Wednesday, 26 November 2008


Published in Analytical Articles

By Vladimer Papava (11/26/2008 issue of the CACI Analyst)

After the five-day Russian-Georgian war in August 2008, and in consideration of the global financial crisis, Georgia has come to face new economic challenges. These include, in particular, undoing the economic damage caused by the war, avoiding a crisis in the banking sector, preventing further growth of an already high inflation rate, and preserving the stability of the national currency’s – the Georgian Lari (GEL) – exchange rate.

After the five-day Russian-Georgian war in August 2008, and in consideration of the global financial crisis, Georgia has come to face new economic challenges. These include, in particular, undoing the economic damage caused by the war, avoiding a crisis in the banking sector, preventing further growth of an already high inflation rate, and preserving the stability of the national currency’s – the Georgian Lari (GEL) – exchange rate.  Also, for post-war Georgia it is of no less importance to make a successful transition to the free-trade regime proposed by the US and the EU.  A timely and adequate response to those challenges will pave the way for Georgia to overcome the present economic hardships.

BACKGROUND: Generally speaking, the Georgian economy stood the test of the five-day Russian-Georgian war in August 2008, even though it faces considerable difficulties in the aftermath. Direct economic losses consist in ruined settlements and infrastructure, along with considerable environmental damage.

The war threatens Georgia’s banking system, as well as the stability of the national currency GEL exchange rate. August 11 was an especially perilous day for the banking sector; in anticipation of further advancement of Russian occupation forces, individuals and entities started withdrawing their savings and deposits from the banks. In a few days, some half-billion US dollars were withdrawn. In the month following the war’s end, only 30% of this amount was returned to the banks.

Huge social problems of internally displaced persons (IDPs) from the conflict regions affected by the Russian aggression require Government spending. First, the Government is building temporary homes for those people. These efforts create additional demand for construction materials and labor and may contribute to an economic revival, but with some negative effects. The Government’s expenses in the construction sector, however essential they may be, will inevitably cause a further growth of inflation in a rather short period of time because it is the Government, not private individuals or entities, which is buying those homes. Furthermore, the Government announced that it will distribute vouchers to IDPs to pay gas and electricity bills, which will add to inflationary pressures. It is true that the Government has no choice. But this also makes increased inflation inevitable.

Foreign direct investments (FDI) in has dropped significantly. The primary reason is that, with the global financial crisis, investors have been trying to make their investments in relatively safer countries. Georgians living abroad have had to reduce remittances to relatives living in Georgia. Considering Georgia’s huge foreign-trade deficit (Georgian imports are four times greater than exports) it is no surprise that the GEL exchange rate has become unstable.

The proposed transition to a free-trade regime with the United States and the EU would encourage a continued flow of FDI into Georgia. the negotiations with the US are still embryonic, but the EU’s conditions are at hand; as decided by the Extraordinary European Council that met in Brussels on September 1, it depends on Georgia’s meeting the conditions of the European Neighborhood Policy. These include the adoption of a new labor code, which would secure for employees the same rights as those protected in the EU, and the enactment of a European-style antimonopoly and consumer-rights protection legislation.

IMPLICATIONS: In October 2008, the donors’ conference held in Brussels under the aegis of the World Bank allocated US$4,5 billion in aid (2 billion in grants and 2.5 billion in loans). Georgia will receive these funds during 2008–2010, and much of it will be spent on undoing the economic damage caused by the Russian military aggression.

To avoid a banking crisis, the central bank – the National Bank of Georgia (NBG) took the right decision when it renewed commercial-bank refinancing, thereby opening a channel of cheap credit resources for the country’s commercial banks. At the same time, the basic interest rate on certificates of deposit was reduced from twelve percent to ten percent (to discourage commercial banks from buying NBG securities), and the minimum reserve requirements for commercial banks were reduced from fifteen percent to five percent. With these steps the NBG safeguarded Georgia from a major banking crisis, but at the same time it contributed to the growth of money supply, which, in turn, spurs inflation. Having faced a Hobson’s choice, the NBG opted for an inflationary rescue, because a banking crisis might have destroyed the economy.

After the war, the IMF, acting within the scope of its stand-by arrangement, extended US$750 million, of which 250 million were already transferred to the NBG reserves. Instead of allowing a gradual devaluation of the GEL, the NBG attempted to ensure an almost imperceptible devaluation by effecting regular interventions into the currency market, in one month spending more than US$300 million of its hard-currency reserves. As a result, the GEL lost only 2.5% against the dollar. However, on November 7 in the Inter-Bank Currency Exchange, commercial banks’ demand for dollars soared to more than US$31 million against a zero supply on their part (as it had been for more than a month before that day). In response, the NBG offered for sale just US$270,000 and then quit transactions, ostensibly for some technical problems. A general panic ensued: cash machines were cleaned out and currency-exchange outlets drastically raised the dollar exchange rate, with many simply refusing to sell dollars. The NBG then arranged for a “Green Friday”. The panic in the currency market continued on Saturday and Sunday as well. On Monday, November 10, when the Inter-Bank Currency Exchange renewed operations, the NBG offered for sale US$47 million, thereby setting a new dollar exchange rate. Compared to the morning of the “Green Friday”, the Lari was devalued by 15%. Only then did the NBG leadership make a statement claiming that the events of November 7 had been planned in advance.  Whatever the case, after the “Green Friday” people have been trying to get rid of GEL, the commercial banks have been reluctant to extend loans in them, and the dollarization of the Georgian economy has grown drastically. As imports account for 80% of Georgia’s consumer market, exchange-rate induced inflation is one of the most serious economic problems in post-war Georgia.

Although the Georgian government has generally welcomed the EU’s initiative regarding the free-trade regime, it has disregarded the EU’s conditions. For example, the Letter of Intent, sent by the Georgian government to the IMF on 9 September with the Memorandum of Economic and Financial Policies for 2008–2009 avow that in the observable future the Georgian government does not plan to amend the Labor Code and to adopt new antimonopoly and consumer-rights protecting legislation. So, the Georgian Government is by no means hurrying to implement a transition to the free trade regime with the EU.

CONCLUSIONS: In the process of undoing the damage to the Georgian economy as a result of the war, donors must monitor the spending of all those funds that they are giving Georgia. The spending must be as transparent as possible.

In the aftermath of the war, the devaluation of the GEL is inevitable. However, to maintain the country’s macroeconomic stability it is essential that the devaluation takes place gradually, so that any panic in the currency market, like the one which took place on the “Green Friday,” could be avoided. The US$4.5 billion that Georgia is going to receive in 2008–2010 is a solid foundation for preventing further startling devaluations. However, unless the organizers of the “Green Friday” are held responsible for their decisions and actions, at least politically, similar experiments may be repeated. The restoration of public confidence in the GEL depends on good management of further devaluation.

The transition to a free-trade regime with the EU is of vital importance for Georgia.  The Georgian Government should not tarnish this issue with political speculations. Up to now, the government provided only intimations that it sought to get closer to the EU. In fact, the Government has made no concrete effort to meet EU requirements. In this context, it is of particular importance that the Bretton Woods institutions and the EU closely cooperate and coordinate efforts.  Such steps will force the Georgian government to show greater consistency in its actions.

AUTHOR’S BIO: Dr. Vladimer Papava is a Senior Fellow at the Georgian Foundation for Strategic and International Studies, a Senior Associate Fellow of the Central Asia-Caucasus Institute & Silk Road Studies Program Joint Center, and author of Necroeconomics, a study of post-Communist economic problems. He was a Minister of Economy of the Republic of Georgia (1994-2000), and a Member of the Parliament (2004-2008). E-mail: This email address is being protected from spambots. You need JavaScript enabled to view it. .
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