Georgia: Boosting Access and Development

Home , Georgian lari, Georgian Stock Exchange, Liberty Bank (Georgia)

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)

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.

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 financial markets, a lack of trust in the local currency and institutions, and poor liquidity all combine to constrain growth in securities. Reforms of the pension system will address some of the challenges, but without greater capacity in the local fixed-income market, fund managers would have to invest in foreign currency, thereby increasing foreign- exchange risks.

Technical assistance could help develop the securities market by expanding the contribution of the banking sector to economic growth and strengthening the nonbank financial sector to underpin domestic savings. A deeper, more diversified nonbank financial sector supporting growth in the real economy would be a desirable outcome. The technical assistance would embrace four phases: (i) policy and consensus-building measures; (ii) development of the primary market for government securities, and (iii) the secondary market for government securities; and (iv) the creation of more options for corporate funding. All phases should aim to: (i) implement an effective institutional structure including securities market regulation and legal and accounting/audit frameworks; (ii) cultivate a benchmark debt-issuance program; (iii) expand the institutional-investor base; and (iv) build capacity.

I. The Financial Sector: An Overview

A. Macroeconomic Development

2. The Georgian economy, although still relatively small by global standards, has grown over the recent past to reach $15.8 billion in 2012 as measured by GDP (Table 3). The country has a relatively narrow economic base, little wealth—Georgian lari (GEL) 5,812 ($3,514) in 2012 on a per capita GDP basis—and political and economic institutions that are still developing. As in several Commonwealth of Independent States countries, economic imbalances have increased in Georgia over the past decade owing to fast credit growth and asset-price inflation. This came to an abrupt end with the advent of conflict with the Russian Federation in August 2008, followed shortly after by the global financial crisis. These two events combined to slow down output, and to increase credit losses associated with a sharp contraction in lending to the private sector. The correction phase has now bottomed out but it is possible the residual impact on the banking sector over the next few years may be high.

3. The economy remains vulnerable to external shocks due to dependence on energy imports and as a result of the country's trade structure. Foreign direct investment (FDI) over the past decade initially increased thanks in part to privatization. However, since the 2008 conflict with the Russian Federation and due to subsequent domestic and global economic pressures, FDI has declined. Some of this investment has been replaced by multilateral funding and donor grants, in the process providing critical external liquidity. GDP shrank in line with world markets in 2009 but recovered in 2010 and has since maintained growth of at least 6% a year. However, external debt remains high and the current account deficit rose to 11.5% of GDP at the end of 2012.

4. Although relations between Georgia and the Russian Federation remain tense, the signing of a bilateral World Trade Organization (WTO) free trade agreement in late 2011 has contributed to a relative normalization of ties. Further, the political context has stabilized since the election of the new President.

B. Fiscal Sustainability

5. Public investment has increased in recent years aided by commitments from donor agencies. These additional inflows have also helped the fiscal deficit to significantly narrow from a high of 9.2% of GDP in 2009 to 3.0% in 2012. However, an Article IV Consultation by the International Monetary Fund (IMF) in 2013 determined that public spending is still too high, and the national budget is still reliant on external funding (both from public institutions and remittance inflows).

6. Georgian central government debt liabilities have increased at a compound annual rate of 13.4% since the crises of 2008. Total central government debt liabilities as a percentage of GDP rose from 27% that year to peak at 36.8% in 2010, and fell back only to 32.6% in 2012 (Figure 1). As important is the prominence of foreign currency debt in the government’s portfolio, albeit much of it in the form of donor lending at concessional rates. Since the end of 2008, foreign debt has increased at a compound annual growth rate of 18.7%. It comprised 77% of total central government liabilities at the end of the first half of 2013.

Figure 1: Central Government Debt Liabilities

Note: GEL = Georgian lari Source: Georgia Ministry of Finance, http://www.MoF.ge/en/5136.

C. Business Environment: Access to Financial Services

7. The government has voiced a commitment to market-oriented policies, structural reforms, an efficient tax structure, and significant transparency in public sector activities. It has also taken steps to reduce corruption. Georgia ranks eighth (out of 189 countries) in the ease of doing business according to the World Bank’s “Doing Business 2014” annual report while the country’s overall ranking in the Global Competitiveness Index (GCI) 2013–14 was 72 out of 144 countries, up from 77 in 2012–13 (the regional benchmark Armenia ranks 79, up from 82 in the previous year).1

8. However, in spite of the financial system being profitable, adequately capitalized, and liquid, 2 Georgia is at a competitive disadvantage based on financial market development indicators (Table 1 below), ranking 75 out of 144 countries, but above other Central and West Asia countries such as Armenia (76), Azerbaijan (88) and Kazakhstan (103). Georgia is especially uncompetitive in terms of financing through the local equity market (126) and regulation of securities exchanges (119), underscoring that its capital markets are not yet supporting growth in the real economy. By comparison, Armenia ranks 115 and 110 respectively on these measures, while Estonia ranks 59 and 40.

Table 1: Financial Market Development Index (2013)

Financial Availability of Affordability of Financing Ease of Venture Regulation of Soundness Market Country financial financial through local access to capital securities of banks Development services services equity market loans availability exchanges Index (Rank) Armenia 63 50 115 88 93 53 110 76

Azerbaijan 108 73 78 54 52 112 98 88

Georgia 96 83 126 98 106 82 119 75

Kazakhstan 60 58 100 61 72 100 90 103

1 World Economic Forum. 2013. The Global Competitiveness Report 2013–2014. Geneva. 2 International Monetary Fund. 2013. Georgia: 2013 Article IV Consultation. IMF Country Report 13/264. August. Washington DC. http://www.imf.org/external/pubs/ft/scr/2013/cr13264.pdf.

Tajikistan* 103 88 88 49 50 100 123 124

Estonia 38 41 59 48 30 35 40 35

Latvia 47 42 99 96 58 80 64 45 Note: Ranked out of 144 countries. For indicators, a rank of 50 and below is a competitive advantage and 51 and above is a competitive disadvantage. *For Tajikistan the latest data is available only for the period 2012-2013. Source: World Economic Forum (WEF). 2013. The Global Competitiveness Report 2013–2014. Geneva: WEF.

9. Based on the GCI, Georgia’s banking sector is also at a competitive disadvantage. Georgia ranks at 82 compared to Armenia’s 53 and Estonia’s 35 on the measure of the soundness of banks, while on ease of access to loans Georgia ranks 98 versus Armenia’s 88 and a ranking of 48 for Estonia. On the indicator for the availability of financial services the country is also at a competitive disadvantage, ranking 96 versus Armenia at 63 and Estonia at 38, as is the case for affordability of financial services, with Georgia ranking 83, behind Armenia at 50 and Estonia at 41. Although the government has taken steps to implement structural reforms, for example in provision of universal healthcare system and new agricultural measures, more work is required to ensure the financial sector supports development in the real economy.

1. Small and Medium Enterprise Sector

10. Currently there is no law in Georgia concerning support for small and medium enterprises (SMS) and the government’s small and medium enterprise policies and programs are not clear. The Law on Entrepreneurs does not define SMEs clearly, although the Tax Code of 2011 bases its classification of micro and small-sized businesses on workforce and annual turnover, specifying that a micro-business is an entity with annual income of less than GEL30,000 ($18,138) which is a sole proprietorship, and a small business is an entity with annual income of less than GEL100,000 ($60,459).

11. In 2011, by number of operating enterprises, SMEs were found in most fields of economic activity, and highly represented in eight sectors: (i) hotels and restaurant, 98.5% of businesses; (ii) real estate, 98%; (iii) agriculture, hunting, and foresting, 98.7%; (iv) the wholesale and retail trade, 96%; (v) transport and communications, 92.5%; (vi) construction, 96%; (vii) education, 96%; and (viii) manufacturing, 96%. Large enterprises were concentrated, for example, in electricity, gas, and water supply (37%).3

2. Agricultural Sector

12. The agricultural sector in Georgia can be characterized by low productivity and underutilization of resources, even as a good water supply, fertile land, and a mild climate make conditions favourable for development and expansion. After the dissolution of the Soviet Union the significance of agricultural sector in Georgian GDP declined dramatically from nearly 30% in 1991 to a constant 9% share throughout 2008–2012.4 Output is divided almost equally between crop and meat production.

3 Tatiana Papiashvili and İlyas ÇILOĞLU. 2012. “The Role of SME Sector in Georgian Economy“. Journal of Business. 4 World Bank Indicators. http://data.worldbank.org/indicator.

13. The agribusiness in Georgia is dominated by small farm households with an average size of 1.3 hectare (ha), generally divided into three or four smaller land plots. As of December 2013, 3,743 registered entities were engaged in agribusiness.5 In 2012, the average annual income of agricultural workers was only 20% of urban salaries—equivalent to about $240.

14. Major obstacles for the development of commercial agriculture in Georgia are the weak organization of land holdings (small land plots and inefficient land division), red-tape in land registration procedures, a lack of investment in the sector, and unattractive and unaffordable financing for farmers.

D. Financial Sector: Structure and Development

15. The contribution of the financial sector to economic growth has been amply demonstrated in academic literature over the years and is well understood. Research has identified how the operation of banks and the functioning of securities markets contribute to the economy, albeit in different ways. 6 Typically, in the early stages of financial-market development, the banking sector tends to dominate but later the capital markets play a more active role. Over time the Georgian banking industry may benefit from the government's commitment to market-oriented policies and structural economic reform.

16. As of July 2013, 20 commercial banks, with 160 branches7 and 715 service centers,8 were operating in Georgia, 18 of them foreign-controlled. Other institutions in the Georgia financial market included 18 nonbank depository institutions (credit unions), 64 microfinance organizations, 1,044 exchange bureaus, 15 insurance companies, five pension funds, the Georgia Stock Exchange (GSE) and the Georgia Central Securities Depository (GCSD). The GSE comprised three listed companies and 130 unlisted companies.

17. Various indicators have been used as proxies to measure financial sector development, but since the financial sector of a country can comprise a variety of financial institutions, markets, and products, the indicators provide only a rough estimation and do not capture all aspects of financial development. The size and depth of the financial sector is assessed by several ratios relative to GDP including broad money, bank assets, deposits and private-sector credit. 9 As is evident from Table 2:, Georgia’s domestic financial system is relatively small and, also importantly, is dominated by the banking sector.10

5 Geostat. http://www.geostat.ge/. 6 For example, see Demirguc-Kunt, Feyen, and Levine. 2011. “The Evolving Importance of Banks and Securities Markets”. Policy Research Working Paper 5805. Washington DC: World Bank. 7 There are also two branches of non-resident commercial banks. 8 National Bank of Georgia. 2013. “Bulletin of Monetary and Banking Statistics”. No. 172. Tbilisi. http://www.nbg.gov.ge/uploads/publications/bulletinstatistics/statbiul/2013/bulletinjune2013_eng.pdf. 9 Broad money in Georgia is defined as M3 by the World Bank. http://www.databank.worldbank.org/data/home.aspx. 10 The Asian financial crisis in 1997-1998 demonstrated that over-dependence on the banking system can cause macroeconomic dislocation—especially if the banks are dependent on short-term capital. Macroeconomic disruption will likely be substantially amplified by the presence of foreign (short-term) capital as foreign inflows rapidly reverse, draining liquidity from the system.

Table 2: Financial Market Size and Development (% of GDP)

2007 2008 2009 2010 2011 2012

Broad money 24.1 23.2 26.5 29.9 29.2 30.2 Deposits: GEL share in broad money 28.9 21.7 26.1 28.4 38.1 34.8 Deposits 18.9 18.7 22.0 26.5 27.7 29.3 Bank assets 42.4 46.5 46.1 50.9 52.1 54.9 Domestic credit to private sector 27.8 33.1 30.9 31.8 32.7 34.5 Equity market capitalization 13.7 2.6 6.8 9.1 5.5 6.0 Note: GEL = Georgian lari. Source: The World Bank. www.databank.worldbank.org/data/home.aspx. National Bank of Georgia. www.nbg.gov.ge.

18. Broad money to GDP has been stable at around 30% for the past three years, although this ratio may be distorted by the high proportion of foreign currency. In developed countries the ratios of banks’ assets, loans and (often) deposits usually exceeds 100% of GDP. By comparison, in Georgia the ratio of banks’ assets to GDP has increased progressively from 42.4% at the end of 2007 to 54.9% at the end of 2012. Over the same period, the ratio of bank deposits (demand and term deposits) increased from 18.9% to 29.3% of GDP. One possible explanation for relatively low deposits is the (still prevailing) lack of trust in the banking sector as further shown by the relatively low share of GEL in broad money: from a recent low of 21.7% in 2008, this rose to 38.1% in 2011—only to fall back to 34.8% in 2012.

19. Dollarization is a concern in many developing and transition economies and is often attributed to high and variable inflation: high inflation leads to dollarization which, in turn, can lead to currency substitution. Apart from the inflation outlook, a range of other factors can explain high levels of dollarization, including openness of the economy, economic uncertainty or a lack of confidence in the domestic currency, while it appears that unofficial dollarization may reflect local perceptions regarding the stability of the domestic monetary regime, the credibility of monetary policies, and the perceived stability of the domestic banking system. It has been observed that the breakdown of the command economy in former Soviet countries in the early 1990s was associated with currency substitution as newly established market economies opened up to the outside world. Academic studies note that an economy is considered to be highly dollarized if the ratio of foreign currency deposits to broad money exceeds 30%, which is the case in Georgia. 11

20. In Georgia, foreign currency deposits in broad money have risen steadily from 46.0% in 2004 to 64.3% by the end of the first quarter of 2013, while as a percentage of total deposits, the share of foreign currency deposits has declined from a high close to 86% in 2003 to about 60% in 2011, only to rise again to 64.1% by the end of the first quarter of 2013. Deposits in foreign currency remain high in spite of the reserve requirement12 for foreign currency deposits with maturity of less than 1 year being presently set at 15%13 versus 10% for local currency; effectively a 5% marginal tax for using foreign currency. 14 Interest is paid by the NBG on borrowed funds in domestic currency, presently at the refinancing rate on 50% of required

11 For example, T. Bolino, A. Bennett and E. Borensztein. 1999. “Monetary Policy in Dollarized Economies”. IMF Occasional Paper No. 171. Washington DC: International Monetary Fund. 12 Reserve requirements are calculated with reference to average deposits over the previous 2 weeks (the relevant period in the euro zone is 1 month). 13 The reserve requirement for local currency deposits longer than 1 year is effectively 0%, while for foreign-currency deposits maturing between 1-2 years it is 5%. There is effectively no requirement for reserves on foreign-currency deposits of longer maturities. 14 ECB reserve requirements are 1% for all deposits and securities maturing in less than 2 years; otherwise it is 0%.

reserves, and on foreign currency, although the rates on euro and US dollar deposits are presently 0%.15 Thus, dollarization could be considered a long-term phenomenon, which makes its measurement essential for the conduct of monetary policy in Georgia. The relationship between domestic and foreign currency yields does appear to have some influence on the amount of dollars deposited. A decline in the share of foreign currency deposits tends to lag the decline in the interest-rate differential between deposits in foreign currency and national currency; that is, as domestic currency yields become relatively more attractive so their relative share of national deposits increases.

Figure 2: Movements in Foreign Currency (%)

Source: National Bank of Georgia. www.nbg.gov.ge.

21. Bank loans are the main source of credit for the private sector in a Georgian financial system that lacks a functioning capital market (Table 3). The stock market is small and a corporate bond market barely exists, leaving corporate borrowers wholly dependent on bank finance. Given that bank loans tend to be of short tenor, any shock to confidence in Georgia could leave the economy vulnerable to a disruptive credit crunch. At the same time Georgian banks have denominated many of their loans in foreign currency (Figure 3). Hence, exchange rate depreciation could result in serious balance-sheet damage for the real sector, and thrust highly leveraged corporations into bankruptcy. Lending standards among Georgian banks may be too relaxed as evidenced by extensive loans in foreign currencies and relatively high exposure to the real estate and construction sectors. Furthermore, by advancing foreign currency-loans to local corporations, to the extent these entities do not have access to adequate foreign-currency revenues, banks are replacing foreign-exchange risk with credit risk.

15 Rates for US dollar loans are based on Federal Funds Target Rate less 0.50%, and rates for euros are based on the ECB Policy Rate less 0.50%.

Figure 3: Share of Commercial Banks’ Foreign-Currency Loans (%)

Source: National Bank of Georgia.www.nbg.gov.ge.

22. Bank lending to the private sector has been slow to recover from the events of 2008— as is evident from Table 3—and was only 34.5% relative to GDP at the end of 2012. This can be partly explained by a range of factors, including the absence of institutions that support financial development. The National Bank of Georgia is working to promote GEL lending by banks, especially on a variable-rate basis. To support this activity, the central bank permits banks to pledge certificates of deposit and GEL denominated SME loans or mortgages (haircuts of 5% and 20% respectively) and other bank guarantees (the latter are rarely used).16

Table 3: Financial Market Metrics – Georgia

2007 2008 2009 2010 2011 2012 GDP at current prices ($ billion equivalent) 10.2 12.8 10.8 11.6 14.4 15.8 Equity market capitalization (% of GDP) 13.7 2.6 6.8 9.1 5.5 6.0 Central government debt, total (% of GDP) 22.7 27.0 34.6 36.8 32.5 32.6 Domestic credit to private sector (% GDP) 27.8 33.1 30.9 31.8 32.7 34.5 Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

23. The securities market in Georgia can only be described as nascent. Using equity market capitalization as a proxy to assess development of the securities market indicates that the equity market in Georgia is very small. Market capitalization peaked at 13.7% in 2007 only to fall sharply in 2008 and climb back up to only 6% in 2012. Meanwhile, the domestic debt market is very immature, shallow and illiquid with only a couple of bond issues to date. Since the capital market provides access to longer-term finance, the absence of a securities market— and related dependence on bank loans—is problematic because bank lending tends to be short- term because it is funded by short-term deposits, minimizing the risk due of maturity mismatch.

24. As principal players and beneficiaries in the early stages of market development, banks tend to oppose disintermediation of the financial sector—in particular the development of corporate debt markets. Disintermediation not only introduces competition that may hurt their

16 Liberty Bank has launched a mortgage product with a variable interest rate linked to the NBG refinancing rate.

profits but may also have implications for banks’ human capital resources as new skills such as risk management and credit evaluation come to the fore.17 However, as debt capital markets develop their advantages for banks become more obvious as: (i) a source of long-dated funding; (ii) revenue-earning opportunities via the provision of standby lines of credit (for short-term commercial paper) or bank guarantees (for medium- or long-dated bonds); and (iii) giving access to tradable assets with higher yields than government bonds. Empirical studies have shown that countries with competitive, well-capitalized banking systems have larger bond markets, thereby pointing to a complementary relationship between banks and capital markets in the latter stages of development. 18 A recent paper reported that strong capital market revenues were the main contributor to large US banks’ earnings in the second quarter of 2013, and compensated for falls in net interest margins and weaker mortgage lending.19

25. The problem of banks’ opposition to disintermediation is compounded in Georgia by the level of concentration in the banking sector since the more concentrated this sector, the greater the capacity to deter bond market development. Under these circumstances, the government may need to step in, as illustrated most recently by efforts to develop the corporate bond market in Malaysia (Box 1).

Box 1: Malaysia—Impetus for Corporate Debt Market Development

To support growth of the local bond market the Malaysian government set up a national mortgage corporation, Camagas Berhad, in 1988 to securitize banks’ mortgage loans. Bonds issued by Camagas benefited from favourable regulatory treatment, for example being included as liquid assets for the purposes of bank investments.

At the same time the government encouraged the Employee Provident Fund (EPF) to invest in corporate bonds issued by entities such as Petronas in order to underpin development of domestic infrastructure and energy projects. Bonds floated by low-rated issuers were also backed by bank guarantees to enhance market acceptability, in the process providing an incentive for local banks to support disintermediation.

The net effect of the government directing the application of EPF funds was beneficial for investment in domestic infrastructure and also secured demand for debt-market products. At the same time the government promoted growth of the infrastructure essential for the development of the bond market. For example, the fact that bond ratings were mandatory assured scale, and hence provided economic justification for having a local credit-rating agency.

The success of the government’s strategy was evident in the growth of the corporate debt market—from 4% of GDP in 1989 to 47% in 2000.

Source: Consultant.

26. Stakeholders observed that the Georgian banking sector—while developed in comparison with other sectors of the economy, except perhaps tourism—was lagging behind some peer countries. For the purposes of regional comparison, two countries with economies similar in size have been selected: Armenia, due to geographic proximity, and Estonia, since the

17 Capital market investors welcome high-quality corporate issuers and the quality of a bank’s portfolio may suffer as such borrowers take fewer bank loans. 18 Barry Eichengreen and Pipat Luengnaruemitchai. 2004. “Why Doesn’t Asia have Bigger Bond Markets”. NBER Working Paper 10576. National Bureau of Economic Research, Inc. 19 Standard & Poor’s. 2013. “US Large, Complex Banks' Capital Markets Business Trumped Traditional Banking In Second Quarter”. https://www.globalcreditportal.com/ratingsdirect/renderArticle.do?articleId=1175729&SctArtId=174505&from=CM& nsl_code=LIME.

country ranks as the strongest performer among selected Eastern European peers of Georgia in the Global Competitiveness Report 2012.20 Domestic credit to the private sector in Georgia grew gradually from 27.8% of GDP at end-2007 to 34.5% of GDP at the end of 2012 (Table 3), a rate of growth that lags Armenia, where domestic credit to the private sector as a percentage of GDP grew from 28.4% at end 2010 to 42.9% at the end of 2012 (Table 4). In Estonia, meanwhile, domestic credit to the private sector declined over the same period from 98.4% to 79.3%.

Table 4: Comparative Financial Market Metrics – Armenia, Estonia, and Georgia

2010 2011 2012 Georgia Armenia Estonia Georgia Armenia Estonia Georgia Armenia Estonia GDP at current prices 11.6 9.3 18.8 14.4 10.1 22.2 15.8 9.9 21.9 ($ billion equivalent) Domestic credit to private sector 31.8 28.4 98.4 32.7 35.4 84.7 34.5 42.9 79.3 (% GDP) Equity market 9.1 1.6 12.0 5.5 1.4 7.3 6.0 1.3 10.7 capitalization (% GDP) Note: GDP = gross domestic product. Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

1. Bank Performance

27. Banking regulation and supervision in Georgia is broadly in line with international standards, although the regulator may not have been sufficiently proactive during the period of rapid credit growth in the run-up to the global financial crisis, especially in regard to foreign currency and real-estate sector lending. Governance and transparency within the Georgian banking sector seems relatively strong, possibly due to the concentration of foreign ownership. At the end of March 2013, the five largest banks accounted for slightly more than 80% of total sector assets while the top two banks—JSC Bank of Georgia and TBC Bank Group—accounted for over 60% of banking sector assets. All banks are privately owned and operate on a commercial basis. Asset growth across the sector was high, at 14%, in the 12 months to the end of March 2013. Outstanding loans disbursed by the commercial banks grew by 12% over the same period and the outstanding balance of deposits increased by 18%.

28. The high level of concentration in the banking sector has implications for development of the securities market and the real economy. The activities of the commercial banks do not contribute fully to economic growth, while they are hampering financial intermediation and restricting capital market development. Competition among the larger banks is in effect oligopolistic when two large banks hold 60% of market share. Related to this, funds are expensive and the net interest margin is large (Figure 4). Since January 2008, the market interest rate on local-currency loans for legal entities—typically collateralized—has ranged from 13.5%–19.6%21 while deposit rates for legal entities have been between 5.2% and 14.3%. For individuals the corresponding rates on loans range from 23.9% to 30.2% and for deposits, 9.5% to 13.0%. Overall, the net interest margin since January 2008 has ranged from 8.8% to 15.5% while the average net interest margin has exceeded 11.6%.

20 World Economic Forum. Global Competitiveness Report 2012–2013, http://www3.weforum.org/docs/WEF_GlobalCompetitivenessReport_2012–13.pdf. 21 It was noted that big companies are able to access (collateralized) bank funding in the range of 12%–15%.

Figure 4: Market Interest Rates on Loans and Deposits in National Currency (%)

Source: National Bank of Georgia.

29. As previously noted, the banking sector has significant external debt. While the relative shares of foreign-currency loans and deposits are similar—foreign-currency loans were 66% of total loans and foreign-currency deposits were 64.1% of total deposits at end of June 2013—the figures are troublesome. Commercial banks’ loans in foreign currency to enterprises and households totalled GEL5.96 billion ($3.6 billion) on 1 July 2013, of which GEL4.88 billion ($2.95 billion) were classified as long-term. 22 Against this, the banks held foreign currency deposits of GEL4.24 billion ($2.56 billion) of which 33% or GEL1.4 billion ($0.85 billion) were long-term. 23 Banks have a mismatch in absolute terms between foreign-currency loans and deposits of GEL1.72 billion ($1.04 billion), an exposure that is compounded by the maturity mismatch of GEL3.48 billion ($2.1 billion) between long-term foreign-currency loans and deposits, leaving the banking sector exposed in the event of exchange-rate volatility.

2. Credit Organizations

30. Credit unions established by Georgia’s rural population play only a very small part in the financial sector, and contributed just 0.04% of financial-sector assets at the end of 2012. All credit unions have the legal form of registered co-operatives. The oldest of the 18 credit unions that currently operate was registered in December 2002 and only four new ones have registered since 2008. Five credit unions are based in Tbilisi and the remaining 13 are located in other regions.

3. Microfinance Organizations

31. As of December 2013, 67 microfinance organizations, which support the development of micro, small and medium-sized businesses, were in operation, reflecting efforts to reduce poverty. Their total assets exceeded GEL720 million ($435 million), against total loans portfolio for the third quarter of 2013 exceeding GEL550 million ($332.5 million). The sector is growing at a high speed and the biggest problem is no regulation is yet in place to supervise the activities

22 The corresponding figure for loans in national currency was GEL2.94 billion ($1.78 billion), of which GEL1.79 billion ($1.08 billion) were classed as ‘long-term’. 23 Deposits in national currency totaled GEL1.33 billion ($0.8 billion) at end-June 2013, of which only GEL0.24 billion ($0.15 billion), or 18.3%, are classified as long-term.

11 of microfinance organizations. However, the NBG plans to establish standardized rules and regulations—governing loan ceilings, the scope of products and services they can offer, and the like—to ensure customer protection and the sustainable development of microfinance.

4. Insurance Companies

32. The insurance sector is undeveloped in Georgia, accounting for only 4.01% of financial sector assets at the end of 2012. Presently, 14 insurance companies operate in Georgia but written premiums are low, at less than 2.0% of GDP at the end of 2012 and non-life insurance accounts for 95.6% of written premiums (about 1.9% of GDP). Four classes of insurance contribute more than 90% of the insurance sector’s liabilities (Table 5). Indeed, one business line, health insurance, holds the majority of the sector’s liabilities (73.78% of the value of premiums written) followed by property insurance (7.96%). Until recently the provision of health care was private,24 and although children under 5 years old, pensioners and socially vulnerable people had access to subsidies, there was no state insurance system. On 1 July 2013, the government introduced a new state insurance system to cover everyone. Further reforms are planned, for example the introduction of mandatory third-party liability insurance for motor vehicles, to support development of the sector.

Table 5: Structure of Insurance Market by Class of Business (31 December 2012)

No. Class of Insurance Written Premiums Market Share (%)

1 Life 22,638,777 4.39 2 Travel 3,664,416 0.71 3 Personal Accident 2,902,265 0.56 4 Medical (Health) 380,333,584 73.78 5 Road Transport Means 31,410,515 6.09 6 Motor Third Party Liability 4,224,867 0.82 7 Railway Transport Means 0 0.00 8 Aviation Transport Means (Hull) 5,596,879 1.09 9 Aviation Third Party Liability 4,131,232 0.80 10 Marine Transport Means (Hull) 351,826 0.07 11 Marine Third Party Liability 31,163 0.01 12 Cargo 3,820,441 0.74 13 Property 41,020,206 7.96 14 Financial Risks 2,029,654 0.39 15 Surety ships 4,839,680 0.94 16 Credit 490,656 0.10 17 Third Party Liability 7,985,268 1.55 18 Legal Expenses 0 0.00 Total 515,471,427 100 Note: According to the Dictionary of Insurance Terms (provided by the website www.allbusiness.com/), aircraft hull insurance includes coverage on an all risks basis whether the airplane is on the ground or in the air, while hull marine insurance includes coverage of the hull of a ship and its tackle, passenger fittings, equipment, stores, boats, and ordnance. Source: National Bank of Georgia Insurance Market Statistics. http://www.nbg.ge/index.php?m=489.

33. Life insurance is a very small component of the Georgian insurance market: as at 31 December 2012, life insurance accounted for only 4.4% of written premiums (0.1% of GDP).

25 Georgia Stock Exchange. Financial Statements 2012. http://www.gse.ge/.

However, life insurance policies are typically credit-related; that is the product is effectively term insurance integrated into another insurance product such as health or mortgage insurance. As protection policies, the premium paid for these contracts buys protection only in the event of death. The alternative of permanent life insurance provides for investment policies that accumulate cash value. Banks previously had a mandatory requirement for borrowers to buy (term) life insurance when taking out a mortgage. The (bank’s) insurance subsidiary provided the life insurance contract and the premiums (0.6%–0.8% for 10–18 year mortgages) were added to customers’ mortgage rates. However, earlier in 2013 the NBG instructed banks to reduce mortgage interest rates. As a result banks dropped the requirement for mandatory life insurance in order to create the illusion of decreasing mortgage rates.

34. Regulation of insurance companies came under the remit of the NBG, which strictly monitored insurance reserves (5% of written premium) until April 2013. Although the separation of the insurance sector supervision from the central bank, through an independent Georgian Insurance State Supervisory Service, came into force that month, it was not fully functional a few months later. As of end June 2013 two appointments had been made, but the new regulator was not operational (for example, premises had only recently been secured). In addition, although insurance companies are required to submit monthly reports, the new institution was not yet accepting these reports and although insurance companies were in communication with it, the new insurance regulator had no staff to process them. Hence, the insurance sector was considered not adequately regulated as of mid-2013.

5. Securities Market

35. There is one stock exchange, the GSE. The GSE organizes securities trading only, limited to three sessions a week. GSE total operating income for 2012 was GEL140,772 ($85,110) and included listing fees of GEL22,000 ($13,301), trading commission fees of GEL9,005 ($5,444) and fees for reported over-the-counter (OTC) trades of GEL41,887 ($25,325) as well as income from membership fees and data distribution. 25 Although 133 companies have been admitted to the stock exchange, the securities of only three companies are listed, of which two are considered liquid. It was not possible to obtain current information about the total volume of securities listed and traded on GSE and the data for 2012 was distorted by the transfer of shares in JSC Bank of Georgia to Bank of Georgia Holdings plc.

36. Seven brokerage companies are listed on the Georgia Stock Exchange (GSE) website as offering professional activities in the Georgian securities market as of mid-2013, of which only three are considered active. 26 Brokerage companies accounted only for 0.30% of financial sector assets, or GEL46.6 million ($28.2 million), at the end of 2012. Six brokerage companies regularly publish quarterly reports on the GSE website, although only available in the Georgian language.

37. Suffice to say, the equity market is small with low equity capitalization (Table 3). All trading in government bonds is OTC via Bloomberg and very few issues have been completed in the corporate bond market. The significance of an active corporate bond market in contributing to economic growth is important given the market’s role of spreading (corporate) risk via the capital market rather than concentrating it in the banking sector.

38. Notwithstanding the sluggish domestic bond market, demand has grown for bonds floated by Georgian issuers in international markets. Bank of Georgia floated the first Eurobond

25 Georgia Stock Exchange. Financial Statements 2012. http://www.gse.ge/. 26 NBG website notes nine brokerage companies. http://www.nbg.gov.ge/index.php?m=487.

13 from Georgia in February 2007. This sale, of $200 million worth of debt, was followed by the first international sovereign bond issue from Georgia in April 2008 of $500 million of five-year bonds with an annual yield of 7.5%. Georgian Railways in 2010 issued its first bond of $250 million due 2015 in the international markets. In April 2011, the government floated a second international bond, $500 million of debt maturing in 2021 with a 6.875% annual yield,27 followed by several Georgian entities in 2012, for example Bank of Georgia (a $250 million issue, paying investors 7.75% annually, and due to mature in 2017), Georgia Railways ($500 million of 7.75% bonds, due 2022)28 and Georgian Oil and Gas Corporation ($250 million of 7.125% bonds maturing in 2017).

6. Pensions

39. Georgia made an early start on reform with the introduction of Pillar III pensions in 2001 but although the workforce presently numbers about 700,000 there are only around 22,000 pension accounts and at the end of 2012 pension reserves were just 0.04% of GDP, or GEL11.29 million ($6.8 million).29 Pension fund management is conducted by two insurance companies: Aldagi BCI and GPI Holding. Aldagi BCI holds about 72% of reserves. There appear to be no independent fund managers. Contributions to funds generally come from corporate clients and the bulk of contributions were collected before a change in profits tax law 2003. Since then the combination of a lack of incentives—contributions are taxed at source—and poor returns, means that insurance companies cannot compete with banks. Total contributions to private pension schemes in 2012 were GEL2.4 million ($1.45 million), of which almost 80% accrued to Aldagi BCI, with GPI Holding taking the rest.

40. Investment guidelines under the Law on Private Pension Funds seem to be the same as those for investment of insurance reserves. The government is currently considering the introduction of a Pillar II system,30 possibly as early as 2015, with the Ministry of Economy 31 putting together a working group to review the options for pension’s reform.

7. Leasing Services

41. Georgia’s leasing market is in an early stage of development with only three leasing companies. Georgian Leasing and TBC Leasing are subsidiaries of Bank of Georgia and TBC Bank respectively. Alliance Group Leasing, established in 2006, is the only leasing company in Georgia not owned by a bank.

8. Loan Security

a. Credit Registry/Credit Bureau

42. CreditInfo Georgia was established in 2005 by four leading Georgian banks, CreditInfo International GmbH, and National Credit Information Bureau Ltd. 32 CreditInfo Georgia specializes in credit information and the provision of information essential to bank’s decision on

27 Of the total raised, $417million was applied to redeeming the earlier issue due 2013. 28 88.99% of the proceeds were applied to redeeming the outstanding bond due 2015. 29 Contributions under Pillar III are voluntary. 30 Contributions under Pillar II are mandatory. In most countries contributions are drawn from pretax income and typically placed in a segregated pension account to be withdrawn on reaching pensionable age. Under some plans the beneficiary may access funds early to support spending for a mortgage, health care or education. 31 The World Bank indicated during meetings with the ADB mission team its interest to provide assistance to the government on implementing Pillar II pension reform. 32 A leading supplier of company profiles, marketing lists, and business surveys to local and foreign investors.

loans, leasing companies and other organizations who lend money, provide services and goods in credit. CreditInfo Georgia had 59 clients from the above organizations in August 2013.

b. Deposit Insurance Scheme

Georgia does not have a deposit insurance scheme, nor has the process of establishing one started. According to international experience, such a scheme should have the possible impact of reducing high financial services costs and be operable in Georgia too since its banking sector is relatively trusted, However, because of oligopolistic competition (as described above) some banks, especially the largest, are opposed to the idea. The World Bank is working with Georgian stakeholders on a deposit insurance system.

9. Challenges and Risks

43. Challenges and risks include: (i) continuing volatility in business cycles that is exacerbated by external shocks; (ii) relatively high poverty, inequality and unemployment; (iii) the large current account deficit and external debt (some of it concessional in nature); (iv) stubbornly high dollarization despite countermeasures; (v) high foreign-currency lending where lending standards may be less than robust, and; (vi) lending portfolios that have expanded rapidly and may therefore come under stress.

II. SECTOR PERFORMANCE, PROBLEMS, AND OPPORTUNITIES

A. Agrifinance

1. Background: The Georgian Agrarian Crisis

44. Georgia has outstanding comparative advantages for agriculture. This is based on: fertile land, availability of water (1,140mm of average annual rainfall compared to 460mm in Azerbaijan and 352mm in Armenia), cool winters, and warm summers. Georgia has both favourable agronomic factors for large crops (maize in the humid western part, barley and wheat in the dryer east) and for various types of fruit (citruses, hazelnuts in the west, apple, pears and stone fruits in the Centre and the east), vegetables, wine, and aromatic herbs. Its vast mountain pastures are also suited for animal husbandry. Finally, thanks to the low use of pesticides, Georgia could well carve itself a niche in the organic food market, supplying the European Union (EU). Before independence from the United Soviet Socialist Republics, Georgian agricultural exports exceeded imports by 160% and Georgian products were very well regarded. Today, Georgian agricultural products still benefit from a very positive image in former Soviet countries, even though they have been banned from Russian shelves since 2006. Georgian wine and other products with a very strong cultural identity (such as Tkhemali sauce) also sell well in many EU countries, though export volumes remain modest.

45. Despite these comparative advantages, which are likely to grow given current global food markets (driven by high value-added products such as fruit, vegetables and animal products), Georgia has not managed to expand production as well as neighbouring Armenia and Azerbaijan. Further, agricultural output is low in comparison to nearby countries such as Turkey and Iran.

Figure 5: Gross Agricultural Output (2012)

200 179 180 171 168 166 156 160 151

140 125 120 113 Indexes 97 100 84 78 80 67 60

Source: Faostat. http://faostat.fao.org/ .

46. According to official statistics, most of the decline in output occurred at the end of the 1990s. However, in 2006 a drastic change in the methodology for how crop output is calculated reduced the output that year, making analysis more difficult. In any case, there has not been any substantial growth since the abrupt fall statistically registered that year.

Figure 6: Georgia: Gross Agricultural Output (1992 = 100)

Source: Faostat, http://faostat.fao.org/ .

47. The decline in output has been largely linked to the decline in the area of land under cultivation. Statistics in this field must also be handled with care as there is still limited knowledge of actual activity on Georgian land; nevertheless the downward trend is not in question due to the vast amount of land left fallow. According to the latest data from the National Statistics Office of Georgia (Geostat), total sown areas contracted from 701,900 ha in 1990 (or 88% of arable land) to 539,600 ha in 2005 (65%), and shrank to 330,200 ha in 2006 (41%) and 281,000 ha in 2011 (35%). This contraction is partly explained by problems in agricultural production (lack of access to finance, inputs and machinery, low productivity and profitability of agriculture) and also by the absence of a legal framework and development strategy (uncertainty of proprietary rights, an ineffective land-taxation system).

48. Contrary to other Caucasian and small Central Asian countries where yields have often substantially increased, yields have decreased in Georgia when compared to the end of the Soviet era. Today for instance, yields for maize—for which Western Georgia has ideal hot and humid weather—are nearly four times lower in Georgia than in France despite probably much better agronomic conditions. The only exception is potatoes, where only Tajikistan, faced with a shortage of quality seeds, has lower yields.

Table 6: Crop Yields (hectograms per hectare)

Potatoes Wheat Maize Barley 1990 2011 1990 2011 1990 2011 1990 2011 Armenia 144.8 162.5 39.4 26.4 17.0 54.3 16.8 26.3 Azerbaijan 143.8 235.0 28.0 20.7 13.8 45.5 23.5 23.4 Georgia 105.0 135.6 26.4 21.4 25.2 22.9 25.1 19.1 Kyrgyz Republic 94.8 194.4 23.8 24.4 61.8 60.1 23.7 19.2 Moldova 77.1 144.0 22.5 28.8 34.3 32.5 34.7 18.8 Tajikistan 71.7 120.1 10.1 23.4 51.3 121.2 11.0 10.4 Source: Faostat. http://faostat.fao.org/ .

49. Also, contrary to many former Soviet countries where livestock increased substantially following the beginning of the transition process, there has been a massive reduction in the number of heads.

Figure 7: Evolution of Number of Animals in Georgia and Tajikistan (1990 = 100)

Source: Geostat. http://www.geostat.ge/index.php?action=0&lang=eng. Tajstat. http://www.stat.tj/en/news/70/.

50. In many rural areas globally, the ownership of livestock constitutes both a productive asset (for milk, eggs and/or meat) and a typical “savings tool” for rural populations, given that both the value of the animal and the number of animals may grow with proper care. This savings in kind instrument is particularly prevalent in Tajikistan, which lacks formal financial savings instruments and where it is estimated that cattle represent a capital reserve of more than 20% of GDP. It can be assumed that the nearly 60% reduction in the number of livestock in Georgia indicates a reduction in rural household savings.

51. Whatever the impact of the 2006 statistical revision, it is clear that Georgia has not had the same experience of neighbouring countries, in particular Armenia, which benefited from an impressive rebound in agriculture over the past decade. Georgia also faced an embargo from Turkey and Azerbaijan, and also suffered much from the closure of the military road through the Caucasus, through which most of its agricultural exports to the Russian Federation used to pass.

Figure 8: Gross Agricultural Output: Georgia, Armenia, Azerbaijan (1992 = 100)

Source: Faostat. http://faostat.fao.org/ .

52. The substantial decrease in agricultural production can also be put in light of the substantial economic growth in Georgia following the “Rose Revolution”. While government reforms allowed Georgia to attract vast amounts of FDI and other forms of foreign capital, and become a star performer in the World Bank’s “Doing Business Index”, agricultural production fell.

Figure 9: Output at Constant 2003 Prices (2003 = 100)

Source: Geostat. www.geostat.ge.

53. The previous government’s liberalization, which was positive for sectors such as finance or trade, was not appropriate for agriculture. Thus, much of the work to transition from a command to a market economy remained incomplete at the time the new economic strategy was adopted. Further, the Ministry of Agriculture suffered a large reduction in staff, which delayed the reform.

54. According to Geostat, this led to a large contraction of the share of agriculture in GDP. Between 2006 and 2011, the share in GDP of agriculture, hunting, forestry and fishing fell from

12.80% to 8.84%. Meanwhile, agriculture still employs roughly half of the population33 for lack of other job alternatives.34

55. This state of affairs has led to a consensus among political parties and development agencies in Georgia that after years of being unattended, agriculture requires substantial and sustainable government support. However, donors and international finance institutions want these measures to be part of a strategic plan for reconstruction of the agriculture sector, and insist that government intervention should not stifle the development of the private sector— especially for inputs such as fuel, electricity and fertilizers, and machinery supply.

56. Several strategic papers have been produced, both by the former government and the new government (in its electoral platform), yet a strategic vision with a precise action plan and a clear budget is yet to be finalized. A road map is also yet to be produced to explain how the government will transfer existing agricultural assets to the private sector (or alternatively to cooperatives for which a new law, prepared with the support of the EU, has been enacted).

57. Beyond specific technical measures, a road map for agriculture would need to address two main issues largely specific to Georgia among former Soviet states: an atypical agrarian structure and unbalanced integration in international trade by its unilateral elimination or reduction of its tariff and nontariff barriers, which creates advantages for foreign competitors.35

2. Key Factors in the Breakdown of Georgian Agriculture

58. A first set of explanations is based on external factors over which the government had no or limited influence. Except to a certain extent in Uzbekistan, still the best performer among former Soviet countries in terms of agricultural output, initial costs of changing the system were high. At the end of the Soviet system, agriculture had become heavily subsidized. Farms were provided inputs such as fuel, electricity and fertilizers at very low prices. When the command economy system collapsed, oil and fertilizer companies switched to selling their products abroad in hard currency. Internal terms of trade turned against the interests of farmers. Meanwhile, the disruption of Soviet economic links, both between and within republics, and the accumulation of unpaid debts, destroyed processing and marketing value chains.

59. However, in other former Soviet countries, the initial retraction of the economy due to the transition to a market-based economic system was more than compensated by the higher efficiency of farming. Unfortunately for Georgia, this solid rebound has not occurred.

60. Soviet-era agricultural infrastructure has not been replaced: there are no more systems for seed multiplication or artificial insemination, fertilizers are often faked, plant and animal disease controls are extremely weak, and agricultural education and technical assistance in the field have disappeared despite heavy donor support.

61. Georgia has also suffered from the impact of conflict and lack of control over parts of its territory, and the resulting trade ban imposed by the Russian Federation after 2006. Georgia

33 Job statistics in agriculture in Georgia, as elsewhere, are largely unreliable as individuals who have even just a marginal part of their time dedicated to agriculture are classified as farmers. This is often the case in Georgia, where survival strategies imply the need for people to work more than one job. 34 According to the IMF, formal employment contracted by 5% between 2003 and 2012. 35 One important development here is a recent change in legislation which bans (or imposes moratorium on) any form of foreign ownership of agricultural land. This is particularly problematic for banks which might not be able to take land as collateral in exchange for loans to farmers anymore since the banking system is predominantly foreign- owned, and in case of a default banks cannot take the borrower’s land into possession.

has benefitted from external support to mitigate these effects, notably massive foreign financial support granted after the August 2008 conflict with the Russian Federation which was largely used to rebuild its road infrastructure. Further, similar events of even bigger magnitude occurred in Armenia, Azerbaijan and Tajikistan, currently best performers in terms of agricultural output. Armenia and Tajikistan also suffer from trade disruption and embargoes by their neighbors. This demonstrates that factors which slow agricultural development can be overcome.

62. A second set of explanations for the Georgian agrarian crisis is based on “policy” factors, and reflects decisions concerning land management and Georgian integration in international trade. Following two waves of land privatization in 1992 and 2005, 55% of the arable land has been transferred to family farmers who own on average 1.25 ha. According to a 2011 USAID study, 521,240 “subsistence” family holdings owned 219,451 ha (0.42 ha on average); 164,589 “semi-commercial” family holdings owned 280,604 ha (1.7 ha on average); and 17,303 “commercial” holdings owned 590,887 ha (34.1 ha on average). 36 This means that a rather small group of farmers with medium-sized plots owns more than 54% of total privatized land. This could be sufficient to generate a pool of efficient farm entrepreneurs driving a modernization process and pulling their communities towards better productive standards.

63. In 2011, according to the latest Geostat statistics, family holdings produced 90% of Georgian wheat, 94% of grapes, 98% of barley, maize, and potatoes, 99% of fruit, cattle and pigs, and 96% of sheep and goats. 37 Agriculture enterprises played a substantial role only in poultry (24% of meat and 63% of eggs). These figures appear at odds with those on land ownership. It is most probable that the definitions of commercial and family holdings are not fully cross-referenced, so certain commercial holdings are labelled as family holdings and vice versa. A lack of accuracy in these statistics significantly complicates the work of decision makers in public and private spheres.

64. Family holdings are mostly subsistence farmers. In 2011, according to Geostat, only 7.7% of their income came from the sale of agricultural products. This figure is broadly in line with World Bank’s recent estimates, 10% of all rural income comes from agricultural sales, 35% is in-kind consumption of subsistence agriculture, 27% is salaried and 28% comes from pensions and social transfers. The low cash income from agricultural activities is obviously an issue when developing large-scale credit programs for agriculture.

65. Many analysts, in particular among bankers met during a mission conducted in preparation of this paper, consider that the fragmentation of land ownership and its transfer to families is the main cause of the agricultural crisis in Georgia. However, the best former Soviet performers (in terms of growth in agricultural output) such as Armenia or Tajikistan have based their agricultural development on small scale family holdings. On the other hand, apart from Georgia, the worst results for output in former Soviet countries are found in the Russian Federation, Kazakhstan and Ukraine, which have promoted large-scale farming. While the decline in output in these three countries has been accompanied by an increase in the productivity of agricultural workers, the main issue in Georgia at this stage is to first create or maintain jobs, even with low productivity.

66. Adding to these issues, Georgia has implemented distortive policies destroying medium- sized and large farms which family holdings could have developed, as was often the case in Soviet-era collective farms and household plots. Even in large-scale farming systems, this

36 USAID. 2011. “Analytical Foundations Assessment – Agriculture (Rural Productivity)”. 37 Geostat. Agriculture of Georgia 2011.

21 symbiosis still works to a certain extent, since for instance in 2011 household plots still accounted for 53% of output of Ukraine and 43% of output in the Russian Federation.

67. Tax exemptions are a major cause for concern: individuals earning less than GEL200,000 ($120,919) a year are not subject to income tax and owners of less than 5 ha pay no land tax. Therefore, contrary to countries such as Tajikistan, where there is an obligation to use land, keeping a small amount of land fallow, for years at a time, incurs no cost in Georgia.

68. Tax exemptions are not just a largesse provided to small holders, who can often be urban dwellers with long-term speculative approaches to their plots and are not necessarily poor. They also reflect that the status of land ownership is unclear: according to the USAID, only 15%–20% of land owned by households is registered. The World Bank considers that only 20%–30% of land rights are registered, while land-market activity is low, with leased land representing only 18% of agricultural land in Georgia.

69. One of the factors explaining the lack of registered property rights is that insufficient information technology (IT) tools are in use in public institutions. Initially, no substantial upgrade to IT tools was proposed to limit spending, and while the consequences are clear, there is still no push for innovation. This is in contrast to other sectors, where Georgia has managed the integration of IT tools for administration purposes.

70. This explanation is nevertheless insufficient. No large-scale initiative has taken place to determine land ownership on a national scale, and such an initiative would lead to a large number of land conflicts, which public authorities are wary about starting.

71. Nevertheless, sustainable agricultural development will necessitate determining who owns what. Before this is resolved no substantial investment can take place to improve land productivity through better use of fertilizers, agronomic practices, investments in irrigation, and also in drainage, planting trees, and rebuilding other farm assets. Productive agriculture is a long-term investment that individuals and entrepreneurs are cautious about making if ownership has not been established.

3. Integration into International Trade Is Fraught with Difficulties

72. Georgia’s accession to the WTO in 2000 occurred with substantial trade protectionism in place. While the nation could have continued to benefit from protectionism, the post-revolution government in September 2006 decided to unilaterally abolish import duties on almost 90% of goods (except some agricultural products and construction materials) and to reduce the number of layers of tariffs on imports from 16 to three (0%, 5% and 12%). In the same year, most of its agricultural products were banned from the Russian market. In 2007, Georgia signed a free trade agreement (FTA) with Turkey through which Turkish products could be imported free of tariffs; meanwhile nontariff protection was drastically reduced. Use of WTO safeguards for sanitary and phytosanitary (SPS) controls at the border was virtually inexistent and led to a flood of cheap imports of dubious quality, especially for meat products such as frozen buffalo from India. Georgia is currently negotiating a FTA with the EU, while not benefiting from competitive advantages in most sectors. At this stage, the agreement cannot generate positive short-term results, as Georgia has few eligible goods to sell in EU markets.

73. Georgian farmers, while having faced many internal problems linked to the withdrawal of Soviet-era support and uncertainty on land tenure, have been put into direct competition with farmers from the Black soils (the Russian Federation, Kazakhstan, Ukraine), from Turkey—and

will soon be in competition with farmers from the EU—who benefit from the best comparative advantages worldwide and/or from still very high government subsidies.

74. At the time the FTA came into force with Turkey, this country was, according to the Organisation for Economic Cooperation and Development, providing state support to its farmers equivalent to 30% of gross farm receipts. Even though this support has diminished in recent times, it remains quite substantial and is focused on farmers who have already achieved very high land and labour productivity through modernization. Against this background of very unequal competition, the bilateral trade deficit of Georgia with Turkey ballooned. For instance, between 2008 and 2011, imports of vegetables from Turkey climbed for instance from $15 million to $63 million, according to International Trade Centre figures.

Figure 10: Producer Support Estimates as a Percentage of Gross Farm Receipts

Source: Organisation for Economic Cooperation and Development.

Figure 11: Trade Balance 2012 ($ ’000)

Source: International Trade Centre. http://www.trademap.org/tradestat/Bilateral_TS.aspx.

75. This international trade integration has resulted in a very large trade deficit for Georgia. The trade deficit for farm-produced food alone reached $761 million in 2012, contributing to Georgia’s large current account deficit and external indebtedness reaching 80% of GDP. The external current account remains a “source of external vulnerability”, according to the IMF.

Figure 12: Average Current Account Balance as a Percentage of GDP (2006–2012)

Source: International Monetary Fund.

76. Both the IMF and the World Bank insist that a competitive exchange rate is a necessity for addressing Georgia’s trade deficit. As previously explained, most loans provided by the country’s financial sector are denominated in foreign currency, thus a devaluation aiming at fair value of the lari (20% lower than the current rate according to the latest IMF Article IV Consultations) would have strongly negative effects on reimbursement capacity, as has been witnessed in many emerging countries that have experienced devaluations. Against this background, the NBG recommends a “real” devaluation of the currency should take place with concurrent structural measures to improve Georgia’s competitiveness with other countries. In agriculture, there might effectively be some margin for manoeuvre, subject to quick and effective implementation of a set of reconstruction measures, especially in land use, irrigation and drainage.

77. Instead of reducing the risk of food insecurity, the implemented national foreign trade strategy has increased it. The strategy was implemented at a time when international food markets were extremely unstable, with price-volatility rarely seen in economic history. Today, international prices for wheat and maize are back to 2007 record-highs, despite a bumper harvest in the Russian Federation and other key producers of grain in former Soviet. Georgia had, according to Geostat, a self-sufficiency ratio for wheat of only 13% in 2011. Prices for beef, pork and poultry meat, whose self-sufficiency rates were only 68%, 43% and 21% in 2011, have also all recently surpassed their historical records highs.

Figure 13: International Grain Prices (February 2003 = 100)

Source: Website IndexMundi. http://www.indexmundi.com/commodities/?commodity=wheat&months=300.

78. Dependency on imports combined with increased international agricultural product prices translates automatically into higher local prices for food, and has a strong impact on the 30% of the population living under the poverty line. High prices of imported goods (expressed in local currency) could also be a good opportunity to kick-start the local development process: subsidized imports would be offset by an overvalued local currency, and thus limit the current account deficit.

4. Agriculture and the Finance Sector in Georgia

79. Bank finance was the fastest-growing component of GDP between 2003 and 2012 (372% growth against a 69% increase for GDP as a whole) and now has a role similar to that it plays in richer transition countries. In the Caucasus region, the credit/GDP ratio of Georgia is higher than in Azerbaijan but lower than in Armenia. The Georgian ratio remains much higher than in other former Soviet countries.

80. Lending rates fell initially during 2005–2006 before rebounding prior to the August 2008 conflict and declining again thereafter. Rates remain very high, especially in local currency, and have increased while inflation has remained virtually flat. Among other things, this reflects the risk of a substantial devaluation that is priced in by the market as international finance institutions consider the currency overvalued.

Figure 14: Average Lending Interest Rates in Georgia (%)

Source: National Bank of Georgia.

81. Even for foreign-currency loans, lending rates are nearly 5% higher than in Armenia, as shown in the figure below.

Figure 15: Interest Rates on Loans in Foreign Currency (%)

Source: National/central banks of Georgia/Armenia/Tajikistan.

82. Furthermore, real interest rates for local-currency loans are similar to those in Tajikistan, the least-developed former Soviet country.

Figure 16: Interest Rates on Loans in National Currency (%)

Source: National/central banks of Georgia/Armenia/Tajikistan.

83. High loan rates reflect partly high gross margins in a financial system dominated by few players. However, banks are faced with heavy costs (overheads and bad loans) and have not been very profitable until now despite those margins.

Figure 17: Gross Interest Margins of Georgian Banks (%)

Source: National Bank of Georgia.

84. As shown in the figures, despite significant foreign involvement in local banks, including international finance institutions, the efficiency of the Georgian financial system is much lower than in Armenia for local- and foreign-currency loans.

Figure 18: Gross Interest Margins National Currency (%)

Source: National/central banks of Georgia/Armenia/Tajikistan.

85. The fastest-growing segments of loan portfolios are linked to consumption (trade, households), especially prior to the August 2008 conflict, when a fall in private savings and increased consumption of imported goods led to massive current account deficits.

Figure 19: Outstanding Term Loans of Banks by Sectors (November 2003 = 100, GEL)

Note: Georgian lari. Source: National Bank of Georgia.

86. Lending for trade has a dominant share of bank loan portfolios. This partly reflects the impact of profitability of trade and imports when a local currency is overvalued, and asymmetry in trade protection with major partners fuels current account deficits. The share of activities producing internationally tradable goods is very limited despite these usually being capital intensive. According to NBG figures, on 1 August 2013 industry accounted for 19.60% of total bank loans to legal entities, and construction for only 9.25%. For agriculture, the respective

figure is 1.64%. Judging by these figures, and by high lending rates, the Georgian banking sector has not yet played a substantial role in the financing of the real economy and investment in activities that are needed to reduce excessive imbalances in trade.

Figure 20: Breakdown of Bank Loans to Legal Entities (%, 1 August 2013)

Source: National Bank of Georgia.

87. A recent survey, conducted as part of the European Bank for Reconstruction and Development’s (EBRD) Tajik Agricultural Finance Framework (TAFF) project in Tajikistan, evaluated the financing of agriculture in various former Soviet countries, based on reporting to central banks and on macroeconomic data for GDP and agricultural output. The survey concluded that compared to other former Soviet countries, the share of bank loans to legal entities in agriculture in Georgia in mid-2012 was minimal. While in neighboring Armenia agriculture represented 6.5% of total loans, the figure was only 0.6% in Georgia mid-2012, as shown in the figure below.

Figure 21: Loans to Agriculture as a Percentage of Total Loans (mid-2012, %)

Source: Central banks of the analyzed countries.

88. Three factors have combined to reduce the share of banks’ loans to agriculture and other productive activities in Georgia. First, during the initial phase of liberalization after the Rose Revolution, local banks aggressively promoted either consumer loans or trade loans (that were used for consumption purposes). These were made possible thanks to a large pool of foreign resources provided to the Georgian economy initially through FDI (mainly linked to privatization and not to greenfield investments in productive assets) and through the “SME” credit lines they obtained from international finance institutions such as the EBRD. Banks disbursed these loans extensively until August 2008, when they understood that many of them could not be recovered since household incomes had not grown in step with household indebtedness. Second, agriculture was unprofitable for the reasons previously explained and banks had no reason to enter this field. The overvaluation of the currency (mainly as a result of large capital inflows) and the unilateral decision to eliminate most trade barriers also severely hurt the profitability of manufacturing, leading to the contraction of its share in GDP and in bank lending portfolios. Finally, banks had little capacity to deal with the financing of “complex” assets. Most of the technical assistance for lending they received from donors, based on simple SME financing techniques, was appropriate for consumer loans or “bazaar” loans. Little was done to develop capacity to evaluate the future cash flow of farmers or manufacturers.

Figure 22: Share of Agricultural Loans to Total Loans to Legal Entities (%)

Source: National Bank of Georgia.

89. Until the recent implementation of the new government program for lending to agriculture that will be described below (the Agricultural Development Fund Program), the contribution of banks to agriculture had not improved much despite a change in government direction in 2011, and the implementation of the EBRD/EU Georgian Agricultural Finance Framework (GAFF).38 In fact, the share of credit to agriculture in total bank portfolio fell in mid-2012 to a low similar to that experienced at the heart of the 2006–2007 consumer spree.

90. As of 1 August 2013, total agriculture loans to legal entities reported by the NBG stood at GEL77.66 million ($46.8 million). These figures fit broadly with those put forward by the GAFF -EBRD project at the end of March 2013, knowing that GAFF provided refinancing lines of up to $40 million to five banks. These figures are much lower than those reported by banks in

38 Launched in October 2011 and ended in June 2013.

interviews with the research team and/or in their annual reports. According to GAFF, outstanding loans totalled GEL67 million ($40.51 million) at end-March 2013 for the key banks involved in agriculture (Bank of Georgia, ProCredit Bank, VTB Georgia, BR, and TBC including microfinance organization Constanta).39

91. The breakdown of outstanding loans among GAFF partner financial institutions is illustrated below.

Table 7: GAFF Portfolio of Participating Institutions (31 March 2013)

Outstanding portfolio Quality Average Average Partner Banks PAR>30 days, Volume Number Average interest (%) tenor amount Bank of Georgia 28,205,550 1,316 21,433 7,421 18.6 1.96 TBC + Constanta 18,276,620 1,476 12,383 292,114 32.5 1.38 ProCredit Bank 17,462,890 1,744 10,013 121,410 21.1 2.78 VTB Georgia 2,950,339 298 9,900 - 21.7 1.38 BR 320,900 10 32,090 - 17.2 2.59 Global 67,216,299 4,844 13,876 420,945 24.1 2.04 Note: PAR = portfolio at risk. Source: European Bank for Reconstruction and Development, Tbilisi office.

Figure 23: Total Outstanding Portfolio by Partner Banks (31 March 2013, GEL million)

Notes: GEL = Georgian lari; TBC = TBC Bank; BR = Bank Republic/Société Générale. Source: European Bank for Reconstruction and Development, Tbilisi office.

92. Regarding Bank of Georgia’s Annual Report in 2011,40 agricultural loans accounted for 0.33%, or GEL8.7 million ($5.2 million), of the total loan portfolio. Compared with the GAFF figures in 2013, there has been a huge increase in loans to the agricultural sector.

93. The breakdown of Bank of Georgia’s portfolio reflects that of the whole banking sector. Bank of Georgia lends to traders-importers, to individuals (for consumer loans and mortgages) and to the real estate sector. Its contribution to the production sector is, at this stage, marginal. Due to this imbalance, Bank of Georgia would suffer much from a devaluation of local currency as most of its clients have exposure in foreign currency and income in local currency. The bank

39 The MFO Constanta was bought by TBC Bank. 40 Bank of Georgia’s 2012 Annual report has not been published yet.

31 expressed a strong interest in further agricultural lending—during preparation of this paper— which is not only due to the government’s sector support, but also because of its recent positive experience in the sector.

Figure 24: Gross Loan Portfolio of Bank of Georgia (%, end-2011)

Source: National Bank of Georgia.

94. TBC Bank Group, which includes TBC Bank and microfinance organization Constanta, has a more balanced portfolio. While loans to traders (for services) and to individuals made up 51% of its portfolio at end-2012, and the share of construction and real estate was 12%, the group’s agricultural loan portfolio grew from GEL7.2 million ($4.33 million) at the end of 2010 to GEL110.9 million ($66.8 million) by the end of 2012, corresponds to an increase from 0.5% to 4.7% of the bank’s total lending. That jump reflects the acquisition of the microfinance organization Constanta and the participation of TBC in the EBRD GAFF Project. In addition, the food industry accounted for 5% of the portfolio and mining and manufacturing for 1% each. Even though TBC appears more focused on producers of internationally tradable goods and services, these sectors accounted for only 11% of its total portfolio at the end of 2012.

Figure 25: Gross Loan Portfolio of TBC (end-2012)

Source: Annual Report of TBC Bank. http://www.tbcbank.ge/en/about/financial_highlights/annual_report/.

95. The third key player in the EBRD GAFF project is ProCredit Bank. Outstanding agricultural loans in ProCredit accounted for GEL50.7 million ($30.6 million) at end-2012, representing 6.89% of the portfolio and 14.19% of the total number of loans (against 5.90%

and 12.36% in 2011). Bad agricultural loans accounted for 3.14%, slightly above 2.57% for the total portfolio, and up from 1.80% in 2011.

96. ProCredit provided a detailed breakdown of its agricultural portfolio showing 84% of loans are disbursed for amounts of less than $10,000. Only nine clients have loans over $150,000.

Table 8: Breakdown of ProCredit Bank Agricultural Portfolio (31 December 2012, GEL)

% of Share of Number of Share of Gross Allowance for Loan size gross total outstanding total number amount impairment amount portfolio (%) loans (%) Up to $10,000 21,890 866 3.96 2.95 4,735 11.89 $10,000 to $30,000 16,246 499 3.07 2.21 769 1.93 $30,000 to $150,000 10,028 193 1.92 1.38 140 0.35 Over $150,000 2,561 35 1.37 0.35 9 0.02 Total agricultural loans 50,725 1,593 3.14 6.89 5,653 14.19 Total loans 730,408 18,741 2.57 - 39,908 - Note: - = data not available; GEL = Georgian lari. Source: ProCredit Bank Gergia. 2012. “Annual Report 2012”. http://www.procreditbank.ge/admin/files/AR_2012_eng_low.pdf.

97. This report will not examine the agricultural portfolio of Bank Republic/Société Générale and of VTB as their participation in the EBRD GAFF project was symbolic.

98. If the figures provided by Bank of Georgia at end-2011 and those provided by TBC and ProCredit Bank for end-2012 are added, total of agricultural loans are twice the figures reported by the NBG in August 2013 for the entire banking sector, even though August is a peak period for agricultural loans. This discrepancy reinforces feedback received in preparation of the paper during a visit to Georgia, where Ministry of Agriculture officials stated there are no hard numbers for agriculture loans in circulation.

99. Two factors interact differently. First, many loans disbursed by banks for agricultural purposes are provided to households and will not therefore be captured by NBG statistics that provide a breakdown for loans provided to legal entities. This tends to underestimate the total amount of loans disbursed for agriculture. Second, and inversely, many loans declared by banks working under the EBRD GAFF Project as being for agricultural are disbursed to farmers who use them for nonfarm purposes such as consumption, and weddings, etc. This factor could help understand in particular the gap in Bank of Georgia reporting vis-à-vis NBG and EBRD figures.

100. The GAFF team is currently trying to push the creation of an ad hoc agricultural cooperative bank in Georgia as it believes, as does the EU, that Georgian banks are dependent on consumer loans and do not have a core interest in agricultural development. These ideas have started to be implemented, including through the establishment of a connection with the impressively successful Agricultural Cooperative Bank of Armenia that would be ready in principle to transfer part of its cooperative capacity. The GAFF team has also mobilized the support of the French Development Agency, which has stated a strong interest in such an idea. Finally, the team is also exploring talks with French Crédit Agricole, and the German Federation of Raiffeisen and Cooperative Banks, the main body behind the Raiffeisen system. The idea of setting up an agricultural cooperative bank should be appraised not only taking into account the

33 current role of banks but also that of microfinance institutions who have strong agrifinance potential.

101. There is no real statistical monitoring of microfinance organizations by the NBG as they are loosely regulated. Most of the 64 microfinance organizations in Georgia are in fact pawnshops, with often “predatory practices”. However, some microfinance institutions, usually international, play a positive role and lend largely to agriculture, albeit usually at very high interest rates. Credo, Crystal and FINCA participate in the KfW/EU/German Government Agricultural Lending Program that provides these institutions refinancing lines in local currency at attractive rates—10 million euros in GEL, a 10% first-loss guarantee, and technical assistance. This program is the microfinance equivalent of EBRD GAFF that provided partner institutions with similar benefits.

102. At the end of 2012, Credo provided in $60.1 million in agricultural loans (62.2% of its total portfolio) with a specific innovative approach to individual lending by making use of 2,500 village councils and of plastic cards to disburse loans for agricultural inputs only. Despite that 91% of the loans are provided without collateral requirements except for personal guarantees, the quality of the portfolio is very good, with loans more than 30 days in arrears comprising only 0.4% of outstanding loans. Loans are small ($1,010 on average, and no more than $30,000), and can be given for periods of up to 60 months. On the other hand, annual interest rates are high (between 22% and 36% in GEL) reflecting both high transaction costs and high profits (a 40% return on equity). Credo, as all others microfinance organizations in Georgia, is not authorized to receive deposits.

103. At the end of 2012, FINCA had agricultural loans of GEL27.28 million ($16.4 million) issued through individual and group lending methodologies and comprising 33.9% of its total portfolio. The company’s average agricultural loan is $637, and the maximum that can be disbursed without collateral is $10,000. As for Credo, most loans are only backed by personal guarantees. Interest rates are also very high, between 19% and 38% in USD, on a monthly basis (meaning effective interest rates are close to 50%), and 21% and 38% in GEL.

104. According to the 2012 Annual Report of the microfinance organization Crystal, the third Kreditanstalt für Wiederaufbau (KfW) partner institution, agricultural became the most important sector in its portfolio for the first time, with GEL7.0 million ($4.2 million) making 25.8% of total loans. That was a fourfold increase on its agricultural lending in 2008.

Figure 26: Loans to Agriculture as % of Gross Agricultural Product (mid-2012)

Source: National central banks of the analysed countries.

105. If all agricultural loans declared by the above banks and microfinance institutions are added together, total agricultural finance in Georgia represents about $187 million, nearly four times more than official NBG figures. This would place Georgian agriculture finance on a similar level to Kyrgyz Republic, slightly lower than Tajikistan, and still among lower-performing former Soviet countries.

5. Roadmap for Development of Agrifinance—Transforming a Window of Opportunity into an Opportunity for Change

106. Most measures adopted by the current and previous governments after 2011 have been reactive in order to deal without delay with an acute agrarian crisis. After the Presidential election in autumn 2013, a political clarification may allow structural issues to be handled. The issue of land ownership will be of utmost importance; though it cannot be implemented at this stage, the National Agency for Public Registration, which the World Bank considers highly efficient, has already been created. The currency situation will need to be dealt with since it limits the growth potential of tradable goods by artificially inflating their costs. Progress on these two fronts should be seen as a precondition for major ADB involvement in agricultural development.

107. During the mission, all stakeholders expressed strong interest for an active ADB involvement in agriculture. This was particularly the case during the meeting with Deputy Minister of Agriculture, a former senior member of staff at the World Bank and at USAID.

108. ADB participation is recommended in the rebuilding of Georgian agriculture. If the two preconditions are met, risks of having unsuccessful projects in the field are quite low.

109. The upside potential for well-designed and managed development projects in Georgian agriculture is now considerable. Since independence, there has never been a strong consensus on the necessity to act decisively to pull Georgian agriculture out of its current state of development. Faced with crisis, decision makers need to find an appropriate policy and tools while at the same time rebuilding the capacity of government ministries and agencies involved in agriculture and rural development.

110. With the help of a strong policy advice component, Georgia has the opportunity to rebuild from scratch and therefore to pick up and adapt the most successful examples from abroad. Any sound strategy will reap immediate benefits. Maize yields in both Armenia and Azerbaijan tripled from 1990 to 2011. Such an increase in production, thanks to better agronomic comparative advantages, better access to hybrid seeds, fertilizers, pesticides, irrigation and technical assistance—at a time when maize prices worldwide have reached historical highs—would provide huge opportunities.

111. Furthermore, the country’s relatively small size constitutes a development advantage in the short-term. A small number of successful projects can levy larger positive results nationwide. In particular, successful value-chain projects would build clusters of efficient farmers working with off-takers to target both the local market and exports.

1. Road Map Action Phases

112. As ADB is a relatively recent actor in Georgia, a step-by-step approach to involvement over three phases is recommended.

First Phase

113. During the first phase, ADB could become an active member of the Donor Coordination Council on agriculture, whose key players are currently the EU, KfW, USAID, the Swiss Development Agency and the Austrian Development Agency. This would allow ADB to be represented in its meetings and obtain up-to-date and accurate information, as well as build insights about key players in the sector. At this stage, large players such as the World Bank and the EU have no specific plan in agricultural finance and we assume that intervention of ADB in this field would not only be welcomed by the government but also by the whole development community.

114. As the EBRD GAFF Project ended in June 2013 and the similar KfW Project is of rather small magnitude, we believe that ADB could carve a specific niche in agricultural finance. In particular, cooperative development and credit cooperative development in South Asia (Nabard in India) represents a strong experience on which to build.

115. Assuming quick action on the part of the government to resolve land tenure issues and in parallel the challenges due to the before-mentioned exchange-rate situation, the first phase consisting of information gathering and planning would be rather short.

Second Phase

116. Subject to validation by ADB of our recommendation to be proactively involved in agriculture and in agricultural finance, we would suggest ADB to launch without delay, and in a second phase, a first small-scale development project in the field.

117. It is suggested to concentrate on replicating the methodology of recent projects in agrifinance delivered in countries with comparable characteristics to Georgia. This is in particular the case of the EBRD/EU Tajik Agricultural Finance Framework (TAFF), which has just come to a close and has been recognized by local authorities, private sector and external evaluators as one of the great successes of development agencies in Tajikistan. TAFF has been used as a laboratory for change in other countries such as Turkey, Senegal, and Ukraine. Two factors would be of utmost interest for Georgia: its development of agricredit scoring

systems that allow for a systematic professionalization of lenders to agriculture and also reduce operational and transaction costs; and the coordination of technical assistance providers with financial institutions, farmers (through the coaching of private extension services associated to the project) and agribusinesses (through business-to-business connections with international providers of know-how).

118. Subject of using experienced agrifinance teams who are able to transfer TAFF type of know-how, the second phase can be rather short. This has been actually the case with the transfer of the innovative methodology developed in Tajikistan, and in Turkey through the EBRD lending project for small and medium enterprises.

Third Phase

119. The third phase would aim to develop financial innovation suited to the specific needs of Georgia in strong coordination with the activities of other donors. At this stage, owing to the remote time horizon, we can only make some general suggestions.

120. The first one would be to coordinate with the EU ENPARD Program to build a system of credit using ENPARD cooperatives as a first tier decision-making body to approve lending to their members by a credit cooperative bank, using the Agricultural Cooperative Bank of Armenia as a model.

121. The second would be to develop an effective system of crop insurance based on a modern technology (index-based) pattern of schemes successfully implemented in particular in some sub-Saharan countries. USAID, which is active in crop insurance, could be a strong partner.

122. Finally, warehouse finance using warrants could be an interesting sector to explore, especially if connected with the development of storage cooperatives since warehouse finance in former Soviet countries such as Kazakhstan has been linked mostly to big grain traders and has had limited impact for small farmers.

2. Outputs

First Phase

123. The output of the first phase should be the design and validation of an ADB strategy for agricultural and agricultural finance in Georgia. During the first phase, the concept and other documents for a first ADB project in agrifinance should be prepared. ADB would be able thereafter to build a more comprehensive pipeline of complementary projects.

Second Phase

A Comprehensive Agrifinance Project Based on Successful Regional Experience

124. With the interest-rate subsidy provided by the government, the appetite of both borrowers and lenders for agricultural finance will increase. The ratio of credit/value-added in agriculture will rise and with a higher leverage of farms the risk of default, currently low, will increase. Against this background there is a need to develop more sophisticated tools for agricultural finance. During bilateral meetings in preparation of this paper, both the Ministry of Agriculture and lenders have expressed strong interest for the agricredit scoring systems

37 developed in Tajikistan, Turkey, Senegal, and Ukraine by Frankfurt School of Finance & Management.

125. The efficiency of agricredit scoring systems depends on the capacity of financial institutions to update their data through constant monitoring by local agronomists. Training and coaching these agronomists and fostering the development of dedicated teams for agricultural- sector lending in financial institutions should also be a concrete target of an agrifinance project.

126. Both the interest rates subsidies provided by the government and the willingness of key international finance institutions such as the EBRD and International Finance Corporation (IFC) to increase their involvement in agribusiness will also foster investments in postharvest activities such as processing.

127. As elsewhere, agri-processors will be faced with bottlenecks in terms of access to raw materials. These can be overcome by building value-chain finance platforms to link financial institutions, farmers and off-takers under clear and effective contracts. The support of local and international providers of technology and of effective extension services would be needed to ensure success. In this respect, the experience of the EBRD/EU TAFF project in Tajikistan and of the Dairy clusters (PAI) World Bank project41 could be very valuable.

128. The EBRD GAFF project attempted to set up such a value-chain finance scheme in Georgia with TBC Bank but, according to GAFF, since it was only “morally” binding it had limited results.

129. We believe that an ADB project for Technical Assistance to financial partner institutions (the ones participating in the Agricultural Development Fund program) to improve their lending capacity in agrifinance is exactly what is needed in Georgia, along with other technical assistance such as to a group of farmers to improve their capacity to produce and to form better connections between themselves (as cooperatives) and off-takers (in value chains), and technical assistance for agribusinesses to better connect with international technology providers (through commercial sales and/or promotion of FDI in the field). The project could be infused with lessons learned and tools from the TAFF project.

Third Phase

Explore the Creation of a New Financial Institution Dedicated to Agriculture

130. Transaction costs of microfinance institutions in Georgia are much too high and bank reporting does not seem sufficiently reliable. Both the EU and other experts have therefore put forward the idea of setting-up a credit cooperative bank to leverage the experience of the highly successful Agricultural Cooperative Bank of Armenia that has become the first and most effective Armenian bank since its creation in 1995. The French Development Agency in particular has stated an interest in taking part in such a scheme.

131. Development of a cooperative bank can be envisaged, in close coordination with promotion of business-minded cooperatives that are one of the key objectives of the EU’s

41 The Pôle Agroalimentaire Intégré (PAI) dedicated to the dairy value-chain in the region of Setif in Algeria was launched at the beginning of 2012 by the Algerian Ministry of Agriculture with technical support from the World Bank. It gathers all stakeholders in the dairy value-chains, both in the public and in the private sector, with an aim to identifying key bottlenecks and proposing concrete actions to eliminate them. The regional experience will then after lead to national decisions.

recently launched the European Neighbourhood Program for Agriculture and Rural Development (ENPARD).

132. A decision to support such innovation should be based on analysis of the results of existing financial institutions in the new agricultural environment. If they succeed, the idea will probably not need to be put into practice.

Envisage the Development of Mechanisms of Reduction of Credit Risk: Crop Insurance

133. Some systems of crop insurance have been introduced in Georgia, in particular by Aldagi BCI and microfinance institution Credo, heavily supported financially by the USAID Economic Prosperity Initiative (EPI). These systems are based on traditional damage appraisals in the field and are therefore very costly. Their sustainability after hefty USAID subsidies end is an open question.

134. We believe that crop insurance should be based on the modern index-based management of risk. This would reduce operational costs, especially for small farmers.

135. Meanwhile, as PlaNet Guarantee, the French microfinance consultant, experienced in Tajikistan, crop insurance cannot substitute necessary private and public investments. There is in particular no interest to introduce such instruments until key water and drainage issues are solved on a large scale and farmers have managed to improve their “normal” yields through the adoption of good agronomic and zootechnical practices.

136. However, index-based insurance would require a large array of meteorological data that should be collected as soon as possible and could be used for many other purposes, including assessing the impact of climate change in Georgia.

Envisage the Development of Mechanisms of Reduction of Credit Risk: Warrants

137. Warehouse finance with warrants is currently being implemented in a large number of projects by international finance institutions, even though concrete results are not always obvious, as recent experience in West Africa shows.

138. In transition countries, warrants have been introduced with some success by the EBRD in particular in Kazakhstan and in Bulgaria, but the main users and beneficiaries have been grain traders, not farmers.

139. In Georgia, warrants would require better and more efficient use of storage capacity. They might be an outcome of the EU program to develop cooperatives and in that case could become a good tool for financial-service cooperatives, providing inputs and off-taking outputs from members.

140. In any case, warehouse finance should be seen at most as one component of a comprehensive system of agricultural finance that will be built in the best scenario in a progressive way. It should also be seen as including, step-by-step, the full panoply of financial instruments available in more developed countries such as leasing, factoring for exporters, and other financial tools for which international finance institutions such as IFC or the EBRD provide support.

B. Securities Market Development

1. Supply of Securities

141. Developing countries are typically characterized by underdeveloped capital markets, and Georgia is no exception. As previously noted, in the early stages of financial market development the banking sector tends to dominate but as the financial system deepens the capital markets play a more active role. In Georgia, bank loans are the main source of credit for the private sector in a financial market that is one-dimensional. That said, domestic credit to the private sector grew gradually from 27.8% GDP at the end of 2007 to 34.5% GDP at the end of 2012 (Table 3); a rate of growth that lags Armenia, where domestic credit to the private sector grew from 28.4% of GDP at the end of 2010 to 42.9% at the end of 2012 (Table 4).

142. By way of background, in 1998 KPMG/Barents Group conducted a preliminary study on behalf of USAID to help: (i) develop the legal base for the securities market; (ii) establish a securities regulator; (iii) create the necessary market infrastructure; and (iv) conduct education and training. On the back of the study the Law on Securities Market was adopted in 1998 and the existing Law on Entrepreneurs (prepared and enacted in 1994) was amended to become the new company law. At the same time an (independent) Securities and Exchange Commission (SEC) was created with regulatory, supervisory and controlling powers and the SEC subsequently drafted regulations for the securities market. A tender for the stock exchange was held and in April 2000 the Georgia Stock Exchange (GSE) started activity as a mutual— that is not-for-profit—JSC (in which only the shareholders, licensed brokerage companies, could be members).

143. At present, a separate law on joint stock companies (JSC) in Georgia does not exist.42 The Law on Entrepreneurship as amended in 1998, became company law, yet it is not adequate. In particular, the current law is silent on important features relating to minority shareholders and cross-shareholdings. Hence, legal protection of minority shareholders is unclear.43 At the same time there is no definition of ‘affiliates’ in the regulations: only information regarding employees’ shareholdings must be submitted by the issuer to the registrar. Even here, there are problems with the exchange of information regarding employee shareholders since ownership can be difficult to ascertain due to holdings in nominee accounts.

144. When the capital market was launched in 2000 the business environment lacked transparency, with around 70% of the economy operating as a shadow economy. Corruption was entrenched and property rights were not respected despite the presence of the underlying legal framework. Although petty corruption was eliminated following the Rose Revolution in 2003, the ownership of many companies was concentrated in political hands and thereby violated ownership rights. Over 2007–2008, the government encouraged extensive deregulation and a joint regulator was created under the NBG. The regulation requiring on-exchange trading was removed and around 98% trading became over-the-counter (OTC). Even though trades still had to be reported to GSE, it was felt that the move to OTC trading was associated with a lack

42 The protection of creditor rights is fundamental to the development of securities markets. It is especially important for equity markets and, together with the ability to ensure secured transactions, is also important for debt-market development. While a company is solvent, shareholders have some rights (for example, with respect to cash flow) but in the event of financial distress these rights should pass to creditors - subject to due legal process. If there are issues with the legal framework underpinning creditors’ rights, the regulation of dispute resolution or judicial efficiency, this will likely impact directly on capital-market development. 43 Under the Law on Entrepreneurship if an investor acquires: (i) more than 50% of a company, there is an obligation to make a tender offer at no less than the price paid over the preceding 6 months (this is also subject to price valuation by independent auditor), and; (ii) if more than 95%, the investor has the right to make a compulsory offer.

of transparency. On the back of interest expressed by NASDAQ OMX in 2006–2007 to buy at least 50% of GSE, the exchange was demutualized in 2008, however discussions were overtaken by the conflict with the Russian Federation. 44 Further discussions between NASDAQ OMX and GSE took place in 2008 and again in 2013, but these did not produce any cooperation.

145. Article 70 of the Organic Law of Georgia on the National Bank of Georgia45 (known as the NBG Law) decreed that the central bank would assume responsibility for oversight of the domestic financial sector from December 2009, as legal successor to the (former) Georgian Financial Supervision Agency. Under Article 48 of the NBG Law,46 the central bank was given wide-ranging powers to issue and revoke licenses for undertaking all activities relating to banking, insurance and securities market.47 At the same time, the NBG is also responsible for ensuring the soundness of the financial sector. In early 2013, however, further amendments to the Law on Securities Market were proposed, namely: (i) to reestablish the Securities & Exchange Commission as an independent regulator, that is outside the NBG; (ii) to require mandatory trading on-exchange; and (iii) to require mandatory listing on GSE for a local company wishing to list on foreign stock exchange. At the same time it was decided that the insurance industry regulator would also be established as an independent entity.

146. Stakeholders are of the opinion that the existing regulations should be reviewed and, where necessary, amended.48 Under the previous system of an independent securities market regulator (the SEC), the market view was that regulation worked. However, there are concerns that it will take considerable time for the new independent regulator to be fully functioning, possibly as long as 3 years. At the same time, Georgia is a small economy and the expense of maintaining separate regulators for each nonbank sector is costly and likely unsustainable. It is generally agreed that there are, at most, 50 domestic companies with the capacity and scale to undertake initial public offerings (IPO) and 10–15 with the ability to sell corporate bonds. While it is felt that focus on regulation of the nonbank sector under the NBG is not sufficiently robust, the majority of stakeholders think nonbank financial institutions should be governed by a single regulator given the synergies between the securities market, pension funds, and insurance companies.

a. Equities

147. Equity market capitalization as a percentage of GDP fell sharply in 2008 and the market has struggled to recover since, registering 6.0% at the end of 2012, compared to 13.7% at the end of 2007 (Table 3). It is therefore reasonable to suggest that low market capitalization in Georgia indicates that the securities market is not presently contributing to private-sector growth. As importantly, market stakeholders were virtually unanimous in stating that the GSE does not work in its present form. Indeed, it was noted that the majority of companies admitted to the exchange do not have a diversified shareholding structure: on the contrary, most have either a single owner or, at best, a few owners. In this regard it could be observed that virtually

44 As of the present time, Bank of Georgia formally owns 32% of the GSE and its nominee accounts own a further 12%. 45 Dated 24 September 2009. 46 As amended on 25 May 2012. 47 Particular terms relating to supervision of the insurance and securities markets are set out under Articles 51 and 52 of the NBG Law. 48 Georgia is not a signatory of the Multilateral Memorandum of Understanding of the International Organization of Securities Commissions.

41 all companies are closed joint stock companies (JSC).49 A recent history of the Georgian capital market is set out in Box 2.

148. In common with other former Soviet countries, there are cultural inhibitions in Georgia to ceding ownership of a company: since relinquishing control by selling equity is considered a sign of weakness, local companies are unwilling to list. Their confidence in GSE is also generally low. A corporate governance culture is not well established. There is a reticence to embrace disclosure and manage investor relations and a lack of understanding the proper structuring of a corporate board, the need for independent directors for example. That said, it was reported that all Georgian companies are overleveraged and an average debt/equity ratio around 4 will, in itself, force change. Indeed, the attitude of companies is changing as realization dawns that cash injections are required.

149. At the same time, the national accounting standard of Georgia is tax-based. Georgian companies prepare accounts for tax purposes but not financial reports (balance sheet/income statement) as only tax-accounting requirements are in place. 50 Hence companies do not prepare financial statements as a matter of course and also have no history or experience of having an audit. For a listing to take place, financial statements and a first audit are prerequisites. The introduction of International Financial Reporting Standards (IFRS) was not reconciled with Georgian standards,51 which results in confusion as interpretations (e.g. asset structure classifications) are different under each standard; so if accounts are translated into IFRS investors cannot identify the real situation. Finally, with the exception of banks and insurance companies, no statutory audit requirement exists. Until 1 January 2013 there was no regulation for auditors although the government has now introduced a scheme of self-regulation. Regulations are presently being drafted. However, auditors are licensed by the Georgian Federation of Accountants and as the members include a large number of very small audit firms, concerns have been raised that the federation will be unlikely to support tougher regulation.

150. There are two listing categories on the GSE: A and B. Yet, a substantial number of companies remain unlisted. Therefore, although the number of companies admitted to the GSE is presently 133, only three are listed: one company falls under List A (Bank of Georgia) and two are in List B (Liberty Bank and Teliani Valley). When compared to the requirements for listed companies, the obligations for the 130 companies admitted to the GSE but not listed are considerably less onerous: the company or any member of the exchange presents basic documents including corporate documents (court papers) establishing legality in addition to providing proof that the register for the securities is maintained by an independent Securities Registrar.

49 The shares of an open joint stock company are publicly traded whereas those of a closed joint stock company are distributed among a pre-defined number of shareholders. 50 Companies cannot prepare financial statements according to IFRS and submit to tax authorities. 51 Bookkeeping and financial reporting in Georgia are mainly regulated by the Accounting and Reporting Act and the Enterprises Act, as well as by other subordinated legislation.

Box 2: Evolution of Georgia Capital Market

In 2000 the only instruments available in the local stock market were shares of those former state- owned enterprises privatized during 1994–1998, when around 1,300 companies were sold off by way of a voucher scheme. In order to encourage listings, GSE introduced a simplified regime of documentation and reporting. Over time listed companies slowly began submitting reports in line with SEC requirements, although there was some resistance as once admitted to the GSE, shares could only be traded on-exchange. However, at the same time as GSE was seeking to attract listings from former state-owned enterprises, the government was continuing to sell controlling stakes in other state-owned companies to strategic investors and was not sufficiently focused on corporate governance. Hence corporate governance was weak and companies released little (reliable) information.

The capital markets became more associated with consolidating existing ownership rather than extending the investor base and used the market to gradually increase their ownership. At the same time, the way the exchange was operated led the broader public to an unfavorable understanding of capital market activities.

From 2005 to 2008, seven or eight companies were actively traded on the GSE and there were several initial public offerings through 2006–07. Equity market capitalization peaked at 13.7% of GDP in 2007. However, activity ceased in 2008 following the conflict with Russian Federation and no share offerings or private placements have issued via the exchange since then. Rather, activities on the GSE have been limited to secondary trading of already privatized companies.

As an example, it is appropriate to consider the on-exchange activities of the only A-listed shares, JSC Bank of Georgia, which institutional shareholders initially bought via the GSE in 2004. Over the ensuing 3 years, the share price increased markedly (from GEL1 ($0.6) to GEL33 ($20)) and volumes traded increased 100 times, in the process introducing foreign investors to the exchange. In 2006, Bank of Georgia issued Global Depository Receipts (GDRs) on the London Stock Exchange and the price more than doubled, while Bank of Georgia shares on the GSE peaked at GEL67 ($40.5). In 2011, Bank of Georgia created a UK holding company, Bank of Georgia Holdings plc (BGH) which in 2012 held a tender offer for shareholders of the Georgia- registered Bank of Georgia (both ordinary shares and GDRs) to acquire their shares in consideration for shares in BGH. Thereafter 99% Bank of Georgia shares were transferred to BGH, leaving only 1% traded on the GSE.

Source: Georgia Stock Exchange; Frankfurt School of Finance & Management.

Table 9: Listing Conditions for Securities

Listing category

A B

1 Owner’s capital: no less than GEL X1 thousand X1 1,000 100

2 At least one year operation without losses: from the last X2 years* X2 2 3

3 Number of issued securities: no less than X3 thousand: X3 100 50 4 Compliance with the International Accounting Standards by the Issuer: + +

Reporting (Annual Report: audited; Semi-Annual and Current Reports: not 5 + + audited):

6 Market capitalization: no less than GEL X4 million: X4 10 0.5 7 Annual turnover at the Stock Exchange**:

- no less than GEL X5 thousand; or X5 2,000 200

- no less than Y1% of issued shares Y1 5% 5% Monthly value (or volume) of transactions made at the stock exchange,

calculated as average value (or volume) of last three months***: 8 - no less than GEL X6 thousand; or X6 100 10

- no less than Y2% of issued shares Y2 0.25% 0.25% Free Float****:

9 - no less than Y3% of issued shares; or Y Y3 25% 10%

- corresponding market capitalization: no less than GEL X7 thousand X7 2,500 100 Submission of information on Free Float securities (on the first day of the 10 Quarterly Annually relevant period) Note: *Not applied to companies founded in the year of submitting the Listing Application; ** Compliance with this requirement is evaluated according to the annual results of transactions made at trading sessions during each calendar year; *** Free Float Securities – securities of any class issued by an Issuer that do not belong to any of the categories listed below, except: a) 5% or higher block of a securities class owned by a person (including the Issuer); b) Securities owned by the government or local self-government bodies, or legal entities of public law; c) Securities beneficially owned by the Issuer’s managing body members and/or employees. In case of category “A”, Provisions 9 and 10 shall come into force from October 1, 2008. All provisions set for category “B”, with the exception of Provision 6 of Attachment 1, shall come into force from October 1, 2008. GEL = Georgian lari; X and Y = variables depending on the Listing category. Source: Admission of Securities to the Trading System JSC Georgian Stock Exchange Minutes No. 1 27-Mar-2008.

151. Market participants are of the opinion that the existing lack of activity in the GSE is not a function of the prevailing regulations. While USAID gave assistance to establish the GSE in 1998, the Russian RTS software adopted in 2000 is now outdated, as is the website. Infrastructure at the GSE is weak: technical facilities have not been updated for more than 10 years even as the exchange realized good income during 2005–2008. Although the current trading system is considered adequate, market participants have commented that the exchange operated as a checking point rather than as a trading platform.52

152. Many stakeholders feel that the exchange is not sufficiently proactive. Trading is limited with only three sessions a week, each of 70 minutes, giving a total trading time of 3.5 hours per week. A periodic auction market may be beneficial in boosting liquidity in a small market but this does not appear to be the case in Georgia. As a result, an active OTC market exists and trades are subsequently reported during GSE trading hours, although this activity is not supported by the exchange. Indeed, the financial statements of the GSE highlight the limitations of trading on the exchange, with fees earned from the latter in 2012 representing 17.7% of total trading fees. There are only two liquid instruments on the GSE: Bank of Georgia and Liberty Bank local shares. The GSE is limited to buying/selling, short selling is not permitted. Of the seven brokers only three are active; that is, make bid-offer spreads at each trading session. Finally, the current trading/settlement standard is T+0 while participants would prefer T+3 (the global standard).

153. Some stakeholders say that the GSE does not have the appropriate standards regarding, for example, reporting and disclosure requirements and does not adequately check the veracity of reported financial information. Although financial statements published on the GSE website are meant to be IFRS compliant, this is not the case in practice. Hence, users cannot trust data published there. Furthermore, market operators have stated that the exchange is not sufficiently transparent and the dissemination of information is not robust or timely. Thus

52 All brokers had to physically attend trading sessions prior to 2007 when a program was introduced to permit remote trading.

investors do not have access to information accurate or sufficient enough to facilitate proper evaluation of companies. Of the 133 companies admitted to the GSE, only around 50 submit reports and it has been observed that some of the remaining companies may no longer even exist. That said, market operators agree that the exchange is understaffed, in addition to which it is felt that staff are not sufficiently well qualified. Under current operations it is felt that demands for increased transparency and stronger corporate governance will not be well received. Furthermore, operators believe it will not be easy to change the existing regulations in parliament.

154. In order to encourage companies to list on the GSE, an incentive was introduced by way of a waiver on capital gains tax if the free float is no less than 25%, but ambiguity as to how the tax exemption should be interpreted inhibits companies from taking advantage of this waiver. The definition of a ‘free float’ excludes any shareholding over 5% as well as any employee shareholding. Since staff holdings are extremely difficult to verify due to the use of nominee accounts (see above), there are concerns there could be a retrospective claw-back by government.

155. The Georgia Central Securities Depository was set up as a wholly owned subsidiary of GSE when the exchange was established. The depository is now 99% owned by the GSE with 1% owned by four local banks, and membership includes commercial banks and most brokerage companies. Share registers had been created in 1997, when the model adopted allowed for an undefined number of registrars in order to encourage competition. At the GSE’s inception in April 2000 there were around 10 registrars, but as activity on the exchange has declined the number of registrars has fallen.

156. Market operators say that infrastructure at the GCSD is not robust because it operates with similar outdated Russian software and brokers do not have online access. Securities are dematerialized but securities-clearing and settlement is a combination of electronic and paper- based processes. Executed trades are entered remotely and settled electronically, which means the GSE transfers electronically the proper closing positions on trading accounts after the session is over. However, all trading is prefunded; i.e. counterparties are required to deposit cash and securities prior to actual trading and the necessary papers/reports must be physically delivered to the GCSD. Thus, securities are deposited with the depository53—under the broker’s account if acting as custodian—and cash with one of four local banks.54 Orders are driven by the trade value and (negotiated) share price. Once trade details are agreed the appropriate accounts are credited/debited. If it is necessary to transfer securities from one account to another, for example from a broker’s nominee account to a beneficiary’s personal account, the independent registrar needs to (physically) complete and submit a special form, after which the registrar reflects the movement in its software electronically. Execution of OTC trades on securities admitted to trade on the GSE can be done in the same way—complete the special form and deliver to the GSE disclosing the price and the quantity of the transaction.55 Execution of OTC trades on securities not admitted to trade on the GSE can be done in paper form only, using local software of registrars and brokers.

157. Some stakeholders say that capital market ‘entry’ fees are high, especially for small companies. A public offering of securities attracts a State Registration Fee, payable to the State

53 Clients may open their own accounts with the GCSD but there is a preference for maintaining a sub-account under the broker’s account due to issues around trading. 54 BG, TBC, Cartu or VTB. 55 So called ‘fixing the trade on the GSE’.

Budget, of 0.1% of the value of the offering.56 For an initial public offering of securities through the GSE a trading commission of 0.01% of the transaction value (for each party) is applicable. Fees levied by the GSE for listing are based on the listing category as detailed in Table 10. In the case of secondary trading the GSE levies commissions on each party of 0.01% of the transaction value for debt securities 0.05% of the transaction value for other securities. For OTC trades brokers must pay the same fee to the GSE as for trades conducted on exchange, but no fee is due to the GCSD.

Table 10: Georgia Stock Exchange Fees (GEL)

Admission fees* Periodic fees** Companies admitted to Listing A 2,500 2,500 Companies admitted to Listing B 1,500 1,500 Companies admitted to the GSE trading system Nil nil Note: *paid one time; **paid quarterly; GSE = Georgia Stock Exchange. Source: Georgia Stock Exchange.

158. Trading statistics demonstrate the absence of depth and liquidity in the Georgian stock market (Table 11). As well as being small, the market is shallow: the total value of stocks traded relative to GDP fell from a high of 1.23% in 2006 to 0.02% in 2009, falling further to. The stock market in Georgia is also illiquid: the turnover ratio, the total value of shares traded during the year divided by the average market capitalization in the year, has fallen sharply from a high of 18.6% in 2006 to around 0.2% since 2011. The fact that the total shareholding in Bank of Georgia was transferred to Bank of Georgia Holdings plc in February 2012 somewhat distorts GSE trade data for the year. A total of 877 trades were affected on the GSE in 2012 for a value of GEL735.5 million ($444.7 million), of which the Bank of Georgia share transfer accounted for GEL718.2 million ($434.2 million). Excluding the Bank of Georgia transfer, trading in companies listed on the GSE totalled GEL10.3 million ($6.2 million): by issuer, registrars accounted for around 40% of trades while close to 50% by value were conducted OTC.

Table 11: Equity Market Metrics – Georgia

2004 2005 2006 2007 2008 2009 2010 2011 2012 Equity market capitalization (% of 4.00 5.50 8.60 13.70 2.60 6.80 9.10 5.50 6.00 GDP) Listed domestic companies (total) 277 257 231 161 153 145 143 135 133 Stocks traded, total value (% of 0.49 0.59 1.23 0.44 0.06 0.02 0.02 0.01 0.01 GDP) Stocks traded, turnover ratio (%) 12.20 13.60 18.60 4.40 1.00 0.30 0.30 0.20 0.20 Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

159. By way of regional comparison, as noted earlier, the stock market in Georgia has not yet recovered from events in 2008 and market capitalization has hovered around 6% of GDP since 2011 (Figure 27). The Armenian stock market has also struggled to build momentum following the global financial crisis and subsequent devaluation in March 2009, and market capitalization languishes below 2% of GDP, while the market in Estonia, having also fallen sharply in 2008, only now seems to be regaining traction.

56 This is considered a tax and is a disincentive for companies to float new issues (the rate was previously 0.5%).

Figure 27: Equity Market Capitalization – Armenia, Estonia and Georgia (% of GDP)

Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

160. As previously mentioned, three of the 133 companies admitted to the GSE are listed. By way of regional comparison, 12 listed companies in Armenia were in the Secondary List (B) category at the end of 201257 and the remaining 10 companies were traded on the Free Market (C category),58 while in Estonia 13 companies were in the Main List and three were in the Secondary List (Table 12).59

Table 12: Comparative Equity Market Metrics – Armenia, Estonia and Georgia

2010 2011 2012

Georgia Armenia Estonia Georgia Armenia Estonia Georgia Armenia Estonia Equity market capitalization (% 9.10 1.60 12.00 5.50 1.40 7.30 6.00 1.30 10.70 GDP) Listed domestic companies (total) 143 12 15 135 12 15 133 12 16

Stocks traded, total value (% GDP) 0.02 - 1.70 0.01 0.01 1.10 0.01 0.01 0.80

Stocks traded, turnover ratio (%) 0.30 - 13.10 0.20 0.40 12.60 0.20 0.80 9.10 Note: - = data not available. Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

161. At 0.8% of GDP at the end of 2012, the equity market in Estonia is considerably deeper than both Georgia and Armenia. However, Georgia lags both countries in terms of market liquidity as measured by the turnover ratio. Liquidity in the Armenian stock market peaked at a lower rate than Georgia (9.4% in 2006) 60 but having fallen to 0.17% of GDP in 2009 has

57 Requirements for listing on the secondary list are: (i) minimum capital AMD500 million; (ii) issuer operating more than 3 years; (iii) financial statements for last 3 years, independently audited;, and (iv) a minimum 10% free float. 58 There are no requirements for companies to be admitted to the Free Market (C): being admitted gives the company a reliable channel for disclosing financials and other material information to investors. Companies that are under liquidation, including for the reason of bankruptcy, cannot be admitted even to the Free Market. 59 Companies admitted to the Main List must: (i) have a minimum capital of 4 million euros; (ii) have been in operation for no less than 3 years; and (iii) have audited annual reports for preceding 3 years. Admission on the Secondary List requires: (i) have minimum capital of 1 million euros; (ii) have the last 2 years of audited annual reports (if in business for at least 2 years); and (iii) have an ‘adequate’ free float. 60 World Bank. www.databank.worldbank.org/data/home.aspx.

47 recovered to 0.75% in 2012. Meanwhile liquidity in the Estonian equity market fell steadily from around 35% at the end of 2007 to just over 9% five years later, as consequence of the severe effect of the global financial crisis in 2008 and the real-estate market.

Figure 28: Turnover Ratio – Armenia, Estonia and Georgia (%)

Source: The World Bank. www.databank.worldbank.org/data/home.aspx.

162. During the mission visits to Georgia, it was acknowledged that the stock market is not working in its present form and several options were enunciated as to the way forward. As previously noted, NASDAQ OMX had been in discussions with the GSE but these did not develop. One alternative the government is exploring is the possibility of a link with the Warsaw Stock Exchange. It was mentioned that an initial public offering is being planned for JSC TBC Bank although current thinking is to conduct the offering on an external exchange, for example in London or Warsaw. Since international finance institutions have expressed a commitment to contribute to local capital market development, including a domestic tranche in the initial public offering would be highly desirable. Government officials commented that the current focus is on expanding the bond market, in particular the corporate bond market (see below). This approach is consistent with the hierarchical order of domestic financial markets as enunciated in academic literature, 61 although typically equity market development precedes that of bond markets in developing economies due to the complexities of fixed income products vis-à-vis equities. That said, as an ex-Soviet country Georgia has prior experience with bonds,62 whereas equities are a new asset class.

b. Bond Market

163. The bond market allows borrowers to obtain long-term funds through the issuance of debt securities while providing investors with an opportunity to trade these securities. As importantly, selling debt provides an alternative to bank lending as a form of long-term finance, and in the instance of asset-backed securities63 allows an issuer to, in effect, convert illiquid

61 Karacadag, Sundararajan & Elliott. 2003. “Managing Risks in Financial Market Development: The Role of Sequencing”. IMF Working Paper WP/03/116. 62 Debt service of bond issues in the Soviet era was, at best, unreliable. This has had implications for market participants’ confidence in present-day government bond issues. 63 Income payments and principal repayments are dependent upon a pool of assets such as loans.

assets into tradable securities. An active bond market also allows credit risk to be spread over a wide range of investors, hence reducing the potential for concentration of credit risk to develop, and at the same time providing issuers with up-to-date information on the market views of their creditworthiness. Bonds also provide a long-term opportunity for investors with long-term- liabilities, such as pension funds.

164. The interbank market is critical to the efficient functioning of the bond market as it provides the means for banks with excess liquidity to can lend to other banks experiencing a shortage of funds, often overnight and usually on an unsecured basis. An efficient interbank market supports the financial system by enabling the central bank to add or drain liquidity more effectively while facilitating the redistribution of liquidity among banks without causing undue interest-rate volatility. If funds do not flow freely in the interbank market, the liquidity management of individual banks is impeded—in the process posing a risk to financial stability— and this could result in the central bank having to supply liquidity to banks on a case-by-case basis, complicating the management of monetary policy.

165. In Georgia, the NBG refinancing rate serves as the policy rate for the financial markets. Having peaked at 12% in 2008 the rate has been progressively falling as market conditions have improved, and currently stands at 4%. More recently there has been a structural excess liquidity in the Georgian financial market as the budget deficit is financed through concessional borrowing and the trade deficit is financed via FDI. In implementing monetary policy the NBG sought to control short-term interest rates, but without success. In 2011, in an effort to manage liquidity and reduce interest-rate volatility, the NBG introduced overnight loan and overnight deposit facilities with interest rates tied to the policy rate (+/- 1.5%) thereby creating an interest- rate band in the money market. In effectively tightening medium-term liquidity and easing short- term liquidity, interest-rate volatility decreased significantly and the interbank interest rate stabilized around the policy rate (Figure 29). That contributed to expansion of money market turnover. Most importantly, the NBG brought short-term interest rates under control, a necessary prerequisite for efficient functioning of monetary policy.

Figure 29: Tbilisi Interbank Overnight Rate (%)

Source: National Bank of Georgia.

166. The repurchase market is not fully developed in Georgia. The NBG prefers collateralized lending but repo transactions do not make a big difference for the central bank as

49 the volume of Treasuries is insufficient to allow it to conduct large-scale open market operations. Hence, a repurchase agreement (repo) in George is a form of collateralized lending as opposed to a typical repo elsewhere, which will not be introduced until there is adequate collateral to support interbank repurchase agreements. Liquidity management is based only on issuance of certificates of deposit in maturities of 3 and 6 months and adjustments to the refinancing rate, the NBG target for refinancing loans. The refinancing rate is the minimum rate at which the central bank will lend at refinancing auctions, but the actual rate on the auction may vary. The volume of funds offered at the refinancing auction is based on the NBG’s liquidity forecast and, as a multiple-price auction, every successful bidder get its own price. The average rate is calculated based on the auction results and published. Later on the auction day, unsuccessful bidders can apply for a 7-day refinancing loan, but the cost is at a penalty rate 1% higher than the average rate on that day’s auction.

167. With a view to deepening the interbank market, the NBG established a Georgia master repo agreement (based on the Global Master Repo Agreement) and set up the technical infrastructure to do so, which includes the Law on Payments Sector (with a section on financial collateral). However, it was observed that there is no secured interbank trading. The challenge in enhancing collateralized lending between banks relates to the availability of collateral: stakeholders note there is insufficient collateral to support interbank repos due to a relative scarcity of government papers. It is essential to create a pool of collateral comprising marketable and nonmarketable securities, the latter being SME and household secured loans with a 20% haircut, which banks can borrow against.

168. Rather than deal interbank, most banks prefer to transact with NBG on a collateralized basis. An interbank repo facility exists but virtually all interbank lending is unsecured. Smaller banks prefer to invest in the large banks,64 but if constrained by credit limits will buy government securities close to maturity. Typically, commercial banks place liquidity in government securities and/or certificates of deposit, which leads to cash deficit, so they borrow either: (i) overnight/1- week from smaller banks at the refinancing rate, or (ii) 1-week at the refinancing auction (held weekly on Thursday).65 As the refinancing rate at each auction is market determined it does not act as a ceiling on the overnight rate although it is unusual for the Tbilisi interbank overnight rate to exceed the policy rate (Figure 30). It was noted that banks do not have liquidity risk on government bonds as it is always possible to obtain funds at the refinancing auction. However, banks do run market risk since funds obtained at the refinancing auction may be funding longer- dated securities. With a view to stimulating interbank activity, consideration could be given to widening the band around the policy rate for overnight loan and deposit facilities and/or raising the penalty rate for the 7-day refinancing loan. However, this may prove challenging while there is a scarcity of collateral.

64 Large banks are net borrowers and small banks are net savers. 65 When borrowing from NBG, it is necessary to pledge securities of equivalent value - subject to a 5% haircut.

Figure 30: Interest Rate Differential – Short Term Rates (%)

Source: National Bank of Georgia.

169. An alternative source of interbank funding is via foreign-exchange swaps: typically depositing US dollars against GEL for up to 2 weeks, although many of the banks have credit lines out to 3 months.

i. Government Bonds

170. Government bonds are widely utilized as the pricing reference for other fixed-income securities due to their status as the ‘risk free’ instrument and because issues of government bonds tend to be (relatively) large and liquid. However, liquidity in government bonds tends to be concentrated in benchmark issues that are not continuously available across the maturity spectrum. At the same time it is possible that a large government bond market may ‘crowd out’ the corporate bond market. While studies have suggested that private sector products such as interest-rate swaps can provide a more reliable benchmark reference for fixed income products it is widely acknowledged that government bonds are still the most popular reference, especially in developing markets.

171. Government securities on issue in Georgia comprise certificates of deposit issued by the NBG with maturities of 3 months and 6 months (this instrument can only be bought by banks) and securities issued by the Ministry of Finance. The securities include: (i) 1-year Treasury bills; 66 (ii) 2-, 5- and 10-year Treasury notes, and; (iii) Government bonds, as a special instrument with a 2–5 year maturity sold to banks in 2012. Outstanding certificates of deposit are in the order of GEL800 million ($483.7 million) while outstanding government bonds totalled GEL637.02 million ($385.14 million) at the end of June 2013.

172. As previously noted, stakeholders have observed that government securities available in the market are of insufficient volume, saying that Treasury notes and obligations outstanding should be in the order of 10% of GDP, whereas the present portfolio is worth slightly more than

66 It was observed that the Ministry of Finance contemplated dropping Treasury bills but, at the request of the NBG, did not. (NBG noted that there are insufficient Treasury notes for large-scale open-market operations so Treasury bills provide additional securities for market intervention, to facilitate monetary policy implementation).

2% of GDP. Excess demand is evident from the fact that the coverage ratio at auctions of Treasury obligations consistently exceeds 2. Furthermore, it was noted that the volume of government bonds outstanding could be doubled with little risk of creating excess supply.

173. In response to investor demand, particularly from commercial banks, and to foster the development of the domestic capital market, the Ministry of Finance has been gradually increasing volumes issued, and hence the outstanding stock, of Treasury obligations. Emission volumes in 2010 totalled GEL608 million ($367.6 million) but in 2011 and 2012 emission volumes comprised, respectively, GEL413 million ($249.7 million) and GEL424.02 million ($256.4 million), while GEL235 million ($142 million) has been issued to August 2013. More importantly, where less than 24% of new issues in 2010 had more than 1 year to go before reaching maturity, by August 2013 the comparable proportion was almost 60%. Hence there has been a corresponding increase in bonds outstanding as the duration of government bonds has lengthened. At the end of 2010, the outstanding portfolio of Treasury notes and obligations was GEL456 million ($275.7 million) and this had grown to GEL587.02 million ($354.9 million) by two years later, further increasing to GEL637.02 million ($385.14 million) as of the end of June 2013. Meanwhile, the number of Treasury auctions planned for 2013 is 60, an increase from 38 in 2011.

174. Regarding the issuance process, government bonds are sold via auction in order to enhance the efficiency of issuances.67 The Ministry of Finance agrees the following year’s full calendar with the NBG in December, but the schedule is only published quarter-by-quarter. This means only 1 week’s notice is given for any auction held the first week of a quarter. It was noted that the ministry would like to publish the full year’s calendar but this is not possible because the government may have to adjust its borrowing requirement during the forthcoming year as cash forecasting is not sufficiently robust—in the past, for example, there have been sizeable changes to the planned issuance schedule part-way through the year. Final auction details are sent to the central bank 5 days before the auction and the central bank simultaneously notifies the banks and publishes the details on its website. If the Ministry of Finance does not write to the NBG within 1 hour of the auction’s conclusion to vary the cut-off volume, the central bank will automatically fill the volume on issue. The auction result is based on weighted-average bids and published on Bloomberg, but as the Ministry of Finance does not have a Bloomberg terminal its officials are unable to view details about auctions, including results/trading. Market operators also commented that there is only communication with the NBG regarding government bond issuance, and no interaction with the ministry. It was thought that regular discussions with the Ministry of Finance regarding the government’s strategy and plans in respect of debt management would be helpful.

175. At the same time, since 2011 the Ministry of Finance has made good progress in extending the maturity of securities on offer from 2 years to 10 years. As of end-2010 around 70% of the portfolio matured in less than 2 years with the remainder maturing in 2 years giving a weighted average maturity of 0.8 years for the portfolio of Treasury obligations. In 2011 the Ministry of Finance began issuing 5-year Treasury notes and in 2012 the portfolio was extended with the issue of 10-year securities. As of the end of June 2013, slightly less than 40% of the portfolio has a maturity longer than 5 years while the weighted average maturity of the portfolio was 2.4 years.

176. As well as increasing volumes outstanding and extending the maturity profile, in 2012 the Ministry of Finance initiated the benchmark issues by reopening existing bonds in order to increase the total outstanding in specific maturities. At present, there are three tranches of 5-

67 In this regard it is important to pursue regularity, standardization and fungibility of bond issuance.

year Treasury Notes and four tranches of 10-year bonds issued. There are now two issues totaling GEL 60mn ($ 36.3mn) due in January and April 2014 and a third issue for GEL 55mn ($ 33.3mn) due in March 2015—all initially tranches initially issued as 2-year T-Notes (Figure 31). With a view to building a benchmark yield curve, it would be beneficial to have fewer bonds of the same tenor maturing in any one year; for example, four 5-year bonds are currently due to mature in 2017 (January, April, July and October). At the same time, an issue of GEL5 million ($3 million) of 10.8% bonds due 1 August 2022, matures a day before one with identical terms in an amount outstanding of GEL20 million ($12.1 million). In this regard, it was mentioned that some consideration is being given to consolidate outstanding issues into fewer lines.

Figure 31: Government Bonds Outstanding ($ ‘000, 31 July 2013)

Source: National Bank of Georgia.

177. Although all stakeholders acknowledged that there is excess demand, officials are concerned about the market’s capacity to absorb a single, larger issue. The largest to date has been GEL20 million ($12.1 million) for a maximum maturity of 2-years with issues for 5-years and longer being GEL5—10 million ($3–6 million). The result is that the average issue size, even allowing for reopenings, is only GEL21.04 million ($12.7 million). At the same time, interest rates (coupon and discount rates) have been steadily falling: the weighted-average yield for 5- year bonds sold at auction was 13.94% in 2011, 10.09% in 2012, and 9.68% to the end of June 2013. This gradual decline in yields may reflect investors’ growing confidence in the fiscal policy of the Georgian government and the stable macroeconomic framework.

178. The secondary market cannot be described as liquid, though trading volumes are reasonable. A total of 129 trades in government securities have taken place in 2013 for a nominal value of GEL582.2 million ($352 million) giving an average size per trade of GEL4.5 million ($2.7 million). There were five trades in securities very close to maturity (only 3 days remaining) and 25 trades in securities maturing within the following 2 weeks. Trades in bonds maturing more than 1-year hence numbered 31, and 10 trades took place in bonds maturing beyond 1 January 2017. Two issues accounted for close to 18% of trading: 12 trades with a participation of 7.4% issued 19 April 2012 and due 19 April 2014; and 11 trades in Treasury bills issued 19 July 2012 and due 18 July 2013.

179. Clearing and settlement of government bonds is conducted through the Central Securities Depository at the NBG. This is a fully automated process, that is, delivery versus. payment with no manual involvement. Investors may have their cash/securities sub-account at the NBG through commercial banks, i.e. sub-custodian arrangements are possible. As Bloomberg is linked with the depository and a real-time gross settlement system, primary (and secondary) trading and settlement are integrated on this electronic platform. All banks have Bloomberg terminals and can access Georgian secondary markets. Transactions are settled within 1 minute: presently the standard is T+1 for primary auctions and secondary trades (or T+0 by negotiation). The major players in the government bond market post two-way prices on Bloomberg each day but the secondary market is described as very liquid as the spreads are wide (100–150 basis points).

ii. Corporate Bonds

180. Few corporate bonds have been issued in the domestic market. It appears that the first corporate bond was issued in 2005 when ProCredit Bank floated GEL5.4 million68 ($3.2 million) of 14%, 364-day discounted notes due November 2006. Georgian Railways in December 2009 issued GEL25 million ($15.1 million) of 13.5% bonds due December 2011 as a private placement since it was difficult to syndicate the issue. The bonds were placed with onshore investors and redeemed within 12 months.

181. Various explanations were offered for the failure of the domestic bond market to develop. Most importantly, it was felt that in situations where a prospective corporate issuer considers capital-market funding, the commercial banks are quick to agree a loan and will match the cost of funding from the alternative source (although bank borrowings must be secured). At the same time due to the difficulty of syndicating a bond issue, the arranger struggles to guarantee the amount that will be raised through a debt sale.69 It is permissible to issue corporate bonds denominated in US dollars, but the coupon payment must be denominated in GEL, based on the exchange rate prevailing on the coupon payment date although the principle repayment is denominated in US dollars. 70 Finally, a distortion favors government bonds in that debt-servicing of corporate bonds is taxed while all government securities are tax-exempt.

182. Stakeholders generally believe that the corporate bond market will develop in time: indeed some institutions are already negotiating with a couple of prospective issuers of GEL- denominated bonds.71 NBG officials are also presently making preparations for an international financial institution to float a GEL corporate bond in the domestic market. Some regulations have already been amended in order to facilitate the issue; for example, to allow a sale by a nonresident borrower, and as the first issue will be costly it is possible that the prospectus may not be translated into Georgian. The issue will also be included in the collateral base for repos. There are also ongoing discussions with Clearstream to include clearing and settlement of GEL bonds.

183. That said, it will be difficult for the corporate bond market to gain traction in the absence of a deeper and more liquid government bond market that will facilitate, in time, growth of essential hedging products such as futures and interest-rate swaps. Additionally, it was

68 Representing about 77% of the GEL7 million ($4.2 million) offered. 69 It was mentioned that 80% of the Georgian Railways bond floated in 2009 was bought by Bank of Georgia as the issue could not be syndicated. 70 The same process applies to US dollar-denominated corporate loans. 71 It was mentioned that one borrower is considering floating a bond with a variable rate.

observed that issuers and investors lack understanding of fixed-income products. Capacity building within market intermediaries—to develop for example a deeper understanding of pricing fixed-income products—is also needed.

2. Demand for Securities

184. Contractual savings institutions play a critical role in financial market development. The presence of diversified institutional investors—including pension funds, insurance companies and mutual funds—is a key component for building the debt market. Such investors can contribute by: (i) providing a stable source of demand for medium- and long-term debt securities as well as equity; (ii) improving market efficiency, infrastructure and financial innovation; (iii) enhancing market discipline and corporate governance: and (iv) creating an incentive for establishing a robust regulatory and supervisory framework in order to minimize systemic risks.

185. In the aftermath of the global financial crisis, international financial institutions became equity investors in Georgia for a time (the EBRD holds about 20% JSC TBC Bank). Presently, however, institutional investors are absent and there are few high net worth individuals, leaving commercial banks as the dominant investors in the domestic capital market. Since November 2009, the domestic commercial banks have held some 65% or more of government bonds outstanding.72 Furthermore, as at the end of July 2013, almost 80% of the GEL763.02 million ($461.3 million) government bonds outstanding were held by domestic commercial banks. As the banks buy government bonds for liquidity purposes (not for trading), the securities are not ‘available for sale’ and therefore do not have to be marked-to-market. Hence, there is no incentive for banks to trade government securities in order to minimize any impact on the profit and loss account.

186. Other resident investors, excluding the NBG,73 only began buying bonds in November 2012 and held less than 0.05% at the end of July 2013. Nonresident investors first purchased domestic Georgian government bonds in November 2011 and, having peaked at marginally less than 34% in February 2013, accounted for approximately 15.4% of bonds outstanding at the end of July 2013. One large (potential) institutional investor commented that the company would be happy to invest in securities markets if the right instruments were available but in the absence of such products shareholders decided it should only invest in bank deposits.

187. Plans to support growth of the institutional investor base are at an early stage in Georgia. As previously mentioned, although 14 insurance companies are present the bulk of insurance liabilities relate to health insurance (almost 74% of written premiums).74 Furthermore, it is unlikely that life insurance is significant in the demand-side of the securities market as not only is there limited demand for this business line but existing demand is almost exclusively for term insurance.

188. As one asset manager explained, the regulations require insurance reserves to be invested with 10%–20% on current account and 80%–90% held in time deposits (typically of 3– 12 month maturity). No more than 20% of time deposits can be invested in ‘liquid assets’, specifically short-dated government bonds. 75 Deviations from this policy incur a penalty. Investments must be spread across several banks with a cap 30% on investment held in a single bank. Based on the insurance sector’s summary income statement for the year ending 31

72 NBG. http://www.nbg.gov.ge/index.php?m=306. 73 NBG held slightly more than 5%. 74 NBG. “Insurance Market Statistics”. http://www.nbg.ge/index.php?m=489. 75 US Treasury bonds are not included as an asset in liquidity guidelines.

December 2012,76 more than 58% of investment income was attributed to ‘credit institutions’ (i.e. time deposits), followed by 30% in investment property. In 2012, the summary income statement of the insurance sector showed a loss from financial assets available for sale of GEL10,367 ($6,268), 77 with close to 60% of investment-income deriving from credit institutions and a further 30% from investment property. It is reasonable to assume that life insurers are not active in the securities market due not only to a lack of term-liabilities and scarcity of instruments but, most importantly, due to the regulations on investment of insurance reserves.

189. Pension reform can make a critical contribution to growth of securities markets. In particular, implementing Pillar II reform requires the presence of a pool of investible instruments in order to absorb pension contributions. Given the requirement for long-term assets to match liabilities, the growth of assets-under-management subsequent to the introduction of Pillar II reforms will critically boost demand. Associated with this, albeit with a lag, there will be an increasing need for life insurance products—in particular annuities—that will provide a further impetus to demand for (long-dated) capital market products.

190. As noted earlier, pension reform in Georgia is at an early stage, and pension reserves measured only 0.04% of GDP at the end of 2012. Apart from the fact that assets-under- management at private pension funds are small, asset management is complicated by beneficiaries being legally entitled to withdraw contributions at any time (accessing funds is not linked to retirement). Fund managers accordingly do not have a long-term investment horizon. At the same time, it seems that investment guidelines for pension funds are the same as for insurance companies (i.e. the focus is on bank deposits) so assets under management are invested mainly in renewable bank deposits of 12–18-month terms, with a small share in real estate. Government bonds are not attractive as the interest rates are some 3–4 percentage points below bank deposits.

191. There is currently no law on mutual funds and no legal form for funds, although it was mentioned during the mission that a draft law on mutual/investment fund is presently under review. For the time being, should an asset manager wish to establish a mutual fund, the relevant legal form is the same as that for a joint stock company, which creates tax issues. Hence, although the law allows for investment funds, investors may be taxed—in addition to which the investment fund is taxed as a joint stock/limited liability company.

3. Constraints to Securities Market Development

192. Some of the issues identified by stakeholders, for example those associated with problems such as scale, will only be addressed as the economy grows. At the same time, the dollarization in the economy requires institutional focus, as does investor confidence in the economy. Specific constraints that require attention in respect of securities market development include: i) the absence of a securities market culture. Practices such as sharing ownership of a company and submitting to disclosure are anathema; ii) an ineffective and inadequate supporting legal framework, including the Law on Securities and the Law on Entrepreneurship; iii) weak reporting, accounting and audit practices; iv) the impractical regulatory framework for nonbank financial institutions taking into account the potential scale;

76 NBG. “Financial Indicators of Insurance Companies”. http://www.nbg.ge/index.php?m=488&lng=eng. 77 As defined by financial assets available for sale, held to maturity, and at fair value through profit or loss.

v) inadequate public debt management. Volumes on issue are insufficient, and cash forecasting is not robust; vi) the narrow institutional investor base, with a need to improve the regulation of, and consistency in, treatment of all investors; vii) trading, settlement, custody and delivery mechanisms are not in line with international standards; viii) creation of markets for financial derivatives, for example repos, swaps and, in time, asset-backed securities, and in the process improving access to domestic hedging facilities for nonresident investors. Associated with this is increased market surveillance and upgrading of risk management capabilities across the industry; and ix) the widespread lack of financial literacy and understanding of capital markets.

4. Roadmap for Development of the Securities Market

193. The expected impact of the proposed technical assistance to develop the securities market focuses on strengthening the nonbank financial sector (here referring to insurance companies, pension funds etc.) to underpin domestic savings and support growth of the real economy. The desired outcome would be to achieve a more diversified, deeper nonbank financial sector, at the same time expanding the overall financial sector in order to underpin economic growth. Thus, technical assistance would have four outputs sequenced in four phases where the activities may take place simultaneously or sequentially.78 The four phases develop: (i) policy and consensus-building measures; (ii) the primary market for government securities; (iii) the secondary market for government securities, and; (iv) corporate funding options. The four outputs: (i) implement an effective and appropriate institutional structure, to include securities market regulation and legal and accounting/audit framework; (ii) cultivate a benchmark debt issuance program; (iii) expand the institutional investor base; and (iv) build capacity.

194. Development of securities markets can be conceptualized as generally occurring in four phases,79 although some activities from different phases can take place in parallel. Although the roadmap identifies four key phases, given the links between public and private sector bond markets, elements of each may proceed at the same time. For example, it is not practical to wait until the primary and secondary market for government bonds is well-established before starting work on aspects of corporate bond market development, such as corporate governance. Within each phase, some activities may take place in parallel: for example, within corporate funding options, reviewing prudential regulations and the streamlining of clearing and settlement. The phases include policy development with an emphasis on consensus and building effective primary and secondary markets for government securities, thereafter progressing to an efficient corporate bond and equity market. Progress with the roadmap should be closely monitored as authorities will need to make decisions about which paths to take at various points, based on assessment of the benefits and drawbacks of each option. Such decisions should be made in close consultation with the financial-services industry and other stakeholders. It is crucial that measures should be carefully sequenced, not just to reflect the hierarchy and complementarities of markets and related institutional structures, but also to mitigate risks in parallel with reforms to expand the market.

78 Asia-Pacific Economic Cooperation. 1999. “Compendium of Sound Practices”. http://publications.apec.org/publication-detail.php?pub_id=698. 79This is consistent with the stages suggested in the “Compendium of Sound Practices” for the development of domestic bond markets, APEC, September 1999.

195. The emphasis in the initial phase should be on policy development and consensus- building. Gaps are evident in respect of economic policy development and achieving consistency and concurrence with the development strategy for the securities markets in Georgia. Linking, for example, government-debt management and budget execution with broader economic goals would also potentially enhance the role of the securities market in contributing to growth in the real economy. While a broad consensus exists with regard to the development of the government bond market, in some areas—pension reforms, for example— discussions appear to be at an early stage. The consultation process should not end at phase one; rather it must continue as the market evolves with the advent of new technologies, products, and services. It is critical that the government remains engaged and has an active dialogue with market intermediaries and the wider financial community so that it can accurately anticipate the markets’ needs and continually adjust the environment to enable and encourage the development of the bond markets while controlling risk.

196. With reference to phase two, Georgia is making good progress with developing an effective primary market for government securities. However, greater focus on strengthening government’s cash-management capability would be beneficial as accurate cash forecasting is key to public debt management and monetary policy operations. There is also a need to increase the volume of government bonds on issue and consolidate outstanding issues with a view to building a benchmark yield curve. For primary auctions, consideration has been given to introducing a dealer system but it has not yet been adopted due to the small number of banks that buy government securities and the limited volume of securities on offer. As importantly, since building the government bond market was prioritized in 2010—and only for market development purposes—officials have been keen to include as many banks as possible in primary market activities, rather than be seen to as giving some institutions privileges. It should be noted that while the authorities have progressed with benchmark issuance, the data points to a few minor issues with implementation of the strategy (paragraph 176–7). Apart from the need to increase the volume of government bonds outstanding—scarcity of these instruments currently restricts the NBG’s use of open market operations for monetary policy purposes— the consolidation of outstanding issues is a crucial area for development of the primary market.

197. The Ministry of Finance endeavours to promote the timely availability of detailed facts about the government’s debt-management strategy and issuing calendar—information which is key to building an effective primary government bond market given its importance to the decision making of intermediaries and investors. But there appear to be some issues with cash management—in particular cash forecasting—whose resolution will enable further progress in this area. Converting to in-country financing of the budget deficit rather than donor financing would be beneficial in the long-term as it would encourage development of the government bond market, albeit with an immediate increase in debt-servicing costs. The benefit to the real economy of accelerated development of the domestic financial markets would more than compensate for the additional short-term cost. With the progressive increase in government borrowing it is crucial to build trust and credibility in the government’s commitment to market forces and to this end investors need to be confident that its debt managers are acting transparently. To minimize investor uncertainty, as well as publishing the annual auction calendar 12 months in advance the Ministry of Finance should regularly engage with banks active in the primary and secondary government bond market. The ministry could for example provide timely and relevant information every quarter on: (i) government finances; (ii) the debt portfolio, including its redemption profile; (iii) its borrowing strategy; and (iv) activity on the

primary and secondary markets. 80 Note that this is a two-way process as it gives the government’s debt managers the opportunity to listen to the views of investors' and market- makers on matters such as ways to improve the efficiency and openness of financial markets at the same time as providing information on a range of topics such as the government's debt management objectives, debt strategy, current and projected borrowing needs and arrangements surrounding the sale of government securities.

198. At the same time, steps should be taken to widen the range of targeted investors beyond the banking system. The introduction of Pillar II pension reform—presently under discussion, but unlikely to be implemented until 2015 at the earliest—will provide much-needed stimulus to the investor base. However, careful thought should be given to ensuring the availability of adequate local-currency products by simultaneously developing the supply side as otherwise the volume of funds generated by this reform could aggravate issues such as foreign- currency exposure.

199. In the third phase, which often overlaps with the work of the second phase, the focus is on the development of a secondary market for government securities. With a view to improving market liquidity, three aspects of a work program could be pursued:

(i) Enhance market infrastructure: this includes the legal and regulatory framework, the market for repurchase agreements and bond borrowing and lending arrangements as appropriate. Establishing a facility to support bond borrowing and lending would potentially contribute to repo activity, thereby enhancing money market liquidity, and liquidity in the secondary bond market.81 (ii) Conduct a comprehensive study to first identify and then commence the process of mitigating the legal, regulatory, accounting and tax impediments to investment in and trading of bonds. (iii) With the objective of improving the depth and liquidity of the market, the role of intermediaries such as primary dealers, market-makers and interdealer brokers should be considered once government bonds outstanding achieve a critical mass. Establishment of a bond or interest rate futures market also merits consideration once the cash market has attained adequate maturity.

200. Finally—and again there is some overlap between the last two phases—the development of efficient corporate bond and equity markets should be emphasized in phase four in order to avoid concentrating financial intermediation in the hands of commercial banks.82 It is critical that development of the corporate bond market and the equity market is balanced, especially since (as previously noted) legal entities in Georgia are building up high leverage that makes them more vulnerable to shocks. At the same time, funds raised through equity markets are typically applied to financing projects with higher risks—and hence higher returns—whereas funds raised via bond markets are applied to less risky projects. The balanced growth of both markets contributes to containing systemic risks.

201. With a view to building market efficiency and integrity, attention must be paid to transparency in financial information and market prices. Accurate and timely disclosure of financial information must be built in so investors are able to make informed investment

80 Producing and disseminating debt and budgetary information generated by different government agencies and departments will entail considerable coordination and it requires modern information systems that link various data producers with the debt office and link the debt office with the market. 81 Securities lending would also provide fund managers with an additional source of revenue. 82 Over-reliance on bank funding due to the absence of bond markets was a key factor in deepening the recessions in countries affected by the Asian credit crisis in 1998.

59 decisions, while pre- and post-trade information should be widely disseminated to improve efficiency and thereby foster confidence in the pricing process. Concerns were raised about the integrity of financial reports submitted to, and published by, the GSE. There are apparently issues related to the capacity of existing software used by the GSE and concerns about the GCSD as clearing and settlement functions are not fully automated. In addition, the present mechanism for capturing trade data on the GSE does not seem robust, in particular in respect to prices and volumes for securities traded OTC. The OTC market is key for growth of the corporate bond market: provision of reliable trade data is critical as it not only feeds into investors’ confidence but provides investors with actual prices to be used for mark-to-market calculations as well as supplying a pricing reference for new issues. The contribution of The Thai Bond Market Association (BMA, Box 3) to development of the baht-denominated corporate bond market by, among other things, wide dissemination of post-trade information, was highlighted. Given the current focus of the authorities on developing the corporate bond market, NBG officials expressed an interest to speak with the Thai BMA.83

Box 3: The Thai Bond Market Association

In December 2004, the Bond Market Development Committee (BDC) chaired by the Finance Minister initiated major reform of the bond market. One of the measures was to centralize the trading platform at the Stock Exchange of Thailand (SET) while the development committee would expand its functions as the self-regulator and information center for the bond market. Hence Thai the BDC sold its electronic trading platform to the SET in 2005. To emphasize its focus on self- regulatory functions and being an information center, on 8 September 2005 Thai BDC, with support from the Securities and Exchange Commission (SEC), changed its status and name - to The Thai Bond Market Association and was granted the license of a securities related association under the SEC Act.

Bearing in mind that trading in the Thai bond market is mainly over-the-counter, as opposed to on- exchange, the objective of bond market association is to bring market stability and integrity. To this end, the association plays key roles in four areas:

(i) as a self-regulatory organization: performs market monitoring and surveillance, established ethics and codes of conduct, issues rules and guidelines regarding trading, examines and registers bond traders and provides education, and determines enforcement procedures; (ii) as an information center and pricing agency: disseminates information on primary and secondary markets including trading information, bond features and the reference yield, and market news and regulatory updates; (iii) in setting market conventions and standards: establishing unique symbols for debt securities and standard formula for price/yield calculations as well as internationally accepted bond registration standards; and (iv) for market development and education: provides on daily basis (via website and the media) information on government bond yield curves and benchmark bonds, conducts seminars and training programs for market participants and the general public, initiates financial data innovations as additional tools for bond investment and portfolio management.

To support the roles of bond market association, membership is mandatory for dealers and interdealer brokers and there is also a requirement that all bonds be registered with the association

Source: Thai Bond Market Association. http://www.thaibma.or.th/aboutus/aboutus.html.

202. Equities as an asset class require robust and efficient mechanisms to enforce legal ownership rights and facilitate transfer of ownership. The current legal and regulatory framework should be developed to better support market development. In particular, the Law on

83 An introduction to the president of the Thai Bond Market Association was subsequently arranged.

Entrepreneurship is not an adequate basis for company law: there should be a Law on Joint Stock Companies setting out, among other things, unequivocal protection for minority shareholders. The Law on Securities should be amended to specify unambiguous requirements for public offers, with clear differentiation between equity and bond issues as well as regulations covering private placement issues. Strong investor protection should be coupled with effective recourse for investors in the event of misrepresentation, insider trading and fraud. Hence transparency and disclosure requirements, the appropriate utilization of credit rating agencies, tax and other regulatory issues should be addressed during this stage. Related to the accounting regime, a robust audit methodology should be implemented to increase confidence in financial statements. This will underpin growth of the equity market and also contribute to growth of the corporate bond market. An approval process for new corporate bond issues should be established and based on full disclosure. As the market evolves, given the constraints imposed by a relatively small economy, consideration could be given to developing regional links with a view to boosting efficiency and scale.

203. In preparing the roadmap the issue of appropriate sequencing in the four phases is fundamental, as discussed above and developed further below.

Phase 1: Policy Development and Consensus Building

(i) Define a vision detailing the contribution of capital market development to Georgia’s economic growth strategy. Include relevant government ministries, for example the NBG, Ministry of Economy and Sustainable Development, and Ministry of Finance in discussions to develop supporting policies. Incorporate objectives for the real economy into the strategy for: (1) sovereign debt management and the bond market; (2) fiscal and monetary policies; and (3) financial sector development.

(ii) Develop broad consensus among all stakeholders concerning the stated policy aims and strategy for developing securities markets.

Phase 2: Effective Primary Market for Government Securities

(i) Implement an action plan for money market development:

(1) review the legal framework, including accounting and prudential regulations for repos, sell-buybacks, and securities lending; (2) permit an automated facility for securities lending; and (3) consider the introduction of interdealer brokers to ensure anonymity.

(ii) Enhance the benchmark government bond issuance program:

(1) increase the total volume of government securities outstanding; (2) consolidate outstanding issuance in maturities longer than 3 years; and (3) progressively build benchmark issuance in pre-specified maturities of, for example, 3, 5 and 10 years.

(iii) Review and amend prudential guidelines for institutional investors;

(iv) effect capacity-building measures for financial institutions in risk management and credit analysis; (v) develop licensing examinations for securities market professionals; and (vi) promote investor protection and education through awareness programs.

Phase 3: Effective Secondary Market for Government Securities

(i) establish a system for systemic risk management; (ii) create procedures for bond borrowing and lending; (iii) define and enforce trading practices for market intermediaries; (iv) develop markets for government bond futures and options; and (v) establish a central registry for all securities.

Phase 4: Efficient Corporate Funding Options

(i) consider incentives for financing through the stock market; (ii) streamline clearing and settlement procedures to allow full delivery versus payment; (iii) strengthen and enforce the rights of minority shareholders; (iv) establish and enforce adequate corporate governance standards; (v) adopt prudential regulations to strengthen market surveillance and enforcement; (vi) address weaknesses in market information dissemination, in particular related to the OTC market; (vii) strengthen legal framework to facilitate the realization of collateral and promulgate an asset securitization law that permits (bankruptcy remote) special purpose vehicles; (viii) approve and enforce a full-disclosure framework for corporate bond issuance; (ix) introduce infrastructure to support private placements; (x) encourage issuance of equity-related bonds, such as convertible bonds; and (xi) identify a securities industry association as a potential forerunner to a self- regulatory organization.

Output 1: Address gaps in the existing policy and regulatory framework, including accounting and reporting standards

204. Reconsider the structure of separate regulators for each sector within the nonbank financial institutions. The potential scale of the nonbank sector is not large and a single regulator with an independent board of directors is a cost-efficient solution. The cost to business of supporting two (new) regulators for the securities market and insurance sector—with duplication of data collection and analysis—will constrain growth.

205. Conduct an extensive review of institutional infrastructure including regulations, prudential guidelines, and supervision of nonbank financial institutions. Identify elements which create distortions and/or act as disincentives to market activity, and revise regulations and prudential guidelines accordingly. In particular: (i) review and revise the Law on Entrepreneurship; (ii) draft new laws where necessary, on mutual funds for example; and (iii) develop investment guidelines for pension funds and insurance companies that are consistent with the objective of capital market growth.

206. Strengthen accounting and auditing standards and ensure consistency between tax and accounting standards. Ensure compliance with international standards, including International

Financial Reporting Standards (IFRS), International Auditing and Assurance Standards (IAAS), International Association of Insurance Supervisors (IAIS) and International Organization of Pension Supervisors (IOPS), and identify policy and regulatory gaps. Thereafter, develop recommendations on changes to the policy and regulatory framework. Devise regulations for reporting standards, including disclosure, and reinforce prudential guidelines and supervision of stock exchange.

Output 2: Build a robust benchmark debt-issuance program

207. Establish a robust cash-management facility at Ministry of Finance. This will enable more accurate cash forecasting at the NBG as well as annual publication of a calendar of planned government bond issues for the coming year.

208. Increase the total volume of government bonds on issue with a focus on longer-dated maturities. Build an accurate and reliable benchmark yield curve through the issuance of bonds at appropriately spaced benchmark maturities along the yield curve (at 3 years, 5 years and 10 years). Ensure a large volume issuance and consolidation of outstanding issues—in any single year there should only be one government bond with a 5-year maturity.

209. Develop derivatives markets and facilities such as futures markets, swaps markets, repo markets, and securities lending, as appropriate, to help investors build their investment portfolios and risk-management strategies. The availability of a broad range of hedging products will help to increase liquidity and trading.

Output 3: Facilitate development of the institutional investor base

210. As noted earlier, there is a strong correlation between pension reforms and the development of financial markets (paragraph 191). The manner in which investment activity is realized influences the overall performance of pension fund managers and insurance companies which, in turn, has implications for the economy at large. An efficient life insurance market is an essential element of systemic pension reform due to the derived demand for term- life and disability insurance from workers and the purchase of annuity products by retirees. While several insurance companies offer term-life insurance, the product range should be extended to whole-life cover. At the same time mortgage insurance can be driven by lending and provides security of repayment in the event of the death of the borrower. Borrowers were previously covered for accidental death but even this requirement was dropped in 2013 as banks sought to lower mortgage rates. The reintroduction of mortgage life insurance may be one way of encouraging growth.

211. Address demand-side weaknesses by:

(i) implementing a law on mutual funds and developing a regulatory regime to facilitate entry of fund managers; (ii) making progress in plans for the implementation of Pillar II pension reform; (iii) assessing the market potential for whole-life insurance. Developing a regulatory regime to facilitate entry of (independent) life insurers and the supervision of operations. This would include a study of the existing life insurance regime with a view to integrate and align it with the planned pension reform; (iv) conducting a study to assess the feasibility of standalone asset management companies. If appropriate, developing a regulatory regime to facilitate entry of

(independent) asset managers—bearing in mind that guidelines for asset managers may differ from those for insurance companies and pension funds; (v) developing infrastructure to support whole-life insurance products including mortality tables and loss-reserving guidelines; and (vi) reviewing options for the training of actuaries.

Output 4: Build capacity

212. Capacity development should include strengthening the training of supervisory staff once a new regulatory regime is implemented. Assistance could also be provided to the NBG to promote collaboration with agencies such as the Thai Bond Market Association. Finally, support the Ministry of Finance by investing in cash forecasting capacity and building risk management skills.

213. The introduction of independent pensions and insurance regulatory and supervisory regimes, as well as the expansion of the market, will place enormous strains on the available skills base. There will be an increasing need to apply actuarial techniques to long-tail claims provisioning, particularly as and when compulsory motor third-party-liability insurance is introduced. Hence, as the institutional investor base grows, consider collaborating with external institutions on advanced training and coaching in, for example, insurance and asset management, and encouraging individuals to take internationally accredited examinations.

214. Invest in programs to support financial literacy across the country.

III. GOVERNMENT SECTOR STRATEGY

A. The Government’s Development Goals

215. According to the Resolution of the Parliament of Georgia on Major Directions of Monetary and Foreign Exchange Policies, the development strategy of the NBG for the years 2013–2015 is as follows:

(i) The inflation rate shall not exceed 6% during 2013–2014 and 5% in 2015. In this respect the NBG will apply such policies as refinancing loans, certificates of deposit, operations with government securities, foreign-exchange interventions, standing facilities, minimum reserve requirements and some others.

(ii) Consumer behaviour is influenced by risks of changes in world prices of oil and food, changes in geopolitical risks, changes in administrated prices, and imported inflation from main trading partner countries. The NBG will intervene should deviation be high enough to influence on inflation.

(iii) In order to sustain stability of the financial sector and maintain prices, the NBG will aim to reveal and mitigate risks which endanger the entire financial system of Georgia.

216. Each year an annual strategy plan titled Basic Data and Directions is elaborated by the government. The document for 2012–2015 outlines the medium-term program, which includes the following priority directions for the government’s economic strategy for reforming:

(i) Macroeconomic stability:

a) to maintain the rate of inflation within a single digit for a long period of time;

b) to monitor the real exchange rate to avoid damaging the competitiveness of the Georgian economy;

c) to ensure the sustainability of the country’s financial system and to increase the external shock resistance;

d) to facilitate establishment of a liquid market in government securities on the back of prudent management of public financial liabilities and their consistent reduction;

e) to ensure the reduction of bank interest rates, loan maturities and to dilute the sector/regional concentration of banks, which will ultimately lead to the increased SME financing, greater growth, and job creation;

f) to increase investor confidence towards the country, allowing the banking sector to attract cheap credit resources, which will result in increased deposits; and

g) a major goal is to have achieved a multiple of nine times for the increase in the value of assets, deposits, and loan portfolios of the country’s banking sector in 2015 compared to 2005.

(ii) Improved current account balance:

a) to build such a structure of economic development that by 2015 the trade deficit will be half that of 2011 in percentage terms of GDP; such reduction is feasible through the increase in commodity exports;

b) to maintain and improve the taxation environment in the country to increase the role of Georgia as a business platform, and boost foreign direct investments;

c) to have increased the export of goods, services and tourism on average by 15%– 20% annually from 2010 to 2015; and

d) to use the assets of a Public Partnership Fund (established by the government) to implement large investment projects currently judged as too risky by the private sector absent public participation; major projects will be carried out in such sectors as energy, agriculture, and tourism and attract credit resources from international finance institutions.

(iii) Better investment and business environment:

a) to maintain a corruption-free environment;

b) to establish favourable conditions for the development of entrepreneurship such as simplified taxation system (already reflected in the new Tax Code) 84 and administration; and

c) to increase foreign direct investment to at least 6% of GDP.

(iv) Developed agriculture:

a) to create a modernized and commercialized primary and processing agriculture sector, in supplement to traditional, household land cultivation and harvesting;

b) to increase the volume of cultivated agricultural land starting in 2013 by 50% by 2015;

c) to facilitate the grain production and to increase food self-sufficiency (to meet 50% of demand with domestic production by 2015);

d) to improve the quality of export diversification, to reduce the dependency of seasonality and railway transportation; and

e) to provide financing by the Georgian Agriculture Corporation for rehabilitation and development of the irrigation system, which should help ensure an increase in the volume of fertile land and in productivity.

(v) Transformation into a regional trade and logistics hub:

a) to establish an open economy and turn Georgia into a platform for business development for the neighbouring countries and the region at large; and

84 The new tax code and its subordinate legislation came into effect on January 1, 2011.

b) to provide streamlined multimodal logistic infrastructure as well as a reliable and financially stable energy system.

B. Government Strategy for Agriculture and Agrifinance

1. A Strongly Proactive Government Strategy in Agriculture

217. The new government since 2011 has decided to reinforce measures to develop agriculture, by providing even more financial and human resources to the sector. According to the IMF, the State Agricultural Development Fund was established to foster this goal, and will have disbursed 0.8% of GDP of support to agriculture in 2013. This makes around 7% to 8% state support to producers. Acknowledging that added-value in agriculture accounts for approximately 9% of GDP, this represents a substantial amount, but still much lower than EU and Turkish support for agriculture.

218. For agricultural machinery, support is channelled mainly through the state-run Mekanizadori85 that operate 1,731 tractors all over the country. For inputs such as fertilizers or seeds, the state had provided vouchers to 670,581 beneficiaries through 510 suppliers by the end of April 2013. According to a survey recently conducted by the US International Republican Institute, this voucher program is currently perceived as the government’s main achievement. Institutions such as the World Bank are, however, critical of such a system as constitutes a short-term response to a long-term problem, while market mechanisms will in the long term be best-placed to find solutions.

219. For output, the government has managed to reopen access to the Russian market for numerous Georgian products (including for mineral water and wine) thanks to diplomacy and WTO rules that members respect. The government is also progressing well in negotiations with the EU on a comprehensive FTA. However, at this stage, the economic returns from such an agreement would be limited as very few Georgian products are able to be sold profitably in EU markets. It might be a good economic option as the main market for Georgian manufactured products will remain former Soviet countries in the near to medium term, especially if Ukraine were to join the EU. What remains clear is that the new government intends to have a concrete and pragmatic approach of international trade that contrasts with a past liberal approach which has not brought convincing.

220. Georgia is also massively investing in the rehabilitation of irrigation and drainage networks. According to a recent Bank of Georgia study, if government plans are effectively implemented, total areas under irrigation and drainage will increase by a factor of 10 in the 4 years to 2017 (see Figure 32).

85 Mekanizatori LTD was founded in 2009 as an initiative of Ministry of Agriculture of Georgia and by the order of Ministry of Economic Development of Georgia. From March of 2010 Mekanizatori LTD is a subsidiary company of Georgian Agriculture Corporation JSC and the largest agricultural mechanization service-provider in Georgia.

Figure 32: Land Irrigated and Under Drainage (ha ’000)

Source: Bank of Georgia. Ministry of Agriculture.

221. Donors have supported government strategies to reengage the Georgian state in agriculture. There have also been some concerns.

222. For the IMF, the new focus on agriculture is most welcome, as GDP growth in the last decade has not been socially inclusive and has been accompanied by unsustainably high current account deficits. In the Article IV Consultations published in August 2013, the IMF considered that the reallocation of workers from subsistence agriculture will play a key role in improving productivity and Georgian competitiveness.

223. However, the IMF insists on better mechanisms to allocate public funding to agriculture by clarifying the objectives, governance structure, and size of the Agricultural Development Fund and the Private Equity Fund. The IMF view is that the authorities should carefully design the governance of these funds to ensure that sponsored projects will not receive preferential treatment, and to avoid conflicts of interest.

224. Finally, the IMF insists that financial support should be complemented with sector reforms.

225. The World Bank in its 2013 Draft Policy Note insists that “maintaining a competitive exchange rate is a basic requirement for addressing the country’s trade deficit”. The World Bank also wants the government to better focus “public spending on the provision of critical public services and infrastructure such as irrigation networks, veterinary services, sanitary and phytosanitary controls, research, innovation and advisory services”. It recommends that the government foster the development of the private sector by Public Private Partnerships where needed (in sectors providing public goods and services and/or generating strong positive externalities) and to divest from activities such as machinery services where it is crowding out the private sector.

226. The EU is also a major supporter of the government’s drive to develop agriculture. Its recently launched ENPARD Program will provide up to 40 million euros of grants by 2016,

including 18 million euros of direct budget support. If that is deemed a success, it will likely be followed by another 70 million-euro tranche.

227. The EU budget support comes with strings attached. To obtain it, Georgia must have adopted an action plan for agriculture development, approve a new law on cooperatives (removing in particular the tax bottlenecks that hamper their emergence), reinforce extension services, and implement a new population census in 2014 that will include agricultural workers and assist in obtaining reliable data. A policy unit already in place at the Ministry of Agriculture will also be supported by international experts financed by the EU, and managed by the Food and Agriculture Organization of the United Nations.

228. The EU has already disbursed a first tranche of 4 million euros as the government has already sent a bill for new law on cooperatives to Parliament. In this respect, it can build on the work it has previously done with the Agrarian Committee in Parliament to create a national consensus on the promotion of cooperative concepts.86

229. If we combine massively underused production capacities (land in particular), abnormally low yields compared to agronomic potential, a widespread internal consensus for more state involvement in rebuilding agriculture, concrete undertakings in this field by the government and the Ministry of Agriculture, and strong commitment of support from international finance institutions and donors, then the agricultural sector could grow substantially in the near future.

230. As a prerequisite, a substantive action plan will need to be developed. The Food and Agriculture Organization has already started the process to recruit international experts who will work with the policy unit, knowing that their counterparts in the Ministry of Agriculture are experts in the development of agriculture and of modern value chains, with strong experience since the beginning of the transition process. Many staff of the Ministry of agriculture are former personnel of international finance institutions such as the World Bank or international development agencies such as the US Millennium Challenge Corporation.

231. As Georgian farmers would benefit from booming international commodity prices that compensate the overvaluation of the currency, Georgian agriculture may see similar growth as neighboring Armenia and Azerbaijan.

2. Government Strategy for the Development of Agrifinance

232. Agrifinance is an essential component for an agriculture development strategy. In this respect, the government has decided to intervene through the use of large interest-rate subsidies. The World Bank has been somewhat critical of this approach, and recommends “avoiding ad hoc preferential credit lines which distort lending decisions and create a dependency on unsustainability low interest rates”. However, while containing risks, there are potential upsides for temporary state intervention in the economy.

233. Plenty of successful international experiences can be seen in schemes of “ad hoc preferential lines”, in particular in agriculture. France’s Crédit Agricole bank is an offshoot of a similar plan, as the French central bank provided interest-free advances to get credit

86 According to Peter Eklund, former head of the EU delegation in Georgia, “The disadvantage of having small, fragmented farms in Georgia can best be overcome by creating agricultural co-operatives and this is the fastest option too. The option is not to choose one or another alternative. Both options, i.e. promoting big farms on state- owned land and promoting co-operatives to organize small farmers, can go hand-in-hand as they do in most European countries.”

69 cooperatives started. Similar examples can also be found in Brazil, which took the decision in 1995 to submit interest rates on consumer credits to value-added tax to avoid the very buying spree that has taken place in the past decade in Georgia.

234. To guard against the risks of this approach, public entities should avoid making lending decisions. In this respect, the government is tougher than the EBRD GAFF project and KfW Program for Agriculture Finance that provided a 10% first-loss guarantee to their financial partners. In the government scheme, the risk that borrower will default is borne by lending institutions.

235. Reducing potential risks, the budget cost of subsidizing interest rates would be minimal since the share of agricultural loans/GDP in Georgia is quite low. Should the scheme work, depending on banks’ risk appetite for agricultural lending, there would be room for a renegotiation of the whole package of support by cutting bank margins and/or slightly increasing interest rates for borrowers. A gauge of success of subsidized interest rates would be a program ratio of loans to agriculture/GDP similar to the 2.4% achieved in Armenia. A flat 10% interest- rate subsidy would account for 0.24% of GDP. Such a program could potentially reach 50% of Georgia’s population, including external effects.

236. One of the key factors in the success of the program will be its capacity to track the effective use of subsidized credits. Taxpayer money should not pay to subsidize loans granted for purposes other than agricultural development (land, machinery, training, working capital, etc.) In this respect, IMF recommendations on sound management of government funds, including the Agricultural Development Fund launched in March 2013, are fully accurate.

Figure 33: Loans to Agriculture (% of GDP, mid-2012)

Source: National central banks of the analysed countries.

237. The first component of the government lending program via the Agricultural Fund, is the following:

(i) Commodity credit for small farmers up to GEL5,000 ($3,023), of 6 months duration and interest-free, provided through partner financial institutions that bear the commercial risk of default and receive an interest-rate subsidy from the government;

(ii) The credit is paid directly by the financial institutions to the account of input suppliers (of seed, pesticides, veterinary products, but not fertilizers already provided through vouchers), thereby avoiding the pitfalls of the EBRD GAFF project;

(iii) A penalty of 3% per month is paid by farmers who fail to repay their loans according to schedule;

(iv) In March 2013, the partners of this component were VTB Bank, Bank Constanta, Credo, Crystal, and Liberty Bank;

(v) According to the KfW-financed “Agricultural Finance Bulletin”, 1,410 farmers had applied for this program by the beginning of July 2013.

238. The second component of the government lending program via the Agricultural Fund, is the following:

(i) Preferential loans with a maximum interest rate of 8% for medium and large farms [GEL5,000 to GEL100,000 ($3,023–$60,459.5)]. Partner financial institutions receive a 9% interest-rate subsidy from the government, capping their income at 17%, which is higher than current average lending rates in GEL to legal entities (13.7%). In return, they hold all the risk of default;

(ii) The loans can be used for working capital (seeds, pesticides, fertilizers, labor, labor of agricultural machinery) or for financing fixed assets including livestock, poultry, greenhouses and irrigation systems. The tenor for working capital is no more than 12 months for crops, 18 months for animal husbandry, and no more than 24 months for fixed assets;

(iii) In March 2013, the partners involved in this component were Basis Bank, Bank Republic, Cartu Bank, VTB Bank, TBC Bank, Constanta, KSB, Liberty Bank, ProCredit Bank, Bank of Georgia, and Halyk Bank;

(iv) In July 2013, 1,272 loans had been disbursed under this component for a total of GEL24.49 million ($14.8 million).

239. The third component of the government lending program via the Agricultural Fund, is the following:

(i) Preferential loans in US dollar with a maximum interest rate of 3% for agricultural industries (from $30,000 to $600,000). Partner financial institutions receive a 12% interest-rate subsidy from the government, capping their income at 15%, which is higher than current average lending rates in USD to legal entities (12.5%). And they keep all the risk of default;

(ii) This component can finance postharvest facilities (dry and cold storage, grading, packaging, and processing facilities) as well as some projects in primary agriculture (modern experimental farms, irrigation systems, and greenhouses);

(iii) In March 2013, the partners involved in this component were Basis Bank, Bank Republic, Cartu Bank, VTB Bank, TBC Bank, Constanta, KSB, Liberty Bank, ProCredit Bank, Bank of Georgia, Halyk Bank;

(iv) In July 2013, 81 loans had been disbursed under this component for a total of GEL21.66 million.

240. The program provides comprehensive support to all key stakeholders in agriculture. This is a big plus as interactions between input providers, farmers and stakeholders involved in postharvest activities are critical to ensure that Georgia will be able to rebuild effective value chains.

241. The program is also facing a lack of appetite among banks for lending to agriculture. During the mission, a development agency stated that the program had not met expectations and that it should have organized a tender with banks to save taxpayer money. While potentially valid, an explanation could that banks have benefitted from easy consumer lending and therefore need a strong incentive. It is probably best to remain cautiously optimistic that more profitable agricultural loan portfolios will attract more parties and bring greater commitment to the sector.

C. Government Strategy for Finance Sector Development, Including the Securities Market

242. After the conflict with the Russian Federation in 2008 was followed by deepening global financial crisis, the government undertook a number of policy reforms in the macroeconomic and fiscal framework to assure stability in the financial sector. As a result, economic recovery became noticeable in 2010-2011 and by 2013 Georgia ranked ninth (out of 185) in the ease of doing business according to the World Bank’s annual report.

243. The institutional framework of the banking sector in Georgia is in line with international best practices and standards. The major supervision principles were introduced into Georgian banking legislation throughout 1995 and 1996. Among them, the NBG was granted the right to supervise all banks. In the banking sector, the NBG concentrates on the enforcement of Basel- III capital adequacy standards. The capital-adequacy ratio currently meets minimum Basel requirements.

244. In the legal and regulatory framework of the nonbanking sector of the securities market, the NBG’s main functions are directed at promoting securities market development, protecting the interests of investors, and ensuring that trading is transparent and fair. The NBG aims to ease the regulation since that will open new opportunities for the Georgian stock market. Thus, in 2008 the Georgian Parliament passed amendments to the Law on Securities Market, which included issuance of government securities in order to attract financing from international capital markets. In 2010, a list of foreign stock exchanges was recognized by the NBG, which meant that the gap between the regulations of local and international stock exchanges shrank and hence favored competitiveness in the Georgian financial sector.

IV. ADB SECTOR EXPERIENCE AND ADB PROGRAM

A. Summary of Experience

245. Georgia became a member of ADB in February 2007 and was classified as a Group B1 country, making it eligible for resources from the Asian Development Fund as well as ADB’s ordinary capital resources. Georgia’s current loan portfolio comprises both resources. Even though ADB has only been working with Georgia since 2007, the partnership is strong, and ADB’s country portfolio has grown rapidly.

246. The Board of Directors endorsed ADB’s Economic Report and Interim Operational Strategy in 2008. A country operations business plan for 2014–2016 for Georgia was approved in December 2013 and ADB’s first country partnership strategy for 2014-2018 for Georgia is to be approved in 2014. ADB’s assistance will continue to focus on the core area of infrastructure development (road transport, urban infrastructure and services and power). In addition, public sector lending for economic infrastructure, complemented by policy advisory and capacity development technical assistance will support government objectives of more inclusive growth and private-sector-driven employment generation.

247. ADB’s first project for the Georgian financial sector, Promoting Financial Sector Resilience, a technical assistance project approved in November 2012, focuses on risk management and supervisory capacity building. Promoting Financial Sector Growth and Service Diversity, a private-sector loan and equity project, was approved in January 2013. It considered a $50 million senior loan to help TBC Bank increase access to micro, small, and medium enterprises.

248. An emergency loan of $70 million was provided following the 2008 war with the Russian Federation and $80 million was provided in quick-disbursing financial support to mitigate the impact of the global financial crisis in 2009.87 In 2010, a loan of $100 million was provided to support the delivery of social services. It ensured continuity in maintaining critical public expenditure for social services and social protection. ADB support focused on ensuring that essential public expenditures—primarily pensions—were paid.

B. Harmonization of Activities with other Financial Institutions

249. ADB maintains close ties with development partners to improve the effectiveness, efficiency, and impact of its programs. It has regular development partner meetings and bilateral consultations with partners such as the EU, the EBRD, the European Investment Bank, the International Finance Corporation, the International Monetary Fund, the Japan International Cooperation Agency, KfW, the Swedish International Development Cooperation Agency, USAID and the World Bank. ADB also cooperates with the private sector and civil society organizations to enhance the effectiveness, impact, and sustainability of the assistance it provides.

87 ADB. 2008. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Georgia for the Emergency Assistance for Post-Conflict Recovery. Manila; ADB. 2009. Report and Recommendation of the President to the Board of Directors: Proposed Loan to Georgia for the Growth Recovery Support Program. Manila.

Appendix 1 73

Appendix 1: Current ADB and Donor Activities in Georgia (Finance and Agriculture sectors only)

Sectors and Current ADB Other Development Partners’ Strategies and/or Main Activities Themes Strategy and/or Activities Multilateral Institutions and the UN System Bilateral Sector Agriculture and Rural finance EBRD Agribusiness, market infrastructure, non- Germany (KfW) Access to machinery and grant natural resources through SME crop value chain, rural enterprise projects for farmers, land lending to private development cadastre and forest probation sector EU Capacity development, policy support for USA (USAID) SME development statistics commercial farmer cooperatives, extension services, integrated water resource banks regulatory reform, agricultural census, food management safety, agricultural education, irrigation IFAD Farmer credit, rural infrastructure, Sweden (Sida) Milk and dairy sector community-based rural development, upland area development IFC Agricultural enterprise finance Switzerland (SDC) Agriculture productivity and UN Food processing, agriculture competitiveness, vocational competitiveness policy education and training World Bank Farmer credit, rural infrastructure, community-based rural development, irrigation Public sector Financial access EU Democracy and the rule of law, human Sweden (Sida) Human rights protection management and and service rights, law enforcement, indigenous finance delivery peoples resettlement, public financial improvement management UN Regional governance reform, development US (USAID) Financial products , SME of democratic institutions, judicial and financing, housing refinancing, legislative reforms indigenous peoples resettlement IMF Public financial management, tax policy Germany (KfW) Public financial management, and administration, payments systems, indigenous peoples resettlement pension reform, national statistics World Bank Public financial management, growth, social safety nets, national population census, indigenous peoples resettlement EBRD Policy and strategy formulation,

74 Appendix 1

accounting and audit, financial sector policies and strategies, real estate finance, commercial banks, money markets, equity markets, SME finance IFC Competitiveness related policy advise Private sector Financial access EBRD Private sector investment, policy reforms, USA (USAID) Inclusive economic growth development retail-tourism investment, private equity funds EIB SME finance USA (MCC) Private enterprise development EU Agricultural cooperatives IFC Private sector investment, tax administration, SME financing World Bank Policy and technical advice on competitiveness Regional Transport EU Enhancing regional cooperation for climate Japan (JICA) Transport corridor improvement cooperation and corridor change adaptation and biodiversity integration improvement conservation EIB Transport corridor improvement USA (USAID) Cross-border trade facilitation World Bank Cross-border trade and transit, transport corridor improvement