Georgia - Country Assistance Strategy

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 17000-GE MEMORANDUM OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ONA COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR GEORGIA September 22,1997 Armenia and Georgia Country Unit Europe and Central Asia Region 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.  DATE OF LAST CAS March, 1995 (limited) CURRENCY EQUIVALENTS (as of end August 1997) Currency Unit = Lari US$1.00 = 1.29 Laris WEIGHTS AND MEASURES Metric System ABBREVIATIONS AND ACRONYMS AIOC - Azerbaijan International Operating Company CAS - Country Assistance Strategy CEM - Country Economic Memorandum CG - Consultative Group CIS - Commonwealth of Independent States EBRD - European Bank for Reconstruction & Development ECA - Europe and Central Asia EDI - Economic Development Institute ESAF - Enhanced Structural Adjustment Facility ESW - Economic and Sector Work EU - European Union FIAS - Foreign Investment Advisory Services FSU - Former Soviet Union GIC - Georgian Investment Center GDP - Gross Domestic Product GEF - Global Environmental Facility IBRD - International Bank for Reconstruction and Development IDA - International Development Association IDF - Institutional Development Fund IFC - International Finance Corporation IMF - International Monetary Fund MIGA - Multilateral Investment Guarantee Agency NEAP - National Environmental Action Plan NGO - Non-Governmental Organization PER - Public Expenditure Review PFP - Policy Framework Paper SAC - Structural Adjustment Credit SATAC - Structural Adjustment Technical Assistance Credit SIF - Social Investment Fund TACIS - Technical Assistance to the CIS UNDP - United Nations Development Programme, USAID United States Agency for International Development GEORGIA - FISCAL YEAR January 1 -- December 31 Vice President: Johannes Linn, ECAVP Country Director: Judy O'Connor, ECCO3 Sector Leader: Hafez Ghanem, ECSPE Responsible Staff: Michelle Riboud, Principal Country Economist, ECSPE Cyril Muller, Senior Country Officer, ECCO3 Joseph Owen, Resident Representative, ECCGE  FOR OFFICIAL USE ONLY Table of Contents EXECUTIvE SUMMARY ...................................................i I. RECENT ECONOMIC, POLITICAL AND SOCIAL DEVELOPMENTS ................................................... 1 A. Introduction ...................................................1 B. Political and Economic Background ...................................................1 C. Social Developments ...................................................3 II. GOVERNMENT'S DEVELOPMENT AGENDA: CHALLENGES AHEAD ...................................................4 III. MEDIUM-TERM PROSPECTS AND CREDITWORTHINESS ...................................................8 A. Economic Prospects ...................................................8 B. Extemal Environment ...................................................9 D. Creditworthiness .................................................. 10 IV. BAN / ID A ASSIS TANCE To DATE ................................................... 11 A. The Bank's Strategy and Policy Performance .................................................. 11 B. Portfolio Performance/Management .................................................. 11 V. BANK GROUP ASSISTANCE STRATEGY .................................................. 13 A. CAS Objectives .................................................. 13 B. Selectivity and the Bank's Comparative Advantage .................................................. 14 C. Risks and Rewards of the Assistance Strategy .................................................. 15 D. The Role of Other Donors .................................................. 16 E. Bank Program .................................................. 17 Lending and Guarantees Program .................................................. 18 Non-Lending Services .................................................. 20 IFC and MIGA .................................................. 21 ANNEXES Annex Al Georgia - At A Glance Annex B2 Georgia - Selected Indicators of Bank Portfolio Performance and Management Annex B3 page 1 Georgia - Bank Group Program Summary page 2 Georgia - Bank Group Fact Sheet (IBRD/ IDA Lending Program) page 3 Georgia - IFC and MIGA Program Annex B4 Georgia - Summary of Non-Lending Services Annex B5 Georgia - Poverty and Social Development Indicators Annex B6 Georgia - Key Economic Indicators Annex B7 Georgia - Key Exposure Indicators Annex B8 Georgia - Status of Bank Group Operations Statement of IFC Investments Annex B9 Georgia - CAS Program Matrix Annex B10 Georgia - CAS Summary of Development Priorities This document has a restricted distribution and may be used by recipients only in the perfonnance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.   MEMORANDUM OF THE PRESIDENT OF IBRD AND IDA TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR GEORGIA EXECUTIVE SUMMARY i. Introduction. Georgia is a country of 5.4 million people strategically located as a transit corridor in the Caucasus, between Europe and the land-locked countries of Central Asia, and between Russia and the Middle East. Following its independence from the Former Soviet Union (FSU) on April 9, 1991, Georgia was marked by a number of internal armed conflicts, precipitated by secessionist movements in South Ossetia and Abkhazia and compounded by a brief civil war. President Shevardnadze returned to Georgia in early 1992 and played a major reconciliation role. By end 1993, these conflicts abated and a cease-fire came into effect. While a permanent political resolution remains to be worked out, there have been recent signs of progress. ii. Economic and Social Context. In early 1994, Georgia emerged from these two years of turmoil with a collapsed economy - GDP suffered one of the worst collapses in the FSU dropping to 30 percent of its 1990 level, government revenues plummeted from 30 percent of GDP in 1991 to 2 percent in 1993, and the financing of the resulting huge deficits triggered hyperinflation and a sharp depreciation of the domestic currency. External debt, zero at independence, grew to almost US$1 billion - an unsustainable 200 percent of exports, by end 1994. These developments inevitably had significant negative social impacts on the population: real wages fell by 90 percent and health, education and poverty indicators worsened with the subsequent sharp cuts in public expenditures. iii. In mid-1994, the Government embarked on a comprehensive reform program to rebuild the economy, with the support of the World Bank and the IMF. Drastic fiscal adjustments and a tight monetary policy together with the introduction of a new currency, the lari, in 1995 helped to achieve a remarkable turnaround. By end 1996, the fiscal deficit had been reduced to 5.5 percent of GDP (excluding grants), annual inflation stood at 14 percent, the exchange rate was stable and the economy registered a growth rate of 10.5 percent. A wide range of structural measures was taken to create an enabling environment for private sector development, including, inter alia, elimination of subsidies; liberalization of prices and trade; downsizing of budgetary sector employment; a strong start on medium and large scale privatization coupled with completion of small-scale privatization; establishment of the basic legal framework; land reform, and banking and energy sector reforms. iv. The external environment also improved considerably. A 20 percent export growth in 1996 contributed to a reduction of the current account deficit to below 8 percent of GDP, down from 37 percent in 1994. Almost all of Georgia's bilateral external debt has been rescheduled on concessional terms. After a slow start, significant foreign direct investment is flowing into Georgia - the largest investment being the rehabilitation of an existing oil pipeline and construction of a new terminal facility for the transit of "early" Caspian Sea Oil to the Black Sea coast at Supsa.  -ii- v. Notwithstanding these impressive accomplishments, Georgia's economic recovery remains fragile. The Government's development agenda aims at consolidating the recently achieved stabilization and at strengthening the fundamentals for sustainable growth. The Government's policy agenda focuses on the following four themes: (a) strengthening public finances; (b) deepening and diversifying the sources of growth; (c) protecting the environment; and (d) reducing poverty. As the government's expenditure program is already severely constrained (at 13.7 percent of GDP in 1996), strengthened public finances requires mainly a wide range of measures to enhance government revenues - only 9.4 percent of GDP in 1996. Emphasis will be placed on greater cost recovery, private sector participation in the provision of social services and local government development. To promote private sector growth, the government aims to rehabilitate basic infrastructure, improve financial intermediation and capital market activity, accelerate privatization, and strengthen legal and judicial institutions. A high priority has also been given to the sustainable management of Georgia's rich biodiversity and natural resources, particularly forests and water, and improvements in the environmental conditions on the Black Sea coast. Ongoing reforms in health, education, pensions and social assistance will be deepened to provide these services more efficiently and equitably, with better targeting to address the needs of the most vulnerable groups, within a public expenditure envelope that is likely to remain rather constrained for the next three years at least. vi. During the first phase of World Bank assistance (1994-1996), the Bank's priority was to support the start of reform processes in all key areas: macroeconomic stabilization; strengthening of the institutional capacity of the Government; and a social safety net to alleviate the economic and social collapse of the early 1990s. The Bank also started to provide support - to a large extent of an emergency nature - to prevent further degradation of physical and social infrastructure. The program was delivered through a combination of policy advice and a balanced lending program, all on IDA terms, consisting of adjustment, technical assistance, and investment credits, as well as related Economic and Sector Work, Institutional Development Fund grants, and project preparation technical assistance through Policy and Human Resource Development Fund grants. Policy and project implementation, as well as results, have been very positive. Reasons for this include: strong government ownership of the reform program; increasing emphasis on capacity building; intensive Bank support in project preparation and supervision, and well coordinated and complementary donor support. Both IFC and MIGA concluded their first transactions in Georgia in 1997. vii. Building on the results to date, the Bank's Country Assistance Strategy (CAS) for the period FY98-00 has the following priorities. The first priority is stabilization support as continued weaknesses in public finance jeopardize the stabilization objective. Through adjustment and related technical assistance credits, the Bank plans to promote improved revenue performance and expenditure management, as well as provision of a limited range of public services. The second priority is to strengthen and diversify the sources of growth by removing remaining barriers to private sector development. Here Bank interventions will support completing privatization, rehabilitating basic infrastructure, putting in place a regulatory framework that can attract substantial private investment, including foreign direct investment; and strengthening the financial sector and the legal and judiciary framework. A third priority is to assist the Government in introducing the institutional and policy reforms needed to protect Georgia's environmental and natural resources. The fourth and overarching priority is to address poverty issues within the context of a recovering economy. The strategy  - iii - aims at preventing a deterioration of the stock of human capital (the country's most valuable asset) and at strengthening the social safety net. This is to be achieved by fostering reallocation of public expenditures toward social sectors, improved targeting of benefits and pension reforms, and building institutional capacity to change the role of the state in the provision and financing of social services. viii. The proposed strategy envisages a mix of lending and non-lending services, as well as possible guarantees. It assumes increased activity by IFC and MIGA. The most likely scenario is the high case with continued strong commitment to reforms, a favorable extemal environment and high levels of donor support. It is also predicated on a positive creditworthiness assessment around the middle of the CAS period. It corresponds to a lending program of about US$320 million for FY98-00, which includes the possible introduction of IBRD lending in late FY99. The failure to reach expected outcomes despite continued implementation of structural reforms would move the program to a medium-case of about US$220 million which would not include any IBRD resources. Substantial policy reversals would lead to a low-case scenario comprising a minimum level of assistance to maintain country dialogue and focused on poverty alleviation and environmental protection. ix. Risks. The main risk is the failure to reach expected outcomes, due either to unsatisfactory implementation of agreed policies and/or deterioration of the extemal environment. A failure to increase tax revenues as expected could result in an inability to meet basic expenditures needs and increase social discontent. Altematively, it could result in renewed inflationary finance. Export growth could also be lower than expected. Given the fiscal constraints, high debt burden and the country's external financing requirements, the sustainable growth path is fairly narrow. The best strategy to minimize this risk is to strengthen institutional capacities, to move rapidly on critical reforms, to pursue actively the difficult restructuring needed to ensure sustainable growth, and to seek a sustainable solution to the civil conflicts in South Ossetia and Abkhazia. The risk of policy reversal arises from vested interests that favor tax loopholes, protectionist policies and non-transparent privatization. Rapid progress on accession to the World Trade Organization and policies enhancing competition would mitigate this risk. Although a permanent political solution has yet to be found, there have been some recent signs of rapprochement which suggest that at the least, risks of renewed civil conflicts appear relatively small. The economic benefits of a permanent solution would be very high. x. Agendafor Board Discussion. It is proposed that the discussion focus on the following: * Reform Agenda. Weak public finances, remaining barriers to private sector development, needed reforms to protect the country's environment and natural resources, inadequate social protection and the risk of emergence of structural poverty are identified as the key issues to be addressed during the CAS period. * Bank Program. Does the Bank program adequately meet the challenge? Is the strategy adequately focused? * Risks. The design of the strategy and its consistency with the perceived risks of failure to reach expected outcomes, of policy reversal, and of resumption of civil conflicts.   MEMORANDUM OF THE PRESIDENT OF IBRD AND IDA TO THE EXECUTIVE DIRECTORS ON A COUNTRY ASSISTANCE STRATEGY OF THE WORLD BANK GROUP FOR GEORGIA I. RECENT ECONOMIC, POLITICAL AND SOCIAL DEVELOPMENTS A. Introduction 1. This document discusses the proposed World Bank Country Assistance Strategy (CAS) for Georgia for the period 1998-2000. The proposed strategy has benefited from consultations with the Georgian Government. It takes into account many priorities highlighted during meetings, held with the Government's full encouragement, with representatives of civil society including the business community, academia, journalists, and NGOs. The strategy has been discussed with key development partners, including the EU, EBRD, UNDP, IMF, and bilateral donors, including USAID. A summary of the comments received is presented in Box 3 on page 16. B. Political and Economic Background 2. Georgia is a country of 5.4 million people bounded by the Black Sea, Russia, Azerbaijan, Armenia and Turkey. On April 9, 1991 it became the first non-Baltic state to declare independence from the Former Soviet Union (FSU). Before 1991, Georgia had a relatively strong economy, specializing in exports of agricultural products (almost exclusively to the other Soviet republics), in metal extraction, and in assembly of a wide range of industrial products. Income per capita was just below 3,000 rubles (about US$1,600), placing Georgia in the middle of the 15 former Soviet republics. Thus, at independence Georgia appeared well-placed to make the successful transition to a market economy. It had a highly educated labor force, a long tradition of entrepreneurship, a significant underground economy, a prosperous agricultural sector, substantial natural resources, and was well-located as a primary transit corridor in the Caucasus for the land-locked countries of Central Asia, and between Russia and the Middle East. 3. In the early years following independence, Georgia's economy went into a tailspin, precipitated by intense armed conflicts, first in South Ossetia, then in Abkhazia, as well as with ex-President Gamshakurdia's followers. President Shevardnadze returned to Georgia in early 1992, was elected Chairman of the State Council, and played a major reconciliation role. Toward the end of 1993 the civil conflicts abated and a cease-fire came into effect in Abkhazia with agreement (involving Russia and the United Nations) to work out a peaceful resolution. While a permanent political resolution of these conflicts remains to be worked out, there have been recent signs of progress. 4. In early 1994, Georgia emerged from the two years of civil conflict with a collapsed economy and an erosion of the Government's authority. Officially estimated GDP was 30 percent of its 1990 level. Electricity consumption, often considered a better proxy for real GDP in transition economies, is estimated to have fallen by 55 percent in the same period. The decline in government revenues was even more striking. From 30 percent of GDP in 1991, tax revenues collapsed to 2 percent in 1993. Financing of the resulting huge deficits led to hyperinflation and a sharp depreciation of the domestic currency - by August 1994, the  - 2 - Georgian coupon had depreciated relative to the US dollar from 5,600:1 in August 1993 to 2,400,000:1. External debt, zero at independence, had grown to almost US$1 billion by 1994, an unsustainable 200 percent of exports, mostly on commercial terms, with short maturities. 5. A Remarkable Turnaround. The Government, having achieved some measure of political stability, turned in mid-1994 to rebuilding the economy. It embarked on a stabilization and structural reform program with support of the IMF and the World Bank. Since then, implementation has been sustained and achievements have been impressive. The monthly inflation rate has been brought down from hyperinflation levels to about 0.5 Fig. 1: GDP growth rate (%/6) percent by end 1996. The exchange rate 20.0% has remained stable since the end of 1994 and a new currency - the lari - was 0.0% successfully introduced in September .10 1995. The current account deficit -20.0% narrowed to below 8 percent in 1996, -30.0% from 37 percent in 1994. Gross official -40.0% reserves, virtually exhausted in 1994, have -50.0%_ been rebuilt; most bilateral debt has been 1992 1993 1994 1995 1996 1997est. rescheduled; and after four years of continuous decline, real GDP grew by 2.4 percent in 1995 and 10.5 percent in 1996 - see Figure 1. 6. An Ambitious Reform Program. The government's ambitious reform program introduced in 1994 helped to achieve this economic turnaround. Stabilization efforts relied on drastic fiscal adjustments and tight monetary policies. As illustrated in Figure 2, the fiscal deficit (excluding grants) was reduced from 26.2 percent of GDP in 1993 to 20 percent in 1994 and 5.5 percent in 1996, mainly through reduced expenditures. The core objective of structural reform was to establish an appropriate incentive framework for sustainable private sector development. Subsidies were virtually eliminated, prices and trade liberalized and the main elements of a legal framework introduced. Small-scale privatization is virtually complete and about 75 percent of medium and large-scale enterprises have been privatized to date. In the agriculture sector, over 55 percent of cultivated land has been distributed to private farmers and the legal basis for the functioning of a land market is in place. In the banking sector, prudential regulations and the regulatory framework were upgraded Fig. 2: Fiscal Account and a restructuring strategy is under implementation. The collapse of public finance compelled the Government to 30.0- l. 0- X~i-..Xg;4.......... impose hard-budget constraints on 20.0 state-owned enterprises, and to increase 0.0 - ~~~~~~~~~the participation of the private sector in .100- ~~~~~~~activities which used to be largely -30.0-~~~~~~~ publicly financed, such as health, 1992 1993 1994 1995 1996 1997est education, and transport. In a number of cases - perhaps simply as a result of MRevenues/GDP(exc1graNs) UExperditLir/GDP Dreficit/GDP(excIgrars) the very difficult circumstances it faced - the Government took fairly radical measures, such as increasing the  -3- retirement age by five years, granting financial and management autonomy to all hospitals, and removing 120,000 employees of the health sector from the Government payroll. ,, ' ' :. :' .- .'- - .,B .... '' I -.gresS6 ince the Limited CAS Since Ih limite' CAS wspented t oa in:M Mrh1995, Geor ga has impTemented sustantial .refo,rm,'s,. Ma,jor.a aciv mensclude+':':-',- - Sabilizationrntdgrotfh..AhnuAl inflaton ga-1e 6 w and 4.6% by mid-1997. The fiscal deficit (on acciual basis: and excluding grants) declineid -to 5.5%i in 1996, down from 20% in 1994. The current account .:-:.-.i.deficit(e.xclud.ig gr---)rrwdfrm - in : 94