English Languages – Geor- Gian Economic Trends and Georgian Law Review

Georgian-European Policy and Legal Advice Centre (GEPLAC) GEPLAC was established in 1997. It is an EU-funded project to facilitate the closer relations between Georgia and the European Union. In providing its recommendations to the Georgian Government, GEPLAC follows the provisions of the EU-Georgia Partnership and Cooperation Agreement. The fifth phase of the project is being implemented by Altair Assesores, the British Council, the European Social and Legal Economic Projects (ESTEP) and the Georgian Foundation for Strategic and International Studies (GFSIS). GEPLAC issues two quarterly publications in Georgian and English languages – Geor- gian Economic Trends and Georgian Law Review. Although these publications are issued within the framework of the EU Technical Assistance programme, they represent the views of the authors and do not represent any official opinion of the European Union. Georgian Economic Trends Quarterly review March 2006 No 4

This project is funded by the European Union Georgian Economic Trends

Georgian Economic Trends (GET) is a quarterly publication of the Georgian-European Policy and Legal Ad- vice Centre (GEPLAC), which aims at providing all interested readers with a review of developments in the Georgian economy and analysis of economic reform and policy pursued by the government. GET is issued in both Georgian and English languages and is available on the internet. GET is an independent publication. The materials represent the views of the authors and do not represent any official opinion of the European Commission, the Georgian-European Policy and Legal Advice Centre, or the Georgian Government.

For further information please contact: Georgian-European Policy and Legal Advice Centre, 3a, Chitadze Street, Tbilisi,0108, Georgia Tel: (095 22) 243555 Fax: (095 22) 921371 E-mail: [email protected] www.geplac.org

Editorial Board:

Christophe Cordonnier, Kakha Gogolashvili, Merab Kakulia, Vladimer Papava, Alexei Sekarev, Ivan Samson.

Separate chapters were prepared by the following experts:

Lela Bakhtadze GDP and Real Sector, Public Finance Nata Kakabadze Money and Banking, External Sector, EU-Georgia Economic Relations Veronika Schneider Labour Market and Households Budgets ContentS

Introductory Note______7

Part I. Overview of the Georgian Economy

Main Economic Events______9

Summary Macroeconomic Indicators______15

1. Gross Domestic Product and Real Sector______17

2. Public Finance ______23

3. Money and Banking______27

4. Labour Market and Households Budgets______33

5. External Sector______38

6. EU-Georgia Economic Relations______43

Part II. Economic Trends and Policy Analysis

1. Georgia’s economic growth: how to avert possible risks in future ______48 Cristophe Cordonnier, Professor, GEPLAC economic expert 2. Trends in levying excise goods and mobilizing revenues in Georgia______57 David Narmania, PhD of Economics, Chairman of Board of Georgia’s Young Economist’s Associations

Part III. Economic Reform Agenda

The search for a development path: challenges for Georgia______62 Ivan Samson, Professor, Director of Espace Europe Institute at UPMF University, Grenoble; GEPLAC economic expert, with support of Anastasiya Zagainova, economic researcher at PEPSE laboratory, UPMF, Grenoble

Introductory note

Macroeconomic framework in 2005 and GET contribution to policy discussions

It is widely recognized that Georgia’s economic performance has been improving in the recent years. Data presented in the current issue of Georgian Economic trends confirm this conclusion. In 2005, real GDP grew by 9.3 percent (5.9 percent in 2004), driven by the sectors of construction (23.3 percent increase over 2004) and services, most notably telecommunications (29.5 percent) and financial services (52.5 percent). Industry and agriculture were on the growth path as well, with a year-on-year output increase of 11.4 and 12 percent, respectively.

In manufacturing sector, significant output increases were registered in food processing, production of fer- roalloys, construction materials, alcoholic beverages as well as timber processing. Energy sector (electric power generation, natural gas and water generation and distribution) saw an increase in output of 5 percent over 2004. Domestic demand was strong in 2005, as indicated by the increase in monetary aggregates and credits to the economy, thus underpinning the real GDP growth.

An important positive development in 2005 was further fiscal consolidation. The tax/GDP ratio for the central government increased from 13.5 percent in 2004 to 15.8 percent in 2005, which is mainly attributed to improvements in tax administration. This has strengthened the financial position of the authorities. Total expenditure increased from 16.6 percent of GDP in 2004 to 22.6 percent in 2005, in particular on social protection, education, health care programs and defence. Substantial funds were spent on transfers to local budgets. Authorities managed to reduce the stock of domestic expenditure arrears significantly, by an estimated 0.9 percent of GDP, while the full elimination of these arrears is envisioned in 2006.

The year-average consumer price inflation increased in 2005 to 8.2 percent, from 5.7 percent in 2004. For 2006, the IMF projects an average consumer price inflation of 5.3 percent, which, given there is no external or internal shocks, seems quite realistic in the current macroeconomic environment.

The Lari was broadly stable against foreign currencies in the last two years. However, an appreciation trend has been persisting in both nominal and – even stronger – in real terms. The nominal year-average exchange rate in 2005 was 1.81 Lari per U.S. Dollar (1.92 Lari in 2004). In real terms Lari has been appreciating since early 2004, reflecting a strong demand for the domestic currency under a buoyant real GDP growth, and foreign exchange inflows from investment and workers remittances. The National Bank data show that the index of real effective exchange rate (REER), measured against December 1995, grew from 106.8 in January to 110.3 in December 2005. The related competitiveness losses have been compensated so far by internationally very low domestic wage levels, but a narrow export base is a source of concern in the medium- and long-term perspective.

According to the World Development Indicators of the World Bank, poverty in Georgia remains high. In 2005, 52 percent on households were living under the official subsistence level and 17 percent in extreme poverty.

The external sector performance presented a mixed picture in 2005. Compared with the previous year, both export revenue and import expenditure (goods and services, in fob terms) increased by 32.9 percent, as shown in the balance of payments data. Since the current account balance was negative at USD 349 in 2004, equal growth rates of exports and imports caused a widening of the current account deficit to USD 689 million in 2005. At the same time, Georgia’s foreign debt has been decreasing steadily since 2000 and reached a level of 22 percent of GDP in 2005.

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The current issue of Georgian Economic Trends, prepared by GEPLAC team of experts, sheds more light on the economic situation in the country. The data series have been composed so as to give a consistent six-year retrospective of main indicators. The numbers for the more recent period, usually starting from 2003, are given in a quarterly breakdown. We believe that such approach to data presentation offers a comprehensive view on Georgia’s economic development over the recent years.

It should be noted that some data series have been revised to reflect the new updated numbers released by the Georgian Department of Statistics. The Department has introduced, with the support from international institutions, serious improvements to the database, related mainly to the coverage and integrity of data. These improvements of the statistics should be taken into account in the interpretation of the economic trends. For example, it is widely believed that parts of the growth of GDP and exports should be attributed to a better coverage, in particular to the incorporation of shadow sector activities into the official statistics.

A new element in this issue is the comparison of Georgia’s economy with that of the enlarged EU, along such key indicators as real GDP growth, GDP per capita in PPP terms, lending rates and others. While the income disparity remains high, Georgian economy has been growing much faster that that of the EU25. A source of concern is, however, the quality of growth in Georgia: despite high annual rates, it has not resulted in a notable job creation and higher living standards yet.

This situation clearly calls for adequate medium- and long-term policy responses. The Georgian Government is aware of that and has recently taken a number of adequate measures in the fiscal and regulatory areas. Other policy options, which the authorities might consider, are discussed in the analytical papers in this issue of GET.

These refer to the excise taxation as one of the effective instruments of revenue mobilisation by the fiscal authorities (article by David Narmania). The paper by Prof. Christophe Cordonnier looks on issues, which the author believes necessary to avert possible risks in future. He argues that broadening the growth base (e.g. by non-inflationary involvement of currently idle production capacities) is essential to strengthen the real sector. The medium- and long-term sustainability of growth is needed also to maintain the external equilibrium for the Geor- gian economy, currently at risk due to the widening current account deficit and an upward pressure on the nominal and real exchange rates. Decisive in this respect will be domestic productivity gains, which the government may support by a mix of business facilitation, proper contract enforcement and improved governance.

Finally, the paper by Prof. Ivan Samson looks at the experience of other transition countries, which have faced similar development problems. It discusses the different policy approaches to the choice of the development strategy and puts forward a number of basic elements of such strategy for Georgia, which are believed to bring workable long-term solutions for the country.

Alexei Sekarev

Team Leader of GEPLAC

Part I. Overview of the Georgian Economy

Main Economic Events 2005 October 3 President Nursultan Nazarbayev on a visit to Georgia stated that Kazakhstan’s major interest with Georgia is the latter’s transit capabilities to transport Kazakh oil and other freight to Europe. Georgian President Mikheil Saakashvili hailed relations with Kazakhstan as free from any problems. The two presidents were speaking at a joint news conference after talks in Tbilisi. Economic cooperation with Georgia is of major interest for Kazakhstan. Mr. Nazarabayev stated that “on the shores of the Caspian Sea we have built the largest port in the Caspian Sea Aktau - which is currently capable of handling 15 million tons of oil [per year]. Another port of this kind is being constructed, designed to obtain access from Kazakhstan via the Caucasus and Black Sea to Europe. This was the reason for my trip to Adjara and my visit to port of Batumi there. To become acquainted with the port’s capacity was very important in this regard and I want to thank Mikheil Saakashvili and the Adjarian leadership for giving us the opportunity to see the capabilities of the Batumi port. Secondly, the railway link between Baku [Azerbaijan] and the Black Sea in Batumi is also very important and interesting for us in respect of transportation of ferrous and non-ferrous metals and other freight.” Mr. Saakashvili responded by saying “We have the most pleasant experience of relations with Kazakhstan. Kazakhstan never creates any problems to anyone. And Kazakhstan’s participation in international processes is welcomed and we count on.” October 12 Two chief executives of British Petroleum (BP), which led construction of the multi-billion Baku-Tbilisi-Cey- han (BTC), oil pipeline said in Tbilisi that the pipeline, which has the potential to supply of world oil demand, will promote stability in the region. Iain Conn, BP Group Executive Officer, and David Woodward, President of BP-Azerbaijan, held a joint news briefing in Tbilisi on October 12 after the Presidents of Azerbaijan, Georgia and Turkey officially opened an oil pumping station in Georgia’s Gardabani district, marking the launch of the Baku-Tbilisi-Ceyhan (BTC) oil pipelines Georgian section. He said that 1 million barrels of oil will be trans- ported through the oil pipeline per day, 1 percent of the world oil consumption. Iain Conn also noted that the total project, including the fields in Azerbaijan, cost some 20 billion dollars and one billion dollars has been invested in Georgia. The BP executive officer also said that 72 percent of all foreign investments in Georgia last year were made by BP. A total of 10 million barrels of oil is needed to fill the 1,760 km long pipeline, 248-km of which is in Georgia. This pipeline is expected to bring Georgia an estimated USD 50 million per year for transit of Azeri oil to the Turkish port of Ceyhan, where it will be made available to western markets October 12 The Ministry for Economic Development announced that it has sold a Metallurgical Plant in Rustavi, near the capital Tbilisi, at a bankruptcy auction to two Georgian companies - Energy and Industry Complex and Ted- Oil. The Energy and Industry Complex purchased the major assets of the plant for USD 20.5 million. The Energy and Industry Complex also purchased a limestone workshop located in Dedoplistskaro district for USD 500,000. According to the Ministry, the company undertook to pay the sum before December 13, 2005. Other part of the enterprise, involving a limestone and dolomite workshop, was purchased by Ted-Oil for USD 6 million. October 22 The International Monetary Fund (IMF) Mission, which arrived in Georgia to assess performance under the Poverty Reduction and Economic Growth Program. The results of the assessment were satisfactory. The Na- tional Bank of Georgia has fulfilled all the parameters envisaged by the program, President of the National Bank of Georgia said. The IMF’s Executive Board approved a three-year arrangement for Georgia last June. The total sum of this arrangement will total close to USD 150.3 million. November 1 The London-based Stanton Equities Corp. has won a tender on the privatization of 97.25 percent shares of the Madneuli mining company and 50 percent shares of the Trans Georgian Resource Ltd which focuses on exploration of ore - after offering USD 51.1 million, Georgian Minister for Economic Development Irakli Chogovadze announced on November 1. The Russian Industrial Investors Group (Promyshlennye Investory) reportedly owns shares in the Stanton Equities Corp. Out of this sum, USD 35.1 million will be paid for the 97.25 percent shares of Madneuli, while USD 16 million will be paid to the state budget to cover debts. Madneuli itself owns 50 percent of shares of the Georgian-Australian joint gold mining company Quartzite LTD. The Minister said that the Stanton Equities Corp. has undertaken the commitment to pay 50 percent of the sum by November 15, 2005 and the rest by December 15, 2005. The Hong-Kong-based company Energy and Industry Complex also participated in the tender and offered USD 40.6 million. The British company offered USD 10 million more [than Energy and Industry Complex] so we preferred the British company, Irakli Chogovadze said. The main operations of the Madneuli include mining, processing and production of copper concentrate. November 14 At a meeting with representatives of the business community, President Saakashvili vowed to improve the business climate through a number of new legislative initiatives he plans to submit to Parliament for consideration in one month’s time. The President also called on businessmen for coordination and interaction with the authorities. “Our long-term interest is to create conditions for the development of your business. This will in itself settle the problem of unemployment. The first proposal involves further simplification of the Tax Code; the second one concerns simplification of export-import procedures - since these procedures are very complicated today; we also plan to liberalize and simplify the Labour Code. One more proposal concerns judiciary reform, envisaging simplification of judicial procedures on the one hand and simplification of the language of law on the other, in order to avoid double interpretations’, Saakashvili said. He also said that the authorities plan to liberalize the banking system, which, according to the President, will simplify the procedures for foreign businesses to invest in the country s banking system. Saakashvili said that all these new initiatives aim at lessening interference and regulation by the state. November 25 Prime Minister Zurab Nogaideli and Chairman of the Russian energy giant Gazprom Alexei Miller discussed issue of gas supply to Georgia, transit of Russian gas via Georgia, as well as cooperation between Gazprom and energy companies in Georgia in Moscow. In a press release Gazprom said that an agreement was reached about the supply and transit of gas in 2006 on conditions corresponding to international norms. But the press release does not specify the details of the deal - specifically the price Georgia will have to pay for gas starting from 2006. Earlier, Gazprom announced plans to increase gas prices from the current USD 63 to USD 110 per 1000 cubic meters. Alexei Miller and Zurab Nogaideli also reached agreement to set up a joint Russian-Georgian venture for exploration and development of Georgia’s gas transportation system. December 6 Credit rating agency Standard and Poor’s has assigned “B+” long-term and “B” short-term sovereign credit ratings to Georgia and said that the outlook is positive. Georgian Prime Minister Zurab Nogaideli hailed Georgia’s first-ever international credit rating at a government session on December 7. Standard & Poor’s credit analyst Luc Marchand said in a statement issued by the credit rating agency that the ratings on Georgia “are supported by the government’s strong political commitment to prudent financial policies and market-oriented structural reforms.” But the analyst added that the ratings are ”constrained by weak external liquidity, still-high inflation, and substantial infrastructure development needs, in the context of a poor institutional framework and political uncertainty arising from regional conflicts. According to Standard and Poor’s short-term obligation rated “B” is regarded as having significant characteristics; in this grade the obligor currently has the capacity to meet its financial commitment on the obligation; however, it faces major ongoing uncertainties that could lead to inadequate capacity to meet financial commitments on the obligation. December 7 Parliament will start discussions on government-proposed amendments to the law on pensions. The document envisages increasing the minimum pension from the current GEL 28 (USD 15.5) to 38 (USD 21) and a decrease of the maximum pension from the current GEL 5000 [approximately USD 2700] to 560 (USD 311) starting from next year. The maximum pensions are reserved for former high-ranking officials. The initial draft also envisaged the introduction of a new retirement age of 65 for both men and women. Currently the retirement age for men is 70 and 60 for women. But, as the opposition Democratic Front announced on December 7, a compromise has been reached and the retirement age for women will not increase and remain at the current 60. Authorities say that the pension system based on length of service will only be available after the minimal pension will be increased up to subsistence level, which is currently about GEL 150 (USD 83.3) per month. December 13 The European Commission adopted a new humanitarian aid decision to allocate Euro 2 million for the victims of the Abkhaz conflict, according to a press release issued by the European Commission. Hundreds of thousands of people are still displaced and live in dire conditions in Abkhazia and the rest of western Georgia, the press release reads. According to the European Commission, this decision will concentrate on western Georgia, including breakaway Abkhazia. It will provide basic food to 35,000 of the poorest people and fund food and income generating projects for some 5,000 vulnerable people. The European Commission has provided more than Euro 98 million in humanitarian aid to Georgia since 1993. December 15 In his address to the Sixth World Trade Organization (WTO) Ministerial Conference in Hong Kong Geor- gia’s Economic Development Minister Irakli Chogovadze focused on the relationship with Russia, saying that the existence of two illegal checkpoints in breakaway South Ossetia and Abkhazia is most actual in this relationship.

10 Illegal trade turnover between Russia and Georgia’s separatist regions violates the bilateral agreements reached between the two countries. Moreover, the Georgian government considers such actions as a violation of trade rules that contradicts the key principles of the World Trade Organization. Georgia supports legalization of the checkpoints, the Minister said. Another issue pushed by Georgia concerned provision of legal trade between the two countries on the Kazbegi-Zemo Larsi checkpoint and in the port of Kavkaz. Georgia also demands Russia to fulfil the existing agreements and eradicate the cases of falsification of Georgian wines and mineral waters on the Russian market. The Minister said that if Russia meets these demands, it will secure Tbilisi’s consent on membership into the World Trade Organization (WTO). Georgia reiterates readiness for a constructive dialogue with the Russian Federation and hopes that Russia’s adequate steps will be followed, Chogovadze added. At the summit Georgia supported the accession of Ukraine and Kazakhstan to the World Trade Organization. December 16 Georgian Prime Minister Zurab Nogaideli and Russian Transport Minister Igor Levitin, who chair the Rus- sian-Georgian intergovernmental commission for economic cooperation, signed a final protocol which envisages setting up a joint consortium on restoration of the Russian-Georgian railway via breakaway Abkhazia. The decision over setting up a consortium was made at the session of the Russian-Georgian intergovernmental commission in Tbilisi, where the sides expressed readiness to resume the railway link. Deputy Economic Devel- opment Minister Natia Turnava told reporters that initially the sides will develop a mechanism for setting up a joint consortium, and only afterwards a particular technical project on resumption of the railway will be prepared. However, the exact dates of setting up the consortium are not defined in the protocol. December 19 The Russian Ministry of Agriculture imposed temporary restrictions on the import of agricultural products from Georgia to Russia starting from December 19, the Russian Ministry’s press office reported. The Russian side cited its decision due to phytosanitary concerns and violation of international and Russian sanitary requirements by Georgia. According to the Russian Ministry of Agriculture, the temporary restrictions will be in force, until Georgia eradicates the reasons for violations of international and Russian sanitary requirements. December 20 Although an agreement has been reached over the gas price for Georgia, issues related with purchase of shares in Georgia’s gas pipeline system, as well as tariffs for transit of Russian gas into Armenia via Georgia remain unsolved, the Russian energy giant Gazprom’s top executive Alexander Ryazanov said after two-hour talks with Georgian PM Zurab Nogaideli in Tbilisi. The Deputy Chairman of Gazprom said at a joint news conference with PM Nogaideli said that Gazprom will increase gas price for Georgia from the current USD 63 up to USD 110 per 1000 cubic meters from 2006. Nogaideli said that Gazprom will also increase the amount of gas deliver- ies to Georgia from the current 1,30 billion cubic meters up to 2,25 billion cubic meters next year. He also said that Gazprom will have a common approach in respect of the price policy in the South Caucasus region and will deliver gas to all three countries of the region for USD 110. December 22 Prime Minister Zurab Nogaideli said while speaking at the parliamentary session that the Russian energy giant Gazprom is interested in purchasing Georgia’s major gas pipeline network. But this is not currently on the agenda and [the issue] still needs to be discussed. According to the Millennium Challenge Compact signed between Georgia and the United States , the government undertook a commitment not to sell its major gas pipeline system until the expiration of the agreement in 2010. The government also has no right to sell or transfer controlling shares in the Georgian Gas International Corporation, a state-run company which operates the gas pipeline system in the country. The U.S. allocated USD 49.5 million, under Millennium Challenge Account (MCA) assistance program, towards rehabilitating the gas pipeline system. December 23 Parliament approved the 2006 draft budget with a 162 to 20 vote. Revenues for the 2006 fiscal year are put at GEL 3 068 600 000 (approximately USD 1.7 billion) and expenditure at GEL 3 285 400 000 (approximately USD 1.8 billion). Although opposition parliamentarians hailed the increased budgetary targets for 2006, they criticized the draft budget as non-transparent. December 24 The first cargo train left Georgia’s port of Poti which will deliver cargo to Kazakhstan’s port of Aktau and further to Alma-Ata. According to the Railway Department, the train will perform regular trips twice a month. The operation of the Poti-Baku-Aktau-Alma-Ata route will increase the competitiveness of the TRACECA route. The decision about operation of the new cargo train route was made during talks between the heads of the railway companies of Azerbaijan, Kazakhstan and Georgia in Tbilisi on December 5-6.

11 December 26 The Georgian Economy Minister and top executive of the Kazah KazTransGaz company signed a memorandum in Tbilisi which says that the Kazakh state-owned company will buy 100 percent of shares of the capital city Tbilisis gas distribution company TbilGazi. Amount of deal is not yet agreed, but according to the memorandum the Kazakh company will take over TbilGazi after the bankruptcy procedures of the latter are over. 2006 January 4 According to the annual publication by the Heritage Foundation/Wall Street Journal the Index of Economic Freedom-2006, Georgia’s overall score has improved by 0.31 point this year, causing Georgia to be moved from ’mostly unfree” into ’mostly free‘ category. The 2006 Index of Economic Freedom, which measures 161 countries, ranks Georgia as 68th with 2.98 points. Low scores are more desirable. The higher scores indicate a greater level of government interference in the economy and the less economic freedom a country enjoys. January 9 For the first time in last three years inflation rate has not exceeded 7 percent and dropped to 6,2 percent in 2005, the National Bank reported on January 9. Suspension of increasing inflation level was made possible through reasonable fiscal policy and stable exchange rate of GEL, Davit Amaglobeli, Vice-President of National Bank, said. In recent years the highest level of inflation was in 2004 at 7.5 percent. According to the National Bank is far ahead of some other countries from the Commonwealth of Independent States (CIS), where consumer price inflation rate has reached two-digit figures, including in Russia, Azerbaijan, Ukraine, Moldova and Belarus. Inflation rate is set at 5-6 percent for 2006. But opponents say that the forecast is unrealistic, especially after the increase of gas price by Russia. Our target next year [in 2006] will be for inflation not to reach two-digit figures, Roman Gotsiridze, the President of the National Bank, said at the parliamentary hearing on December 22. January 11 President Saakashvili said that the Georgian ski resorts in Bakuriani and Gudauri have no competitors in the region. This means that now there is the chance to attract hundreds of thousands of tourists, which means additional income. Saakashvili was speaking in Bakuriani, where he attended a ceremony to open a new ski run and a 35-car gondola lift. Construction of the new skiing infrastructure, worth Euro 18 million, was financed by tycoon Bidzina Ivanishvili, who handed over these assets to the local authorities under the provision that this infrastructure will never be privatized. Saakashvili also said that the number of tourists visiting Bakuriani has increased more than two fold since the 2004-2005 seasons. Last year, Georgia applied to host the 2014 Winter Olympic Games in Bakuriani and Borjomi. January 11 President Saakashvili said in the Kazakh capital Astana that the Adjara Autonomous Republic will become one of the most fashionable resorts on the Black Sea coast thanks to investment projects the Kazakh BankTuranAlem (BTA) plans to carry out in the region. President Saakashvili met with BTA representatives in Astana and, according to Georgian media reports, an agreement that the BTA will invest in the construction of several hotels in Adjara was reached. The first results will already be obvious by summer. In 2008 Adjara will become one, huge, ultra-modern resort complex, similar to those which are in Turkey and Bulgaria. Adjara will become one of the most fashionable places for both Georgians and foreigners, Saakashvili said. Mukhtar Ablyazov, the BTA Chair- man of the Board of Directors, was quoted by RIA Novosti news agency as saying that the Bank plans to invest about USD 200 million in Adjara’s tourism infrastructure. Kazakh Bank TuranAlem (BTA), which holds assets of USD 5.5 billion, opened a branch office in Tbilisi last August. The Bank started implementation of a USD 100 million investment project, involving reconstruction of the hotel Iveria, in downtown Tbilisi, into a five-star hotel, as well as renovating all of Republic Square, where the hotel is located. The Silk Road Group is BTAs major partner in Georgia. After talks with his Kazakh counterpart Nursultan Nazarbayev in Astana on January 10, President Saakashvili said that Kazakhstan will soon become the number one investor in Georgia. January 13 Prime Minister Zurab Nogaideli said that the authorities plan to complete the privatization process of the country’s energy facilities in 2006. Except for high-voltage power transmission lines, the sector will be completely transferred to private ownership. The Enguri hydro power plant will also remain state-owned, due to its vital importance, Prime Minister Nogaideli said during a meeting at the Energy Ministry on January 13. The Lajanuri, Rioni, Gumati, Shaori and Dzevrula hydro power plants are among those energy facilities which are included in the privatization list. January 22 Explosions of two gas pipelines in Russia’s North Ossetian Republic early on January 22 suspended gas supply to Georgia and Armenia. The first explosion occurred on the North Caucasus-Trans Caucasus gas pipeline, 30 kilometres away from the North Ossetian capital Vladikavkaz at 02:52 am Moscow time. 20 minutes later a

12 second explosion hit another gas pipeline the Mozdok-Tbilisi. No reasons of for the explosions were immediately reported, but later Interfax news agency quoted North Ossetian officials, who cited probable technical or low temperature reasons behind the explosions. Giorgi Gvichiani, top executive of the TbilGazi company, which distributes gas in Georgia said on January 22 that the gas supply will be cut to consumers by the evening on Sunday. Russian agencies reported that restoration of gas pipelines in North Ossetia will take four days. January 26 Georgian Prime Minister Zurab Nogaideli held talks with Donna Dowsett-Coirolo, Country Director for the South Caucasus Country Unit, Europe and Central Asia Region of the World Bank. Nogaideli briefed the WB representative over the recent situation in the country’s energy sector and said that the only way to avoid a similar crisis in the future is to diversify the country’s energy suppliers February 5 Turkey wants to increase its trade volume with Georgia up to USD 2 billion from the current USD 500 million over the next few years, Anadolu news agency reported quoting Turkish Foreign Trade Minister Kursad Tuzmen after talks with visiting Georgian Prime Minister Zurab Nogaideli. He also said that Turkey wants to significantly increase the volume of activities of Turkish contractor firms in Georgia from the current USD 350 million. Georgian Prime Minister Nogaideli, who was accompanied by the Energy and Economy Ministers, visited Turkey on February 4-5. Nogaideli discussed bilateral cooperation with his Turkish counterpart Recep Tayyip Er- dogan late on February 4. At a meeting of the Turkish-Georgian Business Council on February 4, Nogaideli called on Turkey to look at the privatization process in Georgian scheduled this year, especially in the energy sector February 9 A Mission of the International Monetary Fund (IMF) is paying a working visit to Georgia on February 8-15. The delegation, led by John Wakeman-Linn, Head of the IMF’s Middle East and Central Asian Department, met with President of the National Bank of Georgia (NBG) Roman Gotsiridze on February 8. According to the NBG’s press office, the Mission’s visit aims at assessing the current economic situation in the country and discussing Georgia’s performance under the Poverty Reduction and Economic Growth Program (PREGP), through which Georgia has already received USD 60 million in 2004-2005. The IMF’s Executive Board approved a three-year arrangement for Georgia in June, 2004. The total sum of this arrangement will total USD 141 million. Following talks with Georgian officials, the IMF mission will develop a memorandum on mutual understanding, which will be submitted to the IMF Board of Directors. If this memorandum is approved, Georgia will receive further dis- bursement of funds under the PREGP. February 13 The Ministry for Economic Development will launch the acceptance of privatization bids for three electricity distribution companies and six hydro power plants on May 16, 2006, Minister Irakli Chogovadze said on February 13. The list includes the United Energy Distribution Company of Georgia (UDC), which distributes electricity throughout the regions of Georgia. According to the Ministry, the initial price of the UDC is USD 30 million. The company is currently managed by a U.S. company PA Consulting, which is a USAID contract company in Georgia. February 14 In an annual state of the nation address to Parliament President Saakashvili said that Georgia’s economy is “growing rapidly,” which will enable the country to overcome poverty by 2009. “Today we are still a very poor state from the economic point of view, but we are on a path which will help us overcome problems… GDP is expected to reach USD 1670 per capita in 2006; in 2010 GDP will be USD 2400 per capita - this means that by 2009 Georgia will no longer be classified as a poor state.” He said that GDP growth was about 9 percent in 2005. “This is despite the fact that oil prices increased last year,” Saakashvili added. The President said that the government privatized 816 facilities in 2005. “Total revenue from the privatization process last year amounted to GEL 522 million [USD 290 million].” Saakashvili also said that foreign trade turnout increased by 33 percent in 2005. “What is most important is that we increased export by 36 percent last year,” he added. He said that reforms are planned in the customs system. “Hundreds of customs officers were arrested for bribery, but it still did not help. We need a new liberal customs code,” Saakashvili said. He said that the government plans to cut the number of customs dues from the current 16 to 3. “Tariffs will also be reduced… This will trigger GEL 80 million less going to the budget but this will be a huge investment in the economy in a long-term perspective,” Saakashvili said. He also said that the labour code, banking system, as well as bankruptcy legislation should also be liberalized. February 17 The World Bank approved a USD 5 million grant for Infrastructure Pre-Investment Facility (IPF) Proj- ect. This project will facilitate infrastructure investments that have strategic importance by ensuring that proper feasibility work is carried out in a timely manner in order to enable the government to make sound investment decisions. The IPF Project has two major components: (1) Technical Assistance for the Khudoni Hydropower Project Preparation, and (2) Technical Assistance for Preparation of Transit Corridor Projects. Georgia joined the

13 World Bank in 1993. Since then, the commitments to the country total approximately USD 816 million for 40 operations. March 3 The U.S. Trade and Development Agency (USTDA) granted USD 356.000 to the Energy Ministry to enhance the country’s energy security and promote economic growth in. According to a press release issued by USTDA on March 2, the grant will fund a feasibility study on developing a second high voltage transmission line between Zestaponi (western Georgia) and Gardabani (south-eastern Georgia) stations. The grant was conferred in a sign- ing ceremony held during the opening reception for the Invest in Georgia Forum in New York. USTDA Director for Policy and Program Geoffrey Jackson and Georgian Energy Minister Nika Gilauri signed the grant agreement on behalf of the U.S. and Georgian governments, respectively. Georgian Prime Minister Zurab Nogaideli was present. The USTDA grant will be used to prepare preliminary design and cost estimates, review financing options, and prepare tender documents. March 10 The second round of talks over Georgias EU Neighbourhood Policy (ENP) Action Plan was held in Brus- sels during which the sides agreed over a large part of the Action Plan, the Georgian Foreign Ministry reported. The representatives of the European Commission explained that additional consultations will be held with the EU member states to agree the remaining sections of the text. The third round of talks is scheduled for the second half of May. Georgia joined the European Neighborhood Policy in June 2004, along with Azerbaijan and Armenia. March 15 Georgian Energy Minister Nika Gilauri told reporters that privatization of Georgia’s gas pipeline system is not currently planned. He said that Georgia plans to offer proposals to Gazprom over a long-term agreement, which will define terms of gas supplies, including its tariffs, as well as cost of transit of Russian gas to Armenia via Georgia. March 16 Georgian Finance Minister Lexo Alexishvili and Japanese Ambassador to Georgia Tadahiro Abe signed an agreement on granting USD 6.7 million to Georgia for structural and economic reforms. According to the Georgian Foreign Ministry a joint Georgian-Japanese fund will be set up to oversee spending of this grant. March 20 The minimum monthly pension increased from GEL 28 up to GEL 33 (USD 18.1) starting from March 20, Director General of the Pension Fund Zaza Sopromadze stated. For this purpose the state budget will allocate approximately 4 million Lari monthly to provide increased pensions for about 800 thousand pensioners. The state pension will increase further by GEL 5 and reach GEL 38 (USD 20.8) in September, 2006. March 22 Georgian Energy Ministry Nika Gilauri announced that the process of merger of Georgian International Gas Corporation (GIGC), Georgian International Oil Corporation (GIOC) and Georgian state oil company SakNav- tobi has started. The merger of three state-run energy companies is aimed at better coordination and management of the sector and the decision has nothing to do with allegations that the authorities plan to sell the country’s trunk gas pipeline. March 28 Russia’s chief sanitary inspector Gennady Onishenko recommended that the country’s customs service ban the import of wine from Georgia and Moldova, citing violation requirements of state sanitary-epidemiological rules and norms. In a letter sent to the head of the Russian customs service Aleksandr Zherikhov on March 25, the chief Russian sanitary inspector stated that the inspection revealed 60 percent of the examined wines imported from these countries [Georgia and Moldova] in Moscow alone fail to meet requirements set by sanitary-epidemiological rules and norms on safety conditions. The letter also says that the Russia will stop issuing sanitary- epidemiological conclusions for Georgian and Moldovan wines starting from March 27. Russia’s warning to ban imports of Georgian wines has already been condemned as a political move, which will be a painful blow not only for wine producers, but for the country’s economy. Up to 90 percent of Georgian wine export goes to the Russian market. March 31 The Executive Board of the International Monetary Fund (IMF) completed today the third review of Georgia’s performance under the three-year program supported by the Poverty Reduction and Growth Facility (PRGF). Completion of the third review will enable Georgia to draw SDR 14 million (about USD 20.2 million), bringing total disbursements under the arrangement to SDR 56 million (about USD 80.7 million).

14 Summary Macroeconomic Indicators*

2000 2001 2002 2003 2004 2005 GDP and real sector Nominal GDP mln GEL 6043.1 6674.0 7456.0 8564.1 9824.1 11591.9 Real GDP mln GEL, 1996 4618.2 4840.1 5105.0 5669.6 6001.7 6562.8 Nominal GDP per capita GEL 1298.6 1445.0 1625.9 1880.0 2166.1 2563.7 USD 657.5 697.0 741.4 876.9 1139.1 1415.6 Real GDP per capita GEL, 1996 992.4 1047.9 1113.2 1244.5 1323.3 1451.5 GDP by sectors Industry % of nominal GDP 17.3 16.6 17.6 17.7 16.1 15.6 Agriculture % of nominal GDP 20.6 21.0 19.2 19.3 16.4 14.8 Construction % of nominal GDP 3.7 3.9 5.1 6.4 8.1 8.8 Real GDP growth % over prev. year 1.8 4.8 5.5 11.1 5.9 9.3 Real growth by sectors Industry % over prev. year 3.2 -2.5 8.4 7.7 4.0 11.4 Agriculture % over prev. year -12.0 8.2 -1.4 10.3 -7.9 12.0 Construction % over prev. year 4.0 10.3 43.1 46.6 35.9 22.3 Price indexes GDP deflator 1996=100 130.5 137.5 145.8 150.6 163.2 175.9 Consumer prices (year average) 2000=100 100 104.7 110.5 115.8 122.4 132.5 Producer prices (year average) 2000=100 100 103.6 110.8 113.9 119.2 128.0 Investments GFCF3 % of nominal GDP 25.4 27.2 25.4 26.7 27.5 26.3 Net FDI4 inflow mln USD 131.7 109.9 163.3 336.3 489.5 537.3 Labour market Population mln 4.63 4.60 4.57 4.54 4.52 4.52 Labour force mln 2.05 2.11 2.10 2.05 2.04 Unemployment rate % 10.3 11.1 12.6 11.5 12.6 - Wage Average nominal wage GEL 72.5 82.6 99.1 101.5 116.4 - %, over prev. year 7.1 13.9 20.0 2.4 14.7 - Average real wage %, 1997=100 56.5 61.4 69.8 68.3 60.8 - Living standard Level of poverty % population 51.8 51.1 52.1 54.5 52.0 - Depth of poverty 20.2 19.3 19.8 21.1 20.0 - Severity of poverty 10.7 9.9 10.3 11.2 10.6 - National accounts Household consumption % of nominal GDP 89.4 78.6 77.0 71.6 72.8 66.9 Government consumption % of nominal GDP 8.5 9.6 9.8 9.8 14.0 18.5 Gross capital formation % of nominal GDP 26.6 28.3 26.4 27.8 28.3 26.8 Net exports % of nominal GDP -16.7 -14.4 -13.2 -14.6 -16.6 -17.8 Government finance Revenue mln GEL 639.4 740.3 905.2 933.2 1705.9 2607.5 Expenditure mln GEL 833.9 906.4 1049.4 1207.1 1930.2 2616.5 Deficit(-) or Surplus (+) mln GEL -194.5 -166.1 -144.2 -273.9 -224.3 -9.0 Financing of deficit Domestic % of deficit 77.4 13.5 17.7 34.2 8.9 398.0 Foreign % of deficit 22.6 86.5 82.3 65.8 91.1 -298.0 Total Debt mln GEL 4192.5 4449.5 4843.3 4608.1 4306.6 4076.0 Domestic % of debt 35.7 33.5 31.4 34.0 36.6 37.7 Foreign % of debt 64.3 66.5 68.6 66.0 63.4 62.3 Monetary indicators M2 (year-end) mln GEL 382.1 403.8 462.3 527.4 846.1 1069.9 Velocity of money (M2) 19.53 17.89 17.78 16.05 11.78 10.83 Deposit rate** % per annum 12.2 11.1 11.4 10.6 9.5 8.7 Lending rate*** % per annum 25.3 24.0 23.1 21.6 20.2 17.9 Treasury bill rate % per annum 17.14 29.93 43.42 44.26 19.66 12.57

15 2000 2001 2002 2003 2004 2005 Balance of payments Current account mln USD -161.2 -211.4 -197.6 -369.5 -346.9 -688.8 Capital account mln USD -4.8 -5.2 17.6 19.9 40.8 59.6 Financial account mln USD 92.1 218.7 222.2 356.3 483.3 729.0 Net errors and omissions mln USD 53.8 44.8 -4.5 -23.6 1.3 11.8 Overall balance mln USD 20.0 -46.9 -38.5 17.6 -178.5 -111.6 External economic position Gross international reserves mln USD 109.7 159.9 198.4 191.6 383.7 474.1 Import. coverage (month) 1.4 1.8 2.3 1.6 2.3 2.1 Exchange rate (year average) USD/GEL 1.9759 2.0723 2.1945 2.1459 1.9168 1.8126 Real effective exchange rate %, 1995=100 110.2 108.2 102.7 94.9 107.0 110.3 Terms of trade (year-and) 1995=100 yoy 99.5 97.8 96.9 97.7 99.0 - NPV8 of external debt % of nominal GDP 38.9 37.1 37.5 34.1 31.3 - Foreign debt service % of total exports 9.1 6.3 5.0 4.6 6.5 5.0

Source: Department for Statistics, Ministry of Economic Development; Ministry of Finance; National Bank of Georgia Note: *The figures above based on the data revised by the Department for Statistics in March 2006, therefore these figures differ from those published in previous edition of Georgian Economic Trend, December 2005 ** the numbers of deposit rate reflect weighted average rates on time deposits denominated in domestic and foreign currency *** the numbers of credit rate reflect weighted average rates on short term (up to one year) and long term (over the one year) credits denominated in domestic and foreign currency Acronyms used: 1.GFCF -Gross Fixed Capital Formation 2.FDI - Foreign Direct Investments 3.NPV- Net Present Value

16 1. Gross domestic Product and real sector Table 1: Nominal and real Gross Domestic Product (GDP)*

Change in real Nominal GDP Share of Rela GDP Share of Share of Real GDP GDP compared (mln GEL operating GDP deflator per capita labour cost net taxes (in 1996 to last year’s in current surplus (1996=100) (in 1996 (%) (%) prices) corresponding prices) (%) prices) period (%) 2000 6043.1 27.6 64.9 7.5 130.5 4618.2 1.8 992.4 2001 6674.0 25.2 66.9 7.9 137.5 4840.1 4.8 1047.9 2002 7456.0 22.3 69.6 8.2 145.8 5105.0 5.5 1113.2 2003 8564.1 20.3 72.1 7.6 150.6 5669.6 11.1 1244.5 Q 1 1806.6 22.0 70.5 7.5 147.2 1225.1 5.6 268.3 Q 2 2109.4 20.4 72.0 7.6 152.0 1385.3 11.9 303.8 Q 3 2247.4 21.3 71.1 7.6 152.1 1475.2 10.4 324.0 Q 4 2400.7 18.1 74.2 7.7 151.3 1584.0 15.6 348.4 2004 9824.3 20.7 69.5 9.9 163.2 6001.8 5.9 1323.3 Q 1 2021.5 24.9 67.2 7.9 154.8 1302.5 6.3 286.9 Q 2 2431.0 20.5 70.1 9.4 163.4 1487.0 7.3 327.8 Q 3 2575.2 19.7 69.5 10.7 166.0 1551.3 5.2 342.1 Q 4 2796.6 18.7 70.5 10.8 168.4 1661.0 4.9 366.5 2005 11591.8 19.8 68.3 11.9 175.9 6562.8 9.3 1451.5 Q 1 2414.1 21.6 67.1 11.3 175.0 1375.3 5.6 303.9 Q 2 2820.2 21.6 66.5 12.0 171.0 1644.0 10.6 363.5 Q 3 3057.4 19.4 68.0 12.6 175.7 1734.7 11.8 383.7 Q 4 3300.1 17.3 70.9 11.8 181.9 1808.8 8.9 400.3 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations Note: * This and other tables are based on data verified by the department for statistics in March, 2006 According to the latest official data, real GDP still showed a high annual growth rate in Q4, 2005, though it was somewhat lower than the 2005 indicator. This can be explained by higher growth rates in the second and third quarters. The relatively high growth rate of GDP in the reviewed period was mainly determined by the increase in domestic demand on the part of households and the government, as well as exports. This demand was met by using spare capacities available in the economy and by increasing labour productivity (added value per employee). Labour productivity in 2005 reached GEL 4859 in current prices, while its real growth was 18.3 percent. Given a stable Lari exchange rate and a moderate rise in prices, the increase in output became possible thanks to investments in fixed capital assets. GDP structure by production did not change much in Q4, 2005 compared to last year’s corresponding period. The share of produced goods and services at basic prices decreased by just 1.7 percentage points, including a decrease in agriculture by 1, in industry by 0.6, and in services by 0.1 percentage point, while the share of net taxes on products (VAT, excise and customs duties minus subsidies) increased by 2.2 percentage points. The rise in consumer expenditure by households and the government as well as an in external demand, resulted in an impressive increase in real supply. Real annual growth of industry, agriculture and construction in the accounting period well outstripped annual GDP growth rate, with some service spheres increasing as many as 6 times. In particular, the real annual growth in the communications sectors comprised 44.8 percent and in the sphere of financial intermediation - 95.3 percent. (%1TUSVDUVSFCZQSPEVDUJPO

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2 2 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations An upward trend in the area of financial intermediation was determined by increased revenues to commercial banks due to the growth of deposits and of the volume of credits to economy. The rapid growth in the communications sector was achieved through enhanced use of electronic and cellular phone networks and internet communications.

17 Compared to the same period in 2004, the reviewed period saw a decrease in GDP share of agriculture, industry, trade and transport on the one hand, and on the other, an increase in GDP share of construction, financial intermediation and net taxes, which can be explained by the growth of business activity in construction and financial services and further improvement of fiscal efficiency. Table 2: Contribution of selected sectors of the economy to GDP real change 2005, Q4

Change to last year Contribution to GDP Contribution to GDP real

corresponding period (%) real change (%) change (percentage points) Agriculture 11.4 1.9 20.8 Mining -7.0 -0.1 -0.6 Manufacturing 22.0 1.8 19.9 Energy -1.2 0.0 -0.4 Household production 10.8 0.4 4.9 Construction 20.1 1.6 18.0 Trade -3.7 -0.5 -5.3 Hotels and restaurants 5.9 0.2 1.7 Transport 3.5 0.3 3.7 Communications 44.8 1.8 19.4 Financial intermediation 95.3 1.3 13.8 Real estate 21.4 1.2 13.6 Public administration -23.6 -1.4 -15.4 Education 16.2 0.6 6.1 Health care 6.1 0.2 2.5 Other social services 8.5 0.2 2.7 Hired employment in household 47.6 0.0 0.5 FISIM 89.3 -0.7 -7.6 GDP at Basic Prices 9.6 8.7 97.8 Taxes 1.4 0.1 1.4 Subsidies -12.5 0.1 0.8 GDP at Market Prices 8.9 8.9 100.0 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations It is noteworthy that in terms of GDP by expenditure in the accounting period the economy continued to be oriented on consumption (about 81.2 percent of GDP) and dependent on imports (about 57.2 percent of GDP accounts for imports against a 35 percent GDP share of exports). In Q4, 2005 the volume of household and government services continued to increase and their nominal annual growth rate comprised 4.6 percent and 34.1 percent respectively. At the same time, the growth rate of household consumption costs, if revised according to CPI, is moderate against the high growth rate of real GDP, especially, against indicators of selected GDP sectors. There are some discrepancies in the accounting period as well as in previous periods between the GDP volume calculations made according to production and expenditure meth- ods. The annual increase in fixed capital formation comprised 15.3 percent in nominal terms in the accounting period. Its share in GDP totaled 27.1 percent, thus exceeding the previous quarter indicator by 0.2 percentage points. Investment activity stepped up thanks to projects in the energy and communications sectors. At the same time, investment in agriculture and industry was less dynamic because of the relatively difficult entrepreneurial environment and high risks. Due to a 35.8 percent annual increase in demand on imports in Q4, 2005, which can be largely explained by seasonal factors, a nominal annual growth rate of exports was 5.4 percentage point lower than that of imports. Further improvements in fiscal administration in Q4, 2005 allowed the sustainment of growth of net taxes in the income structure of GDP. Their annual growth comprised 28.1 percent. However, the relatively low GDP share of net taxes (11.8 percent) is indicative of existing reserves in fiscal administration. The share of labour costs in GDP for the reviewed period was quite small at 17.3 percent. (%1CZJODPNF 2

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Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations 18 In Q4, 2005, an increase was observed in such aggregate indicators of the national accounts as the Gross Na- tional Income (GNI) and Net National Disposable Income. The annual growth of GNI comprised 17 percent and showed a 7.8 percent increase compared to the previous quarter. The growth of Net National Disposable income showed a 13.5 percent increase compared to last year’s corresponding period and totaled GEL 3250.9 million. A reduction in the unobserved segment of total output continued in the accounting period. The share of the shadow economy decreased by 2.3 percentage points compared to the previous year’s corresponding period. The share of the unobserved segment is quite high in the spheres of utilities and social services (49.7 percent), health care (49 percent), real estate (41.1 percent), hotels and restaurants (45.1 percent), construction (41.1 percent) and trade (33.8 percent). Table 3: Indicators of industry

Real value added Share of value added in industry Value added in in industry at basic Index of at current basic prices (%) industry at current prices industry basic prices (% changes over the Energy (1996=100) (mln GEL) same period of the Mining Manufacturing production and Other previous year) distribution 2000 1044.2 107.9 3.2 3.9 49.5 25.2 21.4 2001 1111.0 105.2 -2.5 3.4 46.4 23.1 27.1 2002 1315.8 114.0 8.4 3.8 47.5 23.7 25.0 2003 1515.3 122.8 7.7 5.0 49.2 21.4 24.4 Q1 289.2 90.4 -4.2 4.3 40.3 32.5 22.9 Q2 347.4 112.9 7.9 4.8 55.8 19.3 20.0 Q3 416.1 133.2 5.8 5.2 52.6 16.0 26.2 Q4 462.6 154.8 17.9 5.3 46.9 20.7 27.1 2004 1581.8 127.8 4.0 4.9 50.8 19.2 25.1 Q1 328.3 103.2 14.1 4.9 46.5 27.0 21.6 Q2 371.3 119.7 6.0 5.0 56.1 18.7 20.1 Q3 407.2 129.1 -3.1 5.1 51.8 14.1 29.0 Q4 475.0 159.1 2.8 4.5 48.8 18.7 28.0 2005 1809.1 142.4 11.4 4.7 54.8 18.0 22.5 Q1 376.2 111.4 8.0 5.0 51.5 24.2 19.3 Q2 416.6 130.3 8.9 4.8 58.3 18.4 18.5 Q3 475.1 145.8 12.9 4.7 55.7 14.2 25.3 Q4 541.2 181.9 14.3 4.5 53.6 16.7 25.2 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations Real annual growth of industry comprised 14.3 percent in Q4, 2005. The share of industry in nominal GDP continued to decrease, albeit slightly, due to relatively low price increases in this sector against the backdrop of higher real growth compared to total GDP. The dynamics of fields of industry was asymmetric in the reviewed period. Manufacturing which is the largest segment of industry, increased by 22 percent in annual terms. As domestic demand grew, there was a significant increase in food processing. The production of alcoholic beverages grew speedily during the year, mainly due to an increase in exports. Other manufacturing showed quite dynamic growth, namely production of ferroalloy, construction materials and timber processing. The utilization of spare capacities and an increase in labour productivity still continued to favour the growth of this sector. In contrast to the impressive increase in manufacturing, mining was still in a grave situation showing a 7.1 percent decrease in Q4, 2005 as compared to the last year’s corresponding period. Lack of investment, depreciated capacities and difficult financial state still impeded the development of this sector. 3FBMJOEVTUSJBMQSPEVDUJPOBUCBTJDQSJDFT

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Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations The decrease, albeit much insignificant, was observed in the field of electricity, natural gas and water generation and distribution in the corresponding period. Moreover, the reduction in added value in this field was not

19 caused, unlike the mining industry, by fundamental economic factors, which is proved by a 5 percent real annual growth in 2005. In Q4, 2005, compared to the same period last year, the products processed in households enhanced by 10.8 percent in real terms, which is traditionally in close relation with the agricultural dynamics. Table 4: Indicators of agriculture

Value added in Real value added in ag- Share of value added in agriculture agriculture at Index of riculture at basic price at current basic prices (%) current agriculture (% changes over the Animal basic prices (1996=100) same period of the Plant growing Other (mln GEL) previous year) husbandry 2000 1245.0 91.3 -12.0 43.2 45.6 11.2 2001 1399.0 98.8 8.2 46.7 44.2 9.1 2002 1434.6 97.3 -1.4 46.7 47.3 6.0 2003 1653.0 107.4 10.3 46.9 41.0 12.1 Q1 406.1 108.3 9.2 27.4 62.5 10.1 Q2 453.0 114.6 12.7 51.7 39.5 8.8 Q3 396.2 98.2 6.4 63.1 33.4 3.5 Q4 397.6 108.5 13.0 45.1 50.7 4.2 2004 1610.7 99.0 -7.9 44.4 46.6 9.0 Q1 344.1 84.7 -21.8 29.2 52.6 18.2 Q2 471.5 114.7 0.1 48.4 42.1 9.5 Q3 420.7 100.0 1.8 50.8 46.0 3.2 Q4 374.4 96.4 -11..2 45.9 47.5 6.6 2005 1717.7 110.8 12.0 46.9 45.3 7.8 Q1 465.2 101.0 19.2 31.0 56.5 12.5 Q2 461.6 117.8 2.7 50.2 40.5 9.3 Q3 382.1 117.2 17.2 62.5 33.8 3.7 Q4 408.9 107.4 11.4 46.8 48.8 4.4 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations Real added value in agriculture increased by 11.4 percent in Q4, 2005 compared to the same period last year, and by 12 percent during the year. Such an upward movement can be partially explained by low basic indicators of the sector’s development in 2004. "HSJDVMUVSFQSPEVDUJPOBUCBTJDQSJDFT

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2 2 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations It should also be taken into account that the verification of statistical data resulted in changes to 2004-2005 quarterly indicators. Nevertheless, some positive moves took place in this leading sector of the economy despite its obsolete infrastructure, outdated material-technical basis and lack of working capital.

20 Table 5: Indicators of transport and communications

Value added in Index of Real value added in transport & Structure of value added in transport transport and transport & communications at basic prices and communications at current basic communications communication (% changes over the same prices (%) at current basic prices (1996=100) period of the previous year) (mln GEL) Transport Communication 2000 858.8 239.9 13.1 82.4 17.6 2001 911.1 243.3 1.4 79.6 20.4 2002 1057.4 264.6 8.7 79.3 20.7 2003 1187.5 286.9 8.4 74.2 25.8 Q1 254.7 246.3 13.3 75.1 24.9 Q2 296.9 290.6 10.3 76.6 23.4 Q3 315.0 304.5 8.2 73.7 26.3 Q4 320.8 306.2 3.4 71.6 28.4 2004 1313.2 303.6 5.8 71.0 29.0 Q1 281.4 260.7 5.8 69.6 30.4 Q2 312.2 286.1 -1.5 70.0 30.0 Q3 365.6 339.1 11.4 71.5 28.5 Q4 353.9 328.6 7.3 72.3 27.7 2005 1462.5 333.6 9.9 67.7 32.3 Q1 296.9 272.1 4.4 66.0 34.0 Q2 359.6 335.5 17.3 68.8 31.2 Q3 400.5 363.5 7.2 67.7 32.3 Q4 405.6 363.3 10.5 68.1 31.9 Source: Department for Statistics of the Ministry of Economic Development and GEPLAC calculations Real annual growth in the transport sector comprised 3.5 percent in the reviewed period, which given the transit potential of Georgia is a very low indicator. The reason is the reduction of added value in overland transport, caused by the rise in oil prices. Besides, cargo handling and storing indicators showed an improvement and auxiliary transport services and the tourist business expanded. Unlike transport, high growth was observed in the communications sector. The added value created in this sector went up by 45 percent compared to the previous year’s corresponding indicator. Cellular communication and use of internet grew on a large scale. Irrespective of the high growth in the communications sector, the price of services decreased by almost 10 percent thanks to the introduction of new technologies and cuts in operational costs. Table 6: Indicators of construction

Real value added in construction at Value added in construction at Index of basic prices current basic prices construction (% changes over the same period of (mln GEL) (1996=100) the previous year) 2000 224.7 167.3 4.0 2001 259.6 184.6 10.3 2002 379.5 264.2 43.1 2003 547.4 387.3 46.6 Q1 63.7 185.4 7.8 Q2 128.5 362.1 67.6 Q3 150.4 422.8 38.6 Q4 204.8 578.7 59.1 2004 793.2 526.3 35.9 Q1 151.6 419.0 126.0 Q2 170.1 437.5 20.8 Q3 223.5 592.0 40.0 Q4 248.0 656.8 13.5 2005 1015.3 643.7 22.3 Q1 105.1 278.6 -33.5 Q2 228.5 628.6 43.7 Q3 346.1 878.4 48.4 Q4 335.7 789.0 20.1 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations In Q4, 2005, compared to the same period in 2004, real growth of added value in construction comprised 20.1 percent, thus being 2.2 percentage points less that the 2005 indicator. Growth was mainly determined by the implementation of state programmes on infrastructure development, including the construction and rehabilitation of roads, educational and health care facilities, which received significant budget allocations. Individual housing development was also carried out on a wide scale and was mainly financed through bank loans. The volume of loans to this sector increased by 69 percent, reaching GEL 75 million by the end of 2005 as compared to the same period in 2004. The construction works in large energy projects did not show a significant reduction despite the completion of the Baku-Tbilisi-Ceyhan oil pipeline. It should also be noted that following the verification of statistical data construction indicators suggest a relatively faster development of the sector than in previous times.

21 Table 7: Indicators of trade, hotels and restaurants

Real value Value Real value Value added added in hotels added in added in trade Structure of value added in hotels & Index of & restaurants trade at Index of at basic prices in hotels & restaurants restaurants hotels & at basic prices current trade (% changes at current basic prices at current restaurants (% changes basic (1996=100) over the same (%) basic prices (1996=100) over the same prices period of the (mln GEL) period of the (mln GEL) previous year) previous year) Hotels Restaurants 2000 762.3 119.4 10.8 141.1 165.1 8.2 19.7 80.3 2001 871.0 129.9 8.8 192.1 220.9 33.7 46.2 53.8 2002 956.2 135.0 3.9 218.6 237.5 7.6 35.2 64.8 2003 1137.6 151.3 12.1 244.9 271.2 14.2 30.9 69.1 Q1 239.0 128.9 -5.6 49.7 227.5 4.2 48.9 51.1 Q2 279.0 149.2 19.1 48.8 207.1 -15.5 35.9 64.1 Q3 290.0 156.8 11.3 80.7 358.8 34.7 18.8 81.1 Q4 329.6 170.1 24.1 65.8 291.2 32.3 28.4 71.6 2004 1247.2 163.6 8.2 266.2 279.8 3.2 24.5 75.5 Q1 247.6 131.4 1.9 67.3 286.4 25.9 31.4 68.6 Q2 309.3 164.3 10.1 61.1 254.7 23.0 18.7 81.3 Q3 317.1 171.3 9.2 64.6 269.2 -25.0 23.1 76.9 Q4 373.2 187.6 10.3 73.2 308.9 6.1 24.2 75.8 2005 1315.7 169.2 3.4 328.2 325.7 16.4 29.5 70.5 Q1 292.6 148.3 12.9 69.8 303.9 6.1 29.9 70.1 Q2 327.5 180.7 10.0 85.8 369.2 45.0 31.7 68.3 Q3 336.0 167.3 -2.3 83.5 303.2 12.6 23.6 70.4 Q4 359.5 180.6 -3.7 89.0 326.6 5.7 27.1 72.9 Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations The situation was different in the trade sector, where the yearly drop comprised 3.7 percent in Q4, 2005. This was mainly due to high basic indicators by the end of 2004. There was a reduction of added value in the retail (except the retail fuel trade) as well as wholesale trade. 5SBEF IPUFMBOESFTUBVSBOUTFSWJDFBUCBTJDQSJDFT

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Source: Department for Statistics, Ministry of Economic Development and GEPLAC calculations The reviewed period saw a 5.9 percent increase in a hotel and restaurant services. Added value in the hotel sector was higher compared to that in the restaurant sector but due to a higher share of the latter, restaurants contributed more to the increase of total added value of the sector. It should be underlined that the verification of statistical data caused significant corrections in the indicators of this sector.

22 2. Public Finance Table 8: Consolidated Budget Revenues

GDP %

Total tax revenue (mln GEL) VAT duty Total (mln GEL) revenue Total tax Total Customs Profit tax revenues Social tax Income tax Total revenues Total Excise duty

2000 905.2 854.3 15.0 14.�1 4.6 1.3 1.5 1.8 0.9 2.1 2001 1033.9 954.7 15.�5 14.�3 5.2 1.0 1.3 2.0 0.8 2.1 2002 1135.3 1054.7 15.2 14.1 5.4 1.1 1.2 1.9 0.8 1.7 2003 1272.7 1186.6 14.9 13.9 4.8 1.2 1.2 1.8 0.8 2.1� Q1 295.1 269.8 16.3 14.9 6.1� 1.2 1.0 1.7 0.8 2.3 Q2 309.9 296.9 14.7 14.1 4.8 1.4 1.2 1.8 0.9 2.0 Q3 349.8 331.2 15.6 14.7 5.3 1.2 1.1 1.8 0.9 2.2 Q4 317.9 288.7 13.2 12.0 3.2 1.0 1.4 2.0 0.7 2.0 2004 2102.0 1827.6 21.�4 18.�6 6.4� 1.6 1.6 2.7 1.0 3.0 Q1 391.2 328.6 19.�4 16.�3 5.1� 1.7� 1.4� 2.6� 0.7� 2.9 Q2 511.5 445.2 2��1.0 1��8.3 6.1� 2.0 1.6 2.6 1.0 2.8 Q3 562.8 501.0 2��5��.0 19.�5 7.0� 1.5 1.7 2.6 1.1 3.0 Q4 636.5 552.8 22.�8 19.�8 7.0 1.4 1.8 3.0 1.2 3.3 2005 3152.7* 2411.5 27.2 20.8 8.5 1.8 2.4 2.5 1.1 3.7 Q1 618.2* 471.1 2��5��.6� 19.�5 8.1 1.8� 2.2 2.8� 1.0 3.1� Q2 831.3* 566.0 2��9��.5� 20.1 8.2� 2.1� 2.7 2.4 1.0 3.1 Q3 784.6* 655.2 25.�7 2��5��.7� 8.4� 2.1 2.7 2.4 1.2 3.9 Q4 918.6* 719.2 27.8 21.8 9.2 1.4 2.3 2.6 1.1 4.5 Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations Note * verified data Revenues and grants mobilized in the consolidated budget in Q4, 2005 were 22.5 percent higher than in the previous quarter, and 52.8 percent higher than in the corresponding period last year. This can be explained by higher tax collections than targeted and the increase in amounts from capital transactions. Total actual revenue exceeded the target by 36 percent in the accounting period and made up 27.8 percent of the GDP. It exceeded last year’s corresponding indicator by 5 percentage point, thus reflecting the further growth of fiscal efficiency. The significant increase in tax revenues continued in Q4, 2005. Quarterly growth of this indicator comprised 9.7 percent while annual growth was 30.1 percent. VAT and social tax shares in total tax revenues increased by 7.1 percentage points and 3.9 percentage points respectively, as compared with the previous year’s corresponding indicator. Income and profit tax shares decreased by 3.4 percent and 0.4 percent. VAT remains the major source of tax revenue. Compared to the previous quarter, VAT revenues in Q4, 2005 grew by 18.9 percent and compared to the corresponding period in 2004 - by 56.2 percent. Revenue from VAT on imports was almost twice as much as VAT on sales and services on the territory of Georgia. The social tax, with it rate decreased from 31 to 20 percent under the new Tax Code, still represented an important revenue source. The share of this tax in consolidated budget revenues increased by 25 percent in the reviewed period compared to the third quarter and by 60.9 percent compared to the same period last year. Affected by seasonal factors, income tax revenues increased significantly (by 18.7 percent) in Q4, 2005 as compared with the previous quarter. However, the annual increase in revenues from this tax comprised a mere 0.1 percent, which resulted from the introduction of a 12 percent flat rate instead of differentiated rates, on the one hand, and on the other, from a significant reduction of public sector employees. Excise revenues collected in the accounting period were 47 percent higher than in Q4, 2004 and 6.8 percent lower than in the previous quarter, which is the result of a decrease in local beer and tobacco output as well as filtered cigarette imports at the end of the year. Profit tax revenues in the consolidated budget increased by 14 percent in Q4, 2005 compared to the previous year. However, compared with the previous quarter, this indicator decreased by 28.1 percent. This can be explained by a drop of construction and household’s mixed income. Increased imports and improvements in customs administration led to an increase in customs revenues that showed a quarterly growth of 5.7 percent in the reviewed period and an annual growth of 11.1 percent. Other tax revenues were 21.2 percent less in Q4, 2005, compared to the previous quarter, and 42.8 percent less compared to the previous year, which can largely be explained by the reduction of the number of taxes under the new Tax Code.

Total revenues include tax and non-tax revenues as well as revenues from capital transactions. 23 4IBSFPGTFMFDUFEUBYFTJO$POTPMJEBUFE#VEHFU5BY3FWFOVF 2

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Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations Q4, 2005 saw a drop in non-tax revenue collections by 11.4 percent compared to the previous quarter and by 6.8 percent compared to the corresponding period last year. This mainly resulted from the reduction of revenues received from government loan interest and the return of issued credits. Revenues raised from capital transactions in the accounting period were 3.2 times more than in the previous quarter and 1.8 times more than in the same period last year. An important factor contributing to the growth of capital revenues was the wide-scale privatization carried out in the country. The proceeds from the privatization of state owned buildings, machinery and equipment was USD 46.3 mln in Q4, 2005. In total in 2005, the consolidated budged received GEL 412.6 mln (USD 227.6 mln) as proceeds from privatization, thus exceeding the same indicator for the previous year by 5.7 times.

$POTPMJEBUFT#VEHFU3FWFOVF4USVDUVSF 2

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Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations Compared to the previous quarter, the amount of grants from abroad in Q4, 2005 increased by 4.2 times, while compared to last year’s corresponding period decreased by 34.5 percent. Most of these amounts were received from Germany, World Bank and EBRD in the form of on-going grants. Table 9: Consolidated Budget Expenditures

% to GDP - Total - - expenditures, - tion and care mln GEL debt Total Total tures Gen social safety Social Health service service Educa Foreign der and security security expendi Defence, public or eral state

2000 1126.5 18.�6 2.2 1.7 2.2 0.6 3.4 2001 1237.9 18.�5 3.1 2.0 2.1 0.8 2.9 2002 1409.5 18.9 3.5 2.0 0.9 2.2 0.9 3.0 2003 1522.1 17.8 3.1 1.9 0.9 2.1 0.4 4.0 Q1 334.4 18.5 3.1 3.4 1.3 2.2 0.4 3.9 Q2 364.3 17.3 2.8 1.8 0.6 2.1 0.4 4.0 Q3 430.7 19.�2 3.3 2.2 0.6 2.2 0.4 4.6 Q4 392.7 16.4 3.1 1.6 1.0 1.9 0.3 3.7 2004 2412.2 24.�6 3.6 4.4 0.5 2.9 1.0 4.7 Q1 417.5 20.�7 4.4 2.9 0.6 2.1 0.4 4.2 Q2 516.9 2��1��.3� 3.0 3.1 0.6 3.2 0.5 5.1 Q3 576.1 22.�4 3.4 4.0 0.4 2.5 0.9 4.5 Q4 901.7 3��2��.2� 3.7 6.8 0.4 3.1 1.9 5.0 2005 3280.8 28.3 3.1 5.9 0.3 2.5 1.8 5.4 Q1 621.2 25.�7 3.2 5.5 0.5 2.2 1.4 6.4 Q2 773.4 27.�4 2.5 5.4 0.3 2.1 1.7 6.0 Q3 827.8 27.�1 2.8 5.7 0.2 2.4 1.8 4.8 Q4 1058.4 32.1 4.8 6.8 0.4 3.1 2.0 4.6 Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations 24 The quarterly growth of consolidated budget expenditures reached 27.9 percent in the accounting period, while the annual growth was 17.4 percent. 74.4 percent of that accounted for expenditures from the central budget and 25.6 percent accounted for those from local budgets. Social insurance and social security expenditures increased by 6.1 percent compared to Q3, 2005 and by 5.7 percent compared with last year’s same period. They were mainly used to finance pensions, allowances for internally displaced people and refugees, programs for the alleviation of poverty, social protection of unemployed and improvement of employment opportunities. The financing of pensions remained one of the priority areas of social expenditures in Q4, 2005. The state program “Pension 2005” was completed, which was designed to develop a database of pensioners. All pension arrears of previous years were paid off. Regressive pensions were fully covered through annual budgetary allocations. The quarterly growth of health care financing in the accounting period comprised 70.5 percent, while the yearly growth comprised 12.2 percent. These amounts were mainly spent on state programs for medical-social expertise and in-patient and out-patient assistance to the population. The financing for the defence sphere was quite substantial for the reviewed period. It increased by 42.2 percent compared to the previous quarter and by 60.5 percent compared to the corresponding period in 2004. The largest portion of funds was spent on the improvement of the structure of military forces, training of reserves and military training programs. A significant increase was also observed in expenditures allocated for general state service in Q4, 2005. It increased almost 1.4 times compared to the previous quarter and by 10.6 percent compared to the same period in 2004. These amounts were used mainly to improve the coordination of the executive authority, to regulate economic processes, to support the development of civil society and to finance regional development projects. The financing of public order and security in Q4, 2005 decreased by 20.1 percent compared to the previous year’s same period, which can be explained by the fact that 40 percent of all expenditure planned for 2004 was financed in the fourth quarter. However, the quarterly growth of this expenditure was 20.6 percent. The largest portion of these funds was used to finance improvements in the border guard service and measures against crime. Expenditure for education was 70.5 percent higher in Q4, 2005 than in the third quarter and 12.2 percent higher than in Q4, 2004. They were mainly spent on the improvement of education system management, the development of a national evaluation system and national curricula, general knowledge programs and projects on reform- ing and reinforcing professional higher education. Those expenditures, which do not fall under main categories, almost doubled in Q4, 2005 compared to the previous quarter. This was mainly caused by an increase in transfers to various public administration levels and in costs of government liabilities’ service. However, these expenditures decreased by 31.1 percent if compared with the corresponding period in 2004, which can be explained by allocating 8.2 percent less funds for these expenditures in 2005 than in 2004. It should be noted that in the accounting period, transfers from the central budget to local budgets increased by 26.9 percent compared to the previous quarter and 2.2 times compared to the previous year’s corresponding period. $POTPMJEBUFE#VEHFU&YQFOEJUVSFT$PNQPTJUJPO 2

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Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations. The state debt was GEL 4,076 million at the end of the year, thus comprising 35.2 percent of GDP and showing a significant 8.6 percent - decrease compared to the previous year. 62.3 percent of the state debt accounted for foreign debt, while the remaining 37.7 percent – for domestic debt. By the end of 2005, as compared to the end of 2004, domestic debt decreased by 2.5 percent, which must be the result of the annual growth of expenditures on debt service. The largest share of the domestic debt comprises the amount of indexation of those accounts, which Georgia’s population deposited to former state commercial banks (32.4 percent) and the government’s debt to the NBG (30.9 percent). Regressive pension – compensation of an injury sustained in the line of duty. 25 Due to the increase in budgetary revenues and over-performing revenue targets the foreign debt service increased by 19.4 percent in the accounting period as compared with last year’s same period and by 2.2 times as compared with the previous quarter. The debt burden indicator in 2005 was about 35 percent of the GDP (of which 13 percent of GDP accounted for domestic debt and 22 percent for foreign debt), which does not pose a serious threat to economic development. It is also noteworthy that the limit of the foreign debt service does not exceed 20 percent of the annual export revenues. The alleviation of the country’s foreign debt burden can be mainly explained by the increase in budgetary tax revenues, the growth of expenditures on debt service and the restructuring of a large portion of foreign debt in Paris Club in 2005. Table 10. Budget Balance

Balance Balance Balance deficit (-) preficit (+) (expenditure %) (GDP %) 2000 - 207.0 18.4 3.4 2001 - 155.9 12.6 2.3 2002 - 251.6 17.9 3.4 2003 - 201.3 13.2 2.4 Q1 - 38.1 11.4 2.1 Q2 - 49.8 13.7 2.4 Q3 - 67.4 15.6 3.0 Q4 - 46.0 11.7 1.9 2004 - 288.4 12.0 2.9 Q1 - 25.0 6.0 1.2 Q2 - 5.1 1.0 0.2 Q3 + 3.4 0.6 0.1 Q4 - 261.7 29.0 9.4 2005 - 24 0.7 0.2 Q1 + 7.5 1.2 0.3 Q2 +78.8 10.2 2.8 Q3 - 29.7 3.6 1.0 Q4 - 80.6 7.6 2.4 Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations The consolidated budget deficit reached GEL 80.5 million in the accounting period and comprised 2.4 percent of the GDP. The financing of the deficit was shared between domestic sources - 22 percent, and foreign sources – 78 percent. According to Q4, 2005 results the consolidated budget deficit increased 2.7 times compared to the previous period, while it decreased by 69.2 percent compared to the previous year’s corresponding period and comprised 7.6 percent of budget expenditures, which can be explained by the high level of budgetary revenue collections. %ZOBNJDTPG$POTPMJEBUFE#VEHFU3FWFOVFT &YQFOEVUVSFBOE%FGJDJU

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Source: Treasury Service, Ministry of Finance; Department for Statistics, Ministry of Economic Development and GEPLAC calculations The annual growth of total revenues and grants comprised 53.4 percent in 2005 compared to the previous year. With the 9.3 percent economic growth, the total revenues to the consolidated budget increased by 50 percent. Tax revenues showed a 31.9 percent increase. VAT and excise shares in total revenues increased by 6.5 and 3 percentage points. A significant growth was observed in non-tax revenues (1.2 times) and revenues from capital transactions (5.8 times). Moreover, the share of grants in consolidated budget revenues reduced: revenues from domestic sources increased by 2.4 percentage point while those from foreign sources decreased by 2.2 percentage points.

26 3. MONEY AND BANKING Table 11: NBG accounts (thousand GEL, end of period)

Banks’ deposits Real Cash NBG in- NBG Claims Balances Reserve Currency in ternational on General Balances on Index money�� (M1) circulation Required reserves Government correspondent (December reserves accounts 1995=100)* 2000 217 058 760750 391 737 329 157 38943 23636 2100 2001 332 861 749415 429 857 365 669 53300 10888 2256 2002 414573 766681 5089��69 417178 72228 19525 2442 2003 397636 795572 579��91�2 473242 81405 25214 2590 Q1 402166 758876 490559 398629 74104 17826 2296 Q2 396705 769985 505182 407710 84646 12827 2330 Q3 414106 786886 550281 445283 83477 21521 2558 Q4 397636 795572 579912 473242 81405 25264 2590 2004 700174 841414 836536 676158 92334 68045 3442 Q1 424325 815639 594008 466212 89946 32550 2527 Q2 527641 811349 655670 504188 74223 71259 2781 Q3 671522 816652 747390 600225 75342 71793 3252 Q4 700174 841414 836536 676158 92334 68045 3442 2005 851599 832849 1001451 811400 129833 60218 3890 Q1 699838 841691 809154 658218 97725 53211 3253 Q2 794216 841972 879314 694576 109141 75597 3513 Q3 802746 836230 933404 746508 122067 64829 3757 Q4 851599 832849 1001451 811400 129833 60218 3891 Source: the National�� Ba��nk�� of G��eorgia�� and GEPLAC calculations Note: * The real cash balances index is derived from dividing the indicator for currency in circulation by CPI (December 1995=100) for the corresponding period The dynamics of international reserves of the National Bank of Georgia (NBG) in the accounting period was again influenced by proceeds from the privatization of state assets and NBG’s foreign currency purchases at the Tbilisi Interbank Foreign Currency Exchange (TICEX). The proceeds from privatization were 46.3 million USD in Q4 2005, while net foreign currency purchases at TICEX - 18 million USD. At the same time, the NBG transferred 29 million USD as foreign debt service. As a result of these operations, the NBG’s international reserves for the accounting period were 474.1 million USD thus exceeding last year’s corresponding indicator by 22 percent and the Q3 2005 corresponding indicator by 6 percent. The NBG’s claims on General Government kept decreasing in Q4 2005 thanks to the over-performing of Bud- get revenues targets. Claims decreased by 0.4 percent compared to the third quarter and by 1 percent compared to the previous year’s corresponding period. A moderate growth of currency in circulation during the accounting period was still determined by NBG interventions at TICEX and changes in government deposits as well as by maintaining the money supply through monetary policy instruments. This indicator was 9 percent higher than the previous quarter indicator and 20 percent higher than the indicator for last year’s corresponding period. The growth of reserve money (M1) in Q4 2005 was influenced not only by the increase of currency in circulation but also the increase in commercial banks’ required reserves. The latter resulted from a significant intensifi- cation of intermediation by banks, which was expressed in the increase of their deposit liabilities. The required reserves of commercial banks placed with the NBG increased by 6 percent compared with the previous quarter and by 41 percent compared with the Q4 2004.

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27 As reserve money increased, amounts on commercial banks’ correspondent accounts in the NBG kept decreasing. This indicator in Q4 2005 fell by 7 percent while compared to Q4 2004 it fell by 11.5 percent. Since 2004 this trend has been largely influenced by the flow of budgetary means. Table 12: Commercial bank’s accounts (thousand GEL, end of period)

Deposits Share of Commercial Share of credits Net households banks’ credits to to non-budgetary foreign in national in foreign cur- in deposits economy sector (%) assets currency rency (%) 2000 430315 100��.00�� -12610 67094 235868 - 2001 489783 99.51 3708 54989 328606 42��.5� 2002 629486 98.93 25040 71478 401301 53��.5� 2003 785923 98.42 42456 85863 532989 60��.3� Q1 690352 98��.50�� 16080 75264 438014 57��.9� Q2 730829 98��.00�� 11889 75515 475695 65��.3� Q3 762747 98��.52�� 79285 93001 549498 60��.3� Q4 785923 98��.42�� 42456 85863 532989 60��.3� 2004 964917 99.97 54595 230104 665836 50��.5� Q1 726407 99��.33�� 85595 115454 570494 57��.0� Q2 739842 99��.74�� 66743 127018 589566 58��.3� Q3 875977 99.92 19311 173273 610244 54��.8� Q4 964917 99��.97�� 54595 230104 665836 50��.5� 2005 1730466 100.00 -231480 333611 841285 54.7 Q1 1070710 99��.98�� 20984 203870 684471 57��.2� Q2 1229399 99��.98�� -18482 253233 738697 58��.2� Q3 1431937 99��.98�� -22138 296225 825201 54��.0� Q4 1730466 100.00 -231480 333611 841285 54��.7� Source: the National�� Ba��nk�� of G��eorgia�� and GEPLAC calculations Increased lending by commercial banks continued into the accounting period. The quarterly growth of loans to private enterprises (excluding loans to other banks) comprised 23 percent and showed an 84 percent increase compared to the previous year’s corresponding period. The largest portion of issued loans accounted for trade and service, transport and construction. At the same time, the downward trend was observed in lending to industry. Its share in total loans made up 21 percent in Q4 2005, which is one percentage point less than the previous quarter’s corresponding indicator and 7 percentage points less than the same indicator for Q4 2004. The share of lending to agriculture comprised a mere 0.8 percent in the accounting period, showing a downward trend. Despite a drop in the growth rate of Lari supply during 2005, the amount of loans issued in the national currency increased in Q4 2005. It grew by 26 percent compared with the previous quarter, while loans issued in foreign currency increased by 23 percent. In Q4 2005 commercial banks’ loans to the economy in national currency increased by 200 percent compared to the corresponding period in 2004, while in foreign currency – by 66.7 percent. The accounting period saw an 88 percent increase in commercial banks’ foreign liabilities, which can be explained by credit lines received from foreign banks and international organizations. Much less increase – 16 percent - was observed in foreign assets. Consequently, net foreign assets of commercial banks increased sharply compared both to the previous quarter and the corresponding period in 2004. Along with the increase of total deposits in commercial banks, the increase in national currency deposits continued at a growing rate growing in the accounting period. The deposits in national currency grew by 13 percent compared to the previous quarter and by 45 percent compared to Q4 2004. The foreign currency deposits have increased respectively by 2 and 26 percent. All these led to the decrease of deposit dollarization indicator: in Q4 2005 it dropped by 1.9 percentage point and comprised 72 percent while, compared to the previous year’s same period, it dropped by 2.7 percentage point. Although total deposits of commercial banks grew in Q4 2005 the share of household deposits in it did not change; however, if compared with Q4 2004, it grew by 4 percentage points. And still, it showed a significant drop compared to 2003, which seems to be the result of decreasing share of savings in households’s total monetary income since 2004.

28 Table 13: Money aggregates (thousand GEL, end of period)

Money Outside Reserve Broad Money Broad Money Money Multiplier Money Velocity Banks Money (M2) (M3) (M0) (M1) M2 M3 M2 M3 2000 315007 391 737 382101 617969 0.98 1.58 19.53 11.67 2001 348850 429 857 403839 732445 0.94 1.70 17.89 10.23 2002 390787 508931 462265 863566 0.91 1.70 17.78 9.54 2003 441536 579912 527398 1060388 0.91 1.83 16.05 7.98 Q1 372834 490559 448098 886113 0.91 1.81 16.49 8.34 Q2 374885 505182 450400 926095 0.89 1.83 17.51 8.52 Q3 411735 550281 504736 1054234 0.92 1.92 16.19 7.75 Q4 441536 579912 527398 1060388 0.91 1.83 16.05 7.98 2004 615993 836536 846097 1511933 1.01 1.81 11.78 6.59 Q1 431144 594008 546598 1117092 0.92 1.88 18.24 8.92 Q2 467749 655670 594768 1184334 0.91 1.81 16.76 8.42 Q3 537663 747390 710937 1321181 0.95 1.77 14.02 7.55 Q4 615993 836536 846097 1511933 1.01 1.81 11.78 6.59 2005 736284 1001451 1069895 1911181 1.07 1.91 10.83 6.07 Q1 608555 809154 812425 1496897 1.00 1.85 14.27 7.74 Q2 636495 879314 889728 1628425 1.01 1.85 13.03 7.12 Q3 686116 933404 982341 1807542 1.05 1.94 11.80 6.41 Q4 736284 1001451 1069895 1911181 1.07 1.91 10.83 6.07 Source: the National�� Ba��nk�� of G��eorgia Broad Money (M2) showed a quarterly growth of 9 percent and an annual growth of 26.5 percent in the accounting period. The Broad Money (M3) aggregate grew by 6 percent and 26 percent respectively. Moreover, the quarterly and annual growth of M2 multiplier was still observed. This trend reflects the more intense use of Lari-denominated deposits by commercial banks for creating new money, which was facilitated by the moving of currency circulating outside banks towards banking channels and the increase of competition between banks. The growth of the real cash balances index also continued and reflected the increase in monetization of the economy in the national currency. However, the growth of this indicator in the accounting period was less than in Q3 2005. The velocity of M2 and M3 Broad Money also slackened. Table 14. Change in prices

Producer Price Change in Consumer Change in Core Consumer Price Index Index Price Index Inflation (%, as December 1995=100 December (%, as compared with compared with the (the latest month of 2000=100 the latest month of latest month of period) (the latest month of previous period) previous period)* period) 2000 156.7 4.6 0.9 100.0 2001 162.1 3.4 1.3 108.9 2002 170.9 5.4 0.5 111.3 2003 182.7 7.0 2.3 118.7 Q1 173.6 1.6 0.1 113.3 Q2 175.0 0.8 0.0 112.8 Q3 174.1 -0.5 0.0 114.4 Q4 182.7 5.0 2.1 117.3 2004 196.5 7.5 2.2 120.1 Q1 184.5 1.0 0.2 119.1 Q2 181.3 -1.7 -0.3 119.5 Q3 184.6 1.8 0.9 119.7 Q4 196.5 6.4 1.4 120.8 2005 208.6 6.2 3.0 130.1 Q1 202.4 3.0 0.6 129.8 Q2 197.7 -2.3 0.0 128.3 Q3 198.7 0.5 1.1 127.4 Q4 208.6 5.0 1.2 129.2 Source: The Department for Statistics, Ministry of Economic Development and the National Bank of Georgia Note: * The core inflation indicator mainly no longer includes exogenous factors and reflects the impact of monetary policy on the change in prices. Stable core inflation reflects the fact that the pursued monetary policy did not induce sharp change in consumer prices Consumer prices showed less fluctuation by month in the accounting period. In October it grew by 1.7 percent. A significant rise in prices for meat and sugar was observed, reflecting the increase in import price for these commodities. A seasonal rise in the price of some vegetables was also significant. Although October witnessed a little drop in prices on oil products, the significant rise in prices on this product in previous periods pushed the price on some transport services up. The 1.4 percent growth in consumer prices in November mainly resulted from seasonal increase in prices on some vegetables. At the same time, prices for separate transport and communications services decreased.

29 The dynamics of consumer prices in December was affected by seasonal factors. Prices rose on meat, cheese, dairy products and vegetables. A relatively insignificant increase was observed in prices on alcoholic beverages and tobacco products, fish, fruit and grapes as well as on public utilities and transport. In total, consumer prices went up by 1.8 percent in December 2005. At the same time, annual inflation in December 2005 (compared to December 2004) was just 6.2 percent, being the lowest indicator since 2002. .POUIMZ$1*BOE$PSF*OGMBUJPO

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Source: The department for Statistics, Ministry of Economic Development and the National Bank of Georgia All in all, the consumer price index significantly increased in the accounting period, though decreased compared with the previous year’s corresponding period. Price dynamics in 2005 were strongly affected by exogenous factors of which the rise in world prices on oil products and on some food products, sugar for example, should be singled out as primary reasons. The increase in excise rates on tobacco products and alcoholic drinks is also worth mentioning. A moderately strict monetary policy pursued against the background of the impact of exogenous factors resulted in an insignificant change in core inflation. It went up by 1.2 percent in Q4 2005 and was less than the Q4 2004 corresponding indicator (see Table 14). The growth of consumer prices was somewhat curbed by a significantly strengthened nominal exchange rate of Lari, which was caused by low real income and savings of households, and by a slackened velocity of money circulation. Nevertheless, the growth of consumer price index in 2005 determined the increase of average annual inflation up to 8.2 percent compared to 5.6 percent in 2004. The increase of producers’ prices was more moderate than that of consumer prices, though the increase was significant if compared with the previous year’s same period. This increase was caused by the overall increase of prices in mining and oil extracting industry, in metal, electricity, gas and water production. Table 15: Interest rates

Commercial Banks’ interest rates (annual weighted average) Money Market Money on loans on deposits Rate Market Rate (Foreign GEL Foreign Currency GEL Foreign Currency (GEL)* Currency)** Short- Short- Short- Short- Long-term Long-term Long-term Long-term term term term term 2000 - - 22 17 30 20 11 2 11 13 2001 - - 24 17 27 21 8 3 11 12 2002 24 16 25 16 25 20 11 12 11 12 2003 12 13 25 19 23 19 10 12 10 11 Q1 14 15 24 17 24 19 10 11 11 11 Q2 13 14 24 18 24 19 10 12 10 11 Q3 10 15 25 20 24 19 9 13 10 11 Q4 11 11 26 20 23 18 11 13 10 11 2004 8 8 27 20 22 17 8 12 9 11 Q1 17 11 27 20 23 18 10 13 9 11 Q2 16 8 29 19 23 18 8 13 9 11 Q3 6 7 27 20 22 17 7 12 9 11 Q4 6 7 25 21 22 17 7 12 8 11 2005 8 7 22 21 20 16 9 12 8 10 Q1 9 5 23 21 22 16 8 11 8 10 Q2 7 7 22 22 21 16 9 11 8 10 Q3 8 8 21 21 20 16 8 12 7 10 Q4 10 8 21 20 20 15 9 13 8 11 Source: The National�� Ba��nk�� of G��eorgia�� and GEPLAC calculations Note: * Money market interest rate in national currency includes an annual weighted average interest rate on up to 1 year maturity loans issued through Interbank Credit Auctions and bank to bank market ** Money market interest rates in foreign currency include an annual weighted average interest rate on up to 1 year maturity loans issued directly at the bank to bank market The accounting period saw an upward trend in interest rates on inter-bank loans issued in the national currency. The quarterly growth of currency market rates made up 2 percentage points, while the annual growth made up 4 percentage points. This change was caused by the increase in interest rates on up to 1 month maturity loans 30 at the Interbank Credit Auctions, thus reflecting the growth of demand on short-term liquidity. The interest rates on foreign currency loans have not actually changed. Interest rates on medium-term loans in foreign as well as national currencies remained the same in Q4 2005. Moreover, compared to Q4 2004, a significant drop in these rates was observed: the interest rate on medium-term national currency loans dropped by 4 percentage points, while that on foreign currency loans by 2 percentage points. Compared with the previous quarter, the interest rates on long-term loans both in national and foreign currency did not change in the accounting period. As compared with the corresponding period in 2004, the rates on these loans in foreign currency showed a significant 2 percentage point decrease, while in national currency – 1 percentage point. Interest rates on all types of deposits slightly increased in Q4 2005 compared with Q3 2005, while compared with Q4 2004, the increase was observed only with regard to deposits denominated in the national currency. The deposit rate in foreign currency did not actually change. The increase of accrued benefit in national currency by commercial banks is a significant factor for the increase of Lari-denominated deposits. Table 16: Exchange Rates and NBG Net Interventions

Nominal Exchange Rate Real Effective USD/GEL Banknote (average for the period) Exchange Rate NBG Net Interventions Rate December 1995=100 (thousand USD) (average for the period) USD/GEL Euro/GEL (end of period) 2000 1��.9759�� - - 110,2 -71416 2001 2��.0723�� 1��.8473�� 2��.0816�� 108.2 -35448 2002 2��.1945�� 2��.0714�� 2��.3822�� 102.7 -40459 2003 2��.1459�� 2��.4243�� 2��.1502�� 94.9 -��42685 Q1 2��.1742�� 2��.3325�� 2��.1784�� 100.3 -4760 Q2 2��.1536�� 2��.4421�� 2��.1585�� 94.1 -��16094 Q3 2��.1281�� 2��.393��0 2��.1308�� 94.9 -14699 Q4 2��.1276�� 2��.5292�� 2��.1334�� 94.9 -��7132 2004 1��.9168�� 2��.3814�� 1��.9160�� 107.0 -182662 Q1 2��.0589�� 2��.5753�� 2��.0587�� 97.3 -21982 Q2 1��.9506�� 2��.3513�� 1��.9475�� 100.7 -60226 Q3 1��.8484�� 2��.2582�� 1��.8455�� 108.5 -80379 Q4 1��.8094�� 2��.3409�� 1��.8124�� 107.0 -20075 2005 1��.8126�� 2��.2601�� 1.8154 110.3 -42919 Q1 1��.8272�� 2��.3995�� 1��.8302�� 103.9 10600 Q2 1��.8250�� 2��.3032�� 1��.8276�� 104.1 -10885 Q3 1��.8046�� 2��.2039�� 1��.8068�� 104.6 -24652 Q4 1��.7936�� 2��.1338�� 1.7960 110.3 -17982 Source: the National�� Ba��nk�� of G��eorgia�� and GEPLAC calculations In the accounting period the domestic currency market was still affected by such factors as the issuance of money into circulation from government deposits, increase in imports along with the rise in world oil prices, the privatization of state assets and the increase in budgetary revenue inflows at the end of the fiscal year. The NBG continued with its bilateral interventions, though at a lower degree, to avoid the exchange rate fluctuation. In Q4 2005 the NBG net purchases comprised 18 million USD, which is less by 7 million than in the previous quarter and by 2 million than in the corresponding period last year. As a result, the nominal rate of Lari against USD strengthened insignificantly in both quarterly and annual terms. /#(JOUFSWFOUJPOTBOE64%(&-OPNJOBMFYDIBOHFSBUF

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Source: the National�� Ba��nk�� of G��eorgia October was especially stable in Q4 2005. The total TICEX trading decreased more than twice compared to September. The NBG net purchase made up just USD 3.3 million. The nominal average exchange rate showed a mere 0.1 percent depreciation compared to September. Although the TICEX turnover sharply increased in No- vember, the NBG net purchases showed no increase, thus reflecting the stability of the domestic currency market.

31 At that time, the nominal Lari rate strengthened by 0.1 percent. In December the market livened up mainly due to increased movement of budgetary flows at the end of the fiscal year. The NBG stepped up its interventions in order to avoid undesirable appreciation of Lari exchange rate against USD. Its net purchases reached USD 11.3 million. As a result, the national currency strengthened by just 0.6 percent. 64%(&-OPNJOBMBOE(&-3FBM&GGFDUJWF&YDIBOHF3BUFJOEFYBOE$1* %FDFNCFS $1*

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Source: the National�� Ba��nk�� of G��eorgia The Lari real effective exchange rate showed a tendency towards strengthening in the accounting period, which, along with the strengthening of nominal exchange rate, was also determined by a faster growth of consumer price index in Georgia than in its trade partner countries. This indicator grew by 2 percent in October compared to the previous month while in November and December it grew by 1.7 percent in each month. In total, the Lari real effective exchange rate strengthened by 5.5 percent in Q4 2005 since the consumer price index grew faster in the accounting period than in previous quarters. The Lari real effective exchange rate ap- preciated by only 3.1 percent compared to the last year’s corresponding period because Q4 2004 saw a significant depreciation of real effective exchange rate compared with the previous quarter. It should be noted that despite the strengthening of the real effective exchange rate in the accounting period, Georgia’s exports still increased.

32 4. Labour Market and Households Budgets Table 17: Population and Employment (thousand persons)

Economically Employed active population * Total Employment population Employment Total Labour rate among over 15 rate among employment force Self- people older years old Total Total Hired people of rate (%) participation employed then working rate (%) * working age (%) age (%) 2000 3148.1 2051.6 65.2 1839.3 684.3 1043.9 79.2 20.8 58.4 2001 3191.1 2113.3 66.2 1877.7 654.6 1135.9 80.2 22.0 58.8 2002 3239.5 2104.2 65.0 1839.2 650.9 1184.9 80.0 20.1 56.8 2003 3104.9 2050.8 66.1 1814.9 618.5 1195.2 79.8 18.9 58.5 Q1 3086.9 1940.9 62.9 1679.1 593.5 1083.4 81.7 18.3 54.4 Q2 3066.7 2039.1 66.5 1806.3 603.5 1201.9 87.6 19.9 58.9 Q3 3132.1 2120.5 67.7 1897.2 640.3 1255.4 91.3 21.7 60.6 Q4 3133.7 2102.6 67.1 1877.0 636.6 1239.9 88.8 23.0 59.9 2004 3151.1 2041.0 64.8 1783.3 600.9 1180.8 77.9 19.2 56.6 Q1 3142.6 2006.7 63.9 1746.4 619.8 1125.4 83.4 20.6 55.6 Q2 3121.7 2053.9 65.8 1809.0 608.1 1200.6 87.1 20.7 57.9 Q3 3180.9 2093.1 65.8 1819.2 577.5 1239.3 86.2 22.1 57.2 Q4 3159.3 2010.2 63.6 1758.6 598.1 1158.1 84.2 20.5 55.7 2005 Q1 3177.9 1999.4 62.9 1705.1 595.1 1108.7 80.3 19.7 53.7 Q2 3148.7 2035.5 64.6 1763.2 604.5 1158.0 82.9 17.1 56.0 Q3 3131.5 2011.8 64.2 1744.9 587.4 1156.7 81.2 18.8 55.7 Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development Note: * ILO “strict” methodology The labour market in Q3 2005 was in line with recent years’ trends, characterized by a large portion of the population of the working age being either underemployed or non-employed and those new jobs that were created were highly unstable. Employment was dominated by agricultural subsistence self-employment. Many non-agricultural self-employment activities were unofficial, unregistered and largely low-paying ones. The share of the population of the working age who had waged or salaried jobs was 19 percent and many of those employed were hardly earning a living. The labour force participation rate fell both in quarterly and annual terms in Q3 2005 (the latest available sets of figures from the Integrated Household Survey at the time of working on this GET issue),. While the seasonal decline this time was marginal, the annual one suggests a clear trend, especially if analyzed in line with the data of the two first quarters of the year. Compared to two years before, this indicator fell by 3.5 percentage points – another sign of a downward trend. This trend is consonant with the annual fall of the participation rate in 2004 compared to the situation in 2003. Though the participation rate is on a downward trend, it is still relatively high. This could be a reflection of the extremely hard household income situation that urges those outside the labour force to start job searching again, and therefore, re-enter the labour force. According to figures from the Integrated Household Survey of the Department for Statistics of the Ministry of Economic Development, hired employment decreased since 2000 through 2004. In the first three quarter of 2005 this trend continued, in annual terms. This could be a reflection of massive staff cuts that took place in the public sector on the one hand, and poor job creation in the formal sector, as well as instability of those jobs that are being created on the other. In Q3 2005, hired employment showed fall in quarterly terms, but surprisingly enough grew in annual terms. In Q3 2005, hired employment did not only shrink in absolute terms but its share in total employment also reduced. Wage and salary earners accounted for just over 33.6 percent of total employment in Q3 2005. Irrespec- tive of the contraction of the state sector it still accounted for almost 65 percent of dependent employment. Self-employment figures have not been on an upward trend since 2003, with the exception of seasonal waves. While self-employment remained unchanged in Q3 2005 in quarterly terms, it decreased in annual terms by 6.6 percentage points. Persistently dominating both the employment and the labour force and being largely represented by rural frequently unpaid self-employment, it accounted for 66.3 per cent of the former and 57.5 per cent of the latter in Q3 2005. Its share in both employment and the labour force grew, as opposed to that of hired employment.

33 Table 18: Unemployment (thousand persons)

Non-active population of Unemployment �* Unemployment rate (%) * 15-70 years old * Total Among population Among people older over 15 Unemployment people of Employed in “Discouraged” Total then Total years old Rate (��%��) * working household workers working age ** age ** 2000 3148.1 212.2 10.3 12.2 2.6 898.8 265.0 117.7 2001 3191.1 235.6 11.1 13.4 1.8 872.4 250.5 116.3 2002 3239.5 265.0 12.6 14.9 2.2 910.0 280.2 70.4 2003 3104.9 235.9 11.5 13.4 2.3 847.1 257.3 61.9 Q1 3086.9 261.8 13.5 15.6 2.6 931.2 275.0 83.6 Q2 3066.7 232.7 11.4 13.3 1.9 819.9 248.3 57.5 Q3 3132.1 223.3 10.5 12.3 2.3 811.4 255.1 49.6 Q4 3133.7 225.7 10.7 12.7 2.3 825.8 250.6 57.0 2004 3151.1 257.6 12.6 14.9 1.8 895.4 257.1 62.9 Q1 3142.6 260.2 13.0 15.3 1.8 923.2 268.5 82.1 Q2 3121.7 244.9 11.9 14.0 1.7 861.5 242.2 52.6 Q3 3180.9 273.8 13.1 15.5 2.2 868.9 254.2 53.2 Q4 3159.3 251.6 12.5 14.8 1.6 927.9 263.3 63.6 2005 Q1 3177.9 294.3 14.7 17.3 2.3 941.5 258.8 72.1 Q2 3148.7 272.3 13.4 15.9 1.3 902.5 241.0 55.4 Q3 3131.5 266.9 13.3 15.7 0.8 911.7 244.9 41.9 Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development Note: * ILO “strict” methodology ** Working age is given as 15-60 for women and 15-65 for men Contrary to the labour force participation rate, that is showing a downward trend, the unemployment rate is growing. Having grown by 2.8 percentage points compared to two years before, the national unemployment rate calculated by the ILO “strict” methodology grew by a marginal 0.2 percentage points compared to a year before. Its quarterly decline was marginal as well. Distorting the national figures is the rural unemployment rate that is usually way below the urban one. Table 19: Wages (GEL)

Average monthly wages and Average nominal monthly Nominal monthly wages and salaries wages and salaries share salaries Wage in minimum subsistence arrears

Real (thousand

GEL) of a working of a family Pubic sector in- Nominal Absolute 1997=100 Private man of four cluding Budgetary terms (%) sector (%) (%) organizations 2000 72.5 56.5 119.3 62.9 35.9 54.0 106.1 2001 82.6 61.4 129.7 70.0 39.9 63.0 120.6 50524.7 2002 99.1 69.8 146.8 79.0 45.0 77.6 139.4 38074.9 2003 101.5 68.3 143.4 77.7 44.3 79.3 145.8 43298.1 Q1 95.6 64.1 157.7 73.4 41.8 74.3 137.1 93526.0 Q2 99.6 67.4 149.2 76.5 43.1 78.7 143.7 109664.5 Q3 103.2 69.4 138.7 79.2 46.2 80.8 146.7 163716.6 Q4 107.3 72.0 132.3 82.4 45.8 83.1 154.4 2004 116.4 60.8 156.0 84.9 48.4 93.7 160.0 23032.7 Q1 109.5 69.3 170.6 80.6 45.9 86.6 159.8 250473.4 Q2 112.8 72.8 161.1 84.1 47.9 88.9 155.9 332502.5 Q3 121.8 77.6 155.1 91.1 51.9 98.9 165.7 394840.7 Q4 121.6 76.7 140.9 84.0 47.9 101.3 158.4 2005 Q1 128.0 74.1 182.4 84.2 47.9 108.3 162.9 Q2 146.1 86.2 190.7 96.5 55.0 124.0 182.4 Q3 156.4 93.2 186.2 102.4 58.9 142.9 184.8 Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development According to the IDS Integrated Household Survey figures, the average monthly nominal salary of hired employees across the economy grew substantially in Q3 2005. This also found its reflection in the respective growth of average monthly salary in absolute terms. The share of the average monthly salary in the minimum subsistence of a family of four grew compared to a year ago by 7 percentage points. The share of the average monthly salary in the minimum subsistence of a working man grew compared to a year ago by 11.3 percentage points, surpass- ing the minimum subsistence (by 2.4 percentage points) at the end of Q3 2005. The share of the average monthly 34 nominal salary in total monetary household income was 59 percent and in total household income – about 48.5 percent. About 79.2 percent of all public sector workers or 49.6 percent of all hired workers – budgetary organisations employees – were earning on average GEL 132.9 per month in Q3 2005. Employees of public enterprises and organizations, accounting for another 15 percent of hired workers, were paid GEL 164.3 per month on average in Q3 2005. Average monthly remuneration of another category of wage and salary earners accounting for over 32.4 percent of all the hired workers, private sector employees, was GEL 170.1 on average. About 4.8 percent of hired workers, those working in foreign organizations or joint ventures, had a monthly salary of GEL 293.9 on average. In Q3 2005, salaries of both public sector employees and the majority of private sector employees remained predominantly way below the subsistence minimum for a family of four. Many of those salaries are the major if not the only source of income for many households, since many of those employed are the only breadwinners in their household. The salaries and wages of private sector employees, however, managed to exceed the subsistence minimum for both a working man and an average consumer in Q3 2005. Compared to a year ago, average monthly salaries and wages across the economy grew both in nominal and real terms. The hired employees’ remuneration grew, mainly at the expense of staff cuts of civil servants. Start- ing from January 2005 the minimum remuneration of civil servants was fixed at GEL 115. The official minimum salary in the country, however, still remains GEL 20. Salaries of most senior government officials have risen dra- matically. This was supposed to serve as a precondition of such posts being staffed by well trained professionals. While many of those lower ranked bureaucrats who survived the staff cuts had their salaries raised as well, the great majority of civil servants and public sector employees remain low paid, and this effectively obliges them to seek additional income to support the family. Being as unstable as any other source of household income in the country, wages and salaries remain the primary source of income for urban households. Table 20: Monthly Household Monetary Income (GEL)

Nominal

ings Self- (1997=100) (1997=100) Real income capita (GEL) income Income salaries benefits income) produce property Wages and Wages income per capita employment Remittances of agricultural Debt or use of Total monetary Total savings, sale of Monetary income per from asset hold Income from sale Real monthly monetary Wages (% of total Wages family allowances, Pension, stipends,

2000 43.9 21.6 20.9 1.3 8.5 11.9 26.9 135.0 32.5 105.2 36.0 28.0 2001 52.7 24.3 21.4 1.6 12.3 18.1 18.6 149.0 35.4 110.9 38.8 28.9 2002 57.5 28.9 28.9 1.0 12.2 23.6 44.4 196.5 29.3 138.5 52.7 37.1 2003 60.4 32.2 30.8 1.6 8.3 38.6 41.7 213.7 28.3 143.7 57.0 38.3 Q1 54.7 32.0 28.5 1.7 8.3 42.3 40.2 207.6 26.3 139.2 55.3 37.1 Q2 61.0 31.4 28.6 1.3 8.4 42.4 45.5 218.6 27.9 148.0 58.1 39.3 Q3 63.2 33.0 28.0 1.8 9.3 28.9 37.3 201.5 31.4 135.4 53.5 36.0 Q4 62.8 32.4 38.3 1.8 7.3 40.6 43.9 227.1 27.7 152.3 61.0 40.9 2004 67.4 36.6 34.3 2.3 15.6 34.1 42.7 232.9 28.9 132.1 61.6 35.2 Q1 62.0 33.5 36.5 2.3 8.0 31.3 40.6 214.1 29.0 135.6 56.9 36.0 Q2 65.6 34.9 30.5 2.3 15.6 31.4 46.0 226.2 29.0 146.1 60.1 38.8 Q3 72.4 37.0 30.6 2.0 19.6 35.0 42.5 239.2 30.3 152.3 62.9 40.1 Q4 69.5 41.0 39.5 2.7 19.4 38.6 41.8 252.5 27.5 159.2 66.3 41.8 2005 Q1 73.9 41.1 31.1 3.6 22.2 34.7 40.5 247.0 29.9 143.0 65.0 37.6 Q2 87.3 41.5 24.5 3.1 26.8 32.7 36.9 252.7 34.6 149.1 67.2 39.6 Q3 90.6 39.7 28.6 3.1 25.5 37.5 40.2 265.2 28.1 157.9 70.8 42.2 Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development According to the IDS Integrated Household Survey, the average monthly household income nationally was GEL 322.6 in Q3 2005. Non-monetary income, that accounted for as much as 17.8 per cent of the total monthly household income in Q3 2005, plays a very important role in the budgets of many Georgian households, and especially of rural ones (18.1 percent of the total income, compared to just 6.7 percent for urban households). In comparison to the national proportion, the non-monetary income share in total household incomes in Tbilisi is usually close to marginal - it was 2 percent in Q3 2005.

A budgetary organization is a public organization fully financed by the state budget. An average household in Georgia consists of four members. 35 .POUIMZ)PVTFIPME.POFUBSZ*ODPNF 2

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Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development The largest share in the total monetary household income in Q3 2005, as usual, belonged to salaries and wages - 34.1 percent, that was higher in annual terms and lower than in the previous quarter. Debt, use of savings and sale of property accounted for the second largest share in the total monetary income - 15.1 percent. The share of this item in the total monetary income was larger a year before and smaller in the previous quarter. Another source of monetary income with a substantial share was income from self-employment - 14.9 percent, a decrease of share in total in both annual and quarterly terms. Assistance from relatives and friends and their remittances from outside Georgia traditionally represented quite an important source of monetary household incomes - this time their share in total was 14.1 percent, it increased compared to the previous quarter, and showed an annual decrease. Monetary income from the sale of agricultural produce was 10.8 percent in total monetary income, a decrease in share in annual terms and an increase in quarterly terms. This is no surprise considering the seasonal susceptibility of this item. 9.6 percent in the total monetary household income was accounted for by pensions, stipends and allowances. The share of this item in the total monetary income was smaller a year before and larger in the previous quarter. It is worth mentioning that while seasonal factor has more impact on some items, than on others, the overall picture is always affected in seasonal terms. That is why annual changes are much more interesting than quarterly ones. Table 21: Monthly Household Monetary Expenditure (GEL)

% of monetary - income

GEL) 7=100

wear heating tobacco property Transport 199 �� (mln �� Consumer Health care purchase of expenditure expenditure goods Savings and and services) Electricity and and recreation Other consumer Food, beverages, Household goods Purchase of Clothing and foot Real consumption Education, culture Total savings Total and services (purchase of goods

2000 197.0 100.9 12.7 27.1 10.2 15.8 13.6 7.0 9.7 20.0 88.4 8.9 173.7 2001 201.8 106.7 12.2 25.6 11.5 17.1 12.4 7.3 9.2 20.6 88.1 9.0 170.4 2002 216.7 113.0 12.4 7.6 15.7 20.0 25.7 13.3 9.1 23.2 81.2 8.7 188.0 2003 219.8 116.8 13.3 7.6 13.8 20.0 22.2 6.2 19.9 26.1 81.6 9.7 181.3 Q1 209.4 106.6 13.6 8.1 13.8 21.6 21.9 6.1 17.7 26.2 82.8 10.4 169.6 Q2 209.1 113.8 11.2 6.8 14.0 16.9 22.7 6.7 17.1 25.0 80.8 9.7 175.3 Q3 208.7 114.0 11.9 6.8 13.5 17.4 20.7 4.6 19.8 22.2 81.2 8.6 172.7 Q4 252.3 133.1 16.7 8.6 13.8 24.1 23.4 7.6 25.0 30.9 81.5 10.0 207.7 2004 245.7 131.6 14.5 9.1 15.3 21.8 23.5 6.6 23.1 22.7 84.2 7.8 185.6 Q1 233.0 124.4 14.0 10.1 14.5 22.0 20.9 6.8 20.3 28.6 82.7 10.1 178.3 Q2 232.8 128.0 12.5 8.8 15.1 18.0 22.4 7.7 20.4 23.4 82.0 8.3 183.3 Q3 238.1 131.4 12.4 8.0 16.0 18.1 24.3 4.6 23.2 19.1 84.4 6.8 179.7 Q4 278.9 142.8 19.2 9.7 15.8 29.2 26.4 7.3 28.6 19.6 87.4 6.1 201.2 2005 Q1 261.1 131.7 15.0 10.2 18.4 27.1 26.5 8.6 23.5 18.5 89.1 4.3 169.6 Q2 257.4 132.0 12.9 8.7 20.3 22.9 27.3 9.0 24.2 16.4 88.4 3.9 171.9 Q3 250.0 128.6 13.3 9.2 18.8 22.7 25.5 5.8 26.1 22.2 85.5 4.4 174.2 Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development In Q3 2005, monetary expenditure accounted for 83.5 percent of average monthly household expenditure. Monetary expenditure for the purchase of goods and services accounted for as much as 85.5 percent of total monetary expenditure that was substantially lower than a year before, as well as in the previous quarter. Money spent on food, beverages and tobacco dominated consumer household expenditure - as much as 47.2 percent of the total household monetary expenditure. The share of this item in total monetary expenditure fell slightly in quarterly terms and substantially in annual terms.

36 .POUIMZ)PVTFIPME.POFUBSZ&YQFOEJUVSF 2 QFSDFOU HPPET QSPQFSUZ $MPUIJOH 5SBOTQPSU &MFDUSJDJUZ )PVTFIPME 4BWJOHBOE QVSDIBTFPG )FBMUIDBSF BOEIFBUJOH BOEUPCBDDP FYQFOEJUVSF BOEGPPUXFBS BOESFDSFBUJPO 'PPE CFWFSBHFT 0UIFSDPOTVNFS &EVDBUJPO DVMUVSF

Source: Integrated Household Survey, Department for Statistics, Ministry of Economic Development Other household monetary expenditure accounted for the following items in Q3 2005: 9.4 percent of Georgian households’ spending went to pay for transportation (practically unchanged compared to the year before, while slightly decreased against the previous quarter), 8.3 percent were spent to pay for electricity and gas (while unchanged in quarterly terms, increased in annual terms), and another 6.9 percent were accounted for by payments for health care services and purchase of medicines (an annual increase and quarterly decrease). 8.2 percent of total household monetary expenditure and 6.3 percent of total household expenditure were accounted for by total savings and purchase of property taken together in Q3 2005. This was an increased share in the total monetary expenditure in both quarterly and annual terms.

37 5. External Sector Table 22: Main components of external economic relations (million USD)

Trade Current Change International Current Net foreign Total foreign balance of account Portfolio in gross reserves account bal- direct invest- debt (GDP goods and balance investments international by import ance ments %) services (GDP %) reserves months 2000 -533.7 -161.2 -5.3 131.7 2.7 -23.3 1.4 50.1 2001 -479.6 -211.4 -6.9 109.9 0.0 50.2 1.8 50.0 2002 -447.5 -197.6 -5.8 163.3 0.0 38.5 2.3 51.5 2003 -582.0 -369.5 -9.3 336.3 0.0 -6.7 1.6 46.3 Q1 -146.5 -100.9 -12.1 56.8 -0.5 -9.1 1.5 44.3 Q2 -146.8 -100.0 -10.2 81.5 0.0 -1.2 1.5 45.2 Q3 -113.8 -51.3 -4.9 83.8 0.5 8.0 1.6 45.7 Q4 -174.8 -117.3 -10.4 114.2 0.0 -4.4 1.6 46.3 2004 -858.6 -346.9 -6.8 489.5 -13.1 192.0 2.3 34.2 Q1 -181.7 -100.5 -10.2 117.5 0.0 20.0 1.3 38.6 Q2 -159.3 -58.5 -4.7 117.1 0.0 63.2 1.6 36.2 Q3 -238.8 -98.3 -7.0 131.3 0.0 90.1 2.2 33.9 Q4 -278.7 -89.6 -5.8 123.6 -13.1 18.7 2.3 34.2 2005 -1142.3 -688.8 -10.8 537.3 15.5 90.4 2.1 26.9 Q1 -195.8 -117.4 -8.9 86.4 5.6 -2.1 1.7 28.9 Q2 -216.1 -134.0 -8.7 198.0 2.9 56.6 2.0 27.5 Q3 -321.5 -180.5 -10.7 75.1 7.0 9.7 2.0 27.3 Q4 -408.9 -256.9 -14.0 177.8 0.0 26.2 2.1 26.9 Source: Department for Statistics of the Ministry of Economic Development of Georgia The current account balance deteriorated sharply in Q4, 2005 compared to both the previous quarter (1.4 times) and the same period in 2004 (2.9 times). Therefore, the annual indicator of the current account deficit doubled. Although the upward trend was observed in exports, its share in trade turnover was still much lower than that of imports. The growth of imports largely offset the growth of exports. As a result, the trade deficit grew 1.5 times in Q4 and reached USD 421.8 million. The deterioration of the current account was also caused by a reduction in government grants in 2005 - both in quarterly and annual terms, which led to a 18.0 percent decrease in the positive balance by current transfers, totalling USD 124 million compared to USD 151 million last year. The revenues account also deteriorated by USD 10 million. The external trade balance by service, however, remained almost unchanged in the reviewed period. Thus, the main tendencies in the balance of payments were still largely determined by a trade balance, though the deficit partially worsened due to other current operations. According to revised foreign trade data reflected in the Balance of Payments, imports comprised USD 877.3 million in the fourth quarter. In nominal terms it increased by almost USD 240 million, while against GDP it increased by 6.5 percentage point. The increase in imports was partially due to the rise in world oil prices, which resulted in higher imported oil prices than of imported volumes. Besides, the completion of the Baku-Tbilisi Ceyhan oil pipeline construction caused a decrease in the import of investment commodities although the Shah Deniz gas pipeline project partially substituted it. The volume of exports, revised for the sake of the Balance of Payments, increased by 31.9 percent in Q4, 2005 compared to the previous year’s corresponding period and made up USD 455.5 million. In the same period the share of exports in GDP grew by 2.4 percentage points. Such a high growth rate of exports was observed against the background of an unusual decrease in export dynamics in the same period last year. The added value created in agriculture remained as one of the main components favouring the GDP growth. This, in its turn, facilitated an increase in such export categories as hazelnuts and grape wine as well as other agricultural products. The share of hazelnuts in total exports increased from 3 to 8 percent in the fourth quarter, while that of wine from 4 to 6 percent. The growth of export volumes was due to seasonal factors and some other exogenous factors, including the growth of demand on the part of Russia mainly due to an increase in revenues of this country from oil exports. Moreover, the price on raw material and scrap metal rose on world markets in 2005, the fourth quarter inclusive. This resulted in an increase of nominal export value as well as of export volumes of scrap metal, ferroalloy and other raw materials from Georgia. It is noteworthy that the share of scrap metal in total exports was decreasing throughout 2005 and in the final quarter comprised a mere 2.7 percent. Nevertheless, scrap metal, by annual indicators, is still in the lead among export commodities. Service revenues increased by 30.6 percent, while expenditure went up by 32.8 percent in Q4, 2005 compared to the same period last year. Nevertheless, the service balance remained almost unchanged, comprising USD 12.9 million. The main sources of positive contributions to services in the reviewed period were business and personal tourism (USD 60.9 million), railway transport (USD 25.4 million), marine and air transport (USD 40.9 million), financial flows from pipeline services (USD 10 million), communications and financial services (USD 6 million each), government service (USD 18.7 million). At the same time, the outflow of financial resources mainly -oc curred in such service spheres as marine transportation (USD 28.5 million), road transportation (USD 24.3 million), air transportation (USD 22.8 million) and cargo insurance (USD 15.5 million).

38 4FSWJDFFYQPSUT 4FSWJDFJNQPSUT 2 2

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Source: Department for Statistics, Ministry of Economic Development Thus, the total balance of goods and services in Georgia in the fourth quarter deteriorated by 46.7 percent and comprised USD 408.9 million, making up 22.2 percent of GDP. The accounting period saw a slight decrease in cash received from Georgian residents abroad or foreign sources, which comprised USD 64.9 million. They remain the main category counterbalancing the negative balance of this account from direct, portfolio or other investment revenues. However, if compared with the same period last year, the balance of revenues deteriorated by USD 10 million. The outflow of money from Georgia was determined by dividends and interest costs accrued on investments and government borrowing. In total, this amount made up USD 35.5 million in the accounting period. Besides, the dividends paid on direct investments comprised USD 17.0 million while the cost of foreign debt service by the government was USD 7.8 million. The cost of foreign capital services in the banking sector doubled in the second, third and fourth quarters in 2005, thus reflecting the growth of credit lines from abroad. Besides, the means received as a result of placing international reserves into high-rating securities by the NBG was the source of positive balance of revenues from portfolio or other investments. As net government grants decreased by USD 31.9 million in Q4, 2005, it almost halved during the year. Out of USD 56.4 million worth of grants received by the government in Q4, 2005, USD 27.6 million represented intergovernmental flows. Workers’ remittances and other similar transfers by non-resident natural persons remained the main source of quarterly-increasing current transfers. The balance showed a 6.5 percent increase by this category, reaching USD 77.6 million in the fourth quarter. In total the balance of current transfers in Q4, 2005 increased by 18.0 percent and made up USD 123.9 million. The current account deficit in Q4, 2005 was mainly financed through direct investments. Although the Baku- Tbilisi-Ceyhan pipeline construction ended, the Shah Deniz gas pipeline entered an active phase of construction and in the reviewed period attracted USD 78.0 million worth of investments to Georgia. USD 14.3 million investments in the Kulevi terminal construction is also worth noting. Moreover, direct investment made in the manufacturing sector in the reviewed period comprised USD 10.3 million. However, the annual indicator of direct investments was negative due to USD 43 million worth foreign shares purchased by Georgian residents in the same period. Direct investments into the banking sector comprised USD 16.3 million during the year, including USD 7.6 million in the fourth quarter. Given the intensified activity in the banking sphere, portfolio investments comprised USD 15.5 million during the year, although no such operation was carried out in Q4, 2005. External proceeds from privatization made up USD 58.3 million in the accounting period and USD 94.8 million during the year. Hence, the financing of the increased current account deficit did not prove to be a problem. Apart from direct and portfolio investments, other investment inflows comprised USD 110.6 million in Q4, 2005, while outflows were worth USD 22.2 million. The balance of these investments increased sharply – by 113.0 percent compared to the same period last year. The government borrowed USD 51.2 million in long-term loans and paid off old debts in the amount of USD 24 million. The fourth quarter saw a sharp increase in long- term liabilities of the banking sector, which more than doubled compared to 2004. The trend was observed throughout 2005. In the reviewed period the banking sector assumed USD 62 million worth of new long-term and USD 6 million short-term liabilities and covered USD 33.4 million worth of liabilities. The volume of cash and deposits increased significantly. The outflow in this part of the balance of payments was determined by the costs of covering debts, liabilities and fines (USD 34.5 million). Thus, the positive balance of financial and capital accounts comprised USD 284 million, completely covering the current account deficit. Reserve assets grew by USD 48.1 million. Gross international reserves increased by USD 90.4 million by the end of Q4, 2005 compared to last year’s corresponding period and made up USD 474.1 million, which equals 2.1 months of imports. The difference between profits from large or small capital invested in the national economy by non-residents and revenues from investments made by Georgian citizens abroad. The grants received by the Georgian government minus amounts hypotetically issued by the government, which mainly comprises taxes paid from revenues received abroad by Georgian residents. The latter is derived by expert assessment. The figure does not incorporate proceeds from the sale of ocean shipping company assets as this company was under foreign ownership and the balance of payment reflects the sale of these assets as the reduction of balance of investment outflow from Georgia. 39 Table 23: Imports structure by commodity groups

Turbo Phar- Medical Oil Natural Total imports Motor cars engines, gas Sugar maceuti- and veterinary Other products gas turbines cals equipment

% % % % % % % % % mln mln mln mln mln mln mln mln mln USD USD USD USD USD USD USD USD USD 2000 709.2 100.0 71.8 10.1 15.4 2.2 0.0 0.0 25.4 3.6 50.3 7.1 45.8 6.5 14.5 2.0 485.9 68.5 2001 753.0 100.0 87.7 11.6 13.1 1.7 8.8 1.2 24.1 3.2 48.8 6.5 53.6 7.1 15.6 2.1 501.3 66.6 2002 795.5 100.0 88.9 11.2 21.9 2.8 0.1 0.0 34.7 4.4 52.4 6.6 62.0 7.8 17.7 2.2 517.8 65.1 2003 1141.2 100.0 104.8 9.2 46.5 4.1 0.4 0.0 53.0 4.6 66.0 5.8 62.9 5.5 26.4 2.3 781.2 68.5 Q1 229.1 100.0 17.7 7.7 7.3 3.2 0.1 0.0 4.2 1.8 19.6 8.6 14.8 6.5 16.5 7.2 148.9 65.0 Q2 259.7 100.0 23.1 8.9 12.4 4.8 0.3 0.1 14.7 5.6 12.1 4.7 16.8 6.5 3.6 1.4 176.8 68.1 Q3 320.5 100.0 33.4 10.4 14.3 4.5 0.0 0.0 19.6 6.1 10.7 3.3 13.5 4.2 0.4 0.1 228.6 71.3 Q4 331.8 100.0 30.5 9.2 12.5 3.8 0.0 0.0 14.6 4.4 23.6 7.1 17.8 5.4 5.9 1.8 226.9 68.4 2004 1847.9 100.0 186.3 10.1 116.3 6.3 27.3 1.5 50.8 2.8 80.1 4.3 78.0 4.2 32.3 1.7 1276.8 69.1 Q1 328.7 100.0 28.3 8.6 18.1 5.5 4.2 1.3 6.2 1.9 26.0 7.9 17.3 5.3 17.1 5.2 211.4 64.3 Q2 438.5 100.0 41.1 9.4 21.1 4.8 4.5 1.0 16.5 3.8 14.4 3.3 17.9 4.1 4.7 1.1 318.3 72.6 Q3 490.0 100.0 56.9 11.6 30.4 6.2 18.3 3.7 13.3 2.7 12.2 2.5 15.3 3.1 0.3 0.1 343.3 70.1 Q4 590.7 100.0 60.0 10.2 46.7 7.9 0.3 0.1 14.7 2.5 27.5 4.7 27.4 4.6 10.2 1.7 403.8 68.4 2005 2490.9 100.0 336.3 13.5 178.5 7.2 53.8 2.2 78.2 3.1 90.8 3.6 92.5 3.7 40.1 1.6 1620.6 65.1 Q1 454.5 100.0 56.8 12.5 28.6 6.3 0.3 0.1 16.7 3.7 28.4 6.2 23.3 5.1 17.5 3.8 282.9 62.2 Q2 527.3 100.0 74.0 14.0 36.5 6.9 1.1 0.2 13.1 2.5 19.2 3.6 28.0 5.3 3.4 0.6 352.1 66.8 Q3 687.7 100.0 104.1 15.1 48.1 7.0 0.1 0.0 19.6 2.9 14.4 2.1 18.4 2.7 1.6 0.2 481.3 70.0 Q4 821.5 100.0 101.4 12.3 65.3 7.9 52.3 6.4 28.7 3.5 28.9 3.5 22.8 2.8 17.7 2.0 504.3 61.4 Source: Department for Statistics, Ministry of Economic Development According to preliminary data on foreign trade, imports increased by 39.1 percent in Q4, 2005 compared to the corresponding indicator last year. It was still affected by high oil prices, government expenditure on imports and sharp seasonal growth of domestic demand by the year end. Oil and oil products remained the largest import category in the reviewed period. Compared to the corresponding period in 2004, the volume of this category increased by almost 70 percent. Some 52 percent of oil products were imported from Azerbaijan. This indicator comprised 69 percent last year. The increase in this import category was partially determined by the rise in world oil prices, though in Q4, 2005, compared to the previous quarter it dropped a little both on the world and Georgian markets. Despite rising oil prices the volume of imports did not decrease but, increased. The second largest import category in Q4, 2005 was still motor cars. The increase in the price of imported cars was proportionate to the annual growth rate of imports and therefore, its share in total imports did not change. Last year the main exporter of motor cars to Georgia was Germany and accounted for 53 percent of this commodity imports. In the reviewed period Germany’s share dropped to 47 percent while imports from the USA increased twice and even more, reaching 22 percent of total motor car import. In Q4, 2005, USD 52 million worth of turbines were imported from the USA for the construction of a thermal power generator in Gardabani, which put this commodity into the group of large import categories. Due to seasonal demand on sugar, the import of this commodity almost doubled in the accounting period. Un- like the corresponding period last year the largest importer of this commodity was France with a 64 percent share. Sugar imports from Brazil increased as well, though its share decreased. Natural gas from Russian comprised 96 percent of this category imports in the accounting period and showed a 73 percent increase compared to last year’s same period. Nevertheless, its share in total imports decreased by 12 percent. Pharmaceutical imports showed a downward trend both in absolute and comparative terms, which must be the result of toughened control over contraband. Thus, the share of medication in total imports dropped from 4.2 percent to 2.8 percent. The share of other category imports in total country’s imports was around 2 percent.

$PNNPEJUZ*NQPSUT $PNNPEJUZ*NQPSUT 2 2

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Source: Department for Statistics, Ministry of Economic Development

40 The import structure comprised 97 countries in Q4, 2005 (93 countries in last year’s corresponding period) with the share of 10 key trade partners comprising 74 percent of total imports, which was a bit higher than last year’s same indicator. Moreover, the share of imports from Russia increased by 37 percent (USD 34 million) and from Azerbaijan by 43 percent (USD 21 million). Officially registered exports grew by 38.5 percent in the reviewed period as compared to the same period in 2004.

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Source: Department for Statistics, Ministry of Economic Development According to the commodity structure exports were more focused on main commodity categories than imports. The table below shows that in the reviewed period almost half of exports accounted for seven commodity groups. Table 24: Exports structure by commodity groups

Mineral or Alcohol ratafia Walnut fresh Natural gra- chemical, Black metal Unprocessed , liquor and Total exports or dried, Ferroalloy Other pe wine nitrogen scrap gold other alcoholic other fertilizers, drinks

mln mln mln mln mln mln mln mln mln % % % % % % % % % USD USD USD USD USD USD USD USD USD 2000 322.6 100 19.3 6.0 29.0 9.0 13.6 4.2 16.2 5.0 39.0 12.1 - - 3.0 0.9 202.4 62.8 2001 317.6 100 9.8 3.1 32.2 10.1 17.6 5.5 4.9 1.5 33.1 10.4 12.5 3.9 3.9 1.2 203.5 64.1 2002 345.9 100 6.7 2.0 33.2 9.6 15.5 4.5 12.0 3.5 36.5 10.5 28.6 8.3 5.6 1.6 207.7 60.1 2003 461.4 100 12.6 2.7 42.6 9.2 26.1 5.7 18.4 4.0 60.1 13.0 20.3 4.4 13.1 2.8 268.2 58.1 Q1 72.1 100 1.6 2.2 7.1 9.8 4.6 6.4 0.4 0.6 12.2 16.9 6.9 9.5 1.5 2.0 37.9 52.5 Q2 104.0 100 1.4 1.3 10.0 9.6 5.2 5.0 4.0 3.9 14.3 13.8 6.5 6.2 3.4 3.2 59.2 57.0 Q3 146.5 100 2.1 1.4 11.6 7.9 6.2 4.2 5.8 4.0 16.7 11.4 6.4 4.4 3.4 2.3 94.3 64.3 Q4 138.7 100 7.5 5.4 13.9 10.0 10.2 7.3 8.2 5.9 16.8 12.1 0.6 0.4 4.9 3.5 76.8 55.4 2004 646.9 100 17.7 2.7 48.7 7.5 42.5 6.6 28.8 4.4 95.9 14.8 18.8 2.9 18.9 2.9 375.6 58.1 Q1 95.5 100 0.5 0.5 8.2 8.6 10.1 10.6 4.8 5.0 18.4 19.2 - - 2.2 2.3 51.3 53.7 Q2 199.8 100 0.2 0.1 12.7 6.3 11.7 5.9 5.3 2.6 22.6 11.3 10.5 5.2 4.6 2.3 132.2 66.2 Q3 157.9 100 5.4 3.4 13.2 8.4 6.9 4.3 5.8 3.7 21.5 13.6 4.7 3.0 6.4 4.0 94.0 59.5 Q4 193.8 100 11.5 5.9 14.6 7.5 13.8 7.1 12.9 6.7 33.4 17.3 3.6 1.9 5.8 3.0 98.1 50.6 2005 866.7 100 70.3 8.1 81.3 9.4 80.2 9.3 35.8 4.1 84.2 9.7 34.7 4.0 29.2 3.4 450.9 52.0 Q1 170.3 100 8.0 4.7 13.2 7.8 21.4 12.6 4.9 2.9 28.0 16.5 6.3 3.7 5.6 3.3 82.8 48.6 Q2 202.7 100 4.4 2.2 18.6 9.2 16.5 8.1 7.9 3.9 24.5 12.1 9.6 4.8 6.1 3.0 115.0 56.7 Q3 225.3 100 19.8 8.8 23.1 10.3 20.3 9.0 9.1 4.0 19.2 8.5 9.6 4.3 8.5 3.8 115.6 51.3 Q4 268.4 100 38.0 14.2 26.4 9.8 22.0 8.2 13.9 5.2 12.5 4.7 9.3 3.5 8.9 3.3 137.5 51.2 Source: Department for Statistics, Ministry of Economic Development Hazelnuts moved up to the first place by volume. Its export in the accounting period increased over three times. The main consumers of this product were Italy (32.6 percent), Germany (23.9 percent), Russia (16.3 percent), the Czech Republic (9 percent), Greece and other countries. The export of natural grape wine to Russia and Ukraine showed a significant increase (by 81 percent and 361 percent respectively) and were 87 percent of wine exports. The export of this commodity to Russia was caused by increased external demand, while the growth of trade with Ukraine can be explained by intensified relations in business. The end of 2005 saw a sharp increase in ferroalloy demand on the world market resulting in a 70 percent increase in exports as compared to the previous year’s corresponding period. The geography of trade in this commodity has also expanded. The large importers of ferroalloy were Russia, the USA, Turkey, and Korea. This list extended to include Ukraine and Seychelles. A relatively insignificant growth was observed in mineral fertilizer and nitrogen imports, though its share in total imports decreased by 1.5 percentage points.

41 The share of black metal scrap in total imports was quite small in the accounting period and it was mainly exported to Turkey. It should also be noted that according to annual indicators this commodity is still the first among export categories. A large amount of unprocessed gold was exported to Canada in Q4, 2005, putting this commodity among large export commodity categories. In the same period last year the demand on this commodity was almost three times less. Table 25: Georgia’s foreign trade with CIS (million USD)

Imports Exports Total balance Other Other Other Total CIS Total CIS Total CIS countries countries countries 2000 709.2 229.3 479.9 322.6 128.3 194.3 -386.6 -101.0 -285.6 2001 753.0 253.9 499.2 317.6 144.3 173.3 -435.4 -109.6 -325.8 2002 795.5 292.3 503.2 345.9 168.7 177.2 -449.6 -123.6 -326.0 2003 1141.2 370.1 771.1 461.4 224.8 236.6 -679.8 -145.3 -534.5 Q1 229.1 84.4 144.7 72.1 25.2 47.0 -157.0 -59.3 -97.7 Q2 259.7 82.4 177.4 104.0 52.1 51.9 -155.7 -30.2 -125.5 Q3 320.5 93.0 227.5 146.5 81.8 64.7 -174.0 -11.2 -162.8 Q4 331.8 110.3 221.5 138.7 65.7 73.0 -193.1 -44.6 -148.5 2004 1847.9 657.2 1190.6 646.9 327.7 319.3 -1200.9 -329.5 -871.4 Q1 328.7 123.0 205.7 95.5 35.5 60.0 -233.2 -87.5 -145.7 Q2 438.5 142.3 296.2 199.8 119.8 80.0 -238.7 -22.4 -216.3 Q3 490.0 168.7 321.3 157.9 81.5 76.4 -332.1 -87.2 -244.9 Q4 590.7 223.3 367.4 193.8 90.9 102.9 -396.9 -132.4 -264.5 2005 2490.9 997.7 1493.2 866.7 408.4 458.4 -1624.2 -589.3 -1034.9 Q1 454.5 181.0 273.5 170.3 62.4 107.9 -284.2 -118.5 -165.6 Q2 527.3 210.3 317.0 202.7 110.1 92.6 -324.6 -100.3 -224.3 Q3 687.7 287.1 400.5 225.3 97.9 127.4 -462.3 -189.2 -273.1 Q4 821.5 319.3 502.2 268.4 138.0 130.4 -553.1 -181.3 -371.8 Source: Department for Statistics, Ministry of Economic Development A faster growth of imports from CIS countries was also observed. Even though the CIS share in imports was lower in the fourth quarter than in the third quarter, this indicator showed a 1.1 percentage point increase compared to last year’s same period. There was an average growth of 0.5 percentage points throughout the year and a totalled to 40.1 percent. This could be the result of the rise in oil from Azerbaijan and the legalization of commodity imports from Russia. With regard to geographic structure, it expanded to include four more countries compared to 2004. This allowed Georgia to diversify its own trade outside the CIS. Although the share of Georgia’s exports to countries outside the CIS decreased, its nominal value increased by USD 27 million. In the reviewed period the government had bilateral agreements with 16 creditor countries. The debt to these countries amounted to USD 627.9 million, which was 9.4 percent less than the debt at the end of 2004. In Q4, 2005, the government paid its bilateral creditors USD 21.9 million as a principal amount and USD 1.7 million as interest. Under multilateral agreements, the IMF, WB, EU and IFAD continued to be the main source of Georgia’s international financing. The aggregate state debt to these institutions comprised USD 1022.8 million, which is 4.3 percent less than the amount at the end of 2004. Debts denominated in currencies other than USD underwent significant changes throughout 2005 due to the strengthening of the USD exchange rate. The benefit from the change in rates by multilateral agreements alone made up USD 88.7 million in 2005. In Q4, 2005 the government paid USD 3.4 million as a principal amount and USD 3.9 million as interest. The state guaranteed debt to Germany and EBRD made up USD 84.2 million thus being USD 12 million less than last year’s corresponding indicator. In reality there was USD 3.7 million paid off while the rest was the benefit gained by depreciation of the Euro during the year. By the end of 2005 Georgia’s foreign debt totalled USD 1734.9 million and comprised 26.9 percent of GDP (compared to 35.4 percent by the end of 2004). USD 89.4 million was paid off as a principal amount and USD 21.3 million as interest throughout the year. As a debt restructuring agreement was reached with the Paris Club in the summer of 2004, several agreements on debt restructuring were signed in 2005, including the fourth quarter, which allowed the negotiation of new, preferential terms with a number of countries.

42 6. EU-Georgia Economic Relations Table 26: Main indicators of economic relations between EU and Georgia*

Trade FDI by EU countries Exports Share Imports Share Turnover Balance Volume (thou- in total (thou- in total Share in (thousand (thousand (thousand sand exports sand imports Total FDI (%) USD) USD) USD) USD) (%) USD) (%) 2000 264559 76389 24 188170 22 -111781 39780 30 2001 302451 61605 19 240846 34 -179241 69812 64 2002 295474 63220 18 232254 29 -169034 58446 35 2003 512749 81590 18 431160 38 -349570 95708 28 Q1 102528 14674 20 87854 38 -73181 Q2 131255 18033 17 113222 44 -95189 Q3 151023 22626 15 128397 40 -105772 Q4 127943 26257 19 101686 31 -75429 2004 728912 111363 17 617549 33 -506185 195622 39 Q1 127846 15414 16 112431 34 -97017 Q2 199630 31543 16 168087 38 -136544 Q3 184268 28717 18 155551 32 -126834 Q4 217168 35689 18 181479 31 -145790 2005 836655 165270 19 671385 27 -506116 242903 50 Q1 155123 32483 19 122640 27 -90157 Q2 175994 23956 12 152038 29 -128082 82920��** 43 Q3 233099 52247 23 180852 26 -128605 49362 66 Q4 272439 56584 21 215855 26 -159271 110622 51 Source: Department for Statistics, Ministry of Economic Development Note: * Verified date. To avoid possible discrepancy, the data for all the periods include indicators of 25 current EU member states ** Data is for 6 month since there are no indicators for the first quarter Trade turnover with the EU grew by 15 percent in 2005. Annual export growth comprised 48 percent while that of the imports was just 9 percent. The share of exports in the total turnover with the EU was 20 percent, exceeding the 2004 indicator by 5 percentage points. The increase in trade turnover in 2005 where exports grew at a higher speed kept the trade balance deficit with the EU almost the same as in the previous year. Georgia’s exports to EU countries increased by 59 percent in Q4, 2005 compared to the same period last year, while compared to the previous quarter it increased by 8 percent. It is noteworthy that a quarterly change in exports was largely influenced by seasonal factors. Table 27: Exports from Georgia to EU countries (thousand USD)

2004 Q 1 Q 2 Q 3 Q 4 2005 Total exports to EU 111363 32483 23956 52247 56584 165270 Of which: Austria 311 - 244 180 621 1046 Belgium 5068 705 1248 1815 1307 5075 Cyprus 431 22 81 31 108 242 Check Republic 1622 891 185 2099 3457 6632 Denmark 755 43 - 1 175 219 Estonia 873 1040 275 601 865 2782 Finland ------France 9556 2417 291 5887 2950 11546 Germany 15851 4351 3810 6638 13664 28463 Greece 7332 2477 1921 3711 2302 10412 Hungary 83 - - 24 7 31 Ireland 56 - 5 414 523 942 Italy 11591 4814 3980 8409 16351 33554 Latvia 1030 201 229 248 1067 1746 Lithuania 870 119 343 254 256 972 Luxembourg 120 - - - 29 29 Malta 454 1 6 4 1 12 Netherlands 9840 4549 2533 2566 1737 11385 Poland 1516 390 135 166 45 737 Portugal 143 188 2 22 - 212 Slovakia 2628 216 166 892 1625 2899 Slovenia - - - 3 16 19 Spain 9496 3786 1742 6621 2089 14238 Sweden 63 - 8 5 134 147 UK 31675 6272 6749 11656 7253 31931 Source: Department for Statistics, Ministry of Economic Development

43 2005 saw a change in the structure of main commodity categories. In 2004, the share of processed and half processed gold, fertilizers, mineral waters and walnuts in total exports to the EU was almost equal. In 2005, the share of walnut exports increased notably, while the share of processed and half processed gold dropped dramati- cally. Exports of ore and copper saw a strong downward trend in 2005, while the volume of fertilizers exports decreased insignificantly. Walnut exports showed a significant growth in the fourth quarter 2005 comprising 56 percent of total exports to EU countries. It is noteworthy that this indicator did not exceed 29 percent in the third quarter, while in the first and second quarters it made up 15 percent in the aggregate. The walnut exports totaled 33 percent of all exports to EU in 2005. Mineral waters and various fertilizers were the second and the third in the commodity structure in 2005 by their export volumes to the EU. Mineral water exports made up USD 19 million representing 12 percent of total exports to EU countries. The volume of fertilizers sold to the EU decreased in the specified period.

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Source: Department for Statistics, Ministry of Economic Development In 2005, Italy was Georgia’s largest trade partner among EU countries by volume of goods exported. The share of this country made up 20 percent of total exports to EU compared with 10 percent in 2004. Georgia exported mainly walnut and fertilizers to Italy. Walnut exports were worth USD 20 million and comprised 60 percent of Georgia’s exports to this country in 2005. It is worth mentioning that walnut exports to Italy in Q4, 2005 grew as many as 2 times and even more, while fertilizer exports - 4 times. The second country by the size of Georgia’s exports to the EU was the United Kingdom. The UK share in total exports to EU countries comprised 19 percent in 2005. It is noteworthy that the volume of exports to the UK did not change compared to the previous year, but given the increase in total exports its share decreased by 9 percent. In 2005 Georgia exported mineral waters, raw oil and oil products, gold, elevating and drilling machines to the UK. The largest export commodity group was mineral waters which was worth USD 14.5 million in 2005 and comprised 45 percent of Georgia’s exports to this country. The export of gold to the UK sharply decreased compared with 2004, for this export was redirected to Canada. The main export category to Germany was walnuts. Walnut exports doubled in Q4, 2005. In 2005, Georgia exported USD 16 million worth of walnuts to Germany, comprising 57 percent of Georgia’s exports to this country. The growth of walnut export to Germany led to a 3 percentage point increase of this country’s share, reaching 17 percent in total exports to the EU. The share of Georgia’s exports to Spain comprised 9 percent of total exports to the EU in 2005. The main export commodity to this country was copper ore. The export of this commodity was worth USD 6.2 million and comprised 44 percent of all the exports to Spain. 30 percent of exports to Spain accounted for mineral, chemical and nitrogen fertilizers, reaching USD 4.4 million in 2005. The largest commodity category exported to Netherlands in 2005 was ferroalloy. In total USD 5 million worth ferroalloy was sent to this country, that is 45 percent of all Georgia’s exports to Netherlands. It is noteworthy that in Q4, 2005, Georgia started exporting walnuts to this country, albeit in relatively small volumes. Georgia mainly exported fertilizers to France, although by the end of the year, in the fourth quarter, the export of this commodity sharply decreased. The amount of fertilizers sent to France during 2005 was worth USD 6 million and comprised 52 percent of annual exports to this country. The export of walnuts to the Czech Republic increased in Q4, 2005 reaching USD 6 million and contributed to the annual growth of exports to this country.

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Source: Department for Statistics, Ministry of Economic Development Motor cars represented the largest commodity group of imports from the EU in 2005 and 2004, while its share in the total imports from the EU grew in 2005. The share of pipes, various equipment and machines imported for the Baku-Tbilisi-Ceyhan pipeline construction decreased significantly in 2005 following the completion of the project. Meanwhile, pharmaceutical and sugar represented the next largest commodity groups of imports following motor cars. In Q4, 2005 the volume of imports from the EU increased by 19.3 percent. The indicator for import growth was almost the same as in the corresponding period of 2004. Table 28: Imports to Georgia from EU countries (thousand USD)

2004 Q 1 Q 2 Q 3 Q 4 2005 Total imports from EU 617 549 122 640 152 038 180 852 215 855 671 385 Of which: Austria 22 258 3 474 4 530 5 796 5 212 19 012 Belgium 15 518 4 651 6 101 6 216 8 612 25 581 Cyprus 8 056 572 196 669 297 1 734 Check Republic 12 348 1 680 4 766 6 839 7 268 20 552 Denmark 8 385 1 192 2 770 1 417 1 685 7 065 Estonia 445 116 102 843 83 1 143 Finland 6 338 2 971 4 397 2 496 3 387 13 250 France 63 230 11 911 20 473 29 806 35 089 97 279 Germany 151 067 34 202 46 737 56 511 69 310 206 760 Greece 14 485 4 856 2 582 5 346 5 809 18 593 Hungary 10 153 1 480 4 423 4 752 3 685 14 339 Ireland 2 185 493 916 977 1 944 4 329 Italy 61 624 11 390 12 767 20 178 20 088 64 422 Latvia 2 906 1 268 1 282 2 459 1 186 6 195 Lithuania 4 552 1 182 882 1 337 1 613 5 014 Luxembourg 471 89 392 184 275 939 Malta 1 - - - - - Netherlands 34 600 10 725 10 230 11 396 20 735 53 086 Poland 8 430 3 193 3 609 3 288 3 567 13 657 Portugal 2 158 643 1 075 677 748 3 143 Slovakia 1 336 888 391 455 1 216 2 949 Slovenia 3 970 616 1 179 643 1 616 4 054 Spain 6 406 1 173 2 190 2 356 2 732 8 451 Sweden 4 812 4 662 990 3 275 696 9 623 UK 171 814 19 214 19 059 12 938 19 002 70 213 Source: Department for Statistics, Ministry of Economic Development According to 2005 data, Germany was the largest EU exporter to Georgia with a 31 percent share in total imports from the EU. If compared with the previous year, imports from Germany increased by 7 percentage points. Motor cars comprised 39 percent of imported commodities from Germany. France was the second among EU countries by its volume of imports exports to Georgia in 2005. During the year its share increased from 10 to 14 percent. The largest commodity group imported from France was sugar (comprising 37 percent of total imports from the country). The share of Netherlands in total EU imports increased from 6 percent in 2004 to 8 percent in 2005. The most dynamic was the fourth quarter with imports from this country increasing twice, which mainly accounted for by trucks and motor cars. The share of imports form the UK in total EU imports decreased from 28 percent in 2005 to 10 percent in 2005. This was primarily caused by the end of imports for the construction of Baku-Tbilisi-Ceyhan oil pipeline. It should be noted that Q4, 2005 saw a significant increase in imports from the UK in connection with the Shah Deniz gas pipeline construction.

45 Table 29: Direct investments by EU countries in Georgia (thousand USD)

2005 2000 2001 2002 2003 2004 Q1-Q2 Q3 Q4 2005 Total 131232 109840 167362 339393 499107 194936 75048 215821 485806 EU 39780 69812 58446 95708 195622 82920 49362 110622 242903 Of which: Austria 0 0 0 18108 23157 7609 618 6505 14732 Check Republic 0 0 0 250 277 95 620 565 1280 UK 4824 8509 17530 37670 87875 32768 24593 75591 132952 Germany 3210 13420 4228 4145 5141 1576 1234 2222 5032 Ireland 14384 0 37 37 41 14 317 262 592 Italy 2972 6976 9864 15896 32480 10327 6770 5742 22838 Cyprus 3921 19245 1063 676 21333 24244 9028 14265 47537 Luxembourg 0 0 337 250 277 95 214 244 553 Netherlands 4422 1501 0 0 0 0 275 217 492 Poland 6047 2582 0 0 0 0 164 130 294 Greece 0 146 19100 1967 2178 748 490 979 2217 France 0 17434 6287 16709 22863 5443 5040 3901 14383 EU share in total FDI % 30 64 35 28 39 43 66 51 50 Source: Department for Statistics, Ministry of Economic Development According to the State Department for Statistics, the EU made 243 million USD direct investments in Georgia. It is noteworthy that in Q4, 2005, EU direct investments increased by 124 percent, however, the growth of investment inflows from other countries in the same period caused a decrease of the EU share in total FDI’s. Direct investments were mostly connected to the Shah Deniz gas pipeline construction the prime shareholder of which is the British company BP. The UK continued to be the largest EU investor in Georgia. It accounted for 55 percent of total investments in Georgia from this group of countries. Its share comprised 68 percent of total EU direct investments in Q4, 2005, thus significantly exceeding the previous quarter indicator. The second EU country by size of investments in 2005 was Cyprus. The share of investments made in Georgia by offshore companies registered in this country amounted to 20 percent, which is almost twice as much as last year’s corresponding indicator. The following places by size of investments were occupied by Italy, Austria and France the shares of which were much lower than in 2004. It should be noted that investments from the mentioned countries were mainly linked to pipeline construction. The development of EU-Georgia trade and economic relations in 2005 affected the domestic currency market as well. The amount of transactions conducted in Euro outside the Tbilisi Interbank Foreign Exchange segment increased twice and reached 352 million Euro. The growth took place mainly in the fourth quarter - the trade in Euro increased by 44 percent compared to the previous quarter and by 3.3 times compared to the same period last year. Remittances by individuals from EU countries were also characterized with the upward trend. Net transfers by individuals from EU countries in 2005 amounted to USD 40 million, showing a 21 percent increase compared to 2004. At the same time the share of net transfers from EU countries in total transfers fell from 16 to 13 percent due to the increase in transfers from other countries. The main source of remittances from EU countries was money transfers from Greece.

46 Table 30: Georgian economy compared with EU25

Georgia EU-25 2000 2001 2002 2003 2004 2005 2006* 2005** Real GDP growth, % over prev. year 1.8 4.8 5.5 11.1 5.9 9.3 7.0 1.6 GNI per capita (PPP, Euro) - - - 2308 - - - 19644.01 in % of EU-23 (PPP) - - - 11.7 - - - - GDP per capita (nominal USD) 657.5 697.0 741.4 876.9 1139.1 1415.6 1599.0 25178.02 Inflation (consumer prices, year av) 4.0 4.7 5.6 4.8 5.7 8.2 - 4.7 end of year 4.6 3.4 5.4 7.0 7.5 6.2 6.0 - Lending rate, year average, in % p.a. 25.3 24.0 23.1 21.6 20.2 17.9 . 4.03 Fiscal balance, % to GDP -3.2 -2.5 -1.9 -3.2 -2.3 -0.1 -3.1 -2.62 Public depth, % to GDP 69.4 66.7 65.0 53.8 43.8 35.2 33.8 63.42 of which: domestic 24.8 22.3 20.4 18.3 16.0 13.3 - - foreign 44.6 44.4 44.6 35.5 27.8 21.9 - - Current account, % to GDP -5.3 -6.9 -5.8 -9.3 -6.8 -10.8 - 0.02 FDI net inflow, mln USD 131.7 109.9 163.3 336.3 489.5 537.3 - -3720.22 Mamorandum items: Nominal GDP mln GEL 6043.1 6674.0 7456.0 8564.1 9824.1 11592.0 - mln USD 3058.4 3220.6 3397.6 3990.9 5125.3 6395.2 - - mln Euro 3310.7 3594.0 3591.2 3523.7 4119.0 5139.2 - 930043.14 Exchange rates (nominal, year av) USD/GEL 1.9759 2.0723 2.1945 2.1459 1.9168 1.8126 - - Euro/USD 0.9238 0.8961 0.9461 1.1326 1.2443 1.2444 - - Sources: Department for Statistics, Ministry of Economic development; National Bank of Georgia; World Bank; IMF; European Central Bank; Eurostat Notes: * projections ** preliminary estimates 1. 2003 2. 2004 3. the numbers for Georgia reflect weighted average lending rates charged by commercial banks on loans in domestic currency with maturities up to one year; the number for the EU refers to the euro zone (EU12) only and reflects the rate on new loans in Euro with duration of up to one year 4. gross value added (2004), i.e. GDP at producers’ prices, excluding. taxes less subsidies

47 Part II. Economic Trends and Policy Analysis

1. Georgia’s economic growth: how to avert possible risks in future Cristophe Cordonnier, Professor, GEPLAC economic expert Current situation of the Georgian economy: light out of the tunnel According to the IMF team that visited Georgia in February 2006, “Georgia’s macroeconomic performance continues to be impressive”. No doubt many analysts share this sentiment. Allowing for the vagaries of Georgian statistics, GDP grew in 2005 by 9.3 percent over the previous year in real terms. The results appear particularly good in sectors such as manufacturing (+24.6 percent), with substantial progress in food processing (+34.8 percent) where Georgia has comparative advantage. This positions Georgia as one of the best performers among transition countries along with, Azerbaijan, Armenia, and Kazakhstan.

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Source: EDRD The Fund is also pleased that, despite its initial fears, inflation has been kept around 6 to 7 percent, well below double-digit levels. This is also quite an achievement when we take into account the large exposure of the Geor- gian economy to imported oil. That being said, one must also consider this progress against the background of fifteen lost years. In no other country but Moldova have living standards declined so much, with current GDP at only half of pre-transition levels. As in Moldova, part of this bad performance can be attributed to conflicts, which led to the abysmal drop in output prior to 1995 (at that time, according to EBRD, Georgian GDP was only one quarter of its 1989 level). Part of it is also linked to the fact that Georgia used to be a key player in the agricultural sector of USSR, which was then heavily subsidized by other sectors such as energy production or fertilizers (1). As such, it has been one of the main losers following the end of the Soviet division of labour.

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Source: EDRD However, countries such as Albania, Armenia, and Azerbaijan share many of those negative factors and managed to muddle through - and even, in some cases, to improve their output compared to pre-transition levels. Others such as the Baltics, similar to a certain extent to Georgia because of their small size and population, and the initial role of agriculture in their output, achieved a complete transformation of their productive structure and trade flows in less than a decade.

48 (%1MFWFM QFSDFOU -BUWJB 3VTTJB #PTOJB 1PMBOE $SPBUJB #FMBSVT &TUPOJB (FPSHJB 6LSBJOF #VMHBSJB "SNFOJB 4MPWBLJB 4MPWFOJB "MBCBOJB 3PNBOJB )VOHBSZ .PMEPWB ,ZSHZ[JB -JUIVBOJB 5BKJLJTUBO 6[CFLJTUBO ,B[BLITUBO "[FSCBJEKBO .BDDFEPOJB 4FSC.POU 5VSLNFOJTUBO $[FDI3FQVCMJD

Source: EDRD Even though we should not blindly follow these figures (which tend to overestimate the real performance of countries such as Belarus or Uzbekistan that have not really implemented, or paid for, systemic transformation of their economy), daily life offers plenty of proofs of the distressed situation of the Georgian population. While it was one of the richest Soviet republic, Georgia is now, according to World Bank PPP figures, poorer than India. Lamentably, despite the great achievements which followed the Rose Revolution, notably in the fight against corruption, there no clear sign that poverty is being reduced. Official statistics show that more than half of the population is considered poor, and a proxy of social malaise such as the crime rate shows no sign of decline (according to the Ministry of Internal Affairs of Georgia, the number of homicides and attempted homicides increased by twenty-nine percent in 2005). The apparent contradiction between promising economic growth and lacklustre social indicators is largely explained by the dynamic of the labour market, which is leading to greater income inequality. Currently, less than one third of the working-age population is employed in the formal sector, and this ratio is declining. In the recent past, most of the decrease in formal employment has been linked to the restructuring of the state and massive layoffs of civil servants. While this restructuring will undoubtedly yield dividends in the future, it has not been accompanied by an equivalent job creation in the private sector. And in many cases the new jobs being created are for highly qualified personnel, particularly in the financial sector, which offer few opportunities for dismissed civil servants. This tension over job creation is aggravated by the lack of an escape valve through migration abroad. Tradi- tional migration to Russia, which hosts at least a half-million Georgians (more than ten percent of the population), is impeded by geopolitical problems, and flows to the West are blocked by strict visa requirements. In this context, Georgia faces a dilemma. Further reforms, especially in the key agricultural sector, which accounts for more than half of the workforce, may initially generate more unemployment and social hardship, and therefore diminish the political will for reform in the long run. But without these reforms, it will be hard to sustain growth. (%1BOE'PSNBMFNQMPZNFOU (%1 )JSFEFNQMPZNFOU UIPVTBOET

Source: EDRD The gap between social aspirations and social realities aggravates this tension. While many Georgians consider material life to have been better in Soviet times, very few wish to return to that situation. The Rose Revolution and political support from Western countries have raised expectations for a better future. If these expectations are not satisfied by improvements in living standards, social frustration and political cost could be considerable. For this reason, we believe that IMF growth scenarios, which are based on an average 4.6 percent GDP growth in 2006–2010 (compared with 7.2 percent in 2001–2005), may not be consistent with this social equation. At this stage, it may be unwise to put macroeconomic stability first and strong growth second, if it is not clearly demonstrated that similar and even higher rates of GDP growth than the ones recently recorded would not lead to destabilizing inflationary pressure and deterioration of external accounts.

49 Against this background - which may partly explain President Saakashvili’s ambitious 2006 address to Parlia- ment, where he stated that in 2008 Georgia will no longer be a poor country - the purpose of this paper is to open a debate, based on past and comparative experiences, on the macroeconomic risks that a high-growth scenario would entail. We will also try to see what policy mechanisms could be recommended to increase the quality of this growth, which, in the current Georgian situation, means its labour intensity and its capacity to generate new jobs not only for a small elite of high-skilled workers but for the bulk of the population. GDP growth and macroeconomic stability To better define the potential macroeconomic risks faced by Georgia, it is good to review its past experience. The Rose Revolution has brought substantial improvement in its economic environment, thanks in particular to a new generation of policy makers who can communicate well with IFI’s. Macroeconomic risks taken previously, in a much more difficult situation and which did not lead to unsustainable macroeconomic imbalances, could still be taken today to reach levels of GDP that better reflect Georgia’s potential. 1. Growth and inflation For the IMF, inflation is a major cause of concern. However, since the hyperinflation period, which had coin- cided with internal wars, inflation has not been a key issue in Georgia. Since 1997, it has only once been in double digits (10.9 percent in 1999, just after the Russian currency crisis), and never at a level that would be considered critical, based on the experience of developing countries in the last decades. $POTVNFSQSJDFTDIBOHFBWFSBHF

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Source: EDRD As in many emerging economies, the stability of the exchange rate has been a key anchor for price stability. Since 1999, the nominal exchange rate has been moving mainly within a rather narrow band (2.10/1.80 GEL/ USD), with minimal annual fluctuations (except in 2004), even though the IMF has often suggested that the National Bank of Georgia (NBG) let the currency appreciate more when Georgia receives strong inflows from abroad. To a large extent, this stability has been the main policy tool and achievement of the NBG. But it has meant also that its monetary policy has largely been constrained. Basically, the NBG transformed hard-currency inflows into national-currency monetary aggregates (base money) and vice-versa. Following the Rose Revolution, increased confidence from Georgians abroad and large amounts of credits and grants from IFI’s and donors generated a substantial leap in inflows, despite letting the currency appreciate against the dollar nominally by twelve percent (the NBG had to absorb most of these inflows by buying them out while issuing Laris). This lead to a forty-four percent increase in the monetary base in 2004, a level which would have been considered perilous for most economies.

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Source: The National Bank of Georgia Significantly, the impact on inflation of this strong increase in monetary aggregates has been negligible. This is linked to three factors that we believe will still play the same role in the future, should monetary aggregates increase in a similar way because of, for example, privatization receipts.

50 The first factor is a decrease in the velocity of money, which came down from 9.1 in 2001 to 8.1 in 2003, 6.6 in 2004, and 5.8 in 2005 (broad money). As Georgian monetary ratios (M3/GDP) are still low (seventeen percent) compared with most transition countries and, provided confidence in the future remains strong among the population, we believe that this remonetization process will still play a substantial role in the absorption of new money being created either by the NBG (monetary base) or by commercial banks. The second factor, reminiscent of Russia after the 1998 crisis, is that Georgia appears still to have a large un- tapped production potential inherited from the USSR. Much more than a statistical bias linked to the reduction of the informal share of the economy, this may explain the splendid manufacturing performance in 2005, which was obtained with virtually no additional investment in many cases (trade figures show, for instance, that imports of machinery are still negligible). This may be the case in particular in the agribusiness sector, as we have con- cretely experienced. In wine production, for instance, most of the heavy equipment is still in place and often in rather good shape. Provided they get credit from banks or wineries plants, farmers can also significantly increase their output of grapes by using more fertilizers and pesticides. In meat production, we have also seen large output increases with limited investment as facilities have been adapted to Western standards and put back into use. We do not know how much spare capacity is still available for “free” growth, knowing that this concept of includes assets that may require additional investment to be compatible with modern production standards. However, we believe it would be unwise not to make the best use of this spare capacity by putting unnecessary restraints on domestic demand. First, because Georgia would lose much free growth. Second, because this free growth may help it to absorb part of its excess labour capacity. And third, because this excess capacity can generate high profit rates for enterprises, because their depreciation costs are initially minimal. This free growth may, therefore, help them strengthen their balance sheets and enter into sustainable high-growth ventures. *OUFSOBUJPOBMPQFOOFTTPGUIF(FPSHJBOFDPOPNZ

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Source: IFS The third factor for price moderation is by far the most important one, linked to the openness of the Georgian economy. In 2005, exports of goods, services, and transfers accounted for forty-five percent of GDP and imports of the same items for fifty-four percent of GDP. This ratio is much higher than in most emerging markets or developed economies. Of course, despite its ambition of becoming an international hub, which gives sense to its decision to unilaterally scrap its tariffs, Georgia is not yet Singapore, or even Estonia, but it is already as open an economy as France. In such an economy, any increase in monetary aggregates and domestic demand translates mechanically into pressure on imports if the local producers are not able to react by increased output or if they do not produce the goods required by local customers (cars, for instance, in Georgia). On the export side, the impact of increased domestic demand is currently quite limited as most of the products exported by Georgia are not geared towards the domestic market. Because the currency is quasi-fixed, competition from imports prevents domestic producers of tradable goods and services from increasing their prices when faced with excess demand, even when they do not have spare capacity left. This pattern is customary in many economies that use a currency peg to keep inflation in check (2). But it usually leads to differential inflation, as the prices of non-internationally-tradable goods and services, not subject to pressure from abroad, still react to additional domestic demand by an upwards adjustment. Eventually, as seen in Argentina and Brazil prior to their mega-devaluations of the recent past, producer profits in the tradable sector are cut by this scissors effect (they pay higher prices for their non-tradable factors of production, for example from public utilities, and they cannot increase their own prices) and most new investment is focused on the non-tradable sector (retail centres, real estate, etc.) with dubious long-term benefits for the economy as a whole. The same mechanisms can be observed in so-called Dutch-disease economies, as is currently the case in Russia. We do not see strong signs of this differential process of inflation in Georgia, as most of the inflation pressure is linked to staple commodities such as oil products or meat. This is probably due to the fact that services, which make the bulk of the non-tradable sector and which account for fifty-eight percent of the economy, are for the most part subject to high internal competition, in an environment of massive underemployment. However, in sectors such as telecommunication or electricity, providers can achieve oligopoly or monopoly, we could see the

51 appearance of these differential dynamics of prices. This makes their regulation an important concern for policy- makers, especially as they will be transferred to the private sector in the next privatization wave. For these three reasons, we believe that inflation cannot be a major risk and matter of concern for Georgia today. 2. Growth and external accounts As there is no free lunch in economics, in Georgia and elsewhere, the fact that trade openness acts as a strong anti-inflation buffer means also that a large part of increasing domestic demand translates into pressure on imports (imports of cars, for instance, increased by more than one percent of GDP in 2005). In Georgia, the critical factor is the current-account deficit and how it is financed. (%1HSPXUIBOEDVSSFOUBDDPVOUEFGJDJU(%1

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Source: EBRD; IFC Since independence, Georgia’s current-account deficit has never been lower than 4.5 percent of GDP (in 2000, at a time of very low GDP growth) as if there were a structural bottleneck (incompressible level of basic imports). But the elasticity of the current-account deficit with respect GDP growth is rather low. For the period 1998–2005, for a one per cent increase in the GDP growth rate, the ratio of current-account deficit to GDP increases by only 0.39 percent. This partial correlation, which probably reflects the economy not yet fully making use of its unused capital and labour capacity, has consequences for policy making. It means that there is no call for Georgia to put pressure on its level of growth at this stage, as it would have a limited impact on its current-account deficit. Based on the equation linking the ratio of current-account deficit to GDP to the rate of GDP growth, we have conducted four simulations for macroeconomic projections until 2010. In our simulations, we have forecasted for all scenarios an increase in foreign exchange reserves of 50 million USD per year and annual equity investment inflows of 300 million USD (slightly lower than the 2000–2005 average of 330 million USD). Through these calculations, we can assess various hypotheses of external-debt levels. Logically, because of the still low elasticity of the current-account deficit to growth, it is striking to see that there is yet not much difference in the key-external-debt-to-GDP ratio between scenarios of very low growth (two percent on average) and high growth (eight percent). We say “yet” because in our scenarios we consider that the Georgian economy is still within its production frontier, with no significant tension on its inputs of capital and labour. (%1HSPXUITDFOBSJPTBOEFYUFSOBMEFCU(%1SBUJPT QFSDFOU

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In comparative perspective, Georgia would still appear in the high-growth scenario as a moderately indebted country in terms of external-debt-to-GDP ratios, taking into account that these comparative ratios tend to overestimate the real burden of Georgian debt as it has largely been obtained under preferential terms (long grace periods, low interest rates).

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Source: EBRD If high growth does not yet translate into inflation and into unsustainable current-account deficits, we see no reason why the Georgian government would opt for the low-growth path of the IMF-framework scenario, knowing that it is based on the dubious assumption that through lower growth the current-account deficit would be reduced to levels not seen in recent Georgian economic history.

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Some policy recommendations: How to increase the quality of the growth process 1. Budgetary policy The analysis of the macroeconomic impact of Georgian budgetary policies since the Rose Revolution is complex, as it involves the impact assessment of elimination of arrears and many off-budget funds. Nonetheless, in two years Georgia has experienced a revolution in the role of the state in the economy. Paradoxically, the state is at the same time much leaner and much more present than it was previously. The transformation of a highly bureaucratic, needlessly complex, and thoroughly corrupt state apparatus into a much simpler one is a real achievement of the new administration. In many cases, it has just made use of tech- niques that had proved successful in other transition countries. The twelve-percent flat tax on personal income is clearly reminiscent of the thirteen-percent flat tax adopted at the beginning of the decade by Russian liberals, with the same success in terms of tax collection. But in many other fields, such as the massive dismissal of civil servants (up to 30,000 of them) and the complete transformation of the police force, the Georgian reformers have been much more ambitious than in any other transition country. The transformation of the State is far from over, as it is easier to destroy the former rotten part of it than to build new institutions that fit both international standards (EU ones in particular) and reflect Georgian constraints, but the evolution is clearly positive. While being leaner, the State is also more present than it has been since the beginning of the transition. Since 2003, its tax revenues have increased from fourteen percent of GDP to more than twenty percent, mainly because of better VAT collection. But its expenditures have also jumped, from eighteen percent of GDP to nearly twenty- seven percent. Thanks to privatization revenues and international grants, most of the shortfall has been covered without incurring debt. Along with an accommodating monetary policy, the budgetary policy has played a major role in strong growth in 2004 and 2005. It could even be considered as Keynesian, owing to the substantial deficit (before extraordinary items) and to the fact that, as in Keynes’ approach, it benefits from Georgia still being well within its production frontier. This situation, however, is not necessarily comfortable for IFI’s, which may legitimately anticipate that they would have to finance the shortfall after the end of the privatization process. To limit this risk, we believe it would be appropriate for the Georgian government to keep working in parallel on two fronts: Continuing to increase the share of its revenues in GDP and diversifying its sources of funding. Despite their recent improvement, Georgian tax revenues remain quite low by transition-country standards (only Armenia and Tajikistan have lower revenues) and it is not apparent they could continue to rise in the proportion of GDP. A jump in tax revenues from the reduction of corruption and better compliance cannot be 53 repeated. Meanwhile, the progressive elimination of import tariffs will have its costs, even though it should not be overestimated. The problems faced by the Government in its effort to increase the future tax take stem from the very conditions of its initial success. By adopting a single rate for income tax (twelve percent) and social tax (twenty percent), the Government cannot take much advantage of increased earnings of part of the population, contrary to countries where the tax rate is progressive. There remains some room to manoeuvre in the extension or increase of certain taxes. The VAT, for instance, could be paid on credits, as it was in the 1990s in some Latin American countries faced with rapid and unsound growth of consumer credits. Taxes on cars linked to the capacity of their engines could also easily be raised with a positive impact on the volume of imports of oil products. 2. Monetary policies In its last communiqué, the IMF recommended that Georgia develop additional monetary policy tools to manage its liquidity and prevent potential inflationary pressure. Basically, these tools would involve issuance on the domestic market of public securities in GEL to mop up excess liquidity generated by foreign-currency inflows. Even though high inflation is not at this stage a major risk, the introduction of these new instruments makes sense, as Georgia currently lacks any form of financial market. Meanwhile, its commercial banks cannot rely on NBG as a lender of last resort for managing their liquidity, as it has wisely avoided playing this role until now (this would have eventually constrained its capacity to manage the evolution of the exchange rate). This suggests the use of a money market where banks could buy and sell treasury bills and bonds denominated in GEL, thus allowing them to optimize their liquidity management. The development of such a market appears also to be a prerequisite for inter-bank credit based on so-called Repo transactions. To develop such a market, NBG could securitize its claims (GEL 646 million, i.e., ten percent of GDP or sixty- five percent of the monetary base) on the Georgian Ministry of Finance, subject to its preliminary approval. After their transformation into treasury bills or bonds, it would sell them on the financial market to mop up excess liquidity. Such a strategy would require a minimum volume of bills or bonds. If not, the market would remain illiquid. But at the same time, it may be dangerous to develop this market too aggressively, in particular if the major aim would be to try to mop up the monetary impact of financial inflows from abroad. As recent economic history in many emerging countries shows, the rapid development of a market for short- term state securities in this context may paradoxically lead to the total incapacity of the monetary authorities. If the currency is quasi-stable, which is currently the case for Georgia, and if the development prospects of the country are reasonably good, which is also true, then open-market operations conducted on a large scale will generate potentially large arbitrage gains and very strong speculative inflows. If this scenario occurs in Georgia, it would generate a vicious circle. To mop up excess liquidity generated by inflows of capital, Georgian authorities would sell securities in GEL. If their volume were substantial, their liquidity would be attractive for short-term investors (hot money), as would their interest rates (the more securities sold, the higher their interest rates). This would generate a second wave of financial flows, which would require even more sterilization by Georgian authorities by higher volumes of bills sold on the market, which would once again increase their liquidity and yields, bringing forth new inflows of hot money… What would be the immediate consequences of such a vicious circle? First, it would generate a large fiscal cost. When receiving these inflows, there would be a mechanical increase in the level of reserves of the NBG. These reserves would be placed on international markets and would receive the normal remuneration of capital on these markets. On the other side, the issuance of bills in GEL to mop up the liquidity which would be largely linked to these inflows of hot money would be made at higher yield, which would reflect Georgia’s risk premium on the poor efficiency of its financial system. Eventually, this interest rate differential could amount to substantial sums. In Chile, for instance, at the beginning of the 1990s, it was nearly three percent of GDP. The second impact of this strategy could be a dangerous transformation of the asset structure of commercial banks. Today most of their assets (sixty-seven percent in December 2005) are made of loans to the non-financial private sector, and the share of securities is minuscule (1.2 percent). In the future, in case a large volume of such securities were sold on the local market, this asset structure could be substantially modified, with a crowding out of credits to the private sector. This development would be similar to that in Russia at the time of development of GKOs, or in many other emerging countries in the 1990s. While taking these risk factors into account, they can be to a large extent compensated for by adequate strategies. Chile made the choice to tax all foreign-currency inflows except those linked to foreign direct investment. In Mexico, after the crisis of 1994 where short term treasury bills bought by hot-money investors (the infamous “28-days Cetes”) had played a very negative role, the choice was to prevent arbitrage of speculators by increasing their risk: At that time, following another Chilean practice, Mexican authorities began to issue long-term inflation-indexed bonds and opted for more flexibility in the management of the parity rate. 54 In the case of Georgia, we recommend the Mexican approach, as taxing inflows would be quite complex because of the already high dollarization of the economy and the inability to effectively distinguish between non-taxable remittances and taxable financial inflows. Uncertainty on the future value of the currency should be higher than today, with recourse to a tunnel allowing for short-term variations of about five percent in the target rate. And the securitization of the debt of the Ministry of Finance due to the NBG could include from the beginning a rather large array of maturities, eventually including long-term bonds indexed to inflation. 3. Structural policy a) Support to investment The investment rate of Georgia seems to be at a rather high level: According to IMF figures, it reached thirty percent of GDP in 2005, nearly ten percentage points higher than in Russia. Much of it is probably linked to the construction of the Baku-Tbilisi-Ceyhan (BTC) pipeline. Prior to this project, the investment rate was slightly above twenty percent. Even after taking into account the impact of BTC, these figures appear somewhat mislead- ing. This is confirmed by the fact that the acquisition of capital goods (Georgia has virtually no production of these items) still plays a secondary role in imports, far behind imports of energy, food, or cars. As we have seen, the fact that there are still few imports of machinery is logical as many enterprises may still have spare capacity, especially in the agribusiness sector which constitutes the bulk of manufacturing output. However, Georgia may eventually face bottlenecks that could reduce substantially the capacity of its productive sector to keep growing on a sustainable basis. The bottleneck for this agro-industrial economy is the gap between industry and agriculture (the index of production, base year 1998, is 167 for industry against 105 for agriculture). Because it is today extremely fragmented, Georgian primary agriculture will have many difficulties meeting the procurement needs of agro-processors. It is therefore of utmost importance, as we have previously stated (3), to favour the emergence of a new class of mid-size farm entrepreneurs. It would be naive�� to expect this process to occur quickly without a sound agricultural policy implemented by the State. To a large extent, the stagnation of Georgian agriculture is a consequence of badly conceived land pri- vatisation policies of the 1990s. The way out requires proactive policies promoting concentration of land use and ownership. In this respect, credit should play a leading role; credit to agriculture accounts for only 1.4 percent of the total credit portfolio of commercial banks. The second bottleneck is the quality of physical infrastructure. While Tbilisi and main cities are far from international standards, the countryside is in terrible shape. Many villages, including those in prosperous areas, lack access to good roads, electricity, drinking water, etc. This hampers the growth of sectors with strong potential such as agrobusiness and inland tourism. In this respect, one cannot dream that private initiative can be a leading force, nor local-government funding. There is, therefore, a need for a major rural-infrastructure investment programme coordinated by the State with the help of IFI’s. Apart from improving the linkages of rural communities with the market, it would allow for some mopping up of excess labour in rural areas, making possible a parallel process of re-concentration of land. A third bottleneck is the quality of the work force. Georgia today has too little skilled labour and a large un- skilled work force. This is true not only of middle-aged workers but also, unfortunately, of younger generations. Investment in human capital is as important for Georgia’s independence as are defence expenditures. These bottlenecks hamper the development of new investments that would put Georgia on a recovery path create a new, open economic paradigm. In fact, Georgia has not been very successful until now in attracting value-added foreign direct investment - with strong qualitative spill-over as was the FDI received by most Central European countries since the beginning of the transition process. Of course, FDI has been deterred by the extreme corruption of the previous administration (4), and it is still frightened by the complex geopolitical equation of Georgia, which depends heavily on Russia for trade, and even more so for remittances. But these factors could be limited if enterprises were profitable, which is often not the case as we have heard from leading foreign investors confronting these bottlenecks. In terms of economic policy, this situation makes appropriate a dual approach by the State. First, capital expenditure, which has climbed from one percent of GDP in 2000 to four percent in 2005, must remain high in the future, even at the cost of incurring substantial budget deficits. Second, it is necessary, at least in key sectors where Georgia can regain real leadership (e.g., agrobusiness, tourism, labour-intensive manufacturing), to envis- age some incentives for both foreign and local investors to compensate for the costs of structural bottlenecks and geopolitical uncertainty. In this field, we would first recommend considering a tax-free special economic zone (SEZ), based on the Mexican model (maquiladoras), which could be located in Poti, a key site for TRACECA. This SEZ would attract investment in labour-intensive activities such as textiles or footwear. For EU investors, many of which are currently relocating these activities to China, often after having transferred them to Central Europe, it would be a perfect location as Georgia benefits from the General System of Preferences. For Georgia, the development of a successful SEZ could help mop up excess labour, at least during an initial period when economic restructuring,

55 especially in the countryside, will continue to be painful. To a certain extent, it could be a substitute to increased emigration. b) Support to private savings Finally, the cost of capital in Georgia, currently very high, will not diminish without an increase in its savings rate. In this respect, recent figures point to a clear decline. While the domestic private savings rate was 20.3 percent of GDP in 2000 and 17.9 percent in 2003, it has dropped to 14.3 percent in 2004. In 2005, there is no evidence of a substantial rebound. In this respect, it is likely that Georgia, as with most other emerging countries, will not follow the traditional rule of classical economy that says that the saving rate increases in proportion with earnings. On the contrary, Georgia manifestly belongs to the category of aristocratic or oligarchic societies where, when an individual has reached a certain level of earnings and fortune, he must spend it in a highly visible way through acquisition of luxury goods, most of them imported. This Bourgeois Gentilhomme style economic behavior was one the key reasons for the low level of development of Latin American societies, traditionally the most unequal in the world. It led Chilean reformers in the 1980s, followed a decade later by most countries on the continent, to promote forced decentralized savings through private pension funds. In the case of Georgia, we believe that the Chilean model could be quite appropriate, provided that pension funds would have some capacity to invest their savings abroad, mitigating therefore the perception of risk for their members. Eventually, these pension funds would allow Georgia to build a real financial market, and to develop in particular the issuance of medium and long-term bonds, which would progressively substitute or complement financing received from IFI’s. References: 1. Cf. Cordonnier, Christophe. L’agriculture russe : les paradoxes du renouveau , Déméter, 2004; Prospects for the Development of Georgian Agriculture and Rural Society. Proposals for an Action Plan, Georgian Economic Trends, Quarterly Review, December 2005, GEPLAC, Tbilisi 2. Cordonnier, Christophe. La crise économique brésilienne, Probl��è�mes�� d’Amérique latine, 33, avril 1999 ; Russia: natural resource rent and competitiveness, Research Policy�� Paper, RECEP, January 2005. 3. Cordonier, Cristophe. Prospects�� for the Development of Georgian Agriculture and Rural Society. Proposals for an Action Plan, Georgian Economic Trends, Quarterly Review, December 2005, n3, GEPLAC, Tbilisi. 4. It would be naïve to consider that corruption plays a very negative role in the attractiveness of a country for FDI. Russia and China, which currently attract huge amounts of FDI are not among the “cleanest” states. And many econometric studies prove that the quality of institutions is not a determining factor for FDI (cf. in particular, Wheeler, D., Mody, A. International investment location decisions, Journal of International Economics, 33, 1992, p. 57-76). 5. Country Partnership Strategy, The World Bank, Oct. 2005. 6. Country Partnership Strategy for Georgia, The International Development Association and the International Finance Corporation, Aug. 2005. 7. Transition Report 2005: Business in transition, The European Bank for Reconstruction and Development (EBRD), November 2005.

56 2. Trends in levying excise goods and mobilizing revenues in Georgia David Narmania, PhD of Economics, Chairman of Board of Georgia’s Young Economist’s Associations Over the recent years the excise tax has been playing an important role in Georgia’s budgetary revenues. In 2001-2005 the share of excise revenues in total revenue collection was between 8 and 12 percent annually. This tax was introduced in Georgia in 1992. Since then the excise commodity types and excise tax rates as well as rules for levying and administering have changed several times. Table 1: Excise tax rates on basic excise goods in Georgia

Measurement Before Jan 1, After Jan 1, incr/decrease in Type of excise commodity unit 2005 2005 tax rate Sparkling wines (including champagne) 1 liter 0.5 Lari 0.7 Lari +0.2 Lari Fortified wines bottled 1 liter 1.0 Lari 1.2 Lari +0.2 Lari unbottled 1 liter 0.5 Lari 0.7 Lari +0.2 Lari Ethyl alcohol 1 liter 0,7 Lari 1.3 Lari +0.5 Lari Alcoholic drinks distilled from grape wine or Georgian vodka 1 liter 2.0 Lari 2.3 Lari +0.3 Lari Whiskey, rum, tafia, gin and wine infusion 1 liter 2.0 Lari 2.5 Lari +0.5 Lari Vodka 1 liter 1.0 Lari 1.5 Lari +0.5 Lari Liquor and sweet ratafia 1 liter 2.0 Lari 2.3 Lari +0.3 Lari Beer 1 liter 0.12 Lari 0.2 Lari +0.08 Lari Tobacco imports (except raw tobacco): - cigar, cigarillos 1 piece 0.6 Lari 0.9 Lari +0.3 Lari - filter-tip cigarettes 20 piece 0.4 Lari 0.9 Lari +0.5 Lari - all other unfiltered cigarettes 20 piece 0.2 Lari 0.3 Lari +0.1 Lari - other tobacco products and tobacco substitutes 1 kg 20 Lari 20 Lari +0.0 Lari Locally made tobacco products (except raw tobacco): - cigar, cigarillos 1 piece 0.6 Lari 0.7 Lari +0.1 Lari - filter-tip cigarettes 20 piece 0.25 Lari 0.7 Lari +0.45 Lari - all other unfiltered cigarettes 20 piece 0.1 Lari 0.2 Lari +0.1 Lari - other tobacco products and tobacco substitutes 1 kg 20 Lari 20 Lari +0.0 Lari from 0.5 to 1.5 Lari per 15% of customs Motor cars cm3 according - value to the year of manufacturing Oil distillates: light (petroleum) 200 Lari 250 Lari +50 Lari medium (kerosene) 1 t 200 Lari 220 Lari +20 Lari heavy (diesel) 100 Lari 150 Lari +50 Lari Ferrous and non-ferrous scrap metal 1 t -* 25 Lari - Source: Tax Code of Georgia Note: the commodity marked with * was not levied by excise tax until before January 1, 2005 The role of excise tax in Georgia’s budgetary revenues Previously effective excise tax rates were established in the form of either fixed or ad valorem (percentage) rates. For example, ad valorem rate was used for motor cars and natural gas condensates while fixed rate for alcoholic drinks and tobacco products. Currently, all the rates are fixed ones and linked to a specific measurement unit of an excise commodity (ton, litre, piece, etc). The rise in excise tax rates almost on every excise commodity since January 1, 2005 and events induced by that rise, including contraband, brought about just GEL 3.2 million, i.e. 5.2 percent increase in excise revenues from local output in 2005 as compared with 2004 (Table 2). As the demand on excise goods has not changed much and the local production showed a very insignificant growth, the excise revenues to the budget from imports increased by GEL 119.4 million (117 percent) in 2005 compared to 2004.

57 Table 2: Excise tax revenues to the state budget in 2001-2005 (million GEL)

2002 2003 2004 2005 2006 Indicator target actual target actual target actual target actual target

Total tax revenues 807.3 752.2 915.9 806.5 1293.0 1322.1 1726.2 1836.1 2263.1

o/w excise revenues from all 108.5 84.4 111.2 100.1 164.5 163.8 280.4 286.4 338.4 excise commodity types

share of excise in tax revenues, % 13.4 11.2 12.1 12.4 12.7 12.4 16.2 15.6 15.0

excise mobilized in the budget 27.0 26.0 30.1 21.9 62.8 62.0 64.2 65.2 93.4 from local production

excise mobilized in the budget 77.5 63.3 81.1 78.2 101.7 101.8 216.2 221.2 245.0 from imports Source: Treasury service, Ministry of Finance A relatively moderate growth in excise revenues from the local production occurred mainly thanks to the increase in the excise volume on locally produced tobacco products. The amount collected from the sales of excise stamps for Georgian-made tobacco products was less by GEL 5.7 million (17.5 percent) in 2005 than in 2004. It was mainly caused by the drop in local tobacco production in real terms. The local tobacco output dropped from 3 million pieces in 2003 to 2.8 million in 2004 and to 1.8 million pieces in 2005 (Table 3). The dynamics of excise revenue collections to the budget over the past few years shows that the targets for excise tax revenues were not met in 2002-2004 (Chart 1). Accordingly, the budget was short of several million Laris every year. However, despite the failure in the previous year, the target for the following one was always higher than the target and the actual collection of the previous year. A similar tendency is observed in setting excise revenue targets for both local and imported goods (Table 2).

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Source: Treasury service, Ministry of Finance The majority of excise goods consumed in Georgia are imported ones; however the country produces several types of excise goods, which meet some demand of the population (Table 3). Such goods are: alcoholic drinks, wine and wine material, tobacco products, beer, oil distillates. The excise revenues from imports have been increasingly growing over the past few years. In 2005 the budget received GEL 52.9 million from the sale of excise stamps for local production, thus comprising only 20.1 percent of the total excise revenues and being twice as low as the 2004 indicator. The largest share of budgetary revenues raised from the sale of excise stamps for locally manufactured goods accounts for tobacco products; it comprises 61.6 percent of total excise revenues in 2005 and is less by 15.5 points than the corresponding indicator for 2004. The second largest share accounts for beer (18.5 percent), which, at contrary, increased significantly if compared with 2004. The share of vodka also grew reaching 14.8 percent and thus securing the third position. Local production of excise goods in Georgia Budgetary revenues from the sale of excise stamps for local output have decreased in regards to tobacco products and brandy. As for the volume of locally manufactured excise goods in real terms, the drop was observed in oil distillates and tobacco products (Table 3). The above given indicators show that the year 2005 was the most painful for tobacco products. If in 2004 the revenues from locally produced tobacco products made up GEL 38.4 million, in 2005 this indicator decreased by GEL 5.8 million to GEL32.6 million (Table 4). That means that the state should pay more attention to the promotion of the tobacco production and improvement of excise tax administration in this industry.

58 Table 3: Locally produced excise goods in real terms

Description of excise commodity Measurement unit 2003 2004 2005

Refined oil products, total: thousand ton 18.6 41.9 1.8 o/w Diesel thousand ton 3.7 16.5 0.8 Petroleum thousand ton 0.1 3.3 - Kerosene thousand ton 0.2 - - Fuel oil thousand ton 12.8 16.7 0.8 Cigarettes million pieces 3.0 2.8 1.8 Ethyl alcohol thousand deciliter 50.0 192.2 138.2 Vodka and liquor-vodka drinks thousand deciliter 117.7 425.3 577.7 Brandy (cognac) thousand deciliter 141.9 130.7 241.2 Wine thousand deciliter 2.3 2.6 3.9 Sparkling wine (Champagne) thousand deciliter 160.3 163.8 189.2 Beer million deciliter 2.8 4.8 5.9

Source: Department for statistics, Ministry of Economic Development The past few years have seen a dynamic growth in the production and export of high-quality wine, wine materials and some alcoholic drinks (Table 3). The export of this commodity type is taxed with zero VAT and excise rates, it is exempt from customs duty and is subject only to customs fee for customs registration. The only commodity exports, subject to excise tax since January 1, 2005, is ferrous and non-ferrous scrap metal. The excise revenues from this commodity to the budget amounted to GEL 13.3 million in 2005, which comprises a mere 5 percent of all excise tax revenues. Even though the country does not receive significant revenues from the export of excise goods, the revenues raised through the taxation of pre-export local production represent an important source to the budget. In particular, in 2005 the country’s budget raised GEL 2.1 million from the locally produced high-quality natural grape wines and sparkling wines in excise revenues alone (Table 4) on top of VAT and other taxes paid by local producers of excise goods. Table 4: Excise revenues to the budget from the production and import of excise goods (thousand GEL)

Excise from locally produced Excise from imported goods Type of excise commodity goods 2004 2005 2004 2005 Sparkling wine (including Champagne) 670.5 1131.2 2.1 37.2 Natural grape wines 438.3 1011.3 5.9 15.9 Ethyl alcohol 71.5 342.2 2461.6 1830.3 Alcoholic drinks distilled from grape wine or spiritus 873.8 1045.6 45.2 112.1 Beer 4999.7 1035.4 366.2 1832.0 Tobacco products 37800.0 40861.1 9.5 30865.9 Motor cars 0.5 1.4 422.2 42187.0 Oil distillates: light (petroleum) 378.0 73.2 48943.9 82647.1 medium (kerosene) 0.004 333.8 301.3 248.7 heavy (diesel) 334.2 784.9 10093.8 29771.7 Oil and oil products from bituminous minerals, except raw oil 205.7 99.3 396.3 536.2 Other excise goods 6682.7 9 138.6 3 377.5 18257.2 Total: 53057.1 65 178.3 66425.7 210055.4 Source: Tax department, Ministry of Finance The import of excise commodity to Georgia The import remains the most important source in terms of budgetary revenues from excise goods. The collected excise revenues in 2005 made up GEL 221,2 million (Table 4), which comprises 77.2 percent of the total excise revenues. It is noteworthy that this indicator totaled 62.1 percent in 2004. The share of imports grew mainly due to the drop in local output. Oil product is the leading imported excise commodity from the fiscal standpoint with motor cars and tobacco products trailing (Table 5). The excise levied on oil importers in 2005 made up GEL 120.3 million, on motor car importers – GEL 43.7 million and on tobacco importers – GEL 39.1 million. It should be noted that there is discrepancy between the import indicators in tables 4 and 5. The thing is that the Table 5 shows the excise levied on excise commodity imports minus/plus the excise amount, which has been offset; as a result we arrive at the numbers shown in table 4, which represent actual excise mobilized in the budget.

59 Table 5: The amount of excise levied on excise commodity imports (thousand GEL)

Type of excise commodity 2001 2002 2003 2004 2005 Natural grape wines 149.6 14.1 11.1 1.1 10.7 Ethyl alcohol 482.4 454.5 537.3 2664.3 2056.0 Whiskey, rum, tafia, gin and wine infusion 90.6 62.2 37.7 89.8 136.2 Vodka 95.8 110.4 228.0 474.3 1164.7 Beer 14.0 43.7 69.0 346.6 1830.1 Tobacco products 16457.9 21223.3 24747.8 37570.9 39104.3 Motor cars 1626.4 4566.9 11232.6 24612.7 43666.3 Oil distillates: light (petroleum) 53410.3 53842.2 53397.6 58471.3 83598.4 medium (kerosene) 1437.0 743.7 596.0 6421.3 8528.6 heavy (diesel) 6957.3 6592.0 7322.0 10825.1 28156.5 Oily gas and gassy hydrocarbons 3027.5 2659.7 2524.1 2413.1 2165.9 Oil and oil products from bituminous 802.7 1148.4 1776.2 3373.8 3903.6 minerals, except raw oil Other excise commodity 579.1 401.7 586.0 388.8 666.3 Total: 84981.4 91848.8 103054.7 147670.6 214980.1 Source: Tax department, Ministry of Finance Mechanisms of administering excise goods The excise stamp, as a means of administering the excise goods, was introduced in Georgia on 1 February 1999. Also at that time the rule for paying taxes on the production and on the import of tobacco products changed, the pre-payment mechanism for the purchase of excise stamps was established and the value of the stamp was equalized with the fixed tax rate set for the corresponding period. The positive side of the fixed rate was the simplicity of the method of administering: the taxes were collected in advance, thus excluding any arrears to the budget and tax evasion. The negative part was that the establishment of fixed rates on tobacco products by distinguishing only two types of tobacco – “with filter” and “without -fil ter”- violated the principle of social fairness with regard to consumers of low-quality tobacco products. It placed low-income and high-income people in equal conditions despite the fact that the latter category consumed high- quality, expensive tobacco products. The imposition of one and the same fixed rate on cigarettes of different quality and price as well as on various filtered and unfiltered cigarette brands restricted the competitive environment and distorted the principle of free pricing on the tobacco market. The share of a fixed rate on an average sales price for imported medium-quality filtered cigarette (per pack) varied from 40 to 50 percent, while the share of the fixed rate on a retail sales price for the high and top-quality cigarettes of the same class varied from 9 to 20 percent. Consequently, the price of medium-quality filtered cigarettes used to grow by 80-100 percent while the high and top-quality cigarettes, being under the same conditions, used to grow by maximum 15-25 percent. The effective fixed excise rate on medium-quality imported cigarettes was violating the natural process of free price formation and was thus artificially increasing the price of cigarettes and undermining their competitiveness against contraband. Given that the excise stamp was simultaneously charged with the tax collecting function, it turned into a security itself which, for its part, encouraged forgery and multiple use of stamps, and the return of used stamps as if damaged ones. This represents such a way of evading the tax that is very difficult to combat. Tax bodies with special status (first, special legion and then, the financial police) had repeatedly revealed the cases where excise stamps purchased by one person were affixed to packs of cigarette produced by another person or imported ones, also the cases where cheaper stamps intended for unfiltered cigarettes were affixed to packs of filtered cigarettes, etc. Despite huge amounts raised by the budget from levied excise goods, the sales of smuggled excise products still remain a grave problem. The main factor favoring the contraband is the absence of Georgia’s jurisdiction over the self-declared republics of Abkhazia and South Ossetia and high excise rates compared with Russia. Such a situation especially affects tobacco products and alcoholic beverages. It is precisely these commodities that are smuggled in huge amounts from the self-declared republics. Therefore, until the problem of conflict zones has been settled in a political way, it seems reasonable to activate economic levers. The excise rates on oil products have also increased under the new Tax Code, however, the so-called ecology tax (tax on the contamination of environment with harmful substances) has been abolished, thus counterbalancing the tax burden for oil product importers. As a result, the market price has not changed much. There have always been several state bodies fighting illegal turnover of tobacco and oil products in Georgia (such as the ministry of agriculture, the interior ministry, the ministry of security and the finance ministry’s special legion). The function of combating illegal excise commodity turnover was taken away from the ministries of interior and of security after the merger of these two in 2004, while the special legion took the form of the financial police, which assumed an investigative function. The number of controlling bodies has increased to 60 include the excise taxpayers’ inspection, which, within the scope of its competence, regulates and manages the circulation and the issuance of excise stamps. It also ensures the issuance, suspension and revocation of licenses to excise taxpayers in accordance with the legislation and a corresponding register-keeping. In the past, this function was performed by the excise stamp service. Along with this service the excise goods monitoring bureau and the special legion were engaged in the monitoring of excise goods. Moreover, in 2002, a mixed interagency state commission was set up under a presidential decree with the aim to improve the registration and taxation of tobacco and oil products. However, with several agencies being in charge of fighting illegal tobacco and oil products turnover and not having clearly delineated functions, the mentioned measure did not bring desired results. Currently, in Georgia, there are a great number of legal and normative acts regulating the administration of excise goods some of which contradict each other and sometimes even put up difficult administrative barriers. Conclusions and recommendations The increase of excise rates on tobacco products from 1 January 2005 did not seem to be a reasonable measure. It was obvious form the very start that lower excise rates in Russia and the existence of uncontrolled territories – those of Abkhazia and South Ossetia - would not allow Georgia to take advantage of higher rates and would cause increase in smuggled tobacco products. Until the conflicts are settled, it is expedient to combat smuggling of huge amounts of excise goods from self- declared republics of Abkhazia and South Ossetia through such economic levers as the establishment of special economic zones along the administrative borders with Abkhazia and South Ossetia or/and the establishment of such excise rates that will make the contraband from Russia via conflict zones pointless. The establishment of differentiated tariffs for locally produced and imported tobacco products runs counter to the requirements of the General Agreement on Tariffs and Trade. The government has already made an official statement about its intention to revise rates. Nevertheless, we deem it necessary to maintain different tariffs for local and imported tobacco products (whereas the rate on locally produced tobacco should be lower). Otherwise, the scale of the local tobacco production will further decrease. It will be substituted by imports, on the one hand, and by smuggled tobacco products on the other. The excise stamp should be freed from a collection function. Tobacco imports should be taxed at a customs border checkpoint, while local production should be taxed once a month in accordance with the output volume. It is necessary to compile an inventory of legal and normative acts regulating the turnover of excise good and remove contradictions existing among them, also simplify relevant rules and procedures and improve institutional mechanism of administering excise goods. Given the ongoing trends it is likely that the number of excise commodity consumers and the amount of consumption will further increase, which, if administered properly, will lead to the increase in budgetary revenues. Under these circumstances the authorities should take more radical steps towards the promotion of the country’s industry, including the local production of excise goods. References: 1. The Customs Code of Georgia, November 14, 1997. 2. The Decree of the President of Georgia N40, On Immediate Measures to Improve the Registration and Taxation of Oil and Tobacco Products in Georgia, January 15, 2002. 3. Guide to obtaining a license on manufacturing food and tobacco products, Georgia’s Young Economists’ Association, Tbilisi, 2005. 4. Narmania, D., Economic Problems in the Development of Tobacco Industry in Georgia, Tbilisi, 2005. 5. The Program on Comprehensive Measures for the Prevention of Illegal Turnover of Tobacco Products in Georgia, Materials of Meeting of the Government of Georgia, May 15, 2003. 6. A report of the Revenue Mobilization Group, June 24, 2004, BearingPoint, USAID. 7. Rogava, Z., Taxes, tax legislation and tax relations, Tbilisi, 2002. 8. A statistical bulletin of the Analytical Research Center for Oil Products, Alcoholic Drinks and Tobacco Products, Georgian Businessmen Federation, Tbilisi, 2005 9. The Tax Code of Georgia, June 13, 1997. 10. The Tax Code of Georgia, December 22, 2004.

61 Part III. Economic Reform Agenda

The search FOR a development path: CHALLENGES FOR GEORGia Ivan Samson, Professor, Director of Espace Europe Institute at UPMF University, Grenoble; GEPLAC economic expert, with support of Anastasiya Zagainova, economic researcher at PEPSE laboratory, UPMF, Grenoble With the combined burdens of a long transition crisis and internal territorial conflicts, the official drop in GDP since 1990 was 2/3 - the highest among CIS countries. Since then, Georgia has faced huge development problems. After the 2003 Rose Revolution, Georgia’s economic transition was reinvigorated. However the typical means of meeting development needs at the beginning of the 21st century, which have succeeded in different parts of the world, appeared unworkable in Georgia, due to insufficient systemic transformation. This transformation entails a well-focused macroeconomic stabilization; structural reform in the sense of building economic institutions; and economic restructuring at the firm, sector, and national-economy levels. Table 1: Georgia in international comparison

Units Year Georgia China Estonia Euro zone India Romania GDP (2004 dollars) bn USD 2004 5.1 1649.0 10.8 9370.0 692.0 73.2 GNI per capita (2004 dollars) USD 2004 1040.0 1290.0 7010.0 27630.0 620.0 2920.0 Population mln 2004 4.5 1296.0 1.3 307.4 1079.2 21.9 Agriculture share in gross percent 2003 20.0 15.0 4.0 2.0 22.0 12.0 value added Inflation (year average) percent 2003 4.0 2.0 2.0 n/a 3.0 19.0 Electricity consumption per kWh 2002 1158.0 987.0 3882.0 5912.0 380.0 1632.0 capita Internet users per 1000 2003 31.0 63.0 444.0 378.0 17.0 184.0 Life expectancy at birth years 2003 73.0 71.0 71.0 79.0 63.0 70.0 Infant mortality rate per 1000 2003 41.0 30.0 8.0 4.0 63.0 18.0 School enrolment percent 2002 61.0 n/a 88.0 91.0 n/a 81.0 Source: The World Bank (WDI) International comparisons show that Georgia’s development indicators are comparable with those of other poor and developing countries (see Table 1). According to the 2004 World Bank classification, Georgia belongs in the group of 59 “lower-middle-income countries”, with a Gross National Income (GNI) per capita between USD 826 and USD 3255. This group includes most CIS countries (except Russia) as well as Albania, Bulgaria, and Romania; most Middle Eastern and North-African countries; and others like China, Brazil, and Indonesia. As a post-Soviet developing country, its level of industrialization is higher than many in the comparison group (see electricity consumption). But in 2003 it had only half the rate of Internet users as in China. While its life expectancy at birth is high, its infant mortality rate is above China’s. The table also shows how far ahead the Euro-zone countries are. Estonia, a country that is sometimes presented as a reference for Georgia, has a seven-times higher GNI per capita, and Romania, which will soon become the poorest EU country, has a three-times higher GNI per capita. Table 2: Georgia and its neighbours

Units Year Georgia Armenia Azerbaijan Russia Turkey GDP (2004 dollars) bn USD 2004 5.1 3.55 8.52 582.4 302.0 GNI per capita (2004 dollars) USD 2004 1040.0 1120.0 950.0 3410.0 3750.0 Population mln 2004 4.5 3.1 8.3 142.8 71.3 Agriculture share in gross value added percent 2003 20.0 24.0 14.0 5.0 13.0 Inflation (year average) percent 2003 4.0 5.0 4.0 14.0 23.0 Electricity consumption per capital kWh 2002 1158.0 1113.0 1878.0 4291.0 1458.0 Internet users per 1000 2003 31.0 37.0 37.0 (2002) n/a 85.0 Life expectancy at birth years 2003 73.0 75.0 65.0 (2000) 66.0 69.0 Infant mortality rate per 1000 2003 41.0 30.0 75.0 16.0 33.0 School enrolment percent 2002 61.0 83.0 76.0 n/a n/a Source: The World Bank (WDI) (Table 2) compares Georgia with its neighbours. Georgia’s situation is very similar to those of the two other South Caucasus states. The gap is much less high with the two large neighbours, Russia and Turkey. The potential benefits of regional integration are clear.

62 This paper addresses economic reforms after 2003 and the current economic situation. We do not share the optimistic assessment of the IMF and the World Bank, although we agree that this period has seen a strong reform impetus in Georgia. We note the key issues the Georgian economy faces, and similar experiences elsewhere. We place EU technical assistance to Georgia within the European Neighbourhood Policy (ENP). Finally, we discuss how the GEPLAC (Georgian European Policy and Legal Advice Centre) could innovate in advising the Georgian government. Strong reform impetus after 2003 but still fragile macroeconomic stability The IMF observes that the Saakashvili administration has achieved a remarkable turnaround in the Georgian economy during its first twenty-four months in office (1). In a highly orthodox fashion, fiscal consolidation, supported by strong efforts to reduce tax evasion and improve expenditure management, was at the heart of the government’s economic program. The results have been particularly encouraging, thanks also to the reintegration of Adjara in the central-government revenue collection. Tax revenues increased in nominal terms by fifty percent from 2003 to 2004, exceeding expectations at seventeen percent of GDP. Government arrears (mostly wages, pensions, and social allowances) were reduced, and all remaining arrears were paid in 2005 (2). The reform process mainly targeted WTO regulations and EU standards. The EU Partnership and Cooperation Agreement (PCA) and WTO promote free transit, liberalized prices, and a rules-based trading regime. A new customs code, close to EU standards, has been elaborated, and was presented to Parliament in 2005. In 2005 the EC granted to Georgia the “GSP+” scheme of preferences, introducing “zero” import duty on more than seven thousand Georgian goods imported to the EU. Many of the reform efforts focused on improving the business climate. The number of licences required to start businesses was reduced drastically. The tax code was simplified, and the number of different taxes was reduced from twenty-one to seven. Income, corporate and social tax rates were considerably lowered. The new customs code ensures simplified procedures for clearing customs and provides greater protection against evasion. Corrup- tion in customs and tax inspections, as well as abuses by different controlling authorities (including police), has been substantially reduced. New amendments to the corporate law reduce burdens on businesses. A draft labour code is being debated in Parliament. Active screening of legislation has begun, in accordance with the requirement for Georgian legislation to be compatible with EU legislation. Public-procurement legislation is largely harmonised, though procedures and applications require further work. The new law regulating competition only partially responds to EU requirements: Anti-trust provisions are absent and subsidies are not yet sufficiently regulated; a draft law is in process. Implementation of the law on food safety is still pending. Less progress was made in adopting regulations and establishing institutions to safeguard sanitary, phyto-sanitary, and animal-health standards. Environmental regulations compatible with the EU were adopted, but implementation remains a problem; the Government is planning to revise the policy so as not to affect entrepreneurs. Intellectual property rights legislation is mostly harmonised with EU and WTO requirements; however, implementation and enforcement is not guaranteed. One important reason is the low level of preparation of customs officers and their lack of equipment. Lastly, new laws on stan- dardization and certification of goods and services were adopted. Progress is rather stronger in banking, telecommunications, and international trade, as well as in some regulatory fields (e.g. procurement and statistical quality). The elimination of excessive regulations for road transport has created the basis for improved services. The new railway code has established clear rules for flexible tariff policy. Ferry connections with Georgia’s Black Sea neighbours have expanded trade opportunities with Europe. Liberalization of the civil-aviation market has stimulated the operation of European companies in Georgia. Since 1997 the EU has provided assistance to Georgia for sustainable development of the agricultural sector, but progress has been slow. Energy-sector reforms, including privatization of generation and a successful anticorruption policy have yielded better performance. Power outages have been reduced. After a long difficult period, social protection in Georgia has started improving. Arrears on pensions and salaries were almost eliminated. Pension- system reform is aimed at a gradual approach to international standards. Social assistance programs target poor and disabled populations. Health-system reform aims to provide primary assistance services (including to rural areas) and gradually develop preventative medicine (3). A concerted drive to strengthen tax and customs administration has played a key role in Georgia’s improved fiscal performance. The Government bolstered tax administration by reorganizing the Tax Department, strengthening the Large Taxpayer Inspectorate, and establishing the Excise Tax Inspectorate and Financial Police. In addition, customs administration has improved significantly as a result of efforts to curtail smuggling by mod- ernizing border checkpoints and procedures, and reorganizing the central and regional structure of the customs department. The World Bank underlines that the anti-corruption effort is strongly endorsed at the highest levels of the Government (4). Clear messages have been sent to the public and the international community of the Gov- ernment’s intention to improve governance systems and processes. Ministers have been given the authority and responsibility to eradicate internal corruption and are being held accountable for results. The National Anti-Cor- ruption Strategy was prepared by a task force representing government and civil society. The strategy introduces comprehensive measures for prevention and elimination of corruption: (i) civil-service reform; (ii) strengthening of principles of accountability and public disclosure, including facilitation of public-feedback mechanisms; (iii) 63 strengthening the rule of law; (iv) strengthening the control bodies of all three branches of government and civil- society monitors; (v) facilitation of competitive business sector development; and (vi) international integration. Weaknesses in the civil service hamper public economic management, investment, and service delivery. In the area of civil-service reform, government employment was reduced by some 30,000 in 2004. The concomitant savings financed increased remuneration in the ministries, including a phased increase in the civil-service minimum wage to GEL 115 a month (about USD 65) in the course of 2004. A Civil Service Council responsible for coordinating and overseeing civil service reform was established in August 2004. 5FMFDPNNVOJDBUJPOTBTB1SPCMFN%PJOH#VTJOFTT &MFDUSJDJUZBTB1SPCMFN%PJOH#VTJOFTT 1FSDFOUPGGJSNTTUBUJOHUIBUUIFGVODUJPOJOHPGUIFUFMFDPNNVOJDBUJPOTZTUFN 1FSDFOUPGGJSNTTUBUJOHUIBUUIFQSPWJTJPOPGFMFDUSJDJUZ JTBQSPCMFNEPJOHCVTJOFTT JTBQSPCMFNEPJOHCVTJOFTT QFSDFOU QFSDFOU (FP &$" (FP $*4 &$" $*4 5SBOTQPSUBJPOBTB1SPCMFN%PJOH#VTJOFTT 1FSDFOUPGGJSNTTUBUJOHUIBUUIFUSBOTQPSUBUJPO JTBQSPCMFNEPJOHCVTJOFTT

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Source: EBRD-World Bank. Business Environment and Enterprise Performance Survey, BEEPS 2005, (ECA are the last 8 transition European Accessing Countries) Building on these impressive accomplishments, the Government now enters a second phase of structural reforms, focused on accelerated privatization and the revival of private investment. One prong of the strategy targets fundamental obstacles to growth in transport infrastructure and ensuring reliable energy supplies, both of which are essential to improving the business climate. A recent study conducted by Cesar Calderon (Central Bank of Chile) and Luis Serven (The World Bank) of more than a hundred countries from 1960 to 2000 showed that the volume and the quality of infrastructure stocks have a significant positive effect on long-run economic growth (5). As shown in the Business Environment and Enterprise Performance Survey (BEEPS), electricity and transportation are major constraints on businesses in Georgia, the latter increasingly so (see charts above). The government has launched a multi-year effort to rehabilitate roads, which will be funded mostly by external grants and privatization proceeds. This funding method is quite reasonable, as despite an opposite trend from 1996 to 2000, world experience has shown that private investments in infrastructure have not lived up to expectations (6). The EU and World Bank are quite active in financing infrastructure, and the Government is efficiently coordinating their activities. The authorities also aim to mitigate the customary power rationing in the coming winter season, and to provide stable and reliable power supplies to all paying customers by the end of 2006. Beyond this, the authorities are focusing on deeper institutional change, enhanced social protection, and essential infrastructure needed to enable economic growth, job creation, and a reduction in poverty. The Government has reaffirmed its commitment to improving: (i) governance; (ii) macroeconomic policies, particularly in the fiscal area; (iii) the business environment; (iv) human development; (v) the social safety net; (vi) priority sectors of the economy—energy, transport, communications, tourism, and agriculture; and (vii) environmental protection. With IMF support, the authorities have adopted a monetary policy that, between 2001 and 2003, kept inflation at about five percent and kept the exchange rate stable. However, the annual inflation rate rose from 3.6 percent in June 2004 to just over 9.7 percent in March 2005; it was 7.7 percent in September 2005 (7). Contributing factors included an easing of liquidity conditions (partly due to a sharp increase in government spending), weather-related increases in food prices, the rise in international oil prices and a sharp rise in excise-tax rates. The National Bank of Georgia (NBG) is not, however, conducting a relaxed monetary policy and large amounts are sterilised in deposits. The inflation-targeting policy remains oriented towards single-digit inflation. Large capital inflows, due to BTC pipeline construction and privatization, contributed, despite large non-sterilised foreign-exchange intervention, to the lari appreciating by 13.5 percent both against the U.S. dollar and in real effective terms during

64 2004. While additional capital repatriation may be expected as confidence in the economy grows and legalization of the informal economy continues, and given the planned large increase in government spending, an inflationary risk remains if the government spends its deposits in the pre-election political cycle, or in order to tackle the lari appreciation, which creates barriers to export competitiveness. The IMF and other observers are concerned about the ability of authorities to manage reconciling an expansionary fiscal policy with their inflation and competitiveness objectives. Several weaknesses in the reform programme need to be underlined: (1) As noted by the IMF, Georgia’s relatively underdeveloped financial system limits its ability to finance small- and medium-sized enterprises and to expand retail banking. This is especially painful to agriculture. Al- though growing rapidly, the banking sector is still small with total assets of only sixteen percent of GDP. Real interest rates remain high due to weak financial intermediation and high risk premiums. In 2004 lending rates have been between fifteen and twenty-four percent. Longer-term loans are not yet available and therefore, according to the ENP strategy paper, the housing loan market is underdeveloped relative to potential demand. The IMF welcomes the NBG ongoing program of gradually increasing minimum capital requirements and allowing the entry of foreign banks in order to consolidate and strengthen the system. (2) There are major weaknesses in the external sector. The foreign trade deficit jumped from USD 610 mln in 2003 to USD 1.20 mln in 2004, and is expected to be larger still in 2005. Less than USD 100 mln of imports were pipes (for BTC) in 2003 and 2004; imports are mainly energy and consumer goods. Food products and beverages account for thirty percent of exports, scrap metals and minerals twenty-eight percent, and mechanical products from the former aircraft industry, sold for paying gas debts to Turkmenistan, thirteen percent. The structural weakness of the external sector reflects the inadequacy of the current development path of Georgia, which is not sustainable and endangers macroeconomic stability. (3) Georgia relies heavily on IFI financing to cover its current account deficit. The World Bank underlines that Georgia’s external debt position has improved since 2004, but it still faces a “moderate risk” of worsening. As of the end of 2003, total external debt was equivalent to forty-six percent of GDP. An agreement was reached with the Paris Club, which rescheduled payments due its creditors, and the external debt decreased to thirty-five percent of GDP in 2004 and an estimated twenty-seven percent at the end of 2005 (8). However, stress tests indicate that Georgia’s debt burden is vulnerable to a deterioration in the external current account deficit, the volume and terms of future capital flows, and a negative export-growth shock. According to the Bank, these risks can be miti- gated by continued implementation of measures to improve the business environment and to encourage foreign direct investment and strengthen export performance. Economic growth should bring tangible results Real GDP growth was 11.1 percent in 2003, 6.2 percent in 2004, and an estimated 8.5 to 9 percent in 2005. According to official estimates, the share of the informal economy is about thirty percent of total output. Recent estimates indicate that this share started to decline in 2004 in the new political environment. Table 3: GDP breakdown by sectors (percent of value added)

2000 2001 2002 2003 2004 Industry 17 17 18 18 17 Agriculture 20 21 19 19 16 Transport & Communication 14 14 14 14 14 Construction 4 4 5 6 6 Trade 13 13 13 13 13 Hotels & Restaurants 2 3 3 3 3 Others 30 28 28 27 31 Source: Department for Statistics, Ministry of Economic Development and Georgian Economic Trends, Quarterly Review, December 2005 The share of agriculture dropped from thirty percent of GDP in 1996 to sixteen percent in 2004, but it remains the largest sector of the economy and accounts for fifty-two percent of employment. Trade and manufacturing are the second- and third-largest sectors, accounting respectively for fourteen percent of GDP and eleven percent of employment, and sixteen percent of GDP and five percent of employment. Two of the fastest-growing sectors have been transport and communications, which together tripled from 4.6 percent of GDP in 1996 to fourteen percent in 2004. After 2000, construction has become the most dynamic sector of the economy, accounting for 6.2 percent of GDP and 2.4 percent of employment. Currently, growth is driven most by FDI in oil and gas pipelines, and by hotel and restaurant services, trade, communications, and private construction.

65 3FMBUJWFHSPXUIPGTFDUPST

*OEVTUSZ "HSJDVMUVSF 5SBOTQPSUDPNNVOJDBUJPO $POTUSVDUJPO 5SBEF )PUFMTSFTUBVSBOUT

Source: Georgian Economic Trends, Quarterly Review, December 2005 The stake of Georgia’s economic development is to make the private sector central to an economy largely oriented towards foreign markets. Georgia has several important internal resources or comparative advantages: agriculture and agro-processing, small manufacturing, tourism, transit trade activities, and mineral extraction and processing. Georgia has fertile soils, extensive sunlight and substantial water resources. Agro-pastoral traditions are still alive, especially in wine and fruit and vegetable production. Conditions should be created for the revival of this sector, which is crucial to the development of several regions (9). The second major resource is Georgia’s location at the crossroads of Europe, the Middle East, and Central Asia. When political conditions will be allow for it and transport infrastructures are modernized, the natural transit function of Georgia may bring consistent revenues to the country, not just in fees to the state budget (currently BTC could bring USD 50 mln per year and will likely reach USD 100 mln with full use), but by its development effects in several regions. Tourism remains a key resource, deeply rooted in Georgia’s traditions and in the hospitality of its populations with strong local identities. In Soviet times Georgia hosted three million tourists per year; it lost fifteen years in sector restructuring, but has potential for seaside, alpine, adventure, and cultural tourism. As with transportation and agriculture, tourism is a key sector for regional development. Huge efforts and investments in human skills, in organization, and in fixed capital should be devoted to these sectors with high employment potential. However, so far, strong GDP growth has not led to the development of Georgia’s resources. Despite economic growth since 2000, employment has not been increasing. While GDP has grown an average of six percent a year since 2000, total employment declined by three percent including a two-percent decline in wage employment. Besides, growth has not caused any notable reduction of poverty. The overall share of the population below the poverty line is stagnating at just over fifty-two percent, and increasing in rural areas. The overall incidence of extreme poverty has increased from 13.8 percent of the population in 2001 to 17.4 percent in 2004, driven almost entirely by rural extreme poverty. There are several explanations for this non-developing growth, according to the World Bank’s latest report (10). The first is continued restructuring and reductions in public-sector employment. The decline in total employment also reflects some job shedding in the manufacturing sector, typically overstaffed in the Soviet system: manufacturing grew by an average of ten percent a year since 2000, and employment in the sector declined by seventeen percent over the period. Moreover, growth trends in sectors play against employment. Key growth sectors have not shown significant employment-generating capacity and wages remain low in the sectors with the highest employment. The highest wages are in mining, finance, and construction, although these sectors account for only seven percent of wage employment. Self-employment (non-wage) activities in agriculture, small-scale trading, and services are characterized by low earnings that often fluctuate by season and generally offer little potential for long-term earnings growth. There has been relatively low growth (two percent from 2002 to 2004) and low contribution to GDP by SMEs (ten percent in 2004), in spite of the fact that SMEs constitute ninety-eight percent of the total number of companies and account for a large share of wage employment. The World Bank computed that only workers in construction, hotels, restaurants, transport, communications, and real estate can keep four-person households with a single source of income above the poverty line. Other reasons for this situation include revenue concentration, which is typical in a transition period, and the fact that some informal activities became legal. This process, however, is just starting because in 2003 only twenty percent of the working-age population had a formal job. Thus a huge majority of employment is informal or subsistence self-employment. There are two obstacles to growth in Georgia. The first one is the risky environment for doing business and investment. The rapid and thoroughgoing reform process, however, makes it difficult to assess the situation precisely. Several reports have addressed this issue, but most rely on old data, as with the IFC-CIDA 2005 survey on business environment, or the World Bank’s report Doing Business in 2006, based on 2004 data. The most recent survey is BEEPS, which uses 2005 data. Up-to-date appraisals should come from frequent interviews and round- tables with business representatives. One solution to these methodological difficulties is to monitor the most recently published reports in frequent workshops with businesses. For example the EU SPICA project organized a workshop that identified the obstacles to business creation, export and FDI (11). It found: 66 1) Overall policy and macroeconomic policy: The overall economic strategy is not well-enough defined or consistent; Georgia does not yet have the image of a stable and peaceful country. 2) Need for improving the business climate: Large-scale corruption is strongly diminishing, but small-scale corruption is still widespread and connected to a lack of transparency and predictability (12). Bureaucracy and financial and fiscal harassment are still alive and some times increasing, and courts are not properly working and should be made less dependent on the state. 3) Border and customs issues: Inadequate border controls make illegal trade and smuggling easy, and dis- courage entrepreneurship with unfair competition; customs administration works inefficiently and its staff is under-qualified. 4) Infrastructure: Basic infrastructure conditions should be established for normal business activities, such as regular energy provision and transport and communications means. It is also a condition for the rebirth of tourism. 5) The dialogue between state and business: Participants agreed that a new level of cooperation should be found between state and business, where confidence and common interests should replace the lack of communication and mistrust. "DDFTTUP'JOBODJOHBTB1SPCMFN%PJOH#VTJOFTT0WFS5JNF #SJCF5BY 1FSDFOUPGGJSNTJOEJDBUJOHBDDFTTUPGJOBODJOH DPMMBUFSBMSFRVJSFEPSGJOBODJOHOPU #SJCFTBTBTIBSFPGBOOVBMTBMFT BWBJMBCMFGSPNCBOLT BTBQSPCMFNEPJOHCVTJOFTT

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(FP $*4 &$" (FP $*4 &$" 5BYJOTQFDUPSBUF Source: EBRD-World Bank, Business Environment and Enterprise Performance Survey, BEEPS 2005 The first wave of reform improved the situation, having sent promising signals to business. It remains to be seen, however, if the rebirth of business activity and FDI inflows remains sustainable (particularly as BTC-related investments subside). Significantly, there is no noticeable increase in the number of firms. It is clear that corruption strongly decreased, but according to our discussions with the business community, many related issues are still a concern: fiscal harassment, delays in administrative decisions, unmotivated civil servants, the judiciary system, and unclear property rights. This is consistent with the findings of the BEEPS survey. Rent-seeking persists and is considered unfair competition by foreign investors. The second major obstacle to economic development is poverty traps, mainly in rural areas. Poverty traps are places where overall growth has no impact on incomes, and where people are too poor even to leave. The goal of a development-oriented policy is to strongly reduce informal employment by making it formal, and to cut subsistence self-employment in rural areas. This will be enabled by land restructuring, property concentration, access to markets, and access to credit (13). The World Bank considers that job creation in agro-processing and small manufacturing will likely have the largest impact, as it can attract many poor and self-employed workers. However such a process could be developed on a large scale only by foreign investors, which so far have had very few reasons, except strategic ones, to come to Georgia. Further investigations should be devoted to this issue, but it is unlikely that many subsistence farmers could become industry or service workers, productive in newly competitive conditions. According to the 2004 agricultural census, there are about 800 farms and 728 000 mainly subsistence family holders in Georgia, with a total rural population of 2 480 000 persons. The current working population in Georgia is about 1 750 000, of whom 980 000 are in rural areas and 780 000 in cities. The transformation from subsistence to market agriculture may make available 300 000 workers older than fifty-five and 67 at least 300 000 younger workers. This corresponds to a working population of more than 800 000 people, and a total family population between 1 500 000 and 1 700 000 persons. Georgia is thus facing a huge territorial labour adjustment that would double the urban working population. The phenomenon of poverty traps in Georgia is underestimated. Deeper economic and sociological surveys should be conducted to better analyse and differentiate by region, but we believe that poor rural families live mainly out of the market in remote or poorly accessible areas, and are not responding to market signals. This creates a dual economy, where the growth of the market-oriented part has little impact on other part. How to address the issue of poverty traps? This question is being investigated by POVNET, the OECD DAC network on poverty reduction, by analyzing the components of growth that benefit the poor: agriculture, the private sector, and infrastructure (14). Economic growth has been ‘pro-poor’ when the incomes of poor households have grown at rates similar to or faster than average incomes. Two channels have been identified in Africa (15). First, agricultural-market liberalization has been conducive to reductions in rural poverty. Second, market con- nectedness is crucial for poor producers to take advantage of the opportunities offered by economic growth. Some remote regions and households have been left behind when growth picks up. The availability of infrastructure (especially roads) and proximity to markets is crucial: About half of household consumption growth and poverty reduction in Ethiopia during 1989−95 is explained by access to infrastructure. Calderon and Servén (16) came to the same conclusion: The quantity of infrastructure has a robust negative impact on income inequality. Poverty traps may create in Georgia a huge migration crisis; in poverty traps, people start to migrate when their situation improves. So far, there have already been migrations towards Tbilisi, which now has a population of 1 500 000. It is clear that Georgia’s cities are not able to absorb a large flow of migrants, and emigration directly from rural areas is not common. There is an urgent need for analysis of regional differentiation within Georgia, which would locate dynamic economies, job opportunities, poverty traps, and migratory behaviours. The emigration of some part of the population, as a way to absorb the huge shock of labour adjustment, seems difficult to avoid. Russia’s proximity and demand for workers create favourable conditions for such an adjustment. In fact, this process has already started and is expected to increase strongly in the coming years, despite current unfavour- able political conditions. Georgia and the experience of income-driven economies Georgia receives remittances of about USD 300 million per year from about 200 000 to 300 000 emigrants (mainly in Russia). This represents about six percent of GDP, six times more than BTC receipts. Annual foreign aid is of the same magnitude. The support by IFI lending to cover the current account deficit represents six to twelve percent of GDP. The unregistered remittances, the legal income from residents working abroad, and grey or black income entering the country coming from illicit activities, concentrating in the narrow group of “new rich Georgians”, add some further, unknown amount. From international comparisons, remittances may increase two- or three-fold if there is a second wave of migrants. Remittances and illicit private incomes are likely to become equivalent to the state budget. All this makes Georgia increasingly an income-driven economy instead of a production economy. Policies may influence the extent of this phenomenon but cannot overturn it. What kind of economic development can be achieved in such a situation? What are the consequences of such a labour adjustment? Examples of countries given below represent a first overview of the situation and of development features of each country. Further analyses are needed urgently, but it appears already that the comparison with Georgia makes sense. All these are transition countries making or having made labour adjustment with important emigration, which gave specificities to the development process: Croatia in the 1980s, Albania in the 1990s, and Mol- dova and the Kyrgyz Republic since 1995. All except Moldova are mountainous countries, and, except for the Kyrgyz Republic, they suffered from armed conflicts which displaced populations and had border effects. These countries also have more-developed neighbours, easing cross-border migrations: Greece and Italy for Albania, Romania for Moldova, and Kazakhstan and Russia for Kyrgyzstan. Croatia sent its emigrants mostly to Germany, which is not a neighbour. There is a large literature on the impact of emigration on the countries of origin—macroeconomic, regional, and sectoral. One analyses the “push” and the “pull” approaches of the phenomenon, and the networks of former migrants drawing cumulative local effects. Studies typologies migrants according to age, sex, education, and income level, and distinguish among settlers, who have left their country permanently; long-term migrants (over one year); and short-term migrants. Short-term or seasonal migrations usually target neighbouring countries, and the likelihood of returning to the country of origin decreases with the distance of the migration. This process often takes two steps: first the emigration from a poor rural region to a large city, and then from the city to a foreign country. The migration of persons with higher education constitutes a brain drain; it represents a transfer of resources from the origin country to the destination.

68 Table 4: Georgia and examples of transitional income-driven economies

Units Year Georgia Albania Croatia Kyrgyzstan Moldova GDP (current prices) bn USD 2004 5.1 7.59 34.2 2.2 2.6 GNI per capita (current prices) USD 2004 1040.0 2080��.0 6590��.0 400��.0 710��.0 Population mln 2004 4.5 3.2 4.5 5.1 4.2 Agriculture share in gross value added percent 2003 20��.0 25��.0 8��.0 39��.0 23��.0 Trade balance mln USD 2004 -1200��.0 -1675��.0 -8227��.0 -182��.0 -788��.0 Inflation (year average) percent 2003 4��.0 2.9 2.1 4.1 12.5 FDI inflow per capita USD *** 371��.0 450��.0 2106��.0 110��.0 217��.0 External debt mln USD 2004 2039��.0 1537��.0 30 200��.0 2044��.0 10 973��.0 External debt percent of GDP 2004 40��.0 20��.0 88��.0 94��.0 76��.0 percent of Debt service 2004 13.7 4.6 24.2 12.5 11.0 exports Electricity consumption per capita kWh 2002 1158��.0 1390��.0 2855��.0 1269��.0 909��.0 Internet users per 1000 2003 31��.0 10��.0 232��.0 38��.0 80��.0 Life expectancy at birth years 2003 73��.0 74��.0 74��.0 65��.0 67��.0 Infant mortality rate per 1000 2003 41��.0 18��.0 6��.0 59��.0 26��.0 School enrolment percent 2002 61��.0 77.0 87.0 . 69.0 Workers’ remittances mln USD 2004 300��.0 699��.0�� (2001) 727��.0�� (2001) 420��.0 460��.0 Remittances as percent of GDP percent of GDP 2004 6��.0 10��.0*� 2��.0 20��.0 19��.0 Remittances as percent percent of state year ≈ 37.0�� ≈ 27.0�� ≈ 5.0�� ≈ 100��.0 ≈ 72.0�� of State Expenditures expenditure Sources: EBRD; IMF; The World Bank WDI and Global economic prospects: Economic Implications of Remittances and Migrations (2006) Note: * 20% in the 90’s ** IMF gives 27% for 2004 ***cumulative 1989-2004 As emigrants are usually young, emigration is typically regarded as a loss for the country of origin, which invested in emigrants’ education and health care, and as a corresponding benefit for the receiving country. However, the labour-market effect may make emigration beneficial to the country of origin by alleviating unemployment and poverty. Remittances may extend the income effect to families of origin, but the impact of these remittances varies. Whereas it is usually beneficial for the country of origin, in the case of small countries with large emigration, remittances may cause several macroeconomic or regional distortions. This impact will, however, depend on several factors: if remittances are channelled through the banking system, if they fuel household consumption or are invested, how they are focalized (income tax, VAT or import duties), etc. More recently, in the case of transition countries, emigration may become a channel of transformation, through new behaviours, ways of thinking, and technologies or skills, especially in the case of short-term and cross-border migrations. Furthermore, a Dias- pora may become an instrument for development, as shown by China, Poland, and Armenia. The example of Albania Albania has long been the poorest country in Europe, and the internal political regime in the communist period was especially authoritarian. If we consider the development pattern of Albania during transition, three periods can be distinguished with three pillars of development: 1. 1993 to 1996: In early transition (economic and politic crisis), reliant on remittances 2. 1998 to 2001: After reforms, the agriculture sector stimulated the economy 3. Since 2002: Albania receives foreign aid from the US and EU The political changes and economic disruptions of the early 1990s led to the first waves of emigration. Migra- tion was often the only way to satisfy a family’s basic needs. The quest for a better life led to internal migration as a substitute for urbanization. These movements were spontaneous and chaotic; in a few years the population of Tirana grew from 400 000 to 700 000. This type of urbanization did not yield development. Migrants put pressure on public infrastructure and housing, and caused a growth of urban unemployment and the black market. In the regions of origin, labour shortages caused a drop in agriculture productivity, but there was little incentive for migrants to return to rural areas. This situation has caused massive emigration for economic reasons (twenty percent of the population according to UNICEF). Migrations are mainly temporary and recurring (often seasonal in agriculture or housing); only twenty-five percent leave permanently. The destination countries are nearby (Italy and Greece), with strong economies or easy access. Networks of friends and relatives in destination cities help in obtaining visas and jobs, and those with more cash are more likely to succeed since it can be expensive to migrate. In Albania the unemployment rate dropped and social pressures relaxed, but the working-age population fell drastically. About one-third of the intelligentsia (teachers, doctors, researchers, engineers) emigrated. Albanian migrants working abroad have sent home remittances estimated as nearly twenty percent of GDP (the country’s major source of external income after aid). Sixty-four percent of emigrants’ savings are sent to

69 their families in Albania. The main positive effects of remittances in Albania are increases in household income, which alleviates poverty, and some investment in micro-enterprises (shops, bars and restaurants, etc.). However, remittances have little impact on investments because of the poor business climate; other downsides include the risk of permanent emigration, and the risk of external dependency. Agriculture has been the driving force of growth in Albania since the end of communist rule, and its reforms are the key to the “Albanian success story”. Growth in output and income since 1990 has been the result of sound macroeconomic management and key policy and institutional reforms that transformed an inefficient rural sector, dominated by large state and collective farms and farm enterprises, into a rural sector with thousands of small family farms. Though farms are small and fragmented, they nonetheless have recorded a steady increase in output as new farm owners worked intensively to improve their productivity. Households mainly aim to produce enough for their own consumption, with the limited surplus sold where possible in the local market or to the increasing number of small processing plants. Migration led to the abandonment of marginal lands and concentration in more fertile lands. This enabled the importation of tractors and other equipment from Greece. Moreover, the cross-border migration to Greece transferred process-knowledge and technology to Albania (17). Services to agriculture improved through farmers’ and agribusiness associations, water associations, etc. Key investments in rehabilitation of infrastructure, notably irrigation, also helped to fuel growth. However, problems persist, including the trade deficit, small-scale size of farms, competition from EU imports, inadequate mechanization and still poor rural infrastructure, lack of investments because of the poor banking system, and lack of FDI. Foreign aid from the US, EU, World Bank and IMF, before remittances, provides the majority of Albania’s external resources. International aid represents twenty to thirty percent of the annual budget. After the crises in 1990 and 1997 and a liberal policy of “as little state as possible” in a context of widespread corruption, external assistance became the only way out. The international community increasingly plays the role of “referee” and mediator in national politics, through the availability and conditionality of credits, and has become a full stake- holder in domestic affairs. International lending supports the financial sustainability of the country: The foreign trade deficit is increasing and is no longer covered by remittances, and debt is increasing (although stable at about thirty percent of GDP). Albania has had one of the strongest growths of transition countries since 1997, driven by agriculture, remittances, and foreign aid. However, this growth is not developing the country which remains beset by poverty and corruption. Even more than the spiral of debt, the spiral of dependency hurts the country. With a weak state imple- menting a strong monetary policy, but failing to implement consistent structural reform, and a lack of domestic and foreign investments, Albania is losing ownership of its development. The example of Kyrgyz Republic Kyrgyzstan is another poor agricultural country in transition, where migration plays an important role in the adjustment of labour. Despite orthodox macroeconomic policies, it has a high level of poverty, with mostly informal employment or subsistence self-employment in poor rural areas. Lack of structural reforms and widespread corruption dominate the business climate, and there is little investment. Agriculture and tourism are the main engines of growth. Agriculture is the largest sector, with a thirty-six percent share of GDP and a fifty-three percent share of employment (2004). The acceleration of agricultural reforms began in 1995, driven by basic needs: rural communities faced food shortages, and traditional crops went to household subsistence. Land devoted to agriculture grew rapidly during 1995–1998. Most state-owned land was distributed in 1995–2000 (2.5 ha per family). Approximately twenty-five percent of arable land remains available for allocation to farmers. Land transactions were motivated by economic distress and followed by emigration. Irrigation received significant donor-supported investments, and it continues to be subsidised. A large number of non-bank financial institutions have emerged since 1997 (mostly to serve agriculture), as well as private service- support firms, which provide advice to farmers and collect and disseminate market-price information on a wide variety of farm products and inputs countrywide. Less success has been achieved so far in fertilizer and machinery service reforms, where privatization is not complete. In the second phase, since 1999, the impact of market reforms became more apparent. Private farms have been the main driver of agricultural growth. By 2002, small family farms occupied seventy-one percent of the arable land and produced about one-half of the value of production and the majority of the marketed surplus. The expansion of private farming occurred through land leasing (leased land accounts for about one-fifth of the operational land). The average area of leased land is about twenty hectares, which suggests that the land is mostly leased by a small number of larger peasant farms. This allowed increases in land and labour productivity. Over the past four years there has been a significant shift of livestock ownership from households to private farmers through market channels. As a result, in 2002 private farmers held about half of all livestock. The farmers are now facing serious challenges as they negotiate an emerging market economy that can be characterized by high barriers to entry, due to lack of basic capital such as mechanized transportation and high transaction costs, including information and transportation costs. Bargaining power is also a factor in the ability of individual private farmers to negotiate stable, long-term relationships with local processors. If not for the technical assistance they receive from various support organizations, many farmers admit that they would never have considered contracting with a processor.

70 Migrations of the Kyrgyz population started after mass privatization of lands increased rural poverty. Later on, rural unemployment caused by productivity increases, as well as the poverty-trap effect following income increases, fuelled continual migrations. Migrants came from high-altitude and poor Southern peripheral areas of Batken, Djalal-Abad, and Osh to Bishkek. Kyrgyz internal migrants replaced Russian emigrants in the capital area; seventy-four percent work in trade, twelve percent in agriculture, and eleven percent in construction. Bishkek has also become an area of transit for international migration. Because of their proximity, higher living standards, and no need for visas, Kyrgyz emigrate mainly to Russia and Kazakhstan. Called gastarbeiter (the German word for foreign workers concentrated in hard and unqualified activities), they work in construction and municipal services (Moscow and St. Petersburg), in trade (as chelnoky) in Siberia and Kazakhstan, and in agriculture in Kazakhstan. Sometimes working legally but quite often illegally, their numbers are estimated as 300 000 to 700 000 in Russia, and 50 000 in Kazakhstan - over ten percent of the population of Kyrgyzstan, and about twenty-five percent of the labour force. Remittances amount to USD 400–500 million, or about twenty percent of GDP and one hundred percent of the state budget. Remittances are used for buying cattle, increasing agricultural production, and for domestic consumption of basic and imported goods. They are also spent on education, in the country and sometimes abroad. It is reported that 111 ventures were created with remittances, with an employment of 3 700 persons (18). Given the poor business climate, the investment impact of remittances is currently minimal. These migrations strongly reduce unemployment and alleviate poverty, bring additional liquidities to the country, and transfer new-technology knowledge. The main negative aspects are labour shortages, consumer price rises without production increases, and a stronger dollarization of the economy. Lessons about income-driven economies Moldova and Croatia also offer useful experience. Moldova is interesting for Georgia because of the many similarities, in particular the number of emigrants. Moldova has at least twenty percent of its population abroad; it is probably the biggest share in our sample and may serve as an extreme reference. The substantial remittances are not, however, able to significantly reduce poverty, because prices are increasing rapidly; it is not entirely clear whether this inflation is caused by remittances. Croatia, being more developed, closer to the EU, and in the accession process, also provides an experience that is worth studying in Georgia. Specifically, in Croatia a strong and active state managed to create a favourable business climate and attract FDI. The distribution of the economy is similar to Georgia: important sectors are tourism (with twenty-two percent of GDP and twenty-seven percent of employment), transportation, and construction. Agriculture suffered from the war. Distinctively, however, Croa- tia has a dynamic banking sector with significant FDI. Growth is strong despite deficits (budgetary: - 5 percent of GDP; trade with an external debt: 88 percent of GDP; and internal debt: 54 percent of GDP). Economic development based on services benefited from external incomes (remittances at two percent of GDP but high levels of foreign aid). The tourism sector was modernized with private initiatives supported by ad hoc state actions (especially in transport). It is not known to what extent previous emigration and remittances provided the means and skills for tourism development. Despite weaknesses in competition policies that created obstacles to further FDI, Croatia’s success stems also from its ability to master price evolution so as to keep its supply competitive. The lessons for Georgia are obvious. Emigration might ease macroeconomic and territorial labour adjustment; it can reduce internal tensions and promote knowledge, modernity and integration into the world economy. Moreover it is an important lever for restructuring agriculture by the consolidation of farms, developing market connections and access, and reducing poverty traps. Temporary and nearby migration is better than permanent and distant, with less loss of human resources. The literature shows that the bulk of economic gains from migration accrue to migrants and their families, and these gains are often large (19). While the impact of remittances on growth is unclear, remittances do play an important role in reducing the incidence and severity of poverty (with no significant effect on income inequality). Remittances appear to be associated with increased household investments in education, entrepreneurship, and health, all of which have a high social return in most circumstances. In some favourable environments, they may provide a much-needed source of savings and capital for investment. However, migration should not be viewed as a substitute for economic development in the origin country, as development ultimately depends on sound domestic economic policies. Access of poor migrants and their families to formal financial services for sending and receiving remittances could be improved through public policies that encourage expansion of banking networks, allow domestic banks from origin countries to operate overseas, provide identification cards to migrants, and facilitate the participation of microfinance institutions and credit unions in providing low-cost remittance services. Remittances, in turn, can be used to support financial products, like housing and consumer loans and insurance, for the poor. Several origin countries have attempted to improve the developmental impact of remittances by introducing incentives to increase flows and to channel them to more productive uses. Such policies are more problematic than efforts to expand access to financial services or reduce transaction costs, because they pose clear risks. Tax incentives to attract remittances, for example, may also encourage tax evasion, while matching-fund programs to attract remittances from migrant associations may divert funds from other local funding priorities. Efforts to channel remittances to investment, meanwhile, have met with little success. Efforts to increase savings and improve the allocation of expenditures should be accomplished through improvements in the overall investment climate, rather than by targeting remittances.

71 What are the features of income-driven economies? What are the dangers Georgia is facing? Attracting revenues from remittances and donors may boost economic growth, but is not likely to induce development. The attendant threats are twofold. The first is macroeconomic destabilization. In income-driven economies, structural trade deficits are explained by the demand for consumption or investment goods without the existence of domestic capacities. It is even worse when the demand is for high-quality imported goods. A structural deficit yields inflation and may lead the economy into a spiral of debt. The pressure on real exchange rate appreciation caused by large capital inflows, sometimes greater than the state budget, in a narrow financial market is likely to worsen the trade deficit - unless policies target prevention of nominal appreciation, thereby increasing the inflationary risk. The second danger is the spiral of dependency and loss of development ownership. The instability risk connected with macroeconomic destabilization will lead donors to intervene more and more in economic policy and the country’s destiny, thereby increasing the income-driven pattern. The profile of the state determines the trade- off of these risks. In a weak state - one that withdraws in favour of rent-seekers, mafias, and donors - the poor business climate prevents the productive use of remittances and aid and their fiscal appropriation. A strong state creates conditions of fair competition and the rule of law, thus generating a dynamic private sector in a healthy business climate. That case may yield virtuous economic like in Croatia. If not, the country will follow Albania’s path, which is the development trap: the country is too poor to fill the gap by itself, but has too weak a business climate to generate or attract investment activity. How to escape from transition and development traps? Given Georgia’s needs for development, how can it prevent or escape from the development trap and launch the country in a better path than Albania or the Kyrgyz Republic? A first response would be to draw the lessons of other development success stories. Recent experiences of successful development, such East Asia and Mexico show that only export-oriented development strategies can succeed, especially in small countries. But this can succeed under two conditions. The first is to have strong flows of FDI, which bring modern technology, management skills, knowledge of world markets, and the ability to produce competitive goods. Cross-country studies show that the correlation of FDI with growth is well established but the direction of its action is not clear: Quite often one observes bidirectional causation, with virtuous circle effects. A country’s attractiveness to foreign investments (‘investment climate’) has to be maintained and export-oriented investment promoted in order to combat negative-balance-of-payments-effects. The full impact of FDI is not, however, automatically granted, because FDI can have limited technological spill-overs if the foreign-owned sector is isolated from the rest of the economy. To ensure that FDI channels competitive technologies, the industrial-property rights) must be well protected in the recipient country. Quite often, FDI flows go also to infrastructure (e.g., telecommunications) or services (such as retail trade, insurance and banking). For example, more than half of the accumulated FDI stock in Central and Eastern European countries is located outside manufacturing industries. According to the most recent trends in FDI, a firm that invests abroad does not abandon definitively the product after this. It usually improves this product or other products of the same family by exploiting a technological trajectory. Country that receive FDI are partners in processes that don’t stop with the investment, but continue through time and yield new benefits. Moreover, if we consider transition countries, FDI became the best tool to quickly restructure firms and economies. The leading countries in accumulated FDI per capita are among the best transition success stories: Czech Republic, Hungary, Estonia, Slovakia, Slovenia, and Croatia. These countries developed active policies to attract FDI, for example within privatization processes, and resisted the monopolistic pressures of local oligarchs. The second condition of success of an export-oriented development strategy is that authorities conduct strong and consistent policies. As shown in an extensive review of theoretical and empirical literature related to FDI, domestic institutional environment matters a lot (20). “Globalization is good and it’s good when you do your homework…build up high levels of education, respect the rule of law” (Mexican President Vicente Fox). FDI is important for economic growth, but so are appropriate and country-specific domestic institutions and policies. The “homework” of authorities is to set up a fair and transparent legal framework of economic activities, to ensure enforcement. It is also to provide the public goods required for efficient private activities: security of persons and goods, transport and communication infrastructures, and a well-educated and skilled labour force. Nearly all recent success stories were connected with strong state voluntarism. The only exceptions are Chile and Uganda, which are commodity export countries (copper is forty-five percent of Chile’s export and coffee is fifty-seven percent of Uganda’s). State involvement in development does not mean state intervention, but it is the state that ensures a dynamic business climate in a sound macroeconomic environment and promotes consistent development strategy, not affected by political changes. Another option for Georgia is the liberal strategy of a minimal state. Considering that corruption is deeply rooted, the concept is to minimize state in order to minimize corruption. The basic idea is that any regulatory activity of the state is a niche for corruption and bureaucracy, and thus should be eliminated or cut as much as possible. Other features are strong internal and external liberalization and deregulation and a privatization programme. In an economy and a society that still bear the marks of history, basic economic units are often not individuals, but strong groups of interests. The withdrawal of state may have the reverse effect and play against individuals and the business climate by leaving the field to organized economic powers. As shown in a model by M. Selowsky of the World Bank, the key issue for leaving the transition trap in a post-Soviet country is to manage economic 72 reform so, as old forces lose their economic power and benefits, new economic forces come from entrepreneurs and FDI, which “requires focussing on reducing side payments by simplifying licensing, taxation, law enforcement, and accountability of officials” (21). The Political Economy of Transition $FOUSBM&VSPQF $*4$PVOUSJFT

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NEW = New small and medium firms plus FDI; O&I = Oligarchs and insiders’ dominated firms; SOE = SOEs being downsized, shedding assets to new firms. The benefits of initial reform and then the decline of those benefits after a threshold level of reforms for the oligarch/insider-owners firms is much more important in the CIS. It is due to the high rents that can be captured originally from the resources of these countries. The concentration of economic power and rents at the start of reform also results from poor competition in the privatization process, particularly from foreign investors. It also reflects the initial decentralization of control of cash-flow rights to insiders prior to the introduction of reforms that was typical of the Soviet regime. In Central Europe the openness of the political system generated a backlash against insider privatization of large enterprises and encouraged stronger competition, including from foreign investors. This has not happened in many CIS countries. The strong power of oligarchs/insiders and their opposition to reform beyond the level R* will require a minimum (critical) level of extra reforms, dR, in order to move out of the “low equilibrium reform level”, and hence obtain the necessary support from winners. This may be relevant when a new “reformist” administration comes to power. Because of the lower concentration of economic power (as a percentage of GDP) that has emerged from the privatization process in Central Europe, resistance to further reform has been milder, and the danger of a low-level equilibrium reform “trap” much lower. The two canonical responses to the need for preventing or escaping the development trap can thus hardly be applied to Georgia. The state voluntarism for development seems beyond what is currently possible, given the taken policy option and, besides, low efficiency of state administrations. On the other hand, any further withdrawal of state poses a risk to place the country in the transition trap it has just started to leave. Essentially, the question is whether the state is able to set a clear framework for dynamic private activity, or will become captured by private interests. We are not in a take-it-or-leave-it situation, but we need to make the state achieve the former goal. Such a policy cannot be decreed or left to the vagaries of the market. Facing the need for state development in Georgia A modern state should ensure: - its borders and territorial integrity - the security of persons and goods - business stability and predictability of rules - provision of public services as education and infrastructure - territorial and social equilibria What are the means of strengthening the state and making it more efficient? It can be neither spontaneous self organization nor executive decree. Rather, it comes from the interaction among economic, institutional, and political dynamics (22). &DPOPNJD %ZOBNJDT

1PMJUJDBM *OTUJUVUJPOBM %ZOBNJDT %ZOBNJDT Economic dynamics should enable entrepreneurship and create a virtuous economic circle: profitinvestme ntemployment. Another aspect of economic dynamics is the accumulation by firms of technological, productive, and managerial knowledge and the establishment of a consensus between employer and employees, based 73 on work discipline and higher productivity; FDI may foster this process. Institutional dynamics will create a framework for spontaneous economic activity, by establishing clear rules of doing business. Political dynamics is democratization; they must ensure two functions: representation, enabling representation of different economic interests; and the expression of citizens’ preferences. These dynamics are interdependent: Institutional dynamics help firms make profits, which reflects well on the government, which in further improves the business climate. Each country may find its own place to enter the virtuous circle. For example, in Poland it was economic dynamics, based on new small ventures and a tradition of entrepreneurship. The Czech Republic and Hungary based their transition paths on strong institutional processes, coming from the memory of market economies. States with strong patriotic feeling, such as Estonia, rely on political dynamics. In Georgia, economic dynamics are still very weak and institutional dynamics are the main problem–so state development is the key reform issue. Establishing state legitimacy is the means for fighting corruption and bureaucracy; increasing its efficiency, as well as the rule of law and law enforcement, are the means for improving the business climate. The Rose Revolution conferred great legitimacy on the government. Political legitimacy is also given by international support and donors. The government’s orientation towards EU integration speaks to the population because it gives the country a future. The support of the US is also important to the population, as it reduces feelings of isolation in this small country. The crucial question is when will the political benefits from economic development be harvested? There are several possible paths of positive and sustainable state development process. 1 – Endogenous state development path: Legitimacy  institutional design  economic development  political benefits Initial political legitimacy allows for the design of an efficient state administration and modern state functions, which fosters economic development and yields political dividends. This succeeded in Poland and Estonia, and may be likely to succeed in Russia or Kazakhstan. A key condition for success is an initial minimal degree of civil-service culture within the state, which is only starting to develop in Georgia. 2 – Exogenous state development path: International support and capital  economic development  political benefits Failed states are rebuilt by the international community, with huge transfers of money required for acceptance by the population. This was the case of Japan or Taiwan after WWII, and is being attempted in Afghanistan. Is this applicable to transition countries? Probably not, because they function too poorly to be reformed simply by the injection of money and FDI, as in Taiwan, and too well for rebuilding the whole state from scratch. 3 – Combined state development path: Internal legitimacy + international support  business climate  economic development  political benefits This path is relevant to Georgia. It requires that donors consolidate the internal legitimacy of the state and institutional dynamics, help establish clear rules of doing, and help build an efficient civil service. EU integration is a clear option towards this path.. Such an actively pro-development state will identify its priorities, such as energy, transport, and communication infrastructures, as well as agriculture and food processing. These sectors will have the greatest impact on growth, employment, and the business climate. Education is also a sector with long-term development potential. Without distorting competition, measures should be taken to support SMEs. Economic integration with neighbours, especially within the Black Sea context, is also a path to development that is underutilised. On all these priorities, GEPLAC will advise the government and develop specific recommendations. PCA and ENP: How to make an institutional peg work? An institutional peg is similar to a monetary peg in a fixed exchange-rate system; it is an existing set of institutions that are the basis for establishing the rules of doing business, or for democratization process. The Govern- ment of Georgia decided to make EU practices its institutional peg, as expressed in the Partnership and Coopera- tion Agreement (PCA) signed in 1996 and reinforced by the entry of Georgia in the European Neighbourhood Policy (ENP) in 2004. Three precisions should be done in that respect. Pegging Georgia’s institutional development is close to the convergence theory of Gershenkron applied to technological development, better known as the “advantage of backwardness”—that less-developed countries may avoid the trouble of developing technologies by imitating the innovations realized by more developed countries. In a similar way, it is rational for a country like Georgia not to start its institutional development from scratch, but to use the experience of the EU. The EU is ideal due to its proximity and advanced development, and the prospects of deeper economic integration that could follow institutional integration. Its stable institutions are a strong argument for “selling” internally, for example, the ac- quis communautaire. Keep in mind that the aim of convergence is to foster and increase the efficiency of rules of doing business, and all adopted institution should further this aim.

74 The special attention given to institutional development in transition is connected to what international financial institutions call “second generation reforms”, which recognizes the mistakes in the 1990s that followed from the “Washington consensus” - the IMF and World Bank imposing on transition countries macroeconomic stabilization criteria and privatization of state-owned enterprises. The failure of many transition countries in the 1990s revealed that a market economy is also characterized by specific sets of institutions, which are to be understood in the sense given by North (1991) as both formal rules and tacit norms of economic behaviours, deeply rooted in the history and culture of a society. However, this new definition of transition, including the institutional-change dimension does, does not provide a recipe for how to change institutions. Fostering institutional development does not dictate the means of implementation. Institutions that promote efficiency comprise both formal rules and tacit norms, so drafting an adoption process cannot be considered the entire process. Formal rules need to be accepted by organizations responsible for implementation as well as by society. This is a specific process of change that should be organized and that should mobilise special channels as mass media, NGOs etc. The imitation of external innovations, the aim of making laws compatible with EU codes, and the legal approximation are not mere replications. There is an adaptation dimension to institutional development that determines how it should proceed. As noted earlier, two criteria are emerging. Institutional development should increase the efficiency of Georgian economy and firms. This is easy to formulate but difficult to accomplish - consider the debates on “social” or “environmental dumping”. The second criterion is the ability to be accepted by society. As institutions are also informal norms of behaviours, often connected to a set of values, imitation or approximation requires the involvement of society and enforcement organizations (administrative, judicial, etc.). This second criterion does not mean that we support a “populist” approach of the legal approximation, but that resistance and acceptation criteria should be considered if one wants an efficient implementation and an impact on efficiency. This leads to a broader approach to legal approximation, meaning that approximation is not only legal, but be- comes also sociological and communicational. Consequently, not everything from the EU is good for Georgia, at least at the current stage of reforms. We do not intend to retard legal approximation with the EU. On the contrary, we want to so it implemented as effectively as possible. This means that legal approximation should be assessed by its impact on Georgia’s economic development especially on its business climate. Keep in mind that the main obstacle to economic integration with the EU is not Georgia’s legal or regulatory systems, but its low development level. This fact colours consideration of the competition policy or labour code. One should also hear the requests of foreign potential investors in favour of special treatments or special measures and understand that this is explained by a feeling of discrimination that should be analyzed while defining the competition policy. One should also not underestimate in the process of institutional pegging the importance of the ownership required by Government, Parliament and society. It is by taking into consideration all the above questions about Georgia that the GEPLAC team develops an innovative understanding of is functions and an innovative approach of its activities. References 1. IMF Country report 2005, August 2005. 2. European Commission ENP Country Report, 2005. 3. The above findings are reflected in GEPLAC document “Monitoring PCA implementation” January, 2006. 4. Country Partnership Strategy, The World Bank, Oct 2005. 5. Calderon, C., Serven, L. The Effects of Infrastructure Development on Growth and Income distribution, Central Bank of Chile and World Bank, 2004. 6. Söderbäck, Mikael. Pro-poor growth and its linkage to transport infrastructure, in: Promoting and Financing Transport Infrastructure in Africa, OECD Expert’s meeting, January 2006. 7. Georgian Economic Trends, Quarterly Review, 2005/3, GEPLAC, Tbilisi. 8. IbidemGeorgian Economic Trends, 2005/3, GEPLAC, Tbilisi. 9. See: Cordonnier, Christophe. Prospects for the Development of Georgian Agriculture and Rural Society. Proposals for action plan, Georgian Economic Trends, Quarterly Review, 2005/3, GEPLAC, Tbilisi. 10. Country Partnership Strategy, the World Bank, Oct 2005. 11. Roundtable “Revitalizing Georgian Business Activity”, Tbilisi, April 14, 2005, EuropeAid Tacis Support to PCA Implementation Process. 12. This issue was mentioned by President Saakashvili in his annual address to the parliament in February 2006. 13. As shown by EU SIPCA project conference “How to support commercial agriculture?” Tbilisi, May 20, 2005, and EU Tacis Conference “Agricultural and Rural Development in Georgia, Prospects and Lessons from International Experience”, November 17, 2005. 75 14. http://webdominol.oecd.org/COMNET/DCD/PovNet.nsf 15. Christiaensen, Luc, Demery Lionel and Paternostro Stefano. Reforms, Remoteness and Risk in Africa, Understanding Inequality and Poverty during the 1990s, World Bank Discussion Paper, No. 2003/70. 16. Calderon, C., Serven L. The Effects of Infrastructure Development on Growth and Income Distribution, Central Bank of Chile and the World Bank, 2004. 17. Samson, Ivan (dir.). Migration and Rural Development in Albania, Bulgaria and Macedonia, UE-CE research report, 1999, 826 p., http://web.upmf-grenoble.fr/pepse/rubrique.php3?id_rubrique=52 18. Максакова, Л.П., Элебаева, А. Выездные заработки как источник развития бизнеса и предпринимательства: пример Кыргызстана и Узбекистана, Трудовая миграция и защита прав гастарбайтеров, Практика посткоммунистических стран, Кишинев, 2003. 19. Carling, Jørgen. Migrant remittances and development cooperation, PRIO Report (International Peace Research Institute, Oslo) 1/2005; Economic Implications of Remittances and Migration, The World Bank, 2006. 20. Economic Survey on Europe, UN Economic Commission for Europe, 2001. 21. Selowsky, Marcelo. Transition after a Decade, Lessons and Policy Agenda, the World Bank, 2000. 22. Samson, Ivan. The stabilization of transition in post-communist societies, communication at Tacis PROMETEE seminar, Buenos-Aires July, 1994.