GEORGIA'S ECONOMY HOLDS ITS BREATH AS 2008 BEGINS

UNCLAS SECTION 01 OF 04 TBILISI 000190

SIPDIS

SIPDIS
SENSITIVE

STATE FOR EUR/CARC AND EEB/IFD/OMA

E.O. 12958: N/A
TAGS: ECON EINV PGOV GG
SUBJECT: GEORGIA'S ECONOMY HOLDS ITS BREATH AS 2008 BEGINS

REF: 07 TBILISI 652


1. (SBU) Summary: Georgia's GDP grew an estimated 12 percent
in 2007, while inflation was reported at 11 percent for the
year. Growth was based on increasing inflows of foreign
investment and robust government spending. Because political
turmoil has caused foreign investors to hesitate, although
perhaps not abandon, their investment plans, growth will slow
in 2008. Exports grew in 2007 despite Russian trade
sanctions, and Turkey is becoming Georgia's leading trading
partner. Nevertheless, the current account deficit is large
and growing, and continued interest from foreign investors
will be needed to maintain an acceptable balance of payments.
The banking sector continued to grow strongly in 2007.
Although there are no obvious signs of trouble, the health of
the banking sector will bear watching. Unemployment was
slightly higher in 2007 than in 2006. Wages also increased,
however. The government has ambitious plans to further
liberalize the economy, which clocked in at number 18 on the
World Bank's ease of doing business index in 2007, in order
to cut unemployment and continue increasing incomes. End
Summary.


2. (SBU) 2007 opened as a banner year for the Georgian
economy, with real GDP growth accelerating from 11.4 percent
in the first quarter to more than 13 percent in each of the
second and third quarters of the year. It is estimated that
growth will end up at 12 percent for the year. Growth was
based on robust government spending and inflows of foreign
investment, while growth in consumer demand was relatively
flat. 2008 is shaping up to be a year of more modest growth,
principally because the political uncertainty surrounding the
rise and fall of Irakli Okruashvili, the November protests
and the hotly disputed presidential elections in January has
inevitably made some investors delay their investments or
perhaps even reconsider them altogether. The government is
planning to slow the growth of spending and along with it the
boost it has been providing to the economy. Tourism is
already noticeably slower in the ski resorts of Gudauri and
Bakuriani, and continued bad publicity about Georgia would
not help that important sector. The Georgian government's
2008 budget, passed in late December by the parliament,
forecasts only 5.5 percent growth during 2008. The Ministry
of Finance expects to see a per capita income of USD 2800 by
the end of 2008, compared to USD 1200 in 2004.


3. (SBU) A slowdown in the flow of investment will come as a
disappointment, since the government had been predicting a
total inflow for 2007 of USD 2 billion, compared to the USD
307 million the country received in 2003, the last year of
former President Shevardnadze's rule. Some expect the total
to be about USD 1.4-1.5 billion, which nevertheless still
exceeds 2006's USD 1.1 billion of investment. Georgia helped
its image in 2007 by improving its showing on the World
Bank's "Doing Business" report from number 34 in the world to
an impressive number 18. The investment that the country has
been receiving has been concentrated in the financial and
real estate sectors and has not brought readily noticeable
benefits in new employment, a situation that contributed to
dissatisfaction with the Saakashvili administration expressed
in the November protests and the January election. On the
other hand, manufacturing and mining have shown relatively
strong growth, 15 percent in 2006 and perhaps a similar
amount in 2007. This is attributable to strong external
demand for ferroalloys, cement, and domestic demand for food
products, textiles and construction materials. If these
trends continue, the supply of new jobs may begin to more
strongly benefit the average Georgian household and to shore
up support for the government. Unfortunately, such
employment may never spread far enough to benefit older
workers and those who lack skills -- not an insignificant
part of the population.


4. (SBU) The more rancorous political climate has brought a
re-orientation of the government's budget priorities. Fast
growth of the economy, better tax administration and
reduction of corruption continue to give the government more
resources with which to work. At a recent briefing to the
diplomatic corps, Finance Minister Nika Gilauri told his
audience that the government received GEL 5.9 billion (USD
3.68 billion) in revenues in 2007, 1 percent more than the
planned receipts for the year. Government revenues were only
GEL 1.2 billion in 2003. The GOG is budgeting for GEL 5.15
billion in revenues in 2008, of which only 6 percent will
come from privatizations. In a recent Wall Street Journal
interview, PM Gurgenidze said that the government wants to
sell 25 percent of its remaining industrial assets in 2008.
One of the companies to be sold is Georgian Railways, which
has attracted the attention of some American investors.
Gilauri said that the government is planning to turn its

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attention from building and repairing infrastructure to
ameliorating social problems. The areas of expenditure in
the 2008 budget that are receiving the largest increases are
health and education, as well as pensions, and the entire
share of social programs will increase from 28 percent in
2007 to 33 percent in 2008. Defense expenditure will be
sharply down. Total expenditure of GEL 5.7 billion, as
planned, would result in an estimated budget deficit of about
2-3 percent of GDP, compared to 2007's estimated 5 percent.


5. (SBU) Inflationary pressures increased during 2007.
Year-end inflation was 11 percent, and the government was
unable to keep the figure in single digits as it had wished.
Some economic experts, such as the Georgian Foundation for
Strategic and International Studies' Lado Papava, claim that
inflation is really much higher. Poorer Georgians certainly
have been hit hard by higher food prices, and their concerns
are undoubtedly contributing to Saakashvili's unpopularity.
If investment and growth slow down as expected, inflationary
pressure may be somewhat less in 2008. On the other hand,
although the government has expressed a desire to rein in
spending, the fact is that 2008 is an election year and the
impulse to spend, especially on measures that put money in
the consumer's pocket, will be difficult to resist. If it is
unwilling to slow expenditures, the government has only some
very rudimentary tools to use on the monetary side to control
inflation. It has expressed a willingness to allow the lari
to appreciate, bearing some of the brunt of the fight. The
National Bank of Georgia (NBG),the central bank, has
conducted regular auctions of certificates of deposit since
late 2006, but has not met its targets because it has been
unwilling to offer interest rates that will clear the market.
The government has yet to make the government securities
held by the NBG fully marketable and has been reluctant to
issue new domestic debt that could be used for open market
operations.


6. (SBU) Reflecting government concern about inflation, if
not a truly effective response to the problem, the government
in late 2007 announced that it intends to introduce
legislation that will require the president of the central
bank to resign if inflation exceeds 12 percent per year, and
to appear before the Parliament if it tops 7 percent. For
its part, the government is considering legislation to
require budget surpluses. A tighter fiscal policy conforms
with IMF recommendations, even though the IMF's last program
expired in mid-2007. The central bank proposal is in line
with continuing hostility to the NBG and its independence
from some government figures, notably Prime Minister
Gurgenidze and ex-Minister for Reform Kakha Bendukidze, who
will remain in the government as an advisor to the Prime
Minister and head of the Chancellery. Bendukidze is
promoting a currency board for Georgia to strip the NBG of
its monetary policy setting function, but has not achieved
much traction for the idea. He has had more success with a
proposal to fold the NBG's banking regulation function into a
Financial Supervision Agency, that would have oversight of
the stock exchange, insurance and money laundering as well.
No NBG president has been nominated to replace Roman
Gotsiridze since he resigned last year. The acting director,
David Amaglobeli has actually grown in respect since he took
the helm of the bank after Gotsiridze. The pressure on the
central bank is likely to continue and even increase in the
next few months.


7. (SBU) Russian trade sanctions on Georgia continued through
early 2008. There are some signs that the Government of
Russia is ready to discuss lifting the bans on wine and
mineral water exports from Georgia, but only time will tell
whether the statements are sincere, and whether Georgian
officials are ready to respond in kind. Despite the trade
problems with Russia, Georgia's exports continued to grow
through 2007. In 2007, Georgia exported USD 1240.2 million
in goods, 25 percent more than it did in 2006. The CIS
countries as a group were Georgia's biggest export market.
Of them, Azerbaijan stands out as a destination for Georgian
exports. The EU, as a whole, absorbed 21.7 percent of
Georgia's exports. Among individual countries, Turkey was
Georgia's single biggest export partner (USD 171.7 million)
followed by the U.S. which received USD 149.5 million of
Georgian exports, according to Georgian statistics. Russia,
formerly Georgia's single largest export partner, took only
USD 53 million in exports, compared to USD 154 million in
2005, before the embargoes were imposed.


8. (SBU) Wine is the best known Georgian product, and the
Russian embargo has taken a serious toll on exports. Total
wine exports from Georgia to the world declined from USD 81.3
million in 2005, before the embargo, to USD 29.2 million in

2007. Ukraine is now by far Georgia's best market for wine,

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absorbing 50 percent of Georgia's total exports of the
product. Russia took 77 percent of Georgia's wine exports in
2005 but virtually none in 2007. Poland and Czech Republic
doubled their modest imports of Georgian wine since 2006, but
other markets in the EU, including the Baltics, remained flat
or even declined, as did the United States. Overall, leading
Georgian exports in 2007 were iron and steel (including
scrap),mineral ores, beverages (mineral water, wine and
spirits),vehicles and fruits and nuts.


9. (SBU) Despite sharply increased prices for
Gazprom-supplied natural gas, Russia took a back seat to
Turkey on imports into Georgia in 2007. (Note: Turkey
concluded a free trade agreement with Georgia late in the
year that promises further increases in trade with that
country.) Other important sources of imports, which totaled
5.2 billion in 2007, include Ukraine and Azerbaijan. The
latter country became a major energy supplier to Georgia for
the first time in 2007. The EU countries, notably Germany
and Italy, together supplied 35.5 percent of Georgia's import
needs. The United States supplied 3.9 percent (USD 203.9
million). Overall, the figures indicate that Georgia has
rapidly re-oriented its trade away from Russia, although
relationships with other countries of the former Soviet Union
remain strong.


10. (SBU) Even though exports are stronger, Georgia is still
faced with financing a significant 20.2 percent of GDP
current account deficit, which has grown from 15.3 percent in

2006. Remittances from Russia, the U.S. and other countries
(which totaled 7 percent of 2007 GDP),foreign assistance and
stronger inflows of foreign investment have permitted Georgia
to cover the gap and maintain a positive balance of payments.
As a result of these inflows and NBG intervention to dampen
the appreciation of the lari, international reserves at the
central bank were USD 1.3 billion at the end of 2007,
compared to USD 930 million at the end of 2006. This relates
to approximately three months of import cover. The economy's
strong demand for imports is unlikely to abate, and points up
one of the key vulnerabilities of the economy, that is, if
investment slows and less state assets are available for
privatization, it will become more difficult for the country
to fund its appetite for imported goods -- many of which are
consumer items that are not available from domestic
producers. The central bank's reserves peaked in October
2007 and dropped late in the year and in January 2008, as the
inward flow of foreign exchange stalled, perhaps temporarily.
The situation will not become critical if interest among
foreign investors begins to pick up again fairly soon.


11. (SBU) As a result of increasing inflows of investment and
remittances, global weakness of the dollar and more
willingness on the part of the NBG to use the exchange rate
as an anti-inflation tool, the lari appreciated considerably
against the dollar in 2007. It finished the year at 1.59
lari to the dollar, appreciating 7.7 percent over the year.
It gained 3.6 percent against the euro.


12. (SBU) In 2007, the growth of the financial sector
continued. Commercial banking assets increased by 70
percent, and profits by 65 percent. Despite worries about a
global credit crunch, Georgian banks continue to attract
capital, including a USD 65 million credit facility from
Merrill Lynch to Bank of Georgia announced on January 10.
According to the NBG, overdue loans in October 2007 were 1.5
percent of the total, compared to 2.3 percent a year earlier.
However, given rapid growth and the history of financial
problems experienced by other economies undergoing similar
transitions, the health of the banking sector bears watching.
The Galt and Taggart Index, which measures the small stock
market in Georgia, increased from 790 to 1041 over the year,
although it peaked around 1500 in August before news of the
Okruashvili affair broke.

13.(SBU) Available unemployment and wage statistics are not
especially current, but as of the second quarter of 2007, the
unemployment rate was 14.9 percent (ILO strict methodology),
2 percentage points higher than in the same period of 2006.
This figure considerably understates the unemployment
picture, and there has been little change in the poverty
picture, with one in four Georgians living at or below the
official poverty line. At the same time, average private
sector wages were on an upward vector, reaching GEL 385 (USD
240) per month in the third quarter of 2007, according to the
Department of Statistics.


14. (SBU) Georgia's new Prime Minister, Lado Gurgenidze, was
president of the largest commercial bank in Georgia, the Bank
of Georgia. As a financial expert, he is taking a great
interest in Georgia's economic future. In December, he

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announced a low-interest loan program for entrepreneurs that
he said will begin in February or March of 2008. In late
January, after the presidential elections, Gurgenidze
submitted a package of economic measures to the Parliament,
mostly aimed at further liberalizing the financial system,
the tax code, and customs regulations. The package includes
a proposal to reduce the new 25 percent income tax to 15
percent over the next five years. (Note: the social tax on
wages was abolished when the income tax was raised to 25
percent.) Corporate taxes are 15 percent of income, and
plans include eliminating taxes on dividends and interest
income in 2009. The law would require the government to
maintain a budget surplus of at least 0.1 percent of GDP.
The surplus would be saved in funds for "future generations"
(including costs of reconstruction of Abkhazia and South
Ossetia after reunification) and for unexpected economic
challenges. A single regulator for the banking, insurance,
securities and other financial services will be established.
Stock exchange and other investor rules will be liberalized,
and anti-money laundering laws will be amended to
"streamline" rules for bank ownership while increasing
transparency of ownership structures. Gurgenidze's express
objective is to make Georgia an international financial
center in the mold of Cyprus, attracting billions of dollars
of portfolio investment. Gurgenidze and the government are
also banking on the development of a free economic zone in
Poti, where business will be free of almost all taxes, to
boost employment and growth.


15. (SBU) Comment: The government's political difficulties
with the opposition have not dented its resolve to make
Georgia the most liberal economy between Ireland and
Singapore. But whether Georgia can peacefully resolve its
political difficulties -- not only with the opposition, but
also with Russia and the breakaway territories of Abkhazia
and South Ossetia -- will determine how soon Georgia can
reach the peaks of economic success envisaged by the
government and its new Prime Minister.
TEFFT