THE GEORGIAN ECONOMY LOOKS FORWARD TO A YEAR OF

UNCLAS SECTION 01 OF 03 TBILISI 000652 SIPDIS SENSITIVE SIPDIS STATE FOR EUR/CARC AND EB/IFD/OMA COMMERCE FOR 4231 DANICA STARKS TREASURY FOR OIA E.O. 12958: N/A TAGS: ECON PGOV GG SUBJECT: THE GEORGIAN ECONOMY LOOKS FORWARD TO A YEAR OF GROWTH IN 2007 ¶1. (U) This telegram is sensitive but unclassified. Not for Internet distribution. ¶2. (SBU) Summary: Georgia's economy overcame Russian sanctions and grew 9.3 percent in 2006. Growth is expected to continue at a 7-8 percent rate in 2007. Prospects for increased foreign direct investment are good. Exports and tourism receipts grew in 2006 and similar results in 2007, along with investment, would help to keep the economy on track despite a large trade deficit. The main threat to macroeconomic stability is inflation, which reached 11 percent annualized in February 2007. However, the GOG has promised the IMF to maintain fiscal discipline, reduce the growth of the money supply and take a more relaxed approach to the trend of appreciation of the lari. End Summary. GROWTH DESPITE RUSSIAN SANCTIONS -------------- ¶3. (SBU) Georgia has entered 2007 with a realistic chance for growth, macroeconomic stability, a stepped up pace of investment and concomitant job creation -- if it can implement the right mix of policies. Although a thaw in Russian-Georgian relations is not clearly in the offing, the Russian government reportedly is beginning to recognize what the IMF and others in Georgia have been saying for the past few months: Russian sanctions didn't cripple the Georgian economy as much as the Kremlin hoped, and in fact, they opened Georgia's eyes to new markets for its traditional products. Moreover, if it is true that bad news is better than no news at all, worldwide publicity generated by the Russian sanctions on Georgia may have helped to bring the country's three year old westward orientation and accelerated reform program to the attention of foreign investors. ¶4. (SBU) Investors seem poised to act. For the past few years, Georgia's FDI statistics have been buoyed by investment in the Baku-Tbilisi-Ceyhan and Shah Deniz pipelines, and by privatization of many large state-owned enterprises. With the pipelines' completion in early 2006, and the list of major unprivatized state companies rapidly growing shorter, the flow of investment seemed to be about to dry up. However, in 2006, despite these changes, Georgia received an estimated USD861 million in FDI, 63 percent more than in 2005. The government has been citing an even higher figure, USD1.2 billion, in spite of the fact that the USD400 million sale of UEDC and some hydroelectric plants have been delayed into 2007. In the course of their review of Georgia's IMF program, IMF officials interviewed the most important investors identified by the GOG as having plans to invest in 2007. The IMF found their plans to be firm. It is conceivable that Georgia may receive up to another USD1.7 billion in investment in 2007. ¶5. (SBU) Once official figures are out, the 2006 real growth rate of the Georgian economy may be as high as 9.3 percent, in spite of Russia's embargo on Georgian exports and transport. In fact, Georgian exports increased by 14.7 percent percent in 2006. Its most important export was still iron and copper scrap metal. Along with strong growth comes strong demand for imports, especially as the lari strengthened by 4.5 percent against the dollar over 2006, even with a certain amount of National Bank of Georgia intervention to control appreciation. Imports of energy were more expensive and pushed up import figures, with the cost of natural gas doubling in 2006 and doubling again at the outset of 2007. As a result, oil and gas imports increased by 118 percent and the trade deficit by 65 percent in 2006 over ¶2005. Tourism receipts, especially from Armenians visiting the Georgian coast, helped to offset the increase in imports. The National Bank of Georgia's foreign currency reserves nearly doubled from the end of 2005 to the end of 2006. In March 2007 the NBG announced reserves had exceeded USD1 billion for the first time, sufficient to cover more than 3 months of imports. Turkey replaced Russia as Georgia's largest export market, with Azerbaijan not far behind. That imports from Russia grew is not surprising in light of increased natural gas prices, but imports from Turkey jumped 85 percent in one year, reflecting a significant redirection of trade in goods to Georgia's neighbor to the Southwest. ¶6. (SBU) The GDP growth figures are encouraging, even if to a certain extent they are based on continuing legalization of the informal economy that was prominent under the former regime. Construction is booming and is far and away the TBILISI 00000652 002 OF 003 largest component of GDP growth. Significant growth is also occurring in financial intermediation, trade and mining. Labor productivity is increasing and helping to push economic growth upward. Agricultural production, which constituted 11.7 percent of Georgia's GDP, contracted in 2006 due to drought that caused poor harvests. ¶7. (SBU) The financial sector saw significant growth over the year 2006. The French bank Societe Generale purchased a controlling share of Bank Republic, and NBG officials have told us that another major European bank is about to enter the market. The issuance of shares on the London Stock Exchange by the Bank of Georgia is another sign of growth. The assets of commercial banks increased by 58 percent from January 2006 to January 2007. Because of the increased tempo of lending, the quality of the banks' debt portfolios bears watching. However, the overall state of the financial sector is generally judged to be good. The percentage of commercial banks' classified debts was 6.4 percent in the third quarter of 2006. Although deposits and lending are strongly dollarized (91 percent of individuals' bank accounts are in foreign currency, mainly dollars) the growth rate of loans in Georgian lari was greater than that of foreign currency loans. Interest rates on loans in the national currency are about 20 percent and 16-18 percent on foreign currency loans. THE INFLATION CHALLENGE -------------- ¶8. (SBU) With food constituting a major portion of the basket of goods measured for changes in the Consumer Price Index, the poor harvest in 2006 had some effect on inflation, along with increases in energy prices. In August 2006, the 12-month change in the CPI peaked at 14.52 percent, up from 5-6 percent six months earlier. By the end of 2006, inflation had subsided somewhat, resulting in a year-end inflation figure of 8.9 percent. However, with inflows of foreign investment, and new increases in the cost of food, inflation again ticked up in the beginning of 2007, to 10.4 percent year on year in January and 11 percent in February. A revision of the the consumer basket on which the CPI is calculated also affected the inflation statistic significantly. The Georgian Department of Statistics says that monthly inflation would have been 1.9 percent rather than 2.7 percent in January under the old formula. February 2007 month-to-month inflation was 0.72 percent. ¶9. (SBU) The degree to which government policies are contributing to inflation is a bone of contention between the government and the IMF. Clearly, NBG interventions to purchase foreign currency, aimed at keeping the value of the lari from appreciating too strongly, add to the money supply and influence the rise in consumer prices. The national bank's decision to reinstate reserve requirements for commercial banks and to issue its own deposit certificates helped to calm inflation in 2006. Stronger action by the NBG, including increasing reserve requirements and utilizing more effective sales of government securities, along with a more flexible attitude toward the value of the lari, will be necessary to quell inflationary pressures in 2007. The IMF says the government will have to do its part by maintaining strict fiscal discipline. ¶10. (SBU) The government's fiscal stance is a continuous compromise between Georgia's pressing need for infrastructure and social spending and the goal of macroeconomic stability. Government spending added significantly to growth in 2006. While revenues increased 33 percent, expenditures increased 39 percent. The government's deficit in 2006 was 2.9 percent of GDP. With the IMF still having a strong influence under its current Poverty Reduction and Growth Facility, the government somewhat reined in its spending toward the end of the year, which helped to reduce inflationary pressures. The goal for 2007 is a slightly lower deficit, at 2.5 percent of GDP. The government's total debt at the end of 2006 was about 29 percent of 2006 GDP, of which 62 percent is held by foreign creditors. Debt service is 2.2 percent of consolidated expenditures. THE CONTINUING PROBLEM OF UNEMPLOYMENT -------------- ¶11. (SBU) Unemployment remains high in Georgia, around 13.7 percent. The total number of employed people has been TBILISI 00000652 003 OF 003 steadily declining since 2000, while the percentage of that group in self-employment has increased. In the third quarter of 2006, two thirds of the work-force reported themselves as self-employed. However, wages and salaries are important to the average family in Georgia, which may have several household members employed. Wages and salaries constituted 35 percent of total monthly household income. The second largest share was use of debt, savings and sale of property. Remittances from outside Georgia added about 10 percent to household incomes, and there is so far no indication that they are shrinking despite Russian threats and pressure against Georgians living in that country. 48 percent of household expenditures went for food, beverages and tobacco. THE BOTTOM LINE -------------- ¶12. (SBU) The Government of Georgia has stated that macroeconomic stability is a crucial ingredient in its economic growth strategy. In part, the economy's ability to weather the shocks imposed by Russia on Georgia's economy underline the success of the government's reform path. Embassy Tbilisi is seeing an increasing number of investors exploring the possibilities offered by Georgia's agricultural and tourism sectors in response to the improved climate for business, although manufacturers are lagging behind. Inflation remains the principal threat to macroeconomic stability. The government's target for inflation in 2007 is 6 percent or less. This will require a cautious approach to spending. The government has promised the IMF to save any greater-than-expected privatization revenues and above-budget income to finance the budget deficit. Ongoing improvements in the tax administration process may help to realize that goal. On the other hand, President Saakashvili proposed reducing taxes in his recent State of the Union speech, which may complicate keeping the government's promise if Parliament acts quickly on his suggestion. On the monetary policy side, the NBG seeks to limit the growth of the money supply by increasing international reserves. It says it will deal with the increased inflows of foreign investment by allowing the lari to appreciate, with only limited, sterilized interventions. It also intends to strengthen its open market operations through direct sales and repurchases of government securities. It will push development of the secondary market in government securities. If the government and the NBG can stick to their stated intentions, the IMF believes they can meet their goal for controlling inflation. TEFFT