December 2014 – January 2015

The Depreciated Currency – a Mirror of Georgia’s Economy

Georgia’s national currency, the lari(GEL), depreciated twice during last year with respect to the U.S. dollar. The first time was in January 2014 (with 7% depreciation), and the second time was in December 2014 (with 8% depreciation). At some level, instability in the exchange rate reflects problems in the economy: diminished economic growth rate, enlarged trade deficit, and decreased official USD reserves (by 5%) of the country.

The sources of Georgia’s economic problems are: 1)an increase in economic regulations (for example, a moratorium on selling land to foreigners, tightening the visa regime), 2)a high state budget deficit (more than 3% of GDP), 3)a slow down in reforms aimed at improving the business environment, 4)the expansion of state subsidies and state control over the economy.

The tightening of the visa regime, which went into force on September 1, 2014, has already influenced the number of visitors coming to Georgia. The number of visitors increased by 39% in 2011, in 2012 by 57%, in 2013 by 22%, and in 2014 just by 2%.

"One of the significant factors contributing to the stability of the national currency is GDP growth rate, declining in the last months. The economic growth rate was 5.2% in August, 4.1% in September, 3.5% in October and -0.5% in November."

The budget deficit was 3.5 % of GDP in 2014. In 2015 the deficit is predicted to be 3.7% of GDP. About half of the deficit has been accrued through domestic debt. Increased domestic debt accrual pushes up interest rates on loans. In recent years, the budget deficit has become the main source for increasing cash supply towards the end of the year. The sudden increase in the volume of national currency is then one of the main causes of the GEL’s depreciation.

According to the Doing Business index by the World Bank Group, there has been no major reforms in Georgia in the field of business for the past two years. In previous years, the number of reforms aimed at improving Georgia’s business environment was quite high. According to the study, in 2013-2014, Georgia carried out only one reform aimed at making it easier to do business in the country, whereas in 2010 there were four such reforms, four in 2011, and six in 2012.

The GEL’s depreciation has already had a negative influence on Georgia’s economy and society: 1) the high volatility of the national currency damages macroeconomic stability. 2) 60% of Georgian commercial bank loans are in dollars. Borrowers now have to buy an expensive dollar to cover their debts, and they are experiencing significant losses. 3) 74% of Georgia’s state debt is foreign debt. As a result of the GEL’s depreciation, state debt burden increased approximately by 500 million GEL (1.5 % of GDP). 4) The official reserves of the country decreased by 5% (112 million USD).

The main reason for the depreciation of the GEL is Georgia’s external trade balance, which has significantly worsened compared to the previous year. According to data by the National Statistics Office of Georgia, exports decreased by 1.6% in 2014, while imports increased by 7%. The increase in imports and reduction in exports caused Georgia’s external trade balance to worsen. The deficit is 618 million USD more in 2014 than the previous year. In total, outflow, in the process of external trade, was 5.1 billion USD more than inflow. At the same time, the reduction in the amount of USD in the country causes the GEL to depreciate.

Georgia’strade balance was deficient in the previous years as well, which means that import was higher than export. However, the outflow of USD was balanced from other sources, such as trade in services, money transfers from abroad, foreign investments, and credits.

In recent years Georgia has a positive balance in trade in services. For the first three quarters of 2014, the balance was positive at 1.1 billion USD; however, this is 47 million USD less compared to the same period of the previous year.

From January to December 2014, money transfers reduced by 36 million USD, mainly conditioned by a decrease in money transfers from Russia.

In the first three quarters of 2014, inflow of foreign investments and credits increased compared to 2013, but it did not finance the current account balance completely. As a result, the USD currency reserves of the country are decreasing. Accordingly, the demand for USD is increasing whereas the amount of USD is reduced which causes the depreciation of GEL. The National Bank of Georgia was forced to sell 80 million USD in order to stop the depreciation of the GEL.

The uneven distribution of the budget deficit month to month also has negative influence on the exchange rate of the GEL. For example, spending was not in deficit in September 2014, whilst the deficit reached 171 million GEL in October, 126 million GEL in November and 264 million GEL in December.

One of the significant factors contributing to the stability of the national currency is GDP growth rate, which has been declining during in the last months. The economic growth rate was 5.2% in August, 4.1% in September, 3.5% in October and -0.5% in November.

The main point is that the depreciation of Georgia’s national currency is mostly caused by domestic economic problems. The government will have to fundamentally change its economic policy, because the current policy oriented on regulations, state subsidies, and a larger state role in the economy does not appear to be successful.

Georgian Team in Ukraine: Reforms Amidst Stormy Waters

At the end of 2014, Ukraine appointed foreign citizens to senior administrative posts in its new government as the country struggles through a turning point of its statehood. Georgian former officials are present among the appointees, including former Deputy Minister of Internal Affairs, former Minister of Health, former Deputy Minister of Justice and the former Chairman of the Government of the Autonomous Republic of Adjara , Former Minister of Education, current members of Parliament, as well as a dozen of other former officials are involved in either informal advisory structures, or international ventures, which aim providing expertise for the reforms. Saakashvili itself, appears to be very close to president Poroshenko , who obviously listens to his advise. His recent nomination to head the international advisory board of Ukraine is a good demonstration.

"Ukraine is fighting two wars at once. One is the actual war in the East and the other is about reforms. You can’t win one without winning the other."

Bringing in Georgian officials from the Saakashvili administration reveals Ukraine’s intentions to recreate Georgia’s experience and successful reforms aimed a long-term change. Although, the results of applying these reforms yet remain to be seen, attracting the Georgian reformists, who upgraded Georgia from one of the most to one of the least corrupt countries in the world, suggests that fighting corruption is one of President Poroshenko’s key targets.. In fact a main component for successfully fighting corruption –political will- seems to be present among the current leaders of Ukraine. However, the big question is, whether the political in few select leaders in sufficient to tackle rampant corruption and to what extent is the wider political elite ready for substantial, even painful changes.

Combating corruption is unquestionably not an easy task; it does not target one sector, but instead intertwines with an array of institutions and practices. Georgia’s experience made it explicit that in the post-Soviet space, where corruption in the state institutions is notorious and visible , in reality tends to be only a tip of the massive iceberg. Bigger problem rests underneath, where the criminal mentality of the wider population and intertwined interests of oligarchs, organized crime and state institutions create an ocean problems. The problem is further aggravated in crisis-hit Ukraine, which cannot afford gradualism or poor quality reforms; the government has to be both swift and effective, reforms must be carried out immediately and eminently. Most importantly, as the time is ticking away, Ukrainians feel increased disappointment. After a year of new government in power, no one can identify a single field, where the situation has improved, or new reforms were introduced. The Government talks the talk, but whether and when they will walk the walk, remains unclear.

The impasse is further depend by extremely high stakes . The understanding that Ukraine now has a third chance, as it was clearly articulated during Munich Security Conference by many speakers is prevalent. After the missed opportunity at the dawn of the 1990s and failed orange revolution , post –Maidan Ukraine seems to be having a final third try at the European future And then there is a war. Unlike Georgia in 2003, Ukraine is taking steps at transformation in parallel to a fierce war with Russia. “One is the actual war in the East and the other is about reforms. You can’t win one without winning the other.”- this quote by Eka Zghuladze demonstrates the attitudes in the Ukrainian elite.

However, the magnitude of this task cannot be underestimated. While the costs of war are unclear, Ukrainian officials estimate that a month of war costs at least 5-6 billion USD. In 2014 Ukrainian GDO shrinked with at least 8%, while a double figure is probably more correct. Hryvna has devaluated from 8 to 1 USD, to 25 to 1 and free falling. Most alarmingly budgetary deficit is estimated to be at over 10% and state debt has rocketed to almost a trillion Hryvnas. These macroeconomic indicators, together with the war put Ukrainian economy at the verge of collapse and further increase the sensitivities associated with any painful reform, particularly in the field of anti-corruption.

image002Drawing parallels between Georgia and Ukraine is reasonable, given their common historical background, common adversary, and shared goal. Nevertheless, implementing reforms, particularly concerning the fight against corruption, is far more byzantine in Ukraine. Ukraine is almost ten times bigger than Georgia, and has much larger federal administration units. The country is heavily embedded with oligarchies, blurred and intertwined bureaucracies of social welfare programs and public services -- cozy and mighty nests of reigning corruption that have been entrenched in the country for more than twenty years, and make the process of dismantling corruption prodigiously difficult and painful. To compare, while the public services were centralized in Georgia, in Ukraine they are part of the local administrations and various ministries – Ministry of Internal Affairs and Ministry of Justice have a say. Thus, to reform the services, Government needs a larger political will than a will of one particular Minister or a small group of reformers.
Surviving the process requires reform-executors that are not only reforms-driven, but who are also entirely free of connections with local oligarchs and are not striving for local political power. The Georgian reformists -- who bring experience and vision who are experienced and motivated to offset the Soviet phantom in favor of extending democracy, overwhelmingly meet the criteria. Yet, unless the reformists are supported by the political will, courage, and public consolidation, the reforms will remain difficult.

Meantime, Ukrainian Government has already taken its first steps in the fight against corruption by pledging to establish an effective Anti-Corruption Bureau. Enacting the bureau was an important decision because it’s an independent and powerful body. However, in order to make it effective, a sufficient legislative framework has to be also adopted; these legislative initiatives have already been submitted to the parliament and the cumbersome process of selecting the head of the Bureau is underway. While several Georgian candidates have a chance of occupying the post of the Head of Bureau, the selection procedure is long and subject to public and parliamentary scrutiny. This process is a good demonstration of what could be wrong with Ukrainian reforms – while time is not on the side Kiev, any reform takes longer in Ukraine than elsewhere.

Large-scale deregulation, zero tolerance for corruption, confiscating capital obtained through corruption, introducing a plea bargaining procedure, introducing new state symbols, reducing the oversized public sector bureaucracy, and raising the salaries of public officials and civil servants-these are some of the core points of the formula to be applied in order to narrow down the possibility of corruption in practice. But these are easier said than done. Deregulation entails stepping on the interests of influential oligarchs and local administrations, confiscating capital and arresting corrupt officials seems to be a long shot, as none has yet been arrested. Reducing the oversized public sector bureaucracy is ridden with the problem of raising unemployment and further poverty – already a huge problem for a country.

Another central hallmark of the fight against corruption is police reform. In order to make citizens law-abiding, the law enforcers need to be free of corruption first. Likewise in Georgia before the Rose Revolution, the police in Ukraine are an embodiment of the corrupted Soviet militia - a heavy legacy that has to be structurally, systematically, and fundamentally changed. Few may know what an enduring task it is to increase people’s trust of a police associated with corruption and shielding the authorities, instead of guarding order and serving citizens. However, equipped with an efficacious Georgian portfolio, experience, and a sharp vision, Zguladze and team of Georgian and international reformers laid out a five-year plan to reform the Ukrainian police from head to toe. First results of this effort should be seen already in early summer 2015, as up to 10 thousand new patrol officers replace old corrupt GAI first in Kiev and then in other cities. The reform of police is obviously harder in Ukraine. Old regulations have to be changed, or scrapped, requiring a long and cumbersome procedures inside the ministries and the Parliament, often upsetting existing balance of interests among those who comfortably fed off the previous system. Another problem is that nothing can be done simultaneously in the whole Ukraine. Some reforms, like the police reform will need to be piloted in Kiev, and then replicated elsewhere, stretching the patience of the population even further. However, as the first fruits of reforms become visible, public support will hopefully increase.

Ongoing police reform in Ukraine shows that there is no lack of socially motivated citizens, who have applied in massive numbers for a relatively low-paid jobs of a policeman, and who will have to replace 80 % of the current police force in the next 5 years. Transparent and competitive recruitment procedures have already been introduced in police, which could potentially lay ground for the creation of the modern law enforcement free of Soviet symbols.

Ukraine is fighting a decisive battle, and the success of reforms is the major lever for it to survive. Compared to 2008, when Russia swathed Georgia in a full-flagged war to stop its Euro-Atlantic integration, today, Russia is almost “all in”- in Ukraine, to use poker terminology. Winning in Ukraine is a gateway to winning over the whole Eastern partnership region and reviving the archaic concept of the spheres of influence for Putin. The equation is pretty much the same for Europe- Making Ukraine a success story, along with Georgia, sets example for other states in the region, including for Russian Republic too, expands the circle of democracies around Russia, and hence strengthens security and stability of the region and Europe. It is clear why Georgia should be actively engaged in supporting Ukraine in implementing effective reforms and in reinforcing democracy building.

European Energy Community and Georgia’s Political Uncertainty About Its Membership

Georgia recently signed an Association Agreement (AA), which implies the harmonization of the internal legislation with the EU laws in different sectors. While it demonstrates Georgia’s European aspirations, AA provides a framework for new relationships and sets out the requirements for Georgia to comply with EU regulations. As a result, Georgia, as a transit country in the South Caucasus region, seeks enhanced energy relations and cooperates with EU in the framework of the Energy Community Treaty.

In 2007 Georgia was granted the status of “observer” in the Energy Community. Negotiations over intensified energy cooperation between Georgia and the EU resulted in Georgia’s effort to become the member of the Community. In 2013 Georgia officially applied for membership. Discussions over membership started successfully and by now two rounds of negotiations have been held. However, despite successful negotiations, Georgian energy sector faces important challenges.

Precondition of Georgia’s full membership implies harmonization of EU regulations and directives. Implementation of the Directive implies deregulation of the electricity market for creating more transparent and free market.

Over the past years, the Georgian electricity sector partially has undergone the process of deregulation. For example, the state-owned Electricity Company has been unbundled into generation, transmission and distribution companies. However, much remains to be done both in the legal and regulatory and market structure areas to stimulate competition in the market. According to the Electricity Directive, in the absence of effective unbundling there is a risk of discrimination among market participants, which violates costumers’ right to choose their suppliers without legal restrictions. Today, the level of unbundling is not sufficient in Georgia. Third party access and market opening are other primary requirements of the Electricity Directive.

As for the natural gas sector, which is the most actively used energy resource in Georgia, Georgia faces important challenges. Georgia does not have oil and gas reserves and imports about two thirds of the primary energy supply to satisfy its local demand. Almost all natural gas is imported from Azerbaijan (90% of supplies) and Russia (10% of supplies). As a result, dependency on imports from a small group of suppliers hinders competitive natural gas development. According to the Directives, Energy Community member states are obliged to ensure provision of real choice for consumers, competitive gas prices, higher standards of service and security of supply.

Community Directives also regulate energy efficiency and renewable energy usage. In terms of energy efficiency, the key requirement for member states is to develop National Energy Efficiency Action Plan (NEEAP), which means to develop a long term strategy for renovation of buildings. Most of the buildings in Georgia were built during the Soviet era and demonstrate very low energy efficiency levels. Currently, Georgian legislation does not cover any energy efficiency regulation.

As for the development of renewable energy, the key requirement implies establishing binding targets in order to increase the share of renewables in energy consumption. However, Georgian energy legislation does not incorporate any regulation on renewable energy.
What makes Georgia a unique case to study for the Community?

The major change Georgia should make is to diversify its suppliers and create a more liberal energy sector, which will prevent monopolistic activities. But peculiarities of the Georgian energy sector, resulting from the country’s geographical location, need to be addressed. Full implementation of Community Directives will have significant social and political effects in Georgia.

The key challenge to the Georgian electricity sector is the impact of price liberalization for households stemming from market openness. Nowadays, the Georgian electricity sector is characterized by subsidized prices, which allows the government to set relatively low prices for electricity (compared to EU member states). After switching to the new market model, the government will no longer be able to regulate prices, which will significantly increase the electricity price. Increased prices will have momentous effects on vulnerable customers, while keeping in mind the absence of a social package that integrates target subsidies.

Speaking about the huge social effect of the membership, another important political impact is the Government’s readiness to abandon its initial pre-election promises. The new Government of Georgia (elected in 2012) had a socially-oriented political agenda. Decreased electricity and natural gas prices were among the top priorities of the newly elected government. While the social support was significantly affected by the price manipulation from the Coalition of Georgian Dream, it might be very painful for the Coalition to provide a politically justified argument of the membership that will explain increased prices.

In terms of diversifying suppliers, the most sensitive sector for Georgia is that of natural gas. In order to diversify suppliers in this sector, which is a cornerstone of the Community requirements, Georgia is in a disadvantaged position – it has limited suppliers (Azerbaijan and Russia ) and geographical location does not serve as a favorable factor.

Another important issue that needs to be addressed is geographical difficulties. Among Community members there are two countries from the former Soviet Union: Ukraine and Moldova (joined the Community in 2011 and 2010 respectively). Compared to these countries, having direct geographical links to European states, Georgia is excluded from the EU market, which serves as a barrier for Georgia to establish direct connections with European countries. For Ukraine and Moldova joining the EnC was a relatively painless process geographically, but in terms of progress in the energy sector they could not meet the Community requirements after all. The deadline for implementing most of measures of EnC has passed. Even though Georgia might be further ahead than Ukraine or Moldova in terms of energy market development (namely electricity sector), geographical location is an important drawback for Georgia to meet all requirements of the third energy package.

Another important factor that deserves to be addressed is Russia’s attitude towards the Community and its members. When Moldova was joining the Energy Community, Russia tried to use gas as a means of manipulation over Moldova’s decision to join the Energy Community. Russia offered the low-priced gas to Moldova instead of choosing European energy liberalization measures. While the share of Russian energy is significant in Georgia, Russia’s intention to influence post soviet countries and their decision to detach their economy from Russian needs to be addressed as an external factor.

Overcoming these challenges and ensuring successful implementation of AA, including in the energy sector, should be mutual interest of Georgia and the EU. Considering the geopolitical context the stakes of its success are high for both Georgia and the EU. Georgian government should elaborate a transitional plan which would minimize social impact of the changes.

On the other hand, EU should consider being more flexible in granting possible derogations to cooperate with the Georgian government and support Georgia’s successful implementation of the transitional plan.