IMF posted a Staff Concluding Statement of the 2021 Article IV Mission, which BMG offers
The COVID-19 crisis took a heavy toll on Georgia’s economy, although substantial support measures helped protect vulnerable households and businesses. Recently the economic recovery has gained impressive momentum. Significant downside risks remain, however, with the potential for adverse COVID-19 developments the most acute.
In addition to the overarching priority of controlling the pandemic, policies should be geared towards securing macroeconomic stability and a durable and inclusive recovery. As the recovery proceeds, fiscal policy should shift toward unwinding crisis support measures and reducing the deficit and debt, anchored by the fiscal rule. Over time the authorities should seek to expand fiscal space and further strengthen fiscal frameworks.
The National Bank of Georgia (NBG) should remain vigilant against signs that high inflation driven by temporary factors is becoming entrenched and increase rates if needed. Although the financial sector remains resilient in the aftermath of the crisis, continued caution is warranted including by seeking to preserve sufficient retained earnings until the recovery is more certain. Structural reforms remain vital to secure sustainable and inclusive growth.
Recent Developments and Outlook
1. The COVID-19 crisis took a heavy toll on the economy. Domestic mobility restrictions necessary to control the pandemic and a slowdown in tourism drove the largest output contraction since the 1990s with the economy shrinking by 6.2 percent in 2020 and 4.5 percent in the first quarter of 2021. Poverty and unemployment also rose, undoing much of the progress of recent years. The authorities appropriately responded by strengthening healthcare and providing substantial assistance to vulnerable households and businesses, aided by sizeable donor support. Although still elevated, COVID-19 case numbers are well below their peak and most restrictions have been removed.
2. The recovery has recently gained impressive momentum. Monthly estimates suggest a strong rebound in the second quarter of 2021 with growth now expected to reach 7.7 percent for the year, a significant upgrade from just a few months ago, which implies that output will exceed its 2019 level this year. Robust growth in remittances and exports, and early signs of a faster than expected rebound in tourism have supported the recovery and should contribute to a narrowing of the current account deficit compared to its elevated 2020 level. Inflation accelerated to 9.9 percent year-on-year in June, largely reflecting utility price increases, higher commodity prices, and elevated input costs. High inflation is expected through the end of the year, before declining rapidly in 2022 as these temporary effects fade.
3. Significant downside risks remain and contribute to an outlook that is more uncertain than usual. The authorities have made commendable progress in securing vaccine supplies, but more will be needed, and vaccinations have to accelerate substantially to ensure that more than half of the population is vaccinated by the end of the year. New COVID-19 variants or vaccination delays could derail the recovery by requiring new lockdowns and reducing external demand, underscoring the paramount importance of controlling the pandemic. Renewed political uncertainty could increase lari volatility and undermine investment and confidence. These risks could exacerbate underlying vulnerabilities including high dollarization and foreign currency-denominated debt.
4. As the recovery proceeds, the focus of fiscal policy should shift toward unwinding crisis support measures and bringing down the deficit and debt.
The pandemic naturally led to sharp rises in the fiscal deficit and debt as the government provided support to businesses and households, and as revenues declined. Georgia’s fiscal rule has been an essential anchor and source of policy credibility, and the authorities’ strong commitment to the fiscal rule is welcome.
The faster than expected economic recovery has substantially improved the revenue outlook for 2021. In the planned supplementary budget, new revenues will largely finance additional healthcare costs as well as capital and other spending. Saving more of these revenues would help speed progress on the fiscal consolidation required to comply with the fiscal rule by 2023 and provide a buffer against risks.
Accordingly, further revenue windfalls should be saved. The eventual unwinding of COVID-19 support measures as the pandemic recedes will help shrink the deficit, but additional adjustment will still be needed. Faster deficit reduction in the 2022 budget would better balance over the next two years the need for new revenue or saving measures.
5. Rising spending pressures and fiscal risks call for efforts to e xpand fiscal space and further strengthen the fiscal framework.
Ambitious capital spending plans to upgrade infrastructure and address development needs; rising current spending pressures, including for education, pension, and health outlays, along with fiscal risks stemming from state owned enterprises (SOEs) and power purchase agreements could further increase the adjustment needs outlined above and add to medium-term fiscal policy challenges.
Strengthening the public investment management framework would help boost the efficiency of capital spending and maximize growth benefits. To contain fiscal risks in the power sector, clear criteria should be specified in advance for any deviations from the feed-in premium scheme. Additional revenue could be generated by undertaking a comprehensive review of tax expenditures and further strengthening tax administration. Building on the detailed analysis in successive Fiscal Risk Statements, the authorities should continue to advance efforts to manage and mitigate risks. Comprehensive reform of SOE governance will be essential to achieve these goals.
6. Monetary policy should guard against temporarily high inflation becoming entrenched.
The mission welcomes the NBG’s appropriate increases in the monetary policy rate in March and April to help ensure that the temporary effects of commodity price increases and supply constraints remain transient and that inflation expectations stay anchored around the 3 percent target. With recovery now faster than expected, risks to inflation are tilted to the upside, and the NBG should be ready to promptly hike rates further if inflation expectations or core inflation suggest high inflation risks becoming entrenched.
Overall, the inflation targeting framework and floating exchange rate regime have helped Georgia adjust to the COVID-19 shock and remain appropriate. Considering risks, including due to financial dollarization, the NBG should continue prudent use of foreign exchange interventions to prevent disorderly market conditions. The recent introduction of differentiated reserve requirements on foreign exchange liabilities of banks could be a useful step to reduce deposit dollarization.
Financial Sector Policies
7. The NBG’s prudent supervisory approach before the COVID-19 crisis and decisive actions afterwards contributed to the resilience of the financial sector.
Significant steps in recent years include upgrading banks’ prudential requirements in line with the Basel III framework; introducing responsible lending regulations; and comprehensive measures to address foreign exchange-related financial stability risks, which have helped to reduce dollarization in banks over time.
Fiscal support measures to households and businesses have helped cushion the impact of the pandemic on the financial sector. The NBG expanded liquidity provision, required banks to take significant up-front general provisions against potential loan losses at an early stage, and temporarily eased some capital requirements.
8. The banking system remains adequately capitalized and liquid.
Stress tests conducted in the recent Financial Sector Assessment Program (FSAP) mission confirmed that banks have sufficient capital to absorb credit losses stemming from the pandemic under a conservative baseline scenario over the next three years. Under the stress scenario of an extended pandemic and an adverse external financial environment, capital shortfalls are not deemed substantial and assessed to be manageable from a systemic perspective. The FSAP also found that banks are sufficiently liquid, including in a stressed scenario of high deposit withdrawals.
9. Financial sector policies should now aim to maintain adequate buffers and provisions in the banking sector, amidst signs of recovery.
Given the larger than usual uncertainty about the outlook, the NBG should ask banks to preserve sufficient retained earnings until significant downside risks to the economy recede. Identifying effective ways to resolve non-performing loans remains important, even though they appear to be falling from a peak of 8.5 percent in March 2021 and have been significantly provisioned.
The FSAP suggested medium-term priorities for financial sector policies including implementing Basel regulations on banks’ large exposures as planned; formalizing and enhancing supervisory processes; developing a prompt corrective action framework for banks; and taking steps to be able to swiftly implement a bridge bank if needed.
10. Reinvigorating the structural reform agenda is vital to enhancing economic growth and making it more inclusive.
Bringing the pandemic under control offers an opportunity to advance on key structural measures. Implementation of the recently adopted insolvency framework and training of insolvency professionals will help facilitate resource reallocation in the wake of the crisis. High unemployment levels and the associated inequality are longstanding challenges for Georgia, and these have been exacerbated by the impact of COVID-19.
Renewed efforts to improve education and vocational training would help address skills mismatches in the labor market, and the authorities’ planned review of the social protection system could complement these actions with strengthened active labor market policies aimed at tackling entrenched unemployment. Finally, judiciary reform will be an important step to further strengthen the business environment.
The mission would like to thank the authorities for their close collaboration and candid and informative discussions.