Sector update Economics Research 21 December 2016 Economics & Politics Georgia Oleg Kouzmin +7 (495) 258-7770 x 4506 Georgia [email protected] Charles Robertson Has the lari reached the bottom? +44 (207) 005-7835 [email protected] On our estimates, the Georgian lari is now undervalued by 7% (vs our GEL2.55/$ fair value), which is close to the largest gap Figure 1: GEL/$ and TRY/$ seen in the past few years. We would maintain GEL2.50/$ as our USDGEL USDTRY end-2017 target if the Turkish lira stabilises. However, if the lira 4 continues to perform badly, our risk-case estimate of GEL2.75/$ would become the new sustainable level for the lari, in our view. 3.5 3 Georgian currency surprised the market on the weaker side… 2.5 The lari has depreciated by 14% since the start of November and by 8% to date in 2 December. In our recent update on Georgia, we flagged GEL2.50/$ as our base-case end-2017 forecast, but noted that in a risk case of significant Turkish lira or 1.5 Jan-14 Sep-14 May-15 Jan-16 Sep-16 Azerbaijani manat weakness it could reach GEL2.75/$. The lari has reached this level much earlier than we suggested. We see several reasons for the recent weakness. Source: Bloomberg …due to Turkish lira sell-off and unfavourable seasonality… Figure 2: Georgian trade balance The underlying reason for the Georgian currency move was a significant sell-off in Trade balance, $bn (rhs) the Turkish lira, in our view. Turkey is Georgia’s main trading partner, responsible for Exports growth, % YoY 17% of total trade turnover in 9M16 (Figure 5). Lira weakness therefore makes the Imports growth, YoY 80% 0 lari’s fair value weaker. Another reason is unfavourable seasonality, with a lower 60% number of tourists visiting Georgia at this time of year and higher imports of natural -100 gas and electricity compared with the summer months (Figure 2). 40% -200 20% …as well as depreciation expectations and one-offs 0% -300 -20% However, important one-offs – including higher oil imports and deprecation -400 -40% expectations – have also played a role. First, in early December, the government -500 announced a rise in excise tax on oil products from 1 January. As a result, businesses -60% have been trying to import as much oil as possible and the public has been stockpiling -80% -600 2012 2013 2014 2015 2016 oil products on the assumption that petrol prices could pick up next year – leading to Source: NBG, Renaissance Capital higher imports. Second, the lari suffers from depreciation expectations and higher demand for dollars among the Georgian public. Local observers see no signs of large- scale panic or extensive conversion of savings into dollars, but households are Figure 3: Georgian NEER, 1 Jan 2014 = 100 exhibiting the same behaviour seen during previous lari depreciations. -10% -8% The lari may have reached its bottom – if the lira stabilises Overvalued -6% Our nominal effective exchange rate (NEER) model indicates that the lari is now -4% -2% undervalued by c. 7% (Figure 3). This is close to the largest gaps seen between the 0% NEER and the spot exchange rate in the past two years (on this metric, the lari has 2% never been over- or undervalued by more than 8%). We treat this as a sign that lari 4% weakness could be close to its peak and could therefore be reversed soon. However, Undervalued 6% as we highlighted previously, stabilisation of the Turkish lira is likely to be the main 8% prerequisite – if the lira continues to weaken, the lari’s fair value would automatically Jul-15 Jul-16 follow. If the lari stabilises closer to GEL2.75/$, we believe it could be tough for Jul-14 Apr-14 Oct-14 Apr-15 Oct-15 Apr-16 Oct-16 Jan-15 Jan-16 Jan-14 Georgia to avoid a sovereign rating downgrade. However, we believe that: 1) Georgia Source: NBG, Bloomberg, Renaissance Capital would not move from one rating grade category to another; and 2) there are few global fixed income investors in Georgia who would become nervous on such a move. Important disclosures are found at the Disclosures Appendix. Communicated by Renaissance Securities (Cyprus) Limited, regulated by the Cyprus Securities & Exchange Commission, which together with non-US affiliates operates outside of the USA under the brand name of Renaissance Capital. Renaissance Capital 21 December 2016 Georgian lari Central bank has intervened both verbally and by its actions On 20 December 2016, the National Bank of Georgia (NBG) said that the lari had depreciated by more than fundamentals indicated was necessary, and confirmed that it was ready to apply the necessary tools to cool down inflation and depreciation expectations. Later the same day, the NBG said it had sold $40mn from international reserves. The wording of the statement also suggested, in our view, possible rate hikes if necessary (for now, we assume no more cuts in the next nine months, with the 6.5% policy rate on hold at least until 4Q17, with inflation still running at 0.2% YoY – i.e. well below the 4% target for next year). Exchange-rate regime – truly free-floating Overall, the NBG’s FX policy remains prudent and orthodox, in our view, with a floating exchange-rate regime. The NBG follows a flexible exchange-rate regime, using only limited FX interventions to tame excessive currency volatility that is not attributable to fundamental factors. Many central banks claim to pursue this approach, but we believe the Georgian FX policy regime is indeed very close to a free float. First, the NBG clearly understands that there is no need to keep the currency overvalued, which would obviously hurt Georgia’s economic model of acting as a regional logistics, trade and services hub. Second, if the Georgian lari moves in line with the currencies of the country’s main trading partners, the pass-through impact on inflation is likely to remain limited thanks to only limited changes in the NEER. Third, the NBG simply does not have sufficient reserves ($2.8bn, or four months of imports cover) to carry out heavy intervention in the FX market. In addition, the NBG is not using any non-conventional measures to influence the exchange rate, such as a lari liquidity squeeze. Figure 4 shows that the overnight money market rate this year has remained close to the NBG policy rate (and, obviously, within the NBG’s interest rate corridor), although it did increase slightly on 19 December. Figure 4: NBG interest rate corridor The NBG policy rate The rate on o/n stand-by refinancing operations The stand-by deposit rate Interbank market O/N rate (TIBR) 10 8 6 4 2 Jan-15 May-15 Sep-15 Jan-16 May-16 Sep-16 Source: NBG Meanwhile, the budget framework looks good The final budget for 2017 was approved as law on 14 December. The budget targets a 4.1% of GDP deficit, which we treat as a positive sign (i.e. lower than the 4.5% of GDP threshold previously discussed with the IMF). The main difference is that the authorities have also decided to hike excise tax on oil, which helped to ease the headline deficit and provide some room for manoeuvre, but possibly lifted imports and contributed to lari 2 Renaissance Capital 21 December 2016 Georgian lari depreciation. Other austerity measures, compensating for an easing of tax on corporate profits and higher infrastructure spending, included higher excise taxes on tobacco and imported cars; higher taxes for gambling; a reduction in salary financing for government subordinate organisations and other administrative expenses by 10%; and a number of social spending optimisation measures. Figure 5: Georgian total trade turnover in 9M16 (excluding imports of hepatitis C medication financed directly by the USAID programme) Turkey 17% Others 36% Russia 9% China 8% Azerbaijan USA 6% 3% Italy Germany 4% Ukraine 5% Bulgaria 5% 3% Armenia 4% Source: NBG, Renaissance Capital 3 Renaissance Capital Disclosures appendix 21 December 2016 Georgian lari Analysts certification This research report has been prepared by the research analyst(s), whose name(s) appear(s) on the front page of this document, to provide background information about the issuer or issuers (collectively, the “Issuer”) and the securities and markets that are the subject matter of this report. Each research analyst hereby certifies that with respect to the Issuer and such securities and markets, this document has been produced independently of the Issuer and all the views expressed in this document accurately reflect his or her personal views about the Issuer and any and all of such securities and markets. 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