Technical Assistance Consultant’s Report Project Number: 43359 January 2014 Regional: Financial Sector Development in Central and West Asia (Financed by the Asian Development Bank’s Technical Assistance Special Fund) Georgia: Boosting Access and Development Prepared by Patricia McKean, Christophe Cordonnier, Gulshakar Fatkulina, and Otabek Rkhimov of Frankfurt School of Finance & Management This consultant’s report does not necessarily reflect the views of ADB or the government concerned, and ADB and the government cannot be held liable for its contents. (For project preparatory technical assistance: All the views expressed herein may not be incorporated into the proposed project’s design.) GEORGIA’S FINANCE SECTOR Boosting Access and Development FINANCE SECTOR DEVELOPMENT Prepared by Patricia McKean, Christophe Cordonnier, Gulshakar Fatkullina, and Otabek Rakhimov of the Frankfurt School of Finance & Management Currency Equivalents (as of 31 July 2013) Currency Unit – Georgian lari (GEL) GEL1.00 = $0.6046 $1.00 = GEL1.6540 Abbreviations ADB – Asian Development Bank EBRD – European Bank for Reconstruction and Development EIB – European Investment Bank EU – European Union FDI – Foreign Direct Investment GAFF – Georgian Agricultural Finance Framework GCI – Global Competitiveness Index GCSD – Georgia Central Securities Depository GDP – Gross Domestic Product GSE – Georgia Stock Exchange ha – hectare IFAD – International Fund for Agricultural Development IFC – International Finance Corporation IFRS – International Financial Reporting Standards IMF – International Monetary Fund KfW – Kreditanstalt für Wiederaufbau NBG – National Bank of Georgia OTC – Over-the-Counter SME – Small and Medium-Sized Enterprises USAID – United States Agency for International Development WEF – World Economic Forum WTO – World Trade Organization The fiscal year of the government and its agencies ends on 31 December. In this report, “$” refers to US dollars unless otherwise stated. Contents Abbreviations Executive Summary I I. Introduction 1 I. The Financial Sector: An Overview 1 A. Macroeconomic Development 1 B. Fiscal Sustainability 1 C. Business Environment: Access to Financial Services 2 1. Small and Medium Enterprise Sector 3 2. Agricultural Sector 3 D. Financial Sector: Structure and Development 4 1. Bank Performance 9 2. Credit Organizations 10 3. Microfinance Organizations 10 4. Insurance Companies 11 5. Securities Market 12 6. Pensions 13 7. Leasing Services 13 8. Loan Security 13 9. Challenges and Risks 14 II. Sector Performance, Problems, and Opportunities 15 A. Agrifinance 15 1. Background: The Georgian Agrarian Crisis 15 2. Key Factors in the Breakdown of Georgian Agriculture 19 3. Integration into International Trade Is Fraught with Difficulties 21 4. Agriculture and the Finance Sector in Georgia 24 5. Roadmap for Development of Agrifinance—Transforming a Window of Opportunity into an Opportunity for Change 34 B. Securities Market Development 39 1. Supply of Securities 39 2. Demand for Securities 54 3. Constraints to Securities Market Development 55 4. Roadmap for Development of the Securities Market 56 Iii. Government Sector Strategy 64 A. The Government’s Development Goals 64 B. Government Strategy for Agriculture and Agrifinance 66 1. A Strongly Proactive Government Strategy in Agriculture 66 2. Government Strategy for the Development of Agrifinance 68 C. Government Strategy for Finance Sector Development, Including the Securities Market 71 IV. ADB Sector Experience and ADB Program 72 A. Summary of Experience 72 B. Harmonization of Activities with other Financial Institutions 72 Appendix Current ADB and Donor Activities in Georgia 73 Preliminary Draft Report Executive Summary1 The Georgian economy has recovered from the twin crises of recession and political conflict that marred the final years of the last decade and led to a sharp decline in lending to the private sector. Gross domestic product (GDP) growth of 6.1% at the end of 2012 marked a turnaround from contraction in 2008, when the economy was in the grip of the global economic crisis and a territorial conflict with Russian Federation. Banks dominate Georgia’s financial-services sector, accounting for 91.33% of assets in the financial system. Commercial banks number 20 and include two branch offices of nonresident entities. Eighteen of the banks are foreign controlled. Other institutions in the financial market include 18 nonbank depository institutions (credit unions), 64 microfinance organizations, 1,044 exchange bureaus, 15 insurance companies, five pension funds, the Georgia Stock Exchange and the Georgia Central Securities Depository. In turn, three listed companies and 130 unlisted companies have been admitted to the exchange. While agriculture comprised 8.5% of GDP in 2012, according to the World Bank, Georgian banks until recently gave the sector scant attention. Some large microfinance organizations have been more active, dealing mainly with very small land holders. National Bank of Georgia (NBG) data put lending to agriculture at only 1.64% of the loan portfolio of banks (with legal entities) in August 2013, despite agriculture employing roughly half of the population and generating more than 9% of GDP. Official figures must probably be substantially re-evaluated, especially since the NBG does not publish detailed statistics of microfinance organization loans. But agrifinance is still largely underdeveloped in Georgia despite recent implementation of the Georgian Agricultural Finance Framework project—funded by the European Bank for Reconstruction and Development and the European Union—and the ongoing sister project involving three leading microfinance organizations and funded by Kreditanstalt für Wiederaufbau. As a matter of fact, no other former Soviet country has a less-developed system for agrifinance than Georgia. Weak agrifinance results reflect those of agriculture and agribusiness as a whole. While Georgia has impressively good natural comparative advantages that made it a star producer in the Soviet era, 20 years of acute agrarian crisis have led to a drop in output and declines in land and labor productivity. Meanwhile, Georgia, once a leading food exporter, has become a large food importer suffering directly from the instability of prices in international markets. Even though the transition from the Soviet-controlled system to a market economy and the costs of conflict on Georgian soil are partly to blame, the agrarian crisis is related mostly to the liberal approach in agriculture adopted after the "Rose Revolution". With land ownership largely undefined and key elements needed for agricultural development in disarray (irrigation networks, drainage, access to quality inputs and machinery, extension services and technological support), the Government of Georgia took the decision to undergo structural reforms, notably by removing trade barriers characterized by the bilateral Free Trade Agreement with Turkey. Faced with competition from foreign farmers who benefit from a modern and heavily subsidized agricultural sector, Georgian farmers are at a disadvantage. Certain measures have been implemented to lessen the crisis, though these are geared towards resolving short-term problems while the sector faces long-term issues. An ambitious strategy to rebuild agriculture is necessary, and while political uncertainty harms its 1 The Asian Development Bank Resident Mission to Georgia provided administrative and technical support. The assessment was reviewed by Lotte Schou-Zibell. ii implementation, international donors recognize that agricultural development is a key to strengthen the economy and allow more inclusive growth. One recent new component of the government’s approach to agriculture is direct support to agrifinance through interest-rate subsidies provided through local commercial banks and microfinance organizations. A scheme focusing on three different groups—household plots, farmers producing mainly for the market, and large modern agribusinesses—was launched in March 2013 and has already obtained concrete results thanks to its attractiveness both to lenders, by reducing risks of default on loans, and to borrowers who can now obtain funds with more favourable terms. In a global economy where agricultural prices are booming, the addition of direct support to farmers and subsidized lending could alter the picture of agrifinance in the short term. This optimistic outcome, however, is challenged by banks not yet being fully prepared to quickly increase their agricultural loan portfolios while maintaining good repayment rates as lending technology is still rudimentary. Technical assistance could be considered for introducing agricredit scoring tools similar to those recently put in place with success in Tajikistan, Turkey, Senegal, and Ukraine as part of donor-supported projects. A second axis requiring strong technical assistance would be to ameliorate value-chain finance through triangular contracts between financial institutions, borrowing farmers and off-takers. A third longer-term option would concern the setting-up of a credit cooperative bank and the introduction of risk-reduction mechanisms such as index-based crop insurance and warehouse finance. The securities market in Georgia is at an early stage of development. The regulatory framework is still evolving, there are gaps in the required capacity and technology to trade equities and bonds, and demand is rather weak. A limited investor base due to the absence of institutional investors and dollarized