GEORGIA Sub-regional Innovation Policy Outlook 2020: Eastern Europe and the South Caucasus Chapter I ECONOMIC OVERVIEW General overview Georgia is a small, upper-middle-income country in the South Caucasus, connecting Europe to the Middle East and Central Asia. Since independence in 1991, the ensuing civil war and territorial disputes have made the transition to a market economy particularly challenging. Even so, Georgia is now one of the most open and easiest places to do business in the sub-region, with sustained albeit volatile growth. To continue to sustain growth and benefit from its manifold opportunities, however, Georgia needs to make better and systematic use of its potential, moving from a model of filling essential gaps to one based on broader experimentation with new and better ideas, business models, technology and governance arrangements. Reform process The radical improvement in Georgia stems from a series of far-reaching reforms. Following the Rose Revolution in 2003, structural changes in the institutional and legislative frameworks radically reduced petty corruption and improved the efficiency of government. Trade liberalization, including a range of free trade agreements, secured access to a diverse set of markets. Reforms of public financial management are under way, including the recently developed fiscal framework, changes in civil service pay and a transition to compulsory savings for retirement. As a result, Georgia has moved up quickly in the Ease of Doing Business ranking of the World Bank (2020a), reaching seventh place globally for regulatory performance. Although several efforts are under way, such as more investment into infrastructure, education and administration, further reforms are needed to restructure, diversify and increase the productivity of the economy. GDP growth Since 2007 Georgia has maintained robust growth in GDP, at an average annual rate of 5.1 per cent (figure I.1), driven by enhanced productivity resulting from structural reallocation, high government spending and strong inflows from abroad (EBRD, 2018). As a result of reforms, gross domestic product (GDP) per capita in current U.S. dollars has increased from $2,800 in 2009 to $4,770 in 2019, while GDP per capita based on purchasing power parity (PPP) in current international US dollars has doubled, reaching $15,636 in 2019 (World Bank, 2020b). The economy has demonstrated resilience in the face of external 228 Georgia Chapter I Economic overview shocks during this period: the global financial Figure I.1 · Annual GDP growth, crisis, territorial conflictsand now plummeting 1990–2019 (Per cent) commodity prices. As the gains of the first wave of structural reforms have 20 been realized, however, productivity has declined. Looking at the time trends of different elements 10 of GDP, it is evident that capital formation has contributed the most to GDP in recent years, reaching 0 almost 27 per cent in 2019. Continued growth relies more and more on accumulating capital in non- -10 tradables, which drives up asset prices while failing to diversify the economy. The economy depends -20 increasingly on remittances, which exceeded 12 per cent of GDP in 2019, exposing it again to external -30 shocks, causing instability and driving consumption rather than investment. -40 Domestic demand drives the economy. Government spending has been over 25 per cent of GDP since -50 1990 1995 2000 2005 2010 2015 2019 2010, and a recent flourishing of social spending has helped keep the percentage that high. Georgia EESC sub-regional average* Upper-middle-income group The current account deficit of 5 per cent of GDP in 2019 exposed the economy even more to external Source: UNECE, based on data from the World Bank (2020b). shocks and it is expected to increase following *Missing values for Armenia, Azerbaijan and Belarus (1990), as well as the Republic of Moldova (1990–1995). the impact of the COVID pandemic.1 As a result, fiscal space has become ever more constrained. Despite attaining upper-middle-income status, Georgia is still far from achieving broad-based prosperity at the frontier of economic performance, given the overly generous and broad tax exemptions, the inefficiency of State-owned enterprises and the lack of constraints on social spending, all of which impede sustainable economic growth. Foreign direct investment Foreign direct investment (FDI) remains a key source of external financing for Georgia, with net inflows reaching 7.2 per cent in 2019, above levels seen elsewhere in the sub-region, for instance in the Russian Federation and Turkey. Three factors threaten its sustainability. First, as is evident from the 5-percentage point drop in 2018 (from 12 per cent in 2017), most current investment is market- and resource-seeking rather than efficiency-seeking, and thus easily affected by business cycles. An example of one of the most profitable resource-seeking investments made is the South Caucasus Pipeline Expansion Project implemented in 2014–2019. Second, weak support mechanisms, such as underdeveloped value chains and the lack of regulatory transparency, impede foreign investment. Third, access to financing is low and the costs are high, especially for long-term investment, and the banking sector is highly concentrated, further deepening the economy’s microeconomic vulnerabilities (World Bank, 2018a). 229 Sub-regional Innovation Policy Outlook 2020: Eastern Europe and the South Caucasus Sectoral decomposition A sectoral decomposition reveals that services and industry are strong whereas manufacturing and agriculture are in decline. Services accounted for about 60 per cent of GDP in 2019, but most industries have low productivity and cater largely to domestic demand. The large tourism and hospitality industries operate below potential. Manufacturing remains predominantly resource-based (57.7 per cent), with only modest shares of low- and high-tech production. Demographics One long-term impediment to economic growth is the dwindling population. With a constant zero rate of population growth and high net outmigration, the labour force continues to shrink (Geostat, 2019). As the pool of talent declines, economic dualism – large differences in productivity among sectors and regions – poses another threat to productivity-driven growth. Although the unemployment rate stood at 14.4 per cent in 2019 (a modelled estimate from the International Labour Organization), the urban-rural divide entrenches inequality and the large agriculture sector remains underdeveloped. External position Despite the sectoral risks, Georgia’s strategic geographic position and economic openness will boost commerce, especially through the Deep and Comprehensive Free Trade Agreement (DCFTA) with the European Union (EU) and the more recent free trade agreement with China. The recovery of demand from key trading partners has lifted exports and strengthened workers’ remittances (WTO, 2018). Services exports have skyrocketed in recent years. Merchandise exports have also grown, reaching levels significantly higher than those of Georgia’s peers, with the sum of exports and imports constituting 121 per cent of GDP in 2018 – far above the regional average. Several impending megaprojects, such as the Anaklia Deep-Sea Port and Special Economic Zone (box I.1) and the Trans-Caspian International Transport Route, aim to further expand trade and solidify the country’s position as a logistics hub, with alternative modes of cargo transport from Europe to China and Central Asia and a range of opportunities and spillover effects. Despite the potential for diversification, Georgia’s current export basket remains vulnerable to external fluctuations in commodity markets – and limited in terms of potential for capacity accumulation and diversification. The index of merchandise concentration for exports in Georgia was 0.21 in 2018, which indicates that, with values ranging from 0 (diversified) to 1 (concentrated), the country’s exports in merchandise were only the fourth most diversified in the EESC sub-region, after Belarus (0.18), the Republic of Moldova (0.19) and Ukraine (0.14) (UNCTADstat, 2020a). Most of Georgia’s exports are of low-margin commodities as the country is a leading exporter of ores and metals – products for which its revealed comparative advantage (RCA)2 is strongest – 230 Georgia Chapter I Economic overview followed by beverages, animal stock and fertilizers (OEC, 2020; UNCTAD, 2020b). Nonetheless, to ensure sustainable diversification of exports and mitigate the country’s vulnerability to external competition, Georgia can capitalize on its potential for diversification by experimenting more systematically with opportunities that increase both the sophistication and the diversification of tradables. The 2020 Competitive Industrial Performance (CIP) Index shows that industry in Georgia (ranked 96th out of 152 economies) outperforms that in neighbouring Armenia (103rd) and Azerbaijan (120th) (UNIDO, 2020). The 2019 Global Competitiveness Index (GCI) ranked Georgia 74th among 141 economies, a decline from the previous year (66th), and identified as strengths its labour market (37th), institutions (43rd), human capital skills (46th) and business dynamism (58th) (WEF, 2019). Box I.1 Anaklia Deep-Water Black Sea Port Strategically located as a key transit port on the trade route connecting Europe with China (as a part of the Belt and Road Initiative), the Anaklia Deep-Water Black Sea Port is Georgia’s largest infrastructure project. A range of plans are in the works for adjacent