast and in the coastal zone, and in coordination with the Municipal Infrastructure project, technical assistance and project preparation funds are directed toward wastewater treatment and solid waste management in Poti and Batumi and the establishment of a national park in coastal wetlands. Furthermore, given the agreement with the IMF on a program of macroeconomic stabilization and the government's commitment to structural reform, the Bank began working with the government in October 1994 on a reform program that could be supported by this Rehabilitation Credit. 108. To gain a more in-depth understanding of the constraints and possibilities of the Georgian economy, the Bank has broadened the scope of its ESW studies. To date the most detailed work has been on agriculture, energy, transport, municipal services, and health, and an Economic Update has been completed. In addition, the Bank organized and chaired an initial donor meeting in July 1994 and a follow-up session specifically on urgent energy needs. The Bank also chaired a first Consultative Group meeting in November 1994 to mobilize support of stabilization and structural reform from the international donor community. At the CG, donors made financial commitments for 1995 representing about three-fourths of estimated financing needs exclusive of arrears and debt servicing. 109. At the request of the Government of Georgia, and given the build-up of the lending program in the country, the World Bank is planning to establish a resident mission in Tbilisi. The resident mission, which will be opened during FY96, will have the potential to contribute greatly toward maintaining an effective working relationship between the government and the World Bank, and will assist the implementation and supervision of World Bank projects. It will also help to monitor and report on Georgia's economic and financial situation and developments. A key responsibility of the resident mission will be to assist the government's aid coordination efforts, including assistance with the identification of external aid and borrowing priorities.  29 IV. The Lending Program 110. The World Bank's lending strategy addresses Georgia's primary economic constraints and promotes policy reform and investments required to resume economic growth and reduce poverty. Given Georgia's difficult fiscal situation, much of the program will concentrate on improving the cost- effectiveness of government programs and on redirecting public sector involvement in the economy, with the aim of providing a favorable environment for private sector development. 111. The economy faces constraints and challenges in a number of areas. The energy and transport sectors represent key constraints. Despite substantial hydropower potential, Georgia is highly dependent on imported fuels, and there is great need for rehabilitation and efficiency improvements in the existing transmission and thermal and hydropower generation facilities, as well as for policy and institutional strengthening. As a transit economy, Georgia and its neighbors, Armenia and Azerbaijan, need an effective transport and communication infrastructure. However, transport institutions and infrastructure are deteriorating from lack of maintenance and rehabilitation, which has resulted in poor and costly services. Environmental degradation in Georgia and the Black Sea may require country-specific as well as regional solutions. Also key to Georgia's development prospects and to the transition to a market economy will be investment in human capital, capacity-building and institutional development. Follow- through with plans to reform the health sector to improve service delivery to the poor and to privatize the system where possible would not only reduce obligations on the state budget and improve resource allocation efficiency, but would also help to strengthen Georgia's social safety net. 112. In FY95, three operations have been included in the lending program: the Institution Building (US$10 million) and Municipal Infrastructure Rehabilitation (US$18 million) Credits, which have already been approved, and this Rehabilitation Credit (US$75 million). IDA lending during FY95 will thus total US$103 million. The size of this allocation reflects the fact that Georgia is experiencing not only the initial transition costs as elsewhere in the FSU but also additional costs caused by delayed initiation of reform due to the civil conflict. Allocating this amount of IDA resources in one year reflects the judgment that IDA now has a unique opportunity to catalyze market-oriented reform in Georgia and that this lending could make a difference between the success or failure of reform efforts at this crucial time. Beyond FY95, IDA lending to Georgia would be within the normal IDA allocation. 113. Three scenarios for future World Bank lending are envisaged. Each of the three cases assumes that there is continued progress toward achieving a lasting resolution of civil conflicts that will allow more normal trading and other economic relationships to develop. The base and high scenarios are predicated on satisfactory implementation of the macroeconomic stabilization program. Under the base case, only IDA lending is being planned, and the economy is assumed to become IBRD creditworthy after 1998 when reforms have taken hold and peace in the region has been consolidated. In the high case, the reforms promoting fiscal strengthening, export development and overall supply response would strengthen Georgia's creditworthiness earlier and would allow IBRD lending to commence in FY97. 114. The base or medium case would be characterized by continued progress in implementing the structural reforms required to sustain the macroeconomic stabilization effort and to lay a basis for reestablishment of economic growth. While implementation of reform might not be completely even across all sectors, key structural reforms, which form a part of the government's economic reform program, would be expected. These key actions, or triggers, are:  30 * continued progress on small-scale privatization at a pace which would allow the completion of the program by end-1995; * substantial progress toward completion of trade liberalization through elimination of restrictions on exports; * introduction of the framework governing agricultural land reform, including the establishment of full and unrestricted property rights on agricultural land, and advances in its implementation; and * adoption of energy sector reforms including progress toward appropriate pricing, and strengthening of sector management and organization. 115. Under the base case the volume of IDA lending would total approximately US$150-180 million in five projects. One adjustment operation would be planned to help relieve policy constraints and to provide fast-disbursing balance of payments support. The operation would be devoted to economy-wide issues such as fiscal reform; strengthening the competitiveness of markets; the next steps in privatization, enterprise reform and demonopolization; and to priority sectoral constraints. 116. Under this scenario, the Bank's investment projects would focus on restoring and improving public infrastructure and services, promoting an environment more conducive to private sector development, assisting institutional development and achieving a sustainable social safety net. In particular, the investment lending program would include projects to support rehabilitation and efficiency improvements in the energy and transport sectors, strengthening of health service delivery, provision of needed assistance in land reform and the development of competitive production, processing, and marketing in agriculture. Environmental issues would be addressed through components of specific projects and through Bank-supported and administered regional initiatives, rather than through discrete environmental lending operations. To lay a basis for the investment projects, the Government will need to implement, beyond the overall triggers for this case, the specific policy and institutional changes necessary for successful execution of particular programs. For example, setting and enforcing appropriate cost recovery policies will be essential in the energy and transport sectors. In the health sector, the Government has developed a satisfactory program. Implementation of this program, in particular introduction of user fees and an adequate definition of priorities for public intervention, will be needed for lending in this sector. 117. The high case would be characterized by sustained progress in implementing macroeconomic stabilization and success in implementing the structural reform program and resolving structural policy issues. In addition to fulfilling the triggers of the intermediate scenario, the high case would result from: * corporatization and privatization of medium and large scale enterprises in accordance with targets agreed under the Rehabilitation Credit; * enforcement of financial discipline notably through the implementation of bankruptcy and anti- monopoly legislation and of action plans for dealing with the main large, loss-making state-owned enterprises; and * improved targeting of assistance programs and reform of the pension system to improve sustainability. 118. Under this scenario, during FY96-98 a blend of IDA and IBRD lending would total US$250 million in seven projects (about US$180 million from IDA and about US$70 million from the IBRD); there would be two adjustment operations and five investment projects. One adjustment operation would address the economy-wide issues as under the base case and a further operation during the period could focus on transition of the agricultural sector. One investment project would be added to the lending  31 program relative to the base scenario and would support adjustment in the enterprise sector. The program would be predicated on the adoption by the Government of the high case triggers and project-specific actions such as the ones noted above, in addition to implementation of restructuring/privatization plans for the state banks and improvements in banking supervision capacity. 119. The low case would reflect a limited effort on the part of the government to undertake meaningful stabilization measures and structural reforms. This scenario would be triggered by weak budgetary discipline, delayed elimination of administrative controls on trade and the slowing down of the privatization program. Under this case no policy-based lending would be considered, but some investment lending for infrastructure and human resource development would be planned. This lending would have the objective of avoiding deterioration of critically-needed infrastructure, maintaining a basic level of social protection, and keeping open a dialogue on structural reform matters with the government. In this case, IDA lending would be offered at a level commensurate with the poor performance ratings that would result in these circumstances. One project per year could be envisaged, with lending during FY96-98 totalling about US$60-70 million. V. Implications for World Bank Exposure 120. For some time to come, Georgia will need substantial external capital inflows to finance its import needs, build foreign exchange reserves, and meet its debt service obligations. In addition, the burden of payment on external arrears and on debt servicing due in the coming few years will need to be alleviated as part of the financing package. Given its near-term resource constraints and hence its difficulties in servicing harder-term debt, it will be important for Georgia to receive external assistance having long grace periods, lengthy maturities and, if possible, concessional interest rates. For these reasons, under the base case World Bank lending will come from IDA only during the initial period, and IBRD lending will build over time after 1998. Resulting from the medium case noted above, it is estimated that Georgia's outstanding debt, which is estimated to total US$975 million at end-1994 (including arrears), will increase to US$2.8 billion by 2003. The IBRD's share in total debt will increase from zero at present to 2.3 percent by 2003, which is significantly below the average of countries at Georgia's income level. The share of debt service owed to the IBRD in total debt service owed to official creditors will reach 1.5 percent by 2003, which corresponds to 0.1 percent of total exports by that year. This value is well within the Bank's exposure guidelines. Bank exposure will be monitored closely, and to spread risk, co-financing with other donors will be incorporated into project design.  32 Projected Creditworthiness Indicators - high case lerlding (percentafge) Low Inconit 1993 1994 1995 I99'S 20(3 Coumtries (1992) Total DOD/GDP 53.2 92.2 85.; 93.0 77.7 46.! Total DOD/Exports of GNFS 100.6 190.6 264.5 285.0 198.7 212.8 IBRD DOD/Exports of GNFS 0.0 0.0 0.0 0.0 5.2 14. EBRD DOD/Total DOD 0.0 0,0 0.0 0.0 2.3 7.8 IDA DOD/Exports of GNFS 0.0 0.8 16.9 24.4 28.3 21.5 IDA DOD/Total DOD 0.0 0A4 6.4 8.6 14.3 11.9 Debt Service/Exports of GNFS 1.2 31.0 63.2 29.8 36.0 17.4 of which: IBRD 0.0 0.0 0.0 0.0 0.1 2.2 of which: IDA 0.0 0.0 0.0 0.1 0.1 0.3 IBRD Debt Service/Debt Service on public Guaranteed Debt 0.0 0.0 0.0 0.0 1.5 15.8 IDA Debt Service/Debt Service on public Guaranteed Debt 0.0 0.0 0.0 0.3 2.1 2.1 World Bank estimates. IV. Economic and Sector Work Program 121. The World Bank's ESW program with Georgia supports the country assistance strategy's focus on planning and implementing structural reform to move Georgia to a market-based economy. ESW provides analytical means for advising the government on appropriate policy and investment strategies, as well as an intellectual basis for the Bank's policy dialogue. Carefully selected and timed ESW will also underpin the development of future policy-based and investment lending and will assist aid coordination. 122. There are four broad areas where ESW is planned for the coming three years: macroeconomic stability and growth, improving public sector efficiency, private sector development, and poverty alleviation. In the macro area the Bank will continue to update the status of structural reforms and to place them in a medium-term framework through the preparation of policy notes. In future years the Bank will also work with the government and the IMF in the preparation of Policy Framework Papers. To assist the improvement of public sector efficiency, the Bank is planning to undertake a review of public expenditures, particularly public investment. This work would take advantage of, and build upon, the ongoing and planned work in energy, transport, municipal services, health, and environment. In this review, work would also be planned on public sector labor and employment policies. The intention is that the review of the public investment program would serve as a basis for a future consultative group meeting. In the area of private sector development, the Bank is presently undertaking a review of the agriculture sector and is planning to initiate a broader private sector assessment which will include a focus on enterprise reform, including privatization, and the financial sector, augmenting the substantial work and technical assistance carried out in some of these areas under the Institution Building Credit preparation. Using household survey work financed under the IBC, a poverty assessment will be undertaken to measure the incidence of poverty, help identify most vulnerable groups and recommend means of targeting poverty reduction measures.  33 VII. MIGA and IFC Activities 123. Georgia became a member of MIGA in December 1992. To date there have been no investment guarantees issued. 124. Although Georgian officials have spoken on several occasions with IFC staff about possible membership, the government has not yet completed the membership processes. Its assessment has been that up-front membership costs would outweigh possible benefits in a climate of political uncertainty and macroeconomic instability. As economic conditions improve and as the government sees more immediate benefit, Georgia's interest in IFC membership will also likely grow. PART III. THE PROPOSED CREDIT I. Background and Rationale for World Bank Involvement 125. The economy of Georgia is undergoing the transition to a market economy under difficult conditions. In addition to experiencing terms of trade shocks and disruptions in supplies, as well as the effect of output declines in neighboring countries, Georgia's economy is suffering from the aftermath of two years of civil conflicts and political instability. In the short run, economic recovery will operate under sharp financial constraints (weak fiscal stance and large external obligations). The proposed credit would support the initial stage of Georgia's transition to a market-based economy and if implemented successfully would serve as the basis for the World Bank's future lending program to Georgia. The proceeds of the credit would finance critical imports needed to stem the decline in output and would contribute to developing the foreign exchange market. The project funds will be utilized within the overall budget envelope supported by the Systemic Transformation Facility (STF), and thus the local counterpart funds generated through the sale of the foreign exchange will provide non-inflationary financing for the Government's public expenditure program. The project should also provide a framework for the provision of financial assistance from other donor agencies. II. Program to be Supported 126. The Government's program of structural reform to be supported by this Rehabilitation Credit is outlined in Part I and in the attached Letter of Development Policy (Annex 3). The structural reform program described in the Letter complements the macroeconomic stabilization program supported by the STF which was approved by the IMF Executive Directors on December 15, 1994.  34 127. The following key policy measures were iiiplenienited prior io the submission of the proposed credit to the Board: Transfer of Ownership Rights to the Private Sector Privatization of small-scale enterprises * Regulations were issued prohibiting the imposition of conditions on post-privatization business activities and eliminating minimum bid prices for enterprises not sold after the first auction attempt. * About 847 small-scale enterprises were privatized (in addition to the 1,651 enterprises privatized as of October 12, 1994), reaching 40% of target (6,481 small enterprises). Privatization of medium and large-scale enterprises * About 402 medium- and large-scale enterprises were corporatized (in addition to the 335 already corporatized as of October 12, 1994) reaching 73% of target (1,007 medium- and large-scale enterprises). * The following preparatory steps for the Mass Privatization Program (MPP) were finalized: (a) completed collection of lists of eligible voucher recipients; (b) issued guidelines for the completion of the legal framework for MPP, including rules and regulations regarding distribution of vouchers, auctions, and bidding procedures; and (c) identified the large enterprises to be sold at the first three pilot auctions. * Criteria for the selection of enterprises to be privatized through international tenders were developed and adopted, and 15 enterprises were identified for this program. Land Reform * Preparation of a draft law on land reform was initiated: (a) defining the legal framework for transactions related to land including sale, lease and inheritance; and (b) giving landowners unrestricted rights to enter into such transactions. The government agreed to submit the draft law to Parliament for discussion no later than July 1995. Imposition of Hard-Budget Constraints on State-Owned Enterprises * The 25 largest loss-making state-owned industrial or agricultural enterprises were identified, and a decree ordering the preparation of action plans for these enterprises by September 1995 was issued. Restructuring the Government Sector * A restructuring plan for Government's ministries and departments, including a reduction of at least 25 % in the number of employees in the budgetary sector to be achieved through  35 rationalization and reorganization rather than through across-the-board downsizing, was submitted to Parliament. * A decree specifying basic policy lines for a reform of the health sector was issued. The reformn will define a basic package of services to be publicly financed so as to ensure access by the poor. It will also introduce fee-for-service charges, foresee privatization of some hospitals and clinics, and reduce the number of health care providers paid out of the state budget. Promoting the Development of Markets and their Increased Efficiency * All remaining restrictions on converting non-cash into cash money (and vice versa) for foreign currency were eliminated. * All requirements for delivery of goods under the state order system, except for those goods used to fulfill the existing barter trade agreements for energy resources, were eliminated. For remaining state orders, it was agreed that the price paid to producers will be equivalent to the border price, converted to domestic currency at the exchange rate prevailing at date of payment. 3 The number of products under export licensing requirements was reduced. Export controls were only maintained to: (i) fulfill the existing barter trade agreements for energy resources; (ii) protect environment and health; (iii) control arms trade; liv) control exports as required by trade agreements that give market access to limited quantities of Georgian products (e.g. the Multi-Fiber Agreement); or (v) protect temporarily the domestic supply of a small number of basic food items. * A decree was issued establishing a timetable for complete phasing out of the state order system, export licensing and export prohibitions (except for goods related to environmental protection, health, arms control and multilateral trade agreements). * A draft law for operations of the NBG was submitted to Parliament, and revised prudential regulations were issued. Ensuring a Minimum Level of Social Protection * A commission was appointed to prepare a reform plan of the social protection system which will build on the measures taken prior to Board presentation to increase cash transfers to the poorest groups. The plan to be completed by mid-1995 will form the basis for reforms starting later in the year. III. Project Implementation 128. Proceeds of this Credit will be disbursed monthly based upon evidence acceptable to the Bank that imports of eligible goods have taken place. The Credit funds will be disbursed into a Ministry of Finance (MOF) foreign exchange account with the NBG specially set up for this purpose. The NBG will withdraw the foreign exchange as and when needed to meet market demand from both the public and  36 private sectors and will reimburse the MOF at that time with the equivalent local currency at the market exchange rate. 129. The exchange rate applied to the credit proceeds will be determined by the inter-bank foreign currency auction market. This market was established in 1993 by the NBG and a group of commercial banks; currently about 45 of the registered commercial banks are eligible and participate in the auction. Following the decision to channel the totality of the surrender requirement to the NBG and to include non-cash sales/purchases, the frequency of auctions has been raised from once to twice a week since mid- September. The volume of transactions going through the inter-bank auction is currently about US$1.1 million per month. The Government expects this volume to expand as its stabilization and structural reforms strengthen the role of markets forces in allocating foreign exchange. 130. All proceeds of the Rehabilitation Credit will be made available to Georgia upon the credit's effectiveness. In view of the significant reform actions already undertaken since September 1994 and the substantial balance of payments needs of the country, 20% of the credit amount (US$15 million) shall be made available as retroactive financing and will provide reimbursement for imports procured in the four months preceding the date of credit signing. Such retroactive financing would allow the Government to procure energy and other critical imports essential for survival during the winter months. Considering Georgia's urgent need for import financing, it is expected that the Credit will be disbursed in a very short time. The closing date of the credit shall therefore be June 30, 1996. 131. The Deputy Prime Minister responsible for economic reform will oversee, coordinate, and monitor implementation of the policy reform program. He will be assisted by the ministries concerned, including those of Economy, Finance, Agriculture, State Property Management, Labor and Social Protection and the NBG. 132. A senior official from the Cabinet of Ministers has been appointed as project manager. That official will monitor the collection of customs documents and will supervise the preparation of the withdrawal applications and their submission to the World Bank. The project manager will ensure that adequate project accounts are maintained and that timely audits are conducted. Relevant staff in the customs department have been designated to assist in the preparation of relevant documentation and monitoring of the project. It has been agreed that the project staff would have access to the procurement and disbursement experts in the project implementation unit (PIU) of the Institutional Building Credit (IBC) for technical advice that may be required. These staff shall also be encouraged to attend World Bank seminars on disbursement procedures. IV. Procurement 133. Procurement under the project will follow standard procedures as spelled out in the "Guidelines for Procurement under the IBRD Loans and IDA Credits." On the basis of visits with Georgian importers, it is evident that their procurement practices are evolving toward those of a market economy. As in the case of other FSU countries, enterprises in Georgia traditionally had been supplied for the most part through non-competitive arrangements. After the break-up of the FSU and the dislocations caused by the civil conflicts, enterprises have had to seek other sources of supply. While communication with suppliers is not easy, evidence of business practice indicates that enterprises are concerned with market criteria of availability and reliability of supply, price, and quality and that importers have solicited multiple sources of supply from multiple countries. Given the stage of Georgia's move to a market  37 economy, the relative size of the country, and the limited experience to date with procurement in Georgia, the ICB threshold has been set at USS500,000. which is substantially lower than the threshold of US$5 million recommended in the Operational Manual. Below US$500,000. given evidence that importers have begun using acceptable purchasing practices, procurement using normal commercial practices will be allowed. 134. Government purchases are subject to regulations which require competitive procurement. Decree 264 approved by the Cabinet of Ministers in March 1993 specified that government procurement would take place on a competitive basis and set forth procedures for advertisement, bidding, selection and announcement of winning bidders. As for the enterprise sector, the ICB threshold shall be US$500,000. Below that amount, procurement of Government imports shall take place on the basis of quotations solicited from suppliers of at least two different countries. To ascertain greater information on procurement practices in the public and private sectors and to lay out a strategy for its improvement, the Bank will prepare a procurement review by end-1995. This review will serve as a basis for determining how the Bank could assist this effort, for example through use of the Institution Building Credit or a possible Institutional Development Facility grant. 135. In addition to the arrangements noted above, retroactive financing of goods would be allowed provided procurement has taken place according to these procedures and thresholds and that appropriate supporting documentation is available. With the prior approval of the Bank, LIB will be allowed for specialized goods in accordance with the procurement guidelines. Subject to prior approval of the Bank, commonly traded commodities may be procured through organized international commodities markets or other channels of competitive procurement. Direct purchases made in accordance with Bank procurement guidelines and with the prior approval of the Bank may also be financed using this Credit. Pre-shipment inspection will not be required under the proposed credit. The low import tariffs for the bulk of imports limits the probability of tax evasion through under-invoicing while the move toward macroeconomic stabilization will diminish incentives for over-invoicing. In addition, the Institution Building Credit is providing assistance to the Ministry of Finance and the Customs Department for reviewing and strengthening customs operations. V. Disbursement 136. The Bank will finance 100 percent of foreign expenditures for directly imported goods. Imports eligible for reimbursement will be subject to the World Bank's standard negative list. The minimum contract value for this Credit shall be US$5,000. The financing will be provided on the basis of (i) statements of expenditure (SOE) prepared in accordance with the Bank's simplified documentation requirements for adjustment operations (i.e. based on customs certificates) for contracts valued at less than US$500,000, and (ii) full documentation for contracts of US$500,000 and above, provided there is supporting documentation acceptable to the Bank that these contracts were awarded on the basis of open and competitive procedures. For some imports into Georgia (e.g., natural gas) which are not subject to customs inspection, a certificate of delivery shall be an acceptable alternative to the customs documentation requirement. The project manager will prepare the withdrawal applications based on the documents provided by the Customs Department, and will keep photocopies of the relevant customs and full documentation. The original documentation will be retained by the Customs Department for three years after the closing of the project, and will be made available to Bank supervision missions and to the auditors, as requested.  38 VI. Reporting, Accounting, and Auditing 137. The project manager will maintain all project accounts, which will be audited annually by independent auditors in accordance with the World Bank's guidelines on auditing and financing reporting. Audit reports will be submitted to the World Bank not later than six months after the close of each fiscal year, or the date of final disbursement. The project manager will also prepare monthly progress reports detailing the status of all procurement transactions, commitments, and disbursement requests. For the purposes of undertaking the required audits, the government will hire an independent auditing firm acceptable to the World Bank. The foreign cost of hiring of an auditing firm can be financed out of the Institution Building Credit. VII. Enviromnental Safety 138. As an adjustment operation, this project has been assigned to Category U (unrated) for the purposes of Operational Directive 4.01, which does not require an environmental assessment. VIII. Agreements Reached 139. At negotiations, understandings acceptable to the World Bank were reached on: (a) the attached Letter of Development Policy, outlining the Government's reform program and the timing of implementation; (b) the standard negative list of goods precluded from financing under the proposed credit; and (c) accounting and auditing arrangements. IX. Benefits and Risks 140. The potential benefits from the successful implementation of the economic reform program are enormous. With its educated labor force, its long tradition of entrepreneurship, and its already significant private sector, Georgia has substantial assets for becoming a fast-growing economy provided a favorable environment can be established. Over recent years, its potential has been wasted by inappropriate policies and civil conflicts which have added to the costs of the transition and imposed considerable hardship to the population. A successful reform program, adequately supported by external assistance, can lead to a quick reversal of recent trends and improvement of living standards of the population. The proposed credit would contribute to that reversal by easing the transition to a market economy through a rapid downsizing of the state-controlled sector and by setting policies that foster increased efficiency in resource use. The balance of payments support would finance imports critical to economic activity, and the local counterpart funds would provide budgetary support to ease the fiscal adjustment and to maintain a basic level of public expenditures, in particular for the social safety net. The disbursement mechanism of the credit will also support development of the foreign exchange market. 141. There are four main risks involved in the program. First, a lack of continuous political consensus and social tensions could lead to a slippage in implementation of reforms. Although the government has taken a series of decisive and courageous measures over the last few months, and there is a growing number of top government officials committed to reform, there is not yet unanimous support for all aspects of the reform program. The impossibility of providing more than a very limited social safety net could also create social tensions, making it more difficult to implement certain reforms, in particular those  39 related to the enforcement of price increases. To some extent, this risk can be reduced through interventions from the international community. By maintaining a substantial amount of humanitarian aid, through technical support and generous financial assistance, it should be possible to lessen the social costs of the adjustment and to provide continuous support to the team of reformers within the government. Growth of the informal economy should also help to reduce social tensions. 142. A second substantial risk is that adequate and timely external assistance of the magnitude required will not be forthcoming. The macroeconomic prospects are such that even with timely implementation of reforms and substantial external assistance, Georgia's economy will not start growing again before 1996, and will not reach the 1993 levels of per-capita consumption (already depressed relative to 1990) before the end of the century. The failure to achieve a fully funded program, and in particular, to obtain from Georgia's creditors restructuring or refinancing of the external debt on concessional terms, would force a much stronger domestic adjustment, imposing substantial additional'social costs on a population that has already suffered from considerable hardship. This could threaten public support for reforms and could increase the risk of political instability. To address this problem, the Bank will not only be prepared to provide solid financial support, but it will also assist Georgia in mobilizing external resources through the Consultative Group process and other donor coordination efforts. 143. A third risk is delayed implementation due to inadequate capacity within the Govermment and the executing agencies. Given the sharp economic decline experienced by the Georgian economy, timely implementation and rapid materialization of benefits from the program are essential to its success. To reduce that risk, continuous effort will be provided by the Bank, through the IBC and by mobilizing extemal technical assistance, to assist the Government in the design and implementation of the much needed reforms. 144. Finally, there is the risk that civil conflicts might resurface. Although the conflicts in Ossetia and Abkhazia are now quiet and negotiations are taking place for a lasting resolution on the latter, there is still uncertainty regarding the final outcome of these negotiations. PART IV. RECOMMENDATION 145. I am satisfied that the proposed credit would comply with the Articles of Agreement of the IDA and recommend that the Executive Directors approve it. Lewis T. Preston President by Sven Sandstrom Washington D.C. March 7, 1995 Attachments   Nt 'ILA A Georgia: Key Macroeconomic Indicators (in percent unless otherwise stated) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 Real Growth Rates GOP at Factor cost -32.1 -28.7 -3.8 3.1 5.1 5.9 6.6 6.7 7.0 7.1 7.1 Exports of G&NFS 1/ -10.6 0.9 11.4 9.9 9.4 8.8 8.8 8.6 8.7 8.8 Imports of G&NFS 1/ 4.2 -0.2 6.6 5.8 5.9 6.0 5.8 6.0 6.1 6.1 Private Consumption -23.2 -15.0 -3.9 0.1 2.4 2.1 4.5 4.3 4.5 4.6 5.0 INDEX (1994=100) 117.6 100.0 96.1 96.2 98.5 100.5 105.0 109.6 114.5 119.8 125.8 As X of GDP Domestic Savings -18.9 -35.1 -19.8 -10.2 -2.8 2.5 5.2 7.3 9.8 11.7 13.1 Gross Domestic Investment 6.0 3.5 3.5 6.7 9.5 13.0 14.0 14.5 15.5 16.0 16.0 Resource Balance -24.9 -38.6 -23.3 -16.9 -12.3 -10.5 -8.8 -7.2 -5.7 -4.3 -2.9 Budget Revenues 2/ 9.7 6.6 8.5 10.1 11.8 12.9 12.9 12.8 13.6 13.5 13.5 Budget Expenditures 3/ 35.9 17.4 13.3 14.1 13.7 13.8 13.5 13.4 13.9 13.8 13.7 Primary Deficit -26.2 -10.9 -4.5 -3.2 -1.1 0.0 0.2 0.1 0.4 0.3 0.3 Fiscal Deficit -26.3 -10.9 -4.8 -4.0 -2.0 -0.8 -0.6 -0.6 -0.2 -0.3 -0.2 Trade Balance -19.9 -31.6 -16.9 -12.6 -8.7 -7.6 -6.6 -5.7 -4.9 -4.2 -3.2 Exports 40.8 43.9 28.7 29.1 30.3 31.0 31.4 31.7 31.9 32.3 32.3 Imports 60.8 75.4 45.6 41.8 39.1 38.6 38.0 37.4 36.8 36.5 35.5 Current Account 4/ -14.4 -31.2 -23.9 -17.8 -13.5 -12.0 -10.4 -8.7 -7.2 -5.9 -4.4 Total Debt Outstanding 53.2 92.2 85.1 93.0 98.3 99.4 98.4 97.6 91.5 85.4 77.7 Total DOD (millions of USS) 648 975 1380 1744 2005 2221 2419 2635 2726 2791 2781 Amnual avg. Inflation 4085.6 12620.4 118.6 15.7 6.0 6.0 6.0 6.0 6.0 6.0 6.0 Sources: Georgian authorities and staff estimates. 1/ Trade data for 1993 has been revised and it is not compatible with 1992. Exports and Imports for 1994 are based on preliminary data from the IMF. 2/ Includes grants. 3/ Includes off-budget subsidies for bread, electricity and gas in 1993 and the first half of 1994. 4/ includes official transfers.  Georgia: Bslance of Payments ANNEX I (millions of USS) 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 A. Export of Goods and NFS 570.6 487.8 491.8 576.8 652.2 733.7 821.2 919.3 1027.1 1148.7 1263.5 1. Herchandise (FOB) 497.0 464.0 465.0 546.5 618.0 693.5 772.1 856.8 950.4 1054.9 1156.5 2. Non-Factor Services 73.6 23.8 26.8 30.2 34.2 40.2 49.2 62.5 76.6 93.8 107.1 B. Import of Goods and NFS 873.2 947.5 853.1 893.7 903.1 967.7 1037.7 1112.5 1197.5 1290.1 1365.9 1. Merchandise (FOB) 739.8 798.0 739.0 783.2 796.5 862.8 934.5 1009.8 1097.2 1192.5 1270.1 2. Non-Factor Services 133.4 149.5 114.1 110.5 106.6 104.9 103.3 102.8 100.3 97.6 95.8 C. Resource Balance -302.5 -459.7 -361.3 -316.9 -250.8 -234.0 -216.5 -193.2 -170.4 -141.5 -102.3 D. Net Factor Income -3.7 -32.0 -60.8 -51.2 -60.1 -69.9 -74.6 -77.7 -79.6 -85.2 -88.5 1. Factor Receipts 0.0 0.0 3.2 4.9 8.0 8.5 10.9 15.6 25.0 26.9 29.0 2. Factor Payments 3.7 32.0 64.0 56.1 68.1 78.4 85.5 93.3 104.6 112.2 117.6 (Interest on Gap) 0.0 0.0 0.5 35.9 52.5 66.5 71.6 75.2 79.9 78.4 74.7 (Interest on Arrears) 0.0 0.0 12.2 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 E. Current Account Balance -306.2 -491.8 -422.1 -368.2 -310.9 -304.0 -291.1 -271.0 -250.0 -226.7 -190.9 (before official transfers) 1. Official Transfers 131.2 162.0 34.7 34.7 34.7 35.0 35.0 35.0 35.0 35.0 35.0 2. Current Account Balance -175.0 -329.8 -387.4 -333.5 -276.2 -269.0 -256.1 -236.0 -215.0 -191.7 -155.9 (after official transfers) F. Long Term Capital Inflow 506.1 21.9 733.5 368.8 281.2 251.7 270.4 301.1 9.1 -95.6 -205.0 1. Foreign Direct Investment 5.5 0.0 0.0 5.0 20.0 30.0 60.0 75.0 85.0 90.0 125.0 2. Net LT Borrowing 500.6 9.9 -151.8 -51.9 -89.2 94.9 120.0 110.2 -38.5 -92.7 -127.3 3. Other LT Inflows (net) -0.0 12.0 885.3 415.7 350.4 126.8 90.4 115.9 -37.4 -92.8 -202.7 G. Total Other Items (Net) -331.1 305.0 -367.0 0.0 0.0 50.0 50.0 50.0 60.0 60.0 60.0 1. Net Short-Term Capital 0.0 0.0 0.0 0.0 0.0 50.0 50.0 50.0 60.0 60.0 60.0 2. Change in Arrears 62.0 305.0 -367.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 3. Errors & Omissions -393.1 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 H. Change in Net Reserves 0.0 2.9 20.9 -35.4 -4.7 -33.4 -65.0 -118.2 -34.2 -36.3 -31.8 1. Net Credit from IMF 0.0 38.9 38.9 0.0 0.0 -6.5 -13.0 -13.0 -13.0 -13.1 -12.8 2. Other Reserve Changes 0.0 -36.0 -18.0 -35.4 -4.7 -26.9 -52.0 -105.2 -21.2 -23.2 -18.9 (in months of imports) 0.0 0.5 0.8 1.2 1.3 1.5 2.0 3.0 3.0 3.0 3.0  ANNEX I Memo items: Nominal avg. Exchange Rate 13.5 1414.8 1971.3 2037.6 2103.2 2176.1 2250.4 2325.2 2401.8 2484.8 2577.7 (in thousands of coupons) Real Exchange Rate (1993=100) 100.0 85.0 55.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 50.0 Source: Georgian authorities and staff estimates.   ANNEX 2 Schedule A REPUBLIC OF GEORGIA REHABILITATION CREDIT Timetable of Key Processing Events (a) Time taken to prepare: 6 months (b) Prepared by: Government of Georgia with the assistance of IDA staff (c) Preparation Mission: October 10-28, 1994 (d) Negotiations: February 15-17, 1995 (e) Planned Board presentation: March 30, 1995 (f) Planned date of effectiveness: March 31, 1995 (g) Expected program completion: June 30, 1996 (h) Appraisal Report Not applicable  6bJb6O)30VTM6 6DIX63OJOb DEPUTY PRIME MINISTER 3a6o3a3-a8o66oI06 8A VCn D REPUBLIC OF GEORGIA 6aCaQjGo: (8832) - 99-9757 ph: (8832) -99-9757 (8832) - 98-9953 (8832) - 98-99-53 UJOdbo: 495151113060-176 Fax: 495d51/13U060 ext. 176 495151/13086476 495151/13086 ext. 476 (8832) 98-4083 Or (8832) 98-4083 N-____ ,<__,,_ -ebrar 1 L_-- 1995 Dear Mr. President, The attached letter of Development Policy outlines the Program of Macroeconomic Stabilization and Structural Reform of the Republic of Georgia. We request the World Bank to support this program with a Rehabilitation Credit of USS75 million. The program of measures in the Letter is intended to achieve the rapid resumption of economic growth within a sustainable macroeconomic framework. If adjustment and corrective measures are required during the course of the implementation of the program we will, where appropriate, review those measures with the World Bank. Sincerely yours, Temur Basilia Lewis T. Preston President International Bank for Reconstruction and Development  Annex 3 Page I of 10 GEORGIA LETTER OF DEVELOPMENT POLICY 1. Over the last few years, the Georgian economy has been negatively affected by the disruption of economic ties within the FSU, large terms of trade shocks and output decline in Russia and elsewhere in the region, and also by two years of civil conflicts. As a result, Georgia has suffered from a very sharp economic contraction, high and rising inflation, and a substantial deterioration in the standard of living of the population. Today, with the restoration of peace and increased political stability, the way is open for attempting to rebuild the economy, and for undertaking the necessary reforms that will bring about a successful transition toward a market economy. 2. The Government of Georgia is strongly committed to undertaking this task and to implementing a comprehensive program of macroeconomic stabilization and structural reforms aimed at restoring stable macroeconomic conditions and at promoting output recovery. 3. The Government's economic reform program focuses on four key elements, which are interconnected and mutually reinforcing: - First, macroeconomic stabilization will be achieved through fiscal adjustment and tight monetary policies. - Second, reforms of the public sector will be undertaken to reduce and redefine the role of the Government in the economy. The aim is to ensure that the stabilization program is sustainable, the institutions of public management are strengthened and that private sector activity expands rapidly through acceleration of the privatization process. - Third, the development and increased efficiency of markets will be fostered by finalizing the liberalization of domestic prices, as well as of the foreign exchange and trade regimes; promoting competition and creating a favorable environment for private sector development; and by strengthening the financial sector. - Finally, a minimum social safety net, compatible with the limited available resources, will be maintained to protect those who might suffer most during the adjustment process. The critical elements of the Government's economic program, including the timetable of key actions, are described below and also summarized in the attached policy matrix. 4. In parallel to the implementation of its economic program, the Government is committed to regularize relations with its external creditors. Since the country's independence, Georgia has contracted substantial external debt and has accumulated arrears, mostly related to its energy imports. The Government is aware that it now faces debt obligations that far exceed the country's current capacity to pay. To address this issue,  Annex Page 2 of I the Government has requested a stand-still on debt service payments and initiated negotiations on a restructuring or refinancing of its debt and arrears. In addition, the Government is committed not to contract any additional short-term debt and not to increase non-concessional medium- and long-term debt by more thei US23 million between September 1994 and June 1995 without previous consultation with the Bank. I. Stabilization Program 5. To bring about rapid price stabilization, leading to a reduction of the monthly inflation rate from an average of 50-60 percent during the first half of 1994 to low single-digits by the end of 1995, the Government is committed to undertaking a drastic fiscal adjustment, and to maintaining tight fiscal and monetary policies thereafter. 6. The overall fiscal deficit of the general government is targeted to decline from 26 percent of GDP in 1993 to about 9 percent in 1994, and to be limited to no more than 6-7 percent in 1995. The main element of the fiscal adjustment is the complete elimination of remaining generalized subsidies. As of September, 1994, domestic prices for gas and electricity were raised to reflect their full cost (import or production and distribution costs), and will thereafter be readjusted every month. Subsidies for bread and transportation were substantially reduced and will be phased out by mid-1995. Subsidies and transfers to enterprises, including interest subsidies also ceased. In addition, revenue-enhancing measures were adopted. These include the sale of donated imports of wheat and flour at the coupon equivalent of world market prices, and a package of tax measures, the most significant being increased tax rates for VAT, customs duties, and gasoline excise tax all of which became effective on December 1, 1994. To partly compensate for the price increases resulting from the removal of subsidies, modest wage increases were provided to the employees of budgetary organizations as of mid-September, 1994; cash supplements were also granted to the lowest paid employees. Pensions and other social benefits were also increased. Because of the fragile fiscal situation, further increases in public sector wages and social benefits will be limited to target inflation during the first half of 1995; possible increases in real wages and readjustments to the wage scale and to the structure of social benefits will only be considered during the second half of 1995. 7. To achieve stabilization objectives, the National Bank of Georgia (NBG) will tighten monetary policy. Changes in bank credit to general government and in net domestic assets of the NBG will be guided by inflation and international reserves targets. To sterilize part of the massive monetization of the fiscal deficit in the 3rd quarter of 1994, the NBG tightened its enforcement of reserve requirements, including levying penalties for non-compliance. In addition, reserve requirements on foreign currency deposits were raised at the beginning of September 1994, to the same level as domestic currency deposits (20 percent). Directed credits to selected sectors at highly subsidized rates and automatic access by state commercial banks to overdraft facilities, have both been eliminated as of October 1, 1994. To meet the liquidity needs of banks, the Government has undertaken to develop a short-term credit facility since the end of 1994. II. The Structural Reform Program 8. The Government is fully aware that sustained stabilization and output recovery require fundamental structural reforms designed to transform the economy into a market economy. Over the past three years, some measures have been taken in the areas of price liberalization, foreign exchange and trade regime  Annex 3 Page 3 of 10 reform, and private sector development. However, the scope of these reforms still needs to be extended and broadened to form a fully comprehensive program. This is the primary focus of the Government's current program. A. Reducing and Redefining the Role of the State Sector 9. The Government recognizes the need to strengthen the institutions of public management in order to successfully implement the structural reform program. Through reform of the tax system and by strengthening tax and customs administration, reducing collection lags, and enforcing compliance, the Government intends to increase its capacity to collect revenues and administer resources. The stabilization program will also contribute to that objective by reducing the negative effect of inflation on real tax revenues. 10. However, the Government is also aware that even with substantial progress in raising revenues, the current level of revenues is so low that public-sector institutions must be thoroughly reorganized in order to narrow the budget deficit and ensure the sustainability of the stabilization program. Moreover, it recognizes that the restructuring of many Government activities and the divestiture of state assets is desirable, even if the budget deficit remains moderate, in order to foster the development of private sector activity. 11. To address these issues, the Government is committed to a deep reform of the public sector. This will include: (i) rapid transfer of ownership rights to the private sector; (ii) the imposition of a hard-budget constraint on remaining state-owned enterprises; and (iii) restructuring of the Government sector. Transfer of Ownership Rights to the Private Sector 12. The Government recognizes that the need to further reduce the range of its interventions, retaining only a regulatory role for the remaining ones, and to impose hard-budget constraints to remaining state-owned enterprises calls for accelerating the privatization program. 13. Privatization of State-Owned Enterprises. The Government is fully committed to accelerating the program. With respect to small-scale privatization which is already fairly advanced, the Government intends to complete the privatization of 6,481 small enterprises under state ownership by the end of 1995.' Toward this end, the Government has privatized between mid-October and February 1, 1995, 847 small enterprises, which, added to the 1,657 enterprises privatized at an earlier date, already represent 40 percent of the fixed target (up from 25 percent in October 1994). 14. To expedite implementation of the program, the Government has adopted a number of measures. First, minimum bid prices have been eliminated at the second round of auctions for all enterprises not sold at the first auction attempt. Second, all small state-owned enterprises not sold at a second auction will be immediately liquidated and their assets auctioned piecemeal with no minimum bid prices; no more than one month shall pass between a first and second auction attempt. Third, in order to provide an incentive for local authorities to meet these accelerated targets, the Govermnent adopted and started implementing a policy I This target may not be fully met in Abkhazia and South Ossetia, but the Government is committed to making its best effort to complete the programs in these two regions.  Annex 3 Page 4 of 10 allowing all municipalities that have achieved the SPM imposed targets to retain a percentage of privatization proceeds from the sale of local and republican enterprises within each municipality. Fourth, the Government eliminated commercial tenders which imposed conditions on post-privatization business activities, for all small enterprises (except for those selling rationed goods or owning assets deemed to be of historical significance). 15. With respect to medium-sized and large enterprises, the Government will implement a voucher- based mass privatization prograrn (MPP), supported by a comprehensive public relations campaign publicizing the program's objectives, procedures for participants to obtain vouchers, and procedures for the conversion of vouchers to shares in enterprises and investment funds. In order to establish a solid legal foundation for the voucher program, the Government has issued guidelines to complete the necessary legal framework for the MPP, including the issuance of regulations regarding the distribution of vouchers, auctions, and bidding procedures. 16. Successive waves of enterprises will be auctioned, both locally and nationally, throughout 1995, and the MPP will be completed by July 1996. The first wave of the MPP will involve two local pilot voucher auctions, and one national pilot auction, which will be carried out during May and June 1995. In preparation for the MPP pilot auctions, the Government completed the corporatization of 402 large enterprises, in addition to the 335 already corporatized as of October 12, 1994. As of February 1, 1995, about 73 percent of medium- and large-scale enterprises have been transformed into joint-stock companies. The Government has also identified the enterprises to be sold in the first three pilot auctions. Thereafter, it will distribute enterprise preparation packages to the enterprises participating in the first three pilot auctions. 17. Identification of voucher recipients is a binding constraint on the voucher distribution process and hence on implementation of voucher auctions. The Government has recognized the critical need to finish this task in a relatively short period of time and completed in February 1995, the compilation of lists of eligible voucher recipients. 18. In order to facilitate the mobilization of financial resources for investment, the Government will introduce a case-by-case approach to privatizing a select group of large enterprises, targeting the sale of a majority of their shares to foreign or domestic investors with the capital necessary for new investment and the skills and experience required to quickly restructure these enterprises for successful operation in a market economy. Toward this end, the Government has developed and adopted criteria for the selection of enterprises to be privatized through international tenders, and identified 15 large enterprises for this program. These enterprises will be exempted from Decree 178 dated May 29, 1994. The Government expects to complete privatization of these enterprises by mid-1996. 19. Privatization of land. To date, distribution of land has taken place without establishment of a legal framework for land ownership. As a result, land which has been distributed is still legally owned by the state. To facilitate the restructuring of the agriculture sector, the Government is preparing a draft land law with assistance of World Bank staff. The draft will be submitted to and discussed by Parliament no later than July 1995. The draft Land Law will: (a) define the legal framework for transactions related to land, including sale, lease and inheritance; (b) give landowners unrestricted rights to enter into such transactions; and (c) recognize all land previously distributed to Gerogian citizens as their private property. Following the adoption of the land law, the Government will establish land registration procedures and initiate the distribution of property titles.  Annex 3 Page 5 of 10 20. The Government is committed to completing the transitional reforms in agriculture and to foster the creation of economically viable and efficient production units. By mid-1995. it will prepare a program for land privatization which defines the general principles according to which the remaining agricultural land will be distributed, and which also sets targets for privatizing remaining state and collective farms. Implementation of the land privatization program will be completed by February 1996. 21. Privatization of Housing. Most housing units in rural areas and urban apartments have been privatized and owners are free to sell or rent their housing. However, the legal framework is still incomplete and the Government intends to enact by mid-1995 the legislation necessary to define ownership rights for communal spaces and facilities, as well as providing a framework for privatization of buildings. Enterprise Management and Restructuring 22. Notwithstanding privatization and growth of the private sector, state enterprises will continue to play a significant role in the Georgian economy in the near term. Strengthening their economic performance will be critical to improvement in the Government's fiscal position, recovery of output, further development of the private sector, and to the viability of the banking system. 23. The Government will take measures to enforce financial discipline and will signal that the State will not bail out uneconomic activities. It will do so by submitting a draft Law on Bankruptcy to Parliament by April 1, 1995, exposing thereafter the enterprise sector to the provisions of the law. In addition, the Government has identified and made public a list of 25 largest loss-making state-owned industrial or agricultural enterprises and, through a resolution of the Cabinet of Ministers, has ordered the preparation of detailed action plans for these enterprises, including partial or complete privatization, partial or complete declaration of bankruptcy, breaking up of monopolies and divestment of social assets. These action plans will be made public by September 1995 and implemented thereafter. During the whole period of preparation and implementation of the action plans, the Government is committed to maintain these enterprises isolated from the banking system. None of them will benefit from government loans nor from government-guaranteed loans from conmmercial banks. 24. In addition to hard-budget constraints imposed through fiscal discipline, the Government intends to promote increased efficiency of operations in state-owned enterprises through the introduction of management contracts. These contracts include hiring of senior management on a contractual basis, incentive schemes, explicit profit or loss reduction target, and other performance measures. They will be introduced on a pilot basis, by end-1995, in three enterprises of the mining and military sectors which are not subject to privatization in the medium-term. Based on an evaluation of this pilot project, the Government intends to extend the experiment to other enterprises. Restructuring of the Government Sector 25. This part of the reform program is designed to reduce the size of the public sector while strengthening its capacity to perform a limited set of critical public functions. As a first step, the Government is committed to reorganizing and streamlining the public administration in order to reduce staff requirements by at least 25 percent. Two alternative reorganization plans have been submitted to Parliament and will be discussed in early 1995. Reorganization will not be accomplished with across-the-board cutbacks in the staff of each office, but following a detailed examination of the new responsibilities of each office. Some may be  Annex 3 Page 6 of 10 expanded: many will be reduced in size, and some will be eliminated altogether, because their roles duplicate those of another government offices or because their original missions are no longer consistent with the reduced government role in the Georgian economy. The Government intends to implement the reduction in staff requirements by the end of the first quarter of 1995. 26. In addition to reform of the top levels of public administration, the Govermnent is also committed to reform of important public functions which up to now have been managed by government officials and financed out of the State budget. Two of the most important of these functions are the provision of health care and education. In light of the severe constraints on public revenues, part of these two functions will have to be financed on a new basis, including fee-for-service charges to users of the services. The Government will retain a central role in regulating the quality of services provided by these institutions, licensing the nurses, doctors, and instructors, financing a basic package of services and ensuring access to health and education services for needy patients and students respectively. 27 A detailed proposal for reform of the health sector was approved by the Cabinet of Ministers and a Decree by the Head of State was issued in December 1994 to enact these reforms. The reform will guarantee free access to health care in hospitals and polyclinics for a basic but limited range of medical services. All other services will be provided on a fee-for-service basis. Some hospitals and polyclinics will be privatized; all will become self-managing and independent of day-by-day direction from the Ministry of Health. Hospital and polyclinic fees will finance the salaries of the health care providers who work in these institutions and who will no longer be paid out of the State budget. Implementation of the reform started in January 1995 and is expected to take place over a period of two years. 28. The reform plan will include regulations and a financing mechanism to ensure provision of basic health services to all Georgians and especially to those who do not have enough income or assets to pay for these services without help. The Ministry of Health will retain its important role in accrediting hospitals and licensing the doctors and senior health professionals. A plan for accreditation will be adopted by mid-1995. 29. The Government also expects to introduce a reform of the educational sector which would guarantee free basic education for the nine years of compulsory schooling, but would change the financing basis and organizational structure of education for children under age 7 and older than age 15. Under the proposed plan, these very young or older students (or their parents) would be charged fees to cover the costs of the educational services received. Nursery schools, kindergartens, and educational institutions that offer education and training after compulsory schooling ends would become self-financing, though scholarship assistance would be provided out of the State budget to pay for the schooling of some needy and/or talented students. For this academic year, the Government has introduced this scheme on an experimental basis, in two cities. Based on an evaluation of this experiment, a proposal for reform at the national level will be prepared and discussed by the Government by end-1995. B. Promoting the Development of Markets and Increasing their Efficiency. Promoting Competition and Private Sector Development 30. Government intervention in the area of pricing has already been substantially reduced through the liberalization of most retail and wholesale prices in 1992. The Government is aware, however, that remaining price controls - mainly on bread, gas, electricity, and public transportation - have led to huge  Annex 3 Page 7 of 10 distortions in resource allocation and increasing budgetary difficulties. The Government is conmmitted to remove these distortions both to promote efficient resource allocation and to strengthen the budget. As of September 1, 1994, domestic prices for gas and electricity were increased to reflect full import and distribution costs and will be readjusted each month to maintain full cost recovery. Effective September 17, the price of bread was increased from 700 to 200,000 coupons per kilogram. It was further increased to 280,000 coupons in December 1994 and will be liberalized by mid 1995. Subsidies for transportation have also been reduced and will be eliminated by mid-1995. Regulated prices therefore remain only for a very limited number of goods: gas, electricity, transportation, municipal services, and rents (for non-privatized housing). For the most important of these goods, the Government is commnitted to maintaining full cost recovery. 31. Although the recently adopted price realignment for gas and electricity eliminates cross-subsidization between types of energy and will have a favorable fiscal impact, it is only based on average cost. The Government is aware that the structure of electricity prices needs to be based on long-run marginal cost in order to increase the efficiency and reliability of energy supply, provide proper signals for energy demand, and generate the sources of funds necessary for investment in the sector. The Government is currently preparing a restructuring plan for the power industry and will start its implementation by the end of 1995, corporatizing the generating and distribution companies and introducing an efficient price structure. In addition, the Govermnent is committed to opening the power generation sub-sector to private investment in order to address supply constraints and to promote competition in the supply and pricing of energy. Concurrent with these measures, the Government will develop a comprehensive regulatory framework for power generation and distribution. 32. Breaking-up the monopoly of the Bread Corporation is also a top priority for the Government. However, the current need to ration and control prices for this critical staple involves sensitive social considerations in privatizing this enterprise, and the Government wants to move carefully. Therefore, in parallel with liberalization of the price of bread and the elimination of rationing, the Government will, by mid 1995, develop and adopt a restructuring/privatization plan for the Bread Corporation which includes measures to breakup the milling, baking, and retail units so as to introduce competition in the market for bread products. The Government will complete privatization of the Bread Corporation according to this plan by the end of 1995. 33. The Government realizes that the private sector will be the primary source of job creation and growth throughout the economy, and is an important source of competition for existing state-owned enterprises. It is addressing the main obstacles to private sector development by reducing barriers to entry for new businesses, and by completing the legal and institutional framework necessary for private sector activity and competition. To that end, the Government has adopted fairly simple registration procedures, and local authorities now clear new business applications over a relatively short period of time. A law on entrepreneurship -- which provides a comprehensive legal framework for development of private business -- was approved by the Parliament in November 1994. In addition, a law on investment, granting equal treatment to foreign and domestic investors was submitted to Parliament in September and is being discussed. Foreign investors will also be specifically targeted in the marketing of large, strategic enterprises to be sold by international tenders. Finally, an anti- monopoly law is under preparation designed to facilitate the breakup of monopolies and to control abuse of dominant market positions and restrictive trade practices. This draft law will be submitted to Parliament by mid-1995. Upon Parliamentary approval, the Government intends to create an anti-monopoly commission.  Annex 3 Page 8 of 10 34. Liberalization of Domestic Trade. Consistent with the Government's general policv of liberalization. and to further promote private sector development, most restrictions on domestic trade have been eliminated. All fixed margins on wholesale and retail trade have been abolished. Trade-related infrastructure -- such as wholesale storage bases and trucking enterprises -- is either already privatized, or in the process of privatization. Constraints on private sector access to commercial real estate have been addressed through long-term leasing arrangements. 35. The main remaining factor hindering the development of markets was the obligation that many enterprises faced to deliver part of their production domestically under the state order system. These quotas were used for various purposes, including compensation to input suppliers, direct distribution by municipalities, and building of state emergency reserves. The Government has now eliminated these requirements as part of the program to dismantle the state order system in favor of a market-based system of procurement. Fostering Export Growth 36. The Governmnent recognizes the imnportance of rapidly integrating Georgia into the world economy and intends to remove impediments that hinder export growth. To improve the functioning of the foreign exchange market, the Government has, as of September 21, 1994, increased the frequency of foreign exchange auctions to twice a week and is channeling the totality of the 32% surrender requirement through the NBG with rapid reimbursement at the auction rate. In addition, the restrictions on conversion of non-cash to cash coupons and similar restrictions applied to foreign currency deposits have been eliminated. These measures have two salutary effects: removing an implicit tax on exports, and contributing to the development of exchange market institutions. 37. The Government also intends to continue moving toward an interbank foreign exchange market by extending participation in the auction to foreign exchange bureaus and large importers, and by eliminating most restrictions on bidding. By the end of 1995, the surrender requirement for exporters will be eliminated. 38. The Government has also taken action to liberalize foreign trade. There are no restrictions on imports and the import tariff is uniform. Legislation has been approved by Parliament to raise the import tariff rate to 12% (for fiscal reasons) and to eliminate the 8% tax on exports as of December 1, 1994. In February 1995, requirements for delivery of quotas have been removed except for those used to fulfill the terms of the agreements to supply energy resources and a decree has been adopted to establish a timetable for phasing out completely the state order system by the end of the first quarter of 1996. All purchases of goods by the Government to fulfill the terms of the agreements to supply energy resources will be carried out on the basis of market prices in foreign currency converted to coupons at the exchange rate prevailing on the date of payment. 39. The Government has also started eliminating export prohibitions and licensing requirements, with the following exceptions: first, restrictions are maintained for a few goods for reasons of ecological conservation, health (when feasible, these restrictions will be replaced by taxes) or foreign policy (e.g., arms). Second, licenses are retained for export of specified goods to countries with which Georgia negotiates trade agreements that give preferential market access for limited quantities of trade in these products. These licenses, if any, will be auctioned. Third, export licensing requirements temporarily remain in place for a short list of goods that are needed to obtain energy resources. Fourth, also temporarily, the Government will maintain export prohibitions for a small number of goods - mostly basic food items - in order to protect  Annex 3 Page 9 of 10 domestic supply. The Government, however. intends to eliminate gradually these licensing requirements and prohibitions over a period of about one year (except those for reasons of ecological conservation, health, arm control or limited preferential market access for Georgian products). A decree has been issued in February 1995 specifying the corresponding timetable. Strengthening the Financial Sector 40. Prospects for economic recovery will depend much on the capacity to increase financial savings in the economy and to allocate financial resources more efficiently. The Government is, however, aware that the financial sector in Georgia suffers from widespread disintermediation and misallocation of credit and that a number of features of the sector require immediate reform to attend the needs of an emerging private sector. 41. At the end of September 1994, the Government started addressing these issues by eliminating the restrictions on conversion of non-cash to cash coupons which led to a segmentation into a cash and non-cash circuit and discouraged households and enterprises from holding deposits in the banking system. It also eliminated the cash-non-cash distinction for foreign currencies at the end of 1994. Directed credits to state enterprises have been eliminated, and the state banks' access to refinance credits and overdrafts at the NBG has been discontinued as of October 1994. To meet the liquidity needs of the banking system, the Government has undertaken to develop a short-term interbank credit facility. These measures, in addition to strengthening the capacity to monitor and administer fiscal and monetary policy, should promote a more efficient allocation of credit and greater financial savings. 42. The Government also recognizes that establishing an adequate legal and regulatory framework and developing the institutional capaciiy to supervise banks and enforce regulations are necessary conditions for an efficient and competitive financial sector. To that end, the Government has - with the assistance of the IMF - prepared a new law on the National Bank which addresses monetary and credit regulations, NBG interventions in banking activities, and foreign currency regulations. The law was submitted to Parliament in December 1994 and will be discussed in early 1995. The Government also intends to strengthen the supervision function of the NBG with technical assistance provided by the IMF and the World Bank (under the IBC). As part of this strategy, the NBG has suspended the general licenses of 42 commercial banks and the foreign exchange licenses of 28 banks in October 1994. It has undertaken the revision of prudential standards and issued new regulations with appropriate phasing for implementation. It also intends to tighten enforcement of these regulations. 43. The Govermment is aware that the main financial institutions in Georgia are in perilous financial condition. To address the issue of restructuring, possible re-capitalization, and privatization of the state conmmercial banks, the Government is undertaking a diagnostic review of the five specialized state commercial banks with technical assistance financed under the World Bank IBC. Based on the review results, expected by April 1995, the Govermment is committed to define, adopt, and implement an action plan for restructuring and privatizing the five state-owned banks. C. Ensuring a Minimum Level of Social Protection 44. The Government is highly concemed about the decline in living standards for most Georgians, and about the additional fall in real incomes that the stabilization program will impose on the population in the  Annex 3 Page 10 of 10 short run, particularly through the elimination of subsidies. At the same time, the Government is aware that the collapse in revenues of the social security and unemployment funds and the existing financial constraints preclude the implementation of an adequate program of assistance. It is thus committed to use the limited resources available as efficiently as possible, and to improve targeting of the social assistance that can be financed out of the budget. 45. Improving targeting of benefits does however imply drastic reforms in a system of social protection. This system, inherited from the past, covers half of the population. Improved targeting also implies identification of the most vulnerable groups, task which is particularly difficult in a country with deficient statistics and a large informal economy. Aware that denying benefits to large fractions of the population without precise knowledge of their economic situation could entail substantial social costs at times of economic difficulty, the Government has taken a gradual approach. 46. Considering that the pension system could not afford to grant favorable treatment to particular categories of pensioners, the Governrent eliminated, as of September 1994, special pension supplements and transformed the pension system into a simple assistance program providing a flat-rate benefit to all pensioners. By doing so, the Government also reduced the administrative burden linked to the calculation of pensions and the need for staff. 47. To provide compensation for the elimination of subsidies, pensions were raised in September 1994 to 2.5 million coupons per month (about 18 times their level in July 1994). Child allowances and unemployment benefits were also raised. However, other benefits - childbirth and death benefits - were eliminated, and pensions were denied to working pensioners, thus reducing the number of pensioners by 16 percent. Through these measures, the Government was able to provide a larger adjustment to those remaining eligible. The Government is also comrnitted to implement special cash and in-kind assistance programs for the refugees from Abkhazia and the 90,000 families considered as particularly vulnerable. 48. Although the measures described above represent significant steps towards strengthening the social safety net, the level of benefits remains extremely low. The Government recognizes that this set of measures is still insufficient and that a comprehensive reform of the social protection system is needed. Accordingly, in February 1995, an order of the Cabinet of Ministers has been issued to a commission headed by the Minister of labor and Social Security to prepare a reform plan aimed at strengthening the system of social protection. This reform plan will: (a) address the sustainability of the pension system; (b) examine possibilities for further targeting of benefits, in particular the identification of vulnerable groups; (c) evaluate budgetary implications; and (d) recommend a program of actions. It is the Government's intention to complete preparation of the reform plan by mid-1995, and to begin implementation during the second half of 1995.  Page I of 12 OBJECTIVES CURRENT STATUS | MEASURES TO BE TAKEN l | Before Between March 1, 1995 l_____________________________ J (as or sept. 1, 1994) March 1, 1995 and March 1, 1996 1. MACROECONOMIC STABILIZATION To create a stable macroeconomic Inflation showed no sign of Agreement reached with IMF on a Agreement on Stand-by Arrangement environment conducive to economic deceleration: monthly rate of inflation stabilization program. First purchase with IMF in April 1995. growth. remaining around 60% during first under STF approved on December 15, half of 1994. 1594. Reduce the monthly rate of inflation to low single-digit levels by end-1995. Introduction of a new stable national currency, the Lari. a. Fiscal Policy Weakening of the fiscal stance: sharp Budget deficit for second half of 1994 Budget deficit to be restricted to 6-7% drop in revenue collection to 3% of reduced to 3% of GDP. of GDP through monthly readjustments GDP in 1993; budget deficit of 26% of regulated prices, phasing out of of GDP in 1993 financed through Expenditures reduced through sharp remaining subsidies, tax reforms and money creation, external borrowing cuts in subsidies for gas, electricity, strict controls on increases in wages and and grants; budget deficit for the first bread and transportation - subsidies and social benefits. half of 1994 about 32% of GDP on a transfers to enterprises ceased.* cash basis. Partial compensation for removal of subsidies through higher wages in budgetary sector and increases in social benefits as of Sept. 94. Government spending: sharp reduction Revenues increased through: increases in real wages, social spending and in VAT rate, import customs duty, capital expenditures: subsidies gasoline excise tax, presumptive tax on accounting for 70% of expenditures. kiosks, reduction in exemptions from VAT, increases in penalties for non- compliance, effective on Dec. 1.* Tighter control of General Govermnent expenditures through prohibition of bank borrowing by local Governments and centralization of Government bank accounts at NBG.* e Prior action for IMF STF.  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 2 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN Beore Between Marcb 1, 1995 (as of Sept. 1, 1994) M , 199 and Mtich 1, 1996 b. Monetary Policy Initial anempts to tighten monetary Consistent with inflation and Development of short-term credit policy remained ineffective as state international rcserves targets, increase facility. commercial banks did not comply in net domestic assets and net domestic with reserve requirements and made credit to General Government Other measures to be defuned in the extensive use of overdraft facilities. restricted. context of the Stand-by Arrangement. Reserve requirements on foreign currency deposits raised to the same level as domestic currency deposits (20%)* as of Sept. 1; enforcement tightened. Automatic access to overdraft facilities by state commercial banks eliminated as of Oct. 1.* Restriction on conversion of bank coupon deposits into cash removed as of Sept. 23.*  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 3 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN l Before Between March 1, 1995 (as of Sept, 1, 1994) Marcb 1, 1995 and March 1, 1996 IHn. REFORMS OF THE PUBLIC SECTOR A. Transfer of ownership rights to the private sector To accelerate the transfer of ownership Establishment of basic legal and of productive assets from the state to institutional framework through laws private owners. and decrees since 1991: Ministry of State Property Management (SPM) established; Law on Privatization of SOEs (1991); Privatization Program approved by Parliament (1992). In May 1994, to accelerate the process, new decree introduces direct sales and discounts to employees as an additional privatization option. Privatization of small-scale enterprises Decrees and regulations on auctions, October decree streamlined the tenders and valuations of assets (1992). administrative process and imposed a two month deadline to complete privatization following notification by SPM. Regulations issued prohibiting the irnposition of conditions on post- privatization business activities and eliminating the minimum bid prices at second round of auctions, for enterprises not sold at first auction attempt. 847 additional small-scale 1,651 small-scale enterprises (out of enterprises privatized since Oct. Complete privatization of all small-scale 6,481 identified for sale) privatized by 12, 1994, reaching 40% of target enterprises identified for privatization by end- October 12, 1994, by auctions, (6,481 enterprises). 1995. commercial tenders and direct sales.  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 4 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN 040000000 t; 0 00 000 ;E070000 0 0 0 0 ; E0 ; 0 X t 0titi0 illt 0 BEtSe t Betwveen March 1, 1995 ____________________________________ (as of Sept. 1, 1994) n d M arch 1, 1996 A. Transfer of ownership rights to the private sector (cont'd) Privatization of medium and large- Adoption of laws and decrees relative 402 additional large enterprises Corporatize all remaining enterprises by mid- scale enterprises to transformation of SOEs into joint- corporatized since mid-October 1995. stock companies (1992), valuation of 1994 reaching 73% of target assets (1992), voucher program and (1,007 enterprises). investment funds (1993). Finalized following preparatory Implement the Mass Privatization Program: Of the 1007 medium and large steps for the Mass Privatization a. Distribute enterprise preparation packages to enterprises identified for privatization, Program (MPP): the enterprises to be included in the two 335 have been corporatized and eight a. Completed collection of lists of regional and the first national pilot auctions by privatized by October 12, 1994. eligible voucher recipients. May 1, 1995. b. Issued guidelines for the b. Distribute vouchers to the eligible recipients completion of the legal framework and complete the pilot auction by Sept. 1, 1995. for the MPP, including rules and c. Proceed with the voucher program to be regulations regarding distribution completed by July 1996. of vouchers, auction and bidding procedures. c. Identified the large enterprises to be sold at the first three pilot auctions. Proceed with the privatization of 15 large enterprises by international tenders to be Developed and adopted criteria for completed by mid-1996. selection of enterprises to be privatized through international tenders, and identified at least 15 large enterprises for this program. Privatization of Housing Law on privatization of dwellings Complete legal framework for privatization of adopted in 1992. apartment buildings and define ownership rights Privatization of housing nearly relative to communal spaces and facilities by complete, with the right to buy and sell mid-1995. apartments established and a rental market with no price controls.  Page 5 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN l Before Between March 1, 1995 |_______________________________ j (as of Sept. 1, 1994) March 1, 1995 and March 1, 1996 A. Transfer of ownership rights to the private sector (cont'd) Privatization of Land About 650,000 ha of land (about 40% Initiated preparation of a draft Submit a draft land law to Parliament for of total arable land and 52% of land land law: discussion no later than July 1995. for tree-crops) have been distributed to a. Creating full unrestricted private farmers, rural and urban property rights on agricultural land Establish a land cadastre. households with maximum holding of including the right to buy, sell, 1.25 ha. However, distribution took lease and inherit; Distribute property titles for all land already place without legal framework for land b. Providing land already in allocated to private farmers. ownership preventing development of a private use to farmers as their own land market. property. Prepare by mid-1995 a program for land privatization, which defines the general Number of collective and state farms principles according to which the distribution of reduced from 1,433 to 609 between remaining agricultural land will be completed, 1989 and 1994. including targets for privatization of state and collective farms aiming at creating economically viable and efficient production units. Implement the land privatization program: distribution of remaining agricultural land and privatization of state and collective farms by February 1, 1996. B. Imposition of hard-budget constraints to SOEs To ensure appropriate response to The GOG continued to provide support All subsidies and transfers to Submit to Parliament by April 1, 1995 the draft market forces. to SOEs through subsidized credits and enterprises ceased as of Sept. 94.* law on bankruptcy energy subsidies. Identified and made public the 25 Initiate implementation of the action plan for largest loss-making state-owned main loss-making enterprises by Sept. 1995. industrial or agricultural enterprises and initiated Introduce by end-1995, Performance Contracts preparation of an action plan for on pilot basis at three enterprises of the mining these enterprises which would be and military sectors that are not subject to adopted and made public by privatization in the medium-term. Based on September 1995. evaluation, implement performance evaluation and incentive schemes for senior management at other SOEs military and mining sectors during 1996.  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 6 of 12 OBJECTIVES CURRENT STATUS IMEASURES TO BE TAKEN BerorI Between March 1, 1995 .___________________________ (as of Sept. 1, 1994) March 1, 1995 and arch 1, 199 C. Restructuring of the Government Sector To strengthen the institutions of public Composition of budget distorted with Subsidies drastically reduced management. high proponion of spepding for through stabilization measures; subsidies, extremely low level of level of Government revenues To narrow budget deficit and ensure salaries in the budgetary sector, however, remain low and sustainability of macroeconomic declining capital expenditures and insufficient to cover public stability spending on social programs. spending (see la). To make the public role's About 630,000 employees paid out of Strengthening tax and customs Proceed with tax collection efforts and commensurate with growing reliance the budget. administration. enforcement of compliance. on private sector activity. Prepared and submitted to Restructuring Plan to be implemented by end of Parliament Restructuring Plan for 1995. Reduction in staff requirements public administration, including a implemented by April 1995. reduction of at least 25% in number of employees. Public expenditures on health and Adopted in Dec. 94 a reform plan Proceed with implementation of reforms of education reduced to about 2% of for health sector defining basic health sector. GDP; package of services to be publicly financed, introducing fee-for- service charges, foreseeing privatization of some hospital and clinics and reducing number of health care providers paid out of the State budget. Educational reform changing financing basis and organizational Based on pilot experiment, adoption and structure for all but basic level of implementation of reforms of the education education experimented on pilot sector initiated by end-1995. basis in 2 cities. * Prior action for IMF STF  Page 7 ot 12 OBJECFIVES CURRENT STATUS MEASURES TO BE TAKEN I i I i X i i;i Before: I Between March 1, 1995 ________________________________ j (as of Sept.1, 1994) March 1, 199S and March 1, 1996 III. REFORMS ADlMED AT THE DEVELOPMENT OF MARKETS AND THEIR INCREASED EFFICIENCY A. Promoting Competiton and Private Sector Development To complete price liberalization. Government intervention in the On Sept. 1, prices for gas and electricity increased to Monthly adjustment in prices to reflect area of pricing already reflect full import and distribution costs: for any increase in costs. Prices not to be To set regulated prices so as to achieve substantially reduced. Most retail consumers, price of electricity rose 600 times, of gas reduced until improvements in full cost recovery. and wholesale prices liberalized in for cooking 13,000 times, and gas for heating 5 collection of bills allow for achieving 1992. times. For enterprises, price of gas increased 5 times, full cost recovery. and of electricity 10 times.* Price controls maintained for bread, municipal services, energy On Sept. 17, price of bread increased from 700 to products, public transportation and 200,000 coupons per kg.* Price raised again to communications. 280,000 coupons on Dec. 25. Bread price liberalized by mid-1995. Remaining regulated prices Subway fares raised 50 times on Sept. 17.* m aintained constant in nominal terms at times of accelerating inflation and reliance on imports Subway fares raised again until for energy and wheat led to complete elimination of subsidies by substantial subsidies and huge April 1, 1995. distortions in resource allocation. * Prior Acdon for IMF STF  GEORGIA REHABILITATION CREDIT POLICY MAT&UX Annex 4 Page 8 of 12 OBJECTI CURRENT STATUS MEASURES TO BE TAKEN Before Between March 1, 1995 :____________________._________ (as otSept.l, 1994) March 1, 1995 ind March 1, 1996 A. Promoting Competition and Private Sector Development (cont'd) l To promote domestic competition and Fixed margins on wholesale and Price and trade liberalization measures (see above and Preparation of a restructuring plan for foster private sector development retail trade abolished, trade-related nib). the power industry; development of a infrastructure privatized or subject regulatory framework: introduction of to privatization, constraints on Acceleration of privatization process (see 11). an efficient price structure by end- access to commercial real-estate 1995. addressed through long-term Imposition of hard-budget constraints on SOEs (see leasing arrangements. 11). Develop and adopt by mid-1995 a demonopolization/privatization plan of Substantial growth of informal Eliminated all quotas under the state order system for the Bread Corporation economy. domestic uses and replace by a market-based system of procurement [see IJIb). Privatization of the Bread Corporalion However, growth of private sector by end-1995. still hindered by unstable Law on Entrepreneurship adopted by Parliament in macroeconomic environment, Nov. 1995 Anti-Monopoly Law submitted to price distortions, export Parliament by mid-1995 restrictions, incomplete legal Law of tnvestment granting equal treatment to foreign framework and functioning of the and domestic investors submitted to Parliament in state order system. Sept. 1994 No wage controls imposed on the private sector. Wages and other forms of compensation freely To foster rapid increases in negotiated between employers and employees in SOEs productivity through labor mobility Since 1990, employment in the and non-budgetary organizations. state sector decreased by 30% and private sector employment rose by 58%, Actual labor flows towards the private sector may be underestimated.  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 9 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN _________________________ oft00000 Sept.1,;0-: Ma; 0 Before Between March 1, 1995 ________________ i :(as of Sept.l, 1994) M ereb e1 e and March 1, 1996 B. Fostering Export Growth To promote export growth through Open import regime with no Totality of surrender requirement channeled to the Surrender requirement eliminated by elimination of implicit and explicit restrictions and uniform customs NBG to ensure quick reimbursement at auction rate.* end-1995 taxes on exports and development of duty (2%), but strong anti-export Frequency of foreign exchange auctions raised to smoothly functioning foreign exchange bias through: (i) foreign exchange twice a week. market surrender system; (ii) dichotomy Restrictions on convertibility of coupon deposits into between cash and non-cash; (iii) cash lifted on Sept. 23.* system of state orders and procurement, export quotas and Eliminated restrictions on converting non-cash to cash licenses; (iv) export prohibitions; for foreign currencies. and (v) explicit export taxes (8%). Import tax raised to 12% and 8% export tax Establishment of a unified market eliminated as of Dec. 1.* determnined exchange rate, set by the NBG on the basis of weekly Eliminated all quotas under state order system except interbank foreign exchange for those used to fulfill barter trade agreements for auctions, energy resources. For remaining state orders, price paid to producer equivalent to border prices converted to local currency at exchange rate prevailing at date of payment. Eliminated prohibitions and licensing requirements for exports except (i) to fulfill barter agreement for energy resources; (ii) to protect ecology; (iii) to conduct foreign policy (arms exports); (iv) to control exports as required by trade agreements giving limited access to Georgian products; and (v) to protect domestic supply of a small number of basic food items. * Prior Action for IMP STF  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 10 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN Before Between March 1, 1995 (as of Sept.1, 1994) March 1, 1995 and March 1, 1996 B. Fostering Export Growth (cont'd) Issued decree establishing timetable for phasing out of Phase out state order system, state order system, export licensing requirements and remaining export licensing prohibitions (except those for reasons of requirements and prohibitions environmental protection, health, arms control, and according to established timetable. for goods subject to international preferential agreements). C. Strengthening the Fmancial Sector To strengthen the capacity of the The financial sector developed Directed credits from NBG and access by State banks banking system to increase financial rapidly with about 220 private to overdraft facilities eliminated as of Oct. 94 (see savings and allocate financial resources banks created besides 5 large state lb).* more efficiently banks but credit allocation continued to be directed by the Establish interbank short-term credit auctions. All Develop short-term credit facility (see state and provided at highly new credit to be allocated to banks via auctions. lb). subsidized rates. Restrictions on use of accounts, both in domestic* Improve prudential supervision of Functioning of the financial sector and foreign currency eliminated (see lb). banks by the NBG. also impaired by restrictions on use of accounts, both in domestic Licenses withdrawn from 42 commercial banks. and foreign currency. Foreign exchange licenses withdrawn from 28 other banks in Oct. 1994. Bank supervision and enforcement of prudential regulations remains Submitted to Parliament draft law for operations of inadequate to assess the financial the NBG and issued revised prudential regulations. condition of banks and to remedy problem situations. Moratorium on Diagnostic review of the 5 specialized state Based on results of diagnostic review, licensing of new banks imposed in commercial banks undertaken. develop and initiate implementation of May 1994. Minimum level of restructuring/privatization plan by capital requirement raised. mid-1995. * Prior Action for IMF STF  Page 11 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN Before Between March 1, 1995 (as of Sept 1, 1994) March 1, 1995 and March 1, 1996 IV. REFORMS OF THE SOCIAL SAFETY NET To maintain a minimum level of safety System of Social Protection essentially As of Sept. 1994, generalized subsidies Increases in wages of budgetary net during the adjustment and reform identical to the old system of the Soviet for bread, electricity, gas and sector, pensions and other social process, compatible with extremely Union. Unemployment system transportation drastically reduced (see benefits limited to targeted inflation limited budgetary resources. introduced recently. la), and partially replaced by cash until mid-1995. compensations for pensioners, Special assistance programs - in kind unemployed and other beneficiaries of and in-cash - also introduced recently social protection system, and to provide support to particularly employees of the budgetary sector.* vulnerable groups (about 90,000 families and 250,000 refugees from Pensions denied to working pensioners, Abkhazia). These programs are reducing by 16% number of supported in part through humanitarian beneficiaries as of Sept. 1994. aid. Special pension supplements to favored Revenues of social security and categories of pensioners eliminated. unemployment funds drastically reduced over recent years by the sharp Childbirth and death benefits also reduction of employment in the state eliminated as of Sept. 1994. sector, decline in real wages, and failure to tax wages in the informal Complexity of pension system economy. Maintaining benefits in line simplified and administrative burden with revenues have led to benefits that reduced by adoption of a simple are too small to even sustain a assistance program characterized by a minimum standard of living. The main flat-rate benefit set in Sept. 1994 at 2.5 form of social protection consisted of million coupons (equal to lowest salary heavily subsidized bread, energy, in budgetary sector). transportation and municipal services. Commission appointed to prepare Implementation of comprehensive Real wages of employees of budgetary reform plan of the social safety net reform to be initiated during second sector hardly higher than pensions. leading to program of actions, to be half of 1995. completed by mid-1995. Other forms of social protection provided through family ties and the informal economy. e Prior action to IMF/STF.  GEORGIA REHABILITATION CREDIT POLICY MATRIX Annex 4 Page 12 of 12 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN Before Between March 1, 1995 :____________________________ j (as of Sept 1, 1994) March 1, 199S and March 1, 1996 IV. REFORMS OF THE SOCIAL SAFETY NET (cont'd) l Generous eligibility conditions (in particular early retirement) and lack of targeting make the system ineffective and unsustainable even in the medium term: approximately half of the population are eligible for benefits.  Q ~~~~~~~~G E O R G I A o SELECTED CITIES O AUTONOMOUS OBLAST' (AO) CENTER o() AUTONOMOUS REPUBLIC (ASSR) CENTERS \ NATIONAL CAPITAL I -I_ t R U S S I A N ROADS BKHAZIA , < _ ~~~~~~~~~~~F E D E R A T I O N --AUTONOMOUS OBLAST' (AO) BOUNDARIES Gud kumi_rR AUTONOMOUS REPUBLIC (ASSR) BOUNDARIES o MSINTERNATIONAL BOUNDARIES '0gbrchelif _\_ e > beri > < t hyar FZugdidi o OUTHERN * ~~ (< ~Seniaki , t OSSETIA /