Georgia - Structural Adjustment Credit Project (SAC)

Document of The World Bank FOR OFFICIAL USE ONLY Report No. P-6797-GE REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT IN AN AMOUNT OF SDR 41.3 MILLION TO THE REPUBLIC OF GEORGIA MARCH 20, 1996 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.  CURRENCY EOUIVALENTS (as of February 27, 1996) Currency Unit = Lari US$1.00 = 1.26 Laris 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 - Institution Building Credit IBRD - International Bank for Reconstruction and Development IDA - International Development Association IFC - International Finance Corporation IMF - International Monetary Fund MIGA - Multilateral Investment Guarantee Agency NBG - National Bank of Georgia SAC - Structural Adjustment Credit SDR - Special Drawing Rights SOE - Statement of Expenditures SPM - Ministry of State Property Management STF - Systemic Transformation Facility TACIS - Technical Assistance to the CIS UFSS - United Fund for Social Security USAID - United States Agency for International Development ESAF - Enhanced Structural Adjustment Facility GEORGIA - FISCAL YEAR January 1 - December 31  FOR OFFICIAL USE ONLY REPUBLIC OF GEORGIA - STRUCTURAL ADJUSTMENT CREDIT CREDIT AND PROGRAM SUMMARY Borrower: Republic of Georgia Amount: SDR 41.3 million (US$60.0 million equivalent) Tenns: Payable over 35 years, including 10 years of grace, on standard IDA terms Commitment Fee: 0.50% of undisbursed credit balances, beginning 60 days after signing, less any waiver Obiectives and Description: The main objective of the credit is to consolidate stabilization, foster a strong and sustained growth recovery and reduce poverty. The reform program aims at: (a) maintaining a tight monetary program supported by an improving fiscal position: (b) streamlining the Government sector and improving efficiency of public spending; and (c) inducing a rapid adjustment of the productive sector to new market signals. Among the key reforms are removal of tax exemptions and strengthening of tax administration; improvements in collection of energy payments; changes in the provision and financing of social services; restructuring of the pension system and social protection; acceleration of privatization; restructuring of the financial sector; trade liberalization and trade promotion. The other objectives of the credit are to: (i) provide budgetary support to maintain the level of critical public expenditures, in particular for infrastructure and social sectors; (ii) provide foreign exchange for the purchase of critical imports; and (iii) provide a framework for financial assistance from other donor agencies. A technical assistance credit of SDR 3.3 million (US$4.8 million equivalent) is being prepared in parallel to the proposed credit and would facilitate implementation of key reforms. Poverty Categorv: The proposed credit is poverty-focused since it will support improvements in the targeting of social benefits to the poorest groups. Benefits: The main benefits of the credit would be to ensure the sustainability of the stabilization process and to consolidate and deepen the structural changes initiated a year and a half ago after a long period of economic and political turmoil. Over the last months, inflation has been curbed and economic decline has slowed but the situation remains precarious. The deepening of the reform process should consolidate recent achievements, accelerate the transition to a market economy, and lead to sustained growth recovery and improvements in living standards. The proposed credit would contribute to a further downsizing of the state-controlled sector and to efficiency gains in the use of public resources. It would induce adjustment of enterprises to new market signals and thus foster productivity gains, thereby increasing savings and investment. It would also strengthen the country's creditworthiness. 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 social sectors and infrastructure. This documnent has a restricted distribution and may be used by recipients only in the performance of their offilcial duties. Its oontents may not otherwise be disclosed without World Bank authorization.  - ii Risks: The main risk is that adequate and timely external assistance of the magnitude required will not be forthcoming, threatening public support for reforms and the success of the reform program. The macroeconomic prospects are such that even with timely implementation of reforms, Georgia's economy will not reach the 1990 levels of per-capita consumption before the end of the century; savings are also likely to remain negative until 1997. The failure to achieve a fully funded program would force a much stronger domestic adjustment and a lower growth path, imposing additional social costs to the population. To address this problem, the Bank will not only provide continuous financial support, but it will also assist Georgia in mobilizing external resources through the Consultative Group process and other donor coordination efforts. A second risk is that the terms at which bilateral creditors agree to reschedule existing claims may be inconsistent with the country's capacity to pay, lowering the prospects for the attainment of external viability over the medium term. This risk is being addressed through a debt strategy developed in agreement with the IMF and on-going negotiations with bilateral creditors. A third risk is delayed implementation due to weak institutional capacity within the Government and other executing agencies. To date, technical assistance has been essential in assisting the Government in the design and implementation of reforms. The Bank will make continuous effort, partly by providing a technical assistance credit and partly by mobilizing external technical assistance, to provide the much needed support. It is also expected that the reorganization of the Government following the enactment of the new Constitution will improve economic management. Estimated Disbursement: The proceeds of the proposed credit would be released in two tranches of equal size. Proiect ID Number: GE-PA-34583 This report is based on missions which visited Georgia in June and December 1995, comprising Messrs./Mmes. Michelle Riboud (Sr. Country Economist, Mission Leader), John Nash (Trade), S. Ramachandran (Financial Sector), Stuart Bell (Privatization), Barbara Evans (Energy), Gary Burtless (Social Protection), Arup Banerji (Civil Sector Reform), Francois Orivel (Education), Ana Revenga (Public Expenditure), and Cyril Muller (Economic Management). Rosario Hablero provided secretarial support. Peer reviewers were Martha de Melo and Cheryl Gray. Basil Kavalsky and Wafik Grais are, respectively, the Director of the Country Department, and Division Chief of the Country Operations Division, responsible for Georgia in the Europe and Central Asia region.  REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVF, DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT CREDIT TO THE REPUBLIC OF GEORGIA TABLE OF CONTENTS PART 1. RECENT ECONOMIC DEVELOPMENTS AND PROSPECTS FOR THE FUTURE ............................................. 1 A. Background ............................................ 1 B. Policy Achievements since Mid-1994 ............................ 3 C. Remaining Obstacles to Economic Recovery ........................ 5 D. Macroeconomic Prospects and External Financing Requirements ... ........ 5 PART II. THE GOVERNMENT'S REFORM AGENDA AHEAD ................ 7 A. Maintaining a Tight Monetary Policy ............................ 7 B. Improving the Tax System ................................... 8 C. Streamlining the Government Sector and Improving the Efficiency of Public Spending ............................................. 8 D. Fostering Adjustment of the Productive Sector ..................... 12 PART III. BANK ASSISTANCE STRATEGY ............................ 20 A. Background and Objectives ................................. 20 B. Bank/IDA Assistance to Date ................................ 20 C. The Lending Program ..................................... 21 D. Economic and Sector Work Program ........................... 22 E. MIGA and IFC Activities .................................. 22 PART IV. THE PROPOSED CREDIT ................................. 22 A. Background and Rationale for World Bank Involvement ............... 22 B. Program to be Supported ................................... 23 C. Project Implementation .................................... 26 D. Disbursements ............... 26 E. Accounts, Auditing and Closing Date ........................... 26 F. Environmental Safety ..................................... 27 G. Poverty Category ........................................ 27 H. Agreements Reached ..................................... 27 I. Benefits and Risks ....................................... 27 PART V. RECOMMENDATION .................................... 28 ANNEXES Annex 1 Status of Implementation of Policy Measures Agreed Upon under the Rehab Credit Annex 2 Key Economic Indicators Annex 3 Status of Bank Group Operations Annex 4 Timetable of Key Processing Events Annex 5 Georgia Structural Adjustment Credit Policy Matrix Annex 6 Letter of Development Policy   REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED STRUCTURAL ADJUSTMENT 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 41.3 million (amount equivalent to US$60 million) to provide support for the Government'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. It has been prepared in parallel with an Enhanced Structural Adjustment Facility (SDR 166.5 million; 150 percent of quota) approved by the IMF Board of Directors on February 28, 1996. The first Policy Framework Paper for Georgia was distributed to the Executive Board on February 9, 1996. 2. Financing for technical assistance to support a number of measures in the Government's reform program will be provided by the Bank's on-going Institution Building Credit, by other donors, and by a Structural Adjustment Technical Assistance Credit (SDR 3.3 million, equivalent of US$4.8 million). 3. Georgia joined the IBRD in August 1992, MIGA in December 1992, IDA in August 1993, and IFC in June 1995. 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. A Macroeconomic Update was distributed at the Consultative Group meeting held in November 1994. PART I. RECENT DEVELOPMENTS AND PROSPECTS FOR THE FUTURE A. Background 4. Georgia is a country of 5.4 million people bounded by the Black Sea, Russia, Azerbaijan, Armenia, and Turkey. At independence in April 1991, it appeared to be among the best placed of the former Soviet states to make a successful and rapid transition. It had a highly educated labor force, a long tradition of entrepreneurship, a successful agricultural sector, substantial natural resources, and few of the large, heavy industrial complexes with doubtful economic viability. Georgia also had a head start on privatization, with virtually all rural housing in private hands and a significant underground economy. The country's location made it a primary transit corridor in the Caucasus, and its climate and scenic variety offered great potential for tourism. 5. Despite these favorable conditions, the Georgian economy went into a tailspin during the period following independence and the breakup of the FSU. Partly this was due to factors that were common to the newly independent states, including the disruption of traditional payments and trade links, and a large terms of trade shock for energy-imports. However, these difficulties were compounded by civil conflicts, first in South Ossetia, then with the Gamsakhurdian faction and in Abkhazia. As a result, Georgia suffered from one of the sharpest economic declines in the FSU:  between 1990 and 1994 recorded output is estimated to have fallen by 70 percent'. Although the informal economy may have cushioned the impact of this decline on the population, living standards fell precipitously, and by 1994, GNP per capita (estimated at US$410) had shrunk to the second lowest among FSU countries. 6. The civil conflicts severely eroded the Government's authority and ability to conduct sound economic policy. Tax revenues collapsed, falling to around 2-3 percent of GDP in 1993/1994. The resulting huge budget deficits led to hyperinflation and to a sharp depreciation of the domestic currency. By end-1993 annual inflation had reached 8,400 percent and the coupon had fallen to less than 1 percent of its January value. Substantial currency substitution resulted. In order to maintain huge subsidies for energy and bread, the Government let its external debt grow to unsustainable levels and increased its reliance on humanitarian aid. By the end of 1994 total external debt (including arrears) represented almost 80 percent of GDP and grants amounted to about 45 percent of government revenues. 7. Shrinking resources also led to the government's loss of control of essential functions, most importantly of providing basic social services and a reliable safety net for the poor. Expenditures on health and education declined from 12 percent of GDP in 1991 to less than 2 percent in 1994, and in early 1995 expenditures on pensions and the social safety net did not exceed 2.5 percent of GDP, to be compared with 4.6 percent in Armenia and 11 percent in Azerbaijan. Physical infrastructure was neglected and deteriorated rapidly. 8. A marked change in the political and economic situation occurred in 1994 following the establishment of a cease-fire in Abkhazia. With the benefit of an improved political situation, the Goveriunent designed a program to stabilize and reform the economy. Implementation of this program has been sustained since September 1994. The program was supported by a first purchase of SDR 27.8 million under the IMF's Systemic Transformation Facility (STF) in December 1994, a World Bank Rehabilitation Credit (SDR 51 million) in March 1995, and by a second purchase under the STF (SDR 27.8 million) and a standby arrangement (SBA) in June 1995 (SDR 72 million, 65 percent of quota). 9. Recent political events show a growing consensus for reforms. In July 1995 the Parliament approved a new Constitution which establishes a strong executive presidency. Presidential and parliamentary elections held on November 5,1995, affirmed the Government's pro-reform platform. Mr. Shevardnadze was elected president with about 75 percent of the vote and his party became the majority party in Parliament. The structure of the new Government has been modified to strengthen coordination among ministries and a closer cooperation between the executive and legislative branches of Govermment is expected in the future. Precise estimates of output contraction are not possible due to deficiencies in the coverage and quality of economic statistics. As in other FSU countries, the magnitude of economic decline is likely to be overestimated. Indirect indicators such as energy consumption suggest however that the decline has been substantial and exceeds 50 percent.  B. Policy Achievements since Mid-1994 Stabilization 10. The stabilization strategy relied on drastic fiscal adjustment and tight monetary policies. The budget deficit was reduced from 26 percent of GDP in 1993 to about 6 percent in 1995 on an accrual basis. Results have been impressive: the average monthly rate of inflation fell from an average of 64 percent in the first three quarters of 1994 to an average of 3 percent in the first nine months of 1995. The Georgian coupon appreciated from about 5 million coupons per US dollar in unofficial trading in mid-September 1994 to 1.3 million coupons at the end of 1994, and then stabilized at that level. The coupon also strengthened against the Russian ruble. 11. Successful stabilization laid the groundwork for the introduction of a new national currency, the lari, on September 25, 1995. The population converted about US$50 million of foreign currency within a month, leading to a fourfold increase of the domestic currency in circulation and growth in the international reserves of the NBG. The lari appears to have supplanted the ruble as the principal medium of exchange and unit of account. Introduced with a conversion factor of I million coupons per lari, the new currency has since become the sole legal tender. It appreciated slightly with respect to the US. dollar: the exchange rate was 1.26 lari per US$ at the end of February 1996 (vs. 1.30 in September). 12. There are signs that Georgia's economic decline has slowed. The area of cultivated land in 1995 is about 14 percent higher than the area cultivated the previous year. Industrial output is reported to have stabilized except in the large Rustavi metallurgical and chemical plants. Available data suggest output recovery in the service sector, particularly in transport and retail trade. Preliminary estimates indicate that the output decline in 1995 did not exceed 5 percent. In addition, the sharp reduction of the labor force in enterprises of the state sector (over 35 percent since 1991) is indicative that restructuring has begun. Structural Reforms 13. Despite the civil conflicts and the deteriorating macroeconomic situation, Georgia had already introduced important structural reforms in the two years following independence (liberalization of most prices, open import regime, unified exchange rate, some privatization and incipient land reform). Further progress was achieved within the framework of the Government's overall reform program supported by the Rehabilitation Credit. Implementation of the reform program (see Annex 1 for details) has been generally strong with major achievements in privatization of small-scale enterprises, downsizing of the Government sector, elimination of subsidies, improvements in the targeting of social benefits, trade liberalization and development of a legal framework to support private sector development. 14. Fostering Ownership Change. Privatization of small, medium-size and large enterprises made rapid progress in 1995. As of December 1995, 6,432 small enterprises (90 percent of the universe) had been privatized up from 1,657 in October 1994. Privatization of medium-size and large enterprises began with as a first step, their corporatization. To date about 840 enterprises (75 percent of the total) have been corporatized. Transfer of ownership started in mid-1995 through various methods, mainly a buyout option offering 51 percent of shares to employers and employees, and a mass privatization program offering at least 35 percent of shares to the public through voucher  auctions (see para. 53). Investment funds were licensed to buy vouchers and bid in the auctions. The Government also developed a demonopolization and privatization plan for the Bread Corporation. 15. Downsizing Government. The Government initiated a policy of labor retrenchment and in 1995, reduced the number of positions in the budgetary sector by 40 percent. The largest reduction (about 130,000 positions) occurred in the health sector as part of a radical reform aimed at transferring much of the provision and financing of health care to the private sector. 16. Removing Price Distortions and Consumer Subsidies. The Government readjusted the prices of goods and services that remained regulated, namely, those of energy (gas, electricity), public transportation, and rationed bread, all of which had been kept at extremely low levels. Price increases - most of them introduced in September 1994 - have been huge, especially for consumers, ranging from 5 times (gas for heating) to 13,000 times (gas for cooking). The price of bread, the main staple in Georgia, rose 1,500 times. These new prices were calculated to reflect full import and distribution costs and thus to eliminate subsidies. Subsequent price adjustments occurred over the year. In the case of bread, the sharp price increase has already led to a rapid expansion of the private sector which is not subject to price control, and now represents about 20 percent of the market. 17. Developing a Legal Framework. The Government has also progressed in establishing a legal framework for private sector development. In 1994, it adopted simple registration procedures for new business and allowed long-term leasing arrangements for commercial real estate; it also enacted a company law in 1994, and a foreign investment law in 1995. A commercial banking law and a law permitting private ownership of agricultural land were adopted in early 1996 (see paras. 63 and 67). An anti-monopoly law and a civil code have also been submitted to Parliament. The first law is expected to be approved by mid-1996 and the second one at the end of 1996. A bankruptcy law is also under preparation and would replace an existing 1992 decree2. 18. Liberalizing International Trade. The Government began to eliminate export restrictions while maintaining a relatively free import regime. In December 1994, it abolished the 8 percent export tax, and in February 1995 it reduced the number of goods under export licensing and quotas (from 27 to 9). In June, it eliminated the state order system. The Government also improved the effectiveness of the foreign exchange market by abolishing all distinctions between cash and non-cash and eliminating the surrender requirement, thus removing implicit taxation of foreign earnings. 19. Strengthening the Financial Sector. Initial steps have been taken to strengthen the financial sector. The National Bank of Georgia issued new prudential regulations and is gradually strengthening its supervisory function, and Parliament adopted a law in late June 1995 guaranteeing independence of the National Bank in formulating and implementing monetary and exchange rate policies. 20. Improving the Targeting of Social Benefits. The Government took several measures to improve the targeting of social benefits (removing 125,000 working pensioners from the pension rolls; eliminating special pension supplements and childbirth and funeral benefits; and targeting child 2/ The Commercial Banking Law is a prior action and the anti-monopoly law is a structural benchmark under the ESAF. The timing of the bankruptcy law is less urgent as the existing decree provides an adequate legal framework while the law is being prepared.  allowances to families with at least two children). With the resources saved and through some reallocation of public expenditures, the Government was able to modestly increase pensions, unemployment benefits and other social benefits for the neediest. C. Remaining Obstacles to Economic Recovery 21. In spite of this initial success, the economic situation remains fragile. Tax performance remains extremely weak: despite the increase in tax rates, revenues in 1995 rose only to 3.7 percent of GDP. With government expenditures already sharply reduced (13 percent of GDP), the sustainability of the fiscal adjustment in the short run depends largely on the success of efforts to increase tax collections. Moreover, even with improved revenue performance, the financing of critical public expenditures remains constrained without increased efficiency and reallocation of public spending. 22. Many key reforms are still at an early stage. The privatization of medium and large enterprises has just begun and firms have yet to make the critical adjustment to market signals. The development of agriculture remains constrained by the lack of well-defined property rights and incomplete land reform. With most banks either insolvent or inactive, the banking sector fails to intermediate savings efficiently. And the incentive framework to foster export growth is not fully in place. 23. The shortage of energy remains a critical constraint to output recovery. Energy imports declined significantly in 1995 as the Government stopped procuring gas. Because of continued problems in collecting payments from final consumers, producers too were unable to finance energy imports. Urgent energy sector reforms are needed to foster efficiency and growth of domestic production. 24. The reform program underway aims at restoring both public and private savings. But in the short run, it will be impossible to finance essential public investment out of domestic resources. To sustain growth, Georgia will continue to require substantial external assistance. Also needed is private foreign investment which will have to be fostered by a favorable political and economic environment. D. Macroeconomic Prospects and External Financing Requirements 25. The implementation of the Government's reform agenda described below should consolidate stabilization and lead to sustained growth recovery: 26. Inflation and Output. With the continuation of prudent monetary policies, annual inflation is projected to decline to 23 percent during 1996, and to 8-9 percent in 1997. Growth is expected to resume in 1996, building on the recovery of the agriculture and service sectors observed during 1995. It will be bolstered by a greatly improved economic environment, increasing public confidence and a more stable political climate. Further growth of the service sector will be fostered by progress in privatization and by increasing trade, particularly with recovering neighboring countries. Progress in land reform and removal of the remaining barriers to export should contribute to rapid growth of the agriculture sector. In the industrial sector, initial recovery of output will be driven by increased utilization of available efficient capacity; subsequent growth will be led by new investment in response to emerging opportunities in the new envirornent. The fairly high labor mobility that characterizes the Georgian labor market is expected to facilitate enterprise restructuring.  27. Given the present low level of recorded output, fairly high rates of growth are expected to prevail during the early years followed by a gradual return to a more modest growth path. High registered growth rates will also result from progress in measuring output, in particular following the expected integration of the informal sector into the formal economy. Improvements in living standards will be gradual and, only at the turn of the century, will the level of private consumption recover that of 1993. 28. Recent years have witnessed a virtual collapse of investment. Public capital expenditures, even for maintenance have almost come to a halt. However with recent progress toward stabilization and political stability and an appropriate legal framework in place, it is expected that investment will start to recover as early as 1996. Also anticipated is significant foreign direct investment to rehabilitate the oil pipeline which should provide an upward pull for other activities. Investment should thus gradually rise to 5.1 percent of GDP in 1996, and reach about 19 percent in 2005. Public investment will be directed mostly at rehabilitating and rebuilding the physical infrastructure needed to support private sector development. 29. External Sector. Given the size of the economy, the recovery of exports is critical to the resumption of economic growth. Fostered by economic recovery in neighboring countries, the removal of export restrictions, improvements in infrastructure, and increased availability of raw materials, exports are expected to grow at an annual rate of about 11 percent during the next four years. Agriculture and food processing are expected to lead this export drive. 30. The sustainability of the external financial balance will require demand management to allow imports to recover more slowly than exports. Imports, mostly of raw materials, equipment and capital goods, would grow at an average annual rate of about 7 percent. Helped by higher rates of growth for exports than imports, the current account deficit is expected to decrease from 15 percent of GDP in 1995 to about 1.4 percent by 2005. 31. External Debt and Financing Reguirements. Georgia accumulated substantial external obligations in the three years following independence. At the end of 1994, the total stock of debt amounted to about US$1.0 billion (including US$409 million of arrears). The bulk of Georgia's obligations to FSU countries arose of non-payment for natural gas imports from Turkmenistan after a more than fivefold increase in the price of gas in 1993 (total debt to Turkmenistan as of the end of 1994 reached US$440 million). In late 1994, unable to meet these obligations, the Government, in agreement with the IMF, developed a strategy to normalize its relations with its creditors. First, it requested and obtained from its creditors (except Turkmenistan) a standstill on debt service obligations falling due, and remained current on its cash payments for gas supplied during 1995. Second, starting in 1995, it deposited US$8 million per quarter in a special account in the Netherlands Bank to build up a reserve for debt service payments. At the same time, a debt commission was established to lead negotiations with bilateral official creditors on debt rescheduling. Rescheduling would apply to the stock of arrears and debt service due until the end of 1996 (the proposed terms would be 4 percent interest, 5 years of grace and 10 years maturity). Bilateral official creditors have now accepted to discuss the rescheduling arrangements, as well as to maintain during the period of negotiations, the standstill on all debt obligations falling due until the end of 1996. Discussions are underway with Russia and Turkey who have already indicated their willingness to adhere to the proposed scheme. Turkmenistan has also accepted to enter into negotiations provided prior settlement of overdue payments-in-kind for gas imports in 1995. The Government has now made adequate provision in the 1996 budget for clearing in-kind arrears, which should allow negotiations with  - 7 - Turkmenistan to proceed. In the case of the European Union, it is expected that all debt service payments, including overdue payments would be accommodated through the provision of grants within a program of exceptional macroeconomic assistance. 32. In 1996, gross financing needs will amount to about US$445 million. These would be used to finance a current account deficit of US$343 million, US$89 million of amortization payments on existing debt, and US$13 million for building up foreign exchange reserves to cover 2.7 months of imports. In addition, the stock of arrears to be settled amounts to US$528 million. Assuming that the debt strategy will be adhered to by creditors, and thus, that debt obligations in 1996 (including arrears) are met through debt workout, current lending programs of multilateral organizations and other identified commitments (including grants) would close the financing gap. This rests on the assumption of a tight fiscal program, good export performance, and the obtention of US$234 million of official transfers, including humanitarian assistance from the United States and the European Union as well as EU grants to offset debt service payments. 33. For 1997-2005, average annual gross financing requirements are projected at about US$419 million, the amount needed to finance an average annual current account deficit of US$255 million; a modest built-up of reserves of US$25 million, with the reserve cover increasing from 2.7 months of imports in 1996 to about 3.5 months on average from 1998 on; and US$139 million of amortization payments due (taking into account the proposed rescheduling). During these years, the bulk of external resources would have to come from official sources, initially on concessional terns. A good portion of multilateral assistance would take the form of balance of payments support. Private foreign financing is expected to play an important role in the medium term. 34. Georgia's debt burden is projected to decline gradually from 1996 on. Total debt to exports is expected to reach 249 percent in 1996, decreasing thereafter to 174 percent in 2005. The total debt service burden would decrease from 30 to 11 percent in 1996 through debt workout, and increase gradually thereafter to reach 30 percent in 2005. PART II. THE AGENDA AHEAD 35. The goals of the Government's economic program for the months ahead are to ensure the sustainability of the stabilization and to foster a strong and sustained recovery of growth. The program includes measures aimed at: (i) maintaining a tight monetary policy supported by an improving fiscal position; (ii) streamlining the Government sector and improving the efficiency of public spending; and (iii) inducing a rapid adjustment of the productive sector to new market signals. A. Maintaining a Tight Monetary Policy 36. The Government intends to reduce the inflation rate to 20-25 percent in 1996 and to 8-9 percent in 1997, and to strengthen the international reserve position of the NBG. To enhance its capacity to achieve its monetary objectives, the NBG will increase the range of its monetary policy instruments, introducing government securities and developing the interbank credit auction. To reduce the cost of credit, the reserve requirement ratio will be lowered, with a first decrease from 20 to 18 percent already introduced in January 1996.  B. Improving the Tax System 37. The Government is aware that the sustainability of the stabilization depends crucially on mobilizing budgetary resources and gradually reducing reliance on external grants and loans. The goal is not to rebuild a large state, but to ensure that the Government has the resources it needs to perform critical functions. In 1995, revenues (excluding grants) covered only about 40 percent of total expenditures. To reduce the budget deficit to 3-4 percent of GDP in 1996, and reach a revenue-to-expenditure ratio of about 70 percent, major efforts are needed to improve revenue performance. The Government intends to increase tax revenues from 3.7 percent of GDP in 1995 to 6.7 percent in 1996. To reach that objective the Government envisages a series of key measures designed in collaboration with the IMF. First, as of March 1, 1996 the Government has expanded the tax base by removing most tax exemptions (VAT, customs, excises and profit taxes). Second, substantial reforms of tax administration are being introduced over the first half of 1996 with technical assistance from the IMF. The State Tax Service has been made responsible for enforcing compliance with all tax laws; the 25 largest regional tax inspectorates are being reorganized and all remaining ones will be reorganized by June 1996; a taxpayer survey will be completed and identification numbers introduced by July 1996; procedures and regulations for tax assessment, the incentive system for tax inspectors and collection agencies, and penalties for non-compliance will be reviewed and appropriate changes implemented by July 1996. The Government will also, with assistance from the IMF and the World Bank., develop and implement a customs administration reform program to be supported by the SATAC. In addition, the Government intends to review all tax laws and draft a new VAT tax law and a new tax code to be submitted to Parliament by July 1996 and January 1997, respectively. C. Streamlining the Government Sector and Improving the Efficiency of Public Spending 38. Even with improved revenue performance, the Government will have to maintain a tight expenditure program. This implies maintaining only critical functions - undertaking labor retrenchment and radically reforming the administration and financing of activities that were financed from the budget, mostly social services and social protection. It also implies eliminating all subsidies - even implicit ones - which can jeopardize the sustainability of the adjustment. Reforming Government Pay and Employment 39. Public administration in Georgia combines overemployment with the scarcity of key skills, and extremely low pay. The result is low efficiency and motivation of public employees, and a deteriorated capacity to perform essential public functions. To improve performance, the Government needs to define its core functions, develop an organizational structure, and reduce budgetary employment. With the existing wage bill, only about 80,000 employees - rather than the current 367,000 - could be paid a wage equivalent to the cost of the minimum consumption basket. The Government thus has no choice but to combine revenue-increasing measures with continuing cutbacks in civil service personnel. 40. Since January 1995, the Government has reduced the number of budgetary positions by 40 percent (200,000 workers). But this effort will need to continue, in particular by introducing reforms in the education sector (see para. 43). The Government also intends to introduce civil service reforms following changes in the structure of the Government, and is receiving assistance from EU-TACIS and UNDP in this regard.  - 9 - Reforming the Role of the State in the Provision and Financing of Social Services 41. The collapse in budgetary revenues has led to a drastic reduction in public investment in human capital. Public expenditures on health and education currently amount to less than 2 percent of GDP. The Government is aware that restoring public spending to past levels would be impossible and undesirable. It is determined to implement reforms that would radically change the role of the state in the provision and financing of social services. However, it is also cognizant that in a context of negative private savings, the compression of essential expenditures could lead to a deterioration of the country's stock of human capital. It is also aware that certain population groups may be unable to have access to these services. Thus, to ensure the minimum level of expenditures necessary for growth, and to protect access to the poor, the Government has increased the share of public expenditures allocated to both health and education in the 1996 state budget. This results in about 7 percent of total public expenditures to health, and 8 percent to education. The Government intends to pursue this policy so as to gradually restore its capacity of providing a more adequate level of essential public services. 42. Health. The Government has already introduced a radical reform in the Georgian health care system. A new public health insurance fund, financed in part through payroll tax contributions and in part through budgetary contributions, was set up in July 1995. The state's financing role has been reduced to cover only a basic package of medical services, leaving patients to pay for additional services. Employees of the health sector have been removed from the government payroll and will be paid by hospitals and clinics that have become managerially independent firms. Privatization of some medical facilities has begun and is planned to continue until the end of 1997. 43. Education. The need for fundamental reform of the education system is widely acknowledged. Georgia inherited a highly developed education system which it can no longer support with available resources. Public spending in education in real terms is currently less than 10 percent of its 1990 level. In November 1995, the Government adopted a plan of action for education which it started implementing thereafter. This plan gives priority in the allocation of public resources to basic education and to targeted population groups (orphans, students with disabilities). It fosters the creation of private schools at all levels of education and an increased participation of families in the financing of education (tuition). It encourages local initiatives to increase staff compensation, reflects the need to reform educational pay scales and sets targets for substantial cuts in the number of staff paid out of public budgets. The staff of the education sector has already been reduced substantially: from 250,000 initially to 163,000 today. The new plan will aim at a further decrease to 120,000 over the next four years, with a first reduction of 10,000 in 1996. Reforming Social Insurance and Social Protection 44. Georgia faces a dilemma common to all former Soviet states: the economic crisis has increased the need for social protection programs while at the same time drastically reducing the Government's capacity to administer and pay for them. To address this issue, the Government has taken significant steps since the fall of 1994 to improve the targeting of benefits and allow a real increase in benefit levels in 1995. Despite these efforts, benefits remain dramatically low. Monthly pensions (6 laris in December 1995) amount to about US$5, equivalent to about 20 kilos of bread a month. Other benefits, including child allowances and allowances to single mothers, are similarly low. Unemployment benefits remain so low that few unemployed (only 1,500 in mid-1995) bother to collect them. The only sizeable assistance program is directed to the 282,700 officially registered  - 10 - refugees from civil conflicts in Abkhazia and other regions of Georgia. Until refugees are allowed to return to their homes or are integrated into the local economy, transfer payments to them are likely to remain a drain on the government budget. 45. In the short run the prospects for improving social benefits are limited. First, too many Georgians remain eligible for benefits. Despite the reforms introduced in late 1994 (notably removing 125,000 working pensioners from the pension rolls), there are as many people (about 1 million) collecting pensions as contributing to the United Fund for Social Security (UFSS). Second, under-reporting of labor income is significant (the reported wage bill represents only 4% of GDP), and will only worsen as workers move from state-owned enterprises and the budgetary sector to private jobs. Third, possibilities for reallocating budgetary resources from other uses to social benefits are limited. 46. The decline in contributors and under-reporting of wages have been exacerbated by the move toward flat-rate benefits and the high social security contribution rate. The adoption of flat-rate benefits in September 1994 (unavoidable under the circumstances) has transformed the social security contribution into a pure tax on earnings. Breaking the link between contributions and benefits has given workers and employers a powerful incentive to create employment in the informal sector, where the high tax can be avoided. 47. In the longer run, even with a strong economic recovery, two issues will remain. First, it is unlikely that workers and employers will be willing to pay a combined contribution rate of 45 percent for social security, unemployment insurance, and health insurance to a public system that has failed to protect the incomes of the most vulnerable. Second, the age structure of the population combined with generous eligibility rules (retirement age is 55 for women and 60 for men) will inevitably create pressure to further increase taxes on earnings. Given these circumstances, the Government is determined to undertake a fairly radical reform to address sustainability issues, correct the perverse incentive effects, restore credibility and improve support to the neediest sections of the population. The reform agenda has five main elements: (i) Restricting pension eligibility. To lower the high dependency ratio and concentrate pensions on those who are more likely to need support, the Government raised the retirement age from 60 to 65 for men and from 55 to 60 for women, as of March 1, 1996. (ii) Shifting the public social protection system to social assistance. Public social insurance can be effective only if covered wages represent an important percentage of personal incomes. In Georgia, reported wages most likely represent less than 10 percent of personal income. By adopting a flat-rate pension, the Government has moved towards offering social assistance rather than social insurance. But it retains a social insurance framework by using a payroll tax to finance benefits. The Government plans to reduce the payroll tax rate and move towards financing much more of the social safety net through general budgetary revenues. As a first step, the contribution rate to the Employment Fund was reduced from 3 to 1 percent in March 1996. To decrease expenditures, spending from the Employment Fund has been limited to unemployment benefits and operating costs. All worker retraining, job search and job creation programs, considered of less priority, have been interrupted. In addition, the employer contribution rate to the UFSS (in the non- budgetary sector) was reduced by 8 percentage points. The Government envisages further reductions in the contribution rate as the fiscal situation improves, and within the framework of the reforms of the pension system.  - 11 - (iii) Shifting responsibility for paying sickness pay to employers. In addition to pensions, the UFSS finances sickness benefits. To reduce the required contribution to the UFSS, the Government intends to limit the Fund's spending to benefits for invalid and retired workers. Workers' pay during short-term disabilities and illness will become the direct financial responsibility of employers. The Government will prepare the necessary legislation by mid-1996 and put it into effect no later than January 1997. (iv) Introducing private pension plans and building a three-pillar system. The Government will prepare a regulatory framework to encourage workers, enterprises, and financial institutions to establish voluntary, privately funded pension schemes (or tax-free thrift plans). By second tranche, legislation, acceptable to the Bank, will be drafted by the Government and submitted to Parliament. If prudently regulated and supervised, this type of system could mobilize long-term savings and provide improved income security to future retirees and their dependents. It could contribute to the development of a capital market. The Government also intends to develop a plan under which both employers and workers would be obliged to contribute to qualified private, fully funded pension plans. Detailed legislation governing the funds and including a revision of the current pay-as-you-go system will be prepared and adopted by the Government by the end of 1996 and made effective no later than end-1998. (v) Establishing a back-up program of social assistance. The economic crisis in Georgia and the curtailing of many kinds of social protection have placed many Georgian families in economic jeopardy. Some of these families receive government benefits, but other destitute families do not qualify. To assist these unprotected groups, the Government intends to develop an assistance program. Financing for the new program will be obtained by further limiting child allowances and reducing allowances for refugees with adequate incomes from work. The test for eligibility (to be defined after detailed survey analysis) will take into account the presence in the family of at least one vulnerable individual. Vulnerable individuals include children, old persons and invalids. Families will have to periodically demonstrate that they continue to meet the conditions for eligibility. Eligibility limits will be set so that no more than 5 percent of the population qualifies for assistance, and within the limits of budgetary resources. The new backup program will be developed and adopted by end-1996. Eliminating Subsidies 48. Although the sharp increase in the price of energy in September 1994 and subsequent adjustments eliminated explicit budgetary subsidies to consumers and enterprises, implicit subsidies remain, notably through the delivery of gas and electricity to non-paying customers. Collection rates for electricity fell to a historic low of 4 percent in May 1995, and have rebounded only modestly since, to the 6-10 percent range. Cross-subsidization favoring residential consumption was reintroduced in July 1995 and wholesale tariffs vary widely among distributors as a result of billing and accounting irregularities. The gas company also faces severe collection problems, with collection rates of only 2-8 percent during late 1994 and 1995. With no gas metering, residential gas use is billed on the basis of volumetric norms which do not match actual consumption. The persistence of these implicit subsidies jeopardizes the sustainability of the fiscal adjustment, favors the accumulation of arrears and external debt, and undermines the financial position of the electricity company. The persistence of subsidies also dampens the incentives for enterprise adjustment, and thus reduce the prospects for output recovery (see para. 65).  - 12 - 49. To improve collection rates the Government created a Special Commission on Energy Payments in October 1995. This commission is authorized to improve collection of energy payrnents through measures including auditing of debtor's accounts to identify assets available to make payment, auction of inventories, ordering bank transfers, or cutoff of electricity supply. A monitoring system with monthly reporting starting in March 1996 has been established and the Chairman of the Commission for Energy Payments has issued an order to Sakenergo and distribution electricity companies to collect and submit to the Commission in a timely manner the necessary monthly data. The Commission is committed to gradually improving monthly collection of payments from 30 percent in March to at least 55 percent in August and 65 percent in December. To prevent further accumulation of arrears, the use of imported fuel and electric power by the electricity company, Sakenergo, will be permitted only under arrangements clearly specifying the price and terms of repayment, and only to the extent that Sakenergo has sufficient funds to finance the cash costs of such imports on a current basis. To that end, a special account has been established to collect revenues. The primary sources of funds will be electricity payment collections. The account can also operate with borrowed funds provided they do not exceed US$6 million at any point in time and do not imply a government guarantee. The Government is also committed to not resuming residential gas deliveries (interrupted in May 1995) until proper equipment, allowing metering of residential gas consumption is installed. It is also the Government's policy that energy consumers should settle their bills in cash, and that no institutionalized barter-trading companies be created within the energy companies. 50. The Government will also take measures to improve the tariff structure. Retail electricity tariffs during the July - October 1995 period included a cross-subsidy for the first 100 kwh of monthly residential consumption. There was no systematic framework for approving wholesale tariffs and ensuring that retail tariffs permit proper cost recovery by the local distribution companies that were created in May 1995. In January 1996 a unified wholesale tariff in the amount of 2.4 tetris per k-wh was established for all distribution companies. Further tariff reforms will include: (i) Wholesale tariff reform: wholesale tariffs will at least cover the cost of generation, import and transmission by June 1996, with quarterly adjustments thereafter. Tariff calculations will include, as a minimum, fuel and maintenance costs, other operating costs, an allowance for depreciation and bad debt, a reasonable profit margin, and a provision for interest on past-due accounts. (ii) Retail tariff reform: a national tariff formula will be established, allowing retail tariffs to vary according to the cost of operation of different distributors; distribution costs can be quite different depending in particular on the composition of consumption and the geographical area. The national formula for retail electricity tariffs will provide for phasing out of cross-subsidies over a three-year period, with the first adjustment to take place by September 1996. D. Fostering Adjustment of the Productive Sector Accelerating Privatization 51. The Universe to be Privatized. The Government fully recognizes that rapid completion of privatization is key to the structural transformation of the economy, improved enterprise efficiency, and thus recovery of output. The Government's strategy envisages privatizing the vast majority of state-owned enterprises; only a small group of entities necessary to carry out normal government  - 13 - functions, will remain 100 percent state-owned (primarily statutory bodies, such as research institutes, social services and military units). These entities are identified in Cabinet Resolution 249 of May 7, 1995. As this list included some enterprises which would better serve public interest under private ownership, the Government issued a decree in February 1996 amending the list so as to reduce the number of enterprises that will not be subject to privatization. In addition, the Government wishes to keep a majority of shares in a few enterprises for reasons of national security. The list of these enterprises will be revised as part of the review of all decrees maintaining 51 percent of shares under state ownership in a number of enterprises. 52. Small-Scale Privatization. Privatization of small-scale enterprises is nearing completion. The Letter of Development Policy prepared within the context of the Rehabilitation credit committed the Government to privatization of 6,481 small enterprises by the end of 1995. This target has been met and by February 1996, the Government had privatized 6,700 small enterprises. It intends to complete the privatization of all small enterprises (7,200) by the end of April 1996. 53. Medium- and Large-Scale Privatization. Privatization of medium- and large-scale enterprises began in earnest in the spring of 1995. A total of about 1,100 medium- and large-size enterprises were identified. All are first to be converted to joint stock companies, and to date, 840 enterprises have been corporatized. The Government has decided to proceed with privatization by stages and using various methods. In a first stage, the Government intends to fully privatize about 900 enterprises, leaving for a second stage the privatization of the remaining 200. For the latter, most of which produce primary products (such as minerals, gas, oil products and chemicals) or provide critical services (such as trade and wholesaling, construction, airport and port services), the Government intends to sell only a minority of shares during the first stage. To this effect, it issued decrees which temporarily reserve for state ownership 51 percent of their shares. However, except for those enterprises in which the majority of shares would be retained for reasons of national security, the Government will, by second tranche, amend the relevant decrees and eliminate these restrictions, thus initiating the second wave of privatization. It intends to complete the privatization of all enterprises no later than the end of 1997. 54. In 1995, several methods of transferring ownership were adopted. First, employees in state enterprises received 5 percent of shares for free. Second, enterprise managers and employees were given the option to buy an additional 51 percent of the shares of their enterprise. This buyout option, which expired in October 1995, was applied for by 423 enterprises. Employers and employees have until July 1996 to complete the payment (to be made partly by vouchers, and partly by cash). It is the Government's policy to transfer only shares which are paid in full. Third, to ensure some outside ownership, at least 35 percent of the shares of every medium and large enterprise subject to privatization are offered to the public through the mass privatization program ("special" voucher auctions) launched in June 1995. Through these auctions, shares are allocated to bidders based on the number of vouchers submitted. Investment funds have been licensed to buy vouchers and bid in the auctions. To date shares of about 700 enterprises have been offered to the public through the voucher auctions and by July 1996, shares of all medium- and large-scale enterprises will have been offered to the public at least once. 55. These various methods will still leave some proportion of shares under state ownership, in particular if the buyout is not completed. For the majority of enterprises, remaining shares will be sold through auctions either as a single package per enterprise to the highest bidder, or grouped in "packets" of shares. Cash auctions will be used to complete the process once vouchers expire. Cash  - 14 - auctions are identical to voucher auctions, except that payment will be only in cash. Whenever the remaining majority block of shares cannot be sold through the first offering at a cash auction, the enterprise will be liquidated and its assets auctioned. Voucher and cash auctions will be equally open to the participation of all investors, foreign and domestic. Guidelines specifying the detailed conditions and procedures to be applied to voucher and cash auctions were issued in early 1996. 56. The Ministry of State Property Management has identified a few medium and large enterprises which, because of their size and activities, are expected to be attractive to foreign investors. At least 51 percent of their shares will be offered to strategic foreign investors through competitive international tenders. For two of them, services of an investment bank have already been secured. In addition, tenders will be used to privatize a few larger, more complex enterprises in which the Government wishes to obtain investment commitments from bidders. Foreign and domestic investors will be allowed to compete on an equal basis. Guidelines specifying the detailed conditions and procedures to be applied to tenders were issued in early 1996. 57. Employing the above methods, the Government has privatized 125 medium and large enterprises by end-January 1996 and is committed to privatize an additional 200 medium and large enterprises by second tranche. The Government intends to complete the privatization program by the end of 1997. 58. A number of enterprises (public and private) have outstanding claims on the Government for the delivery of unpaid products under the old state order system. Preliminary estimates indicate that aggregate claims are equal to approximately US$4 million for private enterprises, and to US$6 million for state enterprises. These enterprises have been hitherto allowed to exchange these claims for shares in enterprises subject to privatization. However, the Government has concluded that the process by which these claims have been extinguished lacks transparency. Doubts have also been raised about the accuracy of estimates of outstanding claims. Therefore, the Government has established a unit to carefully review each claim and will subsequently issue a Resolution along the following lines: (i) no enterprises in which the state owns more than 25 percent of the share capital may exchange claims for shares in enterprises subject to privatization; and (ii) claims will be exchanged for shares only through competitive processes organized by SPM (eg. open, competitive auctions). Claim holders will be allowed to freely trade (i.e. buy, sell and barter) their claims. 59. Privatization will produce millions of new shareholders and requires an efficient share registry. In order to avoid the problems inherent to enterprise-managed registries, the Government has decided to allow the private sector to operate registries with licensing authority vested with the Ministry of Finance. In February 1996, the Ministry of Finance and SPM established the necessary regulations. Thereafter, the Government will issue a decree requiring joint-stock companies to maintain a share registry with a licensed independent registrar. 60. Privatization of the Bread Corporation. The Government's program, as supported by the Rehabilitation Credit, developed in mid-1995 a plan to break up the state bread making and poultry corporation (SBC), and to privatize its units. SBC is the largest state producer in the food and agriculture sector and still represents about 80 percent of the bread market. Although the plan's implementation schedule is slower than originally agreed, the Government remains committed to privatizing SBC: in addition to two mills, all retail units and small bakeries of SBC were privatized by February 1996 and the Government intends to privatize all large bakeries and at least 10 mills by second tranche. At the same time, the Government will liberalize the price of bread and remove  - 15 - profit margin controls on grain and flour. The privatization of the remaining 4 mills will be completed by the end of 1996. 61. Restructuring and Privatizing Energy Utilities. Sakgazi, which operates Georgia's high- pressure gas pipelines, remains under 100 percent state ownership. However, Sakenergo, the state- owned power generation and transmission company, which operates three thermal plants and more than 100 hydrostations, has begun a restructuring and privatization program. About 10 hydrostations had been privatized by mid-1995, and a few more operate under leasing arrangements. In addition, in May 1995, Sakenergo spun off roughly 40 municipal electricity distributors. This restructuring program was ill-prepared, lacking an adequate regulatory framework governing wholesale tariffs and transactions, and led to the poorest collection performance ever (see para. 48). Moreover, many of the new companies face problems of conmmercial viability. 62. The Government is now aware that successful privatization requires that a framework for sector regulation be first put in place, and the sector be restructured into commercially viable units suitable for privatization. To address this issue, the Committee on Power Industry Restructuring established in October 1995 will first make recommendations for the establishment of a legal and regulatory framework, including setting up an autonomous energy regulatory agency. The agency would be in charge of regulating tariffs for gas and electricity, licensing energy operators, implementing rules that promote inter-fuel competition and prevent monopoly abuses, ensuring fair commercial use of Georgia's energy infrastructure, and promoting energy conservation and least-cost supply policies. The Commission's additional mandate is to make recommendations for the restructuring of the sector, corporatization and privatization of sector enterprises. Based on the Commnittee's recommendations, and in consultation with the Bank, the Government intends to issue a decree defining the proper regulatory framework and related institutional setup and to adopt a plan for power sector restructuring and privatization of sector enterprises. 63. Privatization of Land. About 21 percent of agricultural land and 47 percent of cultivated land (630,000 ha.) is now in private hands. Although this percentage is still low, private agriculture plays a central role. Unlike in other former Soviet states, collective and state farming has nearly come to a halt and the private sector has become the dominant source of domestic supply. Further development of agriculture thus rests on a rapid completion of agricultural reforms - primarily transferring remaining land and other productive assets to individuals - and appropriate definition of property rights to create conditions for a functioning land market. The Government intends to expedite the process of land reform. In March 1996, Parliament adopted a law on land ownership which gives rights to buy, sell, lease and inherit land that is already in private use. Enactment of the law will be followed by the preparation and adoption by second tranche, of a land registration and titling law. The Government has also developed a plan for distributing and privatizing part of the remaining land (about 240,000 ha.) over a period of one year. This will bring the percentage of cultivated land under private ownership to over 60 percent (land located in Abkhazia/Ossetia is currently excluded from the privatization program, as well as land used by research and extension farms). Finally, the Government intends to lease on a competitive basis land that will remain under state ownership and envisages to grant transferable leasing rights. To that end, the Government will adopt the legal framework specifying leasing arrangements to make public land available for private use. Enforcing Hard Budget Constraints 64. Despite the rapid privatization of small enterprises and the adoption of an aggressive program  - 16 - to privatize medium-size and large enterprises, many enterprises will remain under partial or full state ownership in the short run. Restructuring and efficiency improvements in these firms are likely to be delayed unless they are subject to financial discipline and competitive pressures. 65. In principle, hard budget constraints have been imposed in Georgia since the fall of 1994. But experience shows that direct budgetary support is not the only channel through which budgetary constraints can be softened. Other channels include accumulation of tax arrears, interenterprise arrears, and continued lending through state banks. The potential for soft constraints is particularly high in the case of large, politically powerful enterprises, which can often circumvent budget constraints by pressuring authorities to delay tax bills or to continue lending through state banks, despite their inability to service existing obligations. Such enterprises may need to be isolated from the banking sector to stem the flow of losses until they can be restructured and privatized, or liquidated. The situation in Georgia does not warrant this approach in the short term. While there are politically powerful enterprises in Georgia, no major enterprise - except gas and electricity utilities - has been favored by the banks recently. The privatization of banks now underway and restructuring of the banking sector will further reduce the risk of such treatment (see para. 70). In addition, data on enterprise arrears show that most relate to energy. Hard budget constraints will thus be best enforced through improved collection of energy payments. Strengthening tax administration will also help. Maintaining these policies and monitoring their impact over the medium term will be particularly important as the risk of soft budget constraints may reappear with the improvement of the fiscal situation. Restructuring the Financial Sector 66. Besides the NBG, the financial system inherited from the FSU consisted primarily of five state banks (Savings Bank, Industrial Bank, Eximbank, Agrobank, and Housing Bank). In addition numerous new private banks have emerged since independence. In September 1995 there were 130 banks and near-banks operating in Georgia (down from 229 in March 1995), albeit many with just a name plate and a couple of customers. Following the merger of the Savings Bank, Industrial Bank and Eximbank to form the United Bank of Georgia, the state banks are only three, but they dominate the sector with about 75 percent of total banking assets. Hyperinflation eroded the real value of all nominal claims, including bank deposits and loans, as well as confidence in the banking system. Banking assets, at some US$175 million in September 1995, account for less than 7 percent of GDP. Inflation is now under check but confidence in the banking sector must be earned back by resolute, credible actions of the authorities. 67. Such actions have begun. The Government is proceeding with a strategy developed in collaboration with the IMF and the World Bank, which, in its initial stage, focused on establishing a legal framework for the banking sector and strengthening the National Bank supervisory function. In June 1995 Parliament approved the National Bank Law, which establishes the legal basis for an independent NBG to conduct monetary policy, and the Government complemented this law with a Commercial Banking Law adopted in February 1996. With technical assistance from the IMF, the National Bank Supervision Department is undertaking reorganization and strengthening its capacity for on-site bank examination (100 are projected for this year) and off-site surveillance. New prudential standards were issued in February 1995, that apply to all banks, including state-controlled banks. Because of the higher minimum capital level (US$100,000) now required for banks, numerous banks had their licenses revoked (30 of these banks are already in the final phase of liquidation). As a result, the number of banks has decreased, and only 50 to 70 banks are expected to remain by mid-  - 17 - 1996. A further increase of the minimum capital level (planned for later in 1996) will lead to a further reduction in the number of banks. 68. Despite these initial steps, the financial sector remains in perilous shape. Many licensed banks are either insolvent or inactive, and all but 30 fail to operate in accord with prudential banking standards. The three major banks have severe asset problems and a negative net worth. The merged bank is the largest in terms of number of branches, with 40 percent of total banking assets. 69. The Government is aware that fostering savings mobilization and efficient intermediation by the banking sector is critical for the economy's recovery. At this stage its strategy is to ensure that banks restructure rapidly without jeopardizing the Government's budget, and to promote competition between sound private banks. Implementing this strategy implies privatizing the former state banks, preventing non-viable banks from expanding until they meet all of the NBG's requirements, and encouraging the consolidation and merger of small private banks and branches of larger banks with sound banks. 70. Unlike other FSU countries, Georgia made rapid progress in privatizing state-owned banks. In 1995 the state permitted the merger of three state-owned banks into one entity and began privatizing all remaining state-owned banks largely to their managers and employees. By February 1996 the state had eliminated its direct ownership in the merged bank (United Bank of Georgia), the Agrobank and the Bank of Georgia (former Housing Bank). The buyers did not demand that the loan portfolio be guaranteed or that its negative net worth first be recapitalized (the valuation of banks shares included only buildings). In addition, the ownership of government-controlled enterprises (defined as 25 percent or more state-owned) was reduced to less than 20 percent. The Government is convinced that privatization of banks will reduce the likelihood of a government bail-out in case of bank failure and will create incentives to improve operations in a cost-effective way. It is committed not to increase its direct and indirect ownership from their current level. 71. The second set of measures is to restrict the activities of the non-complying banks until they meet all of the NBG's prudential requirements. The certification of banks which comply with the NBG's prudential requirements has begun at the end of 1995. The NBG will either prevent all non- certified banks from accepting additional deposits or impose a 100 percent marginal reserve requirement. In addition, no cash dividends will be allowed until the banks are certified. This will force banks to address the source of their problems (poor lending decisions and high operating costs) and will not permit them to overcome illiquidity by attracting deposits through excessive interest rates. The NBG will enforce this if necessary by transferring any nominal increase in deposits (both household and enterprise) into a non-interest bearing reserve account with the NBG from funds passing through the banks' correspondent accounts. 72. The third set of measures involves the restructuring of the banks. In April 1996 the NBG and the three major non-complying banks (the United Bank of Georgia, the Agrobank, and the Bank of Georgia) will agree on a timetable, with monthly or quarterly benchmarks to monitor progress toward meeting all prudential requirements. If the prudential ratios do not improve as agreed in the timetable, the deviating bank will be given one month to return to the agreed timetable. It could do so either by selling assets or finding additional private equity. Once the delay has expired, the NBG will either withdraw the licenses of selected branches or force their sale to other banks, thereby obtaining the funds necessary to enable the bank to adhere to its agreed timetable. This last approach will be particularly effective in dealing with the United Bank of Georgia which has inherited the vast  - 18 - branch network of the former Savings Bank. Adherence to the agreed timetables will be enforced or appropriate penalties will be imposed. Similar timetables will be agreed upon with all other non- complying banks. Small private banks unable to meet minimum prudential standards will be encouraged to restructure through merger or self-liquidation. 73. As part of this overall strategy, neither the Government nor the NBG will insure banking deposits because they would distort incentives. The Government and NBG will not oppose private banks organizing mutual insurance schemes or purchasing private insurance, but will not take any responsibility for this. 74. To implement this strategy, the NBG has strengthened its supervisory function by setting up a bank certification program. Only banks fully complying with the prudential banking standards will be certified. The restriction that household deposits cannot exceed capital will be gradually relaxed for banks which are certified, and a decree to this effect has been issued in November 1995. The Government intends to support the development of those banks found to be sound and viable, and technical assistance and credit lines from multilateral agencies will be directed only toward the banks which have been certified. Some of this institutional development support will be provided by the Agriculture project under preparation, which will complement the policy measures supported under the proposed SAC. Fostering Export Growth 75. One goal of trade policy is to encourage the building of productive activities in which Georgia has a true comparative advantage, while avoiding incentives to revive inefficient activities and trade patterns. Both theory and experience show that this goal is best met by creating an open trade regime with minimal anti-export bias in the incentive structure and with institutions supportive of export development. 76. Georgia starts from a good base, with its fairly low (12 percent) and uniform import tariff (on non-barter trade with non-CIS countries). Maintaining this tariff policy, with the eventual goal of reducing tariff further when fiscal considerations permit, will help to avoid the kind of implicit anti- export bias created in many other countries by incentives to produce domestically goods that can be imported more efficiently. Until recently however, barter trade with non-CIS countries was taxed at 20 percent. As there is no reason to discriminate against barter trade the Government has reduced the duty on barter trade to 12 percent, the same rate as that on non-barter imports in February 1996. 77. The main trade policy issue in Georgia is export policy. Export industries, including agricultural products, have traditionally been subject to export restrictions. These restrictions were designed to protect domestic producers that used these products as inputs, to keep prices low for domestic consumers, and to provide leverage to force enterprises to fill their quota under the state order system. These controls created large implicit taxes on exports. Much progress was made on this front with the elimination of the export tax at the end of 1994, the abolition of the state order system, and the removal of export licensing requirements on 18 products in 1995. Progress notwithstanding, at the end of 1995 export licenses were still required for 9 groups of products and export prohibitions for 10 groups of products. 78. Removal of Export Prohibitions and Licensing. The Government has now recognized that prohibitions and export licensing requirements create obstacles for exporters, and that there are better  - 19 - ways to handle any legitimate concerns for which they are used. In addition, since the prices of most of these products (except bread) are no longer controlled, it can no longer be argued that their export will be encouraged by artificially low domestic prices. Thus in November 1995, the Government issued a decree eliminating export prohibitions and removing requirements for licensing from most exports (except for the standard list of exceptions). In the case of scrap metal , the export prohibition will be eliminated and temporarily replaced by an export tax. A plan for the phasing out and discontinuation of the tax will be adopted. 79. As a temporary measure, exporters of 5 types of goods' will be required to register export contracts ex ante with the Government. The registration mechanism will be transparent and will be used only for purposes of health and safety control and to reduce tax evasion through underinvoicing. With technical assistance from the World Bank and the UNDP, the Government will put in place alternative, more appropriate, mechanisms to address these concerns and by second tranche, will eliminate the transitional system of ex ante registration. Tax laws applying to exporters will be enforced by the Tax Inspectorate and Customs service in accordance with their normal procedures, based on ex post monitoring and investigation when there is cause for suspicion of non-compliance. 80. Export Promotion. After removing direct barriers to exports, the challenge is to create an appropriate enabling environment. Constraints facing potential exporters in Georgia include lack of contacts and information for marketing abroad, lack of adequate technology to produce high-quality goods for export markets, high cost of imported inputs, unavailability of trade finance, and poor infrastructure. 81. A number of these constraints could be mitigated by encouraging foreign investment. Top priority needs to be given to enacting an adequate foreign investment code. The current law has a number of positive features, including granting foreign investors unlimited rights to repatriate profits, but is also deficient in several areas. It requires approval of investments based on rather vague criteria and relies on tax holidays as fiscal incentives for attracting investors. By second tranche, the Government will amend the law to resolve these problems. The amended code will introduce a system of expeditious approval of investments, with certain clearly delineated exceptions based on national security concerns. In recognition that temporary concessions and holidays generally are not effective in attracting efficient investment, the code will not contain such fiscal incentives. 82. Priority should also be given to setting up the institutional framework for free trade zones in Georgia. These zones can serve as useful stop-gap devices, since they allow the quick resolution of some problems (infrastructure, lack of duty-free regime for exporters) that will take longer to resolve on an economy-wide basis. Similarly, the Government should move to improve the system of customs warehouses or private bonded warehouses to encourage importers of inputs to pay duties only as they use or sell the goods. This would benefit both exporters who use imported goods, and other importers. It would also give modest relief to entrepreneurs complaining about tax burden without risking loss of tax revenues altogether. In the long run, tax exemption and drawback schemes for exporters are also useful instruments for export promotion. At this stage of institutional development, however, it is better to concentrate on administratively less demanding mechanisms. 31 The five goods are ferrous metals, manganese/copper concentrates, mineral water, alcoholic beverages and tea.  - 20 - 83. To implement this strategy of support for exporters, the Government will put in place several types of schemes (with technical assistance from the World Bank and UNDP). First, the current legal framework for bonded warehouses will be improved. Producers that export virtually all of their production will be exempted up front from payment of duties, VAT, and excise taxes on their imported inputs. Second, the Government will establish a legal framework for free trade zones. Services for exporters also need to be improved. One step in that direction will be to allow for reincorporation as private companies the former state trading corporations, Gruzimpex and Agroimpex freeing these organizations from the constraints of the public sector and allowing them to raise capital on their own. Another step will be to expand the volume of trade finance which is now quite limited. To that effect, the Government intends to review and improve the law governing negotiable instruments. PART III. BANK ASSISTANCE STRATEGY A. Background and Objectives 84. A limited country assistance strategy for Georgia was discussed by the Board on March 30, 1995 as part of the President's Report for the Rehabilitation Credit, and the proposed credit is consistent with that strategy. The objectives of the strategy are to help reverse the sharp economic decline of the past few years, to accelerate the transition to a market economy and to alleviate the poverty that has recently emerged in Georgia. A full Country Assistance Strategy will be prepared in FY97. B. Bank/IDA Assistance to Date 85. During the first two years of Georgia's membership4 in the Bank, the development of a comprehensive assistance program was hindered by the civil conflicts. During that period, the Bank focused on building macroeconomic and sector knowledge, and providing limited technical assistance. A Country Economic Memorandum was prepared (and distributed to the Board in May 1993) and introductory missions on transport, agriculture and the environrment took place. 86. Improvements of the political situation at the end of 1993 and new emphasis of the Government on economic issues in early 1994 opened the way for initiating a broader assistance program. The Institutional Building Credit (US$10 million), approved by the Board in July 1994, provides support to the country's privatization efforts, financial sector reform, tax and customs administration, and economic policy development. Implementation is advanced and the project has played a key role in facilitating an acceleration of structural reforms, in particular of privatization. During the summer of 1994, the Bank prepared a Municipal Infrastructure Rehabilitation Credit (US$18 million) which addresses the severe deterioration of municipal infrastructure in Tbilisi and other large cities. Implementation of this project, approved by the Board in November 1994, is proceeding satisfactorily. In January 1996, the Board approved a Transport Rehabilitation Project (US$12 million), to support policy reform in the transport sector, and to repair and maintain some of the most critical elements of Georgia's transport system. In addition to these activities, Georgia is benefiting from the GEF-funded Black Sea Environmental Program jointly executed by the Bank, 4/ Georgia joined the World Bank in August 1992  - 21 - UNDP, and UNEP. With the aim of addressing environmental problems along the Black Sea Coast and in the coastal zone, and in coordination with the Municipal Infrastructure project, technical assistance and project funds are directed toward wastewater treatment and solid management in Poti and Batumi and the establishment of a national park in coastal wetlands. 87. Following the agreement with the IMF on a program of macroeconomic stabilization supported by a first purchase under the STF facility, the Bank prepared a Rehabilitation Credit to support the Government's structural reform program. This credit (approved by the Board on March 30, 1995) provided US$75 million of quick-disbursing balance of payments support. Disbursement is complete and implementation of the reforms supported by the credit has been strong (see detailed description in Part I and in Annex 1). Overall, IDA lending during FY95 amounted to US$103 million. This large allocation reflected the judgment that it was crucial to catalyze market-oriented reforms and that such a lending level could make a difference between the success or failure of reform efforts. 88. To gain more in-depth understanding of the constraints and possibilities of the Georgian economy, an Economic Update was completed in November 1994. The Bank also undertook ESW on agriculture, transport, energy, municipal services, and health. In addition, the Bank organized and chaired an informal 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. C. The Lending Program 89. 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 concentrates 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. Special emphasis is put on programs aimed at improving the social safety net and at ensuring access to basic services by the poor. 90. All three projects approved in FY95, the transport project approved by the Board in January 1996, and the proposed SAC fit within this strategy as do projects under advanced preparation in the health, energy and agriculture sectors. It was assumed in the limited CAS for FY96-98 that continued progress in stabilization and in the main areas of reforms would enable a medium case program of US$150-180 million of IDA over the three years and IBRD lending starting only after 1998. Strong and sustained progress in stabilization and implementation of an economy-wide reform program, accompanied by fiscal strengthening, export development and overall supply response would strengthen Georgia's creditworthiness earlier and justify moving to a high-case program of US$250 million (including US$70 million from the IBRD starting in 1997). Both scenarios5 would include 5/ The medium case assumed continued progress on small-scale privatization, substantial progress on trade liberalization, introduction of a legal framework for land reform, and adoption of energy sector reforms. The high case assumed progress on privatization of medium- and large-scale privatization, enforcement of financial discipline and improved targeting of the social safety net.  - 22 - adjustment operations. IBRD lending would only be considered if adequate creditworthiness could be established and in the context of a full CAS. Over the last 12 months, rapid progress in implementing stabilization and structural reform policies has meant that most of the high case triggers specified in the limited CAS have been met. Georgia is currently performing at a level between the suggested medium and high cases. Strong implementation of the proposed SAC would imply that all triggers for the high case would have been met. 91. If stabilization and structural reform policies were to be reversed, assistance would be reduced to a low case program of about US$20-25 million a year on IDA terms only. Under such a scenario, policy-based lending would not be considered and investment projects would focus on basic infrastructure and the social sector. The objective would be to avoid the deterioration of critically- needed infrastructure and to maintain a basic level of social protection. D. Economic and Sector Work Program 92. The Bank's lending program is supported by economic and sector work in the following areas: macroeconomic stability and growth, 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. To foster public sector efficiency, the Bank is undertaking a review of public expenditures. This work is taking advantage of, and build upon, the ongoing and planned work in energy, transport and health. It will include work on public sector labor and employment policies, education and social protection. In the area of private sector development, the Bank has completed a review of the agriculture sector and is planning to initiate an assessment of the financial sector, augmenting the substantial work and technical assistance carried out in some of these areas under the IBC. 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. E. MIGA and IFC Activities 93. Georgia became a member of MIGA in December 1992. To date there have been no investment guarantees issued. Georgia joined IFC in June 1995. A mission to assess the climate for foreign investment took place in December 1995. Possible IFC investments are under consideration. PART IV. THE PROPOSED CREDIT A. Background and Rationale for World Bank Involvement 94. Georgia initiated the transition to a market economy under difficult conditions. After suffering from the aftermath of two years of civil conflicts and political instability, over the past year and a half, the Government has been implementing a stabilization and structural reform program that has already succeeded in curbing inflation, stabilizing the exchange rate and slowing down the rate of economic decline. Economic recovery will require the pursuit and deepening of the economy-wide reform process underway. In the short run, it will operate under sharp financial constraints (weak fiscal stance and large external obligations) . The proposed credit aims at ensuring the sustainability of the stabilization process underway and at fostering a strong and sustained growth recovery. It will be instrumental in maintaining the reform momentum. The proceeds of the credit would finance  - 23 - critical imports needed to foster growth recovery and would provide budgetary support to maintain a level of basic public expenditures. The project funds will be utilized within the overall budget envelope supported by the Standby Arrangement (SBA) and the Enhanced Structural Adjustment Facility (ESAF), 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. B. Program to be Supported 95. The Government's program of structural reform to be supported by this Structural Adjustment Credit is outlined in Part I and in the attached Letter of Development Policy (Annex 6). The structural reform program described in the Letter complements the macroeconomic stabilization program supported by the Enhanced Structural Adjustment Facility (ESAF) approved by the Executive Board of the IMF on February 28, 1996. 96. The measures which were taken by the Government as a result of agreements reached during preparation of the proposed Credit are: Streamlining the Government Sector and Improving Efficiency of Public Spending Allocation of Public Expenditures * The share of public expenditures allocated to both health and education in the 1996 state budget has been increased to reach about 7% for health and 8% for education. Education * A plan of action for the education sector was adopted. This plan gives priority in the allocation of public expenditures to basic education and targeted population groups, fosters the creation of private schools and the participation of families in the financing of education, encourages local initiatives for staff compensation, and sets targets for reducing the number of educational personnel paid out of public budgets and for modifying the pay structure. Social Protection * The retirement age has been increased from 60 to 65 for men and from 55 to 60 for women. * The contribution rate to the Employment Fund has been reduced by 2 percentage points. Spending from the Fund is now limited to unemployment benefits and operating costs; all other programs have been discontinued. In addition, the contribution rate to the United Fund for Social Security (in the non-budgetary sector) has been reduced by 8 percentage points. Eliminating Energy Subsidies * In October 1995, the Government created a Special Commission on Energy Payments, which is authorized to take steps to improve collection of payments. A monitoring system with monthly reporting has been established and the Chairman of the Commission has issued an  - 24 - order to Sakenergo and the distribution companies to ensure timely collection of the necessary data. * Sakenergo's use of imported fuel and power is now limited to arrangements that clearly specify the price and repayment terms in advance. Imports are allowed only to the extent that Sakenergo has sufficient funds to finance their cash costs on a current basis. A special account has been set up with electricity payment collections as primary source of funding. Borrowed funds will not exceed US$6 million at any point of time and will not benefit from government guarantee. Fostering Adjustment of the Productive Sector Privatization and Enterprise Reform * A decree amending resolution #249 has been issued and reduces the number of enterprises which will remain 100 percent state-owned. * A total of 6,700 small enterprises and 125 medium- and large-scale enterprises have been privatized. * Guidelines and procedures to be applied to auctions and tenders for the sale of residual shares of medium- and large-scale enterprises have been issued. The Ministry of Finance and the Ministry of State Property Management have established procedures for authorizing private sector entities to operate private share registries. * All retail units and small bakeries of the State Bread Corporation have been privatized. Land Reform * A law on land ownership defining the legal framework for transactions related to land including sale, lease and inheritance has been adopted by Parliament. Financial Sector * The privatization of former state-owned banks has been completed. The direct ownership of the Government has been reduced to zero and the indirect ownership through state-owned enterprises has been reduced to less than 20 percent. * All commercial banks have been notified of the certification program and informed that the activities of non-complying banks will be restricted until existing capital, reserve and other prudential requirements are satisfied. Payment of dividends by non-complying banks will be prevented. Trade * The tariff rate on barter trade has been unified with the rate for other imports (12%).  - 25 - * A decree has been issued eliminating prohibitions on the export of all products, with the exceptions of antiquities and artwork of museum value, weapons, and metal scrap. * A decree has been issued eliminating all requirements for licensing exports, with the exceptions of 1) materials for mineralogical, biological, archaeological, paleontological, ethnographic and numismatic collections; 2) seeds of Caucasian fir trees; 3) timber and logs; and 4) raw materials for medicines of animal or vegetal origin. Licenses for export of logs and timber will be given automatically upon demonstration that the trees were cut in accordance with conservation regulations. As a transitional measure, a non-restrictive mechanism of ex ante registration of export contracts is set up for five products. 97. Agreement on a timetable, satisfactory to the Bank, to monitor progress toward meeting NBG prudential requirements for the three major non-complying banks is a condition of effectiveness of the proposed Credit. 98. Proposed Second Tranche Conditions are as follows: * Comply satisfactorily with the collection targets for electricity at the end-consumer level, and between Sakenergo and the distribution companies, as agreed with IDA (see para. 49). i Submit to Parliament legislation regulating voluntary private pension schemes. i Complete the privatization or initiation of liquidation of all 7,200 small enterprises and of an additional 200 medium- and large-scale enterprises. * Amend the following decrees: #875 (December 26, 1994; #22 (January 28, 1995); #81 (February 17, 1995); #12 (February 17, 1995); #248 (May 10, 1995); #166 (May 14, 1995); #228 (June 11, 1995); and #303 (August 7, 1995), to allow privatization of all enterprises listed in the above decrees except for those in which the Government would keep 51 percent of shares for reasons of national security. * Offer for sale all remaining bakeries and at least 10 mills of the State Bread Corporation; liberalize the price of bread and remove profit margin controls on flour and grain. * Make satisfactory progress in the distribution of the land that remains to be privatized; establish the legal framework for land titling and land registration; and adopt procedures, satisfactory to IDA, for leases to make remaining public land available for private use. * Adhere satisfactorily to timetables for compliance with prudential ratios for the three major banks (or impose appropriate penalties). *. Eliminate ex ante registration requirements of export contracts. * Amend the code governing foreign investment to introduce a system of expeditious approval of investments, with clearly delineated exceptions based on national security concerns, and to remove preferential tax treatment for foreign investors. 99. In addition, satisfactory implementation of the overall reform program described in the Letter  - 26 - of Development Policy (Annex 6), with particular focus on the key reform measures listed in an attachment to the Letter will be required for second tranche release. C. Project Implementation 100. The proposed Structural Adjustment Credit (SAC) of SDR 41.3 million (equivalent of US$ 60 million) would be made to the Republic of Georgia represented by the Ministry of Finance. Disbursements will be made into a Ministry of Finance (MOF) 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 private sectors and will reimburse the MOF at that time with the equivalent local currency at the market exchange rate. The exchange rate to be applied will be determined by the inter-bank foreign currency auction market. This market was established in 1993 by the NBG and auctions are held daily since January 1996. The volume of transactions going through the inter-bank auction has greatly expanded over the last year as stabilization and structural reforms strengthened the role of market forces in allocating foreign exchange. 101. The credit will be released in two tranches of equal size: the first on effectiveness and the second on fulfillment of the specific tranche release conditions outlined above. The credit would be on standard IDA terms, including a 35 year maturity and a 10 year grace period. A technical assistance credit in the amount of SDR 3.3 million (equivalent of US$4.8 million), prepared in parallel to the SAC, would support implementation of the measures contained in the LDP. 102. The Aide to the President for Economic Reforms 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. 103. A senior official has been appointed as project manager. The project manager will be responsible for preparing the simplified withdrawal applications, maintaining the project's Deposit Account and if requested by the Association arranging for its timely audit, and monitoring overall credit implementation. On the basis of the information from the various agencies involved in the implementation of this credit, the project manager will prepare the Borrower's contribution to the Project Completion Report within six months of the closing date. D. Disbursements 104. The Borrower will open an account in the National Bank of Georgia. Upon notification by the Association of tranche release for each tranche, proceeds of the credit will be deposited by the Association in this account at the request of the Borrower. If after deposit in this account, the proceeds of the credit are used for ineligible purposes (i.e., to finance items imported from non- member countries, or goods or services in the standard negative list), the Association will require the Borrower to either (a) return that amount to the account for use for eligible purposes, or (b) refund the amount directly to the Association, in which case the Association will cancel an equivalent undisbursed amount of the credit. E. Accounts, Auditing, and Closing Date 105. Although routine audit of the Deposit Account will not be required, the Association reserves  - 27 - the right to require it. The credit is expected to be fully disbursed within six months of the release of the second tranche. It is therefore proposed that the closing date of the credit be December 31, 1997. F. Environmental Safety 106. The project will have no direct impact on the environment. For the purposes of Operational Directive 4.01, it has therefore been placed in Category C which does not require an environmental assessment. G. Poverty Category. 107. The proposed credit is poverty-focused since it will support improvements in the targeting of social benefits to the poorest groups. H. Agreements Reached 108. At negotiations, agreement was 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 (d) accounting and auditing arrangements. I. Benefits and Risks 109. Benefits. The main benefits of the credit would be to ensure the sustainability of the stabilization process and to consolidate and deepen the structural changes initiated a year and a half ago after a long period of economic and political turmoil. Over the last months, inflation has been curbed and economic decline has slowed but the situation remains precarious. The deepening of the reform process should consolidate recent achievements, accelerate the transition to a market economy, and lead to sustained growth recovery and improvements in living standards. The proposed credit would contribute to a further downsizing of the state-controlled sector and efficiency gains in the use of public resources. It would induce adjustment of enterprises to new market signals and thus foster productivity gains, thereby increasing savings and investment. 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 social sectors and infrastructure. 110. Risks. The main risk is that adequate and timely external assistance of the magnitude required will not be forthcoming, threatening public support for reforms and the success of the reform program. The macroeconomic prospects are such that even with timely implementation of reforms, Georgia's economy will not reach the 1990 levels of per-capita consumption before the end of the century; savings are also likely to remain negative until 1997. The failure to achieve a fully funded program would force a much stronger domestic adjustment and a lower growth path, imposing additional social costs to the population. To address this problem, the Bank will not only provide continuous financial support, but it will also assist Georgia in mobilizing external resources through the Consultative Group process and other donor coordination efforts. A second risk is that the terms at which bilateral creditors agree to reschedule existing claims may be inconsistent with the country's capacity to pay, lowering the prospects for the attainment of external viability over the medium term. This risk is being addressed through a debt strategy developed in agreement with the IMF and  - 28 - on-going negotiations with bilateral creditors. A third risk is delayed implementation due to weak institutional capacity within the Government and other executing agencies. To date, technical assistance has been essential in assisting the Government in the design and implementation of reforms. The Bank will make continuous effort, partly by providing a technical assistance credit and partly by mobilizing external technical assistance, to provide the much needed support. It is also expected that the reorganization of the Government following the enactment of the new Constitution will improve economic management. PART V. RECOMMENDATION 111. 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. Gautam S. Kaji Acting President Washington D.C. March 20, 1996  Annex 1 Page 1 of 4 STATUS OF IMPLEMENTATION OF POLICY MEASURES AGREED UPON UNDER THE REHABILITATION CREDIT MhEASURES TAKEN PRIOR TO BOARD | PROGRAM IMPLEMENTATION SINCE MARCH 1995 | COMMENTS PRESENTATION . I. MACROECONOMIC STABILIZATION STF approved in December 1994. All end-June 1995 quantitative performance criteria agreed upon with Stabilization laid the SBA approved in June 1995. the IMF met by significant margins. ground work for the introduction of a new Average monthly inflation fell from an average of 64% in the first national currency, the lari, three quarters of 1994 to 3% in the first 9 months of 1995. on September 25, 1995. Exchange rate of the coupon appreciated from 5 million per US$ in September 1994 to nearly 1.3 million at end 1994 and stabilized since then. A. Fiscal Policy Reduction of subsidies through sharp price Implementation of all measures led to budget deficit reduced from Reduction in budget deficit increases for bread, gas and electricity, as of nearly 50% of GDP during the first half of 1994 to 8.5% of GDP in achieved mainly through September 1994; monetization of wheat grants; the first half of 1995. Deficit at about 6% of GDP for the whole of sharp cuts in expenditures, increase in tax rates and improvements in tax 1995. tax revenues remained at administration; increases in social benefits and 3.7% of GDP in 1995. government wages; improvements in expenditure control. B. Monetary Policy Restrictions on conversion of deposits lifted in Compliance rate for reserve requirements increased from 50% in September 1994. September 1994 to 83% in June 1995. Reserve requirements orn foreign currency deposits raised to same level as domestic currency deposits; enforcements tightened since September 1994. Automatic access to overdraft facilities from the NBG eliminated as of October 1994.  Annex 1 Page 2 of 4 MEASURES TAKEN PRIOR TO BOARD PROGRAM IMPLEMENTATIONISMCH1995 COMMENTS PRESENTATION : II. REFORMS OF THE PUBLIC SECTOR A. Transfer of Ownership rights to the Private Sector Privatization of Small-Scale Enterprises: 6,432 enterprises privatized by December 1995. Targets achieved. Procedures simplified. 2,500 enterprises privatized (target exceeded). Privatization of medium and large scale 840 enterprises corporatized by December 1995. Agreed measures enterprises: Mass Privatization Program launched in June 1995. implemented and targets 737 enterprises corporatized; guidelines issued 20 auctions held from end June until December 1995. achieved. for completion of mass privatization program; lists of voucher recipients completed; list of enterprises to be sold at first three auctions established; selection of 15 enterprises for case-by case privatization. Privatization of housing: Preparation of legal framework for definition of ownership rights Not yet approved by Privatization of housing practically complete. relative to communal space and facilities. Parliament. Privatization of Land: About 630,000 ha. of land distributed to private Preparation and submission to Parliament of a draft land law: Approval of law by farmers; (a) providing land in private use to farmers as their own property; Parliament delayed until Number of collective and state farms reduced (b) giving rights to sell, buy, lease and inherit. after elections. from 1,433 to 609 between 1989 and 1994. [still includes restrictive features] Distribution of remaining land not yet started. B. Imposition of hard-budget constraints to SOEs Imposition of hard budget constraints to SOEs: Enforced throughout 1995 Subsidies and transfers to enterprises ceased as of September 1994. Identification of largest loss-making state-owned enterprises.  Annex 1 Page 3 of 4 MEASURES TAKEN PRIOR TO BOARD P PROGRAM IMPLEMENTATION SINCE MARCH 1995 | COMMENTS PRESENTATION | l C. Restructuring of the Govermment Sector Strengthening of tax and customs administration (on-going). Reduction in staff Reduction of employees of the budgetary sector by 40% since requirements exceeded January. agreed target (25%). Implementation of health reform underway. Preparation of Education sector reform underway. m. REFORMS AIMED AT IMPROVING EFFICIENCY OF MARKETS A. Promoting Competition and Private Sector Prices of gas increased to reflect import and Price of rationed bread raised to 300,000 coupons per kg. in June New bread price increase distribution costs; price of electricity increased 1995. from 0.3 laris to 0.42 per 600 times for consumers, 10 times for Price of gas readjusted in function of costs. kg. planned for February enterprises. 1996. Price of rationed bread increased from 700 coupons per kilo to 200,000 coupons per kg. in September 1994, raised again to 280,000 coupons in December 1994. Cross-subsidization Subway fares raised 50 times in September. Subsidies for subway eliminated in April 1995. reintroduced through changes in electricity Law on entrepreneurship adopted in November Foreign Investment Law adopted in June 1995. tariffs in July 1995. 1994. Anti-monopoly law submitted to Parliament. Demonopolization/Privatization Plan of the Bread Corporation Implementation underway. adopted in July 1995.  Annex 1 Page 4 of 4 MEASURES TAKEN PRIOR TO BOARD PROGRAM IMPLEMENTATION SINCE MARCH 1995 1 COMMENTS PRESENTATION B. Fostering Export Growth Totality of surrender requirement channeled to Elimination of state order system in June 1995. NBG. Frequency of foreign exchange auctions raised to twice a week. Surrender requirement eliminated in December 1995. Restrictions on convertibility of deposits into cash lifted. Import tax raised to 12%; 8% export tax Further reduction in number of products subject to prohibitions and eliminated. licensing requirements. Reduction of quotas under state order system. Reduction of number of products subject to prohibitions and licensing requirements. C. Strengthening the Financial Sector Directed credits from NBG and access to Revised prudential regulations issued. L overdraft facilities eliminated as of October 1994. Development of interbank short-term credit facility. Restrictions on use of accounts eliminated. Diagnostic review of the 5 state banks completed in June 1995. Privatization of state banks underway. Licenses withdrawn from banks not complying with prudential standards. NBG Law approved by Parliament in June 1995. IV. REFORMS OF THE SOCIAL SAFETY NET Generalized subsidies for bread, electricity, gas Increase (in real terms) in wages of budgetary sector, pensions and and transportation replaced by targeted cash other social benefits. compensations. Pensions denied to working pensioners. Child allowances targeted to families with at least two children. Pension supplements eliminated and adoption of flat-rate benefits. Childbirth and death benefits eliminated.  Annex 2 Page I of 3 Georgia: Main Economic Indicators 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Real Growth Rate GDP -11.4% -5.0% 8.0% 10.0% 10.0% 8.0% 8.0% 8.0% 6.0% 6.0% 5.0% 5.0% PrivateConsurnption -17.9% 0.9% 6.0% 5.6% 6.1% 5.8% 5.6% 4.2% 4.5% 3.7% 3.1% Inflation (average) 17271.5% 169.3% 49.8% 10.0% 7.0% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% Inflation(endofperiod) 7144.0% 64.8% 23.1% 8.5% 6.6% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% 6.2% Exports(GNFS) -9.8% 9.4% 11.2% 12.7% 11.9% 10.1% 9.0% 7.6% 7.2% 7.0% 7.0% Imports (GNFS) -10.6% 5.3% 11.7% 9.4% 8.9% 7.9% 6.3% 5.5% 5.4% 5.0% 5.0% 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 As % GDP Exports 38.0% 16.8% 10.8% 10.0% 10.0% 10.1% 10.1% 10.2% 10.2% 10 3% 10.4% 10.4% Imports 71.7% 29.0% 16.6% 14.4% 13.4% 12.9% 12.4% 12 1% 11.9% 11.5% 11.2% 11.0% Resource Balance -33.7% -12.2% -5.8% -4.4% -3.4% -2.8% -2.3% -I 9% -1.6% -1.2% -0.9% -0.6% Current Account (Incld Grants) -21.7% -8.4% -2.3% -3.2% -3.2% -2.9% -2.5% -2.2% -2.0% -1.7% -1.4% -1.2% Current Account (Excid Grants) -36.0% -15.3% -7.2% -5.4% -4 2% -3.7% -3.1% -2 7% -2.4% -2.0% -1.7% -1.4% Domestic Savings -33.4% -8.6% -0.6% 3.6% 7.8% 10.4% 12.4% 14.2% 15.6% 16.8% 17 5% 18.3% Investment 0.3% 3.6% 5.1% 8.0% 11.2% 13.2% 14.7% 16 1% 17.2% 18.0% 18.4% 18.9% o/w: Public 0.3% 1.0% 1.2% 2.2% 2.9% 3.6% 4.1% 4.5% 4.8% 4.8% 4.8% 4.9% Government Revenue 7.7% 7.1% 9.4% 11.3% 12.7% 14.1% 15.5% 16.6% 168% 17.3% 17.6% 17.6% o/w:TaxRevenue 3.7% 3.7% 6.7% 8.1% 9.7% 11.6% 13.2% 14.0% 14.6% 14.9% 14.9% 14.9% Government Expenditure 24.2% 12.8% 12.8% 14.5% 15.7% 17.1% 18.2% 18.4% 18.5% 18.5% 18 5% 18.5% Fiscal Deficit (Incld Grants) -16.5% -5.7% -3.4% -3.1% -3.0% -2.9% -2.7% -1.8% -1.7% -1.2% -0.9% -0.9% Fiscal Deficit (Excld Grants) -20.0% -7.7% -4.2% -3.8% -3.5% -3.3% -3.0% -2.0% -1.8% -1.4% - 1.0% -1.0%  Annex 2 Page 2 of 3 Georgia: Balance of Payments (millions of US dollars) 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 MerchandiseExports(FOB) 380.7 347.4 389.1 438.6 498.4 556.1 619.6 691.6 753.8 823.2 889.9 962.1 NonfactorServices 92.2 114.3 123.8 160.8 191.2 220.8 246.7 281.1 312.7 346.3 383.1 421.4 Exports of GNFS 472.9 461.7 512.9 599.3 689.6 777.0 866.4 972.7 1066.5 1169.4 1273.0 1383.5 Merchandise Imports (FOB) 746.0 690.4 702.3 758.3 814.3 877.7 936.5 1018.7 1088.2 1152.5 1217.1 1284.6 NonfactorServices 147.3 105.4 83.2 102.2 110.4 118.5 127.0 137.5 146.8 155.4 164.7 175.0 hnportsofGNFS 893.3 795.9 785.6 860.5 924.8 996.2 1063.5 1156.2 1235.0 1307.9 1381.8 1459.6 o/w: Energy 190.6 105.0 95.3 105.6 117.2 128.7 141.2 154.2 165.5 176.5 187.9 199.1 Resource Balance 420.4 -334.2 -272.6 -261.2 -235.2 -219.3 -197.2 -183.5 -168.5 -138.5 -108.8 -76.1 Net Factor hncome -28.0 -84.8 -70.1 -62.6 -58.3 -62.6 -65.5 -72.9 -81.6 -91.2 -100.8 -113.9 Factor Payments 28.0 86.3 71.6 65.2 64.3 68.6 73.7 81.0 90.6 100.8 111.0 124.8 oAw Interest 24.0 82.3 64.3 57.4 55.7 58.1 61.0 64.4 69.0 73.7 78.1 85.4 o/w. Profit Remittances 4.0 4.0 7.3 7.8 8.6 10.5 12.8 16,6 21.6 27.1 32.9 39.3 Factor Receipts 0.0 1.4 1.5 2.6 5.9 6.0 8.2 8.1 8.9 9.6 10.2 10.9 Current Official Grants 170.0 189.0 234.0 133.0 71.0 61.0 49.0 44.0 40.0 36.0 32.0 29.0 Current Account Balance (Incld Grants) -270.9 -230.() -108.8 -190.8 -222.6 -220.9 -213.6 -212.4 -210 1 -193.7 -177.5 -161.0 Current Account Balance (Excld Grants) -448.4 -419.0 -342.8 -323.8 -293.6 -281.9 -262.6 -256.4 -250 1 -229.7 -209.5 -190.0 Foreignlnvestment 8.0 6.0 10.0 25.0 50.0 75.0 85.0 100.0 115.0 130.0 145.0 160.0 Net Long-Term Loans -31.0 -168.1 37.3 115.8 129.1 191.9 174.8 157.5 151.6 136.4 116.9 79.6 Disbursements 86.0 105.0 126.5 227.3 150.5 207.2 267.4 295 3 331.1 324.7 333.7 340.7 Amortization 117.0 273.1 89.2 111.5 21.5 15.3 92.6 137.8 179.5 188.3 216.8 261.! Change inArrears 0.0 119.0 -528.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Rescheduling 0.0 224.0 500.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Other Capital Flows 0.0 78.1 19.5 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 0.0 Change in Reserves (-=increase) 42.5 -104.0 -13.0 -33.0 -34.3 -22 5 -21.0 -27 1 -21.8 -21.5 -20.7 -21.9 IMif Credit 40.5 75.0 83.0 83.0 77.8 -23 5 -25.2 -18 0 -34.6 -51.2 -63.6 -56 7 Memo: GDP (mil US $) 1245.8 2744.2 4735.6 5979.3 6917.3 7703.4 8572.3 95402 104141 11370.2 12299.4 13305.2 Average Exchange Rate (Lari/$) 1.10 1.28 1.20 1.15 1.17 1.21 1 24 1.28 1.32 1.36 1.40 1.45 RealExchangeRate 1/ .. 100 64 57 55 54 54 53 53 52 52 52 I / Decrease = Appreciation  Georgia: Debt Indicators Page 3 of 3 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 Total DOD(USSM) 992.0 1083.1 1279.9 1478.7 1685.6 1854.0 2003.6 2143.1 2260.0 2345.2 2398.4 2421.3 Debt Service due after rescheduling (USSM) 1/ 149.9 132.4 55.0 168.9 82.4 96.9 178.8 220.3 283.2 313.2 358.5 403.3 Total Debt/GDP 79.6% 39.5% 27.0% 24.7% 24.4% 24.1% 23.4% 22.5% 21.7% 20.6% 19.5% 18.2% DebtServiceafterrescheduling/GDP 1/ 12.0% 4.8% 1.2% 2.8% 1.2% 1.3% 2.1% 2.3% 27% 2.8% 2.9% 3.0% Debt Service after rescheduling/ Total Exports 1/ 31.7% 28.6% 10.7% 28.1% 11.8% 12.4% 20.4% 22.5% 263% 26.6% 27.9% 28.9% DOD/Export 209.8% 233.9% 248.8% 245.7% 242.4% 236.8% 229.1% 218.5% 210.2% 198.9% 186.9% 173.7% IBRD Debt (USSM) 0.0 0.0 0.0 0.0 3.3 18.0 43.7 80.4 122.6 170.9 224.3 274.2 IBRD Debt Service Due (US$M) 0.0 0.0 0.0 0.0 0.1 0.7 2.2 4.3 7.1 11.3 17.1 233 IBRD Debt/GDP 0.0% 0.0% 0.0% 0.0% 0.0% 0.2% 0.5% 0.8% 12% 1.5% 1.8% 2.1% IBRD DebtVTotal DOD 0.0% 0.0% 0.0% 0.0% 0.2% 1.0% 2.2% 3 7% 5.4% 7.3% 9.3% 11.3% IBRD Debt Service/ GDP 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 01% 0.1% 0.1% 0.2% IBRD Debt Service / Total Exports 0.0% 0.0% 0.0% 0.0% 0.0% 0.1% 0.2% 0.4% 0 7% 1.0% 1.3% 1.7% 1BRD Debt Service / Total Debt Service 0.0% 0.0% 0.0% 0.0% 0.1% 0.8% 1.2% 2.0% 2 5% 3.6% 4.8% 5.8% IDA Debt (USSM) 0.9 83.8 165.3 226.8 282.1 315.7 347.1 3799 4156 447.1 473.0 490.6 O IDA Debt Service Due (USSM) 0.0 0.2 0.6 1.0 1.3 1.5 1.7 1.8 2.0 2.2 2.9 5.1 Li IDA Debt/GDP 0.1% 3.1% 3.5% 3.8% 4.1% 4.1% 4.0% 4.0% 4.0% 3.9% 3.8% 3.7% l IDA Debt/Total DOD 0.1% 7.7% 12.9% 15.3% 16.7% 170% 17.3% 17.7% 18.4% 19.1% 19.7% 20.3% IDA Debt Service / GDP 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0 0% 0.0% 0.0% 0.0% IDA Debt Service/Total Exports 0.0% 0.0% 0.1% 0.2% 0.2% 0.2% 0.2% 0.2% 02% 0.2% 0.2% 0.4% IDADebtService/TotalDebtService 0.0% 0.2% 1.1% 0.6% 1.5% 1.5% 0.9% 08% 0.7% 0.7% 0.8% 1.3% Preferred Creditors Debt (US$M) 41.4 206.5 391.0 563.1 723.8 769.3 830.5 9140 991.9 1055.3 1104.3 1146.4 Preferred Creditors Debt Service Due (US$M) 0.9 2.8 6.9 9.0 17.2 39.6 45.9 43.8 66.9 92.0 115.2 121.1 Preferred Creditors Debt/GDP 3.3% 7.5% 8.3% 9.4% 10.5% 10.0% 9.7% 9.6% 9 5% 9.3% 9.0% 8 6% Preferred Creditors Debt/Total DOD 4.2% 19.1% 30.5% 38.1% 42.9% 41 5% 41.5% 42.7% 43.9% 45.0% 46.0% 47.3% PreferredCreditorsDebtService/GDP 0.1% 0.1% 0.1% 0.2% 0.2% ().5% 0.5% 05% 0.6% 0.8% 0.9% 09% PreferredCreditorsDebtService/TotalExports 0.2% 0.6% 1 3% 1.5% 2.5% 5. 1% 5.2% 4.5% 62% 7.8% 9.0% 8.7% Preferred Creditors Debt Service/Total Debt Service 0.6% 2.1% 12.6% 5.3% 20.9% 409% 25.7% 19.9% 23.6% 29.4% 32.1% 30.0% 1.' Debt service figures correspond to debt service due after rescheduling of all arrears and non-EU debt service due in 95 and 96 at 10 year maturity, 5 year grace and 4 percent interest Debt service ratios before rescheduling would be 76.7 percent of total exports in 1995 and 29.8 percent in 1996. These correspond to 12.9 percent and 3 2 percent of GDP respectivelv. Preferred Creditors include World Bank, IMF, and EBRD. All the debt is public.  Anne 3 Status of Bank Group Operations in Georgia IBRD Loans and IDA Credits in the Operations Portfolio Difference Original amount in USS millions between expected Project Loan or Fiscal and actual ID Credit No. Year Borrower Purpose IBRD IDA Cancellations Undisbursed disbursements' Number of Closed Loans/Credits: I Active Loans GE-PA-39892 C28090 1996 GOVERNMENT OF GEORGIA TRANSPORT 12.00 11.95 GE-PA-8413 C26410 1995 GOVERNMENT OF GEORGIA INSTITUTION BUILDING 10.10 4.94 GE-PA-8417 C26580 1995 GOVERNMENT OF GEORGIA MUNICIPAL INFRASTRUCTURE 18.00 12.49 2.75 TOTAL 0.00 40.10 0.00 29.38 0.38 Active Loans Closed Loans Total Total disbursed (IBRD and IDA) 12.03 77.44 89.47 Of w1hich repaid 0.00 0.00 0.00 Total now held by IBRD and IDA 40.10 75.00 115.10 Amount sold 0.00 0.00 0.00 Of which rppid 0.00 0.00 0.00 Total undisbursed 29.38 0.00 29.38 a. Intended disbursements to date minus actual disbursements to date as projected at appraisal. Note: Disburment data aupdated at the end of the first week of the month. D taaof311V96  - 37 - Annex 4 REPUBLIC OF GEORGIA STRUCTURAL ADJUSTNMENT CREDIT Thnetable 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: September 6-23, 1995 December 3-20, 1995 (d) Technical Discussions/Negotiations: February 19-24, 1996 (e) Planned Board Presentation: April 18, 1996 (f) Planned Date of Effectiveness: May 03, 1996 (g) List of relevant PCRs and PPARs Not applicable  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 1 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO I MEASURES TO BE TAKEN BY ____________________I [ BOARD PRESENTATION MID-1997 A. MAINTAINING A TIGHT MONETARY POLICY To reduce inflation to 20-25 percent in Monthly inflation rate fell from an Reserve requirement ratio decreased Maintain quarterly targets on net 1996 and to strengthen the international average of 64 percent during the first from 20 to 18 percent in January 1996. domestic assets of the NBG, net position of the NBG nine months of 1994 to an average of 3 domestic credit to the General percent during the first nine months of Government, and net international To increase the range of monetary 1995. reserves. instruments and enhance the capacity of the NBG to achieve monetary Foreign exchange reserves rose from Introduce government securities and objectives 0.9 months of imports cover in 1994 to NBG bills by mid-1996. 2.5 months in 1995. Develop the inter bank credit auction. Consider further reduction of the reserve requirement ratio. B. IMPROVING THE FISCAL SYSTEM To ensure the sustainability of Weak fiscal performance: tax revenues Most tax exemptions (VAT customs, Strengthen tax administration: stabilization. only reached 3.7 percent of GDP in excise and profit taxes) removed, Reorganize 25 largest regional tax 1995 while total expenditures amount effective March 1, 1996.1/ inspectorates and all remaining ones by To increase tax revenues to 6.7 percent to 13 percent of GDP. June 1996; Complete comprehensive of GDP in 1996.21 1996 Budget approved; Budget deficit taxpayer survey and distribution of to be maintained at 3-4 percent of taxpayer identification numbers by July To reach a revenue to expenditure ratio GDP. 1996; Review penalties for non- of 70 percent in 1996 and maintain compliance, tax assessment, collection budget deficit at 3-4 percent of GDP in and audit, and incentives for inspectors 1996. and agencies and implement by July 1996. 1/ Prior action under the ESAF 2/ Financial benchmark under the ESAF  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 2 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 Develop and implement a comprehensive customs administration reform program by June 1996. Submit to Parliament new VAT tax law by July 1996. Submit to Parliament new tax code by January 1997. C. STREAMLINING THE GOVERNMENT SECTOR AND IMPROVING THE EFFICIENCY OF PUBLIC SPENDING To maintain critical public functions Public expenditures are extremely within the framework of a tight compressed. expenditure program (expenditures to be maintained at about 13 percent of GDP in 1996) Reforming Government Pay and Overemployment and extremely low New structure of Government adopted Introduce civil service reforms. Employment pay characterize public administration. following enactment of the new The Government reduced the number constitution; several branch ministries To improve capacity to perform of budgetary positions by 40 percent in eliminated. essential functions 1995 (about 200,000 workers).  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 3 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 Reforming the Provision and Financing Public spending on health has fallen to Larger share of public expenditures Pursue implementation of health sector of Social Services 10 percent of its 1990 level in real allocated to health and education in the reform; scaling down facilities and terms; expenditures on education are 1996 state budget than in the previous staff; privatizing hospitals and clinics; less than 3 percent of their 1990 value. year. (About 7 percent to health and 8 focusing the role of the Ministry of percent to education). health on establishing the appropriate To prevent further deterioration of the Introduction of a radical reform of the regulatory framework: and developing health status of the population and health care system - mechanisms for ensuring access to ensure access to health services by the State's financing role reduced to cover health services by the poor. poor. only a basic package of medical services; health insurance fund set up Action Plan adopted for the education Reduce staff by 10,000 in 1996. in July 1995; 130,000 employees of the sector, giving priority in the allocation health sector removed from of public resources to basic education Implement action plan for education government payroll; privatization of and targeted population groups, sector health facilities began. fostering the creation of private schools and the introduction of tuition, setting To prevent deterioration of the Public resources insufficient to support targets for cuts in staff and allowing education sector and improve efficiency the highly developed education system changes in compensation policy. 0 in the allocation of public resources. inherited from the past; staff reduced from 250,000 to 163,000 over last year; elimination of free textbook policy.  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 4 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 Reforming Social Insurance and Social Protection: To improve the protection of the most Despite significant steps toward Retirement age increased from 60 to 65 Shift responsibility for paying sickness vulnerable groups of the population. improving the targeting of social for men, and from 55 to 60 for benefits to employers. benefits, pensions, allowances and women, effective March 1, 1996. unemployment benefits remain Submit to Parliament legislation for extremely low. Numerous families in Payroll contribution rate to the introduction of voluntary private economic jeopardy remain unprotected. Employment Fund reduced from 3 to I pension plans.* To address sustainability issues, correct percent. Employer contribution to the perverse incentive effects, and restore Sustainability of the public pension Social Security Fund (non-budgetary Establish a back-up program of social credibility in the public system of system affected by the decline in the sector) reduced by 8 percentage points, assistance. social protection. number of contributors, under- effective March 1, 1996. reporting of wages, the age structure of Prepare legislation for introduction of the population and generous eligibility All programs financed from the mandatory contribution to fully-funded rules. Employment Fund except pension plans by end 1996. unemployment benefits eliminated, effective March 1, 1996. * Second tranche release condition  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 5 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 Eliminating Energy Subsidies To improve the financial position of the The Government has stopped providing Special Commission on Energy Payments Improve monthly collection rates from energy companies state guarantees for gas imports. created in Oct. 1995, authorized to improve 30% in March to 55% in August, and collection of payments through cutoff of 65% in December 1996.* To avoid further accumulation of Collection rates for electricity payment electricity supply, auction of inventories, arrears and external debt at about 6-10 percent. and other measures. To promote enterprise adjustment While tariffs introduced in September Monitoring system for collection of 1994 were uniform and covered costs, payments established in March 1996. cross-subsidization of residential consumption was reintroduced in July Sakenergo's use of imported fuel and power Maintain special account current for 1995. restricted with: (i) price and repayment the full period. terms to be agreed prior to imports; (ii) Wholesate tariffs are unregulated and special account established; and (iii) imports Do not resume residential gas vary widely among distributors. funded only through revenues of this deliveries until equipment allowing account. Revenues limited to electricity metering is installed. Collection rates for gas payment payment collections and borrowed funds (up remain below 10 percent. to US$6 million and with no government Encourage payment of energy bills in guarantee). cash. Unified wholesale tariff established for all Implement tariff reforms (wholesale distribution companies in January 1996. and retail tariffs). D. FOSTERING ADJUSTMENT OF THE PRODUCTIVE SECTOR Accelerating Privatization Universe to be privatized Resolution 249 of May 1995 identifies Resolution 249 amended to reduce the To foster structural transformation of units to remain under 100 percent state number of enterprises remaining 100 the economy and improve enterprise ownership. percent state-owned. efficiency Decrees issued in 1995 temporarily Amend decrees to reduce the number reserve for state ownership 51% of of enterprises in which the state would shares of 252 enterprises. keep 51 percent of shares.* * Second tranche release condition  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 6 of 10 OBJECTI'v'ES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY MID- BOARD PRESENTATION 1997 Small-scale Privatization 6,700 small enterprises privatized by Complete privatization of sinall enterprises Privatization of small-scale enterprises Feb. 1, 1996. (7,200) by end-April 1996.* is very advanced: 89 percent of small enterprises privatized by December 125 medium- and large-scale Privatize an additional 200 medium- and 1995 enterprises privatized by Feb. 1, 1996. large-scale enterprises.* Medium and large-scale Privatization - (1,138 enterprises) 423 enterprises applied for the Only 140 enterprises out of the 423 Payment of shares under buyout option employer-employee buyout option. which applied have made the first expires in July 1996. Transfer shares only payment. when paid in full. Sale of at least 35 percent of shares At least 35 percent of shares of about Continue voucher auctions until July 1996. through voucher auctions started in la.e 700 enterprises offered to the public by June 1995 (shares allocated to bidders end-Feb. 1996 according to number of vouchers submitted). As of end-November Starting early 1996, organize voucher After voucher expiration, sell remaining 4 1995, 20 auctions have been held and auctions to sell remaining shares (as shares through cash auctions. 58 million shares in 598 enterprises one package to the highest bidder, or have been offered to the public. as "packets" of shares). Use tenders for a small number of enterprises. Guidelines specifying detailed Whenever remaining block of shares conditions and procedures to be applied remains unsold, initiate bankruptcy to auctions and to tenders issued in proceedings. Feb. 1996.* * Second tranche release condition  GEORGIA STRUCTURAL ADJUSTMvtENT CREDIT POLICY MATRIX Annex 5 Page 7 of 10 OBJECTIVES CURRENT STATUS MEASURES TO BE TAKEN PRIOR MEASURES TO BE TAKEN BY TO BOARD PRESENTATION NMID -1997 Regulations for licensing private sector Issue decree requiring joint-stock entities to operate share registries companies to maintain a share registry issued in Feb. 1996. with a licensed independent registrar. Issue resolution to ensure that claims Enterprises with outstanding claims on Unit established within the Ministry of are used through a competitive process the Government for the delivery of Finance to review accuracy of claims. and only by enterprises in which the goods under the state order allowed to state owns less than 25 percent of exchange these claims for shares of share capital. enterprises. Process lacks transparency. Bread Corporation Bread Corporation Privatize all large bakeries and at least Plan to corporatize and privatize the All retail units and small bakeries 10 mills; liberalize the price of bread Bread Corporation adopted in July privatized by end-February 1996. and remove profit margins on grain 1995. Two mills privatized in summer and flour.* 1995. Finalize privatization of remaining 4 mills by the end of 1996. * Second tranche release condition  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 8 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 RestructurinR and Privatization of Energv Utilities Restructuring plan implemented in Issue decree defining proper regulatory 1995, ill-prepared and without framework and related institutional regulatory framework. Many new setup. distribution companies face problems of viability. Adopt a plan for power sector restructuring and privatization of sector enterprises. Privatization of Land About 21 percent of agricultural land Law on land ownership giving rights to Establish legal framework for land and 47 percent of cultivated (630,000 buy, sell, lease and inherit adopted by registration and titling.* ha) in private hands. However, Parliament in March 1996. appropriate definition of property rights Make satisfactory progress in the is lacking and distribution of land distribution of land that remains to be remains incomplete. privatized (about 240,000 ha)* Draft land law submitted to Parliament. Adopt procedures for leasing remaining public land to make it Legal Framework available for private use.* Entrepreneurship law adopted in November 1994. Simple registration Enact anti-monopoly law by June procedures for new business adopted. 1996. Enact civil code and bankruptcy Long-term leasing arrangements for law by end-1996. commercial real estate allowed. Bankruptcy decree in place to be replaced by law under preparation. * Second tranche release condition  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 9 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY BOARD PRESENTATION MID-1997 Restructuring the Financial Sector To foster savings mobilization and National Bank Law approved in June Commercial Banking Law, includiig efficient intermediation 1995. provisions for liquidation of banks adopted by Parliament in Feb. 1996. Supervision Department reorganized and strengthened: new prudential standards issued. Licenses revoked for about 100 banks. Financial sector remains in perilous Privatization of the three major banks Do not increase state ownership of shape with many banks insolvent or completed (direct state ownership banks from their current level. inactive. The three major banks have reduced to zero and indirect ownership severe asset problems and negative net through state-owned enterprises less worth. Privatization of these banks than tO%) underway. > Audit of major banks underway. Bank certification program set up announcing that only banks fully complying with prudential standards are certified. Payment of dividends by non-complying banks prevented. Decree issued in November 1995 to Establish timetable with periodic relax restriction that household deposits benchmarks to monitor progress cannot exceed capital for banks towards compliance.* Impose complying with NBG's requirements. penalties as appropriate.** Refrain from ensuring banking deposits. * Condition of Effectiveness ** Second Tranche release condition  GEORGIA STRUCTURAL ADJUSTMENT CREDIT POLICY MATRIX Annex 5 Page 10 of 10 OBJECTIVES CURRENT STATUS MEASURES TAKEN PRIOR TO MEASURES TO BE TAKEN BY MID- BOARD PRESENTATION 1997 Fostering Export Growth Removing direct barriers to exports and Uniform Import Tariff (12%) on non- Tariff for barter and non-barter imports creating an enabling environment barter trade with non-CIS countries. unified at 12 percent, effective March Barter trade currently taxed at 20 1. percent. Export licenses still required for 9 Export prohibitions and licenses Replace export prohibitions on scrap metal groups of products, export prohibitions eliminated in Nov. 1995 (except for the by a temporary export tax. Adopt plan for for 10 groups of products. standard list of exceptions). phasing out export tax. Ex ante registration of export contracts Eliminate transitional system of ex ante required temporarily for 5 products. registration. * Encouraging foreign investment Foreign investment law adopted in June Amend Foreign Investment Code to 1995 grants foreign investors rights to introduce a system of expeditious approval repatriate profits; however is still of investments and remove temporary deficient regarding approval of concessions and tax investments and tax holidays. holidays for foreign investors.* Improve the legal framework for bonded warehouses and free trade zones. Allow for reincorporation as private companies the former state trading organizations. * Second tranche release condition  - 48 - 48 bd15&.n)30Q'(9b 360%0Q)660 PRESIDENT OF GEORGIA March 6,1996 Dear Mr. Wolfenson, The attached letter of Development Policy outlines the Structural Reform Programme of Georgia. We request the Wodd Bank to support this programme with a Structural Adjustment Credit of US$ 60 million. The programme of measures in the Letter is intended to achieve the rapid resumption of economic growth within a sustainable macroeconomic framework. If adjustments and corrective measures are required during the course of the implementation of the programme we will, where approprate, review those measures with the World Bank. Sincerely Yours, Eduard Shevardnadze President of Georgia Mr. James D. Wolfenson President The World Bank  - 49 - Annex 6 Page I of 14 LETTER OF DEVELOPMENT POLICY 1. After three years of sharp economic decline, financial imbalances leading to hyperinflation, and political instability, the Government of Georgia has focused its attention since the beginning of 1994 on rebuilding the Georgian economy. With the benefit of greater law and order and an improved political situation, the Government designed with the assistance of the IMF and the World Bank a program to stabilize and reform the economy. Implementation of the reform program has been sustained since September 1994 and remarkable progress has been made in curbing inflation and stabilizing the external value of the currency. Progress has also been achieved toward eliminating budgetary subsidies, liberalizing prices and trade, and reducing the size of the state sector. It also appears that economic decline has slowed. 2. Despite this initial success, the economic situation remains fragile. The tax effort remains very weak; the transformation of the economy into a market economy is still in an early transition stage; and the productive sector has not yet adjusted to new economic signals. 3. The Government believes that ensuring the sustainability of stabilization and fostering a strong and sustained growth recovery requires the pursuit and deepening of the reform process currently underway. To achieve these goals, it has identified a set of policies which are key to the success of its efforts. These policies aim at: (i) maintaining a tight monetary program supported by an improving fiscal position; (ii) streamlining the Government sector and improving the efficiency of public spending; and (iii) fostering a rapid adjustment of the productive sector to new market signals. A. Maintaining a Tight Monetary Policy 4. The Government intends to reduce inflation to 20-25 percent in 1996 and to strengthen the international position of the NBG. To that effect, policies will be consistent with quarterly targets on net domestic assets of the NBG, net domestic credit to the General Government, and net international reserves. To enhance its capacity to achieve its monetary objectives, the NBG will increase the range of its policy instruments, introducing government securities by mid-1996 and developing the interbank credit auction. To reduce the cost of credit, the NBG has decreased the reserve requirement ratio from 20 to 18 percent in January 1996 and intends to reduce it further later in the year. B. Improving the Fiscal System 5. The Government recognizes that the sustainability of the stabilization program and the ability to perform a set a critical public functions depend crucially on the mobilization of resources for the budget. The Government intends to increase tax revenues from 3.7 percent of GDP in 1995 to 6.7 percent in 1996 and to rely mostly on domestic resources to finance current government expenditures. To reach that objective major efforts are needed to improve revenue performance. Effective March 1, 1996, the Government has expanded the tax base by removing most tax exemptions (VAT, customs, excises and profit taxes). Over the first half of 1996, it will strengthen tax administration by reorganizing all tax inspectorates; completing a comprehensive taxpayer survey and distributing identification numbers; simplifying procedures and tax regulations for tax assessment; reviewing the incentive system for tax collection agencies and inspectors; and imposing higher penalties for non-compliance. The Government  - 50 - Page 2 of 14 also intends to develop and implement in cooperation with IMF, World Bank and UNCTAD staff, a comprehensive customs administration reform program, including development of effective procedures for control over and clearance of imports and exports, duty assessment and collection. 6. In view of the many changes introduced in the tax system in recent years, the Government will review all tax laws, and draft a new VAT tax law and a new tax code for submission to Parliament by July 1996 and January 1997, respectively. In the context of the VAT, another major change that the Government intends to carry out, but which must be done in consultation with its partners in the CIS, is to change the basis of taxing trade with these countries from the "origin principle" (whereby VAT is not imposed on imports, but is on exports) to the "destination principle" (whereby imports are VAT- taxed, but exports are not), which currently governs its trade with non-CIS countries. C. Streamlining the Government Sector and Improving the Efficiency of Public Spending. 7. The Government is aware that, even with improved revenue performance, it will have to maintain a tight expenditure program. This implies maintaining only critical functions - reforming government pay and employment and changing the role of the state in the administration and financing of activities which used to be fully publicly-financed, mostly social services and social protection. It also implies the elimination of all - even implicit - subsidies. (i) Government Pay and Employment 8. The Government recognizes that the extremely low wages prevailing in the budgetary sector not only lower efficiency but also jeopardize the Government's ability to perform basic functions. It is also aware that, given existing budgetary constraints, it has no choice but to combine revenue-increasing measures with continuing cutbacks in civil service personnel. Although the 40 percent reduction in the number of budgetary positions was a substantial step in 1995, it intends to pursue further this effort by undertaking reforms in the education sector - which accounts for about 40 percent of budgetary employment - and by introducing civil service reforms following changes in the structure of the Government and the consolidation of agencies. (ii) Provision and Financing of Social Services 9. In recent years, the collapse in budgetary revenues has led to an unprecedented reduction in public investment in human capital. To ensure the minimum level of public expenditures necessary for growth, and to protect access to the poor, the Govermnent has allocated a larger share of public expenditures to health and education in the 1996 state budget than in the previous year. This results in about 7 percent of total public expenditures allocated to health, and 8 percent to education in the 1996 budget The Government is committed to increase these shares further over the following years as the fiscal situation improves, so as to gradually restore its capacity of providing a more adequate level of essential public expenditures. 10. Reform of the Health Care System. The Government has already introduced significant reforms in the Georgian health care system. It has introduced a new public Health Insurance Fund, and a new method for financing health care, insuring a core set of medical services under the new health insurance program and leaving it to patients to pay for other medical services. Approximately 130,000 doctors, nurses, and other medical personnel have already been removed from government budgetary accounts. Privatization of medical facilities has begun and the Governmnent is committed to pursue the  - 51 - Page 3 of 14 implementation of reforms under a plan of action already adopted. 11. Reform of the Georgian Education System. The Government acknowledges the need for fundamental reform in the Georgian educational system. Georgia has inherited a highly developed educational system, with high enrollment rates at all levels, that it can no longer support with available public resources. Public spending in education in real terms is currently less than 10 percent of its 1990 level. 12. The Government adopted in November 1995 a Plan of Action for education which it started implementing thereafter. This plan gives priority in the allocation of public expenditures to basic education and to targeted population groups (orphans, students with disabilities), and envisages the preparation of a privatization program of educational facilities. It fosters the creation of private schools at all levels of education and an increased participation of families in the financing of education (tuition). It also encourages local initiatives to increase staff compensation. The Plan reflects the need to reform educational pay scales to attract and retain qualified teachers, but it also sets targets for reducing the number of teachers and other educational personnel who are paid for out of public budgets. The staff of the education sector has already been reduced substantially: from 250,000 in 1992 to 163,000 in 1995. The new plan aims at a further decrease to 120,000 over the next four years, with a first reduction by 10,000 to be implemented in 1996. During the transition process, public resources are simply too limited to pay adequate wages. Only a combination of increased resources and reduced staff will allow for the provision of adequate salaries to teachers. The action plan does not envisage the establishment of a state educational fund financed through payroll or other earmarked taxes. (iii) Social Protection 13. The Government is determined to undertake a fairly radical reform of the social protection system to improve public support to the neediest groups of the population. This reform also aims at addressing sustainability issues and correcting perverse incentive effects that lead to under-reporting of wages and low payroll tax collection. 14. Restrictions on eligibilitv for old-age pensions. In order to concentrate pensions on Georgian citizens who are most likely to be in need and unable to support themselves, the Government raised the retirement age from 60 to 65 for men, and from 55 to 60 for women, as of March 1996. By restricting old-age pensions in this way, higher monthly pensions can be provided to the remaining pensioners. 15. Reduction in the contribution rate to the Employment Fund and the United Fund of Social Security. The Government intends to decrease the payroll tax rate in the non-budgetary sector to reduce incentives to create employment in the informal sector and avoid taxes. As of March 1, 1996, the contribution rate to the Employment Fund has been reduced from 3 to 1 percent. Spending from the Employment Fund is now limited to unemployment benefits and operating costs, and all worker retraining, job search and job creation programs, of less priority, have been discontinued. No accumulation of deficit will be allowed. In addition, the employer contribution rate to the United Fund of Social Security (for the non-budgetary sector) has been reduced by 8 percentage points. The Government envisages further reductions in the contribution rate as the fiscal situation improves, and within the framework of the reforms of the pension system. 16. Preparation of legislation on voluntary private pension plans. The Government proposes to enact a legislative and regulatory framework, acceptable to the Bank, for a voluntary, private pension system.  - 52 - Page 4 of 14 By mid-1996 legislation will be prepared and approved by the Government for submission to Parliament that will encourage and regulate the creation of voluntary private pension plans. These plans may be sponsored by individual employers or groups of employers or voluntary associations of employees. The legislation will permit individual workers to accumulate retirement savings in accounts whose safety and soundness is subject to supervision by public authorities. The legislation will become effective no later than January 1, 1997. 17. Preparation of a program obligating employers and workers to contribute to private pension plans. The Government proposes to adopt and announce a basic plan describing (i) the obligation of workers and employers to contribute to compulsory, fully-funded pension plans, (ii) the regulatory framework that will govern the funds, and (iii) the public institutions that will supervise the funds. Detailed legislation governing the funds will include a revision of the current public, pay-as-you-go pension scheme to specify how the total compulsory contribution rate will be split between the current pay-as-you-go system and the fully-funded scheme. It will also specify the mechanisms governing the transition to the new system. This legislation will be prepared and adopted by the Government by the end of 1996, and will become effective no later than end 1998. 18. Reform of sickness pay. In order to reduce the required contribution rate to the United Fund, the Government intends to confine the spending of the United Fund to benefits received by invalid and retired workers. Most benefits received by active workers will become the direct financial responsibility of employers. In particular, responsibility for financing workers' pay during short-term injury or illness will be shifted from the United Fund to employers. The Government will prepare by mid-1996 final legislation removing responsibility for sickness pay from the United Fund. The legislation will become effective no later than January 1, 1997. 19. Creation of a back-up system of social protection. The economic crisis in Georgia and the curtailment of many kinds of social protection have placed many Georgian families in economic jeopardy. Some of these families receive allowances or other government benefits, but other destitute families no longer qualify for benefits. For example, poor families with only a single child may not qualify for help. In the future, older workers who are not yet entitled to pensions may be unemployed and without any support. 20. To address the serious problems faced by these groups, the Government intends to establish a limited program to extend allowances to needy families that do not qualify for benefits under any existing program. Financing for the new program could be obtained from further limiting child allowances to families with three or more children, reductions in allowances for refugees who have adequate incomes from work, or other restrictions in social welfare eligibility to be agreed with the World Bank. 21. Benefits under the new assistance program will be available only to families not entitled to other cash benefits which can demonstrate that their resources are very limited. The test for eligibility (to be defined after detailed survey analysis) will take into account the presence in the family of at least one person in vulnerable circumstances. Vulnerable individuals include children, old persons, and invalids. Families will have to demonstrate that they meet the conditions for eligibility no less than once every three months. The eligibility limits for this program will be defined so that no more than 5 percent of the Georgian population qualifies for assistance, and within the limits of budgetary resources. This new program will be developed and adopted by the end of 1996.  - 53 - Page 5 of 14 (iv) Energy Subsidies. 22. Collection of Energy Payments. Although the sharp increase in the price of energy (gas and electricity) eliminated in principle, budgetary subsidies, implicit subsidies have not yet disappeared. Delivery of gas and electricity to non-paying customers is one of the principal methods for providing hidden subsidies to enterprises and to the population. The Government intends to end these subsidies, which are a major contributor to external debt and which are delaying enterprise adjustment. It is the Government's policy that energy consumers should settle their bills in cash, and that no institutionalized state barter-trading organizations be created within the energy companies. 23. To that effect, the Government created in October 1995, a Special Commission on Energy Payments. The Commission is authorized to improve collection of energy payments through measures including auction of inventories of industrial debtors, auditing of debtor's accounts to identify assets available to make payment, ordering bank transfers, placing restrictions upon investments by indebted enterprises, and implementing rules for fair sharing of revenues between distributors and their upstream energy suppliers. The Commission intends to gradually improve monthly collection of payments so as to reach at least 30 percent of supply for March 1996, 55 percent for August, and 65 percent for December 1996. These minimum targets apply both to the collection rates from end consumers, and to the payments between distribution companies and Sakenergo. A monitoring system with monthly reporting starting in March 1996 has been agreed, and the Chairman of the Commission for Energy Payments has issued an order to Sakenergo and electricity distribution companies to collect and submit to the Commission in a timely manner the necessary monthly data. The Government is also committed to ensure timely payments of energy bills of budgetary organizations, within the limit of their budgetary allocation. To that effect, the Ministry of Finance will transfer directly to Sakenergo the amount allocated in the budget to different organizations for their energy consumption. Sakenergo will supply electricity to such organizations within the limits of the received budgetary allocations 24. The use of imported electric power and power-station fuel by Sakenergo will be permitted only subject to arrangements that clearly specify the price and terms of repayment in advance, and will be allowed only to the extent that Sakenergo has sufficient funds to finance the cash costs of such imports on a current basis. To that end, a special account has been established; imports of electricity and power- station fuel will be funded only through this account. The primary sources of funds will be electricity payment collections. The account can also operate with borrowed funds from commercial banks, provided that this does not imply a government guarantee and that the total outstanding debt incurred through such borrowing does not exceed US$6 million at any point in time. The account will remain current for the full period. Outstanding fuel and electricity purchases will not exceed the monthly balance in the account at any point in time. 25. Natural Gas Pricing. Since September 1994, all gas customers have been charged a uniform price (per thousand cubic meters) that is generally adequate to cover costs. However, there is a heavy hidden subsidy to residential consumers, as bills are based on volumetric norms which used to be lower than actual consumption. As of May 1995, no residential gas deliveries are occurring, and the Government pledges that it will not resume residential deliveries until proper equipment, allowing metering of residential gas consumption at the level of individual households or household collectives, is installed. 26. Electricity Pricing. Retail electricity tariffs during the July - October, 1995 period included a cross-subsidy for the first 100 Kwh of monthly residential consumption. There was no systematic framework for approving wholesale tariffs and ensuring that retail tariffs permit proper cost recovery by  - 54 - Page 6 of 14 local distribution companies that were created in May 1995. In January 1996 a unified wholesale tariff in the amount of 2.4 tetris per kwh was established for all distribution companies. Further tariff reforms, acceptable to IDA, will be implemented. They will include: 27. Wholesale Tariff Reform: (i) Wholesale tariffs will at least cover the costs of generation, import, and transmission by June 1996, with quarterly adjustments thereafter; (ii) Wholesale tariff calculations will include, as a minimum: fuel and maintenance costs, other operating costs; an allowance for depreciation, a reasonable profit margin, an allowance for bad debt, and a provision for interest on past- due accounts. 28. Retail Tariff Reform: (iv) A consistent national tariff formula will be established, allowing retail tariffs to vary according to the respective costs of operation of distributors; distribution costs can be quite different depending in particular on the composition of consumption, and the geographical area; (v) The national formula for retail electricity tariffs will provide for phasing out of cross subsidies over a three- year period, with the first adjustment to take place by September. C. Fostering Adjustment of the Productive Sector. (i) Accelerating Privatization 29. The Government considers privatization to be one of the most critical elements of its structural reform program and rapid implementation is its primary objective. The vast majority of state-owned enterprises will be privatized. Only those few enterprises essential to normal Government functions will remain 100 percent Government-owned. The list of enterprises that are to remain 100 percent state- owned was specified in Resolution 249. As this list included some enterprises which might better serve the public interest under private ownership, the Government reviewed and amended the list so as to reduce the number of enterprises that will not be subject to privatization. To this effect, a decree was issued in February 1996. The Government also wishes to keep a majority of shares in a few enterprises for reasons of national security. The list of these enterprises will be revised as part of the review of all decrees maintaining 51 percent of shares under state ownership in a number of enterprises (see para. 31). 30. Privatization of small-scale enterprises is nearing completion. The Letter of Development Policy prepared within the context of the Rehabilitation credit committed the Government to privatization of 6,481 small enterprises by the end of 1995.' This target has been met and by February 1, 1996, the Government had privatized 6,700 small enterprises. It intends to complete the privatization of all small enterprises (7,200) by the end of April 1996. 31. Privatization of medium- and large-scale enterprises began in the spring of 1995. All of these enterprises are first to be converted to joint stock companies, and to date, 840 enterprises have been corporatized. A total of about 1,100 medium- and large-size enterprises have been identified. The Government has decided to proceed with privatization by stages and using various methods. In a first stage, the Government intends to fully privatize about 900 enterprises, leaving for a second stage the privatization of the remaining 200. For the latter, most of which produce primary products (such as minerals, gas, oil products and chemicals) or provide critical services (such as trade and wholesaling, 'I/ This was the earlier total of small enterprises subject to privatization. After including small enterprises from the State Bread Corporation and the health sector to the program, the number increased to 7,200.  - 55 - Page 7 of 14 construction, airport and port services) (the State Bread Corporation is also included in this category) the Government intends to sell only a minority of shares during the first stage. To this effect, it issued decrees which temporarily reserve for state ownership 51 percent of their shares. The Government has agreed to eliminate by second tranche these restrictions for all enterprises except those in which the Government would keep 51 percent of shares for reasons of national security. Thus, a decree will be issued allowing SPM to sell the majority of shares of such enterprises listed in the following decrees: #875 (December 26, 1994; #22 (January 28, 1995); #81 (February 17, 1995); #12 (February 17, 1995); #248 (May 10, 1995); #166 (May 14, 1995); #228 (June 11, 1995); and #303 (August 7, 1995). The Government is committed to completing the privatization of all enterprises no later than the end of 1997. 32. In 1995, several methods of transferring ownership have been adopted First, employees of all enterprises received (on average) 5 percent of shares for free. Second, enterprise managers and employees were given the option to buy an additional 51 percent of the shares of their enterprise. Finally, at least 35 percent of the shares of every medium and large enterprise subject to privatization are offered to the public through the mass privatization program ("special" voucher auctions). The buyout option, which expired on October 15, 1995, was applied for by 423 enterprises. Regulations stipulate that 30 percent of the total payment must be made by November 15, 1995; privatization vouchers may be used for this payment. The remaining 70 percent of the payment must be paid in cash by July 1, 1996. It is the Government's policy not to grant extension of payments and to transfer only shares which are paid in full; failure to make required payments on time results in forfeiture of all rights to remaining shares. Only 140 enterprises out of the 423 which applied have complied with the schedule. The "special" voucher auctions began in June 1995 and will continue until July 1996. To date shares of about 700 enterprises have been offered to the public through "special" voucher auctions. 33. These various methods will still leave some proportion of shares. under state ownership. At this stage. SPM's main objective is to maintain speed, administrative simplicity, and to sell remaining shares - whenever possible -- as one package, thereby ensuring effective enterprise management and control. For the majority of enterprises, SPM will use voucher auctions and cash auctions; tenders will also be used to privatize a few enterprises. Managers and employees of enterprises will no longer have special privileges to purchase controlling blocks of shares, and must compete on an equal basis with all other interested buyers. 34. Voucher auctions which began in early 1996 differ from the "special" voucher auctions. initiated in June 1995. Voucher auctions will involve the sale of all remaining shares in each enterprise as one package to the highest bidder, or sale of "packets" of shares (for example, 10 percent allotments). After expiration of the vouchers, cash auctions and tenders will be used to complete the process. Whenever the remaining majority block of shares cannot be sold through the first offering at a cash auction or tender, the enterprise will be subject to reorganization (without budgetary transfers) or to bankruptcy proceedings. Cash auctions are identical to voucher auctions, except that payment will be only in cash. Voucher and cash auctions will be organized in a manner which engenders public confidence and is equally open to the participation of all investors -- foreign and domestic. Detailed conditions and procedures to be applied to voucher and cash auctions have been established at the end of February 1996, and guidelines issued thereafter. 35. Tenders will be used, where appropriate, to attract foreign investors, or to privatize a few larger, more complex enterprises requiring special treatment (for example, enterprises needing significant investment). Foreign and domestic investors will be allowed to compete on an equal basis. It is the Government's policy to limit the use of tenders to the smallest number of enterprises possible, as this  - 56 - Page 8 of 14 method does not serve our primary objective of rapid privatization. Thus far, SPM has identified 5 medium and large enterprises which, because of their size and activities, are expected to be attractive to foreign investors. At least 51 percent of their shares will be offered to strategic foreign investors through competitive international tenders. Detailed conditions and procedures to be applied to tenders have been established at the end of February 1996 and guidelines issued thereafter. 36. Employing the above methods, the Government has privatized 125 medium and large enterprises by end-January 1996 and intends to privatize an additional 200 medium and large enterprises by second tranche. The Government intends to complete the privatization program by the end of 1997. 37. A number of enterprises -- both public and private -- have outstanding claims on the Government for the delivery of unpaid products under the old state order system. Preliminary estimates indicate that aggregate claims are equal to approximately US$4 million for private enterprises, and to approximately US$6 million for public enterprises. These enterprises have been hitherto allowed to exchange these claims for shares in enterprises subject to privatization. However, the Government has concluded that the process by which these claims have been extinguished lacks transparency. Doubts have also been raised about the accuracy of estimates of outstanding claims. Therefore, the government has established a unit to carefully review each claim and will subsequently, issue a Resolution along the following lines: (i) no enterprises in which the state owns more than 25 percent of the share capital may exchange claims for shares in enterprises subject to privatization; and (ii) claims will be exchanged for shares only through competitive processes organized by SPM (eg. open, competitive auctions). Claim holders will be allowed to freely trade (i.e. buy, sell and barter) their claims. 38. Privatization will produce millions of new shareholders and requires an efficient share registry. In order to avoid the problems inherent to enterprise-managed registries, where in other FSU countries, enterprise managers have neglected to register outside shareholders who could threaten their positions, the Ministry of Finance and SPM have established guidelines for authorizing private sector entities to operate share registries. Share depositories -- should physical share certificates be issued -- may also be managed by private sector entities. The Government will issue a decree requiring joint-stock enterprises to maintain a share registry with a licensed independent registrar. 39. In parallel to its efforts toward rapid privatization the Government will continue to make progress in establishing the legal framework for private sector development. In addition to the Commercial Banking law and the Land law mentioned below, the Government intends to enact an anti-monopoly law by June 1996, and a civil code by end 1996. A bankruptcy law is also under preparation to replace an existing 1992 decree. 40. Privatization of the Bread Corporation. Implementation of the privatization plan fof the State Bread Corporation (SBC) agreed with the World Bank and the IMF has been delayed. Given the sensitive nature of this product, the Government wishes to proceed cautiously. However, the Government is committed to substantially meeting the originally agreed targets. In addition to two mills, the Government has privatized all retail units and small bakeries of SBC, and by second tranche will privatize all remaining bakeries and at least 10 mills. At the same time, it will liberalize the price of bread and remove profit margin controls on grain and flour. The Government intends to complete the privatization of the remaining 4 mills by the end of 1996. 41. Privatization of Energy Sector Facilities. Successful large-scale privatization of energy facilities requires that a framework for sector regulation first be put in place, and that the sector's integrated  - 57 - Page 9 of 14 monopolies be restructured into commercial business units suitable for privatization. To address this issue, the Committee on Power Industry Restructuring established in October 1995 will first make recommendations for the establishment of a legal and regulatory framework, including setting up an autonomous energy regulatory agency. The agency will be in charge of regulating tariffs for gas and electricity, licensing energy operators, implementing rules that promote inter-fuel competition and prevent monopoly abuses, ensuring fair commercial use of Georgia's energy infrastructure (transportation, transmission, and storage), and promoting energy conservation and least-cost supply policies. The Conmmittee's additional mandate is to make recommendations for the restructuring of the sector, corporatization and privatization of sector enterprises. Based on the Committee's recommendations, and in coordination with the Bank, the Government will issue a decree defining the proper regulatory framework and related institutional setup. It will also adopt a plan for power sector restructuring and privatization of sector enterprises. 42. Land Distribution and Privatization. Although only 21 percent of agricultural land and 47 percent of cultivated land is in private hands, private agriculture has become the main source of domestic supply. Yet further development of agriculture rests on a rapid completion of agricultural reforms - primarily transferring remaining land and other productive assets to the private sector - and appropriate definition of property rights to create conditions for a functioning land market. 43. The Government intends to support development of the agricultural sector first by expediting the process of land privatization. A law on land ownership that gives rights to buy, sell, lease and inherit land that is already in private use, has been adopted in March 1996. Enactment of the law will be followed by the preparation of a land registration and titling law and the distribution of titles to allow effective transactions to take place. Second, the Government has developed a plan for privatizing part of the remaining land (about 240,000 hectares), and leasing on a competitive basis the land that would remain under state ownership. The privatization program involves the distribution of about 240,000 additional hectares over a period of one year. By second tranche, the Government will have established the legal framework needed for land registration and titling, distributed about half of the land that remains to be privatized, and adopted procedures, acceptable to IDA, for leasing arrangements to make public land available for private use. (ii) Restructuring the Banking Sector 44. The Government and the National Bank of Georgia (NBG) recognize that solvent, competing banks are important for the economy's future growth but that they are in a poor state today. The NBG and the Government will ensure that banks improve and efficiently intermediate savings. Savings will rise in a few years when the economy revives, but institutions take time to improve and the Government recognizes that the necessary changes in banks must begin now. 45. The NBG and the Government have already taken many important actions. The NBG Law defines the legal role of the central bank in overseeing the banking system; new private banks are being licensed and the privatization of the five former state-owned banks is underway; scores of unsound, unlicensed banks and near-banks have been closed with minimal cost to the budget; and prudential regulations and supervision have improved with technical help from the IMF and the World Bank. A Commercial Banking Law which covers the liquidation of banks has been approved by Parliament in February 1996. 46. Much, however, remains to be done. Inflation until 1994 was higher than nominal interest rates  - 58 - Page 10 of 14 and the real value of both loans and deposits was eroded. The entire banking system's assets were a mere US$175 million in September 1995, roughly 7% of GDP, and it will be several years before this proportion rises to levels typically found in thriving economies. Although inflation reduced enterprise debts in real terms, many enterprises are unable to service even their diminished loans because they operate at a fraction of their normal capacity. Banks claim that many defaulting loans are backed by sufficient borrower collateral; but the banks' ability to foreclose on such a scale is untested, and the collateral may turn out to be worthless, obsolete equipment. The banks also claim that some loans to enterprises were made against their better judgement and under Government duress. The Government undertakes to desist from such practices in the future. The NBG will evaluate the extent of such loans and define the Government's liabilities by the end of June 1996. 47. At this stage, the Governments' strategy is to ensure that banks restructure rapidly without jeopardizing the Government's budget, and to promote competition between sound private banks. This strategy comprises of three sets of measures: (1) completing the privatization of the former state banks, (2) preventing non-complying banks from expanding their activities until they meet all of the NBG's requirements, and (3) encouraging the merger of small private banks and branches of larger non- complying banks with sound banks. These measures are explained further below. 48. The former state banks are being privatized largely to their managers and employees. By February 1996, the state eliminated its direct ownership in the recently merged state bank (United Bank of Georgia), the Agrobank and the Bank of Georgia (former Housing Bank). In addition government- controlled enterprises (defined here as 25 percent or more state-owned) own less than 20 percent in these three major banks. The Government is convinced that privatization of banks will create incentives for banks to improve operations in a cost-effective way and reduce the pressures to bail out depositors in the event of bank failure. Indirect ownership of banks will fall further as the enterprises are privatized, and the Government undertakes to not increase its direct or indirect ownership from their current level (zero and 10 percent respectively). 49. The second set of measures is to restrict the activities of the non-complying banks until they meet all of the NBG's prudential requirements. The certification of banks which comply with the NBG's prudential requirements has begun. The NBG will either prevent all non-certified banks from accepting additional deposits or impose a 100 percent marginal reserve requirement. This will force banks to address the source of their problems (poor lending decisions and high operating costs) and will not permit them to overcome illiquidity by attracting deposits through excessive interest rates. The NBG will enforce this if necessary by transferring any nominal increase in deposits (both household and enterprise) into a non-interest bearing reserve account with NBG from funds (such as loan repayments, etc..) passing through the banks' correspondent accounts. The NBG also intends to prevent the distribution of cash dividends unless the banks are certified. 50. The third set of measures involves the restructuring of the banks. By early April 1996, the NBG and the three major non-complying banks (the United Bank of Georgia, the Agrobank, and the Bank of Georgia) banks will agree on a timetable, with monthly or quarterly benchmarks to monitor progress. If the prudential ratios do not improve as agreed in the timetable, the deviating bank will be given one month to return to the agreed timetable. It could do so either by selling assets or finding additional private equity. After the delay has expired, the NBG will either withdraw the licenses of selected branches or force their sale to other banks, thereby obtaining the funds necessary to enable the bank to adhere to its agreed timetable. Strict monitoring will be necessary to ensure that timetables are adhered to and/or that imposed penalties are appropriate.  - 59 - Page 11 of 14 51. As part of this overall strategy, neither the Government nor the NBG will insure banking deposits because they would distort incentives. The Government and NBG will not oppose private banks organizing mutual insurance schemes or purchasing private insurance, but will not take any responsibility for this. 52. To implement this strategy, the NBG will strengthen its supervisory function. A bank certification program will begin. Only banks fully complying with the prudential banking standards will be certified. The restriction that household deposits cannot exceed capital will be gradually relaxed for banks which are certified, and a decree to this effect has been issued in November 1995. (iii) Fostering Export Growth 53. Georgia's hopes for a speedy recovery and rapid growth depend on trade. As a small trading nation, Georgia is dependent on world markets to supply its needed consumer goods as well as many of the inputs for agricultural and industrial production. Likewise, Georgia depends on world markets to provide an outlet for its production of exportables. 54. The government recognizes the critical importance to the economy of facilitating both import and export transactions. Consequently, it has imposed no non-tariff barriers to imports, and has adopted a relatively low and uniform import tariff structure of 12%, a policy which it intends to continue. Until recently, the only exception to this general rule was the tax on barter transactions, equal to 20%. The government has unified this with the rate for other imports in February 1996, so as not to discriminate between these two types of trade. 55. The government has also eliminated all taxes on exports (with the exception of exports to CIS countries), and has made great progress in dismantling other export barriers. This includes most recently the abolition of the state order system, which previously imposed a significant implicit tax on a number of important exports. 56. Until November 1995, the following products remained under export prohibition: 1) Antiquities and artwork of museum value; 2) Weapons; 3) Oil and its products; 4) Milk and dairy products; 5) Meat and its products; 6) Ferrous and colored metal scrap; 7) Cereals, grains, and pasta; 8) Flour; 9) Sugar; 10) Combined feed. With the exceptions of items 1) and 2), the export of these goods was prohibited because in a period of economic turmoil, it was feared that their export would lead to severe scarcity in the domestic market. Many of them were also under price control. With the liberalization of prices and the more tranquil environment of the domestic market, the government has now eliminated prohibitions on the export of these products, with the exceptions of 1, 2, and 6) and will not impose export licensing or registration requirements on them. Export prohibitions on ferrous and metal scrap will be replaced by a temporary 50 percent export tax and a plan for the phasing out and discontinuation of the tax will be adopted. 57. In 1995, the following products required a license for their export: 1) Precious metals, including ore, alloys, products, and scrap; 2) Precious and semi-precious stones and their products; 3) Materials for mineralogical, biological, archaeological, paleontological, ethnographic and numismatic collections; 4) Ferrous metals and their products; 5) Alcoholic beverages; 6) Seeds of Caucasian fir trees; 7) Wood (logs, timber, lumber); 8) Leather and its raw materials; 9) Raw materials for medicines of animal and vegetal origin. The licensing system for items 1), 2), 4) and 5) was not applied in such a way as to intentionally restrict exports of these products; rather the intention was to ensure that the export prices  - 60 - Page 12 of 14 do not run afoul of European Union anti-dumping regulations, and that the exporters report an accurate price when calculating their profit taxes and repatriating their foreign exchange. The licensing requirements for wood and leather, on the other hand were explicitly restrictive, and were intended to ensure a source of low-price supply for domestic industrial processors of these products, as well as for forest conservation in the case of the former. 58. The government has now recognized that full development of Georgia's export potential required removing barriers to exports of all products except those required by environmental concerns or foreign policy considerations. Therefore it issued a decree in November 1995 to remove the requirement for licensing exports of all of these products, except for the standard list of exceptions. In the case of wood, the requirement has been removed for lumber, but licenses for export of logs and timber will be given upon demonstration that the trees were cut in accordance with conservation regulations. After licensing requirements are removed, there will be no other requirements imposed, such as for ex ante registration (with the exceptions specified below), nor will other products be put under export controls or registration requirements of any kind. 59. As exceptional measures during a transition process, exporters of a few (5) goods have been required to register export contracts ex ante with the government. The mechanism for this will be designed with assistance from the World Bank and UNDP; it will be transparent and will be used for reasons of health and safety control and to avoid tax evasion. With additional technical assistance from the World Bank and UNDP, the government will put in place alternative, more appropriate mechanisms to address these concerns and eliminate the transitional system of ex ante registration within a few months. Enforcement of tax laws for exporters will be carried out by the Tax Inspectorate and Customs service in accordance with their normal procedures based on ex post monitoring and investigations when there is cause for suspicion of non-compliance. 60. Beyond removing legal barriers, export development will require a number of active steps by the government. First, the government intends to encourage foreign investment. As experience in other countries has shown, foreign investors can use their contacts abroad and their knowledge of international market conditions to help ameliorate many of the problems currently faced by exporters in Georgia. The government is already developing a capacity for informing foreign investors about Georgia. It has also enacted a law governing foreign investments, which has a number of positive features, including granting foreign investors unlimited rights of repatriation of profit. However, the code also is deficient in several areas. It requires approval of investments based on some rather vague criteria and relies on tax holidays as fiscal incentives for attracting investors. The government intends to amend this law to resolve these problems. It will enact a code governing foreign investment, which will be based on a system of automatic approval of investments, with certain clearly delineated exceptions due to national security concerns. In recognition that temporary concessions and holidays are not generally effective in attracting efficient investment, the code will not contain such fiscal incentives. 61. The Government also will put in place several types of schemes to ensure that exporters can import their required inputs tax free. First, the current legal framework for bonded warehouses will be improved by mid-1996. Also, either as part of this scheme or as a separate legal scheme, producers who export virtually all of their production will be exempted up front from payment of duties, VAT, and excise taxes on their imported inputs. Second, the government will establish by November 1996 a legal framework for free trade zones. Third, the government will ensure that exporters as well as other producers will be able to get timely refund of any VAT taxes paid on their inputs, rather than just a credit, as is now the case. This latter action will be helpful to producers who export only part of their  - 61 - Page 13 of 14 production, and who cannot take advantage of up-front exemptions, as well as other non-export producers. 62. The Government recognizes that exporters and potential exporters in Georgia suffer from the lack of services available to exporters in other economies. While there are only a limited number of policy options available to help resolve this problem, one thing that the government will do is to allow for reincorporation as private companies the former state trading corporations, Gruzimpex and Agroimpex. Freed from any constraints imposed be state ownership, they will better be able to pay workers a market- determined wage and raise capital, and will be able to provide better service to exporters.  - 62 - Page 14 of 14 Attachment Key Reform Measures * Implement satisfactorily tax and customs administration reforms including reorganization of all tax inspectorates, completion of a taxpayer survey and distribution of identification numbers, review of procedures and regulations for tax assessment, of the incentive system for tax inspectors and agencies, and of penalties for non-compliance. * Reduce staff in the education sector by 10,000. * Shift responsibility for paying sickness benefits from the United Fund for Social Security to employers. * Maintain current for the full period the special account used for imports of fuel and electricity. * Implement wholesale and retail tariff reforms acceptable to IDA with first adjustment to phase cross-subsidies. * Issue decree defining the regulatory framework for the energy sector. Adopt a plan for power sector restructuring and privatization of sector enterprises. * Issue a decree requiring joint-stock companies to maintain a share registry with a licensed independent registrar. * Replace export prohibition on scrap metal by a temporary export tax. Adopt a plan for phasing out the export tax. * Allow for reincorporation as private companies, the former state trading organizations, Agroimpex and Gruzimpex.   IMAGING Report No: P- 6797 GE T.ype: PR