International Conference

«Conflicts in the Caucasus: History, the Present and Prospects for Resolution»

Baku (Azerbaijan) 22-23 October, 2012 and Tbilisi (Georgia) 25-26 October, 2012

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ECONOMY

Dr. Nodar KHADURI

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Nodar Khaduri, Associated Professor, Department of Economics and Business, Ivane Javakhishvili Tbilisi State University (Tbilisi, Georgia)

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Introduction

In 2005, the country’s economic development was relatively stable, without sharp fluctuations. Among the main factors determining this development was the post-revolutionary situation in the republic, and also natural disasters (floods and landslides), which caused great damage to the economy in the spring of 2005. Another unfortunate circumstance was the country’s failure to resolve its energy problems, which kept erupting throughout the year.

In the first few years of independence, the decline in production reached, so to speak, record figures. For example, real GDP¹ in 1994 was almost three-quarters lower than in 1990 (which in itself was not a very good year for the economy of Soviet Georgia). But in 1994 the country managed to halt this decline, and in 1996-1997, to achieve fairly good results: real economic growth in these two years added up to almost 25%.

Despite the fact that during these years Georgia was in the forefront of economic reform in the CIS countries, in the second half of 1998 it plunged into a fiscal crisis.² The state could not meet its obligations, which resulted in huge wage and pension arrears, and was often unable to discharge its debts to economic agents that provided it with goods and services. Unfortunately, some of the consequences of this crisis have not been overcome to date.

Apart from objective factors, the country’s economy was adversely affected by subjective factors as well: a large shadow sector,³ high level of corruption among government officials, and lack of political will required to resolve economic, social and other problems. The country entered a period of economic and political stagnation. In the final pre-revolutionary years, there was minimal economic growth against a steadily worsening social background.

The Rose Revolution of 2003, apart from its important political aspect, had a significant economic basis as well.⁴

In 2005, the government took a number of unpopular steps, which helped to strengthen financial discipline in the country and carry out vital transformations, including so-called “aggressive privatization.” The serious institutional and personnel reform of the government, including its economic block, was continued. Naturally, no one expected the structure of executive power to remain intact after the Rose Revolution, but the pace of change was impressive: a more or less stable Cabinet was formed within a year.

Unfortunately, the unemployment level remains high (according to official data, around 13.5%). Moreover, since the start of large-scale reforms in the public sector many government employees have lost their jobs.

Fiscal Sector

In 2005, GDP grew by about 16% compared to 2004, and prices rose by 6.2%. Naturally, such results could not have been achieved without serious institutional changes. This includes, first and foremost, the new Tax Code, which entered into force on 1 January, 2005.

Compared to the previous document that was in force from 1997, the new Tax Code has a number of obvious advantages. First of all, the range of taxes was sharply reduced: from more than twenty to seven. The rest were either abolished (such as the taxes on advertising, on the use of local symbols, on hotels, etc.) or integrated with other taxes, while some taxes of an economic nature were transformed into fees or administrative penalties. Thus, the tax on the use of natural resources was replaced with a fee, and the tax on exceeding the axle weight limits for trucks was replaced with a new fine in the Code of Administrative Offences. An almost 40% reduction in the rate of the single social security tax can be regarded as revolutionary. Before 2005 it stood at 31% for employers and 2% for employees, adding up to 33% of gross wages, whereas the new Code reduced it to 20%. Income tax was reduced as well, but what is more important (than its simple mechanical reduction) is that the old progressive tax with rates ranging from 12% to 20% and a tax-free income of 9 lari (about $5) was replaced with a proportional tax of 12%. The rate of value added tax was reduced from 20% to 18%, although this was evidently a populist move: businesses hardly felt an easing of the tax burden, while the state budget lost hundreds of millions in tax revenue.

According to a study carried out by the U.S. Forbes magazine, Georgia ranked third among 50 countries in terms of what is known as the Employee Happiness Index. In other words, taxes on wages are lower only in the United Arab Emirates and Malta. Georgia is followed by Russia, which is fourth on this list. In view of the huge tax rates characteristic of previous years, employers and employees sought to reduce the gross payroll, so running a great risk of being drawn into corrupt deals with members of tax and law enforcement agencies.

In the view of independent experts, one of the most attractive and interesting provisions of the new Code was the establishment of a special independent Arbitration Court as the main instrument for resolving disputes between the tax authorities and taxpayers. However, it proved to be short-lived: having lost several cases in this Arbitration Court, the state hastily amended the Tax Code and abolished this institutional innovation.

A Law on Amnesty and Legalization of Undeclared Tax Liabilities and Property entered into force together with the new Tax Code. As intended by its initiators, the law was to enable enterprises to disclose their hidden tax liabilities and property without fear of punishment. But in 2005 the country’s population legalized property for the amount of only GEL 13.5 million (just over $7.5 million). According to the Finance Ministry, payments to the treasury amounting to 1% of the sum (property) being legalized were made by about 30 persons and added up to only GEL 135,000. This shows that the post-revolutionary government does not yet enjoy sufficient confidence among the population and business people.

Nevertheless, tax revenues going into the state budget markedly increased. According to Finance Ministry data, the amount of taxes collected into the budgets of all levels (consolidated budget) in 2005 was over GEL 2.5 billion (106% of the forecast adjusted during the year), or 25% more than in 2004. These figures were achieved despite the liberalization of the Tax Code and the tax system in general, resulting from a stepped-up fight against smuggling, corruption and other economic crimes.

Unfortunately, in spite of these successes, Georgia was unable to meet all its debt obligations. Moreover, the country’s authorities postponed the implementation of a number of social programs, and at year-end most of them were scrapped altogether.

The country’s budget system was changed as well. In the past, the state budget consisted of an autonomous central budget and extrabudgetary funds (pension and road), whereas today all of these have been integrated into a single state budget.

Main Areas of Economic Recovery

The Law on Free Trade and Competition adopted by parliament in the summer of 2005 can be regarded as a serious institutional innovation. This law liberalized relations between the state and economic agents, and also abolished the Antimonopoly Service and the State Price Inspection. The state’s abandonment of antimonopoly regulation of the economy and consumer protection suggests that some public servants who came from business are interested in facilitating the implementation of their own business interests. At the same time, a great many licenses have been abolished, the bureaucratic apparatus has been downsized in most cases, and many agencies and departments have started operating on the “one stop shop” principle. Since September 2005, all institutional and procedural aspects of business activity are registered by tax agencies instead of judicial bodies.

Economic development requires significant investments, but the virtual absence of a stock market (despite the existence of the appropriate institutional attributes) rules out the possibility of accumulating funds required for investment through the sale of bonds or shares. Few enterprises have equity capital available for reinvestment. This is coupled with high interest rates in the capital market (up to 15-20% per annum), which naturally makes credit resources inaccessible to many businesses. In addition, even though real wages have increased by almost 30% and nominal wages by 40%, average monthly household income covers only about 85% of household expenses. Consequently, foreign capital remains the only real investment opportunity.

It should be noted that the events of 2005 provided fresh evidence of the importance of Georgia’s international economic function.⁵ Thus, ferry crossings to Russia and Ukraine were put into operation; a container train started running along the Poti-Baku-Aktau-Almaty route, and on Bulgaria’s initiative this project is to be extended to the Varna and Burgas ports. Another important project is the North-South route, which links Russia with Armenia, its strategic partner in the Southern Caucasus.

The Baku-Tbilisi-Ceyhan oil pipeline went into service on 25 May, and the opening ceremony for its Georgian section was held on 12 October. Eventually, this pipeline is to reach the eastern coast of the Caspian Sea and is to carry oil from Kazakhstan as well. An important point here is that the U.S. and the European countries will not only obtain an oil source alternative to the Persian Gulf, but will also expand their zone of influence. Work on the construction of the Baku-Tbilisi-Erzurum gas pipeline is also proceeding apace. All of this will significantly diversify the system of oil and gas supplies from the FSU countries to the world market. At the same time, Georgia today is regarded as an attractive investment destination. Kazakhstani businessmen, among others, are planning to invest over $1 million in the country’s economy.

Privatization can be seen as a continuation of the investment topic. As noted above, government officials describe the privatization process as “aggressive.” In 2005, several large enterprises of strategic importance to the country, including the state shipping company and the aircraft manufacturing complex, passed into private hands. Attempts were also made to privatize the Chiatura manganese deposits. Overall, budget revenues from privatization totaled GEL 370.6m, or over $205m (compared to GEL 12.8m in 2000, GEL 5.6m in 2001, GEL 8.7m in 2002, GEL 23.6m in 2003 and GEL 71.7m in 2004); out of 92 privatized facilities, 71 were sold at auctions, 15 on a competitive basis, and 6 through direct sale.

According to government data, the most successfully privatized facilities were the Georgia Shipping Company (initially priced at $30m, it was sold for $93 million); 51% of the Elmavalmshenebeli locomotive building plant ($3m and $4.15m, respectively); the former fire service building in a prestigious Tbilisi neighborhood ($1.5m and $3.04m), a railway car repair plant ($1.5m and 6m); and JSC Madneuli ($32.25m and $35.10m).

At the same time, many questions arise in connection with the insufficient transparency of the privatization process, when backstage talks with potential buyers were held in circumvention of the law.

Foreign Trade and Exchange Rate

Despite the efforts of the authorities and the business community, it has so far proved to be impossible to achieve the country’s energy independence: the construction of oil and gas pipelines through its territory has not yet led to the appearance of alternative energy sources. Russia remains virtually the only supplier of natural gas, which enables it to manipulate this opportunity in order to achieve its primarily political goals.

Apart from energy resources (oil, oil products, natural and liquefied gas, electricity), which make up about 19% of total imports, Georgia imports large numbers of passenger cars, mostly used ones, from EU countries (about 7% of total imports in 2005). Of course, to some extent this indicates that living standards in Georgia have been rising but, unfortunately, the share of new cars in the import structure is very small. The list of the top ten import items also includes pharmaceuticals (about 4%), turbojet engines (2.5%), flour and wheat.

The main export item is scrap metal (10.4%), followed by ferroalloys (9.4%), wines (9.2%), aircraft (8.8%), nuts (7.7%), copper ore (4.4%), mineral water, raw gold, fertilizers (about 3.8% for each group) and sugar (3.5%). The list of these goods shows once again that Georgia mostly exports raw materials. Special note should be taken of exports of scrap metal: contrary to the generally accepted rules of foreign trade, this is the only commodity group subject to excise tax (25 lari per ton), which is evidently a good source of revenue for the state budget.

The list of Georgia’s major economic partners remains stable. It is headed by Russia with about 16% of the republic’s foreign trade turnover. Then come Turkey, Azerbaijan, Ukraine, Germany, Turkmenistan, the U.S., Bulgaria, Great Britain and France, whose share adds up to about 75%. Unfortunately, Georgia has a deficit in trade with all these countries. This is fresh proof that the Georgian economy is still insufficiently competitive and that the government should first of all focus its efforts precisely in this area.⁶

One of the key macroeconomic instruments in foreign economic relations (and in other areas) is the exchange rate of the national currency. As noted above, the Russian Federation remains Georgia’s leading economic partner. At first glance, this means that the Russian ruble should outperform other currencies in foreign trade transactions. But since the ruble itself is not a stable, freely convertible currency, Georgian businessmen (as well as Russian ones) prefer to use the U.S. dollar even in economic relations with Russia itself.

Despite the stability of the lari, the share of deposits denominated in foreign currency in the country’s commercial banks is still much higher than the share of deposits in national currency, although the latter tended to increase throughout 2005. According to the National Bank of Georgia, the share of foreign currency deposits in the total volume of deposits is 77%, while the share of lari deposits is 23%. The continued pursuit of a prudent monetary policy is of special importance in this context.⁷

Promising Ratings

Authoritative international organizations take an optimistic view of the economic processes recorded in Georgia in 2005. These organizations include the IMF, which has approved the reforms underway in the country and its macroeconomic performance.

Special note should be taken of the tariff preferences for export products granted to Georgia by the European Union under the GSP+ program (a more favorable regime compared to the basic arrangement under the Generalized System of Preferences), which entered into force on 1 July and is to operate until the end of 2008. The new program offers duty-free access to the EU market for about 7,200 goods out of a total of 11,000 goods produced in Georgia.

The Board of Directors of the U.S. Millennium Challenge Corporation (MCC) has included Georgia among 23 countries which are to receive financial assistance under its Millennium Challenge Account (MCA) in 2006. And Standard & Poor’s rating agency has assigned “B+” long-term and “B” short-term sovereign credit ratings to Georgia (outlook positive).

According to a joint study of economic freedom in 161 countries carried out by the Heritage Foundation and The Wall Street Journal, Georgia ranks 68th in the world in terms of the index of economic freedom (with a score of 2.98 points), for the first time having been included in the category of “mostly free” countries. At the same time, as noted in the report, the economic situation in Georgia remains extremely grave. The study covers several areas, with scores assigned on a 5-point scale (1—best, 5—worst). Thus, Georgia’s index of economic freedom was 3.48 in 2002, 3.40 in 2003, and 3.19 in 2004. At the beginning of 2005, the country ranked 100th with a score of 3.32 points. The Heritage Foundation report notes that by the beginning of 2006 the situation in the banking sector and in foreign investment had improved, with a corresponding improvement in the scores for both these categories by one point to 3.0 and 2.0 points, respectively. The figures for monetary policy (2.0), trade policy (3.5) and fiscal burden (2.3) improved as well. Compared to 2004, there was no change in government intervention in the economy (1.5), wages and prices (3.0), property rights (4.0), state regulation (4.0) and the informal market (4.5). As a result, Georgia’s current rating improved by 0.31 points and it was ranked as a “mostly free” country.

Georgia’s classification as a “mostly free” country within two years of the Rose Revolution can be regarded as an encouraging factor, although it is important that Georgia’s own citizens should see their homeland in this light.

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¹ The relevant information was obtained from the Statistics Department of Georgia’s Ministry of Economic Development and from the website [http://www.statistics.ge/index_eng.htm]. _{Back to text}
² See: V. Papava, Necroeconomics. The Political Economy of Post-Communist Capitalism, Universe, New York, 2005, pp. 123-136, 159-163. _{Back to text}
³ See: T. Beridze, “Measuring Georgia’s Nonobserved Economy,” Problems of Economic Transition, Vol. 48, No. 4, 2005, pp. 43-54. _{Back to text}
⁴ See, for example: N. Khaduri, “Mistakes Made in Conducting Economic Reforms in Postcommunist Georgia,” Problems of Economic Transition, Vol. 48, No. 4, 2005, pp. 18-29; V. Papava, “Georgia’s Macroeconomic Situation Before and After the Rose Revolution,” Problems of Economic Transition, Vol. 48, No. 4, 2005, pp. 8-17. _{Back to text}
⁵ See, for example: V. Papava, “On the Special Features of Georgia’s International Economic Function,” Central Asia and the Caucasus, No. 2 (14), 2002, pp. 143-147. _{Back to text}
⁶ For more detail, see: N. Khaduri, “Macroeconomic Determinants of Competitiveness of the Georgian Economy,” Georgian Economic Trends, No. 3, 2005, pp. 60-68. _{Back to text}
⁷ See: M. Kakulia, N. Gigineishvili, “The Primary Objectives and Priorities of Monetary Policy in Georgia,” Problems of Economic Transition, Vol. 48, No. 4, 2005, pp. 30-42. _{Back to text}